Pricing on Purpose E-Book

Ronald J. Baker

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 720

Veröffentlichungsjahr: 2010

Beschreibung

Pricing on Purpose explores the importance of pricing, one of the four Ps (product, promotion, place, and price) of marketing, that is largely ignored in business literature. Pricing is the opportunity for a business to capture the value of what it provides to the customer, and deserves as much attention as promotion, product and place in the marketing strategy of any business. This book calls attention to the market share fallacy, explains the difference between cost-plus pricing and value pricing, and provides best-practice pricing examples. It presents the theory of value--long established in the economics profession--and how any business can use various pricing strategies to communicate and capture the value of their products and services.

Leseprobe

Table of Contents

Praise

Title Page

Copyright Page

Dedication

Epigraph

Foreword

PREFACE

Acknowledgements

ABOUT THE AUTHOR

Chapter 1 - WHY IS MOVIE THEATER POPCORN SO EXPENSIVE?

MY COVENANT WITH YOU

Chapter 2 - WHY ARE WE IN BUSINESS?

YOU REAP WHAT YOU SOW—THE FOUR Ps OF MARKETING

YOU ARE WHAT YOU CHARGE

Chapter 3 - MIND OVER MATTER

THE PHYSICAL FALLACY

THE THREE TYPES OF INTELLECTUAL CAPITAL

NEGATIVE INTELLECTUAL CAPITAL

Chapter 4 - THE OLD BUSINESS EQUATION

“ANALYZING” THE PREDOMINANT BUSINESS EQUATION

Chapter 5 - THE NEW BUSINESS EQUATION

COGNITIVE DISSONANCE

WHERE DO PROFITS COME FROM?

Chapter 6 - NINETY-NINE-CENT PRICING, ENGAGEMENT RINGS, AND THE ASSUMPTION OF RATIONALITY

Chapter 7 - THE INVISIBLE HAND: NO ONE PERSON KNOWS HOW TO MAKE A PENCIL

THE ROLE OF PRICES IN SOCIETY

Chapter 8 - A TALE OF TWO THEORIES

THE LABOR THEORY OF VALUE

KARL MARX, FALSE PROPHET

THE MARGINALIST REVOLUTION

WHY ARE DIAMONDS MORE EXPENSIVE THAN WATER?

THE MARSHALLIAN SCISSORS

TIME IS MONEY?

WE LIVE IN A BARTER ECONOMY

WRONG THEORY, SUBOPTIMAL RESULTS

Chapter 9 - COST-PLUS PRICING’S EPITAPH

A TALE OF TWO AUTOMOBILES

WISDOM IS TIMELESS

MORE LESSONS IN THE SUBJECTIVE THEORY OF VALUE

LESSONS FROM JAPAN

COST-PLUS PRICING, RIP

Chapter 10 - THE WRONG MISTAKES

THE ALMIGHTY HOURLY RATE

IS ACTIVITY-BASED COSTING ANY BETTER?

MAKING THE WRONG MISTAKES

SCIENCE OR AN ART?

Chapter 11 - PRICE-LED COSTING REPLACES COST ACCOUNTING

TOYOTA—NO COST ACCOUNTING?

THE PRICE-LED COSTING REVOLUTION

Chapter 12 - WHAT AND HOW PEOPLE BUY

THERE’S NO SUCH THING AS A “MARKET”

HOW PEOPLE BUY

Chapter 13 - THE VALUE PROPOSITION

MOMENTS OF TRUTH

WHAT IS BEYOND TOTAL QUALITY SERVICE?

IS BEING TRUSTED ENOUGH?

FROM ZERO DEFECTS TO ZERO DEFECTIONS

WHY COMPANIES LOSE CUSTOMERS

CUSTOMER COMPLAINTS

THE 100 PERCENT MONEY-BACK GUARANTEE

CAN CUSTOMER SERVICE BE RESUSCITATED?

Chapter 14 - THE CONSUMER SURPLUS AND PRICE DISCRIMINATION

PRICE ELASTICITY

TEN FACTORS OF PRICE SENSITIVITY

CONSUMER SURPLUS

PRICE DISCRIMINATION PRINCIPLES

THE USE OF KNOWLEDGE IN SOCIETY

Chapter 15 - CUSTOMER SEGMENTATION STRATEGIES

SEARCH, EXPERIENCE, AND CREDENCE ATTRIBUTES

PRICE PSYCHOLOGY AND RISK

UNDERSTANDING CUSTOMER RISK

PRICING AND THE COMPETITION

Chapter 16 - PRICE DISCRIMINATION IN PRACTICE

United States Postal Services

Tape

Hardcover versus Paperback Books

Senior Discounts

Children’s Prices

Nightclubs

Newspapers

Automobiles

Lexus Lanes and Congestion Pricing

Free Extras and Trade-in Discounts

Cosmetics

Satellites

Exports

British Pubs

Local Resident Discounts

Weight Out

College Tuitions

Hotels and Resorts Minimum Stay

Theaters

Value—Not Cost—Drives Price

Customer Loyalty Programs

Men’s Shirts versus Women’s

Planned Obsolescence?

Nonmarket Price Discrimination

New Product and Service Offerings

Skim Pricing

Penetration Pricing

Neutral Pricing

Chapter 17 - THERE IS NO SUCH THING AS A COMMODITY

THE PERILS OF BENCHMARKING

COMPETITIVE RESPONSES

PURGING THE COMMODITY WORD

Chapter 18 - BAKER’S LAW: BAD CUSTOMERS DRIVE OUT GOOD CUSTOMERS

THE ADAPTIVE CAPACITY MODEL

GRADING YOUR CUSTOMERS

THE CONCIERGE SERVICE MODEL

THE FORCED CHURN

THOUGHTS ON REQUESTS FOR PROPOSALS

Chapter 19 - ETHICS, FAIRNESS, AND PRICING

THE MORALITY OF PRICE DISCRIMINATION

PROSPECT THEORY

Chapter 20 - ANTITRUST LAW

ANTITRUST ENFORCEMENT AND THE CONSUMER

THE SHERMAN ANTITRUST ACT, 1890

THE FEDERAL TRADE COMMISSION ACT, 1914

THE CLAYTON ACT, 1914

THE ROBINSON-PATMAN ACT OF 1936

PRICE DISCRIMINATION AS PROHIBITED BY THE ACTS

CRITICISMS OF ANTITRUST POLICY

THE CASE AGAINST MICROSOFT

THE PROBLEM WITH ANTITRUST LAWS—THE WRONG THEORY

Chapter 21 - WHO IS IN CHARGE OF VALUE?

THE MARKETING CONCEPT

THE WORLD’S FIRST CVO

VALUE, NOT COST, DETERMINES PRICE

FRAMEWORK FOR THE CHIEF VALUE OFFICER

LEADERSHIP

ATTITUDE

COMMITMENT

EXPERIMENTATION

YOUTH

NOT FINAL THOUGHTS

Chapter 22 - PRICING ON PURPOSE: GETTING PAID FOR THE VALUE YOUR COMPANY CREATES

THE DIFFUSION OF AN IDEA

OBSTACLES TO DIFFUSION

DNA

WOULD YOU WANT YOUR SON OR DAUGHTER TO WORK THERE?

BIBLIOGRAPHY

SUGGESTED READING

INDEX

PRAISE FORPRICING ON PURPOSE

“Once again Ron Baker has delivered logical and well supported arguments to build a compelling case for the benefits of a strategic and value-focused approach to pricing products and services. At NewLevel Group, we practice what Ron Baker preaches, and our firm as well as our clients are better off because of it.”

—John Heymann, CEO, NewLevel Group, Napa, California, www.newlevelgroup.com

“Pricing on Purpose is an essential--not to mention great--read for anyone who wants to take their business to the next level. To enjoy what you do, be valued by your customers, and be rewarded for it. What a concept!”

—Jayme Schneider, Chief Value Officer, Easdown & Partners, Wagga Wagga, Australia

“In this extremely well researched and entertaining book, Ron Baker provides a compelling argument to abandon the traditional cost-plus pricing method for a formula that better fits the 21st Century business.

He combines his 20+ years of pricing research with proven economic theo- ries, and sprinkles it with historical references and fun anecdotes. Pricing onPurpose teaches how to create value for the customer and how to price to cap- ture that value. I recommend this guide to all business leaders who dare to think outside the box.”

—Niquette Kelcher, Editor, SmartPros Ltd., www.smartpros.com

“Despite finding it hard to agree with Ron Baker on some points I have to say I am a huge fan of his work. In Pricing on Purpose he has, once again, given us a fascinating book that is extraordinarily well researched and cogently argued. It’s too bad that more people aren’t following Ron Baker’s lead in seriously chal- lenging some of the cherished and entrenched beliefs that define contemporary business models and drive decision-making—especially in service firms. No matter what business you’re in, pricing decisions are unquestionably amongst the most important you’ll make in driving its success. With that in mind, thisentertaining and provocative book is essential reading.”

—Ric Payne, Chairman, Principa, www.principa.net

“Pricing on Purpose is a practical ‘hands-on’ discussion about pricing in the marketplace and what the ‘value proposition’ means to the customer. Ron Baker has very skillfully woven theory and practical examples throughout this “must read” book and examines the art of pricing as one of the core competencies required for business as they grapple with an ever changing marketplace. Ron focuses on business looking out rather than looking in, of asking the right questions of the customer by putting price where it belongs--at the forefront of business development and success. It is a fascinating book full of challenging examples of modern price theory and practice.”

—Peter Byers, Chartered Accountant, Byers & Co Ltd, New Zealand

“What a great read for business owners everywhere. Ron Baker is truly a pricing expert. He first breaks the traditional mold of pricing and flows right into how to do it better. Business executives with an open mind will absorb every word and will find new ways to create more value for their businesses. The concept of putting someone in charge of the value of your business is revolutionary.”

—Mark J. Koziel, Director of Media Planning, Joe Slade White & Company, Inc., East Aurora, New York

“This is a must-read book. It is extremely well reasoned and has a solid business approach to leading organizations and changing their culture from cost-plus pricing, which is totally inefficient compared to the new business model of value pricing offered. If the reader just read the quotes and examples they would remind the reader of the basic and successful business models. But much more, the book is a true insight into what will make businesses great and profitable. The key point? Value is in the eye of the beholder and not in the eye of the seller. Efforts and costs do not equal value. Ron Baker has nailed it. If leaders pay attention and change their business model and culture, they will survive and prosper. If they do not, they will die.”

—William Cobb, Cobb Consulting, Houston, Texas

“Ron Baker has written one of the best primers on pricing I have ever read. By exploring and clearly explaining the economic theory behind pricing, combined with leading-edge pricing strategies from businesses in a wide-range of industries, Pricing on Purpose is an entertaining, informative, and refreshing look at one of the most important functions in any business: creating and capturing value. It is rich with real life examples of where strategic pricing led to a quantum leap in perceived value and profitability.”

—Sheila Kessler, Ph.D., President, Competitive Edge and author, Measuring and Managing Customer Satisfaction, www.CompetitiveEdge.com

“Like a master cartographer, Ron Baker charts a new course for today’s businesses to explore their pricing strategies and uncover the true value of their products and services.

Pricing on Purpose provides a compelling call to action to all of us in customer service businesses to re-examine our pricing practices and demand that the focus be on output and results, not internal costs and the mere doing of things. As a representative of the advertising agency business, I am appreciative of the brilliant insights this book provides and look forward to sharing it all with colleagues and clients as we attempt to break out of the antiquated cost-plus pricing model that has so dominated our industry for much too long.”

—Steven Koskela, CPA, Chief Financial Officer, Ground Zero Advertising, Inc., Los Angeles, CA

“You don’t need to be a cost accountant to appreciate Ron Baker’s newest book, Pricing on Purpose. All leaders who feel shackled to commodity and cost-plus pricing will profit both personally and professionally from Baker’s sage advice.”

—Matthew W. Homann, President and Chief Thinking Officer, LexThink, Inc., www.nonbillablehour.com

“Ron Baker’s pricing theories have resonated with me since I first read and heard him in 2000. His messages--true wisdom--expand and improve, literally, by the day. Resistance to value pricing usually begins with “well, how do I…?” and, in Pricing on Purpose, Ron gives excellent direction through the implementation process as well as the rationale behind it. I heartily applaud Ron’s artful dissemination of value pricing messages--he’s a worthy teacher.”

—Michelle Golden, President & CEO, Golden Marketing Inc., St. Louis, Missouri, www.goldenmarketinginc.com

“Pricing is such a core function of any business yet it is overlooked at our peril. We set up structures that allow us to operate inside of our competencies and we seek to control our business so fully that we restrict its capacity to thrive. Pricing is a key competency not understood by so many of us in business. It requires the focus of the mind of the pricer to be outside of the organization and actively seeking to understand the behavior of the customer. The power of this action should not be ignored simply because it cannot be controlled. In Pricingon Purpose, Ron Baker has given us an almanac for better understanding and capturing the value we create. It is an invaluable and entertaining read, and a sig nificant contribution for organizations interested in better understanding the eco nomics of creating and capturing value.”

—Brendon Harrex, Chief Value Officer, Ward Wilson Business Advisors, Gore, New Zealand

This book is printed on acid-free paper.

Copyright © 2006 by John Wiley & Sons, Inc. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data

Baker, Ronald J.

Pricing on Purpose / Ronald J. Baker.

p. cm.

Includes index.

ISBN-13: 978-0-471-72980-8 (cloth) ISBN-10: 0-471-72980-9 (cloth)

1. Pricing. I. Title.

HF5416.5.B344 2006

658.8’16—dc22

2005023685

To my Mother, Florence Baker, for her enduring love and inspiration.

The composition of this book has been for the author a long struggleof escape, and so must the reading of it be for most readers if theauthor’s assault upon them is to be successful--a struggle of escape fromhabitual modes of thought and expression. The ideas which are hereexpressed so laboriously are extremely simple and should be obvious.The difficulty lies, not in the new ideas, but in escaping from theold ones, which ramify, for those brought up as most of ushave been, into every corner of our minds.

—John Maynard Keynes, General Theory of Employment, Interest, and Money, 1937

Perhaps the sentiments contained in the following pages are not yetsufficiently fashionable to procure them general favour; a long habit ofnot thinking a thing wrong, gives it a superficial appearance of beingright, and raises at first a formidable outcry in defence of custom.But tumult soon subsides. Time makes more converts than reason.

—Thomas Paine, Common Sense, February 14, 1776

FOREWORD

When Ron Baker attended our Strategy and Tactics of Pricing class at the University of Chicago five years ago, it was an opportunity to finally put a face to an author, consultant, and practitioner in the art and science of pricing for professional services. With his new book, Pricing on Purpose, Ron has expanded his focus to include pricing of both business and consumer products and services. This is clearly his best book.

His quotes and stories show both the depth and breadth of his research for this effort. He seamlessly blends the works of others to create a well-written piece on the history of price, including some of the initial theories on how they evolved and how today’s pricing manager should apply those works. He has approached pricing as an accountant, an economist, but most of all as a practitioner. It is about time that the field of pricing has moved beyond the mechanical field of finance to the realm of the marketer in a customer-focused world.

Too many times, authors present models that are allegedly all encompassing in their ability to solve a wide range of business problems. Ron hasn’t done that. He admits that he doesn’t have all the answers to today’s business problems. As such, the book presents the many conflicts in the wide range of theories in pricing. Fortunately, that struggle is in itself a useful exercise since it is only through our study of history that we develop an understanding of the true complexity in any area of thought.

Ron has woven a delicate fabric of old and new perspective that adds much depth to the current writings in pricing. And, he has done that with a well-turned and informational phrase, drawing on many personal anecdotes to illustrate his points. His extensive research on current businesses lends further depth and credibility to his work.

His discussion of price-led costing turns the traditional focus on cost-led pricing completely around by showing that the latter is internally focused and lacks any real-world, customer-driven orientation. This is a perspective that leading product strategy specialists have been trying to get in place for several years. In pricing, it is quite revolutionary, yet critically important if the traditional approaches of costing are going to be relegated to their proper places in the history of management theory

Pricing on Purpose is one of the first books to move beyond the rhetoric of value, providing concrete examples of value in both a consumer and business context. Further, it provides the logic for the needed shift from cost-based pricing to value-based pricing. In doing so, Ron focuses in great depth on the customer experience in defining the nature and the value of the relationship.

The book contains a number of discussions around classic theories in pricing such as yield management, cost-based pricing, customer segmentation, and anti-trust legislation just to mention a few. Further, Ron has tested a number of “classic assumptions” and, drawing from his wide experience in a number of fields, has presented problems with many of those models and a far richer and more productive way to approach them. His premise that “bad customers often drive out good ones (Baker’s Law)” is a classic that totally changes the way managers think about customer churn. This is a constant theme throughout the book, to offer alternative perspective to current “rules of thumb” and provide a richer understanding of the true issues in pricing.

The chapter on antitrust law presents a complicated range of works and opinions in a simple yet complete manner. It is quite useful to practitioners who are often limited in their ability to adopt more current approaches to price discrimination (a good thing!) by in-house law practices that fail to reflect current antitrust thinking. This chapter provides us with a rich discussion of the evolution and history of antitrust laws as well as many stories and applications in today’s world.

The final discussion around the Chief Value Officer (CVO) provides a look at how leading-edge professional services organizations are “throwing cost-plus pricing on the trash heap” and moving toward a better understanding of what their customers really value and putting someone in charge of that so it is integrated effectively into the pricing, marketing, and sales practices of the firm. He provides a manifesto for the evolution of the pricing committee to the “pricing cartel” in the firm, with extensive lists of objectives and primary activities for success. Finally, Ron has recognized the criticality of the right personal attitude for managers to be successful in the topsy-turvy world of pricing.

As a fellow pigmy who has “stood on the shoulders of giants,” I recommend this book as a fine example of how an author can extend the field of both strategic and tactical pricing. Enjoy!

Reed Holden Holden Advisors, www.holdenadvisors.comConcord, MA He is the author of The Strategy and Tactics of Pricing,Third Edition.

PREFACE

Two roads diverged in a yellow wood,And sorry I could not travel bothAnd be one traveler, long I stoodAnd looked down one as far as I couldTo where it bent in the undergrowth;

Then took the other, as just as fair,And having perhaps the better claim,Because it was grassy and wanted wear;Though as for that the passing thereHad worn them really about the same,

And both that morning equally layIn leaves no step had trodden back.Oh, I kept the first for another day!Yet knowing how way leads on to way,I doubted if I should ever come back.

I shall be telling this with a sighSomewhere ages and ages hence:Two roads diverged in a wood, and I—I took the one less traveled by,And that has made all the difference.

—Robert Frost, “The Road Not Taken,” 1916

With the passage of time comes reflection and hindsight. As a young college freshman, I was faced with two very divergent roads, one leading to the study of economics and the other accounting, with the goal of eventually becoming a Certified Public Accountant. The road not traveled represents the opportunity cost of the choices we make. I chose the CPA road, which led me down a very popular and secure path to a decent career rich with opportunities and a respectable standard of living.

Not only would these two roads lead to entirely different career paths, but they impose radically dissimilar visions of the way the world works on the traveler. Historian Will Durant once wrote, “Education is a progressive discovery of our own ignorance,” a statement I have learned to be profound upon reflecting on these two different paths. The well-traveled road offers only sights already seen; rarely does it lead us to new discoveries.

You may be wondering how this metaphor applies to a book about pricing, yet that is the point. The accounting road took me down the cost accountant’s view of the world, while the road not taken—that of the economist—is one of value, the ultimate determinate of price in any transaction. I used to believe that the two roads were not mutually exclusive—perhaps you could keep one foot on each path as you made your way into the business world to make executive level decisions. I was naïve. The cost accountant’s view of the world is pervasive, calcifying into the arteries of executives at all levels, affecting how they view the world and price their products.

We are ruled by our theories, whether we admit it or not, and a good theory produces what one economist has called an OIC moment (Oh, I see!). The moment of insight arrived for me when I learned the significance of the Marginalist Revolution of 1871 and the Subjective Theory of Value. Finally, I had a better understanding of how prices coordinate economic activity, and how value—subjectively determined by the customer—ultimately affects the prices we are willing to pay for the myriad goods and services offered in the world economy. Indeed, there is nothing more practical than a good theory, and the book you are about to read contains the theories proven to have explanatory and predictive power to explain much—although certainly not all—human behavior.

One of my mentors is Peter Drucker,1 who insists on asking before he publishes any book, “Why this book, now?” It is a good question to ask oneself before setting out to write a book on pricing and value, where much has already been written. I feel the same way about the topic as T.S. Eliot felt about Shakespeare, namely, that it is hopeless to try to say anything original about it; the best you can hope for is to be wrong about it in a new way.

That said, the objective of this book is to share what one very enthusiastic student of price theory has learned after taking the arduous journey of crossing over to the beginning of the road not originally taken in his youth, and finding the way to a new understanding of the way the world works. The hardest part of learning something new is unlearning so much of what one already thinks one knows. In a very important sense, this book is my mea culpa for my prior ignorance related to my worldview.

Unfortunately, price theory is ignored by too many in business today, as if there was nothing to learn from an academic discipline that has been positing and testing theories on this topic for centuries. Yet the economics profession has the intellectual high ground when it comes to value and price, with much wisdom to offer the willing student. It is truly tragic that these economic ideas are not better explored in business schools and MBA curriculums, since a lot of confused and muddled thinking could be avoided. For the most part, the cost accountant’s view of the business world is mainstream, while the economist’s remains heretical. This needs to change, and perhaps this book can begin to start a shift—however slight—in this direction, making what is unorthodox today conventional wisdom tomorrow.

It is my fervent hope that you enjoy the road of price theory we are about to travel together, providing insights into human behavior, some of which may be new and exciting for you. Sometimes you have to go a long way out of the way to come a short way correctly. If I can shorten your path by sharing my learning, this book will have accomplished its purpose.

Ronald J. Baker Petaluma, California July 29, 2005

ACKNOWLEDGMENTS

What has been is what will be,and what has been done is what will be done;and there is nothing new under the sun.Is there a thing of which it is said,“See, this is new”?It has been already,In the ages before us.

—Preacher in Ecclesiastes 1:9-10

A book is purely the product of intellectual capital, and is represented in the tangible form known as structural capital. What the reader does not see is the human and social capital without which this book would not exist. Richard Burton described in The Anatomy of Melancholy (second edition, 1624), “Pigmies placed on the shoulders of giants see more than the giants themselves.” I have stood on the shoulders of some true giants, and although it would be impossible to thank them all, the prominent ones deserve special mention.

So many of my views of the way the world works have been influenced by economists to whom I feel I owe a special debt of gratitude. Milton and Rose Friedman gave me my first introduction to serious economic ideas and I would like to thank them for making complex issues understandable to the masses. It is a very good thing the actuarial examinations are so difficult and that Milton Friedman chose his next best alternative and became an economist instead. Their son, David Friedman, an outstanding economist in his own right, taught me much through his textbooks and general economics books, not to mention through the lectures I have been privileged to attend. Like his mother and father, he provides incredible insight into human behavior.

Another economist who has taught me more than I could ever repay is Steven Landsburg, through his text and general books and his Everyday Economics articles in Slate (www.slate.com). Landsburg is an incredibly brilliant and innovative thinker; and in unison with a gifted and engaging writing style, he makes one want to study the dismal science in greater depth. I had the great good fortune of meeting him in October 2000 at Cato University in Montreal, Canada, where he added even more to my intellectual capital.

A truly special debt is owed to George Gilder, who was my first serious introduction to supply-side economics and the primary importance of the role of the entrepreneur in creating growth, dynamism, and wealth in an economy. It is nearly impossible to classify George Gilder since he writes and speaks on a wide range of topics, from sociology and poverty, to feminism and the telecosm. He is truly an eclectic thinker, and is one of the best writers of his time. He taught me the moral case for capitalism, and I believe he will go down as the Adam Smith of the twentieth and twenty-first centuries.

Michael Novak, who presently holds the George Frederick Jewett Chair in Religion, Philosophy, and Public Policy at the American Enterprise Institute, along with Gilder, makes the moral case for business and capitalism from a religious perspective; he introduced me to the encyclicals of the late Pope, which also affirms the morality of capitalism while at the same time recognizing that any system devised by humans is destined to fall short of the Kingdom of God.

Many other economists have shaped my thinking on human behavior and, especially, the theories of value and price: Martin Anderson, Dominick T. Armentano, Robert J. Barro, Bruce Bartlett, Robert Bartley, Gary S. Becker, Mark Blaug, Warren Brookes, James M. Buchanan, Ronald H. Coase, Hernando DeSoto, Nicholas Eberstadt, Robert H. Frank, James Gwartney, Friedrich A. Hayek, Henry Hazlitt, David R. Henderson, Paul Heyne, Richard S. Howey, John Kay, Arthur Laffer, Dwight R. Lee, Steven Levitt, Deirdre N. McCloskey, Ludwig von Mises, Robert Mundell, Charles Murray, James Payne, Virginia Postrel, Leonard Read, Paul Craig Roberts, Murray N. Rothbard, Paul Seabright, Julian Simon, Mark Skousen, Thomas Sowell, George J. Stigler, Richard L. Stroup, Jude Wanniski, Jonathan B. Wight, and Walter Williams, among innumerable others, all of whom have served as absent educators through their works.

Peter Drucker is one of the only true management consultants who has consistently contributed real insight and wisdom to a profession constantly enamored with the latest fad of the month. In one way or another, everyone who writes on business issues stands on his shoulders. Not only has he originated most of the management theories other so-called gurus now take credit for—and coined terms such as knowledge worker, privatization, and others—but he did it long before many of them were born. His legacy is large, and will endure for the ages. I believe he deserves a Nobel Prize.

Thomas T. Nagle and Reed Holden are two heroic individuals. As the authors of The Strategy and Tactics of Pricing: A Guide to Profitable Decision Making (now in its third edition), they have put pricing on the map—and the organizational charts—in companies around the world. It is impossible to improve on perfection, which is why I hope they forgive me for borrowing generously from their work. I owe them full credit for the graphical depiction in Chapter 9 that proves price determines costs, and not the other way around. Also, I owe them for the five Cs of value, the ten factors of price sensitivity, the seven segmentation strategies, and many other lessons I have learned from their books, public speeches, and their course at the University of Chicago Graduate School of Business, Pricing: Strategy and Tactics, which I attended in April 2001. They both are mentors and pioneers in the pricing movement, and I only hope to have a fraction of the impact they have had on companies and industries around the world. Under no circumstances should the reader condemn the prophets for the ineptitude and errors of the disciple.

Thank you, Eric Mitchell, president of the Professional Pricing Society, for giving me the opportunities to speak at your excellent conferences and to meet other pricing leaders, and for creating a forum where people responsible for pricing can exchange intellectual capital and further pricing skills in order for it to become a core competency in more organizations.

The Talmud says, “I have learned much from my teachers, more from my colleagues, and most of all from my students.” It is my good fortune that my students are also my colleagues, and indeed they have taught me more than I could ever requite. The word colleague comes from the Latin colligare, “to bind together,” and that certainly describes the relationships I have developed throughout the years with many professionals. Thank you to the tens of thousands of professionals around the world who have listened to me rant and rave about the deleterious effects of cost-plus pricing, but more importantly, for implementing the ideas I have proffered. I have learned from your failures and even more from your successes, and there is no greater pleasure than watching your colleagues do better for their customers—and in turn, themselves—than even they thought was possible.

An enormous debt is owed to John Dunleavy, Kurtis Docken, Laura Ritter, and the rest of the team at the California CPA Education Foundation. They continuously take risks by letting us teach new and unproven courses in my home state, and have gone above and beyond expectations in support of my work.

Sheila Kessler continues to provide me with wisdom, insight, inspiration, and knowledge I could not live long enough to learn on my own. I have said it many times, and in many places: Sheila is a remarkable woman whom I deeply respect and admire for her accomplishments. I am proud to call her a colleague.

To Ron Crone, Paul Dunn, Ed Kless, Michael McCulloch, Bill Mees, Ed Miller, Shirley Nakawatase, Paul Dunn, and Ric Payne, colleagues who engage me professionally and—since your friends are an extension of yourself—whose friendships I am blessed with every day.

To my fellow VeraSage Institute founders, fellows, and associates I owe enormous gratitude for furthering the quest of burying the billable hour and timesheets in professional service firms around the world. Your vision, leadership, and commitment to bettering the professions provides me with sustenance and inspiration on a daily basis, and words cannot express what each of you means to me: Scott Abbott, Justin Barnett, Michelle Golden, Daryl Golemb, Brendon Harrex (the world’s first CVO!), Paul Kennedy, Mark Koziel, and Yan Zhu—thank you all.

Peter Byers, founder of VeraSage Institute New Zealand, is a wise man, kind soul, and dear friend. I only hope I am as open-minded and willing to constantly learn, and challenge my views of the world as you continue to do—it is truly heartening.

P.G. Wodehouse once spoke of an author who told all about how and why he wrote his book when a simple apology would have been sufficient, a sentiment I am fairly confident my British Trusted Advisor, Chartered Accountant, VeraSage Institute UK founder, quasi-Marxist—and perhaps most merciless—Creator and Web master of www.ronbakersucks.com, Paul O’Byrne, would agree with. Your Monty Python sense of humor and wit is outrageous—always going for the jugular, never the jocular—your guidance and advice invaluable, and your friendship priceless—even subjectively. Thanks for who you are, all you have done, and continue to do.

Dan Morris, founder of VeraSage Institute USA, and fellow Cognitor and educator, has been a constant source of inspiration. Conversing with Dan is like stepping into a batting cage of ideas, and the result is frequently an even better idea—usually from him. He constantly thinks outside the box—sometimes Pandora’s. I admire his passion, skill, talent, and commitment to bettering the businesses he serves. Most of all, I am grateful for our friendship.

To my editors at John Wiley & Sons, Inc., John Deremigis and Judy Howarth, thank you for taking the ultimate risk by publishing this book, improving every page with your adept editing, and for being patient with the late manuscript by understanding the first thing every writer needs is another source of income. Thank you also to senior production editor Dexter Gasque for managing the production of the book, and to cover designer Andy Leifer.

Another forensics coach, indefatigable supporter, and companion—who also happens to be my brother—Ken Baker deserves special thanks. He always says he cannot possibly live through another one of my books, but he came through again. I am sure he is tempted to say what Groucho Marx did upon publication: “From the moment I picked this book up until the moment I put it down, I could not stop laughing. Some day I hope to read it.”

To my mother, Florence Baker, who taught me patience, understanding, and tolerance, and to whom this book is dedicated as a small token of appreciation for everything she has done for me. To my late grandmother, Angelina Maria Zimmerman, thank you, Granny, for always believing in me, being the center of the family, and always showing your pride in your grandson. I only hope I continue to earn it.

My father, Sam Baker, who taught me the spirit of service and enterprise from the inside of a barber’s chair, and was my first introduction to an entrepreneur, although I did not know it at the time. He has spent many absorbing hours with me recounting the days of the “British Invasion” of the late 1960s and the impact it had on his chosen profession, barbering. His embrace of hairstyling, chemical services, retail, continuing education, and the unisex salon, long before they became commonplace in his profession, truly inspire me to continuously challenge the conventional wisdom of the majority. His experience is a history I treasure, both for the lessons it teaches and the pride it gives me. Goethe wrote, “Was du ererbt von deinen Vätern hast, / Erwirb es, um es zu besitzen,” which translated reads, “What you have inherited from your father, you must earn in order to possess.” I hope I have earned his legacy.

ABOUT THE AUTHOR

Ronald J. Baker started his career in 1984 with KPMG’s Private Business Advisory Services in San Francisco. Today, he is the founder of VeraSage Institute, a think tank dedicated to educating businesspeople around the world.

As a frequent speaker, writer, and educator, his work takes him around the world. He has been an instructor with the California CPA Education Foundation since 1995 and has authored ten courses for them: How to Build a Successful Practice with Total Quality Service; The Shift From Hourly Billing to Value Pricing; Value Pricing Graduate Seminar; You Are What You Charge For: Success in Today’s Emerging Experience Economy (with Daniel Morris); Alternatives to the Federal Income Tax; Trashing the Timesheet: A Declaration of Independence; Everyday Economics; The Firm of the Future; Everyday Ethics: Doing Well by Doing Good; and The New Business Equation for Industry Executives.

He is the author of the best-selling marketing book ever written specifically for professional service firms, Professional’s Guide to Value Pricing (seventh edition), published by CCH, Incorporated. He also wrote Burying the Billable Hour, Trashing the Timesheet, and You Are Your Customer List, published by the Association of Chartered Certified Accountants in the United Kingdom. His prior book, The Firm of the Future: A Guide for Accountants, Lawyers, and Other Professional Services, co-authored with Paul Dunn, was published in April 2003 by John Wiley & Sons, Inc.

Ron has toured the world, spreading his value-pricing message to over 70,000 businesspeople. He has been appointed to the American Institute of Certified Public Accountant’s Group of One Hundred, a think tank of leaders to address the future of the profession, named on Accounting Today’s 2001, 2002, 2003, 2004, and 2005 Top 100 Most Influential People in the profession, and received the 2003 Award for Instructor Excellence from the California CPA Education Foundation.

He graduated in 1984 from San Francisco State University with a Bachelor of Science in accounting and a minor in economics. He is a graduate of Disney University and Cato University. He is a member of the Professional Pricing Society and presently resides in Petaluma, California.

To contact Ron Baker: VeraSage Institute Phone: [phone] Fax: [phone] E-mail: [email protected] Web site: www.verasage.comWeb site: www.verasage.co.nz

1

WHY IS MOVIE THEATER POPCORN SO EXPENSIVE?

. . . [M]en are fond of paradoxes, and of appearing to understand what surpasses the comprehension of ordinary people...

—Adam Smith [1723-1790]

Why don’t we observe movie popcorn price wars, similar to what other industries engage in from time to time? When asked this question, the overwhelming majority of businesspeople will answer, because there is no competition—the movie theater has a captive audience. Other common explanations include:

• Limited selling time

• High fixed cost of operating concession stand

• It is how the theater owner makes a profit

• Higher clean-up costs imposed by snack eaters

• Tastes and smells better than you can make at home

• Part of the experience of seeing a movie

• Because people will pay for it

At first glance, all of these answers appear reasonable, except to an economist. The most popular response—captive audience—leads to the question of why there are no pay toilets in the theater? You are certainly a captive audience in that regard, but perhaps theater owners understand that if they installed pay toilets they would lose at the box office what they made from the bathrooms. The high fixed costs, in terms of scarce square footage, equipment, fixtures, clean-up costs, and required employees, is certainly a plausible reason, but does not really account for the large premium price of popcorn. To say it is where the theater owners make their profits is definitely true, but begs the question of why they do not make the profits from ticket sales and sell more popcorn at closer to cost? Eating popcorn is certainly part of the experience of going to the movies, and people will pay for it, yet this explanation is still incomplete.

Assuming theater owners want to maximize their profits, what do the theater owners know the rest of us, perhaps, do not? The consummate economist Steven Landsburg provides the answer:

I believe he knows this: some moviegoers like popcorn more than others. Cheap popcorn attracts popcorn lovers and makes them willing to pay a high price at the door. But to take advantage of that willingness, the owner must raise ticket prices so high that he drives away those who come only to see the movie. If there are enough nonsnackers, the strategy of cheap popcorn can backfire.

The purpose of expensive popcorn is not to extract a lot of money from customers. That purpose would be better served by cheap popcorn and expensive movie tickets. Instead, the purpose of expensive popcorn is to extract different sums from different customers. Popcorn lovers, who have more fun at the movies, pay more for their additional pleasure (Landsburg, 1993: 159).

This answer is more precise, since the important point is that “some moviegoers like popcorn more than others,” and the theater owner cannot separate these customers when they are outside queuing up for the movie. A method was needed to separate the snack eaters from those who just want to watch the movie, which the concession stand provides since it allows customers to divide and self-identify themselves. This may seem a subtle point, but it is highly profitable, since segmenting different types of customers allows the theater owners to charge them varying prices depending on the value received.

Students, children, and people with large families are usually more price sensitive, and not likely candidates to spend money on snacks. The theater owner does not want to turn these customers away, and hence keeps the box office price lower by charging higher prices to snack eaters. What you are really buying when you purchase a movie ticket is an opportunity set—a chance to enjoy the movie, or to enjoy it with popcorn. Economists call this a two-part tariff, defined as a pricing strategy in which the customer must pay a fee in exchange for the right to purchase the product. Examples abound of this strategy: country clubs charging membership fees and monthly dues; Gillette charging for the razor then the blades; amusement parks charging an entrance price followed by a price for each ride.

Some people recoil at the thought of price discrimination—charging different prices to different customers—claiming the practice is blatantly unfair and should be illegal. But what would happen if the practice were outlawed? Theater owners, airlines, restaurants, and myriad other businesses would have to increase prices for the very customers who are least able to afford a higher price—children, students, large families, senior citizens, and so on. By engaging in price discrimination, businesses are actually increasing social welfare and making more products and services available to the poorest members of society. This is not to imply that price discrimination is based on race, gender, religion, or ethnicity, but rather is based on ability and willingness to pay. As this book will prove throughout, this practice is ubiquitous in any economy, and most price theorists agree it has a salutary effect on societal welfare.

If you found this answer for why movie theater popcorn is so expensive thought provoking, welcome to price theory. The German poet Goethe thought double-entry bookkeeping “among the loveliest inventions of the human mind.” One should say the same about price theory, as it truly is “one of the great products of the human mind,” as economist Donald (now Deirdre) McCloskey explains in his textbook, The Applied Theory of Price:

The theory of price is one among the larger intellectual achievements of the nineteenth century, such as the theory of heat engines, the decipherment of hieroglyphics, the professionalization of history, the invention of abstract algebras, and the theory of evolution. Price theory explains much human behavior (McCloskey, 1985: 1, 4).

Since price theory offers tremendous insight into human behavior, it is worth the time and effort to study it in greater depth. It is sometimes said that economics is nothing but refined common sense, which is certainly true. Yet many myths about this crown jewel of the social sciences persist, even among businesspeople.

This is one of the most glaring weaknesses in most business books and management ideas: They are all practice with no theory. Most do little else than propound platitudes and compose common sense into endless checklists and seven-step programs. Yet, all learning begins with theory. There is nothing as sterile as a fact not illuminated by a theory; we may as well read the telephone book. This may explain why four out of five business books are never read to completion.

The schism between management theory and economics is profound, and one of the reasons is that the study of management theory is relatively young compared to its older sibling economics, which dates back hundreds of years. In their piercing book The Witch Doctors: What Management Gurus Are Saying and Why It Matters, John Micklethwait and Adrian Wooldridge, two staff editors for The Economist, level this charge against the immature discipline of management theory:

Management theory, according to the case against it, has four defects: it is constitutionally incapable of self-criticism; its terminology usually confuses rather than educates; it rarely rises above basic common sense; and it is faddish and bedeviled by contradictions that would not be allowed in more rigorous disciplines. The implication of all four charges is that management gurus are con artists, the witch doctors of our age, playing on business people’s anxieties in order to sell snake oil. The gurus, many of whom have sprung suspiciously from the “great university of life” rather than any orthodox academic discipline, exist largely because people let them get away with it. Modern management theory is no more reliable than tribal medicine. Witch doctors, after all, often got it right—by luck, by instinct, or by trial and error (Micklethwait and Wooldridge, 1996: 12).

I have tried to avoid these four defects by having the theories presented herein drive the ideas, not the other way around.

Therefore, the book you are about to read is more theoretical than you may be used to if you are a regular reader of business books, or attend business seminars. I make no apologies for this, for as the great mathematician David Hilbert wrote, “There is nothing more useful than a good mathematical theory,” and the same is true with respect to economics and the study of human behavior. Price theory will be utilized throughout as the overarching model to gain better insight into value and price.

All theories are subject to falsification, precisely how all science progresses. This is an interesting phenomenon, because it implies that most new theories—and especially management fads of the month—have to be wrong or irrelevant, or else knowledge would proceed at lightning speed and advance by Newtonian or Einsteinian leaps every day. It does not. This makes it difficult for editors and publishers to admit most of what they publish is trivial, or just plain incorrect. In reality, knowledge progresses slowly, in a never-ending iterative process best characterized as knowledge creep.

MY COVENANT WITH YOU

In an attempt to contribute to your own knowledge creep, my goal is to have you think with me, not like me. You should be skeptical about the ideas presented and subject them to your own rigorous analysis and experience. Do not accept anything at face value, even from a so-called expert, for as Harry Truman said, “An expert is someone who doesn’t want to learn anything new, because then he wouldn’t be an expert.” I have been studying price theory for nearly two decades and I still consider myself a student and my knowledge incomplete with regard to this fascinating body of knowledge.

In that spirit, I have tried to follow the wisdom of an inspiring little book by John Milton Gregory, The Seven Laws of Teaching, first published in 1884, which sets forth the seven pillars necessary in order to educate effectively, and this shall act as my covenant with the reader:

1. A teacher must be one who knows the lesson or truth or art to be taught.

2. A learner is one who attends with interest to the lesson.

3. The language used as a medium between the teacher and learner must be common to both.

4. The lesson to be mastered must be explicable in the terms of truth already known by the learner—the unknown must be explained by means of the known.

5. Teaching is arousing and using the pupil’s mind to grasp the desired thought or to master the desired art.

6. Learning is thinking into one’s own understanding a new idea or truth or working into habit a new art or skill.

7. The test and proof of teaching done, the finishing and fastening process, must be a reviewing, rethinking, reknowing, reproducing, and applying of the material that has been taught, the knowledge and ideas and arts that have been communicated (Gregory, 1995: 18-19).

That said, the objective is to have the theories, concepts, and ideas presented become part of your—and your business’s—intellectual capital. Gregory tells the story of a boy, “having expressed surprise at the shape of the earth when he was shown a globe.” The boy was asked, “Did you not learn that in school?” To which the boy replied, “Yes, I learned it, but I never knew it” (ibid.: 88).

Utilizing price theory, we can gain a better understanding of why human beings behave the way the do, especially—but by no means only—in a business context. The great economist Alfred Marshall, responsible for much of modern economics, defined the discipline as “a study of man’s actions in the ordinary business of life; it inquires how he gets his income and how he uses it.” Let us continue this study by asking what is conceivably the most fundamental question any businessperson has to answer.

2

WHY ARE WE IN BUSINESS?

Business must be run at a profit, else it will die. But when anyone tries to run a business solely for profit . . . then also the business must die, for it no longer has a reason for existence.

—Henry Ford [1863-1947]

Why are we here? I think many people assume, wrongly, that a company exists solely to make money. We have to go deeper and find the real reasons for our being. As we investigate this, we inevitably come to the conclusion that a group of people get together and exist as an institution that we call a company so that they are able to accomplish something collectively that they could not accomplish separately—they make a contribution to society, a phrase which sounds trite but is fundamental.

—David Packard [1912-1996]

There is only one boss: the customer. And he can fire everybody in the company, from the chairman on down, simply by spending his money somewhere else.

—Sam Walton [1918-1992]

There is never a good sale for Neiman-Marcus unless it’s a good buy for the customer.

—Herbert Marcus, advice to his son Stanley Marcus, circa 1926

All of these entrepreneurs built businesses that still exist by focusing on the customer, not profits. Put simply, profit is merely the oxygen for the body; it is not the point of life. Profit is nothing more than a lagging indicator of what is in the hearts or minds of your customers.

Peter Drucker, the most profound management thinker in history, has indefatigably pointed out that “there is only one valid definition of business purpose: to create a customer” (Flaherty, 1999: 131). This is known as the marketing concept. The purpose of any organization—from a governmental agency or nonprofit foundation, to a corporation or a church—exists to create results outside of itself. The result of a school is an educated student, as is a cured patient for a hospital, or a saved soul for a church. A business exists to create wealth for its customers.

The only things that exist inside of a business are costs, activities, efforts, problems, mediocrity, friction, politics, and crises. In fact, Peter Drucker wrote, “One of the biggest mistakes I have made during my career was coining the term profit center, around 1945. I am thoroughly ashamed of it now, because inside a business there are no profit centers, just cost centers” (Drucker, 2002: 49, 84). The only profit center is a customer’s check that does not bounce. Customers are indifferent to the internal workings of your company in terms of costs, desired profit levels, and efforts. Value is only created when you have produced something the customer voluntarily, and willingly, pays for. What makes the marketing concept so breathtakingly brilliant is that the focus is always on the outside of the organization. It does not look inside and ask, “What do we want and need?” but rather it looks outside to the customer and asks, “What do you desire and value?”

In fact, what is routinely called “capitalism” is more accurately described as “consumerism,” wherein the customer is sovereign—those with the gold rule. While the marketing concept has existed for decades, it is regularly ignored because businesses routinely lose sight of the fact that the sole reason they exist is to serve customers outside of their four walls.

A company exists to serve real flesh-and-blood people, not some mass of demographics known as “the market.” As Stanley Marcus (the son of one of the founders of Neiman-Marcus) used to love to point out, no market ever purchased anything in one of his stores, but a lot of customers came in and bought things and made him a rich man. In the final analysis, a business does not exist to be efficient, control costs, perform cost accounting, or give people fancy titles and power over the lives of others. It exists to create results and wealth outside of itself. This profound lesson must not be forgotten.

Unfortunately, in many instances, this lesson has never been learned. The conventional wisdom in business is to buy low and sell high and measure the bottom line by the historical profit-and-loss statement, which any first-year accounting student can manipulate. Our 500-year-old accounting model is utterly inadequate at relating internal costs to external wealth created, and simply ignores the wealth-producing capacity of an organization. This is why we see market valuations many multiples of book value. Fra Luca Pacioli, who introduced the world to double-entry bookkeeping in 1494, may have been wrong—debits don’t equal credits, and the gap represents the wealth-creating potential of an enterprise. Our accounting model completely ignores human capital, by treating it as an expense, even though the Nobel Prize-winning economist Gary Becker estimates human capital is responsible for approximately three-fourths of the wealth in any country.

Rather than maximizing shareholder value, leaders should focus on the wealth-creating capacity of their organizations, which is, ultimately, the leading indicator for optimizing shareholder value. As Jack Welch pointed out, “One thing we’ve discovered with certainty is that anything we do that makes the customer more successful inevitably results in a financial return for us” (quoted in Khalsa, 1999: 25).

Another reason we lose sight of the truth that businesses exist to create wealth is that the language of business is drawn largely from war and sports analogies. In sports, a competition is usually zero-sum; meaning one competitor wins, and the other loses. This is not at all relevant in a business setting. Just because your competitors flourish does not mean you lose. There is room for both FedEx and UPS, Airbus and Boeing, Pepsi and Coke, Ford and General Motors, and while their sparring might be mistaken as some war, as John Kay points out “not in Pepsi’s wildest fantasies does it imagine that the conflict will end in the second burning of Atlanta [Coca-Cola’s head office]” (quoted in Koch, 2001: 73). When Coca-Cola changed their recipe to New Coke, company spokesman Carlton Curtis stated, “You’re talking about having some guts—and doing something that few managements would have the guts to do.” If you find it amusing that grown men talk about guts and recipes in the same sentence, then it should be obvious that business has nothing to do with war.

Business is not about annihilating your competition; it is about adding more value to your customers. War destroys, commerce builds. Both sides to a transaction must profit or it would not take place, a point made as far back as the 1700s by Adam Smith. Marketplaces are conversations, derived from the Greek marketplace, the agora. It is where buyers and sellers meet to discuss their wares, share visions of the future, where supply and demand intersect at the equilibrium point with a handshake. It is as far removed from war as capitalism is from communism, and perhaps this war analogy, too, needs to be tossed onto the ash heap of history.

YOU REAP WHAT YOU SOW—THE FOUR Ps OF MARKETING

. . . [S]elling concerns itself with the tricks and techniques of getting people to exchange their cash for your product. It is not concerned with the values that the exchange is all about. And it does not, as marketing invariably does, view the entire business process as consisting of a tightly integrated effort to discover, create, arouse, and satisfy customer needs.

—Theodore Levitt, Marketing Myopia, 1975

Shawn Fleming was a 19-year-old college dropout who in 1999 created Napster. In the first three months of 2001, 2.5 billion files a month were being downloaded, validating the economist’s theory of demand, which states that the lower the price, the larger the quantity demanded, especially a zero price. Nevertheless, from the music industry’s perspective, when you have millions of potential customers breaking the law, you do not have a crime wave, you have a marketing problem.