Pricing on Purpose: How to Implement Value Pricing in Your Firm, Part 1
In this first of a three-part article, Ronald Baker challenges professionals to rethink how they market and price professional services. He reminds us that â€ś[c]ustomers buy value, not hours.â€ť Many practitioners and firms are locked into the current pricing myopia of hourly billing, which prevents professionals from getting paid what their customers believe they are worth. In this first article, Mr. Baker offers some compelling reasons why professionals should make the switch from hourly billing to value pricing.
Price is what you pay. Value is what you get.
You are what you charge for. Indeed, a business is defined by little else. I believe our current pricing myopia is inflicting damage on the profession, worldwide. We seem to believe that we are defined by our “hourly rates.”
Professionals around the world blame “price” for a lot of their problemsâ€”losing customers, not winning that request for proposal, slow payment, customer complaints, services becoming commoditized, etc.
I am convinced that blaming our problems on “It was our price,” has become the biggest excuseâ€”perhaps white lie is a better phraseâ€”of professionals today. Simply put, the conventional wisdom is more conventional than wisdom.
In their award-winning article, “How to Lose Clients Without Really Trying” published in the Journal of Accountancy, August J. Aquila and Allan D. Koltin surveyed thousands of customers who had defected from their accounting firm. Here are the top seven reasons cited by business owners for leaving Â their Certified Public Accountant (the reasons given may apply to other professional organizations):
- “My accountant just doesn’t treat me right” (two-thirds of the answers)
- CPAs ignore clients
- CPAs fail to cooperate
- CPAs let partner contact lapse
- CPAS donâ€™t keep clients informed
- CPAs assume clients are technicians
- CPAS use clients as a training ground [for new team members]Â
What about the opposite side of the same coinâ€“â€“that is, what characteristics do customers use to select an accountant? According to William J. Winston in Marketing for CPAs, Accountants, and Tax Professionals:
- Interpersonal skills
- Interest in the customer
- Ability to explain procedures in terms the customer can understand
- Willingness to give advice
- Perceived honesty
What is conspicuously missing from these surveys? Price. It doesn’t even show up.
Most defections from most professional firms are the result of human failings, poor service quality, and perceptions of indifference rather than price or technical quality. It is how people are treatedâ€”or mistreatedâ€”that determines their willingness to remain loyal.
Why Are We In Business?
When leaders in our seminars are asked why they are in business, more than 75 percent answer: â€śTo make a profit.â€ť
Yet is the answer really that simple?
We must distinguish between the purpose of a business with its goal. Profit is a lagging indicator of customer behavior. The real results of any organization take place in the hearts and minds of its customers because they have to earn a profit as well.
Economists use a different definition of profit from that of the typical accounting financial statement. They consider both parties to a transaction, because both parties must receive more value than each is giving up; otherwise, no transaction would be consummated in the first place.
United States Representative Samuel Barrett Pettengill [1886â€“1974] gave an excellent definition of profit from an economistâ€™s perspective:
The successful producer of an article sells it for more than it costs him to make, and thatâ€™s his profit. But the customer buys it only because itâ€™s worth more to her than she pays for it, and thatâ€™s her profit. No one can long make a profit producing anything unless the customer makes a profit using it.
The Marketing Concept
Peter Drucker explained the same idea by what he termed the marketing concept, in the early 1960s. The purpose of any organizationâ€”from a governmental agency or nonprofit foundation, to a church or a corporationâ€”exists to create results outside of itself. The result of a school is an educated student, as is a cured patient for a hospital, or a saved soul for a church. A business exists to create wealth for its customers.
The only thing that exists insideÂ a business are costs, activities, efforts, problems, mediocrity, friction, politics, crises, and a grapevine. Yet, customers are indifferent to the internal workings of your firm.
Nobody wants to hear about the labor painsâ€”they want to see the baby. Any firm has to understand what customers truly value, since all economic value is in the eye of the beholder.
A Tale of Two Theories
In his writings from the 1800s, Karl Marx posited a definition of value that has been subsequently called the labor theory of value: In its simplest form it says that the price of an item is solely determined by the amount of labor used in its production.
If Marxâ€™s theory was correct, a rock found next to a diamond in a mine would be of equal value, since each took the same amount of labor hours to locate and extract. Yet, how many rocks do you see in the local mallâ€™s jewelry store? If you were to have pizza for lunch today, under Marxâ€™s theory, your tenth slice would be just as valuable as your first, since each took the same amount of labor hours to produce.Â
The Marginalist Revolution of 1871
Fortunately, three economists refuted Marxâ€™s theory and developed the theory of marginalism: William Stanley Jevons [1835â€“1882], Leon Walras [1834â€“1910], and Carl Menger [1840â€“1921].
What made this new theory so revolutionary? As Carl Menger explains in his book Principles of Economics, written in 1873:
Value isâ€¦nothing inherent in goods, no property of them. Value is a judgment economizing men make about the importance of the goods at their disposal for the maintenance of their lives and well-being. Hence value does not exist outside the consciousness of menâ€¦[T]he value of goodsâ€¦is entirely subjective in nature.â€ť
The value of goods arises from their relationship to our needs, and is not inherent in the goods themselves.
In other words, value is like beautyâ€”it is in the eye of the beholder. This theory has enormous explanatory and predictive capabilities because it explains how people buy things. Marx would say pearls have value because people dive for them (thus supplying labor). Menger would retort that people dive for pearls because other people value them.
Cause and effect is confused constantly on this principle. I remember taking a wine tour of Far Niente in Napa where the guide was explaining how one particular vintage had to be bottled by hand, which was why it was more expensiveâ€”due to the extra labor this entailed.
I could not help thinking of the Marginalists, who would retort, â€śNo, you are willing to invest in the labor necessary to bottle the wine by hand because some customers find it valuable (and delicious!) enough to cover the extra labor costs.â€ť
Until Next Time
No matter how far you have gone on the wrong road, turn back.
The above Turkish Â proverb contains sage advice, and I truly believe the professions have gone down the wrong road in the past 100 years by utilizing hourly billing. Although it certainly is a simple pricing policy to maintainâ€”not requiring much thought or creativityâ€”the downside is enormous. It is preventing members of the professions from getting paid what its customers already believe they are worth.
It is an idea for which the French have the perfect expression: â€śausse idee claireâ€ťâ€”a terrific idea that doesn’t work. For a summary of the disadvantages of hourly billing versus the advantages of Value Pricing, see Exhibits 1 and 2.
In part two of this series, Ronald J. Baker will explain more about value pricing, establishing a value council, and appointing a chief value officer.
Ronald J. Baker is a frequent speaker, writer, and educator. His work takes him around the world. In addition, he has been an instructor with the California CPA Education Foundation since 1995 and has authored fifteen courses. Mr. Baker is also a prolific writer and thought leader; his most recent publication is Implementing Value Pricing: A Radical Business Model for Professional Firms (John Wiley & Sons, Inc.). Mr. Baker can be reached at (707) 769-0965 or by e-mail at email@example.com.
Exhibit 1: Disadvantages of Hourly BillingÂ
- Hourly billing misaligns the interest of the professional and the customerâ€“â€“the customer wants their work done effectively, whereas the firm wants to log more hours.
- It does not focus on what customers buy. Customers buy value, not hours.
- It focuses on efforts, inputs, hours, costs, activities, rather than outputs, results, and value.
- It places the transaction risk on the customer.
- It fosters a production mentality, not an entrepreneurial spirit.
- It transmits no useful information as to value, project management, the effectiveness of professionals, or the future behavior of customers.
- It encourages the hoarding of hours and decreases delegation, leading to surgeons piercing ears.
- It penalizes technological advances, lessening a firmâ€™s revenue if it performs work more efficiently.
- It commoditizes the firmâ€™s intellectual capital into one inadequate hourly rate, denying a firm the opportunity to differentiate itself from the competition.
- It does not take into account the risk the firm is assuming working for customers. Risk is not priced by the hour. Actuaries have an axiom: there is no such thing as bad risks, only bad premiums.
- It places an artificial ceiling on a firmâ€™s net income, since there are only so many hours in a dayâ€“â€“indeed, a lifetime.
- It creates bureaucracy. Time and billing programs consume between 7 to 15 percent of a firmâ€™s gross revenue to maintain. These resources are better spent pricing on purposeâ€“â€“by establishing a value council, appointing a chief value officer, pricing all work up-front, performing adequate project management, as well as after action reviews.
- It does not set prices up-front, violating the laws of economics and consumer psychology. Customers want to compare value to price before they buy, not after.
- It diminishes the quality of life. No one became an accountant to bill the most hours, but rather to help people. Knowledge workers resent having to account for every six minutes of their day, as if their leaders do not trust them to do the work and the right thing.
Exhibit 2: Advantages of Value PricingÂ
- Value pricing comports with the laws of economics and consumer psychology, aligning the interests of the firm with those of the customer.
- It manages, clarifies, and offers the firm the ability to exceed the customerâ€™s expectations.
- It prequalifies the customer to ensure they are a good fit for the firm.
- It provides the opportunity to cross-sell additional services.
- It allows you to gain â€śego investmentâ€ť from the customer.
- It improves communication throughout the relationship.
- It projects confidence and experience, as opposed to being unable to inform the customer up-front of a price as with hourly billing; or offering a range of prices, which is done more for the benefit of the firm than the customer.
- It increases a customerâ€™s switching costs, increasing their loyalty and long-term profitability.
- If forces the firm to be effective in project management and getting the work done within the time promised to the customer.
- It overcomes customerâ€™s pricing emotions and maximizes the firmâ€™s price leverage.
- It incentivizes the customer to complainâ€“â€“through triggering the service guaranteeâ€“â€“giving the firm a second chance to win back the customer, and prevent similar problems from happening with other customers in the future.
- Fixed prices can be increased each year, even if there are no changes in services. It is much easier to increase the price of a customized price rather than increasing your hourly rate by $10 per hour.
- It provides a competitive differentiation for your firm when you offer customers certainty in price and less risk of dealing with you.
- It specifies conditions for change orders that are usually value-added services that can command a premium price.
- It utilizes price bundling allowing the customer to focus on the totality of the firmâ€™s value proposition rather than the price of each and every service.