The Profitability Test

Does Your Strategy Make Sense?

ISBN: 9780262364386 | Copyright 2016

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This book teaches readers to understand profitability in a systematic way, equipping them to provide logically coherent answers to questions about whether a new venture will be profitable, if changes in business strategy will generate an increase in profits, or if “staying the course” will result in continued profitability. Unlike books by business gurus that offer one-size-fits-all advice, this book starts from the premise that you, the reader, are in the best position to make difficult judgments about your business. It shows how to turn these judgments into coherent analysis, presenting state-of-the art theory for understanding business strategy from an economic perspective. The basic building block is the value that is created when the buyer and seller make a deal. In simple terms, if a company is to be profitable, it must make a favorable deal with each and every customer.

After setting out key principles and applying them to market situations, the book teaches readers to apply the analysis to their own businesses—in other words, to create their own business game, the main ingredients of which are people and the value that they can create. It addresses how to integrate strategic moves into the book’s theory of value creation and competition in order to address the sustainability of a company’s profits, the effectiveness of the “invisible hand,” and restrictions to competition. Optional appendixes explain the relevant mathematics.

A fine survey of the real economics of business strategy. It explains what others have failed to explain—why different firms facing the same five forces perform differently.

John Kay Professor, Oxford University; author of Other People’s Money and Foundations of Corporate Success

The most comprehensive, clear, and well-organized exposition of value-based business strategy to date, a rich approach that builds a logically consistent framework from first principles to understanding organizational value creation and value capture. The Profitability Test synthesizes the contributions to this body of knowledge of the past two decades and offers a number of new results and ideas. An indispensable reference for readers seeking to develop a coherent ‘story’ of their firm’s value and profitability.

Ramon Casadesus-Masanell Herman C. Krannert Professor of Business Administration, Harvard Business School; editor of the Journal of Economics & Management Strategy

The Profitability Test is a significant contribution for scholars, instructors, and especially students. But it is a significant contribution also for the expert strategist seeking intellectual challenges. Top strategists have two virtues: great instincts and excellent discipline. After reading this book, I can't think of a better manual for sharpening these skills, especially discipline. In fact this is probably the most analytically rigorous strategy manual out there.

Giovanni Gavetti Associate Professor of Strategy, Tuck School of Business, Dartmouth University
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Contents (pg. vii)
Acknowledgments (pg. ix)
Introduction (pg. xi)
I Value Creation and Competition (pg. 1)
1 Value Creation: The Foundation of Profitability (pg. 3)
2 Contributed Value and Unrestricted Competition (pg. 7)
Contributed Value (pg. 8)
Introducing Competition to the Game (pg. 9)
Unrestricted Competition (pg. 10)
Competition and Bargaining: The Pessimistic Base Case (pg. 13)
Competition and Bargaining: A Preview of Being Better (pg. 15)
Translating between Prices and Value Capture (pg. 16)
Prices as a Consequence—Revisited (pg. 17)
Competition and Bargaining: Another Preview of Being Better (pg. 17)
A Note on Restricted Competition (pg. 19)
Three Conceptual Points to Remember (pg. 19)
Appendix: The Mathematics of Unrestricted Competition (pg. 20)
3 Willingness to Pay and Economic Cost (pg. 25)
WTP: The Benchmark for Buyer Profit (pg. 25)
WTP: The Benchmark May Be Subjective (pg. 26)
Calculating WTP (pg. 26)
Fixed Outside Option (pg. 27)
Subjectivity in a WTP (pg. 28)
WTP for a Consumer Product (pg. 29)
Inferring Bounds on WTP: Revealed Preference (pg. 29)
Price Premium: You Have a WTP Advantage at Least as Big as the Premium (pg. 30)
Price Discount: Your WTP Disadvantage Is No Bigger Than the Discount (pg. 31)
Inferring Bounds on Premiums and Discounts (pg. 31)
A Price Premium Can Be No Larger Than a WTP Advantage (pg. 31)
A Price Discount Must Be at Least as Large as a WTP Disadvantage (pg. 32)
Two Implicit Assumptions (pg. 33)
Economic Cost (pg. 33)
Economic Cost Is Not Necessarily Production Cost (pg. 34)
Economic Cost: The Benchmark May Be Subjective (pg. 35)
Inferring Bounds on Economic Cost: Revealed Preference (pg. 37)
Bounds on Salary Premiums and Discounts (pg. 38)
Appendix: Using Decision Trees in WTP and Economic-Cost Calculations (pg. 39)
II Being Better—Winning the Customer (pg. 43)
4 Competing for the Customer: The Value-Gap Advantage (pg. 45)
Value Created with the Customer (pg. 45)
Low Cost, Differentiation, and Profitability (pg. 48)
5 Customer Tastes and Profitability (pg. 53)
Interdependency of Competition (pg. 56)
Potential Profits (pg. 57)
Appendix: Contributed Value and Value-Gap Advantages (pg. 58)
III Being in Demand (pg. 61)
6 Guaranteed Profitability: The Power of Exclusion (pg. 63)
An Excluded Buyer (pg. 63)
Impact of an Excluded Buyer on the Contributed Values of Included Buyers (pg. 66)
Emergence of Price-Setting Power (pg. 67)
Exclusion Can Benefit All Competitors (pg. 68)
Appendix: Monopoly Power and Supply-Demand Reasoning (pg. 69)
7 Envy Is a Form of Exclusion (pg. 79)
The Excluded Chocolate Lover (pg. 80)
Envious Buyers (pg. 81)
Envy and Compensated WTP (pg. 82)
8 Nonconstant Marginal Costs (pg. 85)
Increasing Marginal Costs and Guaranteed Profitability (pg. 85)
The Power to Set a Price Equal to Marginal Cost (pg. 87)
Price-Setting Summary (pg. 88)
Value Gap: A Firm’s Marginal Value Creation with a Buyer (pg. 88)
Marginal Cost as a Capacity Constraint (pg. 89)
Instability: The Dark Side of Economies of Scale (pg. 90)
9 Market-Price Effects (pg. 95)
The Market-Price Intuition (pg. 95)
The Market-Price Effect (pg. 96)
Compensated Willingness to Pay, Revisited (pg. 97)
Market-Price Effects Creating Envious Buyers (pg. 98)
An Example (pg. 99)
10 Being in Demand: Guaranteed and Potential Profitability (pg. 103)
A Useful Benchmark (pg. 103)
Potential Profit and Exclusion (pg. 104)
Be in Demand (pg. 106)
Potential Profit and Market-Price Effects (pg. 106)
Potential Profitability—The General Case (pg. 108)
Being in Demand, Revisited (pg. 109)
Appendix: Supply and Demand Revisited (pg. 109)
11 Profitability under Unrestricted Competition (pg. 113)
Guaranteed Profitability (pg. 114)
Potential and Guaranteed Profitability: An Informal Summary (pg. 114)
IV Your Firm’s Game (pg. 115)
12 Buyers and Competitors (pg. 117)
Buyers (pg. 118)
Competitors (pg. 119)
Buyers and Competitors in the Game (pg. 120)
Players in the Game: The Broader Perspective (pg. 123)
A Common Simplification (pg. 124)
Market Size versus the Pie (pg. 125)
Remember to Segment (pg. 126)
13 Suppliers (pg. 127)
Suppliers (pg. 127)
Value Gaps with Suppliers (pg. 131)
Profit Flow (pg. 132)
Suppliers in the Game (pg. 134)
Accounting for Suppliers Both In and Out of the Game (pg. 135)
Competitors Revisited (pg. 135)
Suppliers and Competitors in the Game (pg. 136)
14 Larger Games (pg. 139)
Multiple Stages (pg. 139)
Firm Complements (pg. 141)
Complementarity (pg. 145)
15 Economic Value: Relative and Subjective (pg. 147)
Value Creation Is Relative (pg. 147)
Value Creation Is Subjective (pg. 150)
When the Boundary of the Game Doesn’t Matter (pg. 152)
V Changes in the Game (pg. 155)
16 Sustaining Profitability (pg. 157)
Assessing the Sustainability of the Pie (pg. 158)
Assessing the Sustainability of Profits (pg. 160)
When the Pie Is Disappearing: A Broader View (pg. 165)
17 Strategic Moves: Changing the Game (pg. 169)
A Basic Strategic Decision (pg. 169)
Price-Setting as a Strategic Move (pg. 172)
Barriers to Entry: Entry as a Bad Move for a Competitor (pg. 172)
Entry and Strategic Change (pg. 173)
Strategic Change and Uncertainty (pg. 174)
Creating Competition, Part 1 (pg. 176)
Creating Competition, Part 2 (pg. 178)
Interaction of Strategic Moves (pg. 179)
Coordination & Management: An Example of Shaping Beliefs (pg. 183)
Incentives and Externalities (pg. 186)
Appendix: Game Matrices for Game Trees (pg. 188)
18 Strategic Moves: Restrictions (pg. 191)
Example: Competition Restricted due to Firm Choices (pg. 191)
Example: Competition Restricted due to Law or Social Convention (pg. 193)
Example: Competition Restricted due to Lack of Information (pg. 194)
Conclusion: A Coherent Story (pg. 195)
Notes (pg. 199)
Part I (pg. 199)
Part II (pg. 199)
Part III (pg. 199)
Part IV (pg. 200)
Part V (pg. 200)
References (pg. 200)
Index (pg. 203)
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