Laws of Business Strategy Part 1
This article is part of a series on what causes a firm’s value to increase and will be in two parts
Do you remember what a law is, not in the legal sense, but laws like the laws of physics, engineering, weather, etc.? Sounds boring correct? I think otherwise. Laws are statements of what causes what and they allow us to make predictions. Laws are a description of an event that does not vary over known conditions. For example, water boils at 212 degrees Fahrenheit at 1 atmosphere of pressure (sea level) no matter what. Laws in the physical sciences also allow us to predict things, with great accuracy. This is how we landed people on the moon in 1969 and brought them back, how we saved Apollo 13, and how we can predict the arrival of hurricanes, to name just a few.
It would be nice to know if we have laws of business strategy that should be followed at all times. Think about this – if there are no laws of business strategy then every decision we make is really following rules of thumb that have been passed down from generations or practicing common sense at the time of the decision. Not bad if these have worked in the past. But were you perhaps just lucky? What if there are laws of business strategy that could help you outperform your industry averages by a wide margin?
In the business world, there are some laws or things that are close to laws. Economics has a few – like supply, demand and prices. Finance may have some but the predictive power for both is much less than in the physical science world. What about the predictive power for possible laws of business strategy?
In this article I will discuss what I and other strategists think are the candidates for the first three laws of business strategy. In Part 2 of this article next month we will discuss the second three candidates and discuss implications of the six candidate laws of business strategy:
Strategy Law #1: Your Industry “Nature” Determines the Average Profitability for All the Competitors in Your Industry
You might be surprised that about 40% of the level of your firm’s profits are caused by your industry’s nature, not your individual decisions. Ever wonder why the pharmaceutical industry has an average industry Return on Invested Capital (ROIC) of nearly 40% and the steel industry has an average of 5% and the airlines industry 2%? Now some pharmaceutical competitors have lower ROIC than the 40% average and some steel and airlines competitors have higher ROIC than their abysmal industry averages (like Nucor steel and Southwest airlines). What causes the industry averages? It is the degree of hostility of bargaining that goes on against you and the other competitors that make up your industry. Implications: Your strategy needs to start with the brutal reality of the amount of hostility in your industry in which you currently play. You need to try to cope with this reality, try to influence it to your favor or consider packing up and leaving if the average industry ROIC continues to spiral downward and you have no ties that bind you.
Strategy Law #2: Prices and Costs Always Decline
Wait a minute you might be saying. The automobile I just purchased was a lot higher priced than the same model I bought seven years ago. This law refers to the fact that if the functionality and benefits of a car were to stay the same over time, the cost to produce and the price charged would drop in predictable ways. Bain’s research (a leading strategy consulting firm) into this shows that industries like microprocessors and VCR’s and digital cameras have very fast reductions in industry costs and prices over time. Industries such as cars and DVDs have slower reductions in industry costs and prices over time. But this is a reality if firms do not do something to counteract this law. Successful firms add features and functionality to counteract this law and have prices float upwards to what the market will bear. Implications: if you are not innovating this law will drive your business to a low cost/low price ball game.
Strategy Law #3: Dominate Something, Do Not Be Spread Thin
Is it better to have a 5% market share in thirty markets or a 30% market share in five markets? In general it is better to have 30% market share in five markets. This was Wal-Mart’s early success in dominating the rural discount retail market. We can measure a firm’s degree of dominating something (called Strategic Market Position) and this measure directly causes increases in firm valuation. The reason is you can better manage costs while having customers with a higher willingness to pay to actually buy your products and services at the higher price. Implications: if you get spread too thinly and do not dominate something your ROIC will suffer, sometimes horribly.
Next Up: The Laws of Strategy Part 2