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Consumption billing can force SaaS companies to conform to the variable consideration guidance in ASC 606

Consumption billing can force SaaS companies to conform to the variable consideration guidance in ASC 606

Consumption, or usage-based, billing models charge customers based on the quantity or usage of a product or service. The model has become increasingly popular in the SaaS business environment, where the rise in consumption billing is a natural next step after adoption of basic fixed-fee, subscription billing. Currently about 90% of public SaaS companieshave subscription-based revenue models, and many of these companies find their customer base prefers consumption billing. Incorporating a consumption-based billing model can bring customers closer to a company. According to Bain & Company Research, 80% of customers report better alignment with the value they receive when using consumption pricing.  

The move from subscription billing to consumption billing may seem simple, but there are potential complications that a SaaS company should consider in advance. Consumption billing often requires additional integrations to receive usage or consumption metrics throughout a given period. Consumption bill models often include things such as minimums or overages to be charged. Tiering considerations can reduce the cost per unit consumption either as each quantity tier is hit or across all quantity once a given tier is hit. These factors can increase the complexity of the pricing calculation and management of the incoming consumption data.

Further, the consumption bill model has impacts to revenue recognition and must align with the revenue recognition guidelines of ASC 606 / IFRS 15, including the points on variable consideration.

Consumption billing and ASC 606 / IFRS 15

ASC 606 outlines five steps to recognizing revenue

  1. Identify the contract with a customer. 
  2. Identify the performance obligations in the contract. 
  3. Determine the transaction price. 
  4. Allocate the transaction price. 
  5. Recognize revenue when the entity satisfies a performance obligation. 

To meet the requirements of ASC 606, a SaaS company using a consumption billing model must identify the contract (step 1), determine the distinct performance obligations within the context of the contract (step 2), and determine the transaction price (step 3). The consumption component of the contract could increase the complexity of step 3, determine the transaction price, by activating the “variable consideration” portion of the ASC 606 guidance. Variable consideration requires a company to estimate the amount of usage or consumption that will occur over the term of the SaaS contract.

Variable consideration and consumption billing 

With consumption billing, SaaS companies also need to consider whether the usage is considered variable consideration. Variable consideration can take various forms and includes price concessions, discounts, rebates, refunds, credits, and royalties.  

A company can use one of two methods to estimate variable consideration:  

  1. the expected value method   
  2. the most likely amount

Let’s look at an example of each:

The expected value method 

Let’s consider a company called “CloudData” that offers a platform for data analytics. Cloud Data runs on consumption billing for payment to access its platform, and customers pay on the amount of services used, in this case gigabytes. CloudData has variable considerations in its contracts, including performance-based initiatives, and the company could use the expected value method for variable consideration as follows in a sample case:

Case scenario: 

CloudData signs a contract with a customer for a 12-month deal to use its data analytics platform, with the customer paying for the amount of data used at $1,000 per month. For each gigabyte of data processed over the $1,000 amount, the company will pay $0.20 per gigabyte of data used.  

Base Usage Fee: $1,000 per month 

Usage-based Fee: $0.20 per additional gigabyte of data processed

This customer has a steady rate of standard data processed for $1,000 a month. However, the overage data can vary wildly, based on the time of year. The company typically has higher overage rates from September to March than from April to August.    

Here’s how CloudData might apply the expected value method for variable consideration: 

  1. Estimate the Range of Possible Outcomes: CloudData would analyze historical data and discussions with the customer to estimate the range of possible overage data usage volumes for each of the periods listed above. For example:
    • Data Usage overage from April to August: 1000 gigabytes/month
    • Data Usage over from September to March: 5000 gigabytes/month 
  2. Calculate the Expected Value: CloudData calculates the expected value of the usage-based fee for each month by considering the probability-weighted average of possible outcomes. Let’s assume CloudData estimates the following probabilities:
    • Probability of Data Usage overage from April to August: 90%
    • Probability of Data Usage over from September to March: 90% 
      • Using these probabilities, CloudData calculates the expected value for each month’s usage-based fee:
        • Expected Usage-based Fee = (Probability of Minimum Data Usage * Usage Fee for Minimum Data) + (Probability of Maximum Data Usage * Usage Fee for Maximum Data)
        • Expected Usage-based Fee = (0.90 * $1000) + (0.90 * $5000) = $900 + $4500 = $5400 
  3. Calculate Total Contract Revenue:  CloudData would then calculate the total contract revenue by summing the base consumption fee and the expected value of the overage fee for each month of the contract term. Assuming a 12-month contract:
    • Total Contract Revenue = (Base contract fee * 12) + (Expected Usage-based Fee * 12) = ($1,000 * 12) + ($5400 * 12) = $12,000 + $64,800 = $184,800 

By using the expected value method for variable consideration, CloudData can recognize revenue from the overage portion of the contract based on the expected value of data usage over the contract term, providing a more accurate reflection of the company’s performance and revenue recognition.

Most Likely Amount Scenario  

Let’s consider another hypothetical example for CloudData. In this example, CloudData offers a consumption-based model with a variable consideration component based on the number of active users accessing the platform. 

Example Scenario: 

CloudData signs a 12-month contract with a customer to access its data analytics platform to be billed on a consumption basis, with a maximum amount of gigabytes used per month. However, the customer’s usage can run higher between September and March, due to various factors. CloudData needs to account for variable consideration using the most likely value method. Here’s how they could do that: 

  1. Estimate the Most Likely Scenario: CloudData would analyze historical data and have discussions with the customer to estimate the most likely scenario for usage overages in the busy period. For example:
    • Most Likely Number of Gigabytes used: 500 / month 
  2. Calculate the Most Likely Value: CloudData would then calculate the most likely value of the variable consideration component based on the most likely scenario for the gigabyte overage. Let’s assume CloudData estimates the following pricing for overages: 
    • Overage per Gigabyte cost: $0.50 / gigabyte 
      • Using this pricing and the most likely scenario for the number of overages, CloudData calculates the most likely value for the variable consideration component: 
        • Most Likely Variable Consideration = Most Likely Number Gigabytes * number of Gigabytes used = 500 * $.05/ gigabyte overage = $250 
  3. Calculate Total Contract Revenue: CloudData then calculates the total contract revenue by summing the base usage fee per month and the most likely value of the variable consideration component for each month of the contract term. Assuming a 12-month contract:
    • Total Contract Revenue = (Base usage * 12) + (Most Likely Variable Consideration * 12) = ($500 * 12) + ($250 * 12) = $6,000 + $3,000 = $9,000 

By using the most likely value method for variable consideration, CloudData can recognize revenue from the variable consideration component based on the most likely scenario for the number of active users accessing the platform, providing a reasonable estimate that reflects the expected value of the contract. 

Consumption billing can be a customer-pleasing and popular offering for SaaS companies. The success of the model from financial and regulatory standpoints will depend on doing upfront calculations and planning. Doing the work to calculate variable consideration will help with forecasting and successful offerings in the long run.

How SOFTRAX RMS Can Help Your Consumption Billing with ASC 606 Compliance

The SOFTRAX Revenue Management System combines consumption billing with revenue recognition all in one platform. SOFTRAX RMS can:

  • Ease reporting for ASC 606 and IFRS 15
  • Easily monitor usage levels, including minimums, overages, and tiers
  • Organizes contract details so you remain on schedule
  • Allows you to easily deploy cumulative and band-tiered pricing

Contact us to learn more about how SOFTRAX RMS can simplify and automate your complex billing and revenue recognition processes.

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