Ahead of the Curve

by Philip Delves Broughton

  A competitive advantage exists in the gap between a company’s costs and what consumers are willing to pay for its product. If your gap is wider than that of your competitors, you have the advantage. If you can keep that advantage over time, despite all the usual competitive pressures, the advantage is sustainable. Building sustainability is the strategist’s next challenge. If you are profitable, rivals will come after you. Success tends to breed complacency, which is why Bill Gates keeps a photograph of Henry Ford in his office. It reminds him that however pioneering and successful you are, you have to keep innovating and protecting your competitive advantage or else a rival will defeat you, as General Motors eventually defeated Ford. The pace of technological change has also shrunk the life cycle of successful business models. When you think you own the very latest cell phone, a new one comes out to trump it, offering entirely new services and features. This is why so many companies, however well they start out, eventually revert to the mean. Very few maintain outstanding returns for any decent length of time, and these are the jewels. Building a durable competitive advantage is the goal of any manager. Finding the companies that achieve it is an investor’s dream.

  Having established the goal of sustainable competitive advantage, the strategist’s next task is to develop and integrate a consistent set of mutually reinforcing activities. The aim is not to have the greatest marketing department in the world but, rather, the best marketing department for your company. You want to build a system in which every activity, including marketing, supports the others. It is the difference between having great individual players and a great team. Wal-Mart’s magic is not just in its low costs and low prices. It also has a frugal corporate culture, low store-construction costs in rural and suburban locations, limited advertising, a stellar logistics operation, no unions, a stranglehold on suppliers, who depend on it to sell colossal volumes of their product, and top-notch technology and inventory tracking. It is the integration of all of this that makes Wal-Mart successful and so hard to replicate. And the more it does what it does, the better it gets, making life for its rivals all but impossible.

  To make their advantage sustainable, all companies should try to develop a pattern of causes and effects that over time becomes an irresistible flywheel blowing away competitors. Procter and Gamble, for example, sells a lot of toothpaste. This means it produces a lot of toothpaste. Producing a lot of toothpaste makes Procter and Gamble a better toothpaste maker and allows it to use its toothpaste factory, employees, and marketing more efficiently. It can then set a lower price, without reducing its profit margin, and sell even more toothpaste. Its rivals may be able to make toothpaste, but because they do not have the scale advantages or marketing muscle of Procter and Gamble, they struggle to compete. The notion of “the more you practice the better you get” is known as the learning curve and was first observed by business academics during the Second World War. The more factories produced military aircraft, the faster the planes came off the production line and the better they were. Companies that move up the learning curve fastest tend to do better than their rivals.

  A similar flywheel effect can be set in motion for willingness to pay. The more people bought Apple’s iPods, the more people wanted them. To reach this audience, music companies made their entire catalogues available on iTunes. Consumers downloaded more and more music, making their iPods even more precious. When rival device makers tried to enter the market, they found they were not just competing on the quality of their device but also taking on the entire ecosystem that Apple had created. Cheaper devices of equal quality failed in the market because people were ready to pay more for an iPod for its familiarity, the cool brand association, and its compatibility with iTunes and other Apple products. Apple had built a sustainable competitive advantage.

  After integration, the strategist must next consider the reactions of his company’s competitors. If I do this, what will my rival do? At HBS we were introduced to game theory as a means of analyzing the consequences of a competitive situation. In its simplest form, game theory involved understanding the financial consequences of a decision for two parties. If Bill opens a new store to compete with Bob, what should Bob do? Should he close his store or compete with Bill? What will be the costs to Bob of competing versus closing? What will be the costs to Bob if Bill decides to stick around? Mapping out these options and applying values to their consequences offers an aid to decision making rather than a specific answer. It is another means of making the best decision with incomplete information, the main goal of our two-year course.

  Finally, we moved to issues of scope. What should our business do? What should it own? Where should it operate? The value test, we learned, should be applied when considering whether you or someone else is better off owning a particular business. General Electric demands that its separate businesses be ranked one or two in whatever sector they operate. If they are ranked lower and cannot be improved, GE assumes it is not the best owner for that company and sells. The ownership test asks whether your business needs to own a certain asset to create value. McDonald’s decided long ago that it was far better off selling franchises and then servicing them than owning millions of parcels of real estate. A fashion designer does not need to own the factories that produce her clothes, provided she can be sure the clothes will be made to her specifications. Sound contracts and long-term relationships, Felix explained, could be far less hassle than ownership.

  With so much fevered discussion of globalization, the ownership and value tests were more relevant than ever. Could an American company with global ambitions adapt to new countries and cultures and run businesses better than local firms? If a product or service worked well in one country was there any reason to believe it would work well in another? Did global growth allow you to reduce your costs? What were the realities of doing business overseas—developing manufacturing capacity, training employees in uncertain political environments, and risking your intellectual property in markets that might not respect it?

  One of the most remarkable companies we studied was called Li and Fung, which was founded in 1906 in Canton as a trading company, helping English and American merchants get access to Chinese factories. Based in Hong Kong, it now managed the supply chains for many of the world’s largest retailers and manufacturers. In 1976, Victor Fung, the grandson of the founder and a professor at HBS, returned to Hong Kong to take over the firm. He and his younger brother, William, a Harvard MBA, decided to expand the scope of the company’s operations. Instead of being an intermediary between foreign companies and Hong Kong suppliers, Li and Fung built relationships throughout Taiwan, Korea, Singapore, and eventually deeper into China. It went from simply fulfilling customer requests to developing unique production programs that allowed manufacturers to create products of a quality and cost they never thought possible. If you wanted shirts made in Asia, Li and Fung would know separate places for cotton, buttons, and stitching and be able to move the unfinished product from one place to another and still deliver it cheaper than if you had picked a single factory. They called what they did “dispersed manufacturing,” and their staff, “little John Waynes,” because they spent their days “standing in the middle of the wagon train, shooting at all the bad guys.” By the time we studied Li and Fung, the firm was working with 7,500 suppliers in twenty-six countries and owned none of them. It organized design, engineering, and production planning, material sourcing, physical production, quality control, and global shipping for hundreds of well-known clients and yet it owned almost no physical assets. Unless you were in the industry you would never have known its name. At the end of our class discussion of the firm, the projector screen dropped down and Victor Fung appeared via satellite linkup from Hainan Island in China to take questions. He talked about the fragmentation of the global supply chain, how even the tiniest step was becoming the preserve of specialists, and how Li and Fung helped customers find their way through the maze. Margret had decided she wanted to see a class and this happened
to be the one she sat in on. Afterward, I asked her what she thought. I had found it riveting but worried she might have been bored.

  “Are you kidding?” she said. “This is what you get to do every day? You get chief executives beamed in from China to take your questions? It was amazing.” Sometimes I needed to be reminded how lucky we were.

  One morning in January I decided to spring for parking on campus. After five months of taking the bus or driving and then spending fifteen minutes cruising around Allston looking for a spot, I thought it was time to treat myself. The previous night, Margret and I had finally cracked and ordered takeout from a very fancy Chinese restaurant on Massachusetts Avenue. We needed a break from the hairshirt life. However good it was for our souls to step off the bourgeois ladder we were on in Paris and return to the stringencies of student life, it was equally good to say to hell with it once in a while. Sesame chicken and dan-dan noodles had never tasted so good.

  So there I was cruising onto campus in my $2,000 used Toyota, unfoldinga five-dollar bill and handing it to the attendant, feeling for all the world like a big-spending Russian oligarch. The roads were covered in ice and slush, and I was looking forward to a briefer-than-usual exposure to the Boston winter, a quick dash from the car park to Spangler and perhaps one of those croissants stuffed with bacon and eggs that Cedric scarfed down every day between classes.

  Once I got to the garage, I found a space on the third story—but not before passing the most extraordinary assemblage of student transport I had ever seen. Ascending the ramp of the car park, they went, roughly, BMW, Lexus, BMW, BMW, Mini Cooper, Lexus SUV, BMW, Porsche, Lincoln Navigator, BMW, and on and on. Finally I found the lower-rent district. There was Betsy, Bob’s ten-year-old Saturn, which he’d told me on a ride home, stroking the plastic dashboard with pride, had done more than 130,000 miles. I also spied an olive-green Chevy Lumina, which belonged to a former submarine captain in the section. “No one likes to buy these cars secondhand because they are only driven by old people,” he told me. “But that means you get a lot of car for a lower price. And old people tend to look after their cars much better.” I was developing a soft spot for the ex-military guys. They were refreshingly sane.

  In the Spangler cafeteria, I found one of my section mates, Vivek, lingering as usual by the coffee station. He couldn’t decide whether to go for a latte today. Aside from knowing everything a man should know about finance, Vivek also happened to know everything about cars. Everything. He knew torque ratios on a Honda Accord as well as the interior specs of a McLaren super car. He knew prices, speeds, RPMs, detailing history. You almost felt bad asking him for advice on buying a car—it was like asking Einstein to help you with long division—but he loved any opportunity to talk cars. He went about your problem like a clinician, diagnosing your situation, personality, and budget and then delivering his answer. “You should take a look at the Acura range” or “The Korean cars aren’t quite there yet. But give them a couple of years.”

  “Have you seen the cars in the garage?” I asked him that morning.

  “Yes.” Vivek only ever answered the specific question you asked him.

  “Well, how come I’m driving a two-thousand-dollar Toyota and everyone else has a BMW?”

  “Lots of people buy them when they get into HBS and want to get financial aid.”

  “What?”

  “Once you get accepted by HBS, you want to clear out your bank account so that you get more financial aid.”

  “I’m sorry, I’m not getting this. You buy a BMW to get financial aid?”

  “When you list your assets in the financial aid application, you don’t have to mention your car, but you do have to list any savings or property. So you buy a car for twenty thousand dollars, maybe you get an extra twenty thousand dollars in financial aid, so basically HBS buys you a BMW. If you hadn’t bought the car, you’d have to pay the twenty thousand dollars out of your savings.”

  “But don’t they check this kind of thing? I thought that if you were caught lying on your financial aid form, you could risk losing your place.”

  “But this isn’t lying. Nor is taking all your money and parking it with your parents while you apply for financial aid.”

  “So your personal accounts look empty.”

  “Right.”

  “This is unbelievable. How many people do this?”

  “Everyone coming from Wall Street knows about this. And the consulting firms. It doesn’t always work. But lots of people try it.” In its brochure, HBS said that roughly half the class received financial aid and that the average financial aid package was worth $10,000 per year. I knew that some, like Bob, had received much more, but the man had four children and had flown the Stealth bomber. He deserved it. I had received $3,000 in my first year. Probably what I deserved. But the idea of these twenty-five-year-old Wall Street jerks fiddling with their financial aid forms, with the connivance of their parents and the local BMW dealerships, ruined my morning.

  No matter how hard it tries, business can never escape the fact that it is the practice of potentially thieving, treacherous, lying human beings. Its challenge is in reining in the thieving, treachery, and deceit sufficiently that the entire edifice of business and society does not dissolve into a medieval vision of hell. Harvard Business School has produced its fair share of ne’er-do-wells. Of the class of 1985, who graduated into one of the great stock market booms, sixty-five were prosecuted for securities violations. The most recent, and spectacular, HBS blowup was Jeff Skilling, the CEO of Enron. In the late 1990s, a job at Enron was one of the most coveted gigs for a graduating MBA. When Skilling visited HBS, he was greeted as a hero, given standing ovations and hotly pursued by professors wanting to write fawning cases about him and his marvelous money-making machine. Beneath him, inside Enron, were scores of other Harvard MBAs built in his mold. When everything was going well, they were geniuses. When it all collapsed and Skilling went to jail, the reputation of the school and its graduates suffered.

  In 2003, a class called Leadership and Corporate Accountability was introduced into the required curriculum to allow students to discuss the perils of chasing dollars down ethical sewers. Here was the time to access the moral compass I had read about all those months ago and which had been going haywire with so much talk of money and power. Our guide was an owlish professor called Joseph Badaracco. He had been a Rhodes Scholar at Oxford, had obtained both his MBA and doctorate at the business school, and had carved out a well-padded niche for himself as a business ethicist. For a couple of weeks each year, he taught in Japan, which provided him with that extra layer of financial comfort all academics crave. He was certainly a change from all the hard-charging, weight-lifting, marathon-running types at the school. His shoulders sloped, he wore rubber soled shoes, and he looked as if he would much rather be dozing in a library or fishing on some quiet New England lake. He prided himself on the leisurely life of the tenured Harvard academic. If our last class of the week with him took place on a Thursday morning, he’d smile and rub his hands together and make a point of telling us that his weekend began the moment class ended. He gave the impression that teaching ethics at a business school was one of the cushiest jobs in the world.

  Before LCA began, it was the subject of considerable scorn. For the hard-core financiers, it was precious time taken away from studying derivative structures. For the aspiring entrepreneurs, it had nothing to do with creativity or cash flow. The only ones who looked forward to it were the wafflers, the isolated individuals who loved to just talk and talk about nothing in particular and who one day soon will be coming to destroy a company near you. Bo loved the course for his own particular reason. It required very little work. The cases tended to be short, with no numbers to run. They could easily be dealt with lying in bed or in front of a basketball game.

  Harvard’s response to skeptics who did not believe that ethics had a place at business school was expressed by an HBS professor, Tom Piper, in a book called Can Ethics Be
Taught? “We reject this assertion emphatically,” he wrote. “These students are at a critical stage in the development of their perceptions about capitalism, business practice, leadership, and the appropriate resolution of ethical dilemmas in business. This is a period for inquiry and reflection . . . Extended time is necessary to develop sufficient strength and sophistication to acknowledge the presence of ethical dilemmas, to imagine what could be, to recognize explicitly avoidable and unavoidable harms. It takes time to develop tough-minded individuals with the courage to act.” Badaracco had written his own book on business ethics, called Defining Moments: When Managers Must Choose Between Right and Right. The title was intended to describe the twilight zone in which most ethical decisions exist. “Life-defining moments,” he warned us, “do not come labeled.” Consequently, we had to be girded for these moments at every turn, forging our characters and morality in everything we did.

  The key framework for LCA divided the responsibilities of corporate leaders into three categories: economic, legal, and ethical. We had to meet criteria in all three categories if we were to satisfy our short- and long-term financial responsibilities without breaking the law or hating ourselves. We began by learning that the U.S. courts take the idea of fiduciary responsibility very seriously indeed. Even the slightest breach of trust with an investor or financial partner would be stamped on. We were given the equation M × F = D. This means that a decision by a court (D) is the product of the legal model (M) and the pertinent facts (F).

  The first real dispute in class flared up during a discussion of bluffing in business. In 1968, the Harvard Business Review published an article by Albert Z. Carr titled “Is Business Bluffing Ethical?” It generated a slew of critical letters. Carr compared business to poker, in which bluffing, short of outright cheating, was a perfectly legitimate activity. He said that many successful businesspeople lived by one set of ethical standards in their private lives and a quite different set in their professional lives. The explanation, he said, was that they perceived business not as an arena for peacock-like displays of high ethical standards, but as a game with specific rules. Knowing that you could win the game of business playing all manner of tricks that you would never inflict on your spouse, children, or friends made for a calm, unstressed, uncomplicated life. But to some, it seemed to be an acknowledgment that business was fundamentally unethical.