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The price of everything and the value of nothing

February 3, 2014

The price of everything and the value of nothing. This Oscar Wilde quote reflects much of today’s business environment, discount retailers have flooded the high-street, online models offer seductive pricing options and even some professional services firms are still cannibalising themselves by sticking to pricing based on hourly/daily rates or offering ‘free time’ to new clients.

I get frustrated when I examine an organisation’s lack of a coherent and intelligent pricing strategy, and just how often they lead their marketing with price. The very essence of Wilde’s quote is that its useless knowing the monetary price of something and yet not fully understanding its true non-monetary value to your customers.

A business is defined by the value it seeks to create for its customers, yet many businesses attempt to seduce and dazzle customers with headline discounts, seeking to mask the true price. Immediately they are undermining the value they are seeking to create – or don’t even attempt to articulate their value proposition in the first place.

Pricing strategy is built upon an understanding of external and internal business drivers of pricing – external includes customers, reputation, competition – all the components of market demand/supply; internal considerations include cost structure, capacity and capability.

Yet businesses struggle in developing a pricing strategy and opt for a play, which misses opportunity, due to their lack of insight into the drivers, and simply focus on ‘that’s the market price’. Many default to a pricing model based on an accounting principle known as cost plus – take all your costs (salaries + materials + overhead) and add your profit wish. Pretty simple. Pretty awful.

As a result, decisions are made at a transactional level and lose sight of the bigger picture. There are many reasons this occurs. Some firms have lost confidence in the value of their offer, while procurement departments have gained power and become increasingly effective at negotiating discounts. For some, unrealistic sales targets lead to aggressive pricing to achieve profit volumes, but this is ugly and hugely misses the point.

Conversely, It is my belief that you define your pricing strategy by whom you say no to. To put it another way, if you are not saying no on a regular basis then you are trying to be all things to all customers. Essentially, you do not have a pricing strategy with an articulated value proposition to a defined market of ‘ideal customers’.

I had a client recently that was growing rapidly, but pricing was out of control. The prices for their services were much lower for new business than in developed and retained customers. This was confusing their growth strategy, impacting profitability and having an adverse impact on marketing. They justified the lower prices as ‘to gain market share’.

For me, the company did not have a pricing strategy and lacked the processes for making decisions on a consistent basis to ensure success. The fear was that pricing and margins were unravelling. Top line revenue was growing, bottom line profit was growing, but profitability and customer based metrics were declining as growth measures.

We needed to embed a pricing strategy that would effectively achieve the organisation’s goals and make the link between value and price. If we didn’t the company had lost its ability to move the business strategically. It needed a framework to guide when to say ‘no’ and when to say ‘yes’ to new customers and to focus on strategic deals with ‘ideal customers’.

How did we get there? We threw away the old cost-plus pricing model and implemented a Value Pricing strategy. Value Pricing can be defined as the maximum amount a given client is willing to pay for a particular service, before the work begins. This is not to suggest we can capture 100% of maximum value, but rather that we have the potential to access some of it with strategic pricing.

It moves away from the hourly/daily-pricing model of many service based businesses. Time based billing, a form of cost-plus pricing, looks like this: Service-Cost-Price-Value-Client. Value pricing inverts this chain by recognising the economic fact that the client is the ultimate arbiter of value: Client-Value-Price-Cost-Service.

Value pricing turns the order of cost-plus pricing inside out. Firms that value price do not ask What prices do we need to cover our costs and earn a profit? Rather, they ask What costs can we afford to incur on this project given the price obtainable from the client and still earn an adequate profit?

Pricing should be a policy driven by strategy, yet in most firms prices are based on the costs incurred and not the value created. These firms have ample data on their costs, hours, activities, efforts and other inputs, but a paucity of information on the value they create for clients.

In firms that use value pricing, costs only determine if a service should be provided, and in what quantities. Costs do not play a role in determining external value to the customer, or setting prices (except as a minimum). Value pricing reverses what is now an artificial ceiling on firm income, inverting the ceiling into a floor.

For professional services firms, determining what to charge clients is done traditionally by estimating the hours to do a job and applying a billable rate. If you’ve estimated hours correctly and your billable rate properly this encompasses your costs and profit you achieve your business model.

It’s overhead recovery plus profit in manufacturing terms – the capacity of a factory, equates to the capacity of your people in a service business – how many hours have we got available to sell?

Under this model companies have a billing capacity, which is a formula to determine the revenue you can make in a year. Cost plus billing assumes staff time is the primary unit of value delivered to clients in the system. You can only bill as many hours as you have.

This means professional services firms can only ever add people or increase their charge rate to grow. This is a weak pricing strategy based on capacity not innovation, and creates a fear of growth as ‘we’ve got headcount to pay’.

But there is a fundamental issue here – there is very little relationship between the time you spend on projects and the value delivered – we can all see things that take very little time having a big impact on a client’s business.

Our business model wants projects to have more hours since we are financially motivated to do so. But we want to be a company that values being nimble and very efficient, and one based on relationships, not projects, with our clients. There is very little incentive to be ‘advisory’ when your business model is based on maximising hours billable.

There is a compelling argument as to why cost plus billing is not only wrong but also economically flawed. The biggest reason is that it misaligns the incentives for clients and the firm. In any system where hours are used to determine the price (cost) of work, its your incentive to convince your client it will take many hours and their incentive to convince you it won’t take that much. This is why price is always the stumbling block. If you are cost plus billing you are selling time – yet we didn’t get into this business to sell time. No one became a professional to sell time.

We do not sell hours here and clients will no longer be able to buy them from us. Fees charged are based on a fixed fee for an agreed assignment. The fee for an assignment varies according to the type of work, the length of the assignment and the people involved. We don’t quote hours, rather a fee for the project.

That’s a value pricing strategy. Your price speaks volumes about your value proposition, more so than any other component of your marketing. Pricing by the hour is simply the wrong way to measure the value created for the client.

Professionals undervalue their services because they are operating under the labour theory of value, which posits that the value of a service is determined by the amount of labour used in its production.  Conversely, professionals who subscribe to the subjective theory of value believe that the services they offer are only valuable to the extent that there is a potential buyer desiring them.

Value is in the eye of the beholder. For any transaction to take place, both the buyer and the seller must profit from the exchange and receive more value – in their subjective perception – than what they are giving up.

We should price our services according to the external value created, as perceived and determined by the client, rather than internal costs incurred in generating those services. Changing the pricing culture will not be easy. It requires confronting the inherent challenges involved with pricing. However, there are a number of strategic and tactical benefits:

– Value pricing comports with the laws of economics and consumer psychology, aligning the interests of the firm with those of the client. It manages, clarifies and offers the firm the ability to exceed client’s expectations.

– It pre-qualifies the client to ensure they are a good fit for the firm. It projects confidence and experience. It increases a client’s switching costs, increasing their loyalty and long-term profitability.

– It forces the firm to be effective in project management and to get the work done within the time promised to the client. It overcomes the client’s pricing emotions and ensures the client is engaged on a relationship with respect and value and collaboration as the bases for working together.

– It provides a competitive differentiation for your firm when you offer clients certainty in price and less risk of dealing with you. It specifies value-added services that can command a premium price. It uses price bundling, allowing the client to focus on the totality of the firm’s offering.

– There is nobility and self-respect in earning what you are worth. Yet if a firm’s leaders do not think it creates more value for its clients than is reflected by time-based billing, clients may never understand a value proposition beyond hourly/daily rates.

Time based billing is a risk-averse and simplistic tradition. We will be unable to adopt value pricing if we continue to denominate everything in hours, thus remaining mired in the mentality that you sell time. Now is the time to change your conversations with clients from hours/days to value.

Free markets tend to undermine themselves, as Marx identified, from the bottom upward – which is why we see a race to ‘cheapest price’.  Many business people are besotted by ‘market rates’, but as Economist Paul Krugman says, this is beauty clad in impressive mathematics for a convenient truth. Equally, opportunist pricing can make short-term gains, but don’t get too rosy eyed, market lovers can be easily bewitched, and scoundrels seeking easy exploitation ultimately fail.

Be intellectually curious and an expert in creating and capturing value for clients. Your firm will become obsessed with value, your clients will appreciate it, and they will not bother asking about time. I guarantee it.

So, the key considerations are:

Change the pricing culture in your firm from one that sells time to a value pricing firm that prices services according to the external value created for the client, rather than the internal costs incurred to generate the services.

Value pricing creates a better overall client experience because it improves communication between the firm and the client, offers certainty in pricing, and creates a service guarantee that allows the firm the chance to win back the client in the event of a problem.

Establish a pricing strategy and make it a core competency within the organisation. There’s a big difference between listening and waiting to talk. Most people do not listen with the intent to understand, rather they listen with the intent to reply. Whatever it takes? No, it takes whatever.

Price on purpose, create and capture value. What are you really selling, what are your customers really buying? A florist isn’t selling flowers, it’s selling love; Dulux don’t sell paint, they sell the colours of life; Harley Davison don’t sell motorbikes, they sell adventurous lifestyles. Software companies don’t sell technology, they sell innovation.

Many folks take a ‘case by case’ basis to pricing, and convince themselves ‘this is a big new client, it’s a valuable opportunity, we’ll reduce our price to win the job’. This is flawed, you’ve already fixed the commercial expectation. Instead, it’s all about respect yourself as a business and selling on value – dna people is not in the business of selling time. We sell momentum for your business. Do you want to haggle over hours, time and costs, or do you want the ideas that will give you innovation, growth and success?

A customer never buys a product, by definition the customer buys the satisfaction of a want, she buys value. Don’t get seduced by the numbers in articulating your value proposition – money is the applause.

Next week’s blog looks at value selling and implementing value pricing – it’s bout innovation, value creation and those critical customer conversations.

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