VeraSage

Baker’s Law: Bad Customers Drive Out Good Customers

Webmaster - 03/05/2007

We hold these truths to be self-evident, that all men are created equal,…
—Thomas Jefferson, The Declaration of Independence, July 4, 1776

Whenever anyone quoted those immortal words from the Declaration of Independence—all men are created equal—Federalist Fisher Ames, an ardent opponent of Thomas Jefferson and a superb congressional orator, would retort: “And differ greatly in the sequel.”

While Fisher’s admonishment might not be the best way to administer a country’s laws—where all should be treated equally—it is profound when it comes to understanding no two customers are equal. A German Proverb teaches, “He who seeks equality should go to a cemetery.”

Maximum vs. Optimal Capacity

All firms have a theoretical maximum capacity and a theoretical optimal capacity. From a strategy perspective, it is essential to see how that capacity is being allocated to each customer segment. Your maximum capacity is the total number of customers you firm can adequately service, while the optimal capacity is the point at which customers can be served adequately while maintaining your competitive advantage and pricing integrity.

Insuring a proper amount of capacity is allocated to various customer segments, while offering a differentiating value proposition within each segment, is an essential element of implementing value pricing strategies. It also prevents bad customers—those who are not willing to pay for the value you deliver—from crowding out good customers.

The Adaptive Capacity Model

Think of your firm as a Boeing 777 airplane, similar the one below.

When United Airlines places a Boeing 777 in service, it adds a certain capacity to its fleet. However, it goes one step further, by dividing up that marginal capacity into five segments:

A. First class
B. Business class
C. Full fare coach
D. Coach
F. Leisure, Priceline.com, and Bereavement fares

The airlines—and hotels, cruise lines, golf courses, car rental agencies, and other industries with fixed capacity—are adept at managing and predicting their adaptive capacity to maximize profitability.

Lessons from Yield Management

The airlines understand it is the last–minute customer who values the seat the most and hence they reserve a portion of each plane’s capacity for their best customers. They do this even at the risk the plane will take off with some of those high price seats empty—and that revenue can never be recaptured since they cannot inventory seats.

Why do they take that risk? Because the rewards of reserving capacity for price insensitive customers comprise the majority of their profits.

Airlines allocate only so many seats to coach, leisure, Priceline.com (or bereavement) seats, which they offer well in advance of the flight. However, no airline adds capacity in order to accommodate these customers.

This point is noteworthy, as too many firms will, in fact, add capacity—or reallocate capacity from higher-valued customers—in order to serve low-valued customers. This is the equivalent of the airlines putting the upper deck in the back of the plane rather than the front.

Furthermore, many companies will turn away high–value, last minute work from its best customers because it is operating near maximum capacity, usually at the low–end of the value curve for price sensitive customers. This is common during peak seasons; the lost profit opportunities are incalculable.

Many worry about running below optimal capacity and cut their prices in order to attract work, especially in downturns or slow cycles. This strategy is fine, but you must understand the tradeoff you’re making. Usually, that capacity could be better utilized selling more valued-added services to your first–class and business-class customers, who are less price sensitive than new customers.

This way, the firm does not cut its price and degrade its pricing integrity in order to attract price sensitive customers, sending a signal into the marketplace it is willing to engage in this strategy and affecting the perception of its value proposition.

The conventional wisdom is you have to be at maximum capacity—where demand exceeds supply—to raise prices. But since when do you have to wait to be fully booked to demand a premium price? Do not confuse working harder (supply-side capacity) with working smarter (demand side pricing).

Prices are determined by value created for the customer, not the internal capacity constraints of your firm.

How much fixed capacity are you allocating to each customer class? What will be the criteria you use to ascertain where in your airplane each customer sits?

By viewing your firm as an airplane with a fixed amount of seats, you will begin to adapt your capacity to those customers who appreciate—and are willing to pay for—your value proposition.

Cosmo Quiz

Webmaster - 11/27/2006

Are you value pricing?

A frequent topic of discussion among groups with whom I talk is whether or not a company is really value pricing. A few months ago, I had an idea to create a quiz that would allow an organization to determine if it was, in fact, truly value pricing.

I jotted down a few questions and submitted them to my VeraSage colleagues asking for refinement and any additional questions. Once we had the list down to a manageable number, I then again called on their brilliant minds to rate the questions using two scales:

1. An importance scale of 1 to 4.

2. A ranking from top to bottom.

Based on this input, I then created a weight system that gave more emphasis to those questions that Team VeraSage felt were of greater importance. The result was the spreadsheet referenced below.

To use it, simply download and answer the questions. Once you have answered them all, hit PageDown (PgDn) and a pithy comment is displayed as the result.

I hope this tool helps to spur some dialogue on the concepts surrounding value pricing. Please post any comments or questions. I will be happy to incorporate any suggested changes into a future version of the tool.

Download the file

Debits Don’t Equal Credits

Michelle Golden - 04/06/2006

by Ron Baker

The present accounting model is over 500-years old and it is in bad shape. The traditional Generally Accepted Accounting Principles (GAAP) financial statements are based upon a liquidation value of a business, essentially historical cost assets less liabilities—a heroic attempt to assign static value to a dynamic concern. 

The balance sheet dates from 1868, while the income statement from before World War II. The P&L statement was set up to account for the most important cost in an industrial society: cost of goods sold. But in a knowledge economy, cost of goods sold—or cost of revenue—is less meaningful, with Microsoft averaging 14 percent of sales, Coca-Cola roughly 30 percent, and Revlon 34 percent.

GAAP:  Irrelevant?

Even though intellectual capital is the main driver of wealth, you will look in vain to find it in the traditional GAAP statements—the balance sheet, income statement, and statement of cash flow. Increasingly, these statements are being referred to as the “three blind mice.”

Enron and the other spate of accounting scandals from the early 2000s were not so much about fraud, malfeasance, misfeasance, or other crimes, but rather the increasing irrelevance of the traditional accounting reporting model. Enron’s legerdemain is not what caused it to fail. Its financial deception allowed it to remain in business for longer than an otherwise similar firm engaged in accurate financial disclosures, but this is a question of timing alone and not causality.

The financial statements were simply lagging indicators of bad business decisions. Had Enron been reporting leading indicators, perhaps the market could have responded sooner.

As Talleyrand said about the shooting of the Duke d’Enghien, “C’est pire qu’un crime, c’est une erreur” (It’s worse than a crime, it’s a mistake).

Compounding the mistake was the passage of the Sarbanes-Oxley Act of 2002, which will not restore relevance to GAAP. All it does is pile burdensome and costly regulations onto a decrepit reporting model no longer relevant to an intellectual capital economy. This is the equivalent of Baron Munchausen’s struggle to extract himself from a swamp by pulling on his own hair.

The accounting profession is a mature profession, and its last true innovation was the financial statement compilation and review standards, effective in 1978. This is a 28-year innovation curve, and counting. Additional governmental regulations will only slow this innovation down further (heavily regulated industries are rarely innovative; if the computer industry were as heavily regulated as auditors and accountants, we would have Vacuum Tube Valley, probably located in West Virginia).

It’s a Profit AND Loss Economy

Nearly everyone accepts the need for regulation. The debate, therefore, is not a dispute over whether we ought to have regulation, but rather about the best way of doing so.

That being said, we need to keep in mind that in a free market economy, innovation and dynamism are the life-blood of wealth creation. Profits come from risk. Yet from Prometheus—who democratized fire by taking it from the gods and making it accessible to mankind—onward, societies have feared the innovation and the innovator. 

The recent securities fraud shareholder suits and the SEC fines imply the current demand is for risk-free investment opportunities. The current whine seems to be: “They didn’t tell me I could lose money!” We seem to want the profit without the loss (or to privatize the gains, and socialize the risks). This is simply an impossible objective.

What we heard prior to the passage Sarbanes-Oxley was the “market failure” argument. Yet, what is never considered is when regulations are put into effect, they often substitute market failure with government failure. Enron, WorldCom, etc. all have gone bankrupt, and its leaders are facing criminal and other sanctions. Arthur Andersen is gone. 

The SEC, on the other hand, will get a bigger budget and even more regulatory authority, especially with the creation of PCAOB. The very agency that was established to “protect the investor” failed cataclysmically, and emerges with more power and authority. This is subsidizing failure, and we can be sure of one thing: it will happen again.

One result of the Sarbanes-Oxley Act will be to increase the moral hazard of investing, because investors will now believe that new regulations have created a safer environment than is in fact the case. The result is they will take more risks than they otherwise would (similar to how deposit insurance increases passed by Congress led to the moral hazard of savings & loans engaging in riskier business dealings in the 1980s, since failure was subsidized by the government).

Accounting is not a Theory

Accountants and auditors focus their attention on the three traditional financial statements: the balance sheet, income statement, and statement of cash flows. These are all examples of lagging indicators, as they report on where a particular business has been. This may or may not be useful in determining where the business is heading. If users extrapolate financial reports into the future, they are relying on an implicit theory: the past will equal the future. A dubious notion.

Real time financial statements would rise to the level of coincident indicators, since they would track present performance. But what every business should develop is a set of leading indicators that would enable it to get a sense of what direction the business is heading.

The accounting profession proffers little help in achieving this objective for a very fundamental reason: Accounting is not a theory.

Developing leading indicators requires evolving a set of falsifiable theories the business can test to determine the relationship between those indicators and future financial performance. The accounting profession has simply not taken the lead in this area. The reason for this may be explained by a joke told by a graduate economics student:

One day in microeconomics, the professor was writing up the typical “underlying assumptions” in preparation to explain a new model. I turned to my friend and asked, “What would Economics be without assumptions?” He thought for a moment, then replied, “Accounting.”

When Fra Luca Pacioli introduced double-entry bookkeeping in 1494, it was no doubt a revolution, which allowed businesses to expand beyond familial and geographical boundaries. Accounting to this day insists, quite rightly, that debits must always equal credits—that is, it is an identity statement, expressed in the following fundamental accounting equation taught in every beginning bookkeeping course:

Assets – Liabilities = Owner’s Equity

An identity statement is true due to its definition. It is not a theory. A demand curve is an example of an identity statement—the summation of how much product customers would purchase at various prices. The supply curve is the same—a summation of how much product businesses would be willing to provide at various prices. It was not until economists combined these two identities into the scissors of the well-known supply and demand graph—inserting some assumptions along the way—that they posited the theory of supply and demand.

The principles of accounting are also not a theory, rather they are simply a set of guidelines, rules, and procedures for measuring financial items such as assets, liabilities, revenues, and expenses, grounded by standards such as relevance, reliability, and materiality.

One cannot use the accounting equation to predict a businesses’ future anymore than you can use the federal government’s budget deficit, or trade deficit, as a predictive tool. We may as well examine bird entrails. It is not the equation, or the measurement, that provides the usefulness, it is the context of the assumptions behind it that matter. 

Milton Friedman points out that he would rather live in a world where the government spent $1 trillion and ran a $500 million budget deficit than one where the government spent $2 trillion with a balanced budget, since the true cost of government is what it spends, not its budget deficit. Whether you agree with him or not is a value judgment, based upon how you view the usefulness of government spending. The numbers, in and of themselves, do not provide enough context to draw any insightful conclusions.

Is it any wonder the accounting profession has not taken the lead in movements such as the Balanced Scorecard, which attempts to look at more indicators than merely historical financial performance metrics? Yet every executive team should develop a set of leading indicators—canaries in the coal mine—they can use in order to properly lead the business to profitability and excellence.

Debits may equal credits to an accountant, but that offers little assistance—and even less insight— into operating a successful business. We need a new financial reporting model, one that provides interested users with leading indicators, which are far more useful in an intellectual capital economy than the lagging indicators we get from GAAP. 

It is time to reform the accounting model. Either the CPA profession takes the lead, or it will become increasingly irrelevant, relegated to part-time employees for the IRS, SEC, PCAOB and other governmental regulatory agencies. We are witnessing the beginning of the end of a once proud profession if our leaders—the Big 4, AICPA, grass root leaders, and academicians—don’t lead the charge to overhaul an increasingly antiquated accounting model. 

The place to start is to recognize when debits don’t equal credits.

Sarbanes-Oxley Needs to Go

Michelle Golden - 04/06/2006

by Ron Baker

On February 8, 2006, The Free Enterprise Fund and the Competitive Enterprise Institute (www.cei.org) launched a Constitutional legal challenge to the Public Accounting Oversight Board (PCAOB) created by Congress as part of the Sarbanes-Oxley Act of 2002 (SOX).

A recent University of Rochester study concluded that the total effect of SOX has reduced the stock value of American companies by a staggering $1.4 trillion dollars. The regulatory burden of this legislation absolutely outweighs its benefits.

PCAOB is unconstitutional for a variety of reasons. It violates the appointments clause (Article II Section 2) of the U.S. Constitution. It grants significant regulatory powers and the power to tax companies to fund its activities. This violates the separation of powers.

It is past time this overwrought piece of regulation was challenged, since it was past in haste, and its unintended consequences on the economy we will be forced to deal with permanently. Not only would SOX not have prevented Enron, WorldCom, etc., it punishes the very people it is designed to protect—shareholders—by imposing regulatory burdens than reduce profitability and stock values. Further, it rewards, with over $1 billion in worth of regulatory revenue, the very profession—auditors—that played a part in the failure of Enron, etc.

If the requirements detailed in SOX were so valuable for companies to implement, some companies would have already adopted them, and the their cost of capital would be lower, conferring upon them a competitive advantage that would be rapidly copied by competitors. The fact that this has not happened should give us pause about the supposed salutary effects of this legislation. The pricing mechanism, guided by the invisible hand, is always far more effective than the dead foot of government regulation.

It is obvious that the think tanks have taken the lead in opposing the wastefulness of this act, as the accounting profession, along with the AICPA and the state societies, has too much to gain from performing SOX work. You could fill a Mini Cooper with competent economists who support SOX, and still have room for a portly chauffer. VeraSage Fellows will fight against this wasteful regulatory act, and we believe an enlightened Congress would repeal it immediately.

To read a copy of the full Complaint filed by The Free Enterprise Fund and Beckstead & Watts, LLP, an accounting firm in Henderson, Nevada, visit: http://www.cei.org/gencon/025,04873.cfm

For the best book written on the downfall of Enron, and the only one that offers any sensible and economically literate alternatives to auditing and accounting reform, see my book review of After Enron, edited by William Niskanen. This book has been virtually ignored in the mainstream accounting press, but among think tanks it is a tour de force, and we would be wise to follow its suggestions for reform.

We will monitor this case closely and periodically provide updates, in our Sox is Broken thread.

Burying the Billable Hour

VeraSage - 04/02/2006

You are what you charge for. A business is defined by little else.

We seem to believe that we are defined by our “hourly rates.” It is as if we took our (and our firms’) collective intelligence, experience, judgment, training, wisdom and knowledge, and commoditized them into a one-dimensional hourly rate. From a marketing standpoint, this is a mistake. Once you understand that customers emphatically, do not buy hours, it becomes self-evident that pricing by the hour is precisely the wrong measurement to use to ascertain the value created for the customer.

One of the main reasons professionals undervalue their services is because they are operating under the wrong theory of value. Value, like beauty, is in the eye of the beholder. What counts is what your customer is willing and able to pay for your services. The subjective theory of value explains how transactions occur in the marketplace. No customer buys hours, and time is not money. Hourly billing measures the wrong things.

Customers only buy one thing: expectations. In today’s world, it is not enough to meet the customer’s expectations; you must exceed them. No two customers are alike, nor do customers want to be treated equally; they want to be treated individually. Always ask what the customer expects up front.

Successful professional firms of today are pricing their services according to external value created—as perceived and determined by the customer—rather than internal costs incurred in generating those services. 

Changing the pricing culture in your firm will not be easy. It takes work, commitment and a dedication of resources to training, education, and constantly confronting the inherent challenges involved with pricing. But it’s worth it.

It’s time to bury the billable hour.