expensiveproblem.com
T H E H O U R LY T R A P
& T H E M A G I C O F VA L U E P R I C I N G
J O N A T H A N S TA R K
1 What You'll Learn:
• The only three numbers that matter when quoting a project
• The four project ROI models (and which is the only good one!)
• How hourly billing artificially limits your income
• The simple math that can 10x your profits
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P R E M I S E
• Custom project
• Non-trivial duration
• Collaborative effort
2 For the purposes of this talk, let's imagine that you've been approached by
client to do a custom project. Something like a website built from scratch,
or some internal workflow system. IOW - The type a project that will take at
least a few months and will require ongoing collaboration between you and
the client team. Like all projects, you want this one to be a win-win (i.e.,
successful for both you and the client). In the simplest terms, you want both
you and the client to realize a positive ROI from the project.
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T H R E E N U M B E R S
3 When determining the ROI for a project, there are three numbers that
matter.

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T H R E E N U M B E R S
• Cost - Minimum amount seller is willing to accept
• Price - Actual amount that changes hands
• Value - Maximum amount buyer is willing to pay
4 Cost, price, and value. Price is typically pretty concrete and objective
(although it's not always known in advance - more on that later). Cost and
value are COMPLETELY subjective (i.e., what the engagement is "worth" to
the buyer and seller individually, based on a wide range of very squishy
factors like mood, context, timing, risk, desire, etc)
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T W O C A L C U L AT I O N S
• Price minus Cost equals Seller's ROI
• Value minus Price equals Buyer's ROI
5 Price minus Cost equals Seller's ROI
Value minus Price equals Buyer's ROI
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P O S I T I V E R O I F O R B O T H
$10,000
$20,000
$30,000
$40,000
Cost Price Value
6 In a perfect world, both ROI numbers are positive. But it's not always a
perfect world, is it?

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T H E H O U R LY T R A P
7 Next, I'm going walk through the ROI calculations that take place
throughout the course of a software project billed on an hourly basis. I'll
begin at the project estimate (because that's where the buying decision
takes place), and continue through the end of the project. As you'll see, the
ROI calculations can change dramatically throughout the course of the
engagement.
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H O U R LY E S T I M AT E
$10,000
$20,000
$30,000
$40,000
Cost Price? Value
8 This chart represents the predicted ROI imagined in a typical hourly
estimate (prior to the start of the project). The price is not REALLY a price -
it's an estimate of hours multiplied by an hourly rate - but the client treats it
as a price and makes a buying decision based on it. Since the client's value
is greater than the (estimated) price, they choose to "buy" (they aren't
technically "buying" at this point because payments are made over time,
but they have authorized development and consented to begin paying as
described in the terms of the agreement - typically, weekly in arrears).
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H O U R LY M I D - P O I N T
$10,000
$20,000
$30,000
$40,000
Cost Price? Value
9 As the project progresses and the costs turn out to be higher than
estimated, the price rises with the cost. If the rising price hits the value
before the project is complete, the client FREAKS because they realize
they're going to lose money. They can either kill the project (and lose the
money spent to date) or stay the course. If they believe that the ultimate
price will be less than double the current actual, they'll probably stay the
course because it's the more economical option. In any case, they will have
lost faith in the seller and attempt to take control of the project (i.e.,
micromanage) to minimize the damage.

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H O U R LY F I N A L
$10,000
$20,000
$30,000
$40,000
Cost Price Value
10 Once the project is complete and it is clear that the actual price was greater
than the value, the buyer will be unhappy. The degree of the unhappiness
will correlate to the magnitude of the loss and it's impact on the buyer. It
could range from annoyance to rage. They wouldn't have purchased if they
had known the real (ultimate) price. NOTE: It does not matter who's fault
this is! They will be unhappy regardless of who they believe is to blame.
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H O U R LY D I S C O U N T E D
$10,000
$20,000
$30,000
$40,000
Cost Price Value
11 Often, a buyer will request a discount / refund (aka the seller has to "eat
hours") which would commonly be negotiated (perhaps subconsciously) to
split the difference between the seller's profit and the buyer's loss. In the
case of this graph, the seller has refunded $5000 of their $10,000 profit.
expensiveproblem.com
H O U R LY D I S A S T E R
$10,000
$20,000
$30,000
$40,000
Cost Price Value
12 In extreme cases, the buyer may refuse to make further payment but
demands that the seller continue working. In this case, both parties lose
money and the situation can become intractable. This can result in refunds,
firings, or lawsuits. I've seen all three of these come to pass.

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R O I P O S S I B I L I T I E S
13 From a logical standpoint, there are four possible ROI outcomes for a
project. Only one of them is good.
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G O O D F O R S E L L E R ,
B A D F O R B U Y E R
$10,000
$20,000
$30,000
$40,000
Cost Price Value
14 "The Middle Finger" - Buyer experiences a loss (i.e., receives a negative
ROI). Creates a strained relationship between buyer and seller. This
outcome results from poorly estimated hourly billing projects.
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B A D F O R E V E RY O N E
$10,000
$20,000
$30,000
$40,000
Cost Price Value
15 "The Basement Stairs" - Both parties experience a loss (i.e., receive a
negative ROI). Creates a nightmare relationship between buyer and seller.
This outcome results from catastrophically bad estimates on hourly billing
projects.

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B A D F O R S E L L E R ,
G O O D F O R B U Y E R
$10,000
$20,000
$30,000
$40,000
Cost Price Value
16 "The Devil Horns" - Seller experiences a loss (i.e., receives a negative ROI).
This outcome results from poorly estimated "time and materials" fixed bid,
or poorly estimated hourly billing projects with "not to exceed" clause.
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G O O D F O R E V E RY O N E
$10,000
$20,000
$30,000
$40,000
Cost Price Value
17 "The Stairway to Heaven" - Both parties make a profit (i.e., receive a
positive ROI). This outcome results from accurately estimating cost and
value and setting price accordingly. The reason this outcome is different
than the others is that it is the only one based on accurate estimates.
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B E T T E R E S T I M AT E S
18 So, the question becomes: how can we make our estimates better?

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B E T T E R E S T I M AT E S
• Financial incentive
• Wiggle room
19 If you provide fixed project bids, you have a VERY strong financial incentive
to get your estimates right (and to work as quickly and efficiently as
possible, but that's a story for another day). But, improving your estimating
skills takes a long time. In the meantime, you need to give yourself more
wiggle room. You do this by seeking out projects where the difference
between the cost and the value are very large. The bigger the difference,
the easier it is to (even accidentally) set a price that is between the cost and
value, and therefore create a profit for both parties.
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H O LY G R A I L ?
$200,000
$400,000
$600,000
$800,000
$1,000,000
Cost
$500
Price
$500,000
Value
$1,000,000
20 So, the holy grail would be to find a million dollar problem that you can
solve in a few hours, and then price it somewhere in between, right? Well,
not exactly... if the client perceives your profit to be 1000x and theirs to be
only 2x, it triggers something called "inequity aversion" (aka, "It's not fair!")
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I N E Q U I T Y AV E R S I O N
21 Inequity aversion is the preference for fairness and resistance to incidental
inequalities. Manifests itself in humans as the "willingness to sacrifice
potential gain to block another individual from receiving a superior reward".
From https://en.wikipedia.org/wiki/Inequity_aversion
Once you are aware of IA, you start seeing it everywhere.

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G O O D F O R E V E RY O N E
$10,000
$20,000
$30,000
$40,000
Cost Price Value
22 As long as the price is between the seller's cost and the buyer's value, both
parties make a profit. If humans were purely rational beings, this would be
the end of the story. However, humans possess an intriguing little quirk
called "inequity aversion" which is triggered when one party benefits
dramatically more than the other.
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S E L L E R D E E M S U N FA I R
$10,000
$20,000
$30,000
$40,000
Cost Price Value
23 Imagine that Bob asks Alice to do a fix to a Wordpress plugin on his site.
Alice estimates it will take a couple hours and therefore sets her cost at
$300. She sets her price at $1000 and Bob pays her. Bob almost
immediately makes $30k from Alice's change.
Alice 3x'd her investment, so should be happy, right? Well, in absolute
terms, Alice made $700 profit, and Bob made $29,000. If a 40x differential
is significant enough to Alice, inequity aversion will kick in and she'll think
"that's not fair!"
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B U Y E R D E E M S U N FA I R
$10,000
$20,000
$30,000
$40,000
Cost Price Value
24 Conversely, imagine that Alice charges Bob $29,000 for the same
WordPress fix. Bob still ends up making money, so he should be happy,
right?
Well, in absolute terms, Alice made $28,700 profit, and Bob made $1,000. If
that differential is significant enough to Bob, inequity aversion will kick in
and he'll think "that's not fair!"
(example: client complains, "but it only took you 2 hours!")

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I D E A L
25 The ideal situation is one in which both parties feel the deal is both "worth
it" and "fair".
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1 0 X F O R B O T H
$10,000
$20,000
$30,000
$40,000
Cost
$300
Price
$3,000
Value
$30,000
26 Setting the price at around 1/10th of the value will lead to a high close rate
if the buyer perceives the seller's cost to be no less than a 1/10th of the
price. In other words, your price seems "worth it" and "fair".
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2 0 X F O R S E L L E R ,
5 X F O R B U Y E R
$10,000
$20,000
$30,000
$40,000
Cost
$300
Price
$6,000
Value
$30,000
27 You can probably get away with a price that is as high as 1/5th the value,
but you risk triggering an "it's not fair!" response if the buyer perceives that
you are "making a killing".

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~ 1 X F O R S E L L E R ,
1 . 5 X F O R B U Y E R
$10,000
$20,000
$30,000
$40,000
Cost
$18,000
Price
$20,000
Value
$30,000
28 Sometimes a seller can convince a buyer to agree to a lower profit multiplier
by increasing the buyer's perception of the seller's costs (i.e., "it's not as
easy as it looks" or "I'm barely making money on this!") but to paraphrase
Obi Wan: "These are not the projects you are looking for" because they are
low profit.
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2 0 X F O R E V E RY O N E
$30,000
$60,000
$90,000
$120,000
Cost
$300
Price
$6,000
Value
$120,000
29 The magic of value pricing is simple math. As you attract larger clients, it
leads typically leads to higher perceived value - and an exponential
increase in absolute profits. In this case, 2-3 hours of work at $6000 equals
an EHR of $2000-$3000.
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– Y O U
“But I REALLY don't want to do fixed bids. What if I
estimate accurately and just increase my hourly
rate? Everyone still wins, right?”
30

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– M E
“Yes, BUT...”
31 As long as you are billing by the hour, you do not have a strong direct
financial incentive to get better at estimating. But let's just say that you're
already awesome estimating and that is not a problem. Continuing to bill by
the hour we'll place an artificial limit on both your income and profitability.
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FA N TA S Y
• Client: "What's your hourly rate?"
• You: "$3,000 per hour."
• Client: "Great! When can you start?"
32 Psychologically, there's a maximum amount that clients are willing to pay
for an hour rate. In my experience that number tops out around $200 for
software developers. I've seen it go as high as $500 or $600 for partner-
level attorneys at prestigious law firms, but that's an exception.
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B E S T C A S E S C E N A R I O
$200 per hour
x 40 hours per week
x 50 weeks per year
= $400,000
33 The best case scenario for hourly billing, you can make $400,000 a year
charging $200 dollars per hour. Of course it's impossible to be billable full-
time and run your business because you have to do marketing and sales. A
more realistic maximum annual income is $200,000 when billing hourly.

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B E S T C A S E S C E N A R I O
$500 effective hourly rate
x 20 hours per week
x 40 weeks per year
= $400,000
34 What if you want to work less and the same amount? What if you want to
make $1 million? It's virtually impossible with hourly billing because people
just won't pay more than a couple hundred dollars per hour for your time,
and you have to spend time on marketing and sales. You have to break the
habit of trading time for money to get there.
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VA L U E P R I C I N G # F T W
• Breaks through income ceiling
• Encourages better estimates
• Rewards increased efficiency
• Maximizes profitability
• (and more...)
35 If you ever want to escape the hourly trap of trading time for money, fixed
price project bids based on value (i.e., value pricing) are the answer.
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Q U E S T I O N S ?
V i d e o Q & A : h t t p s : / / w w w. c ro w d c a s t . i o / e / j s t a r k 6
We b s i t e : h t t p s : / / e x p e n s i v e p ro b l e m . c o m
36 Quite a bit of Q&A on this talk can be found here:
https://www.crowdcast.io/e/jstark6