The 2% Company: Excelling at Efficiency and Innovation
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.
Maintaining an outside-in perspective starts by continuously scanning the market, both demand and supply.
3. THEY EMBRACE NECESSARY DISRUPTIONS (EVEN IF PAINFUL). This 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 long-term objectives. They also fit specific business environments and organizational capabilities. For instance, in industries where disruption is imminent but directionally unclear and when go-to-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 fintechs 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 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 multiple innovation waves, such as online retailing, plastic lenses, sunglasses and low-cost manufacturing in Asia.
Breakthrough innovation is rarely performed by a single actor from end-to-end.
• THE COMMERCIALIZER MODEL. Companies do not always have a monopoly on good ideas. The commercializer model implies scanning externally for relevant products, bringing them in-house and then commercializing them. This strategy requires strong go-to-market capabilities and the resources necessary to acquire the targets identified. It also rests on the ability to scan the market for relevant opportunities and recognize them early, before their market value shoots up. To some extent, this strategy complements a strong in-house innovation engine. Most big pharma companies rely on this model to supplement their own drug pipelines, for instance. By in-licensing products that are already fairly well developed, getting regulatory approval and taking them to market quickly, they can ensure a steady stream of new products with faster time-to-market and lower R&D risks.
• THE WIN-STAY/LOSE-SHIFT MODEL. Another model is to gather, screen and test many ideas quickly, with minimal financial investment in each. This diversified strategy can be far less risky than one big bet-the-farm commitment. But it requires the company to identify early on the ideas that prove less promising and to ‘fail fast’ before too many resources are spent. It therefore necessitates clear criteria and metrics and disciplined objectivity. Once a winner is identified, the company also needs the capabilities to quickly scale up. Fashion retailer Zara has mastered this model. Another good example is Amgen, the biotech company used
to fund as many drugs as possible and hope for the best. Now, although Amgen’s R&D strategy still focuses only on breakthrough drugs, the company evaluates drugs quickly, weeding out candidates that don’t make the grade. This failfast approach saved the company US$ 1 billion in research spending on just a single drug.
• THE INNOVATION PLATFORM MODEL. Some companies are able to create an attractive technology platform on which other companies can build their businesses. Amazon and Alibaba have made this strategy work to great effect, providing partners with tools, data and other services to help online businesses succeed. Key success factors here include a truly differentiated platform, cutting-edge technology, the satisfaction of merchants and business partners, and the continuous incorporation of new ideas and improvements. There must be a clear reason why an outside business would want to use your platform rather than taking products to market themselves or through others.
We offer the following five recommendations for becoming a 2% company:
1. INVITE CHALLENGE AND COACHING FROM THE OUTSIDE. Welcome differing opinions and be willing to learn from others. No one can be right all the time, and welcoming outsiders so that you can benefit from their unbiased, outside-in perspectives will help you stay close to customers and nascent market trends. Having a clear picture of those trends will also prevent your company from setting out in a wrong direction and provides the confidence necessary to make difficult decisions.
2. THINK IN MULTIPLE TIMEFRAMES. Ask yourself what you’re doing to best position yourself for next year, five years from now and ten years from now. This mindset will enable both exploration and exploitation activities and strike the right balance of the two. Thinking in multiple timeframes is also a critical first step
towards defining the right renewal model for your company, as it ensures that your chosen strategy will deliver results for relevant timeframes.
3. GET AHEAD OF ANY CRISIS. Recognize risk and be brutally honest. Once risks and opportunities have been clearly identified, make sure you address disruption in the way that best positions your company and takes full advantage of the disruptive forces. Have the courage to act promptly and preemptively. Establishing an early-mover advantage can be instrumental for sustainable success.
4. BE SKEPTICAL OF YOUR CURRENT SUCCESS. Never rest on your laurels. Successful companies must remain humble and modest so as to avoid creating a culture that rests on complacency and self-satisfaction. Instead, keep a mindset of continuous quest for improvement and search for novel ideas. This will trickle down through the entire organization and ensure that key stakeholders always push the frontier of possibilities.
5. REVIEW YOUR RENEWAL STRATEGIES EXPLICITLY. Pursuing excellence on all four of the previous traits can be exhausting. As a result, explicitly reviewing your company’s performance is necessary to ensure that all dimensions are tackled and that there are no gaps between intention and action. To this end, we have built a simple, pragmatic assessment tool that helps executives rapidly weigh their strategies against the four traits. We call it the 2% cockpit, because it helps to show executives how to pilot their organizations the way that 2% companies do. Figure One provides a sample cockpit view.
As indicated, 2% companies set a high bar. But by emulating these performance leaders and heeding the recommendations set forth herein, other companies can achieve and sustain a higher level of success than they currently enjoy. Ten years from now, we hope to find ourselves talking about new manifestations of exploration and exploitation and an expanded roster of companies that excel at both: the 5% — or more.
is a Professor of Strategy and Deputy Dean of the MBA Program at IMD business school in Switzerland. Martin Reeves
is Senior Partner and Managing Director at the Boston Consulting Group (BCG) and Director of the BCG Henderson Institute. Jules Wurlod
is a Consultant at BCG based in Geneva and an ambassador of the BCG Henderson Institute.
This article appeared in the Winter 2019 issue. Published by the University of Toronto’s Rotman School of Management, Rotman Management explores themes of interest to leaders, innovators and entrepreneurs.
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