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Introduction: Ron Baker is, among professionals, the household name for “the quest to bury the billable hour and trash the timesheet.” This topic brought him to the center-stage of leadership issues in, what he calls, professional knowledge firms. The VeraSage Institute, the think tank he founded with colleagues in 2001, is declared to be “free and independent from the tyranny of time,” even going to the extent of writing a formal Declaration of Independence and allowing others to pledge their names to the quest.
TCL: Ron, you’ve been pursuing your worldwide quest for professional knowledge firms for over twelve years now. What changes have you seen in that time? Ron Baker: Overall, I’m encouraged by the progress we’ve been able to make. As you know, we are trying to diffuse a new theory into the professions, which is measured in decades (sometimes centuries, such as with germ theory), so I’m encouraged, while admitting we have a long way to go. At least the billable hour and timesheet are now on the defensive, and we are certain that, eventually, we will get a death penalty verdict; it’s just a question of when.
TCL: In your Intellectual Capitalism Series of three books, you propose a new practice equation which reads: Profitability = Intellectual Capital x Price x Effectiveness. We would like to examine each of the elements in a moment. But first let us understand your criticism of the traditional formula. Ron Baker: The new practice equation was an outgrowth from my teaching and studying the accounting and legal professions and how most firms operate. Since I firmly believe learning starts with theory, I have noticed most professional knowledge firms (PKFs) have been operating under the following practice equation for at least the past one hundred years––think of it as The Firm of the Past: Revenue = People Power x Efficiency x Hourly Rate
There are several problems with the above theory. First, since most firms have a relatively high contribution margin (revenue less direct labor costs), it gives them a false sense that any revenue is good. This in turn leads them to accept customers who are not as valuable to the firm as others, since marginally valuable customers take up a firm’s precious capacity, and keep it from reserving capacity for its most valuable customers. Second, the way most firms were built in the last century was by leveraging people, literally building a pyramid structure. As technology came on the scene––and especially when the computer hit the desktop––the pyramids began to flatten and firms started to leverage technology. Most firms, however, will put revenue before capacity, always playing catch-up to the workflow and client demand. Most other businesses––think of FedEx, Intel, etc.––will put capacity before demand. Third, most firms focus on efficiency by measuring such things as utilization rates and billable hours. Yet, if you study statistics going back at least fifty years, you’d find utilization rates and billable hours are within a very tight range. In other words, whether PKFs are using a quill pen or a laptop computer, they can charge only so many hours in a year and realize so much on those hours (in terms of standard hourly rates). The theory compels leaders to believe efficiency is the be all and end all of running a profitable firm. This is demonstrably false. I’m sure the buggy whip manufacturers were a model of efficiency before they were replaced by the automobile. What if you are efficient at doing the wrong things? Last, the Almighty Hourly Rate. The profession has taught approximately two generations of professionals the only thing they sell is their time. This is unadulterated nonsense, for a very fundamental reason––no client buys time. How can you sell something the client doesn’t buy? TCL: In what ways is your practice equation different? Why is it better? Ron Baker: The old equation doesn’t explain why PKFs are successful, nor does it offer viable alternatives to leveraging the critical success factors in a knowledge economy. The new practice equation for The Firm of the Future does: Profitability = Intellectual Capital x Effectiveness x Price
This theory has many advantages over the old one. First, rather than focusing on top line revenue, the firm is forced to think about the profitability of each customer. Not all clients are created equal, and many firms could stand to lose up to 40-60% of their customers, and they’d be more profitable if they did so. Second, PKFs don’t sell hours. They create and sell––and their clients buy–– Intellectual Capital (IC). This is a far broader view than thinking about leveraging people and hours. Microsoft didn’t create the wealth it has by pricing by the hour, and I doubt Bill Gates keeps a timesheet. A firm’s IC consists of three components: Human Capital (its people); Structural Capital (its systems, proprietary software, checklists, resources, etc., that enable it to perform its work); and Social Capital (customers, vendors, suppliers, referral sources, alumni, alliances, etc.). These components are the real levers of profitability in any PKF, not people hours. You can’t leverage an hour; time is simply time, and all businesses––indeed, all living beings––are constrained by it. So what? There are so many more ways to leverage the three components of IC, but it requires a radical change of mindset to get away from the notion that “billable hours” drive a firm’s profitability. Third, the firm of the future will focus on effectiveness, not efficiency. There’s not much the average firm can do to squeeze another 15-20% efficiency from its Human Capital, which are only fallible human beings after all. The focus on billable hours has hindered PKFs from focusing on being effective with their clients. If you study surveys of how clients select––or fire––their professionals, efficiency is never mentioned. It is always because of outstanding service, or lack of service––issues such as they don’t ignore me, they are proactive in looking after my interests, they are aggressive in helping me pursue opportunities, etc. You can’t do all of these things if you are focused on nothing but billable hour quotas. Last, PKFs recognize they are businesses just like the airlines, hotels, rental car companies, etc. Businesses have prices, not hourly rates. You’d never fly an airline that tried to charge you $4 per minute. The idea is simply ludicrous. In fact, PKFs need to start pricing up-front for everything they do, period. No more excuses. In conclusion, we believe this theory––and of course there is much more to it, this is just a brief synopsis––is superior to, and will eventually supplant, the old theory.
TCL: The late Peter Drucker called our times the era of the knowledge worker. Do we need to significantly adjust leadership approaches to be successful––and profitable? Ron Baker: Absolutely. Peter Drucker introduced the concept of knowledge workers in 1959, and PKFs have still not come to grips with the significance of this change. The biggest change is knowledge workers own the means of production in their heads, unlike the Industrial Era where tangible capital was owned by Henry Ford, etc. Today, PKFs need knowledge workers far more than knowledge workers need them, which means firms have to earn their loyalty and inspiration. Like it or not, knowledge workers are volunteers, and one doesn’t micro-manage volunteers. Most PKFs still treat their people as if they were assets or resources––look at the terms they use to describe their people––as if they were owned and controlled like cattle. They also try to fit knowledge workers into pre-defined jobs, an idea from the Industrial Era’s organizational chart. But jobs don’t have value, only people do. The first PKFs that truly understand the difference between knowledge workers and service/manual workers will have an enormous window of opportunity to attract, develop, and profit from their human capital investors. The PKFs that don’t will continue to struggle in the competition for talent. It’s the difference between remaining a Firm of the Past or becoming a Firm of the Future. The choice is yours.
Ron Baker is the best-selling author of The Firm of the Future: A Guide for Accountants, Lawyers, and Other Professional Services; Pricing on Purpose: Creating and Capturing Value; Measure What Matters to Customers: Using Key Predictive Indicators; and Mind Over Matter: Why Intellectual Capital is the Chief Source of Wealth. You can reach him at (707) 769-0965, or e-mail at Ron@verasage.com. He Blogs at www.verasage.com.
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