Value Chain Economics:  The Secret to Market Leadership

One of the first things we have our clients do in our Grassroots Strategy workshops is define the market or “opportunity” from their customer’s perspective.  The primary question we ask is “what is the problem you solve for the customer?” Seems simple, right?  Not always.  Answering that question is predicated on understanding who is the customer that you solve a problem for.  It is far too easy, and comfortable, to just focus on your direct customer, the company that buys from you, but is that really where you create differential value?

Often the customer where you really solve a problem is two, three or even more steps down the value chain.  As we like to say, “if there is a better way to solve the end customer’s problem, someone will find it.  Don’t you want that someone to be you?” Said differently, you can do the best job in the world of serving a wholesale channel, but if end-customers start buying online bypassing the wholesaler, you will be out of business. In B-to-B markets, your customer is almost always part of a bigger eco-system.  Understanding the economics of all the players in that eco-system is critical to identifying new opportunities.

Several client examples come to mind. The first example is a company that had developed an additive for asphalt that made the asphalt more stable. Asphalt companies were interested in the new additive but were not willing to pay a significant amount more than existing additives that didn’t perform as well. The asphalt companies argued that a higher priced additive would increase their costs enough to make their asphalt uncompetitive in what was a highly price competitive market. When the company began speaking directly with road construction companies and road owners, they realized that the potential value of their additive was significant; either through the reduction in the amount of asphalt required for a given road and/or in making roads (particularly in high stress environments) last longer.

The company came to the conclusion that in order to get the value out of their new product they would need to market their product to their customer’s customers. The company hired several engineers from the road construction industry and began to market directly to road owners. Eventually they were able to drive specifications in road construction projects to be favorable to the use of their new product and developed a market for their new additive at a significantly higher price-point than other performance additives. Obviously, selling efforts down the value chain can be costly and time-consuming, but if we only focus on our direct customers, we may never understand the true value we create.  In this case, it was enough value to justify a change in business model.

A second example is a company that made tackifier.  For those not in the adhesives industry, a tackifier is the material that makes a glue sticky before it cures.  It is a very important component in an adhesive; so much so that it constitutes about a third of the cost of making an adhesive. Our client had developed a better performing tackifier and wanted to get paid for the value of its better performance. Not surprisingly, when our client talked to their direct customer, the adhesive maker, they wanted one of two things:  lower their price or allow them to use less of the material. 

It quickly became clear that in order to get paid for the value of the better performing tackifier, they would have to solve a problem for their customer’s customer.  The original intended target was food packaging applications, specifically “hot-melt” adhesives on cereal boxes. However, it turns out that current adhesives largely met the needs of food packaging companies and the risk of switching was so high that it wasn’t worth even evaluating new alternatives, because the lost productivity during the evaluation would swamp any potential benefits.  And, it turns out that the cost all of the adhesive going into a box of cereal is less than $0.01, so the cost of the tackifier was less than 1/3 of $0.01 per box.  Even if they lowered the tackifier price to zero, it is unlikely that the cereal maker would consider changing suppliers.  Although not the answer they were hoping for, they were able to refocus their efforts on other applications where a better performing tackifier would actually solve a problem for an end-customer.

Another client was a very successful supplier of hardware for residential security systems.  They had a broad product line and excellent product availability which made them the easy choice for distributors.  They focused their “marketing” efforts on distributors, strengthening their relationships with rebate programs and reward trips. When we tried to get them to think about value further down the value chain, they were reluctant to even consider it.  For example, when we pointed out that their own research showed that nearly 50 percent of home security systems were turned off because of experience with false alarms (a great example of an unsolved customer problem!), their response was essentially “not my problem”.

Eventually their business began to decline and so the company started to look into the economics of the value chain. They  learned that while they made very high percentage profit, measured in dollars, distributors, installers and monitoring companies all made significantly more than they did. Moreover, the monitoring companies had recurring revenue meaning that our client was extracting no more than about five percent of the lifetime value of the system that their hardware enabled. More importantly, it turns out that there IS a better way to solve the end-customer problem – DIY systems such as SimpliSafe were allowing consumers to install components themselves and monitor the system on their smartphones, bypassing the installer and reducing monitoring fees dramatically. 

Because our client had been focused on distributors, they had been missing the opportunity to capture more value, and were now seeing their core business in decline. Developing an understanding of their customer’s customer and the economics down the value chain allowed our client to begin rethinking their approach to the market and begin to take corrective action to preserve their core market and expand into adjacent areas.

There are several things that you can learn by analyzing the economics of your value chain.  Here are some specific things to look for:

  1. How big is the total value chain, not just the direct market for your products?
  2. How important is your part of the value chain to the customer?  From the customers’ perspective, are you their mortgage payment or their dry-cleaning bill?
  3. What are the steps between you and the end-customer and how do they create value?  Are there opportunities to forward integrate to capture more of the total solution?
  4. Who makes money throughout the value chain, and why?  Are there things that you can do to create more value or capture more of the value created?
  5. Are there ways that technology could (or is already) impact the established value chain (for example, could on-line tools dramatically reduce search costs and change the role of personal relationships)?

As you think through these questions, the key is to distance yourself from current products and practices and keep asking, “is there a better way to serve the end customer?”  As we’ve said, if there is a better way, someone will find it.  In fact, in today’s world with technology start-ups and new business models, the reality may be that someone else already has found it.

Bottom line, evaluating every level of your value chain, from you to the very end customer, can help to understand the total potential value of your offering. and identify opportunities to capture that value.  It can help you to think about where you actually create value and break out of the myopic focus on your direct customer.  It may provide an early warning system for big value shifts in your industry and/or highlight opportunities to repackage your capabilities and create even more value for your customers.

Chinese Painting 國畫 – Image © CCCH 9051 Group 64: Chinese Traditional Craftsmanship: https://learning.hku.hk/ccch9051/group-64/items/show/47.

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