A Note On Value-Based Pricing…

It seems like half of the interviews I do these days revolve around the idea of value-based pricing.

In the first edition of this course, I confused a bunch of readers. On the one hand, I was arguing that your price should reflect the (financial) value that you deliver to your clients. But I was also covering setting hourly and weekly rates.

The traditional definition of value-based pricing is the idea that the price of a product (what you do for somebody else) has no relation to the manufacturing cost (your time), but instead the price is tied to the presumed experience they’ll have with the product.

A good example is a company like Apple. When they sell a fully-loaded MacBook Pro to somebody like me, they’re tying the cost to their brand value and the experience someone like me has in using it daily. Apple’s method of pricing is completely counter to how Wal-Mart prices t-shirts. Wal-Mart uses a cost-plus method of pricing, where they leverage their weight to buy large amounts of shirts and pass them off to the consumer for as low a price as possible. What they lack in margins is made up for in volume.

Most of us have very little real overhead in the work we do. We might need to buy stock artwork or special plugins or tools, but ultimately what’s being bought is our time. We have a specific knowledge and the ability to apply that knowledge to a given problem, and the client “buys us” to apply our knowledge to their problem.

So when we discuss value-based pricing as it relates to service-based businesses like freelance consulting, the thought is that once you’re able to quantify the financial upside of a project, you’ll price somewhere between zero and that upside.

So if I can make a company $100,000, they’d be foolish not to pay me $50,000 to do that… even if it only takes an hour or two of my time.

My Unorthodox Approach To Value-Based Pricing

I’m still in favor of rates tied to time. (As long as we can do it in a way where we obfuscate “how the sausage factory works,” which is why I like weekly rates.)

I’ve worked on a lot of fix-rate projects that ended up either making me no money or losing me money after a series of, “Can we make one itty bitty change?”

The way I like to price according to value is to anchor my time-dictated costs against the value that’s produced by my work. I’m not setting my costs based on value; I’m anchoring.

For example…

If the financial upside of a project is $100,000 and my rate is $20,000 a week, anything less than a four week delivery is a good thing for my client. If I work five weeks, they break even. Anything more, and the client loses money.

So as a steward of my clients’ budgets and someone who needs to actively justify my rate, it’s important for me to make sure that the math works out. That the input (time multiplied by rate) is always less than the output (the financial upside.)

Your client is also doing this math, and they’re often doing it subconsciously. If we’re able to bring this equation to the surface (which we’ll cover extensively when we talk about creating proposals), they know that you understand the equation and they’re forced to consider it consciously.

It’s important here to also consider the role of risk, which we covered a few lessons ago. Your perceived risk is also a part of the equation. The likelihood that you’ll fail to deliver that upside is factored into this equation.

Rate x Time < Upside x Risk

If I propose a two week engagement at $20,000 a week (= $40,000) on a project with an upside of $80,000, it’s an easy sell if my client thinks I’m very low risk (Risk = 1.0) versus me being higher risk (Risk = 0.5)

Is $20,000 * 2 < $80,000 * 1? Yes! So the risk assessment has been passed.

Anchoring

Since I have a rate, and my rate is multiplied by the lifespan of an engagement, I need to proactively ensure that the value I’m producing (the product and its financial upside) is always more than my total cost.

When talking with a prospective client, I’m constantly referring to this formula. I want the client to know that I understand what they stand to make off me, but I’m also a pragmatic businessman. They can’t afford to spend two dollars to make a dollar.

If the formula doesn’t work out, I’ll never negotiate on my rate.

Instead, I’ll tweak the other variables to come up with a project that requires less of my time but with a net-positive payoff. (We’ll go in-depth into negotiation in a later lesson.)

Notice my rate: $20,000 a week. That’s considerably higher than the average freelance consultant.

But by anchoring my total cost against the financial upside of a project, I’m getting the same effect that value-based pricing has — a bigger number (the payoff) contrasted against a smaller number (the investment.) I’m doing this, though, without the risk of backing myself into a fixed-price corner.

Should You Ever Value-Price, Then?

Sure. If you’re comfortable now with fixed-price projects or can justify the risk with sufficiently padded margins that projects can balloon, then go for it.

I never sold a repeatable service (except for retainers, which I’ll cover in the last section of this course.) Everything I’ve ever done has been from scratch and totally custom.

But if my product was something productized or predictably turn-key, I’d definitely be using flat-rate pricing according to the value I produce (as opposed anchoring.)