How to Double Your Market Share While Countering a Price War

Several weeks ago, I wrote a blog, “How to Win a Price War.”  A number of readers sent me notes, including my former Harvard/MIT executive student, Tenglum Low. Tenglum was a top executive of both a major Malaysian steel company and a major brewery, and he related his experience doubling his market share in the face of a price war by focusing on turbocharging his company’s value proposition.

Here is his story (slightly edited):

Dear Jonathan,

Your article on “How to win a Price War” is great reading, and a reminder to corporate leaders on how to enhance profitability and market share through value creation and value capturing.

Sun Tzu had often reminded generals and sovereigns that the objective of war is not simply killing the enemy, but instead it is ultimately a means to gain power and kingdoms. The best generals know that the real victory is to win a war without the need to fight any battles.

The most effective generals seek to win a kingdom without destroying its resources, so as to fund their next battle. Hence, in the world of competition, we should destroy the enemies without destroying the industry profitability. When we become the market leader, we can command a substantial portion of the industry profit pool.

I remember fighting the Malaysian steel war in the 1990s as a young Head of Commercial of Southern Steel. Within three years, we grew from 30% market share to 60% market share in domestic wire rod. Many strategic moves were played in the near duopoly market.

Today, I would like to narrate our moves in response to steep price discounts by the market leader at that time.

The steel products were near homogeneous in quality. But despite this, the slight differences of the products of the steel mills –  if synchronized well with the production equipment of the customers –  can make great differences in customer productivity. Hence, if any steel mill became the dominant supplier to the users, it could “re-synchronize” its products with the customers’ equipment, and thereby significantly enhance the customer’s productivity. Then, if the customer used the same drawing process with another supplier’s wire rod, the customer’s productivity would drop significantly – and these losses would be much greater than any price discount offered. This essentially locked in a relationship with very high switching costs.

With this knowledge in mind, we evaluated the customers through a new paradigm. We looked at the concept of “supply chain versus supply chain”, and how we could focus on growing carefully targeted customers in order to grow our sales.

The customers, at that time, could be segregated into six areas of downstream products. We decided that we could not be a supplier to all the customers in each segment because each of them wanted to become the leader in its respective downstream segment. Customer competition was extremely intense. We decided instead to pick a few leading players in each downstream segment and nurture them into market leaders. These customers needed to buy more than 70% of their steel requirement from us in order for us to “re-synchronize” our products with their production equipment, thus giving them the great benefits of higher productivity, and, once this transition was made, the 30% supplied by our competitors would have an inferior value proposition.

To enhance this mutually beneficial relationship and generate more sales, we supplied them with very competitive prices for their export requirement, which filled up their surplus capacity.

Meanwhile, our competitors offered price discounts to their customers in the nail segment to disrupt our dominance.

At that time, nail customers used 0.12 carbon killed steel as their raw material, priced at RM1200/metric ton. (Killed steel is a lower grade of steel, which has a lower drawability than rimmed steel.)

Our competitors offered our customers 0.08 carbon rimmed steel at RM1250/metric ton instead of the usual RM1300/metric ton, which was a big discount.

However, we understood the following issues:

a.         At RM1250/metric ton on wire rod produced from imported raw material, the competitors barely made profit (Malaysian steel mills could only produce killed steel, while rimmed steel is imported);

b.         The 0.08 carbon rimmed steel is good for drawability, but being much softer steel, it is not suitable for the whole range of nails.

Instead of responding by simply following this value-destroying price war, we shifted the basis for the competition by creating a new product of 0.10 carbon killed steel, and sold it to our customers at a price of RM1230/metric ton. This better met our customers’ needs at a lower cost, and our competitors could not follow us.

We made more profit from these products, and the customers also saved more cost!

Eventually, through our “supply chain versus supply chain”, most customers bought more than 90% of their raw material requirements from us.

Best regards,

Tenglum Low

The moral of the story: The best way to win a price war is not to have one – by turning it into a value war; you will take the best part of the market, while your price-oriented competitors will not know what happened to them.

Many thanks to Tenglum Low, a very thoughtful executive and a great friend – JB

Assessing Strategic Investments

Recently, I was involved in a discussion about a major strategic investment that a company was contemplating. This investment was a possible game-changer involving the development of an important new business capability.

The key question on the table was: Will the prospective benefits exceed the costs, yielding returns greater than the cost of capital? What could be more obvious?

Two critical questions

In fact, assessing investments using the cost of capital, often called capital budgeting, is not obvious at all. It is a process that seems like second nature to virtually all managers, but one which only a few use correctly.

And it is critically important. If you get it wrong, it can lock your company in place, block your most important initiatives, and prevent you from getting in front of competitors.

Two key questions lie at the heart of sound investment assessment: (1) What is the cost of capital? and (2) How should I assess the value of investments?

Not so obvious

Let’s start with the first question: What is the cost of capital? Just look it up in a Finance textbook. It is the weighted average of the company’s cost of debt and cost of equity (with a few minor adjustments). Obvious, right?

In fact, the answer is not so obvious.

This seems like a technical question, but in reality it is a very important management issue because it tacitly determines a company’s asset productivity.

The cost of capital is actually a composite. It is the weighted average of the risk/return profile of the company’s portfolio of investments (ranging from buying new machines to developing new product lines) that together constitute the existing business. This portfolio is comprised of some investments that have a very low risk and low return, other investments that have a very high risk and high return, and many in between.

Contrast an investment in a well-tested new machine to improve the efficiency of an existing process, with another investment to develop a new product line. The former investment has a low risk profile, and thus is a sensible investment even if it generates returns that are lower than the company’s composite (overall) cost of capital. The latter has a high risk profile, and thus requires a higher return than the company’s composite.

Here’s the key point: it is wrong to evaluate each investment by the standard of the company’s composite cost of capital – instead the right measure is how its risk-adjusted return compares with relevant investments, those with similar risk/return characteristics, in the company’s portfolio.

As a practical matter, I think of three levels of risk/return: low, medium, and high. This makes the task of specifying a hurdle rate (the appropriate cost of capital) much easier.

Strategic vs. tactical investments

The second question – How should I assess the value of investments? – is vitally important to a company’s competitive success. The bottom line is that assessing strategic initiatives is fundamentally different from assessing tactical investments.

Tactical investments, which produce incremental improvements to the business, are the appropriate domain for traditional capital budgeting, featuring net present value (NPV) and return on investment (ROI) analysis setting well-understood costs against benefits over time. (Remember that even here, most companies’ capital budgeting processes fail to differentiate between low risk/return investments that warrant a lower hurdle rate, from the high risk/return investments that require a higher hurdle rate.)

In the world of major strategic investments, a completely different financial assessment process is needed: one that goes beyond simply adding up costs and benefits to also reflect strategic relevance, the prospective cost of capital, and the payback period.

Bad profits

Should you make all investments that pass the cost of capital recovery test? I wrote a very popular blog about this: What are Bad Profits?

The heart of the blog was this illustration:

The essential point is that in assessing investments, profitability alone is not enough – and this is especially true of major strategic investments. The other critical dimension is whether the investment is strategically relevant.

For example, investing in offering a service that is demanded by only a few customers, but not most customers, probably is not strategically relevant and, if so, you should avoid it even if the investment is profitable. On the other hand, investing in a showcase project to discover an important new customer need in your main line of business may well be very worthy in the long run, even if it does not offer immediate returns.

Yet, a simple business case would favor the former investment and discourage the latter. How can this be right?

Consider a profitable investment that is not strategically relevant, which would indeed pass the cost of capital test. What’s really happening is that this situation has two hidden costs that typically do not appear in the business case calculation.

First, an investment in a new service almost always exponentially increases the complexity of the business in unforeseen ways, and this increases the cost structure of the whole business. (In general, increasing the volume of existing business creates arithmetically increasing costs, but increasing the complexity of the business creates geometrically increasing costs.)

Second, an investment of this sort generates an inexorable future demand for more resources. Why? Because top managers generally do not really act for purely economic reasons – after all, how can you really estimate the costs and benefits of a service offering five years from now? Rather, at the executive level, they often act to ensure “fairness” – i.e. the executive in charge needs an opportunity to show what he or she can do with this new opportunity. And, it is much easier to start trying to grow an opportunity than to end it because the former is easy to measure, while the latter is difficult because turning it around is “just around the corner.”

These issues are central to growing profitability in a robust, lasting way.

Past or future cost of capital?

Let’s return to the question of the strategic investment at the opening of this blog. Here the investment was being judged by the current cost of capital, a measure that is backward-looking by definition since it reflects the current portfolio of investments made in prior periods. Yet the investment in question was being made to have a quantum effect on the company’s future.

For a strategic investment that will really change the business, the right measure really includes the prospective cost of capital, because it will change the basic shape of the company’s risk/return portfolio of investments into the future. It makes no sense to gauge it solely by a measure that doesn’t take into account what the strategic investment is designed to accomplish.

Consider a major strategic investment that promised to really change the company’s relationship with its key accounts – its islands of profit – accelerating major account profitability by increasing the value footprint, and growing high-potential underpenetrated accounts. In this situation the company would have a high likelihood of actually lowering its cost of capital, and a lower likelihood that the cost of capital would stay the same.

Viewed from this perspective, the proper cost of capital to use to evaluate the investment would be a blend of the current cost of capital with the prospective cost of capital – the cost after the strategic investment was made, and not solely the cost in the absence of the game-changing investment. After all, if the strategic investment has the effect of reducing the cost of future investments, shouldn’t this be counted as a major benefit?

This consideration is especially relevant for major strategic investments in public companies, where investment bank analysts’ views of a company’s prospects can have a major impact on the company’s stock price and multiple.

The practical-minded retort is that it is prohibitively difficult to estimate the prospective cost of capital for every possible investment. This is true and compelling. But, it certainly is possible, and indeed feasible, to estimate it for the occasional critical strategic investments that will really change the business.

Managing big risks

So, how do top managers actually assess major strategic investments? An important study conducted a number of years ago found that one of the most important measures actually used by top executives was the discredited measure, payback period.

Payback period is simply the number of years needed to recoup an investment. It is discredited relative to NPV and ROI because it fails to account for the time value of money: two investments may have the same payback period, while the first generates most of the benefits right away and the second generates most benefits at the end of the interval. Clearly, the first investment is superior, even though they both look the same by the payback measure.

So why do top managers pay so much attention to payback period in evaluating major strategic investments? Because a major strategic investment by definition changes the paradigm of the business, creating new value and often provoking competitive response. Therefore it is extremely difficult, if not impossible, to gauge the costs and benefits. It also may well absorb the company’s ability to undertake major change for some time. In this situation, a key top management question is: When will we able to make another major strategic move? Payback period provides an important insight into this critical question.

Cost of confusion

I remember working with a major telephone company in the early days of deregulation. The company served a broad area that included a major metropolitan area with a number of global companies clustered in a few dense locations. These companies were a prime target for new emerging competitors.

As the competitors entered the city and gobbled up the telephone company’s islands of profit customers by deploying fiber and offering new services, the incumbent was hobbled and couldn’t respond. It lost block after block of its most important business.

Why? Because its traditional business case process required an explicit estimate of costs and benefits for each investment (a holdover from the days of regulation). And, preventing a competitor from taking existing business – preventing the erosion of critical customers – was deemed by the finance group as not counting toward investment benefits because it was too “hard” to quantify.

Here, the erroneous use of a tactical investment evaluation process for evaluating strategic investments nearly cost the company its most lucrative business.

Profit maps into action

Thoughtful assessment of investments is the key to maximizing both asset productivity and strategic success.

For tactical investments, the key is developing a hurdle rate that reflects the right cost of capital for the risk/return profiles of the respective investments. As a practical matter, try bundling the candidate investments into three groups: high risk/return, medium risk/return, and low risk/return. Each group requires a different hurdle rate reflecting its different cost of capital. In this context, the traditional assessment measures, NPV and ROI, are very useful.

Strategic investments, however, are fundamentally different from tactical projects. They require a very different assessment process – one that goes beyond traditional cost/benefit analysis to reflect the strategic relevance, the prospective cost of capital, and the payback period.

The strategic relevance incorporates the important hidden costs of complexity and future opportunity costs, the prospective cost of capital embraces the possibility of game-changing gains that fundamentally alter the company’s risk/return profile, and the payback period speaks to the chess-like issue of when the company will be in a position to make its next major strategic move.

In the critical process of converting a profit map into results, wisely assessing investment opportunities is critical. And getting strategic investment assessments right makes all the difference between long-run success and failure.

Great Books for Winter Reading

In my prior blog post (Logistics Clusters – a terrific new book by Yossi Sheffi), I reviewed Yossi Sheffi’s terrific new book – Logistics Clusters – which explains how supply chain dynamics are transforming both company competitive advantage, and regional economies. This book is a must-read for all business managers, supply chain service providers, and government officials. It is fascinating, fast-paced, and packed with compelling factual examples.

Three other great books

For additional great reading, I suggest three other books: Reckless Endangerment, Turn Right at Machu Pichu, and The Seven Daughters of Eve.

Reckless Endangerment, by Gretchen Morgenson and Joshua Rosner is subtitled: “How Outsized Ambition, Greed, and Corruption Created the Worst Financial Crisis of our Time” – and the book certainly lives up to this description.

It is a gripping narration of the forces that led to the near-collapse of the US economy, complete with a blow-by-blow history and names. The really chilling issue is that most of these individuals are still in power, and history appears to be repeating itself in the current fiscal cliff and budgetary crisis.

Turn Right at Machu Pichu, by Mark Adams is a delightful tale. Adams interweaves the history of Pizzarro’s conquest of the Inca Empire, with the story of Hiram Bingham’s fascinating discovery of the ruins of Machu Pichu, with Adams’ own treks in the area tracing the respective histories and stories. The result is a wonderful amalgam by a great writer. By the way, Hiram Bingham is the Yale professor whose story reputedly formed the basis for the character, Indiana Jones.

The Seven Daughters of Eve, by Bryan Sykes, is an incredibly compelling scientific detective story. In this book, Sykes, a professor of molecular genetics at Oxford, describes his ground-breaking genetic investigations into human origins in a very understandable, compelling style that is hard to put down.

His investigations solve long-standing mysteries ranging from the origin of the polynesians, to the story of global human origins. He traces the development of his pioneering genetic techniques that enabled him to trace the lineage of all contemporary humans back through the shrouds of time to just seven women, whom he calls the “seven daughters of Eve.”

Logistics Clusters – a terrific new book by Yossi Sheffi

Logistics Clusters – Yossi Sheffi’s terrific new book – explains how supply chain dynamics are transforming both company competitive advantage, and regional economies.

Why did Singapore rise to international prominence? Why did Memphis outshine its regional neighbors? Why do competitors win by locating near each other and even sharing facilities? How will the transformed Panama Canal affect commerce on entire continents?

Sheffi answers these questions and more in his insightful and fast-paced book. The book’s focal point is an explanation, with multiple examples, of the power of clusters of supply-chain related businesses. These logistics clusters offer compelling advantages for carriers, for customers, and for regional economies.

The book is a must-read for all business managers involved in operations, supply chain management, and strategy – it systematically shows the decisive gains from locating in a logistics cluster.

The book is a must-read for all supply chain service providers – it details the powerful advantages from participating in a logistics cluster, and conversely the problems that result from failing to take advantage of this essential configuration.

And, the book is a must-read for government officials seeking to turbo-charge their economies and upgrade their labor force in a recession-proof, outsourcing-proof, sustainable manner.

This book is written in a fast-paced style that draws the reader through the fascinating story of why logistics clusters are so important to so many top managers and government officials, what benefits they create for all participants, and how to participate to harvest the value.

This is a very important book that reads like a novel. After all, who else but Yossi Sheffi could tell this fascinating story that starts with Roman-era supply chains, continues with the rise of Singapore and the demise of the Erie Canal, and encompasses the founding of Federal Express, the just-in-time distribution of spinal surgical kits, and the economic transformation of the Spanish Province of Aragon?

Three Cornerstones of Profitable Growth

What essential elements does a company’s top management team need to put in place to create years of strong, profitable growth?

Here’s my old family recipe: information, process, and value footprint.

These cornerstones formed the basis for a two-month series of workshops that I recently conducted with my colleague, Lisa Dolin, for the top 150 managers of an extremely effective global company.

All three elements are important and essential; without any of the three, the company will not reach its potential.

Information

A company’s core profitability information is contained in a profit map. I describe profit mapping in my award-winning book, Islands of Profit in a Sea of Red Ink. In essence, a profit map is built by developing a full P&L (including overheads) for every invoice line. Once this is accomplished, the profit map answers the critical question: What is the actual profitability of every product in every account?

It also answers a multitude of other critical questions about product and supplier profitability, as well as highly focused questions like: Are my low-volume unprofitable products largely consumed by my low-volume unprofitable customers (guess the answer…)?

Here are some important tips in developing and using profit maps:

Invoice-line information. Developing fully-costed information on every invoice line is absolutely essential. All too often, managers starting on the road to understanding and managing profitability focus on customers, with a rough invoice-level (as opposed to an invoice-line level) costing usually based on sales volume. These efforts give an inaccurate and incomplete picture. Even in your biggest, most obviously profitable customers, over 20-30% of the products are unprofitable by any measure – and without invoice line costing, this is completely hidden. Also, critically-important opportunities to work with suppliers are undiscovered.

Strategy first. One of the biggest surprises in profit mapping is how obvious the strategic opportunities and problems are. Many managers start the process with the assumption that they will focus on tactical issues like pricing and whether to take certain business. As soon as they see a profit map, they are struck by the fact that big portions of similar business are either very profitable, or very unprofitable. Immediately, they see what the company needs to do for really big improvements that put really big new profits on the table. Only later do they turn to the more tactical opportunities that need systematic grassroots mining.

Big opportunities early. Here’s what almost always happens when you give a profit map to a sales rep without guidance or training: He or she goes after small changes in small accounts (e.g. getting the customer to order three rather than five times per week), declares victory, and goes back to business as usual.

Instead, it is most productive to focus first on the big profitable customers, where you have the best relationships, the highest volume, and most often where you have a 20-30% fast profit upside.

To repeat: focus first on your big, profitable customers – your islands of profit – both because they offer the largest, fastest profit gains, and because securing these critical accounts is the absolute most important way to protect your business from fatal profit erosion.

After that, look at the large, low profit customers. These are more difficult to change because they often are unprofitable due to unfavorable pricing or contractual obligations. These take time to change. The lesson: if you really understand your profit map, your true net profit landscape, you can ensure that your customer relationships are profitable from the start.

Don’t forget your products and suppliers. Most companies have as much, or more, upside opportunities on the product and supplier sides of their business, yet most instinctively focus on their customers. With profit mapping, you can see which customers are buying which products, and it is not at all unusual for over 50% of a company’s products to be unprofitable (and often purchased by unprofitable small accounts).

Keep it simple. Ultimately, your profit information will be used by lower level sales reps, supplier managers, and others. These individuals almost always do best with relatively simple formats and standard ways of analyzing and acting on the information. The lesson: don’t design the information for a highly quantitative analyst who loves to explore data. Instead, design the right tool for the job.

Process

The second cornerstone is process. Without effective processes, even the best profit mapping information will not be converted to action. Here are some process tips.

Regularity and discipline. It is imperative that a company create a set of processes that are regular and disciplined, with clear accountability for results. These processes span strategy, market planning, account planning, product management, and supplier management. In my experience, the best combination is monthly planning and results tracking at the local level (e.g. account planning), and quarterly planning and results tracking at high levels (e.g. strategy, supplier management).

If possible, tie these processes into the company’s natural cadence of planning and control (e.g. profit mapping becomes the core of the planning and budgeting cycle).

Wade in. All too often, companies spend inordinate amounts of time developing information, very little time developing core processes to convert the information into results, and almost no time on training and organizational development. This is a big mistake.

Again, in my experience, the training and implementation process works best in four steps.

First, create custom workshops for the top managers. The objective is to expose them to the information and to help them create the processes to convert the information into results. Here, we have found that the best results come from a combination of teaching cases, custom cases that we write on the company’s own business units, and planning sessions. The custom cases are crucial, as they give teams of the company’s top managers actual hands-on experience in working with profit maps and planning processes.

Second, develop pilot processes. Here, try a few alternative ways to work with the profit maps in formal processes. I suggest using a few great managers and effective sales reps to try things in separate efforts; the same holds with other functional areas like supplier management. It is important to have a few independent initiatives going, so you can see what works, and ultimately develop a combination of the best practices.

Third, create a way to scale the process. Even the best process needs to be changed in order to operate at scale, especially when less capable individuals are involved. Do this over several months in a purposeful way.

Fourth, work the processes into the company’s DNA and muscle memory. It takes time to perfect the implementation and to make the processes a way of life. Without this, the company will fall back on comfortable old practices, even if much less effective.

My old family recipe for wading in is: 6/6/1 – six months for steps one and two, six months for step three, and one year for step 4.

Compensation. If you continue to compensate your sales reps on revenues and gross margin, and they “work their pay plan”, it is obvious that you won’t maximize your profitable growth. Your sales reps need to be carefully trained, and the compensation has to be modified as they develop the new understanding and skills. Compensation is a very sensitive and complex topic, but I suggest that a bonus overlay works well in the first year.

In parallel, we focus strongly on training the trainers (especially the sales managers and their counterparts). Here the relevant metaphor is to school excellence: it the principal of a school is great, the school will be great; but if the principal is mediocre, the school will underperform almost regardless of how talented the teachers are.

Value Footprint

Your value footprint, or value proposition, is critical. The value that you create for your customers and suppliers determines the value that you can harvest. Several chapters in Islands of Profit in a Sea of Red Ink explain how to create a powerful value footprint – for example, check out Chapter 17, “Profit from Customer Operating Partnerships.” Several of my blog posts also focus on how to be effective in creating a value footprint – and importantly, how to match a set of value footprints to sets of customers (necessary for creating big value without having your costs blow up).

Here are a few important aspects of creating a strong value footprint.

Islands of Profit. The absolute most important priority is to secure and grow your islands of profit – your high-volume, high-profit customers – both to gain large, fast profit growth and to protect your core profit source. This is where pushing the envelope on your value footprint is most important and productive. And, in the process you will lower your operating costs by 20% or more, and increase your share of wallet by over 35%, even in your most highly penetrated accounts.

Not just customers. You certainly have an opportunity to develop a decisive value footprint for your customers – indeed, this is where everyone focuses. But, you have an equally strong opportunity to create value for your suppliers. The latter is almost always overlooked.

Showcases. I have written at length in my book and in my blog posts about the importance of showcase projects. A showcase is a small exploratory project, often with a relatively small well-run customer or supplier, in which you can jointly embark on a journey of discovery to find inventive new ways to do business together.

Vendor-managed inventory, cross-docking, category management, and many other widespread innovations grew out of showcase projects.

Here, the key is to keep a completely open mind and to learn by doing.

Resist the strong temptation to work with a major customer or supplier, and instead work with a smaller partner who is well-run and innovative. Work where the conditions for success are highest, and the risks of failure are lowest. Great companies have a constant portfolio of showcase projects. That’s how they stay in the lead.

And, as with any process, creating and improving a value footprint must be a regular, disciplined process with responsibility, regular cadence, results tracking and clear accountability – not just an occasional one-off project.

Huge gains

All companies have an opportunity for huge, fast gains and sustained profitable growth. I have been personally involved in projects involving nine-figure profit gains.

The secret of success is to cement in place the three cornerstones of profitable growth – information, process, and value footprint. With these in place, the company will naturally accelerate its profitability, growth, and competitive advantage.

Big Data – Big Opportunity or Big Headache?

Big Data is the breaking news story in the IT world.

Here’s the picture. Sometime soon company managers will have an enormous amount of information at their fingertips. They will be able to see everything and optimize everything.

What could be better?

Within the past month, two very senior, astute individuals contacted me about this – one a senior IT industry analyst, and the other a senior editor of a major business publication. They both had the same question: If Big Data actually becomes available, what will be the consequences?

My answer – Big Data offers big opportunities, but it carries the very strong likelihood of creating really big headaches in three areas: (1) paving the cowpaths, (2) managing at the right level, and (3) driving without a roadmap.

Let me explain.

Paving the cowpaths

Remember RFID?

A few years ago, RFID was all the rage. The idea was that it was becoming technically and economically possible to affix an RFID tag to every item moving through a supply chain. (An RFID tag is a small passive label that essentially emits a precise identifier when it is hit by an electromagnetic field.) Armed with this capability, managers could know the identification and location of every item in their company, and even those flowing into and out of their companies.

I remember discussing this with a former student, who is a senior operating executive of a Fortune 20 company. His reaction was similar to mine: What ever would you do with all that information?

In fact, several years ago I co-authored a column, Are You Aiming Too Low with RFID? in Harvard Business School’s Working Knowledge. In this piece, I joined with Sanjay Sarma, co-founder of MIT’s Auto-ID Lab, and John Wass, CEO of WaveMark, to argue that the biggest danger with the flood of RFID information was that almost-irresistible temptation to focus on “paving the cowpaths.”

Here’s how we put it. “One of the most exquisite challenges of living in Boston is navigating the labyrinthine maze of streets in the downtown area. This part of town is the oldest part, and the streets follow the original paths formed by settlers driving their cows to pasture. Traffic flows poorly because the city fathers simply paved the cowpaths, making the ineffective more efficient. It’s much easier to navigate Back Bay, a part of Boston with grid-like streets, built on landfill centuries later.”

In the article, we outlined a number of highly focused, high-value analytical uses for the “Big Data” that RFID could produce, and counseled avoiding the large-scale applications that simply automated routine activities.

In the absence of this disciplined, strategic approach, managers are in grave danger of utilizing Big Data to pave the cowpaths, further entrenching existing practices and rendering the possibility of developing sweeping paradigm-changing initiatives more and more difficult.

This will almost inevitably occur because in the capital budgeting process, the tactical payoffs from paving the cowpaths will be clear and easy to measure, while the payoffs from far-reaching strategic changes in the business will be hazy and unmeasurable.

Managing at the right level

This past weekend, I was reminded again of the Big Data question when I re-read Wired for War, a terrific book by P.W. Singer which traces the robotics revolution and the use of robots in  twenty-first century conflict.

In a particularly telling chapter, Singer describes how the real-time video feeds from drone aircraft – Big Data – led to the systematic leadership problems that I call “managing at the wrong level.” (See my HBS Working Knowledge column, Managing at the Right Level.)

Over many years, improved communications technology has enabled commanders to command increasingly at a distance from the actual battles. This has led to a very effective management structure in which top commanders focus on strategy and personnel, mid-level commanders on operational initiatives, and local officers on tactical issues. This parallels the leadership structure of most effective companies.

However, the widespread availability of drone aircraft information feeds has led to serious and systematic command and leadership problems. The ability of top commanders to see battlefield video feeds in real time has rapidly increased the centralization of command and led to an explosion of micromanagement.

Crack for Generals

Singer relates, “Too frequently, generals at a distance are now using information technology to interpose themselves into matters that used to be handled by those on the scene and at ranks far below them. One battalion commander in Iraq told how he had twelve stars worth of generals (a four-star general, two three-star lieutenant generals, and a two-star major general) tell him where to position his units during a battle.”

Singer continues, “An army special operations forces captain even had a brigadier general (four levels of command up) radio him while his team was in the midst of hunting down an Iraqi insurgent who had escaped during a raid. The general, watching a live Predator video back at the command center…ordered the captain where to deploy not merely his units, but his individual soldiers. ‘It’s like crack for generals,’ says Chuck Kamps, a professor at the Air Command and Staff College. ‘It gives them unprecedented ability to meddle in mission commanders’ jobs.’”

This direct meddling by military leaders has led to the rise of what Singer calls the “tactical general,” as the line between timely supervision and micromanagement has became blurred. Officers in the field lament what they call the “Mother may I?” syndrome which has come with these new technologies.

Moreover, power struggles are common when the feeds are available to multiple command groups.  Singer notes, “At its worst, this pattern can lead to the battlefield versions of too many cooks spoiling the meal. A marine officer recalls, for example, that during an operation in Afghanistan, he was sent wildly diverging orders by three different senior commanders. One told him to seize a town fifty miles away. Another told him to seize the roadway just outside of town. And the third told him, ‘Don’t do anything beyond patrol five miles around the base.’”

But, the biggest problem with top-level micromanagement in the military – just like in business – is the huge hidden opportunity cost of failing to manage at the right level: a leader ignoring the critical issues of high-level strategy and organizational capability because he or she is so caught up in real-time micromanagement. This causes two very big, related problems.

First, the top managers fail to plan for the future. For example, in business, vice presidents should primarily be focused on defining and developing the company as it should be in three to five years, since that is the time it takes to develop a new set of capabilities. Their other critical responsibility: coaching and developing the next generation of leaders.

In the absence of this hierarchical discipline, the company is in grave danger of getting mired in the present, and falling further and further behind.

Second, when top managers – or generals – take over tactical decisions, the lower-level leaders cannot develop their skills. Instead, they must be empowered to act with initiative, even if it means making a few mistakes along the way. No – especially since it means making a few mistakes along the way, since false starts and errors are a natural and necessary part of doing anything significant and new.

The answer? Singer calls it “enlightened control,” a concept he credits to the great Prussian generals of the nineteenth century, whose ideal was that the best general gave his officers the objective and left it to them to figure out how best to achieve it. He cites the commanding general who so trusted his officers that the only order he supposedly issued on the eve of the Prussian invasion of the Danish province of Schleswig was, “On February 1st, I want to sleep in Schleswig.”

The action question for managers: Will Big Data be “crack for your vice presidents,” or will they have the insight and discipline to double down on “enlightened control.”

Driving without a roadmap

One might ask: But won’t Big Data let a company’s managers optimize everything? After all, every manager will have, theoretically, the information needed to get everything right. And if a company’s managers optimize everything, won’t the company be great?

This question embodies one of the biggest false assumptions in thinking about Big Data.

The glib answer is that if it weren’t for the humans, this premise might actually happen. Let me explain.

When I think of Big Data, an analogy comes to mind. Imagine that you were living decades ago, at the time of the invention of the automobile. Assume further that all of a sudden, all the dirt roads and tracks were paved. What would you do? Where would you go?

The obvious answer is that either you would stay local or you would be paralyzed in the face of the enormous number of opportunities. In fact, you would need a roadmap, so you could see how to get to different places. Beyond that, you would need to understand the nature of the destinations so you could decide where to go, since you couldn’t get everywhere in one lifetime.

Further, if you had a number of different drivers, it is likely that each would head in a different direction, since each would go after the goal that he or she thought best. If these drivers had to coordinate, like the managers in a company, what would happen? The result would be chaos.

The problem here is two-fold. First, a company can’t do everything, because it takes significant time and resources to manage the change required to harvest any IT-based initiative. And second, the initiatives have to be coordinated and focused on the right long-term strategic goals to be effective. If the availability of Big Data encourages a massive flock of independent tactical initiatives, it will do more harm than good.

The problem with low-hanging fruit

This raises an important related problem. Managers have an almost overwhelming tendency to focus first on opportunities that are near to hand, and have quick, visible payoff. Sometimes these are called “low-hanging fruit.”

The problem is that these relatively small, parochial projects will absorb the organization’s resources and capability to change, even while they give the illusion of progress. The huge opportunity cost is losing the opportunity and ability to focus on the really important initiatives with the really big long-term payoffs.

Think of it this way. The analogy breaks down because the big money is not in harvesting fruit more efficiently, but rather in changing the location of the orchard and the type of trees you plant.

This dissipation of effort, with its focus on a large number of small, incremental projects – rather than on the smallest number of game-changing, high-payoff initiatives – is the ultimate danger of Big Data.

Keys to Success

Big Data offers great opportunities – and huge dangers. How can you navigate toward the benefits while avoiding the hazards?

The key is management insight and discipline.

The true promise of Big Data is to make your company better, not just to make parts of it more efficient. To accomplish this, you need one part technology to nine parts vision and great management.