Building better links in high-tech supply chains

The McKinsey Quarterly

Building better links in high-tech supply chains

As high-tech supply chains increase in complexity, they become harder to manage. Collaboration between OEMs, suppliers, and retailers is the answer.

December 2008 • Gautam Grover, Eileen Lau, and Vivek Sharma

The supply chains of high-tech companies are globe-spanning marvels. Over the past 20 years, looking for ready sources of components, lower-priced labor, and talented designers and engineers, these companies have ranged throughout the world. In a highly competitive and fast-moving marketplace, they have sought to maximize their strengths and flexibility as products change rapidly and prices continue to fall.

But the sprawl and complexity of such networks have made it harder to manage end-to-end operations smoothly. Many technology companies are grappling with volatility and disruptions across their supply networks, and eliminating waste from duplicative efforts is an ongoing challenge. As product life cycles shrink, we see inventory buildups in the supply chains of some companies, while others cope with rising distribution costs, on-time delivery problems, or delays in getting new products to market.

In fact, high-tech companies have let complexity undermine collaboration in their supply chains: they aren’t working as closely as they could with their supply chain partners—sharing information or streamlining processes—to smooth out volatility and eliminate waste. This failure is surprising. The high-tech industry creates products that promote collaboration, openness, and efficiency. We all know stories about companies in other industries such as retail and consumer-packaged goods that have improved their operations significantly by using technology to collaborate more closely with suppliers—yet high-tech companies have been slow to follow. For a host of reasons rooted in the way they are organized and compete, their executives have been less than enthusiastic about pursuing the benefits of collaboration with their supply chain partners.

This lack of enthusiasm is fast becoming more costly for OEMs. Even as product life cycles shrink, consumers are demanding products with new features (such as mobility, greater storage, and more memory) that make products ever more complex. As this complexity increases, it will become harder to manage supply networks, opportunities will be missed, and supply chain costs will rise. The path to improvement, we suggest, lies in better collaboration with suppliers. To achieve it, companies should address their internal challenges and then deal with key stress points that strain supplier relations.

Roadblocks to better collaboration

Closer collaboration in the high-tech industry is an elusive goal. Difficulties arise from the specific nature of high-tech competition and markets, from cultural barriers, and from organizational flaws. In our work with clients, we find that problems in four areas often prevent successful supply chain collaboration. Managers must understand them more fully to diminish their impact.

Partner complexity and churn

High-tech OEMs need hundreds of components from a broad range of global suppliers, which themselves lie at the center of even farther-flung supply chains comprising second-tier companies that make subcomponents. Products generally have short life spans. One mobile-phone maker, for instance, typically uses more than 20 components from tier-one suppliers alone for products with a life cycle of only nine months. There’s a very small window to make crucial decisions about a product’s design, price, quality, and features, as well as to choose the right array of suppliers. Since everything must happen quickly, building deeper collaboration and partner loyalty become secondary considerations. What’s more, supply chain partners often change as product designs and specifications evolve, so collaborative efforts often fail to survive from one model to the next.

Silos and forecasts

OEMs in many industries organize themselves around functional units. But in high technology (and other assembly industries), units such as manufacturing, sales and marketing, and product development often send conflicting forecasts of demand and production to their partners. Not surprising, supply chain responses are often based on guesswork, and forward planning is difficult. In one variation of this problem, OEM sales reps provide “lowball” estimates of demand rather than a truer picture, so they can more easily beat internal goals. Alternatively, when components are in short supply, forecasts by manufacturing functions often are overly optimistic in a play to maximize the allocation of scarce products from suppliers.

Poor quality of data

OEM forecasts often aren’t granular enough to be useful to supply chain partners. Typically, OEMs set broad targets across a number of product lines rather than provide details on expected unit sales for specific products. That combined with rapid product obsolescence makes getting a fix on true demand difficult. Furthermore, the IT systems that capture data across supply networks often are incompatible, thereby walling off vital information and making information-based collaboration a struggle. The mobile-phone industry provides a notable example of poor data: OEM forecasts of consumer demand, provided only four months out from delivery dates, often misstate actual demand by 400 percent.

The mistrust spiral

Given the intense and unpredictable nature of competition, high-tech executives often believe that they must guard information on their business plans and processes closely. This perceived need for confidentiality—OEMs reason that since their suppliers provide parts to competing OEMs, shared data isn’t secure—directly affects suppliers. The mistrust extends to ODMs (original design manufacturers) as well, which are also considered risky, since they work with the OEMs’ competitors, and even to retailers that distribute those competitors’ products. If OEMs do provide data, it’s often inaccurate. This lack of transparency makes the OEMs’ projections less than believable to suppliers, which then compensate by scaling production downward. That causes additional problems if demand is unusually strong.

Building bridges across the supply chain

Solving these problems is a two-step undertaking in which companies must first change their internal processes and then reach outside the organization to partners. A single approach usually won’t resolve all supply chain impediments: if an OEM has a number of channels for distributing its products and many upstream or downstream partners, it should try a range of collaboration strategies. In some cases “anticollaboration,” with little sharing of information, may actually be a legitimate approach. For example, Apple partners closely with its upstream suppliers to increase access to top product design talent. But the company is wary when it deals with retailers, because it aims for tight control over all aspects of product launches and fears that information may leak into the market in advance.

Breaking down silos

To improve the information flow to supply chain partners, an OEM’s leaders need to enforce transparency and collaboration within their own functional arenas. As OEMs set internal forecasts for demand and production, they need to have a clear understanding of how conflicting and confusing data affect partners. Incentives must dovetail with the needs of the supply chain rather than simply further internal goals. A leading manufacturer of flash memory tackled these issues by creating a sales and operations planning (S&OP) team that united stakeholders from marketing, supply chain operations, finance, and other areas. In mandatory monthly meetings, the group hammered out a single, company-wide demand forecast and made data available across the supply network, using simple IT systems. The team ended practices such as allowing executives to adjust production plans and forecasts to meet financial and bonus targets. Senior management raised this new effort’s profile by including discussions about S&OP on the agenda of monthly staff meetings. Greater collaboration and transparency improved the accuracy of the company’s demand forecasts by 40 to 60 percent, which in turn led to gains across the supply chain. Over six months, on-time deliveries rose 30 percent and inventory costs fell 20 percent.

Improving trust

More information can be shared with supply chain partners, but that calls for new thinking. Often, operational details (such as point-of-sale information, customer forecasts, the location and size of inventories, and production capacity) are readily available, but lack of trust undermines an open exchange. In one instance, the supply chain partners of a global networking OEM perennially doubted the reliability of its forecasts—doubts that led to production and delivery delays. Seeking improvements, senior executives from the OEM and suppliers established a framework for collaboration. They determined which types of information could be shared and which (for instance, pricing) were too sensitive and thus had to be left outside the agreement. The OEM then created a central data repository using basic spreadsheet technology that gave both suppliers and the OEM’s functions the same access to data. After four months, the suppliers’ confidence in the OEM’s numbers improved, encouraging forward planning and ending bursts of last-minute production. Inventories dropped by 45 percent, and the cycle time from order to shipment by 70 percent.

Sharing assets

OEMs and their partners often operate separate distribution networks with overlapping inventory hubs and logistics systems. Simplifying and consolidating these networks can reduce complexity, shave costs, and strengthen partner relationships. A consumer electronics OEM and a large retailer, for instance, each maintained separate product warehouses and distribution systems, in part because neither had sufficient visibility into the workings of its partner’s operations. Leaders at the two companies agreed to overhaul this setup by giving the OEM full responsibility for managing store inventories. The OEM, which in the past had relied on incomplete and less-than-current information from the retailer, gained direct access to store sales data. In effect, the OEM’s supply chain extended directly to the stores, and the retailer could eliminate its redundant distribution facilities. With better information, the supply chain could adjust more swiftly to variations in consumer demand. The availability of products at retail stores improved by 70 percent, and overall supply chain inventories declined by 20 percent. This type of asset sharing is easier to implement for OEMs and retailers but can also be pushed further up the chain to include OEM suppliers.

Joint product development and risk sharing

Short product cycles make a certain amount of supplier turnover inevitable, but high-tech companies can solidify their relationships by jointly developing products with their partners and by sharing risks. Such product collaboration needs to go beyond what is now standard: outsourcing of designs to ODMs. Instead, when an OEM’s engineers design key components, they should work with key suppliers from the outset. Suppliers and OEMs may even jointly own pieces of intellectual property. This type of arrangement gives OEMs access to skills they may not have in-house and allows them to leverage scarce engineering talent. It can also reduce time to market for new products. Suppliers benefit from assured demand and the chance to develop specialized expertise.

In the tech industry, new-product introductions are frequent and inherently risky. The risks are often borne disproportionately, with certain supply chain partners providing most or all of a heavy investment. Some partners with a lower risk tolerance may be hesitant to spend. Apple, for instance, faced such a situation when it worked on its iPod supply chain in 2005. Apple’s major worry was uncertainty over supplies, since industry demand at the time was strong. Few suppliers were willing to make sizable investments just to meet Apple’s needs. Apple reduced the risks by providing up-front payments to partners such as Micron, Samsung, and Hynix.

While fostering collaboration is in the interest of all supply chain participants, creating the internal and then external conditions for change will take time. Most OEMs will first need to launch discussions on the scope and speed of new collaborative efforts and think carefully about which companies will be their closest partners. At the outset, the most suitable ones are major suppliers, for the economics create natural bonds.

Early successes that set the stage for further progress help senior executives think about the longer term. The partners should understand that even if they begin with an appropriate model, they will need to change it, both to build on success and to counter the moves of competitors. 

About the Authors

Gautam Groveris a consultant in McKinsey’s Chicago office, Eileen Lau is a consultant in the Silicon Valley office, and Vivek Sharma is an associate principal in the Chicago office.

The authors would like to acknowledge the significant contributions of Bob Dvorak and Vats Srivatsan to this article.

© Copyright 1992-2009 McKinsey & Company

 

Leading through uncertainty

The McKinsey Quarterly

Leading through uncertainty

The range of possible futures confronting business is great. Companies that nurture flexibility, awareness, and resiliency are more likely to survive the crisis, and even to prosper.

December 2008 • Lowell Bryan and Diana Farrell

The future of capitalism is here, and it’s not what any of us expected. With breathtaking speed, in the autumn of 2008 the credit markets ceased functioning normally, governments around the world began nationalizing financial systems and considering bailouts of other troubled industries, and major independent US investment banks disappeared or became bank holding companies. Meanwhile, currency values, as well as oil and other commodity prices, lurched wildly, while housing prices in Spain, the United Kingdom, the United States, and elsewhere continued to slide.

As consumers batten down the hatches and the global economy slows, senior executives confront a more profoundly uncertain business environment than most of them have ever faced. Uncertainty surrounds not only the downturn’s depth and duration—though these are decidedly big unknowns—but also the very future of a global economic order until recently characterized by free-flowing capital and trade and by ever-deepening economic ties. A few months ago, the only challenges to this global system seemed to be external ones like climate change, terrorism, and war. Now, every day brings news that makes all of us wonder if the system itself will survive.

The task of business leaders must be to overcome the paralysis that dooms any organization and to begin shaping the future. One starting point is to take stock of what they do know about their industries and the surrounding economic environment; such an understanding will probably suggest needed changes in strategy. Even then, enormous uncertainty will remain, particularly about how governments will behave and how the global real economy and financial system will interact. All these factors, taken together, will determine whether we face just a few declining quarters, a severe global recession, or something in between.

Uncertainty of this magnitude will leave some leaders lost in the fog. To avoid impulsive, uncoordinated, and ultimately ineffective responses, companies must evaluate an unusually broad set of macroeconomic outcomes and strategic responses and then act to make themselves more flexible, aware, and resilient.

Strengthening these organizational muscles will allow companies not only to survive but also to seize the extraordinary opportunities that arise during periods of vast uncertainty. It was during the recessionary 1870s that Rockefeller and Carnegie began grabbing dominant positions in the emerging oil and steel industries by taking advantage of new refining and steel production technologies and of the weakness of competitors. A century later, also in a difficult economy, Warren Buffett converted a struggling textile company called Berkshire Hathaway into a source of funds for far-flung investments.

What we know

The financial electricity that drives our global economy is not working well. Turning it back on isn’t just a matter of flicking a switch, as central banks and governments have tried to do by providing liquidity, guaranteeing debt, and injecting capital into banks. We must repair the grid itself significantly, and this will require coordinated global action.

By the grid, we mean the global capital market, which evolved over a 35 year period following the breakdown of the Bretton Woods accord, in the 1970s. No one designed the global capital market, but it has been a boon to humanity, stimulating globalization and growth by enabling the free international flow of capital and trade. The financial crisis of 2008 severely damaged this useful system. Through greed, neglect, or ignorance, the participants abused it until they broke some of its basic mechanisms.

The implications are far reaching. Most obviously, congestion in the global capital market is exacerbating the US domestic credit crisis. That crisis has spread globally, hitting Europe especially hard. Banks until recently have been scrambling for deposits to replace sources of funding such as direct-issue commercial paper, medium-term notes, and asset-backed paper. The search for deposits is required to finance existing loans, and borrowers will need significantly more of them because all but the strongest have, like the banks, lost access to the securities markets. The US government, in particular, has aggressively tried to address this problem through huge liquidity programs, such as the purchase of mortgage- and other asset-backed securities. But it remains to be seen how effective those efforts will be in mitigating the credit crunch.

The global capital market crisis worsens this credit crunch by sending into reverse the dynamic of cross-border investment and trade flows. A dollar of capital must finance every dollar of trade, so the global capital market has stimulated the international exchange of goods and services. It has facilitated cross-border investments—in intellectual property, talent, brands, and networks—that help economies and companies grow and profit, and it has enabled the companies that make such investments to repatriate their profits. In short, global integration and growth will revive only if the global capital market does. Yet it has sustained a body blow that will have repercussions for years, even if international leaders make the necessary long-term adjustments.

The changing role of government

Since September 2008, governments have assumed a dramatically expanded role in financial markets. Policy makers have gone to great lengths to stabilize them, to support individual companies whose failure might pose systemic risks, and to prevent a deep economic downturn. We can expect higher tax rates to pay for these moves, as well as for the reregulation of finance and many other sectors. In short, governments will have their hand in industry to an extent few imagined possible only recently.

That’s not all. Protectionism and nationalism will probably feature more prominently in policy debates. We may see not only old-style populist anger against business, high executive compensation, and layoffs but also the emergence of authoritarian populist movements. Already-dilatory trade discussions will encounter renewed resistance. Although greater global coordination is sorely needed, national political pressures will make it hard to achieve. All this will constrain some business activities but also opens the door to new ventures that depend upon collaboration between the public and private sectors.

Deleveraging

The cheap credit of the past few years most likely won’t return for a long time. For many households, this will mean reducing consumption and postponing retirement; for financial institutions—increasingly, bank holding companies—much higher capital requirements, less freedom to operate and innovate, and probably lower profitability; for governments, even more limited resources for health care, education, pensions, infrastructure, the environment, and security; and for corporations, a different role for capital. More broadly, for many companies the high returns and rapid growth of recent years rested on cheap credit, so deleveraging means that expectations of baseline profitability and economic growth, as well as shareholder returns, must all be seriously recalibrated.

New business models and industry restructuring

Companies engaging with the capital markets will encounter funders who are less tolerant of risk, a reduced ability to hedge it, and greater volatility. Hardest hit will be business models premised on high leverage, consumer credit, large customer-financing operations, or high levels of working capital. Businesses with long or inflexible production cycles or very long-term investment requirements will find it especially difficult to manage their funding. Some won’t make it, so industries will restructure. Corporate leaders already recognize this: in a McKinsey Quarterly executive survey launched the day after the US presidential election, 54 percent of the respondents expected their industries to consolidate.

These are all truths we know. They require a significant shift in thinking about government as a stakeholder, the value talent creates when it is harder to leverage, how to conserve capital, and strategies for sound risk taking—among other things.

What we don’t know

Yet there is much that we don’t know, and won’t for some time: how well will governments work together to develop effective regulatory, trade, fiscal, and monetary policies; what will these responses mean for the long-term health of the global capital market; how will its health or weakness influence the pace and extent of change in areas such as the economic role of government, financial leverage, and business models; and what will all this imply for globalization and economic growth?

Although these questions won’t be answered in the short or even the medium term, decisions made in the immediate future are critical, for they will influence how well organizations manage themselves now and compete over the longer haul. The winners will be companies that make thoughtful choices—despite the complexity, confusion, and uncertainty—by assessing alternative scenarios honestly, considering their implications, and preparing accordingly.

In particular, organizations must think expansively about the possibilities. Even in more normal times, the range of outcomes most companies consider is too narrow. The assumptions used for budgeting and business planning are often modest variations on baseline projections whose major assumptions often are not presented explicitly. Many such budgets and plans are soon overtaken by events. In good times, that matters little because companies continually adapt to the environment, and budgets usually build in conservative assumptions so managers can beat their numbers.

But these are not normal times: the range of potential outcomes—the uncertainty surrounding the global credit crisis and the global recession—is so large that many companies may not survive. We can capture this wide range of outcomes in four scenarios (exhibit).

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	The credit crunch and the real economy

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To see them in perspective, consider some results of the McKinsey Global Institute’s research (see sidebar, “The credit crunch and the real economy”). This research, focusing on the United States, the center of the storm, suggests that if capital markets rebound quickly, GDP would be 2.9 percentage points lower than it would have been if trend growth had continued over the next two years. If financial markets take longer to recover, as the middle two scenarios envision, US GDP growth could fall 4.7 to 6.7 percentage points from trend over the same period. At the “long freeze” end of the spectrum, Japan’s “lost decade” shaved 18 percentage points from GDP compared with its previous growth trend.

Regenerated global momentum

In the most optimistic scenario, government action revives the global credit system—the massive stimulus packages and aggressive monetary policies already adopted keep the global recession from lasting very long or being very deep. Globalization stays on course: trade and capital flows resume quickly, and the developed and emerging economies continue to integrate as confidence rebounds quickly.

Battered but resilient

In the second scenario, government-wrought improvements in the global credit and capital market are more than offset—for 18 months or more—by the impact of the global recession, which leads to further credit losses and to distrust of cross-border counterparties. Although the recession could be longer and deeper than any in the past 70 years, government action works, and the global capital and credit markets gradually recover. Global confidence, though shaken, does rebound, and trade and capital flows revive moderately. Globalization slowly gets back on course.

Stalled globalization

In the third scenario, the global recession is significant, but its intensity varies greatly from nation to nation—in particular, China and the United States prove surprisingly resilient. The integration of the world’s economies, however, stalls as continuing fear of counterparties makes the global capital market less integrated. Trade flows and capital flows decline and then stagnate. The regulatory regime holds the system together, but various governments overregulate lending and risk, so the world’s banking system becomes “oversafe.” Credit remains expensive and hard to get. As attitudes become more defensive and nationalistic, growth is relatively slow.

The long freeze

Under the final scenario, the global recession lasts more than five years (as Japan’s did in the 1990s) because of ineffective regulatory, fiscal, and monetary policy. Economies everywhere stagnate; overregulation and fear keep the global credit and capital markets closed. Trade and capital flows continue to decline for years as globalization goes into reverse, and the psychology of nations becomes much more defensive and nationalistic.

Leading through uncertainty

These descriptions are intentionally stylized to enliven them; many permutations are possible. Scenarios for any company and industry should of course be tailored to individual circumstances. What we hope to illustrate is the importance for strategists of considering previously unthinkable outcomes, such as the rollback of globalization. Unappealing as three of the four scenarios may be, any company that sets its strategy without taking all of them into account is flying blind.

So executives need a way of operating that’s suited to the most uncertain business environment since the 1930s. They need greater flexibility to create strategic and tactical options they can use defensively and offensively as conditions change. They need a sharper awareness of their own and their competitors’ positions. And they need to make their organizations more resilient.

Most companies acted immediately in the autumn of 2008 when credit markets locked up: they cut discretionary spending, slowed investment, managed cash flows aggressively, laid off employees, shored up financing sources, and built capital by cutting dividends, raising equity, and so forth. While prudent, these actions probably won’t produce the short-term earnings that analysts expect, at least for most companies. In fact, it’s time they abandoned the idea that they can reliably deliver predictable earnings. Quarterly performance is no longer the objective, which must now be to ensure the long-term survival and health of the enterprise.

More flexible

Companies must now take a more flexible approach to planning: each of them should develop several coherent, multipronged strategic-action plans, not just one. Every plan should embrace all of the functions, business units, and geographies of a company and show how it can make the most of a specific economic environment.

These plans can’t be academic exercises; executives must be ready to pursue any of them—quickly—as the future unfolds. In fact, the broad range of plausible outcomes in today’s business environment calls for a “just in time” approach to strategy setting, risk taking, and resource allocation by senior executives. A company’s 10 to 20 top managers, for example, might have weekly or even daily “all hands on deck” meetings to exchange information and make fast operational decisions.

Greater flexibility also means developing as many options as possible that can be exercised either when trigger events occur or the future becomes more certain. Often, options will be offensive moves. Which acquisitions could be attractive on what terms, for instance, and how much capital and management capacity would be required? What new products best fit different scenarios? If one or more major competitors should falter, how will the company react? In which markets can it gain share?

As companies prepare for such opportunities, they should also create options to maintain good health under difficult circumstances. If capital market breakdowns make global sourcing too risky, for example, companies that restructure their supply chains quickly will be in much better shape. If changes in the global economy could make a certain kind of business unit obsolete, it’s critical to finish all the preparatory work needed to sell it before every company with that kind of unit reaches the same conclusion.

A crisis tends to surface options—such as how to slash structural costs while minimizing damage to long-term competitiveness—that organizations ordinarily wouldn’t consider. Unless executives evaluate their options early on, they could later find themselves moving with too little information or preparation and therefore make faulty decisions, delay action, or forgo options altogether.

More aware

As problems with credit destroy and remake business models and market volatility whipsaws valuations, companies desperately need to understand how their revenues, costs, profits, cash flows, risks, and balance sheets will fare under different scenarios. With that information, executives can plan for the worst even as they hope for the best. If the recession lasted more than five years, for example, could the company survive? Is it prepared for the bankruptcy of major customers? Could it halve capital spending quickly? The answers should help companies to be better prepared and to recognize, as early as possible, which scenario is developing. That is critical knowledge in a crisis, when lead times disappear quickly and companies can seize the initiative only if they act before the entire world understands the probable outcome.

Better business intelligence promotes faster, more effective decision making as well. Companies can often gain insights into the potential moves of competitors by weighing news reports about their activities, stock analyst reports, and private information gathered by talking to customers and suppliers. Such intelligence is always important; in a crisis it can make the difference between missing opportunities to buy distressed assets and leaping in to snare them.

To get this kind of business intelligence, companies need a network, typically led by someone with strong support from the top. This executive’s mandate should include creating “eyes and ears” across businesses and geographies in particular areas of focus (such as the competition’s response to the crisis), as well as gathering and exchanging information. A network is critical because information is most useful if it moves not just vertically, up and down the organization, but also horizontally. Salespeople in a network, for example, should exchange knowledge about what’s working in economically distressed regions so that employees can help each other.

Assembling bits of information, facts, and anecdotes helps companies to make sense of what’s happening in an industry. Say, for example, that a supplier says it has no difficulties with funding, though first-hand knowledge from other sources indicates that the company is struggling to meet its payroll. Such warnings can allow executives to get a full picture much more quickly than they could by sitting in their offices and interacting only with direct subordinates.

More resilient

A crisis is a chance to break ingrained structures and behaviors that sap the productivity and effectiveness of many organizations. Such moves aren’t a short-term crisis response—they often take a year or more to pay dividends—but are valuable in any scenario and could help a company survive if hard times persist. Although employees may dislike this approach, most will understand why management aims to make the organization more effective.

This may, for example, be the time to destroy the vertical organizational structures, retrofitted with ad hoc and matrix overlays, that encumber companies large and small. Such structures can burden professionals with several competing bosses. Internecine battles and unclear decisions are common. Turf wars between product, sales, and geographic managers kill promising projects. Searches for information aren’t productive, and countless hours are wasted on pointless e-mails, telephone calls, and meetings.

Experience shows that streamlining an organization to define roles and the way those who hold them collaborate can greatly improve its effectiveness and decision making. When jobs must be eliminated, the cuts mostly reduce unproductive complexity rather than valuable work. As Matthew Guthridge, John R. McPherson, and William J. Wolf point out in “Smart cost-cutting in the downturn: Upgrading talent” (available on December 4), Cisco took that approach in shedding 8,500 jobs in 2001. When the company redesigned roles and responsibilities to improve cooperation among functions and reduce duplication of effort, talented employees were more satisfied in a more collaborative workplace.

In fact, many functional areas offer big opportunities: greater effectiveness, lower fixed costs, freed-up capital, and reduced risk. This could be the moment to redefine and reprioritize the use of IT to increase its impact and cut its cost. Other companies could seize the moment to control inventory; to reexamine their cash flow management, including payments and receivables; or to change the mix of marketing vehicles and sales models in response to the rising cost of traditional media and the growing effectiveness of new ones.¹

As customer preferences change, competitors falter, opportunities to gain distressed assets emerge, and governments shift from crisis control to economic stimulus, the next year or two will probably produce new laggards, leaders, and industry dynamics. The future will belong to companies whose senior executives remain calm, carefully assess their options, and nurture the flexibility, awareness, and resiliency needed to deal with whatever the world throws at them. 

About the Authors

Lowell Bryan is a director in McKinsey’s New York office, and Diana Farrell is director of the McKinsey Global Institute.

The authors wish to thank David Atkins, Kevin Buehler, Jared Chung, Ezra Greenberg, Jeff Gu, Bill Hoffman, Susan Lund, Christopher Mazingo, Kazuhiro Ninomiya, Hamid Samandari, and Elizabeth Stephenson for their contributions to this article and the research underlying it.

Notes

¹For more on managing technology, operations, and marketing in this environment, see David Court, “The downturn’s new rules for marketers,” mckinseyquarterly.com, December 2008; James Kaplan and Johnson Sikes, “Smart cost-cutting in the downturn: Rationalizing IT spending,” mckinseyquarterly.com (available December 4); and Alexander Niemeyer and Bruce Simpson, “Smart cost-cutting in the downturn: Freeing up cash from operations,” mckinseyquarterly.com (available December 4).

© Copyright 1992-2009 McKinsey & Company

 

Hal Varian on how the Web challenges managers

Hal Varian on how the Web challenges managers

Google’s chief economist says executives in wired organizations need a sharper understanding of how technology empowers innovation.

January 2009

More than ten years into the widespread business adoption of the Web, some managers still fail to grasp the economic implications of cheap and ubiquitous information on and about their business. Hal Varian, professor of information sciences, business, and economics at the University of California at Berkeley, says it’s imperative for managers to gain a keener understanding of the potential for technology to reconfigure their industries. Varian, currently serving as Google's chief economist, compares the current period to previous times of industrialization when new technologies combined to create ever more complex and valuable systems—and thus reshaped the economy.

Varian spoke with McKinsey’s James Manyika, a director in the San Francisco office, in Napa, California, in October 2008. Watch the video or read the transcript of his comments below.

Hal Varian on how the Web challenges managers

Google’s chief economist on how technology empowers innovation.

Launch Interactive

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On flexible innovation

We’re in the middle of a period that I refer to as a period of “combinatorial innovation.” So if you look historically, you’ll find periods in history where there would be the availability of a different component parts that innovators could combine or recombine to create new inventions. In the 1800s, it was interchangeable parts. In 1920, it was electronics. In the 1970s, it was integrated circuits.

Now what we see is a period where you have Internet components, where you have software, protocols, languages, and capabilities to combine these component parts in ways that create totally new innovations. The great thing about the current period is that component parts are all bits. That means you never run out of them. You can reproduce them, you can duplicate them, you can spread them around the world, and you can have thousands and tens of thousands of innovators combining or recombining the same component parts to create new innovation. So there’s no shortage. There are no inventory delays. It’s a situation where the components are available for everyone, and so we get this tremendous burst of innovation that we’re seeing.

On corporations and work

The question is, “What are other periods where we saw technology influence the way organizations work?” One nice example comes from the works of Alfred Chandler, where he describes how the telegraph and the railroad had a big impact on the development of the modern corporation. And this was a synergistic operation: one, you had to have a large organization to manage these technologies, and two, you had to have the communications and transportation infrastructure to enable the management at a distance.

So I think now, with what we’re seeing with mobility, we’re going to have a totally different concept of what it means to go to work. The work goes to you, and you’re able to deal with your work at any time and any place, using the infrastructure that’s now become available.

At the base, there’s the innovation infrastructure making better, faster, cheaper networks. There’s the improvement in the human–computer interface because the big challenge in mobile communication has always been dealing with this—quite limited—interface. But then, the kinds of innovations I think will arise on top of that will be innovations in how work is done. And that’s going to be one of the most exciting aspects, in my opinion.

If you look at the beginning of the 20th century, we saw the rise of mass production. Henry Ford and the entire team were down on the factory floor raising this, lowering that, speeding up the assembly line, changing the way things were built, and were able to extract far more efficiencies than were available before. I think the same thing is happening now with digital technology. When we’re all networked, we all have access to the same documents, to the same capabilities, to this common infrastructure, and we can improve the way work—intellectual work, knowledge work—flows through the organization. And again, in my opinion, that will lead to a substantial advantage in terms of productivity.

On free goods and value

Back in the early days of the Web, every document had at the bottom, “Copyright 1997. Do not redistribute.” Now every document has at the bottom, “Copyright 2008. Click here to send to your friends.” So there’s already been a big revolution in how we view intellectual property. So it’s not so much the question of what’s owned or what’s not owned. It’s a question of how can you leverage the assets you have to realize the most value.

I think that the availability of these very inexpensive platforms you’re creating, in disseminating content, means that it’s become intensely competitive. The content is as valuable as it ever was, it’s just the competition that’s pushed the prices down to something that approximates zero. So it’s not something that the content producers necessarily embrace, but it’s something they’re forced into by the nature of the technological change.

In these models, there is typically a revenue-generating component somewhere in the value chain. And most commonly today we’re seeing it on the advertising side. To look at this from a historical perspective, it’s really not so new. If you look at the 1920s, the technological question in the ’20s was, “How can we build a business model around broadcast radio?” And nobody really had a good idea. And back in the mid-1990s we asked, “How can we build a business model around the Internet?” And the preferred model at the time was a micropayments system. That never happened, for some reasons, but what did happen instead is we moved into the advertising model, and the advertising’s model been phenomenally successful.

We have to look at today’s economy and say, “What is it that’s really scarce in the Internet economy?” And the answer is attention. [Psychologist] Herb Simon recognized this many years ago. He said, “A wealth of information creates a poverty of attention.” So being able to capture someone’s attention at the right time is a very valuable asset. And Google really has built an entire business around this, because we’re capturing your attention when you’re doing a search for something you’re interested in. That’s the ideal time to show you an advertisement for a product that may be related or complimentary to what your search is all about.

On workers and managers

I keep saying the sexy job in the next ten years will be statisticians. People think I’m joking, but who would’ve guessed that computer engineers would’ve been the sexy job of the 1990s? The ability to take data—to be able to understand it, to process it, to extract value from it, to visualize it, to communicate it—that’s going to be a hugely important skill in the next decades, not only at the professional level but even at the educational level for elementary school kids, for high school kids, for college kids. Because now we really do have essentially free and ubiquitous data. So the complimentary scarce factor is the ability to understand that data and extract value from it.

I think statisticians are part of it, but it’s just a part. You also want to be able to visualize the data, communicate the data, and utilize it effectively. But I do think those skills—of being able to access, understand, and communicate the insights you get from data analysis—are going to be extremely important. Managers need to be able to access and understand the data themselves.

You always have this problem of being surrounded by “yes men” and people who want to predigest everything for you. In the old organization, you had to have this whole army of people digesting information to be able to feed it to the decision maker at the top. But that’s not the way it works anymore: the information can be available across the ranks, to everyone in the organization. And what you need to ensure is that people have access to the data they need to make their day-to-day decisions. And this can be done much more easily than it could be done in the past. And it really empowers the knowledge workers to work more effectively.

On computer monitoring and risks

One of the really interesting phenomena that’s been going on in the last 20 years is what I call “computer-mediated transactions.” So now, in the middle of almost every transaction from person to person or organization to organization, there’s a computer. And the computer can monitor that transaction, record the information, collect the data, and assure that the transaction is carried out the way it was intended to be carried out. So one of the subtle implications of this is you can now write contracts and make contracts enforceable that simply weren’t enforceable before.

Let me give you an example. Suppose you go rent a car and they say, “Hey, we’ll give you $10 off if you don’t go over the speed limit.” Well, that might sound like a good deal, but what’s to keep you from going over the speed limit? Well, the answer is now they’ve got a transponder in the trunk and it will monitor your behavior and charge you accordingly. And the same thing happens with semitrucks: virtually every semi on the road today has a computer in it. And that computer improves the logistics. It monitors the performance of the driver and it helps things get to the consumer more quickly. So there are a lot of capabilities of that sort that allow you to contract on terms that were just not available to you before.

[At the same time,] you get a new technology in and people are excited about the positive sides of it. Then you see there are also some negative aspects. And you’ll have a regulatory infrastructure that arises to deal with those. I think everybody is very excited about the intended aspects of this technology—the fact that you can personalize, the fact that you can monitor, the fact that you can provide products that are more closely suited to a consumer’s interests and needs. What people are worried about are the unintended consequences, the downsides, the negative sides, the security, the identity theft, the possibility of extortion or embarrassment. These are the problems: not what people want to do but what could happen if these technologies weren’t appropriately managed.

On reshaping industries

We’re obviously going to see enormous change in the traditional marketing industry. You look at TV, you look at print, you look at radio and other media of that sort. On the Internet, we’ve learned to measure advertising effectiveness, and the challenge now is to move those same effectiveness measures over to the offline media.

That can be done. I think we’re going to see vast improvements in how those industries function in the future. And in general, if we look at service industries—well, everybody I think is in agreement that we’re going to see lots of efficiency improvements in services, because we do have this network capability. We have the technological infrastructure. We can improve communication flows. The second beneficiaries of that will be with service industries who’ve already seen a lot of advances in manufacturing productivity. And the tough nut is the one we’re working on cracking now.

What I actually work on to a large extent is a current feeding of the auction model that we have at Google. As you know, all of our ads are sold by auction. That’s a relatively novel pricing mechanism in the ad world. And there’re a lot of intricacies that involve how you manage that. We’d like to extend that model to the offline world: to radio, TV, print, and other media. It’s a model that was enabled by the Internet. It’s not something you could’ve done without that information technology there. And it’s a great model for all sorts of resource allocation issues.

I think the people who originally designed the model way back in 2001 had a very, very useful insight. They recognized that the content provider has impressions to sell. So you’ve got some space in your TV show. You’ve got some space on your page. You’ve got some space that’s available to put an ad. But what the advertiser wants to pay for is clicks or conversions or visits. So they don’t really care how many impressions they show. Normally, what they care about is getting people into their store and, ultimately, getting people to purchase. So you have to build a system that allows the publisher to sell impressions but the advertiser to buy clicks. And I think we’ve managed to accomplish that in a nice, elegant way.