THE STORY
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).
Subsidies
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.
Trade-Offs
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.
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).
SUMMARY
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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