How to price risk to win and profit

By Dieter Kiewell, Kevin McLellan and Sam Saatchi

Risk can be the most important element in a project’s profitability. Here’s how to make it work.

Any project has an associated risk—delays, cost overruns, unexpected government interventions, market dynamics, etc. For large projects involving significant operational commitment, these risks can turn into considerable and unexpected financial costs. We’ve seen overruns hit tens and hundreds of millions of euros/dollars or more. 

Despite these significant financial penalties, companies rarely give risk its due when it comes to pricing. In many cases, companies still treat risk as an afterthought. Large construction projects, for example, often simply add a standard “contingency cost” of 5 or 10 percent to cover the risks.

We believe that companies need to take a more deliberate approach to managing and pricing the risk in their portfolio. If risks and their potential costs are low for a project, the company can undercut competitor bids knowing they will still hit their target margin. If risks and potential costs are high, the company can either price the risk into the proposal or simply choose not to bid on the project.

More transparency into the risks across their portfolio can also allow executives to make more informed decisions about budget and resource allocation, create more accurate forecasting plans, and take concrete steps to reduce risk exposure when necessary.

When does it make sense to do risk-pricing analysis? In general, when the business model is changing (e.g., moving from per unit pricing to per use pricing); if the provider carries significant operational risk around service management and implementation; and when there is high volatility in the marketplace. While financial instruments to hedge against risk are sometimes available, they generally don’t apply to these kinds of risk. 

The risk challenge

We have seen some notable examples of companies successfully (and profitably) incorporating risk into their pricing. In healthcare, some device companies are starting to manage volatility in ordering by implementing “unfulfilled volume” clauses in their contracts, where discounts are withheld if the buyer (a hospital, usually) doesn’t reach the agreed thresholds in ordering. In healthcare services, entire companies are springing up based on their ability to manage risk on behalf of payers. NaviHealth in the U.S. was founded to improve utilization management of care after a serious illness or surgery. It raised $35 million in September 2013 before the company even launched.1

Far more often, however, companies don’t capture all the benefits of risk-based pricing. Part of the reason is a reluctance to use what are perceived to be overly complex risk models when “experience” has worked well enough in the past. This is compounded by the fact that many companies don’t have the skills to develop sophisticated risk models. 

But it’s not just about running models; it’s also about understanding how to actually price and track risk. That requires understanding the cost, risk, and value drivers of all aspects of a project. A business doesn’t just need to understand what can go wrong; it also needs a fact-based perspective on the probability that something will go wrong. And because projects often last years, companies need to track and adjust their risk over time.

The other significant issue is the disconnect between the commercial people who negotiate the contracts and the operations people who execute them. The incentives of the current contract structure generally reward salespeople for closing the deal, not for carrying it through. On the other hand, the incentive for the operations people is to build in as much risk mitigation as possible, which drives up the cost of the bid. Regardless of incentives, these two groups simply do not sufficiently share insights to competitively price risk.

How to capture the benefits 

1. Know the risk

With the wide availability of data and advanced analytics, companies now can develop risk models that weren’t possible before. They can scale the complexity of the analysis up and down, but the deeper the analysis, the better the information for making decisions. Most companies, however, start with almost nothing, so even putting together a set of “orders of magnitude” estimates based on hypotheses lays a useful foundation for creating awareness of risk and factoring it into the process. 

From this starting point, companies can focus on the top-priority risks and do deeper analysis and develop simulations of potential outcomes for each. For example, construction projects should incorporate pricing trends and market dynamics into the cost estimates of raw materials. Risk analysts then need to calculate the probability of each risk occurring, factoring in distributions and deviations. Calculating the cost of risk outcomes and the probability of their happening leads to a probable-cost range. 

2. Develop a risk-pricing plan

Once the risks have been identified, the company has to price and come up with an approach for each (or at least for the most important ones). Generally this is a choice between pricing the risk into the contract, mitigating it, managing it during implementation, or simply walking away from it. Each option, of course, comes with a trade-off and cost. Almost any risk, for example, can be mitigated. Locking in the price of a basic material needed for a project can reduce the risk of price volatility though it may increase costs. Understanding these trade-offs helps in deciding on which risks to take.

When quantifying risk, companies need to carefully consider how the price affects their bid compared to their competitors’ bid. That requires alignment between sales and operations. One international telecom company addresses this issue by having a deliberate two-phase process. In the first phase, the company assesses the cost of the identified risks. In the next phase, there is a negotiation between the sales and delivery teams about risks and costs. The idea is that through healthy debate, the groups can arrive at a price that is both feasible and competitive. This approach requires first thoughtfully considering risks and mitigation plans, but then building in a reality check so that the company is competitive during the bidding process. 

An important benefit of this internal negotiation approach is that it provides the company with a much deeper understanding of which deals to take and which to walk away from, as well as ensuring that excessive risk buffering does not inhibit the price competitiveness of the offer. One telecoms company that took this approach improved win rates by 5-10 percent in deals where risk played a role.

3. Negotiate the risk

Risk has a cost and a value. In many cases, however, the customer has little idea of the risks and therefore has a limited appreciation of what it’s worth. For this reason, contract negotiation has to include a clear articulation of risks and their value, which is why prior risk analysis is particularly valuable. Negotiators need to understand both the risk and the rationale for pricing it, and be able to defend it when speaking with the customer. 

Given the uncertainty that’s inherent in risk, pricing leaders will often work with their customers to manage and build it into the contract. Managing risk in this way is actually less about coming up with a specific “number” to quantify it than it is a matter of building in agreed-on trigger points over the course of the project that are specific opportunities to adjust the prices or change the offering/service levels if a potential risk occurs. 

Capabilities needed to unlock value from risk

To better manage and price the risk inherent in their deals, companies need to: 

Be targeted with the analysis and simple with the output. The temptation in analyzing data is to use all the data that’s available. That’s a waste of time and resources. Part of any effective risk analysis is identifying which data are relevant and important and working them into the model deliberately. Any model will need to allow for sales reps to get risk-based pricing recommendations by segment. 

Train the reps in risk-pricing negotiations. Front-line reps will also need to be trained to understand the risk calculations and communicate them to customers during price negotiations. Effective training should include mock negotiations so reps understand how to position the risk as well as defend the price. That training needs to be supplemented with support from managers during actual negotiations so that the rep can get quick feedback and build his/her confidence. 

Create a risk review process. Risk needs to be treated like any other contract term with a systematic process for reviewing it and addressing any resulting issues. Risk-review milestones should be part of the contract, to allow teams to reassess risk with the customer (using traditional green, yellow, red codes, for example) and make any necessary adjustments. The process should be both systematic, and flexible enough to respond to changing situations. How regularly risk review needs to be done depends on the length of the project. This kind of active and deliberate risk management also provides leadership with great transparency into changing risk exposure before it’s too late.

Capture learnings for the future. In many cases, we find that companies do not have a strong foundation for assessing risk. Most analysis, when it happens, basically starts at zero. To redress that omission, companies should invest in basic knowledge management to capture and organize risk learnings that can then be referenced for all future risk analysis.

Build risk-analysis talent and capabilities. Companies need to invest in sophisticated analytical tools and models that allow sales reps to both analyze and segment risk as well as develop differentiated pricing recommendations based on that analysis. Developing effective risk-based pricing often requires multiple interactions with the customer to continuously improve its accuracy. Identifying risk and quantifying it are, of course, two different skills. Companies need to find people who can not only create probability calculations but also develop plausible risk scenarios. 

Connect the commercial and operations functions. Both groups need to have a shared understanding of the drivers of risk and costs, which requires actively working together during the bidding process. This coordination can’t be an ad hoc effort but must be part of a deliberate schedule of meetings tied to milestones in the bidding process. To foster the feeling of shared risk and build incentives for working well together, part of each group’s compensation should be tied to how well risk is managed, not just during negotiations but over the life of the project. That often creates some knotty governance questions, but leaders need to address this issue so that both sales and operations people are accountable. 

Risk is often the most important element in determining a project’s profitability. While businesses need to actively invest in new capabilities to manage for it, even taking initial steps to better understand the cost and value of risk and build it into contract negotiations can have a significant impact on profits.

  1.  “The President Wants You to Get Rich on Obamacare,” New York Times, Oct 30, 2013
More on Marketing & Sales

The next-generation operating model for the digital world

Article - McKinsey Quarterly

What makes a CEO ‘exceptional’?

Article - McKinsey Quarterly

Three game changers for energy

Article - McKinsey Quarterly

How functional leaders become CEOs