Value-based pricing is one of my favorite topics and I get lots of questions about it. I decided to compile all of them into this enormous FAQ.
This FAQ is huge, but not complete. Is your question not in the list? Ask in the comments section below and I’ll answer and probably add it to the FAQ.
Questions Answered in this FAQ
25 answers and counting:
- What is value-based pricing?
- Is value-based pricing difficult?
- Is value-based pricing the best way to price?
- When should I avoid value-based pricing?
- Why should I use value-based pricing?
- Is value-based pricing better than traditional hourly billing?
- Can anyone do value-based pricing?
- What do I need to use value-based pricing?
- Is there a method for value-based pricing?
- What are “price bundles” and “options” and how do I use them?
- How do I combine tiered pricing and value-based pricing?
- How do value-based pricing and marketing fit together?
- How do I use value-based pricing for short assignments and tasks?
- How do I price retainers using value-based pricing?
- How do I compete with firms that aggressively underbid me?
- Do I need to do something different to use value-based pricing?
- What are the risks of using value-based pricing?
- Isn’t value-based pricing just another term for charging the client a percentage of their revenue?
- Isn’t value-based pricing opportunistic?
- How do I explain value-based pricing to my client?
- Is a value-based price always higher than an hourly rate-based price?
- How do I know what my clients value?
- Why do so many recommend value-based pricing?
- Will I make more money by using value-based pricing?
- I don’t feel confident asking for this much money, what should I do?
What Is Value-Based Pricing?
“Value-based price (also value optimized pricing) is a pricing strategy which sets prices primarily, but not exclusively, according to the perceived or estimated value of a product or service to the customer rather than according to the cost of the product or historical prices. Where it is successfully used, it will improve profitability through generating higher prices without impacting greatly on sales volumes.” – Wikipedia
Value-Based Prices Are Set According to Buyer’s Perceived Value
The keyword here is “perceived.” This means that your ability to influence the buyer’s idea of value is considerable, sometimes even extreme. This is why value-based pricing is such an exciting topic. The things that eventually dictate a price are often intangible and have more to do with feelings, rather than facts.
Value-Based Prices Are Not Set According to Cost, Historical or Average Price
Many freelancers and agencies price based on cost, historical or average price. This is usually easy and can be a smart move in some circumstances. While cost shouldn’t influence a value-based price, it’s an important figure to estimate and calculate since your price needs to cover your costs.
Is Value-Based Pricing Difficult?
Value-Based Pricing is more difficult than many other forms of pricing. Still, I wouldn’t call it particularly difficult. Though it takes work. To be able to effectively price on value you must understand what is valuable to your clients. That, in turn, requires more work than the most common pricing methods.
Agencies and freelancers most commonly price either neutrally or cost-based. When pricing neutrally, you look at the competition and you set a similar price. When pricing on cost, you calculate the costs involved in producing the service and add a margin.
The easiest way to price is to charge as much as you can and what the market can bear for your segment. This is usually what you can do when charging by the hour and isn’t actively trying to differentiate yourself. For this, all you need to find out is what your competitors are charging on average.
Is Value-Based Pricing the Best Way to Price?
If what you sell is unique, potentially highly valuable and custom-made (which most services are) then value-based pricing is effective.
Using value-based pricing you can maximize value for you and the buyer. This might sound strange at first but makes total sense if you consider that value-based pricing is about capturing value. Applying value-based pricing will result in you creating even more value for your client in order to keep more for yourself.
When using cost-based pricing, there’s no direct incentive to create more value for the client since you won’t be getting any of it. Not directly anyway. You might think that the client might be more loyal to you when they realize how much value they’re getting at a bargain price. But not even that is certain.
Research into pricing psychology has shown that price is a strong psychological indicator of value. So the higher the price, the more valuable your work seems to the client.
When Should I Avoid Value-Based Pricing?
The only time I can think of is if what you sell is a fungible commodity. Such a good is something is so common that individual units can be easily used interchangeably. Any one of it will do. For example, 1 gram of gold is equal to any other gram of gold, regardless of where it was mined.
If your product is truly fungible and your strategy is to make a profit by selling volume, then value-based pricing won’t be of any use. You’d rather try to produce it at the lowest possible cost. Pursuing a low-cost structure is almost always a terrible way to run a business as it forces you to always consider cost over any other factor when making decisions.
Fungibility and going after a low-cost structure are almost never desirable when selling advanced services such as project management, branding, marketing, communication, development or design. These services can potentially create enormous value and savings for clients. You’d be daft not to want a cut of that. I strongly recommend freelancers and agencies to invest their time in learning value-based pricing.
Why Should I Use Value-Based Pricing?
You Will Earn More
You’ll earn more by getting a share of the whole value you produce, not a fixed hourly price based on an arbitrarily arrived-ad market rate.
You Create More Value for Your Clients
You’ll create more value for your clients by forcing yourself to focus on what they consider valuable.
Your Clients Will Be More Loyal and Refer Work to You
Once they realize the value you produce and your commitment to solving their problems, your clients will be loyal and speak well of which further strengthens your pricing power (ability to raise prices without losing customers).
You Will Run a Better Business
Once you get out of the trap of hourly billing, you will suddenly have much more freedom in designing your business and your life. For example, your employees will be able to work result-based, not being required to log at least 40 hours per week. That makes you a very attractive employer.
Is Value-Based Pricing Better Than Traditional Hourly Billing?
Yes, I believe that value-based pricing is better than hourly billing, provided:
- You honestly create more value this way by developing your services.
- You don’t overcomplicate pricing and you take care not to make your value-based price more complex than your hourly rate
Can Anyone Do Value-Based Pricing?
Yes, all it takes is learning a bit about pricing theory and psychology. Certain services and products are a better fit for value-based pricing. Any kind of advanced advisory service that is sold to other businesses (B2B) works well with value-based pricing.
The rule of thumb is, if your service or product helps other businesses make more money, then you can capture some of that value through value-based pricing.
What Do I Need to Use Value-Based Pricing?
- An honest estimation of the worth you bring your customers. This requires research into client gains, pains, and jobs-to-be-done.
- The confidence to ask the price you’re worth.
- The communication skills to explain your pricing in a way that conveys confidence and trust.
Is There a Method for Value-Based Pricing?
In his book Impact Pricing: Your Blueprint for Driving Profits, author Mark Stiving outlines this method to arrive at a value-based price:
“Here are the steps to value-based pricing:
- Identify your customer’s second-best option to your product.
- Determine the price of the second-best option.
- List your advantages and disadvantages relative to the second-best option.
- Estimate in dollars and cents the value of each advantage and disadvantage.
- Calculate your price.
Price of your product vs. the second-best option: + Value of advantages – Value of disadvantages Your calculated price”
As Stiving points out later in his text, this might sound easy in theory but rarely is in practice. Stiving’s method is also a better fit for products than services. For services, I recommend first understanding the differentiating qualities your services have and how these help solve your clients’ problems. The prices you arrive at should be displayed as bundles in tiers with options.
What Are “Price Bundles” and “Options” and How Do I Use Them?
“When a seller packages several products together and charges a total price less than the sum of the individual product prices, it is called price bundling .” – Hermann Simon in Confessions of the Pricing Man: How Price Affects Everything
Take Advantage of Different Willingness to Pay
Bundles offer an ingenious way to take advantage of that fact that different buyers have different willingness to pay. By breaking down your services into smaller parts, you can re-group them into bundles. Bundling works best if you understand the various segments of price sensitivity among your buyers.
Package Bundles Into Options
Bundles can further be packaged into options which can be used as tiers for tiered pricing. Options make it easier for buyers to choose and reduce buying friction. We’ve published an in-depth article on tiered pricing.
A word of caution: When bundling and tiered pricing are pursued too aggressively buyers might be turned away. Bundled pricing works because bundles are less transparent than individually priced items. Don’t use tiers as an excuse to be unreasonable and inflexible or acting immoral. In my view, the beauty of value-based pricing is that it helps to make a bigger pie for everyone to get a share of.
How Do I Combine Tiered Pricing and Value-Based Pricing?
Tiered pricing and value-based pricing are like coffee and chocolate: a match made in heaven. If you don’t know what I’m talking about, trying pouring hot espresso over straciatella ice cream. That’s the taste of tiered and value-based pricing working in unison!
In most cases, you simply price your tiers based on how the features or bundles in included those tiers provide value to your client. This can vary greatly, why there are no standard prices nor standard tiers. Customize each proposal to the specific buyer.
To learn more about this, read our article about tiered pricing.
How Do Value-Based Pricing and Marketing Fit Together?
Value-based pricing is based on your knowledge about your customers. Those are the same insights that drive your marketing strategy. When I say marketing, I don’t refer to advertising. I am talking about the marketing that is tightly coupled to your business module and identifies who your primary buyers are and what value you provide to them.
The business model canvas is a great tool to analyze your business model and your value propositions. Your value propositions are your main differentiators and the reasons why customers are choosing you over others. In other words, having a unique value proposition is one of the ways to avoid becoming fungible and commoditized (easily replaceable by any other agency or freelancer in your niche).
Effective value-based pricing for professional services is dependent on marketing insights to be effective.
How Do I Use Value-Based Pricing for Short Assignments and Tasks?
Good question! This is one of the trickiest situations for value-based pricing. Even though you may have agreed on a fixed value-based price with a client for a well-defined project or service, there might be needs for add-ons. It’s easy to fall back to hourly pricing in these situations and simply bill for the time spent. But there are better ways.
In his book “Implementing Value Pricing,” author Ron Baker gives the advice to use change orders when doing work in addition to a previously specified and priced assignment. Baker advises consultants to ask the client “What is my budget for this?” to get an indication of price for the change. He also notes that change orders usually have to do with wants, and buyers are typically less price sensitive when it comes to that.
Let me know in the comments if this is something you’d like to learn more about and I might write a post about it.
How Do I Price Retainers Using Value-Based Pricing?
Pricing retainers work very similar to how you’d price a proposal: in tiers, with prices based on the value the customer receives. Instead of each tier corresponding to a set of deliverables, it will correspond to a package that includes a set of services.
You can vary the billing period and a number of other factors in your retainer tiers such as:
- The specific services included in each tier.
- Your response time.
- What times you are available for phone calls.
- The channels that are available for contacting you.
- How many support issues that are included (with a “reasonable use” clause you get around the problem with unreasonably complex requests).
- Order-to-service turnaround time – pay more for express treatment.
- The amount of work included. In the example below, an arbitrary unit called points is used to avoid hours. You’d typically estimate the work in advance so the client knows how many points are left.
- Discounts on spin-off projects that aren’t part of the retainer but are ordered while the client has an active retainer.
I’m not going to dig further into the details here since this is an FAQ on value-based pricing. If this is something that interests you, I recommend signing up for our newsletter as I will write more about retainers in the future.
How Do I Compete With Firms That Aggressively Underbid Me?
Smart businesses know the cost of competing with price. It means remorseless cutting of all costs and emulating the cost structure of the underbidder. Since many underbidding agencies use offshore professionals, competing on price will mean relocating. For many, not a fun way to go.
Other business owners choose a different strategy to deal with those that undercut their prices. They understand that they do offer value to their clients. That’s why they have been able to build a business in the first place. They focus their energy on understanding what their unique differentiator is and find ways to make it very hard to emulate. Lacking a differentiator, they create one.
Truth is sellers care more about price than buyers do. If you lose a deal, it’s usually not because of the price (unless the difference between you and the winner was enormous). We buy with our guts and then justify it logically. Value-based pricing coupled with a value-confirming culture and brand will be your best weapons against those that compete on price alone.
This is a topic that we will revisit in the future so be sure to sign up to the newsletter not to miss it.
Do I Need to Do Something Different to Use Value-Based Pricing?
In a nutshell, and as per Stiving’s method above, value-based pricing is about figuring out what value the client sees in the things that make you unique.
In practice, value-based pricing requires looking at your business from the outside. Looking at it with the buyer’s eyes, you must determine what things you do that communicate value, and which deter from it. Anything that undermines a sense of value or trust must be removed or modified. This means that may have to redesign your website and start sending flowers and thank you notes. The things that are involved may seem small and insignificant. But humans aren’t known for being rational.
Whether you manage to come off as inherently more valuable than the competition is for the buyer to decide. Influencing those decisions don’t necessarily cost a lot of money, but it requires commitment and consistency over time.
What Are the Risks of Using Value-Based Pricing?
In his book Impact Pricing: Your Blueprint for Driving Profits, author Mark Stiving retells the following story:
“Fair is in the mind of the beholder. Put yourself in your customers’ shoes and ask how you would feel facing the prices that your company uses. If you would feel cheated, so would they. I was working with a couple of consultants who had the right idea but the wrong implementation. Before I ever talked with them, they knew they wanted to price their projects based on how much value their customers would receive. Every customer, every project could have a different price. Bravo! Then they described their implementation. ‘When a potential customer asks how much we charge, we tell them we have to determine how much value we can provide before quoting a price.’ Put yourself in their customer’s shoes. They just told you that they are going to do their best to charge you as much as possible.”
Stiving’s conclusion is that a better pricing policy would be:
“We charge $500 as an hourly rate. For large projects we are willing to make a fixed bid proposal by estimating the amount of time required and multiplying that times a lower hourly rate of $400. However, if in the bidding process we find we cannot add as much value to you as we normally do, we may use an even lower rate. We want to make sure you receive far more value than your costs.”
This solution will feel fair to the customer.
Why Profit-Sharing Models Are a Bad Idea
The same applies to all profit-sharing pricing models that involve divvying up the benefits resulting from for example consulting work. These usually involve analyzing the client’s accounting to determine the turnover resulting from your work and extracting a percentage of it. Such ideas might look good on paper. After all, the model is sound, you both get a share of the value created. But they don’t work so well in practice and can lead to much resentment. The only way I could see them work would be if you can pool the profits in a jointly owned corporation or similar.
Consultant Alan Weiss also recommends against using such methods and urges consultants to charge a fixed price that is contingent on goals that are defined together with the client. The idea is that once you’ve achieved such results, the client won’t regret paying you the promised contingent price. You can then decide to break it down to a default price and a performance-contingent part that pays out when certain goals are reached.
Isn’t Value-Based Pricing Just Another Term for Charging the Client a Percentage of Their Revenue?
No, not necessarily. There are several ways to use value-based pricing. See the previous question.
Isn’t Value-Based Pricing Opportunistic?
To some, it may seem that way. I’ve met many. They say they’re earning a good salary from a charging a fixed hourly rate. They feel that charging for value means taking advantage of a perceived position of power. I think people arguing that have misunderstood what value-based pricing is about. Done right, value-based pricing will benefit the buyer and seller alike. It’s a way to split the value created, or avoid wasting time on activities that do not yield any value.
Those who raise these arguments also often fail to remember that hourly pricing is in many cases deeply unfair to the buyer. How many times hasn’t a web developer charged a client for setting up a deployment script that benefits all the developer’s clients? How many times have clients paid for an agency’s employees to learn on billable time?
With value-based pricing, only value-creating activities are paid for, which in the end is fairer to seller and buyer.
How Do I Explain Value-Based Pricing to My Client?
To buyers who have been taught to expect the billable hour, value-based pricing may indeed seem strange. But recall that it was us, consultants and agencies, that trained our clients to pay for our time.
“The first person to introduce the idea of the billable hour and recording time was Reginald Heber Smith, a lawyer and author of Law Office Organization, published in 1943. This book was actually a series of four articles published in the ABA Journal from May to August 1940 (written by Smith during his Christmas vacation in 1939). They were so popular they were reprinted in pamphlet form in 1943, with continued printings up to 1983 by the Economics of Law Practice Section (ELPS) of the American Bar Association.” – Source: Implementing Value Pricing by Ron Baker
Now it’s time to reverse what Reginal Heber Smith began in 1943.
Value-Based Pricing Is Easier to Understand than Hourly Rates
Value-based prices are in fact easier to understand than those based on hourly rates. When you use hourly rates the buyer is expected to be able to comprehend the duration of the work needed. Everything is an estimate. You may provide a plan with work items but the final price is dependent on the time it takes to build these features. That is usually not something the buyer can estimate or exercise much control over.
You See What You Get
With value-based prices, it’s all much less obscure. The buyer sees what they get and the price. It’s just like walking into a store and buying a pair of jeans. You see the clothes and the price is right there on the price tag. There’s no uncertainty as to how much this will cost in the end. What they get is clearly described and so is the price. You will already have included a risk factor for overruns when setting your price so the buyer doesn’t need to worry about it. This is an immense reduction in uncertainty for the buyer.
As for the explanation, you simply don’t mention value-based prices at all. What I usually say is “I use fixed pricing for all my work with well-specified deliverables. Any changes and additions are priced individually and in addition to this.”
Is a Value-Based Price Always Higher Than an Hourly Rate-Based Price?
This is is the beauty of value-based pricing. It forces you to only do work that benefits the client and creates value. Many agencies have very foggy ideas about the client-value of much of the work they do. Value-based pricing shines a much-needed light in the proverbial fog and exposes activities that aren’t value-creating.
Since each piece of work is priced individually, the client can’t take it apart to try and get a “discount by dissection.” This also means that you’re in a position to help them make better decisions.
Imagine your client asks for a button in the checkout flow of the e-commerce store. You do the math and realize that the value of that button is probably around $800 but you can’t do it for less than $1,200. If you’re an honest practitioner of value-based pricing you inform the client. You then use the opportunity to suggest something else they can do that will yield the desired result.
How Do I Know What My Clients Value?
That’s the million dollar question.
There are also pricing consultants who can, usually for a hefty fee, perform anonymous surveys to map the so-called “price elasticity” for your service (see below). You can use this information to judge the price-sensitivity of your market and to determine your ideal price, or a create price segmentation strategy.
Price Elasticity and Price Segmentation
In pricing, there’s a concept called “elasticity.” A product with high price elasticity is one where a small change in price has a high impact on demand. Elasticity is said to be low when the opposite is true,
Price elasticity is usually illustrated as a demand curve with the price on one axis and quantity sold on the other. The curve visualizes the idea that if I sell something a higher pricer, I sell fewer units but earn more per unit. If I sell something at a lower price I sell more units but earn less per unit.
As long as you only sell your product or service at one price, you need to figure out where on this curve to put your price to maximize profit. In some cases, it’s easy – such as when the elasticity is unitary.
But in many cases, it’s not. To address this, many companies try to sell to customers who aren’t very price-sensitive as well as to those who are. Luxury clothes brands can do this by setting up a chain of outlet stores. Many do this as a way to access a wider market than the highly profitable, yet small, luxury consumer market.
Here’s a longer explanation of PED, or price elasticity of demand as economists refer to it as.
I will dig more into this in the future and discuss pricing at depth. If that sounds interesting, sign up for our newsletter.
Price Elasticity and Value-Based Pricing
Returning to your situation as a freelancer or agency owner, when using hourly rates you cannot take advantage of the price elasticity of your service. You need to put your standard hourly rate (that everyone pays) price where the volume is the highest (the blue box the biggest).
With value-based pricing, you circumvent this problem entirely. Every pricer’s dream is to give each person a unique price, tailored to their price-sensitivity. With value-based pricing, you can do exactly that!
By doing some research you will start to form an impression of your clients’ problems and what they value. If you’re lucky this will lead to some very concrete suggestions such as higher availability, faster turnaround time and access to more services that you can look into offering as well.
It may also turn out that your existing clients belong to the price-sensitive market segment. If so, they will not respond to value-creating activities since they will only chase low prices. These are quite ungrateful clients to keep. Many freelancers start with clients such as these and “grow out of them.” They are often hard to develop and don’t respond to sales conversations that build visions and discuss potential. However, in order to reach the clients that are less price-sensitive, you need to change how you market and sell your services.
Why Do So Many Recommend Value-Based Pricing?
I think there are many reasons:
It’s an Antidote to Price Undercutting
Value-based pricing is by many seen as an antidote to offshore agencies that undercut hourly rates. This is thanks to how value-based fixed prices are much harder to compare than just matching one hourly rate with another.
It Helps Agencies and Freelancers Play on Their Strengths
Value-based pricing gives an agency or freelancer a chance to emphasize their differentiating skills or competencies. Those are the things that make them uniquely great and which are very hard to emulate. It also allows agencies to brand themselves for even more effective marketing.
It Encourages Agencies and Freelancers to Make Great Work
Value-based pricing encourages sellers to create even more value for the buyer as they will gain a share of it. Once this becomes a part of an agency’s culture, the impact is massive. Every client encounter will center around how the agency can create even more value for them. This is an upward spiral and positive feedback loop as these interactions further strengthen client loyalty.
Will I Make More Money by Using Value-Based Pricing?
That depends on whether you manage to create more client value. Speaking generally, if you keep doing what you do now, you’ll likely earn a bit more. To increase earnings by 50% or more, you probably need to change how you work and market yourself and try to understand your clients’ situation better.
I Don’t Feel Confident Asking for This Much Money, What Should I Do?
This is a common challenge for those adopting value-based pricing. There’s no simple solution. Confidence isn’t built overnight but there are some things you can remind yourself of what will help:
- “I know that I can deliver this value to the client.”
- “I know that this is fairer than an hourly price.”
- “I know that this will shift focus to creating things that will help the client, rather than just help me bill more.”
Value-based pricing is in the client’s interest as well as yours.
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