Are Hourly Rates Justifiable: A Debate with an Australian Consultant

On my recent trip to Australia, I met Colin Jasper, Director of Jasper Consulting.An actuary by education, Colin was an incredibly interesting person with whom to discuss the merits of Value Pricing versus hourly rates.We agree, as Colin suggests, on 95% of the issues. We have an enormous disagreement over whether there are instances where hourly rates still make economic sense.This debate was launched again when Colin sent me an article he had written, with Libby Maynard, for the September, 2009 Asia-Pacific Professional Services Marketing Association's Journal.Colin and Libby have kindly granted me permission to post the article, and our subsequent debate surrounding its contents.It may seem odd that I am engaging in a debate with someone who agrees with 95% of what we stand for, but I do so because economics is concerned with marginal activity—that is, the next unit of production, spending, etc.Thought experiment: you have an incredibly large bag of straws and a camel. You begin placing individual straws on the camel's back, one after the other. At some point, the proverbial camel's back will break.If straws could think and talk, they would shout: "Hey, everything was fine until that last straw got here—he broke the camel's back."The arenas where Colin is arguing that hourly rates are still appropriate is when firms are at the top of the Value Curve—at the margin, where using hourly rates is obviously the most sub-optimal.I find his reasoning unconvincing, but I thought you might like to read the debate, draw your own conclusions, and hopefully, join in.Here was my initial response to Colin's article:

Hi Colin,It was great to meet you as well and have a robust discussion on pricing.I read your article with great interest. As you can imagine, I have many disagreements with its premise.Here are just some:

1. Page 9, you say "few practitioners have sought to truly master the concept of alternative pricing structures..." This may be true as a percentage of firms overall (we estimate somewhere between 5-7% are doing real Value Pricing), but that overlooks that there are thousands of firms across all professional sectors—advertising, accounting, IT, consulting, and law—around the world that have adopted Value Pricing. Some advertising agencies are doing 100% Value Pricing and no timesheets, such as Crispin Porter and Anomaly, and Coca-Coca and P&G have their own Value Pricing compensation models with their thousands of agencies. Neither look at timesheets. These are significant numbers that are hard to dismiss, and they have proven that alternatives to the billable hour exist for all sorts of complex engagements.
2. On page 10, you say both client and firm should be involved in exploring and choosing the pricing approach. Yet this is not the way most industries have changed pricing strategies. Did the airlines or hotels consult their customers and ask if they could adopt Yield Management? Sellers change pricing strategies, and competition insures that customers get value. I have no problem with firms discussing alternatives with clients, but the onus is on firms to bring innovative ideas to the table, not their clients. General counsel have their own businesses to run, and don't sit around and think about the economics of their law firms. Nor should they, anymore than you and I should be innovating the next Apple iPod or its replacement. Firms have used this very logic as an excuse to do nothing, since clients have not driven this change to date (though there are exceptions like Cisco, Pfizer, etc.).
3. You also state that using the wrong pricing structure can destroy value and damage relationships, and that is certainly what hourly billing has done, with its misalignment of interests, and considering it's the wrong theory of value. The alternatives you list on page 10 are simply the billable hour in drag, and in no way are they alternative pricing structures. A price is given up-front, hourly billing is done in arrears. I assure you customers want a price, not a bill after the fact—this is basic economics. And these alternatives are still measuring value in terms of time, which is the wrong economic theory of value—and that is irrefutable, as my books and many others make clear.
4. On page 12 you say hourly rates are criticized because they encourage and reward inefficiencies. But that's certainly not my major argument against them. My argument is the whole idea is based on the discredited and falsified Marxist Labor Theory of Value. Eradicating the "we sell time" mentality does lead to greater value creation, because it's a different theory. This has been proven again and again, as all of our Trailblazer Case Studies prove. You can just read a few and see how the entire mentality of a firm is transformed to an obsession with value and results, rather than hours, inputs and costs.You say that a tradesman complaining that his saw won't drill a hole in the wall, etc. But hourly billing the wrong tool. It's plunging a ruler in the oven to determine its temperature, and you'll never get the right answer with it, period. This is why it's universally hated in the professions, and it's also why NO OTHER BUSINESS ON THE PLANET PRICES THIS WAY. There's a reason for this. It simply is not a measure of value. You are arguing that Jonas Salk's polio vaccine is valuable to the extent of the time it took him to develop, and that is economically illiterate. Period. This was settled by the Marginalist Revolution of 1871, and is well understood by economists.
5. You then argue that since a firm can't define a scope, hourly rates are appropriate. This is nonsense on stilts. A scope of what the firm does know can always be done, as Chris Marston of Exemplar, Mark Chinn, Fred Bartlit (Bartlit Beck, which has never billed an hour for large clients) and Jay Shepherd, have proved in complex litigation cases. Marston's concentric circles are the answer, as is phasing. To say that every job is a complete black hole with no "known knowns" defies reality. It also makes me, as a customer, question the expertise of my firm. As Jay Shepherd has written on his blog (The Client Revolution), there's only one question you need to ask your law firm to determine if they are experts: "What is the price?" If they can't answer that, they are not experts. He's right.

You cite the Johnson and Kaplan book, which was the launch of Activity Based Costing. Have you read the book that Johnson wrote after that one? Profit Beyond Measure. It shows how Toyota doesn't use a standard cost accounting system, and how firms should not let cost accountants drive strategic decision making. It's a seminal book, and I have discussed it in great detail in my Firm of the Future, Pricing on Purpose and Measure What Matter to Customers books.Hourly billing rests on the wrong theory of value, that's our major case against it. If you begin with the wrong theory, I don't care how efficient a firm is in implementation, it will be suboptimal. There is no right way to implement a wrong idea. Cost-plus pricing—of which hourly billing is a cousin—is dying in industries around the world, as part of the pricing revolution.VeraSage has destroyed every single argument for hourly billing. We haven't heard a new argument in over a decade, and your article is no exception. There are answers to every one of your defenses, and they are being done in firms around the world. You can find many examples all over our web site.All that said, I still enjoy our dialogues and hope we will keep in touch.Thanks Colin, enjoying the debate!Sincerely,Ron

Here's Colin's reply to mine:

Hi Ron,I appreciate your thoughtful response and I too enjoy the dialogue. I have spoken to the article's coauthor and we are both happy for you to publish it on your website.With regards your specific comments:

1. I think we both agree that all professionals and their firms can benefit from building their value-pricing capabilities. Jasper Consulting was established with the purpose of helping professional service firms create value for their clients and capture a fair share of the value for themselves.
2. I take your point that firms should the lead the change. I do see differences however in consumer pricing (e.g. Apple iPod) and B2B pricing (e.g. Legal services to corporates and governments). If a consumer does not like a price their only option is to vote with their feet—or wallet. In a B2B environment, particularly at the big end of town, clients negotiate. They do not simply negotiate the price level but also the price structure. The challenge is how to overcome client buying behaviour. Most large organisations have legal panels with multiple firms on these panels. To get on a panel they put out tenders, largely based on hourly rates. If a firm says they do not provide hourly rates, in all likelihood they will not win a spot on the panel. No large firm can afford to be excluded from all of these large panels. Hence I see a role in educating clients as well as firms.
3. Firstly I don't understand why you think the pricing structures listed are 'simply the billable hours in drag.' Do you not advocate that a value-based price be a fixed fee?Secondly, with regards to providing a price up-front, I believe this is exactly why some clients seek hourly rates. In the panel example, they don't know what the work will be in 2-3 years but they want embedded relationships rather than a range of quotes for each individual transaction. The only way they can be sure that the relationship price is fair is to agree a mechanism for charging up front. On a separate example, a law firm has just been awarded the first stage of an extremely large, one-off major infrastructure project in Australia. This first stage might be between 2-5% of the entire project. The client's preference is for a single firm to serve them throughout the project but as the full requirements of the project can't yet be scoped (i.e. the project could take an almost infinite number of directions) how other than hourly rates can the client agree a price that is fair up front?
4. You misrepresent me when you say that I'm arguing the polio vaccine is valuable to the extent of the time it took to develop it. I agree that in most circumstances hourly rates should be avoided. The only point we disagree on is that you believe their is no role for hourly rates and I believe there are some occasions when it is the most appropriate pricing structure (as indicated above).I agree with you that the mindset must be first and foremost on creating value. Where firms do this really, really well—they can justify charging a higher rate (Ron—I can sense your response to this statement from 8,000 miles away).
5. It's not about the firm not defining the scope, it's about the client not being able to define the scope of their requirements. Back to the panel example. If the client wants you to work with them for the next 4 years they are not going to know what their legal needs will be, nor which of this work they will want your firm to do. They don't want to enter a relationship where for each individual matter that seek competitive bids to ensure your price is fair. From an economics perspective perhaps hourly rates are appropriate where a) the cost of scoping is enormous relative to the amount of work to be done and b) switching costs are high.

I think we both agree firms must focus first and foremost on value (creating value).I think we both agree that firms should develop their value-based pricing capabilities (capturing value).I think we both agree hourly rates are over-used in the profession.The only area I think we disagree on is that I believe there are occasions where time-based billing is the fairest structure for both clients and firms.Kind regardsColin

Finally, a short reply to Colin, as this post is already too long:Thanks for letting us publish this on our Website.I still find your arguments unconvincing.I don't think there's much of a difference between B2C and B2B. Economics is economics, and only humans buy things—there's nobody here but us people as economist Herbert Stein used to say. This is why IBM's slogan of "No one ever got fired for buying IBM" was so effective.I heard stories while in Australia from both firms and general counsel that firms that only offer fixed prices, and no hourly rates, were put on the panels of some very large companies. It seems to me that if a firm is able to differentiate itself effectively, then clients will work with them no matter how they price. Firms such as Advent, Optim, Marque in Australia, and Bartlit Beck, Wachtel Lipton among others in the USA prove this point.If the only way a firm can get on a panel is to have hourly rates, that's a very uninspiring reason to hire a law firm. This is a purpose, strategy and positioning issue, not a pricing issue.The alternatives you suggest are the billable hour in drag because firms are still comparing the rates to an hourly rate. Even though a fixed price is quoted, the firm is measuring value by time. If Jasper Consulting wants to help law firms create and capture more value, why are you still letting Marx's labor theory of value drive your thinking?I don't buy your argument that clients will only put firms on panels if they commit to an hourly rate. A fixed price is a mechanism for agreeing to price up-front. This actually is far more transparent than hourly rates, and can easily be shopped.And an hourly rate is not a price. How can a client know what a price is by getting an hourly rate? This reminds me of the communist obsession with inputs over outputs.Why would you want to use the hourly rate in complex jobs. It is precisely these jobs where firms are adding the most value and need to move away from hourly rates. For the life of me, this makes no sense. You're telling firms such as those that defended Bill Gate's Microsoft against anti-trust violations to use the hourly rate because the job cannot be scoped? Any firm that did this would find its pricing to be incredibly sub-optimal.Alright, enough from me, let our readers join the debate.Thanks again Colin, feel free to post a reply.