“Clarity of thought is only made possible by clarity of language. Lacking the latter, the former will forever remain out of reach.”
We are all familiar with the idea that companies have different and specific value propositions (or “value prop” for short). The value prop is what a company offers a customer. At a high level, if we think about Costco’s value prop for example, it would be giving customers a lot of everyday bulk goods at the cheapest prices possible in no frills self-service stores that are easy to navigate. Chipotle’s value prop is good quality, tasty food that is quickly made, fresh, and offered at low prices in clean stores. The value prop is what a company offers, but the other side is: what does the consumer want?
When the value prop doesn’t match what the consumer wants, some would say that there isn’t “product-market” fit. However, just because a product doesn’t have product-market fit, it doesn’t mean the product is not serving any of the consumers’ desires. Similarly, why do some consumers love some products they buy, but not others? Presumably, they would both have a “product-market-fit”. We think the Consumer’s Hierarchy of Preferences explains it all.
Maslow’s Hierarchy of Needs
Our framework is a reformulation of Abraham Maslow’s psychological concept known as Maslow’s Hierarchy of Needs. In short, Maslow’s Hierarchy of Needs helps explain human motivation and behavior. The most pressing needs, such as food for a starving man, would take total precedence before addressing other needs. The most basic physiological needs would be the most important, and then move up to other needs like safety, social relationships, and achievement. This is usually displayed as a pyramid (picture below), but importantly, Maslow himself never actually used a pyramid to depict his ideas. This is because Maslow viewed many needs as coexisting in a more fluid manner, with many of them simultaneously being weighed against each other. It is this original idea that seeded the outline for our Consumer’s Hierarchy of Preferences.
Consumer’s Hierarchy of Preferences
The Consumer’s Hierarchy of Preferences is the idea that consumers have an internal “weighting” of desires, and once a desire is filled to a certain degree, addressing their next order desire becomes more important. When a company addresses a sufficient number of a consumer’s desires, they make a sale. Similar to Maslow’s Hierarchy of Needs, many consumer preferences co-exist, and the consumer may make trade-offs with one preference to get two others—like a customer shopping for a luxury brand and buying an mis-sized jacket on close-out because it was cheaper (to this consumer, the jacket size didn’t matter as much as price and the brand). When Jeff Bezos says no customer is ever going to ask for higher prices, slower delivery, or worse selection, he is hinting at all of the most important preferences on a Consumer’s Hierarchy of Preferences for the majority of all product purchases. Thus, he decided Amazon should focus their value prop on addressing those preferences first.
We can see the Consumer’s Hierarchy of Preferences in action with a man shopping for a new button-down shirt. His Consumer’s Hierarchy of Preferences may go from 1) shirt that is available today, 2) shirt that is available today and fits, 3) shirt that is available today and fits for under $100, to 4) shirt that is available today and fits for under $100 and is machine washable. Meeting the first 3 conditions is sufficient to induce a purchase, but if there was a button-down shirt that also met the fourth condition (machine-washable), then that consumer would be especially happy. However, this example suggests a linear and ordinal progression of desire versus a much more complex mix of preferences in reality.
Thanksgiving Dinner Plates.
Instead of thinking of a pyramid to visualize the Consumer’s Hierarchy of Preferences, think of a Thanksgiving dinner plate. You might first put some turkey on your plate, and then want gravy. Then stuffing and mashed potatoes. But then you might want more gravy again when you realize your gravy to mash potatoes ratio is off. Next, your preference is for something cold and sweet, so you reach for the cranberry sauce. That mac and cheese looks good too, so you want that next. But now you want more turkey though because you took too little relative to how much of the other sides you have. Looking at your plate, you feel a desire for something healthier, so you reach for the green beans. Then, your desire swings to the other end and you go for a slice of pumpkin pie. After you start eating your meal, you might realize that something tastes way better than you thought and so you want more of that and less of the turkey which turned out to be dry. It is all of these co-existing and shifting desires that make up the Consumer’s Hierarchy of Preferences. If you look at the different mixes of food on everyone’s plates at your dinner table, you can see the manifestation of the Consumer’s Hierarchy of Preferences.
Value Prop meets the Consumer’s Hierarchy of Preferences
As consumers, we buy all sorts of things that get a job done for us, but we don’t love. That’s because these items hit a sufficient number of desires on the Consumer’s Hierarchy of Preferences to elicit a sale, but not enough to address all of our preferences. Conversely, when a consumer is totally satisfied with a purchase and raves about the company or product, it is because they have more preferences filled beyond the point that they would have already satisfactorily purchased the item. In such cases, the company is creating a consumer surplus. Great companies create consumer surplus (most companies don’t create any).
Costco is routinely probed by investment analysts on whether they can take prices up ~3% to double their profit margin. The reason why Jim Sinegal has been steadfast in refusing to take prices up is because it would deteriorate the consumer surplus that their value prop creates. When the consumer surplus deteriorates, customers stop saying they “love shopping at Costco”, and eventually you start seeing that show up in higher shopper defections. To put it in finance terms, consumer surplus shows up in lower churn and thus higher customer lifetime value. Costco could raise prices 3% and enjoy a windfall, but their competitive position would be greatly reduced. In the intermediate term you will see higher profits, but that comes at the cost of eroding Costco’s grip on the consumer, and eventually purchasing habits start to move elsewhere.
Whenever you value a company, you are discounting the sum of future cash flows. If Costco erodes the consumer surplus, they are effectively shortening their lifetime cash flows and thus would merit a lower valuation. Of course, financial analysts only count what is countable, and thus might believe it is creating “shareholder value”, when what is really happening is Costco is mortgaging its future and paying it to existing shareholders—they are not creating value; they are temporally redistributing it.
To summarize, a consumer at Costco satisfactorily purchases there because of the everyday items they can get in bulk and at cheap prices. However, when Costco addresses more points on the Consumer’s Hierarchy of Preferences than necessary to get a sale, they are building consumer surplus. This is usually because prices are even cheaper than the customer expects or there is a unique item that the customer didn’t know they wanted—i.e. the “wow factor” of Costco. Eliminating the “wow factor” would be akin to Costco deliberately deciding to debase their value prop and reduce their customers’ lifetime values. Hence, Sinegal’s resolute refusal to raise prices at all, whatsoever.
Investors, Jobs, and Milkshakes.
Clay Christensen invented the “Jobs to Be Done” framework, which is a reframing of the question “What market is this product serving?”. His framework asks the question, what “job” are people “hiring” this product to do? Christensen similarly found the product-market fit concept inadequate when he couldn’t explain why so many people were buying McDonald’s milkshakes early in the morning. The “market”, though, wasn’t people who wanted a sweet, drinkable dessert in morning, but rather people in a rush who needed to eat in their car. He goes on to describe how these customers valued an item that could be quickly prepared, was easy to consume with one hand still on the wheel, and kept them full until lunch. Despite the market being different than intended, the milkshake’s value prop hit all of the important aspects of the Consumer’s Hierarchy of Preferences. The consumers valued timeliness, ease of consumption, and the ability to satiate them until lunch. Knowing that these are the necessary conditions to induce a sale, McDonald’s could work on a product that served all of these desires while simultaneously working on fulfilling other desires as well (ie making it healthier), which would ultimately create a better value prop for consumers. To put it technically, the “Job to Be Done” is like the minimum viable product that hits a sufficient number of preferences on the Consumer’s Hierarchy of Preferences to induce a sale.
Great investors have often spoke about the Consumer’s Hierarchy of Preferences, but in different language. Nomad’s Nick Sleep was early to invest in Costco, identifying that Costco’s very low margins were a choice. Essentially, instead of investing in the business just through the cash flow statement, they were investing in customer satisfaction in the form of price reductions. This isn’t itemized in the financials, but the same way an investor backs-out growth capex from capital expenditures to get a sense of normalized free cash flow, it would be fair to consider normalized cash flows as if they were not making this on-going investment. Nick Sleep would argue that the surplus value Costco is choosing to share with consumers should be a benefit to their valuation, since it essentially increases the company’s longevity. (You do have to be careful, though, that the margins a company has are indeed a deliberate choice by management and not simply an expression of a lousy industry or business).
When a Box of Chocolates isn’t a Box of Chocolates.
The idea that a company’s value and competitive position can stem from something that isn’t easily quantifiable has been spoken about ad libitum by many of the greatest investors. There are all sorts of factors that can be discussed about why one product is superior to others. In such cases, the company is hitting hard-to-fill desires on the Consumer’s Hierarchy of Preferences. We particularly like Warren Buffett’s See’s Chocolates example. The following is from a speech given at Florida University in 1998:
Most people do not buy boxed chocolate to consume themselves, they buy them as gifts— somebody’s birthday, or more likely it is a holiday. Valentine’s Day is the single biggest day of the year. Christmas is the biggest season by far. Women buy for Christmas and they plan ahead and buy over a two or three week period. Men buy on Valentine’s Day. They are driving home; we run ads on the radio. Guilt, guilt, guilt—guys are veering off the highway right and left. They won’t dare go home without a box of chocolates by the time we get through with them on our radio ads. So Valentine’s Day is the biggest day. Can you imagine going home on Valentine’s Day—our See’s Candy is now $11 a pound thanks to my brilliance. And let’s say there is candy available at $6 a pound. Do you really want to walk in on Valentine’s Day and hand—she has all these positive images of See’s Candy over the years—and say, “Honey, this year I took the low bid” – and hand her a box of candy? It just isn’t going to work. So in a sense, there is untapped pricing power—it is not price dependent.
The philosopher Ludwig Wittgenstein points out that the words we use often have different meanings than their most direct interpretations. When a wife is upset that her husband didn’t ask her about her day, she probably isn’t concerned that he doesn’t know the details of her time at work, but is really trying to say, “Do you still care about me?”. Similarly, if your husband brought home the cheaper $6 box of chocolate, thinking that chocolate is just chocolate, he missed the point of what See’s is. For many, See’s value prop isn’t just a box of tasty chocolate, but the conveyance of care and love. The latter is an essential condition of satisfactorily fulfilling the Consumer’s Hierarchy of Preferences on Valentine’s Day. For similar reasons, many couples will not consider gift cards from a significant other as a good gift, even if the dollar amount is very high because many interpret it as a lack of care or consideration [i]. What Buffett is hitting on in his speech is that it is easy to create a tasty, cheap box of chocolate, but it is much harder to create a product that elicits that warm fuzzy feeling when it is received. Similar to Costco, there is pricing power that the company purposely decides to leave in reserve rather than price to the maximum amount a consumer will bear. (The consumer surplus here comes in the form of a more ineffable aspect of “conveying care”, but is expressed in the fact that there is untapped pricing power).
The Consumer’s Hierarchy of Preferences gives us the language to more critically analyze products and companies’ value props. In our next piece, we will expand on the concept by looking at the two core strategies the retail industry employs. Make sure to subscribe to get notified when it is released!
Special thanks to Brett, Kyle, Rez, and Trung for reading early drafts of this and providing valuable feedback.
Thank you so much for reading! This was our first experiment with sharing our frameworks and is the first of (hopefully) many Business Philosophy pieces. If you enjoyed this piece and want to see more of these kinds of write-ups, please let us know via email or Twitter and share it with a friend!
[i] It gets tricky because a lot of this is inherently subjective. However, this is also the point: what is subjective is harder to copy. This is especially true when subjectivity is shared, ie not just what you think about See’s but what the average person thinks other people think about it. Advertising is the field that deals with building subjective beliefs and creating intersubjective realities. When luxury car makers blanket advertise to the masses, it is important to the luxury car buyer that everyone else knows it is luxury too. Status would be a high desire on that Consumer’s Hierarchy of Preferences, and advertising to people who can’t afford the car helps create it.