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The future of the networked company

Even during the present slowdown, networked companies are outperforming conventional ones. What's more, they are likely to go on doing so, according to experts at McKinsey.

When Cisco Systems announced a $2.2 billion inventory write-down in the second quarter of 2001, skeptics immediately proclaimed the fall of the network business model that Cisco exemplifies. Superior information technology and real-time management, the critics reminded their readers, were supposed to have enabled networked companies to avoid precisely such setbacks.

Cisco?s vaunted supply-chain systems were meant to provide greater notice of impending demand slowdowns. But reports of the demise of the network model--in which companies go far beyond outsourcing and collaborate in the delivery of products and services to customers--are exaggerated. "Network orchestrators" like Cisco might be experiencing their first real taste of adversity, but the network strategies they deploy look stronger than ever.

Indeed, Cisco outperformed its peers not only during the boom years of 1995 to 2000 but also during the first-quarter-2001 downturn. By most measures, its fellow network orchestrators did so as well. Our analysis shows that network orchestrators have reached their market milestones more quickly and earned greater value per employee than have their peers. Because they own fewer assets and leverage the resources of partner companies, network orchestrators require less capital and return higher revenue per employee than do conventionally run companies, and they are better able to weather the damage usually inflicted by market volatility.

Network orchestrators like Cisco might be experiencing their first real
taste of adversity, but the network strategies they deploy look stronger than ever. We also compared the network orchestrators? performance with that of market leaders in six industry segments (commercial airlines, consumer products, financial services, high technology, industrial products and retailing). This group was then culled for sector leaders in the period from 1996 to 2000, when networked companies took root. Network orchestrators far outperformed these industry standard-bearers in both shareholder value creation and revenue per employee. And as we have already mentioned, almost every measure of performance suggests that the leading network orchestrators, including Cisco, maintained their advantage even in a broad market decline.

This is how particular companies fared:

From 1995 to 2000, Schwab?s net income grew by 27 percent a year, though the firm made no large acquisitions. At the end of the year 2000, Schwab?s market-to-book ratio was 8.9--more than double the ratio of almost all of its competitors. As of March 2001, this ratio was still almost twice that of the rest of the industry.

During the same period, Cisco?s revenue grew by an average annual rate of 57 percent, and its market value per employee more than tripled--to $8.1 million, from $2.3 million. As of March 2001, Cisco?s revenue per employee was still more than twice that of other industry leaders.

The revenue of eBay grew by an annual average of 92 percent from 1996, when its revenue stood at $32 million, to 2000, when its revenue had risen to $431 million. At the end of 2000, eBay?s market-to-book ratio of 9.1 was the highest in the retail industry. As of March 2001, eBay?s market-to-book ratio had grown to 9.6, almost twice the industry norm.

During the past decade, big corporations learned to dismantle, or "unbundle," themselves into their component parts, while they sold off others. In so doing, they encountered a discomfiting question: If they were not exiting the business but would continue to deliver a complete product or service to customers, what would be their relationship with their former subsidiary or its marketplace counterparts?

As Cisco morphed into a virtual corporation, it answered that question by creating a "gated network" of contract manufacturers and suppliers connected to one another and to itself by a powerful set of network applications running on its proprietary extranet. Cisco itself was disintegrating, but that didn?t mean it was disengaging from the manufacturers, subcontractors, resource planners and other companies on which the delivery of its products to customers depended.

Network orchestrators
Network orchestrators begin by undertaking a self-appraisal in which they identify those activities they do well enough to become the preeminent players in their markets.

Orchestrators then set about establishing a platform across which the network participants will interact. For Cisco, this platform is the Cisco Connection Online, a Web-based channel for organizing and circulating information generated by the company?s customers and partners. For eBay, the platform is the auction software that brings into being a community of sellers and buyers. In effect, eBay provides the product-management and distribution links of the value chain, while the company?s specialist partners handle direct payment, shipping and other services.

For Schwab?s network, the platform is an online system that refers customers to some 6,000 independent financial advisers and provides transaction services to those advisers.

While size is not an end in itself, larger networks do have an easier time attracting additional partners. Networks are not the only set of institutional relationships shaped by information technology. Microsoft?s Windows operating software places it at the center of an "economic web" composed of companies that produce Windows-based software applications and related services for users of personal computers. The market position of a given company will determine which form suits it better. Companies more fitted to the role of network orchestrator do, however, enjoy certain advantages over those choosing to become shapers of economic webs.

Economic webs are the creatures of a Darwinian struggle in which companies vie to establish a user base for their technologies. The technology that current users embrace becomes the "standard" and thereby the choice of most new users. The sheer weight of the market preference for the platform is the source of its influence over the economic web?s existing members and of its ability to attract new ones.

Network orchestrators, by contrast, can control the circle of companies on which they depend even before achieving market acceptance. Demand for the manufacturer?s products and their number and complexity determine the proper size of the network as well as its proper scope. Cisco maintains a well-defined network that mirrors a traditional manufacturing value chain; eBay, a service business with more diverse offerings and a larger number and assortment of customers, manages a more fluid, open-ended network.

Unlike economic webs, networks are not open to all comers; rather, companies are invited into the network by the orchestrator.

While size is not an end in itself, larger networks do have an easier time attracting additional partners. The presence of a greater number of participants in turn lowers transaction costs, amortizes risk, reduces the cost of tangible and intangible assets, and improves productivity.

The key tactical step for an economic-web shaper is to share the technology it wants to see become a standard with companies that will stimulate demand for the technology by developing valuable applications. "Sharing the standard" has become a revered New Economy precept: winning companies do it; losing companies do not.

Orchestrators, however, do not share their core technologies. It is unnecessary for them to do so, since the viability of a network doesn?t depend on its attracting a huge number of partners. One purpose of a network platform is to draw together participating companies by facilitating the exchange of information among them. The platform of an economic web merely makes it possible for companies to develop their complementary applications and has little effect on their organizational relationship with the shaper.

A network strategy enjoys important advantages over the economic-web strategies it superficially resembles. First, the orchestrator chooses both its partners and the standard. Since market-based standards are harder to erect, broader in sweep, and thus fewer in number than proprietary networks, companies have a better chance of launching networks. Second, network orchestrators are in a better position to manage and profit from their growth.

Defining the orchestrator?s role
Before beginning to think about deploying a network strategy, managers must realize that not every company is cut out for the orchestrator?s role. Each company that has built a successful network began with a strong relationship with the ultimate consumer of the network?s products. Unless a business has already created demand among end users, it isn?t likely to succeed in persuading other businesses to clamber onto its platform. A would-be network orchestrator will then have to promise them a continual flow of market intelligence and new strategic opportunities.

A network strategy enjoys important advantages over the economic-web
strategies it superficially resembles. Thus the strengths and limitations of some businesses might make them better suited to a specialist?s role within a network. Companies that are equipped to serve as orchestrators will evaluate candidates for network membership on the basis of criteria such as size and maturity as well as their cultural and performance traits.

The information exchange that standards facilitate most often concerns thorny, intercompany operational challenges. Let us say that a network orchestrator wants to give one of its business partners access to its customer accounts. The information that the partner seeks probably resides in databases and directories on servers in the orchestrator?s IT systems. But these databases will in many ways be different from the databases, directories and servers in the partner?s call centers or shop floors needing such access.

The orchestrator defines the schemas (common automated formats) that enable its business partners and customers to share information about themselves as well as purchase orders, shipping notices, invoices, forecasts and credit authorizations.

Most companies that have made a go of building networks have been in the IT business. Thus, any company that aspires to be an orchestrator but lacks such a background would be well advised to immerse itself in the software that makes it possible to construct an information standard. The second step of such a company should be to evaluate what information is needed at each stage of the value chain and when. The third step would be to present that information in a clear and consistent way.

A network thrives only if the orchestrator looks out for the welfare of all the companies on which it depends. Value-sharing mechanisms and incentives help ensure that kind of cooperation and build trust. Designed correctly, incentives can align the members? behavior with the larger interests of the network, reducing the need for centralized control.

Cisco, for example, never splits revenue 50-50 with partners but instead divides it in their favor. By taking a smaller share, Cisco fosters the growth of the network?s revenue and enhances the value of its own stake. The company also provides non-financial incentives to those distributors that have generated high sales volumes or shown superior technical expertise.

By drawing competitors into the network, Schwab also extends its own distribution channels and builds revenue. Its 6,000 independent investment advisers keep the fees they charge Schwab customers but pay an annual fee to be part of the network and generate more than $860 million by trading on the company?s platform. Similar arrangements with E-Loan, Schwab?s mortgage provider, and almost 150 outside mutual-fund companies assure a full-service offering to customers and motivate the partners to increase the size and value of Schwab?s network by bringing more assets under management. Thus Schwab wraps its name around the names of its competitors, which in return receive what is in effect the Schwab stamp of approval.

Today's network leaders...achieve remarkable success by leveraging the
resources of their network partners. It is not enough for network orchestrators to create information standards. They must use those standards to move their key business processes online, where those processes can be made accessible to employees, partner companies and customers. Cisco, for example, can give customers and suppliers real-time information on the status of an order. By offering these benefits Cisco has been able to move 80 percent of its sales online. The number of its customers that can?t find a suitable product has fallen, and its employees? productivity has increased by 78 percent. Since 1998, Cisco?s online order process has saved the company $130 million a year.

A network also has the potential to move business ideas quickly across organizational boundaries. Because product developers high up in the supply chain are suddenly in touch with the customer, they can carry out market tests and avoid straying far from their market?s needs and tastes. And they hear the reactions of customers and business partners, allowing the network?s members to avoid the insularity and blindness that can afflict freestanding companies. The first customer-service representatives of eBay were eBay customers whom the company invited to conferences and paid to support other customers. Today eBay?s Soapbox collects suggestions for enhancing network offerings, and trials are announced and discussed within the community.

Another example of collaboration is the development of E*Trade Zones, which offer in-store customers access to trading and banking on the Web. E*Trade Zones are now being launched in more than 200 Target stores in the United States. Together with the accounting firm Ernst & Young, E*Trade designed and tested both an online and a face-to-face financial-advice service.

But to co-develop products and services effectively across a network, orchestrators must create cross-organizational teams which sometimes will be led by the orchestrator?s best-qualified partners, not by the orchestrator itself.

What's the bad news?
For 50 years or more, the scale and internal control of resources stood behind the prosperity of vertically integrated corporations. But recently, their very size and structure have slowed their responsiveness. Today?s network leaders, by contrast, achieve remarkable success by leveraging the resources of their network partners. Unfortunately, such connectedness also makes the network leaders more vulnerable to their partners? financial or logistical problems. Moreover, the transparency of networks can make participants in the supply chain overreact to what might be temporary drops in customer demand. While the risk of inventory overhang is probably smaller among networked companies than their non-networked counterparts, the risk of ensuing shortages when demand revives may be greater.

Over the next few years, companies in many industries will form or join networks, which have not only the levels of integration and internal transparency of very large companies but also the openness to market information and the flexibility in responding to it that are the strong suit of small, young ones. In addition, networks give their organizers competitive scale, which they achieve not by taking the expensive route of mergers and acquisitions but by turning their suppliers, subcontractors, and, sometimes, their competitors into close collaborators.

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

Copyright © 1992-2001 McKinsey & Company, Inc.