25239-PR/(022-31)best practice 4:20 PM Page 2222STRATEGYBestpracticeBeststrategyPhilipp M. NattermannBenchmarking is an important way to improve operational efficiency, but it is not a tool for strategic decision making. When competitors all try toplay exactly the same game, declining margins are bound to follow.“As a group, lemmings may have a rotten image, but no individual lemminghas ever received bad press.”—Warren Buffettest may be the most readily recognized and widely used Bof all business management tools. And why shouldn’t it be? To execu-tives, modeling a company’s performance on its best-in-class competitor isan ambitious but attainable aspiration. To investors, the strategy is a guar-antee of the soundness of any company that embraces it. And to consultants,it is the tide that lifts every client’s why is it killing your margins? Everyone who follows business has seenthe fat margins of growing young companies attract scores of new entrants,which eventually crowd the field and drive those very margins down. Whywould top executives convert this regrettable fact of business life into acreed, especially when doing so simply hastens the endgame for everyone—first mover and Johnny-come-lately alike?They act as they do because they don’t understand that benchmarking is simply an operational tool. Instead, they all want to occupy the point on the strategic landscape that their most successful competitor has other competitors can be seen herding, lemminglike, around 1SeeEric D. Beinhocker, “On the origin of strategies,” The McKinsey Quarterly, 1999 Number 4, pp. 38– Nattermannis a consultant in McKinsey’s New York office. Copyright © 2000 McKinsey &Company. All rights article can be found on our Web site at
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25239-PR/(022-31)best practice 4:21 PM Page 2424THE McKINSEY QUARTERLY2000 NUMBER 2that best-practice company’s product, pricing, and channel and services become increasingly commoditized, and marginstumble as more and more incum-bent companies compete for smallerMargins tumble as more and moreand smaller segments of customersand industry companies compete forsmaller and smallersegments ofAlarmingly, strategic herdingcustomers and industry resourcesappears to be in vogue in some of the most dynamic industries of the new information economy. A close look at the behavior of wirelesstelecommunications service providers in Germany indicates that strategicconvergence by itself accounted for a 50 percent decline in margins from1993 to 1998. Strategic herding also appears to be rampant in the manu-facture of computers and consumer electronics goods and in the Internetstrategies of many herding instinctBest-practice benchmarking—the measurement and implementation of the most successful operational standard or strategy available in anindustry—can be one of the most effective tools for increasing a corpo-ration’s efficiency, productivity, and, ultimately, earnings. To see the bene-fits such benchmarking can yield, you need look no further than the US automobile industry, which transformed itself during the 1980s byadopting Japanese manufacturing techniques. More recently, Ericsson and Motorola copied the Finnish cell phone maker Nokia’s use of the same phone chassis across different technologies to achieve economies of scale in design and speaking, strategic decision making occurs along three dimen-sions: product characteristics, price, and market opportunity. When a company enters a new market, management’s choices are restricted to the first two dimensions; the third element, market opportunity, consists of consumer preferences and income, which are beyond a company’s2ability to influence ’s overriding goal is to position a company and its productswhere the market opportunity is highest. The more consumers who arelocated in a specific region of the strategic landscape, or the higher their 2Strategic differentiation is more than simple product differentiation. In the early 1990s, Apple’s computerswere more distinctive than Dell’s, but Dell became the more successful company because its approach tochannel management was more innovative and it was continually reinventing its strategy. In addition, fewcustomers wanted to purchase computers, however well designed or distinctive, that had a shrinking software base.
25239-PR/(022-31)best practice 4:21 PM Page 25BEST PRACTICEBEST STRATEGY25EXHIBIT 1disposable incomes, thehigheYou are here: Mapping the strategic terrainr this particularpeak will rise (Exhibit1). Especially in newerindustries, the task offinding market oppor-tunities is complicatedby a lack of informa-tion about the willing-)Y (eicrPness of consumers tospend, the exact distri-Product charactbuetion of their prefer-ristics (X)ences, and other characteristics of thestrategic really knows only its own company’s location and earnings,and those of its competitors insofar as they make this information then, the information doesn’t fill out the entire payoff a company receives for occupying any part of the landscapedepend on the height of the point it occupies and on the number of compa-nies operating nearby. A single firm operating at a particular peak receives all of the local market value. If a number of companies operate within aregion, the market value or resources must be shared. The more companiesthat are located in a single region, the lower the payoff for the herdThis herding instinct first manifests itself in the corporate search for profitpeaks. To improve earnings, laggard companies typically benchmark theirperformance against the best practitioners and migrate closer to them. Thelaggards do so by mimicking competitors’ product offerings, matchingadvertising and spending targets, using the same sales channels, and offeringthe same services. The migration continues as long as one of the companiesearns higher returns than any of the , clustering around the strategy of the most successful com-pany actually destroys value: the profits the industry leader earns are soon divided among the group of companies converging around its that had been earning profits on lower peaks leave them to jointhe herd. Once forsaken, those sources of profit lie fallow unless othercompanies, seeing opportunity, occupy them. The combination of profitslost through the abandonment of smaller peaks and static overall earningsat the herding point forces industry earnings opportunity (Z)
25239-PR/(022-31)best practice 4:21 PM Page 2626THE McKINSEY QUARTERLY2000 NUMBER 2A strategic-differentiation index (SDI) can document the herding phenom-enon and gauge the ensuing decline in industry margins (seesidebar,“Measuring strategic differentiation”). German wireless telecommunicationsis a prime example of a relatively new industry that has destroyed value byherding. Two companies—Deutsche Telekom’s D1 and Mannesmann’s D2—joined the incumbent operator, C-Tel, in the market in mid-1992. Betweenthen and the end of 1998, operators reduced the industry’s degree ofstrategic differentiation by 83 percent. Herding effectively eliminated differ-ences among the individual carriers’ product offerings, tariffs, and customersegments. One of the alarming effects of this loss of differentiation has been a decline in industry margins by roughly 50 percent from mid-1993 to year-end 1998 (Exhibit 2).D1 and D2, the carriers that entered the business in mid-1992, quicklygained market shares that together exceeded 70 percent of the total wirelessindustry. The carriers very closely matched each other’s pricing schemes,Measuring strategic differentiationThe first step in determining the degree ofprice. (In the case of two cars with identicalstrategic differentiation among competing com-product characteristics, the one with a lowerpanies is to measure their products’ “character-price would have a higher index.)istics” numerically. These include not only eachproduct’s inherent physical attributes (in the caseThe price/product-characteristics index of eachof an automobile, for example, its horsepower,company describes its position vis-à-vis its com-weight, and size) but also the commercial envi-petitors in the strategic landscape. The varianceronment in which it is marketed, including theamong the companies’ individual indexes,customer segments the company has targeted,denoting the degree of strategic differentiationthe channels it employs, its advertising, and theacross the industry, generates the strategic-locations of its index (SDI).Generating a two-dimensional plot that relatesA company with a high individual index has suc-product characteristics to price is the next in differentiating itself clearly from com-The strength of customer preferences for eachpetitors. But the value of the industry’s SDI at product characteristic is estimated, and theseany given time is of little interest; it is changeestimates are used to calculate a price/product-over the long term, or simply over the course characteristics index for all companies in theof an industry cycle, that establishes whethercomparison. The higher the value of the index,herding has taken place. A sharp decline in thethe greater the number of desirable productSDI demonstrates that managers are engaged characteristics the company offers at a givenin strategic herding.
25239-PR/(022-31)best practice 4:21 PM Page 27BEST PRACTICEBEST STRATEGY27EXHIBIT 2with per minute andHerding destroys value in German wirelessfixed monthly pricesnever differing by morethan 3 percent. Both359002 r= heavily on third-30700party sales outlets inIndustry margins256001993 and 1994 and used20500very similar advertising40015methods, channels, and300pitches. Both targeted10Strategic differentiation200the small but affluent5100market of business usersJuly199319941995199619971998Decemberby advertising high fixed19921998charges and lower2 r= the proportion or percentage of variance explained by a regressioncharges per a third digital carrier, E-Plus, entered the market in mid-1994, itattempted to differentiate itself with a pricing package directed at relativelylow-volume private users, including students, families, and senior citizens. To turn these people into customers, E-Plus offered them a low fixed fee andhigher per minute charges. In addition, its charges for calls that both origi-nated and terminated within its network were lower than charges for thosethat did not. Within three months, all of the other networks had imitated E-Plus’s customer-targeting and pricing strategy, effectively destroying that3company’s bold attempt to increase differentiation in the analysis of the impact of such crowding indicates that a 10 percentdecline in the wireless industry’s SDI resulted in an percent decline in margins. The entry of E-Plus into the market in mid-1994 reduced margins by some 19 percent. Between 1992 and 1998, however, the SDItumbled 83 percent, pulling margins down 50 percent from their peak. Inshort, it was the low degree of strategic differentiation engineered by theincumbent operators, not the entry of new companies into the market, thatwas primarily responsible for the lost earnings, which amounted to morethan $780 million in 1998 strategic differentiation and margins decline, companies franticallyattempt to distinguish themselves from competitors, typically with higherad spending. In the case of the German telecom operators, between 1992and year-end 1998 a 10 percent decline in the differentiation index wasfollowed by a percent overall increase in average advertising expendi-tures. The 83 percent decline in the SDI from mid-1992 to the end of 3For a more complete treatment of the German wireless market, seePhilipp M. Nattermann, “The Germancellular market: A case of involuntary competition?” Info, Volume 1, Number 4, August margin, percentStrategic-differentiation index
25239-PR/(022-31)best practice 4:21 PM Page 2828THE McKINSEY QUARTERLY2000 NUMBER 21998 was accompanied by a $21 million average annual increase in adspending, which by the end of that period was 58 percent higher than ithad been at the beginning. All of that excess represents earnings lost to the industry as a result of herding has destroyed margins in the US personal-computerindustry, too. In a 1998 study by the Federal Reserve Bank of Boston,Joanna Stavins, aEXHIBIT 3senior research econo-Follow the leader: Strategic herding in the PC industrymist, examined thedegree of strategic 6060differentiation and its2r = on the margins4040of the 13 companiesStrategic differentiationthat accounted for 983030percent of the market2020Industry marginsfrom 1976 to that period, 00the PC industry’s SDI1976197719781979198019811982198319841985198619871988declined by more than2r = the proportion or percentage of variance explained by a regression37 percent as firmsclustered around thenow dominant IBM-clone PC model. As a result of this decline, marginsfell during the same period by 56 percent (Exhibit 3), representing $ in destroyed margins by 1988. Stavins also showed that increasedclustering eroded “brand’’ effects, which derive from a company’s innatedistinguishing characteristics. Brand effects, including such intangibles asreputation and market image, explain that portion of margins that is notattributable to observable product strategic herding also harms the margins and returns on equity oforiginal-equipment manufacturers (OEMs) of consumer electronics prod-ucts, such as Philips, Sony, Toshiba, and Zenith (which recently filed forChapter 11). The OEMs’ television-manufacturing activities are acute casesof industry herding around a product’s physical characteristics. TVs fromevery manufacturer not only come with the same screen sizes but are also,excluding minor differences, identical inside. Even innovative technologicalfeatures, such as Sony’s Trinitron picture tube, are typically copied within sixmonths to a year. Brand strength, the only discernible difference amongmanufacturers, requires huge advertising expenditures to sustain. Partly as a result of the lack of marginal strategic differentiation among the consumerelectronics OEMs, the market capitalization of the industry’s top five playersincreased by only 8 percent between 1994 and 1998. During that time theS&P 500 rose by 168 margin, percentStrategic-differentiation index
25239-PR/(022-31)best practice 4:21 PM Page 29BEST PRACTICEBEST STRATEGY29Other factors reinforce the herding reflex. For one thing, it dovetails nicelywith the short-term orientation of many current investors, who are morelikely than investors in the past to sell stock in companies that don’t meettheir earnings expectations. That tendency pressures companies to matchthe short-term results of their most successful direct competitors, even iflong-term opportunities are sacrificed in the process. Indeed, many execu-tives don’t regret this; by embracing the industry leader’s product, perfor-mance, and financial goals, they can blame performance setbacks on thefate of the industry as a whole. Finally, equity analysts by and large evaluatea corporation’s results against those of its industry peer group and notagainst the absolute earnings levels of all the urge to convergeUnderstandably, in specific cases executives have trouble distinguishing the operational and strategic uses of best-practice benchmarking. Preciselybecause the slope is so slippery, executives should constantlyask themselves whether they have taken those first fatefulsteps toward destroying companies haveresisted the temptation toextend the best-practice technique into the realm ofstrategy. Chrysler, for example, introduced the minivanin 1984, when the station wagon segment was such company was The Home Depot, whichentered the do-it-yourself home improvement busi-ness in 1979, just as the baby boomers startedbecoming home owners; the company enjoyedgrowth rates of 20 percent a year, well sur-passing the 5 percent rate for the overall building-supply consider Southwest Airlines, which managed togrow at a rate seven times the industry average in an era ofovercapacity and flat demand. Southwest broke ranks with the other airlinesby targeting a customer segment that, while price conscious, cares more thanother price-sensitive customers about the quality of the flight industry these companies competed in, they all actively looked for“white spots”—that is, unexplored areas on the strategic landscape. Whitespots can take the form of new product niches, value-added services, andsales channels, as well as unexploited price points. Venturing into theseuncharted regions obviously entails risk, but companies that do so increasethe number of features from which to draw value and obtain first-mover
25239-PR/(022-31)best practice 4:22 PM Page 3030THE McKINSEY QUARTERLY2000 NUMBER 2advantages. Because such gains are bound to expire quickly, however, managers must continually reinvent niche products or number of white spots is almost unlimited, with opportunitiesranging across all strategic dimensions. Small and midsize enterprises in Germany, choosing to exploit geographic opportunity, entered EasternEuropean markets after the fall of the iron curtain and succeeded because larger players initially hesitated. The Body Shop also prospered by exploiting whitespots: founded in the United Kingdom in 1976 in a single storefront, it had grown so much by 1995that it was operating more than 600 shops in 38countries. Unlike the dominant players in the cos-metics industry, The Body Shop refused to allocate30 percent of its revenue to advertising, conductedno elaborate promotions, and sold its products insimple plastic bottles. Madison Avenue viewed thatapproach with great skepticism, citing the maxim that suc-cessful cosmetics companies create hopes rather than sell products. YetBody Shop founder Anita Roddick stuck to her guns and saw turnoversoar more than 23-fold from 1984 to 1991 while pretax profits grew more than difficulties The Body Shop encountered in the mid-1990s, particularlyin the United States, illustrate the pitfalls of failing to maintain strategic differentiation. Attracted by the high returns the company earned, a largenumber of competitors, including Bath & Body Works, Garden Botanika,+and HOentered the market. (Bath & Body Works increased its sales2from $112 million in 1993 to more than $1 billion in 1999.) The BodyShop’s failure to reinvent its concept to ensure ongoing strategic differen-tiation led to a steady decline in the number of its US franchises, hurtingrevenues and earnings. Between 1996 and 1998, more than 20 franchises,some with more than one location, withdrew, complaining of the company’sfailure to outwit an ever-growing number of imitators by developing newproducts, formats, and company that broke with the herd, Sweden’s IKEA, balances qualityand price in the furniture it offers through more than 130 stores in 26 coun-tries. Contrary to the industry norm of outsourcing as much as possible,IKEA acquires stock in its more than 2,300 suppliers so that it can enforceits quality standards. Control of product design allows the company tospecify construction methods. Careful attention to detail, construction, and packaging has helped it keep costs low. Thanks to this unorthodox butvery well-executed strategy, the number of IKEA stores has grown 12-fold,
25239-PR/(022-31)best practice 4:22 PM Page 31BEST PRACTICEBEST STRATEGY31its staff 15-fold, and its revenue 40-fold over the past 20 years, even as theindustry grew by no more than 2 to 4 percent a practice doesn’t always equal best strategy. Best-practice benchmarking,rightly viewed as one of the most important tools for improving operationalefficiency, can be a double-edged sword. Managers must guard against trans-forming what is a purely process-related technique into the overriding goalof strategic decision making. When industry competitors begin to herdaround a single strategy, declining margins are bound to follow.
