Preferred Capital, the Principle of Tactical Alterations, and the Principle of Strategic Alterations
At the University of Missouri, his Zeta Phi fraternity brothers called him “the Hustler.” He was a born salesman. He belonged to half a dozen campus clubs and was a good athlete, a former Eagle Scout, and the best Zeta Phi recruiter on campus. He paid for his tuition and living expenses with a newspaper route. And unlike his peers, he was notorious for penny pinching and studying hard. Upon graduating, he took a job as a management trainee at JCPenney. It’s there the hustler first learned about retailing.
Like most his age, he enlisted in the army but never went overseas. Afterward, he used his savings and a loan from his father-in-law to buy a Ben Franklin franchise. Ben Franklin was a variety store, also referred to as a five-and-dime since everything in the store was priced at either five or ten cents. Today’s dollar stores are the remnant of this business strategy. For Sam Walton, though, there was another strategy, a simple business model, that would make his store the biggest company in the world and make him the richest man in the world. That strategy, as you know, was a maniacal focus on solving the low-price retailing problem.
Over the next ten years, Walton and his brother, James, acquired eight more Ben Franklin stores and became the most successful franchisees in the chain. Then he proposed a new strategy for the franchise: slash prices; operate at a high volume, with low margins; and position the company as a discount retailer. The Butler brothers, who owned the franchise, thought both the idea and Walton himself absurd. They declined the strategy. So, in 1962, Walton opened the first Wal-Mart store in Rogers, Arkansas. Much to everyone’s surprise, the store was a hit. Although Rogers had a population of only a few thousand people, the store drew in people from dozens of miles away. In a 1989 interview, he said, “We discovered people would drive to a good concept.”
Walton didn’t invent the concept of a discount retailer. In the 1960s, it was an idea that was being executed, quite successfully, in the larger population centers around the country. Ironically, Kmart, Target, and Wal-Mart were all started the same year, and all were solving the low-price problem. At first, Kmart dominated the category in the big cities. Meanwhile, back in Arkansas, Walton was developing the same business model in the small towns of the Southeast, away from prying eyes. Though he was solving the same problem, he focused on developing more and more tactics, and slowly his model became more and more effective.
Walton didn’t buy into the idea of sales or other promotional gimmicks. He didn’t believe in deceit or clever advertising. Ahead of his time, he believed that word of mouth was the real driver of sales, the best form of advertising, and the only way to drive word of mouth was to have a focused strategy and to honestly offer the lowest prices. While other stores were running half a dozen promotions or circulars a month, Wal-Mart was running only one. That reduced his marketing budget to a third of his competitors’, which allowed him to reduce prices even more, which only made the word of mouth even stronger. Walton’s “good concept” was more than just a marketing idea; it was an inherent part of the strategy. The tactics and strategy were the same thing; he had developed a strategically aligned company, and every day he worked to make it tighter and tighter, making alterations that adapted to the moves made by his competitors and the needs, wants, and desires of his customers.
The Principle of Alterations
The Principle of Alterations says that there are two ways a business model evolves from A to B. A strategic evolution is when we use our existing tactics to solve a new problem. Intel evolved strategically when the company shifted from solving a “memory chip” problem to solving a “microprocessor” problem. Wal-Mart, on the other hand, has evolved by constantly modifying its tactics, improving existing ones, and developing new ones. Let’s study it a bit more because this is a critical teaching point.
The Principle of Tactical Alterations
At first blush, you might be tempted to think that the history of Wal-Mart is a case in which Plan A needed no adaptation, since it has stayed focused on solving the same problem for decades. But that’s not true. While the company’s strategy has remained the same, the tactics used to implement it have changed a great deal over time. This is an important point. The evolution of a business model very often is the evolution of tactics.
Wal-Mart’s original tactic was threefold. The first was to keep operating costs extremely low. Wal-Mart stores were not in the most convenient locations; instead, they were in places with low rent. This was contrary to retailing maxims, which touted location, location, location. But early on, Walton had proved that people would drive for a “good concept.” The second was to buy at rock-bottom prices. This meant that Wal-Mart didn’t have the latest fashions or top-of-the-line appliances. It meant that it would stock things that other retailers wouldn’t. But they would be really cheap. The third was the result of Walton realizing that cutting costs was really the responsibility of store managers, so he gave them responsibility for profit and loss and based their compensation on the profit of the individual store. That was unheard of at the time, but it’s a practice that continues at Wal-Mart today. That meant that every decision, from low level to high level, was based on whether it was consistent with the strategy of low prices. That’s how Walton ensured strategic alignment. He knew that a strategy was only as good as the tactics used to implement it and the tactics were, ultimately, the responsibility of the people on the floor.
As Wal-Mart grew, it began to expand into the high-population centers and compete with JCPenney and Kmart. However, by the time it arrived, it had perfected its low-cost tactics and developed some new ones. In the 1980s, in an effort to reduce its logistics costs, Wal-Mart instituted a concept known as “cross docking.” It was an idea first developed by the commercial trucking industry and then adopted by the military in the 1950s. Wal-Mart was the first major retailer to implement it. Instead of shipping and warehousing product, the shippers transfer product from one truck, or one railcar, to another without having to keep it in a warehouse. Instead, inventory is moved from one vehicle to another without incurring the time, effort, and money needed to store it.
Today, Wal-Mart spends very little on corporate furnishings and corporate office expenses. Its headquarters are in Benton-ville, Arkansas, and you won’t find fancy buildings or statues of its founder or any other frivolous expenses. While Sears was building the tallest building in the world on one of the most expensive real estate plots in downtown Chicago, executives at Wal-Mart were working on card tables, sitting on folding chairs, and bringing pencils from home to take notes. Wal-Mart refuses to buy expensive furniture because it’s inconsistent with its strategy.
That doesn’t mean that Wal-Mart doesn’t make investments in infrastructure. It does. For example, it has spent hundreds of millions of dollars on sophisticated logistics software and hired some of the best logistical minds in the business to help. Its current logistical system is tied directly to the shelves. Before the Internet, Wal-Mart invested in a satellite system for stores to communicate with one another, with the home office, and with their key vendors. Today, for example, if you’re a vendor, you can look into the Wal-Mart system and see, on a store level, just how much inventory you have and so can anticipate restocking. If an item’s selling velocity starts increasing at one store, it can send a signal to the other stores. Wal-Mart can replenish store shelves four times as fast as any other retailer, and for a company that’s using a high-volume, high-product-turnover model, this is an essential part of it.
Of course, Wal-Mart’s growth strategy is also consistent with its low-cost strategy. As the company got bigger, it could dramatically reduce costs because of economies of scale. For instance, corporate overhead is spread out over a larger number of stores and so becomes a small percentage of storefront costs. The same is true for its computer system: the price of the complex software would be prohibitive to a smaller store but is affordable on a large scale. And most important, Wal-Mart is able to negotiate more successfully with its vendors. It has the power, since it’s the largest retailer in the world and so can pay the lowest price for products. It’s well known among its vendors that if you sell to a competitor for less, you run the risk of being ousted from Wal-Mart, a move that could send your firm into bankruptcy.
Some Wal-Mart tactics are suspect. It pays low wages and has a poor benefits program. For example, it doesn’t pay benefits to part-time workers, and half of its staff are part-time. New hourly workers have to wait six months to sign up for its health care plan, and it doesn’t cover retirees at all. It has refused to pay for flu shots, eye exams, child vaccinations, and other treatments. It has a higher deductible than most other major employers. The company’s health care costs are 30 percent less than those of any other major retailer and 40 percent less than those of other Fortune 500 companies.
Other Wal-Mart tactics are just plain brilliant. Though it’s accused of bullying its vendors, it’s also very vendor-friendly and realizes that its success is tied to the success of its vendors. In the early 1980s, just as Wal-Mart was beginning to expand to the major metropolitan areas, Walton called all his vendors to a meeting in Arkansas. He told them his growth plans and then offered to help them lower their cost structures and so reduce prices. He was the first major retailer to install scanners in his stores and then give the data to his vendors for free (others charged for the data). You see, he knew that this data would help his vendors reduce their costs and so ultimately reduce their prices. And though he demanded lower prices from vendors, he always passed the savings on to his customers. He continued to operate on the lowest of margins and make up profits on volume. The metric he used to measure the success of his tactics was simple: the shelf price of the product. He was constantly comparing his prices to his competitors and constantly developing tactics to push those prices down.
Sam Walton died in 1992. Today Wal-Mart is the largest corporation in the world and generates a billion dollars a month in profit. That’s a lot of money for a company that passes its savings on to the customer. The question is: Will Wal-Mart continue to stay focused on solving the same problem and stay as strategically focused on low prices?
In February 2009, Mike Duke became the fourth CEO in the history of Wal-Mart. Rob Walton, a son of the founder and chairman of the board, said, “We are confident that the strategy we have in place is the right one for future success and Mike has been actively involved in developing and executing this strategy.” As the economy sank deeper into a recessionary abyss, unlike a lot of other retailers, Wal-Mart was doing fairly well. After all, a focus on low prices is a pretty good strategy in a downturned economy. But then something happened: right after Mike took the helm, he took a step out onto the slippery slope. The history of passing lower costs to its customers was broken. In November, in an effort to try to beat the earnings forecast on Wall Street, Wal-Mart took its vendor price concessions and put them toward the bottom line. It didn’t raise prices, but it didn’t lower them, either. It reported hefty earnings, its stock price rose, and everyone was happy. But it was a step in the wrong direction, a step away from everyday low prices. However, to his credit, Mike Duke reversed the decision to increase profitability over reducing prices. Only time will tell if he can stay focused on the right metric. His competitors, such as Target, are adopting Wal-Mart-like tactics and can deliver low prices, too. That’s just the nature of business.
The Rise and Fall of Tactics
The Principle of Tactical Alterations tells us that the effectiveness of a specific tactic is rarely static. Over time it gets stronger or weaker, rises or falls. Some tactics, by their very nature, require reinforcement. Messaging, for example, requires repeated use in order to become effective. Advertisers call this “frequency.” In contrast, direct-mail tactics tend to decline over time. If you mail an offer to a specific list and get a 4 percent response rate, research shows that if you mail the same list a second time you’ll get a 2 percent response rate, a third time 1 percent, and so on; the tactic degrades by half with each use. It’s called the law of diminishing returns. (Of course, there are always exceptions.) However, when you’re managing by metrics, you have to be sensitive to those movements, whether or not they’re consistent with the inherent nature of the tactic, and what the rise and fall of the tactic means to your business model and its underlying theories.
Business in general and marketing in particular are the fight for a place in the minds of customers. Messaging is a critical part of most business strategies. And it requires frequency. There are many theories about this, like the number of times a message needs to be heard, but they’re all based on a simple cognitive reality. Hermann Ebbinghaus, a German psychologist who studied memory and first coined the term “learning curve,” said that learning requires repeated exposure to a novel concept. My high school teacher taught me a simple technique to memorize different ideas; she’d have me write the idea over and over and then say it out loud. After a few rounds of this, I’d be able to memorize some random fact about organic chemistry and be able to recall it on a test a few days later. Advertisers say that the first time people look at any given ad, they don’t even see it. The second time, they might notice it. The third time, they might read it. And so on, until the twentieth exposure gets them to buy your product.
Most business leaders understand the concept of frequency, just as most military leaders understand the concept of casualties. The first exposure to a message is like the first wave of marines hitting Omaha Beach: the casualty rate is extremely high. Your message is ignored; people don’t even see it. Only a few marines might make it to shore. The second wave fares a little better. Your message is noticed. A few more marines make the beach and are able to establish a beachhead. With each successive wave a few more marines get through, and the beachhead gets bigger and bigger until they can take the beach and drive the defenders off it. And with each successive exposure to a marketing message a business can establish a similar beachhead in the mind of the customer. Business leaders love this type of battle, they glory in it and enjoy the thrill of perseverance. But it creates a dangerous bias: we begin to think that all tactics work this way, that if we send in enough troops, we can overpower our competitors and establish a place in customers’ minds. Unfortunately, it isn’t that easy and isn’t always true.
In fact, over the long term, the opposite is true. Most tactics, even messaging, degrade over time. This erosion is the result of environmental changes. Customers need change. Competitors develop new products and services that better solve the problem you’re trying to solve. And effective tactics are copied by your competitors. Just ask the leaders at Wal-Mart. Their innovations in logistics, turnover ratios, and vendor negotiations have been copied and over time have made them less effective. Target now does that stuff, too. Wal-Mart has to continue to develop new tactics, new ways of lowering its cost structure, in order to effectively solve its low-price positioning problem. It never ends. Evolution is a fluid concept, not a static one.
When I was running Preferred Capital, our strategic goal was to provide “convenient” lease financing for small businesses to acquire capital equipment. We developed a number of tactics for reaching this goal. We created a direct marketing program that sent a preapproved lease card that prospects could activate so that they could have access to their line of credit. The prequalification process and lease card were both tactics that were aligned with the “convenience” strategy. If we needed additional credit information from a customer, we didn’t have an “application”—that wouldn’t have been perceived as convenient—so instead we created a “membership update form.” Our account managers each had his own toll-free number so that the customer could contact him directly, without the hassle of going through a switchboard. As the business model developed, we were in constant search for more financing tactics that would make our service and products even more convenient. Like Wal-Mart, we had a maniacal focus on our strategic goal, and that focus kept us on a search for new tactics. We became the fastest-growing equipment-leasing company in the United States, and the profits started flowing.
But then something happened, slowly at first. Our success threw a spotlight on us, and our competitors began to copy our tactics. The leasing business was similar to the mortgage business in that there were a large number of small companies; it was a diversified industry with no one holding any great market share, except for local banks and GE Capital. The small companies began to do their own preapprovals and send out their own lease cards. Pretty soon the market was saturated with them, and they were rendered useless. The tactic was worn out. In the beginning we were getting a 10 percent response rate on our lease card mailing. A few years later we were lucky to get 1 percent. When it stopped working, our pipeline quickly dried up and our business declined dramatically.
So a successful business model is temporary at best. You have to stay focused on tactics. You have to stay one step ahead of those who are intent on copying you. If you do, your business model will naturally adapt and evolve. Slowly you’ll begin to optimize your model. You’ll reinforce success and abandon failure, and your model will change from the bottom up in a kind of organic evolution.
This means that you’ve got to keep honing your tactics, developing new ones, because you can never count on them continuing to work. This assumption is one of the biggest mistakes that successful companies make and why it’s so important for us to carefully monitor the success of our tactics (by watching the metrics) and sound the alarm as they begin to erode. Leaders have been biased by the concept of “frequency,” and now it pervades business thinking: just throw money at the problem; if we send in enough marines, the tactic will work. It’s a dangerous way to think, just as it’s a dangerous way to construct a battle plan. The Battle of the Somme is a lesson for generals and business leaders alike.
Businesses must be tactically focused. They need to monitor tactical effectiveness and constantly search for new ways to solve old problems. This is the essence of day-to-day operations. This search is the key to the tactical evolution of your business model.
Ultimately, this process will lead to more than just tactical evolution; if done right, it can organically lead to strategic evolution. Over time, your tactics will change your business model into something completely different. You’ll then develop tactics to solve a different problem. Put simply, tactical optimization leads to strategic adaptation.
The Principle of Strategic Alterations
Wal-Mart, to repeat, is the story of a company that has stayed focused on solving a specific problem. The company has evolved by finding new and creative ways to deliver on its low-price promise. The tactics evolved from the bottom up. In contrast to this type of adaptation, there’s a more dramatic type of evolution, a more top-down, intentional evolutionary process that’s called “strategic evolution.” There are two forms of it. The first is when you use your existing tactics to solve a new problem; the second is when you solve the same problem but do it in a different way, using a “new” underlying hypothesis about solving it. Let’s explore the latter.
The evolution of the iPhone and iPad is a good example of strategic evolution through tactical optimization. The iPhone was introduced in January 2007. It was an instant hit, and the company sold more than three million of them within six months. As with the iPod, Steve Jobs drove the evolution of it through tactical optimization. In fact, the iPhone was a project created by Steve to develop capacitive touch screen technology. He didn’t know where to apply the technology, he just sensed that it was an important tactic in the consumer electronics industry. In fact, he originally wanted to create a tablet PC with the technology but opted instead to apply it to the mobile phone. It’s a good example of a solution looking for a problem to solve. Unlike other mobile phones, this one was a software platform, and Jobs opened it up to other developers to create applications—“apps”—to run on the phone. These “apps” included games, calculators, Internet browsers, productivity enhancers, e-mail readers, maps, streaming radio, and hundreds of other clever things. They allowed the device to evolve into much more than just a phone.
And evolve it did. Over the next few years, the touch screen technology improved, the screen resolution was enhanced, and a slew of new apps was making the device more and more useful. However, developers were limited by the screen size and computing power of the iPhone and complained to Apple about it. It became apparent that so much more could be done with a larger device, so Jobs and team went back to the drawing board and resurrected the original idea of developing a tablet PC. This wasn’t a new idea. At Comdex in 2001, Bill Gates introduced a Microsoft tablet PC during his keynote speech. Years before that, Apple had introduced a handheld device called the Newton. Those products failed. But now, using the technologies and tactics derived from the development of the iPhone, Apple was able to create a new type of tablet PC that became known as the iPad. Put simply, the iPad evolved out of the iPhone through tactical optimization, and a new business model was born. That is strategic evolution. Existing tactics were used to solve a completely different problem.
The same thing happened at Intuit a decade earlier. The original product was Quicken, a software program designed to balance a checkbook. Over the years the product evolved into a program used to manage your personal finances—tactical evolution. However, some customers began using it to manage their small businesses. Scott Cook and his team observed this unintended use and created a new product designed to solve the problems of managing the books of a small business. The product is called Quick-Books, and today it’s a billion-dollar business, while Quicken is merely a remnant of itself (online banking killed the business model because it solved the problem better and for free). In other words, the tactics used to manage a personal checking account were repurposed and used to solve a completely different problem and so create a new business model: Plan B.
This is an important point. Plan B is often the result of using your existing tactics to solve a completely different problem. Business leaders rarely think in terms of strategic evolution. Instead, they focus on sending more marines onto the beach in the hope that reinforcements will reverse the degradation of their tactics and bring the model back to prominence. Few look for other problems to solve. It’s a big, bold way to think, and it needs to be incorporated into the planning process. The question needs to be asked: What other problems can we solve? It’s an important question, because as tactics degrade over time, so, too, does the effectiveness of the strategy. And sometimes shit happens that completely destroys your business and you have to be prepared to adapt to these changes. Polaroid was unable to adapt to the one-hour photo business and the digital camera revolution. Digital solved the same problem Polaroid was trying to solve and ultimately destroyed the company.
Let’s look at a dramatic example of two companies that were faced with a situation similar to the one Polaroid found itself in. But those two companies were able to adapt and evolve by using their existing tactics to solve new problems and so create new business models. What’s interesting about this story is that the two companies were founded by the same person, tasked to solve the same problem, but evolved over time into two completely different models.
A Tale of Two Companies
Henry was the son of a Presbyterian minister in Thetford, Vermont. A precious child, he was born with a sobering disability: he stuttered and stammered, finding it difficult if not impossible to express himself. He worked hard to overcome it and went on to open a series of schools for stutterers that he ran for fifteen years. Driven, focused, and determined, he later founded two other companies that have survived for more than a century. This is a tale of two companies and how they changed their strategic focus over time by evolving through the use of tactical adaptation.
In 1836, young Henry took a job as a freight agent on the Erie Canal. It’s there that he learned the business of shipping and receiving. A few years later he put his determination to good use by establishing an express mail company that later merged with another company and became Western Express. Western Express, with Henry as president, expanded rapidly. It turned out that he was a master of logistics and was able to ship letters and packages faster and cheaper than any of his competitors, including the United States Post Office (USPO). Henry used the railroads, horse-drawn carriages, the canal system, and lone horsemen to deliver letters and packages—whatever worked. The USPO was forced to reduce its rates in 1845 in order to compete with Western Express.
In 1850, Henry merged his company and consolidated again, taking on new partners and renaming the company American Express. As founder, he was appointed the first president of the corporation. Like his other ventures, American Express took off. It became the delivery system of choice for commerce, focusing on bills and payrolls. Armored cars provided security. A few years later, Henry proposed expanding the service across the Rockies to California. California, after all, was in the midst of a gold rush, and at the time the only way to get a package from the East Coast to the West was by shipping it by sea, which could take half a year, or giving it to the Pony Express service, which had security problems. The board of American Express thought the venture too risky and too capital-intensive and voted the idea down. So Henry decided to form another company with the sole purpose of providing express mail services to California. Along with another American Express manager, they set up a new company.
In 1852, Henry Wells and William Fargo incorporated the new business and called it Wells, Fargo & Company. Like American Express, the company thrived, and Henry Wells ran both organizations for more than ten years. In order to better serve its customers, Wells Fargo established a bank in San Francisco and was the jumping-off point for the express services, which began to focus more and more on getting gold from the West and into the banks of the East. Wells used an extensive network of stagecoaches and steamships and even purchased the western routes of the Pony Express. For the next decade it dominated the routes and was the shipper of choice. In 1861, however, the first transcontinental telegraph line was completed, destroying a huge part of Wells Fargo’s service. Messages no longer had to be physically delivered; they could now be sent electronically. So Wells Fargo began to focus more on packages.
But then something epic happened in 1869. At Promontory, Utah, the final spike was driven into the ground and the transcontinental railroad was born. Wells was unable to negotiate an exclusive contract with the railroad, so other companies were formed to carry the mail via the new rail system. Once again, Wells Fargo had to make adjustments in order to survive. Its infrastructure of stagecoaches became obsolete nearly overnight. Henry Wells decided to retire and devote his time to building a new college for women, and William Fargo resigned to focus full-time on American Express.
In 1872, Lloyd Tevis became president of Wells Fargo. He embraced the new technology, abandoned his well-oiled infrastructure, and became the leading rail shipper in the country. As a tactic, it was much more effective than the stagecoach and express mail system his company had pioneered. In an effort to increase revenues, he expanded its banking services and opened more than a thousand Wells Fargo offices throughout the country. The offices served as minibanks where people could send money to different parts of the country. Then, by the turn of the century, a new president began to disassemble the banking from the express mail services. For a few years, both divisions of the Wells Fargo company thrived. In 1906, San Francisco was destroyed by a huge earthquake. Most of the buildings were completely leveled, including the main Wells Fargo branch. However, its deposits were safe in the huge vault the company had constructed in an effort to secure more banking business. This proved a windfall, for the other banks in San Francisco were reduced to rubble and didn’t have the resources to rebuild. For the next few years, Wells Fargo would be the lone bank in the city; its deposits would triple as money rolled in from throughout the country in an effort to rebuild California’s center of commerce. At the same time, the express company managed rail service to new heights. It had invested in refrigerated cars and armored train cars and purchased any competitors that began to take business away from them.
About the same time, James Fargo, the younger brother of William, had become president of American Express. On a trip to Europe he carried traditional letters of credit that wealthy people used to get cash while traveling. However, he found that many of the smaller European banks wouldn’t accept them, even though he was the president of American Express. Incensed, he returned home and told an American Express employee, Marcellus Berry, to create a solution to his problem. Berry created the American Express Travelers Cheque.
But in 1918, Wells Fargo and American Express were both dealt a death blow. At the onset of the First World War, the government stepped in and nationalized the railroads and the express mail services. Wells Fargo and American Express were paid for their routes, their buildings, and their equipment and were forced out of the mail business. But by that time, Wells Fargo had established itself as one of the premier banks in the country. American Express, on the other hand, had slowly evolved its travelers check idea into a lucrative business model. Both companies were able to thrive through turbulent times, by developing completely new strategic directions and doing so out of the tactics that they had developed from a different strategy over a long period of time. Tactical optimization had led to strategic evolution.
Unlike Wal-Mart, which has stayed strategically focused, Wells Fargo and American Express developed completely new strategies out of the tactics they used for their original strategy. Wells Fargo was faced by an onslaught of technical innovations that could easily have destroyed the company, the way digital cameras destroyed Polaroid. Undaunted, though, it continued to develop new tactics because staying focused on the delivery of packages was impossible to do. Wells Fargo became one of the most successful banking brands in the country, while American Express evolved into a travelers check company and then a credit card company. Today, few people realize that the companies were founded by the same person and were the original mail delivery companies. Henry Wells himself wouldn’t recognize either company, for each adapted to its situation in a new way and developed a completely new strategic focus and direction. When they were faced with strategic dilemmas, they developed new directions out of the existing tactics.
Wells Fargo, American Express, Intuit, and Apple have all created new business models—evolved strategically—by finding new problems to solve. There’s another form of strategic evolution that’s important for us to understand. Remember, there are two elements to your strategy: (1) the problem to be solved and (2) a hypothesis for solving it. You see, new business models are often created out of new hypotheses. The most common form of this strategic evolution is called “the innovator’s dilemma.”
The Innovator’s Dilemma
In 1997, Clayton Christensen published a book called The Innovator’s Dilemma. In it he asked himself the question, Why do successful companies ignore technological innovations that have an important strategic impact on their markets? At this point, we might rephrase the question as, Why do successful companies ignore technologies that are able to solve the same problem they’re solving but do it for far less money? The answer is cannibalization, and cannibalization is the dilemma.
Disruptive technologies, according to Christensen, tend to happen at the low end of the market. For example, the personal computer was a low-end product that disrupted the mainframe computer market. In the beginning, PC computing power was very limited, so the applications a PC could run were limited. It was a hobbyist toy. Companies such as IBM, Honeywell, and Digital Equipment Corporation were unconcerned because the machines were not powerful enough to solve the computing problems of the day, such as forecasting, inventory control, and financial management. Slowly, PCs’ power increased, and slowly, they began to solve simple forecasting and financial problems. But still the big computer makers did little to block this encroachment. The reason, according to the theory, is that they didn’t want to cannibalize their current market. Mainframe computers were expensive, costing hundreds of thousands of dollars, while PCs cost only a few thousand dollars. It seemed absurd for a salesperson to offer a $2,000 solution when his sales quota was in the millions.
Personal computers were based on a different hypothesis for solving the same problem. Mainframes used a centralized processing solution. Users would queue up, wait in line for computing time, and thus be able to run very complex algorithms. With a PC, the user had complete access to the processor, albeit a less powerful one, and so had to devise simpler algorithms to solve the same kind of problem. However, as PCs became more and more powerful, they replaced mainframes and computing became a decentralized process—a new solution to an existing problem.
The innovator’s dilemma is this: Should we create a new set of products that are cheaper and less powerful but solve the same problem we are solving? The answer is yes. This is an important evolutionary step and the ultimate form of Plan B. You see, if you don’t do it, someone else will. Take, for example, the situation H&R Block finds itself in today. For decades it “owned” the tax preparation marketplace for individual taxpayers. Then TurboTax came along and solved the same problem but at a much lower price point. The average cost of a Block-prepared return was about $300, while the price of TurboTax was less than $50. The managers at Block didn’t want to offer a $50 solution because they felt it cannibalized their core service offering. And they were right, it did. Besides, the program couldn’t cover all of the unique tax situations that a personal Block preparer could. But slowly, over time, TurboTax became more and more complex, able to handle more and more tax situations, and it grew in market share. Today, Tur-boTax is a billion-dollar business with a huge profit margin (the variable cost of a piece of software is negligible, so each additional sale, once development costs are covered, is almost completely profit). H&R Block is struggling. It’s playing catch-up. I know, because I worked for both companies and witnessed firsthand the struggle in the boardroom over the idea of cannibalizing your own market. The thing is, if Block had begun cannibalizing itself in the beginning, today it would have a new billion-dollar business with huge profit margins.
Strategic evolution is a painful process. It requires short-term losses to finance long-term survival. It requires the willingness to cannibalize yourself. It requires the willingness to create new business models. Few managers are willing to take such losses, in part because their compensation and stock price are so closely tied to financial performance.
The time has come, however, for business leaders to grow up and understand the evolution of business models. In this chapter we’ve outlined the various types of evolution and adaptation. Tactical evolution is when a company stays focused on a certain customer problem but keeps developing new tactics to solve it. Strategic evolution is when a company uses its tactics to solve a new problem or develops a new way to solve an old one. Leaders need to understand both types of evolution and develop systems to drive this type of change. The good news is this: the day-to-day process for doing both is the same. I will explain how in the next, and final, chapter.