Wednesday, December 26, 2012

Strategic Planning Analogy #481: Law of Extremes


Back about 40 years ago, Wal-Mart had not yet fully cemented its image as a low cost leader.  Other retailers were still challenging Wal-Mart on price supremacy.  One of those chains was TG&Y variety stores.

TG&Y decided to get into a price war with Wal-Mart.  The item chosen to go to war over was a pair of jeans.  TG&Y would lower the price on jeans and Wal-Mart would retaliate with an even lower price.  This pattern continued for many rounds.

Eventually, Wal-Mart dropped the price of jeans to 9 cents a pair.  At that point, TG&Y gave up and stopped the price war.  Wal-Mart had won supremacy on price, and not too long thereafter, TG&Y ceased to exist.

Yes, 40 years ago, you could buy a lot more for 9 cents than you can today.  But even 40 years ago, 9 cents was an unrealistically low price for a pair of blue jeans.  Every jean sold at 9 cents would be a huge loss for Wal-Mart.  But that was the sacrifice Wal-Mart had to make in order to win the image of price against TG&Y.

Times may have changed in the last 40 years, but this type of activity still goes on.  Business leaders understand the value of owning an image and will go to extremes in order to win that image.  This seems especially true on the internet. 

In order to create a large network, internet firms will go to great lengths to get people hooked into their system.  Most end up giving away their product for free.  Other go even further by “paying” people to get on-board, either with badges, coupons or some other form of promotion.  It’s hard to make a living if you have to pay people to use your product.

And it’s not just price where companies go to extremes.  Luxury automobile brands are fighting against each other to own the word “luxury.”  They keep upping the ante by adding ever more exotic features to their automobiles.  At some point, even many luxury auto buyers will balk at paying the premium so that auto makers can get an adequate return on investment for these exotic features.

For most auto dealers, the maintenance area is among its most profitable areas, even more profitable than selling cars.  But, to increase the luxury treatment experience, many luxury dealers are throwing in maintenance for free.  Now, they’ve cut off a key source of profits.

The world is very competitive.  It takes a lot to dramatically own a position in that competitive market.  Every winner has to go to extremes to own their position, be it in price, luxury, service, convenience, technological innovation or whatever.  It’s as if the whole world is becoming the equivalent of 9 cent jeans—a world where the only way you can win is to create a costly, unsustainable extreme.

How do you create a profit if the entry level cost to achieve a winning position is unsustainably high?  That requires a sophisticated strategy.

The principle here has to do with what I call the Law of Extremes.  It is one of my 23 laws of strategy.  (I know I said in an earlier blog that it was 22 laws, but I’ve since added another law.)  The law of extremes goes like this:  “Creating performance levels needed for ownership requires trade-offs and subsidies.”

Another way of saying this is that when the core business can no longer sustain the extremes, you have to:

1)      Add secondary businesses (called subsidies) to provide cash to cover the extremes; and/or
2)      Subtract secondary activities which take away cash from the building the extreme position (a process called trade-offs).
We will look at each of these separately.

Subsidies are non-core activities or businesses which are principally done only to fund the core.  An example of this practice is the “Freemium” model used by many internet businesses.  The idea is that the core business is free.  Yet in order to afford to give away the business for free, a small subset (often under 3%) pay a price in order to get premium extras.  In other words, around 3% of the users of the internet site subsidize the activity of the other 97% so that the site can make money.  Many internet sites use a freemium model like this, including Linkedin and Pandora.

Another subsidy common on the internet is to use advertising.  If you cannot get the users to pay for your extreme pricing position of free, then you have to get advertisers to pay for the site.  Another subsidy example is when internet sites sell information about you to other business that would pay for that information (watch out when companies put cookies on your device—it can be their door to a subsidy business selling your behavior).   

This subsidy phenomenon also occurs in the retail space.  In consumer electronics, the pricing policies are very extreme, often selling the main items near or below cost.  To subsidize these prices, the retailers need to bundle profitable subsidy purchases to the transaction.  A familiar one is the extended warranty, which is often more profitable to the retailer than selling the item being insured.  Other examples are selling ad space on the screens of the computers being sold, selling extra ink with the printer, selling smartphone accessories, and so on.

This is also seen in fast food restaurants where the core hamburger is sold at a loss and is subsidized by the sales of more profitable french fries and beverages.  (I’ve gotten in the habit of buying a second burger instead of the fries in order to get a better extreme value for myself). 

The irony here is that in a world of extremes, the core business becomes almost like a loss-leader for the subsidy add-on businesses.  At some point, it’s hard to tell what is the real core business anymore.  IF the subsidies are where all the profits come from, does that become the new core?  The extreme image won with the traditional core could now be seen as a loss leader positioning to mask the real positioning, which is to be best at selling the subsidies.

It goes to show that business strategies are getting more complex.  If subsidies are not integral to your business model, the model may no longer work in a 9 cent jeans world.

If subsidies are about adding income to the business, then trade-offs are about subtracting costs from the business model.  The principle behind trade-offs is as follows.  If you try to be all things to all people, you will probably never obtain an extreme position on anything.  For example, if you try to be the highest quality, lowest priced and fastest in innovation, you will have to make compromises which will prevent you from being the most extreme in any of these attributes.   There will be specialists focusing on only price or only quality or only innovation which will be the most extreme and win the battle for these positions. 

Therefore, to win in one space, you may need to stop pouring money into other spaces, so that more money can be funneled to the space where you want to win.

An example would be extreme low price “hard discount” grocers, like Aldi, Save-A-Lot, and Lidl. They have prices substantially below conventional grocers—extreme enough to win the low price image.  Yet those low prices are sustainable because these firms make trade-offs.  They stop doing many things the conventional operators do which add costs.  Examples include:

1)      Smaller, Less Costly Assortments (only one brand in one size per category)
2)      Eliminating Lower Margin Branded Goods by Going Direct to the source to create their own brand.
3)      Large reductions in labor by not having service departments, not stacking products individually on shelves, etc.
4)      Lower rent by building smaller stores in less prime real estate.
By trading away variety, ambiance, convenience, selection and other such factors, they can divert cash flow from those activities into sustainable extreme prices.

Southwest Airlines is another example.  They make money when other airlines don’t because they do more trade-offs than traditional airlines.  Activities like only selling point to point tickets, refusing to sell tickets on third party travel websites, focusing on only one-sized plane, and other non-conventional approaches, they have eliminated a lot of costs borne by their competitors.  This allows them to focus on the things important to their image and still make a profit.

The idea with trade-offs is that your successes is defined as much by what you don’t do as by what you do.  Your strategy needs to delineate what activities go onto each list (the do’s and the don’ts).

In a highly competitive world, it takes extreme levels of performance in order to win a position.  Gaining extreme positions is costly.  In order to afford the cost and still make a profit, firms need strategies about subsidies and trade-offs.  Subsidies are the add-on activities which provide extra cash flow beyond the core.  Trade-offs take away activities which to not reinforce the extreme position in order to provide extra cash flow to invest in the extreme.

The things which “delight” the customer tend to “deplete” the cash of the company.  To remedy the situation, the company needs to “destroy” unnecessary costs and “deploy” subsidy businesses. And that is “de-truth.”

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