THE STORY
I was in a business meeting recently where we somehow got on the topic of Southwest Airlines. I was explaining how Southwest had been so much more profitable than most other airlines for decades because of its unique business model, which in part included the avoidance of the hub and spoke model used by most of its competition.
Someone in the meeting objected to the praise of Southwest.
He countered that the traveling world needs a hub and spoke business model.
Since the hub and spoke model is necessary, it is not proper to praise a
company which avoids this necessity.
In my mind, my reaction was “Necessary for whom?” Is it
necessary for some business travelers? Yes. Is it necessary for Southwest?
Absolutely not.
Two of the key aspects of strategy are determining WHERE to compete and HOW to compete. Answer these concerns properly and success is more likely. Answer them wrong and success is nearly impossible.
One method businesses use to determine where and how to
compete is by looking for necessity of demand. After all, if something is
viewed as a necessity and demanded by a large sector of society, it must be a
good place to be, right?
Just look at the illegal drug business. The junkies feel
that getting their next fix of the drug is the most necessary thing they must
do. And the suppliers of those illegal drugs make a lot of money off that
perceived necessity.
The problem is that there is not a strong correlation
between necessity of demand and profitability. It worked in the illegal drug
business. It didn’t work so well for those satisfying the necessity of hub and
spoke in the airline business.
Southwest chose its “where to compete” principally in the
lower price, non-business portion of the airlines industry. Southwest chose its
“how to compete” by doing a number of things differently, including the
elimination of the hub and spoke model. These were very profitable choices for
Southwest.
In fact, it was a more profitable choice than going after
the demands of the business traveler, even though the demand for business
travel is higher (and presumably more necessary) than for non-business travel.
Just because something out there in the marketplace is a
necessity does not mean that you have an obligation to provide it. Like
Southwest, it may be better to avoid it.
The Southwest example illustrates a common situation in business. This is the principle that the highest profits are often found by avoiding the highest demand. This may seem counterintuitive at first, but there is logic behind this point of view.
Why High Demand
Items Are Often Not Very Profitable to Supply
There are many factors which tend to lower the profitability
of serving many high-demand segments. The first is that high demand segments
tend to attract a lot of competition. Businesses like to flock to where the big
sales potential lies. But when too many companies are fighting for those sales,
the profitability of those sales plummet. Price wars suck the desirability out
of those sales. You may be able to get a much higher return going after
smaller, less competitive markets.
A second problem is that high demand necessities tend to
attract a lot of government regulation. Food and health care are high demand
necessities. Many governments get involved in significant regulation how those
necessities are supplied. This often takes a lot of the profitability out of
the system.
Just look at the results when communism gets involved in the
necessity of supplying food. They impose all sorts of regulations and price
controls. They often insert themselves into owing a lot of the food businesses.
The net result is that businesses pull away and consumers are stuck with
shortages and long lines.
A third problem is that high demand needs pull in the
masses. And the masses do not always have a lot of discretionary income. They
cannot afford to pay as much for their demands as other, smaller segments. You
cannot charge more than they are able or willing to pay, no matter how much it
costs you to serve them. Just look at the automobile industry. Those selling
cars to the masses tend not to do as well as those selling cars in luxury or
high performance segments. Customers in the luxury and high performance
segments are willing and able to pay a lot more for their cars, making them
more profitable, even if the segments are smaller than the mass segment. That's the reason why Tesla decided to start by targeting the high performance end of the electric car business.
When you try to appeal to the masses, you often end up with
“average” offerings. Unfortunately, there will always be competitors who
specialize in targeting the smaller niches. The specialists will offer items
that are cheaper, or of higher quality, or of higher prestige, or of higher
functionality. These more profitable niches will eat away at your mass market,
leaving you with some of the less profitable middle ground. This is what
Southwest did when it specialized in the profitable low price, non-business
segment (and firms like Virgin Airlines and Net Jets at the high end), leaving
the other airlines fighting over the unprofitable middle.
Fourth, high demand areas are often in fairly mature
businesses. Mature and aging businesses, by their very nature, tend not to be
as profitable as businesses in their younger, faster growing stage. Look at
Procter & Gamble. They completely divested out of the food business (an
extremely high demand business). Why? Because it did not have high prospects
for future growth and profitability. It was too mature.
Instead, P&G has been pouring money into beauty care.
You can say that food is a necessity and beauty care is a more discretionary
luxury (less necessary). Yet, beauty care is where P&G have better
prospects for growth and profitability. P&G is doing a great job of
choosing where and how to compete, even if it means walking away from a lot of
high demand products.
Choose Wisely
As a business, you have choices. Strategy is about helping
you make better choices. Those choices need to consider more than just the size
or necessity of demand. They also need to look at the profitability within that
demand. Smaller segments can often be better strategic choices.
In most businesses, there is no law that says that you have
to target unprofitable segments. Even if you think that a particular function
is necessary to make the world work, that doesn’t mean you have to serve it. It’s
okay to walk away from some businesses and leave it to someone else.
Others may have business models better suited to those
situations. Keep in mind that when P&G has been divesting all of its
non-desired businesses, it has been finding buyers for those businesses. Many
of those buyers are companies who do things differently from P&G and are
better suited for wringing value out of mature, slow growth businesses.
Is There a Moral
Obligation?
There may indeed be some moral issues here. Is it right to
only serve the profitable rich and ignore the masses? Can we ignore the poor
because they are unprofitable? Businesses work within a society and they have
some obligations to that society. But they also have obligations to
shareholders, debt holders and employees.
If businesses choose to or are forced to take on bad
business models, this is bad for everyone. If they cannot make an adequate
return, employees lose their jobs, and equity/debt holders don’t get a return.
More importantly, the companies don’t make any profits which can be used for
charity or for taxes to governments to help solve these issues.
Strong, healthy businesses are in a better position to
provide jobs and provide funding for social issues. Then the question turns
from business models to social accountability.
Strategy is ultimately about making choices, such as where and how to compete. These few strategic choices can have a bigger impact on business success than almost any other thing you do. Choosing what not to do is usually more important than choosing what you do. And some of the things you should not be doing are perhaps serving large “high necessity” demands. It’s okay to walk away from them and go in a direction better suited to who you are.
When you look at large, mass oriented businesses, there are usually only a small handful of winners (often only one or two). The rest struggle to stay alive. If you are not the winner in that mass space, it is usually better to walk away and switch to leading in a smaller segment. And that’s okay.
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