To Raise Your Prices, Change Your Theory
Rejecting Marxism, again!
January 24, 2000 (SmartPros) Ideas have consequences, and 1998 is the 150th anniversary of an idea that changed the history of civilizations -- and affected the lives of billions of people in the 19th and 20th centuries. For decades, it was the leading intellectual paradigm on several continents and commanded an enormous amount of influence on the destiny of nations. Communism, as delineated in "The Communist Manifesto," the famous revolutionary treatise published in 1848 by Karl Marx and Freidrich Engels, still wields considerable power over the world's political systems, and yes, even the professional's pricing strategies.
How Communist Theory Permeates Our Profession
Marx is far from dead. Even though Marxist ideology and theory has been thoroughly repudiated by empirical evidence, we still pay him the ultimate compliment: His ideas are so deeply ingrained into our value paradigm that we do not even notice them, let alone analyze their validity. In the 19th century, Marx posited a definition of value that has been subsequently called the labor theory of value. In its simplest form, this definition says that the price of an item is determined by the amount of labor used in its production.
That sounds reasonable, and, in fact, that misconception has deceived many great economists, such as Adam Smith and David Ricardo. It is not uncommon throughout history to measure the value of a product or service as a function of labor time. For example, the work acre in medieval English meant the amount of land that could be plowed in one day. The problem with the labor theory of value is that it does not comport with human behavior.
What Makes Your Work Valuable?
Taken to its extreme, the labor theory of value would predict countries that work longer and harder should have higher standards of living. That is demonstrably false: Under that presumption, China should have the highest standard of living (given its large amount of labor hours available).
In fact, what we see throughout the world is countries with less labor inputs and more entrepreneurship have vastly higher standards of living, including shorter hours for workers. The labor theory of value is obviously false on a macro scale, but what about a micro scale -- in other words, the professional firm?
Because of the entrenchment of the antiquated hourly billing method, most antiquated professionals gauge the value they convey by the amount of hours spent on a given service. And, because the hourly rate has a "desired net income" (DNI) built into it, professionals are satisfied when they achieve the magical goal of 100 percent realization.
But do those hours spent accurately measure the value provided to the customer? There is no doubt they measure the cost of the labor inputs involved, but cost does not necessarily equate value, especially in the minds of customers.
The Fallacy Behind The Almighty Hour
For example, when you go to lunch today, perhaps you will have pizza. Under the labor theory of value, you must necessarily value the 15th slice just as much as you valued the first, because each took the same amount of billable hours to produce. The labor theory of value does not take into account the well-established law of diminishing marginal utility, which states that the value to the customer declines with additional consumption of the good in question.
The last television episode of "Seinfeld" aired earlier this year. There are reports out of Hollywood that some people attempted to bribe the cast members in order to learn the contents of this anxiously awaited final show. If the labor theory of value were true, everyone should be equally willing to pay the cast of "Frasier" in order to obtain a script, since each took approximately the same amount of billable hours to produce.
Marx tried to circumvent these dilemmas by proclaiming that only "socially necessary labor" creates value. But how does one determine what is socially necessary? That is where the consumer enters the theory. In the end, socially necessary labor is defined as that for which someone is willing and able to pay. And that is precisely why a new theory must be used by professionals in order to subjectively measure the value of the services they provide.
A New Theory
Imagine trying to pass the CPA exam without a theoretical understanding of debits and credits. There is nothing as unenlightening as a fact not illuminated by a theory; we may as well read the phone book.
The alternative to the incorrect labor theory of value is the correct theory of value: Value is subjective. The subjective theory of value concludes that goods and services have no inherent value, that they are only valuable to the extent there is a valuer desiring them. Marx derived his definition of value form the assumption that there must be an equality in two goods which are exchanged - namely, labor hours.
But the nature of exchange is the exact opposite: It is based on an inequality in the subjective value of the good received and the good exchanged. In order for any transaction to take place, both the buyer and the seller must profit from the exchange and receive more value -- in their perceptions -- than what they are giving up. Were this not so, we could simply exchange five-dollar bills with each other and achieve a Marxian Utopia.
In 1748, Ben Franklin wrote, "Time is money." Over the past 50 years, professionals have taken this statement literally to mean time is value. But even when I was ten years old, my father would not pay me 25 cents an hour to mow the lawn with a BB gun. When Red Adair put out the oil well fired after the Gulf War -- in record time -- I assure you he did not price by the hour, but rather, based upon the value as subjectively determined by his customers.
Effort -- that is, hours spent -- emphatically does not equate to value. Results are what count to the customer. If you doubt this, take your car to a mechanic who takes over a month to fix it, and willingly accept his explanation, "Well, I spent the time."
You could easily double your firm's billable ours tomorrow by simply cutting off everyone's right arm. That way, it will take twice as long (at least) for your people to perform any given task. Think of the activity: Think of the increase in your billable hours. An instant ticket to prosperity.
I am being facetious, of course. But that is the conclusion you must reach if you subscribe to the labor theory of value, of which the hourly billing method is a direct derivative. Your labor costs are sunk no matter if your staff is doing high-level work or making photocopies. That is why I prefer Oscar Wilde's quote to that of Franklin's: "Time is a waste of money." Value is in the eye of the beholder, not the labor time of the seller.
What counts is what your customer is willing and able to pay for your services. By pricing your services as a function of labor time, you are leaving an enormous amount of money on the table. Focus, instead, on the value to the customer in order to reap what you are truly worth. Replace your labor theory of value with the subjective theory of value.
The labor theory of value, like the billable hour, is an idea from the day before yesterday. We need to forge a new paradigm of value for pricing our services as CPAs in the new millennium, and stop ritualistically accepting the false theory proffered by Karl Marx 150 years ago. Let us relegate the billable hour to the ash heap of history (along with carbon paper, the manual typewriter, and the slide rule) right next to Karl Marx's The Communist Manifesto, as an idea whose time has past.1999, Harcourt Brace Professional Publishing. All Rights Reserved. Reprinted with permission.