This post was motivated by a recent social meeting where my friend and I talked about the management consulting industry. Both of us are University of Chicago MBAs, and as such, I think it is fair to characterize that we believe in the notion of mostly efficient markets, i.e., where buyers and sellers reach fair prices for doing business in aggregate.
Now there are a number of examples in behaviorial finance, economics, and finance areas where puzzles exist and where free market theories do not seem to hold. For example, there is the equity premium puzzle, which tries to address why required rates of return for equity securities is so high relative to risk-free rates of government bonds. There is also the closed end fund puzzle. In this case, it is perplexing why funds comprised of individual stocks trade (when the fund is closed) at a deep discount of the total sum value of the stocks. It seems as there would be close to a riskless opportunity (called an arbitrage opportunity) for someone clever to buy up the entire fund and then sell each of the shares of stock for a profit (even net of transaction costs).
So here’s why I called this post the "Management Consulting Premium Puzzle". My friend basically questioned why management consultants should be able to charge so much money for their services over the cost of using existing employees (to put this in some perspective, average annual billings for the larger consulting firms can go anywhere from $400,000 to over $1 million per year per consultant). Even though I am a management consultant (now freelance), I didn’t take this as a shot at me. I have worked in both camps numerous times, and I can see valid arguments by both operating managers and consultants as to why or why not consultants should have high premiums.
Part of it comes through calibrating the value of management consultants (as I’ve posted before), but there is another way to look at this. Consider some typical questions operating company managers raise:
- is there value to having a third-party facilitator (the management consultant) that is apolitical?
- is there value to outsourcing this vs. insourcing?
- is there value to having a consultant that has seen other businesses?
- is there value to having a specialist consultant?
- is there value to having extra bandwidth to get over a hump?
- is there value to having a high-caliber resource for a temporary period?
- is there value to having a well-known brand consulting firm involved (e.g., no one got fired for hiring McKinsey or IBM)?
My gut feel is that the answer to at least five of these questions must be yes for a company to feel very comfortable in using an outside consultant. Therein lies the reason for the premium.
What would be an interesting study, however, would be to run a statistical analysis that regresses the $ cost of using either internal employees or outside consultants against the factors above (although the factors above are not entirely orthogonal). By doing this, one could get a more scientific idea about which factors clients weigh most and how much those factors contribute to the value proposition (in terms of $, how much value is attributed to the brand, etc.).
Steve Shu
Managing Director, S4 Management Group