The Economics of Subscription Models: Why Businesses Prefer Recurring Revenue Over One-Time Sales
We pay extra to reduce risk. For many consumers and firms, this involves purchasing insurance. In exchange for a monthly premium payment, certain accidents or mishaps are financially covered if they occur. Rationally, we factor in risk of loss when deciding what price to pay or what wage to accept. Businesses behave similarly when it comes to sales, and are willing to sacrifice some profit per unit in exchange for a reasonable guarantee that they will sell more units.
Paying to Reduce Risk
Losses happen, and may be unpredictable and severe. To prevent this severe loss, firms include insurance policies as part of their fixed payments. Risk is now minimized and the firm can spend the rest of its budget with more confidence, knowing that severe losses will be covered by the insurer. Firms may also make other fixed payments to minimize risk, such as preferring longer-term contracts with suppliers. These may entail higher per-unit costs over the life of the contract, but reduce the risk of facing higher prices during routine contract renegotiations.
Reducing Income Risk Through Subscriptions
Many goods do not need to be purchased on a regular basis, and thus sellers face a higher degree of risk. Additionally, when it comes time for consumers to purchase these goods again, they may have many substitutes from which to choose. To reduce income risk, firms may offer subscriptions where customers pay a fee over a fixed period of time, often one year, to be able to access the firm’s goods and services at a discount. It is similar to a membership, which some big box stores like Sam’s Club and Costco require for shoppers.
When customers purchase a subscription, they are providing the seller with a [reasonably] fixed income. This reduces risk and some accounting costs. The firm can more easily budget its expenditures if it can reasonably estimate its upcoming revenue. It can spend less time accounting, less time trying to figure out how many units of output to create, and less time and resources trying to market and sell individual units. As a result, the firm is willing to accept lower revenue per-unit.
Digital Subscriptions: SaaS Model
Some subscription services are physical, but many are digital. This has emerged due to cloud computing, where Internet-capable devices can connect remotely to sellers’ servers. Companies can sell subscriptions to their digital services, including software-as-a-service (SaaS) bundles. Purchasers can buy an annual subscription to a suite of software and then access it from any computer, logging in to their profile.
The SaaS model provides the seller with annual income, greater assurance of future income through automated offers to extend the subscription for lower prices, and built-in market research from tracking customer use data. In exchange for these benefits, the seller is willing to offer the software at a lower per-unit price than selling the entire software retail. Much software today, for example, is no longer available for purchase by CD or portable drive; it must be downloaded.
Customers benefit as well, and are willing to pay to maintain subscriptions due to many conveniences. First of all, SaaS subscribers receive automatic updates to their subscribed software, ensuring that it can connect with their other services. Years ago, software that was loaded onto computers via disk or CD would not update, eventually rendering it obsolete. Subscribers are often automatically eligible for the latest upgrade to a software, meaning they may save money in the long run by not having to re-purchase entire suites of software every few years.
Streaming Model
In the market for entertainment, subscription services are popular because they offer variety and convenience. Those who subscribe to Netflix, Spotify, Hulu, or Apple Music can access thousands of films, TV shows, and songs without having to store them. In the 1990s and early 2000s, people had to store hundreds of CDs and DVDs, or even VHS tapes, to access a library of entertainment. Today, subscribers to streaming media can access thousands of hours of entertainment from any location with an Internet connection, even on smartphones.
Sellers also benefit from streaming subscriptions, as they can track usage data and determine which types of movies, TV shows, and songs are most popular with consumers from different demographics. This allows them to fine-tune their offerings to minimize costs. Instead of having to purchase the rights to thousands of hours of a producer’s content, the streaming service can tailor its bid to hundreds of hours that are most desirable to streamers. By accepting lower per-unit revenue today and tracking user preferences, streaming services can lower their costs of acquiring or producing content tomorrow.
When Subscription Models Work Best: Low Marginal Costs
Not all firms can easily offer subscription services to provide regular goods and services. This model works best in the digital sphere, where marginal costs are typically low. One more customer can be linked to the company’s servers for a negligible cost. For companies providing physical goods, subscriptions work best when they simply provide access to discounted goods that are already being sold: Sam’s Club and Costco do not provide goods in exchange for the membership, but simply access to the stores that are already being operated. In this case, marginal cost is very low.
Low Cost to Offer Tiers of Access
Digital subscription services have an advantage in attracting customers by being able to offer tiers of service. Physical subscription services typically require the seller to provide additional goods and services at higher tiers, which cost the firm money. Online services can simply add additional bundles of services at little or no cost to the seller. For example, many SaaS and streaming services can draw customers in with a freemium model of their product and then offer greater access (or no commercials) to those who decide to upgrade to a paid subscription.
The ability to offer tiers of service for little or no marginal cost allows digital services to attract a wider range of customers. Many customers may be content with a subscription package that offers access to rerun shows and has commercials, but those with higher income may be willing to pay more for the package that offers current TV shows and is commercial-free. Some streaming services are owned by the same company, and consumers can buy subscription packages that bundle multiple services together, such as Disney+ and Hulu.
A Sellers’ Challenge: Streaming Services are Nonrivalrous
It’s easy to access digital subscription services, which presents a challenge: customers may not stay loyal. This has resulted in rising costs for streaming entertainment services as they create content to maintain customers. Gone are the days when customers were just content with reruns - they want to see new content on a regular basis. This has resulted in streaming services producing expensive movies and TV series, ending the era of low marginal costs. If customers do not like what they see, they can switch to another streaming service.
Because streaming services and SaaS are nonrivalrous in consumption, and were somewhat nonexcludable if users gave their passwords to non-paying friends and family members, it is difficult to keep dissatisfied customers paying. They can simply leave and end their payments; competing streaming services will let them join at any time. This may result in a scenario akin to a price war in oligopolies, where firms have to continually offer lower prices and/or more content to keep customers. On the other hand, streaming services may have successfully “figured out” their respective customers and can offer enough new content to keep them without changing their pricing. Time will tell, with analysts closely watching the number of new customers gained by each of the large streaming services.