How to make hourly billing work - if you must

Hourly billing is a widespread pricing scheme in software development and beyond. Inasmuch as it's easy to reason about in accounting terms, it creates unhealthy incentives on both sides of the contractual relationship.

At its core, hourly billing is about buying and selling time spent doing something, not producing any specific outcome or result.

You pay your employees per unit of time, because you expect them to engage in a variety of tasks, and negotiating price over each incremental value would add too much friction.

It's different with vendors and contractors. Ideally, you would have a well-defined job for them, one that they could conceivably value-price and create a win-win scenario.

Value pricing requires that you can create surplus for the customer and still keep a healthy profit margin.

However, it is not a magic method that you could use everywhere and expect a profit for either party.

Hourly billing, if you must

Are there any scenarios where hourly billing is still preferable even with its fundamental flaws?

I would argue that large enterprise change programs would fit.

At their beginnings, there's often just a PowerPoint deck framing the CxO's vision, and a budget. No sane technology salesperson would value-price that.

If you as a vendor had an especially good relationship with the company, you could do proper discovery, break the scope down, and value-price the iterations.

Yet the budget is likely to remain the same, so why expend all the energy and not just go with the flow if there's nothing to be gained by being clever?

The contract is likely going to be signed as an hourly affair. Despite being the best of all possible wrong pricing strategies to apply, it's likely to cause you, the vendor, to under-deliver, miss the deadlines, and become a major nuisance to the CxO in no time.

How would you make hourly billing work there? Could you?

The four riders of budgetocalypse

Here are a few contributing factors that cause enterprise programs to fail when run by hourly contractors.

Incentives, incentives, incentives - rather than assume intentional wrongdoing by the vendor, simply consider the underlying motivation that the contractor has. The only way to "scale" their business and increase "profit" is to bill as many hours as the customer can reasonably be expected to sign off on. The contractor can't be clever and do the work twice as fast without losing half of their income.

Oversight, or lack thereof - a large-scale enterprise program may have dozens if not hundreds of contractors muddling through the backlog. Reviewing each timesheet individually is a non-starter. The company could do it if it had its employees at key positions throughout the teams, but do they? The only people motivated to cut vendors' wings sit in the purchasing department and are no longer involved.

Agile - Scrum is the default now instead of Waterfall, and that has further consequences. As Agile shifted the power balance to favor the developers' interests, it made it completely legitimate for them to say, "this is as much as we are able to in the next two weeks, and not a line of code more." Say what? Yes, you heard me, plus there's no appeals process. Add in hourly billing and brace yourself for timelines shifting into the future indefinitely.

Corporate inertia - it's a cliché to speak disparagingly about things taking forever in enterprise companies, and I won't. They have good reasons to be conservative: they have existing revenue to protect, quarterly earnings to report, and an army of employees to coordinate.

The problem is that these large change programs need to operate at Internet speed to have a chance of succeeding.

When they don't, decisions come late (or never) while the clock is always running. Always. And while a big company can assume a lot of extra costs and still prevail in the end, paying its contractors by the hour with all of these factors combined is guaranteed to accomplish only one thing: spend the budget initially assigned to the program.

I may accomplish a few other things too, of course. Just without any guarantees.

Traits of successful hourly billing arrangements

I've shown you a few ways in which an enterprise change program can fail. Even more so when contractors are running the show. What about possible mitigations, are there any?

It's helpful to start with the first principles. How to work with the vendor's motivation and try to align it with the desired outcome?

Since we are stuck with hourly billing, we have to change the equation to limit its downside. Here are some that I've witnessed make an impact.

Competition - a free market does not need moral values to function. If there's enough competition, it will create and enforce them as if by magic. (Yes, there's more to it, but this isn't an economics textbook.)

I would advise the CTO to be very intentional when hiring vendors to do the job and hire direct competitors. The point is not to promise the "winner" to take over the whole program. That would destroy the competitive environment and put the equation back where it was. The fact that they are not solely in charge is usually enough.

I've seen teams mixed from several vendors, and while there's some rivalry and chemistry to manage, they focus on the mission a lot more than teams manned exclusively by a single vendor.

Oversight, for real - do the reverse of the anti-pattern described in the preceding section and staff your people at key positions. There's no way around this. Nobody is as invested in the future of your company as your own employees, assuming you have a functional compensation scheme that encourages long-term thinking.

When this is not possible, e.g., because of headcount limitations, consider hiring yet another consultancy whose job will be to oversee the program. Yes, everyone will hate them. So what! The point is to have someone on your side to keep the vendors in check. Remember, they are billing by the hour!

Before you ask, no, I don't think these consultants should be billing hourly.

Lessening the Agile impedance mismatch - as demonstrated, enterprise companies typically do not move at Internet speeds. The change program could be the best operating unit in the company, but if it stalls when interacting with the others, it can't deliver on its promise.

The approach that I've seen working best is to give the leaders as much autonomy as possible so that they don't have to consult (and ask for decisions) the parent entity more than once a quarter. Even better if the unit is a standalone entity, owned by the enterprise but operated independently.

Since this topic deals more with how the program interfaces with the stakeholders rather than vendors, I will end here before going off-tangent. Solving it is crucial for the program's success regardless of how the vendors are paid. If hourly, then even more urgently so.

Conclusion

For better or worse, hourly billing is here to stay.

Even if broken, it can be the only pricing tool available, for example on large enterprise programs.

Its inherent flaws and limitations cannot be fixed. You have to tame them, and you can.

Having said all that, if you can avoid hourly billing as a client or vendor, I encourage you to do so. It's a tool of last resort that requires a lot of effort to manage. You could spend that effort creating something valuable instead.

Published on 05 Dec 2022

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