Setting Your Price -- T&M or Fixed Price

By MaryAnn Whiteman, President, Whiteman Consulting - January 27, 2011

You can’t see one or touch one. The customer must purchase one before experiencing it and measuring the results. How do you price something that is invisible? How do you price a promise? Many professional services organizations start with hourly rates, move to cost-based pricing, and then to value pricing as they build their brand and become more experienced in scoping projects.

 
In this article, we’ll explore various ways to set professional services fees. There are two main approaches: time-and-materials pricing (charging for the time spent working on a project), and fixed-price services (providing an up-front quote for a project). Table 1 presents the pros and cons of each approach—from your prospective and the client’s perspective. For fixed-price services, there are several methods to calculate the price: cost based pricing, value-based pricing, and market-based pricing. Let’s take a closer look at each of the pricing methods.
 
Time-and-materials pricing. Without a track record, it is difficult to scope a project and provide a fixed price. For this reason, new professional services organizations often start by charging for projects by time and materials (T&M) expended. With time-and-materials pricing, a services organization bills for services based on the time expended on the project, plus the expenses incurred in delivering the project (e.g., travel, equipment). Most consulting companies have a range of consulting fees based on the seniority and expertise of the consultant. 
 
Your project proposal should include an estimate of the total hours and costs. If the project is taking longer than anticipated, tell the client why your estimate is changing and by how much. Perhaps unexpected problems were incurred or the client requested additional work. Good change control management is critical regardless of the pricing method.
 
Cost-based pricing. Cost-based pricing is one method of determining a fixed price for a project. Calculate the total service cost and add an additional amount to achieve the expected profit margin. Be sure to consider all service costs, including the number of consultants assigned to the engagement, their level of expertise, the time required by each consultant to do the job, travel expenses, and cost of the methodology. Usually, a risk factor is included in the equation. Be sure your contract includes the hourly rate that you will charge if the scope of the project increases. You may want to include a bonus fee for completing the project ahead of schedule.
 
Experienced consulting groups can estimate small projects based on past engagements. If the project is large, PS organizations usually charge for an assessment service to gain the required information to scope the project. The assessment service provides recommendations for the client. And the information gained during the assessment should be sufficient to prepare a proposal for an implementation service with a fixed-price quote or at least a price for the next phase of the project. The client is billed in accordance with the contract terms (e.g., at completion of a deliverable, milestone, phase, entire project).
 
Value-based pricing. In value-based pricing, a price is set based on the value of the service to the client. The fee is earned when the agreed upon goal is achieved; it is not dependent upon the amount of time expended. To determine a value-based price, start by calculating the project cost and applying the minimum profit margin to obtain the lowest possible price you can accept. Then consider the value added and the price you believe the client will accept. The challenge is arriving at a price for a project that appears fair to the prospect and is sufficiently profitable to your organization.
 
To successfully use value-based pricing, you must comprehend the value your service creates for the client and convince your client of that value. This requires experience, business savvy, and top-notch sales skills. Some of the factors that contribute to perception of value follow:
 
  •  Know what your client values most. Your client may be most interested in reducing costs, or increasing competitiveness, or creating a new source of revenue. Or the client’s main focus may be a solution that is delivered quickly to accommodate the increase in client volume during the holiday season. Consider the soft benefits, like better client service or improved corporate image. The better you understand exactly what your client hopes to achieve from the engagement, the more closely you can align your proposal to these goals. 
  •  Demonstrate your competence. To justify the price of your service, show that you understand the client’s issues and how to solve them. If significant challenges are involved, point out the risks, how you will manage them, and walk the client through your plans to complete the project on schedule. If you have a unique methodology, emphasize how your investment in methods and tools will reduce project time, costs, and risks.  
  •  Share valuable insights. Identify issues or ways to improve financial performance that were unknown to the client. This requires knowledge of the client business, as well as effective questioning and careful listening to reveal hidden problems. Estimate the cost savings or increased revenue that the client will realize from the proposed project. Point out the cost of living with the problem. To make it easier to sell the value, get the buyer to participate in estimating the value. 
     
  • Let your reputation speak for you. Customers are willing to pay premium fees to top-notch service providers, such as IBM and McKinsey, because they are well known and respected in their markets. Invest in building your brand image with your target market. Services are sold on reputation and trust, and a strong brand helps establishes these qualities in the minds of your prospects.  
  •  Use success stories and references. Share stories about the value you created for other clients—reduced IT costs, increased IT staff productivity, improved user productivity. Draw attention to quantifiable results that show your contributions to the bottom line. If possible, share business case studies that provide an in-depth analysis of another client’s key challenges, your solutions, and the business value delivered to that client through your solutions. 
  •  Appeal to personal goals. The project’s executive sponsor may have much to gain or lose based on the success or failure of the project. Identify these personal goals, such as career advancement or bonuses, and point out how the project may result in praise, recognition, cost savings, or other benefits that contribute to these personal goals.
 
Market-based pricing. Market-based pricing requires gathering competitive data and setting rates and fees based on competitive prices. However, competitive pricing information for professional services is difficult to obtain. Companies do not usually publish their hourly rates unless their primary market is consumers. Some companies have a wide range of prices for various skill levels of consultants and promote their average price. Periodically, market research companies, such as International Services Marketing Association (ITSMA), do studies that compare pricing practices of professional services organizations. If your company participates in the study, the results are usually provided for free. Otherwise, interested companies can purchase the report. These studies provide aggregate information on pricing policies and practices; they do not release individual price lists.
 
To evolve your pricing from time and materials to cost-based or value-based pricing, keep close track of the hours you spend on major activities and deliverables for each project. Professional services automation (PSA) software greatly simplifies the task of tracking hours and billing services. As you document the efforts expanded, you will gradually build the skills necessary to provide a fixed project price. Of course, fixed price does not mean that your team may be working at no charge for endless hours. The better you do at creating a detailed work breakdown structure and managing scope creep with good change control procedures, the less likely you will incur project overruns. 


 
Responding to Requests for Discounts
Customers want to maximize value and minimize price. If the buyer asks for a lower price, then accommodate the request by reducing the scope of the service, transferring activities to the client team, or replacing your senior consultants with junior ones. This keeps the conversation focused on value. If you don’t focus on value, you will most likely find yourself in a conversation about discounting hourly rates. Deep discounting can turn a Rolex into a Timex. It can undermine your reputation. Don’t let discounting negatively affect your brand and your ability to deliver quality solutions.
 
If you are a product-centric company and a client asks for a discount on your fees, one alternative is to discount the hardware or software associated with the service. Because products are more easily measured against competitor products than services are, discounting the product instead of the service can help position your products as more price competitive. To discourage your product sales force from discounting professional service fees, reduce the commission on the entire deal if it includes discounted services.
 
Pricing Huge Projects
If you have not worked with a client in the past, the company may not be ready to sign up for a huge, expensive service. Breaking the services into phases and discussing the value provided by each phase is one way to make a large solution easier to buy. A customer who is not able to justify the funding for the huge engagement may be amenable to approving an order for the first phase or two. Breaking the project into phases also makes each phase more manageable and easier to price.
 
Let Price Reflect Your Value
Whatever pricing model you choose, always start by discussing value. Present the value that your consultants and your services provide. Ask appropriate questions to keep the conversation focused on the desired outcome and your ability to deliver it—effectively and efficiently. Present strong references from other clients with similar problems. Sell the quality of the relationship and your process of collaboration. Stress your track record of delivering quality results on schedule. Avoid getting into a conversation about fees too early in the interaction. It encourages the buyer to form an opinion based on price without providing the opportunity to first establish value. When you develop a strong relationship with a company and the client values your work, the client is even more likely to pick your team for the next engagement.
 
Price Affects Perception of Service Quality
People use different criteria to select services versus products. Products are most often selected on the basis of features, functions, price, and competition. In contrast, people select the services of professionals based on expertise, reputation, reliability, and trust. The more complex and critical the service, the less likely price is an important factor. Certainly, no one is seeking the lowest priced brain surgeon. In fact, the reverse is usually true—higher priced services are perceived as offering higher quality. With products, the customer has the opportunity to evaluate the quality of something concrete before purchasing. Whereas with services, the lack of tangible attributes makes price an even more important indicator of quality.
 
The simpler and more routine the service, the more likely price becomes a deciding factor. However, in any case, low price is not a formula for long-term success. If the customer is shopping for the lowest price, even if you win one engagement, there is always someone who could come along and offer a lower price next time around. There is no customer loyalty in these situations. And these price-shopping clients often turn out to the most demanding and least grateful.
 
Summary
Most clients are looking for business benefits and good return on investment. Don’t undervalue your consultants and your services. As long as your price is not exceptionally out of line with your competitor’s fees, price is usually not the most important decision factor. Whether you predominantly use time-and-materials pricing, cost-based pricing, value-based pricing, or market-based pricing, focus on marketing and selling the value—not the price.