Based on what we have seen so far, we can consider the requirements that need to be met for a business to be profitable.
Firstly, it is necessary to create value, i.e. that the valuation V made of the product on offer by prospective customers exceeds its costs:
For a business to be viable, it is essential for
product valuation – costs – opportunity cost > 0
Only when this is true can we say that a company creates value and can be viable, because only then can we find a price that is fair for both the customer and the company.
If the value of a product for a customer is V = €100 and the cost of taking care of the latter is C = 60, we can find a satisfactory price for the customer and the company, such as P = 80, and the exchange will be satisfactory for both because the following conditions hold true:
V – P > 0
and
P – total costs > 0
Fulfilment of the condition V – C > 0, however, does not guarantee the viability of a business. To illustrate this, we will go back to our previous example in section 1.1 (product demand), though this time from the point of view of two rival companies trying to win over a customer:
We have two car manufacturers offering two similar models. We have seen that the family valued one of the cars at Va = 40,000 and the other at Vb = 35,000.
Imagine that the manufacturing costs of company A are Ca = 20,000, while those of company B are Cb = 10,000. Both companies manufacture at costs far below the respective Va and Vb valuations.
Therefore, if they had no rival, both companies would clearly be viable as a business.
Now imagine that company B decides to sell its vehicles at the price of Pb = 18,000. Customer satisfaction is
Vb – Pb = 35,000 – 18,000 = 17,000.
Company A must provide a greater – or at least similar – level of satisfaction to gain customers:
Company A gains customers if:
Va – Pa > Vb – Pb = 17,000 only if < 23,000.
Company A therefore has the ability to attract clients and cover costs. However, if we look closely, we see that this company is at the mercy of its rival:
If company B decides to lower its prices to less than 15,000 (e.g. Pb = 14,000), company A cannot continue to attract customers without incurring losses:
Vb – Pb = 35,000 – 14,000 = 21,000 and
Va – Pa > Vb – Pb = 21,000 only if Pa < 19,000, but then
Pa – Ca < 0 !
In this example, company B has a competitive advantage over its rival, company A. The result is that one of two situations occurs:
1) Company B attracts all of the customers, such as when it establishes Pb = 14,000, or
2) The two companies share out the customers, but company B makes more money on each:
They divide the customers between them if Va – Pa = Vb – Pb, but this means that Pa – Ca < Pb – Cb, for example if Pb = 18,000 and Pa = 23,000.
Ultimately, the company with the competitive advantage will guarantee its survival and, in all events, make more money than its rivals.
In the above example, company B had a competitive advantage in costs: although the product was perhaps not best suited to the needs of customers, Va > Vb, was able to produce a reasonable product with costs well below those of its rival.
An interesting example for us to consider on this course is Inditex, the company that owns the clothing retailer Zara. The fashion clothing industry, of which the company forms part, is a highly competitive sector in which companies can copy each other's designs without limits. Nevertheless, there is a very high degree of inventiveness, with new models appearing every season, year after year (and naturally, a considerable number of companies that engage in this activity), and at very low prices. As customers, therefore, we can reap the benefits of a highly competitive and innovative industry.
Despite all of this, Inditex manages to expand its market share each year (i.e. it attracts an increasing proportion of customers) because of its competitive advantage in costs, which appears to consist basically of (1) rapidly detecting the designs that sell best in a given season and (2) immediately adapting production to these designs. As a result, costs are lower because it does not produce clothing that does not sell and it sells a lot of the clothing preferred that year.
And it would appear that this achievement is no mean feat, because its competitors are incapable of copying their behaviour (at least in such a clever way).
A company with a competitive advantage in costs will gain more customers and obtain higher profits because it can sell its products more cheaply.
Alternatively, a company might have a competitive advantage through differentiation, i.e. in offering a product more highly valued than that of its rivals at a reasonable cost.
Adobe
Adobe and its Acrobat software is a good example of a better valued product at a reasonable cost.
And this superior valuation can be general, in the sense that all potential customers consider the product to be of a higher quality (this is the case of prestigious German car brands, for example), or of a niche, i.e. it is a specialised product for a particular type of customer (any village shop fulfils this requirement: it is a shop geared to a particular type of customer, namely, the residents of the village, the only ones for whom it is more convenient to buy bread or the newspaper there).
Competitive advantage through differentiation allows the company to sell more expensively without losing customers.