The Fatal Flaws of Top-Down Management
In late 1999, Michael Schrage, a business innovation consultant, was hired by the video rental giant Blockbuster to help the company address a nagging customer service issue. Market surveys convincingly showed Blockbuster’s executives that they had a large number of angry customers who hated late fees, or what the company preferred to call “extended viewing” fees. Unfortunately, the data also indicated that most of these unhappy renters were their best customers. Schrage’s challenge was to suggest ways to transform these prolific video watchers into happy customers, while maintaining the company’s lucrative profit margins.
Schrage’s task would not be easy because late fees were a major source of the company’s revenue. In fact, Blockbuster often designed promotions to optimize late fees by offering customers two or three videos for the price of one, anticipating that many of these “free” rentals would be returned late. Although these revenues were easy money, they were risky profits because they were made at the expense of the customer, and thus, could quickly disappear if angry customers found a better alternative.
In exploring ways to retain Blockbuster’s best customers, Schrage designed an experiment in which a representative sample of a dozen stores would ask customers if they would like to provide their email addresses and receive reminders a day in advance of the due date. At the time, email addresses were not routinely gathered by companies as they are today. The return rates and the late fees for the experimental group would be compared against a control sample of comparable stores to measure the effect of this potential policy change on revenue.
Anticipating that mitigating customer anger was likely to reduce late fee revenue, Schrage thought the collection of customer email addresses could also be used to open up future possibilities for increased customer engagement, leading to not only happier customers but also increased rental revenue to offset diminished late fees.
When Schrage presented his proposal to the Blockbuster executives, he was stunned by their response. They were not interested in finding new ways to make customers happy. They wanted to preserve their product model and its lucrative late fees. They had expected Schrage to devise a solution that would help customers see extended viewing fees as a good value for the option of viewing flexibility. As Schrage attempted to convince the executives of the value of his proposed experiment, they became hostile. According to Schrage they protested, “Why on earth do we want to remind customers the day before to return their movies on time? Why should we test an idea that’s virtually guaranteed to reduce our profitability? How will this help us make up for the money we’d lose?”
Like every other company that feels it has built a product model that gives it a sustainable competitive advantage, the Blockbuster executives were heavily invested in maintaining the status quo. After all, in 1999, Blockbuster was the dominant market leader in the United States. Its competitors were mostly local video operators with limited movie selections. The video giant easily dominated the competition because, with over 6,500 locations, there was a Blockbuster store with a wide selection of videos within a ten-minute drive of virtually every neighborhood within the United States. Given their strong market position, the Blockbuster executives were convinced it was customer attitude and not the company product model that needed to be changed. The executives were so displeased with Schrage’s proposal that the consultant felt compelled to apologize for wasting the executives’ time and waived his fee.
A few months later, in early 2000, Reed Hastings and Marc Randolph would bring a different proposal to John Antioco, Blockbuster’s CEO. Three years earlier, Hastings and Randolph had founded an internet-based start-up they called Netflix that delivered DVDs by mail using a monthly subscription model. For a flat fee, members received unlimited movies without per-title rental fees, due dates, or late fees. Although the Netflix founders were convinced the internet was the future of home entertainment, the startup was off to a rocky start with only three hundred thousand subscribers and on its way to $57 million in losses for the year. Hastings and Randolph offered to sell Netflix to Blockbuster for $50 million and develop Blockbuster.com as their online video division. They suggested the combination of the two companies could leverage the value of the Blockbuster brand into an innovative product line that would expand the video giant’s market presence and transition the market leader into the next generation of their industry. Antioco was not convinced by the Netflix founders’ proposal, declining it on the spot. The Blockbuster CEO saw no value in building an online presence chiding, “The dot-com hysteria is completely overblown.”
At the time Antioco turned down Netflix’s offer, he was at the helm of a well-established $6 billion enterprise that had raised $465 million in a successful IPO the previous year. Its business model seemed secure as Blockbuster continued to grow throughout the decade, debuting on the Fortune 500 in 2006. The company would remain a fixture on the coveted list for the following four years, but would fall off in 2011 after filing for bankruptcy in September 2010 with $1 billion in debt.
It turned out that Antioco couldn’t have been more wrong. The internet did become the next generation of home entertainment, and because Antioco couldn’t envision a future that could be very different from the past, Blockbuster failed to adapt to a rapidly changing market. Antioco’s passing up the opportunity to purchase Netflix would turn out to be Blockbuster’s single worst management decision.
On the other hand, Netflix would go on to greatly surpass Blockbuster’s short-lived success. After a few years of struggle in the early 2000’s, Netflix’s online business model finally connected with the market as more and more people signed up for their DVD subscription model. Over the next two decades, Netflix demonstrated a robust capacity for keeping up with technological change as it morphed from physical DVDs to online streaming, and eventually movie production. In 2021, the company that offered to sell itself to Blockbuster for $50 million had a market value of over $300 billion.
Blockbuster’s executives didn’t fail to adapt because they were bad managers; they failed because they were following what they understood to be good management practices. At the start of our new century, Blockbuster was a fifteen-year-old company that had cornered its market. The video giant had a financially successful product model and a highly efficient delivery system that set the company apart as the clear market leader. If you were a Blockbuster executive working on the three-year strategic plan in the year 2000, chances are that you too would have been biased toward charting a course that maintained what you would have likely seen as a sustainable competitive advantage. After all, if the business plan has been working well for fifteen years and you see nothing in the near future that indicates the need for change, then it makes sense to stick with the plan. And for the next three years, you would have been right. By the end of 2003, Blockbuster had grown to almost 9,000 locations with healthy earnings on approximately $6 billion in revenue. Few would have argued that Blockbuster wasn’t a well-managed company. That’s because the management practices the executives were following were doing what they were designed to do, and that is to maintain the status quo.
In a stable world, maintaining the status makes sense because business models can be profitable for many decades. However, in a dynamic world, the life cycle of a business model can be reduced to a few years, which means organizations need to be very competent at adapting to change. This has become problematic for traditional managers because planning is inherently change resistant, as we saw when Blockbuster’s executives reacted hostilely to Schrage’s proposed experiment to discover ways to encourage happier customers. Although Schrage was providing Blockbuster with an early warning indicator of how late fees could become potential trouble down the road, this observation was summarily dismissed because it could result in a major shift in what had been a very profitable business model. The executives liked the status quo, felt secure in their competitive position, and had no desire to change.
This tendency to resist change highlights an inherent flaw in top-down management structures: Hierarchies tend to kill innovation. Given management’s status quo bias, people who suggest new ways of doing things—especially if they threaten existing business or product models—typically encounter a bureaucratic gauntlet that few ideas ever survive. Despite the Netflix founders’ market insights and their accurate sense for the future of home entertainment, Antioco quickly rejected a brilliant innovation opportunity because he was incapable of imagining how Blockbuster might manage its own evolution.
This highlights another more dangerous flaw of command-and-control management: Decision-making is often the prerogative of one person. In top-down hierarchies, single individuals have the authority to make unilateral decisions whose consequences can be far reaching across the business. The single worst decision in Blockbuster’s twenty-five-year run was made by one person at the end of one meeting. Had Antioco accepted the offer to acquire Netflix, Blockbuster would likely be a $300 billion company today and still the most popular brand in home entertainment.
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