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Pricing strategy and structure in consulting

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Consulting and Professional Services Radio

Jeff Porter / Lew Sauder

Description: Ideas, Information and Inspiration for Consultants and Service Professionals

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Pricing strategy and structure in consulting

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How consultants price their services can mean the difference between making it in the business and going broke.  Depending on the competitive environment, consultants from large firms and independents need to know how their services compare with their industry rivals and how to successfully price those services to insure success for both their clients and themselves.

  1. How do firms go about pricing their services when they propose on a large project?
    1. The two classic approaches are either time and materials or fixed bid.
    2. Time and materials is essentially charging an hourly rate for every hour worked by each team member on the project.  It also allows for expenses such as travel.
    3. With time and materials, or T&M, all of the risk is on the client, because they’re just paying for the consultant’s services with no defined end date.
    4. The opposite of the spectrum is the fixed bid contract.  Here the consulting firm says, “We’ll do this project for a fixed fee of $x.  Now all of the risk is on the consultant to complete the defined scope of the project by a defined deadline.  If they get behind, they may have to work extra hours or add additional people for free just to get the project done.
  2. I would assume consulting firms push the time & materials projects while clients push fixed bid contracts.
    1. That’s what you see in general.  Both sides are trying to reduce their risk. But it often depends on the client and the nature of the project.
    2. If the scope of the project is a concise statement of what the project will entail and can be easily defined, a fixed bid project can be more easily agreed to by both parties.
    3. If the outcome of the project is ambiguous in any way, or if there is a significant risk of a lot of changes in the project, then a consulting firm is less likely to agree to a fixed bid project.
  3. What type of risks would cause a firm to shy away from a fixed bid project?
    1. Anything that could potentially cause cost overruns really.  Let’s say that the client is using contractors from three other consulting firms.  And their contracts end at different points of time before the project is supposed to end.  That’s a huge risk to the firm because they could lose key people during the project.
    2. That could cause them to spend extra time and resources finding replacements and, assuming replacements can be found, bringing them up to speed on the project and any technology they need to learn.
    3. Another risk could be the number of key client employees that need to commit their time to the project.  If the client commits their key people to the project 100% and they end up only being able to dedicate 50% of their time to the project, the project is going to experience delays which will cost the consulting firm more than they planned in a fixed-bid agreement.
  4. How do firms protect themselves against these overruns?
    1. The two primary ways firms have of protecting themselves is by building in contingency in the project and having a well-defined change control process.
    2. Let me explain contingency first.  I’ve always thought of contingency as a slush fund of time that a consultant or a project manager has in his back pocket to allow for cost overruns.
    3. When a consulting firm agrees to a fixed bid project for, let’s say, $250,000, they may say that they reserve 10% contingency for unplanned changes.  They’re essentially having the client agree to an additional $25,000 in fees if any of the risks become actual issues.
    4. A change control process allows the consulting firm to draw on that contingency as issues occur that will cause the cost to increase outside of their agreed upon fixed fee.
    5. So, using the example of using contractors from other firms whose contracts end before the project ends.  If it turns out that one of those contractors leaves and it takes a month to find a replacement and bring her up to speed, there is a tangible cost to the project.
    6. The project manager for the consulting firm will calculate a fair cost of the impact that that had on the project and will notify the client of the amount of contingency they will be charging them.
  5. Do most firms prefer time and materials then?
    1. I would say that they generally do, but it’s not always that cut and dried.  Some firms don’t want to make their billing rates public and risk another firm getting wind of their pricing and cost structure.
    2. If a firm is proposing on a large project, they may structure their pricing in a variety of different ways.
    3. Each consultant on the team has a billing rate based on their title, experience level and value to the team.
    4. Publish billing rates for individual consultants points out that an entry-level consultant bills at $x per hour while the high-level partner overseeing the project bills at a much higher hourly rate.
    5. So some firms like to just propose on a blended rate which is a weighted average billing rate for the total hours they plan to spend, divided by each team member’s rate, weighted by the number of hours they plan on each team member spending on the project.
    6. This way, they can list each person they plan to staff on the project and the client executive can see the mix of higher and lower level team members planned for the project.
    7. This allows the firm to swap people in and out at various billing rates as they need to, but not deal with exposing their individual billing rates.  They can essentially make it a package deal while still making it time & materials.
  6. How often is that successful?
    1. It usually depends on the relationship a firm has with their client.  Most firms are unlikely to get that kind of an agreement if it’s their first engagement with a client.
    2. But if a firm has developed trust with the client by delivering on a few projects for them already, they may be more likely to get away with it.
    3. Clients are a little leery of a deal like that for a few reasons.  The biggest reason is that it can enable the consulting firm to do a bait and switch and the client usually wants more control over who is delivering this project.
    4. If the consulting firm puts a bunch of inexperienced green consultants on the project without enough experienced veterans to provide direction, the project can go south quickly.  So clients often want to be assured that the staffing model includes enough high-level experience to insure success.
    5. When projects like this are agreed to, the client often has a clause included that a minimum number of certain high-level team members will be included to insure against that bait and switch situation.
  7. It seems to me that the consulting firm would be just as interested as the client, if not more so in the success of the project.
    1. A good firm would be.  But the advantage the firm has if the project goes south is that they can just walk away.  The client executive that hired the firm is left with his career in the balance.  Because of that, the client executive is in a position of ‘trust but verify’.  He’s instilled enough trust in the firm to hire them to execute this project, but at the same time, he’s only going to give the firm so much rope to hang him with.
    2. He’ll want to be involved in staffing decisions to make sure they’re going to deliver the project to his satisfaction.
    3. That’s one of the reasons that trust and relationship building are so important.  You can put everything in the contract to protect against over billing and improper staffing.  But if you don’t trust your consulting firm to be just as dedicated to project success as you are, you’re going to end up spending a lot more time than you want to, verifying that things are going well.
  8. How else does a firm allow the client some of that control without exposing their individual billing rates?
    1. Another approach that many firms try to use is value-based pricing.
    2. With value-based pricing, they may try to define measurements around the value their project will provide.
    3. For instance, let’s say a client hires a firm to help them redefine their marketing strategy.  The firm says that instead of charging them a set fee for the project, the client will pay the firm based on how much their revenues increase as a result of the new marketing strategy they implement.
    4. It reduces the risk to the client because they only pay if the strategy works.  It also requires the firm to have some skin in the game.  They have an incentive to implement a strategy that works.
  9. Does value-based pricing work?
    1. There are two major challenges with value-based pricing.
    2. First, is that it’s very difficult to show with any certainty that any increased revenues are directly tied to the consulting project.
    3. In the example I used above, let’s say they implement a new marketing strategy for a particular product this year and next year’s revenues increase by 20%.  But at the same time, the economy picked up, unemployment goes way down, creating a lot of new customers, and one of the client’s main competitors went out of business.
    4. The client could argue that their increased revenues had nothing to do with the consultant’s strategy, but was due to a number of other outside factors.
    5. The consultant could argue the same thing if everything in the economy went south and the product’s sales had a significant dip.  So there are so many external variables and you have to set up and so many rules and parameters around how you measure the success of the project that it becomes a major challenge.
    6. The other issue is that a firm can define a strategy for the client, but if the client doesn’t implement it correctly or include every factor the consultant subscribes.  In that case, if the client claims that the strategy failed, the consultant can argue that they didn’t implement the strategy exactly as they prescribed.
    7. So both problems hinge on the difficulty of defining success and who is responsible and accountable for that success.
    8. Value-based pricing is also problematic for a consulting firm because it completely transfers all the risk.  In traditional project pricing, the client pays for the consulting fees up front as an investment and then hope to reap benefits over time either from increased revenues or cost savings.  But the client has all of the risk because they pay up front.
    9. In value-based pricing, the consulting firm assumes the bulk of the risk.  They do the work up front and hope to reap the benefit from the client’s increased revenue or cost savings.  The client doesn’t pay the firm unless they benefit by a predefined amount, which may be many months down the road.
    10. There’s also a tradeoff for the client.  With value-based pricing, they could end up paying the consulting firm more than if they just paid the straight fees.  Let’s say the up-front billings would have been $200,000 but they opted to pay 10% of the increased revenue and that ended up being $4 million.  So their bill is now $400,000.
    11. It’s a real risk vs. reward for both the client and the consultant and it has to be a project where the benefit can be easily measured.
  10.  How about pricing for independent consultants.
    1. That’s always something of a dilemma for independents.  Many determine what they need to live on that will give them a decent salary and allow them to pay for some appropriate vacation time and things like health care.
    2. But that’s backwards thinking really.  Using basic economics, a consultant’s pricing should be set at the highest level that the market will bear.
    3. So if the going rate for someone with your skills as an independent is, let’s say $100 per hour and you’ve decided that you need $120 per hour, then you need to make a decision.
    4. Are you able to take that big of a cut in pay?  Or can you prove to the client that you’re worth 20 more dollars per hour.
    5. For many consultants, that’s a tough sell.
    6. You need to de-commoditize yourself.  You can do that by selling your extensive experience, which may give you the ability to be more productive, but it’s hard to convince a client of that.
    7. One way around that, if you’re very confident that you’re more productive than your competitors is to take on the bulk of the risk and offer the client a fixed bid.
    8. Tell them that you’ll do the same amount of work as your competitor.  The catch is that they agree to pay you whatever your competitor estimated his total to be, regardless of how many hours it takes.
    9. Then, if you can finish the work early, you’ve in effect raised your billing rate.
    10. The advantage to the client is that it didn’t cost them any more than it would have with the other consultant, but they get the work completed sooner.
    11. Then once you’ve proven yourself, it gives you some leverage to charge a higher rate for that client next time.
    12. The caveat is whether the quality is at the same level.  You can get it done in half the time of your competitor, but was it at the same quality level.
    13. Most firms will want some protection by defining a minimum quality threshold you will need to meet.  But if you’re as good as you say, then you shouldn’t be too afraid of that.
  11.  Any final thoughts on how pricing works for consulting and professional services firms?
    1. There are as many ways to charge the client as there are firms it seems. Many larger firms don’t like to publish their consultants’ individual rates, so they tend to package them into a total.
    2. Firms also don’t like to discount their rates.  They may do that if they’re in a very competitive situation and they want to win business away from a rival, but they generally prefer to price on value.
    3. Independents have some of the same issues.  They don’t want to discount.  But they struggle more with selling on value until they can prove themselves.

Next topic: The new consultant’s checklist.