How to have a transparent pricing model

To answer the question about transparent pricing – easy, simply tell the world (in some detail) in your blog. Read on to find out about ours.

Why? Well, in a recent comment on Getting To Online Marketing, Edmund Pelgen asked about my thoughts on pricing for services. I’ve also found it refreshing to read some bloggers/online marketers speak frankly about their actual revenues, such as Yaro Starak in his Making Money Online series.

As I’m about to update our pricing to launch our new online marketing services, I figure I should outline our pricing strategy. It is an important part of our philosophy, and think it worth having clients who understand it. I realise businesses aren’t usually about their margins and pricing model. But think of this as a variation on open content. By disclosing not just our price (we have published our prices on our website from Day 1) but also our margins and pricing strategy, we do make it easier for our competitors to understand what we are doing (hi y’all). But we also make it easier for our clients to understand how we operate, and why. So I’ll post this here, and maybe even link to it next to our pricing tables.

When we launched, my initial voodoo-magic-finger-in-the-air spreadsheet came up with something that was real close to:
$1 variable cost (labour) + $1 overhead + $1 profit = $3 sell price.

Looked at another way, that is a 33% gross margin. Gross Margin is profit ($1, being $3 less $2) divided by revenue ($3), or 33%

From my experience in the services/consulting field, companies tend to like a 30-40% gross margin. In highly competitive/large deal situations, they will settle for 20-25% or even less. Some companies go lower – sometimes as part of a cunning plan, but more often than not as part of an (unplanned) downward spiral. Since we have no way of achieving the economies of scale of larger companies (and the math was compellingly easy) I decided to adopt the 1+1+1 rule of thumb and go for a 33% gross margin. I figure we can deliver services that will look like great value with a 33% gross margin – if not, we have to find another business.

Where we can achieve economies is in online marketing, and all things going well our overhead component will reduce as we get better at finding customers online. My experience in the first 12 months is that its hard to separate your cost base into ‘one off startup’ costs and ‘normal’ operating expenses. We certainly aren’t achieving 33% gross margins yet. But you gotta have dreams!

After more than a few discussions with accountants and small business owners it seems that what we are doing with our pricing is quite common for small businesses. Please let me know your experiences in this area, either privately or via comments.

Anyway, that explains margin. But what about pricing approach?

We use fixed price wherever we can. More commonly services businesses use a time & materials based approach. Value pricing (where you price based on the value delivered to a client) was also mentioned. These are the three pricing models I want to discuss.

Value pricing

Trying to price based on value is a great concept. But its not much fun if you are the client:

How much for the car over there? Depends, what do you want to use it for?

Not many clients respond well to that philosophy. In my experience, a value based pricing contract needs to include a genuine risk-reward component. So if you deliver a defined benefit AND have a defined exposure to the risk, you can ask for a share of the benefit (and cop a share of the risk, if it doesn’t pan out). That requires intestinal fortitude on your own part. That said, what I found in practice was that value pricing was often very interesting to the client at the beginning of the discussion, but once it got close to signing up, they figured how much they might be paying. Since clients were optimistic, they would then ask you to give them a fixed price, to keep all the upside. For large contracts, this was fine – nobody minds just settling on a fair price in the end.

The downside – particularly for small business – is the time required if you vary your pricing on each deal based on value. How much extra time does it take to sign off and administer a one off deal? What is your time worth? If you look at this on a cost-benefit basis, its hard to see a payback.

Hourly billing

Hourly billing (or time and materials) appears to take away the risk for the service provider. And it isn’t attractive for the client, for good reason. “It was taking longer than we expected – so we just went ahead and did it anyway, and now here is the bill”. Service providers sometimes say that clients are to blame – they change their mind, or they want to try and get something for nothing. No doubt sometimes that could be the case.

Clients see that service providers get paid even if they aren’t being effective. I think it is hard for all parties to walk away happy after hourly billing, and I think clients will rarely raise their concerns. That is partly out of politeness, and partly because even if it feels wrong, they can’t prove it. Oh, and for larger services companies – often time and materials projects are over-represented (and/or the worst offenders) in the ‘troubled project’ lists.

Fixed price

I like offering a fixed price in return for a well defined service. Its clean. You can talk clearly about what you will deliver, and the client can decide if that is value for money – for them.

Sometimes it’s hard to figure out what the fixed price should be. For example, what if the client changes their mind and we have to go back over some work? That is a big risk in what we do. But rather than drop all that risk on the client, my view is we are the experts. We do this work all the time, so we need to help guide the client. So discuss the key factors up front, and write down the scope. Then work hard to manage the service well. People often worry about unforeseen issues and events (for good reason!) Still, over many years I’ve learned that with a good understanding of what the client wants, and a well defined scope, you can deliver a great result. This approach has worked for me on projects large and small.

Working to a fixed price requires trust and clarity on both sides. And this means you don’t take on every client. We certainly don’t. Just a fortnight ago, as politely as I could, I declined to propose our services, in response to a somewhat out of the ordinary request. After I politely declined for the third time, I copped a serve on my ‘attitude’:

since it is obvious you don’t get it, then we certainly will not waste our time with you. Hopeless attitude indeed.

The prospective client wanted publicity services on the basis we only got paid if we got them coverage – not a problem in itself, we can work that way. But for a variety of reasons, they could not tell us much at all except to assure:

The services offered will be extremely easy to explain – it will only take a one sentence tagline for anyone to know what the website is about and what it can do for them. Let me assure you this will not be brain surgery, it is a very simple idea (as all good ideas are). Whipping out one of your release templates, changing it around and sending it to your media contacts you deal with on a regular basis, coupled with a follow up call will suffice to get it published in industry news and on Today-Tonight or similar.

Hmm. We don’t whip out ‘templates’. Our site makes it pretty clear how we approach publicity. But if the story is so easy, why even use a publicity specialist? So, maybe I declined to offer services to what would have been a great client. But as I said earlier, working on a fixed price requires trust on both sides, and in this case I decided it was too much of a risk (call it ‘going with your gut’). As a complete publicity campaign is well under $2,000, you might argue that the chance of finding a good client outweighs the risk of losing our cost + overhead if the publicity didn’t eventuate. Maybe. But a complicated project (and demanding or unhappy client) can consume more than just cash – it distracts from more important things.

So I am most comfortable when we work on a fixed price basis. Even though some might say the risk is higher, we have a far greater chance of delivering the right outcome (because we have to plan well) and meeting the client’s expectation. And I’ll decline to offer services if I can’t see reasonable chance for clarity and trust to underpin each engagement.

Ok, that is enough for this post. I’ve got a follow up for you about how we are going to adjust our pricing strategy to introduce a new element of risk-reward.