Thursday, 14 August 2008

Structured Pricing

Another area of theory I have been working on in the last few weeks is pricing. It's well-known that suppliers can use price discrimination to distinguish between those customers who can or will pay more, and those who can't. Here are some (edited) notes from a forthcoming report we are publishing about the concept of structured pricing.

Economic theory relies on agents trading products and services in a way that makes all of them better off. Any two people entering into a transaction should both gain from it; whatever is traded must be worth more to the buyer than the money they pay; and the money must be worth more to the seller than the object they’re selling. Any trade therefore provides higher value to both parties than they currently have – or else it will not happen. In classical economics, the price of something is regarded as a signal to tell the buyer and seller how much other people (at the margin where the supply and demand curve intersect) value it, and therefore whether they should buy or sell it, or manufacture more or less of it. However this signal is quite simplistic, and especially difficult to use in cases where two services or products are hard to compare and are not tradable as commodities.

There are more sophisticated economic models which involve the psychology of the buyer and seller, their mental model of the world, and their “utility function” which is a way for them to evaluate different states of the world and determine how happy they are with each. These models allow for more complex interactions than just buying and selling a commodity object at a fixed price. In these models it is possible for people to consider, according to their own subjective preferences, the effects of a complex contract or transaction, and decide whether to enter into it.
Structured pricing, while consistent with the basic laws of classical economics, takes advantage of this new cognitive economics too. Its goal is to set prices in line with the subjective value defined by the client, and pass back value through the supply chain so that participants at each stage are paid by the value of what they produce. This influences decisions by employees or suppliers about how to design the solutions they provide – orienting them around client value instead of around either maximising (in the case of hourly pricing) or minimising (in the case of fixed price projects) supplier cost. Cognitive economics also allows for a richer analysis of what is valuable to people and companies – money is not the only measure of return, particularly for owner-managed businesses where the outcomes of the business are more directly aligned with the benefits for the individuals involved.

The standard microeconomic model for the sale of services is the same as for goods: the supplier offers a fixed service, publishing the service and its price in the marketplace; the client evaluates whether it will give them more value than the money it will cost to buy it; if so, a transaction takes place. This model assumes (among other things) that the service is predictable, and that the client can gauge what value they’ll get in advance.

Neither of these are really true of knowledge-based services. Almost by definition, you don’t know what you’ll get in advance – otherwise you probably wouldn’t need the service. If a lawyer is drawing up a contract for you, or an accountant preparing your tax return, or a software developer creating a bespoke database, knowing what the end result will be is equivalent to having the end result already. What’s more, the buyer rarely knows exactly what it will be worth to them until they get it.

So there is a range of different values that can be created by a project. Certain types of project are notorious for this – bespoke software, litigation and some building or civil engineering projects. Usually not only the value, but also the cost of producing the service is unpredictable. A whole industry of estimation has grown up to mitigate this problem; but the estimator’s role is based on making the project as predictable as possible so that they can come up with a fixed number.

Thus, in order for a transaction to take place, the buyer needs to either be willing to absorb a lot of risk, or the agreed price has to be at the lower end of the range of values. If the project may generate anywhere from £1 million to £3 million in returns, the client will probably want to pay less than £1 million for it. If it works out well for them, they end up with a £2 million bonus which the supplier can’t share in. If it doesn’t, they still get their £1m of value.

In this context, any project which costs £1.5m to deliver, and returns a range of possible returns from £1m to £5m will never be made. Even though it is likely, on balance, to generate value overall. So companies which trade on a fixed-price basis are already losing opportunities for economic value.

(Sometimes this problem can be mitigated by actions such as prototyping, which may help to get a better estimate of the expected end value. But this can only work in limited circumstances, and often tends to slow down the economic process - delaying the value and therefore reducing the total discounted value that is created.)

More importantly, the supplier has lost its incentive to deliver a great result. Because knowledge-based services are unpredictable, the specific choices and performance of the supplier are likely to have a big influence on the outcome and value generated by a project. If they are paid a fixed price, they are incentivised to deliver as little as possible which still meets the basic threshold of the project spec. If they are paid hourly, they are incentivised to deliver as many hours as possible with no regard to their effectiveness. Only if they are paid by the value delivered, are they incentivised to actually deliver what the client wants.

Rational, game-theory-optimising clients may prefer the benefit of a tight negotiation and a reduced price over the cost of writing and negotiating a detailed spec, and losing the supplier’s creativity – as long as they only intend the relationship to live for a single transaction. But if the parties intend to work together beyond the conclusion of a transaction, the incentives of the supplier become more important. The reason is that their behaviour beyond the end of the project is, by definition, not constrained by the specification; the moment when the supplier becomes free is the moment at which their incentives become important again.

At this point, if the supplier is incentivised to deliver value, their knowledge about the client’s business and their understanding of their own field can be combined to deliver new ideas about how to create value for the client. In traditional economic activities, perhaps this did not matter – because everyone (supposedly) knew how to create value, and the constraints on it were only related to available capital or resource, and the skills of the available labour. In intellectual businesses, the constraint is on the knowledge of how to add value, and the supplier is as likely as the client to see how to do this.

Our economic models demonstrate that (under plausible assumptions which are detailed in the appendix) in a typical supplier-client relationship, over the course of a year, structured pricing can deliver substantially more value to the client and to the supplier than conventional hourly rates or fixed project-based quotes. We will publish soon our estimates of the scale of the extra value created.

One of the goals of Inon's Client Value Management software is to help you to implement structured pricing. Although CVM can be used successfully with hourly or fixed price quotes, there is a whole new dimension of profit to be made by entering into a structured pricing relationship with your clients.

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