Is Value-Based Pricing the Silver Bullet of Profitability in Professional Services?
It probably isn’t. Saved you from reading the damn article. Frankly, you should only read this if you’re trying to figure out how to price professional services and are considering value-based pricing. Value-based pricing is a model where a service provider reaps rewards that are correlated to the value generated for the client vs. being compensated for the time spent solving a problem.
We, and I speak for the consulting industry, usually charge for time. Clients seek results, they hire the best of breed to deliver those results, vendors win contracts based on their ability to deliver results at competitive cost and schedule. Many pro’s in the industry today are vocal about the unfairness of such approach — small margins, competitive landscape, unfair clients, getting beaten up for scope creep, and the list goes on. The proposed solution? Value-based pricing.
There are obviously many ways to approach pricing, but I genuinely believe benefits to client should come first, and challenges of execution as second. So do we price based on industry average, cost plus margin, project based (a.k.a. fixed-bid), or value-based? How does the chosen model benefit the client and differentiate the provider in the saturated industry? And ultimately, it is scalable beyond a single practitioner? Beyond a boutique of thirty? How about at a global scale of 500+?
What about conflict of interest in time-based pricing?
There are anecdotes in the industry, such as “if you’re not part of the solution, there’s good money to be made in prolonging the problem”. This statement implies that the consultant benefits from taking longer to solve the challenge at hand — conflict of interest, in terms of client goals. But that’s like eating your own limb because you couldn’t be bothered to walk over to the fridge! Yes, you may make an extra buck producing activity and not results, but at the end of the day the client will simply walk away.
To be scalable you need long-term partnerships. These benefits far outweigh maximizing profitability through an unethical, activity-oriented engagement that is likely to end in termination. It is in your best interest to solve problems quickly, effectively, and at lowest possible cost while maintaining the profit margin that enables growth. This approach guarantees client retention and predictable, recurring business year after year.
What about limited profitability using time-based pricing?
On the contrary, profitability can be and should be managed through a) scale, and b) level of expertise. At the end of the day compensation for consulting services is based on how fast and at what quality level the result can be delivered. The expert practitioner will command higher hourly prices, deliver faster, and produce higher quality. The less experienced will likely command a lower price and may stumble on the path to the finish line. There is no shame in building a cheap service — as long as it is being sold as such, can be scaled, and delivers results. There is also no shame in learning through failure and eventually commanding higher pricing for gained expertise. To summarize — it is to the benefit of all consulting firms to level-up their skill set, vertical expertise, and velocity of delivery as these indices allow control of pricing and differentiation in a saturated market.
Disadvantages of value-based pricing
Let’s get back to value-based pricing for a moment. I have a very real example to consider:
- Company A is bidding on the project using a Time and Materials (time-based) pricing model. The total cost of delivering software to market is estimated at $1M (cost plus markup).
- Company B is bidding on the project using value-based pricing and prices their services at $2M, because they anticipate the new product to generate $10M in sales for their client.
- For the sake of simplification, both companies hire equally expert staff, have the same vertical expertise, and will complete the work in the same timeframe, to the same level of quality.
Company B has just placed itself into a value-disadvantaged position and will start losing market share to companies that can accomplish the same feats at a fraction of their proposed cost. Theoretically, there is room in the industry for B companies, but this model is not scalable. Wouldn’t it advantageous, long term, to deliver maximum value at competitive cost and maximize market share?
While this strategy should theoretically enable expert consultancies command exceptional profitability margins, how is value-pricing beneficial for the customer? Having said all that, there’s a cool pricing model that defines how market share and pricing are related, published by smart people at McKinsey.
Pricing to Acquire Market Share
This article published by McKinsey & Company over fifteen years ago still stands true for pricing services in a saturated market and describes the relationship between price, customer value, and market share. Ralf Leszinski and Michael V. Marn write:
“Customers do not buy solely on low price. They buy according to customer value, that is, the difference between the benefits a company gives customers and the price it charges. More precisely, customer value equals customer-perceived benefits minus customer-perceived price. So, the higher the perceived benefit and/or the lower the price of a product, the higher the customer value and the greater the likelihood that customers will choose that product.”
Furthermore, the article introduces a Value Map — a graph that visualizes the relationship between perceived price and customer-perceived benefits.
“If market shares hold constant (and if you have the right measurement of perceived benefits and perceived prices), then competitors will align in a straight diagonal line called the value equivalence line (VEL). At any desired price or benefit level, there is a clear and logical choice for customers on the VEL. So competitors aligned on the VEL say in such a market that “you get what you pay for.””
The article further explores a situation in which a business falls below the VEL and finds themselves in a “value-advantaged” position. In other words, the business is priced the same as another company, but is offering more value to the customer (value can be many things; will return to the topic). Such a business immediately starts eating up market share and taking work away from other consultancies (such as one’s overpricing their services through value-based pricing).
Scaling and pricing services by using performance metrics
Value-based pricing is misleadingly attractive as a method to maximize profitability with minimal effort, yet one that may lead an organization to run an inefficient, wasteful practice. A sustainable approach is to take an analytic look at team performance and improve accuracy of estimation, delivery schedule, quality, results generated, and so on.
Customer-perceived value, or specifically the dollar amount to charge in value-based pricing, is very challenging (if even possible) to calculate when making strategic investments into new technology or new products. Professional services companies are almost never equipped to accurately predict value created by a new product platform, because if they could — they would be building these products on their own. On the flip side, there are situations where two organizations can enter into a mutually beneficial relationship where performance based compensation models provide incentive for the consultant to deliver results (e.g. meeting revenue numbers through a product platform), but these are more an exception case than the norm and are difficult to leverage as the main business model for growth.
But let’s get back to analytics. During our product design and development journey we track our time to almost a fanatic degree. Some believe time is relative for quantifying actual results generated (e.g. a jr. developer may take 8 hours to write a script that a sr. can ship in an hour). I believe this to be a faulty counter argument because data gets normalized at large quantities and individual experience level is irrelevant as long as the overall organizational knowledge level is high. So time tracking for us is one of very important data sources to make educated, smart decisions about optimizing our process, practicing accountability, and pricing our services to maximize client value. Our metrics help us do the following:
- Track utilization across the organization
- Track utilization across teams
- Track utilization across practices and verticals
- Track utilization across client account and industry verticals
- Track efficiency patterns across projects — where do we run into majority of our cost vs. make the least progress, and so on.
By using a variety of metrics we can make educated improvements to our own process without introducing new pricing models. We want to avoid a situation where we increase our prices to offset organizational inefficiencies because that a) makes us less competitive, and b) prides zero value to the client at the end of the day.
Relationship between client-perceived value and pricing
Increasing client value shifts the provider to a “value-advantaged” state and then decisions can be made regarding market share acquisition and hourly services pricing. Some of the value-adds to consider are:
- unique process that achieves higher-quality or faster results
- Industry expertise (e.g. faster on-boarding, solution delivery)
- superior tools
- quality of customer service and experience
- client integration and quality of relationships
- guarantees of delivery, quality, schedule
- unique company culture
- educational services bundled with delivery of product
- base products that speed up delivery to market
A consultancy offering several of the above value-adds can increase their pricing and still remain competitive in the market. Performance variables have to be closely monitored to make sure that a divide does not form between internally perceived value and actual client value. Tracking time, conducting client NPS surveys, and monitoring project performance help paint a realistic picture.
There is no silver bullet to easily balance client value and profitability in services based businesses. Value-based partnerships can be established for unique opportunities where a client may want to offset some of the risk or provide additional incentives to the service provider, however they should not be taken as a new model to base the whole practice on. These engagements should also be taken as opportunities and not stop gap measures to slow down the sinking of an inefficient agency.
Our pricing strategy for the last seven and a half years has remained time & materials based, or cost plus margin. That doesn’t mean we don’t estimate or control spend. Quite the opposite: spend is, after all, a critical indicator of the projects success. We also believe that using a transparent process we can accelerate delivery of product, create more value to our customers at a competitive price point, and in turn acquire additional market share. Marketing textbooks talk about unique differentiation for service businesses. A combination of process, expertise, uniqueness, and creativity that creates “blue oceans” in the market purely because there are no other organizations that can replicate what these organization offer. How can you use your pricing model to create value for the client?