THE BLOG
08/06/2013 06:21 pm ET | Updated Oct 05, 2013

Think Inside the Box!

I'm really excited! I've just stumbled across the best new technique for boosting the performance of any business. And guess what -- the method is brilliantly retro. But even trend-setters and worshippers of the new new thing can't afford to ignore the technique. Quite simply, it's the best strategic display since the BCG Growth Share Matrix.

Here's a link to the display, and as promised it's a box to think inside!

This box comes from a new book, Think Inside The Box by Tim Nelson & Jim McGee, who are successful entrepreneurs turned consultants and run the Winnetka Consulting Group in Illinois. To be honest, I had never heard of them or their firm, but I predict a great future for them and their clients.

So what's the great breakthrough? We have had 80/20 analysis of customers and products for several decades. This always shows that a small proportion of customers -- usually between 5 and 20 percent -- generate 80 percent or more of any firm's profits; and a similar or even smaller proportion of products -- typically between 1 and 10 percent -- also generate four-fifths of profits. The genius of Nelson & McGee and their box is that they combine the effect of product and customer profit concentration, enabling us to understand exactly what is going on to cause the usual weird skew of profits towards a small minority of the business, and what to do about it.

Quad 1 -- The Core

Nelson and McGee say of Quad 1 "a small portion of your business in terms of products and customers accounts for most of your economic success." This is the double effect of Quad 1 being a very exclusive club to enter. In the example they quote, 9 percent of customers account for 80 percent of profits; and 2 percent of products account for 80 percent of profits. But not all the profitable products are bought by the most profitable customers, so Quad 1 is typically a small part of the firm's total business, measured by the number of customer-product combinations. Despite this, Quad 1 typically accounts for 60-70 percent of total profits. If you reduced your total business to Quad 1 -- not something you necessarily want to do -- you would reduce the complexity and cost of running the business many times over. As Nelson and McGee say, "this combination of your most profitable customers... and your most profitable products typically contributes more to your success than all the remaining Quads. Everything you do should be centered on the efficient and effective manufacturing and servicing of your products and customers in Quad 1."

Any but the smallest business is extremely complex and hard to understand. It is impossible to optimize how a firm is run, because there are more moving parts than anyone can truly understand, involving permutations of product and customer differences compared to the business of the firm's competitors. What really makes the difference in terms of market share and profitability? For the whole business, it is impossible to say. But if we focus our attention on Quad 1, we can find out what is going on in a very small yet most important part of the total business. If we truly understand what is happening in Quad 1, we can make sensible decisions that will drive the success of the total business.

As you look at the list of customers and products in Quad 1, Nelson and McGee say, "you want to understand: Are the products being sold through the same distribution channels? How are the customers spread out geographically? Do you have different segments that exist within Quad 1? Are some customers purchasing one set of products and other customers purchasing a different set of products? Are these products that are made to stock or made to order? Do they use the same manufacturing assets and processes? Is there a technological difference to them?"

They give the example of one company that looked into what was going on in Quad 1 and found it really had two quite different businesses there. The OEM segment - serving customers who were large manufacturers themselves - had "high predictable demand cadence, large volume, and consistent product mix." In truth, this segment was even more super-profitable than the gross margin analysis revealed, because the business practically ran itself and required little managerial intervention or overheads. By contrast, many of the customers were distributors selling on to smaller manufacturers. "The distributor side of the business had tremendous complexity and required the ability to quickly change over equipment and create downstream sub-assemblies that could be brought together on short notice. This required a different set of manufacturing practices than the OEM group."

It was decided that some managers should focus exclusively on the OEM group and other managers on the distributor customers, with different manufacturing flows and pricing policies for each segment. It was decided to streamline the distributor business, and this simplification resulted in a big surge in profits.

The point of looking within not just the box but within Quad 1 of the box is for firms to define clearly what they do best. "What," Nelson & McGee ask, "are your pre-existing constraints and opportunities? What would these look like if they were standalone operations without all the complexity of the other Quads?" Asking these questions nearly always reveals a small, manageable and incredibly profitable sub-set of customers and products.

"Strategy is about defining the core business in terms of sustainable competitive advantage, barriers to entry, and power relative to buyers and suppliers. Starting from a clean sheet of paper with just your Quad 1 allows you to best define key products and services and customers where the value you offer is most appreciated by the market."

What of the other Quads? They are less vital, but still interesting.

Quad 2 -- Supporting Products

These are in the bottom 80 percent of products but they are bought by the core customers. Nelson & McGee say "think of something like milk at McDonald's. Not what pays the overhead, but critical to some of your key patrons. In time, some of your Quad 2 products can grow into Quad 1. When McDonald's first offered salads, they were a Quad 2 offering. Today, they have matured into a Quad 1 product."

Questions to ask about your Quad 2 products:

  • How do they fit into Quad 1 products? Do they share vital costs or expertise?

  • What would you need to do to make them into Quad 1 products? Could you improve them and raise the price?
  • Do you really need all of them -- could you rationalize them? Do customers really care if the product is Royal Blue rather than Ocean Blue? What would happen if you only offered Ocean Blue?
  • What is the depth of usage of the major Quad 2 products amongst your Quad 1 customers? For each of the large Quad 2 products, are they sold to only one or two Quad 1 customers or to most of them? Why do some Quad 1 customers buy Quad 2 products and others not?
  • Are we missing opportunities to expand the sales and profits from Quad 2 products, or just creating unnecessary complexity? I suspect (Nelson and McGee do not say this) that there is typically a small portion of Quad 2 products with potential but most of them are either necessary evils (to keep some Quad 1 customers happy) or unnecessary ones.
  • Quad 3 -- Benefactor Customers

    These customers are not terribly profitable but they exist because they are buying Quad 1 products. In theory they should be easy to service. Nelson and McGee advise you to make sure this is the case:

    "Think about the patron who stops at Starbucks once a week on the trip back from yoga class. Quad 3 customers do not have the buying volume to sustain the business. However, they can still be an important element to overall profitability. While analyzing one business we found that we typically had a Quad 1 customer (distributor) in each major city, and then 3-4 Quad 3 customers (also distributors) as well. We found that Quad 1 customers purchased all their products from the company, while Quad 3 customers were cherry picking the line of products."

    When they dug deeper, they found that the Quad 3 customers bought most of their products from a low-cost competitor who only offered a few high-volume products. The client company was really supporting its rivals by allowing them to focus on a narrow offering that didn't require much expertise to make.

    How should the client deal with this?

    • Cut off the Quad 3 customers?

  • Raise prices to them, since they couldn't easily get these products elsewhere?
  • Insist that Quad 3 customers also buy a certain amount of Quad 1 products?
  • Or, just leave things as they are?
  • Nelson & McGee say there is no right answer all the time. In this particular case, the client decided to raise prices - and kept nearly all the business at much higher margins.

    Quad 4 -- Residual

    These tend to be:

    • Products introduced several years ago that never succeeded

  • Products no one had the time to eliminate
  • Parts for prior models
  • Smaller, one-off customers with special needs
  • New products or customers that need time to develop
  • Clearly, the last group may be worth keeping and encouraging to a much greater degree. The rest may add huge complexity for little reward. Still, Nelson and McGee insist that each business is different and that decisions should not be taken blithely.

    Why do I love this approach?

    I've realized two great truths about business that I've been vaguely aware of for a long time, but which I now think are absolutely fundamental:

    • To understand your business, follow the money. If you really understand where you make and lose money, you can make tremendous improvements. This is extremely hard work and requires a disciplined approach, and 99 percent of managers don't even try, despite the obvious benefits.
  • Business is all about simplicity and complexity, and the never-ending war between them. Some complexity is good, because it leads to product improvements -- indeed, these rarely come without substantial extra complexity. Yet that need not be permanent, and if you don't simplify, somebody else will. Most complexity, most of the time, is the enemy of high returns and a flourishing economy and society.
  • Ultimately, you know, nothing matters except the products you provide and the customers you have. If you understand the few places where you really score with products and customers, and the large majority of places where you don't, you understand your competitive advantage and can increase it. So -- I beg you -- PLEASE -- THINK INSIDE THE BOX!