Weathering Market Volatility with Variable Cost Structures:
Software Pricing Edition
Businesses always need to be vigilant about controlling costs. With the rise of economic uncertainty, the need to reduce financial risk is more pressing than ever.
In this ongoing series of white papers, I discuss new ways to reduce and eliminate fixed costs.
Types of Costs
Companies bear two types of costs: fixed and variable. Fixed costs do not vary with production volume. These costs include rent, baseline salaries, and software subscriptions. Variable costs, on the other hand, fluctuate based on the amount a business produces. Variable costs include sales commissions, raw materials, and utilities.
So if your sales team is exemplary, you will pay more in commissions. You’ll also spend more on raw materials because you’ll need to fill new orders. Likewise, if your sales team isn’t closing, your commission costs will be lower, and you won’t have to order as many new, raw materials.
All Costs Are Risks and Fixed Costs Are Riskier
Fixed costs represent a risk to your business. They tend to be rigid and hard to change. Even if there is a disruption to the supply chain and customer orders shrink overnight, expenses like rent, base salaries, and software still need to be covered. This is why variable costs are easier to manage and cut.
It may be daunting to look at your existing costs and determine how to reclassify them, but reducing your risk exposure is worth it. Let’s look at some examples of real cost savings that can be realized by moving some fixed costs to variable costs.
Variabilize Costs Via Software Pricing—Some Examples
Historically, software has been a capitalized expense. You pay a large, upfront license fee followed by an annual maintenance fee of approximately 20% of the license. Additionally, you pay for hardware and data centers. Salesforce.com revolutionized enterprise software by making software as a service (SaaS) viable. It took the company nearly a decade to change industry perceptions about SaaS. Corporations felt that software that was rented couldn’t possibly be as secure and scalable as software that was “owned,” installed, and maintained on their own infrastructure. Salesforce changed minds by continually proving their platform was more secure, easier to maintain, and less expensive than on-premise counterparts.
Salesforce and SaaS changed how companies account for software purchases. No longer was there a good reason to purchase a depreciating capital asset in the form of a software license when you could simply subscribe to a service. Salesforce provided the application, updates, bug fixes, etc. Customers no longer needed to pay for new features or endure years-long IT projects to upgrade. Salesforce simply released new features and bug fixes throughout the year, providing value to their customers incrementally.
What was once revolutionary is now commonplace.
Value-Based SaaS Pricing—Everyone Wins
There are different variations on the SaaS model. Some companies charge per user. Some charge per virtual instance. Conceptually, these cost models make sense, but they still present a degree of risk because the cost is contractually fixed. What happens in a model where the customer truly pays only for what they use?
Companies like HubTran and Amazon Web Services eliminate fixed costs by implementing a flexible, transactional, pay-per-use model.
For example, HubTran’s software for 3PLs has three different components that customers use on an a la carte basis: Carrier Invoice Processing, Customer Invoice Processing and Document Retrieval. Customers who use the Carrier Invoice Processing service pay 50 cents per invoice. If they process 1,000 invoices in a given month, they pay HubTran $500. If they have a slow month and only process 100 invoices, they pay HubTran $50. It’s uncomplicated and inarguably fair. You pay for what you use. This model vastly reduces cashflow risk. If the economy becomes unstable or a natural disaster strikes, customers needn’t worry about paying for a service they cannot use.
Amazon makes this pricing model possible. The flexibility that HubTran can provide to customers with variable pricing is offered to them via Amazon Web Services (AWS) architecture. With it, HubTran can dynamically scale its infrastructure depending on how many invoices customers are processing. Similar to the way HubTran customers pay only for what they use, HubTran pays Amazon only for what HubTran uses.
By eliminating fixed costs, HubTran is able to weather any economic storm. The decisions made by the company’s infrastructure teams ensure that they have infinite scale—up or down. HubTran processes over 500,000 documents per day. If there is a dramatic shift in the transportation market and HubTran’s customers handle less freight, the cost structure will account for this, keeping the company strong. When those same economic winds shift, HubTran can scale up and pay more to AWS.
With uncertainty impacting the world’s economy, it is important for every business to take a hard look at cost structures. While software selections are vital to your success, it is essential to understand how cost structures are impacted by how your vendors bill you. Now is the time to ask. Is there flexibility in how they charge? Legacy companies may be beholden to the license and maintenance model of the late 1990’s. If that is the case, they are likely feeling pressure from their customers and competitors to move to a SaaS model. Ask them to consider dynamic pricing that ties their success to your success.
If vendors are not willing or able to make the shift, consider alternatives. Look at the big categories of software spending you make on a monthly or annual basis. Are you able to renegotiate any contracts to be more sympathetic to your business cycles? If not, can you find other vendors who will deliver similar services in a way that will reduce your risk exposure in the event of an economic downturn?
It is important to find a vendor that understands your business cycles and ties their success to yours—not only in regard to pricing models but also in regard to value provided. Software vendors should understand that they are delivering service to their customers and build their business around ensuring their customers are successful in the long term—not just in short term profits.