A brutal fact of reality for architecture and engineering firms is that prevailing pricing and compensation methods—setting fees on the basis of direct labor cost (whether selling hours on a time-and-materials or lump-sum basis)—provide only minimal profits for most firms.
They also reinforce client perceptions that engineering, architecture, and design services are simply commodities to be purchased on the basis of lowest cost. The insufficient returns generated by these pricing methods starve firms of the resources they need to grow and foster a survival mentality in which many professionals are unwilling or unable to apply their unique expertise, dedication, and vision to the complex challenges that confront clients, communities, and society.
Alternative Pricing Strategies
To earn a fair profit, firms must separate fees from direct labor costs; firms must simply and absolutely move away from selling hours. There are at least five generic types of pricing strategies that can be adopted by firms to make this shift. The first pricing strategy, value-based pricing, establishes price not on the basis of cost but as a reflection of the benefits or value that will be created or provided for the client. A second related strategy, which we call outcome-based pricing, establishes a contingent fee or profit that depends on the outcome a client actually experiences. A third strategy establishes a retainer fee that reflects the value of an ongoing collaborative relationship between a client and a service provider. The fourth, investment-based pricing, moves firms into a position where they become their own clients, directly leveraging the value they create by taking on additional roles and risks as builders, financiers, and operators of facilities and infrastructure. Finally, firms can use pricing mechanisms that come with new, nontraditional service offerings (tuition for training clients or data maintenance), sales of products (software, data, or furniture), or payment for knowledge and intellectual property transferred or shared with others (copyrights and license agreements).
Value-Based Pricing
Value-based pricing strategies set fees in relationship to the benefits that accrue to clients as a result of the firm’s efforts, not on the basis of the costs a firm incurs delivering services. Firms can shift billing rates for high-value services to higher levels, establish lump-sum (fixed-fee) arrangements or adopt innovative pricing methods that are common in other industries.
The predominant means for doing value-based pricing is the adoption of lump-sum (fixed-fee) compensation methods that set the fee on the basis of value, not cost. Most past and current lump-sum arrangements are cost-based; fees are negotiated based on a bottom-up analysis of costs (an estimation of direct labor costs, assigned overhead, and desired profit margin). Such contracts at least have the advantage of providing the opportunity to enjoy increased rewards in return for better-than-expected efficiency; that is, if a firm controls its costs, it will enjoy increased profits. Even so, this type of lump-sum arrangement seldom reflects either the true value that firms are offering or the risks that they are accepting by agreeing to the contract. In fact, it may, on occasion, actually lead to reduced value (quality) as firms scale back work efforts to the bare minimum required by contract in order to control costs.
In a value-based pricing strategy, lump-sum compensation rests squarely on a determination of the value or benefit that a firm will produce for the client. It also looks beyond the specific project objectives to a consideration of the wider benefits that may accrue to the client and other stakeholders as a result of the achievement of those objectives.
For example, an architect/planner with extensive experience working in a particular urban redevelopment area might agree to meet with a real estate developer who is new to this city to brief him on what it takes to successfully develop projects in this locale. Using the prevailing time-and-materials pricing method, the value of the professional’s effort would be limited to the relatively small number of hours spent preparing for and meeting with the client, generating, at best, several thousand dollars of compensation. The real estate developer, on the other hand, has benefited considerably. He is able to make a more appropriate go/no-go decision on pursuing projects in this redevelopment. He can better identify significant development risks as well as ways to mitigate them. The developer may also have come away with a list of the key decision makers in the area with whom he will need to build relationships. He may even have lined up potential introductions from the design professional. The developer will also have a better sense of what it takes to expedite and accelerate development schedules, win support and approvals from key regulators and stakeholders, and avoid a myriad of other missteps that could bedevil a developer unfamiliar with the local scene. Who got the good deal here? Was the exchange of value fair?
A value-based pricing strategy would approach this situation in the same manner that surgeons charge for specific medical procedures. The cost of a surgery reflects the value of the procedure to the patient and compensates the surgeon for his knowledge and skill, not just the time he spends in the operating room. A value-based, lump-sum approach would compensate the architect/planner more fully and fairly for the knowledge, insights, relationships, creativity, and wisdom that he brought to the table and shared with the real estate developer.
Firms are also adapting compensation arrangements commonly found in other industries or other segments of the design and construction industry, but uncommon for architecture and engineering firms services. The payment of commissions for engineering or design services is one example.
A form of commission-based pricing strategy is being pioneered by Barge Waggoner Sumner and Cannon (BWSC), a Nashville-based engineering firm. Its environmental practice group has formed an alliance with a national real estate brokerage firm to assist large industrial companies with the sale of surplus, nonoperating properties.
These industrial companies (railroads, utilities, etc.) often have bulging portfolios of excess properties—properties that have been abandoned or are underutilized as a result of past mergers, acquisitions, consolidations, or operational changes—that drain cash instead of contributing to operating profits. In an era when Wall Street places a high value on a company’s return on assets, these properties can act as a significant drag on a company’s stock price. However, disposing of them can be difficult, particularly if they are brownfield properties with environmental problems.
BWSC’s alliance helps these industrial companies move these properties off their books. The alliance helps companies identify properties that are candidates for disposal, assess potential environmental issues and develop solutions to environmental problems that may otherwise loom as deal-breakers, prepare offering memorandums, find potential buyers, and broker sales—turning underperforming assets into cash.
The synergy of BWSC’s environmental engineering wisdom and regulatory relationships with the real estate company’s brokerage and marketing know-how creates the potential of speedier disposal of larger numbers of properties.
This alliance rolls both environmental engineering and real estate brokerage services into a single commission structure to be paid by the industrial company upon sale of a property. Up-front services are paid for as they are delivered, and those payments are subtracted from the commission when a sale is complete.
For this work, BWSC is able to avoid the stiff price competition in the mainstream environmental engineering market for industrial clients.
The firm earns higher fees up-front and a significant kicker at the time of any sale as compensation for both the additional risk the firm accepts and its effectiveness in ensuring that sales are completed. The effective multipliers for BWSC’s fees under this program are more than double those typically charged on traditional engineering projects.
Outcome-Based Pricing
Outcome-based pricing (incentive pricing or contingency pricing) starts with the same premise as value-based pricing but adds a degree of performance risk to the compensation equation.
Performance incentives, structured into the contract between client and professional, are triggered by the extent to which the professional actually meets specified performance requirements.
An environmental engineering firm agreed to a fee that provided only a minimal profit to develop and implement an asset management program for a municipal utility. However, the utility agreed to add a clause to the contract that provided a significant performance incentive if the firm was able to reduce the EPA fines the utility was currently paying.
The engineering firm was able to eliminate the EPA fines and earned a substantial bonus that more than tripled the profit it would have normally earned on a project of this type.
For a new laboratory project on its Tarrytown campus, pharmaceutical giant Ciba-Geigy contracted with a design-build team that included the architecture-engineering firm HLW International and the contractor Sardoni Skanska Construction Company. Both agreed to a contract that included a unique set of rewards tied to beating project deadlines, bringing the work in under budget, and meeting quality expectations of building users. The contract put all of the design-build team’s profits at risk. However, if the team met the contract’s performance goals, HLW would, according to HLW CEO Leevi Kiil, “earn more than what our normal fees would have been.”
Schedule incentives tied to milestones for document delivery
accounted for one-third of HLW’s profits. Meeting a key cost goal at the 50-percent design completion milestone netted HLW the second third of its profits. The final third was staked on a more unusual metric tied directly to quality, measured by the satisfaction of the Ciba-Geigy users who would be moving into the laboratory; the final third of their profit would be awarded if they achieved a 75-percent favorable rating by building users on a 15-question survey. The survey, which asked occupants to rate their satisfaction on such factors as noise, lighting levels, temperature controls, quality of construction, and overall appearance and function, was administered 90 days after the 160 laboratory employees occupied the building. When the results were tabulated, the team scored a satisfaction level of 84 percent, and HLW was rewarded with the maximum incentive possible under the contract.
Based on the success of the Tarrytown project, Ciba-Geigy contracted with the HLW/Sardoni team to perform another project at its High Point, N.C., campus with similar incentives. Again, HLW earned all three incentives, earning a score of 93 percent on the user-satisfaction survey. In the end the project director for Ciba-Geigy commented, “Everyone benefited. Sardoni and HLW earned profits, and Ciba benefited more so than we would normally because we know our people are satisfied.”
Investment-Based Approaches
Investment-based approaches to pricing move architecture and engineering firms away from a position of limited risk and reward as the designer or engineer of a project and into a stance where they also bring equity financing to the table. This includes situations where architecture and engineering firms become the sole developers and/or operators of properties or facilities.
Mechanical, electrical, and civil engineering firms have moved into performance management and operations and maintenance contracts with owners (industrial companies, municipal utilities, and health-care organizations, for example) by taking responsibility for design, construction (installation), and the ongoing operation of plant and infrastructure projects. Engineering and architecture firms are becoming equity partners in large real estate development projects, often providing their equity contribution as a share of the value of their services on the project. Large engineering firms are adopting investment positions that take responsibility for the design, construction, financing, and operation of major infrastructure projects, such as municipal water and wastewater systems or toll roads.
Cambridge Seven Associates, a 65-person design firm (urban planning, architecture, and graphic and exhibit design) based in Boston, has pursued investment-based pricing opportunities throughout its history.
In the mid-1970s it took ownership of a multimedia show it had produced for Prudential Insurance, called “Where’s Boston,” which it subsequently managed as a money-making enterprise for 13 years. In the ‘80s, the firm was a co-developer of a $64-million mixed-use project in Cambridge, Mass. More recently, it has proposed a turnkey development for a new aquarium in Lisbon, Portugal.
CH2M HILL, a large global engineering company, offers its water and wastewater clients a complete package of project conception and development, design, financing, construction, and operations services through its Operations Management International (OMI) division. This 1,400-person group now operates more than 140 facilities worldwide. Washington Group International, a large engineering/ construction company, heads the 21st Century Rail Corporation, which in 1996 was awarded a contract to design, build, operate, and maintain the $1.1-billion Hudson-Bergen Light Rail System for the state of New Jersey’s NJ TRANSIT. After completion of the design and build phases (the first segments of the system were opened in 2000), the corporation will operate and maintain the system for 15 years.
To be successful in these ventures, firms are adding new people with new capabilities to their staffs. These include construction managers, operating and maintenance personnel, and, of primary importance, financial analysts and investment bankers that can structure these deals and manage their financial risk. Firms are also beginning to recognize that the role of their chief financial officers should shift from internal financial management and control to a new external focus in which they become active participants and leaders in helping the firm discover new ways of creating value for its clients, structure deals, and manage financial risks on projects. If firms can’t bring people with these skills in-house, an alternative strategy is to form strategic alliances with organizations that already possess them.
Pricing Strategies for New Products and Services
Some architecture and engineering firms may escape the knot of cost-based pricing by adopting pricing mechanisms that are common to a new type of business the firm has chosen to enter but are distinctly different from those used within the design professions. Firms that have developed specific software or database applications that solve client problems or support client operations are beginning to understand that this type of knowledge work constitutes a radically different business from engineering or architecture. Instead of selling the hours expended to develop the software or database for a client, firms are realizing that they are better off being paid for their work as intellectual property, like a software company. Microsoft isn’t in the business of selling hours.
Some design organizations, like the industrial design firm IDEO, actively seek patents on new products designed as in-firm ventures. Gensler, the large architecture and interior design firm, protects its furniture designs as intellectual property and then licenses the designs to manufacturers for production and marketing. MATx, the materials research subsidiary of the Boston-based architecture firm Kennedy & Violich, negotiates royalty payments from manufacturers that contract with it for the development of new products or materials. The royalties provide downstream cash flow to the firm as new product designs move into production. In each case, the value of the intellectual property is commensurate with the potential sales of those products or furniture and is largely decoupled from the labor costs that went into creating them.
A Midwestern engineering firm directly capitalizes on its intellectual property. Landscape architects working for the firm realized that many of its projects included custom-designed landscape elements (trellises, covered walkways, benches, etc.) that had the potential of being sold to a broader customer base. The firm started including a provision retaining intellectual property rights for furniture or any element that could be reproduced and resold as part of its contracts for projects with this potential. The firm then formed a partnership with a local manufacturer to make these units. The engineering firm manages the marketing process, including advertising on the Internet and in such specialty retail catalogs as Brookstone, and the manufacturer makes the units and fulfills the orders. In return, the firm receives an up-front commission on orders, reimbursement for its marketing and sales costs, and a split of the profits.
The same engineering organization has also developed an innovative approach to capitalize on the intellectual property of its Geographic Information Systems (GIS) group. The firm realized that much of the production work for GIS was being commoditized.
The solution to this problem came with the firm’s development of a proprietary GIS application that provided dispatch and routing information for emergency vehicles. The software would automatically reroute response teams around traffic accidents or roadwork. Rather than compete for business from large municipalities, the firm decided to focus on small cities that were underserved by other providers of this type of software. The firm sells these clients a 12-month software license, which includes a base number of stations. Yearly renewals and upgrades offer a continuing revenue stream for the firm, similar to the value proposition used by many software companies. The newest version will also include an option for the engineering firm to manage and maintain the client database for an additional fee.
Moving Toward New Pricing Strategies
To move forward, firms must develop a deep understanding of their clients, their clients’ organization ecosystems, and the corresponding value networks; that understanding must be translated into an operational ability to identify, articulate, and provide what clients value. This can include monetary and nonmonetary benefits as well as tangible and intangible outcomes. In most cases, it is not necessary to specify the exact results (or a magic number) a client will receive. It is often sufficient to communicate the future benefit and/or predict the direction of change with respect to key outcomes that support the price a firm merits as a fair return on the value it creates.
Outcomes can be denominated for project delivery, including construction cost, schedule, and quality of drawings (represented by change orders). More generally, design professionals and consulting engineers can draw from a wide range of other valuation metrics to address value accruing to the client organization itself, including but not limited to the following:
Higher productivity
Lower turnover
Higher morale
Reduced absenteeism
Improved image (brand identity)
Better performance
Higher sales
Increased market share
Greater profits
Improved financial/operational results
Decreased costs
Reduced risk
Improved employee satisfaction
Higher customer satisfaction
Decreased time to market
Increase in new product ideas generated
Decreased response time
Decreased customer complaints
Improved teamwork
Less stress
A firm working with an airport client might choose from a wide variety of metrics, including airport revenue, cost reductions, speed of project delivery, energy use and life-cycle maintenance/ operating costs. Terminal designers might assess passenger satisfaction, looking specifically at ease of use, attractiveness, and speed of connections.
Firms working with baggage systems might set benchmarks for speed of installation, throughput, and lost bags. Concessions designers can look at sales per square foot and customer satisfaction. Parking garage designers might choose to evaluate efficiency of traffic flow and minimization of bottlenecks.
These metrics of value can be used to support the negotiation of a value-based price, or they can be incorporated directly into outcome-based pricing agreements. In either case, architecture and engineering professionals need to be able to identify appropriate metrics for the situation they are addressing and to communicate how they will deliver these benefits to their clients. Instead of defaulting to the easy negotiation of selling hours, firms must learn the language of their new value proposition.
Firm leaders must also help their staff overcome deeply-held mental models that support the current economic model of practice. Some professionals actively resist new pricing strategies, believing that what looks like an excessive markup on direct labor costs is somehow unethical or unfair to their clients. Leaders must surface these mental models and help their staff understand the imperative of these new business models, as well as the basic principles underlying them. In fact, firms with low levels of profitability may be less able to operate with the highest professional standards. Higher profitability levels are fair when compared with the level of value created. Firms will also need to teach principals and project leaders to be comfortable asserting the firm’s interests in receiving these higher returns.
It is important for firms to find the right clients to experiment with new pricing strategies, probably not their mainstream clients. Clayton Christensen’s work has shown that many customers (clients) will reject innovative new technologies, preferring small improvements in the cost or customization of existing technologies (services). This short-term myopia often lures service providers along a path toward further commoditization and ultimately sets them up to be overthrown by a new disruptive technology. Consequently, firms experimenting with new pricing strategies need to find niche clients facing unusual situations in which the value of an innovative approach will be both apparent and attractive. After perfecting a new pricing strategy with a few clients, firms can then roll it out to a larger population of clients.
Finally, firm’s must adopt a prospector’s view of the world. Architecture and engineering firms are proactively identifying opportunities for creating value for clients. Instead of waiting for projects, firms can be entrepreneurial in areas where they see a need that they, and their professions, can satisfy.
Business models are holistic in nature. Both sides of a value proposition must evolve together. To convince clients to accept new pricing strategies, architects and engineers must be able to deliver higher levels and new forms of value. And, to implement new value creation strategies, firms must have the economic resources that flow from these new pricing mechanisms.
Transformation requires experimentation and learning on both sides. As firms are able to deliver genuinely new forms of value through innovation and leadership, new pricing strategies can be put in place. Appropriate remuneration that supports ongoing learning and innovation by professionals will set off a virtuous cycle of value creation that serves firms, clients, and society. Evolving the core of the professions and business model innovation will ultimately produce more non-monetary than monetary value, creating far greater fulfillment for professionals and shaping a brighter, more sustainable future for our world.
—Kyle V. Davy
*This is an abridged excerpt from Value Redesigned: New Models for Professional Practice, by Kyle V. Davy, AIA, and Susan L. Harris, Ph.D., and will be published next month by Greenway Communications. Please visit www.di.net and follow the bookstore link.
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