Billing rates

When I got my house painted three months back, the head painter suggested a new method of calculating his fees. Instead of charging by the man hour, which is how usually painters are charged, this guy proposed that we pay him by the square foot. Once all the work was done, he and I together measured up our house, and calculated his fee based on that.

And he had different slabs of rates, depending on whether we were using a single or a double coat, and there was a different rate for windows and grill work (there’s a lot of those in my house). This method of fee calculation was extremely convenient from my perspective as I didn’t have to run after the painters and make sure they were working. In the traditional model of hourly payment, you need to run after the workers and make sure they are working. If they take a tea break, they are wasting your money. If they are doing something slowly, again you are at a loss.

By hiring someone on a per man hour basis, what you are doing is to assume the risk of the fellow’s performance. You are effectively hiring a guy who you know little about and paying him by the hour. You have little idea as to what he can do in that time. You can’t do anything if he is too slow – he might just tell you that it is his natural speed. Time overruns in the project will result in cost overruns. All this forces you to micro-manage the entire project, and personally keep tab on the workers.

Payment based on quantum of work done takes away this risk from the client and transfers it to the contractor. And given that the contractor has a better idea of the skills of the workers who report to him, this leads to better efficiency. More importantly, the job of monitoring the workers and ensuring their efficient performance is now shifted to the contractor – since now his revenues are fixed and costs variable. You have less of a headache now, and consequently won’t be micromanaging the workers. What this also means is that the workers continue to effectively report to someone who they are used to reporting to, and without anyone looking over their shoulder, will end up doing a better and more efficient job.

In this context, I am extremely surprised at the large number of companies, from McKinsey to Infosys, who charge clients on a per man-hour basis. From the service provider’s point of view, this serves the purpose of smoothing out revenue schemes. However, the way projects go, it’s not good at all. For reasons I had mentioned above, the clients have every incentive to sit on the heads of the service providers, and this might not be good at all from the point of view of the system efficiency.

Then, from the point of view of the employees of the service provider, there is no short-run incentive to be more efficient. Even in the longer term, gains due to efficiency are not easily recognized enough to benefit the employee who has put in additional effort to improve efficiency. This can lead to the system on the whole becoming more inefficient.

Another common problem is to under-sell projects. In other words, you underestimate the efforts needed to complete a project and subsequently quote a lower price. And when the accounting for the service provider is in terms of man hours, you find the employees in such projects (and irrespective of pricing regime, such projects are common) squeezed out.

The widespread use of this pricing regime shows an unwillingness on the part of the service providers to assume part of the risk in these projects. Given that most players follow the same regime, the client has no choice but to take all the risk on his own book. This may be good from the point of view of service provider, but I get the feeling that it is extremely suboptimal from the point of view of the entire system.

One thought on “Billing rates”

  1. Fair points about the moral hazard in hourly billing. In practice this is not such an issue because the service provider won’t get repeat business if he screws around idling hours away. For the kind of companies you mention, cost of acquiring new clients is high, so ensuring repeat business is vital.

    Secondly this is an apples (non-knowledge work) to oranges (knowledge work) comparison. Sizing work anywhere nearly as accurate as area of space to be painted is only possible for extremely well understood and mature knowledge domains. And for such domains, commoditized off the shelf help is availble. External consultants aren’t called in to help.

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