I’m a big fan of value-based pricing. It encourages collaboration and a win-win approach to making business. There are, however, ways of using it that you should avoid.
There seems to be a common yet mistaken assumption that value-based pricing benefits the seller the most. The truth of the matter is, you can’t implement value-based pricing without first delivering the value you intend to sell. If you apply value-based pricing to an existing offer without changing anything except price, you will likely fail. Done right, value-based pricing is a win-win and non-zero sum game in which more value is created and shared. In other terms, the cake grows bigger when all parties strive to increase value. Projects that focus on value create more value for everyone involved.
Many who try to implement value-based pricing make the mistake of looking for a value-based equivalent to the billable hour. While there have been attempts, there is no clear value-based equivalent to dividing work into hours spent. The idea that you can divide work into hours is a delusion, however practical it may seem.
This fact is famously demonstrated by the classic parable about the specialist who was contracted to fix a costly engine at a factory. He walked around for one hour listening to the malfunctioning piece of machinery. Then he took a wrench and whacked the engine in four specific places and voilà, it worked again. He then sent an invoice to the factory manager at the total amount of 10,000 dollars. The manager was upset over how something so “small” could cost so much and asked for a specification. The specialist returned with “Figuring out where to whack: $9,995, whacking engine: $5.”
Despite this, many find comfort in the concept of hourly billing. It’s a part of work culture and our idea of what work is. Hourly billing has been serviceable and worked well enough. It worked decently as long as labor was a commodity. One worker on the production line could replace another without any significant difference in output.
That’s not true anymore for many different professions. Specialists in IT and management consulting aren’t just putting in hours at the conveyor belt, contributing incrementally. We’ve all heard the term “10x developer.” It’s not hyperbole. Certain specialists create multiples of increased productivity and output. We need to capture this value in a way that is fair to buyers and sellers and promotes healthy competition.
It’s clear that replacing the billable hour with an equally misleading pricing model won’t do us any good. Out of all the ways for accomplishing this, there are two pricing models you should avoid.
Shared Risk and Reward With Share Compensation or Contingency Pricing
This model is what comes to mind for many when they hear the term value-based pricing. I can’t count the times I’ve mentioned value-based pricing, and the person across from me asked: “so you take a share of the client’s earnings?”.
That is indeed this model in a nutshell. The basic idea is that you both take a share of the benefits created. In the world of legal practice, this is known as contingency pricing. It’s not looked on favorably everywhere due to how it affects incentives and can under certain circumstances hurt the interests of the client. Even so, the idea isn’t technically wrong. By sharing profit, you can also share risk.
The problem with this model is that you can’t tell the future. Or, put differently, you cannot predict the exact effects of an effort. Nor can you safely exclude other contributing factors. This lack of clarity can quickly lead to conflicts down the road. The client won’t accept that you added as much to the gain as you insist. There is also the risk of the client refusing to pay even when the cause-and-effect is clear as day.
Such conflict can lead to having to take clients to the court which is time-consuming and frustrating. It takes away focus from creating value for other clients and getting more work. It also means that you need to ensure your contract is watertight which involves engaging the services of a lawyer specializing in contract law. Not a cheap endeavor.
Furthermore, many clients aren’t prepared to work this way. Pitched and sold to the wrong way, the client will get the impression that you’re trying to overcharge for your regular services. That will cause harm to the trust you’ve built. You should never attempt this applying pricing model until you have a dialog about pricing and there’s agreement on a clear, measurable and valuable end-result.
This model can work for some consultants and clients with whom they already have a strong and relationship and deep trust. Not every consultant has that and that’s why I recommend consultants and agencies not to try this model.
Pricing by Milestone Using Result-Based Pricing
This model is similar to contingency pricing and sometimes goes under the term performance pricing. It is based on the fulfillment of conditions rather than shares in results. When using this model, you define one or multiple targets tied to specific results and attach fixed fees to them. Many influential consultants, such as Alan Weiss who has written many books about “value-based fees,” recommend this model.
This model suffers the same predictability problem as the previous one. In addition, for this to work:
- The client needs to admit to a problem,
- There must a shared idea of a desired scenario,
- And goal fulfillment can be measured objectively.
That’s no easy feat. It requires kick-ass sales skills, to be frank. I’ve met very few sales people in the world of agencies and consulting that can do this.
In my view, author and consultant Gerald Weinberg hits the nail on the head 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 first, it’s always a people problem.
The Third Law of Consulting:
Never forget they’re paying you by the hour, not by the solution.
and:
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.
From The Secrets of Consulting by Gerald Weinberg
While this is quite cynical, most of us would have to agree that Weinberg has a point. The clients that can point out a problem, or admit to having one and asking you to identify it, and then define success criteria together with you are rare.
In his books, Alan Weiss describes conversation techniques that help encourage clients to define a problem for you both to arrive at a shared definition. This technique isn’t as easy as it might sound, may require a lot of work and a skilled dialog-oriented salesperson to work.
Another drawback of this model is that it requires the consultant to make realistic estimates of expected costs in achieving the goal. Such cost estimation is a learned skill and the result of experience. Beginning consultants will underestimate costs and end up paying more than they earn in the end.
If you’re skilled in sales techniques, are good at establishing trust and building rapport, this might work for you. However, most of us aren’t and should consider a third model.
Focus on Outcomes With a Value-Based Fixed Price
This is the model I recommend to most who want to try applying value-based pricing. It involves working with a fixed price and a fixed project definition that emphasizes value and gains but makes no promises regarding outcomes.
This model revolves around selling your services based on value using value-based selling techniques. You define the work in clear packages with fixed prices which are sold in tiers reflecting the value they provide.
To do this successfully, you need to talk to the customer about value rather than product properties. Many salespeople are comfortable talking about what their product or service does but they rarely connect it to client needs. A value-selling conversation needs to be driven by genuine, not rhetorical, questions.
A seller who asks questions and is a good listener, rather than someone making statement after statement, will be viewed quite differently by the buyer. They won’t associate them with the pushy vacuum cleaner salesman known to knock on their door once per year. Most importantly, they won’t feel like they’re being sold to. Such a salesperson will be viewed as an advisor and given the trust fitting someone in that role.
This technique lets you ask questions to steer the conversation to be about what the client tries to accomplish and how your service or product can be a part of it. A conversation of that kind increases the chances that the buyer will see the value of what you’re offering.
I will return to value-based sales techniques and get more specific about leading conversations by asking the right questions in future posts. Subscribe to our newsletter to avoid missing out.
Value-Based Pricing Affects the Entire Company
I wrote earlier that value-based pricing isn’t just about increased profit for the seller. Value-based pricing is about capturing the value you create. That doesn’t happen by driving in the same old ruts and only considering one’s product and operations, not viewing it from the customer’s point of view. You can’t deliver what the client wants without insights into what the customer values and then using the right method to provide precisely that. This effort doesn’t just affect your market research but the entire organization. “Shared vision” and “increased transparency” aren’t just words. They help create the alignment and trust needed for the whole organization to work customer-oriented.
Use of Language and Terminology
In Swedish we have a saying that goes “talk to farmers in the way of farmers.” In other words, talk to your customers in a way that makes sense to them. Do not hide behind complicated terms or making things seem more complicated than they are. That doesn’t mean downplaying your own competence. It means making it understandable.
Value Arises From Applicability and Use
You need to shift focus from technical requirements to the problems that you’re solving for the client. It’s when the solutions you’ve helped devise and design are used to solve those problems that real value is created.
Orienting Your Business Around the Client’s Needs, Not the Other Way Around
Your processes and ways of working need to be customer-centric. Many companies are self-centric, i.e. making it easier for themselves and not their customers. I have a personal story that is an excellent example of the self-centric mindset at work.
I once emailed an e-commerce company about how to return a product. Instead of asking why I was unhappy, seeking understanding, they wrote: “This is our return policy which I have copied from our website.” They were arrogantly implying that I should have found it there instead of bothering them by emailing and asking. “RepeatCustomers–“ as a programmer would have said.
Communicating Your Value Through Behavior and Actions
You cannot charge for something that isn’t there. Value is very much about perceptions, and those are primarily formed based on what we do, not what we say.
In the (highly recommended) book “Never Split the Difference,” author Chris Voss refers to the research of UCLA professor of psychology Albert Mehrabian who famously formulated the 7-38-55 rule. As Voss explains it: “That is, only 7 percent of a message is based on the words while 38 percent comes from the tone of voice and 55 percent from the speaker’s body language and face.”
In other words, how we behave during meetings, the tone of voice we use when we answer the phone and what words we use in emails affect our pricing power.
In the End, It’s All About Gut Feel
Old wisdom in selling is that emotions guide our decisions and that logic is used to justify them to others. Your clients will not be swayed by facts, regardless of how accurate they are. I’ve experienced this first-hand many times. It inspired me to write a recent post about credence goods. Over the years I’ve seen customers face a range of doubts and fears and I’ve learned to help them overcome them.
The chief insight is that the reasons we have for our willingness to buy are often hard to put into words. Smart salespeople know this, and that logical arguments don’t win work. A perceived sense of value and a strong positive gut feeling do.
This post is based on a blog post I wrote in 2016:
How close are you to start using value-based pricing?
Please post a comment. I read all the comments.
Photo Credits
