In my first post on the Laws of Profit Dynamics I explained that any growth a company experiences beyond what’s driven by overall economic growth is not really value creation, but rather value migration. This parallels the First Law of Thermodynamics. What follows is a comparison between Entropy and commoditization and what it takes for businesses to fight disorder and maintain their value.
The Second Law
The Second Law of Thermodynamics (Entropy) tells us how energy (or its equivalent, matter) moves around. In simple terms, entropy says that systems become more “disordered” over time. Energy dissipates. System becomes spread out, less concentrated.
In business, we call entropy “commoditization.” Profit dissipates. It’s hard for a business to stay hot, or for market share to stay concentrated in the hands of the original innovators.
But how fast does profit dissipate and what drives the value flows? Once again, thinking like an engineer can bring structure to this question. It’s all about the strength of the forces that fight disorder. A bit of food coloring dropped into a glass of water will spread throughout the glass rapidly, achieving maximum entropy. But a chunk of iron dropped into the glass will tend to stay a chunk of iron, because the forces holding it together are strong enough to fight disorder.
So what are the binding forces in business that are strong enough to fight the force of disorder and keep value from rapidly drifting away? There are several:
- Experience. Hard-earned, deep experience that is collaboratively shared within a team but not well understood outside the team. Think maps. Apple wanted to take control of the maps app on its iOS devices, but it apparently underestimated how much learning had gone into making maps look easy. In fact, maps are hard. Like iron. Some experience is embodied in formal patents, but even more is embodied in the collective collaborative knowledge and relationships of the company’s employees.
- Integration. Designing a brilliant product, whether it’s a printer or a phone, is hard. Designing a set of products that work together, like IBM did with the System 360 mainframe in the 1960s, is harder. Designing an architecture that integrates multiple heterogeneous products across an ecosystem, like VMware has done, is hardest. Effort invested in integration creates enduring value by building strong bonds that hold the system tightly together.
- Trust. A strong brand is a measure of the cumulative trust built up through countless transactions and experiences between a company and its customers. A positive brand represents a strong bond that resists decay.
For companies that don’t or can’t create these entropy-fighting assets, the alternative is pure speed — moving quickly from one hot space to another as different opportunities cool rapidly. For example, in the technology industry, Intel has built a model that allows it to extract most of the value from a new chip early in its lifecycle. But the speed required to stay ahead of the game seems to be increasing. HP enjoyed a decades-long run in printers, whereas Apple’s smartphone is already being challenged aggressively by Android and Samsung.
The Laws of Profit Dynamics
The Laws of Thermodynamics apply to steam engines and galaxies. But business isn’t a steam engine fighting for maximum efficiency, nor a galaxy racing away from the big bang and held together by gravity. So what’s the value to business leaders of following analogous Laws of Profit Dynamics? What can we learn from the successes of our engineering colleagues?
In a nutshell, the laws show us what’s possible, even if it’s beyond what we know how to create today, while simultaneously keeping us honest by forcing us to do the math rather than substituting wishful thinking for productive innovation. Applying the Laws of Profit Dynamics encourages a business leader to grow and sustain value by challenging the organization every day with three questions:
- Who is our value coming from?
- Where is our value most likely to escape to?
- What will hold our value in place?
Value is the energy of business, and these three questions can be a powerful mechanism to help a business leader harness and hold value.