Cost-Plus or Value-Based (Services)

In my article titled “Cost-Plus or Value-Based: Who wins?” I challenged the status-quo assumption that believes that value-based selling is restricted to niche market only. Throughout the article I explained why for a win-win situation for both the seller and buyer, value-based pricing is a much more matured and fitting approach to pricing for any product-irrespective of the market. However what needs further explanation is whether value-based pricing is an equally powerful option for services industry. This article evaluates cost-plus and value- based pricing in the context of the services.

Services Pricing

Traditionally most services (except maybe Professional services) were priced using cost-plus approach.

Thus we come across the good old billing metrics such as price per man-hour, price per session etc. Clients were also comfortable negotiating in terms of such metrics.

What we need to also note is that not all similar firms charge the same “man-hour” rate. A same firm may charge a different “man-hour” rate based on the assignment. If a firm is using its own repute or the complexity/impact of the project to quote its rate – is it a cost-plus scenario anymore? Maybe, not!

In the case of professional services (high degree of labor intensity and high degree of iterations/customizations), cost-plus was never really the preferred approach. Thus, from the beginning of time the deviation in the billing rates of professionals in the same profession has been high. For example consider the film industry. For the same number of dates, the fees quoted by two actors would be considerably (or maybe tremendously) different. The same rule applies for doctors, architects, lawyers etc.

Value-based pricing talks about pricing based on whether a product provides more or less perceived value with respect to the next best alternative. In the case of professional services however there is a slight difference — since there is the “human touch” involved we can’t be sure whether the next best alternative is a true alternative at all. However the perceived value in this case is the possibility of a professional to deliver a desired outcome. One key parameter that is used for billing a professional service happens to the track record of the service provider. A professional with a better track record (successful cases in case of doctors and fan-following in case of actors) will charge more as he is more likely to deliver a better result. In other words they come with more promise – and thus the client is willing to pay (at times accept the bet).

What Works Where?

While a metric such as man-hour or per-seat cost seems reasonable at the first glance, there are technicalities involved which might make these methods unfair in some contexts. For example, firm A outsources its website design activity to another firm B. Firm B, at the start of the project quotes a man-hour rate and a total number of man-hours estimated for the project. They do deliver on time but the final output is not satisfactory for the commissioning company. Reworking a new negotiation ensues – what to bill for the additional man-hours?

The above situation was common in the BPO/KPO industry in general during the 1990s. However in the same decade a man named Phaneesh Murthy (credited for taking Infosys up from a $2M startup to a $759M company) shook up the entire industry by introducing the revolutionary pricing concept of “Outcome Based Pricing.” As per “Outcome based pricing” — a company would be paid for achieving specific milestones in a project and not for the number of hours spent on the project. “Outcome based Pricing” is very much the services counterpart of value-based pricing – the client derives value from outcome and not number of hours spent on the project! In fact the opposite of “Outcome based Pricing” is termed “Effort based Pricing” (similar to cost-plus).

In Murthy’s own words– “It (effort based pricing) was a great model (at Infosys), Except I couldn’t answer many questions that CFOs and CIOs were asking me related to the fact that, ‘you’re putting junior kids on the job, you’re taking too much time, you’re learning at our cost, we’re doing rework at our expense, you have nothing invested in our success. I figured that the time was right to create a new kind of company, which was…outcome-based.”

The outcome-based billing model or result-based billing model is definitely catching up with the industry in general, and clients also view it as more reasonable. As per a Forbes insight primary research published in 2013 – Between 2011-13, as many as 52% of CTOs/CIOs who were interviewed admitted to have moved to a “result-based” model.

The outcome-based model is not just restricted to the IT industry. Similar practices are present in other services industries as well. For example consider the distribution industry. A distributor often is in a two tier margin agreement with an OEM – high margin for demand creation and low margin for demand fulfillment. In case of retail we do see several factors such as shelf location, in-store branding etc. impact the retail margin.  In-fact whenever a service can be segmented based on the different levels of outcome possible, we can possibly use outcome-based pricing. This is similar to how proprietary products are sold based on value: more/less benefits with respect to next best alternative.

However for some services (such as “IT HELPDESK” or Call-centre) “outcome-based model” may-not be applicable. For such services typically we see “periodic contracts” or “monthly retainer models” at work. These services are similar to “commodity products” – low entry barrier and not much outcome deviation! Can these firms practice cost-plus pricing? They can, till the day they try to outbid their competitor in a reverse auction. In the case of commodity services, the situation is same as that of commodity products — the lowest cost alternative is the most valued option!

Conclusion

Just like products even in the case of services, the world is fast moving towards a value-based pricing model — maybe with a different nomenclature. A major roadblock in case of services industry would be the customer acceptance of pricing process (not applicable in case of products). A full transformation of the services industry to a value-driven price model would thus require significant participation from the customers too. However it is happening.

In the words of Phaneesh Murthy, “The effects-based, time-and-materials model will continue to grow because some customers are clearly very comfortable specifying…or dictating what needs to be done. And there are customers who want the vendor to participate in a little more risk and don’t mind paying up a little more to basically participate in that risk.”