How do you decide prices? Not just your headline rates, but the actual fee an individual client pays for a specific piece of work. How much do clients really care about prices and how do you communicate pricing decisions to them?

Having good answers to these questions will not only add to your bottom line but will also facilitate stronger relationships with clients in the long term.

A key goal for most firms is to establish 'trusted adviser' relationships with major clients, where they become the firm of choice for all that client's most valuable work. Ironic then that they persist with a pricing model that seems to undermine this objective at almost every turn.

Huge headline rates (come on, how many of us in our personal lives would consider paying anyone £500+ pounds an hour, other than for life-saving surgery or salvation from some unspeakable plumbing disaster?) fuel a sense of grievance on the part of clients from the outset. Though they may rarely end up actually paying these rates, clients use them, consciously or otherwise, as justification for treating their lawyers like outfall in the aforementioned plumbing disaster. Then, as if the grubby two-way horse-trading around discounts were not bad enough, partners will acknowledge that they have to deliberately lowball estimates with a view to pushing the real costs past clients later. ("Well if I tell them what it will really cost I know we won't get the work".) Trusted advisers indeed.

So, given all this, why do firms continue with this approach? Curiously, the answer seems to be that despite all the talk about alternative billing approaches, hourly rates and discounts are what many clients want. There appears to be three principal factors behind this.

First, with hourly rates, clients feel reassured by at least knowing that the hours have been worked – "they have had something for their money". In reality though, clients do not know whether the hours have been worked, and, certainly, on a project of any size will have little idea – other than in an aggregate sense – of whether or not they have been worked productively. Even knowing the pressure individual lawyers are typically under these days to meet or better their firm's target hours (1,600, 1,700, 1,800 or more?), clients seemingly still feel that a list of names and hours provides an appropriate comfort blanket in writing cheques for fees that may run into millions of pounds.

Second, establishing the protocols required to support an intelligent fixed fee regime is just too difficult. Hourly fees are sometimes rubbished by observers who ask "who would ever agree to pay a builder to construct a house on the basis that the longer he took the more money he would make?". Equally, though, one might ask what builder would ever accept a commission with the sort of vague specification often implicit in a client's instructions to a law firm: "something nice looking, reasonable accommodation but not too pricey".

Fixed prices are not uncommon these days. In some sectors such as finance they are probably becoming the norm and, even in M&A, private equity clients in particular have swept aside firms' earlier protestations that fixed fees could never work. While a fixed price might have genuine budgeting benefits and probably feels like a good result for the buyer, it is not always clear, however, that it is. When the money has run out, do you really want your lawyers incentivised to be first into the bar? The problem seems to be that no-one, neither firms nor clients, has yet been willing to invest the effort required to create the sort of robust project specification required to facilitate the approach common in engineering or construction i.e. a fixed price referenced to explicit assumptions and variable on a defined basis where those assumptions have to be revised.

Thirdly, people like getting discounts – even meaningless ones. Watching some recent interviews with purchasers of professional services, it was remarkable how they repeatedly talked about the level of discount they required from firms' standard hourly rates, with no mention of either the basis on which those rates were set or any issues around the hours worked. For a supposedly hard-bitten group, they seemed strangely oblivious to the notion that suppliers might be factoring likely discounts into their starting prices. (Anyone currently paying these 'standard' rates, please step forward.) Even with the increasing influence of procurement professionals, there seems to be little diminution in people's enthusiasm for a discount. Like buying carpets in the bazaar, for the procurement function to be able to report to the chief executive officer that their involvement resulted in an increase in discount from x% to y% seems to count as a win – despite no-one actually knowing whether the answer represents value for money or not.

So, if clients for the most part are happy with hourly rates and discounts why should firms have any incentive to change? And what are the options?

Value pricing

At one level, the answer seems obvious – a move to 'value pricing' should, surely, reward firms fairly relative to the nature of their contribution. The problem is that, despite years of talk about value pricing, few seem to have been able to make it work. Unsurprisingly, suppliers and buyers tend to see value rather differently. Occasionally, as with a bespoke piece of tax planning, there may be a relatively clear-cut case but then the numbers may be so big that, as a practical matter, clients may baulk at paying firms a share of the value. In other areas, a firm may make a key contribution with a few words of wise counsel but how much is anyone going to be willing to pay for what may amount to no more than a 10- or 20-minute conversation? (Though allowing clients to forget or ignore these contributions in discussing fees and bills, as firms sometimes seem to, is certainly not recommended.)

In M&A, many firms would like to adopt the banks' approach to value: "We helped you buy/sell the business for $xm, so clearly we are worth some percentage of $xm." Unfortunately, having let the banks get away with that one, corporates are not keen to repeat the favour and tend to be quick to argue that if one law firm had not been willing to help, another one certainly would so what particular value did the lawyers contribute? This is a problem with this line of approach; it ends up focusing people on the search for unique or exceptional contributions, which by their nature are going to be rare.

Success fees – again promoted by private equity and now very common – can perhaps be considered a species of value-based billing, albeit a slightly odd one given the value a firm might sometimes add by advising against a deal. In practice the attraction to clients seems as much to do with the ability to capitalise costs on successful transactions as much as anything else. Nevertheless, success fees can certainly help some clients feel a stronger alignment with their advisers, though, from a firm's point of view, they need to be approached with caution.

Success fees have very different implications for established players and new entrants. For example, a regime based on a 50% failure discount and 25% success premium requires a two-in-three success rate to break even (if all deals are of equal size/profitability). A reasonable risk profile, perhaps, for a large firm with an established client likely to provide a regular stream of instructions, but quite a different bet for a small firm with no assurance of future work.

Rewarding performance

If the basis for success fees is difficult to measure, or the client does not warm to this concept, attention might shift to alternative discount practices.

For a radical idea, how about firms re-basing (i.e. lowering) their prices onto a footing where discounts, if given at all, are given on clear and objective criteria – not simply because someone asks. Clearly, clients have no difficulty in understanding that certain kinds of discount make sense – they apply them in their own businesses all the time. When the rules on who gets them and why are opaque, however, it simply encourages people to ask for more and to feel disgruntled if they are refused. Used thoughtfully, discounts can be a powerful tool for incentivising and rewarding customer loyalty. So why not use them openly and even-handedly? Is that not what a trusted supplier would do? (See diagram, left, and diagram on page 26 for explanation of two examples that have worked quite successfully in many industries – incremental discounts and weighted volume discounts.)

From the current starting point it might seem unrealistic to think that there is any way back from the current nonsense that goes on around discounting. But that is exactly what has happened in the hotel industry, where after decades of selling rooms at largely uncontrolled discounts off quoted 'rack rates', the big chains have re-designed their price systems and processes so that rates now vary according to demand, and discounts and booking conditions vary with the number of rooms sold. As a result profits are growing despite the pressure from the plethora of internet distributors.

Pricing and profitability

That brings us to the core reason firms might want to re-think their current pricing strategy: improving profitability. One of the fundamentals of pricing is that different customer segments attribute different value to different products, giving them varying levels of willingness to pay. Effective pricing systems take maximum advantage of this.

It might seem a provocative question given the propensity of clients to whinge about fees, but how many firms can honestly say they understand their product/customer segments sufficiently well to be sure they are not leaving money on the table?

In any event, whatever pricing model you adopt, even if it is just to stick with the one you have, experience suggests that there is almost certainly room to improve the effectiveness with which you operate it. Research indicates that in most large companies there are two distinct sets of pricing processes – the formal written down policies that purport to define who can decide what – and the informal "what actually happens" process. In most cases the informal processes result in key pricing decisions being taken much too far down the organisation. Typically, decisions will be made by salespeople who are over-influenced by a desire to respond to their customers' (alleged) unhappiness and who are often incentivised by volume or other targets that do not reflect the rolled through profitability of the product being sold. In most cases, almost immediate improvements in profitability can be made if these decisions are moved up one or two levels, or at least signed off by people who have a fuller understanding of the product's real profitability to the business, and who are better able to take a perspective on whether the customer is really going to defect or is simply having a go for something (discount/delayed price increase/free technical support etc) that in reality they will live without. This does not mean that they make every pricing decision, but that they put strict guidelines in place that define which discounts can be applied when.

In a partnership, perhaps, one might think that formal processes should not be so necessary since every partner should be well informed and incentivised to maximise profitability. Given the damage that casually conceded discounts or write-offs can do to the bottom line (see interdependence: price, volume and profit diagram, page 28) and the difficulty partners can sometimes have in distinguishing between those times when price has actually become a critical issue for the client (occasionally) and those times when the client is saying it has (usually), it is probably worth thinking a bit harder about where the authority to make those decisions should reside. For example, is the partner doing the work actually the right person to be negotiating fees with the client at all?

Monitoring pricing performance

Monitoring the consequences of pricing policies and decisions in relation to individual client accounts in terms of recovered fees net of client 'freebies' (subsidised secondee costs, for example) is also critical if you are to have a proper basis for taking sensible pricing decisions and communicating them effectively to clients over the long term. It may well be that some 'off invoice' costs are unavoidable, but if you do not know which clients are benefiting from them, how can you be sure you are not in the position in which a number of firms have found themselves where some of your largest clients are also some of your least profitable?

Talk about money

Communication with clients about pricing is one area, in particular, where substantial room for improvement seems to exist. Many partners seemingly do not like talking about money. Laudable as this may be at one level, however, it can have pernicious effects. The annual price increase letter – virtually extinct in the manufacturing sector – will rarely fail to stoke the client's blood pressure, grappling as they almost certainly are with internal demands to lower their own costs. This is not to say that you should not increase prices, simply that it might help to show a bit of empathy (and courage) in the way you communicate them. How about face-to-face, rather than via a letter that, as a colleague once remarked, leaves you feeling like someone left you a note apologising for reversing into your parked car – but not leaving any contact details. The latest round of salary increases for assistants, more glamorous offices and enhanced profits per equity partner that clients will have in mind as they read about your "continuing and unavoidable cost increases" may, in fact, be perfectly sensible (and, indeed, in a strategic sense unavoidable) – but it would be unwise to assume that clients will figure this out without assistance.

To sit down opposite a client and openly address a price increase, a partner would need real confidence in the product they were selling and a firm grip both on the strategy for pricing it and the specific rationale for the price increase. And the problem with that is what, exactly?

So why not attempt to raise the pricing bar? Setting, communicating and selling prices based on value-to-customer will end the bazaar-like bargaining game. The positive effect to your bottom line will proof that it is worth it.

Michael Herlihy is a consultant with Jomati Consultants, Stephan A Butscher is a partner and Ruth L Keppeler a senior consultant at the London office of Simon-Kucher & Partners.