Monday, May 27, 2013

Tips, Commissions and Fees
1-30-13 WOSO Commentary
Have you analyzed if the tips, commissions and fees you pay make sense? Let’s take three examples – waiters, real estate brokers and lawyers.

I submit that the standard waiter tip of between 15% and 20% based on the value of the meal often makes no sense. Two of you go to a three hour lunch at a modest restaurant, have three courses, a $25 bottle of wine, coffee and an after dinner drink. The waiter really worked and did a great job, including the recommendation that you share the appertizer and dessert because the servings are very generous thereby saving you $4. The tab comes out to only $50. You pay the 15% tip of $7.50 which is the norm at this modest restaurant.

That evening the two of you eat at a very fancy restaurant, have just two courses and the same brand of wine which now costs $50. The tab comes out to $200.  You give the high end 20% tip of $40 as expected at very fancy restaurants even though the waiter did nothing out of the ordinary for the two of you. You have followed the norm, but have you not seriously under tipped the first waiter at $7.50 and over tipped the second at $40?

A second example are real estate brokers who are paid a commission based on a percentage of the sales price without any reference to the time and effort invested, nor more importantly, whether the final sales price is close to the asking price.

Let’s take two examples in order to illustrate my point.

In case A the property is sold for the $100,000 asking price. The brokers efforts over three months involved some 100 calls, 25 visits to show the property to prospects, and 10 hours working with lawyers, banks, the notary public, CRIM, etc.,. The typical 5% commission is $5,000. The broker, who spent around 100 hours and obtained the desired asking price, is compensated at $5 per hour.  The broker would have been better served by obtaining a quick sale at $80,000 involving some 10 hours of work for a commission of $4,000 thus earning about $40 an hour.

In case B, the asking price is $1,000,000 and the property is sold for $800,000 to the first prospect.  The sophisticated seller and buyer handle all closing issues so that the broker only shows up at the 20 minute closing to pick up the 5% commission check of $40,000.

Was not the first broker underpaid and the second substantially overpaid? A fairer commission would phase in the percentage in accordance with the price achieved so that in the second case the commission could be 3% on the sale price up to $800,000, 4% on the amount above $800,000 up to $900,000, 5% on the amount above $900,000 up to $1,000,0000,  and 20% of the amount above $1,000,000. Under this formula, the commission on the $800,000 sale would have been $24,000 which is still very generous given the time and effort expended, but we all know that real estate brokers very often receive no compensation despite great efforts  If the sales price had been $1,100,000, then the commission would have been $24,000 plus $4,000 plus $5,000 plus $20,000 for a total of $49,000.

Lawyers are normally paid based on the hours invested. The formula incentivates putting in more time instead of resolving the client’s problem expeditiously and effectively. Over the last few years there has been a movement away from purely hourly billing towards what is called alternative billing based on incentivating efficiency and success.

 For example, the lawyer and client agree that the legal fees for a particular project could vary from a low of $50,000 to a high of $100,000. The lawyer would agree to charge 10% below the lawyer’s normal hourly rate but would receive a $15,000 success fee if the project goes through. In addition, the lawyer would receive 20% of the amount not billed up to the $100,000 budget limit. Thus, if the lawyer billed $60,000 and the project closed, the lawyer would receive the $60,000 plus the $15,000 success fee plus $8,000 for billing $40,000 less than the upper budget limit for a total of $78,000. The client closed the deal and arguably saved $22,000 in legal fees.

This example comes from an actual case I handled in the past and I believe demonstrates how creative alternative billing formulas can work well for both the client and the lawyer incentivating efficiency and success.

Although some clients still prefer hourly billing, this is a rare exception and not the rule for my consulting clients.

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