A business is defined by the value it creates for its customers. Your price speaks volumes about your value proposition, more so than any other component of your firm’s marketing. Price is also the number one driver of profitability for all businesses.
A study by the consulting firm McKinsey & Company in Cleveland, Ohio compiled data on over 1,000 manufacturing companies and found that a 1% increase in price, at constant sales volume, would produce an average of 11% increase in profitability—far greater than the impact on profitability of reducing fixed costs by 1% (2.7%); increasing volume by 1% (3.7%); or reducing variable costs by 1% (7.3%). The impact on profitability is even higher for professional firms, since increases between 5-20% in prices are very likely if your firm prices on purpose.
Today, there are thousands of professional firms that are pricing their services according to the external value created—as perceived and determined by the customer—rather than internal costs incurred in generating those services.
Changing the pricing culture in your firm will not be easy. It requires constantly confronting the inherent challenges involved with pricing—all of which take hard work, commitment, leadership, creativity, innovation, and dedication of resources to continuing education. But it is worth it, as the McKinsey study proves.
The word value has a specific meaning in economics: 'The maximum amount that a consumer would be wiling to pay for an item.' Therefore, Value Pricing can be defined as the maximum amount a given customer is willing to pay for a particular service, before the work begins. This is not to suggest we can capture one hundred percent of maximum value, but rather that we have the potential to access some of it with strategic pricing.
This definition contradicts the popular term value billing.The difference is Value Pricing is always done prior to the work being started, whereas value billing is usually marking up—or more frequently, marking down—the invoice to the customer after the work has been performed.
There is a cardinal rule on behalf of customers in firms that value price: No surprises. This creates a much better customer experience, with less write-downs, write-offs, collection and financing costs, as well as greater customer loyalty, not to mention superior profitability for the firm.
Not all pricers in a firm are created equal, which is why I have been a strong proponent of firms establishing a value council, as well as appointing a Chief Value Officer (CVO), in order to centralize the pricing function and make it a core competency within the organization. (See Exhibit 1 below for the value council and CVO purpose and criteria).
Examples of purpose and strategy statements for the role of the value council and Chief Value Officer are:
The criteria to look for when selecting a CVO and appointing a value council can be summarized with the acronym LACEY:
Think of the people currently in charge of pricing in your firm. Some are acceptable—attempting to correlate price with value—but most are mediocre, or, dare I say it, wimps. Why would we let people price if they are not good at it? We wouldn’t let people audit if they were not qualified. Pricing is far too important to the profitability and health of a firm to accept anything less than excellence in this vitally important skill.
If you diagram hourly billing, a form of cost-plus pricing, it would look like this:
Service → Cost → Price → Value → Customer
Now, look at how Value Pricing inverts the above chain by recognizing the economic fact that it is the customer who is the ultimate and sole arbiter of value:
Customer → Value → Price → Cost → Service
By first determining value, which establishes the boundaries for a price, the firm can then decide if the costs required to provide the service will return a desirable profit. If the project cannot be done at an adequate profit level, the service should not be performed. All this analysis has to take place before the work is started. What good is it to know your costs to the penny if the customer can’t afford—or has a different value perception of—your price?
Costs are a fact, but pricing is a policy. What is happening in firms is people are pricing services based on the costs they are incurring without a clue as to the value they are creating. Firms have ample data on their costs, hours, activities, efforts, and other inputs, but a paucity of information on the value they create for their customers.
Costs are only relevant for determining if a service should be provided, and perhaps in what quantities. Costs certainly play no role whatsoever in determining external value to the customer, or setting prices (except as a minimum). Value Pricing reverses what is now an artificial ceiling on firm income, inverting the ceiling into a floor.
In Part III, we will explain the eight steps required for implementing pricing on purpose in your firm.
See Part I for a general introduction to value pricing including a summary of the disadvantages of hourly billing versus the advantages of value pricing.
Ronald J. Baker is a radio talk-show host on the VoiceAmerica show: The Soul of Enterprise: Business in the Knowledge Economy. He is the best-selling author of seven books, including: Implementing Value Pricing: A Radical Business Model for Professional Firms (John Wiley & Sons, Inc.); and The Soul of Enterprise: Dialogues on Business in the Knowledge Economy. You can reach him at +1 707 769 0965, or e-mail at Ron@verasage.com. He Blogs at VeraSage, on LinkedIn as one of its Influencers, and on Twitter @ronaldbaker
To find out how you can borrow books from the Library please see our guide to book loans. You can obtain copies of articles or extracts of books and reports by post, fax or email through our document supply service.
Tomorrow’s Practice is a research project designed to understand the forces that are shaping accountancy practices. View the findings of the research and thoughts regarding the future.