Price-at-Risk: A methodology for pricing utility computing services
IBM Systems Journal
Whereas most companies use the century-old cost-plus pricing, this pricing method is especially inadequate for services on demand because these services have uncertain demand, high development costs, and a short life cycle. In this paper we propose a novel methodology, Price-at-Risk, that explicitly takes into account uncertainty in the pricing decision. By explicitly modeling contingent factors, such as uncertain rate of adoption or demand elasticity, the methodology can account for risk
... ount for risk before the pricing decision is taken. The methodology optimizes the expected "net present value," subject to financial performance constraints, and thus improves on both the cost-based and valuebased approaches found in the marketing literature. Pricing is a crucial business decision in the life of a product. A minor adjustment in price can dramatically affect the profitability of the product, its diffusion in the market, and its ultimate success. Like many corporate decision processes, pricing is driven partly by rational reasoning, partly by established practice, and partly by "black magic" (not necessarily in this order). In the information technology (IT) sector, pricing falls mostly in two classes. For an IT product, such as a hardware device or a software license upgrade, the development costs are small compared to the high initial sunk costs. For example, the costs associated with the production of a new CPU are small compared to the cost of a chip manufacturing plant. The pricing of IT services has strong similarities with instances of pricing in the retail industry. Hardware equipment is sold on a per-unit basis, but this simple unit pricing is supplemented by a variety of price schedule modifications, such as quantity discounts, bundling, and market skimming (gradual price reduction) and dealing (temporary price cutting). Conversely, for IT services, such as services in outsourcing contracts, a fixed-price contract is dominant. In recent years, IBM has promoted a third way to provision information services 1 (other companies have made similar proposals). Utility computing services deliver information services when needed, in such a way that customers neither incur the high fixed costs of purchasing hardware and software, nor commit to long-term fixed-price outsourcing contracts. Instead, they receive the service they need and pay only for what they use. Utility computing services represent a departure from the current ways of doing business. On one hand, they feature attributes that appeal to customers: short lead times in service provisioning, high reliability and survivability, customized service level agreements, a reduced learning curve in the adoption of a new service, and easy access to new technology. On the other hand, utility computing services have direct financial benefits for the customer. These benefits come about in two distinct ways. First, utility computing services reduce the risk faced by the customer because the costs to the customer are proportional to the volume of transactions performed during a certain time interval (say, Copyright 2004 by International Business Machines Corporation. Copying in printed form for private use is permitted without payment of royalty provided that (1) each reproduction is done without alteration and (2) the Journal reference and IBM copyright notice are included on the first page. The title and abstract, but no other portions, of this paper may be copied or distributed royalty free without further permission by computer-based and other information-service systems. Permission to republish any other portion of this paper must be obtained from the Editor.