Tuesday, February 09, 2010

Enterprise Software Pricing - what should be the price of a product?

Feb 09, 2010

How do you price something as amorphous as enterprise software? I still remember a steel company customer of mine telling me about the incongruity of it all. They had written a check for a million dollars to buy software to run their factory. This was their first major software purchase through the line of business organization, in this case the production folks. The production folks pay a million dollars to get a furnace or heat treating machine two stories high for less than a million dollars. For the software purchase of a million dollars, they got two floppy disks and a manual of 200 pages. I can understand their reaction.

With its low marginal cost, pricing enterprise software like any software product has always been a challenge. Slowly the best practice has evolved to differential pricing and value based pricing. Differential pricing of course is selling the same product to different customers at different prices. Value based pricing is where a vendor and a customer agree on some price based on the value delivered for high ticket enterprise software. Of course, this is true whether the transaction is an upfront license model or a subscription model.  Here is how I think about the value pricing model.

The expected price for the solution is a small slice of the expected value from the software for the customer- increase in profit if the solution is implemented instead of doing nothing.  The size of the slice depends on the probability of achieving the benefit, what are the alternatives, and how much effort going into achieving the results. Let us walk through each of these:

Expected benefit: What is the profit impact of the software during the expected life of operation compared to doing nothing?  The expected life of usage of the software will be based on a perception on how fast technology is changing and how soon the customer will have to rip and replace that to get to the next level of performance. On the flip side, enterprises can feel that they are at a competitive disadvantage because competitors are leveraging certain capabilities and have an urgency to protect their franchise by implementing the solution. Even this can be translated back to the profit impact. So for simplicity, I will leave it as "profit impact of the software during the expected life of the software."

Probability of achieving success: Each industry has its own unique dynamics and processes. Each company within that industry has its own differentiation to protect. So the success at one company doesn't translate directly to an assurance of success at another company.  On the other hand, a body of work showing success at different types of companies in the industry or at least companies in other industries improves the perception of the probability of achieving success. A start up or a new product idea has a significant challenge here and will have to depend on early adopters who feel that they have better success with new technology than their competitors.

Alternatives: If the customer perceives the solution as differentiated and doesn't see a lot of alternatives, then they would be willing to pay more for it than something they perceive as commodity available from multiple vendors. Even though something might give a lot of value to them, if there are multiple alternatives, then what the customer is willing to pay for it gets driven to near zero.    

Internal resources for deployment: There is always some amount of effort on the customer's side to get the solution deployed. For some solutions, the change required is very high and that needs to be accounted for in what the customer is willing to pay for a solution.  

How this gets manifested in the "standard price list" and how does this price get negotiated is a discussion for other posts.

What are the other factors that go into the price equation for enterprise software?

Karthik

2 comments:

  1. There are two sides to the pricing equation - the enterprise buyer's side and the technology vendor's side.

    From a buyer's perspective,
    a) he looks at his opportunity cost (enterprise software reduces his operations costs, wastage, etc), so he must have it. More than anything else, the choice is based on cash and capital budget availability
    b)technology menu - this is pretty much like going to a Vegas casino and deciding where do I try my luck - blackjack, poker or roulette. Data Mgmt, Order-to-Cash, SCM or Business Intelligence.
    c) make-or-buy - depending on his inhouse expertise, long term strategy, IT as a competitive differentiator(Leaders tend to make, followers tend to buy), proprietary processes(Walmart), commodity/niche technology.

    From a vendor's perspective,
    a) Upfront development cost for a new product should be allocated across an estimated sales over lifecycle(factoring in estimated competition, market adoption, etc)
    b) Ongoing development and SG&A allocated over the specific product should be identified
    c) Depending on the pricing chosen (from perpetual license to some combination of license+annual maintenance+services+upgrades or SaaS) the cost can be estimated.

    Finally, based on external factors like state of the economy and technology, the pricing can be either closer to Vendor's Cost giving wafer thin margin OR closer to Buyer's Opportunity Cost (offering wafer thin benefits to the buyer). If market penetration is the strategic objective (early days of APO), the pricing could be below cost and subsidized. If quality leadership is the objective, then pricing could will leave little benefit on the table (early days of i2 maybe)

    One challenge with new solutions is the pioneer enterprise buyer will typically have the same cost of in-house development as opposed to having a software vendor custom develop it, especially if bulk of the information is coming from the enterprise processes. This is inherently a lose-lose situation.

    Innovations (specific to an industry or a business problem) coming from academia or within a software vendor when simultaneously presented to the key industry participants (top 5, top 10 players) present a case for immense success especially when the industry is NOT heavily concentrated (top 5 firms have less than 50% market share). Then the software vendor's side of the equation comes into play of how quickly replicable (or otherwise patentable) this innovation is, and how many competing software vendors are there in the market. That decides if its a worthwhile investment to make.

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  2. Karthik,

    Interesting reading.

    Given my academic bent, the following came to mind: Given the ubiquity of enterprise software and the voluminous data gathered on everything, would it be feasible to track the value of the product to the customer over time, and collect a fraction agreed upon at the time of the sale? This could be complementary to other pricing models.

    Madhavan

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