background
Welcome to Wall Street Prep! Use code at checkout for 15% off.
Wharton & Wall Street Prep Certificates
Now Enrolling for September 2024 for September 2024:
Private Equity•Real Estate Investing•
Hedge Fund Investing•FP&A Wharton & Wall Street Prep Certificates:
Enrollment for September 2024 is Open →
Wall Street Prep

Usage-Based Pricing (UBP)

Step-by-Step Guide to Understanding Usage-Based Pricing (UBP)

Learn Online Now

Usage-Based Pricing (UBP)

In This Article
  • The usage-based pricing (UBP) is a pricing model where customers are charged based on their actual usage (or consumption) of a product rather than a fixed rate.
  • The usage-based pricing (UBP) model is characterized by flexibility and transparency—with costs aligned with consumption—which can lead to increased customer satisfaction and loyalty.
  • The UBP pricing model is commonly used in industries such as cloud computing, telecommunications, utilities, and increasingly in SaaS, providing benefits like passive upselling and profit margin stability.
  • The factors driving the rapid adoption of UBP pricing include improved technologies to measure real-time usage monitoring, the market demand for pricing flexibility, successful implementation by early adopters, and the ability to lower barriers to entry for potential customers.

How Does Usage-Based Pricing Work?

Usage-based pricing (UBP) is a pricing model where customers are billed based on their actual usage of a product or service, as opposed to paying a fixed rate.

The pricing model is cost-effective to implement for companies since there is minimal commitment required and the risk of overage charges is reduced (i.e. user exceeds the allotted usage limits).

Unlike traditional subscription pricing models that charge a fixed fee regardless of usage, the usage-based pricing (UBP) model offers flexibility to customers, where costs align with consumption.

The usage-based pricing (UBP) offers customers the option to pay according to how much they use a product.

The measured usage reflects how much value the customer derives from the product, with common metrics being the number of transactions processed, the amount of data stored, or the volume of resources consumed.

In effect, the pricing model can be appealing to both providers and customers because of the variable usage patterns, which ensures that customers see a direct correlation between their usage and costs, enhancing perceived value.

Because the billing is a function of actual usage that is quantifiable, the usage-based pricing model is often viewed positively by customers for its transparency.

Furthermore, managing to establish trust from customers is the initial step toward building customer loyalty, which coincides with creating a recurring revenue stream.

One side benefit to usage-based pricing is that the collection of data can help companies better understand and predict usage patterns—which enables more accurate sales forecasting, resource allocation, and improved operational efficiency—based on the derived practical insights into customer behavior and product utilization.

What are the Different Types of Subscription Pricing Models?

The two most common types of pricing models used by SaaS and subscription-based businesses are fixed-rate pricing and usage-based pricing (or metered billing).

Pricing Model Description
Fixed-Rate Pricing
  • All users pay a specific price every billing cycle, regardless of their actual usage.
  • The fixed-rate pricing model is straightforward and easy to implement, making it attractive for companies that prioritize simplicity and predictability in their revenue streams.
  • Undercharging “heavy” users and overcharging light users can lead to dissatisfaction among customers who feel they are not getting fair value for their money.
  • Fixed pricing can also limit the ability of companies to capitalize on higher usage, potentially leaving revenue on the table.
  • Cost-conscious customers may perceive they are overpaying for their actual usage, impacting customer retention and acquisition.
  • The telecommunications and software as a service (SaaS) industries, where usage can vary significantly among customers, may find this model inefficient or inequitable.
Usage-Based Pricing
  • Monetization aligns with how users consume the product or service, ensuring that customers pay in proportion to the value they receive.
  • The direct correlation between usage and costs inherent to metered pricing enhances perceived value and fairness.
  • Providers gain valuable insights into customer behavior and product utilization, enabling more accurate forecasting and resource allocation.
  • Several variations exist, each tailored to different usage patterns and customer needs, making it a versatile approach suitable for various industries such as cloud computing, utilities, and telecommunications.

Usage-Based Pricing vs. Subscription-Based Pricing: What is the Difference?

Usage-based pricing and subscription-based pricing are two distinct strategies that cater to different business needs and customer preferences.

  • Usage-Based Pricing (UBP) ➝ Usage-based pricing—also known as “pay-as-you-go”—charges customers based on their actual usage of a product or service. The consumption-based pricing model is prevalent among utility companies, cloud service providers, telecommunication providers, and now increasingly SaaS vendors. The key characteristics of the pricing model include the variable billing structure, scalability, and transparency in costs. In short, customers pay only for what they use, leading to fluctuating monthly bills that can efficiently align with their consumption patterns. The pricing model encourages customers to optimize their usage, which can result in cost savings on both ends. However, the drawbacks to the pricing strategy are the unpredictable fluctuations in revenue and complicated billing systems (i.e. monitor usage per user), which can cause forecasting to become more unreliable.
  • Subscription-Based Pricing ➝ In contrast, subscription-based pricing involves charging customers a recurring fee, typically on a monthly or annual basis, for continuous access to a product or service. The subscription-based model is widely adopted by SaaS companies, streaming services, and membership organizations (e.g. gyms). Subscription-based pricing is characterized by fixed costs based on a flat rate, ensuring customers are charged a consistent amount at regular intervals, which simplifies budgeting for both customers and providers. The pricing model can build long-term customer relationships and loyalty, contributing toward a steady and predictable revenue stream. The simplified billing process and the auto-renewal of subscriptions further enhance convenience for both parties. However, the downside is that customers might be paying for services not fully utilized, which can lead to an uptick in customer churn rates (i.e. subscription cancellations).

What are the Different Types of Usage-Based Pricing Models?

There are several variations of usage-based pricing, which are described in the subsequent table:

Variation Description
Tiered Usage-Based Pricing
  • Charges vary based on quantity levels, creating a tiered structure that adjusts pricing according to usage volumes (e.g. the first 10 units might cost $50 each, and subsequent units might cost $40 each).
  • The dynamic pricing model encourages higher usage by offering discounts for larger volumes, making it attractive for customers who anticipate growing their usage over time.
  • The tailored pricing structure accommodates a wide range of customer needs and usage patterns.
  • In industries like cloud computing and data storage, tiered pricing can incentivize larger commitments from customers while providing them with cost savings.
Per Unit Usage-Based Pricing
  • Customers are charged a flat rate per unit consistently, regardless of the total volume consumed.
  • The straightforward approach is easy to understand and manage, but it may not incentivize higher usage since there are no volume-based discounts. Higher costs for heavy users can lead them to seek more economical alternatives or negotiate for better rates.
  • The pricing model may not adequately reflect the value delivered at different usage levels, leading to potential dissatisfaction among users who feel they are not getting a fair deal.
  • The per-unit usage-based pricing model is most prevalent in industries such as utilities and telecommunications, where simplicity and transparency are highly valued.
Volume Usage-Based Pricing
  • Costs decrease as usage volume increases, creating an incentive for customers to use more of the service.
  • High-volume users are rewarded with lower per-unit costs, promoting bulk usage and fostering customer loyalty.
  • The volume usage-based pricing model can drive substantial revenue from large customers while offering them significant cost savings, making it a win-win situation for both the provider and the customer.
  • There is an evident financial incentive for the continued and increased usage by customers that builds more loyalty.
  • In industries like cloud computing and telecommunications, volume pricing can help providers attract and retain large, high-value customers.
Stair-Step Usage-Based Pricing
  • Pricing is based on usage ranges or mixed usage, allowing for flexible elements that can be adjusted as customer needs evolve (e.g. first 50 emails might be free, with subsequent usage priced at different tiers, providing a scalable and adaptable pricing structure).
  • New customers are attracted with low initial costs, encouraging them to scale up their usage over time and creating a pathway for growth.
  • The stair-step pricing model allows for more precise alignment between costs and usage, enhancing overall customer satisfaction.
  • In the SaaS industry, stair-step pricing can be particularly effective for startups and small businesses looking to manage their budgets while gradually increasing their usage.

Which Industries Use Usage-Based Pricing?

Industry Description
Cloud Computing
  • Companies like Amazon Web Services (AWS) and Microsoft Azure charge based on compute time, storage, and other resources utilized by the customer.
  • The usage-based pricing model incentivizes the efficient use of resources, as customers are motivated to optimize their usage to control costs.
  • On the other hand, cloud providers can efficiently scale their infrastructure by aligning revenue with resource consumption (i.e. reduced “waste”).
Telecommunications
  • Mobile and internet service providers often use usage-based pricing for data, minutes, and messaging services.
  • The pricing model enables telecom providers to cater to diverse customer needs, from light users to heavy data consumers.
  • Users are encouraged to monitor and manage their consumption more closely, potentially reducing network congestion.
Utilities
  • Electric, water, and gas companies charge based on the amount of energy or resources consumed by the customer (i.e. metered charge).
  • The consumption-based pricing promotes conservation efforts, as customers are directly incentivized to reduce their consumption (e.g. less usage when not necessary).
  • The variable pricing structure enables utility companies to align their revenue with the variable costs of resource generation and distribution.
Software as a Service (SaaS)
  • In Software as a Service (SaaS) products, vendors with usage-based pricing models charge customers based on metrics like data stored, number of users, or transactions processed.
  • The pricing model contrasts with subscription-based models, where customers are obligated to pay a recurring fee regardless of actual usage, potentially leading to inefficiencies and higher costs for users with fluctuating demands.
  • The adoption of the usage-based pricing model in the SaaS industry is attributable to a multitude of factors, but one, in particular, is the optionality offered to customers, where there is a broader range of selections.

What Factors are Driving Adoption of Usage-Based Pricing?

Several factors contribute to the growing popularity of usage-based pricing (UBP):

  • Real-Time Usage Monitoring ➝ The increasing capabilities to track usage closely and support dynamic pricing models stem from advancements in automation technologies, including APIs and AI, enabling precise tracking and billing of usage. The ongoing technological advancement reduces the administrative burden on both providers and customers, improving operating efficiency while facilitating real-time usage monitoring.
  • Downside Protection ➝ The necessity of flexibility in the pricing plans offered to customers has become a critical factor for SaaS companies, with UBP offering resilience against churn and improved customer retention. The economic pressures and the need for cost efficiency have made flexible pricing models more attractive, especially amid the COVID-19 pandemic. Moreover, UBP can provide a competitive edge in tight markets by offering more appealing and adaptive pricing options.
  • Widespread Adoption ➝ Early adopters have demonstrated there is plenty of demand for a flexible, usage-based pricing structure, encouraging wider adoption in the SaaS market. For example, companies that have successfully implemented UBP, such as Twilio and Datadog, serve as benchmarks for others to follow suit, considering the rate of customer acquisition and recent revenue growth.
  • Lower Barrier ➝ Usage-based pricing (UBP) reduces upfront costs, making it easier for potential customers to test out a product. Lowering the financial barrier to entry allows customers to access the product and determine if the value of the product is worth committing to without a significant initial investment required. By reducing these barriers, UBP can improve trial and adoption rates, causing an expansion in the customer base (i.e. trial and paid customers). Companies can also target a broader range of customers, from early-stage startups to large enterprises.

What are the Benefits of Usage-Based Pricing?

  • Passive Upselling ➝ The increased usage by a customer leads to higher spending without the need for more sales efforts. For instance, as the size of an enterprise client grows, usage of the product (and the need for more seats) is inevitable, which contributes to an increase in spending in direct proportion to the growth and development of the client. The passive upselling that occurs by itself enhances customer lifetime value (CLV) without the necessity for aggressive sales and marketing (S&M) tactics or spending on campaigns. The product becomes more deeply embedded into the operations of a customer once acquired, improving the overall stickiness (and thus, more recurring revenue).
  • Customer Satisfaction ➝ The consumption-based pricing model aligns costs with usage, reducing concerns about overpaying for services not utilized. Therefore, customers view transparency favorably since each bill is directly based on their actual usage, leading to higher customer satisfaction and loyalty. The alignment of costs with usage facilitates a more positive customer relationship, namely around trust, since users understand the tradeoff is fair.
  • Profit Margin Stability ➝ Because of the fact that usage based pricing connects customer billing (and revenue) to actual usage, that causes the company’s unit economics per customer to stabilize. The flexible pricing model helps companies maintain strong profit margins by directly correlating costs and revenues. In effect, a “buffer” is created that can mitigate the risk of revenue fluctuations, as increased usage causes revenue to rise, supporting more sustainable growth in revenue generation (i.e. periods of increased usage can offset periods of reduced usage).
Comments
0 Comments
Inline Feedbacks
View all comments

The Wall Street Prep Quicklesson Series

7 Free Financial Modeling Lessons

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.