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.
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.
Trinidad – thank you for the kind words. I’m glad that you took the time to share your wisdom with the other readers. I’m sure everyone will value your input. Ian
This was an excellent article! We specialize in growing revenue for our clients through Marketing and Business Development. In many cases a CEO or executive will ask what our hourly rates are however in our industry that creates motivation to work slower and could potentially cost more money in lost opportunity for my organization and the clients as follows:
If my staff is taking their time to achieve particular results on behalf of a client it ties up their time which is obviously company money and taking longer than needed would prevent our staff from working on other projects. The client may suffer from lost sales that they would have otherwise received if we achieved results sooner by focusing on value from the beginning and not cost based pricing.
Every organization even in the same industry will have its unique challenges and opportunities. To be successful it’s important to ask the “right” questions and genuinely care about helping the client reach their goals and making sure those goals are achieved.
If our clients do not receive a positive ROI were not doing our job so essentially too create successful long term relationships with your clients your services need to more than pay for themselves.
In most cases not all, focusing on Cost Based or hourly pricing can be a disservice for your client and your organization.
At times it can be more time consuming and challenging to focus on value up front however I strongly believe it creates stronger relationships.
The Obamacare reference was something that she shared with me – so I included it. Just made me laugh. Thanks for sharing your ideas.
I guess the point is to factor in what your clients ultimately value, and try to include those elements into a fixed-fee approach. In other words, if the competition does basic maintenance for $3,500 per month and charges for everything above that, your approach might be to charge $6,0000 per month and include a category of additional items. This means they pay more for you, but know that with the other vendor sometimes their bill is $5,600, and sometimes it is $8,700. With you, it becomes more predictable. They’d be happy to pay $6,000 if they knew everything was taken care of that mattered to them. They don’t want X hours of support. Rather, they want reliable systems, proactive guidance on technology, competitive advantages, and the ability to focus on what they do best as an organization. Don’t sell hours of support, sell results and outcomes. In so doing, you are speaking to value not price.
The other option is to think more about the labor costs… which is focused on what matters to you rather than them. The only way someone can compete on price is to have cheaper labor… which implies less qualified. Sometimes, your best approach to compete is to expand scope and include MORE rather than try to reduce price and offer less.
OK. So this is all great…. (except for the slur on Obamacare…. which is just premature, not necessarily inaccurate 🙂
but what about market pressures and pricing? If you look at our offerings (www.optimalnetworks.com) I think we provide significantly higher value than other IT companies, and we are priced on the high end to reflect our premium approach. But if I were to value price, I would knock us out of the ballpark… and scare off clients who would ultimately end up being really happy with us. Suggestions?
Your points are absolutely valid. There are times when there are great unknowns, and perhaps the only path is to bill by the hour. I know that you do some contingency work where you are paid based on your performance. You share the risk with your clients. Not everyone operates with that degree of confidence. The question I have is how differently would the allocation of resources be on a project where paying by the hour was not employed? Would people figure out a way to be more efficient and effective? Would they chase cases that lack any potential for a positive outcome? In nearly every case, there is a way to set assumptions for the project. You might say “Unless the opposing party is controversion and non-cooperative, the case should require less than 200 hours of effort. We’ll do the project on a fixed-fee basis for $60,000. If they become complete jerks, it could cost $200,000. But, let’s work for the first couple of weeks for $7,500. At that point, if it looks like it is going sideways, you can decide not to proceed.
There are always ways to focus on value over hours, and to constrain the risk so as the vendor you don’t lose your shirt.
Having said all of that, there are still places for hourly billing… it’s just still the vortex of evil and inhibits innovation and efficiency.
Thanks for sharing your insight.
Your examples definitely got me going. While there are times that a lawyer can feel comfortable predicting the amount of time involved in a matter, and therefore quote a reasonable fixed fee to provide the services, litigation with all the attendant uncertainties does not lend itself well to that. This is not estate planning, with a template of necessary documents and a lawyer having a pretty good idea of how long it will take to prepare them. Litigation matters tend to have their own lives, and do not lend themselves well to predictability, at least as far as how long any particular phase of the process will take. The solution in these circumstances may well be a contingent fee, where the lawyer is incentivized to work as quickly and cost-effectively as possible to achieve the client’s goals. Of course, in your example, the lawyer was brought in to defend against a claim, and a contingency arrangement makes no sense without a recovery. In that instance, hourly billing may be a necessary evil.