All men can see these tactics whereby I conquer, but what none can see is the strategy out of which victory is evolved.

Sun Tzu

How much of your current strategy will help you compete in the digital economy? And what have you done to adapt your strategy over the past few years? Perhaps you have acquired companies, expanded your services or products, or optimised your supply chain. You may have changed your organisation’s structure a few times and appointed new leaders with fresh ideas. Perhaps you have met changing customer expectations by updating your website or refreshing your brand in some way. You also may have tried to increase margins by cutting operational expense lines.

Investment in technology and the appointment of new roles gives boards, shareholders and executives a sense that ‘we are doing something’. But what most leaders have failed to do is align their newly implemented technology with their underlying business strategy and external market trends. Many leaders talk about the need to promote a culture of innovation, make investments in start-ups, or invest in technology skills and experience at board and executive level. These individual moves are all worthwhile, but the critical thing is to link them together as a cohesive set of transformation initiatives. To do this you must think first about your business model, and what your customers want now and in the future, and align these fundamentals with the interests of shareholders. Internally, a new kind of strategy will require you to manage the process of change. Meanwhile, the competitive landscape, consumer preferences and technology are changing so quickly — and with such disruptive force — that putting in place a business strategy designed for our digital world is now a matter of survival.

Our solution is to go back to basics, revisit your economic engine and develop a new, digitally integrated strategy. That’s the focus of this chapter. We will also show you how to implement that strategy, building on your current business and competitive advantage.

The old model

By now you are likely aware of the insufficient link between your strategy and technology. You see the symptoms everywhere. You make massive investments in IT, but these fail to make a significant impact on the bottom line. New competitors are taking market share.

Before we look at the solution, let’s look at the problems in detail.

In 1980, Michael Porter published Competitive Strategy, which transformed the theory, practice and teaching of business strategy throughout the world. Porter’s Five Forces framework (see figure 1.1), a model for analysing an industry to determine ideal corporate strategy, has been instrumental in defining the way leaders of pre-digital incumbents identify profitability and attractiveness. The model identified five features that play a part in shaping every market. At the centre is industry rivalry, which is enhanced by the bargaining power of suppliers, the threat of substitutes, the bargaining power of buyers and the threat of new entrants.

But the internet has changed everything, and the application of Porter’s forces needs a refresh. In other words, a new approach to strategy and competitive advantage is needed.

The internet, social media, near-zero distribution and customer engagement costs, the explosion of data and platform-based business models, and the rise of artificial intelligence have forced speed and innovation to the top of the priorities stack for many boards and executives. These same factors have enabled unprecedented speed of transaction, globally scaled supply and distribution, faster time to market for new businesses, and heightened consumer awareness of what they are purchasing and the myriad alternatives. With a nod to Porter, figure 1.2 suggests what our new model of competitive forces in the digital world looks like.

At its heart, our new economy is a customer’s world, one in which buyers enjoy remarkable leverage, choice and influence. These forces can work against you. As a pre-digital incumbent, perhaps in the short term you will avoid the brunt of their impact while savvy new entrants capitalise on these forces to build market share in your category. Alternatively, you can learn to harness the momentum of digital, and use it to fuel your business growth.

One giant juggling act

Your company requires a dramatic change in strategy to respond to new market-shaping forces. You need to pivot your business model while at the same time making the most of your well-known brand and client relationships.

Unfortunately, you’re up against some very well-funded start-ups. According to Crunchbase, as of the third quarter of 2017, both deal and dollar volume are at record highs since the dot-com bubble. With the number of venture funding rounds projected at 6146, and US$60.17 billion invested in that quarter, year-on-year this represented an increase of roughly 50 per cent. With this explosion in capital financing of start-ups, a compounding set of issues arise for larger businesses. The amount of money generally spent by a pre-digital incumbent to transform its business model into a digital business model reliant on data, software and platforms is a fraction of what start-ups invest in technology. Top talent is attracted by the wealth-creation opportunities and innovation culture of the start-up. Glassdoor.com, where employees can review and rate employers, has found for 2018 that all of the top-ranked small- to mid-sized companies in the United States and Europe were founded since 2002. Google held the number-one spot on Forbes magazine’s Best Companies to Work For list in eight of the eleven years to 2017, due in part to the exuberance of its employees. (Says one: ‘I love working for the greatest company in the history of the world! This place has been amazing and keeps getting better. There is nothing we can’t accomplish and everyone walking the halls feels they can change the world.’)

The bankrolled new models and cultural allure of start-ups are just the beginning of the many challenges you have to contend with. As we’ve seen with big tech, companies that invest in data, platforms and systems of intelligence will become more dominant. It follows, then, that those companies that own these capabilities are likely to be more successful. But what about those that don’t? Will they survive?

Over the past decade, platforms of all shapes and sizes have started to change the nature of many industries. Whether you are in retail, manufacturing, business services, health or resources, you will have noticed that platforms play an increasing role in customers’ buying habits and expectations. For example, for accountants there was traditionally a separation between the tool (the accounting system), its configuration, and the professional advice or accounting work itself. Over the past 10 years, however, accounting systems have moved online, making them easier and cheaper for customers to use, as well as giving the software provider access to a vast amount of customer data.

The forces of digital disruption are impacting the professional service industries along with most other industries. So what can you do about it? In order to move forward, there are two key concepts you need to understand. In his 1996 letter to shareholders of Berkshire Hathaway, professional investor and multi-billionaire Warren Buffett said: ‘In business, I look for economic castles protected by unbreachable moats.’ This quote highlights two ideas that are as pertinent to your new strategy in the digital age as they were when Berkshire Hathaway’s stock was riding the mid-1990s economic boom:

1. Your castle. Your castle denotes the drivers of growth in your business — in short, how you make money. A little later we will show you how to apply demand- and supply-side economies of scale to digital platforms to retool the economic engine of your business.
2. Your moat. Your moat represents what is unique about your business and how this helps you take a sustaining and dominating — or, dare we say, monopolistic — position in the market. Your moat is essentially your competitive advantage. Soon we will show you how to re-examine this in the context of our new digital economy.

Along with a focus on your castle and moat, a successful strategy can be mapped into horizons of growth — each running in parallel and focused on a different term of the investment. For example, Mehrdad Baghai and Steve Coley’s book The Alchemy of Growth provides a tool with three contemporaneous phases allowing companies to manage for future growth without killing their core products or services in the short term. Each horizon represents a time period over which you expect returns or a material impact on the financials of your business with the idea of investing in new products or services without impacting current performance.

The benefit of adopting a multi-horizon framework is in helping you to steer the change process within your company by quarantining execution into manageable chunks, allowing you to plan and manage the investments related to your strategy as it develops.

Reconstruct your castle

As a pre-digital incumbent, you know how you make money, right? The challenge you have is maintaining acceleration relative to the fast-moving digital economy. Trying to keep the current money machine working at the same time as pivoting makes you even more vulnerable to disruption. As you know, the internet provides a free, open and instant way to distribute products and services, and engage with your customers. This has forced a change in the traditional rules of business. So what powers your growth moving forward? We believe there are two areas you need to focus on:

• your value chain
• the demand-side and supply-side economies of scale.

VALUE CHAINS AND THE LAW OF CONSERVATION OF ATTRACTIVE PROFITS

In 2004, innovation expert Clayton Christensen wrote about the law of conservation of attractive profits. The premise of this law is that when profits decline at one point in the value chain, often due to commoditisation of an existing proprietary solution, a new opportunity for profit will emerge at an adjacent stage through the introduction of another solution.

This rule has been applied successfully and succinctly in describing the disruption of the taxi industry by Uber, the content and media production industry by Netflix, and the hotel industry by Airbnb.

Earlier we spoke about the professional services industry. The strategy that has been so profitable for professional services firms has been integrating human capital and intellectual property (IP). The professionals that attract the best people and have the best IP — and, in turn, the best reputations — are seen by clients as offering the most value. The final activity within the value chain is trusted deliverables. This is because the professional services are there to provide advice or some form of assurance. This advice or assurance comes in the form of a deliverable the client can then use. Furthermore, the deliverable is trusted, especially when provided from a top-tier or reputable firm.

It is also vital to understand the role data is playing. The pre-digital trusted deliverable is static and normally delivered in hard copy, such as slide decks and letters of advice, driven by thought leadership, much of it qualitative. Clients now expect quantifiable solutions backed by data. They demand dynamic deliverables that they can track and measure for themselves in real time. They also want solutions that help automate away low-value, highly repetitive jobs. Furthermore, IP shifts from pure knowledge, much of it qualitative, to proprietary data, which is both qualitative and quantitative. All of this means that proprietary data sets provide extremely valuable further differentiation. More on data in chapter 4.

Because software and the demand for data have fuelled the change in the professional services value chain, firms are prioritising investments in new technology and data sets. Granted, these purchases are coupled with human capital, but human capital has become easily attainable (commoditised) and less important when it comes to delivery, as new value (and profit) is found when a company’s IP is hard coded into software solutions (deliverables) that leverage large and unique data sets. Figure 1.3 illustrates these changes.

The critical point with this law is that you must spend time deconstructing your value chain and working through options to shift value creation by integrating or modularising different elements. Even if an alternative value chain seems unlikely or difficult to imagine, it is still worth considering as part of your strategy. No doubt there were plenty of early sceptics with Uber, Netflix and Airbnb. So rethink your value chain in the way we have done with the professions above. Can you see opportunities in your industry, and if not, why not? Is there a constraint or norm in the industry that you could consider further?

In all of the examples we’ve mentioned, the point of integration in the value chain moves to the right — closer to the buyer. This also aligns with one of the key moves big-tech companies make, which is to emphasise the demand side of your business. We’ll discuss a number of benefits associated with this approach in detail in chapter 5.

DEMAND-SIDE AND SUPPLY-SIDE ECONOMIES OF SCALE

Traditional economies of scale inform a well-known strategy, which has likely helped you lower input costs on the supply side of your business. What you need to do now, though, relates to demand-side economies of scale. Demand-side economies of scale is where the value of a good or service increases as the number of users increases. The internet has profoundly accelerated the application of demand- and supply-side economies of scale by reducing distribution and marginal costs to near zero. This has created winner-takes-all markets, because once demand-side economies of scale are activated, growth can be exponential.

Some businesses create both supply-side and demand-side economies of scale, combined in a single customer proposition. This is called a platform, where demand- and supply-side forces accelerate the value of the platform itself, beyond the value of the company that creates the platform in the first place. The online retailer Amazon is the canonical example of this. In 2016, more than 100 000 small businesses across the globe achieved sales of more than US$100 000 through selling on Amazon. As of early 2017, Amazon Marketplace helps sellers reach more than 300 million active customers worldwide.

Amazon’s primary driver is to offer the best experience possible, which attracts customers. It initially did this by offering a larger selection of books than any other store. As more customers buy from Amazon, third-party sellers are incentivised to sell through Amazon as this is where the customers are, creating more selection and thus more traffic flow to Amazon. This means that Amazon is able to more cost-effectively utilise its infrastructure, such as warehouses and distribution channels, which is the supply-side economies of scale aspect to Amazon’s business model. This improved efficiency means Amazon is then able to reinvest these savings into improving infrastructure, which enables Amazon to lower its costs, as well as offer a better experience through enhanced delivery, meaning more customers. Customers also mean data, which helps Amazon further improve the user experience through better understanding its customers, allowing it to attract even more customers. So Amazon has created a virtuous cycle, referred to by tech blogger Sam Seely as the Amazon flywheel.

The supply-side economies of scale in this example are straightforward. A more efficient use of infrastructure brings down input costs and in turn lowers the price for customers. What is subtler in this model is the demand-side economies of scale, and the vital role the customer plays in furthering the virtuous cycle. In this feedback loop, customers fuel customer growth, which is why Amazon’s primary focus is customer experience. Therefore, the more customers Amazon acquires, the more valuable its offering becomes. We’ll explore this concept further in chapter 5.

APPLYING THESE STRATEGIES TO YOUR CASTLE

Again, when you consider the strategies for success for your business, think about your castle and moat. In relation to your castle, or how your business makes money, there are three strategies for success you can and should apply.

1. Rethink (and reconstruct) your value chain

Step back and examine the industry you are in, and work out where the points of integration and commoditisation are today. Draw a diagram of your current value chain; try to limit this to four or five value chain activities. Be careful not to construct this like a supply chain. Rather, focus on value. If in doubt, flick back to the professional services industry diagram (see figure 1.3).

Imagine a different world where the point of aggregation in your value chain shifts. To do this, decouple the integrated components into commodities, and consider what this would mean regarding the way you operate and your value proposition. The benefit of this approach is that you start to take into account a different makeup of your industry to help you better understand and manage disruptive threats.

2. Focus on the demand side of your business

Like most pre-digital incumbents, you have most likely focused on the supply side of your business to drive profitability and growth. Try flipping this emphasis to focus on your customers, their integration with your business, the data they create and the value they realise. Here are some ways in which you can do this:

• Map out the current and possible exchanges of data between you and your customer to determine where data can drive value. This concept is discussed in more detail in chapter 4.
• Consider the power of scale, and what additional benefits or services you could offer if you had a significant cohort of customers connected with you digitally.
• Identify complements, products and services you can provide to your customers with demand-side scale benefits.

There are three key benefits of this approach for your business:

1. You gather data about your customers’ interactions with your business, which helps you hone your product and service offerings. This is discussed further in chapter 4.
2. A large customer base naturally attracts supply, either directly or through leveraging a marketplace of third-party sellers.
3. You can strengthen your core offering by complementing it with alternative products or services, further increasing demand.

3. Capture the momentum of the flywheel

Having reconstructed your value chain, and with a greater focus and understanding of the demand side of your business, you have created the operational components of a commercial flywheel. In mechanics, a flywheel is a device continually powered by its own rotational energy. In your enterprise, the flywheel is the virtuous cycle by which your realigned value chain — and both the demand- and supply-side economies of scale — make for a better, stronger value proposition, or a bigger flywheel. Just as a car’s flywheel maintains the vehicle’s momentum, so your business flywheel is designed to generate an ever-increasing amount of free cash flow. Free cash flow is calculated as operating cash flow minus capital expenditures. As some industries are more capital-intensive, you should ensure any comparison is done within your industry. The intrinsic benefit of free cash flow works with other elements of the flywheel to provide other natural points of competitive advantage — driving down operational costs, improving margins and strengthening the value proposition to your customers.

In part II, we will show you how the tools of the digital economy — data, platforms and systems of intelligence — provide revolutionary opportunities to harness the benefits of your flywheel. But first, let’s discuss how to shore up your competitive advantage with an effective defence.

Widen your moat

Traditionally, moats have always protected castles. The wider the moat, the more defensible the castle. Swimming across a wide moat, besiegers were vulnerable to attack from above and to drowning. Conversely, a narrow moat offered defenders less protection. If a sufficient attacking force got over the water, they could gain access to the castle. As we explained earlier, the castle is your business, and the moat is your business’s competitive advantage. The wider the moat, the more sustainable your competitive advantage.

So what does a strong moat in today’s digital economy look like? What are the key ingredients? Though it may seem as if it is forever changing, our research indicates that there is an answer. Three forms of digital technology — data, platforms and systems of intelligence — are the key elements in the moats of the future. We have experimented with this idea, applying it to a wide range of industries and business models. So far, we have not found any industry where this isn’t the case.

We’ll discuss those elements in detail in later chapters. But first, it’s important to recognise some of the elements that no longer make for a strong moat — at least not on their own.

FIVE MOAT FEATURES THAT NO LONGER DIFFERENTIATE

At the time of writing, we have identified some strategies that have been commoditised and do not help with the construction of your moat. They are critical building blocks to assemble digital capabilities for your business, so you cannot ignore them, but they are no longer differentiators:

1. A great user experience. This was once a barrier to entry, but not anymore. Creating an awesome user experience requires creativity and expertise. However, it is not enough to form your moat.
2. Relying on scale and distribution. For the professional services industry, limiting services to a particular location was standard practice, particularly among large law, accounting and audit firms. But investments in cloud computing made by the likes of Amazon, Microsoft and Google have changed the game. Scale and distribution are now a commodity, not a competitive advantage.
3. Using third-party software. If you can buy it (either software as a service or on-premise), it’s not that interesting. Third-party technology itself provides no competitive advantage; it is what you do with it that counts.
4. Basic applications of artificial intelligence. Ultimately, artificial intelligence (AI) is software that learns. Just as a child learns and becomes an adult, AI improves its intelligence over time. What’s unique and sustainable is not that a child can learn, but what they learn and how they learn. The same applies to business. What makes an AI system unique — and provides a competitive advantage — is not the ability to learn, but what the system learns.
5. Digital supply-side economies of scale. The bigger you are, the more operating leverage you have, which lowers your costs. Software as a service (SaaS) and cloud services can have substantial economies of scale, meaning your revenue and customer base can scale while keeping your product the same. That said, digital supply-side economies of scale alone will not provide a competitive advantage, as anyone can access the same cloud infrastructure, tools and distribution channels.

Now that you’re aware of some of the features that won’t make for a strong moat, it’s time to discuss some of the features that will. We’ll start with traditional moats and then move on to digital moats.

THREE TRADITIONAL WINNING MOATS

It is important for a moat to provide a sustainable competitive advantage that cannot be easily replicated over time. Some of the greatest and most enduring technology companies are defended by deep and wide moats. For example, Microsoft, Google and Facebook all have moats built on demand-side economies of scale, network effects and a platform, which we will explain in more detail in chapter 5.

There are three traditional moats you need to consider in relation to your business. The application of each of these will vary depending on the nature of your industry, product and service:

1. Proprietary software, technology or trade secrets. Proprietary software or methods is where most technology companies start. These trade secrets can include novel solutions to hard technical problems, new inventions, new processes, new techniques and patents that protect the developed intellectual property. Over time, a company’s IP may evolve from a specific engineering solution to accumulated operating knowledge, or insights into a problem or process.
2. High switching costs. Once a customer is using your product or service, you make it as difficult as possible for them to switch to a competitor. You build this stickiness through a lack of substitutes, coupling your product or service with other products or services, or integrating part of a crucial customer process. Any of these can act as a form of lock-in that will make it difficult for customers to leave.
3. Brand and customer loyalty. A strong brand can be a strong moat. Over time, with each positive interaction between your product or service and your customers, your brand advantage gets stronger. At the same time, brands are particularly vulnerable to matters of trust, and your brand strength can quickly evaporate if your customers lose trust. This risk is becoming even more acute as companies are more exposed to cybersecurity attacks, which can almost instantly bring a business to its knees.

In addition to traditional moats, there are strong digital moats you can emulate. This is where we return to the notion of the flywheel.

Digital moats: the flywheel revisited

Effective digital moats defend some of today’s largest and most future-proofed companies, including Microsoft, Google and Facebook. These big-tech businesses are dominant precisely because of their dominance. In other words, they are using technology to harness and reinforce the self-perpetuating motion of demand-side economies of scale. They have become digital flywheels.

In part II, we will expand on the digital tools you need to employ in order to capture the value of a digital transformation strategy. However, it is important now to deconstruct the component parts of the flywheel, as each element adds depth to your digital moat. Remember, your product or service achieves demand-side economies of scale if each additional user accrues more value to every other user.

Demand-side economies of scale and the associated flywheel cannot be built overnight. There is a systematic, three-staged approach to creating this digital moat. As discussed earlier, the flywheel gets bigger when you bring supply-side economies of scale into the mix. Let’s take a look at this process.

In phase 1 (see figure 1.4), you start by offering a differenti­ated product or service that creates a great customer experience, attracting customers. Customers fuel your company’s growth, but they also create data, which can be used to improve your product or service. This further improves the user experience, attracting more customers and generating overall company growth. The flywheel has begun to spin.

In phase 2 (see figure 1.5, overleaf), it is all about increasing the ‘spin’. After some time, your company will grow and you’ll be able to invest in improving infrastructure. The goal here is to improve supply-side economies of scale, which in turn feed into bolstering the customer’s experience, attracting more customers and driving growth.

In phase 3 (see figure 1.6), we introduce third parties into the mix. Third-party sellers offer products that complement and improve your product or service, enhancing the customer’s experience, attracting more customers and fuelling growth. Third parties also increase the amount of data you can collect, which will further help you improve your offerings. We’ll discuss third-party sellers in much more detail in chapter 5.

Once in place, the flywheel fuels itself and is therefore self-perpetuating. It’s a powerful beast. Both Apple and Amazon employ this model, which has been the backbone of their success. Again, we’ll explore the concept of supply-side economies of scale in much greater detail in chapter 5. If you are then able to incorporate all or some of the non-digital moats — proprietary assets, high switching costs and loyalty — you suddenly have an extremely wide and defensible moat, which will provide your company, your employees and your customers with fantastic value well into the future. Generating and sustaining a higher volume of free cash flow is the most obvious sign of an effective economic moat. The key to balancing and profiting from all these strategic elements lies in an open-minded examination of the competitive forces in your industry, opportunities for shifts in the value chain and an evaluation of what your customer really wants from your business.