Monday, May 3, 2010

Strategic Planning Analogy #322: Problems of Scale

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 The old cost of goods assumptions are no longer applicable, since the new consumption has altered prices of all sorts of cost components throughout the entire food production pipeline.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.

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