The following is an E-mail I received from the CEO of an Advertising Agency on January 26, 2007 that has begun to implement Value Pricing, and has had stellar success so far. As usual, at this point in the transition, the questions arise: "What about timesheets? Do we need them?"

The answer is unequivocally NO! Warning: this is a long post, but if you're interested in why timesheets don't matter, read on.

Ron, I left you a voice mail message earlier this morning, but thought you might prefer to save the long distance phone charge and respond by e-mail. We are a member of the AAAA's and MAGNET—and I've heard you speak through both organizations. Tim Williams is a consultant and friend. We have come a long way with value pricing and have actually moved from a history of getting around $80,000 of gross income per employee to our 2006 level of $130,400 per employee. Tim Williams tells me he knows of agencies who get $150,000 to $170,000 per employee. We aren't planning on moving to a completely consultative business model, so I don't know if we will get to those levels or not, but we don't think it impossible to get to the $145,000 level with our projections for our gross income in 2007. In recent industry news, some big New York agencies are claiming "We sell ideas, not time!" So, does this mean they really have eliminated the use of timesheets? OR Are they still using timesheets internally to track the manpower/resources needed to provide the thinking and services and then selling that thinking and those services based upon their perceived value to the client? (Which is what we are currently doing). We sincerely want to motivate our people to achieve what we want to accomplish. We want to create great creative ideas / strategy / work that help our clients build their brands and sell more! So, we don't want to send the wrong signals to our people that we care more about billing 75% of their day than a great idea. That said, I still need some kind of measurement to know what our "costs" are so we can sell value and measure margin. Is it possible to do this AND eliminate timesheets? We buy into the concept (got this from you) that people buy things based upon perceived value—not caring how much time it takes to do it. Having said that, if someone buys a $65,000 automobile based upon value, I know the manufacturer knows how much it cost to make that car and what their margins are. So, if you would, please share your thoughts or observations on what you've seen other service business firms doing. Thanks for your time and perspective! [Name withheld on request] CEO of an Advertising Agency

Ron's Response

This is a cross-roads question, usually posed by firms that have already had some success with Value Pricing, which you obviously have, given the growth in your revenue per team member.

Yes, the agencies you've read about recently in the news, especially the AdvertisingAge article that quotes Crispin Porter and Anomaly do indeed operate without timesheets. They understand they sell intellectual capital (or ideas, in your profession's vernacular), not time. They are not using timesheets to track manpower, resources, or costs.

I also need to make this empirical observation: The best pricers we've worked with—across firms in accounting, law, IT, and advertising—have one thing in common. None of them have timesheets. I think this a causal relationship, not merely a correlation. Once you take off the training wheels—as a colleague wrote to me in a recent post—your firm is forced to focus on value. In fact, as my British colleagues, Paul O'Byrne and Paul Kennedy say, "You become obsessed with value."

How do they do it, you ask? The answer is actually in your E-mail, when you state: "...if someone buys a $65,000 automobile based upon value, I know the manufacturer knows how much it cost to make that car and what their margins are." You bet the manufacturer knows how much the car cost it to produce. That's not the right question. The right question is WHEN do they know this cost? The answer lies with Price-Led Costing, which is used by Toyota, among many other enlightened companies.

The interesting fact about Toyota is it doesn't have a standard cost accounting system. It does not make decisions regarding production, pricing or other resource allocation based on cost accounting analysis. Cost accounting is historical, and is riddled with allocation problems. It also doesn't help in understanding value. We do not become better pricers by becoming more accurate cost accountants (and that applies to Activity Based Costing as well, although ABC is a better method of cost accounting in a Professional Knowledge Firm).

Here's how it works, which is detailed extensively in my book, Pricing on Purpose, Chapters 9 through 11. The following is excerpted from these chapters.

COST-PLUS PRICING'S EPITAPH

If one were to lay the two methods of pricing side-by-side, it would look like this:

Cost-Plus Pricing

Product → Cost → Price → Value → Customers

Price-Led Costing

Customers → Value → Price → Cost → Product

Notice how Price-Led Costing turns the order of cost-plus pricing inside-out, by starting with the ultimate arbiter of value—the customer. Goods and services do not magically become more valuable as they move through the factory and have costs allocated to them by cost accountants. The costs do not determine the price, let alone the value. It is precisely the opposite—the price determines the costs that can be profitably invested in to make a product desirable for the customer, at an acceptable profit for the seller. This subtle reordering of the value/manufacturing chain has a dramatic impact on value, price, and profit, as the following story illustrates.

A TALE OF TWO AUTOMOBILES

U.S. soldiers stationed in Europe during World War II were attracted to the sporty British MG car. After the war, General Motors took a calculated risk designing and then manufacturing the Chevrolet Corvette, introduced in 1953, utilizing the DuPont return on investment (ROI) formula to derive a price of $3,490.

As the Corvette was experiencing success, a competing automobile company took note, and by coincidence another executive was looking for his next big hit. When Lee Iacocca developed the Ford Mustang, he reversed the order of the usual car-making pricing up to that point. Rather than giving his engineers carte blanche to develop a sports car and then marking up the resulting costs to arrive at a price—as GM did—he solicited the opinions of potential customers as to what features they would want in a sports car and what price they thought they would be willing to pay.

Knowing people liked the Corvette, but thought it was too expensive at $3,490, Iacocca wanted the price to be low enough to entice the potential sports car enthusiast. He then went to his engineers and asked if they could manufacture a sports car, with the desired features, and sell it at this price—no more than $2,500—and still turn an acceptable profit for Ford.

This constrained the engineers with the final price and forced them to manufacture the car at a total acceptable cost, following the flowchart above for Price-Led Costing.

By building the Mustang on the Falcon's chassis, in the first two years, it generated net profits of $1.1 billion (in 1964 dollars), far in excess of what GM had made on the Corvette. The average customer was spending another $1,000 on options, and while Ford projected that 75,000 units would be sold in the first year, the 418,812th Mustang was sold on April 16, 1965, only 13 months after the first rolled off the assembly line. By comparison, the Corvette reached 1 million in sales in July 1992.

From an engineering perspective, the car was mediocre; from a marketing and profitability perspective, it was one of the most successful cars in automotive history. This led Iacocca to quip:

I'm generally seen as the father of the Mustang, although, as with any success, there were plenty of people willing to take the credit. A stranger asking around Dearborn for people who were connected with the Edsel would be like old Diogenes with his lantern searching for an honest man. On the other hand, so many people have claimed to be the father of the Mustang that I wouldn't want to be seen in public with the mother!

There is a long history of companies that became obsessively focused on cost, at the expense of providing a product or service of value to the customer. The fact of the matter is you can make a pizza so cheap no one is willing to eat it.

This is not to imply that a firm's internal costs are unimportant, or irrelevant, to the pricing decision, for they are certainly not. It is the order of those costs that is important and needs to be reiterated: The profit-optimizing firm will only invest in those costs that can be recouped through the value delivered to the customer, not the other way around.

In other words, the company explicitly understands that its price determines its costs, and does not let its costs dictate its price. You must do your cost accounting BEFORE providing the service (what Toyota calls Target Costing). Historical costs don't matter, it's only future costs that count.

Wisdom Is Timeless

The Price-Led Costing chain above was embedded in the DNA of the Ford Motor Company. Henry Ford understood price-led costing, recognizing that no cost is truly fixed and that value drives price. While price may be taught in business schools as the last of the four Ps of marketing, Ford knew value had to be understood first, as demonstrated in his autobiography, My Life and Work, published in 1922. It is worth quoting for the historical lessons it teaches. The notion that price determines cost was not foreign to Ford:

Our policy is to reduce the price, extend the operations, and improve the article. You will notice that the reduction of price comes first. We have never considered any costs as fixed. Therefore we first reduce the price to the point where we believe more sales will result. Then we go ahead and try to make the prices. We do not bother about the costs. The new price forces the costs down. The more usual way is to take the costs and then determine the price; and although that method may be scientific in the narrow sense, it is not scientific in the broad sense, because what earthly use is it to know the cost if it tells you that you cannot manufacture at a price at which the article can be sold?

The Almighty Hourly Rate

Let us analyze how the standard hourly rate in a professional knowledge firms is calculated, since it is no different from cost-plus pricing in any other industry:

Hourly Rate = Overhead + Desired Net Income ÷ Expected Billable Hours

The first fact to note in the above equation is not cost accounting, it is profit forecasting. There is no cost accounting theory that allocates desired profit—or a return on investment—among its costs. Hence, the more relevant question firms need to be asking is not "Did we make money on this customer," but rather, "Did we optimize the profit from this customer?" The equation—or cost accounting or ABC—cannot answer this more relevant question, no matter how accurate it is.

When you reward people for billable hours, you get billable hours, even if those hours logged on the time sheet are outright lies, or are worthless in terms of creating results for the customer. You also create an incentive measurement that will verify C. Northcote Parkinson's Law: "Work expands to fill the time available."

Pricing takes place in a world of risk and uncertainty, and sometimes the costs cannot be known in advance. Actuaries have to price the risk for natural disasters long before they know how much the damages inflicted are going to cost, let alone any profit left over. No one would purchase insurance under a cost-plus formula, priced in arrears.

The Price-led Costing Revolution

The lesson being taught by Henry Ford, Toyota, and Lee Iacocca with the Mustang, is that a company needs to start with value, then determine price, which finally dictates the costs that can be profitably incurred to produce a good or service desired by customers.

As Henry Ford pointed out, no one knows what a cost should be. Yet, cost accounting has held hegemony for far too long over the pricing strategies of businesses everywhere, embedding the conventional wisdom that costs determine price. Cost accounting, and its more modern cousin activity-based costing, does not deserve to be the apotheosis of pricing, let alone running a business.

In a PKF, your costs are fixed, so cost-accounting is a fairly simple function. We prefer conducting After Action Reviews, which can include a back-of-the-envelope check on your up-front cost accounting. What's important in a PKF—unlike Henry Ford's factories—is learning, knowledge dissemination, effectiveness and value creation.

But who is in charge of value? Who in the firm is keeping their focus on the outside in an attempt to understand and continuously enhance value for customers? Perhaps it is time to create a Chief Value Officer, like Brendon Harrex.

To return to your question: What replaces the timesheet? The answer is Key Predictive Indicators, explained in detail in my latest book, Measure What Matters to Customers.

If people are interested, I can explain in more detail in a future post about KPIs, and how they change the focus from efficiency to effectiveness in a PKF. Also, they measure (and judge) success the same way the customer does, unlike timesheets. They are also leading indicators, meaning they have a predictive value for future profitability, unlike most metrics PKFs track, which are all lagging indicators.

In a follow-up E-mail (after a phone conversation), the CEO wrote:

I want to thank you for the time you spent with me on the phone last week. I went to your website this weekend and was impressed with the content I found there. I...would be happy to communicate with you as we continue our progress on value pricing, eliminating timesheets and building our firm of the future! If I may help you in any way, please do not hesitate to call upon me. Thanks, [Name withheld]

You're welcome! This is why VeraSage exists—to help firms like yours create the future. I hope this explanation, though long, helps you to achieve that goal.