Coping With Margin Squeeze

Viewpoint: November 6, 2002  

Pardon the commercial message at the outset of this blog, but after months of work and preparation, my new book Out of the Box: Strategies for Achieving Profits Today and Growth Tomorrow through Web Serviceshad its official publication on October 28. I was particularly pleased to find out that Strategy + Business (a business journal published by Booz Allen Hamilton) has designated Out of the Box one of the best business books in 2002. Excerpts of the book are also appearing in Harvard Business Review and the McKinsey Quarterly.

Now for the real focus of this blog – margin squeeze. It is something all companies are experiencing in these trying economic times. Michael Mandel in the November 4, 2002 cover story of Business Week entitled “The Painful Truth About Profits” offers some interesting observations about recent profit trends. In particular, he notes that “higher productivity does not guarantee higher profits in a competitive economy.” Specifically, he observes that US corporate productivity has grown by 25% over the past decade but that the after-tax profit rate on corporate investment today is no higher than it was a decade ago.

Some executives seek consolation in the belief that this is purely a cyclical phenomenon. If that is true, then all we need to do is wait for the recession to end and good times, if not boom times, will be upon us again. For those who grasp upon this straw, two other charts may be of interest. 

First, check out the special survey on “The Unfinished Recession that appeared in the September 28th issue of the Economist. There’s a chart in there that should grab the attention of any executive. It shows U.S. profits as a percentage of GDP over a 40 year period extending from 1960 to today. It’s not reassuring. Of course, there are cycles of relative profitability throughout this period, but there is also a long-term secular trendline – it is downward. In fact, over this period, profits as a percentage of GDP declined by about 50%.

Second, to make this point even more starkly, check out another chart in my friend Dick Foster’s excellent book Creative Destruction: Why Companies That Are Built to Last Underperform the Market – and How to Successfully Transform Them. He puts it up front on page 13, of all pages. It tracks the average life-time of companies on the S&P 500. It’s enough to keep any executive awake at night. Back in the 1930’s a company coming on the S&P 500 list could expect to remain there for 65 years. In recent years, the average life-time of a company on the S&P 500 has declined to about 15 years – a decline of almost 80%. Once again, this is not a smooth trendline – there are brief periods when average life-times improve, but then they resume their downward trend again. It’s not only getting harder and harder to generate profits, but it’s getting harder and harder to maintain market position – even when you are the very largest companies in the U.S.

So, we’re not just facing a cyclical recession. Yes, the recession is intensifying economic pressure even more than normal. But there’s something more fundamental going on here. Conditions may improve a bit as the recession ends, but that will only be a temporary respite from much more fundamental trends that are converging to make life more challenging for executives all over the world. As consumers, we reap the rewards. As executives, we wrestle with the challenges.

So, is it all doom and gloom? What is to be done? Before this blog turns into another extended essay, let me just highlight two important initiatives under the broad rubric of “unbundle” and “rebundle”. In an earlier blog entry, “Restructuring the Enterprise” I talked about the various organizational initiatives under way to create more focus in business activities. Throughout the 1990’s, the media celebrated major M&A deals as signs of visionary leadership. The same media now report the scramble to divest the assets that had been acquired during this acquisition binge. See for example, “Firms That Lived by the Deal in ’90’s Now Sink by the Dozens” in the Wall Street Journal. Once again, we learn the painful lesson that most acquisitions destroy, rather than create, shareholder value. They destroy value in large part because they dilute focus. See Business Week’s recent article “Mergers: Why Most Big Deals Don’t Pay Off.” My God, even the Economist is raising questions about whether General Electric – that paragon of performance – ought to be broken up.

Unbundling is essential. It goes well beyond shedding ill-advised acquisitions. We are still at the earliest stages of a much more fundamental unbundling process that will restructure most companies. See my article “Unbundling the Corporation” in Harvard Business Review (co-authored with Marc Singer).

But unbundling is only part of the story. It is necessary for survival. Companies that go beyond unbundling and master the art of rebundling will not only survive, but thrive. These are the companies that will continue to create significant economic value in the face of intensifying competition. By rebundling, I don’t mean launching another wave of acquisitions (although some very focused acquisitions may be part of the program). Instead, I am referring to a variety of techniques to access and mobilize the resources of other companies in ways that add more value to your customers. These techniques come in many forms: resource aggregation, process orchestration and shaping of economic webs. See for example, two of my articles in the McKinsey Quarterly – “Spider versus Spider” and “Loosening Up: How Process Networks Unlock the Power of Specialization” (co-authored with John Seely Brown and Scott Durchslag).

Anyone who wants to master the art of rebundling needs to understand the dynamics of network formation and evolution. Networks are in the air. If we needed evidence of that, witness the virtually simultaneous publication of two books offering rich overviews of recent developments in network theory – Linked: The New Science of Networks by Albert-Laszlo Barabasi and Nexus: Small Worlds and the Groundbreaking Science of Networks by Mark Buchanan. Just a little bit earlier, we also saw the publication of Emergence: The Connected Lives of Ants, Brains, Cities, and Software by Steven Johnson. And there are many books looking at specific manifestations of networks. One of the richer ones in this vein is David Weinberger’s Small Pieces Loosely Joined: A Unified Theory of the Web – a book that provides much insight into the distinctive attributes of the Web (a term David uses to describe both the broader Internet and the World Wide Web).

You should read these books, if you haven’t already. They help us to move from an atomistic view of individuals and enterprises to much more nuanced understanding of the network formations that shape, and in turn are shaped by, their participants. Unfortunately, perspectives on networks are still far too theoretical. They do not yet address very basic issues that are relevant to business executives. 

For example, we need to move beyond truisms that all businesses operate in a network or web of relationships with other businesses. What types of networks or webs exist in business activity? What are the relevant advantages and drawbacks of each type? How can networks or webs be shaped? What are techniques for creating appropriate incentives for network or web participants while still rewarding the shaper for its efforts? How can we measure the health of networks or webs? What are appropriate mechanisms for managing risk in networks or webs? What are differences in competition across networks or webs versus within networks or webs?

These are difficult questions, but the answers hold the key to wealth creation in markets around the world. Yes, competition is intensifying. Yes, pressures are mounting on executives. But this is not a doom and gloom story. We are facing massive structural changes on the business landscape. Change and instability can create enormous threat. But here’s the paradox: at the same time, they create unprecedented opportunity. Our challenge is to understand and address the opportunities. We need to recognize that this is the best possible way to cope with the threats. Rebundling strategies are the foundation for exploiting the opportunities ahead.