By Mike Truskowski

The honeymoon of the mobile application industry is over. The fight for users – and the challenge of building a sustainable flow of money from them – has arrived. And it will only get tougher.

Raise your hand if you have a smartphone. Now think about your friends, family and colleagues. More hands up, right? 

The popularity of these devices has ballooned from 9 percent of mobile phone sales in 2009 to a projected 50 percent by 2013, according to Gartner.

Hardware manufacturers and service providers are having a great time trading up their users to higher-margin handsets and contracts.

But perhaps the greatest untapped opportunity afforded by the smartphone revolution belongs to a third party: the providers of mobile apps and mobile content.

In the balance
With only one small screen to navigate, the mobile user is a captive audience. However, as the number of competing platforms, channels and applications grows, and the fight for consumers’ attention intensifies, turning a mobile app into a sustainable, profitable venture will become increasingly difficult.

Will ad revenues alone be enough for app backers to achieve this sustainability? 

For apps built around the freemium model, how will developers know and establish the right balance between paid and ad-supported users? 

Where firms do decide to charge for their software, content and other features, what will the most successful pricing models look like?

Those are just a few of the fundamental questions facing someone who wants to make money with apps.

In 2001, our firm explored the challenges of selling content online. Back then, those who were brave enough to put a price tag on their offering based their decisions more on “gut feeling and guesswork than hard data.” 

Ten years later, in a new market, with a new crop of leaders, the situation has changed less than you might think.

In October 2010, I had a chance to attend the Billboard Music App Summit in San Francisco. A brief survey of attendees revealed that little to no research was put into the pricing of several popular applications. 

Some marketers from these firms admitted to choosing their price structure and level based on instinct. Others simply followed the benchmarks set by their competitors. 

In both cases, firms seemed to lack the confidence and the know-how to deviate from the path that they and others had already chosen.

Though the mobile app market is a fresh one, many of the challenges it presents – understanding whether and how to use ads effectively, properly distinguishing free and paid offerings, and finding the evidence to drive these decisions – are not.

Therefore, whether you are developing an app, putting money behind it, or have content to distribute to smartphone users, you will need to approach pricing with the same rigor required of all consumer-facing industries. 

In this burgeoning market, the “right” model is hard to identify. As the competition intensifies, how will you approach this challenge, and how will you even know when you have solved it?

Are ads alone enough for apps?
More than a decade ago, the advertising world was enamored with the unprecedented opportunity to engage with and target consumers on the Internet. 

Countless dot-coms were founded, and a seemingly endless supply of IPOs helped drive investors’ confidence – and the stockmarket – to all-time highs.

In many sectors, companies provided their content or services for free, operating at a significant loss as they attempted to drive traffic and attract advertisers. 

Unfortunately, the advertising-only model left many of these businesses vulnerable.

And when these ads did not prove as valuable as expected, and the Googles and Facebooks of the world conquered many sectors, others were forced to fold.

Fortunately, a few factors unique to the mobile market suggest that their ad-supported ventures may have more success than their online predecessors. 

As users move about, developers can push ads for nearby retailers and restaurants. 

The theory is that such precise targeting generates greater returns than broader, online methods, making it a viable option for large chains and small businesses alike. 

Also, users’ smartphones contain a wealth of profiling data for advertisers. 

For instance, a word-game app could search a user’s ebook library to determine which other ebook titles to advertise. 

As social networking and other interactive technologies continue to improve, the opportunity to develop a truly innovative and effective targeting method is ever increasing. 

Not surprisingly, the global mobile advertising industry is expected to grow at a blistering pace, from $914 million worldwide in 2009 to $13 billion in 2013, according to Gartner. 

Still, the lesson of the early 2000s holds: Firms that hitch their wagon to the ad-only business model must understand that their dependence on a single, volatile source of revenue will make them more prone to failure.

What’s the right way to get from free to paid?
To combat this risk, many apps have chosen to take the freemium route, providing a free, ad-supported version to the casual user and one or more trade-up options for higher-value consumers. 

For some, such as the popular Drum Kit music app, the lack of ads is the only feature separating the free and paid offerings.

For others, the carrot, not the stick, is used to encourage users to buy the premium option. 

By providing access to more articles and features to paid subscribers, the Financial Times and other publications create a clear fence that separates the occasional reader from the loyal. 

Popular games such as Angry Birds offer a limited number of levels in their free, ad-supported versions, and additional levels and hints to the serious, paying gamer. 

Using two distinct models – subscriptions and in-app sales – these developers provide a strong incentive to trade up. 

However, whether these firms are providing the right features and the right price structure for their premium versions is a separate question. 

To do this effectively, firms must first understand the unpaid user, and how their download volumes will affect ad revenues and future volumes, as popularity impacts placement in app stores and on bestselling lists. 

At the same time,  knowing what the higher-value users are looking for out of the product, how one firm’s offering compares to that of its competitors on these key features, and what the relationship is between the added value delivered and what users will pay in return could turn paid offerings into the main profit drivers for a portfolio. 

This final, complex issue is top of mind for leaders in any industry. But the nature of the mobile app market offers a unique opportunity to answer this question with more rigor than in most other sectors. 

Where’s the evidence to price apps right?
Let us examine, for a moment, the challenge facing music subscription services. 

For the heavy listener, the ability to access millions of tracks on the go is an incredible value, speaking from personal experience.

Building a profitable business around these services is difficult, especially when you consider the licensing fees to record companies, often for every track played. 

But as these services continue to hone their mobile offerings, and the venture capital community continues to put money behind them3, this is a sector that could be on verge of significant growth. And yet, unfortunately, the major players have already all settled on the same price point: $9.99.

At the Billboard conference, I spoke with a representative from one of these firms.  He explained, frankly, that none of the subscription services have the knowledge or the nerve to try something different.

But there are a couple of valuable lessons that these companies and all firms in the mobile app market can take from this situation: Arguably, the main competitors for these firms are the many other, often free listening options, and not their fellow subscription services. 

To some degree, each has given consumers reason enough to go beyond this $0 threshold. 

So, rather than fighting over the same, small group of users, each can work towards a clearer understanding of what it is that sets their product apart, and whether there is an opportunity to trade-up users further. 

To understand how to differentiate effectively, primary research and live market tests, if managed properly, will pay huge dividends. 

Mobile app users are an especially captive audience and prime targets for surveys designed to help firms understand how to provide even more value. And the simplicity of app stores opens the door for tests to understand consumers’ sensitivity to different price points, as well as to different offerings.

Conclusion
Not two years ago, much of the mobile app space was uncharted territory. Now, those white spaces are becoming harder to find. 

In following the lessons explored above – being careful not to put all their eggs in the advertising basket; understanding what the role of advertisements versus paid will be, and how this affects popularity, short term financials and long-term performance; and finding a way to measure what the loyal consumers want and will pay for – app backers have a chance to set themselves up for sustainable, profitable growth.

Mike Truskowski is consultant at Simon-Kucher & Partners, Cambridge, MA. Reach him at [email protected].