Focus Your Thinking

How Leaders Grow…page 66 Understanding Big Risks…page 78

54 How Strategists Really Think:Tapping the Power of AnalogyGiovanni Gavetti and Jan W. Rivkin

66 Seven Transformations of LeadershipDavid Rooke and William R. Torbert

78 Countering the Biggest Risk of AllAdrian J. Slywotzky and John Drzik

92 The Quest for Customer FocusRanjay Gulati and James B. Oldroyd

102 The Relative Value of GrowthNathaniel J. Mass

14 Forethought

35 HBR Case StudyClass – or Mass?Idalene F. Kesner and Rockney Walters

49 Different Voice Strategic Intensity A Conversation with World Chess ChampionGarry Kasparov

114 HBR at LargeSelection Bias and the Perils of Benchmarking Jerker Denrell

121 Best Practice The Half-Truth of First-Mover Advantage Fernando Suarez and Gianvito Lanzolla

131 Executive Summaries

136 Panel Discussion

Focus YourThinking

April 2005

www.hbr.org

…page 54

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92 The Quest for Customer FocusRanjay Gulati and James B. Oldroyd

What do customers really want? What does your com-pany really need to know about them? You won’t find out simply by conducting a survey or installing a CRMsystem. The road to enlightenment is much longer andharder than that – but those who go the distance have the profits to show for it.

102 The Relative Value of GrowthNathaniel J. Mass

You might be surprised at how much more valuable itcan be to grow than to cut costs. Now you can determinewhich of your corporate strategies are working to delivervalue and whether you are pulling the most powerfullevers for value creation.

continued on page 8

66

54 How Strategists Really Think:Tapping the Power of AnalogyGiovanni Gavetti and Jan W. Rivkin

The exhilarating feeling of “I’ve seen this situation before!” leads sometimes to strategic breakthroughs,sometimes to disaster. Here’s how to make sure your analogical reasoning is on the money.

66 Seven Transformations of LeadershipDavid Rooke and William R. Torbert

Few leaders try to understand their leadership styles.They should, because those who undertake a voyage of personal understanding and development can trans-form not only their own capabilities but those of theircompanies.

78 Countering the Biggest Risk of AllAdrian J. Slywotzky and John Drzik

You can hedge, but you can’t hide from “strategicrisks”– the events and trends that can devastate yourcompany’s growth trajectory and shareholder value.Learn to anticipate and manage these threats system-atically. (You may even be able to turn some of them into growth opportunities.)

HBRApril 2005

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©2005 Merrill Lynch & Co., Inc.

Merrill Lynch provides fi nancial advice and

strategic insight to position both issuers and

investors for success in achieving their objectives.

Our integrated teams working across multiple

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together on behalf of our clients. We leverage

rigorous analysis, knowledge of the markets and

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fi nancial solutions for exceptional clients.

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PROJECTIONS.

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10 F R O M T H E E D I T O R

When Businesspeople Think As several articles in this issue makeclear, understanding how managers’minds churn is often more importantthan knowing what they’re thinking.

14 F O R E T H O U G H T

Professional service firms may no longerbe the best role models for corpora-tions…HR? A launching pad?…A sys-tem for scripting successful TV ads…Think twice before trimming HQ staff…Knowledge work is (basically) here tostay…Consumers do know the differencebetween “tall” and “medium”…The “bro-ken windows” crime-prevention theoryapplies to business as well…Earnings inmiddle-wage countries are stagnating…What your logo font says about you…HR needs to segment talent strategi-cally…Avoid an overload of meetings…The coming of femtosecond lasers.

31 2 0 0 4 M C K I N S E Y AWA R D S

35 H B R C A S E ST U D Y

Class – or Mass? Idalene F. Kesner and Rockney Walters

Neptune Gourmet Seafood has a vastamount of excess inventory. If the com-pany slashes prices or creates a low-priced brand to get rid of the surplus, itcould trigger a price war, cannibalizesales of its other products, and destroyits premium image.

49 D I F F E R E N T V O I C E

Strategic Intensity:A Conversation with World ChessChampion Garry Kasparov

The greatest challenge for highly suc-cessful people is to stay passionateabout being at the top, says the world’snumber one chess player. The secret tolasting triumph? You must be lucky inyour enemies.

D e pa r t m e n t s

10

April 2005

90 ST R AT E G I C H U M O R

114 H B R AT L A R G E

Selection Bias and the Perils of Benchmarking Jerker Denrell

Looking to successful companies forbest practices may seem like a no-brainer, but it’s an approach that’sdoomed to failure.

121 B E ST P R A C T I C E

The Half-Truth of First-MoverAdvantage Fernando Suarez and Gianvito Lanzolla

Sometimes the first company to moveinto a new product category is simplythe first to get clobbered. To improve theodds of success, a first mover needs toanalyze the technological and market-place environments it will be entering.

128 L E T T E R S T O T H E E D I T O R

Matching commitments with convic-tions is important for personal and professional fulfillment. It’s also at theheart of good leadership.

131 E X E C U T I V E S U M M A R I E S

136 PA N E L D I S C U S S I O N

Evil Unnecessaries Don Moyer

It’s one thing to improve or differenti-ate a product by adding functions. It’sanother thing entirely to complicate aproduct beyond users’ comprehension.

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F R O M T H E E D I T O R

When Businesspeople Think

usiness is always in a hurry.“History is more or less bunk,”

Henry Ford proclaimed. Speed is asource of competitive advantage. An ineffective businessperson is all talkand no action, while a successful busi-nessperson gets things done. Indeed, theeminent psychologist Karl Weick advisesleaders to leap before they look.

But spend some time with this issueof HBR first.

Start with “How Strategists Really Think: Tapping thePower of Analogy,” by two rising stars in Harvard BusinessSchool’s strategy unit, Giovanni Gavetti and Jan Rivkin.They’ve been studying executives’ reasoning processes.They’ve found that more often than not, executives developand test their strategic ideas by means of analogies. For example, Toys R Us was founded when Charles Lazarus figured that toy stores could be run like supermarkets.

Reasoning by analogy is highly efficient. It’s faster than de-veloping and sifting through mountains of data, it’s less riskythan trial and error, and it’s highly persuasive. But analogiesare perilous precisely because they are shortcuts and be-cause they are powerful. If you know what you’re doing, ana-logical thinking is a fabulous tool; Gavetti and Rivkin canshow you how to know what you’re doing. Not only will theirarticle make you think, it will help you think better.

Another threat to clear thinking is selection bias, whichoccurs when people draw conclusions from a set of datawithout examining the sample itself to see if it is represen-tative. Someone who has visited London only in the sum-mer might believe it has a delectable climate, for example.In his article “Selection Bias and the Perils of Benchmark-ing,” Stanford’s Jerker Denrell points out that business re-search is riddled with selection bias – starting with the factthat almost none of it is performed on firms that no longerexist. It’s interesting to know that a management practicesuch as empowerment is found in winning companies, butit could be that losers practice it, too.

Understanding how selection bias afflicts business re-search will make you a smarter consumer of business ideas.Take, for instance, the conventional wisdom about first-mover advantage. Conventional wisdoms, I should say, be-cause there are two: that it is a great thing to be first to a market and that first-mover advantage is a will-o’-the-wisp.Both are hasty generalizations that obscure useful detail.In “The Half-Truth of First-Mover Advantage,” Fernando

Suarez and Gianvito Lanzolla, fromBoston University and London BusinessSchool respectively, reveal the circum-stances under which first-mover advan-tage is very real – and the instances inwhich only a fool would pursue it.

Consultant Nathaniel Mass digs intoanother piece of conventional wis-dom in “The Relative Value of Growth.”Among executives, there’s an unspokenassumption that companies have to

choose between managing for value and managing forgrowth. Mass disagrees. Profitable growth, he argues, is a grossly underestimated lever for creating value. His re-search ought to make you think twice about how you reachyour strategic decisions.

In their eagerness for action, businesspeople commonlymake two other kinds of mistakes. First, they let the urgentdrive out the important. Nowhere is this more dangerousthan in the area of risk. As consultants Adrian Slywotzky andJohn Drzik argue in “Countering the Biggest Risk of All,”riskoperates at the strategic level as well as at the tactical onewhere executives are used to meeting it. Second, business-people race through processes that can’t be hurried. Two articles in this issue explore the theme of impetuosity. TheKellogg School’s Ranjay Gulati has been curious about howcompanies become customer focused. His research led himto the surprising conclusion that all of the companies thatsucceed in this quest go through the same four stages in thesame order. It’s not a process you can leapfrog, Gulati andhis coauthor James Oldroyd say in “The Quest for CustomerFocus”– it’s a journey you must complete one leg at a time.Something analogous happens with the development ofleaders, the topic of “Seven Transformations of Leadership”by consultant David Rooke and professor William Torbert.As our adult minds and characters mature, we developgreater capacities for leadership. Often, though, a talentedleader is promoted ahead of his or her maturation. The re-sult can be disastrous – for the company and for the leader.

Business is, indeed, about action–but it ought to be aboutintelligence, too. We hope this issue will make you smarter.

B


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Less remarked upon is the reverse. Sixyears ago, a book by Tom Peters exhortedmanagers to “Transform Your ‘Depart-ment’ into a Professional Service FirmWhose Trademarks Are Passion and Inno-vation!”But traditional businesses havelong been adapting PSFs’ approaches tocustomers, talent, and knowledge. Makersof things, such as General Electric andIBM, have been methodically turningthemselves into providers of services –and in the service category, PSFs add themost value and thus command the high-est margins. They also possess few depre-

Over the past 20 years, professional ser-vice firms (PSFs) have come to look a lotlike their clients. Many, now corporationsthemselves, operate in multiple countriesand have hundreds – even thousands – ofemployees. A small cadre of principals setsdirection, while professional administra-tors impose budgets and other financialcontrols. Functions that were once deemedintegral, such as research, are outsourcedor delegated to paraprofessionals. Thefirms’ proprietors, meanwhile, have over-come their qualms about advertising theirservices, not to mention themselves.

grist

The Limits of Professional Behavior

John W. Boudreau ([email protected])is a management professor at theUniversity of Southern California’sMarshall School of Business and theresearch director at USC’s Center for Effective Organizations.

James Goodnight ([email protected]) is the CEO of SAS Institute.

Michael Goold ([email protected]) is a director of theAshridge Strategic Management Center.

Pamela W. Henderson ([email protected]) is an associateprofessor of marketing at Washing-ton State University and the CEO ofNewEdge.

John Kastenholz is the vice president of consumer insights at Unilever.

Aradhna Krishna ([email protected])is the Isadore and Leon WinkelmanProfessor of Retail Marketing at theUniversity of Michigan’s Ross Schoolof Business.

Peter M. Ramstad ([email protected]) is the execu-tive vice president for strategy and finance at Personnel Decisions International.

Robert B. Reich ([email protected])is University Professor at BrandeisUniversity and the Maurice B. HexterProfessor of Social and Economic Policy at Brandeis’s Heller School for Social Policy and Management. He is a former U.S. secretary of labor.

Amy Salzhauer ([email protected]) is the founder and CEO of Igni-tion Ventures.

Peter K. Schott ([email protected])is an associate professor of economicsat the Yale School of Management.

David Young ([email protected]) is an associate at AshridgeStrategic Management Center andan independent consultant.


A survey of ideas, trends, people, and practices on the business horizon.

TLFeBOOK

















ciating hard assets, while being enviablyrich in knowledge workers who are contin-ually upgrading their mental equipment.

In fact, the primacy of knowledge workmay be the salient common feature ofmost progressive corporations. Thesecompanies wage wars for talented em-ployees, from whom they increasingly expect mature managerial judgment.To encourage these knowledge workersto think like owners, progressive com-panies award options and grant stock;traditional professional service firms, ofcourse, are owned and run by their part-ners. And these companies, like PSFs,are adept at knowledge codification andsharing: Law firms’ file drawers, and nowdatabases, are crammed with modelpleadings that young associates regularlyconsult. What’s more, forward-lookingcompanies are committed to becomingcustomer-centric, an unmistakable echoof PSFs’ sworn subservience to theirclients’ interests.

With so much talent at hand, profes-sional service firms have always felt a responsibility to develop their own lead-ers. That’s why they’ve been such prolificsources of executives, having launchedthe careers of Delta Air Lines’ formerCEO Leo Mullin, Morgan Stanley CEOPhilip Purcell, and Citigroup CEOCharles O. Prince, among many others.The best-governed corporations do thesame. Procter & Gamble has become sogood at executive development, for othercompanies as well as itself, that it has es-tablished an alumni network along thelines of those maintained by up-and-outconsulting and law firms. Inevitably, a bitof the service firm clings to these trans-plants, who prefer to hire people withMBAs – a degree that, like the JD and the MD, is supposed to bespeak masteryof a complex body of knowledge and adherence to strict ethical standards.Trained to be corporate managers, thetop business-school graduates under-standably gravitate instead to invest-ment banks and consulting firms, the

two most lucrative varieties of profes-sional service firms.

Convergence in some areas is un-imaginable, however. For example, ser-vice firms are supposed to offer a singlestandard of care to all their clients, re-gardless of their ability to pay, while cor-porations use dynamic pricing and cus-tomer relationship management to varyservice quality according to spendingpower. But in general, the traits compa-nies share with PSFs attest to those com-panies’ health.

Still, organizations must take carewhen consulting a model that is itselfchanging – and not for the better. In fact,there is evidence that companies havelearned about as much as they can fromtoday’s professional service firms. Truepartnerships remain “effective mecha-

nisms for managing and motivatinghighly intelligent, highly autonomousknowledge workers,” according to LauraEmpson at the Clifford Chance Center forthe Management of Professional ServiceFirms at Oxford University’s Saïd Busi-ness School. But the larger PSFs that hirelaterally instead of investing in home-grown talent; that favor ever-higher ra-tios of associates to proprietors; and thatshow greater concern for shareholdersthan for clients may no longer be worthyof emulation.

The leaders of today’s large profes-sional service firms, unlike their contem-poraries running corporations,“are moreconcerned about their book of businessthan how the group does,” asserts DavidMaister, a Boston-based consultant. Suchfirms resist accountability, refuse to stick

april 2005 15

l e a d e r s h i p

Those Fertile HR FieldsTheoretically, generalist CEOs are better equipped than specialists to navigate

the myriad functions inside, and the complex world outside, their compa-

nies’ walls. In Japan, one of the best sources of generalists is human resource

departments.

In his new book The Embedded Corporation: Corporate Governance and

Employment Relations in Japan and the United States (Princeton, 2004), UCLA

management professor Sanford M. Jacoby reports that in Japan HR departments

have often been springboards to top executive postings – including CEO – as well

as to board membership. Studies from the 1990s showed Japanese CEOs emerg-

ing from HR more frequently than from R&D, engineering, or overseas jobs. In

addition, one-fifth of directors in Japanese manufacturing firms and one-third

of those from other industries claimed past stints in HR.

HR managers in the United States become CEOs or directors only very rarely;

so why have they reached the top of the charts in Japan? For one thing, the Japa-

nese consider HR a good place to get to know leaders and managers throughout

the organization. But more important, Jacoby explains, Japanese HR managers

are often generalists who spend much of their careers in other functions, includ-

ing accounting, finance, strategic planning, production, and sales. In other words,

they are well-rounded, Jacoby says. Perceived as a narrow specialty in the United

States, HR in Japan is a place to go to get ahead. – Leigh Buchanan

Reprint F0504B

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to their stated strategies, and lack vision,drive, and commitment, he says.

In short, if companies have anythingmore to learn from professional servicefirms, it will be from those that operatedin the era before PSFs attached Inc. orLLP to their names and developed thefear of clients’ lawsuits that those lettersbetray. That means the era before PSFsbecame, in essence, profit-seeking com-panies themselves. – Ben Gerson

Reprint F0504A

how we do it

The Spielberg Variablesby john kastenholzCompanies want to believe that all advertising ideas – like the children ofLake Wobegone – are above average.But the bell curve dictates that only 30out of every 100 television ads we test atconsumer-products giant Unilever willbe superior. Forty out of 100 will be justaverage, and, understandably, we don’twant to put average ads on the air.

TV commercial effectiveness is hugelyimportant at Unilever; last year, we spent $3.3 billion globally advertising our brands. Each year, we work with ouragencies to produce a multitude of 30-second spots for the U.S. market at a costof about $400,000 each, not includingairtime. Many of those ads aren’t abso-lute failures but still score low enough–consumers rate them as B players inquantitative research – that we wouldrather not entrust them with our brands.For the past few years, however, we’vebeen using a diagnostic technique thatallows us to reedit just-passable ads intogreat ones.

Working with Albuquerque, New Mexico–based Ameritest/CY Research,one of our two principal testing compa-nies in the United States, we ask targetaudiences the usual questions about our ads: Do they stand out? Are they wellbranded? Do they motivate consumers to act? For the ads with mediocre scores,we then judge whether the problem lieswith the concept (the ad looks great, butthe idea isn’t exciting enough) or withthe execution (the idea is potentially

wonderful, but somethingabout the way the ad was puttogether is holding it back). Ifwe determine that we have abig idea hobbled by flawed ex-ecution, we put “the Spielbergvariables” to work.

That is, we ensure that eachof our ads employs the samestyle and storytelling tech-niques used in feature films.Good movies win viewers’ at-tention, propel the audienceforward emotionally, and con-vey meaning. Good movies arealso often born in the editingroom. We believe the same is true ofgood ads, so our goal is to diagnose problems and then fix them with a newdirector’s cut, as it were. That requiresidentifying flaws at each ad’s narrativeinflection points.

As a part of the process, each ad is de-constructed into frames that represent a change in tone or action – a cut to anew scene, for instance, or different bodylanguage displayed by a character in the ad. These images are randomized andshown to consumers, who have alreadyviewed the ad in its entirety, as part of anonline interview. The consumers providethree levels of feedback. First, they pointout which frames they recall and whichthey don’t. Second, the consumers de-scribe how they felt emotionally (Mildlypositive? Strongly negative? Neutral?)about the images they recall. And finally,they talk about the values (Convenience?Taste? Nutrition?) each image conveys.

The frames give us a visual vocabularyfor probing how viewers respond to dis-crete elements of an ad. When those data are plotted in a “flow of attention”or “flow of emotion” graph we begin tosee where things go wrong. We can tell if the ad hooks viewers right away. If itdoesn’t, we can pinpoint where theirimage recall–and hence their attention–starts to decline. Or we can see exactlywhere viewers shifted from a weak posi-tive feeling to a strong one. If importantinformation – particularly about thebrand – does not appear at those pointsof peak attention, we are missing theboat. If viewers take away the message


“cleans” when we are trying to sell themon “beauty,” we can identify exactly whichimages aren’t doing their jobs. Armedwith this precise definition of the prob-lem, our ad folks can make creativechanges to achieve the desired effects.

Over the past two years, 60 ads fromone of our health and beauty productsunits were approved for airing; 25 ofthem started out as average performers.After recutting on the basis of the Spiel-berg variables, those 25 ads tested in thesuperior range. This ability to optimizeour advertising helps Unilever maximizeROI in what has traditionally been a neb-ulous and difficult area to measure.

Reprint F0504C

headquarters

When Lean Isn’t Meanby michael goold and david youngMost executives believe that corporationswith large headquarters are bureaucratic,out of touch with customers, and slow tomake decisions – and, so, perform poorly.That’s why CEOs slash headquarters staffwhenever they try to cut costs or improveperformance. But do lean headquartersreally perform better?

In collaboration with research partnersaround the world, we studied the sizeand financial performance of the head-quarters of 600 companies in Europe,the United States, Japan, and Chile. Wefound a wide range of HQ sizes and com-position. For instance, for companieswith 10,000 employees, headquarters size

continued on page 18

TLFeBOOK

who knows the market better

than I do and understands my

risk preferences and financial

needs. Searching for profits,

IBM progressed from hardware

to software to services as each

of those offerings in turn be-

came commoditized. Today, the

company’s focus is on special-

ized solutions, consulting, and

custom applications – the next points along the sophisti-

cation arc.

In sum, topflight research communities, and increas-

ingly demanding American customers and their growing

appetite for ever more sophisticated products and ser-

vices, all spell more knowledge work in the United States,

not less. Between 1999 and 2003 (the latest year for which

we have data), the number of IT-related white-collar jobs

in the United States actually increased. IT wages are ris-

ing, too (adjusted for inflation and the business cycle).

The earnings of college graduates continue to outpace

the earnings of those with only high school diplomas; the

earnings of people with graduate and professional degrees

are rising even faster. If demand for knowledge work

were dropping, we’d expect the opposite.

This isn’t a brief for complacency. Unless the United

States invests large sums in education and in basic re-

search and development – and invests wisely – it won’t

have enough knowledge workers to meet future demand.

It won’t even have the majority of the world’s richest and

most sophisticated customers. Decades from now, China

and India may have surpassed the United States in high-

value knowledge work.

A related challenge is to reverse the slide of Americans

without college degrees, most of whom fall into the local

service economy, with its low wages and vanishing bene-

fits. The widening earnings gap between this group and

America’s knowledge workers undermines social solidar-

ity and threatens democracy. Not every American can be-

come a world-class knowledge worker, of course. But mil-

lions more can get the skills they need to be prosperous

members of the world’s wealthiest nation.

Reprint F0504E

Plenty of Knowledge Work to Go Around

april 2005 17

Anxiety over outsourcing mounts as the jobs trekking

overseas increasingly involve intellectual heavy lifting.

Relatively modest knowledge work – back-office support,

customer service, and data entry – was followed by more

sophisticated tasks such as computer coding, insurance un-

derwriting, claims processing, and medical transcription.

Recently, we have been exporting jobs in X-ray diagnos-

tics, software programming, software engineering, and

even some research and development.

At this rate, won’t most of the cerebral work American

companies do be farmed out to lower-cost labor offshore?

The short answer: Not a chance. The slightly longer – and

even more upbeat – answer is that there is far more knowl-

edge work in the United States today than there was a de-

cade ago. In ten years, we can expect to see more.

Some of that work will even come from foreign-based

corporations offshoring to the United States. Global com-

panies deciding where to locate consider first where they

can tap into the highest level of skill they need at the

lowest cost. For that reason, the quality of America’s top

research institutions is a huge boon to the nation’s knowl-

edge workers. A mile from my home in Cambridge, Massa-

chusetts, for example, a research and development zone

plays host to loads of non-U.S. software and biotech firms

eager to absorb some brainpower from Harvard and MIT.

I assume those companies are paying a high price for such

skills, and they’re worth every penny.

At the same time, Siemens, Nokia, and General Elec-

tric, among others, are conducting manufacturing-related

R&D in China, at a much lower cost. That work doesn’t

require a Harvard or an MIT, and it needs to be done close

to where it will be implemented – in this case, China’s

sprawling manufacturing centers.

Yes, proximity to customers matters. And here’s an-

other big advantage for America’s knowledge workers:

They live near some of the richest and most sophisti-

cated customers in the world. Furthermore, as more prod-

ucts become low-cost commodities, those customers are

demanding – and paying more for – additional customiza-

tion, special applications, and new designs and ideas. In

other words, knowledge work. Because I can trade over

the Internet, for example, I no longer rely on a stock-

broker. But I do need advice from a financial consultant

by robert b. reich

TLFeBOOK

varied from a low of ten staff members to a high of well over 1,000 people.

Most surprising, we found no evidencethat a lean and mean headquarters is associated with superior financial perfor-mance. On the contrary, the companiesthat reported above-average profitability(measured by both the return on capitalemployed and total shareholder returns)had headquarters that were, on average,20% larger than the headquarters of com-panies of similar size (in terms of totalemployees) and with similar influenceover business decisions.

This could mean that bigger headquar-ters are more effective than smaller onesand enable companies to perform better.Alternately, it might imply that betterperformance allows companies to sup-port bigger-than-average headquarters.While the latter is sometimes true, wefound that, in many companies, large cor-porate staffs improved performance bycreating value that more than paid fortheir costs. For example, pharmaceuticalcompanies such as Pfizer have big corpo-rate R&D departments, but this costly activity is central to the companies’ strate-gies and essential to their market perfor-mance. Other companies use large HRfunctions at the center to develop man-agement competencies that are especiallyvaluable to their businesses. Unilever’sHR function, for example, concentrates

on developing internationally mobilemanagers with superb marketing skills in the area of fast-moving consumergoods. Because corporate centers addvalue in different ways depending on acompany’s strategy and the businesses in which it competes, the appropriatesize and nature of staff functions arebound to differ, too.

The bottom line: There is no standardor ideal model or size for a successfulheadquarters. To achieve high perfor-mance, don’t reflexively cut staff. Focusinstead on matching headquarters’ sizeand roles with corporate strategy.

Reprint F0504D

marketing

How Big Is “Tall”?by aradhna krishna

To make their products stand out, orseem to deliver more value for their size,companies often invent evocative labelslike Super Size, Value Size, Double Gulp,and Whopper. To discourage consumersfrom making direct brand comparisons,businesses also create ambiguous por-tion sizes like Tall, Sixteen, and Power.The question is, do these labels mean the same thing to everyone?

My colleagues – Nilufer Aydinoglu andBrian Wansink – and I have found that

consumers do share acommon understandingof product labels, placingmany of the labels inunique and consistent po-sitions relative to one an-other. In an initial study,we looked at consumers’perceptions of productsizes in two food catego-ries. Within each cate-gory, we chose 14 com-mon labels, some ofwhich were conventional(such as small, medium,and large), others ofwhich were invented bymarketers (such as SuperQuencher and Big Kids).Study participants wereasked to arrange the

labels in each category on a scale fromsmallest to largest, left to right. For manylabels, the subjects’ perceptions aboutthe product sizes were significantly simi-lar. For example, consumers agreed that“petite” is smaller than “short,” that “sin-gle” falls between “small” and “medium,”and that “tall” is larger than “medium”or “double.” Super Quencher and Jumbotied in consumers’ minds (statistically)for sheer – apparent – size.

Because consumers form clear ideasabout product size on the basis of labels,we wondered whether their perceptions of serving size–regardless of actual size–

would affect how much of a product they ate. In a separate study, we served Rotary Club members individually packedeight-ounce portions of eggs, labeled either medium or large. Those givenmedium portions ate, on average, 35%

more than those whose portions were la-beled as large. The Rotarians’ perceptionshad obviously influenced their behavior.

Companies should test whether theirown views of their product labels matchtheir customers’ perceptions and whetherthe labels achieve what they’re supposedto. Do you want to convey that even yoursmall sizes are big? Then a label like “single” is better than a label like “petite.”Starbucks understood this when it labeledits smallest coffee “tall.” And don’t assumethat consumers think “extra large” is thebiggest. Finally, consider how your labelscan affect consumption: Would some


headquarters staff

total company employees

10,000 100,000 1M 1,000

10

100

1,000

10,000

1

100,000

A Corporate Head CountThe size of a company’s headquarters has little to do with howmany employees the firm has. Companies with 10,000 employees,for instance, have headquarters ranging in size from ten to severalthousand people.


TLFeBOOK

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http://ups.com/supplychain

of your customers buy two servings ofyour product if it were “regular” insteadof “large”?

Reprint F0504F

culture

Sweat the Small StuffIn 1982, James Q. Wilson introduced his“broken windows” theory of neighbor-hood decline in the pages of The Atlantic.

The criminologist famously argued thatby leaving litter, graffiti, and other urbandetritus unattended, authorities signal a lack of concern that tempts miscreantsto commit more serious violations.

Now a business author is suggestingthat companies are similarly vulnera-ble. A stained carpet in the office or aburned-out reading light on an airplanemay seem inconsequential. But whenmanagement ignores such trivial irrita-tions, it is effectively telling employeesor customers that they don’t matter.Such unconcern can depress morale or drive away business, says MichaelLevine, who interviewed criminologists,management experts, and ordinaryworkers and consumers about how tinyoffenses influence their perceptions ofcompanies.

An organization’s true priorities are re-vealed by the small stuff, explains Levine,whose book Broken Windows for Business

will be published by Warner in the fall.The corporate manual may trumpet themessage,“We are all one team,” but the rank and file know better when they see broken vending machines going un-repaired while the executive dining roomfunctions like a Michelin-starred restau-rant. “There’s a significant psychologi-cal impact to dingy surroundings – tostained carpets and broken toilets,” saysLevine, founder of a Los Angeles–basedpublic relations firm.“You can’t convinceemployees that you love and care aboutthem if you’re sending psychic signalsthat you don’t.”

Attention – or inattention – to detail affects service, too. Outsourcing, for ex-ample, is reviled for inflicting major painon workforces; but it also causes plenty of minor injuries to customers, Levine


The Rich (and Poor) Keep Getting Richerby edward e. leamer and peter k. schott

Fact Earnings are rising for the world’s poorest and wealthiestbut remain stagnant for those people in between.

In 1980, isolationist barriers in low-wage countries such as India and China pre-vented businesses in high-wage countries from employing the poorer nations’cheap labor. Many believed that eliminating these barriers would unleash a flood ofoutsourcing that would concentrate GDP growth in low-wage countries and reducewages in developed countries. That hasn’t happened. While the 60% of the world’speople living in poorer countries have seen their earnings grow since 1980, so havethe 20% who live in wealthy countries. It’s the people in the world’s middle-incomecountries – 20% of the world’s population – whose earnings have stagnated.

Why is this? Media reports notwithstanding, global competition has not been veryintense between the poorest and wealthiest countries. Few of the labor-intensiveproducts made in India and China are also made in high-income countries. Conse-quently, workers in wealthy countries have not felt the force of competition fromlow-wage producers. Middle-income countries, however, have not escaped directcompetition with these poorer nations. This is not likely to change anytime soon.Technological advances will continue to drive growth in the high-income countries,while middle-income and poor countries compete for the mundane work. In thatcompetition, large, poorer nations – by virtue of their vast low-paid labor supply –will retain the upper hand. Businesses should weigh this continued dispersion ofgrowth when setting their global strategies.

Send Data Point chart proposals to Edward E. Leamer ([email protected]). Leamer is a professor of management, economics, and statistics at the University of California, Los Angeles, and the director of the UCLA Anderson Forecast.

Reprint F0504H

$10,000

$20,000

$30,000

$40,000

0% 100%50%

per capita GDP

cumulative percent of world population

2000

1980


TLFeBOOK



©UBS 2005. The key symbol and UBS are registered and unregistered trademarks of UBS. All rights reserved. Wealth Management services in theU.S. are provided by UBS Financial Services Inc., a registered broker dealer offering securities, trading, brokerage, and related product and services.UBS Financial Services Inc., Member SIPC.

You & Us

You and us. Bringing all the resources of one of the world’slargest wealth management firms to the table. Any table.

WealthManagement

Global AssetManagement

InvestmentBank

At UBS, we can offer our clients some of the world’s most powerful financial

resources. But, the most important resources of all are the ones your financial

advisor will bring to the table the very first time you meet. They’re called listening

and understanding. And they’re the first steps in the disciplined, on-going process

that we call Wealth Management at UBS.

We believe that the only wealth management plan worth having is the one

that’s specifically customized for your needs. So your financial advisor will always

begin the process by listening to the expert on your situation. You. It’s the key

to understanding where you are, where you want to be, and your risk tolerance

to get there.

We can then access all our resources as one of the world’s largest managers

of wealth, an award-winning investment bank and a global leader in asset

management. We can bring in expertise from asset allocation to estate planning

services. Together, we can design your financial plan.

Yet it’s not a plan set in stone. At UBS we recognize that as your life changes, so

your plan may need to change too. We’ll meet with you regularly to monitor your

portfolio and review strategies. Simply put, we’ll keep listening. Listening, and

understanding. It’s what we mean by a relationship we call ‘You & Us.’

TLFeBOOK

says.“You have a problem with your In-ternet provider, so you call the help lineand you get Bangladesh,” he says.“Theydon’t speak English well; you can barelyunderstand them. But call sales and youget a woman in Texas. That tells youwhat really matters to the company.”

In fact, the worst broken windows areoften broken people, Levine says. Cus-tomers who are ill-treated by a poorlytrained associate, or employees workingside by side with someone clearly in-competent, surmise that the businessdoesn’t respect them. And their angerspreads outward: from the unacceptableemployee to the manager who hiredhim, to the person who trained him,to the manager who hired the trainer,and so on.

Levine recommends that managerseject poor performers as quickly as possi-ble, letting everyone affected know theproblem has been dealt with. That mayprove unpopular among some employ-ees in the short run, but in time they willappreciate the improved environment.“When [former New York City mayorRudolph] Giuliani went after the squee-gee men and the turnstile jumpers, peo-ple called him a bully; they called himracist,” Levine says.“But his actions had a positive impact on the quality of life in New York City.”

Companies frying bigger fish –problems with earnings or ethics, for example – may be less sympathetic tosuch entreaties. But toilets and parkinglots and waiting times matter, Levine insists.“Leaders who don’t get that willnever build truly great companies,” hesays.“Companies need to do whatever ittakes to fix those bad little things beforethey become much, much bigger.”

– Leigh BuchananReprint F0504G

communication

Just My Typeby pamela w. henderson

The one-picture-to-a-thousand-wordsratio unjustly downplays the importanceof typestyles. Academics and marketershave long known that the choice of font

in logos and advertising copy greatly influences legibility, memorability, andpublic perception of the brand.

Companies need typestyles that suittheir images and reflect their inten-tions. To help them choose the rightfonts for their messages, my colleaguesat Washington State University – Joan L.Giese and Joseph A. Cote – and I roundedup 210 typefaces and identified a half-dozen discrete design components ineach. We then looked at how those com-ponents affect consumers’ responses toa brand. Specifically, we asked con-sumers to what degree the fonts con-veyed a message that was pleasing (lik-able, warm, attractive); engaging(interesting, emotional); reassuring(calm, honest, familiar); and prominent(strong, masculine).

The results should get marketersthinking about the messages their logosand ads are – perhaps inadvertently –sending and how they might better exploit typefaces to shape customers’perceptions.

Our research yielded six clusters offonts that produced similar effectsamong consumers.

The first group comprises fonts thatare considered likable, warm, attractive,interesting, emotional, feminine, and del-icate. But they are not especially strongor reassuring. Such fonts have consider-able aesthetic appeal but do not inspiregreat confidence. They include:

ScheherezadeInformal RomanAncientScriptEnviroPepita MT

The second group comprises fonts wedefined as interesting, emotional, excit-ing, and innovative. They are also unset-tling and unfamiliar. They could put offsome marketers but might be effective in edgier campaigns. These fonts include:

BaphometEddaChillerStonehengePaintbrush

The third group of fonts represents theworst of all worlds: disliked, cold, unattrac-tive, uninteresting, and unemotional. Butthese typefaces aren’t useless. Companiesmight, for example, use them to displaycharacteristics or claims of a counter-cultural or competing brand. They include:

PlaybillLoganOnyxIndustria InlineStencilSet

The fourth group of fonts is strong andmasculine. Their weighty lines suggest a forcefulness and solidity coveted bymany brands. They include:

NewYorkDeco BandstandSunSplashMiddle AgesFisherman

The fifth group gets high marks forbeing interesting, emotional, exciting, andinformal. But these fonts are also consid-ered dishonest, cold, and unattractive.They are good for conveying negative in-formation or for targeting such niche mar-kets as punk rock fans. These fonts include:

AluminumShredBigDaddyIntegrityRansomAmazon

The final group, which contains manycommon, highly readable fonts, makesup in comfort what it lacks in excitement.If you want to convey “stalwart of thecommunity,” these are your fonts:

GeorgiaVerdanaJanson TextCentury GothicTimes New RomanCentury Schoolbook

Most important, we demonstrate thetrade-offs corporations must accept inchoosing fonts. Not all the impressions


TLFeBOOK

april 2005 23

hen it comes to schedules,

James Goodnight hates being

fenced in. So the CEO of SAS

Institute, a $1.5 billion maker

of business software based in

Cary, North Carolina, attends as few formal meet-

ings as is humanly possible. He talked to us about

why useless meetings proliferate and what he

views as good alternatives.

Everyone hates meetings, but aren’t they a necessary evil?

Most of them aren’t necessary. Weekly meetings, in particular, in which you’re seeing

the same people and going over the same kinds of information are mostly a waste of

time. Managers and leaders should be constantly having casual interactions with peo-

ple at all levels, in elevators and hallways and just popping into one another’s offices.

The important thing is to be visible and accessible, which you’re not when you’re sit-

ting behind a closed door in a conference room for the better part of your days.

Why are so many meetings a waste of time?

There’s a tendency when you’re looking at an issue to want to cover yourself. So

you copy everyone on your e-mails or ask them to attend your meetings. And they

feel like if they don’t answer the e-mail or attend the meeting, that means they’re

not engaged or they’re out of the loop. How do you tell your boss,“I don’t need to

be part of that discussion,” without it sounding like you aren’t important or you

don’t care? But if you’re not part of it, and you spend that time doing something

that’s actually related to your job, your productivity goes way up.

We talk about the need for companies to be flexible, but what they’re often not

flexible about is people’s time. People tend to think that a full calendar means

they’re working hard. What it really means is that they haven’t given themselves

time to explore new ideas or just visit with folks. And if they have to respond

quickly to something, they have the additional headache of having to cancel a

bunch of meetings. My best days are ones when there is nothing on my calendar.

By the way, not all meetings are a waste of time. At certain levels of the organiza-

tion, it’s appropriate to meet with your team on a regular basis to keep them on

focus. Meetings can also be effective for brainstorming. But it’s important to contin-

ually question: Will this meeting boost or bust productivity? How long will it really

take to cover the issue? Who really needs to be there? Does every meeting need to

last an hour because that was the default appointment in the electronic calendar?

How do you keep meetings short?

I have left many meetings once I stopped getting anything out of them.

– Leigh Buchanan

Reprint F0504L

The Beauty of an Open Calendar

james goodnight on meetings

an organization may want to create canbe achieved at the same time. Some desirable traits – such as engaging and reassuring – are mutually exclusive. Butcompanies can use an understanding oftypestyle attributes to design their ownfonts and, consequently, exert maximumcontrol over their messages. That’s whatDisney and Hallmark did, and their fontshave become integral – and beloved –parts of their brands.

Reprint F0504J

human resources

Where’s Your PivotalTalent? by john w. boudreau and peter m. ramstad

As organizations increasingly competethrough talent, their investments inhuman capital will determine their com-petitive positions. Yet HR’s way of man-aging this key resource stands in sharpcontrast to how other organizationalfunctions operate. Marketing, finance,and most other functions have well-developed methodologies for generatingthe information managers need to makestrategic decisions. HR, however, often focuses principally on its own perfor-mance, carefully measuring cost per hire, the ROI on its programs, and howits initiatives affect skills and attitudes.It’s time for HR to shift its focus fromwhat it does to the quality of the talentdecisions it supports. HR needs to de-velop a systematic process for improvingdecisions, not just implementing them.

HR should be able to help leaders answer critical questions such as, Wheredoes our strategy require talent that isbetter or more plentiful than our com-petitors’? In what new business ven-tures do we have a strategic advantagebecause of our talent? What talent gaps do we need to close in order to keep ourcompetitive advantage? And, most im-portant, Where would a change in theavailability or quality of talent have thegreatest impact?

HR should begin its transformation byapplying the tools of segmentation, theSA

S IN

STIT

UT

E

TLFeBOOK

widely accepted method for improvingdecisions in customer and financial markets. Do you use the same advertis-ing mix for every product line or investcapital equally across divisions? No.Yet when it comes to managing talent,your HR department probably appliesthe same processes and programs tonearly everyone. And even when HR investments are differentiated, they’reoften designed to meet generic bestpractices (“assign everyone a mentor,”for instance) or target broad groups ofindividuals (the top 20% of managers,for instance). Just as marketing system-atically segments customers to target investments strategically, HR needs tosegment talent to deploy human capitalstrategically.

Maybe you think you don’t need a de-cision science to figure out where to con-centrate your A-level talent. But our workwith large companies shows that’s not al-ways the case. Corning, for example, hastraditionally competed as an innovator.As the company expanded globally, itcontinued to invest its HR resourcesheavily in support of R&D scientists. Butwhen Corning’s HR leaders used talent-segmentation techniques to study thedistribution of human capital in the orga-nization, they discovered that the dearthof talent in manufacturing, not in prod-uct innovation, was slowing down thecompany’s expansion into markets insome developing countries.

On closer examination, HR and busi-ness leaders in the company’s DisplayTechnologies division found that, insome regions, there were only a few pro-duction engineers with one type of criti-cal manufacturing knowledge, a particu-lar skill set that takes years to develop.The division made the case for shiftingsome HR assets out of R&D and into hiring and retaining enough of these key production engineers to meet the division’s needs.

As Corning’s experience suggests, tal-ent decisions can be made with the samelevel of logic and rigor as decisions aboutmoney, customers, and technology – andthey can be logically linked to strategy.The ball is in HR’s court.

Reprint F0504K

frontiers

Way Faster than aSpeeding Bulletby amy salzhauer

Femtosecond lasers emit pulses of lightthat last just a millionth of a billionth of a second. These lasers enable surgery soprecise that a single mitochondrion canbe removed without harming the rest ofthe cell, and machining so controlled thatstructures can be micromachined withina piece of glass. Eric Mazur, a professor ofapplied physics at Harvard, likens thesefast flashes to “bullets of light.”

Once confined to phys-ics research laboratories,femtosecond lasers are justnow starting to be appliedby medicine and industry.They are poised to revo-lutionize processes as diverse as drug creationand the disassembly of nuclear weapons.

Tech Talk: Just how fastis a millionth of a billionthof a second? It takes lightonly about a second totravel from the moon to earth.“In afemtosecond,” Mazur says,“light travelsabout 300 nanometers”– or a fraction ofthe width of a human hair. That means a femtosecond laser lets users view phe-nomena previously impossible to observebecause they occur in so short a timeframe. It also means that while theamount of energy used to deliver the light is small, the intensity of light strik-ing the target is high because the pulse is so quick.“The peak power of our laserpulses–that is, the energy they deliver perunit time–is about the same as that of allpower plants in the United States com-bined,” Mazur explains.“Imagine all ofthat power concentrated into a micro-scopically small volume. Of course, thelaser pulse is very short, so we only deliverenergy for a very short amount of time.”

The brevity of femtosecond laser pulsesprevents them from transferring signifi-cant heat or shock. As the laser pulses,the material it hits becomes an ionized

plasma, while the surrounding materialstays cool. As a result, femtosecond lasersare much more precise and can be usedon much more fragile materials than canconventional lasers, diamond saws, watersaws, or other cutting tools. Femtosecondlasers produce a smooth, clean cut. Sowhile conventional lasers used in dentistrycan cause cracks and ragged holes in teeth,for example, femtosecond lasers drill pre-cise holes without collateral damage.

Why It Matters: Femtosecond laserscan remove material one atom at a timefrom substances as diverse as silicon,steel, and heart tissue; and they can ma-

chine very precise struc-tures that range in sizefrom a few microns to afew millimeters. They canalso change the refractiveproperties of transparentmaterials, so they can beused to manufacture inex-pensive optical devices,wave guides, and sensors.Chemical and drug manu-facturers are starting touse the lasers to observeimportant chemical andbiological reactions thatlast only femtoseconds,

such as the interaction of carbon monox-ide and myoglobin, which is critical forunderstanding how muscle cells carryoxygen. And the lasers “provide a muchhigher resolution for medical-imaging ap-plications,” says Melissa Love, of SanDiego–based laser manufacturer Del MarVentures. Taken together, these applica-tions will have a multibillion-dollar im-pact on a variety of industries.

In the Game: Invented at Bell Labora-tories in the 1980s and driven by ad-vances in fiber telecommunications,femtosecond lasers have long been usedin academic labs, where scientists haveoften built their own. A growing numberof small manufacturers have started tomake easy-to-use tabletop lasers that costonly $15,000 to $30,000. The number ofsuppliers should grow with demand, aslarge companies catch on to the lasers’ability to create better, cheaper, and en-tirely new drugs, devices, and products.

Reprint F0504M


TLFeBOOK

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Hot Property The Stealing of Ideas in an Age of GlobalizationPat Choate(Alfred A. Knopf, 2005)

Innovation is not a pure act. Individuals and companies want to create, sure,

but they also want to get paid. If they’re not paid, then progress suffers, and

countries built on innovation tremble to their very foundations. That dire

situation is upon us, argues political economist Pat Choate in his book, Hot

Property. Global intellectual-property theft not only hurts Disney’s profits, it

“threatens America’s technological preeminence, its

economic well-being, and its national security.”

How great is the threat? Piracy, counterfeiting,

and theft cost the United States $200 billion a year,

Choate says, not including damage done to jobs,

innovation, and safety. (The book takes a largely

U.S.-centric view, although Choate acknowledges

the toll on other developed countries.) Hot Property

takes readers on a world tour of idea thievery:

Almost all music sales in Pakistan are of illegally

copied CDs. Cheap medicine flows across the bor-

der from Mexico, nearly 25% of it fake, contami-

nated, or even poisoned. That’s nothing compared to China, which Choate says

is “pursuing [a] national development strateg[y] based on the uncompensated,

unapproved stealing of other nations’ best ideas and technologies.”

Choate does a fine job explaining the evolution of intellectual-property

rights, a long-simmering issue that digital reproduction capabilities brought to

a public boil. Chapters dedicated to Germany, Japan, and China show how

each used – and abused – IP laws to catch up with cutting-edge technologies,

keep out external competition, and eventually dominate whole industries.

He is also persuasively critical of governments that sit by while their nation’s

intellectual wealth is plundered. Again the United States comes in for the

greatest scrutiny; the author cites case after case in which it failed to protect

the rights of companies and inventors. Only six employees in the Office of the

U.S. Trade Representative concentrate on intellectual property. The govern-

ment failed to pursue countless crimes for the sake of foreign relations. Indeed,

the country that fought hard for international laws that strengthen IP protec-

tions hasn’t filed a single case under those laws since 2000.

Unfortunately, Choate is less compelling when discussing solutions. Beyond

the obvious (hire more customs inspectors, FBI agents, and federal prosecutors;

educate the public) he suggests treating copyrights more like trademarks to

move knowledge into the public domain faster while protecting the creator’s

rights. Otherwise, he presents little more concrete than a demand that the gov-

ernment be resolute.“What is missing is the will of the U.S. political leaders to

confront those who are stealing U.S.-owned intellectual properties and with

them the future of the American people,” he pronounces. Yes, but are there

also opportunities to rethink the entire IP system to make it compatible with

new conditions? That would be innovative. And innovation, as Choate knows,

is always worth encouraging. – Eileen Roche

Blink: The Power of Thinking Without Thinking Malcolm Gladwell (Little, Brown, 2005)

We’re taught to be skeptical of first impres-sions, but journalist Gladwell argues thatthose split-second summations are wiserthan we know. Research has shown howstudying a subject in-depth can introduceextraneous information. That informationthen crowds out factors that our uncon-scious mind had pegged as key at the start.Sometimes the unconscious gets the keyfactors wrong, as with ethnic stereotyping,but Gladwell insists we’re better off teach-ing the brain to screen out these mistakesthan dismissing our instincts. This superbbook also offers insights on how serviceproviders can relate better to their clients.

China, Inc.: How the Rise of the Next Superpower Challenges Americaand the World Ted C. Fishman (Scribner, 2005)

You won’t find a more engagingly bullishbrief on China’s economic future. Fishman,a former commodities trader, explains howChina’s disciplined mastery of manufactur-ing has made it the Wal-Mart of world econ-omies, forcing everyone to respond to itslow-cost pressures. And with Chinese stu-dents and companies eagerly moving upto high tech, the country may soon com-pete and innovate along the entire valuechain. But you’ll have to go elsewhere foran in-depth look at the nation’s precariouspolitical and ecological situations.

Brand Sense: Build Powerful Brandsthrough Touch, Taste, Smell, Sight,and Sound Martin Lindstrom (Free Press, 2005)

The eyes are the windows to the pockets,marketers have long assumed, and so theyemphasize visual cues when packagingand promoting products. But Lindstrom,a consultant, urges companies to appeal to all the senses – especially when target-ing younger consumers, who have moresensory acuity then their elders. Smell, forexample, has a powerful influence on theunconscious, as McDonald’s discoveredwhen customers intrigued by its healthiermenu items were put off by the restaurants’continued oily odor. – John T. Landry


TLFeBOOK

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april 2005 31

THEODORE LEVITT. Henry Mintzberg. Abraham Zaleznik.

Michael E. Porter. Rosabeth Moss Kanter. Robert H. Hayes

and William J. Abernathy. John J. Gabarro and John P. Kotter.

Gary Hamel and C.K. Prahalad. John Seely Brown. Charles

Handy. John Hagel III and Marc Singer. All of these world-class

thinkers – and dozens more – have been singled out in the

past for McKinsey Awards. Harvard Business Review assembles

a distinguished group of judges from business, academia, and

consulting to evaluate every article the magazine has pub-

lished in the past year and select its two most significant. This

year’s winners are no exception to the tradition of excellence

in thought-provoking management theory.

T O L E A R N W H O T H I S Y E A R ’ S W I N N E R S A R E , T U R N T H E P A G E .

RECOGNIZING EXCELLENCE IN MANAGEMENT THINKING

T H E 4 6 T H A N N U A L

McKinseyAwards

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Harvard Business Review is pleased to

announce that Peter F. Drucker, the author

of “What Makes an Effective Executive,”

and Ken Dychtwald,Tamara Erickson, and

Bob Morison, the authors of “It’s Time to

Retire Retirement,” have tied for the first-

place 2004 McKinsey Award. The second-

place winner is Hau L. Lee for “The Triple-A

Supply Chain.”

Since 1959, the McKinsey Foundation

for Management Research has presented

awards recognizing the two best articles

published each year in Harvard Business

Review. The awards, judged by an indepen-

dent panel, commend outstanding works

that are likely to have a major influence

on executives worldwide.


What Makes an Effective ExecutivePeter F. Drucker

June 2004

Peter Drucker’s latest article for Harvard Business Review – and his seventhMcKinsey Award winner – ponders a mystery. Effective leaders come in all shapes and sizes. They may be charismatic or dull, number crunchers or visionaries, generous or tightfisted. But none of those traits necessarilyexplains leaders’ success. What does? According to Drucker, effective execu-tives all follow the same eight practices. Among them: Focus on oppor-tunities rather than problems. Run productive meetings. Think “we” ratherthan “I.” Take responsibility. In this concise and wonderfully written article,Drucker distills the lessons of his 65-year academic and consulting careerinto an indispensable guide from which managers and professionals at alllevels, and in all industries, can learn.

Peter F. Drucker is the Marie Rankin Clarke Professor of Social Science andManagement at the Peter F. Drucker and Masatoshi Ito Graduate School of Management at Claremont Graduate University in Claremont, California.He has written nearly two dozen articles for HBR.

F I R S T - P L A C E W I N N E R S[RECOGNIZING EXCELLENCE IN MANAGEMENT THINKING

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april 2005 33

It’s Time to Retire RetirementKen Dychtwald,Tamara Erickson,and Bob Morison

March 2004

Within half a dozen years, baby boomers – some 76 million people, morethan a quarter of all Americans – will start hitting their midsixties andcontemplate retirement. And why not? Long-standing human resourcepractice is to invest heavily in youth and push out older workers. But thismust change – and so must public policy – or companies will find them-selves running off a demographic cliff as baby boomers age.That’s theurgent message of this timely article, the result of a yearlong study of thebusiness implications of population change. Workplace environments;management styles; hiring, training, and promotion practices; outsourcing;and the use of part-time and contingent workers – nearly every aspect of the people side of running a business – will be affected by the agingworkforce. And companies don’t just face a shortage of labor as boomersleave. Skills, knowledge, experience, and relationships walk out the doorevery time somebody retires. Companies must gain the loyalty of olderworkers, the authors argue.They offer innovative recommendations forcreating a more flexible approach to retirement that allows people tocontinue contributing well into their sixties and seventies.

Ken Dychtwald is the founding president and CEO of Age Wave, a SanFrancisco–based consulting firm focused on the maturing marketplace andworkforce. Tamara Erickson is the executive officer and a board member,and Bob Morison is an executive vice president and the director of research,at the Concours Group, a management consulting firm based in Kingwood,Texas.They are all coauthors of a book about the impact of demographicshifts on the workplace forthcoming from the Harvard Business School Press in 2006.

The Triple-A Supply ChainHau L.Lee

October 2004

A strong supply chain is a strategic mandate for nearly every com-pany today. But many firms build their supply chain improvementson a false equation: faster plus cheaper equals competitive advan-tage. In fact, supply chains that focus on speed and costs tend todeteriorate over time.That’s the surprising insight of Hau L. Lee’sauthoritative article, based on his 15 years of studying the supplychains of more than 60 companies. Lee shows it’s the businessesthat create triple-A supply chains – those that are agile, adaptable,and aligned – that get ahead of their rivals.This article offers a rigor-ous look at the changes transforming modern supply chain man-agement, the best practices of triple-A leaders, and the steps compa-nies can take to build their own twenty-first-century supply chains.

Hau L. Lee is the Thoma Professor of Operations, Information, andTechnology at the Stanford Graduate School of Business in Stanford,California, and codirector of the Stanford Global Supply Chain Man-agement Forum. He is coeditor (with Terry P. Harrison and John J.Neale) of The Practice of Supply Chain Management:WhereTheory and Application Converge (Springer, 2003).

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2 0 0 4HBR wishes to thank this year’s esteemed panel of judges for all their work on behalf of the 2004 awards.

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Gurcharan DasAuthor Former Chief ExecutiveOfficerProcter & Gamble IndiaNew Delhi, India

Jane E. Dutton William Russell KellyProfessor of BusinessAdministration Stephen M.Ross School of BusinessUniversity of MichiganAnn Arbor

Michael L. EskewChairman andChief Executive OfficerUPSAtlanta

William HaseltineFounderHuman Genome Sciences Chairman andChief Executive OfficerHaseltine AssociatesWashington,DC

Robert D. Hormats Vice ChairmanGoldman Sachs (International)New York

Bud MathaiselSenior Vice President and Chief Information OfficerSolectronMilpitas,California

Renetta McCann Chief Executive Officer,the AmericasStarcom MediaVest GroupChicago

Samuel J. Palmisano Chairman and Chief Executive OfficerIBMArmonk,New York

Howard H. StevensonThe Sarofim-Rock Professorof Business Administration Harvard Business SchoolBoston

Ludo Van der HeydenThe Solvay ChairedProfessor of TechnologicalInnovation andProfessor of Technology andOperations Management InseadFontainebleau,France

Victor Fung ChairmanLi & Fung GroupKowloon,Hong Kong

David HaleChairman and FounderHale AdvisorsChicago

Fred HassanChairman andChief Executive OfficerSchering-PloughKenilworth,New Jersey

Bill MillerChief Executive Officer andChief Investment OfficerLegg Mason Capital ManagementBaltimore

G. Bennett Stewart IIISenior PartnerStern Stewart & CompanyNew York

Pamela Thomas-GrahamChairmanCNBCEnglewood Cliff,New Jersey

Laura D’Andrea Tyson DeanLondon Business SchoolLondon

David VerklinChief Executive OfficerCarat AmericasNew York

[ T H E 2 0 0 4 P A N E L O F J U D G E S ]

McKinseyAwards

2 0 0 5[ T H E 2 0 0 5 P A N E L O F J U D G E S ]

HBR is pleased to announce the distinguished panel of judges for the 2005 awards.

TLFeBOOK

HBR’s cases, which are fictional, present common managerial dilemmas and offer concrete solutions from experts.

im Hargrove’s startled expression would have been amusing had he

not been in such a pitiable state. Hewas standing in the yacht’s magnifi-cently appointed galley, wondering ifhis stomach would be able to holddown the cola he was pouring into acrystal flute, when his colleague, RitaSanchez, said something outrageous.Now the drink had spilled down thelength of his pleated khakis, and he wassputtering. “You aren’t seriously sug-gesting that we reduce prices by 50%.Are you?”

It had been a long day for Hargrove,marketing director of $820 million Nep-tune Gourmet Seafood, North Amer-ica’s third-largest seafood producer.When the firm’s chairman and CEO,Stanley Renser, had invited his seniormanagers to sail with him to inspectone of Neptune’s new freezer trawlers,

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Stuck with excess inventory,

Neptune Gourmet Seafood

is toying with the idea

of launching a second,

inexpensive product line.

But if Neptune stoops

to conquer, rivals might

retaliate with price cuts,

and the new line might end

up cannibalizing the old.

H B R C A S E ST U D Y

Hargrove had demurred. He hated sail-ing on small boats–they made him sick,he told his boss. Renser had pointed outthat the 120-foot yacht he owned wasn’texactly small. Besides, Poseidon II neverrolled, even in a storm; the renownedTommaso Spadolini had designed it. Infact, it was one of the last boats built byItaly’s famous Tecnomarine boatyard!Eventually, Renser had won him over,and Hargrove had arrived that Fridaymorning as eager to see the yacht as hewas to visit one of the state-of-the-artfishing vessels on which Neptune hadbet its future.

Hargrove hadn’t felt seasick all morn-ing. There were no swells that day. Flatand glassy, the ocean glittered in shadesof turquoise, silver, and gold. Aboardthe freezer trawler, he had been fasci-nated by the technologies that allowedthe vessel to catch fish in an environ-

mentally sustainable way and to freezethem in a manner that gave Neptune anedge over rivals. But when the yacht hadstarted to head back to Fort Lauderdale,Hargrove had crumpled. While his col-leagues had made a beeline for thesundeck, he had spent the afternoon inthe oak-lined main saloon, where he’dsunk into a leather sofa, clenching andunclenching his muscles to fight theocean’s incessant motion.

Tired of trying to take his mind offthe problem by focusing on the distanthorizon, Hargrove was exploring thegalley when Sanchez, his counterpartin sales, had walked in.

“Hey, Jim. You better?”she had askedsolicitously.

“I’ll survive,”Hargrove had grimaced.“We can’t be too far from home now.But let’s not talk about it. What’s hap-pening topside?”

Class–or Mass?by Idalene F. Kesner and Rockney Walters

TLFeBOOK

“Oh, nothing much. Stanley’s show-ing people the garage where he parksthe water scooters and Windsurfers,”Sanchez informed him. She gave Har-grove a challenging look and added:“You want to hear something that’llreally take your mind off your seasick-ness? I’m convinced that we have to dropour prices by 40% to 50%–and soon.”

Big Fish in a Small Pond Hargrove snatched a stack of cocktailnapkins to mop up the cola, but hiseyes never left Sanchez’s face. He hopedshe’d break into a smile to indicate thatshe was teasing him about the price cut.It had to be a joke, right? Seafood wasa high-end business in North America,and Neptune was an upmarket – manybelieved the most upmarket – player inthe $20 billion industry. During the past40 years, the company had earned a rep-utation for producing the best seafood,and Neptune did everything it couldto preserve that premium image amongcustomers.

The company reached its consum-ers, who were extremely demanding,through various channels. Neptune gen-erated about 30% of its revenues by sell-ing frozen and processed fish productsto U.S. grocery chains, like Shaw’s Su-permarkets, and organic food retailers,like Whole Foods Market, all along theeastern seaboard and in parts of theMidwest.

The Neptune’s Gold line of seafoodproducts, manufactured in two sophis-ticated plants near Cedar Key, Florida,and Norfolk, Virginia, dominated mostsegments in terms of quality, and there-fore sold at premiums compared withother brands. For example, Neptune’sGold canned salmon, tuna, sardines,mackerel, herring, and pilchard enjoyeda 30% higher price point, on average,

than other brands; and Neptune’s Goldlump crabmeat, anchovies, clams, lob-ster meat, mussels, oysters, and shrimpcommanded a 25% premium over rivalproducts.

That wasn’t the company’s biggestmarket, though. Neptune had emergedas the supplier of choice to the best res-taurants within 250 miles of its FortLauderdale headquarters as well as tothe biggest cruise lines, which togetheraccounted for a third of the company’ssales. Another 33% came from whole-salers that distributed the company’sproducts to restaurants all over theUnited States. In fact, sushi bars fromNew York to Los Angeles increasinglybought Neptune’s frozen fish insteadof buying fresh fish and freezing itthemselves. And, befitting the humbleorigins of founder John Renser, approx-imately 4% of Neptune’s sales camefrom a fish market outside Fort Laud-erdale that the company owned andoperated.

It wasn’t easy to live up to the tagline“The Best Seafood on the Water Planet.”Dogged by competition – especiallyfrom China, Peru, Chile, and Japan – aswell as tough fishing laws, Neptune in-vested heavily to stay ahead of rivals.Stanley Renser, the company’s largestshareholder, had recently expanded thefirm’s equity base, although doing sohad shrunk his share to 10%. The capitalinfusion allowed Neptune to invest$9 million in six freezer trawlers of thekind Hargrove had visited. Those ships’autopilot mechanisms guided them tothe best fishing grounds, manipulatedfishing gear, landed catches, and re-ported data to shore. Other systems,along with new fishing equipment, en-sured that only mature fish were caughtand that the nets were not overfilled,thus reducing damage to the haul. Asa result, Neptune increasingly landedonly top-quality catches.

What’s more, the freezer trawlersused a new technology to superfreezefish to −70°F (instead of the usual −10°For −23°F) within four hours of capture.The fish would freeze so quickly withthis method that ice crystals couldn’tform in them or on them. That allowed

the fish to retain their original flavor,texture, and color; and when cooked,they tasted like they were fresh out ofthe water. Moreover, by packing thecatch in snow made from dry ice andsurrounding it with liquid nitrogen, theprocess increased shelf life by 50%. Nowonder the gourmet magazine Con-noisseur’s Choice had rated Neptune’sproducts foremost in quality for thetenth year in a row.

Against the Current To Hargrove, the company’s premiumimage, investments in new technolo-gies, and obsession with quality madeany price cut – let alone the notion ofchopping prices in half – unthinkable.But Sanchez refused to back down.“I’mnot kidding, Jim. It’s pretty clear that wehave a big inventory problem. We haveto slash prices to get rid of those excessstocks.”

Hargrove knew exactly what Sanchezwas talking about. In the past threemonths, Neptune’s finished goods in-ventory had shot up to 60 days’ supply–twice the normal level and three timeswhat it had been a year ago. Like manyof his colleagues, Hargrove consideredthe inventory pileup a temporary phe-nomenon; stocks had risen because thecompany had added ships to the fleetand could process catches more effi-ciently than before. Surely, if Neptunesold some old ships and stuck to its planof launching ready-to-eat, fish-basedmeals, its inventory would soon fall tonormal levels.

Sanchez and her sales team, however,were convinced that they faced a moreenduring situation. “I told you this amonth ago, Jim, and I’ll say it again.The new laws have reduced our accessto fish near the coast and forced us togo farther out to sea. Because the fish-ing grounds are richer there, and be-cause we’re using new technologies, ourcatches have grown bigger on average.That’s why, even in the past four weekswhen we’ve seen demand reach an all-time high, our inventory has continuedto grow.”

“First of all, it makes no sense to meto cut prices when demand is rising,”


Idalene F. Kesner ([email protected])is the Frank P. Popoff Chair of StrategicManagement and MBA program chair-person, and Rockney Walters ([email protected]) is a professor of marketingand the Ford Teaching Faculty Fellow, atIndiana University’s Kelley School of Busi-ness in Bloomington.

H B R C A S E ST U D Y • Class – or Mass?

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april 2005 37

Hargrove said, exasperatedly. “Besides,think about how customers would per-ceive a large price cut. If you slash pricesby 50%, people will think there’s some-thing wrong with the fish – like it’s rot-ten or full of mercury! It would destroyour premium image and permanentlyerode our brand equity.”

Sanchez shook her head. “Custom-ers recognize that we sell a perishableproduct and that the supply of fish fluc-tuates from day to day. They expectprices to vary. The prices of fruits, veg-etables, and flowers change all the time,don’t they? A few years ago, coffee beanprices plummeted when growers real-ized they’d be better off selling inven-tories than watching the beans rot.Since then, coffee prices have gone upagain. No one seems to object when theprices of chicken, beef, or pork rise andfall because of changes in the market-

place. I’m not willing to leave money onthe table by refusing to react to supply-and-demand fluctuations.”

“But why do you want to cut prices sodrastically? Why not just offer custom-ers a 10% discount? I can see us doingthat in the winter, when sales are slow,anyway,” Hargrove pointed out.

Sanchez shook her head again. “Itwon’t work, Jim. Our warehouses are sofull that it’s going to take a lot morethan that to make a difference. Andwith $9 million tied up in the new ships,you know we won’t be keeping them in harbor. Our inventories are going tokeep growing unless we do somethingradical.”

“Selling product at a loss is radical,all right,” Hargrove muttered grimly.On many of its products,Neptune wasn’tmaking enough profit after manufac-turing costs to sustain a deep price cut.

In fact, the company’s margins had al-ready shrunk by 10% in the past yearbecause of rising costs and growingcompetition.

“You’re talking about sunk costs,”Sanchez shot back.“Selling product at aloss to generate some revenue is betterthan throwing it away. What I’m propos-ing, though – ”

“Have you considered how our com-petitors will react?” Hargrove cut in.“Ifwe do this, some of them are bound toretaliate with even deeper price cuts,and then we’ll be in a price war noneof us can afford – Neptune least of all,given our cost structure.”

Sanchez held up a hand.“Of course, ofcourse. But you’re assuming it says ‘Nep-tune’s Gold’ on the discounted product.I actually envision a new brand.”

Hargrove exploded.“You don’t createa new brand to deal with a temporary

Class – or Mass? • H B R C A S E ST U D Y

TLFeBOOK

increase in supply! Besides, you won’tfool anybody. Everyone will know who’sresponsible for flooding the market anderoding margins.”

It was clear to Sanchez that shewasn’t making much headway withHargrove.“Look, Jim, this really isn’t theplace for this discussion, and perhapsI’m not being as clear as I should be.I want to put this issue on the MOC’sagenda for Friday.” The Marketing andOperations Council, which comprisedNeptune’s top executives, met twiceper month.

“Fine, as long as Stanley is at themeeting, too. I’ll go up on deck and talkto him right away,”said Hargrove,his sea-sickness all but forgotten. “The sooneryou stop thinking about a price cut, thebetter.”

Swimming with the Sharks As the week progressed, word spreadabout the solution that Sanchez hadproposed to tackle Neptune’s inventoryproblem. Both Hargrove and Sanchezwere drawn into lively debates withtheir colleagues, and they soon realizedthat whether people were in favor ofprice cuts or against them, everyone hadan opinion on the subject.

A day before the MOC meeting, San-chez received an unexpected visitor. Itwas Nelson Stowe, the company’s legalcounsel and a longtime confidant of theRenser family, hovering at her door.“Ah,Rita. Got a minute?”Stowe asked in hismild-mannered fashion.

Realizing that this was no ordinaryvisit–Stowe had never called on her be-fore – Sanchez quickly invited him intoher office. After they had settled in,Stowe got slowly to the point.“I’ve beenhearing that you want to launch a mass-market brand. Interesting! You know,before we opened the fish market, JohnRenser wanted to do something similar.He wanted to sell some of our fish at alow price so that more people would eatseafood. But that was a long time ago.

“I’m sure you’re thinking through theimplications of your strategy,” he con-tinued, “but one issue concerns me.Have you thought about how the Asso-ciation will react?”

Stowe was referring to the powerfulU.S. Association of Seafood Processorsand Distributors, whose members, suchas Neptune, accounted for 80% of Amer-ica’s seafood production. The ASPD in-fluenced American and global policiesrelated to the fishing industry and im-posed quality standards on members. Italso conducted surveys of wholesale andretail seafood prices and, twice a year,published benchmark prices that in-fluenced the pricing policies of seafoodproducers and distributors.

“I don’t know,Nelson,”Sanchez sighed.“But I doubt that the Association can doanything.”

“I wouldn’t be so sure,” said Stowe.“At the prices you’re suggesting, you’relikely to endanger our ASPD Gold Sealof Approval. We’re the only companythat has the seal on every product wesell. But the Association could easilychange that.”

“No!”Sanchez cried out.“It can’t! Re-gardless of the prices we charge, ourproducts will still meet the ASPD’s qual-ity standards. Besides, we’re just sellingthe same fish under a different brand.”

“Don’t fool yourself, Rita. The Asso-ciation has a great deal of discretionabout who gets the Gold Seal and whodoesn’t. If it believes that our pricingstrategy will cost the fishing industry alot of money, it might withhold the sealon our low-end products – for starters.I’d like us to remember that the Associ-ation isn’t going to stand by idly whilewe disrupt the industry,” Stowe warnedas he got up to leave.“Keep me posted,will you?”

A Pretty Kettle of Fish At 8 am on Friday, Sanchez walked intothe conference room on Renser’s heels.“How was Newfoundland?” she asked.

“Lousy,” croaked Renser, who had re-turned late the previous night after de-livering the keynote address at the Cana-dian Fish Producers’annual conference.“I caught a cold,” he complained.“Hap-pens every time I fly commercial.”

“At least riding in planes doesn’t makeyou feel nauseated,” Hargrove quippedas he joined them. “That’s more than I can say for riding in boats.”

Once everyone had settled down,Hargrove got the meeting under way.“We have several routine items on theagenda,” he began.“But Rita and I haveadded a topic we think is important, soI suggest we move to that first.” Wheneveryone nodded in agreement,Sanchezand Hargrove ran through the issuesthey had discussed on the yacht.

As they concluded their summaries,Bernard Germain,Neptune’s COO,spokeup.“Do we know which of our rivals areconsidering price cuts? We aren’t theonly company facing overcapacity. Itwould be naive of us to believe that allour competitors will hold prices for theindustry’s good.”

“I can’t believe it!” Hargrove burstout.“You’re in favor of price cuts?”

“I don’t know yet, Jim. I’m trying tounderstand why Rita’s suggestion thatwe introduce a low-priced seafoodbrand is so off-the-wall. Why can’t weuse a new brand to appeal to value-minded customers? Seems to me thatwe have the product; we can distributeit using our existing channels; and wecan achieve a new positioning throughpackaging, advertising, and pricing. Idon’t see the difference between thisstrategy and what companies like Kel-logg do with their private-label busi-nesses. In fact, if we don’t want tolaunch a second brand, we could thinkabout supplying retailers with private-label products.”

“I’m not suggesting that we get intothe private-label business,”Sanchez wasquick to reply.“That can pose problems,as many consumer goods manufactur-ers have discovered. I feel we shouldcreate a mass-market brand called, say,Neptune’s Silver.”

“That’s terrible!” snapped Hargrove.“By calling it Neptune’s Silver, you’repositioning the cheap product rightnext to Neptune’s Gold in the eyes ofconsumers. Then they’ll be more likelyto try it and, once they do, they’ll realizethere’s no difference in quality. We’ll endup cannibalizing our own sales. Whywould any company in a high-end seg-ment do something so crazy?”

“I guess you don’t remember whattranspired in the wine industry a couple


H B R C A S E ST U D Y • Class – or Mass?

TLFeBOOK

of years ago,”responded Pat Gilman, thehead of Neptune’s institutional busi-ness, whose taste for high-end productswas well known. “A California vintner,Bronco Wines, did something exactlythat ‘crazy.’ It was the same kind of sit-uation: a glut of grapes, huge invento-ries. They slapped a new brand name onthe stuff and sold it through Trader Joe’sfor $1.99 a bottle. It’s called CharlesShaw, but people nicknamed it Two-Buck Chuck.”

“Not only do I know about it, but I’vealso tried it,”Sandy McKain, head of thecompany’s consumer business, piped in.“I can tell you, it’s worth every penny.But Pat, I don’t think the scenario is ex-actly the same. Even in Bordeaux, a lotof winemakers offer a premium wineand several cheaper wines, but theyuse grapes of different qualities tomake the different grades. Would webe doing that?”

“In Bronco’s case, it was the samegrapes they’d been using for higher-priced wines,” Gilman said.“As for Jim’spoint, I’m sure they had some customersmigrate to the cheaper stuff. But thinkabout the upside. In the United States,88% of wine sold is consumed by 12% ofthe population – ”

“Hey, Pat,”Hargrove called out.“Howmuch of that do you personally ac-count for?”

Gilman joined in the laughter beforecontinuing: “The point is, more peoplewill opt for a bottle of wine with din-ner if they can get a passable one onthe cheap. Wine sales have grown at theexpense of other beverages in recentyears. The same thing could happen tous. Even with people eating healthierthings, seafood sales lag behind thoseof beef, chicken, and pork. The way Isee it, this isn’t about reducing inven-tory. It’s about introducing our productsto a bigger market: the more budget-conscious consumer. And if it’s likewine, the educated consumer will thentrade up to Neptune’s Gold.”

A furious discussion followed abouthow hard it would be for Neptune towin shelf space in supermarkets for anew brand, particularly for a low-pricedproduct that might go head-to-head

with the grocers’ own private-label of-ferings. The group was also dividedabout whether it should sell a secondbrand through the same channels orthrough different ones. Germain won-dered aloud whether Neptune shouldtarget new geographic markets – likeSouth America and Central America –with a low-priced offering.

“Hang on!” exclaimed a clearly frus-trated Hargrove. “When we started,weren’t we debating whether it madesense to launch a new brand to dealwith a temporary inventory problem?That would mean we’d kill it once wesolved that problem. I – ”

“If customers like our new brand, itmight constitute a better growth strat-egy,” Sanchez interrupted. “The way Ilook at it, the second brand could proveto be a win-win proposition.”

“I don’t know if it’s as simple as that,”Germain said slowly.“Every luxury com-pany I know of–Gucci, Mercedes-Benz,BMW, Tiffany, even Hyatt – has strug-gled to go mass without destroying itspremium image. For that matter, whenfashion designers like Isaac Mizrahi cre-ate an affordable line for a retailer likeTarget, I wonder if that adds to thebrand’s luster or tarnishes it?”

• • •Renser, who had been quiet until then,cleared his scratchy throat. His col-leagues were starting to rehash territorythey had already covered, and insteadof sharpening their arguments, theyseemed to be obfuscating them. On onehand, they appeared to agree that itwould be important to keep the twobrands separate. On the other hand,they were talking about migrating cus-tomers from the low-end brand to thehigh-end brand, which would meanlinking the two. Renser knew that thegroup was waiting to hear where hestood, but he didn’t yet know what tosay. How long could he leave them hang-ing – along with his company’s for-tunes – between the devil and the deepblue sea?

Should Neptune launch a mass-

market brand? • Five commentators

offer expert advice.

april 2005

TLFeBOOK

Dan Schulman ([email protected]) is theCEO of Warren, New Jersey–based Virgin Mobile USA, awireless voice and data ser-vices provider that focuses onthe youth market. Schulmanpreviously served as the presi-dent and CEO of Priceline.comand as the president of AT&T’sconsumer markets division.


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ita Sanchez first suggests a drastic price cut as a temporary solution to Neptune’s

inventory problem. But, as Jim Hargrovepoints out, she later alters the terms of thedebate. At the meeting with her colleagues,Sanchez argues that the company shouldlaunch a less expensive brand to tackle apermanent increase in supply. Although shedoesn’t realize it, the two suggested actionsare miles apart. The price cut is reactive andwould prove costly in terms of the responsesit would elicit from rivals. Launching a newbrand, however, is a long-term strategy thatcould enhance Neptune’s profits without en-dangering its hard-earned brand equity.

Neptune’s executives have failed to ana-lyze the problem correctly because they’vefocused only on the supply side of the crisis.They need to shift their perspective 180 de-grees to view the challenge from the marketin–not from supply out. If the team views theproblem from that angle, it will find thatthere’s a tremendous upside to creating anew market segment. Indeed, Neptune hasa great opportunity to launch a brand thatwill bring in new customers. Doing so couldmake the pie bigger for all companies in theseafood industry while giving Neptune achance to carve out a generous slice for itself.

Once Neptune’s managers are clear aboutthe opportunity at hand, they can develop anappropriate marketing mix. If Neptune wereto try to gain market share through pricingalone, it would destroy value because com-petitors would feel obliged to meet the chal-lenge. That would lead to a downward pric-ing spiral and take money off the table foreveryone in the industry. Neptune must for-mulate strategies around price, product,promotions, and distribution. When VirginMobile launched its services in the UnitedStates, we could have set prices well below

those of our competitors, thus making priceour main differentiator. Instead, we priced ata level that was comparable to that of ourcompetitors but used a new pricing model.

Neptune has successfully served the high-end of the market for decades. All the factorsthat have made that possible–the company’sfocus on quality, its investments in technol-ogy – underscore the folly of slapping thesame brand on low-cost versions of its prod-ucts. If Neptune does that, it may reducesome of its inventory, but it will drag its cus-tomers to a lower price point and spark anasty price war. Rather than run that risk,Neptune should create a new brand with atotally new look and feel. Smart messagingwould also help. For instance, Neptune couldlaunch a campaign that positions the newbrand as a delicious, value-driven alternativefor everyday eating. Not only would that ap-peal to the right customer segment, but itwould also demonstrate to companies in theseafood industry that Neptune has a desire toeducate consumers for everyone’s benefit.

Neptune should deliberately leave off theASPD’s quality seal to highlight the differ-ences between the new brand and Neptune’sGold. It could label the package “Supplied by Neptune,” which would provide an im-plicit quality assurance to consumers withoutmuddying the firm’s gourmet image. Takinganother page from Virgin Mobile’s strategyplaybook, Neptune must place its new brandwhere entry-level customers shop.That meansselling the new brand through mass-marketnational and regional supermarkets as wellas through big box retailers that sell fresh-food offerings.

But can Neptune’s culture absorb thechange? Companies with established brandsand cultures usually have a tough time en-tering new markets. The new brand will prob-ably face opposition within the company, soRenser may want to create a separate divi-sion to manage the offering.Or,he could forma joint venture with a retailer or a consumerproducts company to launch the new brandand enter into a wholesale supply arrange-ment. That would add the distance from Nep-tune the new brand would need to succeed.

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A new brand could make the pie biggerfor all companies in the seafood industrywhile giving Neptune a chance to carveout a generous slice for itself.

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market by creating a lower-priced standardservice.

Neptune could use the sandwich approachand resegment the market by adding a value-priced offering to its premium product. Thatwould actually be a proactive strategy sincelow-priced offerings are bound to enter themarket, given the trend of rising supply. Thesame thing happened in the U.S. airline in-dustry and, consequently, low-cost carriershave become a headache for the big airlines.Since the airlines’ approach set off a pricewar like the one Hargrove so wisely wishes

to avoid, Neptune mustbe careful about how itlaunches the brand. Thecompany should posi-tion it not as a low-

priced product but as another quality offer-ing directed at a new segment: customerswho want a high-quality product but at acheap price.

By adopting a two-brand strategy, Nep-tune will sustain its competitive advantage.Existing customers who have responded toNeptune’s established brand will probablycontinue to pay a premium for that offering.Customers who are introduced to the firm’svalue-priced line may eventually migrate toits premium line. While launching the brand,Neptune should be careful not to jeopardizeits reputation for quality; a hard-won reputa-tion is easily lost through miscues. The firmmust also avoid alienating existing custom-ers as it expands the market. Finally, whileNeptune must be mindful of cannibalization,losing a customer to your competitor hurtsmore than losing a customer to yourself. Asevery CEO knows, it’s better to keep the can-nibal in the family.

The sandwich strategy offers companies a chance to create and capture value forthemselves and their customers, but suc-cessful implementation demands severalconditions: leadership in cost, innovation, ex-ecution, market creation, and customer rela-tionship management. Until now, Neptunehas demonstrated strength in all those areas,which makes it a good candidate to deploythe sandwich strategy.

Dipak C. Jain ([email protected]) is a profes-sor of marketing, the Sandyand Morton Goldman Profes-sor in Entrepreneurial Studies,and the dean of the KelloggSchool of Management atNorthwestern University inEvanston, Illinois.

eptune should use a line-extension strategy to garner more market share,

but it must proceed carefully to avoid get-ting embroiled with its rivals in a race to the bottom on price. By launching a newbrand, the company will not only be able toaddress its immediate inventory problembut will also be able to deal with both theexcess capacity in the industry and futurecompetition.

Sanchez’s idea of radically dropping Nep-tune’s prices may seem like a viable solution,but it could have several adverse conse-

quences. First, when a company lowers itsprices, it signals to customers that it has beenovercharging them in the past. So customersmay react by taking their business elsewhere.Second, dropping prices gives legitimacy toother firms’offerings because, in price terms,Neptune will then have positioned its brandcloser to competing brands. Finally, slashingprices could trigger a price war in the indus-try, which usually happens when supply in-creases. Thus, Sanchez’s strategy may addressshort-term issues, but the firm will have toadopt additional measures to handle the per-manent increase in supply.

One such measure would be to create an-other brand. Neptune should heed the con-cerns raised by Hargrove, but it should alsoleverage its reputation to expand the seafoodmarket by using what I call the “sandwichstrategy.” FedEx used this approach to com-pete with a low-priced alternative, the U.S.Postal Service’s Express Mail, which guaran-teed the delivery of letters, documents, andmerchandise by noon or 3 PM the next day inthe United States. FedEx created a premiumovernight priority delivery service for 10 AM

and a standard overnight service for 3 PM asa “sandwich.” That allowed it to attack Ex-press Mail from both the upper and lowerends of the market. The company didn’t di-lute its reputation for reliability in the pro-cess, either. Rather, the strategy expanded the

As every CEO knows, it’s better to keepthe cannibal in the family.

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f Sanchez is right about fish production rising permanently, Neptune’s inventory

problem is the least of Renser’s worries. Hemust first consider the impact of the supplychange on the company’s vertically inte-grated business model. Since there will bepressure on seafood prices because of thesupply increase, Neptune must fashion afresh strategy that will allow it to commanda premium for its products even in the future.That’s tough – but not impossible.

Neptune has invested heavily in state-of-the-art fishing vessels. With more seafoodcoming to market, Renser should determineif the firm’s capital is best allocated in physi-cal assets. If the company can easily securesupplies of high-quality seafood, say, by buy-ing more from fish farms and independentfishing boats, then it should sell off its trawl-ers. Renser could then use the proceeds tobolster the Neptune’s Gold brand.

Neptune’s sales are concentrated in theeastern United States. Yet despite the com-pany’s regional presence, its products havebeen ranked best in quality nationwide. Thatranking is an asset, and it should be a keyplank of the company’s future strategy. Nep-tune should expand into markets where itdoesn’t yet sell products, like the West Coast.Given the industry’s fragmented nature, thecompany should contract with fishing boatsand processors to supply areas that it can’tservice. Renser could fund the manufactur-ing and marketing activities in those regionswith the proceeds from the trawler sales.

Renser must still cope with Neptune’s ex-cess inventory. Sanchez has recommendedthat Neptune establish a second brand posi-tioned at a discount to Neptune’s Gold. Wedo not agree with that strategy even thoughwe launched a moderately priced line ofwomen’s clothing in August 2004 under theO Oscar label. Consumers can buy an O Oscaroutfit for less than $100, while our signature

Oscar de la Renta label features garmentsthat retail for more than $10,000 apiece. Weadopted the second-brand strategy to capi-talize on consumer awareness of our brand,which greatly exceeded our sales volume.

The challenge was to capitalize on theawareness of our name without sacrificingtoo much brand equity. After considering sev-eral strategies, such as dramatically lower-ing prices in the signature line (similar toSanchez’s thinking), we decided that estab-lishing a less expensive label made sense. Tominimize the negative impact on our exist-ing brand, we decided not to offer O Oscargoods where Oscar de la Renta clothes weresold. Thus, customers wouldn’t be tempted totrade down in any one store from the pre-mium brand to the moderate label.

The creation of a second brand madesense for our company, but that approachwon’t work in all cases. Introducing a less ex-pensive brand definitely dilutes the equityof the high-end line, is expensive, and takestime. In our case, those risks were acceptablebecause of the increase in profits we had fore-cast. But Neptune faces different challengesthan we did. Given the risks to the company’sexisting brand, launching a lower-priced linewould be an ill-advised response. In our situ-ation, if our concern had been an oversupplyof a raw material such as cashmere – a situ-ation analogous to Neptune’s – we wouldhave acted differently. We would have simplysold premium products based on the addi-tional raw material at a lower-than-usual

price. That would have encouraged new cus-tomers to try our brand. Along those lines,Neptune should offer its wholesale custom-ers–on a onetime basis–seafood they can sellas private-label products. The company willsacrifice profits, but that will have little long-term impact on its most productive asset:the premium Neptune Gold brand. And thatshould be the focus for Renser and his team.

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Alexander L. Bolen

With more seafood coming to market, Renser shoulddetermine if the firm’s capital is best allocated inphysical assets.

Oscar de la Renta

Oscar de la Renta is the chair-man and Alexander L. Bolen([email protected]) is the CEOof Oscar de la Renta Limited,a luxury goods manufacturerbased in New York.

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april 2005 45

Should Neptune Launch a Mass-Market Brand? • H B R C A S E C O M M E N TA R Y

Thomas T. Nagle([email protected]) is the founder and chairmanof the Strategic Pricing Group,a management consultancybased in Waltham, Massa-chusetts, that specializes inpricing and value-based mar-keting strategy.

eptune faces two distinct challenges.One is temporary: how to sell its excess

inventory without undercutting establishedindustry pricing structures. The other is moreenduring: how to profitably exploit a supplyincrease. Both challenges, if handled prop-erly, can become opportunities for the com-pany to grow profitably.

Neptune’s increasing inventory problemmay prove to be costly because the com-pany has neglected it for months. Offeringdeep discounts to move the company’s prod-ucts faster would be counterproductive, asHargrove points out. Neptune’s rivals, whichhave also experienced supply increases,would probably cut prices in response. If they

did, Neptune’s market share gain would beminimal. And since it is possible to store thefirm’s products, retailers might even buy for-ward. Thus, Neptune’s current sales wouldrise mostly at the expense of future sales.

Moreover, if a 45% price cut moved, say,half the excess inventory during the nextthree months, the impact on Neptune’s prof-its would be negative. Eliminating half theexcess inventory over three months wouldmean boosting sales by the equivalent offive days of inventory per month. That’s a 17% increase in sales, which isn’t nearlyenough to compensate for a 45% reductionin prices. Neptune’s plight shows why it israrely in the interest of market leaders to leadprices down.

A profitable solution to Neptune’s inven-tory problem should drive additional saleswithout stealing share from rivals or fromfuture sales, and it should also prevent de-pressing the margin on current sales. Res-taurants, which buy two-thirds of Neptune’sfresh fish, could drive consumption by add-ing more seafood items to their menus. Toensure that those sales were incremental,Neptune could offer restaurants and whole-salers a 50% rebate on purchases in excess of what they had purchased in previous

months. The large discount would motivateNeptune’s customers to buy more, and itwould be less costly to the company than it would appear because it would apply onlyto additional sales.

If tactics like those don’t adequately getrid of the inventory, the firm could recoversomething by contributing the excess tohomeless shelters and other charities andtaking a tax write-off. That’s a better solutionthan trying to dump products in foreignmarkets where they are usually reimportedto higher-priced home markets.

Neptune’s more interesting and less riskyopportunity entails exploiting increased vol-umes in the long run. If the company had

been operating in a saturated market, its bestbet would have been to create a lower-pricedbrand without the Neptune name. Fortu-nately, however, the company sells a productfor which demand is growing–especially in-land, where low quality has traditionally lim-ited seafood consumption. It would there-fore be better for Neptune to target newregions with its high-quality products.

To be sure, the first-year cost of entering anew region would be greater than launchinga discount brand through existing channels.Finding upscale grocers willing to carry thebrand, for example, would require stockingand promotional discounts, supported byadvertising to tell Neptune’s quality story.Eventually, however, consumer preference forthe brand would enable the firm to reducethose promotional costs and enjoy its tradi-tional margins. By contrast, the tiny marginsassociated with a low-priced brand wouldnever rise.

My answers may not be right for everybusiness. But they will work for Neptune be-cause they protect and exploit its competitiveadvantage: the ability to deliver quality.

Reprint R0504A

To order, see page 135.

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Neptune’s more interesting opportunity entailsexploiting increased volumes in the long run.

TLFeBOOK


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april 2005 49

t’s hard to find a better exemplar for competition than chess. The law-

yer in the courtroom, the general onthe battlefield, and the politician on thecampaign trail have all at some pointdescribed their skirmishes in terms ofthe 64 black-and-white squares and 32pieces that make up a chess game. Chesshas become part of the everyday lan-guage of many executives: we check-mate our opponents, we are just pawnsin a game, or we think three movesahead.

Of course, chess is not the only gamethat businesspeople like to invoke.Manyleaders draw inspiration from poker andteam sports, such as baseball and foot-ball. But there is something peculiarlydifferent about chess. The image of twobrilliant minds locked in a battle of skilland will–in which chance plays little or

no apparent role – is compelling. Evenpeople who have no personal knowl-edge of the game instinctively recognizethat chess is unusual in terms of its in-tellectual complexity and the strategicdemands it places on players.

If chess is such a powerful form ofcompetition, is there anything thatstrategists can learn from chess play-ers about what it takes to win? To findout, HBR senior editor Diane L. Coututalked with Garry Kasparov at the Lom-bardy Hotel in Manhattan. The world’snumber one player since 1984, Kasparovbecame the youngest world championat the age of 22 and is considered todayto be the most accomplished chess playerof all time. Although Kasparov is a prod-uct of the Soviet Union’s formidablechess system, which has dominated thegame since the Second World War, heTA

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Strategic IntensityA Conversation with World Chess Champion Garry Kasparov

To be a chess champion,

you have to be more

than a chess genius.

Winning is about putting

yourself in your opponent’s

shoes–then throwing

him off balance.

D I F F E R E N T V O I C E

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has never played the limited, even pas-sive role traditionally expected of Rus-sian celebrities – far from it. A commit-ted political activist, Kasparov todaycontinues to support Russia’s strugglingopposition.

Success in both chess and business,Kasparov believes, is very much a ques-tion of psychological advantage; thecomplexity of the game demands thatplayers rely heavily on their instincts

and on gamesmanship. In the course ofa wide-ranging discussion with HBR,Kasparov explored the power of chessas a model for business competition;the balance that chess players have tostrike between intuition and analysis;the significance of his loss to IBM’schess-playing computer, Deep Blue; andhow his legendary rivalry with Ana-toly Karpov, Kasparov’s predecessor asWorld Chess Champion, affected hisown success.Great champions,Kasparovargues, need great enemies. What fol-lows is an abridged and edited versionof the conversation.

Chess has become a buzzword in everyday language.It has. At one level, there’s somethingrather frightening about the idea that apowerful politician might think of coun-tries and their leaders as pieces on achessboard. Might a president think ofa small country as a pawn that could besacrificed? Of course, that kind of con-cern doesn’t really apply in the busi-ness context, and chess is certainly agood metaphor for business competi-tion. There’s a massive amount of un-certainty and almost boundless varietyin terms of the moves you can make inboth chess and business. Think about it:After just three opening moves by a

chess player, more than 9 million posi-tions are possible. And that’s when onlytwo players are involved in the game.Now imagine all the possibilities facedby companies with a whole host of cor-porations responding to their new strat-egies, pricing, and products. The unpre-dictability is almost unimaginable.

My one caveat would be that whenbusinesspeople use chess as a metaphor,they may sometimes unintentionally

sentimentalize what’s involved in win-ning, because they see chess as a kind ofclean, intellectual engagement. That’snot the case at all. There is nothing cuteor charming about chess; it is a violentsport, and when you confront your op-ponent you set out to crush his ego. Theworld chess masters with whom I havecompeted over the years nearly all sharemy belief that chess is a battleground onwhich the enemy has to be vanquished.This is what it means to be a chessplayer, and I cannot imagine that it isvery different from what it takes to bea top-ranked CEO.

What do you think businesspeople canlearn about winning from chess? The first rule is: Never, ever, underesti-mate your opponent. Whenever I amplaying at grand master levels, I always,always assume that my competitor isgoing to see everything I do–even whenI plan to make an unexpected move inorder to confuse him.

It’s also critical to keep a psychologi-cal edge. I am not a big fan of pop psy-chology, but I do believe that gettingthe other guy off balance is a real skill.You have to go on fighting even if youare in a winning position– in fact, espe-cially if you are in a winning position. Ina long match of many games during

which competitors regularly lose ten to15 pounds, concentration is everythingand it can be very easy to get off track.Your own body language, for example,can influence the way your challengerplays his game. Through your hesita-tions and pauses, you may communi-cate to your competitor that you are un-certain or just not ready. I lost a matchto Vladimir Kramnik in 2000 because I was not psychologically prepared forhis strategy and for his play, and he sawit. And I couldn’t regroup during thematch, despite the fact that I had pre-pared myself excellently for the game.Of course, some people do go to silly ex-tremes in search of advantage. I believethat Dr. Vladimir Zukhar, who was Ana-toly Karpov’s psychologist, once triedto hypnotize an opponent of Karpov’sduring a match.

You also have to make yourself com-fortable in the enemy’s territory. I re-member playing a match against ViktorKorchnoi in 1983. He tried everythingto get me off-kilter. He played quiet po-sitions, he traded pawns, and he dideverything possible to prevent me fromplaying my bold, visionary game. I hadno choice but to play like Korchnoi.I limited myself to small problems onthe board and was able to hold on longenough to get Korchnoi to play thegame my way. That can be a terrific tac-tic for CEOs as well. If you can convinceyour enemy that you’re comfortable ontheir ground, then you can often trickthem into moving into your own terri-tory. That’s just what happened withKorchnoi and me. I put myself in hisshoes long enough to lure him intofighting the game on my territory, andso I won.

Would CEOs be better leaders if they played chess? There are chess players and there arechess players. I don’t think that the factthat you are a chess player would be anyindication of how well you would suc-ceed in business. Some chess players arevery concerned with detail. Other chessplayers, including myself, look at the bigpicture. I expect that my archrival, Ana-toly Karpov, would be very good as a


D I F F E R E N T V O I C E • Strategic Intensity

After just three opening moves by a chess player,more than 9 million positions are possible. Nowimagine all the possibilities faced by companieswith a whole host of corporations responding totheir new strategies, pricing, and products.

TLFeBOOK

manager because he excels at operat-ing with small problems on the board;he would certainly maximize your re-sources. But Karpov dislikes taking risks,which might make him less effective insituations where the CEO has to take agamble. Then you might want someonelike me, who loves risk. The board posi-tions that I try to build are both riskyand complicated. I’m always ready togo into uncharted territories because I have full confidence in my ability towork out what people are going to do inresponse to my moves – maybe not bet-ter than a computer but certainly betterthan all my competitors.

Many people consider chess to be theultimate in human logic, the height ofhuman intellectual accomplishment.Is that the case? People who see chess as a scientific pur-suit played by some kind of human su-percomputer may be surprised, but ittakes more than logic to be a world-classchess player. Intuition is the defining

quality of a great chess player. That’sbecause chess is a mathematically infi-nite game. The total number of possibledifferent moves in a single game ofchess is more than the number of sec-onds that have elapsed since the bigbang created the universe. Many peopledon’t recognize that. They look at thechessboard and they see 64 squaresand 32 pieces and they think that thegame is limited. It’s not, and even atthe highest levels it is impossible to cal-culate very far out. I can think maybe15 moves in advance, and that’s aboutas far as any human has gone. Inevitablyyou reach a point when you’ve got tonavigate by using your imagination andfeelings rather than your intellect orlogic. At that moment, you are playingwith your gut.

Often, your gut will serve you betterthan your brains. I’ve been working nowon a five-volume book called My GreatPredecessors, which reviews the devel-opment of the game of chess by look-ing closely at the playing histories of

the great players of the past 200 years.When analyzing their games togetherwith a computer, I found somethingvery interesting. It was often at the verytoughest moments of their chess bat-tles – when they had to rely on pure in-tuition – that these great players cameup with their best, most innovativemoves. Ironically, when the games werefinished and the players had the luxuryof replaying them at leisure and ana-lyzing them for publication, they typi-cally made many more mistakes thanthey did when actually competing. Tome the implication is clear: What madethese players great was not their ana-lytic prowess but their intuition underpressure.

Speaking of analytic prowess, what was the significance of your famousmatches with IBM’s chess-playing supercomputer, Deep Blue?For a start, they were a huge promo-tion for the game. Nothing made chessmore popular than the match I won

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against Deep Blue in 1996 and thematch I lost in 1997. The official Website got 72 million hits during the sixgames of the second match in NewYork, which was a higher daily rate thanthe Atlanta Olympic Games Web sitegot in 1996.

But the matches meant a lot morethan that to me. Competing with a com-puter was first and foremost a scientificexperiment for me. I thought it was veryimportant for society to start commu-nicating with computers, and I knewthat chess was the only field where man

and machine could meet. You can’t doit with mathematics or with literature.Chess, however, lies somewhere in be-tween. I believed that it would be anideal playing field for comparing humanintuition with the brute force of a ma-chine’s calculation.

The yardstick of victory, I think,should be this: If the best humanplayer – on his best day, at his peak –can still beat the best machine, thenwe can say that the chess master is su-perior to the machine. And for now, Ibelieve that chess masters like me stillhave the upper hand. I can beat themachine unless I make a fatal unforcederror. But when the chess master can nolonger defeat the machine on his bestday, then we will have to take a cold,hard look at issues such as artificial in-telligence and the relationship betweenman and machine.

Unfortunately, I don’t think everyoneshared the same spirit of experiment.The day after the New York matchagainst Deep Blue, the one I lost in 1997,IBM stock immediately jumped 2.5%to a ten-year high. It continued to risedramatically for weeks. For some rea-son, Lou Gerstner did not invite me tothe next IBM shareholders’ meeting to

take a bow! But seriously, I wish thatIBM had accepted my offer for a tie-breaker. To my mind, IBM actuallycommitted a crime against science. Byclaiming victory so quickly in the man-versus-machine contest, the companydissuaded other companies from fund-ing such a complicated and valuableproject again, and that’s the real tragedy.

Did it hurt your pride to be beaten by a computer?No, not at all. Let me explain this bytelling you a little anecdote. In 1769,

the Hungarian engineer Baron Wolf-gang von Kempelen constructed a chess-playing machine for the amusement ofthe Austrian empress Maria Theresa. Itlooked like a purely mechanical device,shaped like a person. And it played chessvery well. But the machine was a fake.There was a chess master cleverly hid-den inside the device who decided allthe moves.

In some ways, Deep Blue was also afake. The machine I played with in 1996and 1997 had no history. Records of itspast games were better guarded thantop-secret documents at the Pentagon.And since IBM refused to release print-outs of earlier games, it was impossibleto prepare for the match. I couldn’t feelbadly about losing because I wasn’tplaying on a level playing field.

What, if anything, did we learn fromyour contests with Deep Blue? We learned, of course, that we are veryslow compared with the machine, likeants compared with a jet. But it’s notjust speed. Playing against a chess com-puter means facing something thatdoesn’t have any nerves; it’s like sittingacross the table from an IRS agent dur-ing a tax audit. Chess between humans

and computers is very different fromchess between only humans. For onething, human players have to cope witha lot of external pressures and distrac-tions: you have a family,you write books,you give lectures, you get headaches,you have to earn money. There’s a lot ofstuff filling up your brain while you’replaying. A machine, on the other hand,is completely without distractions. Thisshows the weakness, the shortcomingsof the mortal mind, which is a dauntinglesson for human beings. We just can’tplay with the same consistency as a com-puter. So it’s all the more fortunate thatwe have our intuition to help us playbetter.

People often comment about the dominance of Russian players. Givenwhat you’ve said about intuition, isthere something in your national cul-ture that nurtures chess genius? A lot of people say that. But I don’t thinkthat there is anything mysterious aboutthe way the Soviet Union dominatedchess. I, for one, have always believedthat talent is everywhere – whereverpeople live, whatever nationality theyare. Essentially, the explanation lies inthe system. The Soviet system offeredvery little opportunity for kids. Chesswas one of the few pathways to big suc-cess – chess, ballet, music, some sports,maybe fundamental sciences. So par-ents pushed their kids in those direc-tions. What’s more, Soviet officials likedto use the country’s success in chess as atool to promote the intellectual superi-ority of the Communist regime over thedecadent West. The result was that therewere always millions of kids getting agood training in chess. And so theycould easily find and develop peoplelike Karpov, like me, like Spassky, likeBotvinnik, like Petrosian, like Tal. InAmerica, on the other hand, there weremany other opportunities for advance-ment open to young people, and onlya few chose to get deeply involved inchess – mostly on the East Coast, somein Chicago, and some in San Francisco.Essentially we are talking only about50,000 to 100,000 kids. America waslucky to have one Bobby Fischer.


D I F F E R E N T V O I C E • Strategic Intensity

Intuition is the defining quality of a great chessplayer. It’s often at the very toughest moments of their chess battles–when they had to rely on pure intuition–that great players came up withtheir best, most innovative moves.

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You were a child prodigy.What can you teach us about how to develophigh performers?

You may be disappointed by my answer.I don’t believe that there was any orga-nizational secret to my success that youcan replicate in a business. The truth isthat my mother was really the drivingforce behind me. My father died when Iwas seven, and she didn’t remarry. Shedevoted her entire life to helping me be-come a child prodigy. She was alwaysconvinced that I had the potential tobecome a powerful man. At the sametime, she never felt that the chess worldchampionship should be my only goal,and she was very creative in figuring outwhat would be important both for mycareer and for me as an individual. Itwas very important to her, for example,that I be a well-rounded person. So al-though the connection between chessand mathematics is very inviting, mymother recognized that fantasy andimagination were also essential, and sheinsisted that I study humanities in highschool. To this day, I do not look for amathematical solution when I playchess. I’m always trying to find some-thing unconventional, even poetic –something more than just analytics.

You’re now 41.What’s the next challenge for you?The greatest challenge for all successfulpeople is to get past their own successes.It’s especially hard when that success isextraordinary. In 1985, after winninggame 24 against Anatoly Karpov, I be-came the youngest world champion inthe history of chess. There was a hugecelebration. I was feeling on top of theworld. Then, in a quiet moment, RonaPetrosian, the widow of Tigran Petro-sian, the ninth world champion and oneof my great predecessors, came up tome and said,“Garry, I am sorry for you.”I was incredulous. “I’m sorry for you,”she said,“because the happiest and bestday of your life is over.” I was too youngat the time to recognize the profundityof her words, but today I understandhow wise she was. Where does a virtuosogo after he has accomplished every-thing that he’s ever wanted to accom-

plish, even beyond his wildest imagina-tion? This is the question for all worldmasters, whether they’re in business,sports, or chess.

I call it the champion’s dilemma, andit’s a real problem for people and com-panies at the top of their game. In theend, I believe that there is only one an-swer: You must be lucky in your ene-mies. For me it was Karpov, Karpov, Kar-pov. If it were not for Karpov, I wouldprobably be the victim of the same com-placency that dooms most other peo-ple. But in Karpov I found my archen-emy, whom I had to fight. He never gaveme the time to enjoy my title. I wasworld champion at 22. For the first fiveyears of my championship, I had toprove every year that I was still the best.And it set a pattern. I know that I cannever stop competing. Competition isnow in my blood. And as I look ahead,I see new enemies nipping at my heels,young people who are still too young tovote. And every day I am grateful forthem because they push me to be pas-sionate about staying at the top.

As someone who has faced the cham-pion’s dilemma, which successful CEOdo you most readily identify with?That is difficult to answer because I donot like details, and to some extent allCEOs must concern themselves withdetail. I’m a visionary in the way I playchess. As I wrote in my autobiography,Unlimited Challenge, I love complex com-binations, and I’m ruthless in breakingmy own fixed patterns. I almost alwayssucceed in avoiding the temptation tosolve problems by using purely techni-cal means. That was true at 24 and it isstill true today. So I guess you could saythat Steve Jobs is probably the CEO whois most like me, a visionary who likes tobreak the mold and who doesn’t like to bury himself in the day-to-day tasksof management. He has also been luckyin his enemies. Without Bill Gates, SteveJobs would surely not be the man he istoday. If Karpov had not existed, youmight not be talking to me today.

Reprint r0504bTo order, see page 135.

april 2005

The Soul of Leadershipjune 1–3

Factory Physics: The Science of Lean Manufacturingjune 5–7

Global Supply Chain Managementjune 7–10

Forensic Accounting for Credit and Equity Analystspart I: june 13–15part II: june 16–17

Competitive Strategyjune 21–24

Managing New ProductDevelopment forStrategic CompetitiveAdvantagejune 26–29

Corporate FinancialStrategies for CreatingShareholder Valuejuly 10–15

Business MarketingStrategyjuly 24–29

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Strategists

trategy is about choice. The heart of a com-pany’s strategy is what it chooses to do and not do.The quality of the thinking that goes into such

choices is a key driver of the quality and success of a com-pany’s strategy. Most of the time, leaders are so immersedin the specifics of strategy – the ideas, the numbers, theplans – that they don’t step back and examine how theythink about strategic choices. But executives can gain agreat deal from understanding their own reasoning pro-cesses. In particular, reasoning by analogy plays a role instrategic decision making that is large but largely over-looked. Faced with an unfamiliar problem or opportu-nity, senior managers often think back to some similar situation they have seen or heard about, draw lessonsfrom it, and apply those lessons to the current situation.Yet managers rarely realize that they’re reasoning by anal-ogy. As a result, they are unable to make use of insightsthat psychologists, cognitive scientists, and political sci-entists have generated about the power and the pitfalls


JIM

FR

AZ

IER

S

Tapping the Power of Analogy

Much of the time, executives use analogies tomake strategic choices.The best strategists knowboth the power and peril of such comparisons.How

Really

by Giovanni Gavettiand Jan W. Rivkin

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april 2005 55

TLFeBOOK

of analogy. Managers who pay attention to their own ana-logical thinking will make better strategic decisions andfewer mistakes.

When Analogies Are PowerfulWe’ve explained the notion of analogical reasoning to ex-ecutives responsible for strategy in a variety of industries,and virtually every one of them, after reflecting, couldpoint to times when he or she relied heavily on analogies.A few well-known examples reflect how common analog-ical reasoning is:

• Throughout the mid-1990s, Intel had resisted provid-ing cheap microprocessors for inexpensive PCs. During a1997 training seminar, however, Intel’s top managementteam learned a lesson about the steel industry from Har-vard Business School professor Clayton Christensen: Inthe 1970s, upstart minimills established themselves in thesteel business by making cheap concrete-reinforcing barsknown as rebar. Established players like U.S. Steel ceded

the low end of the business to them, but deeply regrettedthat decision when the minimills crept into higher-endproducts. Intel’s CEO at the time, Andy Grove, seized onthe steel analogy, referring to cheap PCs as “digital rebar.”The lesson was clear, Grove argued: “If we lose the low endtoday, we could lose the high end tomorrow.” Intel soonbegan to promote its low-end Celeron processor more ag-gressively to makers and buyers of inexpensive PCs.

• Starting in the 1970s, Circuit City thrived by sellingconsumer electronics in superstores. A wide selection, pro-fessional sales help, and a policy of not haggling with cus-tomers distinguished the stores. In 1993, Circuit City sur-prised investors by announcing that it would open CarMax,a chain of used-car outlets. The company argued that theused-car industry of the 1990s bore a close resemblance tothe electronics retailing environment of the 1970s. Mom-and-pop dealers with questionable reputations domi-nated the industry, leaving consumers nervous when theypurchased and financed complex,big-ticket,durable goods.Circuit City’s managers felt that its success formula fromelectronics retailing would work well in an apparentlyanalogous setting.

• The supermarket, a retail format pioneered during the1930s, has served as an analogical source many times over.

Charlie Merrill relied heavily on his experience as a su-permarket executive as he developed the financial super-market of Merrill Lynch. Likewise, Charles Lazarus was inspired by the supermarket when he founded Toys R Usin the 1950s. Thomas Stemberg, the founder of Staplesand a former supermarket executive, reports in his auto-biography that Staples began with an analogical ques-tion: “Could we be the Toys R Us of office supplies?”

Each of these instances displays the core elements ofanalogical reasoning: a novel problem that has to be solvedor a new opportunity that begs to be tapped; a specificprior setting that managers deem to be similar in its es-sentials; and a solution that managers can transfer fromits original setting to the unfamiliar context. When man-agers face a problem, sense “Ah, I’ve seen this one before,”and reach back to an earlier experience for a solution, theyare using analogy.

Strategy makers use analogical reasoning more oftenthan they know. Commonly, credit for a strategic decisiongoes to one of two other approaches: deduction and the

process of trial and error. When managers use deduction,they apply general administrative and economic princi-ples to a specific business situation, weigh alternatives,and make a rational choice. They choose the alternativethat, according to their analysis, would lead to the bestoutcome. Trial and error, on the other hand, involveslearning after the fact rather than thinking in advance.

Both deduction and trial and error play important rolesin strategy, but each is effective only in specific circum-stances. Deduction typically requires a lot of data and istherefore at its most powerful only in information-richsettings – for instance, mature and stable industries. Evenwhere information is available, processing a great deal ofraw data is very challenging, particularly if there are manyintertwined choices that span functional and productboundaries. The mental demands of deduction can easilyoutstrip the bounds on human reasoning that psycholo-gists have identified in numerous experiments. For thisreason, deduction works best for modular problems thatcan be broken down and tackled piece by piece.

Trial and error is a relatively effective way to make stra-tegic decisions in settings so ambiguous, novel, or com-plex that any cognitively intensive effort is doomed tofail. In altogether new situations, such as launching a rad-ically new product, there may be no good substitute fortrying something out and learning from experience.

Many, perhaps most, strategic problems are neither sonovel and complex that they require trial and error nor sofamiliar and modular that they permit deduction. Much


How Strategists Real ly Think: Tapping the Power of Analogy

Giovanni Gavetti ([email protected]) is an assistant profes-sor and Jan W. Rivkin ([email protected]) is an associate pro-fessor in the Strategy Unit of Harvard Business School inBoston.

It is extremely easy to reason poorly through analogies,and strategists rarely consider how to use them well.

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Ohno, the foremost pioneer of Toyota’s famed productionsystem, supposedly invented the kanban system for re-plenishing inventory after he watched shelf-stocking pro-cedures at U.S. supermarkets, and he devised the andoncord to halt a faulty production line after seeing how buspassengers signaled a driver to stop by pulling a cord thatrang a bell.

Reasoning by analogy is prevalent among strategymakers because of a series of close matches: between theamount of information available in many strategic situa-tions and the amount required to draw analogies; be-tween the wealth of managerial experience and the needfor that experience in analogical reasoning; and betweenthe need for creative strategies and analogy’s ability tospark creativity.Reflecting these matches,business schoolstypically teach strategy by means of case studies, whichprovide an abundance of analogies from which the stu-dents can draw. (See the sidebar “Strategic Decision Mak-ing and the Case Method.”) Similarly, some of the fore-most strategy consultants are famed for their ability todraw lessons from one industry and apply them to an-other. Thus we have ample reason to believe that analog-ical reasoning is a key implement in the toolbox of thetypical real-world strategist.

How Analogies FailThough analogical reasoning is a powerful and prevalenttool, it is extremely easy to reason poorly through analo-gies, and strategists rarely consider how to use them well.Indeed, analogies’very potency requires that they be usedwisely. To understand the potential pitfalls, consider for a moment the anatomy of analogy. Cognitive scientistspaint a simple picture of analogical reasoning. An indi-vidual starts with a situation to be handled – the targetproblem (for Intel, the competition from makers of low-end microprocessors). The person then considers othersettings that she knows well from direct or vicarious ex-perience and, through a process of similarity mapping,identifies a setting that, she believes, displays similar char-acteristics. This setting is the source problem (the steel in-dustry). From the source emerges a candidate solution thatwas or should have been adopted for the source problem(a vigorous defense of the low end). The candidate solu-tion is then applied to the target problem.

In a variant of this picture, the solution seeking a prob-lem, an individual starts with a source problem and a can-didate solution, then uses similarity mapping to find atarget problem where the solution would work well. Cir-cuit City’s managers, for instance, had an effective solu-tion in consumer electronics retailing. They then found a new setting, used-car retailing, to which they believedtheir solution could be applied with success.

Dangers arise when strategists draw an analogy on thebasis of superficial similarity, not deep causal traits. Take

april 2005 57


of the time, managers have only enough cues to see a re-semblance to a past experience. They can see how an in-dustry they’re thinking about entering looks like one theyalready understand, for example. It is in this large middleground that analogical reasoning has its greatest power.

Analogical reasoning makes enormously efficient useof the information and the mental processing power thatstrategy makers have. When reasoning by analogy, man-agers need not understand every aspect of the problem at hand. Rather, they pay attention to select features of it and use them to apply the patterns of the past to theproblems of the present. Imagine, for instance, the chal-lenge facing Charles Lazarus in the fast-changing, com-plex toy industry of the 1950s. Had he sat down and ana-lyzed all of the interdependent configurations of choicesin toy retailing – from marketing to operations, fromhuman resource management to logistics – it is unlikelyhe would have come up with a strategy as coherent andeffective as the one Toys R Us adopted. The analogy hedrew to supermarkets was extraordinarily efficient froman informational and cognitive point of view. In onestroke, it gave Lazarus an integrated bundle of choices: ex-haustive selection, relatively low prices, rapid replenish-ment of stock, deep investment in information technol-ogy, self-service, shopping carts, and so forth.

Analogical reasoning can also be a source of remark-able insight. Analogies lie at the root of some of the mostcompelling and creative thinking in business as a whole,not just in discussions of strategy. For instance, Taiichi

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Ford, for instance. In overhauling its supply chain, theautomaker looked carefully at Dell’s key strategic princi-ple of “virtual integration” with its suppliers as a possiblesource for an analogy. On the surface, computer and autoproduction resemble one another. Both involve the as-sembly of a vast variety of models from a set of fairly stan-dardized components. It is easy, however, to pinpoint dif-ferences between the two industries. In the PC business,for example, prices of inputs decline by as much as 1% perweek – much, much faster than in the auto industry. Tothe extent that rapidly falling input prices play a role inDell’s success formula, overlooking this underlying dif-ference could seriously undermine the usefulness of theanalogy. Fortunately, Ford executives thought carefullyabout the differences between the auto industry and the

PC business, as well as the difficulty of changing their ex-isting supply chain, as they used the analogy.

The experience of Enron shows how a seductive butbad analogy can lead to flawed decisions. Many factorscontributed to Enron’s startling collapse, but headlong diversification based on loose analogies played an impor-tant role. After apparently achieving success in tradingnatural gas and electric power, Enron executives movedrapidly to enter or create markets for other goods rangingfrom coal, steel, and pulp and paper to weather deriva-tives and broadband telecom capacity. In a classic exam-ple of a solution seeking problems, executives looked formarkets with certain characteristics reminiscent of thefeatures of the gas and electricity markets. The charac-teristics included fragmented demand, rapid change dueto deregulation or technological progress, complex andcapital-intensive distribution systems, lengthy sales cycles,opaque pricing, and mismatches between long-term sup-ply contracts and short-term fluctuations in customer demand. In such markets, managers were confident thatEnron’s market-creation and trading skills would allowthe company to make hefty profits.

On the broadband opportunity, for instance, EnronChairman Kenneth Lay told Gas Daily, “[Broadband]’sgoing to start off as a very inefficient market. It’s going tosettle down to a business model that looks very much likeour business model on [gas and electricity] wholesale,which obviously has been very profitable with rapidgrowth.” But Enron’s executives failed to appreciate im-portant, deeper differences between the markets for nat-ural gas and bandwidth. The broadband market wasbased on unproven technology and was dominated bytelecom companies that resented Enron’s encroachment.The underlying good – bandwidth – did not lend itself tothe kinds of standard contracts that made efficient tradingpossible in gas and electricity. Perhaps worst, in broad-band trading, Enron had to deliver capacity the “last mile”to a customer’s site – an expensive challenge that gaswholesalers didn’t face.

The danger of focusing on superficial similarity is veryreal, for two reasons. First, distinguishing between a tar-get problem’s deep, structural features and its superficialcharacteristics is difficult, especially when the problem isnew and largely unknown. In the earliest days of the In-ternet portal industry, for instance, it was far from clearwhat structure would emerge in the business. Players inthe market adopted analogies that reflected idiosyncra-sies of the management teams rather than deep traits ofthe evolving industry. The tech-savvy founders of Lycos,for instance, saw themselves competing on a high-techbattlefield and assumed that the company with the bestsearch technology would win. Magellan’s founders, thetwin daughters of publishing magnate Robert Maxwell,aimed to build “the Michelin guide to the Web” and de-veloped editorial abilities. The pioneers of Yahoo, seeing



Strategic Decision Making and theCase MethodThe case method in business education has often been criti-cized, most recently by Henry Mintzberg, because it depictsmanagement as an abstract theoretical exercise removed fromthe reality of managerial work. We believe this criticism missesthe cognitive underpinnings of managerial decision making.In their role as strategists, managers often face situations inwhich thinking by analogy or by case has more power thanother forms of reasoning. Thus, teaching managers with cases,and to reason from cases, is an appropriate and powerful ap-proach. In fact, the case method has extraordinary potential toenable managers to draw better analogies, for two reasons.

First, the case method creates a large repertoire of second-hand experiences from which students can reason. Duringtheir managerial careers, former business students will seldom,if ever, encounter a situation exactly like one they discussed inthe classroom. But having studied and debated hundreds ofcases from diverse settings, managers can draw upon a largeset of vicarious experiences as they make choices.

Second, the case method gives students extensive experiencein deciding what is and what isn’t important in a given busi-ness situation. This skill is crucial to analogical reasoning. Thedifference between a superficial and a deep similarity mappingis relevance. A superficial mapping focuses on irrelevant simi-larity (such as the home state of the president in the experi-ment described in the main text); a deep one emphasizes simi-larity along dimensions that truly drive business performance.

It is probably not surprising that two professors at Harvard,the bastion of the case method, would defend it. Yet our sup-port comes with important reservations. Too often, studentsand managers alike reason loosely and fail to assess whetherthere is a clear causal mapping of their solution onto the prob-lem. Students who are taught by the case method should betrained in the careful use of analogy – and that, we fear, occurstoo rarely. Indeed, that fear was one of the factors that fueledour interest in analogical reasoning.

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the portal industry as a media business, invested in thecompany’s brand and the look and feel of its sites.

But this is only part of the picture. Not only is it diffi-cult to distinguish deep similarities from surface resem-blances in some contexts, but people typically make littleeffort to draw such distinctions. In laboratory experimentsconducted by psychologists, subjects–even well-educatedsubjects – are readily seduced by similarities they shouldknow to be superficial. In a study by psychologist ThomasGilovich, students of international conflict at Stanfordwere told of a hypothetical foreign-policy crisis: A small,democratic nation was being threatened by an aggres-sive, totalitarian neighbor. Each student was asked to playthe role of a State Department official and recommend acourse of action. The descriptions of the situation weremanipulated slightly. Some of the students heard versionswith cues that were intended to make them think ofevents that preceded World War II. The president at thetime, they were told, was “from New York, the same stateas Franklin Roosevelt,” refugees were fleeing in boxcars,and the briefing was held in Winston Churchill Hall.Other students heard versions that might have remindedthem of Vietnam. The president was “from Texas, thesame state as Lyndon Johnson,” refugees were escaping in small boats, and the briefing took place in Dean RuskHall. Clearly, there is little reason that the president’shome state, the refugees’ vehicles, or the name of a brief-ing room should influence a recommendation on foreignpolicy. Yet subjects in the first group were significantly

more likely to apply the lessons of World War II–that ag-gression must be met with force – than were participantsin the second group, who veered toward a hands-off policyinspired by Vietnam. Not only were the students swayedby superficial likenesses, they were not even aware thatthey had been swayed.

The implications are unsettling. Thanks to his or herparticular history and education, each manager carriesaround an idiosyncratic tool kit of possible sources ofanalogies. In choosing among tools or identifying newproblems for old tools, the manager may be guided bysomething other than a careful look at the similarity be-tween the source and the target.

The tendency to rely on surface similarity is made evenworse by two other common flaws in how people reachjudgments:

Anchoring. Once an analogy or other idea anchors it-self in a management team, it is notoriously hard to dis-

lodge. Psychologists have shown that this is true evenwhen decision makers obviously have no reason to be-lieve the initial idea. In a demonstration of this effect,Nobel Prize winner Daniel Kahneman and his coauthorAmos Tversky told experimental subjects they would beasked to estimate the percentage of African countries inthe membership of the United Nations. A roulette wheelwith numbers from zero to 100 was spun, and after it had stopped, the subjects were asked whether the actualpercentage was greater or less than the number showingon the wheel. They were then asked to estimate the cor-rect percentage. Surprisingly, the roulette wheel had astrong impact on final estimates. For instance, subjectswho saw 10% on the wheel estimated the real percentageat 25%, on average, while those who saw 65% gave an av-erage estimate of 45%. The roulette wheel knew nothingabout the composition of the United Nations, obviously,yet it had a powerful influence on people’s judgment. (Thecurrent answer: African nations make up 24% of the U.N.’smembership.)

The anchoring effect suggests that early analogies in acompany, even if they have taken root casually, can havea lasting influence. This is especially true if decision mak-ers become emotionally attached to their analogies. Foryears, Sun Microsystems has focused on delivering entiresystems of hardware and software even as the computerindustry has grown less and less integrated. CEO ScottMcNealy often justifies his contrarian position by high-lighting an analogy to the automotive industry.“You guys

are all focusing on piston rings,” he once told reporters.“Go and ask Ford about its strategy in piston rings. Andcarburetors. You don’t. You talk about the whole car.”Though Sun has suffered financially, McNealy has beenreluctant to shift strategy, and, indeed, he continues to usethe auto analogy. Perhaps that is inevitable for an indi-vidual whose father worked in the auto industry andwhose sons are named after vehicle models – Maverick,Scout, Colt, and Dakota.

Confirmation Bias. The anchoring effect is reinforcedby another problem: decision makers’ tendency to seekout information that confirms their beliefs and to ignorecontradictory data. To some degree, this tendency arisessimply because managers like to be right – and like to beseen as right. But there is evidence from psychology thatpeople are better equipped to confirm beliefs than tochallenge them, even when they have no vested interestin the beliefs.

april 2005 59


Strategists will seek evidence that their analogy is legitimate,not evidence that it is invalid. As a result, a company may

continue to act on a superficial analogy for a long time.

TLFeBOOK

Consider an illustration. Experimental subjects in Is-rael were asked during the 1970s,“Which pair of countriesis more similar, West Germany and East Germany, or SriLanka and Nepal?” Most people answered, “West Ger-many and East Germany.” A second set of subjects wasasked, “Which pair of countries is more different, WestGermany and East Germany, or Sri Lanka and Nepal?”Again, most people answered, “West Germany and EastGermany.” How can we reconcile the two sets of results?The accepted interpretation starts with the fact that thetypical Israeli knew more about the Germanys than aboutSri Lanka and Nepal. When asked to test a hypothesis ofsimilarity, subjects sought evidence of similarity andfound more between the Germanys than between SriLanka and Nepal. When asked to test a hypothesis of dif-ference, they sought differences and found more of thembetween the Germanys. Subjects search for the attributethey are prompted to seek – similarity or difference – anddo not look for evidence of the contrary attribute.

Together, anchoring and the confirmation bias suggestreal problems for strategists who rely on analogies. Hav-ing adopted an analogy, perhaps a superficial one, strat-egy makers will seek out evidence that it is legitimate, notevidence that it is invalid. Intel’s managers will tend tolook for reasons that microprocessors really are like steel;Circuit City will try to confirm that consumer electronicsand used cars truly are alike. Given the variety of infor-mation available in most business situations, anyone wholooks for confirming data will doubtless find somethingthat supports his or her beliefs. Thanks to the anchoringeffect, any contradictory information may well be disre-garded. As a result, a company may continue to act on asuperficial analogy for a long time.

How to Avoid SuperficialAnalogiesReasoning by analogy, then, poses a dilemma for seniormanagers. On the one hand, it is a powerful tool, wellsuited to the challenges of making strategy in novel, com-plex settings. It can spark breakthrough thinking and fuelsuccesses like those of Toys R Us and Intel. On the other,it raises the specter of superficiality. Can managers tap thepower of analogy but sidestep its pitfalls? The bad newsis that it is impossible to make analogies 100% safe. Man-agers are especially likely to rely on analogical reasoningin unfamiliar, ambiguous environments where otherforms of thinking, like deduction, break down. In thosesettings, it’s hard to distinguish the deep traits from the superficial. The good news is that four straightforwardsteps can improve a management team’s odds of usinganalogies skillfully. (See the exhibit “Avoiding SuperficialAnalogies.”)

Before laying out these steps, we must acknowledgeour debt to political scientists, especially Harvard’s Ernest



Recognize the analogy and identify its purpose.

SourceProblem

TargetProblem

TargetProblem

TargetProblem

1

Understand the source.

Apparently similarproblem from

another context

Your company’sproblem

Actively search for differencesbetween the source and the target.

Similarity Mapping

Application

2

Assess similarity.

3

SourceProblem

CandidateSolution

CandidateSolution

CandidateSolution

YourSolution

Adjust the solution for glaring differences.

Fine-tune the solutionusing market feedback.

TargetProblem

Translate, decide, and adapt.

4

SourceProblem

SourceProblem

Avoiding Superficial AnalogiesIt’s often difficult to tell whether similarities between a

familiar and an unfamiliar problem are deep or superficial.

Managers facing strategic choices can improve their odds

of using analogies well by following these four steps.

May and Richard Neustadt, who found that analogicalreasoning often leads policy makers astray.The approachesthey developed to train such people to make better use of history have informed our thinking.

Recognize the analogy and identify its purpose. Todefend against flawed analogies, a management team firstmust recognize the analogies it is using. Sometimes theyare obvious. It is hard to forget that “digital rebar” is a ref-erence to the steel industry, for instance. In other cases, in-fluential analogies remain hidden. They often come from

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executives’ backgrounds. Though Merrill Lynch’s distinc-tive approach to retail brokerage owed much to the yearsthat Charlie Merrill spent in the supermarket business,only occasionally did Merrill confess that “although I amsupposed to be an investment banker, I think I am reallyand truly a grocery man at heart.”

It’s also important to identify how a company is usingany analogies it recognizes. Managers use analogies for avariety of purposes, after all – to brainstorm, to commu-nicate complexity, and to motivate employees, for exam-ple. (For thoughts on the uses of analogies, see the sidebar“A Versatile Tool.”) Often, analogies are used to sparkideas and emotions. In such cases, creativity and impactmay be more important than strict validity. But when acompany moves from brainstorming to deciding, andwhen resources are at stake, managers need to ask tough,objective questions about whether the analogy is morethan superficial. To answer these questions well, strate-gists must analyze chains of cause and effect. It is usefulto break this task into three further steps.

Understand the source. Begin by examining why thestrategy worked in the industry from which the analogywas drawn. The classic tools of strategy analysis are ex-tremely useful here. Indeed, the key is to lay out in-depthanalyses that are familiar to strategists, particularly analy-ses of the source environment, the solution or strategythat worked well (or that failed) in the original context,and the link between the source environment and thewinning (or losing) strategy.

Consider Circuit City’s effort to apply its retailing solu-tion to the used-car business, and start by analyzing thesource environment. When the company began its rise toprominence in the 1970s, the consumer electronics indus-try was dominated by mom-and-pop retailers of varyingquality and efficiency. Burgeoning demand kept the re-tailers afloat, despite three negatives: Consumers weremore committed to the national brands than to the re-tailers, the cost to switch from one retailer to another waslow, and customers often feared that retailers were prey-ing on their ignorance of high-tech products. The envi-ronment was marked by untapped efficiencies (for exam-ple, few economies of scale were exploited) and unmetcustomer needs (each store carried a limited selection ofbrands, and products were often out of stock).

Circuit City devised a highly effective strategy that took advantage of the opportunities and neutralized thethreats in this setting. Key to the strategy was a series offixed investments: large stores that could stock an ex-haustive selection of consumer electronics, informationtechnology that could track sales patterns closely, auto-mated distribution centers that were tied to the sales-tracking technology, and brand-building efforts. The com-pany differentiated itself from competitors on the basis of selection, availability, and consumer trust. It simulta-neously drove down costs. Circuit City’s low prices and its

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A Versatile ToolThis article focuses on the use of analogy as a tool for choosingamong possible solutions to strategic problems, but managersalso use analogies for other purposes. Most important, analo-gies can be catalysts for generating creative options. Seekingoutside-the-box ways to speed customers through gas stations,for instance, Mobil executives looked far afield – at the opera-tions of race-car pit crews. And to improve service, they exam-ined the world-class operations of the Ritz-Carlton hotel chain.Similarly, a management team might choose a company itdeeply admires in a distant business and ask itself,“What wouldit mean to be the Wal-Mart or GE or Dell of our industry?” Wesee little danger in using analogies this way – as long as manag-ers test any analogy carefully when they move from generatingoptions to choosing among them.

Analogies are also powerful tools for communicating com-plex messages quickly. When the executives turning aroundDucati began to speak of the legendary Italian motorcyclemaker as an entertainment company comparable to Disney,they made it clear, to insiders and outsiders, that they plannedto invest more in the experiential aspects of the brand and less in the physical product. Chosen well, analogies have anemotional impact that can rally a management team. By refer-ring to cheap PCs as “digital rebar,” Andy Grove sharpened his colleagues’ fears that Intel could go the way of U.S. Steel.Sports and military analogies are often used in this way, to motivate teams.

other strengths led to extraordinarily large sales volumes,which reduced unit costs. Those cost reductions permittedlower prices, which drove even greater volume, and so onin a virtuous cycle.

Note how well this strategy matched the demands ofthe external environment. By meeting consumer needsand by building a brand that shoppers valued, Circuit Citymade it less attractive for customers to switch from storeto store. As Circuit City’s brand rose to prominence, assales volume grew, and as customers came to rely on therecommendations of Circuit City’s salespeople, the com-pany became far more powerful in negotiations with sup-pliers. Investments in branding, distribution, informationtechnology, and large stores raised new barriers to entry.And scale-driven cost advantages gave the company apowerful way to overcome smaller rivals.

The preceding three paragraphs lay out a chain ofcause and effect that explains why Circuit City’s originalstrategy worked in the consumer electronics environ-ment. The strategist’s goal is to figure out whether thecausal logic holds up in the target environment. In prepar-ing to make that analysis, the strategy maker will find ituseful to compile two lists of industry features: those thatplay a crucial role in the causal logic and those that don’t.In the Circuit City example, the list of crucial elements

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logic. The question is whether the source and the targetare similar or different along these features.

Similarities usually spring to mind quickly. But theteam must also search actively for differences, seeking evi-dence that each essential feature of the source problem isabsent in the target. This process rarely comes naturally–it is often thwarted by the confirmation bias. The teamshould also do something else that doesn’t come natu-rally: ask whether the similarities are largely superficial. Thelist of industry features that are not crucial in the causallogic is very useful in this step. If many of the similaritiesare on this list rather than the list of crucial correspon-dences, the management team should sound an alarm.The analogy may be based on superficial similarity.

Circuit City’s entry into the used-car market illustratesthe process of assessing similarity. In many ways, the tar-get industry in the 1990s resembled the consumer elec-tronics retailing industry of the 1970s:• Many customers were unsatisfied with, and distrustfulof, current retailers.

• Economies of scale and barriers to entry were limited.• The industry was fragmented.• Information and distribution technologies remainedfairly primitive, even though the inventory was highlydiverse.

• Consumers incurred few costs if they switched fromone retailer to another.

Note that all of these similarities match crucial ele-ments of the causal logic in electronics retailing. Thisbodes well for the analogy. On the other hand, there wereimportant differences:• In consumer electronics, Circuit City could rely on alarge base of dependable, reputable suppliers. In con-trast, most used-car dealers bought their autos from individual sellers or from wholesalers, some reliableand some not.

• The inventory of used cars was even more diverse thanthat of consumer electronics. It would be difficult tokeep a predictable range of products in stock. Thismight make it hard for CarMax to detect sales trendsquickly and adjust its inventory to meet demand.Moreover, the distribution expertise Circuit City haddeveloped might not be useful in the used-car industry.

• It was not clear whether economies of scale existed orbarriers to entry could be built in auto retailing.

• The used-car retailing market had an important substi-tute at the high end of the market: new-car dealers.

Translate, decide, and adapt. The final step is to decidewhether the original strategy, properly translated, willwork in the target industry. This step requires, first, thatthe management team say clearly what the strategywould look like in the new setting. Precisely what wouldit take to be the Circuit City of the used-car industry orthe supermarket of toys? This requires some adjustment.Even the best analogies involve some differences between



Background of the Work Field research sparked our interest in analogical reasoning.While exploring the origins of strategies in the Internet portalindustry, we were struck by the prevalence of analogies. Discus-sions with managers and academic colleagues, along with per-sonal reflections, led us to recognize the broader significance of analogical reasoning in strategy making. This recognitionfueled a series of efforts, including a review of the literature on analogy in psychology, cognitive science, political science,and linguistics; an initiative to examine and improve the use of analogical reasoning in the MBA classroom; and develop-ment, with Wharton’s Daniel Levinthal, of a simulation in whichcomputer-modeled “managers” use analogical reasoning tosolve strategic problems. Perhaps the crucial ingredient in theresearch is that we – the authors of this article – come from verydifferent academic backgrounds. One of us was raised withinWharton’s behavioral approach to management, which em-phasizes the limits on human reasoning, and the other comesfrom Harvard’s strategy tradition, which stresses the power of rational economic choice. Analogical reasoning lies in themiddle ground between the two of us. It is a form of reasoningthat is potent because it makes the most of bounded cognitiveabilities.

includes the following features of the pre–Circuit Cityelectronics retailing industry:• unsatisfied customer needs, especially for product se-lection, product availability, and trustworthy retailers;

• untapped economies of scale and latent, but largely unrealized, barriers to entry;

• a fragmented base of rivals, many of them weak;• unexploited opportunities to apply information anddistribution technologies for better inventory man-agement;

• branded, powerful, reliable suppliers;• modest switching costs among consumers; and• an absence of goods that are close substitutes at thehigh end of the market.

At least one notable feature of the industry appears notto have played a major role in the causal logic, accordingto our analysis. Demand for consumer electronics wasgrowing rapidly when Circuit City became a success, butthe industry growth rate does not loom large in the causalstory. The sheer size of the industry plays a role–withouta critical mass of demand, economies of scale cannot betapped – but the growth rate does not seem critical.

Assess similarity. The strategist now maps similaritiesbetween the source and the target and determines whetherthe resemblance is more than superficial. The under-standing of the source that he or she has built up is cru-cial in this step. Rather than wrestling with the entire tar-get problem, which is much less familiar than the source,the strategist can focus on the key features of the causal

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the source and the target settings. By now, executives havea sense of the most important differences, and, in trans-lating the strategy, they try to make adjustments that dealwith them. After the translation comes a go-no-go deci-sion on whether to pursue the analogy in the market-place. This involves a clearheaded assessment of whetherthe translated strategy is likely to fare well in the new con-text. If executives opt to pursue the analogy, they face an-other round of adjustment–adapting in the marketplacein response to feedback from customers, rivals, suppliers,and others. It is here, in the market, that managers trulylearn how good their analogies are.

Circuit City’s translated strategy bore a close resem-blance to the company’s electronics retailing operation.On lots of up to 14 acres, each CarMax superstore offeredan unusually broad inventory of 200 to 550 vehicles. Car-Max went to special lengths to foster customers’ trust. Itsold cars at fixed, posted prices, with no haggling. It hiredsalespeople with retailing experience, but not auto retail-ing experience, and gave them extensive training. CarMaxcompensated salespeople with a flat fee per vehicle soldrather than a fraction of the revenue they generated. Thecompany also put in place a sophisticated inventory track-ing system that mirrored the electronics retailing system,and it offered money-back guarantees and warranties thatresembled those in Circuit City stores.

At the same time, CarMax adjusted the Circuit City for-mula to reflect the differences between the two settings.This required, for instance, that the company find reliablesources of used cars. Toward this end, CarMax placed well-trained buyers in each of its stores and offered to buyused cars directly from consumers, even those who didnot intend to buy a vehicle from CarMax. The companystarted to sell new cars at some sites, in part to generateused cars from trade-ins. By 2002, individual consumerswere CarMax’s single largest source of used cars. Regard-less of source, all CarMax used cars were thoroughly in-spected and reconditioned before they were resold.

The diverse inventory of used cars presented a newchallenge. No single used-car lot could show the full arrayof vehicles in CarMax’s inventory. So CarMax developeda computer system that allowed consumers to peruse thecompany’s full inventory. The system told customers whatwas available nationwide and what it would cost to trans-fer a desired car to the customer’s locale.

CarMax was neither an immediate nor an unmixed suc-cess. It took Circuit City most of a decade to tailor its for-mula to the used-car market. The company built somestores that were too large and adopted an overly ambi-tious rollout plan, and price wars in the new-car marketand expansion by other used-car superstores occasionallyhurt its stock price. Nonetheless, the effort to reproduceCircuit City’s success in the used-car industry has pro-duced a viable company with revenue of $4.6 billion in fis-cal year 2004, a return on sales of 2% to 3%, a multibillion-

april 2005 63


dollar market capitalization, and equity whose returnshave roughly matched the S&P 500’s since the IPO in1997. This positive outcome reflects the close resemblancebetween the electronics retailing industry and the used-car industry, especially in features pertinent to the causallogic of the original success. It also reflects the company’scareful attention to the essential differences between theindustries – or at least the company’s ability to adapt tothose differences.

A critical question in this final step is how much a com-pany should translate the candidate solution, on the basisof forethought alone, before launching it in the market-place. In studying the transfer of best practices withincompanies, say from one bank branch to another, Insead’sGabriel Szulanski and Wharton’s Sidney Winter havefound that managers overestimate how well they under-stand cause and effect relationships and, accordingly, ad-just too much on the basis of forethought. This lesson ap-plies to analogies, too. It makes sense to adjust a candidatesolution beforehand to account for glaring differences be-tween the target and the source. But in novel, uncertainenvironments, where strategists rely the most on analo-gies, it is often wise to hold off on fine-tuning the solutionuntil the market can give its guidance.

Toward Better Strategic ChoicesAnalogies lie on a spectrum. At one end lie perfect analo-gies, where the source and target are truly alike on the di-mensions that drive economic performance. The toy re-tailing industry of the 1950s deeply resembled the grocerybusiness, much to the benefit of Toys R Us, and the de-mands on Toyota’s kanban system closely mirrored thoserelated to supermarket reshelving. At the opposite end ofthe spectrum are profoundly problematic analogies, suchas Enron’s comparison of broadband and natural gas trad-ing, that are based on superficial similarities yet plaguedby underlying differences. The vast majority of analogiesfall somewhere in between–they’re imperfect but useful.The challenge is to get the most out of them. In our ex-perience, the best users of analogy harness deduction andtrial and error to test and improve the analogies that liein the middle of the spectrum. Intel’s analogy involvingthe steel industry, for instance, was supported by a de-ductive theory of cause and effect–Clayton Christensen’sideas about disruptive technologies. It also drew strengthfrom trial-and-error experiments that gradually refinedIntel’s approach to the low end of the microprocessormarket, much as Circuit City’s adjustments served to fine-tune CarMax’s strategy. Managers who wish to tap thegreat power of analogy and sidestep its pitfalls must mas-ter multiple modes of thought.

Reprint r0504c; HBR OnPoint 9661To order, see page 135.

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ost developmental psychologists agree that what differentiates leaders is not so much their philosophy of leadership, their personality, or their style of management.

Rather, it’s their internal “action logic”– how they interpret theirsurroundings and react when their power or safety is challenged.Relatively few leaders, however, try to understand their own actionlogic, and fewer still have explored the possibility of changing it.

They should, because we’ve found that leaders who do under-take a voyage of personal understanding and development cantransform not only their own capabilities but also those of theircompanies. In our close collaboration with psychologist SusanneCook-Greuter – and our 25 years of extensive survey-based con-sulting at companies such as Deutsche Bank, Harvard PilgrimHealth Care, Hewlett-Packard, NSA, Trillium Asset Management,Aviva, and Volvo – we’ve worked with thousands of executives asthey’ve tried to develop their leadership skills. The good news isthat leaders who make an effort to understand their own actionlogic can improve their ability to lead. But to do that, it’s importantfirst to understand what kind of leader you already are.

M

Leaders are made, not born, and how they develop is critical for organizational change.

Transformations of Leadership

BR

IAN

CR

ON

IN

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by David Rooke and William R. Torbert

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The Seven Action LogicsOur research is based on a sentence-completion surveytool called the Leadership Development Profile. Usingthis tool, participants are asked to complete 36 sentencesthat begin with phrases such as “A good leader…,” towhich responses vary widely:

“…cracks the whip.”“…realizes that it’s important to achieve good perfor-

mance from subordinates.”“…juggles competing forces and takes responsibility

for her decisions.”By asking participants to complete sentences of this

type, it’s possible for highly trained evaluators to paint apicture of how participants interpret their own actionsand the world around them; these “pictures” show whichone of seven developmental action logics – Opportunist,Diplomat, Expert, Achiever, Individualist, Strategist, or Al-chemist – currently functions as a leader’s dominant wayof thinking. Leaders can move through these categories astheir abilities grow, so taking the Leadership Develop-ment Profile again several years later can reveal whethera leader’s action logic has evolved.

Over the past 25 years, we and other researchers haveadministered the sentence-completion survey to thou-sands of managers and professionals, most between theages of 25 and 55, at hundreds of American and Euro-pean companies (as well as nonprofits and governmentalagencies) in diverse industries. What we found is that thelevels of corporate and individual performance vary ac-cording to action logic. Notably, we found that the threetypes of leaders associated with below-average corpo-rate performance (Opportunists, Diplomats, and Experts)accounted for 55% of our sample. They were significantlyless effective at implementing organizational strategiesthan the 30% of the sample who measured as Achievers.Moreover, only the final 15% of managers in the sample(Individualists, Strategists, and Alchemists) showed theconsistent capacity to innovate and to successfully trans-form their organizations.

To understand how leaders fall into such distinct cate-gories and corporate performance, let’s look in more de-tail at each leadership style in turn, starting with the leastproductive (and least complex).

The Opportunist Our most comforting finding was that only 5% of the lead-ers in our sample were characterized by mistrust, ego-centrism, and manipulativeness. We call these leadersOpportunists, a title that reflects their tendency to focus

on personal wins and see the world and other people asopportunities to be exploited. Their approach to the out-side world is largely determined by their perception ofcontrol – in other words, how they will react to an eventdepends primarily on whether or not they think they candirect the outcome. They treat other people as objects oras competitors who are also out for themselves.

Opportunists tend to regard their bad behavior as le-gitimate in the cut and thrust of an eye-for-an-eye world.They reject feedback, externalize blame, and retaliateharshly. One can see this action logic in the early work ofLarry Ellison (now CEO of Oracle). Ellison describes hismanagerial style at the start of his career as “managementby ridicule.”“You’ve got to be good at intellectual intimi-dation and rhetorical bullying,” he once told MatthewSymonds of the Economist. “I’d excuse my behavior bytelling myself I was just having ‘an open and honest de-bate.’ The fact is, I just didn’t know any better.”

Few Opportunists remain managers for long, unlessthey transform to more effective action logics (as Ellisonhas done). Their constant firefighting, their style of self-aggrandizement, and their frequent rule breaking is theantithesis of the kind of leader people want to work withfor the long term. If you have worked for an Opportunist,you will almost certainly remember it as a difficult time.By the same token, corporate environments that breedopportunism seldom endure, although Opportunistsoften survive longer than they should because they pro-vide an exciting environment in which younger execu-tives, especially, can take risks. As one ex-Enron seniorstaffer said, “Before the fall, those were such excitingyears. We felt we could do anything, pull off everything,write our own rules. The pace was wild, and we all justrode it.” Of course, Enron’s shareholders and pensionerswould reasonably feel that they were paying too heavilyfor that staffer’s adventure.

The Diplomat The Diplomat makes sense of the world around him ina more benign way than the Opportunist does, but thisaction logic can also have extremely negative repercus-sions if the leader is a senior manager. Loyally serving thegroup, the Diplomat seeks to please higher-status col-leagues while avoiding conflict. This action logic is fo-cused on gaining control of one’s own behavior – morethan on gaining control of external events or other peo-ple. According to the Diplomat’s action logic, a leadergains more enduring acceptance and influence by coop-erating with group norms and by performing his dailyroles well.


Seven Transformations of Leadership

David Rooke ([email protected]) is a partner at Harthill Consulting in Hewelsfield, England. William R. Torbert ([email protected]) is a professor at Boston College’s Carroll School of Management in Massachusetts. They are coauthors of Action Inquiry: The Secret of Timely and Transforming Leadership (Berrett-Koehler, 2004).

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In a support role or a team context, this type of execu-tive has much to offer. Diplomats provide social glue totheir colleagues and ensure that attention is paid to theneeds of others, which is probably why the great majorityof Diplomats work at the most junior rungs of manage-ment, in jobs such as frontline supervisor, customer ser-

vice representative, or nurse practitioner. Indeed, researchinto 497 managers in different industries showed that 80%of all Diplomats were at junior levels. By contrast, 80% ofall Strategists were at senior levels, suggesting that manag-ers who grow into more effective action logics–like that ofthe Strategist –have a greater chance of being promoted.

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Seven Ways of LeadingDifferent leaders exhibit different kinds of action logic – ways in which they interpret their surroundings and react when

their power or safety is challenged. In our research of thousands of leaders, we observed seven types of action logics.

The least effective for organizational leadership are the Opportunist and Diplomat; the most effective, the Strategist

and Alchemist. Knowing your own action logic can be the first step toward developing a more effective leadership style.

If you recognize yourself as an Individualist, for example, you can work, through both formal and informal measures,

to develop the strengths and characteristics of a Strategist.

Action Logic

Opportunist

Diplomat

Expert

Achiever

Individualist

Strategist

Alchemist

5%

12%

38%

30%

10%

4%

1%

Characteristics

Wins any way possible. Self-oriented;

manipulative; “might makes right.”

Avoids overt conflict. Wants to belong;

obeys group norms; rarely rocks the

boat.

Rules by logic and expertise. Seeks

rational efficiency.

Meets strategic goals. Effectively

achieves goals through teams; juggles

managerial duties and market

demands.

Interweaves competing personal and

company action logics. Creates unique

structures to resolve gaps between

strategy and performance.

Generates organizational and personal

transformations. Exercises the power

of mutual inquiry, vigilance, and

vulnerability for both the short and

long term.

Generates social transformations. Inte-

grates material, spiritual, and societal

transformation.

Strengths

Good in emergencies and

in sales opportunities.

Good as supportive glue

within an office; helps bring

people together.

Good as an individual

contributor.

Well suited to managerial

roles; action and goal

oriented.

Effective in venture and

consulting roles.

Effective as a transforma-

tional leader.

Good at leading society-wide

transformations.

% of research sample profiling atthis action logic

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Diplomats are much more problematic in top leader-ship roles because they try to ignore conflict. They tend tobe overly polite and friendly and find it virtually impos-sible to give challenging feedback to others. Initiatingchange, with its inevitable conflicts, represents a gravethreat to the Diplomat, and he will avoid it if at all possi-ble, even to the point of self-destruction.

Consider one Diplomat who became the interim CEOof an organization when his predecessor died suddenlyfrom an aneurysm. When the board split on the selectionof a permanent successor, it asked the Diplomat to carryon. Our Diplomat relished his role as a ceremonial figure-head and was a sought-after speaker at public events. Un-fortunately, he found the more conflictual requirementsof the job less to his liking. He failed, for instance, to re-place a number of senior managers who had serious ongoing performance issues and were resisting thechange program his predecessor had initiated. Becausethe changes were controversial, the Diplomat avoidedmeetings, even planning business trips for the times whenthe senior team would meet. The team members were sofrustrated by the Diplomat’s attitude that they eventuallyresigned en masse. He “resolved” this crisis by thankingthe team publicly for its contribution and appointing newteam members. Eventually, in the face of mounting lossesarising from this poor management, the board decided todemote the Diplomat to his former role as vice president.

The ExpertThe largest category of leader is that of Experts, who ac-count for 38% of all professionals in our sample. In con-trast to Opportunists, who focus on trying to control theworld around them, and Diplomats, who concentrate oncontrolling their own behavior, Experts try to exercisecontrol by perfecting their knowledge, both in their pro-fessional and personal lives. Exercising watertight think-ing is extremely important to Experts. Not surprisingly,many accountants, investment analysts, marketing re-searchers, software engineers, and consultants operatefrom the Expert action logic. Secure in their expertise,they present hard data and logic in their efforts to gainconsensus and buy-in for their proposals.

Experts are great individual contributors because oftheir pursuit of continuous improvement, efficiency, andperfection. But as managers, they can be problematic be-cause they are so completely sure they are right. Whensubordinates talk about a my-way-or-the-highway typeof boss, they are probably talking about someone oper-ating from an Expert action logic. Experts tend to viewcollaboration as a waste of time (“Not all meetings are awaste of time – some are canceled!”), and they will fre-quently treat the opinion of people less expert than them-selves with contempt. Emotional intelligence is neitherdesired nor appreciated. As Sun Microsystems’ CEO Scott

McNealy put it: “I don’t do feelings; I’ll leave that to BarryManilow.”

It comes as no surprise, then, that after unsuccessfullypleading with him to scale back in the face of growinglosses during the dot-com debacle of 2001 and 2002,nearly a dozen members of McNealy’s senior manage-ment team left.

The AchieverFor those who hope someday to work for a manager whoboth challenges and supports them and creates a positiveteam and interdepartmental atmosphere, the good newsis that a large proportion, 30%, of the managers in our re-search measured as Achievers. While these leaders createa positive work environment and focus their efforts ondeliverables, the downside is that their style often inhibitsthinking outside the box.

Achievers have a more complex and integrated under-standing of the world than do managers who display thethree previous action logics we’ve described. They’re opento feedback and realize that many of the ambiguities andconflicts of everyday life are due to differences in inter-pretation and ways of relating. They know that creativelytransforming or resolving clashes requires sensitivity torelationships and the ability to influence others in posi-tive ways. Achievers can also reliably lead a team to im-plement new strategies over a one- to three-year period,balancing immediate and long-term objectives. One studyof ophthalmologists in private practice showed that thosewho scored as Achievers had lower staff turnover, dele-gated more responsibility, and had practices that earnedat least twice the gross annual revenues of those run byExperts.

Achievers often find themselves clashing with Experts.The Expert subordinate, in particular, finds the Achieverleader hard to take because he cannot deny the reality ofthe Achiever’s success even though he feels superior. Con-sider Hewlett-Packard, where the research engineers tendto score as Experts and the lab managers as higher-levelAchievers. At one project meeting, a lab manager – a de-cided Achiever – slammed her coffee cup on the tableand exclaimed, “I know we can get 18 features into this,but the customers want delivery some time this century,and the main eight features will do.”“Philistine!” snortedone engineer, an Expert. But this kind of conflict isn’t al-ways destructive. In fact, it provides much of the fuel thathas ignited–and sustained–the competitiveness of manyof the country’s most successful corporations.

The Individualist The Individualist action logic recognizes that neither itnor any of the other action logics are “natural”; all areconstructions of oneself and the world. This seemingly ab-



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stract idea enables the 10% of Individualist leaders to con-tribute unique practical value to their organizations; theyput personalities and ways of relating into perspectiveand communicate well with people who have other ac-tion logics.

What sets Individualists apart from Achievers is theirawareness of a possible conflict between their princi-ples and their actions, or between the organization’s val-ues and its implementation of those values. This conflictbecomes the source of tension, creativity, and a growingdesire for further development.

Individualists also tend to ignore rules they regard asirrelevant, which often makes them a source of irritationto both colleagues and bosses. “So, what do you think?”one of our clients asked us as he was debating whether

to let go of one of his star performers, a woman who hadbeen measured as an Individualist. Sharon (not her realname) had been asked to set up an offshore shared ser-vice function in the Czech Republic in order to provideIT support to two separate and internally competitivedivisions operating there. She formed a highly cohesiveteam within budget and so far ahead of schedule thatshe quipped that she was “delivering services beforeGroup Business Risk had delivered its report saying itcan’t be done.”

The trouble was that Sharon had a reputation withinthe wider organization as a wild card. Although sheshowed great political savvy when it came to her individ-ual projects, she put many people’s noses out of joint inthe larger organization because of her unique, unconven-tional ways of operating. Eventually, the CEO was calledin (not for the first time) to resolve a problem created byher failure to acknowledge key organizational processesand people who weren’t on her team.

Many of the dynamics created by different action log-ics are illustrated by this story and its outcome. The CEO,whose own action logic was that of an Achiever, did notsee how he could challenge Sharon to develop and movebeyond creating such problems. Although ambivalentabout her, he decided to retain her because she was de-livering and because the organization had recently lostseveral capable, if unconventional, managers.

So Sharon stayed, but only for a while. Eventually, sheleft the company to set up an offshoring consultancy.When we examine in the second half of this article how

to help executives transform their leadership action log-ics, we’ll return to this story to see how both Sharon andthe CEO might have succeeded in transforming theirs.

The StrategistStrategists account for just 4% of leaders. What sets themapart from Individualists is their focus on organizationalconstraints and perceptions, which they treat as discuss-able and transformable. Whereas the Individualist mas-ters communication with colleagues who have differentaction logics, the Strategist masters the second-order or-ganizational impact of actions and agreements. The Strat-egist is also adept at creating shared visions across differ-ent action logics – visions that encourage both personal

and organizational transformations.According to the Strat-egist’s action logic, organizational and social change is aniterative developmental process that requires awarenessand close leadership attention.

Strategists deal with conflict more comfortably than dothose with other action logics, and they’re better at han-dling people’s instinctive resistance to change. As a result,Strategists are highly effective change agents. We foundconfirmation of this in our recent study of ten CEOs insix different industries. All of their organizations had thestated objective of transforming themselves and had en-gaged consultants to help with the process.Each CEO filledout a Leadership Development Profile, which showedthat five of them were Strategists and the other five fellinto other action logics. The Strategists succeeded in gen-erating one or more organizational transformations overa four-year period; their companies’ profitability, marketshare, and reputation all improved. By contrast, only twoof the other five CEOs succeeded in transforming theirorganizations–despite help from consultants, who them-selves profiled as Strategists.

Strategists are fascinated with three distinct levels ofsocial interplay: personal relationships, organizational re-lations, and national and international developments.Consider Joan Bavaria, a CEO who, back in 1985, measuredas a Strategist. Bavaria created one of the first socially re-sponsible investment funds, a new subdivision of the in-vestments industry, which by the end of 2001 managedmore than $3 trillion in funds. In 1982, Bavaria foundedTrillium Asset Management, a worker-owned company,

Initiating change, with its inevitable conflicts, represents a grave threat to the Diplomat, and he will avoid it if at all possible, even to the point of self-destruction.

TLFeBOOK

which she still heads. She also cowrote the CERES Envi-ronmental Principles, which dozens of major companieshave signed. In the late 1990s, CERES, working with theUnited Nations, created the Global Reporting Initiative,which supports financial, social, and environmental trans-parency and accountability worldwide.

Here we see the Strategist action logic at work. Bavariasaw a unique moment in which to make ethical investinga viable business, then established Trillium to execute herplan. Strategists typically have socially conscious businessideas that are carried out in a highly collaborative man-ner.They seek to weave together idealist visions with prag-matic, timely initiatives and principled actions. Bavariaworked beyond the boundaries of her own organizationto influence the socially responsible investment industryas a whole and later made the development of social andenvironmental accountability standards an internationalendeavor by involving the United Nations. Many Achiev-ers will use their influence to successfully promote theirown companies. The Strategist works to create ethicalprinciples and practices beyond the interests of herself orher organization.

The AlchemistThe final leadership action logic for which we have dataand experience is the Alchemist. Our studies of the fewleaders we have identified as Alchemists suggest that whatsets them apart from Strategists is their ability to renewor even reinvent themselves and their organizations inhistorically significant ways. Whereas the Strategist willmove from one engagement to another, the Alchemisthas an extraordinary capacity to deal simultaneously withmany situations at multiple levels. The Alchemist can talkwith both kings and commoners. He can deal with imme-diate priorities yet never lose sight of long-term goals.

Alchemists constitute 1% of our sample, which indicateshow rare it is to find them in business or anywhere else.Through an extensive search process, we found six Al-chemists who were willing to participate in an up-closestudy of their daily actions. Though this is obviously avery small number that cannot statistically justify gener-alization, it’s worth noting that all six Alchemists sharedcertain characteristics. On a daily basis, all were engagedin multiple organizations and found time to deal with is-sues raised by each. However, they were not in a constantrush – nor did they devote hours on end to a single activ-ity. Alchemists are typically charismatic and extremelyaware individuals who live by high moral standards. Theyfocus intensely on the truth. Perhaps most important,they’re able to catch unique moments in the history oftheir organizations, creating symbols and metaphorsthat speak to people’s hearts and minds. In one conser-vative financial services company in the UK, a recently appointed CEO turned up for work in a tracksuit instead

of his usual pinstripes but said nothing about it to any-one. People wondered whether this was a new dress code.Weeks later, the CEO spoke publicly about his attire andthe need to be unconventional and to move with greateragility and speed.

A more celebrated example of an Alchemist is NelsonMandela. Although we never formally profiled Mandela,he exemplifies the Alchemist action logic. In 1995, Man-dela symbolized the unity of a new South Africa whenhe attended the Rugby World Cup game in which theSpringboks, the South African national team, were play-ing. Rugby had been the bastion of white supremacy, butMandela attended the game. He walked on to the pitchwearing the Springboks’ jersey so hated by black SouthAfricans, at the same time giving the clenched fist saluteof the ANC, thereby appealing, almost impossibly, both toblack and white South Africans. As Tokyo Sexwale, ANCactivist and premier of South Africa’s Gauteng province,said of him: “Only Mandela could wear an enemy jersey.Only Mandela would go down there and be associatedwith the Springboks… All the years in the underground,in the trenches, denial, self-denial, away from home,prison, it was worth it. That’s all we wanted to see.”

Evolving as a LeaderThe most remarkable – and encouraging – finding fromour research is that leaders can transform from one actionlogic to another. We have, in fact, documented a numberof leaders who have succeeded in transforming them-selves from Experts into Achievers, from Achievers intoIndividualists, and from Individualists into Strategists.

Take the case of Jenny, one of our clients, who initiallymeasured as an Expert. She became disillusioned withher role in her company’s PR department and resigned inorder to, as she said,“sort out what I really want to do.”Sixmonths later, she joined a different company in a similarrole, and two years after that we profiled her again andshe still measured as an Expert. Her decision to resignfrom the first company, take a “sabbatical,” and then jointhe second company had made no difference to her actionlogic. At that point, Jenny chose to join a group of peerleaders committed to examining their current leadershippatterns and to experimenting with new ways of acting.This group favored the Strategist perspective (and thefounder of the group was profiled as an Alchemist), whichin the end helped Jenny’s development. She learned thather habit of consistently taking a critical position, whichshe considered “usefully objective,” isolated her and gen-erated distrust. As a result of the peer group’s feedback,she started a series of small and private experiments, suchas asking questions rather than criticizing. She realizedthat instead of seeing the faults in others, she had to beclear about what she could contribute and, in doing so,started the move from an Expert to an Achiever. Spiritu-



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ally, Jenny learned that sheneeded an ongoing commu-nity of inquiry at the centerof her life and found a spiri-tual home for continuing re-flection in Quaker meetings,which later supported (andindeed signaled) her transi-tion from an Achiever to anIndividualist.

Two years later, Jenny leftthe second job to start herown company, at which pointshe began profiling as a Strat-egist. This was a highly un-usual movement of three ac-tion logics in such a shorttime. We have had only twoother instances in which aleader has transformed twicein less than four years.

As Jenny’s case illustrates,there are a number of per-sonal changes that can sup-port leadership transforma-tion. Jenny experienced lossof faith in the system and feel-ings of boredom, irritability,burnout, depression, and evenanger. She began to ask her-self existential questions. Butanother indication of a lead-er’s readiness to transform is an increasing attraction tothe qualities she begins to intuit in people with more ef-fective action logics. Jenny, as we saw, was drawn to andbenefited hugely from her Strategist peer group as well asfrom a mentor who exhibited the Alchemist action logic.This search for new perspectives often manifests itself inpersonal transformations: The ready-to-transform leaderstarts developing new relationships. She may also explorenew forms of spiritual practice or new forms of centeringand self-expression, such as playing a musical instrumentor doing tai chi.

External events can also trigger and support transfor-mation. A promotion, for example, may give a leader theopportunity to expand his or her range of capabilities.Earlier, we cited the frustration of Expert research engi-neers at Hewlett-Packard with the product and deliveryattitude of Achiever lab managers. Within a year of oneengineer’s promotion to lab manager, a role that requiredcoordination of others and cooperation across depart-ments, the former Expert was profiling as an Achiever. Al-though he initially took some heat (“Sellout!”) from hisformer buddies, his new Achiever awareness meant thathe was more focused on customers’ needs and clearer

about delivery schedules. For the first time, he under-stood the dance between engineers trying to perfect thetechnology and managers trying to deliver on budget andon schedule.

Changes to a manager’s work practices and environ-ment can also facilitate transformation. At one companywe studied, leaders changed from Achievers to Individu-alists partly because of simple organizational and processchanges. At the company’s senior manager meetings, forexample, executives other than the CEO had the chanceto lead the meetings; these opportunities, which weresupported by new spirit of openness, feedback, and frankdebate, fostered professional growth among many of thecompany’s leaders.

Planned and structured development interventions areanother means of supporting leadership transformation.We worked with a leading oil and gas exploration com-pany on developing the already high-level capabilities ofa pool of future senior managers; the managers wereprofiled and then interviewed by two consultants whoexplored each manager’s action logic and how it con-strained and enabled him or her to perform current andrecent roles. Challenges were discussed as well as a view

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of the individual’s potential and a possible developmen-tal plan. After the exercise, several managers, whose Indi-vidualist and Strategist capabilities had not been fully un-derstood by the company, were appreciated and engageddifferently in their roles. What’s more, the organization’sown definition of leadership talent was reframed to in-clude the capabilities of the Individualist and Strategistaction logics. This in turn demanded that the companyradically revisit its competency framework to incorporatesuch expectations as “sees issues from multiple perspec-tives” and “creates deep change without formal power.”

Now that we’ve looked generally at some of the changesand interventions that can support leadership develop-ment, let’s turn to some specifics about how the mostcommon transformations are apt to take place.

From Expert to AchieverThis transformation is the most commonly observed andpracticed among businesspeople and by those in manage-ment and executive education. For the past generation ormore, the training departments of large companies havebeen supporting the development of managers from Ex-perts into Achievers by running programs with titles like“Management by Objectives,”“Effective Delegation,” and“Managing People for Results.” These programs typicallyemphasize getting results through flexible strategies ratherthan through one right method used in one right way.

Observant leaders and executive coaches can also for-mulate well-structured exercises and questions relatedto everyday work to help Experts become aware of thedifferent assumptions they and others may be making.

These efforts can help Experts practice new conversa-tional strategies such as,“You may be right, but I’d like tounderstand what leads you to believe that.” In addition,those wishing to push Experts to the next level shouldconsider rewarding Achiever competencies like timely de-livery of results, the ability to manage for performance,and the ability to implement strategic priorities.

Within business education, MBA programs are apt toencourage the development of the more pragmatic Achiev-ers by frustrating the perfectionist Experts. The heavyworkloads, use of multidisciplinary and ambiguous casestudies, and teamwork requirements all promote the de-velopment of Achievers. By contrast, MSc programs, in

particular disciplines such as finance or marketing re-search, tend to reinforce the Expert perspective.

Still, the transition from Expert to Achiever remainsone of the most painful bottlenecks in most organiza-tions. We’ve all heard the eternal lament of engineers,lawyers, and other professionals whose Expert success hassaddled them with managerial duties, only to estrangethem from the work they love. Their challenge becomesworking as highly effective Achievers who can continueto use their in-depth expertise to succeed as leaders andmanagers.

From Achiever to IndividualistAlthough organizations and business schools have beenrelatively successful in developing leaders to the Achieveraction logic, they have, with few exceptions, a dismalrecord in recognizing, supporting, and actively develop-ing leaders to the Individualist and Strategist action log-ics, let alone to the Alchemist logic. This is not surprising.In many organizations, the Achiever, with his drive andfocus on the endgame, is seen as the finish line for devel-opment: “This is a competitive industry–we need to keepa sharp focus on the bottom line.”

The development of leaders beyond the Achiever ac-tion logic requires a very different tack from that neces-sary to bring about the Expert-to-Achiever transforma-tion. Interventions must encourage self-awareness onthe part of the evolving leader as well as a greater aware-ness of other worldviews. In both business and personalrelationships, speaking and listening must come to beexperienced not as necessary, taken-for-granted ways of

communicating predetermined ideas but as intrinsicallyforward-thinking, creative actions. Achievers use inquiryto determine whether they (and the teams and organiza-tion to which they belong) are accomplishing their goalsand how they might accomplish them more effectively.The developing Individualist, however, begins to inquireabout and reflect on the goals themselves – with the aimof improving future goals. Annual development plansthat set new goals, are generated through probing andtrusting conversation, are actively supported throughexecutive coaching, and are carefully reviewed at the endof the cycle can be critical enablers at this point. Yet fewboards and CEOs appreciate how valuable this time in-



What sets Alchemists apart from Strategistsis their ability to renew or even reinvent themselves and theirorganizations in historically significant ways.

TLFeBOOK

vestment can be, and it is all too easily sacrificed in theface of short-term objectives, which can seem more press-ing to leaders whose action logics are less developed.

Let’s go back to the case of Sharon, the Individualist wedescribed earlier whose Achiever CEO wasn’t able to man-age her. How might a coach or consultant have helped theCEO feel less threatened by Sharon and more capable ofsupporting her development while also being more opento his own needs and potential? One way would havebeen to try role-playing, asking the CEO to play Sharonwhile the coach or consultant enacts the CEO role. Therole-playing might have gone as follows:

“Sharon, I want to talk with you about your future hereat our company. Your completion of the Czech projectunder budget and ahead of time is one more sign that youhave the initiative, creativity, and determination to makethe senior team here. At the same time, I’ve had to pick upa number of pieces after you that I shouldn’t have had to.I’d like to brainstorm together about how you can ap-proach future projects in a way that eliminates this has-sle and gets key players on your side. Then, we can chatseveral times over the next year as you begin to applywhatever new principles we come up with. Does this seemlike a good use of our time, or do you have a different per-spective on the issue?”

Note that the consultant in the CEO’s role offers clearpraise, a clear description of a limitation, a proposed pathforward, and an inquiry that empowers the CEO (playingSharon) to reframe the dilemma if he wishes. Thus, in-stead of giving the CEO one-way advice about what heshould do, the coach enacts a dialogic scenario with him,illustrating a new kind of practice and letting the CEOjudge whether the enacted relationship is a positive one.The point is not so much to teach the CEO a new conver-sational repertoire but to make him more comfortablewith how the Individualist sees and makes sense of theworld around her and what feedback may motivate herto commit to further learning. Such specific experimentswith new ways of listening and talking can gradually dis-solve the fears associated with transformational learning.

To Strategist and Beyond Leaders who are moving toward the Strategist and Al-chemist action logics are no longer primarily seekingpersonal skills that will make them more effective withinexisting organizational systems. They will already havemastered many of those skills. Rather, they are exploringthe disciplines and commitments entailed in creatingprojects, teams, networks, strategic alliances, and wholeorganizations on the basis of collaborative inquiry. It isthis ongoing practice of reframing inquiry that makesthem and their corporations so successful.

The path toward the Strategist and Alchemist actionlogics is qualitatively different from other leadership de-

velopment processes. For a start, emergent Strategists andAlchemists are no longer seeking mentors to help themsharpen existing skills and to guide them toward influen-tial networks (although they may seek spiritual and ethi-cal guidance from mentors). Instead, they are seeking toengage in mutual mentoring with peers who are alreadypart of their networks (such as board members, top man-agers, or leaders within a scientific discipline). The objec-tive of this senior-peer mentoring is not, in conventionalterms, to increase the chances of success but to create asustainable community of people who can challenge theemergent leader’s assumptions and practices and those ofhis company, industry, or other area of activity.

We witnessed just this kind of peer-to-peer develop-ment when one senior client became concerned that he,his company, and the industry as a whole were operatingat the Achiever level. This concern, of course, was itself asign of his readiness to transform beyond that logic. Thisexecutive–the CEO of a dental hygiene company–and hiscompany were among the most successful of the parentcompany’s subsidiaries. However, realizing that he andthose around him had been keeping their heads down, hechose to initiate a research project – on introducing af-fordable dental hygiene in developing countries–that wasdecidedly out of the box for him and for the corporation.

The CEO’s timing was right for such an initiative, andhe used the opportunity to engage in collaborative in-quiry with colleagues across the country. Eventually, heproposed an educational and charitable venture, whichthe parent company funded. The executive was promotedto a new vice presidency for international ventures withinthe parent company – a role he exercised with an in-creased sense of collaboration and a greater feeling of so-cial responsibility for his company in emerging markets.

Formal education and development processes can alsoguide individuals toward a Strategist action logic. Pro-grams in which participants act as leaders and challengetheir conventional assumptions about leading and orga-nizing are very effective. Such programs will be eitherlong term (one or two years) or repeated, intense experi-ences that nurture the moment-to-moment awareness ofparticipants, always providing the shock of dissonancethat stimulates them to reexamine their worldviews.Path-breaking programs of this type can be found at afew universities and consultancies around the globe. BathUniversity in the UK, for instance, sponsors a two-yearmaster’s degree in responsibility and business practice inwhich students work together during six one-week get-togethers. These programs involve small-learning teams,autobiographical writing, psychodrama, deep experiencesin nature, and a yearlong business project that involvesaction and reflection. Interestingly, many people who at-tend these programs report that these experiences havehad the transformative power of a life-altering event, suchas a career or existential crisis or a new marriage.

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Leadership Teams and LeadershipCultures Within OrganizationsSo far, our discussion has focused on the leadership stylesof individuals. But we have found that our categories ofleadership styles can be used to describe teams and orga-nizations as well. Here we will talk briefly about the ac-tion logics of teams.

Over the long term, the most effective teams are thosewith a Strategist culture, in which the group sees businesschallenges as opportunities for growth and learning onthe part of both individuals and the organization. A lead-ership team at one of the companies we worked with de-cided to invite managers from across departments to par-ticipate in time-to-market new product teams. Seen as arisky distraction, few managers volunteered, except forsome Individualists and budding Strategists. However, se-nior management provided sufficient support and feed-back to ensure the teams’ early success. Soon, the firstparticipants were promoted and leading their own cross-departmental teams. The Achievers in the organization,seeing that others were being promoted, started volun-teering for these teams. Gradually, more people withinthe organization were experiencing shared leadership,mutual testing of one another’s assumptions and prac-tices, and individual challenges that contributed to theirdevelopment as leaders.

Sadly, few companies use teams in this way. Most seniormanager teams operate at the Achiever action logic–theyprefer unambiguous targets and deadlines, and workingwith clear strategies, tactics, and plans, often against tightdeadlines. They thrive in a climate of adversity (“Whenthe going gets tough, the tough get going”) and derivegreat pleasure from pulling together and delivering. Typ-ically, the team’s leaders and several other members willbe Achievers, with several Experts and perhaps one or twoIndividualists or Strategists (who typically feel ignored).Such Achiever teams are often impatient at slowing downto reflect, are apt to dismiss questions about goals and as-sumptions as “endless philosophizing,” and typically re-spond with hostile humor to creative exercises, callingthem “off-the-wall” diversions. These behaviors will ulti-mately limit an Achiever team’s success.

The situation is worse at large,mature companies wheresenior management teams operate as Experts. Here, vicepresidents see themselves as chiefs and their “teams” asan information-reporting formality. Team life is bereftof shared problem-solving, decision-making, or strategy-formulating efforts. Senior teams limited by the Diplomataction logic are even less functional. They are character-ized by strong status differences,undiscussable norms,andritual “court”ceremonies that are carefully stage-managed.

Individualist teams, which are more likely to be foundin creative, consulting, and nonprofit organizations, arerelatively rare and very different from Achiever, Expert,

and Diplomat teams. In contrast to Achiever teams, theymay be strongly reflective; in fact, excessive time may bespent reviewing goals, assumptions, and work practices.Because individual concerns and input are very importantto these teams, rapid decision making may be difficult.

But like individual people, teams can change their style.For instance, we’ve seen Strategist CEOs help Individualistsenior teams balance action and inquiry and so transforminto Strategist teams. Another example is an Achiever se-nior team in a financial services company we worked withthat was emerging from two years of harsh cost cuttingduring a market downturn. To adapt to a changing andgrowing financial services market, the company needed tobecome significantly more visionary and innovative andlearn how to engage its workforce. To lead this transfor-mation, the team had to start with itself. We worked withit to help team members understand the constraints ofthe Achiever orientation, which required a number of in-terventions over time. We began by working to improvethe way the team discussed issues and by coaching indi-vidual members, including the CEO. As the team evolved,it became apparent that its composition needed to change:Two senior executives, who had initially seemed ideallysuited to the group because of their achievements, had tobe replaced when it became clear that they were unwill-ing to engage and experiment with the new approach.

During this reorientation, which lasted slightly morethan two years, the team became an Individualist groupwith emergent Strategist capabilities. The CEO, who hadprofiled at Achiever/Individualist, now profiled as a Strate-gist, and most other team members showed one develop-mental move forward. The impact of this was also felt inthe team’s and organization’s ethos: Once functionallydivided, the team learned to accept and integrate the diverse opinions of its members. Employee surveys re-ported increased engagement across the company. Out-siders began seeing the company as ahead of the curve,which meant the organization was better able to attracttop talent. In the third year, bottom- and top-line resultswere well ahead of industry competitors.

• • •The leader’s voyage of development is not an easy one.Some people change little in their lifetimes; some changesubstantially. Despite the undeniably crucial role of ge-netics, human nature is not fixed. Those who are willingto work at developing themselves and becoming moreself-aware can almost certainly evolve over time into trulytransformational leaders. Few may become Alchemists,but many will have the desire and potential to become In-dividualists and Strategists. Corporations that help theirexecutives and leadership teams examine their action log-ics can reap rich rewards.

Reprint r0504dTo order, see page 135.



TLFeBOOK

How to light up a supply chain.Advance Transformer, a leading component manufacturerfor lighting systems, had legacy IT systems that no longerkept up with production demands. They turned to HP tobetter manage their supply chain. Now, using an IT ServiceManagement approach with HP OpenView software and HP BladeSystem servers, their systems automatically solve problems as they occur. All this has reduced production time from 28 to 5 days, cut inventory levels by 50% andrevealed the bright side of change. www.hp.com/adapt

Solutions for the adaptive enterprise. ©2004 Hewlett-Packard Development Company, L.P.

TLFeBOOK

http://www.hp.com/adapt

hatever your business, consider for a moment the remarkable turnaround over the past decade in the U.S. banking indus-

try. In the early 1990s, the industry – rocked by theLatin American debt crisis, a major real estate bust,and economic recession – suffered massive loanlosses, erratic earnings, and the highest rate of bankfailures since the Depression. A decade later, asmuch of the economy reeled from the dot-com bustand another recession, banks were generally flour-ishing. The number of bad loans was down, earningswere relatively stable, and the banking industry wasoutperforming the market as a whole.


by Adrian J. Slywotzky and John Drzik

MA

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CounteringtheBiggestRisk of All

t

You’re insured and hedged against

many risks–but not the greatest

ones, the strategic risks that can

disrupt or even destroy your

business. Learn to anticipate and

manage these threats systematically

and, in the process, turn some

of them into growth opportunities.

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The turnaround occurred in large part because bankswere able to develop new tools and techniques to counterrisk, in the process giving birth to an entirely new disci-pline of financial risk management. Sophisticated credit-scoring measures reduced banks’ credit losses. New formsof options, futures, and counterparty agreements allowedbanks to redistribute their financial risks. In fact, bankingregulations now require companies to employ financialmodels that quantify their market risks.

We cite this example because the risks that plaguedbanks 15 years ago are emblematic of the challenges thatcompanies across all industries increasingly face today.What if these companies could also employ tools andtechniques that would provide some protection againsta broad set of high-stakes risks?

These looming threats form a category we call strategicrisk – that is, the array of external events and trends thatcan devastate a company’s growth trajectory and share-holder value. The evidence of strategic risk is becomingever more apparent. In the past 20 years, there has beena dramatic decrease in the number of stocks receiving ahigh quality rating by Standard & Poor’s and a dramaticincrease in the number of low-quality stocks. (See the ex-hibit “A Hazardous Environment.”) And our own analysisindicates that from 1993 through 2003, more than one-third of Fortune 1,000 companies–only a fraction of whichwere in volatile high-technology industries – lost at least60% of their value in a single year.

So how should a company respond to threats of thismagnitude? The answer lies in devising and deploying asystematic approach to managing strategic risk.

Broadening the FocusThe discipline of risk management has made considerableprogress in recent years. Corporate treasurers and chieffinancial officers have become adept at quantifying andmanaging a wide range of risks: financial (for example,currency fluctuations), hazard (chemical spills), and op-erational (computer system failures). They defend them-selves against these risks through now tried-and-true toolssuch as hedging, insurance, and backup systems.

Spurred by the banking industry’s success in financialrisk management and by Sarbanes-Oxley’s rigorous stan-dards for corporate governance, some firms have beenadopting the practice of “enterprise risk management,”which seeks to integrate available risk management tech-niques in a comprehensive, organization-wide approach.

Many of these early adopters are at a rudimentary stage,in which they treat enterprise risk management as an ex-tension of their audit or regulatory compliance processes.Other companies are at a more advanced stage, in whichthey quantify risks and link them to capital allocation andrisk-transfer decisions. Even among these more advancedpractitioners, however, the focus of enterprise risk man-agement rarely encompasses more than financial, hazard,and operational risks. Most managers have not yet system-atically addressed the strategic risks that can be a muchmore serious cause of value destruction. (A method forassessing and responding to the strategic risks your com-pany faces is presented in the sidebar “A Manager’s Guideto Strategic Risk.”)

Strategic risks take a variety of forms that go beyondsuch familiar challenges as the possible failure of an ac-quisition or a product launch. A new technology mayovertake your product. (Think of how ACE inhibitors andcalcium channel blockers stole share in the hypertensiondrug market from beta-blockers and diuretics.) Gradualshifts in the market may slowly erode one of your brandsbeyond the point of viability. (Recall the demise of theOldsmobile brand.) Or rapidly shifting customer priori-ties may suddenly change your industry. (Consider howquickly baby boomer parents migrated from station wag-ons to minivans, catching most automakers off guard.)

The key to surviving strategic risks is knowing how toassess and respond to them. Devoting the resources to do


Countering the Biggest Risk of Al l

Adrian J. Slywotzky is a Boston-based managing director ofMercer Management Consulting and a coauthor of How toGrow When Markets Don’t (Warner Business Books, 2003).John Drzik is the president of New York–based Mercer OliverWyman, a global financial services consulting firm. The au-thors can be reached at [email protected].

1985

Low-quality stocks

High-quality stocks

1990 1995 2000 2003

41%

28%

19%16% 13%

35%

53%

63%67%

73%

A Hazardous EnvironmentOne measure of the increased strategic risks companies face

is the sharp drop in the percentage of the 3,000 S&P-rated

stocks receiving a high quality rating (based on S&P’s assess-

ment of a company’s ability to achieve long-term, stable earn-

ings growth) and the increase in the percentage of stocks re-

ceiving a low quality rating. High-quality stocks include those

rated A+, A, and A−. Low-quality stocks include those rated B,

B−, C, and D. (B+ stocks are omitted.)

TLFeBOOK


this is well worth it. Many companies already committhemselves to meticulously managing even relativelysmall risks–for instance, auditing their invoices to complywith new corporate governance regulations. These firmscan realize even greater value by taking a disciplined andsystematic approach to mitigating the strategic risks thatcan make or break them. Of course, no company can an-ticipate all risk events: There will always be unprevent-able surprises that can damage your organization–whichmakes it all the more important to manage those risksthat can be prevented.

Taking this stance promises benefits beyond just pro-tecting your company’s value. When a risk is common toall companies in an industry, taking early steps to mitigateit can put your business in a much stronger competitiveposition. Moreover, many strategic risks mask growth op-portunities. By managing strategic risk, you can positionyour company as a risk shaper that is both more aggres-sive and more prudent in pursuing new growth. Such ben-efits make strategic-risk management a crucial capabilityboth for chief financial officers who need to protect thestability of their companies and for any senior managerslooking for sources of sustainable growth.

An Array of Risks and CountermeasuresWe categorize strategic risk into seven major classes: in-dustry, technology, brand, competitor, customer, proj-ect, and stagnation. Within each class, there are differenttypes of risks. We will describe a particularly dangerousrisk from each category and how individual companieshave – or have not – deployed countermeasures to neu-tralize the threat and, in many cases, capitalize on it. (Fora list of these risks and countermeasures, see the exhibit“Preventive Measures.”)

Industry Margin Squeeze. As industries evolve, a suc-cession of changes can unfold that threaten all companiesin the sector. For example, it can become very costly toconduct R&D, as has happened in pharmaceuticals: Theindustry has experienced decreasing yield rates for newdrugs, and companies are targeting more new therapiesfor chronic rather than acute diseases,which requires largerand longer clinical trials. It can become costly to makecapital expenditures, as has occurred in semiconductorfabrication: Costs have risen because of greater purity re-quirements, larger scale, and more complex equipment.An industry may go through rapid deregulation, like thatexperienced by airlines, which sharpens price competi-tion among companies with high cost structures. Suppli-ers may gain power over their customers because of con-solidation, which occurred among suppliers of flat-paneldisplays, or because of the suppliers’ direct marketing toend users, which Intel did with its Intel Inside campaign.The industry may become subject to extreme business-

cycle volatility, something experienced in telecommuni-cations. Perhaps the greatest risk is that, because of a com-bination of these and other factors, such as overcapacityand commoditization, profit margins will be graduallydestroyed for all players, and the entire industry will be-come a no-profit zone.

The most effective countermeasure to this squeeze onmargins is shifting the compete/collaborate ratio among therelevant firms. When an industry is growing and marginsare fat, companies can afford to compete on nearly allfronts and eschew collaboration. But this 100:0 ratio ofcompetition to collaboration should rapidly shift whenmargins start to erode. Collaboration can take many formswithout violating antitrust laws: the sharing of back-officefunctions, coproduction or asset-sharing agreements, pur-chasing and supply chain coordination, joint research anddevelopment, and collaborative marketing. Most compa-nies, though, fail to respond to changes in the economicsof an industry quickly enough, and collaboration beginstoo late to make a difference. Witness the recent historyof airlines, utilities, textile manufacturers, steel makers,music production companies, and automakers.

Two notable exceptions to this too-little-too-late phe-nomenon are the Airbus consortium of European air-craft manufacturers and the Sematech consortium ofU.S. semiconductor manufacturers, which played criticalroles in helping their members regain market share andimprove shrinking margins. Of course, both of these ini-tiatives involved government participation, but thatshouldn’t be allowed to cloud the issue. The dispute be-tween the United States and the European Union overwhether Airbus has received unfair government subsi-dies, for example, has tended to overshadow the tre-mendous efficiencies the partnership has made possible.And there are numerous examples of collaboration withno government involvement. The Visa and MasterCardnetworks allow member financial institutions to sharepayment-processing and marketing services that aremuch more efficient than any one bank could hope tocreate on its own. The True Value organization gives in-dependent hardware retailers access to marketing, pur-chasing, and loyalty programs that allow them to competeagainst national giants.

Contrast the success of those collaborations with theplight of major music production companies. After filesharing emerged and enabled the widespread download-ing of music, the recording companies collectively suf-fered a decline in sales at an annual rate of 6.5% from2000 through 2003. Collaboration became an economicimperative, but the music companies offered only a frag-mented response. Universal and Sony launched a jointventure for selling music online called Pressplay, whileBertelsmann, EMI, and Warner Music Group worked withRealNetworks to launch MusicNet. The two services re-fused to license songs to each other, which reduced their

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Step 1Identify and assess your risks. Consider the key risks youface in the seven main categories of strategic risk – indus-try, technology, brand, competitor, customer, project, andstagnation – as well as the risks that may be specific toyour industry or business model. For each type, consider:

• Severity. What percentage of your company’s valuecould be affected by the risk? Consider previous analogousevents in your industry or in other industries, as well asfactors specific to your business that could increase or re-duce the risk’s impact – say, your organization’s ability toadapt to external change.

• Probability. What’s the likelihood of the risk occur-ring? Consider previous cases of companies affected bythis risk; input from key customers, leading-edge custom-ers, and other external influencers; and external dataabout probability rates.

• Timing. Can you determine when the risk is likely tooccur? Maybe the timing has been predetermined, as inthe case of patent expirations or regulatory changes. Ormaybe you can estimate the time period during which the risk’s impact will be greatest.

• Changing probability over time. Can you determinewhether the likelihood of the risk is increasing, decreas-ing, or constant? For instance, the risk of a sharp decline insales volume often increases in the fifth year of a business-cycle expansion. By contrast, the risk that a project will faildecreases as successive milestones for the project are met.

A Manager’s Guide to

Strategic Risk

Step 3Quantify your risks. Risks should be comprehensivelymeasured in a common currency – for instance, cash flowat risk, earnings at risk, economic capital at risk, or marketvalue at risk. Companies will then be able to compare andaggregate the risks and link them to decisions regardingcapital allocation, pricing, and risk transfer.

Step 4Identify the potential upside for each risk. What couldhappen if a key risk is reversed? For example, while yourcompany could lose big by not double betting as technol-ogy changes, making two well-placed bets could create significant growth opportunities. Your company can develop a plan to identify and maximize the upside foreach item listed in the strategic risk map.

Step 5Develop risk mitigation action plans. For every majorrisk identified, there should be a team responsible forpreparing a formal mitigation plan. This document willoutline the risk assessments made in earlier steps (natureof the risk, root causes, percentage of market value thatwould be affected, and so on) and assign responsibility forexecuting countermeasures. The team will often need tobe multifunctional. A brand risk, for example, may need to be managed by a team that includes representativesfrom marketing, customer service, and manufacturing.

Step 6Adjust your capital decisions accordingly. After drawingup an explicit profile of the risks it faces, a company maywant to change its capital calculations in two ways. First,business units and certain major projects that face greaterlevels of risk may warrant a higher cost of capital, onethat’s closer to venture-capital discount rates than typicalcorporate capital rates. Second, the company may need to change its capital structure depending on the way therisk level of the overall portfolio is changing over time. Forinstance, a company entering a period of greater volatilitymight need to become more conservative about capital,lowering its customary debt levels on its balance sheet orusing joint ventures or other partnerships to spread thecosts of a major new project.

Step 2Map your risks. Having identified and assessed your mainrisks, map them so you can see your profile at a glance. Theexhibit “A Strategic Risk Map” lays out the risks faced by ahypothetical manufacturing and services firm. (You can fillin the blank lines with risks specific to your business.)

Your organization faces a unique set of strategic risks based onfactors such as your industry, competitive position, sources ofrevenue and profit, and brand strengths. You can mitigate suchrisks by systematically identifying, assessing, and responding

to them. This process can be conducted on its own or as thefourth component of an enterprise risk management system,alongside similar processes for managing financial, hazard,and operational risks.

TLFeBOOK

A Strategic Risk Map

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Severity Changing(% of earnings Expected timing in years probability

Type of risk at stake) Probability 1 2 3 4 5 over time

Industry

Margin squeeze 80% 20% Increasing

Rising R&D/capital expenditure costs 10% 40% Increasing

Overcapacity

Commoditization

Deregulation

Increased power among suppliers

Extreme business-cycle volatility

Other:

Technology

Shift in technology 60% 20% Increasing

Patent expiration 10% 100% Constant

Process becomes obsolete

Other:

Brand

Erosion 40% 20% Increasing

Collapse 70% 10% Constant

Other:

Competitor

Emerging global rivals 40% 20% Increasing

Gradual market-share gainer

One-of-a-kind competitor 30% 5% Increasing

Other:

Customer

Customer priority shift 20% 60% Increasing

Increasing customer power 10% 50% Increasing

Overreliance on a few customers

Other:

Project

R&D failure 10% 80% Constant

IT failure

Business-development failure

Merger or acquisition failure

Other:

Stagnation

Flat or declining volume 20% 80% Increasing

Volume up, price down

Weak pipeline

Other:

The threats faced by a hypothetical manufacturing and services firm

TLFeBOOK

appeal to customers, and neither captured enough pay-ing customers to be viable. This left the field open toApple’s iTunes online music store. It convinced the record-ing companies not only that it had a workable copyright-protection scheme but that customers wanted to buy,not rent, individual songs. In its first eight months, iTunesgrabbed more than one-third of the overall revenues fromsong downloads from the fractious recording companies.

Technology Shift. Risks involving technology – for ex-ample, the probability that a product will lose its patentprotection or that a manufacturing process will becomeoutdated – can have a major effect on corporate perfor-mance. But when a new technology unexpectedly invadesa marketplace, specific product and service offerings mayactually become obsolete in short order. Think, for exam-ple, of the way in which digital imaging has shifted mar-ket share away from film-based photography.

Of course, you often don’t know how and when a tech-nology will win acceptance in the marketplace or whichversion of a new technology will ultimately prevail. That’swhy risk-savvy managers faced with an unpredictable sit-uation insure against technology risk by double betting –that is, investing in two or more versions of a technologysimultaneously so they can thrive no matter which ver-sion emerges as the winner. Betting on both the OS/2 andthe Windows operating systems positioned Microsoft tobe a winner, regardless of which one prevailed. Intel’sdouble bet on both RISC and CISC chip architecturesimproved the firm’s chances of succeeding in the semi-conductor industry. By contrast, Motorola’s failure to pur-sue both analog and digital cellular-phone technology

opened the door for Nokia to supplant it as the industryleader.

In fact, the cell phone market has experienced a seriesof technology shifts over the past decade, each posing a fresh challenge to the established companies. In 2002,for example, Nokia decided to concentrate on high-endsmart phones and directed 80% of its R&D budget towardthis market – failing to double bet on moderately pricedphones. Rival Samsung capitalized on this and investedheavily in midrange phones as part of its broad portfolioof products. Midrange handsets took off in 2003 whilesmart phones fizzled, and Samsung enjoyed 32% salesgrowth for the year, compared with 6% growth for theoverall cell phone market. Nokia’s failure to double bet inthis case has presented the company with a new strategicchallenge against a powerful and committed rival, in-creasing the overall risk level of Nokia’s market position.

Of course, double betting often requires significantshort-term investments, so how you double bet is crucial.In the late 1990s, the Internet’s growth posed a classicdouble-bet problem for financial services firms. Somecompanies, such as Bank One, invested large sums inbuilding Internet banking channels, only to discover thatvery few of their customers – and even fewer profitablecustomers–wanted online-only service. Because the Websites were poorly coordinated with the companies’ tradi-tional service departments, customers weren’t able toeasily move from one channel to another, and the banks’investments were largely wasted. Contrast that ineffec-tive double betting with how discount brokerage firmCharles Schwab managed its Internet hedge. Schwab in-



Preventive MeasuresCompanies face an array of strategic risks. Even the most serious, though, can be mitigated through

the use of effective countermeasures.

Strategic risk Countermeasures

Industry margin squeeze Shift the compete/collaborate ratio.

Technology shift Double bet.

Brand erosion Redefine the scope of brand investment.Reallocate brand investment.

One-of-a-kind competitor Create a new, non-overlapping business design.

Customer priority shift Create and analyze proprietary information.Conduct quick and cheap market experiments.

New-project failure Engage in smart sequencing.Develop excess options.Employ the stepping-stone method.

Market stagnation Generate “demand innovation.”

TLFeBOOK

tegrated its new eSchwab portal into its ex-isting service network, giving investors thefreedom to move from one channel to an-other – from the Web to phones to personalvisits with their brokers – as they accessedaccount information and performed trans-actions. Subsequent market changes havechallenged Schwab’s business model, butduring the 1990s the company was able toride the wave of Internet-driven growth be-cause it double bet on competing customerchannels.

Brand Erosion. Brands are subject to anarray of risks, some predictable and somenot, that can sharply reduce their value. Insome cases, the risk can appear overnightand threaten the brand with outright col-lapse. When some of Perrier’s bottled waterwas found to be contaminated, the companyexperienced a rapid and significant drop inmarket share. And when some Firestonetires were deemed defective, parent com-pany Bridgestone suffered an 80% drop innet income over one year. In other cases, therelevance and attractiveness of a brand mayerode because of underinvestment or mis-directed investment. Think of the gradualdecline of GM’s Saturn brand when, after a successfullaunch, the company failed to develop new models fastenough to satisfy customers.

One of the most effective countermeasures to branderosion is redefining the scope of brand investment beyondmarketing, taking into account other factors that affect abrand, such as service and product quality. Another effec-tive countermeasure involves the continuous reallocationof brand investment based on early signs of weakness iden-tified through constant measurement of the key dimen-sions of the brand.

That is how American Express averted the risk of branderosion over the past decade. A pioneer in the charge cardindustry, Amex came under competitive attack in the late1980s from Visa and several major banks, which began totake market share from Amex worldwide by challengingconsumer perceptions of the Amex brand. Visa, in its ad-vertising, emphasized merchants’ wider acceptance of itscard (“…and they don’t take American Express”), whilethe banks emphasized incentive programs that rewardedfrequent usage. Amex’s brand, built on prestige and ser-vice, was becoming too narrowly focused and less relevantin customers’ eyes.

So Amex made a series of investments, some of themunrelated to conventional marketing, to strengthen andbroaden the brand. To increase the number of service es-tablishments accepting its cards, Amex invested in its re-lationships with merchants – reducing their transaction

fees, speeding up payments, and increasing support fortheir advertising. The cut in transaction fees alone re-duced Amex’s revenues by about $170 million annually,but higher charge volumes more than made up for theloss. Amex also invested heavily in its Membership Milesrewards program, paying more to participating airlinesand expanding the program to include five major hotelchains. This reallocation of investments arrested thebrand’s slide early and contributed to the company’s dra-matic growth in market value over the past decade.

One-of-a-Kind Competitor. A company’s competitors,existing and potential, clearly are one of the main sourcesof business risk, whether the threat stems from a rival’snew product or the emergence of global competitorswith lower cost structures. Perhaps the most seriouscompetitive risk, though, is that a one-of-a-kind compet-itor will appear and seize the lion’s share of value in amarket. It is vitally important to constantly scan the hori-zon to identify and track as early as possible the compa-nies that, whether in your industry or not, could becomesuch a rival. When you’ve identified one, the best re-sponse is a rapid change in business design that minimizesyour strategic overlap with the unique competitor and al-lows you to establish a profitable position in an adjacenteconomic space.

Any retailer tracking the proliferation of Wal-Martstores on a map of the United States during the 1980s and1990s would have been able to predict precisely when

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this retailing tidal wave, driven by Wal-Mart’s unique busi-ness model, would wash through its home territory. Manymajor retail chains failed to do so. A handful, however, didrespond in time, maintaining and growing their value byshifting their business designs to capture their own dis-tinct slices of the market. Discount retailer Target, in theearly 1990s, identified the need to offer a unique productselection to compete with Wal-Mart’s. In response, it re-crafted itself from a conventional discounter to a low-price but style-conscious retailer that appeals to a differ-ent customer set than Wal-Mart’s. By contrast, FamilyDollar stores have driven steady growth by targetinglow- and fixed-income households, offering basic house-hold items, food, and apparel in small, bare-bones storesthroughout neighborhoods that are too down-market,too rural, or too urban for Wal-Mart.

Customer Priority Shift. Many strategic risks involvecustomers – a shift in the balance of power toward themand away from companies, for example, or companies’

cases sell, at retail, in the $200 to $400 range. Known forits conservative styling, Coach faced a high-risk situationas it tried to discern how long its existing customers wouldstick with the company if it ventured down the moretrendy fashion paths that would allow it to expand its cus-tomer base. In the past four years, Coach has managedthis risk well enough to surpass Gucci in revenue growthrate, profit margin, and market capitalization.

Some of this success can be attributed to Coach’s ag-gressive in-market testing of new products – customer in-terviews (more than 10,000 a year), in-store product tests,and market experiments that record the effect of chang-ing such variables as price, features, and offers by com-peting brands. Based on the proprietary information itgathers, Coach quickly alters product designs, drops itemsthat test poorly, creates new lines in a wider range of fab-rics and colors, changes prices, and tailors merchandisepresentations to fit customer demographics at specificstores. Several years ago, Coach had customers preview its



You can position your

company as a risk shaper

that is both more aggressive and

more prudent in pursuing new growth.

overreliance on a small number of customers. But per-haps the biggest risk is the shift – suddenly and dramati-cally or gradually and almost invisibly–in customers’pref-erences. Such shifts happen all the time; the magnitude ofthe risk depends on its speed, breadth, and depth.

Two powerful countermeasures for managing this riskare the continuous creation and analysis of proprietary in-formation, which can detect the next phase of customerpriorities, and fast and cheap experimentation, which helpsmanagers to quickly home in on the right product varia-tions to offer different customer microsegments. Thesemethods can help companies retain and grow their cus-tomer bases–even as customers’preferences evolve–and,over time, increase revenue per customer and overallprofitability.

One company that has rapidly become proficient inthese methods is Coach, which makes high-quality leathergoods. When Coach was spun off from Sara Lee in 2000,it trailed competitors Gucci and LVMH in revenue, prof-itability, and market capitalization. This was also a pe-riod of unanticipated growth and change at the sector’smiddle-market level, where purses, handbags, and brief-

Hampton satchel and learned that they would willinglypay $30 more than the company had thought. In the caseof another bag, Coach solicited customer feedback on thedesign and, learning that customers found it “tippy,” re-sponded by widening the base of the bag. As a result ofsuch close and continuous customer contact, Coach hasavoided numerous market misfires and has been able tomaintain its popularity among its traditional fans whilesimultaneously attracting a new, younger generation ofcustomers.

Although 10,000 individual customer interviews andthe several million dollars a year that Coach spends on in-market testing may seem excessive, the investment oftime and money represents a low-cost form of insuranceagainst getting blindsided by customers’ shifting priori-ties. And Coach isn’t alone in its generation and smart useof proprietary customer data. A number of companieshave developed information systems that keep themplugged in to the microsegments and constant micro-shifts of their customers. Those firms include Capital One,which conducts 65,000 in-market experiments per yearto identify ever smaller customer segments in the credit

TLFeBOOK

card market, and Japanese video and musicdistributor Tsutaya, which analyzes cus-tomer spending patterns through point-of-sale data, surveys, and databases.

New-Project Failure. Any project involvescountless risks. A new product or serviceventure faces the chance that it won’t worktechnically, that it will fail to attract profit-able customers, that competitors will quicklycopy it and poach market share, or that itsgrowth will be too slow or too costly. Thereare also major financial and opportunityrisks associated with a new marketing cam-paign, a major IT or R&D project, or a com-pany acquisition. Indeed, the tough realityis that some four out of five new businessprojects fail.

The best protection against this risk be-gins with a clear-eyed assessment of a proj-ect’s chance of success before it is launched–something that, as everyone knows fromexperience, often doesn’t take place for anynumber of personal or organizational rea-sons. Once this evaluation is completed – forexample, by reviewing data on past com-pany projects or by collecting external dataon the success rate of similar projects–threeapproaches can help a company systematically improvea project’s odds. These are smart sequencing, which meansundertaking the better-understood, more-controllableprojects first; developing excess options when planning a project in order to improve the chances of eventuallypicking the best one; and employing the stepping-stonemethod, which means creating a series of projects thatlead from uncertainty to success.

An example of a company using smart sequencing issemiconductor equipment maker Applied Materials,which has carefully focused on the stages of the chip-making process and mastered each stage before movingto another one. Chip making involves at least 15 differ-ent stages and some 450 discrete steps. Most equipmentsuppliers are involved in just one or two stages of thechip-making process. While no supplier is yet capable ofproviding all the tools needed to create a state-of-the-art semiconductor fabrication system, Applied Materialscomes close. It started by selling equipment for one stage,chemical vapor deposition. Based on its understanding ofthat part of the chip-making process – including the eco-nomics of the process and the preferences of key decisionmakers–Applied Materials added capabilities in adjacentor related stages, such as ion implantation and etching.The company now makes products for 13 chip-makingstages and is the leading company in most of its productmarkets. The risk of taking each step was reduced by theknowledge and customer relationships the company de-

veloped in the previous stage. Investors have rewardedApplied Materials for its smart sequencing: While thecompany’s share of the semiconductor equipment indus-try’s revenues is below 40%, its share of the industry’s mar-ket value has remained between 50% and 60%.

Project failures loom large in the automotive indus-try, where enormous investments are required to retoolplants and develop worldwide marketing, sales, and main-tenance programs around a new vehicle. Hence the sig-nificance of Toyota’s use of excess options in developingits gas-electric hybrid, the Prius. Toyota’s process for creat-ing the Prius was a seemingly wasteful one. As recountedby Jeffrey K. Liker in The Toyota Way, the company “over-invested” in the Prius by generating a proliferation of de-sign options and then sifting through them to find thebest ones. Rather than quickly focusing on a handful ofgood alternatives, the Prius team simultaneously tested20 different suspension systems and examined 80 differ-ent hybrid engine technologies before focusing on fourdesigns, each of which was then tested and refined in ex-haustive detail.

Toyota also took a stepping-stone approach to rollingout the vehicle, a method well-known in the software in-dustry, in which version 1.0 is full of errors, version 2.0shows great improvement, and version 3.0 is a marketsuccess. Version 1 of the Prius, launched in Japan in 1997,was good enough to appeal to a solid base of customerseager to try hybrid technology. Version 2, launched in

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2002, featured improved styling, interior space, handling,and fuel economy. There’s still a months-long waiting listto buy version 2 of the Prius, which has captured 80% ofthe world hybrid automobile market, and Toyota now hasother hybrid vehicles in development, including a versionof the Lexus RX330, that promise to offer even better per-formance for customers.

Market Stagnation. Countless great companies haveseen their market value plateau or decline as a result oftheir inability to find new sources of growth. In somecases, they face a slowdown in volume growth in a maturemarket. In others, despite strong volume growth, pricesfall and produce weak earnings. Even when the market isstrong, an individual company’s weak pipeline of prod-ucts can produce persistent lackluster results.

The most effective countermeasure to the perennialproblem of stagnating volume growth is demand innova-tion. This involves redefining your market by looking atit through the lens of the customers’ economics and ex-panding the value you offer your customers beyond prod-uct functionality–that is, helping them reduce their costs,capital intensity, cycle time, and risk in order to improvetheir profitability.

During the past ten years, Air Liquide, a century-old,tradition-bound supplier of industrial gases, was able topursue demand innovation in a flagging industry. Thecompany, based in Paris, had always excelled at technicalinnovation. But by the late 1980s, its revenue and operat-ing income were flat, and technical innovation was lead-ing nowhere, until the company redirected its innovationefforts to help improve customers’ systems economics.

In the early 1990s, Air Liquide developed technologythat allowed customers to establish small gas produc-tion facilities on-site rather than rely on large centralizedplants and tanker shipments for their energy. One impor-tant side effect of on-site production was the higher levelof interaction between customers and the Air Liquidestaff. The on-site teams soon discovered that their indus-trial customers had a variety of pressing needs that AirLiquide might be able to address – for example, minimiz-ing the risk of environmental and safety violations andimproving their production processes. Senior manage-ment began to see how the firm’s R&D and productionknowledge, which it had struggled to turn into mean-ingful product differentiation, could be harnessed to im-prove customers’ industrial processes.

Air Liquide gradually expanded from its core commod-ity gas business to offer a set of new services that includedchemicals management, supply chain services, environ-mental consulting, and the licensing of software tools andsystems. By seizing these new opportunities, the companyhas expanded its potential markets, gained a greater shareof its customers’ spending, and improved customer prof-itability and loyalty. As a result, Air Liquide has deliveredstrong and consistent financial results since the mid-1990s.

The Upside of RiskBasketball star Bill Russell was a great rebounder, seiz-ing control of the ball after an opposing player missed a shot. While rebounding is considered a defensive skill,Russell always insisted that “rebounding is the start ofthe offense.” By the time Russell grabbed the ball, he wasalready thinking about the teammate to whom he wouldpass and, ultimately, the shot he was setting up. He wasconstantly turning a defensive move into an offensiveopportunity.

Similarly, strategic risk management allows managersto move from defense to offense. People typically focuson the perils of risk, and the managerial response is toseek ways to minimize exposure to it. But the pursuit ofgrowth requires companies to take risks, to place bets onspecific products, channels, customer segments, and newbusiness models. Strategic risk management, besides lim-iting the downside of risk, helps managers improve theodds of success behind those bets by forcing them to thinkmore systematically about the future and helping themto identify opportunities for growth.

In fact, the greatest opportunities often are concealedwithin the defensive countermeasures we’ve discussed.For Airbus, shifting to a collaborative model as a way forits member companies to escape shrinking margins en-abled it to gain market share until it became a true rivalto Boeing. For American Express, the fundamental changein its brand investment mix, in response to threats fromother bank cards, set off a decade of value growth at thefirm. For Target, shifting its focus to a customer segmentthat was different from Wal-Mart’s not only helped it side-step the Wal-Mart juggernaut but also sparked profitablegrowth that is the envy of other retailers.

A new view of the relationship between risk and re-ward is thus emerging. While managers often see a trade-off between the two, creative risk management combinedwith a good business model can allow a company to im-prove in both areas. This shift is analogous to the evolu-tion of thinking about the relationship between cost andquality. Thirty years ago, managers believed there was atrade-off in which higher quality meant higher cost. Pi-oneering Japanese manufacturers turned that thinkingaround by showing that improving the system could ac-tually reduce costs while simultaneously raising standardsof quality.

Similarly, the challenge for managers today is to helptheir companies move to a position of lower risks buthigher financial returns. With the right mind-set andtimely deployment of countermeasures such as those de-scribed here, companies can manage the full spectrumof risks they face and find that risk/reward sweet spot.

Reprint r0504e; HBR OnPoint 977xTo order, see page 135.



TLFeBOOK

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“I’ve become much more decisive thanks tothe rock, paper, scissors technique.”

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“New guy.”


“Rowing harder doesn’t help if the boat

is headed in the wrong direction.”

Kenichi Ohmae“Companyism and Do More Better”Harvard Business ReviewJanuary–February 1989

Destination:Anywhere

ST R AT E G I C H U M O R

TLFeBOOK

april 2005 91

“You’ve demonstrated some fine leadership skills, buthave you forgotten we hired you to be a follower?”

“I try thinking out of the box, but my mind justwanders all over the place.”

“Since when did yelling ‘C’mon, mama,baby needs a new pair of shoes’ becomepart of our quarterly projections?”

TLFeBOOK


ore and more CEOs are hoping a stronger customer focus will be the antidote to escalating commoditization pressures. But as the frustra-

tions of myriad companies can attest, getting closer tocustomers is not just a matter of installing a better CRMsystem or of finding a more effective way to measure andincrease customer satisfaction levels. Tools and technol-ogy are important. But they’re not enough. That’s becausegetting close to customers is not so much a problem theIT or marketing department needs to solve as a journeythat the whole organization needs to make. The compa-nies that do it well follow a surprisingly similar path, pass-ing the same milestones and, in many cases, strugglingwith the same problems. The journey can be arduous, ittakes a long time – years, not months – but there are re-wards all along the way. And for those organizations thathave gone the distance, the payoff is remarkable.

For Continental Airlines, the journey began when thecompany was emerging from bankruptcy and needed to know more about the profitability of its individualcustomers. One of the first things it uncovered was a ser-vice mess that was costing the airline millions of dollarsevery year.

Continental took a systematic look at how passengerswere treated when a plane was significantly delayed,when they were bumped from a flight, or during someother unfortunate event. What it found was that com-pensation was offered on an arbitrary basis by the gateagent, and, somehow, the lowest value customers were, onaverage, receiving the highest compensation. Worse, somepassengers were finding ways to be doubly compensated;a customer who was bumped from a flight might first approach a gate agent, pick up a voucher for a free flight,and then minutes later telephone the airline and ask for JO

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Every company wants to get close to its customers, but wishing doesn’t make it so.

New research identifies four stages of customer focusand maps the organizational changes necessary

to navigate from one stage to the next.

by Ranjay Gulati and James B. Oldroyd

The Quest for

CustomerFocus

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april 2005 93

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that demonstrably cared about them, valued their busi-ness, and recognized them as the same individuals nomatter what part of the bank they did business with.

Based on this insight, RBC set a goal to systematicallymanage all of its customers at every one of the millions ofpoints at which they came in contact with the bank – aprospect that was daunting, to say the least. To its credit,over the last nine years RBC has learned how to reorientthe focus of its entire organization away from productsand distribution and toward the real needs of its cus-tomers. The results are telling. Dividends swelled from68 cents per share (in Canadian dollars) in 1996 to $1.72per share in 2003, driven by a 20% increase in high-valuecustomers and a 13% rise in average customer profitabil-ity between 1997 and 2001. Between 200o and 2004, the

percentage of customers that purchased the bank’s high-margin packages of bundled products and services dou-bled, from 35% to 70%, and the success rate of sales leadsdriven from promotion events rose to 45%. (Compare thisagainst the 2% to 5% response rate typical of standardmarketing programs.) Along the way, RBC has won ahost of information technology awards for its innovativecustomer-facing computer systems.

The Continentals and RBCs of this world are as ex-ceptional as their exceptional results. But they are notunique. What are they, and others like them, doing right?To answer that question, we spent two years conductingan in-depth study of 17 companies that have made sub-stantial progress toward becoming more customer fo-cused. This diverse set of businesses ranges from financialinstitutions like RBC, to the gaming giant Harrah’s Enter-tainment, to the massive telecom carrier SBC Communi-cations. What we found, at a high level, was that customer-focused companies consistently embrace three concepts.

First, they know they can become customer focusedonly if they learn everything there is to learn about theircustomers at the most granular level, creating a compre-hensive picture of each customer’s needs – past, present,and future. Second, they know that this picture is useless

another. The representative answering the phone wouldhave no way of knowing that the same request had justbeen filled.

It was only when the company began to look at cus-tomer information in a more holistic fashion–gathering,consolidating, and analyzing all of its customer interac-tion information in a single pool – that it was able to cor-rect such inefficiencies. Now everyone who is delayed for,say, nine hours gets the same compensation, and when a gate agent hands a passenger a flight voucher, that trans-action is reflected immediately in the customer infor-mation database. The passenger will be denied a secondvoucher even if he gets to a phone within a few seconds.

For Royal Bank of Canada (RBC), the quest for cus-tomer focus began when the company discovered that it

knew much less about the needs of its customers than itthought. RBC is Canada’s largest financial institution, withmore than 12 million personal, business, and public-sectorclients and offices in some 30 countries worldwide. In1996, like most financial institutions at the time, RBC hadbeen investing heavily in making banking as convenientas possible, on the assumption that this would attract new customers and increase loyalty. It extended bankinghours. It built new branches and installed more ATMs. Itadded online access. It created insurance, investment, andother new services. But to the company’s surprise, a sur-vey of more than 2,000 current and potential customersrevealed that people didn’t choose a bank on the basis ofhow convenient it was. RBC scored very well on that mea-sure. But, as the survey clearly showed, that was merelytable stakes. Instead, what customers wanted was a bank


The Quest for Customer Focus

Ranjay Gulati ([email protected]) is theMichael L. Nemmers Distinguished Professor of Strategyand Organizations at Northwestern University’s KelloggSchool of Management in Evanston, Illinois. He is currentlyworking on a book about the customer-centric organization.James B. Oldroyd ([email protected]) is a doctoral student at the Kellogg School.

Getting close to customers isnot so much a problem the IT or marketing department needs to solve as

a journey the whole organization needs to make.

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if employees can’t or won’t share what they learn aboutcustomers, either because it’s inconvenient or because itdoesn’t serve their interests. Finally, they use this insightto guide not only their product and service decisions buttheir basic strategy and organizational structure as well.

Over time, these companies enable and enforce coordi-nation between internal units at progressively more so-phisticated levels, they find new ways to manage the flowof information, they develop routines for decision mak-ing that incorporate customer preferences,and,ultimately,they shift the locus of their customer-focused efforts awayfrom a centralized hub to a more disbursed set of activi-ties that spans the entire enterprise.

Each company we have studied has followed a strikinglysimilar path in its journey,a path that runs through four dis-tinct stages. Skipping stages might appear to speed up theprocess, but in the end it denies the organization the surefoundation it needs to build a lasting customer-focusedmind-set. By understanding the journey, managers will beable to anticipate the challenges ahead and invest orga-nizational resources, including their own time, in those ac-tivities that matter most while avoiding the high-cost, low-return measures that have plagued so many companies.

STAGE 1Communal CoordinationThe journey begins with the creation of a centralizedrepository of customer information, which records eachinteraction a customer has with the company. Creatingthis repository is a two-step process. First, organizationsbring together and standardize information drawn fromcustomer touch points throughout the firm into a singlepool. Second, they organize this information by customer;that is, they make the customer–rather than the account,the purchase, the product, or the location – the funda-mental unit of analysis.

The definition of a customer may not always be obvi-ous. For Continental Airlines, for instance, customerscould be defined as travel agents, corporations, or consum-ers. For a pharmaceutical company introducing a new prescription medicine for children, the customers mightbe physicians, but they could also be parents, their chil-dren, and their insurance companies. As a result, organi-zations may have to manage and collate their interactionswith several interrelated customers together.

Gathering, standardizing, and organizing customer in-formation that comes from all across the organization requires companies to establish a coordination infra-structure. The amount of coordination called for in thisstage can be substantial, but it is not necessarily compli-cated; we call it communal coordination. Organizationalunits need not contact one another directly. Instead, eachgroup contributes its information to the communal pool

separately from the others and then taps into it as needed.In the companies we studied, a neutral entity like IT typically controls and oversees the pooling process. That’s for two reasons. First, employees of a neutral entity like IT have the technical skills to normalize and cleanse in-formation as it comes into the common repository. Sec-ond, and more important, such staff tends to be free of operational biases. Unlike sales, marketing, and othergroups that create and use customer information, neutralentities like IT don’t concern themselves with the actualvalue of the information; they care only that it is accurate,clean, and easily accessible. However, ownership of thisprocess requires employees of the neutral entity to pos-sess a unique mix of skills – an understanding of both the technology and the business needs of all the differentgroups that rely on customer information to make keybusiness decisions. Such talent is not commonly found in most organizations.

The concept of a communal information source is rela-tively simple, but it requires a substantial investment inboth time and technology to make it useful. There is, ofcourse, the challenge of overcoming political boundaries,as people often resist sharing information – and resist losing control over it even more. But at this stage of thejourney, it’s simply the sheer volume of customer infor-mation that tends to make the pooling process so long. AtContinental Airlines, it took more than four years. Just for a start, it took six to nine months to properly clean and aggregate the information as it came in from the finance,marketing, operations, and other units. Often, the devilwas in the most mundane of the proverbial details–in onecase, information might be captured as day/month/year;in another, as month/day/year. Such discrepancies had tobe identified and corrected, often manually.

The need to capture information at a granular level isanother reason the process is so time-consuming. Conti-nental’s database includes as fine a level of detail as a cus-tomer’s choice of seats and preferred methods of booking;the number of times his flight departed on time, was de-layed, or was canceled; and any time his luggage was lost.

If the task is onerous, the payoff is high: The goal of col-lecting information at so comprehensive a level is thatContinental no longer needs to know in advance whatbusiness questions it might wish to ask. The repository haswithin it the potential to answer just about any question.

Pooling the data took even longer at Harrah’s Enter-tainment: six years. Unlike Continental, which was takingover a set of processes that had been previously out-sourced, Harrah’s had to overhaul internal customer in-formation management systems already in place in nu-merous properties scattered across the United States.When Harrah’s began this process in 1991, competition inthe gaming industry was local. Casinos in Las Vegas com-peted with rivals along the Strip, making ever more costlyupgrades to woo customers to their tables from the tables

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next door. But initial research, which the pooled data con-firmed, indicated that customers weren’t really choosingamong competitors on that basis. What they really wantedwas to be properly recognized and rewarded when theyvisited Harrah’s in another market. So Harrah’s sought toshift its strategy away from focusing on competitors toward standardizing and improving its customer experi-ence in all of the company’s properties, thereby creat-ing a national brand. (Harrah’s customer database is de-scribed in detail in Gary Loveman’s May 2003 HarvardBusiness Review article, “Diamonds in the Data Mine.”)Creating a single view of customers is valuable in its ownright: it generates opportunities for cross selling, it revealsglaring errors in customer service, and it can point the wayto efficiencies that reduce costs. But more important still,consolidation sets the stage for the next steps on the jour-ney toward customer focus – in two important ways.

First, as individual business or functional units areforced to share information, companies begin to see ashift in mind-set. Employees in one business unit learn torecognize that “their” customers are shared assets, valu-able to other units as well. This limited amount of coor-dination lays the groundwork for much higher levels ofcoordination to come.

Second, the central repository of customer informationitself serves as a building block for the next stages. Conti-nental Airlines in the mid-1990s had 35 to 40 domesticdatabases and another 50 international databases; morethan half of them were dedicated to customer informa-tion, but nearly all of them housed some important cus-tomer data. Now it has two databases, one for customeranalytics and modeling, and one for operational data. Pre-viously, the different information repositories often pro-duced different answers to the same question. There wasno consensus within the company as to who the highestvalue customers were, for instance. The answer varied de-pending on whether you were looking at miles flown orat ticket price paid. Now there’s no ambiguity–both milesand ticket price are factored in.

STAGE 2Serial CoordinationIn stage two, companies go beyond just assembling cus-tomer information to drawing inferences from it. Coordi-nating gets a little trickier as the centralized coordinationrole expands to manage not only the continued collationof data but also a sequence of tasks performed by certainfunctional units so that information can be analyzed andthe resulting insights shared throughout the company.We call such a coordination architecture serial coordina-tion. The sequence typically starts when the collated in-formation from stage one passes to business analytics experts (who frequently reside either in marketing or in

a separate unit of their own). They analyze the informa-tion and then pass along their results to users in the busi-ness units, who identify how best to apply it in marketingefforts, building on their knowledge of the local markets.The handoff from one unit to another may not occurspontaneously; one of the organizational units may needto take a leadership role to ensure that the entire sequenceof steps is accomplished and properly coordinated.

In some organizations, the information is employed formore than sales and marketing activities, to analyze andimprove a broad range of enterprise operations. For ex-ample, Continental was able to mine its customer infor-mation to configure its flight network more efficiently.Previously, the airline could analyze only the profitabilityover time of each route separately by tracking the num-ber of passengers on each flight and the average fare theypaid. It did not know whether those passengers were com-ing or going or what routes they’d previously flown. Now,with the data pooled from all organizational units, theroute optimization teams can examine the total revenuegenerated by each passenger and the pattern of that indi-vidual’s travel.Viewed in that context,a flight that was pre-viously considered unprofitable–and, consequently, a tar-get for elimination–might turn out to be a key connectionbetween airports used by a substantial pool of very prof-itable customers. In short, Continental can now maximizethe profitability of the whole flight network rather than theprofitability of each independent segment.

Learning to use the communal data in this way requiressubstantial coordination. Employees in Continental’splanning and scheduling group managed the overall pro-cess to ensure that the serial coordination actually oc-curred. In this instance, as they began their analysis, themembers of the group realized they needed input fromseveral different areas of the business, including opera-tions, pricing, sales, marketing, and finance. They ap-proached each one in turn for its input into the analysis of the flight network. The operations group provided in-formation about how scheduling changes would affectwhen and in what way airplanes were serviced. Pricingthen added information on how changes in ticket pricesmight influence customers’ choices. Sales subsequentlyassessed what channels would best suit the offering. Mar-keting got involved to plan the launch of new flight seg-ments. And, finally, finance made sure the assets of the organization were being put to the best use.

The Royal Bank of Canada saw similarly powerful ben-efits from analyzing its pooled data. In one instance, RBCwas examining the effectiveness of one particular serviceoffering. The package combined a checking account,credit card, and some other services, like the ability to paybills at its ATMs. It was popular, but RBC’s analytics teamfound that nearly 60% of the time these packages wereunprofitable. In the past, that discovery might have forcedthe bank to discontinue a product that customers liked or



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to raise fees for the package, either of which might havesolved the bank’s problem but not the customers’. Withits transaction-level data, however, the company couldpinpoint the source of the problem: The ATM bill-payingprocess wasn’t automated. Bank employees had to takethe paperwork from the envelopes inserted into the ATMand enter the transactions in by hand.

Serial coordination was overseen by the marketing and strategy group, which initiated the project. The ana-lytics group provided the analysis, the product manage-ment group reevaluated the content and pricing of theproduct bundle, and the finance group studied the impactof the various options on the company’s performance.In the end, after considering the input from all of thesegroups, the bank kept fees the same but added low-costtelephone and online bill-paying services to the originalpackage. Happy customers began using these convenientoptions of their own volition. And a year later, 90% ofthese packages were profitable.

Serial coordination is not spontaneous and is fraughtwith obstacles. Traditional roles and structures create nat-ural barriers to spreading information and lessons learnedthroughout the company. Some changes to a company’s

social and organizational structure will be required toovercome them. One of the most significant barriers canbe a lack of trust between the group that collates the in-formation, the analytics experts who manage it, and thosewho apply it in the line organizations.

The best way to whittle down those barriers and buildtrust is to show some early successes. For example, whenRBC began using customer information to target sales activities more precisely, the central analytics team begancreating much shorter lists of customers for bankers in theindividual branches to contact with new offers.The bankerswere initially – and understandably – skeptical of the ef-fort when they started getting 20 names instead of the300 they were accustomed to, and they hesitated to usethe pared-down lists. But they quickly recognized that thenew lists yielded much better response rates. That gavethe bankers far more confidence in the analytics team.

Leaders of the coordination effort must carefully de-sign the tasks involved at this stage and set up the links between units in such a way as to minimize conflict. Forinstance, when the centralized analytics group at telecomprovider SBC develops a model for assessing, say, a givencustomer’s profitability or usage pattern, the model is

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The primaryorganizationalobjective

STAGE 2SerialCoordination

STAGE 3SymbioticCoordination

STAGE 4IntegralCoordination

collation of information

gaining insight intocustomers from past behavior

developing an understanding oflikely future behavior

real-time response to customer’s needs

communal coordination between a neutral information owner and the sources of customer information

serial coordination between the neutralcollator of information,analytics experts, andline organizations

symbiotic coordinationbetween the neutralcollator of information,analytics experts, andline organizations

integral coordination among all of the company’s employeesacross divisions,geographies, andother boundaries

corporate strategy leaders and information technology

corporate strategy leaders, the neutral entity that collates information (such asIT), analytics experts,and marketing

corporate leaders,customer segmentmanagers, and/or pivots that move information verticallyand horizontallywithin the organization

corporate leaders and cross-business integrators

STAGE 1CommunalCoordination

The coordinationrequirement

The locus ofleadership

Understanding the Customer Focus Journey

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handed off to the IT department, which uses it to gener-ate a score for each customer on that measure. The scoreis then passed to marketing, which uses it to determinewhich customers to target in promotional campaignssuch as outbound calling and direct mail. In the end,yet another group looks at how much revenue each cam-paign has generated to measure its success. Handing in-formation off from one unit to another in this structuredway, at least once a month, helps make the coordinationbetween units ever more seamless.

The second stage in the quest for customer focus usu-ally uncovers critical gaps in employees’ skills. Most peo-ple are unaccustomed to having so much customer in-formation to work with. Often, those with statistical skillslack business savvy; those with operational knowledgeare not comfortable analyzing data. It’s difficult to findpeople who can be “bilingual.” John Boushy, Harrah’s senior vice president and chief integration officer, and the one responsible for the customer data warehouse,recalled telling his CEO: “I feel a lot like I’ve built an F-14and I have Piper Cub pilots to fly them, and what I’mmost concerned about…is that they’re either going to inadvertently crash and burn, or, worse yet, they’re goingto fire a missile and…take down a friendly airplane.”

In general, we found that best-practice companies centralize this analytic capability because it’s not pos-sible or practical to hire people with PhDs in statistics for every unit of the company. With the entry of COOGary Loveman and his new leadership team in 1998, forinstance, Harrah’s created a central marketing-analyticsteam tasked with interacting with the various casinos andensuring that all of them used the customer data effec-tively. This arrangement was not something that every-one in the corporate organization or the individual prop-erties was good at or comfortable with, which led to someturnover in both units.

STAGE 3Symbiotic CoordinationStage three is a step jump in terms of complexity and theneed for coordination because it requires that companiesshift their focus from an analysis of past customer inter-actions to anticipating, and even shaping, the future. Theybegin to ask questions like: Which customers will be likelyto switch to a competitor? Which are most likely to buy a new product or service in the future? Which are mostlikely to pose an unacceptable credit risk? Addressingthese questions requires organizations to move awayfrom the one-way information flow that characterized theprevious stage toward a dynamic give-and-take. We callthis symbiotic coordination: Information and decisionsflow back and forth between central analytics units, op-erating units, and marketing, sales, and other organiza-

tional units–and even laterally among the organizationalunits themselves.

In this stage, companies embrace an experimental pro-cess comprising four discrete sets of activities: creatingmodels to predict customer behavior; experimenting withvarious interventions designed to alter customer behav-ior; measuring the results of these interventions; andusing feedback from the front line to improve the modelsand subsequent campaigns. In true scientific fashion, com-panies often set aside a control group and compare the ac-tivities of those customers who received an interventionwith those who did not. By repeatedly altering the exper-iments and carefully measuring the results, companieslearn over time which alternatives have the greatest im-pact on customer behavior.

For example, SBC wanted to decrease the number ofcustomers that might defect to the competition. So usingthe analysis done in stage two of virtually every interac-tion between the company and its millions of customers,SBC created various defection models to predict the like-lihood that an individual would switch to another telecomcarrier. It then developed and experimented with variousmarketing interventions designed to hold on to those at-risk customers. In one instance, SBC learned that peoplewho subscribed to the company’s SBC Yahoo! DSL servicewere significantly less likely to switch their local phoneservice from SBC to another vendor. Using propensity-to-buy models generated from its information pool,SBC thenidentified customers with the greatest likelihood of pur-chasing DSL. This in turn allowed product managers toidentify and target only those individuals who would beprofitable in a 12-month period. In one campaign alone,SBC was able to reach only its most profitable potentialDSL subscribers, without significant marketing expense.

At Continental, the analytics group uses feedback fromthe company’s 49,000 frontline employees to continuallydevelop new hypotheses and interventions aimed at re-taining and expanding the company’s customer base. Thedialogue occurs formally in “think tank” sessions and intraining meetings conducted by a group of “ambassadors”from marketing charged with increasing the customerfocus of the organization. In these sessions,flight directors,managers, and flight attendants, both domestic and inter-national, come together to relay their firsthand experienceto the corporate training officers. The customer-focusedgroup, in turn, relays the information back to the model-ers. The modelers then modify and enhance their predic-tive models, hypotheses, and interventions. So, for exam-ple, in one case the company tested different responses tocustomers who had been inconvenienced in some way,such as when a flight was delayed. Some customers weresent nothing (the control group), some received a letter ofapology from the CEO, others got a letter and a flightcoupon, and still others got a letter with a club loungepass. Each group’s subsequent purchase patterns were



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measured, and it turned out that although all of the inter-ventions were beneficial, the letter alone was as effectiveas the other, more costly offers. Frontline employees alsocontribute ideas based on their own experiences as travel-ers. These meetings have been very successful, yieldingover 600 ideas for using customer information to improveservice. One such idea: Add some of the knowledge thePresident’s Club staff had about frequent travelers – suchas their favorite drink–into the database.

Many companies get stuck at this stage because sym-biotic coordination requires people in several units whohave no formal reporting relationship to interact in spon-taneous and unsystematic ways through a constant give-and-take. Work is not handed off serially from one groupto another; people are learning together in real time.Pulling this off typically calls for some major structuralchanges. Most companies take one of two approaches to creating the needed links: They reorganize the entirecompany by customer segments that cut across product,technology, and geographic boundaries. Or they add neworganizational units whose job is to ensure coordinationbetween the centralized IT and analytics experts and thefront line. Either way, it’s a big job.

Royal Bank of Canada took the former approach. Thebank was previously structured around products; em-ployees attended to “mortgage” customers or “deposit”customers rather than to “RBC”customers. Now the com-pany is structured around three customer segments: pre-mium, standard, and foundation customers, each of whichcuts across all of the product lines. To preserve a degreeof accountability for sales, RBC also created a matrixstructure, laying product segments over the customer segments, rather than obliterating the product segmentsaltogether. As expected, the matrix structure engenderedsome tension between the customer and product organi-zations; employees focused on products are interested in selling their own products; employees focused on cus-tomers are rewarded for maximizing the value of all customers to the organization as a whole. To avoid con-fusion, RBC’s leaders have made it explicit that customersegment employees have the final say in all of the product-oriented staff’s customer-related budget decisions.

It takes patience and time to make such dramaticchanges. RBC Banking vice chairman Jim Rager waitednearly five years after beginning the customer focus journey before undertaking this reorganization. To make the change more palatable, he wanted employees first tosee some early successes with the new customer-focused approach.

Harrah’s took the other tack. It created a core marketing-leadership team and an analytics group responsible forbuilding scientific-learning capabilities. Then it made the frontline casino property managers responsible forimplementing these new methods in their markets,within guidelines that offered “several degrees of free-dom.” Under this system, the core leadership team giveseach marketing group in the region a specific performancegoal for each customer segment but also gives it leeway to take its knowledge of local markets into account whendetermining how to achieve the objective. The idea is tofoster a test-and-learn culture. To ensure proper coordina-tion between the groups, the company created a new di-vision structure, organized geographically: East, Central,and West. Each division head acts as a pivot, relaying strat-egy and directives to the individual casinos and reportingback to the leadership team on subsequent performanceand problems on the front line. It helped that COO GaryLoveman was also the de facto chief marketing officer;having marketing and operations staff report to the sameperson enhanced the connections. SBC, too, created a newmarketing group that cuts across geographies and units.Restructuring the company by customer segment wouldhave been cost-prohibitive because the firm operates frommany, many locations, and employees would have spenttoo much time traveling to achieve symbiotic coordination.

STAGE 4Integral Coordination If in the symbiotic stage, companies shift their focus fromthe past to the future, in the integral coordination stage,they focus on bringing a now-sophisticated understand-ing of their customers into the present, incorporating that

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The customer focus journeytakes years, not months, but there are rewards all along the way, and for

those organizations that have gone the distance, the

payoff is remarkable.

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understanding into all of their day-to-day operations.Companies start to move past discrete, formal initiativesto weave customer focus into the informal values anddaily behavior of all employees. Customer focus begins to define the organization and pervade its every aspect.In one example,a Continental flight attendant approacheda passenger and apologized for a flight delay he had experienced less than 16 hours earlier. In another, a rampagent – an individual who works on the tarmac loading luggage – noticed that the airline had lost the bag of a high-value customer on a previous flight. That customerwas currently on board, so the agent notified her person-ally that her bag had been loaded onto the plane.

Whereas previously, central marketing, IT, and analyt-ics groups were the primary drivers of customer-focusedinitiatives, now activities are extended down into the lineorganization, where employees are given the autonomyand latitude they need to focus on the customer in virtu-ally every action. Continental, for instance, allows nearlyall employees in the company access to its customer information–and it also provides them with access to theexperts who can help them analyze and use it. Technologydirector Anne-Marie Reynolds observes that nearly halfof her department’s time is spent helping employees ac-cess and understand customer information.

At this stage, companies are coordinating key activi-ties across vertical and horizontal boundaries, which arein many cases irrelevant to customers. We call this integralcoordination. Companies can build informal overlays thattranscend organizational boundaries, bringing togetherpeople with a passion for some particular customer-focused activity into centers of excellence. At RBC, for example, a data warehouse steering committee, with rep-resentatives from all of the bank’s lines of business–RBCInvestments, Insurance, RBC Banking, and CommercialBanking – establishes priorities and the order in whichcustomer information projects will be funded, makingsure that these projects are aligned with overall strategicobjectives and that existing corporate roles and structuresdo not prohibit learning transfer.

Harrah’s has created a similar organization for market-ing, technology, and operations. The marketing council,which Loveman, now CEO, chairs, includes the core lead-

ership team, representatives from technology, and leadersfrom each division. Marketing presents ideas to this largercouncil to elicit its feedback, thus involving the companyat large in generating ideas for, and becoming committedto, the customer-focused effort.

When customer focus becomes institutionalized in thisway, technology can not only support but even automatedecisions. At Harrah’s, for instance, technology helps em-ployees to more productively allocate its scarcest re-source: its hotel rooms, which run at 95% occupancy year-round. Customers spend more when they stay at the hotelthan when they just visit the casino, so Harrah’s wants tobe able to put customers with the highest potential into

the rooms. A new system that can match up customerprofitability measures with occupancy predictions helpsemployees book rooms in a way that dynamically opti-mizes profitability. Very profitable customers could begiven rooms for free, while unprofitable customers couldbe charged the highest rate. The results of this and othercustomer-focused programs have been outstanding; profitper available room increased 30% between 1999 and 2003,which equates to more than $20 million a year added to the bottom line despite a significant increase in costs,as the number of rooms in the network has expanded.

Integral coordination is a continual process that needsto be constantly revitalized. SBC conducts training exer-cises on a large scale to keep customer initiatives at theforefront of everyone’s mind. The company’s marketingdepartment, which consists of 1,200 people and whichturned out 1,700 campaigns in 2002, offers its employeesprograms like “Campaign List Generation 101”and “Cam-paign ROI 101.”Even Harrah’s, a company widely feted forits use of customer information, recognized in 2003 that,owing to natural attrition and turnover, the customer-oriented skill sets it needed weren’t necessarily under-stood or developed throughout the organization. Late thatyear, it launched an enterprisewide marketing-trainingprogram that educated the head of marketing, the direc-tor of marketing, and finance officers for each property.In all, more than 100 leaders went through the training in2004. Harrah’s also spent more money on its marketing-related IT investments last year than it ever had before.David Norton, senior vice president of relationship mar-



Shifts in attitude cannot be forced.Employees can only be nudged, pressured, coaxed – and provided incentives.

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keting, explains: “We are now reaching for brancheshigher up the tree, so it is only getting harder. But becausewe have had so much success, there is a great appetite toinvest further and create even greater differentiation be-tween us and our competitors.”

While companies can and should distinguish betweenmore and less desirable customers, they should not forgetthat lower-value customers may over time become moreprofitable. Indeed, very few of the companies we studiedtried to get rid of lower-value customers. Rather, we ob-served, they sought to understand such customer seg-ments, to identify profitable characteristics in seeminglyless-profitable customers. For instance, Harrah’s Total Rewards program recognizes people based on their an-nual value so that lower-but-steady spenders can aspire toperks that high rollers enjoy, such as shorter lines at res-taurants. Harrah’s then modified Total Rewards in 2003to allow customers to carry over points from year to yearso that they were treated according to their true long-term value.

Similarly, at SBC, the Small Business Group’s philos-ophy is that whatever works for General Motors is alsolikely to work for small businesses. As Cathy Coughlin,the president of business communication services, ex-plains: “They want the same saving; they want to know if a new product has been introduced that could bene-fit them.”

The challenges in this stage are monumental, primar-ily because integral coordination requires a major shift in attitude on the part of so many employees. As it beganthis stage, Royal Bank of Canada found that some of itsproduct employees would pay lip service to the customer-focused approach and then revert to working in ways thatundermined the new strategy. Harrah’s senior vice presi-dent of business development, Rich Mirman, talksabout the “huddle after the huddle,”a reference tothe words of basketball coach Pat Summitt. Sum-mitt would call the huddle and then call the play,but when the team members got onto the court,they would huddle again themselves and changethe play. At Harrah’s, says Mirman,“we call a play,but the [people from the] individual properties goback and say, ‘That doesn’t pertain to our market.’All of a sudden, you’re spending 25% of your timetrying to get people to run the play.”

Similarly, the credit card division at RBC, whichhad always operated as a separate group, agreed in principle with the customer-focused approachbut continued its independent marketing activi-ties. The group came around only after it did itsown analysis and found that, as the customer-focused strategy was advocating, current bankcustomers were much more likely to add creditcard services than noncustomers. Still, even now,not all of RBC’s employees use the centralized

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“I used to play myself, when I was younger.”PAT

RIC

KH

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DIN

customer information repository in their work, and thebank acknowledges that it will probably never see 100%adoption. Even so, the strategy has had a big impact onthe business.

Shifts in attitude cannot be forced. Employees can onlybe nudged, pressured, coaxed – and provided incentives.Harrah’s invested $40 million in 2004 alone to rewardthose employees who according to their managers had delivered outstanding customer service. And after chang-ing its incentive structure and providing comprehensivetraining, Harrah’s showed how seriously it took its cus-tomer focus initiative by eliminating the recalcitrant re-sisters. As a result of these efforts, Harrah’s increased theshare of its customers’ gaming wallet from 36% in 1998 to 43% in 2003. SBC and Royal Bank of Canada have alsohad to change their incentive structures so that they notonly reward sales but also encourage cross-unit coopera-tion and client-focused behavior.

• • •Much has been written and said about customer rela-tionship management, and companies have poured anenormous amount of money into it, but in many cases theinvestment hasn’t really paid off. That’s because gettingcloser to customers isn’t only about building an informa-tion technology system. It’s a learning journey – one thatunfolds over four stages, each with its own obstacles, andeach requiring people and units to coordinate in evermore sophisticated ways. Companies that recognize thiswill invest their customer relationship dollars much morewisely – and will see their customer-focusing efforts payoff on the bottom line.

Reprint r0504f; HBR OnPoint 9645To order, see page 135.

TLFeBOOK

ver the past year, I’ve been conducting a simple, informal survey of friends and colleagues in business, consulting,and investment banking. I ask just one question: “Which

do you believe is more valuable for your company – achieving anextra percentage point of growth or gaining a percentage point ofmargin?”

On the face of it, a point of margin looks much more valuable:100% of extra margin drops to the bottom line, while, most re-spondents agree, only 7% to 8% of an extra point of growth turnsto profit – and that’s assuming the profit margin is sustained. Butexperienced businesspeople also know that growth has a com-pounding effect over time that amplifies the long-term benefit. Somost of the 30 or so people I spoke with concluded by estimatingthat a point of growth and a point of margin probably contributeabout equally to shareholder value.

I admit that my survey is not scientific. Nevertheless, I find itstriking that experienced business leaders and advisers don’t have


by Nathaniel J. Mass

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Does the real potential for shareholder value lie in more growth or extra margin? Here’s a way to determine what the market will reward–CEOs should keep this tool at their fingertips.

THE RELATIVE VALUE OF

GROWTH

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april 2005 103

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a clear sense of the relative impact that growth and extramargin have on shareholder value. My more formal re-search suggests that growth and margin are anything butequivalent. Growth often is far more valuable than man-agers think. And it’s a mistake to assume that profitabil-ity always has to be sacrificed to achieve growth (thoughthere certainly are cases where it does). For some compa-nies, convincing the market that they can grow by just oneadditional percentage point can be worth six, seven, oreven ten points of extra margin.

In practice, the choice of whether to adopt a growthstrategy or a margin improvement strategy is seldom ob-vious and depends very much on industry and company-specific factors. Some firms routinely underweight thevalue of growth and therefore risk compromising theirperformance and sustainability. Others pull growth leverswhen shareholder value is best served by boosting mar-gins and cash flow. And some doggedly fight the last war,staying with an approach whose time has passed. If man-agers are to make the right decisions in allocating their re-sources and energies across growth projects and marginimprovement initiatives, they will need to better under-stand the relative value of growth. With that information,they can identify the appropriate targets for their compa-nies and build the right organizational skills to achievethose goals.

In the following pages, I present a new metric, calledthe relative value of growth (RVG), and the analyticframework that supports it. First, I will examine theRVGs of several well-known companies and explain whythe numbers differ and what they say about the strate-gies of those companies. As these analyses will show,many organizations would benefit more from giving themarket reason to expect extra growth than from improv-ing their cost structures. Next, I will address the unspokenassumption that growth and profitability are incompati-ble over the long term and show that many companiesare effective at delivering both. Finally, I will show howmanagers can use the RVG framework to help them de-fine strategies that balance growth and profitability fortheir organizations at both the corporate and business-unit levels.

Measuring the Relative Value of GrowthThe RVG metric expresses the value of an extra percent-age point of growth as a multiple of the value of a per-centage point increase in a company’s operating profitmargin.The higher the multiple, the more valuable growth

is to a company. A multiple of 6, for example, means thata firm would generate six times more shareholder valuefrom adding 1% of growth than it would from boostingoperating margin by 1%. RVGs for quoted companies canbe estimated entirely on the basis of publicly availabledata. The process takes six steps:

Step 1: Calculate the company’s weighted average costof capital. This requires using standard balance sheet andincome sheet data to determine the company’s debt-to-equity ratio and cost of debt. I usually estimate cost ofdebt from the P&L and from contractual interest ratessometimes presented in 10-K reports. The cost of equitycan be estimated from historical share-price data usingthe standard capital asset pricing model (CAPM).

Step 2: Build a basic discounted cash flow (DCF) valu-ation model. This involves determining a company’s sus-tainable cash flow, a number that captures the ongoingearnings power of the business. The sustainable cash flownumber is undistorted by onetime charges or by unsus-tainable balance sheet changes (like delaying paymentsto creditors to free up cash) and ideally is adjusted forindustry cyclicality. Next, reverse engineer the growthexpectations of shareholders by combining the DCFmodel with the current stock price. This will yield anequation in which the expected growth rate is the onlyunknown.

Step 3: Use standard algebra to solve the equation todetermine the expected growth rate.

Step 4: Taking that growth rate as a starting point, cal-culate the gain in shareholder value that would result ifyou increased the growth rate by an additional percent-age point.

Step 5: Calculate the impact an additional point ofmargin would have on shareholder value.

Step 6: Determine the relative value of growth by di-viding the value of growth by the value of margin.

Let’s look at a simplified example in which I calculatethe RVG for a real (but disguised) company in the finan-cial services sector. The company has a market capitaliza-tion of $700 million, and the value of its outstanding debtis $300 million, giving it a total enterprise value of $1 bil-lion and a debt-to-equity ratio of 3:7. Annual revenues inthe past year were $400 million, and earnings before in-terest and taxes (EBIT) were $68 million, implying an op-erating margin of 17%. The company’s cash flow availablefor distribution to shareholders was $40 million (EBIT onan after-tax basis, plus depreciation, less capital expendi-tures). A summary of the six-step RVG calculation for thecompany is shown in the exhibit “Calculating the RelativeValue of Growth.”


The Relative Value of Growth

Nathaniel J. Mass is the managing director of N.J. Mass Associates, an investment banking and strategic growth advisory firmbased in New York, and a senior fellow with Katzenbach Partners, a management consulting firm, also based in New York.He was previously the director of worldwide strategic planning for Exxon Chemical Company and is a former partner atMcKinsey & Company.

TLFeBOOK

april 2005 105

The first step in determining RVG is to apply theCAPM formula. This gives us a cost of equity for thecompany of 12.5%. We determine the cost of debt to bean average of 6% (calculated from the debt cost on theP&L and reflecting the maturities of the company’sdebt). With a 3:7 debt-to-equity ratio, and assuming astandard corporate tax rate of 35%, these numbers giveus a weighted average cost of capital of 10%. (See Step 1of the exhibit.)

In Step 2, we build a simple discounted cash flowmodel that enables us to infer what growth rate themarket expects of this company. For simplicity’s sake,we will use a standard perpetuity formula, in which a company’s enterprise value equals its cash flow dis-counted by the weighted average cost of capital (WACC)minus the expected growth rate, or g. Using the as-sumptions given above, we arrive at the following val-uation equation: $1 billion = $40 million ÷ (10% − g). InStep 3, we solve this equation, giving us an expectedgrowth rate of 6%.

Now we are ready to calculate the value of an extrapoint of growth (Step 4). We simply add a percentagepoint to our expected growth rate and feed it back intoour valuation equation to see what impact it has on en-terprise value. We divide $40 million by 3% (10% less7%), which gives us an enterprise value of $1.333 bil-lion. The extra point of growth, therefore, generated$333 million in enterprise value, of which 70% (re-member that the debt-to-equity ratio is 3:7) is equityvalue, yielding $233 million.

Moving on to Step 5, we calculate the value of anextra percentage point of margin. With revenues of$400 million, an extra point of margin is worth $4 mil-lion before taxes. Adjusting for a 35% tax rate leaves uswith a net increase in cash flow of $2.6 million a year.We now use our basic DCF model to see what that cashflow represents in terms of added enterprise value. Wediscount the $2.6 million at the cost of capital less theexpected growth rate ($2.6 million ÷ 4%), giving us$65 million in added enterprise value or $45.5 million


Calculating the Relative Value of GrowthManagers need a clear understanding of the relative impactof growth and extra margin on shareholder value in order tomake appropriate strategic choices. The tool presented hereallows managers to measure the relative value of growth(RVG) for their own companies – and for their competitors.Using basic balance sheet and income sheet data, as well asstandard financial tools, managers first determine the rate ofgrowth that the market expects a company to deliver. Next,they calculate the relative value of growth: the extent to whichone extra percentage point of growth affects shareholdervalue as compared with one additional point of margin.

Company Data:

Enterprise value (EV) $1B

Market cap $700M

Debt $300M

Debt-to-equity ratio 3:7Revenues $400M

EBIT $68M

Cash flow (CF) $40M

Cost of equity 12.5%

Cost of debt 6%

Step 1: Weighted Average Cost of Capital

Determine the weighted average cost of capital using the formula:

Cost of debt × (1 − tax rate) × debt ratio + (cost of equity × equity ratio)

6% × (1 − 35%) × (30%) + (12.5% × 70%) = 10% >> WACC = 10%

Step 2: Discounted Cash Flow Model

Build a basic perpetuity growth model to determine shareholders’average growth expectation over time:

EV = CFWACC − g >> Where g = expected growth rate

Step 3: Expected Growth

Use standard algebra to solve for g:

$1B = $40M

10% − g >> g = 6%

Step 4: Value of Growth

Calculate the value of one additional percentage point of growthusing the valuation model from Step 2:

EV = $40M = $1.333B10% − (6% + 1%)

>> Value of growth = $1.333B − $1B = $333M

Step 5: Value of Margin Improvement

Calculate the value of a 1% operating margin improvement on revenues of $400M (adjusted for the corporate tax rate):

Increase in cash flow = $400M × (1%) × (1 − 35%) = $2.6M

>> Value of margin improvement = $2.6M = $65M10% − 6%

Step 6: Relative Value of Growth

Determine the relative value of growth:

RVG = value of growth ÷ value of margin improvement

= $333M = 5.1 RVG = 5.1$65M

TLFeBOOK

in shareholder value (again reflecting the 3:7 debt-to-equity ratio).

The final step is to calculate the company’s RVG by di-viding the value derived from growth (Step 4) by thevalue derived from margin (Step 5). The RVG of 5.1 tellsus that one extra point of growth yields as much in valueas 5.1 extra points of margin.

This calculation is a simple way to assess the relativevalue of growth for your company and also to provide aquick “outside-in”view of any public company. There are,of course, numerous and more precise ways to get to thenumber. For example, it is sometimes valuable to extendthe basic perpetuity growth model to a more complexDCF model that distinguishes near-term versus long-term growth prospects. Or, company data on cost of capi-tal and growth-return prospects for specific businessunits can be incorporated. It is also possible to breakdown the market’s expected growth rate into numbersthat reflect acquisition-driven growth on the one hand

and organic growth on the other. But in my experience,the simple approach is usually quite revealing. Based onthe data, you can make important decisions about yourfirm’s strategy. And by using publicly available informa-tion, you can look at any number of different companieson more or less the same terms and thus establish a soundbasis for comparison. The exhibit “The Corporate GrowthParade”shows the RVGs for a number of leading publiclylisted U.S. companies, including some mentioned in thisarticle, and highlights interesting discontinuities betweenwhere the real value lies for some companies and theirstrategies.

What RVG Tells UsCalculating RVGs gives managers insights into whichcorporate strategies are working to deliver value andwhether companies are pulling the most powerful leversfor value creation. Let’s now consider four well-knowncompanies to see what their RVGs tell us about them. Theanalysis in these examples is not precise, but it does suf-fice to indicate where these companies’ managers shouldbe looking for value – and how successful they currentlyare at extracting it.

Procter & Gamble. Until the announcement of its$57 billion takeover of shaving giant Gillette, P&G wasbest known as a turnaround story. In 2001, the companyeliminated 9,600 jobs and carried out its first overheadreduction in more than five years. Capital spending wasalso reduced by 1.5% of sales as part of the company’s ef-fort to achieve operating efficiencies. The market seemedto reward these initiatives handsomely. Over the past fouryears, P&G’s market capitalization increased by around$70 billion.

But look at the numbers closely and you’ll see thatProcter & Gamble’s success had a lot more to do with thecompany’s growth initiatives than with its cost-cuttingmeasures. P&G’s stock price (around $55 at the time ofthis writing) implied that investors expected the companyto grow approximately 4.4% a year. (I used the perpetuitygrowth model shown in Step 2 of the RVG methodologyto derive the expected growth rate, assuming an enter-prise value of $157 billion, a sustainable cash flow of

$5.6 billion, and a weighted average cost of capital of 8%.)This was well below recent quarters’ average earningsgrowth rate of around 10% but well above GNP growth,indicating that investors expected P&G to generate realearnings growth over the long haul. More than half ofP&G’s market capitalization reflected these expectationsabout the company’s growth prospects. At the time of theGillette announcement, P&G’s enterprise value due tocurrent performance equaled the $5.6 billion cash flow di-vided by its 8% cost of capital, yielding $70 billion. The re-maining $87 billion of enterprise value, roughly 55% of the$157 billion total, reflected investors’growth expectations.By contrast, four years ago (when, to use July 2000 data inthe perpetuity formula, enterprise value was $85 billion,WACC was nearly 7.7%, and cash flow for the previous 12months was $5 billion), investors were expecting the com-pany to grow by just 1.7%, and less than 25% of the marketvalue could be attributed to expectations about growth.That means investments in growth have delivered over90% of the more than $70 billion increase in P&G’s en-terprise value, while the much touted operational im-provements have accounted for less than 10%.

What did Procter & Gamble do to elevate share priceperformance over the past four years? While it did exe-



For some companies, convincing the market that they can grow by just one additional percentage

point can be worth six, seven, or even TEN POINTS OF MARGIN IMPROVEMENT.

TLFeBOOK

cute several large-scale (and high-premium) acquisitionsincluding those of Clairol and Wella, the real source ofP&G’s added value was probably the company’s reinvig-orated commitment to product innovation and its suc-cess in building larger business platforms. A good illustra-tion is the company’s expansion of its oral care business,which was initially driven by organic innovation in CrestWhitestrips and then reinforced by the small acquisitionof Dr. John’s Spinbrush, whose revenues P&G was able togrow dramatically thanks to its marketing clout. The creation of additional new product categories, such asMr. Clean AutoDry Carwash, also added to P&G’s lusteras a growth company.

The results from the RVG calculations suggest thatP&G should continue on the same track. If P&G were toimprove the combined company’s margin by just a singlepoint, the result would be about $7.35 billion in addedshareholder value – a solid boost of nearly 5% to total en-terprise value. But if management can convince the mar-ket to expect an extra point of revenue growth from P&G,the company will create more than $52 billion in addedshareholder value – boosting current enterprise value bya full 34%. The RVG of 7.2 means that P&G would have towring out 7.2 points of additional operating margin (giv-ing the company an operating margin of 25%) in order todeliver the benefits of just one more point of growth.That would constitute a huge, if not impossible, executionchallenge. Delivering value through raising growth ex-pectations is clearly the easier option.

On the face of it, therefore, the acquisition of Gillettelooks like a move in the wrong direction. Reverse engi-neering Gillette’s stock price just prior to the acquisitionyields an embedded growth rate of 3.1%, more than a fullpoint below P&G’s existing rate. However, if the currentexpectations for Gillette’s growth are poor, the value to beunlocked from raising those expectations is anythingbut. Thanks to the company’s already strong profit mar-gins and cash flow, Gillette has an RVG of 10.4, more thanthree points above P&G’s. An additional point of growthwould add over $20 billion to Gillette’s enterprise value–roughly four times the nominal acquisition premium of$5 billion. In other words, if P&G can apply its market-ing skills to boost growth from Gillette’s operations byjust a third of a percentage point – hardly an impossibletask, given the company’s success with its own operations–the deal will pay off for P&G’s shareholders. And that, ofcourse, does not take into account the margin benefitsthat P&G can easily squeeze out of the deal by eliminat-ing redundancies across both companies after the deal’scompletion. Indeed, if P&G improves margins by just onepoint, delivering $2 billion in value, then all it needs todo to cover the acquisition premium is deliver less than0.2% a year of additional growth, worth $3 billion.

Procter & Gamble also provides a striking illustrationof another advantage of growth–that it has a multiplying

april 2005 107


The Corporate Growth ParadeI studied a number of well-known U.S. companies to deter-

mine what their relative value of growth (RVG) numbers say

about their stated or implied strategic priorities. The higher

the RVG, the more valuable growth is to a company as com-

pared with margin. In this sample, some companies, like

Pfizer, are clearly on the right track, while others, like Merrill

Lynch and Office Depot, show potentially alarming discon-

nects between their strategies for improving shareholder

value and where the real potential lies.

Stated or Apparent Strategy

Growth

Growth

Growth

Margin

Growth

Growth

Growth

Margin/Growth

Growth

Margin/Growth

Margin

Growth

Margin

Growth

Growth

Margin/Growth

Margin

Margin

Growth

Margin

Growth

Growth

Margin

Margin

Growth

Growth

Margin/Growth

Growth

Growth

RVG

14.5

12.8

11.4

10.5

10.4

9.0

8.1

7.4

7.2

5.1

5.0

4.4

4.3

3.7

3.5

3.0

2.4

2.1

2.1

1.7

1.6

1.5

1.4

1.3

1.2

1.0

0.7

0.7

0.7

Company

Mercury Interactive

Pfizer

General Electric

Merrill Lynch

Wells Fargo

Computer Associates

MBNA

American Express

Procter & Gamble

Danaher

Kellogg

Dell

Washington Mutual

Capital One

IBM

BMC Software

General Motors

Exxon Mobil

UnitedHealthcare

Aetna

Wal-Mart

Lubrizol

Allstate

CIGNA

Hewlett-Packard

WellPoint

EDS

BJ’s Wholesale Club

Office Depot

TLFeBOOK

effect on value. The value of two extra points of growthis about three times the value of the first point. That’s notthe case with margin, where the value of two extra pointsis just twice the value of one point, the value of three extrapoints is three times the value of one point, and so on. Inother words, increases in growth have a compounding ef-fect on value while improvements in margin have a lineareffect. For all the publicity around its cost-cutting andefficiency initiatives (both before and after the Gilletteannouncement), P&G’s continued investments in growthand innovation capacity will be the real driver of valuecreation at the company.

Exxon Mobil. This company has nearly $250 billion inglobal energy-related sales, including a chemicals divi-sion that is the same size as DuPont. Over long periods oftime, the total return to shareholders has exceeded boththe Dow and the S&P indexes, even though Exxon Mobil’srevenue growth has been below the average of othermajor oil companies. I estimate that the company’s cost ofcapital is around 7.2% – nearly a point below P&G’s, eventhough Exxon Mobil essentially uses no debt to reduce itscost of capital. Enterprise value is around $260 billion.

Estimating Exxon Mobil’s sustainable cash flow yieldsa range for the company’s embedded growth rate of 1.8%.I find that less than 25% of Exxon Mobil’s valuation isdriven by expectations of future growth. These results re-inforce the image of a company with extremely strongcash flow that has grown earnings slowly but consistentlythrough intense bottom-line discipline.

Shareholders clearly benefit from a continued focuson the bottom-line. Each point of margin improvementis worth about $28.5 billion in shareholder value, which isnearly an 11% boost to enterprise value. But shareholderswould benefit much more if the company were to raiseinvestors’growth expectations. My calculations show thatexpectations of an added point of corporate growthwould be worth nearly $59 billion, adding 22.5% to en-terprise value. Exxon Mobil’s relative value of growth isthus 2.1. Two extra points of growth would add more than$150 billion in shareholder value, close to a 60% boost –once again showing how increasing growth is increasinglyvaluable.

Exxon Mobil shouldn’t change its stripes overnight anddefinitely shouldn’t move away from operational excel-lence, but the company could clearly add a growth goal toits core management metrics. Perhaps that’s why ExxonMobil chairman Lee Raymond recently said he wantedto raise the company’s growth rate to around 3%. Up-grading growth performance by 1.2 points would contrib-ute shareholder value equivalent to nearly three pointsof margin improvement – making growth a compellingoption given that the company’s current operating profitmargin of 12% is already healthy for the sector.

Kellogg. An RVG analysis of Kellogg reveals a strikingcase of potentially misdirected strategic effort by the ce-

real and snack giant. Over the past year, the company’sstock price has risen by 20%, comfortably outperformingits competitors’. The gain has been driven by Kellogg’s in-vestment of time and effort into improving operations.

Impressive as it sounds, this performance should be putinto perspective. The company’s stock price is only backto where it was about five years ago after a rocky fewyears. Moreover, the RVG formula reveals that Kellogghas barely 0.4% of annual growth built into shareholderexpectations – even after the recovery in the share price.As a result, fully 91.5% of Kellogg’s market capitalizationcan be accounted for by currently generated cash flows,and only 8.5% is attributable to growth expectations.Clearly, Kellogg’s investors do not see the company as agrowth stock.

Continuing the RVG calculation reveals that an extrapoint of operating margin is worth $1.05 billion to Kel-logg, conferring a respectable 6.2% boost in market capi-talization. But that number pales in comparison with the$5.3 billion in additional value that would be generatedby a point of growth, implying a 31.3% boost to marketvalue and an RVG of 5.04.

This mismatch between the company’s potential valuecreation from growth and market expectations indicatesthat something is amiss with the company’s strategy. Kel-logg has been acclaimed for its “Volume to Value” strat-egy of upgrading to higher-margin products; for cuttingexcess capacity; and for strengthening direct store deliv-ery (DSD), especially through its Keebler acquisition. Butit looks as if investors believe that Kellogg has strength-ened operations more than it has invigorated growth ca-pacity.The company needs to reenergize the growth leversof R&D, product mix, and innovative distribution to de-liver a more compelling growth story for investors.

EDS. An RVG analysis tells companies not only whento invest in growth, but also when not to. EDS is a $21 bil-lion player in the IT and business-process-outsourcing in-dustry, historically a growth sector driven by economies ofscale and scope in managing complex and geographicallydispersed networks.

CEO Michael Jordan recently ignited controversy whenhe announced a plan to cut 20,000 jobs as part of an ini-tiative to shave the company’s cost structure by 20%. Crit-ics argued that the aggressive cost takeout would impairthe company’s ability to compete in a growth marketagainst the likes of Accenture and IBM Global Solutions.As one industry analyst opined,“In the services business,your people are your assets…so [Jordan] is reducing hischances for future growth…he doesn’t seem to under-stand what business he is in.”

Investors, however, disagree. Despite a run-up in theshare price following Jordan’s cost cuts, investors still donot expect that the company will be able to grow verymuch; the implied growth rate is just 0.2% a year. Thatmeans 98% of EDS’s market value can be attributed to



TLFeBOOK

prevailing profits and cash flow. The fact that the com-pany participates in an ebullient industry has no effect onthe market’s perception of EDS. Turning to the future, thenumbers show that EDS could gain about $1.45 billion inmarket cap for an extra point of operating margin im-provement, compared with $1 billion for an additionalpoint of growth, implying an RVG of 0.69.

EDS, the numbers suggest, is among those companiesthat need to earn the right to grow. The company has arazor-thin operating margin (around 3.5% of sales) and a relatively high cost of capital compared with its embed-ded growth rate. Without first boosting margin and cash

flows and creating a more scalable growth model, EDSrisks destroying shareholder value by attempting to growrevenues. I estimate that EDS needs to add about two anda half points of extra margin to achieve an RVG of 1, atwhich point a balanced strategy of growth and profit im-provement would become appropriate. Jordan is on theright track, but he has further to go. Not least among hischallenges will be changing the company’s ingrained biastoward investment in growth.

The Drivers of RVGWhat are the drivers of a company’s RVG? Why, for in-stance, is Exxon Mobil’s RVG just 2.1 while Procter &Gamble’s is 7.2? Different RVGs result from variations infour key areas: margin, capital intensity, expected growthrate versus cost of capital, and the synergistic effect of allthree of these elements combined. Knowing the drivers ofyour RVG compared with those of other companies caninfluence the strategic choices you make.

The first driver is margin; growth cannot create valueunless it is profitable. With an average operating marginof 18%, P&G has a clear advantage over Exxon Mobil,which has a margin of 12%. If both companies grow with-out reducing their margins, each point of growth will bemore valuable for P&G than it will be for Exxon Mobil.My calculations indicate that the operating margin effectalone accounts for 1.49 points of difference between thetwo companies’ RVG numbers.

Another source of difference between the two com-panies’ RVGs is that Procter & Gamble’s business is less

capital intensive than Exxon Mobil’s and requires lowerlevels of working capital (turning Tide into liquid Tidecosts a lot less than building an oil rig in the Gulf of Mex-ico). Thus, it costs Procter & Gamble less to get an extrapoint of growth than it costs Exxon Mobil. By my calcu-lation, the capital intensity effect means that P&G’s busi-ness generates $.023 more cash flow per dollar of salesthan Exxon Mobil’s does. This translates into 0.78 extrapoints of RVG.

The third factor favoring Procter & Gamble is that ithas a higher expected growth rate relative to its cost ofcapital, which reduces the rate at which future cash flows

are discounted into value. So even though Exxon Mobil’scost of capital is 0.9 percentage points lower than P&G’s,by my estimates, its expected growth rate – that is, thelevel of growth that investors believe is sustainable–is 2.6percentage points lower. This means that Exxon Mobil’scash flows are being discounted at a larger net interestrate than P&G’s. In terms of RVG, this is worth 1.38 pointsfor P&G.

In calculating the impact of these three factors, Ichanged only the variable under review in each case. Soin estimating the value of a lower discount rate, for ex-ample, I did not assume a higher margin, which allowedme to isolate the impact on value of that variable. Butthese individual calculations ignore the fact that thereare considerable synergies between the three factors.These synergies represent the fourth factor differentiat-ing the RVGs of two companies. The fact that P&G en-joys a higher operating margin plus lower asset intensityplus a lower net discount rate makes the combined valueof these advantages more than the sum of their parts. Ifa company can capitalize a higher operating margin at alower growth-adjusted discount rate, then the highermargin is all the more valuable. To ascertain the value ofthe synergy between the lower discount rate and thehigher growth rate, I calculated the impact on value ofchanging both variables together and then subtracted theeffect of the two single changes, which I had already esti-mated. I carried out the same exercise to estimate the syn-ergy value of the lower discount rate and capital intensityand the synergy between capital intensity and growth.Finally, I used essentially the same approach to estimate

april 2005 109


Adding a point of sustainable growth maybe harder to achieve than improving your

company’s margin, but the largest profits usually goHAND IN HAND WITH THE FASTEST GROWTH.

TLFeBOOK

the synergy value of all three factors changing together.I estimated that the net synergies among P&G’s specificeconomic advantages contribute an extra 1.5 points to itsRVG advantage.

Rejecting the Growth–MarginTrade-OffBy now it should be clear that, for most companies, in-vesting in growth generates more shareholder value thancost cutting does. So why aren’t more companies aggres-sively pursuing growth strategies?

Part of the reason, clearly, is the one I highlighted atthe beginning of this article: Few executives have a clearmeasure of their companies’ relative value of growth.And that makes it very unlikely that many of them willhave compensation packages that are linked to profit-able growth targets. Another reason is that the compa-nies that have earned (through financial discipline) theright to grow often lack the management skills to investin growth. Anyone who has tried to turn around a declin-ing company knows firsthand that taking out costs is chal-lenging, but it’s still much easier than reviving growth,which is harder to execute and requires different skills.

For both these reasons, companies often fail to allo-cate the right quality and quantity of resources to growthprograms. This activates a vicious dynamic. If growth pro-grams are not being pursued purposefully and diligentlyunder the eye of top-level management, confidence in theprograms erodes, and the organization doesn’t build asolid experience base. As a result, growth projects fail todeliver on their promises, reinforcing the perception thatprofitable growth is too difficult to achieve. I frequentlyhear CEOs expressing relief that they didn’t dedicate theirbest people to their companies’ failed growth programs,not realizing the self-fulfilling nature of the decision.

But my experience as a senior executive suggests thatthere is a third, even more deeply rooted, obstacle to prof-itable growth. This is the widespread belief that managershave to choose between growth and profitability, that thetwo goals are somehow incompatible. As with many in-grained beliefs, there is an element of truth in the idea.The two goals often do clash in the short term. If youbuild a new plant, for instance, especially in a new geo-graphic market, it is virtually certain that your return oncapital will be low for several years. It’s hardly surprisingthat managers under pressure to produce good quarterlynumbers find that profits and growth make uncomfort-able bedfellows.

To get to the bottom of the matter, I’ve analyzed com-pany performance in a number of industries character-ized by the perception that companies must trade marginfor growth. Let’s look closely at one of these industries –specialty chemicals, a mature, slow-growth business. As

the exhibit “Growth and Performance in Specialty Chem-icals” shows, profitability and growth are not necessarilyconflicting goals. Many companies perform well on bothcounts. Valspar, for instance, a high-tech industrial andconsumer coatings company, has grown profits by nearly14% a year while maintaining positive EVA (mainly drivenby strong margin). What’s more, all the companies thathave succeeded at growth have preserved good prof-itability. In other words, no company in this study had tosacrifice acceptable profitability in order to grow.

The exhibit does show that a number of companieschose to forgo growth in return for better margins. Ananalysis of their share-price performance reveals thatthese companies were generally punished by the mar-kets for making this choice. Lubrizol, for example, consis-tently earns about 3.5 points above its cost of capital. Youwould expect Lubrizol to have a relatively high marketvaluation, but in fact it carries pretty much the same val-uation multiple as Eastman, one of the laggards with bothlow growth and low margins. This emphasizes once againhow much importance investors, if not managers, placeon growth.

Balancing Growth and MarginStrategy, then, is not an either-or decision of whether togrow or to concentrate on margins. To create the mostvalue for shareholders, companies must define more am-bitious and ambidextrous strategies to achieve the rightbalance between cost control and growing revenues. TheRVG framework can help managers achieve this balance.Consider the case of a leading enterprise software playerI recently advised.

An RVG of 3.5 suggested that the market was treatingthe company as a growth investment. But in analyzingits RVG, the company realized that the growth expecta-tion of 5% built into its stock price exceeded its near-termcapacity to grow organically. Once the market saw thatthe company had not, in fact, earned the right to grow,a collapse in the share price was inevitable. To achieve thegrowth necessary to sustain its stock price, the companyneeded to build a solid growth platform. Managers un-derstood that the problem stemmed largely from the factthat the company’s R&D cost structure was bloated bythe high support costs required to maintain and tailorolder products. This prevented the company from gener-ating a fast enough flow of new products. So the firm tooksteps to trim R&D costs and accelerate the commercial-ization of new products. The changes have not only madea target organic growth rate of 7% – which will push thestock price up by 15% – look achievable, they have also in-creased the value of future growth by pushing the RVGup to 3.8 through a more efficient business model.

Determining the balance between cost managementand revenue growth also needs to be done at the product



TLFeBOOK

level. Here again the RVG framework can help. A partic-ularly useful analytic tool is the value equivalence map(VEM), which allows executives to see how various prod-ucts should be managed in order to sustain or increase thecompany’s share price.

The VEM for the software company in our example isshown in the exhibit “The Value Equivalence Map.” Prod-ucts are placed on the map according to their projectedgrowth and the operating margins they deliver. The diag-onal lines, or value equivalence curves (VECs), display themargin and growth rate combinations that will delivergiven values for the company’s stock price. The slope of

the line is the RVG, telling you how many points of mar-gin are equivalent in value to a point of growth. The solidline is the value equivalence curve for the software com-pany’s current stock price and RVG, and the dotted lineshows the combinations that would deliver the company’stargets of a stock price 15% higher and a growth rate of 7%as opposed to 5%.

As the chart shows, of the software company’s five mainproduct lines, products A and E have serious value gapsand are detractors for the company. Managers need to in-tervene if these product lines are to become value neutraland, eventually, higher-value contributors.

april 2005 111


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Growth and Performance in Specialty Chemicals

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Ethyl

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EVA(return on invested capital less weighted average cost of capital)

The misguided notion that companies must sacrifice

margin for growth can have disastrous implications

for companies looking to create long-term value. This

chart illustrates that even in a mature, slow-growth in-

dustry like specialty chemicals, profitability and growth

can go hand in hand.

I looked at the performance of a variety of specialty

chemical companies in terms of their growth rates and

margins. I examined five-year average annual growth

rates of EBITDA (the usual proxy for cash flow) on the

one hand, and EVA, which mainly reflects margin

(since asset intensity and cost of capital are fairly sta-

ble over even a five-year period) on the other. As this

chart shows, companies like Valspar and Avery were

able to both grow and maintain positive EVA due to

strong margins. What’s more, no company had to ac-

cept subpar profitability in return for growth. Particu-

larly striking is the absence of companies in the upper

left quadrant of the chart (with good growth but poor

profitability), in contrast to the multiple high per-

formers in the upper right quadrant (with both good

growth and profitability).

TLFeBOOK

The VEM analysis can also help managers better un-derstand how new business opportunities would affectshare price. Consider product F in the exhibit. At 3.25%,this potential product has a below-average margin for thecompany, but an extremely attractive underlying growthrate. If the company were to make an investment in F andbring product lines A and E to the same level as B, C, andD, then it could achieve a share price increase of morethan 15%, the company’s near-term objective. By continu-ing to upgrade the portfolio’s organic growth to at least 7%per year and by using its strong cash flow to acquire com-plementary businesses, the company should be able tofuel larger increases in share price over time. Currently,the company is launching product F in concert with theproduct performance improvements, and it has alreadyseen the 15% boost in share price.

• • •The relative value of growth framework should be part ofevery top manager’s strategic tool kit. RVG analysis canprovide managers with both a sound understanding ofwhere their shareholders expect them to focus their en-ergies and a report card on their performance. In partic-ular, it will help managers avoid the trap of underesti-mating the potential of growth as a source of value.Adding a point of sustainable growth may be harder toachieve than improving your company’s margin, but asmany companies have found, the largest profits usuallygo hand in hand with the fastest growth. It’s time we putan end to the idea that the two are incompatible.

Reprint r0504gTo order, see page 135.



−10 −5 0 5 10 15 20 25 30

20

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−5

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Value Gap

Average position required to maintain current stock price

Slope of VEC =relative value ofgrowth 3.5

VEC based on current stockprice

Target VEC based on 15%increase in stock price

Operating Margin (percentage)

Five

-Yea

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)The Value Equivalence Map

Companies can use the value equivalence map to better un-

derstand how individual parts of their businesses balance

margin and growth relative to the company’s strategic

goals. It can also provide insight into the value creation po-

tential of new business opportunities.

In the software company example shown here, managers

place products on the map by plotting their projected

growth and the operating margins they deliver. The diago-

nal lines, or value equivalence curves, display the various

margin and growth rate combinations that will deliver

given values for the company’s stock and RVG. As the

exhibit shows, products A and E have serious value gaps.

Managers need to intervene if these product lines are to

contribute value to the company’s portfolio. Introducing

product F, with its attractive underlying growth rate, will

dramatically improve the company’s share price.

F

Value GapA

E

TLFeBOOK

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H A R V A R D B U S I N E S S S C H O O L P U B L I S H I N G

T H E P O W E R O F I D E A S A T W O R K

6 1 7 - 7 8 3 - 7 6 2 6

TLFeBOOK


anagers learn by example.They – and the consultants they

pay for advice – study the methods andtactics of successful companies in searchof the magic formulas for business pros-perity. What could make more sense?

What could be more dangerous. Look-ing at successful firms can be remark-ably misleading. I once listened to a pre-sentation about the attributes of topentrepreneurs. Drawing on a wealth ofimpressive case studies, the speaker con-cluded that all of these leaders sharedtwo key traits, which accounted for theirsuccess: They persisted, often despiteinitial failures, and they were able topersuade others to join them.

That sounded reasonable enough tomost people in the audience. The onlytrouble was, the speaker failed to pointout that these selfsame traits are neces-sarily the hallmark of spectacularly un-successful entrepreneurs. Think aboutit: Incurring large losses requires bothpersistence in the face of failure and theability to persuade others to pour theirmoney down the drain.

Here’s the problem about learningby good example: Anyone who tries to

make generalizations about businesssuccess by studying existing companiesor managers falls into the classic statis-tical trap of selection bias–that is, of re-lying on samples that are not represen-tative of the whole population they’restudying.So if business researchers studyonly successful companies, any rela-tionships they infer between manage-ment practice and success will be nec-essarily misleading.

The theoretically correct way to dis-cover what makes a business successfulis to look at both thriving and flounder-ing companies. Then business research-ers will correctly identify the qualitiesthat separate the successes from the fail-ures. Researchers might conclude – asmany have–that the strength of a com-pany’s culture is associated with successbecause many successful companies havestrong cultures. But if they were to studybankrupt companies as well, they mightfind that many of those also had strongcultures. They might then be moved tohypothesize that the nature of a com-pany’s culture is at least as important asits intensity and then look more deeplyinto the whole issue of culture.

Similarly, if we want to examine ef-fective leadership traits, we cannot lookonly at excellent managers. We mustalso consider managers who failed to bepromoted, were demoted, or were fired.Perhaps their styles of leadership wereequally visionary – or humble. Withoutlooking, we cannot tell.

The Blinding Light of SuccessSelection bias is a difficult trap for busi-ness scholars and practitioners to avoidbecause good performance is rewardedby survival. Any sample of current man-agers will contain more successes thanfailures, if firms’ internal selection sys-tems work properly. Similarly, poorlyperforming firms tend to fail and disap-pear, and so any sample of existing com-panies by definition consists largely ofsuccessful ones.

For that reason, managers are lesslikely to be infected with selection biasif they’re working in an emerging in-dustry. The evidence of failure is allaround them.During the Internet boom,for instance, scores of new companiescame into and went out of business.


H B R AT L A R G E

Selection Bias and thePerils of Benchmarkingby Jerker Denrell

Impressive studies show that following best

practices, focusing on the core, and building a

strong culture are among the secrets of business

success. But beware:These and other received

ideas may also be the secrets of failure.

M

TLFeBOOK

What’s more, many were able to stayafloat for some time with little, or evenno, revenue. Managers trying to evalu-ate the merits of the various strategies at that stage of the online sector’s evo-lution could work off a relatively unbi-ased data set.

Of all managers, venture capitalistsare perhaps the least likely to sufferfrom selection bias. Since only about10% of all investments they make willbecome profitable, VCs invest in manydifferent ventures in the hope that largereturns on the few successes will com-pensate for the numerous losses. SoVCs observe many failures, and theirbase of experience is almost completelyunskewed by success.

It is when an industry matures andthe failure rate falls off that selectionbias becomes a problem. After the dot-com crash, poorly performing compa-nies finally went out of business, andfewer firms entered, which meant thatnot as many subsequently failed. At thesame time, companies like Amazon,Google, and eBay grew larger, and evenprofitable, attracting more attention.Going forward, it is likely that only a few

large firms will dominate in this indus-try, and the myriad companies that havefollowed similar strategies but failed willbe forgotten.

The effect of bias is almost certainlylarger than most people think becausethe winnowing process in most indus-tries is so dramatic. Some studies haveshown that 50% of all new businessesfail during their first three to five years.Consider, for example, the U.S. tire in-dustry. After a period of rapid growth,the number of firms peaked in 1922 at274. By 1936, there were just 49 survi-vors, a decline of more than 80%. Soanyone studying the industry in the1930s would have been able to observejust a very small sample of the popula-tion that had originally entered.

That’s not to say that established com-panies don’t fail. They do, especially inthe wake of radical shifts in technologyor demand. But the fact is that peoplewho work in established companies inmature industries are the most suscep-tible to selection bias. A regional mar-keting manager in a corporation likeCoca-Cola or Procter & Gamble spendsmost of her time administering a suc-

cessful brand and product line. She mayhave failed in implementing a new mar-keting practice at some time or another,but she will only ever have led the in-troduction of two or three new prod-ucts and will probably never have startedup a new business. In other words, herexperience will be heavily biased towardsuccess.

Selection bias isn’t just an issue forindividual companies. Judgments aboutgeneral management practices are alsocolored by it. A new quality program inone company may not work out aspromised and be discontinued. Otherfirms in the same industry may succeedwith the program and keep it. Unlessyou find out about the programs thatfailed, you will be able to observe onlythe successful cases.

I don’t mean to suggest that manag-ers and analysts never study failures. Butthe ones they look at tend to be thereally spectacular fiascoes or those, likeEnron, that provoke strong moral out-rage. And even then, it’s usually only in the moment. How many managersspend their time studying the corpo-rate collapses of the 1980s? Yet they still

april 2005 115

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TLFeBOOK

read books about the manufacturingstrategies of the Japanese innovators ofthat time.

Where the Dangers LieWhat kinds of traps do managers fallinto when they rely on biased data?Three are likely.

Perhaps the most prevalent mistake isto overvalue risky business practices.The problem is easy to see in the exhibit“The Effects of Bias,” which illustrateswhat happens when trends are drawnfrom incomplete data fields.

The graphs plot the relationship be-tween engaging in a risky organizationalpractice and subsequent corporate per-formance. The first graph records datafrom all companies that have ever im-plemented the risky practice, while thesecond one excludes companies thatfailed. As you might expect, the perfor-mance of firms that do not employ thepractice at all is relatively stable. Butthe greater the degree to which firmsengage in the practice, the wider thegap between the successful and unsuc-cessful companies becomes, as perfor-mance either spikes or plummets. Onaverage, though, as the trend line shows,engaging in the risky practice somewhatreduces performance.

Now suppose that we observed thisindustry only after many of the worst-performing companies had gone out ofbusiness or had been acquired by otherfirms. In that case, we would have seenthe successes but few of the failures asso-ciated with the risky practice. As a result,the observed association between therisky practice and performance wouldbe positive, as the second graph shows–the reverse of the true association.

Lee Fleming aptly illustrates this dy-namic in his Harvard Business Reviewarticle “Perfecting Cross-Pollination”(September 2004). Fleming finds that,on average, the value of innovationscoming out of diverse, cross-functionalteams is lower than the value of inno-

vations produced by teams of scientistswhose backgrounds are similar to oneanother. But the innovations that themore heterogeneous teams producetend to be either breakthroughs or dis-mal failures. In fact, the distribution ofthe innovation values as the diversity of team members increases looks quitesimilar to what we see in our first graph.

In most instances, however, data onfailed projects are not available, at leastabout failed projects in other compa-nies, so most managers would be able toobserve just the distribution pattern we

see in our second graph. As a result, theywould overestimate the value of cross-functional teams. Only by collectingdata on both successes and failures, asFleming did, could they spot the risks involved in using cross-functional re-search teams. (Another example of thesame dynamic is described in the side-bar,“How Wrong Can You Get?”)

A second trap for unwary managersarises from the fact that performanceoften feeds on itself, so that current ac-complishments are unfairly magnifiedby past achievements. To see how thisworks, imagine that a company is a run-ner competing against other runners. Ifthe runner wins ten independent races,he is probably better than the others,who can learn from him. But suppose instead that the outcome of one race affects subsequent races. That is, if therunner wins by one minute in the firstrace, he gets a one-minute head start inthe next race, and so on. Clearly, win-ning ten such races is less impressive,since a victory in the first race gives therunner a higher chance of winning thesecond, and an even higher chance ofwinning the third, and so on.

Many industries work the same way.For example, a telephone company or a software firm that had a large marketshare in 2004 will probably also have a large market share in 2005, owing tocustomer inertia and switching costs.Thus, even if managers do a poor job in2005, such a company might still turn in high profits, as managers coast ontheir past accomplishments or good luck.

Focusing on stock market returns in-stead of profits mitigates this problem,since changes in stock prices, in a well-functioning market, do reflect changes

in performance. But defining success bystock market returns introduces otherproblems. As Wharton professor SidneyWinter has pointed out, a company’sstock price will hold steady when oneexcellent CEO succeeds another. How-ever, the share price will increase whenthe company exchanges an inferior CEOfor a better, but still substandard, CEO.Maintaining excellence, in other words,might be less well rewarded than be-coming merely mediocre.

A third problem with looking only athigh performers for clues to high per-formance is the issue of reverse causal-ity. Data may, for instance, reveal astrong association between the strengthof a company’s culture and its perfor-mance. But does a strong culture lead tohigh performance or the other wayaround? The chicken-and-egg problemis especially knotty in this instance sincehigh performance in itself affects cor-porate culture in several ways. To beginwith, it’s probably easier to build a team-based culture in a healthy firm than ina failing one, where workers are likely to be demoralized and disloyal. High-performing companies also can affordto institute programs and practices thatlow-performing firms cannot. Some ofthese expensive and time-consuming activities might actually reduce perfor-mance at struggling companies.


H B R AT L A R G E • Selection Bias and the Peri ls of Benchmarking

Jerker Denrell is an assistant professor of organizational behavior at Stanford Gradu-ate School of Business in Stanford, California. A more-detailed discussion of the conceptsin this article can be found in his paper, “Vicarious Learning, Undersampling of Fail-ure, and the Myths of Management,” Organization Science, May–June 2003.

How many managers study the corporate collapsesof the 1980s? Yet they still read about the Japanesemanufacturing strategies of that time.

TLFeBOOK

The Effects of Bias

What happens when people draw conclusions from incomplete data? Sup-

pose you are investigating the relationship between corporate performance

and a particular risky business practice, such as using cross-functional teams.

If you plotted the results of all companies that engaged in this practice (or

any such practice), you would find that the more widespread the practice, the

more volatile company performance, and your graph would look like this:

On average, as the trend line indicates, any such risky practice is correlated

somewhat negatively with performance.

But suppose that you looked only at existing companies and excluded all

those that had gone out of business while engaged in this practice. Then

your graph would look like this:

Now the trend line will indicate a positive correlation, which of course is

not the case. Thus selection bias will cause you to draw precisely the wrong

conclusion.

What’s more, managers’ expectationsof performance may influence theirchoice of strategies and thus confoundinterpretations of the effect those choiceshave. As William Boulding and MarkusChristen observed in “First-Mover Dis-advantage” (HBR, October 2001), com-panies that have innovative productsand strong distribution capabilitiesoften choose to enter new markets early.Their strong products and capabilitiesproduce high returns. As a result, how-ever, their managers associate earlyentry with high performance in allcases, even when there is a first-moverdisadvantage.

Bias, Bias EverywhereMany of the popular theories on per-formance are riddled with selectionbias. One of the most enduring ideas in management, for instance, is the no-tion that successful firms are those thatfocus most of their resources on onearea or technology rather than diver-sifying. Books such as In Search of Ex-cellence, Built to Last, and Profit from the Core all recommend that managers“stick to their knitting” and “focus onthe core.”

Typically, the research studies behindthese books look only at existing com-panies or – even more narrowly – only at highly successful companies. As a re-sult, their authors overestimate the ben-efits of focus. Consider, for example,Chris Zook and James Allen’s finding inProfit from the Core that 78% of all high-performance firms focused on one set ofcore activities while only 22% of lower-performance firms did. The study com-prised some 1,854 companies, judginghigh-performance according to shareprice returns, sales, and profit ratios, butit included only businesses that survivedthroughout the study period. It did not,therefore, consider any company thatstarted with a focused strategy but thenfailed.

Including those failures would havechanged the picture substantially. Ac-cording to Zook and Allen, 13% of allfirms achieved high performance, ofwhich 78% – or 188 firms – focused onthe core. If in that period just 200 other

april 2005 117

Selection Bias and the Peri ls of Benchmarking • H B R AT L A R G E

zero performance

trend line

low highPrevalence of risky business practice

low

high

Companyperformance

All Companies

zero performance

trend line

low

high

low high

Only Existing Companies

Prevalence of risky business practice

Companyperformance

TLFeBOOK

companies with focused strategies thathad gone out of business had been in-cluded in the sample, then the true re-lationship between focus and perfor-mance would be the precise opposite ofthe one Zook and Allen infer.

Another fond notion often lauded bymanagement gurus and the popularpress is that CEOs should be bold andtake risks. Indeed, many stories in thebusiness press celebrate the intuition of certain great leaders. No less an au-thority than Jack Welch entitled hisautobiography Straight from the Gut.Some leaders – notably Sony’s AkioMorita – have gone so far as to eschewmarket research altogether, believingtheir instincts are a better guide to mar-ket changes.

It’s certainly true that companies canbe handsomely rewarded when theirCEOs take big risks. Suppose you are operating in an industry – fashion, say,or consumer electronics – where firstmovers have an advantage but wherethere is also considerable uncertaintyregarding consumer preferences. Togain first-mover advantage, a companymust act quickly. The top-performingcompanies will be those that, led largelyby the instincts of their senior manag-ers, are lucky enough to launch productsthat happen to appeal to customers.

But the worst-performing companieswill also be those that act on hunches –and happen to launch products thatdon’t appeal to customers. Since fewpeople advertise their failures, andmany of these unfortunate firms ceaseto exist, we hear mainly about the suc-cess of decisions based on gut feelingsand little about the countless “visionar-ies”who similarly tried to revolutionizeindustries but did not.

The point here is not that all the pop-ular theories about performance arewrong. I don’t know. There may be agenuine link between success and focus.In some industries, the strength of a cul-ture may matter regardless of its nature.And the instincts of some managersmay be as sound a basis for strategic de-cision making as any amount of analy-sis. But what I do know is that no man-agers should accept a theory about

business unless they can be confidentthat the theory’s advocates are workingoff an unbiased data set.

Fixing the ProblemThe most obvious step to take to guardagainst selection bias is to get all thedata you can on failure. Within your or-ganizations, you must insist that dataon internal failures be systematicallycollected and analyzed. Such informa-tion can otherwise easily disappear be-cause the people responsible may leavethe organization or be unwilling to talk.Looking outside your company, youshould extend your benchmarking ex-ercises to include less-than-successfulfirms. Industry associations can help youcollect data about failures of new prac-tices and concepts.

Despite your best efforts, it’s unlikelyyou can ever be completely confidentthat your data are unbiased. Fortu-nately, you do have some backup, be-cause economists and statisticians havedeveloped a number of tools to correctfor selection bias. These tools, however,are grounded in certain assumptions,

which may be more or less realistic, de-pending on the context.

Suppose, for example, that we want toestimate the average return on equity ofall companies in a given industry, but wehave available only the ROE data of sur-viving firms. Since low-profit businessesare more likely to fail, just taking the av-erage ROE of all surviving firms wouldlead to too high an estimate. But sup-pose we assume that ROE is distributedalong a standard bell curve and that allbusinesses with a negative ROE will fail.Then we can use the data we have to estimate the average ROE for all firmsbecause the information on hand isenough to tell us how steep the curve is, how broad, and what the average is.

This approach can be used to correctfor bias in any situation in which we canapply formal statistical tools. For in-stance, let’s say we suspect that in a par-ticular industry, the more training acompany’s sales staff gets, the higherthe average salesperson’s performancewill be and the more consistent the en-tire sales staff’s performance will be.Suppose further that we have detailed


H B R AT L A R G E • Selection Bias and the Peri ls of Benchmarking

During World War II, the statisticianAbraham Wald was assessing the vul-nerability of airplanes to enemy fire. Allthe available data showed that someparts of planes were hit disproportion-ately more often than other parts. Mili-tary personnel concluded, naturallyenough, that these parts should be rein-forced. Wald, however, came to the op-posite conclusion: The parts hit leastoften should be protected. His recom-mendation reflected his insight into the selection bias inherent in the data,

which represented only those planes that returned. Wald reasoned that a planewould be less likely to return if it were hit in a critical area and, conversely, that a plane that did return even when hit had probably not been hit in a critical loca-tion. Thus, he argued, reinforcing those parts of the returned planes that sus-tained many hits would be unlikely to pay off.1

1. The Wald story is one of the most widely cited anecdotes in the statistical community. To find out more about it,

see W. Allen Wallis,“The Statistical Research Group, 1942–1945,”Journal of the American Statistical Association, June 1980,

and M. Mangel and F.J. Samaniego,“Abraham Wald’s Work on Aircraft Survivability,” Journal of the American Statistical

Association, June 1984.

How Wrong Can You Get?

TLFeBOOK

data on the investments in trainingmade by most firms currently operatingin the industry. If we can safely assumethat performance follows some speci-fied distribution pattern, we can in prin-ciple use the data we have to obtain anunbiased estimate of how investmentsin training actually do influence the av-erage level and variability of sales staffperformance, even if we do not havedata on firms that failed. Essentially,what we are doing is inferring the shapeof a particular iceberg by observing itstip and making (we hope) a reasonableassumption about the relationship be-tween the tips of icebergs and the rest of them.

The pioneer of these statistical meth-ods was James Tobin, winner of the 1981Nobel Prize in economics. His work waslater built upon by James Heckman,who himself received a Nobel Prize in2000 for his contributions in this area.In recent years, management scholarshave applied these methods to correctfor selection bias in their own researchand have started to advocate for theiruse in the broader managerial com-munity. In “Getting the Most out of AllYour Customers” (HBR, July–August2004), for instance, Jacquelyn S.Thomas,Werner Reinartz, and V. Kumar demon-strate how such tools can be used to im-prove the cost-effectiveness of market-ing investments.

Cautionary words and counsels of fail-ure, I know, are seldom well received.Managers crave certainties and rolemodels from business literature, and tosome extent they have to. They live in afast-paced world, and they often cannotafford to postpone action until they getbetter data. But there really is no excusefor ignoring the glaring traps we’ve de-scribed in these pages. Success may bemore inspirational, but the inescapablelogic of statistics dictates that managersin pursuit of high performance are morelikely to attain their goal if they give thestories of their competitors’ failures asfull a hearing as they currently do thestories of their successes.

Reprint r0504hTo order, see page 135.

april 2005

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april 2005 121

ome management concepts have such intuitive appeal that their

validity is almost taken for granted.First-mover advantage is one such con-cept. Although the fate of its most-convinced adherents, the dot-coms, of-fers a cautionary lesson, managers’ faiththat first-mover status brings impor-tant competitive advantages, even whennetwork effects are not available to ac-celerate and entrench it, remains un-diminished. Business executives fromevery kind of company maintain, almostwithout exception, that early entry intoa new industry or product categorygives any firm an almost insuperablehead start.

But for every academic study provingthat first-mover advantages exist, thereis a study proving they do not. Whilesome well-known first movers, such asGillette in safety razors and Sony in per-sonal stereos, have enjoyed consider-

able success, others, such as Xerox in fax machines and eToys in Internet retailing, have failed. We have foundthat the differences in outcome are not random–that first-mover status can con-fer advantages, but it does not do socategorically. Much depends on the cir-cumstances in which it is sought.

One possible explanation for Sony’ssuccess is that its strong brand name,substantial financial resources, and ex-cellent marketing skills allowed it tomake the most of its first-mover status.But Xerox, too, had a great brand name,deep pockets, and many valuable skills.And Sony, despite its brand and mar-keting muscle, could not translate beingthe first mover in home VCRs into any-thing approaching its success with theWalkman. Yes, a firm’s resources – andluck – are important, but certain otherfactors and conditions can be decisive as well.B

RE

TT

RYD

ER

S

The Half-Truth of First-Mover Advantageby Fernando Suarez and Gianvito Lanzolla

First-mover advantage

is more than a myth

but far less than

a sure thing. Here’s

how to tell when it’s

likely to occur–

and when it’s not.

B E ST P R A C T I C E

TLFeBOOK

Our research, based on a thorough examination of the literature on first-mover advantage, as well as an analysisof more than 30 cases of early entry intonew product spaces, has enabled us toidentify situations in which companiesare likely to gain first-mover advantagesand those in which such advantages areless likely. Specifically, we identified twofactors that powerfully influence a firstmover’s fate: the pace at which the tech-nology of the product in question isevolving and the pace at which the mar-ket for that product is expanding. Know-ing how fast or slow the technology andthe market are moving will allow you to understand your odds of succeedingwith the resources you possess.

What Kind of First-MoverAdvantage?A first-mover advantage can be simplydefined as a firm’s ability to be better offthan its competitors as a result of beingfirst to market in a new product cate-gory. We find it useful to distinguish be-tween durable first-mover advantages,which improve a firm’s market share or profitability over a long period, andthose that are short-lived. Although noadvantage lasts forever, firms that suc-ceed in building durable first-mover advantages tend to dominate their prod-uct categories for many years, from a market’s infancy until well into its maturity. Coca-Cola in soft drinks andHoover in vacuum cleaners unmistak-ably demonstrate both the value andlongevity of early success.

But even when a company cannotbuild a durable first-mover advantage,it may obtain some benefits from earlyentry. The pioneering efforts of Net-scape, the first to market an Internetbrowser, briefly produced enormous

gains for shareholders until the stockprice plummeted in 1997 following therise of Microsoft’s browser, Explorer.Apple declined more gradually – it wasprofitable for several years before pres-sure from Microsoft and Intel took atoll, forcing it to restructure in the early1990s. Whether the end comes suddenlyor slowly, profits can be great enough tomake a short-lived first entry a worth-while investment–and perhaps to makeit a strategic objective. Of course, a busi-ness is free to choose not to enter a newmarket at all. But even a runner-up’smargins may look good compared tothe opportunity cost of staying out of a new market.

Industry Dynamics Are CrucialMost students of first-mover advan-tages have concentrated on how firmsachieve them. One of the three mainways is by creating a technological edgeover competitors. By starting earliest,first movers have more time than laterentrants to accumulate and master

technical knowledge. The second way isby preempting later arrivals’ access toscarce assets–for example, a location ona city’s main street, talented employees,or key suppliers. The third is by buildingan early base of customers who wouldfind it inconvenient or costly to switchto the offerings of later entrants.

What has been largely ignored is theconditions under which those three tactics are most likely to succeed or fail.Just as a swimmer’s ability to cross theEnglish Channel depends as much onthe water’s roughness as on his or herown skill and experience, an early en-trant’s prospects depend as much onbackground factors as they do on thefirm’s resources and capabilities. Thetwo most important factors – the pace of technology evolution and the pace ofmarket evolution–are typically beyondthe control of any single firm.

There can be enormous variation inthe rates at which products’ underlyingtechnologies advance. For example, thefirst manufactured glass dates back toabout 3500 bc, when Middle Eastern


B E ST P R A C T I C E • The Half -Truth of First -Mover Advantage

Fernando Suarez ([email protected]) is anassociate professor of management atBoston University. He is also a regular vis-iting professor at London Business Schooland at the graduate business school ofUniversidad de los Andes in Santiago,Chile. Gianvito Lanzolla ([email protected]) is a faculty research fellowat London Business School.

First-mover status can confer advantages,but it does not do so categorically.Much depends on the circumstances.

TLFeBOOK




artisans heated crushed quartz to makeglazes for ceramic vessels. But it tookthree millennia for the next importanttechnological change, glassblowing, toarise, and 1,600 years more before En-glishman George Ravenscroft inventedlead glass. No other important techno-logical change occurred until AlastairPilkington invented the float-glass pro-cess in the twentieth century.By contrast,a computer today bears little resem-blance to one made even ten years ago.

Some technologies, such as computerprocessors, evolve in a series of incre-mental improvements; others evolve

disruptively, creating a break from thenorm, as was the case when digital pho-tography began to displace film. Thefaster or more disruptive the evolutionof technology, the greater the challengefor any one company to control it. Evenin product markets dominated by firmswith large R&D budgets, new entrantsand other competitors tend to drivetechnological progress.

The pace of market evolution canvary as markedly as the pace of techno-logical evolution. For example, the mar-kets for automobiles and fixed tele-phones developed much more slowly

than, say, the markets for VCRs and cellular telephones. Fixed telephonesneeded more than 50 years to reach a household penetration of 70%; cellulartelephones achieved the same level inless than two decades.

The greater a new product’s or cate-gory’s departure from existing productsor categories, the more uncertain willbe the pace of the market’s growth andits eventual shape–how many segmentsthe market will divide into, for exam-ple. Nokia launched the N-Gage, a gam-ing and music platform that includes a phone, in October 2003. Despite a

april 2005 123

The Half -Truth of First -Mover Advantage • B E ST P R A C T I C E

Vacuumcleaners

TelephonesVCRs

PCs

100%

80

60

40

20

0

Market Penetration

Years from Product Launch

Performance Improvement

Vacuum cleaners

PCs

Personal stereos

Digital cameras

100,000

90,000

80,000

100

90

80

70

60

50

40

30

20

10

00 31 5 7 9 11 13 15 17 19 21

Years from Product Launch

60 1000 2010 30 40 50 70 80 90

U.S

. Hou

seho

lds

Year

ly I

mpr

ovem

ent

Inde

x

The Pace of Change

The market penetration and

performance improvement of

most new product categories fol-

low similar trajectories – they

progress slowly at first, pick up

speed, then level off. But the rate

at which they change varies dra-

matically. Telephones and vacuum

cleaners became widespread

slowly, but VCRs caught on almost

overnight. PCs improved rapidly,

while personal stereos remained

little changed for years.

The yearly performance

improvement index shows

the factor by which each

product’s technical perfor-

mance has multiplied

each year.

TLFeBOOK

massive marketing campaign, positivecomment from experts and the public,a superb brand, and market dominancein the related category of mobile phones,the company shipped in 2004 only afraction of the “several million” devicesit said it would.

The exhibit “The Pace of Change”shows how the rate of technology andmarket evolution can vary across prod-uct categories. The trajectories of bothtechnological improvement within aproduct category and that category’s expansion in the market are roughly S-shaped – slow progress at the begin-ning yields to rapid progress and then a flattening in the growth rate. But theprecise shape of the S varies from onecategory to the next.

The Likelihood of a First-Mover AdvantageThink about a new product categoryyour company recently entered. Are innovations continually popping up? Ordo they appear infrequently enoughthat you can stay current? Now considerthe market for that product. Is it grow-ing so fast that you can hardly keep up with demand, or is it expanding onlygradually, giving you and others in theindustry plenty of time to plan andreach new customers?

The exhibit “The Combined Effects of Market and Technological Change”illustrates the four possible combina-tions of slow and rapid technology andmarket evolution. We use the term“calm waters” for the upper left cell of the matrix, where the technology and the market are evolving grad-ually. In the upper right, technologi-cal change is modest while the marketgrows rapidly–thus the market expandsfaster than the technology evolves. Inthe lower left, the technology leads –performance improvement is rapid com-pared with the evolution of the market.The lower right is the “rough waters”area, where both the technology andthe market evolve quickly.

When the Waters Are CalmGradual evolution in both technologyand markets provides first movers withthe best conditions for creating a domi-nant position that is long lasting. Thevacuum cleaner industry protected its first mover by evolving slowly andsmoothly. In 1908, in Ohio, WilliamHenry Hoover produced the first com-mercial bag-on-a-stick upright vacuumcleaner, but it made little headway.As late as 1930, fewer than 5% of house-holds had purchased one. The technol-ogy changed as slowly as the market.

When innovation did occur, the changewas enduring. In 1935, Hoover designerHenry Dreyfuss encased the vacuumcleaner’s components in a streamlinedcanister, creating a technological blue-print that more or less persists to thisday. In such a benign environment,Hoover had little trouble keeping up-to-date technologically and meeting demand. The company’s machines be-came the reference point within the cat-egory. The British even turned the brandinto a verb –“to hoover.”

A gradual pace of change in the tech-nology makes it hard for later entrantsto differentiate their products fromthose of the first entrant. Even if com-petitors discover some means of doingso, the differences are not rapid enoughor drastic enough to prevent the firstmover from mastering them and foldingthem into its product line in a timelyfashion, as Hoover did with the rela-tively few minor innovations introducedby competitors Electrolux and Eureka.(With globalization, however, the vac-uum cleaner market has fragmented,creating niches for European makers,such as Miele, that Hoover and othermass-market manufacturers are nowtrying to occupy as well.)

An initially slow pace of marketgrowth also tends to favor the firstmover by giving it time to cultivate andsatisfy new market segments. Thoughdevastating to most businesses, theGreat Depression was kind to ScotchTape, which was invented by 3M’sRichard Drew in 1930. At first, Drewthought the product would be used inindustrial settings – perhaps to seal cel-lophane wrapped around baked goods.Instead, it was taken up by ordinary people, who were looking to repairitems that in more affluent times theymight have discarded. The gradualgrowth of Scotch Tape’s appeal gave 3M time to organize production and distribution. Technological change wassimilarly modest, enabling 3M to keepup-to-date and preventing later entrantsfrom both introducing superior versionsand “inventing around” 3M’s patent.Indeed, the product remained basi-cally unchanged until 3M released the



The Combined Effects of Marketand Technological Change

The pace of change in a

technology and a market

can have a profound effect

on a company’s chances of

achieving a first-mover ad-

vantage. Four possible sce-

narios face a would-be

first mover.

Slow

Fast

Pace of Market Evolution

Slow Fast

Calm WatersScotch Tape

The TechnologyLeads Digital cameras

The MarketLeadsSewing machines

Rough WatersPersonal computers

Pac

e of

Tec

hnol

ogic

al E

volu

tion

TLFeBOOK

almost-invisible Magic Transparent Tapein 1961. As with Hoover, Scotch Tape sodominated its category it became syn-onymous with it.

The combination of a slowly chang-ing market and a slowly changing tech-nology makes company resources lesscritical than they would be in the othertechnology-and-market environments.By “resources” we mean the skills or ca-pabilities and the assets that organiza-tions develop over time. Among themost important capabilities are productdevelopment, production, and market-ing. One important asset is brand rec-ognition. Others are physical assets,such as strategic locations, and financial resources. Of course, having the mostabundant resources and the most valu-able skills is always desirable, but incalm waters, a first entrant lacking thoseadvantages may still have the latitudeand the means to defend its productagainst later competitors.

When the Market Leadsand Technology FollowsConsider the Walkman, the first productin a clever new category – the personalstereo. The Walkman, pioneered bySony in 1979, used mature technologiesreadily available at the time, and itsbasic technical design remained un-changed for a decade. By contrast, itsmarket grew abruptly, with sales reach-ing some 40 million units in less thanten years. Indeed, the personal stereo is often cited among the most success-ful consumer-electronics innovations ofour time. Given the market’s enormous expansion rate and potential size, onemight think that only a short-term advantage should have been available to the first mover. Yet Sony’s marketshare was close to 48% even ten yearsafter the Walkman’s launch, thanks toits superior resources – in particular itsdesign skills, marketing muscle, andstrong brand.

A first entrant with limited resourcesand skills would probably have to settlefor a short-term first-mover advantage,however. Boston’s Elias Howe intro-duced the first commercial sewing ma-chine in the late 1840s,but the machines

obtaining durable first-moveradvantages. Deep pockets al-low a firm to wait until thepace of technological changeslows, or the fundamentallynew technology its productline embodies becomes thenew standard, and the markettakes off. Of course, the com-pany also needs a superb R&Dcapability to keep it at thetechnological forefront in themeantime.

In 1981, Sony launched thefirst digital camera, the Mavica.Sales of digital cameras did not begin to gather momentumfor at least ten years, and salescontinued to be modest for another decade, during which

the relentless pace of technological im-provement rendered products obsoletewithin a year. A key area of improve-ment was the density of information adigital image could handle. In the early1980s, a high-end camera could produceimages with up to 60,000 pixels. By2000, the pixel count had reached 5 mil-lion. Sony’s considerable financial re-sources and world-famous technologicalcapabilities allowed it to stay on top ofthe category and grab a commandingshare of the slowly evolving market. In2003,Sony was still the leader in the U.S.market, with about a 22% market share.

When the Waters Get RoughSometimes, both technological innova-tion and consumer acceptance advancerapidly, leaving first movers highly vul-nerable. AT&T and Netscape are exam-ples of companies capsized by the rapidchurning of technology and markets.AT&T was the first company to de-ploy a cellular telephone system in theUnited States. It built a prototype in1977 and a year later held the system’sfirst public trial, involving 2,000 cus-tomers in Chicago. However, in 1983,Ameritech, not AT&T, offered commer-cial analog cellular operations after they were authorized by the FCC. As for Netscape, Marc Andreessen, a co-developer of Mosaic, teamed up withJim Clark in 1994 to invent Netscape’s

april 2005 125


made by Isaac Singer, a later entrantwith greater resources,were soon able tofind more customers than Howe’s. Thebasic sewing machine changed little overthe next half-dozen years, but demandincreased to such an extent that Singerbegan expanding into Europe. (AlthoughHowe could not achieve a durable first-mover advantage in the product cate-gory, the patents he owned on competi-tors’ products allowed him to extractsubstantial rents for some time.)

When Technology Leads and the Market FollowsWhat happens in the reverse situation,in which technology changes abruptlybut the market is slow to accept the newproduct category? A short-lived first-mover advantage is very unlikely here.Early entrants face many years of flatsales and operating losses and, conse-quently, the skepticism of stock marketanalysts. At the same time, the furiouspace of technological change brings innew competitors, who think their im-provements will draw customers awayfrom the incumbent and its dated prod-ucts. A durable advantage, for mostearly entrants as well as most later ar-rivals, is also unlikely.

Only a company with very deep pock-ets could enter such a market first,survive in its hostile environment, andwithstand a considerable delay before

TLFeBOOK

browser, which kicked off the era ofwidespread Internet access. Yet Net-scape today survives only as a small unitof Time Warner.

Neither AT&T nor Netscape was ableto make a profit in the new productspaces due to the strength of later entrants’ offerings. Our research sug-gests that a good part of the reason wasthe type of waters both had steppedinto. Cellular telephones and Internetbrowsers would fall in the lower rightcell of the matrix, with both the tech-nology and the market evolving rapidly(irregularly for cell phones, smoothlyfor browsers). In such conditions, it isvery difficult for companies to gaindurable first-mover advantages.

If a product’s underlying technologychanges very rapidly, the item quicklybecomes obsolete. More often than not,such products are overtaken by versionsfrom new entrants, which aren’t bur-dened by maintaining and servicingolder product lines and can innovate

without fear of cannibalizing prior in-vestments. Some researchers have usedthe term “vintage effects” to character-ize the tendency of new generations oftechnology to usher in winning en-trants. One can observe vintage effectsin many product categories. In the gam-ing console market, which MagnavoxOdyssey entered in 1972, at least six gen-erations of technology emerged in rapidsuccession, each pushing forward a newwinner. The same thing happened inhard drives and laptop computers. TheOsborne 1, generally considered to bethe first commercially available, trulyportable computer, weighed 24 poundsand was soon superseded by lightermodels. But laptop technology evolvedso quickly that each successor, afterbriefly achieving dominance, was soonsupplanted itself.

A fast-growing market adds to a firstmover’s challenges by opening attrac-tive new competitive spaces for later en-trants to exploit. The incumbent tends

to be at a disadvantage, since it oftenlacks the production capacity or mar-keting reach to serve a rapidly expand-ing customer base.

A rapid pace of market evolutionmakes long-term dominance unlikely,but it does not necessarily bar a firstmover from achieving worthwhile short-term gains – provided it has an acutesense of when to exit. Consider oncemore the Internet browser market. In1994, the Internet started growing ex-tremely quickly. Within two years, thenumber of Web sites had increased 50-fold. This frantic pace enabled later en-trants, chief among them Microsoft,with its enormous resources, to findplenty of space in which to grow. But before competitors could destroy Net-scape’s business, Netscape arranged to be acquired by AOL in an amazing$10 billion deal.

Achieving a durable advantage undersuch conditions is not, however, impos-sible. Here is where a firm’s resources



Is a First-Mover Advantage Likely?

Your company’s odds

of succeeding with

the resources it pos-

sesses depend on

how well you under-

stand the market and

the technology. Use

this chart to match

your company’s skills

and resources with

the environment you

face in a particular

situation.

The Situation Your Company Faces

Calm Waters

The Market Leads

The Technology Leads

Rough Waters

Key ResourcesRequired

Brand awarenesshelpful, but resourcesless crucial here

Large-scale marketing,distribution, and pro-duction capacity

Strong R&D and newproduct development,deep pockets

Large-scale marketing,distribution, produc-tion, and strong R&D(all at once)

First-Mover Advantage

Short-Lived

Unlikely Even if attainable,advantage is not large.

Very likely Even if you can’t dominatethe category, you shouldbe able to hold onto yourcustomer base.

Very unlikelyA fast-changing technol-ogy in a slow-growingmarket is the enemy ofshort-term gains.

Likely A quick-in, quick-out strategy may make goodsense here, unless your resources are awesome.

Durable

Very likelyMoving first will almostcertainly pay off.

LikelyMake sure you have theresources to address allmarket segments asthey emerge.

UnlikelyFast technologicalchange will give laterentrants lots of weaponsfor attacking you.

Very unlikelyThere’s little chance oflong-term success, evenif you are a good swim-mer. These conditionsare the worst.

TLFeBOOK

can make a big difference. Only a firstmover with mighty resources, far supe-rior to those of competitors, has anychance of achieving longer-term first-mover advantages when both technol-ogy and markets are moving rapidly. Forinstance, all else being equal, a first en-trant with a very strong brand name willtend to be more successful in locking in customers than one without a recog-nized brand name. A good example of a firm today that makes the best of itsendowments in the most difficult of circumstances is Intel. By putting all itstechnical and marketing muscle behindits product development process andbeing “paranoid” about competition,

Intel has been able to dominate a prod-uct category in which markets keep expanding and technology keeps chang-ing at a furious pace.

But do not take the possession of sub-stantial resources as a guarantee of win-ning. When IBM, for example, intro-duced the hard drive in the late 1950s, itwas the largest computer maker in theworld. Since then, a sequence of fast-growing markets for minicomputers,personal computers, and laptops hasgenerated relentless demand for newversions of the device. Despite a superbbrand name and plenty of resources,IBM could not stay atop the hard-driveindustry for long. Neither could oppor-tunistic later entrants.

We expect Apple’s iPod to face similarrigors. Famously strong in marketing,R&D, and design, Apple launched theiPod in October 2001 and by 2003 hadaround 70% of the market for digitalmusic players containing hard drives. Inthe first quarter of 2004 alone, the com-pany sold more than 800,000 units; bythe third quarter, it had increased itsshare of the retail market to 82%. How-

ever, the iPod mini has already im-proved upon its predecessor, and Dell is offering price cuts and a 12-hour battery for its 20-gigabyte player. Eventhough the mini is Apple’s own inven-tion, Apple will be hard-pressed to staythe leader for long.

To Be or Not to Be First?The four scenarios in the matrix placepremiums on very different sets of as-sets and capabilities. Large-scale mar-keting, distribution, and production capacity is key in situations where themarket leads; R&D, new product de-velopment, and deep pockets are key in situations where the technology

leads. If you step into a given environ-ment with the wrong type of resources,you can expect a rough time (see the exhibit “Is a First-Mover AdvantageLikely?”). Polaroid, for instance, had a great brand name in photography andexcellent access to distribution chan-nels in the early 1990s, but it was rela-tively weak in R&D and new productdevelopment. Indeed, its leading prod-uct back then, the instant camera, em-bodied a 15-year-old design. After almosttwo decades of fruitless diversification,the company had to file for bankruptcyprotection. Even if Polaroid had beenthe first mover into digital cameras,a category it wanted to dominate, ouranalysis suggests its fate would havebeen the same. It didn’t have the where-withal to triumph over or even survivefurious technological change, rapid andfrequent product obsolescence, and aslow market takeoff.

Right now, Symbian is contendingwith Microsoft to establish the operat-ing system for the new product categoryof “smart phones”– cellular phones ca-pable of multimedia and wireless broad-

band. Symbian’s total revenues for 2003were slightly more than $100 million,whereas Microsoft spent $7 billion juston R&D. Although the leaders in thehandset market, including Nokia andSiemens, organized Symbian to keepMicrosoft at bay, margins are so thin intheir industry that they could very wellchoose Microsoft’s operating systemover Symbian’s if Microsoft were to provide it for free or very little. AlreadyMotorola, a Symbian founder, has cho-sen Microsoft’s OS. It remains to be seenwhether Symbian and its backers will be able to stand up to Microsoft’s supe-rior resources in a fast-growing marketfor a fast-moving technology.

New product categories are con-stantly emerging around us. In most instances, companies struggle not withwhether to enter a new product cate-gory altogether but with whether toenter early or later. Sometimes execu-tives wonder if it would be wise, for example, to wait until the companies in the first wave have been weakened by competition and seen their techno-logical edge dulled. But by that point,there might not be enough time left to master the technology in question.Still, in some situations, it may not makea lot of sense to try to be the first mover.In environments where a first mover’s advantage is likely to occur only afteryears of losses, and then to be short-lived, discretion would probably be thebetter part of valor. After all, first-moveradvantage occurs not when you enter a market, but when you start makingreal money in it.

To make real money in an evolvingmarket, you need to analyze the kind of environment that surrounds the new category; to assess the characterand depth of your resources, compar-atively speaking; and then to decide on the type of first-mover advantage –short-term or durable, immediate or delayed – that is most achievable, if indeed any is. Remember, once you’vegone into the water, you have no choicebut to swim.

Reprint r0504jTo order, see page 135.

april 2005 127


A rapid pace of market evolution does notnecessarily bar an incumbent first mover fromachieving worthwhile short-term gains–provided it has an acute sense of when to exit.

TLFeBOOK


We welcome letters from all readers wishing to comment on articles in this issue. Early responses havethe best chance of being published. Please be concise and include your title, company affiliation,location, and phone number. E-mail us at [email protected]; send faxes to 617-783-7493;or write to The Editor, Harvard Business Review, 60 Harvard Way, Boston, MA 02163. HBR reservesthe right to solicit and edit letters and to republish letters as reprints.

sre t o t h e E d i t o rL e t t

can’t simply say you value money andfamily; you have to say how much moneyand what in particular about family isimportant. Similarly, for leaders to findgaps between their commitments andtheir convictions, they need to get spe-cific about their leadership values. Theymust ask themselves, “Do I mainly seepeople as good and bad? Then I’ll wantto lead justly and spread fairness.”“DoI see people as fulfilled or in despair?Then I’ll want to promote harmony andcreate teams.” “Do I see people as smartor stupid, claims as true or false? ThenI’ll want to lead analytically and createa world of right answers.” If a leader’sconvictions are not aligned with his ac-tions or the needs of the corporation,then some form of change – either or-ganizational or individual – is in order.

Charles SpinosaGroup Director

Vision Consulting

New York

Springboard to a Swan Dive?

The February 2005 case study “Spring-board to a Swan Dive?” by Ajit Kambiland Bruce Beebe captures very nicelyseveral contemporary issues. While thefour commentators did an excellent jobof grappling with those issues, two fur-ther considerations warrant attention.These points relate specifically to Bench-mark’s apparent intention to make JohnClough its audit committee chair andto designate him as an “audit commit-tee financial expert” (ACFE). (Inciden-tally, contrary to what the case suggests,Sarbanes-Oxley does not require audit

Do Your Commitments Match YourConvictions?

In their article “Do Your CommitmentsMatch Your Convictions?” (January2005), Donald N. Sull and DominicHoulder give a convincing account ofhow people’s small, quickly made deci-sions can lead them away from theirdeeply held convictions. Sull and Houl-der offer a beautifully simple tool foruncovering these gaps between peo-ple’s habitual actions and what they

value most. But the authors do not ex-tend their framework to helping man-agers improve their leadership skills.We admire leaders whose commitmentsmatch their convictions and who con-stantly uncover and promote specificand appropriate cultural values (orconvictions) in their companies. JackWelch’s constant development and pro-motion of GE values is a case in point.Lorenzo Zambrano at Cemex is another.

To identify personal gaps, the Sull-Houlder framework forces you to getspecific about your convictions. You

TLFeBOOK


committees to have an ACFE but doesrequire disclosure if there isn’t one.)

The first consideration concerns therequirements for ACFE designation. Inassessing an audit committee member’seligibility to serve as an ACFE–a term ofart under the final SEC rule– the boardmust deal with five separate require-ments, and a prospective designee mustmeet all five. While Clough undoubt-edly has an understanding of GAAPand financial statements (one of the re-quirements), he would also be requiredto have (i) experience preparing, audit-ing, analyzing, or evaluating financialstatements that present accounting is-sues that are generally comparable tothose raised by the issuer’s financialstatements or (ii) experience activelysupervising others who are engaged insuch activities. Clough’s involvementin financial-statement preparation forNetRF (a small technology company)presumably did not present accountingissues comparable to those raised byBenchmark (a Fortune 500 packaged-goods company). If Clough falls shorton that experience requirement, and ifthe directorship invitation depends onhis designation as an ACFE, Benchmarkmight withdraw the directorship offer.Regardless, Clough should not acceptthe ACFE designation.

The second consideration pertains toACFE designations in general. The con-ventional wisdom in corporate Americaappears to be that having an ACFE onboard is essential. (Some boards evendesignate every committee member asa financial expert!) As a consequence,public companies now proliferate withACFEs who, like Clough, probably donot meet all five requirements. That willbe the case until the proverbial whip-ping cream hits the fan again; that is,until we hear about the next accountingcause célèbre in which the class-action

bar hammers (and embarrasses, if notworse) the unsuspecting ACFE who doesnot qualify. The point here is that theJohn Cloughs of the world should bealerted to the five demanding ACFE re-quirements and should carefully assesstheir own qualifications. Whether theywish to take on this as yet undefinedrole, assuming that they do qualify, isanother issue for another commentary.

Joseph HinseyH. Douglas Weaver Professor of

Business Law, Emeritus

Harvard Business School

Boston

America’s Looming Creativity Crisis

I was amazed to see that Robert Clare-brough’s letter (January 2005),which wasbased on such simplistic arguments,man-aged to get past the editor’s critical eye.

As a former Fulbright student to theUnited States, I am a particular admirerof this great country. The nation’s great-ness certainly does not need to be un-derlined by hyping its achievements atthe expense of other countries. Surely,Bill Gates and Sam Walton are out-standing businessmen, though in thesame fields, the Albrecht brothers ofAldi supermarkets and the founders of SAP have also created new, success-ful, and profitable businesses–all whilehaving to cope with much smaller homemarkets. In Asia, consider Sony’s AkioMorita or Formosa Plastics’Yung-ChingWang, who arguably needed greaterentrepreneurial skills than Jack Welchto create their multinational companiesfrom scratch.

The greatest irony in Clarebrough’sletter, though, is his use of the image of a Ferrari stuck on a Los Angeles free-way. Clarebrough conjures this analogyto highlight the notion that in Europe

april 2005

HARVARD BUSINESS SCHOOL PRESSwww.HBSPress.org

“Two of Europe’s brightest businessthinkers…provide a sizeable challenge to the way managers think about practice and strategy.”The Sunday Times (London)

“Packed with tested real-world advice designed to help executivesmake a strong first impression.”The Wall Street Journal, CareerJournal.com

From “The world’s best strategist.”Fast Company, February 2005 cover story

Available wherever books are sold, including:

Citigroup Center160 East 54th St., NYC

Rockefeller Center5th Ave. & 48th St., NYC

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http://www.HBSPress.org

http://CareerJournal.com

or Asia there might be enormous po-tential but little chance to demonstrateit. That Clarebrough tries to illustratethe superiority of the American spiritthrough the image of a high-poweredEuropean car – the brainchild of an en-trepreneurial Italian family–stuck in anAmerican traffic jam strikes me as morethan a little odd.

Christian KoberDirector

Degussa

Shanghai, China

None of Our Business?

The commentaries in response to Rob-erta A. Fusaro’s case study “None of OurBusiness?” (December 2004) all sailedpast an obvious flaw. KK Incorporated’splan to increase sales using radio fre-quency identification tags is depen-dent not only on technology but alsoon store personnel welcoming custom-ers by name and steering them to pre-

ferred items, as stated in the piece. Thestore personnel described in the case donot strike me as up to the task. PerhapsKK would get more bang for its buck, aswell as fewer ethical or legal entangle-ments, by tackling its staff motivationand incentive problems.

Kathlene CollinsPublisher

Inside Higher EdWashington, DC

Overloaded Circuits: Why SmartPeople Underperform

I read with interest Edward M. Hallow-ell’s article, “Overloaded Circuits: WhySmart People Underperform,” in theJanuary 2005 issue. The author’s term“attention deficit trait,”or ADT, remindsme of what we in the IT industry used tocall “thrashing.”

In the world of computers, parallelprocessing is performed by a centralprocessor that switches back and forth

L E T T E R S T O T H E E D I T O R

quickly among several tasks, doing a lit-tle bit of each task one at a time. This ac-tion is performed so rapidly that, to theobserving eye, it appears as if the com-puter is performing several tasks simul-taneously. In the old days, a mainframecomputer’s hard drive could get so over-loaded with jobs that it could end upspending all of its time switching be-tween tasks without processing any ofthem, resulting in thrashing. This phe-nomenon could bring an entire systemto a grinding halt.

Colleagues in my old IT departmentused to measure each other’s personalthrashing levels. The simplest solution,as with our old mainframe computersystems, was quite obvious: Take onfewer tasks, or delegate more to others.ADT sufferers who want to cut downon their thrashing levels would do wellto try this approach.

Steve O’HearnVice President

Sysorex

Vienna, Virginia

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E x e c u t i v e S u m m a r i e s

april 2005 131

April 2005

COMING IN MAY 2005

Building Breakthrough Businesses Within

Established OrganizationsVijay Govindarajan and Chris Trimble

How Business Schools Lost Their Way

Warren G. Bennis and James O’Toole

Break Free from the Product Life CycleYoungme Moon

Page 14

FORETHOUGHT

The Limits of Professional Behavior. Pro-fessional service firms were once greatmodels for corporations – until they startedto resemble them. Reprint f0504a

Those Fertile HR Fields. In the UnitedStates, HR management is perceived as anarrow specialty. In Japan, it’s a place to go to get ahead. Reprint f0504b

The Spielberg Variables. Unilever appliesthe principles of feature film directing andediting to turn so-so commercials into win-ners. Reprint f0504c

When Lean Isn’t Mean. The trend is to downsize corporate headquarters –but sometimes a bigger HQ is better.Reprint f0504d

Plenty of Knowledge Work to Go Around.The furor over offshoring knowledge workis a tempest in a teapot. Reprint f0504e

How Big Is “Tall”? Consumers make clearand consistent distinctions among sizes.Reprint f0504f

Sweat the Small Stuff. The “broken win-dows” theory of crime prevention – pay attention to the details – pertains to com-panies, too. Reprint f0504g

The Rich (and Poor) Keep Getting Richer.Earnings have stagnated for people in the world’s middle-wage countries.Reprint f0504h

Just My Type. Your choice of typeface tellscustomers whether your brand is attrac-tive, innovative, dishonest, or unpleasant.Reprint f0504j

Where’s Your Pivotal Talent? Decisionsabout talent should be made with the samerigor and logic as decisions about money,customers, and technology. Reprint f0504k

The Beauty of an Open Calendar. Compa-nies want to be flexible, but they’re not flex-ible about people’s time. Reprint f0504l

Way Faster than a Speeding Bullet. Femto-second lasers will revolutionize processesin a variety of industries. Reprint f0504m

Book Reviews. HBR reviews four books.

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E X E C U T I V E S U M M A R I E S

Page 35

HBR CASE STUDY

Class – or Mass?Idalene F. Kesner and Rockney Walters Jim Hargrove, the marketing director of

$820 million Neptune Gourmet Seafood, is

having a bad week. Neptune is the most

upmarket player in the $20 billion industry,

and the company is doing everything it

can to preserve its premium image among

customers. But Neptune’s recent invest-

ment in state-of-the-art freezer trawlers,

along with new fishing regulations, is re-

sulting in catches that are bigger than ever.

Though demand is at an all-time high, the

company is saddled with excess inventory–

and there’s no relief in sight.

Neptune’s sales head, Rita Sanchez, has

come up with two strategies that Hargrove

feels would destroy the company’s pre-

mium image: cut prices or launch a new

mass-market brand. Not many executives

in the company are in favor of cutting

prices, but it’s clear that Sanchez is gaining

ground in her bid to launch a low-priced

brand. Reputation worries aside, Hargrove

fears that an inexpensive brand would can-

nibalize the company’s premium line and

antagonize the powerful association of

seafood processors. How can he get others

to see the danger, too?

The commentators for this fictional case

study are Dan Schulman, the CEO of Vir-

gin Mobile USA, a wireless voice and data

services provider; Dipak C. Jain, a professor

of marketing and the dean of the Kellogg

School of Management at Northwestern

University; Oscar de la Renta, chairman,

and Alexander L. Bolen, CEO, of Oscar de la

Renta Limited, the New York–based luxury

goods manufacturer; and Thomas T. Nagle,

the chairman of the Strategic Pricing

Group, a Massachusetts-based management

consultancy that specializes in pricing.

Reprint r0504a

Page 49

DIFFERENT VOICE

Strategic Intensity: A Conversation with World ChessChampion Garry KasparovIt’s hard to find a better exemplar for com-

petition than chess. The image of two bril-

liant minds locked in a battle of skill and

will – in which chance plays little or no

apparent role – is compelling. Even people

who have scant knowledge of the game in-

stinctively recognize that chess is unusual

in terms of its intellectual complexity and

the strategic demands it places on players.

Can strategists learn anything from chess

players about what it takes to win? To find

out, HBR senior editor Diane L. Coutu

talked with Garry Kasparov, the world’s

number one player since 1984. Kasparov

believes that success in both chess and

business is very much a question of psycho-

logical advantage; the complexity of the

game demands that players rely heavily on

their instincts and on gamesmanship.

In this wide-ranging interview, Kasparov

explores the power of chess as a model for

business competition; the balance that

chess players strike between intuition and

analysis; the significance of his loss to

IBM’s chess-playing computer, Deep Blue;

and how his legendary rivalry with Anatoly

Karpov, Kasparov’s predecessor as World

Chess Champion, affected his own success.

Kasparov also shares his solution to what

he calls the champion’s dilemma, a ques-

tion for all world masters, whether they are

in business, sports, or chess: Where does a

virtuoso go after he has accomplished

everything he’s ever wanted to, even be-

yond his wildest imagination? If you are

lucky, says Kasparov, your enemies will

push you to be passionate about staying

at the top.

Reprint r0504b

Page 54

How Strategists Really Think:Tapping the Power of AnalogyGiovanni Gavetti and Jan W. RivkinLeaders tend to be so immersed in the

specifics of strategy that they rarely stop to

think how much of their reasoning is done

by analogy. As a result, they miss useful

insights that psychologists and other scien-

tists have generated about analogies’ pit-

falls. Managers who pay attention to their

own analogical thinking will make better

strategic decisions and fewer mistakes.

Charles Lazarus was inspired by the

supermarket when he founded Toys R Us;

Intel promoted its low-end chips to avoid

becoming like U.S. Steel; and Circuit City

created CarMax because it saw the used-

car market as analogous to the consumer-

electronics market. Each example displays

the core elements of analogical reasoning:

a novel problem or a new opportunity, a

specific prior context that managers deem

to be similar in its essentials, and a solu-

tion that managers can transfer from its

original setting to the new one.

Analogical reasoning is a powerful tool

for sparking breakthrough ideas. But dan-

gers arise when analogies are built on sur-

face similarities (headlong diversification

based on loose analogies played a role in

Enron’s collapse, for instance). Psycholo-

gists have discovered that it’s all too easy

to overlook the superficiality of analogies.

The situation is further complicated by

people’s tendency to hang on to beliefs

even after contrary evidence comes along

(a phenomenon known as anchoring) and

their tendency to seek only the data that

confirm their beliefs (an effect known as

the confirmation bias).

Four straightforward steps can improve

a management team’s odds of using an

analogy well: Recognize the analogy and

identify its purpose; thoroughly understand

its source; determine whether the resem-

blance is more than superficial; and decide

whether the original strategy, properly

translated, will work in the target industry.

Reprint r0504c; HBR OnPoint 9661;

OnPoint collection “Why Bad Decisions

Happen to Good Managers” 9653


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april 2005 133


Page 66

Seven Transformations of LeadershipDavid Rooke and William R. TorbertMost developmental psychologists agree

that what differentiates one leader from

another is not so much philosophy of lead-

ership, personality, or style of management.

Rather, it’s internal “action logic”– how

a leader interprets the surroundings and

reacts when his or her power or safety is

challenged. Relatively few leaders, how-

ever, try to understand their action logic,

and fewer still have explored the possibility

of changing it. They should, because lead-

ers who undertake this voyage of personal

understanding and development can trans-

form not only their own capabilities but

also those of their companies.

The authors draw on 25 years of consult-

ing experience and collaboration with psy-

chologist Susanne Cook-Greuter to present

a typology of leadership based on the way

managers personally make sense of the

world around them. Rooke and Torbert

classify leaders into seven distinct action-

logic categories: Opportunists, Diplomats,

Experts, Achievers, Individualists, Strate-

gists, and Alchemists – the first three asso-

ciated with below-average performance,

the latter four with medium to high perfor-

mance. These leadership styles are not

fixed, the authors say, and executives who

are willing to work at developing them-

selves and becoming more self-aware can

almost certainly move toward one of the

more effective action logics. A Diplomat,

for instance, can succeed through hard work

and self-reflection at transforming himself

into a Strategist.

Few people may become Alchemists, but

many will have the desire and potential to

become Individualists and Strategists. Cor-

porations that help their executives and

leadership teams to examine their action

logics can reap rich rewards.

Reprint r0504d

Page 78

Countering the Biggest Risk of AllAdrian J. Slywotzky and John DrzikCorporate treasurers and chief financial

officers have become adept at quantifying

and managing a wide variety of risks: finan-

cial (for example, currency fluctuations),

hazard (chemical spills), and operational

(computer system failures). To defend them-

selves, they use tried-and-true tools such

as hedging, insurance, and backup systems.

Some companies have even adopted the

concept of enterprise risk management, in-

tegrating available risk management tech-

niques in a comprehensive, organization-

wide approach. But most managers have

not addressed in a systematic way the great-

est threat of all – strategic risks, the array of

external events and trends that can devas-

tate a company’s growth trajectory and

shareholder value.

Strategic risks go beyond such familiar

challenges as the possible failure of an ac-

quisition or a product launch. A new tech-

nology may overtake your product. Grad-

ual shifts in the market may slowly erode

one of your brands beyond the point of

viability. Or rapidly shifting customer pri-

orities may suddenly change your industry.

The key to surviving these strategic risks,

the authors say, is knowing how to assess

and respond to them.

In this article, they lay out a method for

identifying and responding to strategic

threats. They categorize the risks into seven

major classes (industry, technology, brand,

competitor, customer, project, and stagna-

tion) and describe a particularly dangerous

example within each category. The authors

also offer countermeasures to take against

these risks and describe how individual

companies (American Express, Coach, and

Air Liquide, among them) have deployed

them to neutralize a threat and, in many

cases, capitalize on it.

Besides limiting the downside of risk,

strategic-risk management forces execu-

tives to think more systematically about

the future, thus helping them identify

opportunities for growth.

Reprint r0504e; HBR OnPoint 977x

Page 92

The Quest for Customer FocusRanjay Gulati and James B. OldroydCompanies have poured enormous

amounts of money into customer relation-

ship management, but in many cases the

investment hasn’t really paid off. That’s

because getting closer to customers isn’t

about building an information technology

system. It’s a learning journey – one that

unfolds over four stages, requiring people

and business units to coordinate in pro-

gressively more sophisticated ways.

The journey begins with the creation of

a companywide repository containing each

interaction a customer has with the com-

pany, organized not by product, purchase,

or location, but by customer. Communal co-

ordination is what’s called for at this stage,

as each group contributes its information

to the data pool separately from the others

and then taps into it as needed.

In the second stage, one-way serial coor-

dination from centralized IT through ana-

lytical units and out to the operating units

allows companies to go beyond just assem-

bling data to drawing inferences.

In stage three, companies shift their

focus from past relationships to future be-

havior. Through symbiotic coordination,

information flows back and forth between

central analytic units and various organi-

zational units like marketing, sales, and

operations, as together they seek answers

to questions like “How can we prevent cus-

tomers from switching to a competitor?”

and “Who would be most likely to buy a

new product in the future?”

In stage four, firms begin to move past

discrete, formal initiatives and, through

integral coordination, bring an increasingly

sophisticated understanding of their cus-

tomers to bear in all day-to-day operations.

Skipping stages denies organizations the

sure foundation they need to build a last-

ing customer-focused mind-set. Those that

recognize this will invest their customer

relationship dollars much more wisely–and

will see their customer-focusing efforts pay

off on the bottom line.

Reprint r0504f; HBR OnPoint 9645;

OnPoint collection “Customer Data – Use

It or Lose ’Em” 9637

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Page 102

The Relative Value of GrowthNathaniel J. MassMost executives would say that adding

a point of growth and gaining a point of

operating-profit margin contribute about

equally to shareholder value. Margin im-

provements hit the bottom line immedi-

ately, while growth compounds value over

time. But the reality is that the two are

rarely equivalent. Growth often is far more

valuable than managers think. For some

companies, convincing the market that

they can grow by just one additional per-

centage point can be worth six, seven, or

even ten points of margin improvement.

This article presents a new strategic

metric, called the relative value of growth

(RVG), which gives managers a clear pic-

ture of how growth projects and margin

improvement initiatives affect shareholder

value. Using basic balance sheet and in-

come sheet data, managers can determine

their companies’ RVGs, as well as those

of their competitors. Calculating RVGs gives

managers insights into which corporate

strategies are working to deliver value and

whether their companies are pulling the

most powerful value-creation levers.

The author examines a number of well-

known companies and explains what their

RVG numbers say about their strategies.

He reviews the unspoken assumption that

growth and profits are incompatible over

the long term and shows that a fair num-

ber of companies are effective at delivering

both. Finally, he explains how managers

can use the RVG framework to help them

define strategies that balance growth and

profitability at both the corporate and busi-

ness unit levels.

Reprint r0504g

Page 114

HBR AT LARGE

Selection Bias and the Perils of Benchmarking Jerker DenrellTo find the secrets of business success,

what could be more natural than studying

successful businesses?

In fact, nothing could be more danger-

ous, warns this Stanford professor. Gen-

eralizing from the examples of successful

companies is like generalizing about New

England weather from data taken only in

the summer. That’s essentially what busi-

nesspeople do when they learn from good

examples and what consultants, authors,

and researchers do when they study only

existing companies or – worse yet – only

high-performing companies. They reach

conclusions from unrepresentative data

samples, falling into the classic statistical

trap of selection bias.

Drawing on a wealth of case studies, for

instance, one researcher concluded that

great leaders share two key traits: They

persist, often despite initial failures, and

they are able to persuade others to join

them. But those traits are also the hallmarks

of spectacularly unsuccessful entrepre-

neurs, who must persist in the face of fail-

ure to incur large losses and must be able

to persuade others to pour their money

down the drain.

To discover what makes a business suc-

cessful, then, managers should look at both

successes and failures. Otherwise, they will

overvalue risky business practices, seeing

only those companies that won big and not

the ones that lost dismally. They will not

be able to tell if their current good fortune

stems from smart business practices or if

they are actually coasting on past accom-

plishments or good luck.

Fortunately, economists have developed

relatively simple tools that can correct for

selection bias even when data about failed

companies are hard to come by. Success

may be inspirational, but managers are

more likely to find the secrets of high per-

formance if they give the stories of their

competitors’ failures as full a hearing as

they do the stories of dazzling successes.

Reprint r0504h

Page 121

BEST PRACTICE

The Half-Truth of First-MoverAdvantageFernando Suarez and Gianvito LanzollaMany executives take for granted that the

first company in a new product category

gets an unbeatable head start and reaps

long-lasting benefits. But that doesn’t

always happen. The authors of this article

discovered that much depends on the

pace at which the category’s technology

is changing and the speed at which the

market is evolving. By analyzing these

two factors, companies can improve their

odds of succeeding as first movers with

the resources they possess.

Gradual evolution in both the technol-

ogy and the market provides a first mover

with the best conditions for creating a

dominant position that is long lasting

(Hoover in the vacuum cleaner industry

is a good example). In such calm waters,

a company can defend its advantages even

without exceptional skills or extensive fi-

nancial resources.

When the market is changing rapidly

and the product isn’t, a first entrant with

extensive resources can obtain a long-

lasting advantage (as Sony did with its

Walkman personal stereo); a company

with only limited resources probably must

settle for a short-term benefit. When the

market is static but the product is chang-

ing constantly, first-mover advantages

of either kind – durable or short-lived – are

unlikely. Only companies with very deep

pockets can survive (think of Sony and the

digital cameras it pioneered).

Rapid churn in both the technology and

the market creates the worst conditions.

But if companies have an acute sense of

when to exit – as Netscape demonstrated

when it agreed to be acquired by AOL – a

worthwhile short-term gain is possible.

Before venturing into a newly forming

market, you need to analyze the environ-

ment, assess your resources, then deter-

mine which type of first-mover advantage

is most achievable. Once you’ve gone into

the water, you have no choice but to swim.

Reprint r0504j


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april 2005 135

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Evil Unnecessaries

P a n e l D i s c u s s i o n by Don Moyer

Parents want their children to be special;companies want their products to be pre-mium. Where’s the glory in competing on price when you can compete on howpowerful, fast, accurate, tangy, plush, orgreaseless your offering is? As TheodoreLevitt reminded us in his 1983 classic The Marketing Imagination: “Everybody –whether producer, fabricator, seller, bro-

ker, agent, merchant – engages in a con-stant effort to distinguish his offering inhis favor from all others.”

One way to differentiate a product is to add stuff to it. When the stuff is useful,we praise it as “functionality.” When thestuff is just stuff, we dismiss it as “bellsand whistles” (which are actually prettyuseful if you happen to be in the locomo-

tive or steamship business). Excessive fea-tures confound buyers with complexity.Useless features anger them, especially if they detect a trade-off with economy,portability, or convenience.

A mousetrap isn’t better because it in-cludes an electronic rodent counter or acheese freshness gauge. It’s better becauseit does a superior job catching mice.

Don Moyer can be reached at [email protected].

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C A D I L L A C.C O M

FOR DIFFERENT DRUMMERS, AND THEIR HEDGE FUND MANAGERS The WallStreet Journal proclaimed, “It has the biggest potential to shake up the market.”1 Why? An available 15-speakerstereo, 320-hp Northstar V8 and available performance-tuned AWD. Cadillac STS V6 starting at $41,220.*

*MSRP. STS V8 as shown $62,735 MSRP. Tax, title, license, dealer fees, gas guzzler tax and other optional equipment extra.1December 31, 2004. ©2004 Dow Jones and Company, Inc. All rights reserved.

©2005 GM Corp. All rights reserved. Break Through® Cadillac® Cadillac badge® Northstar® STS®

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