Looking In From the Outside

Today, the pressure is on to deliver on the demands of customers and investors—and to do it right now. More than ever, every business executive needs to be thinking carefully about how markets develop and how to sustain them, what customers and markets value, how to best serve these markets, and how to reallocate resources to succeed. As a company’s business model shifts to meet changing market requirements, its business strategy and IT infrastructure must be ready to shift as well.

Put more simply, every business, and every function within a business, needs answers to the following questions:

Looking In From the Outside

As we write this, the economy is in the doldrums; the Federal Reserve’s “beige book” reports “sluggish” activity in manufacturing and retail, earnings announcements continue to disappoint, and things don’t seem likely to get very much better in the near term. (For those of us in high tech, of course, this is hardly news.) Practically speaking, we as individuals cannot change these things. But we can change our perspective—and our IT strategy--by focusing on what markets do value.

Consider your company and organization from an investor’s view, as a financial instrument that must appreciate in value to serve its function. In this context, your current valuation is analyzed in terms of the present value of forecasted future earnings, discounted for risk. A change in strategy and/or execution is relevant to your stock price when it impacts one or more of these three variables: present value, forecasted future earnings, or discount for risk.

Enterprises often seem to worry about economic factors over which they have no control. But investors do not ask management teams to influence the factors that affect the present value of money, or even discount for risk on a global level (though at a local level, risk is company-specific, or even product-specific, and thus directly under management’s control.) Your role as an executive is simply to factor in and account for the uncertainties, and accommodate your strategy to them.

It’s over the third element of value, forecasted future earnings, that companies have most control. Investors ask management to take direct accountability for increasing both the size of forecasted future earnings and the probability that they will actually appear, relative to comparable companies. Both these variables are a function of the company’s competitive advantage--the more competitive advantage a company has, the greater its potential for increasing its earnings, and the higher the probability that it will in fact do so.

Thus, day in and day out, managing for shareholder value equates directly to managing for increases in competitive advantage, in the differentiation a company can achieve relative to its direct competitors. We call this the Competitive Advantage Gap, or GAP.

In the domain of GAP, answers to the fundamental question of what’s happening (and how might others see it) might include:

These negative surprises can undercut your company’s differentiation and cause its competitive advantage position to deteriorate. And because they tend to be public knowledge, they can quickly cause your revenues and margins to degrade, and your share price to suffer.

By contrast, when it comes to managing the probability element of shareholder value, investors frame the challenge as follows: we see that your company enjoys a competitive advantage today, but how sustainable is it? Investors want to understand how much weight to assign to the future years of your earnings forecast in determining their present value. We call this projected interval the Competitive Advantage Period, or CAP for short. Because length of CAP is a measure of sustainability, it belongs to the domain of discount for risk, and it is here that investors’ and managers’ perspectives are often divergent and potentially contrary.

A company’s ability to sustain its competitive advantage is a function of its position and status in its product category, and the status of that category relative to other categories. The stronger your company is in market share, brand position, access to customers, barriers to competitive entry, and switching costs, the more inertia there is likely to be among its customers, and the better your chance of sustaining your leadership position into the future.

The impact of CAP on company valuation is huge and can lead to drastic revaluations for even a small miss in forecasted revenues or earnings. Investors are not simply recalibrating the magnitude of your competitive advantage, extrapolating a reduction in near-term earnings into a forecasted future; they are also inferring a reduction in sustainability, foreshortening CAP, and thereby radically devaluing earnings forecast in the future.

The lesson: Forget about what you can’t control, and focus on what you can.

Listen to the stock market in these new terms, and use them to proactively explain your strategy for improving and expanding your competitive-advantage position and the role IT will play in it. Most companies communicate their competitive advantage well, expounding at length on new products and new markets. But they do poorly on explaining how they will sustain their lead, failing to account adequately for changes in competitor power, value migration, decay of differentiation, and technology life-cycle disruptions. This failure leaves investors free to think the worst, and shareholder value suffers accordingly.

Even beyond the communications issues lies the non-trivial challenge of actually dealing with the sustainability issues that soured investors’ confidence. It’s the responsibility of management not only to recognize them and change its perspective vis-à-vis your current position, but also to acknowledging the severity of the emerging challenge, and get on with creating new business and IT strategies to combat it. Read on, and we’ll tell you how to do just that.

Changing Strategy

It’s in vogue these days to argue that success is mostly a function of execution, as Larry Bossidy does in his new book, Execution: The Discipline of Getting Things Done. But we’d argue that strategy is still the key to maintaining sustainable competitive advantage. Granted, changing strategy is both difficult and expensive, and should not be undertaken lightly. But at some point we must acknowledge that no amount of further tinkering with the status quo can restore things to their previous luster. As investors continue to clamor for additional net increases in competitive advantage, management teams must rethink the basics. The framework that describes this evolution is value migration over the course of a business category life cycle.

As a business category passes through stages from incubation to growth to maturity to obsolescence, the locus of value creation shifts, causing as many as five business models to gain ascendancy at different times. Each of these models is advantaged at a different point in the life cycle and leverages that advantage to supplant its predecessor. Here’s how it all plays out:

1. The project model. Newly emerging business categories lack sustaining infrastructure, so the only viable business model at the outset is project-based. Sponsored by visionary customers, these projects pair a disruptive innovation with an expert services organization to enable a high-risk, high-reward opportunity. Product differentiation (GAP) is extreme, coming both from novel product technology and exceptional services expertise, and is reflected in very high prices. Sustainability (CAP) is the real challenge here, as there is no guarantee the category will ever establish itself beyond a few daredevil customers. In this world of venture investing, success requires not only establishing a new company, but a new category as well. Such a model requires IT resources that are very much ad hoc or outsourced completely.

2. The solutions model. As sufficient demand develops to create a category, the high margins of the project model attract competition in the form of lower- cost, prefabricated solutions. This model still supports a high degree of customization, but it reduces both product and service complexities through packaged frameworks and applications. GAP is still strong, particularly when the solution is focused on a single vertical market, and CAP is secure because the category has become accepted. Valuation jumps dramatically, and the market realigns around the new leader. The project model now must either retreat to the very high end of the market or redirect itself to another category altogether. The solutions model, on the other hand, can look forward to building out the category, segment by segment. IT resources must be devoted to supporting both the needs of the segments targeted and the solution crafted for each segment. Indeed, the IT platform itself may be a source of advantage to the extent that it can provide such support over and above that of the competition.

3. The product model. As the solutions model continues to scale, it solidifies around a standard architecture or infrastructure. Profit margins attract competition from generic products at even lower cost. Special user needs are met through configuration rather than customization. This one-size-fits-all approach enables a mass market, thereby enhancing the sustainability of the category as a whole and causing CAP to lengthen. The product model can look forward to vibrant growth as long as price elasticity continues to enable market expansion. When revenue growth eventually flattens, however, and margins continue to shrink, further strategy adaptation is required. IT resources in this model should be organized around scalability and rigorously analyzed as to whether they contribute to the further scaling of this model.

4. The consumables/transaction services model. As products themselves become commodities, value creation migrates from the product to either the consumables or the transaction-services model. The former calls to mind the familiar shift from razors to razor blades, inkjet printers to inkjet cartridges, selling automobiles to servicing automobiles. CAP for the category is now very long, and it’s a challenge to create any kind of meaningful GAP to warrant higher margins. In the consumer packaged goods arena, companies tackle this challenge by making minor but customer-motivating modifications to their basic offering, called line extensions or flanking products. When products can function as “platforms,” companies often increasingly discount them as a way to seed more potential users of consumables. Now the standalone product model becomes unattractive. Alternatively, value may migrate from the product company to the service provider, enabling a transaction-services model, such as online books and airline tickets. Like Amazon, companies can earn additional margin here by enhancing the customer’s experience beyond the product, by adding convenience, value, or prestige. Whichever model is enabled, it will last until the end of the category. The IT platform must support this model and even exemplify it, as Dell does, or outsource parts of it, so scarce resources can go to supporting this margin-sensitive model.

5. The maintenance/outsourcing model. For categories where the complexity of the solution remains relatively high, there is no transition from the solutions to the product model. Instead, the solutions model evolves to a maintenance model, where more and more revenues are earned from existing customers. This is highly predictable revenue with high margins, for the customer is held hostage by high switching costs. This, in turn, drives the customer to seek relief through outsourcing the entire system to a third party. Manufacturing in the technology sector has recently passed through a wave of outsourcing, and data centers are not far behind. This model isolates solution providers from the end customer, eroding their ability to earn high margins on their offers, and ultimately transforming them into commoditized suppliers. The outsourcing model creates enormous inertia, allowing lower investment in GAP while still retaining the customer. Unchallenged by competition or regulation, the greatest threat is technological obsolescence at the hands of a future disruptive innovation. This model supports the outsourcing of IT resources as well, because of the model’s exposure to such disruptions. Better someone else is caught out rather than you.

So is it time for a strategy change at your company? If your category is evolving toward a different model, the company has two options: it can stay with the category and change models, or it can stick with the business model and change categories. Decisions, decisions.

Regardless of which you change, category or business model, your company will have to undergo a dramatic reorientation. Your attitudes and focus—and your IT strategy--will have to change with it.

Beyond the business model

It’s not only business models that need to shift with the vagaries of customer and market expectations. Our experience in working with hundreds of companies over the past ten years leads us to observe that there also are two fundamental types of business organization between which companies can choose. The customer-centric organization is optimized for handling low-volume, high-complexity systems and is linked to the project, solutions, and outsourcing models. IBM, EDS, and Boeing are examples of this model.
The operations-centric organization is optimized for high-volume, low-complexity systems and is linked to the product, consumables, and transaction-services models. Microsoft, ExxonMobil, McDonalds and Charles Schwab exemplify this model in their own ways.

Our view is that early in the life of a company it embraces one or the other of these models, and from that point on finds it natural to operate that way and unnatural to operate otherwise--much like being either right- or left-handed. Though you can utilize both hands, using your “off” hand seems awkward for certain things, notably those that require strength or acute coordination.

Let’s consider each model.

The customer-centric organization is designed to sell and support complex, capital-intensive product innovations to meet emerging market requirements, primarily in a business-to-business context. It takes its direction from the needs of a major customer who sits at the top of a pyramid of resources focused on serving it (see Figure 1). The customer is engaged initially via a consultative sales organization, which in turn is supported by a business and technical consulting services capability. These two layers focus on understanding the business challenge and determining the systems solution to it; they can implement the project model successfully by themselves. The remaining layers add products encased within two architectures: a solutions architecture to organize interactions with customer requirements and a technical architecture to manage interactions with legacy systems. Services-led organizations build their pyramid from the top down and stop at solutions architecture, partnering or outsourcing the remainder. Systems-led organizations build from the middle out, staffing top layers initially by themselves, but over time looking to partner increasingly with independent service providers. We can also imagine a final layer sitting below it all: the business process architecture necessary to support the all the layers above it.

Operations-centric organizations focus on a set of enabling technologies that support a variety of offers to a vast numbers of customers (see Figure 2). Such offers may be commodity products, consumables, or service transactions. The technologies themselves may be design-, manufacturing-, distribution-, procurement-, or marketing-oriented. Whatever the case, they will deliver the critical source of differentiation for the offers. Product organizations differentiate at the center of this diagram while service organizations differentiate at the edge. Operations-centric organizations are designed to populate established categories with a high volume of offers, providing increasing scalability through simplification, standardization, and cost reduction.

Both customer-centric and operations-centric organizations are well understood by virtually everyone in the business community, but in any particular enterprise one or the other gains dominance. After that point, management must understand that business models that play to the dominant organizational model are far easier to execute than ones that do not. The challenge of championing a subordinate model may play out in several ways:

While model shifts are not commonplace, they are required whenever the market mandates a shift to the subordinate model. This can affect business unit or departmental interactions; power relationships; operational process, and IT requirements; indeed the company’s very culture. It is a rare enterprise indeed that can meet these demands without stumbling.

Whenever you are empowering a business model that requires the “other” organization model, you must empower your programs through senior-management intervention and sponsorship to ensure that disputes are resolved quickly and unreservedly in favor of the new model. The team itself will be structured internally around the subordinate model and thus must be isolated from the business-as-usual organization operating on the dominant model. This means it needs its own milestones, operating ratios, metrics, compensation program, and the like. The resulting structure will be suspiciously unfamiliar to the hosting organization at large, and the executive team must be united and clear that everyone in the company is expected to give this novelty their full support.

Changing Back

As with any strategy, the accommodations you struggle to put in place today are not likely to last forever; sooner or later, your focus may flip back to resemble what it was before. That’s fine, as long as it’s based on authentic evidence that conditions have changed once again—and not on inertia and fear. Asking the important questions is not difficult; doing something different as a result of your answers is. Proceeding apace using a common framework seems a pragmatic—and even-handed—approach.

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