Pricing Services: The Pricing Pentagon

This week, there was an interesting recommendation from a panel that advises the government regarding contracting procedures. An article in the Federal Times titled GSA should drop ‘lowest price’ clause covered the ruling:

General Services Administration contracts should stop using a pricing clause that guarantees the government gets a professional services company’s lowest prices, an advisory panel will recommend.

The 15-member Multiple Award Schedules Advisory Panel, which was set up by former administrator Lurita Doan to study the value of the so-called “price reduction clause,” decided Friday that the clause was unenforceable for services contracts.

Because professional services are tailored to meet the needs of the buyer, apples-to-apples comparisons cannot be made to weigh the price for a government service order against those charged to a company’s commercial customers, said Elliot Branch, chairman of the panel.

Other articles covering the ruling emphasized the fact that services cannot be price compared as readily as products. The most telling quote comes from the panel chairman, Elliott Branch: “Pricing for services is largely dependent on the unique needs of each agency and each task order.”

Compared to tangible products with definable features, intangible services are much harder to price. So what influences the list price of a service? In Mastering Professional Services, I wrote an appendix that touched on this very question.

In the appendix, I introduced 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? 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? With no target profit 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. Competitor’s 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 customer’s price sensitivity, the better your target pricing will be.

5. Value

Where a customer finds value in your service should clearly influence how you position that service. Value influences final pricing. Do you have a clear sense of what value the customer receives by purchasing the service? One of key tactics 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.

These five elements are summarized in the image for today’s blog entry:  The Pricing Pentagon. Each point in the pentagon influences the pricing of a service offering. The logic is simple: The better your understanding of each variable, the more effective and profitable your service pricing will be.

The Pricing Pentagon

The Pricing Pentagon

With these five variables in mind, there are three distinct approaches you can take to create pricing for a service offering:

1.            Cost Based Pricing

2.            Value Based Pricing

3.            Market Based Pricing

Each pricing approach requires different levels of mastery regarding the five variables. 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.

At this point in time, our data tells us a vast majority of service organizations pursue a brute force, cost based pricing strategy.  Even when projects are bid with a fixed price, they are often structured in a time and materials fahshion with a not to exceed cap. In other words, the service provider still approaches the project from a cost basis and does not base the fixed price on the value of the project to the customer. As Peter Drucker pointed out years ago, there is incredible market risk with a cost based pricing approach.

If there is strong viewing for this post, I will dedicate a future post to introducing a new service pricing framework I am working on titled “Pricing Time Zones”.  It is another framework service organization can use, like the Pricing Pentagon, to formulate a strategy for pricing those pesky, intangible services.

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5 Responses to “Pricing Services: The Pricing Pentagon”

  1. Kathy Macchi Says:

    The government is spot on that apples to apples comparison is nearly impossible for services. If PS organizations wants to gather market intelligence about their services and how they stack up against the competition in terms of price and performance – a win/loss study is the way to go not a typical pricing comparison model that is used with products. Your recently won customers and lost prospects are the only ones that have done that apples-to-apples comparison and can give you key insights into how the competition measured up in their eyes. PS-oriented win/loss studies go beyond the traditional attempt to find out why an organization won or lost a deal. They should delve deeper into understanding the selection and decision-making process of the customer or prospect. That is the best way to find out how your organization compares to the competition. It’s not always you see the government being out in front of business on business issues but they certainly are on this front.

  2. Price Dropping Competitors « Service Visions Says:

    […] Dropping Competitors In response to the entry on the services pricing pentagon, a frustrated salesman in a product company contacted me. His question was […]

  3. Jared Says:

    What method is best used to determine these numbers?

    • Thomas Lah Says:

      The best sources of data to feed The Pricing Pentagon is actual project data from past engagements. A combination of project performance data with project review data. The project performance data is best gathered through a PSA system. The project review information is best gathered in a formal project review conducted shortly after engagements are completed.

  4. Pricing Services: Changing the Game « Service Visions Says:

    […] in 2008, I posted a framework titled The Pricing Pentagon. The framework identifies the data streams required to enable effective service pricing. That has […]

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