Implementing Value Pricing

A Radical Business Model for Professional Firms

Ronald J. Baker

• Publisher: Wiley
• Year: 2010
• ISBN:
  9780470929575
• Edition: 1
• Topic: Business
• Subtopic: Managerial Accounting
• Index: Business

Praise for IMPLEMENTING VALUE PRICING

A Radical Business Model for Professional Firms

"Ron Baker is the most prolific and best writer when it comes to pricing services. This is a must-read for executives and partners in small to large firms. Ron provides the basics, the advanced ideas, the workbooks, the case studies—everything. This is a must-have and a terrific book." —Reed K. Holden founder and CEO, Holden Advisors, Corp., Associate Professor, Columbia University www.holdenadvisors.com

"We've known through Ron Baker's earlier books that he's not just an extraordinary thinker and truly brilliant writer—he's a mover and a shaker on a mission. This is the End of Time! Brilliant." —Paul Dunn Chairman, B1G1 ® www.b1g1.com

" Implementing Value Pricing is a powerful blend of theory, strategy, and tactics. Ron Baker's most recent offering is ambitious in scope, exploring topics that include economic theory, customer orientation, value identification, service positioning, and pricing strategy. He weaves all of them together seamlessly, and includes numerous examples to illustrate his primary points. I have applied the knowledge I've gained from his body of work, and the benefits to me—and to my customers—have been immediate, significant, and ongoing." —Brent Uren Principal, Valuation & Business Modeling Ernst & Young ® www.ey.com

"Ron Baker is a revolutionary. He is on a radical crusade to align the interests of service providers with those of their customers by having lawyers, accountants, and consultants charge based on the value they provide, rather than the effort it takes. Implementing Value Pricing is a manifesto that establishes a clear case for the revolution. It provides detailed guidance that includes not only strategies and tactics, but key predictive indicators for success. It is richly illustrated by the successes of firms that have embraced value-based pricing to make their services not only more cost-effective for their customers, but more profitable as well. The hallmark of a manifesto is an unyielding sense of purpose and a call to action. Let the revolution begin." —Robert G. Cross, Chairman and CEO, Revenue Analytics, Inc. Author, Revenue Management: Hard-Core Tactics for Market Domination

Part I: A Radical Business Model

There is nothing like returning to a place that remains unchanged to find the ways in which you yourself have altered.

—Nelson Mandela

CHAPTER 1

The Firm of the Past

I’m willing to be occasionally wrong. But what I hate most in life is to stay wrong.

—Paul A. Samuelson, Nobel laureate economist

A business model is nothing more than a theory. I am defining a business model as follows:

How your firm creates value for customers, and how you monetize that value.

Let us analyze the predominant theory of professional firms. In Greek language, analyze means “unloosen, separate into parts.” Almost every book that discusses professional firms is based on this equation:

Since this model dominates the thinking of firm leaders to this day, it is worth explaining the model in greater detail to understand both its strengths and—as will be increasingly detailed—its fundamental weaknesses.

Consider a professional firm—such as accounting, legal, consulting, advertising, IT, and so on—the archetypal pyramid firm model rested on the foundation of leveraging people power, in effect their “capacity.” The theory is this: Since the two main drivers of profitability are leverage (number of team members per owner) and the hourly rate realization, if each partner could oversee a group of professionals, this would provide the firm with additional capacity to generate top-line revenue, and thus add to the profitability and size of the firm. If a firm wanted to add to its revenue base, it had two primary choices: It could work its people more hours, or it could hire more people. It is no secret which choice the average firm tends to choose, much to the chagrin of its already overworked team members.

Now compare this practice with other industries—this process of adding capacity after revenue is backward. If you think of any other industry or company—from Intel and General Electric to FedEx and Microsoft—capacity is almost always added before revenue. Consider specifically FedEx: Before Fred Smith could deliver his first overnight package, he had to have trucks, drivers, airplanes, and facilities throughout the country, all at enormous fixed costs. Most organizations operate with capacity to spare, which is vital to maintain flexibility in changing market conditions.

Next, let us look at the second element in the old theory—efficiency. Efficiency is a word that can be said with perfect impunity, since no one in his right mind would dispute the goal of operating efficiently. The problem is there is no such thing as generic efficiency. It all depends on what your purpose is, and how much you are willing to pay. In professional firms, the pendulum has swung too far in the direction of efficiency over everything else. It seems innovation, dynamism, customer service, investments in human capital, and effectiveness have all been sacrificed on the altar of efficiency.

The next component in the old model is hourly rates—a form of cost-plus pricing. The real antecedent of cost-plus pricing is the Labor Theory of Value, posited by economists of the eighteenth century and Karl Marx in the middle nineteenth, and falsified by the 1871 Marginalist Revolution.

Last, consider revenue. It is one thing to get more business; it is quite another to get better business. The “bigger is better” mentality is an empty promise for most firms. Acquiring more customers is not necessarily better. Growth simply for the sake of growth is the ideology of the cancer cell, not a strategy for a viable, profitable firm. Eventually, the cancer kills its host.

If market share explained profitability, General Motors, United Airlines, Sears, and Philips should be the most profitable companies in their respective industries. Yet they have all turned in mediocre profitability records, and two have been through bankruptcy. Growth in profitability usually precedes market share, not vice versa. Wal-Mart, for example, was far more profitable than Sears long before it had a sizeable market share. It seems profitability and market share grow in tandem with a viable value proposition customers are willing to pay for.

Peter Drucker once wrote, “Most business issues are not the result of things being done poorly or even the wrong things being done. Businesses fail because the CEO’s assumptions about the outside provide decision frameworks for the institution which no longer fit reality” (Edersheim 2007: 243). Nowhere is this truer than in the professions. The “We sell time” mentality is not simply a wrong pricing strategy, but far more systemic—a flawed business model.

It is a valuable accomplishment in and of itself to point out defects in a theory—or falsify it entirely. Another way to advance knowledge is to posit a better theory—a new business model for the firm of the future.

CHAPTER 2

The Firm of the Future

Revamping a business model is not easy; it requires visible, consistent commitment from the top. It takes time. First, the more established an industry’s norms, the more difficult it is to innovate business models. Everyone has a big stake in preserving the status quo, but it is critical to resist the temptation to do so.

—A.G. Lafley and Ram Charan, The Game-Changer, 2008

Only a theory can replace a theory. If we reject our old notions of the way the world works, we need a new place to go. Certainly we can make incremental improvements to the old business model presented in Chapter 1. Indeed, business books are full of such ideas—Total Quality Management, Lean, Six-Sigma, reengineering, benchmarking, and so on. But if we endeavor to make significant improvements in performance and effectiveness in today’s intellectual capital economy, we have to move beyond tactics and techniques. We have to work on our theories. Doctors used to believe in leeches and bloodletting, and no matter how efficiently they executed those therapies based on those theories, they simply were not medically effective. There is no right way to do the wrong thing.

In the previous chapter, I described the flaws in the traditional professional firm business model. I want to be very specific about the charge I am making. I am not arguing that the old business model is not profitable. That would defy the reality of many profitable firms. Instead, I am saying it is suboptimal. Engineers, for example, use this term to describe the mindless pursuit of one goal to the detriment of broader organizational interests. This is certainly the case with the pursuit of billable hours at the expense of effectiveness, customer service, innovation, creativity, and professional morale.

I want to posit a more optimal business model—meaning the best solution relative to a stated set of objectives, constraints, and assumptions.

The Business Model of the Firm of the Future

The correspondence principle is what scientists use when comparing two theories. The new theory should be able to replicate the successes of the old theory, explain where it fails, and offer new insights. It is time to replace the old firm model of “We sell time,” described in the previous chapter, with a radical business model.

Why radical? Because it comes from the Latin for “getting back to the root.” In this case, the root means customers buy value, not time, which leads us to a more optimal business model:

Let us explore each component of the above equation; then we will discuss why it is a better theory for explaining the success of firms operating in today’s intellectual capital economy.

Revenue Is Vanity—Profit Is Sanity

We start with profitability, rather than revenue, because we are not interested in growth merely for the sake of growth. As many companies around the world have learned—some the hard way, such as the airlines, retailers, and automobile manufacturers—market share is not the open sesame to more profitability. We are interested in finding the right customer, at the right price, consistent with our purpose and values, even if that means frequently turning away customers.

Adopting this belief means you need to become much more selective about whom you do business with, even though that marginal business may be “profitable” by conventional accounting standards. Very often the most important costs—and benefits, for that matter—do not ever show up on a profit-and-loss statement. There is such a thing as good and bad profits. Accepting customers who are not a good fit for your firm—either because of their personality or their unwillingness to appreciate your value—has many deleterious effects, such as negatively affecting team member morale and committing fixed capacity to customers for whom you simply cannot create value. Growth without profit is perilous.

Businesses Have Prices, Not Hourly Rates

Everything we buy as consumers we know the price upfront. The billable hour violates this basic economic law, and it does so at the peril of the professions. No customer buys time—it measures efforts, not results. Customers demand to make a price/value assessment before they purchase, not after.

The word value has a specific meaning in economics: “The maximum amount that a consumer would be willing to pay for an item.” Therefore, value pricing can be defined as the maximum amount a given customer is willing to pay for a particular service, before the work begins.

Why Intellectual Capital Is the Chief Source of Wealth

The Intellectual Capital Management Gathering Best Practices conference in 1995 defined intellectual capital as “knowledge that can be converted into profits,” which is an adequate definition for our purposes since it equates knowledge with a verb (Lev 2001: 155). Intellectual capital should not be confused with knowledge management, which is merely a process, whereas intellectual capital (IC) is an entity.

Today, intellectual capital is sometimes thought of as nothing more than another “buzzword.” However, IC has always been the chief driver of wealth, as economists have argued since the term human capital was first coined in 1961, and as far back as the late eighteenth century when Adam Smith discredited the idea of mercantilism. Wealth does not reside in tangible assets or money; it resides in the IC that exists in the human spirit, which is then used to create valuable goods and services. For our purposes we are going to separate a company’s IC into three categories, as originally proposed by Karl-Erik Sveiby, a leading thinker in knowledge theory, in 1989:

• Human capital (HC). This comprises your team members and associates who work either for you or with you. As one industry leader said, this is the capital that leaves in the elevator at night. The important thing to remember about HC is that it cannot be owned, only contracted, since it is completely volitional. In fact, more and more, knowledge workers own the means of your firm’s production, and knowledge workers will invest their personal HC in those firms that pay a decent return on investment, both economic and psychological. In the final analysis, your people are not assets (they deserve more respect than a copier machine and a computer); they are not resources to be harvested from the land like coal when you run out. Ultimately, they are volunteers and it is totally up to them whether they get back into the elevator the following morning.
• Structural capital. This is everything that remains in your firm once the HC has stepped into the elevator, such as databases, customer lists, systems, procedures, intranets, manuals, files, technology, business models, and all of the explicit knowledge tools you utilize to produce results for your customers.
• Social capital. This includes your customers, the main reason a business exists; but it also includes your suppliers, vendors, networks, referral sources, alumni, joint ventures and alliance partners, professional associations, reputation, and so on. Of the three types of IC, this is perhaps the least leveraged, and yet it is highly valued by customers.

The crucial point to understand here is that it is the interplay among the three types of IC above that generates wealth-creating opportunities for your firm. Human capital, for example, can grow in two ways: when the business utilizes more of what each person knows, and when people know more things that are useful to the firm and/or its customers. And since knowledge is a “nonrival” good—meaning we can both possess it at the same time without diminishing it—knowledge shared is knowledge that is effectively doubled throughout the organization. That is why former Hewlett-Packard CEO Lew Platt said, “If HP knew what HP knows, we would be three times as profitable.”

Another useful way to think about IC is by ownership. Human capital is owned by the knowledge worker; structural capital is the only component of IC that is owned by the firm; and social capital is owned by no one, though it can be leveraged, monetizing benefits to the owners of the firm. When Robert Goizueta, then CEO of Coca-Cola, was asked what the lesson was from the New Coke debacle, he replied that he learned that Coca-Cola did not own its brand—the consumer did (Tedlow 2001: 105).

A fascinating study by the World Bank, Where Is the Wealth of Nations?, finds that 75 percent of the world’s wealth resides in human capital. In the United States, 82 percent of our 2000 per capita wealth resided in intangible capital (16 percent is produced capital, and only 3 percent in natural capital). The poorest country, Ethiopia, derives 50 percent of its wealth from intangible capital, 41 percent from natural capital, and 9 percent from produced capital (World Bank 2006).

Knowledge firms are the ultimate “asset-less” organizations, since 75 percent of their value-creating capacity is owned by the volunteers who work there. This is a tectonic shift not only in the nature of wealth-creation but in how firms need to think about how they work. So before we leave this brief discussion of IC, it is necessary to explain something that may, at first impression, not seem obvious.

Negative Intellectual Capital

When IC is discussed, it is normally done in a very positive context, as most of the examples used are from successes in leveraging IC, such as Microsoft or Pixar. But it is important to understand there is such a thing as negative human capital, negative structural capital, and negative social capital. Certainly, this sounds counterintuitive, but it is nonetheless true. Not everything we know is beneficial. Think of the IC a thief possesses; it is knowledge in the sen...