I’ve written about Robert G. Cross, of Revenue Analytics, in the past. He’s a giant in the pricing world, responsible for implementing Yield Management at Delta Airlines.
His book, Revenue Management, is a must-have for any one serious about pricing.
Cross, along with his colleague, Jon A Higbie, and his son, David Q. (Dax) Cross, has written a fascinating article, published in the February 2009 issue of the Cornell Hospitality Quarterly: “Revenue Management’s Renaissance: A Rebirth of the Art and Science of Profitable Revenue Generation.”
There’s much that is interesting in this article, but I’d only recommend you read it if you are interested in pricing beyond professional knowledge firms, our main focus on this site.
The article is based on interviews with sixteen revenue management leaders from some of the largest organizations in the hospitality industry.
Here are some of the interesting insights from this article.
...Hotels will need to consider price elasticity and not simply match competitors’ prices, with a goal of optimizing prices.
From Yield Management to Revenue Management
A brief history of Yield Management in airlines is discussed, along with this statement by Robert Crandall, then CEO of American Airlines (circa mid-1980s):
Yield management is the single most important technical development in transportation management since we entered the era of airline deregulation...We estimate that yield management has generated $1.4 billion in incremental revenue in the last three years.
Once again, management ideas and innovation are more valuable than their mere execution.
Because of the differences between hotels and airlines, the hospitality industry began to call its systems Revenue Management (RM) around the mid-1990s.
The article also discusses how J.W. “Bill” Marriott began to implement Yield Management based on a chance conversation with Robert Crandall in the mid-1980s.
This allowed Marriott International to add between $150 and $200 million to its top line. Other hotels have experienced anywhere between 2 and 5 percent increases in top line, with some reporting even higher returns from RM.
Even better, because pricing is all about profitability, Disney has named its department “Revenue and Profit Management.” Excellent!
From tactical pricing to strategic pricing
RM is moving beyond just managing demand to actually joining with sales to create demand. It’s transforming from short-term tactical thinking to long-term strategic thinking.
It is also changing focus from revenue to profitability.
It’s all about understanding the elasticity of demand of different customer segments, and the value you are creating for them.
Rather than answering “Is it a good business decision to take the group at the requested rate?” the new focus is “What is the best rate for this group if we do decide to accept?”
To illustrate how sensitive profits are to price, the article points out:
A $1 reduction in average daily rate (ADR) in a five-hundred-room hotel with 70 percent occupancy would decrease annual room revenue by $127,750.
This is why so many companies are beginning to invest in the pricing function.
Marriott has pioneered a Revenue Opportunity Model (ROM) where they compare “optimal revenue that could have been achieved” divided by “actual revenue” to compute a “revenue opportunity index.”
As the RM manager at Marriott says, “It’s Monday morning quarterbacking.” It helps to answer “If I knew then what I know now, what decisions would I have made differently?”
Another interesting idea from John Q. Hammons is identifying “holes in the basket”:
This concept has evolved from retailers who analyze customer purchase patterns to identify certain customers who may, for example, buy baby food at their store, but not diapers.
This is similar to the Value Gap that we advocate for PKFs—potential revenue from each customer less actual revenue. Closing that gap should be a priority for everyone in the firm, which is why it’s such an excellent Key Predictive Indicator.
For example, hotels may analyze why they have a large percentage of a business customers’ hotel spend, but not their leisure spend. Targeted RM programs, such as those used by Harrah’s Casinos, can help capture a larger share of customer wallet.
Growth in pricing personnel
The article also points out that RM is one of the most rapidly growing disciplines in the hospitality industry. Leading hotel chains have hundreds of team members devoted to RM.
Hilton has 50 RM employees at its corporate office alone, along with a RM employee on-site at a lot of its properties. Marriott has RM managers on every property.
Along with these increased numbers, RM is now sitting at the table when major strategic decisions are being made.
Also discussed was identifying the right people for RM.
It’s a necessity that they find pricing interesting, and that’s not an easy hurdle to overcome. Omni launched a program to allow candidates to test drive working in RM for six months to see if it was right for them.
RM = Revenue Music?
But here’s the most interesting correlation in identifying talent for RM, from Jim Rozell at Carlson Hotels:
The people who are really good at revenue management have the mathematical and data skills, and they also have a little of the artist in them. They say, ‘These two things sound good together, but if I did this, it might sound better.’ I’ve found that the people who are really successful at revenue management are also passionate about music. There seems to be a correlation between musical aptitude and revenue management.
I’ve never seen this before. In my book, Pricing on Purpose, I laid out the following criteria for a successful Chief Value Officer, the LACEY criteria:
Leadership skills
Attitude—curious, open-minded, and is moving through the five levels of learning: awareness, awkwardness, application, assimilation, and art.
Commitment
Experimentation
Youth—the fact that those below 40 are responsible for most innovations.
I talked with Ed Kless about this morning. Ed does have musical talent, sings and plays the piano. My older brother is an excellent piano player who also grasps pricing.
I, on the other hand, can only play my iPod, and our late VeraSage colleague, Paul O’Byrne, couldn’t carry a tune or hear lyrics of songs very well.
So we remain skeptical of this specific correlation. But, it may be that those who understand the theory of music—those who move from liking music to true appreciation of music—do so because they understand a theory of music.
We’ve concluded its folks who like theory who are most likely to be the best pricers. This may explain why CPAs are lousy at it, since accounting is not a theory.
We’d love to hear your thoughts on the correlation between musical aptitude and pricing.
In any event, a fascinating article detailing the evolving nature of pricing and its importance to profitability.
Hopefully, I’ve tempted you to read it, and if not, go buy Robert Cross’ book and read it instead.
Below are the slides from my presentation I delivered at the Information Technology Alliance Spring 2009 Members Meeting in Atlanta on Tuesday, April 28.
As a follow-up to my prior post on Coca-Cola’s Value Based Compensation Model, here’s an Advertising Age article from today that provides more details.
There are some interesting quotes in this article, such as:
Some agency executives, speaking privately, said they couldn’t argue with the theory behind the shift, but had concerns about how it might work in practice.
‘Look, if you’re talking about getting paid more because you’re adding value to a project, I think that’s terrific,’ said a senior executive at one Coke agency that has yet to switch to the new model. ‘The tricky part is how you define value.’
Very true. But consider the status quo. Counting up hours is no way to get to value, hence Coke’s model is a move in the right direction. If one agrees with the theory, it’s hard to discredit the outcome, difficult or not.
Also, in contrast to the conventional wisdom that all customers care about is lowering cost, here’s Sarah Armstrong—director of worldwide media and communication operations—on the real motive behind Coke’s switch:
Though the shift comes amid a brutal economic downturn that has prompted many marketers to slash agency fees to save money, Ms. Armstrong said cost savings had little to do with Coke’s move to a new compensation model. It’s ‘ironic,’ she said, but the shift began in 2006. She declined to comment on whether Coke saw any savings in the five test markets—Australia, China, Germany, the U.K. and the Philippines—in which it deployed the new model last year.
I am traveling to Atlanta next month for a meeting with Sarah Armstrong to get more details on the model.
The article also discusses Procter & Gamble’s newly revised model, which we also believe is a move in the right direction.
Here’s a thought experiment for advertising agency leaders: If you don’t step up to the plate and offer your customers alternative pricing strategies, some will do it for you. So far, it’s the major advertisers who are taking the lead, creating history by forcing a pricing change down the throats of sellers.
If you rather be in charge of your own destiny, doesn’t it make sense to innovate new pricing models on your own? Anomaly, Crispin Porter, among others—some of which are on the Trailblazers section of this Web site—prove it can be done.
The customers are doing it because agencies won’t. All they have been doing is complaining, though there are many more exceptions than when I began working in this profession.
At least Coke is moving the goal posts, and for that it should be commended.
This is not the last word on this historical transformation among advertisers and their agencies.
As promised in my prior post, I want to follow-up on the book I’ve now read by Reginald Herber Smith, the father of the billable hour and timesheet in the legal profession.
For those of you interested in more detail on Reginald Herber Smith’s book, Law Office Organization, a detailed review can be found here.
Smith Priced on Purpose...sort of
The Service lawyers render is their professional knowledge and skill, but the commodity they sell is time, and each lawyer has only a limited amount of that. Efficiency and economy are a race against time. The great aim of all organizations is to get a given legal job properly done with the expenditure of the fewest possible hours.
In spite of Smith’s insistence to keep timesheets in tenth-of-hour increments, and his belief that the commodity lawyers sold was time, his views on pricing are more nuanced, since he also knew there was more to pricing than the labor involved.
Even though he’s credited with creating the billable hour, he did primarily use the timesheet as a cost accounting tool, not a pricing method. Here’s how I know this—Smith wrote:
The trouble is that legal services, with few exceptions, cannot be standardized. No two cases are exactly alike. The time necessarily spent, the responsibility assumed, the amount at stake, the skill required, the result—all these are variables.
In arriving at a conclusion, the report on what it cost to do the job is an illuminating and steadying factor. For the exact determination of a bill there probably is no perfect answer, but I know of no better method than open discussion with one’s partners and associates.
[Later in Chapter 4 Smith writes], That is the cost. Maybe the bill will be more than that; if so there is a profit. Maybe it will be have to be less; if so there is a loss. In practicing a profession, knowledge of cost is a helpful guide towards arriving at a fair bill but it’s not a determinant [emphasis added]. However, if the bill must be below cost, the firm at least knows what it is doing.
The variables Smith writes about are now codified in the ABA’s Model Rules of Professional Conduct. Here’s what Rule 1.5 says about “fees”:
A lawyer shall not make an agreement for, charge, or collect an unreasonable fee or an unreasonable amount for expenses. The factors to be considered in determining the reasonableness of a fee include the following:
the time and labor required, the novelty and difficulty of the questions involved, and the skill requisite to perform the legal service properly.
the likelihood, if apparent to the client, that the acceptance of the particular employment will preclude other employment by the lawyer.
the fee customarily charged in the locality for similar legal services.
the amount involved and the results obtained.
the time limitations imposed by the client or by the circumstances.
the nature and length of the professional relationship with the client.
the experience, reputation, and ability of the lawyer or lawyers performing the services. and
whether the fee is fixed or contingent.
I count fifteen different variables in the above list, but which one gets all the attention? The only one that can be measured—time involved.
Not even the ABA’s own rules mandate lawyers only look at time. Those fourteen other variables have an enormous impact on the value—and hence the price—a customer is willing to pay.
Proponents of hourly billing are just being lazy. They choose to be precisely wrong with their hours rather than approximately right by taking into account other factors. Even the father of the billable hour understood this.
As promised in my prior post, I want to follow-up on the book I’ve now read by Reginald Herber Smith, the father of the billable hour and timesheet in the legal profession.
Law Office Organization was actually a series of four articles published in the ABA Journal in May-August, 1940 (written by Smith during his Christmas vacation in 1939). They were so popular they were reprinted in pamphlet form in 1943, with continued printings up to 1983 by the Economics of Law Practice Section (ELPS). The pamphlet I purchased is the 11th edition (1983, 51 pages), with a Foreword by James E. Brill, chairperson of ELPS, 1982-1983.
Brill writes in the Foreword:
The Section of Economics of Law Practice believes Smith’s principles are as valid today as they were forty years ago…
In [Smith’s] words, ‘the whole purpose is to let the work in the office flow where it will be done best, most quickly, and at lowest cost.’ In our words, ‘Better, Faster, Cheaper.’
Reginald Herber Smith graduated from Harvard Law in 1914, after which he became chief counsel of the Boston Legal Aid Society. This is where he implemented his Frederick Taylor-inspired ideas of implementing Scientific Management principles into a law firm—specifically, completing a timesheet in order to track efficiency and perform cost and profitability accounting.
In 1919 he joined the Boston firm of Hale and Dorr as managing partner, where he practiced until his death in 1966.
New Found Respect
Since I’m dedicated to destroying what Smith implemented, I came to this book with an incredible bias, expecting to lay waste to Smith’s ideas and policies. Yet, I attempted to keep an open mind, as always, and hear him out.
Good thing, because the book is better than I expected, containing much wisdom. Even though I have major disagreements with Smith, I’ve learned to appreciate his counsel, and can forgive his sins as a result of the intellectual ideas in the air at the time he practiced.
As you will see, he even implemented many of the ideas that are contained in The Firm of the Future, along with other guiding principles we here at VeraSage advocate.
Allow me to share some of his wisdom. I particularly like this from Chapter 1, “Law Office Organization: An Overview,” as it destroys the argument I hear so often from critics of Value Pricing as it applies to lawyers:
We are apt to take refuge in the thought that after all we are engaged in a profession, not a business. But does it follow that we are entitled to practice our profession in an unbusiness-like manner?
He went on to discuss the benefits of specialization, something doctors and lawyers were beginning to do in the 1940s and 1950s, while it took CPAs until the 1980s to get serious about specializing.
In Chapter 2, “The Client Comes to the Office,” Smith suggests the attorney fill out a “New Case Report” form, which includes all information needed to set up the client.
The most interesting thing about this form, to me, was the line: Estimated Value of Case $____. Smith recommended that the accounting department reviews this amount with all attorneys two or three times a year to see if the estimate needs to be revised.
What was this used for? Smith explains:
As has been said, the true value of a case cannot be told until its termination. Up to that point an estimate is only an estimate and has a margin of error. But the total estimated value of all cases in the office is a significant fact for the partners. That total also contains a margin of error, but what is important is the trend.
If the trend is going down and continues down, the partners have some soul-searching to do; they have got to trim sail and seek every possible way of cutting cost…
If the trend is going up, the partners face the converse problem. [It is] a signal that it is about time to employ another junior or possibly to seek another partner.
Thus the ‘estimated value’ method does enable a firm to look a little way ahead, to have at least a rough gauge by which to appreciate its own future, and to make its plans accordingly.
Despite Smith’s erroneous statement that value can only be determined at termination of a case, this “estimated value” was a Key Predictive Indicator for Smith’s firm, and not a bad one at that!
Making professionals think about value, as opposed to cost—or even price—is always a worthwhile task. I believe Smith was way ahead of his time with this method.
In Chapter 3, “The Lawyers Work On the Case,” Smith explains how he implemented the “firm meeting,” held in the office each Thursday at 7 p.m., three per month of which are open to the entire firm, and one is reserved for partners only.
One agenda item is “calling the cases,” whereby:
The responsible attorney gives a brief statement of what it is about. Then the firm tries to pool its brains and to give all the help it can.
This is Knowledge Management way before it became in vogue! Essentially, it’s a Before Action Review; coupled with After Action Reviews, we believe these to be the most important techniques for sharing intellectual capital.
They also discussed client bills at this meeting, in an attempt to determine if the bill was fair and satisfactory to both customer and firm. All members could have input, but the responsible attorney had the final say. This is an early incarnation of the pricing cartel!
Well, actually, the customer had the final say, which brings us to Smith’s pricing philosophy. It must be said: I believe Smith understood pricing better than most lawyers today.
Smith Priced on Purpose...sort of
The Service lawyers render is their professional knowledge and skill, but the commodity they sell is time, and each lawyer has only a limited amount of that. Efficiency and economy are a race against time. The great aim of all organizations is to get a given legal job properly done with the expenditure of the fewest possible hours.
In spite of Smith’s insistence to keep timesheets in tenth-of-hour increments, and his belief that the commodity lawyers sold was time, his views on pricing are more nuanced, since he also knew there was more to pricing than the labor involved.
Even though he’s credited with creating the billable hour, he did primarily use the timesheet as a cost accounting tool, not a pricing method. Here’s how I know this—Smith wrote:
The trouble is that legal services, with few exceptions, cannot be standardized. No two cases are exactly alike. The time necessarily spent, the responsibility assumed, the amount at stake, the skill required, the result—all these are variables.
In arriving at a conclusion, the report on what it cost to do the job is an illuminating and steadying factor. For the exact determination of a bill there probably is no perfect answer, but I know of no better method than open discussion with one’s partners and associates.
[Later in Chapter 4 Smith writes], That is the cost. Maybe the bill will be more than that; if so there is a profit. Maybe it will be have to be less; if so there is a loss. In practicing a profession, knowledge of cost is a helpful guide towards arriving at a fair bill but it’s not a determinant [emphasis added]. However, if the bill must be below cost, the firm at least knows what it is doing.
The variables Smith writes about are now codified in the ABA’s Model Rules of Professional Conduct. Here’s what Rule 1.5 says about “fees”:
A lawyer shall not make an agreement for, charge, or collect an unreasonable fee or an unreasonable amount for expenses. The factors to be considered in determining the reasonableness of a fee include the following:
the time and labor required, the novelty and difficulty of the questions involved, and the skill requisite to perform the legal service properly.
the likelihood, if apparent to the client, that the acceptance of the particular employment will preclude other employment by the lawyer.
the fee customarily charged in the locality for similar legal services.
the amount involved and the results obtained.
the time limitations imposed by the client or by the circumstances.
the nature and length of the professional relationship with the client.
the experience, reputation, and ability of the lawyer or lawyers performing the services. and
whether the fee is fixed or contingent.
I count fifteen different variables in the above list, but which one gets all the attention? The only one that can be measured—time involved.
Not even the ABA’s own rules mandate lawyers only look at time. Those fourteen other variables have an enormous impact on the value—and hence the price—a customer is willing to pay.
Proponents of hourly billing are just being lazy. They choose to be precisely wrong with their hours rather than approximately right by taking into account other factors. Even the father of the billable hour understood this.
The first service guarantee among law firms?
Smith then goes on to argue that, in reality, it’s the customer who has the final say regarding the price. His firm allowed the customer to fix their bill, in alignment with value received.
His firm actually informed the customer of this policy up-front, usually after the customer asked, “What will it cost?”
He qualified this by stating that most customers were honest, but if the firm believed a customer was being unfair, they would respectfully decline to accept further work.
Now of course Smith goes on to justify not being able to answer the cost question by analogizing an architect building a house. He cannot give you a price until he sees all the specifications, and no attorney can know the specifications in advance, especially in litigation.
Nevertheless, you have to hand it to Smith and his firm for informing the customer of this policy up-front. Talk about transparency.
Smith on cost accounting
Smith argued that cost accounting in a law firm was far less complex compared to that of a factory, since most costs are fixed—rent, salaries, etc.
He suggested firms calculate the following ratio:
Total figure for overhead ÷ Total figure for direct expense (partner draws and professional salaries) X 100%
This ratio is then multiplied by each professional’s draw or salary to determine how much each must earn to pay their own way—breakeven.
Smith argued that any imprecision in this formula is outweighed by the advantages of its simplicity. In other words, it’s close enough for government work. This is true.
It has always amazed me that CPAs believe that cost accounting has to be accurate down to the sixth-minute increment. This is an incredible waste of intellectual capital, where the cost exceeds the benefits of the information gathered.
Further, Smith argued that there might be misallocations to any one member of the firm using this ratio, but that the total cost for the firm is exact. Again, very true, and close enough for hand grenades.
Smith’s firm expected 1,600 hours from juniors and 1,520 from partners, with partners over 50 years old at 1,200. Not bad compared to the horror stories you hear today of 1,800-2,000 hour quotas, with actual hours being even higher.
Smith also pointed out that there was no way to make a lawyer’s cost per hour cheap. Even if you take away all the overhead of office, clerical, etc., at best you’d only reduce the cost by 50%.
This is, of course, an opportunity cost, as it is calculating what the lawyer needs to live on. Opportunity cost is important, but it has nothing to do with the value of a particular service to any client.
All said, as Smith’s comments on pricing above make clear, the timesheet was introduced mainly to perform cost accounting, and not for pricing.
It was a way to manage and cost the inventory, but after lawyers became acclimated to filling one out every day, it became the inventory lawyers sold.
Smith on partner compensation
Smith claims to have dispelled the nightmare that is partner compensation, as no partner ever left his firm after 43 years.
He presents an interesting model to allocate the profits of the firm in the final chapter. It’s formulaic, and weights three factors for each partner:
Work done (60%)
[New] Business credit (30%)
Profit credit (10%)
As pricing is about profit, I believe profitability should be given much higher weight, but I don’t want to get into discussing the details of partner compensation, since we at VeraSage don’t like the partnership model to begin with.
As they say, the only firms happy with their partner compensation model are sole proprietorships.
Summing Smith
Smith probably did more good than harm. He imparted much wisdom in these articles, and despite the fact that we believe the billable hour and timesheet are antiquated, if Smith hadn’t introduced these tools to the legal profession, someone, somewhere, most certainly would have.
But I also think Smith would be the first to embrace new ideas, as he did with Taylorism and Scientific Management. I think he would have supported VeraSage and our Quest to bury the billable hour and timesheet, since he believed systems in law firms were nothing but a means to an end.
And what was that end? Here’s what he wrote in the 2nd Epilogue, Author’s Note, in December 1963:
What I reproach myself for is that, in my enthusiasm to set out the principles of a system for a law office, I failed to make it plain that any system is only a means to an end.
The end, the goal, is to enable a group of people to work together happily and without friction, secure in their belief that the system is just and their good work for clients will be immediately reflected in the records.
The ideas and ideals VeraSage advocates have the same purpose in mind—that is, to maintain and advance the dignity and honor of professionals everywhere, while acknowledging that we are knowledge workers, and hence any system needs to be our servant, not our master.
It is up to future generations to carry on Smith’s innovative spirit. Are we up to the challenge?
How many times have we heard this?: Socialism and communism aren’t bad theories, they just haven’t been tried by the right people yet.
Well, the same is said about the billable hour. Oh, no, it’s not inherently unethical, doesn’t misalign the interests of professional and customer, and with the right person it’s a fine system. Anyway, you can’t condemn hourly billing just because a few people cheat the system.
This is precisely why economists aren’t concerned with compliance. They are concerned with incentives. There’s no good way to implement the wrong theory.
There’s no way any of this type of billing chicanery could happen with fixed prices quoted up-front.
I am thrilled to announce the latest VeraSage Trailblazer, Karen Smart of Smart e-Solutions Inc. (WAC Consulting).
Karen’s amazing story, Do you want fries with that?, is detailed in our Trailblazer section. She give some amazing details on proposal development and before and after comparison.
The world’s most famous brand, Coca-Cola, created major waves at the recent Association of National Advertisers (ANA) Advertising Financial Management Conference this week with the announcement of its new Value Compensation Model for its advertising agencies.
My colleague Tim Williams attended the presentation and was impressed that Coca-Cola has already piloted the model and is rolling out globally this year to 35 markets. It wants to be converted to what it calls Value Based Compensation (VBC) for all agency compensation by 2011.
Sarah Armstrong, Director, Worldwide Media & Communication Operations at Coca-Cola gave the presentation, which provided details of the model.
Coca-Cola is sharing the model publicly with both advertisers and agencies because it believes VBC needs to be adopted as an industry standard.
As Sarah said in her presentation (paraphrasing here):
Under the commission model we rewarded spending. Under the labor model (hourly billing), we rewarded effort. Under VBC we will reward results.
Sarah also said that they will no longer be dictating the profit margin that their agencies can make, as it’s none of their business how the agencies run their businesses. This is revolutionary thinking!
Henry Ford once said “History is bunk.” This may also be one of the first examples of a customer changing the pricing paradigm of a seller’s industry. Time will tell whether or not agencies apply similar models to the rest of their customers.
For all of those agencies that constantly asked us, “Which big advertisers truly subscribe to the concept of value based compensation?” we now have another titan to add to Procter & Gamble.
I wonder what the excuse will be now? Ed, fire up your keyboard. (That’s easy for them, they’re Coca-Cola).
As Tim said, this is another very large and important penguin that has made the plunge off the iceberg. When will others—from both agencies and advertisers—follow?
Congratulations to Sarah Armstrong and her entire team at Coca-Cola for not only blazing the trail for others, but recognizing that cooperation in sharing intellectual capital will help focus both agencies and their customers on the right things—creating value for all involved.
VeraSage fellow Chris Marston was recently profiled as a Trailblazer law firm in the April, 2009 issue of the ABA’s Law Practice magazine, along with three other firms.
I’m happy to announce I’ll be conducting a Webinar for the CPA Leadership Institute on “Value Pricing as a Business Model.”
It’s Website says:
CPA Leadership Institute offers Webinars designed to promote its mission of continuous improvement in leadership and management in CPA firms. Our cadre of Webinar leaders includes some of the most outstanding in the nation. These programs are available free to Professional Members of CPA Leadership Institute, and at special low prices to Premium Members.
Kodak in a recent open letter to their customers announced changes to their terms of service for their Kodak Gallery on-line service. It has been hailed in the Twitterverse as an example of how to communicate change to customers.
While I admire Kodak for their openness, I have sharp criticism for the core message. Essentially, they are saying that the must raise their prices to offset costs. Who cares? Certainly not their customers, nor should they. It is not the responsibility of customers to cover a seller’s cost. Should consumers pay more for General Motors cars just because they have a higher cost structure than Toyota? (In essence, the government has told you that yes you are and oh, by the way, even if you never bought a GM car you need to pay for one anyway, but that is another post.)
Kodak should instead focus on the value they are creating through the service and create a pricing model that attempts to capture this value. Kodak is attempting to regroup after years of denial that the photo industry was going/has gone digital. They have been somewhat successful, but they clearly still do not get it. Being in business is about value creation, not cost recovery or profit without creating value.
I tweeted this last week - ”The problem occurs when companies focus on increasing or maintaining profit while not increasing the value they provide to customers.” I believe the moment a company pays more attention to cost structure and maintaining profitability rather than focusing on value creation is the moment that they begin to die.
The billable hour is about cost recovery not about creating value for customers. Please take heed professional firms. You are dying you just don’t know it.
I recently finished reading Herbert A. Simon’s autobiography, Models of My Life. Simon was the 1978 Nobel Prize winner in economics and the father of artificial intelligence. Among economists, he’s best known for his theories of bounded rationality and satisificing.
Mr. Spock vs. Homer Simpson
Rather than man being a completely rational calculator always trying to maximize his utility, similar to Mr. Spock of Star Trek fame, it seems in many areas of life we act more like Homer Simpson of The Simpsons. It’s doubtful a Mr. Spock would need Alcoholics or Gambling Anonymous, or the idea of a self-control credit card that, in advance, voluntarily limits one’s spending in various categories automatically.
Not all economists are convinced by the research that man is not rational, let alone willing to forego their useful assumption of rationality. Ludwig von Mises refused to call bad decision making “irrational.” He stated:
Error, inefficiency, and failure must not be confused with irrationality. He who shoots wants, as a rule, to hit the mark. If he misses, he is not ‘irrational,’ he is a poor marksman.
David Friedman, in his book Hidden Order (highly recommended by the way), explains the assumption of rationality this way:
...the assumption describes our actions, not our thoughts. If you had to understand something intellectually in order to do it, none of us would be able to walk.
Economics is based on the assumption that people have reasonably simple objectives and choose the correct means to achieve them. Both assumptions are false—but useful.
Suppose someone is rational only half the time. Since there is generally one right way of doing things and many wrong ways, the rational behavior can be predicted but the irrational cannot. If we assume he is rational, we predict his behavior correctly about half the time—far from perfect, but a lot better than nothing. If I could do that well at the racetrack I would be a very rich man.
...rationality is an assumption I make about other people. I know myself well enough to allow for the consequences of my own irrationality. But for the vast mass of my fellow humans, about whom I know very little, rationality is the best predictive assumption available.
In short, I find both assumptions of rationality and irrationality useful. If Friedman is right, then we can predict 50% of human behavior with rationality, and perhaps some portion of the other 50% with irrationality.
And this is where I find Herbert Simon’s bounded rationality and satisficing concepts extremely explanatory. Bounded rationality posits that both elements of irrational and nonrational behavior bound the area of rational behavior.
Coupling the concept of satisficing to bounded rationality is how Simon explains how people really make decisions. Rather than attempting to maximize or optimize, people search for “good enough” actions. Simon writes:
Since my world picture approximates reality only crudely, I cannot aspire to optimize anything; at most, I can aim at satisficing. Searching for the best can only dissipate scarce cognitive resources; the best is the enemy of the good.
[Even Darwin’s] natural selection only predicts that survivors will be fit enough, that is, fitter than their losing competitors; it postulates satisficing, not optimizing.
Could Simon’s satisficing concept explain why so many professional knowledge firms cling to their billable hours and timesheets?
It’s simply good enough, and certainly neither require much cognitive resources. Like driving, it’s an unconscious competence we don’t have to think too hard about.
If satisficing does explain it, then how do you overcome it?
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