Notes – The Art Of Profitability (#profitability, #business)

Notes – The Art Of Profitability (#profitability, #business)

Notes from The Art of Profitability, by Adrian Slywotzky

Chapter 1, Customer Solution Profit

The Customer Solution Profit (CSP) model encapsulates the idea of understanding the customers problems and then providing them with a solution to their problems.

In the narrow sense, the CSP model captures the idea of having an intense, personal and detailed understanding of the challenges a customer faces and then providing them with a unique, custom-tailored solution that meets their needs. Such a relationship requires upfront investment of time and resources from both parties (the business and the customer) and it entails high switching costs because finding a competing business who can offer that same level of personalized service would require the loss of previous investments made in the existing relationship. This helps to create a “moat” around a CSP model business. Some examples of a narrow-CSP business would be a software solutions firm (a company producing custom back-end software that an operating company runs off of), a consultancy business, the professional relationship of a trusted lawyer or doctor, or a manufacturer of custom fabrications. The recent rise of information analytics engendered in data mining through web browsing activity also represents a form of narrow-CSP business modeling– think about the way Google can track your browsing habits to serve up targeted ads, or the way Amazon tracks your browsing and purchasing history to suggest items you may be interested in purchasing from them.

In the broad sense, the CSP model actually applies to ALL businesses. Every business seeks to create customers, and the way businesses create customers is by finding problems customers have that the business can solve. In Chapter 1, the guru David Zhao asks the protagonist, Steve, “Can you be profitable without knowing the customer?” It’s possible to think of semantic games you could play to answer this question in the positive, and surely there are some businesses which know their customers better than others, but in a general sense the answer is clearly “No.” To provide someone with a solution, you have to know them enough to know their problem.

The context of this question is partly related to Chapter 1’s exploration of the company Steve works for, Delmore, which by Steve’s judgment is a business which has seen growth in the past but seems to be stumbling and may even be heading for a downfall. Steve believes Delmore has lost its way and is not focused on serving the customer. Zhao’s question resonates even more in this regard because Delmore’s management seems more focused on administering the business rather than knowing its customers. In the present, Delmore still appears to be profitable (though much less profitable than its heyday), which seems to suggest that even a company that doesn’t know its customer can be profitable. But the implication of Zhao’s questioning is that over the long-run, Delmore will not be profitable if it can not find a way to focus on understanding its customers better.

Another idea explored in Chapter 1 is the role of company culture. Zhao talks about consulting for a company after learning the secret sauce of their competitor. He says he hand delivered the total solution to the business he was advising and they only ended up implementing part of it– they saw a pick-up in their business as a result, but it was not as dramatic as it could have been if they had implemented his ideas wholesale. Why, Steve asks, do some businesses behave this way?

To succeed in business you need to have a genuine, honest-to-goodness interest in profitability.

This suggests that differences in margin structure and net profitability for companies in the same industry could come down to the “profit culture” of the business, likely established by the original founders and permutated by succeeding hires and executives. They could have the “technology” or strategic know-how to earn a profit, but simply be disinclined to work hard enough or with a unified purpose or without the ego necessary to fully capture the opportunity available to them. This idea also introduces additional context for why much M&A activity rarely seems to bring the “synergy” promised by combining two companies into one– if they have wildly disparate cultures, getting the same performance out of the new company as was available in the two separate companies may be impossible, and cultures may clash so wildly that the overall profitability is in fact harmed by corporate unification.

The subtext to the entire chapter on Customer Solution Profit models is that to really understand the value of a business, you must look at what customer problems the business solves, and how. By studying what is unique about the customer solutions the business offers, you are able to have a better analytical window into the durability of its competitive position, the source of its profitability and profit potential, its opportunities for growth and the stability of its margin structure.

Chapter 2, Pyramid Profit

The Pyramid Profit model consists of multiple quality and price tiers for products, targeted at multiple types of customers (and customer preference), which creates two powerful dynamics for the business:

  1. Protects them from competition from market entrants below (commodity market)
  2. Creates profitable “customer migration” opportunities as loyal customers move up the steps of the pyramid (franchise market)

Why is this model so powerful?

As guru David Zhao teaches,

Your pyramid has to be more than just a collection of different products at different price points. A true pyramid is a system in which the lower-priced products are manufactured and sold with so much efficiency that it’s virtually impossible for a competitor to steal market share by underpricing you. That’s why I call the lowest tier of the pyramid the firewall. But the most important factor is the nature of your customer set. The customers themselves form a hierarchy, with different expectations and different attitudes toward price.

The competitive environment all businesses would prefer to have is that of a franchise, where their product is deemed uniquely valuable and essential such that the business can capture a franchise premium in its margin structure, a premium which is enduring and protected from competition over time by the proverbial “moat.”

Simultaneously, the competitive environment all businesses fear is that of a commodity market, where the only way to distinguish your product from someone else’s and incite the customer to buy is by offering the lowest price. It is a true race to the bottom and the turnover for businesses in commodity markets can be quite high.

As discussed in Clayton Christensen’s classic, The Innovator’s Dilemma, most innovators arrive in a market as low-cost entrants. Incumbent firms see no problem in giving the low-margin business dregs to them as they’re happy to play in the higher-margin markets upstream. The hungry commodity firms are constantly looking above them at the juicy margins available in this other market– can they apply their innovative, low-cost practices to this higher-margin space and move in for the kill? As Christensen details, so often they try and succeed.

This is the genius of the Pyramid Profit model. Incumbent firms are protected from innovative, low-cost competition by offering a low-to-no margin product that creates a competitive “firewall” at the most vulnerable place in the market, the violently dynamic commodity space. Then, they are free to play in the middle and higher margin markets without stress.

There is an additional benefit, as well. By capturing new customers even at the low-margin end of the market, the firm is able to increase customer loyalty and brand familiarity over the customer’s lifecycle. Over time. these (presumably) younger, poorer customers turn into older, richer customers following the circumstances of life.

The value of a Pyramid Profit model depends on the shape of the pyramid. A pyramid with a wide base and a narrow top is relatively inefficient and less valuable as most of the business volume is captured in the low/no-margin mass market whereas the high-margin premium market remains under-promoted. An ideal shape would resemble something more like a skyscraper tower– the same width for all tiers, all the way up, with enough segmentation via price/quality tier to progressively move customers up the pyramid at a rapid pace. The more business that is concentrated at the upper levels of the pyramid, the better the margins and the more profit the firm can earn.

The Pyramid Profit model can be found in many well known businesses, even though it is a rarer circumstance than that of the Customer Solution Profit model discussed in chapter 1. A good example is the automobile industry with its “economy” and “premium” brands (for example, Honda and Acura, or Chevy and Cadillac). Even within each brand, many manufacturers have managed to create a “pyramid” of quality, price and even features/capabilities (for example, Honda has the LX base model, EX, EX with leather and EX-L with navigation; it also has the Civic for the entry buyer, the Accord for the more sophisticated, the Odyssey for the family buyer, etc.). Another example would be the airline industry, such as Virgin Atlantic’s “Economy”, “Premium Economy” and “First Class” seating and service tiers. However, no airline seems to have created separate brands/carriers that focus on one tier of the pyramid over another, instead this segmentation always occurs per aircraft (contrast this to a “single class” carrier such as JetBlue or Southwest Airlines, though notice that even these firms have begun to offer new passenger tiers for additional money such as early boarding, extra luggage capacity, etc.)

Speaking of the auto industry again, one of the most prodigious Pyramid Profit employers has been Toyota. Toyota offers three brands in the United States: Scion, Toyota and Lexus. Scion was a brand developed specifically for the young car buyer, initially offering lower price points, simpler model choices and a “no bargaining” purchase experience that was supposed to capture a first-time buyer and put them into the “Toyota system” for the rest of their automobile-buying lives. Then, there was the mass market, multi-trimmed and multi-segmented Toyota brand, offering cars, vans, SUVs and light trucks to the everyman. And finally, there was Lexus, the flagship brand for wealthy, older, image-conscious and highly-demanding customers.

Toyota’s pyramid is awkwardly shaped, however. It’s base, Scion, is miniscule and definitely low/no-margin. The middle step is enormous and fairly profitable relative to the rest of the industry. And the top is much wider than one would expect it to be, being both relatively high-volume for a luxury market and quite profitable despite ongoing margin erosion in the industry overall. Indeed, Lexus auto dealership franchises are consistently one of the most valuable and sought-after brands in the industry alongside BMW and Audi, commanding high market multiples reflective of their premium value.

The key to a successful and highly profitable pyramid is twofold. First, you must be lucky enough to operate in a market that is conducive to segmentation of customers (especially self-segmentation). Second, you must know your customers well– the Customer Solution Profit at work again! The better you understand your customers and their specific needs, the better you will be able to create custom quality and pricing tiers in your pyramid that will meet their subjective needs.

Chapter 3, Multi-Component Profit

The central idea to the Multi-Component Profit is “same product, several businesses,” in contrast to the Pyramid Profit which targets distinct customer sets with distinct product offerings (differentiated in terms of quality and price). The example given in the book is Coca-Cola, which may be offered at several prices in several different venues ranging from a 6-pack at a gas station to a 2-liter bottle at the grocery store to a glass at a restaurant. The price per unit is different in each case,  meaning variable margin structure, but the customer is captured nonetheless at each consumption opportunity.

While each of these margin structures and business opportunities combine to average out to one margin for the controlling firm, Coca-Cola, each product represents a unique business opportunity from the standpoint of marketing and advertising, competitive dynamics and ultimately, profitability. And this is where the secret of the Multi-Component Profit lies– just as an entire economy can benefit from the division of labor by breaking large tasks into smaller ones that individuals can specialize in, an individual firm can benefit from identifying ways to segment its large business into several smaller, distinct components, managing each one uniquely.

How is this possible? If the price of a firm’s good is set at one price regardless of the volume, and marketed in a uniform way, the firm can miss opportunities to sell their product to a.) people who don’t see value in marketing not aimed at their needs and tastes and b.) people who would be willing to buy the product at a different price and in different quantities than how it is normally offered. By catering to these preferences as distinct markets, the business is able to offer optimum combinations of price and quantity that meet each markets needs better, thus increasing total volume and profit.

Another example of a Multi-Component Profit model at work would be a software operating system company, such as Microsoft, which has different business units for Business/Enterprise, Government/Education and Retail and Wholesale channels. Each user buys a different amount of software licenses and pays a different price for them. This would also be a principle at work in a computer manufacturer’s business, such as Dell (same business lines), or a networking component company like Cisco.

Would an oil producer qualify, such as Exxon Mobil? An oil producer actually produces a number of slightly differentiated products depending on source and quality of the oil sold (West Texas Intermediate, Brent, etc.) which would seem to put it more into a Pyramid Profit model, though even that relationship is tenuous because oil is a nearly ideal commodity product in the sense that it is hard to create a “firewall” product as well as to move customers up a pyramid structure, especially with the fact that oil tends to trade at a uniform price across world markets no matter where it is produced (if it is of the same type). An oil firm probably does not give significant discounts to “different customers” based on quantity ordered, either.

Similarly, an oil refiner would seem to be a Multi-Component Profit model with its different kinds of refined products marketed in different ways (kerosene for lamps, or kerosene for jet engines) but again, these markets are so commoditized and regularized across world markets that it is hard to imagine these businesses creating separate marketing and pricing initiatives for differing customer demand, instead just dumping their product into various wholesale markets that then re-sell the products to end users (though perhaps these businesses are in the Multi-Component Profit model).

Over time if I think of other examples, which there undoubtedly are, I’ll post them but for now I will close out these notes with this summary from the book’s protagonist:

Different parts of a business can have wildly different profitability. The customer behaves very differently on different purchase occasions. Different degrees of price sensitivity.

The value of this lesson, as the book’s guru says, is that constant innovation is a key ingredient to maintaining and growing the profitability of any business, and one way to innovate is to find ways to break your existing business into smaller and smaller components which can be separately managed with unique marketing, growth and profit trajectories.

Chapter 4, Switchboard Profit

The Switchboard Profit model combines three essential elements to generate outstanding profit:

  1. Packaging; the provision of necessary component resources for a task in one place/package that can be hired together instead of separately
  2. Monopolization; control of a critical resource that all users need to hire
  3. Market share; control of a critical mass of the total market (approximately 15-20% minimum in practice) which gives the perception of dominance and incentivizes economic actors to utilize the switchboard firm, thereby creating a multiplicative network effect that enhances the value of the switchboard with every additional increase in market share

Those are the essential ingredients. The way they work together to create outstanding profit opportunities is like so: limiting competition and reducing transaction costs. Those are the primary principles at work. By putting together various resources which would normally be hired separately (and thus, would be exchanged each in their own competitive markets), the Switchboard Profit model brings these resources under one roof where they can be hired together (packaging), where they can be hired no place else (monopolization) and where other similar resources, typically skilled labor, are thus attracted to because they see the probability of being hired at advantageous rates themselves to be much higher by participating in the network effect of the Switchboard Profit model firm (market share).

The result is a constrained supply which can negotiate for a higher total hire price. It is valuable for those hiring the products of the Switchboard Profit model firm to pay this higher price because they save on search costs and they also face the alternative option of hiring lower quality substitutes. The more that the resources in question come under the control of the Switchboard Profit model firm, the greater profit the firm can generate from being the central hub for hiring the resource out.

One company that sounds like a Switchboard Profit model on its face is Amazon, a logistics giant that aggregates numerous consumer goods in one place. This satisfies the packaging criteria, and it almost satisfies the market share criteria as suppliers of goods want to participate in Amazon’s marketplace because it can increase their market exposure and thus the chance that the product will be purchased. But Amazon does not maintain anything close to a monopoly on these goods because they’re widely available “commodities” rather than unique or limited supply products carried only by Amazon.

The example given in the book was the Hollywood talent agency of Michael Ovitz. Ovitz combined top star power with “total production resources” (writers, actors, directors, etc., all in one place) and he commanded a large share of the market such that additional writers, actors, directors, etc., had a strong incentive to join his firm and thus increase his profitability as his market share grew. An obvious additional example would be any other large, dominant talent agency such as for sports stars, musicians or other celebrities who each represent unique products that can be easily “controlled” and “constrained” by one firm.

The network effect seems to be a key aspect to the profitability of the Switchboard Profit model. Google’s dominance in search means it is largely the central hub by which people conduct their internet searches, meaning a person buying ad space in the Google network is getting a better package deal than other search network ad buyers.

A television network might also qualify as a Switchboard Profit model: if you have the best shows on TV and a large market share with all the kinds of shows in one place that people might want to watch, advertisers will be more attracted to you and so will TV show producers and so, too, will TV viewers. And the more people who utilize your TV network, the more valuable it is to everyone involved.

Other examples might include a health insurance network which includes top medical professionals under the insurance plan; a legal association with the best legal minds in a market in one place; or even a top university or research institution known to have the brightest minds.

Something interesting about the Switchboard Profit model is that most of these businesses seem to revolve around human resources, rather than non-human resources (commodities which are common or rare alike).

Chapter 5, Time Profit

Many of guru David Zhao’s profit models come with simple illustrations which capture the essential ingredient of the profit model. The image of the Time Profit model is an X-Y axis with “$/unit” on the Y-axis and “time” on the X-axis. Plotted across this chart is one line, which runs from the top left corner toward the bottom right corner at a 45-degree angle reading “Price”, and another line below that labeled “Cost” at a more mild angle, eventually intersecting with the “Price” line near the right side of the chart and then overtaking it.

The concept is simple: Time Profit is generated by being the first to market a new product or service because over time imitators will compete and eventually drive price toward cost. Time, therefore, is of the essence.

In TAOP, Zhao and Steve discuss Time Profit models in the context of firms without special legal protections (such as patents or copyrights) on their works which serve to shield them from competition. However, whether such legal protections are permanent or limited in duration, the Time Profit model principle is the same– only by being first to market would you even be afforded such legal protections in the first place, so there is an incentive to be first else you finish last.

Zhao and Steve discuss the Time Profit model within the context of an investment bank constantly innovating with new financial products. But this model could also easily apply to pharmaceutical and software development companies (which enjoy legal protections on their products), as well as a tech product manufacturer, such as a smartphone manufacturer, whose core product features are likely not subject to legal protections. Here, the Time Profit model is essential as the first firm to get a product to market with a valuable innovation that creates a consumer craze can capture a premium for their products while competing firms figure out how to duplicate this technology and make it standard in their follow-up product offerings. These “second place” firms are doomed to earn commodity returns on their products, only the first-mover gets to enjoy a profit premium.

Like the Customer Solution Profit model, the Time Profit model is more than just a specific business model, it is something of an essential feature to the competitive conditions of any firm in any industry facing innovative development which, practically speaking, is all firms in all industries. Whether a new product, a new service or a new internal or customer-facing process, all businesses seek to adopt one another’s best practices to save costs and increase profitability. The first firm to innovate something that is eventually imitable by others gets a profit advantage during the period of time between innovation and imitation by others. Time Profit models can be thought of as temporary competitive advantages due to periodic innovation.

As David Zhao teaches, a key component of the Time Profit model that is often overlooked is the role diligence in the innovative process plays:

Tedium is the single greatest challenge for a business that’s built on innovation

The first act of innovation is thinking, the arriving at of a brilliant new idea. The second act, and far more important, is the doing, the translation of an innovative idea into an innovative product, service or process. This part requires the same rigmarole of standard business practice: making phone calls, sending emails, training people, holding meetings, crunching numbers, keeping people on task and pulling in the same direction, etc.

Innovating, idea-making, is sexy and fun. But turning innovative ideas into real profit is often boring, common and time-consuming. The people and firms that are able to apply energy and determination to this part of the process are the ones who can most consistently capture the Time Profit. As innovator Paul Cook says, “What separates the winners and losers in innovation is who can master the drudgery.”

Ancillary Notes

Chapter 5 had a few other points worth mentioning, some of which were connected to carryover discussions from earlier chapters.

The first point concerns the power of critical numerical thinking. When working through a number problem, Zhao advises,

Getting the order of magnitude right is what matters, not the details

This is similar to Buffett and Munger’s “approximately right versus precisely wrong” dictum. Zhao also talks about using the numbers to ask and answer critical questions; the numbers of business (assumptions, projections, actual results, etc.) can tell us a story, but we have to be curious about the numbers. It’s not enough to wonder, “Why are the numbers what they are?” we have to be able to put forth some effort to attempt to answer such questions ourselves. As Zhao says,

Being able to take the measure of the world is one of the most crucial skills we can develop

The second point, which is arrived at in a discussion of business innovation, is the “paradox” Zhao observes in the semiconductor industry, which is that the firms involved “copy each other’s chips, but not each other’s business models.” It is the business model which is responsible for mastering the Time Profit concept and other models discussed in TAOP– why don’t more managements focus on copying successful business models rather than imitating successful products and services?

It brings to mind a question for potential investors, too. Which businesses could see their value dramatically improved by focusing the company’s efforts on copying the leading business model in the industry rather than engaging in the rat race of perpetual product innovation/imitation?

The final point has to do with the nature of learning. Steve the student asks Zhao for a copy of his notes from a previous meeting. Steve wants to see how Zhao solved a problem they both worked on. Zhao suggests,

you’ve got to learn how to solve these problems in your own way

the idea being that true knowledge means being able to solve a problem in your own way, not by imitating somebody else. This is why some firms are innovators while the rest are imitators. Innovators are capable of solving problems their own way; imitators just copy the innovator’s solution. But it’s a lesson that’s important to the budding business analyst, as well. How will you solve problems when there is no guru there to teach you? You have to find your own path and do your own thinking.

Until you can do that, though, as Steve says, copying a few “Picassos” to practice a known master technique can be helpful.

 

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