The 5 pricing models companies need to consider when innovating

July 18, 2018


Sometimes the best product innovation is the monetization model itself.

In the early 2000s, Michelin invented a new truck tire that, impressively, would last 20% longer than any other tire on the market. Under increasing competition and price pressure, the CEO was very happy with this development and asked his sales team, “How much more can we charge for this product?” The answer was, to his disappointment, somewhere around 5-6% more – a typical rate of monetization. This would have serious consequences for Michelin’s bottom line given new Michelin tires would need to be replaced 20% less. How could this conundrum be explained to the financial community

ichelin’s executives decided to revisit the company’s long-established monetization model. They found by switching from a price-per-tire to price-per-kilometer model, a classic pay-as-you-go approach enabled by GPS technology, 100% of the additional value from their innovation could be monetized – and they went on to gain the biggest profits in the industry.

Putting price before product

We know the most successful innovators start by understanding their customers’ needs and developing products around what they are willing to pay to address those needs. But a key component of the monetization process is not just determining how much to charge, but how to charge.

How you charge is often much more important than how much you charge.”

The rapid evolution of technology has opened up many new possibilities to different industries in how they can charge for products or services. But no matter which model is selected, we can’t stress enough how important it is to choose the right monetization approach early on in the product development process.

Here are 5 monetization models to consider when launching any new product or service:

1. The subscription model
Under a subscription model, the customer provides periodic and automatic payment for continued delivery, or access to, a company’s offering. While not a new idea, with the advent of digitalization we’ve seen huge growth in subscription setups in industries where it was previously not possible. One of the most successful cases is Netflix, and other good examples include music streamers and online newspapers.
Best for: An option for both online and offline businesses, subscription models are beneficial in industries where customers use the product continually. This model often works so well because customers today prefer sharing over owning and it leverages off the increased desire among consumers to access goods and services immediately.

2. Dynamic pricing

The primary examples of dynamic pricing can be seen in the travel industry where prices can greatly vary from one day to the next.

And with the growing dominance of OTAs (online travel agents), who have significantly transformed the competitive landscape, travel companies are able to finely tune their pricing based on the slightest market sensitivities.

With digitalization, however, dynamic pricing
is broadening and will continue to be adopted by companies outside the travel industry. They have started to see that dynamic pricing can help to further tap into willingness to pay and to introduce more sophisticated price differentiation models. Examples include the pricing of Uber for rides based on supply and demand, and the gas station chain Tanq4you that bases its prices on current oil prices and weather conditions.
Best for: When demand and price elasticity in your industry vary significantly, or if supply is constrained or fixed. Keep in mind, though, dynamic pricing requires huge investments in technology and business process changes. Furthermore, end-consumers can sometimes be cautious when it comes to making purchase decisions out of fear they are getting ripped off or buying at the wrong moment. Amazon retailers’ use of sometimes volatile pricing algorithms is an example of how dynamic pricing can be damaging to consumer trust.

3. Market-based pricing auctions
Under this model, prices are set based on competition for goods or services and eBay would probably be one of the most famous examples. Auctions have also been the reigning monetization model for the online advertising market since 2000. While Google didn’t invent online advertising auctions with Adwords – Google’s main source of revenue – it undisputedly has been the best at perfecting and making money from them.
Best for: So-called seller markets, where inventory is constrained, the power is with the seller, and demand is high. Pricing auctions are effective because customers feel they have some control over the price and often walk away feeling like they got a fair deal.

4. Pay-as-you-go

Many companies have succeeded by pricing transactions based on a pay-as-you-go system – and Michelin is one of the best examples. Often these alternative metrics are very effective at delivering maximum product value while targeting specific customer needs.

Another great example is the industrial giant GE. In 2011, the company launched a large initiative to attach and embed digital sensors to its medical equipment, aircraft engines, power turbines, and other equipment. This was just the start. GE is a major bricks-and-mortar company that has shifted towards a digital business, offering “outcomes-based services” where customers only pay for efficiencies provided by GE based on KPIs set by the customer. And this service approach has paid off. The company is now generating $1 billion per year from the outcomes-based services it provides.

Best for: Those who have total control over how customers use their product, and when the innovation creates significant value to end-customers, but a fair share of that value cannot be captured using traditional monetization models. Customers appreciate this model as they don’t have to make a huge upfront investment — they only pay for what they use and the benefits delivered, thereby minimizing risk. And, again, customers don’t mind sharing instead of owning products or services. However, it requires an extensive investment in software and data to measure usage and the value being provided.

5. Freemium pricing

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. LinkedIn and Dropbox are good examples of successful freemium models, and there’s a plethora of other internet and software companies, as well as apps, attempting the same.
Best for: Those with a very low cost of production (preferably no productions costs at all) and minimal fixed costs that can and will be offset by the generally smaller percentage of paying customers. This model is advantageous as it allows customers to ascertain the value of a product or service before having to pay anything.

Knowing your customers
While companies today can certainly be creative with how they charge for their goods and services, in the end it comes down to how well you know your customers and knowing how likely they are willing to accept your chosen model.
Know your customers’ preferences and make sure your monetization model favors those preferences. Is your model fair and transparent? Is there a risk your pricing will negatively impact consumer trust? Is it flexible enough to cater for future developments in your business? And finally, what are your competitors doing? The reason for asking this question is not to mimic your rivals’ approaches, but to set yourself apart.

An in-depth analysis of your customers’ needs must form an integral part of your monetization strategy and be tackled early on during the product development process. Taking a structured approach to monetization is the key to successful innovation.