Legal pricing (Part 4): Value pricing basics

In the first post in this series, we noted that the two pricing strategies of greatest interest to law firms are cost-plus and value pricing.  Almost all law firms currently use variations on cost-plus pricing, as we described in Part 2 and Part 3 of this series.  But anyone who has ever heard of the ACC Value Challenge knows how important perceived value is to clients today.

If you have thought about applying value pricing with your clients, you have probably read about the work of Ron Baker.  His most recent book, Implementing Value Pricing: A Radical Business Model for Professional Firms, provides an excellent overview of the theory of value pricing, and how it applies to accountants, lawyers, and other professional services firms.

As Baker defines it (p. 233): 

The word value has a specific meaning in economics: ‘The maximum amount that a consumer would be willing to pay for an item.’  Therefore value pricing can be defined as the maximum amount a given customer is willing to pay for a particular service, before the work begins. This is not to suggest we can capture one hundred percent of maximum value, but rather that we have the potential to access some of it utilizing strategic pricing.

Does that sound like price gouging? It’s not. As Stanley Marcus (former president of Neiman Marcus), put it (p. 22):  “You’re really not in business to make a profit, but you’re in business to render a service that is so good people are willing to pay a profit in recognition of what you are doing for them.”  

In cost-plus pricing, cost is known before you set the price.  In value pricing, you start with the price the customer is willing to pay and control your costs to meet that price. 

Baker sums up the difference in these two diagrams:

Cost-Plus Pricing

            Services  » Cost »  Price » Value » Customers

Value Pricing

            Customers » Value » Price » Cost » Services

Baker feels strongly that value pricing should be embraced by lawyers, and that timesheets and hourly billing should be eliminated. 

His web page bio begins with the mission statement:  “To, once and for all, bury the billable hour and timesheet in the professions.” Chapter 17 of his book Implementing Value Pricing is titled “The Deleterious Effects of Hourly Billing” and describes numerous disadvantages including misalignment of interests, a focus on effort instead of results, hoarding of hours, leaving money on the table, and diminishing the quality of life.  Chapter 18 explains why timesheets should be eliminated.  Its title indicates the strength of Baker’s feelings on this issue:  “Why Carthage Must Be Destroyed”.

Baker (p. 160) also emphasizes that value pricing can sometimes produce far more revenue than the hourly approach.  He gives the example of an accounting firm that was engaged to develop an exit and management succession strategy which produced substantial tax savings. Initially the CPA billed at standard hourly rates, but at some point he said to the client “I don’t believe hourly rates [are]… appropriate [in this case]…  You tell me what all the value of this is to you… I know I will be happy with whatever you come up with.”  Ultimately he was extremely happy, because the total payment was “a little bit over $1 million.” 

By then, he had stopped tracking time on this engagement, so it is impossible to say exactly how much he would have gotten on an hourly basis.  However, he did say his prices had “skyrocketed” and reading between the lines our guess is that hourly rates would have totaled less than $100,000.

Any lawyer would love the concept of value pricing if it meant that she could get paid 10 times what she would earn for billing hours.  And many law firms see value pricing as a ray of hope in a troubled marketplace, an opportunity to increase profitability at a time when there are unrelenting competitive pressures to charge less.   

Baker notes that “These types of engagements are certainly not the rule in any firm, they are the exception.  Nonetheless, they do arise, and when they do it is critical to recognize the value you are creating and to utilize innovative pricing strategies to capture it.” 

Companies like Apple have become very profitable by creating consumer perceptions of value, and pricing products like the iPad and iPhone accordingly.  But there is only one Apple, and there are dozens of companies like Dell, HP, Samsung, Lenovo, and Asus who find themselves competing on price.

A small number of the most profitable law firms in the world have been using value pricing for years, just as Apple has.  But they are at the top of the profession and specialize in “bet the company” work.  If a client is defending a billion dollar law suit, or acquiring a powerful rival, or being accused of a white collar crime, she will care much less about the price than about the outcome.

When Jim Durham published The Essential Little Book of Great Lawyering, he estimated such “bet the company” matters at only about 5% of all legal work.  The rest he classified as important matters (65-70%) or commodity work (25-30%). In the six years since Durham published this book, all signs are that legal commodity work is growing, and “bet the company” and “important” work are shrinking.

In my new Legal Business Development Quick Reference Guide, I’ve written about the traditional marketing implications of these three different types of legal work, as summarized in this table:

Type of legal work	Value’s significance in marketing	Relationships’ significance in marketing
Bet the company	High	Low
Important	Medium	High
Commodity	Low	Low

But the world is changing, and when it comes to getting new business, the marketing significance of providing value is going up, and the importance of prior relationships is going down.

A few weeks from now, we will post Part 5 of this series, discussing the nuts and bolts of Ron Baker’s eight steps to implementing value pricing.  We will argue that the problem with value pricing is an expectations gap.  Law firms want to believe value pricing will lead to higher prices and profits.  Sometimes it can.  But in most cases these days, when legal clients say “value” what they mean is “I need to pay you less.” 

 

This post was written by Jim Hassett and Matt Hassett.