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NEWS

FT Mastering Strategy article - 'Lessons from professional services


firms'
8 July 2000

ANNUAL REVIEW E-BROCHURE


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"WHAT EXACTLY ARE


PROFESSIONAL SERVICES
FIRMS? HOW DO THEY
WORK? WHAT CAN WE
REALLY LEARN FROM
THEM? IS IT CORRECT TO
THINK OF THEM AS ROLE
MODELS FOR BEST
PRACTICE NOW OR IN
THE FUTURE?"

Summary
Professional services firms like McKinsey and Andersen Consulting are
increasingly held up as a model for other businesses - but according to
Laura Empson the picture is more complex. In this article she describes how
such firms operate and how they are organised. She explains the key
concept of "leverage" which not only underpins their knowledge
management strategies but drives profitability. And she argues that they
need to be particularly adept at managing market perceptions - "seeming"
knowledgeable may be more important than "being" knowledgeable. There is
much diversity within the sector; the fact that these firms account for 17 per
cent of all employment in the US and Europe indicates that they are an
important phenomenon in their own right.
In his recently published book, The Intellect Industry, Mark Scott boldly
states: "the professional services firm is the model of the firm of the future".
Whereas the "excellent" companies of the early 1980s were usually drawn
from manufacturing and retailing, professional services firms like McKinsey
and Andersen Consulting are regularly cited as models of best practice by
current management writers. This raises a number of questions. What
exactly are professional services firms? How do they work? What can we
really learn from them? Is it correct to think of them as role models for best
practice now or in the future?
One term, many meanings
Before we can accept that the professional services firm presents a model
for all companies in the future, we need a clear definition of what a
professional services firm is.
This is no simple task. Surprisingly there is no consensus about the
meaning of the terms "profession" and "professional".
While many people like to refer to themselves as professionals (after all the
term does imply high status and high rewards), the number of individuals
who qualify according to the formal definition of the term is relatively small.
Strictly speaking, a professional is someone who has won the right to
membership of a professional association by completing an accredited
programme of training and examinations. This definition represents a very
narrow group of organisations - accountanting, law, architecture and
engineering practises.
But Mark Scott does not mean to imply that all companies should model
themselves on legal practices. In common with other important writers in this
field, like David Maister, Mats Alvesson and Bente Lowendahl, he uses the
term more broadly to include organisations like consulting firms, advertising
agencies and investment banks.
According to this broader perspective, a professional services firm is any
firm that uses the specialist technical knowledge of its personnel to create
customised solutions to clients.
What distinguishes these kinds of companies from the broader concept of
the knowledge-intensive firm, or knowledge-based organisation, is the
emphasis on customisation.
Thus pharmaceutical companies and software companies can justifiably
claim to be knowledge-based organisations, but they are clearly not
professional services firms.
The difference is that once a drug or software company has created a
physical product to resolve a specific problem, it can exploit the innovation
by selling it to multiple consumers.

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Professional services firms, however, tailor each solution to the unique


requirements of the individual client - or so at least they would have us
believe.

Figure 1

Core management activities


The core management activities within a professional services firm are:
To create and disseminate knowledge within the firm;
To recruit and motivate workers who embody that knowledge;
To develop close and potentially collaborative relationships with clients.
These activities tend to take place within a working environment where
individuals require considerable autonomy to respond flexibly to client
needs.
At the same time the authority of top management is constrained by the
need to win approval from senior colleagues for major decisions and by the
fact that staff at all levels tend to be resistant to formal administrative
controls.
Management writers are now encouraging companies of all kinds to become
more flexible and innovative; these writers hold up professional services
firms as relevant examples. But in many important respects professional
services firms are fundamentally different from other kinds of companies.
Money making model
A professional services firm makes money by charging clients for hours
worked.
The total potential output of a professional services firm is a simple function
of the fee-earning staff in the firm, multiplied by the number of working
hours. Total billable hours will be less than total potential output because
professionals must also devote time to non-billable activities such as - sales,
administration, and training.
Actual hours billed depends upon the firm's ability to win sufficient client
work at appropriately attractive fee rates.
The profitability of a professional services firm is determined by the
relationship between hourly fee rates charged and hourly salary rates paid.
Salaries are by far the biggest cost in a professional services firm. Plant
and equipment are relatively limited and most project-related expenses are
passed on to the client. Clients may not be aware of the actual number of
hours worked and the fee rate charged by each professional employed. It is
often in the interest of the professional services firm to bury this calculation
in lump sum billings. But clearly the economic viability of all professional
services firms depends on both maximising hours billed and maximising the
margin between fee rates charged to clients and staff salaries.
Fee rates and salary rates are determined by an individual's position within
the organisational hierarchy.
Unlike companies in most other industries, the economic and organisational
structures of professional services firms can be seen as opposite sides of
the same coin because the staff are also the primary means of production.
Organisational structure
The basic economic structure described above applies equally to a small
start-up operation with say three partners and a major global corporation of

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150,000 professionals. In larger companies the organisational structure is


inevitably more complex.
In their recruitment literature, professional services firms like to present
themselves as "flat" and non-hierarchical organisations. In reality
professional services firms are structured around a hierarchy that is every
bit as precisely defined as that of a conventional bureaucracy.
It is true that junior staff may be able to progress through the hierarchy
relatively rapidly, compared to their counterparts in other companies.
However, the key tasks they are required to perform, their cost to the client,
and their remuneration is precisely defined at each level in the organisation.
The typical professional services firm is organised by three generic levels of
professional staff, (see Figure 2 below). As David Maister explains, this
basic hierarchy is a fundamental condition for the efficient functioning of
"leverage". This is one of the defining differences between the most and
least successful businesses operating in the professional services sector.

Figure 2

The concept of leverage


Professional services firms seek to persuade clients that they possess
distinctive and valuable expertise derived from years of solving complex
problems for clients. How then can they justify charging a substantial fee for
the services of a recent university graduate? Leverage is one way in which
they seek to resolve this conundrum.
According to the concept of leverage, junior staff work alongside more
experienced staff in close-knit project teams and learn the trade through an
informal apprenticeship process. This enables senior professionals to
communicate the highly personalised tacit knowledge that they have
acquired through years of experience.
Not only is leverage an effective knowledge management strategy, it is also
an efficient means of making money for the firm. A sceptic might argue that
such leverage enables professional services firms to make money by
underpaying juniors and overcharging clients.
Professional services firms make profits by maximising their margin the
gap between fee rates charged and salaries paid. The daily fee rates of
senior professionals may be no more than two or three times that of junior
colleagues, but their total earnings will often differ by much larger multiples.
Junior professionals accept relatively low salaries because they are still
considerably higher than those available in alternative graduate-entry
occupations. Clients will pay high fees because they accept juniors are
leveraging the expertise of senior professionals and because they cannot
afford to pay for large amounts of senior professionals' time.
Making the most of markets
Professional services firms, notes David Maister, must seek to achieve a
balance between four fluctuating factors: (1) organisational structure, (2)
economic structure, (3) the market for professional staff, and (4) the market
for professional services.
The relationship between a professional services firm's organisational and
economic structure has been already been demonstrated.
The relationship between the two external markets is as follows:
Clients will only employ a professional services firm if they believe it
has sufficient numbers of staff of sufficiently high calibre to deliver the
appropriate level of professional service.
Professionals will only join and remain with a professional services firm
if they can see a sufficient flow of interesting and lucrative client work
and reasonable prospects for advancement.
If staff members leave or are promoted, the organisational and economic
structure of the firm is inevitably affected. To mitigate this the professional
services firm must recruit and train new staff to an appropriate standard so

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that those moving up or out can be replaced. If the professional services


firm does not compete successfully in the market for professional staff, it
risks losing its ability to compete effectively in the market for professional
services.
In a recently published article Tim Morris and I develop further the Maister
basic model of the balanced professional services firm. We argue that the
two sets of demands that emanate from the market for professional services
and the market for professional staff are linked by a third consideration - the
knowledge base of the professional services firm.
The knowledge base represents both an input and an output. How this
knowledge is created, articulated, disseminated and renewed has
implications for the recruitment and training of staff, as well as the definition
and delivery of services to clients. The form and content of the knowledge
base affects the level of fee rates a professional services firm charges and
the degree of leverage it achieves. The knowledge base thus connects its
two external markets to its organisational and economic structure.
Managing knowledge
In accredited professions like engineering and architecture, all members
share a common body of codified knowledge acquired through professional
training. A large part of their competitive advantage, therefore, derives from
possessing a unique base of expertise.
Traditionally, professional services firms have been regarded as
organisations of highly trained, extremely clever technical specialists, who
apply their esoteric knowledge to the creation of innovative and
sophisticated solutions of clients' complex problems. It is certainly true that
some firms operate successfully in this way. However, in reality there are
not that many extremely clever people to go round and most clients'
problems are not that sophisticated.
As a result, most highly expert professional services firms remain small and
specialised "boutiques". Firms such as McKinsey would like us to believe
that they are exceptions to this rule. But such claims should always be
treated with caution. A professional services firm wishing to grow large must
learn to codify the esoteric and tacit knowledge accumulated within
experienced staff and disseminate this throughout its organisational
structure. If this knowledge can be expressed in terms of established
procedures and applied to a wide range of client problems, the potential for
leverage increases. Codification relaxes some of the more stringent
constraints of the apprenticeship model of knowledge transfer. Increasing
the number of juniors supervised by a senior professional increases the
degree of leverage and, therefore, profitability. But the process of
codification can also threaten the profitability of the professional services
firm in two ways.
Firstly, knowledge that is codifiable can be easily copied. Staff who
leave may take their knowledge of procedures with them to a
competitor. Clients also may pass this intellectual capital on to
competitors.
Secondly, and perhaps more importantly, the act of codifying
knowledge will ultimately diminish its market value as codified
knowledge becomes demystified.
Managing perceptions
As we start to explore the nature of knowledge here we move into the realm
of smoke and mirrors. Do professional services firms really possess
valuable esoteric knowledge or are they just very clever at persuading their
clients that they do? Mats Alvesson has shown that the ability to manage
perceptions is an essential condition for success.
It is not enough for professionals to be expert in a particular field; they must
also be able to persuade clients that they are. Indeed, for staff in a
professional services firm "seeming" to be knowledgeable may be more
important than actually "being" knowledgeable.
The importance of managing perceptions derives from the fact that
professional services firms operate according to a credence-based model of
service acquisition. Clients hire professional services firms because they
believe they have complex and significant problems beyond their own
capacity to resolve. How do I design a new head office building? How do I
defend myself in a takeover battle? How do I avoid bankruptcy?
But the client cannot sample the product of the professional services firm
before acquiring it. Indeed, clients may not be able to judge the success or
failure of the professional service they have purchased until many years
after the project is completed. The client's purchase must be made on the
basis of trust.

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This trust is derived from two primary sources: (1) the relationship that
develops between the individual client and the professional during the sales
process or through previous experience of working together, and (2) the
reputation which the individual professional and the firm as a whole has
developed in the external market.
Typically professional services firms have been quite discreet in their
marketing activities and secretive about the internal operations of the firm.
The recent trend for major professional services firms to launch high profile
marketing campaigns and to allow academics to conduct research into their
organisations can be seen as an attempt to disseminate the image of
professionalism to a wider audience.
In the early stage of a firm's development, high quality clients confer status
on it. If the firm succeeds in developing a high quality reputation, it can
return the favour by conferring status on its clients. A corporate
headquarters building designed by the Richard Rogers Partnership for
example, carries cachet and prestige far beyond that which can be
explained purely by the physical structure of the building.
So when management writers cite McKinsey and Andersen Consulting as
models of best practice, they are making an incalculable contribution to the
revenue of these firms by advancing their mystique and reputation in the
marketplace.
The positive benefits feed through to the market for professional staff and to
the market for professional services. It is no accident that year after year
these firms feature among the most popular potential employers for
undergraduate applicants.
Professional vs. commercial
For some years, writers have speculated that the drive for commercialisation
among accounting and law firms may be undermining some of the
underlying principles of professionalism.
Professionalism implies a dedication to the delivery of high quality client
service and careful management of client relationships.
This is not inherently inconsistent with the concept of commercialism.
However, professionalism also implies that the individual remains dedicated
to maintaining professional norms over and above the demands of the
employing organisation and the ability to pursue work that is intellectually
satisfying or socially beneficial, rather than merely profit maximising.
Professionalism has also typically been associated with the concept of
partnership, though this organisational form is by no means universal among
professional services firms. In a partnership, a group of senior professionals
combine the roles of owners, managers and core producers. They also
share unlimited personal liability for each other's actions. This engenders
mutual trust and collaboration among senior colleagues. In this respect also
professional services firms can be taken as models for organisations in
general.
On the downside, the partnership model implies a slow and potentially
risk-averse approach to strategic decision making because of the need to
build consensus within a diffuse authority structure.
Partly for this reason, professional services firms are increasingly
abandoning the partnership form of governance, or are seeking to
accommodate more conventional managerial structures within the
partnership form. It is ironic that, at a time when manufacturing and retail
companies are being encouraged to emulate professional services firms,
many professional firms are starting to adopt management practices more
often associated with manufacturing and retail service firms.
A future role model
Professional services firms embody many of the qualities which
organisations in general are encouraged to emulate. In theory at least they
are relatively efficient mechanisms for developing and disseminating
knowledge; they create an environment in which highly motivated individuals
can enjoy a reasonable degree of autonomy; and they place dedication to
client service above all other considerations. All this occurrs within a
non-bureaucratic organisational environment , which enshrines mutual trust
and collaboration within the professed value system.
It is important, though, not to confuse rhetoric with reality.
While professional services firms may aspire to achieve all of these
qualities, the extent to which they succeed varies widely. By fastening upon
the professional services firm as an ideal archetype, management writers
risk overlooking the considerable diversity within the sector and the threat to
traditional professional practices posed by increasing commercial

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pressures.
Professional services firms now represent a large and rapidly expanding
segment within most industrialised economies.
According to statistics from the Organisation for Economic Co-operation
and development, the professional services sector accounts for 17 per cent
of all employment in the US and major western European countries. The
sector has enjoyed annual growth of 15 per cent in revenue terms over
recent years. PwC, the accountancy firm for example, is now the single
largest recruiter from UK universities. With 155,000 professional staff
worldwide and annual revenues of Dollars 15bn, PwC, if publicly quoted,
would qualify as a Fortune 100 company.
To focus on the professional services firm as a model for organisations in
general is to lose sight of the fact that they are now an important
phenomenon in their own right.
Copyright (C) Financial Times Ltd, 1982-1997
Further reading:
Alvesson, M. Management of Knowledge-Intensive Companies, Berlin:
Walter de Gruyter, (1995). Lowendahl, B. Strategic Management of
Professional Services Firms, Copenhagen: Handelshjskolens Forlag,
(1997).
Maister, D. Managing the Professional Service Firm, New York: The Free
Press, (1993).
Additional reading may be found at www.ftmastering.com.

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