REVOLUTIONARY THINKING.

Business strategy in the "new" economy

The above observation, while perhaps somewhat cynical, is rooted in the fact that over the last three volatile decades, economic forecasting has indeed been an uncertain exercise which has defied conventional wisdom. A case in point is our experience since the early 1990s, when the conventional economic scenario based on the historic business cycle with its expectation of a "boom" followed by a predictable "bust" has proven to be wrong. Rather, the duration and strength of the economic growth cycle has exceeded expectations by far, breaking previous records.

Despite this growth and even a labour shortage in the U.S., the increase in inflation, which could normally be expected under these circumstances, has not materialized and consequently, the interest rates have remained relatively low. The stock market has reached historic highs and consumer spending has reached the levels where it exceeds income but consumer confidence remains high. There has been unprecedented surge of entrepreneurship and new business start-ups supported by a strong flow of venture capital. These have created a legion of new millionaires and even billionaires.

These developments, particularly the unusual combination of prolonged strong economic growth without significant inflation, have left economists scrambling for an explanation. The new conventional wisdom has become that we are in a new economy where the old rules no longer apply and that we can look forward to a long period of uninterrupted economic growth. Some investment analysts have proclaimed the existence of the "new paradigm" to explain why the traditional rules for valuing stocks are obsolete and why the current lofty prices of stocks are justified.

The advent of this new economy is almost universally attributed to the emergence of information technology, which has transformed our basic economic structure. To understand the implications of what is happening, we must examine both the historical precedents and the specific effects of these developments.

The historical context

The term "new economy" could have been used a number of times in history. It describes a period in which there is discontinuity in the normal progression of economic events that is the result of a fundamental change in the structure of the economy. This has usually been caused by technological change. Here are two earlier examples of such major discontinuities:

* In the 1800s, the "industrial revolution" resulted from the advent of steam power, which made possible both the mechanization of production in large, centralized factories and the railways and steamships necessary to take this mass production to the larger markets that it required.

* In the late 19th century, electrification freed manufacturing from the constraints of the cumbersome central power source and accelerated the mechanization of production, ultimately making possible the assembly line which was essential to mass production. This in turn led to the inexpensive automobile that changed lifestyles and the tractor that provided the major improvement in farm productivity, which made available the labour force necessary for rapid industrial growth.

In both cases, the improvement in productivity provided by the mechanization of a craft-based economy and the efficiency of the assembly line in manufacturing led to rapid growth of the economy. This was facilitated by cheaper transportation. This economic growth was enhanced by the investment spree required to create the new industries and their supporting infrastructures. Over a period of years, the economy made a transition from one state to another. In each case, technological developments created a "new" economy.

The current situation, based on the advent of information technology, is another such transition that can be described as a third industrial revolution although its effects are not likely anywhere near as profound as were the historical examples. Its implications can be understood by examining its direct effects.

Effects of information technology

To begin, let's define what "information technology" does. It can electronically gather data from various sources, transmit it, process the information in accordance with defined specifications and feedback results, and adjust or control processes according to new conditions. These capabilities are derived from the various uses of the microprocessor and developments in telecommunications. But IT has an incredibly broad range of applications and impacts:

* It has significantly increased the productivity of labour in both manufacturing and clerical functions. Manufacturing has been automated by computer control of machine tools and robots. Computerization has automated the clerical functions in virtually every aspect from banking, accounting, and order processing, for example. Internet banking, for instance, is almost 90% cheaper than its conventional predecessor. It has also created excess production capacity in virtually all industries.

* It has improved the efficiency of the utilization of capital by making possible better asset management allowing fewer dollars to do more work. This has been particularly apparent in inventory control where just-in-time (JIT) practices have become the norm in virtually every industry from retailing to manufacturing. The automated checkout of a Wal-Mart store is directly connected to a supplier via satellite, assuring an orderly flow of goods with no stock-outs despite a low level of inventory.

* It has created new industries and destroyed others, and changed the fundamental economics of many industries by increasing or decreasing the need for economies of scale.

* It has significantly narrowed the scope of company operations by facilitating outsourcing. Nobel laureate Ronald Coase pointed out in his landmark 1937 paper, The Nature of the Firm, that companies were vertically integrated because the cost and complexity of negotiating and administering multiple contracts outweighed their benefits. The computer and communications technology have made multiple transactions manageable and reduced their cost to the extent that companies are able to concentrate on their core capabilities and tap multiple sources of supply. This outsourcing has increased bargaining power with suppliers which is difficult to achieve with internal sourcing, thereby lowering costs and freeing capital tied up in internal operations. Automobile companies, which were once highly integrated to the extent of accounting for 80% of the value of the product, now provide less than 30% and have become product developers, assemblers and marketers with components supplied by a wide range of suppliers.

* The sourcing of goods and components has become global, making geography irrelevant. Drawings and specifications can be instantly transmitted and orders tracked. As a result, virtually all labour intensive manufacturing of standardized consumer goods such as shoes has moved offshore to low wage countries.

* Capital markets have become global and more efficient. The ability to complete transactions and move money electronically to virtually anyplace in the world makes capital available where it can be most efficiently used.

* The personal computer and the Internet have provided a new medium for interactive communication. It has become an alternative channel of distribution for goods and services.

* It has increased the speed of business in virtually all functions from product development to delivery, forcing companies to restructure their organizations to be able to respond quickly.

The cumulative effects of these developments explain the characteristics of the new economy, which can be summarized as follows:

1. Productivity improvements, excess production capacity and competition from low wage economies have kept inflation in check and consequently, interest rates down.

2. Low interest rates have helped to sustain the growth of consumer expenditures, particularly consumer durables.

3. Major investment in information technology, both hardware and software, have contributed to the growth of the economy. Information technology is currently absorbing about one-half of expenditures on capital equipment. Further, the high level of these capital expenditures has been sustained by the rapid technological improvement, which has prematurely made earlier equipment obsolete and has forced replacement.

4. Low interest rates and increasing corporate earnings from economic growth have spurred the stock market to its new highs. This has created wealth, which shareholders have shown willingness to spend even before it has been realized.

Information technology cannot take sole credit for these developments. Such advances in transportation technology as low cost airfreight and containerization have also facilitated globalization, which have reduced delivery lead times. Governments have contributed by adopting freer trade, deregulating key sectors of the economy and adopting more prudent fiscal policies. The central banks have played a role through more effective monetary policies.

In assessing this "new industrial revolution," we must keep in mind an important difference between it and its predecessors. In the earlier revolutions, there was a profound change in the industrial process, that is, in the way that goods were produced and distributed. In our current revolution, the change is primarily in procedures, that is the way in which we are doing the work. There is no basic change in the services which we use, be it stock brokerage, retail sales or even education -- only in the way that these services are delivered. In television terms, the previous revolutions can be compared to changing channels. Currently, we are only fine-tuning.

One of the sources of misunderstanding information technology comes from the fact that we speak of the "information society" as if information or knowledge is the end in itself and is by itself the source of value. You cannot eat information, wear it, ride in it, nor will it deliver the goods that you require. Information is only raw material and its value arises from the use to which it is put. For business management, the information must be placed into a context that allows judgements and skills to be applied and decisions made. This context may be day-to-day operating decisions such as efficient production scheduling or long-term strategic decisions such as those required in the allocation of resources. Without these analytical and decision-making skills, information by itself has little value. To speak of information or knowledge as alone providing the foundation for a national economy is therefore a gross exaggeration.

Implications for business strategy

By now, most companies have adopted productivity-enhancing information technologies in their production, administrative and asset-management functions as a primary strategy, and have taken advantage of the economies of outsourcing and global procurement to remain competitive and survive. However, the information technology industry sector, which includes a large number of industries, does have some unique characteristics which have strategic implications to those in the industry and to its customers and suppliers.

The product life cycle. Typical of a new technology, the economy as a whole has a larger than usual number of industries in emerging, growth and verging-on-maturity phases of the product life cycle. At these stages, the product life cycle is an important determinant of strategic priorities. For example, the emerging phase of a new industry is based on innovation and experimentation, which results in the development of new products and services. When these reach the stage where they demonstrate commercial potential, they attract new capital that leads to the growth phase. The strategic priority in the emerging phase is to develop a unique or proprietary product or service, which will attract capital and provide the basis for sustainable competitive advantage. Multimedia applications, teleconferencing and business-to-business e-commerce are currently in the emerging phase.

In the growth phase, the industry becomes operational and requires sound basic management. The rapid market growth attracts a large number of new entrants and the industry progresses toward becoming hypercompetative. The strategic priorities are establishing the brand, building a loyal customer base and establishing economies of scale. Currently in this phase are cell phones and business-to-customer e-commerce. The information technology industry as a whole is being flooded with more venture capital than it can efficiently use, fuelling new entrants -- most of which are making the common strategic error of entry late in the growth phase.

As the growth phase makes its transition to maturity, market growth starts to slow down and hypercompetition becomes a war of attrition, which forces the consolidation of the industry into a few large winners and a number of smaller players focusing on niche markets. The bargaining power switches from the suppliers to the distributors. The makers of PCs, semiconductors and networking equipment are currently in such a transition. Deli, for example, has become the performance leader in PCs because of its effective distribution. During the rationalization of the electrical industry, the number of large companies dwindled from 15 to three over a period of 14 years. There are currently 400 public Internet companies, which are likely to be reduced to under 50.

Mainframe computers are already in a mature industry with slow growth and a relatively small number of players competing on the basis of performance and cost, but with strong loyalties created by the installed systems base. Fax machines are also mature.

Growth potential. Beware of overestimating the growth potential of information technology-based industries. One of the characteristics of the growth phase of the product life cycle is optimism about the prospect of unbounded growth. While we are seeing this in many of the information technology industries, it is particularly evident in electronic retailing where exponential growth is expected. Is Internet retailing not in effect a revival of catalogue retailing in a more convenient electronic form which, at its peak, amounted to no more than 10% of total retail sales? While online retailing has room to grow from its current 0.6% market share, its potential may not be as limitless as some observers are currently predicting. Many of the developments over which we become enthusiastic require a change in consumer habits and behaviour, which usually comes slowly.

The new consumer. The basic economics of information technology industries are different from the traditional industries. The maker of a car or any tangible goods must not only invest in factories, but spend a considerable amount of additional money on materials and labour to build the product necessary to meet the needs of the new customer. These costs limit the amount that it can earn from that new customer. In most of the information technology industries, there is a high front-end investment to develop the technology and establish the infrastructure, but very little additional cost to service the new customers. For example, when a company sells a software package or a cell phone system or an Internet server recruits a new user, there is little, if any, additional variable cost. The additional revenue therefore flows almost entirely to the bottom line. This multiplies the economies of scale and focuses competition on a battle for market share and building market bases, often by making acquisitions. Conseq uently, prices will continue to decline until the growth of the market levels off and the various segments of the industry are shaken out to a relatively small number of large companies that are efficient enough to prosper despite the low prices.

Bargaining power. Information technology will change the balance of bargaining power between sellers and buyers in many industries, one of the fundamental variables which affects the overall profitability of an industry. Communications technology, through its ability to connect buyers and sellers conveniently and without the constraint of geography, is creating a better-informed buyer and thereby a more efficient market in goods and services. This condition usually works in favour of the consumer and will result in squeezing corporate profit margins and perpetuating the urgent search for economies in other areas of operation

Social change. There is no reason to expect any significant political reaction because of the social changes being caused by the new economy. Both of the first two of our industrial revolutions had profound social consequences. The first industrial revolution accelerated urbanization with its visible poverty and the exploitation of labour. The electrification revolution resulted in a change in lifestyle with its cheaper consumer products, convenience and mobility, but also spawned an increase in the role of government through regulation and stricter labour laws. While there have been some protests, such as the "battle in Seattle," the social consequences of the current revolution have been too mild to prompt any significant political reaction, particularly in the face of the benefits of the prolonged economic growth.

Be prepared for the new economy boom to end, perhaps suddenly. There is nothing in the current situation that eliminates the occurrence of the excesses and retrenchments that cause business cycles. Every structural transition in the economy, such as the one which we are now experiencing, eventually runs its course and levels off onto a new plateau as the contribution of the new technology is reduced from its initial quantum leaps to incremental improvements.

While the technologies will improve by becoming faster and cheaper and have yet to fully spread globally, the major portion of their benefits have likely been realized. It is already apparent that the current boom has reached the stage where it is fragile and that the expectation of uninterrupted high growth may be unrealistic. While the tapering of capital expenditures for technology and the slowing down of productivity growth would lead to a soft landing, the interdependency of the various factors contributing to the current boom creates a situation where the risks can come from a number of directions, such as: the re-emergence of inflationary pressures due to labour shortages; increasing commodity prices; a decline in the value of the U. S. dollar; a stock market decline caused by weakening corporate earnings and a leveling off of productivity improvement; a retrenchment of consumer expenditures caused by such a stock market decline; and the record level of consumer debt and even trouble in financial mark ets, which have become globally linked to the extent that serious problems in one area of the world will ripple through the system as did the Asian crisis of 1997. The new economy should not be expected to promise a trouble-free economic future. It suggests that corporations have ready contingency plans for an economic slowdown, perhaps even a serious one.

The new economy has attained a mystique based on the assumption that "this time it's different." This is a dangerous belief for both corporate strategists and investors. How long the current transition will last is impossible to predict, but it will eventually end and the new economy will become the old economy waiting for the next transition. Typical of such transitions, fortunes will be made but many of these lost when the psychological fantasies of the new economy give way to its economic realities. As that eminent philosopher, former baseball player Yogi Berra, once observed: "Its deja vu all over again."

Ray Suutari is the author of Business Strategy and Security Analysis (1996, Irwin Publishing, Burr Ridge, ILL) and currently coaches CEOs on strategy formulation.