VeraSage

Ask VeraSage: Accounting for Intellectual Capital?

Ron Baker - 07/13/2010

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. 

Would love to hear your opinions on this topic.

Ask VeraSage: A Majority of Our Customers Don’t Want Value Pricing?

Ron Baker - 07/11/2010

Ron,

Long time ago you answered my Carthage question and with my current company we tried a few times to sell fixed price packages.

Some clients bite it although many ask us to switch to the hourly rate. What I observe is that it’s easier (read, they’re used to) for the clients to get quotes and compare hourly rates than match and analyze various criteria from different service providers. Sometimes it gets even worse: the client wants an hourly rate but at the same time to cap the SOW [Scope of Work] with the total allowed maximum sum.

That leads to the very same ethical issue when project managers effectively get the red line and mentally the mission to bill the client as close from the bottom to the limit as possible.  I tried to put all the cards on the table: propose the hourly-based project plan, come up with the estimation and then bid with the fixed price which is lower? Surprisingly even in such cases some clients ask for the hourly rate motivating that they can easier pass it through the budgeting group and legal.

I’m ready to accept the hypothesis that we run into the clients which don’t understand the value-selling benefits, maybe we don’t articulate enough, maybe they don’t trust the approach for some reason but certainly in our case such clients are majority in our pipeline.

What do you advise to undertake?

Thanks,
[Name Withheld]

Hi [Name Withheld],

I think the last part of your fourth paragraph answers your question.

It’s obvious the firm isn’t doing an effective job articulating its value proposition—by that I mean, comprehending, communicating, and convincing the customer they must pay for value.

Don’t despair, this is common, though not to the level your letter seems to suggest. It’s usually a minority of customers, not a majority as you say.

You need to stop talking about hours completely, and just tell your customers you don’t price that way. It’s unethical.

No client can tell you how to price—that is your decision. Also, your firm doesn’t do timesheets or track time. You have better things to have your knowledge workers do—such as add value and provide outstanding customer service to customers. Then what will the customers say who want to see hours? Force you to do timesheets? Then they aren’t the right customer.

If you’re not willing to do the above, Pricing on Purpose will never become a core competency in your firm. There’s simply too much empirical evidence from all the firms out there that customers love this approach. The push back we get is from firms, not customers. I know this for an absolute fact, since I’ve spent the last four years speaking to customers across all professional firms and they all say the same thing: they want certainty in price, period. It’s how they buy everything else.

Do you have people pricing and selling who aren’t good at it? Then upgrade their skills or remove them from pricing.

Blaming it on the idea that your customers don’t prefer fixed pricing is a cop out and simply doesn’t comport to human behavior and the laws of economics.

The only other thing I can think of is your customers do not trust you; and that’s not a pricing problem. That’s much deeper. I hope this is wrong?

Either you want to do this or you don’t. Your customers are not an excuse.

I hope that helps.
Ron

Of course, we welcome the thoughts from other firms that have made the transition from hourly billing to Value Pricing.

Ask VeraSage: Does Value Pricing Work for Photography?

Ron Baker - 07/11/2010

Hi Ron,

I hope all is well with you and Value Pricing. I’m sure you don’t remember me, but I was in the IT industry for many, many years as a Sage Partner and was in the small Value Pricing group started by Ed Kless.

If you recall, we had the special training groups, one in Windsor Ontario, and others at the Sage conferences, etc. Well I am no longer involved in that industry and a couple years ago decided, at my age, to have some fun and follow my true passion of photography. So for the last year or so, I have been building an infrastructure, upgrading and purchasing photo equipment, building a web site, and off on photo shoots with the intention of building a photo business.

Have you ever applied the VP concept to a photography business? Photography is such an illusive medium in that it is so personal to the viewer. How would one go about perceiving the value and charging accordingly? I’m not sure how or if it could work, but I think there is room for a lot of improvement in how good photographer’s can increase the value of their work in the client’s eyes.

I belong to a number of photo specific forums, camera cubs, etc. and a huge and ever present topic is pricing of custom photography; how customer’s want great photography for very little. Most people have no idea and don’t understand the amount of skill, creativity, training and equipment that goes into being a good photographer and the value that is created in all aspect’s of life and business.

Any thoughts and ideas you may have are welcomed.

Garry

Hi Garry,

Congratulations on following your passion. That by itself is an enormous accomplishment! I toast you for making such a courageous decision, since so many people do not follow their dreams.

Value Pricing absolutely works in the photography business. I know this from working with advertising agencies, who have to buy the Copyrights to photos, sometimes at a very high price!

One of the best strategies you can deploy is to offer your customers options. I’m not intimately familiar with your business, but things like black and white vs. color, who will own the Copyright, for what time period, where the pictures will be taken, etc.

Think about what drives value to customers? There has to be a myriad of things for a wedding gig that you could offer up as a Green, Gold, Platinum, and Black card offering (to use American Express’ offerings as an example).

We have been having incredible success with options, mostly for this reason: it changes the customer’s focus from “Should I work with them/” to “How should I work with them?” That’s a great mindset to get your customer in and block out the competition, making price less of a factor.

Remember, most customers don’t care about, or indeed know, all of the complexities that go into your craft. Nobody wants to hear about the labor pains—we want to see the baby. Make it look easy, but give the customer options, and your value proposition will be distinctive.

You may also find my new book to be helpful, due out from John Wiley in December:

I hope that helps, Garry. Keep me posted on your progress, and again, congratulations for chasing your dreams.
Ron

Ask VeraSage: Advice to a Value Pricing Champion

Ron Baker - 06/24/2010

I met Len Pepe back in 1997 when he was a partner at BDO. Len took to the Value Pricing message like a fish to water, even providing a blurb for the very first edition of my Value Pricing book.

We reconnected recently, and Len has moved to another firm in Boston: CCR LLP. We’ve been exchanging emails on his attempt to implement Value Pricing in the firm.

Most firms have an internal champion that is incredibly enthusiastic about VP, and it’s not always a partner (although Len is).

We understand how hard it is to transition to VP—I like to say the concept is revolutionary but the implementation is evolutionary.

Len recently sent me the following email:

Ron,

Tomorrow I have my Alternative Billing Arrangements Task Force meeting and then I have to report to the Equity Partners.

Do you have any words of wisdom as to:

• Other CPA firms that this has worked successfully for in this area— as I know how well it works for Law firms (Jay Shepherd and Chris Marston).
• Do you run a simultaneous time system to see where you are with profitability for the na-sayers?
• Will it work as well for audit departments as it would for tax departments?
  

Any insight is appreciated—it’s coming down to putting up or shutting up for me.

Thanks my friend,
Len

Here’s my reply:

Hi Len,

Here’s some Words of Wisdom guided by experience:

If the firm is serious about making pricing a core competency (this is what we mean by Pricing on Purpose), appoint a Value Council and a Chief Value Officer (CVO).

Don’t call it “Alternative Billing,” as billing is always done in arrears, after the work has been performed.

Instead, call it Fixed Pricing (with the client anyway, hence the Fixed Price Agreement term), because pricing is done upfront, before the work begins.

There are literally thousands of firms that have successfully implemented Value Pricing, some of their stories you can find on VeraSage under “Trailblazers.”

There’s a top 100 accounting firm that has also appointed a Pricing Panel and a CVO and has about one-third of its revenue under VP (but it hasn’t gotten rid of timesheets—yet). There are also law firms, advertising agencies, IT and consulting firms where VP is being used.

You can access an article I wrote for the Journal of Accountancy article profiles four Firms of the Future:

You can also access an article I wrote for the Journal of Accountancy on Pricing on Purpose, which also includes 11 Exhibits firms can use to aid implementation.

A simultaneous time system is almost inevitable, because very few firms have trashed timesheets before, or at the same time as, implementing VP.

But between you and me, I do believe trashing timesheets is the only thing that will make a firm better at pricing. As long as timesheets exist, we look back to time to measure price—precisely what we are trying to get away from.

VP will work in any department. In fact, it’s not department-dependent; it is customer-dependent.

I don’t think a firm should allow different pricing based on departments, especially if the customer experiences more than one service. Imagine being billed by the hour for one thing, and given a fixed price for another.

We are doing VP for the benefit of the customer (to give them certainty, a “no surprises” rule), and thus that experience is created one customer at a time, not one department at a time.

Although VP is revolutionary, its implementation is evolutionary—one customer at a time. We always suggest to firms that are serious, but are not ready for a value council and/or CVO to do all of its pricing, the following steps:

1. Each partner do five Fixed Price Agreements over some time period (one to three months)
2. No partner gets to price their own work. You have to bounce every price off someone else. I’m a wimp when it comes to pricing my services, but I’m brave as a lion when pricing Len’s because I know how much value Len creates and I hate to see him give it away.
3. Be vigilant about scope creep and using Change Orders. It’s very rare that any but the simplest engagement is not going to have scope creep. When it happens, you must discuss with the client, and agree upon the price.
4. The Golden Rule is: No surprises to the client. In fact, many firms offer a price guarantee: if the client ever receives an invoice that was not agreed upfront, they don’t have to pay. This forces us to price everything, no exceptions, before we do the work.
5. Perform an autopsy (After Action Review) on every FPA done, using the questions from the JofA article above (in one of the Exhibits).
   

Does that help?

Good luck Len!
Ron

Any other suggestions for a quick-start to VP for Len would be greatly appreciated.

Why is VeraSage a think tank?

Ron Baker - 05/09/2009

I get asked this question all the time, and I’m afraid I’ve never given a completely satisfactory answer.

We get asked constantly for endorsements, for example, or affiliations to promote various products and services, and I always have to explain we are a think tank and that’s not part of our Purpose.

But a lot of people don’t have much contact with think tanks. I’ll freely admit I’ve been “over-invested” in think tanks for at least twenty years and have learned an enormous amount from all of them, as well as having mentors in nearly all of them.

So I thought I’d share with the VeraSage community the origins of our founding. It dates back to September 4, 1999, in a paper titled “Operation Telescope.”

This was written for Paul Dunn (and Ric Payne), at that time the founders/owners of Results Accountants’ Systems (RAS).

Obviously, the original vision did not come to fruition since Paul Dunn sold his portion of the company in 2001.

But the idea didn’t die, and my colleagues, Dan Morris and Justin Barnett, and I founded VeraSage in 2001.

As an organization, it’s a disembodied entity held together by an idea—that is, to improve the professions.

I recently read the Noble prize winning economist Herbert Simon’s autobiography—Models of My Life—wherein the last page reads:

To make interesting scientific discoveries, you should acquire as many good friends as possible, who are as energetic, intelligent, and knowledgeable as they can be. Form partnerships with them whenever you can. Then sit back and relax. You will find that all the programs you need are stored in your friends, and will execute productively and creatively as long as you don’t interfere too much.

Measured by this standard, VeraSage has certainly met my expectations. I get to work with some of the brightest people I’ve ever met, with the added bonus that they are all good friends.

I’d like to express my deep appreciation and gratitude to everyone of them:

• Justin Barnett
• Dan Morris
• Scott Abbott
• Peter Byers
• Michelle Golden
• Daryl Golemb
• Brendon Harrex
• Paul Kennedy
• Ed Kless
• Chris Marston
• Tim McKey
• Paul O’Byrne (R.I.P.)
• Tim Williams
• Yan Zhu
  

And of course thanks to our community who support us: readers, friends, colleagues, and a myriad of others too numerous to list.

Ask VeraSage: Who is responsible for the message?

Ed Kless - 03/20/2009

Eric Fetterolf wrote to VeraSage with an interesting question:

“Group fed up with baffling government jargon” is an article from Yahoo news.

I’ve heard you encourage people to extend our vocabulary.  Using broader vocabulary encourages readers and listeners to improve their own vocabulary to achieve understanding.  Having stated that, I agree that one should not use language to confuse or obfuscate the intended message. 

In your opinion, who is ultimately accountable for the message: the Speaker or the Listener?

Ron: The speaker is always responsible for the message. But that does not mean that the Listener has no responsibility. In fact, listening is probably the most least used skill of all. Most people are awful listeners. But that said, the onus is still on the speaker to get his point across in a way the listener can grasp. Peter Drucker has written about this very topic, I want to say in his The Effective Executive book, but don’t quote me on that, it might be in another one of his books.

Ed: The creation of the message is clearly the sender and it is the responsibility of the sender to develop to the best of one’s ability a message that one believes will be understood by the listener. The listen can choose to ignore the message regardless of what the sender does. It is mutual, but I would say the focus needs to be on the creation of the message by the sender.

What say the rest of you?

Ask VeraSage: Pricing Litigation Support Services

Ron Baker - 02/20/2009

I received the following questions regarding pricing litigation support services over the prior week.

Mr. Baker.

As a thought-leader in value pricing I was hoping that you could take a few minutes to share your thoughts and comments with me about value pricing in my practice area.

I am located in California and I offer litigation support services to family law attorneys. I am regularly hired by family law attorneys to perform valuations of closely-held and professional service businesses, analyze apportionment of community and separate property claims, perform forensic tracings and complex special accountings, and calculate child and spousal support. Ultimately, these assignments result in me providing expert witness testimony either by written declaration or by oral testimony.

I am writing to ask your opinion about somebody (me) providing the aforementioned litigation support services in a value pricing format.

This is something that I feel confident that I could successfully do from a project management standpoint on my side. However, I am wary of how it would be perceived by the family law attorneys that hire me and the Courts that consider my testimony.

I am curious what your opinion is on whether or not this non-traditional approach to pricing would be either a turn on/off to family law attorneys who only know the billable hour, if as an expert witness I can charge my clients in this manner and avoid be perceived/labeled as a “hired gun,” what potential pitfalls may lie ahead when I am on the stand being cross-examined about my billing practices, and finally how would I market a value pricing approach without offending the bill-by-the-hour attorneys that hire me.

Thank you in advance for your time and comments.

My reply:

Thank you for your email.

My take is you should be able to provide a Value Price for this type of work. If the attorneys ask for “number of hours” simply reply that you don’t do timesheets, but rather agree upon a fair price up-front for value delivered. As long as the price is not “unreasonable” I can’t see why the lawyers or the court would disallow it, especially as it was agreed to up-front. There is nothing more transparent than pricing up-front, despite how proponents of hourly billing twist themselves into pretzels denying.

I would also think the family law attorneys would appreciate the certainty in price; I know the clients would! As for “hired gun,” I think that risk exists just as much with hourly billing as it does for a fixed price.

Perhaps if you offered an “Unconditional Money Back Guarantee” on your service, you’d be in a much stronger position to command a premium price. Note that this is not a guarantee of a specific outcome in the case, only with your service level. For an example of such guarantees from law firms, visit here and here.

I also realize state law varies on this, but if a court has jurisdiction over your fees, it may require billable hours. But again, only if it’s questioned; and as long as your fee is reasonable, you’d be able to submit an estimate of the time you spent extemporaneously.

Another question, this one more specific:

I have a practical question.

Hypothetically let’s assume that a client and I agree on a value price of $20,000 for a particular case.

And let’s further assume that I had a very thorough meeting at the very beginning of the case and we identified four specific items that needed analysis.

Then as I am working through the analysis the case settles.

• Does the client still pay me the full amount even if I have not actually performed all of the analysis?
• Would I price each item separately and collect on a percentage of completion basis?
• Even if priced separately what if I did the work but never presented it?
• Do I renegotiate a final price for what was done and refund the difference?
• Isn’t there an intangible value that I provide just by being in the case? Maybe the work that I did complete was so convincing that opposing counsel chose to settle on the other issues? Should I not be compensated for this intangible value and collect the full amount?
  

Value pricing is something that I really want to put into practice but I am trying to think through as many of the future headaches and initial questions I will face.

Thank you in advance for your help.

Again, my reply:

You’re going to get used to hearing this answer from pricers: “It depends.”

You’ve actually answered your own question through the thought process in your bullet points.

As long as you have an agreement with the client, up-front and BEFORE you begin the work, you can have a clause read any way you want in the event of settlement before the work is done. Depending on the value of that settlement, that will help you set the price.

This is where you have to think like an actuary. What are the odds of a settlement? What are the odds you’ll have to complete all the work scoped? You bet there is substantial value just having you involved, which could lead to a quicker settlement. That value should be reflect in a settlement clause price.

Make sense?

The important lesson is to always comprehend your client’s value drivers, and plan for the contingencies you estimate to have a reasonable chance of happening. Price them in advance, giving your client certainty. You’ll be amazed at the results.

As always, we’d appreciate any feedback and experience of others who have priced these types of services.

Ask VeraSage: Is $250,000 per employee the max a CPA firm can achieve?

Ron Baker - 10/26/2008

I received an incredibly thought-provoking email from Jonathan Iannacone, CPA, who blogs as well.

Ron,

I hope this email is not too presumptuous but I consider you one of the rare thought leaders of public accounting. I subscribe to VeraSage (RSS) and am always happy with the thought provoking discussions that you create.

First a disclaimer: I run a small CPA firm that specializes in outsource CFO services for growing businesses. I do not charge hourly (all FPAs) and I do not use timesheets. In short I am a raving Firm of The Future believer.

I would like your thoughts on a question that continues to bother me regarding the K[ey] P[erformance] I[ndicator] we use at the firm, Revenue per Employee.

Recently a list from Inside Public Accounting (IPA) came out listing the Best of the Best accounting firms for 2008 (top 25 and then next 25 honorable mentions). Using the data from that table, you can crunch the numbers to get partner/staff, rev/partner, and rev/employee results. For me, the Rev/Employee is most important since is let’s me fact check my own firm goals.

Looking at the numbers it made me questions a few things:

1. Is there a terminal velocity for Revenue/Employee for CPA firms? Data seems to suggest that whether your $6M or $600M, California or Arkansas, that $200K per employee is pretty much what the best firms do.
2. Timesheets or no timesheets? Does the admission of a terminal velocity render the argument meaningless because at the end of the day it is whatever the market will bear and this list pretty much tells us what that number is? In other words, are there “no timesheet” and “timesheet” firms side by side in this list that scale in the very same way and limit out at the same point?
3. How can we rethink the PKF to escape these constraints. Is there a way to “productize” and package it in a way that makes it infinitely more scalable (Turbo-tax and QuickBooks seem to point to yes).
   

I would love to have your input as to what the numbers are telling you and how you would then go about moving and addressing the questions that inevitably arise.

Thanks in advance for any time and knowledge share.

Sincerely,
Jonathan

Jonathan attached an Excel spreadsheet that crunched the numbers from the IPA article, computing revenue per partner, revenue per team member, and revenue per all employees.

The highest revenue per all team members was from Gerson Preston Robinson & Co., of Miami Beach, FL, at $250,685.

The lowest was Novogradac & Company of San Francisco, CA, at $118,092.

Jonathan asks difficult questions, ones we around VeraSage have discussed for years.

The first issue you confront when looking at studies like this is to realize that these firms are pricing by the hour, which is a self-imposed ceiling on any organization’s income potential.

The Firm of the Past

As my colleague Tim Williams says—with a little exaggeration, but you get the point—if you sell time, and want to make a million more dollars, you have to charge a million more hours.

Not a very effective lever for creating wealth. This is what we call The Firm of the Past, and it’s theory is as follows:

Revenue = People Power x Efficiency x Hourly Rate

All of the firms in the IPA report have, in effect, the above theory as their talisman. I detail the problems with this theory in my recent Journal of Accountancy article.

This is why we believe a new model is needed among Professional Knowledge Firms (PKFs) that leverages the real source of wealth in our knowledge economy: Intellectual Capital (IC).

The Firm of the Future

Hence, our New Practice Equation, or what we call The Firm of the Future:

Profitability = Intellectual Capital x Effectiveness x Value Price

This enables a PKF to leverage its IC in a myriad of ways, rather than relying on the head count of billable hours.

Jonathan’s second question is an excellent one. All of the firms in the IPA report use timesheets, and price by the hour. So we don’t have a controlled experiment within those firms where we are able to study the differences in results.

The best we can do is look at the firms we know that have trashed timesheets and implemented Value Pricing. These firms are, of course, much smaller than those in the IPA report.

When you run those numbers, you find pretty much the same results—that is, not much over $200,000-$250,000 per employee.

Though we do have some firms that top over $300,000 per employee, mostly sole proprietors, which tend to be the most profitable firms on the planet.

Eventually, we will have Top 100 firms whose performance we’ll be able to compare to timesheet firms, but I don’t expect radically different results.

Keep in mind that we are not advocating eliminating timesheets so that firms will be wildly more profitable. We are advocating their elimination because we think they are demoralizing to knowledge workers, along with measuring exactly the wrong the things.

If they made no difference in the profitability of firms, wedd still rally for their elimination.

To Jonathan’s third question about re-thinking the PKF model to escape these constraints, that is exactly what our New Practice Equation is designed to do.

I think you are right on about “productizing” PKFs intellectual capital so they can generate what we call “sleep revenue"—money you earn while in bed. You can’t do that if you’re selling hours.

We have seen some innovative advertising agencies doing exactly this. They are creating their own portfolios of IC, thereby escaping the constraints of selling time.

Among our CPA Trailblazers, what we are seeing is more investment into their “invisible balance sheet.” O’Byrne & Kennedy (OBK), in Great Britain, for instance, has created a knowledge bank wherein it captures its IC so it can leverage it across more customers.

In the long-run, this will make OBK more valuable, with a higher resale value, since it’s not dependent on the IC in the heads of its owners.

But this is a long-term strategy and it will not show up in the revenue per employee calculation anytime soon.

Looking at these revenue per employee numbers also teaches that there are no economies of scale in a PKF. So firms that are merging as a source of growth are not getting any great gains in that area.

PKFs are incredibly labor intensive, and until the business model changes from selling time to selling IC, I don’t think you will see great movement in these numbers—regardless of whether timesheets are kept or trashed.

One more point is worth mentioning. Value Pricing will, inevitably, help push up the revenue per employee numbers, while allowing the firms to do so with fewer customers.

This is a change from economies of scale to economies of scope. Fewer customers equates to more profitability.

But Value Pricing is limited to the value firms create. If all they want to do is play financial historians by offering attest and low-level compliance work, then unless they innovate new product and services to climb up the value curve, they are going to struggle to break the $300K barrier, let alone any higher.

Another number I would love to see calculated for these firms is revenue per customer, which would shed some light on these firms’ value propositions.

In any event, this is not meant to be the final chapter on this topic. It’s precisely this ceiling that inspired Paul Dunn and I to write The Firm of the Future.

How long it takes for the New Practice Equation to diffuse throughout the profession, let alone impact on these calculations, is anyone’s guess. Mine is past my lifetime.

[I will have a future post on this very topic of the time it takes for new theories to diffuse within professions, in the form of a book review. The book I just finished has literally blown my mind, and has made me far more pessimistic regarding the ability of firms to change from selling time to selling IC. Stay tuned].

As always, I welcome any and all comments from our Fellows, Trailblazers, and readers on this very thought-provoking analysis from Jonathan, and the questions he raises.

Ask VeraSage: Why Carthage must be destroyed?

Ron Baker - 10/23/2008

I received an email yesterday challenging me on why I am so adamant about ridding the Professional Knowledge Firm (PKF) of timesheets. At the request of the author, I am not disclosing his name, but I thought his questions were worthy of a response.

This is an excellent example of why the timesheet mentality is such a cancer in the PKF world. It does, indeed, keep professionals mired in the mentality they sell time. I don’t think Bill Gates thinks in terms of $300 per hour.

I have indented my responses to the original email below.

Ron,

Reading your books and the site materials I share your confidence that value-based pricing is the right thing for service selling. I feel, though, that your obsession to wipe out timesheets is akin ”delenda est Carthago” motto.

Maybe the evil is not in time-based pricing itself but in its mighty acceptance which obscures the principle of value-based pricing making it the ultimate end instead of a means.

Indeed, you’re fighting cost-based approach but what if one uses time as a driver of value? Airlines or tailors don’t charge for time they spent because it’s irrelevant. The scope is clear and predefined so the customer doesn’t care how much time it would take or what internal cost would accrue. In the scope-defined engagements it makes sense but I have two examples where I’m struggling to justify a Fixed Price Agreement (FPA).

I don’t understand how you can reconcile the subjective theory of value while asking “but what if one uses time as a driver of value?” That’s the whole point. Time is not value. You have simply asked if the labor theory of value isn’t true. It’s not true, it was refuted in 1871.

Time spent in Professional Knowledge Firms is just as irrelevant as with airlines and tailors. It’s not because they have a more defined scope. It’s because the labor theory of value is false across all human behavior.

I’m a “trusted adviser” and sell my brain-time to the customer via meeting or calls attendance. Say, I have a retainer to spend 1 day a week with him and we sign an FPA for the advisory service for $2400/week (read, 8 hours/day). Now the customer wants to change the scope to 2 days/week. What should I charge him? Something like $4800, right?

It’s logical, clear, and simple. If the customer gives me some unusual “homework” and occasionally I need to spend between half to 2 days additionally on her projects how should we agree on that? Regardless whether we shape it as a change order or a new FPA (taking into account the average extended time) the time will be the driver for the calculation. I’m not saying the customer buys my time—she buys my value—my advisory service, measured via the time we spent. I’m capable of charging $300/hour not because I’m a commodity but certainly because I’m differentiated and the customer recognizes it. We use a Timesheet here just as a measure of the scope and due to the lack of any project-finite scope. I see no other way to measure my services but to multiply the time I spend servicing her on the value the customer perceives to get from the service.

Again, you are not selling your “brain-time” since that is an input. What if you spend a long time thinking but creating no results for your customer? What you are selling is knowledge that creates wealth for your customer.

In your example of $2400 to $4800, you state the customer is not buying your time, but rather your value. But how? You priced this based on time, and that’s not value. What if you come up with a million dollar idea in an hour in that marginal second day? Under your method, it’s worth the same $300 per hour as an hour in the first day. This is suboptimal pricing that has no relationship to your value. The fact that it’s “logical, clear, and simple” does not mean it comports to reality—the subjective theory of value.

You’re still locked into the $300 hourly rate mentality, which demonstrates you are still selling time. This is the exact problem with the timesheet. It’s keeping you mired in the mentality that you sell time.

You ask how you should price another half or 2 additional days, and I would say up-front, before you do the work. Value is subjective, and contextual. It all depends on what you are doing.

You then say that the timesheet is used “just as a measure of the scope and due to the lack of any project-finite scope.” This is why you are still selling time, and not Value Pricing. Timesheets are backward looking, whereas project management, which always defines a scope no matter how limited it may be, projects forward.

You say you see no other way to measure your services, but there are, indeed, other ways to value your services when there is no project-finite scope. We’ve discussed this at length elsewhere. You are letting a problem kill an opportunity to add value to your customers. As a result, you are sub-optimally pricing yourself by the hour. Some would argue—I being chief among them—that this is the result of your timesheet.

Another example is about a typical project in high-tech consulting, solution integration. Timesheets makes life easier when we do have a project scope but the customer has to develop (supply, prepare, deliver) additional tasks my execution is dependent on which. If the dependency is very tight then often times I won’t be able to progress without customer’s delivery. Another pitfall is just so many unexpected things that may happen (which, honestly, may happen with FPA too). So the whole project becomes a huge change order. In that case timesheet becomes a good protection for me since the customer knows that his inefficiency really costs him and I’m not its hostage. So should I drop such customers or just use timesheet as a shield against his inefficiency?

No, you should quote a price for a defined scope up-front, with a covenant that the customer is responsible for providing certain tasks by a deadline. If they fail to deliver, you have a Change Order. Keeping your customer worried about the time you spend is exactly the wrong thing to have them focus on. It’s not a shield to protect you, it’s a shotgun pointed at their head.

You then say that so many unexpected things can happen that the whole project becomes a huge change order. That’s usually the result of very poor planning and project management. It may also indicate incompetence. Face it, if things are that out of control, why are you doing the project in the first place?

But even allowing for your logic, so what? My insurance company provides me earthquake insurance, yet they don’t know every contingency, nor do they even know what their costs are going to be. They still give me a fixed price because I, like all customers, demand it. No one would buy insurance being priced on a time & materials basis.

Your timesheet is preventing you from being a better project manager.

The last reason for timesheet is it’s much more accepted (I guess you heard this one many times) in the industry, customers know how to measure and value my service, and I’m protected against inefficiency or unexpected things. On the other hand, when the scope is concrete and I can trust the customer I’m all for using FPAs (and surely the time then is not the primary driver but the value the customer gets is).

Again, so what? Everyone used to think the world was flat, that didn’t make it right. Customers accept the hourly rate, but they don’t like it. Who wants uncertainty in the price of what they buy? You are way too focused on the internal machinations of your business. This is hindering you from focusing on external value.

Actually I’m negotiating now an offer to join a practice and I was re-reading your books thinking, maybe, to influence my new partners to switch to FPAs. The above is a result of “critical thinking” where playing a devil advocate I wanted to reveal FPA weaknesses and exceptions.

We love critical thinking. We love the fact that you are wrestling with this issue. We love it when people ask “when won’t this theory work?,” since that is how you falsify a theory and come up with better ones.

Critical thinking also means looking at empirical evidence, and the fact is we have over 600 firms that have trashed timesheets. They have solved every one of the problems you point out. You have added nothing new here. That’s not to belittle you, that’s just to say we’ve overcome these hurdles. Read our Trailblazers section for examples of IT firms that have made the transition. Also, read this post that provides additional resources broken down by category of things you have to do to implement Value Pricing and trash timesheets.

I think that the advantage of FPAs is in the value-based approach but must I dig up timesheet completely to sell value? I think I can sell value and still use timesheet for certain cases.

Yes, I believe you must ditch timesheet in order to become better at pricing. Your email is even an illustration of why this is so.

I used to not believe this. I used to say, “Keep your timesheet, but use them as they were originally intended, as a cost accounting tool only, but price on value.” I no longer say this, because empirical evidence has changed my mind.

The best pricers across all PKF sectors—from accounting and law, to advertising and IT firms—all have one thing in common. None of them maintains timesheet.

I used to believe this is because they became so good at pricing, timesheets became superfluous. But I now believe that they became good at pricing precisely because they got rid of the timesheet, which forced them out of the “we sell hours” mentality and made them obsessed with value.

We are very reluctant at VeraSage to state a causal relationship. Too many confuse causation with correlation, as if to say wet streets cause rain.

But here is where I will state a causal relationship emphatically: If you want to become a better pricer, you have to trash timesheets. You have to do other things as well (project management, KPIs, AARs, leadership, etc.), but there’s no doubt in my mind, if you are serious about creating and capturing value, the timesheet must be buried.

To borrow a phrase: Ceterum censeo Carthaginem esse delendam.

An LSD (Low Satisfaction Day)

Ed Kless - 10/13/2008

We often talk at VeraSage about our HSD (High Satisfaction Days), however, I thought it would be fair to post an example of the reverse.

Last week I received this email from someone who attended my workshop on consulting theory. (The firm name has been redacted to protect the guilty.)

What I realize is that project management is really simple but it requires a whole new way of doing things.

Everything here at ZYX firm is so very complex and it makes it really difficult to do a good job for the customer. Most of the problems can be pointed to the billable hour and staff moral is so low that hardly anyone gives fig about the outcome.

Of course the fundamental issue is with the management team revolving around control and the misuse of power. It will take a miracle to see some changes around here.

Clearly, this person will be leaving this firm soon, and that is a good thing. What is sad is that there are some many people out their who continue to labor in firms mired in the muck of the billable hour. If you are one of them do something today by planning your escape. You are not a slave! Sign the Declaration today! Or, post an anonymous comment in this space declaring your own emancipation.

Ask VerasSage: All About T & A

Ron Baker - 07/29/2008

Excuse the salacious title, it’s not what you think. This past week I received two more emails with questions about timesheets, so All About T[imesheets] & A[nswers] seemed like a catchy title we could remember and refer back to often.

We have a lot of excellent resources on this issue throughout this Web site, so I thought it might be helpful to summarize our best ones in a single post, as well as answering the two emails.

There’s no shortcut through this topic, which is precisely why most firms haven’t ditched their timesheets yet. It requires that you take the time to read, think, innovate, and creatively apply the replacements for timesheets.

There’s nothing easy about any of this folks. We are very up-front about the commitment and courage it takes to make this change. If it were easy, more firms would have done it by now. But can you name anything worthwhile that is easy?

Let’s start with the two emails I received, because the first one asks a question that we have not dealt with as of yet. It comes from Carol, a CFO in an advertising agency:

Hello Ron,

You and I have met a couple different times over the last few years at 4A’s seminars. I’ve always been intrigued and inspired by what you have to say and try to implement a value mindset in our estimating and billing practices.

The one area that has always been a hard pill to swallow has been the ‘no timesheet’ issue. Not only does this practice allow for us to gage how long it takes to get something done, it allows us to predict staffing needs, inefficiencies, and most important for the purpose of my reaching out to you now, it allows us to record a WIP accrual every month of time incurred, not yet billed = revenue earned. The majority of our projects are just that, projects, rather than monthly ‘retainers’ with a fixed fee.

This may be a very naïve question, but if you could shed some light on it, it may be a life-changing event at this agency. The question is: If we don’t have reports that tell us how many hours have been worked on any given job so we know what to accrue for, (because we’ve abandoned timesheet entry) how would we determine the revenue accrual each month? Any alternative we seem to come up with only creates much more work for the finance team and seems to produce very guesstimated numbers at best.

So there is my quandary. Or at least one of them, I should say. Is there any knowledge you could share with me that might point me in the right direction and further my cause down the road to total Value compensation?

I so look forward to hearing from you and thank you for your time.

All the best,
Carol

Most of these questions, especially regarding forecasting “staffing” needs and “inefficiencies” are answered in the resources below.

The question we haven’t dealt with is how to book revenue without timesheets. As you know, timesheets are used for WIP [Work In Progress] reports, which is how most firms accrue their revenue.

Of course, do we really think that just because a firm “spends time” working on a project that it has earned revenue? Is the timesheet really the best measure of that process?

A better method is the percentage of completion accounting method. If a project can be broken down into milestones, you can then estimate what percentage of the job is completed at the end of any one accounting period. Rather than being based on time, you are basing it on the actual work that needs to be performed.

I’d love to hear how some of our Trailblazers are handling this, especially firms like Mark Bailey’s that do audits that may overlap between two years.

In any event, we at VeraSage are far more concerned with establishing an external price—commensurate with value. How you account for that internally, I believe, can be established utilizing good accounting principles on a consistent basis.

The second email is from Toby, a CFO for an engineering firm:

Ron,

I have been reading your pamphlets and find them to provide an excellent solution for changing the way Professional Service firms operate.

I have some questions:

I am the CFO at an Engineering Service firm. In our case many of the “jobs” are unique to each client. Do you have any examples of how this type of firm can apply the value pricing concept? Would we still use Fixed Price Agreements?

Also, I noticed that a “calculated price” based on “billable” rate assumptions was used by several of the examples you cite. It seems there can still be a value in keeping a billable rate handy. Am I missing something? Would it be reasonable to use the “billable” rate per person in arriving at the FPA amount?

Finally, wouldn’t we still need to report time (at actual paid rates) in order to measure the profitability of each client? (We would not be using a billable rate.) This would allow us to have information for use in renewal of the FPA, or give information as we price FPAs for new clients.

Any guidance would be helpful.

Thanks in advance.

Toby

Here’s my reply, which has been expanded upon for purposes of this post:

Dear Toby,

Value Pricing is ideal for unique jobs, since value is subjective. A pricer’s dream is to charge a price commensurate with each customer’s perception and actual value received—like at an auction.

It’s known as first-degree price discrimination, which is very difficult for most businesses to implement, but Professional Knowledge Firms can get closer to it since they meet with customer individually, especially since so many projects are customized and unique for each customer.

Advertising agencies are very similar to engineering firms, since their jobs are also very unique to each customer, and we have had ad agencies that have adopted Value Pricing (VP) and ditched timesheets. Our recent Trailblazer ad agency Fletcher Martin is one example.

See our Trailblazers section of the Web site for case studies from firms across the Professional Knowledge Firm (PKF) sector who have made the transition.

We don’t advocate a “calculated price” based on a billable rate, since that is cost-plus pricing. Of course, many people will compare a value price to a “billable” rate, just to prove that VP is higher. Once you do this a few times, you realize time tracking is superfluous.

There is no value in keeping a billable rate handy, since it’s an arbitrary rate. This is not to say you don’t do cost accounting. But the important point is to do the cost accounting BEFORE you do the project, not during or after. Toyota does this quite successfully, it’s know price-led costing.

It’s also important to remember that a “billable rate” is not cost accounting, since it includes a profit margin. No cost accounting theory that I know of allocates desired profit, just costs. To be true cost accounting, you must remove the built-in profit from the hourly rate.

As to measuring profitability of each client, there are other ways to do this without timesheets. After Action Reviews, and project management (which you engineers are excellent at, far better than the average CPA or attorney), are two such methods.

What Replaces Timesheets?

Here is a list of what replaces timesheets, based upon the empirical evidence from firms that have made the transition:

• Price-led costing
• Project management
• Key Predictive (not performance) Indicators
• After Action Reviews
• Before Action Reviews
• Fixed Price Agreements, Change Orders
• Chief Value Officer and/or a Pricing Cartel
  

The following is a partial list of resources dealing with each of the above.

Price-Led Costing

Cost-plus Pricing: The Democracy of the Dead.

How Much Are You Leaving on the Table Because of Mediocre Pricing?

Sellers Change Pricing Strategies, Not Buyers.

Hourly Billing is the Opium of the Profession.

My ACCA book, Burying the Billable Hour, in pdf.

My The Firm of the Future and Pricing on Purpose books.

Project Management

Our resident expert on Project Management is Ed Kless, who has written, and inspired, many brilliant posts on this topic. My favorites are:

The Triangle of Truth.

Elements of a Scope Document.

Elements of a Change Request.

A Critique of Project Management: A Means to Efficiency.

The difference between goals and objectives.

Defining the Word “Project.”

Ask VeraSage: Timesheets and resource planning.

How should professionals scope complex jobs, inspired by Ed and Chris Marston of Exemplar Law Partners. 

Key Predictive (not performance) Indicators

No Timesheets vs. Utopia.

He Who Says “A” Must Say “B.”

No Timesheets?  Is it Possible?

Ask VeraSage: How do you measure client profitability and employee productivity?

Ask VeraSage: Why get rid of timesheets?

Why we don’t need consultants.

Timesheets are Training Wheels.

A Firm with No Timesheet: O’Byrne and Kennedy LLP. A case study by VeraSage Senior Fellow Paul O’Byrne (one of the few things from him on this blog, be sure to read it!).

An Essay on Timesheets, by Paul Kennedy. This is one of the best explorations of this topic ever written. A must read.

The Yank Strikes Back.

My ACCA book, Trashing the Timesheet, in pdf.

My The Firm of the Future and Measure What Matters to Customers: Using Key Predictive Indicators, books.

After Action Reviews and Before Action Reviews

After Action Review—The Army Way. This post includes an excerpt from a US Army manual on how they conduct AARs. Highly recommended.

My books, The Firm of the Future; Pricing on Purpose; Measure What Matters to Customers; and Mind Over Matter all deal with After Action Reviews and Before Action Reviews are dealt with in Mind Over Matter.

Fixed Price Agreements and Change Orders

Why Your Firm Needs to Offer Fixed Prices.

Sample FPA and Change Order documents and other resources here.

Ask VeraSage: Fixed Price Agreements and Engagement Letters.

A Blinding Flash of the Obvious, which contains an example of a price menu from an Australian Trailblazer accounting firm.

If You Don’t Discuss Value, Expect to Discuss Hours.

Utilizing Change Orders in Your Firm.

My books cited above, including Burying the Billable Hour contain sample Fixed Price Agreements and Change Orders.

Also, my Professional’s Guide to Value Pricing, Sixth Edition (out of print), can be partially accessed from Google Books.

Chief Value Officer/Pricing Cartel

Your Firm Should Establish a Pricing Cartel.

Who’s in Charge of Value in Your Firm?

Ask VeraSage: Creating a Pricing Cartel.

Ask VeraSage: How does a firm implement Value Pricing?

Ed Kless’ Cosmo Quiz to determine if your firm is truly Value Pricing.

My book, Pricing on Purpose, also explores pricing cartels and the successful characteristics of a CVO.

If this is so rational, why haven’t more firms done it?

This is a great question, one which we at VeraSage have spent a lot of time trying to answer and understand. Here are some thoughts on why more firms haven’t trashed timesheets.

The Diffusion of a New Idea.

Old Dogs Don’t Create New Tricks.

The Answer to How Is Yes

We believe if you understand “why” to do something, the “how” becomes much easier—merely the plumbing. Since there’s no way to implement a bad idea, the “why” is critical.

Read Peter Block’s The Answer to How Is Yes for why this is so.

I know, this is overwhelming. But think of it this way: All you have to do is read it and implement it. We’ve done most of the hard thinking for you.

I will leave you with this analogy. Trashing the timesheet is a true revolution, perhaps not as dramatic as the signing of the Declaration of Independence, but a difficult objective to achieve across all PKF sectors nonetheless.

In his book, Peter Block describes the six questions that are always asked when people are confronted with significant change:

1. How do you do it?
2. How long will it take?
3. How much does it cost?
4. How do you get those [other] people to change? [we get this all the time: I’m all for this, but my partner(s) won’t go for it].
5. How do we measure it?
6. How have other people done it successfully?
   

How would Thomas Jefferson have answered these six questions?

1. I don’t know.
2. I don’t know.
3. Possibly your life.
4. I don’t know.
5. I don’t think you can measure Life, Liberty, and the Pursuit of Happiness.
6. No country has ever done it successfully the way we are proposing. Sign here.
   

Block suggests two better starting questions:

1. What [type of future] do we want to create together?
2. What is the price [we are] willing to pay to achieve it?
   

It is simply impossible to know how to do something until you attempt it. It is the leap, not the look, that generates the indispensable understanding and the necessary knowledge to generate wealth.

I hope you find this list useful, refer to it often, share it with others and most importantly, implement the ideas as hundreds of other firms are doing.

Along the way, keep us posted on your progress.

I hope to see you in our Trailblazer section.

Ask VeraSage: Designing team and partner compensation without timesheets

Ron Baker - 07/06/2008

We are constantly asked how partner and team member compensation should be handled in the absence of timesheets. This is always a difficult question since there is no easy answer to this even when timesheets are present.

Here’s an email I received from Patty, a fellow CPA, on July 2, 2008:

Hi Ron,

I’ve heard you speak a year ago at the AICPA PCPS conference and have read your book Professional’s Guide to Value Pricing.  Our firm adopted fixed price agreements about 8 years ago and have been very successful as a result.  Our clients appreciate the fixed fee and we have billed much more than we ever would have if charging hourly.

We have embraced your nontraditional view of professional firms, and hope to discontinue timesheets eventually.  Presently, we are redesigning our partner & team compensation system.  We are struggling with this since most of the models we have found are based, at least in part, on the chargeable hours, realization rates, etc. from the time & billing system.  We want to design a compensation system that will be useful even after we discontinue time sheets.  Hopefully we can find a hybrid compensation system that we can adopt.  We want to keep it simple.

Do you have any advice for us?  We’ve spoken to a few consultants that design partner compensation systems but they are more of the traditional firm model.  I would appreciate any referrals to consultants, seminars, or books that could assist us.

I have purchased The Firm of the Future and hope to read it soon, maybe it can provide some guidance. 

Thanks,

Patty

Thank you for the question Patty. I would first say to avoid consultants since all they are going to be able to do is to show you what other firms of the past have/are doing, not exactly enlightening when you’re blazing a trail.

I also think what you said is quite wise:  “We want to keep it simple.” Indeed.

In that spirit, for partner compensation, how about replacing charge hours with revenue? Or, if you have some partners who are more admin or rainmaking, than value-added or revenue traced to rainmaking.

I’ve never seen two partner comp models that are the same; each firm must fit the model to their purpose and strategy. The two extremes seem to be eat-what-you-kill and perfect egalitarianism. What I will tell you is that more and more firms are figuring out that having an objective formula, with no subjective judgment, is crazy. Life is subjective, so is partner performance, and can’t be reduced to one number.

I should also state that VeraSage is no fan of the partnership model, since it’s a consensus model not a leadership model. We’d prefer a more corporate governance and compensation structure. In that vein, Procter & Gamble doesn’t trace revenue to each employee. Don’t we all work for the same firm? Why trace revenue to particular people, it creates silos, hoarding work and customers.

As for team member compensation, what we see in Firms of the Future is a base salary, a profit bonus pool, and a discretionary bonus pool for individual team members who contribute value above the call of duty. This does not always just relate to customer work. O’Byrne and Kennedy, for example, rewards team members for making contributions to the firms knowledge bank.

Notwithstanding what I said above, if you want to trace revenue per person and can’t figure out how to do it in the absence of timesheets, here’s what some firms do:  throw the entire team responsible for the customer work in a room and let them allocate it. You’ll be amazed how fair they’ll be based on merit, not to mention hold each other accountable for results.

You may also find these two prior posts under Ask VeraSage quite helpful:  December 31, 2006 and January 1, 2007. Be sure to read all the comments as well.

Finally, I’m going to ask the community to chime in with their advice and experience. I know some of our Trailblazer firms are doing some innovative things in this area.

I hope that helps Patty. Keep us posted on your progress—I can’t wait for you to become one of our Trailblazers.

Is RPE Important?

Ed Kless - 07/03/2008

Under the heading of Ask VeraSage comes the following:

Over a year ago I posted on the difference profit per employee (PPE) and revenue per employee (RPE). Tonight, my wife, Christine and I had a dialogue about a case study she had written earlier in the day for a customer of hers.

The customer had stated, “RPE is my ultimate measure and all I can tell you is that since implementing the new system, it is up.” Christine then asked, “Is RPE a good measure of effectiveness or efficency?”

My gut reaction was effectiveness, but I am not so sure. Perhaps it is both, but here is where you, our loyal VeraSage readers, come in. What do you think?

Ask VeraSage:  Q&A follow-up from RainToday Value Pricing Webinar

Ron Baker - 03/30/2008

I presented a Value Pricing Webinar for RainToday on February 28, 2008.  Although I answered a lot of questions during the program, there were still many left over.

I responded to each one in writing, which RainToday posted on their Web site here.

There are many frequently asked questions here, along with some that have a new twist. 

I’d be interested in how others would have answered some of these.

RFPs and the Dreaded Winner’s Curse

Ron Baker - 03/14/2008

A couple of weeks ago I received another email from Chris Forsman, who had alerted me to an article about movie theater popcorn, which I blogged about here.

In this new email, he related this fascinating story.

Good Afternoon Ron:

I have been fascinated by pricing models for as long as I can remember and as a salesperson, it is my job to “extract” as much money as humanly possible.  I remember being in an opportunity once in which we were competing against several firms in which all of our pricing came in at roughly $750,000 for an end-to-end solution.  This number was given to us by the prospect as their desired budget and we all had to “massage” our numbers to fall into this price range.  How do you pick the winner when everyone has the same price?

One competitor, who had several recent wins in this industry priced their solution at $1,200,000.  They understood that their references would be stronger and that would somehow show that they had deeper domain knowledge. It would also insulate the executive from making a bad decision since their peers purchased the same solution.  Naturally, they chose this higher priced solution.

Best regards,
Chris

What a great story!  The $1.2M firm separated itself from the competition based on value, not price.  We always say, high price tempts, and here’s even more empirical evidence.

This got me thinking about Requests for Proposals.  We at VeraSage recommend that you don’t do them, because they subsidize dysfunctional buying behavior, often being used as a club to beat up the current provider by customers who have no intention of changing.  Or they are used by price sensitive customers you don’t want anyway.

We also think you should charge for an RFP.  Why not?  The customers are asking you to compete, which has value in and of itself.  If you charged for an RFP, it might actually be a process that had some value, rather than merely reciting deliverables.

That said, we realize many PKFs have to do a certain amount of RFPs.  If you do, you should be well versed with what economists call the winner’s curse.

Never forget that your weapon is made by the lowest bidder.
—Law Number 20 of Murphy’s Laws of Combat

In auction markets, economists refer to the dreaded winner’s curse—whereby the winning bidder is often a loser.  In other words, the only RFPs sellers will accept are ones you should not make.  One of the ways to avoid the winner’s curse is to bid more conservatively when there are more bidders.  Thomas Nagle and Reed Holden explain why in their seminal book, The Strategy and Tactics of Pricing:

To understand the curse, imagine first that you are one of two bidders and you win a bid with the lower price.  You will probably be quite happy.  Now imagine that you are one of ten bidders and you believe that your competitors are sophisticated businesspeople who know how to bid a job.  Again you win.  Are you still happy?  What does it mean that you bid below nine other knowledgeable bidders?  Perhaps it means that you were willing to take less profit on the job.  On the other hand, it could also mean that you underestimated the cost to complete the work.

The more bidders there are, the more likely you will lose money on every job you win, even if on average you estimate costs correctly and both you and your competitors set bids that include a reasonable margin of profit.  The reason:  The bids you win are not a random sample of the bids you make.  You are much more likely to win jobs for which you have underestimated your costs and are unlikely to win those for which you have overestimated your cost.

The only solution to this is, in effect, to formalize the principle of “selective participation.” You do that by adding a “fudge factor” to each bid to reflect an estimate of how much you are likely to have underestimated your costs if you actually win a bid.  Needless to say, adding this factor will reduce the number of bids you win, but it will ensure that you won’t ultimately regret having won them (Nagle and Holden, 2002:  225).

RFPs have become more commonplace as competitive bidding has replaced negotiation for price buyers.  It is as if dysfunctional buying practices have arisen to counter dysfunctional selling practices. 

It is important to judge the seriousness of potential buyers going out to bid, as a lot of the RFPs are, in reality, nothing but hammers used against existing suppliers to obtain price concessions.  Your company should not waste its resources drafting RFPs to anonymous buyers whose criteria for judging your company’s offering are not known to you.  It is important to have some contact with the economic buyer, that is, the person who can actually make the decision to hire you, rather than just the procurement department.  Establishing relationships and having internal advocates in the customer’s enterprise also helps to ensure your value is being considered, not just price.

In their book Co-opetition, Adam Brandenburger and Barry Nalebuff offer this sage advice with respect to RFPs:

There seems to be a natural impulse to offer competition for free.  After all, that is what business people are supposed to do, is it not?  You want a bid?  I’ll give you a bid…

The right question to ask is:  How important is it to the customer that you bid?  If bidding is so important, then you should get compensated for playing the game.  If it is not so important, then you are unlikely to get the business and even less likely to make money.  You might want to reconsider bidding at all (Brandenburger and Nalebuff, 1996:  84).

Another strategy with responses to RFPs is:  No surprises.  Your potential customer should know everything in your proposal before you submit it.  Gaining an understanding of your customer’s expectations, business model—how they make money—and how your company can add value is imperative to increase your odds of a successful proposal, one that will not suffer from the winner’s curse.  Search for the differences that will ultimately be weighed in selecting a new supplier.  If customers are worth bidding on, they are worth spending some resources on in order to improve your chances. 

Brandenburg and Nalebuff also discuss the following eight hidden costs of bidding (in bold, with commentary added), which are also worth considering:

1. There are better uses of your time. Keeping current customers happy may be a better strategic advantage as opposed to chasing after other company’s customers.  Attracting a new customer can cost three to six times more than holding on to an existing one, and the existing one is most likely less price sensitive.

2. When you win the business, you lose money. A customer won on price alone is signaling they have no loyalty, and will leave you once they find a lower price.  Do not fall into the trap of thinking you can start with a low price and raise it later; the evidence is overwhelming this will not work, as once you set a low price you are rewarding the customer for beating you up in price.

3. The incumbent can retaliate. If this is a good customer, then your win is someone else’s loss.  If it is a bad customer, then you have already made a mistake.  The incumbent supplier is likely to respond, perhaps by targeting one of your good customers.  He may not be successful, but he can force a price concession on your part.  If he is successful, you both have achieved nothing but turning two high-margin customers into two low-margin customers—a real lose-lose scenario.

4. Your existing customers will want a better deal. Lowering your prices within RFPs sends a distinct message into the marketplace that will no doubt find its way to your existing customers.  Some will believe you’ve been overcharging them and may leave; others will demand price concessions.  Is winning one job worth the risk?

5. New customers will use the low price as a benchmark. Once again, sending the wrong signal to all potential future customers.

6. Competitors will also use the low price as a benchmark. Since your competitors can easily discover your RFP price, they will use this as a reference price in future RFPs, most likely resulting in lower priced RFPs in the future amongst all bidders.

7. It does not help to give your customer’s competitors a better cost position. Your future and that of your customer are naturally linked.  If your future is tied to Boeing, you do not want to help Airbus get a lower price.  Unless you have very good reason to believe that you can get Airbus’ business while keeping Boeing’s, bidding for Airbus’ business is costly.  You help your competitor’s customer and thereby hurt your own.

8. Do not destroy your competitor’s glass houses. The notion you win if your competition loses is simplistic and potentially dangerous.  If you lower your rival’s profits, he now has more reason to become aggressive by going after your accounts with abandon, potentially launching a self-destructive price war.  In contrast, the more money your competition is making, the more it has at risk from getting into a price war (Ibid:  86-88).
   

This is where the firm’s value proposition becomes a critical differentiator from its competitive bidders.  By offering an unconditional money back service guarantee and competing on total quality service, your firm can maintain a premium over the competition. 

Do not let the proposal be the first time you test your price, as this can result in a waste of resources going after price buyers who have no intention of considering value. 

Another effective strategy is to offer various value propositions, in the form of differing options, within the proposal, thereby preventing it from becoming merely a one shot, take-it-or-leave-it option.  You can even use Chris Marston’s concentric circles to help you, not only to scope a job, but to offer different options. 

Maintaining your pricing integrity on the RFPs you decide to respond to sends an important message within your firm that pricing is a strategic decision—one based on value—and not just a number to be arbitrarily derived in order to make the next sale.

Be sure to maintain a mortality log for proposals submitted but not accepted.  Perform post-mortems on lost bids and determine the reasons.  This will help you focus on value for future RFPs rather than merely cost and price.  The better you know the customer and the more thorough you are at ascertaining both their needs and wants, the higher probability you have of securing your share of profitable RFP work. 

Keep the winner’s curse in mind as you prepare to respond to RFPs and be sure the potential customer is serious about doing business with you and not just using your bid as a way to lower their existing price.  Some firms have tested this commitment by charging for a proposal and then offering a full credit if the bid is accepted.

Utilizing the above advice could help your firm secure a $1.2 million engagement when everyone else’s price was $750,000.  That’s win-win all the way around.