Playing To Win
Shutting Down Losers
Overcoming the Shared Economics Argument
At a client this week, we discussed getting out of a losing business. Doing so was a huge challenge, as it always seems to be. It feels like a universal challenge. To help executives struggling with this issue, I decided to dedicate my 48th Year II Playing to Win/Practitioner Insights (PTW/PI) piece to Shutting Down Losers: Overcoming the Shared Economics Argument. You can find the previous 100 PTW/PI here.
Reflecting on my Time as Dean
As many know, I served as Dean of the Rotman School of Management at University of Toronto for 15 years. Coming directly to the job from the business world, I found some things as strikingly strange. But when I better understood them, they turned out to make total sense. For example, it was incredibly difficult to get Faculty Council approval of anything new. The finance department wanted to start a new Masters program in financial engineering — a very sensible thing. But it took forever to wind its way through the various committees to Faculty Council and then back to the committees, and so on. It was so onerous that I wondered why anyone would ever try to do something new.
But it made more sense to me when we tried to end a program that just wasn’t working. The program was clearly failing and had no strong supporters. But it was almost impossible to end. There was always someone asking for still more consideration of this or that. I almost gave up because I questioned whether it would be worth the effort.
Then I realized why it was so hard to get anything new started. Everyone who had been around for a while knew how hard it was to end anything. So, they were loath to start something unless they were absolutely certain it would last forever.
Upon reflection, I came to understand that the corporate world isn’t as logically consistent on this front. Compared to the academic world, it is almost as hard to stop something that isn’t working, but it is way easier to start something new. Companies start too many things without a lot of thought and struggle mightily with stopping, which is why companies end up continuing lots of things that don’t make sense but form part of the entrenched status quo.
As a result, I see the pattern above almost universally across companies. Cumulative profit is on the vertical axis and what I call, somewhat facetiously, ‘stuff’ on the horizontal. Stuff can be products/services, regions, customers, vertical stages — it doesn’t matter; the curve looks the same. About 20% of stuff (say, products) makes up 100% of eventual net profit. I say ‘about’ because that would be the median and I have seen it as low as 10% and as high as 50%. Another about 30% gets companies to about 140% of eventual net profit. Again, there is a range around the peak profit — from around 33% to 67% of stuff. The remaining about 50% of stuff takes the company back down to 100% of profit, with again a range around the 50% mark. It is what one client (Canadian, no surprise) called “the upside-down canoe chart.”
But whenever I ask about getting rid of the 50% of stuff that takes profits down from 140% to 100%, I get concerted pushback as to why it would be a bad and/or infeasible idea. The arguments take one of two forms, both variants of shared economics.
The first is that the business absorbs some of the shared corporate overhead and the losing business is profitable on a marginal cost basis, so total corporate profitability would fall if the business was cut. This is not an argument to which I give any credence. If a corporation can’t resize corporate overheads to support only its winning businesses, it doesn’t deserve to be in business — and won’t be for long.
The second is a trickier rationale. Here the argument is that the losing business in question shares economics with another winning business and that if the losing business were jettisoned, the profitability of the winning business would collapse. For instance, one of my clients had a branded cookie business and a private label cookie business that shared procurement, manufacturing, and distribution costs. The branded business had very attractive profitability, while the private label one vacillated between negative and marginal profitability. The private label business was never shut down because that would cause the economics of the branded business to fall apart.
In my experience, and certainly in this case, the losing business is kept running indefinitely based on the shared economics argument.
So, What’s the Problem?
Now I could imagine the reaction being: what’s the problem? It is just the price we need to pay to keep making money on the attractive business. But my view is that it damages its sustainability. The attractive business is always one of the businesses that is either in the 20% that generate the first 100% of cumulative profit or the 30% that get the company to 140%. These businesses face huge pressure within their company to raise prices to generate the profits to pay for the 50% of losers.
That has two negative impacts. First the resultant price umbrella invites competitive entry against one of the company’s most profitable businesses, which is the last thing any company wants to see for a big profit contributor. Second, by raising the price premium it charges, the business is limited in the market share it can gain and is likely to have a smaller-sized business than it would have if it wasn’t supporting a losing business. Both of these factors impair the long-term competitiveness of the winning business.
Overcoming the Shared Economics Argument
In some cases, the shared economics claim simply isn’t true. For this reason, it is always important to crunch the numbers and make sure the claim has any basis.
However, if the claim that the wining business would cease winning without continued operation of the losing business is actually true, then the winning business isn’t actually a winning business. In fact, it is not a separable business. The two are one business that (typically) is a mediocre performer. One just looks like it is a winning business because it isn’t being charged the full costs of its operations but rather is being subsidized by the losing business absorbing some of its costs. It is important for the combination to be treated as one mediocre business — which is what it actually is. There should be no more heaping of praise on the winning business for winning to such a lovely extent. It is just part of a mediocre business — and in due course, mediocre businesses should be exited.
The key is to provide motivation for both businesses to change their behaviors. Typically, the winning business has no incentive to change its dependence on the existence of the losing business because it enjoys much praise for being such a good business and bears none of the costs borne by the losing business. And the losing business has no incentive to change because it is given a pass for aiding the good business. It is a stable mediocre equilibrium, not necessarily the inevitable reality.
The way to motivate the ‘winning’ business to change its behavior is to make it responsible for the costs on which it depends. I estimate the cost to the company of maintaining the losing business to enable the winning business to enjoy the economics it currently does. The simplest method is to take the difference between the profit of the losing business and the profit that would enable it to earn the company average (or the company cost of capital, whichever you prefer). Then I assign that lump sum as a cost to the winning business. As long as it needs the company to keep the losing business running, that cost will be assigned to its Profit and Loss Statement (P&L). The resultant P&L should be used for investment and compensation purposes. This motivates the winning business to work to reduce the degree to which it is dependent on the losing business and to work with the losing business to improve its economics. In some sense, it makes the winning business a customer of the losing business and the winning business needs to become a much more demanding customer.
The way to motivate the losing business to improve is to inform it that the company doesn’t support losing businesses over the long run and that it has one year to come up with a plan that makes itself a business that earns its cost of capital within five-seven years (depending what is realistic in the industry in question). If it can’t come up with a plan, it should be told that it will be shut down or sold within the next three years.
This combination of actions spurs lots of things that wouldn’t happen with both just resting on their laurels and doing little if anything to fix the problem. First, the winning business works very hard at minimizing the cost that is now allocated to them — including figuring out how to replicate favorable economics without the losing business remaining open. Second, faced with termination, the losing business gets more creative about how to turn the loss into a win.
The upside-down canoe chart is pervasive and unfortunate. It needs to be seen as the product of the specious shared economics argument, otherwise it will just keep going forever and, at the same time, suppressing the profitability and reducing the competitive sustainability of the parent company.
Never accept out of hand the shared economics argument that protects losing businesses. If the shared economics argument is fallacious, just reject it. If there is a real shared economics argument currently, don’t accept its permanence. It is a path to ruin — a slow path to be sure, but a clear one.
The key is not to coddle and celebrate the ‘winning business’ that is co-dependent with a losing business. Call it out and recognize that a co-dependent ‘winning business’ is, in fact, a mediocre business. And put in place motivations that help the ‘winning business’ reduce or even eliminate its co-dependence and push the losing business to face the music as it should.
Don’t accept the status quo as inevitable and permanent. It isn’t. It is a recipe for failure. Work to put in place motivations to have both the winning and losing businesses to do better. The upside is that you can migrate both to a more sustainably competitive place.