Author: Hermann Simon
Flat rates are among the most important innovations in pricing. With flat rate systems, a customer pays one-fixed price per recurring period and then can use a product or service for as much as he/she wants within that paid period. This pricing system works well for some industries but, as the author explains, can cause problems for others if not used wisely. Hermann Simon is Founder and Chairman of Simon, Kucher & Partners Strategy & Marketing Consultants. He can be reached at hermann.simon@simon-kucher.com. His latest book, Confessions of the Pricing Man, tells his story from student to professor to global pricing guru.
The Pricing Advisor, January 2017
Flat rate is the modern term for a lump-sum price. A customer pays one fixed price per month or per year, and can then use the product or service as much as he or she wants in that period. Flat rates are very widely used today in telecommunications and internet services. Cable television subscribers generally offer one flat rate per month to gain access to all available channels and watch them as often as they like. The BahnCard 100, used for trains and transit systems in Germany, is also a flat-rate offer. Cardholders can ride the rails as often and as far as they would like. Flat rates are very effective tools for price differentiation. Heavy users realize huge discounts when they have a flat rate. For example, if someone travelled by rail so often that they would pay 20,000 Euros per year at regular prices, they would earn a discount of 79.6 percent if they bought a second-class BahnCard 100. This heavy usage is precisely the risk that companies face when they offer flat rates. They should expect lower revenues from their heavy users, and potentially also higher costs (for example, additional investments in a telecommunication network).
Nonetheless, flat rates are among the most important innovations in pricing. We see monthly or annual passes to museums, theaters, and fitness studios all having a flat-rate character. The all-you-can-drink offers for soft drinks at fast food restaurants follow the same principle. The “all inclusive” offers in tourism combine flat-rate elements (e.g. for food and drink) with price bundling. “All you can eat” buffets are another example of flat-rate pricing. The risk for the restaurant owner is limited, because guests can only eat or drink up to certain personal limits anyway. In Japanese bars, a popular price model is a flat rate which allows guests to eat and drink as much as they want during a certain period. The prices range from 1,500 yen (roughly $15) for one hour, 2,500 yen (roughly $25) for two hours, and 3,500 yen ($35) for three hours. These flat rates are particularly popular among Japanese students. The time limit helps reduce the bar owners’ risks. When I once tested this system in Tokyo I also had the impression that service was somewhat slower for flat-rate guests.
For telecommunications and internet companies, flat rates can present a problem. One European company offered its readers the following deal: for a flat rate of 19.90 Euros (around $24.70), they would have unlimited free calling and also have unlimited free internet usage. They would also receive a Samsung smartphone.[1] What is the problem with these flat rates? One can only talk or surf for 24 hours in a day, but data amounts know no limits. They continue to increase. The discussions around flat rates in telecom and internet businesses began in earnest in the late 1990’s in the U.S. and soon spread abroad. Heavy users, who benefit the most from such price models, intensified their pressure on companies to offer more of them. On November 20, 2000, I made a presentation to T-Mobile entitled “Internet and Flatrate – Strategic Considerations,” during which I presented two theses:
- Thesis 1: Flat rates mean that the vast majority of light users subsidize a small minority of heavy users.
- Thesis 2: Flat rates lead with a high probability to lower revenue and profits. From an economic standpoint, flat rates make no sense.
Whether one can still speak of a “small minority” of heavy users nowadays is an open question. As for the second and most important thesis, I still stand by those words today.
Data volume has been growing massively. Because of their flat rates, however, telecom companies have not participated in that growth the way they could have. Their revenues have stagnated. At the same time, they need to invest billions of dollars in new network infrastructure. They will not be able to harvest the fruits of these investments, though, because their flat-rate price policies have capped the maximum amount of revenue they can receive from an individual customer. I am not claiming that any single telecommunications company could have withstood the flat rate wave on its own. The industry as a whole has done itself a disservice with flat rates. In recent years more and more telecommunications companies stopped offering their customers contracts with unlimited data usage. I expect that such price strategies will become a new standard in the industry and offer the telecom companies a way out of the flat-rate trap. When I shared my two theses from above in 2013 with Rene Obermann, at the time CEO of Deutsche Telekom, the parent of T-Mobile, he admitted that such attempts to pull back “demonstrate that you and your team did in fact foresee this development in the year 2000.” [2]
From a consumer perspective, flat rates offer many advantages. Some consumers opt for a flat rate, even when it is not their most economical choice. One reason is that a flat rate acts as a kind of insurance policy. It limits the consumer’s out-of-pocket risk to the fixed amount. When one treats the flat rate as a sunk cost, the consumer’s marginal cost for voice or data usage is zero. One has the perception that these services cost “nothing.” They also avoid the “taxi meter” effect. From the perspective of prospect theory, every phone call or online interaction provides a positive utility. We have these experiences daily, and their sum is greater than the negative utility of the flat rate, which we pay once a month.
If consumption or usage is not constrained by some natural or artificial limits, companies should be very careful with flat rates. It is critical to have detailed information about the distribution of light vs. heavy users and to run rigorous simulations. Otherwise, one can experience a nasty surprise with flat rates. If the number of heavy users is large, flat rates put profits at considerable risk.
