The Mythology of Service Pricing©

By Al Hahn

I believe that no single topic is more misunderstood than services pricing. I have traveled much of the world, training people in services marketing and selling, and the mistakes that are being made in this critical area are costing companies billions each year. Why? I propose two reasons:

      Not enough people are studying services pricing.
      Product pricing concepts overwhelm services pricing knowledge.

The most common myth is that your services are priced too high. This could be true, but since 1990, I only have seen prices of five vendors that actually were too high. During the same time, I have seen hundreds of services underpriced. My company provides competitive analysis of services for many large technology firms. Each year, we research hundreds of services and their prices. For hardware, prices have been trending down for the past decade. At the same time, pricing complaints are up. What’s going on? Well, call rates also are going down, as hardware has become more reliable. Services themselves are evolving. About 60 percent of some companies’ calls are handled on the phone, without dispatching anyone to the customer’s site. When these factors are combined, customers lose touch with the value of the services that they are buying. We make it look easy, and they complain that it costs too much. We need to get better at articulating the value of our services. Since the problem is not actually caused by our pricing, we cannot cure it by changing price; we need to get to the root cause.

Misunderstanding price elasticity causes another common mistake. While this economic theory is very valid, it is a carryover from product pricing that does not fit services. I have been testing this for years, and I cannot find a market for our services that has useful price elasticity; by “useful,” I mean that my studies have shown that you would have to reduce the typical service price by 60 to 65 percent in order to change the volume significantly. Our services are essentially price-inelastic. There is actually price elasticity, but it is so out of bounds financially that it is not useful.

Another pricing misunderstanding is that our product sellers often don’t bring up services because they are afraid that adding a service will raise the price of the whole deal to a point that it is non-competitive. Research has shown this assumption to be untrue. Quality of service accounts for 10 to 20 percent of the reasons that customers cited for choosing a product in the first purchase from a vendor and 40 percent of reasons for a repeat sale. Price of service accounts for under one percent of the reasons that customers stated for making a product buying decision. I wish we were more important, but we are not.

Pricing services as a percentage of the product is a worst practice. This is an old method of pricing that refuses to die an honorable death. It is bad for two reasons. First, there is no relationship between the two prices, except in some people’s minds. They certainly are not economically tied. The economies of manufacturing or software publishing are totally unrelated to the delivery of a service. In fact, I can think of one major player that offers some high-availability services that cost more than the product. As a consequence to this method of pricing, we often leave money on the table.

The other big problem is that we usually forego annual inflationary price increases. The main virtue of this technique is its simplicity. However, when we publish a nice, round number for the percentage, such as eight percent or 15 percent, there is a huge resistance to changing it. How do we implement, say, a 3.6 percent increase? It ruins the nice, round number and creates a big pushback. As a consequence, those using this method of pricing tend to forego regular increases and wait until corporate finance forces a large increase due to declining margins. There are many techniques that are better than this one.

The best-practice method of services pricing is called value-based pricing. It is best because customers pay more and are more satisfied. Unfortunately, it tends to be complex, and few can jump right into it. It requires modeling for each industry segment and pricing according to the value that you provide to the customers in that segment.

Other recommended methods include cost-plus pricing and market-based pricing. Cost-plus pricing is also an old technique. We either measure or estimate cost and add a profit to set the price. This tends to be somewhat disconnected from the customer, but it usually keeps you out of trouble. Financial people like this method because it is very regular and can be programmed into pricing software easily. Market-based pricing is another favorite of mine. It requires gathering competitive information and then strategically pricing based on where in the competitive landscape we want to be positioned. Of course, we also have to manage our delivery costs to make sure we are profitable, but this technique usually yields better margins than cost-plus pricing.

Let me conclude by saying that it is not necessary to have the lowest price in order to be competitive. Market leaders are expected to command a 25 percent price premium. Manufacturers and publishers command the same difference over independent services providers. When we study competitive markets, we find a threefold price spread between the lowest priced and the highest priced services provider on a regular basis. Of course, there are big differences between these services, but they happily exist in healthy markets, and the lowest priced services do not win all of the business. In fact, the middle and top-end services usually have better margins and market share.
So this concludes my counter-intuitive pricing lesson. I hope this sends a message of hope to those of you taking heat for prices. I understand you, but don’t expect others in your company to get the message so easily.