How to Set Prices: Revenue Models and Pricing Mechanisms

2nd in a series on How to Set Pricing

In setting prices, three major elements need to be considered:

1. Pricing Strategy
2. Business Revenue Model
3. Pricing Mechanisms

Last post, we discussed Pricing Strategy.  This post, we give an overview of Revenue Models and Pricing Mechanisms to show how they impact pricing decisions.

FULL DISCLOSURE:  Most of this information has been paraphrased from Business Model Generation by Alexander Oesterwalder and Yves Pigneur.  If you are interested in business models, I highly recommend this book.

Revenue Models
As with pricing strategies, while there are many variations, the most common generic revenue strategies are as follows:

• Title Passes to Buyer
• Asset Sale - The straightforward one.  Buyer pays Seller; Seller gives Buyer the goods which the Buyer then owns.
• Title Stays with Seller
• Usage Fee - Buyer consumes a service.  The more consumed, the more paid.  Example:  telephone minutes.
• Subscription Fee - Buyer pays for time based access to a service.  Example:  gym memberships, Netflix streaming
• Renting - Similar to a usage fee but in this case Buyer pays for temporary exclusive access to an asset.  Example:  office rental, car rental
• Licensing - Buyer pays for right to use intellectual property owned by Seller.  Example:  media rights
• Middleman
• Brokerage Fee - Company takes a fee for providing services to connect two or more parties.  Example:  real estate, credit card issuers
• Advertising Fee - Company takes a fee for providing and promoting Buyer access to a prospective Seller base

The different pricing strategies discussed before - predatory, skimming, bundling, and multi-tier - can be applied to each of the revenue models.  For example, American Express pursues a premium brokerage fee pricing model and strategy vs. Visa which pursues a more mainstream brokerage fee model.  Both charge fee for card usage but American Express's is substantially higher than Visa's.  This fits American Express's strategy of going after higher net worth individuals.  In line with this strategy, American Express also charges a relatively high annual subscription fee for card access vs. Visa, which in many cases does not charge any annual fee.  This goes hand-in-hand with American Express's travel and other services most likely to be of interest to higher net worth consumers.

Pricing Mechanisms
Once you understand the revenue model and pricing strategy you wish to pursue, you need to decide on the actual mechanism of how you will charge.  Once again, while may variations and combinations are possible, the generic options are:

• Fixed Pricing
• List - The basic one.  Fixed price for an individual product or service.
• Feature Priced - Price depends on the number, quality or type of features offered.  The default mechanism used with a bundling pricing strategy.
• Segmented Discriminated  - Price depends on the type of customer being targeted.  The default mechanism used with a multi-tier pricing strategy.
• Volume Based - Price is a function of the quantity purchased with price usually decreasing with increasing volume.
• Dynamic Pricing
• Negotiated - Price is set by active negotiation between Buyer and Seller.
• Yield Management - Price depends on inventory and time of purchase.  Often used where capacity is fixed and perishable.  Example:  airline seats
• Real-time Market - Price is based on supply and demand usually facilitated by an active exchange.  Example:  stocks
• Auctions - Price determined by competitive bidding.  An auctioneer often establishes a floor reference price then facilitates the bidding up process.  In the case of a reverse auction, a Buyer sets a ceiling reference price, then facilitates a bidding down process.  The reverse auction is only possible where the Buyer has unique leverage over a group of Sellers.

Again, it is possible to combine any of the pricing mechanisms with any of the price strategies and revenue models, although in this case, some price strategies fit together better with some price mechanisms (e.g. bundling with feature pricing).

Once a decision has been made with respect to pricing strategy, revenue model, and pricing mechanism, the final decision that needs to be made is what price to charge.  In the case of dynamic pricing, the question is what reference price to open with as the final price will be ultimately be determined by the market.

Next blog post:  Tangible Pricing Methods

How to Set Prices: Pricing Strategy

1st in a series on How to Set Pricing

I recently received the student feedback from BUS213:  Monetizing Marketing Models, the course I taught for Stanford Continuing Studies during the Winter 2011 quarter.  Overall, the course was well received.  But the number one area where students would have liked to go deeper was in how to set pricing.

So for those of my former students who may be reading this blog,  I've decided to do a series of in-depth posts that I hope will be helpful in this area. The first few posts will deal with an overview and frameworks.  The last with tactics and practical tips.

Pricing Overview
As anyone who has studied Marketing 101 knows, Price is one of the classic "4Ps" of the marketing mix (the others being Product, Promotion, and Place).  In setting prices, three major elements need to be considered:

1. Pricing Strategy
2. Business Revenue Model
3. Pricing Mechanisms

Setting prices can be a fairly technical marketing specialty, particularly in well established consumer product categories like packaged goods, the travel industries, and commodities.  For the purposes of this discussion, I will focus on the less scientific and more "seat-of-the-pants" situations encountered by entrepreneurs in less well defined B2B and B2C markets.

Pricing Objectives
There are three main objectives to be considered in setting prices:

1. Cost/profit - Pricing must be set sufficient to cover costs and generate a sufficient profit to support and grow the business.   What complicates this is the nature of the revenue model and time frame over which profits are generated.
2. Market positioning - Prices are a key signal to prospective buyers of a product or businesses market position.  In known product categories, they can establish buyer expectations for the product.  For example, if a car sells for $90,000 and another sells for $15,000 a buyer will have a certain image of what one car is versus the other.  Where a product category is new to the buyer, pricing can establish a reference point for comparative expectation versus competitive substitutes.  The main thing to remember is that pricing should be set consistent with a company's brand and market positioning.
3. Market share - Pricing can affect the rate at which a product penetrates a market.  In general, cheaper pricing creates less buyer resistance during the sale process and promotes faster product adoption and share growth.  But not always.  When Mercedes first released the C-Class with pricing in the low $30,000s, because the price was so counter to the company's luxury brand image, it actually impeded consumer acceptance.  The other factor here is what competitors are charging.  Depending on the nature of competition within an industry, this may limit what prices can be set.  For example, in commodity businesses, it is almost impossible to establish premium pricing due the existence of interchangeable competitive substitutes.  And price decreases are matched almost instantly by competitors.  But in luxury goods, where the value of the products are more intangible, a wide variation in pricing can exist.

Ideally, prices should be set to maximize business profitability over time.  Profit over time is a function of unit price, unit volume (i.e. share), and time.

Pricing Strategies
A company's price strategy is the way in which it decides how to blend the tradeoffs between the various objectives above.  It must be set as part of a company's overall competitive strategy.  For example, if the company is in a new technology sector with low barriers to entry (i.e. social media) where much of its value is based on its network, it may need to pursue a first to market, fast growth approach. In this case, it may want to pursue a loss leader price strategy in order to facilitate this.

While the variations are endless, the most common generic price strategies are:

• Predatory - This is where a company prices its product at very low margin, or even at cost* in order to gain entry into a new market. Over time, as the company establishes a more dominant share position, it increases prices to be more in line with its target brand position.  This often used where a new entrant is seeking entry into an existing market with established competition.  Predatory pricing is not without its pitfalls including:
• Sending the wrong positioning signal to the market
• Difficulty in raising prices due to customer backlash
• Sacrificing negotiating room
• Leaving money on the table
• Difficulty in covering costs
• Skimming - At the opposite end of the spectrum, this is where a company prices at a premium to capture the high end segments first.  Then as it saturates a buyer segment, it drops prices to appeal to new buyer segments.  This strategy requires that some meaningful differentiation exists to support a premium price segment.  Skimming also has its pitfalls including:
• Increases sales resistance, lowers demand, and slows sales adoption
• Creates an umbrella for competitive entry
• Creates customer "ill will"
• Gives customers an incentive to search for alternatives
• Bundling - This is an intermediate strategy where a company groups together different products and features in such a way that it can offer variations at different prices.  This gives the company great flexibility to offer a combination of features that appeals most to different buyer segments while maximizing the profitability of the various offerings.  An example of this is the automobile industry where the variety of packages can be overwhelming.  By bundling together desirable but costly features (e.g. automotive transmission) with less desirable but more profitable features (e.g. "all weather" package), the overall profitability of the car can be optimized.
• Multi-tier  - This is another intermediate strategy where the company offers distinct product categories at different price segments to appeal to different buyers.  Again, an example from the auto industry is Toyota used to offer a mainstream (Toyota) and luxury (Lexus) model under different brands for substantially the same car (Camry vs. ES300).  Another example would be the freemium model practiced by the SaaS industry where it is common to offer both a basic free version and a premium paid version.

Next post:  Revenue Models and Price Mechanisms

*  Note:  Setting prices below direct costs is illegal in many countries. While often difficult to prove given the creativity in cost accounting allocations, the practice of "dumping" or predatory share pricing has been the subject of several WTC actions in the past.  One such high-profile case involved the sale of Korean DRAM memory chips to the U.S. in the 1990s.

Perspective

March 10, 2011 around 11:45pm PST my wife was watching TV in the other room when she rushed out with a grim look on her face.  "Ed, you need to see this."

I slowly hauled myself up from my desk, tired after a 15 hour day in what had been a long week.  Wife and son recovering from the flu.  The usual frenetic round of weekly kid's activities and business meetings, capped by a couple of client rush jobs.  Our Volvo had broken down yet again. And we'd been preparing for a visit by a Japanese exchange student from Tsuchiura* this Saturday.

As I shuffled into the family room, my wife just pointed at the TV.

Perspective hit.

I watched a wall of water rush across farmlands while the screen ticker explained that a tsunami had been unleashed by an earthquake off the Sendai coast.  Disbelief as I realized that the small objects being swept away were houses!  Shock as I realized the water was moving faster than the cars on the highway!  Horror as it sank in that this was not a Hollywood movie.

How trivial my little problems.

Please pray for the people of Japan as they struggle with the aftermath of the disaster. Here is a link to the Red Cross website if you want to help.


*  Understandably and unfortunately, the Tsuchiura exchange visit has been canceled.  Tsuchiura is a city 50 km (~30 miles) north of Tokyo but south of Sendai.  While not directly affected by the tsunami, the city did sustain damage from the numerous aftershocks of the earthquake, has experienced disruption of utility services, and is concerned about the potential threat posed by the partial meltdown at the nuclear reactor complex in Fukushima just 200km (~125 miles) away.

Dealing with the Nitty Gritty: Resources and Wrap Up

Part 6 and final post in a series in Startup Stages

Co-founders.  Suppliers.  Employees.  Customers.  Government.  So what are the compliance and risk management resources available to a startup?

• Do-It-Yourself Resources – There are a host of websites, guides, and other resources supplying legal templates, HR compliance kits, on-line payroll management etc. While inexpensive in terms of dollars, this route can be very time consuming, requiring the entrepreneur to learn about, select, integrate, implement, and manage all of the separate pieces.
• Attorneys, CPAs, and Other Professional Outsource Firms – Legal, accounting, HR, and other compliance professionals can be hired on an outsourced basis, greatly simplifying the management burden on the entrepreneur and increasing the quality of compliance and risk management. But these professionals are very expensive, need to be actively managed, and in the end, you the entrepreneur will need to integrate it all together. In addition, these professionals are advisors, not operating people, and are often more risk averse than the entrepreneur needs them to be, resulting in unnecessary expense.
• CFOs, CAOs, HR In-house Staff – Of course, you can hire your own CFO, CAO, or HR staff who will be able to take care of many of these issues directly, thus minimizing the use of the more expensive professionals.  They can also manage the professionals when more complicated issues arise, reducing the time burden on the entrepreneur. But it may be the case that you don’t need these positions staffed on a full-time basis, in which case hiring internal staff may not be the most cost effective solution.

In Summary…
While the startup must manage a number of compliance and risk issues, the main ones are liability protection, tax compliance, and employment law compliance. In terms of summary practical guidelines, the startup should:

1. Organize formally early to put in place basic liability protection and establish the most favorable tax treatment for the business.
2. Define intellectual property strategy and processes early in order to maximize the value of the startup’s intellectual property and minimize the risk of infringement.
3. Do the appropriate trademark searches, and register your domain names and trademarks early on, to minimize the risk of having to change your name after brand equity has been built up.
4. Be aware that hiring employees is a significant step up in legal compliance requirements and insurance overhead that the startup will need to bear and should have the processes in place to handle beforehand.
5. Delay leasing dedicated space, with its attendant addition of long term liability and insurance overhead, as long as possible. Consider hosted office space as an alternative.
6. Be aware that customer contracts will introduce an additional step up in potential liability and insurance overhead. The startup should have the processes in place to handle this before accepting a contract.
7. Select the appropriate resource/cost for the level and complexity of risk.  Do-it-Yourself resources are fine for simple, more mechanical processes, while ill-defined or complex issues, like intellectual property strategy, should be handled by the appropriate specialists.

Related posts in this series:
The "Nitty Gritty" of Startup Formation
Intellectual Property Creation and Startups
Startup Stage:  Buying Stuff and Independent Contractors
The BIG Risk Trigger:  Hiring
Space (and) The Final Frontier