The billable hours model is an antiquated method for generating and tracking revenue in public accounting firms. This model, which is also commonly used in law, engineering, and architecture firms, is based around charging clients and recognizing revenue for the hours accountants work on client engagements. Despite its numerous shortcomings, including the much-maligned “utilization” metric, the billable hours model endures due to its simple approach for quantifying and billing accounting services. In this article, we’re going to dissect the billable hours model. Where did it come from? Why are we still using it? And for the love of all that is holy, how can we replace it with something that reflects the nature of public accounting in the 21st century?
Origins of the Billable Hours Model
If we’re to believe the lawyers (and who are they to lie?), the billable hours model started gaining popularity in the 1960s. Up until then, most American lawyers charged their clients based on the perceived value of their services. Put simply, they made numbers up. This resulted in two problems:
1. Many lawyers weren’t making as much money as they should have because they did a poor job estimating their value; and
2. There was no standard on what a particular service should cost.
In response to this overwhelming tragedy, the American Bar Association published a pamphlet in 1958 that lamented how lawyers’ salaries were falling behind doctors’. They suggested lawyers start using the billable hours model to track and charge clients for their services, and by the 1960s, this was standard practice in many law firms.
Accounting firms, ever aware of the wealth of their prestigious peers, latched on to this idea in the 1960s and 1970s. At first, clients supported the billable hours model because it allowed them to see exactly how much the accountants were working on their projects. It was also a winning solution for the PA firms. Bean counters love counting, and now firms could track the hours spent on each client and bill accordingly. Tracking billable hours also improved internal accountability and resource management, helping firms understand the productivity and efficiency of their staff.
On paper, this all sounds great. Accountants make more money, clients are happier, and internal tracking becomes easier. What changed?
How the Model is Supposed to Work vs. How the Model Actually Works
In theory, the billable hours model should work like this:
Accountants record the time and expenses they spend on various tasks and projects for clients. These hours are then multiplied by an hourly rate, which varies based on the seniority of the accountant and (sometimes) the complexity of the task. For instance, a partner’s hourly rate might be $1000 per hour, while a new associate might have an hourly rate of $150.
Each day, every accountant records the hours they worked on each client and project in their timesheet. Clients are billed based on the total hours worked multiplied by the accountants’ hourly rates as captured in the timesheets. The model encourages meticulous time tracking to ensure accuracy and transparency in billing. If the client has any questions about the amount billed or the work performed, the accounting firm can reference the timesheets (which should also include brief descriptions of the tasks), and provide additional details. In theory, everyone wins.
In practice, the billable hours model works like this:
Accountants record the time they spend on various tasks and projects for clients. For internal revenue recognition purposes, these hours are then multiplied by an hourly rate, which varies based on seniority. The accounting firm sees that Partner Pete worked 4 hours on Acme, Inc.’s tax return and that Associate Anna worked 15 hours on Acme, Inc.’s tax return. The firm recognizes revenue in the amount of $5,000 ($4,000 from Partner Pete [4 hours at $1,000/hr] plus $2,250 from Associate Anna [15 hours at $150/hr] reduced by 20% for expected deliquencies, leakage, etc.).
Accountants are encouraged to record these hours daily, but some only do it weekly, and others forget to record any time at all on occasion. Clients are billed based on an agreed-upon fixed fee, which is theoretically an estimate of the anticipated hours it will take to the complete the project, but which is in reality the cheapest option available to the client when they asked around for services. This is why rate cards, including the one above, show “discounted rates.” No sane client would ever agree to pay a senior associate $300 an hour to fill out their tax forms; you show them a discounted rate to make them feel like they’re getting a deal on these very valuable services.
We have now achieved a full disconnect between what the client pays and how the accounting firm tracks revenue. Internally, the model encourages half-baked time tracking because there is no direct link between the input (hours in the timesheet) and output (dollars received from the client). If the client has any questions about the amount billed, the accounting firm won’t publish the timesheets, because they have no bearing on the engagement letter the client signed. The client doesn’t care if you spent 15 hours doing their tax return, or 150. They’re only paying what they agreed to pay, internal revenue recognition be damned.
Advantages of the Billable Hours Model
The billable hours model has stuck around for 50+ years because it’s flexible and can be used effectively for a wide variety of assurance, tax, and advisory projects. We’re going to pick it apart later, but it’s important to recognize the upside it provides, especially for the accounting firms. Additional benefits include:
Transparency and Accountability: One of the primary advantages of the billable hours model is its transparency. Clients may receive detailed invoices that outline the specific tasks performed and the time spent on each. This transparency allows clients to monitor the status of their projects and adapt quickly if things are becoming inefficient. As an industry that prides itself on fostering trust in the financial systems, accounting firms recognize the importance of providing evidence of the work they’ve done.
Revenue Predictability: By billing based on time, accounting firms can predict their revenue more accurately. If your associates are spending a significant amount of time on Project X, you can expect to be paid by the client for Project X in the near future. This predictability is beneficial for financial planning and managing cash flows. It’s not perfect, but it’s good enough.
If it isn’t clear yet, “good enough” will be the theme of these benefits.
Performance Measurement: The billable hours model provides a convenient way to measure the productivity and efficiency of employees. Firms are already tracking billable hours for revenue recognition purposes. Using the same data, the firms can calculate utilization (billable hours worked over a defined hours target), which may help identify high-performing employees.
We wrote a separate article about utilization, but it comes part-and-parcel with the billable hours model. Utilization is an imperfect way to measure employee production, but it’s easy and doesn’t require any new resources. If it ain’t broke, we certainly ain’t gonna fix it!
Ease of Use: The billable hours model is relatively straightforward to implement. Using existing software, firms can easily track time and calculate bills, reducing the administrative burden associated with more complex methods. It can be adapted to any engagement or project with minimal effort. Our suspicion is that this is the primary reason that most accounting firms still use the billable hours model.
Is it a great system? No.
Is it still applicable to our business structure? Not really.
Is it a system that mostly works and also one that we don’t have to spend millions of dollars and man hours overhauling? You betcha! Kick the can, and let the next generation of partners figure it out!
Criticisms of the Billable Hours Model
The billable hours model is woefully outdated. It no longer serves the public accounting industry because things have changed so much since the 1960s. Specifically, it fails in these areas:
Incentive Misalignment: The most egregious feature of the billable hours model is that it causes misaligned incentives between the clients, the partners, and the employees.
Clients no longer prefer the billable hours model because it makes their cost forecasting too variable. Most clients have an annual budget for professional services. Fixed fee engagements are preferable because they can accurately predict how much they’ll be charged for each service. There are open-ended engagements, like audit defense, where the client will need to pay by the hour because the timeline and the outcome are uncertain at the beginning of the engagement. But for annuity work and common services, clients expect to pay a fixed fee. Whether or not the accounting firm is efficient enough to profit from the engagement is not the client’s concern.
The accounting firm, and by extension the partners, prioritize making as much money as possible and keeping clients happy. We’ve already seen that modern clients are at best ambivalent towards the billable hours model; they want to pay an agreed-upon amount for services, and they don’t care about their service provider’s internal accounting procedures. The partners rely on the billable hours model to inform their revenue projections, which looks roughly like this:
- Partners will have a revenue target for the fiscal year. This is derived from the prior year’s actual revenue, projections about the upcoming year’s project revenue, and some fudge factors (winning unexpected projects, clients defaulting on their payments, etc.).
- Partners measure their progress towards this goal using the firm’s internal revenue tracking system, which is built on the billable hours model. They see that their team cumulatively worked 100 hours on Client X, 250 hours on Client Y, and 500 hours on Client Z. If the sum of these rate hours is below the revenue target, they’ll try to sell more work and encourage the team to work more hours. If the sum of these hours is above the revenue target, they’ll try to sell more work and encourage the team to work more hours. You know, for “bigger bonuses.”
- Clients pay for the services when the accounting firm sends them an invoice. Partners usually send invoices when the Work In Progress (“WIP”) on a specific engagement reaches an arbitrary threshold. The WIP is calculated using the billable hours model and is intended to provide an estimate of how close to completion a project is. If you have a high WIP, it means your team has worked a lot on a specific project but has not been paid for that work yet. Most accounting firms like to carry low WIP values, ensuring that cash is regularly flowing into the business.
- The partners keep sending invoices until the total fixed fee amount is exhausted (or until the work is complete, for time and expense engagements). If there is extra WIP in the engagement when it’s complete, the partners take a write-off. Write-offs are considered bad; this means that the actual hours of work it took to finish the project exceeded the estimate. If the firm was actually paid by the hour, it would also mean they left profit on the table.
If the reverse is true, and the team finished the project in fewer hours than expected, the partners take a write-up. From the partners’ perspective, a write-up is pure profit. However, for fixed fee engagements, the firm was never going to be paid more than the agreed-upon amount, so these profits and losses are measures of internal efficiency, not real dollars.
- At the end of the year, the firm compares the projections to the actual amount of cash received and panics. Partners frantically process all of their write-offs and write-ups, send hundreds of invoices to clients they haven’t spoken to in weeks, and generally try to juice their numbers before the fiscal year end. Bonuses will be higher if the revenue and cash collection goals are reached or exceeded.
Meanwhile, the employees of the accounting firm are incentivized to maximize billable hours rather than focus on the quality and efficiency of their work. As a senior associate, you’re typically graded based on your utilization score, your annual reviews, and the timely completion of your administrative tasks (filling out time sheets, CPE hours, etc.). Since you have control over your utilization, you want to charge as many hours to client codes as you can. You’re not incentivized to work quickly and efficiently because then your utilization would suffer.
In summary, here are the motivations of each party in a public accounting engagement:
Clients – Pay the agreed-upon amount for a specific service, and have that service completed in a timely manner.
Partners – Collect as much money from the client as possible, while maintaining a healthy business relationship. Also, accurately forecast firm revenues and profits for the fiscal year.
Employees – Ensure KPI targets are met or exceeded. Try to enjoy work, or at least not actively despise it.
The billable hours model fails across all three spectra. Clients are ambivalent towards it at best. Employees will input inflated numbers to improve their performance metrics. Partners receive inaccurate forecasts due to employees’ timesheet shenanigans. In no case is any party better off due to the use of the billable hours model.
Quality vs. Quantity: We discussed this briefly above, but the emphasis on billable hours can undermine work quality. Accountants who are angling for promotions or good performance reviews (read: desirable employees) will prioritize tasks that generate more billable hours rather than those that deliver the most value to the client. They may intentionally slow their pace on certain projects to ensure they can charge more hours. Ultimately, this focus on quantity over quality can harm the firm’s reputation and client relationships.
Stress and Burnout: If you ask someone that left public accounting for industry about their favorite features of the new job, one of the first three things out of their mouth will be “no timesheets.” The pressure to meet billable hour targets, and even just fill out a daily timesheet, is a significant cause of stress among accountants. The need to constantly track time and justify hours spent enables a high-stress work environment, demoralizing employees. It just isn’t fun to compare your hours worked against your peers’ for years on end.
Finally, it can be especially demoralizing for an associate to see the firm charging clients $150 per hour for her time when she’s getting paid $40 per hour. Of course the firm has to profit off of the labor of its employees. That’s the entire business model! But comparing your take-home pay to some arbitrary figure contrived for internal accounting purposes is a recipe for disillusioned workers.
Alternatives to the Billable Hours Model
We have an entire article planned that details some alternatives to the billable hours model for public accounting firms. To keep this article a reasonable length, we’ll highlight a few here:
Fixed Fees: Would you look at that! The preferred method for clients is typically the fixed fee method. Switching the internal accounting processes for PA firms over to a fixed fee model would be tricky in certain situations, but would provide a more accurate forecast for annual revenues and income. When most of your revenue and most of your costs are already fixed, it just makes sense.
Value Billing: We’ve come full circle. Like the lawyers of yore, accountants can use value billing to charge clients based on the value of the services provided rather than the time spent. This method requires a deep understanding of the client’s needs and the value the accounting services bring to their business. It looks something like charging the client $10,000 for each basis point you reduce their effective tax rate. In short, when they win, you win. Value billing works well in certain scenarios, but it’s wildly difficult to apply in others. Smaller CPA firms benefit more from value billing because they have narrower service offerings.
Retainer Agreements: For clients who have predictable service requirements, a retainer agreement provides the most consistent payment structure. Clients pay a fixed monthly or annual fee for regular services, and extra services are negotiated in addition to the retainer. This model provides a steady revenue stream for the accounting firm and can foster long-term client relationships. However, it can become onerous if the client is growing quickly and their service requirements change.
We’ll dig into how alternative models could be applied in a future article. For now, you can rest assured that billable hours model, warts and all, isn’t going anywhere. Until a method comes along that is cheaper to implement, simpler to utilize, and better aligns the motivations of clients, partners, and employees, billable hours reign supreme. As always, blame the lawyers. They started this nightmare.