October 13, 2010

When Your Customers Leave Your Business Model Behind

My middle school daughter is struggling today with how to think about competing geological theories. Specifically, why fossils of similar animals were found on continents separated by vast oceans. One theory stated that the animals moved and migrated across large land bridges that, the proponents of that theory imagined, were conveniently located to explain the facts. The other theory stated that the continents themselves moved, separating the animals. Continental drift won the day because it explained why the climate didn't migrate, and later scientists were actually able to observe it in action.

I pondered these two theories when thinking about why corporate leaders come to be displaced by new firms — sometimes dramatically. One theory suggests that it must be incompetence. Those corporations that have assets and capabilities spanning product generations should surely be able to migrate their customers over the bridge they create. If they don't, they must have incompetent leaders. Another theory suggests that the customers drift. Small factors initially tip the balance in favor of a new company over the old and even as the company sees the drift occurring, it has few options or incentives to split its assets and capabilities between the old and the new. Being unable to spread its efforts across the divide, the company is left behind. As in geology, so in strategy: the customer drift theory is looking increasingly favorable as an explanation of the life cycle of firms.

Writing in the New Yorker this week, James Surowiecki provides us with the latest data point in support of customer drift: Blockbuster, which dominated the movie rental business with convenient locations, solid inventory management, and a known brand. But a combination of Netflix, cable companies, and downloads hit on Blockbuster's weak-points — what Blockbuster thought were convenient locations were not convenient compared to door-to-door delivery, even if door-to-door delivery required consumers to plan ahead their Saturday night movie viewing. Put simply, spur-of-the-moment customers were the same ones likely to procrastinate in movie returns — and get socked by Blockbuster's hated late fees. As behavioral economics tells us: the counter to procrastination is to bind oneself to thinking ahead which is exactly what other options achieve.

What is interesting about Surowiecki's account is that while Blockbuster was late to see change coming, it did see it. Blockbuster tried to take what it did well — the "bricks" — and combine it what it was lacking — the "clicks." If you believe that you can build a bridge from the old to the new, that strategy makes sense. After all, if you see a path that allows you to leverage your existing capabilities, that will also give you a competitive advantage over newcomers. The problem, however, is that if the theory is wrong, then the bridge will hold you back in that same competition.

Many accounts of similar patterns in corporate life suggest that what Blockbuster should have done was taken out a corporate insurance policy. Rather than trying to bridge the divide, Blockbuster should have set up a new division that ignored the past and focused only on the future. Of course, in this case, it would be doing no more than its newcomer competitors. Furthermore, where are the future profits in such head-to-head competition? Indeed, do it well and you improve the new product generation in a way that accelerates the decline in the old. That seems like all cost to the corporate bottom line with no gain.

According to new research (pdf) by economists Tim Bresnahan, Shane Greenstein, and Rebecca Henderson, the challenges to old firms in leaping across when customers drift are particularly great. They describe IBM's foresight in investing in personal computers in the early 1980s using a separate division only to reverse course when they found that two sales teams were selling distinct products to their valuable customers. They argue that IBM had a valuable asset — its customer relationships — but that there was simply no way to that asset to be shared between its old (mainframe) and new (PC) divisions. As the mainframe division was still profitable at the time they made their key decisions, IBM decided to leave the PC market to newcomers (HP, Compaq, Dell, etc).

Where does that leave successful corporations facing change? Blockbuster did not seriously consider customer drift a possibility. So how should you react if customer drift proves to be the correct theory in your industry? Leaping ahead of it is challenging and may not bring continued glory, while trying to ignore it and let what you have built up fade away is painful. No one knows the right response quite yet but trying at least to gather the evidence as to what is moving your customers in an impartial way seems a good place to start.

Joshua Gans is an economics professor at the Melbourne Business School, University of Melbourne. He is currently a visiting scholar at the Harvard University Department of Economics, and the author of the book Parentonomics.

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