lessons from professional services firms

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Summary

Professional services firms like McKinsey and Andersen Consulting are

increasingly held up as a model for other businesses - but according to

Laura Empson the picture is more complex. In this article she describes how

such firms operate and how they are organised. She explains the key

concept of "leverage" which not only underpins their knowledge

management strategies but drives profitability. And she argues that they

need to be particularly adept at managing market perceptions - "seeming"

knowledgeable may be more important than "being" knowledgeable. There is

much diversity within the sector; the fact that these firms account for 17 per

cent of all employment in the US and Europe indicates that they are an

important phenomenon in their own right.

In his recently published book, The Intellect Industry, Mark Scott boldly

states: "the professional services firm is the model of the firm of the future".

Whereas the "excellent" companies of the early 1980s were usually drawn

from manufacturing and retailing, professional services firms like McKinsey

and Andersen Consulting are regularly cited as models of best practice by

current management writers. This raises a number of questions. What

exactly are professional services firms? How do they work? What can we

really learn from them? Is it correct to think of them as role models for best

practice now or in the future?

One term, many meanings

Before we can accept that the professional services firm presents a model

for all companies in the future, we need a clear definition of what a

professional services firm is.

This is no simple task. Surprisingly there is no consensus about the

meaning of the terms "profession" and "professional".

While many people like to refer to themselves as professionals (after all the

term does imply high status and high rewards), the number of individuals

who qualify according to the formal definition of the term is relatively small.

Strictly speaking, a professional is someone who has won the right to

membership of a professional association by completing an accredited

programme of training and examinations. This definition represents a very

narrow group of organisations - accountanting, law, architecture and

engineering practises.

But Mark Scott does not mean to imply that all companies should model

themselves on legal practices. In common with other important writers in this

field, like David Maister, Mats Alvesson and Bente Lowendahl, he uses the

term more broadly to include organisations like consulting firms, advertising

agencies and investment banks.

According to this broader perspective, a professional services firm is any

firm that uses the specialist technical knowledge of its personnel to create

customised solutions to clients.

What distinguishes these kinds of companies from the broader concept of

the knowledge-intensive fi rm, or knowledge-based organisation, is the

emphasis on customisation.

Thus pharmaceutical companies and software companies can justifiably

claim to be knowledge-based organisations, but they are clearly not

professional services firms.

The difference is that once a drug or software company has created a

physical product to resolve a specific problem, it can exploit the innovation

by selling it to multiple consumers.

"WHAT EXACTLY ARE

PROFESSIONAL SERVICES

FIRMS? HOW DO THEY

WORK? WHAT CAN WE

REALLY LEARN FROM

THEM? IS IT CORRECT TO

THINK OF THEM AS ROLE

MODELS FOR BESTPRACTICE NOW OR IN

THE FUTURE?"

NEWS

FT Mastering Strategy article - 'Lessons from professional servicesfirms'

8 July 2000

versity of Oxford, Sad Business School: FT Mastering Strategy artic... http://www.sbs.ox.ac.uk/news/archives/Main/FT+Mastering+Strategy+a...

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Professional services firms, however, tailor each solution to the unique

requirements of the individual client - or so at least they would have us

believe.

Figure 1

Core management act ivities

The core management activities within a professional services firm are:

To create and disseminate knowledge within the f irm;

To recruit and motivate workers who embody that knowledge;

To develop close and potentially collaborative relationships with clients.

These activities tend to take place within a working environment where

individuals require considerable autonomy to respond flexibly to client

needs.

At the same time the authority of top management is constrained by the

need to win approval from senior colleagues for major decisions and by the

fact that staff at all levels tend to be resistant to formal administrative

controls.

Management writers are now encouraging companies of all kinds to become

more flexible and innovative; these writers hold up professional servicesfirms as relevant examples. But in many important respects professional

services firms are fundamentally different from other kinds of companies.

Money making model

A professional services firm makes money by charging clients for hours

worked.

The total potential output of a professional services firm is a simple function

of the fee-earning staff in the firm, multiplied by the number of working

hours. Total billable hours will be less than total potential output because

professionals must also devote time to non-billable activities such as - sales,

administration, and training.

Actual hours billed depends upon the firm's ability to win sufficient client

work at appropriately attractive fee rates.

The profitability of a professional services firm is determined by the

relationship between hourly fee rates charged and hourly salary rates paid.

Salaries are by far the biggest cost in a professional services firm. Plant

and equipment are relatively limited and most project-related expenses are

passed on to the client. Clients may not be aware of the actual number of

hours worked and the fee rate charged by each professional employed. It is

often in the interest of the professional services firm to bury this calculation

in lump sum billings. But clearly the economic viability of all professional

services firms depends on both maximising hours billed and maximising the

margin between fee rates charged to clients and staff salaries.

Fee rates and salary rates are determined by an individual's position within

the organisational hierarchy.

Unlike companies in most other industries, the economic and organisational

structures of professional services firms can be seen as opposite sides ofthe same coin because the staff are also the primary means of production.

Organisational structure

The basic economic structure described above applies equally to a small

start-up operation with say three partners and a major global corporation of


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150,000 professionals. In larger companies the organisational structure is

inevitably more complex.

In their recruitment literature, professional services firms like to present

themselves as "flat" and non-hierarchical organisations. In reality

professional services firms are structured around a hierarchy that is every

bit as precisely defined as that of a conventional bureaucracy.

It is true that junior staff may be able to progress through the hierarchy

relatively rapidly, compared to their counterparts in other companies.

However, the key tasks they are required to perform, their cost to the client,

and their remuneration is precisely defined at each level in the organisation.

The typical professional services firm is organised by three generic levels of

professional staff, (see Figure 2 below). As David Maister explains, this

basic hierarchy is a fundamental condition for the efficient functioning of

"leverage". This is one of the defining differences between the most and

least successful businesses operating in the professional services sector.

Figure 2

The concept of leverage

Professional services firms seek to persuade clients that they possess

distinctive and valuable expertise derived from years of solving complex

problems for clients. How then can they justify charging a substantial fee for

the services of a recent university graduate? Leverage is one way in which

they seek to resolve this conundrum.

According to the concept of leverage, junior staff work alongside more

experienced staff in close-knit project teams and learn the trade through an

informal apprenticeship process. This enables senior professionals to

communicate the highly personalised tacit knowledge that they have

acquired through years of experience.

Not only is leverage an effective knowledge management strategy, it is also

an efficient means of making money for the firm. A sceptic might argue that

such leverage enables professional services f irms to make money by

underpaying juniors and overcharging clients.

Professional services firms make profits by maximising their margin the

gap between fee rates charged and salaries paid. The daily fee rates of

senior professionals may be no more than two or three times that of junior

colleagues, but their total earnings will often differ by much larger multiples.

Junior professionals accept relatively low salaries because they are still

considerably higher than those available in alternative graduate-entry

occupations. Clients will pay high fees because they accept juniors are

leveraging the expertise of senior professionals and because they cannot

afford to pay for large amounts of senior professionals' time.

Making the most of markets

Professional services firms, notes David Maister, must seek to achieve a

balance between four fluctuating factors: (1) organisational structure, (2)

economic structure, (3) the market for professional staff, and (4) the market

for professional services.

The relationship between a professional services f irm's organisational and

economic structure has been already been demonstrated.

The relationship between the two external markets is as follows:

Clients will only employ a professional services firm if they believe it

has sufficient numbers of staff of sufficiently high calibre to deliver the

appropriate level of professional service.

Professionals will only join and remain with a professional services firm

if they can see a sufficient flow of interesting and lucrative client work

and reasonable prospects for advancement.

If staff members leave or are promoted, the organisational and economic

structure of the firm is inevitably affected. To mitigate this the professional

services firm must recruit and train new staff to an appropriate standard so


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that those moving up or out can be replaced. If the professional services

firm does not compete successfully in the market for professional staff, it

risks losing its ability to compete effectively in the market for professional

services.

In a recently published article Tim Morris and I develop further the Maister

basic model of the balanced professional services firm. We argue that the

two sets of demands that emanate from the market for professional services

and the market for professional staff are linked by a third consideration - the

knowledge base of the professional services firm.

The knowledge base represents both an input and an output. How this

knowledge is created, articulated, disseminated and renewed hasimplications for the recruitment and training of staff, as well as the definition

and delivery of services to clients. The form and content of the knowledge

base affects the level of fee rates a professional services firm charges and

the degree of leverage it achieves. The knowledge base thus connects its

two external markets to its organisational and economic structure.

Managing knowledge

In accredited professions like engineering and architecture, all members

share a common body of codified knowledge acquired through professional

training. A large part of their competitive advantage, therefore, derives from

possessing a unique base of expertise.

Traditionally, professional services firms have been regarded as

organisations of highly trained, extremely clever technical specialists, who

apply their esoteric knowledge to the creation of innovative and

sophisticated solutions of clients' complex problems. It is certainly true that

some firms operate successfully in this way. However, in reality there are

not that many extremely clever people to go round and most clients'

problems are not that sophisticated.

As a result, most highly expert professional services firms remain small and

specialised "boutiques". Firms such as McKinsey would like us to believe

that they are exceptions to this rule. But such claims should always be

treated with caution. A professional services firm wishing to grow large must

learn to codify the esoteric and tacit knowledge accumulated within

experienced staff and disseminate this throughout its organisational

structure. If this knowledge can be expressed in terms of established

procedures and applied to a wide range of client problems, the potential for

leverage increases. Codification relaxes some of the more stringent

constraints of the apprenticeship model of knowledge transfer. Increasing

the number of juniors supervised by a senior professional increases the

degree of leverage and, therefore, profitability. But the process of

codification can also threaten the profitability of the professional services

firm in two ways.

Firstly, knowledge that is codifiable can be easily copied. Staff who

leave may take their knowledge of procedures with them to a

competitor. Clients also may pass this intellectual capital on to

competitors.

Secondly, and perhaps more importantly, the act of codifying

knowledge will ultimately diminish its market value as codified

knowledge becomes demystified.

Managing percept ions

As we start to explore the nature of knowledge here we move into the realm

of smoke and mirrors. Do professional services firms really possessvaluable esoteric knowledge or are they just very c lever at persuading their

clients that they do? Mats Alvesson has shown that the ability to manage

perceptions is an essential condition for success.

It is not enough for professionals to be expert in a particular field; they must

also be able to persuade clients that they are. Indeed, for staff in a

professional services fi rm "seeming" to be knowledgeable may be more

important than actually "being" knowledgeable.

The importance of managing perceptions derives from the fact that

professional services firms operate according to a credence-based model of

service acquisition. Clients hire professional services firms because they

believe they have complex and significant problems beyond their own

capacity to resolve. How do I design a new head office building? How do I

defend myself in a takeover battle? How do I avoid bankruptcy?

But the client cannot sample the product of the professional services firm

before acquiring it. Indeed, clients may not be able to judge the success or

failure of the professional service they have purchased until many years

after the project is completed. The client's purchase must be made on the

basis of trust.


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This trust is derived from two primary sources: (1) the relationship that

develops between the individual client and the professional during the sales

process or through previous experience of working together, and (2) the

reputation which the individual professional and the f irm as a whole has

developed in the external market.

Typically professional services firms have been quite discreet in their

marketing activities and secretive about the internal operations of the firm.

The recent trend for major professional services firms to launch high profile

marketing campaigns and to allow academics to conduct research into their

organisations can be seen as an attempt to disseminate the image ofprofessionalism to a wider audience.

In the early stage of a firm's development, high quality clients confer status

on it. If the firm succeeds in developing a high quality reputation, it can

return the favour by conferring status on its clients. A corporate

headquarters building designed by the Richard Rogers Partnership for

example, carries cachet and prestige far beyond that which can be

explained purely by the physical structure of the building.

So when management writers cite McKinsey and Andersen Consulting as

models of best practice, they are making an incalculable contribution to the

revenue of these firms by advancing their mystique and reputation in the

marketplace.

The positive benefits feed through to the market for professional staff and to

the market for professional services. It is no accident that year after year

these firms feature among the most popular potential employers forundergraduate applicants.

Professional vs. commercial

For some years, writers have speculated that the drive for commercialisation

among accounting and law firms may be undermining some of the

underlying principles of professionalism.

Professionalism implies a dedication to the delivery of high quality client

service and careful management of client relationships.

This is not inherently inconsistent with the concept of commercialism.

However, professionalism also implies that the individual remains dedicated

to maintaining professional norms over and above the demands of the

employing organisation and the ability to pursue work that is intellectually

satisfying or socially beneficial, rather than merely profit maximising.

Professionalism has also typically been associated with the concept of

partnership, though this organisational form is by no means universal among

professional services firms. In a partnership, a group of senior professionals

combine the roles of owners, managers and core producers. They also

share unlimited personal liability for each other's actions. This engenders

mutual trust and collaboration among senior colleagues. In this respect also

professional services firms can be taken as models for organisations in

general.

On the downside, the partnership model implies a slow and potentially

risk-averse approach to strategic decision making because of the need to

build consensus within a diffuse authority structure.

Partly for this reason, professional services firms are increasingly

abandoning the partnership form of governance, or are seeking to

accommodate more conventional managerial structures within thepartnership form. It is ironic that, at a time when manufacturing and retail

companies are being encouraged to emulate professional services firms,

many professional firms are starting to adopt management practices more

often associated with manufacturing and retail service firms.

A future role model

Professional services firms embody many of the qualities which

organisations in general are encouraged to emulate. In theory at least they

are relatively efficient mechanisms for developing and disseminating

knowledge; they create an environment in which highly motivated individuals

can enjoy a reasonable degree of autonomy; and they place dedication to

client service above all other considerations. All this occurrs within a

non-bureaucratic organisational environment , which enshrines mutual trust

and collaboration within the professed value system.

It is important, though, not to confuse rhetoric with reality.

While professional services firms may aspire to achieve all of these

qualities, the extent to which they succeed varies widely. By fastening upon

the professional services firm as an ideal archetype, management writers

risk overlooking the considerable diversity within the sector and the threat to

traditional professional practices posed by increasing commercial


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pressures.

Professional services firms now represent a large and rapidly expanding

segment within most industrialised economies.

According to statistics from the Organisation for Economic Co-operation

and development, the professional services sector accounts for 17 per cent

of all employment in the US and major western European countries. The

sector has enjoyed annual growth of 15 per cent in revenue terms over

recent years. PwC, the accountancy firm for example, is now the single

largest recruiter from UK universities. With 155,000 professional staff

worldwide and annual revenues of Dollars 15bn, PwC, if publicly quoted,

would qualify as a Fortune 100 company.

To focus on the professional services firm as a model for organisations in

general is to lose sight of the fact that they are now an important

phenomenon in their own right.

Copyright (C) Financial Times Ltd, 1982-1997

Further reading:

Alvesson, M. Management of Knowledge-Intensive Companies, Berlin:

Walter de Gruyter, (1995). Lowendahl, B. Strategic Management of

Professional Services Firms, Copenhagen: Handelshjskolens Forlag,

(1997).

Maister, D. Managing the Professional Service Firm, New York: The Free

Press, (1993).

Additional reading may be found at www.ftmastering.com.


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