Subscription Business Explained
Written by Michal Dallos
Subscription Business Explained

Business principles, key metrics and success factors

Today it seems like companies are embracing the (digital) membership economy: subscription businesses are literally booming everywhere. We, the consumers, are offered subscriptions to basically every product and service: starting with the good old newspaper and gym memberships, through many software and video streaming services, up to food boxes, socks delivery, and car usage.

This article summarizes the key principles and metrics of subscription-based business model, providing furthermore a few practical tips of dos and don’ts on running a subscription business.

What is a Subscription Business?

A subscription company provides a product or a service in exchange of a customer’s recurring, periodical payment.  In traditional setups, like newspaper or book club subscriptions, the customer claims full ownership of the delivered products. In recent years, due to the rapid development of digital technologies, new concepts are increasingly popular: not the ownership, but the right of product usage, is granted. Well known examples of the ‘right to use only’ subscriptions include Software-as-a-Service (SaaS) companies or audio / video streaming platforms.

The first historical example of a subscription business dates as far back as to the 15th century, when a map publisher offered subscription to future updated versions of the world map, covering newly discovered lands. The origin of the newspaper and magazine subscription dates back to 17th-century England, where numerous book publications were enabled through a “fashion to subscribe” by the “nobility and gentry”.

Key Advantages of Subscription Business Models

Subscription business is advantageous for both vendors and customers.

Vendor Perspective Advantages

Customer retention: In comparison to conventional sales, the customer doesn’t need to be re-convinced to make future purchases – the customer enters a ‘permanent buying mode’. On the contrary, he/she is required to actively opt-out to cancel a subscription. This leads to customer’s extensive product attachment, removes his/her purchase barrier for follow-up purchases, and introduces a switching barrier for competitors.
By effectively having only ‘regular customers’ in subscription businesses, this allows the vendors to individualize the communication with their subscribers as well as to upsell and cross-sell additional products to them.

Business predictability: A subscription business has a significantly higher predictability of its revenue stream, compared to one based on unique, one-time sales. For physical products, this means a good predictability of warehouse and shipping capacities. In digital business models, subscription allows fast scalability, as revenue grows with only very low marginal costs. In businesses like magazine or book clubs, the subscription has even an advanced payment character.

High overall revenue per customer: Typically, the overall revenue from subscription is considerably higher compared to that from nonrecurring, one-time purchases. This leads to a much higher average customer lifetime value (LTV).

Customer feedback loop: due to a close relation with its customer, based on the user data collected and the customer’s direct feature requests, the vendor is better aligned with its customer towards common goals. Compared to a business based on one-time-purchases, the vendor needs to keep the customer happy for the overall subscription period – otherwise an unhappy customer will cancel the subscription or leave it to expire. 

Customers’ Perspective Advantages

Customer Convenience: It is the key argument for a customer to prefer a subscription, as the repeated delivery of a product or service saves time and repurchase efforts.

Exclusivity: The exclusive right to premium services, to usage of goods, to priority delivery or extended returning policies are but a few examples. Others may be linked to the concept of ‘sharing economy’, such as the right to use a good for a limited time period. In social context, the exclusive access to groups with similar interests is one of the extra benefits, often associated with sports or other social club memberships.

Affordability: In some subscription models, like newspapers and magazines, the price per item is lower for subscribers than one-time customers. In other cases, subscription can be an affordable way of “purchasing” expensive goods, as subscription payments have by nature the character of installment payment.

Influence on the vendor: Due to the close relations between the vendor and the customer described previously, the customer expects to benefit from any new features and new updates. Given the vendor’s high motivation to keep its customers from churning out, the customers as a group have a strong influence on the vendor’s product-related decisions.

Subscription Business Model: Understanding the Metrics

The key metrics of a subscription businesses consists of the relationship of the customer acquisition costs (CAC), the customer lifetime value (LTV), and the pricing strategy. Before we dive into the math, it is important to understand the concepts and the economics behind each term:

  • Lifetime value (LTV) represents the sum of all future profits generated by a customer – simply put, LTV describes what an individual customer is worth to your business.
  • Customer acquisition costs (CAC) represent the amount you spend to “acquire” a new customer in terms of getting her to buy your product. While in conventional one-time-sale businesses you need to “re-acquire” the customer over and over, the beauty of subscription is that your customer remains with you forever – or at least much longer, than in case of one-time-sales.

In order not to lose money, the value of LTV obviously needs to be higher than the value of CAC, which means: the total profit generated by a customer needs to be higher than the marketing & sales costs required to convince him/her to buy your product. In reality the minimal LTV:CAC ratio required for a sustainable growth of a business is >3. Highly efficient SaaS subscription companies may achieve LTV / CAC rations as high as 11.

The third crucial component of a successful subscription business metrics is the pricing strategy based on the following elements:

  • Positioning: addressing various customer segments by product alignment – the x-axis of the subscription offer
  • Packaging: finding the right mix of product features for each customer segment
  • Pricing: setting the price of a product that reflects its value for the customer

Subscription Business Model: Math behind the Metrics

After understanding the background of the economic parameters, let’s breakdown the individual parameters into formulas:

Customer Aquisition Costs

` CAC = \frac{\text{Marketing & Sales Expenses}} {\text{# of New Customers Aquired}} `

Marketing & sales expenses includes: marketing- & sales-related salaries, costs of tools, and marketing expenditures. As CAC refers only to the acquisition of new customers, only the corresponding one-time cost component should be included. Recurring costs of customer service, like servers and support, should not be considered, as they are calculated in the Gross Margin (GM).

Lifetime Value

` LTV = \frac{APRU*GM}{\text{Churn}}`

ARPU stands for Average Revenue per User
GM stands for Gross Margin
Churn stands for the fraction of subscribers leaving the subscription within a given time period

Note, that for digital business models like SaaS, the GM=1 (in reality 0,8-0,9), which leads to the simplified, widely known equation: LTV = ARPU/Churn. Futher explanations see the corresponding Gross Margin section.

For the full list of relevant formulas see the corresponding Subscription Metrics Guide or go directly to the Customer Lifetime Value and Gross Margin sections.

In order to better understand the formulas above, let’s apply them to model situations:

Example 1: LTV of a snack subscription company

Our fist model company provides a 19.90€/month subscription on snack boxes. The company has currently 250 subscribers, with average 4 months of customer life span. The company’s monthly spending on material and shipment is 2,000€. What is the customer lifetime value LTV?

With ARPU = 19.90€/month of subscription and 250 active subscribers the revenue is 4,975€ (= 19.90€ x 250).

Based on the monthly 2,000€ Cost of Sales, the Gross Margin is GM = 0.6 = (4,000€ -2,000€) / 4,975€

The average customer life span of 4 months corresponds to churn = 0.25. This corresponds to 25% of average loss of customers per month. Now we can calculate the LTV as: LTV = (19.90€*0.60)/0.25 = 47.60€

Example 2: LTV of a video streaming company

Our second example company provides a video-on-demand streaming service for a fixed monthly subscription fee, combined with a premium video rental option for recently released movies. The total current revenue is 15,000€. What is the LTV value with 750 customers and a churn of 18%?

` ARPU = \frac{15.000€}{750}=20.00€`

` LTV= \frac{20€*1.0}{0.18}=111.11€`

Note that the costs of sales incurred by a downloadable software are negligible; hence gross margin of 100%, or GM=1, is a reasonable assumption for this type of businesses.

Setting up a Successful Subscription Business Model

Nearly all businesses can be designed in form of subscriptions. Customers can subscribe to intangible assets such as media, games, software or durable goods, such as food, cars, bicycles, electronic devices, furniture, and many others. From the business model perspective, a the term ‘subscription’ determines mainly the type of revenue stream.

A general outline of the subscription business model is summarized by the following canvas:

Value proposition in subscription business models

The value proposition in a subscription business model certainly depends on the type of business and the customer segment targeted. However, popular subscription businesses show one or more of the following characteristics:
– Convenience commerce: automatic re-supply of regularly used products. Examples: ‘Subscribe & Save’ service for many products on Amazon
– Discovery commerce: food boxes with new recipes, sample surprise boxes. Examples: birchbox (monthly delivery of 3-5 beauty product samples), hellofresh (meal-kit provider)
– Access to utilities and other services not available for ownership: software licenses, cellular network contracts, utility contracts
– Access to communities: gyms, country clubs, business clubs
– Access to exclusivity: priority shipment / faster delivery, pre-order of new product, priority treatment
– Access to costly goods: instead of purchasing an expensive product, you subscribe to the right of using it. Example: audi select (audi’s ‘car as a service’ allowing to drive the latest car models incl. concierge service), swapfliets (‘bike as a service’ providing customers a carefree long-term use of a serviced modern bicycle)

Revenue Stream and Cost Structure in subscription business models

The main revenue source in subscription businesses is the subscription fee. However the profits from cross- and upselling can be significant. The reason is the close customer relation, consequently the possibility of precise customer targeting with cross- and up-selling offers.  Similar to the pricing strategy, cross- and up-selling activities should be performed on the basis of thoroughly analyzed customer data only.

The cost structure consists of 3 basic components:
1. CAC – Customer Acquisition Costs: we have already discussed previously.
2. Productions costs of the goods or services provided
3. Operational costs: covering subscription management costs and other administrative costs

Key activities in subscription business models

The key activities in a subscription company comprise of two parts:
1. Continuous offering improvement, and
2. Management of the Pricing – LVL – CAC triangle.

Continuous offering improvement

Over the subscription duration, the customer typically expects continuous product updates. In case of SaaS companies, software updates are expected. In case of technical services, performance improvement is expected. For example a mobile network operator should increase the bandwidth and download volume over time. For tangible assets, an upgrade in the hardware is typically expected. For example subscribers to mobility solutions may expect the access to the latest generation of vehicles.

Management of the Pricing – LTV – CAC triangle

Beside an attractive value proposition, the key to a successful subscription business is the management of the interplay between the product pricing, customer acquisition costs (CAC) and customer lifetime value (LTV). Together with the cost of the offered product and overhead costs, it determines the overall profitability of the subscription business.

The following options are available for profitability increase:
– Optimize your spending on new customers acquisition: minimize CAC
– Keep your customers subscribed as long as possible: maximize LTV
– Set the price at a level reflecting the customers willingness to pay: optimize price

How to optimize the Pricing – LVL – CAC triangle?

As a first step, a segmentation of the (potential) customers should be determined. This allows you to address the right segment with the right product offering an optimized feature alignment. Furthermore, it allows you to setup a customer segment specific funnel, addressing the expectations of new customers optimally. This leads to an increase in the effectiveness of the sales and to the optimization of marketing costs.

As a second step, the right pricing for each segment should be defined. Because of the close customer relation inherent to a subscription business, the value-based pricing approach should be used. This means that the price should be based on what the product is worth to the customer. This information can be obtained by extensive communication with the client to understand his purchase motivation. One approach is to identify the value drivers from the customer’s perspective. This can be achieved by comparing the product’s ‘features’ with competitor’s: is your product faster, cheaper, more reliable, with better priority support, or more individualized, than comparable offerings on the market? What are the (economic) benefits for the customer using your solution over other solutions available? Finally, the value based price reflects exactly these benefits the customer receives by using your product or service.
Note that this analysis should be performed for every customer segment.

Example: priority support, such as resolving an issue within 24 hours, will empower your PRO and Enterprise customers to concentrate on earning money with their own service or product. Consequently this feature leverages their own businesses and can be priced based on the customers’ enabled potentials. On the other hand, a Tester or Startup client is still trying out various solutions. Hence providing good quality documentation may be sufficient accompanied by a low subscription price.

Common Mistakes in the management of the Pricing – LTV – CAC triangle

Wrong Focus: Many companies only focus on the growth of customers through marketing & sales activities. However, sustainable growth means an increase in revenue and not necessarily a broadening of the customer base. Instead the focus should be on the pricing strategy.  Pricing unifies the customer expectations (marketing) and customer experiences (support) with overall product costs (procurement / production / finance). Hence the optimization of pricing leads to an overall improvement in the economic fundamentals of the company. Despite its importance, pricing often lacks key responsible personnel and is dealt with “by the way”.

Wrong Pricing: Wrong product pricing means either the price is too low, not covering the overall unit costs, or too high to be accepted by the customers. In the first case, with every product sold, the company is losing money. I do not recommend setting the product price by the formula: ‘price =   basis product costs + premium’, as this does not takes customer’s expectations into account.
Generally speaking, if the price is not set to be optimal, namely either too low or too high, it does not reflect the expectations of the specific customer segment.

Insufficient statistic basis: with only a few customers present in a segment, any new customer data will lead to a distortion in the LVL and CAC values. Keep in mind that statistics is only reliable when based on substantially large samples.

Inappropriate or rigid business metrics: Even the general metrics of a subscription business is well known, every business needs to develop its own set of KPIs and re-evaluate them on a regular basis. Various business intelligence (BI) platforms provide an ideal tool to evaluate and visualize all data. Further the KPIs should be connected to the cash flow planning of the finance department.

No up- and down-scale concept available: Successful management of a fast scale-up is not only a technical question of server capacity, but also an organizational challenge. In particular, startups need to switch from ‘founder mode’ to a ‘regular company mode’, by clarifying responsibilities and setting up business processes. Down-scale on the other hand is even more neglected by companies: every company should take the possibility of downsizing into consideration and have a contingency plan in place.

Key resources and key partners in subscription business models

Specific to subscription businesses is the constant requirement of subscriptions management in term of billing, communications, and analytics. All these processes need to be streamlined as much as possible. Several external service providers may help to complete these tasks, such as: OrderGroove, Hive9, Monsum, Nexnet, Billwerk, Chargebee and many others.

Customer Segmentation, relationship, and channels

The importance of proper customer segmentation has been pointed out previously. The process of customer segmentation starts with the knowledge of your customer, by answering the following example question:
– Which product features my customers value, and why?
– How much is the customer willing to pay for the right product?
– What is the unit economy of the (CAC, LTV and profitability) of your customer?
– What kind of business background does your customer have, in terms of industry, company size, position, …?
– What are the demographic and geographic characteristics of your customers?

In order to obtain answers, the company needs to reach out to current and potential customers through interviews and preference studies, with the aim to create quantified buyer personas. Based on such quantified data, and not on anecdotes or gut-feelings, the customer segmentation should be executed. The aim is to provide every segment with the desired product features for a price that these features are worth for them. Such researches also help to answer to a great extent further questions such as ‘How to reach out (CH – Channels)?’ and ‘How to keep close relation (CR – Customer Relationship) with individual segments?’.

Summary: Specifics of the Subscription Business Models

There are no shortcuts to success in subscription business!

It is a time-consuming and complex task to develop the individual company metrics, acquire the deep knowledge of the customers, understand their segmentation, provide products and services of relevance for the customers, and streamline all subscription management services. Mastery of these topics is genuine hard work, but it will be paid out by loyal and happy customers as well as a highly profitable business.

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