Volume 5, #5, October, 2007
Designed for Success: Riding the Customer Value Curve to Achieve Targeted Gross Margins
by
Wayne Mackey
"Imitation is the sincerest flattery."
-- attributed to C. C. Colton (1780–1832) in "The Lacon"
Imitation may be the sincerest form of flattery, but it's one that many companies would rather do without. No matter how innovative your offering, sooner or later competitors will try to imitate what made you successful, perhaps tempting customers to trade some functionality and value for a lower price. Your gross margin begins to erode.
Your response to this situation could be to cut costs or raise prices. These approaches may boost margins in the short term but are unlikely to sustain future growth. Another response, ratcheting up innovation to match competitive threats, may restore your margins -- or may not.
How can you know for sure whether a newly designed product innovation will contribute to improving gross margins?
PDC has developed a design-for-gross-margin system that enables you to connect product design decisions to gross margin. Using a new design vocabulary of price and cost, you relate price to features and functionality and cost to implementation (hardware, manufacturing, marketing) and create a customer value curve to put new power into the hands of product designers. (Gross margin, also known as the profitability of a product or service, is basically the difference between what it costs you to make the product and what price customers pay for the features delivered by the product.) Read on to find out how design for gross margin ties bottom-line results directly to design decisions and takes the guesswork out of improving gross margin.
Eyes-Open Tradeoffs
Designers make tradeoffs all the time, both consciously and unconsciously. There are only so many hours in the day, only so many engineers on the team, only so much money in the budget. Using a design-for-gross-margin system makes those tradeoffs explicit and ensures that they're being made in the service of achieving the gross margin you desire. This puts the ability to contribute to bottom-line results into the hands of designers as they make design choices and tradeoffs, giving them information they have never had before.
You may be familiar with design-to-cost systems, which help companies constrain design based on available funds and manufacturing costs. Design for gross margin is a new and more powerful way of connecting design and the bottom line because it also considers value to the customer, which translates into what the customer is willing to pay.
A Different View of Your Product
Doing design-for-gross-margin work requires laying a foundation that is essential for any design undertaking: understanding your strategic business needs in relation to the product/service portfolio you are building, knowing what gross margin you're targeting, and gathering insights about the customer's unmet needs.
With the foundation in place, you begin to look at your product's features in a different way. Marketers often view products in terms of features and related benefits. In design for gross margin, each feature and sub-feature of a product represents a piece of value to the customer. In the example of a cell phone, the customer buys a bundle of features such as style, reception, size, and convenience, each of which consists of sub-features and which together add up to something useful. Size, for example, consists of the sub-features footprint (which allows the customer to fit the phone in various places like pockets and purses), keypad size (which enables the customer to dial easily without incorrect keystrokes), and screen size (which lets the customer view pictures, surf the Internet, or use menus).
Looking at the product this way enables you to examine value at a very granular level, which is important if you are going to determine the value to the customer of each sub-feature. To move closer to this goal, you assign the product a total of 100 points representing total value to the customer. That's it -- all you get is 100 points. Having a finite number of points to assign forces a disciplined assessment of the relative value of each feature and sub-feature. While later you'll translate the points into dollars representing the price of the product, staying away from dollars initially helps everyone involved in the process focus on the sometimes challenging job of divvying up points among the features. Eventually, you'll re-introduce dollars into the equation and end up with a view the product's main features like the one below, which assumes a total price for the phone of $300.
Assigning points helps you drive price -- which represents value to the customer -- down to the feature level of the product.
Note that the assignment of points does not have to be completely accurate. You base it on your best available knowledge, which could include customer research, market data, discussion, and sometimes direct feedback from customers.
Finding a Target on the Customer Value Curve
To achieve your desired gross margin through the design process, you explore whether there is a better way and a worse way to approach the design of a particular feature. You're looking for design features that are both important to customers and flexible in terms of how they're designed. In the case of phone reception, for example, you might dramatically improve reception by figuring out how to design a more powerful antenna.
Each key feature has its own customer value curve, which embodies the idea that there is an optimum investment point for time, energy, and money after which returns will not be proportional to the amount invested. The curve also directly represents what customers are willing to pay for each feature. The two end points of the curve correspond to opposing -- and usually impossible -- expressions of value: 100 percent on one end equals perfect performance and zero on the other equals complete absence of value from that feature. In the cell phone reception example, 100 percent value would be a phone that achieves five-bar service over every square mile of the world. Zero would represent service only at one particular point inside a customer's house.
Customer value starts at the top-most point on the Y axis of the curve and moves down and to the right from the best solution to the worst. For the phone sub-feature key size, the customer value curve might drop slowly at first and then more rapidly when the key size becomes so small that a user's finger often hits more than one button. Plotting each feature on its own customer value curve yields a map showing the price the customer will pay for various levels of performance of each feature. Testing the curve with customers or getting customer input can help you further refine the curves and the resulting map.
You can now identify a target point on each customer value curve. This target becomes a single vertical bar on the curve; you aim to design just a little bit past the "good" side of the curve. For cell phone reception, the target might be five-bar service within 500 miles of any major city. This target tells your design team exactly how good the feature reception needs to be.
The two-dimensional customer value curve allows you to pinpoint a target that optimizes your investment in providing value for a particular feature.
Targets are important because overdesign is as much of a challenge on the road to achieving desired gross margin as is underdesign. Often, companies spend a lot of money designing things that the customer won't pay more to purchase. Customer value curves can prevent you from investing money and resources to make a feature exceed a level that satisfies customers.
You can also look at whether you will be able to charge more or less by moving the target along the customer value curve. Would three-bar service be worth $100? Would five-bar service over the whole U.S. be worth $200? You can look at the design alternatives you might introduce to charge more. Is there a sharp part of the curve where you could offer a little bit more and the customer will pay much more?
The Other Side of the Equation
To drive cost -- the other side of the gross margin equation -- down to the feature level as you have done with price, you use the same breakdown of features you came up with initially and then look at the materials and processes required to create and deliver each feature. The reception feature might consist of the antenna assembly, the charging assembly, and the battery. You then assign a percentage to each sub-assembly depending on what it contributes to the feature. With each feature broken down into its sub-assemblies, your manufacturing and supply chain management/procurement departments can work out the cost to manufacture each of these pieces.
Make vs. Buy
Once you have all of your sub-assemblies broken down with associated cost targets, you can begin the discussion with your manufacturing and supply-chain management personnel to make informed decisions on make-versus-buy based on your strategy, core competencies, and competitive positioning. It's not as simple as saving a dollar here or a dollar there. You must consider carefully whether you outsource those elements of your product that represent the essence of your brand, even if doing so can save you money. While it may be less expensive overall to buy a component than make it in-house, giving away the core value of your product can erode the margins you're working so hard to build. In the worst case, you may find yourself funding the education of your next tough competitor. At the same time, for non-strategic elements of the product where a large and viable marketplace exists outside, it is a waste of your scarce company talent to keep it inside. A great deal of the leverage you have in affecting gross margin both short- and long-term exists in this make-buy question.
The Big "Aha!"
The revelation of the design-for-gross-margin process happens when you put together the two sides of the equation: the new way of examining price (what the customer is willing to pay) and the cost (what it takes to build it). By employing a design process that accounts for both, you achieve a direct view of your gross margin on each sub-feature of the product. You have, essentially, embedded price into the design process. Now you can determine a gross margin for each sub-feature and set a goal. (See the sidebar.)
Advanced Degree Not Required
Designers want to design, not spend time learning things that don't enhance their ability to create. The beauty of this system is that it relies on simple tools. The only software required is a spreadsheet. You don't need extensive training, just a short facilitated workshop.
Will design for gross margin eliminate competitors? No -- but you'll have a big jump on them with a process that embeds financial success in every part of your product design.
Contact Wayne to find out more about how you can begin designing for gross margin.
