In part one of this Time-Billing four-part series, author and founder of the VeraSage Institute Ron Baker explained why hourly billing is an incorrect theory of value, contending that law firms of the future should price their services based on external value provided, not internal effort generated.
In part two, he analyses the components of value and puts forward the case for a Chief Value Officer.
My VeraSage Institute colleagues and I have had the privilege of posing this question - Who's in charge of value in your firm? - to thousands of professionals around the world. We are usually met with a momentary staring ovation, and then someone will inevitably shout out: "Everyone!"
Really? I live in California, where I'm told everyone "owns" the Golden Gate Bridge. I would like to sell you my portion; unfortunately I encounter what economists call the tragedy of the commons. If everyone owns something, no one does. No one has an incentive to protect and maintain the value of the asset in question. Think public toilet.
In a professional knowledge firm, someone needs to own the value function - someone who can be held accountable for creating and capturing value. One throat to choke. We at VeraSage recommend creating a Chief Value Officer and a Pricing Cartel, thereby elevating these vital functions to the executive suite.
The Marketing Concept
The sole purpose of a business is to create wealth outside of itself. Unlike a biological organism, the true test of a firm's success lies outside of its four walls. All results are external, there is no such thing as a "profit centre," there are only cost, activity and effort centres. The only profit centre in your firm is a client's cheque that doesn't bounce.
The Four Ps of Marketing - Product, Promotion, Place and Price - all must look outside of the firm and ask "What do our customers value, and how can we increase that value?" Marketing executives must focus on the outside of the firm where the results are created, whereas cost accountants focus on the inside of a firm.
For firms to price on purpose, they must understand the Five Cs of Value.
1. Comprehend value to clients;
2. Create value for clients;
3. Communicate the value you create;
4. Convince clients they must pay for value; and
5. Capture value with strategic pricing based on value, not costs and efforts.
These five components determine the wealth-producing capacity of any firm, and will drive internal profits in the long run.
Pricing for Profit
A recent McKinsey study demonstrated a 1 per cent improvement in pricing results in a nearly 12 per cent increase in net income, dwarfing what can be achieved with a similar 1 per cent improvement in reducing fixed or variable costs, or increasing volume (you can excel at rainmaking, but if you bring in that additional work at the wrong price you are simply adding layers of mediocrity to your firm).
Other studies put this 12 per cent at between a 20 per cent to 50 per cent increase in the bottom line, depending on the industry. In other words, value and pricing deserve a promotion, because this is a strategic function.
The Fortune 500 companies already understand this, because nearly all of them have a director of pricing who oversees a pricing department. UPS has approximately 200 pricers, while FedEx has nearly 100.
Why are these organisations investing such an enormous amount of human capital into the pricing function? Because they realise they can only cut costs, re-engineer, implement TQM and Six-Sigma programs to a certain point, and diminishing returns have already arrived. By focusing on creating value, and then capturing it through pricing more intelligently, they are realising large returns for their investment.
Cost is a fact, but pricing is a policy, and in order for it to be effective someone must be accountable for results. Who is in charge of this function in your firm?
Grading Your Pricers
Engage in this thought experiment: Rank the individuals in your firm on their pricing skill as either excellent, mediocre or wimps.
Given that pricing is the number-one driver of profitability, why are people who are mediocre - and wimpy - allowed to price? Just because they are partners? Your airline pilot is a great airman, but he doesn't set your airfare.
Pricing is a core competency - a separate body of knowledge - and not everyone is adept at it. If I am a lousy litigator, you wouldn't let me near a court room. Why let your sub-optimal pricers continue to handicap the profitability of your firm with bad pricing? This is ballistic podiatry.
Value - Not Cost - Determines Price
No clients buy hours, and hence lawyers don't sell time. Yet two generations of lawyers have been taught that they do, and by forcing them to account for every six minutes of their day, they begin to internalise this attitude to the detriment of focusing on wealth creation for their clients.
Consider first how lawyers have traditionally been taught to think of the pricing function.
Cost-Plus Pricing - The Labor Theory of Value
Product >Cost >Price >Value >Customers
Notice you start with the product (or service), determine its cost, mark up that cost with a desired profit to set the price, and then pray the customer values the output at a level higher than the price they are being asked to pay.
Notice where the client is in this chain of events - right at the end! This is the paradigm of pricing held by cost accountants, and it is wrong both in theory and practice. Value Pricing inverts this chain to correspond with the economic realities of the marketplace.
Value Pricing--The Subjective Theory of Value
Customers >Value >Price >Cost >Product
This value chain recognises that value is like beauty, it is in the eye of the beholder - in this case, the subjective value of the client.
Clients don't care about your internal costs, nor your profit desires. They demand value higher than the price they are paying, and they want to make that comparison before they buy, not after (as is typical with hourly billing).
This inversion reveals a further fact of economic life: your costs do not determine your price; rather, your price determines your costs. This is anathema to a cost accountant, but self-evident to a professional pricer.
You should ask yourself before taking on any client if the price charged will allow you to invest in the costs required to complete the engagement at a profit the firm can tolerate - known as price-led costing. If not, you should not undertake the case. The important point about this process is when you are making that determination -before you provide the service, not during, and certainly not after.
Pricers understand that the hardest part of this new value chain is determining value. After all, cost is relatively easy to determine, because law firms are comprised mostly of fixed costs, at least in the short-to-medium-term (in the long run, all costs are avoidable, as you can close the firm's doors, or sell it). Setting price above cost is also not difficult, because even the most inept businessperson can accomplish this.
In determining value, cost accounting, timesheets, realisation rates, and all the other metrics firms have historically analysed provide absolutely no help. Your clients don't have much of an incentive to contemplate your value, since they purchase your services infrequently.
But your firm sells thousands of times, and gaining a deeper understanding of the value you create, how you can increase it, and better capture it, is well worth your time and investment to study.
No one entered the profession to bill the most hours. Who in your firm is measuring value? An old proverb advises that "Trees die from the top," and unless someone in your firm owns the value function, it will not get the proper executive attention, respect, and resources it deserves.
For too long, the legal profession has relegated the pricing function to an administrative task of completing a timesheet and letting the time and billing program spit out an invoice, which is then usually written down.
It's time to stop this practice, and to invest in the value and pricing functions, which will enable firms to create value for their clients, capture that value for its partners, team members, and future growth of the firm, simultaneously making the profession more attractive to posterity.
So, who's in charge of value in your firm?
Go to part 3 of this series: why your firm needs to offer fixed prices