The Fundamental Assumption of ERP Systems — and How This Is Holding Enterprises Back

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At the heart of any system is its fundamental data model. The core data model that forms the foundation of ERP systems is based on one key assumption: that enterprises sell “items. These businesses that sell items make up what we will refer to as “product economy” businesses.

Everything in ERP systems revolves around this fundamental assumption, and core processes and workflows in ERP systems are built with this assumption in mind.

But therein lies a problem.

In the age of digital products and services, this assumption no longer holds true. In today’s world, businesses are increasingly adopting subscription business models to monetize their products and services. These are businesses that we refer to as Subscription Economy businesses.

At the heart of the subscription model lies the idea of monetizing a long term recurring customer relationship. Traditional order management, ERP, and accounting systems were never designed to monetize, manage and measure recurring relationships. They were built to monetize items.

To monetize, manage, and measure recurring relationships, enterprises need a new system.

When a company decides to adopt a subscription business model in order to monetize long term recurring relationships, it creates a major shift across 4 core areas of how a business is run:

1. PRICING AND PACKAGING

Let’s look at pricing and packaging through the example of file storage. A USB stick has a single price for a single product that provides customers with a fixed amount of storage. When customers fill up that USB stick they buy another one, and maybe this time they might buy one that has more capacity, and they pay a fixed price for that. Or if you’re the company that makes these USB sticks, you go back to the factory and manufacture a whole new batch that has more capacity.

The key thing that drives the price of this stick is the cost of manufacturing it. And if someone only needs half the capacity of what you manufactured you can’t sell them half a USB stick. One product. One price. One way to purchase it: purchase the whole thing or purchase nothing.

Now contrast that with storing your files in the cloud with Dropbox, Box, or similar. When you need more storage, you can just switch to a different plan. Or maybe you stay on the same plan and you get billed an overage when you start storing more than what was included in your plan.

A cloud storage subscription service provider can take the same service, and price it differently for individuals, for enterprises, by GB, by user, by frequency of use or any number of consumption characteristics that define how a customer might use the service. One service. Infinite pricing options. Infinite possible options of consumption.

This is what makes pricing different in the subscription economy. But this is also what makes it difficult for ERP systems to meet the needs of subscription pricing. ERP pricing engines were designed for configuring the price of an item. An item has a fixed price. It does not have the notion of frequency, or time or consumption levels.

In an ERP system, these subscription pricing strategies often:

  • Are not natively supported, and require significant custom development efforts just to make small changes or roll-out new pricing models.
  • Create SKU explosion, where “items” are incorrectly utilized to represent different ways in which customers consume and pay for the same service.

Subscription businesses need to change pricing frequently—for growth, in response to external market forces, etc. And they often need to deploy multiple pricing strategies for a single product depending upon their business objective.

2. ORDER MANAGEMENT

In the product economy, every order is considered a new sale. In the subscription economy, an order can be a new sale, an upgrade, a downgrade, an add-on to an existing subscription, a renewal or a cancellation. And each of these types of orders can happen in many ways. In the subscription economy, customer needs are constantly changing, and customers expect that, as their needs change, they should be able to adjust their subscriptions to meet those needs.

ERP order management modules were designed to handle orders in the product economy, and they are great at processing orders that represent a new sale. But where they start to fall short is with all the other types of orders: upgrades, downgrades, add-ons to existing subscriptions, renewals or cancellations.

Often, subscription businesses try to force their ERP systems to take on subscription order management. But significant custom development is required to make ERP order management modules meet all the order processing needs of a subscription business model.

3. TRANSACTION PROCESSING

In the product economy, one order typically results in one invoice and one payment. In the subscription economy, financial transactions resulting from a single order become infinitely more complex.

In the subscription economy, one order leads to multiple billing schedules, multiple collection events, and multiple revenue schedules. And when subscriptions change (which they always do), all of the billing, collections and revenue schedules need to be adjusted to accommodate for the change.

Let’s break these down into individual components:

Recurring Billing Transactions

In the product world, the idea of time doesn’t factor into how you get billed for something. If you go to the store and buy a movie on the 1st of the month vs. the 20th of the month, you still pay the same price.

Now compare that experience with something you subscribe to on a monthly basis. Even a simple $10/month service can get complicated when customers sign up or change their service in the middle of the month. ERP billing engines were not built to natively manage mid-cycle billing changes that result in prorations and credits. Most will require heavy custom development to manage these changes.

Recurring Payment Transactions

In the product world, when businesses sell a product, they collect a payment once. Typically this payment is collected at the time of purchase. Contrast that with another service you subscribe to. You sign up for the service once, but the service provider has to collect money from you continually and consistently. And how often they collect money from you varies based on the plan you signed up for.

Now think about the processes that a subscription business needs to put in place to actually collect the money. Collections processes need to be different for collecting from consumers, vs.collecting from a business that might pay for the service using purchase orders or checks.

Each segment of customer base might have different payment preferences, including electronic payment methods like credit cards, debit cards, and non-electronic payments like POs, checks, and cash. And when a business is constantly collecting for the service, it needs to automate as much of this process as possible, including automating the exceptions that occur when credit cards expire or when payments fail.

And in the subscription world, businesses also need to prepare to start or stop access to a service based on the outcome of collections. ERP systems were not architected to handle the recurring nature of payments, and many lack basic high volume payment automation capabilities.

Recurring Revenue Schedules

In the product economy, the financial impacts of transactions associated with a sale were simple. For example: if you booked an order in January, you typically collected payment for it immediately, you shipped it as soon as possible, and you recognized the revenue for it immediately. Transactions were rarely spread across many time periods.

In the subscription economy, each sale spawns transactions that spread over multiple accounting periods. This gets even more complex when a customer decides to make changes to their subscriptions.

In addition to all the billing and collections schedules that need to be adjusted for the change, the original revenue recognition schedule has to be adjusted to match the new subscription. This creates a great deal of complexity for finance teams when it comes to managing revenue recognition schedules for subscription services.

4. METRICS AND REPORTING

When a business sells a subscription to a service, rather than selling a physical product, the whole business model changes, and as a result, the way a business measures itself changes.

When a business sells products, they are typically focused on reporting on how many units of USB sticks were sold and for what price. This means businesses are typically measuring billings and cash that has been collected in the past.

But in the subscription economy, businesses are selling services that add future value to the business because a subscription represents a recurring revenue stream that will pay into the future.

In addition to traditional financial metrics, businesses need to measure forward-looking recurring metrics like ARR or MRR, TCV, net retention, and churn—at the most granular level. And instead of just measuring how many customers a business has, the business needs to measure customer lifetime value so that they can make decisions on what products/services will increase the value or the length of subscriptions their customers have.

ERP systems that were designed with “items” at the core of their data model do not have the concept of time or recurrence inherently built into the data model. These metrics are not natively captured by an ERP application, and typically require custom work and custom data algorithms.

ERP FALLS SHORT

ERP systems form backbone of today’s enterprise IT infrastructure. But these systems fall short in 4 areas critical to the success of a subscription business. In the subscription economy, enterprises need to consider supplementing their ERP systems with a complete order-to-cash system like Zuora Central which was custom-built to manage complexities intrinsic to subscription business models introduce that ERP systems were not designed for.

Without a subscription management system to supplement and integrate with your ERP application:

  • Businesses find their growth strategies limited by ERP systems, resulting in lost revenue potential.
  • Finance operations teams resort to manual processes and spreadsheets, resulting in operational inefficiencies.
  • IT leaders spend precious dollars and significant amounts of time and development resources to force ERP applications to meet the needs of the business.
  • You’re unable to measure the value of recurring relationships and form business decisions based on real data.

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