Five Levels of Pricing Success
Blair combines a few of the deeper topics he and David have already covered to provide a larger view of the overall pricing journey he recommends creative firms take.
Sketchnote by Emily Mills
Transcript
David C. Baker: Blair, Today, we're going to do something that we don't do all that often, that's both of us be super intelligent.
Blair Enns: We're going to think of the listener
David: Now, that's way down the road. That's not on the plan for a while. No, today we're going to wrap some things up and combine them. We tend to choose a really tight deep subject. Then we dive way down there. What we're doing today is we're taking a helicopter down view of some pricing things. In particular, we're really looking at different levels of pricing success. Those of you who've listened to our stuff for a long time, you'll pick up repeated things from here and there, but that's not our focus. Our focus is how to wrap this up into something.
Blair: If I understand you correctly-
David: Wait, I'm not ready for you to talk. I will let know. Now, go ahead. Do you have some corrections or something useful?
Blair: Well, it sounds like what you're saying is this is a superficial episode on a bunch of stuff we've talked about before in more depth because we've run out of meaningful material. Is that right?
David: That's not it at all.
Blair: I'm down with that. I just want to be clear about what we're doing.
David: You're not going to enjoy this episode as much as you think you are, because I am going to be the annoying reporter in Joe Biden's press conference, where he gets angry and says, "Come on, man." There are some questions I have, some serious questions here. I'm going to save them for a little bit later. Why don't you start by talking about why this and what are firms getting wrong that prompts you to think about this? Then we'll talk about the five levels and then we'll go in each one.
Blair: The topic is five levels of pricing success. This is you and me discussing a post that I've published on winwithoutpitching.com fairly recently. The impetus for the posts was there's some, but there's not a whole lot of new material in the post. It was really me trying to clarify some things. Number one, point out that your pricing journey is just that, it's a journey. You start out thinking, this is the way it's done. Then you hear some crazy ideas about value-based pricing or retainers or whatever else, and you think, "Oh, that's the way to do it. I'm supposed to be doing it that way. I in this piece was just trying to point out that you should really see yourself on a journey, and there are really levels of success, and even levels isn't quite right.
A point I want to make early here is just because the highest level, level five, performance pay, is the highest level, it doesn't mean that you should aspire to be there.
David: You and I haven't touched base on this particular point, but I hear a lot of misunderstanding around this. I'll give you an example. I hear people who love the idea of value-based pricing and they think that therefore they should get on this journey of converting every one of their clients to value-based pricing. You're saying, no, it's a journey, and it's often a mix of different things. We need to understand the place of each one and how they relate and how you move up to the next one. You're not trying to move all of your clients to the highest most sophisticated level. Well, you are, but that's just not very likely, right?
Blair: I think that's the right way to think about it. I think in other forms of knowledge-based businesses that aren't what I typically think of when I think of an independent creative firm, it actually might be possible and even advisable to shift your entire model over to value-based pricing. I think for the vast majority of our listeners, it can be an ideal that you aspire to, but as you just pointed out, it's not very realistic. At least I don't think it is. I know there are some advocates of value-based pricing, some quite intelligent and well-informed ones who would disagree with that point of view, but I'm pretty confident that you should really be understanding what it means to price based on value.
You should be picking your spots rather than looking to convert every client. Again, there are very obviously some exceptions set up, but I think, generally speaking, that's how we should think about it. Any other form of pricing as well.
David: We did an episode recently on performance bands, we talked about fee billings per full-time. You do see a connection between where people are on those journeys, those two journeys, the billings plus how they do pricing. Just wondering.
Blair: In fact, you can almost overlay this topic over that episode.
David: You're giving specific clues in here for how to self-identify where you are on the path, which you could look at your billings too, to get a sense of it. Is this a good time for you to list the five and then we'll go into each one in a little bit more to that?
Blair: Level one I call labor arbitrage, that's where you're selling time for money. Level two is maximum utilization. The maximum expression of level one, it's the peak of level one. There's a reason that I break it out and talk about it, and we'll get into that. Level three is what I call progressive pricing, which is using some simple, fairly easy-to-implement techniques to break out of the ceiling or the inertia you might be experiencing in level two. Level four is value-based pricing, and level five is a form of value-based pricing known as performance pay.
David: One simple question before we get into this first one a little bit, is it really just figuring out where you are and then going to the next one, or could you skip ahead some levels as people think about this?
Blair: Totally. You could skip level one. You could skip level two. In fact, level two, the reason I pointed out maximum utilization is I think it's kind of a trap. It's not the world's worst trap as we get into it, but if you pursue that maximum utilization for too long, and you get close to the maximum and you stay there too long, you're going to create some problems for yourself that makes it difficult to move on to the next level. I think you could absolutely skip some levels.
I have met a couple of firms in my career that have not only value-based-priced every engagement, they've put skin in the game in every engagement. They went right to level five on every engagement. One of them I've never heard from again, so I don't know if they're still around, and then another one became quite successful. In fact, he made so much money, he went on to do a whole bunch of other things with that money. It's possible, you could skip them all and just go right to performance, pay. If that's you, if you have that propensity for risk, and that's something we'll talk about.
David: The first one, we probably won't spend much time here, but the first one is labor arbitrage. Give us a little bit deeper explanation, identify how people can determine whether they're in here, and so on.
Blair: I should be turning this back on you because I'm just describing what most firms do, and there's nothing wrong with this, but there are other levels beyond it than it's simply selling time for money. In the beginning, you open your doors and you have no employees and you start selling your time for money. Then at some point, you realize, "I think I'm going to use some leverage here," and leverage, in this case, is actually leveraging through other people. Via hiring other people, you effectively buy hours in bulk in blocks of 1,800, like the annual salaries or 1,600 or 1,650, or 2,000 or whatever the number is but let's just take what I think is a decent average of 1,800 working hours in a year.
You buy them in bulk, so you get them cheaper, and then you turn around and sell them at a lower volume, higher rate. That's essentially level one, labor arbitrage, where you're buying labor cheaper than you're selling it.
David: This is probably under some of the assumptions about I need to be bigger to make more money. I need more bodies to arbitrage, which doesn't necessarily become the case. What's the next step above level one, which you're calling maximum utilization, how's that different? I would have thought that in the first case, they would realize they need to sell all the time they can. How is this different in level two?
Blair: This is where I really want to get your feedback on it, but I think we've unpacked this a little bit in a previous episode. How it's different is when you hit the ceiling, there are two ceilings here. One is the maximum rate that you think your market will bear. The second is the maximum-- You're capturing and billing the maximum number of hours. You tell me in a typical firm what's firm-wide utilization, where would affirm max out? When you're including the non-billable time in there, what's the benchmark?
David: Sixty percent is the industry standard. Now the industry actually never hits that on average, but that's what everybody's trying to hit, a 60% across all the firm, billable or not.
Blair: I am speaking in generalities here, but I see firms and I've worked with firms where they're above 60% shooting for 70%. They're at this place of maximum utilization where they've kind of hit this ceiling of what kind of margins they can earn or command. For them to increase the bottom line, they have to increase the headcount. Again, we talked about this in a previous episode, but so I see these firms getting trapped in this utilization band. I'll just throw out some numbers from what I've seen most recently, it's going to be different firm to firm, but this narrow utilization band of like below say 65%, the firm isn't that profitable, or maybe even profitable at all, maybe that line is 60%.
Above 70%, they're understaffed and they have to add more headcount. What's tricky about this spot is it's almost like the math of trying to get closer to the speed of light. It takes this exponential increase in energy to get this marginal increase in speed, and you and your firm, it takes this exponential amount of efforts to eke out just a few more margin dollars when you get close to this threshold, this maximum utilization threshold. What happens is you start to engineer the firm in terms of systems, software, and more, particularly people, middle management people whose expertise is operations and efficiency-seeking. You throw all of this effort at trying to just squeeze a few more profit dollars out in an effort to grow the bottom line. Instead of growing the bottom line, you end up growing the size of the firm.
David: It's almost like taking a manufacturing environment to a business that's selling advice or should be selling advice. When I see people try to increase their utilization percentage, say they're at 50 and they want to get to 60, the highest I've ever seen somebody achieve that is about one and a half percentage points per month. That would be what, six months? But more typically, it's one percentage point per month. If you're trying to get from 50 to 60, it takes 10 months. I see way more firms now arbitraging labor in other less expensive labor markets, whether that South Africa or Chile or Colombia or India, whatever-
Blair: Ukraine.
David: Where does that fall on here? Is that under the first level where there's an arbitrage in terms of the cost of the labor itself?
Blair: Yes, it can fall into either of those levels. Level two, maximum utilization, is the place at which you're approaching the speed of light and it just takes an infinite amount of effort to net out an increase in margin dollars. At that level two, at some point, you give up this idea that you can increase the bottom line without increasing the size of the firm. You just give up on it and you think "It's theoretically not possible." Then the focus of the principle is, "Well, let's grow the size of the firm."
David: Yes.
Blair: One of the problems here, and we've talked about this in previous episodes, is this idea, I've coined the term The Inofficiency Principle. When you're operating at this place, and you're throwing all this effort at trying to increase margin dollars, what you're doing is you're pushing the firm more towards the efficiency end of the spectrum, and you're giving up your ability to innovate. Again, the Inofficiency problem is the idea that innovation and efficiency are mutually opposable objectives. You try to increase efficiencies, you can't help but decrease innovation.
The longer you're here, at level two, the more you push your firm to the efficiency-seeking end of the spectrum, and the less innovative you become. Then there are all kinds of follow-on effects from that. I talked about that, in the post The Complex Battle for Margin if people want to dive deeper into that.
David: Let's go to level three because this is where it gets way more interesting. Here, you're calling this progressive pricing. I haven't heard you use that phrase before. I've heard you use lots of these other phrases, but not that one. I think we're going to need a really good explanation of that one first.
Blair: I don't know where I got this term from, but it's just an umbrella term to cover a few of the slightly more innovative approaches to pricing. These approaches are covered in my book, Pricing Creativity. Let me just list a few of them. They're really the first three rules of the book. Number one price the client, not the service, not the job. Number two, offer options in your proposals. Number three, make sure you anchor high. When you're delivering three or four option proposals start with the most expensive one. If you just do those three things, if you just start thinking about, "Oh, this client has a higher willingness to pay, therefore, we'll charge more," and you let go of the idea that your standard services have a standard price.
You just let go of that idea completely and embrace the idea of the subjective theory of value and the notion of price discrimination, which sounds like a bad thing, but it really means the willingness to pay. Then you start to free yourself up to put higher prices in front of clients who will value that service more. Then you start to offer options. You create the context that enables them to make the decision that they want to make.
The options also help you overcome the baggage that you bring to your pricing. You have this idea that a client will pay x and they won't pay any more, but then you put a three-option proposal in front of them, where the most expensive one, the anchor option, might be a multiple of that middle price because you're adding in some other features that you hadn't previously thought to add in.
You're making the cheaper price cheaper by taking some of the features out, and then lo and behold, you are surprised. when your client immediately takes the most expensive option. I've heard that story hundreds of times now about firms' first foray into Multi-option proposals, shocked that the client took the highest price. Again, the third rule is just anchor high. When you're putting forward your proposal, when you're discussing it, start with the highest one first to create the context that makes the other ones seem more affordable. If you just follow those three rules, and we've talked about those rules in previous episodes before, when we're going deep into the book, Pricing Creativity, just follow those three rules. You'll break out of this pricing ceiling that you see yourself in.
I think any firm that is not currently following those rules, you can follow them tomorrow and you'll immediately see your average selected price go up. You'll see your closing ratio go up, and you'll see your profit margins go up.
David: The boundary between level two and level three is so obvious to me, much more obvious than between level one and level two because levels one and two, you've got your head in a spreadsheet. You're thinking like a COO. Level three, none of these three things that you've talked about come from a spreadsheet. They come from a different mindset. That's why there's such a massive boundary as I'm following along here and listening to the levels and I see a huge boundary between one and two together and three because it's a different way of thinking. It's just not mastering the spreadsheet, it's a different way of thinking.
Blair: Yes, you're exactly right. That level two is really the mastery of the spreadsheet. Then you're trying to push it farther than that model. We'll let you go. At some point, you give up and think, "Okay, I'm just going to try to live out at the edge of what this model will allow," but there's a whole level beyond that. There are levels beyond that, that you don't see. The Lindy Effect is the idea that the longer an idea or a book or something is in existence, the longer it is likely to continue. The rule of thumb is if a book's been around for 25 years, in circulation for 25 years, it's likely to be in circulation for another 25 years. I think that same Lindy Effect applies back at level two, where the longer your firm is operating at that level--
If you're operating there for 10 years, you're likely to be there for another 10 years because the systems and these people that you add, they get entrenched and it becomes harder to break free of. I've been the consultant who shows up and tries to help the firm break free of that place. The larger the firm, the longer it's been there, the harder it is to move. There are people who are just not interested in throwing out all of their systems, all of their ways of thinking, and all of the hard work that they've done to try to eke out a few more profit margins. To begin to think about things entirely differently as you point out, that's what we're doing here, beginning to do it at level three.
David: I've got to pause to talk about that for a minute and then we'll go straight into four, value-based pricing, but the bigger firms don't have bigger firms to emulate usually, they feel like they've arrived. They're not just automatically questioning themselves like a smaller firm who says, "How come I'm not a bigger firm?" They're always questioning themselves, including things like pricing, and all the other things we talk about here in this podcast, a bigger firm is like, "Maybe you can add a little bit to the conversation, but we don't think we're screwed up here. We are successful." It's just such a different mindset.
Blair: I think you're touching on is the smaller firms look to the bigger firms and aspire to do things the way they do things. I would say, and there's a whole set of problems you can just skip right over that larger firms have.
David: All right. Level four, value-based pricing, which we have talked a lot about, but summarize it a little bit in this context and why it comes at this point.
Blair: You talk about a line between level two and level three, where you start to embrace progressive pricing principles. I like to use the metaphor of a prison. Some people are giving me a hard time about using that metaphor. I think we're getting to be too politically correct.
David: Just telling people that we're getting too politically correct I'm sure we'll go over super well.
Blair: I've just been canceled, I'm out. Just put my headphones down now and walk away.
David: 1Bobs.
Blair: I'm fond of saying that your pricing is a prison cell of your own making, it's in your mind. You think it's a prison cell. You see yourself caught in this very narrow band of like what you're able to charge. A narrow range of what the market will bear in air quotes. Really, the band or the prison cell is in your mind. At level three, progressive pricing principles, if you follow those rules we talked about, you just expand the size of your walls. Early on, you'll think, "Oh, I'm free." Then after a little while, you realize, "I'm not free. I've just found a lot more room above the threshold that I was stuck at before, but now I met a new threshold. It's hard to move past this one." To move past the next threshold, you really do need to take that first rule of pricing creativity, which is price the client, and you really need to fully embrace that.
The idea that different clients value things differently, and you need to start putting prices in front of your clients based on what the work is worth to them, rather than what it costs you, your inputs, or what you feel the market value is of the deliverables. Now, having said that, it's really not as straightforward as that. You have to be clear and you have to communicate to your clients that if you want to engage us this way, if you choose this option, the most expensive option typically, you will be paying us not for our time, not for the deliverable. You will be paying us to work with you until the results are achieved. Value-based pricing represents not just charging, not just a new way of pricing, it represents a new way of doing business with your clients.
Now we're starting to get into this area of partnership. It really is the beginnings of true partnership, where you're being paid to achieve goals. The understanding is there will be some deliverables wrapped up in the work that you do to help the client achieve goals, and there are going to be inputs involved, of time and materials, to deliver those outputs or deliverables, but the client isn't paying for those inputs or those outputs, they're paying you to create value. When you do business on that basis, there needs to be a massive delta between your price and your costs because it's really hard to estimate how much time you're going to spend, how many deliverables you'll have to create to hit the outcomes.
You do an estimate, you do this rough order of magnitude estimate on the cost, but you have to have so much room to maneuver between cost and price that it's okay if it takes you 50% longer, maybe even a hundred percent longer because there's so much margin built-in. It's not just a new way of pricing, it's a new way of thinking about your business. It's a new way of doing business with your clients, and not all your clients will be worthy of that type of relationship. Not all of your clients will want to work with you on that basis. Not all of your engagements will make sense to actually do business that way. Sometimes it just makes more sense for you to sell time.
David: You can always check to see how they react to the idea of value-based pricing, but in some cases, pushing that issue on a client that's not ready for can be very counterproductive. Moving from level two to level three required getting out of your spreadsheet and thinking very differently. Moving from level three to level four is about developing a very specific skill, and that's the value conversation. I've been actually in a room where you and Shannon, the team are working with 20, 25 people all at once back when we used to meet and listen to them, practice with each other the value conversation, practice specific parts and layer each on the other. It's pretty interesting to watch their eyes open wide to see how you can have.
They all understand what a value-based conversation is but they come into it with a bad assumption that it's really about manipulating the client, and instead, it's really listening very differently and being open to a different partnership. I had my eyes open just listening to this training about doing a value conversation, but my main point here is that you can't do level four unless you have developed a strong skill around value based conversations.
Blair: Absolutely. At the highest level of value-based pricing is mastering the value conversation, which is rule number five in the book. People can listen to you and I talk about this, they can read about it in the book, but as you say, once they start doing the exercises, they think they've got the theory and they do the exercise and they have this realization, and we did a whole podcast episode on the value conversation, so people can reference that. They have this realization that, "Oh my God, my focus is almost never really on the client." They would adamantly disagree with you before the experience of trying a value conversation. They would say, "No, no, we're really client-focused. The typical creative firm or probably the typical knowledge-based business in any sale, you're not. Clients start talking, you immediately start matching your service to their problem. You think, "Yes, I've seen this before. I know what you need. I know what we need to charge," and you quit listening. For you to be good at value-based pricing, as you've pointed out, David, you need to be good at the value conversation. For you to become good at the value conversation, you really have to let go of the idea that the sale is about you, and you need to shift your focus 180 degrees to the client.
David: If we apply this to a slightly different model, if you think about the employees you have on the team, you're not having value-based conversations about their compensation, but there will be two or three people on your team who want a value-based compensation arrangement. They're fine with the risk, they love the upside. It's the same thing with your client base. A lot of them are just not going to be interested in that. That's okay. That's not failure on your part. Your role is to find the best way to maximize making money for you in a way that that's going to fit the client. You can stretch yourself like you just said and you will discover that some clients will-- They will all benefit from your listening differently even if it doesn't lead to a value-based pricing approach.
Blair: Yes, absolutely. I think it's Stef [unintelligible 00:26:20]. I always pronounce his name incorrectly. I have a few of his books. He's got a PhD in pricing theory. Somewhere in one of his books, he says the line, the goal of value-based pricing isn't to charge more, and I'm going to butcher it, but it's basically to create an organization that's customer-focused. I think most people don't appreciate how profound that statement and insight is because everybody thinks, "Oh yes. We're pretty customer-focused." Well, it doesn't show up in how you sell it, it doesn't show up in how you price, and you won't know that until you try on getting good at the value conversation, and you see how it's so simple but it's so hard to do. It's so hard to do because you keep thinking about and talking about yourself.
David: Oh, man. This could be a therapy session. The fifth one is performance pay. Assume that I'm like the other listeners. I'm particularly interested in understanding the difference between value-based pricing, number four, and number five, performance pay.
Blair: Performance pay is a form of value-based pricing where you are putting some skin in the game. Value-based pricing, at the simplest form, is, "Hey, you're going to pay us to deliver on the outcomes and our fee is x." Performance pay would be, "You're going to pay us to deliver on the outcomes. I'll just pull out some numbers, our fee is 0.5x, but we have other incentives that add up to x. Our fee ends up being 1.5x." Let me back up and see if I can restate that in a way that makes more sense. Where value-based pricing without skin in the game or without putting compensation at risk might net you a higher fee, value-based pricing with performance pay, with incentives means you give up some of that fee in exchange for earning even more, and sometimes a lot more when certain KPIs or benchmarks are hit. That's when you have skin in the game.
That's when you are a true partner to your clients. I've said this before and I think I talk about it in this article. I actually wrote an article called You Don't Really Partner With Your Clients. What I've said before is like so many agencies say we partner with our clients, they even put it on their websites. I said, "That's bullshit. Partnership is when your financial fortunes are tied together. When you have financial skin in the game, that is partnership." Quit saying you partner with your clients. You should partner with some of your clients some of the time once you understand how to do this. This blanket statement of like selling somebody time as partnering them. that is such bullshit.
David: We got through a whole episode, and now we have to put an E on it just because you couldn't control yourself. There's so many thoughts running through my mind about that. Like clients telling you what to do, which is an indication you're really not a partner. It's more of anyway-- Five levels. The first is arbitraging labor, so labor arbitrage. The second is maximum utilization of that. Then there's a pretty big boundary between the first two levels and the third one, which is progressive pricing. Here, you're stepping out of a spreadsheet and you're beginning to think very differently. Level four is value-based pricing. That requires being open to a different relationship with your client, and then a skill at uncovering what's really happening and how you can be the most effective partner.
Then level five, which you're calling performance pay, is a mix of terror and exhilaration where you're really selling out to this. You're probably not going to jump to number five because in number four, you discovered the advantages of this thing. You're really hungry for more of it. You're hungry for a different client. You're pickier, you have different and earlier conversations. This has been really interesting. Have I left anything out here in our summary or things you want to say to them?
Blair: I think the one thing I'd like to finish with is this profound insight from Ron Baker in his book, Implementing Value Pricing, where he says you should think about your client portfolio, the way you would think of your investment portfolio. Everybody as an investor has a different propensity for risk. You should balance your client investments in a way that lets you sleep at night. It should be this mix of low-risk, low-reward engagements with a few, depending on your propensity for risk, a few higher-risk, higher-reward engagements. Some people have a really high propensity for risk and will take on a larger number of those value-based pricing clients or performance-based pricing clients, and some just have no appetite for that at all.
A lot of engineering-based firms like software engineering-based firms, digital firms, the idea of doing anything other than selling sprints, which is labor arbitrage, is just terrifying to them.
If that's terrifying to you, then that's fine. Don't do it. Give up the greater reward, but also give up the risk and sleep better at night. Find your place on that spectrum. The last thing I would add is like Nassim Taleb's idea of balancing risk that you should never take on so much risk that it's an existential threat to the firm. There's a substantial portion of your client base where you're selling time, from my point of view, that's okay. That keeps the lights on, that keeps people paid, and then look for your spots, pick your spots.
Everybody should strive to get to level three, applying those progressive pricing principles, but then you pick your spots on the value-based priced engagements, and the higher expression of that, the performance pay value price engagements. Then the highest expression of that we haven't even talked about, what is contingency pay, I don't want to open the door here to get us into trouble, but that is the highest risk, highest reward pricing model. It's price based on value where you don't earn a thing until the key benchmarks are hit, where you put all of your compensation at risk. I just bring that up because that is the highest level. That is the maximum risk reward ratio that is available to you.
I'm not suggesting that you should do it or even consider it, I'm just saying that is the end of the spectrum. On one end, it's selling time, labor arbitrage, and the other end, it's contingency payment, and in-between there's a whole lot of different ways to do this.
David: I was just talking with a friend yesterday who bailed on an experiment after two months. It's a very well-run firm, they make good money, really deep expertise. They did a hundred percent contingency. They invested all their own time and money. Then they would make a lot of money if they got results. It didn't work like they thought, he pulled the plug, and he didn't lose any sleep over it because he had that portfolio. The rest of his clients were paying very steadily. There's a lot of profit involved, and because it was a very well-run firm, he could take those sorts of risks. Don't hear this stuff and then intend tomorrow to switch everything to the risky category, just inch up this path slowly over time.
Blair: That's good advice.
David: Thank you, Blair. This was really interesting and really fun. I appreciate it.
Blair: Thanks, David.