You’ve probably heard of the classic 80/20 rule – that 80 percent of outcomes result from 20 percent of the causes. This rule often holds true when analyzing the source of a company’s profits, with 80 percent of profits coming from 20 percent of its customers.
In order to improve focus and profitability, companies are often advised to identify the lower 80 percent and determine whether there are steps they can take to improve the profitability of those relationships. If not, traditional logic dictates that they should discontinue those relationships and focus time and energy on the more profitable ones. While this may seem logical on the surface, it could actually threaten the long-term viability of the business.
Almost 20 years ago, Harvard professor Clayton Christensen published Innovator’s Dilemma, which provided groundbreaking insight into the challenges many companies face as a result of their own success. In that book, he demonstrated a common pattern that occurred across a wide variety of industries. First, a company enters the market by finding an innovative way to meet a customer need. As the company grows, it follows a predictable trajectory of performance improvement, enabling it to grow market share and profits by providing a better product to its customers. As it moves up the performance improvement curve, it sheds lower margin customers who don’t have a need for the company’s higher margin, more complex offerings, allowing the company to focus on more profitable relationships.
So what's the problem?
The problem arises when the company’s performance improvements overshoot the needs of the market, because this leaves the door open for another innovator to peel away market share by providing a less sophisticated offering. While that may not sound like innovation, Clayton Christensen demonstrated that many industry-changing innovations are not the result of massive technological breakthroughs; rather they result from a new entrant using existing tools or technologies in a new way to meet the needs of the least profitable customers.
Initially, incumbents don’t see this as a threat, because that customer base isn’t attractive. However, the new entrant doesn’t stand still; it also follows a predictable pattern of performance improvement. A tipping point occurs when the incumbent has overshot the needs of the market and the entrant reaches the point where it has the capabilities to meet the needs of mainstream customers. Unfortunately, by that point, it's often too late for the incumbent to innovate quickly enough to defend its position in the market.
This pattern teaches us a few lessons.
- Customer retention decisions need to include consideration of the potential long-term risk associated with ceding those relationships to a competitor. Walking away from relationships because the customer isn’t creditworthy may make sense; however, walking away because the customer no longer sees the value in your more sophisticated product or service may not. In fact, it may be a glaring sign that you've overshot the needs of the market and are at risk of attack from underneath.
- As your core business moves up market, it may be wise to create an autonomous unit to focus on finding ways to deliver less sophisticated products or services to those customers. This may not sound attractive, but research has shown that the resulting innovations are the ones that serve as the basis for success when the market enters a new phase.
- The new unit needs to be built with a low cost structure, rather than leveraging the cost structure of the parent. If it doesn’t, then it may get undercut by new entrants that aren’t saddled with the incumbent’s baggage.
- Success requires the resolve to commit resources to the new unit through both good times and bad. Initially, profits will be low or nonexistent, and management will feel pressure to abandon efforts prematurely—this is dilemma part of the The Innovator’s Dilemma.
Finally, success requires a conscious commitment to engage in efforts that may cannibalize your existing business. If that sounds frightening, just remember one thing: if you don't, somebody else will.
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