Wednesday, January 26, 2011

Strategic Planning Analogy #374: Black Bananas

Large grocery chains in the US purchase their bananas from the fruit companies in the unripened “green” stage. They do this because hard, green bananas are easier to transport to the US.

Then, after the green bananas get to the US, the grocers put them into their produce warehouses. These warehouses have gigantic, pressurized gas chambers in them. These gas chambers chemically “ripen” the bananas. Depending on the length of time the bananas stay in the gas chamber, you can “manufacture” whatever level of ripeness you want. After they reach the desired ripeness, the bananas are shipped by truck to the grocery stores.

One company I know wanted to increase efficiency by shipping both bananas and flowers to the stores on the same truck. Unfortunately, something unexpected happened. The flowers arrived at the stores already starting to wilt and die—something which hadn’t happened when the flowers were shipped by themselves.

Upon further investigation, it was determined that some of the ripening gas which was infused into the banana via pressure (while in the gas chamber) started to leak out of the bananas when they were in the truck. This ripening gas was absorbed by the flowers while they shared the ride in the truck. As a result, the ripening process of the flowers was accelerated, causing them to die prematurely.

As soon as the company figured this out, they stopped carrying the flowers and bananas on the same trucks.

Bananas and flowers are called “perishables,” because they have a short life. They soon “perish,” or die. You cannot stop a banana from turning black. You cannot stop a flower from wilting. It is inevitable, and it happens rather quickly.

Although we may not want to admit it, strategies are also perishable. Every strategic initiative eventually dies, just like bananas or flowers. And like those flowers in the truck, our strategic initiatives often die faster than we had hoped.

The reason strategic initiatives die is because the environment in which the strategy operates changes. Consumer desires change, technology changes, competition changes, innovation changes, the economy changes, and so on. These forces of change act on the strategy like the gas in those gas chambers. They cause the strategy to move through a lifecycle until it is no longer relevant and dies.

Think of the travel agents, whose strategy of being an intermediary between travelers and the travel industry died when the internet allowed travelers to interact directly with the travel industry and buy their own tickets. At that point, the old travel agent strategy lost most of its relevance.

Think also of Kodak, which is struggling to find a new strategy now that its old strategy, based on analog photographic film, is no longer very relevant.

Strategies based on growth in established economies are currently being replaced by strategies focusing on emerging markets. And retailer JCPenney this week announced it was shutting down its catalog operation, a strategy made irrelevant due to the internet.

In a similar fashion, some day your strategy will also become irrelevant, if you do not adapt. It will turn black like a banana, perhaps before you are ready to move on.

The principle here is that since all strategies eventually die, a good strategist should try to proactively manage this process. Just as the grocers can manage the life a banana via the gas chamber, strategists can manage the life of their strategy via various tactics.

In particular, we will look at three areas to consider.

1) Managing the Gas Pressure
There are many things businesses can do to hasten the growth of a new business. You can increase advertising, lower prices, do a public relations push, expand distribution, get celebrity endorsements, win awards, go viral on You Tube, etc. These act like those gas chambers act on bananas, because they push your business from early entry to maturity.

In many ways, this is good, because it quickly increases your market potential. However, just as all that extra gas caused the flowers to prematurely die, too much early pressure to grow can cause your strategy to die more rapidly.

Consider the high fashion industry. A lot of the appeal of high-end fashion brands has to do with their exclusivity. The more you push to expand the market into the middle class, the more you destroy that exclusivity appeal. Soon, the high end customers will abandon the brand because of that tarnished image. And once the high end abandons the brand, the middle class will soon follow. The brand dies an early death. Had less pressure been put up front, the fashion brand might have had a longer, more prosperous life.

Hence, too much pressure up front can push what could have been a lucrative long-term trend into a less profitable short-term fad. However, too little pressure may cause your strategy to never get beyond the introductory stage. Therefore, strategic planning needs to consider what is the proper amount of pressure to apply.

2) Keeping the Pipeline Full
Supermarkets do not make just one large purchase of bananas per year. If they did, they would have two major problems: a) a lot of the bananas going black before getting sold; and b) there would be no bananas to sell in the later half of the year once all the black bananas are thrown away. To avoid these problems, supermarkets buy small batches of bananas all year long. By having a continual supply of fresh bananas coming in all year, they can optimize sales and reduce waste.

The same is true for strategies. Companies need a continual pipeline of strategic innovation, experimentation and development That way, a company is ready when its current strategy begins to die and can seamlessly move on to the replacement strategy. One of the keys to the long-term success of GE has been its ability to continually modify its portfolio in order to remain relevant. It has moved through heavy industry to financial services to entertainment and is now moving to green energy. It does it seamlessly because GE built an infrastructure specifically designed for seamless transitions by focusing on:

a) Great general management (regardless of the business);
b) Mastering portfolio management techniques; and
c) Merger & Acquisition expertise (to help shift the portfolio more effectively).

It’s hard to quickly shift a strategy from a focus on mature markets to a focus on emerging markets if you have never experimented in emerging markets before. That’s why a strategy 100% focused only on the “strategy of the moment” can be so risky. It leaves you vulnerable when the strategy of the moment begins to die. Precious time is lost in transition, because you are unprepared and inexperienced in what comes next. You may not even survive the transition.

It is safer to be like the grocer who keeps the pipeline full of fresh product all the time. Otherwise, you can be like Kodak, who was so focused on photographic film that it did not build up an adequate pipeline of post-film strategies while it still had the time and the cash flow. Now, Kodak is struggling to catch up and it may not make it.

3) Exit Early
I’ve seen supermarkets try to sell black bananas. It’s not a pretty sight. They try to hide the ugliness of the bananas by putting them inside brown paper bags. They put a sign next to them saying something like, “Black Bananas; Perfect for Making Banana Bread.” Then they give it a very low price. And it still won’t sell.

You’d find it difficult to even give away black bananas for free. They just aren’t very desirable.

The same can be true for your strategy. Once a strategic initiative turns black and is dead, almost nobody wants it. You cannot sell it at any price. You may even have to pay somebody to take it off your hands.

As I’ve mentioned in prior blogs (here and here), holding onto a strategy after it turns black is a bad idea. Just as it is better for a supermarket to get rid of a banana when it’s only starting to turn brown, it’s better for a company to dispose of a dying strategy when others can still see a little life in it.

Many companies make the mistake of hanging on to a dying strategy too long. Emotional ties or historical heritage make it hard to let go. However, waiting until the strategy turns black hurts everyone. It is almost always better to error on the side of exiting a strategy a little too early than sticking with it a little too long. The value plummets too quickly at the very end.

All strategic initiatives eventually die. If you don’t want your company to die along with its strategic initiative, then you need to occasionally adjust your strategy. To optimize the return over the life of a strategy, a) manage the speed at which you pursue growth, b) maintain a pipeline of strategic alternatives, and c) exit dying strategies before it is too late.

Just as it was wrong to put bananas and flowers together on the same truck, it is usually wrong to manage mature and emerging strategies in the same way. They have different needs, so you have to approach them in a different way, with different benchmarks and expectations.

Monday, January 24, 2011

Strategic Planning Analogy #373: Value is in the Context

A couple of years ago I put together a wish list on so my family would have some ideas about what to get me for gifts (at their insistence). One of the items I put on that list was a book of comic strips from one of my favorite comics.

Recently, my wife bought me a copy of that book. I was enjoying the comics. The note from Amazon said it was a used copy of the book. I assumed that meant that my wife got the book at a discounted price, since when I put the book on my Amazon wish list, used copies were selling for about $5.. Thinking that the book didn’t cost much, I found myself enjoying the value of all the jokes in the comics. What a bargain!

Halfway through reading the book, my wife informs me that she had to buy the book used because it was out-of-print. It was so scarce, that she had to pay $150 to buy the book, a very steep premium over the original list price.

Suddenly, the jokes in the remainder of the book didn’t seem funny enough to justify the price. The enjoyment value to me dropped considerably.

I guess I should have checked how much the price of the book had changed between the time I put it on my wish list (and was still in print) and today (when it was out of print).

Strategic planning has a lot to do with choosing among options:

a) Should I buy company A or B?
b) Should I sell division C or D?
c) Should I increase or shrink investment in product E?
d) Should I pursue opportunity F?

In making these choices, we tend to rank order the options in terms of value and then choose the option(s) with the best value (adjusted for risk tolerance).

As a result, the level of success in strategic planning has a lot to do with how well one places values upon the various options. If you place the wrong values on the options, you will make the wrong choices.

At first, one might think that value is based solely on what you are getting, since that is what you are buying. For example, this line of reasoning would say that the value of a box is equal to the value of the contents of that box.

Yet, this did not appear to be the case with my book of comic strips. The quality of the humor in the book stayed constant over time. The jokes in the book didn’t change. The number of pages in the book didn’t change. Yet the price of the book fluctuated wildly. Some paid about $20 for a new copy of the book. Some paid about $5 for a used copy of the book. Others paid about $150 for a used copy of that same book (30 times more than the $5). Today I checked and Amazon is trying to sell the book for over $700 (140 times the $5). Obviously, the value of that book is not based solely on adding up the intrinsic value of each joke within the book. Something more is going on here.

If a little book of comics can fluctuate in value by so much, even when its contents are easily comprehended and do not change, then it shouldn’t surprise us that values on our more complex strategic options can also vary wildly. Like that book, more is going on in determining the value of these strategic options than just looking at the contents within that option. If you only look at the contents of what you are getting, you may value the option improperly.

And just because some people may be willing to pay as much as $700 for that book does not mean that it is worth $700 to everyone. The proper question is not “What is the book worth?” That question mistakenly assumes that value is based on something constant—like the constancy of the contents of the book. However, the value has more to do with the user of the book (an external factor) than the content of the book (an internal factor). Depending upon the user, you will get a different value for the book.

So instead of asking “What is the book worth?” (a question which has no single answer), we need to ask “What is that book worth to me?” This latter question may require a more detailed analysis of me than of the book.

The principle here is that values need to be computed within a context. If you only look at the contents, you will come up with the wrong value. To get the proper value, one must also factor in the context in which the contents find themselves. For example, a bottle of milk within the context of a refrigerator is worth more than a bottle of milk under a heat lamp. The contents are the same—milk. However, the refrigerator keeps the milk from spoiling, so it makes the milk more valuable.

In particular, there are three types of context which should be included in your valuation analysis.

1. The Context of the Marketplace
One of the great contributions to strategic analysis was Michael Porter’s Five Forces. The premise behind this concept is that a strategic option’s value changes depending upon five forces external to the contents of the option. These five forces are:

1. Bargaining Power of Buyers
2. Bargaining Power of Sellers
3. Threat of Substitute Products or Services
4. Level of Rivalry Among Current Industry Participants
5. Threat of New Entrants into the Business

For example, when my book of comics was still in print there were many sellers of many copies of the book, so the Seller’s power was low (and the price of the book was low). Once the book was out of print, there were fewer copies for sale, increasing the bargaining power of the Seller, causing the price to shoot up to over $700.

Therefore, when valuing a strategic option, one must not only value the contents, but also the marketplace in which the contents operate. Otherwise, you will miss out on the impact of these five forces upon the value. And in most cases, these five external forces have far more to do with the real strategic value than an intrinsic evaluation of the internal contents. The market determines the value, not the contents. Ignore these five forces at your own peril.

2. The Context of the Recipe
By itself, the desirability of flour as a food is not very high. If you don’t believe me, try to eat a spoonful of plain flour. It’s awful. However, if you put that flour into a recipe for bread, its desirability as a food goes up. And if you put that flour into a recipe for cake, the desirability goes up even further. The point here is that the value of an ingredient (like four) changes depending upon the context of the recipe.

In addition, if you are missing some of the ingredients for your recipe, it impacts the value of all the other ingredients. For example, if I have all of the ingredients needed to make a nuclear weapon except one, I really do not have a nuclear weapon, so all of the ingredients I do have are fairly worthless. Until I get that last ingredient, I have nothing. But once I get that last ingredient and make the bomb, I have created something of great value. So how much is it worth to me to get that last ingredient? How much am I willing to pay to complete the recipe?

Great strategies are like great recipes. They take a number of strategic components (ingredients) and add them together in such a manner as to create a finished product worth far more than merely the sum of the parts. Apple is a great company because it has a great recipe: cool products, with cool features, with tons of cool apps, sold in a cool way, from a company with a cool culture and a cool leader. The value lies in the way all of this seamlessly works together. Take away the ingredient of the cool apps and the value of the iPhone drops dramatically. Or a great app store without a cool device for the apps to play on isn’t worth much either. You need the whole recipe to create the optimum value.

Therefore, when creating your strategy, keep in mind the context of the recipe. First, make sure your strategic plan has a greater recipe. If all you have is a collection of individual ingredients (or businesses) working in isolation, you haven’t created much value. For a strategy to create great value, it must end up converting those ingredients into a finished, integrated plan with a value worth well more than the sum of its parts.

Second, don’t value the strategic options in isolation. Think of their impact on the value of the entire recipe of your strategic positioning. Your greater recipe helps determine how much value each option is worth to you. Just as steel is a more valuable ingredient to an auto maker than it is to cake baker, some strategic options will be more or less valuable to you depending on your recipe. Make sure you understand what ingredients make your recipe the best.

Third, make sure your strategic plan includes all the ingredients necessary to create the finished strategic product. Be willing to pay extra to get the last missing component.

3. The Context of Time
Things change over time. These changes can impact value. For example, the value of that book of comics changed when the book shifted from being in print to being out of print.

Never assume a constancy of value. The power of the five forces can change over time. Your recipe can change over time. Consumer interests can change over time. Products and industries move through lifecycles, where each phase (introduction, rapid growth, maturity, & decline) impacts value. Things which used to have a lot of value in the past may have very little value in the future (and vice versa).

Strategic planning is supposed to be maximizing the longer-term interests of the firm. Therefore, when making valuations, be sure to look at those values within the context of the future, which is where the strategy is going to be operating. Don’t be afraid to radically change your portfolio in order to optimize the times. The single most important factor to the long-term success of GE has been its willingness to add and subtract to its portfolio in order to stay relevant to the changing times.

The true value of a strategic option usually has more to do with factors external to the option than factors internal to the option. Therefore, make sure you consider external factors in your evaluation. This would include externals like Porter’s Five Forces, the context of your Strategic Recipe, and the context of Time.

After finding out how much the price of that book had changed between the time I put it on my wish list and the time my wife bought it for me, I decided I needed to go back and monitor that wish list more frequently. For the same reason, it’s probably a good idea to go back and monitor the values of your strategic portfolio on a regular basis as well. Otherwise, you may not see when the values change (and they will change).

Monday, January 17, 2011

Strategic Planning Analogy #372: Spreadsheet Games

Sudoku is a wildly popular number game throughout the world. It is based on a 9x9 grid. This grid is further sub-divided into 9 3x3 grids. The idea is to fill all 81 squares in the grid with a number from 1 to 9 such that:

a) Every row will have exactly one occurrence of each number from 1 to 9.

b) Every column will have exactly one occurrence of each number from 1 to 9.

c) Each 3x3 grid will have exactly one occurrence of each number from 1 to 9.

Although the origins of the game go back to the 18th century, its recent popularity began back in 1986, when the Nikoli company in Japan started publishing books of the puzzles (they were the first to label the puzzles “Sudoku").

However, the global popularity didn’t begin until Wayne Gould, a retired Hong Kong judge, developed a software program making it easy to develop new Sudoku puzzles. This software started to be used in 2004. Nearly all Sudoku puzzles today are made with Gould’s software.

It is estimated that the size of the global Sudoku business is in the many hundreds of millions of dollars annually. However, neither Nikoli nor Gould see much of that money. Nikoli never bothered to trademark Sudoku outside of Japan, so they only get Japanese royalties. And Gould decided to let others use his software royalty-free (all they had to pay for was the software). It is estimated that of the hundreds and hundreds of millions made on Sudoku, Nikoli only sees about $25 million and Gould only earns about $1 million.

Although Sudoku is a very popular number game, it has not financially benefitted Wayne Gould to anywhere near the extent of its popularity.

In strategic planning, we have a different number game which is also very popular (at least with strategists). It is the discounted cash flow analysis. The object of the game is to estimate future cash flows and then discount them back into today’s value by taking out the annual cost of capital requirements. When you solve this number puzzle, you will supposedly know how much a particular business or strategy is worth in today’s currency.

Companies spend a lot of time and money playing these discounted cash flow number games. However, I am afraid that many of the businesses using this game are like Wayne Gould. They are not reaping rewards anywhere near the size that one would expect.

In fact, I would argue that much of the claimed benefits of discounted cash flow analyses are no longer there. Much of the effort put behind them is wasted effort. You might be just as well ahead if you let your financial analysts play Sudoku as to have them play Discounted Cash Flow.

The principle here is that merely solving a discounted cash flow puzzle is not the same thing as developing a sound strategy. And often, solving a discounted cash flow puzzle does not lead to as much insight as one might think. Therefore, you may want to reallocate your resources to solving fewer of these puzzles and more to deeper strategic thinking.

Is Cash Flow As Important As We Think?
Discounted Cash Flow puzzles are based on the assumption that cash flow is the most important determinant of value. And the proponents of using this game can point to historical evidence showing that cash flow has one of the strongest correlations to value. However, I believe that in the future that correlation will significantly weaken. Here is why I think so.

Cash flows measure how a business earns profits through operations. The underlying assumption is that the value of the business is based on how profitable its operations are. In other words, if you assume that business operations are the way money is taken out of a business, then modeling the cash flows of those operations will give you a good idea of what the business is worth to you.

However, it appears more and more that the primary way companies in the future will extract value out of a business will have little to do with operations. Instead, nearly all of the value will be created at the time ownership transfers.

For example, take a look at a lot of the recent activity in the digital space. Companies like You Tube, Alibaba, Webex, Google and Doubleclick created nearly all their value at the time they either sold out or went public. The value created at that instant was far in excess of any type of cash flow profits that they had created in their past or could be expected in their near future. In fact, it is hard to envision how any sort of cash flow could reasonable get to the evaluations firms such as these created at the moment of ownership change.

I think this will get even more distorted when firms like Facebook, Groupon, Zynga, Twitter and others do their change in ownership. You’re already starting to see it with the ownership money already flowing into these firms. The valuations are incredibly high.

If you put these values into a discounted cash flow model and solve for future cash flow, you get numbers which boggle the mind. Sure, I can mathematically make the models work. The models will solve for cash flow. But just because the model can determine what cash flow is needed to make the model work does not mean that those future cash flows are likely to occur.

Flip that Business
In the new reality, if value is made by ownership transfer rather than through operations, perhaps operational cash flow is the wrong place to be looking when trying to determine value.

Keep this in mind. If I know that I am running a business to create value through ownership change rather than through operations, how do you think I am going to run that business? Obviously, I am not going to fixate on operations, but rather fixate on that which influences the transfer of ownership. My definition of customers is no longer the people buying or using my product. No, my customers are now the people I am going to transfer the ownership to.

Think of the people who flip houses. These people find a distressed house, fix it up, and quickly flip it to someone else at a profit. These people have no intention of ever living in these houses. These people to not make investments which are in the best long-term interests of the house. Instead, they focus on superficial cosmetics (how nice the lawn looks—curb appeal) which make the house more appealing to the next buyer. Let the buyer beware!

Many of the businesses of the future will be operated the same way as house flippers. The original owners have no intention of sticking around long term. They are not incented to do what is best for the company long term. Instead, effort will be placed on the superficial cosmetics which increase the appeal to the next owner. Things like how many visits there are to the site (which may be adding no value but be appealing to future owners) will be focused on rather than building a viable long-term business model (the source of cash flows). Let the buyer beware!

Now you might think that future owners would still be fixated on cash flows. They may say so, and they probably should be, but that is not necessarily reality. With all of the well-financed hedge funds and deep-pocket companies out there right now, there is too much money chasing too few great opportunities. As a result, the rules of supply and demand overtake the rules of cash flow. Businesses get bid up beyond appropriate cash flow values due to supply and demand.

In addition, keep in mind that the next owner may not be a final owner, either. They may be purchasing the business in order to quickly flip it to a third buyer. Look how many businesses are taken private (new owner) just so that it can be flipped back public again a few years later (third owner). Therefore, the new owner may be just as disinterested in everyday operations as the old owner.

So What Should We Do?
If this is the case, then what should we do? If you are the owner wanting to flip the business, look for places where supply (companies) and demand (potential new owners) are in your favor. Focus on things which impact desirability at time of sale rather than fixating on cash flows.

If you are the buyer of businesses, spend more time looking beyond the hype to understand the fundamentals. Warren Buffett always puts more value on business fundamentals than on the magic of pushing around numbers in a spreadsheet. If the basic fundamentals of the business are solid and the business model is solid, then good things usually happen (regardless of the numbers).

Unfortunately, the reverse is often not true. You can make a pretty model with nice numbers, but end up with a disaster because the assumptions are not based on solid fundamentals. Without a solid underpinning, a completed cash flow model may not be any more valuable than a completed Sudoku puzzle.

This is not to say that cash flow puzzles should be abandoned. They are still a valuable tool. Think of them as like the speedometer on an automobile. If you glance at them every once in a while, they can be very useful. But if you stare at them constantly (and fail to look out the window), you will end up in a crash. Rather than agonizing over them to the utmost detail, just use them to check for broad reasonableness.

As value creation shifts more towards ownership transfer and less towards operational cash flows, the value of cash flow tools also diminish a bit. More thought must be given to supplementing such analysis with deeper looks at either the fundamentals of the business model (if a buyer) or the tricks to increasing appeal to a buyer (if a seller).

Sudoku is played by a narrow set of rigid rules. This makes it easy to know if you have won. By contrast, strategy is played using a wide set of vague rules. As a result, in strategy you can solve the puzzle, yet still lose the game. Don’t assume that strategy is a simple as filling out a few spreadsheets.

Friday, January 14, 2011

Strategic Planning Analogy #371: Strategy by Spying

Back in December, I visited the Museum of Communism in Prague. It was a very interesting museum. One display talked about all of the spying that was done back around the 1950s. The Communist governments in those days did not trust the loyalty of their people, so they continually spied on their citizens in order to assess their loyalty.

The museum showed examples of some of the spying devices used back in the 1950-60s. There was a special camera mounted onto a rifle frame for taking long-range photos. There were also all kinds of tape recorders. However, the most common form of spying was by just getting people to talk to officials about their neighbors.

This was a very expensive and labor intensive program, and the results were usually not very meaningful. Therefore, the spying on citizens by the Communist governments was eventually scaled way back.

Today, it’s a lot easier to know what’s on people’s minds. All you have to do is go to their Facebook page, listen to their Tweets on Twitter, or visit their blog. People today seem willing to volunteer all sorts of intimate details about their lives and their passions—for free. Burglars know exactly when it is safe to break into people’s homes because it is so easy to track where people are.

With data so easy to obtain, it kind of takes away the fun of being a spy.

The communist governments did not get a very good return on all the investments they made into spying on their citizens. Yet today, many businesses are following a similar tactic. They are, in essence, using internet tools to “spy” on their customers. It may be wise to ask if the returns on those investments are worth it.

In fact, customers are so willing to share a dialogue with businesses that it can hardly even be called spying anymore. This has led to a business strategy approach I call “Do Whatever The Customer Says.” The reasoning behind the approach is as follows:

1) Companies succeed by serving the needs and wants of the customers.

2) Customers know what they want.

3) Technology makes it easy to find out what they want. It’s hardly even spying anymore.

4) So use the technology to find out what the customers want and then give it to them. In other words, the strategy becomes “do whatever the customers tell you.”

Unfortunately, these premises are wrong. As a result, the conclusion is wrong. And just as the communists eventually figured out that managing a county by spying on their countrymen was not very effective, companies will eventually figure out that managing a business by spying on their customers is not very effective, either. Just because it is easier does not make it better.

The principle here is that although much benefit can be gained by staying close to the consumer and listening to them, this is not an effective way to create company strategy. There are two basic flaws to the “Do Whatever the Customer Says” approach to strategy.

First, companies do not succeed merely by serving the needs and wants of the customers. Instead, they succeed by having a viable business model. As we will see in a minute, these are not the same thing. Second, customers do not always know what they want, particularly when it comes to new and transformational ideas for which they have no prior exposure.

Therefore, if serving the customer is not necessarily the core of success, and the customer is not always knowledgeable about the best way to serve them anyway, then why put them in charge of determining your strategy?

Let’s dive into this a little bit more, to explain this in more detail.

1) Your Goals and Your Customer’s Goals are not Necessarily the Same
Customers’ goals tend to center around things like solving their problems, increasing their enjoyment, or enriching their sense of self-worth (status issues). By contrast, a company’s goals tend to center around things like making a profit, providing its investors with an adequate return on investment, or providing a great income (or status) for its management, etc. As it turns out, you can focus on meeting those customer goals (and succeed wildly), yet still not achieve the company goals.

For example, look at companies like Facebook and Twitter. Both are wildly successful at meeting an aspect of consumer goals. Large sectors of society love them and use them all the time. However, neither company is providing an adequate return on investment. And unless these companies change their business models, I highly doubt they will ever achieve an adequate return on investment.

At the current time, the Facebook and Twitter business models are broken. They will not lead to the types of returns necessary to pay back their investors at an adequate rate relative to the size of their investments (particularly the latest investments in Facebook brokered by Goldman Sachs). And, for the most part, the users do not care about the fact that Facebook and Twitter have broken business models. In fact, they like many of the reasons why it is broken, because the lack of adequate monetization makes the businesses “free” and more consumer-friendly.

Many of the ideas which have been thought of to “fix” the business models of companies like Facebook and Twitter require monetization schemes which the customer does not want. And the consumers have made it clear that if the business model is tweaked too much against them, they will bolt, en masse, to an alternative which does not impose those negative constrains on them. With all the cash-rich investors out their looking for the next “Facebook” or “Twitter”, a start-up with the old broken business model will be well funded and replace them, leaving Facebook and Twitter in the dust if they monetize improperly.

The point here is that just pleasing the customer is not good enough. Pleasing the customer does not necessarily lead to a long-term successful business. Businesses need a viable business model in order to succeed. And since customers really don’t care all that much about your business model, they are the wrong people to ask to develop that business model for you. Their advice will lead to a business model which maximizes their concerns, not yours. And that will lead to financial ruin.

Yes, a successful business model depends upon having customers willing to patronize it, so you cannot ignore their needs and wants. However, if your business model is solely based on doing whatever the customer says, it most likely will not succeed over the long haul. This is because their goals are not the same as your goals.

In other words, you cannot abdicate business model development to the consumer. You must control it internally. You need to make the tough decisions—the difficult tradeoffs—which balance the needs of the customers against the needs of the company. You cannot always give the customer everything they want, because they will want it all and they will want to pay less for it than it costs you to deliver it. These are tough issues to deal with, and require sophisticated strategic planning (and serious thinking time) to resolve. The answers will not come from a quick question broadcast to your customers.

2) Customers are Poor Sources for Transformational Ideas
The second problem with abdicating strategy to your customers is that fact that they are not the best source for creating something new within the unknowns of the future. Customers, for the most part, are focused on near-term concerns. The problems of today are more than enough to occupy their mind.

If you ask a customer what you should change to be better, most of the answers will be incremental improvements to what already exists. In other words, they can tell you how to tweak the status quo. However, they rarely have the insight to create the next great paradigm shift. Consumers have almost never begged for what became the next big revolutionary thing before it occurred. Consumers didn’t beg in advance for the Apple iPod business model or the iPhone Apps Store. Consumers didn’t beg in advance for the Google search algorithm. Consumers didn’t beg in advance for Facebook. They only reacted after it was presented to them.

Why? Customers are great at telling you what bothers them about things they have experienced. However, they are not that good about discovering things for which they have no prior experience. They have not yet experienced the future, so they are not good at articulating the best way to approach the unknown.

Consumers are too busy trying to live today’s life and cope with the current crisis. Their lives are preoccupied just trying to stay afloat while swimming in the current red seas. They are too busy to imagine for you some yet-to-be discovered blue ocean. If you find it, they may follow, but they will not find it for you.

Their job is not to preoccupy their time pondering revolutionary new ways for you to make money off of them in the future. They do not have the time nor the inclination to do so. That’s YOUR job. YOU need to devote the time and energy into envisioning a better future. You can use the customer as a sounding board to evaluate your visions, but don’t use them as the primary source of your vision.

Envisioning a radical new future takes the time and effort that will only occur if you proactively devote meaningful amounts of internal resources to that effort. It will not come by merely asking a question to your customers.

While it may be true that it is impossible for a company to succeed if it does not please customers, it is equally true that it is impossible to succeed if all you do is what the customer tells you. First, the company’s needs are not identical to the customers’ needs, so if all you focus on is the customers’ needs, you may not fulfill the company’s needs. Second, customers may be good at providing incremental improvements to the status quo, but they are not well equipped at inventing a radically new paradigm for you. Therefore, Strategic Planning should not be abdicated to the customer. This is your responsibility and you need to be proactive at it, devoting sufficient time and effort to the cause.

The Museum of Communism showed that even with all the power behind the communist system, it could not endure, because it was a flawed model. Similarly, all your power will not save you if you have a flawed business model. Eventually, you will fail like Communism. This task is too important to be left entirely to the consumer.

Monday, January 3, 2011

Strategic Planning Analogy #370: Infrastructure

Although China and India are both large countries with rapidly growing economies, there are many differences in how the countries operate. One of those areas where countries differ is in the approach to building the national infrastructure (transportation, utility grid, etc.).

In general, China has tried to get in front of the issue by attempting to build the infrastructure in advance of growth. The idea is to anticipate future needs and build the infrastructure prior to building the economic elements which will rely on that infrastructure. By building extra capacity into the infrastructure in advance, China believes that the infrastructure can be built more efficiently. In addition, by building in extra capacity, the Chinese hope that economic growth will continue to remain strong, since the economy is less likely to be held back by a lack of infrastructure.

By contrast, India tends to have more of a tradition of chasing the economy with its infrastructure. The current infrastructure tends to be left in place until economic growth stretches the infrastructure to near its capacity (or a bit beyond). Then the Indian government steps in and tries to upgrade to infrastructure to catch up with near-term capacity. Unfortunately, by the time the upgraded infrastructure capacity is in place, the economy has already outgrown this capacity, so the infrastructure rarely ever catches up with demand.

Both approaches to infrastructure have their plusses and minuses, and taken to an extreme, either approach can lead to problems. However, most experts would say that a more proactive approach to infrastructure (similar to China) is preferable to a reactive approach (similar to India).

Just a countries need to build an infrastructure for their economy, companies need to build an infrastructure for their businesses. A company’s infrastructure would include things like:

1) Manufacturing Capacity
2) Distribution Network
3) Sales Network
4) Intellectual Capacity
5) A Sufficient Amount of Adequately Trained Labor
6) Access to Raw Materials in Sufficient Amounts at Competitive Prices
7) Access to Customers
8) An Adequately Filled and Functioning Innovation/New Product Pipeline

Unfortunately, it seems that a lot of companies take more of an approach like that of India when it comes to their infrastructure, rather than following the approach of China. There is this idea that the only “good” infrastructure is a “lean” infrastructure, and that every cost which can be driven out of infrastructure should be driven out. Additional infrastructure expenditures are never spent in advance and are instead always trying to catch up with current needs. As one can see by looking at many of the problems facing India, such an approach can become costly and counterproductive.

Now I’m not advocating big, bloated, bureaucratic infrastructures. Waste is never a good thing. However, if you do not feed your business with an adequate infrastructure, you will starve the business and limit your ability to grow and prosper.

You may have the greatest business idea in the world. But if you have no way to get adequate amounts of raw materials, or no way to manufacture adequate quantities, or not enough qualified employees to product sufficient quantities at the required quality level, or no way to get the goods to the customer in a timely manner, then you will most likely fail. At the very best, you will far less prosperous than you would have been if that entire infrastructure had been in place.

The principle here is that infrastructure concerns should be an integral part of a strategic plan. If the business infrastructure is not of sufficient capacity to meet the demands of the plan, then you will not achieve the plan. For example, having a strategic goal to sell a billion dollars worth of goods is a worthless goal if your infrastructure can only support the production, distribution and selling of a thousand dollars worth of goods. To win, you need an infrastructure with the capacity to achieve what you desire. And the only way to achieve that is by putting infrastructure capacity concerns directly into the plan.

To those who prefer to chase after infrastructure like India, I have the following responses.

A) You Do Not Operate In A Vacuum.
In most cases, there are other companies operating in the same space as you are, trying to give the customers a similar solution. If the competition invests in adequate infrastructure and you do not, then they will be in a superior position to capture most of the demand. For example, I know of a retailer who refused to adequately reinvest in their store infrastructure. Their stores became old, ugly and in disrepair. The customers had moved to newer and nicer neighborhoods, but the stores were stuck in the old, decaying neighborhoods. At the same time, competition built nice, new stores in the better, newer neighborhoods, closer to the customers. As a result, the customers defected to the competition—because they had the superior store infrastructure.

B) Human Capital Is Fluid.
In today’s knowledge-based economy, a key part of one’s infrastructure is the knowledge in your employees’ brains. Unfortunately, that employee is relatively free to leave your company at any time. When that employee walks out the door, a lot of your intellectual capacity leaves as well. That is why Google treats its employees so well, spending money on things like free food, and recently giving everyone a 10% raise in pay. Google realized that was money well spent if it keeps that intellectual capacity in place at a time when other companies are trying to hire that capacity away from them. The patience level of employees only goes so far. If you wait to long to reward them, or deny them the tools they need, they will leave.

C) Playing Catch-Up Never Leads to First Mover Advantage
You can never build a leading edge if all of your investments in infrastructure lag behind the industry. Much has been written about the advantage of being a first mover. To be a first mover, one needs to get the capacity in place quickly. Apple had first mover advantage with the iPhone and iPad because it had the infrastructure needed to get to market well before the competition. Microsoft keeps failing in its attempts to catch up to Apple in these spaces, because its infrastructure is not built in a way which allows them the speed and creativity to win in these areas. You can read more about this principle here.

D) Spending More Up Front Often Costs Less in the Long Run
Many times, it is cheaper to spend the money to build a better infrastructure than to try to limp along on the “lean” process currently in place. For example, I know a retailer who refused to upgrade its outdated warehouse & distribution system. Yes, it would have cost money to do so, but the payback was less than a year. And the old system was so inefficient that it made it impossible for the retailer to make a profit on a large percentage of the products going through the old system. The inefficient costs in the old system wiped out much of the profits.

I know of another situation where a retailer liked to brag that it had one of the least expensive IT departments in the industry. Of course, it also had one of the least effective IT departments in the industry, which cost the company dearly. The bare bones IT operation starved the company of the data it needed to be competitive in the marketplace. Lowest cost infrastructure is rarely the most cost-effective.

E) Not All Infrastructure Solutions Are Costly
Some are reluctant to build sufficient capacity because they are afraid it will be prohibitively expensive, particularly in the near-term. However, there are often ways to get capacity without a lot of upfront investment. For example, one can arrange for outsourcing. There is a reason why so many companies in the US outsource their payroll infrastructure to ADP. It is a way to get a state of the art payroll infrastructure without having to make a huge up-front capital expenditure.

One can also come up with creative payment plans. For example, it is common for retailers to place both a fixed and variable component into their store rent. The variable amount of the rent goes up in proportion to store sales. By making part of the infrastructure cost variable, the retailer only has to pay the higher rent if it is justified (and affordable) with higher sales.

Just because one has access to infrastructure does not mean they have to own it. There are lots of creative ways to partner with others to get that access without a lot of up-front investment.

Strategic goals are only as good as the infrastructure capacity behind them. Without the proper infrastructure investments, one cannot reach one’s goals. Therefore, the strategic process needs to concern itself with infrastructure.

Remember, the ultimate goal is not to spend the least on infrastructure, but to make the most in profits. Wal-Mart is a very large and very profitable company. It did not get there by being cheap on infrastructure. They spent a ton of money on infrastructure, especially in IT, distribution and new stores. It would have been impossible for Wal-Mart to get as large as it has without that huge infrastructure investment. And, even though it spent more on infrastructure than any other retailer, it has one of the lowest cost structures in the industry. The investments caused Wal-Mart to be more efficient. It was money well spent.