Is Market Diversification A Good Growth Strategy For Me? (Part 1)

In other words, should my software company enter new markets with our current offer? Or do something else?

This is the first part of a two-parts article on strategy choices in software companies.

Abstract

A few years ago, a small Belgian software company that produces and sells tools for certain engineering tasks requested the help of our Mistral program - Mistral being Sirris' consulting program on technology strategy for high-tech SMEs (Small and Medium-sized Enterprises). With the help of a team of Solvay Business School students, we analysed the competitive position of that company and made a few discoveries that we will share in this series of articles. In a nutshell, we discovered interesting symptoms of fading competitiveness, and upon further analysis we derived a two-pronged pattern that seems to predict the fate of companies.

SMEs are more competitive, right?

As a general rule, all SMEs must achieve and defend a strong competitive edge against large, established incumbents. This is a condition to their long-term survival. From Mistral experience I can say that the business community folklore on deadly self-complacency holds true for SMEs.

The company that had called us is an SME-sized software editor, i.e. a small company that produces software and then sells it to other companies (therefore a B2B business). The company operates in many engineering domains. Examples of engineering domains are mechanical engineering, fluids physics, electrical engineering, thermal engineering.

The SME that had just turned to us is famous for the world-class quality and performance of its software, ahead of just everybody else on technical benchmarks. This, we thought, should give them an edge over competitors.

My students and I then looked into yearly financial statements. The first ominous sign came from the Operating Profit & Loss (P&L). While the sector leader, a US-based company with a few thousand employees on payroll plus a network of partners and resellers, was earning almost 30c on every US Dollar of turnover, our Belgian SME was earning a meager 10c per Euro of turnover. Disquieting, but not yet conclusive evidence of trouble.

When we analysed the structure of operational costs, we saw that the incumbent US competitor was incurring operational costs at only 50% of turnover, broken down into sales costs at 25% (that is, for every US Dollar of turnover approx. 25c went into Sales Dept.) and R&D costs also at 25%. Our SME suffered a whopping 70% of turnover eaten by operational costs, of which also half was due to Sales and to R&D costs.

We then looked at historical growth ratios and were in for a major surprise: the market leader was growing clearly at the same pace as the "nimble" SME.

Finally, we listed the markets (i.e. the sectors in which client companies operate, for example the market of certain motor manufacturers) served by each company. We were very surprised to see both companies treading on the same grounds, thus selling to similar customers.

The many tasks in engineering a complex machine

We refined our idea of engineering tasks served by products and services. In the lifecycle of products like aircraft, the successive design phases concentrate a lot of engineering tasks. There will be preliminary studies, early stage designs, a detailed design, and then a manufacturing-ready design.

Software editors who serve such customers offer tools to relieve engineers from work that can be automated, or empower them to perform work that cannot be done manually reasonably quickly. Notwithstanding the differing capabilities of single software packages, we considered the engineering tasks that they were supporting. We regrouped these tasks into "engineering domains", thus simplifying our analysis of the scope of products and services offered by our Belgian SME client, the US incumbent competitor, and all other software editors from that sector.

We started collecting three pieces of data from all software editors (SMEs or larger) in that category of engineering software: how many markets they address, roughly how many different engineering domains their products covered, their size (world-wide employee headcount). A whole new picture emerged in front of our eyes. We plotted a graph with two axes (number of markets served, number of engineering domains covered), the third dimension being the size of companies here represented by the surface of the corresponding dot. Hence the sector snapshot here below:

Competence Jump Pattern inspirational graph

Observed software engineering companies snapshot

In later research projects we projected the snapshot in time and found companies moving along paths of growth and diversification that remained consistent with the first snapshot. Thus, the original snapshot was also revealing a pattern in time!

Next week, come back here and discover what we discovere