April 20, 2024

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Consumption-Based Pricing – The Next Value Driver in IT Services

Pricing in the IT services industry is complex. Despite many evolutions in the last several decades, how internet software vendors and SaaS companies should structure their pricing remains a topic of discussion in every boardroom and newsroom alike. How vendors price their products and services reflects both the brand and the nature of the work the firm undertakes.

In this article, we will look at a brief history of ISV and SaaS pricing and the catalysts that caused them to evolve. We will also break down the pricing structure that mutually benefits the vendor and the customer and aligns with current economic conditions.

Cost as the Primary Driver of Value

The IT sector has been playing on cost arbitrage since the 90s. This led to the widespread adoption of time & material contracts for most engagements. Like much of the labor industry, the IT sector initially charged a fixed hourly rate plus the cost of materials for all services. These pricing schemes were balanced, with the onus on the customer to push work forward in order to realize the corresponding return on investment.

More and more, as customers outsourced large IT projects, service providers responded by providing managed services contracts, or contracts that included which services the vendor would provide, the minimum response time, and liability protection for the vendor usually at a prefixed fee. The risk and reward in this pricing structure were balanced by each party’s adherence to the service agreement. This structure worked for a time but in the current climate when more advanced technologies like Cloud provide resilience and 99.99% uptime, these types of contracts are losing their appeal.

Fixed Up

In the last decade, we have seen the rise of fixed time and fixed price IT service contracts. The success of these types of contracts largely depends on straightforward requirements and are project driven with shorter durations. Through the proliferation of the agile model of execution and the mindset shift to prioritize continuous improvements, the notion of fixed requirements is becoming less reliable, leading to endless revision cycles. This has led to a lot of time spent justifying the changes and increased project spending to accommodate the current style of app development.

Demand Shaping the Price

Largely, the services industry has graduated from the cost-based pricing structures of the early 90s to competition-based structures of the last several decades to demand-based pricing, which is more apt to fit the needs of our current environment. For years, both cost and competition-based structures seemed to be the yardstick for appropriate pricing. Because of the changes accelerated by Covid, increase in inflation, geopolitical stressors & supply strain, there is an increase in the number of programs pushing digital transformation forward. As a result, demand-based pricing was added as a superstructure.

Pay-As-You-Go and Charge as You Deliver

As enterprise IT companies and ISVs foray into the SaaS world—currently dominated by scrappy, flexible startups— there is a new business model that is gaining prominence: consumption-based pricing. The rapid adoption of this pricing structure is predominantly driven by the companies scaling at hyperspeed and an ecosystem that demands companies accelerate digital adoption, increase automation, and reduce manual intervention in order to remain competitive.

Cloud-based SaaS is rapidly replacing legacy perpetual licensed models. The benefits are lower upfront costs (don’t have to invest in infrastructure, software updates are pushed to users automatically, and reduced security risks. These consumption-based pricing contracts are often multi-year agreements, benchmarked by the success of business and IT outcomes. The success of these outcomes is linked to customer usage, API-driven network effects, and geographic expanse with zero tolerance for non-compliance.

Two to Tango

Given the growing trend of consumption-based pricing to accommodate agile, IT services firms should be ready to adapt to new pricing models that keep pace with the current business trends.

Part of the shift to consumption-based pricing means a narrowed focus on building a partnership between vendors and customers, not just a transactional relationship. The key benefits of a consumption-based pricing model combine the best of all the previous pricing structures we have discussed and include:

  1. Equal value for all stakeholders. By aligning vendors and customers to a similar pricing model, both parties are tied to yearly expenses, which ensures a high degree of transparency about the work being done.
  2. Alignment to business outcomes. Service partners are responsible for rolling out features quickly, continuously improving CX, and focusing on augmenting value for end customers. End customers also include internal stakeholders where automation is paramount, and value delivered is measured not only in the resources that are freed up but also in the new technologies like AI/ML that are put in place for automated, proactive decision-making.
  3. Adopt a product-based engineering process. Responsible pricing structures aid in creating clear divisions between platform engineering and feature rollout. This also helps to measure engineering productivity and drive the partnership program’s maturity.

As difficult as it is, it is imperative for IT services firms to focus on training sales teams and client partners to think about and be immersed in the customer’s business objectives. A strong understanding of the business structure and adoption of a pricing model that is made to scale quickly is the way forward.

On Your Mark, Get Set, Go!

When you are ready to embrace a consumption-based pricing structure, there are a few key things to remember:

  1. Achieve transparency in cloud spending by the enterprise customer and ISV by understanding the contracts.
  2. Set benchmarks like, services spending equals 3x of cloud spending and track the spending every quarter.
  3. Most companies committed to hyper-scaling are willing to do joint investments for the initial build or construction of key programs.
  4. Create a fixed-price contract for the minimal viable product as it sets the groundwork for future projects.
  5. Continuously measure the feature usability through A/B tests and strive for constant improvement.
  6. Top-ups and penalties when appropriate ensure balanced risk and reward for both parties. This is key to success because it brings in disciplined governance at all levels.
  7. KPIs to measure effectiveness go beyond the number of servers running on cloud or server storage. The important ones to watch out for are: feature usage by end users, hyper-automation of key processes and cost saving thereof, and minimization of APIs invoked for network effects.

Why Now and the Benefits?

Most firms are moving towards a SaaS model and pay-as-you-go scheme. But customers are looking for partners who can play an integral role in their digital disruption and continuously drive value. The goal in the current, fund-expensive market is an inverted Rule of 40, where profits come before growth.

In brief, the timing is right for IT services to move up the value chain. This will also bring about changes to the sales process and how firms take measured risks. Beyond annual contract value or total contract value, sales will now be measured on consumption as well. As a wise man said, “Growth comes from chaos and not order.”It is time for the system to shake up and deliver.

By Anand Krishnan

By Anand Krishnan

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