Profitable, fast-growing companies like Microsoft and Home Depot are the darlings of Wall Street and the envy of their competitors. But what factors determine their success? And what can managers do to emulate such stellar businesses within their own organizations?

To answer these questions, we screened the 9,450 publicly listed companies on the Compustat database for those that have grown dramatically over the past ten years. We also analyzed individual businesses such as Microsoft Windows, Medco’s pharmacy benefits management (PBM) program, Lotus Notes, Apple Newton, Hughes DirecTV, Enron Capital and Trade Resources, and Midland Bank’s First Direct.

We discovered that highly profitable fast growth is not confined to just a couple of firms. Between 1984 and 1993, 41 publicly listed companies focusing on one major line of business managed to increase their revenues and operating income by 20 percent per year. They created over 300,000 jobs and added $110 billion in market value during this period of sustained fast growth. These "tigers" are the swiftest, most powerful enterprises in the global marketplace.

New games

Our case studies reveal that these tigers have pursued "new game" strategies. First, they provide radically improved products and services to customers, thereby creating entirely new markets. Lotus Notes, for example, is a network software product that enables groups of people to work together and share knowledge efficiently. It was designed from the ground up to support collaboration, and includes advanced workflow routing, synchronized replication of databases, and sophisticated encryption. Medco’s PBM allowed healthcare payors to monitor drug use among their patients efficiently, ensuring lower costs and better medical outcomes.

Second, tigers shape industry structure in the markets they create. Lotus has built an entire industry around Notes, with application developers, system integrators, trainers, and hardware companies working together to provide value to end users. Lotus plays a major role in defining the interrelationships between all these different players. Medco’s PBM is at the center of pharmaceutical care, selecting drugs from pharmaceutical companies, delivering them via mail order or pharmacies to patients, submitting claims to payors, and collecting information on patterns of drug usage.

Tigers present a paradox for traditional microeconomics, which holds that outstanding performance is hard to sustain

Our field research indicates that tigers create new markets with few if any rivals, and are able to preserve their competitive advantages for long periods. This presents a paradox for traditional microeconomics, which holds that outstanding performance is difficult to sustain. Similarly, conventional strategy frameworks are not very useful in understanding the dynamics of new markets or how companies can actively shape these markets to their advantage. To analyze barriers to entry, switching costs, exit costs, supplier power, and so on may work well when an industry is well established and stable, but it is of little use in predicting the eventual structure of an emerging industry. Otherwise, why would other players in the industry have allowed Microsoft and Intel to secure their current position?

For answers, we must turn to new ideas bubbling up on the fringes of microeconomics and organizational theory. They focus on the dynamics of market development and offer fresh insights into the methods by which some firms maintain successful position.

The economics of increasing returns

Increasing returns economics rejects the conventional wisdom that industries are rapidly prone to diminishing returns as a result of competition between firms for scarce resources. This view states that returns from marginal investments quickly shrink as competition mounts. Soon firms cut back their investments to levels justified by average industry profits, and industry structure stabilizes.

As firms invest, their profitability grows, and eventually one or two dominate the market

Under increasing returns, however, returns from marginal investments go up rather than down. Some firms continue to invest, their profitability grows, and eventually one or two firms are able to dominate the market. Other firms are unable to keep up the necessary investments. Utilities are classic examples of increasing returns and are therefore regulated as natural monopolies.

In today’s global knowledge-based economy, there are many markets in which increasing returns play a large role for a long time. First, when competitors are unable to match each other’s investments evenly, increasing returns can persist for long enough to determine industry outcomes. Second, as the marginal cost of production is almost nil for many knowledge-based products, such as software, all media, and drugs, additional market share has a disproportionate impact on profits. Third, increasing returns occur repeatedly across the world as firms jockey to take advantage of a global economy and enter one large market after another.

Organizational coevolution is another development in economics that helps explain fast growth. It refers to the process whereby groups of firms work together to ensure the success of a joint product or service, forming a business web. Thus, the Ford Motor Company, its suppliers, and Ford dealers are coevolving to compete against Toyota, its suppliers, and Toyota dealers. Once firms make commitments to support a particular product or service, they are locked into that web.

Coevolution is a major source of increasing returns because adding more firms to a group not only enlarges it, but actually draws other firms in as well. This process may determine whether one or another technology will acquire momentum and be successful.

The drivers of growth

While these insights are now widely accepted by economists, they have not yet been translated into practical concepts that managers can use in making strategic decisions. We need to move beyond observing that increasing returns occur to learning how they can be created and sustained.

For the tigers, fast growth fuels itself. Multiple reinforcing feedback loops conspire to create a "virtuous cycle," unleashing a momentum that competitors are powerless to stop.

Reinforcing feedback loops

In the case of Microsoft’s Windows, one reinforcing feedback loop immediately springs to mind: the reason why most buyers want Windows is the large number of applications that run on it. Equally, software developers are keen to produce programs that run on Windows because of its large installed base, now numbering some 100 million. The choice of Windows applications is so vast simply because there are so many Windows users (Exhibit 1).

Other reinforcing loops are operating here, too. Knowing that your colleagues, customers, and suppliers are more likely to use Windows than any rival interface prompts you to choose it for your own computer. This, in turn, persuades your colleagues, customers, and suppliers to make the same choice. The sheer size of the network of Windows users creates an incentive for new buyers to join the network, which increases its size still further.

Distributors and value-added resellers are part of another reinforcing loop. As their revenue depends on the size of the market they can serve, they tend to concentrate on the most widely available system. This makes it easier for end users to work on Windows, which again contributes to the growth of its installed base. The same logic induces hardware manufacturers to equip their computers with Windows.

Finally, once software has been developed, the marginal cost of an extra copy is negligible. The resulting economies of scale represent yet another reinforcing feedback loop. In sum, at least five reinforcing loops drive the Windows installed base—and are driven by it (Exhibit 2).

Growth cycles

This pattern of reinforcing loops converging on a customer base is what we call a growth cycle. Growth cycles drive the growth of businesses pursuing "new game" strategies.

Lotus Notes, for instance, can have had little or no value to its first individual user. For communication software, the size of the installed base is not just the measure but the engine of success. Notes exhibits the same reinforcing loops that apply to Windows: distributors, developers, and value-added resellers support the application because of its large installed base, and in doing so fuel further growth.

Moreover, the cost of the physical infrastructure required to operate Notes—servers, local area networks, and so on—falls as more users choose the program, so that it becomes cheaper for others to follow suit. As with Windows, Notes’ success rests on its ability to build and ride a powerful growth cycle.

Growth cycles are not confined to high-tech industries. Medco’s success also relies on reinforcing loops (Exhibit 3):

1. The company is able to offer cost-effective claims processing and mail service because of the economies of scale its size confers. Its plans are thus attractive to employers and patients.

2. Medco’s patient base encourages retail pharmacists to participate in its plans (and grant it sizable discounts). The resulting large network of pharmacies should lead employers to choose Medco because it will offer employees convenient service in many locations nationwide.

3. As Medco demonstrates its ability to influence the drugs chosen by the patients it covers, pharmaceutical manufacturers are forced to sell to Medco at a discount—or walk away from some thirty million customers. Medco passes on some of these savings to employers in the form of lower prices, and ends up managing still more lives.

4. Finally, the wealth of data that Medco collects on the patients it covers (and their doctors) enables it both to offer additional services (such as drug utilization reviews) to employers and to tailor its plans more effectively to keep costs low.

Sustaining increasing returns

Reinforcing feedback is the underlying force that drives increasing returns. The growth cycle is a powerful representation of this phenomenon.

The cascading effects of combined reinforcing feedback loops can produce sustained increasing returns

Every additional computer that runs Windows, for instance, fuels the five reinforcing loops that we have examined. In turn, they lead more users to choose Windows. Each dollar invested in selling an extra copy will yield much more than the direct marginal profit. The cascading effects of the feedback loops driven by the installed base will generate still more sales. In this way, combinations of reinforcing feedback loops can produce sustained increasing returns.

Obviously, this is not a general rule. In most cases, market saturation, competitive pressures, and other forms of counteracting feedback will quickly emerge and lead to diminishing returns. Sustained increasing returns can happen only under certain circumstances, which we will consider later.

Generic growth accelerators

First, let us take a closer look at the inner workings of growth cycles. Why do they lead to success for one company rather than another? How can they be managed? And how do we even know they are there?

Every innovative strategy creates its own unique growth cycle, so there can be no definitive answer to these questions. However, our analysis identified a number of generic feedback loops that can act as a useful, though not exhaustive, checklist for managers. We call these effects growth accelerators, since they are all reinforcing loops that drive (and are driven by) the customer base to produce accelerating growth.

There are three broad categories of growth accelerators: business web, market power, and learning-based accelerators.

Business web accelerators

Many of the feedback loops that drive growth cycles are not under the direct control of the companies concerned

In the cases we have examined, many of the reinforcing feedback loops that drive growth cycles are not under the direct control of the companies concerned. Instead, they rely on the behavior of external partners motivated by their own interests. A company’s success in generating these feed-

back loops will depend on its ability to build and sustain a web of partners that coevolve with it. This ability is most critical in the early phases of market development as businesses race to secure the best partners and distribution channels.

There are several types of business web accelerators:

1. Content. Just as the success of Windows depends on the availability of applications based on it, many consumer electronics businesses are dependent on content. It was for content that Sony and Matsushita bought Columbia Pictures, MCA, and CBS Records. Other players in content-dependent markets may choose to rely on external partners; Lotus Notes, for instance, fosters the development of applications through its developer relations program.

2. Other products. In a few cases, the same reinforcing loop structure applies also to complementary products, such as the satellite dishes needed to receive Hughes DirecTV’s service.

3. Distribution and support. Generally speaking, distribution is a reinforcing feedback loop for any business, in that the morale and effectiveness of salespeople increase with success, which then fuels further growth. Distribution and support are particularly powerful when a product requires service long after purchase, which is why car makers have dealer networks to sell their vehicles and support their installed base.

4. Infrastructure. Few people would buy cars if the necessary infrastructure (roads, gas stations) were lacking. Indeed, the limited success of alternative fuels like liquid petroleum gas derives partly from the absence of a supporting infrastructure. As a rule, the development of infrastructure (roads) creates demand for products (cars) that justify building more infrastructure.

5. Network effects. These arise when a product’s attractiveness relates to the size of its customer base. Network size is a key growth accelerator for communication products, as Lotus Notes attests.

Users get to know their program so well that the main commands and keyboard shortcuts become "hardwired" in their brains

6. Customer switching costs that harness the power of lock-in. Spreadsheet users, for instance, often become familiar with a particular application. Users of Lotus 1-2-3 or Microsoft Excel get to know their program so well that the main commands, screen layouts, and keyboard shortcuts become "hardwired" in their brains. Customer learning is a source of enduring loyalty, both for repurchases of the same product and for line extensions that exploit familiarity, such as suites of PC applications sharing the same look and feel.

Market power accelerators

These are the virtuous cycles that result directly from increased volume and market share. They come into effect once a market has matured and businesses can begin to exploit their market leadership. Tigers use these loops to cement early advantages and build unassailable positions.

1. Amortization of fixed costs. Every manager knows that expanding production reduces fixed costs per unit output. Although the direct benefits of scale are sometimes overestimated, they play a key accelerating role in industries where fixed costs are high and marginal costs low. Back-office data processing as practised by FIServe, First Financial Management, and ADP is an example.

2. Market image and brand. Whether through advertising, word of mouth, or a "fashion effect," market leadership enhances visibility and credibility, which in turn strengthen leadership. Many businesses—from fashion through computer software to drugs—actively manage word of mouth via programs aimed at opinion leaders.

3. Sourcing power. In many businesses, size and market leadership confer bargaining power with suppliers, including suppliers of capital. This translates into lower costs, which can be passed on to customers, breeding further growth. Medco illustrates how sourcing power can fuel growth.

4. People selection. Successful businesses are more likely to attract and retain top talent—a key growth accelerator in many service businesses (such as investment banking, advertising, and consultancy) and in the critical functions of industrial companies. This accelerator depends not on bargaining power, but on the fact that "the best want to work with the best."

5. Intermediation. Some companies are by nature intermediaries. For them, a key growth accelerator is making the market. Enron, for example, became an intermediary for natural gas risk-management products. As the largest trading center for these products, Enron can diversify its risk better than any other company. Consequently, it can offer more tailored, cost-effective products, which in turn attract more customers.

Learning-based accelerators

The final category of growth accelerators is related to the skills that an organization acquires on the strength of its customer base. Though important at all stages of a market life cycle, learning economies are most crucial early on, when businesses are trying to understand customer needs and satisfy them through the design of their products or services. Later, the focus shifts to improving production processes and replicating a winning formula in other geographic markets.

Many companies exploit customer information to obtain a competitive advantage

1. Customer knowledge. Many companies in many businesses exploit the information they possess about their customers to obtain a competitive advantage. By developing expert systems to study the geodemographics of its customer base, First Direct was able to deepen its penetration of existing accounts. In one marketing campaign, it achieved response rates of 25 percent, as against an industry average of 1 to 2 percent. The bank was also able to screen the UK electoral roll using its customer characteristics as a filter to develop much more targeted direct marketing campaigns. As a result, the acquisition cost of a new account was cut by three-quarters.

2. Experience curve effects. Successful organizations do not just learn about their customers; they acquire process knowledge that helps them to serve more customers better. They also use what they learn from their customers to improve their current products or services and develop new ones.

3. Environment knowledge. Many businesses build on their successes to acquire less tangible, but nonetheless essential, information and skills. For venture capital firms, for instance, more deals mean more contacts in the communities in which they operate. Improved knowledge of their environment leads to yet more deals, thus accelerating growth.

4. Ability to replicate. In virtually all businesses, a company’s ability to replicate what it has already done is a key growth accelerator, enabling it to penetrate new geographic markets and unfamiliar market segments. Successful retail businesses, for instance, strive for consistent store formats, as this helps their staff to replicate behaviors that have proven effective in the past. As such businesses grow, they train more and more staff to replicate the winning formula in new markets, at the same time developing better processes and procedures to achieve this objective.

Building a growth cycle

Growth cycles do not merely resolve the paradox raised at the beginning of this article. They also raise new questions for managers: Are you managing your growth cycle to its full potential? Can you "turbo-charge" it to achieve dynamic competitive advantage and sustained increasing returns? Finally, do you think dynamically about your strategy?

Are you managing your growth cycle?

Growth accelerators are the building blocks of growth cycles. Identifying possible growth accelerators is therefore the starting point in building a growth cycle. But successful strategies also require two further steps: effectively combining growth accelerators, and renewing them.

Identifying growth accelerators. In most industries, some of the generic accelerators have become so widespread that they are actually required merely to compete. Successful investment banks thrive on their excellent management of people. Leading consumer goods companies ride the virtuous cycle of market image. Excellent retailers combine sourcing power with replication capability. In many cases, all participants play essentially the same game, and success for one hinges on its ability to push harder.

This means that "new game" strategies can be implemented only by introducing fresh growth accelerators. One pharmaceutical company operating in a developing country had grown at 30 percent a year for three years, but was running out of steam. A hard strategic look at the business revealed an untapped reinforcing loop. By shifting its distribution system from wholesalers and pharmacists to direct sales and delivery to doctors, the company could provide doctors with financial incentives to prescribe more of its leading product: a drug with no competitors, but only 25 percent penetration of its target market.

Though this approach might give the company an advantage for a few years, it would run the risk of alienating traditional channels and exposing future products to retaliation. Moreover, any competitor entering the market would be able to replicate this strategy. So, while it provided an impetus, this single growth accelerator did not seem to have the potential to trigger sustained growth.

Combining growth accelerators. One or two accelerators alone are not normally sufficient to generate fast growth. As our examples suggest, a combination of three, four, or more accelerators is usually needed to establish a powerful growth cycle.

The reason is simple. Each reinforcing loop is inherently self-reinforcing. But when they are combined, loops with a common element become mutually reinforcing as well. When you bring together reinforcing feedback loops related to the customer base, every loop boosts every other loop. And since each reinforcing feedback loop in isolation leads to exponential growth, mutually reinforcing loops produce not just faster growth, but exponentially faster growth.

Two things happen when growth accelerators reach critical mass. First, growth really takes off. It is in the nature of exponential curves to move slowly at the beginning.

Second, and more important, the bar is raised for competitors. Each growth accelerator is a battleground in itself, but a company’s lead in one field strengthens its lead in the others. This means that slowing down the growth momentum of a leader that relies on a combination of accelerators would entail beating it on three, four, or five fronts at the same time—a tall order.

The pharmaceutical company mentioned earlier identified two additional growth accelerators. Infrastructure was one: the product, an injectable drug, required an uninterrupted cold chain from factory to patient. Existing channels were unreliable. The company realized that investing in a temperature-controlled delivery system and storage capacity at surgeries would make doctors more confident in prescribing the drug—and raise entry barriers for competitors.

Another powerful accelerator was customer knowledge. By being physically closer to doctors, the company would be in a much better position to collect and analyze prescription patterns and epidemiological data, and could improve its ability to predict market needs and launch new products.

Renewing growth accelerators. Even a combination of accelerators cannot guarantee perpetual growth. Growth cycles naturally erode under the pressures of competitive response, market evolution, and internal challenges. As we have seen, using conventional accelerators in mature industries does not trigger growth, although failing to use them would certainly precipitate decline.

In order to ride their growth cycles for as long as possible, fast-growing companies continuously devise new "layers" of reinforcing feedback

In order to ride their growth cycles for as long as possible, fast-growing companies continuously devise new "layers" of reinforcing feedback. Microsoft’s aggressive entry in the suites market was followed by rapid price cuts exploiting its much higher volumes. Self-renewal focused on existing accelerators is a distinctive feature of many growth tigers.

Can you push for a dynamic competitive advantage?

Some growth cycles are more powerful than others. The difference lies in what might be called a dynamic competitive advantage: an advantage that is sustainable, widens with time, and cannot be copied, even by deep-pocketed competitors. It generates a turbo-charged growth cycle capable of producing increasing returns on a large scale for a long time.

Such successes are sometimes explained by first-mover advantage. But this alone is little use if a determined competitor creates a more powerful growth cycle. First-mover advantage is clearly an asset in kicking off a growth cycle, but it is the better growth cycle, not necessarily the first mover, that ultimately wins. Thus Apple has done well in the computer industry, but it is the Microsoft-Intel camp that has been most successful.

Dynamic competitive advantage is created when a growth cycle is protected by immensely powerful lock-in—or what other observers have called "architectural control." The key here is to create high real or perceived switching costs for partners in the business web and, most important of all, for final customers. Only this can ensure the resilience of a growth cycle to competitive attack.

Clearly, not every company can create a powerful growth cycle with strong lock-in. Hidden opportunities may exist, however. Let us return to the pharmaceutical company. With the reinforcing loops it has identified and combined, could it lock in its customer base: doctors?

The answer is yes—provided that its cold-chain distribution system can be made proprietary, and as long as no competitor emerges with a major breakthrough that addresses an important medical need and requires the same type of distribution.

Do you think dynamically about your strategy?

Growth accelerators, growth cycles, and dynamic competitive advantage are concepts that can help us think dynamically about strategy. By way of example, here are a few counterintuitive lessons from the growth tigers:

• Do you believe you can shape your market? The tigers did not identify an industry, analyze its structure, and decide to enter it; on the contrary, each of them invented a new industry and shaped its structure. Microsoft, Medco, First Direct, Hughes DirecTV—all believed that latent demand existed, and tapped it by making bold strategic moves and managing strong growth cycles.
• Do you do all the right things right? Many managers believe they should focus single-mindedly on one or maybe two key success factors. But the tigers demonstrate that success actually relies on pushing several growth accelerators at the same time. Because the effects of reinforcing loops are multiplicative, not additive, it is essential for managers to do all the right things right. Trying to beat a competitor that exploits four growth accelerators by focusing on two will probably produce not half the results, but none at all.
• Are you fighting a lost battle? Given the number of ingredients required, not every company can create a dynamic competitive advantage. But if you find yourself fighting the market leader and wondering why your product is not better received, take a closer look.
• Are you keeping your strengths under control? The same reinforcing feedback loops that accelerate your growth today can hasten your decline tomorrow. The virtuous cycle of salespeople motivation—success, high compensation, motivation, retention, success—can quickly turn into a death spiral: low sales, low bonuses, loss of motivation, defection of the best, lower sales. The more powerful the reinforcing loop, the more vulnerable it is to being flipped over by mismanagement, counteracting forces, or chance events.

  The more powerful the loop, the more vulnerable it is to being flipped by mismanagement, counteracting forces, or chance events

• Are you measuring the right things? In a dynamic world, sales and growth matter less than your customer base. You know your sales—but do you know how big your customer base is? If you believe that this customer base will naturally drive growth through loyalty repurchases, do you know how much of it actually does repurchase? What is your market share among new buyers, and among your competitors’ customers? Do you analyze separately the behavior (and needs) of "loyalty," "first-time," and "conquest" customers?
• Are you making linear plans? Without realizing it, we are all trained to think in a linear manner. But the impact of feedback loops is difficult to predict, which is partly why many managers feel the world is chaotic and unpredictable, and would rather give up making plans and forecasts altogether. Fact-based simulations that recognize the impact of feedback loops and take them into account can be a great help in supplementing judgment and intuition in order to avoid the trap of linear planning.

The growth cycle concept presents a new model of competitive dynamics that advances current strategy frameworks and helps explain how some of today’s outstanding companies have achieved their dominance. In identifying the factors that drive and nourish growth, this new framework offers pointers to managers seeking to devise more robust and effective business growth strategies.