The Profit Zone: How Strategic Business Design Will Lead You to Tomorrow's Profits

CHAPTER ONE

MARKET SHARE IS DEAD

The number one problem in business today is profitability. Where will you be allowed to make a profit in your industry? Where is the profit zone today? Where will it be tomorrow?

The profit zone is the area of your economic neighborhood where you are allowed to earn a profit. To reach and operate in the profit zone is the goal of every company.

You've been told how to get there. "Get high market share and the profit will follow." "Get high growth and your profits will expand." As a manager, you were schooled in how the pursuit of market share and growth automatically places you on a direct route to business success.

However, these formerly direct roads have become mazes riddled with traps, wrong turns, and dead ends. Many large companies, after taking the turn toward market share and volume growth, have only hit a profitless wall.

* * *

Market share was the grand old metric, the guiding light, the compass of the product-centric age. Companies focused on improving their product and building economies of scale. This product-centric thinking led to the battle cry: "Get more market share and the profit will follow."

In the past decade, some disturbing examples began to subvert the widespread faith in market share as the ultimate goal and guarantor of business success. Consider the experience of IBM, DEC, GM, Ford, United Airlines, US Steel, Kodak, Sears, and Kmart. All achieved leading market share positions: number one or number two in their industries. Yet all these market share leaders saw their profitability begin to erode during the 1980s. Their dominant share positions did not protect them. As profitability began to be detached from market share, shareholders began to suffer. Despite their strong market position, these market share leaders significantly underperformed the S&P 500 from 1985 to 1995.

Several of these companies have recently initiated radical changes in their business design. Their new focus on profit, not just market share, has led to dramatic rebounds in value. As a result, many other traditional market share leaders have been encouraged to reconsider the assumptions on which their business design is built.

As you think about your own business, ask yourself: Am I managing for market share, or for profit? Is the market share I own profitable and alive, or is it profitless and dead?

There are countless businesses with high market share but low profitability and low shareholder value. The Japanese have a lock on the memory chip market. USAir once dominated air travel in the eastern United States. Philips is a leader in consumer electronics. None of these companies has experienced significant value growth.

Nor are these isolated cases. The list goes on:

* A&P had a high share of grocery sales.
* Intel had a high share of memory chips.
* WordPerfect had a high share of word processor software.
* DEC had a high share of minicomputers.
* Kmart had a high share of the urban discount business.

Each company was a market share triumph and a profitability disaster. In a broad cross-section of high market share situations, the right economic response has been: "So what?"

Many companies simply hoped that profitability would return. Some managers inside the companies suspected that it would not, but were hesitant to bring that suspicion to the surface and open up a debate. How could they possibly argue against a high market share position?

Other managers, in their private, honest moments, knew that the profit would never come back but were hesitant to confront the issue openly, fearing that the organization's morale would plummet.

Intel was an exception. It was the one company on the above list that confronted the issue head-on. It had high market share in memory chips in 1985, but Intel's managers recognized that its market share was dead, valueless, and profitless. The 1980s game was over; it was time to build the company's next business design.

Companies like Intel force us to think harder about--or to completely rethink--market share as a predictor of profitability.

AM I MANAGING FOR VOLUME
GROWTH OR VALUE GROWTH?

"Be in high-growth markets." In the old economic order, in the age of market share, volume growth was a guarantor of success. Growth was what we were taught to pursue. It created higher profits for all, including market share laggards, companies with poor business designs, and companies that were poorly managed. A rising tide raised all boats. One manager articulated the classic view: "There are no management problems that volume growth can't solve. Even if we manage poorly, rising revenue helps cover the mistakes we made."

This maxim, too, has been shaken. Industry growth and a company's value (stock price) growth no longer have a one-to-one correlation. Fast-growing industries such as PC manufacturing, consumer electronics, telecommunications, and software have each produced scores of terminally unprofitable companies. By contrast, no-growth or low-growth industries have produced some of the most successful companies in the world. Coca-Cola achieved significant value growth in the low-growth beverage industry, as did General Electric (GE) in a collection of low-growth manufacturing industries, and Swatch in the low-growth watchmaking industry.

The two most valuable ideas in the old economic order, market share and growth, have become the two most dangerous ideas in the new order. To apply these ideas appropriately (and safely), you must understand the rise of no-profit zones in the economy.

NO-PROFIT ZONES

Companies used to be able to command a premium price by simply showing up. There were relatively few players in any competitive arena, and customers held little power. Over the past two decades, however, advances in industrial technology, innovation in business design, increases in global competition, and tremendous improvements in information technology have altered the game. In the face of intense competition, companies in many industries have leveraged efficiency gains and competed for market share by lowering price.

Simultaneously, information has become more accessible to customers, allowing them to conveniently shop for the best deals and the best prices. This forces all contenders to match price reductions or lose customers to a lower-priced competitor. It creates no-profit zones. In the old world, the rule was: Every industry makes money, and the market share leaders make the most money. There have always been one or two exceptions, such as agriculture or passenger rail travel, but they were few and far between.

In the past decade, the rule was broken. Today, no-profit zones are everywhere, and they are growing. The map of the economy is covered with more and larger patches of unprofitability. No-profit zones come in various forms. They can be a part of the value chain (e.g., distribution in computing); they can be a customer segment (e.g., the Medicaid segment in healthcare, or the grocery segment in carbonated beverages); they can be an entire industry (e.g., environmental remediation); they can be individual customers (e.g., Wal-Mart or other large, powerful buyers); or they can be entire business models (e.g., hub-and-spoke airlines, or integrated steel mills).

No-profit zones are the black holes of the business universe. In a physical black hole, light waves go in, but never come back out. In an economic black hole, investment dollars go in, but the profit dollars never come back out.

Paradoxically, the devout pursuit of market share may be the single greatest creator of no-profit zones in the economy.

Imagine an industry with ten competitors. By definition, their market shares add up to 100 percent. Read their strategic plans. They all plan to increase market share. Not by a little, but by a lot.

Add up the 5-year market share objectives, and you get a number that adds up to 150 to 170 percent of market share.

This, of course, cannot happen. It doesn't make sense; but even as you read this, it is going on around you--perhaps in your own industry or in your own company.

The vigorous pursuit of market share and the rise in customer power have driven profit from many activities and products, and even from entire industries. More and more no-profit zones have been created. Still, many companies continue to pursue a market share and volume growth strategy, trying to get a bigger piece of a pie that is losing all of its value.

A senior manager at an equipment manufacturer captured perfectly the spirit of market share myopia that dominated the thought processes, and the business press, in the age of market share:

We are all focused on market share, on units,
units, units. Units sold vs. competitors'. Units
sold this quarter vs. same quarter last year. We
focus on every single point, or fraction of a point,
of market share gained, or lost.

And it's not just our management team. It's our
competitors' management teams. And it's the
periodicals that follow our industry. The market
share tables come out and we all follow them as
closely as NBA standings.

All too often, the vigorous pursuit of market share is done at the expense of business design innovation. However, market share leadership in a no-profit zone, or high market share with the wrong business design, is more of a curse than a blessing.

GROWTH, WITH THE WRONG BUSINESS
DESIGN, DESTROYS VALUE FASTER

It is easy to understand the trap of market share and growth in a no-profit zone. It is more difficult to understand how growth in a thriving industry can be dangerous. Growth is important, but how growth is achieved is much more important.

There are three curses of growth. First, high growth with a bad business design destroys value faster. Witness the value destruction occurring in so many high-tech, high-growth industries today. Growth is attractive, but growth carries high risk, especially when the business design is wrong.

Second, besides being riskier, high growth is much harder to manage. The euphoria of being in a high-growth environment blocks out the reality that growth creates a much higher management challenge.

An aerospace industry executive explained:

Managing in a downturn is hard, but managing
high growth intelligently is much harder. You're
tempted to overbuild capacity, add infrastructure,
headcount, lots of fixed cost. Then when the
growth waters recede, you're stuck in a no-profit
zone with lots of resources and lots of red ink.
It's a great way to destroy shareholder value.
Businesses do it all the time.

The third curse of growth arises when a business grows by stretching its business design to serve customers that the business design was not intended to serve. To make up for the mismatch, the company is forced to lower prices or expand its scope into areas where it is not operationally efficient. Both of these actions depress profitability. Once again, the end result is a no-profit zone.

No-profit zones are emerging every day. Activities that were once valuable turn profitless. Value migrates toward activities that are more important to customers--activities where profit is possible.

Yesterday's profit zones are becoming, with increasing frequency, today's no-profit zones.

REINVENTORS

In the past decade, several business leaders have emerged who have figured out, or intuitively understood, how the rules of the game have changed. Their record of value growth is all the more remarkable when compared to the growth prospects of their industries and the lagging value performance of the market share leaders.

These reinventors think differently; they see things differently; they act differently. They start with the customer and work their way back. They start with the profit question ("Where will I be allowed to make a profit?") and work their way back. They are constantly focused on how the profit zone is shifting. Where is it today? Where will it be tomorrow?

A decade ahead of their peers, the reinventors saw the move from the old product-centric, market share world to the new customer-centric and profit-centric environment. They were not alone; the investment community also understood that the sands were shifting. It downgraded the "old order" market share stocks and reallocated its investment dollars to the "new order" reinventor companies. The old order companies concentrated on market share and yesterday's profit zone. The new order companies reinvented their business design every five years to stay relevant to customers and to move into new profit zones. Several hundred billions of dollars of value shifted from companies that had dominated yesterday's profit zone to those that were finding or creating the profit zones of tomorrow.

LONG LIVE MARKET SHARE

Ironically, the reinventors all created high market share for their companies, but their way of thinking about market share was diametrically opposed to the logic of the conventional approach.

The sequence of the conventional approach was:

1. Gain market share.
2. Profitability will follow.

The reinventors' logic was:

1. What's most important to the customer?
2. Where can we make a profit?
3. How can we gain market share in that space?

This difference in sequence reflects two very different ways of thinking. The conventional approach was market share-centric. The reinventors' approach is customer-centric and profit-centric.

Reading about how the reinventors created a record of sustained value growth can help you to learn a different way of thinking. You will gain an expanded repertoire of strategic and tactical moves that you can use to create the next profit zone in your industry. The reinventors' experience can help you to understand:

* What specific business design moves can
manufacturers with disappearing margins adapt
from GE's business design in order to reestablish
a path of profit growth?

* What principles of business design did
Nicholas Hayek apply to build a 20 percent
profit growth business for Swatch in what
appeared to be a terminal no-profit zone?

* What are the three changes in its business
design that allowed Coca-Cola to grow its value
from $10 billion to $150 billion?

* What two specific profit models did Disney
use to grow the company's profit from $100
million to $3 billion in less than a decade?

* How did Intel repeatedly change its business
design to grow its value from $3 billion to $100
billion in the past 20 years?

Part Two of this book answers these questions and provides insight into how these and other reinventors systematically built customer-centric and profit-centric business designs to create value for shareholders. Each example highlights the strategic and organizational challenges that each leader faced and the innovative moves that were made in response. Like many innovators in other arenas, the reinventors have been able to see things that others couldn't (or wouldn't) see. You can learn to see those things by studying their success.

INNOVATION IN BUSINESS DESIGN

Each of the questions listed above asks how a major company fundamentally redefined itself and the way it does business--how it reinvented its business design. We all know intuitively what a business design is, but it helps to be explicit about the key strategic dimensions that define a company's business design.

A company's business design is composed of four strategic elements: (1) customer selection, (2) value capture, (3) strategic control, and (4) scope. If the business is to succeed, it must be designed in such a way that its key elements are aligned with customers' most important priorities. It must be designed for profitability. And, its elements must be tested for consistency with each other, to ensure that the business design functions as a coherent and mutually reinforcing whole.

The customer selection dimension of a business design describes the company's chosen customer set. A business has the opportunity to choose and to segment its customers based on the customer set to which it is best suited, or the one it is best able to serve. A business may change the customers it chooses to serve as value migrates to a new customer set or new customer segments. This can be a wrenching change for an organization. Moving away from customers is among the most difficult decisions a company can make. But it is critical. It is as important for you to ask yourself, "Whom do I choose not to have as my customer?" as it is to ask, "Whom do I choose to be my customer?"

The value capture dimension of a business design describes how the company gets rewarded for the value it creates for its customers. Traditionally, companies have captured value through product sales or service fees. Product-centric thinking limits itself to these traditional means of capturing value. Today, reinventor companies employ a more extensive repertoire of value capture mechanisms than they ever have before financing, ancillary products, solutions, downstream participation in the value chain, value sharing, licensing, and many others. They get rewarded for the value they deliver to customers in highly innovative ways.

The strategic control of a business design refers to the company's ability to protect its profit stream. It answers the questions: "Why should a customer buy from me? Why must a customer buy from me?" There are at least ten different ways to create a strategic control point for a business (see Chapter 3). Strength of strategic control is a critical element in successful business design innovation.

The scope of a business design refers to the company's activities and its product and service offerings. Companies increase or decrease their scope constantly. The key question for business designers is: "What changes in scope do I need to make to remain customer-relevant, to generate high profits, and to create strategic control?"

EXHIBIT 1.1 The Dimensions of Business Design





Dimension               Key Issue              Key Questions





1. Customer Selection   Which customers do I   To which customers    


                         want to serve?         can I add real value? 


                                                Which customers will  


                                                allow me to profit?   


                                                Which customers do    


                                                I not want to serve?  





 2. Value Capture        How do I make a        How do I capture, as  


                         profit?                profit, a portion of  


                                                the value I created for


                                               customers? What is    


                                                my profit model?      





 3. Differentiation/     How do I protect my    Why do my chosen         


    Strategic Control    profit stream?         customers buy from       


                                                me? What makes my        


                                                value proposition        


                                                unique/differentiated vs.


                                                other competitors'?      


                                                What strategic control   


                                                points can counterbalance


                                                customer or competitor   


                                                power?                   





 4. Scope                What activities do I   What products,          


                         perform?               services, and solutions 


                                                do I want to sell?      


                                                Which activities or     


                                                functions do I want to  


                                                perform in-house?       


                                                Which ones do I want    


                                                to subcontract,         


                                                outsource, or work with 


                                                a business partner to   


                                                provide?

Exhibit 1.1 profiles the four strategic dimensions of a company's business design. Each dimension is linked to all the others. For example, which customers I choose depends in part on which customers will allow me to make a profit. How I make a profit depends in part on the scope of activities I perform. Decisions about differentiation and strategic control depend on who the customers are and the scope of activities the firm is capable of. Decisions about scope should support decisions about what customers to serve, how to create profit, and how to create strategic control.

When these choices match customer priorities and are internally consistent and mutually reinforcing, they can produce an extraordinarily powerful business design for the company. The reinventors have achieved an extraordinary level of excellence in the design choices they have made.

Great business design is just like great product design. Extraordinary achievement in product design is a combination of superb engineering and great imagination. Similarly, great business design is a combination of superb knowledge about customers and profit ("You can't intuit the facts"), together with great strategic imagination. The reinventors' unique skill is strategic creativity: constantly reversing traditional assumptions, developing new options, and making more inspired choices.

To ensure long-term viability, a company's business design must be reinvented as customers' needs and priorities change and as value migrates away from the industry's traditional business designs. Just as products become technologically obsolete, business designs become economically obsolete. Over time, because of the competitive nature of business, most business designs are no longer allowed to make a profit. Their profit zone has moved. If a company hopes to create value for shareholders and wants to continue operating in its profit zone, it must reinvent its business design every five years, or even sooner.

THE NEXT TURN OF THE WHEEL

The reinventors know that the game is never over. For each company, the ground is shifting and the profit zone is moving once again. Intel faces the K6-chip challenge from Advanced Micro Devices (AMD). Coca-Cola faces a newly focused Pepsi. Microsoft faces the Internet. Disney faces accelerating imitation from Time Warner.

Similar types of challenges face the other reinventors. Unless their business designs are reinvented, their profits will start to bleed away. More importantly, their customers are changing. For every customer group, yesterday's magic is turning into today's commodity.

Lew Platt, CEO of Hewlett-Packard, has an invaluable perspective on reinventing: "The single biggest problem in business is staying with your previously successful business model ... one year too long."

Whether you think of it as "paranoia" a la Andrew Grove ("Only the paranoid survive"), or as staying with the old formula too long, the message is identical: When customers move, the profit zone moves. You must reinvent your business design to move with them.

This is not news to the reinventors. Most have created a new architecture for their business model every five to seven years. But having done it successfully in the past is no guarantee that the next design will work. Each design has to be right for the customers and right on the economics. Each reinvention takes incredible concentration and hard thought. The case examples developed in Part Two are provided to help you through the process.

CRACKING THE CODE ON PROFITABILITY

Roberto Goizueta, CEO of Coca-Cola, likes to say: "You can think through a problem so hard that you develop a sweat." The problem to think about that way is profitability. Where is it today? How does it really happen? Where will it be tomorrow?

If organizations don't answer these questions correctly, much of their efforts will be wasted.

Where is the profit? In yesterday's world, the answer was: with the player who has the highest market share. In today's world, the answer is: with the player who has the best business model, a model designed for customer relevance and high profitability.

Thinking about profitability isn't easy, for several reasons. First, the profit zone, the arena in which high profit is possible, keeps changing and keeps moving. The customer doesn't stand still, and the business design must respond (see Chapter 2). Second, there are at least twenty-two different ways that high profit happens--twenty-two different models that explain and quantify the mechanism by which profit occurs (see Chapter 3). Third, most organizations use two or three of these profit models. Understanding which ones to apply in which circumstances requires careful thought and considerable organizational persistence.

In this new economic order, characterized not by equilibrium but by fluidity, customers and profit zones always shift. To reinvent its business design and stay a step ahead of these shifts, a company must move beyond product-centric thinking to a customer-centric approach. Market share thinking must yield to a profit-centric approach. The ideas behind customer-centric and profit-centric thinking are critical to success in the new world of business. We will spend the next two chapters developing these two ideas.