BUSINESSJOURNAL

IMPROVING THE PRACTICE OF MANAGEMENT

PATTERN thinking: HOW TO IDENTIFYTOMORROW'S PROFIT ZONES

BY ERICH ALMASY AND ADRIAN 3. SLYWOTZKY

SEPTEMBER/OCTOBER 1999

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One of the newer risks that many companies face today isstrategic risk. It is concerned with one overriding question:Can a firm's business design deliver sustained, above-averagegrowth in shareholder value? This question is equallyrelevant for established companies and start-ups alike. It iswhy all managers need to understand the implications of thisrelatively new, less-understood type of risk.

When investors spot strategic risks that are threateninga company's health, they react swiftly and decisively, attimes Mdth devastating results. A recent study by MercerManagement Consulting found that 10 percent of Fortune1000 companies lost more than one-quarter of their share¬holder value in a one-month period at least once betweenJune 1993 and May 1998. These drops were almost alltriggered by reduced quarterly earnings or reduced expect¬ed future earnings. Nearly 60 percent of these earningsshortfalls were caused by poor management of strategicrisk factors such as a drop in demand, badly alignedchannels or increased competitive pressure.

A collapse in value is not the only consequence of poorlymanaged strategic risk. Increasingly—and across a growingnumber of industries from soft drinks to toys—^investors arerewarding gold-medal-winning business designs with adisproportionate share of value; the silver medallists, oftenstrong value performers themselves, must settle for a worththat's only one-third to one-twentieth of that value. When thestandards were being set for desktop computing, the marketincluded Microsoft, Apple, Lotus and Corel. As Microsoftconsolidated its power and set the standard, the othercompetitors were slow to react. Microsoft was rewarded withfar more than its fair share of market value. Even strategicallysound actions taken by the other companies in recent yearshave been insufficient to close the gap with Microsoft.

The typical strategic planning process is unsuited to thetask of anticipating strategic risk, as it tends to workincrementally rather than holistically Senior managers toofrequently settle for continuous improvement whencustomers are calling for revolution. Those managers willfind that pattern thinking, a new sense-and-respondapproach, is more effective both for characterizing risk andidentifying and exploiting new profit opportunities.

HKIMG

AS A STUATEGIC SHO

Every industry is reshaped by patterns that can shift profitand power drastically The ability to anticipate how and why

By ERICH ALMASY AND ADRIAN J. SLYWOTZKY

a company's strategic landscape is changing, and to createstrategies that lead to significant, sustained growth in value,is an art and a skill that everyone in business can cultivate.

It is also a skill that is crucial in a world where the half-lives

of business designs are growing ever shorter. Industries areevolving constantly and executives don't have time to eval¬uate their options. Managers need a shortcut to speed up theprocess and identify their portfolio of options on the fly

The good news is that business people are already engagedin pattern thinking. Many managers can describe and applythe "consolidation-and-shakeout" pattern. Many can alsoarticulate the characteristics and consequences of commodi-tization, disintermediation or deregulation patterns. Even ifpatterns are not new, they are becoming more important.

RECOGNIZING PATTERMS

Pattern recognition is part of a process that we callStrategic Anticipation®. It is not about predicting the futurewith certainty Instead, it is about being prepared to exploitchange and making informed decisions. It is about movingthe management team along the strategic anticipationspectrum from "I'm totally oblivious to the potential changesthat might transform my industry" to "I see it coming."

In the late 1980s, IBM found itself in the unfortunateposition of being the first major victim of a relatively newpattern, the "Deintegration of the Value Chain." Others hadprofited from deintegration before. For example, in the1960s, Toyota dispensed with the integrated automotivemodel of the "Big Three" and focused on those parts of thevalue chain that were critical to meeting customers' mostimportant priorities. It outsourced those parts of the chainthat were less important. But this pattern swept through thecomputer industry far more quickly and with greater value-destroying power than it had elsewhere.

IBM understood the priorities of personal computer userswho wanted inexpensive computing power and compatibilityBy endorsing Intel's microprocessor and Microsoft's operatingsystem, IBM sought to drive unit volume by establishing anopen standard for personal computing. By allowing otherfirms to own those parts of the value chain most relevant tocustomers, however, it shut itself out of the industry's largestprofit zone. Its business design choices set in motion adramatic flow of shareholder value—something we call ValueMigration®—across a no-longer-integrated computing valuechain. Value flowed to the businesses that owned thestandards (Intel and Microsoft) and away from just about

THIS SECTION IS MADE POSSIBLE THROUGH THE GENEROUS SUPPORT OF DELOITTE & TOUCHE CONSULTING GROUP

everybody else. IBM lost U.S.$100 billion in market valuefrom 1985 to 1992. In 1986, IBM owned 55 percent of theshareholder value in computing. By the end of 1997, it hadless than 13 percent. Meanwhile, Microsoft had capturednearly 20 percent of the value and Intel over 14 percent.

Pattern thinking alone would not have enabled IBM to stopits collapse. Deintegration was too new and the disci-pline ofpattern thinking was only just emerging. Deintegration is re-emerging, with early signs of it appearing in telecommu¬nications, chemicals and utilities. Are executives in these andother industries better prepared than IBM's?

priorities. For example, as the users of a company's productsbecome increasingly sophisticated and heterogeneous, they areno longer well served by a standard product. When this shiftoccurs, a company that once served its customer base in onesegment must look upon them as microsegments—segmentsthat may be as small as one person. When a company offersproducts and services targeted to these very small segments, itis exploiting the "Microsegmentation" pattern. A good exampleoccurred when Levi Strauss started the Personal Pair/OriginalSpin program to offer customers customized jeans made totheir specifications.

PROFIT PATTERNS

Patterns can identify how different industries are evolvingas well as the winning business designs in those industries.These patterns are organized along two dimensions: incidenceand type. Incidence records patterns that are emerging, whiletype expresses the primary areas of the pattern's impact. Thesepatterns are the distillation of several decades of observationand success in crafting winning business designs.

There currently are seven discrete types of patterns.

Illl... Mega-patternsThese patterns are found in many areas of business over long

periods of time, often decades. Examples include convergence,when several industries merge into one. Supplier conveigenceis happening in financial services, for instance, as banks, mutualfund complexes, brokerage firms, insurance companies andcredit card issuers compete for the same customer assets.

\^lue-chain paltenigIndustry value-chains used to be incredibly stable. Today,

they are compressed, broken and put together again.Examples include "Strengthening the Weak Link," in whicha stronger value-chain participant removes impediments tosatisfying customers by buying or helping weaker value-chain participants. Thus, Harley-Davidson provided qualitystandards and extensive training to upgrade its dealer/distrib¬utor network to serve the needs of new customer segments.

::*' ͣ Customer patternsCustomers are the ultimate arbiters of value. Value creation

and value destruction are the results of their constantly shifting

"Channel patterns 'As power and influence have shifted to customers, the

distribution channel has become more important because ofits access to critical information on customer preferencesand behaviour. In the "Compression" pattern, upstreamplayers go directly to the customer by assuming some or allof the functions previously controlled by the channel. DellComputer was one of the first personal computer companiesto disintermediate traditional distribution channels byselling directly to customers.

Product patterns"

Recently, profit and value have begun to migrate from"products" in several directions. In every case, the tangiblevalue that existed in the product itself moved next door,economically speaking, to new, scarce, intangible assets suchas brands and solutions. General Electric anticipated changingcustomer-systems economics by developing solution pack¬ages—including maintenance, service and financing—^in thejet engine and hospital equipment businesses.

Knowledge patternsKnowledge can be disorganized, dissipated and squandered.

Or it can be organized and focused to benefit the supplier andcustomer As the economy continues to shift from themanufacture of goods to the application of useful ideas, thiscategory of patterns will increase in importance. Oneimportant example is the "Knowledge to Product" pattern inwhich scarce, labour-intensive expertise is packaged into aproduct. Intuit created tremendous shareholder value byconverting specialized tax knowledge into a shrink-wrappedsoftware application, TurboTax, for the general taxpayer

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Organizational patternsFirms will increasingly need to be more observant of and

responsive to the needs of customers and top employees. Forexample, the promise that digital technology vwU revolu¬tionize the relationship with both of these stakeholders hastriggered an emerging pattern, "Conventional to DigitalBusiness Design." Even firms in traditional industries canexploit this pattern: Cemex, a major supplier of cement inMexico, uses a global satellite system and computers in ever)'truck to improve scheduling, purchasing, production, distri¬bution and responding to customer needs. Many customersgladly pay a premium for Cemex's greater reliability

Pattern recognition is still more of an art than a science.Nonetheless, there are specific steps that managers can taketo improve their ability to recognize patterns.A Evaluate their weekly business reading by fitting it into

an existing pattern

B Read about developments in other industries whichmight find application in theirs

C Try recasting their company's history in terms of patterns

With a foundation of pattern knowledge, managers wallbe able to employ the three-stage process of Strategic PatternRecognition that follows.

|i: Scan the strategic landscape, collecting and analyzing::!. data on the three categories of leading indicators:

• Dysfunctionality: mismatches between the priorities offuture-defining customers and the offerings of currentsuppliers

• VariabiUty: important differences in profitability amongcustomer segments

• Shifts in the rate or direction of change, such as rapidlychanging customer prioritiesCompare the leading indicators you have identifiedwith your own portfolio of patterns, looking for those

patterns most Hkely to developAssess the impact these patterns may have and develop

. :; an array of strategic responses, based on the type ofpattern and how early in the lifecycle it has been spotted.

Incorporating pattern thinking into your planningprocess will represent a significant competitive advantage.Pattern thinking, rigorously applied, allows every managerto think like a grandmaster and empowers the hard-workingto challenge the best.

ERICH ALMASY IS A VICE-PRESIDENT AND THE HEAD OF THE TORONTO OFFICE OF

MERCER MANAGEMENT CONSULTING.

ADRIAN]. SLYWOTZKY IS A VICE-PRESIDENT IN THE BOSTON OFFICE OF MERCER

MANAGEMENT CONSULTING. REPRINT ORDER# 9A99TD04