*This is the 2nd article in a series of articles related to project-based accounting.
Read the 1st article: Developing an Effective Project Billing Process
Traditionally, professional services organizations (PSOs) have used time-based billing – hourly, daily, weekly, monthly – to bill clients for services rendered. The most common billing method is hourly, but many PSOs make good use of the others as well. All involve charging a set fee for supplying a set amount of professional service time.
At first, time-based (a.k.a., fee-based) billing may seem like the smart way for a PSO to operate. As a case in point, consider hourly vs. salaried workers. The vast majority of hourly employees are happy knowing they’ll be compensated for every minute they’re on the job. Contrast this with the morale of salaried workers who consistently find themselves working a 70-hour week for a 40-hour-a-week paycheck. Like an hourly wage protects the hourly employee, fee-based billing protects the PSO, helping it avoid leaving unbilled hours sitting on the table.
Fee-Based Billing Drawbacks
But fee-based billing is no panacea – and for two reasons. First, as Dann Anthony Maurno points out, “fee-based billing practically invites complaints from clients.” It’s easy to see why. Every invoice is an open-ended surprise that leaves clients feeling like they never quite have a handle on what they’re being charged. This can lead to tense billing conversations, invoice write-downs…and strained PSO-client relationships.
A second downside to fee-based billing is the changing face of professional services. Increasingly, PSOs are being asked to complete client projects that are more long-term. A good example is in the software industry. Rather than assign a team of in-house developers to produce its next great app, a software company delegates the task to a PSO in a contract that will run for months. Since fee-based billing typically hinges on project completion, waiting to bill until the application is “done and delivered” can create a major cash flow problem for the PSO – and an unmanageable one-time expense for the client.
Two alternatives to fee-based project billing, however, can take the sting out of the invoicing process, allowing clients to know in advance exactly what their project costs will be, while also enabling PSOs to receive equitable and timely compensation for their efforts. These two billing techniques are project-based billing and milestone billing.
Project-Based Billing: What’s the Total?
Dann Maurno defines project-based billing as charging for a project “based on the value of the work, not its aggregate cost.” In other words, project-based billing asks the question “What should that software application, building plan, product design, etc. cost to deliver?” and answers that question – to the satisfaction of both the PSO and the client – before the project even begins. According to Maurno, project-based billing offers several critical advantages:
- Upfront Pricing – All project cost issues are negotiated and resolved before the start of the project. This frees both parties to focus on the project objectives once the work begins.
- Simplified Invoicing – The PSO doesn’t have to account for every little fee or expense, and the client doesn’t have to experience “sticker shock” because project costs are suddenly way out of line with what was originally expected.
- Better Cash Flow – Because the PSO and the client know what amount is due when, both can do a better job of shepherding their cash flow to meet current obligations.
Still, project-based billing has its downside if not carefully managed. As Maurno points out, to be successful, all project billing must result from an extremely well-defined scope of work. That way, the PSO won’t suffer from “scope creep” (a project that continues growing due to a poorly defined scope of work), and the client won’t suddenly discover that an essential – and additionally billable – task or phase is missing from the project scope.
Project-based billing also doesn’t eliminate the need for accurate time and expense tracking. In fact, the opposite is true: The more closely a PSO monitors all costs related to a current project, the more accurately it can estimate the next project. This will help a PSO avoid underpricing a project and, thus, reducing profitability. At the same time, it will keep the PSO from overpricing a project – and pricing itself out of contract contention. All this tracking, however, does require time and commitment.
Milestone Billing: What Do I Owe When?
Project-based billing is great for getting upfront agreement on what a project should cost, but it still says, “This is the amount due once the project is complete.” That’s fine for short-term projects (ones lasting from a week to a month). But what about projects that run two, three, four months or more? Here’s where milestone billing can be invaluable.
An offshoot of per-feature-or-requirement billing, milestone billing designates specific tasks or series of tasks as significant events – or “milestones” – in a project’s scope of work. Each milestone receives a billing value, and both the milestones and their values are agreed to by the PSO and the client before the project begins. As the PSO reaches each milestone, it invoices the client for the billing value assigned to the milestone. A longer-term project can involve many such milestone billings.
- Assurance of at least some payment for services if a project is canceled partway through
- Faster identification of clients who are non-payers
- Less risk that the client won’t pay and that the PSO won’t finish the project
- Greater upfront structuring to ensure the project stays on track with its schedule
- Improved cash flow management by the PSO and the client
- Better acceptance by banks and factoring companies
Additionally, milestone billing can be integrated with project-based billing to create a hybrid billing system that easily adapts to the needs of projects of nearly any size or duration.
Provisioning for a Good Deal
The Entrepreneur Encyclopedia states: “Having the right payment provisions will help your company hold on to the profits it earns.” Like any other business arrangement, the “right” provisions are the ones that benefit both buyer and seller. Remember, it’s not a good deal unless it’s a good deal for everybody.
With their ability to help (a) PSOs receive a fair ROI, (b) clients better anticipate cash requirements, and (c) both groups improve cash flow, project-based billing and milestone billing might just be the payment techniques that can turn every project you complete into a good deal. They’re definitely worth considering when writing your next proposal.
Part 3 of this series will explore various aspects of setting effective billing policies.
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