Sunday, August 3, 2008

Analogy #197: Change the Rules

I used to live in a city that was having some problems with the quality of the municipal water supply. There was too much of a certain chemical in the water.

By law, when a city was in violation of water standards they had to send a letter to every household in the community. This letter had to do three things:

1) Inform people of the problem with the water;
2) Explain the risks in using the water;
3) Provide details on how the city was planning to fix the problem.

In essence, this is a summary of what the city said in the letter.

1) The levels of a particular chemical in the water exceed the maximum allowed by the government.
2) We don’t think it’s a big deal.
3) Our primary solution is to petition the government to raise the allowable levels for this chemical, so that our current levels would be considered safe.

For some reason, I did not get a lot of comfort from that letter.

Every industry tends to have a certain accepted way of doing business. They become the standard operating procedure—the rules for how things get done. Most of the time, these rules aren’t written down—it is just how the industry evolved.

There are reasons why these standardizations are useful:

1) Getting the entire supply chain in an industry to work smoothly requires the cooperation of many different firms. The more procedures are standardized, the easier it is for these firms to work together.

2) There is usually a limited pool of quality employees in a given industry. It’s difficult to tap into that pool of employees if your procedures are radically different from the norm, because they are trained and experienced to excel within these norms.

However, it should also be pointed out that these accepted ways of business are somewhat arbitrary. They do not have to work that way. Other processes could have just as easily have evolved over time.

In the story, it seems rather audacious that one little community would challenge the water standards set by the Federal Government. After all, it is assumed that scientists picked the maximum levels for that chemical in the water based on solid evidence. Similarly, it may seem audacious for a business to ignore the operating standards of its industry.

However, I am reminded of a conversation I had with a doctor at Mayo Clinic who was on a team of experts to determine what was the acceptable range of health should be for one of those common measures used in medicine, like blood pressure or cholesterol. He said that it’s not as if you are healthy and that all of the sudden after reaching a certain point you suddenly become unhealthy. He said it is a gradual thing and that as measures like blood pressure and cholesterol gradually go up, you gradually become less healthy.

According to this doctor, the point at which you declare one of these ranges to go from “healthy” to “unhealthy” is somewhat arbitrary. And in fact, he disagreed with the committee he was on and thought the range for “healthy” should have been narrower.

So maybe it was not that audacious after all for that city to challenge the federal water standards. And maybe it is a good thing if your business’ strategy challenges the standards of your industry.

The principle here is that industry standards are arbitrary to some degree and that sometimes it is in your best interest to change them. There are several reasons why you might want to change industry standards.

1) The standards tend to protect the established leaders. If you are not an established leader, they may become a barrier to your success.

2) The standards may not play to your natural strengths. A different set of rules might give you more of a competitive advantage.

3) Standards tend to reinforce the status quo. True innovation may require abandonment of some of these standards. In fact, almost every major innovation creates a new set of standards for how things are done. If you are unwilling to bend the rules, you may never truly innovate.

Here are some examples of firms which changed the rules in order to get an advantage. We’ll start with the typical rules in furniture. Furniture brand firms in the US tended to be large companies who desired to made their furniture in their own factories. They spent lots of money to create a consumer demand for their brands. Labor costs were high, but they were able to pass the costs on to the smaller, and less powerful retailers.

Then along came Ashley furniture. Ashley had no desire to own manufacturing facilities. When cheap labor markets like China opened up, they aggressively went into these countries to source their products from anyone who could meet their specifications. Ashley didn’t care about establishing a strong, separate brand name for their products. They just sold them under the name of their retail brand.

By abandoning the status quo and rewriting the rules, Ashley had several advantages. First, they were able to secure products far cheaper than the status quo, who were burdened with factories and unions and other costs, which were higher and less flexible. Second, by sourcing directly, Ashley entirely avoided the branded manufacturing middlemen, saving even more costs.

These savings allowed Ashley to provide a far superior value to the customer. The customer responded, and Ashley thrived. Most of the large, established furniture retailers in the US who played by the old rules have gone bankrupt. In the mean time, Ashley has catapulted to becoming the largest furniture retailer in the US.

And, of course, everyone knows the story of Starbucks. Before Starbucks, the rules about coffee went something like this. Coffee was something you consumed at home or at work. Coffee was purchased by consumers in bulk in ingredient form. The customer manufactured their own coffee. The ingredients tended to be heavily couponed and sold in supermarkets, with the choice usually made on the basis of price.

The key manufacturers, like Folgers and Maxwell House knew the rules and played by them. The consumers knew the rules and played by them. That is, until Howard Schultz came along and changed the rules. At Starbucks, you consume the coffee at the coffee shop. You buy it one cup at a time, prepared by someone else. Quality became far more important than price.

Now, consumers are drinking a lot more coffee, but Folgers and Maxwell House are struggling, because they stuck to the old rules.

I am very excited about the prospects for Alan Mulally, the new CEO at Ford Motor Company. He is an outsider who has no personal connection to the old rules about the automobile industry. As a result, he is far more inclined to rewrite those rules. I hope he is able to do so.

Industries tend to run using generally accepted rules and procedures. However, just because everyone tends to do things in a similar manner does not mean that it is necessarily the only or even the best way of doing things. It may be a result of historical quirks or factors which are no longer as relevant in a changing society. Therefore, when developing strategy, the best tactic is not always to look for ways to outdo everyone within the current paradigm. Instead, you may be better off looking for a new paradigm which plays by another set of rules.

Even if you like the status quo, one must not get too cozy with them. It is important to keep your eyes on the horizon, looking for firms who want to destroy the rules which are helping to create your success. As we have seen, if you stick to the old rules when society is migrating to the new rules, you will lose out. As a consequence, even if you prefer the old rules, you may need to quickly shift gears in order to remain relevant.

When I received that letter from my city water company and found out how little they were prepared to do to fix the water quality, I changed the rules about the way my family consumed water. I bought a home water filtration system.

Not all rule changes are driven by innovative businesses. Some are driven by rule-changing consumers. Keep an eye on the leading edge consumers. They may already have a new set of rules in mind. All you have to do is tap into them.

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