Management: The five deadly sins

Peter Drucker
Sunday 23 October 2011 04:28

Recent years have seen the downfall of one once-dominant business after another - General Motors, Sears Roebuck and IBM, to name just a few. In every case the main cause has been at least one of the five deadly business sins - avoidable mistakes that harm the mightiest business.

The first and easily the most common is the worship of high profit margins and of 'premium pricing'. The prime example of what this leads to is the near-collapse of Xerox in the 1970s. Having invented the copier, it soon began to add feature after feature, each priced to yield the maximum profit margin and driving up the machine's price. Xerox's profits and stock price soared.

But the vast majority of consumers, who need only a simple machine, became increasingly ready to buy from a competitor. When Japan's Canon appeared it immediately took over the US market. Xerox barely survived.

GM's troubles - and those of the entire US motor industry - are in large measure also the result of the fixation on profit margin. By 1970 the Volkswagen Beetle had shown there was US demand for a small, fuel-efficient car. Yet domestic car makers were content for many years to leave it to the Japanese, since small car profit margins appeared so much lower than those for big cars.

In the end, GM, Chrysler and Ford increasingly had to subsidise their big car buyers with discounts, rebates and cash bonuses.

The lesson: the worship of premium pricing always creates a market for the competitor. And high profit margins do not equal maximum profits. Rather, maximum profit is obtained by the profit margin that yields the largest total profit flow, and that is usually the one that produces optimum market standing.

Closely related to this first sin is mispricing a new product by charging 'what the market will bear'. This, too, creates risk-free opportunity for the competition.

The Japanese have the world's fax machine market today because the Americans - who invented the machine, developed it and first produced it - charged what the market would bear, the highest price they could get. The Japanese, however, priced the machine in the US two or three years down the learning curve - and had the market virtually overnight.

In contrast, DuPont has remained the world's largest producer of synthetic fibres because, in the mid-1940s, it offered its new and patented nylon on the world market for the price at which it would have to be sold five years hence to maintain itself against competition.

This not only delayed competition, but also immediately created a market for nylon that no one at the company had even thought about (for example, in car tyres). And this soon became both bigger and more profitable than the womenswear market could ever have been.

The third deadly sin is cost-driven pricing. Most American and practically all European companies arrive at their prices by adding up costs and putting a profit margin on top. And then, as soon as they have introduced the product, they have to cut the price, redesign it at enormous expense, take losses and often drop a perfectly good product because it is priced incorrectly. Their argument? 'We have to recover our costs and make a profit.'

This is true, but irrelevant. Customers do not see it as their job to ensure a profit for manufacturers. The only sound way to price is to start out with what the market is willing to pay - and thus, it must be assumed, what the competition will charge - and design to that price specification.

Cost-driven pricing is the reason there is no American consumer electronics industry any more. If Toyota and Nissan succeed in pushing the German luxury car makers out of the US market it will be a result of their using price-led costing.

Starting out with price and then whittling down costs is more work initially. But in the end it is much less work than to start out wrong and then spend loss-making years bringing costs into line.

The fourth of the deadly business sins is slaughtering tomorrow's opportunity on the allure of yesterday. It is what derailed IBM.

IBM's downfall was paradoxically caused by unique success - catching up, almost overnight, when Apple brought out the first personal computer in the mid- 1970s. But then, when IBM had gained leadership in the PC market, it subordinated this new and growing business to the old cash cow, the mainframe computer.

This did not help the mainframe business. But it stunted the PC business just as, 40 years ago, when IBM first had a computer, it threatened its future by trying to protect the existing punch card business.

The last of the deadly sins is feeding problems and starving opportunities. All one can get by 'problem-solving' is damage containment. Only opportunities produce results and growth.

I suspect that Sears Roebuck has been starving the opportunities and feeding the problems in the retail business these past few years. This is also probably what is being done by the leading European companies - for example, Siemens - that have steadily lost ground on the world market.

The right thing to do has been demonstrated by GE, with its policy of getting rid of all businesses - even profitable ones - that do not offer long-range growth and the opportunity for the company to be number one or number two worldwide.

Then it places its best-performing people in the opportunity business, and pushes and pushes.

All this has been known for generations and has been simply proved by decades of experience. There is thus no excuse for managements to indulge in the five deadly sins. They are temptations that must be resisted.

The author is a professor of social sciences at the Claremont Graduate School in California.

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