Alternative fee structures – mirage or the future?

The professional service (PSF) world is currently reeling under the impact of globalisation and the rise of the procurement department at many of the biggest and best PSF clients. Established relationships have become subject to review and margins have consequently come under pressure.

One of the ways to protect these margins, i.e. compete on non-price terms is to explore changes in fee structures. It is no coincidence that those segments of the PSF world most affected by increased purchasing sophistication have been the most active in considering alternative fee arrangements (AFAs). For the legal and consulting segments this has meant exploring alternatives to long established time based billing methods, i.e. the hourly or per-diem rate.

In the legal world, the death of the billable hour has been forecast(1) for some time, yet it remains the single most used billing structure. Nevertheless the use of AFAs is growing. A report by Altman Weil ( www.altmanweil) showed that whereas 20% of lawyers surveyed in 2009 considered AFAs as established, by 2012 this had risen to 80%.

The problem however is that most of the firms reporting an increased use of AFAs also reported a fall in profitability when using AFAs. The questions are therefore: are AFAs inherently bad for profitability? Will they disappear when business picks up or will professional service firms get better at using them?

The power of alternative fee structures

Few professionals realise the power of alternative fee structures as a competitive tool. Clients do not necessarily have a problem with the total size of a professional services bill (although they usually prefer to pay less). Rather, the problem that many clients have is that they either don’t know or understand what they get for their money or they are uncomfortable about the risk of a fee increase. This is why many clients want a fixed price, even if higher, rather than run the risk of exposing themselves to a bottomless pit.

The former issue is best dealt with accurate scoping and good client communication. The latter however is an area in which fee structuring can play an important part. Clients know that complex projects may develop a life of their own. They look to the experts to help them address these complexity challenges but also expect the expert, who after all should have experience in these kind of projects, to help manage the cost of these.

Professionals who fully understand their clients’ requirements, constraints and aspirations are in a position to offer superior value to their clients. A typical example would be a client who, although currently cash constrained would, upon the successful conclusion of a project, be in a stronger financial position. Under such circumstances exploring some form of risk sharing in return for a success fee may well answer the client’s need better than a comparable fixed fee.

So what are the problems associated with AFAs?
Some clients resist new structures because they don’t understand or trust them and others insist on them hoping that they can force through reductions in overall costs. The majority of profitability problems however reside firmly on the service provider side. This is because few providers have understood that a fee structure has to match the work delivery structure.

For example, a consultant or law firm that charges on a per diem or hourly basis may be very profitable when the client is willing to pay for the time required to solve a complex problem. However, for work that is highly repetitive and that can be scoped very easily a fixed rate approach may well be advantageous for both sides. The client gets a fixed price and has certainty and the service provider can generate extra profits through economies of scale and efficiency improvements. On the other hand it makes little sense to apply a fixed rate approach to a novel piece of work where it is impossible to determine how much work there will be. Likewise applying a blended rate approach will only work if the provider is able to maximise the use of junior resources on the team. This is not something every firm is willing or able to do.

The principle that fee structures should not only match client requirements but also the service providers’ work methodology still has to reach many PSFs. Until PSFs are able to adapt their working practices to the specific nature of the work required they are bound to run into trouble when the fee structure fails to meet the realities of life. Once professionals achieve this matching AFAs are likely to become the new normal in the world of PSFs.

How to use fee structures as a competitive tool and how this fits in with fee negotiation and project management is described in greater detail in the recently published book High Impact Fee Negotiation and Management for Professionals.

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(1) For a recent example see: www.americanbar.org/publications/gp_solo/2013/january_february/billable_hour_dead_long_live.html, accessed 19/10/2013