Why Value-Based Fees Rarely Work in Consulting
Every consulting firm talks about value-based fees and they usually want to price themselves in this way since the value-based fees model offers a very high margin. Sometimes they succeed. Yet, they usually fail.
This post and related podcast address why value-based fees are widely misunderstood and rarely work in consulting. The key insight is about the forces of supply and demand.
Value-based fees can only work if certain supply and demand conditions in the market are met, or if your client is naïve. If a firm understands this concept, they have a higher probability of securing higher-margin value-based fees.
What are value-based fees
So let me explain what value-based fees are. Let’s assume you go to a client and you tell them, “We believe we can generate a hundred million dollars of savings for you. Will you be interested in considering this engagement? In terms of pricing, we believe value-based fees will be appropriate here, given the enormous value we can deliver. How about fees in the amount of 10% of the value we deliver?”
Now, think about this for a second. Some of you may say, “Hey, hold on a second! That makes sense. We are going to generate $100 million of value for this client, so we should get paid 5% or 10%. That seems reasonable.”
And that is what value-based fees are. You get paid for the value you create.
Increasing profit, of course, is only one example of delivering value. As another example, you could find a way to create 200 million dollars worth of new revenue for a client and that is how you can try to justify value-based fees. You could go to the client and say, “We believe we can create 200 million dollars worth of additional revenue. If you are interested in considering this engagement we believe value-based fees will be appropriate, given a significant return to you. How about fees in the amount of 10% of the value we deliver?”
Why value-based concept rarely works
Those who think that type of thinking makes sense misunderstand or are not familiar with a core concept of economics.
Let’s look at another example to illustrate why this logic does not work. Assume you have a friend named Sara who has solid skills in software engineering and she works at a company like Adobe or Facebook, or one of the other major tech companies. And because she has these amazing skills she goes to her boss and says, ”I have these great skills that company truly needs and because of these outstanding skills I think I deserve a 20% increase. Are you open to discussing this?”
The problem with Sara’s logic here is this is not how economics works when it comes to markets. Open markets anyway.
In economics, you are worth what the market says you are worth. So, for example, if there is another person out there in the market who has the same skills as Sara, or worse for Sara, if there are a lot of other people with similar skill-set as Sara, her worth will not be judged by her skills, it will be judged by the availability of those skills in the market.
And if there are a lot of people in the market, Sara’s boss will likely say something along the following lines, “Sara, we appreciate your work and understand you want to be rewarded. However, to stay competitive we can’t afford to pay you 20% more. I hope you will stay with us but if you choose to leave we will just have to hire someone else with a similar skill-set, maybe even at a lower level of compensation.”
So the insight here is that Sara’s salary is not exactly determined by her skills but by the availability of those skills in the market. This is a very important insight, which many people don’t realize.
When multiple people can offer a similar skill-set the leverage lies with the buyer. The only way to charge higher rates is to have a skill or some capability or combination of the skills that the rest of the market doesn’t have and which the buyer needs.
Why value-based fees rarely work in consulting
Now how is this linked to the use of value-based fees in consulting?
Many consulting firms think about value-based fees without realizing they have to ask themselves, “Is there anyone else who could do this?” And when I say “do this” I mean to conduct a specific engagement the consulting firm is considering to undertake, such as generating the hundred million dollars of cost savings or 200 million dollars of additional revenue examples we mentioned earlier.
This question is crucial to ask because if there are other consulting firms that could do this, then value-based fees will not work unless the client is naive. Value-based fees will not work in such a situation because there is someone else in the market who can do this work and who could probably do it at a lower fee.
When people think why value-based fees don’t work in consulting, they often think its because the value consulting firms create is insufficient or too uncertain to justify value-based fees. This is not the reason. It’s about the value you create but its also whether you are the only one who could create that value.
If a client believes your consulting firm is the only one who could create that value then you could go with the value-based fees model. If a client believes many other consulting firms could create that value then they put out a tender, they allow many consulting firms to bid, and they generally will go with the firm that has the best price versus value.
And when the firm hires McKinsey or BCG, a client usually does that because they believe that McKinsey or BCG has something other companies don’t have, which justifies higher fees. The client usually believes that the skills McKinsey or BCG will bring to an engagement are not common in the market.
So when you are working with a client, and you want to use the value-based fees approach, it’s important you convince the client that you have an ability to do what the rest of the market cannot do and that this work is something the client needs.
This is the insight. It’s not enough that you can generate 200 million dollars of additional revenue for a client. It is the fact that the way you will generate 200 million dollars worth of additional revenue is unique and is unique in a way that is beneficial to a client. Basic economics is at play here.
It is common to misunderstand value-based fees concept. People often think the skills they have is what determines how much they get paid. It is actually the scarcity of those skills that determines how much they get paid.
The same with a consulting firm. Value-based fees are not based on whether a consulting firm can generate value. Its whether the consulting firm is the only one able to generate that value.
You can see these supply and demand forces at play all the time in consulting work that becomes commoditized.
Think of something like business process reengineering, which is highly commoditized work. When firms put out a tender they usually go for the lowest-cost provider. Alternatively, think about outsourcing centers. It is a significant way to cut costs but have you ever heard of someone winning an outsourcing tender because they were the best at it? Most likely your answer is no. It’s a combination of price vs value that usually determines which firm will win such a type of engagement. And the power usually lies on the lower end of that scale, meaning price usually plays a bigger role in awarding contracts compared to value when commoditized work is being awarded.
So in anything you compete, it is not enough whether you are adding value to a client, ask yourself whether you are the only one who could do that. The odds are you are not the only one who could do that. Then the question becomes: can you do it in a way that is unique and can you get the client to understand that your value is unique.
And if you could do that then value-based fees will work. If you can’t do that, don’t try value-based fees because it will just put a strain on your relationship with your client. The client will likely consider you unreasonable for suggesting value-based fees in such a situation and you will likely get upset with the client when they don’t want to pay you what you think you are worth. And unfortunately, the sad reality is you are not worth value-based fees if your skill is available in surplus capacity in the market.
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