Dude, Where’s My Predictable, Growing Revenue?

XaaS Key #2:  Right Product And Service Design

Part 3:  Mixing It Up – Blended Product/Services Offers

A lot of product companies want to build anything-as-a-service plays.  In my introduction to this series, “From Transaction To Relationship: 6 Keys To Winning In XaaS”, I mentioned these examples:

• Hewlett Packard: in 2019, signaled it will make its entire portfolio available in XaaS offers by 2022. 
• Cisco Systems: in 2020, longtime CEO John Chambers said "If I had to do Cisco over, I'd do it all as a subscription based model”.

Of Course You Do It.  Everybody Does It.  Right?

Yet not every product company moves to XaaS.  And not every product company moves to XaaS elegantly:  

• XaaS?  Whatever:  Too often, product companies will price a new connected/”smart” product at a premium, and then will treat the XaaS component of the offer as an afterthought, capturing no value from XaaS.  

Example:  a B2B durables company charging $800 for a $50 piece of IoT-enabled commodity networking hardware.  Then pricing IoT services at $2.99 per month.  Then wondering why their XaaS revenues are so small.

• Surprise!:  Others will intend to capture value from XaaS – but will forget to make the recurring monthly services clear to customers, leaving them confused about why they have to pay so much every month after having already paid for a product.  

Example:  my bicycle trainer cost me $300 – but to actually use it, I have to pay another $60 per month for the app that controls it.  I didn’t know the app was required when I bought the trainer – and I can assure you, I won’t buy from them again.

• Outta here:  Still more will simply abandon XaaS altogether, moving back to a purely product-only offer.  Or they won’t even try in the first place.

Example:  too many to mention!  

Unsurprisingly, the most common concern I hear from product companies wanting the benefits of XaaS but too hesitant to try is how to price their combined product and service offerings.  For example:

• Do I make the product free, and only monetize the services?
• What’s the appropriate pricing blend between the product I sell up-front, and my XaaS packages?  70:30?  60:40?

What’s making this so difficult?  

Cash Is King

In my introduction to this series, “From Transaction To Relationship: 6 Keys To Winning In XaaS”, I also mentioned that XaaS is similar to a leasing model.  Fundamental to leasing is the concept that the buyer can have access to a product or service, without having the full amount in cash required to immediately purchase that product or service.  Therefore, the seller also does not receive the full cash amount of the product or service value up-front, but over time.

However, the typical product sales model involves buying raw materials or components (cost of goods sold), adding value to them (gross margin), then selling them (revenue), then receiving cash, one-time, for the full value of the product.  

So for product companies, cash is king:

• I want value:  A lot of product companies are “value stocks”, meaning that investors reward management for delivering consistent cash, not for plowing cash into innovation – including new business models.   
• I want it now:  Product companies aren’t accustomed to capturing “deferred” cash flows.  Instead, they’re accustomed to selling their product and then receiving the full cash amount within 30-45 days. 
• Junk in the trunk:  Product companies have something most software and services companies don’t:  significant cash tied up in components, raw materials, and finished product: inventory.  Lots of money in inventory means lots of cash tied up.  Lots of cash tied up makes value stock investors unhappy.  And lots of unhappy value stock investors can make management at value stock companies…unemployed.
• Rocket science:  Some product companies in mature, commoditized businesses may still be practicing cost-plus pricing, delivering the cash their value investors demand, but requiring very little pricing innovation.  Any pricing models involving deferred value capture, penetrating product to drive services revenues, recurring relationships…require skills typically not in the typical product company toolkit.  

So What Do I Do?

My last article, “Dude, Where’s My Predictable, Growing Revenue? XaaS Key #2”, covered how to price XaaS offers.  I mentioned that pricing XaaS for product + services offers is tricky.  But I also mentioned that there is a way to do it.

This approach involves converting any incremental profit from your new offer into an XaaS package.  This way, you are able to continue to deliver the profits and cash your investors expect, and you are able to convert some revenue to XaaS without risk.  The product (perpetual) part of the offer is priced at bill of materials + your typical gross margin; the XaaS subscription is priced to capture the incremental value beyond the product price.  

In Plain Language, Please!

"Speak to me as you might a young child, or a golden retriever.  It wasn’t brains that got me here, I assure you that."

John Tuld, “Margin Call”, J. C. Chandor, Lionsgate and Roadside Attractions, 2011 

Let’s say your company, Widgetech, makes widgets.  It costs you $5 to make a Widget Classic.  You sell it for $10.  Your gross profit is therefore $5 per widget, or 50% gross margin.  In fact, since you are in a stable business, your gross margin has been 50% since the 1960’s, and your boss, the CEO and his or her bosses, the board of directors, reward you handsomely for keeping the margin right at 50% (this happens more often than you may think).   Being extremely simplistic, you make $5 in cash for every widget. (Figure 1)

You hire some smart whipper-snapper strategy geek to shake things up in your company, because you’ve heard of this XaaS stuff and how wonderful it is.  We’ll call this person SG, for simplicity.  SG recommends making your product connected, with some memory and some firmware added, and creating a suite of related applications and services.  This newfangled widget, let’s call it Wonderwidget, costs $6 to make.

While SG leaves to get a cup of coffee, your management team proposes pricing the Wonderwidget at $12.  That way, you would earn your typical gross margin of 50% on a gross profit of $6 ($12 - $6 = $6; $6 / $12 = 50%).  Heck, you even earn $6 in cash (again, very simplistically).  (Figure 2)

Everybody’s happy, right?

We’re Gonna Get Our Bonus!  Right?

No, everyone is not happy.

SG comes back into the room with a fresh keg of steaming hot latte, and says no to the pricing scheme.  SG has done their homework and figured out that customers are willing to pay $15 for Wonderwidget, based on:

• Customer surveys and focus groups;
• Comparable products; 
• Genuine benefits the Wonderwidget creates for customers, in terms of productivity value, time saved, etc.  

$15 for the Wonderwidget?  GREAT!  Now your gross profit is $9 ($15 - $6 = $9), and your gross margin is 60% ($9 / $15 = 60%).  Again, being extremely simplistic, you make $9 in cash per wonderwidget.  Margins are up, cash is up, everyone is happy.  You want to give SG a raise, maybe you’ll even let SG fly business class for once.  (Figure 3)

Everybody’s happy, right?

Hold It Right There

No, everyone is still not happy.

You’re still not getting the benefits of XaaS, notes SG.

SG proposes setting the up-front sales price of the product at $11, holding the gross profit per Wonderwidget at $5 and the (simplistic) cash at $5.  Then, SG proposes different services packages to offer on a subscription basis.

Your controller, product managers, and the sales manager (you invited him/her to the meeting as a guest on a junket) explode.  Our margins will erode!  We won’t get out bonuses!  You’ll destroy the business! 

Why The Heck Would Someone Do This?  

Easy.  You’re (very simplistically, again) earning the same cash you did as before - $5 per widget.  But now you have a full $4 ($15 - $11 = $4) of value to capture in XaaS offers (Figure 4).

And, you realize all the benefits of XaaS: (Figure 5)

1.     Predictable, smoothed revenues.  

2.     Predictable, lower costs.  

3.     Larger addressable markets.  

4.     Sticky, direct customer relationships. 

You’ve got room to experiment with the service package pricing – it’s essentially risk-free money, since your product price is below what your customer perceives as the value of the solution, it includes your typical profit, and you therefore are delivering roughly similar cash flows.

What’s Going On Here?

This approach relies on the concept of perceived value, which I had the privilege to learn from Professor Mohanbir Sawhney at the Kellogg School of Management (I barely deserved the “B” I got in his course, I assure you that!).  Professor Sawhney defined perceived value as “the perceived worth of the set of benefits received by a customer in exchange for the total cost of the offering, taking into consideration available competitive offerings and pricings.” (Mohanbir Sawney & Deval Parikh, “Where Value Lives in a Networked World”, Harvard Business Review, Jan. 2001). 

There are two key implications:

• Price is not based on the vendor’s cost, or on traditional margin expectations.
• Customers will pay an incremental price for something, if the incremental benefits outweigh the incremental cost. 

In this example, SG figured out that customers saw the incremental benefits of Wonderwidget as being worth $5 more than Widget Classic.  Therefore, the vendor can set the price of Wonderwidget up to $5 higher than Widget Classic.

But Wonderwidget only costs $1 more to make.  And for a company working to deliver cash to investors, Widgetech is tempted to capture that $4 in incremental profits immediately.  But this won’t deliver XaaS benefits to Widgetech.  

Say It Again, SG

So here is a summary of how to make blended product/services offers: (Figure 6).

1. Calculate the total perceived value of the new solution.

• Take the existing price of the old solution.  
• Calculate the incremental perceived value to your customer.  You do this through customer surveys, focus groups, comparisons to comparables, and a deep understanding of the benefits you can actually deliver to your customers. 
• Add the incremental perceived value to the existing price.  This becomes the new value you are entitled to capture from the new, XaaS-enabled solution.

2. Calculate the new product price.

• Take the existing cost for your existing, non-XaaS-enabled product.
• Next, calculate your incremental costs for the new solution that can support services, through connectivity, applications, etc.  This is your incremental bill of materials for connectivity, and new operating costs for development, IT operations, etc.  (We left out the operating costs in the above example, for sheer simplicity.)
• Add the incremental costs to your existing costs for the old solution.  This is your new cost for the new solution.
• Take your typical gross profit, and,
• Calculate your new product price by adding your typical gross profit to the new cost, ensuring you can deliver cash to your shareholders. 

3. Calculate your incremental XaaS value.

This is the total value, less product price.  Design services packages to capture the incremental XaaS value.  As mentioned, you’ve got room to experiment with the service package pricing – it’s essentially risk-free money, in this simplistic model.

What’s The Catch?

• What if the incremental perceived value is less than the incremental costs?  Then you have a problem – either your customer doesn’t see much value in the new solution, or it costs too much to deliver that value.  But don’t throw the baby out with the bath water – iterate.  
• This financial model is simplistic; it assumes gross profit is cash.  Obviously, it isn’t, and obviously, there are going to be several incremental costs to offer services on top of a product platform, including new IT, sales, and marketing capabilities.  I wanted to highlight the basic concepts – which can be expanded to include these costs.  In a future article, I’ll talk more about the new skills and capabilities required to offer XaaS – and how there’s a vibrant ecosystem of enabling solutions that relieve you of the burden of doing it all yourself, from scratch.

What’s Your Take?

I’m interested in your take – especially if you work in a product business that has worked on XaaS offerings.  How have you handled this?  What challenges have you faced?  Comment here, or feel free to contact me; I’d love to hear from you!