The Dangers of Value Based Pricing in Agencies

May 30, 2023
Michael Taylor

In the contentious world of agency pricing, one debate has been going on forever: value-based pricing vs cost-based. The appeal of value-based pricing? A potential increase in profits, a shared focus on quality, and a tighter bond between agency and client. However, reality often reveals a different story.

In my journey as the founder of Ladder, a 50-person marketing agency, I've had my fair share of encounters with the challenges of value-based pricing. This article will serve as your map, guiding you through the uncharted territories of this complex pricing strategy.

Unpacking Value-Based Pricing

Value-based pricing sounds straightforward enough: price your services based on the value your clients perceive they're getting, not just on your costs or what your competitors are charging. But here's the catch: value is a slippery concept, and it varies wildly from client to client.

Think of it this way: it's like trying to price a painting. One person might see a priceless masterpiece, while another sees something their kid could have drawn. Therein lies the first challenge of value-based pricing – its subjectivity.

Yet, the idea of potentially higher profits and a client-aligned model lures many of us in. I've watched this scenario play out at Ladder and in numerous other agencies. The appeal of value-based pricing is strong, but it's crucial to know what you're stepping into.

The Attraction of Value-Based Pricing: More Than Meets the Eye

The allure of value-based pricing is powerful. It's like a shiny new toy in the world of agency management. It whispers of higher earnings, satisfied clients, and a business model that aligns everyone's interests. Who wouldn't want to make more money? It's a tale that's hard to resist. I've been there myself, bewitched by the promise it holds.

In some cases, value-based pricing can be the boost that introverted founders need. Those who, in their pursuit of honor and fairness, might seriously undervalue their product or service. This strategy can help them charge more - advice famously given by Patrick McKenzie, better known as @patio11, in his famous post "You Can Probably Stand To Charge More", which might be a contender for blog posts that have delivered the most collective increase in net worth.

But there's a cautionary tale here too. It's easy to be drawn in by industry "gurus" who paint a rosy picture of value-based pricing. They'll tell you it's the next big thing, the secret to scaling your agency, and that you’re a fool for leaving money on the table. However, it's essential to separate the hype from the reality. The potential benefits of value-based pricing are real, but they don't come easy. It's a path that requires careful navigation, strategic decision-making, and a deep understanding of your clients' needs and perceptions.

The Reality Check: A Case Study from Ladder

Let's step back from theory and dive into a real-world example. At Ladder, we once grappled with the challenge of pricing our tracking implementation service. On paper, value-based pricing seemed like the perfect strategy. After all, correct tracking can unlock enormous value for clients by providing them with crucial data to make informed decisions.

But here's where the reality of value-based pricing kicked in. Our clients, mostly non-technical, often underestimated the complexity involved in proper tracking setup. As a result, the perceived value of the service was often much lower than its actual cost. In our attempt to align the price with perceived value, we ended up underpricing our service, leading to lower-than-expected revenues.

I think this is the reason why professions such as accountancy and law typically charge by the hour rather than the value. Their clients, not being experts in these fields, often underestimate the complexity of the work. Unforeseen issues can turn into extra billable hours. If they were to charge a fixed fee based on perceived value, they'd risk undercharging and potentially even bankruptcy for prolonged engagements.

While value-based pricing can be effective in certain situations, it's not always the best strategy. It's crucial to ensure that your costs are covered in any scenario, and then consider any additional earnings as upside.

The Dangers of Value-Based Pricing

Despite its potential benefits, value-based pricing is not without its perils. Its implementation requires a deep understanding of your customers' perceived value of your services, which can be incredibly complex and difficult to gauge. Misjudging this can lead to undercharging for your services, as we experienced at Ladder.

Moreover, value-based pricing can inadvertently encourage a focus on short-term gains at the expense of long-term client relationships. If not carefully managed, this approach might lead to charging high prices without truly delivering corresponding value. This can damage your reputation and client relationships in the long run.

One of the biggest risks of value-based pricing is the financial danger if you get the pricing wrong. If a contract turns out to be more challenging or time-consuming than initially expected, you may find yourself on the hook to deliver at a loss. In extreme cases, this could even lead to bankruptcy, particularly for smaller agencies or those with tighter margins.

In sectors where the perceived value is significantly higher than the actual cost, or where a company holds a monopoly, value-based pricing can work effectively. However, in competitive markets where your brand is not well-known or where others can easily replicate your services, this pricing strategy can be more challenging.

Finally, the implementation costs of value-based pricing can be higher due to the need for extensive research and effort to differentiate your service. Yet, despite these challenges, it's essential to remember that pricing strategies are not one-size-fits-all. Each agency must find a balance that works best for its unique situation.

Mitigating the Risks of Value-Based Pricing

While value-based pricing comes with its own set of challenges, there are strategies to mitigate these risks and increase your chances of success. Here are some strategies:

  • Ensure Costs are Covered: First and foremost, always ensure your costs are covered even in the worst case scenario. This approach provides a safety net, preventing any potential loss. For example we had a non-negotiable ‘base’ fee which covered our fixed costs, then the remaining fee was flexible based on performance.
  • Regularly Review Pricing: Value changes over time as the market changes, competitors emerge, and as you build more credibility in the industry. Adjust your pricing strategy as you gain more knowledge and experience, or if competitive threats arise.
  • Communicate Value: Clearly communicate the value your clients receive. Transparency helps build trust and sets the stage for long-term relationships, and the more perceived value you can transmit, the easier time you’ll have charging more.
  • Consider Tiered Services: providing tiered services allows clients to choose the level of service that matches their perceived value. This way, you can cater to different value perceptions and budget levels, with a mix of cost-plus and value-based pricing.
  • Differentiate Your Services: Carve out a niche where you can truly excel and be recognized as a leader. This can help create a quasi-monopoly situation, enabling you to command higher prices based on your unrivaled expertise. Be selective with your clients and only work with those who recognize and appreciate the value you provide, or you risk burning out your team and tying up resources in bad relationships.

Value-based pricing can be a powerful tool when used correctly. By being aware of the risks and taking steps to mitigate them, you can better align your services with your clients' perceived value and potentially unlock higher revenues.

Conclusion

Value-based pricing in agencies is a complex yet rewarding pricing model. It's not a one-size-fits-all solution and demands a deep understanding of your clients' needs and perceived value, along with a keen awareness of market dynamics.

While value-based pricing can potentially maximize revenue, it also requires diligent risk management. Remember to cover your costs, continue to learn and adapt, communicate transparently, and differentiate your services. Consider a hybrid model if value-based pricing seems too risky.

Ultimately, the choice of a pricing model should be a strategic decision that aligns with your agency's capabilities, your clients' needs, and the market you operate in. As with all things in business, it's about finding the right balance.

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Note: this post was generated with AI assistance by ChatGPT, based on my answers to interview questions on the topic. If you want to see my process including all the prompts, it's outlined here: https://www.saxifrage.xyz/post/ai-writer

September 26, 2020

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