Amid constant disruptions and fluctuations across economic, political, and social spheres, companies are increasingly seeking recurring revenue. And that includes exploring consumption-based business models to help create resilience in the face of uncertainty. New research from Boston Consulting Group and Zuora found that almost half (46%) of companies used some form of consumption-based pricing from 2020 to 2022, the most recent years studied. And there’s a payoff: These models provide flexibility to both businesses and their customers, helping companies grow faster and minimize churn. On top of that, businesses using consumption-based pricing have seen up to 22% higher net dollar retention and 11% higher subscriber growth year-over-year compared to other businesses.
Consumption-based pricing charges customers only when they use a service or product, giving them the flexibility to pay for only what they need when they need it. This model enables businesses to start small and grow over time. For finance leaders, it provides transparency for spending habits and true consumption.
But as with any new business model or organizational shift, scaling consumption-based pricing comes with inherent growing pains. Companies need to balance value while ensuring enough revenue exists to cover costs. Finance teams must be part of early strategy and planning discussions to ensure long-term success and establish a firmer grasp of potential risks. Those teams also need to consider the impact of consumption pricing to date and how recurring revenue has contributed to growth during tumultuous times to determine an approach that aligns with organizational goals.
Why Consumption Use Has Increased
At its core, consumption-based pricing depends on how much a customer uses a service. Businesses that implement consumption-based models need to objectively, precisely, and defensibly measure use—whether it’s per gigabyte (GB), minute, or kilowatt hour. The unit of consumption is how a business will quantify service use and helps determine billing.
Another important factor in consumption pricing is how to determine the price per unit of consumption, also known as the rating logic. Rating logic could be a flat price for every unit or a multidimensional algorithm. To incentivize customers toward increased consumption, organizations often offer discounts. The lower entry barrier can appeal to customers looking to maximize value from service providers, especially during turbulent economic times when usage habits can change or customers seek increased flexibility.
With consumption-based models, customers are typically billed only after they have used a service (arrears billing) or on a usage-based or pay-as-you-go cadence. Companies tend to attribute the success of consumption pricing with arrears billing, which heightens visibility into spending and vendor value, improving customer satisfaction. This solidifies a simple truth of business: Predictability has inherent value to both service providers and customers. And this predictability is underscored by implementing successful consumption pricing models.
Let’s look at how arrears billing compares with advance billing models (also known as prepaid, committed, and pre-commitment). For example, a service provider plans to sell data storage for $1.00 per GB to customers who prefer a pay-as-you-go model but will sell the same storage for $0.50 per GB if a customer commits to using 100 GB per month. Initially, customers might find it appealing to test the service at the $1.00 price point. But over time, the customer would get more value if they trade flexibility and low contract risk for predictability and cost savings. This reinforces the versatility of consumption pricing and how the model can adapt to a customer’s needs.
Consumption models aren’t just about usage vs. recurring or arrears vs. advance. The best consumption pricing introduces a foundational value metric and then evolves by carefully balancing between low-risk pay-as-you-go and high predictability to achieve long-term success. To truly customize, businesses can apply hybrid consumption-based models, driving both set recurring and usage revenue. Hybrid models can provide the competitive differentiator of flexibility and predictability as they enable a lower sale cost and reduced entry barriers.
Companies have increasingly adopted consumption-based models, both in isolation and in combination with subscriptions over the past few years. Businesses that had hybrid revenue consumption models have experienced a rapid increase, representing 26% of companies in 2022 vs. only 9% in 2020 (see figure below). Simply put, consumption revenue is on the rise.
Source: Boston Consulting Group and Zuora, How consumption models contribute to business success, 2022.
This amplifies the value and relevancy associated with consumption models to conduct modern business today. A well-rounded approach to consumption via hybrid models provides companies a flexible option to develop new revenue streams as they monetize new products and services.
Which Consumption Model Fits Your Business?
With many pricing models at hand, the choice comes down to which one best matches your business goals. The traditional pay-as-you-go model, which charges customers for what they use, has historically been a good starting point for those with unpredictable needs. This option allows for spikes in usage and costs associated with spikes. Pay-as-you-go provides the most flexibility for customers in addition to the lowest adoption barriers.
However, companies are increasingly looking for more sophisticated options. There’s overage pricing where businesses offer different packages for a value metric at various price points, charging customers extra if they exceed the contracted usage. Alternatively, the minimum commitment model allows organizations to charge customers a pending amount on each invoice, even if a customer doesn’t consume the full committed usage. The minimum commitment model provides the most predictability in terms of revenue projections. In prepaid drawdown, customers pay up front for a set of units that is drawn from over time, offering customers the flexibility to choose a prepaid amount and giving businesses revenue predictability.
Other consumption-based options include tiered or step pricing—when pricing changes progressively as volume increases. A price table aids calculations, as units might be priced differently. There’s also the tiered with overage model, where customers pay extra for any units consumed above the ending units of the final tier. Another option is volume pricing, where costs are based on the volume purchased, an option best suited for specific use cases. It can also provide a strong incentive for consumers to use more of a service as the price per unit will decrease as usage goes up. Lastly, multi-attribute pricing is where consumers are charged by a combination of differing metrics, considering multiple factors into the final rate.
With no one-size-fits-all model, companies increasingly are opting to implement a hybrid consumption model that combines both subscription predictability with consumption flexibility. This combination can help to endure market headwinds and unpredictability, providing more stability while meeting the customer’s consumption needs.
Industry research found that businesses that implement hybrid consumption models have been shown to outperform competitors at all sizes. Specifically, businesses with hybrid consumption models outperformed all other businesses in year-over-year annual recurring revenue (ARR) growth (see figure below).
Source: Boston Consulting Group and Zuora, How consumption models contribute to business success, 2022.
Regardless of which consumption-based model you choose, flexibility is at the core—providing options for customers to consume based on their specific needs, which can help mitigate churn overall.
The same report by Boston Consulting Group and Zuora found that companies with an ARR of less than $100 million that implemented hybrid consumption charges grew 8% faster on average—the result of being able to retain and expand existing customers. Businesses with an ARR of more than $100 million with hybrid consumption models grew 13% faster on average, driven by new customer acquisition and the expansion of existing customers. The big takeaway: When successfully implemented, consumption pricing can drive growth and develop new revenue streams.
Navigating the Complexities of Consumption Pricing
When shifting to a consumption pricing model, organizations need to be prepared to change their views on revenue recognition. Finance leaders need granular visibility into consumption revenue at any given time, especially during strategic planning. This can help companies better predict, forecast, and mitigate financial risks related to consumption pricing models. And it helps identify expansion opportunities for customers with high consumption. To successfully implement consumption pricing, finance leaders will need to be involved early on with teams to understand the operational complexities and common fluctuations associated with revenue under this model.
Consumption models need access to customer usage at any given time to accurately recognize revenue. That’s why finance teams need to understand a business’s consumption strategy to ensure financial health. Astute forecasting provides a way to anticipate how much revenue can come from consumption-based models. Forecasting variables to consider include usage, customer lifetime, and potential overage charges.
The multifaceted nature of revenue policy for a consumption model can be complex to understand. During the initial planning, revenue accounting teams will need to determine whether variable consideration should be included and how it should be treated in each situation. This complexity might also lead to exploring how revenue automation can help reduce errors, risks, and audit costs. But there’s a human benefit, too: Revenue automation introduces a hands-off data management approach that can relieve stress on financial teams.
The complicated nature of consumption models reinforces the need for financial teams to collaborate early in the implementation process. To reduce errors, mitigate risks, and accurately recognize revenue, financial teams play a leading role in the success of consumption pricing, especially as more companies take a multifaceted approach.
After a business chooses a consumption pricing model, implementation can seem complex. Especially as more complex products and services enter the market, such as generative AI, consumption-based models are becoming more valuable and relevant for companies. But a successful migration requires early discussions with finance teams around how to define and understand your customer market. Specifically, when implementing a new model, it takes time to convert target segments and budget for enablement and incentives for sales and distribution teams. When finance is involved in prelaunch conversations, it helps to set realistic milestones and contingency plans.
Once a consumption-based model launches, finance leaders often focus on margin building through process standardization to ensure repeated successes. Moreover, sustaining collaboration with other teams, such as sales and product, helps to gain a holistic understanding of customer trends and to streamline new processes. Consumption data can provide valuable feedback from your customers to iterate and improve your offerings. Cross-functional collaboration on reporting goals and metrics for data consistency will help teams make informed business decisions swiftly.
Driving Growth and Improving Customer Loyalty
In a competitive landscape, companies that customize their charge models can achieve value and address specific customer needs. That environment also heightens the need to invest in strategies that provide revenue predictability. With a hybrid consumption model, consumption pricing can pave the way to boost customer satisfaction while also increasing the bottom line.
Consumption’s decreased barriers to entry means customers can reap immediate benefits with a small plan and scale as needed when the time is right. As customer demand increases, businesses can adjust resources to accommodate higher consumption levels. Moreover, consumption-based models give customers greater clarity into a service or product’s value. These customer-centric strategies can, in turn, foster loyalty to improve long-term retention.
Consumption-based models also demonstrate tangible value to customers, which is a differentiated value proposition. If a business can offer consumption based on a different value metric that more strongly aligns to a target market, it can be a more appealing option to potential and current customers. Customers can also benefit from the real-time consumption visibility associated with the model. With consumption pricing, customers can track daily progress, anticipate overages, and view billing charges in ways that deliver real-time usage insights. These capabilities can also improve customer satisfaction, as businesses can send threshold notifications that monitor usage. For example, a business can estimate when a customer has hit their committed amount and notify them to upgrade their plan to avoid overage charges. Consumption data also provides forecasting capabilities for service providers: They’re able to closely monitor behavior and predict expansion opportunities for customers with high consumption.
By continually evaluating and adjusting pricing models, businesses can maintain competitiveness in the market and ensure value is being delivered to customers. Consumption pricing generates a wealth of data, providing organizations with insights, trends, and opportunities to better understand customer preferences. This data provides an advantage to businesses with consumption-based models, as this helps attract and retain new customers.
Consumption data will often help organizations identify the right pricing iteration, helping companies become more agile so they can adapt to customer needs. Given consumption can be unpredictable, especially amid economic instability, this data provides businesses with a deep understanding of how a product is used—and reveals new customer insights to quickly experiment with pricing that aligns with customer value. When leveraged properly, consumption data identifies future opportunities to monetize and new strategies to improve customer experience and provide services to promote long-term usage.
While consumption-based business models can spur the flexibility and agility needed to help companies grow during economic uncertainty, it’s important to acknowledge the challenges associated with consumption implementation and the foundational infrastructure needed for its success. By looping in finance teams early during the planning process, companies can make informed decisions on how to best implement a consumption pricing model that aligns with business goals and customer expectations. Finance teams also play a significant role in managing consumption data, recognizing revenue accurately, and ensuring a company is getting the most out of its consumption-pricing approach. Collaboration is at the heart of a successful implementation of consumption-based models, especially as businesses confront new challenges and risks in today’s unpredictable economic landscape.
