Part 2- Risks and Customer value in Hardware+Software pricing models

Introduction

In the first part of this 3 part Deep-Dive, we have explored different pricing models available for Hardware and Hardware + Software Products.

Today, we will be analyzing closely the risks and opportunities coming from each one of them; in particular, we will be analyzing what are the alternatives, how to understand the inherent risks in these models, and how to balance the seller interests (aka viability) with the buyers interests (desirability).

We suggest reading the 3 parts of this article in the right order and If you’ve not already done so, start by reviewing the different Pricing Options in Part 1. Here is the overall outline of this Deep-Dive

• Part 1 – Review of Hardware and Hardware+Software pricing options
• Part 2 – Risks and Customer Value in Hardware+Software pricing models [This article]
• Part 3 – Opportunities and Complexities of Hardware+Software pricing models in the Energy industry.

We conclude today’s part about the Risks and Opportunities of the different Pricing models, proposing a simple checklist you can quickly run your products’ pricing model through.

Specific Risks in Hardware and Software Pricing Models

It should be clear by now that bundling software and hardware allows companies to not only align more closely with their customer’s needs but also to open up opportunities for sustained engagement and revenue growth by creating new units of value. This evolution in pricing strategy mirrors a broader shift in the market towards solutions that offer not just a product but an ongoing service that adapts and grows according to user needs and preferences.

While diversifying business and pricing models presents new avenues for revenue, it also introduces a set of risks. Some of these risks are inherent to hardware sales, such as the risk of limiting oneself to adding a markup to the bill of material (“Cost Plus” approach), and neglecting the value generated to the customer; some other risks are specific to the pricing model selected and often arise from borrowing too heavily from the SaaS playbook without fully appreciating the distinct value propositions of hardware, or from misinterpreting the value these models bring to customers. Here are the most common:

Cost-Plus Pricing

Mispricing products by relying solely on cost-plus pricing remains a significant risk for hardware-based products, particularly when creating a new category or when the value generated is non-trivial. The primary danger with a cost-plus approach is in setting prices too low, leaving potential revenue unclaimed, or too high, making the product uncompetitive. The good news is that, once you start abandoning cost-plus pricing for real value-based pricing, not only you’re doing yourself a favor (unlocking additional revenue), but you’re also aligning your interests to those of the customer. It’s complex and requires a strong understanding of customers and their needs, but it’s a win-win.

Risk of Complexity

The appeal of innovative pricing models can introduce complexity in managing multiple pricing strategies, straining operational capabilities and obscuring the product’s value proposition.

Stretched Pricing Models

Attempting to emulate subscription or rental models without a clear and direct customer value proposition may lead to resistance or subscription fatigue. It’s essential to align pricing models with actual customer needs and preferences to circumvent such challenges. In some instances, despite being technically feasible, rentals, leasings, HaaS, and similar subscription-like models may not make sense for the provider, the customer, or both.

Deviating from Core Business

Venturing into financial models such as leasing or rentals can divert focus from a company’s primary offerings, potentially diluting brand identity and alienating the core customer base. Additionally, subscription-based models require significant capital investment; managing this capital can distract providers from their core business, especially if it does not involve “playing the bank.” Establishing a beneficial ecosystem, possibly with external capital or third-party providers, may offer a viable alternative in certain scenarios

Perception of Ownership

In certain markets and for specific products, the psychological value of ownership is paramount. Alternatives such as leasing or renting may not be appealing in contexts where ownership is deeply valued, highlighting the necessity of grasping cultural and market-specific nuances.

Perception of Lock-in

A strong connection between hardware and software may create in the customer a fear of being locked into a particular service or product without the ability to switch. This can deter customers from engaging with subscription-based or integrated hardware-software models, especially when the pricing model does not transparently allow for substitution. Hardware with an Independent Software License and openness to third-party providers (interoperability) may mitigate this sentiment. Moreover, interoperability can open the door to additional stream revenues and pave the way for a Platform Ecosystem model.

Complexity of Creating a Platform Ecosystem: 

Developing a successful platform ecosystem demands considerable technological investment, strategic partnerships, and the cultivation of developer relations. The intricacy and resources necessary for these efforts bring about significant risks, with success never being assured. In practice, there is a prevalent tendency among companies to overestimate their capacity to initiate the virtuous cycle required to generate sufficient value for both customers and partners to commit to the ecosystem, (also known as “network effect”).

Overestimation of Data Value: 

The assumption that data collected through hardware and software inherently represents significant value is a common misconception. The belief that “lots of data” equates to “lots of value” is frequently encountered, often accompanied by the optimistic proclamation that one is “sitting on a goldmine of data.” While this might be true under certain conditions, business models predicated on data monetization need to be grounded in clear use cases (desirability) and the capability to deliver (feasibility, including considerations around data ownership) to avoid constructing strategies on unstable foundations. Developing a clear strategy for data monetization that focuses on specific, valuable use cases and factoring viability (e.g. compliance with regulations) from day one, can prevent overestimation of data’s value.

Customer Value vs Business Viability 

Balancing Customer Value and Revenue Generation

The key to successfully implementing Hardware Sales with the Bundled Software model lies in striking a balance between providing significant value to the customer and ensuring viable paths for revenue generation to cover long-term costs. While planned obsolescence can drive recurrent hardware sales, it may not always be in the best interest of customer satisfaction or environmental sustainability. Conversely, developing a rich platform ecosystem can offer a more customer-centric approach, providing additional value that customers are willing to pay for over time.

About value-based pricing

A cautionary note on value-based pricing: As we delve into the various models for pricing pure hardware products, it’s crucial to rigorously assess the value each model delivers to customers. This evaluation will guide the choice of the most appropriate pricing model and assist in pinpointing the most effective pricing strategies and levels within that framework.

While adopting a specific pricing model among those reviewed does not inherently guarantee success or pose a barrier to value-based pricing strategies, some models naturally align more closely with value-based pricing than others.

The transition towards hardware plus software sales necessitates a thorough analysis of the value proposition. Customers are purchasing not just the hardware but the benefits it provides. Accordingly, the pricing model, especially the pricing unit, should reflect this benefit-centric perspective.

However, this approach should be adopted with caution to avoid misapplication. Implementing recurring models where they may not be suitable can stretch the strategy beyond its effective limit, emphasizing the importance of a nuanced understanding of each scenario’s unique demands and opportunities.

Strategic Considerations for Sustainable Revenue

If desirability is important on the one hand, financial viability for the business is equally important when looking at Hardware and Software pricing models. 

While recurrent models (subscriptions, platform, rental …) make the long-term product viability less of an issue, the situation is different for “buy once, use forever” models such as hardware with bundled software models.

A significant challenge of this model involves managing recurrent expenses, such as software maintenance, operations (for example, server costs), and the continuous evolution of software—all crucial for preserving the product’s value over time. Given the one-time purchase nature of hardware, companies have explored various strategies to secure a steady revenue stream that can support these ongoing costs:

• Planned Obsolescence and Recurrent Repurchase: One strategy is designing products with a lifespan that prompts consumers to upgrade to newer models periodically. Often linked to the rapid release cycles of smartphones, this approach maintains a continuous sales cycle but may draw criticism for encouraging consumerism and contributing to environmental waste. (Did you say iPhone?)

• Additional Platform Revenue Models: As an alternative, companies can cultivate a platform ecosystem around their bundled hardware-software products. Offering additional services, subscriptions, or apps that augment the core product enables companies to create continuous revenue streams. For instance, the Apple ecosystem, extending beyond the initial iPhone purchase, includes app sales, media subscriptions, and cloud services, all contributing to sustained revenue.

While the problem of recurring costs without recurring revenue is clear-cut—for example, supporting a companion app—the issue of ‘Planned Obsolescence and Recurrent Repurchase’ is more nuanced. With consumers increasingly focusing on sustainability, strategies that push for hardware repurchases rather than creating and capturing value through services could backfire significantly. This approach may initially seem profitable but can alienate environmentally conscious customers and potentially harm the brand’s reputation in the long run.

Not adopting a strategy for sustainable revenue can be equally problematic. Without continuous support for the software stack embedded in their appliance, manufacturers may leave users wondering how they will operate the machine in the future, presenting a risk of investing in a short-lived hardware solution (remember the story of Google Netst’s hub, back in 2016?)

With this exploration of the diverse hardware and software pricing models, we hope to help the reader recognize the breadth of options available. The integration of software with hardware opens up new avenues for improved monetization and facilitates a shift towards value-based pricing—benefiting both users and businesses. Nonetheless, taking this reasoning too far risks creating pricing models that, while appealing in theory, may amount to little more than wishful thinking. 

A checklist for new Pricing models of your Hardware products.

To synthesize our discussion, we propose a straightforward test to assess your pricing model effectively:

• Strategic Alignment: Does it support your overarching pricing and revenue strategy?
• Desirability: Is it desirable to your customers? Does it meet their expectations?
• Financial Viability: Is it viable for your company from a financial and operational standpoint?
• Feasibility & Simplicity: Is it feasible to implement for your company and to adopt for your customers, without adding undue complexity?
• Value Reflection: Does it serve as an accurate reflection of the value provided?
• Perception: Does it consider intangible factors, such as the perceived value of ownership? Does it come across as “fair” and justified?

Beyond hardware-specific pricing models, the strategies employed—be it value-based pricing, cost-plus, competitive, or skimming pricing—are the same available with any other product. And, just like with any product, the only ineffective strategy is the absence of a clearly defined one.

In the next Parts of this Deep Dive

In the next part of this Deep Dive, we will analyze the Energy industry, which is extremely well positioned to fully leverage new business and pricing models to monetize what historically have been pure hardware sales. With an increasing focus on renewable energies, leveraging smart pricing models in the Energy industry is a topic that shouldn’t be overlooked.