Monday, August 08, 2005

Value-Based Pricing

My recent commentary for the CBDI Forum on Service Economics has been picked up by a number of other industry analysts and commentators, including Britton Manasco (ZDNet), Phil Wainewright (Loosely Coupled) and Sadagopan. I am widely quoted as advocating output-based pricing.

I certainly believe that output-based pricing has some key advantages over input-based pricing, especially within a service economy. But there is a third option we have to consider - value-based pricing. So what's the difference?

Pricing Definition
Payroll Example
Word Processing Example
Input-Based
The consumer pays for the components (or resources) that are required (or consumed) to implement and deliver the service - including hardware units, software units, support units, and so on. [Updated for clarity]
If you buy a payroll package to run on your own machine, you typically pay a licence fee to the software provider that might be related to the size of the machine, but not directly to the number of payroll transactions. I buy a copy of Microsoft Word.
Output-Based
With output-based pricing, the consumer pays for the direct results of a service. This is what Phil is referring to when he says "customers buy access to the functionality the software provides". If you buy payroll processing as a service, you typically pay for the number of payroll transactions, regardless of the quantity of hardware and software that is required to deliver this service.
I make a micropayment to Microsoft every time a save or print a document.

(Oh, and I want a micropayment refund every time the software crashes.)
Value-Based
With value-based pricing, the consumer pays for the indirect consequences of a service. This is what Britton is talking about when he says "software companies will have to begin charging for – dare I say it — business results"
If you buy payroll processing as a business service, you might negotiate a contract that was based on the total financial value of the payroll, rather than the number of transactions.
I pay a percentage of my royalties to Microsoft every time I sell an article or report.

In a simple world, you might expect a simple linear relationship between input and output, and also between output and business value. Under these conditions, it wouldn't matter whether you had input-based pricing, output-based pricing or value-based pricing, because they would all be equivalent.

But in a complex and diverse world, these relationships are non-linear, possibly even chaotic. The price will be commensurate with the business value only if a value-based pricing scheme is in operation. Although this would seem to be a Good Thing, there seem to be all sorts of hesitations and resistances in practice. Service providers are wary of value-based pricing, because if the consumer does not properly embed the service into an effective business process, the consumer may never get any value from the service, and the service provider may never get paid. Consumers are wary of value-based pricing, because they fear that if they start to get huge amounts of value from a service, they will end up owing huge amounts to the service provider, which the service provider might not truly deserve.

For example, suppose you buy information about a stock price. If you subsequently use this information to speculate on the stock and make a million dollars, does this mean you should pay the information provider more than if you simply buy a few hundred shares to put into your long-term savings plan? What happens if you lose money on the stock - does the information provider share the risk? Value-based pricing makes some important assumptions about the nature of the relationship between the parties.

In 1987 I was working in Chicago, feeling a little homesick, watching British acts on American television. Tracey Ullman had her own weekly show, which included a cartoon interlude of a dysfunctional family. I am told that in return for granting airtime to this unknown cartoon, Ullman negotiated a small percentage for herself. The cartoon later expanded into a full show and Tracey Ullman is now a very wealthy woman. (Do you need me to tell you which cartoon it was? Doh!) That's value-based pricing.

Value-based pricing seems like a brilliant scheme for both sides. The supplier gets the possibility of unlimited revenue; the consumer only pays if he can afford it. But there is considerable resistance to this scheme as well. Consumers are reluctant to sign a blank cheque - there is a feeling that the windfall profits for the supplier (like Tracey Ullman's wealth) are in some sense undeserved. Meanwhile, suppliers may be suspicious of the calculation of value, especially if this is produced out of the consumer's accounting system.

See separate blog posting for software industry reaction.

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