Five Tools for Strategic Analysis from Richard Rumelt

Rumelt’s strategic analysis can broadly be divided into five tools. --- The first tool is comparison with similar cases. In 2017, American media debated why building a New York subway was so expensive. A new tunnel on Manhattan’s East Side was to link two sections of the subway. As construction dragged on, costs ballooned to US$12 billion. Most people have little feel for large numbers. Reporters interviewed the various stakeholders, and everyone seemed to have a reasonable argument. Unions, for example, said they had to protect workers’ interests. Perhaps New York is simply expensive? To Rumelt, comparing New York’s subway construction costs with those of similar cities would reveal what was happening. This New York section cost US$3.5 billion per mile, seven times the average cost of subway tunnels worldwide. You say New York is expensive—but are London and Paris cheap? New York’s construction costs were four times London’s and more than ten times Paris’s. What was going on? One possible answer is that Paris has a design review committee for subway construction that keeps costs under control. The United States has no such committee. Typically, companies submit bids, and the winning contractor subsequently changes designs and adds costs for all sorts of reasons, leaving you with no means of control. This points to a problem in the American system. The approach is simple, like a doctor first checking basic indicators such as blood pressure, blood oxygen, and liver function. If readings fall outside healthy ranges, something is wrong. --- The second tool is understanding human behavior. A company was evaluating whether to launch an innovative project. The department manager responsible produced an impressive report showing future cash flows: the initial investment required, outflows only in the first two years, positive cash flow from year three, increasingly high earnings thereafter, and investment recovered by year six… (Almost every startup business plan seems to contain similar financial assumptions.) The logic sounds intuitive, but Rumelt found it strange. In fact, few people in venture capital calculate cash flows this way, because such calculations are meaningless. Innovative projects never turn out exactly as you imagine; such certain profit expectations are wishful thinking. On investigating, Rumelt discovered that consumers did not even like the supposed new product. Eventually, the department manager told the truth. Of course the report had to highlight good news and conceal bad: he was competing on his department’s behalf for headquarters’ resources and had to secure that investment or resource allocation! The manager’s behavior illustrates a problem that can arise in any large organization. Rumelt says it appears whenever knowledge, resources, and decision-making authority do not reside in the same person. If someone else has the knowledge and you have the resources, the knowledgeable person will try to mislead the resource holder. The board did not fully understand the innovation model, but it was relatively cautious, and ultimately did not approve the project. Another company told Rumelt it already had a strategy and asked him to analyze it. Its strategy report was an attractive slide deck presenting financial conditions, market size, and growth rates over previous years in neat categories. It concluded: “We will continue investing in growing market segments.” After reading it, Rumelt said it was not a strategy, and the final sentence meant nothing. Every company invests in growing markets. That is like everyone’s New Year’s resolution being to exercise more—isn’t it empty? He asked them to describe the difficulties currently facing the company. It turned out that, from the CEO down, these executives had never seriously considered the company’s real, current difficulties! They vaguely sensed a problem. Although still profitable, the company was less profitable than before and showed signs of decline. Yet no one had confronted the difficulties; they had long grown used to reporting good news and hiding bad. Rumelt led them through the issues one by one… much as a doctor helps patients describe their symptoms. The reality is that most people avoid acknowledging problems and seeking help. ---- The third tool is data analysis. This is more specialized and requires precise measurement to obtain data. A Brazilian company made window blinds in various sizes. It had little cost awareness and did not do much accounting. It sensed margins declining but did not know which part of the business was responsible, so it engaged Rumelt’s team. Rumelt found that the company had never calculated the cost of producing each type of blind. Naturally, it did not know which was most profitable. His team spent a month inside the factory, carefully observing how much time workers needed to make different blinds as a measure of production costs. (P.S. Many startups actually have similar problems. When business comes in, are product prices and SaaS subscription revenues reasonable? A detailed breakdown of every item may reveal that all that hard work ultimately produces a loss.) They found that small blinds made no money, medium-sized ones were profitable, and large ones were the real money-makers. This contradicted the company’s assumptions: it had thought large blinds cost too much to be worthwhile. The opposite was true. Relative to their selling prices, large blinds had the lowest unit costs. The strategy became clear: sell as many large blinds as possible. The company immediately knew what to do—offer discounts on large-blind orders to encourage customers to buy more. It had found its source of profit. A women’s clothing chain wanted to expand but did not know how large each store should be. Larger stores cost more to rent but could display more merchandise. Was it worthwhile? Rumelt’s data analysis found that profitability depended less on store size than on location: traffic was what mattered most. In high-traffic areas, an excessively large store was actually disadvantageous because rent was so expensive. With good traffic, a smaller store did not hurt sales and therefore generated higher profit. ---- The fourth tool is applying established thinking frameworks. Many companies operate international shipping—the container vessels carrying goods from China to the United States. A major problem is extremely low margins, not at individual companies alone but across the industry. Owners work hard and have little left after paying crews. What is happening? Rumelt identified overcapacity as the crux, with game theory at work. From a physics standpoint, a bigger ship carries more cargo and lowers transport costs per unit. Everyone therefore likes buying large vessels, as large as the Panama Canal’s width permits. This creates overcapacity. Cheap shipping capacity is everywhere, and when everyone has capacity, you have to cut prices. Economists applaud container shipping as a model of perfect competition! The industry itself, however, cannot bear it. As we discussed in earlier lessons on game theory, escaping this prisoner’s dilemma of destructive competition requires a coordination mechanism [1]. Rumelt found an analogy in his collection of frameworks: airlines. They face similar problems. Bigger aircraft carry more passengers, so airlines want to buy larger planes and open more routes, potentially falling into destructive competition. Yet airlines later solved this problem to some extent, principally in two ways. First, agreements between American and European airlines let two carriers share a flight code. Suppose you want to travel from Portland to London. You can buy a through ticket, while actually flying Portland–Chicago and then Chicago–London. American Airlines operates the first leg and British Airways the second, but you buy just one ticket from Portland to London. Both carriers earn revenue, creating a form of cooperation. Its greatest benefit is reducing the need to expand into each other’s territory and thereby easing competition somewhat. The second approach follows changing demand. Passengers increasingly dislike connections and prefer nonstop flights. Airlines have opened many point-to-point routes, including direct services to smaller destinations. Those destinations attract fewer passengers, so routes do not need very large aircraft or maximum capacity… This indirectly reduces the appeal of large planes and the competition over capacity. Rumelt believes shipping can learn from both approaches. First, companies can form alliances. If I do not yet serve a route, an alliance partner can carry the cargo; everyone need not operate the same route. Second, Rumelt argues that waterborne transport is already cheap; the largest costs now lie on land. The difficulty is not moving cargo from, say, Shanghai’s port to Los Angeles’s port, but getting it from Los Angeles to destinations throughout the United States. This might offer a breakthrough. Could more small ports along the coast let cargo land closer to its destination, saving part of the overland journey? ✵ The fifth tool is insight from the front line. People solving problems on the ground often see things that purely academic researchers miss. You may already know the term “disruptive innovation.” The initial theory held that an unexpected small company uses new technology to defeat an established large company. Yet when scholars examined the actual rise of new technologies, they found few real cases of large companies being defeated by small ones. Rumelt’s insight is that large companies are not actually defeated by small companies—they are defeated by new ecosystems. Consider Kodak. Rumelt argues that digital cameras did not defeat it. Kodak developed its own digital camera as early as 1975 and intended people to take digital photographs. But surely those photographs still needed to be printed using film? Weren’t photographs meant to hang on walls or sit in albums? Kodak therefore remained focused on film, believing the market would always need it. What Kodak did not anticipate was that people would stop printing photographs and no longer need film. In the new era, they viewed photographs on phones, iPads, and similar devices. No particular competitor disrupted Kodak; the entire ecosystem changed. You could hardly expect Kodak to invent phones and tablets, could you? When made obsolete by its times in this way, Kodak could only accept its fate. Generally, when a new technology emerges, a large company first considers an acquisition. If it cannot acquire the technology, or faces a transformation of the entire ecosystem, perhaps it should decline gracefully? ✵ A doctor’s final answer is that not every problem can be solved; the same is true of strategists. Yet both solve real problems. They can distinguish wishes from strategy, identify what is wrong, and tell who in the room is talking nonsense. We should learn from such people.