Yet another Compelling Case for Purpose Model Driven Purpose Bundles

On the other day – I had lunch with one of our business network contacts and the conversation slowly turned towards our last week’s blog on sensitivity analysis framework (http://strategywithapurpose.blogspot.com/2010/11/sensitivity-analysis-framework-for.html). More specifically, his hypothesis was that- the granular value drivers covered within our sensitivity analysis framework (e.g. pricing, volume, COGS etc) is useful only to develop “bottom line focused operation excellence strategies” and not the top line focused innovation strategies. While I agreed with him in principle, I immediately pointed out the other variable within the ROIC called “VELOCITY” (or, the capital intensity as some folks call it when we reverse denominator and numerator) is what helps us to develop the top line focused innovation strategies. What do we mean by that? Let us go back to our ROIC formula –

ROIC = NOPAT/Sales x Sales/Capital => Operating Margin x Velocity

While most organizations focus on improving the operating margin within this ROIC equation- few in addition, also simultaneously focus on increasing the velocity to improve the ROIC from both top and bottom line standpoint. They usually do that- either by increasing their top line revenue (using innovative product lines and/or new business models) or by reducing the capital intensity by smart integration strategies (vertical, tapered and/or forward/backward integrations) and/or efficient sourcing strategies.

I ended up convincing him with few real world examples – where one of our client had specifically asked us to help them to increase their velocity – given the fact that consumers in the recent months have started to be very value focused (partly because of the down economy) when it comes to shopping household and personal-care products. One of the biggest conundrums facing this client is - the emerging shift in value perception is no longer a short term phenomena anymore– rather, as most experts predict, it is going to continue to stay even after the economy starts coming back again- which means it is imperative that consumer focused companies to have a value strategy if they already do not have one. For example, Store brand market shares, while stalling in the last spring after a big run up, resumed their growth this summer. While packaged food and beverages did perform reasonably well as people ate out less, store brand shares have grown in F&B categories as well.

When we analyze these store brand growth numbers holistically within its context, there is an interesting dynamics emerging– although consumers have cut back on commodity type packaged goods, they are still spending money on electronic gadgets (Smart phones, HDTV’s and iPads etc) – despite the fact many of them have high monthly subscription fees on top of their already high price tags. What does this tell us? Consumers, of late, have redefined their value equation – i.e. being value minded is not necessarily buying cheaper goods anymore– rather, it is being smart in purchasing products that solve their unmet needs with a longer lasting “higher award status” or experience.

In other words, consumers in their mind have started categorizing the products and services based on their consumption experience patterns as – “value-add vs. non value-add” - not just based on the price tags anymore, but also, based on the perceived long lasting award status those products (and services) leave behind them. Within the context of this renewed insight - the biggest innovation strategy question facing most consumer focused firms regardless of the industry vertical is- how to innovate with an end goal of increasing consumers’ award status, yet increasing the velocity from financial algorithm standpoint?

Before answering that question- first things first – let us recollect the value definition we had laid out in one of the earlier blogs - Value from consumers standpoint is “… the proposition of experiencing the “good enough” product/service consumption attributes (it varies depending upon the product/service) within an acceptable price point that is accessible and relevant to their life situations and experiences.”. In other words, the term value to consumer is the summation of all the experience attributes divided by the price they are willing to pay.

Consumer Value Equation = Top Experience attributes/Price

Within the context of this foundational definition – we sharpened our consumer insight analysis to answer our innovation strategy question using the Award Status Portfolio (ASP) Framework as outlined in the top of the page. Our research suggests that more than 50% of the consumers are looking for better “award status” based value deals when it comes to consumer products/services - followed by another 30% who are willing to exchange their high price commodity products for high price “value-add” products. This is definitely an alarming trend for commodity players and so we did some “deeper dive analysis” on the spending patterns of consumers across various product/service categories.

The insights we garnered was all the more intriguing - that consumers have altered their spending patterns not just based on usage needs, but also based on the way they map their preferred products/services to their personal award status experience. With this new insight and findings – we grouped the products/services under five award status categories and plotted them in the award status framework – with “degree of spending” on X axis and “degree of award status” in Y axis as outlined below and on the top of the page.

• Commodity – addressing the basic commodity experience -where consumers are cutting down on paying higher prices for national brands as 80% consumers now believe that store brands are made by the same manufacturers that make the national brands - especially when it comes to packaged goods and household items.

• Standard – addressing the standardized or mechanized product and/or service experience - where consumers, although are less likely to reduce their spending, yet are not willing to increase their spending e.g. some mechanized packaged/ household services and subscription based utility/content/TV services.

• Transformational – addressing the “inner” soul enhancing experience – where consumers are likely to increase their spending to increase their inner award status e.g. H&W focused nutritional supplements, Workout services, books, CD, music, SPA etc.

• Value-Add – addressing the “outer” prestige enhancing experience – where consumers are likely to increase their spending to increase their outer award status e.g. electronic gadgets, HDTV, value-add content services like context TV, iPads etc.

• Blended value – addressing some combination of the above four categories – where consumers are more likely to balance them on a daily basis to reach their personalized optimum category - and this is where our “purpose model based purpose bundles” (http://strategywithapurpose.blogspot.com/2010/10/transforming-so-what-opposites-in-to-so.html) come in the picture.

As we recognize from these “award status” based category maps – consumers are likely to increase their spending on higher award status experience providing “value-add” categories than other categories– and above all – consumers are also trying to balance their consumption experience portfolio on a daily basis to arrive at their personalized “Blended value” category. This is where our concept of “inter industry vertical” based purpose bundle strategy - of bundling commodity and standard products with transformational and value-add categories-come in to the picture. As it turns out, it is also a win: win strategy (as outlined in one of our earlier blogs), for both consumers and providers alike – as consumers see the synergistic value of the “cross industry” purpose bundles - i.e. sum of the total bundle award status is higher than the individual part’s award status.

What does this tell us? There is a new reality or an “award status based value equation” seems to be evolving when it comes to consumer spending - and so, it is time to accept this new reality and devise an appropriate “purpose model based purpose bundle strategy” to answer this emerging award status perceptions of 21st century consumers. However, by no means – we are suggesting that commodity products and services have lost their relevance – rather, it is time for commodity players to come up with more of value-add/innovative products and services with a higher award status – where, historically, CPG/Retail firms have been lagging behind the electronic gadget firms. I guess the right answer is “doing both” (i.e. innovating commodity product categories and formulating purpose bundles) is the way to go in the words of Inder Sidhu and Roger Martin and as summarized below.

To whom shall we ask… and whom shall we send (to find)
Those who are seeking for this “award status”?
Pay attention pals, sit tall, and don't look so content!
For it is an honor coveted by us all, the normal consumers…
It’s been dreamed of and prayed for so long …
Reflecting the true inner self esteem of the highest scale
No bribes, no pleas, no threats will prevail – and so,

It is time that we fulfill that dream, by

Balancing "value with spending" to achieve that aim,
Reducing the “commodity” quadrant as there exist few choices to claim,
Keeping the “standard” quadrant as basic necessities remain the same,
Sustaining the “transform” quadrant to enhance the inner exclaim,
Increasing the “value-add” quadrant to enrich the outer fame, (yet with a goal of)
Reclaiming the “blended value” quadrant as it is the ultimate acclaim, (so…)
The name of the game tomorrow is for "purpose bundles" to proclaim!

Sensitivity Analysis Framework for Improving Profitability and Valuation

Some of the ideas we have been promoting in the last few weeks – appear to have caused some buzz within the blogosphere- more specifically, our sustainable valuation formula, definitely has caught the attention of few readers (http://strategywithapurpose.blogspot.com/2010/11/purpose-profit-balanced-sustainable.html). One of our fellow readers made a casual observation - “our simplified valuation formula [i.e. V= NOPAT x (1- g/ROIC)/ (WCCP-g)] does not seem to take in to account the impact of all key value drivers (e.g. pricing, margins, volume, COGS etc) –and, hence it trivializes the whole valuation exercise”.

While we agree that it is a simple formula, it is an accurate one from financial algorithm standpoint. The reason we took McKinsey’s “Zen of Corporate Finance” as the base in our article last week was -to build a simple yet compelling case for discounting the free cash flow with a purpose value driver (WACP) very much like how WACC is used to discount the free cash flow. At the same time, we definitely empathize with our readers –who, otherwise perform the detailed valuation exercise with multiple spreadsheet pages of DCF cash flow projections and value driver assumptions. We still recommend our readers to go through the similar DCF process and validate the result with our summarized formula. In other words, our formula is more of a validation formula than a working formula.

The question however is – does that mean our sustainable valuation formula do not take in to account the impact of those granular value drivers? Before answering that question, let us first dissect ROIC within the valuation formula

ROIC = NOPAT/Sales x Sales/Capital => Operating Margin x Operating Velocity

As we further inspect the Operating margin and its sub components– some of the key value drivers that contribute towards the operating margin are – Price, COGS and Volume - which are further dependent upon promotion scenarios (including their depth and frequency), competitor responses, elasticity and boundary conditions to name a few. We sure can expand our formula mathematically to explain how these value drivers are indirectly accounted for within our valuation formula. However, it does not communicate the causal chain relationship effectively, and so we thought that it is a worthwhile exercise to come up with a sensitivity analysis framework to show the impact of these value drivers on margin using a real world case study – clearly showing the impact of price changes on volume (& hence on margin and the overall NOPAT/enterprise value).

Our goal for this case study is to develop a flexible framework model from the methodology we had used for one of our client CPGR-Co Inc. (our fictitious CPG/Retail Corporation pronounced as ZipGyarCo) who had asked us to help them to increase the profit by 10% (& hence enterprise value) by increasing (or decreasing) price by a certain percentage, yet without substantially impacting the volume.

The Working Framework Model

As part of that exercise, we decided to develop a working framework model (and a mathematical formula) of linking all the input and output variables that contribute towards increasing the operating margin, profit and valuation as outlined in the schematic at the top of the page. With all things being equal (consumer purchase criteria, brand perceptions, trade promotion rates and efficiency etc), we quickly realized that there still exists few cost differences (e.g. supply chain/distribution costs) across the market regions and hence we decided to develop a region specific pricing model (as opposed to one mammoth corporate model) to better simulate the real world business conditions. Within that approach, we then divided the CPGR-Co’s markets in to 5 RMA’s (East, West, Central, South and North) selling all of their top 5 Product models or package sizes (P1, P2, P3, P4, P5) – resulting in 25 model cells (i.e. one model each for each cell). Please note that the more granular we divide the markets the more accurate our models will be.

The objective of our case study was to develop an analytics based pricing model with a regression based mathematical formula producing the following projected results.

• Recommendation to price up or down in each cell.
• Projected volume, profit, share and valuation outcomes from price changes.
• Optimization recommendations for competitive response scenarios.

To achieve these objectives - we went through a systematic problem solving process with the following steps.

1. Calculate VCOGS matrix – at the product model level for each RMA.
2. Arrive at the optimum adjusted trade price (from retail price) to better negotiate with retailers/vendors.
3. Load the Product/RMA matrix with historical volume and price data from IRI/Nielson.
4. Develop the analytics based CORE Pricing model with all the inputs, outputs and their interdependent relationship.
5. Develop the equivalent log-log form mathematical equation simulating the core model- more specifically, develop a formula to arrive at the unit volume – which is a function of
   • Current price (e.g., P1)
   • Previous period’s price (e.g., P1_PriorPeriod)
   • Price of our other pack and/or model sizes (e.g., P2, P3)
   • Price of our competitors (e.g., CPCp1, CPcp2,C Pcp3, CPcp4)
   • Brand Equity impact
   • Other ancillary variables (e.g., Holiday, Trend etc)
   

The corresponding equation format is

New Volume = e0 + b1*ln(PP1) + e2*ln(PP1_Prior_Period) + e3*ln(PP2) + b4*ln(PP3) + …
e5*ln(CPCP1) + e6*ln(CPCP2) + e7*ln(CPCP3) + e8*ln(CPCP4)…
e9*Brand Equity + 110*Holiday …

Where

• e1 - own price elasticity (negative) - “If we raise P1 price by 1%, P1 volume will change by e1%”.
• e2 - lagged price impact (positive) - “If we raise P1 price by 1% this period, next period’s P1 volume will change by e2%.
• e3 and e4 - own model size cannibalistic -elasticities (positive) - If we raise P2 price by 1%, P1 volume will change by e3%.
• e5-e8 - competitive elasticities (positive) - “If competitor raises CPcp1 price by 1%, P1 volume will change by e5%.
• e9 - Brand Equity impact (could be negative depending upon the depth and frequency of the promotion and where the firm is on the innovation maturity curve) - Every additional period we move forward in time, we expect P1 volume to change by e9 * 100%.
• e10 Holiday impact (positive) - For holiday periods, we expect P1 volume to be e10*100% higher than for non-holiday periods”.

6. Calculate the price elasticities for three scenarios (SELF, SELF CANNIBALISTIC and COMPETITIVE) based on IRI/Nielson data.

7. Adjust the results based on competitor responses.

8. Adjust the results based on boundary condition analysis.

9. Use economic model to further optimize the results across various regions/accounts.

10. Finalize the projected volume, profit, share and valuation changes from price changes.

Value Driver Strategy Execution Considerations

As we can recognize from the steps above, we can easily extend this working model and mathematical formula for other value drivers like COGS containment, inventory cycle reduction, idle capacity containment (& few more) as well for arriving at a similar set of recommendation/results for improving profitability and valuation. However, one of the big challenges in implementing those recommendations within large organizations like “CPGR-Co” is building the consensus across various stake holders – from the standpoint of - first identifying the right set of appropriate value drivers, developing the right framework, arriving at the the action plan and finally implementing them.

For example, although there is a substantial opportunity to achieve profit/valuation goals by making the pricing changes as identified by our analysis - executing those price changes in a timely manner, is not an easy thing to do- given the fact pricing is embedded in a wide range of broader business decisions like strategy development (e.g., capacity utilization, new product pricing), price optimization (e.g., average price targets) ,trade strategy and sales execution (e.g., EDLP vs. HiLow) scenarios. In addition, the optimal pricing decisions require the input and expertise of a wide range of domain “experts” from both business units and front line sales strategy teams.

To circumvent these execution challenges, we made a recommendation to our client “CPGR-Co” to form few cross functional Value Driver Councils (VDC’s) to coordinate and proactively shape these value driver decisions (e.g. pricing decisions) across accounts, channels and brands. More specifically, within the context of our value driver council for pricing, the VDC will be chartered with the following

• Define pricing strategies/moves across the portfolio.
• Identify other value drivers that compliment pricing.
• Communicate approved pricing strategies to the field.
• Ensure region/account-level trade policies fit with strategy.

In addition, create a forum or platform for regular review of pricing trends, and other value driver needs by analyzing

• Market trends, competitor behavior
• Performance of new products
• Performance of competitor products

Finally, also act as the steering committee or governance layer for long-term pricing improvement

• Identifying “next level” pricing challenges
• Pricing pilots/tests—spreading best practices
• Upgrading analytics foundation (tools, processes, techniques, policies and organization models)

“Winning by Analytics” Considerations

As we can clearly recognize from the framework model steps and VDC’s governance layer requirements, Analytics is critical for successfully executing the tasks in every step of the way. We cannot stress the importance of analytics enough - that we encourage organizations like CPGR-CO to develop a solid analytics foundation with a right set of tools, techniques and templates to reach the winning level of "Level 5 analytics maturity" as promoted by Davenport & Harris and as explained in some of our articles published by Academy of Business Strategy (http://theacademyofbusinessstrategy-businessanalytics.com/). Within the context of that winning spirit, we specifically encourage our client CPGR-Co to develop the following set of tools.

• RMA/Product Matrix level optimization tool, techniques and templates to develop tailored pricing decisions across pack and model sizes and RMAs.
• IRI /Nielson price elasticity tool, technique and templates to estimate profit and volume impact of these decisions across competitive scenarios.
• Average price to trade calendar tool, techniques and templates to estimate impact of trade calendar scenarios on average price/unit.
• Category management tool to develop compelling cases to support field execution of pricing decisions.
• Forecasting and sales management tool to provide input to financial management system and to track progress against pricing targets in the form of “what if analysis based” drill down dashboards.

Bottom Line:

At the end of the day – developing winning strategies is definitely a great thing to do – but, institutionalizing them is all the more important - as strategy in its "execution form" is what brings the tangible outcome to stakeholders. Let us face it - fully empowered price strategy decisions (or for that matter, any other value driver strategy decisions) requires extensive consensus building in most organizations- and this is where- our Value Driver Councils (VDC) come in to the picture. So, it is a call to action for our client “CPGR-Co” and other similar clients-not only to develop winning strategies to improve profitability (and valuation), but also, institutionalize them using VDC’s.

Purpose-Profit Balanced Sustainable Value Equation Framework

Happy Diwali (or the festival of light) to our readers from both east and the west alike!

Based on the extensive coverage of purpose-profit value concepts in the last few weeks - one of our fellow bloggers posed an informal observation – "while it all sounds great to talk about the purpose agenda, the thing that matters the most at the end of the day is just profit – as profit is the primary variable within the valuation formula". As we thought more about this observation, there seems to be some merit in that argument- given the fact, most of the modern day valuation frameworks are being built with just profit variables- and so, we decided to come up with a valuation hypothesis - with an enhanced WACCP (Weighted Average Cost of Capital and Purpose) that is calculated as a weighted average of WACC and WACP.

Let us face it – the reason we discount the free cash flow (FCF) with WACC within the valuation formula is - that it does not make sense to valuate (or run) a business that does produce the minimum hurdle rate of WACC- like wise, our hypothesis also proposes that - it does not make sense to valuate (or run) a business that does not meet the minimum purpose hurdle index of WACP. Assuming we have a behind-the-scene formula for accurately arriving at the WACP index (using the purpose scores we had proposed in our previous blog) that is further "weight averaged" (with WACC and WACP) with appropriate weight factors– our renewed sustainable value equation will look as outlined on the top of the page.


At this juncture, we also would like to remind our readers that this is a hypothesis based formula and so will need lot more analysis and research before we can publish this as a working formula. Under the normal circumstances where WACC and WACP happen to be the same (say 10%) with an equal weight factor(say, 0.5+0.5), then our sustainable value equation formula will indeed work like the Mckinsey’s valuation formula. On the other hand, on scenarios( with ROIC of 15% , growth rate of 5% and WACC of 10%), where WACP is changed by a percentage point, we have seen the valuation changing by (+ or - ~10%), the intended effect we were hoping for. However, lot more regression testing and research needs to be done before proposing this as a working formula - and until that time, please treat this as a hypothesis formula.

With this renewed sustainable value equation definition as the foundation– we then did some more qualitative analysis to strengthen our hypothesis using the Purpose-Profit balanced Value quadrant framework as outlined on the top of the page. With the tough economic conditions still lingering- most of the H&W/Green minded consumers, of late, have started changing their buying patterns - that they have started to buy their products and services only from those corporations whose purposes and values align with that of theirs. In addition, our research has also found that over 35% consumers say that they are likely to do business with only greener brands (source: “2010 ImagePower Green brands Survey) and among them, a substantial percentage of consumers are also looking for a better value deals while buying their products/services.

This is definitely a new trend and another compelling reason for corporations to be purpose minded - and so we did some more “deeper dive analysis” on the extent of purpose adoption within various corporations. The insights we garnered was all the more intriguing - that most corporations, not only have started pursuing purpose initiatives , but also have started revising the way they measure their internal successes. In other words, corporations have started measuring their performances with both profit and purpose KPI’s like corporate sustainable index and corporate social responsibility index etc.- which is very encouraging.

At the same time, with all things being equal, the extent of the purpose adoption, however varied from corporation to corporation (and industry to industry) - and rightfully so, our valuation numbers did end up being all over the map as well. With this variety of values in our findings – we then grouped the resultant values under five value categories and plotted them within our framework – with “degree of profit” on X axis and “degree of perceived purpose” in Y axis as outlined below and on the top of the page.

• Surviving Value – addressing the “ordinary outcome” quadrant -where most corporations start (or arch) their purpose journey from. As the name suggests – although most corporations can survive by being on this quadrant for a period of time, they are advised to move on to other quadrants to be relevant in the 21st century.

• Sacrificial Value – addressing the “extraordinary" outcome” quadrant where purpose driven corporation’s angle there for a period of time, before moving on to the other quadrants. These are corporations who go the extra mile to fulfill their mission – at times even at the cost of not meeting their profit goals. Although not a place to be in for a longer period of time, definitely a worthwhile quadrant as it teaches us the discipline of what it takes to practice what we preach.

• Startling Value – addressing the “aggressive outcome” quadrant – where corporations aim to achieve the startling profit performance with “just good enough” purpose agendas to keep the momentum going. Although, it is a good path way quadrant to be in, sustaining the profit performance without sufficient purpose agenda for a longer period of time is not an easy thing to do -and so, they are advised to move on to other quadrants!

• Soaring Value – addressing the “utopia” quadrant – where corporations aspire to achieve the perfect performance numbers in both purpose and profit dimensions. Although, an ultimate path to aspire for, a very difficult quadrant to sustain the numbers for a longer period of time!

• Sustained Value – addressing the “optimal outcome” quadrant – where corporations ace towards achieving the optimum values in both purpose and profit dimensions and it is indeed a perfect quadrant to be in - as it produces "sustainable purpose profit balanced value" for the long haul!
  

Interestingly enough, four of these value categories fell perfectly in to the four quadrants of the framework with an exception of one category – which got placed in the centre of the framework covering all the four quadrants. What does this tell us? There is a new reality or a “new sustained value equation formula” seems to be evolving within the context of corporations balancing purpose and profit when it comes to assessing their intrinsic value. This new reality - is indeed a wake up call for most corporations – and so, it is time that corporations to reevaluate their internal business units and capital investments with this sustained value equation mindset to respond effectively to the emerging consumer spending pattern changes towards purpose brands. This does not mean that businesses have to become charitable organizations – rather, the optimal goal is acing in to the sustainable value quadrant as outlined in the framework and summarized in the poem below.

We have a dream, where all businesses bubble up by,
Balancing profit with purpose as their ultimate way, (via)
Arching in to the “surviving” quadrant as the initial lay,
Angling through the “sacrificing” quadrant as the mid day, (yet)
Aspiring to the “soaring” quadrant as the ultimate way, (but),
Aiming for the “startling” quadrant as a path way, (yet)
Acing in to the “sustaining” quadrant as the best way,
That’s the dream; we wish that it comes true today!