On Value and Profitability

Van Gogh and the Nature of “Value”

Vincent van GoghWhat does Vincent van Gogh have to do with manufacturing? He makes a critical point about “value”. During his lifetime, he produced about 900 paintings, any one of which would fetch millions at auction today. While van Gogh lived, he was able to sell exactly one of those 900 paintings – and surely not for millions of anything. [1]

The point here is that “value” is a subjective term. An item has no “value” until two parties agree to make an exchange. And that “value” may change dramatically from time to time, place to place or circumstance to circumstance. The “value” of an item is not intrinsic to that item, nor does it have anything to do with its cost, unless buyer and seller (or their proxies) so agree.

Profits, of course, are the lifeblood of any business. But “profit” is a calculated term, and “value” is part of that calculation. So, profits, as important as they are, have something of a subjective nature. Managers need to be aware of – and take advantage of — that subjective nature. Creating and Capturing Value, an essay from a year and a half ago, provides a good place to start.

Creating and Capturing Value – from 26 July 2014

Profit from Slywotzky

Adrian Slywotzky is one of my favorite business writers. Why? Because he writes about profitability. Almost no one else does. He explains how profitability does — and doesn’t — happen. To beg the obvious, a business must consistently be sufficiently profitable in order to continue to exist, let alone to thrive in perpetuity. Profitability, unlike taxes, doesn’t just happen. It needs to be understood and cultivated.

No-Profit Zones

Consider the value stream of a manufactured product, from the origins of raw materials through a sequence of value adding steps, culminating in delivery to an end user. Each of those value-adding steps can be viewed as an individual business that receives inputs from upstream, adds cost and (hopefully) value, then passes the product-in-process downstream. At each step, the incremental and the rolled-up cost can be calculated. The value, however, is determined by market forces, including supply, demand and competitive offerings.

Value Chain DiagramSo, for some steps (again, thinking of each step as an individual business), the market’s assessment of the value added may substantially exceed the incremental cost. For others, the situation may be very different. For some steps, the market may allow a generous profit. Other steps may well be no-profit zones, or even negative-profit zones.[2]

Take the automobile industry, for example. Automobile manufacturers buy in large quantities from suppliers that are, in most cases, considerably smaller than themselves. Automobile manufacturers buy very well, so profit opportunities for suppliers are limited, at best. Automobile manufacturers enjoy great economies of scale, so conversion of parts and materials to finished automobiles is quite efficient. Still, for each manufacturer, a few models generate most of the profits — others may be outright losers. Consider that Volkswagen’s Audi division generates half of the profits, while, at Ford, pick-up truck sales drive the profits. For automobile dealers, sales of new vehicles generate very little profit. Sales of used vehicles, maintenance and financing generate the profits.

Slywotzky points out that situations where suppliers all offer comparable products (in the customers’ opinion) and compete for business primarily on the basis of price are likely to be (or soon become) no-profit zones. This is especially true when “no profit” is taken to mean a level of profitability that is insufficient to justify the resources employed.

In short, the value created across a value stream is not necessarily captured where or by whom it is created.

Capturing Value

The Art of ProfitabilityWarren Buffett, along with most competent securities analysts, doesn’t simply extrapolate from historical data. Rather, he seeks an understanding of how a business makes a profit and, more importantly, of why those profits should continue into the future. Sustainable profitability requires a mechanism by which sufficient value is reliably captured. No kidding… a mechanism. Slywotzky describes twenty three of them, although there are likely many more. Better yet, one of Slywotzky’s books amounts to an engaging self-study short course in recognizing and applying those twenty three mechanisms.[3]

For Smaller Manufacturers

Slywotzky teaches that value capture is at least as important as value creation, and that value capture, hence profitability, results from business design. This applies to businesses of all sizes and descriptions. For smaller manufacturing firms, however, there are some additional considerations.

>> Smaller firms must, of necessity, focus. Larger firms may enjoy the luxury of some degree of diversification.

>> Manufacturing firms, big or small, are generally fixed asset intensive. Task-specific fixed assets limit agility.

>> Slywotzky’s books were published before the full impact of both globalization and the Great Recession on manufacturing became apparent.

None of this changes the need to design your business to capture value. However, the global business environment changes increasingly rapidly now. When that happens, even the best value capture mechanism may become moot, perhaps suddenly. So, your present value capture mechanism is important, but so is your next.

This means every manufacturer needs a method for maintaining a zoomed out view of entire business world and its relentless changes. It also implies new forms of cooperation among manufacturers, in view of globalized business realities. Start with your trade organization and re-examine its functions for the 21st century.

Chuck - FranceThoughtful comments and experience reports are always appreciated.

…  Chuck Harrington (Chuck@JeraSustainableDevelopment.com)

P.S: Contact me when your organization is serious about pursuing Sustainability … CH

This blog and associated website (www.JeraSustainableDevelopment.com) are intended as a resource for smaller manufacturers in the pursuit of Sustainability. While editorial focus is on smaller manufacturers, all interested readers are welcome. New blog posts are published weekly.

[1] Facts about van Gogh are from The Redhead Riter,  http://www.theredheadriter.com/2011/06/vincent-van-gogh-30-interesting-facts/

[2] For more on profit zones and no-profit zones, see:  Adrian Slywotzky and David Morrison, The Profit Zone, Three Rivers Press (1997, 2002)

[3] Adrian Slywotzky, The Art of Profitability, Warner Business Books (2002)