The Laws of Profit Dynamics (Part 1)

Since the mid-1800s, the Laws of Thermodynamics (e.g., the First Law, Conservation of Energy) have guided the thinking of generations of engineers, ensuring that their dreams of a better machine were channeled into the art of the possible. Rather than constraining innovation, the laws ensured that creative energies were focused on productive invention and not wasted on fantasies like perpetual motion machines.

Business leaders could benefit from a comparable set of laws – not lofty, idealized theories like the Efficient Markets Hypothesis, but simple, engineering-style Laws of Profit Dynamics. We could start by leaning on the laws used by our engineering colleagues.

The First Law

The First Law of Thermodynamics states that energy can be moved around and converted from one form to another, but it can’t be created out of nothing. The same is true in business — the rate of value growth for companies in total is limited by the rate of global economic growth. Any company that “creates” value at a faster rate has to take the value from someone else. We understand this easily enough when we take share from a direct competitor, but the First Law of Profit Dynamics says that it’s always true, which means sometimes we have to dig deeper to see where the economic “energy” comes from. For example:

  • When Google exploded on the business scene early in the millennium, was its growth fueled by taking share from direct search competitors like Alta Vista and Yahoo? No, its “energy” came from newspapers. Online advertising grew in the U.S. from about $7 billion in 2003 to roughly $32 billion in 2011, while advertising spending with newspapers fell from about $45 billion to less than $20 billion. The energy equation balanced. Google didn’t create economic value; it drained “heat” from another system.
  • Sometimes a company grows by tapping into successive sources of energy. According to unconsolidated market cap numbers from Thomson Reuters, between early 2001 and early 2005, Apple “created” incremental market value of about $25 billion as the iPod took off. During that same period, Sony (creator of the Walkman) saw its value drop by roughly $25 billion. During Apples’ next growth surge, from 2007 to 2010, this time driven by the new iPhone, Apple’s market value grew by nearly $120 billion. During that same time, the combined market values of Nokia, Motorola, and RIM fell by more than $160 billion. Having drained energy from both consumer electronics and mobile phones, Apple then turned its sights on another heat source, its original business of personal computers. Between early 2010 and early 2012, as Apple’s tablet business took off, its value jumped by more than another $150 billion, while the market values of the aforementioned companies along with HP, Dell, and Microsoft fell by a total of nearly $140 billion. In one decade, Apple tapped into and drained the heat from three successive pools of energy in order to fuel its own value growth.

Just as the First Law of Thermodynamics (conservation of energy) forbids creating something from nothing, the first Law of Profit Dynamics notes that any value growth beyond what’s driven by general economic growth is not really value creation, but rather value migration (a phrase coined by business writer Adrian Slywotsky). This means that business leaders must relentlessly and rigorously challenge themselves with two questions:

  1. If your business plan calls for more than simple economic growth, who are you taking the value (energy) from? This is not a casual exercise. You can’t assume profit into existence. Like a good engineer following the laws of thermodynamics, you must “balance the equation” and account for all of the profit in the system.
  2. Who may be looking to tap into the heat (profit) of your system? Anticipating the potential leaks out of your business system can be a daunting process. In a perverse inversion of the boiled-frog syndrome, many businesses grow surprisingly cold before they realize their profits are being bled away through the un-insulated walls of their industry.

Keep an eye out for Part 2 in this series which aims to explore how business leaders apply the Laws of Profit Dynamics to grow and sustain value.

About the Author: Jon Fay