Wednesday, January 2, 2013

Strategic Planning Analogy #482: Owning Vs. Driving

In automobile racing, the drivers get all the glory.  They are the heroes; the ones who get in all the photos and are adored by the race car fans.

Yet are the drivers really all that special?  Most are mere employees of large race car companies.  They don’t own the car they drive in the races.  Heck, they don’t even own the clothes they wear while driving.  Both the clothing and the cars are covered with decals and logos of the company sponsors who invest in these large racing enterprises.

Winning in car races requires more than just drivers.  There are the car designers, the pit crew, and a whole host of others.  Yet the glory goes to the one driving the car.

In an episode of The Simpsons, there was a child’s race of coasting “soapbox derby” cars down a hill.  While all the boys were clamoring to be the drivers, one of the coaster car designers lamented, “It’s all in the design.  The drivers are basically ballast in these cars.”  Yet the drivers get the glory.

The drivers don’t own anything but they get all the glory.  That’s because, to most fans, it’s not who owns the car that is important, but who drives it. 

A similar idea applies to all businesses.  Many business leaders seem possessed with the idea that their company has to own a lot of things.  They are constantly involved in a wide variety of acquisitions and other M&A activity.  They focus on building a portfolio of owned businesses.

Yet is ownership really all that important?  In auto racing, the glory goes to the one who drives the car, not the one who owns it.  Similarly, as long as your company is driving the way an industry works, does it really need to own that many pieces of the industry?

The key is not ownership, but control.  And as long as you are in control (behind the steering wheel), you can have as many people putting their logos and decals on the venture as they want.  Because it is the driver who gets the biggest prize.

The principle here has to do with control.  Those who control how an industry or business ecosystem works control how the money flows.  So a business with more control can make more of the money flow to themselves.  

Increasing ownership does not necessarily lead to increasing control and increasing profitability.  In fact, as we will see later, increased ownership can actually reduce control and profitability.

There are many alternatives to ownership, including alliances, joint ventures, partnering, outsourcing, buying on the open market, and a host of contractual arrangements.  These can often lead to greater control and greater profitability than ownership.  If you do these types of arrangements properly, you can be in the driver’s seat for the industry—and get the glory (and the biggest prize).

Problems With Transfer Pricing
Ownership can destroy control and profitability in many ways.  First, there is the problem of transfer pricing.  As an item moves through the pipeline—from raw material to the hands of the ultimate consumer—there are numerous places to transfer ownership, from the extractor to the part supplier to the assembler/manufacturer to the distributor to the retailer to the consumer. 

At each point along this chain a transfer price is negotiated.  Those with power control who benefits the most from how the transfer price is negotiated.  For example, Walmart is a very powerful part of many pipelines. When manufacturers sell to Walmart, I’m sure the Walmart does much better on the transfer price than do the manufacturers or other retailers negotiating with those same manufacturers.

A problem can frequently occur, however, if a company owns too many parts of that pipeline.  If they forward and backward integrate significantly through acquisition, they can end up owning most of the transfer points.  In essence, the company ends up negotiating with itself.  Therefore, the fully integrated company cannot use control, power and leverage to extract above average returns through transfer pricing.  After all, if you own both sides of the negotiating table, if one side wins and the other loses, you are no further ahead in total, because you own the winner and  the loser in the negotiation.  In other words, the extra ownership reduces your control over how the money flows in transfer pricing.

Problems With Alienation
The mere fact that you own an additional piece of the supply chain can destroy the value of what you have purchased due to the reaction of others.  For example, let’s assume you buy one of your suppliers—someone who was a supplier to you as well as some of your competitors.  Those competitors, who were happy to purchase from that supplier before you owned it, may no longer want to use the supplier after you own it, because they don’t want to give business to their competition.

For example, when Walmart purchased McLane Distribution, it thought it would gain knowledge of fast moving consumer good distribution in groceries.  What they failed to consider was how many convenience store customers would drop McLane as their supplier because they didn’t want to help Walmart.  Walmart had to sell McLane in order for McLane to keep its customers.  So, by owning McLane, Walmart destroyed McLane’s power to control its other customers.

Problems With Focus
The more diversified your ownership, the less focused one tends to be.  It takes considerable effort to be state-of-the-art at everything all the time.  There are more opportunities to slip up.  However, if you keep your sphere of ownership smaller, you can specialize at being the very best in a narrow focus.

There are reasons why people outsource things like payroll and IT and other back-office functions to specialists.  That way, they know that there is someone whose whole livelihood is based on being the very best in that area doing the work for them.  Specialization makes those outsourcing firms more powerful and it allows their customers to focus on the areas more critical to their success.  It is a win win.

Nike and Apple
Nike and Apple are two firms which avoid a preoccupation with ownership and instead preoccupy themselves with control.  In both cases, Nike and Apple focus on only two areas—design (business model and product design) and consumer image.  Pretty much everything else is outsourced (including the making of the products).  Nike and Apple own the key drivers for their whole ecosystems.  It puts them in a powerful position to drive how the rest of the entire ecosystem operates, even though they don’t own it.  And both are doing well.

Apple is able to focus in on what matters and leave the rest to the other experts.  And because it is the driver, it negotiates tough deals.  Just ask anyone in media who has had to deal with Apple.  By contrast, Sony tried to own everything—from design to manufacturing to even trying to own the media.  The added ownership worked against Sony.  They lost focus and could not win the battle on transfer pricing.  Worse yet, even though it owned most of the parts, Sony did not build as integrated a business model as Apple.  So Apple—owning fewer of the parts—created a superior integrated model.  Apple was like the race car driver—they didn’t own the car, but they made it go in the right direction because it was their hands on the wheel.  And now, Apple is very profitable and Sony is struggling.

The key implication of all this is that ownership should not be the automatic default option when looking at how to gain an element for one’s strategy.  In fact, there are so many reasons why other alternatives may be superior that acquisition may need to be the option of last resort.  Ownership may need to become the exception, not the rule.

Before jumping to the conclusion of ownership, check to see if there are ways to gain control without the need to own.  Find a way to drive someone else’s car and steal the glory.

And finally, instead of focusing on how to do M&A deals, focus on how to do non-ownership deals in such a way they you get to be the driver.

When developing strategies, one often finds a need to add certain elements in order to succeed.  But just because you need them does not mean that you have to own them.  It only means that you have to control them.  And in many cases, you gain more control and more profitability if you do not own them.  Therefore, do not automatically default to acquisition as the way to get what you need.

A read a study recently which looked at businesses and their level of successes with acquisition, partnerships and building from scratch.  Their conclusion was that acquisition tended to produce the least amount of success when compared to building or partnering.  Their conclusion was to only acquire when building or partnering didn’t make sense.  That sounds logical to me.

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