Strategic Planning Analogy #504: Fixing a Plane After it Crashes

THE STORY

After 17 years, the tragic crash of TWA flight 800 is back in the news. A documentary has come out claiming that the official explanation of the crash (static electricity igniting the fuel) is wrong. Instead, the documentary endorses the alternative explanation that the plane had been attacked with a rocket, perhaps sent by terrorists.

I have a couple of thoughts about this. First, I can easily understand why so many prefer the rocket attack explanation. After all, it always feels better to blame some outside force (beyond our control) for our problems than to admit internal incompetence, either in the plane design, maintenance or operation.

My second thought is that for the 230 aboard that flight who died 17 years ago, it largely doesn’t matter anymore which theory is correct. Neither explanation will bring them back to life or restore the plane so that they could reach their original destination. For them, it is too late.

THE ANALOGY

The business world is full of tragedies. Companies crash and burn, negatively affecting hundreds, if not thousands, of people. In terms of financial impact, these corporate tragedies are larger than the tragedy of TWA flight 800.

When these events happen, it is common for the leaders of these destroyed organizations to take an approach similar to the one in the TWA documentary—they try to blame it on outside forces beyond their control. “It wasn’t me or my leadership which caused the disaster,” they say. “No. It was the fault of some evil outside force which nobody could have prevented.”

Outside forces which get the blame can include international economic conditions, the weather, political unrest, too much (or too little) government intervention, illegal market manipulations, unfair competitive environment, and so on. The logic is that despite the Herculean effort of management to counter these evil outside forces, the situation was just too great. Nobody could have saved the company.

In a narrow sense, there may even be some truth to these claims. Dire situations can be devastating to companies. But this explanation only works if your time horizon is narrow.

In reality, strong, well run companies can anticipate most of the potential tragedies which could occur. Using strategic planning and scenario analyses, they can anticipate and be prepared for the worst. In fact, the great strategic plans avoid the disasters entirely by steering their company in a new direction before the outside forces come to pass.

Sure, it’s easy to claim that nothing can be done if you wait until your “plane” is on fire and already close to crashing before looking for a solution. But, in most cases, advanced strategic thinking years earlier could have provided a solution so that you avoid the fire altogether.

The best time for analysis is not after the crash occurs. By then, it is too late. The tragic results have already occurred; the damage is already done. No, the best time for analysis is years, if not decades in advance. That way, you have sufficient time to use the knowledge to create a path which puts a company out of harm’s way.

THE PRINCIPLE

The underlying principle here is that the best time for critical strategic analysis is not during (or after) a crisis, but before the crisis, when times are still relatively good. By attacking potential future disasters while times are still good, you have many advantages:

1)     You have more time to prepare and implement a solution;

2)     You have more cash flow to apply to the solution;

3)     You still have a strong reputation, good market share, and a consumer following, making the transition easier for your key stakeholders;

4)     You can analyze the problem more rationally, instead of making rash moves in the heat of the disaster.

5)     If you have to retreat from a business to avoid the future disaster, there is still time to find buyers for it who will pay a good price.

By contrast, if you wait until the disaster is upon you before creating an exit strategy, the situation is working against you:

1)     You have very little time to find and implement a new course;

2)     Your options are limited because your cash flow is already decimated and customers have already started abandoning you.

3)     The crisis is so obvious that nobody wants to bail you out by paying a handsome sum to take over your disaster.

Example #1: Department Stores

Look at the situation JCPenney is in. It’s on fire and looks like it could be headed for a crash. There is a lot of speculation about what or who to blame for the disastrous results of late, such as losing about a third of their business.

Some would say that the problems for the department store industry are so bad that there was really nothing that any leader could have done to save JCPenney, be that Ron Johnson, the recently fired CEO, or Mike Ullman, the replacement executive (as well as having been the top executive prior to Johnson).  The reasoning is that the department store industry was doomed due to outside economic, technological and competitive forces. It is beyond redemption.

But that is only if you start trying to fix the problem now, after the plane is already on fire.

Look at the Dayton Hudson Corporation. They used to be a major player in the department store industry decades ago. The executives there were smart. They knew that the best days for the department store format were behind them. They knew that the format was on a course headed for eventual bad times.

So while times were still good, Dayton Hudson started selling off its department store properties. First, they got rid of their holdings in the fast-growing southwestern part of the US in the 1980s, when competitors were trying to out-bid each other to buy them. They finally sold the remainder of their department stores to the May Company (another department store company) in 2004 (for a good price).

But then the bad times started to hit the industry. Soon thereafter, the May Company was in such bad shape that they had to sell themselves to Federated (now called Macy’s) at a terrible price. And now, almost all the remaining department store companies are struggling to find a winning strategy, like JCPenney, Sears and Bon-Ton.

What did Dayton Hudson do? They took the money from the sale of the department stores to invest in the future, their Target store chain. Dayton Hudson (now called Target Corp.) is doing well and avoided the department store mess.  

The point is that if you wait until the industry is in trouble (like JCPenney) before crafting a solution, you will find it very difficult. But if you start crafting a solution while the times were still good (like Dayton Hudson), you have a greater chance of success.

Other Examples

A similar situation occurred in grocery wholesaling. To an astute observer, it was obvious decades ago that the small independent grocer (the key customer of grocery wholesalers) was entering a troubling future. Walmart supercenters and the big grocery chains were putting pressure on many of the independents. Eventually, it was likely that many of these independent grocers would be out of business. It doesn’t take an expert to figure out that if your key customer is going out of business, it doesn’t bode well for those supplying them.

Therefore, while times were still good, Cardinal Foods decided to act. They used their cash flow to diversify into a field where their distribution expertise had longer life—pharmaceuticals. Now, Cardinal Foods, whose name was changed to Cardinal Health, is a strong #21 on the Fortune 500 while many of the few remaining grocery wholesalers are in challenging times.

Google did not wait until its computer-based business model was in trouble before pushing hard into the smartphone space with Android. Google did it while it could still leverage its strength. Amazon did not wait for its strength in the computer-based ecommerce era to end before launching Kindle.  By contrast, Zynga was already in trouble from smartphones taking over gaming from the computer when it decided to take the challenge seriously (and is having serious problems now making the transition because it waited until it was in a position of weakness).

There are many more examples I could mention. I’ve talked about some in previous blogs here, here and here.

SUMMARY

All strategies eventually fail. If you wait until failure comes before starting to change, you will most likely not change successfully.  By contrast, if you start adapting while times are still good, you are more likely to make a successful transition.

FINAL THOUGHTS

Think of strategic planning as a parachute to help escape problems. But a parachute is of no use if you wait until the plane has already crashed before putting it on. It only helps if you escape while the plane is still flying.

Strategic Planning Analogy #503: Unbundled Subsidies

THE STORY

When I used to eat at a fast food restaurant, I’d order a burger and fries. But then I realized that the low price menu would have burgers for about the same price as those french fries. After that, I skipped the fries and ordered a second burger.

My logic went like this: Fries are merely grease sponges—just empty calories filled with fat and covered with too much sodium. By contrast, at least with the cheap burger I was getting some protein. They cost about the same and filled me up about the same and were equally tasty. Therefore, instead of getting a burger and fries, I started getting two burgers.

That was all fine by me. But I don’t think the fast food restaurants enjoyed my new decision. After all, they made a good profit on the fries but were losing money on that low-cost second burger.

THE ANALOGY

No matter what business you are in, your customer has choices. Even in a monopoly situation, the customer has choices. They can choose a substitute from another industry or choose not to purchase at all.

Many of the decisions businesses make affect those choices, such as product assortment and pricing. When the fast food industry added low-price value items to their menu, they changed the way I made choices about how I eat.

Unfortunately, my change was to the detriment of the fast food restaurants. I switched from high-margin fries to a negative margin value burger. And it was THEIR decision which caused my changed behavior to work against them. Their actions made me a less profitable customer.

So don’t limit your discussions about what is strategic only to big issues like positioning and productivity. Even smaller issues, like the pricing of a burger, can have a huge impact on performance for years to come.

Think of it like making a small decision about whether or not to bring a woodpecker on board your boat. It’s just a little bird. But one day the woodpecker pecks a hole in the boat. Even then, one little hole is not a big deal—it can be repaired. Over time, however, the woodpecker pecks a great many holes in the boat and it sinks. It is the accumulation of many small, bad consequences from that one little decision about birds which sank the boat.

This is also true for business. It is usually not the big decisions which bring a company down. After all, executives spend a lot of time making sure they get the big decisions right—that’s why they’re called “Big Decisions.” No, it’s the accumulation of many small daily decisions (decided poorly) which sink a company.

Little decisions start chain reactions in how customers make choices. Any one of them may not hurt you, but in total they can create a disaster. If those daily decisions are not made within a strategic context or are not thought through thoroughly, they can destroy the grand design or your larger strategy. After all, your strategy is not what you say, but what you do. And what you do is determined every day with those small decisions. So strategy needs to “sweat the small stuff.”

THE PRINCIPLE

The underlying principle behind the fast food mess is “unbundled subsidies.” And if you are not careful, unbundled subsidies can ruin business models for a lot more industries than just fast food.

1) The Origin Of Subsidies

Many industries are highly competitive. This creates severe downward pressure on prices (competition won’t let you raise prices). And to top it off, we’ve trained consumers to not have to pay full price for anything. Just ask the customers of JCPenney. When JCPenney eliminated sales, they lost over one quarter of their business. It turns out that people expect deals and won’t willingly pay full price.

Therefore, highly desired items are often sold at little to no margin (or even a negative margin). So how do you make money when your key items are sold at or near a loss? The answer is subsidies. You get customers to buy additional items that have a high enough margin to offset the loss on the core.

In fast food, the high margin drinks and fries subsidize the low margin burgers. On big-ticket electronic items, high margin extended warranties traditionally subsidized the low margin device. The base sticker price on a car is kept low, but they get you with high margin upgrades, accessories, financing and repair work. Low margin industrial goods are often subsidized with service contracts. Low margin printers are subsidized with high margin ink.

It has become the way of the world. In order to compete on price versus competitors and satisfy customers who want a deal, core items are becoming like loss leaders, forcing businesses to surround them with subsidies in order to survive.

2) Unbundling of Loss Leaders and Subsidies

Originally, the idea was to try to bundle the loss leaders and subsidies as tightly as possible. That way, every purchase could still remain profitable because the loss leaders and subsidies were sold together. In the fast food world, they were called “Combo Meals”—you had to buy the whole bundle of food to get the deal.

Other industries followed with their own version of the bundle. Cable and telecom companies bundled phone/internet/TV. HP used patents so that you could only use their high margin ink on their printers.

But the hypercompetitive world started causing the bundle to fall apart. Between 2000 and 2002, McDonald’s rolled out the Dollar Menu in the US. Now you could buy the cheap items without also buying the subsidies.

In the telecommunications industry, companies started turning subsidies into additional loss leaders. For example, charges for texting used to be the subsidy for voice calls. Then texting became free and had to be subsidized by data downloads. I was talking to someone in the industry who said it is a constant race to find the next subsidy, because someone in the industry is always trying to turn the current subsidy into a loss to get an edge.

And then the dotcom world came up with the “Freemium” model. In this model, most people pay absolutely nothing for the service (it’s free) while a small minority pay for a premium version. This is how linkedin works. I pay nothing for the basic service because it is subsidized by a totally different customer, usually a recruiter, who buys a premium version. Or Zynga had most people playing Farmville for free while a small minority subsidized the whole system by purchasing virtual farm equipment.

This all starts to become dangerous territory when loss leaders and subsidies are unbundled. In fast food, you get people like me who now load up on the loss leaders and avoid the subsidies. In telecommunications, there is the risk of running out of new sources for subsidies to support the ever expanding list of loss leaders.

The price of loss leader consumer electronics got so low that it became “disposable pricing.” If something went wrong, you could afford to just replace it, erasing the need to buy the extended warranty subsidy.

The freemium model runs the risk of the two audiences getting out of balance, with not enough payers to subsidize the freeloaders. Zynga just announced huge layoffs because they are having trouble with their business model.

And it is hard to go backwards on these trends. The telecommunication folks want to dial back the unlimited data plans but are meeting strong resistance. When the fast food people try to dial back the value menus, the customers revolt. Newspapers have been trying to get people to pay for the online version (which used to be free) with only varying levels of success.

Once you set up a subsidy system, you redefine the expected cost for the loss leader. “Regular” price becomes the loss leader price. Consumers see anything higher as outrageously high pricing. This makes it very difficult to reverse the pricing once the loss leader position has been made.

But now that the subsidies are becoming ever more unbundled from the loss leader, it is more difficult to ensure that enough subsidies are sold to offset the loss leader prices. Profits become more elusive. Risk of failure is increased.

3. Lessons Learned

What can we learn from this? First, small actions today have consequences well into the future. And it may not be initially obvious today what those consequences may be. Therefore, before making some of these small actions, we need to take time to consider their impact on the larger picture. Otherwise, we may unintentionally be dismantling our grand strategy one brick at a time.

Second, if strategists (or strategic thoughts) are only limited to an annual offsite meeting, they will be unable to adequately impact all those little day to day decisions. We need to get strategic context around a larger proportion of our decision making.

SUMMARY

Strategy should be more than just big thoughts around big decisions. It needs to permeate the organization more regularly and further down the organization, where many of the more mundane decisions are made. After all, these more “mundane” decisions can accumulate to the point to where they threaten the entire strategy.

FINAL THOUGHTS

How many decisions are made in your business without asking the question “How can this decision impact the long-term viability of our strategy or company?”

Strategic Planning Analogy #498: Snapshots vs. Paintings

THE STORY

I recently got back from a combination trip to see my new grandson and a vacation.

I wanted a good picture of my grandson. To get it, I took a lot of pictures of him. Some of the pictures were pretty awful, but eventually, that process lead to getting a good photo of him (see photo above).

Afterwards, I went vacationing and toured some old houses. There were old oil portraits of people on the walls.  They may have looked fancy—even a bit regal—but I’d rather have the simple snapshots of my grandchild than any of those old paintings.

THE ANALOGY

In the business world, we have the option of building two types of planning processes—either one like the process used to create fancy oil paintings (like the ones I saw in the old houses) or like the process used to create digital snapshots (like the ones I took of my grandson). 

The painting process may create something worthy to display on a wall for generations, but it is usually time consuming, costly and inflexible. Those don’t sound like good qualities for a strategic plan. 

Conversely, taking digital snapshots is quick, inexpensive, and flexible. It may produce a few duds, but eventually you get some good photos in a very efficient way. Those qualities also sound good for strategic planning.

THE PRINCIPLE

The principle here is that the goal of strategic planning is not to create perfect documents and statements to proudly display on walls and bookshelves. The goal is to figure out how to move a company forward in an efficient and timely manner. To do so, we can learn more from the process I used to get a photo of my grandson than from the artists who made those old paintings on the walls of those old houses.

The Problems With Paintings

Oil paintings can look great on the wall and last for generations. The artist of great paintings can achieve great fame. And that can sound appealing. There is a certain appeal for planners to want to create plans great enough to “hang on the wall” for generations and give the planner fame and glory. But great plans should not be the desired endpoint; instead, the desired endpoint should be great companies. The plans are just a means to that greater end.

The important thing to remember is that you don’t need “perfect oil portrait” plans in order to effectively and efficiently move a company forward.  In fact, the desire for this perfection can actually be counterproductive. 

One of the problems with oil paintings is that they take a long time to create. Time is a precious resource in our fast-moving world. Time lost in perfecting a plan can become advantage lost to faster competitors. A “good enough” plan received in a timely manner is more valuable than “perfection” which comes too late to be of any use. Is your planning process geared more towards timely completion or excessiveness and grandeur?

Another problem with oil portraits are that they are posed. The people being painted have to remain in a stiff, usually unnatural position in an artificially positive environment.  And if the posing still doesn’t look good, the artist will alter reality to make the painting more flattering than reality.  The end result may be great art, but not an accurate accounting of reality.

Bad planning can fall into the same trap. The plan may try to place the company in the best light rather than show the harsh reality of the truth of what’s happening out in the marketplace. The most positive assumptions can be used. The plan may try to please the egos of the leadership rather than tell the truth they do not want to hear. Wrong strategic decisions are made, because judgment is clouded by unnatural flattery in the “posed” strategic plan.

Sometimes the flattering distortions are the result of trying to hit unrealistically high profit numbers with the plan. The only way to fit these numbers into the plan is by surrounding them with unrealistically optimistic scenarios, since you cannot get there just by incrementally tweaking the harsh reality.

The result is that the plan becomes a failure and the numbers are never achieved, because the plan was never achievable once reality overcame the false optimism posed in the assumptions.  It would have been better to paint the real picture and show that the desired profit numbers were not achievable. Then, you would be aware that radical change was necessary and you could take steps in advance to avoid the inevitable failure of the flattery approach.

Finally, oil paintings have to problem of being hard to modify once the paint has dried. We live in a dynamic world.  Adjustments are inevitable.  Is your planning process hard to modify once the ink has dried?  If the world changes shortly after the plan is put into play, do you have to wait a year until the next planning cycle to make adjustments?

The Benefits of Snapshots

Digital snapshots avoid a lot of the problems we saw with the painting approach.  They are fast and easy to create.  They capture reality rather than an artist’s distorted vision of flattery. They provide rapid feedback of what is happening. And it is easy to keep taking snapshots so that your latest picture is accurately telling you what is happening NOW.

What does a snapshot oriented planning process look like?  First, it gets out of the portrait studio inside the corporate offices and goes out into the marketplace to capture reality where money is changing hands. And it doesn’t care what camera the snapshots come from. It gathers impressions from social media, customers, competitors and a variety of other sources, so that the information is not a one-sided bias of “corporate-think.”

Second, snapshot planning is very experimental. When I was taking snapshots of my grandson, I tried all sorts of approaches to getting his picture.  Some of these experiments did not work.  But some picture-taking experiments were great.  The planning analogy is to do a lot of small experiments. Test hypotheses to see how well they fly out in the marketplace. The results of a test can often provide far better guidance for strategic decisions than having internal executives guess about what will happen in the real world.

Try things on a small scale. The disaster at JCPenney was not that CEO Ron Johnson tried something different. The disaster was that he did a full rollout before testing it.  There was little downside risk to my taking a bad snapshot of my grandson, so I could afford to try a lot of things before finding what worked.  Set up your tests in a similar manner, so that you do not risk much and can pull the plug early if it doesn’t work. That approach would have saved JCPenney a fortune.

Being flexible and experimental does not mean that your planning becomes random. This is not a process of just clicking a camera continually in random directions until you get a good shot. No, there still must be a focus to where you point the camera.

Winning strategies need to position your company in a place where is can bring a competitive advantage. There may be very few places where you can create that kind of advantage. Random acts are not the best way to find these places. First you need to understand the marketplace, what you bring to bear on the marketplace, and what others can do. This preparatory work helps you to know the general space where you are most likely positioned to succeed. Then you get flexible and experiment within that space.

The emotional connection between me and my snapshots was the fact that I wanted a record of my grandchild. Random photos of anything, or of other babies, would not have worked.  I needed to point my camera in the general direction of my grandson in order to get a satisfactory photo. In the same way, your plan needs to know the focal point. This provides guidance for the experimentation.

SUMMARY

Plans are not the endpoint, but a means to a greater end—the long-term improvement of the business. Therefore, rather than wasting time perfecting the plan, focus your effort on building a tool which quickly and effectively points to where success is most likely, so that you can win the race to finding the fortune that such a place offers.

FINAL THOUGHTS

You rarely see oil portraits of the young and unaccomplished. Instead, most portraits are of older people after they have made their great accomplishments.  They look backward at past successes rather than towards where future success will come. Planning processes which are too focused on the successes of the past (like oil paintings) will hang on too long to obsolete strategies and miss out on winning the battle for next big thing. 

"We Suck Less" Is Not a Strategy

THE STORY
I worked with a retail company one time that had two problems:

• It’s main product was becoming obsolete, with worldwide demand dropping at a significant rate.

• It charged more for the product than just about anyone else, without providing any meaningful differentiation to justify the higher price.

A strategic plan was developed to radically transform the retailer into a relatively new concept—one with potentially high growth, but also high risk, because the concept was unproven. The president of the company decided that the risk of transformation was too high, so he decided instead to fix the current business model.

He built a team of people who worked very hard with him to improve the company. They made the stores nicer and more inviting. They added a little bit of variety to the product offering. They added some efficiencies behind the scenes. The stores were very nice.

This plan to “fix” the chain, however, had a couple of serious problems:

• The chain was still highly dependent on a product that was becoming obsolete.

• The chain still charged more for the product than just about anyone else.

• The changes overall increased the cost of doing business without increasing demand for the product.

It didn’t take long for the employees to realize that taking an obsolete, non-competitively priced product and putting it in a nicer store would not solve the problem. In private, they referred to the president’s vision as the “we suck less” strategy. Yes, the stores were better, but the proposition to the customer still “sucked.”

Needless to say, that retail chain is no longer in existence today.

THE ANALOGY
Over the course of time, many businesses find themselves in a situation where their current business model becomes broken. Sometimes the threats to the business model come from the outside. Take, for example what the growth of the internet and digital Web 2.0 capabilities have done to destroy many traditional business models, from industries as diverse as newspapers, magazines, travel agencies, stock trading, advertising agencies, the music industry, or insurance, just to name a few.

Other times, the threat comes from the inside. Lack of controls, insufficient investment, quality control issues, not shifting with your customer’s changing needs, and poor service can also destroy a company’s business model.

Once one realizes that there is a problem, one’s first inclination is to try to fix the problem. Fixing usually involves trying to make the bad things better. Operational excellence or getting to parity with the best in the business becomes the new goal. Eventually these goals to get better are treated as the company’s strategy.

Getting better is not a real strategy. Becoming “less bad” does not make you a winner. To say you “suck less” does not give potential customers a compelling reason to prefer you over the competition. In the story above, all that getting better achieved was to raise the cost structure and speed up the chain’s demise.

THE PRINCIPLE
In my prior blog (see “Tearing Down The House”), I talked about how it can be a mistake to tear apart a good strategy and throw it away, just because it may have a few flaws in it. The tragic consequences of such a major disruption can cause more problems than the flaws that one was trying to fix. Small changes which reinforce the current strategy would tend to be a better course of action in those cases.

This principle, however, only works if a company is already on rather solid ground with respect to its market positioning and consumer acceptance. As you may recall, the companies I referred to in the prior blog were JC Penney and Kohl’s—two companies already on rather solid ground. If your company is poorly positioned, has a negative image, or is seen as an inferior alternative to someone else, then this principle does not apply.

In those cases, just “getting better” is not enough. Making a rotten apple less rotten does not make it tasty. In a prior blog (see “Rule of 1.5”) we talked about how industries tend to consolidate to a point where only one or two players in a given space are strong enough to earn a decent return on investment. If you improve your position from being 5th best in a space to being 4th best, you are still not good enough to unseat the leader.

Your financial woes will not go away with that type of effort, because you are investing in an area where the marketplace will not give you sufficient credit to justify the expense. The question in the back of their head will be, “If you are as good as you say you are, then why are you not the leader? Since you are not the leader, it must not be as good as you say.” Their conclusion will be that even if you now suck less, you must still suck.

Your only real alternative is to change yourself into something different. You need to find a different, neighboring space where you can reposition yourself as the leader. This is not about taking who you are and making better. This is about taking who you are and making it different; making it uniquely superior in some fashion, based on a different mix of attributes than those used in the prior space. Instead of being about improvement, it is about transformation.

For example, if low price is the defining attribute of the segment you are in and you have a relatively high cost structure, you can never effectively win in that segment. However, there may be a neighboring segment where there are a sufficient number of consumers looking for something similar, except that quality and service is more important to them than price. If no business currently has a solid lock on the quality/service angle, then perhaps you can transform yourself and migrate to that new position and become #1 in that neighboring space.

The idea is to change who you are compared to in the minds of the customer (and on which attributes they compare you). Rather than having people compare you to others who are better at providing lower prices, get them to compare you to others who are inferior at providing quality/service.

In the example used in the story above, just such a proposal was made. A strategy was developed to transform the retailer from being product-based (where it had a distinct disadvantage) into something that was more lifestyle based (where it had an opportunity to invent a new type of retail format in relatively uncontested space).

Unfortunately, this proposal was rejected and instead the “we suck less” alternative strategy was put in place. Why? In the near term, transformational strategies tend to require more resources (time, money, people) and have a longer payback. There also appears to be greater risk, because one is moving away from the historical foundation of the business. By contrast, an incremental improvement program can look more practical for the immediate future.

Unfortunately, you cannot indefinitely postpone the inevitable, and the “we suck less” approach never leads to long-term success. Usually, this harsh reality comes sooner than you think (see “The Room is Smaller than you Think”). In the story above, it only took two years under “we suck less” before the company was sold at a loss.

In reality, the higher risk is not in transforming the company. Instead, the higher risk is in the “we suck less” strategy, because it nearly always fails—and usually fairly rapidly. At least with a transformation strategy, you have a shot.

JC Penney was not always the successful company it is today. There were many lean years when some people thought the company might not survive. It was a mediocre performer at the low price end of the fashion continuum. However, instead of trying to become better at the Price First-Fashion Second space, it decided to transform itself into what it saw as a better space: Fashion First-Price Second. There were a few tense years in the middle of the transition, but now that it has successfully crossed over to the other side, JC Penney is showing great results and is back on an aggressive growth strategy.

Once, I was working with different company that had an inferior position in the marketplace. I was trying to convince the President of the Company to take on a transformation of the business, but his basic response was “I don’t have time for that now. I’m too busy trying to fix the company.” At that point, those words “we suck less” came back to my mind.

SUMMARY
Unless you are already a leader, getting better is not a winning strategy. Being good at what you do is merely the minimum table stakes needed to get in the game. If you want to win, you must go beyond merely being good (or even as good as the industry leader) and seek out points of differentiation and superiority.

FINAL THOUGHTS
It takes patience to transform a company. Not all stakeholders have that kind of patience. That is one of the benefits of going private, which many firms are doing. In the private environment, it is often easier to push through a transformational agenda.

Tearing Down the House

THE STORY
Bob and Joe each had a house they wanted to sell. Bob was a little bit concerned about the condition of his house. His house had a couple of leaky pipes. Bob’s solution to the leaky pipe problem was to tear down the whole house and build a new one in its place. Bob was very careful about supervising the construction of the plumbing. After all, he did not want to repeat the leaky pipe problem. However, he was so focused on the plumbing, he failed to notice that the electricians put in faulty wiring. The faulty wiring would leave you in the dark at night.

Joe had a couple of problems with his house, too. But instead of replacing the house, he brought in a repairman to fix the problems. Then Joe did some research on home values. He discovered that there are certain key areas where one can spend just a little bit of money and get a dramatically higher resale price. So Joe spent a little bit of money on landscaping the front yard (increasing the “curb appeal”) and a little money to upgrade the master bathroom.

When it came time to sell the houses, Bob was in a bind. He couldn’t find anyone who wanted to buy the house he just built for what it cost him to build it. Part of the reason was because of the faulty electricity. Part of the reason was that if someone wanted a brand new house, they would prefer to design the home themselves. He took a big loss on the sale.

Joe made out much better. Because his house had been around awhile, Joe had built up considerable equity in the property. In addition, property values had risen over that time. The improvements Joe made increased the value of the house at a much higher rate than what the improvements cost. Joe made a good profit on the sale of his house.

THE ANALOGY
Businesses can often be like old houses. They aren’t perfect; they have a few flaws that have crept in over time. Sometimes, leadership will look at these flaws and see the business as “broken.” To fix the business, they essentially tear it down and start over again. This could include actions like:

• Eliminating key members of management
• Getting a New Ad Agency
• Throwing away the old strategy and designing a new one
• Going after new customers
• Selling off lines of business
• Changing the core business model
• Etc.

This type of response would be similar to the actions Bob took on his house. He saw some problems and decided he needed to replace the whole house. This drastic response by Bob did not solve his problem. It only created other problems. The same can be true when companies see a problem and decide to revamp everything. Some examples of problems which this could cause include the following:

• By eliminating too many people, a lot of the intellectual capital of the company could be lost, leaving you in the dark on how to run parts of the business. They might go to competitors and use the knowledge against you.

• Too many changes to marketing and positioning can confuse the public as to what you stand for, and you end up standing for nothing.
Even though there may have been problems with the strategy and the old business model, there is no guarantee that the new model won’t have equal or worse problems of its own. It is untested for your business.

• All of these changes can be very expensive and may not prove to have a positive return on investment.

Conversely, Joe took a different approach to his situation. He fixed the problems he could see. Also, instead of tearing down the house, he prudently improved the house in ways that had a good return on investment. As a result he made out just fine.

The business analogy to what Joe did would be to stick with who you are and what your strategy is and just do two things:

• Repair the obvious blunders.

• Invest in activities which enhance the current strategy in a cost effective manner.

This process minimizes confusion in the marketplace and in fact may help strengthen one’s position in the consumer’s mind. Intellectual capital remains, and you do not place a lot of new unknown variables into the mix which would increase risk.

Too often in business, I have seen people eager to take out the axe and try to chop down much of what the business stood for and start over. This is particularly true when new management comes in. The heritage from the old regime is eliminated to make room for the entirely new vision of the new management. Often times, the better approach is to be like Joe—fix up a few problems and then build upon the old foundation to make it even better.

THE PRINCIPLE
The principle here is the mathematical concept of compounded leverage. The idea, in simple terms, is this: A few small changes to the metrics in one’s income statement and balance sheet can make a huge improvement to the bottom line. There are three primary reasons why this is true. First, in most businesses, net income as a percent of sales is much smaller than many other lines on the income statement. Therefore, a small improvement to a large line in the middle of the income statement creates a proportionately larger percentage improvement to the smaller net income line.

Allow me to illustrate with an example. JC Penney and Kohl’s recently released their 2006 annual reports. At JC Penney, the year over year increase in gross profit percent (before expenses) increased from 38.3% to 39.3%, an increase of 1 full percent (or 100 basis points). Because most of their costs remained similar as a percent of sales, the improvement in gross profits fell to the bottom line, where net operating income grew from 8.7% to 9.7% (the same 100 basis point improvement).

However, because the Gross Profit line is so much larger than the Net Operating Profit line, it only took a small improvement at the top to get a huge improvement at the bottom. For example, at JC Penney, to get from a gross profit of 38.3% to 39.3% requires an improvement of only 2.6%. This little change at the top, however, caused the net operating percentage to increase by 11.5%.

A similar situation occurred at Kohl’s Department Stores. Their 2006 gross profit was 36.4% versus 35.5% in 2005, an increase of 90 basis points. Because Kohl’s made some slight improvements in expenses as well, net operating income increased 110 basis points, from 10.6% to 11.7%. In the case of Kohl’s, a 2.3% improvement to gross margin combined with a 1.1% improvement in operating costs (as a percent of sales) created a 10.5% improvement in net income (as a % of sales).

The second reason why small changes at the top can make bigger changes at the bottom is because multiple changes at the top can have a compounding impact upon each other. For example, if you can improve both gross margin as a % of Sales, as well as increase sales, the two work together to make gross margin dollars much larger than if only one of the two factors (sales or gross margin %) was improved. In essence, you have made a larger percentage slice of a larger pie.

In the case of Kohl’s we saw that gross profit as a % of sales increased 2.3%. What I failed to mention earlier was that at the same time, sales for 2006 at Kohl’s increased by 16%. As a result of the compounding of these two factors, Kohl’s gross margin $ increased by 18.7% and the operating margin $ increased by 28.2%. So, as you can see, a combination of smaller improvements at the top can multiply the benefits at the bottom.

The third reason why small changes can have a big benefit is because some tactical improvements impact multiple lines. For example, if a retailer found a way to run its business using slightly less inventory, it could gain improvements on many lines in its income statement, balance sheet, and cash flow, including:

• Lower operating costs at the store and the distribution center due to processing less inventory.

• Fewer reductions to gross profits caused by large price markdowns to get rid of excess inventory, since you now have less excess inventory.

• Less working capital tied up in inventory (potentially reducing debt and interest)

• Better sales from having fresher merchandise on the sales floor (due to increased inventory turnover).

As a result, the small improvement to inventory could end up having a huge impact on free cash flow due to its ability to impact multiple lines and compound the benefit.

Therefore, it is not always necessary to abandon a strategy and start from scratch in order to make significant improvements. Sometimes all it takes is renewed efforts around a handful of small improvements to the current strategy. This approach is often far less risky and usually requires less time and money to create the positive impact.

SUMMARY
Not all problems require the abandonment of the strategic path one is on. Often, great improvements can come by just focusing on a few key initiatives which modestly improve a few metrics while reinforcing the current strategy.

FINAL THOUGHTS
Albert Einstein allegedly said that “the greatest force in the universe is compound interest.” The compounding of small improvements throughout the income statement, balance sheet and cash flow can have a similar type of power.