The future of software is usage-based pricing

Every software company preaches customer-centricity. Yet the subscription pricing model commonplace for most cloud software is anything but customer-centric.

In a subscription pricing model, customers have to opt into paying a recurring fee per month. The recurring fee is determined upfront before the software purchase. It’s usually calculated based on the cost of a license times an estimate on the units of that license needed during the next year, or a longer contract term. These subscription models are a great deal for the software provider because they get paid for the contract term even if the software is not being used. That’s not so great for you as the customer. If you use too little, you’re wasting your budget on shelfware. If you use too much, you’re stuck with overage penalties.

Compare that to how we consume water in our homes. The resource is always available, and you can throttle your usage based on your needs. When you decide you need an extra-long, hot shower, or you have guests visiting, you simply consume what you need and then pay for the additional value you received. It’s intuitive and predictable with a price based on the value you receive. Now imagine if we subscribed to a set amount of water usage each month. Why should you pay for the water you didn’t use because you installed more efficient showers? That’s just unfair. Or worse, why should you risk running out of water because your visiting guests took a long shower? That just doesn’t make sense.

Similar to water at home, software has become a lot like a utility at work. That’s why consumption pricing for software is increasingly becoming the norm. Amazon Web Services (AWS) is a prime example. It popularized consumption pricing, where customers only pay for the capabilities they use and from which they derive value. Since then, a number of other high-profile, high-growth software companies have adopted this model with success, including Twilio and Snowflake. And the data supports this trend: According to the 2021 SaaS pricing survey from OpenView Venture Partners, 39% of SaaS providers now offer usage-based pricing as compared to about 23% in 2014.

Consumption- or usage-based pricing fundamentally shifts the relationship between software companies and their customers away from unfair subscription models and towards an inherently equitable exchange of value. By aligning revenue with usage, software companies understand that they won’t get paid unless they build products that customers both enjoy using and gain value from with each use. Companies that continuously innovate and provide differentiated value will be rewarded with accelerated revenue growth and customer loyalty, and the virtuous cycle continues. Consumption is more than a business, pricing, or revenue model; it is the commitment to focus every function in a company around making customers successful and ensuring that they get true value from its platform, products, and/or services.

Today, it’s evident that consumption pricing will continue to gain acceptance as the preferred business model by customers, from hyper-growth startups to the largest global enterprises. Looking back and drawing from our conversations with customers, here are three factors that we learned will contribute to the continued success of consumption pricing:

• Consumption pricing makes it easier to get started: Subscription pricing forces an upfront commitment, which is an artificial barrier for customers to know if the software is going to be useful for them. Sure, 15- to 30-day trials help, but that’s too short a period for anyone to truly understand the value. In contrast, consumption pricing allows customers to start for free and without any commitment. Customers can scale up as they find value and only then pay for the value they get. Internally at the software provider, this model also frees customer-facing teams from negotiating and renegotiating complex deal structures and allows them to focus on ensuring customers achieve value, collaboratively helping drive engagement and increase product utilization based on customer need.
• Consumption pricing provides more flexibility: The “all-or-nothing” aspect of subscription pricing can have a negative impact on customer satisfaction and retention. As we’ve seen through the global pandemic, when companies are forced to cut costs, they may no longer be able to keep up with a high flat fee. Consumption-based pricing enables customers to throttle up and back that consumption in real time as business needs evolve — which creates a better customer experience and inspires loyalty. It also alleviates the customer’s burden of managing software and high up-front costs. In other words, it truly shifts cost control to the customer. As an example, the hospitality industry has understandably suffered throughout the last 18 months, having to quickly scale down or make changes to their offering models to align with declining demand.
• Consumption pricing is more scalable: As we’ve seen in the past decade, today’s startup can be tomorrow’s global enterprise. Consumption pricing offers an attractive option for growing companies that may need to scale quickly in the future. With legacy subscription pricing, scaling up requires renegotiation and re-contracting, which can be time-consuming and creates added pressure for companies trying to scale up quickly. Just as consumption pricing offers the flexibility for customers to pare down their consumption when necessary, it makes it easy to scale quickly and keep pace with rapid growth; no new contracts or negotiations are required to use more software. As a recent example, the scalability of consumption pricing was well suited to support the sudden and fast growth of digital business and accelerated innovation timelines brought on by the pandemic. In just days, businesses had to scale their digital presence more rapidly than ever — including grocery stores, meal delivery apps, video conferencing tools, online education apps, streaming video platforms, exercise apps, and more. Thanks to consumption pricing, the path to meet customer demand was straightforward.

However, as with every change, consumption pricing has its critics. The main concern revolves around enterprise IT budget controls. Many IT teams, especially at larger enterprises, have to manage their software expenses to a monthly budget. A sudden increase in software costs due to higher usage in a given month, without proper controls to rationalize the increased usage, is a scary proposition. There’s a strategic solution to address this “staying within the budget” concern: Offer real-time usage reporting as well as an “Annual Pool of Funds” option. Real-time usage reporting allows admins to gain full visibility into how their teams are using their software tools and to be alerted to changes in usage patterns. This way, they are always in the know, can be sure that the increased usage is valuable to the business, and, if needed, throttle back. The Annual Pool of Funds option should/could give customers the ability to pay for their usage over a 12-month period and accommodate seasonal spikes and dips in usage with monthly roll-overs. Collectively, these capabilities give IT teams the controls and confidence they need to adopt consumption pricing models. Twilio, AWS, Stripe, and other top SaaS companies have succeeded with this next evolution in software pricing.

In summary, consumption pricing will eventually become the de facto standard for all software companies. It is the latest step in the software industry’s three-decade journey to put customers’ best interests at the center of everything they do. It’s all about aligning with customer success. Forward-thinking software companies will continue to embrace this model as true vendor partners. Those that don’t evolve risk seeing an erosion not just of their top-line growth, but in customer trust and loyalty as well.

Manav Khurana is chief growth officer at New Relic. He previously held product and marketing leadership roles at Twilio, InVision, Aruba (HPE), and Motorola.