The subscription business model has disrupted many traditional businesses and the trend isn’t slowing down. Netflix’s subscription model disrupted the video rental industry and drove Blockbuster out of business. Microsoft moved away from selling copies of software to licensing with monthly charges. Apple’s upgrade program is essentially a subscription service for the newest iPhone at a fixed monthly charge.
Advantages of the subscription business model
So what makes the subscription business model superior to the traditional transaction model? Essentially, the subscription business model gives businesses the following advantages:
1. Recurring Revenue
In the transactional business model, businesses spend money on sales and marketing to acquire customers for sales transactions. Customers paid a lump sum upfront and the relationship likely ends when the transaction is completed.
On the contrary, businesses do not have to re-acquire customers in a subscription model. After a prospect becomes a customer, the company can continue to monetize the same customer a smaller amount periodically as long as the relationship continues.
There are obviously pros and cons between the two models and not all businesses are suited for a subscription model. However, with the trend of increasing customer acquisition cost in almost all industries, the subscription business model is becoming more and more compelling.
In the transaction model, the booked revenue shows what the business has done in the past and may not be reproducible in the future. However, because of the recurring revenue, businesses with the subscription business model can predict revenue more reliably. From the management perspective, predictability is a valuable asset because they can plan and allocate resources accordingly to minimize waste and maximize productivity.
There inevitably churn where your customers stop subscribing due to whatever reasons. The key to maintaining this predictability is to measure and maintain a stable churn rate within short periods of time and to reduce the churn rate over a long period of time.
3. Commitment to long-term customer relationship
Unlike the transaction model, where the sales ends after each transaction, businesses with a subscription model can foster a much more meaningful long-term customer relationship. If the customer relationship is managed properly with good customer experience, businesses can be greatly benefited from upselling more products to this existing pool of customers. This relationship also allows businesses to measure their customers’ activities and get meaningful feedback that is otherwise hard to come by.
Key metrics to consider for the subscription model
1. Annual Recurring Revenue (ARR)
As the name suggests, ARR is how much recurring revenue you can expect from your existing customer base. Notice that a subscription model does not mean that all revenue are recurring. Businesses often have other revenue streams that are not recurring (e.g., software onboarding cost at the initial stage).
Churn measures the % of customers in your customer base that stops the subscription. Churn normally measures on a monthly basis and is a telltale sign for the sustainability of the businesses. If the churn rate is high, the business should focus on lowering the churn before going for growth. It doesn’t really matter how fast you can grow if you can’t retain the existing customers.
3. Recurring Costs
Recurring costs can be broken down into two separate categories: 1. cost to maintain your existing customers and 2. cost to grow new customers.
The cost to maintain your existing customers includes:
- Cost of revenue: The cost it takes to maintain your product or service commitment to your customers (e.g., server costs, maintenance work, etc.). This is generally proportional to the number of customers.
- Research & Development: the cost to make modifications and improvements to keep your existing customers happy
- General & Admin: Other admin expenses to maintain your product or service commitment to your customers (e.g., HR, finance, etc.). This is generally not proportional to the number of customers.
The cost to grow your customer base is the cost for sales and marketing.
4. Recurring Profit Margin
The recurring profit margin is essentially the recurring revenue subtracting the recurring costs. Since the sales and marketing costs are meant to grow new customers, the management must decide the balance between realizing short-term profits and reinvesting for future growth.
Consumers nowadays are becoming more and more comfortable with the subscription model. The subscription model is here to stay and therefore it is important for businesses leaders to understand the monetization tradeoffs between transactional and subscription models.