Monday, March 28, 2011

How to Set Prices: Revenue Models and Pricing Mechanisms

2nd in a series on How to Set Pricing

In setting prices, three major elements need to be considered:
  1. Pricing Strategy
  2. Business Revenue Model
  3. Pricing Mechanisms
Last post, we discussed Pricing Strategy.  This post, we give an overview of Revenue Models and Pricing Mechanisms to show how they impact pricing decisions.

Business Model Generation: A Handbook for Visionaries, Game Changers, and ChallengersFULL DISCLOSURE:  Most of this information has been paraphrased from Business Model Generation by Alexander Oesterwalder and Yves Pigneur.  If you are interested in business models, I highly recommend this book.

Revenue Models
As with pricing strategies, while there are many variations, the most common generic revenue strategies are as follows:
  • Title Passes to Buyer
    • Asset Sale - The straightforward one.  Buyer pays Seller; Seller gives Buyer the goods which the Buyer then owns.
  • Title Stays with Seller
    • Usage Fee - Buyer consumes a service.  The more consumed, the more paid.  Example:  telephone minutes.
    • Subscription Fee - Buyer pays for time based access to a service.  Example:  gym memberships, Netflix streaming
    • Renting - Similar to a usage fee but in this case Buyer pays for temporary exclusive access to an asset.  Example:  office rental, car rental
    • Licensing - Buyer pays for right to use intellectual property owned by Seller.  Example:  media rights
  • Middleman
    • Brokerage Fee - Company takes a fee for providing services to connect two or more parties.  Example:  real estate, credit card issuers
    • Advertising Fee - Company takes a fee for providing and promoting Buyer access to a prospective Seller base
The different pricing strategies discussed before - predatory, skimming, bundling, and multi-tier - can be applied to each of the revenue models.  For example, American Express pursues a premium brokerage fee pricing model and strategy vs. Visa which pursues a more mainstream brokerage fee model.  Both charge fee for card usage but American Express's is substantially higher than Visa's.  This fits American Express's strategy of going after higher net worth individuals.  In line with this strategy, American Express also charges a relatively high annual subscription fee for card access vs. Visa, which in many cases does not charge any annual fee.  This goes hand-in-hand with American Express's travel and other services most likely to be of interest to higher net worth consumers.

Pricing Mechanisms
Once you understand the revenue model and pricing strategy you wish to pursue, you need to decide on the actual mechanism of how you will charge.  Once again, while may variations and combinations are possible, the generic options are:
  • Fixed Pricing
    • List - The basic one.  Fixed price for an individual product or service.
    • Feature Priced - Price depends on the number, quality or type of features offered.  The default mechanism used with a bundling pricing strategy.
    • Segmented Discriminated  - Price depends on the type of customer being targeted.  The default mechanism used with a multi-tier pricing strategy.
    • Volume Based - Price is a function of the quantity purchased with price usually decreasing with increasing volume.
  • Dynamic Pricing
    • Negotiated - Price is set by active negotiation between Buyer and Seller.
    • Yield Management - Price depends on inventory and time of purchase.  Often used where capacity is fixed and perishable.  Example:  airline seats
    • Real-time Market - Price is based on supply and demand usually facilitated by an active exchange.  Example:  stocks
    • Auctions - Price determined by competitive bidding.  An auctioneer often establishes a floor reference price then facilitates the bidding up process.  In the case of a reverse auction, a Buyer sets a ceiling reference price, then facilitates a bidding down process.  The reverse auction is only possible where the Buyer has unique leverage over a group of Sellers.
Again, it is possible to combine any of the pricing mechanisms with any of the price strategies and revenue models, although in this case, some price strategies fit together better with some price mechanisms (e.g. bundling with feature pricing).

Once a decision has been made with respect to pricing strategy, revenue model, and pricing mechanism, the final decision that needs to be made is what price to charge.  In the case of dynamic pricing, the question is what reference price to open with as the final price will be ultimately be determined by the market.

Next blog post:  Tangible Pricing Methods

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