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DON TAPSCOTT • C.K. PRAHALAD • MARSHALL GOLDSMITH • GARY NEILSON • A.G. LAFLEY • DAVID ROCK

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ANNIVERSARY

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Special Issue

CELEBRATING15 YEARSOFTHE BESTBUSINESSTHINKING

Special Issue, Autumn 2010US $12.95 Canada C$12.95

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a sound federal budget headingtoward surplus, and strong businessconfidence. How could anythingpublished in those years matter toanyone in 2010?

Yet despite all the turbulencesince then, there has been a slow butsteady increase in knowledge abouteconomic value and organizationaleffectiveness. The importance ofman agerial capability has been dis-counted by economists (and others)for years, but it is now becomingincreasingly apparent. Variance inmanagerial prowess explains whysome companies weathered the eco-nomic storm and others did not,and why some new CEOs succeedwhile others crash and burn. That’swhy, at s+b — through the editor-ships of Kurtzman (1995–1999),Randall Rothenberg (2000–2005),and me (since 2005) — our primaryeditorial mission has been to helpreaders find the most profound andmost pragmatic business insight,and put it to use.

Consider, for instance, “WhyCEOs Succeed (and Why TheyFail): Hunters and Gatherers in theCorporate Life” (page 8), written in 1996 by an innovative venturecapitalist (Edward F. Tuck) and a prominent anthropologist (Timo-

thy Earle). They show how theCEO and the board of a major com-pany play out the same roles in ourtime that the chiefs and elders ofprehistoric tribes established manythousands of years ago. In that con-text, the passage of 15 years is al -most nothing.

Similarly, the 1997 article “10XValue: The Engine Powering Long-term Shareholder Returns” (page16) anticipates many of the ideasemerging now about the value ofcoherence. Leslie Moeller (now aBooz & Company partner) andBooz alumni Charles E. Lucier andRaymond Held studied 30-yeargrowth patterns of 1,300 publiclytraded companies in the U.S., andfound it is possible to raise a com -pany’s value 10-fold in that time, ifyou know how to muster the rightkind of innovation.

Don Tapscott’s 2001 article,“Rethinking Strategy in a Net-worked World (or Why MichaelPorter Is Wrong about the Inter-net)” (page 24) remains currentbecause the controversy it raised stillendures: Does the Internet makecorporate boundaries obsolete?Should companies emulate Apple,which retains tight control overevery aspect of its enterprise, or

Since its inception, strategy+businesshas focused on the value of manage-ment thinking and practice. Be -cause business knowledge is a mov-ing target, in which there is alwayssomething to learn from practiceand reflection, the best insightsabout management often seem coun-terintuitive at first. But they canmake a significant difference in youreffectiveness and the per for mance of your enterprise — whether you’rea CEO, a student, an entrepreneur,or anyone else in business. This year,we celebrate the magazine’s 15thanniversary by looking back at thewisdom we have published in ourpages. Much of it is still worth read-ing now.

When s+b was founded in 1995by former Harvard Business Revieweditor Joel Kurtzman and a group offarsighted partners at Booz & Com-pany (then part of Booz AllenHamilton), the dot-com era was justbeginning, and the shape of theworld economy was very differentthan it is today. Amazon andGoogle did not yet exist; neitherChina nor India was seen as a globaleconomic force. The United States,where the magazine’s focus was cen-tered at the time, was at a peak ofprosperity, with rising equity prices,

15 YEARS OF SIGNIFICANCE

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terns of CEO succession and thequalities of effective CEOs — con-tinues to appear in s+b.

Another author who has be -come more prominent while writ-ing for s+b is Marshall Goldsmith,the executive coach’s executivecoach, now known for his bestsellersWhat Got You Here Won’t Get YouThere: How Successful People BecomeEven More Successful (with MarkReiter; Hyperion, 2007) and Mojo:How to Get It, How to Keep It, Howto Get It Back if You Lose It (withMark Reiter; Hyperion, 2009). In2004’s “Leadership Is a ContactSport: The ‘Follow-up Factor’ inManagement Development” (page56), Goldsmith and his coauthorHoward Morgan reveal the mostimportant factor in helping leadersbecome capable: following up withother people about their own im -provement. The Ed Koch “How’m Idoing?” style of leadership may havebeen right all along.

“Manufacturing Myopia” (page66), published in 2006, describes aperennial affliction that is demand-ing more attention now as produc-ers of goods wonder where theirindustries went. Authors Kaj Grich-nik, Conrad Winkler, and Peter vonHochberg posit a culprit differentfrom the usual suspects (China andoutsourcing): the conventionallyfragmented approach to manufac-turing management. Competitive-ness, on both a corporate and anational level, depends on takingthis kind of guidance seriously.

One of the great executives ofour time is Procter & Gamble’s for-mer CEO A.G. Lafley, the author of “P&G’s Innovation Culture”(page 78), published in 2008. Heand noted management writer RamCharan (who introduces the article)conceived of it as a follow-up to

or “missing chapter” of their best-selling book, The Game-Changer:How You Can Drive Revenue andProfit Growth with Innovation(Crown Business, 2008), which dis-cussed the human changes neededto foster Procter & Gamble’s re -markable strategic renaissance dur-ing the 2000s.

This special issue also includes2009’s “Managing with the Brain inMind” (page 88) by David Rock,founder of the NeuroLeadershipInstitute and one of the first writersto explore the relationship betweenneuroscience and organizationallead ership. Change efforts can takehold only when leaders recognizethe deep, brain-based needs peoplehave for status, certainty, autonomy,relationships, and fairness.

These articles are classics; theywill always be relevant. (For a list ofother classics we’ve published, seepage 104.) In this special issue, wealso celebrate some of the great busi-ness books we have reviewed overthe years; see the survey by SeniorEditor Theodore Kinni, an experton business books, on page 98.

Society’s growth curve is drivenby the quality of its ideas, particular-ly those about management. That isthe real engine behind increases inwealth and productivity at manycompanies, and it represents a pri-mary source of strength in dealingwith today’s immense social andenvironmental issues. We (and Booz& Company, the firm that publish-es s+b) are proud of our track recordin bringing this type of knowledgeto you. +

Art Kleiner

[email protected]

IBM, which thrives by providing itscustomers access to an open sourceworld of software, services, anddevices? The debate is far from set-tled (especially with Apple ascen-dant right now), but Tapscott laysout a compelling case for opensource enthusiasm.

Perhaps the most prescientwork that s+b has published to datewas “The Fortune at the Bottom ofthe Pyramid,” by C.K. Prahalad andStuart L. Hart (page 32). This arti-cle, published in 2002, foresawbusiness models targeteted at thebillions of “aspiring poor” in emerg-ing markets. To reach them, multi -national companies would need tocreate low-margin, low-cost goodsin “culturally sensitive, environmen-t ally sustainable, and economicallyprofitable” ways. Prahalad, whopassed away in April 2010 after asud den illness, lived to see this seem -ingly outlandish concept be comepart of the strategy of com paniesaround the world. (See the discus-sion of his book in “Essential Read-ing: Highlights from 15 Years of s+bBook Reviews,” by s+b Senior Edi-tor Theodore Kinni, on page 98.)

The concept of organizationalDNA began life in our pages as“The Four Bases of OrganizationalDNA” (page 46), published in 2003as an effort to isolate the factors thatshape a company’s culture. As au -thors Gary Neilson, Bruce A. Paster-nack, and Decio Mendes describe it,company be havior is influenced bythe design of structures (reportingrelationships and hierarchy), deci-sion rights, motivators (incentivesand career options), and informa-tion flow (the informal networks bywhich people share knowledge).Neilson’s ongoing work — on bol-stering organizational capabilitiesfor better execution, and on the pat-

8

MANAGEMENT

Why CEOs Succeed (and Why They Fail):Hunters and Gatherers in the Corporate LifeEdward F. Tuck and Timothy Earle In the corporate world, the laws of the jungle still rule.CEOs and boards fall prey to the habits and practices ofprehistoric hunters and gatherers.

STRATEGY & COMPETITION

10X Value: The EnginePowering Long-termShareholder ReturnsCharles E. Lucier, Leslie Moeller, and Raymond HeldYour company can pursue 10-fold growth over 15 yearsthrough strategic innovation: changing the rules of thegame for your industry.


Rethinking Strategy in a Networked World Don Tapscott The original manifesto for open source, Internet-conscious competitive advantage argued that MichaelPorter was wrong about partnerships and alliances.Here’s why working outside your boundaries is centralto business success.

Six Reasons There Is a New Economy

GLOBAL PERSPECTIVE

The Fortune at the Bottomof the PyramidC.K. Prahalad and Stuart L. HartLow-income markets present a prodigious opportunityfor the world’s largest companies to seek their fortunesand bring prosperity to the billions of aspiring poor whoare joining the market economy for the first time.

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featuresMANAGEMENT

The Four Bases ofOrganizational DNAGary Neilson, Bruce A. Pasternack, and Decio MendesHow does a company design its organization toexecute its strategy and successfully adapt whencircumstances change? The first step is to under-stand how four key traits of an organization influ-ence each individual’s behavior: the organizationalstructure, the decision rights for processes, themotivators, and the flow of information.

Focus: Testing Quest Diagnostics’ DNA

MANAGEMENT

Leadership Is a ContactSport: The “Follow-upFactor” in ManagementDevelopmentMarshall Goldsmith and Howard MorganA review of leadership development programs ateight major corporations reveals that nothingworks better than interaction with colleagues.Executives who follow up their training by discussing their improvement plans and progresswith co-workers become the best leaders.

MANAGEMENT

Manufacturing MyopiaKaj Grichnik, Conrad Winkler, and Peter von HochbergWhy do manufacturers lose relevance and competi-tiveness? Because their operations strategies areoften the same as they were 10 or 20 years ago.Instead of drifting into decline, producers of goodshave a chance to seize the future by cultivating bet-ter awareness about manufacturing costs andmeans: learning to see their operations moreclearly and redesign them more flexibly.

The Roots of Myopia


P&G’s InnovationCultureA.G. Lafley, with an introduction by Ram CharanLafley, the CEO of Procter & Gamble, explains howhis company built a world-class organic growthengine by investing in people. Going beyond theirbook, The Game-Changer, the authors explore therole of social systems in turning new ideas into commercial success.

Becoming a Great Innovation Team LeaderRam Charan

MANAGEMENT

Managing with the Brain in MindDavid Rock Neuroscience research is revealing the social nature of the workplace and its implications formanagement. The brain’s social needs — for status, cer tainty, autonomy, relatedness, and fairness —matter more than money.

BEST BUSINESS BOOKS 1995–2010

Essential Reading:Highlights from 15 Years of s+b Book Reviews Theodore Kinni Our all-time favorite business books.

ENDPAGE

Articles of SignificanceOf s+b’s many classic articles over the years, hereare a few of the editor’s favorites.

Cover illustration by Opto

Special Issue, Autumn 2010

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EDITORIAL

Editor-in-Chief Art Kleinerkleiner_art@ strategy-business.com

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Contributing Editors Edward H. BakerNicholas G. CarrDenise CarusoMelissa Master

CavanaughMichael V. Copeland

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It is enormously destructive and expensive tochange the chief executive of a growth company whostumbles in office. The human cost is high, as well: competent executives, used to success, fail withoutunderstanding why. They are branded with their failure.Some succumb to bitterness and despair; a few are suicides.

Why do these otherwise successful, competent,well-trained people fail? Why, in the face of good advice,do they do things that bring about their ruin? Why, afterthey fail, can people of less training, skill, and intelli-gence turn their failures into successes?

The authors of this article are an early-stage ventureseed capitalist and an anthropologist who specializes inleadership. We have examined the most common waysthat CEOs fail by applying the findings and techniques

of anthropology to business organizations. We havefound that the cause of these systematic failures is notthe CEO’s lack of skill, nor even his or her psychology;it is the changing institutional context in which theCEO must perform.

A chief executive officer will fail most often in thesethree situations:

• He or she has moved to a much smaller company,either as an entrepreneur or to take over a startup orearly-stage company.

• The CEO’s small company has grown into a mid-sized company.

• The CEO has been a successful vice president orchief operating officer and has been promoted to chiefexecutive, or has been recruited as chief executive foranother company.

BY EDWARD F. TUCK AND TIMOTHY EARLE

WHY CEOS SUCCEED (AND WHY THEY FAIL)

HUNTERSAND

GATHERERS IN THE

CORPORATE LIFEWhat are the factors that determine

which CEOs succeed and which fail? Even in the high-tech world,

the laws of the jungle still rule.

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These three modes of failure seem unrelated; theyare not. Something changes when a company reaches acertain size that makes it somehow different to manage;also, running an independent company is different fromrunning a division of a large company. In short, small-company CEOs fail in large companies, large-companyCEOs fail in small companies, and CEOs who haverisen through the ranks can’t work with their boards.

Camp, Corporation, and Community

Every company is a polity: a politically organized com-munity. Even though employees may be hired and firedat will, and may be called “resources,” “heads,” “directs,”or some other impersonal term, each director, officer,manager, and employee of a company is a functioningmember of the polity. This is true regardless of thedegree of democracy that exists in the company, regard-less of an employee’s position and regardless of whetherhe or she or the company’s management wants it to betrue. Everybody in a company is part of a politicallyorganized community, a polity, and each person’s roleand behavior in that polity is determined by his or herinherited nature, upbringing, and training. In a com -pany, as in any polity, each person behaves according tohis or her rules about behavior in groups. Some of theserules come from upbringing and training. According toanthropologists L.J. Eaves, H.J. Eysenck, and N.G.Martin (Genes, Culture and Personality: An EmpiricalApproach, Academic Press, 1989), half of this behavior is inherited.

These rules come from our ancestors, and to a greatdegree they are shared among the other members of our species. When we are born we are humans, and weknow how to behave with other humans. When we try

to succeed in a group, we unconsciously call on thoseprim itive patterns of behavior that have evolved overmillions of years of living and working in groups; andthe structure of our groups comes from the way webehave together.

Anthropologists have found patterns in these“primitive,” isolated human polities that will help CEOsunderstand and solve difficulties in their relationshipswith their boards and their employees. We have foundthat corporations and their boards have strong parallelsin primitive polities, and that boards are therefore orga-nizationally different from the corporations to whichthey are attached. We learned that the founder who isruined by his or her company’s success, the captain ofindustry who cannot run a small company, and the sea-soned executive who cannot be promoted are all victimsof the same simple and ancient effect, and we propose areason for that effect. First, let’s compare organizations.

Inside Primitive Organizations

Three primitive organizations have counterparts inmod ern companies: the working group, camp, and hier-archy. A fourth organization, the state, evolved later —and it, too, has counterparts in modern companies.

1. The working group. A “working group” is foundin all cultures. It is a temporary association of two to sixpeople with useful skills, and it has a specific purpose: tohunt, to lay a section of railroad track, to right an over-turned car, to catch a criminal. Working groups are vari-ously called “hunting parties,” “task forces,” “work par-ties,” “posses,” and “patrols”: names fitting the purposeof the group and the group’s societal context. They existonly for the purpose at hand, and they are organizedquickly and informally.

Edward F. Tuck

[email protected] is the principal of Falcon Fund,

a venture capital and private

equity fund for seed and early-

stage investments, and CEO of

Social Fabric Corporation, a

relationship-prediction service

that uses DNA samples. At the

time of publication, he was a

general partner of Kinship

Partners II, a venture capital

fund. He has also been the

founder or cofounder of

sev eral companies, including

Magellan (the GPS pioneer)

and Teledesic Corporation.

Timothy Earle

[email protected] is professor and chair of the

department of anthropology at

Northwestern University, posi-

tions he held at the time of

this article’s original publica-

tion. Formerly, he was a pro-

fessor of anthropology at the

University of California at Los

Angeles and director of its

Institute of Anthropology.

Originally published Fourth

Quarter 1996.

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When a hierarchical organization like a corporationor an army sets up a working group, a leader is namedby the hierarchy (“chairman” or “squad leader”),although the real leader of the group emerges inform ally.Sometimes the group chooses its own leader by accla-mation (“team captain”) or by lottery (“straw boss”);usually, the leader arises without any special action as thework progresses, and leadership passes from one personto another smoothly as the nature of the work changes.A working group has a problem to solve and works dem-ocratically, accepting suggestions from any memberregardless of his or her status outside the working group. When the problem is solved or abandoned, thegroup disbands.

The result of the group’s work has a strong effect onthe mood of its members. If the work is successful, theyare elated and often celebrate. If the work is a failure, itsmembers are depressed and uncommunicative for atime. Working groups are short-lived, have only a fewmembers, and are re-formed as needed.

2. The camp. Hunting and gathering “camps” usu al-ly comprise about 30 people, from up to six families.The business of the camp — hunting, gathering, cook-ing, building — is done by temporary working groupsas defined above. Though many jobs in a camp are sepa-rated by sex, little other specialization exists; today’shunter may be tomorrow’s gatherer or hut-builder,although special skills such as stone tool making are rec-ognized by all.

The hunting–gathering camp does not admit tohaving a leader; in fact, members of the camp will denythere is a leader. They will say, “We’re all leaders.”Nonetheless, a member of a nearby camp will say,“That’s Joe’s camp.”

The camp thus does have a person who facilitatesdecisions. He or she does not command, but is respect-ed because of knowledge, judgment, and skill in orga-nizing opinion. As Andrew Schmookler has noted, thisperson does not give orders, but focuses the decision-making process. Decision making in a camp is a politi-cal, deliberative, consensual process. The camp’s eldersare expected to choose courses of action that are accept-able to the camp, and to accept suggestions from every-

one. The whole camp behaves in a consensual manner,and there is strong social pressure to conform. (In func-tioning camps, all members are interested in the facts,are fully informed of them, continuously discuss them,and are aware of the alternatives being considered.) Atno time are the people in the camp invited to solve aproblem as a group, nor do they wish or expect to do so.

Where a consensus is not found and distrust anddisagreement linger, the usual solution is for the smallerfaction to leave, striking off on its own. This is a fairlynormal event, as families frequently move from camp tocamp; but it is not without risk. The faction that takesoff risks its very survival if a new camp receptive to itcannot be found.

When a camp grows to about 50 people, it becomesunstable and splits into two or more camps. This patternof size-related instability is repeated in organizations ofall kinds across human society.

3. The hierarchy. The tribe, which may encompassseveral camp-sized groups, is a hierarchy. Hierarchicalorganizations have a clearly defined leader and oftenmany strata of authority. They have clear lines of author-ity, and no inherent means to achieve consensus. Theyevolved as a means of providing a mechanism for rela-tions with other tribes (including commerce and war),for conducting religious observances, and to allow occu-pational specialization. But they had the fortuitousresult of solving the problem of instability in largeorganizations. The tribal hierarchy made it possible formore than 50 people to live and work together, at thecost of personal and group autonomy.

Simple tribes are organized into local groups of afew hundred, each with its own leadership. More com-plex tribes are organized into regional chiefdoms ofseveral thousand, each with a hierarchy of leaders. At thetop of every stable hierarchy there is a camplike consen-sual group. Even in outright dictatorships there must bean egalitarian council, as Machiavelli advised in ThePrince 500 years ago: “A prudent prince must…[choose]for his council wise men.… He must ask them abouteverything and hear their opinion, and afterwards de lib-erate by himself and in his own way, and in these coun-cils and with each of these men comport himself so that

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everyone may see that the more freely he speaks, themore he will be acceptable.”

4. The state. Eventually, in the archaic world, statesevolved to organize much larger populations, whichwere often living together in cities and relying on marketexchange. It was at this time that real bureaucraciesemerged, both to solve efficiently the problems of largegroups and to control those groups for the will of dicta-torial rulers.

In the 18th and 19th centuries, with industrializa-tion and the introduction of cheap transportation, peo-ple began to live together in even larger groups. Thebureaucratic state then developed fully and became thepreferred method of managing any continuing enter-prise employing more than a handful of people. At first,these were outright dictatorships, but improvements incommunication, education, and the economy led to arevision of societal values so that now all members ofhierarchical societies have some voice. This voice variesfrom union grievance procedures through election ofleaders and managers through public approval of certainactions to formal consensus meetings; however, thestructure of any stable organization of more than 50 to100 people is some form of hierarchy.

Size Determines Structure

Why are human organizations of different sizes struc-turally different? Why does a small organization becomeunstable as it grows? Why is the triggering size the samein different cultures? It appears that six or seven is thelargest number of relationships that one person can dealwith continuously. We need the hierarchy, with its well-defined roles and patterns of behavior, to allow largenumbers of people to work together without overload.

A study by anthropologist Gregory Johnson at theCity University of New York has shown that decision-making performance in egalitarian groups falls off rap-idly as the group size grows beyond six. This is a resultof a well-documented limitation of the human brain,which cannot simultaneously retain and process morethan about seven “information chunks” at once. (Onesuch study by the Bell System set the size of local tele-phone numbers at seven digits.)

To make larger groups work while still retainingtheir egalitarian nature, six or seven groups form a“sequential hierarchy.” In this structure, consensus isachieved first within small units — for example, nuclearfamilies — and then is attempted among the formativegroups themselves, with full consensus finally reached

after a lengthy process of referring the issue back andforth from the smaller to the larger entities. The largeststable group in which this process has been observedcontains about 100 people, and involves three levels ofconsensus; the usual maximum is about 50 people (7times 7), and uses two levels of consensus.

Two points to hold in mind are: 1) As group sizechanges, so must its organizational structure. This is astrue for the long-term evolution of human society as itis for the short-term evolution of a company; 2) Withina single social system, groups of different scale exist andrequire different organizational structures. A major dys-function occurs when an organizational structure appro-priate for one scale is used for groups of other sizes.

The Modern Organization

Thus, four types of organization have arisen when peo-ple live together and try to do something in common:the working group, the camp, the general hierarchy, andthe state bureaucracy.

The most primitive of these is the working group,up to six people. It is also the one that elicits the mostprofound emotional response. The camp, up to 30 to 50people, is the next most primitive, and is also a very oldstructure.

The most modern organizations, and therefore theones for which we are by nature least adapted, are thehierarchy and the bureaucracy. Behavior in a tribe, acompany, or a nation is not innate: It is learned, in con-trast to behavior in camps and working groups. An indi-vidual’s success in a hierarchy depends on how well he orshe has learned its rules, and to what extent his or herinnate behavior allows that person to conform to thoserules. A modern corporation employing more than 100people is a hierarchy; a company of more than 1,000 isa bureaucracy. A camplike board of directors is at thetop, to offer guidance by diverse experience and to pro-vide intercorporate information. The corporation’s bestwork is done by working groups.

The advantages and satisfactions of recognizing theegalitarian nature of the working group are now under-stood; most traditional companies attempt to exploitthis. Very little analysis in a similar vein has been donewith boards of directors. Yet in corporations, the camp-like consensual group, the prince’s council, is the board.

Since today’s boards are like the camps of primitivesocieties, a successful CEO must remember how campsbehave.

A board is not a working party. It cannot solve

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problems, it can only approve or disapprove courses ofaction proposed by its leader. If it is forced to choosebetween alternatives, a crisis of leadership often arises.

The CEO’s leadership role is not openly acknowl-edged by outside board members, who strongly asserttheir equality. The CEO thus must reach consensusamong board members before proposing importantissues. This process is called “keeping in touch.”

The CEO is the natural leader of the board. Evenwhen a board has a chairman who is not the CEO, aperson close to the company will refer to “Joe’s [theCEO’s] board.” If the chief executive refuses to lead,then the CEO and board will flounder or another indi-vidual member will assume leadership. In either case, theCEO must be replaced. This is because the surrogateleader cannot lead well unless he or she assumes theCEO’s role inside the organization and on the board.

Board members expect the CEO to be their leaderand will treat him or her as such until they decide to firethe person. Anything the CEO says or does will be dealtwith by experienced board members in the context ofCEO-as-leader. If an act or utterance of the CEO isunreasonable in this leadership context, the other mem-bers will believe at a deep, unconscious level that he orshe is incompetent or even insane. Since in either ofthese cases the CEO must be replaced, an extremelyunpleasant and difficult task, a member will sometimesopt for denial by assuming that a chief executive whoexhibits such behavior is manipulative or evil, either ofwhich is a disquieting but acceptable alternative.

The Ways CEOs Fail

We can now examine CEO failure modes by comparingmodern companies with polities in primitive cultures,

and by recognizing that much of our behavior is geneti-cally determined and will be similar when working with-in groups of the same size. Our understanding of theshort-term development of companies can thus be aidedby knowing the long-term evolution of human society.

These comparisons confirm anecdotal evidence thatsuccessful management techniques are fundamentallydifferent for companies above and below a critical size,and that techniques that succeed in a company abovethe critical size will fail below it, and vice versa. Thecomparisons also explain why CEOs who are successfulas division or subsidiary managers in large companies areunable to run independent companies. These failures arerelated to their inability to deal with their camplikeboards of directors.

Consider the following scenarios:Problems with the board: the new CEO’s surprise.

Those few extraordinary individuals who succeed byclimbing to the top of a hierarchy are surprised andsometimes quickly fail when faced with the need toimmediately lead the board. The new CEO is in thesame position as a camp leader, but without the usefulexperience of having lived in a camp.

The result is that the CEO often arrives at his or herposition as head of the board without realizing that therole has fundamentally changed.

A CEO in this position assumes that the wholeorganization is simply like his or her old division orfunction. If his or her whole experience has been in hier-archies, the CEO may define the role as giving or receiv-ing orders; he or she has always been told what to do orhas told others what to do. If the CEO has had no expe-rience with boards of directors, he or she may make thefatal error of regarding the board as a new boss, as a

Since today’s boards are like the camps of primitive societies,

a successful CEO must remember how camps behave.

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working group to solve the company’s problems, or as apart of the organization that he or she must supervise. Ifthe CEO is told to lead the board but not command it,and to work by consensus, he or she may find this guid-ance incomprehensible. Denying the realities of the newsituation, the CEO may either actively avoid assumingleadership of the board or try to manipulate it or dictateto it. He or she can be further confused by fellow boardmembers, who may insist either that the board has noleader or that the leader is the aging chairman.

If, in fact, the CEO does not lead the board, theboard’s other members, who are operating out of theirprimitive, innate rule book, have little conscious insightinto the situation. They are confused and become un -ruly. The CEO and sometimes the organization it selfthen fail. Often, neither the board members nor theCEO can explain the failure. They then go on to repeatthe pattern until the board gets a CEO who will lead oruntil the CEO accepts his or her leadership role or re -turns to a subsidiary role in another company.

Problems with becoming big: the faltering founder.

Unless he or she has access to an enormous amount ofmoney, the founder of a company must first found acamp. In a camp, as we have seen, there is little special-ization; in a new company, it is common to hear, “I weara lot of hats.” It is also common to operate by consen-sus: Members marvel at the speed with which decisionsare made, and at their feeling of mutual support, clearobjectives, and clean, unambiguous communication.Employees at all levels speak as though they know whatis going on throughout the company. Most of the com-pany’s people work far more hours than a normal work-day; they enjoy their work.

If the company succeeds, it grows. At first, the com-

pany’s members are elated with the growth, and point tothe company’s new people as evidence of its success.Soon, however, typically when the company reaches 25people, a few dissonant voices are heard: “She’s trying todo my job,” “I don’t know what’s going on anymore,”and, as the company continues to grow beyond the sizeof a camp, “We’ve lost something important. I don’tknow what it is, but it’s gone. It isn’t fun anymore.” Atthis point, one or two key employees decide to leave, orsimply begin to work 40-hour weeks.

If an insensitive CEO doesn’t understand what ishappening, he or she will say that the people areungrateful and will withdraw; a more sensitive CEO willredouble efforts to communicate. Both will fail.

The appropriate action is to assemble a hierarchy,using experienced people, when the staff numbers morethan 20. Some key people will be dissatisfied and leave,because they left a hierarchy for the camplike feeling ofthe small company; some will feel betrayed. Others willadjust. The CEO must gradually abandon his or her roleas consensus leader and take on the role of chief.

This is a difficult transition even for CEOs whounderstand the problem. Often, founders have chosentheir role because of difficulties in the hierarchy of a pre-vious company; they see the transformation of theircompany to a hierarchy as a personal failure. At best,they must deal with alienation and feelings of betrayal inpeople with whom they have worked closely, and withwhom they shared the bonding and elation of a success-ful working party. Sometimes, even if their companiessucceed, they are unhappy and unfulfilled.

Problems with going small: a chief without a tribe.

The opposite occurs when a CEO is recruited from alarge company to run a young one. Such people often

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time, and whose work has largely been in hierarchies,would be wise to find an insightful friend who has suc-cessfully run a small company, or a person with exten-sive board experience, to act as an advisor.

Venture capitalists, executive recruiters, and boardmembers of young companies who have a stake in thesuccess of the people they fund or recruit can reducetheir risks considerably by discussing consensual organi-zations with their candidates.

One of the authors of this article has made a recenthabit of exploring the central issues that have been dis-cussed here with company founders (who are frequentlypro-consensus and anti-hierarchy) and with experiencedcandidates for top management jobs (who are dramati-cally the reverse). In two cases, after such a discussion, afounder suggested that he take the role of a functionmanager in the new company rather than be its CEO,and that he and the investors go out together to recruitan experienced hierarchical CEO to run the new enter-prise when it grew to an appropriate size.

In both cases, the company was unusually suc cess-ful. Perhaps more important, the founder happilyremained with the company in a productive and reward-ing role. +

Reprint No. 96402

Resources

Timothy Earle, “Chiefdoms in Archaeological and EthnohistoricalPerspective,” Annual Review of Anthropology (Annual Reviews, 1987): Asource of the insights in this article.

Eric Flamholtz, How to Make the Transition from Entrepreneurship to aProfessionally Managed Firm (Jossey-Bass, 1986): Describes what happenswhen a camplike company must become a hierarchy.

Allen W. Johnson and Timothy Earle, The Evolution of Human Societies(Stanford University Press, 1987): Includes observations on the structureand leadership of primitive polities. Insights from this book have beenused throughout this article.

Gregory A. Johnson, “Organizational Structure and Scalar Stress,” inTheory and Explanation in Archaeology, edited by C.A. Renfrew, M.J.Rowlend, and D.A. Segraves (Academic Press, 1982): Why consensusdoesn’t work in groups larger than six people.

Niccolò Machiavelli, The Prince, translated by Luigi Ricci (New AmericanLibrary, 1952): The classic for leaders of a state — or a hierarchy.

Andrew Bard Schmookler, The Parable of the Tribes (University ofCalifornia Press, 1984): This work, subtitled The Problem of Power inSocial Evolution, contains many strong parallels to modern corporatebehavior.

For more thought leadership on this topic, see the s+b website at: www.strategy-business.com/organizations_and_people.

have no experience with consensus-based groups.When the CEO arrives at his or her new company

and finds that everyone has a title and a place in anorganization chart, he or she is pleased, and often beginsthe process of interviewing people to see if they are wellqualified for their positions.

The CEO is then usually dismayed. If he or sheconcludes that the staff is incompetent, however, thatconclusion will be wrong. If, on the other hand, he orshe believes that the titles and the organization chartdescribe the real organization, and then attempts tooperate the company accordingly, the CEO will failimmediately. There is no hierarchical organization; it isa camp. The CEO cannot delegate; he or she must workby consensus.

Gaining Anthropological Guidance

The literature and techniques of anthropology and cul-tural evolution can be used to understand businessorganizations at different scales. We have explained threefamiliar failure modes of chief executive officers, derivedfrom studies of primitive societies and their leadership.We have shown that these failure modes can be avoidedif the CEO and the company’s employees understandand conform to the deep structure of their organization.

We have also shown that the board of directors of amodern corporation is a more primitive and intrinsic allydifferent structure from the organization it serves, andthat CEOs must use fundamentally different techniquesto work with their boards and with their companies.

Many failures of companies and their chief execu-tives can be avoided by supplementing graduate businesstraining, which now deals largely with the structure andmanagement of hierarchies, with training in consensualorganizations such as boards, skunkworks, and smallcompanies. The goal is for the new CEO to have thetraining to understand the differences between theorganization he or she is entering and the one he or sheis leaving.

In the absence of knowledge, people do the thingsthat have worked for them in the past. When thesethings fail to work, people simply do them more inten-sively, like a tourist in a foreign country who just shoutslouder if he or she is not understood.

But new CEOs have staked everything on their newjobs and they desperately want to succeed. When theyarrive in an unfamiliar organization, they are receptive toguidance they believe may keep them from failing. Aperson who is entering a small company for the first

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The question of how to achieve long-term sustain-able growth in shareholder value is at the top of theCEO agenda. Many companies have successfullyfocused their efforts on cost reduction through increasedlabor and asset productivity, and have achieved short-term increases in shareholder value as a reward. Withtheir businesses running efficiently, these companieshave refocused their energies into developing long-termgrowth strategies.

Aggressive revenue-oriented strategies are the mostcommon approach to creating long-term value forshareholders. These strategies typically include acquisi-tions, new products that extend the line, and marketingprograms to improve customer loyalty and retention.

Unfortunately, our research indicates that thesestrategies can cause more harm than good. Superior

long-term value for shareholders is derived only from aspecific type of revenue growth: growth that resultswhen a company delivers an order-of-magnitudeincrease in value to its customers, which we call “10Xvalue.” An order-of-magnitude improvement in thevalue proposition — obtained through a mixture ofproduct, image, service, and price — not only stimulatesgrowth by compelling customers to purchase, but alsoenables a company to earn superior profitability. A 10Xvalue innovation changes the industry’s basis of compe-tition and forces competitors to react, often by trying tocopy the innovation.

We find that attempts to grow revenue rapidly with-out a 10X improvement in value are seldom successfuland often counterproductive. They involve either costlyacquisitions that are subsequently divested, “renting”

BY CHARLES E. LUCIER, LESLIE MOELLER, AND RAYMOND HELD

10X ValueTHE ENGINE POWERING LONG-TERM SHAREHOLDER RETURNS

What does it take to grow shareholder value at world-class rates? More than profit and

revenue increases. It takes strategic innovation to make it into the top tier.

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new customers with the latest promotion, or the exten-sion of product lines at the expense of the long-term loy-alties of current customers. The only reliable way to earnreturns for shareholders in the top 10 percent over aperiod of 10 to 15 years is through a 10X value innova-tion. Of course, our findings do not invalidate theimportance of rapid productivity improvements andrevenue growth in all businesses. To sustain even averagereturns for its shareholders, a company must achievecontinual improvements in its productivity and targetincreases in market share.

This article relates our findings on 10X value as acause of shareholder value growth and discusses theimplications for senior managers. These findings resultfrom an ongoing effort to uncover the dynamics ofgrowth. They are based on an assessment of the creationof long-term shareholder value by more than 1,300 largecompanies publicly traded in the United States between1967 and 1997, supplemented by case studies of 65companies in the top 10 percent of shareholder valuecreation for at least a decade. Although the quantitativeresearch that underlies this article focuses on UnitedStates companies, our subsequent research suggests thatthe conclusions are equally valid in other countries.Indeed, many top-performing U.S. companies (forexample, the Coca-Cola Company) achieved much oftheir growth by replicating their 10X value in othercountries.

Several findings from this research contradict con-ventional wisdom. First, the relationship between rev-enue growth and growth in shareholder value — definedas increases in stock price plus dividends, adjusted forstock splits — is not close in either the short term or thelong term. For example, despite significant growth in

revenue between 1985 and 1994, USAir, Fleming, andBlack & Decker had a modest or negative growth inshareholder value.

Additionally, industry growth rates are almost com-pletely unrelated to the likelihood that a company willcreate superior shareholder value over the long term.Contrary to prevailing strategic thinking, companies inslow-growth, mature markets are somewhat more likelyto create superior returns for shareholders than compa-nies in fast-growth industries.

Finally, the tactics implied by traditional strategicplanning — which focuses on achieving better marketand cost positions than competitors through superiorplanning and management — results, at best, in growthrates a few points faster than average and significantlyless than the top-performing companies.

Innovation: The Value Multiplier

What then are the drivers of sustained superior long-term growth in shareholder value? More than 90 percentof the companies we studied that achieved top-decilereturns for at least 10 years have been able to sustainrapid increases in operating earnings through the con-tinual creation of 10X value for customers. They thenachieved top-line growth by replicating the 10X value toattract new segments of customers (what we call a“growth superhighway”).

To accomplish this, they relied on continual, high-ly productive innovation: developing and constantlyenhancing unique approaches to serve customers moreeffectively and sharing the value with customers. Thisoften resulted in value propositions that offered bothbetter differentiation and lower pricing. Although theresult of innovation is often a breakthrough that changes

Charles E. Lucier

[email protected] is a writer and contributing

editor to strategy+business.

He was instrumental in the

founding of this magazine.

At the time of this article’s

publication, he was a senior

vice president at Booz Allen

Hamilton (whose commercial

business later became Booz &

Company), and the managing

partner of its Cleveland office.

Leslie Moeller

[email protected] is a partner with Booz &

Company in Cleveland. He

leads the firm’s North

American work in the con-

sumer, media, and retail

industries. He is the coauthor

of The Four Pillars of Profit-Driven Marketing: How toMaximize Creativity,Profitability, and ROI (McGraw-

Hill, 2009).

Raymond Held

is the chief financial officer

of Kellogg de Mexico. At the

time of this article’s pub lica-

tion, he was a senior associate

in the engineering and manu-

facturing group at Booz Allen

Hamilton.

Originally published Third

Quarter 1997.

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the rules of the game, all of the companies we studiedrelied on a series of innovations, not a single “big idea.”

The highest-performing companies were dividedinto two types of innovators. Strategic innovations —dramatic improvements in the entire business systemthat deliver value to customers — powered about half ofthem. For this group of “strategic innovators,” willing-ness to share the benefits with customers was an essen-tial factor — to drive top-line growth, and to stimulateadditional improvements in the business system andremain ahead of competitors. Innovation in products orservices that create 10X value for customers powered theother half of the top-performing companies.

• Strategic innovators. Although it is not surprisingthat a successful strategic innovator creates extraordinaryvalue for its shareholders, we were surprised to discoverthat nearly half of the top decile of companies for each ofthe three decades we studied fall into this category.Strategic innovation is unusual in any one industry: inthe 75 industries in the United States that we investi -gated, we found an average of 0.6 successful strategicinnovations per industry per decade. Nonetheless, 5 per-cent of all large publicly traded companies are strategicinnovators, which is a significant number.

Because strategic innovators change the rules of thegame in their industries, most of their stories are wellknown. Nevertheless, three findings common to all ofthe strategic innovators deserve mention.

First, strategic innovations are not brainstorms orconcepts that emerge fully formed: The initial concept isdifferent from the typical game-changing innovation.Strategic innovation requires not only a breakthroughidea, but also the commitment and the feedbackprocesses to refine the idea until it is successful. For

example, FedEx Corporation was founded to provideguaranteed overnight delivery, which was a break-through idea. However, the initial target market waspurveyors of critical supplies, such as medical suppliesand parts. It was the later discovery that most of the vol-ume of material sent was paper, and the subsequentpositioning of FedEx to provide the reliable delivery ofimportant business material, that really drove growth.Innovations that in retrospect may appear to be a singleidea were in fact the result of a series of linked innova-tions and adaptations.

Second, strategic innovation is difficult and time-consuming to put into practice. Home Depot Inc., forexample, was a strategic innovator in its transformingthe category of home improvement retailing. An in di -cation of the magnitude of the difficulty is the 15 yearsrequired for any of its competitors to create an equallysuccessful format — even though they could build uponHome Depot’s experience. A strategic innovator’s com-petitive advantage is not the breakthrough idea, butrather the myriad details of the successful business sys-tem and the ability to adapt rapidly and improve.

Finally, to create superior value for shareholders,strategic innovators don’t need to start in a large marketsegment. In fact, the companies that created the high estrate of return for their shareholders over a decade weresomewhat smaller (in revenue) than the average largepublicly traded company at the beginning of the decadeand larger than the average large publicly traded com -pany at the end of the decade. Strategic innovators aremuch more likely to succeed when they initially focuson a peripheral segment. The innovator can learn howto make its breakthrough idea really work to deliver 10Xvalue in the periphery, often without reaction from the

The initial target market was purveyors of medical supplies and parts.

Then FedEx discovered that most ofthe material sent was paper.

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dominant competitors focused on the core markets. Nucor Corporation illustrates the pattern. Nucor

began as a manufacturer of steel joists and a regionalmanufacturer of reinforcing bars — the lowest-qualitysteel, of least interest to the major integrated mills. Overtime, it moved into light structural shapes, mediumstructural shapes, and finally, flat rolled steel. By themid-1990s, Nucor had become the second-largest steelproducer in North America.

• Product and service innovators. These companiesbring a series of successful “new to the world” productsto market. Their success lies in coupling an effectiveinnovation process with a superior product concept, andrepeating this success time after time. Just one newproduct is no longer enough to power superior share-holder value; top-decile growth in shareholder valuerequires getting new products right consistently.

Although the most successful product innovatorsare effective throughout the innovation stream of activi-ties, it is excellence in one of four activities that powerssuccess. These are market understanding (defining cus-tomer and channel needs and opportunities ahead ofcompetitors); technology management (ensuring thatthe correct high-impact technologies are available whenneeded); product planning (integrating market needswith product architecture to enable competitive specifi-cation, development, and delivery of products); andproduct development (translating a product line orprocess specification into an engineered design that canbe competitively delivered to customers).

For instance, Nike Inc.’s success comes from anunderstanding of its customers’ total experience with itsproduct, including intensive managerial experience withthe products and a special panel of athletes to providefeedback on designs and trends. Leading-edge productscombine with powerful advertising campaigns using rolemodels to enhance the customer’s athletic shoe experi-ence. Intel Corporation, on the other hand, creates valuefrom a focus on maintaining market leadership by usingtechnology to constantly improve physical product per-formance. Before a new product is launched, a designteam is working on the next-generation technology thatwill make the new product obsolete — bringing a con-tinuous stream of higher-powered chips to the market.

In capital-intensive industries, driving valuethrough continual product innovation often requires“new to the world” innovations that “bet the company.”For the Boeing Company, the development of each newaircraft is a major decision, one that could permanently

damage the company if it fails. For instance, from thelate 1980s to the early ’90s Boeing spent US$4.5 billionto develop the 777 aircraft, at a time when the compa-ny’s equity was $8 billion. The success of this aircraft wasinstrumental in helping the company turn its sales num-bers around during the industry rebound of the late1990s. Intel has to make similarly risky bets on eachnext wave of microprocessor technology. Although mak-ing these bets can be frightening for all involved, theymust enable the stream of continual product innovationrequired to deliver 10X value. In addition, big bets cre-ate a barrier to entry by less-experienced companies, andthis helps to maintain the product innovator’s superiorvalue over its competitors.

The Growth Superhighway

To earn superior returns for shareholders, a companymust effectively exploit its 10X value to sustain annualtop-line growth of 15 to 25 percent without mistakesthat negatively impact earnings. Whatever the source oftheir 10X value, the companies that created the greatestlong-term value for their shareholders all created agrowth superhighway — that is, the capability to repli-cate revenue growth along one targeted path.

All companies seek growth through some mix ofmarket share gains within current segments, new seg-ments, new geographies, and acquisitions. Most compa-nies try to generate growth through most of these paths.The companies that create the most long-term value fortheir shareholders are unusual in that they focus on oneprimary path. For example, Walmart and Home Depothave grown primarily through geographic expansion,the Shaw Group and WMX Technologies (formerlyWaste Management Inc.) expanded by acquisition;

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Nucor and Rubbermaid pursued adjacent segments; andIntel has primarily focused on rapid rollout within itscurrent segments.

Global expansion is an increasingly importantgrowth superhighway. Coke’s ability to replicate its 10Xvalue proposition overseas — especially in developingand supporting the local bottlers who sell and distributethe product — has been the principal driver of itsgrowth. Similarly, Carrefour SA, the leading Frenchhypermarket retailer, has had tremendous success inexpanding its format in Latin America. In Carrefour’scase, international expansion into less-developed mar-kets has been especially effective because the hypermar-ket value proposition is more than a 10X improvementover the small local supermarkets and general merchan-dise retailers.

The best-performing companies invest in routiniz-ing expansion along the targeted growth path. For exam-ple, Walmart has a standard, very efficient process tobuild a new store, Home Depot excels in quickly pene-trating a new metropolitan area with a critical mass ofstores, and Shaw and WMX learned to install their 10Xvalue-creating system quickly in the companies theyacquired. Once these companies stray from their growthsuperhighway, their performance can become highlyvariable. For example, Home Depot’s entry into Canadaby acquisition and its formats targeted at other customersegments (for example, Expo) have not really panned out.

It appears that more than one growth superhighwaymay be viable in an industry. For example, between1972 and 1985, WMX and Browning-Ferris Industrieseach created 10X value for customers and top-decilereturns for their shareholders, even though WMX grewprimarily by acquisition and Browning-Ferris mainly by

geographic expansion. Hence, the imperative appears tobe less to select the correct growth path than to focus onone path and invest in building the capability to make ita superhighway.

Implications for Management

Our findings demonstrate that creation of 10X value forcustomers along a growth superhighway leads to superi-or long-term value for shareholders. The four impera-tives top management must heed to develop and exploita 10X value proposition are: challenge; focus; differenti-ate your management approach; and lead, don’t follow.

• Challenge. Companies that create superior long-term returns for their shareholders have financial per-formance that is significantly — not incrementally —better than average. Increasing the rate of growth inearnings and revenue of an average company by two orthree points will not result in 80th or 90th percentilereturns to shareholders.

By setting the strategic long-term challenge ofachieving dramatically higher financial goals, a CEO canhelp stimulate a fundamental rethinking of the businessthat might yield 10X value for customers.

• Focus. The best-performing companies that wehave studied all prospered by creating 10X value for cus-tomers in one business and by exploiting their advantagedown one growth superhighway. Focus enables a com-pany to continue to innovate, to gain leverage from scaleas it grows, and to sustain its advantage over competi-tors. Companies that lose their focus on one growthsuperhighway often falter in creating superior long-termreturns to shareholders.

The multibusiness corporations like GeneralElectric Company and PepsiCo that have created 10X

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value have done so in only one business unit at a time(specifically, GE Capital and Frito-Lay). In part, this factmay merely reflect the inherent difficulty of creating10X value. However, we believe that it will be very difficult for any corporation to create and exploit 10Xvalue in two distinct business units simultaneously. 10X value creation is simply too demanding in terms ofmanagement talent, investment to finance rapid growth,and the attention of the CEO.

One principal reason that large multibusiness com-panies have been less likely to create 10X value than single-business companies may have been an unwilling-ness to focus on a single business unit as the driver ofsupe rior long-term shareholder value creation.

The good news is that even in a corporation as largeand diverse as GE, one division that creates 10X valueand exploits the advantage along a growth superhighwaycan yield excellent long-term results to shareholders. Forexample, GE is an extremely well-managed companywith returns to shareholders in the 75th percentilebetween 1985 and 1994. However, without GECapital’s 23 percent annual earnings growth, the corpo-ration’s earnings would have grown at only 6 percentinstead of 9 percent, and returns to shareholders proba-bly would have been only average.

• Differentiate your management approach. Cre-ation of 10X value for customers requires a distinctivemanagement model. This involves the rapid incorpora-tion of feedback from customers into the evolving valueproposition; investment in rapid growth, often before acompelling case can be made that the investment will payoff; an entrepreneurial culture with rapid decision mak-ing; and compensation heavily incentivized toward bot-tom-line growth or superior returns to shareholders.

Although single-business companies can embracethis model, multidivision corporations face a formidablechallenge. The usual multidivision corporate planningand budgeting processes, culture, and compensation sys-tems are inconsistent with the 10X value creationmodel. For example, traditional strategic planning usu-ally focuses on what is and what has been, whereas 10Xvalue creation involves “new to the world” innovation.An analytical demonstration that something that hasnever been done will prove to be a superior investmentis very difficult.

The solution for a large multidivision company thatwants to create 10X value in a business is to differentiateits management systems. That is, it can use differentplanning, budgeting, and compensation systems in thedivision targeting 10X value and allow that business’sculture to diverge somewhat. More traditional planningand budgeting systems are better adapted to businessesthat are not trying to create 10X value. These systemscan stimulate productivity improvements, target oppor-tunities for profitability increases and market sharegains, quickly match successful initiatives by competi-tors, and ensure that business units create and executenear-term plans consistent with a long-term strategicdirection.

• Lead, don’t follow. 10X value creation requiressenior management leadership. There are two key rolesto be played: a senior champion who makes the refine-ment and success of the 10X value innovation his or hersole objective, and a CEO who decides which bets tomake and who creates the environment for success.

Creating 10X value starts with the conviction that amarket is ready for value innovation, like that shown bySam Walton in leaving Ben Franklin stores when that

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improve products significantly (its R&D spending isabout 4 percent of sales whereas Unilever’s is about 2percent) and has developed the ability to globalize theproducts rapidly. Although P&G cannot claim everybreakthrough — indeed, it missed such product ideas as pull-up diapers and peroxide and baking soda intoothpaste — it creates a sufficient stream of global win-ners, such as two-in-one shampoo and compact deter-gents, to fuel returns to shareholders, as of 1997, in the81st percentile.

CEOs of companies with successful 10X value cre-ation strategies consider them to be low risk: As long asthey can sustain the 10X advantage, there is no need toworry about the actions of competitors or the cyclicalityof the underlying market.

Superior long-term growth in shareholder value isfeasible only with creation of 10X value for customersthrough strategic or product innovation, sharing part of the value with customers and capturing part of thevalue in attractive profitability. Ultimately, 10X valuecreation is strategically liberating: Virtually all compa-nies, even large corporations in mature industries, havethe potential of creating superior long-term returns fortheir shareholders. +

Reprint No. 97302

Resources

Paul Leinwand and Cesare Mainardi, “The Coherence Premium,”Harvard Business Review, June 2010, Reprint R1006F,www.booz.com/global/home/what_we_think/capabilities_driven_strategy/hbr_article: Takes the concept of focus further by showing howaligning strategy, capabilities, and products and services leads to a long-term “right to win” in the market.

Charles E. Lucier and Amy Asin, “Toward a New Theory of Growth,”s+b, Winter 1996, www.strategy-business.com/article/8660: Paved the wayfor this article by asserting that increasing revenue is not enough; 10Xshareholder-value growth requires strategic innovation.

Kenichi Ohmae, “The Godzilla of the New Economy,” s+b, First Quarter2000, www.strategy-business.com/article/10401: A prescient look at therapidly growing 10X-value companies of the turn of the century: Amazon,Nokia, eBay, Docomo, Cisco Systems, and more.

For more thought leadership on this topic, see the s+b website at:www.strategy-business.com/strategy_and_leadership.

company rejected the idea of a “Walmart” or by GaryWendt and Larry Bossidy in building GE Capital acqui-sition by acquisition during the 1990s. We are not say-ing these leaders had a vision that popped fully formedinto their minds, but they did have the commitment torefine the idea until it succeeded, the willingness tomake mid-course corrections, and the ruthless executionto make the financials attractive while evolving along agrowth superhighway. Although the CEO usually playsthe champion’s role in small entrepreneurial companies,in large companies the role does not have to be playedby the CEO (for example, at GE Capital it was playedby the head of the business).

The CEO plays three critical roles in the creation ofsuperior value for shareholders. He or she sets the objec-tive of truly superior (top 10th or 20th percentile) long-term returns to shareholders. He or she evaluates theopportunities for 10X value creation across the businessunits, betting on no more than one or two prospectivegrowth engines and adjusting the bets as new informa-tion comes to light. Finally, the CEO ensures that man-agement processes, incentives, and leadership of the tar-geted bets support 10X value creation.

In our discussions with CEOs of large companies,their major concern is risk: How likely is an innovativegrowth strategy to succeed? What is the downside if itfails? Our response is that if the CEO’s objective is top10th or 20th percentile long-term returns to sharehold-ers, then there is no real alternative to a 10X value cre-ation strategy.

Because 10X value creation strategies typicallyinvolve pilot programs to refine the concept, signifi cantfinancial commitments may not be required initially.The downside of the pursuit of an innovative strategythat is ultimately unsuccessful is less the financial lossthan the loss of time and management attention thatwould have been used more productively elsewhere.Partially successful 10X value creation strategies can stillproduce excellent returns for shareholders, albeit returnssustained for a shorter period of time (because competi-tors can match the innovation quickly) or fall “only” inthe 70th or 80th percentile. For example, Procter &Gamble Company spends heavily on tech nology to

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BY DON TAPSCOTT

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Rethinking

(or Why Michael Porter Is Wrong about the Internet) in a Netw

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For decades, the starting point for strategic think-ing has been the stand-alone, vertically integrated cor-poration. These powerful companies do everything fromsoup to nuts and dominate the competitive landscape. Wethink of them as intrinsic to the economy, and they pro-vide the context for theories about competitive strategy.

Companies prospered with this model of produc-tion because it was cheaper and simpler for them to per-form the maximum number of functions in-house,

rather than incurring the high cost, hassle, and risk of part-nering with outsiders to execute vital business activities.

This is no longer true.The CEO of Boeing Company says his company is

no longer an aircraft manufacturer; it has become a sys-tems integrator. Mercedes-Benz doesn’t build its own E-Class cars; the Magna Corporation does the work,including final assembly. IBM has become a computercompany that doesn’t really make its computers; its part-

Strategy

The Harvard strategy guru errs when he says partnerships erode competitive

advantage. Instead, they are now central to business success.

orked World

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ner network does. Indeed, we are seeing spectacular growth in contract

manufacturing — with companies such as Celestica,Flextronics, and Solectron partnering with computerand telecommunications vendors to provide core elec-tronics manufacturing services. Virtually overnight, thetop five contract manufacturing firms have achievedaggregate revenues of more than US$50 billion, averag-ing return on invested capital of more than 25 percent.

All of this is possible because of networking —specifically, the Internet. This deep, rich, publicly avail-able communications technology is enabling a new busi-ness architecture that challenges the industrial-age cor-porate structure as the basis for competitive strategy. Mycolleagues at Digital 4Sight and I have studied hundredsof different examples of this architecture, what we call abusiness web, or b-web. We define it as any system com-posed of suppliers, distributors, service providers, infra-structure providers, and customers that uses the Internetfor business communications and transactions. B-websacross industries, in which each business focuses on itscore competence, are proving to be more supple, inno-vative, cost-efficient, and profitable than traditional ver-tically integrated competitors.

Established companies, not dot-coms, are the mainbeneficiaries of b-web thinking. Successful businessessuch as Citibank, Herman Miller, Dow Chemical,American Airlines, Nortel Networks, and Schwab arenow transforming themselves by partnering in areas thatwere previously unthinkable. The perfor mance advan-tages of a b-web also explain why new Internet-basedcompanies such as eBay, Travelocity, E-Trade, andAmazon are growing dramatically and competing welldespite volatility in their stock prices. And b-webs ex -

Don Tapscott

[email protected] is president of the New

Paradigm Learning

Corporation and cofounder of

Digital 4Sight, a company that

designs and implements new

business models for corpora-

tions. He is the coauthor, with

David Ticoll and Alex Lowy, of

Digital Capital: Harnessing the

Power of Business Webs

(Harvard Business School

Press, 2000).

Originally published Third

Quarter 2001.

plain why an upstart e-business entity like Napster iswreaking havoc in the music industry, and why opensource software such as Linux poses a huge threat toMicrosoft.

Profound changes to the deep structures of the cor-poration are under way. Yet most of this underlyingrestructuring has been either unnoticed or underappre-ciated by the financial media and business schools. Theyremain shell-shocked at the rise and collapse of theNasdaq. And since “Nasdaq” and “New Economy” areso frequently (but incorrectly) used interchangeably, the Nasdaq collapse is often cited as proof that the NewEconomy is a bogus notion. (See “Six Reasons There Is a New Economy,” page 28.) As for eBay, Amazon,Linux, Napster, and others, they are dismissed asInternet aberrations.

Michael Porter’s obituary for the New Economy,“Strategy and the Internet,” published in the March2001 Harvard Business Review, is typical of this think-ing. In it, Porter exhorts business leaders to “return tofundamentals” and abandon thoughts of “new businessmodels” or “e-business strategies” that he says encouragemanagers “to view their Internet operations in isolationfrom the rest of the business.”

When a politician makes a motherhood statementthat receives wide support, pollsters say it “resonateswith” the voters (i.e., it’s considered credible and is con-sistent with citizens’ values). Such is the appeal ofPorter’s article. Profitability still counts. True economicvalue, measured by sustained profits, is the arbiter ofbusiness success — not eyeballs, stickiness, hits, or evenmarket share. To compete, companies must operate at alower cost and/or command a premium price, eitherthrough operational effectiveness or by creating unique

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value for customers. Being a first mover does not guaran-tee competitive advantage over the long haul.

Unfortunately, he uses these truths to prop up afalse thesis. Because corporate objectives remainunchanged by the Net, Porter argues, the best methodsof achieving these goals, including operating within avertically integrated structure, must be unchanged, too.

Porter sees the world as two warring camps: theInternet zealots and the defenders of tried-and-true business thinking, such as himself. And it’s pretty clearwho’s winning. This gives him the basis on which toassert that “the experiences companies have had with the Internet thus far must be largely discounted and…many of the lessons learned must be forgotten.” Ifyou were an industry leader prior to the Internet’s burst-ing on the scene, continue your time-tested businessprocesses. Use the Net as a “complement to traditionalways of com peting,” he says, rather than “cannibalizing”a healthy company.

Regrettably, a much-needed return to fundamentalshas become a new fundamentalism that argues managersshould turn back the clock for business wisdom. Al -though there is some merit in Porter’s view that “in ourquest to see how the Internet is different, we have failedto see how the Internet is the same,” it is utter folly to believe the Internet brings nothing fundamen-tally new.

What Is the Internet?

Much of Porter’s reasoning stems from his misunder-standing of the Internet itself. He concedes that theInternet is important — it’s just not that important.“But for all its power, the Internet does not represent a break from the past; rather, it is the latest stage in the ongoing evolution of information technology,” he writes. Rather than viewing the Net as the emerginginfrastructure for economic activity, he puts the Internetarchitecture on the same level as “complementary tech-nological advances such as scanning, object-orientedprogramming, relational databases, and wireless com-munications.”

It is wrong to trivialize the Net in this way. The Netis much more than just another technology develop-ment; the Net represents something qualitatively new— an unprecedented, powerful, universal communica-tions medium. Far surpassing radio and television, thismedium is digital, infinitely richer, and interactive. TheNet is becoming ubiquitous; it will soon connect everybusiness and business function and a majority of

humans on the planet. All other communications tech-nologies, such as telephone, radio, television, and wire-less, are being sucked into the Net’s maw.

Porter also makes an all-too-common mistake inassuming that the Internet we see today — a networkthat connects desktop PCs — is the same Internet wewill see tomorrow. This is nonsense. The Internet oftomorrow will be as dramatic a change from the Internetof today as today’s Internet is from the unconnected, pro-prietary computing networks of yesterday.

The Net continues to soar in reach, power, andfunctionality. It is not only the means to link computers,but the mechanism by which individuals and organiza-tions exchange money, conduct transactions, communi-cate facts, express insight and opinion, and collaborateto develop new knowledge.

Mobile computing devices, broadband access, wire-less networks, and computing power embedded ineverything from refrigerators to automobiles are con-verging into a global network that will enable people touse the Net just about anywhere and anytime. No facetof human activity is untouched. The Net is a force ofsocial change penetrating homes, schools, offices, facto-ries, hospitals, and governments. When an institutionsuch as the Massachusetts Institute of Technology says itwill post its entire curriculum on the Net — includingsuch items as lecture notes and course reading lists — itis attempting to shape the nature of pedagogy and learn-ing everywhere.

The 20th-century corporation was based on aninfrastructure that included the electric power grid,roads, railroad tracks, and primitive analog networkslike the telephone. Rather than viewing the Net as com-parable to “scanning,” Porter should see it as the newinfrastructure of the 21st century. Many strategists lookbeyond individual corporations to think about thestructure of industries. However, the Internet precipi-tates one of those rare occasions in economic historywhen we must think even more broadly in order tounderstand how the entire infrastructure for wealth cre-ation is changing.

What Is a New Business Model?

Porter believes there is no such thing as a “businessmodel,” let alone a new one, and I don’t fault him forquestioning the validity of the term. Analysts have usedit loosely, in reference to everything from selling rocksonline to a Vickery auction for financial services.

Often the term business model is used more or less

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synonymously with business strategy. For example, AdrianSlywotzky describes it as “the totality of how a companyselects its customers, defines and differentiates its offerings(or response), defines the tasks it will perform itself andthose it will outsource, configures its resources, goes tomarket, creates utility for customers, and captures profits.It is the entire system for delivering utility to customersand earning a profit from that activity.”

Our view is narrower than this. Quite simply, a business model refers to the core architecture of a firm,specifically how it deploys all relevant resources (not justthose within its corporate boundaries) to create differen-tiated value for customers. Historically, strategistsweren’t particularly concerned with business models,because each industry had a standard model, and strate-gists assumed the model in that industry. Although theauto manufacturer, the integrated steel company, the

insurance company, the retailer, the oil company, andthe bank were different, they shared the characteristic ofvertical integration.

Traditional business theorists like Michael Porterfavor vertical integration and argue against partnering.In his seminal book, Competitive Strategy, he devotes anentire chapter to a vigorous defense of the vertically inte-grated firm. Today he writes how the “myth” that “part-nering is a win–win means to improve industry eco-nomics” has “generated unfounded enthusiasm for theInternet.” He cites a litany of reasons he believes it’s bet-ter not to partner.

However, it is indisputable that the Net dramatical-ly reduces search, coordination, contracting, and othertransaction costs between firms. Because of this, myriadnew business models have emerged that are differentfrom the industrial-age template, and there are hundreds

Six Reasons ThereIs a New Economy

here is nothing fundamentally

new about the way capitalism

works. In capitalist countries, there is

still private, not state, ownership of

wealth, and the economy is based on a

market. The traditional business cycle

(overproduction, inventory gluts, tight

employment markets, inflation) is

alive and well. Profits are still the ulti-

mate measure of success. Yet, there

are characteristics of 21st-century

capitalism that make it entirely differ-

ent from its predecessors.

1. New infrastructure for wealth

creation. Networks, specifically the

Internet, are becoming the basis

of economic activity and progress.

This is not unlike how railroads, roads,

the power grid, and the telephone

supported the vertically integrated

corporation.

2. New business models. Instead of

thinking of New Economy companies

as Internet companies or dot-coms,

think about them as companies that

use the Internet infrastructure to cre-

ate effective b-web–based business

models. In this sense, the New

Economy can include steel compa-

nies, banks, gas distribution compa-

nies, and furniture manufacturers,

just as the old economy can include

high-technology firms.

3. New sources of value. In today’s

economy, value is created by brain,

not brawn, and most labor is knowl-

edge work. Knowledge infuses itself

through out products and services.

Michael Porter is right to say that

intellectual capital has no intrinsic

value. However, recent experiments in

measuring knowledge-based assets

suggest wealth contained in such

assets can outstrip the wealth con-

tained in physical assets and even

bank accounts.

4. New ownership of wealth. The

silk-hatted tycoons owned the most

wealth in industrial capitalism. Today

60 percent of Americans own stock,

and the biggest shareholders are

labor pension funds. Most economic

growth comes from small companies;

entrepreneurialism is everywhere.

5. New education models and insti-

tutions. As lifelong learning becomes

the norm, the services of private com-

panies, not public institutions, are

proliferating to meet growing de -

mand. The model of pedagogy is also

changing with the growth of interac-

tive, self-paced, student-focused

learning. Colleges are becoming

nodes on communications networks,

not just places where people go to

study.

6. New governance. Industrial-age

bureaucracies rose simultaneously

with the vertically integrated corpora-

tion and mimicked its structure. New

Net-driven governance structures,

such as the Knowledge Network of

Los Angeles, enable Internet-based

cooperation between public and pri-

vate organizations to deliver services

for citizens. Expect to see similar

changes in the democratic procedure

(e.g., the voting processes) and the

relationship between citizens and the

state.

—D.T.

T

of old and new companies that are winning by focusingon their core capabilities and letting partners do the rest.

For example, Siebel Systems Inc., one of the fastest-growing software companies in America, has establisheda vast and unique network of customer, supplier, andemployee relationships to deliver its products and ser -vices. Tom Siebel claims his company’s b-web is themost important element in its success: “We only have8,000 people on our payroll, but more than 30,000 peo-ple work for us,” he says. The relatively small core com-pany creates software products and orchestrates anextensive b-web composed of consultants, technologyproviders, system implementers, suppliers, and vendorsthat take its products to the global marketplace. Theresult: Siebel Systems’ revenues soared more than 1,400percent in just three years, from $118 million in 1997 to$1.8 billion in 2000.

Yesterday’s strategy orthodoxy blinds managers tothese unprecedented corporate opportunities. The busi-ness strategist needs new tools, including strategic concepts and analytical methods, to comprehend andexploit business architectures, like b-webs, that are sud-denly possible because of the Net. I call this “businessmodel innovation.”

When the superiority of the vertically integratedindustrial corporation was taken for granted, it wasassumed that most resources would be internal to thecompany. A business’s human-resources strategy dealtwith people on the payroll. Accounting handled cus-tomer payments. Simple.

But in the Internet era, we know firms can profitenormously from resources that don’t belong to them.This is much more than what we call outsourcing today.In the future, strategists will no longer look at the inte-grated corporation as the starting point for creatingvalue, assigning functions, and deciding what to manageinside or outside a firm’s boundaries. Rather, strategistswill start with a customer value proposition and a blankslate for the production and delivery system. There willbe nothing to “outsource” because, from the point ofview of strategy, there’s nothing “inside” to begin with.Instead, managers, using new tools of strategic analysis,can identify discrete activities that create value and par-cel them out to the appropriate b-web partners. A leadfirm in a b-web (e.g., Siebel Systems) choreographs theprocess, acting as a “context provider.”

Given the Internet’s power, a reasonable personmight ask: Why can’t corporate managers simply deployintranets to get at the resources they need and reap the

rewards? Economics 101 tells us why: Intra-corporatesolutions fail to capture the tonic of the marketplace.

Most of what companies do is not based on theircore competencies. Instead, firms attempt to make dowith some combination of in-house design, manufac-turing, marketing, and other capabilities that are oftennot best-of-breed. Now with the Net, business functionsand large projects can be reduced to smaller componentsand farmed out (often simultaneously) to more special-ized companies around the world with virtually notransaction costs. This captures the enormous benefitsbrought on by the competitive environment. Suppliersstrive to reduce costs and increase quality and innova-tion. They know there are other specialized workers andcompanies around the world keen to replace them.

In this environment, the management of partner-ing, corporate boundaries, distribution channels, indus-try restructuring, and strategic repositioning is suddenlymuch more complex. And there are new issues, too. Itused to be that sellers simply established prices. Nolonger. Transparency across the value chain, customerpower, and global real-time information make variablepricing mechanisms far more important.

The Net and Competitive Advantage

Porter avers that “as all companies come to embraceInternet technology…the Internet itself will be neutral-ized as a source of [competitive] advantage.” The morerobust competitive advantages, he says, will arise insteadfrom traditional strengths such as unique products,strong personal service, relationships, and sustainableoperational efficiencies.

This astonishing statement has two problems. First,effectively implementing the Internet is not a binarymatter like turning a light switch on and off, buying aT1 line, or installing an off-the-shelf application. As wesaw during the dot-com craze, there are 1,001 ways toemploy the Net, many of which make no sense whatso-ever. Moreover, there is a continuum of business trans-formation that occurs, from setting up a website, toimplementing radical new business models, to trans-forming an entire industry. The Net enables many newapplications, technologies, and business innovations.Firms that understand strategy in today’s more complexbusiness environment will plumb deeper into the grow-ing pool of possibilities.

Second, Porter doesn’t see how the Net is precipi-tating profound changes to the structures and cultures ofsuccessful businesses. In fact, these changes enable com-

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panies to compete better — precisely through deployingresources that allow them to create better and uniqueproducts, stronger personal service, relationships, andsustainable operational efficiencies. These three coreareas are ripe for business model innovation:

• Unique products. IBM has shifted its mentalityfrom vertically integrated fortress to b-web proponentand player. In its earlier incarnation, it reaped huge prof-its by locking customers on a treadmill of high-marginproprietary hardware and software. Today IBM trum-pets Linux. This year it will invest more than $1 billionin the open source software, collaborating with its part-ners on the Net to develop, enhance, and market Linux-based applications and services. A typical initiative hasIBM joining 18 other companies, such as Hewlett-Packard, Dell, and Intel, to underwrite a $24 millionOpen Source Development Lab solely to support proj-ects already under way in the open source community.

In 1997, IBM decided its customer relationshipmanagement (CRM) software needed to be the best inthe world. It mothballed a massive internal developmenteffort and a $40 million revenue stream to partner withSiebel Systems. Today IBM’s CRM business is over $2billion and one of its most profitable.

Critics of partnering, such as Michael Porter, con-demn IBM’s decision to build a PC industry based onthe Microsoft standard. Allegedly, this depressed indus-try profitability and hurt IBM. Not true. PCs became acommodity, leading to a vast explosion in the use ofinformation technology and, ultimately, networking,which is the foundation on which the 21st-century IBMis based. Today [in 2001], the revenue and earningsfrom IBM’s software and services dwarf all hardwaresales, not just the sales of PCs.

Compare this to Apple Computer Inc., which clungto the vertically integrated approach of designing andbuilding everything from chips to applications. If it hadlicensed the Macintosh operating system to partners,Apple Computer would probably be more importanttoday than Microsoft.

Remember, in the early 1990s, that IBM’s rivalsincluded half a dozen vertically integrated minicomput-er companies such as the Digital EquipmentCorporation, Prime Computer, and Data General.These companies failed to embrace partnering to deliv-er the best products to their customers and exploitindustry standards. All but one, Hewlett-Packard, whichadopted the partner model, failed.

The power of business-model innovation is just asevident in service companies. For example, eBay Inc.doesn’t just compete well against flea markets, auctionhouses, and classified ads. It has changed the rules of competition by creating a new type of service companythat has become a leader in applying auction-baseddynamic pricing. The most important contributors toeBay are its customers, who create the primary value ofthe business web; eBay is simply the provider of thebusiness context. This b-web also includes companiessuch as Wells Fargo, Visa, SquareTrade.com, and othersproviding ancillary services that make buyers and sellersmore confident and competent.

• Operational efficiencies. Around the world, theInternet is allowing companies to wring out waste fromtheir operations, differentiate themselves, and reach newsuppliers and customers. Jack Welch calls e-business ini-tiatives “a game changer for GE” that are expanding “farbeyond our original vision.” His company’s first step wasto imitate Amazon and sell goods and services online.This initiative was an immediate success; the $8 billionin goods and services GE sold online in 2000 is expect-ed to soar to $20 billion for 2001.

In procurement, reverse auctions alone are antici-pated to save GE $600 million this year. The companyruns global auctions daily — $6 billion worth last year,growing to an estimated $12 billion this year. Therewards are so great that rather than cutting back on ITspending because of the weak economy, the companywill increase spending this year by 10 to 15 percent.

• Customer service and relationships. When itcomes to customers, many pundits view the Net as sim-ply another channel. Porter writes, “On the demandside, most buyers will value a combination of on-lineservices, personal services, and physical locations over

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The years from 1997 to 2000 were the dog days ofstrategy. A get-rich-quick mentality distorted the asser-tion that “the Internet changes everything” (which istrue) into the hope that “all things done on the Internetwill prove lucrative” (which is rubbish). For a marketeconomy, it was a shameful period. We saw egregiousexcesses and spectacular market capitalizations based onabsurd or nonexistent business models. Momentuminvesting set in and massive damage was inevitable.Thankfully, those times are past, and sanity is returning.But what’s important to understand is that the headline-grabbing dot-com machinations, be they startups orspin-offs, were largely a distraction and represented onlya sliver of the businesses trying to harness the power ofthe Internet.

Today, in the broad space between yesterday’s irra-tional exuberance and today’s equally irrational ortho-doxy, there is a new frontier of business strategy. Thereare great new possibilities for creating economic value,customer value, shareholder value, and communityvalue. Business strategy is an idea whose time has comeonce again. But new rules for competing require somefresh thinking. Business fundamentals, indeed.Fundamentalism, no. +

Reprint No. 01304

stand-alone Web distribution. They will want a choiceof channels.” But the Net is more than a channel. Itchanges all channels. Effective competitors equip salesagents with Net-based information and tools in the cus-tomer’s living room. Call-center personnel with superiorNet-based customer relationship management systemscontaining complete customer records deliver bettercustomer service. And bricks-and-mortar stores thatexploit emerging location-based services will have morecustomers who find them through the Net.

No to Fundamentalism

Regrettably, many, including Porter, lament theincreased knowledge and power that customers areacquiring in this new world. In fact, much of the com-petition theorists’ language has disdain for customers.It’s best when customers are “locked in.” When they areignorant or have no choice, profitability in an industrycan be maintained and advantages can be achieved.Because the Net can undermine this, Porter concludesthis powerful communications technology “is not neces-sarily a blessing.” Indeed, he writes “it tends to alterindustry structures in ways that dampen overall prof-itability, and it has a leveling effect on business practices,reducing the ability of any company to establish anoperational advantage that can be sustained.”

Of course the Net creates efficiencies through theeconomy, intensifying rivalry between competitors andlowering barriers to market entry. It can arm consumersand suppliers with greater power because of theirincreased access to information, enhanced ability tocommunicate with each other, and greater freedom ofchoice. It increases the metabolism of the economy andreduces friction — as did, say, the telephone.

But would it have been sensible to judge the tele-phone as “not necessarily a blessing?” Overall itadvanced the economy and benefited society enormous-ly. It was a threat only to the firms that didn’t want tochange. This becomes even more important when youconsider that the telephone’s impact pales compared tothe Net’s.

It is good that customers will be smarter, moreactive, and more powerful. Because of this, more realvalue will come to the fore, and fewer businesses will tryto make garbage smell like roses. As businesses increas-ingly deliver what their customers value, it may turnout the capital businesses earn from customer relation-ships will dwarf the value of physical assets or money inthe bank.

Resources

Lawrence M. Fisher, “From Vertical to Virtual: How Nortel’s SupplierAlliances Extend the Enterprise,” s+b, First Quarter 2001, www.strategy-business.com/casestudy/01113/.

Keith Oliver, Anne Chung, and Nick Samanich, “Beyond Utopia: TheRealist’s Guide to Internet-Enabled Supply Chain Management,” s+b, Second Quarter 2001, www.strategy-business.com/special/01209/.

Michael E. Porter, “Strategy and the Internet,” Harvard Business Review,March 2001, www.hbsp.harvard.edu/hbr.

Don Tapscott, David Ticoll, and Alex Lowy, Digital Capital: Harnessing thePower of Business Webs (Harvard Business School Press, 2000).

David Ticoll, “Strategy and the Internet,” Letters to the Editor, HarvardBusiness Review, June 2001.


BY C.K. PRAHALAD AND STUART L. HART

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Low-income markets present a prodigious opportunity for the world’s wealthiest

companies — to seek their fortunes andbring prosperity to the aspiring poor.

With the end of the Cold War, the former SovietUnion and its allies, as well as China, India, and LatinAmerica, opened their closed markets to foreign invest-ment in a cascading fashion. Although this significanteconomic and social transformation has offered vast newgrowth opportunities for multinational corporations(MNCs), its promise has yet to be realized.

First, the prospect of millions of “middle-class” con-sumers in developing countries, clamoring for productsfrom MNCs, was wildly oversold. To make mattersworse, the Asian and Latin American financial criseshave greatly diminished the attractiveness of emergingmarkets. As a consequence, many MNCs worldwideslowed investments and began to rethink risk–rewardstructures for these markets. This retreat could becomeeven more pronounced in the wake of the terrorist

attacks in the United States last September.The lackluster nature of most MNCs’ emerging-

market strategies over the past decade does not changethe magnitude of the opportunity, which is in realitymuch larger than previously thought. The real source ofmarket promise is not the wealthy few in the developingworld, or even the emerging middle-income consumers:It is the billions of aspiring poor who are joining the market economy for the first time.

This is a time for MNCs to look at globalizationstrategies through a new lens of inclusive capitalism. Forcompanies with the resources and persistence to com-pete at the bottom of the world economic pyramid, theprospective rewards include growth, profits, and incal-culable contributions to humankind. Countries that stilldon’t have the modern infrastructure or products to

The Fortune

PyramidBottomat the

of the

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meet basic human needs are an ideal testing ground fordeveloping environmentally sustainable technologiesand products for the entire world.

Furthermore, MNC investment at “the bottom ofthe pyramid” means lifting billions of people out ofpoverty and desperation, averting the social decay, polit-ical chaos, terrorism, and environmental meltdown thatis certain to continue if the gap between rich and poorcountries continues to widen.

Doing business with the world’s 4 billion poorestpeople — two-thirds of the world’s population — willrequire radical innovations in technology and businessmodels. It will require MNCs to reevaluate price–performance relationships for products and services. Itwill demand a new level of capital efficiency and newways of measuring financial success. Companies will beforced to transform their understanding of scale, from a“bigger is better” ideal to an ideal of highly distributedsmall-scale operations married to world-scale capabilities.

In short, the poorest populations raise a prodigiousnew managerial challenge for the world’s wealthiestcompanies: selling to the poor and helping themimprove their lives by producing and distributing prod-ucts and services in culturally sensitive, environmentallysustainable, and economically profitable ways.

Four Consumer Tiers

At the very top of the world economic pyramid are 75to 100 million affluent Tier 1 consumers from aroundthe world. (See Exhibit 1.) This is a cosmopolitan groupcomposed of middle- and upper-income people indeveloped countries and the few rich elites from thedeveloping world. In the middle of the pyramid, in Tiers2 and 3, are poor customers in developed nations and

the rising middle classes in developing countries, the tar-gets of MNCs’ past emerging-market strategies.

Now consider the 4 billion people in Tier 4, at thebottom of the pyramid. Their annual per capita income— based on purchasing power parity in U.S. dollars —is less than $1,500, the minimum considered necessaryto sustain a decent life. For well over a billion people —roughly one-sixth of humanity — per capita income isless than $1 per day.

Even more significant, the income gap between richand poor is growing. According to the United Nations,the richest 20 percent in the world accounted for about70 percent of total income in 1960. In 2000, that figurereached 85 percent. Over the same period, the fractionof income accruing to the poorest 20 percent in theworld fell from 2.3 percent to 1.1 percent.

This extreme inequity of wealth distribution re -inforces the view that the poor cannot participate in theglobal market economy, even though they constitute the majority of the population. In fact, given its vast size,Tier 4 represents a multitrillion-dollar market. Accord -ing to World Bank projections, the population at thebottom of the pyramid could swell to more than 6 bil-lion people over the next 40 years, because the bulk ofthe world’s population growth occurs there.

The perception that the bottom of the pyramid isnot a viable market also fails to take into account thegrowing importance of the informal economy amongthe poorest of the poor, which by some estimatesaccounts for 40 to 60 percent of all economic activity indeveloping countries. Most Tier 4 people live in ruralvillages, or urban slums and shantytowns, and they usu-ally do not hold legal title or deed to their assets (e.g.,dwellings, farms, businesses). They have little or no for-

C.K. Prahalad

passed away on April 16, 2010.

He was the Paul and Ruth

McCracken Distinguished

University Professor of

Strategy at the University of

Michigan’s Stephen M. Ross

School of Business and

coauthor of several significant

books, including The New Age

of Innovation (McGraw-Hill,

2008) and The Fortune at the

Bottom of the Pyramid (Wharton

School Publishing, 2005).

Stuart L. Hart

[email protected] a professor of strategic

management, Sarah Graham

Kenan Distinguished Scholar,

and codirector of the Center

for Sustainable Enterprise at

the University of North

Carolina’s Kenan–Flagler

Business School.

Originally published First

Quarter 2002.

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mal education and are hard to reach via conventionaldistribution, credit, and communications. The qualityand quantity of products and services available in Tier 4are generally low. Therefore, much like an iceberg withonly its tip in plain view, this massive segment of theglobal population — along with its massive marketopportunities — has remained largely invisible to thecorporate sector.

Fortunately, the Tier 4 market is wide open fortechnological innovation. Among the many possibilitiesfor innovation, MNCs can be leaders in leapfrogging toproducts that don’t repeat the environmental mistakes ofdeveloped countries over the last 50 years. Today’sMNCs evolved in an era of abundant natural resourcesand thus tended to make products and services that wereresource-intensive and excessively polluting. The UnitedStates’ 270 million people — only about 4 percent ofthe world’s population — consume more than 25 per-cent of the planet’s energy resources. To re-create thosetypes of consumption patterns in developing countrieswould be disastrous.

We have seen how the disenfranchised in Tier 4 candisrupt the way of life and safety of the rich in Tier 1 —poverty breeds discontent and extremism. Althoughcomplete income equality is an ideological pipe dream,the use of commercial development to bring people outof poverty and give them the chance for a better life iscritical to the stability and health of the global economyand the continued success of Western MNCs.

The Invisible Opportunity

Among the top 200 MNCs in the world, the over-whelming majority are based in developed countries.U.S. corporations dominate, with 82; Japanese firms,with 41, are second, according to a list compiled inDecember 2000 by the Washington, D.C.–based

Institute for Policy Studies. So it is not surprising thatMNCs’ views of business are conditioned by theirknowledge of and familiarity with Tier 1 consumers.Perception of market opportunity is a function of theway many managers are socialized to think and the ana-lytical tools they use. Most MNCs automatically dismissthe bottom of the pyramid because they judge the mar-ket based on income or selections of products and ser -vices appropriate for developed countries.

To appreciate the market potential of Tier 4, MNCsmust come to terms with a set of core assumptions andpractices that influence their view of developing coun-tries. We have identified the following as widely sharedorthodoxies that must be reexamined:

• Assumption #1. The poor are not our target con-sumers because with our current cost structures, we can-not profitably compete for that market.

• Assumption #2. The poor cannot afford and haveno use for the products and services sold in developedmarkets.

• Assumption #3. Only developed markets appreci-ate and will pay for new technology. The poor can usethe previous generation of technology.

• Assumption #4. The bottom of the pyramid is notimportant to the long-term viability of our business. Wecan leave Tier 4 to governments and nonprofits.

• Assumption #5. Managers are not excited by busi-ness challenges that have a humanitarian dimension.

• Assumption #6. Intellectual excitement is in de -vel oped markets. It is hard to find talented managerswho want to work at the bottom of the pyramid.

Each of these key assumptions obscures the value atthe bottom of the pyramid. It is like the story of the per-son who finds a US$20 bill on the sidewalk. Conven -tional economic wisdom suggests if the bill really exist-ed, someone would already have picked it up! Like the

Exhibit 1: The World Economic Pyramid

* Based on purchasing power parity in U.S. dollars.Source: U.N. World Development Reports

Annual per Capita Income*

More than $20,000

$1,500–$20,000

Less than $1,500

Population in Millions [2002]

75–100

4,000

Tiers

1

2 & 3

4

1,500–1,750

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$20 bill, the bottom of the pyramid defies conventionalmanagerial logic, but that doesn’t mean it isn’t a largeand unexplored territory for profitable growth. Con -sider the drivers of innovation and opportunities forcompanies in Tier 4. (See Exhibit 2.) MNCs must rec-ognize that this market poses a major new challenge:how to combine low cost, good quality, sustainability,and profitability.

Furthermore, MNCs cannot exploit these newopportunities without radically rethinking how they goto market. Exhibit 3 suggests some (but by no means all)areas where an entirely new perspective is required tocreate profitable markets in Tier 4.

Tier 4 Pioneers

Hindustan Lever Ltd. (HLL), a subsidiary of GreatBritain’s Unilever PLC and widely considered the best-managed company in India, has been a pioneer amongMNCs exploring markets at the bottom of the pyramid.For more than 50 years, HLL has served India’s smallelite who could afford to buy MNC products. In the1990s, a local firm, Nirma Ltd., began offering deter-gent products for poor consumers, mostly in rural areas.In fact, Nirma created a new business system thatincluded a new product formulation, low-cost manufac-turing process, wide distribution network, special pack-aging for daily purchasing, and value pricing.

HLL, in typical MNC fashion, initially dismissedNirma’s strategy. However, as Nirma grew rapidly, HLLcould see its local competitor was winning in a market ithad disregarded. Ultimately, HLL saw its vulnerabilityand its opportunity: In 1995, the company respondedwith its own offering for this market, drastically alteringits traditional business model.

HLL’s new detergent, called Wheel, was formulatedto substantially reduce the ratio of oil to water in theproduct, responding to the fact that the poor often washtheir clothes in rivers and other public water systems.HLL decentralized the production, marketing, and dis-tribution of the product to leverage the abundant laborpool in rural India, quickly creating sales channelsthrough the thousands of small outlets where people atthe bottom of the pyramid shop. HLL also changed thecost structure of its detergent business so it could intro-duce Wheel at a low price point.

Today, Nirma and HLL are close competitors in thedetergent market, with 38 percent market share each,according to IndiaInfoline.com, a business intelligenceand market research service. Unilever’s own analysis ofNirma and HLL’s competition in the detergent businessreveals even more about the profit potential of the mar-ketplace at the bottom of the pyramid. (See Exhibit 4.)

Contrary to popular assumptions, the poor can be avery profitable market — especially if MNCs changetheir business models. Specifically, Tier 4 is not a marketthat allows for the traditional pursuit of high margins;instead, profits are driven by volume and capital effi-ciency. Margins are likely to be low (by current norms),but unit sales can be extremely high. Managers whofocus on gross margins will miss the opportunity at thebottom of the pyramid; managers who innovate andfocus on economic profit will be rewarded.

Nirma has become one of the largest branded deter-gent makers in the world. Meanwhile, HLL, stimulatedby its emergent rival and its changed business model,registered a 20 percent growth in revenues per year anda 25 percent growth in profits per year between 1995and 2000. Over the same period, HLL’s market capital-

Exhibit 2: Innovation and MNC Implications in Tier 4

Increased access among the poor to TV and information Tier 4 is becoming aware of many products and services and is aspiring to share the benefits

Deregulation and the diminishing role of governments and international aid

More hospitable investment climate for MNCs entering developing countries and more cooperation from nongovernmental organizations

Global overcapacity combined with intense competition in Tiers 1, 2, and 3

Tier 4 represents a huge untapped market for profitable growth

The need to discourage migration to overcrowded urban centers MNCs must create products and services for rural populations

Drivers of Innovation Implications for MNCs

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ization grew to $12 billion — a growth rate of 40 per-cent per year. HLL’s parent company, Unilever, also hasbenefited from its subsidiary’s experience in India.Unilever transported HLL’s business principles (not theproduct or the brand) to create a new detergent marketamong the poor in Brazil, where the Ala brand has beena big success. More important, Unilever has adopted thebottom of the pyramid as a corporate strategic priority.

As the Unilever example makes clear, the startingassumption must be that serving Tier 4 involves bring-ing together the best of technology and a global resourcebase to address local market conditions. Cheap and low-quality products are not the goal. The potential of Tier4 cannot be realized without an entrepreneurial orienta-tion: The real strategic challenge for managers is to visu-alize an active market where only abject poverty existstoday. It takes tremendous imagination and creativity toengineer a market infrastructure out of a completelyunorganized sector.

Serving Tier 4 markets is not the same as servingexisting markets better or more efficiently. Managersfirst must develop a commercial infrastructure tailoredto the needs and challenges of Tier 4. Creating such aninfrastructure must be seen as an investment, much likethe more familiar investments in plants, processes, prod-ucts, and R&D.

Further, contrary to more conventional investmentstrategies, no firm can do this alone. Multiple playersmust be involved, including local governmental author-ities, nongovernmental organizations (NGOs), commu-nities, financial institutions, and other companies. Fourelements — creating buying power, shaping aspirations,improving access, and tailoring local solutions — are thekeys to a thriving Tier 4 market. (See Exhibit 5.)

Each of these four elements demands innovation intechnology, business models, and management process-es. And business leaders must be willing to experiment,collaborate, empower locals, and create new sources ofcompetitive advantage and wealth.

Creating Buying Power

According to the International Labor Organization’sWorld Employment Report 2001, nearly a billion people— roughly one-third of the world’s workforce — areeither underemployed or have such low-paying jobs thatthey cannot support themselves or their families.Helping the world’s poor elevate themselves above thisdesperation line is a business opportunity to do well anddo good. To do so effectively, two interventions are cru-

cial — providing access to credit, and increasing theearning potential of the poor. A few farsighted compa-nies have already begun to blaze this trail with startling-ly positive results.

Commercial credit historically has been unavailableto the very poor. Even if those living in poverty hadaccess to a bank, without collateral it is hard to get cred-it from the traditional banking system. As Peruvianeconomist Hernando de Soto demonstrates in his path-breaking work, The Mystery of Capital: Why CapitalismTriumphs in the West and Fails Everywhere Else (BasicBooks, 2000), commercial credit is central to building amarket economy. Access to credit in the U.S. hasallowed people of modest means to systematically buildtheir equity and make major purchases, such as houses,cars, and education.

The vast majority of the poor in developing coun-tries operate in the “informal” or extralegal economy,since the time and cost involved in securing legal title fortheir assets or incorporation of their microenterprises isprohibitive. Developing countries have tried govern-mental subsidies to free the poor from the cycle ofpoverty, with little success. Even if the poor were able tobenefit from government support to start small busi-nesses, their dependence on credit from local money-lenders charging usurious rates makes it impossible tosucceed. Local moneylenders in Mumbai, India, chargeinterest rates of up to 20 percent per day. This meansthat a vegetable vendor who borrows Rs.100 ($2.08) inthe morning must return Rs.120 ($2.50) in the evening.

Extending credit to the poor so they can elevatethemselves economically is not a new idea. Considerhow I.M. Singer & Company, founded in 1851, pro-vided credit as a way for millions of women to purchase

Exhibit 3: New Strategies for the Bottom of the Pyramid

Price Performance

• Product development• Manufacturing• Distribution

Views of Quality

• New delivery formats• Creation of robust products for harsh conditions (heat, dust, etc.)

Sustainability

• Reduction in resource intensity• Recyclability• Renewable energy

Profitability

• Investment intensity• Margins• Volume

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global perspective

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sewing machines. Very few of those women could haveafforded the steep $100 price tag, but most could afforda payment of $5 per month.

The same logic applies on a much larger scale inTier 4. Consider the experience of the Grameen BankLtd. in Bangladesh, one of the first in the world to applya microlending model in commercial banking. Startedjust over 20 years ago by Muhammad Yunus, then a pro-fessor in the economics department at ChittagongUniversity in Bangladesh, Grameen Bank pioneered alending service for the poor that has inspired thousandsof microlenders, serving 25 million clients worldwide, indeveloping countries and wealthy nations, including theUnited States and the United Kingdom.

Grameen Bank’s program is designed to address theproblems of extending credit to lowest-income cus-tomers — lack of collateral, high credit risk, and con-tractual enforcement. Ninety-five percent of its 2.3 million customers are women, who, as the traditionalbreadwinners and entrepreneurs in rural communities,are better credit risks than men. Candidates for loansmust have their proposals thoroughly evaluated and sup-ported by five nonfamily members of the community.The bank’s sales and service people visit the villages fre-quently, getting to know the women who have loans andthe projects in which they are supposed to invest. In thisway, lending due diligence is accomplished without themountain of paperwork and arcane language commonin the West.

With 1,170 branches, Grameen Bank today pro-vides microcredit services in more than 40,000 villages,more than half the total number in Bangladesh. As of1996, Grameen Bank had achieved a 95 percent repay-ment rate, higher than any other bank in the Indian sub-continent. However, the popularity of its services hasalso spawned more local competitors, which has cut intoits portfolio and shrunk its profits over the past few years.

In addition, Grameen Bank’s rate of return is noteasy to assess. Historically, the bank was an entirelymanual, field-based operation, a structure that undercutits efficiency. Today, spin-offs such as Grameen Telecom(a provider of village phone service) and Grameen Shakti(a developer of renewable energy sources) are helpingGrameen Bank build a technology infrastructure toautomate its processes. As the bank develops its onlinebusiness model, profitability should increase dramatical-ly, highlighting the importance of information technol-ogy in the acceleration of the microcredit revolution.

Perhaps the most pertinent measure of GrameenBank’s success is the global explosion of institutionalinterest in microlending it has stimulated around theworld. In South Africa, where 73 percent of the popula-tion earns less than R5,000 ($460) per month, accord-ing to a 2001 World Bank study, retail banking servicesfor low-income customers are becoming one of the mostcompetitive and fast-growing mass markets. In 1994,Standard Bank of South Africa Ltd., Africa’s leadingconsumer bank, launched a low-cost, volume-driven e-banking business, called AutoBank E, to grow revenueby providing banking services to the poor. Through theuse of 2,500 ATMs and 98 AutoBank E-centres, Stan -dard now has the largest presence in South Africa’s town-ships and other under-serviced areas of any domesticbank. As of April 2001, Standard served nearly 3 millionlow-income customers and is adding roughly 60,000customers per month, according to South Africa’sSunday Times.

Standard does not require a minimum income ofcustomers opening an AutoBank E account, althoughthey must have some regular income. People who havenever used a bank can open an account with a deposit of as little as $8. Customers are issued an ATM card and shown how to use it by staff who speak a variety of African dialects. A small flat fee is charged for each

ATM transaction. An interest-bearing “savings purse” is attachedto every account to encouragepoor customers to save. Interestrates on deposits are low, butsuperior to keeping cash in a jar.The Sunday Times also reportedthat Standard Bank is consideringa loan program for low-incomeclients.

Computerization of micro -lending services not only makes

Exhibit 4: Nirma vs. HLL in India’s Detergent Market (1999)

Source: Presentation by John Ripley, senior vice president, Unilever, at the Academy of Management Meeting, August 10, 1999

Total Sales (US$ Million) 150 100 180

Gross Margin (%) 18 18 25

ROCE (%) 121 93 22

Nirma HLL (Wheel) HLL (High-end Products)

global perspective

39

the overall operation more efficient, but also makes itpossible to reach many more people — lending moneyto individuals with no collateral and no formal address.Since there is lower overhead and little paperwork,AutoBank’s costs are 30 to 40 percent lower than thoseat traditional branches.

At the 1999 Microcredit Summit, the UnitedNations, in conjunction with several major MNCs, suchas Citigroup Inc. and Monsanto Company, set a goal ofmaking basic credit available to the 100 million poorestfamilies in the world by the year 2005. Unfortunately,the success of this undertaking has been slowed by high transaction costs, a lack of automation, and poorinformation and communications infrastructures inrural areas.

To address these issues and accelerate the develop-ment of microlending, French banker Jacques Attali, thefounding president of the European Bank forReconstruction and Development and a former chiefaide of French President François Mitterrand during the1980s, has created PlaNet Finance. Its website,www.planetfinance.org, links thousands of microcreditgroups worldwide into a network to help microbanksshare solutions and lower costs.

Ultimately, the development of an automated solu-tion for tracking and processing the millions of smallloans associated with microlending should be possible. Ifprocessing and transaction costs can be reduced enough,they can then be bundled together and sold in the sec-

ondary market to multinational financial institutionslike Citigroup. This would greatly expand the capitalavailable for microlending beyond the current pool fromdonors and governments.

In the United States, microlending has also takenroot over the past decade in poor urban neighborhoods.For example, the ShoreBank Corporation, formerlySouth Shore Bank, has demonstrated the profitability ofbanking for the poor in Chicago’s troubled South Side.Project Enterprise, a Grameen-like program based inNew York City, is aimed at minority entrepreneurs.

Several multinational banks are beginning to offermicrobanking services in developing countries.Citigroup, for instance, is experimenting in Bangalore,India, with 24/7 services for customers with as little as$25 on deposit. Initial results are very positive.

Shaping AspirationsSustainable product innovations initiated in Tier 4, andpromoted through consumer education, will not onlypositively influence the choices of people at the bottomof the pyramid, but may ultimately reshape the wayAmericans and others in Tier 1 live. Indeed, in 20 years,we may look back to see that Tier 4 provided the earlymarket pull for disruptive technologies that replacedunsustainable technologies in developed countries andadvanced the fortunes of MNCs with foresight.

For example, Unilever’s HLL subsidiary has tackledthe lack of practical, inexpensive, low-energy-consum-ing refrigeration in India. HLL’s laboratories developeda radically different approach to refrigeration that allowsice cream to be transported across the country in stan-dard nonrefrigerated trucks. The system allows quantumreductions in electricity use and makes dangerous andpolluting refrigerants unnecessary. As a bonus, the newsystem is cheaper to build and use.

Electricity, water, refrigeration, and many otheressential services are all opportunities in developingcountries. A U.S.-based NGO, the Solar Electric LightFund (SELF), has creatively adapted technology andapplied microcredit financing to bring electrical serviceto people in remote villages in Africa and Asia who oth-er wise would spend money to burn hazardous kerosene,candles, wood, or dung for their light and cooking.SELF’s rural electrification system is based on small-scale on-site power generation using renewableresources. A revolving loan fund gives villagers the finan-cial means to operate these electrical systems themselves,also creating jobs. Since its founding in 1990, SELF has

Exhibit 5: The Commercial Infrastructure at the

Bottom of the Pyramid

Improving Access

• Distribution systems• Communications

links

Shaping Aspirations

• Consumer education• Sustainabledevelopment

Tailoring Local

Solutions

• Targeted productdevelopment• Bottom-up

innovation

Creating Buying

Power

• Access to credit• Income generation

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launched projects in China, India, Sri Lanka, Nepal,Vietnam, Indonesia, Brazil, Uganda, Tanzania, SouthAfrica, and the Solomon Islands.

The success of SELF and other NGOs focused onsmall-scale distributed energy solutions has begun toattract the attention of Western companies such as theU.S.’s Plug Power Inc. (fuel cells) and Honeywell Inc.(microturbines). They see the logic in moving into awide-open market in Tier 4 rather than trying to forcetheir technology prematurely into applications for thedeveloped markets, where incumbents and institutionsstand in their way. With several billion potential cus-tomers around the world, investments in such innova-tions should be well worth it.

Improving Access

Because Tier 4 communities are often physically andeconomically isolated, better distribution systems andcommunication links are essential to development of thebottom of the pyramid. Few of the large emerging-market countries have distribution systems that reachmore than half of the population. (Hence the continueddependence of the poorest consumers on local productsand services and moneylenders.) As a consequence, fewMNCs have designed their distribution systems to caterto the needs of poor rural customers.

Creative local companies, however, lead the way ineffective rural distribution. In India, for instance,Arvind Mills has introduced an entirely new deliverysystem for blue jeans. Arvind, the world’s fifth-largestdenim manufacturer, found Indian domestic denimsales limited. At $40 to $60 a pair, the jeans were notaffordable to the masses, and the existing distributionsystem reached only a few towns and villages. So Arvind

introduced “Ruf & Tuf” jeans — a ready-to-make kit ofjeans components (denim, zipper, rivets, and a patch)priced at about $6. Kits were distributed through a net-work of thousands of local tailors, many in small ruraltowns and villages, whose self-interest motivated themto market the kits extensively. Ruf & Tuf jeans are nowthe largest-selling jeans in India, easily surpassing Levi’sand other brands from the U.S. and Europe.

MNCs can also play a role in distributing the prod-ucts of Tier 4 enterprises in Tier 1 markets, giving bottom-of-the-pyramid enterprises their first links tointernational markets. Indeed, it is possible throughpartnerships to leverage traditional knowledge bases toproduce more sustainable, and in some cases superior,products for consumption by Tier 1 customers.

Anita Roddick, CEO of the Body Shop Inter -national PLC, demonstrated the power of this strategyin the early 1990s through her company’s “trade not aid”program of sourcing local raw material and productsfrom indigenous people.

More recently, the Starbucks Corporation, in coop-eration with Conservation International, has pioneereda program to source coffee directly from farmers in theChiapas region of Mexico. These farms grow coffeebeans organically, using shade, which preserves songbirdhabitat. Starbucks markets the product to U.S. con-sumers as a high-quality, premium coffee; the Mexicanfarmers benefit economically from the sourcing arrange-ment, which eliminates intermediaries from the businessmodel. This direct relationship also improves the localfarmers’ understanding and knowledge of the Tier 1market and its customer expectations.

Information poverty may be the single biggest road-block to sustainable development. More than half of

Bringing modern IT equipment to Tier 4 villages makes possible such applications astele-education, telemedicine, microbanking,

and agricultural extension services.

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humanity has yet to make a single phone call. However,where telephones and Internet connections do exist, forthe first time in history, it is possible to imagine a single,interconnected market uniting the world’s rich and poorin the quest for truly sustainable economic develop-ment. The process could transform the “digital divide”into a “digital dividend.”

Ten years ago, Sam Pitroda, currently chairman andCEO of London-based Worldtel Ltd., a company creat-ed by a telecommunications union to fund telecomdevelopment in emerging markets, came to India withthe idea of “rural telephones.” His original concept wasto have a community telephone, operated by an entre-preneur (usually a woman) who charged a fee for the useof the telephone and kept a percentage as wages formaintaining the telephone. Today, from most parts ofIndia, it is possible to call anyone in the world.

Other entrepreneurs have introduced fax services,and some are experimenting with low-cost e-mail andInternet access. These communication links have dra-matically altered the way villages function and how theyare connected to the rest of the country and the world.With the emergence of global broadband connections,opportunities for information-based business in Tier 4will expand significantly.

New ventures such as CorDECT in India andCelnicos Communications in Latin America are devel-oping information technology and business models suit-ed to the particular requirements of the bottom of thepyramid. Through shared-access models (e.g., Internetkiosks), wireless infrastructure, and focused technologydevelopment, companies are dramatically reducing thecost of being connected. For example, voice and dataconnectivity typically costs companies $850 to $2,800per line in the developed world; CorDECT has reducedthis cost to less than $400 per line, with a goal of $100per line, which would bring telecommunications withinreach of virtually everyone in the developing world.

Recognizing an enormous business and develop-ment opportunity, Hewlett-Packard Company has artic-ulated a vision of “world e-inclusion,” with a focus onproviding technology, products, and services appropriateto the needs of the world’s poor. As part of this strategy,HP has entered into a venture with the MIT Media Laband the Foundation for Sustainable Development ofCosta Rica — led by former President Jose MariaFigueres Olsen — to develop and implement “telecen-ters” for villages in remote areas. These digital town cen-ters provide modern information technology equipment

with a high-speed Internet connection at a price that isaffordable, through credit vehicles, at the village level.

Bringing such technology to villages in Tier 4 makespossible a number of applications, including tele-educa-tion, telemedicine, microbanking, agricultural extensionservices, and environmental monitoring, all of whichhelp to spur microenterprise, economic development,and access to world markets. This project, namedLincos, is expected to spread from today’s pilot sites inCentral America and the Caribbean to Asia, Africa, andcentral Europe.

Tailoring Local Solutions

As we enter the new century, the combined sales of theworld’s top 200 MNCs equal nearly 30 percent of totalworld gross domestic product. Yet these same corpora-tions employ less than 1 percent of the world’s laborforce. Of the world’s 100 largest economies, 51 areeconomies internal to corporations. Yet scores of ThirdWorld countries have suffered absolute economic stag-nation or decline.

If MNCs are to thrive in the 21st century, they mustbroaden their economic base and share it more widely.They must play a more active role in narrowing the gapbetween rich and poor. This cannot be achieved if thesecompanies produce only so-called global products forconsumption primarily by Tier 1 consumers. They mustnurture local markets and cultures, leverage local solu-tions, and generate wealth at the lowest levels on thepyramid. Producing in, rather than extracting wealthfrom, these countries will be the guiding principle.

To do this, MNCs must combine their advancedtechnology with deep local insights. Consider packag-ing. Consumers in Tier 1 countries have the disposableincome and the space to buy in bulk (e.g., 10-poundboxes of detergent from superstores like Sam’s Club) andshop less frequently. They use their spending money to“inventory convenience.” Tier 4 consumers, strapped forcash and with limited living space, shop every day, butnot for much. They can’t afford to stock up on house-hold items or be highly selective about what they buy;they look for single-serve packaging. But consumerswith small means also have the benefit of experimenta-tion. Unburdened by large quantities of product, theycan switch brands every time they buy.

Already in India, 30 percent of personal care prod-ucts and other consumables, such as shampoo, tea, andcold medicines, are sold in single-serve packages. Mostare priced at Rs. 1 (about 1¢). Without innovation in

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packaging, however, this trend could result in a moun-tain of solid waste. Dow Chemical Company andCargill Inc. are experimenting with an organic plasticthat would be totally biodegradable. Such packagingclearly has advantages in Tier 4, but it could also revolu-tionize markets at all four tiers of the world pyramid.

For MNCs, the best approach is to marry local capa-bilities and market knowledge with global best practices.But whether an initiative involves an MNC enteringTier 4 or an entrepreneur from Tier 4, the developmentprinciples remain the same: New business models mustnot disrupt the cultures and lifestyles of local people. Aneffective combination of local and global knowledge isneeded, not a replication of the Western system.

The development of India’s milk industry has manylessons for MNCs. The transformation began around1946, when the Khira District Milk Cooperative, lo -cated in the state of Gujarat, set up its own processingplant under the leadership of Verghese Kurien and cre-ated the brand Amul, today one of the most recognizedin the country.

Unlike the large industrial dairy farms of the West,in India, milk originates in many small villages. Villagersmay own only two to three buffaloes or cows each andbring their milk twice a day to the village collection cen-ter. They are paid every day for the milk they deliver,based on fat content and volume. Refrigerated vanstransport the milk to central processing plants, where itis pasteurized. Railroad cars then transport the milk tomajor urban centers.

The entire value chain is carefully managed, fromthe village-based milk production to the world-scaleprocessing facilities. The Khira District cooperative pro-vides such services to the farmers as veterinary care andcattle feed. The cooperative also manages the distribu-tion of pasteurized milk, milk powder, butter, cheese,baby food, and other products. The uniqueness of theAmul cooperative is its blending of decentralized origi-nation with the efficiencies of a modern processing anddistribution infrastructure. As a result, previously mar-ginal village farmers are earning steady incomes andbeing transformed into active market participants.

Twenty years ago, milk was in short supply in India.Today, India is the world’s largest producer of milk.According to India’s National Dairy DevelopmentBoard, the country’s dairy cooperative network nowclaims 10.7 million individual farmer member–owners,covers 96,000 village-level societies, includes 170 milk-producer unions, and operates in more than 285 dis-

tricts. Milk production has increased 4.7 percent peryear since 1974. The per capita availability of milk inIndia has grown from 107 grams to 213 grams per dayin 20 years.

Putting It All Together

Creating buying power, shaping aspirations, improvingaccess, and tailoring local solutions — the four elementsof the commercial infrastructure for the bottom of thepyramid are intertwined. Innovation in one leveragesinnovation in the others. Corporations are only one ofthe actors; MNCs must work together with NGOs,local and state governments, and communities.

Yet someone must take the lead to make this revo-lution happen. The question is, Why should it beMNCs?

Even if multinational managers are emotionallypersuaded, it is not obvious that large corporations havereal advantages over small, local organizations. MNCsmay never be able to beat the cost or responsiveness ofvillage entrepreneurs. Indeed, empowering local entre-preneurs and enterprises is key to developing Tier 4 mar-kets. Still, there are several compelling reasons forMNCs to embark on this course:

• Resources. Building a complex commercial infra-structure for the bottom of the pyramid is a resource-and management-intensive task. Developing environ-mentally sustainable products and services requires sig-nificant research. Distribution channels and communi-cation networks are expensive to develop and sustain.Few local entrepreneurs have the managerial or technologi-cal resources to create this infrastructure.

• Leverage. MNCs can transfer knowledge fromone market to another — from China to Brazil or India— as Avon, Unilever, Citigroup, and others havedemonstrated. Although practices and products have tobe customized to serve local needs, MNCs, with theirunique global knowledge base, have an advantage that isnot easily accessible to local entrepreneurs.

• Bridging. MNCs can be nodes for building thecommercial infrastructure, providing access to knowl-edge, managerial imagination, and financial resources.Without MNCs as catalysts, well-intentioned NGOs,communities, local governments, entrepreneurs, andeven multilateral development agencies will continue toflounder in their attempts to bring development to thebottom. MNCs are best positioned to unite the range ofactors required to develop the Tier 4 market.

• Transfer. Not only can MNCs leverage learning

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from the bottom of the pyramid, but they also have thecapacity to transfer innovations up-market all the way toTier 1. As we have seen, Tier 4 is a testing ground forsustainable living. Many of the innovations for the bottomcan be adapted for use in the resource- and energy-intensivemarkets of the developed world.

It is imperative, however, that managers recognizethe nature of business leadership required in the Tier 4arena. Creativity, imagination, tolerance for ambiguity,stamina, passion, empathy, and courage may be asimportant as analytical skill, intelligence, and knowl-edge. Leaders need a deep understanding of the com-plexities and subtleties of sustainable development in thecontext of Tier 4. Finally, managers must have the inter-personal and intercultural skills to work with a widerange of organizations and people.

MNCs must build an organizational infrastructureto address opportunity at the bottom of the pyramid.This means building a local base of support, reorientingR&D to focus on the needs of the poor, forming newalliances, increasing employment intensity, and rein-venting cost structures. These five organizational ele-ments are clearly interrelated and mutually reinforcing.

• Build a local base of support. Empowering thepoor threatens the existing power structure. Local oppo-sition can emerge very quickly, as Cargill Inc. found inits sunflower-seed business in India. Cargill’s offices weretwice burned, and the local politicians accused the firmof destroying locally based seed businesses. But Cargillpersisted. Through Cargill’s investments in farmer edu-cation, training, and supply of farm inputs, farmers havesignificantly improved their productivity per acre ofland. Today, Cargill is seen as the friend of the farmer.Political opposition has vanished.

To overcome comparable problems, MNCs mustbuild a local base of political support. As Monsanto andGeneral Electric Company can attest, the establishmentof a coalition of NGOs, community leaders, and localauthorities that can counter entrenched interests isessential. Forming such a coalition can be a very slowprocess. Each player has a different agenda; MNCs haveto understand these agendas and create shared aspira-tions. In China, this problem is less onerous: The localbureaucrats are also the local entrepreneurs, so they caneasily see the benefits to their enterprise and their village,town, or province. In countries such as India and Brazil,such alignment does not exist. Significant discussion,information sharing, the delineation of benefits to eachconstituency, and sensitivity to local debates is necessary.

• Conduct R&D focused on the poor. It is necessary toconduct R&D and market research focused on theunique requirements of the poor, by region and bycountry. In India, China, and North Africa, for example,research on ways to provide safe water for drinking,cooking, washing, and cleaning is a high priority.Research must also seek to adapt foreign solutions tolocal needs. For example, a daily dosage of vitamins canbe added to a wide variety of food and beverage prod-ucts. For corporations that have distribution and brandpresence throughout the developing world, such asCoca-Cola Company, the bottom of the pyramid offersa vast untapped market for such products as water andnutritionals.

Finally, research must identify useful principles andpotential applications from local practices. In Tier 4, sig-nificant knowledge is transmitted orally from one gen-eration to the next. Being respectful of traditions butwilling to analyze them scientifically can lead to new

New business models must not disrupt local cultures and lifestyles. An effective

combination of local and global knowledge is needed, not a Western system.

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knowledge. The Body Shop’s creative CEO, AnitaRoddick, built a business predicated on understandingthe basis for local rituals and practices. For example, sheobserved that some African women use slices of pine -apple to cleanse their skin. On the surface, this practiceappears to be a meaningless ritual. However, researchshowed active ingredients in pineapple that cleared awaydead skin cells better than chemical formulations.

MNCs must develop research facilities in emergingmarkets such as China, India, Brazil, Mexico, and Africa,although few have made a big effort so far. Unilever is anexception; it operates highly regarded research centers inIndia, employing more than 400 researchers dedicatedto the problems of “India-like markets.”

• Form new alliances. MNCs have conventionallyformed alliances solely to break into new markets; nowthey need to broaden their alliance strategies. By enter-ing into alliances to expand in Tier 4 markets, MNCsgain insight into developing countries’ culture and localknowledge. At the same time, MNCs improve their owncredibility. They may also secure preferred or exclusiveaccess to a market or raw material. We foresee threekinds of important relationships: Alliances with localfirms and cooperatives (such as the Khira District MilkCooperative); alliances with local and internationalNGOs (like Starbucks’s alliance with ConservationInternational in coffee); and alliances with governments(e.g., Merck & Company’s alliance in Costa Rica to fos-ter rain forest preservation in exchange for bioprospect-ing rights).

Given the difficulty and complexity of constructingbusiness models dependent on relationships withnational or central governments (e.g., large infrastruc-ture development), we envision more alliances at the

local and regional level. To succeed in such alliances,MNC managers must learn to work with people whomay not have the same agenda or the same educationaland economic background as they do. The challengeand payoff is how to manage and learn from diversity —economic, intellectual, racial, and linguistic.

• Increase employment intensity. MNCs accus-tomed to Tier 1 markets think in terms of capital inten-sity and labor productivity. Exactly the opposite logicapplies in Tier 4. Given the vast number of people at thebottom of the pyramid, the production and distributionapproach must provide jobs for many, as in the case ofRuf & Tuf jeans from Arvind Mills: It employed anarmy of local tailors as stockers, promoters, distributors,and service providers, even though the cost of the jeanswas 80 percent below that of Levi’s. As Arvind demon-strated, MNCs need not employ large numbers of peo-ple directly on their payroll, but the organizationalmodel in Tier 4 must increase employment intensity(and incomes) among the poor and groom them tobecome new customers.

• Reinvent cost structures. Managers must dramat-ically reduce cost levels relative to those in Tier 1. To cre-ate products and services the poor can afford, MNCsmust reduce their costs significantly — to, say, 10 per-cent of what they are today. But this cannot be achievedby fine-tuning the current approaches to product devel-opment, production, and logistics. The entire businessprocess must be rethought with a focus on functionality,not on the product itself. For example, financial servicesneed not be distributed only through branch officesopen from 9 A.M. to 5 P.M. Such services can be providedat a time and place convenient to the poor consumer —after 8 P.M. and at their homes. Cash-dispensing

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machines can be placed in safe areas — police stationsand post offices. Iris recognition used as a security devicecould substitute for the tedious personal-identificationnumber and card for identification.

Lowering cost structures also forces a debate onways to reduce investment costs. This will inevitablylead to greater use of information technology to developproduction and distribution systems. As noted, village-based phones are already transforming the pattern ofcommunications throughout the developing world. Addthe Internet, and we have a whole new way of commu-nicating and creating economic development in poor,rural areas. Creative use of IT will emerge in these mar-kets as a means to dramatically lower the costs associat-ed with access to products and services, distribution, andcredit management.

A Common Cause

The emergence of the 4 billion people who make up theTier 4 market is a great opportunity for MNCs. It alsorepresents a chance for business, government, and civilsociety to join together in a common cause. Indeed, webelieve that pursuing strategies for the bottom of thepyramid dissolves the conflict between proponents offree trade and global capitalism on one hand, and envi-ronmental and social sustainability on the other.

Yet the products and services currently offered toTier 1 consumers are not appropriate for Tier 4, andaccessing this latter market will require approaches fun-damentally different from those even in Tiers 2 and 3.Changes in technology, credit, cost, and distribution arecritical prerequisites. Only large firms with global reachhave the technological, managerial, and financialresources to dip into the well of innovations needed toprofit from this opportunity.

New commerce in Tier 4 will not be restricted tobusinesses filling such basic needs as food, textiles, andhousing. The bottom of the pyramid is waiting for high-tech businesses such as financial services, cellulartelecommunications, and low-end computers. In fact,for many emerging disruptive technologies (e.g., fuelcells, photovoltaics, satellite-based telecommunications,biotechnology, thin-film microelectronics, and nano -technology), the bottom of the pyramid may prove to bethe most attractive early market.

So far, three kinds of organizations have led theway: local firms such as Amul and Grameen Bank;NGOs such as the World Resources Institute, SELF,The Rainforest Alliance, The Environmental Defense

Fund, and Conservation International, among others;and a few MNCs such as Starbucks, Dow, Hewlett-Packard, Unilever, Citigroup, DuPont, Johnson &Johnson, Novartis, and ABB, and global business part-nerships such as the World Business Council forSustainable Business Development. But to date, NGOsand local businesses with far fewer resources than theMNCs have been more innovative and have made moreprogress in developing these markets.

It is tragic that as Western capitalists we haveimplicitly assumed that the rich will be served by thecorporate sector, while governments and NGOs willprotect the poor and the environment. This implicitdivide is stronger than most realize. Managers in MNCs,public policymakers, and NGO activists all suffer fromthis historical division of roles. A huge opportunity liesin breaking this code — linking the poor and the richacross the world in a seamless market organized aroundthe concept of sustainable growth and development.

Collectively, we have only begun to scratch the sur-face of what is the biggest potential market opportunityin the history of commerce. Those in the private sectorwho commit their companies to a more inclusive capi-talism have the opportunity to prosper and share theirprosperity with those who are less fortunate. In a veryreal sense, the fortune at the bottom of the pyramid rep-resents the loftiest of our global goals. +

Reprint No. 02106

Resources

Robert Chambers, Whose Reality Counts? Putting First Last (ITDGPublishing, 1997).

Hernando de Soto, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else (Basic Books, 2000).

Thomas L. Friedman, The Lexus and the Olive Tree: UnderstandingGlobalization (Farrar, Straus and Giroux, 1999).

Stuart Hart, “Beyond Greening: Strategies for a Sustainable World,”Harvard Business Review, January–February 1997, www.hbsp.harvard.edu/hbr/index.html.

“Is the Digital Divide a Problem or an Opportunity?” Business WeekSupplement, December 18, 2000.

C.K. Prahalad and Kenneth Lieberthal, “The End of CorporateImperialism,” Harvard Business Review, July–August 1998, www.hbsp.harvard.edu/hbr/index.html.

Amartya Sen, Development as Freedom (Alfred A. Knopf, 1999).

For more thought leadership on this topic, see s+b’s website at: www.strategy-business.com/global_perspective.

Trait by trait, companies can evolve their own

execution cultures.

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Every economic era has a theme. The 1960s are still recalled as the “Go-Go” years, when Wall Street wasfueling mergers and conglomerations of unprecedentedscale. The 1990s were the “Internet Boom” years, whena rising economic tide lifted the boat of just about anycompany with a plausible business model tale to tell.The agonizingly slow recovery since the Internet bubbleburst has inspired the latest motif. Executives no longerbelieve that a strategy — consolidation, transformation,or breakaway — is enough. “We’ve made the rightstrategic decision, but my organization isn’t motivatedor set up right to get on with it,” they are saying.“Everyone says they understand the vision, but the businesses and functions just aren’t working together toget results.”

Welcome to the Era of Execution.

Execution has become the new mantra for this firstdecade of the new millennium. Larry Bossidy, who ledAlliedSignal Inc.’s turnaround and its merger withHoneywell International Inc., wrote a book with RamCharan, titled Execution: The Discipline of Getting ThingsDone (Crown Business, 2002), that’s been on the busi-ness bestseller lists for more than a year. Former IBMCEO Louis V. Gerstner Jr. put forth the same messagein his memoir, Who Says Elephants Can’t Dance? InsideIBM’s Historic Turnaround (HarperBusiness, 2002). Init, he says flatly that the revival of the computer giantwasn’t due to vision. “Fixing IBM,” he wrote, “was allabout execution.”

Boards of directors, increasingly impatient withCEOs who don’t deliver, have climbed on the executionbandwagon too. Booz & Company’s annual study of

THE FourBases OF

Organizational

DNA

BY GARY NEILSON, BRUCE A. PASTERNACK, AND DECIO MENDES

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CEO succession trends showed that forced turnover ofunderperforming CEOs at major corporations reached anew high in 2002, rising a staggering 70 percent from2001 and accounting for 39 percent of all chief execu-tive transitions.

But is execution simply a matter of firing the CEOand bringing in a charismatic leader who can get onwith “getting things done”? Not at all. Underlying thequest for an execution-driven enterprise is one centralquestion: How does a company design its organizationto execute the strategy — whatever the strategy is — andsuccessfully adapt when circumstances change?

Execution is woven deeply into the warp and woofof organizations. It is embedded in the managementprocesses, relationships, measurements, incentives, andbeliefs that collectively define the “rules of the game” foreach company. Although we often think of companies asmonolithic entities, they’re not. They’re collections ofindividuals who typically act in their own self-interest.Superior and consistent corporate execution occurs onlywhen the actions of individuals within it are alignedwith one another, and with the overall strategic interestsand values of the company. Performance is the sum totalof the tens of thousands of actions and decisions that, atlarge companies, thousands of people, at every level,make every day.

Because individual behaviors determine an organi-zation’s success over time, the first step in resolving dys-functions is to understand how the traits of an organiza-tion influence each individual’s behavior and affect hisor her performance. We like to use the familiar meta -phor of DNA to attempt to codify the idiosyn craticcharacteristics of a company. Just as the double-strandedDNA molecule is held together by bonds between base

pairs of four nucleotides, whose sequence spells out theexact instructions required to create a unique organism,we describe the DNA of a living organization as havingfour bases that, combined in myriad ways, define anorganization’s unique traits. These bases are:

Structure. What does the organizational hierarchylook like? How are the lines and boxes in the organiza-tion chart connected? How many layers are in the hier-archy, and how many direct reports does each layer have?

Decision Rights. Who decides what? How manypeople are involved in a decision process? Where doesone person’s decision-making authority end and another’s begin?

Motivators. What objectives, incentives, and careeralternatives do people have? How are people rewarded,financially and nonfinancially, for what they achieve?

Gary Neilson

[email protected] a senior partner with Booz

& Company in Chicago. He

works on the development of

new organizational models

and designs, restructuring,

and the leadership of major

change initiatives for

Fortune 500 com panies

across industries.

Bruce A. Pasternack

is a former senior partner with

Booz & Company. He is now

an operating partner with

Venrock Associates.

Decio Mendes

is a former principal with Booz

& Company. He is now at the

Boston Consulting Group.

Originally published Winter

2003.

Exhibit 1: The Hourglass Organization

Source: Booz & Company

Vice President (8 to 9 direct reports)

Senior Director (6 to 8 direct reports)

Director (3 to 6 direct reports)

Lead Manager (4 to 6 direct reports)

Manager (5 to 7 direct reports)

Supervisor (8 to 14 direct reports)

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What are they encouraged to care about, by whatevermeans, explicit or implicit?

Information. What metrics are used to measure per-formance? How are activities coordinated, and how isknowledge transferred? How are expectations andprogress communicated? Who knows what? Who needsto know what? How is information transferred from thepeople who have it to the people who require it?

Any metaphor can be pushed too far, of course.Although the basic comparison of corporate and humanDNA is often invoked in general discussions of institu-tional culture and conduct, we think it provides a practi-cal framework senior executives can use to diagnoseproblems, discover hidden strengths, and modify compa-ny behavior. With a framework that examines all aspectsof a company’s architecture, resources, and relationships,it is much easier to see what is working and what isn’tdeep inside a highly complex organization, to understandhow it got that way, and to determine how to change it.(See “Focus: Testing Quest Diagnostics’ DNA,” page 50.)

Structure

In principle, companies make structural choices to sup-port a strategy (for example, the decision to organizebusiness units around customers, products, or geogra-phy). In practice, however, a company’s organizationalstructure and strategic intent often are mismatched. Thevariance can usually be exposed by, in effect, super -imposing the organization chart — an efficient commu-

nicator of power and status in a firm — over a businessunit’s strategic plan.

A common structural problem impeding the execu-tion of strategy is the existence of too many manage-ment tiers (deep layers), with too many individuals ateach tier having too few direct reports (narrow spans).Portrayed graphically, this structure resembles an hour-glass. (See Exhibit 1.) Narrower spans in the middleoften result from unclear decision rights and the com-pany’s mix of motivators. Generally, a structure shapedthis way indicates trouble.

There are many reasons a certain management posi-tion may legitimately call for a narrower or wider spanthan another position’s. Managers in complex jobs thatrequire them to create and maintain multiple informa-tion linkages across individual units cannot handle thesame number of direct reports as managers with simplerinformation aggregation roles. But it’s also easy for spansto become too narrow for no legitimate reason.

Consider the spans of control for three senior posi-tions at one consumer goods company with which wehave worked. As shown in Exhibit 2, the catego-ry/product line manager had five direct reports, com-pared with seven and 10 reports for senior managers attwo best-practice companies. The vice president of saleshad six direct reports, versus eight and 10 at the othercompanies. The manufacturing manager had only sevendirect reports; in other companies, similar managers had11 or more. We have taken this measurement at more

Exhibit 2: Comparing Spans of Control

Source: Booz & Company

Best-practice Company

25

20

15

10

5

Consumer Goods CompanyConsumer Goods Company

Category/Product Line Manager

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Vice President, Sales Manufacturing Manager

Co. A

10

75

10

8

6

23

1211

7

Co. B CG Co. Co. A Co. B CG Co. Co. A Co. B Co. C CG Co.

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than 100 companies, and our data indicates that thiscompany fell well outside the range found at compara-ble firms.

In our experience, numbers this far off the normprovide strong evidence that a company’s spans are narrower than they should be. Often this results in astructure that has too many layers as well. This became evident when we explored how senior managers at theconsumer goods company spent their time. About athird of it was devoted to making plans, ensuring targetcorporate goals were met, and dealing with exceptionsand high-impact/high-risk decisions, all appropriateroles for these managers. But they were spending far toomuch time (roughly 40 percent) justifying and reportingperformance to senior executives above them and par-ticipating in tactical, operational decisions with theirdirect reports. In other words, too much of their timewas devoted to second-guessing the work of peoplebelow them and preparing reports so that superiors

could second-guess their work. They should have beengiving more of their time to preparing action plans toachieve the strategic and operational objectives of thecompany.

This structure kept the consumer goods organiza-tion from executing to its potential. Among specific dys-functions we found:

• Because there were no clear standards that allowedbasic decisions to be made at lower levels, decisions re -garding such matters as authorization for PC purchasesand travel were decided too high in the organization.

• Managers and supervisors tended to discouragetheir staffs from troubleshooting to resolve routine prob-lems on their own.

• Managers rotated rapidly through jobs, reachingsenior positions without sufficient experience. Not onlydid they require close supervision, but they continuallystruggled to figure out what they needed to know.

• The company seemed to rapidly promote its best

Focus: TestingQuest Diagnostics’DNA

NA testing can be as valuable

to corporate health as it has

become to human healthcare. An

analysis of a company’s “genetic

material” can isolate the underlying

causes of and potential solutions to

organizational dysfunctions, and even

head off problems before they start.

Consider the case of the U.S.-based

medical laboratory testing company

Quest Diag nostics. Originally a divi-

sion of Corning Inc., Quest Diag nostics

grew in the 1990s through the acquisi-

tion of hundreds of small independent

testing laboratories. Spun off from

Corning in 1997, the company was los-

ing money and battling fines for billing

fraud and other abuses in a number of

the laboratories it had bought.

Chairman and CEO Ken Freeman,

then the newly appointed leader of

Quest Diagnostics, recognized that the

DNA of an enterprise formed by the

union of so many different entities,

each born in a different time and

place, with many different parents,

could readily become a monster. So he

was determined to focus his attention

on improving organizational DNA

across the entire company.

Immediately after the spin-off,

Freeman and his top management

team took control of key decision

rights to ensure that the company’s

turnaround effort was coherent and

driven hard. When the company

acquired SmithKline Beecham Clin ical

Labs in August 1999, they again delib-

erately centralized decision rights

among a small senior team. A set of

integration teams headed by the lead-

ers of both companies methodically

worked through the long-term vision

and short-term tactics for each area

of the new company, again, to ensure

consistency across the enterprise.

The financial payoff was immediate:

Prior to the deal, revenues had typi-

cally declined upward of 20 percent

following a major acquisition. In this

case, Quest Diagnostics not only didn’t

lose business, revenues grew at or

above industry growth rates during

the integration process. This was the

first time such postmerger growth

occurred in the industry.

As Quest Diagnostics’ turnaround

progressed, decision rights were

decentralized gradually, first by plac-

ing supervisors into various units who

led change and taught employees new

behaviors, and then by empowering

frontline staff. Although many parts of

the Quest Diagnostics organization

are now high performers and largely

self-directed, it has taken seven years

to get there.

Today when Quest Diagnostics

acquires a company, Mr. Freeman and

his team concentrate on two of the

four organizational bases, motivators

and information, recognizing their

interdependency and combined influ-

ence on individual and organizational

D

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and brightest just so it could retain them. This addedunnecessary layers to the hierarchy and created morework at lower levels.

• Large cross-departmental meetings filled theworkday. The rationale was to have all parties “in oneroom to resolve the issues.”

All of this activity is costly — these are managerswith salaries in the low six figures. Their compensation,plus the actual cost of their activities, pushed the com-pany’s general and administrative costs to a level that was20 percent higher than the average of our benchmarkcompanies. Because each of its many layers got involvedin almost every decision, the company’s speed to marketwas slowing, and it was losing share to new, more nim-ble competitors in several categories.

The obvious structural change was to reduce layersand increase spans — that is, to add direct reports toeach manager. We recommended a new structure thatresulted in a reduction of 10 percent of the positions

in the management ranks across all six divisions.Ultimately, with the elimination and repositioning ofmanagers and support staff, about 2,300 managementjobs were cut, which saved the company more thanUS$250 million.

Still, simply cutting layers and extending spanswould have had little long-term effect if underlyingbehaviors didn’t change. One way the company coulddo this was by setting clear standards (e.g., which PC tobuy and which airline to fly) so high-level managerswould not need to review every transaction and provideapprovals. With a monthly report, they could easilytrack exceptions to the standards. Another solution:Reset promotion expectations to slow the upward move-ment of managers and encourage more horizontalmoves — use promotions not just as a reward, but todevelop a manager’s breadth of experience. Long andcumbersome reporting processes designed to satisfy theinformation preferences of each layer and the tremen-

behavior. Among the first “gene thera-

pies” they perform is to introduce a

comprehensive and varied set of met-

rics that go well beyond the typical

financial performance measures that

most companies use. There are

measures for customer retention, the

time it takes to pick up a call in the call

center, the time it takes to process a

specimen in the labs, employee satis-

faction and attrition rates, and more.

The system is designed so that all

employees know how they can per-

sonally influence one or more core

performance measures.

The only way this information can

influence the day-to-day behavior and

decisions of employees throughout

the organization is if decision makers

have the information on hand when

they need it. Quest Diagnostics posts

various metrics on different time -

tables depending on the type of man-

agement issue: Customer retention

metrics are posted at least once a

month; specimen turnaround time is

posted every morning.

Finally, the company ties these

metrics to individuals’ bonus pay-

ments so that information not only

informs, but also motivates productive

behavior. Since virtually everyone in

the company can affect customer

retention in some way, Quest Diag -

nostics uses the customer retention

metric very broadly in its perform-

ance-based compensation programs.

Ultimately, the bonuses of all 37,000

Quest Diagnostics employees depend

in some way on meeting the customer

retention target.

“If we have a shared goal that says

we’re going to reduce customer attri-

tion, that doesn’t mean it is only for

people in sales. It impacts people pick-

ing up the specimens, people who

draw and perform tests on the speci-

mens, and certainly people in billing. If

there are lots of complaints, the cus-

tomer is going to leave. By having

shared goals, you get speed and align-

ment,” says Freeman.

To make the motivators as specific

and powerful as possible, customer

retention metrics are measured not

just organization-wide. They are di -

vided up by region, so that people are

paid on the basis of customer reten-

tion performance in their own region,

where they can have the greatest

influence.

The aligning and motivating power

of bringing information and incentives

together is reflected in the firm’s

strong financial performance. Since

Quest Diagnostics was spun off from

Corning in 1997, the company’s stock

price has increased 730 percent, com-

pared with a 41 percent increase in the

S&P 500 Index during the same

period. Having successfully carried

out a classic turnaround and taken the

lead in consolidating the industry,

Quest Diag nostics is now driving

growth organically and has become

the clear leader in the U.S. medical

laboratory testing market. In 2002, the

com pany earned US$322 million on

$4.1 billion in revenues.

—G.N., B.A.P., and D.M.

Executives promoted to new positionsoften cling to their prior responsibilities,

burdening themselves with unnecessarytasks and disempowering their subordinates.

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dous desire for detail also had to go. In their place wouldbe a report on the key lagging and leading measures ofcritical business activity, a top-down setting of targets,and the monitoring of variances. To further dissolve thereflexive addition of layers, the company also had to domore managerial training and communicate betterabout the change in promotion principles. Followingthe restructuring and changes in management, time tomarket for product introductions shrank by months,enabling the company to regain the first-to-marketadvantage it had traditionally held.

Decision Rights

Decision rights specify who has the authority to makewhich decisions. Clarifying these rights puts flesh on anorganization chart and makes crystal clear where respon-sibility lies.

Clear decision rights enable wider spans and fewerlayers, which translates into lower costs and speedier exe-cution. Unarticulated decision rights are more than atime sink; they’re a central cause of substandard per-formance — and even of nonperformance. An em ployeeat a financial-services company expressed this problemquite concretely in a focus group we conducted, saying,“Responsibilities are blurred intentionally around hereso everyone has an excuse for not getting involved.”

At one industrial company, we found yet again thatsenior executives were spending too much time review-ing small projects. It turned out the company had notreassessed managers’ spending-approval limits in morethan 10 years. We suggested the authorization process beadjusted so that managers lower in the organizationcould be accountable for the final approval of more proj-ects. The capital expenditure amount requiring CEO

authorization was raised from $5 million to $15 million.The objective was to free up senior management’s timeto focus on the longer-term issues associated with mar-ket growth and potential acquisitions. Based on histori-cal analysis, it was determined that raising the level atwhich projects required CEO authorization to $15 mil-lion would reduce the number of projects crossing theCEO’s desk by 49 percent. All large projects would stillcome to the CEO, so the aggregate value of projectsapproved at the top would decline by only 13 percent.

Decision rights become blurred for many reasons,not all of them intentional. After a large industrial com-pany completed a leveraged buyout, the management ofone of its business units became the new entity’s corpo-rate management, charged with reviewing the operatingdecisions of all business units. That change requiredevery level of management to take on greater decision-making responsibility — an unnatural act for executivesaccustomed to hands-on involvement in operating unitdecisions. Rather than allow their general managers tomake basic decisions about product design and resourceallocation, the CEO and COO still involved themselvesdeeply in these activities. Meanwhile, they were neglect-ing other areas where their attention was expected,notably strategic planning, long-range business portfoliodecisions, and the firm’s financial condition.

The solution was to create a process for corporateofficers to delegate decisions to the business unit’s gen-eral managers. An executive committee was establishedto review business unit decisions, and several generalmanagers were charged with integrating marketing,product engineering, and manufacturing. These struc-tures and processes made effective delegation possible.

It doesn’t take a leveraged buyout to distort a com-

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pany’s decision-rights structure. People naturally leantoward the familiar when faced with change. Executivespromoted to new positions often cling to their priorresponsibilities, burdening themselves with unnecessarytasks and disempowering their subordinates. The pressof the urgent at the business unit level drives out theimportant at the corporate level. The lesser decisionsseem concrete and knowable. Forward thinking and bigdecisions regarding long-term direction seem undefined,amorphous, and tougher to tackle.

Often the process of assigning decision rights is aresponse to a crisis or a shift in political power. Whenthis happens, decisions can fall between the cracks. Orthey can be made twice by different parties. Or they canbe reviewed repeatedly, becoming a Sisyphean exercisein backsliding.

It is possible to assign decision rights system aticallyand rationally. At a global industrial company, wehelped create an organizational matrix of functions,products, and geographies. The structure was under-girded by a set of specific organizational and decision-making principles, among them: Responsibility doesnot imply exclusive authority; different units shouldhave joint goals and performance measures; and certainpositions need to report upward to multiple managers.

Over several months, we worked with the companyto apply these and several other principles to more than300 critical decisions. Because we undertook this effortexplicitly while also changing the structure, the com -pany was able to execute its new strategy faster, and withfewer missteps. The overall change process took twoyears (one less than had been anticipated). The com panyreturned to profitability, reduced its net debt by the tar-geted amount, and reached several other critical finan-cial goals a year ahead of schedule.

Making decision rights explicit in companies inwhich they are not requires management to set rules for the most common business situations — and foreach position. In effect, the company is creating a constitution that says who will decide what and underwhat circumstances.

The decision rights of groups must also be clear. Ata consumer goods company, we saw large numbers ofexecutives meeting frequently to resolve conflicts amongfunctional units. It appeared that operations, finance,and marketing were each doing an excellent job of ana-lyzing new factories, new products, and new businessopportunities, but they weren’t talking to one anotheralong the way. Operations planned the perfect factory

— without guidance from finance on the cost. Inmarathon meetings, managers from each functionbrought their independent analyses together. Then theystruggled to reach a joint conclusion, because each unit,by that time, was wedded to its own recommendation.

To solve this silo problem, one top executive wasmade responsible for managing a cross-functional team,so there would always be communication across dis -ciplines. As a result, only a few top executives were needed to make routine decisions, and the companyreduced dedicated staff support for these efforts by morethan 30 percent.

Motivators

The third of the four bases in a company’s DNA-likemakeup involves motivation. Employees generally don’tdeliberately act counterproductively; they don’t try toderail a company’s strategy. Rather, they respond quiterationally on the basis of what they see, what theyunderstand, and how they’re rewarded. An exhortationto follow the vision and pursue the strategy is only somuch air if the organization’s incentives and informationflows make it difficult for employees to understand anddo what they’re supposed to do.

An organization can send confusing signals to indi-viduals in many ways. Think about what happens whenan appraisal system inflates performance ratings. At aconsumer goods company we once worked with,employees were appraised on a 1 to 10 scale. Eighty per-cent received a rating of 9 or above, and everyone feltgood. But superior employees didn’t feel they needed todo any better. Other workers thought their performancewas acceptable when it wasn’t. Appraisers were avoidingthe unpleasant task of delivering bad performance rat-ings, and the organization wasn’t giving them any reasonto be tough. For every deficient employee who stayed atthe company because the organization said he or she wascompetent, the company’s execution suffered. Becauseof its unwillingness to differentiate people’s contributionsthrough performance assessments and raises, the com-pany lost the opportunity to send important feedback toemployees on what was relevant to executing the strat -egy — and where their performance was unsatisfactory.

Several years ago we worked with the new CEO ofa technology company who had been the head of a busi-ness unit and had served for several years on the execu-tive committee that made investment decisions. Thenew CEO knew from experience that the committeewasn’t tough enough on new investment requests. They

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were a collegial group; members supported their col-leagues’ investment requests with the understandingtheir own requests would be supported in return.

The new CEO wanted a more discriminatingprocess that would judge investment proposals on theirmerits. He also knew executive committee membersfaced little downside from approving unsound invest-ment requests. Future bonuses might suffer if companyperformance wasn’t good, but that money wasn’t alreadyin their pockets.

So the CEO introduced a new system to changethis attitude: Each committee member was required totake out a personal loan of $1 million and invest it incompany stock (the loan was guaranteed by the com -pany, so the individuals could borrow at good rates).Unlike an outright stock grant, this scheme ensured thatthe executives had existing wealth at risk, and that theywould lose money, and perhaps the ability to repay thedebt, if they permitted poor investment decisions. Withthis new incentive to scrutinize investment requests, thecommittee became much tougher and more effective.And after a few sessions, teams began bringing better-researched and smarter investment proposals to the tablebecause they knew if they didn’t, the committee waslikely to turn them down.

There are other market mechanisms that can beused to send more accurate signals to managers aboutthe cost and value of certain activities. This approachwas used successfully at a large agribusiness companythat came to us for help in improving the services of itshuman resources department. The HR department’sperformance had always been judged by how well itstayed on budget. Internal customer satisfaction wasrarely measured. Each customer was allocated a share ofthe HR budget, but these figures didn’t represent thetrue cost of the services. Meanwhile, customers had lit-tle influence on the kind and amount of services theyreceived. Neither HR nor its customers had an incentiveto offer or ask for services tailored to the specific needsof a division.

Working with the company, we created a scorecardto measure HR performance on such things as call cen-ter response time and payroll errors. Achieving scorecard

targets became a significant component of managementincentives and rewards. HR’s internal customers weregiven the right to negotiate service-level agreements withHR. The true cost of services was established using out-side benchmarks. Once HR’s customers understoodwhat they were paying for and could better manage theircosts, they had an incentive to use HR services morewisely. Today, they often decline or reduce some ser vicesand request new ones. The market-based measurementand incentive program improved the quality of the company’s HR services and reduced costs by more than15 percent.

Organizations that are ready to implement multipleprofit-and-loss statements and market-based motiva-tional systems will find that these powerful new toolscan help them operate effectively with less command-and-control oversight. But not all companies are readyfor these systems; it takes strong leadership, persistence,and patience to introduce them and overcome employ-ee resistance to using them.

Information

Underlying a company’s ability to ensure clear decisionrights and to measure and motivate people to applythem is one critical matter: information.

Making sure high-quality information is availableand flowing where it needs to go throughout a compa-ny, all the time, is among the most challenging tasks ofthe modern corporation, and one of the most under -appreciated contributors to high performance and com-petitive advantage. A 2002 study of the managementand financial performance of 113 Fortune 1000 compa-nies over the five-year period 1996 to 2000, conductedby Booz & Company and Ranjay Gulati of the KelloggSchool of Management at Northwestern University,found that the companies with the highest shareholderreturns were more focused on managing and enhancingcommunication with their customers, suppliers, andemployees than other firms in the study.

We have seen this information–performance link-age often in practice. A few years ago, the board of anagricultural grower and processor became concernedabout the company’s operating efficiency. Among otherproblems, farm managers were using equipment with-out discipline — ordering a machine at will, driving ithard, and returning it with an empty gas tank, allbecause headquarters was responsible for maintenanceand replacement costs. Our benchmark data indicatedthat this company’s expenses were far higher than those

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of independent farms. We worked with corporate andfarm management to develop a new business model,centered on turning each farm into an independentbusiness. For this to happen, farm managers needed newinformation — specifically, individual farm P&Ls thatreflected, among many other things, the cost of theequipment they used. The redesigned organization exe-cuted more efficiently, as reflected in a 48 percent jumpin its imputed share price in the first year.

Better information flows did more than keep costsdown; they helped allocate scarce resources far more effi-ciently than before. The company had a silo problem —literally and figuratively. Any field ready for harvest hada peak yield window of about 15 days. But there wasonly so much mill capacity during the peak window.Coordinating and timing the harvesting and millingactivities fell to a hapless employee at headquarters, acentral planner who relied on historical data that didn’treveal much about current conditions.

We showed in a simulation that if farm managerscould bid for use of the mill on particular dates, it wouldstrikingly improve the company’s efficiency. If a man -ager saw that his highest-yielding acreage was ready toharvest and couldn’t wait because rain was predicted, hecould bid more for mill time. No longer would someoneback at headquarters have to hunker down with aspreadsheet, making educated guesses based on the pre-vious year’s yield data and taking frantic phone callsfrom farm managers. Market-based pricing of mill timewould allocate scarce resources better than a centralplanner could. And with this new system, decisionswould reflect the real-time knowledge of the farmer inthe field observing the sky, testing the ripeness of thecrop, hour by hour, acre by acre.

Adaptive DNA

Although we have illustrated the four bases of organiza-tional DNA separately to emphasize their distinct char-acteristics, they clearly are intertwined. Changing struc-ture requires changing decision rights; to make effectivedecisions, employees need new incentives and differentinformation. At the agricultural grower and processor,the new structure touched each of these elements — theindividual farm as a business required new decisionauthority for farm managers, new metrics by which tomeasure their performance, and new rewards based ontheir individual success. This interdependency is evidentin all of these company stories.

Considering — and changing — a company’s

DNA holistically means weaving intelligence, decision-making capabilities, and a collective focus on commongoals widely and deeply into the fabric of the organiza-tion so that each person and unit is working smartly —and working together. It’s one thing to achieve well-coordinated intelligence among senior executives. It’sanother thing entirely to touch every level of an organi-zation all the way down to the loading dock. What everyemployee does every day, aggregated across the com -pany, constitutes performance.

The best organizational designs are adaptive, areself-correcting, and become more robust over time. Butcreating such an organization doesn’t happen quickly; itcan take several years to get the basics right, and there isalways a need for fine-tuning. This may explain whyleaders of companies that are truly ailing — and whoneed to reassure shareholders as fast as they can — oftendon’t have the patience for changing decision rights,motivators, and information flows. They’re more likelyto cut the structure and see what happens than to taketime to ensure that structural changes actually result insustained productivity improvements and steady gainsin shareholder value. But neglecting this hard work mayalso partly explain why some of these CEOs are nolonger in charge.

No company may ever totally master the enigma ofexecution. But the most resilient and consistently suc-cessful ones have discovered that the devil is in thedetails of organization. For them, organizing to executehas truly become a competitive edge. +

Reprint No. 03406

Resources

Jeffrey W. Bennett, Thomas E. Pernsteiner, Paul F. Kocourek, and StevenB. Hedlund, “The Organization vs. the Strategy: Solving the AlignmentParadox,” s+b, Fourth Quarter 2000, www.strategy-business.com/press/article/14114.

Michael C. Jensen, Foundations of Organizational Strategy (HarvardUniversity Press, 1998).

Paul F. Kocourek, Steven Y. Chung, and Matthew G. McKenna,“Strategic Rollups: Overhauling the Multi-Merger Machine,” s+b, SecondQuarter 2000, www.strategy-business.com/press/article/16858.

Chuck Lucier, Rob Schuyt, and Eric Spiegel, “CEO Succession 2002:Deliver or Depart,” s+b, Summer 2003, www.strategy-business.com/press/article/21700.

Gary Neilson, David Kletter, and John Jones, “Treating the TroubledCorporation,” s+b enews, 03/28/03, www.strategy-business.com/press/enewsarticle/22230.

Randall Rothenberg, “Larry Bossidy: The Thought Leader Interview,” s+b,Third Quarter 2002, www.strategy-business.com/press/article/20642.

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Leadership is not just for leaders anymore. Top companies are beginning to understand that sustainingpeak performance requires a firm-wide commitment todeveloping leaders that is tightly aligned to organiza-tional objectives — a commitment much easier tounderstand than to achieve. Organizations must findways to cascade leadership from senior management tomen and women at all levels. As retired HarvardBusiness School professor John P. Kotter eloquentlynoted in a previous issue of strategy+business, this ulti-mately means we must “create 100 million new leaders”throughout our society. (See “Leading Witnesses,” s+b,Summer 2004.)

Organizational experts Paul Hersey and KennethBlanchard have defined leadership as “working with andthrough others to achieve objectives.” Many companies

are stepping up to the challenge of leadership develop-ment and their results are quite tangible. In Leading theWay: Three Truths from the Top Companies for Leaders(John Wiley & Sons, 2004), a study of the top 20 com-panies for leadership development, Marc Effron andRobert Gandossy show that companies that excel atdeveloping leaders tend to achieve higher long-termprofitability.

But it sometimes seems there are as many approach-es to leadership development as there are leadershipdevelopers. One increasingly popular tool for developingleaders is executive coaching. Hay Group, a humanresources consultancy, reported that half of 150 compa-nies surveyed in 2002 said that they had increased theiruse of executive coaching, and 16 percent reported usingcoaches for the first time.

LeadershipIsaContactSport The “Follow-up Factor” in

Management Development

BY MARSHALL GOLDSMITH AND HOWARD MORGAN

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Yet even “executive coaching” is a broad category. Inreviewing a spate of books on coaching in 2003, DesDearlove and Stuart Crainer identified at least threetypes of coaching: behavioral change coaching, personalproductivity coaching, and “energy coaching.” (See “MyCoach and I,” s+b, Summer 2003.) Our own book, TheArt and Practice of Leadership Coaching: 50 Top ExecutiveCoaches Reveal Their Secrets (with Phil Harkins; JohnWiley & Sons, 2004), includes discussions about fivetypes of leadership coaching: strategic, organizationalchange/execution, leadership development, personal/lifeplanning, and behavioral.

Given the increasingly competitive economic envi-ronment and the significant human and financial capi-tal expended on leadership development, it is not onlyfair but necessary for those charged with running com-panies to ask, “Does any of this work? And if so, how?”What type of developmental activities will have thegreatest impact on increasing executives’ effectiveness?How can leaders achieve positive long-term changes inbehavior? With admitted self-interest — our work wasdescribed in the Crainer–Dearlove article, and is fre-quently cited in reviews of and articles about leadershipcoaching — we wanted to see if there were consistentprinciples of success underlying these differentapproaches to leadership development.

We reviewed leadership development programs ineight major corporations. Although all eight companieshad the same overarching goals — to determine thedesired behaviors for leaders in their organizations andto help leaders increase their effectiveness by betteraligning actual practices with these desired behaviors —they used different leadership development methodolo-gies: off-site training versus on-site coaching, short

duration versus long duration, internal coaches versusexternal coaches, and traditional classroom-based train-ing versus on-the-job interaction.

Rather than just evaluating “participant happiness”at the end of a program, each of the eight companiesmeasured the participants’ perceived increase in leader-ship effectiveness over time. “Increased effectiveness”was not determined by the participants in the develop-ment effort; it was assessed by preselected co-workersand stakeholders.

Time and again, one variable emerged as central tothe achievement of positive long-term change: the par-ticipants’ ongoing interaction and follow-up with col-leagues. Leaders who discussed their own improvementpriorities with their co-workers, and then regularly fol-lowed up with these co-workers, showed strikingimprovement. Leaders who did not have ongoing dia-logue with colleagues showed improvement that barelyexceeded random chance. This was true whether theleader had an external coach, an internal coach, or nocoach. It was also true whether the participants went toa training program for five days, went for one day, or didnot attend a training program at all.

The development of leaders, we have concluded, isa contact sport.

Eight Approaches

The eight companies whose leadership developmentprograms we studied were drawn from our own roster ofclients over a 16-year period. Although all are large cor-porations, each company is in a different sector and eachfaces very different competitive pressures.

Each company customized its leadership develop-ment approach to its specific needs. Five of the eight

Marshall Goldsmith

[email protected] a founder of Marshall

Goldsmith Partners, a leader-

ship coaching network. He

has worked with more than

70 major CEOs and their

management teams and is the

author or coauthor of many

books on leadership and

coaching, including Mojo: How to Get It, How to Keep It,How to Get It Back if You LoseIt (with Mark Reiter; Hyperion,

2009).

Howard Morgan

[email protected] the founder of 50 Top

Coaches, a collective of many

of the world’s leading execu-

tive advisors. He specializes in

executive coaching as a strate-

gic change-management tool.

He is co-editor of The Art andPractice of LeadershipCoaching: 50 Top ExecutiveCoaches Reveal Their Secrets(John Wiley & Sons, 2004).

Originally published Fall 2004.

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focused on the development of high-potential leaders,and between 73 and 354 participants were involved intheir programs. The three other companies includedalmost all managers (above midlevel), and involvedbetween 1,528 and 6,748 managers. The degree of inter-national representation varied among organizations. Attwo companies, almost all of the participants wereAmerican. Non-U.S. executives made up almost half ofthe participants in one company’s program. The otherfive had varying levels of international participation.

Some of the companies used traditional classroom-based training in their development effort. In each ofthese companies, participants would attend an off-siteprogram and receive instruction on what the desiredcharacteristics were for leaders in their organization, whythese characteristics were important, and how partici-pants might better align their own leadership behaviorwith the desired model. Some companies, by contrast,used continuing coaching, a methodology that did notnecessarily involve off-site training, but did rely on reg-ular interaction with a personal coach. Some companiesused both off-site training and coaching.

Along with differences, there were commonalitiesamong the programs. Each company had spent exten-sive time reviewing the challenges it believed its leaderswould uniquely face as its business evolved. Each haddeveloped a profile of desired leadership behaviors thathad been approved by upper management. After ensur-ing that these desired leadership behaviors were alignedwith the company vision and values, each companydeveloped a 360-degree feedback process to help leadersunderstand the extent to which their own behavior (asperceived by co-workers) matched the desired behaviorfor leaders in the corporation. All eight placed a set of

expectations upon participants. The developing leaderswere expected to:

• Review their 360-degree feedback with an inter-nal or external consultant.

• Identify one to three areas for improvement.• Discuss their areas for improvement with key

co-workers.• Ask colleagues for suggestions on how to increase

effectiveness in selected areas for change.• Follow up with co-workers to get ideas for

improvement.• Have co-worker respondents complete a confi-

dential custom-designed “mini-survey” three to 15months after the start of their program.

Each participant received mini-survey summaryfeedback from three to 16 co-workers. Colleagues wereasked to rate the participants’ increased effectiveness inthe specific selected behaviors as well as participants’overall increase (or decrease) in leadership effectiveness.Co-workers were also asked to measure the degree of follow-up they had with the participant. In total, we col-lected more than 86,000 mini-survey responses for the11,480 managers who participated in leadership development activities. This huge database gave us theopportunity to explore the points of commonality anddistinction among these eight very different leadershipdevelopment efforts.

Three of the organizations permitted their names tobe used in articles or conference presentations, enablingus to reference them in this report; the rest have request-ed anonymity, although we are able to describe their sec-tor and activities. Two of the organizations also haveallowed their results to be published elsewhere, withoutdisclosure of the organization’s name. The companies

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whose programs we studied were: • An aerospace/defense contractor: 1,528 managers

(ranging from midlevel to the CEO and his team)received training for two and a half days. Each personreviewed his or her 360-degree feedback in person withan outside consultant. All received at least threereminder notes to help ensure that they would follow upwith their co-workers.

• A financial-services organization: At GE Capital,178 high-potential managers received training that last-ed five days. Each leader was assigned a personal humanresources coach from inside the company. Each coachhad one-on-one sessions with his or her client on anongoing basis (either in person or by phone).

• An electronics manufacturer: 258 upper-levelmanagers received in-person coaching from an externalcoach. They did not attend an off-site training program.They were then each assigned an internal coach who hadbeen trained in effective coaching skills. This coach fol-lowed up with the managers every three to four months.

• A diversified services company: 6,748 managers(ranging from midlevel to the CEO and his team)received one-on-one feedback from an external coachduring two training programs, each two and a half dayslong, which were conducted 15 months apart. Althoughthere was no formal follow-up provided by the coach,participants knew they were going to be measured ontheir follow-up efforts.

• A media company: 354 managers (including theCEO and his team) received one-on-one coaching andfeedback during a one-day program. An external coachprovided follow-up coaching every three to fourmonths.

• A telecommunications company: 281 managers

(including the CEO and his team) received training for one day. Each leader was given an external coach,who had continuing one-on-one sessions with his or her client.

• A pharmaceutical/healthcare organization: John-son & Johnson involved 2,060 executives and managers,starting with the CEO and his team, in one and a halfdays of leadership training. Each person reviewed his orher initial 360-degree feedback with an outside consult-ant (almost all by phone). Participants received at leastthree reminder notes to help ensure that they would fol-low up with their co-workers.

• A high-tech manufacturing company: At AgilentTechnologies Inc., 73 high-potential leaders receivedcoaching for one year from an external coach, an effortunconnected to any training program. Each coach hadone-on-one sessions with his or her client on an ongoingbasis, either in person or by phone.

Personal Touch

The overarching conclusion distilled from the surveys inall the programs was that personal contact mattered —and mattered greatly.

Five of the corporations used the same measure-ment methodologies, while three used a slightly dif -ferent approach. All eight companies measured the frequency of managers’ discussions and follow-up withco-workers and compared this measure with the per-ceived increase in leadership effectiveness, as judged byco-workers in the mini-surveys. The first five firms —the aerospace/defense contractor, GE Capital, the elec-tronics manufacturer, the diversified services company,and the media company — used a seven-point scale,from –3 to +3, to measure perceived change in leader-

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ship effectiveness, and a five-point scale to plot theamount of follow-up, ranging from a low of “no follow-up” to a high of “consistent or periodic follow-up.” They then compared the two sets of measurements byplotting the effectiveness scores and the follow-up tallieson charts.

The remaining three firms used slightly differentmeasurement criteria. The telecommunications compa-ny used a “percentage improvement” scale to measureperceived increases in leadership effectiveness, as judgedby co-workers. It then compared “percentage improve-ment” on leadership effectiveness with each level of follow-up. Johnson & Johnson and Agilent Technol -ogies measured leadership improvement using the sameseven-point scale employed by the first five companies,but they did not categorize the degree of follow-up be -yond the simple “followed up” versus “did not follow up.”

As noted earlier, follow-up here refers to efforts thatleaders make to solicit continuing and updated ideas for improvement from their co-workers. In the twocompanies that compared “followed up” with “did notfollow up,” participants who followed up were viewedby their colleagues as far more effective than the leaderswho did not. In the companies that measured the degreeof follow-up, leaders who had “frequent” or “periodic/consistent” interaction with co-workers were reliablyseen as having improved their effectiveness far morethan the leaders who had “little” or “no” interaction withco-workers.

Exhibit 1 shows the results among the first fivecompanies, which, despite their different leadershipdevelopment programs, used the same measurementmethodology. This apples-to-apples comparison showsstrong correlations across all five companies between the

degree of follow-up and the perceived change in leader-ship effectiveness.

Leadership, it’s clear from this research, is a rela-tionship. And the most important participants in thisrelationship are not the coach and the “coachee.” Theyare the leader and the colleague.

Most of the leaders in this study work in knowledgeenvironments — in companies where the value of theproduct or service derives less and less from manufac-turing scale and, to use Peter Drucker’s formulation,more and more from the processing and creation ofinformation to define and solve problems. In discussingleadership with knowledge workers, Drucker has said,“The leader of the past was a person who knew how totell. The leader of the future will be a person who knowshow to ask.” Our studies show that leaders who regular-ly ask for input are seen as increasing in effectiveness.Leaders who don’t follow up are not necessarily badleaders; they are just not seen as getting better.

Ask and Receive

In a way, our work reinforces a key learning from theHawthorne studies. These classic observations of factoryworkers at suburban Chicago’s Western ElectricHawthorne Works, which Harvard professor EltonMayo made nearly 80 years ago, showed that productiv-ity tended to increase when workers perceived leadershipinterest and involvement in their work, as evidenced bypurposeful change in the workplace environment. Ourstudies show that when co-workers are involved in lead-ership development, the leaders they are helping tend tobecome more effective. Leaders who ask for input andthen follow up to see if progress is being made are seenas people who care. Co-workers might well infer that

Leadership is a relationship, not between the coach and the “coachee,” but

between the leader and the colleague.

TYPE OFFOLLOW-UP

MuchLess

MuchMore

SomewhatLess

SomewhatMore

SlightlyLess

Slightly moreNo change

PERCEIVED CHANGE IN LEADERSHIP EFFECTIVENESS

NONE

A LITTLE

FREQUENT

CONSISTENT

SOME

Distribution of respondents

Exhibit 1: The Impact of Follow-up

Combined results from five companies — with very different leadership development programs, but that measured leadership effectiveness the same way — show how the perceived quality of leaders correlates to the frequency of their follow-up. Follow-up, here, means efforts by leaders to solicit ideas from their coworkers about their own improvement.

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leaders who don’t respond to feedback must not carevery much.

Historically, a great deal of leadership developmenthas focused on the importance of an event. This eventcould be a training program, a motivational speech, oran off-site executive meeting. The experience of the eightcompanies we studied indicates that real leadership de -vel opment involves a process that occurs over time, not aninspiration or transformation that occurs in a meeting.

Physical exercise provides a useful analogy. Imaginehaving out-of-shape people sit in a room and listen to aspeech on the importance of exercising, then watchsome tapes on how to exercise, and perhaps practiceexercising. Would you ever wonder why these peoplewere still unfit a year later? The source of physical fitness

is not understanding the theory of working out; it isengaging in exercise. As Arnold Schwarzenegger hassaid, “Nobody ever got muscles by watching me workout!” So, too, with leadership development. As Drucker,Hersey, and Blanchard have pointed out, leadershipinvolves a reliance on co-workers to achieve objectives.Who better than these same co-workers to help theleader increase effectiveness?

Indeed, the executive coach is, in many ways, like apersonal trainer. The trainer’s role is to “remind” the per-son being trained to do what he or she knows should bedone. Good personal trainers spend far more time onexecution than on theory. The same seems to be true forleadership development. Most leaders already knowwhat to do. They have read the same books and listened

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to the same gurus giving the same speeches. Hence, ourcore conclusion from this research: For most leaders, thegreat challenge is not understanding the practice of leader-ship: It is practicing their understanding of leadership.

Beyond the basic finding — that follow-up matters— several other conclusions arise from our research. Forexample, the eight-program study indicates that the follow-up factor correlates with improved leadership effec-tiveness among both U.S. and non-U.S. executives.

As companies globalize, many executives havebegun to wrestle with issues of cultural differencesamong their executives and employees. Recent researchinvolving high-potential leaders from around the worldhas shown that cross-cultural understanding is seen as akey to effectiveness for the global leader. (See, for exam-ple, Marshall Goldsmith et al., Global Leadership: TheNext Generation, Financial Times Prentice Hall, 2003.)

Our study addressed this issue as it affects leader-ship development programs. Nearly 10,000 of therespondents in the eight companies whose programs wereviewed — almost 12 percent of our mini-survey sam-ple — were located outside the United States. We foundthat the degree of follow-up was as critical to changingperceived leadership effectiveness internationally as itwas domestically. This was true for both training andcoaching initiatives.

At Johnson & Johnson, there were almost no dif-ferences in scores among participants in Europe, LatinAmerica, and North America. The group seen asimproving the most was in Asia. In analyzing the find-ings, J&J determined that the higher scores in Asia weremore a function of dedicated local management than ofcultural differences, again supporting the correlationbetween a caring, contact-rich leadership and its per-

ceived effectiveness.That follow-up works globally contravenes assump-

tions that different cultures will have differing levels ofreceptiveness to intimate conversations about workplacebehaviors. But the universality of the follow-up principledoesn’t imply universality in its application. Leaders learnfrom the people in their own environment, particularlyin a cross-cultural context. Indeed, research by theCenter for Creative Leadership in Greensboro, N.C., hasshown that “encouraging feedback” and “learning fromthose around us” are both central to success for leaders incross-cultural environments. Companies with successfulleadership development programs encourage executivesto adapt the universal principle of follow-up and the fre-quency of such conversations to fit the unique require-ments of the culture in which they working. Despiteother cultural differences, there seems to be no countryin the world where co-workers think, “I love it when youask me for my feedback and then ignore me.”

Inside and Outside

Interaction between the developing leader and his or hercolleagues is not the sole connection that counts. Alsovital is the contact between the leader and the coach. Ourthird major finding concerns that relationship: Bothinternal and external coaches can make a positive difference.

One reason coaching can be so effective is that itmay inspire leaders to follow up with their people.Agilent, for one, found a strong positive correlationbetween the number of times the coach followed upwith the client and the number of times the client fol-lowed up with co-workers.

The coach, however, does not have to be part of thecompany. This conclusion was readily apparent when

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we compared the two companies most distinct in thecomposition of their coaching corps. Agilent used onlyexternal coaches. GE Capital, by contrast, used onlyinternal coaches from human resources. Yet bothapproaches produced very positive long-term increasesin perceived leadership effectiveness.

Given the apparent ease of accessibility to internalcoaches, firms might naturally use this finding to justify“going inside.” But there are at least three importantvariables to consider in determining whether to use aninternal HR coach: time, credibility, and confidentiality.

In many organizations, internal coaches are notgiven the time they need for ongoing interaction withthe people they are coaching. In some cases, they maynot seem as credible as trained development experts. Inother cases, especially those that involve humanresources personnel filling multiple roles, there mayappear to be a conflict of interest between a profes -sional’s responsibilities as coach and as evaluator. If theseperceptions exist, then external coaches may well bepreferable to internal coaches.

But internal coaches can overcome these obstacles.At GE Capital, the internal coaches were HR profes-sionals who were given time to work with their“coachees.” Coaching was treated as an important partof their responsibility to the company and was not seenas an add-on “if they got around to it.” Moreover, thecoachees were given a choice of internal coaches andpicked coaches they saw as most credible. Finally, eachinternal coach worked with a leader in a different part ofthe business. They assured their coachees that thisprocess was for high-potential development, not evalua-tion. As a result of this thorough screening process,client satisfaction with internal coaches was high and

results achieved by internal coaches (as judged by co-workers) were very positive.

Inside or outside, we discovered that the mechanicsof the coach–leader relationship were not a major limit-ing factor. Our fourth finding was that feedback orcoaching by telephone works about as well as feedback orcoaching in person.

Intuitively, one might believe that feedback orcoaching is a very “personal” activity that is better doneface-to-face than by phone. However, the companies wereviewed do not support this supposition. One company,Johnson & Johnson, conducted almost all feedback bytelephone, yet produced “increased effectiveness” scoresalmost identical to those of the aerospace/defense organ-ization, which conducted all feedback in person.

Moreover, all the companies that used only externalcoaches similarly found little difference between tele-phone coaching and live coaching. These companiesmade sure that each coach had at least two one-on-onemeetings with individual executive clients. Some coachesdid this in person, whereas others interacted mostly byphone. There was no clear indication that either methodof coaching was more effective than the other.

Although sophisticated systems — involving somecombination of e-mail, intranets, extranets, and mobileconnectivity — are available, follow-up needn’t beexpensive. Internal coaches can make follow-up tele-phone calls. New computerized systems can send“reminder notes” and give ongoing suggestions.However it’s done, follow-up is the sine qua non of effec-tive leadership development. Too many companiesspend millions of dollars for the “program of the year”but almost nothing on follow-up and reinforcement.

Companies should also take care to measure the

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effectiveness of their leadership development initiatives,and not just the employees’ satisfaction with them. Ourresults indicate that when participants know that surveysor other methods of measuring program effectiveness areslated to occur three to 15 months from the date of theprogram, a higher level of commitment is createdamong them. This follow-up measurement creates afocus on long-term change and personal accountability.

Although measuring outcomes would seem to besecond nature for most companies, the success of lead-ership development programs has conventionally beenassessed through the satisfaction of the participants. Thismetric is of limited relevance. Among the companies inour study that offered leadership development training,virtually all participants came away highly satisfied. Atthe aerospace/defense contractor and Johnson &Johnson, the average satisfaction rating among morethan 3,500 participants was 4.7 out of a possible 5.0.Executives loved the training, but that didn’t mean theyused the training or improved because of it.

Learning to Learn

Of even greater import is this: Continual contact withcolleagues regarding development issues is so effective itcan succeed even without a large, formal program.Agilent, for example, produced excellent results, eventhough its leaders received coaching that was com pletelydisconnected from any training. In fact, leaders who donot have coaches can be coached broadly by their co-workers. The key to changing behavior is “learning tolearn” from those around us, and then modifying our behavior on the basis of their suggestions. The aerospace/defense contractor and the telecommunica-tions company used very streamlined and efficient train-

ing processes and “reminder notes” to help leadersachieve a positive long-term change in effectiveness,without using coaches at all.

If the organization can teach the leader to reach outto co-workers, to listen and learn, and to focus on continuous development, both the leader and the organ-ization will benefit. After all, by following up with col-leagues, a leader demonstrates a commitment to self-improvement — and a determination to get better. Thisprocess does not have to take a lot of time or money.There’s something far more valuable: contact. +

Reprint No. 04307

Resources

Diane Anderson, Brian Underhill, and Robert Silva, “The Agilent APEXCase Study,” in Best Practices in Leadership Development — 2004, editedby Dave Ulrich, Louis Carter, and Marshall Goldsmith (Best PracticesPublications, 2004).

Des Dearlove and Stuart Crainer, “My Coach and I,” s+b, Summer 2003,www.strategy-business.com/press/article/22062.

Marshall Goldsmith, “Ask, Learn, Follow Up, and Grow,” in The Leaderof the Future: New Visions, Strategies, and Practices for the Next Era, editedby Frances Hesselbein, Marshall Goldsmith, and Richard Beckhard (PeterDrucker Foundation and Jossey-Bass, 1996).

Marshall Goldsmith et al., Global Leadership: The Next Generation(Financial Times Prentice Hall, 2003).

Linda Sharkey, “Leveraging HR: How to Develop Leaders in Real Time,”in Human Resources in the 21st Century, edited by Marc Effron, RobertGandossy, and Marshall Goldsmith (John Wiley & Sons, 2003).

Elizabeth Thach, “The Impact of Executive Coaching and 360 Feedbackon Leadership Effectiveness,” Leadership & Organization DevelopmentJournal, vol. 23, no. 4, 2002; http://fiordiliji.emeraldinsight.com/vl=2762214/cl=12/nw=1/rpsv/lodj.htm.

For more thought leadership on this topic, see the s+b website at: www.strategy-business.com/strategy_and_leadership.

Continual contact with colleaguesis so effective it can succeed even

without a formal program.

During the past few decades, many industrialcompanies have attempted to achieve manufacturingexcellence. They have had at their disposal any numberof methodologies and theories, quality initiatives, andcost-reducing concepts. But few companies have mademuch headway. Manufacturing strategies — decisionsrelated to siting, designing, and running factories — areoften the same as they were 10 or 20 years ago. Plantsoften look and feel as they did then. Programs intendedto improve performance, such as “total quality manage-ment,” “lean production,” and “Six Sigma,” seem to ebbaway, without producing the desired results. Sometimesit seems as though the harder manufacturers try toimprove, the worse they perform.

Consider, for example, the bad news from theMiddle East that hit Household GmbH, a Europe-

based consumer goods manufacturer, in 2003. (Thecompany name is changed, but the details are accurate.)Household’s market share in hygiene products, one of its flagship divisions, had recently tumbled in such citiesas Cairo and Abu Dhabi. When Household’s regionalmanagers investigated, they discovered that a private-label pro ducer based in Egypt had begun to aggressivelyundercut the shelf price of Household’s products.

At first glance, it seemed as if Household could eas-ily win a price war with any local private label. After all,Household’s Middle Eastern manufacturing sites wererunning at higher capacity than the competition’s sites,with advanced proprietary technology and a highly pro-ductive, well-trained staff. But the private-label manu-facturer refused to go away, and its prices remained lowwhile its market share kept rising. Il

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BY KAJ GRICHNIK, CONRAD WINKLER, AND PETER VON HOCHBERG

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MyopiaMANUFACTURING

Instead of drifting into decline and irrelevance,

producers of goods have a chance to seize the future.

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Household’s managers had assumed that their com-petitor was selling under cost. But gradually it becameclear that despite Household’s scale and technologicaledge, the competitor spent less to make most hygieneproducts, without any sacrifice in quality — at least asperceived by customers. In short, Household’s ostensiblemanufacturing advantage — its distinctive technology— had become its biggest disadvantage. To make mat-ters worse, Household had nearly completed a new fac-tory in Ukraine, which had been intended, in part, toadd capacity to serve the Mideast, but which now wouldsimply add to Household’s manufacturing costs.

There are many such stories in manufacturingtoday. Executives do all the right things to improve oper-ations, but somehow get outperformed on cost, quality,or delivery. They may turn to benchmarking exercises,but those are rarely meaningful. Low-cost competitorsappear with prices that can’t be completely explained bylower wages. Rising warranty costs or dramatic productrecall levels indicate the ongoing erosion of quality.

As a last resort, companies outsource production,and thus erode their own company’s competence in it.Gradually, manufacturing is treated more and more as anoutcast, and plant communities become disenfranchised.

We call this condition “manufacturing myopia.” Itis akin to the “marketing myopia” that Harvard BusinessSchool lecturer Theodore Levitt identified in the 1960s.Levitt argued that companies made themselves vulnera-ble when they defined their brands too narrowly.Railroads are not in the passenger-train business, heargued; they’re in transportation. Every business shoulddefine itself through the interests of its market, not itsown production priorities.

Today, myopia is even more prevalent and danger-

ous in manufacturing than it was in marketing fourdecades ago. Like marketing myopia, manufacturingmyopia is caused by isolation; it is the inevitable out-come of keeping manufacturing strategies contained tothe functional or even plant level, with little or no con-nection to enterprise-wide strategies. As the factoriesand supply chain oversight functions are cut off fromthe rest of the executive decision makers, the manufac-turing focus grows narrower, and overall competence canatrophy. This compels companies to cut costs even moreblindly and irresponsibly, often by setting company-wide targets determined by financial fiat rather than bycompetitive or customer insights. (See Exhibit 1.)

Building Awareness

Surprisingly few major multinational or large-scale man-ufacturing companies have been able to break free of thistrap. Household GmbH was one of them. The MiddleEast episode prodded its senior executives into a multi-year, systematic endeavor to rethink the company’s oper-ations and to glean and use better information about itsmanufacturing costs. Today, rather than a few state-of-the-art plants, Household operates a variety of plants thatare designed for flexibility and can be moved or re vampedas customer needs and the competitive climate change.

The cure for manufacturing myopia is 20/20 vision— that is, the cultivation of awareness about manufac-turing costs and means. Com panies can sharpen theirown ability, as Household did, to see their operationsmore clearly and redesign them more flexibly. For com-panies that achieve this kind of manufacturing prowess,the manufacturing function is no longer seen primarilyas a cost center, ripe for cutbacks or outsourcing. Instead,the ability to produce higher-quality goods at lower

Kaj Grichnik

[email protected] is a partner with Booz &

Company based in Paris and

a leader of research and

practice in manufacturing.

He focuses on the pharma -

ceutical, food, aerospace,

and automotive industries.

Conrad Winkler

[email protected] a partner with Booz &

Company based in Chicago. He

advises companies across

industries on supply chain

management improvement

and manufacturing strategies,

with a focus on the automotive

and aerospace sectors.

Peter von Hochberg

[email protected] a partner with Booz &

Company based in Düsseldorf.

He has extensive experience

in consulting with clients on

manufacturing and lean

production, focusing on

automotive OEMs and

suppliers, and industrial

goods manufacturers.

Also contributing to this article

were John Potter, a Booz &

Company partner based in

London, and Georgina Grenon,

a former Booz & Company

senior associate.

Originally published Spring

2006.

69

prices in a more flexible manner is a key component oftheir long-term competitive strategy and a central,dependable part of their identity.

This involves two major commitments: first, dedi-cation of resources to building awareness. Leaders canpeel back the layers of their own manufacturing opera-tions and those of their competitors so that processes,advantages, and disadvantages can be viewed more clearly. This means becoming more aware of a com -pany’s unique technological capabilities, the unfulfilledpotentials of each plant (for reaching the appropriatemarkets), and the specific drivers responsible for theircosts. Many manufacturers look at cost data primarily as justification and leverage for continually trimmingexpenses, rather than as a source of insights about scale,capital spending, labor deployment, technology, logis-tics, and supply chain efficiency — all critical factors inmeasuring how well a company’s manufacturingprocesses stack up against the competition. Toyota’s

manufacturing competence, widely admired for manyyears, stems in large part from the company’s insistenceon building fine-grained awareness of every facet of pro-duction, at all levels of the company.

The second commitment is patience, demonstratedby investing the time and resources to address manufac-turing productivity as a long-term, organization-widestrategic imperative and not as an isolated operational orfunctional issue. Plant managers are often expected toshow the same fast pace of change as marketing, finance,and procurement, where six- to 18-month transforma-tions are feasible. But those metrics don’t apply to man-ufacturing efforts, where improving results requires avery different set of time frames. A new manufacturingprogram frequently involves motivating, as well as hiringor moving, thousands of employees; new construction;new technology deployment; and perhaps the closing ofa plant or two, which takes years rather than months.That time is well invested if it is used to develop an

“We need 10% cost

reduction across all

plants.”

“We need a

comprehensive

manufacturing

strategy.”

Who chooses the cost

reductions?

What guides the

decision?

What are the

results?

Exhibit 1: The Anatomy of a Manufacturer’s Dilemma

Companies facing manufacturing pressure can seek to solve the problem in one of two ways: cost reduction, mandated from the top, or strategic realignment of manufacturing resources. This diagram shows four possible decisions as they play out in the manufacturing system and the real-world results they produce.

KPIs do not reflect leverage in reducing product complexity or designing cross-plant strategies. Few long-term gains. No strategic shift in process or product.

Strategic changes (probably) lead to cost, quality, speed, and service advantages.

2%–4% cost reduction; evolutionary changes; no strategic shift in process or product.

Targets considered unfair; plants object. Excuses, “passive- aggressive” resistance. No strategic shift in process or product.

Option #3

Reduction is based on selected key performance indicators, or KPIs (such local metrics as costs, etc.).

Cost data (shows opportunities and limitations in the system), strategic objectives, competitive position.

Consultation with local team, perhaps with shop floor workers.

Option #1

Locally controlled: Plant reduction targets are voluntary.

Centrally controlled: Top executives and central staff establish the process for a 10% cost reduction.

Option #4

Top executives and manufacturing managers look at the constellation of plants and priorities together.

Option #2

Company-wide rules and uniform reduction targets are applied to all plants.

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effective, flexible manufacturing capability, unique tothe business and its customers, as a platform for morerapid change once it is established.

How does one go about building this kind of aware-ness? At most companies, there are four dimensions ofmanufacturing in which highly visible data and analysis,projected farther into the future, can yield both short-term gains and long-term advantage: technological distinctiveness, network sophistication, in-plant trans-formation, and labor modernization.

Technological Distinctiveness

One of the first places to eliminate myopia is in thedesign, engineering, or purchasing of manufacturingtechnology. (We call this the “inherent” dimension ofmanufacturing, because it involves the physical nature ofthe products and the processes that create them.) Thereis a staggering level of underinvestment in businessprocess innovation as compared with product innova-tion. In 2004, according to Booz & Company analysis,only 10.2 percent of the R&D budgets at the top 500industrial companies was set aside for process innova-tion, down from 15 percent in 1980. Because they’veneglected this essential activity, manufacturers tend torely on machine builders and other vendors to fill in thegap. In most cases, this is counterproductive. Equip -ment manufacturers do not generally have a strong trackrecord for innovation, particularly for the kinds of cre-ative and customized solutions that would enable indi-vidual companies to overcome their manufacturingshortcomings. And even when equipment providers areinnovators, their technology is unlikely to give manufac-turers a competitive edge, because it generally can befreely purchased by any of their rivals.

Moreover, in many organizations, there is littlepatience for process innovation, which in manufactur-ing is by its very nature a long-term event. After the pro-duction technology is replaced, it could take two tothree years before the capital investment bears fruit inthe semiconductor sector, five years in major manufac-turing, and as much as 20 years in process industries,such as petrochemicals and electricity production.Additionally, to improve processes, companies have totrain entire plant communities in dozens of differenttools and techniques and completely different ways ofworking. All of that consumes time and resources.

Some extremely successful manufacturers, such aspackaging giant Tetra Pak, Procter & Gamble, andToyota, have bucked the trend and used in-housemachine development and internal process innovationto protect their competitive advantages. P&G has longbeen a pioneer of novel factory floor environments; forexample, letting shop floor employees not just lay outthe flow of machinery but design the machines them-selves. This approach began at P&G in the early 1960sand has developed in scope, efficiency, and sophistica-tion ever since. In one celebrated example at a P&Gplant in Lima, Ohio, a team of shop floor “technicians,”as hourly workers were called, designed a machine forplacing detergent bottles into position on the assemblyline — a mechanical feat that P&G’s professional engi-neers had said was impossible. The team commissioneda machine-tool supplier to produce the device, and putit successfully into operation.

But for every P&G, there are dozens of companiesfaced with an equivalent to Household’s dilemma in theMiddle East: Their state-of-the-art factories, more capa-ble than those of competitors on a worldwide basis, are

A manufacturer of air conditioning supplies built its factories on freighter ships

that can be moved from port to port as the seasonal marketplace changes.

71

not flexible enough to respond to local conditions. Sometimes, a promising process innovation effort is

disbanded because top management changes or becausethe sponsoring executives lose interest, even though theyhave known all along about the nature of the investmentthey’ve been making. As a result, outmoded technologi-cal principles may endure for 30 or 40 years while thecompany cycles through a series of half-realized quality-improvement or plant-restructuring initiatives. Othertimes, process innovation is consigned to the plant levelonly. When approached in this way, companies becomelittle more than multiple small organizations with noscale, unable to harness process technology as a compet-itive advantage.

Myopia also afflicts efforts to modify existing man-ufacturing processes. For example, there has been a lotof excitement in the last 15 years about design for man-ufacturing (DFM), an approach by which companiesengineer products not just for their intrinsic qualitiesbut also for how efficiently they can be manufactured.But despite the allure of DFM, the relationship betweenengineering and manufacturing groups at most compa-nies is chilly or nonexistent. The shop floor communityis often excluded from direct communication about the manufacturability of products with the engineering/design function. Even if the two groups are allowed tocommunicate, manufacturing companies may not havethe budget to cover the engineers’ internal rates andtherefore may lose contact.

Network Sophistication

Most companies organize their production and supplyoperations on a project-by-project basis. As market conditions change, they move plants from Detroit to

Mexico, and a few years later they shift subassembly toAsia. They do not envision their manufacturing systemfor what it must be: A global, flexible supply chain net-work that can be reconfigured anywhere in the world asmarket conditions change. (We think of this dimensionas “structural,” because it involves such infrastructure-oriented features as the location and size of plants andthe supply chain flow among them.)

Companies that realize this and design their plantsaccordingly gain a tremendous time advantage. It cantake two years to close down a factory — and that’s typ-ically after several years of wavering over the decision toshutter it in the first place. It is far better to design theconfiguration of individual plants so that it is easy toenlarge, shrink, or reconfigure them based on the busi-ness landscape. Then fewer factories ever have to beabandoned and the manufacturing network needn’t becompletely overhauled. There’s also an expense advan-tage as the one-time cost penalty of moving plants fromone place to another is reduced.

This approach, known as flexible footprints, is prac-ticed with great success by a few dozen large organiza-tions — among them, the U.S. Army, which constantlyand proactively reassigns military bases to fresh uses. Inan extremely novel implementation, a European manu-facturer of specialized air conditioning supplies built itsfactories on large freighter ships that can be moved fromport to port as the seasonal marketplace changes. Thecompany chooses not to broadcast this manufacturinginnovation publicly, perceiving it as a competitiveadvantage. A Qatari company, Cement International,has recently begun similar operations, putting a cementfactory onboard a ship that docks in ports around thePersian Gulf, wherever building materials are needed.

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Unfortunately, we observe that there is little coop-eration among companies within a supply chain tojointly optimize plant networks, another potentiallylucrative example of flexible footprints. In the outdoorequipment industry and in basic chemicals, some com-panies have shared parts of their production capacity,sometimes spinning off manufacturing. But capacitypooling is a rarity outside those two industries.

In-plant Transformation

It is now more than 30 years since the notion of manu-facturing excellence — variously attributed to theToyota production system, socio-technical systems,quality management, lean manufacturing, and high-performance systems — became widely known inEurope and the United States. By now, practically everymanufacturing manager can tell you about pokayoke,kanban, or self-steering teams. But plants that have suc-cessfully implemented the manufacturing practices thatproduce efficient and optimal operations are few and farbetween. And most of these are greenfield sites: previ-ously undeveloped locations where elite processes could

be designed into the factory from the beginning. Thecompetitive advantage of process optimization remainshigh, in part, because of the woefully poor record of themanufacturing industry in general.

We think of in-plant transformation as “systemic,”because it takes place when people see the processes onthe shop floor as interrelated parts of a whole system.Why has this kind of in-plant transformation lagged sobadly, even though its successes are so visible? Manu -facturing myopia is the primary reason. Typically,process improvement is seen by company executives as a“go ahead, just do it” manufacturing issue managed sole-ly by the plants.

This isolation contributes to the lack of patienceamong decision makers, who feel pressured to showresults before the systemic change is ready. By contrast,a well-designed manufacturing change initiative is delib-erately set up like a developmental path, with a menu ofresults expected in the short term, medium term, andlong term. Some systemic drivers can have an effect oncosts almost instantly (e.g., changing maintenance con-tractor purchasing procedures); some take a bit longer

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The Roots ofMyopia

ow did manufacturing myopia

be come so prevalent? There

are several roots. Probably most per-

nicious was the separation of manu-

facturing, marketing, and finance in

corporate structures that date back to

the mid-20th century. “Turf wars”

often unconsciously reinforce those

divisions, particularly when the stakes

are high.

Here’s one typical story we recently

encountered in a consumer products

company: The vice president of manu-

facturing stated at a meeting that his

factories could deliver at lower costs,

“but only if R&D can come up with a

better factory blueprint and reduce

the number of product parts.” Also, he

said, it would help if sales provided

reliable forecasts “and didn’t ask us

for last-minute changes for important

clients.” And finance would be less of

a hindrance if the CFO would finally

approve funding for new machines to

simplify operational bottlenecks.

The company’s vice president of

sales responded that manufacturing

needed to eliminate its oversized

workforce and sharply curtail labor

costs by shifting more of the produc-

tion to low-cost countries. Only then

could his team sell significantly more.

The vice president of R&D ex -

pressed the opinion that manufactur-

ing still had not managed to suffi-

ciently operate the existing production

technology. “We’re simply not up to

world-class standards,” he said.

Later, the CEO said privately that he

was fed up with all these points of

view. None of them had much to do

with the problem as he saw it: an

unsustainable status quo of rising

fixed costs and a widening gap

between projected and actual profits.

Manufacturing companies are usu-

ally not set up with the kinds of incen-

tives and decision rights that would

encourage executives to review plant

operations with a full understanding

of the company’s competitive cost

drivers. Consequently, a narrow, self-

interested view of plant performance

tends to prevail, even when everyone

involved has the best interests of the

whole company at heart.

Business education reinforces the

division. Students interested in manu-

facturing are tracked into a “ghetto” in

many business schools; they don’t

share many classes or associate

much with their counterparts in

finance and strategy. Nor do they

expect to cross over to other positions

when they enter the working world.

“Once a plant manager, always a plant

H

(e.g., installing “pull” systems, in which the productionline sets its own pace, to replace the top-down controlsof a manufacturing resource planning approach). Evenin full-scale manufacturing transformation initiatives, itshould not take more than two years for the first visibleeffects to appear. The leaders of many manufacturingprojects stop paying attention after that. But in a well-designed initiative, those first results become a base forcontinuous improvement.

In a so-called brownfield site (an established factorywith a long-standing workforce), one may often findhigh fixed costs or blatant overstaffing. Installing “intel-ligent tools,” “lean solutions,” or “high-performance sys-tems” will not solve these problems. If there are alreadymore workers than work to do, improving productionspeed or throughput will not lead to higher levels of pro-ductivity, in part because overcapacity breeds “processcreep,” in which workers and managers merely overlaythe new work rules and practices on top of their old rou-tines. Despite knowing this, all too often, manufacturersmyopically push a “lean” program through plants thatare overstaffed and have a high share of non-value-added

work. We call this the fat ballerina syndrome: Onlyslimmed-down organizations stand a chance of perform-ing smart moves.

Companies also are often greedy or formulaic whenit comes to assigning improvement objectives to plants.It’s not atypical for a factory manager to be told to save10 percent of fixed costs, while improving output andquality by 20 percent. Often a basic analysis will revealthat enhancing a plant’s productivity dwarfs the value of firing a group of maintenance technicians and engi-neers, and more importantly that increasing productiv -ity and cutting personnel are not mutually compatibleobjectives. For one thing, plant communities often resistcoop erating with management to alter their work methods and increase output while their colleagues arebeing let go.

Labor Modernization

Let’s face it: In most plants, industrial relations andtreatment of the workforce are reminiscent of the 19thcentury. This statistic illustrates the point: From 1999 to 2004, there were more strikes in most western

manager,” people say. Manu facturing

functions consequently suffer in the

“war for talent”; they recruit from a

smaller pool. The result is often an

unnecessary tension between manu-

facturing and finance; manufacturing

executives may have far more contact

with, and feel more loyalty to, employ-

ees than shareholders. And finance

executives may not appreciate the

strategic importance of manufacturing

talent, particularly on the shop floor.

This tendency was exacerbated

during the service boom of the 1990s,

when it became fashionable to assert

that mere manufacturing was not

strategically important. Some compa-

nies followed cost-cutting strategies

that downplayed the importance of

their long-standing manufacturing

knowledge, and then found them-

selves needing to rebuild it. This was

one of the key components of the

decline of the American manufacturer

Sunbeam. After being acquired by

Allegheny International in the early

1980s, the company’s manufacturing

division was “starved of capital to

update its factories and refresh its

product line,” as management writer

John Byrne put it. This ultimately

led the shareholders to appoint cost-

cutting turnaround artist Al Dunlap as

CEO in 1996; manufacturing capacity

suffered even more erosion during

Dunlap’s time as CEO. In his book

Chainsaw: The Notorious Career of Al

Dunlap in the Era of Profit-at-Any-Price

(HarperBusiness, 1999), Byrne de -

scribes how Sunbeam shut down a

high-quality, efficient hair-clipper

plant in McMinnville, Tenn., and moved

production to a chaotic, money-losing,

poorly managed new facility near

Mexico City.

To counterbalance all these trends,

some companies now make deliber-

ate efforts to integrate manufacturing

with the rest of the enterprise. Toyota

sends manufacturing employees and

managers on sales calls — to areas

including those where their products

have low penetration. ASML, a Dutch

company that is a leading producer of

lithography and semiconductor man-

ufacturing equipment, went from a 10

percent to a 70 percent market share

in its product categories, in part by

bridging this gap. ASML’s head of

manufacturing started as an account-

ant, then led a finance function, and

only then moved into production. This

perspective recently helped the com-

pany reduce lead times and generally

improve the integration of manufac-

turing with other functions.

—K.G., C.W., and P.V.H.

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European countries than occurred between 1950 and1975. In one German aerospace plant, where three gen-erations have worked on the shop floor, absenteeism andillness rates have risen a steady 3 percent per generation.Overall, Western companies made few strides in align-ing factory workers more closely to the companies thatemploy them. Only 20 percent of production workers inwestern Europe and the U.S. receive compensationlinked to performance, and more than 75 percent workunder a compensation system that is so rigid it uninten-tionally drives people to take overtime.

We use the term realized because the modernizationof a labor force takes place only in the real-world dimen-sion of the community around each manufacturinglocation. The principles of effective workforce manage-ment are universal: The improvement of labor practicesand customization of human resource policies are essen-tial to developing creative, innovative, and motivatedemployees. But the most appropriate methods foraccomplishing those things are decidedly local. Laborissues vary significantly from one place to another.Workforces in different locales have their own particularcultures, holidays, workdays, family structures, commu-nity resources, demographics, education levels, and as -sumptions about the type of work they will do. Pro -ductivity can also deviate dramatically among regions.

Over the years, effective manufacturers have exper-imented with a wide variety of means for engaging shopfloor employees. Some companies establish worker-focused principles. At one Dutch chemical company,the budget line for work space and plant maintenanceand modernization was sacrosanct and could not be cut.This was important because workers perceived the com-pany as a reliable protector of their safety. A cosmetics

manufacturer demonstrated the same kind of commit-ment by installing an on-site health spa, free to employ-ees. We have seen plants in which windows and skylightsare carefully placed to make the most of natural light,the architecture fits local styles, and social spaces reflectthe way employees naturally interact.

These types of factories, which fit their social andphysical environment so well, are usually owned bycompanies that realize the value of an inspired workforceto the finished product. Such companies often makeconcerted efforts to link employees with more in-depthknowledge of the company and the product. Danone,Procter & Gamble, Harley-Davidson, and Mercedes-Benz are all known for plant communities that take partin word-of-mouth and face-to-face sales campaigns andprovide testimonials for marketing and public relationsprograms. Mercedes, for example, encourages customer-to-factory interaction by suggesting that car buyers pickup their new vehicles at, say, the Sindelfingen plant,where they can talk to plant workers about quality andother issues pertaining to the making of their automo-biles. Very successful companies create products thatcommand an emotional premium, and they make cer-tain that their manufacturing employees are among thefirst to emotion ally promote them. Ultimately, how canyour product be loved by your customers if thousands ofyour own employees who make the product don’t loveproducing it?

In a brownfield site, labor modernization often rep-resents a daunting challenge. Managers may believe thatthey can employ greenfield policies (those applicable toa new factory) in a brownfield plant, but this assump-tion is flawed. The brownfield workforce is generallyolder; they may have already lived through shutdowns,

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layoffs, and closures. Moreover, unions don’t usually for-get the bitter relations they had with the prior plantmanagement and are less willing to forge alliances withthe new factory team. In some locations, sophisticatedlean production concepts, implemented in a one-size-fits-all pattern, have been viewed by the cynical, dispir-ited workforce as micromanagement and paternalism.

For a brownfield renewal to succeed, the surround-ing community has to be fundamentally remotivatedand more closely tied to the enterprise through newcompensation systems and governance roles. TheGerman agricultural equipment maker Claas demon-strated the value that can be unlocked if the right formu-la is found. In the midst of substantial growth and aspart of a constant drive to improve flexibility, Claas spunoff a large part of the factory through a managementbuyout and made the newly independent plant a pri-mary supplier. The newly formed business unit was ableto secure quality standards and to better balance itscapacity, signing up additional customers besides Claas.Meanwhile, employee motivation improved in the fac-tory as managers used the space they had reclaimed tofundamentally reengineer activities, aiming at a one-

piece-flow philosophy. The plant’s positive developmentdefied the long slump in commodity machining andmetalworking factories in the region.

Manifesto for Manufacturers

A company seeking to overcome its manufacturingmyopia may find the task daunting at first, but easierover time. The goal is not to “fix” manufacturing, but tobuild the capacity for long-term and medium-termmanufacturing management among engineers, suppli-ers, and staff (including unionized staff ), and to redesignthe technology to take advantage of these capabilitiesand augment them.

There are no universal rules for doing this becauseeach manufacturer has a unique combination of in-house capabilities, labor histories, supply chain relation-ships, market demands, and technological innovations.A holistic manufacturing strategy emerges only from ananalysis that assesses the critical operational data buriedin the four dimensions of manufacturing design: inher-ent, structural, systemic, and realized. (See Exhibit 2.)

Consider the recent case of a European auto manu-facturer. The company was desperate for a way to cut

Exhibit 2: A Framework for Building Awareness

Technological distinction: the machines and production techniques that either allow for unique combinations of features or reduce costs.

Inherent Maintaining command over technological adeptness; continuing to improve and increase quality; reducing complexity.

Capital investment requires a five- to 10-year outlook.

Network sophistication: recognizing that a company’s manufacturing competence depends on its total supply and production chain, not on individual components of that chain.

Structural Continuing willingness to adapt factory networks to new products and markets as conditions demand; design for flexible footprints and capabilities.

Up-front investment in greenfields may require slightly more time than converting old plants to this way of thinking; structural change gradually becomes ingrained, taking place on an ongoing basis.

In-plant transformation: continuous improvement of process quality and effectiveness.

Systemic The adoption of lean production techniques, self-organizing teams, and many of the other process innovations of the past 30 years.

With comprehensive, long-term initiatives, some initial results can be seen within months. Efforts begin to pay off in one to two years and continue to produce gains thereafter.

Labor modernization: recognition of each plant’s unique community and workforce needs, and the ability to meet those needs more than halfway.

Realized Policies and plant designs that attract workers, engage local governments, and enhance communities; executive recruiting and training practices oriented toward these goals.

This requires immediate moves, but it may be five years or more before a cynical community is willing to admit that the plant is actually worthy of their respect and commitment.

DefinitionDimension Commitment Time Frame

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costs per car, which had risen to almost 30 percent abovethose of its nearest competitor. The carmaker’s initialinclination was to close plants and implement flexiblemanufacturing lines that could produce multiple modelsin remaining factories. Pressure from unhappy unionsconvinced the company to think twice about this plan.

Analysis of the automaker’s cost drivers found thatthe gains from minimizing inherent costs (by increasingplant flexibility) and structural-level costs (by eliminat-ing plants) would do little to close the gap between itsmanufacturing costs and those of its closest competitor.In fact, the only way that the company could catch upto its rival was by systemic improvements (adopting leanprocesses), a category that accounted for 65 percent ofthe cost gap. The automaker would never have learnedthis had it relied only on traditional analyses and notexposed the interconnections among all of the criticalcomponents of its manufacturing operations. To addressits shortcomings, the company appointed experiencedmanagers from outside the region to critical posts in its European plants, retooled its production system, andbegan to implement those lean manufacturing processes.

By separating manufacturing operations into theirfour dimensions and exploring the way they are inter -related, management can accurately measure manu -facturing costs and perfect “what if?”–style decisionmaking. This is not possible with a conventional costaccounting approach. Even the most advanced costaccounting systems are usually designed for only twotasks: calculating product costs to provide marketingwith a basis for pricing, and tracking actual and forecast-ed results in individual cost centers.

In addition, accountants at most companies do nothave the experience in operations to spell out the finan-

cial consequences of manufacturing decisions. Forexample, they cannot estimate the overall cost positionof a plant that would result if more automated equip-ment were installed, specific processes were farmed outto a low-cost nation, the demand for a product doubled,the number of SKUs were reduced, or the competitionopened two new plants in eastern Europe using the lat-est manufacturing technology.

Even in the best of circumstances, it is tricky to dis-tinguish the effects of individual manufacturing drivers.For instance, how much advantage does a competitorgain from operating continuous instead of batch pro -cesses, and how does that balance out the disadvantageit has maintaining smaller plants with greater indirectand overhead requirements? Manufacturing, finance,and research and development executives can’t answersuch questions in isolation from one another; they needregular opportunities to think and strategize together.

Companies that are willing to invest in a long-termchange cycle discover that the learning curve in manu-facturing is nonlinear. Even though the investment maybe steady, measurable improvement is typically slow atfirst and accelerates over time. It may take five years tocross the initial threshold of a new production system,but after that first experience, the capacity for changingtechnology grows rapidly — in part because the tech-nologies themselves become more flexible, and in partbecause employees develop the skills and knowledge todeploy new production machines more efficiently.

The candy and chocolate manufacturer Cadbury[since acquired by Kraft Foods] grasped this particularlywell. When the company installed a new productionsystem, it assumed it would take up to five years for theplant to reach maturity. Cadbury measured this evolu-

Resources

John A. Byrne, Chainsaw: The Notorious Career of Al Dunlap in the Era ofProfit-at-Any-Price (HarperBusiness, 1999): Myopia and its consequencesat the formerly competent manufacturer Sunbeam.

Neil Hopkinson, Richard Hague, and Philip Dickens, editors, RapidManufacturing: An Industrial Revolution for the Digital Age (John Wiley &Sons, 2006): Flexible and customized manufacturing, grounded in computer-based prototyping techniques.

Bill Jackson and Conrad Winkler, “Building the Advantaged SupplyNetwork,” s+b, Fall 2004, www.strategy-business.com/press/article/04304:Focused, flexible, and lower-cost manufacturing through supply chain network innovations.

Art Kleiner, The Age of Heretics: Heroes, Outlaws, and the Forerunners ofCorporate Change (Doubleday, 1996): History of socio-technical systemsand Procter & Gamble’s manufacturing innovations.

Art Kleiner, “Leaning Toward Utopia,” s+b, Summer 2005, www.strategy-business.com/press/article/05208: Profile of “lean” experts James P.Womack and Daniel T. Jones.

Jeffrey Liker, The Toyota Way: 14 Management Principles from the World’sGreatest Manufacturer (McGraw-Hill, 2003): Comprehensive, accessiblelook at a company with renowned production awareness.

Josh Whitford, The New Old Economy: Networks, Institutions, and theOrganizational Transformation of American Manufacturing (OxfordUniversity Press, 2005): Myopia in the U.S. Rust Belt.

James P. Womack and Daniel T. Jones, Lean Solutions: How Companiesand Customers Can Create Value and Wealth Together (Free Press, 2005):Evokes a world of customer-oriented manufacturing foresight.

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tion by how well employees responded to the new sys-tem. As the plant matured and its capabilities grew, pro-ductivity was expected to increase. Man age mentassumed that either head count would decrease or pro-duction quality would increase during the first fiveyears, depending on the level of sales and scope of theplant’s market. Indeed, as employees became morefamiliar with the processes, the cost of productiondropped and quality stayed high.

This type of approach represents an alternative tothe prevailing despondent mood at many manufactur-ing companies. Indeed, perhaps the most tragic result ofmanufacturing myopia, for many companies, is the lostopportunity for manufacturing leadership. Computertechnology, materials science, and energy innovationhave progressed dramatically over the past 20 years.There are many futuristic manufacturing options avail-able. They include “instant” and “inkjet” manufactur-ing, where computer-based molding machines turn outindividually customized plastic components with thespeed of mass fabrication; biomimicry, in which indus-trial processes reproduce the cell-by-cell process bywhich, for example, a seashell is formed; and environ-mentally friendly fermentation-based fabrication meth-ods that eschew toxic chemicals and reuse waste moreeffectively. In many industries, there exists great unful-filled potential for moving beyond commoditization byrethinking manufacturing prowess as part of the com -pany’s identity. Few companies today are trying to real-ize that potential; there are few 21st-century equivalentsto the original Ford Motor Company, with its break-throughs in assembly-line manufacturing, or even to the1990s-era Intel. We believe that manufacturing myopiahelps explain why.

Over the past 20 years, manufacturing managershave learned that even the most effective supply chainmanagement will not lead to results unless these capabil-ities are implemented — not just within the function,but at the level of the executive suite. In a confrontation-al, competitive environment, the choice is engaging inmanufacturing competence as the core of your corporateidentity — or continuing to pay the price of myopia. +

Reprint No. 06105

Computer technology, materials science, and energy innovation have progressed

dramatically, but few companies are trying to realize their potential.

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P&G’SINNOVATIONCULTURE

As they lead to repeat purchases, these offeringsreshape the market, so that the company is playing anentirely new (and profitable) game to which others mustadapt. A number of game-changing innovators are oper-ating today, including such household-name enterprisesas Procter & Gamble, Nokia, the Lego Group, Apple,Hewlett-Packard, Honeywell, DuPont, and GeneralElectric. Wherever you see a steady flow of noteworthyinnovations from one company, you can probablyassume that it is a game-changing innovator, with thedistinctive kinds of social connections, culture, and sup-

porting behaviors that enable it to play that role. Consider the case of Procter & Gamble

Company. Since A.G. Lafley became chief execu-tive officer in 2000, the leaders of P&G haveworked hard to make innovation part of the dailyroutine and to establish an innovation culture.Lafley and his team preserved the essential part ofP&G’s research and development capability —world-class technologists who are masters of thecore technologies critical to the household and personal-care businesses — while also bringing

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How we built a world-class organic growth engine

by investing in people.

THE HEART OF A COMPANY’S BUSINESS MODEL should be game-changinginnovation. This is not just the invention of new products andservices, but the ability to systematically convert ideas into newofferings that alter the very context of the business.

BY A.G. LAFLEY, WITH AN INTRODUCTION BY RAM CHARAN

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more P&G employees outside R&D into the inno-vation game. They sought to create an enterprise-wide social system that would harness the skills andinsights of people throughout the company andgive them one common focus: the consumer.Without that kind of culture of innovation, a strat-egy of sustainable organic growth is far more diffi-cult to achieve.

A.G. Lafley and I coauthored The Game-Changer: How You Can Drive Revenue and ProfitGrowth with Innovation (Crown Business, 2008) toexplain how to make game-changing innovationdrive growth on a consistent, well-paced basis. Thecritical factors that we cover in the book includekeeping a laser-sharp focus on the customer; estab-lishing a disciplined, repeatable, and scalable inno-vation process; creating organizational and fundingmechanisms that support innovation; and demon-strating the kind of leadership necessary for prof-itable top-line growth as well as cost reduction.

One aspect of building an innovation culturedeserves more attention than we could give it inThe Game-Changer: designing a social system thatwould spark new ideas and enable critical deci-sions. In the article that follows, A.G. explains thehuman factors that fostered innovation at Procter& Gamble. It could be thought of as the “missingchapter” to The Game-Changer; a vital com ponentthat isn’t always obvious, even to experts, preciselybecause it is so fundamental.

—Ram Charan

hen I became CEO of Procter & Gamblein 2000, we were introducing new brandsand products with a commercial success rate

of 15 to 20 percent. In other words, for every six newproduct introductions, one would return our invest-ment. This had been the prevailing ratio in our industry,consumer packaged goods, for a long time.

Today, our company’s success rate runs between 50and 60 percent. About half of our new products suc-ceed. That’s as high as we want the success rate to be. Ifwe try to make it any higher, we’ll be tempted to err onthe side of caution, playing it safe by focusing on inno-vations with little game-changing potential.

The decision to focus on innovation as a corestrength throughout the company has had a direct influ-ence on our performance. P&G has delivered, on aver-age, 6 percent organic sales growth since the beginningof the decade, virtually all of it driven by innovation.Over the same period, we’ve reduced R&D spending asa percentage of sales; it was about 4.5 percent in the late1990s and only 2.8 percent in 2007. In that year, wespent US$2.1 billion on innovation, and received $76.5billion in revenues. We’re getting more value from everydollar we invest in innovation today.

The focus on innovation has also had a direct effecton our portfolio of businesses. The Game-Changer de -scribes how we sold off most of P&G’s food and bever-age businesses so we could concentrate on products thatwere driven by the kinds of innovation we knew best. Asit turns out, with this narrower mix of businesses, we canmore easily devote the resources and attention needed tobuild a broad-scale innovation culture.

We also focused on creating a practice of open inno-vation: taking advantage of the skills and interests of

A.G. Lafley

[email protected] the chairman and CEO of

Procter & Gamble Company

when this article was

published. He was named

Executive of the Year by the

Academy of Management in

2007. He is the coauthor, with

Ram Charan, of The Game-Changer: How You Can DriveRevenue and Profit Growthwith Innovation (Crown

Business, 2008).

Ram Charan

www.ram-charan.com is a Dallas-based advisor to

boards and CEOs of Fortune

500 companies and the author

or coauthor of 14 books,

including the bestsellers

Execution (with Larry Bossidy;

Crown Business, 2002),

Confronting Reality (with Larry

Bossidy; Crown Business,

2004), and Know-How (Crown

Business, 2007).

Also contributing to this article

was Geoffrey Precourt.

Originally published Autumn

2008.

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people throughout the company and looking for part-nerships outside P&G. This was important to us for sev-eral reasons.

First, we needed to broaden our capabilities. Eachof our businesses was already practicing some form ofinnovation improvement, but they were not all improv-ing at the same rate. As the CEO, I could lead andinspire the company as a whole, but I could not substi-tute my judgment for that of other leaders who knewand understood their specific businesses far better than Icould. The decision makers in each business would haveto examine their competitive landscape and their owncapabilities to figure out what kinds of innovationwould work best and win with consumers.

Second, building an open innovation culture wascritical for realizing the essential growth opportunitypresented by emerging markets. During the next 10years, between 1 billion and 2 billion people in Asia,Latin America, eastern Europe, and the Middle East willmove from rural, subsistence living to relatively urbanand increasingly affluent lives. They will have morechoices, a greater connection with the global economy,and the ability to realize more aspirations. Along theway, they will become, for the first time, regular con-sumers of branded products in categories such as per-sonal care, fabric care, and prepared food.

It would seem relatively simple to execute a strategyfor reaching these new consumers. But the days ofachieving automatic growth by entering new marketsare essentially over. Just as retailers often reach a level ofsaturation — where it doesn’t make sense to open anymore stores in a particular market — many mature con-sumer products companies are rapidly running out ofthe so-called white space in new regions. P&G, for

example, already has a market presence in more than160 countries, with large operations on the ground inmore than 80 of them. We can grow our business inthese countries only by consistently developing newproducts, processes, and forms of community presence.And to do that, we need to involve people, inside thecompany and out, who are comfortable and familiarwith the values and needs of consumers in these parts ofthe world.

A third reason for focusing on open innovation hadto do with fostering teams. The kinds of innovationneeded at Procter & Gamble must be realized throughteams. The idea for a new product may spring from themind of an individual, but only a collective effort cancarry that idea through prototyping and launch. If inno-vation is to be integrated with both business strategy andwork processes, as we believe it should be, it requires abroad network of social interactions.

Moreover, our experience suggests that many of thefailures of innovation are social failures. Promising ideas,with real potential business value, often get left behindduring the development process. Some innovations aretimed too early for their market; others are lost in exe-cution. Often, the root cause is poor social interaction;the right people simply don’t engage in productive dia-logue frequently enough.

For all these reasons, we consciously set in place aseries of measures for building an open innovation cul-ture at P&G.

“The Consumer Is Boss”

Procter & Gamble is known for its highly capable andmotivated workforce. But in the early 2000s, our peoplewere not oriented to any common strategic purpose. We

The days of achieving automatic growth by entering new markets are over. We can grow in

these countries only with new products, processes, and forms of community presence.

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had a corporate mission to meaningfully improve theeveryday lives of the customers we served. If 15 secondswith a deodorant or two minutes with a disposable dia-per have made a small part of your life a little bit better,then we’ve made a difference.

But we hadn’t explicitly or inspira-tionally enrolled enough of our100,000-plus people around theworld in our mission; it wasneither fully embraced by employees nor fullyleveraged by the com -pany’s leadership. Ourinnovation efforts suf-fered accordingly.

So we expandedour mission to in -clude the idea that“the consumer is boss.”In other words, the peo-ple who buy and useP&G products are valuednot just for their money,but as a rich source of in -formation and direction. Ifwe can develop better ways of learn-ing from them — by listening to them,observing them in their daily lives, and even living withthem — then our mission is more likely to succeed.“The consumer is boss” became far more than a sloganto us. It was a clear, simple, and inclusive cultural prior-ity for both our employees and our external stakehold-ers, such as suppliers and retail partners.

We also linked the concept directly to innovation.

From the ideation stage through the purchase of a product, the consumer should be “the heart of all we do” at P&G. I talked about it that way at dozens of com-pany town hall meetings during my first months asCEO. More and more people began thinking about

how to apply the “consumer is boss” con-cept to their work. Resources were

still scarce, and there were fiercedebates about which ideas

deserved the most attentionand where to de ploymoney and people. Butthis concept came tomatter more than thoseother concerns. People

became more willing tosubjugate their egos tothe greater good —

to improving consum -ers’ lives.

It’s natural for amature company to be comemore insular. So we explicit-

ly tried to build better con-nections with the people who

bought our products. For example,in the early 1990s, we had acquired the

Max Factor and Ellen Betrix cosmetic and fra-grance lines from Revlon Inc. Innovation in fine fra-grances had always been driven by fashion. With slowgrowth of 2 to 3 percent a year, low margins, and weakcash flow, fine fragrances didn’t seem to be an attrac-tive business for P&G. But we saw a chance to changethe game.

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We began by clearly and precisely defining the tar-get consumer for each fragrance brand, and identifyingsubgroups of consumers for some brands. We didn’twalk away from the traditional approaches of the finefragrance business. We still maintained partnershipswith established fashion houses, such as Dolce &Gabbana, Gucci, and Lacoste. But we also made theconsumer our boss. We focused on a few big launchesand on innovation that was meaningful to consumers,including fresh new scents, distinctive packaging,provocative marketing, and delightful in-store experi-ences. We also took advantage of our global scale andsupply chain to reduce complexity and enable a signifi-cantly lower cost structure.

The result? Our team turned a small, underper-forming business into a global leader. In 2007, P&Gbecame the largest fine fragrance company in the world,with more than $2.5 billion in sales — a 25-foldincrease in 15 years.

Elsewhere in our company, we experimented withnew ways to build social connections through digitalmedia and other forms of direct interaction. Wedesigned websites to reinforce consumer connections, tobetter understand consumers’ needs, and to experimentwith prototypes. For example, we used to hand-makebaby diapers for a product test. Now, we show peopledigitally created alternatives in an onscreen vir tualworld. If the consumers we’re talking to have an idea, wecan redesign it immediately and ask them, “Do you likethat better? How would you use it?” It allows us to iterate very quickly. In effect, we are building asocial system with the purchasers (and potential pur-chasers) of our products, enabling them to codesign andco-engineer our innovations.

Integrating Innovation

We are constantly innovating how we innovate. We keeprefining our product-launch model — from idea to pro-totype, to development, to qualification, to commercial-ization. Applying this sequential practice on a largescale, and making it replicable, does not mean eliminat-ing judgment. In fact, there’s still a fair amount of judg-ment that’s applied along the way. That’s why we needactive leaders and a strong innovation culture.

Scalability is critical at a company the size of Procter& Gamble. If we can’t scale our processes, they don’thave much value for us. In fact, scalability is often thejustification for our existence as a multinational, diversi-fied company. Our innovation practices are thusdesigned for deliberate learning, across all our functions,product categories, and geographic locations. Once peo-ple understand a particular process, they can replicate itand train others. It soon becomes a part of normal deci-sion making.

P&G had not treated innovation as scalable in thepast. We had always invested a great deal in research anddevelopment. When I became CEO, we had about8,000 R&D people and roughly 4,000 engineers, allworking on innovation. But we had not integrated theseinnovation programs with our business strategy, plan-ning, or budgeting process well enough. At least 85 per-cent of the people in our organization thought theyweren’t working on innovation. They were somewhereelse: in line management, marketing, operations, sales,or administration. We had to redefine our social systemto get everybody into the innovation game.

Today, all P&G employees are expected to under-stand the role they play in innovation. Even when you’reoperating, you’re always innovating — you’re making

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the cycles shorter, or developing new commercial ideas,or working on new business models. And all innovationis connected to the business strategy.

In fostering this approach and building the socialsystem to support it, the P&G leadership has had to be very disciplined. For instance, we are now set up tosee many more new ideas. Our external business de -velopment group is very small; all it does is meet withindividuals, groups, research labs, and other potentialcol laborators, including (as we noted in The Game-Changer) P&G’s competitors on occasion. Any of thesemay propose new technologies, new product prototypes,or new ways to connect us to our consumer base. In2007, the business development group reviewed morethan 1,000 external ideas. In 2008, they saw 1,500. Wetend to act on about 5 to 7 percent of them.

We are also open to ideas from more regions than inthe past. Innovation used to travel primarily from devel-oped markets to developing markets. When new tech-nology appeared in Japan, Germany, or the U.S., itflowed across the regions and down the hierarchy.Today, more than 40 percent of our innovation comesfrom outside the United States. People in India, China,

Latin America, and some African countries have becomepart of our social system. Their presence has made usmore open, and this helps compensate for our naturaltendency to become more insular.

We maintain open work systems in a lot of placesaround the world. Executives’ offices don’t have doors.Leaders don’t have a secretary cordoning them off. Allthe offices on the executive floor at Procter & Gambleare open; the conference room is an open, round space.We made it round as a small symbol of the newapproach. We’re seeing indications that this new socialprocess is catching on all over the world.

The Talent Component

P&G used to recruit for values, brains, accomplishment,and leadership. We still look for these qualities, but wealso look for agility and flexibility. We believe the “soft”skills of emotional intelligence — fundamental socialskills such as self-awareness, self-fulfillment, and empa-thy — are needed to complement the traditional IQskills. (See “Tea and Empathy with Daniel Goleman,”by Lawrence M. Fisher, s+b, Autumn 2008.) Maybe“soft” isn’t the right word: These skills are every bit as

Becoming a Great InnovationTeam Leader

s you read about Procter &

Gamble’s social system and

innovation culture, you may be think-

ing, “There are some good ideas

here…for someone else. In my shop,

we can barely keep the trains running

on time. How am I supposed to do all

this?”

Leaders of innovation take their

game to another level through a par-

ticular set of practices:

• Establish clear criteria and don’t

hesitate to shift resources. Great

innovation leaders keep a sharp eye

on their short-term and long-term

business goals and think through how

and when various innovation projects

will contribute to them. They deter-

mine which projects to accelerate or

cut on the basis of resource consump-

tion as well as market potential. They

don’t hesitate to pull the plug on proj-

ects that don’t clear the hurdles or

that simply consume more time or

money than the business can afford.

• Concentrate on possibility. The

process of innovation is inherently

uncertain. Innovation leaders live with

ambiguity as ideas are shaped and

reimagined; they don’t let ideas die

before they’re fully formed or under-

stood. Once a project is selected,

these leaders inspire the team to keep

going even as they encounter obsta-

cles and go through iterations. At the

same time, leaders are vigilant for

indications that the project’s market

potential has diminished.

• Cross boundaries and help oth-

ers do the same. Innovation becomes

riskier when there are gulfs between,

for example, technologists, marketing

people, and those responsible for

commercializing a new product.

Inevitably, trade-offs will be required

among these groups. Leaders thus

must ensure that communication

channels are open from the start and

that facts and sound judgment prevail.

They must be prepared to break dead-

locks and resolve conflicts by keeping

individuals focused on their common

goal: the customer.

• Reward effort and learning.

Failure is a fact of life for companies

that pursue innovation seriously, and a

leader’s response to it has a huge

effect on company culture and there-

fore on future projects. Innovation

leaders know that failures represent

opportunities to learn. They keep peo-

ple energized by publicly recognizing

their earnest efforts and willingness to

venture from the tried and true.

—Ram Charan

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hard to master as some tough analytical skills. Peoplejust learn them in a different way.

Some people at Procter & Gamble have struggledwith this new approach, but most of our best peoplehave done really well with it. Curiosity, collaboration,and connectedness are easy to talk about but difficult todevelop in practice. We have tried to careful-ly identify and ease out people whoare controlling or insecure, whodon’t want to share, open up,or learn — who are not curi-ous. And in the process, wehave discovered that mostof our people are natu-rally collaborative.

We also try to de -velop people by givingthem new stimulationand greater challenges.As they move throughtheir careers, we deliber-ately increase the com-plexity of their assign-ments. That might meanentering a market that’s notdeveloped yet or a market with acompetitor already firmly established.Whatever the challenge, it stretches them.

We give our most promising people time in bothfunctional and line positions, because we think our bestleaders are great operating leaders and great innovationleaders. We also move people around geographically. Webring people into our Cincinnati headquarters fromaround the world, and we make a point of moving our

headquarters people to our global businesses. Almost allof us have worked outside our home region. Almost allof us have worked in developing or emerging markets.And almost all of us have worked across the businesses.We track that progress very carefully.

We’ve been fortunate that some of this flexible,multifaceted ethic exists in our heritage. For

example, Procter & Gamble pio-neered a technician-based sys-

tem in its manufacturingplants during the 1960s

and ’70s. In this system,we avoided the ap -proach in which one

person was as signed to do only one job.The technician sys-tem still operates to -

day: To get the highestevaluation rating in aP&G factory, you learn

how to do all the jobs onthe line. And, once you have

that rating, we expect you tobe capable of problem identifi-

cation, problem solving, and in -novation. This background has made it

easier for us to plug manufacturing and engineer-ing into the innovation culture.

Once people have succeeded at innovation, you can see the energy in the company changing. Peopleroutinely say, “We can do this. This is feasible.” The atti-tude changes are incredible to watch; once people seethe simplicity, durability, and sustainability of an inno-

Once people see the simplicity, durability, and sustainability of an innovation

mind-set, it continually reinforces itself.

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vative mind-set, it continually reinforces itself.On average, younger managers and younger

employees are more open to fresh, innovative thinking.Since 2000, we’ve lowered the average age of our peopleby almost 10 years because of our acquisitions and ourmoves in emerging markets. We have also recentlybrought in people from outside toenable and stimulate creativethinking. This was unprece-dented for a company thathas traditionally hired onlyentry-level people andpromoted from within.

Virtually every lead-ing practitioner of ournew design capabilitycame from the outsideas a mid-career hire.They arrived from BMW,Nike, and some of thebest design shops in theworld. We probably have150 to 200 such people and,although it’s not a huge pro -portion of the P&G staff, it’s bigenough to make a difference. Theybring us not just the art and science and practiceof design, but an integrative way of thinking.

Integrative Thinking

One of our favorite examples of integrative thinkinginvolves Febreze, a very successful odor-control product.One of the active ingredients in Febreze surrounds amalodor and removes it, as opposed to covering it up or

masking it. Febreze started out as a fabric refresher. Nowit’s also an air freshener in the U.S. and elsewhere.

Not long ago we took the Febreze package, product,and brand name to Japan. We tested it on a small scalewith Japanese consumers. They rejected it. As interpret-ed by the P&G team (a relatively junior-level group), thegut reaction of the Japanese was: “Here’s another Westernproduct that’s not going to work in our country.”

But we persisted. “Were there any Japanese house-holds or consumers who really liked the product?” weasked. The team didn’t know, but they went back andlooked at the research. Lo and behold, 20 percent of thefirst survey group absolutely loved the product.

Personally, I wasn’t surprised. I had spent eight yearsliving and working in Japan and I knew that

Japanese people can be hypersen-sitive to malodors. A man cansmoke cigarettes outside or ina subway station, but manyJapanese women won’t let

their husbands smoke inthe house. When thehusband comes home,he may have to take hissmoky clothes off andwash them before hecan sit down.

So we resolved totry again. The P&G

team changed the viscos-ity of the product. They

changed the fragrance fromhigh profile to a very low

profile scent. They changed the bottle to a much more delicate

design that more Japanese people felt com-fortable having visible in their homes. They changed thespray pattern to a mist. They changed everything but thecore technology of the product, and it became a phe-nomenal success in Japan.

This is a story we tell ourselves at P&G to drivehome the need for integrative thinking. The projectstarted with a consumer-centric concept. It involved

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people in a variety of functions and at least two regions.It opened our team members’ eyes to other possibilities.And it came to fruition because we were skilled at hav-ing the kinds of processes and conversations that wouldlead people to synthesize their ideas.

Our long-standing middle managers, people whohave grown up in the P&G system (as I did), are start-ing to recognize that better innovation processes canexpand their personal and leadership skills. They’ve allbeen through cost-cutting and productivity exercises.But that’s not the same as creating top-line opportuni-ties that can earn kudos from consumers. Nobody istelling them they have to be the geniuses who invent anidea. They will get credit for turning ideas into replica-ble processes and learning from their mistakes. In operating cross-functionally, they are also moving awaynaturally from the old silos.

The result of P&G’s focus on innovation has beenreliable, sustainable growth. Since the beginning of thedecade, P&G sales have more than doubled, from $39billion to more than $80 billion; the number of billion-dollar brands, those that generate $1 billion or more insales each year, has grown from 10 to 24; the number ofbrands with sales between $500 million and $1 billionhas more than quadrupled, from four to 18. Thisgrowth is being led by energized managers — innova-tion leaders — who continually learn new ways to growrevenues, improve margins, and avoid commoditization.Our culture of innovation is helping P&G leaders bemore effective, and in the process, they’re renewing ourcompany every day.

Once people have succeeded at a game-changinginnovation, the level of energy in the company elevates.Even people who weren’t directly involved are affected

through the social networks. It becomes easier for themto expand their idea of what is feasible. Building this sortof capability often has the rhythm of, say, skilled basket-ball practice: a group of people who gradually learnseamless teamwork, reading one another’s intentionsand learning to complement other team members, ulti-mately creating their own characteristic, effective, anduncopyable style of successful play. +

Reprint No. 08304

Resources

Daniel Goleman, Emotional Intelligence: Why It Can Matter More Than IQ(Bantam Books, 1996): Developing individual maturity for an organiza-tional innovation culture.

Larry Huston and Nabil Sakkab, “P&G’s New Innovation Model,”Harvard Business Review, March 2006: Anatomy of an open approach forattracting ideas and consumer insights from around the world.

A.G. Lafley and Ram Charan, The Game-Changer: How You Can DriveRevenue and Profit Growth with Innovation (Crown Business, 2008):Guide for giving large, mature companies the sustainable capacity forbreakthrough innovation.

Roger Martin, The Opposable Mind: How Successful Leaders Win throughIntegrative Thinking (Harvard Business School Press, 2007): Gaining theability to overcome the limits of partisan thinking, to enhance innovationor anything else.

Steven Wheeler, Walter McFarland, and Art Kleiner, “A Blueprint forStrategic Leadership,” s+b, Winter 2007, www.strategy-business.com/press/article/07405: Context for chief executives, drawing on A.G.Lafley’s example, among others.

Procter & Gamble website, www.pg.com: Includes Connect + Develop, aportal for engaging innovation partners, and Everyday Solutions, throughwhich the company connects with consumers.

For more thought leadership on this topic, see the s+b website:www.strategy-business.com/innovation.

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BY DAVID ROCK

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Naomi Eisenberger, a leading social neuroscienceresearcher at the University of California at Los Angeles(UCLA), wanted to understand what goes on in thebrain when people feel rejected by others. She designedan experiment in which volunteers played a computergame called Cyberball while having their brains scannedby a functional magnetic resonance imaging (fMRI)machine. Cyberball harks back to the nastiness of theschool playground. “People thought they were playing aball-tossing game over the Internet with two other peo-ple,” Eisenberger explains. “They could see an avatarthat represented themselves, and avatars [ostensibly] fortwo other people. Then, about halfway through thisgame of catch among the three of them, the subjectsstopped receiving the ball and the two other supposedplayers threw the ball only to each other.” Even after

they learned that no other human players were involved,the game players spoke of feeling angry, snubbed, orjudged, as if the other avatars excluded them becausethey didn’t like something about them.

This reaction could be traced directly to the brain’sresponses. “When people felt excluded,” says Eisen -berger, “we saw activity in the dorsal portion of the ante-rior cingulate cortex — the neural region involved in thedistressing component of pain, or what is sometimesreferred to as the ‘suffering’ component of pain. Thosepeople who felt the most rejected had the highest levelsof activity in this region.” In other words, the feeling ofbeing excluded provoked the same sort of reaction in thebrain that physical pain might cause. (See Exhibit 1.)

Eisenberger’s fellow researcher Matthew Lieberman,also of UCLA, hypothesizes that human beings evolved

Neuroscience research is revealing the social nature of the

high-performance workplace.

Managingwith the Brain in Mind

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SPECIAL REPORT: THE TALENT OPPORTUNITY

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this link between social connection and physical dis-comfort within the brain “because, to a mammal, beingsocially connected to caregivers is necessary for survival.”This study and many others now emerging have madeone thing clear: The human brain is a social organ. Itsphysiological and neurological reactions are directly andprofoundly shaped by social interaction. Indeed, asLieberman puts it, “Most processes operating in thebackground when your brain is at rest are involved inthinking about other people and yourself.”

This presents enormous challenges to managers.Although a job is often regarded as a purely economictransaction, in which people exchange their labor forfinancial compensation, the brain experiences the work-place first and foremost as a social system. Like theexperiment participants whose avatars were left out ofthe game, people who feel betrayed or unrecognized atwork — for example, when they are reprimanded, givenan assignment that seems unworthy, or told to take a paycut — experience it as a neural impulse, as powerful andpainful as a blow to the head. Most people who work incompanies learn to rationalize or temper their reactions;they “suck it up,” as the common parlance puts it. Butthey also limit their commitment and engagement.They become purely transactional employees, reluctantto give more of themselves to the company, because thesocial context stands in their way.

Leaders who understand this dynamic can moreeffectively engage their employees’ best talents, supportcollaborative teams, and create an environment that fos-ters productive change. Indeed, the ability to intention-ally address the social brain in the service of optimal performance will be a distinguishing leadership capabil-ity in the years ahead.

David Rock

[email protected] is the founding president of

the NeuroLeadership Institute

(www.neuroleadership.org). He

is also the CEO of Results

Coaching Systems and the

author of Your Brain at Work(HarperBusiness, 2009) and

Quiet Leadership: Six Steps toTransforming Performance atWork (Collins, 2006).

Originally published Autumn

2009.

Triggering the Threat Response

One critical thread of research on the social brain startswith the “threat and reward” response, a neurologicalmechanism that governs a great deal of human behavior.When you encounter something unexpected — a shadow seen from the corner of your eye or a new col-league moving into the office next door — the limbic system (a relatively primitive part of the brain, commonto many animals) is aroused. Neuroscientist EvianGordon refers to this as the “minimize danger, maximizereward” response; he calls it “the fundamental orga niz-ing principle of the brain.” Neurons are activated andhormones are released as you seek to learn whether thisnew entity represents a chance for reward or a potentialdanger. If the perception is danger, then the responsebecomes a pure threat response — also known as thefight or flight response, the avoid response, and, in itsextreme form, the amygdala hijack, named for a part ofthe limbic system that can be aroused rapidly and in anemotionally overwhelming way.

Recently, researchers have documented that thethreat response is often triggered in social situations, andit tends to be more intense and longer-lasting than thereward response. Data gathered through measures ofbrain activity — by using fMRI and electroencephalo-graph (EEG) machines or by gauging hormonal secre-tions — suggests that the same neural responses thatdrive us toward food or away from predators are trig-gered by our perception of the way we are treated byother people. These findings are reframing the prevailingview of the role that social drivers play in influencinghow humans behave. Matthew Lieberman notes thatAbraham Maslow’s “hierarchy of needs” theory mayhave been wrong in this respect. Maslow proposed that

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humans tend to satisfy their needs in sequence, startingwith physical survival and moving up the ladder towardself-actualization at the top. In this hierarchy, socialneeds sit in the middle. But many studies now show thatthe brain equates social needs with survival; for example,being hungry and being ostracized activate similar neu-ral responses.

The threat response is both mentally taxing anddeadly to the productivity of a person — or of an organ-ization. Because this response uses up oxygen and glu-cose from the blood, they are diverted from other partsof the brain, including the working memory function,which processes new information and ideas. Thisimpairs analytic thinking, creative insight, and problem

solving; in other words, just when people most needtheir sophisticated mental capabilities, the brain’s inter-nal resources are taken away from them.

The impact of this neural dynamic is often visible in organizations. For example, when leaders trigger athreat response, employees’ brains become much lessefficient. But when leaders make people feel good aboutthemselves, clearly communicate their ex pectations, giveemployees latitude to make decisions, support people’sefforts to build good relationships, and treat the wholeorganization fairly, it prompts a reward response. Othersin the organization become more effective, more open toideas, and more creative. They notice the kind of infor-mation that passes them by when fear or resentment

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makes it difficult to focus their attention. They are lesssusceptible to burnout because they are able to managetheir stress. They feel intrinsically rewarded.

Understanding the threat and reward response canalso help leaders who are trying to implement large-scalechange. The track record of failed efforts to spark higher-perfomance behavior has led many managers toconclude that human nature is simply intractable: “Youcan’t teach an old dog new tricks.” Yet neuroscience hasalso discovered that the human brain is highly plastic.Neural connections can be reformed, new behaviors canbe learned, and even the most entrenched behaviors can be modified at any age. The brain will make theseshifts only when it is engaged in mindful attention. Thisis the state of thought associated with observing one’sown mental processes (or, in an organization, steppingback to observe the flow of a conversation as it is hap-pening). Mindfulness requires both serenity and con-centration; in a threatened state, people are much morelikely to be “mindless.” Their attention is diverted by thethreat, and they cannot easily move to self-discovery.

In a previous article (“The Neuroscience ofLeadership,” s+b, Summer 2006), brain scientist JeffreySchwartz and I proposed that organizations could mar-shal mindful attention to create organizational change.They could do this over time by putting in place regularroutines in which people would watch the patterns oftheir thoughts and feelings as they worked and thusdevelop greater self-awareness. We argued that this wasthe only way to change organizational behavior; that the“carrots and sticks” of incentives (and behavioral psy-chology) did not work, and that the counseling andempathy of much organizational development was notefficient enough to make a difference.

Research into the social nature of the brain suggestsanother piece of this puzzle. Five particular qualitiesenable employees and executives alike to minimize thethreat response and instead enable the reward response.These five social qualities are status, certainty, auton o-my, relatedness, and fairness: Because they can beexpressed with the acronym SCARF, I sometimes think ofthem as a kind of headgear that an organization canwear to prevent exposure to dysfunction. To understandhow the SCARF model works, let’s look at each charac-teristic in turn.

Status and Its Discontents

As humans, we are constantly assessing how socialencounters either enhance or diminish our status. Re -search published by Hidehiko Takahashi et al. in 2009shows that when people realize that they might compareunfavorably to someone else, the threat response kicksin, releasing cortisol and other stress-related hormones.(Cortisol is an accurate biological marker of the threatresponse; within the brain, feelings of low status provokethe kind of cortisol elevation associated with sleep dep-rivation and chronic anxiety.)

Separately, researcher Michael Marmot, in his bookThe Status Syndrome: How Social Standing Affects OurHealth and Longevity (Times Books, 2004), has shownthat high status correlates with human longevity andhealth, even when factors like income and education arecontrolled for. In short, we are biologically programmedto care about status because it favors our survival.

As anyone who has lived in a modest house in ahigh-priced neighborhood knows, the feeling of status isalways comparative. And an executive with a salary ofUS$500,000 may feel elevated. . .until he or she is

Neuroscience has discovered that the brain is highly plastic.

Even the most entrenched behaviors can be modified.

assigned to work with an executive making $2.5 million.A study by Joan Chiao in 2003 found that the neuralcircuitry that assesses status is similar to that whichprocesses numbers; the circuitry operates even when thestakes are meaningless, which is why winning a boardgame or being the first off the mark at a green light feelsso satisfying. Competing against ourselves in games likesolitaire triggers the same circuitry, which may helpexplain the phenomenal popularity of video games.

Understanding the role of status as a core concerncan help leaders avoid organizational practices that stircounterproductive threat responses among employees.For example, performance reviews often provoke athreat response; people being reviewed feel that the ex er-cise itself encroaches on their status. This makes 360-degree reviews, unless extremely participative andwell-designed, ineffective at generating positive behav-ioral change. Another common status threat is the cus-tom of offering feedback, a standard practice for bothmanagers and coaches. The mere phrase “Can I give yousome advice?” puts people on the defensive because theyperceive the person offering advice as claiming su perior-ity. It is the cortisol equivalent of hearing footsteps in thedark.

Organizations often assume that the only way toraise an employee’s status is to award a promotion. Yetstatus can also be enhanced in less-costly ways. Forexample, the perception of status increases when peopleare given praise. Experiments conducted by Keise Izumain 2008 show that a programmed status-related stimu-lus, in the form of a computer saying “good job,” lightsup the same reward regions of the brain as a financialwindfall. The perception of status also increases whenpeople master a new skill; paying employees more for

the skills they have acquired, rather than for their seniority, is a status booster in itself.

Values have a strong impact on status. An organiza-tion that appears to value money and rank more than abasic sense of respect for all employees will stimulatethreat responses among employees who aren’t at the topof the heap. Similarly, organizations that try to pit peo-ple against one another on the theory that it will makethem work harder reinforce the idea that there are onlywinners and losers, which undermines the standing ofpeople below the top 10 percent.

A Craving for Certainty

When an individual encounters a familiar situation, hisor her brain conserves its own energy by shifting into akind of automatic pilot: it relies on long-establishedneural connections in the basal ganglia and motor cor-tex that have, in effect, hardwired this situation and theindividual’s response to it. This makes it easy to do whatthe person has done in the past, and it frees that personto do two things at once; for example, to talk while driv-ing. But the minute the brain registers ambiguity or con-fusion — if, for example, the car ahead of the driverslams on its brakes — the brain flashes an error signal.With the threat response aroused and working memorydiminished, the driver must stop talking and shift fullattention to the road.

Uncertainty registers (in a part of the brain calledthe anterior cingulate cortex) as an error, gap, or tension:something that must be corrected before one can feelcomfortable again. That is why people crave certainty.Not knowing what will happen next can be profoundlydebilitating because it requires extra neural energy. Thisdiminishes memory, undermines performance, and dis-engages people from the present.

Of course, uncertainty is not necessarily debilitat-ing. Mild uncertainty attracts interest and attention:New and challenging situations create a mild threatresponse, increasing levels of adrenalin and dopaminejust enough to spark curiosity and energize people tosolve problems. Moreover, different people respond touncertainty in the world around them in different ways,depending in part on their existing patterns of thought.For example, when that car ahead stops suddenly, thedriver who thinks, “What should I do?” is likely to be ineffective, whereas the driver who frames the inci-dent as manageable — “I need to swerve left nowbecause there’s a car on the right” — is well equipped torespond. All of life is uncertain; it is the perception of

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too much uncertainty that undercuts focus and per-formance. When perceived uncertainty gets out of hand, people panic and make bad decisions.

Leaders and managers must thus work to create aperception of certainty to build confident and dedicatedteams. Sharing business plans, rationales for change, andaccurate maps of an organization’s structure promotesthis perception. Giving specifics about organizationalrestructuring helps people feel more confident about aplan, and articulating how decisions are made increasestrust. Transparent practices are the foundation on whichthe perception of certainty rests.

Breaking complex projects down into small stepscan also help create the feeling of certainty. Although it’shighly unlikely everything will go as planned, peoplefunction better because the project now seems lessambiguous. Like the driver on the road who has enoughinformation to calculate his or her response, an em ploy-ee focused on a single, manageable aspect of a task isunlikely to be overwhelmed by threat responses.

The Autonomy Factor

Studies by Steven Maier at the University of Bouldershow that the degree of control available to an animalconfronted by stressful situations determines whether ornot that stressor undermines the ability to function.Similarly, in an organization, as long as people feel theycan execute their own decisions without much oversight,stress remains under control. Because human brainsevolved in response to stressors over thousands of years,they are constantly attuned, usually at a subconsciouslevel, to the ways in which social encounters threaten orsupport the capacity for choice.

A perception of reduced autonomy — for example,because of being micromanaged — can easily generate athreat response. When an employee experiences a lack ofcontrol, or agency, his or her perception of uncertaintyis also aroused, further raising stress levels. By contrast,the perception of greater autonomy increases the feelingof certainty and reduces stress.

Leaders who want to support their people’s need forautonomy must give them latitude to make choices,especially when they are part of a team or working witha supervisor. Presenting people with options, or allowingthem to organize their own work and set their ownhours, provokes a much less stressed response than forc-ing them to follow rigid instructions and schedules. In1977, a well-known study of nursing homes by JudithRodin and Ellen Langer found that residents who were

given more control over decision making lived longerand healthier lives than residents in a control group whohad everything selected for them. The choices them-selves were insignificant; it was the perception of auton-omy that mattered.

Another study, this time of the franchise industry,identified work–life balance as the number one reasonthat people left corporations and moved into a franchise.Yet other data showed that franchise owners actuallyworked far longer hours (often for less money) than theyhad in corporate life. They nevertheless perceived them-selves to have a better work–life balance because theyhad greater scope to make their own choices. Leaderswho know how to satisfy the need for autonomy amongtheir people can reap substantial benefits — without los-ing their best people to the entrepreneurial ranks.

Relating to Relatedness

Fruitful collaboration depends on healthy relationships,which require trust and empathy. But in the brain, theability to feel trust and empathy about others is shapedby whether they are perceived to be part of the samesocial group. This pattern is visible in many domains: insports (“I hate the other team”), in organizational silos(“the ‘suits’ are the problem”), and in communities(“those people on the other side of town always messthings up”).

Each time a person meets someone new, the brainautomatically makes quick friend-or-foe distinctionsand then experiences the friends and foes in ways thatare colored by those distinctions. When the new personis perceived as different, the information travels alongneural pathways that are associated with uncomfortablefeelings (different from the neural pathways triggered bypeople who are perceived as similar to oneself ).

Leaders who understand this phenomenon will findmany ways to apply it in business. For example, teams ofdiverse people cannot be thrown together. They must bedeliberately put together in a way that minimizes thepotential for threat responses. Trust cannot be assumedor mandated, nor can empathy or even goodwill becompelled. These qualities develop only when people’sbrains start to recognize former strangers as friends. Thisrequires time and repeated social interaction.

Once people make a stronger social connection,their brains begin to secrete a hormone called oxytocinin one another’s presence. This chemical, which hasbeen linked with affection, maternal behavior, sexualarousal, and generosity, disarms the threat response and

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The cognitive need for fairness is so strong thatsome people are willing to fight and die for causes they believe are just — or commit themselves whole-heartedly to an organization they recognize as fair. Anexecutive told me he had stayed with his company for 22years simply because “they always did the right thing.”People often engage in volunteer work for similar rea-sons: They perceive their actions as increasing the fair-ness quotient in the world.

In organizations, the perception of unfairness cre-ates an environment in which trust and collaborationcannot flourish. Leaders who play favorites or whoappear to reserve privileges for people who are like themarouse a threat response in employees who are outsidetheir circle. The old boys’ network provides an egregiousexample; those who are not a part of it always perceivetheir organizations as fundamentally unfair, no matterhow many mentoring programs are put in place.

Like certainty, fairness is served by transparency.Leaders who share information in a timely manner cankeep people engaged and motivated, even during staffreductions. Morale remains relatively high when peopleperceive that cutbacks are being handled fairly — thatno one group is treated with preference and that there isa rationale for every cut.

Putting on the SCARF

If you are a leader, every action you take and every decision you make either supports or undermines theperceived levels of status, certainty, autonomy, related-ness, and fairness in your enterprise. In fact, this is whyleading is so difficult. Your every word and glance isfreighted with social meaning. Your sentences and gestures are noticed and interpreted, magnified and

further activates the neural networks that permit us toperceive someone as “just like us.” Research by MichaelKosfeld et al. in 2005 shows that a shot of oxytocindelivered by means of a nasal spray decreases threatarousal. But so may a handshake and a shared glanceover some thing funny.

Conversely, the human threat response is arousedwhen people feel cut off from social interaction.Loneliness and isolation are profoundly stressful. John T.Cacioppo and William Patrick showed in 2008 thatloneliness is itself a threat response to lack of social con-tact, activating the same neurochemicals that flood thesystem when one is subjected to physical pain. Leaderswho strive for inclusion and minimize situations inwhich people feel rejected create an environment thatsupports maximum performance. This of course raises achallenge for organizations: How can they foster relat-edness among people who are competing with oneanother or who may be laid off?

Playing for Fairness

The perception that an event has been unfair generatesa strong response in the limbic system, stirring hostilityand undermining trust. As with status, people perceivefairness in relative terms, feeling more satisfied with afair exchange that offers a minimal reward than anunfair exchange in which the reward is substantial.Studies conducted by Matthew Lieberman and GolnazTabibnia found that people respond more positively tobeing given 50 cents from a dollar split between themand another person than to receiving $8 out of a total of$25. Another study found that the experience of fairnessproduces reward responses in the brain similar to thosethat occur from eating chocolate.

We now have reason to believe that economic incentives are effective

only when people perceive them as supporting their social needs.

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combed for meanings you may never have intended. The SCARF model provides a means of bringing

conscious awareness to all these potentially fraughtinteractions. It helps alert you to people’s core concerns(which they may not even understand themselves) andshows you how to calibrate your words and actions tobetter effect.

Start by reducing the threats inherent in your com-pany and in its leaders’ behavior. Just as the animal brainis wired to respond to a predator before it can focusattention on the hunt for food, so is the social brainwired to respond to dangers that threaten its core con-cerns before it can perform other functions. Threatalways trumps reward because the threat response isstrong, immediate, and hard to ignore. Once aroused, it is hard to displace, which is why an unpleasantencounter in traffic on the morning drive to work candistract attention and impair performance all day.Humans cannot think creatively, work well with others,or make informed decisions when their threat responsesare on high alert. Skilled leaders understand this and act accordingly.

A business reorganization provides a good example.Reorganizations generate massive amounts of uncertain-ty, which can paralyze people’s ability to perform. Aleader attuned to SCARF principles therefore makesreducing the threat of uncertainty the first order of busi-ness. For example, a leader might kick off the process bysharing as much information as possible about the rea-sons for the reorganization, painting a picture of thefuture company and explaining what the specific impli-cations will be for the people who work there. Much willbe unknown, but being clear about what is known andwilling to acknowledge what is not goes a long waytoward ameliorating uncertainty threats.

Reorganizations also stir up threats to autonomy,because people feel they lack control over their future.An astute leader will address these threats by giving peo-ple latitude to make as many of their own decisions aspossible — for example, when the budget must be cut,involving the people closest to the work in decidingwhat must go. Because many reorganizations entailinformation technology upgrades that undermine peo-

ple’s perception of autonomy by foisting new systems onthem without their consent, it is essential to providecontinuous support and solicit employees’ participationin the design of new systems.

Top-down strategic planning is often inimical toSCARF-related reactions. Having a few key leaders comeup with a plan and then expecting people to buy into itis a recipe for failure, because it does not take the threatresponse into account. People rarely support initiativesthey had no part in designing; doing so would under-mine both autonomy and status. Proactively addressingthese concerns by adopting an inclusive planningprocess can prevent the kind of unconscious sabotagethat results when people feel they have played no part ina change that affects them every day.

Leaders often underestimate the importance ofaddressing threats to fairness. This is especially truewhen it comes to compensation. Although most peopleare not motivated primarily by money, they are pro-foundly de-motivated when they believe they are being unfairly paid or that others are overpaid by com-parison. Leaders who recognize fairness as a core concernunderstand that disproportionately increasing compensation at the top makes it impossible to fullyengage people at the middle or lower end of the payscale. Declaring that a highly paid executive is “doing agreat job” is counterproductive in this situation becausethose who are paid less will interpret it to mean that theyare perceived to be poor performers.

For years, economists have argued that people willchange their behavior if they have sufficient incentives.But these economists have defined incentives almostexclusively in economic terms. We now have reason tobelieve that economic incentives are effective only whenpeople perceive them as supporting their social needs.Status can also be enhanced by giving an employeegreater scope to plan his or her schedule or the chance todevelop meaningful relationships with those at differentlevels in the organization. The SCARF model thus pro-vides leaders with more nuanced and cost-effective waysto expand the definition of reward. In doing so, SCARF

principles also provide a more granular understanding ofthe state of engagement, in which employees give theirbest performance. Engagement can be induced whenpeople working toward objectives feel rewarded by theirefforts, with a manageable level of threat: in short, whenthe brain is generating rewards in several SCARF-relateddimensions.

Leaders themselves are not immune to the SCARF

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dynamic; like everyone else, they react when they feeltheir status, certainty, autonomy, relatedness, and fairtreatment are threatened. However, their reactions havemore impact, because they are picked up and amplifiedby others throughout the company. (If a company’sexecutive salaries are excessive, it may be because othersare following the leader’s intuitive emphasis, driven bysubconscious cognition, on anything that adds status.)

If you are an executive leader, the more practicedyou are at reading yourself, the more effective you willbe. For example, if you understand that micromanagingthreatens status and autonomy, you will resist your ownimpulse to gain certainty by dictating every detail.Instead, you’ll seek to disarm people by giving them lat-itude to make their own mistakes. If you have felt thehairs on the back of your own neck rise when someonesays, “Can I offer you some feedback?” you will know it’sbest to create opportunities for people to do the hardwork of self-assessment rather than insisting theydepend on performance reviews.

When a leader is self-aware, it gives others a feelingof safety even in uncertain environments. It makes it eas-ier for employees to focus on their work, which leads toimproved performance. The same principle is evident inother groups of mammals, where a skilled pack leaderkeeps members at peace so they can perform their func-tions. A self-aware leader modulates his or her behaviorto alleviate organizational stress and creates an environ-ment in which motivation and creativity flourish. Onegreat advantage of neuroscience is that it provides harddata to vouch for the efficacy and value of so-called softskills. It also shows the danger of being a hard-chargingleader whose best efforts to move people along also setup a threat response that puts others on guard.

Similarly, many leaders try to repress their emotionsin order to enhance their leadership presence, but thisonly confuses people and undermines morale. Exper -iments by Kevin Ochsner and James Gross show thatwhen someone tries not to let other people see what heor she is feeling, the other party tends to experience athreat response. That’s why being spontaneous is key tocreating an authentic leadership presence. This approachis likely to minimize status threats, increase certainty,and create a sense of relatedness and fairness.

Finally, the SCARF model helps explain why intelli-gence, in itself, isn’t sufficient for a good leader. MatthewLieberman’s research suggests that high intelligenceoften corresponds with low self-awareness. The neuralnetworks involved in information holding, planning,

and cognitive problem solving reside in the lateral, orouter, portions of the brain, whereas the middle regionssupport self-awareness, social skills, and empathy. Theseregions are inversely correlated. As Lieberman notes, “Ifyou spend a lot of time in cognitive tasks, your ability tohave empathy for people is reduced simply because thatpart of your circuitry doesn’t get much use.”

Perhaps the greatest challenge facing leaders of busi-ness or government is to create the kind of atmospherethat promotes status, certainty, autonomy, relatedness,and fairness. When historians look back, their judgmentof this period in time may rise or fall on how organiza-tions, and society as a whole, operated. Did they treatpeople fairly, draw people together to solve problems,promote entrepreneurship and autonomy, foster certain-ty wherever possible, and find ways to raise the perceivedstatus of everyone? If so, the brains of the future willsalute them. +

Reprint No. 09306

Resources

John T. Cacioppo and William Patrick, Loneliness: Human Nature and theNeed for Social Connection (W.W. Norton, 2008): A scientific look at thecauses and effects of emotional isolation.

Naomi Eisenberger and Matthew Lieberman, “The Pains and Pleasures ofSocial Life,” Science, vol. 323, no. 5916, February 2009, 890–891:Explication of social pain and social pleasure, and the impact of fairness,status, and autonomy on brain response.

Naomi Eisenberger and Matthew Lieberman, with K.D. Williams, “DoesRejection Hurt? An fMRI Study of Social Exclusion,” Science, vol. 302,no. 5643, October 2003, 290–292: Covers the Cyberball experiment.

Michael Marmot, The Status Syndrome: How Social Standing Affects OurHealth and Longevity (Times Books, 2004): An epidemiologist shows thatpeople live longer when they have status, autonomy, and relatedness, evenif they lack money.

David Rock, “SCARF: A Brain-based Model for Collaborating with andInfluencing Others,” NeuroLeadership Journal, vol. 1, no. 1, December2008, 44: Overview of research on the five factors described in this article,and contains bibliographic references for research quoted in this article.

David Rock, Your Brain at Work: Strategies for Overcoming Distraction,Regaining Focus, and Working Smarter All Day Long (HarperBusiness,2009): Neuroscience explanations for workplace challenges and dilemmas,and strategies for managing them.

David Rock and Jeffrey Schwartz, “The Neuroscience of Leadership,” s+b,Summer 2006, www.strategy-business.com/press/article/06207: Applyingbreakthroughs in brain research, this article explains the value of neuro-plasticity in organizational change.

NeuroLeadership Institute website, www.neuroleadership.org: Institutebringing together research scientists and management experts to explorethe transformation of organizational development and performance.


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In its premier issue in 1995, strategy+businessreviewed five books. One of them was the fifth anniver-sary edition of Peter M. Senge’s The Fifth Discipline: The Art and Practice of the Learning Organization(Doubleday Currency, 1990), which introduced theconcept of the learning organization to a broader audi-ence. This book remains as relevant today as it was whenit was first published. That’s no mean feat, given thechanges that have occurred in the past 20 years.

Some of the most far-reaching of these changes haveoccurred in publishing, which has become digital andmigrated online. This has created a sea change in theways that ideas are communicated, the likes of whichhasn’t been seen since Johannes Gutenberg invented theprinting press 550 years ago.

Some observers are concerned that this change is

fundamentally altering not only how we write and read,but how we think — and not altering it for the better.In his new book, a polemic titled The Shallows: What theInternet Is Doing to Our Brains (W.W. Norton, 2010),Nicholas Carr describes how the skimming and skippingthat characterize online information gathering actuallyreroute the neural pathways in our brains. Carr warnsthat this could cause us to lose the capacity for the kindof mind-focusing “deep reading” that books engender,and the reflection and creativity that result from it.

Whatever the prevailing trend in reading may turnout to be, it is clear from 15 years of book coverage ins+b, written by a host of distinguished reviewers, thatthere is much to be thoughtful about. Executives who goback to the best books that s+b has covered over theyears would gain a valuable source of information and

BY THEODORE KINNI

15Years A select shelf of books that not only

expanded the corporate lexicon, but stillhave the power to change the way

we see the world and do business.

ESSENTIAL READINGHIGHLIGHTS FROM

OF S+B BOOK REVIEWS

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insight. These are the rare books that have expanded thecorporate lexicon and changed the way we do business.

Seminal Ideas

Peter M. Senge’s The Fifth Discipline is surely one of themost influential management works of the past twodecades. Senge, who founded the Center for Organiza -tional Learning at MIT’s Sloan School of Management,pegged the problems that companies commonly en -counter to the inability to adapt to changing circum-stances — in his words, to learning disabilities. Heasserted (borrowing a theme from Arie de Geus) thatorganizations that are capable of learning possess a valu-able competitive advantage, and went on, in the corechapters of the book, to lay out the now-familiar fivecomponents necessary to create such organizations: sys-tems thinking, personal mastery, mental models, sharedvisions, and team learning.

Paul Idzik, then a Booz & Company partner,reviewed The Fifth Discipline on the occasion of thebook’s fifth anniversary. “Senior executives are devotingmore of their time these days to fostering a culture oflearning within their organizations,” wrote Idzik. “Theyrealize that many of the recurring problems they dealwith would be more quickly and productively resolved ifthey managed and belonged to a learning organization.”That is still true; the organizational learning disabilitiesthat Senge noticed (such as a fixation on short-termevents that obscures the big picture) are still very muchwith us, and the learning disciplines still provide a rem-edy when practiced.

The list of seminal books that s+b reviewed mustalso include The Fortune at the Bottom of the Pyramid:Eradicating Poverty through Profits (Wharton School

Publishing, 2005), a paean to the uplifting effect of capitalism on the human condition, by the lateUniversity of Michigan professor C.K. Prahalad. (Seepage 32 for his article on the same theme.) This book isso compelling that it was featured as one of the year’sbest business books in 2005 in two categories, strategyand globalization.

Prahalad tallied up the 4 billion people who livedon incomes of less than US$1,400 per year, and positedthe original idea that they make up a largely untappedmarket valued at trillions of dollars in aggregate. In theiressay on the best business books on strategy, formerBooz & Company Partners Chuck Lucier and Jan Dyerpicked the book as “essential reading” for four reasons:the emerging market business models it described; thecrucial new source of corporate growth it identified; thecompetitive threat that companies serving the bottom ofthe pyramid represented; and the likelihood that thelow-cost, high-volume models would eventually migrateto developed markets. The Fortune at the Bottom of thePyramid, they wrote, provided “a rare glimpse into thefuture — for those with eyes to see — of the extraordi-nary opportunities waiting in uncharted and seeminglyimpassable waters.”

A third seminal book covered in s+b ’s pages is onewhose relevance grows along with the ecological impactof our industrial society. In Cradle to Cradle: Remakingthe Way We Make Things (North Point Press, 2002),William McDonough and Michael Braungart, an archi-tect and chemist, respectively, identified the convention-al “take, make, and waste” product cycle as a major con-tributor to our environmental problems. They proposedthat human industry be redesigned to echo nature, inwhich every major nutrient is endlessly recycled.

Theodore Kinni

[email protected] senior editor for books at

strategy+business. He has

written or collaborated on 13

business books.

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“Consider this thought experiment, which appearsin [the book]: What would it take to run your companythe way the Menominee tribe of Michigan runs theirforest?” wrote Joe Flower, a regular s+b contributor, whoreviewed Cradle to Cradle in his Knowledge Review essayon sustainability in the Spring 2009 issue. “In 1870, theMenominee counted 1.3 billion board feet of standingtimber on their 235,000 acres of land. Over the last 138years, they have harvested 2.3 billion board feet, andnow they have 1.7 billion board feet. Neat trick. Maybeyou’re not in a resource-extraction industry; maybe yourcapital doesn’t grow on trees. But isn’t there an equiva-lent potential achievement in your sector?”

A Global Trend

If books were to morph into shallow, short-form onlineworks, we would miss those titles that take deep divesinto the new trends that are shaping and reshaping ourworld. One of the most far-reaching and implication-laden of these trends has been globalization, and durings+b’s publishing tenure, a library’s worth of books on thetopic have appeared. Among the most influential andwidely read of them was Thomas L. Friedman’s TheWorld Is Flat: A Brief History of the Twenty-First Century(Farrar, Straus and Giroux, 2005), which HowardRheingold, a leading observer of the social changes stim-ulated by technology, chose as the best business book of2005 in the future category.

Friedman, the foreign affairs columnist for the NewYork Times, argued that globalization entered a newphase around the turn of the millennium. WhereasGlobalization 1.0 was fueled by the drive for empire bynation-states beginning in 1492 and Globalization 2.0was driven by the international expansion of enterprises

starting around 1800, Globalization 3.0 was driven by“the newfound power of individuals to collaborate andcompete globally.” This power derived from 10 “flatten-ers,” according to Friedman, which were all directlyrelated to digital technologies and networks.

Friedman’s flat world explained many of the chal-lenges that companies were facing in a global economy,but business readers had to wait for the publication ofPankaj Ghemawat’s Redefining Global Strategy: CrossingBorders in a World Where Differences Still Matter(Harvard Business School Press, 2007) for a measured,strategic response. In it, the author, a professor of globalstrategy at IESE business school in Barcelona, takes issuewith Friedman’s boundaryless “flat” world. Ghemawatpoints out that there are still plenty of speed bumps forcompanies that rush into the global fray with a one-world strategy that doesn’t account for the myriad dif-ferences between nations.

The core of the book is devoted to Ghemawat’sCAGE framework, a means of understanding the cul-tural, administrative, geographic, and economic dimen-sions of nations and making sure they are reflected incompanies’ business strategies. “With its combination ofsolid data, illuminating case studies, and helpful con-cepts, this book is an effective antidote to both millen-nial and apocalyptic visions of globalization,” wrotes+b ’s longtime Books in Brief reviewer David Hurst inthe Spring 2008 issue.

Managerial Art and Craft

Although many management books might benefit froma shorter format, we wouldn’t want to lose a word of thebest of them. The books of Henry Mintzberg, McGillUniversity’s iconoclastic professor of management stud-

If books were to morph into shallow, short-form online works, we would miss those titles that take deep dives into the new trends

that are shaping and reshaping our world.

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ies, are terrific examples of the latter category and thecareer-expanding insights such works can stimulate,especially the concisely titled Managing (Berrett-Koehler, 2009).

Mintzberg has always been more interested in therealities of managing than its theories. In his first book,The Nature of Managerial Work (Harper and Row,1973), he shadowed five CEOs to see how their dailywork jibed with the various theories of management invogue at the time. In writing Managing some 30 yearslater, he bookended his body of work with a similarproject — this time following 29 managers. This exer-cise confirmed Mintzberg’s conviction that managers arefacilitators, who leverage “the natural propensity of peo-ple to cooperate in communities.”

“Management books often make me feel like Ishould head back to boot camp. But reading Managing,. . . I found my own managerial insecurities meltingaway,” wrote Judith Samuelson, the executive director ofthe Aspen Institute Business and Society Program, whofeatured the book in her best business books essay inWinter 2009. “Mintzberg reminds us that most man-agers are prey to events and demands they do not con-trol, and that a wide range of styles can work well for aboss. Balance is the key: keeping up with the hectic paceof business yet making time for reflection; drivingchange yet maintaining stability; leading and collaborat-ing; leavening analysis with judgment.”

Larry Bossidy, former chairman of HoneywellInternational, and Ram Charan, a prolific consultant,are also great proponents of the realist school. In theirbook Execution: The Discipline of Getting Things Done(Crown Business, 2002), they assert that CEOs havethree primary responsibilities: analyzing the businessenvironment and their companies, closing the gapbetween desired outcomes and actual performance, and,especially, ensuring execution.

In choosing Execution as a 2002 best business bookof the year in the leadership category, Bruce A.Pasternack, then a senior partner at Booz & Company,and James O’Toole, a professor at the University ofDenver’s Daniels College of Business, noted the book’semphasis on practical advice on everything from strat egymaking to plant inspections. “We ended up makingpages of useful notes,” they wrote, “and in discussionsabout the book with clients and colleagues, we notedthey are doing the same.”

MIT management professor emeritus Edgar Scheinhas written a perfect companion volume to the two pre-

vious books. In Helping: How to Offer, Give, and ReceiveHelp (Berrett-Koehler, 2009), Schein deconstructed theact of helping, and in doing so created a valuable guideto a task that many managers face, but few truly under-stand and effectively execute.

“We often ignore [Schein’s] principles amid thedaily course of life, taking for granted relationships andexchanges that may not be what they seem. We get lazy,”wrote Charles Handy, a noted management observer, inhis review of the best business books on leadership in theWinter 2009 issue. “I found this little book a salutaryreminder of too many lapses on my part, while it alsoexplained why some of my well-intentioned attempts tohelp only led to worsening relationships. Any aspiringleader would do well to review his or her own behaviorin the light of this very useful guide.”

Best Cases

Two closely related business book genres that requirelong-form writing are corporate histories and the biog-raphies and memoirs of leaders. Books of this sort can be sanitized to the point that they become cures forinsomnia, but when driven by a spirit of open and hon-est inquiry, they have the power to compel and inspire.

David Packard’s memoir, The HP Way: How BillHewlett and I Built Our Company (HarperBusiness,1995), traces how the now-famous business partnersfounded an electronic instrument business in a garage in Palo Alto, Calif., with $538 in capital; their startupgrew into a $100 billion global corporation. Publishedjust a year before Packard’s death, the book illuminates a leader’s role in creating and transmitting a perfor -mance culture.

The Hewlett-Packard culture was a direct reflectionof the pragmatic philosophies of the company’sfounders. The cofounders believed in participative goalsetting, decentralized authority, and a humane form ofaccountability that moved employees up until theyreached their limits and then moved them around untilthey found their niches. Neither Hewlett nor Packardhad any vision: They just wanted to make a profit mak-ing innovative and high-quality machines that addressedtheir customers’ needs.

And so they did. “Balancing the goals of the com-pany with the realities of the marketplace and the needsof both stockholders and employees is what HP hasachieved. It has done this while also producing a seriesof innovative products, which contributed mightily tobusiness and the country,” wrote Robert Cranny in s+b ’s

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second issue. “The HP Way should be kept in a corner ofevery office and den. It’s good just to know it’s there.”

Louis V. Gerstner Jr. is another leader who famous-ly eschewed the “vision thing” for pragmatic manage-ment — and saved IBM in the process. In Who SaysElephants Can’t Dance? Inside IBM’s Historic Turnaround(HarperBusiness, 2002), Gerstner explains in detail howto restructure a massive organization — radically chang-ing its business model, cutting costs, and reengineeringits processes — and remake its culture without flying itinto an unrecoverable tailspin.

“There are a few good leaders, and a few good newleadership books,” wrote Pasternack and O’Toole onnaming Who Says Elephants Can’t Dance? one of 2003’sbest business books in the leadership category. “Louis V.Gerstner Jr. gets the nod on both counts.”

And finally, there is Alice Schroeder’s monumentalbiography of Warren Buffett, The Snowball: WarrenBuffett and the Business of Life (Bantam, 2008), whichsuccessfully undertook the delicate task of ferreting outwhat makes the Oracle of Omaha tick, with his permis-sion. Schroeder’s portrait is especially compellingbecause she never sidesteps the real Buffett for easyanswers. Instead, wrote O’Toole, who selected the bookas one of 2009’s best business books in biography,“Schroeder offers us a nuanced portrait of a surprisinglycomplex and insecure man whose life is full of paradox-es and contradictions.” It’s good to know that even themost successful businessperson of our time is more manthan mogul.

Disruptive Technologies

For greater insight into how technology will changepublishing in the years to come, Clayton Christensen’sThe Innovator’s Dilemma: When New Technologies CauseGreat Firms to Fail (Harvard Business School Press,1997) is a good place to turn. The book, which DavidHurst reviewed in the spring of 2001, introducedChristensen’s seminal theory of disruptive technologiesand described their cyclical effect on industries.

Christensen, a professor at Harvard BusinessSchool, says that successful companies in a given indus-try are almost always focused on improving their prod-ucts and the technologies that underlie them. This cre-ates innovation races in which the industry’s offeringsoutpace the needs and desires of customers. New com-petitors inevitably arise, deploying disruptive technolo-gies to serve customers in more effective ways, but theincumbent industry leaders ignore them as inconse-

quential. Eventually, the new competitors eclipse theindustry leaders, and the cycle starts again. How doesthis relate to publishing? Well, one hint comes fromAmazon, which announced that its e-book sales hadovertaken hardcover sales as I wrote this article.

Disruptive technologies bring us full circle toNicholas Carr. Before the publication of his current vol-ume, Carr generated controversy with Does IT Matter?Information Technology and the Corrosion of CompetitiveAdvantage (Harvard Business School Press, 2004). In itCarr suggested that IT was well on its way to becominga “commodity technology.” The idea that IT hadbecome merely an ante in the game of business, ratherthan a winning hand, understandably outraged manydenizens within this sector. They were, after all, still reel-ing from the tech-led recession in 2001 and 2002 whenthe book arrived.

When Steve Lohr, a technology reporter for theNew York Times, looked at the book in his KnowledgeReview in the Summer 2004 issue, he found flaws, say-ing that “Carr’s desire to fit everything neatly into histhesis leads him astray” and his “thesis is often the samekind of straitjacket of standardization that packagedsoftware, as he says, is for companies.” But Lohr foundCarr’s indictment of “faith-based investment in technol-ogy” spot on. “The value is not in the bits and bytes,”concluded Lohr, “but up a few levels in the minds of theskilled businesspeople using the tools. Large chunks ofthe technology may be commoditizing, but how you useit isn’t. That is where competitive advantage resides.”

The same can be said for books. Books probablywon’t disappear anytime soon, but their real value is notin their pages. It is in the minds of managers and howthey put what they read to use. The best insights beingcodified in the best business books and then deployedthoughtfully is the way that management knowledgedevelops these days — and books are therefore one ofthe great vehicles of progress in our world. +

BY ART KLEINER

Of strategy+business’s many classic articles over the years,

here are a few of the editor’s favorites.

How to Manage Creative People: The Case of Industrial

Light and Magic

Lawrence Fisher, Second Quarter 1997, www.strategy-business

.com/article/15151: The special effects shop that George Lucas

founded builds its success on good relationships.

Are There Limits to Total Quality Management?

Arthur M. Schneiderman, Second Quarter 1998, www.strategy-

business.com/article/16188: Yes, as you go up the hierarchy,

problems grow too complex for continuous improvement.

The Last Mile to Nowhere: Flaws and Fallacies in Internet

Home-Delivery Schemes

Tim Laseter, Pat Houston, Martha Turner, et al., Third Quarter

2000, www.strategy-business.com/article/19594: The failure of

Webvan shows the trade-off between delivery speed and variety.

Money Isn’t Everything: Innovation’s Big Spenders

Barry Jaruzelski, Kevin Dehoff, and Rakesh Bordia, Winter 2005,

www.strategy-business.com/article/05406: First of our ongoing

studies of global corporate R&D spending — and its complex

link to performance.

Love Your “Dogs”

Harry Quarls, Thomas Pernsteiner, and Kasturi Rangan, Spring

2006, www.strategy-business.com/article/06107: The

conventional wisdom about portfolio management is wrong;

foster poor performers to gain value.

City Planet

Stewart Brand, Spring 2006, www.strategy-business.com/

article/06109: Suddenly, half the world’s human population is

urban. Get ready for cosmopolitan, thriving new cities.

The Future of Advertising Is Now

Christopher Vollmer, John Frelinghuysen, and RandallRothenberg, Summer 2006, www.strategy-business.com/

article/06204: After years of overhype, the digital revolution

finally came — and marketers learned to adapt.

The Neuroscience of Leadership

David Rock and Jeffrey Schwartz, Summer 2006, www.strategy-

business.com/article/06207: Change is pain, behaviorism

doesn’t work, focus is power, and attention changes the brain.

The Flatbread Factor

Alonso Martinez and Ronald Haddock, Spring 2007, www

.strategy-business.com/article/07106: Emerging markets, from

China to Brazil, have strikingly similar life cycles.

Lights! Water! Motion!

Viren Doshi, Gary Schulman, and Daniel Gabaldon, Spring 2007,

www.strategy-business.com/article/07104: The world’s energy,

water, and transportation infrastructure needs a US$40 trillion

makeover.

The Empty Boardroom

Thomas Neff and Julie Hembrock Daum, Summer 2007,

www.strategy-business.com/article/07206: Corporate board

recruits with CEO experience are in short supply — and that’s

good news.

Oasis Economies

Joe Saddi, Karim Sabbagh, and Richard Shediac, Spring 2008,

www.strategy-business.com/article/08105: Open, diversified

economics is a new force for stability in the Middle East.

The Next Industrial Imperative

Peter Senge, Bryan Smith, and Nina Kruschwitz, Summer 2008,

www.strategy-business.com/article/08205: The industrial era is

bursting like a bubble; climate change is just the advance signal.

The Library Rebooted

Scott Corwin, Elisabeth Hartley, and Harry Hawkes, Spring 2009,

www.strategy-business.com/article/09108: These critically

important institutions are redesigning their business models for

the digital age.

The Best Years of the Auto Industry Are Still to Come

Ronald Haddock and John Jullens, Summer 2009, www

.strategy-business.com/article/09204: Millions of new

automobiles will be sold in emerging markets.

Too Good to Fail

Ann Graham, Spring 2010, www.strategy-business.com/

article/10106: India’s Tata, a giant and diverse conglomerate,

bases its global strategy on social entrepreneurship.

Why We Hate the Oil Companies

John Hofmeister, Summer 2010, www.strategy-business.com/

article/10207: How corporate leaders create their reputations for

arrogance, by a former CEO of Shell Oil.

Articles of Significance

S+B

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