Demystifying Service Pricing

by Al Hahn


While there is still some art to pricing, it should be mostly science. The
techniques are well understood and, in concept, easily mastered.


Many people find pricing services to be a dimly understood, mysterious art form. At my consulting firm, we regularly provide competitive service prices to our clients. We also undertake consulting projects each year that involve pricing or repricing services. Over the past 20 years, I have personally taught the techniques of pricing services to thousands of services professionals. I guess that you could say that I am as much of an expert as you are going to find. While there is still some art to pricing, it should be mostly science. The techniques are well understood and, in concept, easily mastered. It is real world considerations such as lack of critical information and complex product lines that make it difficult. Often the most challenging aspect is the misunderstanding of the importance of price in the sale of products and services. This article takes a straightforward approach to rectifying common misunderstandings and explaining correct pricing procedures.

The Importance of Price

Price is just one of the four "Ps" of the marketing mix. The others are Product (in our case, the service offering is the product), Place (distribution channel) and Promotion. Price is important, but not any more than the other marketing elements. Many product and service salespeople are convinced that price is the most important ingredient in selling services. Wrong! In customer surveys, price of service comprises about 10 percent of the reasons why customers buy a service. Of course, product salespeople are forever stating that they are about to lose the "Big Deal of the Century" because of the price of service. Don't believe it. Customer surveys reveal that less than one percent of the reasons given for purchasing a particular product are price of service.

Quality of service is another matter entirely and is much more influential. The facts are that products and services themselves are the dominant reasons for customer purchases. Salespeople that have problems with this need to do a better job of understanding the customer's needs and connecting their products and services to those needs. In an era when priceFourPsdifferent brands of bottled water are being sold at huge premiums, there is no excuse for treating technology products and services as equal commodities. Selling on price is a symptom of lazy, undisciplined selling and poor technique. I get letters about this all the time and am used to dealing with insulted sales types. I have too much researched data and experience to fall for their passionate defense of indiscriminant discounting.

The Science of Pricing

Putting science into pricing quite simply requires information. At a minimum, we need to know either our competitors prices or our own service costs. Ideally, we have both sets of information. Even better would be the addition of customer market research. Armed with this kind of data, we can put some science into pricing. The following are some specific techniques.

Market-Based Pricing

Armed only with marketplace information, we can come up with service prices. One way is to knock off the market leader. Historically, many independent service providers would offer services at 10 to 20 percent less than IBM. It doesn't have to be IBM, any market leader will do. The theory is that smaller companies have less overhead and can provide services at a lower cost. This works if you get enough volume to achieve reasonable economies of scale and if you can provide service quality similar to the leader and still keep those costs down. Those are some big ifs. Surely it would be better if you knew your costs, but we'll get into that soon.

Another form of market-based pricing is to get the prices of your competitors' services and just plop yourself down in the middle of them. The thinking is that it is safe and competitive in the middle, and if they can make money at those prices, you should be able to as well. Again, there are risks if we don't know our costs, but I know that many Value Based Pricingservice organizations just don't have useable cost information. These techniques have the virtue of simplicity and at least have a chance of making money. When you get that competitive information, be sure that you are comparing like services. Most companies offer different levels of services at different prices.

Getting Competitive Information

The above techniques depend upon accurate competitive information. This is not simple to get. Detailed information is required, including the features and specifications of the services as well as their attendant prices. Many service/support prices depend upon the hardware or software product configuration. To get accurate, detailed information, you must understand the products the services address. By the way, beware of competitive information coming back from the field. Salespeople get fed bogus information from customers trying to negotiate better deals. You need to get pricing data direct from the service providers. If your competitors don't post this on their Web sites, you may have to hire a market research or consulting firm to get accurate information for you.

Cost-Plus Pricing

One of the most common methods of pricing is the cost-plus method. In this case, the actual or estimated cost to provide a specific service is computed and a reasonable profit is added to determine the price. This is great if you know your costs. Accounting and financial types love this method because the margins are fairly consistent and predictable. In fact, a cost-plus analysis is often combined with other methods of pricing to insure that minimum margin targets will be met. Keep in mind that it is not actually necessary that you know your costs, only that you are able to estimate them with reasonable accuracy. After all, we never really know future costs anyway. So don't be intimidated if you don't have absolutely accurate historical data. Your experience will often allow you to estimate costs well enough. The cost-plus technique is one of those challenges that make service/support so unique. It is simple in concept, complex in execution. As this is a very common and fundamental methodology, it should be implemented as soon as possible.

Percent-of-List

This is one of the older and more enduring pricing techniques for services. Service/support is priced as a percentage of the list price of the product. The advantage of this method is its simplicity. No price list is needed for service. Salespeople love this method because they can provide a quote on the spot. Just multiply the percentage times the product price. All you need to know is the percentage. In some parts of the world, the locals have locked onto using 10 percent, presumably because it is very easy to work with. In the past, this method was commonly used for pricing hardware service contracts. Today, it is still used for some network services, but not seen much elsewhere for hardware services. This technique is, unfortunately, still popular for pricing software support. While there is a lot of benefit in its simplicity, most notably getting salespeople to actually quote service, it has some downside as well. At best, this is kind of an averaging technique. It ignores the fact that different products may have very different service costs. It also ties product and service prices together. Competition has been forcing product price-cutting. Reducing the product price does not affect service cost. Having a service price arbitrarily reduced because it is tied to the product price is a dangerous aspect of this technique and can kill your profit margin. I do not recommend that you publish your prices this way. Use this method of pricing if you have to, but don't put the percentages in writing. Instead, use a service price list with specific dollar prices for each service on each specific product. Basically, this is an old technique that has largely outlived its usefulness. It is not recommended.

Value-Based Pricing

Without any question, this technique offers the most potential benefits to a service provider. When it is done well, the vendor gets higher prices and margins... and customer satisfaction is actually higher. Sounds too good to be true, doesn't it? The catch is that this technique is much more complex, and often combines a little art with the science. Like other techniques, it is simple in concept. Get the customer to recognize a lot of value in the features of the service, and then price to capture the full, perceived value.

Maybe I should note that this technique only sounds simple. It requires two difficult tasks, however. The first is to understand what the customer will value. The second difficulty is to get the customer to perceive that a high value is being offered. This obviously requires a lot of customer interaction and knowledge about the customer. Value is somewhat like beauty; each person interprets it a bit differently. Significant customer research is usually performed as a first step in this technique. Different features of services must be assessed as to their potential value. Then, features can be selected and services configured to present value to the customer. This, of course, is much more than simply a pricing technique, as it begins with research and service product design.

To illustrate the concept, consider the chart in Figure 1. The smallest circle represents frozen chicken, which is perceived to have lower value than the other circles. Next, we have fresh chicken, which is perceived as better and is expected to be priced higher than frozen chicken. Finally, we have free-range, locally grown, fresh chicken at a premium price. The marketplace easily sustains these perceptions that higher value commands a higher price. It is similar with services. Service from a Mercedes dealer is expected to be better and more costly than service from a local independent service provider. We would expect IBM to provide high quality service on its mainframes or for enterprise systems and would expect them to command a premium price. A nationally or internationally known heart surgeon would be expected to have extremely high skills and to be far from the cheapest alternative.
valuePricingOfChicken
I have tried to find examples of companies that have processes for value pricing and have not found anything that is very precise. Most service marketers feel that they are being very bold by merely disconnecting the fixed relationship between price and the cost, so that services no longer have fixed margins as in the cost-plus technique. As for establishing value, many methods are used. What they have in common is that they rely on comparisons to establish value. This is a sound idea. Customers usually will try to compare your services and prices with those of your competitors. They may also make comparisons with similar services that you may not believe are comparable. Since this is probably going to happen anyway, smart marketers provide favorable comparisons for customers to consider. Without tools to offer comparisons, salespeople will struggle to communicate value to the customer.

There are some models that are commonly used to help establish service value. One is called the value-in-use model. There are many variations of this model, but essentially they all relate to the customer's use of either the product or the service. Cost-of-downtime is one such model, comparing the relatively modest cost of service with the potentially huge cost of downtime. Other models might value time saved by getting fast answers to questions or productivity gained by attending training. Complex cost-of-ownership models can be used to demonstrate that services can provide considerable value over time.

How do you actually determine the price using value-based techniques? For most service marketers, this is where the art of pricing comes into play. Usually a higher price than would be reached by other methods is set, based upon the degree of confidence felt by the marketer. The customer research helps to generate this confidence. Actually testing price as one of the four "Ps" is possible using a technique called conjoint analysis. This is fairly sophisticated market testing more commonly used in consumer marketing. It takes a fairly large customer base and some good software, but it can be worth the effort. In the testing, sets of service features, including price, are tested to see which combinations score the best acceptance with customers. This technique could allow you to find the highest price that still would be likely to achieve a certain market penetration or acceptance factor.

Configuration versus Flat Price

In the past, most service prices have been specific to exact configurations of hardware and software. More recently, the volume of mobiles has made configurations irrelevant for many customers. To simplify the quoting of service contracts, many vendors are coming up with flat price schemes that charge one price for a given product model, regardless of the amount of memory or the size of its disk drive. This has been a helpful practice in desktop services. Some companies use a technique called band pricing. In this method, services for particular products are priced based upon the total product list price compared against a table. For example, a particular level of service is priced at a fixed amount for specific products priced between $10,000 to $20,000. For products priced between $20,000 to $30,000, there is a higher service price. Where configurations are virtually impossible to track, these simplified methods are very useful in adapting to real world complexities.

Where Is the Magic?

The "magic" of pricing is that value-based techniques can actually enhance customer satisfaction. This lofty goal is achieved because value-based methods lead with features that customers actually value. This sets expectations that must be met in service delivery, but also ensures customer appreciation. As discussed, value-pricing techniques require considerably more effort in research, design, tool development, and finally, in selling. The results, however, are well worth it.

Well, there you have it, more science than art. For those that have been mystified by pricing, I hope that this has made the concepts seem as simple as they are. For those who have been frustrated by a lack of data, you are not alone. If you are substituting some art for science, that's all right, your experience is a good substitute for data. If you find that real world complexities are making the job of pricing incredibly complex, welcome to the club.