We will use the insights from the previous two chapters to infer some strategic moves.

These are counterintuitive. Therefore, they demonstrate the thinking required to apply the value driver framework.

Let's get into it.

Recall our assumptions from the initial example

• No secret sauce

• Market size is 1000

• market gross profit is 500

• Fixed cost are 140 (that each player must bear)

As we saw, the market will have two players, each earning a super profit (110 on 500 invested capital).

But what happens when we add strategic moves?

Assume you are first into this market. Your profits are 360.

However, we know that another player will enter (based on the analysis above).

So what should we do?

We know that market profits is a function of gross margins relative to fixed costs (including investment costs and the corresponding minimum profit requirement).

The things that affect this ratio are:

1. Gross profits

2. Fixed costs

3. Investment costs

4. Required returns

The intuition is as follows: when we increase the ratio of fixed costs to gross profits, we reduce the number of players who enter the market. 

Example 1: reducing gross profits

For example, let's consider reducing gross profits. We can to that by reducing prices (or increasing variable costs) - the effect would be the same.

A starting point would be: "what price point would make player 2 not enter ther market"?

Here's how to think about that: Player 2 needs to achieve net profits of at least 50. This means he needs gross profits of 140 (fixed costs)+50 (min profit thresholds)=190. At two players, this implies market gross profits of 380. A reduction of market gross profits from 500 (the previous level) to 380 implies a 12 % reduction in price (120/1000 total market revenues).

Players 2's prospective gross profit for various price reductions is shown below. 

Assume we reduce prices by 12 % to deter player 2.

What is player 1's profits?

Here's the simple math:

• Player 1 gets 100 % of the market gross profits of 380

• Fixed costs remain at 140

• So profits are now 240

Reducing prices by 12 % increased profits from 110 (at two players) to 240.

Below is an interesting way to visualize the buildup: the profits of player 1 with deterrence is equal to the fixed cost of player 2 + the required profit threshold (multiplied by 2).

Example 2: increasing fixed costs

Now let's consider increasing fixed costs (also known as fixed cost escalation) by the same reasoning.

To deter, we must increase fixed costs so that player 2 cannot make the required 50m threshold in profits.

If he enters, he will get gross profits of 250m (50 % of 500m). If fixed costs are more than 200, he will therefore not be able to make his minimum threshold of 50m.

 

In that scenario, player 1's profits grow to 300. Here's how:

• He gets 100 % of the 500 market gross margin

• He has 200 in fixed costs (up from 140)

The delta in profits = 250 (increase gross profit) - 60 (increased fixed costs) = 190.

The chart below illustrates how the profit of player 1 depends on the profit threshold and fixed cost level

 

 

Matematically,we can actually derive that when we deter

Profits = 2x return requirement + fixed costs

In other words, our profits increase with the return requirement and fixed costs. 

That, in my view, is counter-intuitive!

Here are the takeaways:

• We started out with a condition with no investment costs. Players still made super profits due to the relationship between cost structure and market structure

• When we added investment costs The results improved for incumbents, because the market could now only bear two players. Return on capital was 22%

• When we add strategic moves, such as deterrence or fixed cost escalation, profits exploded for the first mover.

  • By increasing fixed costs, profits increases to 300 (from 110 in the "no strategic move" case) - sustainable 60 % return on capital

  • By deterring with price, profits increases to 240. ROIC = 48 %.