This article has an accompanying free workbook. You can download it here. And if you like stories, you can find out real-world implications of not understanding the concepts in this article by reading Even Drug Kingpins and Hitmen Make Pricing Mistakes.

Most service businesses use a pricing model called “cost-plus” pricing.

Cost-plus pricing is a way of arriving at a price by adding together the direct material costs, direct labor costs, and overhead costs for a product and then marking it up to create a profit margin.

There’s a similar method that I often see recommended where you start with the goal salary you want, add in your costs, and then divide by the number of clients you want to work with. That calculation leads you to the goal figure. We’ll call this “salary-based pricing.”

Let’s use a photographer as an example. They decide they want to make a salary of $100,000 per year. Their costs are $70,000 per year. That means they need revenues of $170,000 per year.

To hit that with a little cushion, they need about $15,000 in revenue per month. If they only want to work with 10 clients a month, their average client needs to bring them $1500 in revenue.

Knowing this, they can design their packages and pricing around hitting that average sale price. Simple.

These two methods are how most new business owners set their prices. The problem is, they’re both awful pricing methods.

Both methods suck because they fail to align the value you provide with the value your client will receive.

Let’s use the example of a web developer. She has two clients who both want an e-commerce site and both sites will be of fairly equal complexity.

Both clients are currently selling their product offline and want to move into the online space.

  • Client A is a bootstrapped startup with offline sales of $10,000 per month.
  • Client B is a well-established brand with offline sales of $250,000 per month.

With cost-plus pricing, you’re probably going to bill both of these clients by the hour (the cost of your business expenses plus your time).

  • Client A gets a proposal for 50 hours at $100/hr.
  • Client B gets a proposal for 50 hours at $100/hr.

You’ve told both clients that you can build this e-commerce site for $5000.

With salary-based pricing, you’ll still probably bill by the hour and you’ll take every job that nets you more than the average client value you’re targeting.

Since you can only complete two e-commerce sites per month, you would need an average client value of $7000 to hit your six-figure salary goal.

In this salary-based e-commerce scenario, you say “yes” to both clients because they’re both “close enough” and you’re tight on cash and “need the work.”

The result is that both of these pricing models have brought you $10,000 of revenue in a single month across two very different clients.

But look at what happened here. If Client A generates $50,000 in online revenue in the first year, they’ve made a 10x return on their spend with you (and that only grows year after year). If Client B generates $100,000 in online revenue in the first year, they make a 20x ROI on your work.

You busted your ass to pump these two projects out. You’re taking on all this risk of owning your own business. You have fixed costs and a family to feed. And you have to do it all again next month while what you created is netting your clients a 10x, 15x, 20x, etc. ROI year after year.

Stop saying you’re worth “$X/hr.”

Thinking about hourly value is the wrong mindset. Drill this into your head: your worth is determined by the value that you bring to your client.

In the e-commerce scenario above, the value that you provide to Client A is very different than the value you can provide to Client B.

Client A has a lot more risk. They’re new and they don’t have a lot of revenue. Their product is unproven.

An e-commerce site helps them, for sure, but it’s not a game changer and it’s going to take time and a lot more money to make it work well for them.

Client B has a lot less risk. They’re established and have a lot of revenue. Their products are proven, they’re just not taking advantage of the digital landscape.

An e-commerce site could add six figures to their bottom line in just a few short months, especially with all the buzz they can generate from their existing client base.

Surely you can see that an e-commerce sits is worth more to Client B than it is to Client A.

Client A is going to get a slow ROI with greater risk. Client B is going to get an immediate ROI with much less risk.

As a developer, your work brings more value to Client B than it does to Client A.

Think of it from an investment perspective…

How much money would you be willing to invest in a business that has a proposed return of six figures after five years, but that has a 50% chance of going out of business by then?

How much money would you be willing to invest in a business that has a proposed return of six figures after one year and only a 10% chance of going out of business by then?

I’m guessing that you’d be willing to put up a lot more money in scenario two, yes?

That’s how smart companies are looking at the services you provide, so that’s how you need to be thinking about pricing them.

If I’m going to build an e-commerce site that’s going to net a six-figure profit for my client, you best believe that I’m going to recognize that value to them and price accordingly.

If they’re smart, they’ll be willing to pay $25,000, $35,000, or even $50,000 for the project.

Why wouldn’t they? Even at a cost of $50,000, they’ll have doubled their investment after only one year (and the ROI only continues to increase each year thereafter).

Do you know of any other investment with that kind of return?

“But Kevin, you’re acting like you don’t have any competitors they can go to.”

I’m not ignoring the fact that we all have competition. But having competition doesn’t mean you have to race to the bottom.

The first thing you have to consider are your intangibles. You do have intangibles, don’t you?

  • You have more experience.
  • You’re more trustworthy (in your client’s eyes).
  • You’re faster.
  • You’re more responsive.
  • You fill a gap/need that others don’t.
  • Your knowledge/skills directly contribute to an increase in ROI (maybe your competition designs pretty websites but you design pretty websites that CONVERT at double the rate of your competitors’ sites).
  • You’re more creative.
  • You’re more likable.
  • Etc.

The more intangibles you have, the more you can charge.

If you don’t have intangibles, debating me about pricing is a waste of time because you’re screwed anyway.

The next thing you have to consider is the tangible value you’re adding. For B2B, this is usually what you’re adding to the bottom line through an increase in revenue or a decrease in expenses.

The more tangible value you add, the more you can charge.

The next thing you have to consider is how value-based pricing directly contributes to your ability to serve clients at a higher level.

Who is going to be more responsive to clients? The developer who is working with a single client paying them $50,000 or a developer who has 6 ongoing projects all paying them $7k?

Which developer is more likely to have one or more team members to assist in getting the project done on time or ahead of schedule?

Which developer is less likely to be frazzled and stressed and missing deadlines?

Which developer is more able to invest in ongoing education and knowledge development?

Which developer is more likely to still be around in 5 years?

These are real benefits that your clients will get by paying you more aside from the fact that you’re delivering tons of value for them.

If I submit a proposal for $40,000, there’s nothing stopping that company from hiring a developer that submits a proposal for $20,000.

You might think that I’d never land any clients when they can just go somewhere else.

And you’d be wrong.

They’ll pay the extra because of my intangibles. They’ll pay the extra because it’s time-consuming and frustrating to go find/interview/vet other developers. And most importantly, they’ll pay the extra because it’s still worth it to them based on the ROI they’re going to get.

If you can sell the value, your competitors don’t stand a chance.

Value-based pricing provides the needed margin for freedom and scale.

You have to land almost six $7000 clients to match the same revenue from one $40,000 client.

That’s six projects you have to learn about, strategize for, execute on, and collect payments from. That’s a lot of time and energy.

And there’s little margin in the $7000 client that can be used for recruiting help.

You haven’t built a business with cost-based pricing, you’ve built a job.

That brings me to another point: value-priced owners are the employers of cost-priced workers.

You don’t even have to do the work to develop the e-commerce site if you don’t want to! That $40,000 contract gives you the freedom to hire two great developers at $50/hr or even $100/hr to do the work.

If they cost you $10,000 or even $20,000, you’ve doubled your money.

At that point, your real value comes in finding new deals and providing a high-touch experience for your clients. You remove yourself from the role of coder and transition straight into the role of CEO.

You don’t have to do this, of course. You can go in a different direction if you want. Instead of hiring a team and taking on more high-paying work and building a giant agency, you can make those high-value clients translate into more time independence for you.

Working with one client at a time instead of six gives you a lot of free time and flexibility. It keeps your stress low. It leads to a higher happiness quotient.

You’re also more likely to get higher quality clients. Clients that have the money to invest are typically not as uptight, demanding, and annoying as the nickel-and-dimers.

None of this freedom and scale and opportunity is available to you with the cost-based model.

How do I make the switch to value-based pricing?

Ready to change up your pricing model after reading this?

Good. I don’t want to see you struggling anymore.

I’ve put together a free workbook that will show you exactly how to implement value-based pricing in your business. It includes some important exercises to help you understand your value better and also includes a list of questions you can ask your clients to help you understand the specific and unique value you bring to them.

You can download it by entering your details below…

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