The Firm of the Future
Interviewed by LawTalk for National Law Journal
Ronald J. Baker
LawTalk: Ron, you have been like a prophet in the wilderness preaching about Value Pricing, and your book, Professional’s Guide to Value Pricing, (link to Ron’s Books) now in its Sixth Edition, is the best-selling professional marketing book ever written specifically for the professions. What made you write the book?
RB: Thank you, but I wasn’t really the first person to prophesize about Value Pricing (the legal profession in the United States has been studying the issue since the mid-1980s, with Richard C. Reed blazing the trail in books published by the American Bar Association). What I did with Value Pricing was advance the theoretical argument against it, by tracing its history back to the Marxian Labor Theory of Value. Many people think I am kidding when I make that link, but I am not. The Labor Theory of Value was a serious theory posited in the nineteenth century, and it confounded many brilliant economists of that era (See the Part I of this series). I wrote the book in order to prove hourly billing was the wrong paradigm to price professional services, and to once and for all bury the billable hour in the professions. Ever since the publication of the Sixth Edition, I have expanded that mission to include trashing the timesheet as well.
LAWTALK: I understand that your new book with Paul Dunn (founder of Results Accountants’ Systems), The Firm of the Future, (link to Ron’s Books) was published in April 2003. What do you mean by the Firm of the Future?
RB: The Firm of the Future concept was an outgrowth from my teaching and studying the professions and how most firms operate. Since I firmly believe learning starts with theory, I have noticed most professional service firms have been operating under the following Practice Equation for at least the past one hundred years:
Revenue = People Power x Efficiency x Hourly Rate
There are several problems with the above theory. Let me explain the problem with each component briefly. First, since most firms have a relatively high contribution margin (revenue less direct labor costs), it gives them a false sense that any revenue is good. This in turn leads them to accept customers who are not as valuable to the firm as others, since marginally valuable customers take up a firm’s precious capacity, and keep it from reserving capacity for its most valuable customers.
Second, the way most firms were built in the last century was by leveraging people, literally building a pyramid structure. As technology came on the scene--and especially when the computer hit the desktop--the pyramids began to flatten and firms started to leverage technology. Most firms, however, will put revenue before capacity, always playing catch-up to the work flow and customer demand. Most other ---think of FedEx, Intel, etc.-will put capacity before demand. This constant full capacity utilization seriously hinders a firm’s ability to attract top customers and cross-sell additional services to existing customers, not to mention to innovate. It also makes the partners and firm leaders believe the way to prosperity is to leverage people, and worse, billable hours. We believe a firm should run under the model of what we are calling adaptive capacity. Think of a firm as a Boeing 777 airplane. The airlines do something extremely intelligent with that capacity by dividing it up between First Class, Business Class, Full Fare Coach, Coach, and finally, Priceline.com and bereavement fare passengers. In other words, they implicitly--and explicitly, since customers know what class they are in-understand that different segments of customers value those seats very differently, and they don’t use a cost-plus pricing model to charge for them. As a frequent flyer on United Airlines, I could purchase a ticket today to London, albeit at a very expensive price. But that is precisely the point: the airlines have reserved capacity for their very best customers, even at the risk that sometimes those seats go empty. In comparison, the average professional firm will fill its Boeing 777 with Priceline.com and Coach customers, thereby squandering its precious capacity, which could be utilized more effectively with First or Business Class customers. Further, firms will add capacity for low value customers. No airline would ever add capacity for Priceline.com shoppers.
Third, most firms focus on efficiency by measuring such things as utilization rates and billable hours. Yet, if you study statistics going back at least fifty years, you’d find utilization rates and billable hours are within a very tight range. In other words, whether professionals are using a quill pen or a laptop computer, they can charge only so many hours in a year and realize so much on those hours (in terms of standard hourly rates). The theory leads partners to believe efficiency is the be all and end all of running a profitable firm. This is demonstrably false. I’m sure the buggy whip manufacturers were a model of efficiency before they were replaced by the automobile. What if you are efficient at doing the wrong things? No efficiency expert told Bruce and Jim Nordstrom to put pianos and piano players in their department stores. Yet, how effective--in terms of customer service and competitive differentiation--has that strategy been? The legal profession has let efficiency retard its effectiveness, innovation and creativity. That is what happens when an industry focuses all of its attention on efficiency. I would suggest the most innovative firms--from Intel, 3M, and Disney, to FedEx, Hewlett Packard and Microsoft--are not the most efficient producers. They are, however, amongst the most innovative, and profitable. Consider 3M, which provides its employees up to 15% personal time to work on whatever projects they desire. It’s not the most efficient scenario, but if they didn’t offer that type of personal time for people to create and innovate, we wouldn’t have Post-It Notes. I think most partners would be horrified to implement a similar policy. Hence, professional firms are not hotbeds of innovation and creativity.
Last, the Almighty Hourly Rate. The profession has taught approximately two generations of lawyers the only thing they sell is their time. This is unadulterated nonsense, for a very fundamental reason-no customer buys time. How can you sell something the customer doesn’t buy? Look at how any customer judges the success (or failure) of their attorney. You will not see “I liked their billable hours” anywhere on those surveys. Customers buy expectations, results, sleep, peace of mind, etc, not hours. The focus on hourly rates has held this profession back from getting paid for the value it creates, and that has to change. It is interesting to note, by the way, the American Bar Association established a Commission on the Billable Hour to study its effects on lawyers, which the former ABA President, Robert E. Hirshon, believes are mostly negative. You can learn more about this Commission at www.abanet.org/careercounsel/billable.html.
LAWTALK: That is a fairly strong indictment of the old Practice Equation. What do you see as the new Practice Equation that will guide the Firm of the Future?
RB: Yes, it is a strong indictment, and rightfully so. The old theory doesn’t explain why attorneys are successful, nor does it offer viable alternatives to leveraging the critical success factors in an intellectual capital economy. The new Practice Equation for the Firm of the Future is as follows:
Profitability = Intellectual Capital x Effectiveness x Price
This theory has many advantages over the old one. First, rather than focusing on top line revenue, the firm is forced to think about the profitability of each customer. Not all customers are equal, and many firms could stand to lose up to 40-60% of their customers, and they’d be more profitable if they did so. That may sound counterintuitive, but if you study the Pareto Principle--that is, the top 20% of a firm’s customers provide 80% of its revenue or profits--it is definitively true. Marginal customers may contribute revenue, but they also absorb precious, fixed capacity that is better utilized with First and Business Class customers.
Second, professional firms don’t sell hours. They create and sell--and their customers buy--Intellectual Capital (IC). This is a far broader view than thinking about leveraging people and hours. Microsoft didn’t create the wealth it has by pricing by the hour, and I doubt Bill Gates keeps a timesheet. A firm’s IC consists of three components: Human Capital (its people); Structural Capital (its systems, proprietary software, checklists, resources, etc. that enable it to perform its work); and Social Capital (customers, vendors, suppliers, referral sources, alumni, and alliances). These components are the real levers of profitability in any professional service firm, not people hours. You can’t leverage an hour; time is simply time, and all ---indeed, all living beings--are constrained by it. So what? There are so many more ways to leverage the three components of IC, but it requires a radical change of mindset to get away from the notion that “billable hours” drive a firm’s profitability. As Archimedes said, “Give me a lever long enough, and I shall move the earth.” The real lever in a professional service firm is its IC, and our book sets out to prove that theory.
Third, the Firm of the Future will focus on effectiveness, not efficiency. There’s not much the average firm can do to squeeze another 15-20% efficiency from its Human Capital, which are only fallible human beings after all. The focus on billable hours has hindered professional firms from focusing on being effective with their customers. If you study surveys of how customers select--or fire--their attorneys, efficiency is never mentioned. It is always because of outstanding service, or lack of service--issues such as they don’t ignore me, they are proactive in looking after my interests, they are aggressive in helping me pursue opportunities, etc. You can’t do all of these things if you are focused on nothing but billable hour quotas. Therefore, the Firm of the Future will measure team member effectiveness by utilizing Key Performance Indicators (KPIs), which are leading indicators of performance. Timesheets are lagging indicators, and don’t offer firm leaders a relevant, or timely, measurement of the right things (effectiveness); instead, they focus on doing things right (efficiency). I will take effectiveness over efficiency any day in a knowledge environment. Let me be clear: The Firm of the Future does not have timesheets.
Last, Firms of the Future recognize they are - just like the airlines, hotels, rental car companies, etc. - have prices, not hourly rates. You’d never fly an airline that tried to charge you $4 per minute. The idea is simply ludicrous. In fact, professional firms need to start pricing up-front for everything they do, period. No more excuses. The retort that a firm can’t do that because it doesn’t know exactly how long it is going to take is specious. The customer doesn’t care how long it takes, they only care about the price relative to the value, and they want to make that comparison before they buy, not after. From the firm’s perspective, it is much better to know the customer doesn’t agree with the price before they do the work, which helps it prevent committing precious firm capacity to customers who don’t value the work. Lawyers are subject to the same laws of economics, price, and consumer psychology as every other business. It is time they learned to price on purpose, and stop hiding behind the veil of billable hours (See Parts II and III in this series). In conclusion, we believe this theory--and of course there is much more to it, this is just a brief synopsis--is superior to, and will eventually supplant, the old theory.
LAWTALK: How do you see firms getting there? What do they have to do to make the journey and arrive at the so-called “promised land”?
RB: Mostly, it is a mindset change. Lawyers are going to have to unlearn what they have learned for the past two generations. The old theory is no longer relevant--and most importantly, is no longer profit optimizing--in a knowledge economy. Firm leaders and partners are going to have invest in the education and life-long learning of their Human Capital, and they are going to have to start running their firms differently. I realize this is no easy task, but I also do not believe professionals hate change. That is too simplistic, and it is not historically true. The legal profession has gone through tumultuous change in the past, and it will do so in the future. We are positing the new Practice Equation as a way to focus the profession on its true levers of success, and I have faith my colleagues will not only learn it, they will someday supplant it with even a better theory.
LAWTALK: Ron, are there any firms that are already moving in this direction. Can you talk about one or two of them?
RB: There are literally thousands of firms that have implemented Value Pricing, by utilizing Fixed Price Agreements and Change Orders. I know this because I have met, corresponded and talked with many of the firms that have read my book (which has sold over 25,000 copies worldwide). About three hundred have dumped timesheets. The common characteristic among these firms is a leadership determined to change the pricing culture in their firms, and how they measure the firm’s effectiveness at achieving its mission and strategy. After all, what I am suggesting is a testable hypothesis and if I’m wrong, a firm can easily switch back to the old methods. So far, the largest firm to have trashed its timesheets is a $9 million, 30-team member CPA firm. As of July 1, 2001 they got rid of them, and the morale among the team members has gone up considerably. Also, it has acted like a lighting rod to attract 3-7 year talent, a segment of the labor market in short supply. The other firms--anywhere from $200,000 to $4 million in gross revenue--report similar results. But I want to be clear: this is not an easy transition, and it takes time, education, commitment, and perseverance. I have founded a Think Tank, VeraSage Institute, and a consulting arm--VeraSage Consulting-- to assist firms in making the transition to Value Pricing and no timesheets.
LAWTALK: What do you think is the number one barrier stopping more firms from taking the journey? What are the risks involved? What happens if we get lost along the way?
RB: Other consultants will tell you professionals won’t take the journey because they hate change. I reject this line of reasoning. I don’t think it is change per se lawyers fear, I think it is the uncertainty of the effects of the change they fear. That is a much different issue to deal with. If I was Lloyds of London, and I could insure a firm’s losses for a given period of time if they were to try my theory and it failed, I think many more would change. Unfortunately, I’m not Lloyds and can’t do that. I have to convert my colleagues based upon the logic of my arguments and ideas, through the use of words. I am optimistic I can do that--I have a fairly good track record so far--which is why I will continue to write, lecture, educate, and disseminate my ideas into the national discussion. We are so committed to this process, we offer any firm assistance, in the form of e-mail and telephone consulting, if they are truly serious about making the transition. They can learn from our collective experience--and from other firms--and this will help them avoid the mistakes others have made, thereby lowering their risk.
LAWTALK: Where can our readers go to get more information and start the journey?
RB: You can visit VeraSage Institute at http://www.verasage.com and obtain additional resources there, as well as our public speaking tour for 2006. We do seminars and conferences around the world, as well as private firm retreats and meetings. You can also take various state society CPE courses from the California CPA Education Foundation. (http://www.educationfoundation.org).
LAWTALK: Thank you for your time, Ron. And good luck on your crusade to bury the billable hour and the timesheet.
RB: Thank you for providing me this forum to express my ideas.
TAGS: Law, Value Pricing, Trashing the Timesheet