Cost-based pricing for embedded payments

Embedded Payments Pricing Guide for Vertical SaaS Platforms (Part 4 of 6)

This post is part of a series on the optimal product, positioning, and pricing strategy for embedded payments.

SaaS companies can easily miss out on the full revenue potential of embedded payments because the payments implementation or go-to-market strategy is a little off.

This series will highlight the different factors in building a successful payments strategy and help you determine the best path to success for your particular platform.

1. Why embedded payments
2. Pricing essentials
3. Value-based pricing
4. Cost-based pricing  ⏴ You are here
5. ACH pricing strategy
6. Go-to-market strategy

Payment processing costs

The first step in building a bottom-up estimate is understanding your payment processing costs

Revenue recognition

There are two common revenue recognition models in embedded payments. Your choice won’t impact the pricing, but understanding the two models will allow us to talk about the financials in more concrete terms.

Net revenue recognition

• Payment provider collects processing fees from merchants, nets out interchange passthrough and provider fees, then distributes residual to the SaaS platform.
• Generates much less top-line revenue for the platform because only residuals are recognized as revenue.
• Margin is extremely high because direct costs are so low.

Gross revenue recognition

• SaaS platform collects processing fees from merchants, then remits interchange passthrough and provider fees to payment provider.
• Allows the platform to recognize much more revenue because platform can recognize the entire merchant processing fee.
• Margin is significantly lower because interchange passthrough and payment provider fees are recognized as costs.

Here’s an example. To keep the math simple, we’ll assume $100M processing volume at 3% merchant processing fee, 2% passthrough costs, 30 basis points (0.30%) in payment processing fees – leaving 70 basis points (0.70%) as the net.

Interchange and DFA

Interchange is the largest contributor to credit card processing fees. Interchange rates are determined by the card networks, and the fees are paid to the issuing bank for every transaction. Interchange rates vary based on several factors:

 

At the low end, debit card transactions can carry an interchange rate as low as 0.05% + $0.22. At the high end, a rewards card can be close to 3%. If the data provided with the transaction is incomplete, the transaction may be downgraded and the associated penalty can push the interchange rate to over 3%.

In addition to interchange fees paid to the issuing bank, the card networks also charge dues, fees, and assessments (DFA). These tend to be smaller fees, averaging approximately 24 bps for US merchants accepting US cards. However, for international cards, DFA can be upwards of 150 bps (1.5%). The combination of interchange and DFA is called “interchange passthrough”.

3 ways to find your passthrough costs

In the wild, no platform processes just one type of card transaction, so average interchange rate will depend on the overall mix of the factors listed on the previous page. Here are some methods you can use to estimate interchange for your bottom-up pricing model.

1. Check your residual report or interchange detail report

If you already have integrated or embedded payments, you may already know the answer! Some payment providers include this in monthly residual reports or share it upon request, others bury it and force you to build a spreadsheet to reverse engineer the passthrough rate.

2. Ask your merchants for their processing statements

If some of your merchant have cost-plus pricing with their current payment provider, you can ask them to share their processing statements with transaction-level interchange detail. If you use this approach, make sure the merchants are a representative sample, or validate your findings using another method.

3. Start with an educated guess

These estimates take general trends into account. For example, higher-ticket B2C purchases often have higher interchange and customers are more likely to use rewards cards for these purchases. Low-ticket in-store purchases benefit from card-present rates and will likely see more utilization of debit cards with lower interchange rates. Lastly, with some use cases and card types, there may be an opportunity to reduce costs through interchange optimization.

• B2C in-store low-ticket: 1.6% – 2.0%
• B2C in-store high-ticket: 1.8% – 2.3%
• B2C online low-ticket: 1.9% – 2.3%
• B2C online high-ticket: 1.6% – 2.0%
• Non-profit: 1.5% – 1.9%
• B2B: 2.4% – 3.0%

Regardless of which method you use, Rainforest’s expert team can help you find the right passthrough rate for your bottom-up pricing model!

Payment provider fees

If you have a contract or pricing proposal, you can calculate your “all in” payment provider fees based on your volume fee, per-item fee, revenue share (if applicable), and any ancillary fees your payment provider charges. Low-cost payment providers are notorious for hidden fees, so make sure to take these into account!

If you don’t have a pricing proposal, here are some estimates for your bottom-up model:

Effective rates tend to be higher if the average transaction size is smaller, because the flat per-item fee will have a larger impact on smaller transaction sizes. For example, a $0.30 per-item fee is 30 basis points on a $100 transaction, but it’s only 3 basis points on a $1000 transaction.

Lastly, low cost isn’t always better! No one becomes the low-cost leader without compromising on quality or support. Read more about the true cost of low-cost payment providers here.

Internal costs

After the initial implementation, ongoing support and maintenance costs can be very low.

The choice of payment provider will impact internal support costs. For example, if the payment data isn’t accurate, your support team will field a lot of requests around payment status, deposits, and reconciliation. This will drive higher support costs.

With a high-quality embedded payments product, support costs will be so low that they’re difficult to measure. There may be a small incremental increase in support requests compared to not having a payments product at all, but for many software companies the increase barely moves the needle on overall support costs.

There are also efficiencies when supporting and maintaining payments at scale. The incremental cost increase from 0 to $100M/yr processing volume might be noticeable. The incremental cost increase from $800M/yr to $900M/yr will be less.

Lastly, if you’re moving from integrated payments (a referral model) to embedded payments, conventional wisdom suggests that your support costs will increase. In reality, the opposite is often true. Referral models claim to be very “hands off” for the platform, but they’re also confusing for merchants – which create a lot of support requests for the platform. With embedded payments, the platform is taking on responsibility for support, but the support requirements tend to be so much less that the overall support effort can be less than integrated payments.

Because the internal costs tend to be very small compared to interchange passthrough and payment provider fees, it’s common for software companies and investment firms to exclude them when calculating payments margin. Then make sure that the margin is large enough to cover any expected costs.

Bottom-up pricing examples

Examples are provided to illustrate the process – even if your platform is similar to one of the examples, it’s important to recalculate with your own estimated interchange, provider fees, and desired gross margin!

What if my bottom-up estimate is higher than my top-down estimate?

This can be caused by high interchange estimates, high payment provider fee estimates, gross margin expectations, or a missed opportunity to increase the value of the core SaaS product. It’s time to get outside eyes on your estimates to see where we can make adjustments and get you to more profit. Rainforest offers complimentary payment strategy consultations to SaaS companies with at least $100M annual card processing volume. If this is you, schedule your payment strategy consultation here.

Next post: ACH pricing strategy