A friend of mine sent me an email entitled Four Major Transformations by Herb Meyer. The email said the paper was presented at Davos. I cannot confirm that this is by Herb Meyer or that the contents of the argument are accurate, but I found a copy of the email I received here. I assume that the details of Herb’s paper are accurate, but even if they aren’t I think the point of this post is still applicable.
Here is a snippet of the paper that I would like to discuss:
The Emergence of China
In the last 20 years, China has moved 250 million people from the farms and villages into the cities. Their plan is to move another 300 million in the next 20 years. When you put that many people into the cities, you have to find work for them. That’s why China is addicted to manufacturing; they have to put all the relocated people to work. When we decide to manufacture something in the U.S. it’s based on market needs and the opportunity to make a profit. In China, they make the decision because they want the jobs, which is a very different calculation.
While China is addicted to manufacturing, Americans are addicted to low prices. As a result, a unique kind of economic codependency has developed between the two countries. If we ever stop buying from China, they will explode politically. If China stops selling to us, our economy will take a huge hit because prices will jump. We are subsidizing their economic development; they are subsidizing our economic growth.
The capacity model and enterprise sales.
Enterprise sales professionals frequently use a revenue prediction and management tool called the capacity model. The capacity model assumes infinite demand. So rather than building a bottoms-up demand model, the capacity model simply focuses on the supply side of the equation — the number of quota carrying sales representatives. Assume that each sales rep can sell x million of product per year. Assume that you need y number of people supporting each rep. Assume that each rep attains 25% percent of her quota during the first quarter, 50% percent during the second full quarter, and 100% by her third quarter on the job. It’s a bit more complicated than this, but not much. And it works really well… until demand becomes an issue (e.g., competition, market maturity, recession). Then management often assumes that sales leadership needs to be replaced due to “bad execution” when the reality is that it may be time to change the overall corporate strategy (enter new markets, change pricing model, exit market, use M&A to consolidate market). It’s really hard to predict demand, so most large companies rely on some type of supply driven model far too long.
China and the capacity model.
China is pursuing the capacity model writ large. And as long as supply outstrips demand, it will work. But at some point the combination of a doubling of Chinese labor working on manufacturing (increasing supply), the large number of people moving into manufacturing from India and Eastern Europe (increasing supply), increases in productivity (increasing supply), and the certainty of a global economic downturn at some point in the future (lowering demand) will lead to a collapse in the prices of manufactured things.
There are other constraints that may temporarily slow things down — the availability of energy and other non-labor inputs required for manufacturing could act as a short or medium term throttle on supply. But these issues will be resolved. And then what happens? Economic theory argues that, in an efficient market, prices will drop to near marginal cost. We know that the marginal cost of bits is near zero and that pricing for many of those things is FREE. But what happens when the marginal cost of atoms approaches zero?
Razor and blades.
Might the cost of many manufactured things get close to zero? Is FREE the future of bits and atoms [I haven't read Chris Anderson's new book -- perhaps he has the answer]? Don’t roll your eyes, it’s possible. We may see the razor and blades business model much more frequently in the future.
It is already happening:
+ Free atoms can increase barriers to entry, allowing providers to charge for services. For example, the recent move by Apple to allow carriers to subsidize their phone was a brilliant move by the carriers to keep those consumers addicted to the crack of “cheap” phones. And they already do offer some phones for “free” with an agreement to use their services for 1 or 2 years.
+ Cable vendors use this model with set-top boxes and cable service. TiVO makes a better product, but why buy when you get a DVR for free?
But these cases are examples where average revenue per user (ARPU) is extremely high. With the marginal cost of manufactured products dropping dramatically, service providers will be able to offer free products based on much lower ARPU.
What’s next?
+ Free computers, pay for data plans?
+ Free cars, pay for the gas 
What can you give away for free and then make money on the services?
4 responses so far ↓
jolly // June 12, 2008 at 4:28 am |
PeoplePC tried the “free PC” approach a free years back and it didn’t work. Could have been due to bad execution, though since they were offering unattractive machines at relatively high monthly rates for dialup access.
Samir Raiyani // June 12, 2008 at 7:18 pm |
Hi, Could you provide some pointers to the capacity model for enterprise software that you refer to? I searched for a bit but drew a blank… thanks!
Mike Speiser // June 13, 2008 at 4:04 am |
Samir, it’s something I learned working with sales executives. I’m not sure if it’s written down anywhere, but it should be familiar to IBM or Oracle trained sales executives…
Michael F. Martin // June 22, 2008 at 4:58 am |
Chris Anderson is very good at marketing, but I am dubious about his economics.
In particular, I think that his hypothesis that demand for information follows a power law is incorrect. Information, like everything, is made up of matter and obeys the laws of physics. Some of the consequences of this are that there are finite fixed costs and finite variable costs for its productions. Thus, there are still points of diminishing marginal return. In fact, the aggregate demand for information is integrated up from a poisson distribution, which is only crudely approximated by a power law at its tail.
In short, atoms will never be cost nothing (a/k/a be “free”).
Also, that is very interesting about the “capacity” model for supply. That is really going to come back and bite those companies once they clear their markets.
In general, I think the best way for managers to estimate their need for equipment and people is iteratively in response to demand. In other words, the model needs to be updated after each sale. That couldn’t be done before the computer and modern accounting systems were developed. But now that we have those, it’s a simple matter of asking the computer to apply one more algorithm to each balance sheet account.