I’ve been having a dialogue with a consultant for the last two years, and we recently had a very interesting discussion on intellectual capital (IC).
I thought you might find it of interest, since IC is what the professional knowledge firm is all about.
Our exchange focused on whether or not it is possible—or even desirable—to attempt to value IC, and perhaps placing that value on the financial statements, or a set of parallel statements.
Doug was not advocating this approach, just questioning the validity of doing it, and what the impact would be. I’ve had many other discussions with consultants and CPAs about, for instance, placing the value of a company’s brand on its balance sheet.
Should we account for IC, like GAAP accounts for transactions? Should IC be on the financial statements?
We both conclude no. Here’s why.
Hi Doug,
We do use IC as an integral part of a professional firm’s business model, which is why we refer to them as Professional Knowledge, not Service, Firms. PKFs sell IC, not time.
As for measuring IC, I find the work of others in that area interesting, and have met my share of firms that offer formulas and frameworks to value IC. All fascinating, but I’m still trying to answer, “What’s the point?”
Some insist they want IC to be put on the firm’s financial statements, which will and can never happen, since accounting is designed to capture value after a transaction, not value it before hand.
You certainly could devise parallel financials for IC, but again, what’s the point? The argument is to force managers to think about it, value it, etc.
But it seems to me that this is the “What you can measure you can manage mentality,” and with IC, effectiveness is always and everywhere more important than efficiency (the latter of which is always a measurement, where the former is always a judgment).
Since value is subjective, any formula or model for IC will be flawed from the get go. Not that it’s not a worthwhile exercise, such as how Interbrand values the world’s leading brands, but it’s the illusion of accuracy and precision. I’ve seen companies pay well over IC value calculations because value is subjective.
So, I come back to what’s the point of this? What’s the service being offering by valuing IC? What’s the value of doing so? I don’t think it’s as obvious as IC folks make it out to be. As you know, I wrote an entire book, Mind Over Matter, on this topic, but didn’t try to value IC—it can’t be done with any reliability.
Thanks Doug, look forward to your thoughts.
Ron
Thanks very much, Ron.
This is exactly the kind of response I was hoping for—informed and critical. I’m slowly committing Mind Over Matter to memory, so I have deep respect for your opinions.
I have a lot of skepticism myself. I take your point about accounting being the trail of the past. I have heard the argument that by putting NPVs on assets, is bringing the future into the present, and isn’t it true that IC is exactly about the future, and that is why [we need] a breakthrough in accounting? It is supported by IASB standards on intangible assets and impairment, which also track with FASB standards 38 & 38.
But the IC side intrigues me, because so many people believe there is such a need to recognize (and quantify and monetize) your subtitle (intellectual capital is the chief source of wealth). I think this belief is even more strongly held in the wake of the debacle over people pumping up risky underpinnings (lousy mortgages, among others) into highly leveraged clouds of crap. A wealth creation engine based on human knowledge, experience, relationships, performance, and results seems like a more positive economic foundation. But how to capture, how to harness?
Thanks again for your quick and thoughtful response. One of these days I’ll buy you a beer, or a glass of your favorite wine
Cheers, and great thanks,
Doug
Hi Doug,
I understand the argument, my problem is knowledge is also a social construct—it simply cannot be quantified, tracked, and put into a formula.
There is certainly value in valuing IC for a business sale, and indeed that is what happens. This is why accountants call the sales price over the book value “goodwill"—just a word that describes their ignorance, i.e., their inability to value an enterprise, only capture it after a transaction takes place.
But even formulas for IC won’t capture the subjective value of an enterprise. How many times have you seen a company pay way above a company’s value, as assessed and computed by business valuators? It happens a lot, and that’s because value is subjective.
And no, I do not think putting NPVs on assets is bringing the future into the present. Accounting can’t do that, and even if there existed formulas, they would be full of errors and inaccuracies.
Here’s another reason: knowledge is actually about the past, whereas entrepreneurism is about the future, and you can’t capture the Black Swans of entrepreneurialism by formulas. No amount of sophisticated IC formula could have predicted, captured, or harnessed eBay or Google. It takes the
risk-taking of entrepreneurs to create new wealth. Anything we can capture, measure and harness is almost by definition about the past that is already dying.
I’ve come to the conclusion that we’ll never be able to measure IC. So what?
We know it’s there—like dark matter in the universe—but there are too many variables. It’s spiritual, not material—meaning you can’t measure it.
To believe otherwise is the materialist fallacy—that everything needs to be measured to be understood. It doesn’t work—see the USSR, Cuba, North Korea and any other communist country.
This doesn’t mean we should ignore IC, only that trying to measure and value it is futile—like plunging a ruler into an oven to determine its temperature. It’s the wrong device.
There’s lots more to say on this topic, but it does make my brain hurt.
Ron
Doug made the final salient point about IC, what Joseph Schumpeter called the Creative Destruction of capitalism:
The key point is that the value does not arise from the accounting of it, however elaborate the accounting scheme might be, but rather in the context of a marketplace that is focused on performance and results, enhanced by a skunkworks generator, etc.
I have read most of Seth Godin’s books and am an occasionally reader of his blog. On June 9, 2010, in a post entitled Hourly work vs. linchpin work, he wrote the following:
You should pay people by the hour when there are available substitutes. When you rely on freelancers you can put a value on their time based on what the market is paying. If there are six podiatrists in town, and all can heal your foot, the going rate is based on their time and effort, not on the lifetime use of your foot.
There is no other way to say it, this is just plain wrong.
Once again, a really smart person has fallen prey to Marx’ Labor Theory of Value. Effort does not have value, results do. The value of a podiatrists healing your foot is based on the lifetime use of your foot. This does not mean that the price is solely based on that lifetime value.
All value is subjective, not objective. Assuming a free market for this service (laughable considering it is healthcare), the “going rate” is not based on the time and effort of the doctor, but what a patient is willing to pay the doctor, period. Increased supply does bring price down, but not because any change in time and effort.
One of the key devices I use as a consultant is something I call the “Help me understand” question. I use this when there is an apparent contradiction between two statements or behaviors of a person.
The structure is this: Help me understand how A (one behavior or statement) is in alignment with B (the other behavior or statement)?
For example: Help me understand how letting one of your best people get away from your organization is in alignment with your company’s stated goal of attracting and retaining great people?
Sometimes this leads me to some very good insight and a much deeper understanding of the issues. Very often, I am convinced that A and B are, in fact, in alignment and that what was lacking was my deeper understanding.
Other times however, the person I am working with is unable to reconcile the dissonance and adjusts their behavior or statement accordingly.
Still other times I receive no feedback from the question, especially if I pose it in email. I can only assume that they make no adjustment and go on living a contradiction.
My wife, Christine, and I have recently become devotees of the AMC Original Series, Mad Men. For those of you not familiar the shows follows the personal and business life of a Madison Avenue creative who goes by the name of Don Draper in the early 1960s.
Small spoiler alert if you are planning to watch the show!
In Season 3, Don happens upon an elderly gentleman in the back unused bar of a country club named Connie. It turns out, he is Conrad Hilton. In this later scene, Hilton asks Don for his opinion on a new ad campaign. What follows is a terrific lesson on providing a free sample without giving away too much.
While listening to a recent podcast from the Cato institute on the value of globalization, I was introduced to something called the Stan Shih Smile Curve of Value.
The idea is that the lowest value item in the production chain is the manufacturing of the product. This is why, for example, that the while every iPod and iPhone are considered to be manufacturing imports we should not care. The real value of the product is in the development and end-use. It is estimated that of the $400 price of an iPhone a mere $5 goes to manufacturing in China, about $45 goes to Japan for parts, the other $350 to the US or, in this case, Apple. This is why every iPod and iPhone say, “Designed by Apple in California. Assembled in China.”
Anyway, this got me to thinking about what this curve would look like for software implementation firms. Here is what I came up with:
What this shows is that the value to the customer is actually delivered at the extremes of the relationship.
What are your thoughts? I am just beginning to play with this model, so it is very open to criticism. I am especially interested in hope accountants, lawyers, advertising agencies, et al would view this model.
Hat tip to my buddy Jason for sending this along to me.
This graph originally posted on ReflectionOf.me blog and reposted on The Consumerist and others, once again demonstrates that price is not based on cost. Interestingly enough, most of the comments are railing against Hewlett Packard. Give me a break! You basically get the printer for free and HP recovers the money by charging I higher price for the ink.
One a side note, this graph also shows why it will so hard to get the developing world to shift away from fossil fuels with crude oil being less expensive than bottled water.
The Legatum Institute was founded by Christopher Chandler, a New Zealand billionaire. In the institute’s view, man does not live on bread along, or merely political freedom and economic growth. Thus, there are two halves to prosperity, economic competitiveness and comparative liveability, which includes freedom of choice, ethical values, good health, equality of opportunity, civil liberties, spiritual faith, low unemployment, strong family life, and a temperate climate.
As its Web site reports:
The 2009 Legatum Prosperity Index is the world’s only global assessment of wealth and wellbeing. The Index finds that the most prosperous nations in the world are not necessarily those that have only a high GDP, but are those that also have happy, healthy, and free citizens. Now in its third year, the Index builds on the previous versions with expanded data and refined analysis and assesses 104 nations covering 90 percent of the world’s population.
The top 10 countries are:
Finland
Switzerland
Sweden
Denmark
Norway
Australia
Canada
Netherlands
United States
New Zealand
Sure, it’s a bit subjective, and is unsure about how to weigh religion in the Index, but it’s interesting and worth pondering.
It adds another dimension to assessing political and economic freedom without degenerating into meaningless platitudes that you find in some “happiness” and “environmental quality” indexes.
On my recent trip to Australia, I met Colin Jasper, Director of Jasper Consulting.
An actuary by education, Colin was an incredibly interesting person with whom to discuss the merits of Value Pricing versus hourly rates.
We agree, as Colin suggests, on 95% of the issues. We have an enormous disagreement over whether there are instances where hourly rates still make economic sense.
This debate was launched again when Colin sent me an article he had written, with Libby Maynard, for the September, 2009 Asia-Pacific Professional Services Marketing Association’s Journal.
Colin and Libby have kindly granted me permission to post the article, and our subsequent debate surrounding its contents.
It may seem odd that I am engaging in a debate with someone who agrees with 95% of what we stand for, but I do so because economics is concerned with marginal activity—that is, the next unit of production, spending, etc.
Thought experiment: you have an incredibly large bag of straws and a camel. You begin placing individual straws on the camel’s back, one after the other. At some point, the proverbial camel’s back will break.
If straws could think and talk, they would shout: “Hey, everything was fine until that last straw got here—he broke the camel’s back.”
The arenas where Colin is arguing that hourly rates are still appropriate is when firms are at the top of the Value Curve—at the margin, where using hourly rates is obviously the most sub-optimal.
I find his reasoning unconvincing, but I thought you might like to read the debate, draw your own conclusions, and hopefully, join in.
Here was my initial response to Colin’s article:
Hi Colin,
It was great to meet you as well and have a robust discussion on pricing.
I read your article with great interest. As you can imagine, I have many disagreements with its premise.
Here are just some:
Page 9, you say “few practitioners have sought to truly master the concept of alternative pricing structures...” This may be true as a percentage of firms overall (we estimate somewhere between 5-7% are doing real Value Pricing), but that overlooks that there are thousands of firms across all professional sectors—advertising, accounting, IT, consulting, and law—around the world that have adopted Value Pricing. Some advertising agencies are doing 100% Value Pricing and no timesheets, such as Crispin Porter and Anomaly, and Coca-Coca and P&G have their own Value Pricing compensation models with their thousands of agencies. Neither look at timesheets. These are significant numbers that are hard to dismiss, and they have proven that alternatives to the billable hour exist for all sorts of complex engagements.
On page 10, you say both client and firm should be involved in exploring and choosing the pricing approach. Yet this is not the way most industries have changed pricing strategies. Did the airlines or hotels consult their customers and ask if they could adopt Yield Management? Sellers change pricing strategies, and competition insures that customers get value. I have no problem with firms discussing alternatives with clients, but the onus is on firms to bring innovative ideas to the table, not their clients. General counsel have their own businesses to run, and don’t sit around and think about the economics of their law firms. Nor should they, anymore than you and I should be innovating the next Apple iPod or its replacement. Firms have used this very logic as an excuse to do nothing, since clients have not driven this change to date (though there are exceptions like Cisco, Pfizer, etc.).
You also state that using the wrong pricing structure can destroy value and damage relationships, and that is certainly what hourly billing has done, with its misalignment of interests, and considering it’s the wrong theory of value. The alternatives you list on page 10 are simply the billable hour in drag, and in no way are they alternative pricing structures. A price is given up-front, hourly billing is done in arrears. I assure you customers want a price, not a bill after the fact—this is basic economics. And these alternatives are still measuring value in terms of time, which is the wrong economic theory of value—and that is irrefutable, as my books and many others make clear.
On page 12 you say hourly rates are criticized because they encourage and reward inefficiencies. But that’s certainly not my major argument against them. My argument is the whole idea is based on the discredited and falsified Marxist Labor Theory of Value. Eradicating the “we sell time” mentality does lead to greater value creation, because it’s a different theory. This has been proven again and again, as all of our Trailblazer Case Studies prove. You can just read a few and see how the entire mentality of a firm is transformed to an obsession with value and results, rather than hours, inputs and costs.
You say that a tradesman complaining that his saw won’t drill a hole in the wall, etc. But hourly billing the wrong tool. It’s plunging a ruler in the oven to determine its temperature, and you’ll never get the right answer with it, period. This is why it’s universally hated in the professions, and it’s also why NO OTHER BUSINESS ON THE PLANET PRICES THIS WAY. There’s a reason for this. It simply is not a measure of value. You are arguing that Jonas Salk’s polio vaccine is valuable to the extent of the time it took him to develop, and that is economically illiterate. Period. This was settled by the Marginalist Revolution of 1871, and is well understood by economists.
You then argue that since a firm can’t define a scope, hourly rates are appropriate. This is nonsense on stilts. A scope of what the firm does know can always be done, as Chris Marston of Exemplar, Mark Chinn, Fred Bartlit (Bartlit Beck, which has never billed an hour for large clients) and Jay Shepherd, have proved in complex litigation cases. Marston’s concentric circles are the answer, as is phasing. To say that every job is a complete black hole with no “known knowns” defies reality. It also makes me, as a customer, question the expertise of my firm. As Jay Shepherd has written on his blog (The Client Revolution), there’s only one question you need to ask your law firm to determine if they are experts: “What is the price?” If they can’t answer that, they are not experts. He’s right.
You cite the Johnson and Kaplan book, which was the launch of Activity Based Costing. Have you read the book that Johnson wrote after that one? Profit Beyond Measure. It shows how Toyota doesn’t use a standard cost accounting system, and how firms should not let cost accountants drive strategic decision making. It’s a seminal book, and I have discussed it in great detail in my Firm of the Future, Pricing on Purpose and Measure What Matter to Customers books.
Hourly billing rests on the wrong theory of value, that’s our major case against it. If you begin with the wrong theory, I don’t care how efficient a firm is in implementation, it will be suboptimal. There is no right way to implement a wrong idea. Cost-plus pricing—of which hourly billing is a cousin—is dying in industries around the world, as part of the pricing revolution.
VeraSage has destroyed every single argument for hourly billing. We haven’t heard a new argument in over a decade, and your article is no exception. There are answers to every one of your defenses, and they are being done in firms around the world. You can find many examples all over our web site.
All that said, I still enjoy our dialogues and hope we will keep in touch.
Thanks Colin, enjoying the debate!
Sincerely,
Ron
Here’s Colin’s reply to mine:
Hi Ron,
I appreciate your thoughtful response and I too enjoy the dialogue. I have spoken to the article’s coauthor and we are both happy for you to publish it on your website.
With regards your specific comments:
I think we both agree that all professionals and their firms can benefit from building their value-pricing capabilities. Jasper Consulting was established with the purpose of helping professional service firms create value for their clients and capture a fair share of the value for themselves.
I take your point that firms should the lead the change. I do see differences however in consumer pricing (e.g. Apple iPod) and B2B pricing (e.g. Legal services to corporates and governments). If a consumer does not like a price their only option is to vote with their feet—or wallet. In a B2B environment, particularly at the big end of town, clients negotiate. They do not simply negotiate the price level but also the price structure. The challenge is how to overcome client buying behaviour. Most large organisations have legal panels with multiple firms on these panels. To get on a panel they put out tenders, largely based on hourly rates. If a firm says they do not provide hourly rates, in all likelihood they will not win a spot on the panel. No large firm can afford to be excluded from all of these large panels. Hence I see a role in educating clients as well as firms.
Firstly I don’t understand why you think the pricing structures listed are ‘simply the billable hours in drag.’ Do you not advocate that a value-based price be a fixed fee?
Secondly, with regards to providing a price up-front, I believe this is exactly why some clients seek hourly rates. In the panel example, they don’t know what the work will be in 2-3 years but they want embedded relationships rather than a range of quotes for each individual transaction. The only way they can be sure that the relationship price is fair is to agree a mechanism for charging up front. On a separate example, a law firm has just been awarded the first stage of an extremely large, one-off major infrastructure project in Australia. This first stage might be between 2-5% of the entire project. The client’s preference is for a single firm to serve them throughout the project but as the full requirements of the project can’t yet be scoped (i.e. the project could take an almost infinite number of directions) how other than hourly rates can the client agree a price that is fair up front?
You misrepresent me when you say that I’m arguing the polio vaccine is valuable to the extent of the time it took to develop it. I agree that in most circumstances hourly rates should be avoided. The only point we disagree on is that you believe their is no role for hourly rates and I believe there are some occasions when it is the most appropriate pricing structure (as indicated above).
I agree with you that the mindset must be first and foremost on creating value. Where firms do this really, really well—they can justify charging a higher rate (Ron—I can sense your response to this statement from 8,000 miles away).
It’s not about the firm not defining the scope, it’s about the client not being able to define the scope of their requirements. Back to the panel example. If the client wants you to work with them for the next 4 years they are not going to know what their legal needs will be, nor which of this work they will want your firm to do. They don’t want to enter a relationship where for each individual matter that seek competitive bids to ensure your price is fair. From an economics perspective perhaps hourly rates are appropriate where a) the cost of scoping is enormous relative to the amount of work to be done and b) switching costs are high.
I think we both agree firms must focus first and foremost on value (creating value).
I think we both agree that firms should develop their value-based pricing capabilities (capturing value).
I think we both agree hourly rates are over-used in the profession.
The only area I think we disagree on is that I believe there are occasions where time-based billing is the fairest structure for both clients and firms.
Kind regards
Colin
Finally, a short reply to Colin, as this post is already too long:
Thanks for letting us publish this on our Website.
I still find your arguments unconvincing.
I don’t think there’s much of a difference between B2C and B2B. Economics is economics, and only humans buy things—there’s nobody here but us people as economist Herbert Stein used to say. This is why IBM’s slogan of “No one ever got fired for buying IBM” was so effective.
I heard stories while in Australia from both firms and general counsel that firms that only offer fixed prices, and no hourly rates, were put on the panels of some very large companies. It seems to me that if a firm is able to differentiate itself effectively, then clients will work with them no matter how they price. Firms such as Advent, Optim, Marque in Australia, and Bartlit Beck, Wachtel Lipton among others in the USA prove this point.
If the only way a firm can get on a panel is to have hourly rates, that’s a very uninspiring reason to hire a law firm. This is a purpose, strategy and positioning issue, not a pricing issue.
The alternatives you suggest are the billable hour in drag because firms are still comparing the rates to an hourly rate. Even though a fixed price is quoted, the firm is measuring value by time. If Jasper Consulting wants to help law firms create and capture more value, why are you still letting Marx’s labor theory of value drive your thinking?
I don’t buy your argument that clients will only put firms on panels if they commit to an hourly rate. A fixed price is a mechanism for agreeing to price up-front. This actually is far more transparent than hourly rates, and can easily be shopped.
And an hourly rate is not a price. How can a client know what a price is by getting an hourly rate? This reminds me of the communist obsession with inputs over outputs.
Why would you want to use the hourly rate in complex jobs. It is precisely these jobs where firms are adding the most value and need to move away from hourly rates. For the life of me, this makes no sense. You’re telling firms such as those that defended Bill Gate’s Microsoft against anti-trust violations to use the hourly rate because the job cannot be scoped? Any firm that did this would find its pricing to be incredibly sub-optimal.
Alright, enough from me, let our readers join the debate.
Even the thought of summarizing the premise of George Gilder’s new book, The Israel Test, causes my mind to reel.
To attempt: The cause of the conflict between Israel and the neighboring Arab countries is not religion (although there are certainly elements) nor racism (although there are certainly elements), but rather it is caused by envy. Israel, in the 60 plus years of its existence, has been extraordinarily successful and the perception is that it has done so by taking from the Palestinians. In short, the conflict is about the zero-sum thinking of demand economics versus positive-sum thinking of supply-side economics. It is about the jealousy felt against people who have attained success and the belief that the only way they could have attained that success is by taking from others.
“The real issue is between the rule of law and the rule of leveler egalitarianism, between creative excellence and covetous ‘fairness’,’ between admiration of achievement versus envy and resentment of it,” Gilder says.
In Part One, Zerizus, Gilder, in his best and most brilliant prose since Wealth & Poverty, develops this premise and destroys any and all arguments against it. He posits his Golden Rule of Capitalism - The good fortune of others is also one’s own. One of the troubles with government, indeed with even democracy, is that government (transfers of wealth) and democracy (elections) are zero-sum, while the economic system, capitalism is positive-sum. This influences the thinking of all leaders in democracies that they need to create an equity of outcomes, not just an equality of opportunity. He terms these people, “handi-capitalists!”
In Part Two, Israel Inside, Gilder introduces us to Jewish and Israel scientists and entrepreneurs who have had a profound influence on the world as we know it and a few, who he believes, are about to have even great influence. Intel’s latest microprocessors, they are coming from Israel; Petaflop networking, from Israel; Wireless high-definition interface standards, from Israel; Algorithms which map the human genome, Israel.
In Part Three, The Paradox of Peace, Gilder puts forth his by far most controversial and thought provoking postulate - the Peace Now movement inside and outside Israel, condemn themselves to Peace Never. Gilder quotes Nobel Laureate Robert Aumann, “If you want peace now, you may well never get peace. But if you have time - if you can wait - that changes the whole picture; then you might get peace now.” Gilder states, “Peace requires the imposition of penalties on aggression.”
Simply said, The Israel Test is not a easy read, but it is absolutely a must-read.
In addition to the blood pressure pills I take from stressing out over changing the business model for professional firms (kidding, it is hereditary), I take a few vitamins and supplements on a daily basis. Since I like to take them on a full stomach, after dinner seems to work best for me. However, because I am usually doing several things at once I sometimes forget if I have taken the pills or not.
After debating about it for a few weeks, I finally broke down and bought one of those weekly pill organizers. (Shown at left.) OK, before you start with the comments, there were not many choices.
In any case (pun intended), I loaded it up on Sunday and thus far it is working flawlessly. Coincidently, it has also led to an unintended benefit - I only have to unscrew the child protection lids once a week now, and not once a day.
I got to thinking about it and there is a lesson here for professional firms. Notice that the original problem was one of effectiveness - I could not remember if I had taken the pills. In solving the effectiveness problem I also increase my efficiency - I only open the bottles once a week now. It was through increase my effectiveness that I also increase my efficiency. I submit that this could not have worked the other way. No amount of increasing my efficiency of the original task would have increased my effectiveness.
If I have lined up the bottles and practiced open them with the least amount of effort and streamlined precision of motion, I would have not increased my ability to remember to take the pills each night.
The lesson - I am living proof of Kless’ Second Law - Effectiveness always and everywhere trumps efficiency.
Ed Kless and I had a great time presenting Keynesian vs. Supply-Side Economics in Second Life on Tuesday for the Maryland Association of CPAs.
Second Life is incredible technology. Short of a live presentation, I really believe it’s the next best alternative for conducting an educational event. There is something very tactile about it, both as a presenter and member of the audience.
Sometimes this leads me to some very good insight and a much deeper understanding of the issues. Very often, I am convinced that A and B are, in fact, in alignment and that what was lacking was my deeper understanding. 
After debating about it for a few weeks, I finally broke down and bought one of those weekly pill organizers. (Shown at left.) OK, before you start with the comments, there were not many choices.
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