Lee Frederiksen — June 26, 2019 — June 26, 2019
Today’s professional services firms face challenges from many directions. Increased competition and commoditization of services put downward price pressure on services even as talent shortages drive up costs. And the advent of artificial intelligence and automation threatens to undermine some firms’ core service offerings.
It should come as no surprise, then, that many voices have suggested the adoption of alternative pricing models to reflect new approaches to building and capturing value. This post will focus on one of the most promising of those approaches, value-based pricing.
Value-Based Pricing Defined
Value-Based Pricing is a pricing strategy that attempts to capture the extra value that a particular client segment associates with a particular feature or benefit of your firm’s service. It requires that your service offering is different in some meaningful way from your competitors (i.e., differentiated) and that potential clients value that difference.
Value-based pricing rests on two key concepts. First, the value of a service is subjective and will likely vary for clients in different circumstances. Further, a given service may be perceived as more or less valuable depending on how it is “framed” or explained. This point is particularly important for professional services, since many clients have little understanding of the real business value of the services they buy.
The second key observation is that the cost of providing a service is only partially related to its perceived value. The client is the final judge of the value received and is often unaware of what is involved in providing a deliverable. This can lead to mismatched expectations between client and service provider. In fact, fear of “overpaying” is the second biggest concern of professional services buyers (after not solving the problem).
How a Value Pricing Strategy is Different
A value-based pricing strategy can be contrasted with three other pricing strategies common to the professional services marketplace.
Time and Materials Pricing involves calculating the cost of the labor (time) and other expenses (materials) and adding a markup to cover overhead and profit. This marked up rate is often referred to as hourly billing rate and may vary depending on who does the work. More-senior professionals, or those employed at firms with a stronger brand, typically command a higher rate.
Market Pricing, another common approach to pricing professional services, attempts to price a service at a rate that reflects the price commonly paid for this service at competitive service providers. This pricing model assumes that the service and benefits are comparable across competitors (i.e., undifferentiated). A firm may choose to be at the low end of the market to gain a pricing advantage or at the high end of the market (premium pricing) to capture the value of their brand or reputation.
Package Pricing is a strategy that offers a fixed price for a defined group of services. Sometimes called fixed pricing, this strategy can be used with or without value pricing. However, there is a natural affinity between package pricing and value pricing. Since clients are not being billed based on time spent, they are already focused on the overall value of the package. This makes value pricing easier to implement.
Value Pricing Examples
To understand how value pricing works, let’s start with a simple example. Consider an accounting firm that offers an outsourced bookkeeping and accounting service. Three local competitors offer this same basic service at around $ 1,000 per month. In a market pricing scenario, the firm would charge around the same amount to remain competitive.
However, this firm has observed that clients often ask what the monthly financial reports mean for their business. So the firm decides to provide analysis and basic business advisory services as part of their offering. This increases their cost by about $ 200 per month. In a time and materials scenario, the firm would simply raise its monthly fee to $ 1,200.
But by researching potential clients they learn that a segment of clients feels that the analysis and insight services doubles the value they receive. A value-pricing scenario would suggest that their enhanced package should be priced at $ 2,000 per month and marketed to that prospect segment that perceives the added value.
Now, lets assume that the firm acquires some new software that automates a number of routine functions, reducing their monthly labor expenses by 20%. Do they reduce their monthly fee by a corresponding amount? A value-pricing strategy would say no, as long as the automation does not impact the value clients receive.
But what if the new software offers greater functionality and delivers more insightful analysis? If clients recognize more value because you have explained and framed these new capabilities appropriately, a price increase would be in order. However, if this new value goes unrecognized or unappreciated, you will be unable to harvest that potential value.
Benefits of a Value Pricing Strategy
As you come to understand how value pricing works, it becomes quite clear that it has many benefits to offer the professional services. Below are the top five benefits, in our experience.
- Both you and your client are focused on the same thing: the real business impact of the services. In a traditional hourly billing model you focus on the cost of providing the service. How long will it take? Who will do the work? Your client is focused on the value of the service. Will it be worth the expense? Will it really solve my problem? In a value pricing model, however, both client and provider are focused on the value received. Their interests are better aligned, which promotes better communications and outcomes.
- It allows you to better capture the value of your expertise and insight. One of the cruel ironies of time-based billing is that it punishes fast and efficient professionals. The more skilled you are at a task, the less time it takes you to do it well. In a time-based scenario, a highly skilled professional might charge lessthan a bumbling beginner! This can add administrative and operational burdens, as the client may feel a need to micromanage your choice of resources. To some degree, different billing rates can offset this time discrepancy. But billing rates are only a crude reflection of the value a top-level expert can bring to a project. The right expert could add thousands of dollars of value in minutes. Value pricing frees you to leverage resources as you please. And perhaps more important, you can capture the full value of the greater efficiency and added insight that a highly trained specialist brings to a project.
- It adds predictability to pricing. No one likes “billing surprises.” When competently delivered, value pricing should have no unexpected charges. Scope and price are agreed upon before work is started. If a material change occurs, the price can be adjusted accordingly (with a change order, for instance). From a psychological perspective, this arrangement frees the client from avoiding important questions or discussions simply because they are afraid of incurring hourly fees.
- It encourages you to leverage technology and optimize processes. Why would you invest in time-saving technology or systematic process improvement if it only reducedyour revenue? A value-based approach eliminates this problem. Instead, it incentivizes you to embrace every margin-boosting improvement in process or technology that does not compromise the client deliverable. Further, if the technology or process improvements add more value, even better.
- It reduces common billing questions and disputes. Just because your charges are accurate and well documented doesn’t mean they don’t annoy clients. “You charged me (insert the hourly fee amount) just to photocopy a document? That’s outrageous!” If you currently use time-based billing, some variation of this conversation is probably painfully familiar. Value pricing eliminates these conversations. The client does not see hourly rates or time and task details. Annoyance avoided.
Common Barriers to Overcome
So in light of all these benefits, why isn’t value pricing more widely practiced within the professional services? The answer is probably because there are significant barriers to overcome when implementing it. Here are some of the most common ones and some strategies to get past them.
It requires a change in core administrative processes.
Sometimes a firm’s administrative processes can present barriers to value pricing. If your billing system automatically generates invoices based on tracked time, there may be internal resistance to adjusting these processes. Similarly, if your firm compensates staff and/or equity partners based on billable hours, value-based billing could turn that model on its head. And even if the required changes to your system are relatively minor, you may encounter resistance simply because many people dislike change.
To counter this barrier, focus on educating affected people on the benefits of a value-based pricing strategy. The upside typically outweighs any associated costs by a wide margin. Also consider positioning your initial moves toward value pricing as an experiment that can be adjusted or expanded as you gain experience.
Many professionals are unsure how to calculate the value of their services.
This is a very common issue in many professional services industries. Unless executives and billable staff have prior training and experience with value-based pricing it can seem arbitrary and downright risky. This often creates anxiety and hesitation.
Training and successful experience will typically overcome this concern. And of course, it is incredibly important to have a systematic process to follow for establishing your pricing. Below, we describe the model that we use at Hinge and recommend to our clients. It minimizes the seeming arbitrary nature of value pricing while preserving the ability to be flexible as you encounter various business situations.
It requires a rethinking of the entire business development approach.
Business development is no longer just about describing what you will do and how long it will take. You must now consider the full impact of your services. Do they actually solve the business problem at issue? What is the value of solving those problems? Does your approach add value over and above what a competitor would do? How can you demonstrate that value? Does the potential client trust that you can deliver on your promise?
Each of these questions could have a significant impact on the price you can command for your services. Many professionals will need a new way of thinking about the process of business development and an opportunity to develop the skills needed for success. You need to be a good listener as well as a strong presenter. Your proposal will need to be convincing to justify what may seem like a premium price to the selection team. And above all, you must believe in the value you can create. If you don’t believe in the impact of your approach, it is unlikely that the prospective client will either.
Some potential clients will not accept value pricing.
Not every potential client will appreciate the benefits of value pricing. And even if they do appreciate it, they may not be in a position to act. Some prospective buyers simply can’t afford premium pricing. Or your designated contacts may be reluctant to request the additional funds for fear of putting their career at risk. And just as you may have internal policies or processes that make administrating value pricing a challenge, so to may your potential client.
While you may be able to overcome some of these challenges, you may not be able to conquer them all. You will have to accept the fact that value pricing will not work in all situations. Having said that, the upside is so substantial that it outweighs the loses you may experience. Track you closing percentage and compare it to your pre-value-pricing baseline. Take note of the margins on value-priced and non-value-priced projects, as well. What you will likely discover is that the value-pricing approach delivers superior results.
It demands a higher level of project management.
Time and materials billing can hide a lot of project management inefficiencies and missteps. If it takes more time, you simply charge for more hours. In this scenario, the client bears all the project execution risks. (No wonder they are so nervous!) With a package price or value price model, however, that risk is assumed by you. (Now look who is nervous.) You also inherit the nearly universal problem of “scope creep,” in which the client’s needs evolve as the project unfolds and they want more than originally bargained for. If these adjustments fall outside the original scope, you may need to adjust that scope. Generally, this adjustment is handled with a “change order” that spells out any changes in scope and their associated additional costs.
In many ways, this value-based arrangement is a benefit. It forces you to focus on the project delivery process and relate it to the value delivered. In our experience, it tends to improve both efficiency and the client experience. But it does take dedicated effort and training to make sure you have a methodical project management process that keeps projects within scope and achieves the desired outcomes.
How to Implement a Value-Based Pricing Model
Step 1: Understand the business issues your service is meant to address.
Start by understanding the business context that your services address. Go beyond what specific services clients are requesting and try to understand the “why” behind the request. Is there an unusual urgency? Is this an essential step in a larger business strategy? Understanding this business context will help you determine what you need to accomplish (see Step 2) and the real value that your client will receive (see Step 3).
- Is this a regulatory requirement that triggers a natural instinct to minimize costs? How can you approach it so that you can add real value beyond a simple check the box exercise?
- Is this a situation where anxieties are high and finding an approach that will reduce them will add real value? Remember that value is subjective and is ultimately judged by the client. While it may seem trivial to you, this kind of emotional relief can be very valuable to a client.
- Is this a growth opportunity where the upside potential is key? Think in terms of increased revenue and profits over time.
- Is it a cost reduction or efficiency play where potential savings are the driver? Here again the metric will likely be cost savings or increased efficiencies expressed in economic terms. Think of the savings extend out over time.
Step 2: Calculate your costs to deliver that service.
How will you address this challenge? What is your approach and how will you staff the engagement? To many professionals, this step will feel very familiar, especially if you are used to giving estimates or doing fixed-price projects.Consider similar projects you have done in the past. What did it take to achieve the results you are trying to achieve here? Try to be realistic about what will be required. Take into account this particular prospect and their unique situation. Give yourself a little “wiggle room” in case you are being a bit too optimistic.Then calculate the cost using your billing rate, including overhead and a reasonable profit margin. If you do not have billing rates, take your direct costs and add a sufficient margin to cover overhead and profits. This is your floor. It is (or should be) the minimum that you will accept to do the job.
You might think of this as sort of a package price that does not yet have a value-billing component added. Now we’ll turn to the value add side of your pricing calculation.
Step 3: Estimate the value of fully addressing the targeted business issues.
Start this step by adopting your potential client’s perspective. What is the value to me (the client) of fully achieving the real results I’m seeking? Think back to the first step. If I knew for sure that the proposed approach would work as described what is that outcome worth?
Consider cumulative benefits over a realistic time frame. Include both the tangible and intangible benefits. Now, this is the area where many professionals falter. They feel out of their depth when trying to assess subjective value.
There are alternatives to consider. If you are constructing a package that you want to offer to multiple clients, you may want to do some research on the perceived value of different possible service combinations. This type of research is a common practice in many consumer-focused marketing organizations. Research will reduce your risk and give you a more objective starting place for your pricing decisions. It is an approach favored by many of our clients when making these decisions.
Step 4: Adjust the value price to fit the current business context.
You now have developed your pricing floor by focusing on your estimated costs in Step 2 and your projected price ceiling by focusing on estimated value in Step 3. These are the range of prices to consider. Now it is time to decide what price to offer to the prospective client.
From your perspective you are trying to determine how much of the value you will bring to the engagement can be captured. The client is trying to determine the likelihood that the value you promise will actually be delivered. “Will I actually receive this much savings?”
When making these judgments consider these factors:
- What is the probability that we can deliver the promised benefits? The lower the likelihood, the lower the price.
- What is the emotional impact of the service we provide? Does it reduce anxiety and stress? Remove a serious threat? The greater the relief, the higher the price you can charge.
- What is the client’s ability to pay what you want to charge? Is it easy or will it take a major effort on the client’s part? Even if the payoff is great, if a buyer cannot afford it, they are unlikely to move ahead with your offer.
You may be able to impact these factors by the way you structure the offer to the client. For example some firms will tie their fees to the results actually achieved. Let’s say you are reviewing a firm’s state and local tax filings to find opportunities for savings. The fee may be quoted as 50% of any documented savings. Or you might charge a reasonable base fee (calculated in Step 2) that will be paid no matter what, and set additional fees that will be paid upon achieving specific goals or metrics. This structure dramatically reduces the client’s uncertainty and perceived risk and makes it an easy sale.
Another common mechanism is to offer some type of guarantee. Here again you are removing perceived risk and making it easier for the client to accept your offer.
Step 5: Build the case for your value price.
Your goal with this step is to help the prospective client understand and appreciate the value that they will receive by working with you. Remember that value is based on the client’s perception, so you need to be able to help them “see the value” before you have started work.
The best business developers are able to paint a mental picture of how the client’s organization will be improved or transformed by your work. They can help the client anticipate the emotional relief they will experience or the joy they will feel when the desired outcome materializes. Case stories and examples are very helpful at this stage of the process.
But it is not just the emotional part of the proposal that is important. If you can present relevant analytics and past performance data, that may be very persuasive to others. It’s not emotion or rationale, it’s both.
And remember, often these purchasing decisions will be made by committees. So be sure to arm your advocates with the tools they need to persuade their colleagues that your value-pricing approach is the right one for them.
A Final Thought
The professional services landscape is rapidly changing. Technology, new business models and the threat of commoditization are eroding traditional ways of providing value to clients. Firms will need to find new ways to compete — and new ways to package, and be compensated for, the value they can deliver. Value-based pricing is well suited to this challenge.
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