Friday, May 28, 2010
There’s one thing that has always puzzled me when I watch the local news on TV. It seems like the majority of crimes and burglaries take place in the poor and run-down sections of the city.
I don’t know. It seems to me that if I wanted to be a burglar, I would try to rob from the wealthy people who have a bunch of great stuff to steal. Yet it seems that most of the burglaries shown on local TV take place in poor areas where there is not a lot of great stuff to steal.
I’m reminded of the famous burglar Willie Sutton. When he was asked why he robbed banks, he replied, “Because that is where the money is.” That makes sense to me…steal from the people who have lots of money.
Why do so many try to steal from the poor? I’ve been told that the reason is because burglars tend to prefer staying in familiar surroundings. Since most of the burglars live in the run-down neighborhoods, that is where the burglaries take place.
Maybe if the burglars started stealing from rich people, they could afford to live in the nicer neighborhoods.
Like these burglars, many businesses prefer to stay in familiar surroundings—the industry where they started. Unfortunately, over time many nice neighborhoods (or nice industries) can deteriorate and become run-down. They can move from being dynamic and exciting growth industries to declining, obsolete or mature industries. Just as it can be very difficult to become wealthy stealing from poor people, it is very difficult to be an exciting growth company when you stay in a declining industry.
If burglars want great wealth, sometimes they need to move to wealthier neighborhoods. Similarly, if your want great growth and profitability for your company, sometimes you need to move the business to industries where the prospects for growth and profitability are brighter.
Run-down and poor neighborhoods are not great places to rob. Neither are run-down industries great places for a business to find growth and prosperity. Sometimes, you need to move to a new neighborhood.
The principle here is that it is often easier to find growth and profitability for your firm when the firm seeks a position in a growing and profitable area. If your firm is not currently operating in such an area, it may be time to move to such an area.
It may not be comfortable leaving the neighborhood your firm is comfortable in, but sometimes the best way to have growing results is to get into a growing business. We’ve talked about this idea of abandoning old businesses and moving on to a better neighborhood in a number of prior blogs, so I will just summarize some of the examples we’ve gone into greater detail on in earlier blogs and then provide a link.
Textron started out in the textile business, making yarn back in the 1920s, and was still principally a textile-based business until the 1950s. Unfortunately, the US was no longer a place where the textile industry could thrive (the neighborhood had turned poor and ugly). Therefore, Textron got out of textiles and diversified into more prosperous industries, including Bell Helicopters, Cessna Aircraft, and other such non-textile businesses. For more details, go here.
2. Procter and Gamble
As recently as 1995, processed food products made up about 12% of their portfolio. Most of these categories of food are now very mature (the neighborhood has gotten run down). As a result, P&G has divested of all food except Pringles and has built up its portfolio in higher growing areas like health care and beauty care, which now make up over 50% of the mix (up from around 295 in 1995). For more details, go here.
The Intel company built its initial reputation around DRAM memory chips. This was their heritage—what they were known for—and management had strong emotional ties to the business. Unfortunately, over time that DRAM “neighborhood” had turned ugly and unprofitable. It was tough for Intel to walk away from that heritage, but they did and reinvented the company around newer technologies, which were growing faster and were more profitable (a better neighborhood to steal from). For more details, go here.
4. GE and Limited Brands
GE has continually shifted its portfolio over the years so that “poor neighborhood” industries are shed, and growing, more profitable industries “better neighborhood” are added. Limited Brands started as a ladies’ sportswear retailer with a chain of stores called The Limited. Over time, the mall-based apparel retail industry in the US has matured. Growth slowed. So Limited Brands sold off its apparel retail operations, including its namesake brand, and put its emphasis behind the faster growing and more profitable areas like lingerie (Victoria’s Secret) and beauty care (like P&G).
For more details, go here. As a side note, this blog also discusses a McKinsey study which found that the greatest determinant of being a growing company is to build a portfolio around growing industries. In other words, if you want to steal nice stuff, go to a neighborhood full of nice stuff.
5. Cardinal Health
Back in the 1970s, the company started out in the grocery wholesaling business, under the name of Cardinal Foods. It’s primary customer was the independent grocer. Unfortunately, the big grocery store chains were putting the small independent grocers out of business. It’s not much fun being in a business where your customers are disappearing (sort of like stealing from people whose money has already disappeared). Therefore, Cardinal got out of that declining business and moved to the faster growing industry of health care (a much better neighborhood). For more details, go here.
IBM started out essentially as a manufacturer of large equipment for business. For a time, it was making a fortune off of that business, particularly in computers. Over time, however, that business matured and was no longer very profitable. The profits and growth had moved to software and services. Therefore, IBM sold its PC business to Lenovo and reinvented itself as primarily a software and services company
We could go on and look at a lot more examples, but I think the point has been made. Just like the McKinsey study found, if you want to get the big prize (big growth and fat profit margins) you need to continually modify your portfolio to include more industries where growth and fat profit margins are already occurring. Sometimes this means totally abandoning your heritage and doing a major reinvention. It may sound emotionally and operationally daunting, but a lot of companies have been successful in doing it.
Achieving high growth and profitability is a lot easier if you are in industries with naturally high growth and high profits. Therefore, fill your portfolio with these naturally good industries. However, one cannot rest there. Just as neighborhoods can deteriorate over time, so can industries. Therefore, this is a continual process of moving out of the old and moving into the new.
Timing is very important when moving to the new neighborhood. If you stay too long in the old, deteriorating neighborhood, you will not get much when you sell the house. If you wait too long to get into the hot new neighborhood, you will have to pay more to get into the more limited open spaces. Therefore, it is better to make the switch early.
Tuesday, May 25, 2010
On May 6, 2010, the Dow Jones Industrial Average dropped by nearly 1000 points in a matter of minutes. Companies like Procter & Gamble and 3M lost more than 30% of their value in through computer trades in just 15 minutes. Accenture went from computer trading at around $40 per share all the way down to a penny. There was nothing going on in the world that would create the sudden need for a market drop that extreme at precisely that moment.
A number of hypotheses have been suggested for why this sudden drop occurred. They include everything from a typing error by an analyst to cascading “Stop Loss” orders that were computer generated. The fact that a large portion of that drop came back before the day was over would seem to indicate to me that the original drop was not fully justified in any rational sense. This is further validated by the fact that the stock exchange cancelled many of those trades during that vulnerable time period. Apparently, they didn’t think those trades made sense, either.
Although we may never know exactly what triggered the mess, one thing we do know is this: The mess was compounded by computers blindly doing something which they were programmed to do, regardless of whether or not it was logical or sensible at that moment. Human logic was bypassed as the computers coldly and uncaringly executed orders that were triggered by programming algorithms put in place a long time ago. And because computers can do these calculations so quickly, they can distort markets well before human logic and common sense can intervene.
It seems to me that the more we rely on so-called “rational” computers to do stock trading, the more “irrational” the market swings become.
There has been quite a bit written recently on the decision-making biases of humans. It has cropped up on the web in places like the McKinsey & Co. site, the Booz & Co. site, the Harvard Business Review Blog site and numerous other places.
Many of these biases have been well researched and have become a part of “common knowledge.” As a result of these biases, many “experts” are advising leaders to set aside their gut instincts and instead just load up on numbers…and then let the numbers make the decision.
The assumption in many of these materials is that if we get rid of human biases and just rely on the numbers, we will get better decisions. Unfortunately, when I look at things like the stock market crash of May 6th, I get a little nervous in abandoning human intuition and relying 100% on numbers and computers. So-called “blind” decisions made by computers on that day don’t appear to have been logical or sensible. Why should I abandon my gut intuition to cold mechanics that can bring down the stock market? Couldn’t it do the same to my business?
The crux of the problem, as I see it, is the false assumption that just because you eliminate human biases, you have eliminated all biases. My contention is that numbers can be just as biased as humans. If you fail to take into account the inherent biases in numbers, you will be driven astray as much as you would be by human biases. In fact, I believe that the biases inherent to numbers are even more dangerous that human biases, because numbers cannot step back and ponder about their implications as humans can.
The principle here is that numbers should not be accepted at face value any more than gut intuition. Both have biases that need to be brought out into the open. Until you deal with these biases, you will not be able to see reality. And until you see reality, you cannot make the best decisions.
Since there has already been a lot written on human biases, I will shift the attention of the remainder of this blog to some biases inherent to numbers.
1. Bias of Backwards
Most numbers relate to the past. They tell you about history...what has already happened. Therefore, the numbers are biased by that historical context.
The problem is that your decision-making is about the future. There is no guarantee that the context of the past will continue into the future. Therefore, numbers of the past may not accurately provide guidance for the future. As Warren Buffett put it, “If past history was all there was to the game, the richest people would be librarians.”
For example, consumer data collected prior to the tragedy of 9-11 (or the great recession we just had) may be worthless in projecting behavior after those events. As another example, consumer media behavior data gathered prior to the invention of the next form of media (radio, TV, vcr, internet, ipad, etc.) will not automatically give 100% accuracy to how behavior will change when the new medium appears. Looking at Baby Boomer behavior in their 30s may not give accurate insight into how Millenials will act in their 30s. Or for that matter, looking at how Millenials act in their 20s may not give accurate insight into how Millenials will act in their 30s, either. The contexts are different, so the results may also be different. It takes human intervention to make sense of the changes in context.
2. Bias of Availability
When gathering numbers, one is limited by the numbers available to gather. When looking at the pile of numbers you have gathered, the larger piles are not necessarily more important or more meaningful. There are just more of them available to gather. Just because a number is available does not make it relevant.
The problem is that a lot of strategic decision-making is about finding new, untaken white spaces in the environment—sometimes referred to as Blue Oceans. These new opportunities typically come about by reorganizing things in a new way—looking at things as they have not been looked at before. Almost by definition, if you are gathering numbers that are already available, they are biased by the conventional way of categorizing and organizing numbers.
For example, governments tend to categorize economic data based on the conventional, historical ways in which industries were classified. All the numbers neatly fit into the black spaces (which is why they are black). There aren’t any available numbers in the white spaces, because that’s not how governments deal with numbers. If you are planning to reinvent the marketplace and create new industries (or significantly redefine the borders of old industries), the available numbers will be distorted and not give a good picture of that redefined world. They may even keep you from finding that Blue Ocean, because all the numbers are allocated to black spaces, making it appear that the potential is empty outside those black spaces.
3. Bias of Source
Numbers come from someplace. People compiled those numbers, and the biases of those who created the numbers often distort these numbers. Just look at how different political parties can look at the same world and find numbers to support their radically different positions. So even if you do not inject your bias into the equation, the numbers you have may be full of biases from the people at the source of those numbers.
This bias from the source doesn’t have to even be intentional. For example, if you are trying to gather numbers about the future, there are not many options. Either you gather opinions from “experts,” opinions from consumer research, or results from computer models. Experts can have all kinds of biases that creep into their opinions, intentional or not. Scientists even have a name for this, called “Expert Bias.” Computer models are based on underlying assumptions placed there by people. There can be lots of biases in those assumptions.
Finally, consumers are notorious for their generosity in giving opinions about how they might act in the future, but even they do not really know how they will behave in a new environment. Their guesses often are quite different from what they eventually do. It’s not that they intentionally lie…they are just bad guessers.
4. Bias of Bigness
Numbers are often gathered at the macro level, yet consumers behave at the micro level. Macro level numbers have a bias towards bigness which distorts our conclusions about micro level behavior.
Take, for example, economic stimulus plans. A government might say it is pouring millions, or maybe even billions of dollars into the marketplace. Once could look at all that money at the macro level and conclude that surely customers would be stimulated to spend more on big-ticket items with that much money flowing towards them. However, if you look at the numbers at the micro level, you may see that the stimulus package results in an extra five dollars per household per paycheck. How many people are going to radically change their big-ticket purchases based on a five dollar increase in their paycheck? Heck, they might not even notice the five dollar bump.
In an earlier blog, we talked about how macro numbers tend to portray average behavior, whereas if you get down to the micro level, you can see all the extreme behaviors which are averaged out of the big number. By looking at big roll-up numbers, you may not see all the great niche potential hidden in those averages.
5. Bias of Unusual Event
Numbers gathered for a period of time are biased by the quirky little events occurring at that time. Outcomes would be different depending on the presence or absence of those events. For example, the green movement was on a particular trajectory. Then, Wal-Mart decided that it was going to take green issues very seriously. That one change in circumstances radically changed the trajectory of the green movement, because of the power and influence of Wal-Mart.
Consider that the entire evolution of the consumer technology industry has been influenced by the fact that Steve Jobs is in the business. Had he not been a part of Apple, the entire industry probably would have evolved differently. Have you factored into your numbers the possibility of a “Steve Jobs” person emerging who can change the course of history or the possibility that a powerful force like a Wal-Mart may change its direction? Or what if you decide to inject yourself into your industry the way Steve Jobs did or change directions like Wal-Mart did? You will not see this in the numbers, since those numbers did not include such a circumstance
When computer models are built to predict the future, the assumption is that all of the relevant events are included within the model. As the stock market crash of May 6th showed us, new events may turn up which were not accounted for in the model, causing the models to fail.
We have been told not to rely on our gut instincts at face value, because they are biased. Similarly, I believe that we should not just rely on numbers at face value, because they are also biased. Instead, we need to rely on both our gut instincts and numbers, keeping in mind the biases inherent to both.
To borrow another quote from Warren Buffett, “Never invest in a business you cannot understand.” Just because you have a pile of numbers doesn’t mean you understand what is going on now (and what could go on in the future). You need to comprehend what is behind the numbers. This takes insight, something which transcends mere data and must incorporate human intuition and imagination.
Wednesday, May 19, 2010
When I was in college, I worked as a DJ on the college radio station. The great benefit of this job was that I had access to all of the music being issued (which was quite a lot). Granted, not everything issued was great music, but it seemed to me there was a lot of great music out there that never got the attention of radio stations or became successful.
I tried to figure out what the commonality was between the music that became successful versus the music which did not. I looked at all sorts of things—the level of musical performing talent, the cleverness of the music writing, and so on. I could not see any correlation. For example, some successes were talented, some were not. Some failures were talented, some were not.
After awhile, I determined that musical success or failure was not based on any single factor. There were too many successes and failures sharing the same characteristics. Therefore, I concluded that musical success was either mostly based on luck or based on a complex equation of many factors—too complicated to be obvious. I guess that’s why so much music was issued—if what works is not obvious, then issue a bunch, hoping that there are enough successes in the mix to overcome the failures.
If you spend much time looking at the business literature, you will find all sorts of theories on how to create a successful business. Usually, the literature focuses on getting just one thing right. If you get that one thing right, the literature says you will be a success. Of course, each article or book focuses on a different “one thing” to focus on.
For example, some focus on something related to positioning—just find a unique, winnable, untapped spot in the marketplace and you will be automatically rewarded with success. Many others these days focus on listening to the customer—just do whatever they tell you and you will automatically succeed. Others say just focus on doing good (be a responsible corporate citizen) and you will automatically do well (be very profitable). Yet others say to focus on your employees. If you put together a good team of smart people and give them freedom, they will automatically be successful.
Others said to focus on things like audacious goals, cash flow, the next killer app, leadership, shareholder value, differentiation, speed, streamlining the decision-making process, innovation, and on and on and on the list goes. Some even said the focus should be on creating a focus.
Usually, this literature would “prove” its point by showing examples of successful firms who focused on exactly that one thing the literature was proposing. The logic was that these firms did it and were a success. Therefore, if you do it, you will automatically be a success as well.
Unfortunately, this all seems a bit simplistic to me. I think the situation is more like what I found as a radio DJ. Just as I found musical winners and losers for every single characteristic, you can do the same for these business foci.
In other words, for any “just focus on this one thing” business article/book, I could find the following:
1) Companies who followed the recommendation and succeeded;
2) Companies who followed the recommendation and failed;
3) Companies who did not follow the recommendation and succeeded;
4) Companies who did not follow the recommendation and failed.
And, as many have pointed out, even companies who followed the recommendation and were successful (at least at the time the literature was published), often continued on that path and later failed. The original book of this genre, In Search of Excellence, was famous for having picked a list of successful examples of “excellence,” where most were in deep trouble (no longer excellent) only a few years later. Hence, likelihood of finding automatic success in business by focusing on any one thing is just as likely as what I saw in music—almost none.
Therefore, I think you have to come to a similar conclusion to what I discovered as a radio DJ: success is either based on random luck or a complex mix of factors, working together in a way that is not easy to discern.
So here is the dilemma. If success is random, then it really doesn’t matter what you do. If success is based on a formula too complex to comprehend or apply, then having the formula does not provide much guidance, either. So what should I do to increase the likelihood of my success?
To get out of this dilemma, I will propose a middle ground. The idea is to provide a broad enough scope to encompass a lot of the complex issues involved in success, yet cull it down far enough to provide a relatively simple (and relatively easy to apply) approach for business management. Although not perfect, it is better than betting it all on just one thing or hoping for luck.
This approach is based on keeping an eye simultaneously on three broad areas, which I refer to as the three P’s: Positioning, Pursuit and Productivity. In one short blog, I cannot fully explain all the nuances to each “P,” but hopefully, you’ll get the general idea.
In a nutshell, positioning is the act of getting a targeted consumer group to believe that there is a compelling reason why they should prefer purchasing your product. The battle takes place in the mind of the consumer and you want to “own” a position within that mind. The goal is to convince them that you have a superior solution to one of their problems. A good position for your brand/product/service is one that is desirable, sizable, ownable, preferable, achievable, believable, understandable, and profitable. Your key soldiers in this battle include marketing and strategic planning.
Another way to look at this is to ask yourself these questions: What is the reason why my product needs to exist? Would anyone miss my product if it no longer existed? If your product has no unique reason for existing, then do not be surprised if it fails.
Within this broad area of attention (Positioning), three concerns should be kept in mind:
a) Have I created a winning position? Is my position still relevant? No I need to modify it?
b) Are the actions of my company consistent with this position? Am I doing everything possible to accentuate and strengthen my ability to deliver on the key attributes of this position? Are resources disproportionately allocated towards building/reinforcing the position? Am I making the right trade-offs?
c) Have I adequately communicated the position so that the customer understands and accepts it? Does the consumer continue to keep me as the top-of-mind leader on that position?
Having a good position is not enough. You need to exploit it. The idea behind pursuit is to create as many opportunities to exploit the position as possible. The battleground is the place where transactions take place, where people do the buying. Your key soldiers in this area include operations and sales. This is about out-hustling the others who want to win in the same space. Many people with great ideas fail because they let someone with more hustle out-pursue them and reap the rewards from that idea.
Within this broad area of attention (Pursuit), three concerns should be kept in mind:
a) Have I built up enough relevant competency/expertise in order to deliver on the promises of the position? Am I strongly pursuing innovations in order to remain a leader? Am I keeping an edge over competition in competency/expertise?
b) Do I have enough capacity (points of sale, types of sales channels, sales personnel, inventory, distribution) to satisfy the demands of all relevant customer segments and geographies? Am I expanding my selling/production/distribution capacity at a faster rate than competition in order to create superiority in selling (and putting competition at a disadvantage in reaching these customers)?
c) Have I pursued superiority in relationships up and down the supply chain? Have I created a competitive edge in position with these business partners?
Selling at a perpetual loss is not a good long-term strategy. Ultimately, you have to provide your value at a price which is higher than your cost to deliver. Your business model needs to be engineered for profits. The battle ground is your income statement, balance sheet and cash flow statement. Your key soldiers in this battle tend to include finance, procurement, and operations.
Within this broad area of attention, three concerns should be kept in mind:
a) Am I focusing on the activities which provide the greatest return on investment?
b) Am I managing everything (costs, capital, personnel) for peak efficiency (while still enabling pursuit and position reinforcement)?
c) Am I building and leveraging my power within the business ecosystem so as to extract a larger share of the total ecosystem profits? Am I leveraging my economies of scale?
I have written many blogs about these topics in the past. Check out my keyword topic label links on Positioning, Pursuit and Productivity to learn more.
Business success is not an automatic outcome of doing just one thing right. It is a complicated formula, requiring proper moves in many areas. For simplicity sake, one can categorize most of these moves into one of three concerns: positioning, pursuit and productivity. All are needed to increase the likelihood of success.
All three of these areas need attention because they intermingle to form the formula for success. For example, you cannot exploit the economies of scale in profitability if you have not pursued the capacity for scale or created a position which demands scale. You cannot pursue a position if your do not know what that position is or have not created enough cash flow to give you the funds needed to invest in the pursuit. Therefore, you need to work on all aspects of the formula in concert. Again, we’re back to the music analogy.
Thursday, May 13, 2010
Greece has a problem. For years, Greece has been very generous in its benefits to its citizens, especially those employed by the government. And, for years, Greece has been generously spending this money at a far greater rate than its income. The generosity is has come from borrowed money.
The turning point came this year when those loaning the money said they had had enough. They did not want to fund this generosity anymore because they didn’t see a path to getting their money back.
Greece was forced into a corner. The only way to fix the debt was to have austerity measures imposed from the outside lenders. The Greek citizens, used to the government generosity, rioted in protest. They still demanded the generosity.
And now it looks like Greece may just be the first in a wave of other countries who have followed the same path. What’s a leader to do?
When you live beyond your means for a long period of time, it becomes a habitual pattern. Those living this pattern come to define it as “normal” behavior—at least normal to them. There is not much incentive for change. After all, it has “worked” for a long time.
The problem is that eventually one has to pay back that borrowed money. Even if the time span for living beyond your means is long, eventually the time will run out. The creditors will eventually demand payment for all those loans—money which these people do not have. Then it becomes really messy, because the people who think living beyond their means is normal have no desire to adapt to living within their means, let alone live in austerity in order to pay for their past.
This is not just a problem for Greece. This is a problem for most businesses today. For example, the internet economy has created a world where most people expect to get almost anything digital for free. That sounds a lot like living beyond our means.
Meanwhile, back in the “old” economy, a lot of companies severely slashed prices during the great recession. Customers have gotten used to the low prices, which are viewed as the new normal. Although a lot of firms want to raise those prices back up in the latter half of this year, I think people will resist, similar to the riots of the Greeks (although not as emotionally or violently).
Many parts of the business world have followed the pattern of the Greek government—generously giving value to its customers at a non-sustainable rate. Eventually, someone will have to pay for all this.
Just as Greece is an early warning country of problems to eventually turn up in other countries, there are business industries that are early warnings of problems for other industries. The news and entertainment media are an early warning area, a lot like Greece.
The digital economy has trained many people to expect news to be free. New media were borrowing news from the old media and redistributing it for free. If you can get news from the new media for free, why pay for the old media? As a result, newspapers are disappearing all over the place. Last week, Newsweek magazine was put up for sale and it looks like nobody will buy it (who wants a property that loses millions of dollars a year?).
The problem is this: what will the new media distribute for free when there is nothing left from the old media to borrow? If you can no longer borrow the news, you will have to get it on your own. And then you can no longer afford to be free. But if free is the new normal, customers will rebel when you start charging them what the news is worth. Substitute the words “money” or “government benefits” for the word “news” and it sounds a lot like Greece.
The principle here is about sustainability. I’m not talking about business sustainability the way the media typically uses the term. They are looking at ecological issues like carbon footprints. I’m talking about sustainability in terms of value—giving value in proportion to what the market is willing to support. If the cost required to provide the value you give exceeds what people are willing to pay, your business is ultimately not sustainable. You are living beyond your means.
Consider the value menus at the fast food restaurants. Many of those items are sold well below cost. They have created a new “normal,” where people expect food to be priced below cost (like the Greeks expecting government benefits that the government cannot afford to give). Why pay full price for a Big Mac when you can get all that beef off the value menu for a lot less?
The restaurants are in a bind. Either you have to:
a) Put the value menu on an austerity program (shrink the burgers, take off the cheese) to the point where it is no longer a value;
b) Raise the price of the value menu (which destroys the value); or
c) Hope that there are enough high margin non-value menu orders to subsidize the value menu orders.
The same problem exists in the airline industry. People are used to buying airline tickets at a value that the airlines cannot afford to give (unsustainable). Therefore, the airlines are scrambling to find other way to get money, like charging for baggage, food, and now even toilets. They’re putting more advertising in the planes and getting other firms to subsidize the frequent flyer points programs. Getting others to pay…hmmm…sound a bit like Greece?
Big airline mergers, like United and Continental, are hoped to cut costs to pay for the unsustainable current ticket price business model. Unfortunately, the traditional airlines have tended over the years to treat many of their employees similar to how Greece treated its employees, with high benefits. Therefore, there may be less benefits to consolidation than one thinks, especially if workers (and work rules) cannot be touched.
Then there is the digital world. Facebook is huge, with about 500 million users. Some think an IPO of Facebook could fetch as much as $20 billion. Yet, it is only now starting to reach the point where it may be approaching profitability. And profitability does not mean it has a cash flow that can pay back all the investment from the early years in setting up the servers to run this thing.
Right now, Facebook is free to its customers. No wonder so many people like it. Awhile back, an idea was floated to perhaps charge a small monthly amount to its customers. The negative reaction from the customer base was huge. Many threatened retaliation (like the Greek riots?) and would quickly move to one of the other still-free sites. Ironically, one of the popular pages on Facebook is a page devoted to people against having Facebook charge a fee. And these Facebook customers do not want a lot of advertisements on the site, either (and many advertisers have not found it to be a particularly effective place to do advertising)..
And what about Twitter? It is loved by many (after all, it is free), yet there is no sustainable business model to support it (nor is one proposed for the future). Is this another Greece in the making?
Given this problem of sustainability, what should a strategist do?
1) Consider Sustainability In the Beginning
How you set up the original business model helps determine how people define “normal.” If you start off with an unsustainable model, unsustainable practices are expected forever. It is hard to later add the austerity program needed to sustain the business.
Way back in 1923, Claude Hopkins wrote the classic book Scientific Advertising. In this book, he explains why he invented couponing for new product introductions. He said if you originally introduce a new product at a discounted price or give away samples for free, you are building expectations that the product should be discounted or free. But if you sell it from the beginning at full price (and customers pay for part of the full price with the coupon), customers will accept the full (sustainable) price in the future. This is why the Wall Street Journal started its web site as one you pay for. They wanted people to expect a sustainable model.
2) Give High Priority to an Effective Business Model
It’s great to have an offering that people want. But if you lose money on every sale, then you have a non-sustainable business. Make sure your business model has a path to sustainability. As CK Prahalad speaks about in his campaign for The Fortune at the Bottom of the Pyramid, you can get items profitably priced low enough so that even the poor can afford it (and be sustainable) if you start with this premise at the point when you design the business model.
3) Look for Subsidies
If your customers are not willing to pay enough to sustain the business, make sure you put into your strategic plan additional sources to subsidize the cash flow. That could be subsidies from governments (like for building cleaner technology), or subsidies from advertising, or partnering with complementary businesses, and so on.
In essence, you need to think of these subsidizers as another one of your customers—someone you need to serve well in order to get their subsidy business. If this is not fully thought out in the plan, you will not optimize the subsidy potential.
4) Consider Selling Out Before the Debt Comes Due
If you find it hard to create long-term sustainability, then perhaps the best strategy is build into your plan a way to cash out early. Most business value is created at the point in time in which a company changes hands. Often, the seller achieves the most value, particularly if they proactively time when the company changes hands. If you know the creditors are coming, and you are in a unsustainable debt position like Greece, sell out before others realize what’s coming.
Market bubbles are unsustainable. Sell before the market bursts. Better yet, proactively build your business model so that it is easier to sell (and more desirable) to the type of people who might eventually buy it before the burst. In essence, these potential buyers of the entire company become the true customers of your business strategy (we spoke more about this idea here, here, and here).
Unsustainable businesses eventually die. To avoid this, make sustainability a key part of your strategic planning, particularly when designing the business model for a new concept. And if that doesn’t work, plan to sell before the debt comes due. Otherwise, you may end up like Greece.
All strategies eventually die. Even once highly sustainable business models, like newspapers, can fall apart if the environment changes enough. That’s why we need to go back and challenge our assumptions every once in a while, to make sure the model is still relevant and sustainable...and if it isn’t, change the model.
Monday, May 10, 2010
I used to work for a company where the legal department seemed to get the best perks. They had the larger offices, the better equipment, the larger staffs, and the higher wages. I did some investigation to find out why the legal department was getting preferential treatment.
As it turns out, when budgeting time came about, the legal department would justify their existence using large hypothetical numbers. They would say something like this: “Just one smart move by the legal department can prevent a future legal liability of hundreds of millions of dollars. Considering all the potential legal liability avoidances, they add up to a huge number. By comparison, spending a little more on offices, equipment and salaries in the legal department looks like a real bargain.”
Since that approach seemed to work for them, I decided to try a similar approach for the strategic planning department. I said that good strategic planning puts companies on a path to long-term success and keeps them off a path to failure. Given the alternative of good strategic planning or failure, how much would you be willing to spend on Strategic Planning in order to avoid failure?
I may have over-reached on that appeal, since the top executives would not accept the idea that they could possibly fail if the strategic planning department disappeared. Therefore, in future years, I toned down the message and said that Strategic Planning could find new paths to growth that were worth hundreds of millions of dollars and avoid hundreds of millions of dollars of losses from poor investments. That approach worked better.
In retailing, there is an old saying that “There are no cash registers in the corporate office.” In other words, all the money is made when a customer buys something at the store. Therefore, focus investments on getting the store right, because otherwise there will not be any income to pay for that corporate office.
Yes, it is true that getting things right at the point where sales are made is very important. Without sales, there are no profits. Sales, however, are not the only factor determining profits. As my friends in the legal department pointed out every year, bad legal decisions can cause all of your profits to disappear through legal liability payments. In other words, profits are also impacted greatly by actions at the home office—far away from the cash registers.
If the legal department could portray themselves as a savior of profits, and I could portray the strategic planning department as a savior of profits, I’ll bet a lot of other corporate office departments could do the same. Are we missing a lot of potential profitability if we focus too exclusively on just where the cash register is?
The principle here is that strategy needs to be concerned not only with cash flow creation, but cash flow protection. Without proper concern for protection, the cash flow machine can stop working.
There have been lots of stories in the news recently of threats to cash flow machines:
1) The oil leak in the Gulf of Mexico is putting a big dent in the BP cash flow machine.
2) Several recent mining disasters (like the Massy Energy mine in the US, the Raspadskaya mine in Russia, or the Guomin mine in China) have crippled the cash-making ability of these mines.
3) Quality issues at Toyota have had a negative impact on image and cash flow.
4) A little typing error on a stock trade caused computerized trading on Wall Street last week to destroy stock values, wiping out huge amounts of profits in a short amount of time.
In many of these cases, the disaster occurred due to too much emphasis on cash flow creation and not enough emphasis on cash flow protection.
At Toyota, the cash flow strategy—based on a superior quality product—was taken too much for granted. Emphasis was placed on increasing the cash flow from that strategy through more rapid expansion and more strident cost control. However, those measures to increase the cash flow worked to destroy the cash flow machine. They took the focus off quality and put extras stress on the ability to continue quality. As a result, quality suffered. The core strategy was damaged.
Productive mines and oil wells can be great cash flow machines. However, there is the risk of assuming the cash flow machine will continue all on its own. Hence, one can be tempted to cut back on mine-related costs in order to increase that cash flow. If you do not protect that mine or well with the proper safety, maintenance or employee training, disaster can erupt, shutting down the cash flow machine and causing huge sums of additional costs to fix the problem.
The point here is that all company actions impact the core strategy. Some of those actions may create near-term boosts to cash flow, but destroy the long term functionality of the core cash flow machine. Don’t assume that the cash flow machine will continue on its own. Put into your strategy and tactics proactive means to protect that cash flow.
Sure, I hear people strategize about some of the key threats found in Porter’s Five Forces, like competitive threats or new product threats. But what about some other threats to the cash flow machine, like:
1) Putting the wrong people in charge of key functions (I have seen this mistake literally destroy entire businesses).
2) Ignoring safety, maintenance, and training issues
3) Growing faster than you can manage the growth
4) Legal Liabilities
5) Risk Management
6) Swings in foreign currency translations
7) Tax issues (earlier, we spent an entire blog on just this one issue)
8) Computer programming errors.
9) Breeches of privacy or data theft
Cost cutting in areas such as these may look like a way to increase cash flow. But if the cost cutting damages the core cash flow machine, you are worse off. If cash flow protection investments are made, you can actually increase long-term cash flow while spending more money, because the investments increase the effectiveness of the core cash flow strategy.
So what can we learn from this?
1) Understand what is the core of your strategy
In most cases, strategic success is based on excelling at the key differentiating point of your strategic position. Mess that up and the whole strategy starts to crumble. Therefore, it is essential for everyone in the organization to know where that key focus is, so that it can be protected.
If the key focal point is quality, everyone needs to know that—not just the folks on the assembly line. There are lots of areas in a business where decisions can be made which affect quality, from finance to human resources to expansion planning and so on. If you want to protect quality, you need to protect it from all of the decisions throughout the business that can potentially impact quality.
The best way to do that is by holding everyone accountable for their impact on the core focus of the strategy. And of course, this means that companies must first know what that key focus really is (from the perspective of the customers). Then they must communicate it as a priority for all decision making, regardless of where you are in the organization.
2) When developing a new strategic initiative, design protection into the setup
The best way to protect a cash flow is to incorporate the protection in up front at the beginning. Once the oil rig in the Gulf of Mexico erupts, it is too late to start the protection process.
This applies to numerous areas. For example, how you initially set up a business or an acquisition can have huge impact on your level of legal liability or tax liability. The type of people and process you use to integrate a new initiative may have more of an impact on cash flow than the actual initiative.
Considering all the risk issues up-front allows you to incorporate more protection into the process, before all the contracts are written up and all the deals concluded. Think beyond the point where business in transacted (the “cash registers”) to all the places that could indirectly impact success.
3) Don’t assume that a cash flow machine will work forever if unprotected.
Left unattended, cash flow machines will break down. They can be made less efficient through hundreds of little decisions around the company which each have a small impact of compromising one’s ability to excel at the point of strategic focus. They can be rendered obsolete by competitive advances. Lack of investment in maintenance or R&D can slow it down.
If this is the key to your success, don’t take it for granted. Protect it like the crown jewels, because that is exactly what it is. Protect it from inside threats as well as outside threats. Invest in your point of differentiation so that it is always a step ahead of the competition. Keep awareness of what is the core of your success at the top of mind, so that it will be given its proper attention. Whenever big decisions are being made, always ask yourself “How will this decision impact the core of our cash flow machine?” Be vigilant.
Great strategies need to be more than just great ideas. They need to become the core of how your business operates. This can only happen if you put in place strategies and tactics to protect this core from losing its strategic focus.
One little drop of water is pretty harmless. But get enough of them and the dam won’t be able to hold back the water and it will burst, destroying everything below the dam. Similarly, get enough little, seemingly harmless, decisions that weaken a strategic position and before you know it, the strategy bursts.
Tuesday, May 4, 2010
When I was a child, my parents gave me money so that I could have milk with my lunch at school. My parents thought that this money was giving me two options—either regular milk or chocolate milk.
I, however, found a third option…ice cream. Many was the time I skipped milk and used the money to buy some ice cream in the school cafeteria.
I never told my parents about using the milk money for ice cream. I figured ice cream was a dairy product, like milk, so I was still getting dairy nutrition (and that’s what my parents really wanted…right?).
My parents thought I had only two options with my milk money—regular or chocolate milk. Since they saw the only options as being milk, they referred to the money as “milk money.” I, however, saw the money as “food money” and substituted ice cream for milk. This third option did not occur to my parents.
Businesses can fall into the same trap as my parents. They can conceive of only a small set of options for their customer—smaller than the set of options seen by the customer. As a result, they may mistakenly predict the wrong behavior (choosing milk), because the right behavior (choosing ice cream) was not on their radar.
By defining the money as “milk money” my parents were blinded to any use other than milk. This could be like a business person in the tourism industry who sizes up her potential based on the “vacation money” people have and then become surprised when people skip a vacation one year and use that money to buy a new car.
As strategists, we must be careful not to make our industry definitions too narrow. If we do, we will fail to see the options the way the customer does. And those bad assumptions will lead to the wrong strategic conclusions.
The principle here has to do with choice and substitution. Just as I substituted ice cream for milk, your customers may make all kinds of substitutions when choosing how to spend their money. If you ignore the breadth of these substitutions (and only look at your direct competition), you will improperly define both the marketplace and your competitors.
This principle was made very clearly in an article last week in the New York Times. The article was discussing the high prices that designers were charging for their version of basic khaki pants. Georgio Armani’s khaki’s were $595. Michael Bastian had them for $480. Mary-Kate and Ashley Olsen’s The Row brand was selling a version for $495. Bottega Veneta had a version with elasticized cuffs for $780.
The article then compared these prices to two benchmarks. Traditional retailers, like the Gap and Abercrombie&Finch have basic khakis for $70 and $45, respectively—about one tenth the price.
Then the article compared the designer khakis to electronics, saying that these pants are getting into the price range of the iPad.
The fashion designers in the article were trying to justify their price by discussing the quality of the construction of their pants. But in many ways, that misses the point.
A lot of people are not buying designer khakis because they want khakis. After all, they can get a much better pant value by getting the Gap version. Instead, what these customers are looking for is status and prestige. They want the bragging rights in their peer group of being the coolest of the cool people. Designer khakis can do that.
Unfortunately for these designers, so can the iPad. In fact, the iPad may do a much better job of enhancing the status and coolness of its owner than designer pants. If the price of the iPad and the designer khakis are essentially the same, and the customer is attempting to purchase status and coolness, which will they purchase? My guess is that many will choose the iPad.
You can get immediate bragging rights with the iPad because its distinctive design stands out. People will notice it immediately. By contrast, people may look at your khakis and not know if they are $70 or $700 pants unless you tell them. Also, you can carry around that iPad for bragging rights every day, but you cannot wear those khakis every day.
As a result, many may substitute iPads for khaki pants. It’s a superior status option at that price. Even the fashion writers for the New York Times could see the connection between iPads and Khakis.
Hence, the competition in designer khakis is not just other designer khakis (not just other kinds of “milk”). Instead, the competition includes other status substitutions like the iPad (the “ice cream”). Therefore, when deciding the price to charge for designer khakis, you may need to consider the status value relative to the price of an iPad.
The whole apparel industry in the US has been essentially a low growth business for a long time—even before the recession. I think that part of the reason is because clothing used to be a key visual cue of one’s social standing, but now one’s electronic gear is taking on that role. A cool mobile smartphone provides more status than a cool outfit.
I was at a high school musical performance this past week. There were a large number of high school students in the audience. I never heard any of them commenting about each other’s clothes. I did, however, see them commenting about each other’s mobile phones. The ones with the coolest phones were having others ask if they could borrow them (a sign of status).
I believe that part of the rapid rise in sales at consumer electronic retailer Best Buy is coming from money which used to be spent at the clothing stores in the mall. In essence, Best Buy is providing a better status value than the clothing stores. Until the clothing stores figure this out, they will not break out of their slump. They have defined the competition too small (other apparel), so that they are no longer winning the battle for “cool,” which has shifted to a non-apparel substitute.
Starbucks gets it. They realize that they are not just competing with other coffee restaurants. They are also competing with at-home and at-work consumption. As a result, Starbucks invented Via instant coffee. This gives them a way to compete in the broader coffee world for those who substitute other points of consumption. With Via, Starbucks is now in the supermarket, where many coffee decisions are made.
So what does this mean for strategy?
1) Don’t Define your Market Too Small
People do not substitute products; they substitute solutions. If you define your market as just those selling similar products, you will define yourself too small. Instead, you need to look at anything offering to solve the same solution (like status), regardless of what the product is. Am I in the business of making movies (product) or selling entertainment (solution)? Am I in the business of selling diet pills (product) or selling weight loss (solution)?
People will flock to the best perceived entertainment option and the best weight loss option. And don’t be surprised if they choose a video game over a movie or liposuction over diet pills.
The customer’s definition of substitution options is much more important than your definition. And most often, their definition will be a broader definition based on solutions.
2) Build your Strategy Around Solution Superiority
Once you get that broader solution-based definition properly sized, build a strategy to win within that broad marketplace. Find a strategy which makes your offering so compelling that a significant sector of the population will not only see your product as the best among similar products, but also the best among a broad range of substitutes. Don’t strive to make the best movie…strive to be the best entertainment option, so that you can tap into money that might otherwise go to other entertainment substitutes.
If you are in the business of selling cool, keep migrating to where cool is moving. Add attributes which are cooler than what substitutes can offer. Price to be a better value than other cool substitutes. Computers used to be cool devices, and Apple had the coolest computer. Now computers are mostly just a tool and the coolness has moved on to other devices…and so has Apple. The apps are becoming cooler than the products, so Apple tries to be the king of apps. Apple’s strategy tries to win the solution (cool) rather than win a particular product.
One of Porter’s Five Forces impacting your strategy is the threat of substitution products. Build strategies which protect your business from substitutions within your solution. You may also want to consider reinventing the marketplace by offering a new option which is a superior substitute for the entire status quo (a sort of Blue Ocean approach).
Narrow, product-based definitions of markets miss out on all the various substitutions available to a consumer. If you want to win, your strategy must provide superiority versus all relevant substitutes.
Be careful of the words you use. Just as saying “milk money” can make a parent forget about the other ways a child might spend that money, using product-based jargon all the time can cause a company to forget about relevant substitutes.
Monday, May 3, 2010
The rising prosperity in China is impacting Chinese eating habits. For example, between 1982 and 2002, daily per capita consumption of grain in China dropped 21%, from 509.7 grams to 401.7 grams. At the same time, meat consumption grew 132% and vegetable cooking oil consumption grew 153 % (Source: Chinese National Bureau of Statistics).
If you consider that fact that it takes about 7 or 8 grams of grain to produce one gram of meat, the grain requirements for China are growing rapidly, even though direct grain eating is going down. According to an article in the June 24, 2008 issue of the China Daily, if the Chinese started to eat meat at the same level as in the US, the world would need to produce an additional 277 million tons of grain to grow the meat. That would require finding an additional 68 million acres of quality farm land that is not currently being farmed (about one-sixth of the farmland in the USA).
Add to that the fact that if every Chinese adult drank just one additional can of beer in a year, China would need approximately 150 million more pounds of grain. This starts adding up in a hurry.
It doesn’t sound like much when you say that it takes about 7 kg of grain to make 1 kg or meat, or that it takes about 0.08 kg of grain to make a can of beer. However, when you multiply that against a population in the billions, small changes in meat and beer assumption can really change grain consumption.
This is what happens when you apply scale to these equations. Suddenly, little movements in behavior create large swings in demands all up and down the supply chain. The bigger the scale, the larger the swings.
Strategy is usually concerned with finding ways to change behavior—to your benefit. The equations associated with current behavior may appear innocent enough, and you might apply them to your strategy. However, if there is enough scale to your behavior change, the current equations may no longer be applicable.
For example, changes in the diet of China are affecting global food availability and global food prices. The old cost of goods assumptions are no longer applicable, since the new consumption has altered prices of all sorts of cost components throughout the entire food production pipeline. Add to this the uncertainty of biofuel consumption and the formulas may need to change again.
Your strategic actions impact the environment in which the strategy will operate, rippling out changes in many directions. You need to take that into account when assessing your strategy viability, especially if it starts to scale large.
The principle here is that strategies do not operate in a vacuum. If your strategy is to create large-scale changes in demand, then all the current assumptions about how the marketplace works need to be thrown away, because your changes will impact how the marketplace works.
Here are six factors to consider when contemplating large-scale strategies.
1. Is there Capacity to Satisfy Demand?
Years ago, I talked to someone at McDonalds. They were testing a new meal item—McShrimp Cocktails. The item tested very well. Based on the current economics, it looked like it could be priced to make a profit. Then they looked at what happens when you scale this up to the entire McDonald’s chain.
As it turns out, it would have taken more than 100% of the world’s capacity of shrimp to meet annual the demand projections. So McDonald’s couldn’t meet demand, even if they wanted to. Even scaling back demand, the change to the shrimp market would have been so huge that the old cost estimates would have been invalid. Scarcities would raise the price of shrimp, making it too expensive for the McDonald’s menu. A great test of McShrimp Cocktail was made invalid once consideration was given to scaling it up.
In the early days of Starbucks, Starbucks promoted itself as being a place to get superior coffee, because it was small and could afford to be choosy about the quality of beans it purchased. Now that Starbucks is huge, it has to buy so many beans that it cannot afford to be as choosy as it once was. There are not enough “superior” beans to meet the Starbucks demand. As a result, a promotional approach was no longer valid.
There are retailers who specialize is selling manufacturer overruns and other distressed or excess goods at a deep discount. Over time, some of those retail chains have gotten so large that there is not enough excess in the marketplace to fill their stores. They have to supplement their supply by purchasing goods the normal way, just like they retailers whom they are trying to under-price. Suddenly, the strategy doesn’t work like it used to.
2. Can the Supply Chain Handle the Shift?
I was talking to someone years ago at the Mars candy company. I complained that they had changed the recipe of their Mars Bar candy bar from hazelnuts to almonds. I told him I liked the old taste better.
His response was that the original Mars bar created a large scale change in hazelnut consumption. The hazelnut supply chain was not built to handle that kind of demand. As a result, Mars found that there was not a stable, predictable way to procure the hazelnuts they needed and that the pricing was not stable. By contrast, the almond ecosystem could easily absorb the demand of the Mars bar in a predictable way, so Mars shifted from hazelnuts to almonds.
A similar situation happened with General Mills and their introduction of a buckwheat based cereal. The demand for the cereal was strong. Unfortunately, the supply chain for buckwheat was not able to satisfy the sharp rise in demand created by this cereal. The supply chain was so bad that General Mills decided to stop making the popular cereal. So much for that great buckwheat cereal strategy—foiled because the supply chain ramifications weren’t adequately considered.
This is why, when McDonalds is expanding into new territories, they start years in advance to first change the local supply chain for products like beef and potatoes. They want to make sure the supply chain can handle their large scale before putting that scale into the marketplace. A similar process occurred for the Chipotle restaurant chain. They had to delay their rapid growth strategy until they could convince farmers to rapidly expand the capacity for avocados. Otherwise, there would not have been a stable supply chain for the restaurants.
3. How will your Scale Impact Pricing?
Supply and demand impact prices. If scale radically increases demand, and supply does not keep up, prices for your raw materials will skyrocket. This will make any strategy based on the old supply and demand relationships obsolete (and perhaps make your strategy no longer valid).
To get around this, your strategy may need to consider locking in long-term supply contracts at fixed prices…or maybe consider backwards integration into owning your sources of supply in order to guarantee adequate supply at a reasonable price.
Suppliers need to worry about this as well. In the US food business, the manufacturers saw their primary customer as the supermarket. When the wholesale clubs like Costco and Sam’s Club first started, their demand was tiny when compared to the supermarkets. It was seen as incremental business. Therefore, the temptation was to set prices to the clubs based more on incremental costs rather than full costs (which were disproportionately born by the supermarkets). Of course, once the clubs achieved huge scale, that pricing plan was no longer valid.
4. How Does Scale Impact Image?
Many goods are sold on the basis of image or prestige, such as luxury goods and fashion brands. Much of the appeal is based upon their scarcity—only available to the rich and famous. Once the item is widely available to the masses, the elite customers may abandon the brand.
It can be tempting to take a prestige brand and adapt it to a large scale for the masses. At first, it will create a huge spike in demand and in profits. However, if the large scale destroys the prestige image, the brand will eventually lose its luster. It will be quickly abandoned by the elite customers. And when the masses see the elite abandoning it, they will soon follow. Therefore, the short-term boost can lead to a long term disaster.
There may be greater long-term success by not scaling up for the masses.
5. How Does Scale Impact Competitor Reaction?
If you are a small niche, the big competitors may ignore you. However, if you scale up large enough to threaten the big players, they will retaliate. They will either try to destroy demand for your product or design competing products. Either way typically leads to a price war, which will destroy your profit margin.
Always assume that the scale which comes from success will result in increased competitive retaliation (for more on that, click here). Put the economic impact of those retaliations into your strategic model to see if you can sustain the price cuts and other pressures. It may be more profitable to remain a small niche.
Also, consider in your strategy ways to increase the barriers to entry, making it harder for the eventual retaliation. One of the reasons why the iPod was so successful was the integration of hardware, software and iTunes. By attacking all three fronts with a seamless and superior business system, it was harder for anyone else to break into the market and retaliate.
6. The Additional Scale Does Not Have to Come From You
Even if you do not upset the status quo with large increases in scale, that does not mean that the status quo will remain. Others may upset the scale. Your business will be impacted by the change even if you did not create the change.
For example, China’s rapidly growing economy is impacting the global oil market. That can impact your energy costs, even if your business has nothing to do with China.
There was a road near my house in Ohio that was closed for quite a while due to the lack of a bridge. The reason? The high demand for steel in China had created a global steel shortage. The community I lived in did not want to pay a premium price to get the steel quickly. Therefore, the bridge was not built until they could get cheaper steel (by being willing to wait). If construction in China could affect my little bridge in Ohio, think of what remote activities could affect you.
Scan the environment to see where surges in scale created by others might occur that could affect your strategy. Then come up with plans to deal with these surges caused by others.
Large changes in the scale of demand make the mathematics of the status quo environment obsolete. If you do not change your modeling and assumptions to account for the ways the volume will impact the ecosystem, your strategy will be flawed.
The good news is that China may be opening up a great new surge in demand. The bad news is that China may be opening up a great new surge in demand. The ratio of good news to bad news can be impacted by how your strategy adapts to this news.