Q&A: Should you dump the billable hour?

A growing number of industry pricing experts are urging CPA firms to jettison the venerable billable hour and replace it with a fixed-pricing model, or even the more optimal model of “value pricing.” Few public accounting topics spark as much controversy as this one. Many firms have adopted value pricing in recent years, but others have been reluctant to do so. To give our members additional insight into this important topic, we sat down for a series of Q&A sessions with author and consultant Ron Baker, an unabashed value-pricing champion. These conversations give readers an in-depth look at the reasons a firm should consider switching to value pricing, and the nuts and bolts of how a switch might work. The following Q&A session, the first in the series, focuses on the reason behind making such a move.

Can you talk a little bit about the history of the billable hour and why it has endured for so long?

Baker: CPAs didn’t adopt it widely until the ’50s or ’60s. Prior to then, CPA firms charged by the day. Lawyers began the practice of hourly billing and maintaining time sheets around 1920.

Hourly billing is a form of cost-plus pricing. It allows a fair profit margin. It can be justified by cost. And it is profitable. My argument against it is that it’s suboptimal in terms of profitability. It’s good enough, and that’s a pretty hard inertia and apathy to overcome.

Given what you’ve just said about the billable hour, why should a public accounting firm consider making a change to value pricing?

Baker: A big problem with hourly billing is it’s an internally focused metric. It looks at our costs and our inputs. It doesn’t look at our outputs and outcomes. There’s nothing in the hourly billing formula that looks at client value.

The other problem with it is it limits an accounting firm’s income. As more and more firms are moving to the cloud, a lot of labor that CPAs used to do is now being automated. If you’ve got a business model that says, “I sell time,” and the time it takes you to do more work is being driven down because of all these technological changes, unless your hourly rates are increasing faster than productivity, your income is going to suffer, and your profitability is going to suffer. And our hourly rates have not been increasing faster than our productivity. So it’s a very limiting business model.

What kinds of problems does the billable hour create on the revenue side?

Baker: If you just look at the hard algebra of this equation, once a firm gets past its break-even point, then a large portion of any additional dollar that goes on the top line drops to the bottom. I was taught, back when I started my accounting career, that a professional firm is top-line driven because our costs are so fixed. The problem with that thinking is it makes it look like any dollar of revenue is good, and, of course, since dollars come from clients, it makes it sound like any client is a good client. That’s not true.

We sometimes work with people that we don’t like or who are toxic or rude to our team. Not all clients are great. Bad clients drive out good clients. So the pursuit of revenue, the pursuit of growth and the top line, growth for the sake of growth … it’s not the ideology of a profitable, sustainable business. What you first have to look at is that getting the right clients is just as important as getting the right team members.

The other problem concerns how we leverage the hours of our people. This is how we get the pyramid structure that is prevalent in the profession, certainly amongst the big firms. Unlike most other businesses that, for instance, have to build a plant before they can start producing products and making money, accounting firms are reluctant to hire until they’re ensured that that person they hire can be 70%–80% chargeable, which means that we’re always running at near full capacity, which, I think, burns out our people. It doesn’t give enough time for innovation and great customer service, and investing in [continuing professional education] and other things. We’re always playing catch-up. Also, people can’t produce at the same level every minute, which also makes an hourly rate nonsensical.

Of course, the last component of this equation is the hourly rate. Businesses should have prices, not hourly rates. Nobody would fly an airline who tried to charge $4 per minute. So an hourly rate doesn’t make sense. Clients want to know the price of something before they buy it, because they want to make that all-important price-value trade-off in their minds before they buy it. They can’t do that if they’re quoted an hourly rate, because an hourly rate is not a price.

Can you talk a little bit about how the value-pricing business model works instead?

Baker: The thing that differentiates a value-pricing business model from an hourly billing model is value pricing starts with the client and works backwards. We’re a big believer in offering the client options. I’m not talking about quoting a range to a client. I’m actually talking about giving clients green card, gold card, platinum card options, and then letting them decide what their price-value trade-off is. So it’s basically the value that determines the price. And then it’s the price that the firm has to look at and say, “Can we invest in the resources that it’s going to take internally to produce this work at this price and make a profit we can live with?”

Then you decide if you want to do that work or have that client. It forces you to know your costs before you do the work, not after. You have to do the cost accounting upfront like Toyota does. They know how much it’s going to cost before they build the car because they’ve already set the car’s price before they build it. It’s not set by tallying the cost at the end. That’s not how sophisticated pricing works. It works by the value determining client price and then saying, “At that price, can we invest in the cost?” That’s the big change on how those two business models contrast.

What are some examples of the different options a CPA could offer clients?

Baker: A lot of professionals, when they hear me talk about a green or gold option, they think, “Wait a minute. Are you saying for the cheapest price option, I should do a lower-quality product?” No, not at all. We’re taking quality as a given, just like an airline has to land the plane safely for all passengers from first class all the way back to coach. You have to maintain the quality standards. It’s more around differentiating based on service terms.

Turnaround time is a phenomenal way to differentiate options. How fast does the client want the product delivered? If clients want something within a day or two days or even a week, that’s going to be a higher price than if they can wait a month or two.

Another one that’s really important when it comes to pricing is payment terms. Why not structure the payment terms around their cash flow rather than our work flow? For instance, if they are Christmas retailers, they’re going to pay the firm more in October, November, December, January, when they’re absolutely flush with cash, and maybe they don’t pay anything in the summer months. At a lower price, they have to pay more upfront or maybe they have to pay quicker, but at a higher-priced option, they get these customized payment terms. That’s another great way to differentiate the options.

There are ways to differentiate around technology. Another one is how are you going to transfer your knowledge to the client? Are you going to send everything by email? Are you going to have personal meetings with the client and explain the financials, explain the tax return? Are you going to present to the board, and if so, how often? All of these different things are ways to creatively differentiate green card, gold card, and platinum card options.

Another thing it does is it lowers the negotiation and the pushback from the client. If the client pushes back on the price and says, “Wow, this is more than I thought,” then buy the cheapest option. And that just shuts down negotiation and price pushback. We’re seeing it being a very effective pricing tool.

What are the most common objections that you hear from firms when it comes to implementing value pricing, and how do you respond to those objections?

Baker: This is hard to do, and nobody who advocates this or any firm that’s ever gone through it will tell you that it’s easy. If it was an easy change, more and more firms would have done it by now.

One thing we hear is clients won’t accept it, which is pure nonsense. I don’t know of a client that doesn’t want to know the price of something before buying it. So when clients are actually given a choice of fixed pricing, they love it. (Look at the popularity of fixed-rate mortgages.) In fact, when they’re given options, they love it even more.

I think what a lot of the objections boil down to is fear. We’re talking about how your firm captures its revenue source. That puts a lot of people on edge. I also think a huge component of the underlying reasons for all the objections that we hear is lack of self-esteem out there among CPAs who just don’t believe they’re worth it.

If you don’t believe that you’re worth more than just an hourly rate, how will your clients ever believe that? I think it starts with the reputation you have with yourself. You’ll never get paid more than you think you’re worth.

I also think one other undercurrent out there, which is a very common theme which I see a lot, is what we do as CPAs is a commodity. It’s just a commodity. But that’s nonsense. We provide clients with knowledge, assistance, and a trusted relationship. So this idea that what we do is a commodity, I think, is a very curious self-limitation that we’ve put on ourselves.