Value Pricing 101
If you listen to the occasional business podcast you might have heard the term “value pricing.” If you follow media for the accounting industry you probably hear it once a day. There is a lot of interest and sure seems to be a lot of confusion about it. When I started Tee Lex, I knew I wanted us to be a value pricing organization before we had our first customer. I can report that more than a year later, we are! That's why I want to shed some light on the topic for you.
What is value pricing and why is it a thing?
Value pricing is the idea that a product or (usually) a service is worth whatever a customer is willing to pay, or more specifically it’s worth the value that the customer places on it. Sometimes it’s referred to as “pricing the customer.”
Put another way, it’s the belief that rather than determining price with a calculation (like costs x markup = price), the value of a service should be decided by the consumer. This is highly subjective and highly situational, for example many people would be willing to pay more for a tax return with a big refund than one where they owe. This – and other issues - makes value pricing controversial.
Value Pricing vis-a-vis Hourly Pricing
In a service business, value pricing sets itself directly against the billable hour.
As Ron Baker, the godfather of value pricing, puts it (I’m sure I’m misquoting but you get the idea): Professional services is the only thing we buy where we don’t know the cost before we agree to pay. Pick your metaphor: you walk into a furniture store and ask, “how much is that sofa?” The salesperson smiles and says, “Well, I can’t tell you right now but once I start building it, I promise to keep diligent track of my time and materials, add a fair markup and when it’s ready I’ll let you know.” Would you buy that sofa??
There are so many problems with the billable hour: The more advanced a service provider is, the more efficiently they can accomplish the service. Under a billable hour model, the more advanced provider is penalized for being efficient. Billable hours create a perverse incentive to take longer to do work. Let’s not even mention the issues caused by tying people’s compensation to billable hours… can’t go there in a thousand words.
Value Pricing Theory
I’ve read many books and listened to many podcasts on the topic and while I am no Ron Baker, I’ve come away with my own understanding on how to offer value pricing in a creative service business.
Value pricing is typically offered in tiers: this way the customer gets to decide how much the engagement is worth to them. How you separate the tiers is up to you, but they could be delineated by the number or depth of deliverables, or number of revisions; anything that changes the amount of effort required to deliver and increases value to the customer.
The most straightforward approach is to offer three tiers. Let’s call them Bronze, Silver & Gold
Bronze: the lowest tier is sometimes called the “reserve price.” This is the lowest price you’re willing to take the engagement for and the effort required should be just enough to get the job done. Beyond this threshold, the job isn’t worth it for you to do, nor is it worth it for your customer to buy.
Silver: The middle tier is your goal: your prices and offering should drive the customer towards this tier. The work you’re doing at this tier should be in your sweet spot and the profitability should be your target profitability. This tier is where you prefer to be as a business owner.
Gold: This is the windfall tier: the work in this tier should represent the highest level and capacity you’re willing to offer and (this is critical) it should be more profitable than the services at the lower tiers. For example, if you want your business to run at a 30% margin, the work in the lower tiers should be offered at about a 30% margin. The services at this this tier, however, should be offered at a 40% or 50% margin.
Another way to think of this is in terms of capacity:
let’s say the first 80% of your capacity is sold at a 30% margin.
The remaining 20% of your capacity should be sold at a 50% margin.
You offer the highest tier as a service to your customer, in case they feel they need this level of engagement. But because this level of engagement taxes your firm, it should be more profitable.
Let me underline this: the highest tier is not just more money
for more work. It is more profit for more work.
If you’d like to read more about this, I highly recommend Ron Baker’s book “Implementing Value Pricing: A Radical Business Model for Professional Firms.”
Value Pricing & Risk in Creative Services
I hear your objections already. “We could never do that,” “Our clients would never go for it,” “It's just not practical - how would we invoice?” But let me ask you something: how many engagements do you have with an unlimited budget? Whether you have a contractual not-to-exceed limit, or just know your customer would have your head for going over your retainer, I’ve got news for you: you’ve got the worst of both words.
From a risk management perspective, the most essential difference between value pricing and hourly billing is the assignment of risk:
With value pricing, the service provider assumes the risk of working too much for a fixed price. With hourly billing the customer assumes the risk of the costs being more than were estimated.
At Tee Lex we believe that it’s up to us as subject matter experts to understand how much effort is required to provide our services, and offer our customers the security of a fixed, monthly price they can make part of their overhead.
But what if you’re hourly billing with a not-to-exceed ceiling? If you’re efficient and effective, you make less money. If things drag on, you end up working for free. It’s a lose-lose.
And if you do come in under on hours, do you really let them go? Or do you scrape up every hour from every intern and office manager in the place and make sure you come in just under? If you do this, then guess what, you’re already billing a fixed fee, might as well take the leap and try value pricing.
If you need help with pricing strategy in your business,
drop me a line at email@example.com