What is Consumption-Based Billing?

Consumption-based billing is a billing model where a business charges customers based on usage amounts, rather than a flat rate. Cloud services and certain types of SaaS companies favor it because it offers flexibility for customers, who can scale their usage up or down based on their current needs.

Consumption-based billing works by tracking and measuring a customer’s product or service usage. This can be done through various methods:

• Metering (tracking usage in real-time)
• Monitoring (monitoring and reporting on usage)
• Resource pooling (allocating a certain amount of resources for usage)
• Tiered pricing (charging customers based on different levels of feature access)

In consumption-based pricing models, there’s a set price per “unit” of usage. For example, Uber charges per mile or minute, and AWS charges per GB of data storage or per hour of server usage. Customers only pay for what they use, rather than a predetermined rate.

Synonyms

• Pay-as-you-go billing
• Usage-based billing
• Metered billing

Importance of Consumption-Based Billing

Benefits for Businesses

When businesses implement a consumption-based model, they have less difficulty relating the costs and benefits of using a product to its users. This helps to create a sense of value, as customers are only paying for what they actually use instead of a flat rate that may not align with their usage needs.

The ability to uniquely adapt to customer usage patterns at the individual level has plenty of other perks for businesses:

• Higher rates of customer satisfaction and loyalty
• Greater revenue potential over time as customers increase usage or scale up their services
• Enhanced agility when setting, testing, and improving pricing strategies
• Increased transparency through clear usage metrics and billing data
• Ability to analyze and understand customer usage trends for improved personalization and product development

Benefits for Customers

In industries where fluctuating consumption patterns are commonplace, a consumption-based model is the fairest option for customers. Since costs go up only when they use more, there’s a clear correlation between value delivered and payment made.

There are several advantages to this:

• Understandable costs that translate directly to usage volume
• Low barriers to entry as customers can start out with low usage
• Greater control over budgeting and spending
• No hidden or surprise fees
• Increased flexibility and scalability
• A more personalized product experience

Considerations for Consumption-Based Billing

Implementing a consumption-based model is quite difficult without the right tools. Accurate billing according to usage metrics requires sophisticated software that can monitor, track, and measure usage levels for thousands of customers. 

One-time purchases or fixed subscriptions might make more sense depending on the type of business you’re running. If your customers frequently have high or consistent usage, a standardized approach will probably align with their needs and your value prop more effectively. For instance, people might pay per X,000 marketing contacts, but they’d never do the same for CRM storage.

Even if usage-based billing is the ideal model for your company, you’ll probably need to establish a “baseline” for services. For example, HubSpot’s Marketing Hub starts at $800 for its Professional tier, which includes 2,000 marketing contacts. As you purchase more contacts, you’ll pay an added fee.

When you’re constantly collecting customer data, there are also privacy concerns. Be sure to review laws and regulations around collecting, storing, and managing personal data. Since consumption-based models are designed to track individual usage over time, make sure you’re transparent about what data you collect and why, as well as how you protect it.

Types of Consumption Billing Models

The billing methods you’ll potentially use are practically the same as consumption-based pricing models.

Let’s dive into some common types of consumption billing models:

Simple Pay-As-You-Go

Pay-as-you-go pricing is the most straightforward model — you’ll bill customers based on the exact amount of resources or services they use. It’s commonly seen in utilities like water or electricity but is increasingly applied in cloud services and SaaS products.

Example: Snowflake uses a PAYG model, where you only pay for the storage and compute power your data consumes. It’s a flat rate per terabyte, based on average usage for the month.

Tiered Usage Model

Fundamentally, tiered usage works just like tiered pricing. In this model, usage is bracketed into a few different levels. The price per unit changes depending on the tier. For instance, the first 1,000 units could cost $1 each, the next 1,000 $0.90, and so on. This model can encourage higher usage as the unit cost decreases with volume.

Example: Mailchimp uses a tiered usage model for its marketing contacts. When you purchase 5,000 credits, each one costs $0.03. If you were to purchase 100,000, they’d cost $0.015 each.

Volume-Based Pricing

Volume pricing strategies (e.g., block pricing, graduated pricing) are similar to tiered pricing. But instead of distinct tiers, prices are set based on usage volume brackets. Customers pay according to the bracket their usage falls into, encouraging larger purchases for better rates.

Example: AWS uses volume-based pricing for its S3 storage service. Customers pay $0.023 per GB for the first 50TB of usage, but prices decrease as usage volume increases.

Hybrid Billing Model

If your billing platform supports hybrid billing (it should), it’s possible to combine different models as you see fit for your business. For instance, customers may pay a flat monthly fee for a baseline level of service, with additional charges based on usage over that amount.

Example: Marketing automation software vendors use a combination between flat-rate and usage-based billing by charging a baseline monthly fee, plus usage-based access to features and marketing contacts.

Overage Charges

Customers sign up for a base usage amount, and if they exceed this amount, they are charged additional overage fees. It works when your standard plan is a flat-rate subscription, but you don’t want customers to have to upgrade their plan for occasional or short-term overages. 

Example: AT&T sells multiple different data plans for its mobile service. If you exceed your monthly data allotment, you pay $10 per extra 50GB up to $100.

Freemium to Premium Upsell

The freemium model offers a basic service level for free, with the option for users to pay for additional features or increased usage limits. It’s a popular strategy software companies use to attract new users and convert them into paying customers over time.

Example: Dropbox offers a free version that limits storage and features. Users can then upgrade to one of its premium plans for more space, sharing features, and security options. 

Credit/Packaged Units

Customers purchase a pack of credits or units in advance and then consume services against this balance. This can streamline billing and provide predictability for both provider and customer, though it requires customers to estimate their future usage accurately.

Example: When you purchase iCloud storage, you can either pay $0.99 per month for up to 50GB or up to $64.99 for 12TB.

Dynamic Pricing

With dynamic pricing, prices fluctuate based on demand, time of day, or other factors. While not purely a consumption-based model, it often complements metered billing in sectors like energy rideshare services, where resource availability and demand vary over time.

Example: Your utility company charges a higher rate for electricity used during peak hours and raises rates in the summer months when you’re more likely to use A/C.

Understanding Consumption Billing Receivables

A consumption billing receivable is an amount that a company expects to receive from customers for their usage of a product or service. No matter which consumption-based billing model you use, you’ll have a similar process for tracking and collecting these customer payments.

1. Usage tracking

When you offer a product or service with consumption pricing and billing, you’ll have a mechanism for tracking that usage.

This could be through a metering system, like how a utility company uses a smart meter to track electricity usage. Or, it could be through a counting system, like call data records (CDRs) and SIM data used by telecom companies to track phone usage. If you’re selling a SaaS product, the meter will be integrated with the product itself.

2. Sending consumption data to the billing platform

Your data will have unique identifiers that prove the amount used, who used it, and when. Your billing system will process this data at scale. Based on the consumption data present within the billing cycle, it calculates the cost for each customer.

3. Invoice generation

Based on the data received and the calculations, your billing software auto-generates an electronic invoice for each customer. The invoices include details of the product or service used, the amount consumed, the cost per unit, and the units used.

4. Payment processing and collections

Depending on the nature of your product and the deal you have with your customer, you’ll either automatically charge the payment method they have on file or send them the invoice to pay manually.

• Automated billing is common for recurring subscriptions (e.g., SaaS, phone service). It’s also ideal for instances like taxis and rideshare services, where the variable cost per trip is known and the payment method is already on file.
• Manual payments are more common for one-time transactions, complex deals with custom pricing, and basic services like utilities, where the demand for manual processes still exists. In these cases, the invoice will include payment terms (e.g., due date, acceptable payment methods), and the customer will need to initiate the payment process.

In both instances, you’ll need to keep track of payments and process them accordingly. This involves reconciling payments, tracking down late payments (dunning), and issuing refunds for billing and usage calculation errors.

5. Accounting and reporting

Once the system goes through the AR collections process, you have to officially document it for accounting and revenue reporting purposes. Your billing software will automatically generate invoices, receipts, and other documents as needed. Through an integration with your accounting system, it will automatically update your books and record the revenue accordingly.In your financial reporting, you’ll be able to view important metrics like total revenue, average revenue per user (ARPU), and customer lifetime value (CLV) by product or service line, customer segments, and sales channels.

Industries Using Consumption-Based Billing

Different versions of the consumption-based billing model have been around for decades in sectors where resources are limited or highly variable:

• Energy and utilities (water, electricity, gas)
• Telecom (mobile and landline services)
• Transportation (taxi services)
• Entertainment (movie rentals, pay-per-view TV)

Since the emergence of the subscription economy and the Fourth Industrial Revolution, there’s been a massive wave of new services and business models that have to leverage consumption-based pricing as well:

• SaaS, PaaS, and IaaS (product/feature access, usage activity)
• E-commerce and retail (shipping, storage, and inventory management)
• Digital media (streaming services, gaming)
• IoT (device usage, data consumption)
• Cloud services (storage, compute power)
• Ride-sharing apps (Uber, Lyft)

Consumption metering works a bit different, depending on the industry. 

For instance, an Uber ride would use a meter to track time and distance, which would then determine the final cost of the service. 

On the other hand, cloud storage customers would be charged based on the amount of data storage they used that month, either in a per-gigabyte model or in blocks up to a certain threshold (e.g., 5-10 GB for one price, 10-15 GB for an additional charge).

Software Used in Consumption-Based Billing

To efficiently implement a consumption-based billing model, you need software that can accurately quote for, track, bill, and account for variable usage at scale.

These tools include:

Subscription management software

Subscription management is the process of overseeing and managing subscriptions for a particular service or product.

In consumption billing, subscription management software handles recurring subscription billing, notifications, upgrades, discounts, renewals, proration, and billing period changes. It also integrates with your customer portal, so nobody has to reach out to someone from your team every time they need to update their subscription.

Metering and monitoring tools

These are the tools you’ll use to track usage data and activity. Depending on the industry and service, these will differ.

• Utilities use automatic meter reading (AMR) systems and automated metering infrastructure (AMI) to track energy usage.
• Internet service providers (ISPs) monitor data consumption through routers and modems.
• Ridesharing platforms use built-in digital metering systems and telematics to monitor vehicle locations, trip durations, and distances traveled.
• SaaS companies integrate usage billing software to monitor how applications are utilized across their networks.
• Cloud service providers use monitoring tools to track resource consumption, such as CPU usage, memory allocation, and network bandwidth.

Cloud monetization platforms

A cloud monetization platform helps cloud-based software companies manage variable pricing models and usage calculations for abstract services like 5G, IoT, and cloud services.

Their features include:

• Automated usage tracking for metrics like API calls, data storage volumes, and compute hours.
• Billing mediation to normalize consumption data from multiple sources, ensuring consistency and accuracy in billing calculations
• Support for various consumption-based pricing strategies, such as pay-as-you-go, tiered, and volume-based models.
• Revenue recognition automation according to ASC 606 and IFRS 15.
• Customer invoicing and self-service portals.

Usage-based billing system

If one of the tools above doesn’t handle your billing needs (or you aren’t using it because it doesn’t support your business model), standalone billing software can be integrated into your existing systems for both recurring and one-time consumption billing.

It handles many of the same functions:

• Metering and usage tracking
• Flexible pricing strategies
• Data mediation
• Invoice generation
• Payment processing and collection
• Revenue recognition and compliance

But it offers more flexibility in terms of customization and integration into your existing systems. It also allows you to set up a variety of payment methods, which could include credit card, debit, ACH, and even PayPal.

Configure, price, quote (CPQ)

CPQ (configure, price, quote) isn’t necessarily involved in the billing process. But integrated cloud-based CPQ and billing offer tremendous benefits in terms of billing efficiency and accuracy.

CPQ facilitates (and automates) the creation of complex quotes for consumption-based pricing models. Aside from the fact you need this to be able to quote for consumption-based products in the first place, it eliminates human error and speeds up the sales process.

With the two systems integrated, quotes and orders translate directly into accurate invoices for a seamless end-to-end quote-to-revenue process.

CRM software

Customer relationship management (CRM) software stores your customer records and helps with service delivery tracking. It’s the centralized database you use to manage contact details, preferences, usage/purchase history, and inquiries into things like billing issues.

Business intelligence and analytics

Business intelligence (BI) tools are meant to track and visualize usage patterns over time. They can also help developers get feedback on the quality of their cloud-based service or product. It’s essential to have a good BI tool in your toolkit, as it allows you to spot trends, discover patterns, and identify areas for improvement.

Analytics tools also help you analyze your consumption-based pricing strategy and optimize pricing. For example, if you implement a tiered pricing model, analytics can help you determine the best tiers and pricing levels for maximum profitability.

Payment gateways and processing

Your payment infrastructure is what will actually collect customer payments in real time. You can use payment gateways — third-party services that securely receive and process digital transactions. They typically charge a small transaction fee, but they make the process as seamless as possible and enable you to accept more forms of payment (which reduces delinquency and churn).

Accounting software

An accounting platform manages your financial records and reporting. It’s the system that keeps track of your revenue, expenses, invoices, and taxes. Integrating it with your cloud-based billing software can help you reconcile your transactions and keep accurate records for tax purposes.

This is particularly important if you are a subscription-based service, as it ensures proper reporting, compliance with financial regulations, and preparation for if you’re audited, without you having to lift a finger.

APIs and integrations

APIs connect all these systems together and automate processes. If your billing software can’t integrate with other facets of your tech stack, like CPQ, accounting, or CRM, you’ll need to transfer data manually. This can be problematic for your billing process because it leads to errors and incomplete data.

Future Potential of Consumption-Based Billing

Just as it has been in the past, flexibility, scalability, and alignment with customer value perception will ultimately drive the success (or failure) of consumption-based billing models. Of course, technology also plays a massive role in making these models more viable.

Let’s dive into what the future holds for consumption-based billing.

• Incorporation in diverse technology sectors. Initially popular in cloud services and SaaS, consumption-based billing is expanding across different sectors, including AI and advanced technologies, where it offers a cost-effective means to access cutting-edge tools and services.
• Sophisticated billing platforms. Companies like DealHub are continuously innovating in the billing platform space to support increasingly intricate consumption-based models. Implementing complex billing structures efficiently and accurately is only getting easier for businesses.
• Enhanced data utilization. Detailed tracking and analytics within your billing software offer invaluable insights into customer behavior. You can use them in product development, pricing strategy adjustments, and customer retention efforts.
• Economic resilience and agility. Consumption-based models provide businesses with the agility to adapt to market changes, offering resilience against fluctuating demand and economic volatility. Businesses using them will find themselves able to adjust during economic downturns much more quickly.
• Greater market penetration. As more companies adopt these models, they create competitive advantages, enabling deeper market penetration and the capture of a broader customer base, potentially disrupting traditional pricing structures and business models.

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