Revenue recognition for consumption-based pricing models

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Perhaps your company isn’t considering consumption just yet, but chances are, it could be coming your way sooner than you think.

Even non-tech companies are beginning to realize the benefits of consumption for customers and the business. They may bundle a SaaS (software as a service) offering along with a physical product as part of a consumption-based pricing strategy. For example, electric car companies may bundle vehicle sales with a subscription for charging station use that takes the form of a hybrid consumption-based pricing model.

Turning to more traditional SaaS companies, nearly half (46%) have implemented some form of a hybrid consumption-based pricing model in the last three years. And recent research indicates that consumption-based models are becoming more valuable and relevant for complex product or service offerings, such as generative AI.

Why is it so popular? Consumption-based pricing can enable a lower cost of sale, lower barriers to entry, and higher year-over-year (YoY) annual recurring revenue (ARR) growth. Additionally, this strategy presents an opportunity for companies to deliver greater value to the customer and  pursue product-led growth (PLG). Read more about this in the Expand beyond basic consumption models section, below.

But a consumption-based pricing strategy can also present its challenges. Over three quarters (76%) of revenue accounting team members already report growing pressure to support new go-to-market models, products, and pricing. Adding consumption will only serve to further increase rev rec complexity and the pressure placed on teams.

To help streamline implementation, it’s vital that revenue accounting teams are looped in early on—as soon as the decision to explore consumption strategies is made. Revenue accounting teams are uniquely positioned to help the business understand the key role that rev rec systems and processes will play in the overall success of a new pricing model rollout. We will cover this more in the next section.

By shifting from a traditional back-office role to a comprehensive front-to-back perspective, revenue accounting leaders can ensure stakeholders know the downstream implications of their decisions and how they might come back upstream.

Revenue leaders can also provide guidance on how best to structure pricing to enhance revenue predictability and reduce operational burden. As we’ll discuss later, the most successful consumption businesses are combining several pricing models, along with some level of commitment, to help balance flexibility for the customer and predictability for the business.

However, revenue accounting must also ensure proper processes are in place on the sales side to help customers purchase the appropriate base plans to begin with. Otherwise, the revenue team will be required to estimate the contract value (base value plus expected usage) and adjust that estimate on a predetermined cadence.

Forecast consumption revenue using existing business use cases

Consumption forecasting enables revenue teams to anticipate how much revenue will be gained through consumption-based pricing models. This means forecasting variables such as usage, customer lifetime value (CLV), and potential overage charges. This gets ever more complex when you begin introducing different bundles and offers.

Part of the appeal of consumption models is that they allow customers to vary their use of a product or service, and therefore their charges, but this can make revenue predictability and forecasting tenuous.

Often, the unique challenges and potential pitfalls presented by consumption forecasting are not realized until accounting is tasked with recognizing consumption revenue. For example, FP&A or sales operations teams may develop their own consumption forecasting without incorporating the more complicated, GAAP-compliant revenue accounting policies required for usage data and contracts. This can result in vastly different forecasts from one end of the OTC process to the other and may require a cumbersome reconciliation.

To avoid this, revenue accounting teams should advocate for cross-functional networking within the organization and alignment on the business’s approach to new use cases. Look for technology that can capture and analyze multiple dimensions of upstream data to quickly identify and resolve issues. In addition, real-time reconciliation and a close process dashboard can increase visibility and the accuracy of your revenue forecasts.

Push for data capture and analysis alignment across teams

Real-time usage data visibility and analytics are vital for revenue forecasting. Unfortunately, attaining cross-functional alignment for consumption data processing and flow across the organization can be extremely challenging. Multiple stakeholders within the business—including IT, sales, billing, accounting, and other teams—must be aligned on how data will be captured, metered, and stored.

Working together with the appropriate stakeholders, revenue accounting teams can help drive company-wide initiatives to eliminate unnecessary data silos and implement system integrations. Creating a process map upfront can help identify all potential error points in the flow of data from provisioning through billing, revenue recognition, forecasting, commissions, and other cost calculations.

Companies performing manual consumption revenue recognition will quickly realize the added risks and costs associated with this complicated process. Look for technology that can handle your consumption data and automate processes at every step, from capture through to revenue recognition.

Maintain revenue recognition compliance and associated costs

All revenue accounting teams are familiar with ASC 606 and IFRS15. However, leadership may not have considered the implications of these standards with respect to consumption based-pricing models.

While a usage-based contract is fairly straightforward, companies quickly realize that to stay competitive and increase customer loyalty, they need to begin adding discounts and bundles. And to increase predictability, businesses will often begin introducing some level of customer commitment.

Revenue teams often initiate this process using spreadsheets, manually inputting usage data into Excel. But this manual work and siloed data will increase workloads, errors, and time to close.

In addition, it can become nearly impossible to generate accurate reports and forecasts or keep up with a myriad of new contracts and modifications. While many try to address these issues by increasing headcount, this will only add to costs and doesn’t resolve any of the initial process problems. Without a system in place to handle complex consumption revenue recognition, revenue accounting teams are left to perform data manipulation within thousands of lines of spreadsheets.

Manual extraction and manipulation of data, combined with employees working long hours late into the evening to close the books at the end of the month, creates an unmanageable risk of human error that inevitably results in process failures. In fact, 65% of revenue accounting team members report being concerned about the risk of misstatement because of existing manual processes and control risks.

Manual consumption revenue recognition processes, along with increased scrutiny from auditors, will make audits more time consuming and expensive, as auditors will be forced to sift through thousands of lines of usage data. For companies launching an initial public offering (IPO), issues uncovered during the audit process could cause delays.

Revenue automation reduces errors, risks, and audit costs by taking humans out of the equation with a hands-off data management approach. Companies like The New York Times are already leveraging the power of revenue automation to manage consumption data from millions of customers. From contract modifications to rolling out new offers, your system needs to automate all aspects of your consumption model at scale.

Automate revenue recognition to streamline processes

Successfully managing consumption data can require multiple tools to track data, meter usage, and analyze historic revenue trends.

Even some level of automation in the form of an ERP may not be enough, since legacy systems were not built for consumption. ERP solutions are still built on the basis of handling one-time product fees, and are often not able to fully support consumption pricing models without significant customization efforts. Unfortunately, even with customizations, 60% of revenue accounting team members report that their ERP revenue modules do not fully support their business requirements.

Consumption models also require granular, real-time visibility, not just to total up usage at the end of a billing period, but also to monitor customer usage at any given time. The time and money spent on retrofitting ERP systems for new models can stall initiatives.

Revenue accounting teams are already feeling the strain of this lack of automation—68% report not having the right technology to address growing demands from the business. Adding a new consumption model without the necessary technology is certain to exacerbate these issues.

By centralizing revenue data through automated integrations, you can eliminate sprawling networks of spreadsheets that need to be updated and linked manually. Eliminating a large chunk of time-consuming, low-value manual tasks translates directly into operational efficiencies and significant savings in both time to close the books and money. Many teams experience a reduced time to close, a reduction in employee overtime, and the ability to focus on more strategic tasks.

More and more companies, especially those adopting consumption, have shifted away from managing revenue recognition within an ERP. Instead, they turn to specialized revenue subledger solutions that can operate as a revenue subledger and feed data directly to the ERP general ledger.

The advantage of these point solutions is their native capability to provide features that are critical to the consumption revenue accounting process, such as SSP analysis, contract modification, and revenue analytics—without expensive or complex customizations.

Secure executive buy-in

While 79% of revenue accounting team members agree that they need higher levels of automation, 67% say they struggle to get buy-in from leadership in order to implement these new solutions.

Given the many hats CFOs and other finance executives must wear, it’s not surprising that they might not have full visibility into the nuances of the revenue process, especially with respect to consumption models. Bringing leadership up to speed on the current process, risks, and the implications for supporting a new go-to-market model can help make the business case for automation. And educating finance executives on the benefits of end-to-end revenue automation and the cost of inaction can help revenue leaders further bolster their case.

Expand beyond basic consumption models

While traditional consumption-based pricing strategies, such as pay-as-you-go and overage, are great for giving customers the flexibility they require, they are not always effectively used by businesses. The reality is that consumption models like these, when used in isolation, have the potential to take away some of the revenue predictability to which subscription companies may have become accustomed.

Recent Subscribed Institute and Boston Consulting Group (BCG) research indicates that companies utilizing hybrid consumption models—with a mix of revenue from in-arrears and in-advance models—outperformed all other businesses in terms of YoY ARR growth. Put simply, these companies have tapped into the growth potential of combining simple usage-based pricing with other recurring charge models to increase customer commitment, facilitate better forecasting, and add recurring revenue streams. In practice, this could look like a traditional pay-as-you-go model, combined with an in-advance prepayment and overage charges.

Common consumption-based pricing strategies include:

• Pay-as-you-go usage-based models, paid in-arrears, fully variable, that can go to zero in a month where the customer doesn’t use the product (but they rarely do, in practice).

• Usage-based overages on top of base subscriptions.

• Committed spend contracts with flexible consumption, where the product is consumed flexibly, but the customer pre-commits to a minimum spend amount in exchange for better pricing.

• Hybrid consumption models, where a single offering leverages both recurring and usage-based revenue and utilizes consumption value metrics.

What is the right technology to support consumption?

Implementing a new pricing strategy can be tricky and can entail a lot of IT overhead. The right approach and technology are key factors in the ultimate success of a consumption-based model. Even with a good strategy, out-of-date technology may hamper efforts to evolve. Look for technology that allows you to quickly and easily price, meter, stay informed, and recognize revenue.

• Price. Whether it’s your first time testing consumption or if you’re fine tuning your strategy, look for a solution that provides out-of-the-box monetization models, such as pay-as-you-go, pre-paid with drawdown, minimum and maximum commit, and pooled usage pricing. This will allow you to quickly experiment with and iterate on new pricing models, without reliance on heavy developer involvement and delayed rollouts.

• Meter. A mediation engine can assist collecting, aggregating, analyzing, and monitoring data related to customer consumption. This data-driven approach can help you make informed decisions about which metrics are most relevant for your pricing model, ensuring that you align your pricing with customer behavior and value. The more attributes you have to base your pricing on, the more you can create the perfect offering for your customers. Look for a solution with drag and drop capabilities, making it easy to quickly put together the right combination of metrics.

• Inform. Near real-time visibility and analytics capabilities are vital for revenue forecasting and driving customer retention, giving your business the ability to quickly react and adapt to customer’s needs. The ability to proactively notify customers allows them to monitor their spend and increases overall customer satisfaction and their alignment to value.

• Recognize revenue. To help reduce the risk of consumption-based pricing strategies, consider automated consumption revenue recognition. Consumption-based transaction processing, reporting, dashboards, and analytics allow companies to operationalize and automate consumption revenue recognition policies. This enables revenue accounting teams to better predict, forecast, and mitigate financial risks related to taking on the consumption-based pricing models. To get it right, invest in technology that gives finance and revenue teams the tools they need to automate and scale their operations to support your consumption-based pricing model.