Scan the headlines of any publication devoted to information technology and one will find that articles devoted to SaaS, Software as a Service, are ubiquitous. Most of these articles speak to the effects of this business model change from the point of view of customers or software publishers. Few address the impact to value-added resellers (VARs), or as we call them at Sage, partners. When they do look at the partner perspective, it is always in the context of the current business model—that of the professional service firm.

In his compelling new book Implementing Value Pricing, Ron Baker proposes a radical new business model for professional firms, the PKF (professional knowledge firm) or Firm of the Future. This article will compare this new model to the traditional model and examine each of transformations that these firms must make.

Flaws of the PSF business model

Since all learning starts with theory, and business models are, in fact, theories, let us posit that most companies in the information technology space have been operating under the PSF, or professional service firm, business model. One way to state this model would be the use of the following theoretical equation: Revenue = Capacity x Efficiency x Hourly Rate. This PSF model is the firm of the past.

First, since companies in this space have a high contribution margin (revenue less direct labor costs), the old model advances the business myth that any revenue is good revenue. This leads these providers to accept customers who are not as valuable to the firm as others. These marginally valuable customers then take up a firm’s precious capacity and prevent the firm from reserving this capacity for its more valuable customers.

Second, the way most PSFs were built was by leveraging people, literally building a pyramid structure. Ironically, as technology came on the scene, the pyramids began to flatten as firms started to leverage this technology. The problem is that most firms attempt to build revenue before capacity, always playing catch-up to the workflow and customer demand. This is the inverse of how the majority of other business models work, which all builds capacity before demand.

Third, the firm of the past tends to focus on efficiency by measuring such things as utilization rates and billable hours. Yet if you study PSF statistics going back at least 30 years, you will find that utilization and realization rates fall within a very tight range. In other words, whether they are using a quill pen or a laptop computer, they can charge only so many hours in a year and realize so much on those hours (in terms of standard hourly rates). The theory compels leaders to believe efficiency is the be-all and end-all of running a profitable firm. This is demonstrably false. The buggy whip manufacturers were a model of efficiency before they were replaced by the automobile. So what if you are efficient at doing the wrong things?

Fourth, firms of the past worship at the altar of the ABH—Almighty Billable Hour. At least the last two generations of professionals have been told that the only thing they sell is their time. This is unadulterated nonsense, for a fundamental reason—no customer ever buys time. How can you sell something the customer doesn’t buy? Customers buy results, not effort.

Finally, the model is self-contradictory. Improving efficiency decreases revenue at a faster pace than the hourly rate can increase. Often the first time a professional does something, it takes ten times longer than it does the twentieth time. Unless the billable rate is increased by a factor of ten in the time it takes to do this learning, it will decrease revenue. Worse still, since this is known by the professional, the incentive to get better at something is reduced. This harms everyone—the professional, the firms, and worse, the customer.

A look at the PKF—the Firm of the Future

The old model does not explain why professionals are successful, nor does it offer viable alternatives to leveraging the critical success factors of knowledge workers in a knowledge economy. The new business model for the Firm of the Future does. Expressed as an equation, the PKF of Firm of the Future looks like this:

Profitability = Capital management x Effectiveness x Price

This theory has many advantages over the old one.

First, rather than focusing on top-line revenue, the Firm of the Future will focus of the profitability of each customer. Not all customers are created equally, and many firms could stand to lose up to 40 to 60 percent of their customers, and in fact they would be more profitable if they did so. Almost every firm will immediately agree with the Pareto Principle that 20 percent of their customers produce 80 percent of their revenue. Few firms have understood what this means if one flows this concept through to their bottom line. Studies have shown that 20 percent of a firm’s customers produce 150 to 225 percent of their profit. This means that they are losing money on the bottom 80 percent. If they could figure out how to just break even on this bottom 80 percent, they would increase profit from 150 to 225 percent.

Second, the Firm of the Future realizes that it doesn’t sell hours. It creates and sells, and its customers buy, access to and/or the transfer of knowledge, not time. This is a far broader view than thinking about leveraging people and hours. It is about leveraging the collective knowledge of its people. A firm’s knowledge or intellectual capital (IC) consists of three components: human capital (its people), structural capital (its systems, proprietary software, checklists, resources, and so on that enable it to perform its work), and social capital (customers, vendors, suppliers, referral sources, alumni, alliances, and more). These components are the real levers of profitability in any firm, not people hours. One cannot leverage an hour; time is simply time, and all businesses (indeed, all living beings) are constrained by it. So what? There are so many more ways to leverage the three components of IC, but it requires a radical change of mindset to get away from the notion that billable hours drive a firm’s profitability.

Third, the Firm of the Future will focus on effectiveness, not efficiency. There is not much the average firm can do to squeeze 15 to 20 percent efficiency from its human capital, which are only fallible human beings. The focus on billable hours has hindered professionals from focusing on being effective for their customers. In surveys of how customers select or why they fire their professionals, lack of efficiency is never mentioned. It is always because of behaviors such as: outstanding service, or lack of service; great knowledge or lack thereof; issues such as they don’t ignore me, they are proactive in looking after my interests, or they are aggressive in helping me pursue opportunities. One cannot do all of these things if focused on billable hour quotas.

Last, firms of the future will recognize they are businesses just like the airlines and software publishers. Businesses have prices, not hourly rates. One would never fly an airline that tried to charge you $4 per minute. The idea is simply ludicrous. In fact, firms need to start pricing up-front for everything they do, period. No more excuses.

A superior theory

The late Peter Drucker called our times the era of the knowledge worker. We need to significantly adjust leadership approaches to be successful and profitable. He introduced the concept of knowledge workers in 1959, and most professionals have still not come to grips with the significance of this change. The biggest change is that knowledge workers own the means of production—their brains. This is a radical change from the Industrial Era, when tangible capital was the exclusive property of the business owner. As Drucker said, “In the knowledge society, the most probable assumption for an organization to make is that they need the knowledge worker far more than the knowledge worker needs them.” This means firms have to earn the loyalty of their employees and inspire them. No simple “tweaking of the comp plan” will work.

Like it or not, knowledge workers are volunteers, and one doesn’t micromanage volunteers. Unfortunately, most firms still treat their people as if they were “assets” or “resources” and as if they were owned and controlled like machinery or cattle. They try to fit knowledge workers into predefined jobs, an idea from the Industrial Era’s organizational chart. But jobs don’t have value; only people do.

The first firms that truly understand what it means to be a Firm of the Future—a professional knowledge firm—will have an enormous window of opportunity to attract, develop, and profit from their human capital investors. The firms that do not will continue to struggle in the competition for top customers and talent. The new theory is the difference between remaining a firm of the past or becoming a Firm of the Future.

The choice is yours.