Innovation: How to get a return on the investment from building a digital product?
One of the most important questions of the opportunity assessment questionnaire we saw in the previous chapter is the question: “How are we going to measure success and make money from this product?”. It deals with two subjects: metrics and revenue. We’ll see about metrics in the Growth: Be a data geek chapter. Now let’s talk about revenue.
What are the costs of developing, distributing and operating software?
Every software development has a cost. When this software is a digital product — that is, a software that has users — the product has, in addition to the development cost, the operating cost, which is the cost of getting that software to users and depending on the type of product, the cost of storing data from these users.
Before the internet, software products were sold in boxes with manuals and floppy disks, or installation CDs. The revenue came from selling these boxes with the software. Some companies even charge an annual maintenance fee, which gives customers access to newer versions as they become available.
This digital product runs on the customer’s computers, meaning that all operating costs are his responsibility. The manufacturer recommends a minimum equipment configuration to run this software and the customer is concerned with owning, configuring, and maintaining this equipment.
In addition, administering this digital product is also his responsibility, as well as ensuring that it is running on equipment with sufficient disk space, sufficient memory, and that the generated data is secured and backed up. Revenue from the sale of this software product serves to pay for its development and distribution costs.
With the internet came the possibility of offering software to be used remotely, that is, it became possible to use software that is no longer running on the client’s equipment and does not need to be managed by it. This is what we are calling here a software product. In this new commercialization model, there is not only the sale of the software but also the sale of the service of its operation. Even smartphones apps, which run on users’ phones, have mostly some online component, that is, they search and store data on remote servers, which will also bring operating costs.
That is, every digital product has costs to develop a product plus costs to operate it. To cover these costs, you need to have some kind of return on investment to build the product.
Digital Product Revenue Types
Basically, there are 3 ways to monetize a web product:
USER PAID REVENUE
It is the model used in most business digital products, such as products offered by Locaweb, Google AdWords, MailChimp, and more. In this case, the revenue comes from the periodic payment (monthly, yearly, etc.) for the use of the digital product. Another very common option is pay-per-use (I’ll talk more about these forms of payment later).
Revenue paid by the user is also a form used by some end-user software products, but it is more difficult to charge this type of user. Netflix, Spotify, LinkedIn, and Dropbox are some examples. To understand how difficult it is to charge an end-user, imagine paying for a Google search. That is, even if the end-user perceives a lot of value in a product, it is hard to justify for this type of user that she must pay to use it.
REVENUE PAID BY SOMEONE INTERESTED IN YOUR USER
In this model, you usually do not charge the user of your product, but someone who is interested in your users. This model is widely used in end-user digital products. Typically, the business model is ad selling. One example is Google, which allows anyone to use search, and charges companies for placing ads along with search results.
Another similar example is Facebook, which also offers free access to users, and charges for ads from companies interested in advertising to their users. Another form of revenue is selling reports based on usage data. In addition to advertising and selling reports, another revenue option is to allow other companies to sell services to their customer base and share revenue. An example is the Brazilian personal free finance app Guia Bolso, which offers credit options to their clients, credit offered by financial institutions that share with the Guia Bolso part of the revenue generated with the loans.
An important point to note is that in order to be interesting to someone to the point that they want to pay to gain access to your user, you need to have a lot of users. Think in terms of hundreds of thousands who often return to use your product.
To attract hundreds of thousands of free users, you are likely to invest a lot of money, so you have to look for free ways to market your product. In addition, this should promote frequent user feedback, as this will give you an audience that will be of interest to anyone who wants to pay to talk to them.
To make your user base even more attractive to prospective advertisers, you should try to know a lot about your users, such as demographics, behavior, and preferences. This way you can offer more assertiveness and efficiency to advertisers.
It is the revenue you earn as a result of users using the software but not paying to use it. There are basically two types of indirect revenues:
- Revenue from sale or lease of physical or virtual items: This is the case with online stores that use online store software and services as a software product to sell or rent physical items. Amazon and Submarine are good examples. There are also stores that sell or rent virtual goods, such as Netflix’s streaming service or Amazon’s Kindle book sales. In the case of books, the sale is per item. In Netflix’s service, they charge a monthly fee to access streaming content. It is worth noting that the trading sites that broker the sale of physical items such as eBay and Etsy are not of this type. They are the type in which the revenue is paid by the user of the digital product, that is, by the person who places the physical item for sale, paying a commission for the sale. These sales brokerage sites are in the platform category.
- Cost savings: This is the case of internet banking, high school or college intranet, system for access to laboratory test results, among other software products that do not market anything and do not charge for access. In this type of product, there is no revenue, but cost reduction. Internet banking reduces the costs of face-to-face customer service at branches; the intranet allows for a more streamlined communication flow between school and student or student parents, saving you on college and college visits and meetings; and access to results via the Internet reduces costs for other forms of exam delivery, such as printing and mailing.
Payment Types for Digital Product Use
When you pay for the use of a product, it can be done in two ways:
- Recurring Payment: it is a lump sum payment to use the product, such as a cable TV subscription or a gym membership. If you fail to pay, you can no longer use the product and no longer have access to all information that may be stored on it. The most common periodicities are monthly and annual.
- Pay Per Use: In this case, you pay for the use of the product. This usage should be very easy to measure and track. For example, in an email marketing product, which allows email messages to be triggered to an address book, you may be charged for the number of messages you send. Another good example is paying for ads, which can be paid per view, click, or ad conversion. The commission charged by intermediary sites selling physical items like eBay and Etsy is another example, as is Skype’s charge to make calls to landlines and mobiles.
It is also possible to have a mixed model, with recurring payment plus pay per use. A good example is a product for internet telephony, where you can charge a monthly fee for access to the product, plus a charge for outgoing calls, such as Locaweb’s Virtual PBX. Another example is a product that offers the possibility for its user to have an online store. In this case, you may be charged a monthly fee plus a usage fee based on the number of sales your customer makes using this store.
Getting Return from a Platform
In the chapters What is a digital product? and What is digital product management? I talked about a different type of digital product, the platforms, systems that are valued the more people use it. I explained what differentiates them from a product, and the differences between managing a product and a platform.
Now that we’ve seen how to get revenue from a digital product, some questions that remain are: How to price a platform, especially when I’m interested in having as many people using it as possible to make it more valuable? And in some platform cases, I have people from different groups (buyers and sellers, app developers, and smartphone users). That is, the ideal on a platform would be to charge nobody, to ensure the largest number of users; however, if I do not charge anything, how will I cover the costs of its development and operation? There are four points to consider about platform pricing: who, what, how much, and when we should charge.
WHO SHOULD WE CHARGE?
The first answer to this question is simple: who is least price sensitive. If you have a two-sided platform, identify which one is the least price-sensitive; This will be the side most willing to pay for a platform. The most sensitive side is the one we want to subsidize.
For example, if you are managing a platform that connects attorneys with potential clients, it is very likely that the least price-sensitive side is the attorneys one because they have high margins. On the other hand, suppose you are managing a platform that connects suppliers of equipment and chemicals — which have little margin on their prices — with potential buyers; it may make more sense to charge buyers because of the low margin from suppliers.
However, as I said earlier, this is only the first answer. There are other factors to consider:
- Scale Sensitivity: If one side realizes that your platform is more valuable based on the number of users on the other side, this side will be scale sensitive and willing to pay for the platform. For example, in Google, the more people search, the more interesting the platform gets for advertisers.
- Competition Sensitivity: If one side realizes that the platform is more valuable the smaller its side is and, consequently, the smaller the existing competition, this side will be the competition sensitive side and more willing to pay. An off-line example is the entrance fee charged by bars, which decide whether to charge cheaper from women or not charge them at all, but charge men full entrance, who will be willing to pay because they understand there will be less competition. To attract more female customers, the bars often have a “free entrance for women” policy, sometimes on a ladies’ night. In some cases, these policies have been challenged in lawsuits as discriminatory, and are illegal in some jurisdictions in the United States, but is a good example of competition sensitivity if we frame these bars as a two-sided platform were men and women go to meet.
That is, there are several factors to consider. In some cases, both sides may be willing to pay; in others, only one. Cases like Google and Facebook are simpler to analyze:
- There are always two sides: who advertises and who consumes the platform.
- For advertisers, the more people consume the platform, the better.
- For those who consume the platform, ads or the content itself can be an intrusion if Facebook and Google can’t make them relevant.
- For those who advertise, each business started or deal closed through the platform represents a gain.
- For those who consume the platform, each business started or deal closed through the platform represents an investment with a possible outlay of money.
- For these reasons, especially for the last two, it makes sense for advertisers to pay.
On the other hand, cases such as auction sites, employment, taxi search, and real estate for purchase or rent are more complex:
- There are also always two sides: who advertises and who has an interest in what is being advertised.
- For advertisers, the more people consume the platform, the better.
- For those interested in what is being advertised, the more offers available, the better, as there are more chances of finding what you are looking for.
- For those who advertise, each business started or deal closed through the platform represents a gain.
- For those who are interested in what is being advertised, every business started or deal closed through the platform represents the possibility of getting what you were looking for.
- For these reasons, especially the last two, it may make sense for both sides to pay to use the platform. On the other hand, considering items 2 and 3, it also makes sense that both sides can use the platform at no cost. In this case, it may make sense to analyze who is least price sensitive and what the market practices are.
WHAT SHOULD WE CHARGE?
Usually, people are willing to pay for something when they see the value and benefit it brings to them.
There are 3 benefits that can be charged on one platform:
- Access: People may be charged for access to the platform. Something like a monthly fee, for example. This is the least common way to charge, as one of its main benefits is the number of people on different sides. This model can be found in platforms that work on exclusivity, where member quality is their main value proposition, and quantity is not relevant. Some platforms, after reaching a certain critical volume, may decide to charge for access to ensure quality and exclusivity. It is also possible to implement two levels of access, one free and one paid, with different functionalities and service levels, such as who is free is only supported via the Q&A site, and who pays is entitled to personalized support by telephone.
- Usage: You can charge each time people use the platform. For example, on a job posting site, you may be charged for each job opening advertised. Another example is AdWords, where you are charged each time someone clicks on your ad, that is, each time your ad is used.
- Rate / Percentage: In this model, the amount to be charged is a percentage or a variable rate of the benefit that one side of the platform has with each business conducted on it. Typically, auction and payment intermediation sites (PayPal, etc.) often use this billing model.
You can make combinations of these billing forms. For example, charge a monthly access fee plus a usage fee, or a percentage.
HOW MUCH SHOULD WE CHARGE?
To answer this question, we need to think about lock-in, which means that a user of your platform is less likely to stop using it the more they see and see benefits in its use. The cost of exchange is what explains the lock-in; the higher the cost of exchange, the greater the lock-in. Another important point to keep in mind when we are defining how much to charge for the platform is the network effect, i.e., how much value we generate to the user by having more people using the platform. Typically, the amount to be charged by a platform, whether access, usage, and/or fee, reflects on the lock-in and the network effect.
These values generally change over the life cycle of a platform. In the beginning, when there are few users, and the lock-in and network effect are still small, it is very likely that they will have to be subsidized.
Dropbox can be viewed as a single-sided platform, where the benefit of the network effect appears as more users use it for file exchange. The cost of switching increases as you put more files in Dropbox and you have better acquaintances with whom to exchange there. That’s why it charges for GB and encourages inviting friends to use it too. This incentive, giving free GBs to you and the friends you invite, is the form of subsidy Dropbox uses to increase the lock-in and network effect of its platform.
Another interesting example is an avalanche monitoring service, which launched a platform on which ski resorts would share weather data to predict avalanches more accurately. To be able to participate in this system, the resort would have to install a monitor, and this installation process was costly.
The platform also intended to charge a monthly fee for resorts to use it. The problem is that they were not comfortable paying the monthly fee and had already paid the cost of installing the monitoring equipment. In addition, they did not want to pay monthly in the summer, when there are few avalanches and resorts have low occupancy. The solution was to subsidize the installation of monitors in the resorts and to charge annually instead of monthly, with prices varying by the depth of analysis.
WHEN SHOULD WE CHARGE?
For charging for platform access, you may be charged once or periodically. By periodicity, it may vary from monthly to multiple years. It is not uncommon to see cases where there are multiple period options (e.g. monthly and yearly), where discounts on longer period prices are offered.
In some cases, longer periods may be the only way to show the long-term benefit of its platform or to ward off concerns about its seasonal utility, such as the avalanche monitoring service.
When billing by use, the most common is to make this billing periodically, that is, each period the platform should evaluate how much was used and should be charged. The most common period is the monthly one.
Care should be taken with mixed charging models, with charge-for-access plus charge-for-use. If you charge for annual access, consider whether you can charge for annual use as well, or if it’s best to charge for monthly or quarterly usage.
When charging a fee or percentage, it is best to charge right after the transaction happens. If there is a high frequency of transaction events within a month, another option is to charge this fee monthly.
We just learned that every software product has development and operating costs, and we need to cover them in some way. We have seen different ways to get product revenue, and we learned the differences between product and platform when it comes to earning revenue.
Digital Product Management Books
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