On Value Pricing

I pick on software vendors and VARs a lot in my writing, not because I dislike them. Rather, because I believe that the vast majority of them are increasingly shortsighted. Their customers and marketplace are changing rapidly and dramatically and they are staying the same. They remind me of the lawyer profession after the telephone was invented. Attorneys were some of the last businesses to take on the new telephone technology and then, they did it only at the insistence of the clients -- because their clients wanted to call them!

While I have carried around the concept of value-pricing for some years, I cannot claim credit for inventing the concept (I don't know who did, but I'm pretty sure it wasn't me), and I am not foremost among those that promoted it over the years. VeraSage Institute is a leader in helping professional firms develop and institute value-based pricing for their services. In fact, the link underlying the heading of this article will take you to a FREE WEBCAST from Ronald Baker, founder of VeraSage on the topic of "Measure What Matters to Your Customers."

Nevertheless, an email I received included a quote from Luci Swindoll:

"It has been said that sixty-five thousand thoughts float through our minds each day. Every one of those thoughts has the seed of possibility in it. We choose with our will what we'll do with that thought. Will we stay stuck in 'If only...' or 'Why me?' -- or will we open our minds to 'What if?' and 'Why not?'"

This quote trigger me to reply to the business associate who sent it to me.  Here is my reply:

This brings up an important factor about “knowledge workers.”  Thoughts occur in an instant.  A thought may come into being through years of conscious and subconscious “mulling,” but the thought, when it arrives, is instantaneous.  Breakthrough thoughts are, interestingly, more likely to occur in the shower or in the midst of a long commute, simply because the mind is given opportunity to “think” without a lot of distracting things and “requirements” pressing.  Unfortunately, most businesses are all about “doing” and less about actually taking time to “think.”

Consider this: If an advertising agency staffer has an idea during his morning shower that is worth millions of dollars to one of the firm’s clients, should the agency bill the client for 15 minutes? An hour? What was that “time” worth to the agency and its client?

If the formula for success in a knowledge-based company is nothing more than PROFIT = Capacity * Efficiency * Cost-based Price (e.g., hourly rate), then the only ways for the firm to improve its profits are:
1. Add capacity
2. Work current capacity more hours (i.e., Efficiency)
3. Increase its cost-based rates

However, if the firm discovers value instead of cost, its formula for success becomes PROFIT = Knowledge * Delivered Value.  Under such a circumstance, the advertising agency can bill its client for some share of the value delivered by the multi-million-dollar idea that its staffer had in the shower.  The firm’s profit potential becomes virtually unlimited and, what they need to garner and preserve in the organization – indeed, what the organization needs to value – is more ‘knowledge’ in the organization, not more ‘capacity’ or ‘efficiency.’  Adding capacity only increases overhead that is troublesome in economic downturns, and increasing “efficiency” isn’t always possible (especially in downturns of the economy).

Suppose the advertising agency we are using in our example were to go to its client, and the client agrees that the idea is likely to generate an increase in Throughput (Revenues less Truly Variable Costs) by $4.5 million over the next 12 months. Let us further suppose that the typical billable work for this particular campaign would have been $250,000.  Now, the ad agency makes an offer thus: “We are going to charge you $150,000 (in advance) to put this campaign into effect. And, we will share the risk with you for the expected results as follows: Based on agreed accounting methods for this campaign, you will pay us 15% of your increase in Throughput each month over the next 12 months.”

If the agency-client jointly-concluded estimates are correct, the ad agency will get $150,000 plus $675,000 ($56,250 per month for 12 months) for a total of $825,000.  That’s $575,000 more than the originally estimated $250,000 in hourly billings.

There are multiple advantages to this, not the least of which is the fact that if the firm does this regularly, it will develop an annuity stream of (e.g., monthly, quarterly) income that will sustain the firm during economic downturns and thus allow the firm to hold onto the talent and knowledge it has worked hard to attract to its work environment.

Just some things to think about from the “Thought for the Day.”  What if…?  Why not…?

I owe much of the credit of my response to Ronald Baker and what he presented in the FREE WEBCAST linked above, but the concept has been with me for many, many years.  My thanks to Ron and VeraSage for reminding me just how important it really is.

Please feel free to email me if you would like help in developing value-based pricing at your firm.

(c)2010 Richard D. Cushing