Good Strategy/Bad Strategy: The difference and why it matters

by Richard P. Rumelt

Thus, the first bar on the left represents the best outlet in the chain—its GTO was $1.05 million per year. The next bar represents the GTO of outlet 1 plus that of outlet 2, a total cumulative GTO of $1.05 + 0.63 = $1.68 million. The third best outlet earned $0.5 million, so the third bar shows the cumulative GTO of outlets 1, 2, and 3 (1.05 + 0.68 + 0.5 = $2.18 million). Outlets 4 through 14 added another $2.5 million to the cumulative total, bringing it up to $4.68 million. But, beginning with outlet 15, negative GTOs begin to drag down the cumulative total. In fact, the negative GTOs of outlets 15 through 28 summed to negative $4.4 million, almost totally canceling out the contributions of the positive GTO stores. As you can see, the number one outlet’s GTO was higher than that of the whole chain of twenty-eight!

the end of two years, Denton’s gain to operating had risen from $100,000 to more than $5 million and its accounting profit had doubled. About one-half of the increase came from dropping five weak outlets and the other half from a best-practices program. None of this improvement came from a deep entrepreneurial insight or from innovation. It was all just management—just undoing the accumulated clutter and waste from years of entropy at work. Planning and planting a garden is always more interesting and stimulating than weeding it, but without constant weeding and maintenance the pattern that defines a garden—the imposition of a special order on nature—fades away and disappears.

You will also glimpse almost every building block of good strategy: intelligent anticipation, a guiding policy that reduced complexity, the power of design, focus, using advantage, riding a dynamic wave of change, and the important role played by the inertia and disarray of rivals.

When a product gives a buyer an advantage in competition with others, there will be an especially rapid uptake of the product. When, for example, the first spreadsheet, VisiCalc, appeared in 1979, it provided an edge to MBA students,

financial analysts, and other professionals who used it. VisiCalc was rapidly adopted and helped push personal computers from their hobby niche into the mainstream. Similarly, interactive online 3-D gaming created a demand for the edge provided by better and faster 3-D graphics.

The whole semiconductor industry coordinated around achieving a higher level of integration, based on smaller transistors, about every eighteen months. This rate of progress was called Moore’s law. No one could jump much ahead of this pace because all the technologies, from photolithography to optical design to metal deposition to testing, had to advance in lockstep. The industry called this pattern of collective advance the “road map.”

This is the point where a bad strategist would have wrapped the concept of a faster development cycle in slogans about speed, power, and growth, and then sought to cash in by taking the company public. Instead, the Nvidia team designed a set of cohesive policies and actions to turn their guiding policy into reality. The first step in executing the guiding policy was the establishment of three separate development teams. Each would work to an eighteen-month start-to-market cycle. With overlapping schedules, the three teams would deliver a new product every six months.

The benefit of a faster cycle is that the product will be best in class more often. Compared to a competitor working on an eighteen-month cycle, Nvidia’s six-month cycle would mean that its chip would be the better product about 83 percent of the time. Plus, there is the constant buzz surrounding new product introductions, a substitute for expensive advertising. As a further plus, the faster company’s engineers will get more experience and, perhaps, learn more about the tricks of turning the technology into product.

Standard industry analysis would classify powerful buyers such as Dell as a negative for Nvidia. But without powerful PC makers such as Dell and HP, Diamond might have maintained its hold on retail channels. It was the power of these concentrated buyers that allowed Nvidia to skate around Diamond’s established brand. Note that, in general, if you have a “me-too” product, you prefer fragmented retail buyers. On the other hand, if you have a better product, a powerful buyer such as Dell can help it see the light of day.

McCracken’s “grow by 50 percent” is classic bad strategy. It is the kind of nonsense that passes for strategy in too many companies. First, he was setting a goal, not designing a way to deal with his company’s challenge. Second, growth is the outcome of a successful strategy, and attempts to engineer growth are exercises in magical thinking. In this case, the growth SGI engineered was accomplished by rolling up a number of other firms whose workstation strategies had also run out of steam.

Passing on ArtX was a strategic blunder by Nvidia. The network of human capital in this industry was sparse and well understood. Had there been many pockets of talent like ArtX, acquiring it would make no sense. But even though Nvidia did not need the extra expertise, acquiring it would deny these scarce competencies to a competitor.

An organization creates pools of proprietary functional knowledge by actively exploring its chosen arena in a process called scientific empiricism. Good strategy rests on a hard-won base of such knowledge, and any new strategy presents the opportunity to generate it. A new strategy is, in the language of science, a hypothesis, and its implementation is an experiment. As results appear, good leaders learn more about what does and doesn’t work and adjust their strategies accordingly.

“This strategy stuff is nonsense. Give me a break! There is no clear theory. Look, what we need is a way of knowing what will happen if we do A, versus what will happen if we do B. Then we can work out what will be the best strategy. We are actually very good at planning here. You can’t build a major aerospace system without meticulous planning. But this strategy stuff seems vacuous.”

Where does scientific knowledge come from? You know the process. A good scientist pushes to the edge of knowledge and then reaches beyond, forming a conjecture—a hypothesis—about how things work in that unknown territory. If the scientist avoids the edge, working with what is already well known and established, life will be comfortable, but there will be neither fame nor honor. In the same way, a good business strategy deals with the edge between the known and the unknown. Again, it is competition with others that pushes us to edges of knowledge. Only there are found the opportunities to keep ahead of rivals. There is no avoiding it. That uneasy sense of ambiguity you feel is real. It is the scent of opportunity. In science, you first test a new conjecture against known laws and experience. Is the new hypothesis contradicted by basic principles or by the results of past experiments? If the hypothesis survives that test, the scientist has to devise a real-world test—an experiment—to see how well the hypothesis stands up. Similarly, we test a new strategic insight against well-established principles and against our accumulated knowledge about the business. If it passes those hurdles, we are faced with trying it out and seeing what happens. Given that we are working on the edge, asking for a strategy that is guaranteed to work is like asking a scientist for a hypothesis that is guaranteed to be true—it is a dumb request. The problem of coming up with a good strategy has the s...

In a changing world, a good strategy must have an entrepreneurial component. That is, it must embody some ideas or insights into new combinations of resources for dealing with new risks and opportunities.

Treating strategy like a problem in deduction assumes that anything worth knowing is already known—that only computation is required. Like computation, deduction applies a fixed set of logical rules to a fixed set of known facts. For example, given Newton’s law of gravity, one can deduce (calculate) the period of Mars’s orbit around the sun. Or given the costs and capacities of tankers, pipelines, and refineries, one can optimize the flow of oil and refined product within an integrated oil company. If everything worth knowing is already known, the problem of action reduces to crank winding. The presumption that all important knowledge is already known, or available through consultation with authorities, deadens innovation. It is this presumption that stifles change in traditional societies and blocks improvement in organizations and societies that come to believe that their way is the best way. To generate a strategy, one must put aside the comfort and security of pure deduction and launch into the murkier waters of induction, analogy, judgment, and insight.

Locke would extend the concept of such natural laws to society and proclaim, “The natural liberty of man is to be free from any superior power on earth, and not to be under the will or legislative authority of man, but to have only the law of Nature for his rule.”

Thomas Jefferson penned into American history when he wrote “We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable rights, that among these are life, liberty and the pursuit of happiness.”

A strategy is, like a scientific hypothesis, an educated prediction of how the world works. The ultimate worth of a strategy is determined by its success, not its acceptability to a council of philosophers or a board of editors. Good strategy work is necessarily empirical and pragmatic. Especially in business, whatever grand notions a person may have about the products or services the world might need, or about human behavior, or about how organizations should be managed, what does not actually “work” cannot long survive.

In science, anomalies are the frontier, where the action is.

Since my days in graduate school, a major anomaly has been discovered with regard to galaxies like ours and M31. Because most of the mass of a galaxy lies in its dense bright core, the theory of gravity predicts that stars farther out from the core should not only take longer to orbit the core, they should also travel more slowly through space in their longer orbits around the core. More precisely, a star’s speed in its swing about the core should

be proportional to the inverse square root of its distance from the center. A star one-half as far out from the core as Sol should speed through space at four times Sol’s speed. But measurements of many galaxies began to appear in the early 1980s showing that almost all of the stars in the spiral orbit at about the same speed, regardless of their distance from the core! Galactic “rotation curves” were flat. This is truly a huge anomaly. Something very basic about our worldview seems wrong.

This puzzle of galactic rotation drives a great deal of modern research in astronomy. Two hypotheses are presently under investigation. The favorite is that the glowing star matter we photograph is only about 10 percent of the physical universe—the rest is “dark matter”—not simply unlighted matter, but a special kind of matter that doesn’t interact with light. By imagining galaxies as embedded in an invisible blob of dark matter, the anomaly is resolved by the gravity of this hidden dark mass. But, of course, this leaves open a great many other questions about the hypothesized dark matter. The other theory, less popular, is that received theories of gravity—Newton’s and Einstei...

But as Sherlock Holmes said to Watson, “You see, but you do not observe.”

Schultz formed a strategic hypothesis—the Italian espresso experience could be re-created in America and the public would embrace it.

Opening a single espresso bar would cost several hundred thousand dollars, but not the hundreds of millions or billions that some ventures require.

One of the most important resources a business can have is valuable privileged information—that is, knowing something that others do not.

All alert businesspeople can know more about their own customers, their own products, and their own production technology than anyone else in the world. Thus, once Schultz initiated business operations, he began to accumulate privileged information.

This process of learning—hypothesis, data, anomaly, new hypothesis, data, and so on—is called scientific induction and is a critical element of every successful business.

It was 1890, and there was a cocktail party here in Pittsburgh. All the movers and shakers were there, including Carnegie. He held court in a corner of the room, smoking a cigar. He was introduced to Frederick Taylor, the man who was becoming famous as an expert on organizing work. “Young man,” said Carnegie, squinting dubiously at the consultant, “if you can tell me something about management that is worth hearing, I will send you a check for ten thousand dollars.” Now, ten thousand dollars was a great deal of money in 1890. Conversation stopped as the people nearby turned to hear what Taylor would say. “Mr. Carnegie,” Taylor said, “I would advise you to make a list of the ten most important things you can do. And then, start doing number one.” And, the story goes, a week later Taylor received a check for ten thousand dollars.

Carnegie paid because Taylor’s list-making exercise forced him to reflect upon his more fundamental purposes and, in turn, to devise ways of advancing them. Fletcher’s comment, made fifteen years before, suddenly made more sense. When I asked about his division’s purpose, its competitive strengths and weaknesses, and the management

issues he faced, he had to reflect and bring these issues to the forefront. The interview reminded him about his broader situation and the things he had to do to move forward. He was essentially reminded of his “list” and various priorities during our conversation.

I want to ask you how you arrived at your recommendations. How did you come up with your response to this assignment?” It isn’t the question they have been expecting, and there is a long moment of quiet. People shift in their seats and look at one another. I glance pointedly at the most senior executive. He speaks up, saying that he had “read the case and made some marginal notes.”

“So,” I continue, “in strategy work this quick closure can get us into trouble. Almost by definition, strategy is about very difficult yet very important issues. Because they are important situations, they may deserve more than a quick closure around our first hunch. You know that. And because you know that, we have a puzzle. Why would experienced executives, like yourselves, go with quick closure in a strategy situation?”

Facing a complex situation like this makes most people uncomfortable. The more seriously you take it, the more you will see it as a real and difficult challenge that requires a coherent response. And that realization will, in turn, make you even more uncomfortable. It is so ill-structured. There are too many variables, so many factors, too many unknowns, no clear list of potential actions and no way to make clear links between actions and outcomes. You are not even sure what the problem is. Like a swimmer dropped into very choppy waters, it is hard to get your bearings. Under pressure to develop a way out of the difficulty, that first idea is a welcome relief. Thank goodness, here is something to hang on to! It feels much better to get oriented.

The problem is that there might be better ideas out there, just beyond the edge of our vision. But we accept early closure because letting go of a judgment is painful and disconcerting. To search for a new insight, one would have to put aside the comfort of being oriented and once again cast around in choppy waters for a new source of stability. There is the fear of coming up empty-handed. Plus, it is unnatural, even painful, to question our own ideas. Thus, when we do come up with an idea, we tend to spend most of our effort justifying it rather than questioning it. That seems to be human nature, even in experienced executives. To put it simply, our minds dodge the painful work of questioning and letting go of our first early judgments, and we are not conscious of the dodge.

First, you must have a variety of tools for fighting your own myopia and for guiding your own attention. Second, you must develop the ability to question your own judgment. If your reasoning cannot withstand a vigorous attack, your strategy cannot be expected to stand in the face of real competition. Third, you must cultivate the habit of making and recording judgments so that you can improve.

The kernel is a list reminding us that a good strategy has, at a minimum, three essential components: a diagnosis of the

situation, the choice of an overall guiding policy, and the design of coherent action. The concept of the kernel defines the logic of a strategy—the bare-bones minimum. For a strategy to have any bite, it must chart a direction based on a diagnosis of the situation. Absent a diagnosis, one cannot judge one’s own choice of an overall guiding policy, much less someone else’s choice. A strategy must also translate the overall directive into coordinated action focused on key points of leverage in the situation. (The concept of the kernel and its elements is explored in greater depth in chapter 5.)

I tend to use a problem-first structure. I am better at starting with a frame or diagnosis of the situation and then working through the guiding policy and action elements of the kernel. At the start of most consulting engagements, the client wants an appraisal of a particular course of action or wants advice on what to do. I almost always back up and try to create a better diagnosis of the situation before getting into recommendations. Problem-Solution

To gain this change in perspective, shift your attention from what is being done to why it is being done, from the directions chosen to the problems that these choices address.

The creation of new higher-quality alternatives requires that one try hard to “destroy” any existing alternatives, exposing their fault lines and internal contradictions. I call this discipline create-destroy.

I invoke a virtual panel of experts that I carry around in my mind. This panel of experts is a collection of people whose judgments I value. I use an internal mental dialogue with them to both critique my own ideas and stimulate new ones. I try to do this before putting my ideas before others. The panel of experts trick works because we are adept at recognizing and comprehending well-integrated human personalities. Thinking through how a particular well-remembered expert might respond to a problem can be a richer source of criticism and advice than abstract theories or frameworks.

Jobs’s basic operating principles have become the stuff of legend: (1) imagine a product that is “insanely great,” (2) assemble a small team of

the very best engineers and designers in the world, (3) make the product visually stunning and easy to use, pouring innovation into the user interface, (4) tell the world how cool and trendy the product is with innovative advertising.

Listening to Teece’s and Jobs’s imaginary counsel, I am reminded that good strategies are usually “corner solutions.” That is, they emphasize focus over compromise. They focus on one aspect of the situation, not trying to be all things to all people. As Jobs might argue, TiVo could be a much more interesting proposition were it merged with a major platform, providing something more integrated than current DVR offerings. And as Teece might observe, they are already trying to do too many conflicting things, things that put them in competition with their platform customers. Learning from others can be more than simply listening to them, watching them, or reading what they write. When you build your own panel of experts you go one step farther, trying to shape your understanding of their teachings into a virtual personality. When it works, it does so because we humans have built-in software for understanding other humans, software that is more expert at recognizing and recalling personalities than at almost anything else.

Good judgment is hard to define and harder still to acquire. Certainly some part of good judgment seems to be innate, connected with having a balanced character and an understanding of other people. Still, I am convinced that judgment can be improved with practice. For that practice to be effective, you should first commit your judgments to writing.

What this student has missed is the opportunity to pre-commit to a position and thereby subsequently evaluate her own judgment. To commit to a judgment is to choose an interpretation of which issues are critical and which are not and then to choose an implied action. By committing to a judgment—especially a diagnosis—you increase the probability that you will disagree with some of the assessments of others, and thereby increase the chance of learning something.

The same principle applies to any meeting you attend. What issues do you expect to arise in the meeting? Who will take which position? Privately commit yourself in advance to some judgments about these issues, and you will have daily opportunities to learn, improve, and recalibrate your judgment.

The concept of cost is tricky. People talk as if products have costs, but that is shorthand easily leading to confusion. Choices, not products, have costs. The cost of choosing to make one more unit of a product is sometimes called marginal, or variable, cost. The cost (per unit) of choosing to produce at a fixed rate for a year is called average cost. The cost per unit of choosing to build a plant and produce at a fixed rate is called long-run average cost. The cost of filling a rush or special order has no particular name, but it clearly exists. There really is no such thing as the single correct “cost” of a product. It all depends on the decision—on what is being compared to what. The cost of “deciding” to carry one more telephone call was only that of the electrical power required—essentially zero. The