Sources of profit
As will be discussed later, existing firms, even large firms and government departments, can become more nimble , more responsive to market changes, more pro-active in light of foreseen changes in industry and/or market environments. To do so, they must build a more entrepreneurial culture within their organisation. But first there are a few more building blocks to put in place, starting with a comparison of the different sources of profit available for a firm.
There are six main sources of profit, namely monopoly, customer ignorance, cost leadership, product differentiation, innovation, and speed to market. Not all of them are sustainable.
1. Monopoly profit
It is basic economics that a seller with monopoly power can ask for and receive a price greater than the full cost of production and marketing of their product or service. Monopolies exist because of a lack of competitors in the marketplace , usually because of the existence of significant barriers to entry for potential rivals (see below). Where competition exists, the price is forced downwards until no firm earns excess profit and all competitors earn only ˜normal profit (that is, just enough to induce them to keep their assets employed in that industry).
Barriers to entry include exclusive control (by the monopolist) of necessary inputs to the production process, such as possessing the only feasible location, necessary raw materials, skilled human resources, and so on. Governments may provide legislative or regulatory barriers by allowing only one firm to have legal access to customers in a market (like defence, for example). Patent protection may also allow a monopoly to exist. Economies of scale provide a barrier to entry in markets that are small relative to the ˜optimal scale of plant in a particular industry. [ 6] Transportation costs limit the distance from its manufacturing facility over which a firm can compete with other sellers who are located elsewhere. [ 7]
And finally, product differentiation can provide a formidable barrier to entry, since any new entrant will be at a cost disadvantage , needing to spend substantial sums of money to convince potential customers that their product or service was as good as the brands with which customers are already familiar.
Access to monopoly profits, however, is rapidly decreasing . Illegal control of resources and other restraints on trade are increasingly being punished by the government watchdog, the Australian Competition and Consumer Commission (ACCC). Patents are constantly being challenged or ignored in global markets, and the legal costs of prosecuting an alleged patent violation are becoming higher and higher. Deregulation of traditional monopoly industries has become the norm around the world. Transportation costs have been reduced in the wake of the computer, communication and transportation revolutions. And finally, product differentiation is harder to claim today, with better market intelligence fostered by the Internet. Thus, monopoly as a source of profitability is harder to find and to capture. So, where else can the firm look to earn ˜super profits?
2. Customer ignorance
If customers don t know that a better product is available at the same price, or that the claimed differences are not real, they may pay more money for the product or service than they would if they had better information. Thus, when information is expensive or impossible to get, customers pay more, and firms gain higher profits.
The computer and communications revolution has changed all this for the better, at least as far as customers are concerned . Now, market intelligence and comparative product information regarding many products and services is readily available in the print media, on radio and television, and of course, on the Internet. A quick browse using www.google.com will find information on whatever you seek.
Thus, search cost (the cost of obtaining information about products) is lower than ever before. Customer ignorance is soon removed by the acquisition of relevant information or knowledge. This means that customer ignorance as a source of profit is no longer the goldmine it once was, and is a temporary source of profit at best.
3. Cost leadership
Michael Porter, in the 1980s, taught us that we needed a strategy to gain superior profits, and that there were two main competitive strategies, cost leadership and differentiation. [ 8] Cost leadership can be attained if we introduce process innovations that reduce the cost of production and/or marketing and/or management. Alternatively we might introduce cheaper raw materials or imported components manufactured in a low-wage country.
But with the increasing availability of information, such cost reductions (and the reasons for them) soon become apparent to all of your rivals and they move to match your cost reductions, spurred on by their loss of market share and profitability if they do not. Cost advantages can only be maintained if the firm has intellectual property protection (either patents or trade secrets) on its process innovations, and in most cases this will not last very long.
4. Product differentiation
Customers will pay more for a product that better serves their needs. Thus, a firm might differentiate its products to match the tastes and preferences of a niche market. The firm might add features and capabilities that are desired by specific customers, who will then redirect their purchasing power to reward the firm that has taken the trouble to meet their needs.
Although product differentiation will cost the firm additional expense, it is a profit-making strategy if the firm can raise its price by more than the increase in unit costs. That is, if customers are willing to pay the extra price asked, the firm can make extraordinary profits by differentiating their product for specific market niches and target customers.
Successful product differentiation, however, is usually short- lived. Rival firms notice their loss of sales and look for the reasons why. They notice that customers prefer the newly differentiated product, so they redesign their own product and service offerings to win back market share and profitability. As with the earlier example of pizza delivery, soon the innovative product or service features are offered by all or most of the rivals, and the original product differentiation advantage of the innovating firm is lost to the imitators. Even patent protection offers only a limited period of protection from imitators. A firm might have up to 20 years if the patent is really rock solid, but where the patent is weak and rivals can easily ˜invent around it there will be very little protection from imitation. Indeed, rivals may simply ignore a patent in jurisdictions where it does not apply, or where the legal system cannot prevent imitation .
5. Innovation
Obviously the fuel for such differentiation is innovation. Innovation is also the fuel for cost leadership. But if rivals imitate your differences, you must innovate again in order to step out ahead of the field and maintain cost leadership or claim a further product or service differentiation, and then and only then can you regain an extraordinary profit. Accordingly, firms must practise relentless innovation, in the absence of barriers to entry that prevent imitation, if they are to gain ongoing competitive advantage and thus enjoy sustained and superior profitability.
So, given the relative ease of imitating industry ˜best practice in production, marketing and management, and rivals ability to mimic best-selling product or service design, innovation typically provides only temporary market advantage. Thus a firm must strive to innovate continually if it wants to earn extraordinary profit in the longer term .
6. First to market
But the key to innovation is speed to market. If you are not first to market, you cannot gain the so-called ˜first-mover advantages that allow your firm to move out in front as the cost leader or the differentiator. The duration of the first-mover advantages depends upon any barriers to imitation and the pace at which rivals are able to catch up.
Since many firms may see the innovation opportunity at roughly the same time, a race typically develops to be first to market and to reap the first-mover advantages. Thus speed to market is imperative ”the sooner the firm launches its new product or service into the market, the sooner it can stake its claim to the first-mover advantages.
In the race to be first to market, entrepreneurs adopt the Ready, Fire, Aim mentality . It is often considered better to be the first- mover with an imperfect product, than to spend extra money and time refining the product to best serve customer preferences and meanwhile find that another firm has grasped first-mover advantages. In the new economy we have become accustomed to hardware and software that is launched before all the bugs have been worked out, hastily pushed onto the market to beat another firm s new hardware or software product.
First-mover advantages also provoke entrepreneurs to take higher risks than established firms. The perceived window of opportunity will slam shut if another firm gets through that window first. Thus the higher expected rewards associated with being the first-mover notionally compensate for the high risks involved in going to market before all risks have been minimised.
[ 6] The optimum scale of production is found when unit costs are minimised, and if the firm is still expanding to reach this level when the total market demand is satisfied, there is certainly no room for a second firm. Indeed, if there were originally several competing firms, their shareholders would press for takeovers and mergers to consolidate the resources into a single (monopoly) firm in order to maximise the profitability of the industry.
[ 7] Local monopolies (like small-town bakers and ready-mixed cement firms) have a transport cost advantage in their immediate proximity that prevents other firms in other cities competing with them.
[ 8] M Porter, Competitive Strategy:Techniques for Analyzing Industries and Competitors ,The Free Press, New York, 1980.
