The Pros and Cons of Cost-Based Pricing
When it comes to pricing your services, there are no hard and fast rules to guide your decisions, which is why the subject of pricing is such a controversial topic in most service-based industries. For example, two different web design agencies might be miles apart in what they charge for essentially the same result.
But the lack of rules also presents an opportunity—a flexibility to position your business in a way that generates the revenue you need to meet your financial goals. You have the freedom to carve out your own quiver of clients who are thrilled to pay your prices in exchange for the dependability and outstanding service you provide. Ultimately, you don't need every potential client to agree with your pricing. Only enough of the ones who appreciate the value you deliver.
In this series of articles we'll cover some common strategies you can use for pricing your services. Each one has its own unique benefits. Which one(s) you choose will be based on a blend of what you're comfortable with combined with what makes the most sense for the specific services you offer. For this article let's first focus on cost-based pricing.
Cost-based pricing is arguably the most popular pricing method for service-based businesses. In simplest terms, you're pricing your services based on time and materials. You determine an hourly rate for your services; you combine the cost of any hours required with any additional expenses incurred; and then you charge accordingly.
Business owners gravitate towards cost-based pricing because of its predictability and simplicity, both for you and your client. From your perspective, you know you're earning a predictable amount of revenue for every hour you work. From your client's perspective, they can easily see where their money is going based on the hours and expenses required. There's a one-to-one relationship between the actual work performed and the amount charged.
Cost-based pricing can also act as a buffer when projects unexpectedly grow beyond their original scope. When a client requests extra work, the time involved will be compensated for, because the client is being charged by the hour. There's a sense of comfort and control to that aspect of hourly billing that many businesses find appealing.
But there are some downsides to be aware of with cost-based pricing, the biggest one being your income is directly tied to time. You typically won't make more money than the time it takes to produce the work. And you're only making money when the "timer is running."
If you're accustomed to hourly billing, this might not seem like an obvious downside. After all, you can always raise your hourly rate to increase your revenue. But when you tie your services to time, you're essentially "training" your clients to focus on the clock rather than focusing on your expertise. In other words, the benefits you provide your client are usually worth far more than the time it takes to produce those benefits. But with cost-based pricing, you won't be compensated accordingly, and your clients usually won't make the connection between you and the benefit. As a result you could be giving up a much greater upside than cost-based pricing allows.
Fixed vs. Actual Hours
If you do decide to take a cost-based approach, you'll also need to determine if your prices will be based on a predicted fixed estimate or based on the actual number of hours worked.
A fixed estimate is typically an upfront, flat fee that (hopefully) covers all of the time and materials predicted for the project. Clients usually appreciate a fixed price because they know ahead of time what they'll be paying. The downside of a fixed approach is you lose that "scope creep" buffer mentioned earlier. If the project ends up taking more work than your fixed estimate allows, you're left in an uncomfortable situation.
In contrast, pricing based on the actual number of hours worked might be more uncomfortable for the client, but provides many of the inherent benefits of cost-based pricing we mentioned above. Essentially the exact, total price of the project remains unknown until the work is finished and the hours are tallied.
Tip: Even if you don't charge your clients by the hour, you'll benefit from having your team track any time spent on your clients' projects. Having a record of tracked time is extremely valuable when scheduling new projects and trying to predict costs. Harpoon's time-tracking system makes it easy for your team to track their time, whether or not you charge by the hour.
Cost-based pricing is just one of a few strategies we'll be covering. In our next post we'll look at the pros and cons of value-based pricing and its unique benefits. Until then, happy pricing!