Leveraging the Incumbent’s Advantage

People often talk about business competition as if it’s a short race: Get to market first and you are bound to win. Indeed, the importance of first-mover advantage has been drummed into the heads of many business executives, and some have almost been brainwashed to think that speed is everything. But when a new technology threatens to transform an industry, the companies that are quickest to respond aren’t necessarily the ones that reap the greatest benefits. In fact, choosing a fast strategy can lock them into a set of decisions that actually hurt them in the long run. Instead, organizations that choose the right strategy for the entire race — both for the early and late stages — will come out ahead. In other words, business competition is a marathon, not a sprint.

For any company faced with an innovation like digital photography or the Internet that could transform its business, one of the fundamental decisions it will need to make is organizational: Should it spin off an autonomous group to respond to the development, or should it instead use a more integrated approach?1 It must also decide when to act: early, when the innovation is taking shape, or later, when the impact and viability of the new technology is better known. Furthermore, because the nature of competition changes over time, the company must also decide how to evolve its strategy.

In our research, we have found that spinoffs often enable faster action early on, but they later have difficulty achieving true staying power in the market. Even worse, by launching a spinoff, a company often creates conditions that make future integration very difficult. For enduring success, incumbent companies are better off creating a group that is — or will eventually be — integrated within their organizations. Only then will they be able to tap fully into their numerous strengths, leveraging their incumbent’s advantage.

In other words, there are just three viable strategies for long-term success. A company can create an autonomous unit that is reintegrated later (the separated-integrated approach) or an internal unit that remains that way (the integrated-leader approach). Or it can wait until the technology converges on a dominant feature set and then respond with an internal effort (the integrated-follower approach). All three strategies end in integration, but they use different ways to get there. Successful companies choose the approach that best matches their strengths, capabilities and market conditions.

The Lure and Dangers of Separation

When faced with an innovation that could shake up their industry, many companies are tempted to respond by spinning off an autonomous venture. After all, radical new innovations are often slowed down or even killed by large, bureaucratic organizations. Spinoffs seemingly offer an easy solution. By separating the innovators, a big corporation can react with speed, agility and focus. Those at the spinoff will be able to make decisions quickly and adapt swiftly to rapid changes in the competitive environment —without worrying about coordinating with the existing business. Also, life is easier back at the existing organization. Managers there don’t need to spend their time resolving conflicts between the old and new businesses.

But there’s a huge disadvantage to spinoffs. By isolating innovators, an organization can inadvertently block them from using its most powerful assets. Sure, a spinoff can exploit some resources of its parent organization, such as financial capital or brand equity. But the spinoff often has difficulty leveraging any assets that require coordinated efforts, such as marketing campaigns or production facilities. What’s worse, separation makes it very difficult to build on synergies: The spinoff typically has trouble taking advantage of the ways in which the old business might help it to scale up, and the old business is unable to learn valuable lessons from the spinoff ’s experiences. As a result, the spinoff finds itself trying to play the game of startup firms — on their field with their rules.

To understand some of these issues, consider the example of Silicon Graphics Inc., a manufacturer of high-end computer workstations. In the early 1990s, SGI was threatened with the development of the Microsoft Windows NT operating system. Competitors were using NT in workstations that had lower performance but were significantly cheaper that SGI’s products, which used a variant of the Unix operating system.

In response, SGI created an autonomous venture to develop computers that ran NT. The new unit was separated both physically and organizationally. It had its own profit-and-loss structure and was encouraged to develop novel designs for its products. Moreover, it had the freedom to implement new approaches to supply-chain management, manufacturing and sales.

This textbook move helped SGI get off the block quickly, but it also nearly killed the company. Developing a new organization and the required capabilities from scratch was much more challenging than expected. This caused massive inefficiencies and delays across the board — products were late and buggy, and they weren’t sufficiently supported by the sales channels. Furthermore, the autonomous venture had trouble leveraging SGI’s traditional capabilities and company relationships in product development, operations and sales. Lastly, the move was a source of frustration and disappointment for employees who were left behind to manage the older line of computers. As a result, those products, which still provided the company’s lifeblood, suffered. These problems eventually forced SGI to absorb its NT venture back into the main organization. But because SGI had not planned for that, the new business had difficulty getting internal support, and today the booming NT market remains only a small part of SGI’s business.

The Value and Difficulties of Integration

SGI’s experience is hardly unique. In fact, we have found that separated innovators almost always need to be reintegrated at some future point. (See “About the Research.”) For example, in one study we examined a sample of 31 ventures that companies spun off to address the challenge of the Internet. Some of the companies chose the separated approach after failing to develop the innovation internally. Others did so in order to capture the stock-market premiums that dot-com firms were then enjoying. Still others made that move because experts had advised them to. Regardless of the motivation, the results were the same. Of the 31 spinoffs launched from 1999 to 2000, none had survived as independent organizations by 2002. This does not mean that they all went out of business. In fact, about three-quarters of them were absorbed back into their parent companies. The reintegration, however, was often a difficult process that sometimes hurt the performance of both the parent and child.

In another study of the retail industry, we investigated spinoffs versus internal efforts and found that the latter were much more efficient at generating revenue. The differences were striking: Integrated operations were roughly three times as productive in terms of revenues per employee and revenues per marketing dollar. Companies that launched e-commerce through autonomous ventures encountered two layers of problems. First, by not leveraging their existing assets, they were much less efficient. So, for instance, the new ventures had to buy revenue rather than generate it from an existing customer base. Second, when it became clear that the independent units could not compete and the companies attempted to reabsorb them, they often had great difficulty because the autonomous groups had become too different in terms of technology, processes, people and relationships.

That said, the integrated approach is far from easy — which is why many companies avoid it. To be successful with internal projects, organizations must balance the old and the new businesses, while allowing both to flourish. Senior management has to support and encourage intense collaboration while extinguishing turf battles. The innovating team needs a strong leader who is respected in both the old business and the new unit, and its members must include people who are able to bridge the gap between the two. Lastly, the old business should have an architecture of systems and processes that allows the new business to be added easily, or the innovating team must build an architecture that enables increasing levels of integration back to the old business.

Relative Advantages

To appreciate the relative strengths (and weaknesses) of the separated and integrated approaches, consider the recent experience of the two leading drugstore chains in the United States: CVS Corp. and Walgreen Co. (Walgreens). In August 1998, both companies learned that well-funded startups were about to enter the market as online pharmacies. Threatened by that development, CVS and Walgreens responded with very different approaches.

Initially, CVS executives considered building their Internet store internally but then decided to look outside, and in May 1999 they bought a startup for $30 million. After the acquisition, CVS pretty much left that e-commerce group intact 3,000 miles away in Seattle, with its own president and all the functions it needed to be a self-sustaining business. CVS changed the look and feel of that group’s Web site and relaunched it as CVS.com just three months later. From the start, there were some links to the CVS bricks-and-mortar business: Online customers could pick up prescriptions at a store, the stores displayed signs promoting CVS.com, and CVS.com enjoyed volume discounts from suppliers by piggybacking its business onto that of its parent. Overall, though, the operations of the online and offline organizations were kept separate. For instance, because CVS chose not to change store-based systems to connect the online and offline businesses, online customers could not check the status of an order to determine if it was ready for pick up. Instead, they had to call the store or go there and take their chances.

Walgreens executives used a more integrated approach. To build their online site, they hired contractors for much of the initial development but also relied heavily on employees who were from the company’s traditional organization and were familiar with its approach to business and technology. The online team, located at headquarters, linked the Web site tightly to existing Walgreens systems for dispensing prescription drugs, processing health-insurance forms and checking the order history of customers. Consequently, from its launch the Web site provided customers with real-time access to the status of their orders, and they could elect to receive an e-mail when their prescriptions were ready to be picked up at a particular store. If an online customer chose instead to receive a prescription by mail, that order was handled on the same processing lines as the millions of mail-service prescriptions that Walgreens was already filling for its offline customers. Achieving such integration took considerable effort: Walgreens had to change its processes in more than 3,000 stores to accommodate its online business.

As expected, CVS launched its site earlier than Walgreens. For the first year it could handle orders for both prescription drugs and other drugstore merchandise, such as shaving cream, batteries and film. Walgreens, on the other hand, missed its launch date by six weeks. And when its Web site did go live, it could handle just prescription orders. Not surprisingly, the CVS Web site initially had substantially more visitors than the Walgreens site.

But CVS.com’s early lead was not sustainable. Managing processes and decisions across 3,000 miles and two distinct organizational cultures eventually became too expensive and unwieldy. The company decided to absorb CVS.com by moving it from Seattle to CVS headquarters in Rhode Island. In the process, CVS.com lost its most senior managers and reduced its staff by half. It also lost its marketing focus, and online traffic suffered as a result. In the two years since, CVS.com’s online performance has improved significantly, but the transition was painful because the two organizations were so different in many fundamental ways.

Walgreens, meanwhile, has continued to increase the quality and functionality of its Web site, all while consistently maintaining a close integration between the company’s online and offline organizations. Within nine months of launch, in-store pharmacists began taking people’s e-mail addresses, making them instant online customers who could order refills and obtain their full prescription and payment histories over the Web. When those people ordered online, the site could check drug interactions across all prescriptions that Walgreens had filled both online and offline. During tax season, they could use the Web site to print out a record of their purchases of prescription drugs for the previous year. And when Walgreens wanted to sell nonpharmacy products on its Web site, it modified the processes in an existing distribution center to fill the orders, thereby leveraging its existing infrastructure to allow a quick ramp-up. (Initially, CVS used a separate distribution center for its online business, which increased the company’s overhead costs.)

Choosing the Right Strategy

When an innovation first appears, companies are not sure whether it will succeed, and they are uncertain about the features to include and the pricing for them. As a result, firms jockey for position as they try different variations to explore the customer response. At this point, early in the life cycle of a new technology, the premium is on speed and learning — the ability to crank out new versions and revise them quickly.2

Here, the separated approach can be very effective, because innovators at an autonomous venture are typically fast and focused. But they can easily expend considerable resources responding to every whim of the marketplace. And they can be inefficient by reinventing the wheel, creating separate versions of infrastructure and assets that already exist in the parent firm. What’s worse, they can evolve increasingly farther away from the parent organization’s existing capabilities, making reintegration difficult (as was the case for CVS and SGI).

The integrated approach can be effective, too, because it uses resources efficiently, leveraging the skills, assets and infrastructure of the parent organization. It also allows a company to build synergies between the new and the old. But it requires considerable management attention and the right team members to remove organizational roadblocks and to resolve conflicts between the new and the old. This can be extremely difficult, which is why the integrated approach runs the significant risk of being unable to launch products at all. Typically, internal groups are also initially less agile than external ventures (as was the case for Walgreens).

Later in the life cycle, the situation is much different. As the innovation becomes more defined — and its impact understood better — there’s less value in being able to make changes quickly. By this time, customers have a much better feel for what they want, and companies have converged on a similar set of features in their products or services. Now the game is about delivering high-quality products or services at prices that customers are willing to pay. Here it’s important to be efficient in scaling up a business to meet increasing demand.

In the long run, the integrated approach usually outperforms the separated approach for two reasons. First, it can leverage more resources from the parent company. Second, the integrated approach is able to find solutions that combine new and old for the advantage of both. When Walgreens modified the processes in its stores to provide online customers with their prescription and insurance history over the Web, the company not only created a convenient self-service option, it also helped free pharmacists and clerks at the stores from performing that tedious task.

In comparison, the separated approach has far fewer advantages later in the life cycle. At that point, agility is not as important as efficiency, and the separated approach typically fails in that regard. Spinoffs have difficulty leveraging the advantages of their parent companies, especially when their organizational infrastructures, processes and cultures have deviated greatly. Any company that is considering a long-term separated strategy should ask itself the following: If there’s little value in leveraging your existing assets, why are you launching the venture in the first place? In other words, any innovating group usually must, at some point, eventually be integrated with its parent organization.3 Thus there are just three viable strategies for responding to an innovation: separated-integrated, integrated leader and integrated follower. (See “Three Strategies for Responding to Innovation.”)

Separated-Integrated

The separated-integrated approach blends the early hare with the later tortoise. It, however, is difficult to implement because it requires the right architecture for processes and systems and the appropriate set of rules for the new organization. From the beginning, the new business must be encouraged to use as much of the old organization’s assets as possible and to resist continually the temptation to choose its own path just because that’s easier than negotiating with the existing business. Otherwise, the new group will become increasingly different from its parent, making integration that much tougher later.

Consider Charles Schwab & Co. which used a separated-integrated approach for its online brokerage business. Initially, e.Schwab was set up as an independent unit reporting directly to co-CEO David Pottruck. This allowed the new venture to focus on fierce competition with E*Trade Group Inc. and Ameritrade IP Co., even if it meant taking customers away from Schwab’s traditional retail-brokerage business.

But e.Schwab was not free to do whatever it wanted. From the start, it obeyed a simple rule: Deviate from the traditional business only when it’s absolutely essential to meet the demands of the market. So the unit was led by a highly respected senior executive from Schwab’s retail organization and staffed with a mix of experienced Schwab employees, new hires and consultants. Moreover, e.Schwab’s technology platform was designed to integrate with Schwab’s IT systems: The Web essentially became a different front end for the parent company’s legacy back-end trading system and was integrated with other existing channels and PC-based applications — such as Intuit Inc.’s Quicken, Microsoft Corp.’s MSN and Schwab’s own StreetSmart. Last, but not least, e.Schwab was very careful not to alienate people from the traditional retail business. Managers from e.Schwab met regularly with their colleagues at the parent organization to resolve issues, and the process was facilitated by the fact that the two groups of executives already knew and respected each other, having worked together for years at Schwab’s traditional business.

Such tactical decisions had deep implications, including restrictions on pricing models (e.Schwab had to charge customers a fixed fee per transaction, instead of using more creative pricing approaches) and system architecture (new computer hardware and software had to be technologically compatible with existing systems). They also enabled e.Schwab to leverage its parent’s traditional assets and capabilities from the outset. The strategy worked. By January 1998, e.Schwab was the most successful online broker in the United States.

In early 1999, though, Schwab realized that it had to integrate its online and offline businesses. A major problem was that e.Schwab customers were complaining that they couldn’t walk into a Schwab office and have access to their accounts to conduct any transactions. But in combining the two operations, Schwab did not encounter the same kinds of problems that CVS did. From the outset of its online project, the company had no definite plans to reintegrate e.Schwab, but it had wisely built in an option to do so. Because of that, it had paid careful attention to aligning the new business with the old, which made the later reintegration process relatively quick and painless.

The separated-integrated approach can be the best option for companies that lack the organizational will and momentum to mount an internal effort. Particularly when the full impact of an innovation is uncertain, the existing business often has difficulty getting motivated because it’s unsure whether it will be affected. Like Schwab, though, companies that choose a separated-integrated approach must constantly question any divergence from the old business and continually build bridges to ease the future reintegration process.

Integrated Leader

Entering early with an integrated approach can be very effective but risky. Unless managed properly, integrated efforts can stall because of conflicts between the new and the old businesses or simply because of inertia in the organization. And even when internal projects do get off the ground, they tend to proceed slowly. But they also have the potential to outperform autonomous ventures over time because they can utilize resources more efficiently by leveraging their parent firm’s existing assets. To accomplish that, a company following the integrated-leader path must ensure that the project has a well-respected full-time manager and considerable management attention. Team members must have expertise in diverse skill sets, deep knowledge of the existing business and interpersonal links they can use to resolve conflicts and identify creative synergies.

Walgreens was successful with an integrated-leader strategy, but more than half of the incumbent pharmacy retailers that used that approach were unable to launch a competitive online pharmacy in their first attempt. Those online ventures sputtered along until they were reorganized with the right level of skills and management attention. One reason for the Walgreens success was the commitment and constant involvement from the CEO down to the people in charge of the effort. For example, the project was initially led by a well-respected executive who was trusted to look out for the interests of Walgreens as a whole. That individual was effective in making informal connections between the online group and the rest of the company. In addition, Walgreens held monthly meetings of the top 12 managers in the company to ensure that the offline business units always knew what the online group was doing so that they could better help each other. Interestingly, the nature of the conversations in those meetings changed over time. Early on, the offline executives used to feel burdened by requests from their online counterparts. Now, they view the online operations as a potential tool for improving the traditional business.

Integrated Follower

Entering later in the game with an integrated approach can be particularly effective when an innovation appears to be disruptive but its viability is uncertain. Often, companies are better off waiting for the technology to take shape before making their move. Then, once they do decide to act, they can build a stronger business case, which will enable them to obtain important buy-in from people throughout the firm. That kind of organizational momentum is crucial for making changes in the old business so that it can coexist with the new.

Consider investment powerhouse Merrill Lynch & Co., which was slow to adopt online trading, an innovation that enables customers to buy and sell stocks and other financial instruments without the help of professionals. One major reason for Merrill’s delayed action was the company’s value proposition of generating world-class research delivered personally to clients by 14,000 financial consultants. Thanks to those professionals, the company could charge high trading commissions that accounted for as much as 65% of a financial adviser’s salary. This system had always been problematic — the financial incentives sometimes motivated the wrong behaviors in employees — but it had historically been very resistant to change.

Eventually, faced with increasing competition from organizations such as E*Trade — and a year after Schwab had already made its move — Merrill management acted. But in doing so, it didn’t take the easy route of launching an external venture that could compete in online trading without requiring any changes in Merrill’s existing operations. Instead, it established an online channel within the traditional business, and the company used that initiative as an opportunity to fundamentally rework its existing system.

Merrill announced two products: Unlimited Advantage, which charges customers an annual fee based on a percentage of their portfolio value (with members receiving free financial advice and an unlimited number of transactions), and the Web-based Merrill Lynch Direct, which charges $29.95 per online trade. The new products were integrated with the company’s existing operations and IT infrastructure, offering both new and old customers a complete menu of choices for trading and asset management.

The products were extremely effective in neutralizing the advantages gained by Merrill’s faster-moving competition. Perhaps more important, Merrill’s move to online trading enabled the company to change its traditional ways of doing business, including its problematic compensation structure. Now the incomes of the financial advisers are based on a percentage of the assets they manage, which tends to motivate behavior more aligned with the interests of customers.

The integrated-follower approach can succeed for two reasons. First, as it turns out, few innovations change an industry overnight, so many leading firms can afford to bide their time. But waiting doesn’t mean ignoring. Incumbents should use the time wisely to understand what would be needed if they were to act. Merrill studied online trading extensively, including surveying online and offline customers at different points in time. It acquired a smaller firm to get key technology and online trading knowledge. Then, it used what it had learned to assemble a strong product mix, all while building a powerful internal case about the need to act.

Second, once a company does decide to make a move, it needs to do so with conviction from the top down. After David Komansky, chairman of Merrill Lynch, made his announcements championing the project, all employees knew the new direction that the firm was taking. The point was punctuated when former Internet nonbeliever Launny Steffens was tapped to lead the effort. Merrill was going to change its entire organization, and senior management wasn’t going to tolerate anything (or anyone) that stood in the way.

Competing for the Long Haul

We believe that our findings have general applicability and that the lessons of SGI, CVS, Walgreens, Schwab and Merrill are relevant to companies in a variety of industries. For example, many providers of financial services have tended to launch new products through autonomous units. They might have separate units for life insurance, property and casualty, retail banking, commercial lending, retail brokerage and private-wealth management, for instance. However, those companies have increasingly found that such businesses need to be integrated, allowing them to share back-office infrastructure and to cross-sell products. So, for example, a company could then make special offers of life-insurance coverage to people who have just taken on a mortgage for a new home, or could provide checking accounts to brokerage customers.

Even Johnson & Johnson, well known for its autonomous operating companies (192 at last count), practices a significant amount of integration. From its inception, each of those operating units is encouraged to use centralized IT services. In addition, many of the marketing-focused operating companies will utilize R&D and manufacturing services from other operating companies. J&J has even created sector-level organizations to build synergies among different operating companies in the same industry.

The overall message is clear: The effectiveness of an incumbent’s response to changes that could disrupt an industry should be measured not necessarily by speed but by overall impact. And impact, for established firms, typically comes from their ability to integrate new technologies and practices with their existing assets and capabilities. Completely autonomous ventures may win sprints, but integration wins marathons, and to remain competitive, companies should avoid the pursuit of short-term gains that will sacrifice their effectiveness over the long haul.