The Power of Options
David asks Blair to clarify his advice on offering proposal options and anchoring. Is it about more than just scope and price?
Links
Implementing Value Pricing: A Radical Business Model for Professional Firms by Ronald Baker
Pricing with Confidence: 10 Ways to Stop Leaving Money on the Table by Reed Holden and Mark Burton
Negotiating with Backbone: Eight Sales Strategies to Defend Your Price and Value by Reed Holden
“6 Psychological Tactics Behind the Starbucks Menu” by Kent Hendricks
Transcript
David: Blair, I just got back from a really fun RV trip. On that trip, I didn't think about you at all. Actually, I forgot your name. I had to go look it up when [crosstalk]
Blair: [laughs] Oh, you liar. We were texting the whole time, girlfriend.
David: Yes, I know. [laughs] Here's a little bit of behind the curtain of this podcast. We take turns, and if it's going to be my turn to do most of the talking, then I'll say, "Hey, Blair. Why don't you interview me on this," and you say, "No, I'm not interested," which you've done a few times, or, "Yes, great one," and then I'll say, "Okay." Then I'll put together, I don't know, six or seven bullet points, and then you'll use that. You'll interview me, and then we switch every week. But in this case, I'm actually telling you what I want you to talk about, and here's why. It's partly because I'm confused, so if you pretend that I'm really smart, this might be sort of a 60-second episode. If you pretend I'm dumb, this might be unnecessary. [laughs]
Blair: No worries.
David: Yes, I've really set myself up for that one. Then, it might take 30 minutes to explain this to me, but here's why it came up in my mind. We probably overlapped maybe 20% or 30% of our clients. In other words, the people that have gone to your training, about 30% of those have been my clients in one form or another, and so I get to hear the impact that you've had on these clients. Over and over again, they tell me that the two most impactful things that they have heard and implemented are these. One is the one-page proposal. In other words, something much simpler, and we've talked a lot about that in earlier episodes. The other is the options on the proposals including a high anchor.
As I started to look into that and probed what they meant by that, it got confusing to me, because you talked a lot about how you need to think about how you're going to transfer risk in one form or another, and the three options on a proposal are not just simply more scope, more price, but actually a different way of working together. I don't think some of my clients have gotten that. They’ve mixed up a few things. Even if it's just for me, selfishly, I just want to clear that up, and so that's our subject today. Are you game for diving into this?
Blair: Yes. Hit me with whatever questions you have on the topic. It's kind of a deep topic, and it's even deeper to me now than when I wrote about it in Pricing Creativity back in January 2018. Let's fill in some blanks, and then we'll file this podcast with the bunch of the others, and they're listening to this podcast instead of having me do active consulting because I think that was your goal, right?
David: [laughs] Yes, right. For that to really work, we're going to have to monetize this podcast, because eventually, I'll be making no money at all. The first question is why options? Because most proposals don't have options. Most proposals are: “Here, I've listened to you as carefully as I could. This is what I think you need. This is what we can do for you. This is what it will cost. Yes or no?” Your approach is very different, and the biggest difference there, at least the first big difference is options. Why options?
Blair: I'll give you a couple of different reasons why options. First, I'll say, the approach isn't that different. It's not my approach. I didn't invent this. So many of the pricing principles in my book are attributed to me, but almost every one of them, I've borrowed from somewhere else, and I try to cite the source wherever possible. Much of what I've learned, I first learned from Ron Baker and his two books.
The most recent is called Implementing Value Pricing and that's the one I would suggest people read. Ron himself is an excellent student of the field of pricing, and he's done a lot of the legwork of reading all of the background material, and I've read most of it. What I found hard to get through is the stuff that I think Ron really did a good job of getting through the textbook-like books like The Strategy and Tactics of Pricing. Sometimes cited as the bible of pricing. It's just like an inaccessible, unreadable book.
One of the authors of the later editions is a guy by name of Reed Holden, and he's published some really accessible books in the subject of pricing and negotiating, so Pricing with Confidence and Negotiating with Backbone. Those two small books tend to go hand in hand, and if people are looking for more accessible reading on value-based pricing, both of those books are good. That's a long way of saying, "I don't remember where this idea of options first came from," but options are powerful because they provide the context that is required for the client to make a decision, and if you do not provide that context via your options, you're forcing them to go get it somewhere else. Let me just explain that a little bit more.
It's widely understood that value is subjective. That value is something that exists not externally in the world, independent of an absorber, but within people, within the subject, or within the observer. This wasn't always understood. For about 130 years or so, we had a different formula for value, and then, around 1905, I think it was Carl Menger, one of the founders of the Austrian School of Economics, arrived at this subjective theory of value that said, "Value is something within us. Value is in the eye of the beholder." It's subjective and it's purely contextual. We all value different things differently, even at different times, and we'll value things in different contexts. If you as the salesperson provide the context by which the client essentially assesses value, then you can have a big impact on how the client values something.
I proved this in my book by showing an image there effectively getting you to confuse black with white, and the message is, "If you let me control the context, I can get you to think that black is white. I can get you to think that heavy is light. That wet is dry. That cold is hot. That dim is bright." All of these things. Because these are not absolute values, they're subjective values, and they're entirely contextual. It's a long ramble. A way of saying when you put forward a prosal to a client with one option and one price, and let's say the price is $10,000, the client can't really--
This isn't entirely true, but it's true enough for me to say it. The client can't really look at that proposal and answer the question, "Is this worth $10,000?" The question the client's brain is wired to answer is, "Which of these is the best value?" If you don't context, a comparison, another option to the client, then you force them to go and get it. They go get context by getting bids from other vendors, other experts, or suppliers. That's one way. You’re forcing the physically leave to get some other bids in search of the context that they require, or you force them to leave mentally by thinking, "What if I paid you before? What else might I do with $10,000, et cetera?"
Just first appreciate that the decision around value is a subjective and contextual decision, and if you can provide the context, you will impact the decision being made, and in the world of behavioral psychology, that's sometimes known as choice architecture or nudging. Nudging people in a direction to make a decision based on the way you architect the choices. That's the long answer to the question of why we provide option. We're changing the question that we're asking the client from: "Is this worth $10,000?" to "Which of these options is the best value?" That's the question the brain is really wired to answer.
David: I buy that argument now that we should use options, but how many options is really going to work against us? Is two enough? Is three too many? Is four too many? Is there the same science around how to buy professional services that would impact? If we buy the idea of options, how many options we should use?
Blair: The short answer is three or four options is best, and I'll explain it. A psychologist once explained to me that some people need choice. They just need it. That's the way he viewed it. An economist would look at it differently. His guidance to me was, those people who need choice really just need two options. We weren't talking about pricing at that time. We were talking about the psychology of presenting creative solutions when you get briefed by the client, and you come back and present the solution.
His point was, some people need options and you really just need to give them two. When it comes to pricing, you want to provide three options. Four is okay. Five, you start to introduce this idea of the paradox of choice, where too much choice immobilizes people. At least, I believe five is where the paradox of choice kicks in. Three or four is better than two. Let's just stick with three. The reasons three is better than two is if I were presenting some options to you David, to buy a product or service from me, and let's say I presented two options.
Option number one was priced at $10, and option number two was priced at $15, and let's say put these two options in front of you every day. You're coming into my coffee shop would be a great example. I'll come back to that. Option one is $10 option two is $15 when I average out your selections over time, the average selected price is going to be somewhere between $10 and $15. Let's call it $12.5. Now, if I add a third option that's higher at $20 your average selected price is going to go up. It's going to be closer to something like $15. That's why you want to add a third one and you want to add it at the higher end because the average selected price will go up. Now, if I were to add a third option at a lower price at $5 now we had five 10 and 15 instead of 10, 15 and 20 your average selected price would go down.
Ron Baker and Ed Kless in their podcast, The Soul of Enterprise which I've mentioned many times before here. They did an entire show on Starbucks pricing. You think of Starbucks, you go into Starbucks, there are three options. Do you drink coffee?
David: I do. Grande, Venti. What's the other one?
Blair: Tall. It’s starts with tall is the shortest, which sounds odd. Then there's Grande then there’s Venti. That's tall, medium, and large but whatever happened to the short? It used to be Short, Tall, Grande. The average selected price, I'm just approximating here, would be something close to the middle. It always averages out towards the middle because of a principle known as extremeness aversion. When presented with more than two options, people avoid the danger of the extremes and retreat to the safety of the middle.
The extreme at the low price is the danger that you underbuy. That's the danger, and the danger at the extreme of the high end is that you overbuy or overpay. We tend to retreat to the safety of the middle. I’m reminded of this every time I drive through a car wash and there's the gold, silver, bronze option, or sometimes there's four options. I don't even stop to read what's involved in these. I just choose the middle one or one of the two from the middle and we all do that reflectively as we avoid the extremes and we retreat to the safety of the middle.
Back to Starbucks, it's Tall, Grande, Venti. It used to be Short, Tall, Grande. What they did is they took the Short off the menu. You can still order the Short, it's just not on the menu and you know it's there because if you order a Tall, which is the smallest size on the menu, and you go-- If you grabbed the smallest lids, they don't fit. The lids are there for the Short. It's just not on the menu. You can still order it, but instead, Starbucks took the Short off the menu and they introduced this Venti 20 ounces of coffee.
Now, they never dreamed that the bulk of the population would end up drinking 20 ounces of coffee. That is a uniquely American thing in Canada too. You don't see it in Europe. It's absurd, but what happened as soon as they made that switch, they dropped the Short, they added the Venti. The average selected price went to the Grande. That's why we want to use three options.
David: So that there's a middle essentially?
Blair: Yes, your expectation is the client will end up in the middle.
David: Right.
David: Okay, down to the crux of what I think some clients are confusing. There are these phrases that they have learned from going through training and reading your book and so on listening to the podcast, reading articles. They talk about a high anchor. Some of them I think are viewing the high anchor as really more scope and more price. They aren't necessarily weaving into that higher price, a different transference of risk. I want you to get to that at some point. This may be too early in the discussion to get to it, but that's at the heart of this confusion. Is it just three choices that reflect a difference in scope and price or are we weaving in here a different view of risk transfer as well?
Blair: Let me just explain the high anchor and then I'll rephrase your question as what should they be options of? Because that's where you're seeing the confusion. Anchoring is the idea that the first piece of information on a subject will skew your final decision. When it comes to pricing, price anchoring simply means when you're putting forward multiple prices, in the case of our example here, three prices, you always begin with the highest one.
The job of that anchor price point is not to sell that anchor solution. It is to make the other options look more affordable by comparison. We'll leave anchoring for now because that's a different topic, but it absolutely comes into play when you're putting forward options. Back to the question that I've rephrased as: “Options of three options of what?” What you're alluding to, the crux of all of this in the conversations we've had on this podcast and elsewhere, it's become clear to you that I didn't necessarily mean that when you're putting together your options, it's just three different sized buckets of deliverables.
David: Like the coffee cups, right?
Blair: Yes, and that's mostly what you're seeing because I see it too. Clearly I haven't done a good enough job of explaining, even though I thought I did in the book. We need to revisit this topic of explaining the fact that it's not just the cheapest option is a small bucket of deliverables and the middle option is a larger bucket and the expensive anchor option that you would lead with first is the largest bucket, but that is the first step that people almost always take when they move to this idea of options. It's okay. It's perfectly fine to move there as a first step, but my belief strongly, people should look beyond that.
It's not just about different bucket sizes. There's probably an infinite number of ways that you can slice and dice your three options. Let me talk about a fundamental principle here and break this out in the options. Fundamentally, there are really only three things that your clients can buy from you. Therefore, there are three things that you're selling and pricing. The first one is the inputs of time and materials.
David: Timekeeping, timesheets.
Blair: Yes, timekeeping. You can sell them blocks of time. The second one would be outputs or deliverables. The third one would be outcomes or the value that you propose to create. In one example, let's say a client comes to you and wants you to design a website and they say, “How much?” If you're pricing inputs, you would say, “Well, I don't know how much it is, but it's $20,000 a sprint, or it's $5,000 a day, or it's $200 an hour,” or whatever the math is. If you're selling inputs in the purest form, and we talked about this in a recent podcast, where we talked about agile and how it clashes with value-based pricing.
If you're just selling units of time, you're pushing all of the risks to the client. You could say, “Well, I'll sell you some time. I don't know how long it’ll take. I'll just bill you each cycle, each sprint, or each month,” et cetera. The second level is outputs. You would use time, sometimes market value to make an estimate of how much it would cost. Let's say you determine it would take between 100 and 200 hours and then you take your hourly rate and if it's $100 to keep it simple, it's going to be between $10,000 and $20,000 that's your estimate of how long it's going to take and then you price towards the higher end of that range.
You say to the client, “If you were looking for price certainty, the price is 18,500.” That is you pricing the outputs. You are pricing the outputs in this case, based on the inputs. Let's say you arrive at 18,500 and you think, “There's some pricing pressure. I know others will do it for less. I'll give it to the client at 15,000.” Now you're factoring in the market value. I'm using air quotes of the outputs in addition to the inputs, but the client is buying the deliverable. They're not buying your time, they're buying the deliverable, and if it takes you longer, you have to eat it. You can't bill the client afterwards because it took you longer.
Then the third thing that you could sell to the client and price is basically the value or the outcomes. In the sale, you would ask, “Why do you need a new website? What are you trying to accomplish?” Let's say you learn that the client company's trying to arrest a sales slide of 10%. Sales are down 10% and you determine through the conversation of the client, annual sales were 100 million. Now it's they're down 10 million to 90 million. They're looking to make that 10 million back. The average gross margin on what they sell is 20%. They're looking for you to increase profitability by $2 million or reclaim the last lost profitability of $2 million.
Instead of selling the inputs of time and materials saying, “It's this much per sprint or per day or per hour,” or pricing based on the market value of the outputs. You could propose to get paid based on the outcome. If we help you reclaim $2 million in lost profit, would you pay us $200,000, 10% and the answer might be yes, it might be no. That's getting paid based on the outcome. Let's say the client agrees. Then there's still some nuance around how you get paid that you have to figure out. Are you willing to put some of that compensation at risk? The higher number that you propose to get paid as a percentage of the value you propose to create the more likely it is that you're going to have to put some compensation at risk.
That's almost an entirely different subject. Getting paid based on value and then the price that you propose to get paid based on the value you propose to create and then the means by which you get paid. Do you just get it all upfront under the assumption that you are going to deliver this value? Do you get paid based on performance? Do you get paid a combination of a ratainer maybe to cover your costs and then incentives based on performance? Et cetera.
This is a real long ramble. What I'm pointing out here is there three different ways that you can get paid and these three different ways might represent three different options. Imagine you sit down with the client and say, "I have a proposal with a few different ways that we could work together and it really depends on what you want to buy from me. Do you want to buy time and we'll just bill you as we go and when we're done we're done?" Or, "Do you want some price certainty? Do you want to buy the deliverable and we'll put a price on it based on a factor of time and maybe some other things? Or do you want a business partner here?
Do you want us to be incentivized to actually create the value that we talked about?" Different clients value different things. It's a mistake for you to think that everybody wants to buy inputs or everybody wants to buy outputs or everybody wants to buy value.
What you're really trying to uncover in the sale is what does this client value and then you put the options in front of them. Sometimes you won't know. It's sometimes just the act of putting forward three options is an exploration of learning what it is that the client does value. They might come back and say, "Well, I'm really intrigued with this idea of paying you based on the value that we're trying to create here, but I'm really only interested in it if you're willing to take some sort of performance pay where you get paid when we create that value."
Again, there are an infinite number of ways you can slice and dice this. You could put all of your compensation at risk. You could put none of your compensation at risk or you could put some of it at risk. This third option, the high anchor, the one where you're not getting paid for inputs or outputs, but where there's some shared risk, it's more expensive in part because you are functioning as a business partner, which means you have to get into their situation deeply enough to really make a difference.
Because there's more at risk for you, you are paying attention in a slightly different way. If we take this silly Starbucks example, and I know this is going to break down pretty quickly. We have the Tall, the Grande, and the Venti and let's say they're $4, $6, and $8. Starbucks could decide, "All right, we're just going to charge you $4 for the Venti." Then come back at the end of the day and if you were a lot more productive because you loved the experience and the caffeine was really good, you can see how this is going to break down really quickly.
You pay nothing if you want or give us what you-- How did it impact the rest of your day? It's more complex. There's a wider variety. It's not necessarily more expensive. It actually could be-- You actually might make less money if you don't deliver on what this is. To clarify this, to get back to my original question, you're saying our options are good. To simplify this a little bit, we ought to think about three options. I'm going to ask you in a few minutes here what order these options should be presented in.
But the more complex one is more complex because it involves more partnership. There's more to measure, there's more risk, there's more risk for both parties essentially. Is that correct? Is that a correct summary so far?
David: Yes. It's largely correct.
Blair: The thing is, when you're selling time, it's not necessarily the cheapest option because there's no price certainty. The danger from the client's end is the client is taking the pricing risk because you're not offering any price certainty at all, so it might be the cheapest option. It might end up being the most expensive option and then outputs. There's some level of price certainty and then outcomes. This is a more complicated subject. If we take performance pay out of the equation, it's not really a partnership.
It's a step towards partnership. I say to you, David, “I'm going to help you create $2 million in net new profit here. I want to be paid $200,000 for that.” If you agreed based on that, then okay, you've agreed to buy the value than I'm selling to you. Now, we agree we don't have to track time. We know deliverable wise there's going to be a website, but the understanding is that I'm going to get in there and keep tweaking the website until we create that value. There's no limits on number of revisions, time, et cetera. We're in this together. You're going to pay me a large amount of money above and beyond any kind of a measure of time, or even market value of the deliverable.
That's approaching a partnership, but it gets real complex and it becomes a real partnership when I put skin in the game. Instead of saying, "You pay me $200,000." I say, "Listen, you're just going to pay me $50,000 or $10,000." If we go back to the previous options of a range of $10,000 to $20,000. I might say, "You pay me $10, 000." I would lead with saying, "The price is $100,000." Now, here's how it breaks down. It's a base fee of $10,000 and it's $90,000 worth of incentives once we start to create this value. Once sales get back to this point, and I could structure that as a commission.
I could structure it as a percentage of sales. I could structure it as equity in the company. Like Phantom shares, if I wanted. There's so many different ways I could structure it. It can be just a straight percentage. It can be a bonus that gets paid to me when sales get to a certain level. It's stairsteps all the way up to a $100, 000. That last option of pricing on outcomes or value can get really, really complicated. In the simplest form, it's just you agree to pay me a larger number because you understand you're not buying limits of time or limits of deliverables.
You understand that I'm going to stick with you until we get the results. The next level of complexity up from that is all of that is still true, but my base compensation is low and then I get paid incentives as the value is created.
David: If a firm were going to employ a more perfect version of the theories that you've worked out in the marketplace, their third option, regardless of what order these are presented in, I need you to speak to that in a minute, but the more expensive, the more complex option is not just more scope for more money, it involves a different view of risk. That's a true statement?
Blair: At the highest level, yes. We've talked about two ends of a spectrum. The most basic level is you have three different buckets of different sizes of deliverables. The most maybe complex level would be this idea that your options are based on the three things that you're able to sell and price. Inputs, outputs, and value or outcomes. In between those two spectrum points of complexity, there's still a whole bunch of other ways that you can think about options. One might be just a sense of risk or performance risk.
You might say to the client, "All right, I've got three different ways that we can work together and I want you to choose the one based on your comfort level with risk so at the highest priced option, I have for you is an engagement or a way of working with you where we take away as much risk as possible." That might mean so many different things, but it's like, “We're going to do all of these things, or work until these things are true,” but just back to me explaining three different options at three different risk levels.
At the expensive version, I can make almost all-- Not all, but almost all of your risks go away. Like in theory, I could provide an option that makes all the risk go away, but let's just stay practical here. At the most expensive option, I can make a bunch of risks go away. If it's important for you to try to get this done as cheaply as possible. I have a far less expensive option, but it sees you taking all the risk. We'll do certain things, but the rest of it you're on your own. Then in the middle, I have a moderate level of risk. That's performance risk. That's one way to think about your options. How much risk does the client want to take on and how much do they want you to make go away?
I have to quote Peter Drucker again because it seems like I have to on every podcast and every speech. "In business, all profit is derived from risk." The client goes to the market and take some risk and then they hire you to make some of that risk go away. Some of the clients want you to make a very small amount of risk go away because the more risk you make go away, the more you're going to get paid and somewhat, you'd make a whole bunch of risk go away.
You can also think of it in terms of financial risk. Maybe it's just the engagement doesn't change. How we work together doesn't change, but I'm going to give you three different ways that you can pay me. Option one, with my high anchor is cash. You pay me $200,000. If I go to the other end of the spectrum, it would be maybe it's no cash, you don't pay me any cash, you pay me incentives based on performance. In this case, it might be based on sales or net profit, but if we hit this target, you're going to end up paying me more money. In the middle, it's a combination of cash and incentives. That's just another way to think about putting together your options, basically, on the level of financial risk. It depends on how much financial risk you want to take on.
David: As we wrap this up, I've got two quick questions. One is, "Is there some best practice around the order in which you present these or talk about them?" Then "What about naming?" Because I keep coming across people that are following the SaaS model good, better, best.
Blair: Gold, silver, bronze.
David: Yes. Can you touch on those two points? The order? Is there a magic to the order? Are there some best practices around naming as well?
Blair: Yes, as we've already talked about with anchoring, the high number always starts first. It's a matter of personal preference on whether you go from the high anchor to the middle option or the lowest option. I actually like to go from the high anchor option to the lowest one and then come back to the middle, knowing that the clients basically going to go on this journey with me. First, they're gonna have some price shock when I deliver the high anchor then they're going to come around and see why the price is the way it is.
Then I'm going to move to the cheap end of the spectrum. If the client has stated a budget to me, this is where I'm saying, "Well, here's what I can do for your budget." In contrast to the high anchor option, it's not very much. Then I moved to the middle and I say "No, I have this kind of compromise option. It's in the middle. It's only a little bit more than your stated budget." A little bit more still might be multiples of it depending on how high the anchor was.
David: Right.
Blair: I like that order. When it comes to putting on the page, it doesn't really matter moving from left to right. I used to do low, medium, high. Now, I prefer high, medium, low. But it really doesn't matter. What matters is the one that you begin with. What matters is the first number that comes out of your mouth. That's order. When it comes to naming, I would suggest that you name your options based on what the client is buying from you. One set of options like types of value, we didn't really talk about this, but it might be types of value. One option might be speed to market. Another option might be access to principles. Another one might be risk mitigation, just mixing things here.
The name of the option is explaining the net benefit in that option to the client rather than volume or grade. Like this idea of gold, silver, bronze implies a grading system. Good, better, best implies a grading system. Your cheapest option might not necessarily be the lowest grade. Another way you can split up the options or think about options is a level of "Do-it-yourself-ness ". Your low option might be "You can do it. You just pay us to come in, do a diagnostic, we'll give you findings and recommendations. You pay us to deliver the plan. Then you can implement the plan." That would be the lowest price option.
The highest price option your anchor that you would begin with would be full implementation. "We can do it. We'll do the diagnostic, we'll develop the plan and then we'll implement against that plan." The middle option is what we call the Home Depot option. "You can do it. We can help. We sell you the diagnostic and then we offer some degree of oversight." Those might be pretty good names for those options. "You can do it. We can do it. You can do it. We can help."
To put gold, silver, bronze on that or some kind of rating system of good, better, best, that's you overlaying a subjective judgment on what the client values and would be wholly inappropriate in this example. Don't do that. It's not a matter of good, better, best. It's not a matter of gold, silver, bronze. Describe what it is. What the client would be getting from you.
David: I have read or at least skimmed thousands of proposals over the years and I have never seen a firm name the options like you just described. There are so many deep nuggets in here. It's probably one of those episodes that folks might want to listen to multiple times and take notes because we've addressed so many different things. We've dug really deep on a particular topic. We've talked about this broader topic many times, but we haven't dug this deep on the options, the pricing, and the naming. This answered my question. I appreciate it.
Blair: Yes, my pleasure. I'm here to help, David. Anytime.
David: Thank you, Blair.
Blair: Thank you.