The firm of the future: new model shuns time sheets, favors value creation.

EXECUTIVE SUMMARY

* The traditional business model of focusing on top-line revenue has several limitations when it comes to running a CPA firm because it overemphasizes the benefit of every marginal dollar of revenue and every client and places an artificial ceiling on income potential

* Measuring efficiency based on indicators such as billable hours, utilization and realization rates comes at the expense of creativity, innovation and effectiveness.

* The new paradigm for firm management is based on intellectual capital (IC), or knowledge that can be converted into profits. A firm's IC is comprised of human, structural and social capital.

* By focusing on effectiveness over efficiency, firms are forced to consider each client's profitability and how that client fits within the firm's overall purpose and strategy.

* Firms that understand the difference between knowledge workers and service/manual workers will have an enormous window of opportunity to attract, develop, inspire and profit from their human capital investors.

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To a large extent, your company is being managed right now by a small coterie of long-departed theorists and practitioners who invented the rules and conventions of "modern" management back in the early years of the 20th century. Management is out of date. Like the combustion engine, it's a technology that has largely stopped evolving, and that's not good.

--Gary Hamel, The Future of Management, 2007

The reigning paradigm of how to manage a CPA firm hasn't changed for more than a half-century:

Revenue = People Power x Efficiency x Hourly Rate

Unfortunately, this model has several limitations. First, it overemphasizes every marginal dollar of revenue--and hence any client--as beneficial. But low-value clients consume a disproportionate share of a firm's precious capacity, while keeping it from reserving capacity for its most valuable clients.

Second, most fire, s attempt to leverage people hours, which is how the traditional pyramid structure was formed. Yet with technological advances and a talent shortage, it becomes increasingly restrictive for firms to think their capacity resides in head counts.

Third, firms attempt to measure efficiency using indicators such as billable hours, utilization and realization rates. These metrics compel firm leaders to believe efficiency is the archetype of running a profitable firm, but what if you are efficient at doing the wrong things? A relentless focus on efficiency comes at the expense of creativity, innovation and effectiveness.

Last, the hourly rate--along with a "you sell time" mentality--has been taught to at least two generations of CPAs, or "Firms of the Past." In reality, clients don't actually buy time, so it is difficult for firms to sell something that clients don't think they are buying. The hourly rate places an artificial ceiling on income potential.

It seems that since the profession invented this model, it should be able to reinvent it as well.

AN IMPROVED MODEL

A new paradigm is gradually supplanting the old way of thinking because it offers viable alternatives for leveraging the chief source of wealth in today's knowledge economy--Intellectual Capital (IC):

Profitability = Intellectual Capital x Effectiveness x Price

The new model, or the "Firm of the Future," has several advantages over the old. Rather than focusing on top-line revenue, the firm is forced to think about the profitability of each client, and whether that client fits within the firm's overall purpose and strategy.

Despite common belief, CPAs do not sell hours. A firm's capacity to create wealth for its clients resides in its IC--that is, knowledge that can be converted into profits, rather than simply focusing on leveraging people and hours. A firm's IC has three components:

1. Human capital. Its people's knowledge, approximately 75% of its wealth-creating capacity, according to the World Bank.

2. Structural capital. Its systems, proprietary software, tools and resources that enable it to perform its work.

3. Social capital. Clients, reputation, vendors, referral sources, alumni, alliances and networks.

Firms of the Future focus on effectiveness over efficiency This implies the metrics that have been used to manage a CPA firm are irrelevant to knowledge workers. The time sheet has been supplanted with key predictive indicators.

CPA firms are subject to the same laws of economics and customer psychology as every other business. Businesses have prices, not hourly rates. You'd never fly on an airline that charged $4 per minute. Firms of the Future price all work upfront.

MEET FOUR ANOMALIES

Today, hundreds of firms worldwide--across all professional sectors, from accounting and law to advertising and IT firms--have begun the journey toward becoming Firms of the Future. These firms might be considered anomalies because they defy the conventional wisdom regarding the proper way to lead a professional firm.

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Mark Bailey is founder and managing partner of Mark Bailey & Co. Ltd., a Reno, Nev.-based SEC audit boutique firm. In 2008, the firm is projected to produce $2.8 million in revenue and employs 14 full-time equivalent, or FTE, team members. The firm prices every piece of work upfront, offering its clients certainty in price. It does not use time sheets. To capture, share, and leverage its IC, the firm hired a chief knowledge officer. It abolished annual performance reviews and has a waiting list of talent eager to join its ranks. Here, Bailey describes his journey to becoming a Firm of the Future:

      Beginning with the realization,
   three years ago, that CPA firms do not
   sell time, but rather value based on intellectual
   capital from knowledge
   workers, our firm has undertaken the
   challenge of implementing an operational
   and pricing model based on
   value rather than the traditional model
   based on time spent times hourly rates.

      The initial challenge was to abandon
   time sheets as a benchmark for pricing
   services, relying instead on a fixed-price
   agreement and annual client service
   plan for each client, established by the
   firm's pricing committee. This agreement
   incorporates a comprehensive
   suite of tailored services, which recognizes
   the individuality of each client
   and is priced accordingly Not only are
   the services to be provided specifically
   discussed, the responsibilities of the
   client are as well. Modifications and
   scope changes are negotiated and documented
   in a change order appended
   to the fixed-price agreement as the engagement
   progresses. While initially
   unsettling, the axiom of profit as a reward
   for risk is true. In three years, the
   firm has experienced a 350% growth in
   revenue and a 500% growth in profitability,
   while the professional team
   (FTEs) has grown from five to 14.

      More importantly, the quality of the
   service provided and the overall client
   satisfaction have seen marked improvement.
   Employee retention has
   been outstanding and the recruiting
   efforts of the firm extremely successful
   in attracting high-quality talent
   from top-tier firms as a direct result of
   not being tied to the time sheet. This
   has furthered the opportunity to implement
   a positive work/life balance
   for everyone by almost eliminating
   overtime while offering a superior
   compensation package.

      Micromanagement of knowledge
   workers is the culture of most firms.
   Tracking time in six-minute increments,
   measuring productivity, measuring
   efficiency, and measuring
   relative worth all are driven by time
   sheets. The management attitude that
   anything that is not billable is not
   worthwhile has destroyed the intellectual
   pursuit of knowledge and self-improvement
   that is critical to the
   long-term success of every professional
   knowledge firm.

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Snyder & Co. of Lancaster, Ohio, with $1.3 million in 2008 revenue and 13.5 FTE employees, trashed its time sheets as of Jan. 1, 2008, part of a three-and-a-half year transformative journey Partner Victor E. Christopher explains the firm's shift to becoming a Firm of the Future:

      Our journey began in 2003. We
   created a development committee to
   begin formulating the "nuts and bolts"
   of how we would begin making the
   conversion. The committee consisted
   of individuals from throughout the
   firm, eventually including administrative
   personnel, as the change to
   value pricing certainly impacted
   many of our internal administrative
   processes. We established our initial
   pricing committee, which we envisioned
   as the group having overall
   authority to approve prices. We also
   wanted the pricing committee to be
   fluid, wherein we would periodically
   rotate team members through the
   committee. The idea was that in doing
   so it would make us better at pricing
   across the organization.

      Our fixed-price agreements (FPAs)
   are designed to detail the services to be
   provided, the price and the payment
   terms. Each FPA includes "unlimited
   access" to us, where if a client has a
   question, they pick up the phone and
   call or send an e-mail without worrying
   about a clock running.

      As a way to minimize our risks
   during the transition, we decided to
   implement value pricing by way of a
   phased-in approach. In late 2004, we
   began upfront pricing for new clients.
   For the new clients who were coming
   to us with an existing CPA relationship,
   our upfront pricing philosophy with
   unlimited access was an easy sale.
   Many of those businesses complained
   about receiving a bill for a 10-minute
   phone call. The idea of getting an upfront
   price and knowing that we would
   be there for any questions they would
   have during the course of the year was
   a jaw-dropping experience for some of
   them.

      Our goal was to have every client
   on a fixed-price agreement by 2007,
   which we ultimately achieved. After
   completing our first busy season without
   time sheets, it has never been clearer
   to us that pricing needs to be based
   on value and not hours. It is my belief
   that the negative aspects of time tracking
   have played a major role in driving
   highly qualified individuals out of
   our profession, not to mention discouraging
   young, intelligent individuals
   from entering the profession. If
   price and staff worthiness are based on
   hourly billing, it is inevitable that the
   trend will continue. At Snyder & Co.,
   we are committed to making a difference
   in the lives of our professionals,
   our clients, our community and our
   profession.

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Harrex Group is in Invercargill and Gore, New Zealand. The firm was founded in October 2007 by Brendon Harrex--the world's first chief value officer at his prior firm. He launched his firm, embracing the new business model in its entirety In its first fiscal year, ending March 31, 2009, Harrex Group is projected to gross $2.2 million with 21 FTEs. It also has a waiting list of eager talent. Harrex and CEO Nicki Morsink convey the firm's philosophy:

      Creating a culture of collaboration
   and becoming more effective means
   caring for your employees enough to
   know their strengths and release them
   to work in those areas. There is overwhelming
   research that indicates people
   are more passionate, motivated, and
   enjoy higher job satisfaction when they
   work in their areas of strength.

      Getting your organizational structure
   right is critical in order to get the right
   work to the right people and, therefore,
   best serve your clients. However, you
   still have to run the business. A focus on
   time and cost only creams the illusion of
   managing a professional knowledge
   firm. It accounts for the hard costs of
   input and output but does not measure
   what we consider to be the lifeblood of
   any business--value creation.

The Harrex Group's key predictive indicators (KPIs), which essentially replace the time sheet, are:

* Ability to think strategically on behalf of clients

* Client Communication

* Delegation

* Turnaround Time

* Client Feedback

* Effective Listening and Communication Skills

* Knowledge Elicitation/Coaching

* Risk Taking, Innovation and Creativity

* Continuous Learning

* Passion, Attitude and Commitment

* Team Player

We acknowledge that many of these KPIs are, indeed, subjective, but we are managing people, and people are subjective! It is our belief that the ultimate flaw in the time and cost model is ignoring this fact. In a knowledge firm, a judgment is more important than a measurement in evaluating professionals. We would rather be approximately right than precisely wrong.

In conclusion, being a Firm of the Future, providing top-quality service for your clients, and building great careers for your team are certainly not easy goals. You have to be focused, dedicated, willing to face great change, innovate, and constantly challenge the status quo of complacency and comfort. The results, however, are nothing short of stunning.

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Kennedy and Coe LLC is the first Top 100 firm (No. 86 as of 2007) in the United States to embark on the voyage to becoming a Firm of the Future. CEO Kurt Siemers makes clear why he believes this transition is essential:

      Kennedy and Coe LLC is in the
   midst of a significant transition in how
   we think about our firm, our people,
   our clients and the professional services
   we provide. At the core of this transition
   is a different, and we believe
   better, way of approaching--value how
   we create it for our clients and how we
   are compensated for its creation in a
   manner that leaves everyone better off.

      Through the years, we have delivered
   many valuable services to our
   clients. Often, however, the payment
   we received had very little relationship
   to the value we provided the client, primarily
   because we were limited to an
   hourly rate for billing clients. Even
   "premium" hourly rates and "value adjustments"
   often did not approach the
   value the client received.

      Our current transition is a deliberate
   attempt to supersede the "hourly rate"
   paradigm with one that measures value
   in the way our clients individually value
   our services. Historically, the approach
   has been that people need to work more
   and/or become more efficient in order
   for a firm to be more profitable. Since efficiency
   is a zero-sum game over time,
   we have been left with working more
   hours to earn more. This mode of thinking
   found itself on a collision course with
   our firm's commitment to the well-being
   of our people.

      In 2007, we went through a process
   that resulted in the decision to transition
   completely away from billing
   clients based on the hours involved in
   a service to what we call Value Creation--a
   process to determine the services
   our clients need and want and how
   they might measure the worth of those
   services. That sense of worth may be
   "real" in financial terms, or perhaps only
   "perceived," but determining the reality
   of their sense of value is imperative
   to the process. Only then do we establish
   pricing based on client value. The
   scope and parameters of service are
   written into a Value Creation Agreement,
   which is signed by the client and
   someone in the firm before services
   begin.

The following represents a summary of some of the major steps we have taken:

1. Provided education and created an understanding with our staff of the old and new paradigms and why we are making the change.

2. Formed a Value Creation Panel with a chief valuation officer to lead the transition and create processes to guide a successful transition.

3. Set a minimum fee level for each client and agreed to terminate about 40% of our clients (about 10% of our fees) in the first year that do not fit our "Best Client" profile and set up specific plans on how to accomplish this.

4. Started using the Value Creation Agreement process with selected clients to refine the process and have now expanded this process to all client groups.

5. Set a transition goal of having all clients converted to Value Creation Agreements by summer of 2009.

6. Set a goal of eliminating time sheets by June 30, 2009, severing the final link in the traditional "time and billing" model.

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One of our firm's core values is to practice creative destruction by destroying some traditional paradigms and creating a business model that is focused on providing relevant and valuable services to our business clients and attracting devoted staff with the passion to provide those services. We acknowledge that the road ahead has many unknown curves, but we firmly believe in the decision and feel confident in our ability to respond to the challenges and keep moving forward. Thus far, it has been an exciting and challenging journey!

A PARADIGM WORTHY OF A PROUD PROFESSION

Embracing the new model requires leadership and vision: an attitude of experimentation; less measurement and fear, and more trust; and the self-respect and dignity to believe that you are worth every penny you charge. By focusing the firm on the external value it creates for the client and committing to work only with clients with integrity, whom you enjoy and respect, you are building the type of firm people are proud to be a part of and contribute to--the sort of organization you'd want your son or daughter to work for.

The first wave of firms that understand the difference between knowledge workers and service/manual workers will have an enormous window of opportunity to attract, develop, inspire and profit from their human capital investors. The firms that don't will continue to struggle in the competition for talent. It is the difference between remaining a Firm of the Past or emerging as a Firm of the Future. The choice is yours.

AICPA RESOURCES

Private Companies Practice Section The Private Companies Practice Section (PCPS) Firm Practice Center has related archived Web forums, articles and publications. Visit the Fee Pressure/Pricing page of the PCPS Firm Practice Center at http://pcps.aicpa.org/Resources/Fee+ Pressure+Pricing.

OTHER RESOURCES

Books

* The Future of Management, by Gary Hamel with Bill Breen, Harvard Business School Press, 2007

* The Myth of Market Share: Why Market Share Is the Fool's Gold of Business, by Richard Miniter, Crown Business, 2002

* Peter Drucker: Shaping the Managerial Mind, by John E. Flaherty, Jossey-Bass, 1999

* Profit Beyond Measure: Extraordinary Results through Attention to Work and People, by H. Thomas Johnson and Anders Broms, Free Press, 2000

* The Strategy and Tactics of Pricing: A Guide to Profitable Decision Making, Second Edition, by Thomas T. Nagle and Reed K. Holden, Prentice-Hall, 1994

* Where Is the Wealth of Nations?: Measuring Capital for the 21st Century, The World Bank, Washington, D.C., 2006, at http://siteresources.worldbank.org/ INTEEI/214578-1110886258964/ 20748034/All.pdf

* Abolishing Performance Appraisals: Why They Backfire and What to Do Instead, by Tom Coens and Mary Jenkins, Berrett-Koehler Publishers Inc., 2000

* The Firm of the Future: A Guide for Accountants, Lawyers, and Other Professional Services, by Ronald J. Baker and Paul Dunn, John Wiley & Sons Inc., 2003

* Pricing on Purpose: Creating and Capturing Value, by Ronald J. Baker, John Wiley & Sons Inc., 2006

* Measure What Matters to Customers: Using Key Predictive Indicators, by Ronald J. Baker, John Wiley & Sons Inc., 2006

* Mind Over Matter: Why Intellectual Capital Is the Chief Source of Wealth, by Ronald J. Baker, John Wiley & Sons Inc., 2007

Web site

Visit www.verasage.com to download free PDF copies of the following:

* Burying the Billable Hour, by Ronald J. Baker, The Association of Chartered Certified Accountants, 2001

* Trashing the Timesheet, by Ronald J. Baker, The Association of Chartered Certified Accountants, 2003

* You are your Customer List, by Ronald J. Baker, The Association of Chartered Certified Accountants, 2004

Blog

Visit the =Trailblazers" section at www.verasage.com for more case studies of firms that have made the transition to a Firm of the Future. A host of free resources can be found throughout the site.

Ronald J. Baker is the founder of VeraSage Institute. His e-mail address is [e-mail].