Community Section -
Book Reviews
Ron Baker - 02/01/2010
I haven’t been blogging very much lately, so big thanks to Ed for keeping up!
I’ve been working on my new book since December.
My publisher (John Wiley & Sons, Inc.) and I are struggling with the title of the book, so I thought I’d solicit the “wisdom of the crowds,” because there is so much of it in this community.
Structure of the Book
The book deals with much more than just implementing Value Pricing. When professional firms eliminate billable hours and timesheets, it changes the DNA of the firm, not just its pricing, but everything: its marketing, it value proposition, how it communicates with clients and manages their expectations, what it measures for customers and team members, and so forth.
The book is actually proposing a new Business Model, from “We sell time” to “We sell intellectual capital.”
It will have a toolkit, along with a 7 step process for pricing an engagement. Moreover, an Appendix for each professional sector—advertising agencies, CPA, Law and IT firms— and will include customized checklists, sample forms, examples, issues, etc., from that particular profession.
So, it’s a Toolkit + Reference Book + an explanation of a revolutionary business model. It’s a one-stop read that is not dependent on reading any of my other books.
Some Titles So Far
The Timeless Practice: VeraSage Institute’s Revolutionary Business Model for Professional Firms
Transitioning to Timeless: VeraSage Institute’s Guide to Selling Intellectual Capital, Not Time
From Time to Timeless: VeraSage Institute’s Guide to Selling Intellectual Capital, Not Time
The Timeless Firm: VeraSage Institute’s Revolutionary Business Model for Professional Firms
Professional Firm 3.0: VeraSage Institute’s Revolutionary Business Model for Professional Firms
Timeless: The Professional’s Guide to Profitability, Effectiveness, Intellectual Capital, and Value Pricing. Thanks to Ed for the subtitle on this one!
Any suggestions folks? There’s a bottle of Dan Morris’ finest wine in it for the best suggestion.
Ed Kless - 11/18/2009
OK, I’ll just admit it, I am a lousy book reviewer. So, rather than go through the motions, I have decided to just post my nuggets that I have taken away from Robert B. Laughlin’s The Crime of Reason.
- While most knowledge is freely available, most economically valuable knowledge is kept secret. What is more, it is not kept secret because it is technical in nature, rather, we define it as technical when it is kept secret.
- The book made me think about the availability of knowledge on the Internet differently. Rather than access to all knowledge, it has become a great cover for those who want some knowledge hidden. I am not talking about JFK or 9/11 conspiracies, I am talking about knowledge that are held as proprietary or trade secrets.
- There are certain things that it is just plain illegal to know. Try to gain the knowledge of how to build an atomic bomb for example. The closer you get to knowing, the more likely you will end up in jail.
- Explaining a genuinely new idea is extremely difficult because the listener does not possess the contextual knowledge of the speaker.
- Most entertainment is the celebration of disposable knowledge. In fact, when we are relaxing we avoid useful information. This is why some people do not like my Facebook posts and Twitter updates. They are on these technologies to relax and I am confronting them with potential useful information. (Sorry, but I do not plan to stop. Just unfriend or unfollow me, I am really OK with it.) Let me quote from the book, “Soap operas are enjoyable because their intellectual maintenance costs are low.”
- All advertising is information you do not want to see. “Advertising is Fun’s evil twin brother. The two go everywhere together.” If you want to enjoy yourself from free you have to accept advertising.
- TV commercials are spam. Once you realize this the email variety is not as bad as we think.
- Gaining real knowledge has a cost. What is worse, the more you try to reduce the cost of gaining knowledge, the more spam you will have.
- I close with this quote, “The right to learn is now aggressively opposed by intellectual property advocates, who want ideas elevated to the status of land, cars, and other physical assets so that unauthorized acquisition can be prosecuted as theft.” This is a dangerous belief. For more on this read this article entitled IP and Libertarianism by Stephan Kinsella.
Ron Baker - 07/19/2009
Ed Kless - 06/30/2009
This blog post kills three birds with one stone.
First, I have been serving on an internal team at Sage regarding pricing and the ideas found in this book will help this team. Second, Ron as me in January to write about the most impactful book I read in 2008. While I would not have written about this book then, but upon reflection it has been the book that has influenced me the most thus far in 2009. Third, I have an email from Amazon.com dated March 14, 2008, asking me to write a review. Talk about procrastination!
Executive summary (and Amazon.com review)
Reed Holden and Mark Burton’s Pricing with Confidence makes the complex topic of pricing strategy understandable and usable to businesses of all industries and sizes. Many of the examples are easily transferrable from one industry to the next. Their approach is logical and rational and can be adapted to a sole proprietor with an entrepreneurial idea to the largest of companies. The only thing, I severely disliked about the book was the poker analogy which runs throughout the book. Business, unlike poker, is not a zero-sum game. I understand the analogy they are trying to make, but, in my opinion, it detracts from the overall value of the ideas presented.
Important ideas in the book
Develop and offer options. Having at least three options with different value propositions positions the organization to make fewer concessions during negotiation. When a prospect balks at price you can always direct them to a lower cost, but lower value (to them) option. Companies should establish a “walk-away” price for your lowest priced option. This assists in making sure you do not take on a bad customer.
Create a good “fence” between options. A fence is the way to protect one option from the other by providing a clear trade-off of price and value between the options. Well developed fences will make sense for both the customer and provider. The most utilized fence strategy is bundling. When you bundle, if a customer asks for a break down, you should explain that while you could provide that for them, the overall price will be higher.
Setting price is one of the most difficult decisions leaders and managers can make. The strange thing is they often delegate it to others including allowing competitors to be a large influence on price. Price competition (price war) can only work during the high growth phase of a business’ life cycle. At any other time, price competition is never a sustainable business model. Lowering price is the least sustainable competitive advantage.
If you discount to meet the numbers, you will inevitably kill your long-term profitability. It should not come as a surprise that few businesses (if any) have ever created a long-term profit strategy around discounts. Discounting demolishes the self-esteem of the sales force to the point that they themselves begin to question the value of the very products and services that they are selling. This is poison to an organization.
Business must focus on creating greater value for customers. Companies that focus on value, in dollars, delivered to customers are more profitable. Talking about anything other than real financial value is just noise.
Great new term: discount creep - the propensity of a company to begin discounting for good reasons and having it then become systemic. If you must discount by all means measure it. Holden and Burton suggest creating a “discount bucket” that is only allowed to be emptied over a certain predetermined time period.
Pervasive discounting is usually a function of poor customer selection. The authors cite a study which says that 79 percent of business-to-business companies respond in some way to all prospective customers. Going further they posit that there is not just an 80/20 rule for customers but a “20-225 rule.” 20 percent of customers account for 225 percent of the profit. Yes, kids, this means that 80 percent of customers account for a 125 percent loss.
There are only three, count ‘em, three, pricing strategies: skim, neutral and penetration. Skim only applies when you are clearly differentiated from your competition. Chances are, unless you are Apple, you are not clearly differentiated. Neutral pricing is used when you want to compete on something other than price. Penetration pricing is used when you want to establish a dominant position in a new market place.
There are four, count ‘em, four, buyer types: price, value, relationship and unknown (OK, they call these guys poker players, but I dismiss the analogy). Aside from the poor term, the book is worth reading just for this deeply developed idea.
Most companies think they sell to price buyers, they are sadly mistaken. The following sentence clearly excludes all professional knowledge firms from thinking they deal with price buyers - “Price buyers are very careful not to let themselves get committed to any particular supplier by making sure they have no switching costs.” Emphasis added. This is clearly not the case for professional knowledge firms. If all of your customers look like they are price buyers, it is because your sales force is not establishing trust during the sales process.
You need to be paid for your high value knowledge as soon as you begin providing it. The trouble is usually some demonstration of knowledge is needed to get you in the door. Their suggestion is to set a minimum price for knowledge.
A great strategic question for a company to mull is “What can will do (other than discount) that would force our competition to react?” Answering this question is not easy, but it does get to the very heart of innovation.
In conclusion
I thoroughly enjoyed this book and looking back on it has made me realize what an impact it made on me. Many of the ideas listed above have come to the forefront in my coaching conversations with Sage partners. It is clear that this book will continue to influence my thinking for years to come.
Ron Baker - 05/18/2009
Ron Baker - 04/30/2009
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.
Ron Baker - 04/26/2009
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.
Of course, there are solutions to this—phasing, change orders, offering different levels of protection to the customer as with insurance, as advocated by Chris Marston.
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?
Ron Baker - 04/19/2009
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?
What do you think?
Ron Baker - 12/28/2008
Ed Kless - 12/19/2008
Nothing comes from nothing; nothing ever will. - Oscar Hammerstein
Boy, is that lyric ever wrong. (Bonus points, if you can name the song without Googling it.)
Recently, I read Charles Seife intriguingly titled book, Zero: The Biography of a Dangerous Idea and while I know it was recommended to me, I
cannot recall who provided me with the recommendation. I thought it was Ron Baker, but no, he has not read it. So, in a sense, even this review comes from nothing.
In this short, but fun read, Seife traces the history of the zero from its humble beginnings as an idea, through its use as a placeholder, to its current status as the only number capable of destroying everything (including temporarily disabling the USS Yorktown on the high seas. The humble zero shook the foundations of philosophy, caused arguments, even wars, and now is beginning to play its part in understanding the very origins and substance of the universe.
While I highly recommend reading the book, I did extract a few nuggets for reading here.
First, there are at least three ways that we can prove that something comes from nothing or to express it mathematically that 0 = 1.
Proof A:
Let a = 1 and b = 1; therefore b = a.
b2 = ab, Premise 1
a2 =a2, Premise 2
a2 - b2 =a2 - ab, subtract premise 1 from premise 2
(a + b) (a - b) =a(a - b), Factor
a + b = a, Divide both sides by (a - b)
b = 0 Subtract a from both sides
Since a = 1 and b = a, therefore 0 = 1.
Proof B:
Let a = (1 - 1) + (1 - 1) + (1 - 1)… = 0
Let b = 1 + (-1 + 1) + (-1 + 1) + (-1 + 1)… = 1
The ellipses in the previous two equations indicate the infinite repetition of the parenthetical express. Therefore the two are arithmetically the same, they are just grouped differently, therefore a = b, therefore 0 = 1.
Proof C: (hat tip to Joe Santoro)
00 = 1, therefore 0 = 1.
Why is this so important? Well, because if you can prove that 0 = 1, you can then prove that 0 = anything, certainly any number. For an example of this simply replace the 1 that leads the Proof B, let b example with any whole number, fraction, or decimal number. (By the way, there are an infinite number of decimal numbers between any two whole numbers.) In short, proving that 0 = 1 is the ultimate in understanding the idea of subjective value - value is what the customer says it is.
What is fascinating about the book was learning that some of the foundational mathematical concepts that we accept today are based on this idea that 0 = 1. Calculus is based on the idea than we can compute the area of an irregular object as long as we allow our estimations to set 0 = 1. Had this been explained in this manner to me back in high school or college perhaps I would not have dreaded the course so much. I equated calculating the area under a curve to torture. Theory is important.
One last idea I had while reading this book was to create a new formula (tongue in cheek of course) for computing value. Seife clearly points out that calculating speed in the old “A train leaves New York” type word problems is not always as simple as distance = rate times time. What train moves at an absolute constant speed? Any train would begin slowly, speed up, slow down around curves and crossings, etc. It does no good to calculate speed at a constant rate, i.e., 140 mph for 3.5 hours. What was required for mathematicians was a higher degree of understanding. They achieved this through Newton’s calculus. (Remember 0 = 1.)
An example would be calculating the velocity of a falling object, which falls at 32 feet per second per second. After one second, the object is falling at 32 feet per second after two seconds it is falling 96 feet per second and so on. This is expressed as v = gt2/2 where v is velocity, g the force of gravity and t is time. As Seife puts it, “Rate times time equals distance is not a universal law; it doesn’t apply under all conditions.”
Look at the last sentence again and replace the word distance with value. See where I am going. Imagine a formula for a professional firm using the “falling object” model (which, by the way, while still wrong, is less wrong than value = rate x hours). It would look something like this — value = rate x hours2/2. Picture explaining this to a customer, “Well we bill you $150 for the first hour, than $300 for the second, $675 for the third, etc., since we spent a total of ten hours on your matter, our bill comes to $7,500, any questions.”
Again, while still wrong, the above is less wrong. What is needed is for professionals to make the leap that 0 = 1 (that value is subjective). VeraSage has been sounding the alarm on this for years. Dare I say Ron Baker = Issac Newton.
We now have the math! Worshipers of the ABH give up! We have proven you wrong again, this time with your own beloved mathematical formulae.
Ron Baker - 11/02/2008
Ron Baker - 08/06/2008
Ron Baker - 07/22/2008
Hat tip to Ed Kless for turning me on to Shelfari, a resource that allows readers to share, discuss, rate, tag, and organize books onto your own bookshelf.
It’s like standing in front of someone’s bookshelf in their office. If you are what you read, then your bookshelf can tell others a lot about you.
Since we are asked all the time what books we would recommend, Shelfari is a dynamic way you can keep up-to-date with what we are reading. If you find a book that looks interesting on someone’s shelf, it’s very easy to put it up on yours.
You will find an example of my shelf under our Resources, Recommended Reading section.
This displays what I’m currently reading, as well as my all-time best business books. If you scroll over the title, my review pops up, along with my 1-5 star rating.
If you want more information, visit my shelf here. Below the shelf you will find many tags, sorted by topic—history, business, politics, economics, ethics, price theory, etc.
If you click on the “bbb” tag, you will find my all-time top 100 business books, though there are more than 100.
You will also see the “top ten business books” tag, which contains Baker’s dozen—thirteen of my top business books of all time.
If you want to establish your own shelf, you will have to sign in with a password. If you do, then you can request to become friends of people who you share a common reading interest.
You can visit Ed Kless’ shelf here.
Dan Morris’ shelf here.
Tom Hood of the Maryland Association of CPAs shelf here.
Mark Koziel, with the AICPA, shelf here.
We have also established a VeraSage group you can join, as well as becoming friends of any of our fellows.
Warning: Shelfari is incredibly addicting! Enjoy.
Ron Baker - 07/20/2008
Ron Baker - 07/04/2008
Three professors recently reviewed my latest book, Mind Over Matter: Why Intellectual Capital is the Chief Source of Wealth, in the July/August 2008 issue of The Journal of Corporate Accounting & Finance.
The authors also review another book that looks rather interesting: Extraordinary Circumstances: The Journey of a Corporate Whistleblower, the story of the Chief Audit Executive at WorldCom.
I was actually surprised that one of my books would be reviewed in an accounting academic publication, let alone by professors. The review is quite fair, especially considering how hard the book is on the current accounting paradigm. I actually pose the question of whether or not the accounting profession could go the way of the scribes? Not a popular thought among accounting academics.
The book also discusses why the current accounting paradigm is flawed, as it can only record value after the fact, and does not take into account at all the value of intellectual capital. Nor do I think it can be modified to do so.
I also take on Sarbanes-Oxley, which I truly believe is one of the worst pieces of legislation to emerge from Congress in decades. I’m sure this runs counter to the views of the reviewers, since in the review of the other book they claim that corporate governance and regulatory deficiencies created the need for SOX. This is highly debatable, especially if you read the literature coming out of the think tanks, especially Cato Institute and the joint American Enterprise Institute-Brookings Institution project on regulatory studies. The former is a conservative think tank, while the latter is a liberal one. Both conclude that SOX has major deficiencies and the costs outweigh the benefits.
The reviewers say one of the major insights of the book is the concept of negative intellectual capital. In my opinion, examples of negative IC include timesheets, cost-plus pricing, and Taylorite management techniques being mindlessly applied to knowledge workers.
They also say the book is difficult to categorize (good!), and could have benefited from more extensive editing, citing my inclusion of a ten-page Ronald Reagan speech and extensive quotes from other thinkers.
This is a fair comment. I would just like to say that the fault is not with the editors at Wiley, it’s with me. I write things because they interest me. I also acknowledge that I’m standing on the shoulders of giants who’ve come before me, whose ideas I am building on. One of the major objectives I start with in writing a book is not to bore the reader. By exposing other ideas, books, and thinkers I’m hoping to inspire the reader to further their own research, but the trade-off is a longer book. It may very well be a cost not justified by the benefits.
I would like to thank David M. Cannon, Joseph H. Godwin and Stephen R. Goldberg for both reading and reviewing the book. I appreciate your perspectives and comments.
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