It’s time to turn the concept of value into some hard numbers. First, keep these three important value-based strategy principles top of your mind:
- Capital equipment value is pure economics.
- The customer determines value.
- Value is relative to competing alternatives.
You will use these principles to develop a concise financial expression that describes the economics of a capital equipment purchasing decision. This expression will be the foundation from which you derive product strategies that produce compelling value propositions and develop marketing strategies that ensure customers pay you prices that reflect your equipment’s value.
This financial expression of value is called the value metric. For capital equipment, the comprehensive value expression captures all the economics associated with a capital equipment purchase. This is often referred to as the total cost of ownership. The value metric reduces the comprehensive value expression to only the factors that drive the purchasing decision.
Introduction to the Value Metric
Suppose a fix-’n’-flip real estate investor just bought a house that he intends to sell quickly for a profit. To fetch the highest possible sales price, he decides that the house will need a fresh coat of paint. He wants to purchase the paint brand that will make him the most profit. See the financials of this investor’s paint purchase below.
Comprehensive Value Expression = Delta House Price – [$Paint + $Labor+ $Other]
Delta House Price = Increase in house price as a result of fresh paint
$Paint = Cost of paint
$Labor = Cost of labor to paint the house
$Other = Other costs associated with painting the house
The expression above is called the comprehensive value expression. It’s comprehensive because it captures all the economics of painting the investor’s house. It covers everything.
As a paint seller, you are most interested in how this real estate investor will make his paint-purchasing decision. You need a financial expression that gets right to the heart of the matter. You want all signal, no noise. That signal is called the value metric. You can find the value metric in the comprehensive value expression by choosing only those factors that are both
- Critical to the buyer’s economics and
- Different between competing solutions.
Continuing with our example, suppose that the paint seller’s market research has revealed the following:
- All brands of paint have the same effect on the selling price of a freshly painted house.
- Nonpaint and nonlabor costs, such as paint brushes and drop cloths, are insignificant and also not affected by the brand of the paint selected.
- Available paint brands exhibit different prices and coverage per gallon.
- Also, paint brands vary in the coats required for full coverage, which affects labor costs.
This data shows that not all factors in the comprehensive value expression are necessary to make the most profitable paint-purchasing decision. We can eliminate house price changes (paint brand doesn’t matter) and other costs (insignificant and not different across paint brands).
After we eliminate these, the remaining expression is the value metric for this investor’s paint-buying decision:
|Eliminate factors:||Delta House Price – [$Paint + $Labor+ $Other]|
|Value metric:||$Paint + $Labor|
The investor will increase his profit by painting the house before selling it. It’s also true that there will be some other costs besides paint and labor. But according to the data in this example, these don’t matter to the paint-buying decision; only paint and labor costs do. Therefore, only these factors belong in the value metric.
The value metric is a concise financial expression that expresses the economics of your customer’s buying decision.
Capital Equipment Value Drivers
Countless types of capital equipment exist. Each has its specific use cases and target markets. However, capital equipment buyers represent a market segment that we can clearly define. They are organizations that buy equipment to provide a service or to make, market, keep, or transport products.
All capital equipment buyers derive value from their purchases in a similar way. At the highest level, value drivers for capital equipment buyers are the same, whether they’re buying manufacturing equipment, bulldozers, or jet airplanes. See these value drivers in the table below.
|Revenue/unit||Revenue that the buyer extract from each unit of the product or service that the equipment produces|
|Throughput||The rate at which the equipment processes the unit|
|Yield||The percentage of good units that the equipment produces out of the total processed|
|Uptime||Percentage of time that the equipment is available for use and not in a repair or maintenance state|
|Operating costs||All costs associated with running the equipment, such as utilities, maintenance, and consumable materials|
|Capital expense||Equipment purchase price (or period depreciation expense)|
Capital Equipment Comprehensive Value Expression
We can create a comprehensive value expression for capital equipment purchases from the universal value drivers above. See the figure below.
This comprehensive value expression describes the revenue that your customer can earn with your equipment, divided by the cost of producing that revenue. It captures all the gains and costs associated with a capital equipment purchase.
This expression is in the form of output over cost. You may recognize this as similar to the reciprocal of equipment cost of ownership, which is usually expressed as cost over output. The reciprocal is used here for no reason other than to make larger numbers indicate more value.
Pay Attention to Units
The capital equipment comprehensive value expression and its simpler cousin, the value metric, represent actual economics. Therefore, these expressions must be in a form that an accountant would recognize. You have to pay attention to units.
The figure below shows the units of the capital equipment comprehensive value expression.
From this expression, you’ll derive the value metric for your particular capital equipment product and target market. The numerator will end up being expressed as either $/Time or Units/Time, depending on whether the $/Unit factor is present after you reduce the comprehensive value expression to your value metric.
The place where you are most likely to get tripped up is in the denominator.
You need to remember that operating costs are usually expressed over a period of time, most commonly on a per-year basis. If operating costs exist in your value metric, you must express equipment price in terms of period depreciation expense. For example, a $5M equipment purchase depreciated over five years would have a $1M-per-year depreciation expense.
In cases where operating costs do not make it to your value metric, you can use the actual capital expense (i.e., equipment-acquisition price) in the denominator. See the figure below.
Just be aware that the value metric no longer expresses output divided by costs; it expresses output divided by capital expenditure.
Six Steps to Create Your Capital Equipment Value Metric
The capital equipment’s comprehensive value expression is just a starting point for the value-based strategy practitioner. You need to reduce it to a value metric that expresses the economics of the buying decision for your specific capital equipment market segment. To do that, follow this six-step process:
- Start with all the value drivers in the capital equipment comprehensive value expression.
- Select the value drivers critical to the customers’ economics.
- Determine where meaningful differences exist among market alternatives.
- Keep only value drivers that are both critical and different.
- Never remove the price of your product.
- Ensure the result is a valid financial expression.
Value Metric Definition Example
Mr. Melty is a multicrystalline silicon ingot growth furnace sold to silicon-wafer manufacturers who sell these wafers to photovoltaic (PV) solar-cell makers. An ingot growth furnace turns polysilicon feedstock into PV-grade multicrystalline ingots. An ingot growth furnace melts polysilicon at over 2,000°C, then slowly cools it to precipitate contaminants and form a multicrystalline ingot. Wire saws slice these ingots into wafers used to manufacture PV solar cells. See the figure below.
From the information above, it’s clear that an ingot growth furnace sold to PV-wafer manufacturers fits the definition of capital equipment. That means you can use the capital equipment comprehensive value expression’s value drivers (step 1). See the table below for the description of each value driver as it relates to ingot growth furnaces.
Table 9: Value drivers for ingot growth furnaces
|Value Driver||Description for Ingot Growth Furnace|
|Revenue/unit||Material quality affects ultimate solar-cell efficiency, and ultimately the revenue PV manufacturers can derive from each kilogram of material produced|
|Throughput||The amount of material (charge size) divided by the time it takes to process it|
|Yield||The percentage of good material in each ingot produced; called mass ingot yield|
|Uptime||Percentage of time the furnace is available for use and not in a repair or maintenance state|
|Operating costs||All costs associated with running the equipment, such as crucibles, utilities, and maintenance|
|Capital expense||Furnace purchase price (or depreciation expense)|
Now suppose that after extensive engagement with the market, you have determined the following:
- The price that the PV-wafer manufacturer gets for each wafer has a big impact on his profitability. Material quality from ingot growth furnaces determines wafer pricing.
- The total output of each ingot growth furnace is very critical to the PV-wafer manufacturer’s economics. This means that the equipment must produce acceptable material, process it quickly, and be reliable.
- Melting the polysilicon consumes an enormous amount of electricity. It’s one of the largest costs associated with producing multicrystalline ingots.
Given this information, you can determine which value drivers in the comprehensive value expression are critical to ingot growth furnaces’ economics (step 2).
Continuing with our example, suppose competitive analysis has revealed the following:
- All ingot growth furnaces on the market produce the same quality material.
- There are big throughput differences among ingot growth equipment suppliers.
- The amount of good material vs. scrap material produced from each furnace run also varies across equipment suppliers.
- All ingot growth suppliers use similar resistive-heating technology, so no meaningful electricity consumption differences exist.
- Equipment reliability across all suppliers is roughly the same.
From the above, you can determine where there are meaningful differences among ingot growth furnace suppliers (step 3). Now you are sufficiently armed to select the value drivers that belong in the ingot growth furnace for PV-wafer manufacturers’ value metric (steps 4 and 5). See the table below.
|Step 1||Step 2||Step 3||Steps 4 & 5|
|Value Drivers||Critical to Economics?||Major Differences between Suppliers?||Include in Value Metric?|
The last column in the table above marks the surviving value drivers that constitute your value metric. See the figure below.
In the case of an ingot growth furnace, you can further define throughput as the charge size divided by process time. Also, since you do not have operating expenses in the denominator, you can use “Price” instead of depreciation expense. The figure below shows the final value metric expression.
The last step is to ensure the result is a valid financial expression. Our value metric expresses the amount of material per unit of time divided by the price paid to acquire the equipment. Your accountants would approve.
Don’t Be Seduced by the Value Metric’s Simplicity
The mechanics of the value metric are deceptively simple. Don’t be seduced by this. The math is easy, but getting the definition right for your particular market requires a deep understanding of your customers and competitors. Your value metric is the foundation for your entire value-based strategy. Cavalier value-driver selection will all but guarantee failure. Your value metric must truly reflect
- The buying behavior of your target market and
- A financial expression an accountant would recognize.
Otherwise, it will not work. Take the time to define your customers and your competitors. Use that insight to draft your value metric. Then, continually validate it with your target market to ensure that you have it right.