[IMGCAP(1)]In my previous article, Avoid Being a Firm of the Past, we analyzed the antiquated business model of professional firms based on “We sell time.”

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.

I am not arguing that the old business model is not profitable. That would defy the reality of many profitable CPA 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.

It is time to replace the old firm model of “we sell time” 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:

Profitability = Intellectual Capital x Effectiveness x Price

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.

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.

Defining Intellectual Capital
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.

A firm’s IC can be separated into three categories:

• Human capital. This comprises your team members and associates who work either for you or with you. The important thing to remember about HC is that is cannot be owned, only contracted, since it is completely volitional. 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, 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.

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.”

Why Effectiveness Trumps Efficiency
Attacking the concept of efficiency is similar to attacking motherhood and apple pie, but I am going to do it anyway. The fact is, a ruthless focus on efficiency is the wrong talisman in a professional knowledge firm, or indeed in any business.

Since all transformations are linguistic, let us start with definitions:
Efficiency is a measurement.
Effectiveness concentrates on doing the right things, and is always a judgment.

Productivity and efficiency are always a ratio, expressed as the amount of output per unit of input. Mathematically, it seems straightforward, as if there were one widely agreed upon definition of the components of the numerator and denominator. In an intellectual capital economy, however, it is a conundrum.

Take the denominator in the ratio. Which inputs should be included? If we are dealing with wine, we could count the costs of the grapes, the bottles, corks, and so on, none of which would help us define—let alone value—the final product. As they say, it is much easier to count the bottles than describe the wine.
Firms have learned that 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.

Efficiency cannot be meaningfully defined without regard to your purpose, desires and preferences. It cannot simply be reduced to output per man-hour. It is inextricably linked to what people want—and at what cost people are willing to pay.

Indeed, if we were to measure the “efficiency” of most automobiles based on an output/input ratio we would discover most cars are completely inefficient, since they are idle a majority of the time. So what? When we want to go somewhere, they are very effective, and we gladly pay the price of the reduced efficiency.

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; but if it is, so what? All of your competitors are too.

The new business model offered herein is not about predicting the future; it is about helping to shape and create the future. No one can predict the future, and only a fool tries. But we can influence the future based upon the decisions and choices we make.

Even better, if the business model posited here is someday replaced with a better one, it will contribute to the advancement of the CPA profession—and nothing would please me more.

Ronald J. Baker is founder of VeraSage Institute and the best-selling author of The Firm of the Future: A Guide for Accountants, Lawyers, and Other Professional Services; Pricing on Purpose: Creating and Capturing Value; Measure What Matters to Customers: Using Key Predictive Indicators; Mind Over Matter: Why Intellectual Capital is the Chief Source of Wealth; and his latest book, Implementing Value Pricing: A Radical Business Model for Professional Firms, from which this article has been adapted. E-mail him at Ron@verasage.com and follow his blog at www.verasage.com

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