Incentives Matter

Sift Media
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Even ardent supporters of hourly billing will admit that there exists, right from the start, a conflict between the professional's interest and the customer's. When you make hours important, then the customer is bound to focus on hours, rather than value. Those professionals caught "padding" their timesheets because they believe the value of what they created exceeded the price measured in hours will lose the respect of their customers.

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. Cost-plus is the antithesis not only to effectiveness, but even the pursuit of efficiency. Customers are beginning to recognize this, which explains why many sophisticated customers--such as Coca-Cola, Procter & Gamble, Pfizer, Cisco, among others--are innovating new pricing paradigms with their advertising agencies and law firms.

Incentives matter, as any good economist knows. No one washes a rental car and you should not ask your hairstylist if you need a haircut. While I am not arguing that hourly billing causes unethical behavior--although it certainly has--it is a system with a built-in conflict of incentives. Aligning incentives is difficult enough to achieve without the added burden of an inherent conflict in how your price your services.

One of the reasons why procurement and in-house counsel will audit their law firm's or advertising agency's overhead costs, labor rates, full-time equivalents, etc., is because they are insuring compliance with their processes and procedures. Since they have no way to determine the results until after the fact, they obsess on the inputs. If you change the incentives, however, you make the processes and compliance obsolete.

No better example exists than the convict ships that took criminals from England to Australia during the eighteenth century, as told by Charles Bateson's The Convict Ships. At first, the captains were paid based upon how many prisoners boarded the ship in London. This gave the captain the incentive to pack as many prisoners onto the ship, regardless of the health or safety of the prisoners, for the six-month journey. In addition, the captains usually hoarded the food so they could sell it upon arrival in Australia. This created a mortality rate of nearly one-third for the prisoners. Those lucky enough to survive the journey arrived "lean and emaciated" and "full of filth and lice."

There are many ways of dealing with this problem from a "process and compliance" point of view. One could pass a law, such as Sarbanes-Oxley, that forced captains to comply with procedures for limiting the number of passengers, assuring an adequate diet, competent medical care, sufficient food and medicine on board, and so forth. In fact, you could even hire external auditors to attest to the compliance of these standards.

From an economists' perspective, all of this is quite bureaucratic, expensive, ineffective, and unnecessary. If a way can be found to align the incentives, the processes and compliance will take care of themselves, which is exactly what happened. Once the compensation was changed from paying for each convict loaded in London to paying for each one that arrived alive and well in Australia, the "financial incentive to treat convicts humanely" dramatically improved. The first three ships to sail under this new compensation plan experienced only two deaths out of 322 prisoners. As Bateson concludes, "the gross abuses earlier practiced were almost entirely eliminated" (Bateson 1969: 20-21).

This type of thinking must be applied to the billable hour, which is vulnerable to thought. Firms need to stop dealing with the symptoms of the billable hour--penalizing partners and associates for write-downs and write-offs, appointing administrative people to hound customers for speedier collection, insisting that timesheets are submitted on time, etc. All of these processes will amount to nothing because they do not deal with the cause, only the symptom, like plunging a thermometer into ice water to deal with a fever.

To align the incentives between the firm and the customer, a fixed price should be agreed upon, up-front, before any work begins. This way, the customer can make the vital price/value comparison, knowing exactly what their accounting cost will be, just like everything else we buy as consumers--we know the price before we buy it.

It also protects the firm. After all, when would you rather learn that the customer does not like your price--before or after you've done the work?

Look for ways to align incentives with your customers and employees, and you will have a much more effective firm.

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