Mon Jul 11 2022

What is Usage Based Billing?

Overview

There are many different ways to charge users for the same experience. In this blog post, we'll explore the different recurring revenue models you can have as a business and the tradeoffs for each business model. These options include your basic subscriptions up to metered plans with volume based discounts.

Over the past decade, there has been a meteoric rise in subscription services, most notably in SaaS services, but in other areas too, such as dating apps, gym memberships, food delivery and even coffee.

With the number of subscriptions growing, there has been great value created for household consumers and businesses who continue to explore value across different services and at various price points. We will review the disadvantages of subscription pricing and how other business models might be better suited for both consumers and the business trying to generate money themselves.

Keep in mind that businesses can also launch new products using only usage based models and never touch subscriptions. In this case, those businesses would only focus on the flexibility and dynamic pricing of usage based models while optimizing from there. For example, let's take a look at Stripe, this usage-based is based on the number of transactions you make based on the amount you sell, there is no recurring subscription fee.

Subscription

When a business is charging for a subscription fee, they are offering their product to a user for a set price. Netflix is able to charge a standard subscription fee of $15.49 per month. This allows the users to watch an unlimited amount of movies and TV shows across any device and allows Netflix to collect a steady stream of recurring revenue to continue to acquire more content for their subscribers.

As Netflix grows and continues to build its customer base, the value each user is receiving from the Netflix subscription service will vary. Think of your usage vs. your neighbor Ben. You are super active and only plan to watch Netflix on Monday Movie night. You plan to watch a single movie that night and not again until the week after. At the standard price of $15.49/per month, you believe you are paying quite a lot for your time spent watching.

Compare this to Ben, who chooses to stream old movies and TV shows every single day. As you can see, you and Ben are paying the same amount for Netflix but seem to be using the service for very different amounts of time and watching completely different content. These deviations in usage bring us to the discussion around a new model called Usage Based Billing.

Usage Based Billing, or Metered Billing, is the overarching term for a newer pricing strategy in software services that allows a business to think smarter about their pricing models and ideally provide better value to their users AND drive increased revenue for their business. Let's break down the different ways a business can charge using a usage based pricing model.

Graduated Pricing

Remember how you and Ben watch Netflix differently? Under a new usage based model imposed by Netflix, a user will pay a set price for all minutes consumed up to a certain amount, and pay a lesser amount for another amount of minutes, and so on. For example, if a user watches any number of minutes less than 120, they pay 5 cents per minute. If they watch over 240 minutes, they pay 5 cents for the first 120 minutes, 3 cents for the next 120 minutes and then 1 cent going forward. See table below for reference.

Price Per TierNumber of Minutes
$0.050-120
$0.03121-240
$0.01241+

As you can see, users who frequently watch TV will pay more for their total usage than those who watch less. Do notice however that the initial time spent watching, the Netflix customer base is paying the same price for their initial 120 minutes and only when they enter the next tier does pricing begin to drop. This pricing strategy allows Netflix to get maximum value from users early on while discounting further usage.

For example if a user were to stream for 800 minutes - similar in watch time to your favorite 36 Friends episodes, the breakdown would look as follows:

Price Per MinuteNumber of MinutesGraduated Cost
$0.050-120$6.00
$0.03121-240$3.60
$0.01241+$5.59
Total User Cost$15.19

Pricing usage on their graduated pricing model can be far better suited for Netflix and its users than a flat subscription fee.

Volume Discounting

Another way to explore implementing a usage based pricing model is to apply a similar pricing model to how your local gravel yard might price sand. When you approach your gravel yard, the yard will simply fill your vehicle and discount based on the amount of sand purchased. The more you buy, the cheaper it gets. I would imagine the yard would charge you far more for a single 50/lbs bag of sand on a per pound basis than if you filled up an entire dump truck full.

Similar to graduated pricing, this model works best for Netflix to entice new users to join the platform and stress they 'only pay for what they watch' and to get far more value out of "power users" who might binge watch every single show on the platform. These power users are now paying an amount that better aligns with their usage.

Keep in mind there does remain the key difference where volume pricing is similar to getting a deal when buying in bulk, whereas graduated pricing allows the service to charge users a higher price up front and offer discounts on purchases later, while still getting full value for their users early consumption.

Under a volume based scenario, the same user who watches 800 minutes of Netflix would ONLY pay 1 cent across their ENTIRE number of minutes, which equals to a much cheaper price of only (800*1 cent) = $8. This is almost half what they would pay under the tiered pricing model. Keep in mind there are ways to optimize this pricing to best match the implied value each user is getting from Netflix.

Endpoints

Another key difference between a flat subscription fee and usage based pricing models is allowing services to segment their content or data. Endpoint pricing is a feature that services can implement to their usage based strategy. Let's revisit the difference between how you and your neighbor Ben watch Netflix. In addition to the difference in hours, you tend to only watch new films and super premium content while Ben continues to watch low budget indie films from the early 2000s. The films you are watching are of far greater expense to Netflix than those reruns Ben likes to watch.

Under this new scenario, it makes sense for Netflix to charge Ben far less per movie watched than what Netflix would charge you. This idea can also be applied across the entire Netflix catalog. Under this usage based pricing solution, each category of movie could be priced differently. Netflix Originals and high demand Action films are more expensive and restricted, while 1990s rom coms are under an "All Access' tab, and so on.

Final Thoughts

There are many business to business (B2B) or business to consumer (B2C) subscriptions that can begin to think about trending away from very restrictive subscription pricing models and explore usage based pricing.

With variations in pricing that include graduated pricing, volume based discounting and endpoint specific pricing, businesses can better charge an amount that better aligns with the value their users are getting from their services.

In our next post, we will take a deeper look at other usage based pricing models that include coupons, commitment and more. There are nuances to the overarching usage based pricing model that can drive increased value for all parties.

In the meantime, go on ahead and check out Archetype.dev and the Docs to get started by applying some of these usage-based models.

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