How to calculate your real hourly rate

question mark clockDo you know what your time is worth?

If you’re a professional and you have an hourly rate, you’re probably used to measuring your time in tenth-of-an-hour increments. You keep track of the work you do on timesheets, and then you multiply those totals by your hourly rate. That calculation gives you a value of the work that you performed for your client.

Or does it?

Let’s say that you’re a CPA with five years of professional experience. Let’s further say that you spend an hour working on the audit of a client. Your rate is, say, $120 an hour. By that calculation, at least in theory, the work you performed during that hour was worth $120. And that’s the amount that the client will be charged.

But an hour is an hour. (Einstein’s Special Theory of Relativity is of course beyond the scope of this post.) So what if I spend the hour doing audit work for that client, instead of you? Isn’t it also worth $120?

“No, you idiot,” you say. “You’re not even an accountant.”

That’s true, I reply. But what if I send away for my very own CPA license from an ad in the back of a magazine? Then suddenly I’m an accountant, too. Now is my hour of work on this client’s audit worth $120?

“Of course not,” you scoff. (I get a lot of scoffing.) “It’s not about the license, you maroon. It’s about the knowledge I accumulated over my five years of working.”

Bingo! You just figured the whole thing out. It isn’t the hour of work that creates the value. It’s the knowledge that you’ve accumulated that creates it. You and I could spend an identical amount of time working on that audit, but because I don’t have any knowledge beyond “debits on the left and credits on the right,” the accounting work I do would be essentially worthless. So the single hour on the timesheet does nothing to measure the value that you and I create with our hour.

This is what Peter Drucker meant when he coined the phrase knowledge worker. The value created by a knowledge worker — an accountant, a lawyer, a designer, a consultant, an architect, or an advertising professional — derives from the knowledge that he or she is transferring or applying.

And where does this knowledge come from? It primarily comes from two places: education and experience. So if you’re going to use the amount of time spent to measure the value you create, then you had better account for all the time spent. (You realize, of course, that I don’t advocate trying to measure the value you create by marking the passage of time. I’m just making the point that if you choose that particular metric, you’d better make sure that you’re measuring everything.)

So let’s now try to figure out what your real hourly rate is. First we’ll look at your education. If you grew up in the United States, you were most likely required to go to school from first grade through twelfth grade, plus kindergarten. Most professionals also attended college, so you need to count those hours. Depending on the profession, you probably also attended some graduate school. During all these years of education, you amassed much of the knowledge that you now transfer to your client in your professional life. So you need to add up all those hours.

(Yes, I appreciate that some of those hours are apt to be more valuable then others. You probably learned more things in your second year of law school than you did in kindergarten. Or did you? I don’t remember much from my second year of law school, but I still know what a silent e does. But based on your current timesheet usage anyway, hours are hours. You know that some of the hours you spend working are more valuable than others. You just figure that it all evens out in the end. Using that same assumption, we can measure your education hours as a single total.)

Once you’ve added up your time spent being educated, we need to turn to your professional experience. Obviously, an accountant who has been practicing twenty years knows a heck of a lot more than an accountant who’s only been practicing for one year. So we add up the hours you’ve spent working, too.

So to calculate your Actual Hourly Amount, we need to add your total education hours plus your total professional-history hours plus the hour that you’re doing the actual work for the client. Then we take your hourly billing rate and divide it by that sum. That gives you your Actual Hourly Amount.

You can use this handy calculator to calculate your figure. Just replace the numbers with your own. The grade-school and high-school hours are built in. (If you are reading this post in an email or an RSS reader and don’t see the calculator after this paragraph, click here to go to the post on jayshep.com.)

Surprised? Now that you include all the time that you spent being able to do the work for that client, you suddenly realize that you’re only earning pennies an hour. And I don’t care how experienced you are or how high your billing rate is. Using this calculator, top lawyer David Boies, who bills at $1,220 an hour, only earns one penny for each of those hours when you account for all his knowledge-gathering time spent (education plus 46 years of practice). (I find it ironic that I earned 1.1 pennies an hour, based on 17 years experience and a phantom rate of $600 an hour. I was a very good lawyer, but I was no David Boies.)

Try the calculator with other rates or different levels of professional experience. See what you can look forward to later in your career. Go ahead; I’ll wait.

The point of calculating your Actual Hourly Amount is to show you once and for all that timekeeping is a ridiculous way to measure the value of a professional’s work. I hope that your AHA moment will lead you to realize that the value of the knowledge you sell is based on what it’s worth to your clients when you use that knowledge to solve their problems.

What kind of price is it?

We’ve been hearing about so-called alternative billing in earnest for the last five years. But many professionals today find the definitions confusing. That’s why most law firms claim to use “alternative fee arrangements,” and yet the billable hour is showing no sign of shuffling off its mortal coil.

So here’s a handy info graphic that my VeraSage colleague Michelle Golden and I created to clear up some of the confusion. With it, you can figure out what kind of prices you’re using.

What kind of price is it?

Click it to embiggen. You can also download it as a PDF. Feel free to share it.

How to price mediocrity

I know this lawyer. Let’s call him “Bob,” because, quite frankly, palindromes are fun (and “Stunt Nuts” doesn’t work as well). He’s not the best lawyer in the world; he’s not the worst. In fact, he’s far from either extreme. He’s right there in the middle.

He’s mediocre. When it comes to mediocrity, he’s the best. I’m not being judgmental here; he’s fine. As in when you go to a restaurant and your steak is overdone and your fries are underdone but you don’t want to sound high maintenance so when the waitress asks how your meal was, you say, “Fine.” That kind of fine.

Now because the work that Bob does is mediocre, the very best way for him to price it is by billing his time on an hourly basis.

You see, there is nothing fundamentally wrong with doing mediocre work. It’s incredibly common. In any profession or industry, if you were to draw a bell curve to show the normal distribution of quality, you would see that most performers end up in the middle. Only a few would be truly poor performers, and only a few excel.

And not every customer needs excellent performance. Sometimes, people just want to get the job done adequately, and they don’t want to pay for a higher level of quality when they don’t need to. So I mean it when I say that I’m not criticizing people who choose to do mediocre work. There is certainly a market for it. There are plenty of times when I have chosen not to pay more to get higher quality. If I’m hiring a lawyer to do a basic real-estate closing, for example, I don’t need David Boies to handle that for me.

Because Bob does mediocre work, there’s no need to differentiate the work that he does. The clients who come to him for that level of service all expect roughly the same from him.

For that reason, when all the work and all the clients are essentially equal, then the best way for Bob to price his work is by merely measuring the time spent and multiplying it by his standard hourly rate (which is, unsurprisingly, average for his market). In other words, Bob is effectively “weighing” time on a scale, rather than assessing the value and quality of the work. When a consumer is buying a commodity like sugar, it makes no sense to do sophisticated lab analysis of each individual crystal. Just weigh it. Five pounds of sugar? That will be five dollars, please.

So if Bob is content doing mediocre work for customers who aren’t looking for more, then by all means he should bill his hours. It’s the most efficient way to track his work when all of it is essentially the same. It’s only when work is differentiated — based on the types of customers and the value that they place on the results — that it makes sense to price.

As I said, Bob is fine (as a pseudonymous, palindromic, mediocre lawyer). If you’re a professional and you want to be like Bob, keep billing your hours. But if you’re not interested in being mediocre (or if you suffer from aibohphobia), then it’s time to learn how to price.

Don’t do what you’re good at

Here’s a short (19:47) video of a talk I gave recently at Super Conference II in Boston. In it, I warned over a hundred lawyers that the advice that they’ve been given — “Do what you’re good at” — is actually bad advice. Instead, they should find their outstandingness. (Yes, I know: that’s not in your dictionary. Well maybe your dictionary is broken. Or quite possibly, I made it up. Either way, you already know what it means.)

By the way, even though I was addressing lawyers, this advice holds for anyone in business.

Thanks to the Massachusetts Law Office Management Assistance Program and the Massachusetts Bar Association for hosting the conference and providing the video.

How to increase revenue 43%

Ron Baker, the Yoda of value pricing, spoke about the use of options in his talk at the AICPA PSTech Conference in Vegas today. He showed a terrific short Dan Ariely video, which I wrote about on The Client Revolution a couple years ago. Here is that post, along with the video.

How can you increase revenue by 43%?

Short answer: offer an additional pricing choice. Even a stupid one.

Longer answer: Check out this video. It’s almost perfect. It shows how adding a single pricing choice can add 43% to total sales revenue. It’s presented by Professor Dan Ariely, a delightful MIT economist. And it’s only 114 seconds long.

Why don’t you take the 114 seconds to watch it? I’ll wait …

Here’s the math on the different options:

With two choices:

68 x $59 = $4,012

32 x $125 = $4,000

Total: $8,012

With three choices, one of which is stupid:

16 x $59 = $ 944

84 x $125 = $10,500

Total: $11,444 (an increase of 43%)

OK. Interesting, huh? Ariely’s main point is that customers often aren’t very good at knowing their own preferences, and they take cues from outside indicators of value, such as pricing options. By offering a third choice, even a ridiculous one, customers end up perceiving more value in the more-expensive choice. That’s why Wendy’s sells a triple cheeseburger — not to sell lots of triple cheeseburgers (they don’t), but to sell more double cheeseburgers.

The moral of the story is not to offer ridiculous choices; it’s to offer choices that lead your customers to find differing amounts of value in the various options — something you can’t do if you bill by the hour.

The rest of Ariely’s TEDtalk lecture is here. It’s great, and it’s only 17 minutes long. His book, Predictably Irrational, is here.

What do you think? What kind of options can you offer to help your clients discover their preferences? Share your ideas in the comments below.

Bad advice from Harvard Business Review

Author Rafi Mohammed advises JCPenney to dump what he calls its “risky” pricing strategy:

The best retailers succeed by offering highly differentiated products (as the Apple Store does) or a unique shopping experience (as Nordstrom or Target does). Today, J.C. Penney sells semi-differentiated products and provides a ho-hum shopping experience — it doesn’t have much “mojo” to draw customers into its stores. So what’s the only lever that can excite and bring in customers to make often discretionary purchases? Discounts…

I believe that even if customers fully understand its pricing strategy, J.C. Penney is not going to get the revenue/loyalty windfall that it is hoping for. It’s time to put pride aside and revert back to a discounting strategy.

Mohammed is a very smart guy and he’s written a couple of good pricing books: The 1% Windfall and The Art of Pricing (both affiliate links). But I don’t care for his advice that JCPenney should surrender and return to the brainless approach of discounting. When you rely on discounts, you send a message to customers that your stuff isn’t worth as much as you originally said it was. This is true whether you’re a midmarket retailer, a car company, or a law firm. Discounting belies a lack of creativity.

In fact, Penney’s path to success lies in something Mohammed said above. Since it’s not likely to start selling highly differentiated products like Apple, its best option is to create a unique shopping experience. It needs to figure out what “JCPenney” is supposed to stand for. In other words, something better and more interesting than “also-ran department store.” (And a name change might be necessary, too.)

No one is going to ever say, “Hey, let’s go to JCPenney because they have a new pricing strategy.” Ever.

Writers need to write more, faster

In a front-page story with a bizarre exclamation mark in the title, the Sunday New York Times explains that the growth of the e-book market is forcing writers to churn out more books and stories faster. This of course makes me wish I’d learned how to type properly.

But some authors said that even though they are beginning to accept them as one of the necessary requirements of book marketing, they still find them taxing to produce.

“I have been known to be a little grumpy on the subject sometimes,” said Steve Berry, a popular thriller writer who writes short stories that are released between books. “It does sap away some of your energy. You don’t ever want to get into a situation where your worth is being judged by the amount of your productivity.”

Maybe that’s why writers don’t bill by the hour. Writers know that their value isn’t based on the time spent writing. Instead, it comes from the messages that their words deliver. Of course, you can say the same thing about lawyers. Huh …

The so-called art of billing

Lawyer James Conway describes the art of billing on the site JDs Rising:

This is very simplistic, but you only get paid for things you actually bill to the client. If it doesn’t make it onto the bill, you won’t get paid for it. Remember that quick email you sent from your blackberry? Bill it. Remember that “two-second” question that turned into a ten minute diatribe? Bill it. Remember when your partner walked through your open office door and you had a twenty minute brainstorming session on litigation tactics? Bill it. Unless you express your time, you can’t get paid for it. Further, unless you describe all of your work, your client doesn’t understand all the value you are providing for the fee that you charge.

No wonder people hate lawyers.

It’s not that the “client doesn’t understand all the value you are providing.” If the lawyer thinks that the value comes from the time spent sending a quick Blackberry email, then the lawyer doesn’t understand the value. A lawyer (or any other professional) who understands value prices it. Everyone else just measures time and bills it. And annoys the hell out of their clients.

Libraries are learning that fines don’t work

From The Boston Sunday Globe:

In Carlisle, it was a decision that the library trustees began discussing with Gleason’s director, Angela Mollet, almost a year ago. When Mollet mapped out the financials, she discovered that as a revenue stream, overdue fines are actually as much a cost as a benefit….

Moreover, processing the monies collected from overdue books bears its own costs in terms of staff time, for collecting and reconciling accounts, and infrastructure such as change boxes and safes….

“At the rate we were collecting fines, the management cost was greater than the revenue.’’

Too many businesses use fines and penalties to control customer behavior, usually without success. These “sticks” are more likely to cause resentment rather than encourage the desired results. Companies who resist this temptation, like the libraries in this article, give their patrons more credit while suffering no downside:

But she says that most library users seem to have a moral compass that compels them to return items punctually, and there has been essentially no discernible difference in the amount of time that people keep materials since the library began its no-fines policy.

Does your company penalize its customers? Might be time to rethink that.

Airlines struggle with cuisine, common sense

Interesting piece on airlines’ attempts to improve the quality of inflight dining. The article, by Jad Mouawad in Sunday’s New York Times, showed the efforts and difficulties of making food suck less while you’re trapped in a metal cylinder six miles above the ground. And I’m happy to give the airlines credit for trying to make the food better.

But one thing jumped out at me: the airlines’ focus on cutting costs. For example, Delta carefully tracks how much money it can save by diminishing its culinary offerings:

A decision a few years ago to shave one ounce from its steaks, for example, saved the airline $250,000 a year….

Delta also calculated that by removing a single strawberry from salads served in first class on domestic routes, it would save $210,000 a year.

I appreciate that the airlines have struggled financially since 9/11. But for every nickel saved on removing a passenger’s strawberry (who puts strawberries in a salad, anyway?) or fifty cents saved on offering an ounce less steak, there is a passenger whose experience on a long and expensive flight just got a little bit worse. Delta and the other airlines would do better to focus on improving their customers’ experiences, and then add 55 cents to the price of the ticket to cover the strawberry and extra steak. I’d pay it. Wouldn’t you?

Kudos to JCPenney for simplifying its pricing

Can new JCPenney CEO Ron Johnson turn around the fortunes of the ailing department store? He certainly hasn’t wasted any time making changes. The former head of Apple’s retail arm recently announced that Penney was radically restructuring its pricing strategy to make it simpler and less dependent on discounts:

“The customer knows the right price,” Johnson said. “To think you can fool a customer is kind of crazy.”

In the past, only 0.2 percent of sales came from full price items and Penney’s 590 unique promotions a year were confusing and failed to draw shoppers, he said.

Discounts are almost always a bad idea, as it makes it impossible for customers to discover the value of what you’re selling. And complexity in pricing inevitably frustrates customers, and sends them to your competitors. It will be interesting to see if these changes are in time to save JCPenney.

Two kinds of lawyers

There are only two kinds of lawyers in the world:

Lawyers who price, and lawyers who don’t. Everything else is lip service, or window dressing, or sleight of hand.

Lawyers who price work very hard to try to figure out what their client’s needs are and what the value is to the client of satisfying those needs. They then come up with a price that is less than or equal to that value, and they tell the client that price before performing the service. The client either accepts that price or does not, and if so, the lawyer does the work at that price. And the price for that service doesn’t change. If the needs unforeseeably change, then a new price will be arrived at. But remember: we’re talking prices, not estimates.

And that’s it. It’s that simple. (It may not be easy, but it’s simple.)

If you don’t do this, then you’re the other kind of lawyer: the kind who doesn’t price.

Obviously, lawyers who bill their time make up the bulk of this category. Telling a client what your rate is and then giving a vague estimate of the time you think you might spend is not pricing. Not by a long shot. Making adjustments to the bill at the end of the month to put the total amount more in line with the value delivered is not pricing. Tracking your time to try to determine any kind of concept of value is not pricing.

Capped hourly fees are not pricing. Blended rates are not pricing. (They’re just a ripoff.) Hybrid fees are not pricing. AFAs (“alternative fee arrangements” — the in-vogue thing to call different alternative billing schemes) are not pricing.

Giving clients a choice between a price and hourly billing isn’t pricing. It’s a copout, and it tells the client that you don’t believe in the value of your services. Tracking your time to see if your “losing money” on priced engagements is the same kind of copout.

Project management is not pricing. Six Sigma is not pricing. Neither is Lean Six Sigma. Or Portly Six Sigma. Or whatever. (And I don’t care if you’re a black belt, orange belt, or a braided-leather belt with a giant John Deere buckle. It ain’t pricing.)

You can go to all the two-day seminars on AFAs you want, but mostly you’ll be learning about Not Pricing. Your time would be better spent learning about your client and how they value the solutions to their problems and whether you can make a profit solving their problems for that amount.

That’s pricing.

Originally published on The Client Revolution

There are only 2 types of law-firm fees

If I read another article about “alternative fee arrangements” or hear of another two-day seminar explaining all the various and complicated AFAs out there, I’m going to try to swallow my tongue. (Disclaimer: This is of course hyperbole. I’m not going to do that. And don’t you try it either, just to see if you can do it. You can’t. End of disclaimer.)

Lawyers beholden to the Prohibition Era model of billing and the consultants who court them are desperately trying to show how complex and scary AFAs are. The clients and other lawyers who read these articles and go to these seminars walk away shaking their heads and surrender to sticking with the old billable-hour model. Maybe with a discounted rate, please.

But I’m here to tell you that it is not at all complicated. In fact, if you have seven seconds, I can tell you about all the different types of law-firm fees. Ready?

There are two:

  1. Time-based pricing
  2. Solution-based pricing

That is all.

No, really. It’s no more complicated than that. Time-based pricing is what nearly every law firm does, where the price of the legal services depends on the time spent doing the work and the rate of the “timekeeper.”

(In truth, I’m being generous here, because it’s not really “pricing” at all. Pricing is when you tell the client what something will cost them before they buy it; time-based law firms don’t do that at all.)

Under the time-based-pricing model, invented in 1919, every activity is worth the same amount on a minute-by-minute (or really, six-minute-by-six-minute) basis, regardless of how important the task is. With few exceptions, every client is charged the same per hour, regardless of their differing needs. The only measurement of value is the amount of sand that has dropped in the hourglass.

Solution-based pricing is when a law firm sets a price based on the value of the solution to the client. It’s that simple. I’m not saying it’s easy, because it’s not. It takes a lot of thought and preparation and understanding and empathy and experience to figure out how much this particular client values this particular solution at this particular moment. But that’s OK because we’re professional knowledge workers, not pieceworkers in a pin factory.

Clients — simple question: Do you want the price of your legal work to be based on the time lawyers spent, or on the value you place on the solution? It’s one or the other.

(See, I just spared you that two-day seminar on AFAs. You’re welcome.)

What do you think? Can you come up with any other methods? Bet you can’t. But give it a shot in the comments. (I particularly look forward to time-based lawyers protesting about how hourly billing is a kind of solution-based pricing. Good luck with that.)

Originally published in The Client Revolution

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