New Threats to the Subscription Model

Subscriptions have all the hallmarks of a can’t-miss revenue model. Customers love how they lower their barriers to access, while companies embrace their simplicity and ease of communication. Investors prize them because they generate more predictable long-term revenue flows than conventional one-off transaction models.

Proponents of the so-called subscription economy — a term coined by the CEO of platform provider Zuora — argue that customers are better served by subscription experiences built around services than by static offerings or a single product. Software giant SAP asserts that a subscription model shortens time to market and speeds delivery of services to customers, in addition to accelerating cash collection and enabling businesses to define and modify pricing models.1

Two unanticipated risks, however, currently threaten to undermine these vendor advantages as well as the premise that subscriptions offer a better customer experience. These risks are supply chain disruption and inflation, the two most persistent causes of economic uncertainty over the past two years. Their combined effects are confronting many managers of subscription-based businesses with a challenge that never seriously crossed their minds during the relative stability of the 2010s: Can we still afford to meet the obligations we’ve made to our customers?

Subscription Models at Risk

Supply chain disruptions — such as delayed shipment of inputs and finished goods, as well as ongoing labor shortages — mean that what a company promises its subscribers today might no longer be available at the same level of quality next week or next month. This creates the potential for dissatisfied customers, exacerbating a more fundamental risk in the subscription model: the ease with which customers can cancel. The same low barriers to entry that make subscriptions accessible also make them easily interchangeable.

The threat of inflation, meanwhile, is particularly acute for companies with a large base of long-term subscribers or for companies that deliver physical products under a subscription plan.

Inflation squeezes margins because costs are rising, but the amount of revenue that companies earn from each customer remains constant until customers renew. In some cases, these rising costs expose incompatibility between a company’s cost structure and its subscription model. Managers may be able to disregard this when subscriber growth is robust, but they can no longer ignore it when growth stalls or when it hinders their ability to meet demand.

Supply chain disruption and inflation create a perfect storm that can reduce customer satisfaction and prompt customers to seek alternatives. Companies that derive the bulk of their revenue from subscriptions need to assess their risk profile with respect to supply chain reliability, cost structure, inflation, and customer retention. Each area poses its own set of risks that can constrain or cripple a subscription model, even one that still has a very strong appeal to customers. Depending on that risk assessment, such companies may need to consider alternative revenue models that supplement or even replace subscriptions.

Can You Still Meet Customer Obligations?

Subscriptions represent a commitment that suppliers need to honor. In the software industry, Adobe succeeded in honoring its commitments when it shifted users to its Creative Cloud subscription software suite, by making more tools available to more users and by introducing updates much faster and with less friction.

But for many companies, the ability to provide a steady flow of goods and services is no longer guaranteed. Any subscription service based on the availability of physical goods — whether diapers, printer ink, or an automobile (in the case of mobility services) — depends on the consistent availability of products that work and the means to deliver them. The products cannot be held up in ports, warehouses, service garages, or delivery trucks.

Network capacity — regardless of the type of good or service — has also become a constraint. To look at an extreme illustration of how this constraint works, imagine what would happen if the state of Texas offered a flat-rate subscription for unlimited access to electricity. The system would quickly collapse, because demand would outstrip the network’s ability to serve it. The utility could expand the network, but that would lead to a significant step change in fixed costs and would also take too long to address supply-and-demand imbalances in the short term. Such network effects can affect streaming services, mobile telephony, and software applications — essentially any business that currently offers unlimited access at a fixed price.

Cost structure incompatibility may pose the greatest risk to a company’s ability to meet its obligations to subscribers. It’s also hard to detect, because it usually becomes apparent only when companies become victims of their own success. Let’s take a streaming service such as Netflix as an example.

When one incremental subscriber watches an episode of an original program such as Ozark or Stranger Things, the marginal cost of that incremental viewer is effectively zero. But what happens when that subscriber finishes streaming those two popular series? They want to stream something else. The marginal cost of one piece of incremental new content for that viewer is not zero. That’s where the problems start.

The more subscribers Netflix acquires, and the more content those subscribers binge-watch, the more quality content Netflix needs to generate through licensing or its own investments in production. At the same time, the pool of available quality content and quality content producers is limited, making it harder and more costly to acquire an incremental piece of high-value content.

This means that the cost curve for this kind of service is convex: It increases as a function of volume, rather than decreasing. It’s hard for a company to generate the revenue to fund those investments, because flat-rate subscriptions are essentially a mechanism for offering quantity discounts. The more someone streams, the less they pay per unit for the incremental show.

This issue is particularly problematic if companies are unable to allocate revenue to costs. They can’t isolate the effect of making an incremental addition or subtraction and therefore can’t determine how much variety is optimal. A reluctance to add cost creates a disincentive to invest in quality. A desire to cut costs creates an incentive to eliminate components of the subscription bundle based on how expensive they are, not the returns they generate.

The worst-case scenario occurs when these risks turn each advantage of the subscription model into a liability, because companies have limited leeway to manage costs without putting the quality of their offerings at risk. Predictability becomes inflexibility. Simplicity and ease of communication give way to complexity and a struggle to manage demand and customer satisfaction amid persistent uncertainty. Low entry barriers become low exit barriers for customers.

The Challenge of Customer Churn

Customer retention is one of the hardest and most important marketing challenges, given this ease of exit. Low prices per unit of time (whether weekly, monthly, or annual) offer customers affordable access to goods and services, but they also lower the perceived risk of switching when the customer has alternatives. From a behavioral standpoint, factors that tend to encourage customers to stick with solutions after they have made purchases — the endowment effect and sunk cost fallacy, for example — are weak or nonexistent when customer outlays are much smaller, as they tend to be under a subscription model.

Some subscription models treat this as a tactical challenge of churn management and attempt to lock in customers by automatically renewing unless the customer proactively cancels. This approach depends in part on the belief that customers won’t act when the cancellation deadline arrives, but customer inertia is sometimes too weak to reduce or discourage churn. A study conducted by researchers at the University of Chicago tested different subscription models for a media product and learned that “any short-term revenue gains that were due to the inertia of subscribers who were automatically enrolled were outweighed by the longer-term effect, as locked-in customers gradually left.”2 Finally, if competitors also offer subscriptions, customers can easily switch providers with minimal commitment to something new.

Other factors are subscription fatigue and subscription saturation. The term great cancellation has come into vogue in the U.K., referring not to the effects of censorship and cancel culture but rather to something more mundane: People feel they have more subscriptions than they need, including many that overlap, and have become more selective about what they sign up for.3 One driver of this shift, besides subscription saturation, is inflation. A reduction in disposable income and the risk of persistent higher prices force consumers to become more cost-conscious.

How Managers Can Mitigate the Risks

Unless companies have established exit barriers through superior performance, upgrades, or attractive cross-selling, they face the risk of easy churn. There are both short- and longer-term solutions that managers can explore.

In the short term, one solution is to incentivize customers to consume less at constant prices. That is helpful if your business faces long or uncertain lead times, but this solution can also have unintended consequences: It can increase opportunity costs and also lead to lower customer satisfaction if the situation persists. In the short to medium term, companies can start to explore supplementary revenue models. Netflix, for example, has launched an ad-supported subscription plan to generate additional revenue.

The longer-term option for companies is to revisit and rethink the choice of a subscription revenue model strategically. As Marco Bertini and I explain in our book, The Ends Game, subscriptions are an excellent way to lower barriers to access. That helps explain why people have gym memberships instead of buying their own equipment and why people subscribe to Netflix or Spotify instead of buying downloads or songs.

But equal access does not mean equal consumption. That’s why subscriptions can still be a poor proxy for the value a customer derives. The heavy user gets more bang for their buck at the gym but also consumes more resources than the occasional user. Equal access and equal consumption, in turn, do not mean equal outcomes. Is the customer who loses weight, improves their health, or runs a 5K for the first time deriving more value than someone who adds 20 pounds of muscle or someone who spends all of their gym time building flexibility on the Pilates machine?

The problem is that value is always personal, fluid, and hard to estimate at any given time. Revenue models reflect a company’s best attempt to approximate that value for a large number of customers. Deciding what your model should be — ownership, subscriptions, usage, or performance — has two dimensions. The first is your own objectives. What customer behaviors are you trying to incentivize? What balance are you trying to achieve across customer acquisition, customer retention, revenue, and profit? How do these objectives and the potential models fit your capabilities, your cost structure, and your internal incentives? The second dimension considers value to your customers: What kinds of efficiencies or benefits do you want to help customers obtain?

Subscriptions are not always the best way to achieve your objectives or meet customer needs. Real-time information and communication technology offer businesses unprecedented insights at a very detailed level into how customers access and consume products and services. By measuring and understanding the misalignments and waste they have created in terms of access, consumption, and performance, companies now have the means and the motivation to overcome their own inertia and replace their proxies with new revenue models. Eliminating the waste and inefficiency in value capture is a transformative opportunity for companies, not just a means to establish or reinforce customer loyalty.