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Getting beyond the next big thing

McKinsey says a post-boom tech industry can profit mightily by taking stock in the operations of many slower-growth industries.

Getting beyond the next big thing
From the McKinsey Quarterly
Special to CNET News.com
August 15, 2004, 6:00AM PT

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 of 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.

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, have 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.

They should take a cue from high-performing companies in slow-growth sectors.
These companies offer their customers products comparable to those of their rivals as well as lower prices and thus represent a serious challenge to competitors slower to start the productivity race.

Dell, for instance, poses a threat in the market for enterprise networking products, where its lower-cost switching gear matches high-end routers in some respects. Huawei Technologies, a Chinese company with engineering labor costs one-eighth those of U.S. players, charges about half of what many competitors ask for routers and other products.

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 (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 failing 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 about 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.

Companies that bet the farm on major investments without bothering to improve processes, organizations and strategies may be disappointed.
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 enjoy again 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 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 rearchitecting of enterprise computing platforms and the increase in connectivity--led IT 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.

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.

A second surprise lurks behind the high-tech sector's seemingly rosy productivity performance: The large gap between strong and weak performers, for a handful of leaders, skewed the overall productivity results.

In the computing and communications equipment sector, for instance, Dell's labor productivity stands at $900,000 per employee, against a sector average of only $240,000). More than 70 percent of the companies in the sector 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.

Even among some of the productivity leaders, including Cisco Systems and Intel, the numbers aren't necessarily encouraging: Their lead, as measured, is diminishing. In sharp contrast, companies such as Adobe Systems and Dell have continued to expand their edge.

Rather than relying on a "silver bullet," the productivity leaders have adopted an integrated, end-to-end approach--including process innovation and redesign, and offshoring.
Worse yet, fierce competition is pressing margins and redistributing demand. In some cases, companies are challenging the leaders with equivalent products that satisfy the needs of some customers at a lower cost. Examples: Linux-based servers, networked "Wintel" machines that provide supercomputing capabilities at a fraction of the cost of systems built around prior architectures, switches that substitute for high-end routers in enterprise networking and modular network-attached storage systems.

Typical responses--cutting prices and watching margins sink or standing pat and losing market share--are unattractive. Raising productivity would be better.

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 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-growth sectors such as retail, 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 onetime 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.

Consider the well-documented success of Wal-Mart Stores in retailing, a sector that until the 1990s hadn't experienced rapid productivity growth for years. Wal-Mart popularized and reproduced the big-box (large-store) format across North America, generating labor efficiencies and offering a compelling value proposition consisting of "everyday low prices," product categories historically limited to specialty stores and a superior shopping experience for mainstream consumers.

This combination created a virtuous cycle of scale-driven productivity growth and market share gains. As the volumes of Wal-Mart increased, so did its cost advantages from scale, distribution and purchasing power. Several factors characterize such productivity leaders.

They focus on improving the productivity of their core business processes, for investments in ancillary ones often yield little return and may even complicate the overall business system. Examples of such pivotal processes include new techniques for inventory management in general-merchandise retailing and the new product introduction processes of high-tech original equipment manufacturers.

Once the leaders determine which processes drive their productivity, they decide where to lead and where to match, and then build an enduring competitive advantage through continual improvements. By offering clean stores, friendly salespeople and a broad product variety, Wal-Mart merely matched competitors like Kmart and Sears Roebuck.

Wal-Mart took the lead with its store format and distribution system, whose efficiency made possible the low prices that drove consistent market share increases--from zero in 1962 to 9 percent in 1987 and 31 percent in 2000. Moreover, Wal-Mart hasn't rested on its low-cost laurels: Only through continual improvement has it sustained its 40 percent productivity lead, even as its competitors grew more efficient in response.

In high tech, Adobe Systems is among the few software companies that have increased their productivity year over year, even through the downturn.

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 intended to realize year-over-year productivity gains.

Of course, the business issues high-tech companies face differ from those in many slow-growth industries. But applying the principles that the lower-tech brethren employ--particularly by focusing on core business processes and picking a few for 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.

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

Copyright © 1992-2004 McKinsey & Company, Inc.

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