A fresh look at strategy under uncertainty:
An interview
Although even the highest levels of uncertainty don’t prevent businesses from analyzing predicaments rationally, says author Hugh Courtney, the financial crisis has shown us the limits of our tools—and minds.
McKinsey Quarterly, DECEMBER 2008

I am trying to share with our community the importance of dealing with uncertainty in general but particularly in these times. It is one of the most critical components to driving affordable and efficient innovation. You will see more on this topic going forward.

Hugh Courtney’s book, 20/20 Foresight: Crafting Strategy in an Uncertain World, was published the day before the terrorist attacks of September 11, 2001. As the economist and former McKinsey associate principal recalls, in the following weeks interviewers often asked him, “Does this change everything? Is this stuff still valid? The world is so much more uncertain.” Says Courtney, “The honest answer then was that the only thing that had changed was our perception of risks and uncertainties that were always there. And it’s the same answer I give today about the current global business and financial situation.”

One of Courtney’s contributions to the literature of strategy was a four-part framework to help managers determine the level of uncertainty surrounding strategic decisions. In level one, there is a clear, single view of the future; in level two, a limited set of possible future outcomes, one of which will occur; in level three, a range of possible future outcomes; and in level four, a limitless range of possible future outcomes. Courtney, an associate dean of executive programs and professor of the practice of strategy at the University of Maryland’s Robert H. Smith School of Business, discussed the relevance of this idea in a recent interview with the Quarterly.

The Quarterly: How do you evaluate the level of business uncertainty today?

Hugh Courtney: The financial crisis has actually brought greater clarity because it has forced us to recognize that we have a lot more level three and level four situations than we would have admitted a few months ago. They probably were there all along, yet the bias was toward thinking that issues were more at level one and level two. Specifically, we have learned how interdependent our financial markets are and how systemic failure in any important node of the network can work very rapidly through the system and bring liquidity to a halt. So our scenarios about the availability of capital around the world have changed significantly.
Maybe the world and the uncertainties we face haven’t changed all that much as a result of the financial crisis, but our perception of risks has. That means there is a real opportunity to rethink the way we make strategic decisions, the way we plan under uncertainty. We should realize that, across sectors, for most important decisions we’re actually pretty far to the right—levels three and four—in the uncertainty spectrum.

The Quarterly: What does that mean in practice for managers?

Hugh Courtney: Level four situations are, by definition, ones for which you can’t really bound the range of outcomes, because it’s anybody’s guess. I’m sure we’ve all felt a little bit of that in the last few months. So the question is, do you just have to wing it? Is that what strategic decision making comes down to? I don’t think that’s true at all, but level four does require a different mind-set.
From level one to level three, the presumption is that you can do some bottom-up analysis. You can figure out what the value drivers are and do some market research and some competitive intelligence. All this may not give you a precise forecast, but you’ll be able to bound the outcomes somehow. That’s impossible in level four situations, by definition. There’s just stuff that’s fundamentally unknowable—truly an ambiguous world. On the other hand, that doesn’t mean you can’t be rigorous in thinking through strategic decisions in level four. It just requires you to work backward from potential strategies to what you would have to believe about the future for those strategies to succeed. The classic example would be biotech—early-stage biotech investments have always faced level four uncertainty, because you’re playing with therapies with an ultimate commercial viability that is unknown. (Those who have taken our classes or been exposed to the Market Driven Growth process know we discuss tools (Options Management, Discovery Driven Planning, etc.) to deal with Risk Levels 2 to 4. The McKinsey 3 Horizon model we discuss also categorizes these risk levels – Horizon 1 initiatives are generally in Risk Level 1; Horizon 3 is clearly Risk Levels 3 and 4; while Horizon 2 deals with Risk Levels 2 and 3.)

The Quarterly: How does that play out?

Hugh Courtney: You could ask, “What’s the return on investment of starting up a lab in this particular therapy?” The answer would be, “Who knows?” Honestly, no amount of analysis would allow you to bound the ROI. But say you told me the following: “We’re thinking about investing in a lab to work on a therapy. The lab’s going to cost $10 million. Should we do it?” Of course, I could say, “Well, I don’t know.” But I could also work backward from that $10 million investment and reply along these lines: “Say you need a 15 percent return on that investment. I can develop a scenario about the conditions needed to achieve this—what you would have to believe about the probability of finding a viable treatment, the amount of time it would take to get to market, the physician uptake rate on that treatment, the compliance rate of patients over time, what you’d be able to price it at, for how long, and how long you’d have patent protection.” I could tell you all that. In fact, I could give you a range of scenarios, all of which will give you that 15 percent return.

Now, the reason that approach would be useful is that even though I can’t do any bottom-up analysis, I can look at analogies. There’s a whole history of drug development, and I can at least place those scenarios within the range of other outcomes in the past. Then I could tell you, for example, “We know now that this project would have to be the most successful drug launch in history to earn the return you want on that $10 million. I can’t say whether it’s going to play out that way, but are you willing to roll the dice given those odds?” Alternatively, “Hey, it only has to be as successful as the median drug-discovery process.” In other words, you can think about a level four problem in a very structured way. It’s just that your mind-set has to change from a bottom-up analysis based on the value drivers to one based on what we know from similar situations in the past. You don’t have to wing it. (This is a sanity check)

The Quarterly: Let’s say I’m a strategist for a financial-services company. How should I think about today’s uncertainty?

Hugh Courtney: This is a really interesting time because it provides unprecedented opportunities for the survivors. I think the fundamental strategic issues are whether there will continue to be benefits of scope and scale in financial services and whether there will be a big pure-play investment-banking industry in the future.
We learned very well with Glass–Steagall1 reform that the benefits of scope and scale are highly dependent on regulatory structure—that is, what you’re allowed to do with that scope and scale. For example, regulations will influence to what extent scope and scale will give you preferential access to low-cost capital, as well as how much you’re able to leverage and what you can and can’t do to hedge risks. And that’s why even the healthiest financial-services players today face tough strategic choices: they have the opportunity to make bold scope- and scale-building plays, yet the payoffs are highly reliant on future regulatory decisions that are up in the air.

The Quarterly: So what level of uncertainty does this represent?

Hugh Courtney: I imagine most of the leaders of the financial powerhouses understand the possible regulatory alternatives, and they’re well enough connected to people in Washington to see how this could play out. Potentially, it could be level two. There really are discrete alternatives, and there’s usually only a number of fairly well-defined ways to regulate any market environment. If you layer on top of this the fact that our political process tends to even out the extremes, maybe the range of alternatives is actually even narrower. So these are the sorts of things that can be bounded, and multiple scenarios can be run and quantified. The hard part for the decision makers is that even if you can define the scenarios, they have quite different implications for strategy. Still, the example illustrates why applying this kind of disciplined thinking is extremely helpful when you make such bets in uncertain times.

The Quarterly: What advice would you give to a chief strategy officer today?

Hugh Courtney: I would start with, “What were you doing in strategic planning before the financial crisis hit?” and “How well do you think it worked?” As I said, what’s changed is largely our perception of uncertainty. Most CSOs would reply, “Well, we had a pretty standard strategic-planning process. We did some industry analysis and market research and tried to do some long-term discounted cash flow on our opportunities. It was very financially driven and we felt it worked pretty well.” In the end, though, you would probably find that they were treating a lot of level three and four issues like level one and two issues and relying on the wrong tool kit. (Something I see all the time and it is a critical error)
So I would start with scenario-planning techniques—even though scenario planning has been around for decades, it’s still a niche tool in strategic-development and -planning efforts. The CSO and I would also talk about using analogies better. The basis of the analogy doesn’t have to be the exact thing you’ve done in the past, but it should be a similar space, geography, or basic business model that you can learn from. Many people today are asking what might be analogous situations, such as the Great Depression or the 1997 Asian financial crisis, and I really understand why they are focused on them: it’s a classic example of using level four reasoning when it’s hard to use any other.

Finally, this is a good time to rethink your planning process. Have you been doing strategic planning on an annual basis as a paper-pushing exercise? That will have to change. In the months to come, you’re going to have to make decisions very quickly on fundamental opportunities that may drive your earnings performance for the next decade or more, and you’ve got to be prepared to make these decisions in real time. That requires a continuous focus on market and competitive intelligence and far more frequent conversations—daily, if necessary—among the top team about the current situation. Senior executives already may be in closer contact because of the emergency they face, but that doesn’t necessarily imply that they have the raw material and the structure to work through strategic decisions systematically. These daily conversations have to move beyond getting through that day’s crisis to more fundamental strategic issues as well, because the decisions made today may open up or close off opportunities for months and years to come. (Remember the senior leadership focus from DuPont to conserve cash in our last posting. These times put much more pressure on senior leaders to “roll up their sleeves” to manage their companies.)

The Quarterly: Your book discusses the shaper and adapter models. How should strategists think about shaping and adapting in these times?

Hugh Courtney: That depends on how prepared or fortunate you were going into this downturn. No one player can shape the fundamental uncertainties that are driving global capital markets. Interdependent players all over the world are making decisions. No one player—not even a Warren Buffett—can say, “You know, I feel great about things,” and change the dynamics all that much. So in some sense, everyone has to adapt to that macro uncertainty.

When it comes to fundamental strategic decisions, the paradox is that for a lot of companies in the most uncertain environments, there’s actually very little uncertainty about what they’re going to do. The situation is very clear because of the condition of their balance sheets. They really have to hunker down. They just don’t have the degrees of freedom to think about fundamental changes in their strategy. (The DuPont example)
On the other hand, there are the fortunate few that have very healthy balance sheets, aren’t so dependent on financing today, and don’t hold a lot of bad assets. They have a real interest in shaping opportunities. Again, they cannot shape the macro environment; they must adapt to that. However, they can fundamentally reshape their industry landscapes with bold M&A plays, R&D that others can’t finance, and entry into new markets. They can make bold moves that may shape the way their markets and industries play out for many years to come by fundamentally changing the competitive dynamics or product positioning. They do have degrees of freedom and thus the opportunity to be successful shapers.

The Quarterly: Who are these fortunate few?

Hugh Courtney: They tend to be companies with business models that generate a lot of cash and don’t have much debt. That would include a lot of high-tech companies and service businesses in general, which tend to scale up through people rather than through $100 million plants. Similarly, some businesses in the energy, utilities, and telecom sectors rely on fully depreciated assets generating a lot of operating cash. So the fortunate companies are in sectors that have real cash cow businesses, even if these companies can’t completely escape the profitability and growth challenges that will be difficult for any company to avoid in the near future.

The Quarterly: Would your message be the same for companies in emerging markets like India and China?

Hugh Courtney: Yes, and in many cases the shaping opportunities are even greater. The fortunate companies are those that have healthy balance sheets and don’t need reliable, cheap financing right now, because such a reliance would put the brakes on a lot of current entrepreneurial efforts, particularly in countries like India and China. Some of the larger incumbents—the Tatas of the world—may have profound shaping opportunities in their home markets because a lot of global companies are going to retrench and pull back a little. These trends are at work in economies all around the globe, and companies with healthy balance sheets, the right capabilities, and a tolerance for risk can put together positions that could drive competitive advantage for years.

The Quarterly: How has your thinking changed since you wrote 20/20 Foresight?

Hugh Courtney: The financial crisis and 9/11 are wake-up calls to think about better management of risk and uncertainty. I find myself these days taking uncertainly more seriously. Remember, in the book I wrote that everyone should take uncertainty seriously, but day to day I fall into standard patterns that behavioral scientists have described—for example, I tend to have too much confidence in my ability to predict the future.

In the aftermath of the financial crisis, I’ve been thinking a lot about how these fundamental human cognitive biases influence everything we do in strategy development. We actually know more about the world today than we did a few months ago, because there’s information in the meltdown. But the message behind that information is really, “You fools, remember that you’re human.” Remember the biases that lead us to be overconfident in our ability to forecast the future. Remember that the most important decisions for most companies will truly be level three and, many times, level four decisions. Our standard strategic-planning tool kits—the ones that we are most comfortable with and that we learn in MBA programs—don’t do a really good job for that.
So we ought to pay attention to this wake-up call. Embrace uncertainty. Get to know it. In uncertainty lies great opportunity. If you don’t try to understand what’s separating the known from the unknown from the unknowable, you’re really missing out. You’re just playing roulette with big money—usually other people’s money. It behooves us to take uncertainty seriously and to fundamentally rethink the way we do strategic thinking and planning.

The McKinsey Quarterly

DuPont's Swift Response to the Financial Crisis
In an excerpt from his latest book, Ram Charan describes how CEO Charles Holliday Jr. activated a crisis management plan to fortify Dupont
By Ram Charan

Business Week

This is a story about corporate survival, not necessarily growth. These are not normal times and I applaud DuPont’s effort and wanted to share this with our blog community!

In Leadership in the Era of Economic Uncertainty: The New Rules for Getting the Right Things Done in Difficult Times (McGraw-Hill), renowned management consultant Ram Charan offers chief executives a detailed guide to surviving the worst financial and business crisis since the Great Depression. The key, Charan says, is "management intensity"—deep immersion in the operational details of the business and the outside world, combined with hands-on involvement and follow-through. (this is also true when focusing on major growth efforts)

Plans and progress must be revisited almost daily. Big-picture, strategic-level thinking cannot be abandoned, but every leader now must be involved, visible, and in daily communication with employees, customers, and suppliers. In this world, CEOs need detailed, up-to-date, and unfiltered information. And they have to act decisively when trouble looms. "If you don't prepare for the worst," says Charan, "you will put both your company and career at risk."

What follows is an excerpt from Charan's book that describes how one of his major clients, chemical and life sciences giant DuPont (DD) , has responded to the crisis. CEO Charles O. Holliday Jr. reacted with maximum speed, rallied his entire company to confront the emergency, and put a sharp focus on maintaining cash flow, which Charan considers the lifeblood of any company in a severe downturn.

The first clear sign that the economic crisis was spreading globally came to DuPont CEO Chad Holliday in early October of last year, while he was visiting a major customer in Japan. The CEO of the Japanese company, among the largest and most highly regarded in its global industry, told Holliday he was worried about his company's cash position. The Japanese boss had ordered his executives to conserve cash in case the financial contagion affected his ability to raise capital.
That conversation was a wake-up call. When Holliday's plane landed back in the U.S., he immediately summoned the six top leaders in his company to a meeting at 7 a.m. the next day. He asked them the following questions: How bad is it now? How bad could it get?

The answers that came back over the next few days were grim. The financial industry's problems were pervading many aspects of DuPont's business both at home and abroad. What had seemed to be a crisis of confidence on Wall Street had the potential to become a global crisis as panic swept Western Europe, Russia, and most of Asia. Credit was disappearing, leaving companies struggling to finance their operations.

Evidence of how serious the problems were becoming appeared in different places. Wilmington, Del., where DuPont has its headquarters, is usually a hotbed of legal activity: Many companies are chartered in the state, and corporate lawsuits are routinely filed in Delaware Court of Chancery in Wilmington. Yet bookings at the hotel DuPont owns in the city's downtown had plunged more than 30% in 10 days. Lawyers handling litigation for companies had canceled their reservations when their clients decided to settle their disputes and stop incurring legal fees.

SPRINGING INTO ACTION
More telling was the rate at which production at many companies was slowing. DuPont paint covers more than 30% of all American automobiles, and the company generally manufactures the paint less than 48 hours before it is sprayed on new cars. To maintain such a short lead time, the automobile companies share their production schedules with DuPont. Suddenly there weren't any production schedules. The automakers didn't know what they were going to produce in the face of collapsing sales.

Clearly it was time to take action.

DuPont has long stressed the paramount importance of contingency planning. Its Corporate Crisis Management plan, if invoked, instantly brings together senior managers to appraise the cause of the crisis and put appropriate disaster control procedures in place. The plan is seldom activated. It was used in the wake of the September 11 attacks and in the aftermath of major hurricanes.

Holliday had to weigh whether the gathering financial storm was serious enough to warrant implementing the plan or whether declaring a crisis might frighten the company's 60,000 employees needlessly. As the evidence of a deepening economic downturn quickly mounted, he decided that activating Corporate Crisis Management was right.

Immediately, 17 standing teams met at DuPont headquarters. Over four days of meetings, it became clear that the nature of the crisis was strictly financial, and eight teams—those that dealt with such issues as security and plant safety—stood down. At the end of the four days, the remaining nine had determined what needed to be done to ensure DuPont's viability. It was time to let the troops around the world know what was going on.

Holliday enlisted the company's chief economist and the head of its pension fund, both of whom are highly regarded in the organization, to explain in nontechnical language the roots of the crisis and the way it was affecting DuPont. (Selecting a person who is highly respected is critical)The pension fund manager also took time to develop some instructional material advising employees about investment options for their $18 billion in retirement funds.

Within 10 days of the crisis plan's creation, every employee in DuPont had a face-to-face meeting with a manager who explained what the company needed to accomplish. Employees were asked to identify three things they could do immediately to help conserve cash and reduce costs. Within a few days after the communications program was rolled out, the company conducted polling to see how well employees understood the nature of the crisis and to determine their psychological reaction. Were they scared, or were they energized and ready to confront the crisis? The company also wanted to see whether the rank and file were doing what they needed to be doing.

TOO CONFIDENT?
Overall, the employees seemed to get it. It helped that the news media were full of stories about the developing financial crisis. The actions aimed at conserving cash took hold quickly. Travel was curtailed sharply, internal meetings were canceled, and consultants and contractors were eliminated where possible. (this is the easy stuff)

Yet Holliday felt people still didn't grasp the urgency with which they needed to be acting. "In hindsight, maybe we were too good at giving them the reassurance and confidence that we could come through this," Holliday says. "We gave them so much confidence that they just weren't responding as fast as the slowdown demanded." (very interesting)

Together with his chief operating officer and chief financial officer, Holliday took the time to spend an hour and a half with each of the company's top 14 leaders. They were asked to explain what they were doing to cope with the crisis. They all brought long lists, and it seemed they were doing a lot. But the problem was how fast it was getting done. "They were talking about things that would be implemented by January or February, but they were things we needed implemented in October," Holliday says. So Holliday and his senior team assigned the executive vice-presidents sharply revised targets for cost, working capital, and other metrics for the rest of 2008 as well as the first quarter of 2009. (often goals have to be set top down)

Even as immediate measures were being taken, DuPont had three top executives looking at longer-term actions the company needed to embrace. (see my comments at the end) It would take a while to figure out which production facilities could be closed permanently or shut temporarily to reduce costs. So the fastest way to save the most cash was to cut back as much as possible on the more than 20,000 outside contractors the company was using. In most cases a contractor could be released with one week's notice and without any severance costs. Where possible, employees whose operations were slowing or would be closed were shifted into what was formerly contract work.

DuPont's initial reaction to the spreading crisis took place in less than six weeks. (I spent 30 wonderful years at DuPont and this type of speed is incredible) There will be much more to do, depending on how the global economy fares over the next year or two. And when the slowdown ends, Holliday predicts that inflationary trends will reassert themselves. But DuPont will be ready for resurgent inflation—and any other emergency—if and when it happens.

The lesson CEOs should draw from Holliday's experience: You must recognize reality. This is the single most important task confronting a CEO, and it is extremely difficult to do in this environment. Facing wrenching uncertainty, many become fearful. Others indulge in wishful thinking: "We'll soon be back to normal." Don't believe it. Though we don't know what the new world will look like, we can be certain it won't look the way it did before. (this raises a thought that while all this is going on, DuPont may want to put a team together to look how the Company could possibly reposition itself in these rapidly changing markets so it not only survives but thrives as the world returns to whatever normal will be.)

The Year of the Simpler Gadget
By DAMON DARLIN
Published: NYT December 20, 2008

Clay Christenson’s book the Innovators Dilemma highlights that perhaps the best place to compete are in markets where there are large incumbents. This counter intuitive belief (remember the classic “stop light analysis” where there was a big red light for markets with very strong players) stems from his observations that entrenched leaders tend to protect what they have by continually focusing on and increasing functionality. The examples of Nintendo’s Wii and Pure Digital Technologies Flip video camera are classic examples of Christenson’s hypothesis. Both exemplify the power of targeting customer segments not being served by the incumbents and then delivering new levels of simplicity and ease of use of their products. The success of these products this year is accelerated by their low cost vs. the respective incumbents but there are deeper reasons that have been in play for awhile.

THE National Bureau of Economic Research hardly stunned the nation this month when it announced that the United States had been in recession since December 2007.
And, as it turns out, the buyers of consumer electronics could very well have been a leading economic indicator. Over the last year, they chose to buy two inexpensive and simple products, the Wii and the Flip, over competing gadgets bristling with more features.

Nintendo has sold more than 30 million Wii game consoles since they were introduced two years ago. The machine is still luring shoppers: lines of buyers still form on Sunday mornings outside electronics stores. Best Buy put the Wii, not big-screen high-definition TVs, on the cover page of its Sunday circular last week, in its bid to get resistant holiday shoppers into the store.
The machine is dimwittedly simple. The console itself is hardly bigger than a DVD. It lacks the deep rich graphics, the rumbling sound and many of the violent games of the Microsoft Xbox 360. But at $250, it is outselling the more expensive Xbox 360 and the Sony PlayStation 3 combined by almost 2 to 1. (Nintendo knew they could not compete with these two giants by playing their game. They came in by satisfying untapped customer segments with a much simpler product. It took both Microsoft and Sony by complete surprise)

The $130 Flip camcorder is also simple, and two to three times cheaper than camcorders made by Sony or JVC that have optical zoom, an optical viewfinder and special effects. The original Flip didn’t even have a headphone jack. Revenue at Pure Digital Technologies, its manufacturer, grew 44,667 percent, the highest rate of any company in Silicon Valley, over the last five years, according to Deloitte, the business services firm. Pure Digital Technologies says it has sold more than 1.5 million Flips since it unveiled the product line in 2007. (Exactly the same story here)
This shift in consumer preference to the cheaper electronic device could well be a reaction to the recession. But it isn’t the same as the consumer suddenly, and consciously, reaching for the house brand of creamed corn instead of the one with the Jolly Green Giant on the label. It is not just the economics of a shopping-fatigued nation at work here. Consumers found the simple devices, which don’t need instruction manuals to set up and use, more appealing.(Simplicity is often the impetus for major innovative growth)

That shift in consumer preference could be ominous. As the United States enters a deflationary period, all kinds of companies will have to grapple with the consequences of falling prices. This is nothing new for electronics makers. Every year, competition and the effects of Moore’s Law forced prices down.

The one defense that seemed to work was to offer a new product at the same price as the old one — but with more features. The laptops got better graphics, the hard drives spun faster, the cameras picked up more detail, the memory cards held more. (Classic protection of an existing market position)
Feature-itis was a disease, but it was better than the affliction known as consumer boredom.
Even the Flip is experiencing some feature creep. It has a popular model that shoots high-definition video. It’s still the smallest HD camcorder, but it has U.S.B. port rechargers and power adapters, fast forward and rewind and four times as much memory as the original. Wii is still aimed at the market that Microsoft and Sony neglected: young children, older people and others who never played video games. (Innovation should always start with finding new customer segments or outcomes that could be targeted)But it is selling add-ons like the Wii Fit, a souped-up bathroom scale that allows a person to play skiing games, balance contests and musical play-alongs.

Apple, innovator of business models as much as it is an innovator of electronic geegaws, may have found a solution to the problem of simple products becoming more complex. The Apple iPhone is one of the easiest-to-use devices ever created. At $300, plus a two-year contract that quickly pushes the real price to $1,800, it is hardly in the thrift class with the Wii and the Flip. But it is one of the most popular consumer electronics devices of 2008. Apple is expected to sell more than 14 million of them this year, and it is already the best-selling handset in the United States, according to the market researchers at the NPD Group.

As much as it is part of the distinct trend toward the simple, the iPhone is also part of a trend to make a device versatile. (Another major driver for dramatic growth is bundling/integrating functionality as they have done in the iPhone where the whole brings more value that the individual components.). It is a pretty thing, with a sleek touchscreen that does away with a keyboard. But it is also a hand-held game machine and a musical instrument that plays cowbells or imitates an ocarina. It’s clearly an entertainment device, one that can identify the song playing in a movie or find friends on a map.

While it is not clear that mainstream electronics manufacturers have caught on, some scrappy start-ups have noticed its utility. One of them, Sonos, has turned the iPhone into a pretty nifty remote control for managing music on Sonos’s whole-house entertainment system. (The application can be downloaded free from the Apple AppStore.) The iPhone taps into a home’s wireless network to control the wireless entertainment system in multiple rooms.
John MacFarlane, the Sonos chief executive, says creation of the software that makes the iPhone a Sonos controller lifted the company’s sales by 20 percent in November. “In this economy,” he noted.

The company gave up some revenue — a regular Sonos controller is about $300 — but the new device exposed the entertainment system to a new audience and thus expanded the market.
Sonos isn’t interested in anything other than music, but a versatile little device that you never let out of your reach could also manage burglar alarms and heating and cooling systems. “I think that is the universal remote control of the future,” Mr. MacFarland said. “And that’s the direction we are headed.”

Right along with stingier consumers.

Pricing in an inflationary downturn
In the current environment, costs are rising as price sensitivity increases. Six tactics can help companies get pricing right.


http://www.mckinseyquarterly.com/Pricing_in_a_downturn_2189

SEPTEMBER 2008 • Cheri N. Eyink, Michael V. Marn, and Stephen C. Moss



Some very practical insights!



Getting pricing right is always a challenge in an economic downturn, as decreasing demand, excess capacity, and greater price sensitivity all conspire to drive down prices. In most downturns, the cost of raw materials, feedstocks, and other upstream supplies—as well as the cost to serve customers (for delivering goods, for example)—tends to stabilize and even decrease as business activity slows. As a result, decreases in downstream prices are at least partially offset by lower upstream costs. But in the current environment, not only is weaker demand from the end user making it harder to maintain prices, but significantly higher and more volatile input costs mean that companies caught in the middle are getting hit from both sides.

What’s a business to do? In this unusual downturn, companies need to manage the profitability of individual customers and transactions with greater precision, develop richer insights into their customers’ changing needs and price sensitivities, and understand more clearly the microeconomics that shape their own industries and those of their suppliers. We’ve assembled six tactics aimed at maintaining the best balance possible between sales volume and profit margins in the current challenging environment.

Watch for sudden shifts in price structure

Companies should be vigilant in monitoring pricing policies that reduce revenue—such as volume discounts, rebates, and cash discounts—as well as cost-to-serve, including freight and sales support. In the current downturn, rising costs and declining demand can cause these elements to change more dramatically and quickly than they have in the past. Rapidly increasing fuel prices (correct at the time of printing and will happen again) , for example, are putting intense pressure on delivery costs. Declining demand means that some customers may be collecting volume discounts they no longer deserve. Best-practice companies are reviewing much more frequently their pocket margin waterfalls, which show how much revenue companies really keep from each of their transactions, and adjusting their pricing policies accordingly—for example, by adding delivery fuel surcharges to every order. Without the extra attention and quick action, erosion at all points of a transaction can quickly destroy profits in times like these.

Monitor customer-level profitability

Companies should use transaction-level data to measure precisely the profitability of each customer. By doing so, companies can detect if the cost to serve particular customers or declining order volumes are nudging those customers below target profitability levels. In this downturn, for example, many customer groups are becoming simultaneously smaller and more costly to serve. One industrial company found that more than 20 percent of its customers had fallen below breakeven profitability, forcing it to raise prices selectively and, where possible, lower cost-to-serve by decreasing delivery frequency, reducing sales support, or fulfilling orders through alternate channels.

Adjust to changing customer needs

Downturns always prompt changes in customer needs and in the benefits they value when choosing a supplier. The dynamics of the current downturn mean that such swings can occur even more rapidly. In this environment, the best companies are constantly assessing—through market research and direct contact—how economics are changing for their customers. Even more important, they are reacting quickly by retooling their price and benefit offerings accordingly. For example, one plastic resins supplier that had developed a fast-curing resin (to enhance capacity of injection molders when the economy was strong) has now developed a less costly resin that doesn’t cure as quickly. The new resin helps the supplier’s customers decrease costs, because molders are not running at full capacity during the downturn. With other supplies raising their prices, many molders see the slow-curing resin as an attractive alternative. As a result, the supplier can maintain its profit margins even while selling the alternative resin at a lower price. The combination of lower demand and higher input costs in the current downturn makes it critical to get these kinds of adjustments to the cost/benefit balance correct.

Update price sensitivity research

Dramatic increases in energy and food prices have made consumers much more sensitive to prices across a wide range of product categories. Each price increase for necessities such as food and fuel has cut a little more from discretionary budgets, sharply increasing price sensitivity. Market price tests become obsolete after just a few months. To get price points right, pricing sensitivity research and market price tests should be rerun immediately to track these changes.

Monitor your industry’s microeconomics

Radical shifts in costs and demand have thrown previously predictable market pricing mechanisms into chaos. Responding correctly requires a keen understanding of the microeconomic forces at play at the industry level. In one example, a building materials company found itself in a precarious position as the downturn deepened: a precipitous decline in US housing starts meant diminishing demand, while the costs for raw materials, energy, and transportation were increasing rapidly. In response, the company reassessed the industry’s microeconomics, looking in particular at the latest supply, demand, and cost dynamics. With this new information, managers cut capacity at a plant in an area where the decreased supply would not cause a local shortage. The capacity reduction, which would have had little if any effect on market prices a year earlier, brought about a better balance between supply and demand and kept market prices an estimated 10 percent higher than they would have been without the change.

Study your suppliers

The extreme volatility in this downturn demands that companies reexamine not only the microeconomics of their own industries but also the microeconomics of their suppliers’ industries. Recently, a specialty chemicals company invested in modeling the current industry supply, demand, and cost dynamics for one of its primary raw materials. By doing so, the company predicted an industry-wide, 15 percent price increase for that raw material three months before it happened—a feat of some significance because there hadn’t been an annual price increase of more than 5 percent for that material within the past six years. Suspecting an imminent and unusually large price increase, the chemicals company began adding clauses covering raw-material price increases to its customer contracts, a move that would have met extreme resistance if made after the price increases were announced. Instead, the move established an industry precedent for passing cost increases through to customers.

Discovery Driven Planning: Most barriers to growth are self-inflicted

Rita McGrath is a colleague of mine who played a key role in developing the Market Driven Growth process that is the underpinning of our executive education programs at The Kellogg School. The Discovery Driven Planning process is an extremely valuable tool in implementing growth strategies when there is a high level of uncertainty and is the backbone of our class on Implementing Growth Strategies. I think her incites are worth sharing and I refer you to her blog site and highly recommend her new book discussed below.

HAPPY NEW YEAR TO ALL

http://ritamcgrath.com/blog/comments/discovery-driven-planning-most-barriers-to-growth-are-self-inflicted/

I am spending today with a very well-managed, large company, and even here the long fingers of the economic slowdown are creating even more obstacles to innovation - led growth than in more ‘normal’ times.
The issues they raised as barriers to growth include:
• The “de-risk” mode that many companies have gone into which makes anything even remotely unpredictable look dangerous
• A lack of a global mindset that leads to local optimization of investment and cuts off more promising corporate projects
• Brand conflict - when a new project isn’t a great fit for the existing brand
• Churn among the managers and leaders involved in innovation projects
• Silos within the organization
• Existing metrics and rewards that are not suitable for innovation
• Fear of cannibalization of the existing business
• Fear, in general
• Short-termism driven by quarterly results pressure
• Politics
• Existing power structures in the company

What I find absolutely fascinating about this list (and remember, this is an extremely well managed firm) is the extent to which the barriers to growth are essentially self-inflicted. They are internal processes, systems, relationships and politics that can get in the way of doing anything new. Existing companies tend to have accumulated lots of these sorts of barriers - but it doesn’t have to be a foregone conclusion that these will be or should be in place. Here is where adroit innovation leadership, to me, can make all the difference. This is one of the key themes in our forthcoming book Discovery Driven Growth.