The pros and cons of consumption-based pricing

The pros and cons of consumption-based pricing

Consumption-based pricing models are rapidly transforming how businesses approach monetization, particularly in high-tech and SaaS sectors. 

These models, which charge customers based on their actual usage, help align costs with the value delivered and they offer flexibility to scale services according to user needs. This can lead to higher customer satisfaction and help drive recurring growth for your business. 

But while the benefits are clear, the implementation of consumption-based pricing also presents a unique set of challenges. In this article, we’ll explore the intricacies of these models, highlighting the pros and cons, as well as presenting practical solutions.

What are the advantages of a consumption model?

An ever-increasing number of consumers and businesses have encountered consumption-based pricing and billing—and they’re demanding more. In fact there has been a significant increase in the adoption of hybrid consumption models over the last 3 years. 

Let’s explore some of the benefits of implementing a consumption-based pricing model.

Customer-centric approach 

Consumption-based models focus on providing value that directly correlates with customer needs and usage, rather than imposing flat rates or bundles. Usage data can provide valuable insights into customer behavior and preferences. Companies can use this data to offer personalized upgrades or additional services tailored to the specific needs of each customer, enhancing the perceived value and differentiating their service in a crowded market.

This pricing model also allows businesses to cater to a wide range of customers, from startups to large enterprises, by offering plans that scale according to usage.

Differentiated value proposition 

By targeting the right value metric and optimizing the level of usage pricing businesses can differentiate themselves from competitors and create a strong value proposition. Plus, consumption-based models enable companies to quickly adapt to market changes and evolving customer needs without significant restructuring of their pricing strategies. 

Recent Subscribed Institute research also indicates that SaaS companies employing consumption-based models are maintaining a long-term revenue growth advantage over their non-consumption counterparts.

Flexible and scalable growth

Because the barrier to entry is lower, customers can start small, see the product in action, and consider if they want to sign up for a more robust package when the time is right. As customer demand increases, businesses can then adjust resources in order to accommodate higher consumption levels.

Visibility and control 

Customers value real-time consumption visibility, enabling them to track daily progress, anticipate overages, and view billing charges. With the right technology in place, consumption models can enable your business to push out threshold notifications. This allows customers to monitor their usage and spending, and ultimately, increases overall customer satisfaction. 

Usage forecasting can also enable your business to monitor behavior and predict expansion opportunities for high-consumption customers.

Predictable revenue streams 

While consumption-based pricing models are typically associated with variable costs based on actual usage, companies can introduce predictability by linking prior commitment to customer spending habits. These hybrid consumption models can lead to higher YoY ARR growth across all company sizes. 

This approach is often referred to as “committed usage” or “pre-paid consumption.” These strategies are fast emerging as the models of choice for companies launching AI and GenAI, due to their potential to drive growth and profitability even in the face of astronomical costs.  

What are the challenges of a consumption model?

Implementing a consumption-based pricing strategy can also present its challenges. Companies need to balance value, while also having enough cash to cover costs. Pricing too high could put some customers off, while pricing too low will result in a loss.

Implementing consumption-based pricing requires planning and consideration of the potential risks and challenges.

Surprise overages or shut-offs 

Surprises lead to terrible customer experiences. For this reason, customers tend to dislike simple pay-as-you-go billing—it may not provide the predictability they require. The nature of consumption pricing means that customers might not realize how much they’re using. 

The answer is transparency and mediation—customers need to stay apprised of their consumption patterns. And if you can do it right, it’s not only a better experience, but can be a key growth lever as well.

Customers may overcommit

Consumption-based pricing models may introduce a situation where customers end up overcommitting or pre-paying for too much. Businesses will then have to decide how to handle the extra credits, money, or units customers already paid you for.

Billing becomes substantially more complicated 

Consumption charges are typically billed in arrears, after the billing cycle. This may be different from the way your billing team operates today, if your customers are typically billed in advance. 

This new process means that billing teams will have to ensure charges are calculated accurately, invoices are sent out on time, and billing operations are maintained for customers who may not be on a consumption model. This often means that billing teams are having to work out of multiple systems to collect the data they need for accurate billing.

The role of Billing Operations will have to expand 

In a traditional subscription model, a customer can’t dispute that they bought 5 seats after they sign the contract and pay the invoice. They might dispute the terms or proration calculations, but it basically ends there. 

In a consumption model tied to usage, there’s a myriad of opportunities for billing confusion and inaccuracies to spiral out of control and destroy customer experiences and bog down your support team. Billing Ops now will need to expand from deal support and invoice accuracy to forecasting, notification, and dispute defensibility.

Revenue recognition and reporting can hinder the success of the model 

Under ASC606 and IFRS15, there are specific revenue recognition rules that accounting teams will need to adhere to. Without a system in place to handle complex consumption revenue recognition, this will lead to manual efforts and hundreds of thousands of lines of spreadsheets to reconcile.

Revenue accounting teams are often asked to do this additional work with no added headcount, adding stress to the teams and increasing control risks. And since consumption pricing is dependent on how customers consume the product, there’s a lot more dependency on data from the product team.

In addition, reporting and forecasting consumption revenue is critical for business leaders when reporting to investors and executing strategic planning. Companies must be able to have granular visibility into their consumption revenue at any given time, especially with the fluctuation some consumption models can bring.

Solutions for successful consumption implementation

With the right solutions in place, you can embrace the advantages and overcome the challenges of consumption-based pricing models. Successful implementation requires:

Flexible pricing tools

To accommodate the variable nature of consumption-based pricing, businesses need tools that allow them to adjust pricing quickly in response to changes in usage data. This flexibility helps in aligning pricing more accurately with the value provided to customers, fostering fairer and more satisfying customer relationships​​.

Real-time data processing

Investments in technologies that support the real-time tracking and billing of usage data are crucial. This ensures that data is accurate and minimizes revenue leakage. It also provides customers with immediate feedback on their consumption, which can improve their user experience and satisfaction​​.

Continuous adaptation and testing

Regular testing and adjustment of pricing models are necessary to find the optimal balance between revenue growth and customer satisfaction. This involves using platforms that support rapid experimentation with minimal coding, allowing businesses to innovate and respond quickly to market changes​​.

Cross-functional cooperation

Effective implementation of a consumption model requires collaboration across multiple departments within a company, including product, finance, and customer service. This cross-functional work ensures that all aspects of the consumption model—from pricing strategy to customer communication and billing—are aligned and effectively managed​​.

Make consumption-based pricing work for you

Quickly launching and scaling a consumption-based pricing model requires a strategic approach that combines flexible pricing tools, comprehensive data integration, and continuous analytics. By leveraging advanced platforms like Zuora, companies can not only implement these models effectively but also stay ahead in competitive markets by adapting to customer needs and consumption patterns rapidly.

Learn why leading companies use Zuora to move fast and quickly add usage to their pricing mix.

 

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