A Consulting Client's Minimum ROI

I've also heard whispers of a mythical ratio that can be used by consultants to price their services.

Unfortunately, you're forcing me to be the bearer of bad news: the world of pricing isn't so simple. The truth is that no such ratio can, or does, exist. Here are a few reasons why:

There Often Isn't an Objective Measure of Return on Investment

Some consultants have it easy. An engineer might be able to point to a 10 percent reduction in a factory's defect rate or a doubling of its throughput.

Other consultants aren't so lucky. How would one calculate the ROI from a political advisor, psychologist, or interior decorator? We could hire a dozen economists to estimate the ROI of each, and still find ourselves without a definitive answer.

Sure, a consultant could still devise a ratio based upon his clients' subjective measures of value delivered, but a consultant who relies upon his clients to determine his own worth may have bigger issues to deal with.

Risk Cannot Be Ignored

As a general rule, buyers don't like to accept risks. As their risk of loss increases, they will tend to demand higher and higher risk premiums.

If two consultants promise the same ROI, but one requires customers to knowingly accept significant risk, the other will tend to enjoy higher degrees of pricing power.

It should be noted that it's not just a matter of actual risk. Even apparent risk can have quite the effect upon a consultant's earning potential. Sometimes guarantees, warranties, and contractual agreements can cause clients to feel safer and thus willing to accept higher prices.

ROI Doesn't Always Matter

It may seem like heresy for me to admit, but sometimes ROI isn't a driving force behind a purchasing decision. We've all heard that businesses are supposedly driven by an unrelenting focus on returns. This seeming pearl of wisdom doesn't always ring true.

Many businesses and individuals spend considerable sums on products and services with negative ROIs.

Consider insurance. Whether one realizes it or not, buying insurance is almost always a losing proposition. The vast majority of customers spend more for their policies than they ever hope to collect.

This isn't to say that insurance is a bad idea - it limits the damage caused by relatively rare outcomes. Many consultants provide a similar service. Their offerings aren't intended to increase ROI, so much as to help protect against worst-case scenarios.

Competition Matters

Some markets are far more competitive than others. A statistician specializing in biomedical research would likely find himself vying against far fewer vendors than would a person who offers general IT support. One of the fundamental concepts behind modern economics is that larger pools of suppliers tend to drive prices down, as each attempts to underbid his competitors.

Unless a consultant is perceived as fundamentally more desirable than, or differentiated from, other vendors, he will have to take his competitors' pricing into account.

Opportunity Cost Can, in fact, Cost

Customers are often presented with a wide variety of opportunities, including the one that is most often forgotten: doing nothing at all. A firm that is hemorrhaging money due to financial mismanagement will likely find it makes far more sense to spend money on an accountant rather than on a marketing expert.

Time Horizons Matter

Although I'm not a financial advisor, I'm willing to make the following offer: I will guarantee (in writing) that my firm can triple the value of any investment.

Sounds good, right?

Hold up. The devil is in the details. While many investment advisors talk about time ranges in terms of years, I don't. My offer covers a period of 110,000 years at an annual interest rate of .001%.

Hello? Are you still interested? I am providing an excellent return on investment.

My example may be a little extreme, but it demonstrates an important point. ROI isn't just a number. The longer it takes for returns to be received, the lower the value of the returns.

Conclusion

Rules that always work in pricing are rare. Even the most fundamental laws of supply and demand, considered by many to be the central tenets of capitalist economics, don't hold true in every case.

There are a multitude of factors that go into pricing. Don't listen to the sirens' call of a magical ratio that will work in every case. Such thinking has led, and will continue to lead, to ruin for those foolish enough to accept it as gospel.

Questions come from readers like you. If you'd like your questions answered, send them my way.