Ensuring Delivery of Maximum Value

The following add value to a business:

  • Direct additional revenue. "We get paid for doing this."
  • Cost reduction. "We spend little or nothing on this and/or we stop spending after doing this." Value is subtracted instead of added whenever your costs (investment) exceed your revenue (return).
  • Immediacy. "We benefit sooner rather than later."

Indirect additional revenue also adds value, but adds risk that must be managed. Therefore, the following are value additions that go together:

  • Indirect additional revenue. "We could get paid for doing this."
  • Risk reduction. "Make it more likely that we will benefit."

The ideal product development effort adds value in each and every way. You build something that multiple customers could use, thereby ensuring potentially large indirect revenue at the (lesser and limited) cost of producing the first instance. By finding a customer who will pay for the first instance, you derive direct revenue, and you simultaneously reduce the risk that a 2nd customer will pay for the second instance.

Custom development does add value in the form of immediate direct additional revenue. Risk is minimal, being limited to risk of non-payment by the customer. Cost could be high, but a minimal margin is easy to earn. However, indirect additional revenue is, by virtue of it being “custom” development, zero.

A manufacturing business will generally have a fixed investment in a factory with fixed production capacity. The business will be wary of adding capacity. Production capacity is always associated with fixed costs (maintenance, rent, etc.). When business is slow, machines in the factory become idle. This is what is meant by excess capacity. The fixed costs continue, and this rapidly erodes the value of the business. Similarly, in a high-tech business, the development organization is associated with fixed costs (salaries and benefits). To avoid “excess capacity,” high-tech businesses will be wary of hiring additional developers.

The choice between custom development and product development is analogous to the choice between a factory producing a low-price (low-value) product or a high-price (high-value) product. Value is maximized if the factory chooses to produces the highest-price product whenever possible. Similarly, value is maximized if the high-tech business chooses product development whenever possible.

In both cases, the choice may not always be available. For example, the factory may be forced to commit itself for a long period of low-value production. During that time, it may miss opportunities to produce high-value products. Similarly, a high-tech business may be forced to commit itself for a long period to custom development. During that time, it may miss product development opportunities.

Options, by definition, ensure choice. A business that possesses options can exploit opportunities. Therefore options have value and the business may have to pay for them. For example, a factory may keep some capacity in reserve. This gives it the option to produce high-value products when opportunities arise, at least in small runs. The cost of the option is the fixed cost of this capacity.

High-tech organizations often have R&D departments actively exploring new opportunities for product development. They represent options for the business. (Regrettably, as articulated in The Innovator’s Dilemma, businesses do a poor job of exercising options, preferring to continue with low-value production at the expense of high-value opportunities.)

Sales personnel are typically given incentive in the form of commission, meaning a portion of direct additional revenue. In an attempt to add value by ensuring immediate direct revenue, the sales organization of a young, immature company will typically close deals without regard to cost.

While at such a company, I raised this issue to the VP of Sales. I said, “I question revenue that comes attached with a high cost.” He smiled knowingly and answered, “Milind, even so, revenue solves a lot of problems.”

I later asked the CEO, “Why do you de-value our products by giving them away for free, while over-valuing our professional services by charging a premium?” His answer was, “Because if we valued things correctly, we would risk losing the deal entirely.”

This is why at some companies, there is a close relationship between sales and professional services. The professional services organization is less likely to walk away from a deal.

Another trap companies fall into, one which they rarely survive, is developing a product in a vacuum and then trying to sell it.

It is a difficult discipline to discover a product defined by a market and then deliver it to that market. It requires your sales organization to sell your product only, to walk away from deals that come at a high cost.

Tags: Business, Finance

Created at: 14 April 2010 12:04 PM