The subscription business model has been around since medieval times since it became popular with guilds that would provide protection and other benefits to its members. Today, companies like Netflix and Amazon Prime use it to provide entertainment content to consumers on a monthly basis.
The subscription model helps businesses align their goals with their customers’ needs by focusing on the recurring revenue potential and instilling loyalty while increasing customer lifetime value by making customers feel like they are getting a good deal.
This article will explore subscription business models, pros and cons, and the key metrics you need to know to incorporate this modality in your business successfully.
What is Subscription as a Service Business Model?
A subscription-based business model is a payment for a set of products or services that continues until canceled by either the customer or the provider.
With this model, customers pay at regular intervals for a service (e.g., monthly, quarterly, annual) until they request to cancel their subscription. Subscription business models generally offer high customer loyalty, which translates into higher profitability.
How does it work?
There are two types of business models – B2C and B2B- depending on who’s buying and selling.
B2C Subscription Business Model
The most common type of subscription business model is business-to-consumer, also known as B2C. Business-to-Consumer business model is the exchange of goods between a business and consumers, as goods or services are sold to an individual instead of an organization or entity.
In these transactions, the seller markets and sells their product to a consumer for personal use.
For example, in a retail store, customers purchase items for use in their homes. Businesses operate on various models, from small retail stores to exclusively online. Still, all offer some form of customer service to ensure their products meet customer needs and expectations.
Examples of this economic relationship between a business and consumers include:
- Amazon
- Spotify
- Netflix
B2B Subscription Business Model
B2B, or Business-to-business, is a transaction between two or more businesses. These transactions can be anything from the purchase of raw materials to the sale of services. In most cases, B2B is used to refer to a transaction where one business provides its goods or services to another company for some compensation.
B2B marketing is targeted at businesses rather than individuals. Some B2B marketers use email marketing, direct mail, social media, search engine optimization (SEO), public relations/publicity, lead management tools, and content marketing to cultivate potential clients.
Examples of this business model include:
- WeWork
- IBM
Pros and Cons
The recurring revenue stream provided by the subscription business model is an asset to any company since it is usually more predictable than other sources of revenue like advertising or product sales. However, like everything else, it does not come without its cons.
Pros:
Customer loyalty and lifetime value
One of the major advantages of subscription business models is that they eventually contribute to building a loyal customer base. Instead of focusing on sales volume, subscription-based business models encourage lifetime value which can lead to decreased client churn rates. Thus, customers are constantly engaged in the company’s product or service and are less likely to cancel their subscriptions.
Reliable revenue and increased profit margin
Subscription business models are a great way to generate reliable revenue. By fostering a sense of affinity between customers and the service provider, customers are more likely to remain with the service provider for a long time, finding it difficult to switch to another service provider. Ultimately, this increases profit margins on products and services due to pricing strategies such as bundled pricing and price varieties.
Improved customer needs analysis and bigger scalability
By providing access to new services or products without the need for front purchases, subscription-based models better understand customers’ needs. It’s better since companies or businesses regularly communicate with customers without one-off orders or sporadic queries. Consequently, subscription-based models are highly scalable and less risky than other business models, which can be unpredictable or rely on one-time purchases.
Cons:
Relatively more expensive
The biggest drawback of this model is that it can be more expensive than other options, such as one-time purchases. For example, the monthly fee may be too high for some customers, which is why pricing structure is a vital factor in the success of a subscription service. It is important to consider what customers will pay for a certain service and adjust accordingly to ascertain the best price.
Customer long-term commitment issues
For monthly plans, customers are paying for an entire month of service, which means they are willing to pay more since they believe their experience will be worth the commitment. On the other hand, annual plans can cause people to think twice about getting involved with a company, and due to the high upfront cost of the service, customers on a budget will be more hesitant to sign up for annual plans.
Loss of interest
Businesses face challenges in maintaining the value of their services. If customers find the service replaceable or no longer needed at some point, they are more likely to cancel their subscription. It is also important to remember that customers who plan on canceling their subscription are usually only able to do so once their contract expires, which can be very frustrating for customers.
5 Subscription Business Model Metrics to Know
Subscription business models are a popular choice for startups to start their go-to-market strategy. Here are the key subscription business model metrics for success:
Monthly Recurring Revenue (MRR):
Monetizing a product is the most common way a company establishes its value. In the subscription business model, customers are given access to products or services they want, but with a recurring payment on an agreed monthly basis.
Monthly Recurring Revenue (MRR) is the total of all monthly revenue generated by a company’s subscriptions for its products or services. It can be calculated by multiplying the number of paying customers by the average monthly subscription cost per customer. It is important to note that MRR does not include canceled or suspended subscriptions as well as one-time fees such as activation fees.
Annual recurring revenue (ARR)
Annual recurring revenue informs the health of the recurring revenue. It is crucial to calculate ARR to answer questions such as “How much is the company making on a yearly basis?”, “What percentage of total revenue is recurrent?” and “How sustainable is the business model?”
ARRs are calculated by dividing yearly revenue by the number of subscriptions that year. For example, if the previous year’s revenue were $2,000,000, with 500 subscriptions that year, then the ARR would be $4000.
Churn Rate
It is the percentage of customers that cancel their subscriptions in a given period. We can calculate it by dividing the number of cancellations by the total number of customers to get the percentage.
There are two methods to calculate churn rate in subscription-based business models, Net Churn Rate and Gross Churn Rate. The formula for Net Churn Rate is the percentage of customers who cancel their subscriptions over a given period, while Gross Churn Rate is calculated by counting cancellations, subscription downgrades, and add-ons in existing subscriptions.
The churn rate can be challenging to predict since it depends on customer acquisition cost and customer retention rate, so it is difficult to determine how many customers will cancel their subscriptions in the future.
Customer lifetime value (CLV)
Customer Lifetime Value is crucial in business as it indicates the expected revenue before a customer cancels the subscription. In addition, it helps to determine the anticipated costs for a customer to stay until the end of their subscription cycle.
CLV is calculated by several factors: subscription, frequency, lifetime value, and revenue per purchase/user. These four factors are essential in calculating CLV with various inputs and outputs, which are important for business decision-making.
Customer acquisition cost (CAC)
A company’s customer acquisition cost is the total cost incurred to acquire a customer. It includes all costs incurred, such as sales and marketing, and other expenses (such as product development or support) to attract new customers.
CAC is usually calculated by dividing the overall amount spent on advertising, marketing, and other expenses by the number of conversions generated. The key way to reduce CAC is to focus on customer retention when a business focuses on retaining its customers instead of solely acquiring new ones.
Final Thoughts
The subscription business model is a relatively new way of doing business, and companies like Amazon have popularized this novice form of entrepreneurship in recent years. By carefully monitoring key metrics, companies can generate better revenue by meeting the customers’ needs, thus earning long-term loyalty and increasing profits.
