We live in a world of mounting performance pressure. Our Shift Index reveals that return on assets for all public companies in the US has eroded by 75% since 1965. Companies clearly are failing to respond effectively to these mounting pressures. If we hope to turn this around, we need to step back and take a systematic look at the performance levers that drive these results and question the approaches of the past.
What drives company performance? It’s actually quite simple. Most businesses can be understood as bundle of three core operating processes, each driven by a unique performance lever. These three operating processes are: customer relationship management, product innovation and commercialization and infrastructure operations. Each of these core operating processes is under increasing pressure. Let’s look at each one in sequence.
Customer relationship management
Customer relationship management is all about connecting with a set of customers, getting to know them deeply and delivering more and more value to them. The metric that drives the performance of this core operating process is simple: customer life-time value. Customer life-time value itself is a function of three variables:
[(Profit generated per year) x (years of relationship)] – cost of customer acquisition
While simple to state, these variables are more and more challenging to manage. In fact, each one is under growing pressure. In most industries, customer loyalty is eroding, leading to a significant reduction of the average life of a customer. To make matters worse, margins are eroding as well, diminishing the profit generated per year of a customer relationship. In many industries, the cost of customer acquisition is also rising. Other than that, everything is find with the customer.
Product innovation and commercialization
This core operating process focuses on the research and development required to generate innovative new products and services, getting new products and services quickly into market, accelerating adoption of these products and services and then striving to extend their lives in the market as long as possible. Similar to customer relationship management, the metric that drives this core operating process is simple: product (or service) life-time value. This metric can also be decomposed into three variables:
[(Profit generated per year) x (years of market life)] – cost of developing the product
Once again, each of these variables is under increasing pressure. Across virtually all industries, product life cycle compression has become a fact of life. Product margins are under increasing pressure. Greater efficiencies in procurement can help to offset these growing margin pressures to some degree. Brand used to help a lot in charging a price premium, but the brand premiums are rapidly eroding in most industries. As if that is not bad enough, the cost of developing new products and services is also increasing in many industries. And yet we keep churning out more of them. In many cases, we seem to be compensating for diminishing product profitability by making more of them - we desperately hope to make it up on volume.
Most businesses require some type of asset intensive infrastructure to operate. The nature of the infrastructure differs significantly across industries. In many product businesses, it might be factories to produce the products. For retailers, it would be the physical store fronts. For banks and brokers, it could be the back office processing facilities that they operate to execute transactions, not to mention the branch offices to engage with customers. Even digital Internet businesses typically require large data center operations.
Whatever the physical facilities, they typically consume significant assets and require substantial operating expense. In this context, managers tend to focus on asset life-time value:
[(Profit generated per year) x (years of asset operation)] – cost of building/acquiring asset
By now, the story becomes monotonously similar. Margin pressure reduces profit generated per year, accelerating technology and consumer preference changes diminish the average years of asset viability and cost of building/acquiring assets tends to increase. In this particular case, asset utilization can also have significant impact on profit generated per year. Finding creative ways to increase asset utilization can often help to offset increasing margin pressure.
Begin by measuring
In coping with increasing performance pressure, it is important to tightly manage these performance levers. Of course, it's hard to manage these levers, if they are not even measured. I continue to be amazed at the number of companies that have yet to even systematically measure and monitor these levers. Most companies do a pretty good job at focusing on product life-cycle value but the attention to customer life-cycle value and asset life-cycle value is far more sporadic. If you're not relentlessly measuring these performance levers, you'll have little chance for success in the global economy ahead.
These operating performance levers are especially critical because they represent leading indicators of financial performance. By aggressively measuring, monitoring and managing these performance levers, executives can anticipate how their company will do financially.
As companies develop measurement and monitoring systems for these performance levers, they need to be wary of the tyranny of averages. Customers, products and facilities often vary dramatically in terms of life-cycle value. In fact, the Pareto principle is often missed by companies – 20% of the customers, products and facilities usually generate 80% of the profits. But which 20%? Few companies can answer this with any assurance or precision.
One way to start improving performance dramatically is to ask two questions. First, what are the characteristics of the 20% that generate the 80% of the profitability and is there anything that can be done to increase the share of these highly profitable parts of the business? Second, is there a compelling reason to retain the other 80% of customers, products and facilities given their low contribution to profitability and, if so, what can be done to increase their profit contribution? Alas, few companies even ask these questions in any systematic way, much less answer them.
But measuring is not enough
Measurement is just the beginning. The key is: what actions can managers take to improve the overall performance of these operating levers? Unfortunately, the prevalent instinct of executives as they focus on these operating levers is to cut costs. While certainly understandable, and worthy of pursuing wherever feasible, cutting costs is a diminishing returns proposition. The more costs are cut, the harder and harder it will be to achieve the next increment of cost reduction. In a world of steadily increasing performance pressures, cost reduction is never enough to sustain performance improvement.
In this kind of environment, executives will need to broaden their horizons and look for more powerful ways to drive performance improvement.
The power of pull platforms
One way to drive increasing value from all three of these core operating levers is to shift to a platform mindset. What does this mean? Let’s take a look at each of these core operating processes through a pull platform lens.
Customer relationship management traditionally has been viewed as a narrow pipeline. Nirvana is to build an enduring one to one relationship with each customer – me, the vendor, working closely with you, the customer, and with no one else to distract us from doing business with each other. This is a much too narrow view of the opportunity, especially in a world where customers are gaining increasing power and seeking ever more value at lower cost.
What if we viewed the ideal customer relationship as one where I, the vendor, seek to build an expanding platform to help customers connect more effectively with the resources that are most valuable to them individually? Now we have an opportunity to generate increasing value from the relationship and the potential to build a much for sustaining relationship. We might even reduce customer acquisition costs as word spreads among the customers regarding the increasing value available on this platform.
Similarly, we've become much too accustomed to viewing products and services as standalone offers to the customer. What if we began to re-conceive products and services as platforms that would invite and support third parties to add customized modules and extensions to the functionality available in the core platform? Such an approach might reduce the cost of development since we no longer have to design in all the functionality at the outset, it might extend the life of the offer (particularly if network effects begin to kick in) and we might generate more profit with each year that the platform is available.
Finally, how might we re-conceive infrastructure as a platform? Perhaps rather than viewing it as a captive resource only available to our company, we might explore ways to make it available to third parties so that we can increase utilization of the resource and generate more profitability from our investment. It was this shift in mindset that set Amazon down the path of offering Amazon Web Services, its hugely successful infrastructure as a service offering – it was wrestling with the challenge of investing for peak loads and the availability of spare data center capacity for much of the time.
In exploring the potential of a pull platform approach, executives might think about the three distinct levels of pull that we developed in our book The Power of Pull – access, attract and achieve. The big win would be to design platforms that address all three levels of pull.
The unbundling option
If any of the three operating levers are underperforming and the option to develop pull platforms appears unrealistic, executives should explore the most radical option of all – shedding the core operating process that is underperforming.
I explored this option in a Harvard Business Review article – Unbundling the Corporation – which has gotten a lot of attention from executives around the world. The article had a provocative proposition – companies will ultimately have to choose one of three business types to focus on and shed the other two. These business types map closely, but not completely, to the three core operating processes outlined above.
Through this lens, the outsourcing and offshoring trend of the past several decades can be understood as a systematic shedding of infrastructure management processes by larger companies. In turn, the successful outsourcing providers can be viewed as creating very effective pull platforms for infrastructure management operations. We'll also see increasing options to shed either the customer relationship management or the product innovation and commercialization business processes. If you can’t fix it, shed it.
The bottom line
Does your company explicitly and systematically monitor these key performance levers? Has your company applied the Pareto lens to understand where your real profitability is? What steps is your company taking to manage these performance levers in a more effective way? Are you aggressively pursuing pull platform or shedding options? What are the barriers that prevent more effective pursuit of these options? Do you have a going out of business plan?