Developing a pricing model for any service is a tricky thing, but following the Global Financial crisis, subscription pricing boomed for purveyors of procurement technology. With subscription pricing, providers sell individual seat licenses. This was an alternative to the prior regime of enterprise licenses and maintenance contracts. Both models entail fixed costs.
Yet procurement is a transactional business. It can be lumpy, driven by projects. It can be seasonal in industries such as mining. It can oscillate with the fluctuations in the customer’s underlying revenue.
Procurement is variable.
Why assume that a fixed pricing model makes sense for a variable activity?
The best pricing model for an event with fluctuating demand is a variable one tied to volume as it occurs.
In the old way of doing things, a software company (say an enterprise resource planning technology firm) would sell a version of its software, execute a painful on-premises implementation, and then sell an additional maintenance package with access to upgrades until the next major release. Contract duration might last several years.
Subscription pricing grew out of the transition to selling software-as-a-service, provided in the cloud as a web application with continuous updates and standardized, comprehensive feature sets. This new model reflected the change in the way the customers obtained and consumed the technology. Software-as-a-service was ingenious in that the customers were interested only in the persistent delivery of outcomes; they were indifferent to the messy business of installing,
One could argue that SaaS subscription fees are a blended version of the prior model. The scale of the offering, its lack of customization, and its continuous updating approach permitted the evolution to per seat marginal pricing.
From the perspective of the service provider, subscription pricing has (at least) two attractive characteristics.
One, ironically, individual seat licenses (even bundles of seat licenses) fall below the threshold for procurement authorization. Before subscription pricing, the decision to purchase any kind of business-to-business software was typically an enterprise one, negotiated by the sourcing team. After subscription pricing, any individual employee could sign up. One can imagine the explosive proliferation of SaaS offerings within the enterprise for all kinds of business-to-business applications.
This article refers to a study from before the Pandemic, a period in which SaaS offerings bloomed, a study that seeks to measure the scale of this growth.
“According to a recent analysis of more than 30 million transactions, Zylo—a local firm that helps its customers track and manage software subscriptions—found enterprise companies are spending an average of more than $10,000 per employee per year on software. So, for every 100 employees, companies are spending $1 million on software subscriptions.
In comparison, the average cost for a company to provide health care to an employee and his or her dependents is about $14,000 per year, according to the National Business Group on Health.
‘Companies are spending tens of millions, if not hundreds of millions, of dollars a year on software’ subscriptions, said Zylo CEO Eric Christopher.”
Or there is this updated piece from Zylo on so-called subscription sprawl:
“Today, the average organization spends $65 million annually on SaaS. That number rises to $244 million for large enterprises with 5,000+ employees and continues to grow. Gartner forecasts end-user SaaS spending to reach $171 billion in 2022, an 18.1% increase from the previous year.”
To be fair, many core procurement systems (like ERP modules or standalone source-to-pay systems) have expensive subscription pricing. The incentive to take on an extra seat is lower. Given the importance of the procurement function, procurement tends to centralize the technology decision for the core system with a contract to purchase a set number of seats, making the contract resemble a permanent maintenance contract of old. Of course, this means that fewer people internally have access, reducing the benefit of potential collaboration and diminishing the value of the embedded procurement data. One can imagine an enterprise spending several hundred thousand dollars (or more) annually so that procurement can have access to one of these behemoths.
But there are still myriad products offering ancillary solutions such as vendor risk management, supplier intelligence, etc. These are too easy to tack-on.
Also, there is the never-ending, pulsating struggle in which centralized procurement fights the natural organizational entropy to execute purchases locally, especially when it comes to technology. One can imagine a CTO with a healthy ego refusing to submit to procurement, instructing his department to obtain their own system and to execute purchases independently.
Subscription pricing models benefit from this leakage and the ease with which an employee can purchase a seat (or several) and just expense them. Often this behavior is opaque to the CFO. She may not know exactly how much her company is spending on software.
Two, the subscription pricing model is driven by the independent software vendor’s cost structure. A company that develops and sells software has a tremendous amount of operating leverage; their expenses are essentially fixed. Once they have covered their development costs and the fixed costs of the sales force, they can earn extraordinary margins. It’s not unusual for overall gross margins to exceed eighty percent or ninety percent, with operating margins in the thirties, or higher.
Subscription pricing enables the company to develop a fixed, consistent, and predictable revenue stream to match their largely fixed expense base.
What’s more, this ability to forecast revenue much more accurately reduces the perceived risk in the business model.
Throw in some assumptions about customer stickiness and investors reward these subscription models with higher valuations. A really daring provider would add financial leverage to the operating leverage if they were sufficiently confident in the revenue projections, using the additional funds to recapitalize their companies (further juicing valuations higher) and/or to reinvest in sales and marketing, given the extraordinary contribution margin of incremental revenue.
None of which is to say that subscription pricing is in the interest of the procurement buyers.
The ideal model for procurement would be elastic procurement™.
With an elastic model, the high fixed expenses of subscription pricing models compare unfavorably to the low variable expenses of transactions-driven procurement in which the procurement department only pays to run reverse auctions, even as they have access to a baseline set of tools, data, community, and intelligence for free.
Consider the following financial markets analogy.
Some brokers and investment advisors offer a fixed annual fee for their service, one that includes trading commissions. The alternative is to pay a trading commission on each trade you make. Which one suits someone who trades infrequently or irregularly?
The calculus as to which system is best for which individual comes down to frequency. For a meme-driven day-trader, the fixed cost model might make the most sense because he is continuously in and out of the market.
Someone with a longer-term perspective who trades infrequently, should prefer the transactional fee arrangement. In a trending market where all of her positions are working, she might not trade for months. Imagine if she had owned big technology stocks since 2011, for example.
Similarly, there will be companies for which subscription pricing makes sense, but they’re more likely to be large enterprises who have confidence and visibility into their trading patterns. For them a negotiated subscription price is a bespoke bundling of pre-arranged transaction fees based on assumed levels of activity.
For most companies, where purchasing is sporadic or irregular, with little visibility into the cadence of procurement events, variable pricing is the way to go.
One ancillary benefit of transactional pricing is that the cost of the procurement technology used to implement the purchase can factor into the cost of the good or service being acquired. It is no longer an operating expense; it is part of the all-in price. This means that CFOs can allocate the technology cost by purchase. It also means that there should be an analysis of what kind of competition on price and solution the technology was able to drive, as a way of assessing the value paid for executing the transaction with a particular service provider.
A transactional business model also makes it easy to switch. In the stock trading example, if you don’t like your broker because you think they are overcharging or not giving you the best execution, you can switch your accounts to another brokerage seamlessly. Subscription pricing doesn’t permit that kind of flexibility, a key benefit for the service providers at the expense of the customer.
If and when the economy enters into a recession, the pressure on CFOs to reduce subscription sprawl will be immense. This may be the catalyst for a broader evolution to the next phase of business-to-business pricing in which high fixed costs transition to low variable expenses with cost allocation and a quantitative evaluation of value.
EdgeworthBox is built around the principal of elastic procurement™. With a baseline set of tools, data, community, and intelligence for free, buyers pay only to execute procurement events as a percentage of the total contract value. We help you source suppliers and execute. Give us a shout. We love talking about procurement.