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What high tech can learn from low tech

McKinsey experts say high-tech executives should focus not just on technological innovation but also on business process innovation if they want to find new ways to increase productivity.

What high tech can learn from low tech
From the McKinsey Quarterly
Special to CNET
September 28, 2003, 6:00 AM PDT

During high technology's boom years in the late 1990s, companies across many sectors tried to emulate their high-tech counterparts. The business models, the creativity and innovation, the speedy decisions, the headlong growth in revenues, profits and shareholder value--slower-growth industries aspired to all these blessings.

But now, with no technology rebound in sight, high-tech vendors must look to the business practices of their former admirers in slower-growth industries such as retailing and banking. There they will find lessons about increasing productivity and using the improvement strategically to expand their market share and improve their financial performance. The challenge goes beyond simple cost cutting; it's about changing the ratio of inputs to outputs--the value of what companies put into a production process compared with what they get out of it.

High-tech companies have always focused on product innovation, and the economics of producing and selling technology in a high-demand environment enabled them to increase the value of their output for a given amount of labor, capital, and purchased goods and services. Now they must put a similar effort into delivering the same or greater output with fewer inputs and developing innovative operational processes, not just products and services.

A handful of high-tech vendors, grasping this new reality, has developed extremely productive business processes or taken advantage of lower factor costs--and sometimes both--to create and then widen their advantage over the competition.

Dell, for instance, poses a threat in the market to enterprise networking products because its lower-cost switching gear matches high-end routers in some respects. Huawei Technologies, a Chinese company that has engineering labor costs one-eighth the amount of those of U.S. players, charges about half of what many competitors ask for routers and other products. Although Cisco Systems is suing it for infringement of intellectual property, it has gone from playing catch-up in routers during the 1990s, to providing near-equivalent performance, at least as measured by line board speed (per port). That success is reflected in Huawei's commercialization rate, which improved sevenfold from 1995 to 2002.

For high-tech companies that have long thrived by creating innovative products and services in response to technological discontinuities--in other words, by launching the "next big thing"--the transition to a new operational philosophy and approach won't be easy. Yet companies that fail to make this shift risk being caught in a dilemma intrinsic to slowing industries: Either protect margins and concede market share to competitors or protect market share at the expense of margins. The productivity imperative arising from this dilemma applies even to high-tech's leading names.

An end to hit making?
It may seem strange to talk of a productivity imperative in high tech, since it accounted for more than a third of the U.S. economy's productivity surge in the 1990s--far more than any other sector, though it was responsible for only 8 percent of gross domestic product at the start of the boom. But much of the sector's productivity growth was driven by unusually high demand for increasingly powerful products--an environment that technology vendors may not again enjoy for some time.

Furthermore, the success of a few stellar performers, some of which are now seeing their advantage slip, masked substantial differences among companies in the high-tech sector as a whole. More ominous, still, are three trends that may amplify the effects of slowing technology demand: the emergence of products offering equivalent value propositions at lower prices, the embedding of previously stand-alone technologies into broader offerings and the entry of credible offshore vendors exploiting lower factor costs.

A close examination of the numbers shows that most of high tech's productivity gains during the 1990s resulted from extraordinary gains in computing power and a strong demand for products with ever better performance, capacity and features. These advances--along with demand created by phenomena such as the Year 2000 bug, the e-business boom, the restructuring of enterprise computing platforms and the increase in connectivity-led information technology spending growth to accelerate from about 10 percent a year in the late 1980s and early 1990s, to more than 20 percent from 1995 to 2000. As a result, technology spending surged from 22 percent of the total capital expenditures of U.S. companies in 1980, to 39 percent in 2000.

High-tech companies, in other words, increased their measured productivity (encompassing quality improvements such as faster processing speeds) as a result of greater demand and the market's willingness to pay without necessarily increasing their process efficiency. The electronic equipment sector, for example, achieved rather high rates of annual productivity growth from 1994 to 2001, while also increasing its labor inputs, because each new generation of chips was so much more powerful than the preceding one. During that same period, by contrast, the slow-growth metal mining, coal mining, apparel and textile industries increased their productivity by significantly reducing the amount of labor they used.

Since 2001, of course, demand for high-tech products has plummeted, but aggregate operating expenses haven't always come down at the same rate. No rebound is in sight; the most optimistic forecasts for the next three to five years show IT spending growth only in the high single digits. Nor can "hit making" companies take comfort from current technological advances such as service-oriented architectures that are based on Web services or infrastructure "resource virtualization," or utility computing. After all, these innovations are designed mainly to help companies get more out of the IT resources they already have without increasing expenditures.

A diminishing lead
A second surprise lurks behind the high-tech sector's seemingly rosy productivity performance: The large gap between strong and weak performers skewed the overall productivity results for a handful of leaders. In the computing and communications equipment sector, for instance, Dell's labor productivity stands at $900,000 per employee, against a subsector average of only $240,000. More than 70 percent of the companies in the subsector fall below even this average, and more than 60 percent fall below the average level of capital productivity. The same holds true in software and other high-tech sectors.

Worse yet, fierce competition is pressing margins and redistributing demand. At the same time, new high-tech features, traditionally pioneered in stand-alone products, are migrating to existing core products at an accelerating rate. For example, vendors of application servers, which act as platforms for modern business applications, began aggregating stand-alone but related applications (such as enterprise-application integration tools and business process management software) into their suites of middleware.

They then saw the middleware being embedded into the broader offerings of, for example, vendors of enterprise resource planning (ERP) systems and databases. This trend toward incorporating features into core products while keeping prices steady will redistribute demand and cut aggregate margins.

Meanwhile, offshore players with very low factor costs--especially for labor--are becoming increasingly competitive. Rather than merely playing catch-up, many of these companies, such as Huawei in communications equipment and Wipro and Infosys Technologies in services, offer value propositions almost equivalent to those of their U.S. rivals, at a much lower cost.

Each of these forces by itself makes raising high-tech productivity more urgent. Together, they make increased productivity an absolute imperative for many high-tech companies in the United States and Europe.

Learning from slow-growth industries
As technology vendors target productivity, they should take a cue from high-performing companies in slow-revenue-growth sectors such as retailing, whose 5 percent annual productivity growth from 1993 to 2000 was more than twice the rate for U.S. industry as a whole, and wholesaling, which also increased its productivity rapidly during the 1990s. In these sectors, where the demand environment is more mature, companies must perfect the art of raising productivity year after year--not as a one-time event--and exploit that growth for strategic gain. Although they also search for innovative, next-generation products and services, they relentlessly identify and close gaps with industry best practices in process efficiency and pursue breakthrough productivity gains by investing in business innovations.

Rather than relying on a "silver bullet," the productivity leaders have adopted an integrated, end-to-end approach--including process innovation and redesign, the targeted application of IT, carefully crafted outsourcing arrangements and offshoring. They generate gains from a combination of organizational change, targeted investment and the ability to measure the right things. In contrast, companies that bet the farm on major investments such as ERP systems without bothering to improve processes, organizations and strategies may be disappointed. The integrated approach is characterized by short-cycle, well-defined initiatives that are intended to realize year-on-year productivity gains.

Making the switch
Of course, the business issues high-tech companies face differ from those in many slow-growth industries. But applying the principles lower-tech brethren employ--particularly by focusing on core business processes and leadership--will make a great difference for high-tech companies. Just as important, they must shift their focus and culture from a preoccupation with the next big thing and learn to emphasize the importance of process improvements as well.

The effect on profitability can be substantial: Raising the productivity performance of a software company with $1 billion in revenue from sluggish to median would typically create $120 million in additional profit, a figure that would rise to more than $180 million if the company achieved top-quartile performance. Clearly, however, not all of this value will necessarily be captured as profit; the company might well choose to reinvest its surplus to build other advantages.

Our work with a variety of high-tech companies has highlighted large differences in their performance in six operational processes. The first thing a company must do to improve its productivity is to establish which business processes have the biggest impact on the economics of its sector (for instance, software). Then it must find out where its performance lags behind in those key processes; catching up is critical. The final step is to identify processes in which the company could develop innovations that might make it a leader in productivity.

Once the priorities are set, companies can get down to the nitty-gritty of making improvements. A myriad of approaches is possible, of course. A software company that finds a critical gap in the productivity of its product-development organization, for instance, could redesign its idea-to-product capabilities through a range of targeted initiatives.

The organizational challenge
The biggest challenge may be for senior management to extend its focus to the more difficult (and, for some, less exciting) world of business process innovation. Many high-tech companies, still in denial, believe that they need only cut costs and hold their breath until the good old days return. Others believe their own marketing claims--that the application of IT alone will improve productivity. The struggles of their customers testify otherwise. IT plays a critical enabling role-but only in conjunction with organizational, behavioral and business process changes.

Furthermore, most high-tech companies value and reward technology innovations rather than business process improvements. When these companies do think about productivity, their efforts are typically scattered and deep in the organization. Disjointed programs probably can't move the needle.

What is vital is a commitment from the top to view productivity as a strategic imperative and to realize the organization's agreed-upon process priorities. Employees, motivated by reward and recognition systems, should understand and agree with the focus on productivity. Assembling the right team may require new skills and talent--particularly senior operating managers who can shake up the company. Some of them will probably come from more process-intensive industries.

High-tech executives face a choice: continuing to bet that they can generate and ride the next wave--when none is yet in sight--or getting their organizations to focus on business process improvements that drive productivity. We think that most should choose the latter course. This approach doesn't mean forgoing the development of new products, but top management will have to spend time on long-overlooked process innovations as well.

For more insight, go to the McKinsey Quarterly Web site.

Copyright © 1992-2003 McKinsey & Company, Inc.

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