The 2% Com­pany: Ex­celling at Ef­fi­ciency and In­no­va­tion

Com­pa­nies that ex­cel at both ef­fi­ciency and in­no­va­tion share some key char­ac­ter­is­tics. And there are far too few of them.

Rotman Management Magazine - - CONTENTS - By Knut Haanaes, Martin Reeves and Jules Wur­lod

Com­pa­nies that ex­cel at both ef­fi­ciency and in­no­va­tion share some key char­ac­ter­is­tics. And there are far too few of them.

VERY FEW COM­PA­NIES ex­cel at in­no­va­tion and ef­fi­ciency at the same time. Of the 2,500 pub­lic com­pa­nies we re­cently an­a­lyzed, just two per cent con­sis­tently out­per­form their peers on both growth and prof­itabil­ity dur­ing good and bad times. Th­ese ‘2% com­pa­nies’, as we call them, are able to re­new them­selves in large part by driv­ing ex­plo­ration and ex­ploita­tion si­mul­ta­ne­ously.

Be­ing ex­cel­lent at both ex­plo­ration (the quest for new ideas and in­no­va­tion) and ex­ploita­tion (op­er­a­tional ef­fi­ciency) is par­tic­u­larly chal­leng­ing be­cause th­ese ac­tiv­i­ties pull a com­pany in dif­fer­ent direc­tions. They re­quire dif­fer­ent skills, dif­fer­ent ap­proaches to per­for­mance man­age­ment, and an abil­ity to drive suc­cess with dif­fer­ent time per­spec­tives. Each is also a po­ten­tial trap in its own way: Pur­su­ing too much in­no­va­tion tempts com­pa­nies to seek fur­ther change be­fore they see the ben­e­fits of the ini­tial change; and con­versely, op­er­a­tional suc­cess makes it more dif­fi­cult to make time to ex­plore. Fol­low­ing are a few ex­am­ples of how com­pa­nies man­i­fest their ‘2% sta­tus’ in very dif­fer­ent ways:

• Fash­ion re­tailer Zara has de­vel­oped ‘fast fash­ion’ DNA that com­bines adap­tive in­no­va­tion with speed-to-store. It con­sis­tently taps into un­pre­dictable changes in taste through ex­cel­lence in de­sign agility and fos­ters con­tin­u­ous im­prove­ments in ef­fi­ciency through a very tight sup­ply chain.

• Ama­zon CEO Jeff Be­zos con­stantly pushes for a cul­ture of in­no­va­tive think­ing through his ‘day one’ mantra—stress­ing how the com­pany should never stop be­hav­ing like a start-up. In par­al­lel, the global re­tailer is able to drive ef­fi­ciency by build­ing an ever-tighter cus­tomer in­sight, lo­gis­tics and de­liv­ery op­er­a­tion.

• Toy­ota has been on a long-term quest to de­velop new prod­ucts (such as hy­brid en­gines) and con­tin­u­ously im­prove its lean man­u­fac­tur­ing sys­tem. By play­ing the long game, it has shown that grad­ual im­prove­ments in qual­ity and man­u­fac­tur­ing can be com­bined with break­through in­no­va­tion and in­dus­try shap­ing.

Th­ese and other 2% com­pa­nies share four traits:

1. THEY ARE HIGHLY SKILLED AT BOTH EX­PLO­RATION AND EX­PLOITA­TION. They con­tin­u­ally re­think and re­vise their strate­gies and op­er­at­ing mod­els while im­prov­ing their cur­rent prod­ucts and op­er­a­tions.

2. THEY RE­TAIN AN ‘OUT­SIDE-IN’ FO­CUS, EVEN WHEN THEY BE­COME SUC­CESS­FUL. By bring­ing out­side per­spec­tives in, they avoid suc­cumb­ing to the risks posed by suc­cess and growth, which, al­though they are pos­i­tive and de­sired out­comes, tend to in­crease or­ga­ni­za­tional com­pli­ca­tion and push com­pa­nies to­wards

an in­ter­nal fo­cus. In a rapidly chang­ing en­vi­ron­ment, any com­pany with too much of an ‘in­ward gaze’ will fail to de­tect fun­da­men­tal ex­ter­nal mar­ket changes.

3. THEY EM­BRACE NEC­ES­SARY DIS­RUP­TIONS (EVEN IF PAINFUL). They also im­plies de­pri­or­i­tiz­ing pre­vi­ously prof­itable busi­nesses to bet on fu­ture growth ar­eas and build early-mover ad­van­tages.

4. THEY HAVE A CLEAR MODEL FOR RE­NEWAL. Re­newal mod­els help to man­age the in­evitable trade-offs be­tween short- and longterm ob­jec­tives. They also fit spe­cific busi­ness en­vi­ron­ments and or­ga­ni­za­tional ca­pa­bil­i­ties. For in­stance, in in­dus­tries where dis­rup­tion is im­mi­nent but di­rec­tion­ally un­clear and when goto-mar­ket ca­pa­bil­i­ties are strong, com­pa­nies can cap­i­tal­ize on in­no­va­tion from out­side by scan­ning the mar­ket for rel­e­vant in­no­va­tions, bring­ing them in-house and com­mer­cial­iz­ing them. This al­lows them to build an early-mover ad­van­tage while avoid­ing the risk of go­ing full steam in the wrong di­rec­tion.

Be­com­ing Part of the 2%

Hav­ing stud­ied th­ese com­pa­nies closely, we have de­vel­oped three prin­ci­ples for get­ting your or­ga­ni­za­tion into the 2% club.

PRIN­CI­PLE 1: MAIN­TAIN AN ‘OUT­SIDE-IN’ FO­CUS, EVEN AMIDST SUC­CESS

Dis­rup­tion usu­ally comes from the out­side, and be­ing too in­ward-look­ing puts com­pa­nies at risk of miss­ing key cus­tomer or mar­ket trends. The 2% com­pa­nies don’t just ex­cel at both ex­plo­ration and ex­ploita­tion ac­tiv­i­ties, they also man­age to keep an ex­ter­nal (out­side-in) fo­cus, even as they suc­ceed. This is not as easy as it seems, be­cause suc­cess­ful en­ter­prises very of­ten be­come ‘in­tro­verted’. His­tory is paved with ex­am­ples of com­pa­nies that reached the top of their in­dus­try but failed to re­main there. Just think of Mo­torola, Block­buster, Dell, Nokia and Ko­dak.

Some cur­rent in­dus­try lead­ers — flush with cur­rent suc­cess — might be over­look­ing emerg­ing threats. Tra­di­tional banks, for ex­am­ple, may be un­der­es­ti­mat­ing fin­techs. A re­cent re­port from the Bank of Eng­land found that tra­di­tional banks be­lieve they can cope with fin­tech com­pe­ti­tion with­out mak­ing big changes to their ex­ist­ing mod­els or tak­ing on more risk — but also that fin- techs may cause greater and faster dis­rup­tion to their busi­ness mod­els than the banks them­selves project.

When suc­cess­ful com­pa­nies grow, so do the breadth and depth of their busi­ness re­quire­ments. As a re­sponse, they tend to cre­ate ded­i­cated struc­tures, pro­cesses, sys­tems and met­rics that in­crease the com­plex­ity fac­tor of the or­ga­ni­za­tion. Sig­nif­i­cant re­sources and at­ten­tion must then be de­voted to in­ter­nal man­age­ment.

Suc­cess can also make com­pa­nies look in­ward be­cause, by gen­er­at­ing too much free cash flow for al­lo­ca­tion, it can ex­ac­er­bate an agency prob­lem. Man­agers might push to keep as many re­sources as pos­si­ble un­der their con­trol and thus in­vest all ex­tra cash in projects in-house, while in con­trast, board mem­bers might want to max­i­mize the pay­off for share­hold­ers and thus avoid in­vest­ing in projects that grad­u­ally be­come, ac­cord­ing to the law of di­min­ish­ing re­turns, less at­trac­tive.

Main­tain­ing an out­side-in per­spec­tive starts by con­tin­u­ously scan­ning the mar­ket, both de­mand and sup­ply. On the de­mand side, suc­cess­ful com­pa­nies must see them­selves through the eyes of the cus­tomer and con­stantly look out for early signs of po­ten­tial mega­trends. On the sup­ply side, they must be will­ing and able to en­gage in part­ner­ships and col­lab­o­ra­tions.

For ex­am­ple, in 2011, Umi­core, a Bel­gian met­als and min­ing com­pany, wanted to ex­pand its re­cy­cling ac­tiv­i­ties in or­der to re­cover rare earth el­e­ments from recharge­able bat­ter­ies. The com­pany pos­sessed a state-of-the-art bat­tery-re­cy­cling process — the Ul­tra High Tem­per­a­ture (UHT) process — but lacked the ca­pa­bil­i­ties to re­fine rare earth el­e­ments. It thus part­nered with Rho­dia, a French chem­i­cal com­pany, and to­gether, the two com­pa­nies de­vel­oped the first in­dus­trial process that closed the loop on the rare earths con­tained in bat­ter­ies. The fact is, break­through in­no­va­tion is rarely per­formed by a sin­gle ac­tor from end-to-end. Par­tic­i­pa­tion in rel­e­vant part­ner­ships, plat­forms or ecosys­tems can be key.

PRIN­CI­PLE 2: EM­BRACE DIS­RUP­TION

When dis­rup­tive shocks hit, they must be fully em­braced — but do­ing so first re­quires com­pa­nies to rec­og­nize risks. Strate­gic de­ci­sion-mak­ing in the con­text of risk can be sub­ject to

Main­tain­ing an out­side-in per­spec­tive starts by con­tin­u­ously scan­ning the mar­ket, both de­mand and sup­ply.

mul­ti­ple cog­ni­tive bi­ases. One ex­am­ple is loss aver­sion, whereby the thought of los­ing some­thing one cur­rently has is more painful than not tak­ing ad­van­tage of a new op­por­tu­nity for gain. As a re­sult of this com­mon bias, there is a ten­dency to over-value cur­rent busi­ness mod­els com­pared with new, dis­rup­tive mod­els and their op­por­tu­ni­ties. To side­step this prob­lem, com­pa­nies must be bru­tally hon­est and rec­og­nize that mar­ket con­di­tions will not re­main the same for­ever; they never do. Prof­itable busi­nesses in­evitably at­tract po­ten­tial en­trants with in­no­va­tive busi­ness mod­els.

In prac­tice, fully em­brac­ing dis­rup­tion means that at times, com­pa­nies must re­spond by be­ing dis­rup­tive them­selves, rather than mak­ing small in­cre­men­tal fixes to their cur­rent model. Tobacco com­pa­nies un­der­stood this when they in­vested mas­sively in elec­tronic cig­a­rettes. Eci­garettes have been around for nearly 30 years, but they gained strong mo­men­tum only re­cently, pushed by small emerg­ing play­ers such as V2, Juul and Mig Va­por. Large tobacco com­pa­nies de­cided to em­brace dis­rup­tion by bring­ing to mar­ket their own so­lu­tions. Philip Mor­ris In­ter­na­tional (PMI), for ex­am­ple, in­vested about US$ 3 bil­lion to de­velop its Iqos — de­spite the high can­ni­bal­iza­tion risk to its cur­rent busi­ness. PMI’S CEO An­dré Calant­zopou­los has even de­clared that this new technology will even­tu­ally fully re­place tra­di­tional cig­a­rettes. Else­where, when tele­com com­pa­nies faced the ar­rival of mo­bile tech­nolo­gies, they could have re­sponded ei­ther by in­cre­men­tally re­fin­ing their old land­line busi­ness or by us­ing those in­no­va­tive mo­bile tech­nolo­gies them­selves to be­come part of the dis­rup­tive force. In the longer term, only the lat­ter ap­proach would en­able them to re­al­ize the full ben­e­fits of dis­rup­tion.

Over­all, when dis­rup­tion hits, ma­jor com­mit­ments must be made, and that might mean de­pri­or­i­tiz­ing prof­itable ac­tiv­i­ties to fo­cus re­sources — man­age­ment at­ten­tion, tal­ent or fi­nan­cial re­sources — on dis­rup­tive trends. Neste, a Fin­nish oil-re­fin­ing com­pany, in­vested heav­ily in re­new­able-diesel pro­duc­tion, fore­see­ing reg­u­la­tory changes in the EU that would cre­ate a mar­ket for diesel made from re­new­able sources. The firm de­vel­oped a technology that al­lows it to pro­duce diesel from veg­etable oils and waste an­i­mal fats. With this technology, it is pos­si­ble to slash CO2 emis­sions by 40 to 60 per cent. This strat­egy has paid off: Thanks to high mar­gins, re­new­able prod­ucts have reached close to 50 per cent of its to­tal op­er­at­ing mar­gin, for ap­prox­i­mately 20 per cent of to­tal rev­enue.

PRIN­CI­PLE 3: HAVE THE RIGHT MODEL FOR RE­NEWAL

The 2% com­pa­nies have an ex­plicit model for man­ag­ing the in­evitable trade-offs be­tween near- and long-term pri­or­i­ties. The right model for the sub­se­quent re­newal also op­ti­mally lever­ages the ca­pa­bil­i­ties of the com­pany and fits the or­ga­ni­za­tional cul­ture. Need­less to say, th­ese mod­els are com­pany spe­cific and there is no ‘one size fits all’; but we have iden­ti­fied a few com­mon ex­am­ples.

• THE SPE­CIFIC TIME­FRAME MODEL.In this model, com­pa­nies de­fine a spe­cific time hori­zon and op­er­ate within this win­dow to op­ti­mize their ex­ist­ing prod­uct port­fo­lio and pur­sue ex­plo­ration ac­tiv­i­ties ac­cord­ingly. This can be a good strat­egy if, for ex­am­ple, man­age­ment has lim­ited long-term pri­or­i­ties, can pre­dict the near fu­ture fairly con­fi­dently, has the re­sources to in­vest in the de­sired prod­uct en­hance­ments, and be­lieves that build­ing th­ese en­hance­ments up­front will de­liver a com­pet­i­tive ad­van­tage. Pri­vate eq­uity firms are good ex­am­ples of busi­nesses that in­vest to cre­ate value within a de­fined time win­dow — usu­ally three to five years. When tak­ing on a com­pany, they will do the ex­plo­ration that cre­ates vis­i­ble value in the medium term.

•THE NO-RE­GRETS MODEL. This strat­egy means mak­ing sure that your com­pany en­coun­ters no sur­prises in its mar­ket do­main. Com­pa­nies need to iden­tify the do­main they are play­ing in and then, within it, en­gage a wide va­ri­ety of tech­no­log­i­cal op­tions. By adopt­ing this strat­egy, they guar­an­tee an early-mover ad­van­tage, what­ever win­ning op­tion the mar­ket ul­ti­mately picks. Com­pa­nies need to be able to rec­og­nize win­ners early by pick­ing up weak sig­nals. A case in point: Es­silor, the world leader in eye­glass lenses, has proved that it can stay suc­cess­ful by con­tin­u­ously scan­ning and en­gag­ing with all nov­el­ties in its do­main that might dis­rupt the in­dus­try. With this strat­egy, the com­pany has suc­cess­fully caught

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