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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
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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
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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
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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.
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