In Part 1, we looked at what most service businesses sell, and why selling hours can be a bad idea. In Part 2 we looked at why customers buy outcomes, not hours.
If the customer is willing to pay $100,000 for a certain outcome or deliverable, you can then decide if you can or want to deliver it for that price. In many cases, the customer will compare the price with quotes from more traditional firms who are billing based on time and materials. If you’re competing with someone overseas who is charging $30/hour, you don’t want to have to justify why you are $300/hour, even though you will take 10x fewer hours to complete the project. You don’t want to have to justify $90/hour, even if it will take you a third as many hours. You want to keep the focus on the benefits and the overall price. Is this a good investment for your customer? You don’t want to be in the business of convincing them to make bad investments, right?
The closer you can get to the real outcome, the more easily you can use value-based pricing. You may not be able to get a 40% revenue share like a trial lawyer, but even doctors, who can’t guarantee outcomes, get paid different amounts for different activities. (Medical pricing is pretty screwed up, but I don’t hear anyone saying they think doctors should get paid by the hour, regardless of what they are doing.)
So if customers really care about outcomes, not hours, and if hourly pricing lowers the profit and increases the drudgery of providing services, why do so many service proposals have hourly billing? When everyone is doing it, it becomes standard practice. People start asking, “what are your rates?”, not “how much will it cost?” And when companies start comparing bids, hourly rates are easy to compare. Furthermore, if you can’t differentiate your offering from a competitor’s hourly option, the solution becomes commoditized and the market drives rates towards marginal cost. This means that you can’t simply charge a portion of the benefit, even if you could quantify it, because other competitors could then deliver better returns at lower prices. You can only price up to your perceived differential value.
Sounds bad, but if you’re trying to get out of hourly billing, you can actually use this to your advantage. You know approximately what other providers will bill, based on the estimate of work and hourly rates. You can differentiate in terms of value delivered (might be hard) or time spent. If you can truly do the same work in less time, you can bill similar total amounts, leading to a higher effective rate. For example, when I did a lot of high end pricing analytics, we built custom tools to allow us to crunch through certain “what-if?” scenarios much more efficiently than you could in Excel. We could do in a week what a typical consultant might do in a month, and we could do in 3 man months what another firm might do in 6 or 12. Of course the effective rates were higher. The company from Part 1 that refused to pay $175/hour later gladly paid twice that effective rate because we recast the project as a deliverable with a due date.
For this to work, you have to be able to do something better, cheaper, and/or faster than your competition. Note that “better” means better in the customer’s eyes. If they don’t perceive the value, it’s not real. If they do, even if you don’t think it’s important, it is. Cheaper and faster are amenable to technological improvements (like our custom software tools), or other templates and prebuilt intellectual property that you can use repeatedly.
One great thing about this method is that you have a lot of flexibility to serve the customer. For example, in one case, we realized that it would be better and cheaper to buy an off-the-shelf software package rather than doing the work by hand or implementing certain software features ourselves. If we had been on a typical hourly contract, we never could have won approval to do this in time. It would have broken the model and required another legal review. Since we were responsible for the results, we made the decision in an afternoon and were able to accelerate the project and deliver better results. Using the project approach, you want to think about ways to deliver value faster, more easily, and in a more automated fashion. If you’re just billing by the hour, there is a strong disincentive to improving delivery efficiency. Even if you’re not simply billing lots of hours, your mind will be thinking in a different way– one that is ultimately not as good for you, your team, or your customers.
In addition, customers aren’t exactly dying to handle extra paperwork. Some projects I’ve worked involved consultants, subcontractors (too specialized for me to hire full time, but essential for certain pieces of certain projects), and other 3rd party services. Simply getting approvals for all these pieces, let alone managing them, invoicing, and processing payments, would have taken significant time for the customer and for me. Instead, we wrapped it up nicely, saving time for the customer and ourselves, so we had more time to focus on actually delivering the solution.
Many service providers would love to get out of the hourly pricing cycle. They would love to deliver “outcome-based proposals”, but they are scared of the risk. So in the next part, we’ll talk about how to mitigate risk and set your project up for success.