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Usage-based pricing a complement and not a substitute

Steven Forth

Steven Forth is a Managing Partner at Ibbaka. See his Skill Profile on Ibbaka Talent.

The Subscribed Institute (the research organization associated with billing system provider Zuora) has recently published some useful analysis on the impact of usage-based pricing.

Usage-Based Pricing in Subscription Business by Nick Cherrier

They felt this important enough that Zuora founder and CEO Tien Tzuo reinforced the message in his weekly post Goldilocks Companies & Usage-Based Pricing.

The key finding is that the sweet spot for usage-based pricing is to have it contribute 15 to 20% of your revenue. Below that, and above 25%, led to lower revenue growth.

From Subscribed Institute - Usage-Based Pricing in Subscription Business

This is based on Zuora’s customer base, and as such skews to companies with a sophisticated approach to subscriptions and subscription management. One cannot attribute this finding to immature subscription practices.

What could account for this finding? Let’s look at both sides of this question.

  • Why does a usage-based pricing component outperform a pure subscription model?

  • Why does an over reliance on usage-based pricing lead to slower revenue growth?

Why does a usage-based pricing component outperform a pure subscription model?

There are two answers to this question, and either or both could apply to your situation.

Usage-based pricing tracks value

A well designed usage-based pricing program picks the usage metrics associated with value. The greater the usage the higher the value created for the customer. The more value created, the higher you can price. If your service is delivering value then usage-based pricing can result in higher value capture and higher revenue growth.

Usage-based pricing reduces the risk discount

Most subscription pricing includes a hidden risk discount. You can read more about why this is in our post on the OpenView blog, Risk Discounts and Value-Based Pricing, but the basic point is that buyers impose an implicit risk discount on value claims. This discount suppresses prices. By shifting some of that risk from buyer to seller, one can raise overall prices. Usage-based pricing does this. The seller accepts the risk that usage may be lower than anticipated.

Why does an over reliance on usage-based pricing lead to slower revenue growth?

Given the advantages of usage-based pricing and the way it increases pricing power, why not go all in and move to a purely transactional model?

Usage-based pricing does not track your full value

Most applications and services do not collect all of the data needed to track value. Value comes from outcomes, and these outcomes are frequently measured outside of the application that contributes to them.

There are exceptions of course. A CRM (Customer Relationship Management) will generally track sales directly. This is one reason for the relatively high prices for the best CRMs (although they are under commoditization pressure). Customer success management software is a rapidly emerging category of software that reflects the importance on actually delivering on value promises made during sales. One of the best books on category creation is Category Creation: How to Build a Brand that Customers, Employees, and Investors Will Love by Anthony Kennada of Gainsight. Customer success platforms generally have two simple metrics they measure - churn and upsell. They are a good candidate for introducing some level of usage-based pricing. The same is true for subscription management systems like Zuora itself.

A good value-based pricing program needs to identify all of the different variables that contribute to differentiation value. Failing to do so, and just relying on usage metrics, will leave money on the table and could lead your customer success to make poor choices as they chase usage at the expense of value.

Relationships matter

Purely transactional pricing works best for commodities. If you are selling a commodity there is no point in pursuing value-based pricing as the value that can be priced is your differentiation value (the value you can create that the alternatives cannot). The common value, provided by you and the alternatives, is priced by the market.

Usage-based pricing is a form of transactional pricing, but done well it is connected to value and can help to build relationships. This is an important reason why one does not want to rely on usage-based pricing alone. A more conventional subscription, with a commitment over time, helps to build a relationship.

Blending the relationship building aspects of a conventional subscription with the potential of usage-based pricing to track value gives the best of both worlds. And this is why you want to layer in usage-based pricing as a part of your pricing model but not as the only metric in your pricing model.

Value Metric: The measure of consumption that tracks value

Pricing metric: The measure of how consumption determines price

How to connect value and price

The underlying theme for all of this is to connect price and value. How do you do this? The simplest and most compelling way is to find the shared variables that track value and usage and to use them in your pricing model.

There are a few things to note here.

In the context of usage-based pricing, usage variables that do not track value are an anti-pattern, in other words, avoid them.

The bullseye is variables that connect usage and value to price. This is what you are aiming for.

Pricing metrics that do not track value should be avoided (remembering that value has economic, emotional and community components). There are some exceptions. Pricing is a very powerful way to shape behavior, to give nudges so to speak (the book Nudge by behavioral economist Richard Thaler and legal scholar Cass Sunstein is a wonderful read). One may want to use pricing to incent customer behaviors that lower your costs, or to move a customer from one service to another, or to benefit the environment. So there are cases where one may want pricing metrics that do not correlate with value, but this should be done intentionally.

The other point is that value metrics that are not captured by usage of your platform need to be documented somehow and somewhere. This can be difficult as it is hard to automate. But if a significant part of your value is not captured through usage then you need to do it.

Ibbaka is addressing this with its Value Pricing Dashboard. This is a web application that is part of our service. It is a place where your value model (you do have a formal value model, right) and your pricing model are connected and the value you are delivering is documented.

For most offers value unfolds over time. It is unusual to deliver value all at once, and when you do this you should not be using a subscription model. The Value Pricing Dashboard is where you can document and track the Value Ratio Snapshot, Value to Customer (V2C), Lifetime Customer Value (LTV) and the economic value over time.

Ibbaka on Usage-Based Pricing

Implement Customer Value Management with the Ibbaka Value Pricing Dashboard

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