Chapter 7
Go beyond the Price Point
Five Powerful Monetization Models
So you've taken our advice in Chapter 6 and determined the right set of features to incorporate in your new product or service offering. You've also decided whether to combine it with other offerings. You know which of your features are leaders, fillers, and killers, as well as what product configurations or bundles to sell.
The next step is coming up with a monetization model. What is that? In a nutshell, it's how the customer pays for your new product or service.
This is no small matter. In fact, establishing a favorable monetization model can be as important as the new product itself and the price you charge for it. A highly innovative monetization model can make a new offering take off like a rocket.
A number of innovative—yet proven—monetization models are in use today: subscription, dynamic pricing, and freemium to name just a few. You need to choose one carefully; the right model can make or break your new product, your business, or even an entire industry. How you charge trumps what you charge.
That's a bold statement. Don't believe it? Read on.
How You Charge Trumps What You Charge
The first thing to realize is that most companies perpetuate the monetization model they've always used. They select a model without reflecting on it, thinking strategically about it, or testing it. That's a missed opportunity and a huge mistake.
Some of the world's most successful companies have made the biggest leaps by revolutionizing their monetization models. For example, take the “pay as you go” model. It's a model that has helped companies that provide hosting and cloud computing services, telecommunications, transportation services, construction machines, and aircraft engines (yes, you read that right!) achieve game-changing results.
Let's take a few examples. Xerox has been transforming its model through the years, charging some customers based on how much they use Xerox printing and copying equipment rather than selling or leasing those machines. Enercon, a German wind turbine manufacturer, charges based on the amount of electricity its customers generate. The more electricity the customer produces using Enercon turbines, the greater Enercon's revenue. Marketing software firm Adobe, after many successful years of selling software by the unit and charging a one-time fee, has moved most of its popular products to a cloud-based subscription model.
You might be tempted to think innovative monetization models are the preserve of newer companies—firms unconstrained by decades of conventional wisdom. But you'd be wrong. One of the most radical and successful monetization models was the brainchild of a 126-year-old company, one that virtually every driver knows: France's Michelin Group. Let's take a closer look.
Michelin: From Selling Tires to Monetizing Miles
Michelin has been known for decades for the quality of its tires, which have commanded a premium in the global marketplace. But in the early 2000s, Michelin's premium prices faced enormous pressure from a range of tire makers, including fast-rising Chinese and South Korean tire manufacturers.
Continuing to expect customers to pay a premium for Michelin tires—especially trucking firms, for which tires are a big cost of doing business—was the equivalent of driving on tires with nails embedded in them. It risked a blowout. And the executives at Michelin knew it. So Michelin, a company that has introduced numerous product innovations in its 126-year history (from the detachable bike tire in 1891 to the first radial tire in 1946 and the run-flat tire 50 years later), fell back on the strategy it knows best: product innovation.1 It invented new tires that lasted longer—much longer, in fact. And it hoped it could retain its premium prices as a result, or perhaps even raise them. But competition in the tire market was relentless.
At the turn of the twenty-first century, the firm was ready to launch a new tire that would last about 20 percent longer. However, the head of sales predicted Michelin could only charge a few percentage points more for the new tires than it did for its standard tires. What's more, given that the new tires would last longer, they would reduce customer demand by 20 percent. Customers wouldn't have to buy Michelin's longer-lasting tires as frequently. To the company, a small increase in its premium pricing that would unleash a big drop in demand did not make sense at all.
With these hazards facing the firm, Michelin's executives realized they needed more—much more—than a superior tire. So they revisited Michelin's long-established monetization model—how the company charged for its tires. The new monetization model that Michelin's Fleet Solutions came up with in 2001 turned out to be as big a breakthrough as its longer-lasting tires: charging trucking fleets by the mileage they drove their Michelin tires, not by the number of tires they bought.
It was a bold move by Michelin, one that put its money where its mouth was. The company dubbed its monetization model “the TK”—short for ton-kilometer. Michelin started negotiating a per-kilometer rate with truckers, contract by contract.
Setting price by distance traveled delivered benefits to both Michelin and its trucking customers. The new approach allowed fleet managers to pay for performance rather than simply the privilege of owning Michelin rubber. What's more, it gave industrial vehicle owners the flexibility to manage costs appropriately in good times and bad times. If a recession set in, reducing demand for products shipped by truck and thus demand for trucking services, fleet owners would pay less for those tires since they were being charged by the kilometer, not by the tire.
Michelin took on the customer's cost of product problems; if a tire fails early, Michelin bears the risk. On the flip side, when tires exceed quality expectations—say, when they last 20 percent longer than before—Michelin generates 20 percent more revenue per tire.
Michelin's new monetization model allowed the firm to fully capitalize on its new invention—that is, to monetize a tire that lasted much longer than the previous generation did. And Michelin did this without having to spend more on sales and marketing to convince customers these new-fangled tires were worth the premium they were being asked to pay.
Michelin simply changed its monetization model. It was a brilliant move. Michelin soon boasted the biggest profits in the industry; by 2011, its earnings before interest and taxes were 25 percent higher than Bridgestone's and more than three times Goodyear's.2
Innovative Monetization Models: More the Rule Than the Exception
Since the turn of the century, innovative monetization models such as Michelin's have swept through other industries as well. One of them is the $369 billion global computer software industry,3 where the “software as a service” monetization model has taken hold. In the construction industry, equipment such as backhoes and tractors now have sensors that transmit data when they're about to break down (so customers can fix them before they break). This demands a rethinking of the industry's monetization model. If you charge by the hour for an engineer to fix the equipment on site, your maintenance revenue may disappear. A better model might be to include proactive maintenance services into your machine's price and then increase that price.
With technological advancements such as these, increasingly the monetization model is the innovation. But those advancements have been in the making for a few years. For example, in 1999, a then two-year-old movie rental firm named Netflix began charging a flat monthly fee (a subscription model) for unlimited movie rentals by mail rather than the per-disk rental people paid at the neighborhood video store. Customers took to this model in droves, and Netflix later displaced Blockbuster.
Since 2000, the reigning monetization model for the online advertising market has been the auction. This is how Google has made most of its immense profits. While Google didn't invent the online ad auctioning monetization model, it undisputedly has been the best at perfecting and making money from it.
Uber has disrupted the taxi business with a dynamic pricing model based on supply and demand in a given location. Medtech and General Electric have begun charging hospitals and physician groups according to their use of medical equipment rather than selling or renting the equipment. Metromile, an auto insurance startup,4 tracks customers' driving behaviors using telematics (onboard digital devices) and calculates their total premiums on a per-mile basis. These innovative monetization models have differentiated these companies and enabled dramatic success.
However, selecting the wrong monetization model can have just as significant an impact. A European trucking company found this out soon after signing a three-year contract to distribute a TV manufacturer's goods. The distributor charged the TV set maker a fixed price per TV delivered. Over time the size of the TVs increased exponentially, which meant the distributor couldn't fit as many TVs into each truck as it used to, and thus had to make more truck runs. Costs increased massively, but revenue did not because of the fixed price. Hence, the TV distributor ultimately lost money on the deal.
The TV set distributor learned a harsh lesson: Monetarily, a bad monetization model can be worse than a bad price.
Five Powerful Monetization Models
Sifting through dozens of pricing and revenue strategies, we have identified five monetization models that have been proven over time to help companies launch an innovative product or service, differentiate it, or dominate their marketplace. These five are not the only monetization models out there, but they are among the most valuable for new product launches.
Let's look at how each model works, its advantages, and the new technologies that make it possible, then how to decide which one best suits your business.
1. The Subscription Model
What Is It?
The customer provides periodic and automatic payment for continued delivery of (or access to) a company's offering. For example, customers may opt to subscribe to the Wall Street Journal rather than buying it on a newsstand. Netflix customers today choose among several subscription rate plans to receive video via digital streaming.
The number of companies embracing this model for products and services is exploding as the Internet has spawned a subscription economy (sometimes called “the membership economy”). Companies that offer subscription options for everything from clothing and shaving supplies (the Dollar Shave Club) to household goods are challenging established businesses.
The Advantages
The subscription model lifts lifetime revenue overall, and customer lifetime revenue specifically. A customer who buys the Wall Street Journal intermittently generally spends less money than a customer committed to a year of delivery. Obviously, this generates more revenue for the WSJ. A customer on subscription is also likely to stay for a longer time without churning (since you increase switching costs after getting the customer more familiar with your offering).
The WSJ loves subscription revenue models for their recurring revenue. For example, if the weather is bad or newsstand operators go on strike, a publication will lose sales. But with subscriptions, the money keeps coming, rain or shine.
While selling a long-term subscription is generally harder, it limits the number of buying decisions customers must make and locks them in. With a subscription, a newspaper buyer doesn't have to decide Monday whether to buy that day's edition. Add automatic renewal to the equation, and the company is in even better shape.
Subscriptions also open up cross-selling and upselling opportunities. Companies can use the data collected on subscribers to make other offers based on preferences and behaviors. Netflix has used its subscribers' movie-watching habits to create original TV series that have become huge hits, such as House of Cards and Daredevil. These shows have helped Netflix more than double its number of streaming service subscribers between 2012 and 2015, from 33 million to 69 million in 2015's third quarter.5
Last, the relationships between subscribers and brands also prove stronger and stickier than transactional ones. While the company gets to know the consumer, the consumer becomes more intimate with the brand and perhaps even emerges as an unofficial ambassador for the product or service, thereby increasing the brand's value.
Is It Right for You?
A subscription monetization model is an option for products and services sold both online and offline. Subscription models are also beneficial in industries where customers use the product continually. A great example is the music sector, where subscription plans for online music services from firms like Spotify and Pandora have taken a firm hold. In 2014, such streaming subscriptions accounted for nearly a quarter ($1.6 billion) of the global music industry's digital revenue, a six-fold increase since 2009.6
Subscription models also work in highly competitive industries in which market share is divided among many firms—a land-grab scenario. In these situations, subscriptions can help lock out competitors whose goods or services are only available on an individual transaction basis.
Last, subscriptions are becoming popular in industries such as software that formerly required customers to make big upfront investments to purchase the products. By letting customers buy the products in bite-size chunks, subscriptions make them more affordable and predictable for everyone.
2. Dynamic Pricing
What Is It?
A dynamic pricing monetization model is one in which a given product's or service's price fluctuates based on factors such as season, time of day, weather conditions, or other considerations that could impact willingness-to-pay, demand, and supply.
For decades, the airline industry pioneered dynamic pricing, changing ticket prices based on the time of booking, class of service, and other factors. As one of the pioneers of dynamic pricing, American Airlines' former CEO Robert Crandall, eloquently put it, “If I have 2,000 customers on a given route and 400 different prices, I am obviously short 1,600 prices.”7
With rapid advancements in data collection and analytics technologies, companies in other industries can now use more complex algorithms to adjust prices more frequently. Uber is a prime example. The firm, launched in 2010, has disrupted the taxi business with a dynamic pricing monetization model that ties price to the real-time demand and supply of taxis. The benefits go both ways: to Uber's drivers and to the consumer. An increase in price during peak hours attracts more Uber drivers to meet the demand. Consequently, consumers don't have to fight for a taxi or wait in the rain trying to flag one down, and they're willing to pay more for that benefit. More on Uber in Chapter 13.
Dynamic ticket pricing is becoming more prevalent in professional and collegiate sports, with higher- and lower-profile games priced accordingly, even in the regular season.8 Some supermarkets have applied dynamic pricing at the level of the individual consumer, offering personalized pricing based on repeat purchases.9 Frequent buyers of a product will get a lower price to encourage the behavior; people who haven't bought the product before, or buy it infrequently, pay a higher price. French home improvement chain Castorama has installed electronic shelf pricing that adjusts prices in real time according to demand.10
But dynamic pricing can backfire. Coca-Cola began testing a vending machine in 1999 that automatically raised prices for its soft drinks in warmer weather.11 The company abandoned the experiment; customers didn't like it one bit.
The Advantages
As the travel and hospitality industry has known for years, dynamic pricing boosts the monetization of fixed and constrained capacity. Companies don't want expensive, costly-to-maintain assets, like jumbo jets or five-star hotels, operating with empty seats or rooms. Dynamic pricing models let you adjust price (in this case lower) to monetize your unused capacity. Similarly, you can raise prices if your capacity is fully constrained. The more volatile the demand, the bigger the benefits from dynamic pricing. In addition, dynamic pricing can help a company that doesn't have capacity constraints, but whose demand and price elasticity is volatile. For example, UK grocery chain Tesco prices products higher in the evenings because high-income evening shoppers tend to be willing to pay more.
Is It Right for You?
First, dynamic pricing should be considered when demand and price elasticity in your market vary significantly. If they do, you then must ask what factors influence the volatility and whether you could set your price based on these factors. Second, you should consider dynamic pricing if your supply is constrained or fixed.
But dynamic pricing is a complex undertaking. Companies that wish to use it effectively must make significant investments in technology and business process changes.
As Coca-Cola and other companies have found, dynamic pricing can irritate customers who believe they're being taken advantage of. Dynamic pricing generally requires a customer base that is willing to pay a higher price for other benefits—like a taxi on a cold, rainy evening.
3. Market-Based Pricing: Auctions
What Is It?
Auctions set prices based on competition for goods or services. They've been around for centuries. In fact, the first auctions date back as far as 500 BC.12 Today, thanks to networking technology, it seems as if everything can be auctioned, from securities to artwork.
Auctioning is a primary way Google makes oodles of money. Google AdWords, which drives the advertising displayed alongside search results, is powered by an auction. Advertisers outbid one another for the most prominent placement based on keywords. During the first half of 2015, that auction-based ad business accounted for 70 percent of Google's $35 billion in revenue, according to company earnings reports.13
“Two-sided” marketplaces (those that connect sellers and buyers) have also embraced auctions. The most prominent is eBay, which has built an $18 billion-a-year business helping people sell household items through auction pricing. In a similar vein, Manheim, an automobile auction company (which we will explore in more detail in Chapter 9), is the world's largest auction provider for buying and selling used cars.
The Advantages
With auction-based pricing, you can withdraw from the act of price setting and let the market figure out what it wants to pay. In other words, even though you are the seller, the market perceives you as the neutral party; customers outbid each other to buy and raise prices for you. In addition, when you use an auction model, you can influence the price without being too explicit about it. For example, you can set a minimum price for the auction and dictate how long the auction takes and the process of bidding.
Is It Right for You?
Unlike the auctions of old, which required little more than a room, a podium, and a fast-talking auctioneer, today's high-tech auction-based pricing requires sophisticated systems and processes. If they are not executed properly, they can produce huge, costly mistakes.
The auction model might not work if the market has excess inventory and your customers have many options, or if you are in a competitive environment and don't have the pricing power required to make an auction model successful.
However, auctions are ideal for so-called seller markets, where inventory is constrained, the power is with the sellers (as owners of inventory), and demand is high. If you are one such seller or can become one, as Google did with AdWords, you should seriously consider this model.
4. Alternative Metric Pricing/Pay As You Go
What Is It?
Many companies have succeeded by pricing transactions on measures other than the industry per-unit standard. Often these alternative metrics are closer to product value and customer benefits.
Industrial giant GE has used such alternative metric pricing in recent years, embracing the power of analytics software, digital sensors, and data. In 2011, the company launched a big initiative to attach and embed digital sensors to its medical equipment, aircraft engines, power turbines, and other industrial equipment. The company generates $1 billion a year from the “outcomes-based” services it now provides—which, for example, help airlines identify problematic engines sooner and thus reduce downtime.14
Instead of selling or leasing a CAT scan machine or a jet engine, GE charges customers by the hours of usage for a medical practice or the miles flown for an airline. As such, customers pay when they use or benefit from the product. If GE reduces its customers' downtime, that goes into GE's pockets. It has monetized 100 percent of the value of its offering, exactly as Michelin has been doing with tires.
Software companies have also successfully employed alternative pricing metrics. A software company that produces lab reports increased revenue by 20 percent just by changing its pricing metric from fixed perpetual license to charging per lab report. It considered this alternate metric model to be much more aligned with the perceived value. The model also minimized customers' upfront investment commitments. Of course, this was also beneficial to the software firm since it could now charge a higher price for a lab report (compared with breaking even on the perpetual fee).
The Advantages
If your innovation enhances customers' performance in a way that is superior to the alternatives, the alternative pricing model might be for you. By aligning the metric to your customers' performance, you achieve full monetization potential. But you must be able to deliver on your promise, as Michelin did with its fleet operator customers.
An alternate pricing model can be very successful when you can align the metric directly to how customers perceive value. For example, let's assume you are a manufacturer of robotic surgery equipment that can be installed in hospitals. If a hospital is small to medium in size, they typically don't have the capital to invest in machinery you provide. The traditional way is to price by the upfront cost for the instrument. What if you price by surgery? This alternative is totally aligned with the value delivered to the hospital as compared to them paying a really high upfront cost. In other words, you are participating in the revenue your customers generate by using your product and services. Ultimately you can showcase your intentions as a win-win situation for you and your customers.
Finally, this monetization model could be effective if you are an adept predictor of future trends. For example, telecommunication providers have long anticipated the trends of increased usage of digital data and devices and have proactively changed their metric to “gigabyte-based pricing” or “device and gigabyte-based pricing.”
Is It Right for You?
The alternative pricing model makes sense when your innovation creates significant value to end customers but you cannot capture a fair share of that value using traditional monetization models. Michelin is an excellent example of this.
This model makes more sense when you have total control over how customers use your product. For example, if Monsanto is paid via yield per acre, it must make sure that its herbicides are applied in farmers' fields as prescribed. Only then does Monsanto have full control over the impact of its products on customers. And this, in fact, is how Monsanto's monetization model works.
5. Freemium Pricing
What Is It?
With the freemium model, a company offers two or more tiers of pricing for its products and services, one of which is free. The goal of a freemium monetization model is to attract a huge customer base to the free version and later convert a significant percentage to paid subscriptions. This model is also called “land and expand.” You try to land with a freemium offer and expand with paid offers.
Both LinkedIn and Dropbox are good examples of companies that have succeeded with freemium pricing. Customers with basic needs can access a limited version of LinkedIn's career networking and Dropbox's storage services for free. But customers with greater needs pay for more sophisticated features.
The Internet has greatly expanded freemium possibilities by reducing the cost of distributing many services to zero. In fact, freemium is now the dominant business model for many Internet start-ups, online service providers, software companies, and smartphone apps.15
The Advantages
Because freemium services lower the cost of customer entry to zero, they spur rapid adoption. The free offering becomes, in effect, a marketing tool for the premium offering. That helps companies reduce their cost of customer acquisition compared with more expensive traditional marketing and sales methods.
Is It Right for You?
The freemium model is definitely not right for everyone. It only works if you have a very low cost of production (preferably no production costs at all) and minimal fixed costs that can and will be offset by the generally smaller percentage of paying customers.
What's more, companies often struggle to turn the freemium model into long-term monetization. The land-and-expand approach fails for 90 percent of companies. (For an exception to the rule, see the LinkedIn case study in Chapter 13.) In fact, the number of free customers who convert to premium is typically below 10 percent in software companies. In video games, freemium games have an average life span of less than a year, losing 75 percent of free users after just one day and retaining just 2 percent after a month of play.16
If you decide to offer a freemium service, you must double down on your efforts to convert customers to the premium version. It is extraordinarily difficult to get consumers to buy something they previously received for free. One need only to look at the scores of Web-based businesses that failed to monetize free online offerings in the last two decades. For example, most newspapers (apart from ones like the New York Times and the Wall Street Journal) have failed to convert free readers en masse to paid online subscribers.
This is the same dilemma for Evernote, a mobile app that helps people take notes on the fly. The firm became one of the first “unicorn” start-ups, joining the exclusive club for private tech companies worth $1 billion or more. Despite reaching 150 million registered users this year, Evernote has been slow to generate revenue, according to Business Insider.17
To have a chance at converting free customers to paid customers, you need to test what benefits they will pay for and ensure a functional free experience. You also need to know exactly how many customers will actually be willing to pay. What's more, you must avoid giving the farm away for free because it will leave your premium offering with very little value.
Five Questions to Choose the Right Monetization Model
We have provided five monetization models and explained when they apply. These models are by no means the only ones you can use. You can also combine pieces of each one. For example, the $112 billion U.S. retailer Costco charges a membership (subscription) fee to use its warehouse stores on top of charging for products you purchase. OpenTable charges restaurants a monthly subscription fee and a transaction fee for every diner in a reservation.
Before implementing any of the models, you should have extensive conversations with customers and then test them. Whichever model you choose, it should not only play to your organization's strengths, but also benefit your customers. It should also take into account future trends for your product, company, and industry. Here are five questions to consider when assessing which monetization model is right for you.
1. How Likely Are Your Customers to Accept the Model?
Different customers like different pricing models. Is your model predictable, flexible, fair, and transparent enough for your particular customer base? Customers almost always have preferences for certain models. Make sure your model is in line with their preferences. Test out different models to discover your customers' favorites. One way to do this is to provide your customers with options, the prices of which always total the same amount (if you did the math), and ask them whether they have a preference or are indifferent. If your customers are rational they will always say they are indifferent, since the price is the same across options. However, we have done such testing hundreds of times and have yet to see the “indifferent” option win! People always have a preference.
2. How Will Future Developments Impact the Model?
Make sure you do scenario planning around the model. What are the key trends in your business? For example, if you're a mobile phone service provider, is the number of phone calls increasing or decreasing? How about the number of devices? What risks and opportunities do those trends present long term? How will the pricing metrics hold up? Michelin, for example, factored improvement in tire durability into its distance-based pricing model. Google anticipated an auction-based model would serve it well not only in the early days when prices would be low, but also later on as demand increased.
3. What Stage Is Your Company In and Does Your Model Choice Fit That?
A monetization approach has to suit your company's situation—its life cycle, competitive position, and relationship to customers. If you're a start-up, for instance, you may want to keep things simple and transparent, as payment processor Square did with its 2.5 percent no-hidden-fee model. A mature company may need to differentiate itself from rivals with a more complex approach. Also important is what you have in your innovation pipeline. When your new offerings come to market, will your model help you monetize them (as Michelin's model did with its new tires)?
4. What Are Your Competitors Doing?
The reason to ask this question is not to mimic your rivals' monetization approaches but to set yourself apart. Wherever possible, use your monetization model to create a competitive difference, as Netflix did to the point of transforming the video rental business and displacing video store competitors like Blockbuster. The question becomes especially relevant when competitors are not equipped to react to any model changes you can bring.
5. How Difficult Is the Monetization Model to Implement?
A monetization model is good only to the extent you can make it work. Assess factors like feasibility, difficulty of customer adoption, and scalability. Make sure you can measure the data necessary to enforce the pricing. In addition, you must be able to communicate the model easily to customers and partners. Don't exclude yourself from a particular monetization model based on existing infrastructure and system limitations, but be sure to factor in the additional investments needed to make the model work. Gauge the total cost of ownership and the ultimate return. Most of all, make sure your model is driving value to customers and your pricing is commensurate with the value you deliver.
The marketplace performance of companies such as Google, Netflix, Michelin, General Electric, and Uber irrefutably shows the power of choosing the right monetization model when bringing new products and services to market. These companies demonstrate that a winning monetization model can help a firm leapfrog the competition in ways even a winning product or service offering alone cannot.
The rapid evolution of the Internet and other technologies has created abundant opportunities to capitalize on monetization models that are new to your industry. You and your colleagues need to explore them, and quickly, to get out in front. Sometimes the best innovation is the innovation in the monetization model itself!