Two Pricing Models to Avoid for Successful Value-Based Pricing
Yesterday there was a meeting for our meetup group on value-based pricing (Stockholm Value-Pricing Meetup) and as usual the discussion continued long after the meeting was over.
One question that came up was how value-based pricing works in practice. Value-based pricing is a way of charging that is more honest, fair, transparent and supports sellers and buyers to work towards the same goal. But he found it difficult to implement in practice. "How do you get customers to agree to this?" was the idea. It's a question I often hear.
Value-Based Pricing Is About Much More Than Just Increasing Profitability
There is an underlying assumption that value-based pricing benefits the seller the most. Many people who adopt value-based pricing do so because they want to increase their revenue and are attracted by stories of companies that have increased their profitability by adopting this approach. Those of us who offer advice and consultancy on value-based pricing often make that argument too. It's simple and concrete. Not fluffy like "stronger customer relationships" or "increased transparency" whose benefits are more difficult to define for many.
You Can't Retrofit Value-Based Pricing to an Existing Offering Without Making Changes
Increased revenue is only half the story. You can't introduce value-based pricing without first delivering the value you want to sell. If you try to apply value-based pricing to an existing offer and don't change anything except the pricing, you are likely to fail.
Value-Based Pricing Has No Equivalent to the Billable Hour
One thing many people trying to make the move to value-based pricing do is to find an equivalent unit to the billable hour. But there is no actual equivalent in value-based pricing to dividing work into hours. The idea that you can divide work into hours is a fallacy. A practical one. But an illusion nonetheless. However, it is hard to change your mindset about this. Hourly billing is deeply rooted in the minds of consultants and developers. They have simply not had to question the model, even though it is an obstacle.
Two Difficult and One Less Difficult Ways of Pricing Value
So what do you do instead? There are roughly three different ways to apply value-based pricing and two of them are difficult to achieve:
Contingency Pricing
This is the pricing model that most people think of when they hear the term 'value-based pricing'. The model is based on taking a percentage of the results you create for the customer. As in the price being contingent on the result.
Contingency pricing has long been used by claims lawyers in the US. This has tainted the idea for some. However, the idea is not inherently wrong. It makes sense: by sharing the outcome, you can also share the risk.
The problem with this model is that the exact impact of an intervention cannot always be predicted. Nor can you rule out other causes. It can easily lead to conflicts later on.
It is also not uncommon for customers to refuse to pay even though they got what they wanted. In such cases, the supplier is forced to take legal action, which is expensive, time-consuming and takes away focus. It also requires that you have a lawyer to help you draw up properly designed agreements before your project can be implemented, which is a major initial cost.
Not all customers are prepared to work in this way either. The customer feels that you as a supplier are simply trying to get paid more for the same work. This will damage their trust in you. So don't try this until you have a clear dialog about value and there is a well-defined, measurable and valuable result to work towards.
I advise consultants and agencies not to use this model for the reasons mentioned above.
Performance-Based Pricing
A similar model to contingency pricing but instead of being based on results, it is based on conditions. With this model, you set a target and tie it to a fixed amount. This is advocated by many consultants, including consultant Alan Weiss who has written several books on value-based pricing.
The disadvantage of this model is that the client needs to acknowledge a problem and that there is a scenario to be achieved and that it can be measured objectively. To think that this is always easy to do is politically naive, I think.
Gerald Weinberg writes in his book The Secrets of Consulting:
The First Law of Consulting:
In spite of what your client may tell you, there's always a problem.
The Second Law of Consulting:
No matter how it looks at ο¬rst, it's always a people problem.
The Third Law of Consulting:
Never forget they're paying you by the hour, not by the solution.β¦β
In order for a consultant to get credit, the client would have to admit there had been a solution. To admit there was a solution, the client would have to admit there was a problem, which is unthinkable. As a result, the only consultants who get invited back are those who never seem to accomplish anything.
The sarcasm is unmistakable. But it rests on a core of truth. All of us who work as consultants know that meeting a client who can point out a problem, identify a solution and define a metric with you is rare.
Nevertheless, there are people who advocate this. In his books, Alan Weiss describes techniques to drive a conversation so that the customer defines the problem for you, and you agree on a definition together. Unfortunately, this often requires quite a lot of work and strong skills as a conversational salesperson.
This model also requires consultants to be able to estimate the costs of achieving the goal. Over time, you get better and better at it. But initially, you will run out of money a few times and have to work significantly more to reach the goal than you planned for.
Value-Based Fixed Price
The model I recommend to most people is to work with a fixed price against a project definition that emphasizes value and benefits (but makes no guarantees).
This model involves selling your services on value, for example by using value-based selling techniques. The work is defined in clear packages and with a fixed price. These packages are sold in different versions (which I will write more about in the future) and based on the value they bring to the customer.
To do this, you need to talk to the customer about value rather than product features.
Many salespeople are very comfortable talking to customers about what their service or product can do but rarely link it to the customer's needs. If the salesperson asks questions and is a good listener rather than making claims, the customer does not feel like they are being sold to.
If you do this, you are perceived more as an advisor or consultant. This allows you to use questions to steer the conversation towards what the customer wants to achieve and how your service/product can be used to achieve it. This increases the chances of the customer seeing the value of what you offer.
Here is a slide from one of my presentations. This is about value-based selling and how to go from open to framing to closed questions in a sales dialog:
OPEN: What do you hope to accomplish? Used to establish goals and open a conversation.
FRAMING: How do you do X today? Uncovers the current situation and problems.
CLOSED: With better Y, would your X lead to better results? Helps create a vision.
Once the customer agrees on the value, you can move on to announce the price and talk about implementation. This is best done in two steps, e.g. in two different meetings.
Two steps
ANALYZE AND DIAGNOSE: Have the customer admit to a problem. Break down feature requests using 5 WHY's. Ask questions to diagnose the problem and help the buyer arrive at a solution.
CONFIRM AND PRESCRIBE: Visualize and confirm usage of product to solve the problem. Provide information about price. Agree on terms and schedule.
Value-Based Pricing Affects the Entire Company
I wrote earlier that value-based pricing is not just about increased revenue for the seller. We often talk about capturing the value you create. But to capture it, it needs to be created. You don't create more value by doing the same old thing, which is only based on the product and your own business, instead of the customer's.
Value-based pricing means a bigger cake: more value is created and shared. Projects implemented in this way create more value for the customer and more profit for the supplier.
It means delivering the things that create the most value for the customer. To do this, you need to understand what the customer perceives as valuable to them and use the right methodology to deliver it. Value-oriented project management is a topic in itself that deserves its own blog post, so I won't go deeper into it. If you don't want to miss it, I recommend you subscribe to our newsletter.
But there are other things that also need to be in place in order to be able to work in a value-oriented way. Beautiful-sounding goals such as "shared vision" and "increased transparency" are not fluff but help build the necessary consensus and trust. But to succeed, you have to work in a customer-oriented way throughout the organization.
This means, for example:
A Conscious Use of Language and Terminology
Avoiding jargon and technical terms and trying to explain things in a way that the majority understands.
Focusing on Benefits Arising From Use
Starting from the customer's interest and focusing less on technical specifications and more on how they can be used to solve the customer's problem.
Orienting Your Activities to the Needs of the Customer
Organizing processes and working methods around the customer's needs rather than your own. A lot of people make it easy for themselves rather than the customer and expect the customer to adapt.
I recently emailed an e-commerce store about a return and received a snotty reply along the lines of "This is our return policy which I copied from our site". The implication was that as a customer I should have known better and checked the site before bothering them with an email. The company in question was clearly not customer-oriented.
Communicating Value Through Your Behavior and Actions
In order to charge for value, the customer must experience it. It is said that how we behave communicates more than what we actually say. If we assume that this is true, it means that you also have to influence your behavior. This includes how you word your emails, answer the phone and act in meetings.
Many years ago, a colleague and I attended a client meeting. During the meeting, we were discussing how a project should be implemented. At multiple times during that meeting, my colleague spoke for several minutes with his back turned to the customer in a way that I felt communicated lack of interest. It is not certain that the customer reacted the same way, but it made me think about body language and what we unconsciously communicate.
At the End of the Day, It's Your Gut Feeling That Counts
At the end of the day, it's the gut feeling that determines the customer's decision. When I was involved in running our web agency around 2011, it sometimes happened that we lost tenders to agencies that were significantly less suitable for the assignment than us.
When you struggle with an offer for several days and lose to such a competitor, it stings. It is easy to judge the customer as ignorant or incompetent to make an informed choice. But of course this was not the case. The customer made the best decision they could with the knowledge they had.
People make decisions based on what they know and are familiar with. Some of this knowledge is based on concrete facts. Other is emotional. The agencies that beat us were simply better at getting the client to like them. They understood how to communicate value all the way through. The client felt more comfortable with that choice than us, even though we were demonstrably and objectively better.
But objectivity doesn't win contracts. Perceived sense of value does.
This article first appeared on Leancept's old blog.