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Beating the Odds in the Strategy Room

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Several times a year, top management teams enter the strategy room with lofty goals and the best of intentions: they hope to assess their situation and prospects honestly, and mount a decisive, coordinated response toward a common ambition.

Then reality intrudes. By the time they get to the strategy room, they find it is already crowded with egos and competing agendas. Jobs—even careers—are on the line, so caution reigns. The budget process intervenes, too. You may be discussing a five-year strategy, but everyone knows that what really matters is the first-year budget.

So, many managers try to secure resources for the coming year while deferring other tough choices as far as possible into the future. One outcome of these dynamics is the hockey-stick projection, confidently showing future success after the all-too-familiar dip in next year’s budget. If we had to choose an emblem for strategic planning, this would be it.

In recent times, there are strategies set up out to help companies unlock the big moves needed to beat the odds. Another strategy framework? No, there are already plenty of those. Rather, the need to address the real problem: the “social side of strategy,” arising from corporate politics, individual incentives, and human biases. How? With evidence.

The social side of strategy

Nobel laureate Daniel Kahneman described in his book Thinking, Fast and Slow the “inside view” that often emerges when we focus only on the case at hand. This view leads people to extrapolate from their own experiences and data, even when they are attempting something they’ve never done before. The inside view also is vulnerable to contamination by overconfidence and other cognitive biases, as well as by internal politics.

It’s well known by now that people are prone to a wide range of biases such as anchoring, loss aversion, confirmation bias, and attribution error. While these unintentional mental shortcuts help us filter information in our daily lives, they distort the outcomes when we are forced to make big, consequential decisions infrequently and under high uncertainty—exactly the types of decisions we confront in the strategy room.

When you bring together people with shared experiences and goals, they wind up telling themselves stories, generally favorable ones. A study found, for instance, that 80 percent of executives believe their product stands out against the competition—but only 8 percent of customers agree.

Then, add agency problems, and the strategy process creates a veritable petri dish for all sorts of dysfunctions to grow. Presenters seeking to get that all-important “yes” to their plans may define market share so it excludes geographies or segments where their business units are weak, or attribute weak performance to one-off events such as weather, restructuring efforts, or a regulatory change.

Executives argue for a large resource allotment in the full knowledge that they will get negotiated down to half of that. Egos, careers, bonuses, and status in the organization all depend to a large extent on how convincingly people present their strategies and the prospects of their business.

That’s why people often “sandbag” to avoid risky moves and make triple sure they can hit their targets. Or they play the short game, focusing on performance in the next couple of years in the knowledge that they likely won’t be running their division afterward. Emblematic of these strategy-room dynamics is the hockey-stick presentation. Hockey sticks recur with alarming frequency, as the experience of a multinational company, whose disguised results appear in Exhibit 1, demonstrates.

The company planned for a breakout in 2011, only to achieve flat results. Undeterred, the team drew another hockey stick for 2012, then 2013, then 2014, then 2015, even as actual results stayed roughly flat, then trailed off.

EXH 1

To move beyond hockey sticks and the social forces that cause them, the CEO and the board need an objective, external benchmark.

The odds of strategy

The starting point for developing such a benchmark is embracing the fact that business strategy, at its heart, is about beating the market; that is, defying the power of “perfect” markets to push economic surplus to zero. Economic profit—the total profit after the cost of capital is subtracted—measures the success of that defiance by showing what is left after the forces of competition have played out.

From 2010 to 2014, the average company in our database of the world’s 2,393 largest corporations reported $920 million in annual operating profit. To make this profit, they used $9,300 million of invested capital, which earned a return of 9.9 percent. After investors and lenders took 8 percent to compensate for use of their funds, that left $180 million in economic profit.

Plotting each company’s average economic profit demonstrates a power law—the tails of the curve rise and fall at exponential rates, with long flatlands in the middle (Exhibit 2). The power curve reveals a number of important insights:

EXH 2

  • Market forces are pretty efficient. The average company in our sample generates returns that exceed the cost of capital by almost two percentage points, but the market is chipping away at those profits. That brutal competition is why you struggle just to stay in place. For companies in the middle of the power curve, the market takes a heavy toll. Companies in those three quintiles delivered economic profits averaging just $47 million a year.
  • The curve is extremely steep at the bookends. Companies in the top quintile capture nearly 90 percent of the economic profit created, averaging $1.4 billion annually. In fact, those in the top quintile average some 30 times as much economic profit as those in the middle three quintiles, while the bottom 20 percent suffer deep economic losses. That unevenness exists within the top quintile, too. The top 2 percent together earn about as much as the next 8 percent combined. At the other end of the curve, the undersea canyon of negative economic profit is deep—though not quite as deep as the mountain is high.
  • The curve is getting steeper. Back in 2000–04, companies in the top quintile captured a collective $186 billion in economic profit. Fast forward a decade and the top quintile earned $684 billion. A similar pattern emerges in the bottom quintile. Since investors seek out companies that offer market-beating returns, capital tends to flow to the top, no matter the geographic or industry boundaries. Companies that started in the top quintile ten years earlier soaked up 50 cents of every dollar of new capital in the decade up to 2014.
  • Size isn’t everything, but it isn’t nothing, either. Economic profit reflects the strength of a strategy based not only on the power of its economic formula (measured by the spread of its returns over its cost of capital) but also on how scalable that formula is (measured by how much invested capital it could deploy). Compare Walmart, with a moderate 12 percent return on capital but a whopping $136 billion of invested capital, with Starbucks, which has a huge 50 percent return on capital but is limited by being in a much less scalable category, deploying only $2.6 billion of invested capital. They both generated enormous value, but the difference in economic profit is substantial: $5.3 billion for Walmart versus $1.1 billion for Starbucks.
  • Industry matters, a lot. Our analysis shows that about 50 percent of your position on the curve is driven by your industry—highlighting just how critical the “where to play” choice is in strategy. Industry performance also follows a power curve, with the same hanging tail and high leading peak. There are 12 tobacco companies in our research, and 9 are in the top quintile. Yet there are 20 paper companies, and none is in the top quintile. The role of industry in a company’s position on the power curve is so substantial that it’s better to be an average company in a great industry than a great company in an average industry.
  • Mobility is possible—but rare. Here is a number that’s worth mulling: the odds of a company moving from the middle quintiles of the power curve to the top quintile over a ten-year period are 8 percent (Exhibit 3). That means just 1 in 12 companies makes such a leap. These odds are sobering, but they also encourage you to set a high bar: Is your strategy better than the 92 percent of other strategies?

EXH 3

The power of big moves

So what can you do to improve the odds that your company will move up the power curve? The answer is lurking in our data. Consider this analogy: To estimate a person’s income, we can start with the global average, or about $15,000 per year. If we know that the person is American, our estimate jumps to the average US per capita income, or $56,000. If we know that the individual is a 55-year-old male, the estimate jumps to $64,500. If that guy works in the IT industry, it jumps to $86,000. And if we know the person is Bill Gates, well, it’s a lot more than that.

Adding ever more information similarly helps to zero in on the probabilities of corporate success. Even if you know your overall odds, you need to understand which of your attributes and actions can best help you raise them. We identified ten performance levers and, importantly, how strongly you have to pull them to make a real difference in your strategy’s success. These levers were divided into three categories: endowment, trends, and moves. Your endowment is what you start with, and the variables that matter most are your revenue (size), debt level (leverage), and past investment in R&D (innovation). Trends are the winds that are pushing you along, hitting you in the face, or buffeting you from the side. The key variables there are your industry trend and your exposure to growth geographies. In analyzing the odds of moving on the power curve, we found that endowment determines about 30 percent and trends another 25 percent.

The moves that matter

However, it is your moves—what you do with your endowment and how you respond to trends—that make the biggest difference. Research reveals that the following five moves, if pursued persistently, can get you to where you want to go:

  • Programmatic M&A. You need a steady stream of deals every year, each amounting to no more than 30 percent of your market cap but adding over ten years to at least 30 percent of your market cap.
  • Dynamic reallocation of resources. Winning companies reallocate capital expenditures at a healthy clip, feeding the units that could produce a major move up the power curve while starving those unlikely to surge. The threshold here is reallocating at least 50 percent of capital expenditure among business units over a decade.
  • Strong capital expenditure. You meet the bar on this lever if you are among the top 20 percent in your industry in your ratio of capital spending to sales. That typically means spending 1.7 times the industry median.
  • Strength of productivity program. This means improving productivity at a rate sufficient to put you at least in the top 30 percent of your industry.
  • Improvements in differentiation. For business-model innovation and pricing advantages to raise your chances of moving up the power curve, your gross margin needs to reach the top 30 percent in your industry.

Greater than the sum of the parts

Big moves are most effective when done in combination—and the worse your endowment or trends, the more moves you need to make. For companies in the middle quintiles, pulling one or two of the five levers more than doubles their odds of rising into the top quintile, from 8 percent to 17 percent. Three big moves boost these odds to 47 percent.

Patterns of movement

You should be mindful of several dynamics when undertaking major strategic moves. First, research shows that really big moves can “cancel out” the impact of a poor inheritance. Making strong moves with a poor inheritance is about as valuable as making poor moves with a strong inheritance.

And even small improvements in odds have a dramatic impact on the expected payoff, owing to the extremely steep rise of the power curve. For example, the probability-weighted expected value of a middle-tier company increasing its odds to 27 percent from the average of 8 percent is $123 million—nearly three times the total average economic profit for mid-tier companies.

Big moves are also nonlinear, meaning that just pulling a lever does not help; you need to pull it hard enough to make a difference. For instance, productivity improvements that are roughly in line with the improvement rates of your industry won’t provide an upward boost. Even if you are improving on all five measures, what matters is how you stack up against your competitors.

And four of the five big moves are asymmetric. In other words, the upside opportunity far outweighs the downside risk. While M&A is often touted as high risk, for example, in reality programmatic M&A not only increases your odds of moving up the curve but simultaneously decreases your odds of sliding down. Capital expenditures is the one exception. By increasing capital expenditures, your chances of going up on the power curve increase, but so do the chances of dropping.

In general, making no bold moves is probably the most dangerous strategy of all. You not only risk stagnation on the power curve but also miss out on the additional reward of growth capital, which mostly flows to the winners.

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Are we long—or short—on talent?

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  • By looking at their supply of skills and talent in a new light today, organizations can take actions that better prepare their companies for tomorrow’s challenges.

 

CEOs and HR leaders worried about the viability of their talent strategy may be excused an occasional sleepless night. After all, there’s a closetful of bogeymen to pick from as disruptive technologies such as digitization, automation, and artificial intelligence combine with demographic forces to continue transforming the nature of work, how it gets done, and by whom. The resulting job displacement could be massive—think Industrial Revolution massive—affecting as many as 800 million people globally by 2030 and requiring up to 375 million of them to switch occupational categories and learn new skills.

Companies are already feeling the heat. Fully 60 percent of global executives in a recent survey expect that up to half of their organization’s workforce will need retraining or replacing within five years. An additional 28 percent of executives expect that more than half of their workforce will need retraining or replacing. More than one-third of the survey respondents said their organizations are unprepared to address the skill gaps they anticipate.

The competitive implications are profound. Organizations that expect to benefit from a digital transformation or a promising new strategy won’t get very far if they lack the people to bring the plans to life. What might seem like an irritating talent gap today could prove a fatal competitive liability in the not-too-distant future.

 

How can organizations better prepare for what’s coming?

For starters, they should embrace a more expansive and dynamic view of their talent supply—one that tosses out the usual preoccupation with titles and traditional roles and looks instead at the underlying skills people have. Indeed, we find that when companies start with skills—the ones they need, the ones they have, and how the mix may change over time—they can free up their thinking and find more creative ways to meet the inevitable mismatches.

In this narrative, we’ll show how forward-looking organizations are grappling with these challenges and highlight ways that CEOs and senior leaders can spark progress that is tangible, practical, and quite often beneficial for both employer and employee alike. Oftentimes, taking the first step can be as simple as asking: For our five most important skills, are we long—or short—on talent?

 

Shift happens

Consider the European bank whose market position was threatened by new, more digitally savvy rivals. The shifting competitive landscape required action, but when the bank’s leaders compared their proposed strategic response with a three-year projection of the bank’s talent pool, they saw a mismatch. The plan made sense, but executives feared that their people couldn’t execute it.

For example, the bank would soon have serious skill gaps in its retail-banking unit, particularly among branch managers whose roles needed to change to encompass areas such as sales expertise, customer orientation, and digital capabilities, given the new strategy. Meanwhile, the bank’s IT group faced both undersupply and oversupply: programming skills would be too scarce, while IT infrastructure skills would be too plentiful. To complicate matters, the bank faced strict regulatory and labor restrictions that prevented most layoffs. Any solutions would require flexibility and creative thinking.

To respond to the imbalances, the bank developed a range of interventions. For example, the bank is rolling out upskilling programs to help prepare its retail bankers for the aspects of their jobs that are changing; elsewhere, reskilling and retraining programs (including new digital and analytical skills) are helping employees’ secure new roles in the company. Still other employees have been offered part-time positions, an option intended to appeal to those nearing retirement.

Finally, for some employees, the bank is exploring secondment opportunities with selected not-for-profit organizations. Under the arrangement, both organizations pay a portion of the employee’s salary. In principle, this benefits everyone: the not for profit (which gets a talented employee for less money), the employees (who are doing meaningful work using skills that are in high demand), and even the bank (which pays less for skills it already has in surplus, while potentially enhancing its visibility in the community).

While the bank’s overall approach is still a work in progress, its example is instructive not only for its breadth but also for the outlook of its leaders. Instead of just looking at its talent supply through the lens of its traditional jobs or roles, which after all are changing, the bank’s executives pushed themselves to take a more objective, skills-based look. Similarly, the bank’s experience underscores the importance of setting aside long-held assumptions about which roles are most important, as prevailing opinion may be outdated or biased.

 

Are we long—or short—on talent?

Adjusting the skills of a workforce requires a blend of rigor and creativity; it also requires dedicated commitment and attention from senior management. One way to spark a fruitful C-suite conversation about talent supply is to borrow a page from the dismal science and look at skills in the context of surplus and shortage.

Starting with a thought exercise such as this can help break down an otherwise intractable problem into smaller chunks that can be approached with discipline. At the same time, testing potential interventions using the logic of microeconomics can help managers see a wider portfolio of options beyond reskilling at one extreme, and layoffs at the other (exhibit).

 

The following snapshots highlight ways that organizations have addressed both talent gaps and overages.

 

 

We’re short on talent: Build, acquire, or rent?

While talent shortfalls arise for many reasons, the supply-side remedies can be summarized in just three watchwords: Should we build on our existing skills? Should we acquire them? Or should we “rent” them?

A global manufacturer investigated these options as it looked for ways to fill several looming skill gaps. One of the most acute shortfalls was in data science, a problem complicated by the company’s suspicion that it was losing ground to high-tech firms as an employer of choice.

On closer look, their fears were justified: a talent-supply forecast that used machine learning to predict the likelihood of employee attrition found the company’s data scientists would be eight times more likely to leave than other colleagues. Clearly, the company couldn’t simply hire its way out of the problem; filling the skill gap would also require better employee retention.

Subsequent analysis helped the manufacturer spot opportunities in both areas, starting with a plan for more meritocratic career paths and redesigned leadership tracks to keep employees engaged and happy. The company is now working on simple changes to its recruiting and interviewing processes, to be more responsive and to help make candidates feel more valued throughout the process.

Of course, another way that companies can acquire skills en masse is through M&A, an approach pioneered in the tech industry, where it was given the portmanteau “acquihiring.” It has since become more common in other industries. Walmart used it in 2011 when the company bought Kosmix, a social-media company, to form the nucleus of what would become Walmart Labs, the retailer’s digital-technology unit.

Companies can also start nurturing skills today that they may benefit from later. Programs such as this are intriguing to employers, because it lets them tap a new pool of talent and then create and shape the specific skills they need. The approach also holds considerable social promise, as it can be designed to support underemployed groups, such as young people or military veterans.

Finally, companies can obtain skills by “renting” talent; for example, through outsourcing partnerships that bring specialized skills or by tapping the gig economy, where the rise of digital platforms has rightly captured executives’ attention.

 

We’re long on talent: Redeploy—or release?

Invariably, the changing nature of work will create skill overages that even the most inspired corporate upskilling or reskilling programs can’t manage. In these cases, companies must choose whether to redeploy workers or to find thoughtful ways to let them go.

As the case of the European bank demonstrated, there may be regulatory reasons to consider the redeployment of workers by offering their skills to a third-party organization for a fee. There might also be cultural, financial, strategic, or even social reasons for redeploying skills.

In the private sector, meanwhile, the video-game industry has long “loaned out” the specialized skills of software engineers to other video-game companies, including competitors, when their own projects hit unforeseen snags. While the approach may seem counterintuitive, the arrangement helps the sponsoring company maintain ready access to skills that are particularly rare and hard to recover once lost. The engineers, meanwhile, appreciate the change of pace and the chance to work on high-visibility projects with talented counterparts.

To be sure, redeployment programs such as these tend to be the exception rather than the rule. And no program can forestall all the job separations that come with technological change.

 

Work, Adapt, Repeat

The nature of the evolving workplace confronts leaders with the need to think quite differently about people’s relationship to work. In this vein, we are particularly intrigued by concepts such as “lifelong employability” that prioritize helping people successfully adapt—again and again, if necessary—as the economy evolves.

Yet if companies are to bring ideas such as these to fruition, and truly reorient their organizations around skills and not just roles, they will need more than just a mind-set shift. Many, if not most, companies will find their people-operations infrastructure and talent-management system creaking under the strain of new challenges. Designing a winning employee value proposition, for instance, is much harder when career paths are themselves in flux.

Indeed, HR will need to sharpen its own skills, not only in traditional areas, like employee retention and performance management, but also in new ones, such as managing the risks associated with gig work. In this respect, HR leaders are no different from those in any other function—all of whom must be prepared to evolve if they are to be effective in helping the larger enterprise adapt to the changing nature of work.

 

  • By Megan McConnell and Bill Schaninger

 

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