Pricing for value: Develop a winning value-based pricing strategy

23 Mar 2015News

Sally Calverley and John Campbell discuss how to create a value-based pricing strategy to increase matter profitability and client loyalty

Five things you will learn from this Masterclass

Where law firms lose money on pricing
What clients mean by ‘value’
The benefits of value pricing at a matter level
How to address differing price sensitivities across your client base
The attitudes and processes needed to enable value-based pricing

It's time for law firms to increase their prices. Studies by both McKinsey & Co and AT Kearney¹ conclusively demonstrate that a one per cent uplift in prices has the most immediate and greatest impact on profitability compared to a one per cent improvement in fixed/variable costs or volume (see Figure 1). In addition, a survey of over 200 businesses found that firms with value-based pricing strategies earn 31 per cent higher operating income than competitors whose pricing is driven by market share goals or target margins.²

It can seem daunting, even counterintuitive, to increase prices in this climate, but law firms must adapt to survive in changing markets. This article will examine what is involved in adopting a new pricing strategy from the contextual and value analysis through to how to manage pricing discussions with clients.

Traditional pricing problems

The traditional approach to pricing (chargeable hours x charge rate) has
four main problems.

It leaves money on the table. Pricing is an art, not a mathematical exercise. We look at this further below, but suffice it to say the cost of production is not the price.
It takes no account of the value to the client. Like a taxi meter, it is only interested in the time taken to reach the destination, not the experience or the end result. Even a fee expressed
as a fixed rate invariably starts life as
a time calculation based on experience and best guesswork.
It is rife with discounting. Law firms have grown up with practice management systems that value each time entry at an aspirational selling price. The charge rate is set on the basis of cost plus, calculated by reference to overhead costs, with individual weighting for each fee earner, plus a mark-up for profit margin. It might be tweaked according to the firm's business information on competitors' fees - often obtained from clients who are using that information to negotiate with you (see Figure 2).

A range of discounts is then applied to the charge rate. Clients routinely ask for discounts which are handed out in bands of five per cent: 10 per cent, 15 per cent or 20 per cent. These are often handed out at the discretion of partners who may not have fully grasped the profitability implications of that additional five per cent they agreed to when the client threatened to instruct a competitor instead.
It relies upon people with insufficient training to negotiate the final price. With constant discounts, it is little wonder that lawyers start the pricing game with an ingrained belief that they are too expensive. The result is that the starting point is set low and the only direction of travel is lower still. For many law firms, their pricing strategy involves reducing discounts by placing controls over the mathematical pricing process. A better approach (which some firms are already adopting) is to consider the value they are creating for the client and sharing the risks and rewards of the transaction.

Figure 2: Bad reasons for giving clients discounts
1. The client says we are too expensive
2. The client says (or we fear that) the competition will bid lower
3. The job is really not that complicated – we’re really good at it
4. This is a ‘loss leader’ and we hope to get loads more work
Value-based pricing

As noted above, pricing is an art, not
a mathematical exercise. The same task for different clients may command different prices.

The UK's Royal Mail understands
this: delivery of a letter by first-class mail costs 62p, whereas guaranteed next-morning delivery with a signature required costs £6.40.

That's a price increase of more than 1,000 per cent for the same result - but the timing, process, security and experience differ. Clients will pay more for a service if they understand your value proposition and value the additional features you offer.

Value is entirely subjective: while both client and lawyer can tell you the price for the service, only the client can say whether it was good value. The following equation explains this:

Value = Result x perception

Price

The client's perception depends upon both benefits and detractors - some of which are not within the lawyers' ability to control (see Figure 3). In addition, features that initially impress can become an expected part of the firm's service (see Figure 4). And, as competitors adopt disruptive technologies, clients start to demand discounts based on the assumption that, if Firm X can deliver the service for £1,000 rather than £10,000, so should you.

Finally, value has nothing to do with the cost of providing the service. To quote management expert Peter Drucker: "A product is not quality because it is hard to make and costs a lot of money as manufacturers typically believe. This is incompetence. Customers pay only for what is of use to them and gives them value. Nothing else."³

The fact that a case raises a novel point or requires years of experience in a rare specialism has no value to the client. The difficulty of providing it is not a feature or a benefit. The client is only interested in the outcome, the ease of achieving that outcome and the benefits.

The 'right' price

In our private lives, we instinctively know when something is the 'right' price - it's the point at which we think that something is good value and we will be motivated to buy.

Instead of competing blindly on price, forward-thinking firms are looking at what is the right price to reflect more directly the value they deliver. They will have to balance the cost of delivery with the value to the client. The right price will result in soaring profitability for the firm that successfully understands and manages both parts of this equation.

How can you tell what the right price is? The quick answer is that a client's propensity to buy will increase, perhaps dramatically, when you hit that sweet spot. It doesn't have to be cheap: Apple announced the largest profits ever this year on the back of products that are reassuringly expensive; people queue overnight to buy them.

The right price may not be consistent across all parts of your service. Google abandoned its list price for AdWords in favour of an auction where the price is based on the popularity of the search term. Income doubled in three weeks! Google had been massively undercharging for the most popular search terms.
Implementation process

Finding the right price involves listening, thinking, risk taking, creativity and imagination, as well as consistent management, process engineering, blood, sweat and tears (that's just for the finance director!). It also requires complete confidence in the value you are creating for the client. Anyone who tells you that this is easy probably hasn't actually done it. But the rewards are worth it: happier clients, more clients, better profitability and stronger relationships.

There are four main challenges to implementing a value-based pricing strategy: research, planning, management and communication. You need to understand why a client is buying from you, plan the work accordingly and then manage it to minimise variances and protect profitability. Finally, you need to communicate clearly, both with the client and internally.

1. Client research

Find out what the client values about your service. Gather as much information as you can, preferably in a face-to-face meeting or at least over the phone. This is an opportunity to learn about the client, not for you to set out your stall (see Figure 5). Listen, ask questions, and listen some more. Lawyers are used to telling clients the answers rather than listening; preparation and peer group learning exercises really help with making these meetings more effective.

Figure 5: Questions to ask clients during the scoping process
1. How do you make a profit and what are your plans for the future?
2. What are your critical success factors?
3. What will the success of this project look like?
4. What is your budget for this type of work?
5. How important is price certainty to you?
6. Why are you changing firms? What did you not like about the previous firm that you would not like us to repeat?
7. What growth plans do you have?
8. Are there any financing requirements?
9. Are you considering acquisitions/ mergers / divestitures / reorganisations?
Which specific factors (benefits and detractors) are most important to the client? What would be a dealbreaker? What happens if the deal doesn't come off? What are the internal pressures for success and what does that success look like? Is there a budget for this or is this an unexpected issue that could cause the client embarrassment if not dealt with discretely?

Who else at the client is involved or needs to be informed of developments? Are there conflicting agendas or sensitivities at work that need to be managed as part of the service?

Where the meeting is with a prospective client, don't be afraid to ask what they liked about their previous service provider - take those value points and improve on them. But, do not just ask the client what your services are worth to them - several studies show that clients immediately shift to negotiation mode and will understate its value.

Try not to make assumptions. As explained earlier, what clients see as being good value changes over time.

Once you have identified the key drivers and priorities, relay them back to the client. Ask them to confirm that
your understanding is correct and that
the priorities are in the correct order.
The reasons for this are twofold:
1. to check you haven't misunderstood; and
2. to help the client to clarify their own expectations. This is often the first time the client will look at the matter objectively through the eyes of another person; simply asking the question helps to confirm the value points in the client's mind.
2. Planning and scoping

First-class passengers travel on the
same plane to the same destination as second-class passengers, but receive
a different service at a different price.
Audi, BMW and Mercedes all offer an entry-level car that has few of the luxuries of their top-of-the-range vehicles, but carries the quality assurance of their
brand. It is possible to offer a stripped-down service whilst maintaining quality;
law firms can do this too.

"I like this approach but it's
impossible to scope the sort of work I do" is something that law firms often say but, in each case, the model that follows has worked. This is known as the Marston circles of scoping and can be used to scope any matter (see Figure 6).
1. Yes - the absolute minimum requirements, the least you can do
  and still get it done. The key here
  is to understand what 'it' is. Keep cutting down the range of the work
  until you can scope a single element.
  If necessary, divide the work into
  phases or simply look at the work required in week one. Everything in
  the 'yes' circle must be completed
  for the job to get done.
2. Likely - the elements likely to be required. There will be grey areas between the 'yes' and the 'likely'
  areas of required work, and you will become more proficient at determining these with practice. Both of these areas will dictate your minimum price, below which you will not undertake the work because it will cost you money to do so.
3. Maybe - the possible extras on the matter, the additional comfort or
  reduced risk that the client is willing to pay for. For example, the client wants
  the price certainty of a fixed fee or payment terms that fit with their budget. Maybe they want the matter handled by a particular individual. All of these involve additional risk for the firm, bringing
  with it an additional charge but also, crucially, additional value to the client.
4. WHK - or, who the hell knows.
  These are things that may happen,
  but it is too early to say at this stage.
  The client will not expect the cost of these items to be included… yet. Let
  the client know that there are aspects
  of a matter that may come up and, if
  they arise, you will provide an estimate for each one and some pricing options for them to decide whether the risk warrants the costs involved.
The benefit of scoping matters like this is that you can not only plan the matter properly but also offer the client options. Options create a sense of ownership
and achieve a greater buy-in to the agreed course of action. Some clients will buy
the service at the agreed minimum cost,
but most will want the additional features and accept the cost for you to manage
the outcomes.

For example, you might send a letter you don't care much about in the second-class mail. But, for something urgent and important, you may feel special delivery is worth the extra £6 or so, as it provides reassurance that it will arrive on time.
A Nokia may be a highly functional phone, but people will pay substantially more for
an iPhone because of its user interface
and app store.

In either case, whether minimum price
or not, the client is receiving what they
want at a price they believe is good value and on which the matter should achieve its required profitability. And, this is all done without referring to the chargeable hour, except as a cross check to ensure that the firm's overheads and profit targets have been exceeded.

3. Managing the assignment

Value-based pricing demands a change in approach and behaviour to realise maximum profitability. Simply agreeing a price for a scoped piece of work is not enough; you must also change the way that work is managed to keep it within scope. You will lose money if you deliver a full service at a stripped-down service price.

Previously, there was no real incentive to find ways to minimise effort. The client could increase the scope of work - simply by asking - without the price being affected at all. Maybe the fee earner didn't record the extra time, or perhaps the extra time recorded was written off because it exceeded the agreed fixed fee, even though it was out of scope. All of that
has to change.

Every matter must be managed and any out-of-scope activities identified early to allow you to design and present options to the client before the work is undertaken - a service required is always worth more than a service delivered. Avoid surprises and keep the client informed and in control of the costs.

Under the new pricing regime, planning, process management and project management are vital to ensuring the client receives what they bargained for in the way that they want it, consistently. For some tips on how to differentiate your firm from others in the same boat, see Figure 7.

Figure 7: Creating a differentiated value-based pricing offering
1. Use experienced, expensive lawyers carefully. Look hard at how lawyer resource is used and reorganise processes with that in mind. Use careful triage, with planned processes and defined escalation points.
2. Pool ideas and experience. Planned processes allow everyone involved in an area of work to contribute ideas for improvement, so reduce the variables and gaps in individual experience to optimise outcomes. Keep fine-tuning this over time.
3. Optimise the cost of achieving the outcome. Consider what resource is required at every stage to realise the outcome in terms of time, material, finance and labour. Plan for disbursements and when the client will need to, put in new funds. Look for opportunities to cluster tasks or people to improve efficiency.
4. Better manage risks. A well-managed plan will allow you to forecast and mitigate risks. Consider what might go wrong on a matter and how you can avoid that happening. Take into account client and staff holidays that might otherwise cause unnecessary delays and resource pinch points.
4. Communication

As noted earlier, it's important to listen to the client at the early stages of a matter in order to position the transaction on the value curve and to keep the client informed of any changes to scope. This need to listen and communicate continues throughout the matter, both internally and externally.

Has the client's perception changed as the matter progresses? Do they actually enjoy the features they thought they wanted? Are there ways to improve the process and therefore deliver better profitability or an improved service? The firm's client satisfaction systems may be used to fine-tune delivery over time, as well as to map how the client's perception of value is changing (for better or for worse).

Getting started

Value-based pricing is not a destination, but rather a journey, and one that you have to start from wherever you are, rather than where you would like to be. Introducing it at a matter level, rather than top down, is the best way forward: it can be introduced swiftly through training programmes and produces faster rewards in terms of improved processes and, with a bit of luck, invoices being paid quicker.

Once embarked upon, value-based pricing has the power to deliver great change within your organisation. Even the best get it wrong occasionally, but at least you will know why and where it went wrong and be able to adjust future pricing decisions to ensure the correct level of profit is made on the next assignment.

Sally Calverley and John Campbell are consultants at law firm business consultancy Richmonte Wells (www.richmontewells.com)

References
1. See Implementing Value Pricing,
  Ronald J Baker, Wiley, 2010
2. See ValueScan Survey, Monitor
  Group, 2008
3. See Innovation and
  Entrepreneurship, Peter Drucker, Butterworth-Heinemann, 1985