What's value?
Value is the key to profit. Understanding value can tell you a lot about how to generate greater profits in any business.
Profit is the difference between your costs and the price you get for something – anything – in the marketplace. A good way to think about this is:
Price
– Cost =
Profit
This means that great profits always come from a good understanding of your costs and pricing, but that can be much more difficult than it sounds.
Profit can be thought of in a lot of different ways, but it's important to understand the role that profit plays in capitalist societies to really get a handle on the thing. The purpose of profit – in a free market – is to attract people and investment to activities that are valuable to others. Period. This means that most businesses that have issues with profitability are most likely having issues with one of the following items:
1) Pricing
2) Getting customers
3) Controlling cost
4) Creating value.
Many people in business get hung up on the concept of controlling cost, and cost is given far more attention than it describes. The reality in most industries is that cost, while usually important, is not the MOST important factor in the customer's buying decision. The reason people tend to focus on cost cutting is that it's easy. This is exactly the wrong sort of thing to do if you want to make insane profits.
The secret of insane profits
As you may have guessed from the previous paragraph, insane profits are simply a matter of creating huge value for a group of customers who have money to spend. By the way, that last bit about having money to spend is really important. I know people who have built grand schemes of enterprise around customers who basically have little or no money to spend, only to fail because the money just is not there. Remember what Willie Sutton said when asked why they rob banks:
"Because that's where the money is"
Creating value can be simple and easy, or it can be difficult. Many people can do simple and easy value creation, while very few will do difficult or complicated value creation. The difficult stuff will almost always make you more profit, if you understand how to charge for it. This is really important to you because you need to be aware of the effects of competition. Consider this question: What is a glass of water worth? If you are sitting at home or in your office right now, a glass of water probably is not worth all that much to you. Maybe a nickel, on the outside. Why? Because you can easily walk over to a faucet and, for less than a nickel, fill a glass with water without spending a lot of time or having a lot of knowledge about water. Let's consider, on the other hand, what that water would be worth to you if you were in a plane crash in the desert. The alternative would not be there, and the need for water definitely would be there. If I were standing next to you with the only glass of water for 100 miles, you'd put a much higher value on that glass of water. This leads to an important concept about value:
Your available alternatives define value
In other words, where there is an easily available substitute for anything – goods or services – most customers will value them about the same. This is one reason why banks tend to offer very similar interest rates and airlines tend to offer very similar fares. If you do not see a difference between two options, why would you pay more for one than another?
This is exactly where competition comes in. When you do something easy that creates value, a competitor can do the very same thing – and may do it for a nickel less just to get the customer. The limit to most competitors' willingness to cut price is almost always defined by cost. This means that most competitors will cut their prices to take customers away from you up to the point where they start losing money on the deal. Of course, if you look at this another way they are giving up their profits for customers, but most competitors in most industries will actually do this, thinking that volume sales will somehow make up for the loss. The reality of this situation can easily be understood by considering a lemonade stand.
Let's say you run a lemonade stand and you are using lemonade mix, glasses and a whole bunch of other stuff that puts your cost per glass of lemonade at 20 cents. You decide you will charge 50 cents a glass for your fine lemonade, so you have a profit picture that looks like this:
Price = $ 0.50
-Cost = $ 0.20
Profit = $ 0.30
When we look at any enterprise with more than one sale, we have to add up all of the sales and all of the costs to get a total profit picture. A good way to think about this is:
Sales = Units X Price
For lemonade, the "unit" is a glass of lemonade, so:
Sales = Glasses of lemonade X Price
Let's say that there are 100 customers who buy lemonade every day in this neighborhood. Yeah, my neighborhood was never that good when I was a kid, but we are pretending so work with me on this. This means that your total profit picture looks like this:
Sales = $ 50.00
-Cost = $ 20.00
Profit = $ 30.00
Let's say one day Evil Egbert sets up a stand right next to yours. Let's assume that you have the same costs – you both run to the corner store and buy lemonade mix that ends up costing you about 20 cents per serving. When you open your lemonade stand, your profit picture may look like this:
Price = $ 0.50
-Cost = $ 0.20
Profit = $ 0.30
Now, of course, Egbert, being a competitor, is evil and can not hide the thought of you making money. So Egbert decides to steal your customers by lowering his price. Customers, being who they are, will sometimes switch for a lower price – but some will not. Let's say Egbert decides is happy with this profit picture:
Price = $ 0.40
-Cost = $ 0.20
Profit = $ 0.20
You will almost certainly lose some customers to Egbert over this. And who can blame them? The customer is getting exactly the same lemonade for 10 cents less – what a bargain! Now here is where the real world gets tricky: some customers will not switch, and will prefer to buy from you. Why? I've given up trying to understand, but it's absolutely true. Some people, given the choice, will still pay more for something than the lowest price available. Perhaps they like your eyes. Or they just can not be bothered to go the extra 5 steps over to Evil Egbert's stand. Who cares? You keep those customers even though you have a higher price. Sound good? It is. All other things being equal, most of the customers will buy from Evil Egbert, let's say he gets 80 of them. You, due to your charm, witty sales banter, and excellent location, still hang on to 20 customers. This means that your total profit picture looks like this:
Sales = $ 10.00
– Cost = $ 4.00
Profit = $ 6.00
While Egbert's total profit picture looks like this:
Sales = $ 32.00
-Cost = $ 16.00
Profit = $ 16.00
As you can see, Egbert is making more money than you are. Since evil never wins, you want to get some of those customers back. You cut your price to 40 cents, just to match Egbert. What happens? Very likely, you and Evil Egbert end up splitting the market right down the middle, with 50 customers each. This leaves both of you with a profit picture that looks like this:
Sales = $ 20.00
-Cost = $ 10.00
Profit = $ 10.00
Think about what has happened here. Once you started, you were making $ 30.00 a day selling lemonade. Egbert came in and cut your profits to $ 6.00 a day – so he could make $ 16.00 a day. And when you matched his price, you both ended up making $ 10.00 a day. In this example, the total profit that ALL lemonade sellers in your neighborhood made went from $ 30.00 (when it was you alone), to $ 22.00 (when Evil Egbert came in a cut prices) and finally to $ 20.00 (when you were both priced the same And had $ 10.00 of profit each). The lemonade did not change, and the customers did not change, so what ate up that profit?
Competition Eats Profit.
A. Creating Value
One of the most important elements of profitability is value creation. If you go to a grocery store and buy something from that store (say a box of dog trees), you will not be able to stand outside the store and sell the box of dog treats for more than you paid for it. This is simply because the box of dog beats sold just outside the store is not worth much more or less than the same box inside the store. In one sense, this is because you are competing with the store by selling the same products that the store sells in a nearby location. But, more basically, you simply have not created any value. To the customer, your box of dog trips is worth no more nor less than the one in the store. You can only get most customers to buy your dog trips for more than they would pay in the store if you add value in some way. Here are some things that might add value to your dog trips:
You take them out of the box and feed them to the dog
You improve them by sprinkling sugar on them
You put them in a different box that looks nicer
You make the customer feel good about buying from you
You give the customer a hug for buying from you
You sing while selling the dog treats
Hopefully, you get the idea. You can improve the product, change the packaging, or do anything you like to improve the customer's total buying experience – any of these things will add value. Perhaps not a ton of value – maybe only a nickel or two per treat. But if you sell enough trips, this can certainly add up. And you will certainly have a better ability to make money on whatever you sell than your competitors.
B. Achieving Uniqueness
The competitive situation we described earlier with Evil Egbert is not all that unusual. Unless you are doing something that no competitor is able to copy, you will have some competition, even if it is not particularly good competition. How can you get your profit picture looking like you do not have any competitors again? The key is finding some way to be unique. Ideally, you want to find a uniqueness that is considered valuable by some of your customers, but even simple strangeness and oddity can count for something – just look at the success of Ben & Jerry's or the Rainforest Café. In a vanilla world, people will pay a little extra for chocolate. Remember, though – if your uniqueness works, and gets you profitable business, your competitors will probably try to copy it, sooner or later.
One key to maintaining the competitive edge that uniqueness brings is to make it very difficult for competitors to copy you. There are several ways to do this. Competitors will fail at copying when one of four things happens:
1. They are unable to copy your uniqueness
2. They choose not to copy your uniqueness
3. They are invented from copying your uniqueness
4. The competitor copies you weakly because they fail to focus
Let's look at the keys to maintaining uniqueness in the light of these four factors.
1. Competitors will be able to copy distinguishing characteristics that are extremely difficult, or that require skills that can not easily be acquired. To use this factor, choose distinctions that require know-how that you possess and your competitors do not.
2. To convince a competitor to do anything is extremely difficult. To prevent competitors from choosing to copy your distinction, you may want to choose a distinction that is particularly unattractive. For example, any distinction that increases costs, or violates conventional wisdom about how people make money in your industry might be passed over by your competition because it is "impractical". I've worked with companies who have made millions by targeting the least attractive customers in their markets simply because their competitors did not want to sit down and figure out why no one wanted those customers.
3. There are only a few ways to actually prevent a competitor from copying you, and most of them require legal and / or government intervention. A good example of this is patent protection, which is certainly a viable method for maintaining uniqueness. Unfortunately, most of these approaches have a finite life span, so you had best being increasing your uniqueness in some other form while you have the protection of the government. If you do not, you will find that reliance upon legal protection can be a debilitating addiction – and cold turkey withdrawal is often fatal.
4. The focus advantage is unquestionably one of the simplest and easiest tools available to the smaller company. It is particularly useful when you are competitive with a much larger company. If you choose to focus on a specific market that is much larger than your larger competitor, you will likely become the preferred supplier for that niche. The downside of this approach is that you will become less successful outside of your focus area – but you should be able to reap much higher profitability as a result of focusing your efforts on meeting the needs of a specific type of customer. Many smaller companies avoid this approach because they feel it limits their ability to grow – but the exact opposite is usually true. In insurance, for example, we have seen companies make excellent profits and achieve superb growth by focusing on a market that is less than 5% of the market their competitors have targeted.
Conclusion
Understanding how uniqueness leads to profit is a great way to differentiate your company and attain higher than average profitability in your business. Too many people treat profit as a simple, black-and-white item that can only be tackled in predictable, copyable ways such as cost cutting. With a little care, you can set your business apart and really put your company in a position that yields long-term advantage in the marketplace.
Copyright 2007 by Center for Simplified Strategic Planning, Inc., Ann Arbor, Michigan – Reprint permission granted with full attribution.