Monday, July 16, 2007

Distinguishing Price-Lead Costing from Cost-Plus Pricing

We are finally making some progress on the details of executing on a value-priced model. A reader and fellow attorney commented on a prior post with confusion on the differences between Cost Plus Pricing and Price-Lead Costing, writing:

"I am confused. Throughout your blog you mention that attorneys need to know their costs in order to have an adequate basis on whether to take on a job/client or not. Simple enough, get the accountants/bookeepers rolling and you have your cost basis per day/week/year.The confusion sets in when you say that you must get away from a cost + profit margin model and go to the more ephemeral value billing proposition. I get your value based theory, but I get lost on the details of arriving at "value" without factoring costs per day/week/year, etc. If what you are saying is like Lucky Brand - it costs them $5 per pair of jeans to make, but we as the client value them at $100.00 per pair of jean, then they have provided a value we are willing to pay for (don't get me going on Diesel or Sevens). Regardless, there is the value and then the price you are willing to pay for "fashion". Is this what you are talking about? In your paradigm, is cost important to know the minimum amount you would take from a client and still earn a profit?

On the one hand you state - know your costs. On the other you state that costs + margin should be avoided. Isn't it always cost plus margin. If you know your cost and propose a value billing system to your client, wouldn't it be cost + plus margin with a different definition of margin? "

This reader asks great questions and everyone needs to understand the differences and the subtleties here. First, let's do away with the notion that "billable" hours has anything at all to do with costing. . . IT DOES NOT!!! It costs you the same in salary, benefits, and overhead to pay your secretary whether she's writing a client letter or doing her nails! The attorney is absolutely right that I am saying you must "know your cost," but there are some key operational differences in the two business models:

I think the hang up is that the reader is trying to conceptualize costing the same way he does operating in his current billable hour environment In a cost-plus model, you mark up by a desired profit margin all of your resources so all that you have to account for is time multiplied by a rate. Can I challenge you to change your paradigm for a moment? Think of your business this way: (I simplify)

You have 10 attorneys at a fully loaded cost of $200k/yr each (average)
You have 5 paralegals fully loaded at $80k each
You have 5 Secretaries fully loaded at $60k each.

At a very simple level, your operational costs are $2.7Mil/yr whether you are all playing poker in he conference room or doing hard work. You know and I know that the cost by function can be broken down into monthly costs per resource, and that you have practiced long enough to get a sense of how many full-time equivalents at each level should be required to complete a trial or a legal project with NO CREATIVITY. Remember SCOPE???? This is really important because you have to first sit down with the client and SCOPE the job and let them define the desired boundaries. . . remember with a SCOPE defined you no longer have to "guess" what the boundaries will be because you will have defined it). Now, you are able to arrive at a rough cost.

NOW that we have "roughly" achieved a minimum cost (meaning that we need to add and charge for at least this value to make a profit), let's take a look at the differences between a Cost-Plus Model and a Value Priced model in operation by giving examples of each: first, note the language difference in Cost Plus Pricing (the word cost comes before pricing) and Price-Lead Costing (Price comes before true costing:

Cost-Plus Pricing law firm: Managing attorney evaluates the estimated "cost" of resources fully loaded to be $150,000 based on the Scope that customer provided in the fixed price agreement. As a firm, you decide that a desirable profit (mark-up) is 100 percent, so you give the customer a fixed price of $300,000 for the work. (Note: Take your Lucky Jeans example above . . . I just paid $100 each for the damn things even though I know it costs them $5 bucks to make. . . trust me, when I was shopping I was not thinking about how "lucky" I just make the Lucky Jeans executives, I was thinking about whether my butt looked good in the jeans (ask anyone in my firm!!!). I wish YOU were pricing those things because I could have paid much less than I valued them. Like the law example, you would have decided that 100 percent profit is good enough and in true cost-plus pricing fashion I would have myself a nice looking back end for only $10. I thank you deeply for the good deal! What is your problem? Look outside of your ivory tower. . . . see tall buildings. . . . your firm (and any other law firm) does not own a single one? Why the hell do you think that is? Do you think it could have anything to do with the hamster-wheel pricing model and minimizes profit in the name of risk-aversion? Well, the reason you think this form of pricing makes less sense in the law is because now you have shifted the risk of over-using resources to the firm without any premium in spite of the fact that customers will pay a premium to have peace of mind and certainty. . . . all things that you have not charged for.

Exemplar's Model: Take the same facts as above: We ROUGHLY estimated minimum resource requirements for the desired SCOPE at $150,000. Now, that number stays internal and is put away in a safe for the moment. Now, we use good questioning and understanding of what the customer VALUES to see what all of the non-time related value adds are in the job, what the customer's objectives are, and how we can be CREATIVE to accomplish the customer goals in less time (thus lower cost). We estimate the VALUE of this great creativity and work product to the client based on what THEY want. Remember I said we provide what customers VALUE, not that we provide a list of legal work we can do. Customers VALUE a lot of things. . . . hell, we'll send a town car to pick you up and serve you Godiva chocolates at every meeting if that is what you value. . . we are the Ritz! I will wear a pink underwear if a client values it as much as I do my Lucky Jeans and it only cost me $5 to buy it. Really, we give them a proposal offering a few different options of how we can achieve their objective and price based on the value to the client. Let's say we offer 3 options:

1- Bronze - (economy class)
2- Silver (Coach/Business class)
3- Gold (Premier Class)

If the VALUE of any package falls below our RESERVE price (the internal Least-Cost Estimate) then we will not include it in our proposal. You see, We are not really costing first, we are pricing first and ONLY comparing the Value Price against the Accept/Reject price of $150K.

Now, our work is not done: Project management and creativity is KEY to making a significant profit. Let's say you have a litigation and say our least-cost-estimate is $150k and our client valued it at and paid $450K. Now, I know that they want to resolve the matter as quickly as possible and they have certain bargaining points and are willing to give up others to get a resolution.. . . .we are now able to use effective and creative strategies to get exactly what the client wants WITHOUT spending all those resources. As a client, your interests are now aligned with mine. . . YOU WANT IT DONE!!!! So, If we resolve the case in 3 months at a resource cost of $80K, we made a significant profit and achieved a superior outcome to any law firm in the city. After all, when big firms bill by the hour why on holy earth would they not bill hours adding up to $450k if the client could afford it? Then, they have a big bill, a long trial with no peace of mind or resolution, pissed-off shareholders, and an executive team that is endlessly focused on your clock and not your superior strategy and business savvy.

So, in a Value Pricing model, pricing is made without regard to cost with the only exception that we quote only prices above a rough least-cost-estimate. Then, true costing is an exercise of effectiveness, efficiency, and creativity of our project managers.

I really hope this helped you reconcile my statements about knowing your cost yet not using a cost-plus model. At the end of your comment you wrote:"A little guidance would be helpful as getting away from the billable hour would be a life goal and free up a lot of extra time to spend with people who will appreciate your time more."I am everyday connected with the people who read my blog and whose lives could change if they were able to escape from the billable hour. I see attorneys burning out, losing loved-ones (divorce) and leaving the profession as a result of the never-ending billable hour wheel. My heart is with everyone of you who lives this way and I am living my professional life to help you to discover how you can change yours. . . so that you can see your family. . . see your children smile before they go to bed, to do the things you dreamed to do in your life . . . and to find new meaning in the work you do every day. . . so that you wake up one day and realize that it is not much work at all. It is a passion. A true profession!

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