By Stephen A.Wilson & Andrei Perumal
Complexity is now top of the agenda for many Chief Executives. In today’s world—that is, after the financial collapse—companies’ plans for top-line growth are being scrutinized to determine whether they will deliver profitable top-line growth. Investors are questioning cost structures that are out of line. Management teams are facing a knot of processes and organizational structures, and wondering how they will remain agile and responsive enough in the market place. At the root of these challenges is complexity, which injects cost, noise, and distance between you and your customer. We discuss the issue in depth in our book, Waging War on Complexity Costs, and suggest strategies for companies to take action. In our ongoing work with companies over the last two years we have seen nothing to suggest this issue is retreating. In fact, even more so than when we wrote the book, our perspective is that complexity—and companies’ response to it—is one of the biggest factors in determining whether companies will thrive or falter.
This may sound dramatic, but consider how “non-value-added” complexity, the type that customers do not value and would not pay for, whether it be product, process or organizational in nature, amounts to a tax—a complexity tax. Some companies, maybe most companies, will pay the tax. They will pay it because they’ve always paid it. Some companies, maybe your competitors, will refuse, and instead take on the hard work of cutting through the complexity. They will reap the benefits of greater margin, options for reinvestment, and organizational clarity. Over time these advantages are decisive. We have had the privilege of partnering with leading companies to take on this issue. Below we share a few perspectives from our experience, our Lessons from the Front:
Lesson #1: Complexity is a systemic issue. Therefore, to go after it requires different strategies and approaches than most companies use today.
It was Bertrand Russell, the English mathematician and philosopher, who commented that, “the greatest challenge to any thinker is stating the problem in a way that will allow a solution.” This is certainly the case with complexity. As a systemic issue, it is defined by a large number of interdependencies. Therefore, to remove complexity costs requires taking an integrated approach, which may combine a few “concurrent actions” in order to release benefit.
[ms-protect-content id=”9932″]Unfortunately, this is not how companies typically approach problems: the default is to take a big issue, and break it into more manageable “bite-size” portions. This is understandable, but with complexity, it’s ineffective as cause and effect end up in separate initiatives.
For example, one of our clients, a leading consumer goods company, was living with a riddle: they had the leading brand, highest price points and greatest market share. Yet they made less money than competitors, both in percentage and absolute terms. In the previous several years they had worked hard trying to improve their situation: they had optimized their logistics; they had worked plant by plant trying to improve their manufacturing; and they frequently revisited their portfolio. But the broad strokes of their situation did not budge.
What was missing was a top-down, systemic view. And the answer was to put more in play. The diagnostic work revealed the following: the chief driver of their profitability issues was an expensive distribution system. Theoretically they could serve demand locally, given the number of plants in the system, but the product portfolio had grown too large to fit into any one or few plants, mandating a lot of cross-shipping from plant to plant. This teed up a giant opportunity: by consolidating the size of their product portfolio it would enable the company to move to a “local” model, where product is largely produced locally for local demand, hence doing away with the need for an expensive distribution system.
This highlights the difficulty of tackling complexity: in the example above, working the levers in isolation did nothing to change the fundamental shape of the issue. But it also highlights the opportunity: once the company could re-imagine the business with a new operating model (and a vastly improved cost-structure), the common barriers against SKU consolidation fell away.
It also underscores a separate notion: understanding over precision. If the onus is on “connecting the dots” over a larger scope, rather than detailed understanding of a single lever, then companies need to adjust their expectations and mindsets accordingly when thinking through analytical burden of proof. Our experience: 80% is sufficient. The remaining 20% will usually not change the outcome, will delay action for another 6 months and is probably very expensive.
Lesson #2: Complexity Costs are rarely accounted for, leading to a distorted view of profitability. Understand your profit drivers, and it may change your strategy.
We were recently at the headquarters of an industrial products company. The conference room was crowded as more people had come to the Executive Session than we’d anticipated. And the room was tense. The client in question had asked us to do an assessment which included a quantification of complexity costs, in order to get to a true picture of the company’s profitability by segment. And we were now talking through the results; the picture was revealing, and for the company’s leadership, somewhat surprising.
“But we’re the market leader in that segment,” the CEO said, in reference to one particular segment that we’d identified to be profit-destroying, after accounting for complexity costs. “We’d built our strategy around dominating this segment.”
Complexity costs are the non-value-added costs associated with offering a larger number of items, or with having process or organizational complexity. They arise at the intersection of product, process, and organizational complexity and are the single biggest determinant of companies’ cost competitiveness today. We say this because a) they are geometric in nature and have risen dramatically over the last decade1 and b) companies usually fail to accurately capture them, which leads to a subsequent distortion of costs.
Figure 1 illustrates this well. In the original costing, the view was that only one segment (D) was unprofitable at the gross profit level. However, once accounting for complexity costs, the picture changed dramatically: only 2 of 6 segments were actually driving profits. This knowledge is a critical platform upon which good strategies are built: if it is not clear where you’re creating value, the path forward will be awfully foggy.
Note: How we got there is worth touching on. In our experience, while cost-accounting methodologies such as Activity-Based Costing can clarify a cost position, the investment to get there is considerable and it only provides a very static picture, so when the business changes, the costing is obsolete. To improve upon that situation, we use what one of our clients refers to (warmly) as “poor man’s ABC.” We innovated Square-Root Costing based on our discovery of how complexity costs behave, and the result is the same business insight considerably faster than Activity-Based Costing2.
Lesson #3: New competitive realities have made many organizational structures obsolete, and this misalignment often results in greater complexity.
Today, companies are dealing with the new realities of a global marketplace: 1) tremendous cost pressure as customers refuse to pay for a company’s wastefulness, and 2) the need for customer intimacy; a company’s product or service has to meet customer needs, not approximately, but exactly.
The implication here is that companies are increasingly faced with a new polarity: how to create sources of scale and at the same time build stronger intimacy with customers. For many companies, this task is complicated by organizational structures that do neither, and have simply “evolved” over time. But what worked 10 years ago won’t fly today.
Retailer Macy’s, prior to its My Macy’s initiative and restructuring, is a case in point3. Its regional structure consisted of seven different operating divisions, and was both “complicated and cumbersome” according to Jim Sluzewski, Senior Vice President. Each division was its own organization. Each had a Chairman, a President, a Chief Financial Officer, a buying group, a planning group, and a marketing organization, and those divisions operated the stores in their geographic regions. “Which meant that there were really seven different Macy’s.”
As a result, buying decisions were fragmented and the company missed scale opportunities. At the same time, decision-making was slow. This all changed in 2008, when Macy’s consolidated its seven semi-autonomous regional divisions into four, and in 2009, combined the four into one truly national organization. The company unified core functions such as finance, human resources, marketing and buying in New York and Cincinnati. In total, the restructuring eliminated about $500 million in annual operating expenses.
The restructuring enabled Macy’s ambitious, customer-centric localization initiative. The company preserved a team of 1,600 former buyers who were redeployed to 69 local markets, where they now work in teams of 2 to manage merchandising and planning decisions for clusters of 10-12 stores. Previously, the buyers were responsible for as many as 100 stores.
The new structure means Macy’s can identify local variations in taste and customer behavior and better respond to customer needs. These insights are pooled into the head office where buying decisions are now made, driving better leverage from national relationships with vendors. (See Figure 2.)
While it may seem like a recipe for increased complexity, localization for Macy’s has actually led to a net decrease in the number of SKUs it offers.
The benefits of less complexity are clear. “If we have nine brands of white shirts, it’s hard to keep them in stock in all the sizes all the time because we cannot buy in sufficient depth,” says Sluzewski. “By having three brands, we can buy in much greater depth, have more in stock, and serve the customer better.” Less complexity for Macy’s means: less missed sales, less discounting, and better purchasing power.
But how has Macy’s managed to reduce the net number of SKUs it carries? There are two levers: the first is that Macy’s is now better at targeting its inventory. It knows better what customers want. Therefore a scatter-shot approach is no longer required, which in itself trims the portfolio down—Macy’s is selling fewer items that customers don’t want. The second lever is the greater visibility to demand due to the pooling and sharing of information between local stores and the head office. This allows Macy’s to respond to demand in a coordinated fashion. What matters, for instance, is a good range of white shirts in different sizes. If local buyers were to respond to this demand in isolation, the result would be a hundred slightly different portfolios of white shirts. That is no longer the case, which means a more tailored portfolio at the aggregate level and better availability at the stores.
To emphasize this point, Macy’s has remarkably just achieved their best results ever, despite the challenging retail environment with which we are all familiar.
Lesson #4: There is a certain level of complexity that your business can support; there is a point of equilibrium. The implication is that complexity management is a critical counterpoint to innovation
“Ninety percent of people hate coconut,” said Paul Kruse, CEO of Texas-based Blue Bell Creameries, the #3 ice cream maker in the US by volume and the #1 by profitability. “But the 10% that love it just go crazy.” Which is why they launched the flavor, Coconut Fudge.
“People went nuts, they couldn’t find it. We buy enough for three months, and it was gone in five weeks.” Kruse is clear that not every new flavor works. But it was the same spirit of innovation that led Blue Bell to come up with Cookies ’n’ Cream 30 years ago.
Equally important, however, is Kruse’s claim that “we can only support 25 to 30 flavors at one time.” The reason: shelf space (“it all starts with that”), impact on production and distribution, and to enable innovation.
“Our space in the stores dictates how many flavors we can carry; you can put an adequate amount of vanilla and the big sellers and still get all your other flavors represented. That is the starting point. But we’ll have 8 or 10 additional flavors during the year that we’ll rotate for three months or six months.”
What Kruse says is intuitive and makes sense. However, very few companies operate like this. Most have formalized innovation processes; very few have an iron-clad sense of what the level of complexity is that they can successfully support (see Figure 3), nor, more broadly, the link between complexity management and innovation.
Lesson #5: Your growth strategy is either creating scale or creating complexity. Learn to understand the difference.
“This is what killed our scale,” said the head of strategy. He was pointing to one of our charts, the one that showed the geometric growth of complexity costs. “Ten years ago, no one was thinking costs would rise like this. But this is exactly what happened to us. We never got the scale economies we expected. Complexity killed our scale.”
His company, a multi-billion dollar technology venture, had seen tremendous growth over the last several years, in line with the original business plan and strategy that had attracted plenty of investors in the first place. The strategy had been simple and compelling: the company would build upon its business and technology platforms and in the process attain ever increasing economies of scale. At some point, the volume of business would be such that the Fixed Costs associated with the technology platforms would no longer erode all the profit.
And that would translate, according to the plan, to profits. That was the plan. But while the revenues came, the company never achieved the scale economies it had planned for. Its costs continued to rise, and moreover, rise at an increasing pace: the geometric growth of complexity costs.
Many growth strategies are built on the presumption of scale. But, it is worth remembering that complexity erodes scale. Figure 4 illustrates the notion of Scaling Curves. The idea is simple, understand the potential for scale economies by assessing the level of complexity costs inherent in the segment (which we do using our costing methodology). You can then war-game to understand if there is truly a fixed-cost leverage opportunity, or whether your scale-chase is likely to become a goose-chase.
Conclusion
The case for waging war on complexity is clear. But—and we say this from experience and with empathy—it is far from easy. It is difficult because you are attempting to unwind and dismantle systemic issues. The world has changed; if we were to re-imagine the business to better serve our customers in a more effective way, what would it look like? What would our portfolio be? How would we structure to better serve our customers? What would fall away? Re-imagining the business gives you clues as to where the big opportunities reside. It is a top-down exercise. For that reason, it is not an issue you can resolve with teams of six sigma Black Belts, or through incremental changes from the bottom-up. As we like to say, complexity “creeps” in, but you need to remove it in chunks. While it may not be an easy task, it’s worth noting that your competitors will likely find it just as hard, with their systemic issues equally entrenched. For some, this will serve as a major deterrent. We think it equals an opportunity to get ahead.
About the authors
Stephen Wilsonand Andrei Perumal are co-authors of Waging War on Complexity Costs (McGraw-Hill) and managing partners and co-founders of Wilson Perumal & Company, an international strategy consulting firm. They can be reached at [email protected] and [email protected]
Notes
1.See Waging War on Complexity Costs (McGraw-Hill) for full discussion of this topic
2.For more information on Square Root Costing, go to: http://www.wilsonperumal.com/about/SQRT-costing.php
3.For a longer case study on Macy’s, see WP&C’s Vantage Point at: http://www.wilsonperumal.com/publications/PDFs/Vantage_Point_2011_Issue1.pdf
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