Cost based vs. value based pricing

Whether you’re taking the plunge into freelancing and consulting or running a studio, there is one question that always looms over you: how am I going to price my services? This is one of the questions I’ve answered more than almost anything else over the years.

There are a couple approaches you can take that we’re going to review:

  • Value-based pricing.
  • Pricing based on cost (time and materials).

There are pros and cons to each method, and what’s worked for us in the past may not be the best decision for you. Hopefully this outline can guide you to make the best choice for your business.

First, a few definitions

Let’s start by defining what value-based pricing and cost-based pricing mean.

diamondValue-based pricing is a selling approach where you sell a project based on its value to the client. The idea is to frame the project as an investment in future value. For example, if website redesign for an ecommerce site has the potential of creating $1 million in additional revenue, a designer could price that redesign at 10% of its value, or $100,000.

There are many cases of successful value-based pricing. The Westinghouse logo design by Paul Rand is rumored to have sold for $100,000. Looking at revenue growth and long term value to the client is one way to maximize profitability of your consulting or design work. But it’s not the only way…

bagCost-based pricing means getting paid on time and materials—an hourly rate plus expenses. In the custom web design industry, trading money for time is the standard. It’s also called cost-plus pricing: “cost” meaning time and materials and “plus” meaning profit. The hourly rate is determined by a number of factors: the size of the design shop, overhead costs, market demand, employees’ salaries, vacation and sick days, marketing objectives, and so on. There is a reason cost-based pricing is the standard—it’s transparent and allows for greater accountability between designer and client.

Value-based pricing pros and cons

Value-based pricing is both a selling technique and a pricing model. If you can sell based on value you can make much more money than if you’re using a cost-based model. FreshBooks co-founder Mike McDerment breaks down the objective of value-based pricing nicely in his e-book Breaking the Time Barrier:

“The value of what I do,” Karen said, “is based on the impact I can have on my client’s business. Impact is how they value my services. So I look at pricing from their point of view. They don’t hire me to design a website for the sake of designing a website. They hire me to design a website that’s going to help them grow their business. I find when I look at it like that— from their perspective—it’s clear I’m not selling time. Instead, I’m selling a solution that is going to make an impact for my client and achieve some business objective.”

Selling based on value can work a lot of the time, but it doesn’t always work for web services. What we’ve learned in twelve years of custom web design is that large projects often contain hidden variables that can wildly escalate costs.

This is the problem of value-based pricing that is specific to web designers—you don’t always know that a problem exists. When you work on a flat project fee, if you have unknowns you have to account for them. This is where web designers get killed.

Here’s something that happened to us: we signed onto a project that included hardware integration system. After a good bit of research, we estimated that the hardware integration would cost us about $7,000 and we planned for a potential cost of $20,000; so plenty of room for profit on that. We didn’t know how to do this piece, so we needed to a hire a third-party to do the integration. The first sub-contractor cost us $10,000, which was fine because that was well within our estimation. Then, that contractor didn’t work out, and we had to hire another. And one more contractor was hired on top of that. All told, we spent $60,000 on sub-contractors for just one aspect of the project. We only sold the contract at about  $40,000: needless to say it was a loss. If we had been on a time and materials contract, we could have avoided taking such a big hit. Of course, you can always look at the situation and say that there were management processes that could have been implemented, better ways to determine issues with subs, etc. But at the end of the day, this same thing happens to developers all the time and we’re focusing just on this one aspect of how to solve the problem in this blog.

The lesson here is that the larger a project the higher probability there will be of having unknown variables. In the example above, we didn’t know the hardware integration was going to be so expensive. It’s because of these unknown unknowns that value-based pricing isn’t always a good fit for those in custom web development.

Finally, when you’re selling value, you are going to be held to providing value. If the client is paying a lot of money for the value of what you provide, then decides to make ‘modifications’ as the project progresses, and your ideas and value are diminished, you will still be held accountable to some extent for the success or failure of the project.

Even though value-based pricing doesn’t make sense for our design shop, it doesn’t meant that it can’t work for you. There are many designers who work solely on value-based pricing. If the risk for unknown variables is low, then value-based pricing can make you hugely profitable. If you’re a smaller design shop or just starting out, value-based pricing could help you expand your clientele and increase revenue. If you decide to use a value-based approach, the key is in smart project scoping. So long as you price the value of the project high enough, a change in project scope will have minimal effect on profitability.

This separation of fees from time was very relieving. But it wasn’t like he ignored the concept of time altogether. He still tracked his hours, but only to better manage his time and more accurately scope out projects. – Breaking the Time Barrier

Cost-based pricing pros and cons

The biggest advantage of pricing based on time and materials is that you get paid for any work that you do. Have you ever signed onto a project at a flat fee and spent way more time and money than you had expected? More than likely, you’ve had many projects like that. Unless you have value-based pricing down to an art and a science, flat rate projects can leave developers and designers overworked and underpaid. Calculating cost based on time and materials is the best way we’ve found to avoid financial nightmares.

The other important advantage of time and materials pricing is that clients can make as many changes to a project as they want. So long as you are transparent about project scope, the client has more flexibility. What I mean by that is you must inform the client how each change to the original project scope will affect total cost and delivery deadline.

No matter how much I endorse cost-based pricing, you have to realize it’s not a panacea. You have to be diligent about managing projects and client expectations. Managing the information on a project, hourly rates, materials and reporting to the client in a professional manner can be difficult and expensive. You may need to hire a project manager if you don’t already have one. You have to track the hours of every employee and contractor. You have to approve expenses. You have to show progress. And you need to provide all of this information in a professional and clear manner the client easily understands on a very regular basis.

Some have argued there is a conflict of interest in cost-based pricing, saying when you charge hourly, it’s in your best interest to delay and prolong projects. I think this is a fallacy. To charge hourly, you have to be even more transparent than in value-based pricing. It’s not about maximizing profitability by prolonging hours. You maximize profitability by being an efficient shop and charging an appropriate hourly rate. If you’re ripping people off, it’s going to get out and you’ll eventually be out of business.

To put it more simply, you have to be more transparent with the client under this pricing model. You have to do an excellent job setting expectations, providing deadlines that allow time for developers and designers to get their work done without having to work overtime.

Because big projects tend to have big problems, scope can quickly double or triple as a project moves forward. The best way to anticipate these costs is to explain potential variables to clients while you discuss budget and scope of the project. Moving to a time and materials pricing model will cover any of those unexpected costs you may encounter. We’re working on another post on how to do estimates for small and large projects that will help you break down costs during conversations with clients.

To briefly overview the pros and cons of each:

Value-based pricing

Pros Cons
Potentially large increase to profitability Unknown variables
Risk of being underpaid/overworked
Requires great selling techniques

Cost-based pricing

Pros Cons
Flexibility More transparency required
Accounts for unknowns Expensive (project management costs)
Always paid for time worked More complicated (time tracking software)


Mixing value-based and cost-based models

A third option available is to combine both pricing models described above. If you can deliver high value results, then absolutely sell your services on a value-based price. Then, if the client asks for more work beyond the original scope, charge on time and materials. So long as you have a solid project scope and contract to begin with, you can always charge extra for programming or design work beyond the original scope.

A few examples of how to mix value and cost-based pricing are:

Branding: If you are developing a logo or branding, charge a flat fee for the first round of logos and maybe the first round of revisions, then charge an hourly rate for everything beyond that. So, provide 6 to 10 initial drafts and revisions on 2 of those, then charge hourly for everything beyond that. This way, the client can tweak the their hearts content and you still remain profitable.

HTML / CSS Slicing and Coding: Lets say you have a project that is going to take you roughly 100 hours. Of that amount, 40 hours are going to be design and another 30 hours are going to be slicing, HTML, & CSS. If you know it would take you 30 hours to slice a site and you are charging $100 per hour (I kept the numbers round to make the math simple), than your price to would be $3,000, right? Well how about charging your standard hourly rate for the comp design and photoshop work, then charging your normal rate for the time you would do the slicing, but send that portion to something like PSD to HTML which will cost you about $1,000? The value of the work is the same, but now you get just made a cool 3k on the HTML and CSS portion.

It may take getting a few clients under your belt before you find the right pricing method for your business.

The last word you ever want to hear

The last word any developer wants to hear from a client is ‘should.’ This is a final point to this blog that is a bit outside of general discussion on the subject, but I added it because it is so important no matter what kind of costing system you use.

“Facebook does it, my site should as well”
“There should be a way to opt-in to the newsletter on our app.”
“My project should do X!”

No matter what pricing model you choose to follow, every project that walks through the door has the potential to run into ‘shoulds’, unless you have a well-defined scope. Accurate project scoping can help you avoid difficult client situations, account for unexpected expenses and give a clear picture of the final product to the client. With any project scope, the goal is to avoid ever hearing the word “should” from a client. And, if the client wants extra functionality beyond the original project scope, just be honest and tell them, “Sure, it should do this, but it will cost more money.” As long as you have a solid scope and contract you in a good position, but if not, then maybe it should do just what Facebook spent a million dollars making their site do. After all, there is nothing to say otherwise.

If you are looking for more in depth writing on pricing models, I suggest looking at Breaking the Time Barrier for insight on value-based pricing. For more on cost-based pricing, check out Jeff Archibald’s article on web design pricing or Smashing Magazine’s article on estimating a project.
What’s been your experience pricing design and development services? We want to hear the good, the bad and the ugly!

– Diamond designed by Jordan Delcros from the Noun Project
– Thumbs Up designed by Jon Testa from the Noun Project
– Money Bag designed by Lemon Liu from the Noun Project