Episode #136: Free-Rider Friday - March 2017

Ron’s Topics

“European country imposes ‘social parasite’ tax on the poor,” March 27, 2017, New York Post (originally published in News.com.au).

Belarus, country of 9.5 million, lies between Russia and Poland, has implemented a “social parasite tax on the chronically unemployed (also known as the “spongers” or “freeloaders” tax).

It’s $233 (a month’s average wage in the country), for those “work shy” for longer than six months.

President Alexander Lukashenko issued Presidential Decree number 3, in 2015. Failure to pay could ultimately lead to imprisonment, redolent of the old USSR’s concept of “social parasitism.”

After protests, the president agreed to delay the tax, but not eliminate it. It’s estimated that one million are out of work in the country.

This story reminded me of a Harvard Lampoon story from the 1970s about how unfair the tax system is to the rich, since they cannot deduct their Rolls Royce’s and private jets, but the poor can deduct all the kids they have.

The difference is, this story on Belarus is real.

“Counsel of protection: the future of insurance,” The Economist, March 11, 2017

the insurance industry is estimated to be $4.6 trillion worldwide.

New York startup Lemonade is a homeowners and renters insurance company, with an app that makes insurance claims easier, and appeals to the digital generation.

It sold 2,000 policies in the first 100 days, 80% to first-time buyers. It uses AI and machine learning to process claims and underwrite policies.

It further rewards under-claiming, giving a share of the savings to your choice of charity (25% Americans defraud insurance companies).

On policy holder used the app to file a claim for a stolen coat, answered a few questions, and in three seconds the claim was paid.

Two Sigma, a large “quant” hedge fund, is also betting number crunching algorithms can gauge risk and set prices better than humans.

Simplesurance, a German firm, has integrated product-warranty insurance into e-commerce sites.

New kinds of risk-prevention services are being implemented thanks to the Internet of Things, such as sensors on incoming water pipes that can detect minuscule leaks, and prevent larger claims for flood damage.

Insurance companies are enticing policyholders with cutting premiums rather than making money from these additional services.

Volvo and Mercedes have announced they are so confident in their self-driving cars, they will not buy insurance at all!

“The wonder drug,” The Economist, March 4, 2017

Digitising the health care industry--$18B of capital has been invested in USA digital startup funding between 2015-2018.

Three groups are fighting over the “heath care value chain”:

1. Traditional innovators—pharma, hospitals, medical tech companies

2. Incumbent players—health insurers, big pharma buyers, UK’s NHS

3. Tech insurgents—Google, Amazon, Apple, creating apps, predictive diagnostics systems, and new devices

Buyers increasingly demand “value-based” reimbursement: If the drug and device doesn’t function, it will not be bought. One analyst says if pharma firms don’t put the patient, rather than drug sales, at the center of strategy, they risk losing relevance.

Also, the point of care will move rapidly into the home where heart condition can be monitored, concussions diagnosed and perhaps even predict the onset of Alzheimer’s, Parkinson’s, menopause, etc.

London-based startup Babylon can schedule an online Dr. appoint for $24, and estimates that 85% of consultations don’t need to be in person.

But government could slow down the diffusion of this technology, as this article makes clear: “Cronyism thwarts telemedicine and other innovations,” by Veronique de Rugy.

High-resolution camera phones are good for diagnosing moles, rash, and even eye exams.

However the California State Board of Optometry launched, with taxpayer money, a PR campaign against one such startup.

Indiana passed a law last year that prevents online eye exams, as did Georgia and South Carolina, while VA is about to do the same.

Also, State Boards in various states prohibit doctors in another state offering telemedicine to its residents.

“A Brief History of Blockchain,” Vinay Gupta, Harvard Business Review, February 28, 2017

In just 10 years:

1. Bitcoin

2. Blockchain (could be separated)

3. Smart contract, ethereum

4. New innovation: “proof of stake” rather than “proof of work” (group with largest total computing power makes decisions).

5. Blockchain scaling: now every computer processes every transaction, which is slow. New: figure how many computers are necessary to validate each transaction, divide work efficiently: speed can go head-to-head with VISA, and SWIFT in terms of processing payments.

Dubai’s blockchain strategy: issue all government documents on blockchain by 2020, which was designed by Vinay Gupta, the author of this post.

“Furry profitable,” The Economist, February 4, 2017

VCA, animal hospital chain has a 42,000-square-foot clinic in Hollywood.

VCA was purchased in January by Mars for $9.1B. Mars is second only to Nestle in pet food, and has been getting stiff competition from Amazon, so they are turning towards animal health.

In the USA, spending in pet clinics was $13.7 billion in 2012, and $16 billion in 2016.

VCA will own 1,900 veterinary clinics in America and Canada, four times as many as National Veterinary Associates, its nearest competitor.

The average vet used to be a generalist, but today there are over 40 specialties.

Technically, in many states, it is illegal for corporations to own veterinary practices, but there are ways to structure ownership to get around this.

And since pets count as property, malpractice risk is not very large.

Ed’s Topics

1. Ad Agency in UK drops Google - How responsible is Google for links that are associated with other searches?

2. The Guardian, 3/28, Robots vs. Human Experts, by Richard and Daniel Susskind - The Susskinds reflect on the reaction to their book over a year and half after its publication. (Listen to Daniel Susskind's appearance on our show.)

3. Japan Times, China’s toilet paper thieves - High tech solution to a low tech problem.

4. US Obamacare, Congress fails to repeal - The GOP had seven years to think about this and they dropped the ball on the goal line. 

5. NY Times story stating 39% of colleges have reported declines in international student applications. They attributed this to Trump's election. Tyler Cowan analyzed the story on his blog - One real blooper I cannot let pass. 

6. Live action Beauty and the Beast, Dan Sanchez, FEE article, Belle's Tax-funded Fairy Tale. Fun, true, and why libertarians ruin everything. 

BONUS article: How Beauty & the Beast is an example of anarchy done right. 

Episode #135: Request for Proposals: Avoiding the Winner’s Curse

“Never forget that your weapon is made by the lowest bidder.” –Law Number 20 of Murphy’s Laws of Combat

Simply put, don't do them

We at VeraSage recommend that you do not do RFPs, because they subsidize dysfunctional buying behavior, often being used as a club to extract concessions from the current provider by customers who have no intention of changing suppliers. 

Or they are used by price sensitive customers you do not want anyway. We also suggest you charge for an RFP. Why not? The customers are asking you to compete, which has value in and of itself. 

If you charged for an RFP, like charging for admission into your firm, it might actually be a process that created some value, rather than merely reciting deliverables.

That said, many firms have to do a certain amount of RFPs. If you do, you should be well versed with what economists call the winner’s curse.

Avoiding the Winner's Curse

In auction markets, economists refer to the dreaded winner’s curse—whereby the winning bidder is often a loser, because obviously all of the other bidders believed the engagement had less value.

The Strategy and Tactics of Pricing: A Guide to Growing More Profitably

By Thomas T. Nagle, John E. Hogan

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In other words, the only request for proposals (RFPs) that buyers will accept are ones you should not make. One of the ways to avoid the winner’s curse is to bid more conservatively when there are more bidders. Thomas Nagle and Reed Holden explain why in their book, The Strategy and Tactics of Pricing:

The more bidders there are, the more likely you will lose money on every job you win, even if on average you estimate costs correctly and both you and your competitors set bids that include a reasonable margin of profit. The reason: The bids you win are not a random sample of the bids you make. You are much more likely to win jobs for which you have underestimated your costs and are unlikely to win those for which you have overestimated your cost.

The only solution to this is, in effect, to formalize the principle of “selective participation.” You do that by adding a “fudge factor” to each bid to reflect an estimate of how much you are likely to have underestimated your costs if you actually win a bid. Needless to say, adding this factor will reduce the number of bids you win, but it will ensure that you won’t ultimately regret having won them.

RFPs have become more commonplace as competitive bidding has replaced negotiation for price buyers. It is as if dysfunctional buying practices have arisen to counter dysfunctional selling practices.

It is important to have some contact with the economic buyer—that is, the person who can actually make the decision to hire you, rather than just the procurement department. You need to find the person who can say “Yes,” not just the ones who can say “No.”

Establishing relationships and having internal advocates in the customer’s enterprise also helps to ensure your value is being considered, not just price.

Another strategy with RFPs is: No surprises. Your potential customer should know everything in your RFP before you submit it. Gaining an understanding of your customer’s expectations, business model—how they make money—and how your company can add value is imperative to increase your odds of a successful RFP, one that won’t suffer from the winner’s curse.

Co-Opetition

$11.71

By Adam M. Brandenburger, Barry J. Nalebuff

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Co-opetition by Adam M. Brandenburg and Barry J. Nalebuff also discuss the following eight hidden costs of bidding that are also worth considering:

1. There are better uses of your time.

2. When you win the business, you lose money.

3. The incumbent can retaliate.

4. Your existing customers will want a better deal.

5. New customers will use the low price as a benchmark.

6. Competitors will also use the low price as a benchmark.

7. It does not help to give your customer’s competitors a better cost position.

8. Do not destroy your competitor’s glass houses.

Other RFP strategies

• The RFP is not about your firm, it is about the value you will add to your customer—focus on how they will change, not your firm’s history and processes.

• What is your competitive differentiation? If you do not have one, do you expect to be successful with this RFP?

• Always submit options, at various value/price points, with any RFP.

• What would justify the customer paying a premium price?

• Are you dealing with the economic buyer? If not, you probably should not waste your time with an RFP.

• Is the organization using the RFP process as “column fodder”—that is, to beat up its existing firm?

• How you sell is a sample of how you solve—be creative, innovative, and different.

• RFPs do not sell, people do.

• Never submit an RFP to people whose criteria for judging your success are unknown.

• What does the customer expect from their firm? How will you exceed those expectations?

• Do not let the RFP be the first time you “test” your price with a customer.

• Do not be constrained by the customer’s “budget.” As the opening email of this Appendix confirms, budgets are elastic, and if the economic buyer understands the value, the money will be found from somewhere else in the budget.

• See if you can propose on a greater share of the customer’s business.

• Consider charging for your RFP to test the customer’s seriousness, providing a full (or partial) credit if your firm is selected.

• If you win this RFP, what will be the impact on the firm’s self-esteem?

• If you have a 25 percent market share, you should be losing 3 out of 4 of your RFPs. In other words, do not worry about losing more RFPs than you gain.

• Once you submit an RFP, you lose all control and leverage, leaving you asking “Have you made a decision yet?” If your RFP is innovative and surprises the customer, you will change the standard operating procedures.

• Put a deadline on the price. No price should last indefinitely. Three weeks is a good rule of thumb.

• Copyright all your RFPs so the firm retains the intellectual property rights (especially for advertising agencies).

• If the customer asks you to match a competitor’s lower priced bid, be sure to understand the scope of work that the lower price is based on.

• If your RFP is rejected based upon price, ask the economic buyer:

• Do you not believe the value we discussed is accurate?

• Do you not believe that we will be able to create that value?

• Or do you think you will be able to acquire that value from another firm?

Recognizing not all customers are created equal, should be charged the same price, or accepted, or proposed for, in the first place, is essential to avoiding Baker’s Law: Bad Customers Drive Out Good Customers.

Episode #134: Second Interview with Father Robert Sirico

Defending the Free Market: The Moral Case for a Free Economy (NONE)

$16.76

By Robert A. Sirico

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Biography

Father Robert Sirico is the president of the Acton Institute, He lectures at colleges, universities, and business organizations throughout the U.S. and abroad.  His writings on religious, political, economic, and social matters are published in a variety of journals, including: the New York Times, the Wall Street Journal. He is also a parish priest in Grand Rapids Michigan. In his recent book Defending the Free Market: The Moral Case for a Free Economy, Rev. Sirico shows how a free economy is not only the best way to meet society's material needs but also the surest protection of human dignity against government encroachment.

Segment One—Ed      

Note: Our first interview can be heard here. 

Has the bishop in Grand Rapids given you the dispensation to eat corn beef and cabbage today (St. Patrick’s Day)?

Father Sirico is working on an Italian edition of his book, Defending the Free Market, due out this Spring.

I see, based on your twitter page, that you have met the Holy Father. How did that go? Father Sirico gave the Pope a copy of the movie, Poverty, Inc.

Regarding Pope Francis, is it too simplistic to excuse his thoughts on capitalism as just being due to his Weltanschauung of capitalism equaling cronyism?

On Twitter, one person said, "Since [Father Sirico] propagates views opposite to  decades of established Catholic social teaching, however, he ought to be excommunicated.”

Today, I was told in a Catholic Social Teaching Facebook group, when I suggested that federal welfare programs perhaps do more harm than good, he replied, "More harm than good? Wow, not allowing destitute senior citizens and at-risk poor kids starve to death is somehow harmful? We in America are a society, a community, and will be judged on how the weakest among us are treated. And you, sir, get an F.” 

I think this is because many people fail to understand the difference between civil society and government. Your thoughts?

Segment Two and Three—Ron

The entire discussion in these two segments were about Acton Institute’s latest movie, Poverty, Inc.

The movie open with this Machivelli quote: “The reason there will be no change is because the people who stand to lose from change have all the power, and the people who stand to gain from change have no power.”

Why does that describe the “global aid system” today?

It’s hard to compete with free. How can markets develop when shoes, food, etc., are given away for free. When Peggy Noonan asks Ronald Reagan: “What’s wrong with socialism?” Reagan replied, “Well, it doesn’t work”

The movie takes on the Christmas song by Band-Aid song (“Feed the World”). It gives the impression that Africa is desolate, that nothing grows there, etc. Yet Africa is rich in oil, diamonds, gold, and other natural resources. The problem is it is disconnected from trade.

Government-to-Government Aid

The movie shows Bill Clinton admitting he was wrong with regard to Haiti by selling rice so the country could supposedly leap past the agriculture stage of development and skip to the industrial stage.

Agricultural subsidies keeps out poor farmers from selling to rich countries, while rich countries produce surpluses which they then sell/give to poor countries, which drives out of business local farmers.

The dignity of work is so important.

The only antidote to poverty is wealth, yet the poverty infrastructure never discusses wealth creation.

NonGovernment Organizations

Someone in the movies discusses a conversation where the person says, Now that you survived the earthquake, I hope you survive the arrival of all the NGOs.

There are over 10,000 NGOs in Haiti!

But when you give someone something for free, continuously, not only do you create dependence, but eventually you create resentment as well.

There’s nothing wrong with disaster relief, but when they stay for 40 years we have a problem.

Foreign Aid (“Official Development Assistance”)

Since Post WWII, the Breton Woods system created the International Montetary Fund and the World Bank, and of course we had the Marshall Plan. Even the Catholic Relief Charities receive 70% of its funding from government.

But not one country has ever developed from aid, not one!

Social Entrepreneurs

Does the founder of TOMS shoes really want people to not have shoes for the rest of lives?

If TOMS shoes is successful within the existing framework, all you are doing is making the existing system more harmful. Doing the wrong thing more efficiently is just creating more harm.

Adoption

The movie shows a couple who were spending $20,000 to adopt a Haitian child whose mother wants him. Approximately 80% of Haitians kids have at least one parent; they are called “poverty orphans.”

Because orphanages are coveted positions: they provide an education, food, shelter, etc.

One mother got a job, and moved from a tent to buying her own two-bedroom home.

Credit

The movie interviews Muhammad Yunus, the microfinance founder. While small and  large companies can get credit, the middle-sized business does not. If they do, it can cost 6-10% per month in interest.

As microfinance failed, or perhaps not lived up to its hyped expectations?

The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else

$13.26

By Hernando De Soto

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Rule of law

Poor countries lack secure private property rights, functioning courts to adjudicate disputes, and most people are locked out of the formal economy.

The economist Hernando de Soto says in 2/3 of world, there’s no rule of law.

No property rights means for the 60-70 million farmers in Ghana, they might have to buy their land 4-5 times. In Peru, it takes 289 days, working 8 hours per day, to start a business. De Soto documents all of this, and more, in his book: The Mystery of Capital.

Theological Question

Rabbi Daniel Lapin wrote in his book, Business Secrets of the Bible: “The opposite of wealth is evil. If wealth is not being created, then evil is being done.”

Do you agree?

Celebrities (the “Icons of charity”)

Bono admitted that commerce lifts more people out of poverty than aid. However, he insists aid is still needed, unless you are “brain and heart dead extremists.” He also insists that we need to move from paternalism to partnership.

There’s not enough talk about wealth creation.

Ron’s Thoughts on the Movie

1. Wealth is the only known antidote to poverty. We only have the word poor because of the Bible.

2. The road to hell is paved with good intentions.

3. Modified Christopher Hitchens quote: The icons of charity are “not friends of the poor, but friends of poverty.” It’s obvious that who benefits from the existing system are all of the players mentioned above, not the poor they sanctimoniously say they are helping.

Last Segment—Ed

During the end of our last interview, you said you were considering writing a book on economics and the parable of our Lord. Here is one I often use, but I wonder if I perhaps am taking it too far out of context?

Luke 12: 13 Someone in the crowd said to him, “Teacher, tell my brother to divide the family inheritance with me.” 14 But he said to him, “Friend, who set me to be a judge or arbitrator over you?”

What are your thoughts on the difference between empathy (I feel your pain) and compassion (to suffer with)?

Another word we do not hear talked about much today is “maturity.” It certainly isn’t displayed by both sides of the aisle in Washington DC.

What are your thoughts on sanctuary cities?

Episode #133: Interview with Tim Williams

Positioning for Professionals: How Professional Knowledge Firms Can Differentiate Their Way to Success

$45.00

By Tim Williams

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Ron and Ed interviewed Tim Williams, a noted author, international speaker, and presenter for major advertising associations, agency networks, universities, and business conferences worldwide. Tim is author of the books, “Take a Stand for Your Brand: Building a Great Agency Brand from the Inside Out,” ranked by Amazon as one of the top ten books on brand building; “Defining the Agency Brand,” published by the American Association of Advertising Agencies is regarded as the standard in agency brand development; and his latest book is Positioning for Professionals: How Professional Knowledge Firms Can Differentiate Their Way to Success. Tim is a major thought leader and consultant to advertising agencies worldwide, specializing in pricing, business model innovation, positioning, and strategy.

Segment One - Ron's Questions

With Hollywood about to release CHPS - The Movie, is this proof that ideas are more valuable than their execution?

In your book, you say, "In business, imitation is not the sincerest form of flattery, it is just lazy," why is that?

Every value prop falls in somewhere in following three areas: points of parity, points of relevance, and points of differentiation, please explain these ideas.

How is a firm defined by what it is NOT?

Segment Two - Ed's Questions

Click to listen to Tim's first appearance. 

What are the four sides of the strategic box or brand boundaries?

Other than calling which one do professional firms struggle with the most.

What is the complexity tax or diversification discount?

Explain Magic work vs Logic work. Does the line between them shift?

Segment Three - Ron's Questions

How are AI, deep learning and other technologies unfolding in the advertising agency space?

How is it encroaching on the Magic work?

Five holding companies own 85 percent of advertising agencies, are they innovating? If so, how?

Do you see agencies making progress in pricing?

Do you see agencies making progress on getting rid of timesheets?

Some of the world's best know brands were not created with the help of an advertising agency, explain the effect of this on agencies.

Segment Four - Listener Question

Justin asks, “As agency leadership, how should you balance the need for specialization (in order to grow faster) with synthesizing other disciplines to come up with greater innovation?”

Do you view more ideas coming from independent thinking or brainstorming meetings?

Do you see more agencies getting involved in behavioral economics?

What are working on?

Episode #132: The Deleterious Effects of Hourly Billing

Custom doth make dotards of us all. –Thomas Carlyle, Sartor Resartus, III, 1836

If people are supposedly rational, why have the professions continued to apply the wrong theory of value to their services?

The fact that hourly billing is so deeply entrenched and has been widely used for decades proves that is has some advantages.

The case against the billable hour is not that it is not a profitable pricing policy.

Rather, the case being made is that hourly billing is suboptimal (if profitability is your goal), and its disadvantages outweigh its advantages.

The Advantages of Hourly Billing

Hourly Billing is Easy and Efficient

Hourly billing can be handled simply with appropriate time and billing software, turning the pricing function into an administrative task handled by less costly personnel, freeing up the professional team to take care of what is more important—customer relations.

Hourly Billing is Perceived as Fair

Since hourly billing is largely justified based on a firm’s costs and a “reasonable” profit margin, it is perceived as “fair” by customers.

Hourly Billing Provides Market Stability

Since hourly rates remain relatively stable, this provides a desirable stability and predictability among buyers and sellers, as opposed to widely varying prices that may arise under a value pricing scenario.

Sometimes the Customer Demands Hourly Billing

It is rare, but there are instances when customers will insist on being charged by the hour. One encounters this attitude most frequently in the legal profession, and to a lesser extent, in the accounting profession.

Probably because the people hiring the firm were themselves alumni, raised on the virtues of hourly billing. But it is folly to turn this type of power over to your customers.

You control your pricing strategy, not your customers.

They judge your value, but cannot dictate how you price. This is not a large barrier to overcoming hourly billing. The problem is not with customers; it is with the professionals.

Hourly Billing is Required in Case of Litigation

Certain court cases require time recording due to legal precedent, fee shifting, and legal ethical rules.

Bankruptcy requires attorneys to keep time in six-minute increments. If your firm does a majority of this type of work, then you may very well be stuck with the billable hour.

Hourly Billing Leads to Higher Volume

Higher prices would dampen demand for professional services, and some projects simply cannot be quoted upfront without a high price being specified.

Hourly Billing is a Cost-Accounting, Productivity, and Project Management Tool

Check out our shows, #109, Trashing The Timesheet, and #112, our interview with Dr. Reginald Tomas Lee on lies and cost accounting.

Hourly Billing Transfers Risk to the Customer

This advantage is truly a double-edge sword. Professionals tend to be risk adverse, and hourly billing places a comfortable floor on their profits.

However, professionals have paid a high “reverse risk premium” to the customer for this floor. If the customer assumes the risk, the professional will only receive their hourly rate; no more, usually less.

Hourly Billing Has Served Us Well, Why Should We Change?

Economist Herbert A. Simon’s autobiography, Models of My Life. Among economists, Simon is best known for his theories of bounded rationality and satisficing.

Bounded rationality posits that both elements of irrational and nonrational behavior bound the area of rational behavior.

Satisficing posits that people search for good enough actions rather than optimal ones. Coupling the concept of satisficing to bounded rationality is how Simon explains how people really make decisions.

Rather than attempting to maximize or optimize, people search for “good enough” actions. Simon writes:

 [Even Darwin’s] natural selection only predicts that survivors will be fit enough, that is, fitter than their losing competitors; it postulates satisficing, not optimizing.

The Disadvantages of Hourly Billing

Hourly Billing Misaligns the Interests of Professional and Customer

Even supporters of hourly billing will admit that there exists, right from the start, a conflict between the professional’s interest and the customer’s.

This conflict of interest also exists because in a cost-plus pricing system one way to increase a firm’s revenue is to increase its costs.

Aligning incentives is difficult enough to achieve without the added burden of an inherent conflict in how your price your services.

Hourly Billing Focuses on Hours, Not Value

Whenever professionals have to justify price to a customer, they inevitably resort to discussing hours spent. Marketers would never do this, as they always try to create value in the minds of the customer first, and talk price later.

Hourly Billing Places the Risk on the Customer

Risk is where profits come from. If you offer customers fixed prices you will be able to charge a premium simply because you are reducing their risk.

If this sounds counterintuitive, consider the mortgage market. Which commands a higher interest rate, a fixed rate or an adjustable rate mortgage?

Hourly Billing Fosters a Production Mentality, Not an Entrepreneurial or Knowledge Worker Spirit

Over the decades of the billable hour’s hegemony, the professions have lost sight of the all-important question: “What did we accomplish?” It has been replaced with: “How many hours did you bill?”

Hourly Billing Creates a Nonsensical Subsidy System

An example of a nonsensical subsidy is a tax research project that is billed to the first customer for, say, $10,000. If a second customer appears the following week with the exact same issue, how much should the firm charge the second customer? Following the logic and ethics of hourly billing the answer is clear: you can only charge the second customer for the actual hours spent.

Under this method, one could argue that the first customer underwrote the R&D costs for the second customer. It would be as if a pharmaceutical company charged the first customer for all its R&D, while the following customers were charged just the marginal cost of producing the drug.

Hourly Billing Cannot Price Risk

Completing a divorce for Brittany Spears is fraught with more risk than a couple with limited assets. Risk cannot be priced by the hour. Actuaries have an axiom that is useful to remember: There is no such thing as a bad risk; only bad premiums.

Hourly Billing is not Predictive of a True Professional

One of the most useless pieces of information we can gather as outsiders about a firm, or a professional who works in it, is billable hours. It transmits little information of value, though it does highlight the “finders” (rainmakers), the “minders” (managers), and the “grinders” (technicians)—billable hours are hardly necessary, though, to make this distinction.

Far more meaning is discovered by judging a professional’s customer service attitude, customer defection and retention rates, customer loyalty, profitability and collection speed, creativity and innovation, risk taking, willingness to delegate, teaching and learning skills, and practice development activities. Billable hours shed no light in these virtues, as most need to be judged and experienced, not measured.

Hourly Billing Encourages Hoarding of Hours

David Maister and Patrick McKenna say that “Estimates given to us by our clients of the amount [of work they do] that could be done by someone more junior range up to 50 percent or more of each senior person’s time.

Surgeons piercing ears is not the road to maximum profitability.

Hourly Billing Focuses on Effort, Not Results

Who buys efforts in the marketplace? One brilliant epiphany that occurs while in the shower or driving may be worth more to the customer than 1,000 plodding, ineffective hours spent researching and pondering an issue. Hourly billing simply does not reward creativity and ingenuity. On the contrary, it rewards inexperience, inefficiency, and even incompetence—the slowest horse wins the race.

Hourly Billing Penalizes Technological Advances

Every year, professional firms make substantial investments in technology that allow any given task to be performed in less time. Perversely, under the billable hour, firm revenue will then decline, unless hourly rates keep pace with productivity increases—what economists call the productivity paradox.

Hourly Rates Are Set by Reverse Competition

This means you look at the rates of your fellow professionals operating in your geographical market, make a decision on where you want to fit in on the competitive spectrum, and set your rates accordingly.

Hourly Billing Prices the Service, Not the Customer

In a world where value is subjective, no two customers are alike, and professional firms have the enormous advantage of meeting personally with each and every customer, the mindset of pricing services is obsolete. Instead, the customer needs to be priced.

Hourly Billing Creates Bureaucracy

We estimates that somewhere between 7 and 20 percent of a firm’s gross revenue is spent tracking, reporting, compiling, reviewing, and billing time, an astonishing investment. What’s the ROI? Most firms don’t even ask.

Hourly Billing Does Not Set the Price Up Front

The most absurd and economically illogical effect of hourly billing is how it denies the ability to quote a price before the work begins. Few products or services in the marketplace are purchased without the customer knowing the price in advance.

Hourly Billing Does Not Differentiate Your Firm

Converting their crown jewels of experience, expertise, culture, intellectual capital, and relationships into a commodity, codified in an hourly rate, is no way to differentiate your firm from the competition.

Hourly Billing Does Not Measure How Much Money is Being Left on the Table

Even though one of the major defenses of hourly billing and timesheets is they are essential cost-accounting tools to determine profitability, this method has a glaring weakness: It has no way to capture how much the price could have been.

In other words, how much money is the firm leaving on the table by setting prices too low? No cost accounting, realization, or, timesheet report can answer this question.

When Google began its auction-based AdWords program, CEO Eric Schmidt was petrified it would not set prices as high as Google’s salespeople were getting.

In three short weeks Schmidt’s fears were calmed when the new pricing strategy had doubled revenue.

It became obvious at that point that salespeople were under pricing ads, not over pricing them, which is the direction most pricing mistakes are made.

Without the willingness to test this new pricing strategy, Google would have left untold millions on the table, and worse, if they had been using the billable hour, they would have never learned about it.

Hourly Billing Diminishes the Quality of Life

There is no doubt that morale in the professions is suffering, and one major cause is the relentless pursuit of the Almighty Billable Hour.

This lessening in the quality of life results in a high cost to firms, measured in associate turnover, low morale, absenteeism, ineffectiveness, neglect of practice development, continuing education, and so on.

These costs should be included in any cost/benefit analysis of maintaining hourly billing; these costs, in and of themselves, are likely to dwarf any benefits derived.

Hourly Billing Limits Your Income Potential

This is, without a doubt, the most egregious effect of the hourly billing regime. There are only so many hours in a year. On average, Bill Gates has just as much time on this mortal coil as the rest of us, so why does he make more money? The difference is he does not believe he sells time.

Summary and Conclusions

Oscar Wilde’s line sums up hourly billing with just the proper amount of irony: “He has no enemies, but is intensely disliked by his friends.”

It has become, to borrow a term from the medical profession, an iatrogenic illness—that is, a disease caused by the doctor.

Albert Einstein once wrote, “Our theories determine what we measure.” Hourly billing is the wrong theory that measures the wrong things.

Funny video from North, a 40-person ad agency in Portland, Oregon that has been operating without timesheets since 2011:

Ed’s blog post on the David Ricardo Effect

Thanks to BJ Lee for his recent iTunes Review:

I thought this podcast was going to be two ivory-tower, automaton-sounding economists discussing how many angels it will take to run a big enterprise. But they have warmly shifted the way my mind words when it comes both to my little online business and freelancing, and to larger economies. And it has made us much more profitable. Can’t wait to pass this wisdom on to my kids. If you love Freakonomics Radio, you will love this podcast. Thanks Ron and Ed!