At Harvard Business School, I learned several simple broad strategy theories, which have always stuck with me and set my “strategic sails.’” One of these theories was: “the profit margin rapidly increases with identical repetitious products, while the risk of failure dramatically decreases.”
I met with a venture capitalist, who described his acquisition strategy as buying a set of “razor blade” businesses. “Razor blade” strategy specifically refers to the business concept that, if a company like Gillette sells a new Fusion razor with a proprietary design for the blade head, they are actually selling a multi-year annuity of razor blade replacements. These proprietary razor blade heads are mass-produced for several pennies and yet sold for close to $1 per blade, yielding an enormous profit that lasts as long as the person uses the razor. In fact, so much profit is generated in the annuity that it pays to spend enormous amounts on advertising in order to get people to switch to the newest razor. The razor itself can even be thought of as a lost leader.
Of course, this concept is well documented in pharmaceuticals, CDs, water purity cartridges, apparel, automotive parts, software products, iPod and tablet apps, etc. The real profit is not made in the original capital cost of the first item, but rather the repeat sale of a proven solution. Additionally, the greater the volume, the higher the margin goes up. Therefore, the profit can be exponential for repeatables. Repeatable product companies carry the highest profit margins in all industry sectors.
Many service company firms think very differently. They believe in customization and near “perfect fitted” solutions. They traditionally make profit from the margin in the labor rate and are not motivated to standard products. Customization requires more labor, thus more profit. Regardless, it just so happens that continuous customization without a sellable repeat is the least profitable thing you can do. It is akin to consistently producing the first razor with no blades in the aftermarket. Customization is also the prime characteristic of the most risky businesses.
Engineers are perhaps the worst when it comes to needing customization. Engineers are taught through years of education that there is a “right” mathematical answer to every problem. The professors and instructors demand to see not only your answer, but also the calculations that lead to that solution. There is only one right answer; leaving no room to estimate that a 25 horsepower (HP) motor is needed, when the answer they are looking for—the “right” one—is 23.67HP. It is only in the real world of equipment and pipe suppliers that engineers encounter people who understand razor blade and “racking” theory, and subsequently make and stock certain repeatable sizes, forcing engineers to round up to the nearest equipment fit.
This revelation caused me to study other consulting industries staffed with people holding advanced degrees. I started with the higher-margin labor sectors—accounting/auditing, financial and management consulting companies all generate considerably higher profit than engineering firms. I looked at how these sectors did their work and if there were “repeat” processes and solutions versus a continuous customization.
I found that if you divide a client consulting engagement into (a) the process of approach; (b) the data, content or client’s information; (c) the analysis or conclusion; and (d) the final physical presentation—you could see a repeatable pattern. For those higher profit industries, the process approach (sometimes called a template) and the final presentation formats create “repeatables,” using a set of company standards. The only customization needed relates to data/content specific to that client/project and the analysis/conclusion. The different audit firms I researched all had standard covers, formats, approaches and density. The data and the conclusions were the only customizable elements. This drastically reduced the cost of doing a project. It also increased the quality, as the approach was proven over and over. This launched me into the journey of creating standard corporate process templates and changing the pricing from hourly rate to lump sum.
Like the custom tailoring industry of the early twentieth century, we are heading swiftly into the era of “racked” products and solutions. Firms will realize that they can be leaders or laggards in this macro-trend. The Digital Age will drive efficiency through repeatable, proven solutions. Automation will crash the number of hours required to customization. It will make a significant headwind into the profit growth potential of services firms that depend on hourly profit margins. They will need to move to racked approaches at lump sum prices or shrink. Labor-based service companies that formerly judged their success on growing headcount will realize that profit potential tops it, and a growing head count might actually indicate a failing strategy.
We are already seeing this in the construction industry (a formerly renowned customizer) through the rapid emergence of modular construction that replaces customized construction approaches to custom designs. Construction companies are becoming the assemblers of modules or ‘kits,’ which are built offsite. The modules are racked solutions. The construction by modulization proves faster and cheaper, with more consistent quality. This trend will reduce labor while increasing quality. It will disrupt the profit models of the industry. So, even construction is headed to using the ‘razor blade’ theory.
Welcome to the repeat world.
© 2016 Robert Uhler and THE UHLER GROUP. All rights reserved.