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Their 5/40 rule quantifies a tough decision established companies often get wrong
What do you do when your company is comfortably selling a product, and then suddenly a competitor offers a similar one for free? Well, if you’re like two-thirds of the companies in a new study, you’ll get it wrong.
Three BYU business professors researched this scenario, increasingly familiar in the digital age. A one-time start-up Skype can start offering free voice and video calls over the internet, sending established phone and video-conferencing companies scrambling, and eventually be acquired by Microsoft last month for $8.5 billion. Or Craigslist’s free online classifieds can gut the profits of 100-year-old newspaper companies.
But, as the researchers point out, offering physical products for free is also increasingly common. Among the 34 companies they studied was European discount airline Ryanair, which offers some flights for free. Its market share now exceeds Air France’s.
The authors share their observations of how to compete against free products — garnered from and analysis of businesses in 26 different markets over the last five years — in the latest issue of the Harvard Business Review (which is not free – subscription required).
“Some of the companies that got this wrong panicked and offered a free product too fast, instead of waiting for the new competitor to self-destruct or for the structure of the market to play out a little more,” said David Bryce, lead author on the piece. His coauthors are Jeffrey H. Dyer and Nile W. Hatch – all three are faculty at BYU’s Marriott School of Management.
But even more companies erred by doing nothing, he says. So how do you know which path is the right one? Based on the outcomes of the battles they followed, the researchers established a formula businesses can use to make the choice.
If the new competitor is stealing less than 5 percent of your customers a year and is growing less than 40 percent a year, don’t worry too much. It will probably flame out.
When the opposite is occurring, and more than 5 percent of your customers are defecting and the competitor is growing faster than 40 percent a year, your very existence is threatened. That’s what Craigslist did to the newspaper classified business in all of the top 50 U.S. metropolitan areas except one – Salt Lake City.
Deseret Media Company, which owns the Deseret News, KSL TV, and KSL NewsRadio (and is owned by BYU’s sponsor, The Church of Jesus Christ of Latter-day Saints), launched its own free classified site on ksl.com. The researchers hail that and the company’s other moves to change its business model, pointing out that last year its print and online audience grew at the industry’s second-fastest rate and that online “profits exceed those of the traditional businesses, including the newspaper.”
“Overall, Deseret Media is thriving,” the authors write.
The article gives advice for how to react to situations in between those two extremes. For example, Bryce says a traditional radio or satellite radio company would do well to acquire Pandora — the free Internet radio firm – before it displaces them.
The researchers also share overall guidance about how established firms can shake up their management structures to win these battles.
“If a company that was dealing with a free product competitor called me and asked how to respond, the first thing I would say is, ‘Help me understand where the revenue responsibility and where the cost responsibility are in your organization, and we’ve got to split those apart fundamentally,’” says Bryce, who was an industry consultant after earning an MBA and master’s in accountancy at BYU. He later earned a Ph.D. from Penn’s Wharton School of Business while coauthor Dyer was on the faculty there.
The researchers suggest that one team manage the product as a cost center, making it the best it can be with the most efficient costs. An entirely separate team should have responsibility for generating revenues, not just from the product’s price, but from upselling or cross-selling customers to other products, charging third-parties to advertise to them or bundling the free product with paid offerings.
Those are the principles that guided Bryce’s advice to Microsoft about integrating Skype, which he recently published on the Harvard Business Review site.
“Free competitors are typically new businesses that have been built from the outset on a different business model,” Bryce says. “A traditional business, built on the prospect of a product that gets revenue directly through price, often has a very difficult time changing over.”
Bryce is on Twitter: @dave_bryce