Usage-based pricing is often lauded as the holy grail of SaaS pricing models. Since it tethers your company’s profits to your customers’ degree of success, it can set you up for a massive win-win where your customer’s windfall becomes your own.
And lately, the usage-based pricing trend is gaining steam. Seven out of the nine SaaS IPOs that had the best net retention in the last few years used usage-based pricing models, including companies like Snowflake and Datadog. What’s more, companies that implement usage-based pricing have an average of 137% net dollar retention.
However, the model is not for the faint of heart—it carries definite risks and also significant overhead to implement effectively.
In this article, we’ll cover both the upsides and downsides, as well as how Troy Goode, Founder and CEO of Courier decided on usage-based pricing and tweaked his model to perfection.
What is usage-based pricing?
Usage-based pricing is a popular alternative to subscription-based pricing wherein customers are free to modulate their usage—and companies measure usage and bill accordingly. It’s designed to capture more value, based on the assumption that the functionality customers are paying for is measurably improving their own bottom line, so they’ll be happy to pay. For example, if they’re using more API calls, that means they’re delivering more orders.
Examples of companies:
- Twilio, which charges per API call
- Zapier, which charges “Zap,” or task
- Courier, which charges per message
Advantages of usage-based pricing
1. It’s appealing to users
The straightforwardness of usage-based pricing appeals to many customers. It’s simple: Pay for what you use and nothing more. Much like a mini fridge in a hotel, you’re free to consume whatever you wish and you’ll get charged accordingly. Similarly, if you don’t touch anything, you won’t incur a charge.
Buyers tend to underestimate their usage, so it doesn’t feel like a big commitment to get started. It’s often refreshing not to pay for what you don’t use, unlike a languishing gym membership that will still charge a monthly payment no matter how rarely you visit. Businesses love it because they know customers will underestimate and start small but grow quickly.
2. Low barrier to entry
Usage-based pricing and product-led growth tend to go hand-in-hand. Since customers don’t have to sign an upfront contract or hand over a substantial budget to get started, they can begin with a small amount of usage, and quickly scale up as they receive more value from your product. Customers only pay more as they benefit from increased usage —and you get to share in your customer’s success as you scale with them. This approach may even widen your addressable market by making your product accessible to smaller companies.
3. Potential for quick spikes in revenue
When customer usage surges, it means you’ll capture a large amount of revenue in a short period of time. Of course, the flipside of this is when usage plummets, you may run into a cash flow problem. (More on this in the next section, and ideas to mitigate that instability.)
4. Discounting can incentivize usage
It’s common with usage-based pricing to offer discounts when customers hit a certain threshold of usage. Much like buying the value pack of toilet paper at the grocery store, more consumption means paying less per roll. Bulk discounts mean accepting lower margins, but higher overall contract values.
5. Higher net dollar retention
Companies that leverage usage-based pricing far outperform their peers in terms of net dollar retention. According to the State of the Cloud 2021, these companies average roughly ten percentage points higher in net dollar retention than companies that use a more traditional subscription-based model.
Downsides of usage-based pricing (and how to mitigate them)
1. “Sticker shock,” can cause customer dissatisfaction or churn
Sticker shock can degrade customer experience. It’s a jarring and stressful experience, so you never want to put your customers in that position. Yet, it’s a real risk with a usage-based pricing model, especially one that doesn’t have a cap on spending.
Take Amazon Web Services for example. One developer had a side project unexpectedly take off on Reddit—leaving him with an unexpected $3k bill. Numerous stories like this of public outrage prompted AWS to release spend caps, where users can set a limit and have their accounts frozen after they hit that spending threshold.
This unpleasant experience can cause users to switch providers, short of some generous damage control from customer success. It can also lead to poor CSAT or NPS scores.
How to mitigate: Be transparent about costs—start with blazingly clear expectations and send alerts when customers are about to be charged more than usual. Create controls for usage to give customers peace of mind (for example, give senior employees the power to delegate or retract authority to/from their teams).
2. Low switching costs
While an annual contract locks customers in, usage-based pricing lacks the same upfront commitment. This allows users to switch software providers on a whim. One bad experience is all it takes to lose them instantly. Usage-based pricing may prompt users to constantly consider and reconsider whether the value of your product is worth it. Moreover, they’ll come to think of things they paid for but didn’t truly need as a waste (something that’s much easier for customers to overlook with yearly subscriptions).
How to mitigate: Invest in a stellar customer experience, even for lower-paying customers. Give support and service reps authority to discount to win back disgruntled customers.
Try to build “stickier” features, making it harder for customers to rip out your solution. For example, AWS productized numerous features making it harder for developers to switch providers.
3. Creates revenue (and cash flow) insecurity
Since customers are free to modulate their usage at-will, you can’t guarantee a steady flow of revenue. It also becomes harder to forecast future revenue since customers can turn down their spend anytime.
How to mitigate: Recognize that usage decreases from some customers will often be by increases from other customers. Invest heavily in data science and personnel to forecast, accounting for unknowns and complex factors like seasonality.
4. Scaling mechanism may feel opaque to customers
Can you honestly say that you know what a kilowatt-hour is? Most of us cannot. And yet this is the metered metric upon which we’re charged on our energy bills. Similarly, if your customers don’t clearly understand the value metric their charges are tethered to, it can lead to frustration and confusion.
How to mitigate: Pick the right usage metric. According to TechCrunch, it should meet five criteria: “value-based, flexible, scalable, predictable, and feasible.” It can also be helpful to build a pricing calculator to help customers gauge their approximate spend commitment.
Why Courier relies on usage-based pricing
For Troy Goode, CEO and Founder of Courier, opting for usage-based pricing was a no-brainer. Courier is a multi-channel notification platform that relies on SMS providers like Twilio and email providers like SendGrid. Since these providers already charge per message, layering on another per-message cost makes it easy for a customer to calculate their costs.
In the early days, the team used a classic pure usage-only model. But Troy started receiving feedback from larger customers who wanted more support. Sometimes these requests came from companies whose usage didn't drive sufficient revenue to offset the more time-intensive services. “We learned that usage is usually a good proxy for the value a customer receives, but it isn't perfect.”
For example, B2C customers tend to send a lot more volume than B2B customers. Many B2B firms would send less than 10,000 notifications per month, but each of those notifications was incredibly valuable to their business.
The mismatch between pure usage metrics and value derived prompted Troy and team to pivot to a hybrid model. They blended usage-based pricing with the traditional SaaS “Good-Better-Best” model. “Creating ‘Good-Better-Best’ plans with minimums help us make sure we can sustainably offer an amazing experience to larger customers even when their volumes aren't sky-high,” says Troy.
And while Courier’s pricing model is closer than ever to pricing model perfection, Troy insists that pricing should be an ongoing and iterative process. He foresees the need for more tweaking in the near future to closer match the costs the company incurs with what they charge customers. They’ve been absorbing extra costs to avoid making the pricing model more complex for customers to understand, something Troy wishes to avoid.
“Ultimately, the best advice I have is: Keep it simple,” he says. “Do your best to resist unnecessary complexity. Your customers will thank you.”
Usage-based pricing is a powerful tool—but needs to be wielded carefully
Usage-based pricing is more than a passing fad. It’s simple, logical, and lucrative. It holds serious potential to upend subscription-based pricing’s stronghold in SaaS. But it’s not without its risks. When picking a pricing model, make your choice wisely. And be armed with a thoughtful plan to minimize risks.
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