Hourly Billing is Just a Theory
Tim Williams
Business and revenue model strategist for advertising agencies and other professional services firms
Most professionals were born and raised in the world of the hourly rate. Lawyers, accountants, and advertising executives have been taught that hourly billing is eminently defensible because of its practicality. Time is recorded and billed based on hourly rates, which makes labor-based invoices look like a factual, objective way to charge clients.
When presented with the concept of pricing based on value instead of time, these same professionals insist that value-based pricing is “just a theory.” They fail to realize all pricing methodologies are based on a theory of some kind — including the hourly rate.
Definitions of value
Writing in his landmark book?Das Kapital, economist Karl Marx penned the following definition of value:
“The value of a good or service is equal to the amount of labor required to produce it.”
This is the infamous “labor theory of value,” a relic of the industrial revolution. This particular theory of value should look familiar to most professional firms, because it's the postulation upon which their revenue models are built: labor determines value, so keep timesheets and bill for hours.
A contemporary examination of this theory immediately reveals its flaws. If a talented professional solves an important business problem in five minutes, should she bill her client for five minutes of her time? Similarly, if hundreds of hours are spent on the same problem and still no solution is in sight, should your client pay for the hours nonetheless? The labor theory of value is patently false, yet precious few firms question it.
Thankfully, a group of forward-thinking economists like?Carl Menger appeared on the scene after Marx and developed another theory of value, which states:
"Value is subjective, since the same item will have a different utility to different people under different circumstances."?
This is clearly a better definition of value, and it constitutes the theory accepted in today's business world. Pricing professionals in virtually every industry know that pricing should be based on the value to the buyer, not the cost to the seller. Modern pricing as practiced by most 21st century businesses is customer-based and solution-based, not cost-based.?
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The burden of proof
When criticizing value-based pricing as “theoretical,” executives in professional firms also mean to imply that value-based methodologies aren’t actually practiced in the real world. In truth, it’s difficult to find examples of contemporary pricing that?aren’t?value-based. The pricing revolution of the last 20 years has produced an explosion of innovative value-based pricing methods that include:
These revenue models are all based on the modern theory of value: value is subjective, variable, and contextual. It lives in the mind of the buyer, not the cost structure of the seller.
Meanwhile, it's mostly professional firms who are still mired in the industrial era labor theory of value. And let's be clear; it's the wrong theory. This might explain why advertising agencies in particular are experiencing a decades-long decline in profit margins. Businesses that base their revenue model on a defective theory of value will never get paid what they’re really worth.?
Faulty theory, faulty practices
It might well be said that hourly billing is not only based on a theory, but that the theory doesn’t work very well in practice. Professional firms are constantly writing off time, adjusting time, transferring time, and attempting to justify time to clients who don’t see that any value was provided. Timesheets are notoriously inaccurate (and sometimes fictitious). Professionals subjectively add or subtract hours from their timesheets if they feel their clients either will or won’t pay the resulting invoice. Every time tracker in every firm on the planet knows that time spent by the seller does not equal value received by the buyer.
If any theory of value needs to defend itself, it’s the labor theory. Value-based pricing is practiced successfully in every type of business imaginable. It is not “theoretical” or “nice in theory.” It’s the way goods and services are bought and sold every day in every corner of the world.?
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Tim Williams?leads?Ignition Consulting Group, an international consultancy that advises?professional service firms in the areas of business strategy and revenue models.?Tim is the author of several books, including "Positioning for Professionals: How Professional Service Firms Can Differentiate Their Way to Success." Tim also writes a monthly blog,?Propulsion, and shares insights on Twitter?@TimWilliamsICG.
Chairman at Faith
3 年Thought provoking article that shows how difficult it is to get a commercial model that reflects the value of IP and creative thought.
Craftsman, Construction Manager, Consultant.
3 年Excellent article about subjective value. Austrian economics for business 101.
CPA (SC, VA, MI) on Career Break | GL Accounting and Financial Reporting | Analytical | Tenacious | Problem-solver
3 年100% agree. If accounting firms moved to a value-based pricing, that would also change the way that employee evaluations are done. What I've experienced is most evaluations focus on the hours you're putting in and your "realization" percentage (i.e. how much of the hours you put in can actually be billed to clients). If employees are being judged on the value they bring to the firm and clients, then it is easier to give them a work/life balance. The onus is on the managers to know their employees well enough to be able to judge them on the value they bring, not just the work hours they put in.