The Pros and Cons of Value-Based Pricing
In our previous article about pricing we covered the pros and cons of a cost-based approach, which is essentially pricing your services based on time and materials. An alternative approach is value-based pricing.
Value-based pricing is the opposite of cost-based pricing in almost every way, including countering the pros and cons of cost-based pricing with its own. In simplest terms, value-based pricing is charging based on the value your service is providing the client, not necessarily on the time and materials involved.
To illustrate the contrast, let's take a sample project being priced by a web design studio. The project is a site redesign. After meeting with the client and detailing out the requirements, the studio is able to closely estimate how many hours will be involved in the redesign. Based on that time estimate, they price the project at $50,000.
But what if the studio instead took a value-based approach? In the client meeting, in addition to documenting the project's technical requirements, the studio also focused on learning more about the business problems this redesign will be addressing for the client. Based on that information the studio includes some ideas in the redesign that have the potential of increasing the client's revenue by $1.5 million. That being the case, the value of the redesign is worth far more than the $50,000 of estimated time. And you'd have no argument from the client if that price was doubled, tripled, or even more. It'd be well worth the investment.
With value-based pricing, you're aligning the amount you charge with the impact your services have on your client's business. In many situations, this provides a much greater potential upside to your earnings. Because your fees are tied to value and not time, your amount of profit isn't limited by an hourly rate. And this helps your clients focus on your expertise instead of focusing on the clock, positioning you as an investment for their business rather than just a time-based commodity.
Value-based pricing rewards you for your skills, expertise, and expediency. For example, it might require a new web designer 20 hours to design and code a project for a client. But as the designer gains more experience they can complete the same project in 10 hours, or half the time. If the designer is charging by the hour they're actually being "punished" for their experience and increased efficiency. Yes, they could always increase their hourly rate to compensate for their increased efficiency. But a value-based approach dodges the issue altogether, as the client is charged what the work is worth to their business, regardless of the time involved. Increased experience and efficiency then becomes a reward for the designer, as the faster they work doesn't mean less income, but instead more time left over to take on more projects to make even more money.
Despite all its benefits, value-based pricing has its challenges. It requires a deeper understanding of your client's business and the problems they're asking you to solve. This might mean the need for in-depth research, multiple meetings and interviews, and more complex proposals. In the eyes of your client, you'll need to position your business as a strategic partner instead of a labor-based commodity. In other words, the amount of upfront work required to discover and propose the value of a project goes far beyond simply gathering the necessary technical requirements.
Because most value-based projects are priced up front, you must also be careful that the determined value of the project meets or exceeds the actual amount of work involved. Otherwise you'll be losing money on the project. This can happen if you've misinterpreted the technical requirements for the project or if the client requests unpredicted features in the midst of the project.
A Mix of Both
Because of these potential "gotchas" many businesses use a blend of cost-based and value-based pricing from project to project. Some businesses might opt for a value-based approach only when the determined value is far enough beyond the predicted amount of work that it's very unlikely to lose money on the project. Cost-based pricing might then be reserved for the tighter, more unpredictable projects.
You can also use a blended approach within the same project. For example, you might give your client a project estimate based on value, but state that a cost-based fee will kick in for any work required due to the documented scope of the project changing.
In our next post we’ll look at the unique benefits of offering retainers to your clients. Until then, happy pricing!