The Underappreciated Strategic Implications of Digital Products

We have heard the prognostications, repeatedly, that digital products and services are “changing everything.” What started with music has been echoing across industries, upending incumbents and carving new pathways past middlemen to end users. But there is a more profound, and yet underappreciated, strategic dynamic underway. You can hear its faint undertones here and there, but the change marching toward us has not yet fully arrived.

Sure, we know that electrons travel faster than atoms, data is proliferating, and our analytical capabilities allow us to do ever more with that data. But so far, we have mostly been considering the first-order changes these allow. What we should appreciate is that proliferation of digital products (apps, information services) and digitation of physical products (smart watches, cars) are not just turning physical value into digital; they are eroding a fundamental economic assumption that underpins most of the global economy.

Now, despite having a PhD in economics, I would not call myself an economist. That said, I was force fed enough about basic microeconomics during my program. I took Econ 101 three times: first at Yale during high school as part of a program that lets local high school students take classes at the university, then Wharton in college, and, because Columbia didn’t trust either one of them, again in grad school.

The economic theories taught in each class rested on the same foundational graph. On the Y axis a line launches from the point of fixed cost (FC) and rises always upward at a slope equivalent to marginal cost (MC). That MC must be positive is as universal an assumption as gravity attracts or the Earth is round. But that line is flattening. And this is starting to open up exciting possibilities for how we design businesses.

In our recent interview with Jean-Manuel Izaret (or JMI, as he goes by), head of BCG’s Marketing, Sales, and Pricing (MSP) practice, he pointed out that the marginal cost of producing a digital good is effectively zero. Once I’ve created one digital book, online course, digital skin, or WordPress plug-in, I can sell the next one or the next 1,000 at no meaningful additional expense.

Now, you may not be selling a digital product. But the value your customers pay for is likely increasingly digital. They used to buy your doorbell because it looked aesthetically pleasing next to their door, your watch for its craftsmanship, or your lights because of their efficiency. Now your customers increasingly choose you because your doorbell can see, your watch can track, or your lights can connect to their phones. As more of the value your product delivers becomes digital, the lower your blended marginal cost falls.

We are headed toward a world of low – and in many cases no – marginal costs. Let’s imagine that for a moment. How would you price your product if you had no marginal cost to recoup for producing it?

Michael Porter famously proposed that strategists have two generic options to choose from: cost leadership or differentiation. Choosing the cost leadership path in an efficient market eventually leads – as Adam Smith, 18th-century Scottish philosopher and economist known as the father of modern economics, showed 200 years earlier – to a price equal to marginal cost or, in our pending scenario, a price of zero. A free product.

This is not necessarily a losing strategy. You can always make your money somewhere else. U-Haul doesn’t profit from truck rentals but instead sells you high margin packing supplies while you are waiting in line. Grocery stores don’t profit from milk but from the products you pick up on your way to the milk corner (strategically placed furthest away from the entrance).

But for this strategy to work in a digital world, you must have some other differentiated product to sell. Porter’s second generic strategy – differentiation – becomes tantamount.

There are many ways to differentiate. One of the most exciting in a zero-marginal-cost world is price.

Click here to listen to Kaihan’s perspectives on this topic on YouTube.

Redefining Pricing and Business Models in the Digital Age

In my interview with BCG’s JMI, he introduced some exciting possibilities for companies looking to differentiate with price in a digital world. I’ll summarize his points here:

  1. In the past, all products had a marginal cost, so we defaulted to pricing per unit (a bundle of corn, a loaf of bread, pounds or kilos of coal).

  2. But as margin costs reduce, we can think of other units of price. For example, per month (Netflix), users (Salesforce), mile (Rolls-Royce selling “propulsion as a service”). The entire “as a service” movement which has upended media, software, and other industries is simply a change in the basis of pricing.

  3. So, how do we pick a new basis of pricing strategy for digital? We look at when or where our customers’ “willingness to pay” (or WTP) changes. If I am stocking up on salt for my kitchen for next month, I have no urgency and will buy the least expensive bag I can find. But if it’s 6am, I have to get to work, and my driveway is frozen over, I need salt pretty badly, and I’m willing to pay a lot more to anyone who can get me salt right then and there to melt the ice.

  4. The more proximate my customer’s payment is to the value they receive, the more they will be willing to pay. Rob Wolcott and I are publishing a book in May about this “proximity” concept (pre-order the book here), showing that across industries we are moving into a world in which value is produced and delivered ever closer to the point of the demand. To see the power of proximity in pricing strategy, consider how much investment bankers make vs. lawyers and accountants who work equally as hard. The bankers’ payment, being a percentage of proceeds, is paid at the time the client collects the proceeds of their offering. At that moment, the clients’ willingness to pay is the highest. Lawyers and accountants submit invoices they must often fight to collect weeks or months later.

  5. With digital components included in our products, we can now customize at zero cost. Let’s say you sell a coffee mug and you add sensors and a heating element to make it a “smart” mug. You could sell it as a regular mug for one price. Or you could sell it as a “stay warm” mug that retains its heat for an upgraded price; as a “get a head start in the morning” mug that turns on at the time the customer schedules it for, and you could charge for each time they use it; or as a “health tracker” mug that measures how much and how often a customer drinks, where you charge a monthly subscription.

  6. Changing your pricing model (the basis and timing) can completely change your business model. Salesforce didn’t just price differently, they created Software as a Service (SaaS). Netflix didn’t just rent movies per month instead of per movie, they created the entertainment subscription market. By rethinking our pricing model, we have the opportunity to transform our businesses and our industries.

Creating Digital Customer Engagement

Let’s elevate the implications of digital one step further. My favorite book on digital strategy this year is The Future of Competitive Strategy by Mohan Subramanium. One of several intriguing concepts he introduces is the idea of a “digital customer.” Barnes & Noble has mostly physical customers who may spend an hour in a store but only generate one digital fingerprint for the company (at checkout) if they buy something. Amazon has digital customers who may spend an hour on the site and yet, even if they buy nothing, generate hundreds of digital fingerprints. Think of your products and customers not as products and customers but rather as sources of data.

Going back to this hypothetical coffee mug example, what if the mug was simply a way to get data? What if you were in the business of data and happened to choose a coffee mug as your measurement device? This allows you to explore charging entirely different stakeholders by asking “who else benefits from this data?” You could, say, sell the mug to a healthcare provider or fitness trainer that gives it for free to their clients as part of a home monitoring program. The possibilities are endless.

Rethinking Innovative Pricing Strategies

There is so much more to unpack here, so many implications which we may get into in the future. But for now, to rethink what digital may make possible for you, ask seven questions:

  1. How much of the value that your customers pay for is physical vs. digital, and how could you increase the value you deliver digitally (e.g., adding sensors and a Wi-Fi antenna to a coffee mug)?

  2. When customers use your product, how does their willingness to pay (WTP) change? When is their WTP the highest?

  3. What new units of pricing might you consider?

  4. What would it look like to put the moment when people pay in closer proximity to the moments of high WTP?

  5. What if your product was not a product but rather a tool to create a digital customer and capture data? How might this change who pays?

  6. Think about combining three pricing dimensions – pricing unit, pricing proximity, and who pays. What combinations offer the greatest potential?

  7. If you chose this new pricing strategy, what business would you be in and how would that kind of company act differently (e.g., how does that kind of company organize, recruit, operate, market, brand, partner)?

Image courtesy of CNN