Activity Based Pricing: When Is It The Right Choice for Your Startup?

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Pricing is taxation. A pricing plan taxes some element of a product’s use. For a startup, choosing what to tax and how to tax it can be one of the most perplexing decisions because the tradeoffs between usage and revenue aren’t always clear.

Activity based pricing or usage based pricing is one of the more common pricing plans in utility computing and software these days. Need to spin up another server immediately? Did another user sign up to use this software? No problem - we will just add it to your bill.

ABP offers a few advantages, namely easy trial/low cost of failure, aligning cost with use and transparent pricing. The low cost of failure increases product trial rates. Also, the transparent and simple pricing builds trust with the buyer. These two advantages combine to reduce the need for sales intervention to convert a customer to paid.

But activity based pricing does confer some costs. First, churn measurement is complicated. If a customer uses a product every third month, a standard monthly churn calculation will show the account churning and reactivating constantly, skewing the measurement. Second, building a sales team compensation plan for ABP is difficult because the value of the account can’t be measured at point of sale. Third, capacity planning can be challenging because a startup has reduced visibility into maximum capacity requirements. Last, ABP does ask the customer to make a new purchasing decision every billing period, instead of signing up for a year or some longer period of time.

Every decision carries trade offs. ABP tends to foster account growth at the expense of revenue maximization and predictability. Therefore, it’s common to see ABP at a product launch ($10 per active user per month) and then a slow trend toward standard pre-purchase licensing agreement either based on seats or capacity ($120 per user per year).

Some examples: Amazon Web Services has created a hybrid of the two: a spot market for instances charged with ABP and a pre-purchase market where capacity can be bought for discounts of about 50%. Salesforce started as ABP before moving to annual seat contracts when churn rates became significant and revenue predictability faltered.

Understanding the trade-offs of ABP and taxing the right things with your pricing plan is the key to balancing growth and revenue predictability.

Apr 4, 2013

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