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The Pricing Pentagon
- by Thomas E. Lah, author of Mastering Professional Services
The Pricing Challenge
In a previous article, The Positioning Pentagon, I provided a framework that service providers can use to improve how they position and differentiate their service offerings. After the challenge of effectively positioning a service, the equally challenging task of actually pricing that service still awaits the management team. Personally, I have seen very little written on how to face this challenge. Everyone wants to do value based pricing. “Hey, that is where the margin is”. But what does “value based pricing” really mean? More importantly, what information is required to get there? In this article, I will provide a framework service managers can use to baseline their service pricing strategy.
Overview of The Pricing PentagonTM
So what influences the list price of a service? In my last article, I introduced five factors that influence service positioning. There are also five elements that influence service pricing:
1. Costs
It is impossible to pursue any pricing strategy without understanding the cost line. What are the costs you will incur to deliver the solution or service at the customer site? Costs could include:
- Hardware: Hard infrastructure required to support the new solution.
- Software: Custom or off the shelf software required to support the solution.
- Outside Services: Consulting services required from other companies to implement and integrate the solution.
- Staff Time: Actual effort required by service staff to implement the solution.
Regardless of your pricing strategy, the objective is to make the cost component as accurate and tangible as possible. The better you understand costs, the greater chance you have of pricing services profitably.
2. Financial Objectives
What revenues and profits does the company expect to receive from the service offering? This is where the setting of the business model for the services organization becomes very helpful (refer to The PS Business Model). Having a target business model helps guide what margins and growth are required from a service offering to support the overall services business model. With no target business model in mind, financial objectives for a service offering must be debated on a case-by-case basis and can end up all over the place.
3. Competitors’ Price
If the service you are offering is available from other companies (and more than likely it is), it is helpful to understand what those companies are charging. As always, it is risky to determine appropriate pricing in a market vacuum.
4. Customer’s Price Point
What is the customer willing to pay for the service? Such a simple and obvious question. Yet, not an easy one to answer. The salient point is that the more you understand about the customers’ price sensitivity, the better your target pricing will be.
5. Value
Yes, we have returned to that pesky question of value. Where customers find value in your service should clearly influence how you position that service. Value also influences pricing. Do you have a clear sense of what value the customer receives by purchasing the service? When discussing the topic of pricing professional services, Philip Kotler introduces the following equation 1:
Value = Benefits - Costs
The trick to profitable service pricing is to accurately assess the benefits the customer receives from the service and the total costs incurred to deliver that service. The more tangible you can make both the benefits and the costs, the clearer the value of the service becomes. No great insight so far. Most Service Marketing managers have a clear understanding of this equation. However, how many Marketing Managers are actually using this truthful equation to help guide their pricing decisions? That is what needs to change. These five elements are summarized in Figure 1: The Pricing Pentagon. Each point in the pentagon influences the pricing of your service offerings. The logic is simple: The better your understanding of each variable, the more effective and profitable your service pricing will be.
Figure 1: The Pricing PentagonTM |
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The Viable Pricing Range
A viable pricing range represents two extremes:
- The most a customer would be willing to pay for a service.
- The lowest amount of compensation you would be willing to accept for the service.
The top and the bottom of a viable pricing range are determined by two of the five variables found in the Pricing Pentagon: Cost and Value. The top of the range is determined by how much value the service actually brings to a customer. Not many customers will pay you more than the benefits they receive. The bottom of the range is determined by how much it actually costs you to deliver the service. Hopefully, you are not in the business of delivering valuable services for less money than it actually costs you. Figure 2: Viable Pricing Range shows the viable pricing range for a service offering that delivers $50,000 in benefits to the customer and costs $25,000 to deliver.
Figure 2: Viable Pricing Range |
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Figure 2 makes it obvious to me why pricing services is so difficult. How many service organizations have a clear sense of what it costs to deliver some of the more complex services and solutions? Next, how many service organizations can articulate the true value of the solution? Without these two lines firmly in place, the service organization can be very handicapped when trying to determine pricing. But all is not lost; the next section will present three pricing models that the service organization can pursue—even if all five variables of the pricing pentagon are not known.
Pricing Models
There are three distinct approaches you can take to create pricing for your service offerings:
- Cost Based Pricing
- Value Based Pricing
- Market Based Pricing
We will review each approach as it relates to the Pricing Pentagon.
Cost Based Pricing
Cost based pricing is the most straightforward approach to pricing a service. It involves two simple steps:
- Determine the costs required to deliver the services.
- Add on your target margin to meet financial objectives.
Figure 3: Cost Based Pricing and the Pricing Pentagon shows the two variables of the pricing pentagon you must understand to create cost based pricing that will meet your financial objectives. Figure 4: Cost Based Pricing on the Pricing Range shows how these data points map to the viable pricing range.
Cost based pricing is the lowest effort approach to pricing. That is the good news. There is some downside, however. First of all, to meet your financial objectives, this approach banks on your cost estimations being accurate. If the services involved are complex and new to your organization there is obviously a decent chance the cost estimations will not be accurate. Secondly, there is the issue of the market. What if your customers are not willing to pay the “cost plus” price you have come up with? Yes, in theory, you can meet your financial objectives—but that is assuming you actually get some customers to purchase the service at the target price.
Figure 3: Cost Based Pricing and the Pricing Pentagon |
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Figure 4: Cost Based Pricing on the Pricing Range |
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Value Based Pricing
If managers get together to talk about pricing services, the phrase “value based pricing” will inevitably be uttered in the first 120 seconds of the conversation. Because EVERYONE knows that value based pricing means HIGH MARGINS. And everyone knows that value based pricing is the most straightforward approach to pricing a service. However, to pursue value based pricing, the marketing manager must now understand three variables of the pricing pentagon. Value based pricing involves three key steps:
- Determine the actual value the customer receives from the service.
- Determine the cost of delivering the service.
- Pick a price between the value line and the cost line that meets financial objectives.
Figure 5: Value Based Pricing and the Pricing Pentagon shows the three pieces of the pricing pentagon you must understand to create value based pricing that will meet your financial objectives. Figure 6: Value Based Pricing on the Pricing Range shows how these data points map to the viable pricing range.
This approach to pricing clearly takes more effort than cost based pricing. Now, you must somehow quantify, in real dollars, how the customer benefits from the service. This is the bad news. The good news occurs after you do that work. By doing the homework on value, you now can draw a clear value line on the pricing range. By having that line drawn, you now have the potential to set your pricing anywhere between costs and value. This means you can price significantly above the cost line (i.e. high margin) and still have a potentially viable price. This is why managers like value based pricing. It can equate into high margins. Using the example shown in Figure 6: Value Based Pricing on the Pricing Range, this means the marketing manager has the potential to price the service anywhere from $32,500 to $50,000. In cost based pricing, the marketing manager is forced to stay closer to the $32,500 because the value line is unknown.
Figure 5: Value Based Pricing and the Pricing Pentagon |
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Figure 6: Value Based Pricing on the Pricing Range |
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Value based pricing brings pricing flexibility to the table. It also removes some of the risk associated with cost based pricing. By documenting the value line, there is less risk the price of the service is completely out of line. However, we have not removed all the risk.
Market Based Pricing
The final approach to service pricing is one advocated by none other than Mr. Peter Drucker1. In the book Managing in a Time of Great Change, Mr. Drucker slams both cost based pricing and value based pricing. In itemizing his five deadly business sins, Drucker lists “premium pricing” as sin #1 and “cost driven pricing” as sin #3. His recommendation to companies is to use market based pricing. In other words, first determine what customers are willing to pay. By understanding this target price, a company can then work backwards to determine what costs are allowable. Drucker’s point is simple:
“Customers do not see it as their job to ensure companies a profit. The only sound way to price is to start out with what the market is willing to pay—and thus, it must be assumed, what the competition will charge—and design to that price specification.” 2
Following Drucker’s advice, Value based pricing involves three key steps:
- Determine what the customer is willing to pay for the service;
- Subtract the target margin required to meet financial objectives;
- Arrive at the target cost for the service offering.
Figure 7: Market Based Pricing and the Pricing PentagonTM shows the three pieces of the pricing pentagon you must understand to create market based pricing that will meet your financial objectives. Figure 8: Market Based Pricing on the Pricing Range shows how these data points map unto the viable pricing range.
Figure 7: Market Based Pricing and the Pricing PentagonTM |
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Figure 8: Market Based Pricing on the Pricing Range |
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This approach to pricing requires the greatest amount of effort and discipline. Which is why few service organizations pursue this approach. However, there is huge upside to market based pricing. First of all, by researching what customers are actually willing to pay for a service, the marketing manager minimizes the risk of releasing a service at a price that is unacceptable to customers. In other words, this approach minimizes “market risk”. Secondly, this approach provides the greatest chance to generate the most profits. By understanding the customer price point and assuring you can deliver the service profitably at that price point, you should generate true profits on every engagement. With cost based pricing, you may face unforeseen price pressure from customers that requires you to discount the service below costs. The same can be true in value based pricing. In market based pricing, your price target already reflects what customers are willing to pay.
Summary Table
Table 1: Pricing Strategy Comparisons compares the three pricing strategies side by side on three dimensions:
- Effort: How much effort is required to pursue the pricing strategy in comparison to the other strategies?
- Potential Profits: How much profit does the pricing strategy have the potential to generate in comparison to the other approaches?
- Market Risk: How much market risk does the approach introduce?
Table 1: Pricing Strategy Comparisons |
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As the table demonstrates, there are no free lunches. Each approach has strengths and weaknesses. Cost based pricing is the low effort approach but it results in the minimal required profits—pricing does not exploit the true value of a service. Also, cost based pricing creates the highest amount of market risk. Your service may simply be over priced and deliver little value. Value based pricing takes more effort but increases profit potential because you are now exploiting the value line by matching price to value. Value based pricing also has less market risk than cost based pricing. Market based pricing requires the most effort but rewards you with the greatest potential of owning the market.
Pricing Scenarios
Now, let’s look at a real world scenario. We will review a pricing difficulty that service sales representatives often experience. We will map the scenario unto the viable pricing range diagram and discuss what your options are to respond the pricing difficulty.
Scenario: Competitor Price Dropping
Challenge: Even when the value of a service offering is clearly documented, competitors are dropping their prices to win the business. This scenario became very common four years ago when the economy slowed. Today, offshore service providers are keeping the pressure on professional service providers of all types.
Viable Pricing Range: Figure 9: Competitor Price Dropping shows the scenario on the viable pricing range. The service delivers $50k in documented benefits. You charge $35k for the service and it costs you $25k to deliver the service. Now, a new competitor enters the market and starts offering the service at $20k—below your actual cost to deliver the service.
Figure 9: Competitor Price Dropping |
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Options: To respond to this impasse and still get the business, the company has three options:
- Lower the costs and price. This option requires you to rework your delivery strategy and determine if you can profitably meet your competitor’s low price point.
- Stay firm, defend the difference. Perhaps the customer is not looking for the low cost provider. If the service is executed well, there are $50k in benefits. Perhaps the most important factor is execution! If you can convince the customer your price premium provides some type of business benefit, they may be comfortable with the premium price.
- Take a percentage of the value delivered. Change the conversation. If you are convinced the service deliver the $50 in benefits, offer to be paid a percentage of that savings. Unfortunately, this tact places the business risk squarely on your shoulders. Few service firms are willing to accept this responsibility. Even fewer are truly equipped to profitably handle it.
Table 2: Competitor Price Dropping summarizes the effort and risk of pursuing each option. There are no easy outs when responding to severe competitive price dropping. In this scenario, simply matching prices is not a long-term response because you are losing money on each deal. Once again, the task at hand is to revisit the cost and value lines to determine if and how they can be moved. If the lines cannot be moved, you may need to exit the market.
Table 2: Competitor Price Dropping |
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Feeding the Pricing Pentagon
For all of the talk about value based pricing, I believe most professional service organizations go to market with cost base pricing. How much do our consultants cost? How much mark up can I put on them? The only professional service firms willing to drive a market based pricing strategy are those offshore providers with strong price advantages. This current landscape is making pricing a painful exercise for many service providers. Especially when data from key components of the pricing pentagon are missing. A key objective of this framework is to identify what data should be driving intelligent pricing decisions. The more complete the pricing pentagon data is, the easier the pricing process becomes. How many services are being priced with only one or two of the variables clearly understood? Is it any wonder service pricing can be so hard to defend to both customers and sales reps?
There are ways to feed the pricing pentagon. Figure 10: Feeding the Pricing Pentagon maps company activities that provide critical data for the Pricing Pentagon.
Table 3: Feeding the Pricing Pentagon comments on each of these activities.
Figure 10: Feeding the Pricing Pentagon |
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Table 3: Feeding the Pricing Pentagon |
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Closing Comments
When I work with technology solution companies, I am amazed at their service pricing process. It often involves setting a price for an offering because “that is what the sales force can sell it for.” I am often assured that the price agreed to has “lots of margin built in.” Yet, when I ask for cost data to substantiate the claim of high margins, I am told that data “is really hard to get.” When I ask the actual dollar value of the benefits the customer receives by purchasing the service, I am told “that data is really really hard to get.” I think service pricing is an exercise that needs to become less art and more science. A product company would never base the list price of a new product solely on the input of the direct sales force. The product company would query customers, check the pricing of potential competitors, and validate profitability targets. Why should service pricing be so, so different?
1 Marketing Professional Services, Philip Kotler, page 281.
2 Page 47, Managing in a Time of Great Change, Peter F. Drucker, 1995, Penguin Group, New York, New York.
Thomas E. Lah, author of Mastering Professional Services and Building Professional Services: A Siren's Song, currently consults with companies to establish or improve their professional services organization. Thomas is actively engaged with The Ohio State University to host an executive education program focused on frameworks and strategies to successfully build professional services at product-centric companies.
He received an undergraduate degree in Information Systems and holds an MBA from the Fisher College of Business at The Ohio State University. |
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