Day 3 is all about creating the blueprints that outline how your business will operate and the type of inputs required to launch and sustain it over time! Today we are going to cover 4 core concepts that are the foundation of your business operations and product development efforts.
We will be covering the following:
- Key Partnerships
- Key Activities
- Key Resources
- The Cost Structure of your Business & Product Offering
As we’ve done in previous parts, we are going to start with the overall structure of what we are going to cover today. Then we will start at the end and work our way backwards so we are confident each step of our process is appropriately leading us to our desired result.
Cost Structure of Product Offerings
On Day 1 we did some back of the napkin financial projections for the business and products that we were brainstorming.
Today we are going to dive a little deeper and do some additional analysis to get us closer to our final idea candidate that we will move forward with after Day 5.
First we are going to talk about the Cost Structure of the Product or Service that your business idea will generate.
A great way to get a good picture of data is to create a chart. So, let’s build a chart that includes all the different elements that go into the cost of building a product.
We’ll start simple and then add elements as we go so we can see the full picture.
Imagine we are going to sell a fidget spinner. The complexity of the cost model that we create to capture the cost of selling fidget spinners is largely dependent on how much of the process we want to be involved in. If we intend to only participate in the resale of existing fidget spinners, then our cost model will have very little detail around the cost of the fidget spinner. The cost would be the price we purchase the fidget spinner at, plus any logistics cost like warehousing and shipping.
On the other hand, if we want to do more than just sell existing fidget spinner designs, if we want to design new ones and manufacture them ourselves, our cost model immediately becomes much more complex.
Like most things we’ve covered, there are some trade-offs when deciding how much of the product development process you want to be involved in. When you take on the entire development process, there are many more cost elements that you’ll need to keep track of. However, if you are able to take on more of the development cost, you stand to make more money in the end because the margin that your fidget spinner supplier was making when you purchased from him/her is no longer part of the costs you have to absorb.
Lets look at an example of this:
The first chart is the simple cost model where you are only interested in reselling existing fidget spinners. You are able to purchase them for $1.10 and have a cost of $0.05/unit plus $0.30/unit to ship them to their final destination. Let’s assume that consumers are able to purchase fidget spinners like the ones you are selling for about $5. With this simple cost model, you’ll have a $2.45/unit margin. That’s a 49% gross margin – which is pretty good.
Now, let’s say hypothetically that some competition entered the market, and they were selling their fidget spinners for $4. To make matters worse, they are actually buying from the same supplier that you are so they are offering the exact same product for $1 less. Which means your sales are starting to tank – and lots of people are starting to ask for refunds!
So, you bite the bullet and lower your prices to $4/unit. Now your profit margins are at 36% and your sales volume has been cut in half because another player has entered your market! How rude, right?!
To continue with this hypothetical, your direct competitor again lowers their price, this time to $3. Now you have a serious problem!
With the competition lowering their price to $3, you are forced to lower your price as well, or cede the market. So you do. But now you have some serious problems because your margins are 15% and you are making $0.45/unit.
To explain why this matters, we need to understand how your product margins impact your overall business margins. Because, not only do you need to cover the cost associated with buying, storing, and shipping fidget spinners with the money generated by each sale, you also need to cover the costs of running the rest of your business. And, oh yeah, you need to pay your self too!
So, let’s take a look in the next section what sort of problem you’re facing with this competitor coming into your market and driving down the price.
Cost Structure of your Business
To start out, we’ll make a few assumptions about how many fidget spinners you’re able to sell in any given month. We’ll say you originally were selling 20,000 fidget spinners per month and $5/unit before your competitor entered the market. This is scenario 1.
Once your competitor entered the market, your sales volume was cut in half, and you were then selling 10,000 fidget spinners per month at $4/unit. This is scenario 2.
And finally, your competitor reduced their price to $3/unit and so your response was to reduce your price as well. You then were selling 10,000 fidget spinners per month at $3/unit. This is scenario 3.
As you can see in the chart below, something pretty awful happens to the viability of your business as the price reduces and all other expenses stay the same:
If you look at scenario 1 in isolation, you’d feel pretty good about your business. Your gross margin is healthy, your business expenses are reasonable, and your net profits are also pretty healthy. You end up with $34,000 in your pocket after each month! Nice work!
But, things can dramatically change for the worse when the perfect storm hits. Recall that when the competitor entered the market, they took 50% of all sales going forward and also entered the market at a lower price, $4/unit. You had to match their price or be pushed out of the market, so you did.
But look what happened when you lowered your price by $1 and you product volumes went down!! At the end of scenario 2 you’re $500 in the hole! That’s not good at all!
So, assuming that the month was just a fluke, because the previous month was basically 34,000 times better than the most rent monthly, you decide to stay in the market and hope for better luck in month 3. But, things get even tighter when you competition lowers their price yet again and now sell for $3/unit.
In this hypothetical scenario, you followed their pricing lead and at the end of month 3, you have lost $10,500. In the last 2 months you’re down $11,000. Over the 3 months, what would have been 0ver $100,000 in net profits has turned into a measly $23,000 profits.
Now how are you going to afford that downpayment on the yacht you’ve been eyeballing?!
The fidget spinner industry is tight indeed. And the competition engaged in a race to the bottom and won. Because you realized after running the numbers in your cost model that it would be better for you to close the door on that product line than continue bleeding cash.
Ok, before you do this next exercise, go ahead and think some happy thoughts and get forget the negative experience outlined above… Ok, is your mind clean? Good.
Action Item: What would you have done in this scenario? Are their things you would have done to prevent this from happening if it was your business? Write up your own cost model for the fictitious fidget spinner company above, and see what (realistic) changes you would have made to save this company from closing their doors.
Key Resources
Each business has resources that it needs to survive. Some of those resources are mundane and might be niceties instead of necessities. But there are a certain category of resources that aren’t niceties or merely necessities, they are key resources that are required for your business to continue to operate.
Here are some examples of some businesses and their key resources:
- Bakery — Flour
- Shoe Factory — Rubber
- The Office — Steve Carell
- Apple — Glass, Aluminum, Silicon, etc.
- Microsoft — Computer Scientists
- Google — user data
- Facebook — user’s stories and photos
In each of the examples above, the company would need to completely halt operations if (one of) the resources listed next to it was no longer available to them. In some cases, like The Office, planning ahead can help make the end of operations less abrupt – there was 1 season after Steve Carell left the office, but it stopped after that. But, in all of the other cases, if the resources were no longer available to the companies, they would need to dramatically change their business model and find replacement resources or face shutting the door on those business units or the company as a whole.
Action Item: What are the key resources for in the business you came up with on day 1? What type of mitigation plan should you have in place in the event one or many of your Key Resources are threatened or completely cut off?
Key Activities
As we talk about key Activities, I want to make sure we include a discussion on proper planning. Mostly because the previous section ended with a sort of scary tone.
Let me share an example that show how you can weather any storm if you plan ahead. I’ll share a positive example because it’s all too easy to point to situations where the underprepared suffer greatly when the world doesn’t operate as expected.
I’ll give 2 examples of how Apple, the company who has held the #1 position globally for having the best supply chain for nearly 15 years, weathered 2 globally catastrophic events.
Ok, weathered is the wrong word – because if the news hadn’t reported on these events, or if everyone else wasn’t suffering and complaining about it, you would have never known that Apple had overcome the impossible.
Example #1: in 2011 there was a massive earthquake in Japan that damaged nuclear reactors and damaged the infrastructure of several large cities. The damage that occurred as a result of this earthquake rendered all the computer component supplier in Japan closed until further notice. The customers of these component suppliers includes Apple, Samsung, Microsoft, LG, Motorola, etc. All the big tech companies.
The battery industry was hit particularly hard and industry analysis believe the entire tech industry would be hit hard as a result. Even with Apple’s superior supply chain, supply shortages were expected.
Apple announced the iPad 2 on March 2, 2011. The iPad 2 would go on sale 9 days later on March 11, 2011. On that same day, the Japan earthquake hit, complexly crippling the supply chain of the tech giants. Except, it didn’t cripple all of them.
Apple seemed to be completely unscathed by what had happened. And just like all Apple product launches, the iPad was flying off the shelf. In fact, the iPad 2 sold 2.5M units in the first 30 days of availability, and then sold 11M more units the following 3 months.
Yes, Apple has some inventory, but they don’t carry more inventory than 2-4 weeks worth (you should know that warehousing goods costs money – the smaller the warehouse, the lower the cost). So, Apple must have had some magic up their sleeve that enabled them to Ship over 13M iPads in the 4 months following a global-supply-chain-crippling earthquake in Japan.
Well, no tricks. No magic. And it wasn’t the quick response of brilliant people that stepped up to solve the problem once it happened. The real story is that it is a Key Activity at Apple to mitigate risk with every relationship, every component purchase, every product release. It is a key activity to diversify suppliers, specifically in different global geographies.
Yes, Apple’s sprawling supply chain organization can rapidly solve impossible problems, but not because they are magic or any more intelligent in the heat of the moment. They are able to do the impossible because they deigned their business and maintain their business that way.
The second example happened at the end of 2019. The world became aware of a vicious virus coming out of Wuhan china, COVID-19. At the time, I was covering the Virtual Reality industry and the tech companies who were selling headsets. Every single VR Headset maker was forced to shut down their manufacturing operations. Facebook, the owner of Oculus, was not able to ship headset for christmas, Valve, the creator of Steam VR and the Valve Index VR Headset, was not able to build and ship any VR Headsets, and HTC put a hold on the shipment of their newly announced but unreleased headsets. Everyone stopped.
At this same time, Apple was gearing up to release a new product, that required a new set of manufacturing facilities and supplier partners. Apple announced the AirPods Pro on October 28, 2019 and started shipping them 2 days later on October 30. The available inventory was quickly sold out leading up to the holidays, but manufacturing never stopped, never slowed down. The “shortage” in this case seamed to be driven purely by demand. Even with shutdowns happening globally for the COVID-19 Pandemic, AirPods Pro continued to ship, with delivery times getting shorter and shorter as the supply started to keep up with the demand.
Oculus missed out on a massive VR holiday season. They ran out of VR Headsets to sell and then were frozen in their tracks once COVID-19 reared it’s head. No plan, no ongoing mitigating or planning activities as part of their culture. They had to wait it out.
Valve was also hit hard, with the Index facing the same shortages and customers experiencing the same disappointing Holliday season.
Action Item: What type of key activities can you adopt to create a more resilient business? Think of what could go wrong to cripple your business and identify what ongoing activities should be a part of your key business activities that will help you weather the storm the way Apple has demonstrated.
Key Partnerships
You might be able to run your business completely by yourself. Perhaps you a one man/woman show! If that’s you, awesome!
Also, if that’s you, knock it off! You’re doing your partners work! Specifically, your key partners are the ones that you would trust with work that you would do yourself but but are constrained by time or resources so you aren’t able to. The key partnerships of your business are those that enable your key activities and are often categorized as a key resource of your business.
Perhaps you have a key partnership with a customer service provider who answers all the phone calls that come in from customers. In this type of relationship, you are trusting somebody else to present themselves as your company, brand, or even you!
If you must outsource portions of your core business functions, select partners that you trust will act with the same judgment and values that you would as the owner.
Action Item: What parts of your business do you need external support with? Where do you plan to look for partners that you can trust with the keys to your business and act as you would?