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 / Spring 2007 / Issue 46(originally published by Booz & Company)


Lessons of the Last Bubble

The phrase network effects — or its more formal economic equivalent, network externalities — refers to the phenomenon of a network’s value increasing as more members join. Consider the network effects of Skype, the Internet communications company that enables free voice and video communications among its members. As each new member joins, the value increases for existing members because each member now has additional potential points of contact.

Bob Metcalfe, founder of The 3Com Corporation and developer of the Ethernet technology for networking computers, adapted the theory to technology businesses in what became known as Metcalfe’s Law. He argued that the value of a network grows as the square of the number of users. (See “The Big, the Bad, and the Beautiful,” by Tim Laseter, Martha Turner, and Ron Wilcox, s+b, Winter 2003.) Online auction mecca eBay, another company that clearly benefits from network effects, acquired Skype for $2.6 billion in September 2005, when the company boasted 54 million users. A year later, the network had more than doubled to 113 million users spread across virtually every country in the world.

Intellectually appealing in its simplicity, Metcalfe’s Law seemed to offer a justification for the astronomical valuation of early dot-coms and provided a mandate to move first and get big fast. Simple insights generally prove more useful than complex theories. But simplistic application of a concept replaces critical thinking far too often. In the end, the value of a network effect depends on the business model. It obviously works for eBay: More individual buyers bring on more individual sellers who bring on more buyers in a virtuous circle. But a retailer of new products — using traditional stores or the Internet — doesn’t experience this same network advantage.

Bigger Is Riskier
Independent of network effects, a “get big fast” strategy offers both benefits and risks. On the one hand, scale economies certainly accrue to a big company. Wal-Mart can buy and then transport goods at a lower cost because it sells more than $300 billion in goods each year. In addition to having the resources to scour the world in search of the lowest-cost suppliers, Wal-Mart can invest in state-of-the-art radio frequency identification (RFID) technology to run its distribution network. The distribution network has enough density for economical cross-docking operations, which transfer goods between trucks without the extra cost of storing them for long periods of time. As a result, Wal-Mart turns its inventory eight times per year versus a median of four times for the industry as a whole.

 But a “get big fast” strategy in pursuit of scale economies has a dark side, especially in unpredictable markets. Webvan, for example, was founded in 1996, went public in 1999, and filed for bankruptcy protection in 2001. In the summer of 1999 it reported that revenues from the six months ending in June totaled $395,000, with net losses of $35.1 million. Despite those financial results, the company signed a $1 billion contract with Bechtel Corporation to build 26 distribution centers across the country, modeled on its unproven pilot operation in Oakland, Calif.

Webvan ultimately built three of the highly automated, large-scale distribution centers, and none of them reached break-even utilization levels. Each distribution center offered sales potential equivalent to 18 traditional grocery stores — a huge amount of capacity to bring online at one time in a mature industry. Webvan’s projections had estimated costs based on high utilization rates; but at the 30 to 40 percent utilization rates actually achieved by the facilities, the company’s costs were well above those of the traditional model, and its cash quickly dissipated.

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