The Man: The Kim B Clark Professor of Business Administration at Harvard Business School beat cancer, made the world understand why companies fail to evolve along the technology curve and told us why highly educated and successful executives fail to have normal lives. He tells us why it is important for companies to always stand by the moral line no matter what the temptation.
The Oeuvre: Wrote the widely read—hopefully followed as well—article ‘How Will You Measure Your Life?’. An unexpected area of focus for an innovation expert, but as Christensen puts it, he wanted to help people who were bright, but did not know how to manage their lives.
X-Factor: Empathy, grace and wisdom, in spite of personal adversity.
The Message: Don’t try and compromise even once.
Companies are biased to leverage what they have put in place to succeed in the past, instead of guiding them to create the capabilities they’ll need in the future. If we knew the future would be exactly the same as the past, that approach would be fine. But if the future’s different—and it almost always is—then it’s the wrong thing to do.
Every time an executive in an established company needs to make an investment decision, there are two alternatives on the menu. The first is the full cost of making something completely new. The second is to leverage what already exists. Almost always, the marginal-cost argument overwhelms the full-cost. When there is competition, established companies continue to use what they already have in place and end up paying far more than the full cost—because the company loses its competitiveness. Thinking on a marginal basis can be very dangerous.
The Trap of Marginal Thinking
In the US, in the late 1990s, Blockbuster dominated the movie rental industry. It had stores all over the country, a significant size advantage, and what appeared to be a stranglehold on the market. Blockbuster had made huge investments in its inventory for all its stores. But, obviously, it didn’t make money from movies sitting on the shelves; it was only when a customer rented a movie and a clerk scanned the movie out of the store, that Blockbuster made anything. It therefore needed to get the customer to watch the movie quickly, and then return it quickly, so that the clerk could rent the same DVD to different customers again and again. To prod customers to return the DVDs quickly, the company levied big fines for every day that the customer forgot to return the DVD on time—if Blockbuster didn’t, it wouldn’t make money— because the DVD would be sitting in a customer’s home rather than be rented to someone else.
It wasn’t long before Blockbuster realised that people didn’t like returning movies, so it increased late fees so much that analysts estimated that 70 percent of Blockbuster’s profits were from these fees. Set against this backdrop, a little upstart called Netflix emerged in the 1990s with a novel idea: Rather than make people go to the video store, why don’t we mail DVDs to them? Netflix’s business model made profit in just the opposite way to Blockbuster’s. Netflix customers paid a monthly fee—and the company made money when customers didn’t watch the DVDs that they had ordered. As long as the DVDs sat unwatched at customers’ homes, Netflix did not have to pay return postage—or send out the next batch of movies that the customer had already paid the monthly fee to get.
It was a bold move: Netflix was the quintessential David going up against the Goliath of the movie rental industry. If Blockbuster decided it wanted to go after this nascent market, it would have the resources to make life very difficult for the little start-up. But it didn’t. By 2002, the upstart was showing signs of potential. It had $150 million in revenues and a 36 percent profit margin.
Blockbuster investors were starting to get nervous—there was clearly something to what Netflix was doing. Many pressured the incumbent to look more closely at the market. “Obviously, we pay attention to any way people are getting home entertainment. We always look at all those things,” is how a Blockbuster spokesperson responded to these concerns in a 2002 press release. “We have not seen a business model that is financially viable in the long term in this arena. Online rental services are ‘serving a niche market’. ” Netflix, on the other hand, thought this market was fantastic. It didn’t need to compare it to an existing and profitable business: Its baseline was no profit and no business at all. This ‘niche’ market seemed just fine.
So, who was right? By 2011, Netflix had almost 24 million customers. And Blockbuster? It had already declared bankruptcy. Blockbuster’s mistake? To follow a principle that is taught in every fundamental course in finance and economics. That is, in evaluating alternative investments, we should ignore sunk and fixed costs (costs that have already been incurred), and instead base decisions on the marginal costs and marginal revenues (the new costs and revenues) that each alternative entails. But it’s a dangerous way of thinking. Almost always, such analysis shows that the marginal costs are lower, and marginal profits are higher, than the full cost. This doctrine biases companies to leverage what they have put in place to succeed in the past, instead of guiding them to create the capabilities they’ll need in the future. If we knew the future would be exactly the same as the past, that approach would be fine. But if the future’s different—and it almost always is—then it’s the wrong thing to do. As Blockbuster learned the hard way, we end up paying for the full cost of our decisions, not the marginal costs, whether we like it or not.
You End Up Paying Full Price Anyway
Case studies such as Blockbuster/Netflix helped me resolve a paradox that has appeared repeatedly in my attempts to help established companies that are confronted by disruptive entrants—as was the case with Blockbuster. Once their executives understood the peril that the disruptive attackers posed, I would say, “Okay. Now the problem is that your sales force is not going to be able to sell these disruptive products. They need to be sold to different customers, for different purposes. You need to create a different sales force.” Inevitably they would respond, “Clay, you have no idea how much it costs to create a new sales force. We need to leverage our existing sales team.” And they’d find a string of reasons why this wasn’t possible.
The language of the disruptive attackers was completely different: “It’s time to create the sales force.” Hence, the paradox: Why is it that the big, established companies that have so much capital find these initiatives to be so costly? And why do the small entrants with much less capital find them to be straightforward? The answer is in the theory of marginal versus full costs. Every time an executive in an established company needs to make an investment decision, there are two alternatives on the menu. The first is the full cost of making something completely new. The second is to leverage what already exists, so that you only need to incur the marginal cost and revenue. Almost always, the marginal-cost argument overwhelms the full-cost. When there is competition, and this thinking causes established companies to continue to use what they already have in place, they pay far more than the full cost—because the company loses its competitiveness. As Henry Ford once put it, “If you need a machine and don’t buy it, then you will ultimately find that you have paid for it and don’t have it.” Thinking on a marginal basis can be very dangerous.
An Unending Stream of Extenuating Circumstances