I’ve talked a lot over the years about how hourly billing problems can destroy profitability in small service businesses. But a new service business owner asked me recently to explain again, in detail, how hourly billing hurts a service firm.
I’m going to repeat here the comments I shared, hoping they help other small service businesses escape the rat race called “hourly billing.”
How Hourly Billing Works
Just so we’re all on the same page, however, let me go over how hourly billing works.
With hourly billing, you bill someone some specified rate for the number of hours you work. For example, if you bill your time at $100 an hour and a project or task takes 5 hours, you bill $500 for the work.
The appeal of hourly billing is that it sort of makes sense at first blush. And you can imagine (if you’re new to business) that the approach guarantees you a certain base level of profitability.
But as many professional service firms have found out the hard way, the hourly billing system can actually destroy profit.
The Hourly Billing Alternative
The alternative to hourly billing is to simply set a fixed price for your service. In other words, you might bill $500 for some service which you used to bill based on hours and a hourly billing rate.
Some people, not surprisingly, call non-hourly billing “fixed price” billing. Some people call non-hourly billing “value billing.”
And note: With non-hourly-billing, you probably do look at the hours a project or task takes, since that’s an important variable in determining your profitability and probably an important variable for competitors setting prices. But what you mostly look at is how the customer or client gets value from the project or task
And with this background information, let me quickly identify the six big problems with hourly billing…
Hourly Billing Problem #1: Focuses Customer Attention on Rate and Hours
A first obvious problem: If you or I bill by the hour, we call attention to our hourly billing rate and the hours we estimate the project will take.
That seems reasonable, but what it means usually is that the next step is a discussion of either or both the rate and the hours with customers or clients. And that’s regularly an unprofitable discussion to have.
Quite understandably, customers or clients tend to think two things: First, they wonder why the hourly rate is so high (unless they’re in a service business)… Second, they’ll worry that the hours you quoted or estimated will turn out wrong.
Both you and your customer really will be happier with something like “Well, we charge a flat $500 for that service.”
Compare this statement to what you really don’t want to say, “Well, it’s $100 an hour and I think it’ll take five hours.”
Both pricing approaches probably result in a $500 invoice. But one approach seems wishy-washy and almost invites a discussion of detail there’s really no reason to dig into. Yikes.
Hourly Billing Problem #2: Focuses Employee Attention on the Wage-Billing Rate Differential
A second problem regularly appears if you have employees on the team billing their time: If your firm bills by the hour, that approach can tend to focus employee attention on the difference between the employee’s hourly pay and the hourly billing rate. Some team member who you bill at $100 an hour and who you pay $20 an hour, for example, reasonably wonders about that $80 an hour gap.
But what gets missed if any of us superficially looks at something like an $100/hour vs. $20/hour chasm is that the employee will get paid many hours that aren’t actually billed: paid time off for vacation or personal leave, training, and also probably administrative work. (In an accounting firm, for example, the goal is to bill three of every four hours an experienced staff person gets paid for and maybe two out of the four hours an inexperienced staff person gets paid for or a partner works.)
Furthermore, not all work for customers or clients get billed or collected.
Finally, team members looking at a wage-billing rate differential often don’t remember to include the variable costs of their work (like payroll taxes). And then often don’t know the fixed costs that need to be paid out of that wage-billing rate differential.
Much of the wailing and gnashing of teeth that flows from employee angst about the wage-billing rate differential can go away if a service firm simply charges a flat price like $50 or $500 or $5000 or whatever for some service.
Hourly Billing Problem #3: Penalizes Investments in Infrastructure and Human Capital
A third problem isn’t obvious until you’ve used hourly billing for a while… That problem is the way the approach penalizes your investments in your business. But a couple of examples illustrate how this penalty occurs.
A first example: If you can buy a $50,000 piece of equipment that lets every team member do their job in half the time, hourly billing destroys your profits if you continue to bill time at (say) the same $100 an hour you used before buying the new equipment.
You see why, right? You’ve made a big $50,000 investment in equipment. And the investment produces giant gains in efficiency–a doubling of output. But the firm doesn’t get anything for the investment if you’re billing people by the hour at the same old rate. You only lose with your investment. And actually you lose twice: You lose (really you waste) the $50,000. And then you lose half your billing.
Note: You can try bumping the hourly rate to $200… but this just lets you experience all over again problems #1 and #2. And note that you’ll need to reset hourly rates every time you buy some new piece of equipment if you’re using the hourly billing approach. Ugh!
A second example: What if you can invest $10,000 per person to get great additional training for five team members. Let’s pretend this $50,000 investment, though it takes people out of the pocket for a month, will let you double the efficiency of your people. Sounds good right? Well, it isn’t unfortunately.
In this case, you actually lose three times: You essentially waste the $50,000 you spend training people because you get nothing for it. You lose half of your billings when people do the work in half the time. And you also pay team members for the month you’re training them.
The two preceding examples seem pretty negative. But at the end, with an hourly billing approach, investments you make in your business actually only hurt firm profits. And that’s crazy if you think about it. Just crazy…
Hourly Billing Problem #4: Leads to Inefficiently Designed Services and Processes
A quick fourth point related point #3: With hourly billing, the service firm gets no reward only penalties for well-designed products and services and for well-engineered processes.
For example, if the firm creates a clever new recipe for delivering some service in one hour rather than the industry-standard three hours, hourly billing gives the value created by that recipe to the customer if you continue to bill by the hour.
Yes, yes, this sounds nice enough if you’re a customer, I guess. But this approach—the approach inevitable with an hourly billing model—totally removes incentives for the mature service business to become ever more efficient. That’s not good.
Hourly Billing Problem #5: Fosters a Sweat Shop Culture
A fifth problem about hourly billing: Focusing on hours and the billing rate tempts us to bump profits simply by working overtime.
Many service businesses take this route to increased profits unfortunately… but overtime eats away at the work-life balance for firm owners and employees and risks creating a sweat shop situation. (Overtime should be an exception handling technique, not a standard practice.)
Hourly Billing Problem #6: Profitable Products
A sixth and final and somewhat fuzzy problem with hourly billing based business models: The hourly-billing approach, by causing owners to focus on selling hours, allows owners to de-focus on developing high value products and services for customers and clients.
If our focus is on selling and then billing for hours, for example, we naturally focus on the hours sold and billed. But that’s not really a very customer-centric way to sell work.
If instead our focus is on selling and delivering services, we hopefully focus on the services and on the value they provide to the customer. That focus on the service and its value can lead itself to a more attractive offer in terms of the client’s needs and wants.
Here ends the rant.