Future Proofing Your Agency’s Pricing Strategy
Every year we find ways to do things 2x as fast. While productivity is always celebrated, this rise in work-done-per-hour is creating more and more issues for agencies who bill hourly. So what can they do?
These days, every thing is getting faster. The pandemic has taught us that people can do more with less hours. Remote work has increased productivity and forced companies to innovate at a quicker speed. And new technology that automates routine tasks continues to roll out.
Furthermore, as we wrote in our previous article, studies show that working too many overtime hours leads to lower productivity. That means, contrary to popular belief, long hours do not equal more productivity.
Bottom line:
We’re doing more in less time
Long hours actually decreases employee output
So how does this impact agencies billing on an hourly basis? Blended hourly rates have been relied on for decades. For some, the pricing model is so ingrained into their operations and industry that its paralyzing to imagine another option. But due to the conflicts building between productivity, profit, and time spent, forward-thinking advertising and digital agencies are are beginning to look towards different pricing models.
In fact, we have many clients who work from an hourly basis who are going through this transformation themselves. To help, we’ll go over:
The rising disadvantages of the hourly rate model (especially when it comes to optimizing talent), and
Alternative pricing strategies companies are adopting to future-proof themselves
Why hourly rates aren’t doing you any favors
CFOs still cling to hourly rates, and we understand why. Hourly rates help you cover your biggest expense (labour), simplify profit margins and predict labour needs based on estimated hours. But with productivity doubling over less than a decade, the disadvantages of blended hourly rates have started to do more harm than good.
How Hourly Rates Are Hurting Companies
Profit Plateau: Standardizing a profit margin across an hourly rate is easy, but limiting. Even when you do a faster or better job, your profit margin remains static.
Efficiency Is Penalized: If pricing is based on estimated hours, and your ongoing efficiencies lower the hours needed, you’re ultimately billing less revenue.
Conflicting Employee Objectives: For most hourly-based companies, employee’s performance and bonuses are measured based on how well they accomplish projects within the priced hour limits. Once the hour quota is met, employees are incentivized to stop working on a client even when the project requires further work.
Overworked & Tired Employees: Due to the static profit margins of hourly pricing, companies look to increase profit based on the Revenue/Employee Salary ratio. Companies will try to squeeze as many hours out of each employee as possible so that their revenue over salary ratio increases. Unfortunately, overwhelming research shows that overworking employees actually decreases their productivity (and work quality) - so this method of increasing profits is ineffective and can lead high employee turnover.
Limits Your Talent Strategy: Rockstars don’t come cheap. And your best employees are typically known for doing everything better and faster. But if you’re pricing based on their hours spent, that could mean billing less hours overall - and therefore lowering the agency’s revenue-over-salary profit margin. This disconnect between outcome and profit leads many hour-based companies to hire more junior positions, and in some cases, lower-salary candidates who are underqualified for a role.
Now, some people will say “You can always charge more hours than needed to do a project and pocket the savings”. That’s true. However, this band-aid fix often backfires in the long run. Why? Clients are starting to learn more about all of the services they outsource and are challenging the hour-based companies who inflate their hour estimates.
To prepare for a future of endless efficiencies, many companies have started adopting new pricing strategies like the ones below.
Alternative price strategies for the future
COST-BASED PRICING
At first glance, hour-based pricings sounds a lot like cost-based pricing.
Here’s the difference. With hourly-based pricing, companies often charge a blended rate based on an average for each seniority level (i,e. juniors, intermediates, directors, executives). With cost-based pricing, you price based on the true costs per individual employee.
For example, you could have 4 Account Directors at a service company. Each of them performs similar daily tasks, but because they have varying levels of skill, experience and clientele, they have differences in salary - with Account Director #1 having the lower experience (and salary) and Account Director #4 having the highest level of experience (and salary). How would the differences in these models impact your pricing and profits? Let’s do the math for this example below.
Blended Rate Pricing
Billed rate is calculated by adding the average employee cost-per-hour to the overhead cost and then applying applying a 20% profit margin.
Cost-Based Pricing
Billed rate is calculated by adding each individual’s employee cost-per-hour to overhead and then applying a 20% margin.
As you can see in the example above, with a blended rate the agency makes more money on putting their less experienced directors (i.e. Account Director #1) on projects - and they make less money by utilizing their top people. In contrast, companies with cost-based pricing continue to benefit from hiring and utilizing their best employees.
The last and lesser talked about benefit of cost based pricing is that it is inherently up-to-date with your costs. What does that mean? Well, companies who use a blended rate sometimes fail to update that rate for years. Over those years, your actualized profit margin will decline as salaries and inflation rise. With cost based pricing, you’re always using the most up-to-date salary of every employee, which ensures companies continue to price their profit margin against actual (and rising) costs.
PERFORMANCE-BASED PRICING
This one is definitely for well-established agencies with a high level of confidence in both their work and the clients they choose to work with.
Performance-based (or outcome-based) pricing is when you tie price to your ability to successfully achieve a measurable outcome like lead generation or sales. To price in this model, companies need to establish measurable KPIs, how these KPIs will be monitored and the value of each successfully achieved outcome. Then, you charge based on how many of those KPIs you achieve, and may also charge a one-time upfront fee for setting up the engagement and strategy.
Performance-based pricing can have huge profit upsides if the agency is able to meet and exceed their KPI goals. It’s important to note that this model works best when success is easily measurable and when the services provided are not heavily dependent outside factors (such as the client’s own resources or other vendors).
VALUE-BASED PRICING
Value-based pricing is not about the costs you incur or your competition. It’s about how much value you’re providing to clients.
In this model, if you spend 5 hours on a project, but that work creates $20,000 in value for your client, you shouldn’t charge for just one hour of time. You would charge a price that embodies the value created. In essence, you are charging what clients are willing to pay based on the ROI they expect. This is the pricing strategy Web Canopy Studio currently leverages.
“With this kind of value based pricing model, you separate yourself from things like time materials, number of hours you're working, and your hourly rate.”
- John Aikin, CEO Web Canopy Studio
Some agencies, such as Ready North, have established a points system as a form of value-based pricing. In this model, clients buy a one-time or monthly package of points that they can spend on services. For example, the creation of a landing page might cost 5 points and a short blog post might cost 3 points. The agency determines the point-price of each service based on how valuable they believe that service is (and not just on hourly costs).
“We’ve gone through dozens of pricing-model iterations since I first started pursuing a better way back in 2004. We’re still very early in the evolution of point pricing, but we can already see positive impacts on efficiency, productivity, accountability, transparency and, most importantly, client performance.”
- Paul Roetzer, CEO Ready North (formerly PR 20/20)
Value based pricing rewards companies for both saving time on projects and hiring talented employees who can deliver better value. The one flip side is that it requires companies to be constantly in tune with clients’ perception of value for each project, and adjusting price as changes in perception develop.
Our Take
At the end of the day, clients aren’t looking to buy hours of time. They’re looking to achieve their own business goals. So the better agencies can align their pricing to their clients true objectives, the better they’ll position themselves for client acquisition and long term retention.
Equally important is how well your pricing strategy enables you to deliver a truly differentiating quality of work. Hourly billing in general penalizes innovations to processes, time-saving technology, and amazing people who simply work faster. Blended hourly rates in particular incentivize companies to hire less experienced and lower salary candidates instead of reaching for that rockstar. Neither of these qualities help you impress clients. Afterall, clients want the crème de la crème on their teams - experienced, talented, and strategic people. They also want quick turnarounds.
Our recommendation is to always focus on the outcomes - of your company, employees, and client performance - and to find a pricing strategy that embodies and rewards those things. In our experience, we’re seeing more and more companies transition to value based pricing. For the companies hesitant to fully let go of hourly billing, we’re seeing those companies at least move towards cost-based pricing.
At Ari Agency & Ari Executive, we work with digital leaders and disruptors who rely on our ability to find transformation people. If you’re interested in the trends impacting workforces or looking to hiring new game-changing talent, contact us today to learn more on how we can help.
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