Pricing on Purpose
How to Implement Value Pricing in Your Firm
In this second article of the three-part series, Ronald J. Baker challenges professionals to move from value billing to value pricing. Value pricing inverts the hourly billing model by recognizing the economic facts that it is the customer who is the ultimate arbiter of value. If value is created, the customer understands that cost is secondary.
I canâ€™t understand why people are frightened of new ideas. Iâ€™m frightened of the old ones.
Â A business is defined by the value it creates for its customers. Your price speaks volumes about your value proposition, more so than any other component of your firmâ€™s marketing.Â Price is also the number one driver of profitability for all businesses.
A study by the consulting firm McKinsey & Company in Cleveland, Ohio compiled data on over 1,000 manufacturing companies and found that a one percent increase in price, at constant sales volume, would produce an average of 11 percent increase in profitabilityâ€“â€“far greater than the impact on profitability of reducing fixed costs by one percent (2.7 percent); increasing volume by one percent (3.7 percent); or reducing variable costs by one percent (7.3 percent). The impact on profitability is even higher for professional firms.
Today, there are thousands of professional firms that are pricing their services according to the external value createdâ€“â€“as perceived and determined by the customerâ€“â€“rather than internal costs incurred in generating those services.
Changing the pricing culture in your firm will not be easy. It requires constantly confronting the inherent challenges involved with pricingâ€“â€“all of which take hard work, commitment, leadership, creativity, innovation, and dedication of resources to continuing education. But it is worth it, as the McKinsey study proves.
All Change is Linguistic
The word value has a specific meaning in economics: â€śThe maximum amount that a consumer would be wiling to pay for an item.â€ť Therefore, value pricing can be defined as the maximum amount a given customer is willing to pay for a particular service, before the work begins. This is not to suggest we can capture one hundred percent of maximum value, but rather that we have the potential to access some of it with strategic pricing.
This definition contradicts the popular term value billing. The difference is value pricing is always done prior to the work being started, whereas value billing is usually marking upâ€“â€“or more frequently, marking downâ€“â€“the invoice to the customer after the work has been performed.
There is a cardinal rule on behalf of customers in firms that value price: no surprises. This creates a much better customer experience, with less write-downs, write-offs, collection and financing costs as well as greater customer loyalty, not to mention superior profitability for the firm.
Transitioning from Hourly Billing to Value Pricing
Not all pricers in a firm are created equal, which is why I have been a strong proponent of firms establishing a value council as well as appointing a chief value officer (CVO) in order to centralize the pricing function and make it a core competency within the organization. (See Exhibit 1 for the value council and CVO purpose and criteria).
Think of the people currently in charge of pricing in your firm. Some are acceptableâ€“â€“attempting to correlate price with valueâ€“â€“but most are mediocre, or, dare I say it, wimps. Why would we let people price if they are not good at it? We wouldnâ€™t let people audit if they were not qualified. Pricing is far too important to the profitability and health of a firm to accept anything less than excellence in this vitally important skill.
If you diagram hourly billing, a form of cost-plus pricing, it would look like this:
Service â†’ Cost â†’ Price â†’ Value â†’ Customer
Now, look at how value pricing inverts the above chain by recognizing the economic fact that it is the customer who is the ultimate arbiter of value:
Customer â†’ Value â†’ Price â†’ Cost â†’ Service
By first determining value, which establishes the boundaries for a price, the firm can then decide if the costs required to provide the service will return a desirable profit.Â If the project cannot be done at an adequate profit level, the service should not be performed.Â All this analysis has to take place before the work is started.Â What possible good is it to know your costs to the penny if the customer canâ€™t affordâ€”or has a different value perception ofâ€”your price?
Costs are a fact, but pricing is a policy. What is happening in firms is people are pricing services based on the costs they are incurring without a clue as to the value they are creating. Firms have ample data on their costs, hours, activities, efforts, and other inputs, but a paucity of information on the value they create for their customers.
Costs are only relevant for determining if a service should be provided, and perhaps in what quantities.Â Costs certainly play no role whatsoever in determining external value to the customer, or setting prices (except as a minimum).Â Value pricing reverses what is now an artificial ceiling on firm income, inverting the ceiling into a floor.
In third installment, Ronald J. Baker will explain the eight steps required for implementing pricing on purpose in your firm.
Exhibit 1: Value Council and CVO Purpose and Criteria
Examples of purpose and strategy statements for the role of the value council and chief value officer are:
- To ensure the firm prices on purpose, according to the value received by the customer, not the costs incurred in performing the work
- To make pricing for value a core competency within the firm
- To change the marketing culture within the firm from one that believes â€śwe sell timeâ€ť to one that comprehends, creates, communicates, convinces, and captures the value of the intellectual captial we provide to our customers
The criteria to look for when selecting a CVO and appointing a value council can be summarized with the acronym LACEY:
- Leadership Skills. Since pricing is a multi-disciplinary function that cuts across the entire firm, pricers need to be respected and have demonstrable leadership skills.
- Attitude. Leaders who believe there is nobility in being paid what the firm is worth and who have an attitude of abundance and value creation, rather than a zero-sum view of the world.
- Commitment. A CVO and value council who do not have the support of the managing partner are destined to fail.
- Experimentation. Pricers have to be willing to experiment and cannot be prisoners of the past because â€śthat is the way we have always done it.â€ť Excellence in pricing requires learning from both failures and successes.
- Youth. Organizations, like people, tend to calcify with age, and youth can keep the blood pumping at a more vigorous pace. Young professionals are not as tied to the billable hour as are the older generations.
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.