Knowing and Making

I was curious to notice that the UK's aircraft carrier contracts have been allowed to overrun their budget by around 25% . This seems to be a common phenomenon in public sector contracts - but should it be? Why aren't the contracts signed at a fixed cost with the private sector allowed to take the risk? This is a common question in my own field of software development. There are traditionally two ways you can approach a contract - with a third variation now emerging which might solve some of the traditional conflicts between client and supplier. The old-fashioned approach - which I believe is still used in many military contracts - is that the supplier bills on a time and materials basis. This reduces the risk for the supplier and places it all on the client. This may well be appropriate if the client is responsible for specification and design - if that is the case, the supplier might not be able to estimate the timescale accurately enough, and many overruns are caused either ...

I have written a guest post which is up at the Professional Pricing Society blog today. Regular readers may already have seen it here last week, but if you missed it, do click over and have a look. The PPS site is in my blogroll as pricing is an important topic in business and the psychology of it is not well-understood. It's a critical area for companies to develop both in pure financial terms, because of the impact on margins, and in marketing terms, because it creates an image and positioning for your business.

Daniel Hamermesh reminded me of a subject I have been planning a post on. In case you made the mistake of thinking cutthroat price competition is always efficient, I have a small demonstration for you. Imagine a market where there are three consumers of sausages, A, B and C. A derives £5 of benefit from a sausage; B gets £10 and C £15. Suppose now there is a single butcher in town, and he has to charge a fixed price. The variable cost of producing a sausage is £4 and the fixed cost for the period is £5. If the butcher prices his sausages at £15 he'll sell one unit at a cost of £9 and make a profit of £6. If he prices at £10 he'll sell two units at a cost of £13 and make a profit of £7. If he prices at £5 he sells three units at a cost of £16 and makes a loss of £1. Naturally then, the butcher will set the price to £10, make £7 profit and generate consumer surplus of £5 (all of which goes to lucky C). However, imagine that he develops the ability to price-discriminate and charg...

Ed Kless at VeraSage points out that BearingPoint has filed for Chapter 11 protection, wiping out shareholders equity. VeraSage campaigns for a switch from hourly-based to value pricing (mainly among accountants) and so Ed asks how BearingPoint could possibly have lost money on hourly contracts, unless most of its consultants were sitting around doing nothing for months on end. However, even though BearingPoint came out of KPMG, I doubt they were charging on an hourly rate for most projects. In my experience consulting and IT firms are much more likely to use fixed-price agreements than accountants. A number of such firms have made serious losses on these agreements in recent years - IT projects of course being notorious for going over budget. I would expect that this is the reason for BearingPoint's problems. While government IT projects used to be notorious for going over budget at the taxpayer's expense, they are now getting just as bad a reputation for causing losses on th...

Rod Blagojevich has been caught exploiting something given to him by the Illinois legislature – his right to appoint the state’s next senator. But isn’t he just doing what economics orthodoxy says he should – making sure the position goes to whoever can create most value from it? Ronald Coase demonstrated that the seat will go to the person who values it most in any case – the only question is who has the property rights and therefore who will get paid for it? Now, Coase does exclude transaction costs from his analysis and there is certainly the potential for Blagojevich to incur a very high cost for this transaction. But in principle, selling the seat is not (economically) a sin. The doubtful aspect of what he has done is to appropriate the benefits of selling the seat to himself, instead of letting them be distributed to the media and electorate of Illinois via the campaigning process. But what I want to know is: how smart was Blagojevich? How much is a Senate seat worth and was he g...

Ron Baker of Verasage asks in a posting this week "what the burning platform will be that will, ultimately, force firms to give up the Almighty Hour" - will it be the recession or something else? The recession - like any change in the economy - accelerates capitalism's process of creative destruction, putting more pressure on broken and unworkable models than on better ones. However I agree with him that, on its own, that will not be enough to trigger the change. A combination of factors will contribute to this - and their combined strength will determine when the tipping point is. A recession, by making buyers risk-averse, will encourage value pricing because it acknowledges and reduces the buyer's risk New information technology enables better measurement of the value generated for clients, and therefore allows prices to be based more directly on it Competition will operate - once a significant number of supplier firms start to offer structured or value-based prici...

I have been researching the concept of client value management (also known as customer value management). The idea has been around for a while, and is mentioned by lots of people as an evolution of CRM (customer relationship management). A number of marketing experts and consultancies discuss it as a business process but surprisingly it does not seem to be an established software category and few of the approaches have been implemented in software. Everyone has their own version of what CVM means. Some of the main distinct approaches are: maximising the value of a client over the lifetime of your relationship with them ( this report by BusinessObjects , and some research it cites from Bain and Company). This is approached by analysing value during acquisition, relationship management and retention. understanding customer value added and targeting your marketing and customer service improvements to where they achieve maximum benefit ( a consultancy called CVM from New Zealand ) finding ...

Pricing, fundamentally, is a way of transferring a fair share of value from buyer to seller in return for the service the buyer receives. However, it is sometimes challenging to measure the value that each party obtains in a transaction. Also, economic theory contains a concept called asymmetric information which means that either the buyer or seller has information that the other does not. This is often as simple as “how much do I really want this” but it may be that one party actually knows something concrete that the other doesn’t, and can take advantage. For these reasons, in the early stages of development of a market, simplified pricing models arise. These act as proxies for the real value of the transaction – making it easier for people to negotiate. In the property sector, the typical proxies are fees based on a percentage of sale or rental price. In professional services, the typical proxy is a fee per hour which may vary according to the experience of the individual being emp...

Dennis Howlett has a great post on his ZDNet blog: A fresh model for software maintenance . He targets a number of things that vendors should do to reduce the cost and burden of software maintenance - treating customers individually, training their resellers and partners better, and helping the customers to build their own centres of excellence so they can support themselves better. The ideas are based in part on C.K. Prahalad and M.S. Krishnan's book, The New Age of Innovation: Driving Cocreated Value Through Global Networks . Looks like something I should be reading soon. This is an issue close to my heart, since it is a very sore point for many clients. Software buyers are much more likely to query the maintenance charges than the initial build costs - and yet maintenance seems to be an area where most small software companies don't make any money. Oracle seems to be an exception (Dennis quotes their 30% margins and says that much of it is from maintenance revenues), while S...

Another area of theory I have been working on in the last few weeks is pricing. It's well-known that suppliers can use price discrimination to distinguish between those customers who can or will pay more, and those who can't. Here are some (edited) notes from a forthcoming report we are publishing about the concept of structured pricing. Economic theory relies on agents trading products and services in a way that makes all of them better off. Any two people entering into a transaction should both gain from it; whatever is traded must be worth more to the buyer than the money they pay; and the money must be worth more to the seller than the object they’re selling. Any trade therefore provides higher value to both parties than they currently have – or else it will not happen. In classical economics, the price of something is regarded as a signal to tell the buyer and seller how much other people (at the margin where the supply and demand curve intersect) value it, and therefore ...