FAQs about Change Orders, customer profitablity, and "productivity"

The following E-mail was sent to Ron Baker on December 28, 2006 from Mark Bailey, one of our Trailblazer whose firm has shifted to Fixed Pricing and no timesheets. It's a multi-faceted question, so this is a long post.

Happy New Year Ron,

I'm wrestling with some issues that I hope you can help me with by sending me to some reading material.

I am trying to get an administrative protocol in place that will help us with evaluating pricing, and help us capture the services not covered under the fixed fee agreements. There is a fairly significant amount of leakage there.

We're adapting a software program "Tracker" which is essentially due date monitoring. Part of the inputs come from our engagement budgeting, which by necessity is based on hours. The engagement budgeting isn't used as a staff management tool. It is important for engagement management on large engagements. On an annual basis it could provide a good denominator for a KPI. It necessitates each staff person to input the time they've spent in the respective areas of the engagement on a weekly basis, and a memo explaining variances. The purpose of the variance explanations is to generate any necessary change orders. The whole process smacks of time sheets, which we don't want to get back to, but that leaves me with a couple of additional measurement problems.

Pricing—if I don't know what my costs per engagement were,(1) how can I effectively evaluate the desirability of that specific client, and (2) on the largest engagements, how can I be sure I'm invoicing for everything we provide (some of our engagement teams are 5 or 6 people providing service over a 12 month period)?

Another issue I'm wrestling with is perceived productivity by the staff. I'm really laissez faire about workdays. Total flex time. If you have work be here and do it. If you don't, don't. When we are really busy, the work momentum ensures high productivity out of everyone, but when it's slower, there's no individual motivational conscience (in the absence of a benchmark, all good people are convinced they are working hard. For all the bad things it is, the clock is a benchmark)—that's just human nature, even from your best employees. Administrative responsibilities particularly seem to fall through the cracks. The individuals however, remember all the hours they put in from Feb to June, as a good faith rationalization for not putting in solid work weeks now. In other words, it's easy to remember those nights at work until 10 or on Saturday, but not as easy to remember that you come in every day at 9:30 after dropping your kid off at daycare, and leave at 4 to get in a game of racquetball before you pick her up.

How do you measure the differences in effectiveness of two people doing the same job? Productivity has traditionally been measured by hours x rate x % billed. I an get around it easily enough on small engagements where Joe does all the work and the fixed fee is $XX, but how do I do that when 4 people worked on that engagement?

Ok. Give me some direction to research. (You are not allowed to say "Mark, you're a trail blazer, figure it out.")

Mark Bailey

Ps—just writing this has given me some ideas.

Pps—the discussion in the blog regarding your Brit counterpart who wants to tell his client that his pricing was based on hours was interesting, but easily addressed. Try sending a $150,000 change order, after the work was performed, to an audit committee, and then explaining how you came up with the amount, without using the additional hours as a basis for your pricing. I did it and they are still a happy client.

Here is my response to Mark:

Happy New Year Mark,

Thank you for your questions. It inspired us to create an "Ask VeraSage?" section on our Blog. Hopefully, this will help future Trailblazers learn from the experience of others, since no one has enough time to make all the mistakes on his or her own.

Your question is multi-faceted, and will require the same type of response. I've also distributed it to all of the VeraSage Fellows, and I'm sure some of them will also provide answers, which will probably differ from mine on some points.

Let's deal with your first question, contained in your first two paragraphs, regarding leakage and Change Orders. Nothing will derail a fixed priced environment quicker than not issuing Change Orders on all "scope creep"—that is, work outside of the scope of your FPA (Fixed Price Agreement). This is the main reason why firms that have tried FPAs have reverted to the billable hour. It's an enormous issue, and demands—more than any administrative protocol—a culture change. The firm has to provide education to all team members on the importance of only performing work that is within the scope of an FPA or a Change Order. Since team members are usually the first to spot scope creep—since they are at the "coal face," to borrow an Australian phrase—it's vital they understand the Change Order process.

You can put administrative processes in place, but only after adequate education and leadership. Some firms even allow team members to negotiate Change Orders that are below a certain dollar amount; although I'm more partial to having a Pricing Cartel perform this function. I think it's time your firm appointed a Pricing Cartel and possibly a Chief Value Officer in order to deal with the procedures, processes and education that are essential to deal with this leakage issue.

The "Tracker" software program you mention is not the answer, because it will only show a variance after the work has been performed. And as you know, you MUST PRICE EVERYTHING BEFORE DOING THE WORK. Period. What possible good is it to learn after the fact of a variance? When do we want to learn that a customer doesn't like our price? I'd rather find out before I begin the work, not during or after. Since your team members are knowledge workers, they will be able to spot scope creep before it happens, thereby prompting communication with the customer and a Change Order to be drafted by a member of the pricing cartel. If contractors and auto mechanics can be taught how to do this, I remain hopeful CPAs can be as well.

Your comment that the hours from "Tracker" could be part of a denominator and used for a KPI is certainly true. We can divide many things into many other things, but the question remains: what is important to measure? Any KPI that would result from Tracker would be lagging, and what you want are leading indicators. Also, they must define the success of your firm the same way the customer does. No customer cares about how many hours it takes you to complete a project.

To your pricing questions: "Pricing—if I don't know what my costs per engagement were,(1) how can I effectively evaluate the desirability of that specific client, and (2) on the largest engagements, how can I be sure I'm invoicing for everything we provide (some of our engagement teams are 5 or 6 people providing service over a 12 month period)?"

Mark, let me suggest you do know the costs of your engagements, since your firm is a fixed cost environment. If I were to take your total overhead and divide by the number of customers you have, I'd get cost per customer. I could then adjust this number for simple, medium and complex customers. Would I be close enough for government work and cost accounting? You bet.

We are not going to become better pricers by becoming more accurate cost accountants. We will only become better at pricing by understanding the value we create. Does that mean you don't need cost accounting? No. But what's important is when you perform your cost accounting. I want you to perform it before you do the work, not after. This way, the value of your work will drive the price; then the firm can decide if it wants to invest in the costs it will take to provide that service at that price. Will it leave an acceptable profit? If not, you don't do the work. This is known as price-led costing.

This is exactly how Toyota builds all of its cars. It doesn't have a standard cost accounting system (and never has!), because it knows value drives price, not costs. So before it sinks a penny into making a car, it already knows its sales price (determined by value), then it can decide to invest in the costs required to produce the car. The problem with cost accounting is manyfold, but probably the worst thing about it is its emphasis on historical costs and lagging information. Sure, we can count every cost, but no one knows what a cost should be. What if one of your team members finds a better way to do something? Costs would actually go down. What if they find a better way, but then have to develop some tools to be used on future engagements? Costs would go up in the short run, but down in the long run. Cost accounting doesn't distinguish between these scenarios. It's myopic; it only sees the costs right in front of it.

As to the desirability of a specific customer, let me suggest you know this without looking at any financial information. What's your gut say about the customer? What does your team think about working for these people? Why must everything be quantified? Most things in life require judgment, discernment, and intuition, and for the life of me I don't know why CPAs (and MBAs) aren't comfortable with this. They rather be precisely wrong rather than approximately right. I suppose quantifying gives us a sense of objectivity, but whether or not to continue to service a particular customer is a judgment, and should not be driven by the economics alone (especially in a Professional Knowledge Firm—PKF—where customers add so much to its social capital).

As for #2 in your question, you should be invoicing for everything you provide because your Pricing Cartel is doing Change Orders and FPAs before any work is started.

There are two other tools to be used, which I'll introduce at this point, even though they are the answers to your other question of determining the "productivity" of your team. The first is project management. If you can convert "Tracker" to a true project management tool, you should. I cannot believe how bad our profession is at project management. No matter how a firm prices (even by the hour), it should be good at project management. Yet, because of the billable hour and timesheets, we can be pretty crappy at this essential skill. We call this one of the deadly sins of the billable hour. It allows us to be crappy at determining our value, at project management, at customer communication, etc.

Good project management allows you to project, and allocate, your capacity perspectively, rather than historically as with timesheets. It plans project milestones, due dates, resources, risk, etc., and allows for excellent customer communication (certainty in delivery). Someone in the firm should be responsible for PM on each job. It needs to become a core competency, just like tax and auditing (and pricing!).

But it's important to remember this: project management is not pricing. The two are different functions, and while they need to communicate with each other, PM should be decoupled from pricing. Think how closely related they are under billable hours and timesheets. As the file gets loaded with hours, we invoice (in arrears of course). But Toyota already knows the price of the car before they run it through the factory! The pricers are not down in the factories tracking the car's progress, anymore than your price should be determined by watching the file wind its way through your firm.

The second tool is the After Action Review (AAR), developed by the US Army. We are huge advocates of this procedure for all large engagements. Everyone who works on it essentially asks four questions:

1. What did we expect to happen?
2. What actually happened?
3. Why was there a difference?
4. How could we do it better next time?

It's the AAR where you can perform historical cost accounting, by simply asking: "Mark, about how long did you spend on that engagement?" Again, close enough for horseshoes and cost accounting. This will also help identify team members who are making substantial contributions to serving customers better, innovating for the firm, developing reusable intellectual capital, etc. The AAR is a critical tool for all PKFs since it's a learning tool. Too many firms just bounce from one job to the next without reflecting on what they've done, how it could be done better, what they learned, etc. Yet doing without reflection is mindless activity.

As for your last question, productivity of the team. Let me posit there is no definitive, let alone accurate, method to calculate the "productivity" of your team. These are knowledge workers, not factory workers. They think. Thinking is invisible, how do you measure it? Sure, we can count the hours they log at work, but what if they are doing auctions on e-Bay or stressed over a sick child? What if they have a flash of brilliance and save a customer $10,000 in ten minutes?

Productivity is nothing more than a ratio, usually: outputs divided by inputs. This is fairly simple if you work in a factory making widgets, it's much harder if your a knowledge worker using your brain. What are the outputs? Number of tax returns completed? Number of audits? What about the quality of the work? What about the attitude and passion of the team member? What about their customer service ethic and interpersonal skills? These are vital outputs of a successful professional, but there's not a statistic in the world that will be able to capture them. Too many firms think they should price based on 100% efficiency, but this is totally unrealistic in a human, knowledge environment.

And what about the inputs? What should we use? Hours? But then what about the ten minute, $10,000 idea? Or what about someone spending a week developing a tool that the firm will be able to use on future engagements for several years?

In other words, forget productivity. What matters is effectiveness (hence effectiveness replaced efficiency in our equation for The Firm of the Future). Would you rather have an efficient surgeon or an effective one?

There's nothing more useless than doing efficiently something which should not be done at all.

Effectiveness can't be measured; it has to be judged. Yes, that is subjective, but so what? I rather judge the right things than precisely measure the wrong ones.

To your question of two people doing the same job, and how do you measure the differences. Again, you can't measure the differences, you have to judge them. One person could take ten times as much time to do the same task, but so what? What if they are new and learning? What if they had to hold the customer's hand over a rough situation? Are we going to charge more for the less effective person? Or charge less for the more effective one? The price has already been set, so assign the team member who has the right skills to do the job, and keep the customer happy.

If you're asking how you allocate revenue per person, I would again ask: Why? Aren't we one firm? Who cares what each person's revenue is? My brother works for Procter & Gamble, and he doesn't have revenue assigned to him. But if you insist: put the 4 people in a room and have them divide up the fixed price amongst themselves. They will figure it out, trust me.

Now Mark, I've thrown a lot at you in this response, and I know it's hard to digest. But read it a couple of times, and let your team read it. You are bright people, you will figure out how to overcome these challenges if you are committed to staying a Trailblazer.

For future reading, though, I want you to read Measure What Matters to Customers. It discusses a lot of the issues in this response, especially the "productivity" vs. effectiveness of a knowledge worker, After Action Reviews, and leading KPIs for knowledge workers. It's also a short book (less than 200 pages). Yes, I know, incredibly self-serving of me to suggest my own book, but I feel better about it after giving you this response. Besides, you know I'd buy it back from you if you don't get any value from it.

Also, my Pricing on Purpose discusses pricing in great detail, Toyota's success with no cost accounting (using price-led costing), and the function of a Pricing Cartel and a Chief Value Officer. It also has a sample After Action Review form.

Better yet, assign specific chapters of these books to your team and let each one lead a "Lunch and Learn" on one topic at a time. You will be amazed how much someone can learn from a book when they know they have to present it to their colleagues.

I'm going to stop, since this response is much longer than I hoped (I didn't have time to write a shorter one). I'm sure my colleagues will weigh in as well, and I'm looking forward to their responses to you.

Mark, the challenges you cite are not insurmountable. Every firm has overcome them that has blazed this trail. You have to keep the faith and commitment. I would also suggest involving your team more in the answers. I'm constantly amazed at the innovative ideas and creativity that team members come up with when confronted with issues similar to yours. They have an enormous collective IQ—tap into it. None of us has all the answers.

Also, just to clear something up in your Pps: Did you price the $150,000 Change Order after the work had been done, or before?

I hope this helps. Keep up the great work.

Ron

Mark responded to my last question before I posted this, so I thought I'd include it as well. Regarding the $150,000 Change Order he received from the audit committee, I had asked if he issued the change order before or after the work is performed, and here's Mark's response:

The $150,000 invoice was after the work had been done.

We've also had similar situations with other clients for large invoices. Our FPA has the 'don't pay if you don't feel you got the value' clause, as well as the 'you don't have to pay, if you don't get a change order before the work is done' clause.

We do a lot of auditing, of which a fair amount is for publicly traded companies. Typically, post Sarbanes-Oxley, the small and medium sized clients find themselves up against the filing deadline, which frequently (virtually always) results in pressure on the auditor. With the additional regulation and the constant change in complex accounting standards, most clients don't have the expertise to prepare the financials as they should. Unfortunately because of the deadline, the audit team ends up going above and beyond in the last month, and in our case there was not a benchmark, which would trigger a change order. Consequently we didn't realize how badly under water we were until after the engagement was signed off. When we did we went back to the audit committee with our 'good faith' argument. Fortunately they are a quality company, and the recognized the commitment we had made and honored our invoice for an additional $150,000. We've incorporated some changes that we hope will prevent this from happening again.

This year we have set more specific parameters in our fixed price agreements, regarding the obligations, responsibilities and timing required of the client. As an example we now incorporate wording that results in a change order if we have to review more than two drafts of the filing; a change order if documents are not received when agreed on; a change order if we find management's assessment of internal control to be deficient; a change order if the opinion is qualified, or if there are undisclosed transactions, e.g. discontinued operations that they haven't accounted for properly.

We also make sure the engagement supervisors are schooled on the fixed price agreement, and are very aware of what we have and have not committed to, so they can timely identify situations requiring a change order. We did not do a good job of that last year.

Mark

Excellent Mark, that's a very well thought-out analysis of the mistakes you made this past year (very similar to the AAR process). You simply must price all work before you do it. From a pricing standpoint, this is also when you have the maximum amount of leverage, and the customer perceives the highest value. I think the company paid the $150,000 because you showed good faith, and your service guarantee is certainly a big plus. But what if you could have received $175,000 agreed to up-front?

I think you are already know the benefits of pricing up-front, so I will not beat a dead horse. I like your concept of laying out a tighter scope with the customer, listing their responsibilities and deadlines, and triggers for Change Orders. Many firms do this, and the more you do, the better you get. Your team, no doubt, which catch on regarding scope creep. Then you'll be able to change your woding on the Change Orders, from not having to pay if you don't authorize a Change Order before the work is done, to before the work is begun!

Many firms insist their team members don't pick up pencil, boot up a computer, or crack a book on behalf of a customer that doesn't have an authorized FPA or Change Order, no different than a contractor or mechanic. It works. I'm looking forward to other VeraSage Fellows input on this.

Ron