when hourly-billing hurts profits

the rule of three algorithm vs. the new cost-plus worksheet.

by august j. aquila

the time has come for the accounting professional to rethink the paradigm on which pricing has been based.

most now agree that the traditional methods of price setting can have a negative impact on a firm.

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somewhere along the line accountants began to believe that an hour of their work had a set value to their clients. as we shall see, this false assumption has led to the current state of affairs and has caused accountants to:

• produce more chargeable hours by constantly reinventing the wheel
• hoard work and, consequently, do a poor job of delegating
• inhibit the creation of more efficient ways of producing accounting services
• hinder the development of more efficient project management

in short, the hourly billing system, under which we now work, rewards inefficiency and penalizes productivity. let’s take a look at the two traditional systems of setting hourly fees, the rule of three and the cost-plus methods.

the rule of three method

in the accounting profession, we have all heard of the rule of three. the rule of three mainly applies to leveraged practices, in which the practitioner employs other professional staff and administrative personnel. this rule of thumb states that one third of the fee covers overhead, one third covers compensation and the last third goes to pay the partners or owners. a number of medium-sized firms today would be happy to have a 33 percent profit margin for distribution to the partners or shareholders. most sole practitioners laugh at the rule of three; they follow a rule of two. in other words, they generally net 50 percent on their gross fees.

price is what you pay. value is what you get. – warren buffett

here is a quick and simple way to figure what your billing rate should be based on the rule of three. if you want to figure your billing rate (i.e., the price you are going to charge for your time), take the salary you want to make, multiply it by three and then divide the total by the number of billable hours you think you are going to work.

the following example demonstrates how a leveraged practice would determine a practitioner’s billing rate based on the rule of three. assume you are a practitioner and want to make $200,000 in your first year of practice. the equation you would use to compute the rule of three is as follows:

the preceding example shows that when using the rule of three, billing rates are determined solely by the number of billable hours without any consideration to any other market factors (for example, competition, demand, services offered). the bottom line is volume, that is, production. in other words, the emphasis is on how many billable hours each and every professional can accumulate. added to that, of course, is the emphasis on billable rate and realization of those billable hours.

some firms even kid themselves into thinking that production is the be-all and end-all. they do not realize that production in and of itself doesn’t mean anything if the fees billed aren’t collected. the most profitable firms place just as much emphasis on fees collected, gross margins, client retention and growth, and compensate partners accordingly. another common oversight made by firms that focus too heavily on production and the firm’s need to meet billable hour goals is the lack of emphasis on the client’s needs and providing the services that clients require and want. firms that do their homework and change their pricing strategies are finding out that the rule of three has become obsolete.

the cost-plus method

because the traditional accountant’s paradigm is that we sell time, the most popular method of setting fees in the accounting profession has been and continues to be the hourly billing method or cost-plus pricing method.

the real key to the cost-plus method is gaining a complete understanding of the cost of running your practice. the following exercise will help you determine the true cost of providing your services. first, write down the figure you think is the cost of running your accounting practice. next, take a few minutes and calculate the real cost of running your firm. every firm, whether a multi-office or sole practitioner, needs to know what this number is. let’s see how close your estimate comes to the actual cost.

let’s go through an example: you are a sole practitioner and your annual cost of running your practice is $85,000. you bill 1,400 hours net. the cost of overhead per hour is $60.71 ($85,000 divided by 1,400 hours). this figure of course will vary from year to year, but the variance will not be significant, even if the firm has dramatic growth. knowing the cost of overhead per hour now permits you to add a profit amount. this is the “plus” part of the equation.

if you want to have an income of $150,000, then you must add an additional $53.57 per hour (1,400 hours x $107.14). the cost-plus billing rate for this practitioner would then be set at $167.85 ($60.71 + 107.14).

of course, i would hope that most accountants would compare this rate with what the competition is charging in the marketplace. if the rate is too much higher than the going market rate, then our sole practitioner might lower her rate, or decide to perform a specialized service with a higher value for her client.

if you find that your rate is below the going rate, then you will raise it. in one case, i saw a practitioner double his rate; he only lost $5,000 in fees and increased his net revenue significantly. in another case, a firm raised its billing rates by $20 to $50 over a two-year period. again, the net effect was to increase net revenue without working more hours.

as long as you know the true cost per hour you will never unknowingly quote an engagement at an hourly fee below your cost for any engagement. there is a story in the retail business that goes like this: “well, we may be losing a little bit on each shirt that we sell, but we’ll make it up in volume.”

that would be like an accountant saying, “well, we may be losing a little on each hour of work that we do, but don’t worry about it, we will make it up in volume.” if you know the true cost of doing business, you will never have to say this.

the preceding example shows that in using the cost-plus method, the focus is once again on billable hours, even though it is based on cost estimates. furthermore, when using the cost-plus method, you are also focusing on cost. think for a moment about what this implies. if you determine your fees based on cost and billable hours, you are looking inward. it is as if you are working in a vacuum.

unfortunately, too many accountants continue to function this way. if, on the other hand, you are truly client-centered, you know that the client is at the center of your thought process and that everything you do is to better serve the client. it is the client who ultimately determines the value of your service.

posted on june 23, 2022