Digitalization is often seen merely as a means of optimizing processes, or as an IT initiative. The same misinterpretation applies to pricing: with regard to price management, digitalization is often limited to topics like “automated pricing”, “AI Pricing”, or the “pricing for online channels”.
In the following I will show that the digital transformation is hardly an IT phenomenon or tool for boosting productivity. Digitalization isn’t a project; it’s a comprehensive process. In essence, the key aspects include
- responding to customer needs that remain unmet and/or could not previously be technologically addressed
- the rapid identification of and agile capitalization on new business opportunities, and
- technologically supported innovation in the broadest sense.
In order to understand the new business opportunities and their implications for price management, it is essential to make a distinction in terms of definitions. The basis for digital pricing is the business model. A business model serves to visualize the logical connections between how a company generates value for its target customers, and how it generates profits by monetizing that value. An elementary component of the business model is the perceived value-to-customer. The willingness-to-pay is the mirror of the value-to-customer and consequently refers to a company’s business model.
The critical point here is: customer needs are the basis for business! Accordingly, a product-oriented definition of business is too narrow. Above all, two arguments support this stance:
- Customers never pay for a product, but for the fulfillment of a need. What the customer perceives as the solution to their problem is what shapes their decision-making process.
- How customers perceive products is dynamic: products’ relative importance, and customers’ priorities and preferences, can change. The status of established products can be jeopardized by changes in these needs structures, especially in the digital age.
This means: A customer-centric view is a precondition for sustainable market success.
Value creation through data and data-driven business models
In a digital economy, information is at the heart of value creation. The commercialization of technological advances like the Internet of Things and artificial intelligence requires both historical information and the latest physical and economic data. In the case of successful electronics manufacturers (Apple, Samsung, Sony etc.), the hardware is increasingly serving as the value-creating basis for innovative software and digital services. The result of all these developments: in business models, physical assets and goods are becoming less and less important. Data-based commerce already contributes more to global growth than the exchange of goods. And data is the core resource for the world’s most valuable companies. In this regard, the challenge for pricing consists of two dimensions:
- Pricing data as a value driver.
- Optimizing the prices of innovative digital services produced on the basis of data.
These two sources of revenue are interdependent, since data (dimension 1) provides the basis for digital services (dimension 2), which in turn generate new, highly valuable data. The value of customer data can be clearly seen in the example of search engine operators. Search engines like Google and Baidu coordinate advertising customers (companies) and information users (business and private customers). In the context of the platform business model, customer information is the key resource and source of revenue. The more users they have, the more data companies like Google and Baidu possess. The critical point here is: customer data is what determines the benefit for both target groups of Google. Both advertising customers and search engine users profit from the quantity and quality of the information. Customer data offers a means of optimizing the search results (and determines the value for the user in the process). At the same time, it increases the platform’s value for advertising customers. The larger the search engine’s market share, the greater the demand on the part of advertising customers who want to put their advertisements on the platform. In turn, increased demand strengthens the search engine providers’ bargaining power when it comes to the pricing of advertisements. Successful companies like Amazon stand out in terms of their data, the ideas that stem from data, and the implementation of those ideas in digital business models. Two influencing factors describe innovations in digital business models:
1. A customer-centered definition of business. This focuses on addressing unsolved customer problems, or on responding to changed customer needs.
2. Technological advances. We can find a successful example of an innovative, data-driven business model by looking at a traditional sector: the long-distance coach bus business. In just a few years, Flixmobility has established a dominant position on the market. When it entered the market in 2013, Flixbus did not define long-distance coach bus travel as an infrastructure business. Its vision was summarized in just one sentence: In an age characterized by digital marketing, coach travel is a networking business! Customer data – not vehicles – is the resource most critical to success. As such, the resulting core competency consists in using the customer information gained to shape the routes offered, set prices, etc. This business model is what allowed Flixbus to become the dominant online marketplace for travellers. Flixbus is not a bus company and possesses no vehicles of its own. Rather, it operates as an online platform where customers can digitally order tickets. The number and quality of contact opportunities is the central value-to-customer. Consequently, in the early days of the company’s market penetration, it was absolutely vital to establish as many connections as possible, as quickly as possible. Thanks to its steadily growing market share and concomitant economies of scale, Flixbus was able to use penetration pricing to squeeze competition out of the market. On the domestic coach bus market, the platform, following major market consolidations, now has virtually no competition. With a market share of more than 90% in Germany, Flixbus effectively holds a monopoly. The lessons to be learned from the successful example of the start-up Flixmobility are as follows:
1. In digitalized sectors, making the market share a target figure is particularly important; the provider with the largest market share very often arrives at the best cost position. Due to these dynamic relations, market share has a separate value as a determinant of future profit potential.
2. High market share has a positive effect on all three profit drivers. Fixed cost degression and the improved ability to demand certain prices produce a twofold positive effect on profits. In addition, enhanced market power unlocks further sales potentials, producing economies of scale. As a result, thanks to its current monopoly on the coach bus market, Flixmobility has excellent chances of expanding its business model to become a major mobility provider. By founding “FlixCar” and “FlixTrain,” it is diligently pursuing that vision.
3. Especially in dynamic markets and for innovative business models, market-share-oriented rules of thumb are highly relevant. At its core, the strategy that Amazon has pursued in online commerce is comparable to Flixbus’ approach, even if the two business models, relevant competitors, etc. are quite different.
4. In other digitalized sectors (e.g. the shared bicycles sector), too, the innovation drivers do not stem from the industry itself, but from the digital economy. These companies have essentially become data experts. A primary example: bike-sharing, which both the Asian technology company Tencent (with Mobike) and Uber (with the acquisition of Jump) have massively invested in.
5. The ability to profitably employ users’ data and movement profiles is critical to success. Accordingly, access to customers and control of customer data are indispensable aspects.
Distinction: Revenue models
A revenue model provides answers to the following questions:
- How do we intend to generate profits, with which products, services etc.?
- Which revenues come from which sources?
- Can individual sources of revenue be combined? Or do we prefer to offer and invoice these products, services, software, etc. separately?
- At which levels in the value chain do we want to generate profits?
- Who are our revenue partners? Who provides our profits?
- Could we tap into completely new sources of revenue? How would we need to change our portfolio in order to tap new revenue potentials?
In many cases, the use of digitalized offers (e.g. electronic books) involves four interlinked sources of revenue:
- Digital services
Apple sells its hardware (e.g. the iPhone, iPad, Apple Watch), digital content, and complementary digital services as part of a comprehensive ecosystem. It is also (and increasingly) generating profits via software-based services (e.g. the sale of additional memory capacity). In terms of all four central sources of revenue, Apple is profiting from digitalization in various ways. Amazon’s revenue model for eBooks is based on the digital business model for provision of content. Jeff Bezos explained this business as follows: “We don’t plan to make any money with the devices. We’ll make profits after the device is sold, when customers buy books, MP3s or movies!” Amazon primarily defines the value delivered to customers in the form of content; the hardware is secondary. Electronic devices like its eBook reader represent the “lever” for the lucrative core business with digital content. Content (e.g. eBooks) is the most important revenue driver and tends to be sold at profitable prices. In contrast, hardware (e.g. eBook readers) is in some cases sold for less than the variable costs. In the case of Apple, the turnover and profit shares are just the opposite: the iPhone still generates a major percentage of the turnover. The relevance of digital services (like music and video streaming or payment services) for turnover is still disproportionately low. What is particularly important for Apple’s future pricing: the online services are the most powerful growth driver. The revenue model that Google uses for its hardware products follows the same principles as Amazon’s electronic device business. Google primarily defines hardware (e.g. its Pixel smartphone) as a lever for the profitable follow-up business with software, services and apps. The purpose of these devices is to encourage customers to use Google services, and the profits are largely generated by the use of online services. The profit exploitation is determined by the frequency, intensity and duration of use.
Case study on music streaming: Spotify
The business model of the global market leader for music streaming is not profitable: the fees that Spotify has to pay the music companies (labels) and musical artists are so high that the streaming service provider has operated at a loss for the past several years. Or, to put it another way: its profit model is not sustainable – despite the fact that there are over 200 million Spotify users worldwide (including 100 million with a Premium account). And economies of scale won’t solve the problem. This is what sets Spotify apart from many other major digitalized companies: its costs grow with the number of users, since the fees paid to the labels are based on the number of music streams. In contrast, the video streaming service Netflix pays fixed prices (flat fees) for external content. Moreover, Netflix produces a considerable amount of content in-house. The result: Netflix profits from economies of scale! The gap between revenues and costs grows as the number of users increases, making the market leader for streaming profitable. Spotify will never experience the same effect – unless it modifies its business model. Since it’s likely impossible to significantly change the cost structure, Spotify’s only option is to address a second pillar of the profit model – its sources of revenue. The question here is whether future profits can be achieved by tapping into additional sources of revenue. The point of departure and prerequisite for redefining the revenue model is an analysis of the company’s value-creation processes. In Spotify’s case, the analysis reveals that the benefit for end customers is very high: in comparison to its strongest competitors (Apple Music, Amazon and YouTube), the market leader offers superior service in terms of personalized offers and recommendations. This is reflected in its enormous growth rates and the comparatively high percentage of paying subscription customers. This raises a key question: who are the other parties involved in the value chain? Musicians, labels and concert organizers, all of whom can reap additional benefits from Spotify’s tremendous data resources. Thanks to its unique knowledge of user preferences, Spotify could offer labels and musicians alike direct access to music fans. The following is just one of numerous new opportunities for value creation: musicians’ tour planning could be optimized on the basis of extensive data analyses. Spotify enjoys complete transparency with regard to which artists and songs are listened to the most often, and in which countries. This additional benefit for its value-creation partners could be monetized via corresponding revenue and price models, which would significantly expand the revenue basis. Spotify would then be able to generate profits not only from its users, but also from musicians, event organizers and music labels.
Overview of selected revenue models
Revenue Model 1: Free content; revenues are generated by advertising
Advertising-financed revenue models are based on the assumption that users do not pay for the company’s digital services. Rather, revenues are produced by the sale of advertising space or information: Google offers its main service – information research on the Internet – free of charge since 1998. In turn, it draws on users’ search entries to create interest profiles, and generates revenues by selling these customer profiles to advertisers. Google can only offer its search services for free because of its highly profitable advertising revenue streams. In Google’s business model and revenue model, the basic premise is: the user is the real product. Advertising companies are its paying customers. On the mobile Internet, Google generates revenues through context-specific advertising. In order to promote its mobile advertising business, Google has offered mobile-phone manufacturers its Android operating system free of charge since 2008. In the meantime, Android’s free-of-charge model has helped it reach a global market share of nearly 90% in the M-Commerce business.
Revenue Model 2: Free content; revenues are generated by the sale of complementary products or services
The “follow-the-free” model begins with offering a base product free of charge, which produces networking and lock-in effects among product users. In turn, revenues are generated by the sale of complementary offers. One example: providers of open-source software (e.g. Red Hat Linux in the B2B segment). In this software segment, the core product is free of charge; revenues are produced by supplemental services like consulting, implementation, documentation and repairs. These product-related services are characterized by high profit margins.
Revenue Model 3: “Bait and hook”
The “bait and hook” model is based on linking two different products that customers use together (“tied products”). Cross-product ties can be found in a broad range of sectors, especially on B2B markets. In the long term, the purchase of the main product (e.g. a machine) results in the purchase of further products (e.g. replacement parts). If sales for one product increase, they also increase for the other(s). In these complementary product relations, the cross-price elasticity of demand is negative. Reducing the price of the base product results in increased sales for the tied product. In the case of clearly defined usage relations (e.g. car – car tires), this is referred to as “fixed complementarity.” The quantity of the tied product can also vary. In terms of pricing, one very important tie is that between one product, which is constantly used, and another, which is a regularly used. Examples of “reusable base component” and “consumable component“ include the following product combinations:
- Copy machine and paper
- Shaving razor and replacement blades
- Printer and toner cartridges
- Water filter and replacement cartridges.
The reusable base components (e.g. a water filter) are offered at very affordable prices. This motivates customers to use the high-priced complementary components (e.g. replacement cartridges). These consumable products – which have to be purchased on a regular basis – are sold at comparatively high prices. Example: A shaving razor from Gillette is sold at a low price. For the merchant or the online shop, revenues are primarily generated by the subsequent sale of replacement blades. The success enjoyed by Gillette is chiefly due to its consistent implementation of this revenue model. Thanks to the successive expansion of its product line, the average price for disposable replacement blades has risen substantially. The transition from the Sensor Excel version to the Mach 3 system, and subsequently to the Fusion (with five blades) entailed a price rise by a factor of 3. At the same time, Gillette enjoys a dominant competitive position in terms of global market share. The goal is to optimize profits for the entire product group. In the case of Gillette, the focus is on achieving the optimal mix of margin and quantity (market share). “Tying” is also used in the industrial goods sectors. When it comes to these goods, the initial purchase price for the main product is negligible in comparison to the long-term successive transactions: the value of downstream products and services is often several times higher than the initial purchase price.
Revenue Model 4: Freemium
The fundamental idea behind the freemium concept is the combination of “free” and “for-pay” components. Freemium – from the perspective of a firm – is a two-tier revenue model. A substantial part of the total offer (e.g. a standard service) is provided free of charge. For the user, this “beginner version” also offers only limited features. Extensions on the basic version (e.g. via premium features) have to be purchased. The freemium concept combines two aspects: free (basic services provided free of charge) and premium (only available as an additional purchase). The basic version is cross financed by the sale of premium services (“basic for free, premium for fee”). The freemium model arose together with the Internet. In terms of content, service providers like T-Online were already using product differentiation at the turn of the 21st century. Customers had the choice between free standard information or more advanced, for-pay packages. Paid content is predicated on users’ willingness to pay for extended services. The combination of these two approaches yielded the freemium model. Thanks to the evolution of information technologies and increasing penetration of digitalization, the freemium has now become a highly successful revenue model in a broad range of sectors. Two-tier revenue models are particularly relevant for digital services like software, content, video games, dating platforms, etc. Today, paid premium content is still based on the core arguments of timeliness (offering the latest information), good compilations, and more content (depth of information).
Case study on music streaming: Spotify
Spotify, the world’s largest music streaming provider, uses a two-tier revenue model. Those users who opt for the free version have to tolerate advertising spots between the songs they listen to. The paid premium version, which costs just under EUR 10 per month, grants users download access to more than 50 million songs from major music labels’ databases. The pioneer for streamed music launched its app in October 2008; by mid-2019 it had more than 200 million users worldwide, including over 100 million paying subscribers. In contrast to Spotify, its major competitor “Apple Music” does not offer any free service. As such, Apple Music uses a single-tier revenue model. The example of Spotify demonstrates that freemium – depending on its ties to the organization, and on the business model – can be seen either as a pricing model (customer perspective) or as a revenue concept (company perspective). After all, with regard to the premium revenue component, a broad range of pricing models (e.g. “pay per stream” or a flat rate) can be used. The clear distinction between revenue model and pricing model is one that I’ll return to in more detail in chapter 4!