How to Set Up Your Firm in the Correct Model
Simply put, a business model is how your firm creates value for and captures value from your customers. What's your model? It's probably an old one. In his compelling new book, Implementing Value Pricing, Ron Baker proposes a radical new business model for professional firms, the professional knowledge firm or "Firm of the Future." Let's compare this new model to the traditional model and examine each of transformations that these firms must make.
Flaws of the Professional Service Business Model
Most firms have been operating under the professional service firm model. One way to state this model would be the use of the following theoretical equation:
Revenue = Capacity x Efficiency x Hourly Rate.
This model is the firm of the past. Why?
Reason 1: Some revenue is bad. Since companies in this space have a high contribution margin (revenue less direct labor costs), the old model advances the business myth that any revenue is good revenue. This leads these providers to accept customers who are not as valuable to the firm as others. These marginally valuable customers then take up a firm’s precious capacity, and prevent the firm from reserving this capacity for its more valuable customers.
Reason 2: You don't grasp capacity. The way most service firms were built was by leveraging people, literally building a pyramid structure. The problem is that most firms attempt to build revenue before capacity, always playing catch-up to the workflow and customer demand. This is the inverse of how the majority of other business models work. For example, FedEx, Google, Apple, all build capacity before demand.
Reason 3: Efficiency isn't all that important. The firm of the past tends to focus on efficiency by measuring such things as utilization rates and billable hours. Yet, if you study statistics going back at least 30 years, you will find that utilization and realization rates fall within a very tight range. In other words, whether firm 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 compels leaders to believe efficiency is the be all and end all of running a profitable firm. This is demonstrably false. The buggy whip manufacturers were a model of efficiency before they were replaced by the automobile. So what if you are efficient at doing the wrong things?
Reason 4: Time billing is wrong. Firms of the past worship at the altar of the ABH—Almighty Billable Hour. At least the last two generations of professionals have been told that the only thing they sell is their time. This is unadulterated nonsense, for a fundamental reason: No customer ever buys time. How can you sell something the customer doesn't buy? Customers buy results, not effort.
Reason 5: The whole model is self-contradictory. Improving efficiency decreases revenue at a faster pace than the hourly rate can increase. Often the first time a professional does something it takes 10 times longer than it does the 20th time. Unless the billable rate is increased by a factor of 10 in the time it takes to do this learning, it will decrease revenue. Worse still, since the professional knows this, the incentive to get better at something is reduced. This harms everyone: the professional, the firms and worse, the customer.
But there is a solution.
A Look at the Firm of the Future
The old model does not explain why professionals are successful, nor does it offer viable alternatives to leveraging the critical success factors of knowledge workers in a knowledge economy. The new business model for the Firm of the Future does. Expressed as an equation the Firm of the Future looks like this:
Profitability = Capital management x Effectiveness x Price
This theory has many advantages over the old one.
Advantage 1: It's a profitability thing. Rather than focusing on top-line revenue, the Firm of the Future will focus of the profitability of firm in its entirety rather than the revenue of each customer. Not all customers are created equal, and many firms could stand to lose up to 40-60 percent of their customers. In fact they would be more profitable if they did so. Almost every firm will immediately agree with the Pareto Principle that 20 percent of their customers produce 80 percent of their revenue. Few firms have understood what this means if one flows this concept through to their bottom line. Studies have shown that 20 percent of a firm’s customers produce 150 to 225 percent of their profit. This means that they are losing money on the bottom 80 percent. If they could figure out how to just break even on this bottom 80 percent, they would increase profit from 150 to 225 percent.
Advantage 2: Forget selling time. The Firms of the Future realize that they don’t sell hours. They create and sell, and their customers buy, access to or the transfer of knowledge, not time. This is a far broader view than thinking about leveraging people and hours. It is about leveraging the collective knowledge of its people. A firm’s knowledge or intellectual capital (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.
- Social capital—its customers, vendors, suppliers, referral sources, alumni, alliances, etc.
These components are the real levers of profitability in any firm, not people hours. One cannot leverage an hour; time is simply time, and all businesses (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.
Advantage 3: It's effectiveness, not efficiency. There is not much the average firm can do to squeeze 15-20 percent efficiency from its human capital, which are only fallible human beings. The focus on billable hours has hindered professionals from focusing on being effective for their customers. In surveys of how customers select or why they fire their professionals, lack of efficiency is never mentioned. It is always because of behaviors such as: outstanding service, or lack of service; great knowledge or lack thereof; issues such as they don’t ignore me, they are proactive in looking after my interests; they are aggressive in helping me pursue opportunities. One cannot do all of these things if you are focused on billable hour quotas.
Advantage 4: Work like a business, not a firm. Firms of the future will recognize they are businesses just like the airlines, and software publishers. Businesses have prices, not hourly rates. One would never fly an airline that tried to charge you $4.00 per minute. The idea is simply ludicrous. In fact, firms need to start pricing up-front for everything they do, period. No more excuses.
A Superior Theory
The late Peter Drucker called our times the era of the knowledge worker. We need to significantly adjust leadership approaches to be successful and profitable. He introduced the concept of knowledge workers in 1959, and most professionals have still not come to grips with the significance of this change. The biggest change is that knowledge workers own the means of production—their brains. This is a radical change from the Industrial Era where tangible capital was the exclusive property of the business owner. As Drucker said, “In the knowledge society, the most probable assumption for an organization to make is that they need the knowledge worker far more than the knowledge worker needs them.” This means firms have to earn the loyalty of their employees and inspire them. No simple “tweaking of the comp plan” will work.
Like it or not, knowledge workers are volunteers, and one doesn’t micro-manage volunteers. Unfortunately, most firms still treat their people as if they were “assets” or “resources” and as if they were owned and controlled like machinery or cattle. They try to fit knowledge workers into pre-defined jobs, an idea from the Industrial Era’s organizational chart. But jobs don’t have value, only people do.
The first firms that truly understand what it means to be a Firm of the Future—a professional knowledge firm—will have an enormous window of opportunity to attract, develop and profit from their human capital investors. The firms that do not, will continue to struggle in the competition for top customers and talent. The new theory is the difference between remaining a firm of the past or becoming a Firm of the Future.
The choice is yours.
About the author:
Ed Kless is the senior director of partner development and strategy for Sage. He is a contributor to industry publications, including the Journal of Accountancy and has spoken at many conferences worldwide on project management, pricing, and knowledge workers and delivers regular content as part of the Sage Leadership Education for Accounting Professionals. For more visit http://na.sage.com/leap.