Consumption-based pricing is on the rise, especially in the SaaS world. Also called usage-based pricing, this model charges customers based on their actual product or service consumption, rather than a fixed subscription fee. While some industries such as utilities or even cloud-computing have long embraced this pricing model, its adoption in SaaS is relatively recent.
And while the shift to this pricing model has mainly been driven by the customer because of its many benefits, as we’ll see, suppliers stand to benefit as well. However, these benefits aren’t without their challenges, and suppliers must carefully weigh both the benefits and consequences before making the shift. The following article will unpack the intricacies of consumption-based pricing to ensure suppliers are abundantly informed before updating their pricing models.
Customer Benefits of a Consumption-Based Pricing Model
1. Budget Scrutiny by the CFO
For one, customer budgets are tightening and subsequently, every dollar that is invested in technology is under intense scrutiny by the CFO. A usage-based pricing model gives the buyer the security that they only pay for what they use. This pricing model also motivates technology suppliers to innovate in areas of their technology that generate usage and subsequent value, since more usage means more revenue for the supplier (we’ll discuss whether usage equates to value in a later section). This is certainly to the benefit of the customer.
2. Changing Customer Expectations
Another reason for the shift is changing customer expectations and familiarity. Frequent customer exposure to usage-pricing models in other industries such as cloud-computing, where it is ubiquitous, has led to demands for similar pricing models from suppliers that have not yet made the switch. And while familiarity plays a role, it is likely also about efficiency, particularly for procurement teams. It makes the job of the procurement team much easier and more efficient if all their vendor contracts adopt a similar pricing model.
3. Artificial Intelligence
Lastly, the rise in AI is certainly playing a role in the shift to usage-based pricing. In many cases, the productivity gains realized by AI mean that customers are spending less time in their software. As a result, customers are doing more with less and see an opportunity to reduce costs by shifting to a consumption-based pricing model.
Supplier Benefits of a Consumption-Based Pricing Model
The shift to a consumption-based pricing model is not without benefits for suppliers as well.
1. Increases Revenue with AI
The traditional SaaS license model uses people as the unit of measurement. With the efficiency and productivity gains provided by AI as well as the desire to shift investment money into R&D, customers may decrease headcount. As a result, keeping a subscription or license-based model would lower revenue for suppliers.
At the same time, AI is driving up costs for suppliers. Many have not yet monetized AI offerings, making them deliver their solutions at the same cost in the original product with AI as a value-add with no added fee (yet). By adopting usage-based pricing, the supplier and customer can align on the correct unit to measure usage, establish the correlation of that unit to the value provided to the customer, and charge based on that. This way, the customer is paying more for the added value received, not the number of people working to produce that value.
2. Drives Internal Alignment and Efficiencies
If usage is positively correlated with value (again, we’ll discuss the reality of this correlation in a later section), then it gives suppliers a north star to follow, making sure they stay on track and invest in the product innovation that really matters to the customer. Usage becomes the customer insights that are used to make future product investments. It also becomes a simplifier. Product builds for usage, measures for usage, and innovates for usage. The whole product development process can boil down to one simple yet powerful question: will the customer use this? Or put differently, how can we drive more usage?
It also forces alignment across the organization. While product and engineering are building to drive usage, customer success is supporting customers with a similar goal. Onboarding is focused on removing barriers to getting customers in the software and using it immediately. As a result of better usage, sales and marketing are presented with the blueprint for what to highlight and focus on in external communications. Potential customers see current customer usage success and want to do the same, creating the momentum required to initiate the much sought after flywheel in the Saas world.
3. Simplifies Incentives for Front-Line Sales and Customer Success Teams
Adoption of usage-based pricing can also lead to better alignment on incentives. For example, if done right, sales, onboarding, and customer success teams can be incentivized to shorten the time to usage and value. They become solely focused and incentivized to achieve the one outcome that matters: usage.
Even the product and engineering teams, which are typically the last teams to adopt a variable incentive plan, can be incentivized to drive more usage. It gives them something quantitative to measure that is perfectly aligned with customer outcomes.
In the end, everything and everybody in the organization starts to row in the same direction. This is the promised land so many SaaS executives desire. And it’s possible with the usage-based pricing model.
4. Improves Net Revenue Retention by Decreasing Customer Churn
A last benefit of this pricing model for suppliers is that it typically results in better retention. Unlike the flat subscription fee pricing model, where it is easy for customers to feel that they are paying too much relative to their usage (because they are locked in to one flat fee), the usage-based pricing model ensures customers only pay for what they use, resulting in happier customers, and better retention.
Ultimately, usage becomes a shared language between customer and supplier as well as across the supplier’s different departments, creating more efficiencies, fostering better alignment, and generating better outcomes for suppliers and customers.
The Challenges of Consumption-Based Pricing for Suppliers
Consumption-based pricing does not come without its challenges, however.
1. To be Successful, Supplier and Customer Must Align on Value
First and foremost, usage does not always mean value, as was alluded to earlier. For example, I can drive my car in circles around my block until my tires are bare, but if my goal was simply to drive to the store and back, my usage of my car was fruitless. The usage of my car didn’t result in my desired outcome. In this example, perhaps the better measurement of usage would be the number of times the car was driven to the store (with AI guiding those trips to make them the most efficient possible for the customer and supplier).
The same wasted behaviors occur with software as well. This is the first pitfall of usage-based pricing. If your customer can’t tie their usage to their outcomes then the usage-based model isn’t going to work for either the customer or the supplier, and will likely lead to the same results of the flat subscription fee pricing model - namely, churned customers.
One way to overcome this challenge is to align with customers on how usage is driving value. This starts by creating a shared value realization framework. Technology like Ecosystems’ Collaborative Value Assessment can make creating this shared plan easy, ensuring you are aligned on the right value and KPIs.
2. Difficulty to Predict Revenue and Budget
Secondly, usage-based pricing models can be a nightmare for predicting revenue if not built with safeguards for both the customer and the supplier. If finance or revenue operations can’t predict how much customers are going to use their software, then they can’t predict revenue making it more difficult to allocate investments. On the other hand, the customers’ CFOs would be upset if sent a bill 10X what the bill last year was because their teams decided to use the product 10X more.
Some of this volatility and unpredictably can be offset by historical usage data. SaaS companies that have been around a while and have tracked past usage, can be fairly confident in their usage and revenue predictions. Tracking past value delivered relies on historical usage data as well, so anyone who has been actively doing value realization with customers will have the upper hand in determining a model that will drive revenue while also keeping the customer happy.
The other way often used to protect against this variability is to establish an expected usage range. The supplier would use historical data to align with the customer on the range the customer will probably use the product. In the example above, the supplier might look to the amount of times the customer went to the store last year, and then add or subtract 25%. Anything outside of this range would require the parties to renegotiate the contracted price.
Similarly, a third way to eliminate variability would be to establish an up-front base price for usage. For example, the customer will commit to going to the store at least 25 times a year, and any usage over that amount would be billed at a fixed fee.
Finally, the supplier could front-end charge the customer and bill from that amount, like a legal fee is held in escrow. The supplier would get the benefit of using that money for its own investments, and any remaining credits at the end of the billing cycle could be negotiated for upgrades or rolled over.
Conclusion
The shift to consumption-based pricing is a significant trend that is reshaping the business landscape. While it presents challenges, it also offers significant opportunities for businesses that are willing to adapt. By understanding the key drivers of this shift, addressing the challenges, and embracing best practices, SaaS executives who are responsible for pricing and revenue can navigate the transition to consumption-based pricing and position their companies for growth in the evolving market.
