This is a topic that I’ve been passionate about for many years. I had a discussion with someone today that inspired me to actually write an article about it.
So many of my consulting industry colleagues seem to think that “value-based” pricing, also refered to as “fixed price”, is some kind of magical cheat code that leads to more business and higher profits. I don’t fully share this view, and I would even go so far as to say that in some sense, it can even foster an unnecessary sense of mistrust or conflict.
Let me explain.
The value-based idea
The principle of value-based pricing is as simple as it is appealing. If you go out to get a spicy Thai red curry along with a tasty beverage for dinner, you’re not really negotiating with the restaurant for the time and materials it takes to prepare your meal. As a customer, you’re mentally comparing your expectation of a sumptous meal to the price on the menu. The price likely does not even correlate to the effort or cost of making the product.
The appeal of the value-based pricing is that the customer does not know or care about the work or the cost involved in producing the goods. It’s either worth the price, or it isn’t.
The thing is, though, you won’t be hanging out in the kitchen having meetings with the chef, doling out advice on how to cook the food, bringing some of your own ingredients, or trying out how spicy you like it.
In this regard, a restaurant meal – like getting your car washed, hiring a carpenter to fix your window frames, buying a plane ticket, even cloud services! – can be predictably priced and delivered, partly because the client is not that involved in the production.
It’s a commodity. The work is specific and clearly delimited. The customer has a reasonable expectation of the outcome, and the seller knows what goes into delivering the service.
The exact opposite of most IT consulting work, in other words.
An adversarial business relation
Whether you’re the client or the consultant, when you choose a fixed (“value-based”) pricing strategy, there’s an inherent risk of ending up in a competitive relationship with your counterpart, because your incentives are diametrically opposed.
The customer wants the best possible outcome at the lowest possible price. They have an incentive to increase the scope, since “you’re already here”. The consultant, on the other hand, wants to do the least amount of work necessary, before invoicing the client and uncorking the champagne.
This creates an uncomfortable choice between control and risk, between predictability and profit. The quoted total price needs to take into consideration the potential for underestimations or scope creep.
Assuming your initial estimate of the project was accurate, it’s a losing proposition for the customer, because in a fixed-price scenario, you’ll need to add a risk premium to protect yourself against runaway requirements. Then again, that added risk premium might even drive the price estimate up enough to simply lose the project entirely.
You can mitigate some of this risk by diligently specifying the work to be done, although this is not a perfect strategy either. For a specification to be useful, it needs to be very detailed, which takes a lot of time and meetings to write. This is typically unpaid work that you need to recoup in your total price. And once that specification has been written, you’ve essentially defined the premise for a conflict:
In one scenario, the client may think that some detailed requirement was “obvious” from the context of the specification (remember, they know their business and all its nuances – the consultant often doesn’t), and may feel that the consultant is just trying to squeeze them for more money.
I’ve seen plenty of consulting businesses quote a laughably low amount at the outset, only to go begging the customer for more money when the hours inevitably run out half-way through the project. This is super-common with public tenders, where the price is the main decider for who gets the business. But I digress.
In another scenario, the consultant gets stuck in scope-creep hell, and has to spend an ever increasing amount of time keeping up with the client’s changes and additions. One or both parties will inevitably end up having to making concessions.
I’ve been in all of these three situations, luckily with a project manager or key account manager who was not me.
Value-based is great for commodity services
Before you go into the comment section, let me clarify some context. Value-based pricing is great for commodities. And by that, I also mean small consulting projects. By all means, if you’re quoting a two-day project, I’m sure you know exactly what goes into it, what the client expects, and how to mitigate some of the risks.
Hourly work is honest work
When you’re billing time and materials, the work is transparent and honest. The client has an incentive to make the work predictable and clear to the consultant, to keep their cost to a minimum. The consultant has an incentive to deliver good value to the client. No risk premiums. No fights.
Projects and clients can change their minds in order to keep up with changing realities. Heck, they can even stop the work entirely and regroup, if things get completely out of hand. No lawsuits, no hard feelings, as long as both parties did a good job.
Then again, maybe there’s a reason I’m still not collecting rare Porsches after all these years.