Cost-Based Pricing


How do you come up with pricing for your services? I graduated from one of the top 25 economic institutions in the world. I recall lectures about how to generate pricing models based on costs. The topics were challenging, thought-provoking, and in retrospect, a complete waste of time. The fact is that if you can quantify your value, your internal cost just doesn’t matter.  Here is a better strategy to establish a pricing model that is based on the value you’re delivering to the client.

The Entrepreneur

I was speaking with a talented woman who is starting a consulting business after spending years working in corporate America. I asked how she came up with her fee structure. She explained that she took the amount she was being paid in her former job, added the costs of insurance (turns out it was much higher than anticipated – so much for Obamacare), and then divided those costs by the number of hours available each month.  She also added a little buffer and that is how she came up with her consulting fee.  I encouraged her to reconsider that cost based pricing method and instead assess the value she anticipated delivering to clients.

Given her expertise, we agreed that for the right client, she could expand their business by 10-30% annually.  For a company currently doing $10 million per year, that would equate to $1 million to $3 million. Let’s say her client was confident she could deliver those results. How much would that be worth to them?  Answering that question provides a better way to establish her consulting fee.  Does her insurance cost even enter into the calculation?  Of course not.

Focus on Results and Value

Our economy is based largely on the concept of a fee per hour worked. If you work in a factory, or are a first-responder, then hourly wages might make sense. Part of the value of a firefighter is knowing they are there “in case” something happens. However, for most professions, the value you deliver has an inverse-correlation to the number of hours you spend. Simply put, the faster you can successfully deliver results, the more you are worth to the client.

For example, let’s say you are an entrepreneur and another company threatens a lawsuit against your business. You need to hire a lawyer and here are the options you found:

Lawyer A says they can help you for $250 per hour.

Lawyer B says they can help you for $450 per hour.

Lawyer C says they can help you for $600 per hour.

Who would you pick?  How many hours of their time would you like?

The answer is NONE.  In fact, you don’t want to buy hours.  You just want the issue to go away.

In the same scenario, let’s say that Lawyer C (the one with the most expensive hourly rate) says “I’ve reviewed the matter, and unless one of these two unlikely scenarios comes up in the first two days, I’ll solve the whole matter for $5,000. If those other situations comes up, I’ll know quickly, and we can jointly decide how to proceed.” The other lawyers still give you an hourly rate.  Perhaps Lawyer A has lower overhead than the others.  Who cares?  The Lawyer’s hourly rate and their cost structure do not matter to you.  You don’t care how many hours they spend, you just want a solution to your problem.

Cost-Based Pricing Is The Vortex of Evil

The most successful companies know the value they deliver to their clients matters the most. They price their services based on value, not the underlying cost structure. They are rewarded for innovation and creativity. They don’t have an incentive to add more people to a project, unless it would improve efficiency or results.

In sharp contrast, the federal government and other organizations often award contracts on a cost-plus basis. This means that the contractor might earn 11% more than their total cost per hour worked. In this model, the contractor has a disincentive to be efficient or innovative. The more hours they spend doing the project, the more money they make. Why would you want to encourage that type of behavior?

Whatever you do, please avoid this vortex of evil at all costs. If you are already billing for hours, get creative to deliver value and results, not hours and bodies.

It’s your turn

Post a comment to share your horror stories of cost-based pricing.