Software Vendors will face a new reality in software pricing when using GenAI
Dr. Petri I. Salonen
AI Transformation, Business Modeling, Software Pricing/Packaging, and Advisory. Published author with a strong software business background. Providing interim management roles in the software/IT field
Independent Software Vendors (ISVs) face a new reality regarding pricing solutions, including consuming GenAI services. If the ISVs price the solution using traditional methods, they might lose money rather than make money. If you are a software vendor, you should really pay attention to where the GenAI market is pricing, as it is a different model than traditional SaaS solutions.
Based on my experience with the business model transformation from on-premises perpetual licensing models with annual maintenance/support contracts to a subscription-based pricing model, the transformation was easy from a mechanical perspective. The industry "standard" was that the perpetual licensing fee (plus maintenance cost) was divided between 3-5 years to get the annual subscription fee. This transformation was based on a "one-to-one" transformation, moving the solution from on-premises as it is to a cloud environment. In our TELLUS International software pricing/packaging workshops , we had ways for the ISV to think through the pricing differently but add some "cloud native" features that would allow differentiated pricing. But that is different from the topic of this article today.
Generative AI applications require a different and new approach to pricing due to changed cost dynamics and characteristics of the solution. Based on Ibbaka , the key aspects include the following:
When you review the list above, it becomes obvious that due to the characteristics of GenAI, there are elements in GenAI's pricing that we did not have before. For example, GenAI might allow different users to have different configurations "on-the-fly" when using the solution, which could dramatically impact the cost structure. In my previous article , I described the impact of GenAI on business models using the industry-standard Business Model Canvas framework. The Value Proposition of a GenAI could be an enhanced ability to offer highly personalized products or services based on the user persona using the solution (configuration on the fly). Different customer segments could have different pricing models due to the segment's characteristics and the solution.
In my article , I also described why a consumption-based monetization model could benefit AI SaaS software vendors. I referred to the famous TSIA Fish model software vendors and solution providers have faced in the past few years, and this has caused a lot of anxiety for the leadership team, especially from an initial cash flow perspective.
Organizations also require transparent pricing so the customer can justify the spending, which is one of the most challenging tasks for an ISV. How can an ISV price the solution without having a good grip on the underlying cost structure? In my experience facilitating tens of software pricing/packaging workshops, this is one of the key questions the ISV leadership will ask. I'd always like to include the solution architects in the pricing/packaging exercises. The old-fashioned model where the "pricing team" sits in their ivory tower using cost-plus pricing models is gone. Pricing is tied to the architectural model, and a bad architectural model will lead to a solution that customers are unwilling to pay for. I have seen this too many times with organizations. I will only facilitate software pricing/packaging workshops with the product management/development team members. It will most certainly fail. There will be a misalignment between what the architects can do and what the "pricing team" will define.
Our recommendation is to apply value-based pricing as the foundation. It is not easy as it includes multiple aspects one must consider. We have based our approach on Tom Nagle who introduced economic value models in his book "The Strategy and Tactics of Pricing". The first edition was published in 1986 and co-authored with Reed Holden. The seventh Edition was published in 2023 and co-authored with Georg Müller, Evert Gruyaert . From 2013 these models have been referred to as Economic Value Estimation models (EVE). The foundation for value-based modeling is as follows:
The reference value is the value of the closest competitor or alternative solution costs. The building blocks in yellow represent the potential value drivers the solution will bring beyond your competitors. The building blocks in red represent the natives or shortcomings of your solution. The differentiation value is between the closest alternative costs and the net positive value you bring with your solution. The economic value combines the nearest alternative and your differentiation value. To put this into a real case, the following picture portrays how a solution and its positive and negative value drivers impact the potential solution value (=price).
According to Ibbaka , the value drivers can be organized into six types as follows:
??Increase Revenue - a powerful set of value drivers when validated
??Decrease Operating Costs - the most common value driver, one people are over-reliant on
??Decrease Operating Capital - often overlooked but more important as the cost of capital increases)
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??Decrease or Defer Capital Investment -
??Decrease Risk - important in a risky world
??Increase Optionality -the ability to do more different things leading to a more adaptive and resilient organization, hard to quantify but of growing importance.
The Ibbaka team asked Tom Nagle what a good value model looks like and this is what he concluded:
"There is a bias toward building models based on features of the offer.? So there is the reference value for the "commodity" alternative and then a value assigned to all the features that distinguish the offer from the commodity.? The problem with focusing on features is that the same differentiating feature will be valued very differently based on the economics of the customer. Better value models, in my opinion, quantify the value of differentiating?benefits (revenue enhancements, cost reductions, risk reductions) that the customer experiences."
The quote from Tom Nagle is revealing and needs to be considered, especially when defining potential features within the solution and valuing them.
In summary, this article emphasizes that software vendors (ISVs) must learn the new aspects of pricing GenAI solutions. GenAI has characteristics that don't act like traditional SaaS solutions, and if not considered, they could lead to software vendors losing money. In the upcoming articles, I will drill into how GenAI differs, what composable applications are, and what conversational interfaces between applications could mean to your pricing.
As always, I would love to hear your views on this topic and whether you have run into issues or questions or have even figured out how to price your GenAI-based solution.
Yours,
Dr. Petri I. Salonen
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