Fee structures are a hot topic in the agency space. Many agency leaders have spent time worrying that they’re leaving money on the table by not pricing their services correctly.
And that’s understandable. The unfortunate truth around agency fees is that most agency owners are setting themselves up for failure from the get-go. While it’s easy to fall into the trap of focusing on the quantity of revenue coming into your business, it’s the quality of that revenue that will ultimately determine your success.
Let’s examine how you can charge for project work properly and create the best possible pricing structures.
What do agencies need to charge for?
The first question you need to ask is “what exactly are we pricing?” No matter the project, there are always billable and non-billable tasks.
There are so many different kinds of services that can be offered to clients, and unlimited ways to package them up. There are ranges of customizability, from cookie-cutter templated services all the way to completely custom and dynamic services. Sometimes, the scope of work is clear and other times, it’s impossible to define what will be required to get the work done.
At the most fundamental level, though, agencies typically charge for one of three things: time, deliverables or outcomes. And, the cost of delivering the promised outcome to the client largely comes down to the people doing that work.
Four pricing models to consider
1. T&M pricing (time & materials)
The first method of billing is the tried-and-true time and materials (T&M) strategy. It’s a method of invoicing clients for the hours worked by your team plus the cost of materials used for a particular project or service.
Let’s say you’re selling logos, and your client has agreed to pay you $100 for each hour your team works on a logo. This would be T&M billing.
The fee will be complemented by the cost of materials; in this case, software licenses, third-party services, or tools required to design and deliver logos.
So, if your team took 10 hours to complete the logo, at $100 per hour, and spent $200 on material expenses, you’re charging the client:
($100 * $10) + $200 = $1,200 per logo
To be able to bill the client correctly with this model, you need a reliable way to track hours worked. Float's resource planning software has built-in time tracking capabilities, so you can always know how much time each billable task takes.Learn more
2. Abstracted T&M (Time & Materials) Pricing
The abstracted T&M is an agency fee structure where you’re billing T&M without ever having the conversation around billable hours. With this model, you move away from hours as a way to charge and more towards abstract concepts, like:
- Larger blocks of time (weeks, sprints, months etc.)
- Larger blocks of resources (teams, pods, etc.), or
- Abstracted currencies, such as points or credits.
The most common way of using abstracted T&M billing is by essentially leasing a cross-functional team in weekly, bi-weekly or monthly increments. Clients are billed on a set cadence for however long it takes to achieve their desired outcome.
For example, if a client wants to hire your firm to help build a new mobile application, you might lease a cross-functional mobile app development team for $5,000 per week, and work with them to build the app in an iterative fashion until it meets their desired business objectives.
3. Flat Rate Pricing
A flat fee pricing model is exactly what it sounds like. The client is given a fixed rate for a set of deliverables and pays that amount regardless of how much time and cost is incurred by the agency.
For example, imagine a firm is selling a logo design and knows it will take them 10 hours to complete. They could choose to charge $150/hr and make $1,500, but they could also charge a flat fee of $3,000 and effectively double their hourly rate.
4. Value-based pricing
The value-based pricing is the practice of pricing services based on the value they provide to the customer, rather than on the cost of production, or even the market price.
The simplest form of value-based pricing looks a lot like a flat fee. The difference is that the price is not predetermined based on the estimated cost and scope of the deliverables. Rather, the price is agreed upon by having a value conversation with the client.
During that conversation, the agency tries to determine the value of the deliverables and outcomes based on two approaches:
- Estimated value. For example, for a website development project, you can compare the revenue the client’s current website generates with the expected increase from the new website. If you determine that an extra $1M in revenue could be added to your client’s bottom line, it might be reasonable to ask for 10% of that in order to build the website.
- Actual performance. This is where your agency is compensated based on results and outcomes. For example, rather than charging $100k for the new website, you might ask to be compensated at a rate of 20% of the additional revenue generated for the next 12 months. This is by far the most advanced form of value-based pricing, and one reserved only for agencies that have enough experience and cash flow to take on high risk.
Using the Agency Pricing Quadrant to determine your model
The agency pricing quadrant (APQ) can help you determine which pricing model is best by examining the relationship between value and risk for each potential project.
Start by asking yourself the following two questions:
- For the work that you’re doing, how much value does your client perceive your service to deliver?
- For the work involved, how much risk are you taking on in the engagement?
Asking yourself these two questions before pricing any project will help you choose a pricing model that can maximize the value you capture while protecting you against taking on outsized risk.
To do this, you can identify where a given engagement sits in the Agency Pricing Quadrant™, aka assessing your level of risk and your level of value.
1. Assessing your level of risk
First, determine your amount of risk in the proposed project. It really comes down to how accurately you can predict the time and cost required to complete the service for your client.
- Low risk: If you are able to consistently estimate within 10% of a project’s actual cost, you’re likely low on the risk axis. For example, if you’ve been building landing pages for dental clinics for years, and have a repeatable formula that takes a consistent amount of time, you’re likely doing low-risk work.
- High risk: If it’s extremely difficult to define the scope of work, or the amount of time it will take to complete the scope is very uncertain, you’ll likely end up on the high-risk end of the quadrant.
Another important consideration is how fluid your methodology for doing the work is. For example, if you use an agile methodology, you’re likely doing high-risk work as the methodology is inherently iterative. The scope will likely change at the end of every sprint.
Once you’ve determined if the engagement you’re pricing is high or low on the risk axis, evaluate the level of value your client perceives this engagement to have.
2. Assessing your level of value
Value can be set by determining how valuable the service is to your client. There are many factors that influence value, but two of the most important ones are positioning and relative value.
Consider how specific your positioning is. Are you providing a service that is offered by hundreds or thousands of other firms? It’s not necessarily about how commoditized the service is, but rather how specific your positioning is to a client.
Imagine a scenario where you have a website development firm. One competitor is a firm that specializes in website development for orthodontic clinics in Canada. In this scenario, both are selling a highly commoditized service (website development), however, if the client is a Canadian orthodontic clinic, it’s likely to perceive the firm with tighter positioning as being capable of delivering more value.
Next, consider the amount of Relative Value that your service provides. That is, the value your service has for a business based on their context. What is this service really worth to them? A logo for an international airline is much more valuable than a logo for the convenience store down the road. The more your service is worth to your clients, the higher you can push your service up the value continuum.
Relative value can be influenced by many factors, including the size of the client, the industry they are in, regulatory requirements they have to abide by, changes in their industry, or new technologies entering the market. The important question to ask is “how much value do we stand to create for this client, and what would it cost them not to work with us?”
By considering your positioning and the relative value your service stands to provide to the client, you should be able to identify whether or not this opportunity puts you on the high or low end of the value axis.
Now that you’ve got your approximate levels of risk and value, we’re ready to see where you land on the spectrum.
How to choose pricing model
You can now place your service on the Agency Pricing Quadrant, and it will tell you the ideal pricing model for this service. You can do this for multiple service lines if needed since not everything needs to be priced the same way at your agency.
Let’s go over the options:
A) The T&M model falls in the High Risk and Low Value range of the quadrant.
This means that the T&M method is helpful for work that is risky and low in value by nature, and depends on many unclear variables making it too risky to agree on a set price ahead of time.
The client pays for however long it takes to complete the work. You’re sharing that risk with the client.
The drawbacks of the T&M model include the fact that it can set downward pressure on your talent costs, therefore making it difficult to retain top talent. This is while also being open-ended on the client side because there’s always a risk for clients that they’ll have to pay more for a deliverable if they aren’t happy with the first iteration.
B) The abstracted T&M model falls in the high risk and high value range of the quadrant.
This kind of billing method is extremely useful for high-risk work that is also high risk. It’s most common in highly technical disciplines like software development and large scale creative or problem-solving projects. This is because it allows you to work in an iterative and fluid way and make adjustments to the scope and priorities without constantly having to go through pricing negotiation. Plus, it protects your margins and ensures your team’s time is always paid for.
One potential downside is that it might be hard to sell to clients, since it’s not typically an engagement style they're used to seeing and requires them to take on some risk. While they can save money on the engagement if it takes less time, they are also at risk of ending up with more cost than they anticipated.
Also, the abstracted T&M model presents limited rewards for increases in efficiency in your delivery team.
C) The flat fees model falls in the low risk and low value range of the quadrant.
Where a T&M Model struggles to give clients the safety they may need to close the deal, the flat fees model allows you to set a scope of work and budget ahead of time. It puts all of the risk on your team to deliver, making it easier to sell.
It encourages delivery team efficiency, as no matter how long it takes you to complete the work, you’re getting the same amount of money for it. This model is designed for services where the agency defines a predictable scope and can influence operational efficiency to drive higher hourly rates.
D) The value-based model falls in the low risk and high value range of the quadrant.
This method allows you to maximize profitability for high-value clients when the price can be increased enough to capture the risk associated with delivery.
If you took a T&M or flat-fee approach for designing a website for a large client, you may make only a fraction of the money you’d make with a value-based approach. Furthermore, the drive to the finish line is not tied to hours and therefore encourages efficiency in your team.
However, this can be a tricky situation to navigate in the sales process. Not to mention that you’re still taking on risk that can ultimately lead to lower profit margins if scope and cost are not managed.
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What really matters is your delivery margin
Let’s just throw a wrench in everything you’ve just read, and drop the most important line of this blog post. Delivery Margin is the only thing that matters in a given pricing model.
Increases in price, or decreases in cost, are only effective to the degree in which they increase the ratio of AGI (Agency Gross Income) to Delivery Cost in your agency, in other words, the delivery margin.
Ideally, you’re looking for your delivery margin to be above the 60-70% mark on a given project to be healthy.
Let’s explore how you can calculate your delivery margin based on whatever kind of pricing model you’re using.
T&M + delivery margin
Are you charging by the hour using the T&M method? Then, you need to know what your delivery margin is per hour.
Consider a project where you’re charging the client $100 per hour for a logo design. You’re estimating that it’ll be completed in 20 hours. Your AGI in this scenario will be projected at $100 per hour, and your delivery costs can be found by calculating your ACPH (Average Cost Per Hour) for the team member doing the work (ACPH calculator here).
Let’s say you’re getting a $41 cost-per-hour on your Jr. Designer.
Delivery Margin = (AGI - Delivery Costs) / AGI
($100 - $41) / $100 = 0.59, or 59%
At 59% Delivery Margin, this project is on the cusp of healthy profitability, assuming you bill for every hour your team works.
Rate card + delivery margin
Are you charging using rate cards? What is the Delivery Margin on each rate you have?
When you’re handing out your rate card, and you’ve got different rates for all of your different departments that could be involved in a given project, you can calculate your delivery margin on these to ensure you’re baking in profitability.
Similar to above, calculate your ACPH for the department/role in question. Maybe one hour of your Strategy team costs you $110 per hour, so you can calculate it with your current standard rate (let’s say it’s $150 per hour) to figure out your current delivery margin:
($150 - $110) / $150 = 0.26 (26%)
Or reverse engineer this to your desired Delivery Margin (let’s say 65%) and solve for X:
(X - $110) / X = 0.65
X = $314.29
You’ll need a standard rate for one hour of this team’s time to be at the very least $314 to hit your desired Delivery Margin target.
Similar to above, calculate your delivery margin on a given project by finding your AGI and comparing it to your delivery costs. Your delivery costs will include mostly the cost of your team’s time (again, calculation can be done for the team using this resource) plus any other costs associated with delivery of the work.
After you’re done doing your calculations for ACPH, you may have something that looks like this:
With a total cost of $426, plus let’s pretend a $100 pass-through aside from labor, your total Delivery Cost for this project is $426 and $100 in pass-through expenses. Let’s imagine we’re charging the client $2,700 for this project, in order to calculate delivery margin.
Firstly, we deduct pass-through expenses from revenue to calculate AGI:
$2,700 - $100 = $2,600 in AGI
Then we use the margin formula to calculate delivery margin on that AGI:
($2,600 - $426) / $2,600 = 0.83, or 83%.
Value + delivery margin
Charging based on Value? Then, one question to ask would be: what is the minimum price to hit your delivery margin target?
The same process that you used to reverse engineer your rate card price above can be used to find your base price for the value-based model. If you’ve sold a project that will take your team 60 hours to complete, and have a total delivery cost of $1200 for this time, you can reverse engineer the lowest price you can possibly do this project for to hit your desired delivery margin (let’s call it 70%), and go from there:
(X - $1200) / x = 0.70
X = $4000
And you guessed it, the same process can be done in a flat fee scenario based on the total cost by setting your target and solving for X.
Managing costs on the project level
Being mindful of the project budget is always important, but the how depends on the pricing model.
In a T&M or Abstracted T&M projects, focus first on making sure timelines are being followed, and that the team isn’t working non-billable hours. Keep the client's budget in mind and stay on top of risks that might cause the project to exceed the budget. This way you can be proactive about expectation management and backlog prioritization.
In a flat rate or value-based pricing scenario, the client's budget is less of a concern, but every hour you put into the project affects profitability. In this case, you want to be extremely mindful of your own budget, tracking it very closely. If you don’t, there is rarely any recourse for incurring overruns (unless it's a result of an explicit change in scope). If you’re using a project planning software like Float, you can easily track work hours and get budget reports in real time.
As timelines are usually the most inelastic part of a project, you also need to make sure your team isn’t overworked. This is easy to do by monitoring the team’s schedule and assigned work.
The ideal pricing structure varies
The moral of the story is that the ideal pricing model is the one that allows you to maximize your delivery margin on any given engagement.
While it’s important to capture value, it’s also important to take risk into consideration. At times, it makes sense to cap the upside of a project’s margin in order to also limit risk.
In the end, consistently profitable projects lead to a consistently profitable agency. Without setting projects up for success from the start, we put ourselves, our clients, and our team at a disadvantage.
Price your projects to be profitable from the start, while also maintaining fair and competitive fees—this balance is the recipe for success.