Chapter 3: Digital Strategy

The best way to predict the future is to invent it—Alan Kay

If cyberspace is the new business environment, Moore's Law describes the behavior of its most basic elements, while Metcalfe's Law describes how you can create a kind of chain reaction between them. Coasean and public goods economics provide the basic rules of survival: the lowest transaction costs prevail; new wealth is created by mining information assets. Killer apps are the results of these principles operating together.

Now that you understand the basic problem, what are you going to do about it? Nearly every executive we have spoken to in the last two years recognizes that they must do something. Perhaps, like many of our clients, you are already trying to make sense of the digital age and formulate a strategic response. To respond to changed circumstances, clients often dust off the old strategic plan, identify which assumptions have changed, and try to adjust the plan accordingly.

This response will get you only part of the way there—in any event, not far enough. What we do is take strategic planning as the starting point and work with clients to see how both the tools and processes must be altered to function in the new environment. Radical change is the order of the day. It isn't only the planning assumptions—a new competitor, perhaps, or a decision to expand the operation overseas—that have changed. What has changed in addition are the basic principles underlying how you develop products, operate, and yes, even plan. To succeed digitally, you need to eat, sleep, breathe, and think digitally.

It can be done, and not just by companies like Microsoft or the latest Internet start-up, companies whose actual goods and services are already digital. Our clients have included a major fast-food franchiser, an integrated oil and gas giant, a large European conglomerate, and even the British Post Office. Like astronauts learning to perform basic tasks in zero gravity, the executives in these decidedly undigital companies find the first few times through are hard going, but after that the process comes much easier.

We have developed a new approach to strategic planning, which we call digital strategy. Digital strategy consists of twelve design principles that guide the process for finding and shaping killer apps, and techniques that organizations of any size and in any industry can use to achieve market dominance. The design principles are described in Part 2 of this book; Part 3 provides examples of how organizations have made the transition to the new operating model.

In this chapter, we describe the key differences between digital strategy and today's approach to planning, a model that has dominated for the last twenty years. It doesn't matter if your organization doesn't do strategic planning now, or if you aren't yourself directly involved. In the new business environment, as the story of Chris Brennan and the BP kiosk demonstrates, managers (and everyone else) are the strategists. This means you need to understand how the basic approach works. You also need to recognize the many pitfalls of traditional strategy that you should avoid. Table 3.1 summarizes the key differences.

3.2: The Rise and Fall of Strategic Planning

Michael Porter's Competitive Advantage, published in 1980, is the classic statement of traditional strategic planning. Porter argues that sustaining above-average performance requires a strategy and the will to implement it. His book explains how to analyze market conditions, assess competitive strengths and weaknesses, and develop long-term strategies for keeping a competitive edge, as well as how to monitor the progress of those strategies.

While many of Porter's techniques are still salutary, we believe they are largely unsuitable to life in cyberspace. Porter implicitly recognized this himself in a 1996 Harvard Business Review article in which he criticized the failure of most executives to follow his original advice, a failure he blamed on distractions like business process reengineering, total quality management, and a host of avoidance behaviors like preparing mission statements and corporate visions that masquerade as strategy. (Cartoonist Scott Adams makes a similar point, with an acid tongue, in The Dilbert Principle.)

Porter concedes that "developing a strategy in a newly emerging industry or in a business undergoing revolutionary technological change is a daunting proposition." He just doesn't believe that most industries have or will soon enter "a new era of competition," in which, owing to digital technology, "none of the old rules are valid." He believes, in other words, in clean lines separating industries and competitors from each other and stable markets in which companies can experiment with new goods or services. In Porter's view, the relationships between the major players in any given industry are largely fixed.

It is here that we part company with Porter. Every industry we can think of is already in the midst of "revolutionary technological change," and will be for at least as long as Moore's Law holds. Though the primary technology of industries like transportation, oil exploration, and manufacturing may be relatively stable, industries whose primary product or service is or includes information, such as entertainment, retailing, financial services, and chemicals, are involved in major technological shifts.

More to the point, every industry is going through a revolution in its use of information technology. In transportation today, logistics is the key to the leverage exploited by package deliverers like FedEx and UPS; carriers of larger sized loads are trapped in a commodity-priced market. In retail, databases and computer networks allow customers to find out quickly and easily who has what they need, when they'll have it, and how much it really costs them to produce and deliver it. The information component of every business transaction is significant, if not dominant. As digital technology reduces the transaction cost of collecting and exploiting that information, seismic shifts between the participants occur.

Traditional planning simply doesn't work in times of great change. Henry Mintzberg, in his 1994 book entitled The Rise and Fall of Strategic Planning, argues that one of traditional strategic planning's false assumptions generally is that the future can be forecast based on current climatic conditions in the business environment. Part of the problem, he says, is that "discontinuities" like technological innovations make forecasting practically impossible. And discontinuity, as the Law of Disruption suggests, is the primary characteristic of the new business environment. The current batch of killer apps, including the global computing network, inexpensive high-speed data transmission and storage, and a revolution in new software interfaces, is sending shock waves into the information component of every industry. The effects cannot be easily predicted or systematically addressed—not, in any case, by the traditional methods of planning.

3.3: The Practice of Digital Strategy

Digital strategy, as Table 3.1 suggests, departs in many key respects from traditional strategy work. The foremost difference is the role played by technology itself. In our work as consultants, we confess to having preached a dogma that has since become heresy in the new world. In developing large-scale information systems with Andersen Consulting, participating in corporate strategy projects with McKinsey & Co., and working on massive reengineering projects as part of CSC Index, we treated digital technology as the critical tool for implementing change. Our project teams would decide how the business should change and then would throw the new model over to the Information Services (I/S) department, which was expected to design the systems components of the new solution. I/S was rarely included in the process of forming the business solution. Technology, as Michael Hammer and James Champy wrote in Reengineering the Corporation, was the "essential enabler" of change.

This attitude toward technology is wrong today and will be wrong in the conceivable future. Business change now originates with digital technology, in particular with the killer apps. Executives from every department must learn that in the new world technology has become and will remain the essential disrupter of current operating models and their underlying assumptions. Technology, as we've said, isn't the solution. It's the problem.

There are more subtle differences between the old and new approaches. In traditional strategy, the plan produced is largely static. A team goes off for a period of time, performs its analysis, and returns with a document (often bound as a book), which remains the plan until the next planning cycle. In theory, this book predicts the future well enough to serve as a guide for the organization's key decision-makers; but in practice the plan is rarely referenced, and then only to chill unplanned innovative thinking that might escape from the field organization. The team is generally made up of senior executives, or the staff of a specialized department devoted full-time to strategy and corporate planning.

This is not the case with digital strategy. A digital strategy is at its core a dynamic plan, one that requires not just regular but constant rethinking. The responsibility for questioning the strategy is not the specialized task of a single person or department, but is open to everyone, particularly line managers in large organizations or functional heads in smaller ones. The accelerated change of the new business environment is best observed, in our experience, by people on the line who see competitors, meet with customers, and negotiate with suppliers, regulators, and shareholders. These are also the people who, given a chance, will produce the best ideas. As Disney Fellow Alan Kay says, "Context is worth 50 IQ points." Context comes from listening and observing, and that is what managers need to do.

3.4: Time Frame

The time frame for traditional strategy work, in practice, is three to five years, though it is increasingly rare to find organizations that are comfortable with the high end of that range. Even three years is too long. Thanks to Moore's Law and Metcalfe's Law, killer apps are entering the bloodstream of commerce quickly and in many cases reach critical mass—the knee of the Metcalfe curve—in less than two years. Executives in industries as varied as education, advertising, government, pharmaceuticals, consumer products, retail, and wholesale tell us that their basic assumptions about products, channels, and customers will be completely changed by digital technology in the next two years, perhaps more than once—even if they don't know exactly how.

Electronic commerce, for example, wasn't part of anyone's strategic plan (not even Microsoft's) two years ago, but it is already a force in nearly every industry. Networking giant Cisco Systems has already moved credit checking, production scheduling, customer support, and other functions to the Web. The company claims a cost savings of $535 million for the first year.

The new planning horizon is now closer to twelve to eighteen months and, as Moore's Law continues its exponential journey, is a vanishing horizon at that. This acceleration means less time to respond and, therefore, less time for analysis or detailed planning. Managers, executives, and entrepreneurs we have worked with increasingly embrace the prospect of implementing strategy well before it is entirely thought out, or before a detailed business case can be developed, in part because of the shrinking window of opportunity. In addition, the new technologies themselves have made it possible to experiment cheaply.

Playboy Enterprises CEO Christie Hefner told us she simply had "an instinctive feeling" that it was time for Playboy to experiment with electronic distribution of its content. The Playboy brand was too valuable, she knew, to cede control to a commercial on-line service like AOL or CompuServe, even though these services had superior technical knowledge and an established customer base. So Playboy launched its own photo archive, initially giving away digital photographs (at a manufacturing and distribution cost of nothing) on the unproven World Wide Web. Hefner had a hunch that something interesting would develop.

It did. The site was so successful—5 million visits a day in 1996—that Playboy was soon able to sell enough advertising to pay the full costs of running the experiment. The site has been redesigned many times, adding and subtracting features as Web technology evolves. Playboy is now offering a subscription-based service, something Hefner avoided doing until technology became available that allowed subscribers to retain anonymity. Hefner is now evaluating new "watermarking" technology, hoping to minimize unauthorized redistribution.

Planning for quick execution begins to lose the appearance of a traditional plan. Instead it resembles more the design of a series of small experiments. For companies operating today in cyberspace, the plan disappears, replaced by a constant tweaking of existing projects and a vigorous marketplace of ideas where new ideas can be floated, argued, and selected or rejected. It is again digital technology that makes these compressed time frames possible.

3.5: The New Forces

Sustainable competitive advantage, Porter wrote, requires leverage over at least one of the "Five Forces": our customers, suppliers, competitors, new entrants, and substitutes. The strategy of a cost cutter like Wal-Mart was to establish such significant presence that suppliers are forced to give up margin. For a premium provider, like FedEx, the idea was to offer such unique and valuable services (guaranteed next day delivery and convenient pickups) that customers were willing to pay premium prices. Competitive advantage is whatever strategy a company has to maintain such leverage. Wal-Mart's sheer size makes it difficult for more specialized department stores to duplicate its approach, as these stores have learned to their near destruction. FedEx, as with most "premium" strategists, continually invests in technology to improve their already excellent service.

Achieving competitive advantage was already hard. Now it's even harder. Surrounding the five forces are three new forces: digitization, globalization, and deregulation (see Figure 3.1). These forces, generated by the interaction of digital technology and Coasean economics, exert tremendous new pressure on the competitive environment, superseding the old forces as the focus of planning.

3.5.1: Digitization

As discussed in detail in Chapters 1 and 2, computing power and communications bandwidth, thanks to Moore's Law, are becoming cheap enough to treat as disposable. As costs come down, competitors and the market in general force organizations to move information-intensive activities not only to computer systems but to increasingly public networks, open databases, and collaborative environments, where the new economics multiplies their value. In doing so, traditional business principles and industry rules are suddenly brought to light. They soon disintegrate, leading to a period of chaos followed by the rise of new, but less stable, relationships.

3.5.2: Globalization

The world can be thought of as a very large network, and as Metcalfe's Law has shown us, the attraction of such a network is irresistible. Improvements in transportation and communications have taken many businesses long considered local to global status, sometimes overnight. In capital markets, for example, globalization is old news, acknowledged as long ago as 1974, when the United States permanently abandoned the gold standard and chose instead to allow its currency to float with the international market. Today, trillions of units of currency are traded electronically every day. National banks are unable to have an impact on exchange rates even when they want to intervene.

The impact of globalization is felt throughout the production and distribution life cycle. In upstream activities, it is now common to have component sourcing and assembly provided by a global network of partners and suppliers. For time-sensitive processes, industries as varied as manufacturing and finance take advantage of the earth's rotation by passing work back and forth between Asia, Europe, and the Americas, engaging in 24-hour operation.

Downstream, customers are already used to the idea of borderless commerce. Given the chance, they are more than willing to shop on an international basis for everything from entertainment to software to cars and electronics, and even for many goods and services traditionally considered national or even local.

3.5.3: Deregulation

Regulation exists in some form for every industry. It often begins as an attempt to restore consumer leverage to markets where, because of scope or monopoly conditions, Adam Smith's "invisible hand" of supply and demand appears not to be operating to regulate price. Such regulations, and the bodies responsible for them, are often captured by the industries they are regulating and become a tool for reducing competition and freezing out new entrants—the very opposite of their objective.

The move for deregulation is generally stimulated by a widespread belief of buyers and sellers that the cure has become worse than the disease, a recognition that the free market, thanks to plunging transaction costs, is now the better regulator of an industry than government. Sometimes, as in the case of U.S. railroads earlier this century and banking today, deregulation follows a realization that some substitute has become available from an unregulated set of providers, making it difficult, if not impossible, for the regulated players to compete.

The current mania for deregulation, evident in everything from the airline, communications, utilities and banking industries in the United States and Europe, the passage of GATT and NAFTA, the dramatic development of the European Union and the even more dramatic collapse of the highly regulated economies of the former Soviet republics, might be grossly simplified as an expression of the Law of Diminishing Firms. Regulated markets, like firms, are nonmarket solutions aimed at reducing the transaction costs of a variety of activities. Like firms, regulated industries do not avoid all the costs but try to replace market costs with a set of cheaper alternatives. When they do not, pressure builds to deregulate.

In international telephone calling, for example, regulated prices encouraged the rise of companies that used technologies like leased data lines, satellites, and automated callback systems to circumvent local monopolies. The success of these companies encouraged the national telcos to sign a pact in early 1997 to open markets and reduce inter-company charges. Deregulation will spur additional competition and the development of more technology. The net result is that consumers will save as much as a trillion dollars over the next 10 to 12 years.

3.6: The Forces in Operation

Impressive enough on their own, the new forces in operation interact with each other, so much so that they begin to look like one and the same thing. Together, they are an overwhelming and disruptive influence everyone senses but no one can see. Digital technologies make it possible to manage a wider variety of relationships with buyers and suppliers, which feeds globalization. The more global the economy becomes, the more local regulations tend to hold back the industries they were written to protect, increasing the velocity of deregulation. Deregulation opens previously closed markets to competition, exposing chronic underinvestment in technology. Then the whole cycle starts over again.

In commercial banking, the industry itself spearheaded efforts to ease regulations that limited the use of technologies, including ATMs, telephone banking, and now Internet banking, each of which has been introduced to improve costs. Inadvertently, these applications also opened banks to new competitors, like network operators and software providers, that can extract value from high-volume transaction processing. The technology also revealed how little customers actually value in-person branch banking.

In 1995 Security First Network Bank became the first entirely virtual bank, operating solely on the Internet. Its customers pay minimum fees but have the convenience of tellerless banking anytime and anywhere. Thanks to the regulatory structure still in place, bank deposits at Security First are insured by the U.S. government and are therefore as secure as they would be at a traditional bank. Security First could not have come into existence without the deregulation traditional banks lobbied for to enable their own use of technology. But Security First has used the same technology as a threat. Even though Wells Fargo, as noted in Chapter 2, uses the Internet and other digital technologies to reduce the number of branches it operates, Security First has no branches whatsoever. Its infrastructure costs are insignificant compared with those of Wells Fargo, even after the consolidation that followed Wells Fargo's merger with First Interstate.

Companies like Intuit and Microsoft, as well as brokerage firms and insurance companies, go further still, offering banking-like functions from outside the regulated environment. These providers have the cost advantage of Security First as well as flexibility that banks lack. Banks, eager to expand into other services to compete with these nonbanks, find themselves restricted by regulations aimed at minimizing competition. Their attempts to control deregulation for their own advantage seem likely to have done just the opposite, creating a panic in the industry to deregulate, globalize, and digitize even faster.

3.7: Caution: Value Chains under Extreme Pressure

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In the United Kingdom, Barclays Bank has launched an electronic shopping mall, BarclaySquare, to give the merchant customers of its credit card business a quick and powerful entry point into electronic commerce. BarclaySquare consists of electronic catalogs for academic bookseller Blackwell's, wine merchant J. Sainsbury, and others, and offers electronic reservations and ticketing for the EuroStar train. Transactions are backed by the solid reputation of a stately English bank.

Compare the value chain of Barclays with that of a traditional shopping mall developer and you find very little in common. The developer's key asset (and cost) is real estate, and it derives margin primarily from rent. The actual cost of construction and operation of the electronic mall, on the other hand, is trivial, and Barclays makes money as a percentage of credit card transactions it clears on behalf of its "tenants," just as it does on nonelectronic transactions. Barclays created its mall solely to increase the volume of transactions of its merchant customers, but in doing so it linked the incentives for mall operator and retailer in a way that doesn't exist in the physical mall, or at least not to the same extent.

How does the shopping mall developer, a real estate company, compete with a bank that has none of its operating costs and a very different set of financial incentives? What happens when the mall's competitive advantage, based almost entirely on location, is turned against it by a new competitor that lets consumers shop from any location in the world at any time of day or night? Three years after BarclaySquare opened its doors, is there a shopping mall developer in the world that recognizes the bank as a competitor, let alone a competitive threat?

As this example suggests, Barclay-Square and other electronic malls have the potential to destroy the value chains of a variety of today's retail firms. Shopping mall developers are an obvious target, but so too are subsidiary industries like advertising, construction, customer service and distributors. Barclays is not just a new competitor but the creator of an entirely new way of deriving revenue. If it is successful, BarclaySquare will erase competitive advantage for companies far removed from its own sphere of activity. And its development is being led, not enabled, by digital technology.

3.8: Strategy’s Dirty Little Secret

Gary Hamel wrote in a 1997 Fortune cover story that the "dirty little secret" of the strategy industry, of which he is a leading practitioner, is that it "doesn't have any theory of strategy creation." The truly innovative strategies, he says, "are always, and I mean always, the result of lucky foresight." Digital strategy is a radical new approach to strategic planning, one that doesn't pretend to create strategies so much as to create an environment where lucky foresight is more likely to make an appearance. It shares few features with traditional strategy development and deployment techniques. It values creativity and intuition. Its development is not the task of a few individuals, but of an entire organization, communicating on as open and wide a channel as technology will permit. Most of all, it recognizes technology not as a tool for implementing a static strategy but as a constant disrupter creating both threats and opportunities that wide-awake organizations can turn into killer apps for their own benefit.

The techniques of digital strategy are being developed by companies around the world today as they experiment with digital technologies and attempt to let loose their own killer apps. From our participation in these efforts, and from studying both winning and losing examples, we have gleaned a few rules of thumb that can help you develop a digital strategy of your own. These rules are the subject of Part 2.