My column this month will discuss the topic of value pricing.
One of my PR clients is engaged by a large company to provide PR services. That company is having an in-house procurement department negotiate billing rates with the firm. I use the word negotiate loosely; it has specific criteria that it follows. I can only assume that once that criteria is determined, it’s used across the board for all agencies they work with. What’s interesting is the procurement department sets rates based on formulas that I’ve written about over the years.
In establishing rates for a PR agency, three elements are considered: salary by level, overhead and desired profitability. The process I go through is to determine overhead as a percentage of direct labor. I usually look for overhead to be between 80 percent and 100 percent of direct labor costs. When overhead exceeds 100 percent of direct labor, there is, for the most part, lower profitability.
The procurement department allowed a 100 percent overhead factor. By this I mean if direct labor is $100,000, overhead is then $100,000. To this, a profit factor is added. If the profit factor is 25 percent, then 331/3 percent is added to the total. Therefore, $66,666 is added to $200,000 for a total of $266,666. $266,666 times 25 percent profit factor is $66,666. The result is divided by annual billable hours of 1,500 arriving at a billing rate of $178 per hour. Of course, the procurement departments don’t do it this way. They would multiply $200,000 times 25 percent or allow a profit of only $40,000. They also would use 1,800 annual billable hours rather than 1,500 to arrive at an allowable billing rate of $133 per hour. In calculating billing rates and billable hours, I don’t consider overtime billable hours. Please remember the goal is to determine a billing rate that will generate a percentage profit.
So, what’s the wrong with the above model? Nothing! It just doesn’t take into consideration value! Here is a story to highlight this concept. A client asks its PR agency about an idea it developed for the client. “Did we pay you for that idea?” “Yes, it took us about two hours and was billed as part of our monthly retainer invoice.” “Great, responded the client. It was worth about $1 million to us!” How would you feel if this was you?
Another story. A woman was strolling along a street in Paris when she spotted Picasso sketching at a sidewalk café. She asked him if he might sketch her.
Picasso obliged. In minutes, there was an original Picasso. “And what do I owe you?” she asked. “5,000 francs,” he replied. “But, it only took three minutes,” she politely reminded him. “No,” Picasso said. “It took me all my life."
So, what’s value pricing in the PR business, or the accounting business for that matter? I once asked the late Al Croft if he ever used value pricing when he was in the agency business. He told me he had three billing rates: administrative, tactical and strategic. This does meet the definition of value pricing; however, it’s still tied to hours and a service rate. Regardless, consider it and use it. While it doesn’t capture the value surplus that a client may be willing to pay, it’s better than an agency rate per hour for all services. Develop different rates for different services.
What’s value pricing anyway?
According to Ronald Baker in his book “Professional Guide to Value Pricing,” a successful professional firm will price its services according to external value, as perceived and determined by the customer — your clients are customers! — rather than by internal costs. By doing so, they will restore pricing to the strategic marketing tool that it is.
So, what’s value pricing anyway? According to Baker, value pricing can be defined as the maximum amount a given customer is willing to pay for a service, before the time of delivery. It doesn’t mean a percentage markup on your standard rate, or a contingency arrangement based upon a certain result, or a bonus added to the agreed price, though any price negotiations may include these factors. Value pricing requires that you price on the margin for each customer, for each service, disregarding the following: what you charge other customers for the same service, what you have charged the customer in the past, what your competition is willing to charge the customer, what your competition used to charge the customer.
More on this next month. I trust the topic will provide value and food for thought! If you do nothing else, consider the three-tier pricing strategy used by Al Croft.
Richard Goldstein is a partner at Buchbinder Tunick & Company LLP, New York, Certified Public Accountants.