2 Sep 2020

Image courtesy of Richard Borge/theispot.com

In his 1969 bookThe Marketing Mode, Harvard Business School professor Theodore Levitt immortalized a gentleman named Leo McGivena, who reportedly said: “Last year 1 million quarter-inch drill bits were sold — not because people wanted quarter-inch drill bits but because they wanted quarter-inch holes.”1 A half-century later, this insight is as compelling as it ever was — customers still want to buy meaningful outcomes (a particular sensation, a tangible benefit, or some combination of the two), not products and services. What’s changing is companies’ ability to become more accountable for those outcomes by helping customers navigate three critical checkpoints: accessing the solution, consuming (that is, experiencing or using) it, and getting it to perform as expected or above expectation.

Even so, most companies do not stake their success on these checkpoints. Instead, they sell quarter-inch drills and promise customers that the quarter-inch holes they desire will follow. Indeed, a revenue model focused on transferring the ownership of a product or service to the buyer may appear prudent because revenue accrues up front, and any risk associated with access, consumption, and performance is passed on to customers. But in reality it places an unnecessary burden on customers and ultimately shrinks the opportunity in the market. This contraction occurs when, for instance, customers are priced out or forgo a purchase because it is inconvenient, when they perceive ownership as too risky and decide not to buy, and when they resolve to pay less to account for the possibility that they will not make sufficient use of their purchase or that it will not perform as advertised.

Technological advances are enabling companies to rewrite the rules of commerce. Mobile communication, cloud computing, the internet of things, advanced analytics, and microtransactions offer sharper, more timely information that can illuminate when and how customers access and consume their products and services, and whether and how well those products and services perform. We call this information impact data — it enables companies to track and understand what happens to their solutions beyond the moment of purchase.

The way we see it, impact data — and the technologies that deliver and analyze it — is transforming corporate accountability for customer outcomes from a fashionable marketing slogan into a strategic imperative. Some organizations dismiss this imperative, hoping that it is another passing trend. Others (often intentionally) make their prices more ambiguous and thus less comparable across competitors, which impedes sound purchasing decisions on the customer side. These will not be winning plays in the long run. Instead, companies should start to embrace accountability for outcomes and change their revenue models accordingly before they are forced to do so by more enlightened competitors and disruptive startups.

In this article, we’ll describe three types of revenue models that can help companies win customers and drive growth in today’s increasingly transparent markets. The framework draws on insights from our respective academic areas of behavioral economics and operations, our research, and our ongoing interactions with companies. We’ll also provide guidance on developing and implementing the right revenue model for your company, unlocking the untapped market potential of your solutions, and capturing the lion’s share of the resulting value.

From Promises to Proof

With three revenue models, companies can progressively deliver access, consumption, and performance. One step removed from standard ownership (or transactional) models are what we call access models. These include subscriptions and memberships; they anchor payments to periods of time rather than physical goods or services. Next up are consumption models, which include unbundling, metering, and sharing; they not only facilitate access but also enable customers to pay only when they use a product or experience a service. Finally, performance models address all three needs — access, consumption, and performance — together by enabling customers to pay on the basis of the outcomes they achieve. In the past, pay-by-outcome agreements have been used in settings where performance is easy to quantify and monitor. In recent years, however, we have seen them taking hold in more complex arenas, such as health care, education, insurance, and even live entertainment.

Facilitating access. Access inefficiencies can be traced to physical and financial hurdles. Physical hurdles include conditions like stockouts and inconveniences, such as when a purchase requires too much time or effort to consummate. Subscription services, such as HP Instant Ink and the Dollar Shave Club, are designed to lower or remove these hurdles by eliminating much of the pain associated with buying printer ink and razors, respectively, such as running out of them and running out for them.

Less obvious physical hurdles are the unwanted accumulation of expensive or idle assets and the disposal of assets, as well. Disposal is not always easy, especially when products contain toxic materials or are relatively large. Signify, formerly Philips Lighting, addresses this challenge by offering “light as a service” to corporate clients such as Schiphol Airport in Amsterdam and steel and mining giant ArcelorMittal. Under these contracts, Signify retains ownership of all fixtures and installations while the client pays for the light it uses. Similarly, Ikea is testing ways to shift the standard ownership model for flat-pack furniture toward a rental model to meet customers’ needs for affordability and sustainability.

Financial hurdles to access arise when customers lack the capital to purchase a product outright, such as a fleet vehicle or household furniture. Mobility subscriptions — such as Care by Volvo, which includes a car payment, insurance coverage, comprehensive maintenance, and additional digital services in one monthly fee — are increasingly popular because they ease this constraint. Another financial hurdle can arise when customers want an assortment of items that are collectively expensive, such as a music or film library or a stylish wardrobe. Spotify and Netflix are household brands in this space. In fashion, successful upstart Rent the Runway offers three monthly plans for designer clothing and accessories that let members decide how many items they rent at one time.

The common denominator across these and other access models is that revenue accrues as a function of time. At first glance, these are familiar, long-established renting and leasing models, but a host of recent technological advances pertaining to monitoring, prediction, logistics, and payment have extended their applicability across most sectors of the economy. Today, companies can lower the barriers to entry in a market by transforming almost any product into a service with enhanced convenience. Indeed, XaaS (everything as a service) has become the mainstream revenue model in the software and tech industries, rendering the licensed software CD obsolete.

Consume and pay. Consumption inefficiencies take many frustrating forms. They occur when an asset — say, a car, apartment, or medical device — either sits idle for a large portion of its useful life or is not acquired in the first place because customers cannot justify owning it. Automobiles, for example, sit idle about 95% of the time — a disturbingly low level of utilization for such an expensive product. Consumption inefficiencies also result when customers must purchase a predetermined package size that is too small or large given their needs. Finally, they occur when some barrier, such as a related risk or the price of a complementary good, prevents customers from using a product or service they already own. Companies have three options for tackling these problems: unbundling, metering, and sharing.

In the past, physical constraints made it economical to bundle offerings together (songs on a compact disc, articles in a newspaper, and so on). But digital technologies changed the economics: Now, companies can digitalize certain offerings and deliver them to match customers’ actual consumption patterns. The recent experiences and struggles of traditional media companies with digital transformation can be traced in large part to this push toward unbundling.

In metering models, a company supplies the product but charges customers only for using it. The German company Winterhalter, which specializes in commercial dishwashing machines, racks, detergents, water treatment supplies, and services, adopted such a model with a program it calls Pay Per Wash. Instead of selling or leasing its products, the company charges customers for completed wash cycles. Similarly, Thermo Fisher Scientific’s next-generation genetic analysis systems feature “pay per lane” DNA sequencing. The platform is the first to enable laboratories to run just one, a few, or all sequences and pay only for the reagents used in the sequences they choose.

In sharing revenue models, sellers either manage or join a platform to distribute a product or service across many interested users. These collaborative-consumption ventures are growing at an impressive rate because they not only reduce waste for customers but also improve the utilization of assets — and, therefore, the return on investment — of asset owners. Uber and Airbnb are obvious examples of this. So is logistics startup Flexe, which matches retailers with warehouses that have excess space, and SpotHero, which helps drivers find open parking spots in crowded cities by pooling the spare capacity of its participating partners.

Perhaps the biggest impact of sharing models, however, is felt in less-developed and rural economies, where information technology enables the sharing of critical assets, such as farming equipment, on a much larger scale than was previously possible. One example is Hello Tractor, whose platform enables farmers in Nigeria to access farm machinery on a pay-per-use basis while providing the security that the owners of the machinery demand through remote tracking. Similarly, Trringo, a tractor and farm equipment rental service in India, strives to make these scarce resources easily accessible and affordable to farmers across the country. These examples underscore the inherent relationship between initiatives that tackle consumption waste and those that tackle access waste. While access to farm equipment does not guarantee consumption, there is no consumption without access.

Each of these models aids customers by removing barriers to the use of solutions and activating dormant or underutilized capacity. But consumption models do not guarantee outcomes: They may or may not produce the performance customers seek from a product or service.

Performance, guaranteed. Value delivered is the ultimate outcome. In B2B markets, delivery of value implies that a particular solution improves the profitability of the customer, but agreeing to a contract based on profit impact can be a challenging task. For example, it is often hard to isolate the influence of a single contributing factor when a complex mix of factors are in play. In B2C markets, value combines impressions or sensations with tangible benefits, and research technology has not yet progressed to the point where a company can identify and measure the changes in brain activity that signal the overall satisfaction individuals derive from everyday products and services at scale. Even if this could be achieved, social norms might render collecting and using such intimate impressions impossible. In both contexts, the practical alternative is to settle on a proxy that represents value accurately, can be quantified by the company, and, in turn, can be verified by the customer. Let’s consider three examples.

Instead of selling explosives, Australian multinational Orica adopted a revenue model based on the quality of the blasts it delivers to customers. Its rock-on-ground contracts are possible because the size of the broken rock that results from a blast has a significant impact on the operating cost of a mine (greater fragmentation makes it cheaper to handle and dispose of unwanted debris) and therefore a mine’s profitability. These contracts have become a defining characteristic of Orica, both internally, in terms of innovation and product development, and externally, in terms of its ongoing relationships with customers and positioning in the market.

In health care, Roche, a Swiss pharmaceutical multinational, is developing personal reimbursement models, a clear break from the tradition of charging for a pill or treatment — the legacy ownership model in the industry. Under this new model, Roche acknowledges that the effects of medications can vary by indication (that is, the patient’s specific condition), combination with other medications, and response, and customers are charged in light of that reality.

Lastly, Teatreneu, a popular comedy theater in Barcelona, Spain, brought a performance-based revenue model to live entertainment by charging patrons according to how much they enjoyed it. Customers entered the theater free of charge in its pay-per-laugh system, and a facial recognition system mounted on the seat back in front of them registered each time they laughed during a performance. Each laugh was priced at 30 euro cents, with a maximum charge of 24 euros per show, or 80 laughs, so that “no one would need to cry because they laughed more than they could afford.”2

Performance models represent the cutting edge of outcome accountability. Such models charge directly and as precisely as possible for the value or utility that customers derive from a purchase. There is no need for intermediate measures — outcomes are monetized, and access, consumption, and performance inefficiencies can be minimized.

Walking the Outcomes Walk

The existential question for company leaders who are uneasy about the new technologies and disruptive competition that may be threatening their livelihood is, What are we asking customers to pay for? The hard truth about how a company can successfully earn revenue lies in how leaders answer this question, not in the promises being made in advertising, online, or on sales calls. Evolving your revenue model requires a different mindset and new competencies. In particular, there are five critical questions to answer:

1. What do we mean by outcome? The starting point is clearly defining outcome in the organization. To be suitable as the basis for a revenue model, an outcome must be:

  • Meaningful to customers. This may seem obvious, but many companies still lapse into navel gazing — focusing on product or service features in which they have an inherent interest or technological advantage, even when these characteristics are irrelevant or matter little to customers. (See “The Quality Paradox.”)
  • Measurable. The organization and its customers must agree on the parameter(s) that best reflect outcomes, and when and how these will be captured.
  • Independent. Neither the company nor its customers, nor third parties, can tamper with the measurement of the outcome to their benefit.

Beyond this, leaders have to consider the number of outcomes they want the organization to deliver and the degree of control they have over each outcome, as these factors can force trade-offs between complexity and financial returns. The right number of outcomes relates to the heterogeneity of customer needs and wants in your market. This determines whether you can serve the market with a single outcome or should champion multiple outcomes. Clearly, the company that delivers multiple outcomes is likely to require greater coordination and face greater challenges along many dimensions, from product development and operations to marketing and communications, but in return it often serves — and monetizes — more customers.

At the same time, outcomes tend to be less complex when their delivery depends only on the selling organization or when they can be broken down into a small set of clear, manageable steps. Conversely, outcomes tend to be more complex when they involve intermediaries and customers themselves or when the underlying process is unclear or difficult to control. Ultimately, complexity here is an issue of how many moving parts a company must track and coordinate to implement and maintain an outcomes-based model. For instance, the number of contributors is important because if a market evolves to the point where customers pay according to some measure of performance, then the team responsible for delivering that performance needs to share the resulting revenue.

2. What happens after our products and services reach customers? “How many miles does it have on it?” is one of the first questions a mechanic will ask when someone brings in a vehicle for service. It is also one of the most important questions a potential used-car buyer will ask. This single number sets expectations on wear and tear, repair needs, warranty costs, residual value, and more.

What mileage cannot do is tell us anything about the car’s usage or performance with certainty. Once the vehicle leaves the dealer’s lot, the rest is a black box of sorts. Odometers cannot tell us who sat in and used the car, the conditions under which any mile was driven, and how well the vehicle performed for each individual mile. Odometers also offer no insights into miles not driven because of a breakdown or other mechanical or technical issues with the car.

The missing link in understanding the value customers ultimately derive from their purchases is impact data. Over the past decades, customer-focused organizations have made important progress in understanding customers’ needs and wants, as well as mapping their purchase processes and experiences. (See “Beyond Needs and Journeys.”) However, prior to the widespread availability of information technologies, a company could not efficiently observe customers’ post-purchase behavior directly, completely, and in real time.

This is no longer the case. Impact data enables companies to take customer focus full circle and define effective revenue models. Without impact data (in combination with traditional information on needs, wants, and journeys), companies would have no reliable means of identifying the access, consumption, and performance inefficiencies that can plague traditional revenue models based on ownership. Accordingly, they would have no reliable means to hold themselves truly accountable for the value they can offer customers.

One big consideration is the extent to which customers want to share their impact data. While collecting information on customers’ needs, wants, and decision journeys is typically not invasive, collecting impact data is. It can reveal facts, patterns, tendencies, and behaviors that customers purposely keep to themselves. Any data-driven quest for a better revenue model may feel like theft to customers unless companies protect their privacy and foster trust. Protecting privacy involves putting the appropriate safeguards in place to keep data confidential. Building trust involves reassuring customers that the company collects and uses impact data for purposes that are ultimately in their interests.

3. Are our products and services optimized for impact? A surprising but critical byproduct of answering the two questions above is that leaders suddenly have a sharp, unequivocal metric for assessing innovation. Innovation does not always serve the customer. Sometimes, even the most customer-obsessed companies take their eyes off the prize and look inward for inspiration — seeking the most cost-efficient solution, pushing features that internal factions desire, or making compromises that deliver an initially higher return on investment.

Answering this question allows leaders to review and adjust the current product and service portfolio. It enables them to better align their innovation efforts with the way customers derive value, and it motivates or pushes them to strip away internal distractions and focus on (re)designing for impact.

4. How do we engage customers who participate in the creation of value? Companies that adopt a performance-based revenue model are assuming the risk associated with the delivery of value to customers. Bearing this risk is not an issue if the company is confident that it can consistently create quality outcomes on its own. But what happens when customers are active participants in the creation of value? For example, a new drug may provide superior relief, but this depends on whether a patient complies with instructions on when and how to take the medication. Likewise, a well-designed course or educational platform may provide superior learning, but this outcome depends on whether a student puts in effort and follows the syllabus.

When customers participate in value creation, the ensuing risk may be excessive to the company, unless it can offer the right incentives to ensure they make the proper contribution. Perhaps the simplest way to motivate customers to behave is to reward them proportionally for acting in a manner that improves the underlying quality of the outcome. In other words, as the value pie expands in the exchange between the company and the customer, the customer should benefit from an increasingly larger slice.

Aside from financial rewards, companies have three options to mitigate the risk they have assumed from customers. First, they can enter into formal contracts so that both the company and its customers recognize their rights and obligations in a pay-for-performance exchange. Second, they can use elements of gamification — competition, a point system, or some other motivational mechanism — to nudge customers toward the behaviors that make the greatest contribution to outcome quality. This is particularly relevant for consumer markets and, for example, is a feature of many modern pay-as-you-drive auto insurance products. Finally, the company can extend its operations and take over the activities that are typically undertaken by customers. This option makes sense whenever customers lack sufficient know-how, skills, or resources to ensure a result on par with what the company could provide — something that we see frequently in industrial markets, where many leading suppliers have reinvented themselves as solution providers.

5. What is the transition plan? Changing the way your company makes money is not easy. The nature of your product (physical versus digital), the pace of technological change in your market, and beliefs about how long it will take your customers to change habits are likely to be important factors in deciding when to make a move. When the time comes, you will need to choose between the radical approach of launching the new model while switching off the old and easing into a new reality by operating multiple revenue models for some period of time. Neither approach is a walk in the park, and both depend on your ability to manage expectations inside and outside the company.

The first approach is risky, as you put all your eggs in one basket. And it is almost guaranteed to trigger short-term losses as transition costs quickly accrue and revenue is postponed from the point of purchase to some point in the future — periodically upon access, upon consumption, or upon performance, depending on the model selected. For a public company, these effects can alienate investors unless they understand (and agree with) the strategy and recognize the temporary nature of the downturn.

The second approach appears safer but is by no means risk-free. When given a choice, existing customers are likely to switch to whichever revenue model makes them better off. Because this results in cannibalization, the short-term impact on sales to existing customers will be negative, which can create friction inside an organization that is caught off guard. Accordingly, it is important to set expectations and establish clear ground rules if the active revenue models are led by different teams, to avoid internal competition for the same customers. Prices must also be carefully calibrated to minimize cannibalization.

Irrespective of which of these approaches you take, the organization will soon need to ask itself what the business would look like if it dealt with customers on the basis of a changed revenue model. Imagining this scenario requires creativity and the proper perspective. What is the right benchmark when a company judges a future course of action? Although it is often the case in practice, the point of comparison (the control group, so to speak) should not be the status quo — as expressed by current performance in terms of the key financial and commercial indicators. This confers a false sense of security. Instead, the organization should draw a comparison between multiple futures, contrasting the likely consequence of the planned change in revenue model with the likely projected consequence of inaction (that is, the decision to maintain the existing revenue model). Moreover, the proper time horizon for this comparison should not be a short-term one, and any anticipated dip in sensitive metrics, such as number of customers, revenue, or profitability, should be viewed as an investment in a more sustainable future.

Companies that earn their living by selling products and services tend to presume that there is a direct and strong link between the amount of money customers spend on a specific offering and the achievement of the outcomes they desire. But this is often not the case, and the consequence of any disconnection is borne by the customer. Ownership in and of itself does not enable access, nor does it imply consumption. And it certainly does not guarantee performance.

When a company truly possesses a superior product or service, especially when it has the resources to innovate and maintain a technical advantage, it can do itself and its customers a disservice by stubbornly holding on to a revenue model based on ownership. This company is not properly pricing its competitive advantage. Indeed, claims of superior customer value are cheap talk unless companies back them up by not only delivering the solutions customers need and want but also adopting a revenue model that aligns its success with that of customers. This should be intuitive to companies — especially those that claim to put customers at the heart of their operations and have spent the past several decades sharpening their ability to gather meaningful insights about their motivations and decision journeys.

We urge you to act on this intuition. Not every company can or should rush to implement a performance-based revenue model, however. Performance models may be the final destination, but they are not necessarily the next destination.

Even so, companies should recognize that revenue models anchored in the mere ownership of a product or service are patently inferior. Making the transition to better alternatives anchored in time or use is within reach for most businesses — so they can start pursuing access and consumption models now.

Read the full article here.
This content was originally published by MIT Sloan Management Review. Original publishers retain all rights. It appears here for a limited time before automated archiving. By MIT Sloan Management Review

Covid-19 – Johns Hopkins University

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