Episode #132: The Deleterious Effects of Hourly Billing

Custom doth make dotards of us all. –Thomas Carlyle, Sartor Resartus, III, 1836

If people are supposedly rational, why have the professions continued to apply the wrong theory of value to their services?

The fact that hourly billing is so deeply entrenched and has been widely used for decades proves that is has some advantages.

The case against the billable hour is not that it is not a profitable pricing policy.

Rather, the case being made is that hourly billing is suboptimal (if profitability is your goal), and its disadvantages outweigh its advantages.

The Advantages of Hourly Billing

Hourly Billing is Easy and Efficient

Hourly billing can be handled simply with appropriate time and billing software, turning the pricing function into an administrative task handled by less costly personnel, freeing up the professional team to take care of what is more important—customer relations.

Hourly Billing is Perceived as Fair

Since hourly billing is largely justified based on a firm’s costs and a “reasonable” profit margin, it is perceived as “fair” by customers.

Hourly Billing Provides Market Stability

Since hourly rates remain relatively stable, this provides a desirable stability and predictability among buyers and sellers, as opposed to widely varying prices that may arise under a value pricing scenario.

Sometimes the Customer Demands Hourly Billing

It is rare, but there are instances when customers will insist on being charged by the hour. One encounters this attitude most frequently in the legal profession, and to a lesser extent, in the accounting profession.

Probably because the people hiring the firm were themselves alumni, raised on the virtues of hourly billing. But it is folly to turn this type of power over to your customers.

You control your pricing strategy, not your customers.

They judge your value, but cannot dictate how you price. This is not a large barrier to overcoming hourly billing. The problem is not with customers; it is with the professionals.

Hourly Billing is Required in Case of Litigation

Certain court cases require time recording due to legal precedent, fee shifting, and legal ethical rules.

Bankruptcy requires attorneys to keep time in six-minute increments. If your firm does a majority of this type of work, then you may very well be stuck with the billable hour.

Hourly Billing Leads to Higher Volume

Higher prices would dampen demand for professional services, and some projects simply cannot be quoted upfront without a high price being specified.

Hourly Billing is a Cost-Accounting, Productivity, and Project Management Tool

Check out our shows, #109, Trashing The Timesheet, and #112, our interview with Dr. Reginald Tomas Lee on lies and cost accounting.

Hourly Billing Transfers Risk to the Customer

This advantage is truly a double-edge sword. Professionals tend to be risk adverse, and hourly billing places a comfortable floor on their profits.

However, professionals have paid a high “reverse risk premium” to the customer for this floor. If the customer assumes the risk, the professional will only receive their hourly rate; no more, usually less.

Hourly Billing Has Served Us Well, Why Should We Change?

Economist Herbert A. Simon’s autobiography, Models of My Life. Among economists, Simon is best known for his theories of bounded rationality and satisficing.

Bounded rationality posits that both elements of irrational and nonrational behavior bound the area of rational behavior.

Satisficing posits that people search for good enough actions rather than optimal ones. Coupling the concept of satisficing to bounded rationality is how Simon explains how people really make decisions.

Rather than attempting to maximize or optimize, people search for “good enough” actions. Simon writes:

 [Even Darwin’s] natural selection only predicts that survivors will be fit enough, that is, fitter than their losing competitors; it postulates satisficing, not optimizing.

The Disadvantages of Hourly Billing

Hourly Billing Misaligns the Interests of Professional and Customer

Even supporters of hourly billing will admit that there exists, right from the start, a conflict between the professional’s interest and the customer’s.

This conflict of interest also exists because in a cost-plus pricing system one way to increase a firm’s revenue is to increase its costs.

Aligning incentives is difficult enough to achieve without the added burden of an inherent conflict in how your price your services.

Hourly Billing Focuses on Hours, Not Value

Whenever professionals have to justify price to a customer, they inevitably resort to discussing hours spent. Marketers would never do this, as they always try to create value in the minds of the customer first, and talk price later.

Hourly Billing Places the Risk on the Customer

Risk is where profits come from. If you offer customers fixed prices you will be able to charge a premium simply because you are reducing their risk.

If this sounds counterintuitive, consider the mortgage market. Which commands a higher interest rate, a fixed rate or an adjustable rate mortgage?

Hourly Billing Fosters a Production Mentality, Not an Entrepreneurial or Knowledge Worker Spirit

Over the decades of the billable hour’s hegemony, the professions have lost sight of the all-important question: “What did we accomplish?” It has been replaced with: “How many hours did you bill?”

Hourly Billing Creates a Nonsensical Subsidy System

An example of a nonsensical subsidy is a tax research project that is billed to the first customer for, say, $10,000. If a second customer appears the following week with the exact same issue, how much should the firm charge the second customer? Following the logic and ethics of hourly billing the answer is clear: you can only charge the second customer for the actual hours spent.

Under this method, one could argue that the first customer underwrote the R&D costs for the second customer. It would be as if a pharmaceutical company charged the first customer for all its R&D, while the following customers were charged just the marginal cost of producing the drug.

Hourly Billing Cannot Price Risk

Completing a divorce for Brittany Spears is fraught with more risk than a couple with limited assets. Risk cannot be priced by the hour. Actuaries have an axiom that is useful to remember: There is no such thing as a bad risk; only bad premiums.

Hourly Billing is not Predictive of a True Professional

One of the most useless pieces of information we can gather as outsiders about a firm, or a professional who works in it, is billable hours. It transmits little information of value, though it does highlight the “finders” (rainmakers), the “minders” (managers), and the “grinders” (technicians)—billable hours are hardly necessary, though, to make this distinction.

Far more meaning is discovered by judging a professional’s customer service attitude, customer defection and retention rates, customer loyalty, profitability and collection speed, creativity and innovation, risk taking, willingness to delegate, teaching and learning skills, and practice development activities. Billable hours shed no light in these virtues, as most need to be judged and experienced, not measured.

Hourly Billing Encourages Hoarding of Hours

David Maister and Patrick McKenna say that “Estimates given to us by our clients of the amount [of work they do] that could be done by someone more junior range up to 50 percent or more of each senior person’s time.

Surgeons piercing ears is not the road to maximum profitability.

Hourly Billing Focuses on Effort, Not Results

Who buys efforts in the marketplace? One brilliant epiphany that occurs while in the shower or driving may be worth more to the customer than 1,000 plodding, ineffective hours spent researching and pondering an issue. Hourly billing simply does not reward creativity and ingenuity. On the contrary, it rewards inexperience, inefficiency, and even incompetence—the slowest horse wins the race.

Hourly Billing Penalizes Technological Advances

Every year, professional firms make substantial investments in technology that allow any given task to be performed in less time. Perversely, under the billable hour, firm revenue will then decline, unless hourly rates keep pace with productivity increases—what economists call the productivity paradox.

Hourly Rates Are Set by Reverse Competition

This means you look at the rates of your fellow professionals operating in your geographical market, make a decision on where you want to fit in on the competitive spectrum, and set your rates accordingly.

Hourly Billing Prices the Service, Not the Customer

In a world where value is subjective, no two customers are alike, and professional firms have the enormous advantage of meeting personally with each and every customer, the mindset of pricing services is obsolete. Instead, the customer needs to be priced.

Hourly Billing Creates Bureaucracy

We estimates that somewhere between 7 and 20 percent of a firm’s gross revenue is spent tracking, reporting, compiling, reviewing, and billing time, an astonishing investment. What’s the ROI? Most firms don’t even ask.

Hourly Billing Does Not Set the Price Up Front

The most absurd and economically illogical effect of hourly billing is how it denies the ability to quote a price before the work begins. Few products or services in the marketplace are purchased without the customer knowing the price in advance.

Hourly Billing Does Not Differentiate Your Firm

Converting their crown jewels of experience, expertise, culture, intellectual capital, and relationships into a commodity, codified in an hourly rate, is no way to differentiate your firm from the competition.

Hourly Billing Does Not Measure How Much Money is Being Left on the Table

Even though one of the major defenses of hourly billing and timesheets is they are essential cost-accounting tools to determine profitability, this method has a glaring weakness: It has no way to capture how much the price could have been.

In other words, how much money is the firm leaving on the table by setting prices too low? No cost accounting, realization, or, timesheet report can answer this question.

When Google began its auction-based AdWords program, CEO Eric Schmidt was petrified it would not set prices as high as Google’s salespeople were getting.

In three short weeks Schmidt’s fears were calmed when the new pricing strategy had doubled revenue.

It became obvious at that point that salespeople were under pricing ads, not over pricing them, which is the direction most pricing mistakes are made.

Without the willingness to test this new pricing strategy, Google would have left untold millions on the table, and worse, if they had been using the billable hour, they would have never learned about it.

Hourly Billing Diminishes the Quality of Life

There is no doubt that morale in the professions is suffering, and one major cause is the relentless pursuit of the Almighty Billable Hour.

This lessening in the quality of life results in a high cost to firms, measured in associate turnover, low morale, absenteeism, ineffectiveness, neglect of practice development, continuing education, and so on.

These costs should be included in any cost/benefit analysis of maintaining hourly billing; these costs, in and of themselves, are likely to dwarf any benefits derived.

Hourly Billing Limits Your Income Potential

This is, without a doubt, the most egregious effect of the hourly billing regime. There are only so many hours in a year. On average, Bill Gates has just as much time on this mortal coil as the rest of us, so why does he make more money? The difference is he does not believe he sells time.

Summary and Conclusions

Oscar Wilde’s line sums up hourly billing with just the proper amount of irony: “He has no enemies, but is intensely disliked by his friends.”

It has become, to borrow a term from the medical profession, an iatrogenic illness—that is, a disease caused by the doctor.

Albert Einstein once wrote, “Our theories determine what we measure.” Hourly billing is the wrong theory that measures the wrong things.

Funny video from North, a 40-person ad agency in Portland, Oregon that has been operating without timesheets since 2011:

Ed’s blog post on the David Ricardo Effect

Thanks to BJ Lee for his recent iTunes Review:

I thought this podcast was going to be two ivory-tower, automaton-sounding economists discussing how many angels it will take to run a big enterprise. But they have warmly shifted the way my mind words when it comes both to my little online business and freelancing, and to larger economies. And it has made us much more profitable. Can’t wait to pass this wisdom on to my kids. If you love Freakonomics Radio, you will love this podcast. Thanks Ron and Ed!

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Ed Kless

Ed Kless joined Sage in July of 2003 and is currently the senior director of partner development and strategy. He develops and delivers curriculum for Sage business partners on the art and practice of small business consulting. Courses include: Sage Consulting Academy, Business Strategy and Customer Experience Workshops. Ed is the author of The Soul of Enterprise: Dialogues on Business in the Knowledge Economy, a compendium of a few of the episodes of his VoiceAmerica talk-show The Soul of Enterprise: Business in the Knowledge Economy with Ron Baker, founder of the VeraSage Institute where Ed is also a senior fellow.