The surprising relationship between the second law of thermodynamics and business excellence
Those who may remember their physics lessons back in school may recall the laws of thermodynamics. Simplified, the second law of thermodynamics says that heat will transfer from a hotter object to a colder object until both reach the same temperature. A similar thing happens in every business, the innovation and uniqueness of hot products or services transfer to colder, not as interesting, products or services of the competition. This transfer of interesting or valuable features does not mean that the competitions’ products or services become more valuable, it just means that it leads to commoditization – every company in a market vertical offering identical products or services.
But the fact is that you have a choice; keep your company hot, or accept a cooling off and commoditization.
So, from a pricing perspective, what is the difference between a hot product and a cold product (or service for that matter)? Well, a hot product or service or company has “pricing power.” Meaning that there is uniqueness or innovation that may be directly related to features, functions, go-to-market strategy, or even the brand. These differentiators are strong enough to generate a higher willingness to pay among at least a portion of buyers. A commoditized product or service can be one of two things: a product or service that has no differentiators compared to the competitions’ product or service. Zero. Nada. Nothing. This is extremely unusual. Almost every product or service has some aspects of it that are unique and that can be used to gain at least a little bit of pricing power. What is more common is that a company look at the main features or benefits of their product or service and find them to be identical to the competition, but are unaware that some lesser features or benefits may drive a substantially higher willingness to pay among a smaller portion of the marketplace. Then, because they believe they are completely commoditized, they price their product or service just like the competition. (This is under the assumption that competitors’ prices are published. If they are not, they set the price based on a guess of what their competitors charge.)
But let’s go to an example where the product is a true commodity and the prices are published. Gas. Here is a link to a short article from the Harvard Business Review.
https://hbswk.hbs.edu/item/when-your-customers-don-t-care-what-you-charge-what-should-you-charge
This is an interesting article in which they conclude that the majority, albeit small majority, of gas buyers, do not look around for the cheapest gas but instead, follow habits, simple inertia or in their minds they consider the “switching cost” of going to a gas station they are not familiar with, as being off-putting (that would be a very low switching cost, by the way).
But in the article, the authors fail to make one important conclusion. They correctly assess those price-sensitive customers are the least loyal. This is valid not only for simple commodities like gas but for other products or services, too. Thus, companies chasing price-sensitive customers with low prices and rebates often end up being less profitable than peers who focus on delivering customer value, and therefore, earn the right to charge higher prices while maintaining customer loyalty. The reason is obvious; if they price low to attract those price-sensitive customers, the price will be low for all customers, including those who are actually willing to pay higher prices for the product or service and the result is that they leave money on the table. And in some cases, a lot of money!
But how do you make sure that the heat of your product or service is not transferred to colder, competitive companies’ products or services? Well, the truth is that you cannot. It will happen. Even if you have patents for your products or services this process is slowed down, but it still happens—just a little slower than otherwise.
The only way to protect the pricing power you may have with your product or service is to innovate. And this is really hard, but consider the following:
- You cannot trust everything you hear from your customers, especially for a couple of very important reasons. First, they are your customers because they appreciate, and are willing to pay, for the features/functions and benefits your product or service has – not what it is missing. So, to ask them what they are missing is not going to be a very productive discourse. Your customers have already self-selected your current product or service buying it. They have accepted the bundle or feature and functions. They have accepted your marketing and accepted the price. Thus, asking your customers is not the same as asking the entire market. The key is to understand what would make those who did not buy, to buy.
- Secondly, customers will lowball what they value. In some cases, even making things up and certainly withholding information that you would value knowing. They simply don’t want you to know how much they value your product or service – in the hope that you will lower prices further. They are after the best possible deal from you and price-sensitive customers always purchase on price, the lower the better.
- Thirdly, a market rarely knows what it wants in terms of features/functions and benefits. It knows the problems and frustrations it has with current products or services, but a market rarely knows how to solve these problems.
Let me give you some examples. I’m an Apple guy, so I like to use examples from the time when they were a true innovator:
- Early MP3 players were hard to use and moving digital songs, from ripped CDs or illegal downloads (which were often distorted or abruptly cut off) from your computer to your MP3 player was a difficult and unreliable process. With the creation of iTunes and the integration to the iPod, Apple solved all these problems in one fell swoop. Few, if any, consumers would say they “were looking for a website to buy songs that sound good and magically appear on their MP3 players.” Apple identified the problem and came up with a solution.
- The iPhone was neither the first smartphone nor the first cellphone without buttons. Yet, its innovation disrupted an entire industry. That innovation was the App Store. Not the phone. At the time, cellphones were mainly used for calls and the occasional email, text or simple games. Being a user of some of the pre-iPhone smartphones, I certainly wished for a few very specific apps and maybe better games. I did not, nor did other consumers ask themselves: “I need to select games and applications from 10,000s of game and app developers, and I want to find those on a website and then they magically appear on my phone.” But Apple realized that if this service and product is offered, consumers will soon find ways to see the value of using such a service and product, driving both sales of the iPhone and the Apps.
But Apple became complacent and stopped finding a better solution to consumers’ problems. They did not hear consumers saying, “I want access to more songs than I can afford, especially if I have to buy every song for 99 cents.” This opened up the market to Spotify to become the dominant streaming music player. Nor did they listen to consumers saying, “I want access to more movies than I can afford, especially if I have to rent every movie for $4.99.” This opened up the market to Netflix to become the dominant video streaming player in the market. The current Apple+ streaming service is, by the majority of analysts and commentators described as a joke. Too little too late.
So, my point here is how important it is to understand the problems your market has, so you can come up with a solution to fix those problems. The key is to understand the difference between “the market” which include all possible buyer and “customers” that are self-selected to your existing products or service or company. Once you know “the market” you can come up with a solution, an innovation, that is better than that of your competitors. That is the only way to fend off commoditization. In order to do so, not only do you need to know what problems your market wants to have solved but more specifically, you also need to know what problems the market wants to pay for them to be solved. And how much. There is no use coming up with innovation “everybody wants” and “nobody wants to pay for it”!
But here is the big difference between business and the second law of thermodynamics: A hot body in thermodynamics has no choice but to lose heat. But a hot company or a company with a hot product or service has a choice. It can elect to retain or even increase the “heat,” or not. The choice is yours!
Per Sjöfors
Founder
Sjöfors & Partners
www.sjofors.com