Ron Baker and Ed Kless continue their tour through Ron Baker’s book Implementing Value Pricing:A Radical Business Model for Professional Firms. This a part two of three on Chapter 2 – The Firm of the Future. In this episode, we discuss what is affectionately known in the halls of VeraSage as the Eff’ing Debate – Efficiency vs Effectiveness vs Efficacy.
Fearless lawyer Mike Ayotte who is never afraid to express his opinions as The Last Honest Lawyer, recently wrote a post titled “The Billable Hour is Dead” and likened lawyers use of the billable hour to the demise of dinosaurs, whilst conceding that even after dinosaurs met their fate lizards pulled through (as did crocodiles and sharks!).
As you know, I would so love to believe that the billable hour is indeed dead-but I regret to report it is not- at least not yet. It is no doubt sick, but if it is dying its death throes are still reverberating.
I recently returned from the US attending some legal conferences and meeting with many lawyers, law firms, legal commentators, consultants, academics, legal authors and law students. Almost without exception (the exceptions primarily being legal consultants and software vendors who peddle time “capture” methodologies and who perpetuate the “lawyers sell time” myth) all agreed that the billable hour is pretty crook, is a sub optimal model and is no longer meeting the business needs of either the law firms or their clients (let alone the social and cultural needs of those who work in law firms).
What then has largely been the response from the profession to this sickness?
Apart from the innovative and courageous outliers- whose numbers I hasten to add are increasing all the time- and who have put the billable hour out of its misery by completely changing their business model- most firms apply a bandaid approach and continue to work within, and therefore prop up, the existing leveraged based business model.
Some firms have come up with all sorts of ingenious ways to increase the billable hours of their lawyers especially by spending huge dollars on technology & training so lawyers can better (“more accurately”) record their time wherever they might be and whatever the day or night of the week. (Atticus Finch’s tombstone would these days read something along the lines of “Here lies Atticus-a heroic biller & time recorder”). Whilst it is true many firms have adopted Alternative Fee Arrangements (mostly in response to client demands, rarely of their own volition), most of those AFA’s look to me to be billable hours in drag (“if it walks like a duck, quacks ……”) based around fixed fees, capped fees, blended rates, etc- all calculated on the time x rates x people model.
Is it any wonder good people are increasingly looking for better alternatives than working in a private legal practice; clients are looking to other providers to add value to their businesses; and that external disruptors will continue to flock to the legal profession in droves to exploit law firms’ soft underbelly-our lack of flexibility, failure to innovate, unwillingness to collaborate, our short term greed for the almighty dollar, our 19th century governance structures, absence of diversification-and most of all our cultural desert.
Regular readers of this space will know I am not a fan of the cult of efficiency that enraptures most businesses today. In my project management classes I stress that duration is the more important metric both the the professional and the customer.
That said, I would like to update the idea of comparative advantage as originally put forward by economist David Ricardo, but updated for the knowledge worker, especially the small firm. This idea seems to be about efficiency, but if one looks deeper, one will see that it is truly about effectiveness.
Adam Able is the owner/operator of a small IT consulting firm. Adam has been working in his industry for over 20 years and has a wealth of knowledge and domain expertise with the products with which he works. Because of this Adam, can slam out a new customized report in an average of two hours. He can also do an average migration of data in one hour.
Igor Egit is relatively new his profession; he has been at it a little over a year. Igor is not the brightest bulb in the drawer. On average it takes him three hours to deliver a new custom report, 50 percent more than Adam. While Igor does not suck at reports, he is a migration moron and it takes him four hours to develop a workable data migration, 400 percent longer than Adam.
This table shows the comparison.
If each does one report and one migration the total is 10 hours and the yield is two reports and two migrations.
Comparative advantage says that while Adam is better at both, and could theoretically do it himself in six hours, he is better off specializing in migrations and allowing Igor to do the reports, even though this runs counter to the idea of efficiency.
This table demonstrates the results of specialization.
Notice again, that the yield is still two reports and two migrations, however, each received an hour of additional discretionary time. In addition, the total effort decreased to eight hours.
Now, some may argue that from an efficiency standpoint, it would be better to have Adam do both, since the total would be six hours not eight. What would that do to Adam’s leisure time? It would reduce it by four hours.
Looked at in this light, we can see that the question is: does it make sense for Adam to trade four hours of discretionary time in exchange for two reports from Igor. This is a value tradeoff that only Adam (and in a sense Igor) can make.
The trap is set, however, if we introduce the idea of a billable time rate to this example. Since it is unlikely that Adam’s rate would be three times that of Igor’s. Adam’s customers will either a) insist that they pay a reduced rate for Igor, or worse, b) insist that Adam himself do the work.
The traps is sprung! Adam, in the name of good service, will acquiesce to the customer. Likely, Igor will be out of a job; and Adam will miss more Little League games.
In his latest book, Wealth and Poverty: A New Edition for the Twenty-First Century, George Gilder weighs in on the efficiency vs. effectiveness debate, validating my matrix on the difference:
Firms at the top of their S-curves of growth: the time when innovation dwindles and heavily bureaucratized companies seek minor new adaptations, packaging changes, and manufacturing efficiencies in order to wring the last gains of productivity from an essentially static industry that has already long passed its phase of “fast history.”
Auto companies at the very pinnacle of productivity had lost all room to maneuver. New developments almost never emerge from the leading companies in an industry. None of the carriage makers and buggy whip producers could create a salable automobile, and the gaslight and candle businesses neglected the promise of electricity; slide rule people at Keuffel and Esser succumbed without response to the handheld calculator; just as IBM lagged behind other companies in adopting most major innovations in business machines, from copiers to word processors; and as even Texas Instruments finally became relatively rigid and uncreative in the microprocessor field.
The very process of rationalization and bureaucracy by which a company becomes the most productive in an industry tends to render it less flexible and inventive. An exclusive preoccupation with statistical productivity—simple coefficients between inputs and outputs—can lead to a rigid, and in the long run, unproductive economy.
This is precisely why we warn firms to avoid putting efficiency ahead of effectiveness.
Any industry at the apogee of efficiency is an industry in decline.
Regular followers of VeraSage will already know we are huge fans of Rory Sutherland, Vice-Chairman, Ogilvy Group, in the UK, where he’s been working since 1988.
We’ve been showing his Zeitgeist talk all over the USA, Australia, and Canada. It is simply one of the most profound talks we’ve seen in at least a decade.
Rory was the president of IPA in the UK, where he made it his platform to spread behavioral economics into advertising agencies.
He is a devotee of Austrian economics; Ludwig von Mises is his hero.
Rory has published an eBook, The Wiki Man, I believe only available on Amazon Kindle.
It’s not really a book. It’s a long interview, then a collection of articles he’s written over the years. But what a short and sweet read it is.
It’s difficult to write a review of his book, since, like his Zeitgeist talk, he moves a mile a minute, tossing out an incredible range of erudite thoughts, topics, and funny lines.
The best I can do is to arrange some of his more cogent thoughts into categories.
How did Rory get so deep into economics?
I got interested in economics just because I was ill for a few days and ended up reading a few books—one very good one by Steven Landsburg called Armchair Economist. It’s a really, really good read.
I also credit Landsburg for providing me with an incredible education in price theory, and this book is on my Top 100 Best Business Books of all time.
He goes on to discuss the concept of “Satisfice,” from the economist Herbert Simon.
“Satisfice” is the combination of suffice and satisfy.
I don’t think you can really understand brands without understanding satisficing.
[It’s] killer blow for market research—when you are put in a group of people and you’re researched, you behave like a maximiser because we want to be seen as one. Everybody says they obviously want to find the best television they can within their price bracket.
Most people, in most fields of consumption, NOT maximisers at all.
The vast bulk of the money in any market at any time is in the hands of satisficers. Self-image being a more stubborn force than self-interest.
Before the iPod most important thing with any sound system was of course sound quality. Then the iPod, and sound quality isn’t all that great.
[But it] satisfices, that’s the point.
On Behavioral Economics
It’s not mass hysteria that really frightens me, it’s mass rationality. Spend just as much time working on how you can reduce consumer transaction costs as you do trying to reduce manufacturing costs.
Maybe you only need the hard sell because your product isn’t easy to buy. All airport car parks should have a number of parking spaces, which are three times more expensive than any others.
We do not stand a chance of selling them—or of seeing them happen. And the reason for this is simple: these are all behaviour changing ideas, not attitude shifting ideas. And the job of an agency is now just to do the attitude stuff…
[It’s a] dangerous assumption that behavioral change is the product of attitudinal change: in reality it happens more often the other way.
On Advertising Agency Value
…agencies have so overplayed the “brand” justification for their activities that they have sometimes disqualified themselves from adding value to clients anywhere else.
[The] job of anyone in marketing is to turn human understanding into business advantage or social advantage, okay? That’s the only job.
I think there are really only two types of people in advertising agencies. Good people and crap people. It’s more important to have good people than to obsess about what they. Incidentally our business of charging by the hour makes it difficult to hire except by specialism, which is a problem.
As one creative (Chris Wilkins?) remarked to a planner: “You and I both drink from the same well of inspiration. The difference is that you get to piss in it first.”
Incidentally, one way to get your own bloody clients to do it is to get their competitors to do it; they’re bloody lazy most of these organisations, and they only actually do anything when their competitor does it.
How true is this last line!
[The] best way to build a brand is to set out to build a brand. I really don’t believe this. I think if you set out to build a great business, you’ll stand a fair chance of building a great brand. I am not equally confident that someone aspiring to build a great brand will build a great business.
Great brands are often built obliquely, a by-product of something (ideals, vision, focus) and not a product of anything.
Andy Warhol’s beautiful insightful comment: “What I like about Coke is that the President of the United States can’t get a better Coke than the bum on the street.” Do you think the Prime Minister drinks the same wine as the local wino?
Great brands are like great pubs. One of the requirements is that they cross a demographic divide. Who is the typical Google user?
Ordinary people do not demand rigorous sequential logic from their friends; do they want it from their brands?
I suggest it is by far the more valuable economic role that brands play: not to be a promise of ultimate superiority but a cast iron assurance of pretty dependable non-shitness.
Jack Welch said, “Shareholder value is an outcome—it’s not a strategy.” Maybe greed isn’t bad for business. It’s certainly bad for brands.
We too often forget the power of advertising to alienate. Our first reaction is often to find a reason to reject it.
To decide that young people are the only audience which matters, we lose the largest and richest swathe of the population. Remove anything that enabled a recipient to go: “obviously not for me.”
Wine does defy logic in one sense—in nearly everything else we buy we value consistency. If one in three bottles of whisky we bought, or one in three pints of beer we bought in the pub were total shit, we would never go to that pub again, and yet one in three glasses of wine we try are just rubbish, and yet we persist in trying to drink wine, and I genuinely don’t quite know why it is.
On Second Homes
[A] second home is not a necessary investment. [Who] really wants these encumbrances now they are no longer rising in value? Do you want to spend your precious fortnight’ holiday practising the Italian for “My septic tank appears to have exploded.”
On Efficiency vs. Effectiveness
Rory has the same disdain for the mindless pursuit of efficiency at the expense of effectiveness that we do.
The most dangerous technology is the spreadsheet. Metrics or values invariably override any conflicting human judgment.
“The Arithmocracy,” a powerful left-brained administrative caste which attaches importance only to things which can be expressed in numerical terms or on a chart. Holocaust and the Soviet famine were both the product of meticulous government officials in dutiful pursuit of numerical targets.
We have an economic system that is much better at delivering efficiency than it is at inspiring affection.
We have probably spent quite long enough trying to make this industry leaner and more efficient. We should try to make it jammier instead.
How, in their endless, dogged pursuit of a false efficiency, organisations can be rendered slightly useless. And stupid. (Remember that the word “dogged” is derived from the word “dog” meaning “energetic and stupid”).
[A] belief in false efficiency is very simple; it comes from the belief that improvement comes from the elimination of apparent waste. [The] problem with this approach. It fails to pay any tribute to luck.
If you look at all the really important breakthroughs made in any field, what you will find is that the unplanned, unintended or fortuitous connection plays just as great a role as the planned, the processed and the organised.
A Perfect Mess details how a messy desk and the accidental juxtaposition of two apparently unrelated papers led to a Nobel prize.
Are we trying too hard to mimic our clients obsession with efficiency (not effectiveness, which is something different) when we should be making the case for chance? Is payment by the hour making us too focused? Too dogged when we should be “catted”?
Henry Ford’s reaction to a consultant who questioned why he paid $50,000 a year to someone who spent most of his time with his feet on his desk. “Because a few years ago that man came up with something that saved me $2,000,000,” he replied. “And when he had that idea his feet were exactly where they are now.”
Be sure to watch Rory’s Zeitgeist talk, and read this book. As he says, it’s a great book for the loo.
Follow him on Twitter @rorysutherland, where his bio reads: “Fat bloke at Ogilvy, IPA; The Wiki Man.
VeraSage Founder, Ron Baker has often used Snow White and Seven Dwarfs to illustrate the problem of applying efficiency to knowledge work.
“A LEAN six sigma guru would have advised Walt Disney to make Snow White and the Three Dwarfs as it would have improved efficiency by over 50 percent,” he intones.
Recently I was reminded of a scene from the Academy Award winning film Amadeus where the Holy Roman Emperor Jozef Franz (or was it Franz Jozef) criticizes Mozart’s opera for having, “Too many notes.”
Unfortunately, the clip cuts off before Mozart’s brilliant response, “Which few did you have in mind, Majesty?”
Knowledge work cannot be LEAN six sigma-ed. Once again, effectiveness trumps efficiency!
I had an interesting exchange this morning with Bill Kizer, founder of the Sage Partners, Employees and Alumni Networking LinkedIn Group.
He posted, “Want to know what’s wrong with business today? The prioritization of profit over principle is built into American corporate culture.”
I disagree, at least partially.
Pursuit and prioritization of profit is not a bad thing per se. The problem occurs when the pursuit of profit is driven by an over focus on efficiency and cost reduction rather than innovation and satisfaction of customer needs and wants.
The problem comes when the question, “How are we to be profitable?” is answered primarily by saying, “We will need to cut and recover costs.” Yes, short term thinking as Bill points out is part of it, but it is the loss of the entrepreneurial spirit (or as some would say – purpose) that is the real problem.
I believe all companies begin to die when more energy is spent on creation of profit through cost reduction (efficiency) than on the creation of profit through innovation for customers (effectiveness).
Yes, this is a derivative of the Eff’ing debate.
On August 9-10 in San Francisco, Ron Baker and I will once again be presenting our Firm of the Future Symposium sponsored by Sage North America.
This symposium will be dedicated to the possibility that a professional organization can be run more effectively when it becomes a knowledge firm rather than a service firm. Creating such an organization is hard work and not for everyone as it requires professionals to think differently than they have in the past about what it is that they do.
- From a focus on revenue to a focus on profit
- From a focus on capacity to a focus on capital management
- From a focus on efficiency to a focus on effectiveness
- From a focus on cost-plus pricing to a focus on pricing on purpose
Sage (Ed’s employer) has agreed to open a limited number of spots for firms that are not partners of Sage. If you are interested in joining us, please send me an email and I can get you registered. The price is $2,500 per person and comes with a 100 percent money back guarantee!
One of the more interesting stories to emerge from our previous FotFS, was that of Peter Coburn of Commercial Logic. They are publishers of, you guessed it, time and billing software. Peter underwent a conversion of sorts and posted a terrific article on it.
This goes right to the heart of what Ed Kless calls the “E’ffing Debate”—that is, efficiency vs. effectiveness.
Since efficiency is always a measurement, and effectiveness is always a judgment, is there any doubt which is more valuable.
As Stephen Covey wrote: “We are efficient with things; we are effective with people.”
Based upon the comments to this HBR post (47 at this writing), I’m encouraged that maybe some businesspeople are beginning to see the importance of judgment, and the moral hazards of measurement.
Target costing is a term often used in pricing circles but rarely defined. We know it was pioneered by Japanese companies, especially Toyota, but what, exactly, does it mean? Target Cost Management: The Ladder to Global Survival and Success by Jim Rains sets out to shed light on a practice that is all but unknown in the USA.
Rains has an interesting background: He worked for 32 years at General Motors. He learned about Target Costing (TC) in 1993 from an Arthur Andersen report, “Product Development: Global Best Practices.”
Rains admits he’s never deployed the techniques he writes about because GM wouldn’t listen to him (though he does consult on them now). Further, no USA company he knows of has embraced TC, leaving the USA 40 years behind the Japanese (Toyota began using TC in 1963, but I’ve read elsewhere it was doing it long before then, though admittedly maybe not in the way Rains describes now).
Obviously the book is written for manufacturers, but I think there are some lessons in here for Professional Knowledge Firms, which I’ll share at the end.
The Japanese term for TC is Genka Kikaku, literally ‘planning for the achievement of true costs.” Rains provides his own definition of TC:
TC is a system that plans for and expects a constant, consistent, and acceptable level of profitability now and far into the future.
TC is not about management of cost, but rather management by cost. Rains goes on to distinguish TC from budgets and cost accounting, which deal with past costs, not future costs:
TC is not just about setting cost targets. It is an entire value chain approach to managing an enterprise. Cost targets are not budget targets. Too many managers have been taught that budgets are what you spend. Cost targets, by contrast, are something that you achieve.
TC is not a financial system. Typically financial systems are used by the finance department to report costs that have already been spent, rather than to manage cost expenditures before they occur.
The definition used by the Japanese is probably better since it incorporates the customer:
TC is a comprehensive profit management activity to plan and develop a product through establishing targets for quality, price, reliability and delivery satisfying customer requirements and through striving to achieve the targets simultaneously across the processes.
The formula looks like this:
Market Price — Target Profit = Target Cost (TC)
The process is really value engineering (VE), recognizing that the design phase is where most costs are committed, and value is what drives the market price. This is different from Activity Based Costing (ABC), which allocates past costs based on activities.
VE focuses on the function (Function-Based Costing, FBC), which acknowledges that only a few functions drive the total cost, and the importance of the function has little correlation to the cost to perform the function.
What makes FBC so effective is the focus is on the functionality the customer is willing to pay for. Rains provides an example of door hinges. GM tends to change them every year, whereas Toyota keeps the same ones since the customer doesn’t really care about the aesthetics of the hinge, only its function.
The average car contains approximately 10,000 parts, so it’s easy to imagine how this approach can avoid a large number of costs.
Traditional managerial accounting has no way to capture cost avoidance, hence it’s not rewarded. Japanese companies think about cost avoidance through the entire design and manufacturing processes, which is why they are not guided in their decision making by standard cost accounting procedures. Indeed, Toyota and other Japanese companies don’t even utilize standard cost accounting.
Ladder to Global Survival and Success
A ten-rung ladder is illustrated that plots the journey to TC, while the book is designed to focus on the top three rungs. The bottom 7 include strategies such as Lean, Six Sigma, Value Analysis, Theory of Constraints, Benchmarking, VE, ABC and a host of other acronyms I won’t bore you with.
The top three rungs are “Begin TC; Utilize Cost Tables; and TC Institutionalized.” Developing Cost Tables is the Holy Grail of TC, as they allow companies to project future costs and achieve TC objectives. There are three ways to formulate cost tables:
- Time motion study
- Actual plant floor benchmarks
- Statistically derived parametric estimation or regression techniques
What’s interesting is how Japanese companies have embedded TC into their DNA. Every major Japanese company has a cost planning department, with half of them being separate departments, 40% report to engineering, the rest to purchase and finance.
Nissan alone employs 220 people in cost engineering. Cannon, the most profitable Japanese company, has 267 people, and even Isuzu has 60.
These folks aren’t just concerned with cost, but also are responsible for value creation and establishing the Market Price.
The chief engineer at Toyota, for example, spends one year in between projects in the field interacting with both dealers and customers to determine value. This is similar to the functions we advocate the Chief Value Officer (CVO) perform for PKFs.
Disagreements with the Book
Not everything in this book is worthwhile. The author seems to think that Japanese companies are superior because of TC, and no doubt that may be true among automobile companies. But the USA is far more innovative than Japan in many other sectors, so TC can’t be holy grail he claims it is.
The author also doesn’t seem to realize that costs are prices, and have their own value component built in. He advocates suppliers share full costing data with the company, and then tack on a desired profit—that is, cost-plus pricing, the very opposite of what he thinks companies should be doing.
If Value is right for Toyota, then why isn’t it right for suppliers to Toyota? The contradiction is never addressed.
He also claims that raising prices isn’t normally an option in today’s global economy, but this is nonsense. Price is set by value created, not costs incurred. Lowering costs is just one alternative to increasing profitability. Creating more value is another, not to mention more strategic pricing strategies.
Yet my biggest disagreement with this author is his attitude that business is war, and that you have to be so competitive your competition doesn’t survive.
This, too, is nonsense. Business is not war. It doesn’t destroy, it creates. Sure, a lot of companies fail—like GM—but that doesn’t mean that outcome should be the overarching the goal of Toyota. The market is big enough for many competitors, even in automobiles. The author’s zero-sum mentality makes me question other topics he addresses in the book on corporate strategy.
Lessons for PKFs
Rains also seems to believe in Frederick Taylor’s distinction between managers and workers, writing:
Those involved in intellectual work should not be diverted from it by other responsibilities. Line managers and workers are there to realize the plans created by the intellectual efforts of others.
I don’t know if this attitude comes from his years at GM and its militant unions, but it seems to me that Toyota treats all of its workers as knowledge workers, which is why they implement so many ideas (over a million per year) from line workers.
This attitude is very similar to the strategies laid out in the E-Myth Accountant by Michael Gerber and Darren Root, which are suboptimal because they don’t tap into the knowledge that exists across the entire firm.
In a PKF, everyone is a knowledge worker and is in charge of designing their own responsibilities, contributions, plans, processes, and systems. All the knowledge is not embedded at the top, but dispersed throughout the knowledge workers themselves.
There is no “one best way,” as Taylor and Gerber advocate, in a PKF.
In an auto plant, the worker serves the system and a lot of the knowledge is embedded in that system. But in a PKF, the system serves the knowledge worker, with the knowledge embedded in the human capital.
This is precisely the difference between an Industrial/Service Era organization and a PKF.
Reading this book taught me a lot about TC and it was interesting, but it also convinced me that TC is not the right approach for a PKF. Focusing on creating value, implementing Value Pricing, appointing a CVO, establishing a Value Council, implementing project management, and conducting After Action Reviews are far superior strategies than fretting about costs that are largely fixed.
Cost Tables really don’t apply to a PKF. You have to pay the rent and salaries (the overwhelming majority of costs in the average PKF) no matter what, and trying to allocate those costs to any activity or function by the hour is completely arbitrary and fraught with misguided and misleading assumptions. Hint: you can allocate rent by the hour, but you’re on the hook for the whole lease cost once you sign.
Perhaps Rains himself says it best:
Managing the intellectual effort should focus not on improving efficiency but on achieving effectiveness in product specifications.
Ultimately, effectiveness is achieved by creating value and capturing a fair portion of it, not achieving exact cost targets.
However, if you have manufacturing customers you may want to have them read this book. It could be the beginning of a very interesting journey.
There’s no doubt in my mind that TC is superior to standard cost accounting and Activity Based Costing.
I wonder how many Six Sigma Black Belts advocate TC? Rains is skeptical about Six Sigma, claiming the ROI on it has been much higher for the Black Belts than any company. I wonder why?