This week I was planning to post a step by step guide for succeeding with fixed fees.
But then several experts raised important issues about last week’s post, so I decided instead to expand my discussion about the most important issue in fixed fees: how do you set the price?
Litigator Pat Lamb has an enormous amount of real world experience in this area. In case you missed his post “The Problem with Most Fixed Fee Proposals”, I am reproducing the entire item below:
Jim Hassett's latest in his series of posts on alternative fees is now available. This is a very important post on how to set a fixed fee. Jim notes that there are two ways of getting to a fixed number, cost plus pricing and value pricing. In the former,
estimate what you think it would cost to perform the work on an hourly basis, and then add a safety margin to cover unexpected developments and profit.
This is how most firms calculate a fixed fee and why clients refuse to accept these proposals. Let's start with the "what it would cost on an hourly basis" part of the calculus. Hours times hourly rate. See any problem? To start with, hourly rates include a very hefty profit margin. The lawyers also have no incentive in calculating the fee to be skinny on the hours. The problem is then compounded by "adding a safety margin" (the proper translation of this is "more profit"). So law firms typically come up with a fixed fee that guarantees them more profit under the fixed fee approach than they would get under the traditional hourly system.
What risk has the firm assumed in this approach? None. Well, some might say that "what if" the case turns into a runaway train? Most who quote a fixed fee identify the assumptions on which the fee is based and if those assumptions change, will submit a modified proposal. So, in the end, very few firms assume any real risk.
The thing that makes a winning fixed fee agreement is a quote that is lower than the fee that would be paid under an hourly basis, which then creates huge incentive for the firm to do the work at a lower cost (and I mean cost in the traditional sense of the word, not the lawyer sense) so that the firm increases its profit margin. Client wins. Firm wins.
I leave with one final thought. The second most frequent concern expressed after the "double profit" concern just discussed is that the firm will allocate inadequate resources in order to maximize the profit margin (translation--increase the risk of a bad result). The holdback or bonus component based on the result is an absolute answer. Fees are all about the client identifying that which is most important to them--for most the top two are cost and result--and structuring the fee to maximize the firm's incentive to accomplish those objectives while at the same time giving the firm the incentive and latitude to do the work as cheaply and efficiently as possible.
I agree with everything Pat says, especially his emphasis in the last paragraph on using bonuses to align the interests of the client and the firm. But I see this as an argument against doing cost-plus estimates badly, rather than against doing them at all.
As I noted last week, I think both cost-plus and value approaches to pricing can be useful, and often recommend “a hybrid approach, which starts from cost-plus estimates, and uses value pricing to determine the size of the safety factor.”
When you are preparing a fixed fee bid, the most important goals are to win the work, and to bid a price that makes business sense. Unless you see the work as a loss leader that opens new doors, you must at least cover your costs. Starting out by estimating the hours the work will take is the key to doing this.
But, as Pat pointed out, if you start with the hourly rates clients pay, you will be including both your true cost of doing business and profits. If you then add a conservative worst-case safety factor, the fee is likely to be unreasonably high, and you will probably not get the business, especially as other firms get better at fixed fee pricing.
Another response to my recommendations came in a long thoughtful email from value pricing guru Ron Baker, which said:
Here's where we depart. When you write:
As for trashing timesheets, I’ve done that myself at times, but only when my company was small. And even when I was the only employee, if I signed a contract for a complex or unpredictable job at a fixed price, I tracked my time so I could analyze profit or loss at the end.
In my experience, the more employees I had working for me, the more important timesheets became in tracking productivity and profitability.
We have large firms that don't do timesheets. One is an ad agency with over 350 employees, another is a Top 100 accounting firm that has around 275 employees, that is getting ready to trash them at the end of June. Size simply doesn't matter. Timesheets are the "illusion" of control. You can't tell how good (or bad) an attorney is from a timesheet, nor can you measure their productivity because they only look at inputs not outputs. Further, knowledge work requires a judgment (usually from another knowledge worker), far more than a measurement.
This is why effectiveness is always and everywhere superior to efficiency. Would you rather have an effective or efficient heart surgeon? It's not a flippant question, as it goes to the heart of the issue.
There's no such thing as "generic efficiency." It all depends on what customers want and are willing to pay for. My car is incredibly inefficient, as it sits idle most of the time. However, when I need to go somewhere, it's incredibly efficient. To say a lawyer needs to be more efficient is quite silly without being specific about what you mean. Once you are, you realize effectiveness is what clients want. Was Einstein efficient? Was he on budget? Who cares. Businesses aren't paid to be efficient, they are paid to create wealth for their customers. (For more on this, see my post entitled “Pigs, Productivity, and Purpose”.)
Moreover, timesheets are not a cost accounting tool, since the hourly rate has a profit built into it. So you tracking time tells you nothing about real profitability, only opportunity cost, which again, has nothing to do with external value created for the customer. There are other ways to perform cost accounting. Also, cost accounting has to be done BEFORE you do the work, for what possible benefit is there in knowing after the fact that the customer didn't like your price. In the real world, price determines cost, not the other way around. This is how Toyota is able to run without a standard cost accounting system, which should send a chill down anyone's spine that believes timesheets are necessary for cost accounting.
If you agree that Value Pricing is the correct theory (as opposed to cost-plus pricing, another issue where I strongly disagree with you) then it follows that timesheets must go. This has been empirically proven by the firms that have trashed them. Read some of their stories in the Trailblazers section of our web page to see just how useless timesheets are in a Value Pricing environment.
In this case, Ron and I will have to agree to disagree.
Both law firms and their clients have several decades of experience thinking about cost in terms of the hours each matter will take. And there are good reasons for this approach, since ultimately most of the cost of doing the work will depend directly on the number of hours it takes, and the salaries lawyers are paid. In my opinion, asking law firms to throw this experience out the window is counter-productive.
To get better at pricing, you need to measure which matters produce the largest financial returns, and which people within the organization do. Tracking the time and money spent on each matter is the simplest way to measure that financial return.
In the long run, perhaps the legal profession will change so radically that value pricing will become the dominant system. But in this economy, most firms will need to focus on the short run, on generating enough revenue to survive and prosper with cost-conscious clients. And to accomplish this, they will need to learn how to win with fixed fees, by starting from a cost-plus estimate.