The Art of Profitability

To succeed in business, you have to be a student of profitability.  Where does your profit come from?  How do companies profit from the services and products you use everyday?

Below are 22 different models of profitability presented in examples you can relate to your own business (these are taken from the Art of Profitability, and represent the most common profit models – surely there are more!).  There may be some profit-sources you never considered before.  Some questions to think about as you go through the different profit models:

  • Which of these profit models are at work in your business?
  • How does profit happen in your competitors' businesses?
  • How well do your employees understand our profit models? Is the organization aligned to help capitalize on them?
  • Are there new profit models that you could apply to improve profitability and lower risk?
  • Which of your current initiatives could improve your profitability and should be accelerated? Which may actually impair it, and should be discontinued?
  • Which specific actions can your organization take in the next ninety days to improve our profit position?

If you prefer video, watch entrepreneur Derek Sivers' 20 minute presentation on 8 of these profit models. (start at 8:43)

I have attempted to illustrate each profit model through definition, conditions and examples.

Profit Model Definition Conditions Examples
Customer Solution Profit Invest time and energy in learning all there is to know about your customers. Then use that knowledge to create specific solutions for them. Lose money for a short time. Make money for a long time.Study customers, create a custom solution set with multiple services. Develop relationships. Caters to customers that require relationship building Once Factset identified a company as a potential customer, they'd send a team of 2-3 people to work there for a few months, learning everything they could about the customer, how their systems worked (& didn't work), what they really cared about. Based on this genuine knowledge, they'd develop customized products and services tailored to the specific characteristics and economics of the account. Once they landed the account, they spent a ton of time integrating their product into the customer's systems. During this process, revenues were tiny and costs were huge. But after 3-4 months, they were woven into the daily flow of customer's operations. Software debugged and working fine. Now one person could maintain account, part-time. More people in company use it. Costs fall, revenues grow.
Pyramid Profit Company caters to different levels of price sensitivity. Offer a range of services from low price / high volume to higher price / lower volume.The base of the pyramid consists of low-priced high-volume products, while the apex is made up of high-priced low-volume products.

The bulk of profitability is concentrated at the top of the product pyramid, but the base plays a strategic role -- often through a "firewall" brand -- in protecting the profitability at the top.

Has to be a hierarchy of customers with different expectations and different attitudes towards price.Top of pyramid is the most profitable so make sure you have enough customers at the top. Mattel and Barbie: Barbies were priced $20-$30. But imitators can come in below you, so you build a firewall, a $10 Barbie. Barely profitable but prevents other companies from establishing a connection with your customers. And even girls who start with the $10 Barbie move on to buy accessories. Then made a $100-$200 Barbie for nostalgic collectors.Nokia PhonesSkypePhone Plans
Multi-Component Profit Same product, several businesses.Multiple products and/or sales channels, and only some of these represent the bulk of profitability. The customer behaves very differently on different purchase occasions;  he or she has different degrees of price sensitivity.To maximize sales in the high-profitability components, it's necessary to have full presence in the less-profitable components as well.Caters to customers that consolidate on fewer suppliers. Coke has different prices per ounce depending on whether you buy it in a grocery store, from a vending machine or in a restaurant.HotelsRetail Clothing Stores
Switchboard Profit Multiple sellers communicating with multiple buyers via a power broker associated with the service provider. The more buyers and sellers that join the switchboard, the larger the margin commanded by the service provider. Can't do it with a small percentage of supply: once you have 15-20% of market, an upward spiral kicks in. Perceived probabilities go way up, and all deals start flowing your direction. Profitability per unit of effort also goes up.Need connections with major suppliers, or significant market share of suppliers. Michael Ovits (TV and movie producer)Ovitz put entire movie needs together: representing writers, actors, director, and represented them as a package to studios for greater profits and profitability per unit of effort.Ebay
Time Profit Takes advantage of innovation, newness, uniqueness, to gain time limited competitive advantage. Requires strong early sales effort to maximize high margin revenue.Profit margins quickly erode as competition catches-up.When a product is new, it earns premium profits. Then, when a competitor copies the innovation, price competition drives profits to zero.

Companies relying on this model make continuous innovation the modus operandi.

"When you see #2 in the rear-view mirror, step on the gas".

Need to have major product launches, or ways to “squeeze out the juice before everyone else learns the secret.” Intel CPU’sElectronics
Blockbuster Profit Identify and support blockbuster opportunities or “home runs” and manage the research and development process to maximize chances of success. Usually for products / industries with high research and development costs, highly influenceable demand, or where there still are many discoveries to be made.Usually need an intensive marketing campaign. Movie StudiosBook PublishersDrug Makers
Profit-Multiplier Profit Take a skill, asset or intellectual property and make money from it 5 or 6 times. Take any asset, iterate it, reuse it, give it a different form.Results in better profit from lower development cost, as you don't have to reinvent the wheel every time you use it. Branding helps here: leverage brand to multiply the value of one service by selling loosely related services under the same branding.Different from the Multi-Component Profit because it's not the same product: it's different products from the same original asset. Selling Information Online (blog, whitepaper, ebook, video course, etc)Disney(Lion King movie, broadway play, lunchbox, game, stuffed animals, etc)
Entrepreneurial Profit Totally aligns an organization behind rational, common sense, profit-seeking activity, rather than all the extraneous nonsense that only large organizations can afford or tolerate. A mindset that says, "We can't afford to operate any other way."  Total focus on customer responsiveness, energy and efficiency. Relies on speed, focus, innovation, rapid learning and cost-control.  Essentially a Lean Startup. IMVU
Specialist Profit Specialists usually can achieve a) lower cost through better knowledge b) better price through reputation or unique design of offering c) shorter selling cycles d)more rapid & market penetration because of existing connections.  This results in higher margins than generalists. Budget Airlines

Tennis Shop

Orthodontists

Installed Base Profit Initial product sales or profits are slim and profit is realized on follow-up products and services.This model is about transferring power from the customer (initial purchase with more price sensitivity) to the producer (subsequent purchases with less price sensitivity). If seller makes initial purchase price too high the customer will switch brands.Seller must keep user engaged and its follow-up products easy to buy.

Take some aspect of your business where customers are returning naturally and stimulate it more - market aggressively.

Gilette (Razors and Blades)Nintendo Game Consoles

Laser Printers

 

De Facto Standard Profit The more players who buy and enter the system, the more valuable the network.Being the standard leads to less surprise and allows you to plan more (Surprises cost money by causing you to react, respond, scramble).Your customers do your marketing for you. Microsoft Office

ETS (who run SAT tests)

CFA Exams

Brand Profit The company expends significant marketing investment in order to build awareness which is reinforced by customer experience. You know brand profitability is working when a consumer says, "I only drink Coke" even-though blind tests show consumers are often unable to distinguish the difference between Coke and its competitors. Need time and resources (persistent spending) to build cumulativebrand awareness and loyalty.Need to go after the share determining segment (SDS) – “the SDS is the most important segment in the market. That’s the one where high share today translates into high share of the whole market tomorrow.” NikeCoke

Cigarettes

Specialty Product Profit Similar to brand profit but companies use above standard materials and design to generate higher margins until competitors start to imitate."Find the richest fields: the place where customer need, technical feasibility, and lack of competition intersect." Need to continually develop new niche products with higher margins.Difference from Blockbuster Profit is that this is niche: specialty foods, specialty papers, etc. Finding a legitimate need or variation and addressing it. Ben & Jerry’sPrada

Tumi

Local Leadership Profit Many businesses and their company economies are totally local. Risk occurs when these companies fail to recognize they are a local business model.Strive for local leadership, this could mean x locations per city / county.…

in doing so take advantage of lower purchasing costs, lower recruiting and advertising costs, shops as billboards, foot traffic and higher awareness and potentially slightly higher pricing.“Saturate the circle” or “fill the column.”

Requires financing and operational expertise to multiply quickly StarbucksWalmart

McDonalds

Transaction Scale Profit Turn small business away to focus on the big accounts; bias yourself to big business Big transactions are a function of your relationships, and it takes years to build relationships Real estate agent who only sells houses worth over 1 million dollarsAd agencies

Investment Banks

Value Chain Position Profit Some places are much more critical than others. The high ground. The river ford. The mountain pass. The bridge. The isthmus. The channel - think of Gibraltar, Suez, the Bosphorus.What’s true in geography is true in business. There are places in the value chain that are ten times more valuable than others in terms of profit, power, and control. These special places are the control points of the business landscape and could arise from scarcity, bottlenecks, connection with customers, relative value added, etc. The location of value chain position profit is different for each industry and can change rapidly.Be aware of existing control points, radical shifts in control points, and new control points that could arise. Justin BieberLebron James

Apple OS & Itunes

Google

 

Cycle Profit Industries characterized by distinct and powerful cycle. The company can not control the cycle, but it works to maximize its position within the cycles grip. As capacity tightens the companies lead price increases, as capacity loosens, its lag price declines.When others lose money, you break even. When others break even, you make money. Hard to predict cycles.The key to profiting from cyclical industries is arbitrage –  to “lead” or be ahead of the up cycles and to “lag” or be behind the down cycles.   This can be done through buying low / selling high, reducing costs, or increasing / lowering prices depending on where you are in the cycle. ShippingTravel Industry (adjust rates seasonally)
After Sale Profit Price sensitivity is highest when ticket price is high, variability is high, and there are lots of options (i.e. houses, cars, TVs).  Customers spend a lot of energy finding the best deal.Price sensitivity is lowest when ticket price is low, variability is low, and there are few options (i.e. coffee, service contracts, insurance, accessories). Requires a mini-market has been created or brought into being by the initial sale; usually mini-market items are lower priced and frequency of purchase is greater.Difference from Installed Base Profit is that other companies are profiting from after sale products Insurance companiesIphone / Ipad accessories
New Product Profit The Profit Parabola |_/\_ "The total profit earned by all players in a market goes up, peaks, and comes back down to zero."Manage the parabola strategically by overinvesting on the left-hand side of the parabola, and underinvesting on the right-hand side.On the left-hand side, above all else, fight for mindshare. Be seen as the category leader in the mind of the customer. Merchandise your product mercilessly. Be everywhere. Build plants and do subcontracting deals as fast as you can.Before hitting the peak of the parabola, invest less money to manage the business to maximize cash flow (right-hand side).

“Get off the last wave first, catch the next wave first.”

The objective is to reverse the investment ratio about a year before hitting the peak; therefore, you need a good grasp of when the product will peak.  Could conclude this from growth rates, customer excitement / boredom, etc.Which stage are you in?  The gold rush, peak, or no profit zone? CarsWalkman
Relative Market Share Profit Companies with high market share tend to be more profitable due to a) scale economies in manufacturing b) greater purchasing clout c) lower per-unit manufacturing costs d) lower per-unit costs for overhead and R&D e) attracting the best talent – everyone likes to work for a leader f) more resources, cash or otherwise g) more ability to control / plan the market. General ElectricSamsung

 

Experience Curve Profit Experience in serving the market and strong financial management drives down the transactional cost. Danger with this profit model is that you can miss the forest for the trees; innovations that make you irrelevant, or the invention of a new model that delivers the same thing at a 20-30% lower cost.
Low Cost Business Design Profit The company thrives on reducing the cost per unit through cumulative experience. The low-cost business design doesn't need huge market share to be hugely profitable. It is hugely profitable as long as it continues to be dramatically lower-cost.  Dollar stores
To succeed in business, you have to be a student of profitability.  Where does your profit come from? Are there new profit models that you could apply to improve profitability and lower risk?

Reading List

Adrian Slywotzky, The Art of Profitability

Web

Derek Sivers, Presentation on the Art of Profitability