crash course in the evolution of business models
find the bottleneck, and own it
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short circuiting circuit city: consumers take
What's happening now in the Internet revolution is very simple¾IT
is being introduced at the customer level and, in particular, at the
Why is the Internet interesting?
Because it's the first time we've ever had a technological
revolution playing out at the consumer interface first.
Technology, because of its price and such, has always played
out in government, industry or defense, never at the consumer level
first. That’s why we
have unprecedented growth rates and an unprecedented source of
innovation and models. And
let's not restrict this just to the Internet.
However fast the Internet’s growing, we also have mCommerce
and mobile technology, set-top box technology and more.
PlayStation 2, by the
way, could be the killer technology for Europe.
In the US, PC penetration is fantastic, so it makes sense if
that's the way the Internet plays out here, but in Europe it is very
in some countries¾so
game consoles like PlayStation 2 may become the dominant platform for
Internet access there, not the PC.
If you look at projections for how quickly that market will
grow in the fourth quarter of this year with the holidays, it’s a
very intriguing business model.
Technology has been introduced bringing economies of scale and
scope. Before, it was all
about the intermediary and distribution, the supply chain games we've
been playing for the last decade¾find
a way to pile it high, sell it cheap and squeeze the margins, then we
rock and roll.
Today, this world is all about search economies.
That's really what the economies of scale and scope are.
By search economies I mean access to information and
the Internet lets us have access not just to unfiltered data, but
incredibly insightful opinions as well. What does this mean? It’s
an abstract idea that I’ll try to put in simple terms, but the
contrast is very, very powerful.
Let's talk about some pragmatic examples of it to make it real.
What's the average price of a new car in the US today? You folks know this better than I because I've been out of
the country too long.
a reasonable number. What's
the profit margin for a dealer, on average, selling a $25,000 asset?
Maybe 5-6%, so that’s $1,200 -$2,500, right?
Actually, for cars, the
range seems to be between $14 and $40, so let’s say about $20 for
selling a $25,000 asset. For the quantitative people in the room, we
call that low profit margin.
The decimal point's in the wrong place, and that's not good.
We all know what's happening.
Web sites have come up where you can buy cars, get information
and more. All of a
sudden, two Web sites are responsible for over a billion dollars in
car sales every month.
Two years ago, when we wrote the Fortune
article, one-third of all Americans knew what price they would pay for
a car before they set foot in the dealer showroom.
Last year, it was 67%. It
doubled in one year. Two-thirds
of Americans now use the Internet to determine that.
How did you become a millionaire before Regis came along? You opened a car dealership.
That was the easy way to become a millionaire in America.
They all made a fortune, yet, in less than a decade, we see a
reversal in that industry. We
see consolidation. We see
them getting killed. A
decade ago, 80% of their profits were in selling new cars.
Today, it's less than 20%.
All the profitability, today, is in selling used cars and
Because of the Internet; because car dealers have become a
secured parking lot. They’re
not a part of the decision-making channel.
The guys in the cheap suits, whom we all love, are not winning. Why? There's no
trust; there's no reliability of information.
The dealer showroom is no longer a decision-making point, it's
a car collection point. Basically, you have a secured parking lot,
and, if you have a secured parking lot, you basically get a fee
similar to a parking garage for your services. That's what's happened.
Here’s the general phenomena every one of you needs to think
about in your own business or in the industry you're attacking.
What happens as the decision point moves outside the channel?
Your profit margins go to near zero.
You have to ask yourself a question, whether it’s about the
intermediary channel that you're attacking, your own information
channel, or the intermediary channel that you're creating¾is
it a value adding source of decision-making or is it a necessary evil
that people must go through to acquire your product or service?
If it falls into the latter camp, assume somebody's going to
toast you. Assume they're
going to find a way to attack and eliminate you.
It's just going to happen.
It's a fundamental trend we have to watch.
More importantly, I would only give a decade to anybody playing
this intermediary game in the center of the chart.
If they don't do something, they're going to the cemetery.
I mean banks and businesses like that.
When's the last time anybody in this room went to a bank?
Since I don’t see any hands raised, I'll assume you're either
asleep or that you haven’t been to one recently.
Banks are just going to become mausoleums.
They have these nice shiny marble lobbies, so make them
mausoleums. That's the
only thing they're good for. Who's
going to go there? They
don't have a future. I
can give you very hard data about banking, but let me just summarize
it this way: banks are dead.
Okay? We need
their services, but their business model is dead.
Like I said, I could give you a lot of data, but, basically, it
seems to be that banks are going through the elephant walk.
I don't know if you've ever watched the nature shows, but when
elephants want to die they walk around forever in herds and look for a
place to die. That's what banks are doing.
They're merging; they’re getting bigger and dumber, and
they’ll die. I have yet
to convince banks that intelligence is not cumulative in that way.
They just get bigger, dumber and slower. That's what they're doing.
They're squeezing out cost, but not innovating.
It's very simple. Eighty
percent of all financial dollar movement in the US occurs outside the
commercial banking sector. Eighty
percent! Only one out of
five dollars goes through the commercial banking sector.
Banks are not a product leader in any category they offer. If 80% of the funds flow outside the channel, what does that
mean? That's the market
telling you that you are irrelevant.
Alan Greenspan figured that out about 18 months ago. He made a very simple statement which, to me, was the death
of banking. He couldn't
say it that way because he has to worry about politics and market
reactions, but I don't care. The
simple statement he made is that the Federal Reserve discount rate is
no longer an effective means of controlling the money supply.
Why? Because he
only has access to one out of five dollars since 80% of the funds are
flowing outside that channel. They
still talk about Federal Reserve discount rates and all that because
it's an understood measure, but how do they implement it?
By the amount of short term T-bills they issue at auction.
If the government issues more T-bills, it takes money out of
the economy and drives up interest rates.
If they issue less, it leaves money in the economy.
Well, if the market doesn't need you, and government regulators
don't need you, that's the kiss of death, man.
It's just a matter of time.
I also don’t see how the big retail channels that have been
playing this game are going to work.
I know this because I go to them, right?
As a European, I have discovered something very simple¾good things cost less in the US than Europe.
I'm the classic European.
I come to the US with empty suitcases and fill them up.
That's what I do every trip.
I'm an academic, so I’m incredibly cheap.
They’re the same thing.
“Academic” means cheap.
They go hand-in-hand. My
wife gives me a shopping list any time I'm in the US for more than 24
hours. I'm not a
lecturer, not an academic, not a researcher; I am a personal
global goods allocator. I
am a shopping assistant. I
do this because I don't want the
look, right? I do as
I'm told. I understand that I have these duties. I perform and life is good, so I execute.
Since I'm incredibly cheap, I understand Wal-Mart’s strategy
of everyday low pricing, right? “We've consolidated the channel,”
yeah, yeah, yeah, got it. So
I look up the address of a Wal-Mart, get in my rental car, cruise
there and park in the parking lot.
The first thing I see is a parking lot about the size of
England. Why doesn’t
Rhode Island have any Wal-Marts?
The state's not big enough for the parking lot.
I get there, park and, two time zones later, I get to the front
door where there's some senior citizen greeter saying, “Have a nice
day!” and giving me a shopping cart.
I just want to slap his dentures out.
I'm already a little ticked off.
After I've done that¾I
usually don't but occasionally it happens¾I
take out my shopping list, study it carefully, see five items, then I
look up to see a store of 50,000 products spread over 30,000 square
feet. I want five. It's
the Marquis de Sade’s Easter egg hunt. There's nothing friendly about this process.
You go up soulless aisle after soulless aisle looking for
merchandise. If you
approach a Wal-Mart employee, they scurry away and hide in the back
like cockroaches because they don't want to deal with you.
I use two rules of thumb when I shop at any superstore.
Number one, never buy time-dated merchandise on the way in.
It's clearly an exit strategy because it could well be out of
date. Number two, always
carry emergency rations. If you see a man with a two- or three-day
stubble walking around looking dazed and confused, give him a candy
bar and show him the exit. It's
the superstore Saint Bernard model.
It's what you have to do.
I'm not exaggerating; it's basically like that.
I mean, at Circuit City
and Best Buy, the strategy seems
to be to hire 16-year-old, pimply-faced kids who sell refrigerators in
the morning and stereos in the afternoon.
Ask them a question, something very complicated like, “What's
the warranty on this product ?” . . . well, I know I'm getting old
because they stare at you the way only a teenager can and talk without
moving their lips. When
the Web first came out, I think it was Best Buy and I think they since
changed it, but, if you wanted to have a technical question answered,
you went to their store, logged on to one of their computers and used
the Internet to get your answer.
What's the value-add of being in the store if decision-making
is occurring outside the channel?
These guys have a very serious problem.
The problem with the Internet is actually this¾despite all the hype, and I think the corrections
are occurring now, the Internet is not going to be overnight death,
destruction and chaos. In
most cases, the Internet will be much more evil than that.
Any manager worth his or her salt can manage a way out of a
true crisis, because it's all or nothing¾focus
the entire company, and solve the problem.
For most companies, however, the Internet is the slow erosion
and the death of a business model.
When I was with IBM from 1982
to 1988 I saw a company going through “strategy by denial.”
Every quarter they would lose a few customers. Every quarter, products were not selling as well as they
thought they would, so they introduced new products more quickly,
lowered the price, doubled the number of salespeople.
Each time they expected the hockey stick phenomenon of sudden
up-growth. Instead, it
continued to decline. All
of a sudden, you lose $5 billion.
Even when you were setting record profits four or five years
earlier, it's hard to ignore that.
This is exactly what the Internet will do, because every
quarter you're going to lose a few of your best customers.
Every quarter, a few of your best employees will leave because
they see the handwriting on the wall.
By the time you realize what's happened, the financial markets
have tanked you and you have no clout from which to rebound.
IBM clearly rebounded, but let's be very clear.
If I had come to anybody in 1985 and said, “IBM is going to
lose $5 billion in 1992,” I probably wouldn’t have had a lot of
takers on that bet. If I
had asked in 1992, “Will IBM be where it is today?”
Again, unlikely that I’d have many takers. I think the best thing that happened to IBM, is that this
happened in 1992 and not today. By
it happening then, they had a chance to rebuild themselves, which I'm
not sure they could today.
Anytime somebody has a business model like this, ask them two
questions. Number one,
“Is your business model viable if you lose 20% of your customers?”
As I said, the Internet's not going to be death and
analysis is the fundamental thing we have to think about, because we
all know the future is going to be a hybrid of complex segmentation.
Yeah, yeah, I'll buy all of that crap.
Do a sensitivity analysis.
Is your business model viable if you lose 20% of your
After Mr. Wal-Mart passes out and you revive him, assume that
Then ask them a second question, “Can you guarantee that
you're not going to lose 2% of your sales a year to alternate
channels?” Two percent
a year means that in a decade you're dead.
For US retail, on average, it's worse.
The best data I've seen from an Ernst
& Young study said 15%. If
they lose 15% of sales, the channel is no longer viable.
they've been playing this distribution game.
Leverage is a double-edged sword.
These channels are very volume sensitive because the fixed to
variable cost ratio is enormous.
If they lose a little bit of volume, the whole thing comes
undone. Be aware of
what's happening to you as you play these kind of games.
dr. jeff’s prescriptions
I can't predict the future, but I can tell you things that you
absolutely have to get right, otherwise you're going to die.
Let me start that laundry list right now.
Do a sensitivity analysis around your current business model.
That's the obvious thing.
If you don't do that, you're dead.
If you're attacking the big players, you’d better understand
that sensitivity analysis to know when you're going to get their
attention. The last thing
you want to do is wake up the sleeping giant before you're ready for a
full frontal attack.
better have very accurate customer profitability data, and very few
companies do. The people
with the benchmark are the credit card companies, Capital
One, MBNA, those kinds of
companies. They are
amazing at customer profitability data.
Why? Can anybody
tell me that there's going to be less
competition? Can anyone
tell me customers are not going to have more choice as opposed to
less? As a
businessperson, you are going to have to make the hard decisions to
say, “Fine, I don't want your business.”
If that customer's a significant customer, the natural gut
reaction will be to say, “Yes, I want you.
I will keep you.” Then, all of a sudden, you are going to have the ugly
phenomena in which business is good, but I wonder why we're not making
Do we have anybody in the credit card industry in the room?
Good, I can make up anything I want.
I like that. How many people have an MBNA or a Capital One credit card?
Both are very interesting.
Next time you’re ready to renew your credit card, call them
up and try to cancel. One
of two things will happen. They'll
either say thank you very much, we didn't like you anyway . . . well,
that's what they're thinking, anyway.
It's probably people like you that will happen to, people who
pay the bill off in full every month and use them for a free float.
If you're a person who carries a balance, however, that's where
they make their money. In
that case, something very interesting will happen.
You get sent to a different area in their call center.
As soon as you give them your credit card number, a customer
profitability matrix comes up on the screen.
There's something called the minimum
level of profitability. The
person on the phone gets a commission on the difference between
anything he or she can get you to do to renegotiate your terms and
conditions and the minimum level of corporate profitability.
That's not some minimum wage person on the phone, it's a
profit-incented salesperson. Do
you want no annual fee? Fine,
that's gone. That lowered
the profitability to here. You
want a different interest rate? Fine,
we're still ahead. In
some cases they take off part of the balance.
They'll do whatever it takes to stay above the line because
they have the exact data. In
many cases, these are customers with a few thousand dollars a year,
and they have that real-time decision making capability.
It's hard to compete against that because they have the facts.
Those kinds of information systems don't happen overnight. I would suggest that what happens in credit cards is
something that happens in many industries.
It's a very skewed bell curve in which there’s something like
10-15% at each tail. In
the credit card industry that means most of the profits at this end,
the middle gets them nothing, and they lose money on the far end
because those people don't repay.
MBNA has been very good at asking, “How do I tackle the
profitable part of the market?”
They don't want to serve the whole market, and they select very
carefully through customer profitability analysis. You had better do that.
flip side, of course, is that you'd better have very accurate cost
data¾very accurate, very granular, real-time cost data.
If we believe in mass customization, if we believe in
build-to-order, if we believe in any of those kinds of concepts that
are being floated around, what do they mean?
They mean you can't produce 100,000 black boxes and average the
cost across all of those units. Could
Dell have a build-to-order PC model if they didn't have very accurate
cost data? The price of
the components changes almost daily.
They have to have very, very accurate cost data.
one of these big companies that's doing extremely well.
If you order products from them and you want to change your
order before it's been delivered, go to their Web site.
You can tell them the changes you want to make and it will come
back with the cost to make those changes, real-time, depending on
where your order is in the production process.
It can calculate it and come back and tell you the difference.
You’d better have very accurate cost data because people are
not happy taking things off the shelf.
They want what they want, and you had better understand the
cost of doing those changes or you're absolutely going to get killed.
fourth thing you have to worry about is cross-subsidies.
Any time you see a business model with a cross-subsidy in it,
technology will absolutely rip it apart and blister you.
That's what's happened in credit cards because banks service
the entire spectrum, right? They
said, “These people will cross-subsidize here and here.
These people we break even on, so that's what we're going to
How many business models have a cross-subsidy in them? Look at what's happening in the music industry or the
publishing industry. Eighty-five
percent of music recorded today does not make a profit.
It does not recover production and A&R costs.
Now, that's a bad industry when you have stars and dogs.
Where is the brand recognition in that industry?
Name any recording label and I'll bet that you can’t think of
six artists on that label. The
brand equity is with the individual artist, not the label.
Well, what happens when artists can walk?
We’ve heard about Napster
out the wazoo, but let me give you a very clear example of how
powerful this is. I
taught an undergraduate class when I was visiting at Wharton,
earlier this year. I've
taught MBAs and executives and such, but never undergrads.
These were like 19- and 20-year-old kids and very smart. The average SAT score in the Wharton undergrad business
school is 1570 out of a possible 1600. They’re not stupid. At the same time, I had a problem because they thought I was
an old fart. You could
tell the way they looked at me, like here's a guy who doesn't
understand the world. “What
are you doing here?” About
halfway through the term we started talking about music.
I asked how many people listen to music.
All 65 kids raised
their hands. I asked how
many buy music. One kid
raised his hand. I asked
where they were getting the music.
The obvious choices came up Napster, etc.
They had stored between 300 and 5,000 songs on their computer
hard disks. Now, the one kid who bought music was not stupid, so I
continued to probe what he was doing.
He bought the CDs, took them home, burned and returned them. This kid obviously made an A, right? You've got to reward that.
So, the one person buying music was using sort of a complicated
free rental scheme, but there was nobody really buying music.
It’s the same thing that's happening in the publishing
industry and other kinds of business models where there are inherent
you have to look for in any industry is a bottleneck.
In any industry, the value chain is not one dimensional or two
dimensional; it's always three dimensional.
At some point there's a bottleneck, then it fans back out.
You want to own that bottleneck.
Technology creates the bottlenecks because of the leverage
points. As those leverage
points change, this bottleneck is no longer desirable and future
bottlenecks get created. If
you can be the person who either undoes a bottleneck or creates the
next bottleneck, you're going to make a lot of money.
The bottleneck in the recording industry used to be very simple¾shelf
space. That's the bottleneck in almost any consumer goods industry.
How many brands of laundry detergent does
& Gamble make? Too
many is the answer. They
make about 10 or 12. How
many of those brands make money?
Two. In any
consumer category, the answer's always two.
One makes a lot of money and one barely breaks even.
Why the other nine brands?
That's not a rhetorical question, I'm looking for some help
here. Because they clog
up the shelf space. The
discussion between the manufacturer and the retailer is, “You're
going to charge me that profit margin?
Fine, then you've got to take these six dogs if you want my
number one brand.”
What happens with the Internet is that you enter a channel with
unlimited shelf space. That
is not good if your entire business model is premised on blocking and
controlling that scarce resource.
What happened to P&G's stock price earlier this year within
just a couple of days? It wasn’t good. P&G
has cut out over 4,000 SKUs from their product line this year.
That's different sizes and such, not just the number of brands,
but it’s because they realize that their business model cannot
sustain cross-subsidies. They
realize that it is fundamentally, economically nonviable to have a
cross-subsidization business model, and they're in the process of
retooling themselves. Bottlenecks
in any industry get eroded with new technologies.
Let's play the game one more time, just ballpark to make sure
that you understand the concept.
What happens in a grocery store?
What is the hardest category in a typical grocery store to try
to introduce a new product? Cereal?
Milk? Soft drinks?
Potato chips? Any other guesses?
Ice cream. It's
frozen foods. Why is
that? Because it requires dedicated freezer space.
Any other product I can sell on a shelf, so it's a much more
complicated algorithm. For
frozen foods, it's a fixed capacity. If I want to introduce more products, I have to convince the
retailer to dedicate another shelf of freezer space, so it's very
costly. When Dove Bars
and others wanted to start selling premium ice cream for a buck a pop,
were they able to get shelf space?
No. What did they do? They
gave these small, free-standing freezers for the checkout areas in
convenience stores and said, “You know, you have underutilized floor
space there. We'll put
the freezer in for you.” They
drove up sales and, once they had enough sales, they went to the big
chains and said, “Look, we want in the frozen food
area.” They had to
create their own shelf space.
On the Internet, you get shelf space for free, so the whole
business model and bottlenecks are shifting.
Bottlenecks are always created by technology.
Whether it’s distribution, channel combinations, production,
whatever, you want to own that bottleneck.
We're seeing a fundamental shift in where these bottlenecks are
occurring, so anybody playing this game is going to have to rapidly
adapt to a shifting bottleneck model.
Any time you see cross-subsidies, attack them viciously, or, if
they're your cross-subsidies, you’d better change very quickly or
you're going to be bludgeoned. That's
what's happening in this world.
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