Pricing under uncertainty and the need for usage based pricing
Steven Forth is a Managing Partner at Ibbaka. See his Skill Profile on Ibbaka Talent.
On March 18, we published a post on the OpenView blog ‘Pricing in a time of uncertainty.’ We are in a very fluid environment at present and there are many possible outcomes. We have to be prepared for several different outcomes. Pricing strategies must be adjusted to be viable under many different scenarios. Assuming business as usual is to take on unnecessary risk.
One of the suggestions in this post was to add a usage component to your pricing model. At Ibbaka we see this as one way of building flexibility into pricing and giving reassurance to customers that you understand their own business conditions.
This suggestion provoked a certain amount of pushback on online forums, so it is worth unpacking that pushback and seeing if and how you should be considering some form of usage based pricing.
Why usage based pricing in general?
The subscription management platform Zuora does a lot of research into subscription pricing models. One thing it has found is that companies with a usage based component to their pricing model grow faster than companies that do not include usage based pricing.
Zuora Chief Data Scientist Carl Gold and Director of Product Marketing JJ Xia have looked at data from Zuora users and found that companies that get some, but less than 25% of their revenue from usage grow about 6% faster than companies that make no use of usage based pricing. You can get the full report here.
From Usage Based Pricing - What is the Right Mix by Carl Gold and JJ Xia.
Why might this be? The simplest answer is that usage based pricing can be part of a value based pricing strategy. If you use a usage metric that tracks value (not all usage metrics do) you are connecting price to value. This is at the centre of the Ibbaka Market data model.
You can learn a bit more about our approach to value drivers here.
Note that according to Zuora’s data, companies that get more than 25% of their revenue from usage based pricing grow slower than companies that get less than 25% of their revenue this way. Why might this be? In many cases the other parts of the pricing model lock in the buyer and capture future value before it is actually delivered. The combination of a base subscription plus some usage based pricing is one way to increase willingness to pay (WTP).
Objections to usage based pricing
Given the demonstrated power of usage based pricing, why don’t more companies use it and why are they unwilling to consider it at this time?
The most common objection is ‘predictability.’ Buyers and sellers both need predictability around the cost/revenue associated with any major commitment. A pricing model that makes it difficult to predict future commitments is, well, difficult to commit to.
Along with predictability, especially in the current conditions, is ‘uncertainty.’ Given the fluid situation we find ourselves in it is hard to know how much use there will be. Even online retailers rely on physical warehouses, what happens if the warehouses close down?
Underlying both of these objections is ‘fear of change.’ In a time of rapid change, where the outcome is uncertain, why add in another question?
These are all valid reasons to reject usage based pricing and none of them are new. So why advocate for usage based pricing now?
Why usage based pricing now?
This is not an all or nothing decision. Begin by adding a small usage based pricing component and dialing back other pricing metrics. Remember that the Zuora research shows that one wants to have a usage based component, but that this should amount to less than 25% of overall revenue.
Model your new pricing mix so that it would have been revenue neutral for the past twelve months. This will lead to three outcomes.
For some customers revenues will go down as they are using your service less. This is a desired outcome as it shows you are working with your customers to help them through a difficult period.
Some customers will not be impacted. That is OK, explain to them that you are making this change to provide everyone with more flexibility given the current uncertainty.
There will even be customers that are using your service more. Here you need to be very careful not to be seen as price gouging. Dampen any sharp changes and make sure they are distributed over time. Communicate and consult with these customers before announcing the change. Make sure you are following the three principles of fair pricing and are seen to be doing so. Pricing should be
Transparent - people should be able to understand your pricing model
Consistent - it should be applied in the same way to all customers
Equitable - customers getting the same value should pay the same amount and you need to be fairly compensated for the cost of sustaining the service and investing in ongoing innovation
What is your pricing strategy?
Your pricing strategy needs to change in response to the Covid-19 economic crisis. You need to devise a pricing strategy that is resilient across multiple scenarios. Don’t just ask ‘What has changed?” ask “What could change?”
The best way to do this is by applying scenario planning to your pricing strategy and developing a portfolio of actions that you can take quickly as soon as you know what scenario is emerging.
Pricing action portfolio design and optimization is one of Ibbaka’s core areas of research.
You can contribute to a survey on this here.
We are planning a seminar on pricing action portfolio management for late April. If you are interested in this you can reach out to us by clicking on the button below.
