January 29, 2020
Cost vs Value Pricing
Sent by Jonathan Stark on January 29th, 2020
Hourly billing isn’t inherently unethical, but it encourages all sorts of bad behavior. For this (and other reasons), I’m strongly against hourly billing.
So... how should you charge for your work if not hourly?
Well, when it comes to project work (i.e., a non-trivial collaborative undertaking that is intended to achieve a particular result), I advocate using value pricing instead of hourly billing.
People tend to get all tangled up in the nuances of how to value price a project, so here’s a dead simple way to think about it...
Value pricing is just a way to calculate a fixed price for a project.
As a point of comparison, let’s consider another fixed price approach that most people seem to be familiar with called “cost plus” pricing.
Here’s a definition of cost plus pricing from Google:
> Cost plus pricing involves adding a markup to the cost of goods and services to arrive at a selling price. Under this approach, you add together the direct material cost, direct labor cost, and overhead costs for a product, and add to it a markup percentage in order to derive the price of the product.
For folks like us, generating a fixed price proposal with the cost plus method basically amounts to:
- Estimating how many hours we think a project might take,
- Multiplying the estimated hours by our desired hourly rate,
- Tacking on an arbitrary percentage for “project management” or “scope creep” or whatever, and
- Presenting the resulting amount to the client.
There’s a lot of magic and hand waving going on here (e.g., How’d you come up with your hourly rate in the first place? How good is your scope definition for the project? How good are you at estimating your hours in advance? How’d you come up with the “project management” percentage number?), but everyone seems to believe that they understand the mechanics of this approach.
Value-based pricing is simply the opposite of cost-based pricing.
Instead of thinking about your costs first, you think about your client’s value first.
Put more simply:
Instead of thinking about yourself first, you think about your client first.
Once you have a rough idea of the client’s perceived value, setting a price is a simple matter.
That said, I suppose the big reason that people have such a hard time implementing value pricing in practice is not that they don’t understand the concept, it’s that they don’t understand their clients.