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Pricing by Value

Accountants are communists?

Whilst accountants are usually viewed as the umpires of capitalism, they actually believe in Marx's "Labour Theory of Value". The theory said that the value of a service or product was determined by the amount of labour required to produce it. This was patently rubbish (Marx was a hopeless economist) as things with no labour input (such as land) still have a value. The Austrian School subsequently concluded that the value of something is what somebody is prepared to pay for it, a concept that should be remembered in a housing bubble. 

However, professional service firms persist in equating value to the number of hours worked times the rate per hour. "Time is money". Even my lad quotes this back at me. Have you ever wondered how the rate per hour is set? Traditionally, the practice takes its wage costs and overheads, adds the desired net income (DNI) of the partners and divides by the number of hours available to sell. For an individual employee, the rule of thumb is to set the charge out rate at 3 times salary. This is effectively a cost plus method. Price is determined by cost. 

It follows that, if you want to increase income, all you have to do (on the cost plus method) is to increase your costs. This is exactly what the big Wall Street law firms did in the late 1980s. It was easy enough to take graduates from Ivy League universities, pay them a massive salary and simply pass it on to the customers. By the 1990s, the customers were struggling and they called a halt to this approach. They no longer perceived value, however it was calculated. 

Technology also makes a huge difference. The easiest way to crank up billable hours would be to remove all of the computers and go back to typewriters. We would be awash in billable hours, but nobody would pay for internal inefficiency. 

Cost plus pricing disappeared from the rest of the world in the late 1950s. The best example of this is the car industry. In the mid 50s, General Motors asked its engineers to produce the best sports car they could. Don't worry about the cost, we'll mark it up and pass it on to the customer. The result was the Corvette, a car at the leading edge of technology for its time. Not to be outdone, Ford ran its customer advisory boards and concluded that the Corvette was too expensive for the people it was aimed at. So the man in charge at Ford (Lee Iacocca) went to his engineers, gave them a price and a series of features and asked them to match one with the other. The result was the Mustang, a car which produced a profit of $1.3bn in its first 2 years for Ford. Can you imagine anybody going into a Ford showroom and saying, "Wow, that's a fantastic car. Can I see the time sheets?" So, price determines cost, not the other way round. 

Big business now spends huge amounts of money to create brands where cost and value are completely unrelated. Cosmetics are a particularly good example of this. I understand that different makes of eye shadow sell for widely different prices, even though the material cost is essentially the same. Women swear by one brand in preference to another as that is the perceived value of the particular brand. Nothing to do with cost. Success in the industry is all about selling the same thing to different people at different prices and from different locations. Brand identity stops people switching to the cheapest product. 

How about operating an airline using a professional services/time based approach? Customers would be asked to clock in as they boarded the plane and clock off at the other end. A bill would then be sent (some time later) based on the number of hours in the air, as adjusted for the age and experience of the aircrew and the type of plane used. It would be impossible to fix the ticket cost before taking the flight as nobody can tell exactly how long the flight will take. What if the captain flies into a head wind on purpose, just to get revenue up for the month? 

This sounds absurd, but this is the way the professions operate. Surely the billable hour can't survive? Based on a lecture by Ron Baker.

Chris Duckett

Contact Mark Vickress:

Surely the billable hour can't survive?


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