The High Cost of Free – The Freemium Revenue Model

Is there truth to Milton Friedman’s famous adage that ‘there is no such thing as a free lunch’?  Many technology executives would say no.  Once the sole purview of retailers, consumers goods firms and media channels,  giving away free products and services is now the rage in a number of sectors including software and social media.  Many Web-based B2C and B2B companies, like YouTube, Facebook and Skype, have attracted attracting millions of users by giving away their service in the hope of making money from them in the future through premium upgrades, advertising and up sells like support and documentation. 

This Freemium business model is appealing for firms that enjoy high gross margins, low distribution costs, and where the software purchase cost is a small proportion of total cost of ownership.  On the consumer side, convincing only 1% of millions of users to pay is enough to reach profitability, given rich margins.  The economics are also appealing for B2B software vendors.  Software purchase cost often makes up only about one-fifth of the total cost of IT ownership once integration, training and support are factored in.  For a solutions provider, giving away proprietary or packaged open source software (which helps lock clients in) but charging higher prices for other necessary services has proven to be a lucrative model for many firms including Red Hat, Sun and Dell.

However, while appealing in principle, freemiums are a challenge to make work.  According to reports, Flickr, Skype (which eBay wants to unload), and YouTube are not yet in the black while many others suffer in the twilight zone of low market penetration.  For many of the popular social media sites, advertising and affiliation programs was always the easy answer for making free pay. But that rarely covered expenses even before a glut of advertising space and a severe recession cut the revenue stream. 

Firms that are tempted by the Freemium strategy may want to consider a few things-

  1. Fickle consumers – With zero sunk cost, many consumers will quickly jettison free products or services (can you say Friendster, MySpace) even when there are switching costs.  Ensuring loyalty let alone driving conversion to paid products is difficult to do without higher marketing spending and regular improvements to the customer experience. 
  2. More complex offering – Firms need to define, market and organize themselves more broadly as a solutions providers versus pure-play software builders.  This challenges focus, scalability and operating leverage.
  3. Lower brand value – Free product usually signals low perceived value and brand image.  With that comes low emotional commitment and product loyalty.
  4. Reduced strategic flexibility – Without the pricing lever, charging nothing gives you little strategic room to attract customers outside of functionality and user experience, all of which can not be supported by zero operating margins. 

Perhaps Milton Friedman was on to something after all.

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3 comments so far

  1. Frank Scurley on

    I dont know If I said it already but …This blog rocks! I gotta say, that I read a lot of blogs on a daily basis and for the most part, people lack substance but, I just wanted to make a quick comment to say I’m glad I found your blog. Thanks, 🙂

    …..Frank Scurley

    • mitchellosak on

      I appreciate your kind feedback. If only I could figure out how to turn this content into a major motion picture. Please keep visiting.

  2. Savannah on

    Awesome blog!

    I thought about starting my own blog too but I’m just too lazy so, I guess Ill just have to keep checking yours out.

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