Sunday, January 6, 2008

Strategy Planning Analogy #143: Business Entropy

A long time ago, I learned that if you leave a moist slice of cake exposed to the air, it will dry out. That made sense to me, so I devised a rule that whenever you leave food exposed to the air, it will dry out.

I was shocked, then when at a later time I left dry, crunchy food exposed to the air, like graham crackers and cookies. I expected nothing to happen, since air dries out food, and these items were already dry. However, when I came back, these graham crackers and cookies over time had gotten moist.

Now I was confused. It seemed like the air was just plain mean. It was out to ruin all of my food. If the food was moist, it made it dry. If the food was dry, it made it moist. How, I wondered, did the air know which type of food was out there, so that it would know how to ruin it?

Different types of foods have different points of distinction. Some are very moist, like a slice of cake. Some are very crunchy, like a graham cracker or cookie. It is these points of distinction which give each of them their uniquely desirable taste.

However, if you expose these foods to the environment, they tend to lose that tasty uniqueness. The moist becomes less moist and the crunchy becomes less crunchy. No matter what the original point of distinction, when left out in the air, they become more bland. Rather than having distinctive moistness or crunchiness, they started to all become average, or mediocre, in their moistness.

When I want moistness, I want it really moist. When I want crunchiness, I want it really crunchy. Semi-moist or semi-crunchy won’t do. Yet that’s what happens when food is left out in the elements.

This same principle applies to business strategies. Successful business strategies tend to be based on creating a distinctive point of superiority. Just as a cake is distinctively superior in moistness, a business strategy can be distinctively superior in attributes like quality, price, service, speed, and so on.

However, you cannot just wrap up your strategy in plastic wrap to preserve the distinctiveness, as one would do with a slice of cake to keep it moist. Strategies have to be worked out in the marketplace. You have to expose yourself to customers and the competition.

Just as the environment weakens the distinctiveness of cakes and cookies, the business environment tries to ruin your strategy’s distinctiveness. There tends to be a force at work in the marketplace to weaken distinctiveness and move all companies towards mediocrity.

Unless you are diligent in protecting your differentiating point of distinctiveness, natural forces will work against you. Therefore, you must be vigilant in protecting that point of distinctiveness.

The principle here is the scientific concept of “entropy.” Entropy comes from the second law of thermodynamics. Without getting very technical, the principle behind entropy is as follows: If you unprotectedly place items of different energy levels into the same environment, over time the energy will disperse until the entire environment is at the same energy level.

For example, if you put a glass of ice water into a warm room, eventually the ice cubes will melt and the water will become the same temperature as the room. Similarly, if you take a pumped up bicycle tire and puncture it, the air pressure from the tire will disperse until the air pressure in the tire is the same as the air pressure in the room. If you leave a hot frying pan on the stove, eventually the heat of the frying pan will disperse until the frying pan and the kitchen are the same temperature. These are all examples of entropy in action.

This is not that dissimilar to my story about the cake and the cookie. Moisture will disperse until the room, the cake and the cookie reach a moisture equilibrium. This point of equilibrium is less moist than the starting point for the cake and more moist than the starting point for the cookie.

In a sense, there is a similar force at work in business. We will call it “business entropy.” The principle behind business entropy is as follows: Without special protection, when businesses are placed out into the marketplace, the energy behind points of distinctiveness will dissipate until all of the companies become mediocre in performance.

In retailing, a similar concept was made popular back in the 1960s by people like Stanley Hollander and Robert Buzzell. They called it the “Wheel of Retailing.” The concept went something like this:

1) A new retail format would develop by doing something different which would allow them to price items significantly below the older, established formats.

2) Customers would flock from the established retail formats to the new format in order to save money.

3) Because the new format became so successful, others would try to copy the new format.

4) Eventually, there would become overcapacity in the new format, as similar stores were built in the same location by competing firms.

5) In order to stand out in the crowd and beat the others in the same new format, the stores would start to add various features to appear superior. It could be added services, added variety, added convenience or something similar.

6) Over time, a sort of one-upsmanship would take place in which all the competitors would continue to try to get an edge through adding even more features.

7) Eventually, so many features would be added that the format no longer could support its original point of distinction as being the lowest price. All of these features altered the cost structure until it had to raise prices to levels similar to what existed before the new format came along.

8) As a result, another different new format would come about which could gain popularity because it could significantly underprice the prior new format—and the process would start all over again (another turn of the wheel).

This wheel of retailing helps to illustrate business entropy. When the new, low cost retail format is exposed to the marketplace, there are environmental forces at work to disperse the cost advantage and make it more like the status quo. These competitive forces include competitive pressures (and a desire to get an edge on them) as well as consumer demands for more features. If we give into these pressures, business entropy will take place and the price distinctiveness will go away and we will become bland.

Wal-Mart has been able to buck this trend, but only because it has been extremely clear in its low price strategy and been extremely diligent in defending it. It has taken a lot of energy on the part of Wal-Mart executives in order to keep the distinctiveness of low prices in tack. There were a lot of other discount store chains started around the same time as Wal-Mart, but most of them have failed, because they were less clear and less vigilant about fighting against the forces of business entropy. They let costs and features creep in until they lost the key point of distinctiveness—low prices. And now they are no more.

This is not just a retail phenomenon. Business entropy can attack all types of businesses. For example, high end niche businesses can fall victim to environmental forces which want them to grow quickly. To gain more of a mass appeal, they can compromise the very distinctiveness which appealed to the high-end niche. This happens all the time in the fashion world, which is why fashion brands tend to come and go.

Dell computers started out successfully with a lower cost business model. However, because they did not diligently continue to pursue low cost, they lost that advantage. Environmental pressures have caused them to add all types of more fashionable designs and added features which have raised costs. Now they sell some of the more expensive computers and they are struggling a bit. Another victim of business entropy.

In another example, competitive pressures can overcome a high quality or high service business and put it into a price war. As the company ratchets down prices, there are pressures to trim back on some of the quality or services which gave the company its original point of distinction. Eventually, the company loses its point of distinction and becomes mediocre across the board. Yet another victim of business entropy.

The moral of the story is that points of distinction will not naturally stay that way. The forces of the environment will try to chip away at your successful point of distinction and make you mediocre. The only way to fight this natural law of entropy is to:

1) Be very clear to the organization about what it is that will create your successful point of distinction.

2) Be diligent and expend energy to protect and increase that point of distinction. Be ever mindful of the forces working against it and do what it takes to keep it strong.

One of the biggest environmental forces working against you could be your own shareholders. Their desire for faster growth or bigger near-term profits may create some near-term benefits. However, to hit the near-term goals, one may have to make compromises to your point of distinction which destroys long-term potential. Hence, the forces of entropy could be closer than you think. It is important to help shareholders understand how their pressures can help accelerate the negative forces of entropy.

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