Understanding the price, cost and value of design

This is a true story.

A major university has both a business school and a design school, each one consistently ranked among the best in the country. At the business school, a professor was asked to address a group of visiting international students on the topic of general management. At the design school, an architect was invited to speak about critical success factors in real estate development. Both were former CEOs of major firms and well regarded in their respective fields. They spoke for the same amount of time (90 minutes) and each talk was well received by the respective audiences.

Much to his surprise, a few weeks later the business school professor opened his mail to find a check for $10,000 as an honorarium. The architect also received a check, but for a different amount ($150), which he donated to the school’s scholarship fund. Neither one knew in advance that compensation would be offered, so that had no effect on their topic, preparation or delivery. Taken at face value, the numbers suggest that the business professor’s lecture was worth a great deal more than the architect’s lecture (by a factor of 66.66, in fact).  

Does this sound “fair”? Actually, it is.

The chance to interact with top-level faculty is part of each school’s allure. Both sets of students paid a pre-determined amount to attend a select educational program, and the costs of the respective honoraria were factored into the tuition. The huge discrepancy in compensation was the result of applying different perceptions of value to essentially identical student/faculty experiences.  

In this context, it helps to remember that price, cost, and value are entirely different things. “Price” is what we agree to pay for specific goods or services, whereas “cost” is what it takes to produce those same goods and services. The difference between the two can be called value, or profit, or in certain cases “good will”. While we might suppose that there is a reasonable cause-and-effect relationship between cost and price, that is not necessarily the case, and “value” can depend as much upon perception as anything else. To complicate the mix, value can be measured in a variety of ways (hard currency being only one of them).

Some things which are exceedingly valuable are routinely given away at no cost. For example, nobody pays to use Google; it’s available for free to anyone with a laptop or a smart phone. Yet Google has invested (and continues to invest) hundreds of millions of dollars each year in creating new content and maintaining the website. How does this make business sense?

Google is not giving away its service out of altruism. In fact, the company is paid quite handsomely, though not directly by the users themselves. By building a site that attracts hundreds of millions of visitors each day, Google is able to collect extremely valuable data about consumer behavior. This data is what consumers “pay” for the privilege of using Google (even though it costs them nothing). In turn, Google’s huge user base attracts advertisers who are willing to fork over a great deal (this time in real cash) for the privilege of exposing their wares to a broader market (also known as the “eyeballs”). It’s a triangular transaction which benefits everyone involved. The same basic principle applies when we listen to the radio. We are not charged anything for hearing the music, but we “pay” with our time and attention when we listen to the ads.

Scale is a key ingredient of the value proposition. The ability to reach millions of potential consumers can justify what may seem to be outrageously excessive compensation. Consider the case of a professional baseball player who makes $10 million a year. He comes to bat 400 times in a season and thus will “earn” $25,000 for every at-bat (which lasts only a few minutes each). On a per-hour basis, the compensation would appear to be stratospheric. In addition, that same ballplayer might have an endorsement deal with a sneaker company that pays an equal amount for doing a few ads and making some personal appearances (which is much less strenuous than attempting to hit a big league curveball). The amount of money is the same in each case, but the performance parameters are entirely different. At the ballpark, it can be argued that just by showing up (whether or not he gets a hit) the ball player helps put extra fans in the seats, who in turn buy more hot dogs and Cokes. However, that revenue might well be dwarfed by profits from additional shoe sales. Who gets the better deal: the player, the ball club or the sneaker company? It all depends upon how you look at it.

What does all this have to do with the business of design? A great deal, as it turns out. Traditionally, the A/E/C industry has been relatively ineffective in articulating the basic value proposition that is inherent to the construction of buildings. In the aggregate, the market is huge. In fact, the U.S. economy spends more money annually on designing and constructing buildings that anything else except for healthcare. Even more importantly, the benefits of construction are long-term, as buildings routinely last 40-50 years and more. Buildings not only represent considerable investment in labor and materials, they are also the source of about 45 percent of total carbon emissions each year, and so the environmental implications are profound. It might be argued that the A/E/C industry has a 100 percent market share, in that every individual in the U.S. spends a considerable amount of time in buildings — a “customer base” of 300 million people. If the scope and scale of the industry are self-evident, then why it is so devilishly difficult to make financial sense out of it?

Once again, the answer is how you look at it. By and large, most clients view construction as a sunk cost, not a generator of value. The A/E/C industry is largely “disintermediated”, which means that it consists of thousands of small enterprises rather than a dozen or so big players, like the automobile industry. Real estate developers are acutely aware of the income streams that buildings can produce — they figure very prominently in the financial pro formas — but even they still tend to view design and construction as a commodity business, focusing much more on up-front cost than long-term value.

The key to changing this perception rests on logic and metrics. Viewed one way, investing in a building is very much like investing in a bond; you put money up front to reap the benefit of a long term income stream. In fact, some developers refer to buildings not as architecture but at “vertical product”. The economy has developed a sophisticated ways of assessing investment values in the bond market, enabling top bond traders on Wall St. to routinely earn millions of dollars each year. However, no such metrics have yet been developed for buildings. In fact, the financial aspects of buildings are judged by two simplistic criteria: how much they cost to construct in the first place and how much they sell for when ownership changes hands.

What’s missing is the most important metric of all: long term operations and maintenance (O&M) cost. Various studies indicate that over the total useful life of a building, O&M can dwarf initial capital cost by a factor of 10:1. Logic would suggest that during the design process, it would make a great deal of sense to pay attention not only to the traditional architectural issues of siting, form, massing, and materials selection, but also analysis of long-term O&M costs, since that’s where most of the owner’s dollars will actually go. Of course, the impact of O&M will increase in direct proportion to how long a given owner intends to hold the asset. A building will be worth far more to long-term owners such as universities, medical centers, and pension funds than to build-and-flip developers, and as a result, they will be incentivized to make different decisions.

Nothing prevents the A/E/C industry from including discussion of O&M costs when competing for work, but it’s not currently part of the lexicon. Educating owners about the true implications of their decision-making during design will go a long way toward changing the essential value propositions for all involved, including architects, engineers, and contractors.

While it’s doubtful that architects will be paid as much as bond traders any time soon, it is both feasible and responsible to justify higher professional fees as long as there are corresponding savings to owners of either capital cost or O&M cost. Digging a little deeper, architects can create additional value by maximizing allowable zoning square footage or generating higher utilization ratios. This in no way diminishes the importance of form, function, or aesthetics in the mix; it simply demonstrates the power of good design and provides useful ways of measuring what architects can bring to the table. This begs the question of whether or not the traditional system of compensation (fixed fees based on a percentage of the projected construction value) makes any sense in the new economy. For example, what would happen if an architect’s compensation was pegged instead to the number of occupants using the building each day? This has some parallels to the Google model.

“Process innovation” is also fertile territory for reconsidering the basic value proposition. On average, 30 percent of all projects do not meet either budget or schedule, which is an enormous tax on the industry and greatly contributes to the perception that buildings are primarily about cost rather than value. It’s clear that the traditional method of design/bid/build habitually exposes owners to change orders and schedule delays. Innovative new approaches like IPD, which are based on a fundamentally different way of doing business, including revised contracts, have been shown to save significant time and money while also increasing overall quality. As with most new ideas, the industry has been slow to adapt, but there is an increasing body of evidence suggesting that IPD (and variations thereof) can greatly improve outcomes for all concerned. If the rate of non-compliance for budget and schedule was reduced from 30 percent to 10 percent (or even better, eliminated altogether) how much would that be worth to a client?

In the aftermath of the recession, some traditional professions, such as law and medicine, are under intense pressure to change their cost structures and business models, and the A/E/C industry is no exception. There are also many examples of innovative business models from other industries that could be applied to A/E/C firms. Above all, it’s important to consider the question through the eyes of the person who actually pays the bill. What matters most? Nobody wants to be told that controlling time, cost, and quality are mutually exclusive. That’s not a winning sales pitch, and in that context complaints about low fees are unlikely to fall on sympathetic ears.

Value is essentially a win/win proposition; both sides must benefit. What are you worth to your clients? How do you know? What are the metrics that demonstrate your value? Addressing these questions head-on will open new doors for the entire A/E/C industry.