STRATEGIC GUIDANCE
Successfully launch and scale your consumption business model
Over the last several years, the industry has seen an increase in adoption of consumption-based pricing models, whether in isolation or in combination with subscriptions. Public company darlings like Snowflake, Twilio, and AWS, with their phenomenal growth rates and net retention, have caused the entire market to pause and think about how they can benefit from such consumption models.
And our own customer data supports the value of considering consumption—companies with at least some mix of consumption experience a higher rate of growth.
As always, a key factor here is keeping apace with customer demands. Customers feel that consumption-based charge models give them better visibility into the value they derive from your product or service and it provides better flexibility and scalability.
When you strike the right balance between value and flexibility for your customer and predictability and strategies your business needs for growth, you improve customer retention.
Launching a consumption-based model can seem like an insurmountable challenge, but this guide will provide the knowledge and strategies you need to successfully make the shift.
What is a consumption-based pricing model?
Why do your customers like consumption-based pricing and billing?
Why should businesses adopt consumption-based pricing and billing?
How do you know if and when a consumption model is the right choice?
What are some common consumption-based pricing models?
How do you select the right model or mix of models?
How do you handle consumption data?
How do you determine your value metric?
How do you mediate customer usage?
How do you accurately bill for consumption?
How can you maintain continuous insight into consumption?
How do you track and recognize consumption revenue?
What are the advantages of a consumption model?
What is a consumption-based pricing model?
At the core of any pure consumption model is the fact that the price a customer pays is solely dependent on how much of that service they use. Service providers billing via consumption models need to be able to objectively, precisely, and defensibly measure how much a customer uses—per GB of storage, per minute of phone call time, etc. This concept is often referred to as the “value metric,” “unit of measure,” or “pricing basis.”
In contrast, subscription models are anchored more on access and capacity than on actual usage. Common examples are flat platform fees like the bronze/silver/gold tiers or family/student/individual plans of a subscription offering.
In the B2B domain, it’s not uncommon for pricing models to be based on value metrics that represent a quantity of entitled (vs. consumed) product. The quintessential example here is the “per seat” model. If a customer buys 5 seats of Salesforce, they are actually buying the entitlement to use five seats. Whether or not they use those 5 seats or how much they use them is not germane to how much the customer pays Salesforce.
The next most important feature of a consumption model is the way in which the price per unit of consumption is determined. Commonly called “rating logic,” this approach can be as simple as a flat price for every unit—to as complex as multi-dimensional algorithms that can be based on everything from geography to time of day. In addition, discounting is frequently employed as a strategy to incentivize more consumption.
The final, and in our opinion, most overlooked feature of consumption models is the notion of time. More specifically, when a customer agrees to pay for their consumption of a service.
It’s a common misconception that consumption models only bill for customers after they actually use a service. The technical accounting term for this concept is “in arrears” billing, but these use cases are better known as usage-based or pay-as-you-go models in the market.
Many consumption companies tout that this “in arrears” model is the key to their success. The assumption is that with perfectly aligned incentives and the vendor consistently delivering value, the customer will be happy to pay in-arrears because they know they’ll never get ripped off. This line of reasoning flies in the face of a simple truth of business—that predictability has always and will always continue to be incredibly valuable to both service providers and customers alike.
At Zuora and Boston Consulting Group we’ve seen this truth play out for years. ”In advance” models that are commonly referred to as “prepaid,” “committed,” and “pre-commitment,” etc. almost always accompany “in arrears” models.
To illustrate, a service provider might sell cloud storage for $0.50 per GB to anyone who wants to “pay-as-you-go,” but they’ll sell that same storage for $0.25 per GB if a customer is willing to commit to using 50 GB per month. While more customers might be willing to test the service at the $0.50 price point, eventually, the customers getting the most value will want to trade flexibility and low contract risk for predictability and cost savings.
Therefore, we want to be clear that consumption models aren’t just about usage vs. recurring or in arrears vs. in advance. The best consumption businesses today anchor their pricing on a solid value metric first and then engineer their growth by successfully balancing between low risk pay-as-you-go models and high predictability pre-paid models.
So, how many companies are actually pursuing this strategy today—and are they finding success? We analyzed aggregate, anonymized customer data to gain insights into the latest consumption trends.
Read more below: How do you select the right model or mix of models for your business?
Why do your customers like consumption-based pricing and billing?
Customers are increasingly demanding a clear return on investment (ROI) and lower upfront risk—they want a better picture of what they’re using and how much value they’ll derive from your product. And 80% of customers report that consumption-based pricing provides better alignment with the value they receive.
Customers like flexibility when they are first trying a product, which makes simple pay-as-you-go pricing a good option for onboarding new customers. But as they adopt and grow more confident in your solution, they are going to want more predictability.
Therefore, customers will expect the nature of how they pay for their consumption of your product to change as their relationship with you grows. Subsequently, your monetization capabilities need to be ready to change to meet customer expectations.
Read more below: What are the advantages of a consumption model?
Why should businesses adopt consumption-based pricing and billing?
Many of the fastest growing public companies leverage a consumption-based model. Why? Consumption-based pricing can be a competitive differentiator and may enable a lower cost of sale and lower barriers to entry.
This strategy also presents an opportunity for companies to align on value and pursue product-led growth (PLG). Recent findings indicate that consumption-based businesses have 38% higher forecasted YoY revenue growth than their non-consumption based peers.
61% of SaaS companies are also expecting to adopt some form of consumption pricing in 2023, with another 21% planning on testing in the future.
Read more below: What are the advantages of a consumption model?
How do you know if and when a consumption model is the right choice?
Consumption-based pricing models can be a powerful lever for growth, but in our experience many companies don’t leverage them due to the perceived risks and very real investments involved. Building the capabilities and deploying in the appropriate situation is critical.
We have observed three keys to deploying these pricing models in a way that delivers on the growth potential promise.
The “what”—company and product
When choosing the appropriate pricing model, it is crucial to consider multiple dimensions:
- The stack. How aligned is flexible use with other parts of the technology stack they interact with? For IaaS companies and PaaS companies that sit on an AWS stack, usage flexibility is key and consumption models tend to fit well. AWS EC2, Snowflake, and Fivetran are examples of three different technology offerings that are complementary and aligned in flexible use.
- Product-led vs. sales-led growth. Consumption-based models often work well with product-led growth because they scale naturally without the need for selling a new contract. Sales-led paradigms can work with consumption-based as well, but often are best suited for committed spend or hybrid contracts.
- Fixed vs. variable economics. For products with more predictable COGS and stable usage patterns, a recurring user-based subscription model could serve well. For products with spikes in consumption and variable costs (e.g., in some AI use-cases), consumption or outcome-based models could be a better choice.
The “when”—use cases
Subscribed Institute data reveals that most deployments of consumption-based pricing models involve some mix of consumption and subscription. Companies that succeed in their deployment often use them in a segmented way, targeting use cases that are more aligned with the benefits and value they bring.
A few example use cases where consumption-based models often make more sense include:
- Spiky demand profiles (e.g., certain analytics workloads, Snowflake) where flexibility is more important than predictability.
- Seasonal businesses and industry sectors (e.g., retail technology around the holidays, accountants at tax season).
- Generative AI tools that have a variable consumption of tokens.
The “how”—pricing models
Regardless of where you are in your consumption journey, one thing that will remain is the need to deploy a pricing model that allows you to adequately monetize the value delivered. If you’re just considering or beginning to adopt consumption, you’ll want to quickly launch and test consumption pricing in order to find the right level of usage and mix of models that’s right for your product, business, and customers.
What are some common consumption-based pricing models?
There isn’t a one-size-fits-all model for consumption pricing. As our data shows, you have to find the right level of usage-based pricing within an overall consumption-based business model to maximize growth. Common pricing models include:
- Per-unit or pay-as-you-go. This pure usage model allows customers to pay for what they use. This is a solid option for customers with unpredictable needs, and this method does allow for spikes in usage and those associated costs. This option gives the most flexibility for customers to consume only what they need. A pay-per-ride service like Chariot or pay-per-API offering like Amazon Web Services are great examples of this.
- Volume. Volume pricing is used to charge a price based on the volume purchased. This kind of pricing can make a lot of sense for certain use cases, such as API calls for SaaS. For example, if you do 1-1000 API calls, you might charge $.10 (flat or per unit), but if you go from 1,001-10,000, you will charge $.15 each. This kind of pricing can be a great incentive for a consumer to use more of the product since the price per unit gets cheaper.
- Tiered or step pricing. Tiered pricing is used to change pricing progressively as the volume increases. Like the volume pricing model, the tiered pricing model uses a price table to calculate the pricing. It differs from volume pricing in that the amount to charge varies progressively as volume increases, so different units may be priced differently depending on the tier they fall into.
- Overage. This pricing model gives your customer a certain quantity of included units—for example, minutes for calls per month. If your customer exceeds the quantity of included units within the billing period, the amount used over the included units is charged on a per-unit basis based on the overage price.
- Tiered with overage. This charge model is similar to the tiered charge model, except there is an overage charge for any units consumed above the ending units of the final tier.
- Multi-attribute. This charge model charges customers through a variety of different metrics. For example, Zipcar charges customers through a combination of time of day, type of car, day of the week, and other attributes.
- Pre-paid with drawdown. Customers pay upfront for a set of units (or hold a cash balance) that is drawn down from over a period of time. This offers flexibility for customers, in terms of choosing a prepaid amount, and revenue predictability for business.
- Minimum commitment. This allows you to charge your customer at their commitment level on each invoice, even if they don’t fully consume the committed usage amount. With this model, businesses have a level of predictability into revenue expectations according to the customer’s commitment level.
How do you select the right model or mix of models for your business?
Choosing the right consumption model, mix of pricing, and go-to-market strategy depends on multiple variables, including what you sell, how your customers want to buy, what behavior you’re trying to optimize, which strategies have proven success, and what your competitors are offering.
Implement the right level of usage pricing
Subscribed Institute research suggests that there is a “just right” level of revenue from usage pricing that correlates with better overall business performance. The cohort of Zuora customers with the best performance are those that have some, but no more than, 25% of their total revenue coming from pure usage-based pricing, like pay-as-you-go.
Build a predictable and flexible consumption-based model and go-to-market strategy
Traditional pure usage-based pricing models bill customers solely based on the usage metric. But many businesses are combining several pricing strategies into a hybrid model to achieve the mix that works best for their business, product, and customers.
Subscribed Institute research is revealing that many of the most successful consumption-based models are adding another factor to secure recurring revenue and drive a product-led growth flywheel—commitment.
These companies are orienting their go-to-market motions around driving adoption and building trust, so that customers eventually commit to upfront, recurring contracts. And it’s this commitment that adds the necessary predictability for the business, while maintaining flexibility for the customer.
Image: The most successful consumption-based models combine usage pricing with commitment in the form of a recurring payment
To adapt across the customer journey, the top performing consumption businesses apply product-led growth (PLG) to help reduce barriers to onboarding and drive a continued growth flywheel. Consumption models can also have a massive impact on the go-to-market strategy.
As companies like New Relic have learned, consumption businesses don’t grow by supporting the most complicated rating use cases, they grow by driving commitment in the form of recurring revenue. By orienting your go-to-market motions around driving adoption and building trust, customers eventually commit to upfront, recurring contracts.
Furthermore, the Subscribed Institute findings indicate that the consumption leaders employ hybrid models with 3 to 5 pricing (charge) strategies that include some mix of the following components:
- In arrears pure usage models. Generally, though not always, pay-as-you-go models are kept simple to facilitate PLG customer acquisition strategies.
- In advance charge models with commitment. These models capture commitment in the form of recurring prepayments. Usually, these are similarly structured to the pay-as-you-go pricing but with volume discounts, tiered pricing, etc. to incentivize bigger commitments.
- In arrears models with tracking and prepayment. These models track and bill based on logic tied to the amount committed to in a related prepayment.
Consider the competition
To further help validate if a specific model works and is acceptable in the market, evaluate what your competitors are offering. But, keep in mind, your competitors don’t always get it right. Pricing structure is often a competitive tool you can deploy to stay differentiated amongst competitors.
Work cross-functionally within the organization
To help ensure the successful company-wide roll out of a new consumption-based pricing model, multiple stakeholders, such as sales and revenue accounting teams, must be consulted and included in the planning stages.
For instance, revenue accounting teams are uniquely positioned to help the business understand the key role that rev rec systems and processes will play in the overall success of a new pricing model rollout.
Read more below: How do you track and recognize consumption revenue?
How do you handle consumption data?
Many companies we have worked with are convinced of the value of consumption-based models, but they are daunted by the scale of the new capabilities needed to make them successful. For a successful implementation of a consumption-based model, specific capabilities are required, especially:
- Usage tracking and analytics: Robust tracking mechanisms should be in place to monitor customer usage accurately. Detailed analytics on consumption patterns can provide valuable insights for optimizing pricing and improving the overall offering.
- Billing and revenue management: The billing system should be capable of accurately calculating and processing charges based on actual usage. It should support real-time billing, invoicing, and revenue recognition to ensure smooth financial operations.
- Scalable infrastructure: The infrastructure supporting the consumption model should be capable of handling variable usage levels and data efficiently. It should scale up or down, based on demand, to avoid performance issues during peak periods.
How do you determine your value metric?
Your value metric should not only be a usage attribute that your company can track, but it should also satisfy value alignment, leave room for growth, and offer predictability both for the customer and your business. Common metrics include: number of users, amount of data consumed, or number of events.
When determining the right value metric for you, consider metrics that are:
- Value-based. The value exchange must be apparent to the customer. The more this metric is used, the more value the customer receives.
- Measureable. The metric must be tracked and measured accurately. You cannot charge on things you cannot measure.
- Controllable. If you charge a customer for usage, they must feel in control. Do not leave it to external factors to determine the customers’ bills.
How do you mediate customer usage?
Much like the electric meter on your house measures your power usage and turns it into billable kilowatt hours, mediation meters and measures each of your predefined consumption value metrics.
The process of mediation consists of:
- Data ingestion: Streaming raw usage data from the company’s digital services (e.g. Zoom minutes)
- Data transformation: Transforming raw usage data into meters by modifying, filtering, and removing errors
- Metering: Measuring usage data by a specific definition, using your predetermined value metric(s) (e.g. energy meter: kilowatts per hour)
It’s critical that metering and billing speak the same language by providing data in the same format. Mediation architecture is crucial, allowing you to plug in new sources of consumption data very quickly, in a standard format that billing can consume.
How do you accurately bill for consumption?
After your raw data has gone through the process of mediation, and you’re able to correctly track a value metric, you then need to rate and bill a customer account for their consumption.
Rating is the process of:
- Gathering all the necessary information, such as customer account data, contract details, metered records, currency preferences, and other inputs, attributes, or settings
- Processing charges based on that information Generating a rated output
Unlike your standard subscription charges, which are typically rated and billed altogether, either in arrears or up front, consumption rating and billing may not happen simultaneously. Because consumption is happening continuously, it’s important to have insight into consumption that has been rated over a billing period but not yet billed.
For consumption monetization, the ability to continuously rate charges helps businesses avoid revenue leakage from inaccurate usage tracking. In addition, an automated rating engine helps avoid errors from manual uploads, processing, and calculations.
Learn more: Guide to billing for consumption
How can you maintain continuous insight into consumption?
To stay competitive in the market and keep delivering value to your customers, you need to continually evaluate and adjust your pricing models. This means evaluating data insights, forecasting trends and opportunities, and balancing revenue goals with the need to attract and retain customers.
Customers like to see what they’re paying for, what they’ve used, and what their usage patterns are. This can be achieved through threshold notifications and usage monitoring. By performing continuous rating and mediation, you can process data in near real-time to provide visibility into consumption charges for customers, sales, and finance.
For example, when a customer reaches 90% of their plan, you can send a threshold notification, ensuring proactive communication. Based on this customer’s previous consumption, you may also be able to estimate when they’ll hit their committed amount. Customers can then be presented with the option to upgrade their plan to avoid overage charges.
How do you track and recognize consumption revenue?
Consumption models require granular, real-time visibility, not just to total up usage at the end of a billing period, but also to monitor customer usage at any given time. In addition, consumption forecasting capabilities must be in place, enabling revenue teams to anticipate how much revenue will be gained through consumption-based pricing models. This means forecasting variables such as usage, lifetime of the customers, and potential overage charges.
Usage data from the upstream system will either need to be manually uploaded from the user interface into your revenue recognition system, or if the two are integrated, this data may be automatically synced.
The revenue policy for a consumption model can be complex, due to its inherent multifaceted nature. Revenue accounting teams will need to evaluate whether variable consideration should be included and how it should be treated.
Revenue teams can usually leverage existing estimations as a starting point for new consumption revenue recognition policies. For example, if the decision to adopt consumption has been pushed by sales, then someone in sales should be able to present a business case with estimations around usage and revenue.
All revenue accounting teams are familiar with ASC 606 and IFRS15. However, leadership may not have considered the implications of these standards with respect to consumption based-pricing models. Revenue automation can help reduce errors, risks, and audit costs by taking humans out of the equation with a hands-off data management approach.
Learn more: Guide to recognizing consumption revenue
What are the advantages of a consumption model?
As companies mature in their pricing capabilities and build out technical infrastructure, many try to optimize their charge models by focusing more on customizing pricing schemes to reflect value delivered and address specific customer needs.
At the same time, they must invest in strategies that offer the predictability that the business requires. Many are finding that consumption-based pricing models provide an optimal way to achieve these goals.
Implementing a consumption-based pricing model can yield the following benefits:
- 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 adjust their resources to accommodate higher consumption levels.
- Customer-centric approach: An ever-increasing number of customers have had a taste of consumption-based pricing and billing—and they’re demanding more. Customers feel that consumption-based charge models give them better visibility into the value they derive from your product or service. By focusing on consumption model alignment with customer needs to deliver consistent value, businesses can foster loyalty and repeat business.
- Differentiated value proposition: Because consumption-based models are designed around delivering tangible value to customers, this can differentiate a business from competitors and create a strong value proposition. This is especially true if you’re able to offer consumption based on a different value metric that better aligns to your target market than your competitors are.
- Visibility and control: Customers value real-time consumption visibility, enabling them to track daily progress, anticipate overages, and view their billing charges. The ability to push out threshold notifications allows customers to monitor their spend and increases overall customer satisfaction. And usage forecasting can enable businesses to monitor behavior and predict expansion opportunities for customers with high consumption.
- 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. This approach is often referred to as “committed usage” or “prepaid consumption.” For example, Snowflake or AWS customers can pre-commit to a certain capacity for an additional discount or use the pay-as-you-go method with the list price.
What are the challenges of a consumption model?
Implementing a consumption-based pricing strategy can 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 telemetry—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 then have to decide how to handle the extra credits, money, or units they already paid you for.
- Billing becomes substantially more complicated:Consumption charges are typically billed in arrears (after the billing cycle), which 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.
What is the right technology to support consumption?
Implementing a new pricing strategy can be tricky and can entail a lot of IT overhead. The right approach and technology are key factors in the ultimate success of a consumption-based model. Even with a good strategy, out-of-date technology may hamper efforts to evolve.
Whether it’s your first time testing consumption or if you’re fine tuning your strategy, look for a solution that provides out-of-the-box monetization models, such as pay-as-you-go, pre-paid with drawdown, minimum and maximum commit, and pooled usage pricing.
This will allow you to quickly experiment with and iterate on new pricing models, without reliance on heavy developer involvement and delayed rollouts.
Near real-time visibility and analytics capabilities are vital for revenue forecasting and driving customer retention, giving your business the ability to quickly react and adapt to customer’s needs. The ability to proactively notify customers allows them to monitor their spend and increases overall customer satisfaction and their alignment to value.
Ideally, your technology should enable better cross-functionality between Billing Ops and customer experience teams, to maximize data and outcomes. Usage forecasting capabilities are imperative to help monitor behavior and predict expansion opportunities for customers with high consumption.
To help reduce the risk of consumption-based pricing strategies, consider automated consumption revenue recognition. Consumption-based transaction processing, reporting, dashboards, and analytics allow companies to operationalize and automate consumption revenue recognition policies.
This enables revenue accounting teams to better predict, forecast, and mitigate financial risks related to taking on the consumption-based pricing models. To get it right, invest in technology that gives finance and revenue teams the tools they need to automate and scale their operations to support your consumption-based pricing model.