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.
In the previous post, I described the flaws in the traditional professional firm business model. 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.
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
It is time to replace the old firm model of “we sell time,” described in the previous post, with a radical business model. Why radical? Because it is 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: Profitability = Intellectual Capital x Effectiveness x Price
Let us explore each component of the above equation.
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. 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.” Always remember that bad customers drive out good customers.
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, as it is a measure effort, 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 wiling 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
Intellectual capital (IC) can be defined as knowledge that can be converted into profits. IC has always been the chief driver of wealth. IC consists of three categories:
Human capital (HC). This comprises of your team members and associates who work either for you or with you. HC cannot be owned, but rather, only contracted, since it is completely volitional. Today, knowledge workers own the means of your firm’s production. In the final analysis, your people are not assets (they deserve more respect than a copier machine and a computer); ultimately, they are volunteers.
Structural capital. This is everything that remains in your firm once the HC has stepped into the elevator, such as databases, customer lists, systems, processes, technology, business strategies and marketing plans, which 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.
And, since knowledge is a “non-rival” 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.
You cannot leverage time, since it’s a “rival” asset, meaning it can only be utilized for one purpose at a time. A billable hour is a rival asset. There are many more possibilities for creating wealth for your customers if you think in terms of leveraging your intellectual capital.
The World Bank reports that 80 percent of the developed world’s wealth resides in human capital. Knowledge firms are the ultimate “asset-less” organizations since 80 percent of their value-creating capacity is owned by the volunteers who work there.
Why effectiveness trumps efficiency
“Efficiency means focus on costs. But the optimizing approach should focus on effectiveness. Effectiveness focuses on opportunities to produce revenue, to create markets, and to change the economic characteristics of existing products and markets. It asks not, How do we do this or that better? It asks, Which of the products really produce extraordinary economic results or are capable or producing them? …It then asks, To what results should, therefore, the resources and efforts of the business be allocated so as to produce extraordinary results rather than the “ordinary” ones which is all efficiency can possibly produce?” – Peter Drucker, “People and Performance.”
This is a critical component of the new business model, probably more controversial than value pricing versus hourly billing. It goes to the heart of how we measure, judge, assess and compensate our knowledge workers, and what we measure internally to understand if we are creating value for customers.
We read and hear it repeated everywhere: efficiency needs to be improved in professional firms. But, nowhere is this term defined. What, exactly, does it mean to say that efficiency needs to be increased?
What, exactly, is efficiency?
Efficiency is always a ratio, expressed as the amount of output per unit of input. Mathematically, it seems straightforward.
Firms have learned costs are easier to compute than benefits, so they cut the costs in the denominator to improve the efficiency. This is the equivalent of Walt Disney cutting out three of the dwarfs in “Snow White and the Seven Dwarfs” in order to reduce the inputs, making the resulting ratio look better. Efficient, yes; effective, hardly.
In an intellectual capital economy, efficiency is a conundrum. And, this is true for a very fundamental reason.
There’s no such thing as generic “efficiency”
Efficiency cannot be meaningfully defined without regards to your purpose, desires and preferences. It cannot simply be reduced to output per labor hour. It is inextricably linked to what people want – and at what cost people are willing to pay.
Efficiency in a professional firm, in and of itself, is not a competitive advantage. It is the equivalent of having restrooms.
If your firm is not using the latest technological tools, that is incredibly inefficient, and you will not be competitive. But if it is, so what? All of your competitors are, too. We can be efficient with things, but we have to effective with people.
Efficiency is a table stake – the minimum you need to be in the game. Real competitive advantage is built on effectiveness, not efficiency.
Firm leaders should agonize over effectiveness – that is, doing the right thing, even if it conflicts with efficiency.
Where do profits come from?
In seminars around the world, we show the following three factors of production, and the type of income derived therefrom:
1. Land = Rents
2. Labor = Salaries and Wages
3. Capital = Interest, Dividends and Capital Gains
We then ask a deceptively simple question: Where do profits come from? The answers range from entrepreneurs and value to revenue, minus expenses and customers. Nevertheless, the real answer is that profits come from risk.
In other words, risk is an economic positive. A business cannot eliminate risk because that would eliminate profits. The goal is to take calculated risks and choose them prudently.
For example, by setting a nice comfortable floor under their earnings (via hourly billing), they have commensurately placed an artificial ceiling over their heads, in an attempt to avoid risk and uncertainty.
The new business model offered herein is not about predicting the future; it is about helping to shape and create the future. It is the difference between remaining a firm of the past, or like a chrysalis, emerging as a Firm of the Future. The choice is yours.
