Challenges With Time-Based Pricing

Time-based pricing is the most common way professional service firms charge for their services.  A case can be made for this method of pricing but that is not my purpose in this post.  What I would like to share are my thoughts about are some of the challenges I see with this method of pricing and how it has negatively impacted firms more than their clients.

First, it is time centric rather than customer-value centric which means the firm is neither specifically seeking to address nor capturing the value created for and perceived by the customer.  Some customers would be willing to pay more for the firm’s services but are not being asked to and some customers are unhappy with what they are paying but are consuming the firm’s valuable resources that might otherwise be deployed in more effective ways e.g. doing more higher value work for more customers who appreciate value.

If you have customers who would be willing to pay more for your services then so too do your competitors!  Your attention and marketing efforts should focus on these people NOT on the ones who are looking for lower prices.
Customers who are price sensitive are never going to be as profitable to the firm as the former category because they are not good referral sources, they are not inclined to buy additional services, they lower your sense of value and self esteem by constantly questioning your fee and they are more likely to switch to lower cost suppliers.  As Harry Beckwith says in The Invisible Touch “if people come for your price they will leave for someone else’s.”

Second, when the performance of a team member (including the owners of the firm) is judged on the basis of hours billed with little or no attention being given to customer satisfaction, people tend to hoard work rather than look for ways to better identify and meet the long term needs of the customer.  The growth of the firm suffers as a result but as is the case with most lost opportunities, it is not immediately visible.  Paradoxically, striving for high productivity based on hours billed is considered to be a good thing but the celebration hides opportunities for profitable growth from the attention of management.

Third, when time is the focus and customers have a fee expectation that is not too far from what they paid last year there is very little incentive to explore ways in which greater value can be created. By focusing attention on time expended rather than value created a key element of business success is ignored.  Successful businesses in any industry are those that exceed the service expectations of their customers.  These businesses are the ones that enjoy very high levels of customer loyalty and quality referrals, they are also the ones that attract and retain customers who are less price sensitive and who are more likely to buy additional services.  A time-based focus is not likely to result in expectations being exceeded.

A fourth challenge is that as a firm gets more efficient through, for example, the use of technology all or most of the productivity gain is passed on to the customer in highly competitive markets with low barriers to entry (i.e. the accounting profession).  This is made even worse if people are reluctant to delegate so you end up with higher skilled people doing lower skilled work simply because technology makes it possible for them to do it.  In other words, we see higher skilled people doing lower skilled work because they can not because they should.

Contrary to the more popular argument that time-based pricing encourages inefficiency the cost of which is passed on to the consumer,  my research suggests otherwise and that, in fact, it works against the firm rather than against the customer.  Published industry surveys conducted over a 30 year period in Australia (and I suspect it’s the same in other countries) reveal that inflation-adjusted net profit per partner has fallen by 1%.  This has happened despite a massive injection of productivity enhancing technology and a huge growth in demand for accounting services from individuals and business entities.

Technology has resulted in an improvement in output per person that’s reflected in higher revenue based performance metrics such as revenue per person and revenue per partner.  But these metrics are misleading indicators of performance because technology improvement has flattened organizations by enabling higher skilled and experienced people to do what lower skilled people previously did and could continue to do!  As a result, average labor costs have risen, leverage (i.e. team members per owner) has declined, owners are working longer hours and profitability per owner in real terms has declined.

On the surface, time-based pricing appears to offer no incentive to improve efficiency but in my experience, most accountants are honest ethical people who do not expect customers to absorb the cost of their own inefficiency.  And if that’s not enough then the possibility of losing a customer (or having an unpleasant confrontation) if price is considered to be “too high” tends to drive prices down and results in the firm, not the customer, absorbing the cost of inefficiency. This incidentally is reflected by write-offs of between 5-20% that are common in PSFs.

A fifth challenge with time-based pricing is that it is not possible (without further analysis) to use it to identify the most profitable customers or service lines because the cost of resources other than labor used to deliver the services are for all intents and purposes ignored—they are just assumed to be recovered through the direct labor cost multiple used to set the charge rate.

Although time and billing systems have become commonly known as “a costing system”, that is not the case at all.  Let’s face it, they’re a pricing system.  When people talk about the “value” of WIP they are actually talking about “the amount we have charged to tasks performed for clients and hope to recover” it is not a “cost we have incurred and hope to recover.”

Because management’s attention is not being drawn to its most profitable (and by implication least profitable) clients and services these are going unnoticed.  I consider this to be one of the main reasons so many firms are failing to achieve their full potential and importantly, why they continue to service clients they should have fired long ago.  But the solution to this weakness is not to trash time-sheets in my view.  The solution is to design time recording systems so that they are a source of valuable management information rather than as a pricing system.

I will address how that might be done and how to undertake an analysis of client profitability in my next post.