For SaaS and Cloud Computing
Customer Benefits
Lower Cost, Lower Friction, and Lower Risk than Subscriptions
Usage-based pricing offers a number of advantages to customers in the early stages of adopting a new SaaS or cloud product.
- Low Cost – Perhaps, the biggest advantage of usage-based pricing – as compared to subscriptions – is that you you pay only for what you use. If you use the product for one day you are only billed for consumption during a single day (not the full month). If you don’t use the product at all then you will not have to pay.
- Low Friction – In many cases, the customer experience for a new user that wants to try a product is almost frictionless. Often, the customer can experiment with the product using a free trial then upgrade to a more feature-rich paid plan without having to speak to a sales representative.
- Low Risk – Many usage-based pricing models do not require a customer to sign an annual contract. The customer can register online for a monthly, pay-as-you-go plan that bills in arrears via a credit card. If the customer decides to discontinue using the service, there are no additional fees to be paid.
Customer Challenges
No Discount, No Budget Predictability, No Data Protection
For customers that rely on the product for business-critical functions and need to consume high volumes on a daily basis, many of the advantages outlined above can quickly turn into disadvantages.
- No Discounts on Pricing– With a no contract (monthly, pay-as-you-go plan), the customer typically pays the list price for each unit consumed. Although, the customer is only paying for what they use, they are paying more per unit than they could or should.
- No Predictability for Budgets – The amount billed each period can vary significantly from month-to-month. Although there may not be friction with the vendor, there will be friction with the finance department as business users are not able to predict how much they will spend and when they will spend it.
- No Legal or Data Protection – As more and more users adopt the service across the customer’s organization, there is more sensitive data stored on the cloud platform and more dependency on the service performing as expected. For customers with high volumes of usage, the lack of a formal contract is introducing risk.
These higher costs, friction, and risk can be mitigated by entering into a formal contract arrangement with the SaaS or cloud computing provider. With a contract the customer can negotiate a discounted price, a predictable payment plan, and secure data privacy protections as well as service level agreements.
Benefits to SaaS and Cloud Providers
New Customer Acquisition and Rapid Expansion
Usage-based pricing offers SaaS and cloud providers a number of business model advantages as compared to traditional subscription contracts:
- New Customer Acquisition – When paired with a product-led growth model, usage-based pricing offers an almost unparalleled model for new customer acquisition. End-users are attracted to the combination of low cost, low friction, and low risk. Most prefer the experience over subscription-oriented, sales-led processes that drive customers to sign long-term contracts without offering any hands-on experience with product.
- Pricing Flexibility – Usage-based pricing offers an almost infinite number of choices. Product managers can tie pricing to millions of value metrics based upon transaction count, volume processed, or time consumed. If there isn’t a standardized metric that fits perfectly, SaaS and cloud providers can create their own new, custom value metric for pricing.
- Rapid Expansion – Most subscription pricing models are tied to user counts. Each additional user requires a contract amendment which may require approvals from procurement, legal, and finance. With usage-based pricing there is no approval required to scale. Consumption can quintuple month-over-month without a contract amendment. As a result, revenue has the potential to grow much faster.
Challenges for SaaS and Cloud Providers
Forecasting, Cash Flow, Capacity Planning
There are a number of significant economic challenges that SaaS and cloud providers will need to overcome when scaling usage-based pricing models.
- Revenue Forecasting – Unlike subscription pricing models for which there is a committed monthly fee for the duration of the contract, usage-based pricing offers finance organizations little visibility into future revenue streams. Even if the customer purchases prepaid units, the timing of the consumption and associated revenue recognition can vary.
- Cash Flow – Customers on monthly, pay-as-you-go plans will be invoiced in arrears for the services consumed. In some cases, the SaaS or cloud provider will need to pay their suppliers as far as 30 to 60 days in advance of when they receive payment from the customer.
- Capacity Planning – With limited ability to forecast future usage, it is challenging to ensure that there is adequate capacity available for spikes in demand. Over-provision and your expenses will be high relative to revenues which will lower gross margins. Under-provision and your revenue maybe constrained by an inability to service demand.
Many of the forecasting, cash flow, and capacity planning challenges can be reduced by converting customers onto longer term contracts with monthly minimum fees and some percentage of the committed revenue paid in advance.
The Complexity of Usage-Based Pricing
Pricing, Discounts, Contract Structures
The charges a customer pays each month in a usage-based pricing model are determined from a simple formula:
Charge = per unit price x quantity of units consumed
However, in practice the calculations are rarely this simple. Complexities include:
- Pricing – The pricing may be based upon more than one variable. For example, a customer may be charged $0.50 for each hour the product is consumed and $0.10 for each GB of data processed.
- Discounts – The final charges the customer pays may be discounted based upon the volume consumed. For example, 5,000-10,000 units might qualify for a 20% discount, 10,000-20,000 units a 30% savings, etc.
- Non-Billable Usage – Certain types of transactions such as those that don’t successfully complete may be deemed non-billable. Before quantity can be determined the non-billable units must be deducted.
- Rounding – Actual usage is rounded up before the billing process occurs. For example, the customer may have used the service for 5 minutes on three instances, each of which are rounded up to 1 hour.
- Free/Included Units – The customer may be entitled to a certain number of free credits per month. For example, the customer may have consumed 1,000 units but is entitled to 500 free units per month.
- Prepaid Units – The customer may have purchased a certain volume of usage in advance in exchange for a discount. They purchased 1,000 units and consumed only 100 so they owe nothing this month.
- Rollovers – Unused allowances from prior months may have been eligible to rollover into the current billing period. 300 units rolled over and the customer used only 200 this month so there is no charge.
- Minimum Fee – The customer may have signed a contract that stipulates they pay a minimum fee each month. As a result, $500 may be billed even though the customer only consumed 100 units at $1/unit.
Organizational Impacts and Workload
Sales, Product, Finance
There are a number of significant economic challenges that SaaS and cloud providers will need to overcome when scaling usage-based pricing models.
- Sales reps have to learn how to educate customers on complex products such as prepaid units as well as the associated billing policies for rollovers, expiration dates, and overage fees.
- Rev Ops needs to devise new compensation strategies that fairly pay sales reps based upon newly booked contracts for which the actual revenues might be 2-3X what is committed in the agreement.
- Product Management needs to identify the best unit of measure (value metric) to use for pricing consumption and devise discounting strategies that incentivize customers to increase consumption.
- Engineering needs to develop product features that meter consumption for each individual customer and provide a clean, accurate feed of data to downstream customer portal and billing systems.
- Finance will need to take a feed of raw data on usage and quickly convert it into customer-friendly invoices, journal entries to recognize revenue, and operating metrics to share with investors.
- Customer Success will need to become experts on helping customers accurately forecast future usage patterns so they don’t waste funds on overage fees, expired credits or true up payments.
Adoption Beyond Tech
Usage-Based Pricing in Energy, Telecom, and Aerospace
In this guide we are focused on how usage-based pricing supports SaaS and cloud business models, but it is important to note that consumption pricing models are used in almost every industry segment. A few examples include:
- Energy – Every business from professional services to industrial manufacturing needs electricity and sometimes natural gas to power their day-to-day operations. Commercial utility services are typically priced on a consumption basis such as cents per kilowatt hours or dollars per thousand cubic feet.
- Telecommunications – Local, long distance, and international voice and data services are offered in a variety of formats. Some businesses pay a fixed fee per month for services with a consistent predictable, usage pattern. Others with irregular usage are typically purchased on a price-per-minute basis.
- Aerospace – Aircraft engine manufacturers offer as-a-service versions of their jet propulsion systems that include not only the equipment, but spare parts and servicing. Pricing is consumption based and determined by the number of hours of use.
- Transportation – While some larger companies have their own vehicle fleets, many organizations lease, rent or consume transportation-as-a-service offerings. Agreements for short-term use of cars, vans, and trucks are often priced based upon consumption with the value metric being the number of miles driven.
- Real Estate – Traditional commercial lease arrangements are typically priced with a standard fixed fee per month and various add-on charges. However, new co-working models offer on-demand space rental that is priced based upon consumption at a per day or per seat per hour rate.
More Articles, Webinars, and Resources
About Usage-Based Pricing
Success with Usage-Based Pricing Requires Collaboration Across the Business
Usage-based pricing succeeds when the whole business understands and believes in the model. Everyone from the Human Resources professionals managing sales compensation plans to the Customer Success Managers.
How 10 Cloud Providers with Usage-Based Pricing Report ARR
How do companies with usage-based pricing report on ARR? We compiled ARR definitions from the investor filings of 10 large public companies.
