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Bob Luddy Is A CEO Who Applies Principles Of Austrian Economics In His Business Every Day.

One of the things that I really like about the Austrian economists, regardless of the subject, they work hard to get to the truth of the matter. So they’re not hung up in formulas or things that happened in the past or general beliefs. They’re looking for the truth and the best methodology, and that’s the methodology we use in CaptiveAire, and it’s proved to be tremendously successful.

Podcast Transcript: Conversation With Bob Luddy of CaptiveAire; September 22, 2020

Listen to the full episode here.

Hunter:

Bob, welcome back to Economics for Entrepreneurs.

Bob Luddy:

It’s my pleasure to be here today.

Hunter:

You were our guest very early in our series of podcasts, in episode number four. You talked to us about specialization, which is important for entrepreneurs: choosing your specific target customer and your specialized market and becoming uniquely superior in your offering in that market. You’ve done that with your company, CaptiveAire. It’s the out-and-out leader now in commercial kitchen ventilation systems, which your website calls a complete solution of fans, heaters, duct work, and HVAC equipment. But you also talked to us about systems thinking, selling solutions, customer service, cashflow management, and a host of other things that are really elemental to your success and others too.

You mentioned briefly in that discussion that you’re a student of Austrian economics. Austrian economics has been a companion for you on the road to success. You apply the principles of economics directly in your business. You actually contribute time and resources to teaching everybody in your company some of those principles, both executive management and employees. So we’re going to talk today about how Austrian economics is applicable in business and some of the specific principles you’ve applied.

So I thought I’d start with Say’s law, Bob. You summarize it to me as supply creates demand, and every business wants to create demand, obviously. But tell us how you interpret Say’s law, because it’s not all that easy, and then we’ll talk about how you’ve applied it.

Bob Luddy:

The way I interpret Say’s law is if you bring a new product or service to market, the assumption is that you’re bringing a product to market that someone needs at a price that makes sense. So that’s the underlying assumption. But when new supply comes on the market, it may solve existing problems that are not currently being addressed, or it could be a new piece of clothing that’s attractive, and you may not need it, but you’re compelled to buy it because it’s an attractive offering. In our case, we’re primarily dealing with engineering. So the products we bring to market, while they have to be aesthetically acceptable and pleasing, they’re primarily solving problems within the restaurant or commercial building.

If we can bring products to market that solve those problems in the simplest way possible, at the best possible price, we’ve got a good chance of both creating new markets and also attracting customers from existing suppliers.

Hunter:

So that would imply that the typical words that get used in business writing, which are that firms create demand, are not quite right. It  sounds like identifying potential problems, then making the production leap, you design and produce, and then demand is a result of that. Is that a good way to summarize it?

Bob Luddy:

Yes. That’s exactly correct. I can provide some examples in our kitchen ventilation business. If you went back to the 1980s, many of the harmful effluents from cooking in a restaurant were escaping into the kitchen and sometimes even into the dining room. So that’s a serious problem because those effluents could contain carcinogens, and at the very least, they’re very unpleasant. That was the state of the art. So my thought was, if we could solve that problem at an acceptable price, we’re going to have a lot of customers. That turned out to be exactly right.

Bob Luddy:

Now, you might say other people did the same thing, other companies, and that would be true. But our vision and our target of how to solve that problem was superior to theirs, is that it’s really just that simple. So it’s not just a matter of solving the problem. It’s solving it with an acceptable idea, technology, or service, and also, again, it applies at an acceptable price, not at any price.

Hunter:

Right. But you’ve got to produce, right? Do you take that entrepreneurial risk that you’ve identified the problem correctly, you’ve designed the solution correctly, but you’ve got to produce before you create the market result, or you create the reward?

Bob Luddy:

I can give you countless examples of competitors that had some methodology of solving the problem, which we deem to be either deficient or actually didn’t solve the problem. So many people take a stab at this. But it’s only the ones who have a more precise vision of what’s acceptable to the market. So there’s market risk – that’s Say’s law – and there’s the uncertainty, so to speak, as to whether your product will win and actually create a new market. We know the greatest example of all time: the iPhone literally created a new market. In that case, they did it at a relatively high price. So that would break the CaptiveAire rule, whereas we try to be the low-cost producer. So visions can vary pretty widely. But in the end, the entrepreneur has to be very correctly aligned with that user.

Hunter:

You used a great term there, Bob, which I’ve never heard before, but it’s very evocative. You said precision vision, getting to a precise vision. How have you learned to do that over the years? How do you get to that precision? What’s the secret?

Bob Luddy:

Well, for example, just kind of a mundane product that people don’t maybe put a lot of thought into, but duct systems are fire protection systems, and they tend to be difficult to install and not as effective as they should be. So we developed a duct system that could be put together like an erector set. It’s got a good set of instructions. It actually ships like an erector set. Over time, we were able to buy highly automated equipment. It can produce this at a very low price. So we have price. We have quality. We have sustainability. We have ease of installation. We have guaranteed fire protection with the assumption that it’s installed correctly. All those bases are covered within the product design manufacturing process and installation.

Bob Luddy:

That’s supposing that we had seven of eight requirements, perfect, but one not. If a competitor was able to perfect that last requirement, we might be out of business. So that’s where I came up with the term, you have to be fairly precise and understand all the requirements, meet all those requirements, and meet them in the best way possible, based on technology that exists today.

Hunter:

I was reading an analysis the other day that said… It used the term small details, and it said, “In today’s customer experience, small details are not only important. They’re critical.” Because service and competition are so good these days that it’s the small details that make all the differences. Would you agree with that?

Bob Luddy:

We stress that continuously. So pretty much, you could look at any of our manufacturing engineers, managers, et cetera, and they are very engaged in the very fine details of everything that we do. Many times managers get to a level where they feel like the details are left for other people, so to speak. That’s a completely wrong headed idea because it’s the small details that usually trip you up. So we put a very high focus on those details.

Hunter:

In all that process, when you’re talking about production and design, Bob, what’s the role of feedback from the customers? Is that something that’s going on all the time, or is it something you actively go out and collect with a piece of research? How do you feel about customer feedback?

Bob Luddy:

First, we do our research to ascertain what the problem is. Then we determine how we’re going to solve it. Then once we put together the product, we put it into what we call a beta. So we go to some select customers and saying, “Let’s install this unit in your restaurant and see if it solves your problem.” Then over time, we widen that beta because as you get a wider beta, you get more commentary, and you can figure out some nuance that potentially could have been missed. So we found that to be a very effective process.

Bob Luddy:

But keep in mind in engineering, the end user or the customer, they can be very clear as to what their problem is, but they don’t know the solutions. So if you are able to bring a solution to them that solves those problems, they’re going to intuitively know, is this a good solution, an acceptable solution, or are there some things about it that are not acceptable? So it’s very important to get that user commentary because no matter how brilliant your engineers are or how well thought out your process, nuance is going to be missed, and that brings us back to the point of details are extraordinarily and absolutely important.

Hunter:

But the feedback is to a beta product. It’s not to a survey question or asking an opinion. You’re getting feedback, and it’s feedback about a specific product, not a concept or idea.

Bob Luddy:

For the most part, I find surveys and small groups, et cetera, to be not very useful because all you’re going to learn from them is a status quo. If we’re doing our job correctly, we better know the status quo.

Hunter:

Let’s move to another subject, which is subjective value. It’s one of the core elements of Austrian economics, understanding the value created by the customer. But we tend to associate it, I think more easily with consumer businesses. In fact, at the outset, Bob, you talked about fashion. We understand that people have different subjective tastes and attitudes to fashion, or their attitudes to food might be different. Some like fresh nutrition and others like fast food. Those are subjective values. I think a lot of our entrepreneurs have a little difficulty in dealing with subjective value in business to business. But that’s your space. So tell us about your understanding of subjective value and how it’s helped you.

Bob Luddy:

Mises made some comments about this. So for example, if we bring an integrated system to a restaurant, and if we were successful in explaining all of the problems it’s going to solve, the sustainability of it, then it still comes down to the user saying, am I willing to pay X amount of money to solve these problems? The user very well could say, “No, I’d rather live with some of the problems and depart with that much money. So Mises makes it pretty clear that’s where the decisions are going to be made.

Bob Luddy:

So our strategy is we solve all the problems. We clearly communicate to the user how we solve this problems, and then they make the decision. Now, if we don’t communicate well, the value of the product in the user’s mind may be lower. So part of the issue of getting a higher subjectivity of value is to have a full understanding of what the product does. But in the end, even if we think we’ve established a good price point, and we solved all the problems, the user can just simply say, “I’m not willing to pay that amount of money to solve those problems.”

Bob Luddy:

So the subjectivity is very, very clear, and it’s reinforced in the market every single day. It could be that if the user said, “That’s simply too much money for the problems you’re solving,” he’s sending us back to the drawing boards to say, “Yes, you have an acceptable solution, but the price is wrong. You’re going to have to figure another technology.” So I think the same concept comes into the industrial world and commercial world just as it does in fashion or food or anything else.

Hunter:

Sometimes the trouble that people have thinking that way, Bob, is you’re often not dealing with a single decision-maker, a single buyer. It’s not an individual. It might be a procurement committee, or it might be a decision that has to go up the hierarchy. So people are confused about, whose subjective value is it? Is it the CFO who signs off on the cost, or is it the engineer who signs up on the functionality, or is it the owner who signs off on the decision itself? What’s your experience about dealing with multiple customers in one sale?

Bob Luddy:

Yeah. You’ve just brought up a very important challenge for the entrepreneur. Anything that goes to committee is going to be a challenge. People tend to default to the status quo. So if you have a new type of solution immediately, a committee is going to feel more comfortable even with a poorer current solution. So within groups of that nature, you have to have an advocate, even if it’s going to be a committee decision. I’ve seen cases where you have eight people on a committee. You completely convince seven, and the eighth one is just dead set against making any change or doing anything differently.

Bob Luddy:

We had that occurred recently, and thankfully, we were able to win the day. But that’s a big challenge for entrepreneurs. I gave you an example. There was a company some years ago that had a new type of street sweeper. Of course, they were going to sell it to government. They were convinced that it was vastly superior to what was on the market, and I think they were probably right. But nobody in government ever bought the solution, and they went out of business.

Bob Luddy:

So it’s a prime example where a company says, “Well, we have the right solution at the right price.” People are going to line up a door and buy it is simply not true. You have to convince those buyers or decision-makers that this is the best choice. That is a formidable challenge, even with the best product and best pricing. So it should be always on the mind of the entrepreneur.

Hunter:

You said something really interesting, that communicating better actually raises the value of your offering. I think one of the things that we Austrians believe is that communications – call it advertising, call it marketing, call it sales, whatever you call it – is part of the offering. It sounds like you agree with that. Is that right?

Bob Luddy:

It’s absolutely imperative, particularly with new technologies that users do not understand. In the case of the iPhone, since it was so intuitive, and say since they are good marketeers, they were able to pull it off. But many products that we buy, we don’t have a full understanding of the technology, all the things it can do, and the future value to us. So if we’re not informed, we’re going to make a lot of bad decisions. So I think an effective entrepreneur has to be able to communicate with the user what the advantages of this product are and why they should buy it, and failure to do so essentially devalues their product in the marketplace.

Hunter:

One of our contributors here, Bob, Dr. Mark Packard has divided this subjective value process into components that take place over time. So he says that your customer first anticipates value. So you do the communication. They’ve got to say, is there something in it for me? It’s kind of an absolute judgment. Then they make a relative judgment compared with other choices. Then they make what he calls the exchange value judgment. You called it, do they part with the money? Then they have the actual experience. They use the product and service, and then they assess it afterwards and say, did it meet my expectations? Did it function properly? Is that helpful, do you think in thinking about your relationship with a business-to-business customer?

Bob Luddy:

Absolutely. You’ll probably notice with a lot of consumer products, when you open the box, there’s a little note in there, and it says, “You just made a great choice.” So they’re continuing to reinforce the value of their product. In that regard, if we hear even the minor’s complaint from a user, we take immediate action to make sure that’s resolved. In some case, it could be a software issue that could be corrected. It could be misuse of the product, any number of things. But we’re very tuned into after the fact, and we use the word sustainability in the context that we want our products to last 20 years or longer.

Bob Luddy:

There’s very few manufacturers today that talk about a 20-year lifespan. In some cases, we even have limited warranties that are 20 years. So the idea of having a permanent relationship with the user is very important in this whole process, and very often, manufacturers think in terms of, once they bought it, I’m done with them. I’m moving on. We’re the exact opposite of that. We want that customer for life. Even the most minor thing they’re not happy with, we’re going to fix it, and we’re going to resolve it.

Hunter:

Yes – small details. Talking about Apple, it reminds me about one of the innovations they introduced, which was the beauty of the box and what they call the unpacking experience. So as you said, you get this beautiful box, and you open it, and there’s a so carefully constructed, and there’s communications in there. I bought a pretty industrial product the other day on Amazon. It was shipped to me. It was the same thing. It was in a beautiful box, and you unloaded it, and it had this great piece of communication in there and had the little Apple-like indents in the polystyrene. So you pick everything up carefully. It was beautifully done. Does that come to your business, the unpacking or delivery experience? Is there anything there for-

Bob Luddy:

Oh, absolutely. Maybe not as much in the end packing, although we try to ship things in the most upscale way possible. It comes in if the outside crate is all messed up or the box is a problem. Immediately, you’re going to have a poor perception of that product. But we also are very conscious of aesthetics. So you can have a high function product with poor aesthetics, and just right out of the gate, the user’s going to say, “Well, this is just a piece of junk. They’re going to have a very poor perception of it.” So aesthetics count, and you’ve just iterated how that box counts a lot, even though it has nothing to do with the product. Again, you’re pointing to the details. People fail on these details.

Bob Luddy:

If you look at very complex systems that we’re engaged in, the smallest detail can shut that system down. One short wire out of place can cause a major problem. So if anybody involved with that product is not into the fine details and not executing at a very high level, we’re not going to be as successful as we should be.

Hunter:

I want to turn next to comparative advantage, Bob. We’ve had Dr. Peter Klein and Dr. Per Bylund and others on the podcast. They stress the difference between competitive advantage – I can perform better than my competitor – and comparative advantage, which is something more inherent in the company itself and its leadership. So how do you think about comparative advantage?

Bob Luddy:

I think of competitive advantage as essentially ephemeral for the most part. So you can gain advantage, but it’s very hard to hold that advantage in a highly competitive market. Whereas comparative advantage, you have a very distinct advantage that’s much longer term, maybe not absolutely invincible, but very hard to overcome. So outside of our field, I would say, if you looked at Napa Valley making wine, if you decided you wanted to make wine and compete with Napa Valley, it’s going to be a hard way to go. In our case, over time, we’ve been able to develop those design technologies, techniques, automated equipment software, and when you marry all those things together and you integrate them, we gain a major competitive advantage. It’s very hard to overcome because it’s not one thing. It’s many things, and they’re all well thought out and have been developed over a number of years.

Bob Luddy:

Whereas the competitive advantage is something that can be again, ascertained and overcome in some period of time. So you can gain these advantages, but they’re going to be ephemeral. So the goal of the entrepreneur should be to try to gain a long-term comparative advantage if possible. In many businesses that’s really difficult. In very competitive businesses, you’re lucky to gain a competitive advantage much less even thinking about every gaining comparative advantage.

Hunter:

Let me pick out one word you used there because it’s a fascinating one, and it’s a place where you can perhaps get comparative advantage over time. You call the techniques. Unfold that a little bit for us, Bob. What’s a technique, and how do you gain advantage with techniques?

Bob Luddy:

Well, for example, we have to bend a lot of sheet metal for a product. The way it’s been traditionally done is manufacturers will bend a lot of metal, and they’ll have it ready to go. So when the product comes in, they’ll pull the bent metal off the shelf, and then they’ll assemble it. Well, that requires a lot of storage anticipation of what you’re going to sell – a laundry list of challenges. So over time, we were able to buy automated equipment that will bend that metal in real time and dynamically stack it right up on the assembly line rate to be assembled and all that’s done in hours.

Bob Luddy:

So we can have a very rapid turnaround time. We eliminate all the inventory. We eliminate all the losses for inventory put together that can’t be used, and then we get into the actually assembly of that product, and we have our own unique methodology of assembly that doesn’t require traditional manufacturing jigs and devices. It’s what I call self-jigging. So it’s coming off these high-speed machines, is hitting that line, and then we have a whole series of techniques of how the product is assembled.

Bob Luddy:

So in a matter of hours, it’s the end of the assembly line ready for checkout, and it’s going to be shipped. All that has taken many, many years to develop, but that gives us a very strong competitive advantage that’s not easy to overcome. Many companies have tried it. But they don’t get all the details right, and they may miss some important steps. So it’s very hard to replicate. So I would consider that more than a competitive advantage, it’s a comparative advantage.

Hunter:

Do you design your way to those techniques on a drawing board, Bob, or do you just work your way towards them through trial and error and learning? How do you develop techniques?

Bob Luddy:

Actually, it’s both. So we design our way through initially design. We build prototypes. We revise the design, and we get that product ready for our production process. But once we get in production, we find components that are less sustainable than we wanted. We find a better technique. We may find a component that we could design better. So it’s in a constant state of renewal, looking for again, a better way to do it. We call it Kaizen from the Japanese word for continuous improvement. So our engineers are very connected to those assembly lines, and they’re also very connected to the field, primarily through software-delivered data, which is being fed to them all day long. Any minor problems are aware of, and they’re working on to fix them. So yeah. Our whole team is totally engaged in that process.

Hunter:

One of the techniques I know in Kaizen on continuous improvement is to identify what the Japanese call waste, either wasted time or wasted effort or wasted energy, and then you eliminate the waste. Is that part of the process?

Bob Luddy:

Absolutely. Yeah. That waste could be human, it could be time, could be components, could be any number of things. That’s a constant that we’re working on that process, and our design engineers and our manufacturing team, they’re all on the same team, and they’re working very closely together. Even though we are radically decentralized company, we’re tied together with software, with visits, with telephones. So we function like we’re all in the same building, but in fact, we’re all over the country.

Hunter:

Is the software feeding back from operating machinery and the restaurant or from inspections and people or both?

Bob Luddy:

All the above. So we get inspection reports. We have real-time data being fed from restaurants that will give us any aberration in performance. It also allows the engineers to look at restaurant operations and see if that equipment is performing the way it was designed. Field service is constantly feeding back any concerns they have to the manufacturing plants on a daily basis. Sales teams have software that they communicate with us. If a customer has any complaint, any issue, it’s tabulated on a software program. So the engineer in charge is very cognizantly aware of when, how often this happened. So the information we receive is extremely good, but more importantly is we’re working on it every day.

Hunter:

Do you call it big data? That’s a fashionable term these days.

Bob Luddy:

We don’t use a lot of the conventional terms. We just call it data.

Hunter:

Information.

Bob Luddy:

Yeah. Information.

Hunter:

I’ve got one more item on my list here, and that’s opportunity cost. You said that’s one of the concepts that you apply. I know that I personally have a little bit of difficulty in thinking of that through in application. I understand that the concept is that any choice that, say, your customer makes has an opportunity cost, which is they reject something else, or they don’t take another course. That sounds a bit theoretical. How does it apply in your business?

Bob Luddy:

Well, I’ll give you an example. We bought a make-up air company (see CapitiveAire website for technical explanation) in the year 1999. These companies and the controls for air coming into the building, being heated or cooled, there tended to be a lot of customization from engineering, sales reps, customers. That customization requires an enormous amount of engineering, and it’s fraught with problems because you buy a new component, you don’t know if it’s going to work under the right terms and conditions. There’s endless number of problems. So we decided in 1999, we would move toward what we call high standards. So we would a very high standard product that would suit 95% of all users. There’s flexibility within the ordering software to customize voltage and phase and certain aspects of the product. But it’s all done in software. Whereas our many of our competitors same time said, “We can be all things to all people. You tell us what you want, and we’ll figure out how to make it.”

Bob Luddy:

Most of those companies, 20 years later don’t exist any longer. So it’s an important thing to understand that opportunity costs also means turning down opportunities, getting the best utilization out of your human resources possible, making the most sustainable solutions, which are going to save time and money over a period of time. Companies tend to get these things wrong. So we’re more in the range of, we call it a category killer. We make 10 major categories of products. To keep those products at the right price, at a high level of performance and sustainability requires all of our time. So if we divert any of that time, i.e. opportunity costs, onto something, it better be something really important, or we’re failing at our most primary mission.

Hunter:

Is that an active piece of analysis, Bob, every time you look at something like that, a new opportunity that you also look at the downside, you look at the opportunity cost? Do you actively make that AB decision?

Bob Luddy:

Absolutely. Every single time.

Hunter:

So opportunity cost is an active process for you.

Bob Luddy:

Yes. Entrepreneurs, you’ve heard the term serial entrepreneur, which I don’t like. I think it’s very bad because we’ve been at this business for 44 years. While we’re really good, we’re not as good as we want to be after 44 years. So what does that tell you?

Hunter:

That you always keep going?

Bob Luddy:

That there’s always ways of improving, and the higher you get in perfection, the more and more opportunity costs. The more opportunities arise that you can get to another higher level. That’s not necessarily intuitive because people think in terms of where they want to arrive, and we don’t look at it in those terms. We just know where we’re at today, and we have laundry lists of things that we want to correct and resolve for the long term.

Hunter:

That’s an active list that you keep?

Bob Luddy:

Yes. Yeah. Well, we have long lists of things. If I went to our engineer in charge, he might have a list of 50 items that they’re working on at any given time. He’s got a lot of engineers working on these processes and products. A lot of them are, back to your word, details. They’re small details that make that product perform better, more sustainably, more useful to the end user but unlocking kind of scientific information is a slow arduous process. But every time you make that breakthrough, that product becomes more viable, and it’s gonna have a higher perception with the user. That’s pretty much how we operate the business.

Hunter:

That’s very impressive. I’m going to try and squeeze in one more topic, Bob, if you’ll bear with me. You might not be able to do it justice, but it’s one that entrepreneurs, especially B2B entrepreneurs, I think have a real challenge with, and that’s pricing: getting the price right. You always quote Bill Peterson on this topic whom you’ve mentioned before is as a mentor. So distill for us in just a few minutes, as I say, we might not be able to do it full justice, your experience about price and pricing.

Bob Luddy:

From the very beginning, my idea was that we would price under the market, which would be our primary means of gaining market share. Very interesting, if you went back into the 1980s, very often, people were telling me you’re leaving money on the table. I said, what does that mean? Well, you could charge the customers more money and get away with it. I would continuously say, “That’s just not how we operate.” We want to have the best price we can bring to that user, gain market share and grow as a company. If you fast forward 35 years later, we are still the low-cost producer. We have the highest market share, and virtually no manufacturer can get to our price because we spent 35 years figuring out how to do it. Again, we talked about our comparative advantage.

Bob Luddy:

I hear people make comments where price is not that important. Value is what counts. So my retort to that, which maybe came from Peterson, well, why put prices on anything, just go to the store, buy what you need and put it on the credit card. Well, that undermines their argument very quickly. So when Peterson said, “Price tells us a lot about the product, and it informs us and helps us make a decision if we want to pay that price for that particular product.” So I would say, of the most important strategies for CaptiveAire over a 44-year period, price is number one. Now, obviously, it has to be connected to quality execution service and so on. But pricing is a primary strategy, and our senior engineer and myself, we do all the pricing. We have an ultra short way of pricing, all the products that takes virtually no time and is definitely accurate.

Hunter:

So one of the statements that Dr. Bylund and others have made is that the entrepreneur doesn’t choose the price. The market chooses the price, and the entrepreneur chooses the cost so that you make a profit based on the price that the market gives you. So it sounds like maybe you are in that process. When you say you’re going to price under the market, that means the market’s telling you what that price level is, and then you choose your cost. But would you agree with that, or is that too facile?

Bob Luddy:

Yes. Now, most manufacturers couldn’t price the way we do if they didn’t have a comparative advantage. So we actually price based on cost, which if you go to B schools, they’ll tell you that doesn’t make any sense. As a matter of fact, many of the things they tell you in B school we don’t use as it may not make sense to other people. But us, if we can price based on costs and have a defined profit level, we don’t want to try to make more than that, even though the market may allow it because we’re looking very long term at growing the business every single year.

Bob Luddy:

So this is kind of back to a Peter Drucker argument. Yes, we could price higher, but we would have lower sales. So what does Drucker say? You should price as high as you can, but still have the highest amount of sales possible within the market. There’s obviously no formula for that. My strategy is more simple. We’re going to price based on cost. We’re going to continue to drive costs down, and therefore, we are going to be the low-cost producer, and most of the time, we are going to be the low-cost producer.

Hunter:

But you’ve achieved that without any compromises in quality and service, obviously.

Bob Luddy:

Now, in most cases, our quality is vastly superior to what people could buy. People have what I call bad buying habits. They just keep buying from the same user. So you may have a better product. But until you convince the user you have a better product. You’re not making sales. But our strategy is we’re going to have the best product, the best service, most sustainable, and the lowest price, and that attracts a large volume of customers.

Hunter:

Then you referred earlier to the integration that makes that possible. Every element is so integrated that you can have that combination.

Bob Luddy:

It took us 20 years to fully integrate kitchen ventilation systems. It’s taken another 20 years now here in 2020. We can fully integrate the mechanical systems in a restaurant or most commercial buildings. So it’s taken a long period of time to get there. But futuristic integration is absolutely critical, and even the smallest detail you miss in that integration are very, very critical and may allow a competitor to take the business away. So our long-term commitment is full integration, continuous improvement, Kaizen, figuring out ways and means of driving down price, and that’s where I would say the value proposition comes in. But just to announce that you have the best value in the market, well you know the answer to that. The user will make that determination.

Hunter:

The value is always in the customer’s mind, not in your proposition.

Bob Luddy:

Absolutely. I think manufacturers and developers, people get that very confused. They think in terms of absolute value. We think in terms of subjective value. That puts a burden on us. We have to convince the user, and we have to be right, to begin with, that this is the best value they can buy in the market today.

Hunter:

Bob, you’ve been very generous with your time today, and we really appreciate it. There are so many lessons to learn from your long experience and your great achievement, and we thank you for showing us how these concepts of Austrian economics can be applied in business, and that’s what we’re trying to do with our new economics for business platform is to share those connections between theory and practice, and you’ve shown us how it’s done. So we thank you very much for your time today.

Bob Luddy:

Can I add one last comment?

Hunter:

Yeah, please do.

Bob Luddy:

One of the things that I really like about the Austrian economists, regardless of the subject, they work hard to get to the truth of the matter. So they’re not hung up in formulas or things that happen in the past or general beliefs. They’re looking for the truth and the best methodology, and that’s the methodology we use in CaptiveAire, and it’s proved to be tremendously successful versus when I went into B school, so versus going to B school and learning certain things, and then spending your whole life trying to apply those principles, some of those principles are going to be good, and some of them are going to be, as Dr. Bill Peterson would say, the conventional wisdom is either wrong, or it’s going to be wrong.

Bob Luddy:

So it’s wrong we have to change it. But we also have to aware that someone else may have a better way of doing it. But we’ve got to be paying attention to the market. The Austrians do an excellent job at that, and that’s why I think Austrian economics is critical to every single entrepreneur.

Hunter:

We’ve developed this tagline for our project, Bob. We call it Think Better, Think Austrian.

Bob Luddy:

I love it.

Hunter:

Distilling  that, how do you think better I think is one of our challenges. We’ve got to help people to do that. So as you said, getting to the truth, a lot of that is Carl Menger’s first sentence. Everything is cause and effect. Is that one of the ways you get to the truth?

Bob Luddy:

Absolutely. Clayton Christensen made this comment in his book, the Christensen Reader. If you look at the technology companies that were founded around the same time as CaptiveAire, so these are companies that are well financed, smart individuals, good technology. Virtually every one of them is gone today. Just a couple of exceptions. Either they’re gone, they merged, they were bought out, or they went bankrupt. What does that tell you? They simply did not look ahead. They were enamored with the technology they had. When someone came along with a better technology, they were gone.

Hunter:

There’s a great example of that, I always think, which is Bill Gates at Microsoft when he made the pivot to the internet. That was a really bold decision. It was forward-looking. It was controversial, but he was the boss, so he could make it happen. But that’s one example why Microsoft is right up there now today with Amazon and Apple and so on.

Bob Luddy:

They definitely have pivoted over the years. They’re one of those companies, one of the few that did survive for that reason.

Hunter:

Well, we’ll continue to try and figure out how to think better and think Austrian, and your example will be the leading one, Bob. So again, thank you very much for your time today.

Bob Luddy:

Hunter, it was a pleasure to be with you today.

Hunter:

Thank you.

 

84. Bob Luddy: Five Active Processes of Austrian Economics That Helped Me Build One of America’s Most Successful Entrepreneurial Businesses

Bob Luddy is founder and CEO of CaptiveAire (CaptiveAire.com), the US market leader in commercial kitchen ventilation systems. It’s a $500MM+ business with 1,000+ employees and a 40+-year success record. Bob explains to Economics tor Entrepreneurs how these principles of Austrian economics, applied as active processes, played a part.

Key Takeaways & Actionable Insights

Say’s Law

Say’s Law is a fundamental proposition in support of a production-driven market system as opposed to a consumption-driven view. It’s quite difficult to interpret and pithy summaries like “production creates its own demand” and “production precedes demand” don’t help entrepreneurs very much.

Bob Luddy doesn’t interpret, he applies. His application formula is this: new supply that is brought to market can solve problems that have not so far been solved. In that case, demand will result.

He gave this example: in the 1980s, many of the harmful effluents from cooking in a restaurant were escaping into the kitchen and sometimes even into the dining room. Those effluents could contain carcinogens, and at the very least, they’re very unpleasant. That was a problem – but it was the status quo.

So Bob thought, in Say’s Law mode: if CaptiveAire could solve that problem, and bring the solution to market at an acceptable price, demand (i.e., lots of customers) would follow. That turned out to be exactly right.

Implied in this formula, of course, is attention to market signals regarding unsolved problems, a problem-solution design process, and a communications and customer interaction capability to inform the market of the new solution. Say’s Law applies, but not in isolation from other entrepreneurial actions. Those actions, Bob tells us, include accuracy and completeness in solving the problem, since many competitors may be trying to address it at the same time. Small details can make a big difference in applying Say’s Law.

Subjective Value

Many podcast listeners have asked whether the concept of subjective value — which holds that it is the subjective and emotional evaluation by customers of an entrepreneurial offering that determines its market acceptance – applies equally in B2B markets as in B2C markets. Isn’t subjective value more relevant to consumers’ choices of fashion and food than it is to business customers’ choice of service es from vendors and suppliers?

Bob’s response: The subjectivity of value is very, very clear, and it’s reinforced in the market every single day.

He used the example of bringing an integrated ventilation system to a restaurant. CaptiveAire might be successful in explaining all of the problems it’s going to solve, its sustainability, and all relevant features and functions. Completion of a sale still comes down to the user subjectively assessing the exchange value, by asking “Am I willing to pay X amount of money to solve these problems?” The customer very well could say, “No, I’d rather live with some of the problems and depart with that much money.”

Bob emphasized the importance of communications in addressing the challenges raised in calibrating subjective value appraisal. A strategy of “solving all the problems” requires clear communications to the customer of how CaptiveAire solves the problems, so that the user can make a fully-informed decision. “If we don’t communicate well, the value of the product in the user’s mind may be lower. So part of the issue of getting a higher subjectivity of value is to have a full understanding of what the product does.” Clear communication is a component of value.

Comparative Advantage

There’s a big difference between competitive advantage and comparative advantage. Bob explains it this way: competitive advantage lies in striving to provide the same service and same solution in a better way than a competitor. Such an advantage may be achievable from time to time, but it is temporary and quite easily taken away by a hard working competitor. The market signals are clear and unobscured, telling the competitor where they must improve and the incentives to do so are compelling. No competitive advantage is sustainable over the long term.

Comparative advantage is different. It’s an unmatched capability, often built over time by accumulating unique knowledge and experience and applying them in a unique capital structure. Such an advantage is longer term, maybe not absolutely invincible, but very hard to overcome.

Bob cited an example outside of his field: winemaking in Napa Valley, California. “If you decided you wanted to make wine and compete with Napa Valley, it’s going to be a hard way to go.”

In the case of CapitveAire, “over time, we’ve been able to develop those design technologies, techniques, automated equipment and software, and when you marry all those things together and you integrate them, we gain a major comparative advantage. It’s very hard to overcome because it’s not one thing. It’s many things, and they’re all well thought out and have been developed over a number of years.”

Bob refers to on important element of CaptiveAire’s comparative advantage as “technique”. An example is “bending metal in real time and dynamically stacking it right up on the assembly line”, resulting in elimination of inventory, and very rapid turnaround time. It’s CaptiveAire’s unique methodology, developed over many years. Competitors can attempt to emulate but they fail. It’s a comparative advantage.

Opportunity Cost

The cost of any choice or decision includes its opportunity cost: what option must be declined or given up in order to make the choice you prefer.

Bob explains: Understanding opportunity costs means turning down opportunities that would divert resources, and, instead, focus on getting the best utilization out of your human resources possible, and making the most sustainable solutions, which are going to save time and money over a period of time. We make 10 major categories of products. No more. To keep those products at the right price, at a high level of performance and sustainability requires all of our time. So if we divert any of that time, opportunity costs might result in us failing at our most primary mission.

He gave the example of a line of business that required extensive customization. The benefit of customization is that each customer feels that they enjoy unique value. The opportunity cost is that it’s impossible to be all things to all people — it absorbs too much time and too many resources. CaptiveAire addressed the opportunity cost problem by replacing customization with software-enabled adjustability of certain key inputs like voltage and phase. They found that this solution could effectively address 95% of customer-requested flexibility. While competitors asked, “Just tell us what you want, we’ll figure it out” and spent resources on responding, CaptiveAire was able to stay focused on its core mission and core products and services.

Every opportunity that comes a firm’s way must be examined through the lens of opportunity cost. Austrians see opportunity cost as an active process — the same way they see value and resource allocation and pricing and many other elements of business.

Pricing

Pricing is a discovery process. At the same time, it’s an element of business strategy. Bob made a strategic decision at the outset to price “lower than the market,” while aiming for highest quality. The market informs CaptiveAire of what the pricing norm is, and therefore what “lower than the market” is. The discovery part is: how low to go to maximize unit sales and revenues. The second part of Austrian pricing theory is that producers choose their own costs. Bob chose to seek ways to keep costs low enough to sustain his pricing and quality strategy, which led him to the efficiencies, automation, speed, inventory-reduction, high technology, and opportunity-cost sensitivity that characterize CaptiveAire.

Price, cost, and profit are integrated in a strategic formula that’s tested every day by the customer’s willingness to pay the price of high quality.

Free Downloads & Extras From The Episode

Five Active And Integrated Processes Of Austrian Economics (PDF): Download PDF

Bob Luddy’s Effectuation Process (PDF): View Image

Entrepreneurial Life: The Path From Startup to Market Leader by Bob Luddy: View on Amazon

“The Austrian Business Model” (video): https://e4epod.com/model

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Opportunity Cost Calculator

The entrepreneur must understand the mind of the consumer in order to see opportunity costs in the way the consumer sees them.

Opportunity cost is a subjective evaluation on the consumer’s part. How do they look at alternatives when they are considering the entrepreneur’s offer? Would they assign greater value to the aluminum product compared to the stainless steel product? An entrepreneur needs to be able to answer that question in order to calculate how to design a good deal in the consumer’s eyes. Click here to download the PDF

Preview of the Opportunity Cost Calculator Tool

 

7. Per Bylund on Opportunity Cost

Hunter Hastings talks with Per Bylund about Opportunity Costs. Why is this important? Because, for entrepreneurs, all costs are opportunity costs; and opportunity costs are the only costs. Opportunity cost is the core of economics, and to develop an understanding of how to apply economic principles to real life, it’s the place we must start.

Show Notes

Opportunity cost is the fundamental trade-off. The value of any action or choice is defined by the value of what I am foregoing — of what I can’t do as a result of choosing. If I decide to make my product out of stainless steel, I can’t also make it out of aluminum. The value I create by choosing stainless steel must be greater than the value I gave up by not choosing aluminum.

We calculate opportunity cost as the NPV of different alternatives. The NPV of the second best choice is the opportunity cost of the first.

The entrepreneur must understand the mind of the consumer in order to see opportunity costs in the way the consumer sees them. Opportunity cost is a subjective evaluation on the consumer’s part. How do they look at alternatives when they are considering the entrepreneur’s offer? Would they assign greater value to the aluminum product compared to the stainless steel product? An entrepreneur needs to be able to answer that question in order to calculate how to design a good deal in the consumer’s eyes.

The way to do this is to solve an equation: consumer value = the value of what I am offering minus the customer’s perceived opportunity cost of acquiring it. We must understand what is the first alternative for the consumer (including doing nothing — not buying). That’s one part of the consumer’s opportunity cost. Second, what are the additional opportunity costs of buying — such as the difficulty of getting to the store to buy the product, or the difficulty of ascending the learning curve to use an app. These are the second component of opportunity cost for the consumer — the alternative is not to have to face these costs and may be preferable.

Use our Opportunity Cost Calculator.

It’s possible to segment consumers by understanding their attitudes to opportunity costs. Book buyers on amazon prefer the low cost and fast delivery. Their opportunity cost is going to the book store, where there is a limited selection and prices are higher. Book buyers who go to the brick and mortar store prefer mingling with other book buyers and perhaps getting a cup of coffee — experiences that are unavailable on amazon. For these consumers, the opportunity cost of foregoing such experiences on amazon is high — so high that it makes amazon’s low price unattractive. These attitudes are held by different kinds of book buyers.

The entrepreneur’s first opportunity cost is the value of choosing another career, such as a corporate job.Many entrepreneurs could make more money — and do so with more continuity and security — as a corporate employee. That’s the opportunity cost. But it may not compensate for the excitement and fulfillment of doing what you love as an entrepreneur. Be sure to calculate the opportunity costs carefully!

Once you’re an entrepreneur, every decision is a trade-off, and calculating opportunity cost is an everyday task it’s important to master. Every resource allocation decision is an opportunity cost decision. How much should I spend on product development, if that means less money for marketing and sales? Whom should I hire versus what tasks should I outsource? Once the decision is made the opportunity cost is locked in. This is especially critical for small and start-up businesses with limited resources and tough cash flow constraints. Always think in terms of opportunity costs when making decisions: what’s the alternative?

The allocation of time is often the most important opportunity cost of all. A classic example is engineering time spent perfecting the product versus getting a just-about-good-enough product to the consumer for evaluation and feedback. The engineering trade-off is that the product is not the best it can be. More time would help. The business trade-off is that customer feedback is the most important resource of all, especially negative feedback which tells you how to improve. Delaying it could be fatal. The entrepreneur must weigh these two alternative uses of time. That’s how the concept of the MVP (minimum viable product) and agile programming emerged. They’re both ways to make the best trade-offs of time allocated to the most important tasks.

The entrepreneur must always be thinking of trade-offs. What am I losing or foregoing by making this choice? That’s the opportunity cost. Calculate it, estimate it and put a value on it. Focus on what you are not doing in order to choose the right thing to do.

 

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