Magic of Margin 4: The Customer’s Derived Value

A margin killer is the price reductions associated with the commoditization of your product or service.  However, when viewed from the customer’s derived value and experience, there are no pure commodities! The concept of a commodity comes from the study of Economics and commoditization is referenced extensively in all Finance sections of business schools. There are commodity trading mechanisms, such as the Chicago Board of Trade, to allow markets to “clear”.  A market that trades in core products will always adjust pricing to a point where supply and demand become equal, or clears.

So, how can there be a commodity trading system but no commodities? Take a building commodity, say, concrete.  Concrete is concrete is concrete, and for a stated grade or quality level, it is expected to be equivalent from multiple sources. Aren’t products in a category homogenous?…for example, Grade A Jumbo Eggs are all equivalent or the same…?

The answer is an emphatic YES. Certainly, a core product (like concrete or eggs) can be readily sourced from multiple outlets. However, this requires a market that is mature, very large, and liquid (suppliers can easily sell on it).

Consequently, there are two fundamental problems with “commoditizing” a product or service… a) ability to differentiate the product or service, and b) market segmentation.

1. Differentiation: Defeating Commoditization


Commoditization is often utilized by buyers in procurement negotiations for increasing pricing pressure,  even in the absence of the inherent ability to substitute between suppliers. More importantly, if a product or service can be differentiated, there is no commodity. The pivotal aspect of differentiation is the augmented product. An augmented product is tied to the core product, but it inherently differentiates it. For example, the packaging of a product is a simple augmentation. Go to any grocery store and look at the prices of a 2 liter and 20 oz bottle of Cola on the shelf. Not only is the core product identical, the amount of core product varies significantly. In contrast to intuitive reasoning, less of a product should cost less. However, the price for the smaller product is at least equal to, and sometimes more than the larger version.

The reason for this difference in price, has nothing to do with the core product; it is exactly the same in both instances. The difference is being driven by the “customer derived value and experience”…in this case convenience and single serving size. Perhaps paradoxically, customers seem to be willing to pay more to a) have a more manageable container, or b) avoid discarding most of a 2 liter bottle, after they extracted their single serving. This isn’t rational, because according to economic logic, buying a larger size and throwing away most of it makes more economic sense than buying a smaller size for the same price. So why would a buyer pay the same price for a smaller volume of the core product?…the “customer derived value and experience”.

Another product augmentation would be the temperature at sale. Leave the grocery store, enter  a convenience store, and look at the prices for the same 20 oz Cola…they will likely be priced higher yet, because the product is more convenient, plus, it is chilled and ready to consume when it is purchased.

In your world of more complex products or services, the ability to enhance customer derived value is far greater than it is in the soft-drink industry. For example, the company selling the product can be differentiated, like being a Minority, Woman, or Veteran owned business. This non-core product augmentation changes purchasing criteria for the government, which has a legal right to the lowest available price for a commodity. Other ways to differentiate include differentiation of service offerings, e.g., training, support, logistics support, customer education, and Brand. These are examples of product augmentations that defeat commoditization.

2. Market Segmentation: Making Margin


Having different levels of differentiation increasingly makes sense in a mature market. Why? Different segments of a market have greater similarity to each other than to the market as a whole, for example, economy, standard, luxury. Other examples of consumer market segment are income level, education level, location, gender, ethnicity, and so on. In industrial markets the location, revenues, number of employees, number of locations, and other demographic variables are used for segmentation.

Each segment is therefore a prime “mini-market” or niche to sell into, if the product/service and its augmentation provide an acceptable level of customer derived value and experience. However, in niches, market clearing, and widespread bidding do not happen like in a mass market. Therefore price competition is lower within segments, and price competition is arguably non-existent between segments. For example, a luxury sports car’s price is comparable and therefore somewhat competitive to similarly positioned cars. However, price and product competition is not stimulated by the existence of low cost sports cars. The market segments are different enough from each other that competition and commoditization are squelched.
Still, the fact that products inside a category are potentially substitutable is caused by market segmentation, not the structure or attributes of the core product. Instead, value is created in market segments by the closer alignment of the entire product/service (core and augmented). This alignment causes greater customer derived value and experience, and therefore supports higher margin.

Summary:
In the healthy and sustainable operation of a business, we all need and seek margin. Gaining more margin requires business operators to look at the product from the customer’s perspective, and that customer’s derived value from the product.

When a product or service is viewed from this perspective, there are no true commodities.
There are market segments with different levels of derived value, and tailoring a solution to these segments can resist the procurement practices of commoditization, and actually create more margin for buyer and seller.

For more information about how TIGI could help you resist commoditization, and a) gain more margin, b) increase sales velocity, or c) establish competitive advantage, contact us at info@mytigi.net.

First installment – The Magic of Margin in Deal Making.

Second installment – The Magic of Margin – Generate Margin

Third installment – The Magic of Margin – Create Price Competition

By:
Gunter F. Wessels, Ph.D., M.B.A.
Total Innovation Group Inc., Practice Principal, Partner
and
Sam O’Rear, MA, BS
Total Innovation Group Inc., Senior Partner

Total Innovation Group
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5401 W Kennedy Blvd
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813-814-1902