Goldilocks Companies & Usage-Based Pricing

How much of your subscription revenue should be coming from usage-based pricing? Half? None? All of it? Is there even an answer to this question? As it turns out, there is!?

Last year the Subscribed Institute looked at three year’s worth of anonymized performance data from the Zuora platform and found that companies with 1 to 25% of their revenue generated through usage-based pricing showed the best performance across overall revenue growth (25%), average revenue per account growth (13.6%) and churn (26%). In contrast, companies with no usage-based pricing had slightly slower revenue growth (19%), ARPA growth (9.4%), and higher churn rates (33%).?

As a result, we concluded the 1-25% usage-based pricing range was the sweet spot. While every company is different and this shouldn’t be considered a universal rule, the data told us that 1-25%?was the “Goldilocks Zone” -- not too little, and not too much. The broader takeaway, of course, is that if you’re not currently employing some element of usage-based pricing in your subscription business, you should seriously consider it.?

More recently, Nick Cherrier, a Senior Strategist at the Subscribed Strategy Group, decided to run a similar study focusing on performance data from just the past year. Needless to say, it was a crazy year! We had no idea what to expect. While the companies in our Subscription Economy Index still vastly outperformed their S&P 500 counterparts last year, many of them saw drastically reduced consumption, particularly in verticals like travel and retail.?

So would that mean that companies with usage-based pricing would suffer relative to companies with more rigid pricing structures, particularly during difficult economic times? The answer again was no! The Goldilocks companies still came out on top. Yet again, companies that relied on usage-based pricing for between 1 and 25% of their revenue outperformed those that did not, and those that relied too heavily on it.?

Here are a few other highlights from the report:

• Usage-based pricing is correlated to revenue growth improvement from anywhere from 15% to 20%. Above 25% usage-based pricing, however, that growth decelerates. While this holds true across B2B, the effects are more acute in B2C.?
• Usage-based pricing also leads to better upsell opportunities. Companies that took advantage of usage-based pricing reported 9% average revenue per account (ARPA) growth, while those that didn’t saw a 7% improvement.?
• Usage-based pricing helps with churn. Annual churn rates were 32% for no usage-based pricing, 25% for those that used it for less than 25% of their revenue, and 27% for those that relied on usage-based pricing for more than 25% of their revenue.?

So, that’s the science. What about the art? After all, subscriptions are more than a financial model, they represent a new way of defining relationships between customers and providers. Today’s customers aren’t simply buying a product, they’re committing to a relationship with a brand. Your usage pricing should reflect that ongoing value.?

The key to effective usage-based pricing is metric selection. Assuming you decide you want to demonstrate a clear correlation between usage value and price, whether through a pure pay-per-use go model or a hybrid model, how do you choose the right metric?

Here are three?core considerations in selecting the right usage metric:

• Value-based - The value exchange must be apparent to the customer. The more this metric is used, the more value the customer receives. Zuora, for example, charges by volume of subscription revenue running through our system. We only do well if our customers do well!?
• Measurable - The metric must be tracked and measured accurately. You cannot charge for things you cannot measure. That may sound like an obvious point, but we’re all familiar with long, complicated bills featuring shady surcharges.?
• Controllable - If you charge a customer for usage, they must feel in control. Don’t leave it to external factors to determine the customers’ bills.?Slack, for example, won’t charge you for the users that have signed up, but aren’t actively using the product.?

Ultimately, of course, executing usage pricing will always be a process of experimentation. As I discussed with Tom Tunguz, there’s a usage versus tiered pricing sweet spot for every company, and it’s going to change over time. But it’s important to get your feet in the water if you haven’t yet!?There’s lots more to learn in the report, which you can find here.?

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Disclosure: These opinions expressed are mine, not those of the company. The companies mentioned in this newsletter are not necessarily Zuora customers.?