Derek Sivers

The Profit Zone - by Adrian Slywotzky

The Profit Zone - by Adrian Slywotzky

Go to the Amazon page for details and reviews.

Dryer but deeper prequel to the great “Art of Profitability” book, also recommended here. Start with that one. Only read this if that one fascinated you.

my notes

The number one problem in business today is profitability.
Where will you be allowed to make a profit in your industry?
Where is the profit zone today? Where will it be tomorrow?
The profit zone is the area of your economic neighborhood where you are allowed to earn a profit.
To reach and operate in the profit zone is the goal of every company.

Am I managing for market share, or for profit?
Is the market share I own profitable and alive, or is it profitless and dead?

Fast-growing industries such as PC manufacturing, consumer electronics, telecommunications, and software have each produced scores of terminally unprofitable companies.
By contrast, no-growth or low-growth industries have produced some of the most successful companies in the world.
Coca-Cola achieved significant value growth in the low-growth beverage industry, as did General Electric (GE) in a collection of low-growth manufacturing industries, and Swatch in the low-growth watchmaking industry.

Contenders to match price reductions or lose customers to a lower-priced competitor. It creates no-profit zones.

No-profit zones come in various forms.
- value chain (distribution in computing or the grocery segment in carbonated beverages)
- individual customers (Wal-Mart or other large, powerful buyers)
- entire business models (hub-and-spoke airlines)

The devout pursuit of market share may be the single greatest creator of no-profit zones in the economy.

The euphoria of being in a high-growth environment blocks out the reality that growth creates a much higher management challenge.

The curse of growth arises when a business grows by stretching its business design to serve customers that the business design was not intended to serve.

Activities that were once valuable turn profitless.
Value migrates toward activities that are more important to customers - activities where profit is possible.

Start with the profit question (“Where will I be allowed to make a profit?”) and work your way back.

1. What’s most important to the customer?
2. Where can we make a profit?
3. How can we gain market share in that space?

Expand your repertoire of strategic and tactical moves.

If the business is to succeed, it must be designed in such a way that its key elements are aligned with customers’ most important priorities. It must be designed for profitability.

A more extensive repertoire of value capture mechanisms than they ever have before: financing, ancillary products, solutions, downstream participation in the value chain, value sharing, licensing,

Which customers I choose depends on which customers will allow me to make a profit.

Great business design is a combination of superb knowledge about customers and profit (“You can’t intuit the facts”), together with great strategic imagination.
The reinventors’ unique skill is strategic creativity: constantly reversing traditional assumptions, developing new options, and making more inspired choices.

Must be reinvented as customers’ needs and priorities change and as value migrates away from the industry’s traditional business designs.
Just as products become technologically obsolete, business designs become economically obsolete.
Over time, because of the competitive nature of business, most business designs are no longer allowed to make a profit.

Lew Platt, CEO of Hewlett-Packard, has an invaluable perspective on reinventing: “The single biggest problem in business is staying with your previously successful business model one year too long.”

Where is the profit?
In yesterday’s world, the answer was: with the player who has the highest market share.
In today’s world, the answer is: with the player who has the best business model, a model designed for customer relevance and high profitability.

To create a strategic and dynamic perspective on the customer, one must have a clear and compelling point of view on one question:
Exactly how is the customer changing?
Write this question down. It is your single most powerful management weapon.

When companies succeed, a company’s center of gravity moves.

A company focused on itself - its internal budgets, internal resource concerns, and internal politics - will have a great deal of difficulty with customer-centric thinking.

Spend most of your time outside with customers. Don’t spend your time with customers who like you.
Seek out the customers who are the most demanding, the angriest, and the most insightful about tomorrow.
Don’t go into these customer dialogues asking yourself, “What do I need to know?”
Ask the right questions, such as: “What am I afraid to find out?”

Customer priorities are the things that are so important to customers that they will pay a premium for them or, when they can’t get them, they will switch suppliers.

Decipher what customer priorities are being ignored (a clear link to the words in the left-hand column in Exhibit 2.4).
• Invent a new business design that responds to those priorities.
• Create a new profit zone with extraordinarily high profitability.

Rigorous creativity to reach the silent needs.

Business book publishers, for example, must understand booksellers, and corporations that buy books, and the individual readers within those companies.
Hotel managers must understand travel agents, and corporations that have offsite meetings, and the human resources people who organize the corporate offsites, and the people at the company that will be attending the offsite.
Expanding the customer field of vision is critical.

Given three or four potential customers, who is the mose important?
On whom should a business design be most sharply focused?

If a skill is relevant to the customer and is not currently offered, the company must develop it, or hire it, or acquire it, or license it, or find a business partner who will provide it.

Don’t make another major investment until you have satisfied yourself that the company knows exactly how it will make money and what tactical actions will be required to do so consistently.

IBM, GM, Sears, Kodak, US Steel, United Airlines. The actual list is quite long. Market share leaders? Yes. Profitable? No.




############# CUSTOMER DEVELOPMENT/ CUSTOMER SOLUTIONS PROFIT

Invest heavily to understand their customers’ economics and find ways to make them more favorable.
Reach the profit zone by first probing how their customers buy and use their products and then finding ways - beyond merely selling the products - to help the customers in the difficult, expensive, or time-consuming areas of their process.
Customer selection and front-end-loaded customer investment were the means of creating customer continuity, which was the key driver of profit.
Other successful firms that have applied the discipline of the customer development model include Nordstrom, the United States Auto Association (USAA), Intuit, Northwestern Life, and Leo Burnett, all of which have achieved significantly higher customer continuity than their competitors



############# PRODUCT PYRAMID PROFIT

Customer preferences of style, color, price, and so on, are of utmost importance.
The variations in customer income and preferences make it possible to build product pyramids.
They exist in markets as diverse as watchmaking, automotive sales, and credit cards.

The profit is concentrated at the top of the product pyramid.

Build a “firewall” brand at the bottom of the pyramid: a strong, low-priced brand that is produced at a profit, however slim.
The purpose of this brand is to deter competitor entry, thereby protecting the enormous profit margins at the top of the pyramid.

When a firewall brand isn’t built, competitors have the opportunity to come in at the bottom and then work their way toward the top, where the profits are.
Witness the history of the U.S. automotive market from 1965 to 1995. Japanese competitors first occupied the base with cars designed to be profitable, even at low price levels. They then moved up (Honda’s Acura, Toyota’s Lexus, Nissan’s Infiniti) to where the higher profits were.



############# MULTICOMPONENT SYSTEM PROFIT

Failure to maximize participation in the highest-profit components depresses the profitability of the entire system. On the other hand, full participation in the less profitable components is required to win the market for the most profitable components.

Grocery, 2 cents per ounce; fountain, 4 cents per ounce; vending, 6 cents

In coffee, the components are grocery, cafés, and kiosks.
Grocery is low margin, cafés are high margin, and kiosks are even higher still
Procter & Gamble, Nestlé, and General Foods play against each other in grocery and break even.
Starbuck’s plays in cafés and kiosks and enjoys extraordinary returns.

Multicomponent profit models apply to industries as diverse as
beverages (the profit is in fountain and vending)
hotels (the base business has low margins, the corporate meeting business is highly profitable)
bookstores (the bookstore itself is asset-intensive, low margin; the institutional business from corporations, book clubs, and other sources is high profit, low asset intensity.




############# SWITCHBOARD PROFIT

Multiple sellers communicating to multiple buyers.
High transaction costs are incurred by both.
Often, there is an opportunity to create a high-value intermediary that concentrates these multiple communication pathways through one point, or one channel, by creating a “switchboard.”
The switchboard reduces the costs (both financial expenditures and personal aggravation) of both buyers and sellers, in exchange for a fee to the switchboard operator.
Examples include Schwab’s OneSource, Softbank’s combination of trade publications and trade shows, and Auto-by-Tel.
It builds on itself.



############# TIME PROFIT

Innovator to generate excess returns before imitators begin to erode margins.



############# BLOCKBUSTER PROFIT

Essential for pharmaceutical companies, publishers, film studios, music companies, and software firms, which have large R&D and launch costs, and finite product cycles.
When the cost to develop a new product is fixed (and, usually, high) and marginal costs of manufacturing after development are low, the best way to maximize profits is to improve the chances that the product will achieve very high volume levels.
With these economics, it is better to be the dominant leader in a few products than to support average positions in many products.



############# PROFIT MULTIPLIER MODEL

Reaps gains, over and over again, from the same product, character, trademark, capability, or service.
The best example of a profit multiplier model is Disney. Think about how many different ways Disney packages the same characters. Mickey, Minnie, Hercules, et al. appear in movies, videos, and books; on clothes, watches, and lunch boxes; at theme parks.
Once the investment (often, huge) in creating a brand has been made, the creator may give the brand license across a broad array of products.



############# ENTREPRENEURIAL PROFIT

Many determinants of profitability are economic. Some are organizational.

Customer relevance declines, and the expense structure grows.
The company is vulnerable to entrepreneurs who are in direct contact with customers or proactively solicit feedback, and who remain frugal because they have no cushion of affordability to support unnecessary expenses.
These twin forces of direct customer contact and extreme frugality create the potential for enormous profitability.

ABB has broken itself down into 5,000 profit centers that have direct customer contact and direct profit responsibility.
Softbank has divided itself into profit centers of as few as ten people, again with direct customer contact, and with a five-day cash flow metric.

Upside motivation. The managers of the spin-outs own stock in the spin-out company.

Entrepreneurs hate to compete against Thermo Electron. They’d much rather compete against a larger, slower, more insulated player. It is easier to compete against employees than against owners.



############# SPECIALIZATION PROFIT

Sequenced specialization can be extraordinarily profitable.
Electronic Data Systems (EDS), for example, grew through sequenced specialization:
Mastering the intricacies and economics of computer solutions for many vertical segments (health care, insurance, manufacturing, banking), but doing so sequentially, not simultaneously.
In each vertical segment, EDS establishes expertise that is unmatched.



############# INSTALLED BASE PROFIT

Supplier creates an extensive installed base of users, who then buy the supplier’s brand of consumables or follow-on products.

Microsoft’s strategy was to price low, set the standard, achieve ubiquity, and then harvest the profits from upgrade/revision revenue.


################# LOCAL LEADERSHIP PROFIT
Starbuck’s conquered Seattle first, then Chicago, then Vancouver.
Starbuck’s understood that its economics were local - logistics, word of mouth, recruiting.
It exploited those economies to grow profitably, not just grow.


################# TRANSACTION SCALE PROFIT
Transaction scale businesses reward those who control the largest transactions.
Customer selection - investing in those customers with the largest deals - is key.
In these businesses - typified by investment banking, real estate, commercial lending, long-distance haulage, long-distance travel, etc. - costs do not rise as rapidly as fees as a function of transaction size.
Two equal market shares - one composed of a hundred small deals, the other of five or six big ones - will not produce equivalent levels of profitability. The latter will be several times more profitable than the former.
The costs incurred by Morgan Stanley to manage a $100 million financing were not dramatically greater than the costs of a $5 million financing.


############# LOW COST BY DESIGN:
You can trump cumulative experience with a low-cost business design, which makes the incumbent’s cumulative experience irrelevant.
Nucor did this in steel (the minimill model trumped the integrated mill)
Southwest Air, in air travel (the point-to-point model trumped hub-and-spoke)
Dell, in computing (direct marketing trumped a feet-on-the-street sales force and multilevel distribution channels).
The player focused on building cumulative experience to gain lowest cost is always vulnerable to the player who creates a low-cost position through design.

==================

A lack of frugality was accepted as the norm in her company. “We’re not very careful about our dollars,” she said. “We stay in the best hotels, the annual sales meeting is in a fancy Florida resort, we eat well, we don’t buy our airline tickets far enough in advance to save on the fare. We’ve come to think that this is how it’s meant to be.” She described the very human, organizational consequences of several years of corporate life in the land of illusion, the land of the “perpetual profit zone.” Once formed, these organizational habits are extremely hard to break. As the profit zone moves, they can prove fatal.

Wal-Mart employees double up in budget hotels when they travel.

Profitability is a game of inches.

Transition to efficient company was effective.
It drove return on sales up from a negative 4 percent to a positive 6 percent and kept it there.
The same psychology could have been created 5 years earlier, but, until the crunch came, it wasn’t pursued.

1. Who are the most profitable customers?
2. Within that group, which customers have the highest profit growth potential?
3. What mix and level of investments are needed to meet those customers’ needs efficiently and enable profit growth to occur?
In many companies, this profitability analysis has revealed that 10 to 15 percent of the customer base is unprofitable, consisting of buyers who absorb the company’s resources and do not provide a return.

Strategic control points:
brand
patent
copyright
2-year product development lead
20 percent cost advantage
control of distribution
control of supply
owning customer information flow
a unique organizational culture
value chain control.
Each control point is designed to keep a company in the profit zone and to prevent competitors from stealing away the profitability.

Every good business design has at least one strategic control point. The best business designs have two or more.
Intel, for example, has a 2-year lead, value chain control, and a brand.
Coca-Cola has a brand, a low-cost logistics system, value chain management, and a string of superdominant positions.

In value migration, customers move from A to B, and the profit zone moves from A to B with them.
The incumbent stays at A. The newcomer builds a business design to go to B.

This value shift has occurred often:
from IBM to Microsoft and Intel
USX to Nucor
United Airlines to Southwest Air
Computer-vision to Parametric Technology
Folgers to Starbuck’s
Kmart to Wal-Mart.

Reinventing the business design by using customer-centric and profit-centric principles has great rewards. Customers return. Profits grow. Employee morale rebounds.

Reinvention is about the customer and profitability, but ultimately it is about creativity, about designing a business model that is unique. Perhaps the most important benefit of studying any reinventors and how they discover or create the profit zone in their industries is grasping how the creative process works in business (how business designs change every 5 years), what discipline (in customer and profit thinking) it requires, and how extraordinary its outcomes can be.

Business design innovation drives financial improvement, which drives increased valuation, which drives value growth.

Business design innovation requires major nonincremental moves. Making such moves inevitably leads to major errors.

Management is trying to perfect yesterday’s business design.
The opportunity has passed them by, yet they believe that if they can only get a little bigger or do a little better, they can still win.
They are fighting yesterday’s war.
The battle meanwhile has moved on to an opportunity space redefined by new customer priorities.

Be on the lookout for what the next metrics revolution will be.

Understanding the fundamentals of business design innovation is perhaps the best preparation for an uncertain future.

Move your company into the profit zone. The process involves addressing a sequence of twelve questions:
1. Who are my customers?
2. How are their priorities changing?
3. Who should be my customer?
4. How can I add value to the customer?
5. How can I become the customer’s first choice?
6. What is my profit model?
7. What is my current business design?
8. Who are my real competitors?
9. What is my toughest competitors’ business design?
10. What is my next business design?
11. What is my strategic control point?
12. What is my company worth?


******* 1. WHO ARE MY CUSTOMERS?

Identifying customers really means being able to categorize them into distinct groups whose behavior can be analyzed accurately.

try to segment your customers into different groups - for instance, by behavior or by priority.

Coke’s Major Customer Groups 1. Consumers 2. Fountain and Vending Customers 3. Anchor Bottlers 4. National Chains

Understand their priorities.

Deciphering the priorities that are guiding your customers’ behavior.

Name three products or services in your industry that have become popular over the past 2 years.
Why did customers like them?
What were the underlying reasons for the products’ value?
Did they save money?
Reduce hassle?
Offer security?

Repeat the above exercise but substitute an unrelated market or industry where your customers are actively engaged.
What preferences do they express in that market?

To discover what your customers’ silent or unspoken priorities are is to consider the entire economic system in which your customers operate.

Imagine yourself as the CEO of each of your five most important customers (or as a head of household in your five most important demographic groups).
What would your overall objectives be?
What major concerns would you have?
How could a supplier help you toward your goals?
How is the supplier currently hindering you?


******* 2. HOW ARE THEIR PRIORITIES CHANGING?

Changing customer priorities in the coffee industry (a priority shift away from price to quality, leading to a shift from grocery retail brands to specialty coffee stores) allowed Starbuck’s to prosper.

Look at the other industries where your customers operate.
Do you see any trends that may soon appear in your market?
If customers are trying to save time in one of those areas, aren’t they likely to value saved time in yours?
What advantages can you introduce now, or in the near future, to anticipate your customers’ preferences or needs?


******* 3. WHO Should BE MY CUSTOMER?

Are there new groups who would value what you do?
Can you jump a step along the value chain and serve your customers’ customers?
Can you step in the other direction and become a supplier to other companies like your own?

Innovative customer selection was critical to value creation for each of the reinventors.

Roberto Goizueta realized that Coca-Cola had always thought of consumers as its target customers, when, in fact, bottlers were the buyers of Coca-Cola’s syrup and controlled the commercial availability of Coke beverages. He reoriented the company to see bottlers as the key customers in the system and began organizational reform that led to Coca-Cola’s low-cost distribution system.


******* 4. HOW CAN I ADD VALUE TO THE CUSTOMER?

A business earns no profit when customers are willing to pay only the total cost of a product.
Each company must ask itself: “What special benef it of our product will compel customers to pay us a premium?”
The answer will always say, in some form: “Customers will pay us a premium if we meet their priorities, which are X, Y, and Z.”

Which priorities are your competitors satisfying?
Which priorities might you be able to serve better than your competitors can?
Which priorities might you satisfy at a lower cost than your competitorsare charging?
How large a premium will your customers pay to have each of their priorities met?
Which set of priorities can you serve simultaneously in order to provide the most value for your customers?


******* 5. HOW CAN I BECOME THE CUSTOMER’S FIRST CHOICE?

Who is your most important customer?
What are that customer’s top three priorities?
How do you score?
How does your best competitor score?


******* 6. WHAT IS MY PROFIT MODEL?

A business design that adds value to the customer but is not designed to create high profitability is an incomplete - and in many cases, a fatally defective - business design.

Do any of these models apply to your business?
Does more than one apply?
Which ones?

How does high profit happen in my business?
Who is the most profitable company in my business, and why?

Is there a picture that captures how profitability works in your business?
Can you sketch it?
What is on the X-axis? Time? Scale?
How do the different pieces of your business relate to one another?

Does everybody in my organization understand our profit model?
Does the organization align its actions to create the conditions that will achieve high profitability?
Do we make decisions and allocate resources based on this understanding?


******* 7. WHAT IS MY CURRENT BUSINESS DESIGN?

A company’s business design is composed of four strategic elements:
(1) customer selection
(2) value capture
(3) strategic control
(4) scope

The table below profiles these four strategic dimensions of business design.

In the following chart, what options are relevant for your company?

Examples of business design options:
Customer Selection All segments Segment 1 Segment 2 Downstream customers
Value capture Revenue per unit Licensing fees Service revenue Solutions revenue
Strategic Control Brand Low Cost 2-year lead Customer relationship
Scope Broad line Narrow line Fully integrated Virtual


******* 8. WHO ARE MY Real COMPETITORS?

your true competitors are any companies that share your customers and/or your scope. Your competitors may be in industries that are different from yours. They may provide a completely different set of products and services.

What companies are not competitors yet, but could be in the next year or two?

******* 9. WHAT ARE MY TOUGHEST COMPETITORS’ BUSINESS DESIGNS?

******* 10. WHAT IS MY Next BUSINESS DESIGN?

A business design that is well aligned with customers’ priorities will be in a state of value inflow

******* 11. WHAT IS MY STRATEGIC CONTROL POINT?

Strategic control points:
brand
patent
copyright
2-year product development lead
20 percent cost advantage
control of distribution
control of supply
owning customer information flow
a unique organizational culture
value chain control
and others.
Each one is designed to keep a company in the profit zone and to prevent others from stealing away the profitability.

Review the strategic control point index shown in Exhibit 3.4, repeated here.
Where would your company be situated on a strategic control point index?
Where would your competitors be placed?
What can you do to increase your company’s strategic control index?
How would your profitability increase if you increased your degree of strategic control?

******* 12. WHAT IS MY COMPANY WORTH?

What is my profit model?
What is my strategic control point or points?
These are two of the most important questions in business today.
They determine how profitable we will be, and how long that profitability might last.