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The Four Things You Need to Know about Your Business

After interviewing more than 40 leaders from companies and nonprofit organizations and conducting extensive research into the management practices of dozens of companies for our book The Breakthrough Imperative, we came to believe that four laws provide most of the fundamental knowledge necessary to guide a successful manager’s initial diagnoses and path to success. Here is a brief summary of the four laws, along with some questions to test your own mastery of the fundamentals relating to your business.

Law 1: Costs and Prices Always Decline
Some MBA students (not all) learn the tool known as the experience curve, a downward-sloping curve that shows the relationship between accumulated experience in an industry and the long-term decline in costs and prices. The experience curve takes a commonsense observation—the more often a task is done, the less it should cost to do it—and gives it mathematical expression, hence predictive power. But even those who learn the tool in the classroom seldom apply it rigorously in their business. And many managers have an incomplete understanding of the nuanced competitive economics that define their business, so they set targets based on the wrong curve.

Great managers apply the experience curve correctly. Do you know what the prices of your major products or services are likely to be five years from now? Do you know how your own cost trends compare with the price curve—and how your competitor’s cost trends compare? Is there a price umbrella in your industry—and if so, might it collapse? When? What are the potential ramifications for your company?

Law 2: Competitive Position Determines Your Options
Managers have to make choices about which levers to pull to improve performance. But too many do so in a vacuum. Performance-improvement strategies are successful when they reflect a company’s position in the market and rely on specific insights as to which actions can improve it in the eyes of the company’s customers.

One of the most powerful ways to chart your own and your competitors’ positions in a market is to map where you fall on a simple chart. The chart shows return on assets or another measure of economic performance against relative market share—your share divided by the share of your largest competitor if you are not the leader, or by the share of the number two company if you are number one. Plot these two indicators against each other and you find that companies line up in a handful of typical positions, each with its own opportunities and vulnerabilities. Among other things, this chart shows how market leaders usually earn disproportionate returns, and what you have to do if you’re not the market leader.

Great managers know where they fall on the chart and what it implies for their performance-improvement options. Do you know your relative market share for each of your major businesses? Do you understand the inherent possibilities and constraints that your competitive position creates? Do you know how to improve your position using both customer insight and market power and influence? Do you know your competitors’ market positions, and are you, therefore, able to assess the likely strategies that they will follow? How could their actions disadvantage you, and how can you disadvantage them?

Law 3: Customers and Profit Pools Don’t Stand Still
Who are your competitors, really? Dell obviously competes with Hewlett-Packard, Lenovo/IBM and Gateway in personal computers and accessories, and it is a leader in that market. But look at the entire value chain in this business and you get a different perspective. Much of the profit in this chain flows to chip suppliers, such as Intel and Advanced Micro Devices (AMD), and to software suppliers, such as Microsoft. Intel and Microsoft may be Dell’s partners, but they also compete for profits in the overall industry. We call the analysis of the total profit made by you, your competitors, and other players in the value chain “profit-pool analysis.” Aggressive general managers constantly try to protect existing pools and take over or create new profit pools. So, of course, do their competitors.

The challenge in this kind of competition is that the profit pool is always shifting. A primary reason is that customers’ preferences and behaviors are always changing, either because they grow dissatisfied with what they are currently buying, or because an innovative company learns how to offer them better value. If you were to map your industry’s profit pool ten years ago and compare it with a similar map today, the comparison would almost certainly show dramatic changes in the distribution of profits by competitor. A profit-pool map five or ten years from now probably wouldn’t look much like today’s, either. The maps would also help to explain the reasons behind the changes. Profit pools shift, but they don’t shift randomly. They shift in predictable directions as customers’ tastes and behaviors change, and as other forces in the marketplace (or out of it) exert their influence. What’s more, a company’s share of the profit pool is seldom exactly proportional to its share or revenue in the value chain. This counterintuitive notion has powerful implications for how you compete for profits.

Great managers anticipate profit-pool shifts and plan their strategies and tactics accordingly. Do you know your share of the relevant profit pools and the shares of your key competitors, suppliers, and customers? Have you rigorously identified shifts in your industry’s profit pools during the past several years and likely future shifts? Can you identify the factors that are leading customers to change their preferences and behaviors? Have you planned a series of actions to take advantage of these changes and capture a large share of the relevant pool for your organization?

Law 4: Simplicity Gets Results
Human beings can’t effectively focus on more than two or three things at once. A company with too many products and options drives up costs and confuses its customers. A simple “Model T” analysis—creating a picture of costs and revenues as if you made just one standard product, then adding options back in one at a time—can reveal where the incremental costs or more products or more-complex processes outweigh the benefits.

Great managers keep it simple. Do you know how the number of products or services you offer compares to competitors? Do you understand the full systemic costs of product and process complexity in your organization and how it affects your revenues? How many layers are there between the CEO and the lowest-level employee? Can most people in your organization describe your critical action initiatives during a six-floor elevator ride?

These four laws aren’t prescriptions. They are descriptions of the way business works. They provide the context and constraints in which managers must operate. Managers can’t afford to ignore them; if they do, they will lose customers. Knowing the laws and all of their many implications is the first step on the road to making yourself a great manager.

Reprinted from The Breakthrough Imperative, by Mark Gottfredson and Steve Schaubert, by arrangement with Collins, an imprint of HarperCollins Publishers. Copyright (c) Bain & Company, Inc., 2008.