The future of software is usage-based pricing
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Every software company advocates customer focus. Yet the common subscription pricing model for most cloud software is anything but customer centric.
In a subscription pricing model, customers must choose to pay a recurring charge per month. Recurring charges are determined in advance before purchasing the software. It is usually calculated based on the cost of a license multiplied by an estimate of the units of that license needed over the next year, or over a longer contract term. These subscription models are a Great contract for the software vendor because it is paid for the duration of the contract even if the software is not in use. It’s not that good for you as a customer. If you use too little, you’re wasting your budget on shelves. If you use too much, you end up with overtaking penalties.
Compare that to the way we use water in our homes. The resource is always available and you can limit your usage according to your needs. When you decide you need an extra long hot shower, or have guests, you simply consume what you need and then pay for the extra value you received. It’s intuitive and predictable with a price based on the value you receive. Now imagine if we subscribe to a fixed amount of water each month. Why should you pay for water that you didn’t use because you installed more efficient showers? It’s just unfair. Or worse, why would you run out of water because your guests took a long shower? It just doesn’t make sense.
Similar to water at home, the software has become much like a utility at work. This is why consumer pricing for software is increasingly becoming the norm. Amazon Web Services (AWS) is a prime example. He popularized consumer pricing, where customers pay only for the capacity they use and derive value from. Since then, a number of other leading and high-growth software companies have successfully adopted this model, including Twilio and Snowflake. And the data supports this trend: According to OpenView Venture Partners’ 2021 SaaS pricing survey, 39% of SaaS providers now offer usage-based pricing, up from around 23% in 2014.
Pricing based on consumption or usage fundamentally changes the relationship between software companies and their customers from unfair subscription models to an intrinsically fair exchange of value. By aligning revenue with usage, software companies understand that they won’t get paid unless they create products that customers both enjoy using and gain value with every use. Companies that continuously innovate and deliver differentiated value will be rewarded with accelerated revenue growth and customer loyalty, and the virtuous circle continues. Consumption is more than a business, pricing or revenue model; it is the commitment to focus every function of a business on the success of customers and to ensure that they derive real value from its platform, products and / or services.
Today, it’s clear that consumer pricing will continue to be accepted as the preferred business model by customers, from hyper-growing startups to the world’s largest corporations. Looking back and building on our conversations with customers, here are three factors we’ve learned that will contribute to the continued success of consumer pricing:
- Consumer pricing makes it easier to get started: Subscription pricing forces an upfront commitment, which is an artificial barrier for customers to know if the software is going to be of use to them. Sure, 15-30 day trials are helpful, but it’s too short a period for anyone to really understand the value. In contrast, consumer pricing allows customers to get started for free and without any commitment. Customers can scale as they find value and only then pay for the value they get. Internally at the software vendor, this model also frees up teams in contact with clients from negotiating and renegotiating complex transaction structures and allows them to focus on creating value for clients, helping them in ways collaborative to drive engagement and increase product usage based on customer needs.
- Consumer pricing offers more flexibility: The all-or-nothing aspect of subscription pricing can have a negative impact on customer satisfaction and retention. As we’ve seen through the global pandemic, when businesses are forced to cut costs, they may no longer be able to afford high fixed costs. Consumption-based pricing allows customers to increase and decrease consumption in real time as business needs change, creating a better customer experience and inspiring loyalty. It also alleviates the customer’s burden of managing software and high upfront costs. In other words, it truly transfers cost control to the customer. For example, the hospitality industry has naturally suffered over the past 18 months, having to quickly reduce or modify its supply models to align with declining demand.
- Consumer pricing is more scalable: As we’ve seen over the past decade, today’s startup can be the global business of tomorrow. Consumer pricing offers an attractive option for growing businesses that may need to scale quickly in the future. With pricing for legacy subscriptions, scaling requires renegotiation and a new contract, which can be time consuming and puts additional pressure on businesses trying to grow quickly. Just as consumer pricing offers customers the ability to reduce their consumption when necessary, it facilitates rapid change and keeps pace with rapid growth; no new contract or negotiation is required to use more software. As a recent example, the scalability of consumer pricing was well suited to support the sudden and rapid growth of digital businesses and accelerated innovation times brought about by the pandemic. In just days, businesses had to expand their digital presence faster than ever, including grocery stores, meal delivery apps, video conferencing tools, online education apps, video streaming platforms, exercise apps, etc. Through consumer pricing, the path to meeting customer demand was straightforward.
However, as with any change, consumer pricing has its critics. The main concern is controlling the company’s IT budget. Many IT teams, especially in large organizations, need to manage their software expenses on a monthly budget. A sudden increase in software costs due to higher usage in any given month, without proper controls to streamline increased usage, is a scary proposition. There is a strategic solution to this “on budget” problem: Offer real-time usage reports as well as an “Annual fundraising” option. Real-time usage reports allow administrators to have full visibility into how their teams are using their software tools and to be alerted to changes in usage patterns. This way they are always in the know, can be sure that the increased usage is valuable to the business and, if necessary, slow down. The annual fund pool option should / could give customers the flexibility to pay for their usage over a 12 month period and accommodate seasonal peaks and declines in usage with monthly rollovers. Collectively, these capabilities give IT teams the controls and confidence they need to adopt consumer pricing models. Twilio, AWS, Stripe, and other big SaaS companies have pulled off this next evolution in software pricing.
In short, consumer pricing will eventually become the de facto standard for all software vendors. This is the latest step in the software industry‘s three-decade journey of putting customers’ best interests at the center of everything they do. It’s about aligning with the customer’s success. Forward-thinking software companies will continue to embrace this model as true supplier partners. Those who do not scale risk seeing an erosion not only in their revenue growth, but also in customer trust and loyalty.
Manav Khurana is Director of Growth at New Relic. He previously held product and marketing leadership roles at Twilio, InVision, Aruba (HPE) and Motorola.
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