Pricing Strategy Is My Business

The Pricing Newsletter

August 2020

Hello Pricers!

Unless you've been hiding under a rock, you've probably noticed that the marketplace is very different from what it was just a few short months ago.

With so much change afoot, have you thought about modifying your business and pricing strategies?

Do you think you should?

Pricing Question from a Reader

As a newly minted freelancer, I've been receiving two pieces of advice over and over again. Half of the people say I should use retainers, and the other half say I should use value-based pricing. Strangely not a single person has told me to implement value-based pricing for my retainers. Can I combine the two?

Advantages of value-based pricing and retainers

As a quick refresher, let's review the concepts of value-based pricing and retainers.

  • Value-based pricing is a technique for setting prices in accordance with customer value. At its heart, value-based pricing is a tool to maximize revenue for a given sale.
  • Retainers are a form of guaranteed prepayment, either in part, or in full, for future value delivery. In other words, retainers are tools to reduce the risk of cash flow interruptions.

It makes sense that you'd want to combine the two. Each provides a clear and desirable benefit. What company wouldn't want to increase its income while simultaneously de-risking its revenue streams? In combination, the accrued benefits would allow managers to make long-term investments and permit owners to extract substantial equity without fear of facing the dreaded cash crunch.

It's not so easy

There are plenty of guides that delve into the complexities involved in implementing either strategy on its own.

If combining the two were easy and profitable, you would expect the practice to be quite common - at least, so says the efficient market hypothesis. It might be worth considering why the two are so infrequently paired.

Different units of measure

It might not be obvious, but value pricing and retainers tend to make use of very different systems of measurement. Value pricing focuses upon outcomes. For that reason, the unit of measure tends to be the dollar. Retainers, on the other hand, are typically focused upon effort and are measured in hours.

As a result, a naive implementation would necessarily link the effort to be expended by the service provider with the value to be received by the client. Such a formal declaration would violate the most basic precepts of value-based pricing. Remember, the very basis of value-based pricing is that vendor costs are entirely irrelevant to customer value.

Uncertainty of value

Value pricing is, by its nature, based upon the premise that value is contextual. In other words, one man's trash is another man's treasure. The very same process, tooling, and actors can produce wildly different levels of value, depending upon the situation.

Let's consider the case of a consultant who corrects bugs in custom software. Many of the bugs he's seen lately are cosmetic in nature. Whether or not he solves a single problem, the system will still produce the exact same results for his clients. If he were to assume that future investigations would also focus on unimportant deviations in quality, he would assume his clients would place little value upon his future endeavors.

As they say in the finance word, however, past performance does not guarantee future outcomes. It's possible that the nature of the defects he is asked to investigate will change over time. Should usage patterns be altered, new modules be introduced, or managerial oversight increase, the classes of defects that he corrects may become far more valuable to the business. A standardization of colors used for graphs and a correction to the methods used for calculating interest payments may require the same amount of labor, but do you think a bank would value the two equally?

Uncertainty of expectations

With the increasing prevalence of modern management techniques, such as agile and just-in-time development, many managers now lack the ability to predict their needs in advance. Historically, at least in theory, managers relied upon detailed plans that could be used to predict their resource needs for many months in advance.

Now many firms prioritize responsiveness over predictability. As a result, a manager may not be able to speak with any certainty about the types of work that will be conducted even a week or two hence. With greater uncertainty about what work will be conducted, many firms will have great difficulty, even with skilled assistance, to estimate its dollarized value.

So is it a lost cause?

I'm not ready to write off combining value-based pricing and retainers in all cases. I think that it just needs to be done with care, and limited to cases in which the unknowns can be reduced to a manageable level.

Here are a few goals that should be focused upon when implementing a combined value-based pricing and retainer strategy:

  • Definition of offering by output rather than by effort - In a sense, you'll need to perform a substantial degree of productization, either through standardization, automation, or both. Because labor hours are a poor proxy for value, they shouldn't be relied upon as the basis for any value-based discussions.
  • Consistency of offering - The more narrowly the scope of a retainer is defined, the simpler it becomes to estimate the value that will be received. Consider the case of an economist who offers a variety of services including statistical analyses, database training, and product management coaching. With such a wide range in offerings, it would become a nightmare to dollarize the entirety of the services that could be requested. Even if a valuation could be calculated, clients might respond by changing the nature of the work provided, in order to maximize the value of their consumer surplus.
  • Standardization of customer classes - By minimizing the variety of customer characteristics (such as size, industry, and focus), collected data can be used to improve estimates of value, provide visibility into future capacity needs, and enable the recognition of red flags. This information will help not only at the individual customer level, but across one's entire customerbase as well.
  • Insight into delivered value on a rolling basis - Depending upon the nature of the service being offered, it may be possible to estimate customer value via current or lagging indicators. This information should be integrated into formulas contained within the retainer agreement, allowing prices to float higher when the value received by customers increases. Such contracts are more common than you might think. For instance, vehicle rental agreements often specify a standard rate which is raised when the number of miles driven increases and, by proxy, the value received by the drivers has been augmented.

    It's not always a great idea

    Many consultants face great difficulty implementing either value-based pricing or retainers on their own. Attempting to implement both at the same time may prove too challenging, introduce too much complexity, and subject firms to too much risk. In many cases, it would make sense to implement one before the other.

    Even those who implement a value-based pricing of retainers perfectly may find themselves wishing they hadn't.

    Consider the case of a consulting firm with a steady flow of customers. As luck would have it, each customer is willing to pay far more than the last. Assuming that the firm cannot expand quickly enough, its availability to take on new and more profitable clients will be hampered by its existing, and less valuable, retainers. In such cases, it may make sense to forsake the implementation of retainers entirely. This is doubly true for new entrants that do not yet understand the subtleties of their marketplaces.

    Conclusion

    It's great that you're thinking about how pricing strategies can be combined to improve your business. When approached with great care, such lines of thinking have the potential to generate substantial profits. One must always ensure, however, that the benefits of one strategy do not counteract or play against the benefits of the other.

    Whether you attempt to combine the two systems or not, you'll want to revisit your agreements on a routine basis and ensure that they can be modified or terminated, should the need arise. Even if your implementation proves flawless, market forces will continue to shift the incentives and value propositions for you and for your customers.

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

Pricing in the News

From the Blog Archives

Notable Pricing Quote

"Cutting prices or putting things on sale is not sustainable business strategy. The other side of it is that you can't cut enough costs to save your way to prosperity." -- Howard Schultz

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