Your Self-Imposed Profit Ceiling

Unless you’re running a regulated public utility, can you imagine working in a business that places a cap on its profits? Actually, there are countless thousands of such organizations: they’re called professional service firms.

Most professional firms have a set of hourly rates, a profit margin built into these rates, and a set number of professionals who are expected to bill a set number of hours. Your calculator will tell you the maximum amount of revenue — and profit — you can expect for the year. 

A wildly suboptimal system

If all your billable people work the maximum number of billable hours, you can hypothetically achieve your 15-20% profit margin. But no more than that. No amount of hard work, innovation or dedication will help you beat this figure, because you’ve defined your inventory as buckets of hours, of which there is a finite and limited supply. In effect, professional firms operating on the hourly rate system have a self-imposed ceiling on profitability.

In a capitalist society, what kind of business would consciously design — much less agree to — this kind of business model? From an economic standpoint, billing by the hour is wildly suboptimal. In effect you have a business where:

• The faster you can solve a problem, the less you earn
• The more productive you become through investments in technology and training, the less you can charge
• The expertise, intellectual capital and intellectual property you accumulate cannot be directly monetized

The chronic erosion of your profit potential

To make matters worse, the problem most professional firms have isn’t their self-imposed profit ceiling but rather their inability to achieve their profit targets in the first place. This, too, is a direct result of the hourly rate. Your margin is chronically eroded by underestimated time, unrecorded time, unbilled time, and written-off time. 

The root of this problem is a paradigm in which you imagine your firm consists of a warehouse of hours. Your executives walk down the aisle of this warehouse, pulling hours out of bins and to fill client orders. When the hours are gone, they’re gone. But is that really what’s in your warehouse? 

It’s the firms that define their inventory as intellectual capital — not hours — that are able to consistently achieve above-average margins. Minutes on a clock are the wrong container for knowledge work. 

Manual work vs. knowledge work

At the turn of the last century, as the titans of industry were endeavoring to maximize the productivity of their factories and laborers, Frederick Taylor wrote the bible on industrial efficiency. Scientific Management proposed ideas and methods that helped Andrew Carnegie increase the output of his steel mills and Henry Ford to build more cars, faster. 

Taylor would visit these bustling factories with a stopwatch in hand and recommended techniques designed to produce more with less. Given a finite number of workers shoveling coal into a blast furnace, how do you increase the amount of coal fed to the furnace? You can ask the workers to shovel faster, but there’s a physical limitation to that. Taylor's answer? Make the shovels wider.

There is no equivalent of wider shovels in knowledge work. Management thinkers like Peter Drucker have helped us understand the stark fundamental differences between manual work and knowledge work. These differences have been effectively described in the book Reinvent Your Enterprise by Jack Bergstrand:

When your organization is trapped on the hourly rate treadmill, it’s virtually impossible to scale your business. Not only is your potential profit capped, but so is your revenue per employee. Most advertising agencies produce no more than $150,000 per employee. At Alphabet Inc. (the parent company of Google), that figure is over $1.3 million. At Apple Inc., the average revenue per employee is just over $2 million. 

These figures point to the right way to think of productivity. Even if you achieve perfection in tracking, collecting and billing for time, you will never realize the same return on your intellectual capital as you would by implementing new and better ways of capturing the value you create for your clients.

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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 pricing practices. Tim is the author of several books, including "Positioning for Professionals: How Professional Knowledge Firms Can Differentiate Their Way to Success."

Twitter: @TimWilliamsICG