Pricing Software Engineering Services: Part One

Some years ago, two good friends James and Jared (I’ll call them J&J) started a technology services business doing contract software development. Armed with their top-notch technical skills, they hung out their shingle, and after a short while the work started coming. They billed clients based on an hourly rate near the top of their field based on their skills (always a good choice!), and as they gained experience and the market continued to grow, their hourly rate grew along with it. They added more people to their company, increasing revenues by scaling horizontally. Life was good.

J&J didn’t overthink pricing using an hourly rate. It’s what the market understood. It works easily within procurement, project management budgets, and compares relatively easily to FTE rates. When you’re starting out and aren’t established, it’s often the right thing to do: nobody know who you are, you don’t have the relationships to leverage; you need to compete in the market on the market’s terms.

But over time, things change: you begin to develop a reputation for representing top talent. Customers know that when they buy from you, they’re paying a premium hourly rate, but they do because they get better results. Overtime, these results allowed J&J to incrementally charge more per hour. A virtuous cycle, indeed, which pleased J&J greatly.

Then they noticed another trend. The kinds of work their talent was involved were higher and higher stakes projects for clients. Some of the projects that their people were on, particularly those that developed customer-facing products, were incredibly profitable for their customers.

They still had plenty of other gigs, with internal focus, were ‘critical’ to their clients, but the connection to profit was indirect - like migration or modernization efforts. These new gigs actually made companies money directly, producing ROI at the product, portfolio or organization level.

This observation could have been little more than a talking point. Both kinds of engineering projects commanded good hourly rates. Contracts were often extended as the initial scope estimates were conservative or with too many known unknowns. J&J’s company was doing well. Sure, some companies refused a higher rate, but there was plenty of work to go around.

Until, inevitably, they found the ceiling. To maintain their own growth goals, they were facing a rate above which no company was willing to pay. Whether it was vendor management or some other force, no matter how urgent the need, nobody in the market would pay more than what they were charging. They saw the beginning of the flatline. Adding volume is the common strategy, but this brings risks that quality of talent or pressure to take lower quality projects - weakening their brand.

When I engaged with J&J, they had already scaled up their organization through dedicated sales, recruiting, administrative staff. This enabled more volume, but also pressured profitability. I listened to them describe the challenges they were facing, and the frustrations that were building inside the organization as they pushed for ever-higher rates to support growth and to justify the costs of their substantial investments in the operations staff. Experienced salespeople were coming back unable to further increase hourly rates, and J&J were trying to figure out what to do.

Should they expand geographically? Change their sales compensation model? Do more marketing? None of these were convincing, or in line with their own goals for themselves and their business. I asked if they had ever considered changing their pricing model. A new fee structure based upon the value their work was bringing to the client’s business would open up new possibilities. Would they consider selling using value-based fees.

In a value-based fee world, the focus of pricing is based not on what the customer is willing to pay for the project, but rather on the benefits the customer will receive from its successful completion. When both parties agree on the ROI for the customer, the pricing of the work is simple and straightforward: you should get paid a fee that represents fair compensation for your team’s efforts, and a substantial return on investment for the customer.

This concept was new to J&J, who by this time were highly-skilled at negotiating a top hourly rate for their talent. Hourly rate structures are so ingrained in this industry, it’s took a fair amount of effort to build consensus that this approach was needed. The more we worked together, the clearer the picture because for J&J - to achieve the growth potential that they could see in the market, something had to change: three straight years of flat rates wasn’t cutting it.

The concept of value-based fees is easy to understand. That doesn’t make it easy to do. You can’t just issue a new internal price sheet. And negotiating with the customer to firmly establish the value and boundaries of responsibility takes thorough preparation.

In my next post on this topic, we’ll explore the market forces constraining pricing for software engineers. And we’ll get into the key customer perspective needed to change.

Interested in learning how to bring value-based pricing to your organization? We’d love to help.