Beyond traditional models: Embracing the advantages and acknowledging the risks of a consumption-based pricing model
In today’s rapidly evolving digital landscape, software companies are constantly seeking innovative pricing to remain competitive. One model that I’ve seen in many of the startups that I work with at Atomico is the consumption-based pricing model.
This approach follows the promise of the cloud and allows customers to pay for software services based on their actual and real usage: put simply, you pay as you go and only pay for what you use.
While such a model offers a lot of benefits and advantages for both customers and SaaS companies, this does come with certain risks and considerations, which makes the decision to adopt such a pricing model more complex than one might think.
So, what are the potential benefits of consumption-based model pricing?
Flexibility in cost: A consumption-based model allows customers to align their software expenses with their effective usage. This flexibility can be appealing, particularly for small businesses or startups with limited budgets. Customers have the freedom to scale their usage up or down as per their needs, resulting in cost optimization.
Increased Customer Satisfaction: With a consumption-based pricing model, customers feel empowered as they have control over their expenses. They can easily understand the value they are receiving from the software and adjust their usage accordingly. This transparency and flexibility in pricing contribute to higher customer satisfaction and loyalty, and incentivises customers to use the solution more.
Revenue Growth Potential: For software companies, a consumption-based model opens up new revenue growth opportunities. As customers increase their usage, software companies can generate more revenue without the need for additional sales efforts. This scalability allows companies to capture a larger market share and maximise their revenue potential.
With all these benefits in mind of having a model that is more scalable, more predictable, more used, and adapted to the real needs of customers, a lot of software companies have already embraced the consumption-based model pricing or are migrating to this new way of billing their services. But that’s not to say it doesn’t come without risks, as the way you bill will have a significant impact on your growth strategy, your perceived value on the market and your overall performance. Such risks include:
Revenue fluctuations: Consumption-based pricing can lead to revenue variability, as it relies on customer usage.
Customer adoption and perception: Some customers can be resistant to this model especially if they are accustomed to fixed pricing, so it’s crucial to effectively communicate the value proposition and educate them to address any possible concerns. Ensuring transparency on how you set prices is essential.
Complexity and implementation challenges: Implementing this model may require significant changes to your pricing infrastructure, billing systems, and reporting mechanisms. It can be complex to accurately measure and track customer usage, leading to implementation challenges.
Customer dissatisfaction: If the customer feels the pricing model is unfair or that there is a lack of transparency, it can lead to dissatisfaction and potentially churn. Unexpected costs and complicated pricing tiers far from their business needs can create frustration.
Cost management and profitability: It’s vital to analyse costs associated with infrastructure, support and scaling, ensuring that pricing rates are set appropriately. Customers can get lost on how to predict exactly their needs, as before they had a simple way to fix annual cost.
Competitive dynamics: If competitors offer alternative pricing, it could impact customer acquisition and retention. It's important to analyse the market landscape and stay aware of competitors’ pricing strategies to remain competitive and not off market.
Once you’ve decided to implement a consumption-based pricing model, the next step is to decide on your buying channels. This could be any of the following:
On Demand / Self Service: Anyone can sign up, they pay monthly with no specific pre-commitment at list price, and ideally it's recommended to publish on your website to be always transparent on the way you bill your services.
Pre-Paid on an annual or pluriannual commitment: For businesses who want a more predictable budget, this provides access to discounts or more services such as support or more functionalities.
Cloud Marketplaces: The hyperscalers (AWS, Microsoft and Google) all have in common that they offer access to marketplaces with contractual commitments that software companies can draw down against. The hyperscalers will be sponsors of your solution as you can help them consume these pre-paid commitments where they allow specific conditions and their objective is the same: make sure customers will consume their commitments with their solutions or solutions for their partners.
Define versions of your software with more functionalities: This can help increase the unit of measurement or ensure moving from On demand to an annual contract.
E.g. Standard, Premium, Enterprise
E.g. Bronze, Silver, Gold
Once you have defined your model of pricing and distribution, the next step is to consider the units of measurement that you will use. This needs to be translated into usage of your solution, but must also be easy to understand and translate on the customer side.
Below are some key examples of metrics software companies can use. Software companies may choose one or multiple units of measurement based on the features and resources they offer to their customers.
Users: The number of users accessing the software or platform. This can be based on the total number of registered users or active users within a specific period of time.
Storage capacity: The amount of data storage used by the customers. This can be measured in gigabytes(GB), terabytes (TB), or any suitable unit.
Data transfer: The amount of data transferred between the customer’s system and the software provider’s system. This can be measured in GB, TB, or as a combination of inbound and outbound data.
API calls: The number of times an application programming interface (API) is called by the customer’s software. This metric measures the level of integration and usage of the software’s functionalities.
Transactions: The number of specific actions or transactions performed by the customer within the software. This could be based on the total number of transactions or a specific type of transaction.
Compute resources: The computational resources (such as CPU usage or memory) utilised by the customer’s software. This can be measured in terms of processing power, time, or a combination of both.
After all these steps have been taken, and you are clear on the pricing model, the unit of measurement, and the tiering system and versions of the product, the final piece of the puzzle is to build a consumption table. A consumption table essentially provides a breakdown of the different Unit of Measurements (UoM) to help you calculate the costs associated with the usage of the software or services. This should include:
Unit of measurement: List the different metrics used to measure usage (UoM) of the software.
Tiers or thresholds: Define the different tiers or thresholds at which the pricing changes based on the level of consumption. Each tier may have a different pricing structure or rate associated with it.
Pricing rates: Specify the cost or rate for each UoM. It could be a flat rate, a tiered rate, or a combination of both.
Usage calculation: Show the total usage of each UoM during a specific billing period or the accumulation of usage over time.
Cost calculation: Calculate the cost of each unit of measurement based on the corresponding pricing rate and the usage quantity.
So, while a consumption-based pricing model can massively boost customer satisfaction, increase revenue growth potential, and make costs more flexible, it’s clear that implementing it requires appropriate planning and foresight, and an acknowledgement of the risks involved in such a strategy. Ultimately its success lies in the ability of software companies to strike the right balance between customer value and sustainable business growth. And while it may not be the best fit for all companies, this strategy, when properly implemented, can be a gamechanger.