Cost to deliver elements and price points for professional services

Cost Estimation and Pricing in
Professional Services Delivery

An introduction to a big picture representation of
calculating the cost to serve and identifying three
price points

John Phillips - au.linkedin.com/in/johnphillips11kps/

Worthy but boring title? Is it worth me looking
through this presentation?
There is a wealth of research, data and special interest groups on
pricing strategies and approaches related to products.
For example, industries such as Fast Moving Consumer
Goods, Consumer Electronics, Automotive and Utilities have a rich vein
of research and management consulting material available on pricing
strategies and their impact.
Professional services industries are less well served, and in many
instances, pricing in professional services hasn’t progressed beyond
charging for chunks of time worked.
This presentation deals with more complex opportunities where we
want to deliver an outcome that may involve many
people, subcontractor, payment milestones, risks and financial
provisions.
If that interests you, then its worth looking through this presentation.

How can I get a handle on how important this
is?

Everyone gets that price is important, but sometimes we need a reminder of how
important even small improvements can be.
One simple, real-world business based example was provided by Compustat and
McKinsey, where a 1% increase in average price can realise an 8% improvement in gross

Alternatively, you can quote Warren Buffet

“The single most important decision in evaluating a business is
pricing power. If you’ve got the power to raise prices without
losing business to a competitor, then you’ve got a very good
business. And if you have to have a prayer session before raising
the price by 10%, you’ve got a terrible business.”

It should perhaps be noted that the source of this oft-repeated quote was Warren Buffet’s
explanation during the Federal Crisis Investigations Committee’s early 2011 interview when he
was being asked about his investment in Moody’s Corp. Bloomberg’s piece proposed that, for
Warren Buffett, it seemed that pricing power was more important than good management. If
possible, I’d rather have both!


So what does the big picture look like?


Looks complex. Let’s build the picture up and
explain each element as we introduce it


Reminder: we assume that you’re building an
estimate of the cost to deliver and outcome
Typical scenarios might be work in the engineering services
industry, communications technology and information systems
industry, construction industry etc.
Key elements are:
– A definition of the scope of the work that is good enough to
allow an estimate
– Something that your company has the skillset to do, in whole
as the prime contractor, or in part as a team member
– Something that’s worth doing - that delivers value to the
customer


First we build up our estimate of the cost to
deliver the outcome

That’s this ‘stack’
part of our model


Labour costs are the costs of our own effort in
delivering the outcome
In our model, labour costs are the total effort multiplied by the cost rate for
each person.
You’ll need to consider the impact of inflation if the time to deliver the
outcome is considerable (months or years say), and/or if the delivery period
covers a known salary uplift.
We like to separate out the basic cost of employment for each individual from
the overheads associated with their office location.
We do not include contingency in the base effort estimate – that comes later.

Labour


Overheads are non-direct labour operating costs
that we need to recover
We like to separate out the overheads that need to be recovered from the
basic labour cost so that we can allow for projects that have significant on-site
effort and/or clients that pay for accommodation and other costs. It also
means that low-cost / overhead centres can be more easily seen and taken
advantage of.
The overheads we consider are typically location based costs associated with
each resource and other operational costs and the total cost is derived from
effort x overhead. Remember inflation here too.

Overheads

Labour


Materials and Expenses are things that we need
to buy or pay for to deliver the outcome
These costs can be expenses such as flights, hotels, taxis, meals. We might
need to purchase items like computers or software, or even large material
items to complete the delivery.
We separate out materials and expenses as the nature of their procurement
and reimbursement are generally quite different.
Remember inflation here too.

Materials and Expenses
Overheads

Labour


Subcontractors are those other companies, or
individuals that we need to add to the team
Subcontractors are companies and/or individuals that we need to add to our
team for their specific expertise and to make our offer more attractive to the
client. Their costs may be fixed (through agreement), or variable and based
on agreed rates. The difference is important to the risk profile of using
subcontractors.
Remember inflation here too.

Subcontractors
Overheads

Labour


Cash flow charges consider the cost of the
working capital forecast for the project
Any of us that have been responsible for a business, our own or someone
else’s, will understand the importance of cash – money in our bank. The
concept here is that being paid 180 days after we’ve incurred the expense is
not as good as being paid 30 days after the expense, and certainly not as
good as being paid before the expense is incurred. Cash Flow charges are
based on the monthly Working Capital forecast for the project and use a
monthly interest / charge rate to encourage positive cash-flow (the monies
we’ve been paid exceed the costs we forecast at each point of the project)

Cash Flow Charges
Subcontractors
Overheads

Labour


Contingency is the amount of extra cost that we
think we may incur
There are sophisticated approaches to considering risk and contingency. Here
we are noting that for any outcome where there is uncertainty, we need to
consider what the risks are, what their impact would be, how we might
mitigate them, and what we would need to do if they occur.
The end result is that we have some risks we can’t avoid and that we should
have an appropriate amount of contingency to cover.

Contingency

Financial Provisions
Cash Flow Charges
Subcontractors Total cost of
Materials and Expenses contract delivery
Overheads

Labour


Next we look at four price points
Client Value Proposition
Price Ceiling
(determined by
value to client of (determined by pricing strategy
Price Target and company’s value
contract delivery)
proposition to client)
Competitor’s
price points
Negotiating
Margin

Price Floor
(determined by delivery Minimum commercially
scope, approach, acceptable margin for contract
operating costs and Contingency
minimum margin)
Cash Flow Charges
Simple pricing contract delivery
model for a
Overheads
single valued
price and a fixed Labour
scope of supply

First we need to know what our price floor is –
the lowest commercially acceptable margin
The price floor is determined by the minimum commercial margin that makes
sense to achieve for this contract, based on our understanding of the cost to
deliver. You can think of it as “what do I need to get as a minimum return to
make this worthwhile (and not be better off keeping the money in the bank)”

Price Floor
Minimum commercially
acceptable margin for contract
Contingency

Cash Flow Charges
Overheads

Labour


Then we need to know what its worth for the
client – this gives a price ceiling
Price Ceiling

Here we want to know why the client want’s this outcome achieved. What’s it
“worth” to them? What commercial (or other) gain to they seek to make on
completion?
Knowing this gives us a theoretical price ceiling - it would make no sense to
Price Floor
charge at or above this ceiling as it leaves the clientMinimum commerciallyon their
with no return
investment. Contingency

Cash Flow Charges
Overheads

Labour


And then we should think about where our
competitors will price, and why
Price Ceiling Its likely that our competitors will have prices
that vary from each (determined by pricing strategy
other, sometimes
Price Target and company’s value
dramatically. proposition to client)
Competitor’s
price points Each will be based on a combination of their
Negotiating
understanding of the outcome sought by the
Margin

Price Floor client (the scope), their cost to deliver that
outcome, what they thinkcommercially
Minimum
their unique value
proposition is, and perhaps whether they’re
Contingency

Financial Provisions or aggressive.
feeling lucky
Cash Flow Charges
Knowing as much as wecost of about where
Subcontractors Total
can
Materials andmight price helps to shape our decision
they Expenses contract delivery

to compete.
Overheads

Labour


Our target price considers our own pricing
strategy and what we know of our competitors
Price Ceiling
Price Target

Our chosen price target is determined by our value proposition to the client.
It should reflect our understanding of their price ceiling, our price floor and
Price Floor
be consistent with our own pricing strategy (are we a premium provider, or a
high volume low margin body shop?).
Contingency
Note that while we would like to know our competitor’s pricing strategy,
ultimately we should care more about our own. Our potential price should be
Cash Flow Charges
determined by our unique value proposition to our clients – why they choose
Subcontractors
us over our competitors and how much they are prepared to pay.
Overheads

Labour


So that’s the big picture explained. Now let’s see
one example of how to use it…


We can use the picture to see the choices we
need to make under different circumstances
Nominal situation – we determine a price
within client expectations, the competitive
environment and our value proposition

Rare but still all too common situation - the client's
expectation of price is below our cost to deliver.
Things to consider:
- Can we use a different delivery approach?
- Can we deliver something different (scope)?
If neither work, then we should qualify out.

That’s all folks

Hope you enjoyed the slides.


Cost to deliver elements and price points for professional services

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