Balancing Overhead And Value
This month none other than Henry David Thoreau is going to help us discuss the value your business offers. We’ll touch on the importance of knowing your costs, but our discussion about value is going to take off in a little different direction than what you might be accustomed to. Some of you will come away thinking, “Randall has really gone off his rocker this time…,” while others will be amazed at how much sense it all makes.
My goal this month is not necessarily to educate but merely to give a “permission slip” to a select group of you - and you’ll know who you are - letting you know that you’re not crazy and that it’s OK to strive for a goal that doesn’t fit the mainstream concepts of business success.
Walden, the pond, is a real place near Concord, Mass. “Walden,” the book, was written about a decade before the outbreak of the Civil War, 1854 to be exact. Commerce in the area was flourishing under the free-market ideals of the time. Steam locomotives steadily closed the gap between producers and consumers, bringing wealth and luxury into the quiet countryside.
However, it was already obvious that success had its price. Firewood and hunting were already falling victim to the encroaching civilization in the vicinity of Concord. Thoreau, a naturalist, questioned this progress (perhaps he was the original hippie?). His conviction was that mankind uses too much stuff. I’m sure he would be in the forefront of the ecology debates we see today. His philosophy was evident in his business observations and are as valid today as they were in the 19th century. Here’s an excerpt from “Walden,” in a section titled “Economy”:
“Not long since, a strolling Indian went to sell baskets at the house of a well-known lawyer in my neighborhood. ‘Do you wish to buy any baskets?’ he asked. ‘No, we do not want any,’ was the reply. ‘What!’ exclaimed the Indian as he went out the gate, ‘do you mean to starve us?’ Having seen his industrious white neighbors so well off - that the lawyer had only to weave arguments and, by some magic, wealth and standing followed - he had said to himself: I will go into business; I will weave baskets; it is a thing which I can do. Thinking that when he had made the baskets he would have done his part and then it would be the white man’s to buy them. He had not discovered that it was necessary for him to make it worth the other’s while to buy them, or at least make him think that it was so, or to make something else which it would be worth his while to buy.” (Page 32, emphasis added.)
According to Thoreau, the Indian assumed that going into business was simply a matter of creating something to sell, then selling it. The reality was that he needed to first study his market, determine what it would buy, then produce that product.
In our professions, we take great pains to obtain licenses, skills and equipment in order to ply our craft. It’s easy to assume that once we’ve applied all that effort, we’re doing our customers a favor by letting them buy from us. The reality is that, like the Indian discovered with his baskets, prospective buyers don’t have to buy from us. It is up to us to offer something of value to our customers. To put it another way, we must present our services in a way that helps our customers see the value.
But Thoreau takes the value concept much further by remarking on how economy affects value. He makes his point with an extreme that you or I might be uncomfortable with but it’s a worthy point to consider:
“I too had woven a kind of basket of a delicate texture, but I had not made it worth any one’s while to buy them … instead of studying how to make it worth men’s while to buy my baskets, I studied rather how to avoid the necessity of selling them.” (Page 33, emphasis added.)
The idea here is that by reducing his operating overhead to the least possible amount, he didn’t need the extra revenue of basket sales. In order to reduce his need for revenue, Thoreau limited his overhead. Below is his household inventory:
“My furniture, part of which I made myself and the rest cost me nothing of which I have not rendered an account, consisted of a bed, a table, three chairs, a looking glass three inches in diameter, a pair of tongs and andirons, a kettle, a skillet and a frying pan, a dipper, a wash bowl, two knives and forks, three plates, one cup, one spoon, a jug for oil, a jug for molasses and a japanned lamp.” (Page 104.)
Enhancing Your Value To CustomersObviously, few of us could live as sparingly as Thoreau but that doesn’t mean there’s not a lesson to be learned. Thoreau maintained only what he needed to get by while entertaining an occasional guest. Similarly, we need to justify each overhead expense before adding it to our total overhead.
Ask the question: How will this overhead item enhance my value in my customer’s eyes? A good example is shoe covers. (It amazes me that shoe covers are still a point of differentiation since PM columns have extolled them for more than a quarter century!) Shoe covers are an inexpensive way to impress service customers, in that they offer an excellent ratio of value to overhead.
On the other end of the scale, an imposing office complex might impress sales people and competitors, but will it be valuable to your customer? Oh, sure, you could roll the cost into your overhead and mark it up, but how will that added cost be of value to your customer? Or will your customer just say, “I don’t need your overpriced baskets”?
To illustrate, let’s say your net profit target is 30 percent. That means each dollar of cost will equal $1.43 that your customer will have to fork over. The more dollars of cost, the higher the price and the more difficult it is for customers to see the value.
Here’s how it works: Let’s say 500 customers in a given area need a thermostat replaced. A survey reveals that the lowest price for this service is $150. It also reveals that the highest price for a thermostat replacement is $400. At the low end, all the customers in our group can afford $150, but only a select few are willing and able to pay the upper price. There may be hundreds of contractors scattered along the price spectrum from low to high and no doubt each contractor is charging a legitimate price based upon his costs and profit goals.
Regardless of the selling price, however, the contractor with the best ratio of cost to selling price will have the highest profit percentage. The $400 purveyor may boast of having the highest price in town but with such a small pool of potential customers, he may also have the slimmest margins in town. The lowest-priced contractor may boast of being the busiest in town but may not have margins any better than the high-priced contractor.
Somewhere along the price continuum few contractors have economized their overhead enough to deliver the most profitable service to the broadest possible customer base. They may not be able to serve the bottom tier of potential customers (those who could only pay $150), but their services would be affordable and valuable to those in the middle tier. These contractors might even offer enough value for customers who could pay upper-tier prices.
By offering a good value (as determined by their customers), this optimized group of contractors could find themselves enjoying more add-on sales as well as repeat and referral business, further improving their efficiency and profits.
Thoreau’s goal was to reduce overhead to the level at which he could become self-sustaining. The very nature of our business prevents us from being so austere but that doesn’t mean we can blow the budget either. Somewhere, there is a happy medium between overhead and value. Find it and be profitable.
Quotations from “Walden” by Henry David Thoreau, as published by The Riverside Press, Cambridge 1897.