Better, Simpler Strategy, by Felix Oberholzer-Gee

Strategy is simple. (…) It is liberating to discover the simplicity in strategy.

Felix Oberholzer-Gee

Felix Oberholzer-Gee is a Swiss economist, author, and professor of strategy at Harvard Business School. I discovered him in a recent episode of the Columbia Business School’s Value Investing with Legends podcast, hosted by Michael Mauboussin and Tano Santos.

Below are the key insights from his book Better, Simpler Strategy.

Strategy can be made more powerful by simplifying:

• Strategy has become increasingly sophisticated, yet 25% of the firms in the S&P 500 fail to deliver ROIC in excess of their cost of capital.
• Strategic planning is often a bureaucratic ritual, yielding long decks that are rich in data but short on insights, with no clear guidance of what not to do and what not to worry about.
• When no one knows when to say no, firms end up pursuing a proliferation of initiatives, in other words having no strategy.

Value based strategy:

• Value based strategy helps inform decisions about where to focus and how to deepen a firm’s competitive advantage:
• Companies that achieve enduring financial success create substantial value for their customers, their employees, or their suppliers.
• Value creation is the difference between:
  1. Willingness To Pay (WTP), i.e., the most a customer would pay for the products and services, and
  2. Willingness To Sell (WTS), i.e., the lowest compensation employees and suppliers would accept for their labor, products and services.
• Value creation comes before value capture. Companies create value by increasing WTP and decreasing WTS, and capture value by setting prices, and compensation/cost. Overall value is divided between (1) value for customers (difference between WTP and price), (2) value for the firm (difference between price and compensation/cost), (3) employee satisfaction (difference between compensation and WTS) and supplier surplus (difference between cost and WTS). An obsession with business models (how you capture value) is risky because value capture is a zero-sum game.
• Strategies that lead to exceptional performance are built on three ideas: (1) create value for customers, i.e. raise WTP (enhance customer experience via more attractive products, complements, and network effects), (2) create value for employees and suppliers, i.e., decrease WTS (make work more attractive, make it easier for suppliers to produce and ship products), and (3) raise productivity (lower cost through economies of scale, learning effects, and quality of management). The author notes that only a limited number of initiatives are typically focused on raising WTP or decreasing WTS.
• Best performers (1) focus squarely on value creation and productivity gains (initiatives that fail to increase WTP, lower WTS, or raise productivity are not worth pursuing), (2) invest in a limited number of value drivers to pull ahead of competition (excellence is built on trade-offs, as companies cannot be good at everything), in ways that are (3) simple to explain and visualize (simplicity opens room for creativity and engagement) but (4) difficult to imitate (exceptional product quality and outstanding working conditions do not confer a lasting advantage if they can be matched easily by rivals).
• The potential for performance gains within an industry is usually greater than the gains expected from entering a different industry. There are significant differences in ROIC across companies that operate in the same industry. Note: The author views ROIC, measured over a span of 5-10 years, as the best financial performance metric as (a) it takes into account the resources used to produce cashflows, (b) it can be compared to the cost of capital hurdle and (c) it averages out the impact of business cycles. Michael Porter also views superior performance, measured by above-average ROIC over a full investment cycle, as a necessary feature of competitive advantage.

Value for customers:

• Value for customers can be created in three ways:
  1. More attractive products (including customer journey).
  2. Complements.
  3. Network effects (which create a positive feedback loop).
• A sales-focused mindset ignores opportunities to raise WTP. A product-centric manager wants to sell more, and thus understands purchase decisions and looks for ways to sway the customer. A manager concerned with WTP wants to see customers clap and cheer, considers the entire customer journey, and searches for opportunities to create value at every step, including after they have committed to a purchase. A common thread to bestsellers is that their creators found ways to significantly increase WTP.
• WTP should not be considered in isolation. WTP, price, cost, and WTS are all connected, and having the best quality or the most admired organization is no guarantee of success. The ultimate arbiter of success is an increase in customer delight.
• Companies that focus on WTP enjoy a long-term competitive advantage: (1) they are better at identifying opportunities for value creation and recognizing the needs of customers and intermediaries, (2) they attract the “right” customers (those for whom the value proposition is particularly attractive), retain them with trust, and generate referrals (customer delight is highly contagious).
• Even in organizations whose culture is firmly centered on customer WTP, it helps to develop practices that periodically remind everyone of their firm’s focus. E.g., at Amazon, (1) there is always an empty chair in meetings, reserved for the customer, (2) when a new service is built, managers begin by writing an internal press release, thus “working backwards” to determine a target audience and describe the appeal of the new service.
• Most managers do not pay enough attention to non-customers, especially near-customers. Near-customers have a WTP that is fairly close to the level required to make a purchase. Understanding the determinants of their WTP can reveal substantial business opportunities. Why are they not in the market for your product? Do they misperceive its value? How might you tweak your offering to boost their WTP and turn them into buyers? Are there internal impediments to consider this segment (incentive systems, stereotypes, assumption that it will require significant investment)?
• Complements help raise WTP but require specific efforts to identify. Complements are a powerful means of increasing WTP and creating customer value. They often seem unrelated to the core business and thus identifying them requires to think creatively about the customer journey. Complements can be provided by third parties (in which case you want them to be as cheap as possible) or by the firm (in which case you can shift profits from intensely competitive domains to calmer waters). They can be mistaken for substitutes, and thus require experiments to be properly distinguished.
• Network effects increase WTP via positive feedback loops. There are three types of network effects: (1) direct network effects, which increase WTP whenever additional customers purchase a product (e.g. the WTP for fax machines increases with the number of businesses and individuals who own one), (2) indirect network effects, which raise customer WTP with the help of a complement (e.g. as more customers purchase smartphones, developers will create more apps, which raises the WTP for smartphones), and (3) platform businesses, which attract more than one type of customer or supplier, and for which WTP for one group of customers increases as the other group grows larger (e.g. the WTP for Uber drivers and Uber passengers increases as the other group grows in size). Network effects reward companies with more users and greater market share. However, underdogs can still thrive by (a) lifting WTP in ways that do not depend on scale, (b) catering to neglected groups, or (c) focusing on a small group of customers who place a high value on connections with one another.

Value for employees:

• Services contribute 80% of GDP and both their cost and their value to customers are greatly influenced by the engagement of employees.
• Greater employee satisfaction can be created by increasing compensation (which lowers the firm’s margins) or by creating more attractive working conditions (which creates more value by reducing WTS). The opportunity to exchange money for time is increasingly popular. Companies that find ways to lower WTS (a) have more satisfied employees, (b) attract and retain the “right” employees (those who particularly value the ways in which the company reduces WTS), and (c) allow the firm to participate in that value (by allowing below-market compensation, greater loyalty and engagement, and a larger pool of job applicants).
• Making work more attractive is not rocket science. Identifying opportunities requires that you understand the work performed, and the joys and challenges associated with each activity. Employees have many ideas to make their work more pleasant. Pursue the ones that also raise productivity.
  • E.g., Quest Diagnostics reduced attrition in its call centers from 34% to 16% and increased productivity by (1) breaking the cycle (raise base compensation, introduce incentives that reward tenure and on-the-job performance), (2) setting high expectations (performance metrics, attendance policy), (3) making the job easier (self-serve options, subject matter expert added in each team), (4) building capabilities (employees can apply to a Quest management system team, where they are taught Excel, data collection, root-cause problem solving, Gantt charts and techniques to manage meetings and change, by submitting seven process improvement ideas; teams compete to become model pods, charged with suggesting and implementing process improvements), (5) making change real (the best ideas conceived by model pods or by frontline employees, with “frontline idea cards”, are quickly implemented systemwide), (6) shifting ownership (model pods meet daily for short meetings – huddles – to discuss performance metrics, ideas for improvement, and current projects), (7) recognizing progress (6% bonus pool, “wow calls” to acknowledge employees who have been praised by clients, free snacks for members of the “100 Club”, who achieve perfect performance in monitored calls, small gifts for impactful “frontline idea cards”).
  • E.g., Gap conducted a ten-month experiment to improve the lives of its sales staff, tackling an aspect that is typically of little concern for retailers but important for part-time workers: predictable and consistent hours. Participant stores standardized the start and end time of work shifts, scheduled employees for the same shift every week, provided at least 20 hours for a core group of staff, and allowed employees to trade hours by using a specifically designed app. Compared to non-participant stores, productivity increased by 7% and sales rose by $3 million.
  • Flextime policies include time-shifting, micro-agility (ability to freely move some hours), part-time work, compressed hours (employees work full-time but over fewer days), periods of minimal travel, job-sharing, paid leave, sabbaticals, and ways to “dial up” or “dial down” one’s career. Employees are more likely to use flextime when (a) KPIs and celebrations emphasize productivity not long hours, and (b) senior managers support and use it.
  • Some firms turn to platforms that connect companies to a network of outside experts for short assignments, which can be awarded after contests. This combination of passion and short assignments results in superb quality and reasonable remuneration.
• Differentiation is intuitive for products and services but not for jobs. While most companies think about pricing, they often “pay market” for talent, as if jobs were commodities. Companies competing for talent by offering better working conditions should (1) be specific (“we have a great culture” is difficult to verify), (2) be predictable (focus on initiatives that lower WTS in a predictable manner, e.g. flexible hours and opportunity to work from home), (3) be creative (consider various ways to share value with your workforce), (4) magnify existing benefits (which attracted existing employees) rather than limit current shortfalls (to which existing employees may not be sensitive).

Value for suppliers:

• The logic of value capture dominates many buyer-supplier relationships.
• Your can lower the WTS of your suppliers by making their life easier, making them more productive, and making it more cost effective to sell to you.
  • E.g., Nike decided to teach its vendors lean manufacturing and even tested alternative compensation schemes for its vendors’ workers to see which contributed most to increased productivity and lower turnover.
  • E.g., Raksul, a B2B marketplace for printing services initially allowing customers to compare prices across thousands of printing companies, built a highly efficient matching service (sending client orders to printers with idle capacity and the right equipment, thus a low WTS) and hired engineers to help printers improve their floor-level operations.
• Be selective and limit the number of vendor relationships in which you invest. Deep relationships are advantageous when (1) there is a large value potential (ability to move WTS, cost, and WTP), (2) your requests are specific (e.g. dedicated capacity or process), (3) it is hard to describe in a contract and measure what you expect of your supplier.
• Get to know your suppliers. Being close to your suppliers enables you to see initiatives that may increase supplier surplus.
• Focus on outcomes. Being overly prescriptive robs suppliers of chances to adopt novel processes and introduce innovative products and services.
• Align external and internal incentives. With goals in place, you can define metrics that align with these goals and link them to financial incentives (e.g. FedEx Supply Chain benefits financially if the costs of Dell’s reverse logistics operations decline). Your purchasing department should be made aware that you are building a collaborative relationship with a supplier.
• Keep an open mind. Once you build trust with a supplier, you have limited incentives to search elsewhere. Reevaluating long-term relationships might point you to new opportunities to achieve even lower WTS and cost.

Productivity:

• There are dramatic differences in productivity within the same industry. According to several studies cited by the author, the productivity of the 10% leading companies compared to the 10% weakest companies in the same industry (SIC code) is 2:1 in the USA and 5:1 in China and India.
• Three forces help determine productivity: (1) scale, (2) learning, and (3) operational effectiveness:
  1. Scale. A business benefiting from economies of scale sees its average costs fall as the business grows. This typically reflects the presence of fixed costs, which can be spread over larger volumes (e.g., IT and advertising spend). The Minimum Efficient Scale (MES) is the business volume needed to be cost competitive, a figure every strategist should know. If your business is smaller than the MES, you will not be able to compete with larger rivals on the basis of cost; once you achieve the MES, continued growth no longer results in a greater cost advantage. the MES changes over time, due to trends in technology and consumer tastes, but also due to strategic decisions (e.g., escalating fixed costs to limit competition).
  2. Learning. As companies increase the cumulative volume of production, costs often decline as employees gain familiarity with the product and processes, and find new ways to improve productivity. Learning effects are most powerful if they reduce cost at an intermediate pace, and if you have a long head start. But benefits from running the same process many times may stifle innovation.
  3. Operational effectiveness. The view that you cannot achieve a lasting productivity advantage by adopting modern management techniques is too simple. While execution is no substitute for sound strategy, good management practices and operational effectiveness can serve as a springboard to raise WTP or lower WTS. Many companies fail to adopt basic management techniques such as goal setting, performance tracking, and frequent feedback, typically because the executives in charge (a) lack knowledge of the quality of their management, (b) prefer a hands-on approach to process-oriented techniques, or (c) do not see the benefits.

Implementation:

• Prior to committing to initiatives and projects, it is critical to understand in detail how they would move WTP or WTS. Scale can stand for economies of scale (lower cost and WTS), learning (lower cost and WTS), network effects (increased WTP) or incentives to invest in complements (increased WTP). Depending on which of these mechanisms you employ, different resources and capabilities become critical. For a business with economies of scale, pursuing multiple markets may be reasonable, while for a business with local network effects but no economies of scale, chasing users in various markets can be a mistake. If you come across initiatives that provide no indication of how they will change WTP or WTS, chances are they will not have a lasting financial impact.
• Value maps are a useful tool to decide where to excel and where to underperform. For each group of customers (or group of employees if you create a map for talent), compile a list of criteria that are important to these customers (value drivers), rank them from most important to least important, and indicate how good your company is at meeting each of these demands. This reveals the attributes that determine customer WTP (or employee WTS), where you have an advantage and where you lag, and if your firm is making appropriate trade-offs (Do you excel where it counts?). As smart, ambitious executives want to become better at everything, it is exciting to decide where to make progress, but harder to determine where not to invest. As no company can be good at everything, excellence is built on trade-offs. Next time you make a long list of issues to resolve, projects to complete, and services to improve, remember to ask “What will we stop doing?”.
• Value maps also facilitate the transition from strategy formulation to strategy implementation: they are data driven, enable to see the company and its competitors through the lens of customers, talents and suppliers. It can be used for: (1) Choosing a value proposition. By comparing your company’s value curve to that of your competitors, you can identify relevant differences and devise ways to heighten them. A comprehensive strategic plan includes value propositions for customers, talent, and if required, critical suppliers and complementors. To select changes to your value proposition, the author advises (a) to prioritize initiatives that improve the most important value drivers (vs. the lowest-ranked ones), are part of a theme, deepen an existing advantage (vs. make up a shortcoming), and yield an attractive ROI (impact on WTP vs. resources and capabilities required), and (b) to underinvest in areas that are costly and less important; (2) Customer segmentation. Begin your value curve analyses by employing a fine-grained customer segmentation. If two groups have nearly identical value drivers, you can treat them as one segment; (3) Customer journeys: Value curve data can be employed to guide customers more effectively through the buying process, using a marketing funnel. (4) Implementation: Once you decide which value drivers to strengthen and which ones to deemphasize, the key steps are to generate ideas that have the potential to move the value drivers in the right direction, to assign responsibility for implementation, and to track KPIs. These actions can be visualized through migration maps or road maps.

Value:

• Mixed effects. To achieve performance, strategists employ two levers: WTP and WTS. In practice, most real-world strategic initiatives affect both ends, so it is essential to think through all the changes (WTP, price, cost, WTS) before embarking on a new strategic course. In many cases, an increase in WTP lifts WTS and reduces supplier surplus, forcing companies to decide whom to champion: customers or suppliers.
• Dual advantage. In the best case, an increase in WTP lowers WTS or vice versa. Dual advantages are often found in services, where employee satisfaction and customer experience are linked. The stronger the connections from one set of value drivers to another, the greater the advantage.
  • E.g., Zara’s fast-fashion model reduces inventory (lower WTS) and provides customers with the latest trends in cuts and colors (higher WTP ).
  • E.g., When Intel raises manufacturing yields, product quality increases (higher WTP ) and costs fall (lower WTS)
• Starting the conversation. To begin the conversation in your company, take a piece of paper, draw a value stick, and ask: (1) What do we do to move WTP? (2) How do we change WTS? (3) What are the connections between our value drivers, prices, and costs? This will enable you to (a) Recognize the value you create, (b) Identify value drivers, (c) See the connections between value drivers, prices, and cost (dual advantage or mixed effects), and (d) Coordinate investments and align activities.
• Value for society. In 2019, the Business Roundtable, a group of 188 CEOs of America’s largest companies, announced that corporations needed to deliver value for all stakeholders. According to the author, (1) business creates substantial value for customers, employees, and suppliers even if its goal is to maximize financial returns, (2) competition is the best assurance that companies continue to innovate in service of these stakeholders, (3) prices should reflect the true cost of economic activity, (4) the key to progress is a relentless focus on value creation, not value capture.