Knowledge Based Service Economics and the Big 4

Note to readers:  this is an incomplete white paper that I prepared. I think I can take this and tune it to Veracity so that we show how Veracity is best leveraged and why our model will win.

Openwater Advisors specializes in helping the owners of knowledge based service businesses (KBS) to maximize the value of their investment.  A knowledge based service business is one where the primary product is 'know how'.  Consultants, software makers, colleges and even churches are all KBSs.  Know how is an example of what economists call a nonrival good, meaning that one person's use of a particular piece of knowledge does not preclude others from using it.  Thus a specific unit of 'know how' can be distributed to as many people as are willing to purchase and make use of it.

This nonrival characteristic drives the principal form of differentiation among KBS:  distribution.  Let me provide a mundane example from my consulting past.  One of the services that my firm provided to corporations back in the 1980s was sales force effectiveness.  We would work with sales organizations to identify areas where they differed from 'best practice' and help them develop and implement plans to get there.  Today, much of the content of our traditional effectiveness study is encompassed in an on-line web service called Salesforce.com.  Essentially, what Salesforce.com did was take the know-how from thousands of years of experience running top sales forces and embed it in software and associated workflow that can be accessed at a modest cost from any internet connection.

Several interesting things happen when you take expertise and embed it in this manner:
Knowledge is leveraged - the number of clients a traditional 'meatware' consultant could help at any one time was limited by the hours he had available and the geography he inhabited.  By contrast, with a web service an essentially limitless number of people can make use of the designer's insights and expertise at the same time.
Pricing plummets and demand soars - by disconnecting the expert's time investment from the delivery of the service, the web service provider drives the marginal cost of providing his service almost to zero, enabling far lower prices to the market.  This in turn radically expands the addressable market for the service.  The minimum scale for sales effectiveness solutions, for example, shifted from hundreds of thousands of dollars to hundreds of dollars.


Solution value soars - Despite the massive reduction in price, the overall market value of the leveraged solution is vastly greater than that of a traditional consultant.  In other words the knowledge leverage far exceeds price destruction.  Thus beyond the  minimum scale needed to amortize the investment to embed the know how, a highly leveraged KBS like Salesforce.com is always far more profitable than traditional consulting.
Changing service delivery changes everything else - Leveraging service delivery means lower revenue per unit but many more units.  This change poses serious challenges to the traditional way of marketing, selling and administering the firm.  Even the types and mix of people change.
Value becomes portable - Traditional consultants  have a hard time selling their practices.  This is because the value of the the practice is lodged in the brains of its Principals.  By taking that knowledge and embedding it in software,  the traditional consulting expert creates an asset that is far easier to monetize.

The leverage-price-value connection holds across a wide range of different KBS distribution strategies:  including traditional management consulting, implementation consulting, BPO, traditional application software as well as web services.  See the chart above.

Relationship Holds Within Large Firms
The leverage-price-value relationship not only holds between firms, it applies within large firms that provide   multiple solutions around a specific service line.  Take for example Tax.  Tax services include everything from strategic consulting to return preparation for corporate clients and the affluent down to  HR Block, Turbo Tax and at the bottom: the IRS' online free web service.  (Some hawk eyed reader will point out that the IRS' free service generates no revenue so therefore has no value but of course they are generating immense revenue from the site).

What's interesting is that the top accounting firms with all of the expertise ceded the bottom of the Tax market to outsiders.  Why?  I think one of the reasons lies in the dual nature of the Big 4 value chain.  For some services like tax preparation, the Big 4 have become extremely efficient, by organizing services via large scale software enabled offshore facilities, they are actually able to undercut the middle market firms.

"$65 and hour?  We can't touch that" - Senior Partner of successful mid-market firm (ex PW)

Yet the vast majority of this complex middle market tax preparation business is in other's hands.  This is because while delivery and administration are scale sensitive and highly leveraged, the acquisition and management of client relationships is not.  For economic, historical and risk reasons the Big 4 limit client acquisition and management activities to a limited number of highly paid 'insiders' who bear the enterprise risk and get its rewards (aka:  Partners).  This radically limits the size of the customers that can be economically pursued, captured and managed - it drives the Firms towards a big client strategy.  The mid-market providers don't deliver a better technical service, in most cases the market is extremely fragmented with many small firms and sole practitioners providing supoptimal service.  What they do have is a willingness to accept rewards far lower than Big 4 Partners achieve and have virtually none of the independence or high profile liability issues.

Leveraged Capability Creation
At this point I wanted to discuss how someone with a lot of different intellectual capital could analyze which bits are most leverageable and then take them through a process of doing so.  Didn't get to that.

Information Cascades

John Derbyshire has an insightful post on why last week's temporary market meltdown occurred.  I've chosen to reprint it in full because he does a better job of explaining an interesting market phenomenon than I could ever do.  John is author of Prime Obsession.  You can follow John here.

Forget about the “fat fingers” and “black swans.” Last week’s sensational stock-market drop was just an unusually big instance of a normal phenomenon, the information cascade. Basically, here’s what happened: Seeing a lot of people headed over to the starboard side of the boat, a lot more people headed over to that side, too.

There are good reasons to think that this kind of imbalance will become more common. There is, for example, the current political environment.

Consider two market players,  A and B. A sells a stock to B. Why is this happening? Well,A thinks the stock is overvalued, so he wants to sell it. B, contrariwise, thinks the stock is undervalued, so he wants to buy it.

Why do  A and B have different views, though? They’re both working from the same data. Likely they’re both professionals, with teams of analysts backing them up. (In today’s environment in fact, one of them is probably a computer program; but that’s another story, and doesn’t affect the argument.)

One common reason is that they’re working with different time horizons.  A might be looking two weeks ahead, B may be looking two years ahead. On this basis, they might both be right: the stock may be overvalued in the short term, but undervalued in the long term.

A lot of trading is like that. Most commonly the trade will be between someone with a higher appetite for risk (short time horizon) and someone with a lower (long time horizon — probably an institutional investor). This long-term/short-term balance is one of the things that keeps the market stable.

Politics can upset this balance by introducing uncertainty into the long-term picture. The bailouts did just that. Investors — and many more long-term investors than short-term — are asking: “How do I know who’s Too Big to Fail? How do I know when there’ll be a bailout and when nature will take its course?  What are the rules?”

In an atmosphere of uncertainty like this, with risk harder to quantify, long-term players become short-term players. Trading strategies will then fail more often. If several fail at once, automated high-frequency trading programs all start doing the same thing (buying or selling) and suddenly everyone’s over on the starboard side of the boat. Information cascade.

......tipping your boat over out on the Openwater.

Brilliant presentation of data using video...

...on a fascinating topic - finding natural human community boundaries.  Hat tip to Carpe Deim.

Conventional Wisdom and the Knowledge Problem

A friend sent me an email with photos of a horrible crash "caused" by texting/cell phone use.  You know the drill - a virtual finger wagging designed to intimidate or shock reprobates like me that continue to telephone while driving.  But is their finger wagging justified?  I decided to run some numbers and see.  Now what I've done is only rough and directional but my reasoning was as follows:  We've had massive increases in cellphone usage and texting so much so that it is commonplace to see people using their mobile device while driving.  So, if phoning and texting while driving is such a 'clear and present danger' its impact should show up in increased mayhem on our highways.  So I got the Natinal Highway Traffic Safety Administrations's data series on fatalities per 100 million miles driven and this is what it said:

Source:  NHTSA

Compare this gently declining line to the number of cell phone subscribers in the US.  Measuring subscribers probably understates growth in usage because minutes are rising faster than subscribers as people shift from landlines to mobile devices.  Nevertheless, we've seen at least a sixfold increase in cell phone usage at the same time as steadily declining traffic fatalities per mile driven.  Hmmm.

Source:  Census Bureau

But where the rubber meets the road so to speak is with texting:  it's all those darn kids texting while they drive that creates these outrageous risks.  So here are the texting trends:

Source:  Census Bureau
Double hmmm.  Since 1996 texting has gone from nothing to almost 120 billion messages in 2008.  Cell phone subscriptions have grown six-fold  yet highway fatalities are down 28% per mile driven in a period of time where speed limits increased from 55 to  65, 70, 75, even 80 MPH.  And the steepest declines in death rates have occurred in the last two years when texting added a net 100 billion messages a year.  (Oh, and these trends occurred before most if not all of the highly publicized 'bans').

So what's going on?  Well the simple answer is that people and societies just aren't that simple.  There was probably some improvement in car and roadway safety going on during this time and our population got slightly older and more affluent.  But neither of these trends are sufficient to overcome the horrific carnage that the finger waggers were telling us was happening every day because of cell phones and texting.   My theory is that people are intelligent and adaptive creatures - they know full well that their phone behavior impairs their driving attention and adapt their driving habits accordingly.  But I could be wrong.  Nobody who's honest with themselves really knows.

So why did I come up with such a different conclusion than the waggers?   First, I tested the overall claim of "cellphones increase traffic danger" against the macro data - a trend that demands laws and moral judgment should pretty dang easy to see in the data, shouldn't it?  And if it can't be detected then what's the big deal?  and Second, I didn't presume that I had "the" answer as to what the explanation was or even that there was an answer.  Things are complex, people adapt, we don't completely understand how human societies work - if we did we wouldn't have panics, wars and riots.

This is an important consideration when someone comes to you saying that they have "the" answer to a market opportunity or institutional challenge.  The odds are that they don't.  They may have a handle on a piece of the answer but it is highly unlikely that they understand how the solution will play out in a market filled with countless independent actors making their independent value judgements and responses.  Friedrich Hayek won a Nobel Prize for articulating this "knowledge" problem.  And it's a problem that bedevils anyone bringing a new solution or policy to market.  The more frame breaking the concept, the more creative the solution, the bigger an issue this is.  We just don't know what's going to happen.

This doesn't mean that new solutions are illegitimate or that innovation should be rejected, it simply means that the outcome of innovation or change is seldom predictable.  This rewards organizations and people who are good at sensing market needs, experimenting with new concepts and adapting to changing circumstances.  Indeed, it rewards those institutions organized around markets because markets incorporate everyone's perspective, everyone's knowledge.  Oh, and by the way:  the faster a market changes the bigger the advantage that innovators have because they are driving change rather than reacting to it.

So the next time someone comes to you with 'THE' answer, tell them that it's more complicated than that.  Out on the Openwater.

Stick to your line 2 - Or how do you determine Comparative Advantage?

Peter Drucker adapted Ricardo's theory of Comparative Advantage to the enterprise world.  He argued that organizations should sort out what they considered "Core" - in other words, what activities and capabilities constituted the basis for their differentiation, their competitive advantage.  Everything else or the 'periphery' in his parlance, Drucker said should be outsourced to organizations that in turn made that function their core.  That way peripheral or support services could continually be marked to market in quality, cost and delivery terms, unsheltered by the enterprises' indifference or ignorance.

This insight has been the foundation of the movement towards outsourcing.  Leveraging ubiquitous networks and technology tools, whole business functions have been shifted and entire new industries have arisen to exploit Ricardo’s insight.  But with the transformation has come a question:  is 'core' always core and 'peripheral' always peripheral?  How do changing market conditions and technologies change this assessment?

A pertinent example of this dilemma is storytelling, particularly video.  In the past video messaging was something done at great cost by focused experts who raised the concept of the 30 second advertising spot to a state of high 'art' with its own 'academy awards' and artistic nomenclature.  But with the rise of high speed networks and ubiquitous PDAs video storytelling (messaging, advertising, training) is becoming a much larger and more diverse part of the organization’s communications strategy.  In particular, enterprises selling ideas or knowledge are increasingly dependent on being able to share 'gifts' of stories, ideas, concepts or constructs with their target customers as a precondition for engaging in relationships with them.

This shift in the 'coreness' (forgive me Mr. Webster) of storytelling has led to two seemingly contradictory trends:  On the one hand some enterprises have begun to ‘insource’ parts of their messaging functions - the ability to tailor messages and deliver them inside their competitor's message cycle has become 'core'.  On the other hand, certain groups have begun organizing the tools and infrastructure so that the delivery of video and related content can be 'industrialized' and mass customized by industry vertical.  The key to both of these trends is the core content:  ideas and the ability to communicate them in a compelling manner are rare and valuable commodities and increasingly critical to success.  Big enterprises have the scale to buy or rent top talent, smaller players don't so they are looking for the leveraged solution.

By coincidence, Openwater Advisors just happens to have one: "Comunicato:  Relationship Leverage for a Visual Age" is our answer to the industrialization of the video world.  Working in partnership with Activated Marketing and The Knowledge Transfer Company, we are currently deploying the capability to create and mass customize compelling content by industry vertical - enabling individual knowledge providers to derive personal branding, personal leverage, viral referral and speed to message at a cost far below the existing 'cottage' industry's economics.  We don’t really expect to take business away from the thousands of ‘mom ‘n pop’ video shops out there, rather we plan to generate our own, new demand.  How?  by making it far cheaper and easier for knowledge providers like investment advisers, accountants and lawyers to deliver high quality video storytelling.

The incipient industrialization of a cottage industry:  a storm cloud on the horizon, out on the Openwater.

Stick to your line

We've had a lawnmower ever since I gave my son, Bubba Jr. the contract 4 years ago when he turned twelve.  This week the inevitable finally happened - it broke down.  Should we take it to the repair shop?  nope, too long.  Borrow the neighbors? nope, short term solution.  Buy a new one? stupid.  So with the grass at our knees and our backs against the wall I did what any leader would do:  I turned to my son and said:  "Fix it, Sam".  And despite having never attended a single small motors repair class, or having any help aside from the internet and his size 8 cranium (my skills in the area constitute techno-comedy) he rebuilt the carburetor and made it run as good as new.

That led me to reflect on conversations I've been having with a good friend.  He has a job leading a series of big market facing initiatives and he's not getting the support he needs from the back office technical and communications teams.  Frustrated and needing help, he was constantly being dragged into their meetings to solve problems to get the support he needed 'unstuck'.

This is the wrong approach.  My son solved the lawnmower problem because he had to.  While no expert, he's a technical whiz and he knew that I had faith in his ability to deliver.  I asked him to do something new but well within his capabilities and he did so.  The same is true for technical support of any kind:  it's a mistake to solve their problems for them - it infantilizes them - you get down in the weeds, it becomes your problem, your fault.

The right way to deal with technical delivery is to do your homework - define what outcomes you need, compare them to what competitors or other industries achieve and demand that your team meet or exceed that standard.  Then get out of the way and let them do it.  Either they'll succeed and so will you or they will tell you that they can't keep up - that's the time to either eliminate their legitimate roadblocks or find new support.

The key concept is Comparative Advantage, best articulated by David Ricardo in 19th century England:  while you may be able to do everything that your support team does better, it is best for you to focus on your best and highest use - the thing that the market values the most about you.  By doing so and demanding excellence from those that support you, you'll get the most out of your efforts.  Out on the Openwater.

Envisioning waste

What does it mean to 'waste' a million dollars?

A million dollars really isn't that much money so to waste it isn't a big deal, right?  Well it depends on how you think about it.  Imagine if you hired a person and paid them $40 an hour.  Their sole job responsibility would be four times an hour to take a crisp 20 dollar bill, cut it into small pieces and flush it down the toilet.  If they were paid to do that 24 hours a day, 365 days a year the combination of their wages and the flushing would equal roughly $1 million dollars.

Feels a little different now, doesn't it?

A little humor

Hat tip to Four Block World.

Human Tool Making

A creole is a pidgin language adopted by natives of a region in place or addition to their native language and incorporating many local words and phrases.  If it gets used enough, it can become a lingua franca:  Hindi/Urdu, Bahasa and Swahili are successful lingua francas (as is English, which I'm sure began life as a creole of Low German, with Latin and Celtic incursions).  Apparently Facebook doesn't support Arabic script so Arabic speakers utilize the Roman alphabet to write Arabic.  Technically not a creole or lingua franca, more of a compu-franca.  It's kinda cool.  Some obscenities on the site (they don't like a band that doesn't like Islam).

Of more interest to me is how people take tools and technologies and adapt them to their use.  I suspect that none of the users took a class in Roman-Arabic script translation or consulted Roman-Arabic script dictionaries to participate  (I think they exist).  They took a communications tool that had utility for them and made it their own.  This demonstrates just how effective mobile technology linked to ubiquitous web services can be as tools for change when coupled with the ever adaptable human mind.

Now if I only could decode nouveau Arabic written in Roman script phonetically back into Arabic script so I can use my Arabic dictionary to find out what the heck they are saying.  Out on the Openwater.