Book Cover

Today we begin the re-read of Thinking, Fast and Slow by Daniel Kahneman.  Not counting the endnotes, my copy has 448 pages and is comprised of an introduction, 39 chapters in five parts, and two appendices — if this were a blog the book would be approximately 41 separate entries, which is my current approach to the re-read (plus one week for a recap).  The chapters are, on average, relatively short, however, I am reticent to suggest out of the box that I will combine chapters during this re-read. Therefore, I am planning that this re-read to take 42 weeks. Kahneman’s writing, while engaging, is FULL over ideas that are useful for anyone that thinks of him or herself as a leader and change agent. As I noted last week, I will need your help calling out the parts of the book that resonates with you. If you do not have a favorite, dog-eared copy please buy a copy.  Use the links in this blog to books help to support the blog and its alter-ego, The Software Process and Measurement Cast. Buy a copy on Amazon. Now it is time to get reading!   (more…)

Prices

Prices

In classic economics, a price represents an equilibrium between supply and demand or value and scarcity. This suggests that there should be a close relationship between the estimate and the price. However, the difference between pricing and an estimate is the pricing strategy. Over the long term in commercial organizations the price must be equivalent to estimate plus a planned margin. In the short run for any specific account the relationship can be significantly more variable and nuanced. Pricing strategies work because IT sourcing markets are not perfect markets.

The classic equilibrium theory assumes absolutely free markets without barriers. Software development, operations or other IT staffing scenarios typically have several market imperfections (this is most true in the short run), which make pricing strategies effective. For example, a price to win strategy might be to price the work using lower margin (or negative) in order to get into an account, with price escalation in the longer term to get back to a planned margin. You can see this strategy in your local grocery store where prices are marked down to entice switching or stockpiling (stockpiling is useful to resist competitive pressures).

An estimate describes what sourcer thinks will be required to deliver the work, and therefore is an absolute based on what is known (and many times what is not known). The estimate is a step to a price, but only a step. The most basic formula would be:

 Price = Estimate * Planned Margin

The margin is a function of the pricing strategy. The equation could be enhanced (or complicated) by adding timeframes. In this model the estimate, unless new information is encountered (e.g. scope change, different resource costs, inaccuracies or process improvements), is a constant. That means that if the organization wants to change the price, they will need to change the expected margin or find other efficiencies. What should not happen is that a price change results in a command to change the estimate without some substantive rational.

In internal organizations, the relationship between an estimate and what is charged (charged back or applied to budget) is typically the same with the possible exception of an allocation of overhead. There is little need for an internal pricing strategy, as internal IT organizations are typically run as cost centers rather than as a business. In later articles we can discuss both the positive and mostly negative outcomes of this behavior.

In commercial IT (application development, support and operations), the price that ends up being charged or in the contract should be related to the estimate.  Related as modified by the pricing strategy being used to capture the business. Where there are market imperfections, such as high barriers to switching, that difference between the estimate and price is tilted toward the sourcer. Estimates are an input to the price, but only that – an input.