The Subscription Boom: How Predictable Revenue Is Changing Consumer Markets

In Microeconomics, or the study of firms and markets within an economy, a primary goal is to make economic profit by having a total revenue that exceeds total explicit costs (accounting costs) and implicit costs (opportunity costs).  A high total revenue can be achieved by selling a small number of units at a high price, or a large number of units at a low price.  How high of a price a business needs to charge to make a certain amount of revenue is dependent on the volume of sales: if the business sells a lot of units, it can afford to charge less for each one and have a lower profit margin (difference between sales price and cost of production).

Greater Security Allows for Lower Profit Margins

If a firm knows it will sell a high volume, it can afford to reduce its profit margin.  A great example is grocery stores, which often have profit margins on goods of only 1-3 percent.  While many business owners might be alarmed at having to rely on such a thin margin, grocery stores are traditionally stable due to relatively inelastic demand for food.  Whether it’s boom or bust, people need to eat.  Therefore, even during significant economic recessions, grocery store sales remain stable.  In fact, grocery store sales may increase during recessions as more consumers switch from eating at restaurants to preparing their own food at home. 

The Math Behind Higher Sales and Lower Margins

Assuming a sole proprietorship or partnership, where all profits go directly to the business owners, the business owners can decide that they will be comfortably compensated with X amount of annual profit.  To make this targeted amount of profit, the business owners can either sell more units at a lower profit margin or fewer units at a higher profit margin.  Since price times quantity equals total revenue, an increase in one variable allows for a decrease in the other.  

Producing more units for sale can benefit the company by increasing market share, which can provide long-term stability as some consumers become highly attached to the product.  A firm that produces only small quantities of goods for a high profit margin may be effectively wiped out by small changes in consumer tastes and preferences, as its product is considered “niche” and without widespread appeal.  Niche items that have high profit margins are more likely to be considered luxury goods, which had relatively elastic demand.  These luxury goods will suffer proportionally greater losses in sales if price increases compared to lower-cost, mainstream goods.

Subscription Sales:  Low Profit Margin, Predictable Income

One method that firms use to capitalize on low margin sales is by selling subscriptions.  Consumers pay a fixed amount per month in exchange for access to a certain amount of goods and services.  Many subscriptions today are digital, such as entertainment subscriptions for streaming services.  Thanks to the maturation of the Internet, companies can add customers for very low marginal costs, allowing them to charge relatively low prices in exchange for access to thousands of hours of digital streaming.  Profit margins are very low, but the number of customers is very high, allowing business owners to still make decent economic profit.

Many subscription services require long-term contracts, usually annual.  Customers will have to pay over twelve months before they can cancel without paying an additional cancellation fee; they may receive a deal if they pay for all twelve months in advance.  This gives the firm relatively stable and guaranteed income, reducing risk.  This decreased risk will convince many firms to accept lower profit based on the rules of the risk-return relationship.  For many firms, a lower amount of guaranteed profit is more desirable than a higher amount of profit that has a substantial chance of not occurring.

Benefits of Digital Subscription Sales

In addition to more stable revenue, subscription sales benefit sellers by offering easier access to other revenue-enhancing opportunities, including:

Tiered Pricing

Subscriptions can be easily packaged into tiers where consumers are regularly encouraged to upgrade.  Similar to adding customers at very low marginal cost, existing customers can be upgraded to more comprehensive (and expensive) subscription packages at virtually zero marginal cost.  This allows for the possibility of increased revenue over time without having to pay any additional variable or fixed costs.

Captive Audience for Advertising

Subscribers are captive audiences for a firm’s advertising, as ads can be sent directly to subscribers either through the digital streaming itself or to customers’ provided contact information.  Digital streaming companies can send a steady flow of advertisements of their other products or services to subscribers, increasing the likelihood of additional revenue over the long run.  Other companies are also likely to pay extra to advertise on the streamers’ platform, knowing that subscribers utilize the streaming service regularly.  Selling ad space to third parties is a lucrative additional revenue stream to digital streaming companies.

Perpetual Revenue From Some Consumers

Sometimes, customers sign up for subscription services and forget about them, allowing digital services like autopay to continue billing them for it every single month in perpetuity.  With up to 40 percent of American consumers believed to have forgotten about at least one digital subscription service, this means that companies are making millions in revenue for which they don’t have to provide any services.  However, this is not unethical, as the services remain available but are simply not utilized by the paying customer.

Drawbacks of Digital Subscription Sales

Although subscriptions allow companies more predictable revenue and improved avenues for advertising, there are some disadvantages of having to rely heavily on subscriptions:

Low Profit Margins Make It Difficult to Lower Prices

You can get a lot of customers by setting low prices…but this leaves very little room to lower prices if the need arises.  In the event of a recession, for instance, many firms may try to lower their prices to retain customers.  Subscription services may be unable to do so, as their prices may be set to barely cover variable costs as it is.  The inability to lower prices could result in losing customers to substitutes, such as other digital streaming services.  Firms that sell fewer units, but at higher prices, have some “wiggle room” to lower prices and retain their customer base.

Subscription Services Are Seen as Targets for Budget Cuts

When a recession looms, many consumers begin looking for ways to cut spending.  Most digital subscription services, likely due to being entertainment-based, are often seen as good line items to cut out of a family’s budget.  About 30 percent of U.S. consumers say that they plan to reduce their number of subscription services, but not as many follow through.  This presents a silver lining: many consumers do not follow through with plans to unsubscribe, despite regularly indicating a plan to do so.  This leaves subscription services in a vulnerable position, with demand more elastic than otherwise due to their association with entertainment - a luxury rather than a necessity.

Consideration:  Consumers Like Predictable Budgeting as Well

Although subscriptions are often eyed for cuts by budget-wary families, one reason they are likely retained is the same reason sellers like to use them: predictability.  During a recession, budget-trimming families may ultimately choose to keep subscription services, even at a higher price point, because they value the predictability in budgeting over cancelling the subscription and having to rely on individual purchases.  Consumers may fear that they will end up overspending on individual purchases compared to their subscriptions, and thus keep the subscriptions.  Cutting out subscriptions and relying on individual purchases requires active budgeting and fiscal discipline, which can be difficult for many consumers.