Fee Structures for Professional Service Firms
Are you an accountant or other professional looking to start your own firm? One of the most challenging aspects of having your own firm or working for one where you make decisions about client relationships is fees and fee structures. Clients have to pay money for the services that professionals perform, and if those fees are not in line with the value the customer receives, there is pressure on the engagement and the relationship. Today, we are going to discuss the core fee structures of professional service firms and how to use them.
Most engagements will fall into one of two categories in terms of their base fee structure:
Fixed Fee - The firm and the client agree to a fixed fee up front. Firms usually create this feed based off an estimate of hours needed to complete the engagement and hourly rates for their personnel.
Variable Fee - The firm and the client agree to an hourly rate (usually from a firm's rate sheet) for personnel used on the engagement up front. In many cases, the firm in the client will agree to a reasonable range of fees and the firm will communicate with the client if actual fees are more than expected.
Out of Scope
Before moving into the pros and cons of each, it's important to note that both of these fee structures can face a challenge with regards to out of scope work. Out of scope (OOS) refers to work done on an engagement that does not fit the original scope outlined in the engagement letter or understood by the two parties. OOS work is often challenging because it means more time and therefore more potential fees. On a fixed fee engagement, OOS work can be billed at a variable rate, but will cause the fixed fee engagement to no longer be entirely fixed as a result. On a variable fee engagement, identifying OOS work is critically important because the firm has an obligation to complete the original engagement as efficiently as possible. Sometimes, this extra work is necessary to complete the originally intended engagement, like when a client needs extra bookkeeping or accounting support to make their records usable for an audit or tax return. Lastly, it's important to understand out of scope work because it's generally not a fun conversation to have. You should do your best to identify the needs of the engagement and communicate proactively about what is needed to stay in that scope.
The Pros and Cons
There is no best engagement fee structure. Fixed and variable fee engagements each. Have their pros and cons, and the best outcomes will depend on the nature of the work and client relationship. Because we live in that world of “it depends”, it's even more important for you to understand where each of these engagements succeeds and where they face challenges.
Fixed Fee Engagements:
Pro #1 - Both parties know what they are going to get in terms of fees. Knowing how much something is going to cost and how much revenue the firm is going to get make the engagement acceptance process very straightforward on both sides.
Pro #2 - The firm is rewarded for efficiency. If the professional services firm incurs $9,000 worth of time on a $10,000 fixed fee engagement, they generally get to bill $10,000 to the client. This arrangement incentivizes the firm to be efficient and maintain the client relationships for many years to achieve that efficiency.
Con - Out of Scope conversations can be difficult. The main idea of a fixed fee is that the client knows what they are going to pay, and out of scope work blows that out of the water. Professionals will often find out of scope work while performing their engagement, and it's critical to proactively identify and communicate anything that would affect the timeline of the original engagement. This is the main drawback of fixed fee engagements because clients think that their professionals know everything about their business without seeing anything.
Variable Fee Engagements:
Pro #1 - Variable fee engagements tend to have higher realization. The core idea of a variable fee engagement is that a firm is billing for its professionals’ time. Both the client and the firm have the understanding that if something takes longer than expected, the bill will be higher. Because of this understanding, firms don't need to write off as much time on a variable fee engagement as they do on a fixed fee engagement.
Pro #2 - Out of Scope conversations are relatively easier. If a firm finds additional work outside of the scope of a variable fee engagement, it's easy to bring it in scope with a few phone calls or emails to the client. This is because the fee structure will be the same as the existing fee structure except with a higher estimate.
Con - Efficiency is (kind of) punished - because most variable fee engagements are for professionals’ time as recorded on a timesheet, efficient professionals have fewer billings. When a firm reaches the point of understanding the scope of a client engagement and the level of effort required by its professionals to complete it, it becomes advantageous to convert a variable fee engagement to a fixed fee engagement. As professionals learn and grow, they will become more experienced and efficient with their time, and it is the firm's responsibility to structure engagements so that this experience can be rewarded.
The general rule for engagement fee structures is that fixed fees are for work that is easily scoped and defined while variable fees are for projects that involve more uncertainty in those areas. As A professional service firm becomes more experienced in scoping and performing work, it can shift more engagements to a fixed fee structure from a variable fee structure. Depending on the nature of the work your firm does, it may be advantageous to always have a fixed fee or always have a variable fee structure. Today, I provided you with a baseline knowledge of these fee structures so tomorrow you can analyze your firm’s fees and hopefully make improvements to your chosen fee structures. Good luck!