Danilo Zatta: The Pricing Model Revolution

The context of technological advances and data science progress, paired with new ecosystem and new marketing frontiers, are disrupting old revenue models, accelerating what we call the Pricing Model Revolution: an innovative way to capture the value delivered by the companies to their clients.

Monetization as priority

“The single most important decision in evaluating a business is pricing power.”

Warren Buffet

Adding our margin to the base cost. In a context where demand outweigh supply, where customer’s demands were unsophisticated, where competitors were more or less analogous and technology not widespread, this might have been a sustainable approach. Not today. The time has come for a change.

Profit drivers are fixed costs, variable costs, price and quantity. Out of all of them, the price increase has the most impact on profit.

Once the power of pricing is understood, companies ask themselves which levers to activate to improve their monetization skills. These levers can be assigned to four categories. The first is related to price strategy and contains several facets, like the revenue model, positioning and differentiation. The second category is about price setting. Price logic, portfolio pricing and product and service pricing are key facets here. The third is price implementation. And the final is price steering with price controlling, price analytics and price reporting as its facets. All those levers should be supported by price enablers like pricing organization, pricing processes, pricing IT systems and pricing skills.

The four triggers of the Pricing Model Revolution are:

Technological innovation
Data science progress
New ecosystem
Marketing of the future

With cost plus pricing, the price setting is purely based on internal reasoning and calculations: a target margin added to the cost, which equals to the requested price.

Maturity stages of pricing are: basic pricing, cost plus pricing, competitor pricing, value pricing, pricing model revolution.

Companies on average increase their return on sales between 2% and 8% based on their pricing maturity.

Ten elements that denote innovative monetization approaches are:

Pay-per-use
Subscription
Outcome-based pricing
Psychological pricing
Dynamic pricing
Pricing based on AI
Freemium
Sympathetic pricing
Participative pricing
Neuropricing

Pay-per-use

There is a conceptual limit, according to the pay-per-use view. It’s impossible to bend the market. Instead, it’s better to bend the policies for approaching the market. Then you’ll notice a simple fact: the present pricing model is an obstacle to growth. This is why we must decide to break with the logic of traditional pricing – based on ownership – and find an innovative way of winning new customers.

What pay-per-use means: customers can use the goods they need when they need them, without the burden of ownership and without having to pay for periods when these precious assets are inactive.

»Aligning price with use« is the essence of pay-per-use.

With the increase in digitalization, big data, and AI, the possibility of »winning« customers on an on-demand basis has become feasible.

A key factor in the spread of pay-per-use models, which is the ability to capture latent demand by reducing the initial cost associated with physical assets for customers with a low rate of use.

Technological progress has made this pricing model possible.

In gym-as-you-go model we have equipment with near-field communication, a smartphone and athletes that are charged for the time they use equipment. In this way, gyms can also orientate the demand for certain machines that can be constantly available through surge pricing.

Alternatives to monthly subscription can be a powerful means of distinguishing a business.

The alignment of pricing with usage generates benefits for those clients who use a product infrequently or unpredictably.

It should be noted that in general all the models of on-demand pricing allow for increasingly informed choices, thanks to which clients can test a product and get an idea of its use, what is more without a high initial outlay.

Michelin link the performance of tire to its price. Michelin has thus moved from being a simple provider of tires to a ‘provider of services for mobility’. The solution is based on telematic services and fleet management. It increased customer fidelity.

Every market challenge is a new frontier.

There is the virtuous cycle of good ideas which, like culture, knowledge and good practices, are assets that, when shared with many others, increase in value instead of diminishing.

Closer customer relations meant being constantly faced with the client’s changing demand.

We calibrate systems according to the same measurements we create to control them.

With technological progress, stronger connectivity through the IoT and the potential increasingly smaller dimension of transactions (blockchain), the feasibility and desirability of pay-per-use pricing models will increase, above all on markets on which the products or services can be forwarded swiftly to customers. AI and automatic learning allow companies to gain a far deeper knowledge of when, where and how their customers use products and services.

Mature companies hesitate to adopt business models based on usage: they want to avoid the risk of cannibalizing the income generated by the initial purchase of their product.

The adoption of pay-per-use models will be important for products with a high initial purchasing price on markets where customer use is dynamic, volatile, unpredictable.

Certain limitations in pay-per-use: low-cost physical assets in constant demand are the most resistant.

Compared to renting or leasing that give the consumer complete rights of usage for a limited period of time, pay-per-use model links payment to the customer’s pattern of usage.

Pay-per-use models make it possible to access quality resources without any significant capital outlay. The introduction of pricing models based on payment for use may occur for different reasons: the need for greater flexibility, generation of cash flow, economic accessibility, customer satisfaction or in order to avoid the burden of ownership.

Subscription pricing

Time is the supreme value. After the 1800s had anticipated and overtaken it, the 1900s lost it (Proust), the two wars and then the 2000s accelerated, shattered and even dispersed it, atomic time, today perhaps we have realized that it’s actually the only thing that counts.

There is nothing more desirable, both for investors and for entrepreneurs, than observing ‘regular consumption and a consumption of services, against a fee’, in other words the definition of a subscription.

The trend towards subscription buying is certainly nothing new, especially in the media sector, but the pandemic on the one hand and digitalization on the other have generated truly significant acceleration of growth in this area.

Subscription is different than renting or leasing. The objective here is to establish a lasting relationship with a customer with whom there would be no post-sales contact in most cases.

The customer base is the new engine of growth.

Five steps towards the successful launch of a subscription model:

Plan the transition to subscription.
Basing offer on customers’ needs.
Determining the pricing of the offer.
Testing the offer.
Preparing to launch.

We have shifted from owning things to sharing them. From buying assets to acquiring experiences.

Outcome-based pricing

Outcome- or performance-based pricing, or a revenue model aligned with the performance offered by those who provide a service or product.

The risk is born entirely by the company: they must be certain of the quality of their performance and the value being provided to their customers. What is more, they must establish the pricing meter that is best suited to monetizing the value provided to customers, their audience.

The starting point is to have a clear definition of the result in the organization. The result is marked by three elements. In order to be suitable as a basis for a model of monetization, a result must be:

Important and substantial to the customer.
Measurable.
Independent.

It simplifies the buyer’s life and if customers fail to receive the results guaranteed, they simply don’t pay and, in some cases, penalties can even be applied.

Sellers assume the risk but create value by solving the customer’s complexity, setting the price of the service according to the value created.

Outcome-as-a-service: the result in terms of a service. Result, as a model of monetization, also implies reporting. Continuous communication with the customer is essential and should be defined in the contract.

Whilst the profit margins are often considerably higher in this model, performance risks are, too.

Sales staff must fully understand the results they are selling and guarantee the costs of delivery to the whole organization, as well as the risks.

Integrated teams must collaborate, from the process of price setting right down to the actual delivery, concentrating on the service provided to the customer.

Programmed incentives must be adjusted so that entire teams are rewarded for performance and the creating of value.

Psychological pricing

Behavioral pricing takes into account this concept and acknowledges that customers may also behave irrationally.

The pricing tactics that play on the »dark side«, the customer’s irrational side, are summed up in the term behavioral pricing.

The nine behavioral pricing rules that make a difference:

Contextualizing value with a »price anchor«. People evaluate prices as high or low on the basis of their mood of the moment. By influencing price perception, a monetary reference point for orienting choice is fixed in the customer.
Removing resistance to buying by using the printer/cartridge model. One of the main barriers to purchasing is the cost of the initial outlay. In establishing a pricing strategy, a customer is often acquired by means of a reasonably low initial price, followed by considerable variable costs. This is also the essence of customer life-cycle management.
Taking advantage of maximum readiness to pay by means of “threshold pricing”. “Numerical cognition” is a phenomenon where people tend to evaluate numbers with several decimal places by arranging them on a mental line. Stopping below the “psychological threshold” makes it possible to manipulate preferences even when the advantage offered is negligible.
Facilitating the customer’s choices by means of the compromise effect. The compromise effect suggests that a product will be more likely to be chosen from a group when its attributes are not located at the extremes of the range of choice.
Using pricing as an indication of quality. Price is an indicator of the quality of a product or service: high prices stand for high quality, whilst low prices stand for lower quality. It is mainly customers who are not very familiar with a product that are easily influenced.
Creating scarcity to encourage sales. Impulse buying is obtained by artificially created scarcity. A combination of scarcity with future discounts thus favors future sales. People who tend to behave wisely in everyday life may buy quantities of a product that is scarce or on discount without checking whether the offer really is a bargain.
Using a sense of winning to break down purchasing barriers. Daniel Kahneman confirms: the emotional reaction to loss – payment or a price – can be far stronger than the reaction to winning, for example the joy of possessing a new car. In many customers’ minds, obtaining a discount generates a sense of winning.
Optimizing the relative discount versus the absolute discount. Numerous studies indicate that customers react differently when the same markdown in absolute terms is shown as referring to a different price.
It is preferable to express discounts on products sold at lowish prices in relative terms, that is, by means of a percentage, whilst it has been demonstrated that customers prefer discounts in absolute terms for products sold at prices perceived as high.
Impacting price perception by means of visual design. Elements such as the size of the letters, color, and special offers all influence price perception.

Dynamic pricing

On Amazon prices change on average every 10 minutes, or 144 times a day.

This is the essence of dynamic pricing: the selling price of a product adapts to the contingencies of the market: if the demand for a camera increases, so does the price, since the customer will be more willing to spend money in order to get hold of one of the few remaining items; if the demands falls, so will the price, to encourage demand.

What will change increasingly in the future, thanks to the new technologies, are the frequency of the change and the quantity of products offered.

Dynamic pricing management is an ancient phenomenon, whilst it is fixed prices that are relatively new. Before 1870 it was quite normal not to display prices but to vary them dynamically.

With the development of DINAMO – acronym of »Dynamic Inventory Allocation and Maintenance Optimizer« – American Airlines solved the problems of allocating capacity to the different classes of offer per route and flight. This system, which came into operation in 1985, represents one of the first real dynamic pricing systems in the business field, also known as revenue or yield management.

Three main forms of dynamic pricing can be distinguished:

Temporal
Customer-based
Based on sales channel

Temporal dynamic pricing is considered a »take it or leave it« sort of pricing where the seller changes the price as time passes, on the basis of factors such as sales trends, the evolution of demand and the availability of the products in demand. Dynamic pricing based on time is described mainly in terms of frequency and range. Frequency refers to the number (how many times) of price changes. Range describes the amount of individual price changes.

Dynamic, customer-based pricing, which goes under several names: »personalized« pricing, »behavioral based« pricing, »targeted dynamic« pricing or even targeted promotions.

Channel related dynamic pricing presents itself for multichannel companies, that is, those with both offline and online channels. The idea of dynamic, channel-based pricing is to differentiate between online and offline prices.

The adoption of dynamic pricing is quite a journey for any organization. We can state that four success factors emerge: the first two regard the solution and the second two the integration of this solution into the company.

Data and technologies.
Price logic and pricing tools.
Process and government of dynamic pricing.
Habilitation and competence of the team.

Dynamic pricing management has a limit – it’s as good as the equations that regulate it.

Artificial-intelligence based pricing

AI is a machine’s ability to demonstrate human capacities such as reasoning, learning, creativity, or planning.

In price management AI comes from algorithms able to identify optimal prices or markdowns by analyzing the effects of past business policies, for example, or considering a range of further information that makes it possible to learn and calibrate pricing and adequate discounting.

The factors evaluated by these algorithms include:

Historical sales and transactional data
Seasonal changes
Weather conditions
Raw-material price indexes
Geographical data
Events
Inventory levels
Product features
Prices and promotions offered by competitors
Customer relationship data
Marketing campaigns
Reviews and articles

Using this data, the price applications based on AI can calculate elasticity of price, measuring how demand will fluctuate as a result of changes in conditions.

How exactly does the creation of an AI algorithm for determining best prices work. The process works as follows:

Data collection and cleansing. In context of best prices, database might look something like this: transactional data, description of products, data on cost, data on competition, inventory and delivery data.
Training of the algorithm.
Optimization based on forecast.

Zara only has to sell 15-20% of their products at a discount according to Ghemawat and Nueno, as against the 30-40% of other European retailers.

Six applications of AI-based pricing:

Geo pricing.
Contract margin predictor.
Churn minimizer.
Discount predictor.
Customer segmentation.
Cross- and up-selling.

Freemium

A loss leader strategy. Money is lost on one product, so as to sell other profitable ones.

Freemium is a combination of the world free and premium. A pricing strategy in which the initial function is provided free of charge with the possibility of accessing other connected functions on payment. The freemium can also be interpreted as a form of penetration strategy.

Three forms of cross-subsidization can be distinguished:

Free. Free products directly subsidized by products paid for.
Freemium. Products that are free as a base version and subsidized by advanced versions which are paid for. The digital era has allowed these models to spread more rapidly, so that they are now widespread on the market for digital products.
Triangulation. Bipartition of free products with products which instead are paid for. This is the classical model characteristically used by the media.

Follow the four rules for making the freemium pricing model efficient:

The market must be segmentable.
The product must have a low variable cost.
Freemium customers should act as ambassadors for the pay version.
Gradual addition of restriction to the free version should be introduced.

To trigger paid usage, different types of possible limitations to the free version can be establish:

Functionality
Temporal
Use
Type of customer

Negative pricing is the case when consumer is paid to use a product and not vice versa.

Sympathetic pricing

Sympathetic pricing objective is to transform the customer’s negative experience into a positive one. Sympathetic pricing can be defined as: the application of flexible and imaginative discounts that help relieve peaks of pain in lifestyle and lend a hand in difficult moments or uphold a shared value.

In both the B2C and B2B sectors, sympathetic pricing helps to improve the image and perception of companies that practice it by increasing confidence in them.

Three types of possible applications of sympathetic pricing:

Painkiller pricing – companies use this in its literal sense of “painkiller” to help their customers overcome everyday irritations.
Compassionate pricing – companies offer support to their customers with a message that might be summed up as, “When life is not treating you well … we’ll take care of it!” And companies offer discounts of free services.
Purposeful pricing – by means of purposeful pricing companies help groups of people with shared values and lifestyles, offering discounts, freebies or reductions.

Participative pricing

The conclusion from a history is that people – all of us when we buy something – appreciate transparent prices.

Pay-what-you-want sales represent an opportunity to “build” a trusting relationship with buyers.

The “pay-what-you-want” model works on the basis of customer loyalty. Companies with loyal customers can therefore generate reasonable income using this type of monetization.

You might consider using pay-what-you-want pricing as a temporary strategy.

Participative pricing groups together concepts which are sometimes synonyms like name your own price or pay-what-you-want, choose-what-to-pay or pay-what-you-think-is-fair, is an approach to monetization where buyers can independently choose the amount to pay the company selling a product or service.

An advanced form of participative pricing is the choose-what-you-pay model, also known as pay-what-you-want. Here the customer pays what they want, sometimes without the supplier being able to decide whether to sell at that price or nor, at other times with limits, for example a minimum price. One variation of the pay-what-you-want model consists of components with variable prices that basically depend on how satisfied the customer is. Two additional variations can be gratuities and donations.

Name your own price is a monetization strategy in which sellers allow buyers to decide the end price they wish to pay for the offer, but the transaction only takes place if the offer is equal or superior to the threshold price, which is not revealed by the seller. The American company Priceline is considered the inventor of the name-your-own-price model. The model itself was so far not very successful.

Neuropricing

According to neuromarketing expert Kai-Markus Muller, people do not do or buy what they say they want. What customers would really buy and at what price is, however, revealed by their brain waves.

Brain scans lead to the surprising discovery that the best price is often higher than producers or retailers suppose. The seller’s anxiety about the price is often more acute than the buyer’s.

Stanford University in California, Brian Knutson and his colleagues have studied some of these questions with help of fMRI brain scans.

Researchers have come to the conclusion that desirable products evoke reward and that high prices lead to sentiments similar to pain, in this case speaking of the pain of paying.

Two internationally renowned studies clearly demonstrate the effect of prices. Dan Ariely in research about pain killers used price to differentiate placebo and the effect of more expensive placebo was estimated as better. Hilke Plassmann used the price difference to test the taste of the same vine. The result was the same.

Low prices are not only harmful to the company’s profitability, as Ariely’s and Plassmann’s results show, but they negatively influence the quality for consumers.

Higher prices lead to more profit but also to greater satisfaction and, in the end, to better life quality.

The brain is impatient. The vast majority decided to accept a 10 USD coupon valid immediately rather than a 100 USD coupon valid in two months’ time.

Amongst (too many) conflicting alternatives, the non-choice prevails: our brain halts the buying instinct when the choice is too vast.

Context has a considerable impact both on perception of price and on willingness to pay.

In order to evaluate prices, both in professional context and in a private one, there are some heuristic rules that can be applied, that is, methods for simplifying the decision-making process, which can save us time.

Two important methodologies can be distinguished:

Heuristic of recognition.
Heuristic of willingness.

The essence of the heuristic of recognition is to find something familiar. The mechanism of the heuristic of willingness instead is based on evidence guiding the purchase: by looking at what most other consumers buy.