The following excerpt is from Richard Koch and Greg Lockwood’s book Simplify. Buy it now from Amazon | Barnes & Noble | iTunes
There’s plenty of anecdotal evidence that leaders of large, successful firms consistently tend to use to make their businesses more complex rather than simpler. But why do they do that?
It turns out that there are five reasons managers in market leaders don’t simplify, and they’re all traps. Let’s take a look.
Related: How Uber Used a Simplified Business Model to Disrupt the Taxi Industry
1. The Overhead Trap
In this trap, companies have expectations about gross margins and are unwilling to develop products that deviate either up or down from their existing overhead and margin levels.
One example of the Overhead Trap is DEC’s failure to make its mark in personal computers. From 1965, when the company introduced the first “minicomputer,” until the 1980s, DEC was the dominant force in minicomputers, leaving IBM trailing in its wake. But when the PC market began to sprout in the 1970s, DEC looked into entering the new sector eleven times and held back every time. It finally started to make PCs in 1983, two years after IBM and seven years after Apple. None of its PC products was ever successful.
Why was that? DEC certainly had the design and technical skills. But the firm was used to a market with different economics. Minicomputers required a huge, ongoing research effort and rewarded it with gross margins north of 50 percent. By contrast, PC gross margins were under 30 percent. Also, the new breed of computers didn’t require the massive, continuous research investment that minicomputers did, and customers weren’t willing to pay the sorts of prices that would support expensive research anyway. DEC’s belated move into PCs was at the top of that market, where gross margins were highest but volumes were lowest and customer requirements greatest.
Many firms develop their own rules of thumb about acceptable margins and then become addicted to them. So, if simpler, lower-margin products come along, it’s hard for any successful company to embrace them and realize that, although the margins are lower, the overheads are, too.
2. The Cannibalization Trap
In this trap, the leading firm doesn’t want to eat its own lunch, which allows challengers to do it for them. Following is an example of what we mean.
In 2000, Betfair, a new betting company, started in London. Other online bookmakers already existed, but Betfair’s business model was different from those of all its rivals, online or offline. Instead of setting the odds itself, Betfair created an electronic market — a betting exchange — where gamblers could offer odds to other gamblers or take the odds posted by other individuals.
Within a few years, Betfair was beginning to make significant inroads into the main betting market. This wasn’t surprising, given that Betfair charged an average commission of 3 percent, compared with the mainstream bookmakers’ gross profit margin of about 12 percent. Moreover, Betfair charged commission only on winning bets. So it was charging just 1.5 percent on total bets — a price reduction of 87.5 percent!
You can understand the traditional bookies’ fear of “cannibalization.” They saw no sense in adopting the new system themselves and encouraging their customers to move from the current high-margin way of betting towards a much lower-margin method.
But the bookmakers didn’t realize that, whatever they did, any price-sensitive gambler who wasn’t a total technophobe would soon be beating a path to Betfair’s door. The sensible thing, therefore, would have been for one of the big bookmakers in the UK to start its own online betting exchange or, better still, buy Betfair and thus eliminate a potentially very serious rival. Yet none of them chose those options. For them, Betfair was the enemy — a company to be crushed underfoot, preferably by persuading the government to declare betting exchanges illegal.
Related: Is Your Business Vulnerable to an Attack From a Simplifier? Here’s How to Find Out.
When the government refused to play ball, Betfair went on to become the number-one online betting company in the UK. If one of the big three had acquired Betfair, and kept it as a separate business, they would likely be the market leader now, instead of an also-ran.
With the important exceptions of luxury and niche markets — where customers aren’t price-sensitive — it follows that there’s almost no circumstance in which it makes sense not to introduce a simpler and cheaper product!
3. The Customer Trap
In this instance, a firm rejects the new product because its best customers do. See what we mean in the following example.
The first full-service airline to introduce a budget service was United’s Shuttle service, launched in 1994, twenty-three years after Southwest Airlines started operating. Perhaps it was fear of cannibalizing the firm’s established customers, but we think it was more likely that the full-service airlines assumes their customers weren’t interested in the new business model.
And this was probably true … at first. Southwest appealed to people who wanted to travel point-to-point — those who had previously driven or hadn’t traveled long distances at all. It didn’t appeal to sophisticated frequent fliers who traveled to major cities, often abroad, and comprised most of the scheduled airlines’ market.
But when a mass market is created, the new product gradually becomes increasingly visible. The number of budget airlines grew, and their reach gradually extended, so everyone traveling on a full fare became aware of the much cheaper alternatives. And, ultimately, money always talks. Businesspeople started to use budget airlines when traveling at their own expense, and learned that they weren’t so bad: They still had a seat (albeit with less legroom), and they arrived safely and usually on time, just as on a scheduled flight. Then, when the economy suffered a downturn, ever more firms made their staff use the cheaper carriers for business flights, too, and these habits persisted even when the economy improved.
What happened in the airline market reflects a general pattern. The trap here is that the market leader believes its customers will never switch, and so it ignores the threat from the new product.
What’s more, the typical response of the market leader is “segment retreat” — a move to even more complex and expensive products. This is usually explained as a natural response to short-term earnings pressure from the simpler product. Such an explanation is often valid, but something else may also be involved.
4. The Complexity Trap
In this trap, managers naturally love complexity, or become accustomed to it, believing it is the only route to progress. Here’s what we mean.
How do many ventures start? An entrepreneur innovates, turning an idea into a product that may be sold to other businesses. A viable solution is found and an initial customer is signed up. Whatever the customer wants — whatever adaptations and customization they demand — the new firm eagerly supplies. Keeping this precious customer happy therefore leads to increasing complexity. Soon, a second customer comes along, but they want different adaptations from the first one. More complexity. Then, in the quest to fill all possible niches — in the rational wish to exclude rivals and increase revenue — new features and new technology are added in a hurry in order to provide a product for each segment. Adding features and technology seems entirely logical, and it helps to identify the venture with every aspect of the new market.
The fact is, people don’t design complex products just for the hell of it — they’re driven by a vision of how the products could be more useful and attractive. The danger is, they get locked into the assumption that it’s okay for the product or business system to become increasingly complex — heavier, more expensive, more convoluted and harder for the uninitiated to use — as long as performance continues to improve.
Related: How This Successful Company Simplified the Business Consulting Industry
At the start of its life cycle, the only way to improve a product is to add more resources and energy. After a while, though, this ceases to be true. It becomes possible to simplify — to make lighter, smaller products that have fewer features, are easier to use, cheaper to buy and operate and less costly to produce and deliver. Yet managers who are used to progressing only by adding complexity often see simpler products not as a step forwards but as a step backwards.
5. The Skills Trap
In this trap, the business may not have the right skills for simpler products, but it also fails to appreciate that these can be acquired, often quite cheaply. The requirement for different skills isn’t necessarily a barrier to effective simplifying, provided the new skills are developed and kept outside the original operation, even after acquisition. As we saw earlier, one of the leading UK betting companies would have been well advised to buy Betfair and its new electronic exchange technology at the start of this century, when it was a fledgling but fast-expanding company. Perhaps companies such as Google — which rarely hesitates to buy businesses that are adjacent to its own — are right to do so, both to facilitate growth and to protect themselves from potential rivals.
The bottom line is, it’s not that leading firms cannot simplify. Rather, there are deep managerial tendencies that make firms both reluctant and slow to do so. Don’t let that stop you.