Charting Value

One of my teachers told me to draw a picture to better understand a problem.  So this crude chart is my attempt at making an economic depiction of the value pricing proposition compared to the hourly billing model.  Your service generally has a set value to the client, which is the maximum price they are willing to pay for your work.  If your price is based on hours worked as shown by line P, then as your hours increase, your price increases according to the rate. 

So long as your total hours keep your price under the value line, you will easily collect what you bill, as the client knows they would have paid more and feel they have received your services at a discount to their value.  However, if your hours put you at a price point above the value line, the client will either pay grudgingly or attempt to negotiate back down to the value line.  If you are consistently over this value line, you will encounter haggling with clients who don’t want to pay your price.

If you are consistently under this value line, then you are always leaving money on the table that the client would have given to you if you had asked for it.  This scenario is why value pricing increases profitability.  The efficient service provider is punished in an hourly pricing model (same profit margin with less total revenue), but will be rewarded in a value based model with a higher profit margin and higher total revenue.

Good economics dictates that firms wish to maximize profit, not billable hours.  Be efficient, deliver great value, and make obscene profits by pricing for value.

Score one for value based pricing

A post on CPA Trendlines has really hit the nail on the head with regards to some of the most compelling arguments to abandon an hourly billing rate in favor of a value pricing model.  The key to maximizing your take from what the market place will bear for your services is to walk away from the cost plus model of hourly billing and decide what work you are willing to do at what price.  After that decision is made, you just need to find the clients who see the same value in your services that you do and have the willingness and capacity to pay for those services.

One of the comments on this article outlined several client ‘reactions’ to bills.  The only time reactions to bills are even an issue is when hourly billing is used and the amount of time required is a bit ambiguous, at least to the client.  The professional may have had a good estimate as to total cost up front, or at least sometime in the middle of the engagement (especially if special problems have arisen that cause more work on the project). 

Had cost been discussed in total up front and been set so long as all goes as planned, these reactions would never take place, because the client and the professional would be on the same page in the beginning, instead of finding out there are differences at the end.  Value based, fixed up front pricing can save a lot of headaches, heartaches, and wallet aches for both the client and the professional as engagements with clients who don’t understand your value will not begin in the first place.

Community involvement or survival of the fittest?

An article at Canada.com addresses the issues surrounding business models, client services, employee retention, and recruiting for knowledge based firms like attorneys, engineers, architects, and accountants.  The assertion is that knowledge firms need to move to a more communal structure of governance to maintain their continuity and attract new talent.  

the traditional model of billable hours and working your way up to partnership is under siege thanks to a blend of economic pressures, including new client demands, business consolidation and the fight for talent.

The preceding was uncovered through a survey of mid-sized legal, engineering, and architectural firms.  Although accounting firms were not specifically surveyed, it seems that the issues addressed are similarly applicable to them as a knowledge based industry.  The arguments set forth are rather similar to some of the same arguments set forth by proponents of value based pricing in professional service firms, especially with regards to the treatment of the staff worker in a knowledge based firm.

It appears that the new leaders within the knowledge based industry will be the ones that take the biggest steps in creating loyalty among their employees and an atmosphere that makes work a desirable location. One of the greatest costs and losses for a knowledge firm is when a major investment in time and education walks out the door for another opportunity and that human capital asset is replaced by one fresh from school that must undergo the process of time and capital investment to replace the prior employee.

However, not all partners will see a more communal environment positively (especially the “rainmakers” who are most enriched by the eat what you kill system). This dichotomy of interests is similar to the dichotomy of interests often faced by businesses with divided ownership interests. As accountants we know how we would advise our clients to handle situations where incentive packages do not promote the overall health of the business. We would tell them to change the incentive package so that the health of the business is aligned with the individual motivations within it.

Finally, would a more communal partnership or other system of corporate governance for knowledge based firms disincentivise the rainmakers and drive them away into their own businesses or to other firms where they are more enriched?  Part of this depends on who the people are, how they are motivated, and how loyal they feel towards their current organization.  Will a more communal system really improve the business environment and the services provided to clients or merely drive down revenues and profits as the rainmakers seek opportunity elsewhere?