Hourly Billing is the Opium of the Profession by Ronald J.

Baker, Founder VeraSage Institute

Ideas have consequences. Indeed, man is ruled by little else. The Communist Manifesto, the famous revolutionary treatise, published in 1848, by Karl Marx and Frederick Engels, still wields considerable power over the worlds political systems, American universities, and yes, even law firms pricing strategies.

An Incorrect Theory of Value

Marx is far from dead. Even though Marxist ideology and theory has been thoroughly repudiated by empirical evidence, we still pay him the ultimate compliment: His ideas are so deeply ingrained into our value paradigm we dont even notice them, let alone analyze their validity. In the nineteenth century, Marx posited a definition of value that has been subsequently called the labor theory of value: In its simplest form it says that the price of an item is determined by the amount of labor used in its production.

This sounds reasonable, and in fact this misconception has deceived many great economists, such as Adam Smith and David Ricardo. It is not uncommon throughout history to measure the value of a product or service as a function of labor time. The word acre in medieval English meant the amount of land that could be ploughed in one day. The problem with the labor theory of value is that it does not comport with human behavior.

Taken to its extreme, the labor theory of value would predict countries that work longer and harder should have higher standards of living. This is demonstrably false, since China should have the highest standard of livinggiven its large amount of labor hours available. In fact, what we see throughout the world is countries with less labor inputs, more entrepreneurship, dynamism, and secure private property rights, have vastly higher standards of living, including shorter hours for workers.

As the last of the ardent believers in the Almighty Hour, professionals must face the fact that this theory has been absolutely repudiated by the behavior of customers in the marketplace. For if the labor theory of value was correct, then a diamond found in a mine would be of no greater value than a rock found right next to it, since each took an equal amount of billable hours to locate. Yet how many rocks do you see in your local malls jewelry store?

Look around your office. Do you have any pictures of your spouse, family, friends, etc? Under the labor theory of value, I should, theoretically, be able to replace each one of those pictures with a perfect stranger and it should hold the same value to you, since my pictures most likely took the same amount of billable hours to produce. When you go to lunch today, perhaps youll have pizza. Under the labor theory of value, you must necessarily value the fifteenth slice just as much as you valued the first, since each took the same amount of billable hours to produce. The labor theory of value doesnt take into account the well-established law of diminishing marginal utility, which states the value to the customer declines with additional consumption of the good in question.

A Better Theory of Value

The alternative to an incorrect theory is not to do away with the theory and simply rely on common sense. The alternative to an incorrect theory is a correct theory. All learning starts

with theory. There is nothing as unenlightening as a fact not illuminated by a theorywe may as well read the phone book. Fortunately, the correct theory of value was posited by the Austrian school of economistsamong othersin the late nineteenth century, in the tradition of Eugene von Bohm-Bawerk, Carl Menger, Ludwig von Mises, and F.A. Hayek.

These thinkers posited the alternative to the labor theory of valuea more correct theory of valueby observing value is subjective. The subjective theory of value concludes goods and services have no inherent value, they are only valuable to the extent there is a valuer desiring them. Marx derived his definition of value from the assumption there must be an equality in two goods which are exchangednamely, labor hours. But the nature of exchange is the exact oppositeit is based on an inequality in the subjective value of the good received and the good exchanged. In order for any transaction to take place, both the buyer and the seller must profit from the exchange, and receive more valuein their perceptionthan what they are giving up. Were this not so, we could simply exchange five-dollar bills with each other and achieve a Marxian Utopia.

In 1748, Ben Franklin wrote, Time is money. Over the past fifty years professionals have taken this statementliterallyto mean time is value.

But timethat is, efforts, activity, and costsemphatically do not equate to value. Results are what count to the customer. If you doubt this, take your car to a mechanic who takes over one month to fix it, and willingly accept his explanation: Well, I spent the time. You could easily double your firms billable hours tomorrow: simply cut off everyones right arm. It will take twice as long to perform any given task, at least. Think of the activity, think of the increase in your billable hours. An instant ticket to prosperity.

I am being facetious, of course. But that is the conclusion one must reach if you subscribe to the labor theory of value, of which the hourly billing method is a direct derivative. Your labor costsat least in the short and medium runare sunk, no matter if your associates are doing high level legal work or making photocopies.

What matters is what your customer is willing and able to pay for your services. The focus, instead, needs to be on the value and results delivered to the customer, which is the true measure of what you are worth. The legal profession needs to replace the labor theory of value with the subjective theory of value.

It is the job of the marketing department in your firm to differentiate your offering from your competitors. It also the task of every partner, associate and team member who services the customer to ascertain the subjective value he or she places on your service. It is not enough to multiply hours spent by some arbitrarily determined hourly rate. Doing so is redolent of Marxs labor theory of value, and is absolutely irrelevant when setting a price. No customer buys hours. How can we sell something the customer does not buy? Focusing on hourswhich is really a measurement of efforts, not results or valueis chasing the wrong rabbit. Albert Einstein once wrote, Our theories determine what we measure. Hourly billing measures the wrong things.

Parting Thoughts

The philosophers have only interpreted the world in various ways. The point however is to change it. Inscription, Karl Marxs Tomb, Highgate Cemetery, London

Karl Marx was wrong. The real work of philosophers, historians, social scientists and economists is not to change the world, but rather to understand it. Only by first understanding why people behave the way they do does one have a hope of changing their behavior. I have spent the last two decades of my life dedicated to the study of the billable hour, and I am thoroughly convinced the legal profession needs to eliminate this practice. I could never have come to the conclusions I have unless I understood exactly why the profession so ardently clings to the method as much as it does. The answer lies in the two competing theories of value outlined above.

The labor theory of value, like the billable hour, is an idea from the day before yesterday. We need to forge a new paradigm of value for pricing our services as attorneys in the new millennium, and stop ritualistically accepting the false theory proffered by Karl Marx over 150 years ago. Let us relegate the billable hour to the ash heap of historyalong with carbon paper, the manual typewriter and the slide ruleright next to Karl Marxs The Communist Manifesto, as an idea whose time has past. Copyright 2008 Ronald J. Baker. All Rights Reserved. Ron Baker is the best-selling author of The Firm of the Future: A Guide for Accountants, Lawyers, and Other Professional Services; Pricing on Purpose: Creating and Capturing Value; Measure What Matters to Customers: Using Key Predictive Indicators; and Mind Over Matter: Why Intellectual Capital is the Chief Source of Wealth. You can reach him at (707) 769-0965, or e-mail at Ron@verasage.com. He Blogs at www.verasage.com.