THE STORY
Years ago, I had to make a pitch to some senior executives in order to get funding approval for a new retail concept. I thought I was well prepared for any questions the executive team might ask. One of them, however, asked me a question I was unprepared for.
He said, “I refuse to fund this new retail concept until you can tell me what concept will come next that will eventually make this new format obsolete.”
Since I had assumed that this new retail concept probably had at least a couple of decades to go before obsolescence, it never occurred to me to worry about its end when I was making a pitch for its beginning.
THE ANALOGY
No business environment remains stable forever. Things change. New concepts come; old concepts go away. Business models which once were perfectly suited to the market eventually fall out of favor. Change is inevitable.
Although I think the executive in the story was a little extreme, he did have a point. He wanted to make sure we were preparing a retail format that was designed to withstand the inevitable future change. If we only design to optimize today, we may be hastening our demise.
In particular, this old executive had a theory about retail based on years of observation. In most cases, he saw new retail concepts as appealing more to a niche when they start out. Eventually they gain greater acceptance and a broader appeal. This allows them to expand their offering.
Unfortunately, he also observed that these new niche concepts tend to start out building small stores—only big enough for the small niche of customers and products. Later, when the appeal broadens, those initial stores are too small to handle the added traffic and added merchandise categories. The stores need to be torn down and replaced with larger ones. This is a very costly adjustment.
His theory was that if you assume that eventually the appeal will grow and you can eventually sell more, build the bigger store today. That is a much more cost effective approach than to start with the ideal store for right now and then be too small in the future. Therefore, when this executive was asking me that question, what he really wanted to know was whether I was designing a large enough store to handle the long-term potential.
This approach applies to more than just new retail formats. With almost any business model, there is the risk that if you try to make it perfect for today, you are sub-optimizing the full life of the business. It is better to build a business model which optimizes the profit potential over the life of the project than to make it a little bit more profitable today and forgo much of the long-term potential.
Trying to squeeze out that last extra drop of profits today may close the door to many buckets of future profits when the market changes.
THE PRINCIPLE
The principle here is that strategic plans need to prepare not only for the world as it is today, but also for the world as it will become. This may require strategies and near-term tactics that walk away from some current profits in order to reap even more potential later.
Having the ability to turn down some near-term profit in order to preserve that long-term potential can be difficult. Many stakeholders (lenders, shareholders, employees trying to maximize this year’s bonus) are pressuring to make as much today as they possible can. Resistance is difficult.
To help build your case, here are two approaches.
1) Lay Out The “Natural” Forces of Change
Just because the future will change does not mean that the future is totally unknown or random. Much of that change is reasonably predictable. There are “natural” forces in the lifestyle of an industry. These natural forces tend to create predictable change.
Because this change is reasonably predictable, it can be modeled. These models can then be used to help show why a sub-optimal approach today can be the best long-term option.
For example, when a new industry first emerges, there is usually very little direct competition. The old industry is usually unprepared and quickly loses market share to the new industry. Because of the lack of intense direct competition, early profit margins are high. Just quickly filling the pipeline with product is good enough.
Over time, however, natural forces tend change that environment. The old industry starts fighting back and adjusts in a way to lessen the advantage of the new industry. The new industry attracts additional players, making direct competition more intense. Profit margins drop. Just having a rather generic offering is no longer good enough as differentiation and excellence are needed to stand above the competition.
Eventually the next new big thing comes about to make your formerly new industry become the old, obsolete industry. Now you have to manage a declining business.
Since these types of natural events are highly likely to occur, you can build a strategy around ways to optimize performance throughout this change.
For example, if you are one of the early players in a new industry, you may want to create a strategy which legally helps increase barriers to entry for those who want to come in later. One approach might be to spend money up front tying up suppliers with exclusive or preferential contracts. It may put a small dent in near-term profits, but if it has a dramatic impact on slowing the ability of others to enter the industry, you can forestall many of those negative natural forces. Hence, you are more profitable in the long run.
Also, if you know that inevitable competition is going to create a need for more competitive excellence at some point, it may be more cost effective to build that into your strategy early. Although there were many factors behind the bankruptcy of Circuit City, one of the factors had to do with early real estate strategy decisions. In the beginning, the Circuit City business model was unique and powerful enough that they could locate their stores just about anywhere and customers would flock to them. As a result, Circuit City saved some expenses in the early days by locating stores in secondary (cheaper) sites.
However, eventually the industry became much more competitive. Firms like Best Buy came into Circuit City markets and built in the superior locations. (Best Buy also had larger stores, which would have made that executive in my story happy.) Consumers could see little reason to drive past those nice new Best Buys in the superior locations to get to the inferior location of the Circuit City. As a result, Circuit City eventually found itself at a significant competitive disadvantage. The cost to relocate all those stores to better sites was too much to bear at the end.
Yes, Circuit City was a little bit more profitable in those early days because they cut costs on real estate. However, that early decision locked them into a long-term competitive disadvantage which ruined a lot more future profits than the amount saved on that cheaper rent. If Circuit City had taken into account those natural forces when making those early real estate decisions (and other, similar decisions), they might still be around today.
2) Build in Flexibility for the Factors You Cannot Control
If may cost a little bit more up-front to build greater flexibility into your strategy, but that added flexibility may allow you to more profitably adapt to the uncertainty of the future. For example, Wal-Mart has a habit of leasing all of their stores. I am almost certain that if you did a detailed cash flow model, you would find that Wal-Mart would be slightly better off if it owned its stores rather than leased them. If that is the case, then why lease?
The reason is added flexibility. When Wal-Mart decided to move away from the discount department store strategy to the supercenter strategy, the leasing gave them greater flexibility to make the change. In many cases, they walked away from the discount store property when the lease was over and leased a brand new supercenter practically across the street. The old landlords are stuck trying to figure out what to do with an empty discount store that has little value when Wal-Mart builds across the street. If Wal-Mart had owned those buildings, then Wal-Mart would have been stuck with those old, obsolete-sized buildings. This would have made the transformation to the supercenter strategy far more difficult and far more costly. Foregoing a little cash by leasing was more than compensated for by the huge value it provided in flexibility.
The big thing in building automotive factories these days is flexibility. Sure, it costs more up-front to build a factory which can easily convert to building a wide variety of vehicles. However, it costs a lot more if you have specialized factories which specialize in the wrong thing when the market changes.
SUMMARY
If your strategy is designed to make as much money today as you possibly can, then you will probably make less money tomorrow, because market factors change. Optimizing profits over the life of the business usually requires some near-term sacrifices. To help make the right choices: 1) Anticipate the natural forces of change and work them into your plans; and 2) Add flexibility to adopt to the changes you cannot anticipate.
FINAL THOUGHTS
One of the most spectacular business failures of the 20th century was Iridium. The entire business model was dependent on the assumption that mobile phone fees would stay high forever. This was needed to justify the expense of launching and operating over 60 communications satellites in outer space. Natural forces prevailed, however, and mobile phone fees plummeted (as did the prospects for Iridium). If the folks proposing the initial investment in Iridium had been confronted by a question like the one I received in the story, perhaps this disaster could have been avoided.
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