Breakthrough entrepreneurship is about solving problems -- but it's only half the battle. If you've brainstormed a business idea and have a sense of the customer pain your product can solve. The next step in your billion-dollar business generating process is to figure out if you can fill that need profitably.
To do this, you need to understand the value proposition you're creating. Estimate the economics as best you can so as to figure out ahead of time if customers will actually agree to purchase your product or service for significantly more than it costs you to produce it.
Three factors make up your value proposition:
Production cost: What will it cost you to develop and produce your product or service?
Customer utility: What dollar amount can you use to represent the degree to which your customer will value the product?
Price: How much will your customer be willing to pay?
The lower your production costs and the higher the customer utility, the better the value proposition will be. For example, suppose we wanted to calculate a value proposition for a grande soy latte at Starbucks. We'd need to estimate each of the three numbers so that we can plug them into the three parts of the framework.
Begin with production cost, which is often the number you can estimate with the most precision. If you're selling lattes or planning to manufacture electronics, bake cupcakes or develop games that run on social networking websites, hopefully you know enough to come up with an estimate of what it will cost you to produce them. In this case, you'd probably have direct expenses, such as the cost of beans, soy milk, paper cups and those little corrugated cardboard sleeves so your customers' hands won't burn. You'd also have indirect costs: the tables and chairs you need to furnish the store and the marketing campaigns.
What are the true production costs for a single grande soy latte at Starbucks? An educated guess, based on our research and interviews, we'll say it probably costs Starbucks about $1.75 to produce each latte.
That's step one. Step two is to figure out the customer utility. In other words, what is a single cup actually worth to a customer? The utility to a mildly curious Starbucks customer who has never before tried a soy latte isn't all that high. The utility to a true caffeine addict is higher. Maybe he or she would be willing to spend three times as much as the latte neophyte.
To find out, you could ask potential customers what they think about lattes and other similar drinks. Look at what similar drinks sell for elsewhere, do interviews and conduct focus groups or offer pre-sale deals and see what level people bite at.
Let's say the average utility to a Starbucks customer would be $5, and the estimated $1.75 production cost. Those are pretty promising numbers, and can lead us to the last estimate: what is the optimal price?
Determining how to price products optimally is a never-ending challenge. Often you'll cycle through several pricing experiments before you figure out what works best. Usually, but not always, the higher the price, the lower the demand. The key to keep in mind is that the purchase price you set must be somewhere between what it costs you (or Starbucks) to produce the latte and the utility to the customer.
Spelled out like this, the point seems obvious -- and it is. Yet, the history of entrepreneurship is filled with stories of founders who never accurately figured out these calculations ahead of time, and whose ventures died as a result.
In the case of Starbucks, since we can find one on nearly any urban street corner in America, we can see that its current calculation of the optimal price is about $3.85.
Related: Four Rules for Pricing Products
Two more points to consider: the value created and value captured. If Starbucks produces lattes at $1.75 and the average utility to your customers is $5, then Starbucks has created $3.25 of value. And if they're selling lattes at $3.85, then they are capturing $2.10 of value. This example shows a well-balanced value proposition at Starbucks, and perhaps helps explain why the company's stores remain popular and profitable. At least in this example, based on reasonable assumptions, Starbucks creates significant value for the customer, and it also captures a sizeable portion of that value for itself.
So why even bother with the exercise of calculating a value proposition? First, the process can help you diagnose quickly whether you're on to something promising and potentially profitable.
Second, it shows where you need to focus your efforts to improve a marginal business idea. It can make it easier to identify where the problems lie before you get started. If your customer utility and your production costs are both high, for example, then you might need to focus your efforts on reducing costs.
If customer utility and production costs are both low, you might focus on finding different customers for whom your product might have a higher utility. Can you find customers with more pressing needs? Is there a way to make your product better without spending much more money?
Finally, if costs are low while utility is high, you could focus on how much you can increase the asking price, putting you in a position to capture more value. Hopefully you'll make more money while also building a more interesting, stable and rewarding business.
This article is an edited excerpt from Breakthrough Entrepreneurship: The Proven Framework for Building Brilliant New Ventures (Farallon Publishing, 2012) by Jon Burgstone and Bill Murphy Jr.
Jon Burgstone is the San Francisco-based co-founder and former CEO of SupplierMarket, an Internet technology firm, and teaches entrepreneurship at the University of California, Berkeley. Bill Murphy Jr. writes about entrepreneurship and national security from Washington, D.C.