What Is Value-Based Pricing? An Introduction to a Powerful Concept
In this article I talk about value pricing, the benefits and problems of traditional hourly pricing. I will go into more depth on how to implement value-based pricing in other articles.
The image for this article is not just chosen because it is pretty. One problem with Adam Smith's theory of the origin of value was that it could not explain why water and diamonds are valued as they are. After all, water is essential to life but still costs less than a diamond.
Value-based pricing is about charging as much as the customer is willing to pay, which reasonably corresponds to the value you create and offer.
When I talk about value-based pricing, I usually say that it is about charging for value, not for costs. This distinction should not really be necessary as value-based pricing reflects how most people think about prices. If you as a private individual buy something in the store, you do not think about what the production cost of the product is, but your willingness to pay is about how much it is worth to you to have the product. The fact that we have to make this distinction when we talk about pricing between businesses (B2B) says a lot about how much better consumer-facing businesses (B2C) are at understanding the relationship between price and customer experience.
Most service companies apply an hourly rate of some kind. This way of charging is easy for both buyers and sellers but creates a lot of problems. Hourly pricing is driven by a focus on costs. By shifting the focus to effects and results, you can reason about value created and a value-based price.
My insights into value pricing began when I was a partner in a fairly large web agency a couple of years ago. I felt that our way of working was not very good, but I couldn't really formulate the thoughts until I left the environment. The idea of charging for time was in the walls. There were simply no alternatives. Now I know there are alternatives. I hope this post will convince you to also work towards making time charging a thing of the past.
When you mention value-based pricing, many people are skeptical. After all, hourly pricing is perceived to have a number of benefits, which is why many people stick with it.
Perceived Benefits of Hourly Rates
Some of the perceived benefits of hourly rates for buyers:
You can quickly calculate what it would cost compared to hiring a person.
It seems intuitively "fair" to charge for time.
You can easily compare different suppliers (which has led to frivolous $1/€1 bids).
Some of the perceived benefits of hourly rates for sellers:
You can easily answer the question of what your price is.
It is easy to calculate: you just take fixed costs, add a margin and get the hourly rate.
You don't have to take responsibility for what you deliver; you just need to make resources available to the extent promised.
Actual Disadvantages of Hourly Rates
These two lists are far from exhaustive. But they probably contain a lot of what most service providers would say if you asked them why they use hourly billing. What many misses is that this "convenience" they experience comes at the expense of several other things:
The quality of the deliverables suffers.
The supplier often leaves money on the table.
An inward-looking mindset that hurts both supplier and buyer.
More difficult for suppliers to assert themselves, whose know-how is easily turned into a commodity.
Quality Suffers When Value-Based Pricing Isn't Used
When the supplier's main goal is to provide the customer with hours, the conditions for the supplier to understand the context and the intended effect are often missing. Even if the will is there, there is no incentive to try to look after the customer's best interests. The customer often does not care if the supplier tries to do more, but only looks at price and hours. This becomes particularly obvious when large organizations procure consultants and hours are counted in the same way as purchasing erasers.
By refusing the hourly rate and instead procuring assignments with a value-based pricing model, the focus can be on the delivery, not the price. However, a value-based model doesn't have to be about taking a percentage of the results you create (as many seem to think) but can also be about amounts linked to milestones and subscription agreements that run over several years.
Value-Based Pricing Makes Partnerships Possible
Value-based pricing creates the conditions for a partnership between customer and supplier where both have an interest in the long-term effects of what has been delivered. But it also creates a basis for a strong relationship.
When it comes to IT, services are not purchased on a one-off basis, but more and more companies want ongoing support from a supplier. They want the supplier to take a proactive role and provide their own views, tips, advice and recommendations. Buyers want a relationship, not a "one-night stand" with their suppliers. If you do a perfect job as a supplier, you get to meet the "in-laws" - in other words, it becomes a status for the buyer to be a customer of the supplier.
The Supplier Often Leaves Money on the Table When Not Using Value-Based Pricing
A standard hourly rate is simple and easy for many people. You get a request and you give an answer. It may even seem fair. But there is nothing fair about it.
By having a standard price, the supplier does not have to negotiate, which may seem easy, but the supplier then completely fails to price the customer and the project. Small customers with small needs and little effect of their investment will therefore pay relatively much while large customers will on average pay less.
By not making a distinction between costs and price and not pricing the customer, but instead lumping all customers together, you lose the opportunity to make a strategic analysis.
This is because with a good cost estimate, you know how far you can move down in price without taking too much financial risk. There may be customers that are worth taking despite a lower profit margin in the short term. I think we have all had experience of this. They may be small companies that you think will grow or organizations you want to support.
At the same time, there are other customers with a good willingness to pay and projects that can provide great returns and impact. In such cases, you can assess the value and price accordingly. This ability is lost with a fixed hourly rate. The only way is to try to settle on a "reasonable" standard hourly rate and offer targeted discounts for customers in the first category. Large companies can be dealt with by overestimating the time required. None of these solutions are good.
Discounts Are Incredibly Expensive for Suppliers
Customers easily get used to discounts and when the smaller company grows up, they expect the same discounts next time. A fact many entrepreneurs do not know is that a 10% reduction in price may require selling 50% more to achieve the same financial result. Giving discounts is therefore very expensive even if you can compensate through increased volume. But since service companies don't scale very well - after all, you have a limited number of hours per person per week - you often can't make up the lost revenue by selling more.
The big company will wonder why this particular supplier is taking 20% longer to deliver the same thing as their competitors. This will probably put a spanner in the works for the supplier in a procurement process.
With value-based pricing, the supplier could have offered pricing that was not so easy to compare and appeared interesting to the larger company. They would have been able to increase their profits without manipulating estimated hours. Of the things a company can directly control, price is the one that has the highest impact on profits (Simon, 2015).
An Inside-Out Approach that Affects Both Supplier and Buyer
Not all businesses have a clear objective to increase their profits. For some, entrepreneurship is about other things. They are satisfied with their profits and may think it is right to earn a reasonable amount. You don't want to see yourself as an opportunist. Increasing profits at the expense of the customer therefore seems ethically wrong to some.
But value-based pricing is not necessarily about increasing profits just because the customer is able and willing to cough up more money. Thinking that way does not usually lead to long-term gains. You have to change your approach to the customer as well. With value-based pricing, this becomes crucial and suppliers using value-based pricing have more satisfied customers than suppliers using hourly rates (Baker, 2010).
The irony is that by charging more you create an incentive for yourself to work harder to prove yourself worth the money. Several companies that have switched to value-based pricing have testified to this (Baker, 2010).
Successful Value-Based Pricing Requires Seeing Things From the Customer's Perspective
However, this requires a willingness to look at things from the customer's perspective. And I mean for real. Not just as something you write on your website and throw around in sales conversations.
Companies that apply hourly rates are often much worse at this. For them, it's about delivering hours, not what those hours contain. A small business owner I know recently told me about a project that ran out of hours and his company was the supplier. The client wondered what had happened and why the job was not finished. The supplier had simply said "Sorry, the hours you bought are gone. If you want to finish, you have to buy more".
They thought this was a phenomenally good way to manage the relationship. According to him, the customer accepted the explanation. So his company's business concept is really about transferring time from his employees to his customers. However, I think many of us see our role as quite different.
I suspect that someone in the customer's organization was not at all happy with the supplier's accounting explanation, but had actually expected a result. A supplier delivering value would have started from the customer's situation and tried to maximize the value of the delivery despite the circumstances. Either by dividing it so that each delivery gave value directly (which is how you do it if you work according to Lean). They might also have worked a little more beyond what they promised so that what was built was actually usable, albeit in a limited way.
A supplier who understands the customer's value will also start from the customer's needs when talking to the customer about deliveries and their parts. In such cases, the supplier will advise against items that they feel do not provide enough return for the price they are prepared to offer. They may recommend simpler solutions than the one the customer has in mind. Solutions that provide the same or almost the same benefits but at a fraction of the price. Prioritizing the customer's needs before your own in this way builds trust and increases the customer's willingness to pay (Baker, 2010).
Unfortunately, many suppliers miss this and build things that cost more than they taste, but without reflection. They are happy to get the hours out and the guys and gals on the bench don't have to sit around twiddling their thumbs.
The suppliers also lack incentives to improve their way of working to be able to deliver more quickly because they are not rewarded directly but only indirectly in comparison with other suppliers. When these companies talk about efficiency, they are talking about how to optimize how they work internally to achieve internal goals, not how to increase the effectiveness of what they create for their customers (Baker, 2010). Value-based pricing requires the supplier to ask why the customer is making this purchase, what their goals are and what effect they want to achieve. This creates a stronger relationship between customer and supplier which will generate more business in the long run.
It's Harder to Compete for Suppliers Whose Expertise Is Easily Commoditized
You may have heard that hourly rates for IT consultants have not developed nearly as much as other prices over the past 20 years. There are many reasons for this, but I believe that one contributing factor is that consulting firms are poor at differentiating themselves.
Many are technology-driven, and technology enthusiasts sit in management and on the board.
When service providers from other parts of the world, start coming in, this quickly becomes a millstone around the neck of the national suppliers who cannot match the cost structure. It is not possible to employ skilled people at the salary levels found in countries with vastly lower living costs and consequently, wages.
Part of the solution is to decouple price from wage costs. By stopping offering hourly rates, prices can be set without any link to how long something takes. Local companies also have the advantage of understanding the culture, speaking the language and can often give better advice than a supplier new to the market.
By applying value-based pricing, you can build offers around soft values, relationships, end-to-end solutions and partnerships. The goal is to make yourself as difficult to compare as possible. Hours become only a factor when something can deliver. Hours are therefore decoupled from what the price is based on.
Succeeding with this places high demands on the supplier's ability to communicate and convince the buyer of the value offered. This can be done by building a brand, demonstrating knowledge through training, writing books and articles, blogging and proving their expertise in all parts of the process.
But it can't just happen one way; it needs to result in a dialog. When the supplier effectively listens to the buyer's needs, it builds trust and provides a platform for the arguments the supplier uses to prove the value of what they offer.
Time Is Valuable, But It Also Has No Value
The above reasoning is really quite obvious if you think about it, as time is not worth anything in itself. At the same time, time is extremely valuable because it is the only thing everyone on earth has a limited amount of.
Time is required for us to create change.
The rhetorical question becomes: What should we do with the time we have been given? Should we sell it to the lowest bidder or use it as efficiently as we can to maximize the benefits for everyone involved?
In the next blog post, I will discuss how buyers and suppliers can make the transition to value-based pricing. I will give some concrete examples and tips on things you can do.
References
Confessions of the Pricing Man: How Price Affects Everything; Simon, Herbert; 2015
Implementing Value Pricing: A Radical Business Model for Professional Firms; Baker, Ron; 2010