Outcome-based pricing is based on the achievement of specified business goals. The cost of the service therefore effectively becomes a percentage of the value it delivers to the company. Outcome-based pricing can be highly effective but several prerequisites need to be in place for it to work effectively.
The background to outcome-based pricing
Traditional pricing models have tended to be based on activity rather than productivity. Essentially, they are all variations on the theme of the cost to the manufacturer or service provider plus their profit margin. Traditional pricing models did actually work fairly to very well in a pre-digital world. They can work very well today. At the same time, they do have very clear limitations.
From a buyer’s perspective, the main limitation of traditional pricing models is that they typically skew the risk towards the buyer. If the buyer accepts a higher figure, they may not be getting maximum value for their money. If, however, the buyer accepts a lower figure, they may not get the quality of outcome they need. Either way, they are at risk.
From a seller’s perspective, the main limitation of traditional pricing is that it caps profitability. Buyers can pay low prices for a product or service which adds enormous value to their business. Flipping this to an outcome-based pricing model can unlock major opportunities to drive revenue.
The challenges of outcome-based pricing
Although the theory of outcome-based pricing is compelling, making it work in practice often presents at least three significant challenges. The first is the challenge of attribution. How do you show indisputably (or at least beyond reasonable doubt) that A directly led to B? How do you show that A was the sole (or at least major) factor leading directly to B?
The second is the challenge of end-to-end control. This is a direct corollary of the first point. If more than one product or service is used, then it’s impossible to be 100% certain that the outcome was achieved because of one specific product or service on its own. This is exactly why robust experiments only change one variable at a time.
The third is the fact that the previous two points can make it very difficult to create contracts that are both fair and clear. This can make it hard to resolve disagreements even when there is a high degree of trust and goodwill between the parties.
There is also a fourth point that needs to be at least considered. This is the question of what happens if business outcomes are not met through unforeseen circumstances. The impact of COVID-19 is an extreme example of this. Minor disruptions are, however, relatively common. Typical examples of these are fires, floods, transport disruption and network outages.
The option of hybrid pricing
At present, pure outcome-based pricing only really works well in a small number of environments. Even in these environments, however, it clearly has drawbacks. For example, affiliate marketing typically works on a pure outcome-based pricing model. The affiliate who sends the traffic to the website gets the sales commission.
On the surface, this seems perfectly fair. In reality, however, a customer may do a lot of research at various sites before finally clicking on an affiliate link. It is therefore entirely possible that the affiliate who gets the commission may have had relatively little to do with the buying decision.
This reality may be a minor irritation in the affiliate marketing world. It can, however, be a serious concern to businesses that operate on a larger scale and/or with higher upfront costs. At a minimum, they need to cover their expenses and make at least a small profit. As a result, hybrid pricing tends to be preferred over pure outcome-based pricing.
In hybrid pricing, the seller uses a traditional pricing model to ensure that they can at least break even on the contract. They then use outcome-based pricing to align further payment with the achievement of business goals.