The Business Cycle

Stage 1: Entrepreneurs experiment and take risks to make things to satisfy customers.

Stage 2: When they discover something the consumer values — aka value proposition– the experiment turns into a going-concern, or a business, and the business becomes self-funding.

Stage 3: If that value proposition is strong enough, the going-concern grows and comes to generate a safe and steady income stream.

Stage 4: Eventually, the safe and steady income stream attracts bureaucrats who use it to satisfy their own desires to boss people around and self-importance.

The focus of the going concern shifts from satisfying consumers to satisfying bureaucrats.

Stage 5: And not just the bureaucrats that take residence in the corporate offices. Outside bureaucrats will come seeking to hook up their bureaucratic organizations to the safe and steady business streams generated by those successful customer value propositions.  These bureaucrats will come from government at all levels, non-profits, foundations, consulting groups, lobbying groups, industry associations, employer organizations, unions, education, self-governing bodies, franchise owners and regulatory agencies.

Stage 6: Fortunately, competition is there to continue to find ways to satisfy customers. And when they do so, they have an advantage to the organizations that are satisfying bureaucracies. Remember, a start-up need only satisfy customers. Big, successful businesses must satisfy its bureaucracies, often which is a higher priority to satisfying the customer, no matter what the bureaucrats in-charge pay lip service to the customer.

Stage 4: But, if competition is successful, it too will attract bureaucrats.

A company that has suffered deterioration in its attention to value proposition, sometimes is able to attract turnaround entrepreneurs and refocus on the customer. However, many of the outside bureaucracies will stay interested and impede progress as long as the business has the resources to help them, which usually causes further deterioration and continues to give advantage to start-ups.

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Short lesson in value proposition

I find that many folks don’t quite understand what I mean when I talk about value proposition. Value proposition is the complex web of reasons that you may choose one product over another or may not choose any product at all.

I don’t care for potato chips. I would eat no more potato chips if potato chip companies gave them to me for free. For me potato chips have no value proposition.

I thought of another example to illustrate value proposition with something I use often: iPod/iPhone ear buds. I have three sets.

The first set came with the iPhone. They sound nice and I use them when I listen to podcasts while working around the house where there isn’t a lot of background noise.

The second set I bought because I quickly discovered that the standard ear buds fall out of my ears when I exercise. This set has hooks that go over my ears to hold the ear buds in place.

The third set I bought because I quickly discovered that my other two sets were not good for situations with lots of background noise, like flying in an airplane or mowing the lawn. This set insulates the background noise with cushy buds that I stuff into my ears.

All do well for their specific niche, but not so well for other niches. I purchased two additional sets of ear buds. The makers of the exercise ear buds could not have persuaded me to buy my third set from them if all they did was lower the price of their exercise ear buds.  I already have a set of exercise ear buds, I don’t need another.

The best way for that manufacturer to persuade me to buy their brand is to make what I want for my third set — a set of noise insulating ear buds.

The “cheaper to keep a client than get a new one” myth

I’ve heard this repeated dozens of times to focus an organization on client retention.   The trouble is, it isn’t always true and if an organization focuses too much on client retention when it isn’t true, it can hurt.

Most organizations would love to have 100% client retention, except maybe non-profits whose goal is providing temporary help.

In the real world, no organizations have 100% client retention.  Even the best lose clients. Sometimes clients die, move or change what they value or just discover they want something different.

Good organizations will have client retention in the 70% – 85% range.  Organizations with less than 65% to 70% retention might have the opportunity improve retention, depending on the nature of the business.

But, at some point above 70% retention (and this varies depending on the type of organization and service, etc.) you reach a retention rate where you run into the law of diminishing returns.  To increase the retention by another 1%-point, for example, is costlier than bringing in new clients who value what you offer.

Let me illustrate with an example.

I use to use a small plumber for my home plumbing needs.  He was good and reasonable and good enough, in fact, that sometimes I had to wait a few days for him to come out. Once this proved to be a problem, because I had a leak that couldn’t wait a few days to fix.

I called another company and found they also did good work and I didn’t have to wait a few days.  They could have someone out within two hours.  That convenience advantage, along with their good work and reasonable prices, was enough to get me to switch.

However, my previous plumber still has plenty of work.  Losing me didn’t cost him much business.

For him to change his business to satisfy folks like me would cost him a lot.  He’d need to hire enough plumbers to cover the demand 24/7 and invest in more trucks and equipment. He’d need to hire schedulers and manage a larger workforce.

But, he’s happy with the business and profits he earns from his set of loyal clients, who don’t place as much value on how quickly the plumber arrives.  Perhaps his customers are builders and commercial accounts who can schedule work in advance, or simply people who can get by for a few days with a leak.

Even in a market that appears as homogeneous to outside observers as plumbing, there are some key things that differentiate the value proposition of what different plumbing companies offer and it is difficult for any one company to satisfy all these value differences.

For my previous plumber, it is cheaper to let me go to the competitor that offers what I value while spending his resources on finding another client who values what he offers.

That holds true until you reach a point where fewer and fewer customer value what you have to offer.  At that point, the market (i.e. customers) is sending you a signal that you need to change what you offer, or go out of business.

Admittedly, there’s a fine line and art between knowing when you need to just focus on finding clients that value what you offer and when you need to change.

Based on these thoughts I have a few recommendations for businesses.

First, don’t always assume that increasing retention is cheaper than finding new clients. It’s actually not very difficult to estimate the costs of each for any business.  Try it and see if you can compare the acquisition and incremental retention cost per client.

Second, if your retention is stable within a few percentage points, plus or minus, then that’s likely a sign that it’s just as effective to keep focus on both finding new clients and retention.  You should not favor one over the other.  You need both.

Third, be prepared for when retention does start to plummet.  Consumer preferences do change in unpredictable ways.  One way to prepare your organization for such changes is to run small experiments with various business model approaches and see which ones resonate. Also, keep and eye on what your competitors are doing differently and understand why that may or may not work for you.

I’ve seen too many organizations who only focus on their bread-and-butter value proposition and get caught by surprise when consumer preferences change.  That puts them in a dangerous position of throwing hail mary’s when preferences change rapidly. The chances of hail mary’s succeeding are less than the chances of small, unforced experiments.

I’ve also seen organizations who move too rapidly to change their business model even when it’s doing fine.  In the process, they often fundamentally lower the value proposition for existing clients.  New Coke is a good example.

Starbucks irked some of its faithful recently be introducing a light roast.  But, they didn’t repeat the mistake of New Coke, by replacing dark roast with light roast, they just added the new light roast to the existing product line.  Starbucks’ faithful will get over it, because they can still get the products they love and now more of their friends (the 40% of coffee drinkers who prefer lighter roasts) will come with them.

Fourth, develop a deep understanding of the value proposition your organization offers. Why do customers use your product or service?  Ask them and ask them again.  Don’t take their first answer as the real answer. There is probably four to ten reasons why they use you. Also, don’t just look for the answers you think are right. Some of the worst business strategy blunders come from folks who impose their own incorrect view of the value proposition on the organization.

Value Proposition: Netflix vs. Blockbuster

Megan McArdle’s post Netflix Nation reminded me of this post about my extremely late adoption of the online DVD rental service.

Megan’s post explores why Netflix may have achieved such an advantage over a company like Blockbuster, when other innovators have failed.  She offers Netscape, TiVo and cat scans as big innovations that changed the market, but were ultimately copied and outdone by established players.

I think it’s a great question.

A fellow I met through work earlier this year had previously managed some Blockbuster locations.  He shared with me his view.  He said that Blockbuster execs couldn’t understand the Netflix value proposition.  They thought of movie or game rentals as impulse purchases and that the bricks and mortar model was better than having to sign up and wait to get something through the mail.  I thought that myself until earlier this summer.  I couldn’t imagine why I would want to do that. I moved late.  I could afford to. Blockbuster execs moved much too late.  They couldn’t afford it.

Repeated conversations with a co-worker and facing a summer of bad television got me to pull the trigger.  I chose Blockbuster Online.  Continue reading

Trader Joes: Lesson in Value Proposition

One topic I talk about often in business presentations is value proposition.  It’s a simple concept that few people seem to grasp, even though we each deal with it many times a day.

Value proposition is simply why you bought the product you bought.  But, answer to that isn’t always as simple as you think it is or very clear.  There can be many factors.  Some you may be aware of and some you may not be.  Sometimes we think we understand the value proposition, but it often turns out to be something else.

Trader Joes offers an excellent illustration of value proposition.  It has a successful value proposition as evidenced by  its success.  People want what Trader Joe’s sells.

When I first walked into a Trader Joes, I commented to my wife “this seems to be like an Aldi for organic.”  I then read this article about Trader Joe’s a few days ago.  It turns out there’s some truth to my observation.  An excerpt from the article:

Few customers realize the chain is owned by Germany’s ultra-private Albrecht family, the people behind the Aldi Nord supermarket empire. (A different branch of the family controls Aldi Süd, parent of the U.S. Aldi grocery chain.)

Aldi and Trader Joe’s are both low-priced grocery stores that carry fewer off-brand items in smaller footprints than other grocery stores. On those factors they are very similar.

But, after researching the history of both chains on wikipedia, it occurred to me that the ownership mattered little to producing these similarities as both chains resulted from successful, independent black swans (experiments that worked).

And, while they are similar on some basic descriptors, they serve consumers who want very different things.  Aldi serves cash constrained, practical, bargain shoppers, while Trader Joe’s appeals to a different crowd.  As the article put it:

Who’s a fan of Trader Joe’s? Young Hollywood types like Jessica Alba are regularly photographed brandishing Trader Joe’s shopping bags — but Supreme Court Justice Sonia Sotomayor reportedly is a fan too.  Kevin Kelley, whose consulting firm Shook Kelley has researched Trader Joe’s for its competitors, jokes that the typical shopper is the “Volvo-driving professor who could be CEO of a Fortune 100 company if he could get over his capitalist angst.”

Many business managers and owners could benefit from understanding the simple but subtle art of value proposition.

Coffee Value Proposition

Within two blocks of my workplace are 10 places to buy a cup of coffee.  Starbucks, one block away usually wins the battle of value proposition.  As one of my coffee buddies and I walked there one days, we nailed the key piece of value proposition that keeps us coming back to Starbucks – consistency.    Other places have good cups of coffee and good service, but not all the time.  We take less chance with Starbucks.

Part of that consistency can be attributed to their operations – hiring, training, delivery, brewing, roasting, etc.  They consistently deliver a good cup of coffee and friendly service.

Another part of that consistency has to do with their success.  They pour a lot of coffee, so we know that there’s a much better chance that the coffee is fresh and tasty.

Today, however, we opted for a closer cup of coffee.  With temperatures outside near the single digits, we decided that not having to leave the building was good enough value proposition.

Value proposition is a fickle and ever changing thing.