Is time winding down for the hourly billing model?

Is time winding down for the hourly billing model?

September 27, 2023 | RSM US LLP

Many professional services firms use an hourly-based billing model as a fee structure. With this model, there are only two ways to generate more revenue: by increasing the bill rate per hour or by increasing the number of hours worked.

Historically, this model has worked well. However, the rise of artificial intelligence may soon put pressure on professional services firms to consider other billing systems.

Why is AI poised to change things?

Across multiple industries, AI is bringing efficiencies to singular automated tasks. But it is also causing major disruptions to business models and how services are priced and delivered.

One of the major benefits of AI is the automation of manual processes, which drives cost savings and efficiencies. While this is a welcome reprieve from unfavorable economic factors like a labor or skills shortage, industries that have traditionally priced services by the hour may see these benefits as a double-edged sword.

Professional services firms are finding that many of their clients are well-educated on the benefits of AI. These clients may soon expect firms to take advantage of cost-saving technologies—and may demand that the savings be shared on both sides of the relationship. For example, clients may ask for a reduction of hours billed for automated tasks. These demands may grow in urgency.

The traditional model

Many professional services firms’ fees are based on time spent, and AI is significantly reducing the amount of time spent per task. This means that the traditional time-and-materials billing model may reduce the revenues of firms for providing the same value to clients.

The hourly-based billing model thus demonstrates a key flaw: there is little incentive to optimize billable tasks. This creates a barrier to embracing technology and other innovations—and results in a key misalignment between the client and the firm, as the client does not receive their perceived value of services.

The Cobb Value Curve explains clients’ price sensitivity as it relates to the nature of the work they seek. 

The model describes four types of work and the share each represents:

Unique/nuclear event (4%)

Crucial work that must be addressed immediately, where price is not an issue.

Experiential (16%)

Work that requires expertise in a particular matter, where price is less of an issue due to higher risk.

Brand name (20%)

Routinely important work where the client seeks firms with a solid reputation in that area. In this case, price is more of an issue, as savings can be realized through lesser-known firms.

Commodity (60%)

Work that may be performed by any professional where clients are extremely price sensitive.

Under the hourly billing model, if each type of work requires the same number of hours in various engagements, the flawed assumption is that each category of work has equal value to the client since the client is paying the same amount. Moreover, the hourly billing model fails to recognize the unique value of the different types of services described by the Cobb Value Curve.

Other models

Value-based alternative fee arrangement (AFA) models capture revenue based on the client’s perceived value of the deliverable or work being performed. This allows professional services firms that offer differentiated services to be rewarded more effectively for their skills in performing a service. More importantly, it incentivizes gains in efficiency when working on deliverables.

Firms can leverage AI’s deep automation capabilities and generative insights to drive efficiencies, freeing up their professionals to focus on adding greater value to engagements and improving the overall client experience.

AFA models include the following:

  • Units delivered: Payment is set as a fixed fee for the total value estimated at the beginning of the engagement.
  • Successful outcomes: A contingency fee (whether full or partial) is based on the successful outcome of the engagement.
  • Portfolio fixed fees: Multiple services are bundled under a single fixed fee. The firm calculates and balances profits or losses between services.
  • Retainers: Law firms commonly use this method, in which a client pays a set fee each month for a specific period of time and a finite set of services.
  • Risk collars: This form of hourly billing prioritizes and rewards efficiency. For example, the firm receives a bonus if the work is completed under budget, or the client receives a discount if the work is completed over budget.

The path ahead

The point is not for professional services firms to just switch to a value-based billing model, but to understand the unique value that each firm provides to determine which model makes the most sense for them and their clients. A firm can ease into a value-based structure by adopting a hybrid model first (e.g., a discounted hourly fee, combined with a contingency fee tied to a successful outcome).

As advances in AI and other technology only become more prevalent and customers demand greater efficiencies, professional services firms must consider alternative pricing models to protect and grow their revenue.

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This article was written by RSM US LLP and originally appeared on 2023-09-27.
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