Usage-Based Pricing: An Evolution For The Taking

Published by: Forbes

In this guest-authored article for Forbes, RecVue CEO Nishant Nair, a member of the Forbes Technology Council, discusses the mainstream move for usage-based pricing models and why this will only increase with time.

Is your business in danger of becoming the “boiling frog?” It might be if it’s in the software and technology space and not paying close attention.

If you’re not familiar, the “boiling frog” theory revolves around a 19th-century experiment in which researchers concluded frogs, when thrown into a pot of boiling water, would jump out to survive; but a frog placed in a pot of cold water with the temperature slowly raised becomes unable to sense the small temperature changes and eventually boils to death.

This sad parable remains a useful metaphor for the situation faced by those in software, technology and similar industries touting customer-centricity through subscriptions, oblivious to the slow evolution happening all around them: the rise of usage-based pricing.

Subscription- Versus Usage-Based Pricing Models

Customer expectations in the user-vendor relationship have never been higher, with a lack of audacity to ask for just about anything accommodated by: 1. advances in technology and 2. a seasoned and refined understanding of how best to use it. However, not every company is a good active listener.

Let’s compare subscription pricing with usage pricing from both a user and vendor perspective when it comes to software.

In a subscription pricing model, a customer is expected to opt into paying a recurring monthly fee of an amount determined in advance of the software purchase. That recurring fee is typically based on a license cost multiplied by an estimated number of units of that license needed in the coming year. 

While it’s a nice deal for the software provider, paid for the terms of the agreed-upon contract regardless of actual software usage, it can cause problems for the customer. Too little usage, and a customer’s budget is being wasted on shelfware; too much, and they’re hit with overage penalties. At the risk of relying on too many fables, you become a bit like Goldilocks, seeking just the right amount of usage to warrant the cost. As Forrester noted in its report, “Finding the SaaS Goldilocks Zone,” firms trying to find the right approach to pricing shouldn’t assume all customers want equal value because they share a requirement for the same type of offering. 

With usage- or consumption-based pricing, on the other hand, customers are given the latitude to modulate their usage with companies measuring that usage and billing accordingly.

The fulcrum of the agreement between software company and customer becomes more centered with a more equitable exchange of value. It doesn’t just benefit the customer. Revenue being aligned with usage puts the software maker on notice that payment requires a frequently innovated and differentiated product their customers will enjoy and value. The companies paying attention are rewarded with higher revenue growth and a more loyal customer base.

Beyond a pricing or revenue model, consumption now becomes the focus of every corner of a company, committed to making customers successful and recipients of true value from their products and/or services. A real win-win.

A Model On The Rise

It’s no wonder usage-based pricing is a trend gaining incredible steam.

Seven of the nine SaaS IPOs which had the best net retention over the past few years employed usage-based pricing models, companies including Slack, Snowflake and Elastic, according to “The 2021 State of Usage-based Pricing Report” by venture capital firm OpenView Venture Partners. The recent report illustrates the upward trajectory of this model.

Some other eye-openers from this report include:

  • Companies that implement usage-based pricing have an average of 137% net dollar retention.
  • A doubling of the adoption rate for this pricing model in four years, from 27% in 2018 to a projected 56% in 2022.

It’s clear why this model is viewed as the next evolution in software pricing: Both the appeal and the power are two-way streets.

Beyond the benefits mentioned, consider the scenario where a SaaS solution handles the flow of money and transaction fees can be embedded in the flow of that money. 

Examples of this would include B2B payments for goods and services, such as expense management or purchase-to-pay on the buy side, or e-commerce platforms and other solutions touching revenue and AR on the sell side. SaaS usage fees in these cases can be extracted from—or tagged onto—a business’ flow of money, viewed as part of the “cost of doing business,” as part of COGS. The result? Opportunity for a much greater share of value than one could ever imagine from a basic subscription.

The usage-based pricing model, according to Bessemer Partner Ventures’ annual “State of the Cloud” report, has been on the rise because it goes hand-in-hand with product-led growth. Companies putting it to use are giving more flexibility to their customers, then sharing in the resulting success and scale.

Getting Started With Usage-Based Pricing

While the benefits are clear, the change to usage-based pricing comes with its own set of challenges. Among those are the potential for customer sticker shock, cash flow insecurity, confusing scaling mechanisms and little commitment due to low investment.

To mitigate these challenges, here are a few tips to get started when considering this model:

  1. Sales and customer success roles are impacted, so take this into consideration and adjust accordingly.
  2. The metric you charge against should closely align with the value your customer gets from your product.
  3. By delivering a high level of customer reporting and alerts, you can assist your customers in managing cost, performance and adoption of your solution.
  4. Go the extra mile with the math and technical knowledge to help your customer forecast the estimated usage of your system.

Usage-based pricing may not be for everybody. However, when it fits your business, it can be quite the powerful component.

For any software company, finding the right pricing strategy is crucial. In many cases, however, by not paying attention to their surroundings—namely, their customer needs and how value is assigned to the product or service—it can get overlooked or poorly designed. They’re boiling and don’t even know it.

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