by Jacob Taylor
“That’s right,” he said. “It’s one of the underappreciated benefits of capitalism. Entrepreneurs end up giving away too much of the farm, to society’s benefit for periods of time.” It had never occurred to me that capitalism sometimes makes errors in that direction. I’d always assumed the little guy was cheated and systematically milked. Hmmm.
The game tipped off, the crowd roaring as the Shockers started with the ball. The teams went back and forth with intensity, but neither side getting much of advantage. Like two boxers feeling each other out in the early rounds. Eventually, there was a TV timeout. The crowd quieted down to conserve for later.
“Alright, time for our next insight,” Mr. X said, taking advantage of the lull. “What would you call the wedge between Cost and Price?”
“I assume price is the money coming into the business, which is revenue…” I said, happy to be able to use some of my B-school jargon. Mr. X nodded, so I continued, “And cost is expenses, so revenue minus expense is profit.” At least those were the terms I’d memorized.
“That’s correct, that triangle represents your profit,” he said, writing the word in that space.
”Every company has to eventually make a profit to stay in business,” he continued. “I’ll have a lot more to say about profit later. I’ve found that many captains of industry don’t fully understand its significance. This next one’s a little tougher. What’s the wedge formed between Price and Value?”
I smiled. We had recently covered something like this at school. “I think that would be called consumer surplus. Basically, it’s what the customer would have been willing to pay, but didn’t have to.”
“Technically speaking, you’re right,” he said. “But let’s avoid academic jargon.” Dang. “I like to think of that wedge as your brand.” He wrote the word in that triangle as he said, “That extra bit of surprise value that the customer feels they got compared to the price they paid. Think of it this way: there’s a piggybank in your customers’ minds. With every interaction, you’re either making a deposit or taking a withdrawal. The contents of the piggybank is a measurement of your brand. It exists as an abstraction scattered throughout your customers’ minds, so it’s all but impossible to measure. But that doesn’t mean it isn’t hugely important.”
After the timeout, the Shockers went cold, missing several open shots. The visitors took advantage and sprinted out to a sizeable lead. Mr. X told me that it was still early and he wasn’t worried. The Shockers’ coach signaled angrily for a timeout to refocus the team.
“In general,” Mr. X continued, “there are three ways to make the brand triangle bigger. Be the cheapest. Be the most convenient. Or be the best. Good companies aim for at least one of those objectives. Great companies find a way to achieve two. Doing all three is a rarity.”
I started going through a list of companies in my head and sure enough, they were at least one of those three. “Why am I not learning this in business school?!” I wondered out loud.
Mr. X just smiled knowingly. “So now we’ve got value, price, and cost. We have how they interact to create profit and brand,” he said, pointing to each. “This may surprise you, but we can describe an incredible variety of business situations by sliding these straws around. For instance, what if you’re in the steel industry and the product you sell is a commodity? Meaning the steel you make is identical to the steel everyone else makes. How would you move the straws?”
I thought quietly for a while before responding. Mr. X was happy to watch the game while I sat in contemplation. When it quieted down between plays, I said, “Well, I assume you wouldn’t have any control over the price. It will be whatever the world market price is for steel. I’d also imagine that the perceived value delivered isn’t too far above that price. Unless you could offer something special like just the right quantity or shape the customer wanted. You can’t be ‘the best’ when all the steel is the same, but maybe you could be the most convenient? Better financing terms, delivery, or billing options? I don’t know. Something to make the experience a little more enjoyable or easy. But you’re pretty limited on what you can do to bump up the value versus competitors. I’m sure they’re quick to copy you.”
“I’d agree,” Mr. X said. Although his eyes were still on the action, it sent my ego ticking up a notch to have him agree. He eventually looked back at me. “This situation describes more businesses than many CEOs care to admit. More businesses are providing a commodity than they realize. There’s a saying: In the long run, everything is a toaster. Meaning, it’s very hard to create and maintain a differentiated product for a long time. There’s simply too much competition vying to scratch our subjective human itches. It’s just a matter of time before you get disrupted.”
“You said many don’t realize they’re in a commodity business,” I said. “How would you know if you’re providing a differentiated product then?”
“The answer is surprisingly simple. You only have to answer yes to one question: If you wanted to, could you raise prices and not lose customers? If you can answer yes, you probably have a differentiated product. If the answer is no, you’re in a commodity business. It’s that simple. There’s nothing wrong with providing a commodity, by the way. You’re often keeping the wheels of the world turning. But it does change what you should focus on. Care to take a guess what I’m hinting at? It’s staring you plain in the face.”
I honed in on the straws, willing them to whisper to me an answer. There was only one lever we hadn’t addressed, so I ventured, “It must have something to do with cost since we haven’t moved that straw in a while.”
“You might be onto something...,” Mr. X said leadingly. We sat for a moment as I mulled it over. How can he be so close to Death’s door, and yet so damned patient?
“So are you saying that if you can’t raise the price, you should focus primarily on controlling costs?” I asked.
“That’s exactly what I’m saying,” he replied. “There are many commodity businesses that make a great profit because they are the lowest cost provider in their industry. They know they can’t do much to change value and price, so they become demons on lowering costs. It’s important to be strategic about where you are pressing your advantage. Take the Shockers-- they have a great offense. They space the floor well, move without the ball, and have terrific shooters. If they were a business, they’d be a differentiated product. Other teams focus on playing great defense. In business, defense is like being the lowest cost provider. It doesn’t mean you can completely abandon one in favor of the other, but you have to decide where to direct your focus. Does every player on your team know your strategy? I’ve talked to the Shockers’ coach, and it’s probably no surprise they primarily work on offensive drills in practice.”
Dots were connecting for me. “I think I finally understand the Warren Buffett quote that you sent earlier this week. You either have to be the lowest cost producer or build up a brand that lets you charge more if you want to earn higher returns.”
“That’s correct,” Mr. X said. “It always amazes me how Mr. Buffett can take a difficult concept and make it straightforward in so few words.” Might that be the very definition of wisdom?
The home team had chipped away at the lead. By halftime, they were only down eight points. Mr. X told me it was well within striking distance for the Shockers potent offense. We took advantage of the reduced noise to continue the lesson.
“What about Cootie Burger?” I asked. “It seems like hamburgers are a commodity business. You can get a pretty good burger at a lot of different places these days.”
“I’d agree, and because of that we are relentless with managing our costs. It’s our primary area of focus. But we also strive to differentiate ourselves with a great customer experience. Remember the train from London to Paris that we talked about last time? Never forget to account for your customer’s perception.”
“That adds a lot more texture to the saying, the customer is always right,’” I said.
“It does,” he said. “I’d modify that to say the customer’s experience is always right. We look for ways to lower our expenses, but we do think there are some costs we incur that move the Value straw enough to justify the resources. I have bad news for you: none of this is strictly black and white. It’s a spectrum with lots of gray and fuzzy measurement. But it helps to have a framework like this so you understand what you’re trying to accomplish in your business.”
“I have a question,” I said. “With all of the new technology coming out all the time, how do you know if what you plan on delivering to customers will even move their Value straw? How can you keep up in such a rapidly changing world?”
“It’s a fair question,” he replied. “The answer is, you never really know for sure. There’s a saying that no business plan survives first contact with the customer. And often, the customer can’t even articulate the value they’re feeling because it’s happening at deeply subconscious levels. We’re more like animals than we care to admit. There are a few clues though.”
“Like what?” I asked.
“First, remember that technology is just a tool to accomplish a human want or need. Read up on Maslow’s Hierarchy to see a nice organization of those desires. We have basic needs like food, shelter, clothing, connection, meaning, contribution. How we get our needs met will change based on the tools and technology of our time.”
“OK, what else?”
“Second, in general the longer we humans have been using a particular technology, the longer we are likely to continue using it in the future. There’s a persistence. It’s very likely that humans will be watching a basketball game on Mars someday, and they’ll still be sitting on chairs very much like these and using a fork to eat their food.” Ha, imagine all the technology required to set foot on another planet, yet you’d still use a chair and silverware to eat when you got there. What ever happened to the spork?
“I hope the Martian seats are a little more comfortable than these,” I said shifting around.
“True,” he said. “They make my back hurt. But you can’t beat the view.”
“You’re right,” I said. “I never realized how tall they all are in person. Seeing them on TV is misleading.”
“Their athleticism is remarkable,” he said. “And less than one percent of them will make it to the professional level. They’re here for the love of the game.”
The Shockers came out of halftime on fire. The crowd energy swelled to a fever pitch as they made their run. The ball movement was breaking down the defense and leading to easy scoring opportunities. Before the visitors knew it, they were the team down eight points. Mr. X was confident this would happen all along. He had said the ball movement would eventually wear down the defense, like a boxer working the body, and he was right.
My teacher rearranged the straws back to their original configuration. “What if you had a low cost, provided a lot of value, and could control your price? What some might call having market pricing power. Slide price around and see if anything jumps out at you.”
He went back to the game while I fumbled around with the straws. I slowly moved the Price straw back and forth between the Cost and Value straws. I noticed that the profit and brand wedges would grow or shrink depending on where the price was.
I caught a spark. “It looks like there’s a trade-off between profit and brand. When the Price straw is near the Cost straw, there isn’t much profit, but there’s a lot of brand.”
“When the Price straw is near the Value straw, there’s a lot of profit, but not much brand. So even if you have pricing power and it seems like you can charge whatever you want, you’re still making a tradeoff between profit and brand?”
“Very good,” Mr. X said. There was that odd glow inside again--why? “The more profit a company generates, the more attention they draw to themselves. Competition, government regulators, even customers who might start to suspect they might be getting overcharged. True monopolies try to downplay their dominance and avoid looking greedy. Like slow-playing a winning hand in poker.” Am I being paranoid, or was that a subtle hint that he knew my true motivations?
I stared at the straws, moving the price slowly back and forth in thought. “An analogy just hit me, Mr. X. I’ve always been fascinated by the human body. I probably should have been a doctor or something.”
“Probably not smart enough,” Mr. X teased me without turning away from the game.
“Probably not,” I said. “Anyway, the Price straw acting as a lever reminds me of the role of insulin in the body. This is oversimplified, but insulin is like a switch that tells the body to either burn fuel in your system now as glucose, or save that energy for later in the form of fat.”
“Keep going...,” Mr. X said.
“Well, depending on what you do with price, you create two options. You can decide to store the energy locally in the form of profits which are readily available to you, like glucose in your bloodstream. Or you can tuck the resource away as fat for later use in the minds of your customers as brand. It’s harder to get to and unlock when it’s stored as fat, but I imagine similar to the body, you can store a lot more value in your customers’ minds than you can on your own balance sheet. Looking at the crowd, there’s a lot of brand stored up around here,” I said.
My fat-shaming joke missed because Mr. X didn’t even crack a smile. He was deep in thought. “I’ve never thought of it that way,” he finally said. “But I like that analogy. You know, accountants have tried to get at measuring those fat stores. They call it goodwill. The accountants are pretty good at measuring company profits--the glucose in your analogy. That’s straightforward. Goodwill is harder. When one company buys another, the accountants add up the glucose, and anything in addition to that are marked as fat stores. The fat then gets added to the balance sheet under the title goodwill.”
“I remember goodwill from accounting classes, but it never made much sense to me. So if there hasn’t been a recent transaction, how do they measure goodwill? It could add up to almost anything, right?”
“That’s right,” he said. “It gets worse. The current accounting assumption is that for private companies, those fat stores decay slowly to zero over a period of ten years. They call it amortization. For public companies, they don’t assume decay, but every year you have to run some accounting procedures to see if your fat stores depleted. If the results say yes, you have to write them down as gone.”
“Forever, like liposuction?” I asked.
He chuckled, “Yes, but here’s a hypothetical: what if you’re eating at Cootie Burger and part of your subjective experience is due to feelings of nostalgia? Imagine you’re a parent eating a burger with your kids and the experience brought you back to a fond childhood memory of enjoying the same great food with your parents? Remember, it’s all about the customer’s subjective experience and stored memories. Unfortunately for accounting, that which is important, can’t always be measured.”
“I can see why that would be impossible to untangle,” I said. “How could you make rules that applied for every business situation? I almost feel sorry for the accountants.”
“Don’t, they bring a lot of the scorn upon themselves,” Mr. X said.
By this time, the Shockers were comfortably in the lead and the outcome was no longer in question. Both teams had subbed in their B-teams. The crowd cheered to celebrate as the other team waived the white flag.
“The game’s almost over,” Mr. X said. “Let’s discuss one more topic before you head back. Did you know that a company can actually grow out of business?”
“I must have misheard you. Did you say go or grow...?”
“Grow with an ‘r,’” he replied. “You’ll see it’s not that complicated. It has to do with cash flow. Think of cash as the oxygen of a business. During normal times when cash is plentiful, it’s easy to ignore and take for granted. But when it’s suddenly missing, it’s hard to think about much else.”
“I’ve h
eard the same thing said about sex…” I said.
“Me too,” Mr. X said. The old codger appreciated a dirty joke. “The way that cash moves around in a business is incredibly important. It’s probably the number one thing that trips up small business owners. They think to themselves, ‘I’m selling more everyday, why is there no money in the bank?’”
“That would be confusing,” I said.
“Here’s what’s going on,” he said. “You collect cash from your customers. You use cash to pay your vendors for inventory and your employees for their labor. Some businesses are able to collect cash from their customers very early, well before they have to make these other payments. So there’s always money in the bank to meet their expenses. These are generally easier businesses to run from a cash standpoint. The more you grow, the more cash builds up. Can you guess what a bad cash flow business looks like?”
“Sure,” I replied. “It’d be the opposite.”
“Right, you have to pay everyone before the customer pays you. As that kind of business grows, it requires more and more cash to keep things running. You have to fund the widening gap. And sometimes you never get paid by the customer while you’re still on the hook for all of the bills.”
“Does that happen?” I asked. Does the little guy ever get away with not paying?
“Occasionally,” he said. “You can see how you might grow your way right out of business and into bankruptcy. Especially if you had no way to borrow extra cash to make the timing work.”
“Are companies that require a lot of cash bad businesses then?” I asked.
“Cash flow requirements don’t make a business good or bad necessarily. Plenty of solid, profitable businesses have poor cash characteristics. You just have to know what kind of business you’re in so you don’t get surprised and caught short. It helps to be conservative. When people forget they’re in a bad cash business, the universe has a way of painfully reminding them.”