Monday, November 16, 2009

Market Share, Profit Share, and Use Value

A lot of attention has recently focussed on Apple's success at gaining profit share despite its relatively small market share. For years, pundits were skeptical of Apple's ability to thrive with such low market share and prescribed various remedies which Apple mostly ignored. In this post, I will attempt to clarify these common mis-understandings of business objectives.

Back in the 1960s, when U.S. manufacturing was thriving, business studies showed that doubling production allowed one to reduce per widget cost by around 10%. If you were able to sell twice as many widgets as your next closest competitor, chances are you could produce them more efficiently and enjoy higher profits. The implication is that in each market or market segment, there is only room for a few producers with sufficient volume to be the most efficient and profitable manufacturers. The goal is to dominate your industry and outproduce others at low cost. Having made this connection, it was natural for the trade press to follow the market share leaders and expect them to be the most successful. Market share became king.

How High Tech Manufacturing Changed

By the 1990s, consumer electronics companies increasingly looked to move their high volume manufacturing off shore to take advantage of lower cost labor and efficient supply networks that had evolved to serve high volume consumer electronics production. Through various economic initiatives, China became the global center for manufacturing consumer electronics at low cost. The tight network of suppliers is hard to match anywhere else. In time, this network could even be rented in the form of contract manufacturing. Apple no longer manufactures its own computers, but relies on contract manufacturers in Asia.

Volume, Cost, and Efficiency

Production volume still plays a role in manufacturing cost, but the relationship is more complex. Apple is a fascinating case study. It deliberately produces fewer products that sell in higher volume. It aggressively limits inventory, shipping products directly from the factory to its own retail stores or customers. It contracts with key component suppliers (such as RAM or Flash memory) months or even years in advance to ensure stable supply at low cost.

Shortly after the return of Steve Jobs, Apple dramatically reduced its product line, got completely out of the manufacturing business, cut prices, and focussed on becoming an efficient producer. Long after Apple was selling nearly as many computers of any one model as Dell, HP, or Gateway, pundits still questioned the viability of Apple's low market share, completely missing the point that Apple had become an efficient PC maker.

While Apple has never competed at the low end of the PC market, its products are generally price competitive with PCs offering similar specifications. Apple profits not so much by charging more, but by operating efficiently, carefully considering what can be left out of each product, and using software to replace expensive hardware. Sometimes these decisions are unpopular, like leaving FireWire off the unibody MacBooks, or no camera on the iPod Touch G3. To be an efficient producer, you must focus on reducing cost and reducing waste over the lifecycle of a product. Apple is relentless about making sure each thing it does adds value, and is quick to abandon legacy technologies.

Some of Apple's best products succeed not by doing more, but by doing less really well and eliminating clutter. When Apple first introduced the iPod and later the iPhone, competitors were quick to point out all the things it couldn't do. No 3G, no multi-tasking, no user replaceable battery, no copy and paste, no figamajig. Even to this day, Verizon is running an "i Don't" campaign against the iPhone only a geek could love.

Use Value

The key to understanding any thriving business is how they create or add value for their customers. Apple consistently offers more in "use value" than it charges in "cash value". While pundits questioned the thinking behind a $399 MP3 player, high end consumers loved it because it offered a combination of user experience, convenience, and capability they couldn't get anywhere else. Apple's success with the iPhone has brought this point home.

If your only competitive weapon is low price, you are in a weak position because you don't have the resources to offer a dramatically better user experience that delights customers and builds brand loyalty. There are still pundits who argue Apple needs to cut prices or produce a Netbook to gain market share. While there's always room to improve, Apple is doing quite well with its customers, thank you.

There are others who think the bottom line is king, business only exists to make a profit. I respectfully disagree. The purpose of a business organization is to create value by serving customers. A company that overcharges or doesn't create value for its customers is a house of cards waiting to fall. Their customers are on the lookout for better value and will quickly move when opportunity appears.

If you over simplify the meaning of business to include any activity that makes money or profit, there are many destructive activities that will masquerade as business while actually undermining the public interest and economy. What they are really doing might more accurately be seen as fraud or theft (as in the case of Enron, or securitized subprime mortgage investments). It is our own lack of clarity that allows such activities to gain so much influence.

If I were to pick an area that needs more focus to build the best in class user experience Apple is known for, it would be the App Store and Apple's relationship with its iPhone developers. Apple is still ahead of its rivals, but there are some ways in which the app store business model is not working for some of Apple's long time friends and partners. Since it's easier to keep an existing customer or partner than gain a new one, this is an important signal.

Why Profit Share Matters (or Doesn't)?

Profit in any market is not a fixed pie, but a reflection of the value being created. When a company like Apple grabs a large profit share relative to its market share, it means the company has an effective business model that is creating value and generating the resources it needs to invest in improving its own products or entering new markets. This is the real world feedback that business provides.

Profit share can also reflect a monopoly or government policy. In my experience, the most successful businesses focus on creating value, serving customers, and being efficient at what they do. It's hard to steer a car forward while looking in the rear view mirror. Like a rear view mirror, profit alone does not provide the guidance business needs to succeed.