Tuesday, July 22, 2014

Strategic Planning Analogy #533: Planning the Periphery

Last week I got bumped off an airplane in exchange for a ticket voucher discount for a future trip. I thought that was a pretty good deal until I tried to redeem it.

The airlines said I had to redeem it on their online site. Unfortunately, there was a flaw in the website making it impossible for me to redeem the voucher online. As a result, I had to call the airline on the phone.

After a terrible phone experience, I finally got an email notification of my transaction. There were two parts of the email that irritated me. First, they still had not corrected the problem. Second, they charged me a $25 service fee for using the phone to do my booking.

So I had to call the airlines a second time. It struck me that this was a pretty good deal for the airlines. By creating incompetency on their website and on the phone, they were able to create numerous $25 services fees they would not otherwise receive.

They were getting rewarded for incompetence as my travel voucher was becoming less of a deal.

Airlines have an interesting pricing strategy. They sell the seat ticket at unsustainably low prices and then make up the difference by charging all sorts of associated fees, like the $25 I had to pay for calling them on a telephone. They have other extra fees for things like luggage, earlier pre-boarding, seats with slightly more legroom, pillows, blankets, meals and a host of other things.

How did it get to this point? Well, the core business of selling a seat to get you from one airport to another became commoditized. Let’s face it. There is very little difference between the standard seat experience in one airline over another. If you closed your eyes, you’d never be able to determine which airline you were flying.

I remember one time flying from London to Germany. I was about to go up the boarding steps to the airplane door when I noticed that the steps had the wrong airline logo on them. At first I thought that I might be boarding the wrong plane. But then an airline employee came along with a magnetic sign with the right airline logo. He put in on top of the other logo. Voila! Suddenly I was going up the proper airline set of stairs.

But that’s how it is. The standard airline service is so commoditized that you could slap any logo on it and it wouldn’t make a difference.

And we all know what happens when a core service becomes commoditized. The only way to create a preference is by lowing the price. So all the airlines lowered ticket prices to unsustainably low levels.

Since the airlines could no longer make a profit on the seats, they had to get the money somewhere else. That’s why I had to pay $25 to make a phone call to complain about a defective website.

And the point of this blog is that nearly every industry is moving in a direction towards this airline pricing model. Core businesses in numerous sectors are becoming commoditized. If you cannot come up with ways to make money on the periphery of your business (like charging for phone calls), you will have an unsustainable business model.

The principle here is that in industry after industry, the core business is becoming commoditized. The commoditization is causing core businesses to be priced as a “loss leader.” To remain viable, one has to get nearly all of the profit from non-core elements on the periphery. So, ironically, one’s strategy may need to be more focused on the periphery than the core if one wants to succeed.  So much for all that literature on “sticking to one’s core.”

Fast Food Example
This is not just an airline problem. Look at the fast food industry. The basic hamburger is commoditized. All the major fast food restaurants sell the core hamburger at a loss.

With the core product priced at a loss, the only way to make money is by focusing on the periphery. So McDonald’s adds fancy coffees and fruit smoothies. They all start putting a slice or two of bacon on everything so that they can charge a premium price. They push the higher margin fries and beverages. They try to get you to upsize to a larger combo meal and to add a dessert.

This is their version of what the airlines do. They come up with all sorts of peripheral things to charge you for, because the core item on the menu (the hamburger) can no longer make it on its own.

Or how about the cable TV industry?  Cable TV in the US is commoditized. They all give you essentially the same channels in the same way. When watching your favorite show on TV, the viewing experience is identical, regardless of the cable company piping it to your screen.

As a result, US cable TV companies can no longer price their core TV business at a profit. The only way to earn a profit is by focusing on the periphery—phone service and internet service. Cable TV service has become a loss leader in order to sell the periphery.

In a similar fashion, phone companies sell talking over the phone at a loss and have to make it up on peripheral services like data transfer.

In social media, it is quite common for companies to give away the core business for free and then try to recoup their losses in sales of peripheral features to peripheral customers (think of LinkedIn). It’s called the “Freemium” model. It is very common in gaming, where the core game is free and you pay for periphery features which help in the game experience.

It’s common for digital companies to use the word “monetization.” It is their way of saying that they have to give away the core for free in order to build out network to a critical mass. So, to make a profit, you have to create a secondary strategy for collecting cash—the “monetization.”

When you try to buy something at the store, they try to get you to pick up impulse items at the checkout, get the extended warranty, add on the optional extras, get a matching belt for the pants, and so on. Why? Because the core products are not profitable. The money is made on the peripheral goods. Even big ticket items like cars are sold this way.

I could go on and on, but you get the idea.

So what should a strategist do? Well, first one can try to fight the commoditization by creating uniqueness at the core. It can be difficult, but some can succeed. I’ve talked about this in a prior blog. The problem is that if everyone starts adding the same “uniqueness”, then that becomes a commodity as well.

Therefore, one should seriously consider the periphery while developing the core strategy. The periphery strategy may be even more important than the core strategy. After all, if the core truly is commoditized, all you need to do is copy industry best practices and build scale to get credibility at the core.

It is in the periphery where you not only get a chance to make extra margin. It is also the place where you have the best shot at creating differential advantages. The periphery is where you have a shot at creating a sustainable reason to be preferred over the competition.

For example, Comcast has a reputation for absolutely horrible customer service. A cable TV competitor can take the peripheral element of customer service and create a meaningful advantage over Comcast. Southwest Airlines has created an advantage by treating the peripheral business of baggage differently from its competitors.

Apple tries to get around commoditization in smartphones through the unique peripheral features in the closed system it attaches to its phones. All along, it has been the closed systems circling on the periphery (like iTunes) which have made all the Apple innovations truly successful.

So the periphery may not be at the core of the industry, but it is probably at the core of what helps you to win and make a profit. So treat it accordingly when doing your planning.

There is a tendency for the core business of all industries to become commoditized and/or become a loss leader in price. As a result, if your strategy only focuses on the core, you will most likely never achieve sufficient profitability to make your business a financial success. Real profit tends to come from the periphery, where there are more opportunities to enhance your margins. As an added bonus, the periphery also often is the best place to create meaningful differentiation. With all those potential benefits coming from the periphery, one should not leave the periphery to chance. It needs strategic planning emphasis as much as the core, if not more.

I know a lot of social media companies have a singular focus on building out the core. They say they will get around to figuring out how to monetize it later. That’s like saying I have a great strategy, except that it does not provide me with a differentiating position or a way to make a profit. You’d never settle for a strategy like that. Why would you settle for a business like that?

Friday, July 11, 2014

Is the Christensen Halo Slipping?

Christensen Criticism
Harvard Professor Clayton Christensen is considered by many to be one of the modern great minds of business theory. His 1997 book, The Innovator’s Dilemma, was called by the Economist magazine in 2011 one of the six most important business books ever written. That’s high praise.

However, in the June 23, 2014 edition of the New Yorker magazine, fellow Harvard professor Jill Lepore writes a scathing criticism of Christensen’s seminal work (read it here). Perhaps in an attempt to overcome the damning nature of that New Yorker article, the July-August edition of Harvard magazine has a glowing defense of Christensen’s work (read it here).

The Criticism
So what does Lepore say about Christensen’s work that is so damning? Basically she says two things:

  1. The facts don’t back up Christensen’s theory.

  1. Even if the theory is true, it is relatively useless because it does not predict what type of behavior to take. In other words, there is no advantage to knowing the theory, because it only can explain the past, not predict the future. It is like someone who can tell you in great detail why the stock market did what it did yesterday, but has no clue about what it will do tomorrow. Lepore backs up this claim by pointing out that Christensen’s venture capital fund designed to exploit his theories from the Innovator’s Dilemma was a failure.
Although Lepore’s argument may not be as rock solid as she wants you to believe it to be, it is still very damning to Christensen’s legacy.

Another Chink in the Armor
I first started having my doubts over the “genius” of Christensen back in 2011, when I read an article of his latest “discovery” on the Harvard Working Knowledge website (read it here). I was flabbergasted that Christensen thought he had come up with another brilliant new insight, which looked to me like something that could have come out of an introductory marketing textbook.

He was acting as if he invented marketing. It reminded me of something a radio DJ recently said: “Miley Cyrus acts as if she invented sex.” It makes a person look silly when they act as if they invented something that everyone else knows has been around a long time.

I started thinking, how could Christensen be such a genius in understanding how businesses rise and fall if he hasn’t a basic understanding of marketing? I wrote a blog on the topic here.

Stay Away From Extremes
The reality is that Christensen is not as bad a bum as Lepore says nor as much a genius as Harvard magazine says. And even if much of what Christensen said is not new (a lot of the Innovator’s Dilemma ideas harken back to earlier work by others, such as Schumpeter’s “creative destruction” a half century earlier) it is still valuable work, because it got people to focus on an important topic.

My Core Learnings
My interpretation of the key takeaways from the innovator’s dilemma thinking is this:

  1. Business leaders have a vested interest (and bias) towards protecting and growing their key sources of profitability. 
  1. This causes them to:
    1. Go on the offensive by continually making incremental improvements to their key sources of profitability.
    2. Go on the defense by aggressively counteracting any direct competitive threat to their key sources of profitability.
  1. Unfortunately, the biggest threats are usually indirect, coming from radically different solutions which are unlike the status quo.
  1. Incremental improvements to the status quo won’t save them from the radical new innovation (for example, you can never make carbon paper incrementally better enough to overcome the threat of photocopy machines). And because the attack is indirect, the innovation is relatively immune from the traditional defense.
  1. The best response is to move away from the status quo and embrace its radical replacement. However, to do so requires destroying much of the current profitability within the status quo. That is a difficult undertaking to get approval for. As a result, the future usually goes to the one with no vested interest in the status quo.
  1. The key takeaway: The new is going to destroy the old. If you let someone else destroy your old, you are left with nothing (think Kodak and film). If you destroy your old, at least you have a chance of being left with the new. So overcome your fear of creating your own obsolescence, because obsolescence is inevitable and it’s better if you do it to yourself than to have it done by others.
These six takeaways are highly valuable, even if not new. The problem is that people have read far too much more into this concept. And that is when you get into trouble. Knowing that the new will eventually replace the old does not mean that you can always correctly know which new thing is going to do the replacing. Most new things fail. Therefore, one has to be very careful when making choices about what new things to bet on. And that is where the true genius lies.

Final Thoughts
We get into a lot of trouble when we label people as business messiahs. Eventually, they will not live up to all the hype and will disappoint us. But that doesn’t mean that we should throw away everything associated with them. Useful ideas are still useful, no matter the source. Just don’t read too much into them and think that a single idea solves everything.

Monday, July 7, 2014

Strategic Planning Analogy #532: Planning for Others

Years ago, I worked for one of the largest grocery wholesalers in the world. They were very proud of being the best place for small, independent grocers to get their food supply. This wholesaler continued to put its effort behind becoming even better at supplying groceries to small independent grocers.

There was only one problem. Small, independent grocers were disappearing at an alarming rate. The growth of large supermarket chains and Walmart Supercenters were squeezing the small independent grocers out of business. And many of the more successful, larger independents were being acquired by the large supermarket chains.

As a result, the customer base for this wholesaler was shrinking away. It really doesn’t matter how proud you are of serving your customer if your customer is disappearing. Being the best at serving a non-existent customer isn’t much to be proud of.

Strategists and business leaders work very hard to position themselves for success. They find a place where they can win and then work diligently to improve their ability to deliver that winning position.

The problem is that businesses do not operate in a vacuum. A company’s success is also dependent upon external factors, like customers and suppliers. If your customers and suppliers are going out of business, it really doesn’t matter all that much how well you are executing your strategy. In spite of all your internal efforts to greatness, your strategy will fail if your external partners fail.

In the story, the company I worked for was trying ever harder to perfect a business model designed to service small independent grocers. As the small independent grocer was shrinking away, so was the relevance of the wholesaler’s strategy. Better execution of that strategy would not ultimately turn things around. Even a perfect wholesaler for small independents will fail if its customers go away.

This is true for any organization which relies on having suppliers and customers (which would include nearly all organizations). For your plan to succeed, you need those partners to succeed.

The principle here is that our planning efforts must not just myopically focus internally on our own company. We need to broaden our planning to create strategies to ensure the success of our partners, be they suppliers or customers. If we do not actively plan to help others, then our own well designed and well executed internal strategy may collapse.

We should not rely on luck that our partners will do okay. We should actively plan for their well-being along with our own.

Department Stores
This is not a new concept. Department store owners in the 19th century spent a lot of time away from their stores and focused on boosting the economy of their local community. Why? They knew that if the local economy was strong, the sales at their department stores would be strong. Conversely, if their cities became weak and the population shrank, then their department store sales would shrink.

Therefore, the department store owners spent a significant amount of their planning time planning for their cities. They wouldn’t take the health of their customer base for granted. External planning for the city was as important as internal planning for the department store.

Automotive Industry
Early in the 20th century, Henry Ford did something similar for the automotive industry when he dramatically raised wages for his factory workers. There were many reasons why Henry Ford dramatically raised factory wages, but one reason was very relevant to our discussion: You needed a middle class income to afford a Ford automobile.

By setting a new wage standard, Ford was moving factory wages to middle class levels. Therefore, as others followed Ford’s wage example, Ford was dramatically increasing the number of people able to afford to buy one of his cars. Ford was proactively planning his customers.

Over the decades, the automotive industry seemed to forget this principle. The industry started squeezing their suppliers harder and harder. They didn’t care how much they were hurting the suppliers as long as it helped their internal bottom line. And then came the great recession and the suppliers started going bankrupt. On top of that, the great tsunami hit Japan around the same time, wiping out even more suppliers to the automotive industry.

Because the automakers did not adequately plan alternative sources of supply or other backup provisions, they suffered along with their suppliers. Assembly lines were shut down for extended periods.

Modern Technology
As we all know, modern technology is very disruptive to the status quo. Suppliers and customers appear and disappear rapidly. Being a great traditional travel agent didn’t mean much when their customer base disappeared and went directly to web travel sites. Building a near-monopoly in phone books isn’t worth much if nobody is demanding them due to superior digital information alternatives.

So What Should You Do?
There are three strategic alternatives when planning for your partners. The first is to alter your internal strategy to improve the health of your partners. For example, the grocery wholesaler I worked for knew that the small independent grocer would be stronger if it could be placed in retail formats that competed less directly with Walmart and the big chains. Therefore, they developed these types of formats and reinvented a portion of their wholesale operations to optimize under these new formats. It was a different way of doing business than in the past, but it created a business model that was better for both the independent retailer and its wholesaler.

The second alternative is to alter your strategy to move to where your partners are moving. Netflix redesigned its strategy when customers who wanted DVDs in the mail were moving to getting their movies from the internet. By shifting quickly to an internet option, Netflix migrated at the same pace as their customers, so they were able to keep them connected to the Netflix brand.

The third alternative is play the end game. As a market shrinks, you can consolidate what is left and then cut costs until one can make a profit. This is happening in many processed foods, where growth has disappeared. The original players, like Proctor & Gamble have gotten out of the business and moved to newer growth businesses. In their place are companies like Pinnacle Foods, who are buying up all these brands and playing an endgame.

The grocery wholesale company in the story also played an endgame with many of the traditional independent grocers who were left and did not migrate to the new formats. Although there are far fewer of these independents, the wholesaler has less competition for their business, so it can still create a meaningful business with them.

Common Approaches
Regardless of the strategic outcome, there are common approaches to success.

1)     Don’t just look internally at optimizing your own piece of the puzzle. Optimize the whole puzzle.
2)     Keep an eye on the external environment to understand when market shifts not only impact you, but also your partners.
3)     Treat your partners as partners, not enemies. Be willing to plan jointly and share information for the betterment of all.
4)     Be willing to abandon or modify a strategy when customers and suppliers are at risk of going away.

Businesses do not operate in a vacuum. Therefore, their strategies should not be developed in a vacuum, either. Don’t just plan your internal affairs. Consider plans for your customers and suppliers as well. And if they are moving away from your core business, you may need to change your business to follow them. After all, a “perfect” strategy for a customer who ceases to exist is really not perfect at all.

If you develop a win-lose proposition with your partners, eventually your partners will go away. Instead, build a win-win situation with your partners. That way, you can feed off each other’s success and succeed together for a long time.