TL;DR
- Leverage pricing not just to increase revenue but to strategically manage both the cost of goods sold (COGS) and operational expenses for higher operating profit margins.
- Experiment with pricing models to find the optimal balance between attracting new customers and retaining existing ones, thereby maximizing average contract value (ACV).
- Differentiating between gross and operating profit margins is important for a clearer financial strategy.
- Utilize pricing as a tool to influence key SaaS metrics like customer lifetime value (LTV), cost of acquiring customers (CAC), churn rate, and net revenue retention (NRR).
- Consider innovative pricing strategies, such as value-based pricing, to align your product's price with its perceived value, enhancing customer satisfaction and loyalty.
- Explore Togai's solution for a quick and effective way to test and implement new pricing strategies, ensuring your business remains competitive and profitable.
Looking to increase your profitability? Pricing can be a powerful tool to achieve your goals.
The Basics
What does a SaaS company’s profit and loss statement look like?
In simple terms, the operating profit of a company is the additional cash flow that is generated by running a business. If the profit is negative, that implies that the cash flow is negative which means that the business is spending money at a consolidated level as opposed to generating it. When we talk about increasing profitability, it’s always the operating profit margin we need to be focusing on and not just the gross profit margin.
So, what are the differences between gross and operating profit? Gross profit is simply the total revenue minus the cost of goods sold. The total revenue includes all your sales including subscription revenue, consumption-based revenue, one-time fees, add-ons, support and implementation charges and anything else that the customer pays you, for delivering a product or a service.
#ThingToNoteHere - Revenue is different from MRR and ARR - Revenue is the realization of MRR and ARR. MRR (monthly recurring revenue) are subscription license items that are recognized as revenue on completion of the license time period in most accounting practices. If someone cancels the subscription, they should be discounted from the revenue.
ARR has 2 expansions - annual recurring revenue and annualized run rate. The former consists of the total annual contracted subscriptions and the latter is your latest MRR number multiplied by 12. Both do not account for the revenue line item in your profit and loss statement.
The cost of goods sold is where many companies get creative. Our recommendation is to consider any expense without which the product cannot be functioning in a sustainable way as costs of goods sold. This includes your cloud infrastructure costs, other software tooling costs, salaries to the extent of people who are required for the functioning of the product and other one-time expenses.
Operational expenses are related to the other expenses that are required for the company to function (and not just the product) and this includes all marketing costs, salaries and other administrative expenses.
Operating profit = (Revenue - the cost of goods sold - operating expenses)
Operating profit margin = (Revenue - cost of goods sold - operating expenses) / Revenue
The goal for a business is to maximize your operating profit and as a technology company, it's important to have an operating profit margin that increases as you scale up.
When we look at how your pricing can be used to increase your profits and profit margins, we can start by breaking down the revenue and expenses to understand the impact pricing can have on each of these levers. In a nutshell, your profit grows when the revenue number grows more than the cost of goods sold and operating expenses put together. So, the starting point is the revenue number.
Revenue is a function of the following - number of new customers acquired, average contract value (ACV) of a new customer, number of existing customers who left, their ACV, number of existing customers, their ACV and their revenue expansion (net revenue retention).
Revenue = (New customers * their ACV) - (Customers who left * their ACV) + (Existing customers * their ACV * NRR)
Where does pricing figure in all of this?
Let’s bucket this into the direct and indirect impacts of pricing. Direct impact would mean first-order effects and indirect impacts would be second-order effects and beyond.
The most significant direct impact of a pricing change is on the average contract value. Let’s take an example here. Suppose there is a ticketing software that prices based on the number of support agents per month. There are no other metrics based on which they price the product. In this case, the ACV is the number of support agents (subscription licenses) multiplied by the price per seat per month. Say, the price per seat per month is 10$ and the number of support agent licenses on an average across customers is 25, then the monthly ACV is 25 * 10$ = 250$ per month and the annualized ACV is 3000$.
In this example, if the company raises the price per seat per month from 10$ to 12$, that implies an annualized ACV increases to 3600$. This is a direct impact of a pricing change on the revenue numbers. However, in real life, price changes seldom have only direct impacts. There will always be indirect 2nd and 3rd order effects that happen due to pricing and it is important to be aware of that.
If the price per seat in the above example increases, there would be indirect impacts on both the number of support agent licenses a customer would procure as well as the total number of new customers that are acquired by the company. These are just 2nd order effects. A 3rd order effect could be the impact this causes on existing customers, even if they are on the previous pricing, who will start thinking about the expected pricing changes in the future and might choose to renegotiate the contract or churn out completely.
The above was an example of how changes in the price per unit can impact your revenue. There is another lever you can control with regard to your pricing which is the unit of pricing itself. What you price on matters as much as how much you price. The best case scenario is identifying the unit of pricing that is directly tied to the value of your product as perceived by the bulk of your customers. For example, in the above scenario, if the ticketing software decided to price based on the number of end-user sessions or the number of tickets opened/resolved, instead of the support agents, that would be another way to use pricing to control your profitability.
Until now, we saw examples of pricing being used to improve the topline. How about using pricing to influence your expenses - both COGS and operational costs? By definition, your pricing cannot have a direct impact on your expenses but there are ways to use pricing to improve your operating margins.
Let’s look at the most important metrics in SaaS that need to be tracked - LTV, CAC, churn and NRR. We will start with a brief introduction to these terms.
Important Metrics in SaaS
Lifetime value of a customer (LTV)
Since most SaaS today is not a pay-and-forget model and has continuous streams of cash flow as customers keep using your product, it’s important to model what the lifetime value of a customer is to your business in terms of a dollar figure. Lifetime value is nothing but the ACV of a customer multiplied by the average duration for which a customer is using your product.
We saw earlier how pricing can influence your ACV. But by iterating and finding the right value metric and the price point along with the packaging plans, you can influence the duration for which a customer stays with your product. This essentially ensures that the customer is loyal and has the potential to increase your LTV significantly.
Cost of acquiring a customer (CAC)
It has never been easier than today to create a saas product and it has never been more expensive than today to acquire a new customer. The cost of acquiring a new customer has skyrocketed over the years. So, how can you ensure that your pricing helps keep your CAC in check? An example of this would be to experiment with free pricing strategies including freemium, free trials and reverse trials. Having a freemium product where there is one plan which is free forever gets someone to try out your product and also have constant engagement forever as long as their requirements are satisfied within your plan. A free trial gives out all the features of your product at zero cost for a specified duration and then once they understand your value proposition, you can get them to pay for your product. A reverse trial combines the best of both worlds. It has a freemium plan that is zero cost forever and combines it with a free trial period during which your customers can explore all your features. By using such pricing tactics, you can reduce the friction for your customers and help reduce the CAC which has a direct impact on your marketing expenses.
Churn rate
The churn rate is the total number of customers that leave your product monthly/annually because they don’t see value or ROI on your product. This is a concept that has been brought on due to the current problems plaguing the subscription economy. This is a problem that is caused by incentivizing salespeople to focus on top-line growth without accounting for customer retention. If you are doing seat-based pricing and are charging for people’s time as opposed to value, it is imperative that your customers stop seeing ROI using your product and as their usage drops, they eventually leave when it’s time to renew the subscription. By experimenting with modern pricing models including a pure consumption-based one that focuses on value metrics, you ensure that your business is aligned with your customer’s goals and they always see the ROI in your product, thereby reducing churn. By using pricing to reduce your churn, you also cause 2nd order effects of the lower number of customer success people required to retain your existing customers.
Net Revenue Retention (NRR)
It is the change in revenue from your existing customers over a specified period of time. By using pricing as a lever, you can influence your existing customers to use your product in a specified direction that causes them to use your product more and not less and thereby creating a situation where they pay more as they see more value in your product and not less. For example, in the recent Openview report on the state of usage-based pricing, the net dollar retention rate for companies that do usage-based pricing is 125% - this means their customers are paying them 1.25 times more year on year. This metric for the broader SaaS companies is 114% thereby showing that some pricing models inherently result in higher NRR over a period of time. By improving your NRR, you cause multiple indirect impacts in your employee costs as well as infrastructure costs that have direct economies of scale benefits in a multi-tenant SaaS architecture.
Also Read: A Closer Look At The Problem with The Subscription Economy
Conclusion
Pricing is one of the most important controllable levers in your business and using it to iterate, experiment and arrive at a strategy in a scientific manner can drive profitability in this market when not everything is about top-line growth alone. It is important to understand the infrastructure required to iterate on different pricing models and you would rather leave that to the experts than spend millions of dollars and years building the tooling for this internally when you should be focused on solving your customers’ pain points. That is why Togai exists - we are plug-and-play metering and pricing infrastructure that helps you track, measure and iterate upon pricing so that you can use it to increase your profit margins without sacrificing your growth.
