Managing Small- and Medium-Sized Enterprises (SMEs) – Lessons from the Delta Model

Abstract

Most of what we have discussed in this book applies without much adaptation to any kind of organization. After all, every firm, regardless of its nature and specific circumstances, has customers and competencies – the two pillars of the Delta Model. However, there are two types of organizations that, because of their importance and singularity, deserve special attention. They are the small- and medium-sized enterprises (SMEs) and the not-for-profit organizations (NFPs). We will devote the next two chapters to the analysis of these institutions, examining what lessons can be derived if we approach them from the perspective of the Delta Model.

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Most of what we have discussed in this book applies without much adaptation to any kind of organization. After all, every firm, regardless of its nature and specific circumstances, has customers and competencies – the two pillars of the Delta Model. However, there are two types of organizations that, because of their importance and singularity, deserve special attention. They are the small- and medium-sized enterprises (SMEs) and the not-for-profit organizations (NFPs). We will devote the next two chapters to the analysis of these institutions, examining what lessons can be derived if we approach them from the perspective of the Delta Model.

The Importance of SMEs

There is no uniform and widely accepted definition of what constitutes an SME. The standards vary from country to country. Typically, SMEs are defined by an upper limit in the headcount and/or the sales revenues. An agreement is emerging, particularly within the United States, to classify a company as small if it has less than 50 employees and medium if the headcount is below 250. This gives you a sense of what kind of organization we are addressing here.

Regardless of its definition, we know that the overall impact of SMEs is overwhelmingly large. Uniformly, 95–99% of the total companies in any country are SMEs; they employ between 40% and 60% of the workers; and they contribute between 40% and 50% of the GDP. In addition, they play a central role as a leading source of innovation and creativity.

For these considerations, we feel the SMEs deserve special treatment.

The Challenges of Managing SMEs

We believe that the Delta Model can guide us in defining a successful strategy for SMEs by looking at how an SME can adopt each of the strategic positions represented in the Triangle.

It may seem odd that most of the examples that we use in this chapter are large, successful companies. We do this for two reasons. First, at one point, all companies were small, and it is interesting to understand how our chosen examples were able to make the successful transition from very embryonic companies to the large organizations they became. Second, we want to use companies that are universally well known to greatly simplify the communication process.

The Best Product Strategy

Generally, SMEs are born with a product-centric mindset. Typically, the founder is an entrepreneur with a smart idea that has some potential to be developed into a successful business. This idea – more often than not – is based upon a product that is judged to have unique attributes that make founding a business on the initial product concept to be attractive. When you accept this premise – which we find quite prevalent – it means that at least in its early stages of development, the relevant strategy followed by an SME is the best product option.

Unfortunately, if this is the case, most SMEs start with a very shaky foundation. Why is that? Remember that there are two ways to develop a successful Best Product strategy: low cost or differentiation. The problem is that most SMEs do not have the cost infrastructure that allows them to compete effectively with large corporations or with cheap imports, which means that the low-cost strategic position is either non-viable or inaccessible. With regard to differentiation, we find a seemingly insurmountable obstacle. Remember that a differentiation option does not imply only that the product is somehow unique. It also requires that the customer both recognize this uniqueness and is willing to pay a significant premium for it. This is not easy for an SME to accomplish.

From what we have said, it might be easy to conclude that for an SME to play the Best Product strategy is a sure recipe for certain failure. This is the great dilemma. SMEs almost invariably are Best Product oriented, and that seems to lead nowhere. Therefore, it is not surprising that there is such a great mortality rate among SMEs. The statistic varies from country to country but about 90% disappear in a very short time span.

What can we do? Abandoning the Best Product position is not the obvious answer because, as we have demonstrated throughout this book, the other strategic options – Total Customer Solutions and System Lock-In – not only are more demanding, but they also require the solid foundation of the Best Product positioning. Let us look into this a bit further.

The Low-Cost Positioning

The major issue with this strategic positioning is how an SME, which does not have access to major economies of scale, could compete with those who do. The answer resides in two very critical qualities that the cost infrastructure of a successful SME strategy should possess: modularity and scalability. Modularity means that we are able to operate extremely effectively with small quantities, which implies that we do not need large economies of scale to be productive. Scalability means that we can expand the volume of our operations by reproducing the same successful modular format, while maintaining our cost-effectiveness without constraining our possible growth.

A remarkable example of the effective use of these two attributes is Southwest Airlines, a company that has experienced 36 uninterrupted, consecutive years of profitability in an industry where most of its competitors have dismal performance or are facing bankruptcy. The winning formula is easy to describe: they fly to secondary airports of major cities to avoid crows and delays, using only one type of aircraft, the Boeing 737, to reduce training and maintenance costs; while offering lowest prices and no-frills service. In 1971 they started serving three secondary airports in Dallas, Houston, and San Antonio, with three 737-200 planes. As they increased in popularity, growth became an easy task by gradually adding new cities in secondary airports, and more Boeing 737s to their fleet.

In Southwest Airlines, we can detect unequivocally modularity and scalability in action! We believe that every SME should pay close attention to these two basic requirements to define the proper cost infrastructure. If you do, you can compete effectively with the large established firms, sometimes from a position of strength. How can American Airlines and United Airlines – to mention the two largest airline companies in the United States – counteract the winning formula of Southwest Airlines? The fact of the matter is, they cannot. By establishing a new and effective way to operate the company from the outset, Southwest enjoys a 20% cost advantage over their large rivals, which is unassailable.

If you do not pay attention to the requirements of modularity and scalability, you are going to face a very steep uphill battle to succeed with a Best Product strategy.

The Differentiation Strategy

We know that differentiation is both hard to establish and, even worse, extremely difficult to sustain when it is only based upon the characteristics of the product itself. This involves another great challenge for an SME seeking a Best Product strategy. What is the way to resolve this dilemma? The answer sounds very trivial but we believe it contains some elements of wisdom: Do not directly confront an important competitor; search for niches where you can occupy a secured space that can be filled by creativity and originality.

A company that excelled in this dimension was Digital Equipment Corporation (DEC). It was founded in 1957, and in a very quick time span, about 10 years, became the second largest computer company in the world, after IBM. DEC invented the minicomputer, and it provided individual users an opportunity to “own” such an important device for the first time. Initially, its customer base was intended to be engineers and scientists, who were to develop their own software applications. Consequently, DEC concentrated all its innovative capabilities in designing and manufacturing the unique hardware needed to support its sophisticated customers. In the process, DEC never directly confronted IBM, which was busy establishing a dominant position in the mainframe computer segment. DEC’s creativity was spectacular, legendary. It produced an unrelentingly stream of products – PDP1, 2, 3, …, and 16 – that enhanced the performance of its predecessors but was fully compatible in terms of software applications. By doing so, DEC produced enormous entry barriers to any possible competitor. In fact, during a significant period of time, DEC totally dominated the minicomputer market. It was only after the creation of the microcomputer – introducing the personal computer industry – when this domination began to be challenged.

DEC was a brilliant company which unfortunately was not flexible and adaptable enough to face the challenges emanating from a changing environment. As IBM seemed not to understand the huge impact of the minicomputer, DEC was oblivious to the challenge of the microcomputer. The moral of the story is that you cannot stick to a winning formula forever. To make the tragic ending of DEC almost ironic, Compaq bought DEC in 1998 – at the time, one of the leading PC companies. The triumph of Compaq, however, was short-lived because in 2002 Hewlett-Packard ended up acquiring it.

To conclude, Fig. 9.1 shows the position in the Triangle of the two companies we have discussed in this section – Southwest Airlines and DEC; Fig. 9.2 summarizes the implications of the Best Product strategy for the SMEs.

Fig. 9.1

The triangle: the positions of selected SMEs following a best product strategy

Fig. 9.2

SMEs and the best product strategy

The Total Customer Solutions Strategy

It might seem obvious – and therefore unnecessary to point out – that the customer is the driving force to every business. Nonetheless, because of the extreme product-centric mentality that resides in most SMEs, this basic fact of life is taken for granted and not been recognized as a central management concern. Thus, SMEs are born in a state that is fairly vulnerable for commoditization, because the customers are not targeted in a different way and are regarded as a single, amorphous mess. We have insistently warned against the dangers of commoditization and explained why it is such an undesirable state for a business. If this can be a serious cause for lack of performance in a large corporation you can well imagine how devastating consequences could be for an SME, which inherently faces much more challenging environments. Our claim is, therefore, that from the outset an SME should become customer-centric mentality and offer a value proposition that has the four attributes we have identified in previous chapters of this book: it should be unique; it should be hard to imitate and be substituted for; it should produce significant value added both for the customers and the firm; and, consequently, it should generate unbreakable customer bonding.

This, of course, is easier said than done. To help understand how the SME can adopt a Total Customer Solutions strategy, we will review the three positions which are relevant to this approach: Redefining the Customer Experience; Customer Integration; and Horizontal Breadth. Once more, we will be using examples of large companies that succeeded in the difficult transition from their origins as an SME.

Redefining the Customer Experience

This task is probably the most demanding and the most important for achieving a Total Customer Solutions strategy. It involves not only knowing your customer base deeply and what their needs are, but also approaching the customer with a different and exciting offer that differentiates you from the rest of the field. One of the most brilliant examples illustrating this point is the entry of Dell in the personal computer (PC) industry. Michael Dell, then a freshman at the University of Texas at Austin, founded the Dell Computer Company in 1984 with $1,000 in capital that he had borrowed from his parents. By that time, the PC industry was fairly mature, with extremely strong companies – such as IBM, Hewlett-Packard, and Compaq – engaged in strong rivalry. However, the key players in the industry were not the computer manufacturers but two leading suppliers: Microsoft and Intel. These two companies had developed Wintel, the industry standard, consisting of the Windows operating system, made by Microsoft, and the computer chip, made by Intel. As a result, the PC business was considered a complete commodity and all of the players were experiencing losses or dismal profits. Who could have possibly considered entering into the PC business under these seemingly impossible conditions? Michael Dell did, but he deviated in three fundamental ways from the industry practices:

First, Dell configured each PC according to the individual specifications of the customer. Far from being a commodity, the computer would differ widely in processing speed, memory capabilities, portability, software configurations, modem speed, and screen sizes – to mention just a few options. Surprisingly, the first customers of Dell were major corporations such as Exxon and Mobil, which needed not off-the-shelf computers but properly designed systems and solutions to satisfy their specific needs.

Second, Dell decided to sell directly to the final customer, by-passing all the intermediate channels – retailers, distributors, and value-added resellers. This allowed him to eliminate the mark-up required by the channels – which significantly reduced his total cost – and, most importantly, he gained direct access to the customer. It is well known that who owns the channel, owns the customer relationship. Figure 9.3 presents the contrast between Dell’s Direct Model and the distribution model employing indirect channels used by the other PC manufacturers. The difference has gigantic consequences. Dell targeted major business corporations, those requiring the customized solutions. The singularity of that offer gained Dell an enormous degree of customer loyalty and customer bonding. The other manufacturers have the channels as their customers, and they, in turn, own the end-user interface. As a consequence, the commoditization of the PC became a fact of life for the other PC manufacturers, and there was no way to differentiate and gain customer loyalty.

Fig. 9.3

The contrast between Dell and the other PC manufacturers distribution model

Third, from the very beginning, Dell decided to embrace a strong relationship between itself, its customers, and key suppliers. This is what we call the Extended Enterprise. Figure 9.4 describes the nature of the relationship among the key players.

Fig. 9.4

Dell’s extended enterprise

Obviously, it took time to consolidate what is referred to in the figure as the “Virtual Integration” of customers and suppliers. But this was the form of operation that was pursued from the early states of Dell’s evolution. It was facilitated by the use of Internet technology that allowed both the full integration of a relevant network of players, as well as the treatment of each customer with a totally unique value proposition that satisfied the specific need of each one.

The contrast with the PC manufacturers was outstanding. Dell targeted individual customers to offer customized solutions; the opposite was the case with the commoditized offer of the PC manufacturers. Dell established a strong cooperation among the key players, while the remainder of the industry was fragmented and engaged in serous rivalry. Dell was using direct channels; the other PC manufacturers were relying on indirect channels.

The results of the unique positioning of Dell in the PC industry were outstanding. In the first year of business, Dell’s revenues exceeded $70 Million. During the 1990 s, Dell became one of the fastest growing companies in America. In the long-run, Dell became the only profitable company in the industry.

Dell is a perfect example of how to pursue a successful and original Total Customer Solutions strategy: targeting the customer individually offering a unique customized value proposition, while seeking the support of the Extended Enterprise in its implementation.

Customer Integration

The second task to accomplish the Total Customer Solutions strategy, which, incidentally, Dell fulfilled exceedingly well, is customer integration. The idea is not just to offer a product alone, but to transfer to the customer some expertise, knowledge, or capabilities that allow the customer to perform better in its own business. If an SME can develop this kind of attribute in its value proposition from the start, the degree of customer bonding is greatly enhanced.

The case of DMK, which we discussed in detail in the previous chapter, is a good illustration of an SME that has customer integration from its birth to solidify a strong strategic positioning. DMK is a Chinese company that uses the language and cultural affinity of their citizens of Japanese ancestry – who have developed expertise in mainframe computer technology – to outsource information technology services to Japanese corporations at extraordinary competitive prices.

Try to nurture and develop unique expertise from the very beginning of the SME, and you could have the basis for a successful business.

Horizontal Breadth

Achieving horizontal breadth means that the firm is able to provide a complete set of products and services that satisfy all the needs of the customer in the particular field in which the firm operates. It will be extremely unlikely that an SME would be able to deliver this feast all by itself. It is in this situation where the complementors play an important role. The main question, however, is who is complementing and who is being complemented? In other words, who is playing the leading role in this initiative? Most likely the SME will be the complementor to a large organization. This, however, is far from being a demeaning role; in fact, sometimes it is essential for the SME’s survivability that it aggressively seeks a constructive and enduring association with a major partner that could benefit from some singular capabilities the SME could provide. This kind of cooperation is commonly encountered in technology-intensive industries, where small companies can begin to experiment with innovation in areas that could have enormous future potential and can add significant value to a large organization in need of that expertise. Often, these relationships end up with the large company acquiring the small one – which, again, is not such an undesirable outcome. The owners of the SME normally receive a handsome financial reward and still remain in the larger organization, this time enjoying much more abundant resources and capabilities to push the original business idea to its full, successful potential.

Cisco is a company that has distinguished itself for adopting this practice in quite effective ways. It has been said that Cisco has replaced the traditional R&D activity, meaning the internal process of Research and Development, with a more singular A&D, meaning Acquisition and Development strategy. The idea is to target small companies working in the advanced technological edge of their fields, buy them, and integrate them into the major Cisco organization without disrupting the freedom and creativity of the acquired SME. It is a win-win approach to technology procurement.

To conclude, Fig. 9.5 shows the position in the Triangle of the three companies we have discussed in this section – Dell, DMK, and Cisco; Fig. 9.6 summarizes the implications of the Total Customer Solutions strategy for the SMEs.

Fig. 9.5

The triangle: the positions of selected SMEs following a total customer solutions strategy

Fig. 9.6

SMEs and the total customer solutions strategy

The System Lock-In Strategy

A firm that has reached System Lock-In enjoys an uncontested dominance in the market place; it possesses what is commonly referred to as monopolistic power. Needless to say, this is the most coveted strategic position you could ever aspire to achieve, which guarantees extreme customer bonding, spectacular financial performance, and – unless something highly unpredictable takes place – an enduring sustainability. As expected, this is a most demanding accomplishment that only few firms can claim. How could one pretend, therefore, that a System Lock-In could be a possible strategic positioning for an SME? The obvious answer is that a System Lock-In is extremely unlikely to be obtained by a small upcoming company. Nonetheless, it is important to address in this section for two reasons. First, it could be very useful to think about this option as a final objective, even in the most embryonic stages of a company development, because it establishes an ultimate aspiration that can influence the trajectory we follow in a most constructive way. Not only are we aiming at having an exceptional product – supported by an intelligent cost infrastructure founded on the principles of modularity and scalability; not only are we recognizing from the outset the centrality of identifying our intended customers, and providing them with a unique value proposition; but we also are asking whether there is something that we could begin to do to seize and make opportunities for System Lock-In. It is the mindset that we want to create to manage the business in search of leadership. Second, although a System Lock-In cannot be consolidated for the overall network in which we operate, it might be achievable one customer at a time. As we have said before, System Lock-In is all about barriers – barriers for our customer to exit from us, and barriers for the competitors to enter our customer base. If we have this objective clear in front of us, we might in fact be able to aspire and gain System Lock-In gradually, customer by customer. Let us be more specific by analyzing each of the strategic positions associated with our System Lock-In option.

Restricted Access

This is a kind of System Lock-In that can be acquired by targeting one customer at a time, as we have indicated before – by encircling the customer with barriers of entry and exit. The paramount example of how to carry this strategy to successful completion is Wal-Mart, which today is the largest employer in the United States with annual revenues above US$400 billion. Sam Walton founded the company in 1962 and carried out a very focused strategy: to open stores in rural areas with populations below 25,000, where no discount retail stores were in existence. By moving it into these towns, Wal-Mart assures a de facto monopoly on retail activities in areas within a 25-mile radius.

What is remarkable is to realize how long it took for Wal-Mart to consolidate its dominance. Its relevant competitors were K-Mart and Target, because they use similar approaches to the retail business by heavily discounting prices in their department stores. The three companies – Wal-Mart, K-Mart, and Target – were founded in 1962. Figure 9.7 tells us this incredible story. You could see that K-Mart enjoys a very quick start; in 1966 it reaches more than $600 million in sales, while Target only has $85 million, and Wal-Mart an unimpressive $6 million. During 1970, 1975, and 1980, the superiority of K-Mart, and secondarily Target, over Wal-Mart is quite impressive. It is only in 1985 that Wal-Mart surpasses Target; and it takes until 1990 – 25 years! – for Wal-Mart to assume the leadership position. However, these numbers can be very misleading. What is important to understand is that every store in Wal-Mart’s column is a quasi-monopoly, sustained by a System Lock-In position; while K-Mart and Target are competing against each other in highly contested urban areas. K-Mart filed for bankruptcy in 2002 and merged with Sears in 2005, a de facto disappearance as a company. Figures can be deceiving. The overwhelming strength of Wal-Mart was there all along; it took time to make it from a rural, into a regional, and finally into a national dominance. Now they are expanded globally!

Fig. 9.7

The evolution of the three major discount stores: Wal-Mart, K-Mart, and Target

Wal-Mart was a very small company at the beginning – as all companies are – by playing the System Lock-In strategy at the store level, and expanding by using the modularity and scalability concepts that we have discussed in this section, Wal-Mart became one of the most successful companies that has ever existed.

Dominant Exchange

Think of the companies that have acquired dominance in their respective markets – Amazon, eBay, Google, Yellow Pages, Sotheby's; all of them provide a critical interface for their customers that is unique and very hard to substitute. The exchange connects buyers and sellers providing an option that is not available by any other alternative. It constitutes a most powerful way to achieve System Lock-In, but is not an option very accessible for a small firm. As always, there are exceptions to any rule, and Amazon is perhaps one of the most outstanding examples of a small company that was born with the intent of establishing a Dominant Exchange. Jeff Bezos, the founder of Amazon, thought that the Internet provided opportunities in retailing, but was not clear what that business could be. Then it occurred to him that books represented an ideal target; they were products that people could buy without the need to touch or try them. He developed a business that from the beginning was positioned quite distinctly from the conventional bookstore, particularly in terms of convenience and breadth of offering. While a large bookstore could accommodate a rather limited number of items in inventory, Amazon could offer more than a million titles. The first 300 employees of Amazon were almost exclusively information technology specialists who worked on the development of the exchange – bringing publishers, who want to sell books – to readers, who want to buy them. In addition, these specialists designed a system that registered the past history of purchases of each individual customer so Amazon could suggest a customized recommendation of new titles to buy. This is the basis of the Dominant Exchange: building a bridge between buyers and sellers, and offering a unique and customized value proposition. Amazon subsequently expanded into a wide, diversified set of product lines – music, computer software, DVDs, video games, electronics, apparel, furniture, food, toys – there seems to be no end to what they can offer to the client. In addition, they created the Extended Enterprise by establishing exclusive partnerships with other retailers to incorporate them into the web – such as Target, Sears Canada, Benefit Cosmetics, Timex, Mark and Spencer, Toys-R-Us, etc. Now Amazon is a remarkably successful company with over $19 billion of sales.

This story is not easy to replicate, but it is important to reflect on the benefits of providing system support to your customer base, even if you can only do it one customer at a time.

Proprietary Standard

Of all the ways to achieve System Lock-In, Proprietary Standard is usually the one that provides the highest and most enduring rewards; think of Microsoft and Intel, that constitute the ultimate paradigm in this field. As can be expected, this is also the most elusive and most difficult strategic position to capture. In fact, most industries do not have standards, and those that do, do not have proprietary ones. It is therefore almost presumptuous to address this topic in the context of a viable strategy for an SME.

However, if you are in a situation when – even remotely – you could have a chance to develop an appropriate standard for your industry, it is imperative that you are alert to this option, consider it as an ultimate goal, and take the necessary steps to accomplish it.

I can recall only one personal experience in this area. I was a consultant for PictureTel, a company founded by engineers with MIT connections and that became the leader in the videoconferencing business. From the outset, I was concerned not only with excelling in our immediate business, but also with attempting to develop the standards. In 2001, PictureTel was acquired by Polycom, which was started by former employees of PictureTel. We discussed this company in Chapter 4, where we contrasted it with Sony. In that chapter, we noticed that Polycom did indeed develop the communication protocol that all firms in the industry have to adopt. It was not impossible, after all!

To conclude, Fig. 9.8 shows the positions in the Triangle of the three companies we have discussed in this section – Wal-Mart, Amazon, and Polycom; Fig. 9.9 summarizes the implications of the System Lock-In strategy for the SMEs.

Fig. 9.8

The triangle: the positions of selected SMEs following a System Lock-In strategy

Fig. 9.9

SMEs and System Lock-In strategy

Final Comments

We have purposely used throughout this chapter examples of fairly successful and large companies to draw some lessons from their winning performance, as well as their remarkable evolution from initial SME starts to organizations of great prosperity. We should bear in mind that it is much more likely that an SME will fail than succeed. That is exactly why we believe it is mandatory for an SME to have a carefully laid out strategy from the very beginning, rather than being carried by the prevailing forces of the industry.

A winning strategy for an SME is not an easy pursuit, but it could be a highly exciting and rewarding task. Much has been said about the inherent weaknesses of SMEs because of their limited size and influence. However, those weaknesses can be transformed into major assets. While it is true that SMEs do not have large economies of scale and negotiation power, they enjoy enormous flexibility and the adaptability to respond effectively to changes in the external environment, giving them the potential to be enormously creative and innovative. It is also claimed that SMEs have difficulty in attracting top talent. This is easy to reverse. On the contrary, it is the large corporations that project an image of large bureaucracy that are not viewed as attractive places to work anymore. SMEs, particularly if they use intelligent incentives, profit sharing, and equity partnership mechanisms, are in an exceptional situation to attract young, creative talent. Therefore, not everything is working against the SMEs; one could say that it is quite the opposite.

We hope that the examples we have offered on the application of the Delta Model to small and medium enterprises can be of assistance in defining a winning strategy. We feel that the dangers of commoditization – that we have been constantly addressing in this book – are even more devastating to a small company, for whom differentiation is the key to survival. Also, majority of the SMEs need to grow to allow them to reach a size that allows future stability. These are two major concerns that most affect the SME strategy.