Thursday, October 25, 2007

Friction is Hot

Unfortunately, I experienced Black Ice before I knew what it was. It was the day before Christmas one year when I was living in Minnesota. I was driving to work when in front of me I saw a car lose control and start spinning all over the expressway.

I quickly reacted by slamming on the breaks. That was a mistake. Suddenly, my car was spinning all over the highway as well.

I was shocked, because I did not see any ice on the road. Later, I was told that if the weather conditions are right, ice can form on the highway in a manner that does not appear to be icy. It is called Black Ice because it looks just like the color of the highway.

It may not look like ice, but it acts like ice. There was no friction and it caused me to lose control. Fortunately, because it was the day before Christmas, a lot of people were on vacation, so there were fewer than the normal number of cars on the road. I was able to safely get my car to the side of the road without hitting anything. Then I slowly made it the rest of the way to work.

When a car has no friction with the road, one loses control of the car and significantly increases the risk of danger. The same situation can occur in business. Business friction occurs when the free flow of commerce is hit by an imbalance between supply and demand (or access) for either products, services or information. This friction, also known as business bottlenecks, slows down commerce until the imbalance is straightened out.

At first, one would think that business friction is a bad thing and that the freer the flow of business, the better. However, as we will see in this blog, without friction one looses control of how to create a profit. Friction is the tool which keeps your business model from spinning out of control and provides your firm with the means of adding value (for which you can charge a reasonable fee).

Beware of people promoting a frictionless business model. It may look safe and desirable, but it is Black Ice—which can take you by surprise and spin you out into danger.

The principle here is to proactively create a role for friction when planning your business model. Business friction can be your friend if you plan it wisely.

To understand the importance of friction, let us imagine a business model which is friction-free. In a friction-free world, everyone is pretty much on equal footing, making it difficult to gain a competitive edge. For example:

1) The search for suppliers and customers would be a non-issue, because you would know everything about all of them.

2) It would be difficult to get an upper hand in bargaining, because you would not have much of any differential advantage since all is known and easily available to everyone. If they don’t get it from you, they can easily get it somewhere else. In a sense, if everyone has equal power, then nobody had any power.

3) Middlemen and intermediaries would have no reason to exist, since knowledge and access is easily available to everyone.

4) In a world where everything is known and access is easy, there is much less risk. Less risk leads to less reward.

5) All business transactions would become more like dealing in commodities, which takes a lot of the profit margin out of the business.

6) Customers will be more knowledgeable and have more options. This will give them greater power of choice and a greater ability to demand more for less (which hurts profits).

People like to say that if one can eliminate the friction (that is, get rid of market inefficiencies) one can eliminate a lot of costs from the system. At first, that sounds very good. Isn’t efficiency a good thing? Aren’t people usually rewarded for cutting costs?

However, keep in mind that one company’s expenses are typically another company’s sales and profits. Or to put it another way, every time another company finds a way to increase efficiency, they may be doing it by eliminating the way in which you earn a living.

For example, it’s tough to make a living as a travel agent when sites like take all the friction out of the transaction. What used to be special proprietary knowledge known only by the travel agent is now available to everyone with the click of a mouse. Without that friction of proprietary knowledge, the travel agent business model spins out of control.

It’s tough for a salesman to sell a car at much of a profit when web sites tell customers what the dealer’s wholesale cost is for the car as well as telling the customer what every other dealer is selling the car for. And if you don’t like any of the local car dealers, the internet can connect you with people selling cars in other locations. The old model is spinning out of control.

In today’s Wall Street Journal, there was an article about the $1.8 billion buyout of Goodman Global by buyout firm Hellman & Friedman. What made this deal unusual was the fact that a group of hedge funds directly took on the financing of the project. This debt was not underwritten by one of the large Wall Street houses. They were frozen out of the deal. Given the frictionless way in which knowledge and money now flows, the value added by investment bankers is severely diminished. Deals can be done without them.

In order for your company to gain control over its business model and ensure the ability to make desirable levels of profitability, you need to find ways to create friction in your favor. One needs a strategic plan which un-levels the playing field and tips it to your advantage.

This could be done in a number of ways, such as:

1) Finding where the scarcest resource is in your business ecosystem and then trying to get a disproportionate amount of that scarce resource (be it raw materials, knowledge, business contacts, access to customer lists, distribution channels, etc.)

2) Trying to resist the trend towards commoditization by introducing as much propriety or exclusiveness into the system as possible. For example, instead of selling the same CD as everyone else, get an exclusive on a version of the CD which comes with extra tracks. Or you can do like Wal-Mart has done and become the sole and exclusive distributor for the new CD by the Eagles. Or try to get patents on whatever you do, so that others cannot do it without paying you a royalty.

3) Another way to attack commoditization is by wrapping the common inside the uncommon. For example, you can supply the same basic good, but with so many additional unique services wrapped into the package that you have created a unique total package.

4) Finally, one can become more inclusive in the process with the customer. The more the customer feels they helped to develop the product, the more loyal they will be (after all, if they reject something they helped build, they are in a way rejecting themselves).

Without taking active steps to build friction to your favor, you can end up with what happened during the dot com bubble. During the dot com bubble, people were bragging about how much friction they were taking out of the system. However, as they took out the friction, they also took out the profitability. They were really just pouring black ice onto the landscape. This lead to the dot com bust, when all the unprofitable business models spun out of control.

Back at the height of the dot com phenomenon (October 2000), Scott Rosenberg wrote about this condition in Here is what he said:

“Friction, as it turns out, is the parent of the profit margin. The more you move toward a perfect market mechanism the fewer opportunities there are for anyone to make money. What’s the ultimate embodiment of friction-free economics? A marketplace in which everything is free, instantly available and infinitely duplicable, with no cost of goods, no transaction costs and no inventory depreciation: in other words, Napster. Napster, unsurprisingly turns out to be hugely popular with consumers—and anathema to producers and distributors. The one thing that’s missing from the model is cash. No friction? No revenue, and no profit. Whoops!”

Although friction in business looks like the enemy, it can be your best friend if you manage it properly. To do so takes proactive planning. Put friction into your business model.

When you bend a paper clip back and forth a few times, the friction causes the paper clip to get hot. If you want your business to get hot, put a little friction into the mix.

No comments:

Post a Comment