Sunday, October 09, 2011

Pricing Labour and/or Services

Prices are not absolute, they are only ever relative to a given point in time and set of circumstances, and therefore related costs are also relative. In Australia we have state and federal industrial awards which set minimum working conditions for various occupations, including minimum wages. These awards have embodied within them wage relativities which are typically sustained. It creates something of a new age aristocracy, with ranking being based on academic ranking and some groups perceived importance of the occupation. For an otherwise equitable society this is inappropriate. The flaw with such state or national ranking is that its says engineers for example are always worth more than tradespeople: such is nonsense.  Whilst people do get paid over the award rates and therefore there is scope for variability in the market, the occupational representatives will appeal to the industrial courts and commissions to have the relativities reinstated, that is adjust minimum wages in the awards to market rates to keep one occupation ranked higher than another. The nonsense with such scheme is that it is applied across industries and across the state and/or nation, when relativities should vary between businesses dependent on staff and line functions. An engineer in a consultancy has a line function and is more important to business operations than a carpenter who looks after the buildings. An engineer who works for a building company has a staff function and is less important than the carpenters who fullfill the line function. Staff can be terminated and contracted on an as needs basis, line personnel cannot be contracted on an as needs basis for they are the point and purpose of the organisation.

Giving consideration to a sole proprietor, if they contracted the line function, then effectively handing the work over to someone else who gets paid for the job, and so the  sole proprietor doesn't make anything except maybe a small commission for having the work to handover. However tend to get paid more for doing the work than simply attracting it and handing over to others, so if going to hand the work over to others to do, then need to find a lot more work to do. A modern trend in business is to do exactly that: find work and get others to do it. Some engineering consultancies for example have a small core of personnel, they tender for work, and once they have the contract they then seek out personnel who can actually do the work: that is they don't have the expertise nor the labour capacity in house. But this not really any different than other businesses, builders contract to build, but subcontract to drafters, engineers, carpenters, plumbers, electricians, concreter's: a sole proprietor builder with no personnel at all. So what price, what value the effort of those who distribute work, what commission should they be paid? Should there be an industrial award for such activity, and should there be an occupational title for those who carry out such activity? My feeling is no! The industrial awards whilst useful for new startups, otherwise tend to distort the market. It may be beneficial to set a minimum wage to impose a minimum standard of living, but even that is questionable.

Some 95% of all businesses are small business, and account for some 48% of employment: small business employs less than 20 people in non-manufacturing and less than 100 in manufacturing. Some 80% of Architects, Surveyors and Engineers practices are very small business employing less than 5 people. Whilst industrial awards are imposed on employers, they are not imposed on sole proprietors: some industries are dominated by sole practitioner businesses. There are many activities where by individuals consider that they get a greater share of the potential income if they work for themselves rather than as an employee. For whilst it is possible to be paid over the award rates as an employee, something has to happen in the market place before that will happen. Changes in the market may only affect a few businesses and/or employees. If the market does not provide the desired increase in wages for employees then pressure is applied to bring about changes to the awards. This can impose on all businesses to increase wages even though the individual business has experienced no increase in sales or increase in productivity. Potential exists for big business and/or their employees to manipulate the system to grab a greater share of the market, at the same time as award wages are increased beyond capacity of small employers. Small employers tend to retract to being sole practitioners again. Sole practitioners are not bound by industrial awards, only need to cover cost of living.

For a business enterprise, sole proprietor or otherwise, income is what ever they are able to get, there is no industrial award which sets minimum income levels. The industrial awards however do provide a basis for minimum costs to be covered by the income. Business however is a real world experiment, and just because industrial awards set minimum wages for employees, it does not mean that the business is capable of recovering such costs from its sales and operations. The sales which can be achieved at any point in time are uncertain, therefore total income generated is uncertain. Possibly more importantly is that not all costs are visible, tangible, measurable and allocatable. It is a matter of emergence or synergy: the whole is different than the sum of the parts. For example calculate the visibile costs, release a product to market and it only sells for less than the sum of costs. Release another product to market and it sells for significantly more than the sum of costs. Labour, mind and body, is no different than any other product: it can be bought and sold for what ever price the market is willing to support. Sole practitioners don't allow the industrial aristocracy dictate wages to them, they leave it to the market place to determine their income. For some who quit their stable jobs in hopes of making more money than the industrial awards grant them, this may be a bad move. For those who lost their jobs because of changes in the economy, "recessions we had to have", then owner/operator of a small business may represent income not otherwise available: less than the award but more than unemployment benefits. Cities may represent a different kind of environment than our ancient hunter/gatherer ancestors, but it is still a wilderness and a we are still fighting for survival. Cities, and modern technologies do not gaurantee comfort and luxuries, no matter how hard you work. Further more hard work does not give right to such things.

The basic guide for pricing labour as a owner/operator, is to divide desired income by the number of hours expect to work. Desired income has to cover minimum cost of living to survive, but can otherwise reflect desired lifestyle. The expected hours of work, can reflect the available hours willing to work, having spent time on other activities.Hence it is beneficial if can get paid to do what you like to do, spending as many hours as are able to do so.

Labour rate = Desired Income / Expected Hours of Work  [$/hour]

This only represents the cost of owner/operators labour to a project, also have to cover costs, and determine chargeout rate. For contractors, with little expenses, the typical guidelines reduce the expected hours to account for such things as: public holidays, sick days, vacations, and long service leave. This calculation is some what important to full time employees on industrial awards: for they get paid for more hours than they actually work. For example consider award wage group C14, last I looked $522.15/week, for a 38 hour week, and a 52 week year. Therefore annual income $27,151.80, for total of 38x52=1976 hours per year, leading to hourly rate of $13.74. But allowing some 47 days at 7.6 hrs/day, paid without work, that removes 357 hours, leaves only 1618 hours actually worked. Thus have to recover the costs of labour at rate of  $16.78/hour labour charged out, before additional expenses are added.

How to cover the additional expenses if not easy to directly allocate, or would otherwise cost more to track than the effort is worth. The simplest approach is to take expenses as a proportion of total revenue and otherwise assume zero profit.

P = R - E
if P = 0 then R = E

E = L + OH
Let OH = fR therefore E = L + fR

Therefore : R = L + fR

R = L / (1-f)

Where P= Profit, R=Revenue, E=Expense, OH=Over Heads, L=Labour, f=OH/R

The fraction 'f' may be available in industry surveys, from historical sales data if business already operating, or otherwise some reasonable number adopted, that is guessed. For example if f=0.4, then: R = 1.67L., and so the $16.78/hr becomes $27.97/hr.

Having calculated a labour rate, by the preceding method it doesn't mean that going to get any work. The hours for a project multiplied by the labour rate may produce a price that the market doesn't like: and note the potential customers in the market are not caluclating costs, they are just guessing or have a gut feeling about what they believe to be a fair and reasonable price. If the customer can do this, then so also can the supplier, at the end of the day the price is what both buyer and seller are willing to accept.

"The successful producer of an article sells it for more than it cost him to make, and that's profit. But the customer buys it only because it is worth more to him than he pays for it, and that's his profit. No one can long make a profit producing anything unless the customer makes a profit using it. " [Samuel B. Pettengill]

In the building industry many businesses over value what they sell, from builders, to manufacturers, to designers and engineers. There contribution to a project is low value and unimportant. Many engineers would find themselves unemployed if regulations which imposed their presence was removed. You don't pay an engineer $1000 to remove and save $1000 worth of concrete, better to have the resistance of the concrete than some scribble that says not required. Too many engineers seem to make the mistake that they protect public safety and stuff would be hazardous without an engineers presence: not so. They neither impart real cost savings nor achieve safety. The issue is that the safe economical system has already been provided by heritage, and therefore current batch of engineers contributing little. Part of the problem is the wage relativity nonsense of the industrial awards: choosing to be an engineer because expect to get paid more than trades person. Engineers are being produced because we can produce them, just like we can produce cars we don't need. Having produced them have to make up reasons to need them, to sell them, or create legislation to impose them. Having a degree does not give a person a right to a high salary, nor to public recognition. Far too many modern professional engineers are relying far too much on the contributions of ancestors to conclude the value and importance of engineers. Those ancestors however do not however have the skills to match the modern specification of professional engineer nor did they have the same attitude. Business requires that can generate revenue, society requires that contribute benefit. To gain recognition modern professionals who want the recognition have to do the contributing. Much of the technology provided is not all that important, and people since the dawn of industrial society have questioned its real value, and still question its value. The survival of populations in cities is dependent on water pumped into them: no power supply, then no operational pump and no water, and if no water then no people can be supported in the city. Finite resources consumed to support a growing population, with no real thought to the future. One possible future is population catastrophically wiped out as it runs out of power. Another possibility is that population will simply age and die out without replenishing itself, leaving a ghost city. The future is uncertain and business is trying to predict future income from todays actions. Rather than engineers complaining about their status, and their incomes, they should better understand the nature of business, the environment and uncertainty. Problem is too many engineers worked for the government in the past building infrastructure to herd the population: they consequently have something of a more dictatorial attitude towards the people and sense of own self importance. Such attitude not going to get them very far in the new modern world of privatisation. The businesses the engineers work for have to provide real value at the right time. The infrastructure that engineers provided whilst working for the government is not seen as a benefit by all: though the engineers see it as a benefit. In business, think you have a good idea then pursue at own expense, not the peoples expense. Then again, the business has to get the money for research, design and development from somewhere, and that somewhere is the customers who pay more than the cost of the product they buy. People don't so much object to profits, but to what the profits are used for. Profits used for expensive suites, expensive cars, expensive houses, holidays, world trips, expensive offices, and typically an expensive lifestyle are objected to most especially if the quality of the service provided is low.

So for example there is a lot of DIY because people can cost the materials, and have spare time in which they can do the work. Without getting into complications of comparitive labour rates and opportunity costs, the individuals simply perceive that the cost difference between supply price and material cost is too high, and therefore choose to DIY. So to get the work have to demonstrate the value in service supplied. Builders cannot get the work, drafters cannot get the work because of DIY, but engineering practitioners get the work because legislation imposes a need for calculations that most people cannot DIY. But cannot rely on such captive audience remaining: also having a captive audience diminishes the recognition get from such audience. It is therefore necessary to build real value, and demonstrate that value to potential customers. That is recognition from customers not the population.

Part of that added value is having the solution before the customer turns up. Things can be designed once and made many times, or if a service carried out many times. Car manufacturers build cars with features that the market hopefully wants. Whilst buildings are typically built to customer requirements, and are thus not available when the customer turns up. On the other hand established buildings dominate the available supply, but typically can only buy an established building if it is not in use. However there are market builders who have stock plans, the house isn't available when the customer shows up, but they do have a choice of designs to choose from. Design and engineering are additional costs, new buildings represent delays in supply, and they also have teething problems, all compared to an established building. An established building may however have problems that need resolving. The value of available supplies thus determines decisions made and directions taken. Such decisions are not necessarily taken using any direct costing, or cost-benefit or value-analysis. At the end of the day these are just sophisicated methods to justify a guess. Using such tools the parts maybe weighted and valued, but the sum of these parts doesn't represent the value of the whole. So the opinion relative to the whole is no worst nor better than that based on the sum of opinions relating to the parts. A guess is a guess no matter how sophisticated. In the modern world there are far too many mathematical models which are given unwarranted credence, and yet there is only garbage to feed into them and consequently only get garbage out off them.

Costing methods can be made increasingly complex as can pricing methods, but at the end of the day, acceptance in the market is left to personal opinion or subjective judgement. Business is an experiment, and getting the price right is part of that experiment. The business has to be dynamic, adaptive, and responsive to feedback from its operating environment.

Not suggesting avoid sophisticated costing and pricing methods, just that they have to be appropriate to the age and nature of a business activity. The older an activity, the mre likely all its associated costs can be determined including those intangibles such as allowance for future needs. Further it can be determined whether detailed tracking is required, and the level of detail required. Often tracking costs more than the benefit obtained.

Time Is Life, Time is Not Money!
One problem with the previous rate is that it gives rise to the believe that time is money, and the concept that some engineers have that they sell time. Hourly rates are problematic. Contractors are likely to drag a contract out so that they don't have to find another contract, and so get the most from one contract. One recommendation for calculating contract labour hire rate is to allow 20% loss of time looking for work. This gives rise to different recommended rates for short contracts and long term contracts. Lower hourly rates are charged for longer contracts. The acceptable labour rates determines how long can be spent looking for work, so that more than 20% may be possible: since also dependent on what it costs the individual whilst they look for work. Also don't have to look for work, can spend the time in other activities, such as developing solutions, so that have available when a customer turns up looking for. Got to change mindset away from the 9 to 5 work time mentality. The difference between working on the business, versus working in the business. Most people who give up their job and start a business, are still locked into the employee mentality: do the work that flows in and pay no attention to where it comes from or why? A few years later no work, no business and no income. Firefighters are paid to be on stand by, there can be no doing something else when on stand by, they have to be available for fighting fires. Part of being in business means being available, even if not doing any work, and so there is a cost associated with such availability. For example a cost of not doing any work this week, so that can start work next week: if choose to do work this week may have to spend many more weeks without work. Hourly rates therefore have to be increased to account for reduced hours actually working.

Another issue to consider with hourly rates is that not every hour worked is worth the same value. With extensive division of labour within an organisation lower value tasks are carried out by persons on lower pay rates. But even then not everything that these people do is worth the same value, however the average value of their work is less than the average value of someone elses typical work. By distributing work to a collection of people on different labour rates a lower over all fee for a job can be determined, compared to fee worked out on the basis of the cost of the top level skills required on the project. For example internal to an engineering consultancy an engineer gets paid more than a drafter, the bulk of the work tends to be drafting, and fees worked out with costs distributed between drafter and engineer. As sole practitioners however the fees of the engineer are too high, the work flows to the drafter who subcontracts the engineer on an as needs basis. Further more the engineer typically cannot relate well to the customer, so subcontracting to the drafter, is the wrong direction for the customer, even if preferred direction for the engineer. The engineer has to be doing the drafting work if to relate to the customer, and needs to be charging a lower fee for such work. Since such engineer is doing both drafting and engineering, their average rate is lower than those just doing engineering, but still higher than the drafter. The net fee however may still be too high, however there will be less delay compared to the engineer and drafter combination. So there is a premium for the faster delivery time.

Higher prices have either premiums or penalties incorporated. A premium because there is benefit to the customer, penalties because there is some disadvantage to the supplier. Higher prices do not mean higher value or increased quality. Prices are relative things.High prices may just mean that the supplier doesn't want to do the work. So having found someone who can supply at lower price is no loss or detriment to the supplier with the higher price: they achieved what they set out to do, not be hassled with such work. Its not always a race to drop fees and grab work. Often greater benefit in pushing fees up and pushing the work away, ultimately the price gets high enough that the work no longer seen as a hassle and the work is accepted.

Whilst a project fee may be worked out on the basis of an hourly rate and an estimated time duration to complete with possibly material costs included. The final fee is subject to the nature of the market and may need to be dropped, or it may be possible to increase it. It is not necessary to have calculated detail as to where the fee came from. It is only really necessary for the business to have an accumulative income which stays ahead of the accumulated expenses: not for the individual project. Some projects are a loss, others a gain, on average the business achieves a nett gain. There should be no drop in quality due to a loss on the project, the business still has the resources to do properly, the project is just not self funding, and there is no reason why all projects should be. The problem is owners who extract excessive profits from the business to fund exorbitant lifestyles. Profits have to be retained in the business to fund future uncertainties.

Projects which make a loss are indicating something about the market. Like we are tired of paying large fees to be told what we already know, so if such "service" must be imposed on us, please do so at lower fee. Which means figure out what is really required, what value it has and charge an appropriate fee for. When it comes to engineering there is a perception that it means supply calculations: which is a low quality service to provide. Relevant calculations can now be done by computer in a few seconds, a mere fraction of the time taken by engineers calculating by hand. Selling time thus becomes silly. Further it is what happens prior to and after the calculations that is important not the process of calculation itself, such calculation process is an hindrance and delay. These "fore" and "after" actions are where the value lies. So let other than engineers use the computer programs and play around with the models, it is better than them building the real things and having the real systems fail. They still need some one to validate and certify the final design and a fee to be charged for. The playing around with design concepts however is where it belongs in the hands of end-users and/or makers, getting familar with a concept and experimenting with its benefits and detriments, and otherwise checking the consequence of variations. Designers do not have to be qualified, they do not have to understand scientific laws, they can build prototypes and understand the real thing. If they can build computer based virtual prototypes then they can save time and possibly expense: they get to find out for themselves why some part of a proposal is a bad idea.

Point is things become established, and technologies change, so there is an expectation that supply prices change, and typically that means decrease. What engineers complaining about declining fees fail to understand is that the value of their contribution to projects has been steadily declining, as their output becomes more and more routine, predictable and expected because variants already exist in the technological environment. It may be possible to sell each car produced at similar price because each one takes similar effort to build. But this does not hold true for specifications of a car, or anything else. The first specifications take a great deal of time and effort to create, copying however is a considerably simpler and less time demanding activity. Even variants are less demanding than the original. Heritage diminishes value of future endeavours, it provides a foundation on which to build. So cannot expect to keep charging same price for design work. Experience both diminsihes and adds value. Experience adds value because know the answer now whilst someone else has to work it out. The cost of someone else working it out basically matches the cost of knowing the answer. But once all know the answer, the value starts to decline. So all this hourly rate, time is money, selling time stuff is misleading, as is having national industrial awards. Prices, labour rates, fees are all highly variable and uncertain. Start with something, anything, monitor feedback and then change accordingly. Small business, sole practitioners are typically better able to respond quickly to the market, than large businesses. Larger business more into controlling the market than responding to. There are no certain answers, just got to get good at experimenting and predicting the right response, the desired response from a complex system.