Wednesday, February 14, 2007

This Candy Melts in Your Hand

Once there was a young boy who loved chocolate. He was very happy, because at this moment he had a fist full of chocolates. He was joyfully walking down the street until he walked past a chocolate shop. There, something caught his eye and caused him to stop.

In the display window of the shop was a gigantic glass jar of chocolates—more than enough to satisfy him and all his friends. Next to the jar was a sign which read: “Free Samples. Help Yourself.” That sign certainly got the boy’s attention.

There was a problem, however. The boy would need both of his hands to lift the lid off of the chocolate jar. Because one of his fists was full of chocolates, he could not lift the lid off the jar. The boy thought about setting down his chocolates so that he could lift the lid, but he was afraid to, for fear of losing the chocolates he already had. As a result, he just kept walking down the street, happy for still having those original chocolates in his hand.

Unfortunately, it was very hot that day. Soon, the boy’s chocolate began to melt. It oozed out from between his fingers and dripped to the ground. When he opened his hands, all he had left was a little bit of chocolate smeared on his fingers. This made the boy unhappy.

But then he remembered the gigantic jar at the chocolate shop. “I’ll just go back to the chocolate shop and get some from the jar,” he thought to himself. However, by the time he got back to the chocolate shop, all of the chocolate was already taken. There was nothing left. This made the boy exceedingly unhappy, because now he didn’t get any chocolate to eat that day.

The business world is full of change. Change causes old products/business models to become obsolete and new products/business models to take their place. The trick of strategy is in knowing when it is time to abandon the old and when to embrace the new.

In the story, the boy did not make those decisions very well. He held onto his old chocolates far longer than he should have (until they melted away and he received no benefit). He also waited too long before embracing the new, larger prize of the giant jar of chocolates (he waited until everyone else got there first and took the prize). His dilemma was that he couldn’t figure out how he could have both at the same time. Therefore, he kept the smaller prize (which he already had) instead of letting go so that he could reach for the greater prize.

As odd as that decision sounds, it is the same conclusion that many businesses take. They hold on to the older, smaller business model (which they know & are comfortable with) and miss out on getting the bigger prize of taking claim of the next business model. Then, when the current business model melts away into obsolescence, they are left with nothing, because the competition has already staked a dominant position in the new space, leaving nothing but an empty jar.

The principle we are talking about is fear of cannibalization. It is the fear that if I go after a new business opportunity, it will require letting go of a current business model that is quite profitable, because the new opportunity grows at the expense of the old opportunity. Not wanting to destroy the business model that is currently providing huge profits, the companies decide not to invest in the new model.

There have been numerous examples of this phenomenon throughout time:

1) Back in 1973, Ford Motor Company invented the Minivan, but they did not introduce it to the marketplace for fear that it would cannibalize the profitable sales of their station wagons. When some of the people who worked on the project moved to Chrysler, they introduced the minivan there. As a result, station wagons became obsolete and Ford has never become a major force in minivans.

2) In the late 1980s, supercenters were starting to evolve in the United States. K Mart wanted to be part of the movement, but it did not want to cannibalize its K Mart store sales. Therefore, when it built its American Fare supercenters, it did not put in the types of merchandise found in a K Mart. Instead it combined convenience driven food with high end apparel and durable hardlines like major appliances. The experiment failed and K Mart was never able to recover from it and compete in supercenters.

3) In the late 1990s, Kodak was slow and reluctant to make a big push into digital imaging because of fear of cannibalizing its powerful position in traditional photography. Kodak’s efforts did not save the core photography business and by dragging its feet, it never got a strong position in digital imaging. Now the company is struggling to find a reason for existing in today’s marketplace.

4) In the 2000s, the traditional record labels were reluctant to pursue digital music for fear of cannibalizing the traditional CD market. It took an outsider like Apple to take the market by storm. Until very recently, EMI continued to ignore the inevitability of the fact that digital music was making CDs and the traditional label business model obsolete. Now many bands are ignoring the labels completely and gaining success on their own through downloads made popular on sites like YouTube and MySpace.

5) The latest example I heard of was the recent complaint that the US mobile phone companies, such as T-Mobile, Verizon and AT&T, are resisting the movement into mobile voice over IP (MVoIP) for fear of cannibalizing their current voice business. My guess is that eventually people will flock to MVoIP and the winners will not be the traditional players in the space today.

In every case, the companies above clung on tightly to the chocolates they had and refused to reach boldly with two hands for the next prize. As a result, the chocolates they thought they had eventually oozed away into nearly nothing, while others got the next prize from the big jar before these companies were willing to go after it.

In the end, these companies did not prevent cannibalization of their products. All they did was help determine who would have the honor of doing the cannibalizing. And they decided to let someone else do it. As long as the business is being replaced anyway, one should at least try to benefit from the situation by cannibalizing one’s self. But alas, many companies do not do so.

Why does this fear of cannibalization cause poor decision-making? It is because a one has to significantly increase short-term risk in order to make the leap. Most business hierarchies have so many layers to go through in order to get approval, that conservatism wins out and the known, less risky cash flow (at least in the near-term) nearly always wins. Consider the obstacles facing someone promoting the leap to the new model:

1) The capital is already invested in the old model. It is a sunk cost. To transfer to the new business model, new capital is required. That’s riskier and in the short-run reduces return on investment.

2) The old model has a known cash flow. The new model is harder to predict, making it riskier and harder to defend.

3) Executives often think “I can reap the rewards of the old model today and get big bonuses. If I invest in the new model, it can lower today’s profits near-term (hurting my bonus) and not show profits until later (after I’ve moved on, so the successor to my position gets the bonus).”

4) The new business model may require new skills and processes which the current group has not mastered. That could result in lack of success in transferring to the new skills, and may put the current team out of work, to be replaced by people with different skills. Why risk a career over that?

As you can see, both personal goals and near-term corporate goals lead one to conclude that making the leap early is very risky and may not benefit my personal situation. Hence, the fear wins out and the company ends up losing out.

Change is inevitable. Ignoring change and clinging to the past does not make change go away. The cash flows from the old business models cannot be saved by ignoring the future. In the end, new businesses cannibalize old businesses. Rather than resist, it is better to take advantage of the change and get in early, so that you can get the most out of what happens next.

This has been the pattern at Wal-Mart. In the beginning, Sam Walton was in the variety store business. When he saw that discount stores had the potential to make variety stores obsolete, he quickly jumped into the discount store business and created Wal-Mart stores. Then, when he noticed that supercenters had the potential to make discount stores obsolete, he quickly jumped in with Wal-Mart Supercenters. The others, who stayed in the variety store business, are all gone. Most of those who stayed in the discount store business are gone. Wal-Mart is still here and as big and as profitable as ever, because they did not fear cannibalization.

Often times, the winners with the new business model are outsiders who were not a part of the former business model (such as Apple was to the record labels). These outsiders do not fear cannibalization, because they had nothing to be cannibalized. Sometimes, the only way to remain an insider is to think like an outsider.