Saturday, June 30, 2007

Ski Rental and Value Propositions

Most of us (esp. in the US) would have rented items like Skis, Camping Gear, etc. from time to time. For the occasional skier or camper, this is an obvious choice. However, the more serious enthusiasts have an interesting problem - to rent or to buy? This is a well-researched topic and the math proves conclusively that the optimal strategy involves renting until the aggregate rental cost equals the cost of the ski equipment.

Now consider the following -

1. I bought a pair of roller-blades after taking my first lesson while attending Grad school. Over the course of a couple of years, I became a very proficient skater. Much like the researchers predict in their paper, I had a major accident that required 18 stitches over my left eye. Purchasing the rollerblades outright gave me the option to practice at short notice in my free time (an extremely valuable commodity in grad school) and is a decision that paid off well. Once you master rollerblading, many other sports like Skiing and Ice-skating are easy to learn and enjoy.

2. Taking a similar approach, I bought a cable modem for $200 in 2000 when I moved to the Bay Area. Comcast was renting these modems for approximately $10 a month and I reckoned that I'd my investment would pay for itself in less than two years. However, within a few months of my buying the modem, Comcast reduced the rental price to a ridiculous $2 a month, making me kick myself. A good 6 years after buying the modem, I still haven't broken even!

These examples illustrate why
the ski rental algorithm is great for the average case. Given the amount of skating that I did, I'd not have spent much more had I followed this approach while buying my rollerblades. With the Cable modem, I'd definitely have freed up precious resources for investment elsewhere.

Now, step back a bit and consider a startup (with scarce resources). Following the ski rental algorithm gives the startup great leverage in conserving its resources and investing in the most critical areas. At an early stage, leasing desktops from Dell/HP helps the startup free up capital to invest more on the product. Capital Expenditure can be done later after the product has stabilized and the revenue stream starts picking up.

This idea is also the cornerstone of many SaaS offerings. What do you think is the primary value proposition of Salesforce.com? I'd argue that the primary value proposition of Salesforce.com is not CRM and its software, but the lower cost of ownership of such a solution. As I've noted in my earlier posts, comparable solutions from Siebel, SAP and Peoplesoft were very expensive to procure and had a very high TCO. Salesforce.com's innovation lie not in providing a hosted service, but in identifying that the Ski Rental algorithm is such a no-brainer.

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