CentreSource, being a service provider, continues to evaluate the ideal billing methods for the various projects we accept. Originally, we solely focused on project billing – but various problems sent us back to the safe world of billing by the hour. Recently, we encountered a firm that conducts value based billing – and it prompted me to consider varying merits of each billing method.

Introduction

Over the past 2 years, I’ve continued to analyze the various billing methods associated with a services firm such as CentreSource. My research thus far revolves around three major methods:

Billing based on:

1. Total Hours spent
2. Project
3. Value Provided by the work

In this multi-part series, I’ll give a brief overview of my findings in each area. Each section will provide analysis based on the following criteria:

• Profitability – How profitable can a service provider be with the method?
• Alignment - Does these billing method align the service provider and the customer?
• Management - How easy is it to invoice and collect your money?
• Risk - What are the chances that a billing method can hurt your business?

Before we begin, I’ll point out that CentreSource bills primarily by the hour, with an occasional project based bid.

Billable Hours – Time on the Table

The most basic form of service billing, total invoice value is the calculation of total hours worked multiplied by the agreed hourly rate. Before projects such as these start, a service provider will convey to the client the hourly rate, and often an approximate time required to complete the task. For larger projects, the service provide may provide a reduced rate in return for a guaranteed minimum amount (or possibly a pre-payment).

Profitability: Average

In terms of profitability, hourly billing has its upsides and downsides – thus its average rating. On the upside, you can easily calculate many metrics needed to make your business profitable. If you know your employee’s hourly cost, you have your first metric – they should bill more than their cost!

Billable Hour firms have many ways of setting their rate. They can review industry competitors and set their price accordingly, or they can also see what someone with their skills would make as a salary and add a hefty premium. Once your firm establishes its rate, its easy to calculate the profit margins on hours that are worked.

This leads us to the downsides of profitability – the ceiling of available hours! A major criticism of billable hours is the lack of ’synergy’ available to achieve fast growth and higher profit margins. There are only so many hours in a year for a person to bill – they cannot create more hours. For a service provider, they can expect their employees to bill 6+ hours in an 8 hour day. Time is lost to a variety of factors such a internal meetings, personal time, and ‘lost’ time associated with switching between tasks and projects. All of this leads to ‘non-billable’ time.

One last major downside of Billable hours relates to an employees tendency to ‘forget’ certain segments of billable time. If a client calls and speaks to a service provider for 5 minutes – many times that call will go un-billed. The same is true for a client that asks you to ‘give an estimate’ on doing XYZ – again, typically un-billed by employees. All of this is leaving time on the table and decrease the profitability of the service provider.

Alignment: Very Low

Perhaps the biggest downside to Billable hours is the lack of Alignment between the service provider and the client. The client wants the service provider to work as fast as possible to reduce the total cost associated with the project. The service provider desires the project to take longer so their revenue is higher. Ethics and the desire for repeat business drive the service provider to work as efficiently as possible on the project.

Its also important to note that the service provider ‘feels’ the pressure of billable hours – just like the client. If the service provider gave a ‘time’ estimate, it becomes very uncomfortable if the project takes longer than anticipated. A vicious cycle can occur where the service provider tries to work ‘faster’ to reduce the time overage – often causing more problems or sub-quality work.

Management: Straightforward, but tedious

Time tracking can be very complicated – especially for service firms that have employees on multiple projects at one time. It takes serious focus for an employee to accurately track their time for an entire day – especially if they experience multiple interruptions such as phone calls, email, and other internal requirements. Every time they forget to track that time, the service provider has lost money.

Clients also demand greater detail on project work if the service provider charges by the hour. For long projects that have hundreds or thousands of hours, clients may request detailed breakdowns of time – including what was completed per time block. This is a huge documentation requirements on the part of the service provider – and can lead to various billing issues where clients may challenge small segments of time/tasks.

Risk: Lowest

The great benefit of billing for time is that it effectively guarantees a service provider will be paid for their work – and at a predictable rate & profit margin. Many firms choose Billable hours for the security of its predictable nature – and its non-complicated: you get paid for the time you work. This affords great flexibility when it comes to ‘unknowns’ and ’scope changes’. If a service provider is billing hourly, then they are protected should factors increase the time needed to complete the project.

Hourly billing is also very effective at managing the client’s request list. When a client knows that they will pay for each hour, they are less inclined to ask for things that are not essential to the project – a fact that should not be forgotten as you review the other billing methods.

For a other perspectives on billing by the hours, read these:

• http://civpro.blogs.com/civil_procedure/2004/04/billable_hours.html
• http://www.law.yale.edu/outside/html/Career_Development/cdo-billable.htm
• http://www.aicpa.org/pubs/tpcpa/junjul98/hatehour.htm

Projects – Masterful Guessing

For service providers that know their product & execution methods inside and out, project billing is a powerful way to increase profit margins and align your goals with that of the client. However, project bidding is not for the faint of heart. Its very easy to make a mistake in your bid and ultimately lose money on the project.

Profitability: Depends on Skill

For a service firm that has a highly rigid process with very few variances, project billing affords a great opportunity to increase profitability by being more efficient. Evaluation of standard procedures can uncover little bottlenecks that can be eliminated to increase profits – without changing the price to the client. Project bidding also allows a firm to ‘pad’ the cost estimate to account for unknown factors – giving potential upside if those never materialize.

Service firms that effectively execute project billing often find ways to re-use the work they’ve already completed in the same area. Examples include law firm that use base contract templates to modify for each client – while still charging the full price as if they had to create from scratch (billable hour method). For software development firms, they can re-use standard code objects while still bidding based on the ‘calculated’ hours it would have taken to build from scratch. This breaks out of the confinements of billable hours and can increase profit margins.

However…

For those service firms that do not know their products & services inside and out, project bidding is a quick way to lose money for the firm. If a service firm agrees to do a project for X dollars, miscalculating can be catastrophic to the bottom line and resources in the firm. Be careful…

Alignment: Average

Originally, I thought project bidding would put us perfectly aligned with the clients desires. However, project bidding has a major weakness – quality. In start contract to billable hours, project billing encourages the service provider to get the project done quickly and with the least amount of cost possible. Just like billable hours, these tendencies must be controlled by the service provider’s ethics & desire to obtain repeat business.

Management: Its own Extreme Sport

The hardest part to project billing is the actual management. When a service provider first analyzes a project, its imperative that all aspects (scope) of the project be documented and agreed upon by both parties. To be specific, many project management guides suggest detailed documentation with bulleted entries outlining each deliverable in the project. This process can take many hours by itself – thus making project bidding very difficult in areas that have many unknowns and undefined parameters. This one point alone can eliminate the option for project bidding for many service providers.

When the scope isn’t properly defined, managing the project can be nearly impossible. Clients inevitably will ‘assume’ that items were included in your initial bid – even though you explain it will take 50% longer to do the project due to their request. In addition to their hidden requests, there can also be a long list of ‘changes’ that will become a never ending time drain while the client decides what they want. These risks are enough to scare many firms away from project billing and back to the arms of Billable Hours.

From an invoicing standpoint, project billing is typically the easiest in that both parties agree on a specific payment timeline based on phases or deliverables.

Risk: Possible Show Stopper

Continuing with the theme outlined in management, Project Billing is a VERY, VERY risky endeavor. Risks can range from loss of money to actual legal obligations that may result in the service provider being sued for breach of contract. For some companies, a single mis-estimated project can be a show-stopper… leading to the actual demise of the company.

Project billing risks can be mitigated in various ways, including:

• Slicing the project into smaller estimates/agreements – This gives the service provider a chance to cut their losses if they grossly miscalculated the scope of the project. In addition, it also allows you to add time you lost in one phase to the next phase – so you’re not losing money.
• Know your processes and work requirements inside and out – If a service provider cannot easily analyze the time required to complete a similar project, they should NOT try to conduct Project Billing. Time & resources are precious – be cautious with them.
• Document all agreed upon deliverables – Spend extra time at the beginning of the project to ensure that all deliverables are agreed upon in writing. Have the client agree that anything not in writing will be extra.
• Stick to the document – Inevitably, some gray areas will arise in the project. Be prepared to refer to the deliverables document if the gray areas get out of hand.

Value Billing – The sky is the limit

The utopia of the billing world is Value Based billing. Books such as ‘Million Dollar Consulting’ by Alan Weiss encourage service providers (consultants specifically) to frame their projects so they can bill based on the value provided. For many areas, this is very hard to do, but if possible – its very rewarding. Before we analyze on the 4 factors, I’ll describe 2 value billing services I’ve recently encountered:

• Phone Records Review – A firm will come to your business and audit your phone records for discrepancies and overcharges. They will also help you negotiate with your phone vendor. Their billing rate is 50% of the total savings they provide.
• Search Engine Optimization – A firm will conduct an analysis on your ecommerce site, modify your site to rank higher in the search engines, and ultimately increase your online sales. their billing rate is 3% of total revenues for 1 year.

Profitability: From zero to infinity!

Value billing is a very interesting notion when it comes to profitability. Granted, the downside is that you will make nothing – thus losing money on the project due to your invested time and resources. However, most value billing propositions arise when the service provider KNOWS there will be something to achieve, even if they cannot gage the exact amount.

That being said, value billing has the potential for serious profitability. And depending on how the service provider structures the deal, those profits can continue for a long period of time.

Alignment: So happy together

Value billing is the perfect method for alignment with the client. The better you perform, the better results they receive, and the more you get compensated. In fact, it often takes ethical management on the side of the client to make sure they honor their end of the agreement.

Management: It better be measurable

The toughest part of Value billing is actually measuring the value. For most service providers, value billing isn’t an option because their work 1) Doesn’t have a measurable value other than what they would charge 2) Cannot be evaluated as to how it brings value to the overall organization.

If you determine that part of your services can apply to value billing, make sure you determine a way to measure the value provided. It can be in direct savings, increase to the bottom line, or even metrics related to productivity.

Risk: Its all about pre-screening

The downside risk is that you do not receive any compensation for your efforts because you created no measurable value. To remedy this, the service provider should conduct a ‘pre-screener’ to make sure that their value based service is appropriate. Once the service provider determines the need, they must document the ways in which they intend on measuring the value added. Subjective measurements will not work – both parties must be able to objectively define & measure the value.

I feel I should note one final risk: Make sure you get your value based fee in a contract. Once the service provider completes the work and the value payments begin, its not uncommon for a client to feel the work was not worth the fee. This ‘after the fact’ feeling can lead to a reluctance to pay the initial agreed rate.

Conclusion

Service firms have many options available when deciding what to bill for their work & resources. They must choose the method that affords them the greatest profit, while protecting them from the most risk. For most firms, Billable Hours is the easiest method to accomplish these goals – but its also the most limited in terms of growth. Human capital (and time) will be a major hurdle for any firm wishing to stick with billable hours.

As for the other two methods, Project & Value billing, the service provider should be acutely aware of the risks involved. These methods require excellent mastery of timelines, cost projections, and economies of scale. Ignore them at the peril of your profits, your reputation, and possibly your firm. I suggest you start small and choose your projects carefully.

Remember, not all service providers can open bill by project or value (example: lawyers). They are restricted by their competitors and ‘history’ to bill by the hour. For these firms, they can utilize an interesting hybrid of hourly billing based the time it WOULD have taken a normal firm to complete. This is completely acceptable as long as your prices are fair to the client.

Regardless of the methods you choose, your will encounter billing issues. The most important choice you can make is to be open, honest, and fair to your customers – and your business.

Good luck!