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Why Digital Strategies Fail – Part 1 of 3

This article first appeared on McKinsey&Company.

Most digital strategies don’t reflect how digital is changing economic fundamentals, industry dynamics, or what it means to compete. Companies should watch out for five pitfalls.

The processing power of today’s smartphones is several thousand times greater than that of the computers that landed a man on the moon in 1969. These devices connect the majority of the human population, and they’re only ten years old.

In that short period, smartphones have become intertwined with our lives in countless ways. Few of us get around without the help of ridesharing and navigation apps such as Lyft and Waze. On vacation, novel marine-transport apps enable us to hitch a ride from local boat owners to reach an island. While we’re away, we can also read our email, connect with friends back home, check to make sure we turned the heat down, make some changes to our investment portfolio, and buy travel insurance for the return trip. Maybe we’ll browse the Internet for personalized movie recommendations or for help choosing a birthday gift that we forgot to buy before leaving. We also can create and continually update a vacation photo gallery—and even make a few old-fashioned phone calls.

Then we go back to work—where the recognition and embrace of digital is far less complete. Our work involves advising the leaders of large organizations. And as we look at this small device and all the digital change and revolutionary potential within it, we feel the urge to send every CEO we know a wake-up call. Many think that having a few digital initiatives in the air constitutes a digital strategy—it does not. Going forward, digital strategy needs to be a heck of a lot different from what they have today, or they’re not going to make it.

We find that a surprisingly large number underestimate the increasing momentum of digitization, the behavioral changes and technology driving it, and, perhaps most of all, the scale of the disruption bearing down on them. Many companies are still locked into strategy-development processes that churn along on annual cycles. Only 8 percent of companies we surveyed recently said their current business model would remain economically viable if their industry keeps digitizing at its current course and speed.

How can this be, at a moment when virtually every company in the world is worried about its digital future? In other words, why are so many digital strategies failing? The answer has to do with the magnitude of the disruptive economic force digital has become and its incompatibility with traditional economic, strategic, and operating models. This article unpacks five issues that, in our experience, are particularly problematic. We hope they will awaken a sense of urgency and point toward how to do better. (For more on how companies are redefining their digital strategies, see “Responding to digital threats.”)

Pitfall 1: fuzzy definitions

When we talk with leaders about what they mean by digital, some view it as the upgraded term for what their IT function does. Others focus on digital marketing or sales. But very few have a broad, holistic view of what digital really means. We view digital as the nearly instant, free, and flawless ability to connect people, devices, and physical objects anywhere. By 2025, some 20 billion devices will be connected, nearly three times the world population. Over the past two years, such devices have churned out 90 percent of the data ever produced. Mining this data greatly enhances the power of analytics, which leads directly to dramatically higher levels of automation—both of processes and, ultimately, of decisions. All this gives birth to brand-new business models. Think about the opportunities that telematics have created for the insurance industry. Connected cars collect real-time information about a customer’s driving behavior. The data allow insurers to price the risk associated with a driver automatically and more accurately, creating an opportunity to offer direct, pay-as-you-go coverage and bypassing today’s agents.

Lacking a clear definition of digital, companies struggle to connect digital strategy to their business, leaving them adrift in the fast-churning waters of digital adoption and change. What’s happened with the smartphone over the past ten years should haunt you—and no industry will be immune.

Pitfall 2: misunderstanding the economics of digital

Many of us learned a set of core economic principles years ago and saw the power of their application early and often in our careers. (For more on the changing economics of digital competition, see the infographic below.) This built intuition—which often clashes with the new economic realities of digital competition. Consider these three:

Digital is destroying economic rent

One of the first concepts we learned in microeconomics was economic rent—profit earned in excess of a company’s cost of capital. Digital is confounding the best-laid plans to capture surplus by creating—on average—more value for customers than for firms. This is big and scary news for companies and industries hoping to convert digital forces into economic advantage. Instead, they find digital unbundling profitable product and service offerings, freeing customers to buy only what they need. Digital also renders distribution intermediaries obsolete (how healthy is your nearest big-box store?), with limitless choice and price transparency. And digital offerings can be reproduced almost freely, instantly, and perfectly, shifting value to hyperscale players while driving marginal costs to zero and compressing prices.

Competition of this nature already has siphoned off 40 percent of incumbents’ revenue growth and 25 percent of their growth in earnings before interest and taxes (EBIT), as they cut prices to defend what they still have or redouble their innovation investment in a scramble to catch up. “In-the-moment” metrics, meanwhile, can be a mirage: a company that tracks and maintains its performance relative to its usual competitors seems to be keeping pace, even as overall economic performance deteriorates.

There are myriad examples where these dynamics have already played out. In the travel industry, airlines and other providers once paid travel agents to source customers. That all changed with the Internet, and consumers now get the same free services that they once received from travel agents anytime, anyplace, at the swipe of a finger—not to mention recommendations for hotels and destinations that bubble up from the “crowd” rather than experts. In enterprise hardware, companies once maintained servers, storage, application services, and databases at physical data centers. Cloud service offerings from Amazon, Google, and Microsoft, among others, have made it possible to forgo those capital investments. Corporate buyers, especially smaller ones, won because the scale economies enjoyed by these giants in the cloud mean that the all-in costs of buying storage and computing power from them can be less than those incurred running a data center. Some hardware makers lost.

The lesson from these cases: Customers were the biggest winners, and the companies that captured the value that was left were often from a completely different sector than the one where the original value pool had resided. So executives need to learn quickly how to compete, create value for customers, and keep some for themselves in a world of shrinking profit pools.

Digital is driving winner-takes-all economics

Just as sobering as the shift of profit pools to customers is the fact that when scale and network effects dominate markets, economic value rises to the top. It’s no longer distributed across the usual (large) number of participants. (Think about how Amazon’s market capitalization towers above that of other retailers, or how the iPhone regularly captures over 90 percent of smartphone industry profits.) This means that a company whose strategic goal is to maintain share relative to peers could be doomed—unless the company is already the market leader.

A range of McKinsey research shows how these dynamics are playing out. At the highest level, our colleagues’ research on economic profit distribution highlights the existence of a power curve that has been getting steeper over the past decade or so and is characterized by big winners and losers at the top and bottom, respectively (see “Strategy to beat the odds,” forthcoming on Our research on digital revenue growth, meanwhile, shows it turning sharply negative for the bottom three quartiles of companies, while increasing for the top quartile. The negative effects of digital competition on a company’s growth in earnings before interest, taxes, depreciation, and amortization (EBITDA), meanwhile, are twice as large for the bottom three-quarters of companies as for those at the top.

A small number of winners—often in high tech and media—are actually doing better in the digital era than they were before. They marshal huge volumes of customer data drawn from their scale and network advantages. That triggers a virtuous cycle in which information helps identify looming threats and the best partners in defending value chains under digital pressure. In this environment, incumbents often find themselves snared in some common traps. They assume market share will remain stable, that profitable niches will remain defendable, and that it’s possible to maintain leadership by outgrowing traditional rivals rather than zeroing in on the digital models that are winning share.

This phenomenon of major industry shakeouts isn’t new, of course. Well before digital, we saw industry disruptions in automobiles, PC manufacturing, tires, televisions, and penicillin. The number of producers typically peaked, and then fell by 70 to 97 percent. The issue now is that digital is causing such disruptions to happen faster and more frequently.

Digital rewards first movers and some superfast followers

In the past, when companies witnessed rising levels of uncertainty and volatility in their industry, a perfectly rational strategic response was to observe for a little while, letting others incur the costs of experimentation and then moving as the dust settled. Such an approach represented a bet on the company’s ability to “outexecute” competitors. In digital scrums, though, it is first movers and very fast followers that gain a huge advantage over their competitors. We found that the three-year revenue growth (of over 12 percent) for the fleetest was nearly twice that of companies playing it safe with average reactions to digital competition.

Why is that? First movers and the fastest followers develop a learning advantage. They relentlessly test and learn, launch early prototypes, and refine results in real time—cutting down the development time in some sectors from several months to a few days. They also scale up platforms and generate information networks powered by artificial intelligence at a pace that far outstrips the capabilities of lower-pulsed organizations. As a result, they are often pushing ahead on version 3.0 or 4.0 offerings before followers have launched their “me too” version 1.0 models. Early movers embed information across their business model, particularly in information-intensive functions such as R&D, marketing and sales, and internal operations. They benefit, too, from word of mouth from early adopters. In short, first movers gain an advantage because they can skate to where the puck is headed.

How Tesla captured first-mover value in electric vehicles offers a lesson in the discomfiting effects of a wait-and-see posture. Four years ago, incumbent automakers could have purchased Tesla for about $4 billion. No one made the move, and Tesla sped ahead. Since then, companies have poured money into their own electric-vehicle efforts in a dash to compete with Tesla’s lead in key dimensions. Over the past two years alone, competitors have spent more than $20 billion on sensor technologies and R&D.

The Red Tree is the UK’s leading international beauty brand consultancy and a powerhouse of ideas, insight and inspiration. For an informal discussion on how we might help you, please contact us.

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