Usage-based pricing is a model in which customers are charged based on their product or service usage. Its application has increased significantly over the last few years, either substituting or complementing more traditional subscription-based models.

Some of the most known and successful SaaS companies globally have built their business on this pricing mechanism. For example:

• Amazon Web Services (AWS) charges customers for the amount of storage and number of requests they use
• Twilio, a cloud communications platform, charges customers based on the number of API requests and messages they send
• Salesforce, a CRM software, charges customers based on the number of users and the level of access they require

In this post, we will discuss the pros and cons of this pricing model, and how key SaaS metrics need to adapt.

Pros of Usage-Based Pricing

Usage-based pricing’s adoption has been increasing for a few good reasons:

1. It aligns the interests of the customer with the interests of the company: As customers only pay for what they use, they are more likely to use the service in a way that is efficient and beneficial for both parties. This helps to ensure that customers are getting the most value out of the service, which in turn can lead to increased customer satisfaction and loyalty. Additionally, usage-based pricing can also help to reduce the risk of over-provisioning for customers, which can lead to cost savings.
2. It can help to reduce customer churn: If customers feel like they are getting a good value for what they are paying, they are less likely to cancel their subscription. By using usage-based pricing, SaaS companies can ensure that customers are only paying for what they need, which can help to increase customer retention and improve the overall financial performance of the business.
3. It provides more granular pricing: With usage-based pricing, customers can be charged based on specific usage metrics, such as the number of API calls or the amount of storage used. This can help to better reflect the true value of the service for the customer, which can lead to increased customer satisfaction and loyalty.

Cons of Usage-Based Pricing

However, there are also a few shortcomings one needs to consider:

1. Customers may not understand how the pricing works or what the costs will be until they start using the service: This can lead to confusion and dissatisfaction among customers, which can negatively impact customer retention and loyalty.
2. More complex to implement: Another challenge of usage-based pricing is that it can be more complex to implement. SaaS companies need to have a robust billing and usage tracking system in place in order to accurately bill customers based on their usage. This can be a significant investment in terms of both time and money.
3. Additionally, usage-based pricing may also require more frequent and detailed customer communication to ensure that customers are fully aware of their usage and costs.

Key Metrics

Usage-based pricing doesn’t only change how the company interfaces with its customers. It also affects how the company is run and how success is measured. For example, looking at some of the key SaaS metrics, we can see the logic needs to be adapted:

• Monthly Recurring Revenue (MRR): In a subscription-based business, MRR is calculated by multiplying the number of customers by the average revenue per customer. However, in a usage-based pricing model, MRR can fluctuate as usage changes. It requires a more robust tracking system to ensure accurate billing and to understand the patterns of the business. It often helps to use historical trailing averages on a cohort basis to forecast customers’ usage during their lifetime. More on this in an earlier post
• Lifetime Value (LTV): LTV is calculated by multiplying the average gross profit per customer by the average customer lifespan. In a usage-based pricing model, LTV may be more difficult to calculate as usage patterns can change. Here also it helps to use historical trailing averages on a cohort-basis
• MRR Movement: Churn is another key metric, which is calculated by dividing the number of customers who cancel by the total number of customers at the beginning of a given period. However, in usage-based pricing expansion and downgrades become crucial. A steady increase in usage over time (expansion) signals customer success, but a steady decrease in usage over time (downgrades) signals potential issues. It’s therefore important to track churn, expansion, and downgrades more closely to ensure that customers are getting the value they expect

Conclusion

In conclusion, usage-based pricing can be a valuable model for SaaS companies, as it aligns the interests of the customer and company, reduces customer churn, and offers granular pricing. However, it’s important to be transparent about the pricing structure and to provide clear explanations, as well as to track key SaaS metrics to ensure the pricing model is working effectively for the business and its customers.