As a CFO, you're always looking for ways to optimize revenue and profitability; however, an area that often gets overlooked is how you charge your customers. The default option for many SaaS businesses is a simple subscription model – pay a flat fee and get access to everything. Unfortunately, you’re leaving substantial money on the table with that traditional approach. As you’ll soon discover, when it comes down to usage based pricing vs subscription, there’s a clear winner.
VC firm OpenView shared in a 2022 report that 3 in 5 SaaS companies have adopted usage-based pricing (UBP) - up from 45% of companies in 2021. Chargebee expects that this number will increase to 74% in 2023.
This smarter approach brings a whole new meaning to outcome-based pricing, turning the whole thing into a customer-centric experience. In this article, I’ll show you why UBP is gaining traction as a better option for businesses.
What is Usage-Based Pricing?
Usage-based pricing, also known as consumption-based pricing, is a model where customers pay for their actual usage of a product or service rather than a flat rate. This model is frequently seen in cloud computing providers like Amazon Web Services (AWS) and Microsoft Azure, as well as in SaaS businesses like Twilio and Snowflake.
Pros of Usage-Based Pricing
The principal idea behind this pricing model is to align cost with the functionality and value that customers derive from the product or service. Usage-based pricing is inherently a part of product-led growth, where revenue growth is a reflection of the value customers derive from using the product.
Part of the report by Openview indicated that usage-based SaaS companies outperformed the broader SaaS market in terms of YoY revenue growth, net dollar retention, and revenue scale.
These metrics showcase the potential of UBP due to increased retention, growth rate, and profitability over time. Other major benefits of usage-based pricing include:
Sustainable Pricing: Usage-based pricing allows you to capture more value from "power users" - customers who use your service much more heavily than average. Instead of subsidizing them with fees from lighter users, you can charge them incrementally more as their usage increases. This helps ensure your pricing stays sustainable as your customer base grows.
Facilitation of Easier Product Adoption and Reduced Churn: The UBP model reduces upfront costs, lowers barriers to entry, and builds trust with customers by providing direct value for their money. Aligning costs with the value received results in higher customer satisfaction and lower churn.
Insights into Most Valuable Offerings: Customers can choose specific products and services that meet their needs, instead of being limited to a fixed bundle. This allows for more customized solutions and encourages efficient usage. When customers pay per use, they're motivated to optimize, removing add-ons that don’t help them. If you’ve been investing in a product that none of your customers use, it’s time to target a new demographic or discontinue the product.
Promotion Flexibility: Businesses have the opportunity to delight customers by offering enticing incentives such as discounts, rolling credits, and convenient pay-later options. Customers are more likely to use a product if they can pay for it in a way that suits them, which implies more revenue for the company.
Cons of Usage-Based Pricing
Like every other business model out there, there are some potential drawbacks to consider before making this switch. Here are the most impactful cons of the usage-based pricing model (alongside possible workarounds):
Revenue Unpredictability: UBP can make revenue difficult to predict since it's dependent on how much the customer uses your product or service; if you’re early into your business, you may not be able to tell what’s a normal seasonal fluctuation and what’s a warning sign for your bottom line. One of the best ways to tackle this is by setting a minimum usage threshold, offering customers a pricing plan that includes a cap on usage, or adopting a hybrid billing model that combines usage-based pricing with a fixed monthly fee.
Customer Uncertainty: Everyone's finding ways to save more money. With UBP, customers may worry about exceeding their budget or being charged unexpectedly high fees, leading them to ultimately use your tool less than they otherwise would’ve. Providing usage monitoring tools and alerts is a great way to mitigate this. You can also offer clear and transparent pricing tiers with caps on usage to help customers feel more in control of their expenses.
Risk of Customer Dissatisfaction: Customers who don't fully understand the usage-based pricing model may be confused by a fluctuating bill, leading to dissatisfaction and reputational risk. Prioritizing customer education and providing exemplary customer support are great workarounds.
Best Fit Industries
UBP is ideal for businesses where customer consumption varies significantly and the cost of providing the service or product is proportional to its usage. Industries that benefit from UBP include seasonal businesses, cloud services (e.g. cloud storage, cloud computing), and most SaaS solutions. On the other hand, businesses with predictable usage patterns, low customer acquisition costs, and those that require long-term commitments from customers may want to avoid usage-based pricing models.
For other businesses, a hybrid approach that combines elements of usage-based and subscription-based pricing models may be more suitable. For example, CRM and social media management software companies often offer tiered plans with a fixed subscription fee, coupled with additional charges based on usage.
Companies Charging Based on Use
Some examples of successful companies using usage-based pricing models include:
Twilio is a cloud communication company that has adopted usage-based pricing and subscription billing. With over 250,000 active customer accounts across 180 countries, Twilio offers programmable tools for developers to utilize their web service's APIs. Usage-based fees accounted for 72% of their total revenue in 2021, with customers charged based on their usage of various products. The company reported $2.84 billion USD in revenue in 2021, demonstrating the success of its multiple revenue models.
Azure is a cloud service provider that offers various pricing models to businesses based on their business needs and budget. The available models include pay-as-you-go, reserved instances, hybrid benefit, spot instances, and Azure Dev/Test. With its pay-as-you-go pricing model, customers can pay for the services they use without upfront commitments or long-term contracts.
The Pay As You Go plan offered by Mailchimp charges customers for each email they send. This plan is suitable for users who send emails infrequently or have a small number of subscribers. Each email sent counts as one send and the cost of each email is deducted from the user's credit balance. This pricing strategy allows users to pay only for what they use, making it an attractive option for those who don't want to commit to a monthly subscription.
I think of this service the same way I think of refillable phone credits: it doesn’t make sense for most people, as the unit economics only work for infrequent users; however, that market segment still needs to use their phone, so going after them could mean a nice marginal boost to your revenue.
Amazon Web Services (AWS)
AWS offers a pay-as-you-go approach for pricing for the vast majority of its cloud services, where customers pay only for the individual services they need, for as long as they use them, and without requiring long-term contracts or complex licensing.
Subscription Based Pricing
As a business owner, subscription pricing models seem like an appealing first choice. Customers get to pay a fixed recurring fee for ongoing access to a product or service, regardless of their actual usage. It also comes along with several advantages, such as predictable revenue, simplified billing, easier budgeting for customers, and easier upselling opportunities.
However, subscriptions can be inflexible, as the fixed price may not always match the value provided to customers. Subscriptions can make it difficult to charge more as the service improves, while usage-based pricing allows for revenue to scale directly with the value provided. Subscriptions may limit revenue growth, as it is capped by the number of subscribers, while usage-based pricing offers the opportunity to earn more as customers use the service more.
Consumption-Based Pricing: How to Make the Switch
Transitioning to this model can be complex and requires careful planning.
The first step in implementing a consumption-based pricing model is to decide whether to build or buy the data monitoring capability. If you choose to buy, look for platforms that offer flexibility, the ability to collect any type of data, and the ability to handle data at scale.
Once you have selected a platform, you will need to identify the right metrics to track usage and determine how to price based on usage. One of the key challenges in implementing a usage-based pricing model is selecting the right usage metric. The metric should align with customer value and be flexible, scalable, and feasible.
You will need to adjust your financial reporting to track usage and revenue based on the new pricing model. You may also need to adjust your billing and invoicing systems to accommodate the new pricing structure. Testing, refining, and monitoring before the company-wide rollout are key to achieving a smooth transition.
It's also important to navigate challenges with legal and procurement teams, provide price predictability for enterprise customers, handle overages, structure go-to-market teams, and design sales compensation plans.
Future-Proof Your Pricing Model By Switching to Usage-Based Pricing
Adopting a usage-based pricing model can lead to increased customer satisfaction, improved retention, and enhanced revenue growth. By aligning your pricing strategy with the value delivered to your customers, you can create a win-win scenario for both your business and your customers. Whether you choose a pure usage-based pricing model or a hybrid approach, understanding your customer needs and the value your product provides is key to determining the most effective pricing strategy for your business.
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