My wife, Christine, and I have recently become devotees of the AMC Original Series, Mad Men. For those of you not familiar the shows follows the personal and business life of a Madison Avenue creative who goes by the name of Don Draper in the early 1960s.
Small spoiler alert if you are planning to watch the show!
In Season 3, Don happens upon an elderly gentleman in the back unused bar of a country club named Connie. It turns out, he is Conrad Hilton. In this later scene, Hilton asks Don for his opinion on a new ad campaign. What follows is a terrific lesson on providing a free sample without giving away too much.
While listening to a recent podcast from the Cato institute on the value of globalization, I was introduced to something called the Stan Shih Smile Curve of Value.
The idea is that the lowest value item in the production chain is the manufacturing of the product. This is why, for example, that the while every iPod and iPhone are considered to be manufacturing imports we should not care. The real value of the product is in the development and end-use. It is estimated that of the $400 price of an iPhone a mere $5 goes to manufacturing in China, about $45 goes to Japan for parts, the other $350 to the US or, in this case, Apple. This is why every iPod and iPhone say, “Designed by Apple in California. Assembled in China.”
Anyway, this got me to thinking about what this curve would look like for software implementation firms. Here is what I came up with:
What this shows is that the value to the customer is actually delivered at the extremes of the relationship.
What are your thoughts? I am just beginning to play with this model, so it is very open to criticism. I am especially interested in hope accountants, lawyers, advertising agencies, et al would view this model.
Hat tip to my buddy Jason for sending this along to me.
This graph originally posted on ReflectionOf.me blog and reposted on The Consumerist and others, once again demonstrates that price is not based on cost. Interestingly enough, most of the comments are railing against Hewlett Packard. Give me a break! You basically get the printer for free and HP recovers the money by charging I higher price for the ink.
One a side note, this graph also shows why it will so hard to get the developing world to shift away from fossil fuels with crude oil being less expensive than bottled water.
The Legatum Institute was founded by Christopher Chandler, a New Zealand billionaire. In the institute’s view, man does not live on bread along, or merely political freedom and economic growth. Thus, there are two halves to prosperity, economic competitiveness and comparative liveability, which includes freedom of choice, ethical values, good health, equality of opportunity, civil liberties, spiritual faith, low unemployment, strong family life, and a temperate climate.
As its Web site reports:
The 2009 Legatum Prosperity Index is the world’s only global assessment of wealth and wellbeing. The Index finds that the most prosperous nations in the world are not necessarily those that have only a high GDP, but are those that also have happy, healthy, and free citizens. Now in its third year, the Index builds on the previous versions with expanded data and refined analysis and assesses 104 nations covering 90 percent of the world’s population.
The top 10 countries are:
Finland
Switzerland
Sweden
Denmark
Norway
Australia
Canada
Netherlands
United States
New Zealand
Sure, it’s a bit subjective, and is unsure about how to weigh religion in the Index, but it’s interesting and worth pondering.
It adds another dimension to assessing political and economic freedom without degenerating into meaningless platitudes that you find in some “happiness” and “environmental quality” indexes.
On my recent trip to Australia, I met Colin Jasper, Director of Jasper Consulting.
An actuary by education, Colin was an incredibly interesting person with whom to discuss the merits of Value Pricing versus hourly rates.
We agree, as Colin suggests, on 95% of the issues. We have an enormous disagreement over whether there are instances where hourly rates still make economic sense.
This debate was launched again when Colin sent me an article he had written, with Libby Maynard, for the September, 2009 Asia-Pacific Professional Services Marketing Association’s Journal.
Colin and Libby have kindly granted me permission to post the article, and our subsequent debate surrounding its contents.
It may seem odd that I am engaging in a debate with someone who agrees with 95% of what we stand for, but I do so because economics is concerned with marginal activity—that is, the next unit of production, spending, etc.
Thought experiment: you have an incredibly large bag of straws and a camel. You begin placing individual straws on the camel’s back, one after the other. At some point, the proverbial camel’s back will break.
If straws could think and talk, they would shout: “Hey, everything was fine until that last straw got here—he broke the camel’s back.”
The arenas where Colin is arguing that hourly rates are still appropriate is when firms are at the top of the Value Curve—at the margin, where using hourly rates is obviously the most sub-optimal.
I find his reasoning unconvincing, but I thought you might like to read the debate, draw your own conclusions, and hopefully, join in.
Here was my initial response to Colin’s article:
Hi Colin,
It was great to meet you as well and have a robust discussion on pricing.
I read your article with great interest. As you can imagine, I have many disagreements with its premise.
Here are just some:
Page 9, you say “few practitioners have sought to truly master the concept of alternative pricing structures...” This may be true as a percentage of firms overall (we estimate somewhere between 5-7% are doing real Value Pricing), but that overlooks that there are thousands of firms across all professional sectors—advertising, accounting, IT, consulting, and law—around the world that have adopted Value Pricing. Some advertising agencies are doing 100% Value Pricing and no timesheets, such as Crispin Porter and Anomaly, and Coca-Coca and P&G have their own Value Pricing compensation models with their thousands of agencies. Neither look at timesheets. These are significant numbers that are hard to dismiss, and they have proven that alternatives to the billable hour exist for all sorts of complex engagements.
On page 10, you say both client and firm should be involved in exploring and choosing the pricing approach. Yet this is not the way most industries have changed pricing strategies. Did the airlines or hotels consult their customers and ask if they could adopt Yield Management? Sellers change pricing strategies, and competition insures that customers get value. I have no problem with firms discussing alternatives with clients, but the onus is on firms to bring innovative ideas to the table, not their clients. General counsel have their own businesses to run, and don’t sit around and think about the economics of their law firms. Nor should they, anymore than you and I should be innovating the next Apple iPod or its replacement. Firms have used this very logic as an excuse to do nothing, since clients have not driven this change to date (though there are exceptions like Cisco, Pfizer, etc.).
You also state that using the wrong pricing structure can destroy value and damage relationships, and that is certainly what hourly billing has done, with its misalignment of interests, and considering it’s the wrong theory of value. The alternatives you list on page 10 are simply the billable hour in drag, and in no way are they alternative pricing structures. A price is given up-front, hourly billing is done in arrears. I assure you customers want a price, not a bill after the fact—this is basic economics. And these alternatives are still measuring value in terms of time, which is the wrong economic theory of value—and that is irrefutable, as my books and many others make clear.
On page 12 you say hourly rates are criticized because they encourage and reward inefficiencies. But that’s certainly not my major argument against them. My argument is the whole idea is based on the discredited and falsified Marxist Labor Theory of Value. Eradicating the “we sell time” mentality does lead to greater value creation, because it’s a different theory. This has been proven again and again, as all of our Trailblazer Case Studies prove. You can just read a few and see how the entire mentality of a firm is transformed to an obsession with value and results, rather than hours, inputs and costs.
You say that a tradesman complaining that his saw won’t drill a hole in the wall, etc. But hourly billing the wrong tool. It’s plunging a ruler in the oven to determine its temperature, and you’ll never get the right answer with it, period. This is why it’s universally hated in the professions, and it’s also why NO OTHER BUSINESS ON THE PLANET PRICES THIS WAY. There’s a reason for this. It simply is not a measure of value. You are arguing that Jonas Salk’s polio vaccine is valuable to the extent of the time it took him to develop, and that is economically illiterate. Period. This was settled by the Marginalist Revolution of 1871, and is well understood by economists.
You then argue that since a firm can’t define a scope, hourly rates are appropriate. This is nonsense on stilts. A scope of what the firm does know can always be done, as Chris Marston of Exemplar, Mark Chinn, Fred Bartlit (Bartlit Beck, which has never billed an hour for large clients) and Jay Shepherd, have proved in complex litigation cases. Marston’s concentric circles are the answer, as is phasing. To say that every job is a complete black hole with no “known knowns” defies reality. It also makes me, as a customer, question the expertise of my firm. As Jay Shepherd has written on his blog (The Client Revolution), there’s only one question you need to ask your law firm to determine if they are experts: “What is the price?” If they can’t answer that, they are not experts. He’s right.
You cite the Johnson and Kaplan book, which was the launch of Activity Based Costing. Have you read the book that Johnson wrote after that one? Profit Beyond Measure. It shows how Toyota doesn’t use a standard cost accounting system, and how firms should not let cost accountants drive strategic decision making. It’s a seminal book, and I have discussed it in great detail in my Firm of the Future, Pricing on Purpose and Measure What Matter to Customers books.
Hourly billing rests on the wrong theory of value, that’s our major case against it. If you begin with the wrong theory, I don’t care how efficient a firm is in implementation, it will be suboptimal. There is no right way to implement a wrong idea. Cost-plus pricing—of which hourly billing is a cousin—is dying in industries around the world, as part of the pricing revolution.
VeraSage has destroyed every single argument for hourly billing. We haven’t heard a new argument in over a decade, and your article is no exception. There are answers to every one of your defenses, and they are being done in firms around the world. You can find many examples all over our web site.
All that said, I still enjoy our dialogues and hope we will keep in touch.
Thanks Colin, enjoying the debate!
Sincerely,
Ron
Here’s Colin’s reply to mine:
Hi Ron,
I appreciate your thoughtful response and I too enjoy the dialogue. I have spoken to the article’s coauthor and we are both happy for you to publish it on your website.
With regards your specific comments:
I think we both agree that all professionals and their firms can benefit from building their value-pricing capabilities. Jasper Consulting was established with the purpose of helping professional service firms create value for their clients and capture a fair share of the value for themselves.
I take your point that firms should the lead the change. I do see differences however in consumer pricing (e.g. Apple iPod) and B2B pricing (e.g. Legal services to corporates and governments). If a consumer does not like a price their only option is to vote with their feet—or wallet. In a B2B environment, particularly at the big end of town, clients negotiate. They do not simply negotiate the price level but also the price structure. The challenge is how to overcome client buying behaviour. Most large organisations have legal panels with multiple firms on these panels. To get on a panel they put out tenders, largely based on hourly rates. If a firm says they do not provide hourly rates, in all likelihood they will not win a spot on the panel. No large firm can afford to be excluded from all of these large panels. Hence I see a role in educating clients as well as firms.
Firstly I don’t understand why you think the pricing structures listed are ‘simply the billable hours in drag.’ Do you not advocate that a value-based price be a fixed fee?
Secondly, with regards to providing a price up-front, I believe this is exactly why some clients seek hourly rates. In the panel example, they don’t know what the work will be in 2-3 years but they want embedded relationships rather than a range of quotes for each individual transaction. The only way they can be sure that the relationship price is fair is to agree a mechanism for charging up front. On a separate example, a law firm has just been awarded the first stage of an extremely large, one-off major infrastructure project in Australia. This first stage might be between 2-5% of the entire project. The client’s preference is for a single firm to serve them throughout the project but as the full requirements of the project can’t yet be scoped (i.e. the project could take an almost infinite number of directions) how other than hourly rates can the client agree a price that is fair up front?
You misrepresent me when you say that I’m arguing the polio vaccine is valuable to the extent of the time it took to develop it. I agree that in most circumstances hourly rates should be avoided. The only point we disagree on is that you believe their is no role for hourly rates and I believe there are some occasions when it is the most appropriate pricing structure (as indicated above).
I agree with you that the mindset must be first and foremost on creating value. Where firms do this really, really well—they can justify charging a higher rate (Ron—I can sense your response to this statement from 8,000 miles away).
It’s not about the firm not defining the scope, it’s about the client not being able to define the scope of their requirements. Back to the panel example. If the client wants you to work with them for the next 4 years they are not going to know what their legal needs will be, nor which of this work they will want your firm to do. They don’t want to enter a relationship where for each individual matter that seek competitive bids to ensure your price is fair. From an economics perspective perhaps hourly rates are appropriate where a) the cost of scoping is enormous relative to the amount of work to be done and b) switching costs are high.
I think we both agree firms must focus first and foremost on value (creating value).
I think we both agree that firms should develop their value-based pricing capabilities (capturing value).
I think we both agree hourly rates are over-used in the profession.
The only area I think we disagree on is that I believe there are occasions where time-based billing is the fairest structure for both clients and firms.
Kind regards
Colin
Finally, a short reply to Colin, as this post is already too long:
Thanks for letting us publish this on our Website.
I still find your arguments unconvincing.
I don’t think there’s much of a difference between B2C and B2B. Economics is economics, and only humans buy things—there’s nobody here but us people as economist Herbert Stein used to say. This is why IBM’s slogan of “No one ever got fired for buying IBM” was so effective.
I heard stories while in Australia from both firms and general counsel that firms that only offer fixed prices, and no hourly rates, were put on the panels of some very large companies. It seems to me that if a firm is able to differentiate itself effectively, then clients will work with them no matter how they price. Firms such as Advent, Optim, Marque in Australia, and Bartlit Beck, Wachtel Lipton among others in the USA prove this point.
If the only way a firm can get on a panel is to have hourly rates, that’s a very uninspiring reason to hire a law firm. This is a purpose, strategy and positioning issue, not a pricing issue.
The alternatives you suggest are the billable hour in drag because firms are still comparing the rates to an hourly rate. Even though a fixed price is quoted, the firm is measuring value by time. If Jasper Consulting wants to help law firms create and capture more value, why are you still letting Marx’s labor theory of value drive your thinking?
I don’t buy your argument that clients will only put firms on panels if they commit to an hourly rate. A fixed price is a mechanism for agreeing to price up-front. This actually is far more transparent than hourly rates, and can easily be shopped.
And an hourly rate is not a price. How can a client know what a price is by getting an hourly rate? This reminds me of the communist obsession with inputs over outputs.
Why would you want to use the hourly rate in complex jobs. It is precisely these jobs where firms are adding the most value and need to move away from hourly rates. For the life of me, this makes no sense. You’re telling firms such as those that defended Bill Gate’s Microsoft against anti-trust violations to use the hourly rate because the job cannot be scoped? Any firm that did this would find its pricing to be incredibly sub-optimal.
Alright, enough from me, let our readers join the debate.
Even the thought of summarizing the premise of George Gilder’s new book, The Israel Test, causes my mind to reel.
To attempt: The cause of the conflict between Israel and the neighboring Arab countries is not religion (although there are certainly elements) nor racism (although there are certainly elements), but rather it is caused by envy. Israel, in the 60 plus years of its existence, has been extraordinarily successful and the perception is that it has done so by taking from the Palestinians. In short, the conflict is about the zero-sum thinking of demand economics versus positive-sum thinking of supply-side economics. It is about the jealousy felt against people who have attained success and the belief that the only way they could have attained that success is by taking from others.
“The real issue is between the rule of law and the rule of leveler egalitarianism, between creative excellence and covetous ‘fairness’,’ between admiration of achievement versus envy and resentment of it,” Gilder says.
In Part One, Zerizus, Gilder, in his best and most brilliant prose since Wealth & Poverty, develops this premise and destroys any and all arguments against it. He posits his Golden Rule of Capitalism - The good fortune of others is also one’s own. One of the troubles with government, indeed with even democracy, is that government (transfers of wealth) and democracy (elections) are zero-sum, while the economic system, capitalism is positive-sum. This influences the thinking of all leaders in democracies that they need to create an equity of outcomes, not just an equality of opportunity. He terms these people, “handi-capitalists!”
In Part Two, Israel Inside, Gilder introduces us to Jewish and Israel scientists and entrepreneurs who have had a profound influence on the world as we know it and a few, who he believes, are about to have even great influence. Intel’s latest microprocessors, they are coming from Israel; Petaflop networking, from Israel; Wireless high-definition interface standards, from Israel; Algorithms which map the human genome, Israel.
In Part Three, The Paradox of Peace, Gilder puts forth his by far most controversial and thought provoking postulate - the Peace Now movement inside and outside Israel, condemn themselves to Peace Never. Gilder quotes Nobel Laureate Robert Aumann, “If you want peace now, you may well never get peace. But if you have time - if you can wait - that changes the whole picture; then you might get peace now.” Gilder states, “Peace requires the imposition of penalties on aggression.”
Simply said, The Israel Test is not a easy read, but it is absolutely a must-read.
In addition to the blood pressure pills I take from stressing out over changing the business model for professional firms (kidding, it is hereditary), I take a few vitamins and supplements on a daily basis. Since I like to take them on a full stomach, after dinner seems to work best for me. However, because I am usually doing several things at once I sometimes forget if I have taken the pills or not.
After debating about it for a few weeks, I finally broke down and bought one of those weekly pill organizers. (Shown at left.) OK, before you start with the comments, there were not many choices.
In any case (pun intended), I loaded it up on Sunday and thus far it is working flawlessly. Coincidently, it has also led to an unintended benefit - I only have to unscrew the child protection lids once a week now, and not once a day.
I got to thinking about it and there is a lesson here for professional firms. Notice that the original problem was one of effectiveness - I could not remember if I had taken the pills. In solving the effectiveness problem I also increase my efficiency - I only open the bottles once a week now. It was through increase my effectiveness that I also increase my efficiency. I submit that this could not have worked the other way. No amount of increasing my efficiency of the original task would have increased my effectiveness.
If I have lined up the bottles and practiced open them with the least amount of effort and streamlined precision of motion, I would have not increased my ability to remember to take the pills each night.
The lesson - I am living proof of Kless’ Second Law - Effectiveness always and everywhere trumps efficiency.
Ed Kless and I had a great time presenting Keynesian vs. Supply-Side Economics in Second Life on Tuesday for the Maryland Association of CPAs.
Second Life is incredible technology. Short of a live presentation, I really believe it’s the next best alternative for conducting an educational event. There is something very tactile about it, both as a presenter and member of the audience.
George Gilder responds to a question regarding the idea of banning profits and utters one of the most profound statements I have ever heard - “Profit is an index of altruism.”
While there is much in the article with which I agree (Value is subjective; It is hard to get to value, etc), there is one key point to which I object strongly. The writer’s definition of value is "the amount of money or relative worth that is considered to be the fair equivalent for what is to be received in return." (Emphasis mine.)
This continues the thinking of business-as-zero-sum-game. The value the customer is getting should outweigh, in some cases significantly, the price that they are paying. This is the beauty and morality of the free market. Wealth is created on both sides of every transaction because they are a) mutually beneficial and b) entered into with the freedom to choose. The buyer benefits more than the price they pay and the seller benefits because they provide the good/service/knowledge for less cost than their price. Of course, this is called profit.
The paper has many interesting points, some of which I agree with, others I strongly disagree with. This just goes to show how much work needs be done in understanding knowledge workers, something Peter Drucker wrote about for decades. We just don’t know how to measure their productivity, and the statistics we are using—which were designed for an Industrial Era—are obsolete, and I would add, are probably doing more harm than good inside of Professional Knowledge Firms.
Knowledge work is hard to define, since it’s largely based on tacit knowledge. It’s harder to quantify, so I was skeptical right off the bat with the paper’s title. It confuses effectiveness with efficiency. Effectiveness requires a judgment (usually by another knowledge worker), whereas efficiency is a measurement.
Nevertheless, the paper is worth reading for those of you interested in this topic.
Definitions
The paper begins by defining organizational effectiveness:
While it isn’t limited to productivity, organizational effectiveness certainly encompasses it. Defined narrowly as the amount of physical output for each unit of productive input, productivity has been a human concern for centuries. The Chinese philosopher Mencius (372-279BC) wrote about conceptual models and systems that would qualify today as production-management techniques. Plato (427-347BC) spoke of the division of labor in The Republic: “A man whose work is confined to such limited task must necessarily excel at it.”
Early thinking about productivity remains relevant to production today. Measuring it, however, has become more complex. The U.S. Bureau of Labor Statistics (BLS) measures what it calls “multifactor productivity,” in which “output is related to combined inputs of labor, capital and intermediate purchases. Labor is measured by the number of hours of labor expended in the production of output. Capital includes equipment, structures, land, and inventories. Intermediate purchases are composed of materials, fuels, electricity, and purchased services.”
The problem with measurement comes in defining output for non-manufacturing, service activities commonly thought of as “white collar” or “knowledge work” that the BLS labels “hard-to-measure.”
There’s an understatement, “hard to measure.” Notice how the inputs are much easier to quantify than the outputs. Further, the outputs are usually measured based on price, not value, and therefore “productivity” as measured by the government—and firms themselves—is not only understated, it’s also meaningless.
Economists have a saying that if you’re driving with a broken speedometer you probably shouldn’t get it fixed because at least you’re used to it. I feel the same way about how the government measures productivity for knowledge workers. It’s sort of meaningless, but better than nothing for statistical, macroeconomic comparisons.
But at the microeconomic level of running a PKF, it doesn’t shed much light on knowledge worker effectiveness. Consider Einstein. Sure, we can tally up the amount of inputs he uses, along with their costs, but how do you measure the output? How do you price it? How do you value it? This is the age old problem: it’s easier to count the bottles than describe the wine. Efficiency is the count, the description is a judgment. I’ve posted on this topic before.
Individual vs. Team Productivity
The paper quotes Michael O’Neill who leads a program of research into organizational effectiveness for Herman Miller:
In traditional productivity measures the unit of analysis is the individual. In terms of knowledge work, that may be irrelevant because increases in individual productivity, no matter how they’re measured, do not automatically transfer to the productivity of the organization. Instead, the team, or functional group, becomes the unit of analysis. This requires managers to make a conceptual shift in their thinking, to understand that it’s more relevant to measure activities that contribute to overall business goals and strategies, such as the speed of organizing around new opportunities and the quality of business processes.
This is a good point, since one knowledge worker’s output greatly effects another in the chain. Here’s an example. I was recently hospitalized where my surgeon ordered a CT Scan so he could operate. The technician didn’t read the surgeon’s order properly and did the scan incorrectly.
However, if all you were doing was measuring inputs and outputs with some efficiency metric, the CT Scan would have rated 100%. After all, he got me in and out in record time, processed the image to the doctor on time, etc. However, it wasn’t until the surgeon looked at the results, requiring a judgment, when he discovered the scan had been done improperly and had to be done over. This cost me an extra day or two in the hospital, not at all adding to my satisfaction with the hospital’s service.
In other words, the scan was efficient, but not at all effective. And you can’t measure effectiveness. It has to be judged. Obviously if one knowledge worker screws up on a team, it’s going to have ripple effects throughout the entire project.
This is why the paper points out that “no single measure is likely to capture the outcomes,” which is why PKFs can’t rely on measures alone. As the paper points out:
If the organization’s goal is to guide, motivate, or even control knowledge workers’ behavior, it must supplement measurement with strong cultures and value systems. Measurements may be attractive for their apparent preciseness, but they must be tempered with the observations, experience, and common sense of managers.
Disagreements
The old canard that what you can measure you can manage is nonsense on stilts, since we can’t change our weight simply by weighing ourselves more accurately or frequently. Here’s how the paper addresses this topic:
An old business adage says that whatever cannot be measured cannot be managed. Yet, as Susan Cantrell, research fellow at the Accenture Institute for Strategic Change, points out, knowledge workers resist being measured, “both because they have no history of being measured and because they believe it might take the ‘magic’ out of their work. Most high-end knowledge workers...tend to work on unique, one-off, highly specialized problems, making it impossible to have one measure for all such knowledge workers. Moreover, many knowledge worker...work interdependently, making it difficult to isolate one knowledge worker’s contribution from another’s. And, because the work performed is generally unobservable, a knowledge worker could be working for months, or sometimes even years, before an output is tangibly realized.”
I have an alternative explanation for why knowledge workers resist being measured. It has nothing to do with taking the “magic” out their work. It’s because the measures are wrong. In no way can they capture the value created. Why continue to measure things that don’t matter?
The paper also claims that improving knowledge worker productivity is the only true way to improve a company’s competitive position. Surely this is an overstatement. What about innovation? What about a differentiated value proposition for customers? The most innovative companies, like Google or Apple, are certainly not the most productive as traditionally measured. So what? They are incredibly effective in creating value for their customers.
It just goes to show how theories that are so hardwired in us are so difficult to change. We are going to have to get over our obsession with measuring everything and begin to realize that in PKFs a judgment is far more valuable, effective, and right, than a mere measurement.
Any measurement can be manipulated, so we ultimately rely on judgments in the end. It’s time to face the cold reality: knowledge work cannot be quantified with the metrics we are now using. Our speedometer is broken. And while that might be alright for government cars—statistics—I would suggest we get ours fixed.
This is why we advocate Key Predictive Indicators, most of which are judgments rather than mere measurements.
After debating about it for a few weeks, I finally broke down and bought one of those weekly pill organizers. (Shown at left.) OK, before you start with the comments, there were not many choices.
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