Price Model Optimization

Author: Frank Frohmann.

“This thing called ‘PRICE’ is really, really important. The only difference between companies
ones that SUCCEED and the one that fail is that the champions figured out how to MAKE
MONEY. They were deep-in thinking through the REVENUE-, PRICE-, and BUSINESS
MODEL. That’s under-attended to generally.”
(Steve Ballmer, Microsoft, ex CEO)

My vision is to support companies with an integrated consulting approach which tackles the
challenges mentioned by Steve Ballmer.
The article below gives you a first idea about the definition of business-, revenue and price
model. The definition is based on more than 25 years of business experience.
For more detailed information please contact us or refer to my book ‘Digitales Pricing (Springer
Gabler 2018). The second edition will be published in 2022.

Introduction

1. Price management processes consist of numerous challenges that have different relevance
depending on the sector (B2C, B2B, C2M, C2C), industry and company.
2. Important business decisions are upstream of the pricing process:
• The definition of revenue sources (the revenue model).
• The definition of the value-to-customer and the operating model as central pillars of
the business model.
This means: professional price management must go beyond the pure optimization of the
pricing process. Pricing has to reflect the higher-level decisions on the business model and
the revenue model (cf. Frohmann, 2018).
3. In digital business models (platforms, marketplaces, ecosystems, etc.), price is no longer a
reliable metric for competitive pressure. Many companies (like Google, Amazon, Alibaba or
Tencent) cross-subsidize parts of their business. Not all business units have to contribute
to profit. Services are therefore offered for free (Google, e.g., search engine, cell phone
operating system) or below production costs (Amazon, e.g., Kindle Fire).

The levels of Digital Pricing at a glance

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The starting point for digital pricing is the business model (cf. Figure 1). A business model is
a structured representation of the value creation and value extraction of a company (cf.
Osterwalder & Pigneur, 2010).

Figure 1: Digital Pricing, Frank Frohmann, p.2, 2018

The business model definition results in potential revenue sources (products, services,
software, digital content, advertising, digital services, etc.). The revenue model of a company
or business unit answers the following questions, among others (cf. Frohmann, 2018, p.55ff):
1. with which business offers do we want to generate revenues?
2. which revenues come from which sources?
3. can individual revenue sources be combined? Or do we want to offer our business services
separately?
Most companies operate with multi-tier revenue models. Particularly in the case of digital
business models, these are based on a deliberate decision not to generate revenue from
certain offers. Examples of two-part revenue models are:
1. Software for free - make money on advertising.
Google offers the Android software free of charge. In this way, it promotes the penetration of
its mobile operating system, the number of users and its revenues through context-specific
advertising.
2. Service for free - make money on advertising
Google offers its search engine for free. Advertisers pay for access to user data. Facebook
uses the same revenue model for its social media platform.
3. Software for free - bundled with paid service
Red Hat Linux offers its open-source software for free. Services must be paid for by customers.

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Similarly, there are revenue models that aim to generate revenue in all components. One of
these 2-part revenue models is "Bait and Hook".
"Bait and Hook" is based on the revenue linkage of 2 products that are used jointly. Revenue
is generated with both components. Very important for subsequent pricing processes (price
level optimization and price model definition) is: The link consists of a durable good and a
consumer good that is consumed at regular intervals. Examples of this are the following
product combinations:
• Copier and paper
• Razor and razor blade
• Printer and cartridge
• Water descaler and water filter.

With increasing penetration of digitalization, “Freemium” has become a successful revenue

model in numerous industries. 2-tier freemium models are particularly relevant for digital
services such as software, content, video games, apps, contact platforms and social networks.
The distinction between user perspective and company perspective serves as an explanation:
From the user's perspective: "Freemium" is a combination of free and fee-based parts of the
offer ("basic for free, premium for fee"). The free version is associated with limited
functionalities. Extensions of the basic version (e.g., via premium features) are subject to a
charge.
From a provider's perspective: Many freemium models rely on 2 main sources of revenue:
• Advertising
• Digital service.
The world's largest music streaming provider Spotify operates with a "freemium” revenue
model. Crucially, there are several potential price models for the premium component. For
music streaming, for example, subscriptions (e.g. Spotify) or pay-per-use (e.g. Apple i-Tunes).

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Figure 2: Revenue models (4 examples) Digital Pricing, Frank Frohmann, p.62, 2018

Definition Price model

A price model is based on the revenue model definition. It is created by logically linking six
essential pillars.
The six dimensions (see Figure 3) of a price model can be defined based on the following
questions:
1. are business services combined into a bundle or do we charge for a single offer? →
Scope
2. what does the customer pay for? → Reference base
3. how many components does the price model contain? What is the unit of measure?
→ Price metric
4. how does the customer pay? → Form of payment
5. who sets the price? → Degree of interaction
6. at what point of time is the price set? → Time of price setting

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Figure 3: 6 pillars of price model, Digital Pricing, Frank Frohmann, p.221ff., 2018

Price models (how much to charge?) define the qualitative basis to which quantitative
price levels (how to charge?) refer. All six dimensions of a price model are logically linked.
Linking the answers to each of the six outlined questions defines a model.
1. Scope: As a direct consequence of the higher-level revenue model definition, the number
of revenue sources is defined. A current example is the "Apple One" price model. This
involves the bundling of 4 revenue sources from the field of digital services (Apple Music,
TV+, Arcade and News+).
2. The Reference base of a price model is based on the question: which offer is the customer
paying for? Traditionally, customers pay for a transaction, such as the purchase of a product
(ownership) or service.
Other potential reference bases are (cf. Buxmann/Lehmann, 2009, p.519ff.; Stoppel, 2016,
p.58ff; Frohmann, 2018, p.227ff):
a. Access: the customer pays for access to an offering.
b. Usage: the user pays to use a revenue source (e.g. products, services, software, digital
content, digital services).
c. Outcome: Customers pay based on the results achieved. Fulfilled value propositions
are monetized.
d. Success: customers pay for achieving a defined economic outcome (cost reduction,
profit increase, profitability improvement).
3. The price metric is defined by 2 elements: The unit of measure and the number of price
components. In particular, the unit of measure can take different forms, depending on the
revenue source. Examples are: Price per transaction, Price per storage requirement (in
GB), Price per usage in hours or minutes, Price per mile, Price per number of users.

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As 3 further pillars of the price model, payment form, degree of interaction and time are
added (cf. Figure 3). These serve to describe in more detail how the price model is
implemented for the customer.
The logical connection of the answers to the questions outlined above defines a price model.
Example: A flat subscription model for music streaming (e.g. Apple Music) refers to „a single
revenue source“ - is based on “access” - covers „1 component“ and a „monthly rate per user“
- is based on “regular payments” – is “not interactive” and an “ex ante price model“.

The following Figure 4 serves to precisely delineate the 2 challenges (revenue model definition
and pricing model optimization). The figure shows 4 revenue sources (software, digital
services, advertising and digital content) for Google's automotive division as an example.
The 4 revenue components result in 4 potential price models for the different services of
Google's "autonomous driving" business model (license fee, two-part rate (base fee + cost per
minute), auction/pay-per-click and subscription).

Figure 4: Revenue - and Price model (Smart Mobility)

Digital Pricing, Frank Frohmann, p.219., 2018

The Reference base in particular is of enormous importance in the definition of the price
model, as it determines the first milestone with regard to the price level decision.

Price models which are based on ownership or access are usage-independent systems.
Across different offers, a common denominator is established to which the respective price
level (in the numerator) refers. This promotes the comparability of prices from different
competitors. This forces the intensity of price competition. A particularly striking example is the
music streaming business, in which all competitors operate with a similar pricing model.
Subscription models are interesting for some companies, but they are only one of numerous
price model options.

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Many B2C and B2B companies have been able to differentiate themselves with usage-based
approaches. Examples of sectors that apply "pay-per-use" are:
• Car insurance
• Sharing business models (e.g. bike sharing, car sharing, e-scooters)
• Online advertising (pay per action).

Ultimately, a customer only ever pays for the satisfaction of a need or the solution to a problem.
The needs-based perspective generates a much broader basis for price model design.
Digitalisation triggered the evolution of price models which led to value-driven reference
bases:

- "outcome-based"
- "success-based"

Innovative price models focus on the customer's benefit (outcome, success) rather than the
transaction, access or usage. In creative - outcome-based - approaches the reference base is
aligned with the value drivers of a product. Value metric and price metric are fully aligned.

The basic idea of an ouctome-based price models can be described using a case study from
the B2B sector. In mechanical engineering, pricing is traditionally done on a unit basis: The
business customer pays for a machine or the purchase of certain components. But: the actual
benefit results from the service provided by the machine and the resulting end product.
Therefore, an outcome-based reference base for the price model is appropriate. The basis of
assessment is then no longer the machine, but its performance (e.g., the products
manufactured or the number of operating hours). Outcome-based approaches exist in various
forms:

• Price per “mileage” (Michelin)

• Price per “cubic meter of purified water” (Enviro Falk)
• Price as a “function of transported weight” (Schindler)
• Price per “laugh” (Pay-per-smile; Comedy theater in Barcelona: Teatreneu)

All 4 examples demonstrate the enormous potential of digital technologies (operating model,
level 1) for Price Management processes (level 3). Optimizing products, developing new
services and designing creative price models go hand in hand. In the case of innovations or
significant product improvements, a variation in the pricing model is often the decisive lever for
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profit optimization. One of numerous examples is Michelin's "pay per mile" approach in the
B2B segment (truck tires). With the traditional pricing approach, Michelin would not have been
able to implement a price increase in a double-digit percentage range. Monetization of the
technical advantage required a completely new pricing model (from "price per tire" to "price
per mile").
In success-based price models, the company's revenue is based on the economic benefit
that the customer derives from the offer. Billing is not based on a discrete unit (e.g., time or
data volume). The wind turbine manufacturer Enercon offers a successful price model
example. Enercon only generates revenue when its turbines generate electricity for the
customer. The higher the running performance of the wind turbines (and the electricity
generated as a result), the higher the customer's payment to Enercon. The basis for this is
digitalized value-generation processes, including automated recording of the necessary
process data and sophisticated measurement technology. The price metric is the running
performance of each individual wind turbine recorded via sensors. Through its creative pricing
model, the manufacturer takes some of the risk off its business customers. If the return is low,
Enercon earns correspondingly less.

Conclusion: Price Model Optimization

Digitization offers enormous opportunities for differentiation in pricing. Not via the price level
as such (numerator of the price formula). But via the price model (the "denominator"). The
object of price model design is to answer the questions for what, when, by whom and on the
basis of which parameters the price is designed. Innovative price models do not only lead to
a better monetization of the benefit. As an independent value driver for the customer they
increase the value-to-customer (and thus enhance the business model)! The consequence
of this: price management is not only "value capture" (monetization). Pricing can also
contribute to value “generation”. The selection of the optimal price model is a complex process
that requires methodical support. A prerequisite for decision support logics for price model
optimization is a stringent definition (cf. Digital Pricing, p. 239f).

The introduction of new price models in the market should be carefully planned and
prepared. The decisive factor is the benefit argumentation for the customer.

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Literature

Buxmann, P. & Lehmann, S., 6/2009. Preisstrategien von Softwareanbietern. Wirtschaftsinformatik,

51(6), pp. 519-529.
Frohmann, F., 2018. Digitales Pricing. 1 Hrsg. Wiesbaden: Springer Gabler.
Osterwalder, A. & Pigneur, Y., 2010. Business Model Generation: A Handbook for Visionaries, Game
Changers, and Challengers (Strategyzer). 1 Hrsg. New Jersey: Wiley.
Ramanujam, M. & Tacke, G., 2016. Monetizing Innovation. New Jersey: Wiley.
Simon, H. & Fassnacht, M., 2016. Strategie - Analyse - Entscheidung - Umsetzung (4 Aufl.).
Wiesbaden: Gabler.
Stoppel, E., 2016. Nutzungsabhängige Preissysteme auf industriellen Märkten. Wiesbaden: Springer
Verlag.