Technology, automation and increased competition mean the billable hour is on borrowed time. Firms know it and so do their clients. Focus instead has to move from inputs (hours, costs and activities) to the value created by the engagement. But can value-based pricing work in practice?
The billable hour is frankly nuts
One of the biggest arguments against the billable hour, still the dominant method of charging clients used by professional services firms, is that it misaligns the interests of the firm and their clients.
Because fees are based on units of time, clients want the engagement to be completed as quickly as possible, while the incentive for the firm, somewhat counter-intuitively, is for the engagement to last as long as possible to generate more revenue.
“The billable hour makes no sense even for lawyers. If you are successful and win a case early on, you put yourself out of work. If you get bogged down in a land war in Asia, you make more money. That is frankly nuts.”
This quote also highlights another key argument against the billable hour: it places all of the transaction risk on the client.
For these two reasons, when it comes to pricing, clients have often tried to shift the focus away from inputs (hours, efforts, costs and activities) towards outputs, results and outcomes – where transaction risk is shared – while firms have been happy to stick with traditional activity-driven pricing models.
But now something interesting is happening.
New technology – think digital, robotics and artificial intelligence – means certain routine, standardised ‘process-driven’ tasks that would have taken many man hours to carry out (such as data gathering, data analysis and reporting) can now be automated and performed in a fraction of the time, by significantly fewer people.
For firms, fewer people, working on tasks for less time, means fewer hours billed. This poses a significant predicament for them.
Now, when it comes to pricing discussions, instead of focusing on inputs, which are reducing, firms will have to focus on outcomes and results.
The rise of technology and automation can surely mean only one thing?
The inevitable – and timely – death of the billable hour.
Yet, rather perversely, resistance to the demise of the billable hour could come from the most unlikely of sources: Clients.
The problem for firms is that knowledgeable and informed clients are also well aware of technological advancements. They know that firms are now able to undertake certain processes significantly more efficiently, at a fraction of the cost. And if input levels have fallen, they want their fees to fall accordingly.
Should firms attempt to hold their prices at the same level, despite the fall in inputs, clients will likely feel cheated and start looking elsewhere.
One option – but not a very good one – could be for firms to slow down investment into automation, AI and digital that create internal efficiencies, in order to continue to get the most from the time-based pricing model that served them so well in the past.
Clearly, this would be a poor idea. The reality for professional services firms is that they are facing something of a perfect storm and they have little option but to change. There are new disruptive firms targeting their space who have the technology – and are willing to embrace new business models – who can offer the same services at least as effectively and efficiently at significantly reduced cost.
And clients are aware of this too.
The irony is that while firms now want to shift the discussion towards output-based pricing models, savvy clients are more amenable than they’ve ever been to stick with traditional time-based pricing.
In reality though, there are a number of key reasons why clients may also be happy to see the end of the billable hour.
Why time is finally up for the billable hour
As we mentioned previously, the key problem with the billable hour is that it creates a conflict of economic incentive: firms want more, and clients want fewer and additionally, the transaction risk remains entirely on the client.
But perhaps the clearest reason clients won’t rush to save the billable hour is they realise that paying for hours does not directly relate to results. Savvy client buyers aren’t interested in paying for a number of ‘hours’ but an output that solves their business problems, irrespective of the time it takes.
It is worth highlighting here, in defence of firms, that in some client organisations, buyers do still bring the conversation around to the lowest common denominator – the per day/hour rate – and start forensically comparing the hours they are buying between competing professional services firms. If clients keep focusing on hours, costs and inputs – then their professional advisors are likely to focus on this too.
An interesting question for professional services firms to consider – as posed in this excellent article by Tim Williams – is how many other industries would share their cost structures so readily with procurement departments in the business development process? The answer is very few, if any!
Technology, automation and increased competition is changing the game for professional service firms. It has forced them to turn the attention of their pricing strategies to the outputs, results and outcomes of their work rather than the inputs (hours, efforts and resources) – something clients have wanted for a very long time.
What alternative, progressive pricing options could firms use?
Moving beyond the billable hour, we would expect to see progressive firms and their clients embracing pricing deals where fees are closer tied to outcomes, and risk and reward is better shared by both parties. These could include fixed fees/flat fees; capped fees (hours not to exceed a set number); collar fees (sharing of “savings” or “overages” should actual fees deviate from estimate); contingent fees and broken deal fees.
We might also see more pricing strategies consisting of a fixed price, with success/performance bonuses, dividends or commission paid if certain metrics or targets are achieved. These options perhaps provide the best mixture of risk and reward for both firms and their clients.
Interestingly, while you might expect firms to be uneasy about discussing pricing options that could mean they don’t get as much in fees, in our experience, it’s clients who shy away from these commission-based options.
Why? Because ironically, the potential reward that could be paid to firms for success can be too much of a risk for clients.
Here’s an example based on our own firm’s experience. We are occasionally asked by prospective clients if we will consider a basic payment with an incentive for performance. The client’s motivation in asking this question is usually to cover themselves should something go wrong – to shift the risk onto the firm they are working with.
We are always happy to enter into those discussions, however, as soon as we give a confident, positive response, most clients then question themselves and the new risk dynamic. The question in the client’s mind shifts from “Are we covered if something goes wrong?” to “How much will this cost us if it goes right?”
The other problem with commission-based pricing in professional services is that the value gained from a project is often not realised until long after the engagement has finished. Where clients’ performance metrics are clear (increased revenue, sales, share price or cost savings) and relatively short-term, this type of pricing strategy might work. In practice, it is harder to achieve.
A joint understanding of value
It is our view that firms and clients are better to focus their pricing discussions on a joint understanding of value – often referred to as ‘value-based pricing’ – where fees are based on the value created by the project.
This is a far preferable situation to the prevailing ’us vs. them’ pricing discussions, where firms are desperate to cover, defend, or justify their prices – so focus on the inputs – or where clients remain nervous about entering a relationship where they might end up paying significantly more than expected.
For firms, pricing discussions need to be based on a clear understanding of what the client values and showing how you will deliver this value.
For clients, it’s about agreeing on the value you are seeking and being able to compare the value created by each competing firm.
The clear benefit of a value-based pricing approach for clients is that the amount you pay the firm much better equates to the value you receive. Indeed, the value clients receive should clearly exceed the fees paid.
The benefit for firms is that it stops their technology, intellectual capital, expertise and talent being turned into a simple unit of time and better enables the firm to differentiate itself from the competition. If a firm’s technology and automation help to produce a solution that adds value to the client and solves their problems, then clients will pay for this and time spent will be irrelevant.
“This is all good in theory but value-based pricing rarely, if ever, works in practice,” the cynics say.
Unfortunately, to some extent they are correct. Value-based pricing strategies often fail in professional services for two main reasons:
1. Difficulties making value assessments
The first reason is that firms and clients struggle to make accurate value assessments, mainly because ‘value’ is a highly subjective and personal construct.
Identifying constituents of value is the first difficulty for clients, the second is that individuals within the client’s organisation will often place a different weighting on each of these value components, based on, for example, how scarce they perceive the service to be, or how much the solution will affect them personally.
The challenge for clients is therefore to agree internally on what they really want from an engagement and the value they believe will be created for the firm.
Value-based pricing assumes that a client knows what benefits they want or will receive as a result of an engagement. This is not always the case.
The problem in professional services, particularly in consulting, is that the results of a project may not be seen until long after the consulting firm has left. As a result, it’s even harder for clients to define the true value of a project when determining a fair price.
For the firm, the challenge is to understand exactly what the client values – even when the client might not be sure themselves. Again, the difficulty for professional services firms, particularly consulting firms, is whether they really know themselves what value will be created before an engagement starts.
In order for value-based pricing to work in practice, both clients and firms must be able to determine and agree on the value that will be created.
2. Difficulty communicating value
The second problem with value-based pricing is that many firms struggle to communicate and illustrate the value that they will create for the client, particularly during the business development process, and demonstrate how this value will match up with the client’s perceived needs.
Unfortunately, you can see where this is going… If value-based pricing becomes too onerous, then firms and their clients are likely to return to basing their fee discussions on tangible inputs, costs and hours…
Here’s how value-based pricing can work in practice
We believe it is entirely possible for firms and their clients to move pricing discussions away from billable hours (costs and inputs) towards the value created by the engagement. Here we outline four steps professional services firms and their clients might take to move towards ‘value-based’ pricing:
i. Better dialogue and conversations between firms and their clients
Firms need to have more open conversations with their clients, particularly during the scoping phase of any new project. As we have already discussed, value isn’t necessarily explicit – “This technology will save you £2m a year” – but is often an implicit, personal and unspoken construct. Value can change depending on a client’s worldview, desires, needs, concerns, threats and hopes.
During critical conversations, a firm’s representatives need to find out the client’s priorities, determine what the client would consider a success and uncover any risks and opportunities the client has already identified. They also need to understand how the solution will fit into the overall strategy of the client’s business.
Only by using a structured enquiry strategy, listening carefully and responding appropriately will firms be able to get the information they require. Here’s the important point for professional services firms: develop the skills and behaviours required to succeed in these critical conversations.
ii. Clients need to get better at determining value and revisit their procurement strategy
Clients, your responsibility is to get better at determining desired value internally. Agree which key issues you are facing, know how any solution will fit into your wider strategy and better understand the key concerns and hopes of each stakeholder within your firm before engaging externally.
Clients also need to revisit their procurement department’s performance metrics. If performance is judged on getting the best price possible then of course the focus will be on cost. Instead, procurement departments should be encouraged to focus on the outcome of the project, to understand how the project fits into the firm’s overall strategy and perhaps most importantly of all, to have a better understanding of value beyond the ‘best price’.
iii. Know how to illustrate tangible value in every interaction with the client
In a previous analysis of leading consulting firms, we argued that when it comes to determining value, “It ain’t what you do, it’s the way that you do it” that distinguishes the top performing firms.
Knowing how to translate technical expertise into relevant and unique points of view and having an ability to communicate strategic insight in a way that the client understands and can relate to, particularly in scoping conversations, will help the client to determine the level of value you will create during the engagement.
iv. Use a framework for determining value beyond simply inputs and costs
At The Openside Group, we have developed a framework that can be used by firms and clients (buyers) to determine the level of value that will be created by an engagement well beyond simply costs and inputs.
This framework – based on The National Audit Office’s criteria for assessing value for money (Economy, Efficiency, Effectiveness) to which we have added a fourth factor: Equity – enables firms to structure their value proposition based on a deep understanding of what the client values, and enables clients to agree internally on the value they are seeking from an engagement and better compare firms, beyond simply base cost. We would be delighted to explain this framework further.
Time’s up for the billable hour
The billable hour is on borrowed time. Clients have never liked it and now, with the rise of technology, automation and competition, firms are also motivated to move the conversation away from ‘time spent’ towards the value created by their solutions.
Progressive pricing arrangements, where risk is shared and both parties are focused on the outcome and solution – the value, not inputs – have to be the way forward for professional services firms and their clients.
The end of the billable hour is in sight. It’s about time.