This article is an excerpt from the author‘s successful pricing book – “Digital Pricing: A Guide to Strategic Pricing for the Digital Economy“ – the second edition of which has recently been released in English and is now available for purchase. The excerpt focuses on how digitization influences all aspects of price management, enabling new business models, additional revenue streams, greater integration of customers into business processes, innovative price models, and more. Frank Frohmann is a Senior Advisor at GT Partners, a European management consulting firm, and a seasoned pricing professional with more than 25 years of experience. He can be reached at Frank@frohmann.onmicrosoft.com.

The Journal of Professional Pricing, March 2023

1. Introduction: Digitization and Pricing

The potential for price optimization has increased exponentially in recent years due to digitization. Digitization enables new business models, additional revenue streams, greater integration of customers into business processes, innovative price models, etc. It influences all aspects of price management and enables innovation across the individual stages of the pricing process.

However, the enormous opportunities of digitization for price management have not yet been comprehensively covered in corporate practice. This is very surprising against the background of the following contexts:

1. The characteristics of digital offerings lead to specific pricing challenges. Information goods offer outstanding potentials for price optimization.
2. The enormous dynamics in digital business models, revenue sources and the resulting price models are significantly broadening the spectrum of pricing.
3. Digitization offers a wide range of opportunities, especially in terms of dynamic pricing, price differentiation as well as revenue and price models.
4. Generating new revenue opportunities is critical to success in order to amortize the extensive investments in digitization.
5. Pricing must play a much more important role in corporate processes. This is because price optimization is preceded by important business decisions: firstly, the definition of revenue sources (revenue model). On the other hand, the definition of customer value as the central pillar of the business model. Both of these overriding decisions are an elementary component of price management for digital offerings.

2. The Business Model as starting point of Digital Pricing

Setting prices for products is not sufficient for profit optimization. Critical to the success of digital pricing is the consideration of all four components of the business model (especially the “value to customer”). According to Hermann Simon, the most important aspect of price management is “value to customer.” If the customer’s subjective perception of value is the starting point for pricing, professional price management must necessarily start with the higher-level business model (Level 1).

Fig. 1: The three-level approach “digital pricing” in detail (source: own representation)

However, the linkage occurs in both directions. Creative pricing measures are one of numerous examples of this principle. Innovative price models not only lead to a better monetization of the benefits (“value capture”), but are also an independent value driver for the customer (“value generation”). Creative price models increase the value to customer (and thus enhance the business model)! So price management is by no means just monetization. Digital pricing can also contribute to value generation.

Here is a practical example: Hitachi (B2B). Hitachi changed the value creation architecture (“operating model”) in one of its B2B business units a few years ago. The latest sensor technologies were integrated into Hitachi’s train systems. These new measurement methodologies allowed a significant improvement in the punctuality of trains (value to customer). The business model was transformed from “selling products” to “offering software-based services.” B2B customers (such as UK Rail Networks) were offered “punctuality” in the sense of a “train as a service” concept. The consequence of the business model innovation: the revenue model changed from one-time payments for products to continuous payment streams for a software-based service. The price model is outcome-based. It is derived from the overarching revenue model as follows: the better the on-time performance rate, the higher the price.

Fig. 2: Outcome-based price model (source: own representation)

In digital business models (platforms, marketplaces, ecosystems, etc.), price is no longer a reliable metric for competition. Two main reasons are:

1. Many companies (like Alphabet, Amazon, Alibaba, or Tencent) cross-subsidize parts of their business. Not all business units have to contribute to profit. Services are therefore often offered for free (Google: search engine) or below cost (Amazon: Kindle).
2. Traditionally, monetization models are based on the exchange of a good for money. In digital business models, customers can pay with an exchange value other than money. The equivalent can include non-monetary components or be entirely without monetary payment. Modern monetization models increasingly include non-monetary countervalue components. Example include:
   1. Attention in the context of freemium models (example: Spotify). Here, users accept advertising in order to be able to use the “free” digital service component free of charge.
   2. Users pay with their data (as in the case of Meta (Facebook) and Alphabet).

3. Revenue Models in the age of digitization

The revenue model is defined on the basis of a clear understanding of a company’s added values (“value to customer”) and the underlying value creation processes (“operating model”). Digital business models are leading to a major shift in the revenue models of companies. In most sectors, revenue shares are shifting from products (hardware) to online services, software, and digital content. Online advertising (e.g., Google, Facebook, Amazon) and data have also gained importance as sources of revenue. The revenue model (level 2) defines the sources of revenue (i.e., the company offerings to be priced); this includes, among other things, defining the company offerings that – measured in monetary units – are offered free of charge.

Fig. 3: 5 selected revenue models (source: own representation)

The core decisions within the pricing process (level 3) are derived from this: price strategy, price structures and models up to concrete price levels.

The consequence of the significant expansion of revenue models is that there are many more challenges for pricing. In more and more cases, the first question is which potential revenue sources should be priced at all. This challenge must be optimized before the details of the pricing process (including strategy, price level, price model, rebates, discounts, and incentives) can be addressed.

The decisive factor for the clear separation of levels 2 and 3 is: Most companies work with multi-part revenue models! In the case of digital enterprise groups in particular, these are based on the conscious decision not to generate revenues with certain offerings. This explains the integration and logical linking of levels 2 and 3: for all offers that are not to be monetized, the pricing process (level 3) is not relevant!

4. Price model optimization as a major challenge within the pricing process

The pricing process in my book is based on the following process steps: analysis – strategy – structure – implementation – monitoring. It begins with a comprehensive analysis of all pricing-relevant data.

Fig. 4: The 11 C of pricing (source: own representation)

The integrated process translates the pricing strategy – which follows the analysis – into structural pricing decisions (price points, differentiation approaches, innovative price models, etc.). These form the starting point for the design of price negotiations and the enforcement of prices on the market. Internal and external price communication is also part of the cross-functional discipline of pricing. The process comprises a very large number of detailed tasks and process steps. As a central process phase, the optimization of price levels is of particular importance for value monetization. However, price management goes far beyond setting prices. Among other things, it is also about creating value for the customer, e.g., by introducing creative structures and price models.

Price models (“how to charge?”) define the qualitative basis on which quantitative price levels (“how much to charge?”) are based. Price models are systems with multiple interacting parts. “How to charge” offers particular differentiation potential in price management. The explanation for this is as follows: increased price transparency in the course of digitization increases the likelihood that competitors will undercut each other. Many companies are subject to the temptation to give in to price pressure via automated processes. However, pure price reductions are rarely successful. Prices are data: quickly copied and interchangeable! Price models are systems: difficult to imitate and potentially unique.

The Six Pillars of a Price Model

A price model is based on the overarching revenue model definition. It is created by logically linking six pillars. The six dimensions of a price model can be defined using the following questions:

• Are company offerings (e.g. products/services) combined into a package or is an individual product/service billed? → Scope
• What does the customer pay for? → Reference base
• How many components are included in the price? What is the unit of measurement? → Price metric
• How does the customer pay? → Form of payment
• Who sets the price? → Degree of interaction
• At what time is the price determined? → Time of the price setting.

All six dimensions of a price model are logically connected. The first two pillars (scope and reference base) are of outstanding relevance in the age of digitization.

Pillar 1: Scope

The logical link between the revenue model (digital pricing, level 2) and the price model (level 3) is made via the “scope” dimension. As a direct consequence of the overarching revenue model definition, the number of revenue sources is defined. In many cases, several revenue sources are bundled. The entertainment company Disney sells musical tickets and cruises (services) as well as merchandise (products) in connection with its streaming service Disney+ (digital service). Another example is the price model “Apple One.” This involves the bundling of six different revenue streams (music streaming, video streaming, newspapers and magazines, games, and others). Apple One bundles Apple Music, TV+, Arcade, and News+ and two additional offerings in one price model.

Pillar 2: Reference Base

The reference base of a price model is based on the question: for what does the customer pay? Innovative price models focus neither on a transaction (product, service, software) nor on access or usage. In creative approaches, the reference basis of the price model is aligned with the value drivers of a product. When it comes to “value-based“ reference bases a distinction must be made between outcome-based and success-based price models.

The basic idea of an outcome-based price model can be described using a case study from the B2B sector. In mechanical engineering, pricing is traditionally done on a unit basis: the business customer pays for a machine or the purchase of certain components. The backbone of an output-oriented price model is then no longer the machine, but its performance. The performance is operationalized via the products manufactured or the number of operating hours. In success-based price models, the revenue is based on the economic benefit that the customer derives from the company offering. The reference value is the economic success from the interaction between provider and customer. Billing is not based on a discrete unit (e.g., time or data volume). Customers pay a price only in the event of economic success.

5. Integration of pricing process and price psychology aspects

Innovative price models not only lead to a better monetization of benefits, but are a value driver in their own right for the customer: they increase the value to customer (and thus enhance the business model)! The consequence of this is that price management is not just “value capturing” (monetization). Pricing can also contribute to value generation.

The immediate consequence of this is that professional pricing must incorporate the latest findings in behavioral psychology. Since customer behavior is the most important factor influencing profits, especially in the digital age, the perception of benefits and prices is of paramount importance. Therefore I present the latest findings from brain research as the final chapter of my book.

Fig. 5: Pricing process and pricing psychology (source: own representation)

Against the background of the challenges of the pricing process, it is shown how the perception of customers can be controlled with the help of price-psychological levers. Eleven principles of pricing psychology are assigned to the point in the pricing process where they can be applied in terms of process sequence and content.