The Boston Consulting Group on Strategy

The Nature of Business Strategy

Strategic and Natural Competition

Bruce Henderson captured it classically: “All competitors who persist over time must maintain a unique advantage by differentiation over all others. Managing that differentiation is the essence of long-term business strategy.”

Natural competition is evolutionary. Strategic competition is revolutionary.

Competitors who make their living in exactly the same way in the same place at the same time are highly unlikely to remain in a stable equilibrium.

Strategic competition is not new. The elements of it have been recognized and used in warfare since the human race became able to combine intelligence, imagination, accumulated resources, and deliberately coordinated behavior.

Geopolitics is this larger perspective of the continued competition of this dynamic equilibrium over time.

The general theory of business competition is almost certainly in its infancy.

The earlier work of The Boston Consulting Group attempted to develop a general theory of competition based on the following:

• Observable patterns of cost behavior.
• Considerations of the dynamics of sustainable growth and capital use.
• The role of the capital markets in permitting these effects to be leveraged or discounted.
• The relationship between these in a system of competition.

We recognized early the inappropriateness of accounting theories developed for other purposes as a model of economic behavior. We then developed the concepts that can be summarized as “cash in and out is all that counts.”

We believe that insight into strategic competition has the promise of a quantum increase in our productivity and our ability to both control and expand the potential of our own future.

The Development of Business Strategy

Foundations

This notion put pricing and capacity decisions in a new light.

Preemptive pricing and capacity addition could be used to buy market share, lowering relative costs while making a business seem less attractive to competitors.

The same was true of financial policies.

Employed aggressively, debt could fund preemptive pricing and capacity additions, and thereby buy market share and ultimately lower business risk.

But perhaps the most powerful implication of the value of market share was for resource allocation.

Better to use the excess cash flow of these mature cash cows to fund a play for dominance by the “stars” and “question marks” while growth in their markets remained high.

Bruce Henderson wrote prolifically on the experience curve and its implications in the 1960s and 1970s.

Accumulated experience is not the only route to cost advantage.

Cost differentials and relative market shares cannot be viewed as the sole source and measure of competitive advantage — innovation, customer franchises, and brand value are equally important.

Experience curve is the name applied in 1966 to overall cost behavior by The Boston Consulting Group. The name was selected to distinguish this phenomenon from the well-known and well-documented learning curve effect. The two are related, but quite different.

It has been known for many years that labor hours per unit decline on repetitive tasks. The rate of labor decrease was characteristically approximately 10 to 15 percent per doubling of experience. Over time, the experience curve has become recognized as essentially a pattern of cash flow.

Yet the basic mechanism that produces the experience curve effect is still to be adequately explained.

The experience curve is a contradiction of some of the most basic assumptions of classic economic theory.

“Cost of value-added declines approximately 20 to 30 percent each time accumulated experience is doubled.”

The whole history of increased productivity and industrialization is based on specialization of effort and investment in tools. So is the experience curve. It is a measure of the potential effect of specialization and investment.

Based on the learning curve, labor costs should decline only 10 to 15 percent each time accumulated experience doubles. Specialization permits 10 to 15 percent less time per unit or 10 to 15 percent more output in a given time. Costs decline 10 to 15 percent because of learning plus 10 to 15 percent because of specialization. The sum of 20 to 30 percent cost decline is alone an approximation of the total experience curve effect.

Return on investment does result in cost reduction. Without investment, capacity increase cannot occur and neither can cost reduction at constant capacity. A significant part of the experience curve cost reduction is the result of return on investment.

The experience curve is the result of the combined effect of learning, specialization, investment, and scale.

When prices decline faster than the leader’s costs on trend, then there is always some competitor who is growing faster than the industry average. Differences in growth rate determine the potential rate of shift in margin between two competitors.

If any competitor is willing to sell at a lower price, he will tend to gain share and grow faster and thereafter improve his relative margin unless all others match the price change.

Prices are stable only when three conditions are met: The growth rate for all competitors is approximately the same. Prices are paralleling costs. Prices of all competitors are roughly equal for equal value.

If the fastest-growing competitor maintains a constant margin, he can then lower prices faster than anyone else’s costs can decline.

Price stability is determined by the willingness of the leader and low-cost competitor to set prices low enough to keep any competitor from growing faster than the market.

The profit equation has three variables — price, volume, and cost. Of these, price is the most common candidate for manipulation since nothing else need change to produce profits for everyone, provided everyone changes prices together.

If you have the lowest cost at nominal capacity, then it is to your advantage to keep prices down at all times sufficiently to dissuade competition from making additional-capacity investments.

If your fixed costs are higher but your operating costs are lower than competitors’, then you are more sensitive to changes in operating rate. It is to your advantage to accept any kind of price depression short term that provides a high operating rate. Only under these conditions can you maintain a relative cost advantage.

The interests of high-cost producers must be to keep prices high or to obtain a higher operating rate.

Short-term price increases tend to depress industry profits long term by accelerating the introduction of new capacity and depressing market demand. Short-term price increases favor the high-cost producer relatively more than the low-cost producer. The lower-cost producer has everything to gain and little to lose by depressing prices until he is operating at nominal capacity. The perfect strategy for the lowest-cost producer is one that persuades others to permit him to obtain maximum capacity use with minimum price depression — at the others’ expense in terms of operating rate and profit. The perfect strategy for the high-cost producer is one that persuades others that market shares cannot be shifted except over long periods of time and, therefore, that the highest practical industry prices are to everyone’s advantage.

Market share is very valuable. It leads to lower relative cost and therefore higher profits. It is expensive to maintain unused capacity for very long. Nothing is more obvious than the fact that your capacity limits your market share. The decision to add capacity is a fateful one. Add too soon, and extra costs are incurred with no benefits. Add too late, and market share is lost.

The market-share paradox is that, if the same investment criteria were used by all firms, then the low-cost firm would always expand capacity first and other firms never would.

Without growth, it is virtually impossible to shift market share. Change in market share should be an investment decision. Use more debt than your competition or get out of the business. Any other policy is either self-limiting, no-win, or a bet that the competition will go bankrupt before they displace you.

If you are the low-cost competitor, you can carry more debt with less risk than your competition.

Properly used, debt can increase debt capacity faster than it increases the assets in which the debt is invested.

A stable competitive market never has more than three significant competitors, the largest of which has no more than four times the market share of the smallest.

Shifts in market share at equivalent prices for equivalent products depend upon the relative willingness of each competitor to invest at rates higher than the sum of both physical market growth and the inflation rate.

Near equality in share of the two market leaders tends to produce a shakeout of everyone else unless they jointly try to maintain the price level and lose share together.

The most probable, and perhaps the optimal, relationship would exist when there are three competitors and the largest has no more than 60 percent of the market and the smallest no less than 15 percent.

If you cannot be a leader in a product market sector, cash out as soon as practical. Take your write-off. Take your tax loss. Take your cash value. Reinvest in products and markets where you can be a successful leader. Concentrate.

To be successful, a company should have a portfolio of products with different growth rates and different market shares. The portfolio composition is a function of the balance between cash flows. High-growth products require cash inputs to grow. Low-growth products should generate excess cash.

Products with high market share and slow growth are cash cows. Products with low market share and slow growth are pets. All products eventually become either cash cows or pets.

Low-market-share, high-growth products are the question marks. They almost always require far more cash than they can generate. The low-market-share, high-growth product is a liability unless it becomes a leader.

The high-share, high-growth product is the star. If it stays a leader, however, it will become a large cash generator when growth slows and its reinvestment requirements diminish.

Every company needs products in which to invest cash. Every company needs products that generate cash. And every product should eventually be a cash generator; otherwise, it is worthless.

Investors want their money compounded with safety. Managers want opportunity and defendable security. Business growth seeks to provide both.

The opportunity from growth is real only if it provides a means of returning the invested cash after it has been compounded. Cash really counts only when it is no longer needed to defend the competitive position.

Effective strategy analysis requires that you find a way to proceed and progress from wherever you start to a dependable competitive advantage at maturity and equilibrium.

Milestones

By the early 1980s, a solution to the scale/complexity dilemma began to emerge. Toyota innovated a production process that reduced setup times, work-in-process inventories, and indirect labor by a factor to 5 to 10. But flexible manufacturing was about more than lower manufacturing costs and higher asset turns. The real payoff was in marketing. Producers could offer unprecedented variety in increasingly short cycle times.

Flexible manufacturing and time-based competition inspired a general concern with process excellence in all aspects of business operations in the late 1980s and early 1990s.

It was the emergence of the Internet that transformed the economics of information and accelerated the pace of change.

Globalization and deconstruction have altered traditional value chains beyond recognition.

Deconstruction has added a new dimension to the concept of strategy, and the resulting instability of industry boundaries will lend the search for sustainable competitive advantage new urgency.

Companies who are pioneers develop great technical expertise. This is very valuable to their customers, particularly in the early stages of the development of the customer’s own expertise.

The company’s leadership and success reinforce the corporate culture.

As the market becomes very large, the leader comes under price pressure from much smaller and less well- equipped competitors. If prices are high enough to cover the cost of the most expensive services available, then large portions of the total market will be lost to the specialized competitors who provide limited services and price accordingly. Under these conditions, market leaders usually try to price to preserve their average margin. He becomes a high-price, high-cost, low-volume specialist. If the problem is not recognized and dealt with explicitly, it leads first to unprofitable business and then to inability to compete except in low-volume, high-margin specialties.

Major change in policy takes time, costs money, and does not demonstrate its value until long after the cost and effort are incurred. Management has a disincentive to change.

Average costing leads to the loss of market share. Given the normal accounting procedures of any business, some costs are assigned directly to particular products sold to specific customers. All others are averaged, that is, divided among all products and customers.

Costs are a function of market share. The leading competitor in any business should have the lowest costs. Although costs are averaged across the entire business, overhead and other costs often differ greatly from one product to another. The broader the product line and the larger the number and variety of the customers, the greater the use of overhead cost averaging. The costs to serve different sets of customers are also averaged. Costs are rarely classified by customer group; the real differences in cost of service are hidden by cost averaging.

Despite a basic cost advantage to start with, average costing and average pricing lead to a loss in share. The strategic implications for the new entrant are clear: Focus on sectors in which the leader is negating his underlying cost advantage through averaging. Tailor your offering specifically to that sector’s needs. Price to penetrate. Broaden the offering only as you improve your relative cost position and as the leader’s continued averaging opens other sectors to attack.

If two products are completely unrelated, then they share no scale effect advantage. But neither do they create an overhead cost for coordination.

A limited number of customers usually provide the vast majority of the volume. A limited number of products usually provide the vast majority of the revenue. These combinations of products and customers are the core of the business.

Business competition does not always produce a winner. If the differences between competitors are minimal, their struggle may produce only losers. And conventional strategies may only make things worse.

Stalemate is not confined to manufacturing. Any service where the customers’ cost to switch is low can stalemate, as has happened in bank lending to large corporate accounts, in high-traffic transportation routes, and in non-specialty retailing.

In stalemate, market share is of little value.

Acknowledging stalemate can be difficult. It requires confronting some deeply rooted patterns in the organization’s behavior.

The economic environment and competitive dynamics of each era produce dramatic change in the requirements for strategic success.

In the 1950s, dramatic growth and the postwar requirements for reindustrialization made a company’s success depend on its ability to meet demand and to respond to changing market requirements.

In the 1960s, increased competition and the internationalization of many industries made cost efficiency and market share critical determinants of success. The 1970s brought high inflation coupled with low growth, increased competition in traditional fields, added regulation, and dramatic growth in international trade, which again changed the rules of the game.

These two factors — the size of the advantage and the number of ways it can be achieved — can be combined into a simple matrix to help guide more creative strategy development.

Corporate success requires that most of a company’s businesses retain advantaged positions in volume and specialization businesses. Even high market share or relatively low-cost position in stalemate and fragmented industries may not be exceptionally valuable.

Market share, for example, often lacks value in stalemated and fragmented businesses. In specialization businesses, focus and superior brand image may be more rewarding than mere size.

A revolution in manufacturing is completely transforming the economics of production. It is doing so by reducing the cost penalty of product diversity.

Today, however, the cost penalty for diversity is being sharply cut, thanks to a dramatic shortening of setup times in the factory.

With the aid of computer controls, machines can now switch rapidly from one preset tool-and-die configuration to another, without the need for trips to the toolroom or the trial runs and adjustments usually necessary after manual handling.

Across a broad range of products, reducing factory cost added after purchased materials by 15 percent to 35 percent from earlier levels is well within reach.

The economies of scale which larger competitors in broad-line businesses have enjoyed are changing. The new setup economics will tend to reduce the cost benefits of size between two competitors with similar product mix.

This set of economic relationships is fairly straightforward, but making it work for you is not. It requires both capital and imagination — typically a doubling or tripling of equipment investment and a thorough rethinking of plant flows, layout, and line-balancing logic. The role of workers is also important. Greater flexibility and intelligence are demanded of both people and machines.

Reducing setup times by a factor of 5 or 10 — quite common now for able manufacturers — dramatically increases the effective capacity of machines and plants.

Higher yields and lower maintenance reduce the cost per usable unit of output.

Shorter setup times enable a company to serve distribution channels better and to capture, at acceptable cost, higher-price, low-volume products.

The advent of just-in-time production brought with it a move to flexible factories, as leading Japanese companies sought both low cost and great variety in the market. Cutting-edge Japanese companies today are capitalizing on time as a critical source of competitive advantage: shortening the planning loop in the product development cycle and trimming process time in the factory — managing time the way most companies manage costs, quality, or inventory.

As a strategic weapon, time is the equivalent of money, productivity, quality, even innovation.

Since 1945, Japanese competitors have shifted their strategic focus at least four times. In the immediate aftermath of World War II, with their economy devastated and the world around them in a shambles, the Japanese concentrated on achieving competitive advantage through low labor costs.

In the early 1960s, the Japanese shifted their strategy, using capital investment to boost workforce productivity.

The search for ways to achieve even higher productivity and lower costs continued, however. And in the mid-1960s, it led top Japanese companies to a new source of competitive advantage — the focused factory. Focusing of production allowed the Japanese to remain smaller than established broad-line producers, while still achieving higher productivity and lower costs — giving them great competitive power. Avoiding price competition by moving into higher-margin products is called margin retreat — a common response to stepped-up competition that eventually leads to corporate suicide.

Cutting variety yields higher productivity, lower costs, and reduced break-even points. Leading Japanese manufacturers began to move toward a new source of competitive advantage — the flexible factory.

In manufacturing, costs fall into two categories: those that respond to volume or scale and those that are driven by variety. The sum of the scale-and variety-related costs represents the total cost of manufacturing.

In a flexible factory system, variety-driven costs start lower and increase more slowly as variety grows. Scale costs remain unchanged. Thus, the optimum cost point for a flexible factory occurs at a higher volume and with greater variety than for a traditional factory.

In the late 1970s, Japanese companies exploited flexible manufacturing to the point that a new competitive thrust emerged — the variety war. A classic example of a variety war was the battle that erupted between Honda and Yamaha for supremacy in the motorcycle market, a struggle popularly known in Japanese business circles as the H-Y War. Yamaha ignited the H-Y War in 1981 when it announced the opening of a new factory which would make it the world’s largest motorcycle manufacturer, a prestigious position held by Honda.

Honda cut prices, flooded distribution channels, and boosted advertising expenditures. Most important — and most impressive to consumers — Honda also rapidly increased the rate of change in its product line, using variety to bury Yamaha. Honda’s new product introductions devastated Yamaha. Finally, Yamaha surrendered. Variety had won the war.

While time is a basic business performance variable, management seldom monitors its consumption explicitly — almost never with the same precision accorded sales and costs.

Strategies based on the cycle of flexible manufacturing, rapid response, expanding variety, and increasing innovation are time based. Factories are close to the customers they serve.

Traditional manufacturing requires long lead times to resolve conflicts between various jobs or activities that require the same resources. The long lead times, in turn, require sales forecasts to guide planning. But sales forecasts are inevitably wrong; by definition they are guesses, however informed.

Thirty years ago, Jay W. Forrester of MIT published a pioneering article in HBR, “Industrial Dynamics: A Major Breakthrough for Decision Makers” (July – August 1958), which established a model of time’s impact on an organization’s performance. Using “industrial dynamics” — a concept originally developed for shipboard fire control systems — Forrester tracked the effects of time delays and decision rates within a simple business system consisting of a factory, a factory warehouse, a distributors’ inventory, and retailers’ inventories.

What distorts the system so badly is time: the lengthy delay between the event that creates the new demand and the time when the factory finally receives the information.

Companies generally become time-based competitors by first correcting their manufacturing techniques, then fixing sales and distribution, and finally adjusting their approach to innovation.

Time-based manufacturing policies and practices differ from those of traditional manufacturers along three key dimensions: length of production runs, organization of process components, and complexity of scheduling procedures.

In a traditional manufacturing system, products usually receive value for only. 05 percent to 2.5 percent of the time that they are in the factory. The rest of the time products sit waiting for something to happen.

The combination of the product-oriented layout of the factory and local scheduling makes the total production process run more smoothly.

A manufacturer’s next challenge is to avoid dissipation of factory performance improvements in other parts of the organization.

By the late 1970s, leading Japanese companies were finding that inefficient sales and distribution operations undercut the benefits of their flexible manufacturing systems.

Toyota Motor Manufacturing could manufacture a car in less than two days. But Toyota Motor Sales needed from 15 to 26 days to close the sale, transmit the order to the factory, get the order scheduled, and deliver the car to the customer. In 1982 Toyota moved decisively to remedy the problem. The company merged Toyota Motor Manufacturing and Toyota Motor Sales. To speed the flow of information, Toyota had to reduce the size of the information batches.

In manufacturing, the Japanese stress short production runs and small lot sizes. In innovation, they favor smaller increments of improvement in new products, but introduce them more often. In the organization of product development work, the Japanese use factory cells that are cross-functional teams. In the scheduling of work, Japanese factories stress local responsibility, just as product development scheduling is decentralized.

The possibility of establishing a response-time advantage opens new avenues for constructing winning competitive strategies.

Companies that compete effectively on time — speeding new products to market, manufacturing just-in-time, or responding promptly to customer complaints — tend to be good at other things as well: for instance, the consistency of their product quality, the acuity of their insight into evolving customer needs, the ability to exploit emerging markets, enter new businesses, or generate new ideas and incorporate them in innovations. But all these qualities are mere reflections of a more fundamental characteristic: a new conception of corporate strategy that we call capabilities-based competition.

In 1979, Kmart was king of the discount retailing industry. By contrast, Wal-Mart was a small niche retailer in the South with only 229 stores. And yet, only ten years later, Wal-Mart had transformed itself and the discount retailing industry. The starting point was a relentless focus on satisfying customer needs.

This strategic vision reached its fullest expression in a largely invisible logistics technique known as cross-docking. In this system, goods are continuously delivered to Wal-Mart’s warehouses, where they are selected, repacked, and then dispatched to stores, often without ever sitting in inventory. Instead of spending valuable time in the warehouse, goods just cross from one loading dock to another in 48 hours or less.

Wal-Mart runs a full 85 percent of its goods through its warehouse system — as opposed to only 50 percent for Kmart. Another key component of Wal-Mart’s logistics infrastructure is the company’s fast and responsive transportation system. The job of senior management at Wal-Mart, then, is not to tell individual store managers what to do but to create an environment where they can learn from the market — and from each other. The final piece of this capabilities mosaic is Wal-Mart’s human resources system.

The story of Kmart and Wal-Mart illustrates the new paradigm of competition in the 1990s.

When the economy was relatively static, strategy could afford to be static. In a world characterized by durable products, stable customer needs, well-defined national and regional markets, and clearly identified competitors, competition was a “war of position” in which companies occupied competitive space like squares on a chessboard, building and defending market share in clearly defined product or market segments. The key to competitive advantage was where a company chose to compete.

In this more dynamic business environment, strategy has to become correspondingly more dynamic. Competition is now a “war of movement”.

The goal is to identify and develop the hard-to-imitate organizational capabilities that distinguish a company from its competitors in the eyes of customers.

The building blocks of corporate strategy are not products and markets but business processes. Competitive success depends on transforming a company’s key processes into strategic capabilities that consistently provide superior value to the customer.

Companies create these capabilities by making strategic investments in a support infrastructure that links together and transcends traditional SBUs and functions. Because capabilities necessarily cross functions, the champion of a capabilities-based strategy is the CEO.

A capability is a set of business processes strategically understood. Every company has business processes that deliver value to the customer. But few think of them as the primary object of strategy. Capabilities – based competitors identify their key business processes, manage them centrally, and invest in them heavily, looking for a long-term payback.

What transforms a set of individual business processes like cross-docking into a strategic capability? The key is to connect them to real customer needs. A capability is strategic only when it begins and ends with the customer.

Weaving business processes together into organizational capabilities in this way also mandates a new logic of vertical integration. At a time when cost pressures are pushing many companies to outsource more and more activities, capabilities-based competitors are integrating vertically to ensure that they, not a supplier or distributor, control the performance of key business processes.

Another attribute of capabilities is that they are collective and cross-functional — a small part of many people’s jobs, not a large part of a few.

Because a capability is “everywhere and nowhere,” no one executive controls it entirely. Building strategic capabilities cannot be treated as an operating matter and left to operating managers, to corporate staff, or still less to SBU heads. It is the primary agenda of the CEO. Only the CEO can focus the entire company’s attention on creating capabilities that serve customers.

The prize will be companies that combine scale and flexibility to outperform the competition along five dimensions:

• Speed.
• Consistency.
• Acuity. The ability to see the competitive environment clearly and thus to anticipate and respond to customers’ evolving needs and wants.
• Agility.
• Innovativeness.

Few companies are fortunate enough to begin as capabilities-based competitors.

The starting point is for senior managers to undergo the fundamental shift in perception that allows them to see their business in terms of strategic capabilities. Then they can begin to identify and link together essential business processes to serve customer needs.

Four steps by which any company can transform itself into a capabilities-based competitor:

• Shift the strategic framework to achieve aggressive goals.
• Organize around the chosen capability and make sure employees have the necessary skills and resources to achieve it.
• Make progress visible and bring measurements and reward into alignment.
• Do not delegate the leadership of the transformation.  Becoming a capabilities-based competitor requires an enormous amount of change. For that reason, it is a process extremely difficult to delegate. Because capabilities are cross-functional, the change process can’t be left to middle managers.

Competing on capabilities provides a way for companies to gain the benefits of both focus and diversification. Capabilities-based companies grow by transferring their essential business processes — first to new geographic areas and then to new businesses. But the big payoff for capabilities-led growth comes not through geographical expansion but through rapid entry into whole new businesses. Capabilities-based companies do this in at least two ways. The first is by cloning their key business processes. But the ultimate form of growth in the capabilities-based company may not be cloning business processes so much as creating processes so flexible and robust that the same set can serve many different businesses.

Capabilities are often mutually exclusive. Choosing the right ones is the essence of strategy.

A fundamental shift in the economics of information is under way — a shift that is less about any specific new technology than about the fact that a new behavior is reaching critical mass.

When we think about a value chain, we tend to visualize a linear flow of physical activities. But the value chain also includes all the information that flows within a company and between a company and its suppliers, its distributors, and its existing or potential customers. Supplier relationships, brand identity, process coordination, customer loyalty, employee loyalty, and switching costs all depend on various kinds of information.

The rapid emergence of universal technical standards for communication, which is allowing everybody to communicate with everybody else at essentially zero cost, constitutes a sea change.

THE END OF CHANNELS AND HIERARCHIES – In today’s world, rich content passes through media with limited reach, which we call channels. The existence of channels creates hierarchy, both of choice (people have to gather rich information in an order dictated by the structure of the channels) and of power (some people have better access to rich information than do others).

The alternative to hierarchy is markets, which are symmetrical and open to the extent that they are perfect.

When the tradeoff between richness and reach is eliminated, channels are no longer necessary: Everyone communicates richly with everyone else on the basis of shared standards. This might be termed hyperarchy.

In any business where the physical value chain has been compromised for the sake of delivering information, there is an opportunity to unbundle the two, creating a separate information business and allowing (or compelling) the physical one to be streamlined. All it will take to deconstruct a business is a competitor that focuses on the vulnerable sliver of information in its value chain.

Existing value chains will fragment into multiple businesses, each of which will have its own sources of competitive advantage. Some new businesses will benefit from network economies of scale, which can give rise to monopolies. As value chains fragment and reconfigure, new opportunities will arise for purely physical businesses.

When a company focuses on different activities, the value proposition underlying its brand identity will change.

The proliferation of choice has led to the fragmentation of the small brands and the simultaneous concentration of the large ones. The losers are the brands in the middle.

The U.S. auto industry is creating such an extranet, called the Automotive Network eXchange (ANX). Linking together auto manufacturers and several thousand automotive suppliers, the system is expected to save its participants a billion dollars a year, dramatically reduce errors, and speed the flow of information to second- and third-tier suppliers.

Incumbents could easily become victims of their obsolete physical infrastructures and their own psychology. Newcomers suffer from none of these inhibitions. They are unconstrained by management traditions, organizational structures, customer relationships, or fixed assets.

The Toyota Production System (TPS) owes some of its vaunted responsiveness to open-source traits. In fact, Toyota itself is evolving into a hybrid between a conventional hierarchy and a Linux-like self-organizing network.

The rules of markets are about cash and contracts. The rules of hierarchies are about authority and accountability. But at the core of the Linux and Toyota communities are rules about three entirely different things: how individuals and small groups work together; how, and how widely, they communicate; and how leaders guide them toward a common goal.

The Linux and Toyota communities are both composed of engineers, so members have the same skills as their colleagues and speak the same language. But these groups are far more disciplined and rigorous in their approach to work than are other engineering communities. Both emphasize granularity: They pay attention to small details, eliminate problems at the source, and trim anything resembling excess, whether it be work, code, or material.

In both the Linux and Toyota communities, information about problems and solutions is shared widely, frequently, and in small increments.

At every level, Linux and TPS leaders play three critical roles. They instruct community members — often by example — in the disciplines we’ve just described. They articulate clear and simple goals for each project based on their strategic vision. And they connect people, by merit of being very well connected themselves.

Companies laying the groundwork for high-performance collaboration should follow these principles:

• Deploy pervasive collaborative technology.
• Build communities of trust.
• Think modularly.
• Encourage teaming.

A rigorous work discipline, common intellectual property, and constant sharing combine to distribute knowledge widely and relatively evenly across human networks. That knowledge includes not just the formal, syntactic information found in databases but also the semantically rich, ambiguous knowledge about content and process that is the currency of creative collaboration.

Modularity is a design principle by which a complex process or product is divided into simple parts connected by standard rules. In modular arrangements of teams, each team focuses on small, simple tasks that together make up a larger whole.

When information flows freely, reputation, more than reciprocity, becomes the basis for trust. Where trust is the currency, reputation is a source of power.

“Detroit people are far more talented than people at Toyota,” remarks Toyota president Fujio Cho, with excessive modesty. “But we take averagely talented people and make them work as spectacular teams.” The network, in other words, is the innovator.

Using a methodology developed by J. J. Wallis and Douglass North, we estimate that in the year 2000, cash transaction costs alone accounted for over half the nongovernmental U.S. GDP! We spend more money negotiating and enforcing transactions than we do fulfilling them.

Jeffrey Dyer, a professor of strategy at Brigham Young University, estimates that transaction costs between Toyota and its tier one suppliers are just one-eighth those at General Motors, a disparity he attributes to different levels of trust.

A dense, self-organizing network creates the conditions for large-scale trust. Large-scale trust drives down transaction costs. Low transaction costs, in turn, enable lots of small transactions, which create a cumulatively deepening, self-organized network. Once the system achieves critical mass, it feeds on itself.

The Practice of Business Strategy

The Customer: Segmentation and Value Creation

Business segments can be defined along several dimensions: by customer group (needs), by the economics of serving these groups (cost/price), and/or by the players who choose to serve them (competitive dynamics).

BCG began exploring business segmentation with its clients in the early 1970s. The first insights were analytical.

We helped our clients deaverage their costs, identify the needs and economics of each segment and align their value propositions with customer needs.

Segmentation is a critical aspect of corporate strategy. It is essential in visualizing the competitive arena and analyzing the preferred strategic emphasis. The goal is to find a way to convert differences from competitors into a cost differential that can be maintained. The segmentation of markets for differentiated products rests on the relationship between the cost features to the producer and the value of features to the customer.

A differentiated product remains a differentiated product only until the emergence of the first follower. After that it begins to behave as a commodity.

With the evolution of the market, pioneering companies face the choice of becoming limited-volume, high-priced, high-cost specialty producers or high-volume, low-cost producers of standard products.

Measuring profitability by customer group is important.

A strategic sector is one in which you can obtain a competitive advantage and exploit it. Strategic sectors are defined entirely in terms of competitive differences. Cost-effectiveness analysis optimizes value versus cost. Strategic-sector analysis optimizes margin relative to competition. A given strategic sector can rarely use more than one distribution channel.

Competitors who try to serve both strategic sectors at the same price are handicapped by a too-high price in one sector and a too-high cost in the other sector.

Strategic business units were devised to reverse the effects of over-fragmentation into profit centers. The critical factor, cash flow, cannot be delegated to any SBU.

Market share in the strategic sector, is what determines profitability not size of company.

All competitors are specialists. The differences between competitors are the measure of their specialization.

In a crude way, costs can be divided into two broad categories. The first is those costs required for basic participation in a business. The second category is discretionary costs. These costs are a function of the segments being served.

When the discretionary costs are a large part of the value added, opportunities for segment focus arise.

Superior specialization strategies should result in sufficient cost advantage so that a portion of that advantage can be passed on to consumers in either added quality/service or reduced price.

Specialization is a means of survival in a rich, but competitive, market. Competitive advantage cannot be achieved in all cases, with all customers, relative to all competitors. Where it is achieved, however, the rewards can be exceptional.

Two quite different kinds of specialization are possible, each with its own strategies and risk profiles. Some specialist companies compete by reducing cost and cutting price, others by adding significant amounts of cost and achieving higher price realization.

Successful cost-reduction specialization is not achieved by reducing the level of important cost components but by totally eliminating one part of the industry leader’s cost structure. By eliminating a significant portion of the leader’s cost structure, the specialist can often cut price between 20 and 40 percent.

The risks lie in the market. A shift in consumer taste or user economics can change the size of a niche dramatically while hardly affecting the overall market.

The two types of specialists face different risks and require different strategies. Cost-reduction specialists must concentrate on their areas of strength: focusing, keeping costs down, and resisting the temptation to enter other parts of the market less suited to their approach. Price-realization specialists must understand and optimize the relationship between the costs they incur to serve their segment and the price they can realize.

The foundation for Segment-of-One marketing is the ability to track and understand individual customer behavior. Thanks to the expansion of data-capture opportunities and lower storage costs, such databases are already cost-effective on a large scale. The second requirement of Segment-of-One marketing is the ability to use the information system to customize the product and personalize the service to the individual customer. The ability to gather detailed information about a customer’s purchasing behavior coupled with relationship-oriented delivery of services provides a tool and a context for the third element of Segment-of-One marketing: personalized communication.

Competitive advantage will tilt to those companies that simultaneously own the market and are able to satisfy individual customers’ needs.

When you serve your customers by helping them discover untapped potential in their businesses, you both reap the rewards.

No, brands won’t disappear. But what a brand is and how best to manage it are changing. Increasingly, a brand is far more than just a name on a product. When brands become business systems, brand management becomes far too important to leave to the marketing department. It cuts across functions and business processes. Total brand management can take a variety of forms: In some cases, the brand extends beyond the actual product to include the infrastructure supporting it. In other cases, well-crafted umbrella brands like Gillette or Levi’s stretch across many related products. In still other cases, the entire retail system itself is the brand.

The key word in “coherent brand portfolio” is coherent. It’s no good to cobble together a collection of unrelated brands. This only leads to higher overhead costs, fragmented business processes, and duplication of resources. Strengthen the brand portfolio through innovation.

The kind of innovation that matters is not what managers might expect. It’s not the creation of new brands, an increasingly expensive proposition. Rather, it is the reinvention of existing brands through three basic techniques: repositioning, extension, and transformation.

Secure the brand through close relationships with customers and the trade. Increasingly, customers value the reassurance and stability that comes from an enduring relationship with someone who understands and can respond to their specific needs.

As brand managers manage portfolios of brands, customer segments, and retailers across an entire business system, their role has become more cross-functional and strategic.

Executives often suffer from pricing myopia. They underestimate their power to manage pricing.

Customers are often willing to pay more than the current price. Different customers frequently place different values on products and services, as well as on specific components of an offering. The keys to capturing such value are to: Deepen the understanding of demand elasticity and customers’ behavior by analyzing existing data or conducting experiments. Segment customers more effectively along dimensions besides price sensitivity (such as current and lifetime cost to serve, delivery times, quality, and support). Communicate the value of the offering more effectively. Develop innovative pricing structures that elicit each segment’s full willingness to pay.

Many people “touch” pricing, but nobody owns it. Pricing decisions, expertise, and information are fragmented and diffused across regions, business units, and functions. All too often, precise metrics and processes to monitor pricing are lacking. When companies focus on pricing and get disparate units to operate in sync, they typically deliver at least a three-percentage-point improvement in earnings before interest and taxes.

Today, players in the fashion apparel industry are using yield management to optimize their use of markdowns.

Examples of pricing strategies that can have a tremendous impact on the competitive landscape include the following:

• Experience-Curve Pricing. Costs go down with accumulated experience.
• De-Averaged Pricing. Pricing should reflect a matrix of relative competitive positions by location, segment, customer, or other factors.
• Bundling. If one company has a much broader offering of products and services than others, it can meet customers’ demand for a bundled alternative that puts competitors at a disadvantage.
• Loyalty-Based Pricing. Sophisticated IT is enabling companies to use customers’ purchasing histories, including volume and mix, to make dramatic strides in how they tailor pricing.
• Dynamic Pricing. Setting prices closer to the moment when a customer needs a product or service is increasingly possible, but it requires a deep understanding of full and marginal costs and investments, and of the value proposition for the customer.

America’s middle-market consumers are trading up. They are willing, even eager, to pay a premium price for remarkable kinds of goods that we call New Luxury — products and services that possess higher levels of quality, taste, and aspiration than other goods in the category but are not so expensive as to be out of reach. Trading up spans so many categories and appeals to such a broad range of consumers that it has come to represent a major and growing segment of the economy.

To qualify as New Luxury, a product must connect with the consumer on all three levels of a ladder of benefits:

• It must have technical differences in design, technology, or both.
• Those technical differences must contribute to superior functional performance.
• The technical and functional benefits, along with other factors, such as brand values and company ethos, must engage the consumer emotionally.

New Luxury is a business strategy. It cannot be pursued with the methods traditionally used to develop products and bring them to market.

New Luxury leaders follow eight practices:

• Never underestimate the customer.
• Shatter the price-volume demand curve.
• Create a ladder of genuine benefits.
• Escalate innovation, elevate quality, and deliver a flawless experience.
• Extend the brand’s price range and positioning.
• Customize the value chain to deliver on the benefit ladder.
• Use influence marketing and brand apostles.
• Continually attack the category like an outsider.

Millions of people around the world are redefining what it means to be a middle-market consumer. By purchasing a mix of upscale and downscale products and services, they are creating a new standard of living.

For several years now, we have been writing and talking about the New Luxury movement.

Those same consumers are also trading down. Consumers are spending less on a variety of goods to acquire more of what they need and want. Offshore manufacturing has contributed to the trading-down phenomenon by reducing the cost of value. Trading down is less about compromising than about looking for a good product at a lower price.

Innovation and Growth

There are two sides to innovation and growth: generating creative ideas and translating them into viable businesses. Behind every successful innovation is an unexpected insight.

Lacking a systematic process for developing new ideas, organizations rely too much on the random inspiration of individuals.

Ordinary mortals can generate breakthrough ideas — systematically. What it takes is a rigorous methodology for conceiving new opportunities and a customer-driven discovery process for testing and refining them:

• Expand your business definition and map it exhaustively.
• Get inside the customer experience to tap core dissatisfactions.
• Don’t delegate responsibility for insight.

Sometimes the best opportunities lie hidden in something that, at first glance, makes no sense.

Anomalies can reveal what your customers really want — and what your organization is capable of delivering in response. Wise executives capitalize on anomalies.

What does it take to capitalize on anomalies systematically?

• For starters, you need to have metrics and information systems that are sufficiently refined to identify anomalies in the first place.
• The next step is to separate wheat from chaff: those anomalies that signal a potential business opportunity from those that are merely one-time events.
• Finally, you need to understand the precise mechanisms that animate the anomalies you identify.

One powerful way to grow is through innovations that break the fundamental compromises of a business.

For a company to grow by breaking compromises, it must have the creativity to translate customer dissatisfactions into new value propositions, the flexibility to engage in constant reorientation of its business system, and the nerve to challenge business-as-usual in its industry. There are three basic steps:

• Get inside the customer experience.
• Travel up the hierarchy of compromises. The most powerful compromises are often the hardest to identify: broad social dissatisfactions that may have little to do with your product or industry but a lot to do with how your customers live their lives.
• Reconstruct your value chain.

In fast organizations, new products are developed in a steady stream. No one program is make-or-break, and a feature or performance enhancement that is not available for one generation can be rapidly implemented in the next.

• Lesson 1: Like a magazine, manage new-product development as a continuing process, not an isolated event.
• Lesson 2: To speed new-product development, make time the key variable. Acceptable levels of cost and quality must be maintained, but the clock is king.
• Lesson 3: Companies need to invest actively in the activities that support rapid product development so that they never slow down the process.
• Lesson 4: A new-product development project should be managed by a team whose members bring skills from all relevant functions.
• Lesson 5: Empower the team members to work as a team. They must have common goals and rewards, authority to make decisions, and an elbow-to-elbow environment.
• Lesson 6: Members of product teams must have the experience, expertise, training, and authority needed to make important decisions.

Broad managerial approaches, or models, for turning ideas into cash. There are three basic approaches.

• Most organizations instinctively act as integrators.
• However, organizations can also be orchestrators.
• Finally, businesses can be licensors: they sell or license a new product or idea to another organization, which handles the commercialization process.

A company has to take into account the structure of the industry it’s trying to enter. The physical assets needed to enter the industry. The nature of the supply chain. The importance of brands. The intensity of rivalry.

Four risks when deciding which model to use:

• The first is that the new product may not deliver the improved performance it promises.
• The second is that consumers may not buy the product even if it works; the incremental improvement or even the breakthrough may not be exciting enough.
• The third risk comes from substitutes, whose availability shrinks margins.
• Finally, the risk profile will be influenced by the investment that the company must make to commercialize the innovation.

Innovation-driven acquisitions generate value only if the target’s IP assets provide advantage in the marketplace.

To assess the total competitive position of your target, you need to picture both the competitive landscape of the product and the market, and the IP terrain.

Deconstruction of Value Chains

BCG PARTNERS BEGAN thinking in the mid-1980s about the impact on strategy of the two most powerful — and disruptive — technological developments of our times: cheap, pervasive computing power and high-bandwidth communication. The thesis was — and still is — that these new technologies, plus the new standards that have accompanied them, eliminate the traditional trade-off between the richness and reach of communications. That, in turn, allows companies to deconstruct their value chains.

That deconstruction — and reconstruction — of value chains is far from played out. We anticipate fluidity in their architecture for at least another decade.

When Henry Ford set out to make the lowest-cost car in America, he integrated vertically.

Vertical integration as a business concept fell under a cloud from which it has not emerged. Until now. Leading-edge companies are beginning to reinvent the vertically integrated enterprise. The new vertical integration does not involve ownership or exclusive relationships. Instead, it is about eliminating barriers and costs between independent companies.

To implement the new integration, companies generally progress through three stages:

• First, two companies decide to lower some of the barriers that separate them and begin to operate as one business.
• Second, they build a customized relationship, expanding on the new opportunities they have discovered.
• Third, they extend their new approach to the entire chain of companies surrounding their business

The best place to start the integration process is at the top. Trust is fragile in the early stages. You need continuous project management at senior levels across all the companies.

Information has always been the glue that held value chains together. The cost of getting sufficiently rich information to suppliers, channels, and customers made proprietary information systems and dedicated assets a necessity, and gave vertical integration its leverage.

Successful orchestrators possess powerful brands and use them to retain control of the lion’s share of an industry’s value added while minimizing their own assets.

But maintaining control of the value chain is not easy. The orchestrated — those who focus on a specific value-added step, or layer — have every incentive to drive for scale and scope themselves. If they succeed, they wrest control of the value chain from the orchestrator, as Intel and Microsoft did from IBM.

The business then deconstructs entirely. Each layer becomes a distinct business with its own economics.

After deconstruction, profits are hard to come by. The onset of fragmentation can, however, create opportunities for a new sort of player — navigators that help participants cope with the complexity of doing business in a deconstructed world.

In a competitive environment characterized by deconstruction, commitment to existing business models, however rational they may appear, becomes a liability.

Deconstruction leads to de-averaging. De-averaging means that companies no longer have the luxury of subsidizing poor performance in one activity by combining it with strength in others. But the logic of de-averaging applies not just to the separation of discrete steps on the value chain; it applies also to the information within each step. In most value chains, informational activities and physical activities are intertwined. Information technology — especially the advent of universal connectivity and standard protocols — allows the two to separate. When they do, information businesses and physical businesses will finally be free to pursue their different economics. The ensuing de – averaging is dramatic because the economics of information and the economics of things pull in diametrically opposite directions.

Deconstruction can occur wherever information economics hold a physical bundle together and wherever the informational activities themselves can evolve into separate businesses.

There are three initiatives companies can take to avert the threats and pursue the opportunities that deconstruction offers:

• First, they can mentally de-average their own competitive advantage and that of their direct, indirect, and potential competitors.
• Second, each company can sort out its options. How vulnerable is its current business model?
• Third, and perhaps most difficult, companies can examine their own internal barriers to success.

In most consumer businesses, far more profitability derives from influencing navigation than from any other activity. Companies have three basic ways to capture that profitability: reach, affiliation, and richness.

• Reach is about access and connection: how many customers a business can access and how many products it can offer.
• Affiliation is about whose interests the new business represents. E-retailers tilt heavily toward the consumer.
• Richness is the depth and detail of information — about products and about customers.

When it comes to information about consumers, traditional retailers have a definite edge.

Web-derived data are surprisingly thin compared with the information developed by grocery stores and credit card companies.

If clicks and mortar didn’t exist, somebody would be working feverishly to invent it. The fact that the buzzword is ideologically convenient makes it suspect, of course, but that doesn’t make it wrong.

Physical demonstration and merchandising of a product, handling returns, service and repairs, signage — all of these issues matter to Internet businesses.

The correct pairing isn’t “clicks and mortar.” It’s “clicks and bricks.” There’s nothing reassuring about clicks and bricks. If physical and informational resources are building blocks to be reassembled in whichever combinations yield advantage, that offers precious little comfort to traditional incumbents. If they have any brick worth reusing, it merely puts them in play.

The eternal verities of cost, cash, and compelling customer value matter more than ever, but not necessarily in the same ways as before. Learning how to harness the trends of the information economy in order to exploit legacy assets in fundamentally new ways is a far tougher managerial challenge than simply setting up a Web site or spinning off a dot-com subsidiary in the hopes of making a killing in the market.

Business-to-employee systems use Internet technologies to provide online delivery of employee-related processes — including recruiting, training, and knowledge management.

Effective business-to-employee systems allow employees to take control of various administrative or job-related activities — for example, selecting benefits, finding and taking training courses, and scheduling work.

There are at least four steps that companies need to take in order to build comprehensive business-to-employee systems.

• Understand What Employees Really Want.
• Identify a Killer App.
• Create an Integrated Corporate Portal.
• Monetize the Human Asset.

Outsourcing is generally seen as a means by which to lower cost. But this is only half the story. The other half is about collaborative innovation. Companies therefore need two quite different modes of outsourcing. A failure to segment supplier relations accordingly results in a massive loss of competitive advantage.

There is a near-universal trade-off between richness and reach. Richness is variously the amount, quality, specificity, recency, or trust-worthiness of the information shared in a transaction; and reach is the number of people or entities involved.

By favoring reach over richness, technology has favored markets over hierarchies, thus inserting market mechanisms into previously vertically integrated hierarchies and thereby shifting the boundaries of the corporation.

Sourcing strategy reflects these general principles. Insourcing enables richness. Outsourcing gives you reach — to the most innovative and lowest-cost specialists in the world. Low-richness transactions are fine when the goal is cost reduction.

The analysis required to adopt a network-capital strategy is rarely performed systematically. It comprises the following elements:

• Map the network of productive interactions by individuals and teams within and across organizational boundaries.
• Benchmark the capabilities of alternative suppliers, both inside and out, current and potential.
• Segment the collaboration patterns by balancing the values of richness and reach.

China is still small fry in the U.S. industrial-goods market. Domestic production accounts for 70 percent of industrial goods sold, and imports from Japan and Western Europe account for another 20 percent. Only 10 percent comes from low-wage economies, and China has less than one-third of this — or 3 percent total penetration of the U.S. market, shipping fewer goods than Mexico.

Chinese factories reverse this process by taking capital out of the production process and reintroducing a greater role for labor. Parts are designed to be made, handled, and assembled manually. This reduces the total capital required by as much as one-third. So, output per worker is lower in Chinese factories, but the combination of lower wages and less capital typically raises the return on capital above U.S. factory levels.

There are many reasons to make more things in China. As more companies discover this, the impact on U.S. jobs will grow, making it an increasingly potent political issue.

Performance Measurement

That the metrics employed must be aligned with the strategy that the managers being measured are committed to execute. This requires, first, that information (costs, revenue, cash flow, market share, etc.) be collected in a way that allows progress toward strategic goals to be evaluated objectively. Second, the timing of performance evaluation must match the time horizon of the strategy. If a strategy is meant to play out over five years, managers must be measured against sensible milestones over the entire period. Finally, performance measures need to be evaluated regularly to ensure they are still creating incentives that buttress the strategy.

The most important decisions a manager makes tend to depress short-term reported performance in order to significantly improve long-term results.

There are often real tradeoffs between the personal career and the good of the company. There can be real dilemmas where only short-term survival seems possible because of the tradeoffs between long-term and short-term performance. The conflict between expediency and responsibility can become painful.

Resolution of this conflict can occur only if three conditions are met:

• There must be an explicit corporate strategy.
• There must be an understanding and consensus on the strategy.
• Profit center profit performance appraisal must encompass a time horizon equal to the strategy time horizon.

To optimize performance in a growth business, a manager must use, and be measured on, a long-time perspective. Traditional control systems discourage this. Conventional control systems emphasize profits reported now.

Improving market share requires a commitment of resources and expense that depresses current reported profits for the sake of the future.

In the long run, all that counts is “cash in versus cash out discounted to present value.” Evaluating the changes in the present value of the cash-flow profile is not as easy as accepting conventional “good accounting practice.” Yet it is clear that it is worth the effort.

• Traditional performance measurements focus more on internal goals of cost and efficiency than on external realities of customer satisfaction and competitive capabilities.
• Traditional performance measurements emphasize control at the expense of customer response.
• Traditional performance measurements focus on the end product and overlook the importance of the process.
• Traditional performance measurements focus on particular departments or aspects of a business, often at the expense of overall business goals.

There are some common rules to follow in designing effective measurements:

• Start on the outside of your business, not inside the company.
• Responsiveness to customers overshadows all other marketing goals. Make sure control measures don’t get in the way.
• Think of process and product as equals.
• You compete as a company. Don’t let overall business goals get lost among the many operating measures.
• Train your people to think of the company as one integrated delivery system for the customer’s benefit.

The purpose of performance measurements is to focus the energy of the organization on its strategic goals, to track progress toward the goals, and to provide feedback.

Changing the goals without changing the measurements is no change at all.

Economic value added offers a beguiling solution: an easy-to-understand measure that recognizes improvements in earnings only to the extent that they exceed the cost of the capital employed to secure them. Eminently sensible but for one critical flaw:

• EVA discourages growth.
• EVA is biased against new assets.
• EVA encourages managers to milk the business.
• EVA is biased in favor of large, low-return businesses.

Call this approach total business return (TBR). By comparing the beginning value of a business with its ending value, plus free cash flow, TBR effectively replicates total shareholder return inside the company at the level of the individual business unit.

Increasing the intrinsic value of a business is one thing; realizing that value in the capital markets can often be quite another. Traditional value management largely ignores the gap between intrinsic value and realized value.

There are two ways for a company to improve its total shareholder return (TSR). One way is by generating improvements in the fundamental indicators of intrinsic value.

But it is also possible to increase TSR by improving how the market actually values those fundamental indicators, as measured by a company’s valuation multiple (usually quantified as the price-to-earnings ratio).

Another promise of value management was to get line managers to “think and act like owners” by linking compensation and incentives to some measure of intrinsic value, such as EVA and CFROI.

Business unit managers need to be directly exposed to the demands of investors in the capital markets.

Today’s performance measures focus on yesterday’s success factors.

The challenge for most businesses today is not asset productivity but employee productivity.

The connections between changes in the composition of the workforce, changes in employee performance, and changes in business performance are poorly understood.

Workonomics considers the value created by each employee (employee productivity) to be the amount a company could, in principle, afford to pay for an average employee and still achieve the required return on investment for shareholders. With this approach, the relationship between the traditional capital – oriented system and the employee-oriented Workonomics system is very simple.

Economic Value Added — which we will abbreviate as EVA — is generally calculated as net operating profit (before interest, but after tax) minus a charge for capital employed.

Resource Allocation

The dynamics of cash flow make diversification a viable corporate strategy. Businesses have life cycles, just as products do. Mature businesses generate much more cash than they can reinvest productively. This excess cash is best used to support new or growth businesses, which have a voracious appetite for cash during their sprint for market leadership.

Much of the reported profit must necessarily be reinvested just to maintain competitive position and finance inflation. If the required reinvestment, including increased working capital, exceeds reported profit plus increase in permanent debt capacity, then it is a cash trap. Cash is rarely ever recovered from a cash trap unless relative competitive performance is improved by obtaining a superior market share.

The experience curve effect causes your relative cost to decrease about 20 to 25 percent each time your market share doubles. Both margin and volume increase with increase in market share. The converse is true also, of course. That is why there are many cash traps, and most of them are low-market-share products.

Regardless of reported profit, a business or product is worthless unless it compounds and returns the cash invested in it.

Fast-growth products are even more dangerous cash traps than slow-growth products. Growth compounds the cash input required. But growth alone does not improve relative cost or profit compared to competition.

Take at least twice as much of the growth as your leading competitor in any relevant product-market segment. If you cannot, then plan the process of extricating your investment as expeditiously as possible.

Anytime there are more than two or three active competitors in a given product-market segment, then someone is making a mistake. The leader may be failing to compete by holding an umbrella over higher-cost competition at his own expense. Or it may be that competitors are caught in cash traps.

The first objective of corporate strategy is protection of the cash generators.

By Definition A Cash Cow Has A Return On Assets That Exceeds The Growth Rate. Only If That Is True Will It Generate More Cash Than It Uses.

Diversified company portfolios are the normal and natural business form for efficiently channeling investment into the most productive use.

In a corporation, cash flow and investment can be rechanneled from one business to another. This is a critical capability.

Top management of even a far-flung diversified company is better equipped to appraise the potential and characteristics of a growing business than an outside investor.

This ability to divert and reinvest the cash flows of a mature business is very important.

The diversified company is eminently well suited for this kind of “expense investment.” Only the diversified company can match positive and negative cash flows. Only the diversified company can pair off the tax consequences of expense investment.

Everything favors diversified companies: tax laws, capital costs, sources of funds, breadth of business opportunity.

Companies must choose on the basis of the closely linked combination of sustainable competitive advantage and potential financial contribution to the company. The former yields the high profits that convert to high net cash flow as growth slows and investment requirements moderate.

The portfolio concept stresses the critical need to keep resources fully employed in the areas where they have the highest yield or potential yield. This means focusing technical and human resources where the company can gain and hold an edge over competitors that is valued by customers.

In the 30 years since they first gained broad notoriety, conglomerates have mostly been dismissed as a failed experiment.

As traditional boundaries between businesses erode, simple business definitions are becoming increasingly untenable. Even the most focused companies are finding that they may need to adopt a multi-business perspective.

The best multi-business companies — we call them premium conglomerates — exploit complexity to enhance and extend their competitive advantage.

What distinguishes premium conglomerates is their executives’ skill in managing this complexity. They excel at three key managerial tasks.

• First, premium conglomerates are active, but highly disciplined, business portfolio managers.
• Second, premium conglomerates manage portfolios not just of businesses, but also of people and ideas.
• Finally, perhaps the most distinctive characteristic of premium conglomerates is the way they mobilize and deploy advantaged capabilities to breach competitive barriers and enter new businesses — in effect, making complexity their ally.

Even as many new start-up businesses are going public, many traditional publicly held companies are moving in precisely the opposite direction. They are going private, replacing public equity with private equity and debt, often in alliance with private equity firms.

The companies taking advantage of privatization tend to have three things in common:

• First, they are highly productive and generate significant amounts of cash.
• Second, these companies have modest growth prospects — generally equal to GNP or, at most, to GNP plus 2 percent.
• Third, as these companies pile up cash, they are penalized with low price-to-earnings ratios.

Sustained value creation requires disciplined portfolio choices that drive performance along three critical dimensions: competitive advantage, returns (on capital), and growth. The sequence is important: Without advantage, returns decrease; and without adequate returns, growth destroys value.

Senior managers must frame decisions about portfolio choices at the business level — not just at the project level.

By segmenting the portfolio in this way, you will usually uncover three groups of businesses: those with low returns, those with high returns, and those with erratic returns.

Portfolio strategy can be a huge lever in driving sustained shareholder value. But managers need to pull up from a purely executional focus and skew their goal setting and capital bets aggressively, finding and funding strategies with competitive advantage and high returns, and fixing or disinvesting disadvantaged businesses. Growth without advantage buys size but creates no value. And beating plan and making the quarter are not enough.

Organizational Design

Strategy should drive structure.

Certain mechanisms and interactions can be built into an organization to increase its creativity and serve as platforms for growth.

With growth, and especially global growth, comes a high degree of complexity.

Corporate strategy, corporate policy, and corporate organization are inseparable. They are mutually dependent.

The goal of combining the market map and a good description of customer values should be to get a much better idea of how the market will evolve.

• Combining an understanding of technology and business economics should give a forecast of cost evolution.
• Combining an educated guess about what competitors are doing with a real understanding of the business economics describes how the basis of advantage might evolve.

Designing and managing a network organization requires overturning the old assumptions.

You can’t reason linearly from strategy to structure and on to systems, staff, and so forth. Instead, the process is iterative.

The organization’s purpose is not to control from the top; it is to empower a group of people to get a job done.

One of the messages of reengineering is that companies, once structured as hierarchical pyramids, now need to be “turned on their sides” and restructured as horizontal organizations. It seems obvious. And it is wrong. There are no great horizontal organizations, nor are there likely to be any.

Horizontal organizations won’t survive because they address only half of a company’s needs — its processes. Great horizontal processes don’t make companies great.

The other half of what companies need is a set of core disciplines. While the processes focus on today’s customers, the disciplines are inventing the products — and the customers — of tomorrow.

Companies that build both thriving processes and disciplines. Follow five ground rules:

• Build tension into objectives.
• Give senior executives dual roles.
• Emphasize roles along with positions for every manager.
• Visibly reward people who contribute in both dimensions.
• Remove the one-dimensional barons.

Focusing exclusively on delayering at the management level, on the other hand, speeds up both information flows and decision making.

Taking out layers of management, particularly middle management, requires discipline, a willingness to confront sacred cows, and a clear sense of where you want your company, division, or unit to go.

Any process that aims to restructure an organization by taking out significant numbers of people can’t be executed without an iron will. That means CEO ownership of and commitment to a fact-based and transparent approach.

All too often, major organization redesigns create little, if any, value. In many cases, they actually rob value, frustrate managers, and lower employee morale.

Good design springs from good strategy. You need to understand how you want to compete, where you make money, and what organizational levers will enhance performance.

Unless you look at the combined impact of incentives, culture, resource allocation, and information flows, recommendations will often address symptoms instead of causes.

As corporate walls fall, companies are exploring novel, “open” approaches to organization. Customers and supplier integration is a key to adding business value.

A successful redesign requires clear vision, committed leadership, and exacting project management. That is just for openers. The company also must ensure that key stakeholders are involved in and support the process.

All organizations do change when put under sufficient pressure. This pressure must either be external to the organization or be the result of very strong leadership.

There are three fundamentally different executive functions:

• The first is preservation of the organization.
• The second is control of organization response to deviations from expectations.
• The third is planning future expectations.

All of these are made possible by the personal qualities of leadership.

Wholesale rethinking of strategy in response to every minor competitive or environmental perturbation robs an organization of its sense of direction and its operational effectiveness. Failure to adapt at critical turning points threatens its viability.

Successful business units pass through four phases in their development toward maturity. Each phase is most fundamentally different from the others in orientation.

PHASE – GOAL:

• Creation – Finding the opportunity.
• Growth – Making it real.
• Advantage – Gaining competitive position.
• Efficiency – Tying it down.

Business can be grown into bankruptcy unless competitive advantage is gained and maintained.

While we manage today’s business, we must see the next phase clearly and build a road map for transition. This is sustained success.

The most difficult aspects of learning in connection with strategy are:

• Letting go of obsolete concepts.
• Creating the relationships between people that make learning feasible.
• Appreciating rates of change.
• Developing a systems perspective.

There is a Gresham’s law of executive behavior that causes the urgent to drive out the important. Without a strong executive example to lend some urgency to the learning effort, it will inevitably be crowded out of executive calendars.

Few things are as disruptive to the long-term interests of a large company as a strong function narrowly pursuing its own interest.

Executive learning is hard. Among the major difficulties are letting go of obsolete concepts, developing the relationships that make learning possible, and creating a systems perspective.

The transformation from authoritarian to participative management cannot be accomplished in a single leap, and it should not bypass the middle managers.

Most of our organizations today derive from a model whose original purpose was to control creativity.

Our modern organizations often encourage specialists to pursue the goals of their specialties at the expense of the other functions, the firm, and the customer.

Traveling into new territory is a good metaphor for the experience of major change. No matter how much you prepare and no matter how experienced a traveler you are, you will run into unexpected situations and weird incidents. Things will go wrong and fabulous things will happen.

Stagnation can befall any organization.

Stagnation can only conclude when somebody in a position of power and authority — the CEO, board of directors, a big shareholder or possibly an internal operating committee — demands it. There are two routes out of Stagnation: through external action or internal action.

When leaders are misaligned, it disastrously ripples through the rest of the organization.

Unfortunately, many executives and managers believe that having a clear plan is the final deliverable. Change is not just a blue-print for a new structure; it requires changing people’s mindsets and work practices. Exceptional change leaders realize that their most important legacy is not creating a single transformation, but teaching the organization how to perpetually change and adapt, and helping it muster the will to do so.

Rather than being an obstacle, uncertainty is the very engine of transformation in a business, a continuous source of new opportunities. So instead of reacting defensively to uncertainty, embrace it. Expand radically the range of alternatives, possibilities, and scenarios to consider.

For the true leader, “the fear of hesitation and delay overrides all other human fears.”

In a period of uncertainty and high anxiety, six fundamental tenets of leadership are particularly crucial:

• Be Highly Visible. In times of stress, the more available and approachable leaders are the better.
• Provide Relevant Information. Everyone knows we’re in a recession. But they don’t know, and desperately need to hear, what their leaders think it means for them.
• Ask for Help and Share the Credit. Many leaders find themselves in unfamiliar territory: having to lead during a major recession and a new kind of war.
• Be Human. People want to think their leader is in control and in charge, but they won’t go the extra mile for someone who is all logic and no emotion.
• Offer Hope and a Renewed Sense of Purpose. Business leaders need to put a stake in the ground for the future, to show the way to a better tomorrow.
• Encourage People to Get Excited. The events of recent months have been so depressing that people often feel shallow, disconnected, or even guilty if they are in a good mood.

Sometimes, in order to lead, you need to change perceptions, not reality. Creativity was once defined as a revolution in the way we look at things.

Business Thinking

Business Thinking

Business thinking starts with an intuitive choice of assumptions. Its progress as analysis is intertwined with intuition. The final choice is always intuitive. If that were not true, all problems of almost any kind would be solved by mathematicians with nonquantitative data. The final choice in all business decision is, of course, intuitive. It must be. Otherwise, it is not a decision, just a conclusion, a printout.

Conceptual thinking is the skeleton or the framework on which all the other choices are sorted out. A concept is by its nature an over-simplification.

Concepts are simple in statement but complex in practice.

They start with a generalization of an observed pattern of experience. They are stated first as a hypothesis, then postulated as a theory, then defined as a decision rule. They are validated by their ability to predict. Such decision rules are often crystallized as policies. Rarely does a business concept permit definitive proof enough to be called a law, except facetiously.

Business Chess

Profound parallels exist between business and chess. Both are complex forms of competition. Both have been studied for centuries, and both depend on strategy.

In chess, a good strategist excels over a good tactician. Good individual moves do not add up to good play.

In business, the Japanese gambit has become equally familiar. Take a complex product, but one for which the technology is fairly mature. Begin with simple goods catering principally to domestic or Southeast Asian markets. Build very high volumes to drive costs down and get quality up. Then attack the North American market at the lower end with these low costs. Roll up the market as domestic manufacturers execute a segment retreat to higher-margined, lower – volume specialties suitable only for their market. Add high-end complexity only at superior total volume and cost. Finally, mop up Europe with the full line of higher-quality, lower-cost goods.

The Japanese gambit became a familiar pattern in transistor radios and televisions. The pattern is being repeated in autos, machine tools, trucks, farm implements, engines, and forklifts.

Strategic success requires:

• Appropriate pattern recognition.
• Appropriate rules of thumb.
• Learning.

The grand masters of business may never truly master it. But they do win consistently over the competition.

Probing

The single most important word in strategy formulation is why. Asking why is the basic act of probing.

Good strategy depends critically on knowing the root causes.

Creative Analysis

Entrepreneurs have tremendous drive and energy. They are endlessly creative and imaginative about their business and its opportunities.

This is the creative analytical process of the outstanding entrepreneur. It is the right and left sides of the brain in harness, thinker and doer in one.

Make Decisions Like a Fighter Pilot

Winners complete the so-called O.O.D.A. loop — the cycle of observation, orientation, decision and then action — faster than losers.

Speed in the action stage of the O.O.D.A loop requires a particular operations architecture and a lot of high-quality work.

The Seduction of Reductionist Thinking

Reductionist thinking teaches managers how to respond to complex problems: break them down into simple parts and then attack them separately.

It doesn’t work very well in complex organizations where the whole really is greater than the sum of its parts.

Change is more like the river — it keeps coming and it doesn’t stop.

Choices, Again

When demand is high, the bar is low. Almost everybody can get over it. But in leaner times, the bar rises, and only the fittest competitor can clear it.

Social Commentary

Failure to Compete

Cost and market share are inversely related. The highest market share should produce the lowest cost as a result of the experience curve effect.

Conflicting Tax Objectives

Taxes that reduce both supply and demand for capital while raising the cost of capital are truly self-defeating and punishing beyond measure to the general public.

Dumping

Dumping may be the sale of temporary excess capacity at marginal cost.

Dumping can continue forever and be profitable to the seller if the seller is the lowest-cost producer.

Adversaries or Partners?

The debilitating “English disease” of labor strife is the bitter fruit of the Industrial Revolution.

In Japan, cooperation led to the opposite result.

Where industrywide labor-bargaining monopolies are supported by law, competition between corporations based on productivity is suppressed.

A whole new culture must be built in Western business if it is to realize its potential. True cooperation is based on mutual commitment. True commitment is based on mutual purpose, mutual evaluation, and mutual trust.