by Pat Bodin
You would think that a nuclear power company would be highly protected from new entries, because of the regulations and technical requirements. And you would be right. If you live in the U.S. and a certain nuclear power company services your state, a new competitor is unlikely to pop up anytime soon. That’s not a major threat.
Now, the value proposition of a nuclear power company is high-quality sustainable electricity at low cost. Other business models can have that value proposition too. For instance, the number one generator per site of electricity in the world is not nuclear—it’s hydroelectric. Nine of the top generators of electricity in the world are hydroelectricity plants.26 If you can get water to fall and harness its energy, you can generate the most inexpensive electricity. So, in some places hydroelectricity is a substitute for nuclear power. Both deliver the same value, but using diverse technology models.
Substitution is what happened to the taxi companies of New York. Their value proposition is roughly, we’ll get you from point A to point B quickly, cheaply, and easily. Ride sharing companies said, “We’ll do the same thing, but better.” Uber and similar ridesharing companies democratized the taxi industry so that almost anyone could be a driver, then connected those drivers with passengers through apps. That radically changed the taxi companies in New York City forever. Most of them have lost a tremendous amount of equity inside their medallions.
Suppose you were a technologist working for a taxi company when these ride-sharing organizations first began to emerge. If you ran a Five Forces analysis, you could probably identify them as a threat to your company and help develop a rapid response plan. Your company could even invest in Uber to hedge its bets—and that bet would have paid off big time.
To summarize, the two threats on the Y-axis are the threat of new entry at top and the threat of substitution at bottom. Both threats are from an organization that shares your value proposition, but a new entry shares your business model while a substitute does not. Risk is measured on a scale of 1–5, with 1 being very exposed and 5 being not at all exposed.
Factors affecting threat of substitution include:
• Substitute performance
• Cost of change
Supplier power
On the left of the X-axis is the threat of supplier power. Supplier power corresponds to supplier number—the more suppliers you have, the less power each individual supplier has over you. A sole supplier is administratively easier; plus, you should be able to negotiate a volume discount. The problem is that the supplier eventually comes to have power over you.
Some large chemical companies have a single-source supplier for materials like uranium, which is not exactly plentiful. They simply have to deal with that risk, since diversifying their suppliers is not an option.
Some years back, I founded and managed Firefly, a consulting company that generated revenue through consulting and education activities. The ancient Aztecs considered the firefly to be a source of knowledge in a world of darkness.27 That’s an accurate description of what we were doing at Firefly: we were educators and illuminators. At Firefly, we had a sole provider of data center space and the automation software that orchestrated our global lab environment. We were closely aligned, and they provided a great service, but having a sole provider for such a critical activity was a substantial risk for us. We had frequent conversations with our supplier to stay on the same page. We even entertained the idea of buying them a few times, to mitigate that risk. Do you have a single-source supplier? Then regularly having open conversations is critical.
A chemical company that has a single-source supplier gets a 1 in risk rating; they have a substantial risk in that product area, as putting all of your eggs in one basket is a high-risk endeavor.
Now consider Walmart, which has a great deal of influence over its suppliers. If Walmart is unhappy and they are not getting the level of service that they need, they can replace suppliers. Since Walmart sells products at a high volume through their stores or online, suppliers are willing to do a great deal to keep that relationship healthy and keep their products selling. The risk of supplier power for Walmart is at 4 or higher, since there is little risk to them.
Factors influencing supplier power include:
• Number of suppliers
• Size of suppliers
• Uniqueness of change
• Ability to substitute
• Cost of changing
Buyer power
On the right side of the X-axis is the threat of buyer power. Any organization that represents more than 5% of your revenue has some power over you. If your organization files with the SEC, you must include those organizations when you report risks to your business.
When I first started my consulting company, our first buyer represented 100% of our business. That buyer, whether they knew it or not, had tremendous influence over us. By the time I was ready to sell the company, that same buyer had decreased from 100% to 15% of our thriving business—substantially less risk, though still reportable risk. Any public company in the U.S. has to report when any buyer represents more than 5% of their business revenue.
Think about how much influence your buyers and your suppliers have over you. As a technologist, help your organization mitigate those risks. You can bring practical plans to the strategists and be relevant because you’re decreasing the risks they’re concerned about.
Factors affecting buyer power include:
• Number of customers
• Size of each order
• Difference between competitors
• Price sensitivity
• Ability to substitute
• Cost of changing
Competitive rivalry
The final threat is the threat of competitive rivalry. This is competition from established companies, like Walmart vs. Target or Apple vs. Microsoft or Ford vs. Toyota. Factors affecting this include:
• Number of competitors
• Quality differences
• Other differences
• Switching costs
• Customer loyalty
Completing the analysis
Once you have numbers for the threat of new entries, substitution, buyer power, supplier power, and competition, average them together. That number is the average risk for your organization.
To go the extra mile, compare your average to that of your top competitor to see who is more competitive in the marketplace. Assuming your leverage ratios (debt-to-equity ratios) are similar, then whichever company’s score is higher should be generating better net income. If your score is higher but you’re not generating more income, there’s a variable you are not accounting for. Or maybe your business is not leveraging the power you have. Either way, there’s an opportunity for you to understand your organization’s competitive position better and find innovative solutions.
Risk drives change
Look at the whole business model. On the top are the value proposition and the revenue it creates. The bottom has capabilities, along with the building blocks for the capabilities and the costs associated with creating them. The combination of value proposition and capabilities is called “packaging,” which creates the gross margin. The left includes risks, which oppose the value proposition and lead to change.
That’s the key: risk drives change. Organizations alter direction because of external risks. For instance, consider macroeconomic risk—ridesharing companies like Uber, Lyft, Juno, Didi, and Grab pose a threat to traditional transportation services. Some millennials have chosen to rideshare everywhere instead of buying cars and major automobile manufacturers have taken note. This reality demands a change in business model.
Thus, in 2016 General Motors invested $500 million into Lyft. Why? To head off risk by turning Lyft into a partner, including it in the GM business model. Additionally, Lyft has begun renting GM vehicles to Lyft drivers who need a vehicle and take a certain number of trips per week. Lyft is now a part of GM’s supply chain, so that even if ne
w car purchases drop off, the ridesharing drivers who replace those purchases will still be driving GM cars. The partnership has come full circle.
For technologists, seeing the connections between GM, Lyft, and the car driver allows us to understand where we can insert technology to enable our business to be successful. Take the almost-certain reality that a future generation of Lyft cars will be autonomous. How can old-school GM technologists partner with born-on-the-Web Lyft technologists to produce and utilize such a vehicle? I don’t know the answer, but I know there is one. It’s up to the Blue people to find it and when they do, they’ll be massively relevant.
Linking your projects to risk
Risk to the business model creates the need for change. Green strategists evaluate the needed changes and establish goals. A goal is something that needs to change and it lives at the top of the business model: “Increase revenue by 15% this year.” That goal requires changes on the bottom of the business model. For example:
• Cost structure – Hire salespeople and spend more on salary
• Resources – Replace CRM or update with new module
• Activities – Refine sales process with the help of outside consultant
• Partners – Partner with retail outlets to put our product on their shelves
• Channel – Add an online e-commerce portal to complement direct sales
• Relationships – Create a customer loyalty program for long-term retention and sustainable growth
The one desired change of “Increase revenue by 15% this year” ripples throughout the entire organization. Business initiatives come out of it and lead to the projects we are assigned. We talk about our projects all the time, often not realizing that they came from the rippling impact of a need/change/goal within the business or mission model.
Why does this matter? Because you can link your projects directly to the strategy of your organization, directly to the risks that created this change in the business model. You couch your activities in terms that are relevant to Green’s desire for productivity. You become a relevant enabler.
Do you want to have an effective conversation with your Green leadership? Then you must talk about these things. The only business topic that matters is the business model. If you aren’t talking about the business model, you should focus on their personal interests (fishing, etc.) because nothing else is relevant. The only thing relevant to your leadership is the business model and the risks and initiatives associated with it. You have to connect your daily work in technology to the business model, like this:
Link all these together and you’ll be perceived as relevant to your organization. You’ll be able to secure the funding required for your projects. After a great year, you can ask for capital expenditure (CapEx) to beef up the resources required to meet business needs. And if you have a tough year, you’ll be able to navigate operational expenditures and keep your organization as healthy as can possibly be.
The key is linking what you do to what they do. That’s it. If you link what you do to what Green wants to get done, you are relevant.
Chapter 12.
Financial Analysis
ROI and TCO
Green strategists spend much time discussing numbers. Technologists don’t have to be financial experts but should understand the financial concepts that pertain to their area.
Two frequently used acronyms are ROI and TCO. They stand for Return on Investment and Total Cost of Ownership, respectively. I often hear them used in the same breath, as synonyms, but they are not the same.
The confusion often occurs because technologists are constantly hearing business leaders use these terms without understanding context. The business leader has many investment options which are evaluated with either a hurdle rate or internal rate of return; these are formulas that calculate minimum expected return on any investment. Since no one has ever taught the technologist that a return can only be achieved based on investment with expected cash flows, they may believe that it is just another way of budgeting and that the business leader wants justification for the purchase. Due to the technologist’s core focus on efficiency, they interpret the leaders’ financial motives as another way to save money. But ROI does not mean that.
Total Cost Ownership (TCO) is comparison: we compare one product to another product. This comparison could be between the product we own and something entirely new. We evaluate the variables, like leasing vs. owning. TCO is like comparative shopping. You weigh many variables: location, selection, brand, price, customer service, personal preference.
If someone wants to buy a nice pair of pants at a mall in Dallas, they need to decide where to go. Let’s say that they see a Nordstrom’s and a Macy’s and they are the same distance from each, so location is a tie. Both stores carry the pair of pants they want, so selection is not an issue. Perhaps this person is a lifelong Nordstrom’s customer: Nordstrom’s will tailor their clothes for free and have extraordinary customer service. This person will pick Nordstrom’s unless Macy’s can sway them with a 50% discount. That’s TCO. According to Forbes, a new competitor’s perceived value must be 10x or higher than the incumbent to sway the buyer.28
ROI is not like that at all. Let’s say I invest a million dollars into a project with an expected return of $300,000 per year for five years. That will get me $1.5 million in total cash back. Each year I’m making about 10% profit on my money. From a personal investment perspective, that’s pretty good. But is that a good move for an organization? An organization has other investment options, like buying technology or train locomotives. The business evaluates potential options based on what the business needs. What are its goals? What results need to be achieved?
The “hurdle rate” is the ROI a project must be expected to meet before it can receive funding. For instance, the business might not invest in any projects below a 10% hurdle rate.
ROI is about cash flow. That’s why Green people are much more interested in ROI than they will ever be about TCO (comparison shopping). Those in the Red and Blue worlds, these tactical and operational worlds, care about TCO because they are often short on budget. They need to achieve a result with less money, so they compare.
ROI and TCO can work together if one understands them correctly. Let’s say you want to launch a project with one of your business leaders that will generate 13% ROI and your organization hurdle rate is 10%. If successful, that would greatly benefit your organization, so be sure to call your shot as we discussed earlier. Say, “This project will generate 13% ROI.” Then do your job well and hit the mark. After that, measure what matters. If you measure a successfully achieved 13% ROI, that’s not only what matters, but extremely relevant. When evaluating suppliers for the project, you will choose from different options, you will use TCO to evaluate different options, and choose the best solution based on the variables (price, availability, etc.) that matter most to the project.
Capex vs. Opex
Capex (Capital Expenditure) is an investment. You invest capital dollars into a project which will increase your capabilities and you expect an equal or greater return through that investment. If you are in a commercial organization and your company has had four consecutive quarters of profitability, Capex is essentially free. You are either going to spend it or you are going to pay taxes on it. As you think about the resources needed so that you can support the business model and maintain your capabilities, Capex is a valuable asset. You can use it to shore up your environment and capabilities to be prepared for the next big wave.
Opex (Operational Expenditure) is the necessary expenses to run your organization each day. In a successful organization, you spend operating dollars and earn back more dollars in revenue. Accountants want to match revenue to the expenses used to generate that revenue. Opex is always carefully scrutinized because it generates your operating margins, your EBITDA (earnings before interest, tax, depreciation, and amortization), your net income, and eventually your publicly held EPS (earnings per share). For a pr
ivate company, the company’s worth is typically derived based on a multiplier of EBITDA.
Too many people talk about Capex and Opex without knowing the difference. They don’t realize that the net income of the organization is critically important and that the income statement drives many of our business decisions. The income statement holds the organization’s revenue and expenses. Capex comes from past profitability that is now available to spend. In fact, if you don’t spend your profits then you will be taxed on it. In the US, the corporate tax rate of 2017 was 35%, so at that rate, spending $1 would strengthen the company and effectively cost only $0.65.
You should approach your Green strategist and request Capex during a good year. If your organization has had a poor year, then Capex is just not available. A good year is a good time to shore up internal resources, improve partnerships, and identify opportunities where you should invest heavily. Make capital expenditures at the right time, realizing that money will not be available during a bad year.
Strategic budget thinking
Demystifying ROI, TCO, Capex, and Opex helps us to think strategically. We in IT have historically been handed a budget, told “You have only this much money,” and accepted it. Instead, we must realize that budget is derived from the business model. If we aspire to get in the front boat, we need to understand the budget we’re being handed. There’s no magic about finances. Green strategists are driven by the mission; know that, and you can better decipher the budget they hand you; you can even ask them for what you need.
