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Great brands stumble when they fail to respond to competitive threats.  Motorola, Kodak, Blackberry, Nokia, Best Buy, Blockbuster and Zocor, for example, all struggled when competitors attacked.

One of the reasons business executives fail to defend effectively is that they simply underestimate the risk.  When a competitive development looks like a small threat, it is hard to justify a major defensive effort.  You don’t redirect spending from promising offensive programs unless there is a compelling reason to do so.

It is easy to fall into this trap.

Let’s assume you are running a specialty machine tool business with annual revenues of $350 million.  You have variable costs of $170 million, leaving a variable profit of $180 million.  Your fixed costs total $100 million, which includes both marketing and overhead. This leaves an operating profit of $80 million, or 23% of revenue.

One day a new competitor appears, threatening to take 10% of the market.  How big a risk is this?

The calculation seems quite simple; you just multiply the potential revenue loss of $35 million times the margin, or 23%.  This results in a risk of $8.1 million, a meaningful risk but not terrifying for a business with $80 million in operating profit; worst case, the competitive move will result in a 10% decline in operating profit.

There is just one problem:  this calculation doesn’t come even close to calculating the total risk.

The first problem is that by using the 23% margin figure you are assuming fixed costs will decline as revenue falls. This is not likely to be the case; a brand will find it difficult to cut spending when faced with a new competitive threat.

The correct figure to use is the variable profit margin, or in this case 51%.  With this figure the risk increases to $17.9 million.

But this figure doesn’t capture the full risk, either, because it captures the risk in just one year.  If the new entrant gets into your category your profits will suffer this year, next year, and the year after that.  To properly value the risk you need to look at it as a perpetuity.

If we value a stream of $17.9 million loses at a discount rate of 5%, the risk increases to $358 million.

Yet this figure still doesn’t capture the entire risk.  Once you have a new competitor it might be difficult to increase prices or reduce costs.  And the new entrant will surely seek to grow further after capturing the initial 10% share.

The truth is that a new entrant can do massive financial damage to an established brand.

It is critical to evaluate competitive threats accurately; it is the only way to plan and respond appropriately.  A major competitive threat can warrant a major response:  perhaps a new product launch to make it difficult for the new entrant to get distribution, a dramatic investment in promotions to block the competitor’s trial, or a new advertising campaign to raise doubts about the new entrant’s safety.  A big risk can even justify a multi-billion dollar acquisition; sometimes the best way to deal with a threatening competitor is to buy it.

Many business leaders, especially marketing executives, are by nature optimistic.  This optimism is important for motivating a team and moving projects forward.  But optimism can be dangerous, too.  A manager with a positive mind-set will be inclined to downplay competitive threats and believe in the power of her own programs.  The result will be investment in offensive programs designed to build the business instead of defensive programs that protect the business.  This puts a brand at risk, and companies get into trouble when they can’t address competitive threats.

Defensive strategy is incredibly important; pushing back new entrants and responding to competitors must be a top priority for anyone running a business.  The first step is correctly evaluating competitive threats.