What are the key pricing lessons you need to remember as a startup or founder?
The three pricing schools
The two schools of thought for pricing products or services are Cost Plus and Value.
The value school recommends charging a percentage of value delivered to customers.
The cost-plus school recommends adding a margin on top of expected costs and charging the total to customers.
Value is difficult to get right but wins in the long run. Cost plus is simple, easy and the most common pricing model across services and product companies. Easy and common doesn’t make it the right model for you.
There is a third path. A terrible idea from a long-term perspective, but it has its fans. It’s called the paying capacity school.
What is the paying capacity school?
Find a customer in desperate need and charge him whatever he or she can afford to pay. This is different from value. While it may maximize payouts in the short term, in the long run the paying capacity school kills client relationships.
Imagine going to a restaurant and paying a price for your meal linked to your bank account. Or to a pharmacy and paying a higher price for your prescription because you are in a higher tax bracket. Or getting on a bus and paying higher fare because you own a car.
If you have a bigger bank balance or net worth, you pay more. If you have less, you pay less. Same food, same ambience, same table, same medicine, same bus but different bills because you have bit more or less than the person standing next to you.
Charging customers based on their paying capacity for similar products often leads to models that fleece customers and are viewed as unfair.
A prime example is the aviation industry. Airlines systems have refined paying capacity models to the next level. They do this by using time difference between booking date and flight date as a proxy. A proxy for ability to pay. If you are flying for work or business you have less flexibility but you have a higher capacity to pay. If you are flying for leisure you may have a smaller budget but more flexibility than business travelers. Welcome to fare optimization models we have learnt to hate.
Price conscious passengers book early, stay longer to take advantage of lower prices but are locked in to the airline schedule. Passengers flying for business or work tend to fly at short notice, book late, return early yet pay higher prices.
Companies that outlast competition and build enduring relationships don’t begin with price gouging. You can’t get a customer to trust you or buy again if he thinks he was treated unfairly. The reason it has been been a while since any airline has won the most loved by its customers award.
Value versus cost plus
To do value right, you must numerically quantify impact you deliver with your product or service.
To have a value driven discussion with customers, you need clarity around customer pain and why you are the only one who can bring relief.
Customer should see tangible value delivered with visible impact felt daily.
You can’t get away by saying that it will be delivered, has been delivered or that they are too dumb or slow to see or appreciate what your product, service or team has done for them.
True value results in evangelical customers.
If angry customers are banging on your door waiting for you to step outside so they can beat you up, there is a disconnect. It is safe to assume the customers perceptions of value and yours don’t match.
How can you avoid such disconnects?
Don’t rush to price products. Understand what is driving need and the purchase decision. Figure out how you can help resolve challenges that lead to a solution. Identify and work with customers who understand what you bring to the table.
Quantifying value is a challenge when you attempt it the first time.
Differentiating from competition in noisy and competitive markets is a task.
Determining what to charge customers is an even more difficult ask.
Which is the reason competitive markets gravitate towards cost plus. It is simpler, easier, faster. It works right out of the box. In hyper competitive markets, cost plus often ends up being the only viable choice.
In cost-plus markets, the strategy that dominates is to become the most efficient player in that space. The objective is to increase the margin between your costs and market benchmarks in your favor.
You take more money off the table than your competitors by charging at market and pocketing the difference. If you are not the most efficient player, you get taken out by those who are. There is no rocket science here. Make money on the margin or perish trying.
Young and inexperienced founders and startups short on capital, find it difficult to grow and survive on cost plus. It is also easy to go out of business because the pricing model is unforgiving. You can’t make mistakes because your margins have no fat to cushion the impact of wrong moves.
Value versus paying capacity
How can you tell the difference between value versus paying capacity or price gouging?
My last employer sat between insurance industry and broker dealers who sold tax advantaged saving products to qualified North American customers.
Every time our clients, insurance companies and broker dealers, executed a transaction for their customers, they paid $250 for processing a single ticket.
Using their existing systems and processes they received supporting data set four days later. Four days after close of business on the day of the trade. Because everything was paper; or back end systems took ages to talk to each other; or both.
Insurance industry consumer protection laws dictate once a customer makes a choice of investments, it becomes binding on the provider of the product. If orders are not executed in time, the sellers bear the cost of any price changes.
Imagine a million-dollar investment product not allocated to correct funds and saving vehicles for four days. Now imagine markets and prices moving up by 10% during those four days. The broker dealers, not the customer, were on the hook for the difference in prices. It was called market gain and loss and in wildly volatile markets, it was a pain no one wanted to put on their books.
Enter Annuity Net.
Annuity Net brought cost per transaction down to $25. From $250.
Processing time to get data in systems reduced to less than 12 hours. From 96 hours.
The platform complied with state specific documentation requirements. Client suitability was automated. Delays in issuing correct paperwork were minimized.
How much did we charge? What was our cost base?
We charged $25 per ticket. Customers signed up in droves. Our marginal cost per transaction ranged between $3 – $5 per ticket depending on the product and the transaction.
5 – 8 times cost is not price gouging when value you deliver to customers is ten times your ask. You can charge up to a third of documented savings depending on how much customers are hurting and how good your product is.
In our case issue wasn’t the $250 cost per transaction. It was the four-day delay in getting data that created unlimited legal liability for the customer. The team closed the legal liability loop, made it cheaper, faster, efficient and more accurate in the process. The liability is what drove the sale. Everything else was a much needed and welcome bonus.
Cost plus suggested $9 – $15 per ticket. We asked for $25. The $25 didn’t make sense if we hadn’t understood the use case, customer need and what drove the sale. It took us five pivots to find a model that somewhat worked. But it wasn’t sustainable at the $25 benchmark.
It was great business, but 5 times marginal cost wasn’t enough to save it. We didn’t scale it fast enough. The issue wasn’t technology, it was syntax.
It was creating a general parser capable of reading business rules of one hundred products, forty insurance carriers, twenty broker dealer and staying sane.
Unable to make numbers work for our original investors, the business was sold a few years later.
Sometimes even when you get the math and the context right with value, you still lose the battle. Not because the model wrong but because you used the wrong data.
My introduction to cost plus pricing
A specialized consulting group within a mid-sized services business first introduced me to cost plus pricing. We called it the rule of three.
Estimate the effort required for the engagement in man-months. Translate man-months into cost for deployed resources. Adjust for contingencies. Multiply everything by three. Quote the result to client.
Housed under the protective umbrella of a big 5 accounting practice, the firm had a decent reputation in market for doing above par work. The accounting network gave the group cost plus pricing guidelines.
The guidelines weren’t always followed.
We priced engagement and assignments where other contractors were likely to bid, at market.
Consulting services where similarly ranked firms were likely to bid, were priced just under or around the level being quoted by the competition.
Since everyone worked off similar pricing models, it didn’t take a lot to guess the numbers they were using.
These were standard engagements. We received data from clients, ran it through models, wrote a report, made a client presentation, finalized required disclosures and sent in our invoice. Money came in 60 days later.
The work was regulatory disclosure work. Complex but mechanical. With limited need for supervision from senior partners.
They reviewed our work and signed reports. We took care of data analysis, report writing and account management.
For these engagements, the market set the price. Vendors were price takers.
We were one of five such teams competing against each other. The number three player in our space declared a price war on top two players and was undercutting everyone with lowest possible price.
When a customer called for a proposal, we asked for basic information, plugged values in our pricing model and quoted a price. If the customer came back for a discounted price, given the ongoing price war, we gave the required discount because we were the newest firm and were happy to trade lower prices and margins for market share and credibility. We ignored the rules because we wanted the work.
This was possible because the larger accounting practice, our owner, was willing to subsidize our costs. They had set a two-year window for this new team to breakeven. Having allocated the seed capital to setup the new business, what we booked as revenue reduced overall loss end of year.
When we spoke to each other we called ourselves the marginal player. We had the cheapest cost base and we weren’t ashamed to flaunt it. We were happy to be the cheapest because our salaries were paid for and we had a two-year runway in front of us.
Two years later if we broke even, we would celebrate. Covering our marginal and variable costs would be a bonus. If we locked in these marginal customers based on quality of our work and speed of our service and converted them next year to higher prices, that would be even better.
In a worst-case scenario, credibility, track record and local experience was key to getting new work. If the status quo remained same two years later, we would no longer need to discount our work.
Most startups are the newest kids on the block in their market. They don’t have flexibility in setting prices if comparable products exist in that space. If their cost structure is the same as incumbent players, they are out of luck right at the start. If their cost structure is significantly cheaper (read: orders of magnitude cheaper) they can hope to compete effectively and make money.
Takeaway. In competitive markets focus on doing it cheaper and faster than everyone else as a startup founder.
But to correctly answer the above questions, they must first understand what their cost structure is.
What does it take for us to setup shop? What does it take for us to serve a customer? What does it take for us to keep our doors open and answer emails and phone calls?
We borrowed two desks and a mostly empty room for our team. Rent and utilities were being paid by the accounting firm. We accrued it but we didn’t have to pay it till end of year when the partners settled their accounts. Our monthly salaries were less than a thousand dollars. That meant two engagements a month to breakeven on salaries. One client came through the accounting firm every month. One we brought in by bidding on proposals and letting people know we were open for work at everyday low prices.
The rules of threes
Other than standard work we received requests for proposals for custom work where bids were not competitive. Here we had more flexibility. On custom consulting engagements the model was 3 times costs. If salaries were thousand dollars a month, a one-man month project requiring full allocation of our team for twenty working days had to bill three thousand dollars month plus expenses plus any other incidentals. Remember, a man month was only twenty working days. A sixty working day project was three man months, not two.
One third went to cover salaries. One third for infrastructure and supervision. One third for profits.
Problems occurred when proposal required a fixed price bid. For such contracts we had to estimate the work effort, load it up with a margin for error and then quote using the model. If our work effort estimate was off, we ate into the margin and then into the allocated overhead.
This happened so frequently that we came up with another rule of 3. Whatever our work estimate, multiply that by three to cover room for error. It was possible to be wrong by 20% to 30% but not by 300%.
Between the two rules of threes we grew the practice to twenty people in three years.
Should you, or shouldn’t you?
If you run a consulting services team, you most likely use a version of the two rules of threes.
Should you continue using them? Most consulting teams use a variation of the same rules.
A deeper dive shows a different picture. The rules of threes don’t leave margins. For errors, growth, fair compensation or decent infrastructure.
Here is the truth.
You are not going to send your kids to college or retain a world class team at three times salaries. In the long run three times costs is just enough to keep the lights on and pay your bills. Because our effort and costs estimates are always optimistic while reality is unforgiving and disconnected from our expectations.
Takeaway. You are welcome to stick with 3 times costs. Just don’t continue dreaming your dreams of plenty and prosperity.
I know because I have been there. I lived by the rules for five years.
Things were always tight at the firm. When you joined you could clearly tell that we kept costs low. We survived and grew not because the model worked but because the accounting firm and the consulting work done by the senior partners was insanely profitable. The tab for mistakes we made was picked up by the practice that owned us.
Without that protective cover, we would have gone under within six months. Work and effort estimates are not just off, they are essentially wrong in young firms. Client expect top tier quality work at budget prices. Always a nice to have but neither viable nor sustainable.
You must have a budget to experiment as you initially set up shop so that you can go ahead and make mistakes. Someone must pay for these wrong turns. Add that to your client tab as part of the service. Your rule of three has now become a rule of four.
For the firm and the practice to grow you must invest in research and development. Someone must pay for that. Revise the rates again. Cash flows will always be unpredictable, and clients will rarely pay on time or move payment linked milestones forward. You must build a buffer for delayed payments and milestones. Let’s just throw the old rate sheet out and build a new one. You want world class talent working for you. Guess what, you need to continue to pay and revise marked linked salaries. Yup, you got it right. To do well, to grow, to survive and to last you need to charge six or seven times costs.
Is that practical? Why would a customer pay seven time cost for resources that he may hire for one-time salary himself? He won’t if the work you do is commonplace with an infinite supply of vendors.
Given a choice between work that everyone can do and work so complex that no one can do it, opt for work that no one can do.
Find spaces where only you can do the work. Hard ask but if you look you will find specialties that are rare, awkward and difficult. They won’t support a large practice, but they are good enough for small teams. Specialization doesn’t happen overnight, isn’t easy or obvious when you are struggling to pay your bills with the practice you have chosen.
Look at the intersection of fields and shared interests. One of my role models bills a million dollar a year with his one man firm. He is one of the three people in the world who can do what he does. His work sits at the intersection of the exotic and the truly exotic. It took him four decades to get where he is today.
Given a choice between a range of services and a focused few, pick the focused few. Dig deeper till you find something that most professionals in your space will find difficult to execute or where you have an inherent edge due to your background, education or exposure.
Whenever you evaluate a line of work, ask yourself these simple questions.
- Under what conditions will a client pay seven times salaries for us to do this work for him?
- Are these conditions likely and achievable?
- How long will it take for us to get there?
If your answers sound reasonable dig deeper and explore. If they don’t, walk away.
References and Sources