Effort/Hourly Pricing: A Not-Great but Surprisingly Popular Way to Get Paid
Effort-based pricing as an idea is far from new. In economics, it’s known as the “labor theory of value” (LTV). Adam Smith (the father of classic economic liberalism) was a strong proponent of this idea. But the idea also found support across the political aisle with Karl Marx being another supporter of LTV.
Smith defined LTV this way:
“The real price of every thing, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it. What every thing is really worth to the man who has acquired it, and who wants to dispose of it or exchange it for something else, is the toil and trouble which it can save to himself, and which it can impose upon other people.” – Wealth of Nations Book 1, chapter V, Adam Smith
That LTV gained traction among early theoretical economists is no surprise. The idea makes intuitive sense. As we make and refine products, the total number of hours adds up.
The idea explains why a carriage costs more than the tree, iron, and leather used to make it. The LTV can also be used to explain the hourly pricing rates of corporate lawyers with law degrees that they spent years earning and the decades of experience they’ve spent to perfect their craft.
The Problem of Water and Diamonds
However, LTV doesn’t explain how prices change depending on contextual factors. According to LTV, the “marginal utility” – the benefits that a service or product gives you – is always the same. As a consequence, an ice cream cone should always cost the same since its marginal utility is constant. Still, ice cream trucks park next to beach promenades on sunny summer days and charge three times what you’d normally pay, and people happily cough up the funds. Clearly, an ice cream cone is worth more when it’s sunny outside.
An even more striking problem is the one concerning water and diamonds:
“The “paradox of water and diamonds”, usually most commonly associated with Adam Smith, though recognized by earlier thinkers, is the apparent contradiction that water possesses a value far lower than diamonds, even though water is far more vital to a human being.” – Wikipedia
In other words, LTV doesn’t explain “value” well enough.
How Effort-Based and Hourly Pricing Work in Practice
Since effort-based prices reflect “toil and trouble” (as Smith puts it), there needs to be a way to measure that. When it comes to services, it’s usually time. The time spent creating something is seen as reflecting its worth.
But there are other ways to measure effort. In the construction industry, “piece rates” were long common. A mason was simply compensated for the number feet or meters of the wall he was able to complete in a day.
Clueless managers have tried to apply the same “piece rate” concept to incentivize developers by either counting lines of code or numbers of bugs squashed.
Effort-based pricing can also take the form of fixed prices calculated based on effort. Many make the mistake of offering clients fixed prices which they arrive at by simply estimating hours and multiplying by their “standard rate” without adding a premium for the insurance this gives the client. With “insurance” I mean the client is protected from paying more if the work takes more effort than estimated.
Professions and Services That Price by Effort or Use Hourly Pricing
Some of the professions and types of companies that use effort-based pricing include:
Lawyers and Law Firms Usually Bill By the Hour
Most legal professionals charge a starting fee and an hourly fee. Clients can often get a preferred rate if they buy a large number of hours and sign up for a retainer. What few law firms tell you is that much of the work you’re paying $500 per hour for is done by an underpaid intern under the “supervision” of an actual lawyer.
Accountants and CPAs Are Billing by the Hour, But It’s Changing
Those who do people’s books and accounts usually bill by the hour. Much of this work has become a commodity as the work is often routine. Transactions in a business are added to the books in a consistent manner according to regulations or established practices.
This has created incentives for accounting firms to automate the work. In other words, more and more accounting firms are letting a piece of software perform the work that an accountant used to do while the firm is climbing the food-chain by providing “value-added” financial strategic advice to clients.
Freelance Web Designers and Developers Are Often Stuck with Hourly Pricing
Charging by the hour has sadly become the norm among freelance web designers simply because so few actively think about how they price. Many are sending clients timesheets, as if that would somehow tell buyers anything useful except how much it “costs” to hire this person to do the work.
Most Jobs Are Renumeration for Time
People in the vast vast majority of professions receive a salary based on hours worked Even those who are salaried monthly “owe” their employer a certain number of hours. Firms with highly-skilled and educated employees are regularly requesting timesheets as if the bean-counting mattered more than the results (which, unlike hours and beans, can be hard to measure and define). This view of labor is also limiting companies’ ability to use anything but hourly pricing.
The Tools and Technology You Need to Price Effort
One of the few benefits of effort-based pricing is that it’s usually easy to measure. Common metrics for effort-based prices are hours or units. In many cases, a regular spreadsheet application (Microsoft Excel or Apple Numbers) and a watch will do. For larger organizations that need to keep multiple timesheets, there are thousands of dedicated time-tracking applications.
The Benefits of Using Effort-Based Pricing
Effort-based pricing and billing are clearly popular. There’s got to be a reason for it. Yes, it has some things going for it.
Hours and Pieces are Easy to Track
Counting hours and bricks isn’t hard. And as the old adage goes, “what gets measured gets done.”
It’s Easy to Grok
If you pardon the Heinleinian slang, everyone “groks” hourly pricing. The labor theory of value seems to make intuitive sense. There’s no need to explain it.
It Just Seems Fair to Compensate for Time or Effort
Paying everyone for their time appeals to our egalitarian sense that no one’s time is worth more than anyone else’s. It’s “equal pay for equal work” in practice.
It’s Financially Safe for a Company to Bill for Time
The way many implement this type of pricing is cost-plus. That means that they calculate their average monthly costs, salaries, vacation pay, pensions and insurance and then divide it all by the number of hours they bill every month, plus a markup. In other words, there’s no way to fail to cover expenses in a business that bills this way, as long as you bill enough hours per month.
The True Drawbacks of Effort-Based Billing
As you’ve probably realized by now, I am not a fan of effort-based pricing and remuneration. The problems associated with this type of pricing topic deserve their own blog post and one is forthcoming. In the meantime, let me give you an overview of the failings of effort-based pricing.
It Puts a Cap on Profits
When using hourly pricing, you voluntarily accept that the number of hours per month you can work limits how much you can earn. I’m sorry but that’s just insane. You might counter with “but I can charge a higher price per hour.” Well, that’s true. But why tie down the price to such an arbitrary and limiting factor as hours when you can set any price you want?
It Links Profits to Costs
The way hourly pricing is often used is as a form of cost-plus pricing (as I explained earlier). A company that operates this way will never go bankrupt as long as it manages to bring in work. But it will never have the funds to expand or take risks either, except by asking for a loan. You can call it “success by mediocrity” if you are mean.
It Pretends That All Apples and Pears Are Oranges
Your price is one of the most important ways you can differentiate and stand out on the market. By adopting an easily comparable price, you immediately shift the discussion with clients to be about your easily comparable price or rate, rather than what you, and uniquely you, bring to the table.
Marketplaces like Upwork and Fiverr encourage this form of pricing since it helps commoditize services. In fact, the commoditization of skilled labor is part of the business model of freelance marketplaces.
Their growth and profit potential isn’t in brokering premium services work but to create as big a market as possible with buyers with varying price-sensitivity. They want to do this while being the spider in the center of the web controlling and earning a share of all transactions. To do this, they need to make the services they broker fungible – one marketer is as good as the next.
For freelancers and small businesses, this is a catastrophic development. Commoditization drives prices down and makes it even harder to stand out and offer specialized types of value.
It Encourages You to Maximize Billable Effort (Time), Not Producing What the Client Needs and Wants
Companies that apply hourly pricing at scale will be looking for metrics and performance measures. The utilization rate (“billability percentage”) of a unit, team, or division is an easily measurable metric. Middle managers will feel compelled, if not coerced, to increase the numbers of billable hours per person rather than the value created. Clients will eventually call it quits once they find a firm that doesn’t just look out for “numero uno.”
It Puts Agency and Client at Odds With Conflicting Interests
When your interest as a freelance or agency is to earn more, that means you need to spend more time. Not necessarily make a big cake for you and the client to share. Way too many consultants inflate billings without delivering more results thanks to this twisted pricing strategy.
Effort-based billing is a zero-sum way of thinking: one’s gain is another one’s loss. I recall a phone call with a prospective client years ago who said something along these lines: “there’s no need for me to ask for an estimate since you’ll simply inflate it to maximize profit and I will not be entirely forthcoming about project details to keep the price down”.
I liked the honesty, but yikes! These are the ethics we have to deal with since we’ve made it in our interest as consultants to use as much time as possible to solve the simplest of problems. That’s just downright wrong.
It Makes Projects Focus on Deliverables and Features, Not Impact
When the only currency that counts is price-per-hour and hours-per-feature, the business impact perspective gets lost. More and more people are starting to realize that we need to talk impacts and outcomes with clients, not how many features with can deliver at what hourly price tag.
It Makes Agile Practices and “Story Points” Nothing But a Charade
If you’re a developer, have you ever been asked to estimate a feature in “story points” but have mentally translated those points to hours? Well, there you go. Rest assured you are not alone.
I hold the view that we cannot work truly agile as long as we bill by the hour. The link between user stories, epics, and hours is just too strong. The only solution is to sell sprints according to the value they create, not the size of the team or the collective number of hours… err story points, they can crunch. Only then can story points work the way they were intended.
Companies Bill Based on Effort Won’t Have Access to the Best Talent
An increasing number of businesses are adopting a results-based workplace culture. That means that it doesn’t matter how many hours you sit in front of the computer, what matters is what you achieve.
One way of doing this is to meet with your manager every two weeks to set goals. Once you have achieved or delivered on those goals, your time is yours. If you complete those goals in a week, take the second week off to build a treehouse with your daughter.
Hourly pricing makes this kind of workplace impossible and that’s a much bigger issue than many realize. Millennials are demanding more independence and to be trusted by their employers. They will actively seek employers that embrace this way of working and avoid (and badmouth) those that don’t.
We Are Just Brushing the Surface
This is only a small selection of the things that are bad with effort-based pricing and billing. The list above is based on a blog post I wrote five years ago and based my experiences as an agency owner.
Five years have gone by since then but not much seems to have changed. Some are still stuck working this way for now. For those, it’s all about lemonade – making the most of a bad situation.
Those Stuck With Effort-Based or Hourly Pricing and Billing: You Can Turn Lemons into Lemonade
What if you’re stuck billing by the hour for now, what can you do? There are ways to turn the proverbial lemons into lemonade:
Shift to Fixed Prices If Possible
To counter commoditization, find a way to make your prices harder to compare with your competitors. I recommend shifting to fixed prices and use them, always. Your fixed price isn’t someone’s else fixed price. That makes it hard to compare. That is also obvious as long as you have a secret ingredient.
Find or Create Your Secret Ingredient
Create a secret ingredient such as a unique way of working that you market and have former clients speak well of it in testimonials. Create a sense of mystery and make it clear that this is something your clients cannot get anywhere else and it’s vital to their success.
Build a Brand and Identity
Invest in your brand and identity by having a severely impressive website with lots of resources that cement you as an authority. Start blogging or producing videos with valuable content for your clients, if you aren’t already. Speak at conferences and attend podcasts as a guest.
Side With Your Clients
Be totally honest about what you think the client needs. Be on their side. Clients will appreciate this and return, appreciating you looking out for them.
Guide Conversation to Be About Value
Lead your sales and discovery conversations to be about value and then use what you learn to price accordingly, setting out on your journey towards value-based prices.
Know When to Say No
If the client demands an hourly rate, ask why. Usually, clients haven’t reflected on pricing and simply do what they think is the norm. They might be honest and say they want to compare. If so, suggest you make a proposal with a fixed price and they can consider that. If you have to accept the work on an hourly basis, set an hourly rate that you think is fair but also design your quote in such a way that it’s hard to compare. Give the client the sensation that there’s more to working with you than what meets the eye.
Don’t Accept Dishonest Negotiation
Do not engage in a “race to the bottom” negotiation. You don’t want such a buyer. They’re dishonest and parasitic and will try to strong-arm you at every point and take your money, your time, and the light out of your professional life. I believe that life is too short to be wasted in dealing with certain people.
Coming Up Next: Performance and Equity Pricing
Many seem to assume that value-based pricing is another word for performance pricing. It’s not – it’s something else. We will dig into the idea of being paid for performance, or in some cases being paid in equity, in the next post in this series.
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This post originally appeared on the Bondsai Blog, the blog of Leancept's personal CRM, now known as Elately.