Guide to Revenue Recognition on 4 Common Pricing Scenarios
Revenue Recognition Guide
SaaS billing is rarely fair. Either the vendor gave away too good of a deal or the customer just got ripped off. Someone always wins. Someone always loses. What prevents us from finding a way of billing that is fair for both the customer and the vendor.
To put it concretely, fair SaaS billing is when product value to the customer is proportional to contract size ($) of the product. The challenge of fairly billing is to get customer product value and contract $ value to grow at the same unit rate.
Deviating from the ideal billing scenario (depicted above) will have potential ramifications for either the customer or the vendor.
If contract size is disproportionally higher than product value to customer, you will get significant customer churn. A worst case scenario of this is when you’re paying for a subscription you don’t even use (e.g. unused gym membership).
On the flip side, if product value to customer is disproportionally higher than contract size ($), you will have revenue leakage (untapped revenue potential).
That begs the question, what can SaaS businesses do to make billing more fair for everyone? After interviewing hundreds of SaaS founders and being active ourselves in the space, we’ve come to better understand the options.
B2C is its own beast, so we will stick to B2B billing for now. Even in B2B billing there is no silver bullet, so we will review different popular forms of pricing and understand why or why not they are fair.
Flat Pricing: No matter how much your customer uses your product, your customer gets charged a fixed amount. It is a popular way of pricing because of how easy it is to implement and how predictable the results are. The problem with this pricing is that you have revenue leakage for customers that love your product and unnecessary costs for customers that don’t actively use your product.
Per Seat Pricing: every user you add, you pay the vendor for it. It’s a simple and fairly consistent way of billing.
The big challenge with per seat pricing is that if your inactive users start to increase on that platform, the customer / contract value starts to become disproportionate (customer pays regardless if user is active or non active user).
One good solution here is “Active User Pricing”. Slack popularized this billing style. Check it out in Slack Fair Billing Policy. In Active User pricing, companies only get charged on users that use the system above a threshold of time in a month and are prorated for users that join mid-month.
Multiple Subscription Plans are where companies have multiple price plans set at different amounts and with a different feature set. The challenge here is to properly bucket your customers in the price plans that offer the best ratio of customer product value to contract $ size.
Depicted above is a graph of different customers on different plans. As you can see in Plan 1 and Plan 2, either the vendor wins or the customer wins. If you can create a set of pricing plans that roughly align contract size and customer product value, then you will get close to fair billing.
Usage based billing: Vendors pick the meters/metrics and as the customers uses the product along those metrics - they pay (Pay as you go). If a vendor picks the right customer value metrics, then your contract size will literally grow with customer value. Cloud providers do a good job of this. Take cloud storage for example (e.g. AWS S3 ), these companies do usage billing based on storage consumption per GB. As you store more data into a cloud storage service, it costs more to the end consumer. If cloud providers had used flat pricing instead of usage-based pricing, then the consumer would pay the same amount for 1GB vs. 1TB stored in the service. Obviously, that is not a scalable business model for vendors selling cloud storage.
By comparing a few billing frameworks, it should be clear that usage-based billing is the best billing framework for fair billing. This billing framework effectively scales as customer consumes a vendors product. Fair billing is consistent as long as the right value metrics are billed on.
As usage-based billing is arguably the fairest form of billing, it is important to understand why it is still not ubiquitous amongst most SaaS companies.
There are business and technology reasons behind the lack of SaaS businesses deploying usage-based billing.
From a business standpoint, the risk with usage-based billing is that if you don’t pick the right “value metrics”, you will charge your users on metrics that aren’t valuable to your customers. This would potentially create significant unfair billing scenarios for both vendors or customers.
Picking the right metrics to bill on comes down to really understanding your customer, tracking usage across many product dimensions, and experimenting with different pricing models in a data-driven way. Once you've found the right value metric to bill on, you are on better path to fair billing.
From a technology standpoint, usage-based billing is just plain hard to implement. Accurately tracking customer usage and correlating that to actual bills (e.g. usage-based billing) is technically difficult as there are engineering problems involved such as accurate metering, detailed invoicing, usage protection, etc. Check out this blog to better understand the complexities of setting up usage-based billing.
All in all, if you can get past the business and technology challenges of usage-based billing, then it is the best framework for enabling fair billing for yourself and your customer.
By Nate Matherson, Co-founder & CEO of ContainIQ