Ask any pricing expert about cost plus pricing and they will frown. Then, they will explain that your customer does not care about your costs, and your costs should not be a factor in how you set prices. Press them and they will go on to tell you that with cost plus pricing you are generally leaving money on the table. The smart ones will point out that with cost plus pricing it is difficult to use your pricing to communicate your value. In a competitive market, cost plus pricing favors the low cost supplier. Is that what you want to be?
There are circumstances where cost plus pricing does make sense. The most important of these is when the customer is specifying the solution, not the vendor. If it is the customer that understands what creates value and is calling all the shots, then there is not a lot of room to execute on value-based pricing. The classic example of this is the defense industry. Defense contracts are often cost plus as it is the government that is requiring the 'mil spec' (military specification) and that needs to freedom to change requirements and specifications on a moment's notice. Note that in this case, cost-plus contracts are not low costs contracts. The government may have very high-quality requirements and require the services of very specialized, and expensive, experts. The 'beltway bandits' as the big Washington DC defense contractors are called are not known for low costs or poor pay.
Professional services firms have also generally used some form of the cost plus model. Lawyers and accountants tend to bill by the hour. There are generally two reasons for this.
- It is hard to know what is involved in delivering the service until one is deep into delivering it, making it difficult to give a fixed price in advance.
- The value of many professional services is unclear.
In cases where there is a clear economic return, for example in certain lawsuits where damages might be rewarded or in Canada for SR&ED claims, professional services firms often take a percentage of the money that the client receives.
Over time, most industries where cost plus pricing makes sense will migrate to low cost jurisdictions if they possibly can. Not all can. Governments are not going to move important military contracts offshore for obvious reasons. There are some services where the personal touch is essential but most routine work will move to the lowest cost provider. For the past ten years that has meant offshoring. Over the next ten years that will mean replacing humans with AI and robots. The first place we are seeing AI and robots replace humans is in the well structured and repetitive work that was being sent to lower cost jurisdictions. These countries, India, The Philippines, are going to see their IT and knowledge process outsourcing business come under a lot of pressure.
The other impact of AI and predictive analytics on professional services firms will be a move from cost plus pricing to performance-based pricing. In professional services, performance-based pricing is how value-based pricing gets implemented. New technologies for knowledge representation are combining with predictive analytics and AI to make it possible to better predict the outcomes of a professional services engagement. This will make it easier to bake performance components into the pricing of professional services. This is something we are doing at Ibbaka (see How does Ibbaka price Ibbaka's services?).
If you need help with your pricing and innovation strategy, contact us at firstname.lastname@example.org. We are willing to commit to performance-based pricing!