Category Archives: Pricing in networks

Price models – how to capture value in a business ecology

A business model should give answers to how an organization intends to create and
capture value in the business ecology that it’s a part of. Value creation, as well as value
capturing, is heavily dependent on the pricing strategies that the organization applies.
Without well-grounded price models that identifies necessary value creation conditions
(price models addressed by partners and sub-contractors), and conditions for value
capturing (price models addressed towards customers), there is a great chance that the
business model won’t be realized.

As the digitalization of the society has increased, so has the possibility to develop
innovative price models. In the wake of it a myriad of price models that challenge
prevailing branch standards have occurred. But what are the actual ingredients of a
price model?

The five dimensions of a price model

The research performed by CASIP has enabled us to identify five dimensions that
altogether constitute the ingredients of price models. The Scope of an offering, the
temporal rights, actors influence on pricing decisions, the price base, and the price
formula. Below follows a description of all of these five dimensions.

Price model equalizer

Scope

In this dimension of the price model it is constituted what is the core of the
product and what is at the outer edge of it. The product can be a system, or package,
consisting of many different functions or attributes that are priced together as a whole
(e.g. an all-inclusive trip). Opposite to this the offering can be priced based on single
attribute level, where the customer can choose which attributes are of interest and pay
for them separately (e.g. a trip where you separately book flights, trains,
accommodations, etcetera).

Temporal rights

Dimension number two in the price model deals with five different
types of temporal rights that a customer can obtain when buying product. It can be pay-
per-use, which means that the customer must pay each time they use an offer (e.g. pay
for each visit at the theater). Then there are different variants of time-limited rights
from subscription (pay in advance for something that is not fully developed, e.g. a
streaming service), rent (access for a certain time, e.g. a car rental for a weekend), and
leasing (access for a certain period of time with the possibility of buying eternal rights,
e.g. private leasing of cars). The opposite of the pay-per-use is perpetual, which means
that a customer can theoretically utilize the offer forever and at the same time have the
sovereign and unlimited right to sell the price object if they want (e.g. traditional
purchase of a car).

Influence

The next dimension in the price model illustrates the power balance
between buyer and seller regarding the actual price decision. A price model holds six
different ways in which buyers or sellers may influence a price. If it is determined
exogenously, neither the seller nor the buyer has power over the price decision. Instead
it is entirely external factors that determine it (e.g. commodity prices on a world
market). The influence gradually increases for both parties depending on whether the
price is determined by auction, if the customer gets to pay-what-you-want (e.g. when
visiting cultural heritage institutions), if the price is result-based (e.g. brokerage fee) or
if it is negotiated (e.g. buying service from a craftsman). The other extreme in the
influence dimension is that the seller has complete power and the buyer is offered a
fixed price list (e.g. what we usually encounter as customers in a grocery store).

Price base

The fourth dimension of a price model contains three different stages that
affect the price level. Is it based on calculations of costs that have occurred during
development, production, distribution and sales? Or is it based on the price the
competitors are offering (taking into account if your offering is over or underperforming
in regard to competitors)? Or is the price set based on the value customer perceives in
the offering?

Price formula

The fifth and final dimension of the price model describes how the
price relates to quantity. Here we find five different types of formulas, one of which is
totally voluminous, i.e. price per unit (e.g. per liter of gasoline). Furthermore, there are
various combinations of volume-variable and fixed price formula, such as per unit up to
a certain ceiling (e.g. parking fee per hour up to 6 hours and then for free) or purchase
volume to use up and then you pay per unit (e.g. a certain volume of mobile phone
internet surf that you can use, then you pay for each additional megabyte of surf), or a
fixed price to access the product and then when you use it you pay per unit (e.g.
electricity subscriptions). The fifth price formula is fixed price, i.e. you only pay one
price regardless of how large or small the volume you use (e.g. subscription to a
streaming service).

Pricing impacts risk

Threat or opportunity?

In our daily life we often think of risk as a threat to guard against. In our private and professional lives we plan and prepare for what may happen, take out insurance etcetera. Risks of course can never by avoided entirely. Our future is uncertain. And on reflection, it would be both unpleasant and dull to have full knowledge of what will happen.

Risk

But risk also has an upside. The uncertain future may benefit us, and insurance firms earn money through selling insurance. “One man’s gain is another man’s loss”, it used to be said. Most deals, even in private life, can turn out to be successes or failures. The upside (a good investment) can not be distinguished in advance from the downside (markets go down).

This is where the link between price (and price model) and risk becomes important. The choice between owning and renting is an obvious example. For customers it may be about flexibility, for the supplier between selling the object now or expecting greater profits from continued ownership. In price models we also include the duration of a contract, service promises and how termination is regulated.

Price models allocate risks!

Risk and uncertainty is split between the parties to a deal, depending on the contract. A wise price model may reflect that their views differ. The supplier may have past statistics showing that repair needs are infrequent or that most customers overestimate their use of a service, like the case is with gym cards. A customer may worry about high monthly fees and therefore prefer to buy full service at a fixed, high price on joining.

Especially for objects whose price on the market is highly cyclical, like housing, this may seem rather self-evident. We probably think less about it for price contracts for audit books or an e-book library, or suppliers delivery capacity. But in those cases also, there are price models that mix a fixed (monthly) component with variable charges based on usage. And usage can be measured differently, in the audit book example for instance based on how many books you started reading, how many you actually read through, how long you used them, and if you are allowed to download and keep them.

Mixing different price models for different deals can have a high impact on profitability. A gym that charges per visit, but has high fixed costs for staff and premises, takes a greater risk than another gym which sells annual membership long in advance and can adapt staff and localities after customers usage pattern.

To identify risk and how they can be handled through price models is a field where we at CASIP want to learn more through continued research. In our books and article we have not yet written that much about it, but that will come soon!

The relevance of cost-based pricing

Cost-based pricing means that the price is set based on the organization’s costs for 1) development, 2) production and 3) distribution of the product,. And 4) its administration. Plus, a reasonable profit margin.

In text books, two costing methods are typically suggested. Full costing that takes all resource consumption into consideration. It is used for long-term decision making, to make sure that all resource consumption is funded. Most often full costing is based on direct costs for material and labor, and an (almost) arbitrary allocation of fixed and variable overhead costs. The estimated cost for developing, producing and delivering a product marks the lowest possible price the company can charge for the product, if it wants to survive in the long run. Contribution costing, on the other hand, is used in short-term decision making to see how high the incremental costs are in a specific deal. It is called contribution, since the difference between the price and the incremental cost, yields a margin that contributes to funding the fixed costs. Contribution costing indicates the lowest possible price when offering a product on the margin.

Among consultants and in pricing literature cost-based pricing is often considered old-fashioned or even misleading. The price should not be based on costs, but rather what the customer is prepared to pay. Preferably, willingness to pay should correlate with the value of the product to the customer.

Cost-based pricing can still be relevant

Yet, costs are still important. In the long run it is important that the price is not set lower than the full cost. If that is true for all products in the portfolio, the company will eventually run into bankruptcy. Hence, costing is still important, even though the actual price level should also be affected by other factors than that.

Also, there are many markets where cost-based pricing is still the norm or even mandated. When selling within corporations or network organizations, the parties may have decided to use cost-based prices internally to reduce the “air” (i.e. layers of margins) in the forecasts. The upstream suppliers in the value stream charge for their full costs, while the market-facing entity that is closest to the customer sets a price that is based on the customer’s willingness to pay. Hence, the true profit arises in the final step in this value stream. All partners in the value stream, that do not meet the customer, will use a cost-based price. Also, in more regulated “markets”, cost-based pricing may be mandated (for example when the public sector is charging for services). One such example is pricing of public water and waste management services, where very advanced full costing models are used to calculate the correct cost per year (the cost per year is difficult to calculate since the lifetime of a sewage system is very long, sometimes more than 100 years, and may need unplanned and urgent maintenance depending on how it is constructed).

In summary; despite consultants’ and pricing literature’s advice to avoid costs as a basis for pricing, we argue that there are several situations when it is important to “know what it costs” and that it sometimes even may be reasonable to set the price based on the costs.