The Trap of Marginal Thinking
Here is an excerpt from the book “How will you measure your life?” by Clayton Christensen on marginal thinking. The reason that I am producing it here is that I have questions regarding it, that I have produced in the end. Please comment or email me with what you think. Thanks!
… a little upstart called Netflix emerged in the 1990s with a novel idea: rather than make people go to the video store, why don’t we mail DVDs to them? ….. Netflix customers paid a monthly fee - and the company made money when customers didn’t watch the DVDs that they had ordered. As long as the DVDs sat unwatched at customers’ homes, Netflix did not have to pay return postage - or send out the next batch of movies that the customer had already paid the monthly fee to get.
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By 2011, Netflix had almost 24 million customers, And Blockbuster? It had declared bankruptcy the year before.
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analysis shows that marginal costs are lower, and marginal profits are higher, than the full cost. This doctrine biases companies to leverage what they have put in place to succeed in the past, instead of guiding them to create capabilities they’ll need in the future.
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The right way to look at this new market was not to think, “How can we protect our existing business? Instead, Blockbuster should have been thinking: “If we didn’t have an existing business, how could we best build a new one? What would be the best way for us to serve our customers?”
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Nucor had succeeded in getting an edge in this market by using lower-cost technology than the traditional makers had for making steel, in new types of plants called “mini-mills.”
As Nucor began to eat into U.S. Steel’s market, a group of engineers at U.S. Steel got together and concluded that if U.S. Steel was going to survive, it had to build the kind of steel mills that Nucor had. That way, it could create steel products at a much lower cost, remaining competitive against Nucor. So the engineers put together a business plan, which showed that U.S. Steel’s profit per ton would increase sixfold in the new plannt.
Everybody agreed this was a promising plan… everybody except the chief financial officer. When he saw that the plan involved spending money to build new mills, he put brakes on. “Why Should we build a new mill? We have 30percent excess capacity in our existing mills. If you were to sell an extra ton of steel, make it in our existing mills. The marginal cost of producing an additional ton in our existing mills is so low that the marginal profit is four times greater than if we build a completely new mini-mill.”
The CFO made the marginal-thinking mistake. He didn’t see that by utilizing the existing plant, they were not changing their fundamental cost of making steel at all. Building a completely new mill would have had an up-front cost, but then given the company a new and important capability for the future.
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As Henry Ford once put it. “If you need a machine and don’t buy it, then you will ultimately find that you have paid for it and don’t have it.”
So after this Clayton explains how existing companies want to leverage their existing capcities, brands & not start from scratch in a new kind of disrupting market. And how this is a big mistake. New entrants don’t have an existing cost structure, so they start from a clean slate & this turns out to be their biggest advantage.
Now here are my questions or doubts,
Both Blockbuster & U.S. Steel, didn’t know if the new entrants are a wave or a fad, so they acted late. What would be the story like if these new entrants failed for different reasons, not related to business model? How would that shape the market?
Wouldn’t the right strategy for Blockbuster be to provide both kind of plans, the existing rental ones & the new subscription ones, and push for where-ever the growth came from? Why couldn’t they do it? Existing structure of franchise model, etc…?
Wouldn’t the right strategy for U.S. Steel be to use up that 30% capacity, sell these goods at the new costing & have all further expansion in the mini mills?
What am I missing here?
I really appreciate your questions because they cut to the core issue at hand. In the case of both blockbuster and us steel, the "fad" question isn't really at issue. This is because in both cases there was technology in place that absolutely fundamentally reduces production cost, rather than a sudden change in consumer demands. The question for any company is whether or not to possess the capability to produce at lower cost. For both us steel and blockbuster the resistance came from short term marginal cost analysis in which the sunk costs in the new capabilities represented a relative reduction in short term profit margin caused by an increase in spending. The alternative, especially for us steel, was simply to lower their prices on the low end rebar, which did reduce their profit margin, but which didn't require new capital outlays. But even for blockbuster the first move was to reduce income rather than increasing capital outlays, which they did by eliminating late fees. It's easier to justify profitable operations that are slightly less profitable because of pricing pressure from competitors than it is to explain why all of the profits from one or multiple quarters is being diverted into new capital outlays for production capacities that essentially make existing assets obsolete and which aren't likely ever to operate at the same profit margins at which existing capabilities have historically been able to operate. It's possible in Blockbuster's case that customers would have simply not liked paying less to spend less time shopping for movies (although it's hard to imagine that such customers wouldn't at least represent some viable market share), but it's very hard to imagine how rebar consumers would refuse to buy rebar simply on the basis that it was produced at lower cost. In either case the question is whether your business is better off possessing a capability or better of saving the money in the short term that acquiring that capability would require. Both us steel and blockbuster would ultimately decide to copy their disruptors, but the tension caused by the marginal cost analysis is a tension the disruptors never had to deal with because they didn't have established margin expectations to compare their models against. They just new that if they made certain investments they would be rewarded with a lower cost production capability, and it seemed obvious that possessing such a capability would become a competitive advantage, so they went for it. This issue is key to the entire theory of disruptive innovation, because it's really the only advantage disruptors have over incumbents, that they don't have to justify capital outlays in light of historical margins, but instead are focused merely on the potential for their investments to be able to facilitate profitable operations in the future, whereas incumbents are haunted by their past success as an arbitrary metric used to evaluate their future potentials.