3. Putting a price to Solutions

3. Putting a price to Solutions - Q3'01_Solutions-Part 2...

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Unformatted text preview: Q3'01_Solutions-Part 2 6/21/01 10:51 AM Page 94 94 T H E M c K I N S E Y Q U A R T E R LY 2 0 01 NUMB ER 3 Putting a price on solutions Eric V. Roegner, Torsten Seifert, and Dennis D. Swinford Remember: the whole is worth more than the sum of its parts. S etting the right price for a solution is really crucial: too high, and customers will meet their own needs; too low, and suppliers won’t get paid for the value they are delivering and the effort that went into it. How can suppliers figure out the right premium and the pricing model that will suit their customers? A supplier needs to know precisely what a solution is and to be candid about whether or not it is offering one (see “Making solutions the answer,” in the current issue). A solution isn’t simply the bundling together of related components. Nor is it the mere integration of products and services provided by a customer, even if the supplier itself also provides some of the components: a software integrator that provides a sound card in the process of installing software doesn’t instantly become a solutions provider. A true solution is defined by and designed around a customer’s need, not around an attempt to find a new use for a supplier’s current products. And only as the relationship between supplier and customer becomes more collaborative in defining the customer’s need—designing the product and service components and integrating the whole into a distinctive offering that is better than any alternative—can a supplier be said to offer a true solution (Exhibit 1). Suppliers can earn a premium in any role. But solutions providers are due the largest premium because they create a new way for components to work together to enhance the solution’s overall functionality beyond that of the next best alternative and also spare the customer from the need to deal with multitudes of suppliers and to integrate components and services itself. Add to that the value of a collaborative relationship, in which the solutions provider assumes some portion of its customer’s risk and guarantees responsibility for part of the business. Finally, solutions providers earn a greater margin because the value of the integrated whole exceeds the value of its Q3'01_Solutions-Part 2 6/21/01 10:51 AM Page 95 PU T TING A PRICE ON SOLU TIONS discrete components; indeed, by definition, the margins for a solution’s individual components are not transparent. The size of the premium earned varies depending on the value delivered to each of the customers, but the process of setting a price is similar for all of them. The experience of InfraSolv, a network infrastructure solutions provider, shows how one company arrived at its price. InfraSolv developed a new infrastructure solution comprising hardware, software, maintenance, and professional services—a combination that made it possible for its customers’ networks to handle data more efficiently and flexibly. Each customer could use different subsets of features to meet its needs. To settle on a price for a customized solution, InfraSolv went through three steps. First, it developed a broad price range based on a standard configuration that would meet an average customer’s needs and also identified the maximum and minimum price levels for such a solution. The maximum price was calculated by taking the net present value derived from the functional, process, and relationship benefits that would accrue over the lifetime of the solution compared with the value to be had from the legacy system. The solution’s benefits included operating and capital-cost savings as well as increased revenue. From that figure, InfraSolv subtracted the customer’s incremental operating and capital costs accrued over the same period. It then added the impact of EXHIBIT 1 Solutions are a cut above High Component specialist: Provides discrete products, services, or both to specific customers Solutions provider: Packages and integrates components, bundles, or both to deliver a complex turnkey solution meeting a specific customer need Degree of integration Integrator: ‘Glues’ together components to fulfill a customerspecified need Bundler: Assembles groups of components for specific customers Low High Low Degree of packaging or bundling 95 Q3'01_Solutions-Part 2 6/21/01 10:51 AM Page 96 96 T H E M c K I N S E Y Q U A R T E R LY 2 0 01 NUMB ER 3 its offering compared with that of a competitor’s next best alternative, which was at least six months behind InfraSolv’s in development. (Delay alone could have cost customers that waited for the competitor millions of dollars in lost revenue, and the promised alternative would offer limited functionality when it did arrive.) This figure—combining the value offered by the solution itself and the incremental value it promised over competitors’ solutions—represented the maximum in the starting range. InfraSolv then did a bottom-up analysis to check the actual cost of delivering the solution with all the constituent pieces (including R&D and recovery for software development) and added a margin sufficient to recover allocated overhead and cost of capital. That total became the minimum price. Clearly, if the bottom-up analysis had produced a minimum price that exceeded the maximum value—or left only a narrow range between them—the solution would not have been viable. The next step was to refine this broad range with an analysis based on what InfraSolv hoped its pricing level would achieve. It wanted wide market penetration to establish a base for future expansion, for example. In addition, it knew it would need to accommodate its customers’ perception that adopting an unproven technology was risky. Both factors suggested lowering the maximum price. Other factors—such as the desire of InfraSolv to preserve its reputation for superior technology and to account for the proprietary and intellectual-property-rich components, as well as the advantage a customer would gain over its competitors by purchasing the solution early—elevated the minimum price. Finally, InfraSolv picked a price point for individual customers by analyzing the specific customized elements and the value each customer attached to them. As Exhibit 2 shows, an intimate knowledge of a customer’s business system, economics, and risk/return profile is crucial. Once InfraSolv had decided on a price, the company needed to communicate both the value and the price to the customer. This was tricky because customers were used to getting software free when they purchased hardware. However, the value of InfraSolv’s software had outpaced the value of the hardware. Had InfraSolv continued to provide its software free of charge, it would have tied the extraordinary new capabilities of its software to a hardware product with a declining market price. InfraSolv dealt with this issue by presenting the company’s entire hardware, software, maintenance, and professional-services value proposition directly to its customers’ senior management, bypassing the usual communications with purchasing agents about individual components—negotiations that would have risked undermining the value of the integrated solution. InfraSolv’s approach is the Q3'01_Solutions-Part 2 6/21/01 10:51 AM Page 97 PU T TING A PRICE ON SOLU TIONS EXHIBIT 2 InfraSolv solves for customer value Number of new system’s users, frequency of use Revenue from new system + Revenue with new system Marginal revenue – +/– Customer value of solutions offer Fees Revenue from old system + User fee, access fee x + Add-on product fees and services Revenue from related products and services Revenue from old system Marginal cost +/– Marginal investment (other than for new system) Revenue without new system + Revenue from related products and services Source: Disguised example; McKinsey analysis best because only senior management can authorize strategy, and a solution is typically a strategic answer to a company’s business need. Suppliers must also explore which price-model option will enable them to extract the most value. At the core of any price model is the connection between a customer’s method of paying for value—with a one-time up-front payment, a series of payments as value is delivered, or pure period (monthly or yearly) payments—and the manner in which value is delivered. Since solutions deliver value over time, a combination of methods can be used, accommodating risk and revenue sharing, pay per performance, and scheduled payments as features are completed successfully. In the metals industry, for example, one supplier designed a solutions offering around a new technology for recycling metal. Price-sensitive customers could easily afford— and justify to their shareholders—the cost of the solution because payment was linked directly to financial performance through a higher recycled output per unit of raw material. Eric Roegner is a principal in McKinsey’s Cleveland office, where Torsten Seifert and Dennis Swinford are consultants. 97 ...
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