Cost-plus Pricing: The Democracy of the Dead

In the Sept 4-17, 2006 edition of Accounting Today, CPA firm consultant Gary Boomer has an article entitled "Have you reviewed your economic model lately?"

After citing the average starting salary for CPA firms this past recruiting season of $45,656, he goes on to state how the average firm partner is too busy working IN their firms rather than ON them, and how they are most likely using obsolete billing formulas, such as three or four times hourly cost. Then Gary offers this enlightened advice:

Now is the time to start managing your revenue stream by evaluating pricing alternatives, including value pricing.

Unfortunately, most of the rest of the article goes on to denominate all statistics into hours, including assumptions regarding charge hours, even going so far as to propose firms should manage their head count based upon revenue of full-time-equivalents (FTE—i.e., net revenue divided by 2,080 hours). The national average is approximately $130,000 per FTE. It's suggested this is similar to a golfer's handicap, and constant improvement should be the goal.

This is like declaring you can change your weight by weighing yourself more often. It's not the measurement that is important, but the process that produces the measure. A golfer's handicap doesn't improve because it decreases; it does so because he swings the club better. Focus on the process and the result—the measurement—will take care of itself.

Moreover, the FTE is a lagging indicator. Running a firm based on lagging indicators is the equivalent of timing your cookies with your smoke alarm. What firms need are leading indicators—that is, a measurement guided by a theory of customer behavior that has predictive power, and a correlation to profitability.

After suggesting firms use their time and billing systems as a cost accounting tool, rather than a pricing tool, Gary also recommends firms collect fees in advance in order to reduce accounts receivable. He also advocates this policy, with which VeraSage totally concurs:

Not all partners are created equal when it comes to pricing, billing and collecting. Successful retailers do not allow all of their managers to set prices, and neither should an accounting firm.

Because not all pricers are created equal, we have been strong proponents for years of firms establishing a pricing cartel, as well as appointing a Chief Value Officer, in order to centralize the pricing function and make it a core competency within the organization.

The most specious assertion in Gary's article is this:

Knowing costs and margins in any business is also essential. Setting standard pricing matters, too. In too many accounting firms, people are pricing services without accurate cost accounting, while using assumptions that may be outdated.

Yet this is demonstrably false. CPA firms know their costs to the penny, probably better than any other business on the planet. Being more accurate cost accountants does not make you a better pricer. If it did, CPAs would be the best pricers in the world.

This is not to imply that a firm's internal costs are unimportant, or irrelevant, to the pricing decision, for they are certainly not. It is the order of those costs that is important: The profit-optimizing firm will only invest in those costs that can be recouped through the value created for the customer, not the other way around. In other words, the firm explicitly understands that its price determines its costs, and does not let its costs dictate its price.

Firms that Value Price know they must perform cost accounting before they provide the service, not after. What's important to a pricer are projected costs, not historical costs, since pricing must take place in a world of risk and uncertainty. Further, marginal costs are far more relevant than average costs, or sunk costs, but the latter two is what we get from time and billing programs.

Besides, 90%+ of a CPA firm's costs are fixed; it doesn't take a rocket science to perform cost accounting in that environment, nor should a firm devote precious resources to such a low-value task. What's more, since the hourly rate has a built-in profit, it's not even cost accounting—it's profit forecasting. Once you remove the profit, and perform actual cost accounting, you realize it's pretty hard to lose money in a CPA firm.

If you were to diagram cost-plus pricing, it would look like this:

Service → Cost → Price → Value → Customers

Now, look at how Value Pricing inverts the above chain by recognizing the economic fact that, ultimately, it's the customer that determines value:

Customer → Value → Price → Cost → Service

By determining value first, then establishing a price, only then can firms decide if the costs required to provide the service will return a desirable profit. If the project cannot be done at an adequate profit level, the service shouldn't be performed. All this analysis has to take place before the work is started. What possible good is it to know your costs to the penny if the customer can't afford—or has a different value perception of—your price?

Costs are a fact, but pricing is a policy. By constraining your firm with the price first, you will be amazed with the amount of creativity and innovation you bring to engagements. As Henry Ford wrote in his autobiography, My Life and Work, published in 1922:

...although one may calculate what a cost is, and of course all of our costs are carefully calculated, no one knows what a cost ought to be. One of the ways of discovering what a cost ought to be is to name a price so low as to force everybody in the place to the highest point of efficiency. The low price makes everybody dig for profits. We make more discoveries concerning manufacturing and selling under this forced method than by any method of leisurely investigation.

Notice Ford's objective was to drive price down, so as to put a car in every garage. Our goal today is to maximize the profit from each customer by establishing a price commensurate with the value we are creating. In any event, with Ford's objective in mind, consider what he wrote on the importance of cost accounting and prices, which is profound:

Our policy is to reduce the price, extend the operations, and improve the article. You will notice that the reduction of price comes first. We have never considered any costs as fixed. Therefore we first reduce the price to the point where we believe more sales will result. Then we go ahead and try to make the prices. We do not bother about the costs. The new price forces the costs down. The more usual way is to take the costs and then determine the price; and although that method may be scientific in the narrow sense, it is not scientific in the broad sense, because what earthly use is it to know the cost if it tells you that you cannot manufacture at a price at which the article can be sold?

What's happening in CPA firms is people are pricing services without a clue as to the value they are creating, not the costs they are incurring as Gary proclaims. Firms have ample data on their costs, hours, activities, efforts and other inputs, but a paucity of information on the value they create for their customers.

Costs are only relevant for determining if a service should be provided, and perhaps in what quantities. Costs certainly play no role whatsoever in determining value, or setting prices (except as a minimum). By following the Value Pricing chain above, Toyota is able to operate without a standard cost accounting system, a fact that should give pause to every CPA consultant alive.

How do they do it? They don't spend a penny on building a car until they know what its sticker price will be. The price is determined by studying value perceptions of customers. This forces them to invest only in costs below the target price to derive an adequate profit. Most economists call this price-led costing; Toyota calls it target costing. Call it what you want, it makes enormous sense, and is far superior to cost-plus pricing.

I'm not trying to pick on Gary Boomer by pointing out the flaws in his logic. He's actually moved furthest toward Value Pricing than most other consultants. I'm highlighting these shortcomings to illustrate how hard it is to change a theory within a profession.

Moving from the labor theory of value to the subjective theory of value is not as easy as making technology upgrades. It requires decades, sometimes even centuries, before a new theory is diffused within a community.

Gary's use of the billable hour to denominate costs, and his assertions regarding the correlation of labor costs to pricing, illustrate how endemic the labor theory of value is in the profession. I could just as easily argue firms should track revenue and costs on a per square footage basis, and my measurement would be just as useful—and arbitrary.

To reiterate, it's not the measurement that changes the behavior, but the process. Until we are successful at breaking the link between hours, costs and value, we will not be able to diffuse Value Pricing within the professions. If the consultants would take the time to benchmark the firms successfully implementing Value Pricing they would understand why these firms don't spend much time on cost accounting and timesheets.

Cost-plus pricing is, to borrow a medical analogy, an iatrogenic illness—a disease induced inadvertently by a physician while providing treatment. This model is perpetuated because it is risk-adverse and simplistic, and the theory supporting it has been taught for multiple generations.

Cost-plus pricing is nothing but a tradition, which is nothing more than the democracy of the dead. We won't be able to adopt Value Pricing if we continue to denominate everything into hours, thus remaining mired in the mentality we sell time.

The consultants remind me of a bull retreating to its querencia, a tiny area in the bullring maybe fifty square feet, within which the fighting bull fancies himself safe. It's far easier to consult with CPAs in a language they can understand, and want to hear. Value Pricing is hard, and it turns off a lot of people.

As one famous CPA consultant told me regarding VeraSage's Quest to rid the world of the billable hour and timesheets: "Ron, there's just no market for your message. It's a solution looking for a problem."

Are the consultants just taking the easy way out? Are they ignoring the economic evidence that exists all around them? Why haven't the consultants reviewed their own economic model lately? Are they intellectually lazy?

I'd love to hear your thoughts on this.