Usage-Based Pricing Key to Subscriptions, According to Yale School of Management

Subscription pricing models come in a variety of flavors — from purely usage-based to flat fee to per-unit fees to a hybrid. With several options for pricing your offerings, how do you figure out what’s the right mix to grow your business?

The bad news is that’s not entirely clear. Take usage-based pricing as an example. As Sang Kim explained, “if you use too little usage-based pricing, then the growth rate is maybe not as good as what you might be expecting. On the other hand, … if you’re relying too much on usage-based pricing, the same thing happens.”

The good news is studying the relationship between pricing structure and consumer behavior can help companies make pricing decisions that optimize both revenue growth and customer lifetime value (CLV).

Businesses have traditionally approached pricing strategy by focusing on covering their costs. They use fixed-fee pricing to recover fixed costs and usage-based pricing to recoup their variable costs and attract new customers.

But this way of looking at things is overly concentrated on short-term profitability, and doesn’t take into account customer demand. It’s also not customer-centric — which is the name of the game for subscription businesses.

On top of that, there’s another problem. It’s misleading.

Kim explained, it assumes “customer preference and usage patterns are fixed.” The reality is pricing strategy can “actually change how the customers use your service” by influencing experimentation and habit formation — making them more likely to stick with their subscription for the long-term rather than churn away.

It’s clear subscription businesses need to think about pricing both in terms of the impact on their costs and the effects on customer behavior.

To illustrate how this works, Lee walked through data on gym memberships. You’d think getting customers to sign long-term contracts would be better for company revenue. But people on monthly contracts actually had more consistent usage patterns and higher retention rates than those who signed up for yearly contracts — and that makes them more profitable.

Bundling is another good example of how to maximize customer lifetime value. At first glance, the appeal of product and service bundles seems to be in the increased revenue generated from their higher prices versus for standalone offerings. But that’s only partially true.

Bundles are so effective, particularly for digital products, because they boost customer retention. Data on the cable industry shows companies were able to decrease customer churn rates by close to 50% with subscription packages that included three services.

This “multiplier effect” means customers “are more likely to stay with you the more involved they are with your different product options.” This depends on pricing the bundles right — i.e., what the incremental variable costs are for the products and services you include in the bundles — versus what you can charge for them.

Here are four tips drawn from consumer behavioral data.

1. Uncertainty is part of the value. Leverage uncertainty to increase engagement and retention. Sudhir spoke about how capitalizing on the “gambler in all of us,” using the anticipation of a reward — whether it’s an email, a Facebook “Like,” or a new StichFix package — can keep customers coming back for more.

2. Reminders work…but only after habits are formed. Reminders can be a prompt to action. But too many risks drives customers away. For instance, month-to-month subscribers tend to be stickier. But they also have more opportunities to churn. One way to minimize this and avoid the “pain of payment” is through automatic billing.

3. Concentrate on what really moves the needle. The reason this is so important Seung Yoon Lee stated is because “if you just focus on acquiring people who are not really fully forming their habits, before they get to renew for next year, then that’s a problem… Because a lot of your long-term profits are coming from retention, not acquisition or growth.”

4. Experiment, experiment, experiment to find the pricing structure that works. Every subscription business is different. You can’t one-size-fits-all your way to optimum pricing. Instead, begin with these fundamental or “first order” questions:

– How much should we charge?

– What price tiers should we have?

To answer these questions, you really have to get to know your customers, checking to see how the answers change acquisition and retention rates, and tracking if and how customers are switching between different price tiers.

Kim acknowledged that the handful of customers a typical B2B company has versus a B2C business does change “the equations quite a bit.” But he believes the basic framework is relevant.

Whether you’re B2B or B2C you still need to ask, and answer the following questions to inform your pricing structure:

• What kind of business environment am I operating in?
• How many customers do I have?
• What kind of competition do I face?

Being strategic with user fees is also important. You want to encourage potential customers to experiment with and experience a broad range of your products. But often user fees do the opposite, leading clients to limit the number of users to keep costs down. The downside, which Sudhir outlined is, that chokes off the incentive for users to “try out, understand, learn, …” reducing potential “penetration of the product.”

Balancing these trade-offs might mean that a freemium model makes sense. You could start with a fixed trial period. Or you could offer a basic free offering indefinitely, combined with tiered pricing for a higher level of service.

What really matters for retention is acquiring clients by allowing them to experiment, structuring your pricing in a way that encourages them to form a habit, then retaining them through engagement that creates a sense of anticipation and fun.

The stickiness that comes from that creates a “multiplier effect” that will drive profitability, and ultimately, your customer long-term value.