Consumption-based pricing models: transition guidance for CFOs

January 11, 2022

Consumption-based pricing is best used when you can accurately and easily break down your service offering into small, digestible units.

Many companies in the technology industry are moving toward “pay for what you use” consumption-based pricing models. The trend has been bolstered by several customer benefits — primarily, the model provides a clear linkage between what a customer pays and what they use or value they realize. Additionally, it is a flexible model that allows customers to buy only what they need (i.e., they do not have to overprovision for “just in case” scenarios). There are many vendor benefits, too — it is easier to sell and it embodies a customer success solution orientation that drives high customer lifetime value and revenue.

Four pricing models

There are four predominant consumption pricing models with varying levels of customer commitment. Knowing these four models in critical to understanding the various challenges and transition requirements.

  1. No contract. A pure pay-as-you-go model that allows a customer to pay as they consume and requires no customer commitment. Many times, a customer can just use a credit card to start using a vendor’s solution. Companies that do not need to lock customers in with minimum commitments, particularly in the SMB space, use these types of models.
  2. Uncommitted contracts. These contracts have no associated dollar commitment; rather they include various contractual obligations which generally include pricing and term length. Some companies can estimate the contract value at the time of booking, however, most cannot. These contracts are very common in ‘revenue share’ models (i.e., a vendor receives a share of their customer’s revenue) commonly used in FinTech, E-Commerce, and Digital Media/Ad-Tech industries.
  3. Committed and uncommitted contracts (aka floor with upside). Contracts include a committed dollar spend and uncommitted dollar spend. Some companies are able to estimate the uncommitted contract value upfront, however, most cannot. This contract is commonly used with solutions that have both committed HW/SW solutions that require shipping/deploying coupled with a consumption-based component.
  4. Committed contracts (aka pool of funds). Contracts with a committed dollar spend within a committed term length (e.g., 1 year); however, the customer pays as they use the service. In this model, unused funds are charged at the end of the contract length; however, some vendors may roll over unused funds into the next contract. Many enterprise technology solutions use committed contracts to lock customers in, provide volume discounts, provide customers with budget expectations, and enable revenue predictability.

It is very common for companies to use multiple pricing models for different products, segments, and/or use cases. For example, technology companies like AWS, GCP, and Snowflake offer no contracts for customers interested in using their self-service option or beta-testing the solution. However, to receive volume discounts, they ask customers to commit to a dollar spend.

Challenges and shifts

While there is a growing trend toward consumption-based pricing, implementing these new models presents several key challenges:

  • Revenue cannibalization. Many companies want to migrate their subscription or perpetual business to consumption pricing models; however, it doesn’t always result in incremental business. In fact, it could lead to reduced business as customers buy what they need and no longer overprovision for “just in case” scenarios. Financial plans must accommodate this reality.
  • New coverage models. The shift to consumption-based pricing impacts the customer engagement model significantly; it requires companies to focus on driving continual consumption. In essence, the adoption, expansion, and renewal motions all happen simultaneously and fluidly within the customer journey. Consequently, companies must revisit their Account Executives (AE) and Customer Success Managers (CSM) job responsibilities, how they execute their jobs, and how they are deployed.
  • Less predictable revenue. Many companies, depending on the offering, are not always able to predict their customer’s usage. Thus, almost axiomatically, the model exacerbates the challenge of accurately forecasting revenue, as well as setting accurate quotas. This is true even when there are minimum commitment contracts or a committed pool of fund contracts due to the lack of understanding usage uptake.
  • New tracking systems and processes. Consumption-based pricing models are more complicated to track and report on. Companies need to be able to track granular usage data and model usage patterns to support their invoicing, internal sales crediting, and forecasting.
  • Pay for performance compensation plan. It is challenging to structure simple sales compensation plans that pay for the point of persuasion as there are multiple persuasion points –landing or activating a customer and then driving ongoing consumption. It is noteworthy that some solutions organically grow on their own without any AE or CSM involvement. The most challenging part of a transition is to focus and reward an AE to drive ongoing consumption when they are accustomed to selling committed contracts with little to no involvement in the ongoing adoption of the solution.

Migrating to consumption-based pricing models

Migrate to a consumption pricing model represents a major shift in a company’s go-to-market model. To address the challenges listed above, companies must revisit and update their product/pricing strategy, their go-to-customer strategy & coverage model, their sales compensation and quota program, and lastly their reporting/systems, and tools. This is no small task. Companies must activate the entire c-suite and multiple task forces to manage multiple work streams that include several dependencies.Transition guidanceTo successfully transition to the new consumption-based pricing model, companies should consider the following go-to-market components split across planning & investments, sales strategy, sales compensation, reporting, systems, and tools.

Planning and investments

  • Be holistic and develop comprehensive change management and readiness plan that recognizes the key dependencies and challenges involved.
  • Recognize that migrating pricing models may increase costs in comparison to revenue in the short term. Test different performance scenarios for impact to key financial metrics (e.g., impact on recognized revenue and costs, E/R, SG&A, etc.).
  • Consider the investment in tools, resources, and training to enable sellers and service people to properly execute their job with consumption-based offerings.

Sales strategy and coverage

  • Determine which segments/customers are a fit for a specific consumption offering and pricing. Additionally, consider product preference and whether to lead with consumption ahead of subscription or vice versa.
  • Prepare sample use case examples that demonstrate to a customer the potential outcomes (e.g., the total cost of ownership, impact on cash flow, etc.) and a comparison to traditional pricing.
  • Determine the impact on all customer-facing jobs, with special emphasis on Sales, Services, Customer Success, and Support. How will incumbents in each job need to change their day-to-day activities and what impact will this have on requisite skills and competencies? Job and behavior changes may increase or decrease the number of required incumbents per job.

Sales compensation

  • Align the sales compensation plan to the seller’s role and tie the incentive as close as possible to the multiple persuasion event(s). Pay for closing a contract or signing up a new customer with no contract – use contract value (e.g., ACV, TCV), estimated contract value, or contract/activation signing bonus. Pay for consumption revenue if the seller is responsible for and can influence usage. Lastly, avoid “annuity” payments (i.e., ongoing recurring revenue that does not require any seller persuasion), particularly if the seller does not influence the ongoing consumption.
  • Ensure the sales compensation plan aligns with the company’s consumption pricing goals. Re-evaluate paying dollar for dollar for consumption vs. subscription/term licenses as it will generally favor subscription/term overconsumption.

Reporting, systems, and tools

  • Develop the key metrics, management dashboards, and heuristics that will be needed to manage a consumption business.
  • Ensure the primary Sales and Services tools (e.g., CRM, CPQ, SPM, Customer Success, etc.), are equipped to deal with consumption pricing requirements).

Higher valuations

Many technology companies are interested in migrating their cloud subscription, term subscription, perpetual software licenses, and even hardware sales to consumption-based pricing models to reap its benefits. However, this pricing model does not make sense for all companies or solutions. It is best used when companies can accurately and easily break down their service offering into small, digestible chunks. Before moving to a consumption-based pricing model, companies should fully understand the benefits, challenges, and GTM model changes required to make this major transformation.This article was originally published on CFODIve, and republished with permission.