Friday, February 16, 2007

If You Can Open the Door, So Can Others

The Story
There is a situation I have seen repeated over and over again in the business world, especially in the airlines industry. To protect the people who have fallen into this trap over the years, I will tell a generic version of the story.

Bob sees himself as an entrepreneur skilled at finding opportunities in relatively mature businesses, by getting aggressive and shaking up the status quo. Bob looks at the airline industry and says to himself, “Here is an industry I can shake up in my favor.”

Bob leases some airplanes and starts his bold plan. He notices that some routes are more profitable for the established airlines than others—routes where airlines charge abnormally higher than average fees. Bob puts his planes on these routes and charges ticket prices significantly below the established airlines. This plan gives Bob two strategic benefits:

1. Consumer Benefit: He is making a low price statement to the consumers on the routes where he can get the largest price savings impact with the least impact to his bottom line.

2. Competitive Benefit: He is disproportionately taking away the routes with the greatest source of income from the established airlines, making it hardest for them to finance a retaliation.

Sure, Bob will lose large sums of money at first with his plan. In the long run, though, Bob is confident that he will knock some of the weaker airlines out of business and have the market restabilize with his company having a meaningful market share. At that point, Bob will be able to raise prices and start reaping a respectable return on his investment. Bob thinks he’s a strategic genius.

For awhile, Bob’s plan works very well. He disrupts the status quo and gains market share. Bob continues to add routes and gain public favor with his “too good to be true” low prices. Weaker airlines are in retreat. The losses pile up at Bob’s company, but Bob assures himself that a new stability is just around the corner. Soon, he will have achieved his desired market strength, allowing him the power to raise fares to a profitable level.

Just as Bob predicted, that time of new stability arises. Weaker players have left the industry. Bob’s market share is strong. Bob raises his prices. Then he puts his feet up on his desk, relaxes, and says, “My job is done. I have won the game.”

What Bob doesn’t know is that on the other side of town there is an entrepreneur named Jane who also likes to make money by shaking up established industries. At about the same time Bob is putting his feet up on the desk, Jane is looking at the newly stabilized airlines industry and says, “Here is an industry I can shake up in my favor.”

Jane utilizes a strategy similar to Bob’s and upsets the pricing stability with her “too good to be true” low prices. Bob has to respond by putting his prices back to the old unprofitable levels. Eventually Bob goes out of business and Jane survives. Then Jane takes advantage of the new restabilization of the industry by raising her prices.

At about this time, Lee is looking at the airlines industry, saying, “Here is an industry I can shake up in my favor.” And the cycle repeats itself yet again.

The Analogy
Strategies are based on assumptions. If you choose the wrong assumptions, your strategy will likely fail. There is a failed assumption I like to call “The Last One Through the Door” assumption. This assumption rarely leads to long-term strategic success. With “The Last One Through the Door” assumption, businesses assume that they can enter an industry, buy market share by offering prices or features below cost, and then get their profits later when the market restabilizes and they can raise prices.

The problem with this approach is that it only works if nobody comes behind you and destabilizes all over again. In other words, for this strategy to succeed, the path you took to enter the industry must be a door that you can lock behind you, so that nobody else can enter in the same way you did. You have to be “the last one through the door.”

Unfortunately, if you are able to find a way to open the door, others will often find a way to open that door as well. This is what happened to Bob, whose strategy failed because he could not keep Jane from later entering through the same door that Bob used. Jane fell to the same fate when Lee opened the door behind her.

Bob made a terrible error in his strategic planning. His plan’s success was based on his ability to achieve long-term stability in the airlines industry, long enough to recoup his early losses and provide a respectable return on his investments. This was a bad assumption, because it was based on the false assumption that he would be the last one through the door.

Bob may not have even realized that his strategy depended on being able to lock the door behind him. He probably thought that once he restabilized the market, the war was over. Bob believed that he was the final victor and his enemies were vanquished. If indeed the war is over, there is no need to look back at the door behind you.

However, in business, the war is never entirely over. You may win battles, like Bob did, but new battles are always on the horizon. New enemies crop up where you least expect them. The peace of market stability may never be achieved. All because Bob couldn’t lock the door behind himself.

The Principle
The first rule of strategy, according to Harvard Professor Michael Porter, is to make sure you are competing in an industry that has profits. Some industries are inherently less profitable than others. In some industries, none of the companies make an acceptable return on investment. What good is it to build a strategy to win in an industry where even the winners cannot make a good return on their investment?

What makes an entire industry relatively unprofitable? Usually, it is a result of low barriers to entry. In other words, it is easy for new players to enter the industry. If new players can continually enter an industry, then it will be under constant churn and never achieve the kind of stability required for profitability. These are typically industries to avoid.

For example, the trucking industry is a relatively unprofitable industry. This is because it is easy for an independent to lease a few trucks and start upsetting the industry. By comparison, look at how profitable Microsoft is. That is because there are high barriers to creating a new operating system for PCs that could successfully compete against Microsoft. The best strategies are those where you can get into an industry early, like Microsoft, and then be able to lock the door behind you with high barriers to entry.

Therefore, when building your strategy, keep the following principals in mind:

1. Never forget the fact that if it is relatively easy for you to enter an industry, then it is probably relatively easy for others to enter that same industry. This could be an indication that the industry may never stabilize at a level of adequate profitability. It is usually better to find an industry where it is difficult for you to enter and impossible for others to enter, than to find an industry that is easy for you and anyone else to enter.

2. Once you enter an industry, try to find ways to lock the door behind you. Look for ways to redefine the industry so that others can no longer take the path you did. Find ways to increase the barriers to entry.

3. Don’t ever assume that permanent stability can be reached in an industry. There is always enough change in the external environment to eventually make it possible for another company to find a new way to disrupt it, either through new technology, new processes, or by taking advantage of changes in customer needs and desires. Even if you can effectively lock the door that got you in, others may find new doors to get in. There is never a time when you can say “the war is over,” put your feet up on the desk, and stop having to compete.

4. If temporary advantages are what made you initially successful, don’t assume that you will continue to be as successful once those temporary advantages disappear. When customer loyalty is tied to a tactic your company cannot sustain, like unusually low introductory prices that are below cost, don’t expect your customers to automatically remain loyal to you when that tactic is abandoned. If they are only loyal because of your ridiculously low prices, they may leave when you raise them to more normal levels. Make sure you are providing enough consumer benefits so that once the temporary tactics are lifted, you are still providing a superior value in some form.

The first rule in strategy is to make sure the industries you participate in make money. Otherwise, winning may lead to an unprofitable prize. Industry profits are usually linked to high barriers to entry. If the barriers to entry are too low, there will be constant competitive churning and instability, which typically leads to unprofitable price wars. Therefore, when building a strategy based upon entering a new industry, keep the following principles in mind:

  1. Never forget the fact that if it is relatively easy for you to enter an industry, then it is probably relatively easy for others to enter that same industry and create instability.
  2. Once you enter an industry, try to find ways to lock the door behind you.
  3. Don’t ever assume that permanent stability can be reached in an industry.
  4. If temporary advantages are what made you initially successful in entering an industry, don’t assume that you will continue to be as successful once those temporary advantages disappear.

Final Thoughts
In your quest for growth, you may find yourself looking for ways to enter new industries. Keep in mind that while you are doing that, other firms looking for growth may be trying to find ways to enter your industry. While you are keeping one eye looking out to find new doors to enter, keep your other eye looking in to make sure your doors are locked.

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