Pricing - value based
Welcome to the fourth article in my pricing series, after Fixed Price, Time and Materials, and a Hybrid combination of the both.
So the most common formula for pricing a project is
- You estimate how long it will take for you to complete it
- Based on the time estimate, you decide how much money you want to complete it
Whether it’s fixed or time and materials - price is still tightly coupled to time.
But there’s one pricing method that tries to seperate price from time, and that’s value based pricing.
What is value based pricing? 💵
“Price is what you pay. Value is what you get”
– Warren Buffett
Value based pricing is a pricing method where you charge the client a percent of the estimated profits (or estimated savings) they will see from having the project implemented.
It’s regarded as the best way to decouple time from cost, and to directly map your price to a percentage of what the client hopes they will make (or save).
After all, the software you develop can be worth a lot more to a business than the hours you put in - so your true value can be worth a lot more than your time.
For example, if you are building an automated scheduling system for a logistics company, you determine the overall savings they will gain from reducing human involvement, and charge a percentage of the money they will save.
At a time and materials rate, you may only charge $50,000 for this system.
But that logistics company could save up to 1 million dollars per year just by automating their scheduling system - and that’s worth significantly more to their bottom line than $50k.
Charging this way can see drastically different figures.
How do I actually implement value base pricing? 🤷♂️
“The true method of knowledge is experiment”
– William Blake, Poet
Two key ingredients:
- Knowledge about how the business is performing
- Knowledge about how this project will affect their bottom line
Use your Project Workshop to thoroughly understand your clients business, their revenue, their profit, and what the forecast is for the coming years.
Some clients may be a bit cautious exposing this information, but reassure them it’s in their best interest that you have a clear understanding of how they work. After all, you’re more than just a “dev shop”.
You then uncover what impact this new project will have on their business.
- Will it save them $W per year by automating previous manual human tasks?
- Will it save them $X per year by rebuilding something they currently pay a lot for?
- Will it make them $Y per year by selling more of their existing product?
- Will it make them $Z per year by introducing a whole new product line?
These are all forecasts that their business predicts will be the outcome of going ahead with this project - and they should know this information already - ideally.
But if they don’t know it at all, then you can help them work it out.
Once you have uncovered the estimated impact to their financial position, then you can use this data when formulating your price.
In terms of how to determine your price, the most common method is you charge between 15% to 30% of the clients first year of revenue.
For example if your client expects to profit by (or save) $200,000 in the first year, you could charge between $30k to $60k for the project.
This percentage is just a guide, you can adjust it to meet your niche, and your clients, and the specific project you are bidding for.
Managing the delivery time of the project still needs to be handled internally, as you certainly need to ensure you’re not making a loss. However it’s not as important as time and materials, and if priced correctly (and the project adds real value to them), you should be making more than a fixed price project.
When presenting your pitch and also in your proposal, make sure you clearly state to your client that if the project meets their expectations, that your price is only X percent of their first years revenue.
This is integral, as it draws a line directly between their value and your value, and psychologically makes the projects cost more palatable than one big number not based on their value.
Benefits of value based pricing 👍
- The possibility of getting paid more - maybe a lot more - than fixed price or time based pricing
- Lower psychological barrier, as you are showing your client they will make their money back in X years (based on their own forecasts)
- Encourages transparency and real data about financial expectations
- Decouples your value from time, showing your relationship is worth more than an hourly wage
Negatives of value based pricing 👎
- Clients may not take well to the pricing model, as it is less common and will need some education from you
- Relies on projections about what may happen financially. This may not always come to fruition, and could affect the relationship (e.g. client pays you 15% of projects of 2 years, but two years later projections were down 95%)
- Takes more diligence and work up front to look through real data to determine projections
- Not well suited for projects that are harder to forecast profit. E.g. building a website for a new cafe
My experience with value based pricing 📖
“I really wish I had of tried value based pricing, it would make this section better”
– Chris Rickard, Author
I’m kind of disappointed I never implemented value based pricing in my agency, so I have no validated data here to share I’m afraid.
I always loved the value based pricing method, and have read a lot of success stories about it. As I’ve mentioned in other articles, I started off with fixed price, then moved to time and materials and finally a hybrid approach. From there, most of my clients fell into an ongoing retainer model, meaning we didn’t do project pricing that regularly. After that my agency was acquired - so the opportunity to test value based pricing never arose.
But if you want to learn more, and see whether this is something you want to try out, there is a great series of posts by Jonathan Stark titled How I Realised Hourly Billing is Nuts.
Like any pricing method, you need to experiment to see if it works for you, your niche, and your clients. But one thing is for certain, how you price can have a big impact on your profit. So it’s certainly something that’s worth trying out.