Notes – The Art Of Profitability

Notes from The Art of Profitability, by Adrian Slywotzky

Chapter 1, Customer Solution Profit

The Customer Solution Profit (CSP) model encapsulates the idea of understanding the customers problems and then providing them with a solution to their problems.

In the narrow sense, the CSP model captures the idea of having an intense, personal and detailed understanding of the challenges a customer faces and then providing them with a unique, custom-tailored solution that meets their needs. Such a relationship requires upfront investment of time and resources from both parties (the business and the customer) and it entails high switching costs because finding a competing business who can offer that same level of personalized service would require the loss of previous investments made in the existing relationship. This helps to create a “moat” around a CSP model business. Some examples of a narrow-CSP business would be a software solutions firm (a company producing custom back-end software that an operating company runs off of), a consultancy business, the professional relationship of a trusted lawyer or doctor, or a manufacturer of custom fabrications. The recent rise of information analytics engendered in data mining through web browsing activity also represents a form of narrow-CSP business modeling– think about the way Google can track your browsing habits to serve up targeted ads, or the way Amazon tracks your browsing and purchasing history to suggest items you may be interested in purchasing from them.

In the broad sense, the CSP model actually applies to ALL businesses. Every business seeks to create customers, and the way businesses create customers is by finding problems customers have that the business can solve. In Chapter 1, the guru David Zhao asks the protagonist, Steve, “Can you be profitable without knowing the customer?” It’s possible to think of semantic games you could play to answer this question in the positive, and surely there are some businesses which know their customers better than others, but in a general sense the answer is clearly “No.” To provide someone with a solution, you have to know them enough to know their problem.

The context of this question is partly related to Chapter 1’s exploration of the company Steve works for, Delmore, which by Steve’s judgment is a business which has seen growth in the past but seems to be stumbling and may even be heading for a downfall. Steve believes Delmore has lost its way and is not focused on serving the customer. Zhao’s question resonates even more in this regard because Delmore’s management seems more focused on administering the business rather than knowing its customers. In the present, Delmore still appears to be profitable (though much less profitable than its heyday), which seems to suggest that even a company that doesn’t know its customer can be profitable. But the implication of Zhao’s questioning is that over the long-run, Delmore will not be profitable if it can not find a way to focus on understanding its customers better.

Another idea explored in Chapter 1 is the role of company culture. Zhao talks about consulting for a company after learning the secret sauce of their competitor. He says he hand delivered the total solution to the business he was advising and they only ended up implementing part of it– they saw a pick-up in their business as a result, but it was not as dramatic as it could have been if they had implemented his ideas wholesale. Why, Steve asks, do some businesses behave this way?

To succeed in business you need to have a genuine, honest-to-goodness interest in profitability.

This suggests that differences in margin structure and net profitability for companies in the same industry could come down to the “profit culture” of the business, likely established by the original founders and permutated by succeeding hires and executives. They could have the “technology” or strategic know-how to earn a profit, but simply be disinclined to work hard enough or with a unified purpose or without the ego necessary to fully capture the opportunity available to them. This idea also introduces additional context for why much M&A activity rarely seems to bring the “synergy” promised by combining two companies into one– if they have wildly disparate cultures, getting the same performance out of the new company as was available in the two separate companies may be impossible, and cultures may clash so wildly that the overall profitability is in fact harmed by corporate unification.

The subtext to the entire chapter on Customer Solution Profit models is that to really understand the value of a business, you must look at what customer problems the business solves, and how. By studying what is unique about the customer solutions the business offers, you are able to have a better analytical window into the durability of its competitive position, the source of its profitability and profit potential, its opportunities for growth and the stability of its margin structure.

Chapter 2, Pyramid Profit

The Pyramid Profit model consists of multiple quality and price tiers for products, targeted at multiple types of customers (and customer preference), which creates two powerful dynamics for the business:

  1. Protects them from competition from market entrants below (commodity market)
  2. Creates profitable “customer migration” opportunities as loyal customers move up the steps of the pyramid (franchise market)

Why is this model so powerful?

As guru David Zhao teaches,

Your pyramid has to be more than just a collection of different products at different price points. A true pyramid is a system in which the lower-priced products are manufactured and sold with so much efficiency that it’s virtually impossible for a competitor to steal market share by underpricing you. That’s why I call the lowest tier of the pyramid the firewall. But the most important factor is the nature of your customer set. The customers themselves form a hierarchy, with different expectations and different attitudes toward price.

The competitive environment all businesses would prefer to have is that of a franchise, where their product is deemed uniquely valuable and essential such that the business can capture a franchise premium in its margin structure, a premium which is enduring and protected from competition over time by the proverbial “moat.”

Simultaneously, the competitive environment all businesses fear is that of a commodity market, where the only way to distinguish your product from someone else’s and incite the customer to buy is by offering the lowest price. It is a true race to the bottom and the turnover for businesses in commodity markets can be quite high.

As discussed in Clayton Christensen’s classic, The Innovator’s Dilemma, most innovators arrive in a market as low-cost entrants. Incumbent firms see no problem in giving the low-margin business dregs to them as they’re happy to play in the higher-margin markets upstream. The hungry commodity firms are constantly looking above them at the juicy margins available in this other market– can they apply their innovative, low-cost practices to this higher-margin space and move in for the kill? As Christensen details, so often they try and succeed.

This is the genius of the Pyramid Profit model. Incumbent firms are protected from innovative, low-cost competition by offering a low-to-no margin product that creates a competitive “firewall” at the most vulnerable place in the market, the violently dynamic commodity space. Then, they are free to play in the middle and higher margin markets without stress.

There is an additional benefit, as well. By capturing new customers even at the low-margin end of the market, the firm is able to increase customer loyalty and brand familiarity over the customer’s lifecycle. Over time. these (presumably) younger, poorer customers turn into older, richer customers following the circumstances of life.

The value of a Pyramid Profit model depends on the shape of the pyramid. A pyramid with a wide base and a narrow top is relatively inefficient and less valuable as most of the business volume is captured in the low/no-margin mass market whereas the high-margin premium market remains under-promoted. An ideal shape would resemble something more like a skyscraper tower– the same width for all tiers, all the way up, with enough segmentation via price/quality tier to progressively move customers up the pyramid at a rapid pace. The more business that is concentrated at the upper levels of the pyramid, the better the margins and the more profit the firm can earn.

The Pyramid Profit model can be found in many well known businesses, even though it is a rarer circumstance than that of the Customer Solution Profit model discussed in chapter 1. A good example is the automobile industry with its “economy” and “premium” brands (for example, Honda and Acura, or Chevy and Cadillac). Even within each brand, many manufacturers have managed to create a “pyramid” of quality, price and even features/capabilities (for example, Honda has the LX base model, EX, EX with leather and EX-L with navigation; it also has the Civic for the entry buyer, the Accord for the more sophisticated, the Odyssey for the family buyer, etc.). Another example would be the airline industry, such as Virgin Atlantic’s “Economy”, “Premium Economy” and “First Class” seating and service tiers. However, no airline seems to have created separate brands/carriers that focus on one tier of the pyramid over another, instead this segmentation always occurs per aircraft (contrast this to a “single class” carrier such as JetBlue or Southwest Airlines, though notice that even these firms have begun to offer new passenger tiers for additional money such as early boarding, extra luggage capacity, etc.)

Speaking of the auto industry again, one of the most prodigious Pyramid Profit employers has been Toyota. Toyota offers three brands in the United States: Scion, Toyota and Lexus. Scion was a brand developed specifically for the young car buyer, initially offering lower price points, simpler model choices and a “no bargaining” purchase experience that was supposed to capture a first-time buyer and put them into the “Toyota system” for the rest of their automobile-buying lives. Then, there was the mass market, multi-trimmed and multi-segmented Toyota brand, offering cars, vans, SUVs and light trucks to the everyman. And finally, there was Lexus, the flagship brand for wealthy, older, image-conscious and highly-demanding customers.

Toyota’s pyramid is awkwardly shaped, however. It’s base, Scion, is minuscule and definitely low/no-margin. The middle step is enormous and fairly profitable relative to the rest of the industry. And the top is much wider than one would expect it to be, being both relatively high-volume for a luxury market and quite profitable despite ongoing margin erosion in the industry overall. Indeed, Lexus auto dealership franchises are consistently one of the most valuable and sought-after brands in the industry alongside BMW and Audi, commanding high market multiples reflective of their premium value.

The key to a successful and highly profitable pyramid is twofold. First, you must be lucky enough to operate in a market that is conducive to segmentation of customers (especially self-segmentation). Second, you must know your customers well– the Customer Solution Profit at work again! The better you understand your customers and their specific needs, the better you will be able to create custom quality and pricing tiers in your pyramid that will meet their subjective needs.

Chapter 3, Multi-Component Profit

The central idea to the Multi-Component Profit is “same product, several businesses,” in contrast to the Pyramid Profit which targets distinct customer sets with distinct product offerings (differentiated in terms of quality and price). The example given in the book is Coca-Cola, which may be offered at several prices in several different venues ranging from a 6-pack at a gas station to a 2-liter bottle at the grocery store to a glass at a restaurant. The price per unit is different in each case,  meaning variable margin structure, but the customer is captured nonetheless at each consumption opportunity.

While each of these margin structures and business opportunities combine to average out to one margin for the controlling firm, Coca-Cola, each product represents a unique business opportunity from the standpoint of marketing and advertising, competitive dynamics and ultimately, profitability. And this is where the secret of the Multi-Component Profit lies– just as an entire economy can benefit from the division of labor by breaking large tasks into smaller ones that individuals can specialize in, an individual firm can benefit from identifying ways to segment its large business into several smaller, distinct components, managing each one uniquely.

How is this possible? If the price of a firm’s good is set at one price regardless of the volume, and marketed in a uniform way, the firm can miss opportunities to sell their product to a.) people who don’t see value in marketing not aimed at their needs and tastes and b.) people who would be willing to buy the product at a different price and in different quantities than how it is normally offered. By catering to these preferences as distinct markets, the business is able to offer optimum combinations of price and quantity that meet each markets needs better, thus increasing total volume and profit.

Another example of a Multi-Component Profit model at work would be a software operating system company, such as Microsoft, which has different business units for Business/Enterprise, Government/Education and Retail and Wholesale channels. Each user buys a different amount of software licenses and pays a different price for them. This would also be a principle at work in a computer manufacturer’s business, such as Dell (same business lines), or a networking component company like Cisco.

Would an oil producer qualify, such as Exxon Mobil? An oil producer actually produces a number of slightly differentiated products depending on source and quality of the oil sold (West Texas Intermediate, Brent, etc.) which would seem to put it more into a Pyramid Profit model, though even that relationship is tenuous because oil is a nearly ideal commodity product in the sense that it is hard to create a “firewall” product as well as to move customers up a pyramid structure, especially with the fact that oil tends to trade at a uniform price across world markets no matter where it is produced (if it is of the same type). An oil firm probably does not give significant discounts to “different customers” based on quantity ordered, either.

Similarly, an oil refiner would seem to be a Multi-Component Profit model with its different kinds of refined products marketed in different ways (kerosene for lamps, or kerosene for jet engines) but again, these markets are so commoditized and regularized across world markets that it is hard to imagine these businesses creating separate marketing and pricing initiatives for differing customer demand, instead just dumping their product into various wholesale markets that then re-sell the products to end users (though perhaps these businesses are in the Multi-Component Profit model).

Over time if I think of other examples, which there undoubtedly are, I’ll post them but for now I will close out these notes with this summary from the book’s protagonist:

Different parts of a business can have wildly different profitability. The customer behaves very differently on different purchase occasions. Different degrees of price sensitivity.

The value of this lesson, as the book’s guru says, is that constant innovation is a key ingredient to maintaining and growing the profitability of any business, and one way to innovate is to find ways to break your existing business into smaller and smaller components which can be separately managed with unique marketing, growth and profit trajectories.

Chapter 4, Switchboard Profit

The Switchboard Profit model combines three essential elements to generate outstanding profit:

  1. Packaging; the provision of necessary component resources for a task in one place/package that can be hired together instead of separately
  2. Monopolization; control of a critical resource that all users need to hire
  3. Market share; control of a critical mass of the total market (approximately 15-20% minimum in practice) which gives the perception of dominance and incentivizes economic actors to utilize the switchboard firm, thereby creating a multiplicative network effect that enhances the value of the switchboard with every additional increase in market share

Those are the essential ingredients. The way they work together to create outstanding profit opportunities is like so: limiting competition and reducing transaction costs. Those are the primary principles at work. By putting together various resources which would normally be hired separately (and thus, would be exchanged each in their own competitive markets), the Switchboard Profit model brings these resources under one roof where they can be hired together (packaging), where they can be hired no place else (monopolization) and where other similar resources, typically skilled labor, are thus attracted to because they see the probability of being hired at advantageous rates themselves to be much higher by participating in the network effect of the Switchboard Profit model firm (market share).

The result is a constrained supply which can negotiate for a higher total hire price. It is valuable for those hiring the products of the Switchboard Profit model firm to pay this higher price because they save on search costs and they also face the alternative option of hiring lower quality substitutes. The more that the resources in question come under the control of the Switchboard Profit model firm, the greater profit the firm can generate from being the central hub for hiring the resource out.

One company that sounds like a Switchboard Profit model on its face is Amazon, a logistics giant that aggregates numerous consumer goods in one place. This satisfies the packaging criteria, and it almost satisfies the market share criteria as suppliers of goods want to participate in Amazon’s marketplace because it can increase their market exposure and thus the chance that the product will be purchased. But Amazon does not maintain anything close to a monopoly on these goods because they’re widely available “commodities” rather than unique or limited supply products carried only by Amazon.

The example given in the book was the Hollywood talent agency of Michael Ovitz. Ovitz combined top star power with “total production resources” (writers, actors, directors, etc., all in one place) and he commanded a large share of the market such that additional writers, actors, directors, etc., had a strong incentive to join his firm and thus increase his profitability as his market share grew. An obvious additional example would be any other large, dominant talent agency such as for sports stars, musicians or other celebrities who each represent unique products that can be easily “controlled” and “constrained” by one firm.

The network effect seems to be a key aspect to the profitability of the Switchboard Profit model. Google’s dominance in search means it is largely the central hub by which people conduct their internet searches, meaning a person buying ad space in the Google network is getting a better package deal than other search network ad buyers.

A television network might also qualify as a Switchboard Profit model: if you have the best shows on TV and a large market share with all the kinds of shows in one place that people might want to watch, advertisers will be more attracted to you and so will TV show producers and so, too, will TV viewers. And the more people who utilize your TV network, the more valuable it is to everyone involved.

Other examples might include a health insurance network which includes top medical professionals under the insurance plan; a legal association with the best legal minds in a market in one place; or even a top university or research institution known to have the brightest minds.

Something interesting about the Switchboard Profit model is that most of these businesses seem to revolve around human resources, rather than non-human resources (commodities which are common or rare alike).

Chapter 5, Time Profit

Many of guru David Zhao’s profit models come with simple illustrations which capture the essential ingredient of the profit model. The image of the Time Profit model is an X-Y axis with “$/unit” on the Y-axis and “time” on the X-axis. Plotted across this chart is one line, which runs from the top left corner toward the bottom right corner at a 45-degree angle reading “Price”, and another line below that labeled “Cost” at a more mild angle, eventually intersecting with the “Price” line near the right side of the chart and then overtaking it.

The concept is simple: Time Profit is generated by being the first to market a new product or service because over time imitators will compete and eventually drive price toward cost. Time, therefore, is of the essence.

In TAOP, Zhao and Steve discuss Time Profit models in the context of firms without special legal protections (such as patents or copyrights) on their works which serve to shield them from competition. However, whether such legal protections are permanent or limited in duration, the Time Profit model principle is the same– only by being first to market would you even be afforded such legal protections in the first place, so there is an incentive to be first else you finish last.

Zhao and Steve discuss the Time Profit model within the context of an investment bank constantly innovating with new financial products. But this model could also easily apply to pharmaceutical and software development companies (which enjoy legal protections on their products), as well as a tech product manufacturer, such as a smartphone manufacturer, whose core product features are likely not subject to legal protections. Here, the Time Profit model is essential as the first firm to get a product to market with a valuable innovation that creates a consumer craze can capture a premium for their products while competing firms figure out how to duplicate this technology and make it standard in their follow-up product offerings. These “second place” firms are doomed to earn commodity returns on their products, only the first-mover gets to enjoy a profit premium.

Like the Customer Solution Profit model, the Time Profit model is more than just a specific business model, it is something of an essential feature to the competitive conditions of any firm in any industry facing innovative development which, practically speaking, is all firms in all industries. Whether a new product, a new service or a new internal or customer-facing process, all businesses seek to adopt one another’s best practices to save costs and increase profitability. The first firm to innovate something that is eventually imitable by others gets a profit advantage during the period of time between innovation and imitation by others. Time Profit models can be thought of as temporary competitive advantages due to periodic innovation.

As David Zhao teaches, a key component of the Time Profit model that is often overlooked is the role diligence in the innovative process plays:

Tedium is the single greatest challenge for a business that’s built on innovation

The first act of innovation is thinking, the arriving at of a brilliant new idea. The second act, and far more important, is the doing, the translation of an innovative idea into an innovative product, service or process. This part requires the same rigmarole of standard business practice: making phone calls, sending emails, training people, holding meetings, crunching numbers, keeping people on task and pulling in the same direction, etc.

Innovating, idea-making, is sexy and fun. But turning innovative ideas into real profit is often boring, common and time-consuming. The people and firms that are able to apply energy and determination to this part of the process are the ones who can most consistently capture the Time Profit. As innovator Paul Cook says, “What separates the winners and losers in innovation is who can master the drudgery.”

Ancillary Notes

Chapter 5 had a few other points worth mentioning, some of which were connected to carryover discussions from earlier chapters.

The first point concerns the power of critical numerical thinking. When working through a number problem, Zhao advises,

Getting the order of magnitude right is what matters, not the details

This is similar to Buffett and Munger’s “approximately right versus precisely wrong” dictum. Zhao also talks about using the numbers to ask and answer critical questions; the numbers of business (assumptions, projections, actual results, etc.) can tell us a story, but we have to be curious about the numbers. It’s not enough to wonder, “Why are the numbers what they are?” we have to be able to put forth some effort to attempt to answer such questions ourselves. As Zhao says,

Being able to take the measure of the world is one of the most crucial skills we can develop

The second point, which is arrived at in a discussion of business innovation, is the “paradox” Zhao observes in the semiconductor industry, which is that the firms involved “copy each other’s chips, but not each other’s business models.” It is the business model which is responsible for mastering the Time Profit concept and other models discussed in TAOP– why don’t more managements focus on copying successful business models rather than imitating successful products and services?

It brings to mind a question for potential investors, too. Which businesses could see their value dramatically improved by focusing the company’s efforts on copying the leading business model in the industry rather than engaging in the rat race of perpetual product innovation/imitation?

The final point has to do with the nature of learning. Steve the student asks Zhao for a copy of his notes from a previous meeting. Steve wants to see how Zhao solved a problem they both worked on. Zhao suggests,

you’ve got to learn how to solve these problems in your own way

the idea being that true knowledge means being able to solve a problem in your own way, not by imitating somebody else. This is why some firms are innovators while the rest are imitators. Innovators are capable of solving problems their own way; imitators just copy the innovator’s solution. But it’s a lesson that’s important to the budding business analyst, as well. How will you solve problems when there is no guru there to teach you? You have to find your own path and do your own thinking.

Until you can do that, though, as Steve says, copying a few “Picassos” to practice a known master technique can be helpful.

How Does Amazon Avoid Creating It’s Own Mini-Depression?

According to a new article at Slate, Amazon will soon (within the next 12 months) be offering it’s Kindle e-reader device for “free.” Here’s the part of the story that interested me the most:

Every time Amazon drops the price of the Kindle, sales of the device and sales of Kindle books increase dramatically.

This is curious. According to conventional economic views of the business-cycle, depressions occur when nominal price shocks occur in the economy which reduce the amount of aggregate spending, promoting further price decreases by businesses, which lead to even more reductions in spending as consumers become convinced that if they just wait a little bit longer, they can buy what they need at a lower price.

Next thing you know, spending has collapsed into the notorious and much-feared “death spiral” and the economy grinds to a halt. Mass unemployment, the fall of social morality and Huns impaling the babies of screaming mothers on top of their bayonets. The yooj.

But at Amazon, every time they lower prices, people spend more.

How come when Amazon does it, it creates more business and an environment where everyone (consumers and Amazon as a business) prospers, but when it happens in the economy at large, we get a death spiral and impaled babies?

Somewhere, there’s a disconnect between micro and macro. The secret (that the Keynesians never share and refuse to explain) is how and why this necessarily happens. Good luck figuring it out, I still haven’t!

How Businesses Grow: The Five Guys Story

What does America’s fastest growing restaurant chain look like on the inside and how was the growth accomplished? For the answers to those questions and many others I read a recent Forbes article entitled “Five Guys Burgers: America’s Fastest Growing Restaurant Chain“.

First, “Five Guys” growth in numbers:

  • Doubled number of stores since 2009
  • Started in 1986; since then, has grown to 1,039 stores in the US and Canada with commitments to open another 1,500
  • Grew 792% since 2006, nearest competitor Jimmy John’s grew 241% over the same period and now has 1,329 stores
  • Company-owned franchises 200; franchised 839
  • Projected sales of $1B+ in 2012; corp revenues of $275M with cash flow of $50M
  • Current value of the company estimated at $500M, $375M of which belongs to the founders, on an initial investment of $70,000

Founder Jerry Murrell and his sons came up with the idea in 1986 when Murrell offered his older sons nearing high school graduation a deal– they could go to college, or they could use their tuition money to start a restaurant.

Like many rapid growth successes stories, early growth was slow and hard to come by. Persevering through employee theft, customer service shortcomings and inter-family squabbles behind the scenes, the group opened their second store in 1989 after being turned down for business loans by numerous local banks. Instead, they raised money $10,000 to $30,000 at a time from 100 friends and acquaintances and committed to always paying on time.

Even early on Murrell received suggestions that he stray from the company’s “core competency” of high quality burgers and fries– coffee, chicken sandwiches, milkshakes and more were all brought up and some even tried but every time Murrell found it to be a disaster. Eventually, Murrell and company gave up, and his disciplined reasoning is instructive in demonstrating his understanding of his own brand:

My fear was that we’d add something new and not be good at it, then some reviewer would write about how bad our coffee was and not how good our burgers and fries are… [The demise of other restaurant chains involves one constant.] They all started to offer too many items and got away from their core.

By 2002, they had 5 stores in Northern Virginia and began thinking about franchising. Murrell received a copy of Franchising For Dummies from his son which he read and that, combined with a fortuitous meeting with former Washington Redskins-kicker and burger joint owner Mark Mosley and consultation with Fransmart the Five Guys team moved ahead, selling out all franchise rights to Virginia within three weeks.

The standard franchisee must have a minimum net worth of $1.5M and liquidity of $500,000. He pays an upfront fee of $75,000 per store, the average store costing $350,000-$500,000 to open and generates an average of $1.2M in revenues each year. Five Guys corporate charges 6% of gross revenues and another 1.5% which is collected for “audits” which are used to pay $1,000 weekly bonuses to stores that score will after being visited by independent examiners. According to Five Guys largest franchisee, stores break even within two and a half years and have operating margins in the mid-teens.

There are other entrants in the “better burger” category such as Smash Burger and Shake Shack (note: I’ve had both and I don’t think they offer much competition) and because of the rapid franchising, Five Guys has occasionally run into the problem of overlapping markets where franchise owners cannibalize one another’s sales. Murrell occasionally buys back franchises when he can and the company is currently working on an overseas expansion which will begin in the UK. There’s talk of expanding to the Middle East and private equity and investment bankers have been on the company’s case for years.

Who knows what lies ahead but so far, through all the ups and downs, the company has remained a thoroughly family affair.

How Businesses Grow: “The LEGO Story”

I found this video on the Laissez-Faire Books blog after Jeff Tucker posted it recently.

It’s an entertaining and educational video that provides anecdotes about how and why small businesses grow. In the case of LEGO, because they had to– the owner-operator of the company had no golden parachute to fall back on if he failed. This kept him thinking creatively about how to solve the many challenges he and his business faced. It was “find a way” or else he and his children would starve.

It’s a story of entrepreneurialism, the essence of which is experimentation, vision and constant change.

As you watch the video, it’s hard to imagine a story like this being told about anything other than an initially small, local, privately-owned business. It perfectly captures the idea of the “benevolent dictatorship” style of business and capital management. We also get a look at the innovative process that leads to the creation of a whole new industry (or sub-industry, much like the iPhone was an emergent sub-industry within the industry of smartphones).

 

Review – Billion Dollar Lessons

Billion Dollar Lessons: What You Can Learn from the Most Inexcusable Business Failures of the Last 25 Years
by Paul B. Carroll and Chunka Mui, published 2008, 2009

The seven deadly business sins

The authors of Billion Dollar Lessons identified seven “failure patterns” that typify the path to downfall of most businesses:

  1. synergy; overestimating the cost savings or the profit-enhancement of synergy
  2. aggressive accounting; becoming addicted to creative accounting practices which eventually invites outright fraud to keep up with
  3. rollup acquisitions; assuming the whole is greater than the sum of the parts
  4. blindness to catastrophe; dancing on the deck of the Titanic, ignoring that the ship is sinking
  5. uneconomic adjacency acquisitions; assuming there are benefits to combining similar businesses which are actually dissimilar
  6. disruptive technology; committing oneself to the wrong technology and betting it all
  7. consolidation indigestion; assuming that consolidation is always the right answer and that it solves all corporate problems

In Part I, each chapter addresses one of these failure patterns, explaining the principles and problems of the failure pattern, giving numerous real-world examples of the pattern in action and finishing with a list of tough questions for managers and shareholders/board members to ask before pursuing one of the potentially flawed strategies mentioned.

In Part II, the authors offer a behavioral/psychological explanation for why companies and individuals routinely make these same mistakes, basing their assertions on the idea of “human universals.” The idea is that being aware of them is not enough– one must also put into place processes and self-check systems that are independent of any one person’s self-honesty (or lack thereof) to allow a company to essentially “check itself before it wrecks itself.” The most important corporate institution suggested is the Devil’s Advocate.

Illusions of synergy

According to the text,

A McKinsey study of 124 mergers found that only 30 percent generated synergies on the revenue side that were even close to what the acquirer had predicted… Some 60 percent of the cases met the forecasts on cost synergies

In general, there are three main reasons why synergy strategies fail:

  1. synergy may exist only in the minds of strategists, not in the minds of customers
  2. companies typically overpay for an acquisition, meaning the benefits from synergies realized are not enough to overcome the initial investment cost
  3. clashes of culture, skills or systems often develop following an acquisition, killing the potential for synergies

Double-check your synergy strategy by asking yourself the following tough questions:

  • Do you need to buy a company to get the synergies, or could you just form a partnership?
  • How do you know that customers will flock to a new product, service or sales channel?
  • If you think you’re going to improve customer service, then how exactly will that look from the customer’s perspective?
  • What could competitors do to hurt you, especially during the transition while you integrate the company you’re taking over?
  • Who in the combined organization will resist the attempts for revenue synergies? Whose compensation will be hurt?
  • What are the chances you’re right about revenue synergies?
  • What percent of your customer base might go elsewhere following this corporate change?
  • Acquisition cost:
    • What is the target company worth on a stand-alone basis?
    • What would the business be worth if you achieved all synergies mapped out?
    • What would the business be worth if you discounted the synergies, based on the fact that few companies achieve all the synergies planned?

Faulty financial engineering

Many companies find themselves in hot water because they believe their own creative accounting too much. They let sophisticated financial legerdemain conceal the uneconomic nature or riskiness of their business. Managers often become addicted to this accounting, finding themselves stuck on the “treadmill of expectations” and give in to the temptation to commit outright fraud to keep it going, destroying the business in the process.

There are four primary risks to financial engineering strategies:

  1. encourage flawed financial products which are attractive to customers in the short-term but expose the seller to incommensurate risk of failure over time
  2. hopelessly optimistic levels of leverage
  3. aggressive and unsustainable financial reporting
  4. positive feedback loops which cause the system to implode

Double-check your financial engineering strategy by asking yourself the following tough questions:

  • Can the strategy withstand sunshine? (Would you be embarrassed if it was widely known and understood?)
  • Can the strategy withstand storms? (Is it fragile and susceptible to being tipped over by less-than-perfect conditions?)
  • Will that accounting generate positive cash flow or just make the profit-and-loss statement look better?
  • Does the strategy make any sense? (ex, does it make sense to offer long-term financing on short-term depreciating assets?)
  • When does it stop?

Deflated rollups

According to business research,

more than two-thirds of rollups fail to create any value for investors

The rollup strategy is initially attractive because

the concept makes sense, growth is unbelievable, and problems haven’t surfaced yet

But they rely a lot on positive momentum to succeed because

Rollups have to keep growing by leaps and bounds, or investors disappear, and the financing for the rollup goes with them

There are four major risks to a rollup strategy:

  1. rollups often wind up with diseconomies of scale
  2. they require an unsustainably fast rate of acquisition
  3. the acquiring company doesn’t allow for tough times in their calculations
  4. companies assume they’ll get the benefits of both decentralization and integration, when in reality they must choose between one or the other

Double-check your rollup strategy by asking yourself the following tough questions:

  • Will your information systems break down if you increase the size of your business by a large factor?
  • What other systems might break down at the new scale?
  • How much of senior management’s time is going to go to putting out fires, coordinating activities, etc.?
  • How much business will you lose in the short run as competitors use takeover confusion to try to poach business?
  • What regulations might change and how will they affect the business?
  • Will your cost of capital really decline? If so, how much? How do you know?
  • If you think your pricing power will increase, why?
  • What will you have to spend, both in time and money, to get the efficiencies you expect from a takeover?
  • Who has a vested interest in keeping you from achieving all the efficiencies you expect?
  • How much will prices of acquisitions rise over time, as your rollup intentions become clear?
  • If you’re financing with debt, just how big a hit to your business can you withstand? What if you take a hit to cash flow for a period of years? If you’re buying with stock, what do you do if your stock price falls by 50%?
  • How do you prevent people from cooking the books when the bad times come?
  • Have you discounted the gains you expect to get from integration?
  • How much loss of revenue are you assuming if you replace local managers and systems?
  • What is the end game? How big do you need to get?
  • How slowly can you go?
  • Do you have to be a national rollup, or would a regional one make sense? Can you at least start as a regional rollup and work out the kinks?

Staying the (misguided) course

Businesses often adhere to a failed strategy or a dying technology because they either can’t envision how they’d adapt or can’t admit that they’re on a failed business course.

The three main risks to staying the course are:

  1. tend to see the future as a variant of the present
  2. tend to consider whether to adopt a new technology or business practice based on how the economics compare with those of the existing business
  3. tend not to consider all their options

Double-check your core strategy by asking yourself the following tough questions:

  • Are you considering all your options?
  • Declining business model, based upon Michael Porter’s five forces:
    • does your industry have a favorable structure for decline, where, like steel, it will provide profits even as it declines? Or, is your industry like traditional photography, which would mostly disappear once digital took hold?
    • can you compete successfully for the remaining demand, like Kodak, with a great brand? Or do you not only lack a brand but also lack other assets, such as a low cost structure?

Misjudged adjacencies

Adjacent market expansion entails attempting to sell new products to existing customers, or existing products to new customers, by building on a core organizational strength to expand the business in a significant way.

But sometimes, businesses expand into markets that seem adjacent, but are not– just because your branded-sunglasses customers like your sunglasses brand, doesn’t mean they’ll necessarily like it on their sportscar tires, or on their surfboards, because you imagine your market is “sport lifestyle.”

There are four fundamental risks to an adjacency strategy to be aware of:

  1. the move is driven more by a change in a company’s core business rather than by some great opportunity in the adjacent market
  2. lack of expertise in the adjacent market, causing misjudgment of acquisitions and mismanagement of the competitive challenges of the new market
  3. overestimation of the strengths of importance of core business capabilities in the new market
  4. overestimation of the hold on customers, creating expectations of cross-selling or up-selling that won’t materialize

Double-check your adjacencies strategy by asking yourself the following tough questions:

  • How do the sales channels differ in the new market?
  • How do the customers differ?
  • How do the products differ?
  • Are the regulatory environments differ?
  • Do you have at least a 30% advantage on costs before entering the new market?
  • What if the economy goes seriously south?
  • What if the sector you’re moving into goes into decline?
  • What if your expectations about opportunities for efficiency and revenue growth don’t happen?
  • How much do you have to be off in your estimates of cost savings or revenue increases for the adjacency strategy to be a bad idea?
  • What don’t you know about your new market?
  • What don’t you know about making acquisitions?
  • How many of your acquisitions will be lemons?
  • Will your customers really follow you into your new market?

Fumbling technology

Businesses often bet the farm on a technology that turns out to be nowhere close to as profitable and revolutionary as they initially expect it to. Often, market research is created which suffers from “confirmation bias”.

There are three important technological “laws” to be mindful of, which are often ignored, as well:

  1. Moore’s Law; computer processors double in power every eighteen to twenty-four months
  2. Metcalfe’s Law; the value of a network is proportional to the square of the number of users
  3. Reed’s Law; new members increase a network’s utility even faster in networks that allow arbitrary group formation

There are four major mistakes businesses make when evaluating a technological strategy:

  1. evaluate their offering in isolation, rather than in the context of how alternatives will evolve over time
  2. confuse market research with marketing
  3. false security in competition, believing the presence of rivals equates to a validation of the potential market
  4. design the effort to be a front-loaded gamble instead of developing it piece-by-piece

Double-check your technology strategy by asking yourself the following tough questions:

  • What will your competition look like by the time you get to market? What if you’re six months late? A year?
  • How does your performance trajectory compare with the competition’s?
  • Do your projections incorporate Moore’s Law, for both yourself and your competition?
  • Have you allowed for Metcalfe’s Law and what it says about the relative value of networks? Is Reed’s Law relevant?
  • Is the market real?
  • Do you have to do it all at once? Or can you try things a bit at a time and learn as you go along?

Consolidation blues

Consolidation seems to be a fact of maturing industries. As an industry matures, smaller companies go out of business or are acquired. Most business people figure they want to be the acquirer; in the process, they ignore the possibility that they might be more valuable as a target, or by sitting and doing nothing (neither consolidating, nor selling out).

There are four main issues that tend to muck up consolidation strategies:

  1. you don’t just buy assets as a consolidator, you buy problems
  2. there may be diseconomies of scale
  3. assumption that the customers of the acquired company will be held
  4. may not consider all options (being an acquisition target, doing nothing)

Double-check your consolidation strategy by asking yourself the following tough questions:

  • What systems might fail under the weight of increased size? How much would it cost to fix them? How long would it take? What revenue might be lost in the interim?
  • What relationships might be harmed?
  • What departments are too small, or are for some other reason not up to the task of handling the new size? Which people aren’t up to the task?
  • How much will be lost as people jockey for position in the new organization?
  • How much drag will develop as you try to find efficiencies by standardizing processes?
  • Who will resist change? How effective will they be?
  • What are all the reasons why customers might defect?
  • How does consolidation benefit the customers?
  • What percentage of customers do you think might leave? How much do you think you’ll have to pay to entice these customers to stick around?
  • What are some potential results if you sold out or did nothing, instead of consolidating?

Coda

In summary, the most common problems that result in business failure are:

  • Underestimating the complexity that comes with scale
  • Overstating the increased purchasing power or pricing power or other types of power that come from growing in size (beware of “critical mass” strategies)
  • Overestimating your hold on customers
  • Playing semantic games (any strategy that relies on a turn of phrase is open to challenge)
  • Not considering all the options
  • Overpaying for acquisitions

Avoiding these mistakes: the Devil’s Advocate

How can you avoid these mistakes?

Put in place a process for reviewing the quality of past decisions.

Watch out for cohesive teams who develop the traits of dehumanizing the enemy and thinking they’re incompetent; limiting the number of alternatives they will consider; show even more overconfidence than members would as individuals; create “mind guards” who stomp out dissent.

Probably most important, establish the institution of Devil’s Advocate. Either assign an in-house, permanent DA (who gains experience with each episode, but carries the risk of being labeled as the “naysayer” and ignored) or assign the role on a rotating basis with each new decision (preferable).

The Devil’s Advocate is a powerful tool for avoiding business failure because

More often than not, failure in innovation is rooted in not having asked an important question, rather than having arrived at an incorrect answer

Gary North On Time Management, 80/20 Rule

I am posting this for future reference. Gary North’s point isn’t original (it isn’t even his alone), but he has managed to articulate it succinctly, yet again, in “Putter, Fritter and Guess“:

It turns out that the best way for a businessman to spend his time is the 20% of his hours in a day that produce 80% of his net income. It may not be easy to identify these activities, but for a successful career, a person must do this.

What we find is that even when people do this, they do not have the self-discipline to ruthlessly abandon the 80%. They keep doing these low-return tasks. This may be pure habit. It may be a commitment to the ideal of perfectionism: to be sure that everything gets done right. The person refuses to decentralize and delegate. He cannot bring himself to let go. The result is that the person does not attain his maximum output/income.

The person who steadfastly refuses to delegate and decentralize is violating the principle of the division of labor. This principle says: “You can’t do it all.” In some cases, it says; “You can’t do it at all.” A task may not be a one-person task.

The person who is a perfectionist and who insists on doing an entire project is asking to minimize his output. If, by hiring an assistant, he can double his output and reduce quality only (say) 4% (20% of 20%), this will not matter, if the 4% is related to the 80% of the product’s functions that people rarely use.

Can Best Buy Be Fixed? Reply To @vitaliyk

A value investor by the name of Vitaliy Katsenelson, whose blog I subscribe to, just posted his ideas on How to Fix Best Buy:

Best Buy cannot have lower prices than its online competitors, and its stores lack the breadth of selection of Amazon.com, putting it at a permanent competitive cost disadvantage.

The new strategy Dunn announced a few weeks before his resignation — of closing big stores and opening a lot of smaller stores — made little sense. It was basically turning Best Buy into RadioShack Corp. It would have been great if this approach had worked for RadioShack, but it hadn’t.

Katsenelson is correct. Best Buy’s business model is cooked. It provides a service that is increasingly out of touch with how consumers of its products shop, and it does it within a cost structure that is not price competitive with the other participants in its market.

So, Katsenelson proposes a solution for Best Buy:

Best Buy’s strategy for the brave new world requires thinking that cannot be delivered by somebody who spent 28 years in the Best Buy box. It requires the strategy of an Amazon or Netflix, where management was willing to bring forward and execute a disruptive new approach that undermined its current cash-cow business. Amazon did this by bringing electronic readers to the masses. Netflix did it by streaming movies and TV shows.

The rest of Katsenelson’s proposal, while creative and worth pondering on its own from a strategic value point of view, is unimportant for the purposes of our present discussion, which is actually to highlight the role of innovation.

According to our reading of The Innovator’s Dilemma, Katsenelson is suffering from two confusions in his analysis:

  1. He is confused about the difference between sustaining and disruptive technologies
  2. He is confused about the likelihood of success in a firm disrupting its own business model

Let’s tackle each confusion separately before reaching a new conclusion.

Confusion #1 – sustaining vs. disruptive technology

In building his analysis of Best Buy’s current predicament, Katsenelson cites the examples of Amazon’s Kindle and Netflix’s digital streaming technologies as examples of “disruptive” technology.

It might be useful at this point to revisit the definition of sustaining versus disruptive technology provided to us by The Innovator’s Dilemma before proceeding:

  • sustaining, which are new technologies that improve a product or service in a way that is valuable to existing customers or markets
  • disruptive, which are new technologies that are uncompetitive along traditional performance metrics, which are unusable or undesirable to existing customers or markets but which nonetheless can eventually come to replace the traditional market over time

(A disclosure here, as well– I have not studied Amazon nor Netflix in depth, so I am making some conjectures here about margins and pricing which may be incorrect, and I realize they are central to the point I am making so it could weaken my argument slightly if I am speaking out of turn here.)

Now, judging by the definitions above, I’d say both Amazon’s Kindle and Netflix’s digital streaming service are actually sustaining technologies, not disruptive. A good clue to the truth of this might come in the fact that these technologies each were developed and implemented from within the firms in question, rather than being produced by an entrant, competitor firm.

But even if that is not the give away, sure both of these technologies improved their existing products and services (books and movie rentals, respectively) and both were appealing to existing customers. It is not my understanding that there were a bunch of people who were not buying books and not renting movies until Amazon and Netflix released their new services, at which point they jumped on board. In fact, it is my understanding that many customers who now use the Kindle or digital streaming were previously physical book readers or mail-order movie renters.

Additionally, my understanding is that these new businesses are either similar margin or better margin businesses than what came before. I understand Netflix has had issues with the cost of acquiring distribution rights to film properties but that seems a separate issue from the actual question of the cost of distribution– digital streaming seems far more cost effective than sending things through the mail. Same with e-readership; the question of acquiring separate rights for digital distribution is a different one than the cost of distribution, of which digital book distribution seems to be a far higher margin business than the one involving costs of inventorying and mailing physical copies of books.

This is another aspect of the sustaining vs. disruptive technology debate– firms on sustaining technological pathways look for higher margin business that satisfies their existing customers and provides them with improved, but similar service to what they had before. Disruptive technological pathways involve different (usually lower) cost structures and different products or services which are competitive on metrics or feature sets that were previously not an issue in the pre-existing competitive paradigm.

Best Buy was, in its heyday, an electronics and appliance retailer where customers not only shopped but transacted. Nobody wants to transact with Best Buy anymore. That truly is a disruption as now people just want to shop. Any proposal that involves Best Buy no longer being a retailer (shopping AND buying) is a proposal for disruptive innovation within Best Buy’s existing business model, and a change in cost structure that would go along with it.

Confusion #2 – the likelihood of success in self-disruption

The other thing that’s clear from reading The Innovator’s Dilemma is that responding to a disruptive threat from an entrant firm is hard enough, but successfully disrupting one’s own business model is nearly impossible.

There are myriad reasons why this is so but what it essentially boils down to is that, as Geoff Gannon says, businesses have DNA and part of their DNA is their cost structure. Asking a business to change its cost structure is like asking it to change its DNA; it’s akin to expecting a megalodon to transform itself into a tick.

Another part of a business’s DNA is its management culture and accumulated experience. Just as certain animal species seem to have integrated various memory experiences into their DNA which are expressed as subconscious, instinctive behavior that comes naturally and effortlessly to the animal, a business develops a management culture (tightly interwoven with and often times predicated on the business’s cost and incentive structures) that possesses a kind of collective memory, or instinct. Management culture is “evolutionary”– it’s highly specialized and adaptive, designed to excel in the conditions unique to that business’s industry but which may prove maladaptive in conditions dominating outside of the industry.

Expecting a company’s management to successfully adapt its culture, its DNA, to new competitive circumstances is like expecting a polar bear to hunt successfully after air dropping it into the African savannah, or a jungle on the Indian subcontinent.

Getting rid of the top executive is not enough. CEO Brian Dunn might be gone, but all his lieutenants remain. They’re like mini-Brian Dunns, the children of Brian Dunn, they might not be exact replicas but they’ve undoubtedly learned a lot and probably “grown up” believing in his authority and vision the way children have trouble question their parents. They bring all that along with them. (David Merkel discussed this phenomenon in his bond manager series where he talked about the way a corporate debt team will come to be subtlety but surely influenced by the PM, and it applies in other business organizations outside the world of corporate bond management.)

Everyone who works at Best Buy is used to succeeding (and failing) a particular way. It is unlikely they’ll find themselves succeeding in a new paradigm that’s completely foreign to them when they are failing to sustain their business in a paradigm they’re intimately familiar with and once dominated.

A third way? Dissolution, sub-disruption, liquidation?

Katsenelson’s two examples don’t shed much light on what Best Buy should do because they’re examples of successful adoption of sustaining, not disruptive technologies. Best Buy is facing disruptive competition, it is beyond the point where its business could be improved by a sustaining technology.

And self-disruption doesn’t appear to be a viable strategy because Best Buy has built-in business DNA which can not be easily mutated, if it can be changed at all.

So, what should Best Buy do?

One perfectly reasonable strategy could be dissolution (aka liquidation by change in ownership)– Best Buy could sell itself to a strategic buyer who values Best Buy more as a sum-of-parts than as its currently operating whole. The new owner could salvage and re-orient what it can and then re-sell the rest as “scrap”. Just because the Pinto explodes when it gets rear-ended doesn’t mean the metal and upholstery in the vehicle couldn’t be used elsewhere. This is an option.

Another strategy is for the company to liquidate itself– managed, slow-motion suicide. The company could cut cap-ex to zero, start winding down its inventory buying and other business activities in line with the maturation of its existing facilities leases and then close out the stores one by one (selling property, plant and equipment when possible as this process continues). The proceeds could be distributed as periodic dividends to shareholders or be distributed as a lump-sum cash payment in exchange for shares at the end of the process several years from now.

But there is a third way and it actually does involve self-disruption: Best Buy could set in motion the slow-motion suicide or not, and at the same time use some of its capital to set up a small subsidiary to either compete in the world of Amazon, or work at discovering another disruptive technology which could re-jigger the industry even more and prove a disruptive threat to Amazon. This subsidiary would have completely separate managementcompletely separate capital and a completely separate cost structure which would be appropriate to the new market it is attempting to compete in.

That’s one way Best Buy could successfully respond to innovation in its industry. But it’s most likely far too late for that.

Which is why I think it’s pretty clear Best Buy is a value trap outside a strategic buyer coming into the picture (Schulze might be a little slow to the draw, but at least he’s got the good sense to go for his revolver before his opponent six-shoots him into a shallow grave), or the current management dedicating itself to a program of self-liquidation over the next several years.

Review – The Innovator’s Dilemma

The Innovator’s Dilemma: The Revolutionary Book That Will Change the Way You Do Business

by Clayton M. Christensen, published 1997

Technological innovation always means change, but which kind?

In the world of business technology, innovation can be thought of as coming in two distinct flavors:

  • sustaining, which are new technologies that improve a product or service in a way that is valuable to existing customers or markets
  • disruptive, which are new technologies that are uncompetitive along traditional performance metrics, which are unusable or undesirable to existing customers or markets but which nonetheless can eventually come to replace the traditional market over time

Throughout history, it is the best-in-class businesses which have the most difficult time with disruptive technologies to the point that disruptive technologies are usually the death knell for the leading businesses at the time. But this raises a question: if they’re such good businesses and they’re so well-managed, how come they can’t manage their way around disruptive technology in their industry?

The answer lies at the heart of what the author refers to as the “innovator’s dilemma”:

the logical, competent decisions of management that are critical to the success of their companies are also the reasons why they lose their positions of leadership

Why do good management teams and competent decision-making processes miss disruptive technologies? Disruptive technologies:

  1. are normally simpler and cheaper, promising lower margins, not greater profits
  2. typically are first commercialized in emerging or insignificant markets
  3. are usually unwanted and unusable to leading firms’ most profitable customers

But good management teams with excellent decision-making processes are fine-tuned to search out:

  1. higher margin opportunities at best, and opportunities with minimum margin requirements based upon their existing cost structure
  2. opportunities that market research and querying of leading customers show there is a present demand for
  3. markets and growth opportunities which can have a significant impact on their business relative to their current scale

In short, every successful firm has a unique “value network” DNA that allows them to be especially dominant within a certain set of competitive circumstances.

the value network — the context within which a firm identifies and responds to customers’ needs, solves problems, procures inputs, reacts to competitors, and strives for profit

But disruptive technologies present a paradigm shift of a market into a completely different “value network” that the firm has not been evolved to survive in which results in, similar to biology, an extinction event for firms with the wrong type of value network DNA.

Crafting a response to disruptive technology

But the reality of disruptive technology is not entirely depressing for successful firms, and they can develop successful strategies for coping with disruptive technologies if they first make themselves aware of the five principles of disruptive innovation:

  1. Companies depend on customers and investors for resources
  2. Small markets don’t solve the growth needs of large companies
  3. Markets that don’t exist can’t be analyzed
  4. An organizations capabilities define its disabilities
  5. Technology supply may not equal market demand

Each of these principles holds within it a potential misstep for successful firms within their traditional value networks trying to respond to a disruptive technology. Because firms depend on their customers (primarily their leading, most profitable customers) and investors for their resources, they are often incentivized to ignore the low margin disruptive technology because their customers initially don’t want it. And because disruptive technologies start in emerging or insignificant markets, successful firms often ignore them in favor of better growth opportunities. Meanwhile, firms that DO try to take disruptive technologies seriously often commit themselves to particular investment and marketing patterns based off of market research for a market that is dynamic and prone to sudden and rapid change. At the same time, that which makes a company excellent at doing A simultaneously makes the company horrible at doing B (where B is the opposite of A), and often disruptive technologies require B responses when successful firms are honed to operate at A. The final frustration for these successful firms occurs when they attempt to enter a disruptive market with a solution that technologically exceeds the needs of its current users, causing them to withdraw in defeat only to watch the market then take off anyway!

An ironic twist

As hinted at above, it is ironic that the very strengths of leading firms in adapting their business to sustaining technologies (improvements in performance in relevant metrics that their best customers demand) are the exact things that cause them to fail to respond to disruptive technologies in a profitable, dominant way. And to make a bad story worse, it is these strengths-as-weaknesses that allow entrants in disruptive technological markets to capture important first-mover advantages for themselves, constructing barriers to entry which are later often insurmountable for established firms.

To a dominant firm, disruptive technology looks like low-margin, small market business that neither their customers nor anyone else seems to be interested in. But for entrants in the disruptive market, with radically different cost structures than dominant firms and with organizational sizes and resources better matched to the opportunities presented, disruptive markets are a wild playground full of unchallenged opportunity.

And while the dominant firms look down at lower-margin, smaller market business and shake their heads dismissively, entrant firms look up above at higher-margin, huge market opportunity and lick their chops. Every business ultimately looks upstream for higher-margin opportunities than the ones they have at present.

Is it any wonder why dominant firms are continually defeated by surprise attacks from below?

How dominant firms can successfully respond to disruptive technology

The position of the dominant firm in the face of disruptive emerging technology is not hopeless. For every yin, there is a yang. By inverting the five principles of disruptive innovation outlined earlier, dominant firms can find five guidelines for successfully responding to disruptive technology:

  1. Give responsibility for disruptive technologies to organizations whose customers need them
  2. Match the size of the organization to the size of the market
  3. Discover new and emerging markets through a flexible commitment to “plans for learning” rather than plans for implementation
  4. Create organizational capabilities and strengths which are complementary to the unique demands of the disruptive market place
  5. Resist the temptation to approach the disruptive technology with the goal of turning it into something existing customers can use, rather than serving the customers unique to the market and searching out new markets entirely

Conclusion

This book was published 15 years ago. The subtitle is, “The revolutionary book that will change the way you do business.” I don’t know if 15 years is long enough in the business world for the ideas of a book like this to be fully adapted into the mainstream but I would guess it is not. I am no business expert but this material was completely uncharted territory for me.

Frankly, I never thought I’d enjoy reading something written by a Harvard business school professor as much as I did with this book. Whereas case studies, quirky charts and statistical evidence usually bore me to the point that I often skip over them, this book was something of a page-turner for me and I found myself eager to find out “what happens next” in each subsequent chapter.

As faddish as it has become as of late to hype the increasingly rapid change of markets and business practices in general, the reality is that most markets don’t change that quickly and most business practices are timeless themselves. But for those unlucky enough to find themselves, suddenly or otherwise, in a market or business that is changing due to disruptive technology, this book could be a lifesaver at a minimum and a handbook for profiting immensely from that change at best.

You can get the essential points of the book entirely from reading my review, or skim-reading the introduction and final chapters of the book (which present a comprehensive summary of the ideas outlined above). But the case studies are invaluable in driving the point home and there are numerous nuances to Christensen’s argument that are worth savoring and considering on their own. Because of this, I unequivocally recommend that every interested reader purchase their own copy and read it in full, and thereby grant themselves an invaluable competitive advantage in the market place, whichever value network they might happen to be competing within.

Review – The 22 Immutable Laws Of Marketing

The 22 Immutable Laws Of Marketing: Violate Them At Your Own Risk

by Al Ries & Jack Trout, published 1993

The redundant and contradictory laws of marketing

The 22 Laws is a helpful quick-read book for those looking to dip their toe into the waters of marketing. It takes a high level approach to the strategy of marketing and is definitely a “how-to-do” not “what-to-do” title. As such, my goal in this write-up is to focus on the laws I found to be most reasonable and deserving of consideration, the combine several laws that seemed to be versions of one another or the same concept examined from different angles, and dropped a number of laws I thought were too crude to be of any use.

An abridged journal of immutable marketing laws

My abridged version of The 22 Laws is as follows:

  1. It’s better to be first than it is to be better
  2. If you can’t be first in an existing category, introduce a new one in which you can be first
  3. Target mindshare, not marketshare
  4. Perception is reality; focus on perception, not products
  5. Own an exclusive word or attribute; your product and a category keyword or attribute should be inseparable in people’s minds
  6. The only positions that count in the market are first and second, and second’s marketing strategy is dictated by first’s
  7. Marketing categories will continually bifurcate over time
  8. There is a temptation to extend brand equity to new product lines, which simply dilutes the brand and invites additional competition
  9. You must be willing to give up product line, target market or constant change in order to dominate a market
  10. Failure is to be expected and accepted
  11. Trends, not fads, are the key to long-term marketing success

Putting the 11 laws into practice

Hopefully each of the 11 abridged marketing laws above are self-explanatory. But even as simple as they are, each holds a wealth of additional implications.

Law 1 is related to the concept of competition and is tied to laws 3 and 4. If you are the first product into a market you will not only likely benefit from a first-mover advantage but, if done correctly, you will have positioned yourself to define the market. People form habits and tend to make up their mind once and then not change it. When you’re first into the market you have a fortress position within people’s minds that entrant firms must assault if they hope to dislodge you. People tend to remember those who did things first, not best. It is easier to entrench than dislodge.

This is why law 2 is important– you want to avoid being an entrant in the competitive landscape as much as you can. Much better to create a category where you are the only supplier at best, or force your competitors to be No. 2, 3, 4, etc. at worst. Once you’ve created a category you are first in, promote the category, not your brand.

Marketing is a deeply psychological enterprise, which is why laws 3-5 focus on the role perception and mental imagery play in good marketing practice. But the specific application of these psychological rules is once again strategic in nature– they are each about how you compete and limiting your competition. By owning a word or attribute, as law 5 suggests, you deny your competition the benefit of identifying their product with that word and you often get a halo effect as related words and benefits get associated with your product in the consumer’s mind as well. The most effective words are simple and benefit oriented.

Furthermore, your word should be exclusive and precise, and you should only have one. If you pick something like “quality” you haven’t said anything about your product, because everyone intends to create a product with quality. You haven’t differentiated. And if you try to pick “value and safety”, you’ll lose because you’re now competing with two opponents– the one which prides itself on value and the one which prides itself on safety. It’s harder to fight two people than one. And it should go without saying that, if available, you should always choose the most important word or attribute to focus on.

Law 6 is important to understanding the concept of relativity in marketing. Your marketing strategy should always take account of “which rung of the ladder” you’re on as certain claims and strategies won’t make sense or will sound inauthentic if given from the wrong place on the market share ladder. Further, it will never be appropriate to market as if you’re No. 1, when you’re No. 2. The advantage of No. 1 is telling everyone you’re the best. The advantage to No. 2 is telling people they have an alternative to No. 1.

Laws 7-9 deal with the concept of marketing focus, or concentrating your marketing strategy to a narrow band where you can actually be competitive. Category bifurcation is a natural process (eg., computers –> laptops vs. desktops; automobiles –> family sedans vs. economy compacts, etc.) in market evolution. Many firms make the mistake of trying to maintain leadership in all resulting markets as initial markets bifurcate, instead of sticking to the market they have an advantage in where their brand is trusted most.

Worse, they dilute their own brand by bifurcating their market themselves (eg., 7UP –> cherry 7UP vs. original 7UP). The market that 7UP made for itself as an “uncola” and the marketing strategy it followed to enable that success does not carry over to derivative products and it ends up just competing against itself. Sometimes, you simply expose yourself to more competition in the process as competitors mimic you and you further slice up a slice of the market.

This is why a successful marketing strategy entails “sacrifice”, either of product line, target market or the impetus to constantly change. Expanding product lines mean expanding competition. According to earlier marketing laws, a brand can’t mean everything or it means nothing. Expanding product lines under a brand means movement toward “meaning everything/nothing”.

Similarly, few products will appeal to everyone. Attempts to appeal to everyone usually result in appealing to no one. Focus on the target markets where your product has the strongest appeal and then dominate those markets. And when you have a marketing strategy that works and results in market dominance, leave it alone, don’t go out in search of a new market you might not dominate (while giving up your dominant position in the process!)

The eleventh law highlights the long-term nature of successful marketing strategies. Good marketing is about coming up with an angle or word that differentiates your product and then establishing a long-term marketing direction to maximize the idea or angle over time. This implies avoiding hype and the temptation to market your product as a fad and instead seek to create a trend, which is more enduring and has more competitive inertia making it harder for your opponents to fight.

The law of failure (10) is the one likely most forgotten and least appreciated. Failure will happen. Not every strategy will work out. In the event of a failure, it’s best to cut your losses early and change directions. At the same time, it’s critical to understand that the first several laws of marketing entail risk-taking (for example, being first at anything involves sticking your neck out) so occasional failure is part of the territory.