SaaS and subscription-based companies have embraced usage-based pricing models with open arms over the past several years. Instead of making customers pay a set price upfront, these companies have flipped that paradigm so as to allow customers to only pay for what they use.

Use more, pay more. Use less, pay less. Usage-based pricing works because your customers can grow with you. Customers that find initial success with your service and want to use it more can do exactly that with usage-based pricing. In turn, businesses that employ a usage-based model can get more revenue as customers increase their usage.

It’s a sure way to drive subscription growth … right?

Not quite.

While companies with usage-based pricing see faster growth compared to companies without any usage pricing, there is a tipping point where growth eventually stalls.

To sustain growth, subscription companies need to balance the mix between recurring and usage-based pricing—but finding that mix can be tricky.

The Goldilocks Principle of Usage-Based Pricing

If we take a step back, there are three strategies that subscription companies mix and match to price their products:

• One-time price: A one-time payment—most commonly charged for a device, a sign-up fee, or an implementation cost.
• Recurring price: A recurring payment—whether it’s monthly or annually or quarterly, paid up-front that allows customers continued access to subscription services.
• Usage-based price: A variable payment—paid in arrears (e.g. at the end of a billing period) based on how much of a service was used.

Rather than putting all your eggs in one basket, make sure to find the right balance of usage-based growth and sustainable recurring revenue.

• Too Little: According to a recent Subscription Economy Benchmark report, companies with no usage-based pricing are growing 18% on average year over year. In this model, customers are limited to one-size-fits-all choices, and can’t naturally grow within the pricing model.
• Too Much: Companies with over 50% of revenue coming from usage are growing 24% year over year. Clearly, that’s better than having no usage at all. However, companies should be cautious of relying too much on usage-based pricing and being at the mercy of that usage. If even just a few customers reduce usage, then revenues can fall dramatically.
• Just Right: Companies that have usage-based pricing that makes up between 1-50% of their overall revenue grew the fastest at 28% year-over-year.That is 1.5x higher compared to companies with no usage-based pricing at all. With the right balance of usage-based pricing,  companies can rely on a sustainable recurring revenue stream while optimizing for additional growth.

Finding the sweet spot for your company and customers requires a Goldilocks-style experimentation, but, when you hit that sweet spot, you’ll find a new growth channel that reaps big rewards.

The Challenges with Usage-Based Pricing

If usage-based pricing is so great, why haven’t more companies adopted it? Because it’s a lot more complicated underneath the hood.

Most companies today don’t have the luxury of experimenting with usage-based pricing due to the limitations in their technology systems and architecture. And without the ability to experiment with usage-based pricing, a company’s growth is put at risk.

The challenges fall largely into two buckets: the shortcomings of legacy systems to support usage-based pricing models and the downstream impacts to finance caused by implementing usage-based pricing.

Challenge #1: Legacy Systems Don’t Support Usage-Based Pricing Models

CRM and ERPs were built in the era of selling products, so everything rests on the concept of a SKU (stock keeping unit). But that’s not how a usage-based pricing model works.

Usage-based pricing ranges from pay-as-you-go models to tiered usage models. There are six common types of usage-based pricing models:

1. Per-Unit Usage Pricing—charges add up over a billing period based on a per-unit price.
2. Overage Pricing—customers get a certain quantity of included units, and any amount used over that included limit is charged per-unit with an overage price.
3. Volume Usage Pricing—the per-unit price differs based on how much total usage was captured over the entire billing cycle.
4. Tiered Usage Pricing—the per-unit price differs based on how much usage was captured per tier over the entire billing cycle; once a certain tier is full, the next tier price kicks in.
5. Tiered Usage with Overage Pricing—similar to a tiered usage model, except there is an overage charge for any unit consumed above the final tier.
6. Multi-Attribute Usage Pricing—the per-unit price depends on a variety of factors (such as the type of car, the time of day, and the location).

And all of these models require a technical solution to:

• Meter and track product usage as customers are using the product
• Rate the product usage, and apply accurate charges for the amount of product used
• Add up all charges at the end of a billing period

Since legacy systems do not support usage-based pricing models, IT teams are forced to hard-code existing solutions or build a homegrown hack to support usage.

If your company tries to retrofit usage-based pricing into a SKU-based system, you will inevitably need hard-coded customizations and mountains of custom logic to support metering, rating, and billing customer usage. Retrofitting a usage-based pricing model into legacy systems leads to lengthy, complex, and costly implementations.

Plus, usage-based pricing isn’t a one-and-done process. After the initial launch, most companies iterate and tweak their pricing and packaging to find the right usage model and the right mix of recurring vs. usage. The problem is, every pivot requires the IT team to rewrite hard-coded logic.

If your company is planning to go from one usage-based pricing model to another, you’ll need to hard code the new model and downstream financial rules. If your company wants to change the tier limit on your current tiered usage model, you’ll need to hard code the new tiers across multiple systems. If your company wants to change the usage unit of measure from “Per User” to “Per API,” you’ll need to hard code that too. It’s a never-ending list of customizations.

Challenge #2: Usage-Based Pricing Impacts Downstream Finance Operations

But there’s more complexity to usage-based pricing than just setting the price. Usage-based pricing impacts downstream finance operations, such as billing, revenue recognition, reporting, and customer communications.

Once you start charging by usage, a set of new operations needs to fall in place:

• Usage Billing & Invoicing: With usage-based models, you’ll start invoicing in-arrears (after the billing cycle) rather than invoicing a customer in-advance (before the billing cycle). That way, a customer will get to see what charges they racked up at the end of a billing cycle—similar to your phone bill. Your billing team will need to engage in a new process to accurately calculate charges and send invoices in a timely manner—while maintaining billing operations for customers that are grandfathered into a non-usage model. It gets tricky.
• Revenue Recognition for Usage: Keep in mind, there may be scenarios where revenue recognition for a usage-based service can only happen when usage occurs. In many instances of usage-based pricing models, the transaction price to be used for revenue recognition isn’t available at the inception of the contract (since you don’t know how much usage the customer will consume yet). So your finance team may need to estimate the variable element of your obligation to the customer, and true-up each period. This is called “Variable Consideration,” and can be a fairly complex exercise, especially when dealing with large volumes of transactions.
• Usage Reporting & Customer Communications: For companies that have an overage model, it is important for operations teams to keep an eye on customer usage for two reasons: 1) to notify customers of potential overages and 2) to offer customers the opportunity to upgrade to a different plan to avoid that overage. Not only does this build goodwill with the customer, it is also a potential revenue opportunity. To do this, your notification tools need to be in sync with up-to-date usage records.

Usage-Based Pricing Success Starts with a Three-Cloud Architecture

Because of the dynamic nature of usage-based consumption, subscription businesses need to adopt a three-cloud architecture strategy that will support pricing experimentation and ease the burden of the downstream impact of usage-based pricing.

This three-cloud architecture is comprised of:

• CRM/eCommerce as the acquisition channel
• ERP as the General Ledger
• and an end-to-end subscription management solution in the middle

A three-cloud architecture enables businesses to monetize products through consumption and quickly evolve pricing strategy over time. How?

• Usage is consolidated in an end-to-end subscription management platform so that billing, payment, revenue recognition, and customer communication impacts are handled immediately and contained within one system.
• By linking the platform to CRM, your sales and service teams will always have visibility into a customer’s latest usage.
• By linking the platform to ERP, your finance team will receive the journal entries needed to close the books quickly and accurately.

According to a recent survey on SaaS pricing and packaging from Teneo, a global CEO advisory firm, of customers surveyed, only 10% offer usage-based pricing today—but there is a rise in the expectation and adoption for usage-based pricing. In fact, according to a recent Forrester report, 72% of companies who are not currently using a usage-based model plan to do so within the next two years.

Meanwhile, 50+% of current Zuora customers have already adopted usage-based pricing. With the support of a third cloud, Zuora customers are able to experiment with pricing and packaging to work towards integrating usage-based pricing into their revenue mix. Rather than having to wait for their IT or engineering team to try to figure out how to build a usage-based pricing solution from scratch or hard code endless customizations, companies with a three-cloud strategy can find that right balance of usage-based pricing to increase revenue and optimize for future growth.

Even Goldilocks herself would have to admit that sounds just right.