May 22, 2007
@ 05:54 PM
Comments [10]
Kill the Cash Cow Before Your Competitors Do. Really?

Thanks to books like the Innovators Dilemma it is now an oft repeated bit of business lore, especially within the technology industry, that you should kill your cash cows before two guys in a garage do it for you. The skeptic in me suspects that this bit of industry truism is part of The Halo Effect at work. People have sought out examples that confirm this statement and ignored the hundreds of counter-examples that show how dangerous this kind of thinking can be to a business.

Recently I wrote a blog post entitled Arguing Intelligently About Copyright on the Internet which addressed some of the most common anti-copyright arguments you see on the Web on sites such as TechDirt. Mike Masnick of TechDirt, took umbrage at my post and followed up with a comment to my post as well as a TechDirt article entitled The Grand Unified Theory On The Economics Of Free. In the article, Mike Masnick makes a number of assertions that are similar to the truism around killing your cash cows.

Mike Masnick writes

First off, and this is key, none of what I put forth is about defending unauthorized downloads. I don't download unauthorized content (never have) and I certainly don't suggest you do either. You may very well end up in a lawsuit and you may very well end up having to pay a lot of money. It's just not a good idea. This whole series is from the other perspective -- from that of the content creator and hopefully explaining why they should encourage people to get their content for free. That's because of two important, but simple points:
  1. If done correctly, you can increase your market-size greatly.
  2. If you don't, someone else will do it correctly, and your existing business model will be in serious trouble
If that first point is explained clearly, then hopefully the second point becomes self-evident. However, many people immediately ask, how is it possible that giving away a product can guarantee that you've increased your market size? The first thing to understand is that we're never suggesting people just give away content and then hope and pray that some secondary market will grant them money. Giving stuff away for free needs to be part of a complete business model that recognizes the economic realities. We'll get to more details on that in a second.

As a business, increasing your market size is nice but maintaining your profits is even nicer. If you have 200,000 customers and make $80 profit per customer, would you be interested in doubling your customer base while making $20 profit per customer due to lowering your prices? The point here is that simply increasing the size of your market or the number of your customers does not translate to increasing the business's bottom line. As for the second point listed above, healthy paranoia is good but it shouldn't replace good business sense. After all, the list of successful fast followers includes some of the biggest companies in the world. If it worked for Google and Microsoft, it can work for your business.

Mike Masnick also outlines his business advice for purveyors of intellectual property digital content which is excerpted below

So, the simple bulletpoint version:
  1. Redefine the market based on the benefits
  2. Break the benefits down into scarce and infinite components.
  3. Set the infinite components free, syndicate them, make them easy to get -- all to increase the value of the scarce components
  4. Charge for the scarce components that are tied to infinite components
You can apply this to almost any market (though, in some it's more complex than others). Since this post is already way too long, we'll just take an easy example of the recording industry:
  1. Redefine the market: The benefit is musical enjoyment
  2. Break the benefits down (not a complete list...): Infinite components: the music itself. Scarce components: access to the musicians, concert tickets, merchandise, creation of new songs, CDs, private concerts, backstage passes, time, anyone's attention, etc. etc. etc.
  3. Set the infinite components free: Put them on websites, file sharing networks, BitTorrent, social network sites wherever you can, while promoting the free songs and getting more publicity for the band itself -- all of which increases the value for the final step
  4. Charge for the scarce components: Concert tickets are more valuable. Access to the band is more valuable. Getting the band to write a special song (sponsorship?) is more valuable. Merchandise is more valuable.
What the band has done in this case is use the infinite good to increase the value of everything else they have to offer.

The implicit assumption that Mike Masnick makes here is that losing the profits from cheaply copyable and easily distributed digital content will be made up by selling goods and services that is related to the digital content. I am highly suspicious of the theory that replacing the profits CDs, digital music and ringtone sales with the profits from increasing concert ticket prices ends up being a net positive for successful musicians.  The key reason for this is that,  there are physical limits on how many concerts a band can have or how many people can attend in a given location but such limits barely exist with regards to distributing digital content.

A concrete example is comparing the relative profits of the proprietary software companies with the Open Source software companies. In a recent blog post entitled The 'we win by killing' days are passing Tim O'Reilly wrote

1. Pure open source software businesses are orders of magnitude less profitable than their closed source brethren even as they close in on them in terms of the number of customers. (Compare Red Hat and Microsoft, MySQL and Oracle.) Meanwhile, companies built on top of open source but with new layers of closed source (iconically, Google) are building the kinds of outsized profits that once were the sole province of old style software companies. As growth slows, as it inevitably will (even if it takes another decade), these companies too will seek to maintain their outsized profits.

2. Outsized profits come from lock-in of one kind or another. Yes, there are companies that have no lock-in that gain outsized profits merely by means of scale, but they are few and far between.

The experiences of the software industry seem to contradict Mike Masnick's diagnoses and recommendations for the music industry. Giving away your most valuable asset and hoping to make it up by selling peripheral services and add-ons is more likely to destroy your company than become your redemption.

Counter arguments welcome.


 

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Tuesday, 22 May 2007 19:07:19 (GMT Daylight Time, UTC+01:00)
You are right Mikes's business math is not quite correct but I think is overall point has merit. In as much that digital technology has lowered the perceived cost of music. The distribution costs are now negligible, and that plays into the basic understanding of supply and demand. Simply put,the demand has and still is increasing, but the ability to supply in vast quantities has lessened the value.

I have complete respect for the copyright of material, but the real point here in that the copyrighted material (specifically digital music) has lost value. Why shouldn't we rethink what a piece of music costs if the delivery is so easy. There is no justification for a digital song being worth 99 cents.

As Mike suggests the irreplaceable portion of an music artists service is the live performance. I kind of like that (for music) it seperates the crap artists from the good ones.

http://dotnetinnerspace.spaces.live.com/blog/cns!19D2BF617BEFCC7A!740.entry#trackback

Mark
Tuesday, 22 May 2007 20:49:06 (GMT Daylight Time, UTC+01:00)
Dare-
I think the concept of the innovators dilemma (and Schumpeter's creative distruction http://en.wikipedia.org/wiki/Creative_destruction) is more interesting an apparent when you look at the desktop productivity application market (Office). MS is in the classic innovators dilemma there, with a mature, slowing growth cash cow facing competitors trying to introduce a technological discontinuity - online/hosted apps like Zoho, Google Apps, etc ho rely on free, cheap, or ad-supported revenue models and a "good enough" feature set.

This may not have had a major impact on the incumbent's revenues (yet, jury is out) but it is forcing strategy changes as the incumbent reacts - Office Live and other initiatives both product and marketing designed to begin countering. MS is in the classic position of trying to react to the discontinuity without undercutting it's own cash cow, whereas the competition has no such constraints and is free to introduce radical innovations (in business models if not in technology).

So I can't speak to Mike's arguments on digital content, but the concepts of the innovator's dilemma and creative destruction I feel are both very valid and relevant. The desktop productivity apps market now and over the next 10 years will likely - one way or the other - end up as a business school case study on the concepts in the decades to come.
Kevin
Tuesday, 22 May 2007 21:07:37 (GMT Daylight Time, UTC+01:00)
I agree that giving away your most valuable assets isn't the answer. However, by definition if you enjoy high-margins, there is competitive interest in trying to displace you. Head-to-head battles there often fail and can be easily rebuffed - for a time. But relying on that alone is fatal. Eventually, ALL high-margin businesses face competition. Therefore, smart companies who enjoy high margins should always be working to make their offering better to extend the point when that occurs, but also preparing for being the leader in whatever obsoletes it - even though that invariably means less margin/$. Sometimes the latter even spawns interesting - possibly even more lucrative - markets (e.g. HP ink-jet vs Laserjets and discovery of the even higher-margin consumables business).
bob
Tuesday, 22 May 2007 21:15:16 (GMT Daylight Time, UTC+01:00)
Kevin,
I'm not disputing that instances of "The Innovator's Dilemma" exist. My point is that the knee jerk reaction of 'killing your cash cows before your competitors do' is questionable advice at best.
Dare Obasanjo
Tuesday, 22 May 2007 22:33:31 (GMT Daylight Time, UTC+01:00)
This sentence from Mark's comment above is just silly:

"There is no justification for a digital song being worth 99 cents."

A song is worth whatever the market will bear regardless of distribution method. Why on earth would an artist not seek to obtain what the market is willing to pay? Even in the age of illegal copying of music, an artist is still better off selling rather than giving it away if there are buyers who prefer to remain legal and are willing to pay the listed price.

To be cynical, the music artist can still obtain the “benefits” of the songs being available for free since it is already happening anyway through illegal copying.
Rob
Wednesday, 23 May 2007 00:27:29 (GMT Daylight Time, UTC+01:00)
Hi Dare,

Thanks for discussing this topic again. I think this post is a lot more relevant and interesting than your last post. However, I will note that you neither responded to my comment on your post, nor corrected the many, many errors in that post. I'm surprised and upset that you would leave false statements as they were even after they were pointed out to be false.

So, I didn't "take umbrage" at your post. I "took umbrage" at the fact that you mischaracterized my argument to a degree that was silly and have since refused to correct the clear mistakes. I also find it amusing that after trashing (incorrectly) the points that I made and insisting that it made you feel "dumber" that you would then come back again to take my arguments seriously. Either you're admitting that maybe I'm not as big an idiot as you claimed the first time around, or you like arguing with fools. Which is it?

This new post is much more interesting, but at no point do you address a single criticism of your original post. That seems quite questionable to me, and I can only speculate as to the reasons why.

Your post above raises two basic assertions, and I think both are worth discussing. The first is the idea that competitors will cannibalize your existing business if you don't and the second is that the ability to make more money from the new markets is much greater than the old.

You claim that the first isn't true and that supporters of the idea cherry pick their results. It would be great if you could actually support that with some evidence. I've been going through, in fairly great detail, the economic and historical evidence of growth over the last few years, going through a tremendous amount of data and research and have yet to see a case that disproves the basic claim of the Innovator's Dilemma. Assuming that there is no artificial barrier to competition, then competitors can and do come in and take market share over time. It may not be quick and it may not be the first competitors who show up on the market, but it does happen -- with fairly convenient regularity (well, inconvenient for you). If you have data to disprove this, I'd love to see it.

The basic key economics that we've lived with for a couple centuries are based on this kind of economic growth, so it would be quite interesting to find out that this basic element of economics is totally wrong.

Now, as to the second point. If, as you claim, the first point isn't true, then the second point shouldn't matter. After all, if you don't have to worry about competitors eating into your market, then you shouldn't have to worry about whether you can make better profits in that new market. However, by addressing it, you seem to at least be willing to admit that companies do recognize that competitors come in and eat away at their markets.

So, since you still want to discuss it, your "proof" against it is exceptionally weak. The point of my explanation is to show that the overall market is much bigger, but I do admit that capturing the larger profits takes some work. That doesn't mean that everyone will succeed in profiting from it -- but that those who understand the economics absolutely can profit from it to a greater extent. The fact that a few open source software firms haven't figured out the best model yet doesn't mean you're right. It just means we're early in the process.

Also, I think you're defining the market incorrectly here (though conveniently for what you're trying to prove). If you read my series of posts, you always need to look at the key *benefits* received by users to define a market, rather than the product being sold. You incorrectly define the market as software, but that's not the market. No one buys software for the sake of software. Instead, the market is for productivity -- and that includes much more than just software. Once you understand the appropriate market, your key point doesn't look nearly as strong. You see lots of giant firms, including Sun, IBM and Google making an awful lot of money using the free open source products to make lots and lots of money by better solving productivity issues for buyers.

By focusing just on software, it's like the maker of buggy whips poo-pooing the birth of the automobile because steering wheels aren't nearly as profitable as buggy whips. It may be true in the narrow focus, but it's deathly in the long haul.

I'd recommend that you avoid being the buggy whip seller.

Again, look at the historical data. Every disruptive change to markets has resulted in much larger markets, where the successful innovator/disruptors were able to capture much greater profits. The *margins* may be smaller, but the overall profits tend to be much, much bigger. If you can find counter-examples, again, I'd love to see them.

The thing is, your own employer is a great example of how this process works. It was taken by surprise by a tiny upstart called Netscape, and it responded first by innovating, and then by giving away a browser for free to enhance the value of the other products it was selling. If it had been up to you, you would have charged for IE?

On these points, we can agree to disagree, though there's a ton of historical evidence to suggest that you're dangerously wrong. And, once again, I ask you to correct the mistakes in your original post -- or at least admit that you were wrong.

Thanks,
Mike
Mike Masnick
Wednesday, 23 May 2007 02:57:18 (GMT Daylight Time, UTC+01:00)
Mike,
I didn't respond to your comments in your initial post because my response started getting so long I just wrote this post instead. However I can go back and post a comment in my previous post that addresses your comment when I have some time.

As for this comment, it seems we are talking past each other. I am talking about the actions a company or business should take while you seem to be talking about "the greater good". Let's examine your music industry argument. Record labels (e.g. EMI, Warner Music, etc) promote artists and sell their digital music. Concert promoters (e.g. Live Nation) promote artists concerts and sell concert tickets. If artists decide to give away their music recordings for free and raise concert tickets then the record labels are screwed and the concert promoters are happier. In addition, music fans are getting more music for their dollar so they are happier.

However whether this translates to more money to the artist is unclear although you seem to assume it is a given. Secondly, it definitely screws the record labels.

My point is that if you are a record label [or a movie studio], it would be rather unwise to listen to the folks who say "cannibalize your business" and give away your most valuable asset(s). Your point seems to be that the marketplace grows (obviously since more fans can consume the music and they have more money in their pocket to boot) and this is better for the larger "marketplace". The bottom line in both cases is the same, lots more [non-paying] fans doesn't do the record labels any good.

As a business the question is whether to hasten ones demise because pundits claim it is coming any day now by cannibalizing ones own business or to be ready to be a fast follower if such a threat exposes itself. I lean towards the latter. The road to success doesn't come from betting against your own company.

After all, the dotbomb era was full of noise about companies that would render traditional bricks and mortar businesses obsolete (e.g. WebVan, Pets.com, eToys, Amazon, etc) and it turns out that a lot of bricks and mortar companies ended up doing fine without having to throw out their business models.
Dare Obasanjo
Wednesday, 23 May 2007 06:55:14 (GMT Daylight Time, UTC+01:00)
I think there's an unavoidable lack of definition that makes this discussion impossible to resolve. There is no question that industries change, and that the fortunes of individuals and companies rise and fall. All this talk about evidence for, or against, phenomena such as the innovator's dilemma is somewhat pointless.

Every company successfully selling a product is, in some sense, wisely ignoring the purported lesson, while every company whose fortunes decline can be said to have, unwisely, not learned the lesson. It's not a question of absolutes, it is one of timing. If Microsoft is still making good money on Office, then it can well be argued that they made the right decision last year to keep on selling it. But, at some point, the industry will change enough that they won't be able to make enough money selling the same product, and, at that point, if they haven't changed what they're selling, then they can be said to truly be victims of the innovator's dilemma. Certainly Microsoft can be said to be at risk of mistiming the evolution of their offerings, but that is as far as judgement should go at this juncture.
Anthony Cowley
Wednesday, 23 May 2007 14:24:58 (GMT Daylight Time, UTC+01:00)
"If you have 200,000 customers and make $80 profit per customer, would you be interested in doubling your customer base while making $20 profit per customer due to lowering your prices?"

Anyone can pull numbers out of a hat to 'prove' their point. What if I said "If you have 200,000 customers and make $80 per customer, would you be interested in doubling your customer base while making $50 per customer due to lowering your prices?" to 'prove' that expanding your customer base is a good thing?

Besides, Mike was not necessarily talking about expanding the number of customers, he was talking about expanding the market, which may include more customers. It could me additional purchases by your existing customer base. It could me creating new merchandise and/or services. It could mean anything that expands the value of your market. Take the blinders off and look at the bigger picture.

"The bottom line in both cases is the same, lots more [non-paying] fans doesn't do the record labels any good."

So what? If the net result is an increase in profit for the artist, who really cares about the record labels? The record labels act as a middleman, and in a competitive sector, the goal is to cut out as many middleman as possible. The whole shift in the music industry is more about control than about money (though the two are connected).

Record companies are losing control. Musicians no longer have to book expensive studio time. Computer software allows them to record music in the comfort of their home. The internet provides an alternative method of both marketing and distributing your music and any merchandise. This all points
Vincent Clement
Wednesday, 23 May 2007 15:54:14 (GMT Daylight Time, UTC+01:00)
Aww Dare, you're so passionate about tech business, that's so cute! Maybe when you grow up someone will give you a job that involves thinking.
Villa Servant
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