How to Implement Value-Based Pricing
Most business owners are aware that the concept of hourly or fixed billing can be restrictive and regarded as an outdated pricing structure for service delivery businesses. Whilst in many situations we can replace hourly billing with value-based or value-led pricing but why don’t we? Whilst value-based pricing can be the right structure, we need to facilitate activity tracking as a critical tool to successfully implement the new pricing model.
What is Value-Based Pricing?
Typically value based pricing is based around a pricing strategy where the prices are based predominately on a consumers’ perceived value of the product or service. Is this completely right or is this a strategy that has varying degrees of analysis even with value-based pricing? A slightly different approach can be taken with the pricing based on the differentiated worth of the product or service for a particular customer segment when compared to its competitor.
There are three key pricing methods in the market:
- Hourly Pricing
- Fixed Fee Pricing
- Value-Based Pricing
Often for simplicity cost plus pricing (hourly & fixed price) can have some advantages but all in all there is much greater benefit in value-based pricing. Of course, you still need to be able to cover your costs which you must ensure before applying this approach broad scale to your clientele.
Now with an idea of pricing, how do you introduce value-based pricing? Let’s take a look now.
How to Implement Value-Based Pricing
The reality of the “how to” process of value pricing is to be comfortable with the chosen approach for pricing. There may be some aspects that have been a core of your business that can be removed like detailed tracking of timesheets. Does this mean you lose track of your costs or can you use this as a business improvement process and still maintain a way to track the information you need.
This is critical where the value-based pricing must be incorporated into any strategy. This will ensure that all areas of the business are leading to a value-based approach and therefore not create conflicting processes or to allow an individual to undertake tasks that can limit or damage the effectiveness of the implementation.
Now we know the ‘how to implement’ stage of pricing, the next step is to calculate value.
How to Calculate Value-Based Pricing
To achieve this, I believe in a two-step process:
- Produce a risk-free, clear scope and calculated pricing proposal of the client
- Incorporate processes for internal business analysis
Now let’s look at how we develop a pricing proposal.
Developing a calculated pricing proposal
A calculated price has the following characteristics:
- accounts for the cost
- provides for the gross profit
- incorporates the risk profile of the product or service and the client
- it contains an additional amount for the determined Value.
An effective strategy must eliminate the guesswork of calculating a price based on value. The strategy should enable a value price to be generated that is consistent and comprehensive – each and every time.
Incorporate internal tracking and analysis
Being able to calculate a value price is only part of the value pricing model story. The second part of the model involves internal business processes around tracking and analysis. It is this aspect that requires monitoring of time.
Internal business processes include the following:
- Delivery management
- Client change management
- Risk management
- Individual team capacity monitoring
- Overall team capacity forecasting
- Development of performance review systems – practice, price, and team
The monitoring of each of these internal business processes is achieved by the tracking of budgeted effort against effort used. You can monitor this by the time allowed to achieve the required tasks i.e. time vs. activity. Effort is tracked back to an item of scope and to the person fulfilling that role. Being able to define the effort required involves a client discovery phase.
Client Discovery Phase
Before a value based pricing package can be determined it is critical to get to know the client. This Discovery Phase is where systems around analysis and scoping are used to develop a deep understanding of the client and to further the understanding of the complexity of the work for which you are expected to provide a solution. Once that understanding has been reached, a value package can be prepared for presentation to the client. This preparation is called the Solution Development.
Product or Service Solution Development
The Solution Development enables pricing for profit as part of the pricing strategy. To prepare a solution development, the scope or activities around the requirements as understood during the client discovery phase are documented. Scope analysis requires an understanding of required effort against activity. This clear defining of scope is where the internal business processes commence.
The team executing the delivery needs to be very clear around scope and the effort permitted in order for them to be able to complete their work. Each team member can then undertake their role around the job expectations. Their deep understanding of the client scope of engagement means that they know when the job is no longer within scope. They are able to be attentive to scope creep and as such, to trigger an alert. This scope creep instigates a change management process and should be seen as an opportunity to sell additional value to your clients.
The tracking of effort enables your team to be confident in their roles and assist management or you as the owner to identify instances where there is a potential for profit bleed and to quickly stem that flow.
Risk and Time / Cost Contingency
The next internal process revolves around risk. For each client or client segment we need to identify the potential for risk. When you move to value-based pricing on the majority the onus on delivering the agreed scope is entirely on the business. Risk to an engagement includes issues like client reliability, response time and commitment – each of which can affect service delivery and engagement profitability. The measure of risk is calculated by allowing a contingency for time or cost. This creates a buffer on the scope of work to ultimately mitigate cost overruns. This also creates opportunity as any unused contingency becomes a direct flow through to the business bottom line i.e. your back pocket as the owner of the business.
The service delivery component and tracking of effort enables owners and management to monitor when effort pushes into contingency. This can be acceptable, not desirable or may lead to an agreed variation to the original scope of work depending on the reasons for the time or cost overrun.
Capacity Management uses the concept of a full time equivalent (FTE). Capacity Management is about both individuals and the entire delivery team for a product or service.
Each team member has capacity measured as a partial or full FTE. Being able to associate an engagement back to budgeted effort means that the team members assigned to that client delivery have their personal FTE availability reduced. The available FTE of each team member contributes to the total service delivery of the business. Tracking the available capacity of team member(s) enables you to have a well-informed capacity conversation and determine if it is appropriate for them to take on additional work. As always what can be measured can be managed. Monitoring the FTE of the business as a whole means that the critical point for engaging a new team member can be identified.
Performance & Pricing Review
A business with a vision and goals is a business geared for growth. To track growth, there must be measurable components. The business needs to review actual performance against growth targets as well as to understand the profitability of clients.
- Are clients being fulfilled within the scope?
- Is the effort required to fulfil the scope greater than expected?
- Is the time or cost contingency used?
These are all measurable performance criteria because expended effort is monitored against budgeted effort.
It is critical to perform a pricing review in order to check that your delivery price is in line with scope, changes in the consumer price index (CPI) and the value you are delivering to your client. A thorough understanding of the required effort of the engagement is a precondition for a pricing review.
The goal of a performance review is to measure and enhance work performance and individual (employee, consultant, contractor) development. To judge work performance, it’s necessary to pose and answer the following questions:
- How well has the scoped work been completed?
- Is it completed within the budgeted effort?
- Is the time or cost contingency used?
If activity is diligently tracked against budgeted effort, you can measure whether the engagement is being met or not. Meeting or coming in under budgeted effort is the cream of good service delivery. This can be used by the business or for incentives to give back your team.
Value-based Pricing Outcomes
By you are probably thinking that’s great but what are the outcomes and what is the value. For this we look at Hyundai from how they entered the market to how they are pricing their cars today:
Hyundai entered the car market simply trying to offer some of the lowest prices for their vehicles at cost plus pricing. Now they have established themselves within the market, they now offer slightly higher prices with much higher value by following a value-based pricing strategy.
How did they do this?
Firstly, Hyundai offered ‘the industry’s best warranty’ followed by their own Hyundai Assurance. Hyundai assurance was that if you buy a new vehicle and lose your income within the next year, you can return the car to them. Hyundai is offering this for an additional fee but still at a relatively low price. Their cars represent very high quality and the Hyundai assurance represents good customer service as they try to adapt to the changing needs of their target market. Even though Hyundai isn’t the cheapest car manufacturer, they offer value that accentuates value-based pricing.
The competition responded by offering similar deals but the value and goodwill already created couldn’t be easily replaced. This meant Hyundai built this additional value into the pricing of their vehicles over and above what their cost-plus pricing methodology would have returned.
Dispelling Key Misconceptions About Value-Based Pricing
Value-based pricing is used in every industry to price everything from simple house hold items to large scale projects. Despite its popularity some businesses are not aware of the full benefits and even have some misconceptions about the approach.
- Value-based pricing requires the company to evaluate consumers’ willingness-to-pay for each and every product feature. Some believe that when a company uses value-based pricing, it has to assess how much the customer values every single product feature, assign a dollar amount to each one and then add them all up to calculate the product’s final price. Even the simplest products have dozens of features and that is not a practical approach. The business only needs to identify the featured differences and assess customers’ valuation of these differentiated features. This makes the whole process a lot easier to implement.
- Pricing products or services using value-based pricing will always lead to success. This is likely the most dangerous misconception about value-based pricing because it can create false high expectations. The success of value-based pricing depends on execution and the competition. If the competition has set untenable low prices then value-based pricing won’t save you and it might be the industry or particular product or service that you need to address.
- The brand’s value is part of the value-based pricing calculation. With value-based pricing the goal is to put a dollar amount on its differentiated features. The method’s focus is on features that add value to the customer and that can be converted into dollars and cents. Features such as “longer-lasting by X%”, “faster by Y hours”, “less likely to break down by Z%” all work easily because they can be converted to dollars.But it’s much harder to deal with a brand’s value this way. This is why brand value can be left out of the equation, utilise a simple measure or compare with the competition to allow for an estimated value.
Value-based pricing is an effective pricing method and is actually a lot easier in practice than it appears to be in theory. With a stronger grasp of how this method works owners and managers will be able to make smarter pricing decisions and employ value-based pricing to increase profits.
If your company needs guidance on pricing strategies, contact the Cashflow Tech Systemz team at email@example.com