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Reformation in the Hardware Pricing World

The role of software is becoming increasingly important, and not just for traditional software companies. Perhaps this is nowhere more true than at hardware-focused companies facing the commoditization of their hardware. Hardware without software is nothing more than useless metal and plastic. But if the software is so valuable, why do hardware companies generate so little revenue from it?
Here are three recent examples in how hardware and related pricing models are being transformed:

  • Cisco announced at their December ’05 Worldwide Analyst Conference that it is re-casting itself as a services and applications vendor. It’s a far leap for a company known for selling hardware and pushing packets.
  • IBM sold off its PC business in 2005 because it was no longer an attractive part of its business. By 2004, Software & Services accounted for the overwhelming majority of IBM’s revenues. The PC (hardware) business had fallen to about 20% of IBM’s overall revenue–and its profit contribution was close to being financially insignificant.
  • Avid, the king of postproduction technology for the movie and television industries kicked off a new buying cycle in January with its line of products for creating HDTV programs. This signals a continuing evolution away from hardware to value-added software. Smarter software in this model processes the digital information before it ever sees hardware.

Is this the wave of the future? Is this the future of all hardware companies? We’ll have to watch and see. In the meantime, our pragmatic nature caused us to think about what needs to be managed as hardware-centric companies transform themselves into software and services vendors.
We believe the fundamental transformation is about defining the value of software in the economics and profits of the company. Most products are still fundamentally priced according to what they cost to produce. For many hardware companies, software began as simply a way of making the hardware work. Think device drivers. Gradually, software came to add considerable value to many types of hardware. Think Cisco IOS. For more and more companies, hardware and software remain interdependent, only the relative roles and importance are reversing. Where software used to enable hardware, increasingly it is the hardware that seems to be enabling the software. However, perceptions change much more slowly. Thus, we find increasingly valuable software being discounted ever more deeply in order to sell hardware that looks more and more like a commodity. This is not a sustainable model, but what can be done about it?
Here’s are some options for vendors:

  • Bundle. One option is to bundle hardware and software and move toward a services model. We find McKinsey likes this approach, but not all companies want to get in to the services business or are likely to be good at it. A more basic approach is to look at ways to better monetize the value of the software within the existing business model.
  • Charge by usage. Make the hardware the “give-away” and charge the customer for using the software. While we are not recommending that hardware companies follow the example of King Gillette and give away their hardware in order to make money on the add-on software–at least we are not recommending that everyone do this–we do recommend that companies make the effort to really understand the role and value of the software they provide.
  • Charge by software module. Focus on the software created and price according to the value offered by the software. The software model offers more flexibility in offerings. Instead of selling hardware and using software to enable / disable specific functionality, you may be better off selling a uniform hardware offering and using software to differentiate offerings. Of course, this only works if you charge for software according to its value.

There’s more than meets the eye

In the short term, any of the pricing model changes are complex as they impact nearly all parts of your organization. You will need to re-think how you develop hardware and software products. Sales compensation will need to be completely rethought, and smoother revenue curve generally causes a short term hit to revenue as you transition.
One practice Rubicon focuses on is called Optimization where we focus on Value Pricing for high-tech products. This is a method of pricing where companies determine how much the product is worth to their customers. The goal is to avoid setting prices that are either too high or too low. The value based model is a challenge for those used to traditional cost-based pricing approaches. Vendors and manufacturers that want to adopt value-based pricing approaches without trying to set individual prices for every buyer have to segment their customers into groups of companies with similar needs or patterns of behavior.
Learning your customer’s needs and the value your product offers is sophisticated work. But without it, you can end up leaving money on the table and give up profits that are available to your company.

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