Why Usage-Based Pricing Works
This is a guest post by Ed Arnold, Advisor and Principal Consultant at Ibbaka.
Usage-based pricing has finally come of age. It’s now seen as the go-to pricing strategy for Product Led Growth (PLG) companies. This is truly an evolution of how SaaS solutions are priced.
Pricing for B2B SaaS subscriptions has long been based upon the number of users usually divided by tiers (e.g., gold, silver, bronze packages). Likewise, B2C subscriptions are often tiered by feature-set bundles starting with a freemium trial.
For years this was how it was done. One reason why: it was easy to sell and invoice. Customers understood it. Sometimes all too well because this made it easy for larger enterprise clients to negotiate a price discount. Typical negotiation tactic:
“not many people used it last month, so please lower your price.”
SaaS companies had tended to avoid usage-based pricing because it was considered too complicated and messy, like an old-time monthly telephone bill that had endless pages of itemized long-distance calls. Besides, clients disliked the idea of SaaS being a variable cost—too unpredictable. SaaS product owners objected because it actually discouraged user adoption.
Today’s usage-based pricing isn’t like your dad’s old phone bill. PLG-based companies have overcome those challenges. How they do that brings to mind the lesson of price metrics vs. value metrics. And the best way to do that is by telling you a little story.
The Fable of the Fantastic Material
Once there was a specialty chemicals company that invented a fantastic material that offered higher strength and lower weight than competing materials in the market. The R&D folks were excited because they knew that higher strength/lower weight are very desirable attributes for most manufacturers, but particularly for those in the aerospace industry. When used for molding passenger seats, this fantastic material reduces overall aircraft weight and opens up more space in the cabin. So fair to say, they anticipated huge potential value for this new material.
But when the specialty chemical company’s salesperson came calling to pitch the fantastic material, the customer’s purchasing agent flatly rejected it, insisting, “Your material is too expensive! We currently pay $10.99 a pound for that material, and here you are proposing to charge us almost $20 a pound—that’s ridiculous.”
“No, it’s not,” replied the salesperson, “because your factories won’t need to use as much to make the same parts. Not only that, but the weight and space savings enable you to build a better aircraft.”
The purchasing agent grumbled, “well, maybe … but only if you can prove that we’ll spend less…” and then they immediately engaged in a lengthy mathematical exercise to determine what a fair per pound price was for the fantastic material. A deal was struck, but the salesperson left the meeting feeling a little dejected—the end.
The moral of the story (which, by the way, was inspired by real events) is: don’t confuse a price metric with a value metric!
Value Metric - The unit of consumption by which buyers get value.
Pricing Metric - The unit of consumption for which buyers pay.
The price per pound is unquestionably a price metric that manufacturers use to compare prices between suppliers, as well as tracking the raw materials inventory. In this commodity-minded world, purchasing decisions are easy: the lower price is better—end of story.
Value comes from Using, Not from Purchasing
That isn’t the whole story, of course. Value is different. It highlights differences in outcome. And in many cases, that difference matters. Most skydivers wouldn’t necessarily choose the cheapest parachute (to cite just one obvious example).
Returning to the fable, it is futile to demonstrate the benefit of weight/space saving on a per-pound basis. This explains why the salesperson failed to capture any of that potential value in price, leaving the proverbial money on the table. If, instead, the salesperson used a value metric, they would have stood a far better chance of capturing more of that value in their final contract.
The primary thing to know about value metrics is that they show value in use. Customers only get value by using—not by purchasing. The superior performance of a fantastic material becomes evident only when the aircraft is put into service. Airline passengers immediately see a sleeker, roomier interior that enhances their customer experience - perhaps without ever noticing the seats. Operating cost per passenger mile decreases because of reduced fuel consumption due to the lighter weight.
One obvious value metric is “per aircraft” because the aerospace manufacturer can leverage this to win more contracts and even justify a higher price per plane. No doubt, just knowing the magnitude of these economic impacts would have enabled a higher and fairer price for the fantastic material, thereby recouping more of its R&D costs.
None of this can happen without a value metric. A better moral to draw from this story is: customers don't obtain value until they actually use your product. Value metrics allow you to estimate how much value you are creating.
Why Usage-based Pricing Works
Now we can better appreciate the genius behind next-generation usage-based pricing. It works because it intentionally aligns price with customer value in use. Price and value metrics merge together. This is well explained in a recent blog by Kyle Poyar at OpenView, which provides specific examples such as Hubspot (number of marketing contacts) and Attentive (number of SMS messages). Steven Forth expands on this in his post, How to Introduce Value-Based Pricing.
Usage-based pricing is consistent with the overall product-led growth (PLG) vision, which can be described as driving revenue growth through the product itself and designing a self-service, end-to-end customer experience from initial contact through the entire customer lifecycle. A key principle of PLG is to demonstrate value quickly at the freemium stage without the intervention of a human salesperson.
Conversion to a paid plan becomes frictionless because the user already has a clear idea of what value they can expect as they use the app more.
Usage-based pricing also eliminates the non-active user issue that has long bedeviled per user-based pricing plans. It allows companies to provide unlimited access to the app without worrying about waste. User adoption, therefore, has room to grow organically inside the client’s ecosystem—provided the app continues to serve end-user needs (i.e., the very essence of the PLG philosophy).
For these reasons, usage-based pricing has proven to be an essential part of a successful PLG growth strategy. Yet as I explained in a recent Ibbaka blog post, there is another fundamental reason at work -- PLG is based on a classic economies of scale business model that depends on relatively low average contract values. This explains its popularity within the venture capital community. The drawback is that many companies cannot replicate this success following the PLG recipe, especially those who have a solution that is a mix of hardware, software, data, and services. In these cases, usage-based pricing may become a non-starter.
Key Takeaways
Assuming that your company can’t shift to usage-based pricing at the flip of a switch, what else can be done to better align price with customer value?
Start by discovering your customer’s value metrics. As we saw in the fable above, look past the pounds.
Define your key value drivers. What are your equivalents to weight/space savings?
Quantify how much value you actually create - based on the customer’s value metric.
Connect your price metric to a value metric. The simplest way to do this is to estimate the amount of economic value you create for your client per year and then compare that to what they spend on you each year. Then figure out what drives the correlation.
Embed these value messages into your marketing and sales content and customer-facing processes.
Any company can do that, provided they know how their solution creates value. PLG companies and their Usage-based pricing practices give us many good examples to study. Still, a true value-based product pricing strategy requires additional effort, but one that has proven to be just as successful as PLG and is not dependent on a low price/economies of scale model.
Would you like to talk more about value-based pricing? Feel free to reach out to me at ed.arnold@ibbaka.com with any questions or comments.