Value-based pricing is often touted as the saviour to professional services firms and their profitability woes. It is often misunderstood, or positioned, as a holy grail. But the truth is, value pricing is often executed poorly and doesn’t work at most businesses – and in some instances, it’s actually hurting them.
In my 15 years in the field, here’s what I’ve noticed: many businesses aren’t good enough at, or thorough enough about, basic operations. I’m not even addressing sales and sales systems yet; I’m just talking about the execution of the non-creative basics: scoping the work, setting and managing project budgets, and reverse-engineering and achieving desired hourly rates.
In addition, most firms aren’t true experts in a narrow niche, a desirability factor that is effectively a requirement of value pricing. Only once the company figures these elements out – and, if we’re honest, only once they are operating consistently above the agency average of 13%-15% margins, preferably at 20%+ EBITDA margins – should they even try a value-based pricing model.
Let me start with a couple of examples, and show you a better way to more consistent and reliable profitability.
Definition of Value-Based Pricing
Value-based pricing is a pricing strategy where, in the professional services world, the product or service we provide is priced based on the perceived value it offers to the client, rather than our cost to produce it.
How Most Businesses Screw Up Value-Based Pricing
Most businesses under-plan because most of us are creative people at heart, and want to jump ahead to the fun part: making stuff. That often translates to “value-based pricing” trainwrecks like the following:
“The client wants a new website. It’s sounds pretty simple. I feel like the value of it is $20,000 so I told them we’d do it for that.” The project gets passed over to a team, who doesn’t set an internal budget, manage or track any time. The project turns out to have e-commerce requirements, API integrations, a ton of internal red tape and meeting time, and so on. Overall, the “simple web project with a value of $20k” ends up costing the agency money, since they didn’t put in any work to scope it, manage it, or understand desired outcomes.
Sound familiar? Here’s the thing: this isn’t value-based pricing, but it’s what passes for value pricing at countless firms.
Value-based pricing isn’t gut-feel. It isn’t lazy. It isn’t a shortcut around business development or other types of work. We can’t just throw a number out that “feels right” – which, unfortunately, is often what I’ve seen pass for value-pricing in our world. Businesses still need to understand the value of the work to the client, uncover the expectations, estimate the effort, and base that on a real comprehension of how they’re going to deliver the results. Without that? You’re just guessing. You’re flying in the dark, with no idea if you’re going to at least make back your costs.
That means agency owners need to:
- Know their macro figures: their desired hourly rate and realistic utilization rate, which should trickle down from desired revenue, profits, and team size. These are simple enough to reverse-engineer.
- Have a realistic grasp of what the value actually is to the client – often a huge gap in value pricing.
- Understand and communicate how the team is going to deliver the work at the price they’re pitching, and how long it’s going to take you with those tools. That means a plan, a scope, hard cost estimates, and time estimates based on the tools, approach, and assumptions (e.g. hand-coded custom site vs. customized template, AI copy vs. copywriter, and so forth).
- Set those budgets and track the time and expenses to know if the firm made any money.
I know, tracking time and hourly rates. That’s heathen talk around these parts, but it’s how my firm operated at 20%+ margins for well over a decade.
A Value-Based Pricing Example: How is Supposed to Work
Let’s be clear: I’m not anti-value pricing. I’m anti-lazy execution and shortcuts, which poorly executed value pricing practices have in spades. Here’s a hypothetical showing how value-based pricing can work:
You are an experienced freelance web designer/developer who can get a small one-pager, customized website template up and approved for a small accounting firm in 1 day, or 7 hours of work. You aim to make $140k a year, which equates to about $130/hr at 65% billable over 48 work weeks. At 7 hours and $130/hr, you could charge $910. However, given the speed you can get the work done and the value of having a search-friendly, elegant, fast-loading site up, and the fact that the accounting firm charges $250 per hour, you decide to charge $5000 (or 20 hours of their time). This price reflects the value of your efficiency and the client’s potential savings compared to hiring a slower agency, and is based on what they’d need to bill to earn back the cost.
Here’s another hypothetical in how value-based pricing should work in a larger digital agency setting:
You’re a large agency running a campaign for the provincial/state government to increase the migration figures of folks to the province. You know that the average annual tax revenue per person is about $4,700. In order for this to work, the campaign needs to be a multi-channel campaign that very few competing firms have the personnel to deliver on. Based on the scope of work and effort required, you estimate the six-month campaign will take an average of 100 hours a week to deliver on, and at your hourly rate of $150 plus hard costs, the fees would total just over $750k. However, goals/estimates for the campaign are 25k net new residents, which equates to $117.5M in new tax revenue. Knowing that, you position the campaign at a total cost of $1,175,000, or 1% of the estimated new tax revenue – then set a budget with a healthy contingency so as to ensure strong profits. This pricing reflects the substantial value of the campaign relative to the expected benefits.
The above make sense, and assuming the freelancer or firm still sets budgets and manages projects competently to ensure profitability, are good examples of how value-based pricing can be deployed.
A Consistently Profitable Alternative to Value Pricing
The truth is, most businesses who experiment with value-based pricing have a haphazard approach that’s hindering their firm. If your business falls in that camp, you’d be better off ditching that approach, and focusing instead on nailing tried-and-true operational foundations. They might be less exciting than the promises of value-based pricing, but if you consistently execute on them, you’ll be consistently, predictably profitable.
In my experience, those operational foundations include:
- setting an hourly rate with a healthy margin
- finding a niche, either narrow-horizontal or vertical, and developing efficiencies in operations so as to speed up delivery
- doing a paid Discovery with the client to understand what the true scope of work is and what will be most valuable
- estimating the scope of work thoroughly, including assumptions and how your firm will deliver
- adding a 20% contingency to the estimate
- doing a fixed price contract with scope-management clauses, which they actually act on
- having skilled project managers who: are on top of the project; can have tough conversations with clients; deploy budget to the team in phases; and the like.
Once these processes are reliably in place and you’re consistently achieving 20% EBITDA margins, experimenting with value-based pricing might be worthwhile. Just make sure to approach it with the thoroughness and detail it demands.