Questions every CFO should ask about consumption pricing models

Everyone is talking about consumption pricing these days.

According to recent research from Subscribed Institute and Boston Consulting Group (BCG), nearly half (46%) of all companies studied have implemented some form of a consumption-based pricing model in the last three years.

Benefits of consumption pricing may include: increasing year-over-year (YoY) annual recurring revenue (ARR) growth, responding to customer feedback, and staying relevant in a changing competitive landscape.

While consumption models are great for certain types of services, they are by no means a “one size fits all.” And many of your customers will see it that way too. A recent Deloitte study of CIOs found mixed reactions to consumption pricing, along with strong opinions about how to—and how not to—structure it. If you’re looking at adopting a consumption model for the first time it’s important to take a measured approach.

CFOs need to understand the multi-faceted nature of consumption pricing to decide if it’s the best fit for their business—and if so, what kind of strategy, communication, and organizational buy-in are required for success.

That’s why we’ve created a checklist of four top questions to ask if you’re thinking about taking the leap into consumption. These four questions can help you determine whether it’s right for you and what you need to know to execute consumption pricing successfully.

1. What kind of customer data do you have, and can you use it to forecast customer usage?

The foundation of consumption pricing is customer usage data. You need complete, accurate, and timely usage data that can easily be used for rating and billing customers in a reliable, auditable, and defensible way. Unclear usage on a big invoice can quickly absorb hours of your Billing Ops, Support, and even Sales teams’ time.

Clean data is also important for supporting accurate forecasting. By nature, consumption models are less predictable than traditional subscription models, which makes accurate forecasting more difficult but also more important.

For example, if you have customers paying for a SaaS license with a yearly contract, you can count on that revenue for a full year, regardless of how much the customer uses the product. But with consumption models, revenue can change every month, day, or even minute.

As a CFO overseeing a consumption model, understanding usage patterns in order to accurately forecast will become one of your top priorities.

Without clean usage data, everything about a consumption model becomes significantly more difficult. Whether it’s API calls, number of emails sent, tasks in an application, file uploads, or logins, getting a handle on customer usage data and insights should be the primary focus for any CFO starting a consumption journey.

Consumption forecasting also brings a unique challenge when it comes to recognizing consumption revenue. For instance, here’s a common issue encountered by consumption businesses: FP&A or sales operations teams may develop their own consumption forecasting without incorporating the more nuanced revenue treatments demanded by ASC606. This can result in vastly different forecasts from one end of the business to the other.

Recommendations

Work with your analytics team to consolidate and evaluate usage data to uncover trends and help inform the selection of consumption value metrics. Consider adding a mediation engine—a purpose-built solution that can handle all your consumption data needs and integrate with your current billing and rev rec systems.

To increase the accuracy of consumption forecasts, CFOs should encourage cross-functional collaboration within the organization and alignment on the business’s approach to new use cases.

2. Is your technology flexible enough to support multiple models and meet changing customer demands?

Consumption models shine when it comes to product-led growth. Pure pay-as-you-go pricing reduces risk for customers and gives them confidence to try your product, which in turn may help increase your customer acquisition rates at a lower cost.

Ideally, at some point your customer’s use of your product grows to the point where the cost becomes material to their business. At this point in your customer’s consumption lifecycle, two key concepts become critical—notifications driven off real-time metering and rating and being able to offer more predictable contract terms and pricing models.

Real-time metering and rating

For consumption pricing to work long-term, you need a system that provides real-time usage rating and threshold notifications. There is almost no worse customer experience than being surprised with a surprisingly large invoice they weren’t expecting.

It is an imperative of any consumption business to give your customers as much transparency about their costs as possible, in as close to real-time as possible. The best consumption businesses attack this problem from multiple angles by offering self-service portals, triggering threshold notifications, and arming their field teams supporting customers with data tools to stay ahead of any surprises.

While customized or add-on solutions can be layered on top of your billing system to ingest, meter, and rate data, the most efficient and cost-effective solution for the majority of businesses is a mediation engine—a purpose-built solution that can handle all your consumption data needs and integrate with your current billing and revenue recognition systems.

Adding predictability

If there’s one thing CIOs hate, it’s surprising their CFOs. Pay-as-you-go models work great for enticing customers to try new products, but if you’re not ready to offer contract terms and pricing models that give them more predictability, you’re likely to lose these customers to a competitor who will.

So, while pure usage-based pricing is good for acquisition, adding recurring and pre-paid models to create a hybrid offering tend to be better for retention and allow you to lock customers into a more predictable agreement that serves all parties better.

Recommendations

When determining what consumption pricing model to use for a particular product, Subscribed Institute and BCG recommend considering the following factors:

  • How macro-trends are influencing the landscape
  • Trends and successful strategies observed in other consumption business
  • How customers derive value from the product
  • The nature of the business and product
  • The technology required to support end-to-end consumption model implementation

Assessing this for each product and journey stage will likely lead you to a hybrid consumption model that includes consumption along with other offerings. Therefore, it’s critical that your tech supports multiple pricing models and enables the agility to mix and match models.

3. Are you set up for accurate and compliant financial reporting of consumption-based revenue recognition?

The conversation about revenue recognition should begin as soon as the business elects to incorporate consumption-based pricing. With a consumption model, you might charge a flat fee, offer a volume or tier discount, or use multiple units of measure depending on the country, time of day, or any of dozens of other variables. These varying permutations could create multiple different prices for the same service.

The charge model you implement determines your financial relationship to your customers, and it obligates you to accurately report on that financial relationship in a compliant way. In particular, ASC 606 can make consumption pricing tricky. 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.

Even with the addition of a consumption model, you will need to layer in a recurring component. That could be a true prepaid model, a credit system, or a system tied directly to the usage metric itself—for example, gigabytes of storage. At this point it’s also important to consider what you’ll do if a customer doesn’t use everything they prepaid for and how that discrepancy could impact subscriber experience.

If customers are prepaying on a contract, for example, that creates liability for you as a company and obligates you to deliver against the contract. The customer determines when they want to draw on what they’ve paid for, and that determines when you deliver against it and have to report to the street.

As different customers draw down their balances at different rates, you face another layer of complexity to tracking and reporting earned and deferred revenue.

This is different from a prepaid model based on availability. For example, SaaS subscription companies often charge customers for one seat for one year, even if they collect payment on a monthly basis. How or when the customer chooses to use that seat doesn’t impact the SaaS company’s revenue because their obligation was simply to make the service available.

With consumption, however, tracking usage is important not just for providing the service, but also for tracking revenue.

Recommendations

Work with the business to find the right consumption equation to facilitate growth and adhere to rev rec rules under ASC 606.

Adding a solution with real-time analytics and a close process dashboard can allow you to achieve a high-level understanding of financial data for the current open period, identify data problems, mitigate revenue errors, or make adjustments throughout the month that allow for real-time GAAP revenue reporting.

4. How will consumption pricing impact your go-to-market strategy?

Consumption pricing requires a sales model that doesn’t just bring in customers, but also ensures they use the product.

The role of the sales team in a traditional product sale is over as soon as the product is delivered. With a subscription, the sales team closes the deal and then takes a backseat until renewal time one or two years later.

But consumption pricing requires a sales model that provides self-service, such as allowing customers to come to your website and try your product by signing up and test driving it.

Here, the sales team needs to stay engaged throughout the customer journey to help customers ramp up their use of the product.

Many companies are changing their compensation plans to incentivize reps not only to land big, prepaid deals that capture payments up front, but also to tie compensation to how much customers use the product. Reps only make full commission when they verify the customer has used everything they bought.

This type of go-to-market strategy can also affect the AE to SE ratio, the other technical roles needed to support sales, and the ways partners engage.

Companies often start their consumption journey with a growth team focused on launching product-led growth. They explore how to make the product more self-service-oriented and which consumption models will get customers in the door to test the product.

Then, once they’ve pivoted to product-led growth and gained traction, a second stage of the journey involves getting the customers to commit to a prepaid recurring contract.

Recommendations

At a time when many customers are tightening budgets and consolidating technology, your ability to demonstrate value realization is crucial. With consumption models, it’s imperative to show ROI not just once a quarter or once a year at renewal time, but continuously.

Keep sales in the loop across the customer journey to help support and drive a product-led growth strategy. Begin experimenting with consumption packaging to introduce a prepaid recurring contract. Lastly, consider adding customer success managers and incentives for your sales team.

Explore consumption pricing by asking the right questions

At Zuora, we’ve been helping customers implement consumption models for years. Our data confirms what companies are learning about the nuances of determining when consumption pricing makes sense and how to successfully implement it.

Explore the strategies from successful consumption businesses and delve into the ways in which they are addressing potential drawbacks in this future of consumption webinar.

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