Remember this one: “Total Quality Management”?

As I have said before, firms often imitate each other, and that includes imitating silly things.

Speaking of silly things; Mark Zbaracki, a professor at Wharton, found himself examining Total Quality Management (TQM) techniques in the early 1990s, when the thing was at its heyday. He made extensive visits to five organisations – a defence contractor, a hotel, a hospital, a manufacturing firm and a government agency – to figure out how they came about adopting TQM.

A very consistent pattern emerged. Invariably, when management started to hear about this “new thing” called Total Quality Management, they signed up for seminars and conferences in which representatives from other firms spoke about their experiences with the implementation of TQM. There they would hear about the substantial improvements TQM had brought them, often larded with impressive statistics and commanding jargon. It didn’t take long and the managers became convinced that they too had to make work of adopting this new technique, or risk falling behind forever.

So they started sending their people to TQM training courses and hired consultants that specialised in the new techniques, through which they learned more stories about the power of TQM and its remarkable results. Soon, they put their considerable weight behind a pilot: one department would experiment with the new techniques, so that others could learn from them.

This was often followed by the introduction of a series of internal seminars, a quarterly TQM newsletter sent to all departments within the organisation, and the appointment of dedicated internal TQM experts. Subsequently, all these parties were told to publicise the firm’s early “success stories” to enthral others and raise their enthusiasm to embrace the new technique with equal vigour.

Soon, the newsletters found their way to people at other companies, and the organisation’s managers started to receive invites to come and share their success stories at TQM conferences and seminars. Yet, in reality, every success story also had its problems, and for every “success story” there were always a handful of failures. Yet, those stories did not find their way into the newsletters, the company’s external communications, or the manager’s seminar slide pack.

And in the conference room, the attending managers, who had heard about this new technique called “Total Quality Management”, were in awe of the substantial improvements that TQM had brought the speaker’s firm, and they were impressed with the gleeful statistics and commanding jargon. And they too went back to their firms, and pro-claimed that they really had to make work of adopting this new technique, or risk falling behind forever.

A bitter pill

It was always hard to think of a nicer business to be in than pharmaceuticals. Think about it, how much more price insensitive can customers be? In many countries, due to medical insurance, the people deciding on what product to purchase (i.e. doctors) are not the ones paying for it, nor are the people who are actually swallowing the pill! And what if these consumers were responsible for payment, what are they going to say “are you kidding, 30 pounds for that pill is really overpriced; I’d rather die!” Well, that’s the problem, you just might…

Moreover, it’s not that there are many substitutes available for chemical drugs; acupuncture and an occasional mud-bath and that’s about it. Furthermore, the suppliers of the pharma companies are hardly able to squeeze the profit out of them, as the raw materials are usually bulk commodities. On top of that, the entry barriers into the industry are huge, among others due to lengthy product development times and enormous upfront financial investments required (about half a billion for an average new drug).

Best of all though, is that demand is virtually unlimited! It’s not that we’ve already ran out of diseases to cure. And, if so, many drugs have such severe side-effects that we need other drugs to suppress them! A cycle as virtuous as I have ever seen one. Yep, pharmaceuticals was a nice place to be in.

But lately, pharmaceutical companies have been showing signs of distress. This distress is merely relative – because they’re still making money by the bucket – but once you’re used to a Gucci life it is not easy to downgrade to the Gap. One reason for the damsels’ distress is the fact that for many companies, product pipelines have all but dried up; R&D departments are just not coming up with the goodies.

There may be various reasons for this problem, but it is quite clear from academic research that innovation becomes more difficult when you’re old and rich. For example, Professor Henrich Greve, currently at INSEAD business school, examining Japanese shipbuilders over a period of several decades, found that firms with deep pockets invested quite a bit more in R&D but, concurrently, also launched fewer new products. Professors Jesper Sorensen and Toby Stuart, at the time both at the University of Chicago, examining firms in biotech and in semiconductors, found that older firms came up with more innovations but that these were usually less influential and concerned mere variations on already well-known themes.

The problem for top managers is that a lack of innovation is not solved by money alone. Top managers can decide many things; the can decide to acquire company X, throw in money and a team of bankers and see it done. They can decide to enter country Y, tell business development to make it so, and it will happen. They can choose to change an incentive system from individual to group rewards, and HR will do it. However, you can’t just decide to have more innovation. You can say it, order it, shout it really loudly but that doesn’t mean products will magically materialise. Innovation is a subtle process that involves many aspects of the organisation, some of them tangible but many of them much more tacit and informal. And once those start to ossify, there’s no pill that will cure that.

Boards of directors: cliques and elites

In the US, in the 1980s, shareholders (especially institutional investors) began to advocate that company directors should take certain measures that restrict top managers from having a ball at shareholders’ expense; that is, undertake strategic actions that are in their own interest but not in those of the company’s shareholders. Yet, after making some initial in-roads, two decades later, this reform process has stagnated. For example, the portion of large US companies with an independent board chair or an independent nominating committee for new board members (two of the things advocated by the investors) was only slightly higher in 1999 than in 1989.

How come? Why has this governance reform stagnated? To answer this question, Professor James Westphal – currently at the University of Michigan – conducted an elaborate study. He collected data on 417 firms, interviewed scores of top managers and directors, obtained surveys from no less than 1098 directors and 197 CEOs at multiple points in time, and came up with an intriguing answer.

He found that the top managers and board members of the US’s biggest companies together form an “elite”, which act very much like “the clique of popular kids in high-school”. Let me explain.

Specifically, Jim tracked directors’ voting behaviour when any of the following four measures were being proposed in the company (which each limit top managers’ power):

1. CEOs can not concurrently also hold the seat of chairman of the board (so that the board can operate independently)
2. The company should have a nominating committee to appoint new board members, rather than that the company’s CEO controls this process
3. The director at some point had voted to dismiss the (underperforming) company’s CEO (a measure clearly not in the interest of the CEO!)
4. The company should revoke a so-called poison pill construction – a mechanism that makes it difficult for a firm to be acquired against top management’s will (so that even when top management is doing a poor job, and the company is underperforming, they still can’t be ousted by new owners)

Then, Jim examined what had happened to the directors that had voted in favour of adopting one or more of these ("controversial") measures…

First, what you have to realise, is that people who hold board memberships more often than not also are members of the boards of other companies. If a particular board member, at some point in time, had voted for one of the above measures, which remove privileges away from top managers (i.e. members of the elite) and give it to investors (who are not considered part of the elite), their fellow directors at other boards would subsequently start to give them the cold shoulder. The board member would become unpopular with the rest of the in-crowd, and get treated as “a traitor”.

The questionnaires and interviews (conducted with both the "unpopular board members" themselves as well as with their "friends") clearly indicated that the other boards’ members would start to engage in subtle behaviour intended to punish the deviant person, such as neglecting to invite him to informal meetings, not asking his opinion or advice in formal meetings, not acknowledging or building on his comments in discussion, engaging in exclusionary gossip whereby they would talk about other people and events with which the director was not familiar, etc.

For example, interviewed board members said that the deviant persons “can expect to be ostracized”, “people are less interested in working with them”. One director said, “The directors [who had voted for one of the four changes] get treated differently – I think they get put on notice a bit”, while another commented, “it will hurt you. You won’t get thrown off the board, but you definitely won’t get treated the same. In a way you get treated like the enemy – or at least as suspect”. One director, who had once voted in favour of one of the measures, related his own experience: “after we fired the CEO I got the cold shoulder from colleagues at another board… I didn’t get invited to an important meeting”.

Does this perhaps remind you of your high school days...?

And, guess what, it worked. Jim, in his statistical analysis, also examined what the subsequent voting behaviour was of the directors who had been subject to such treatment. Whenever, in the ensuing years, there would be another vote about one of the four aforementioned measures, the directors would cave in, and vote against it. They didn’t dare do it again.

The success trap

Did you know that when you take the list of Fortune 100 companies in 1966 (America’s largest companies) and compare it with the Fortune 100 in 2006, 66 of those companies don’t even exist anymore? Another 15 still exist but don’t feature on the list any longer, while a mere 19 of them are still there.

It relates to a phenomenon we call “the success trap”; ample research and statistics show, for a variety of industries, that especially very successful firms have trouble staying successful, and adapt to fundamental changes in their business environments (such as new competitors, different customer demand, radical new technologies or business models, etc.). Over the years, they focused on the thing that made them successful (a particular product, service, production method, etc.) and as a result became even better at it.

Yet, this came at the expense of other products, processes and viewpoints, which were considered much less important, and were often discarded. Hence, the company had become very good at one thing, but one thing only… This is not a problem unless, of course, your environment changes. It’s just that most of these darn environments have the nasty habit of doing exactly that...

Then, the company is caught off-guard, and has trouble adapting to the altered circumstances. It is partly a cognitive thing. For example, how come that, in the early 1980s, IBM so dramatically misunderstood the emergence of personal computers? How come Harley Davidson had itself all but wiped out of the market by tiny Japanese entrants like Honda, who made very different motorcycles? How come the once dominant Firestone completely misread the emergence of radial tyres and went down the drains? Laura Ashley, Atari, Digital Equipment, Tupperware, Revlon; the list goes on and on of once dominant companies that at some point seem to lose the plot and get into severe trouble. Some of them recovered, some of them went under, arrogantly assuming that what they always had been doing – and what had brought them so much success – would always work just fine. Only to find out - the hard way, and often too late - that they were wrong, and the world did not need them any longer.

Does downsizing work, ever?

No it doesn’t.

Workforce downsizing has been a popular pass-time lately (i.e. over the past decade or two); more and more companies announcing mass lay-offs programmes, even if they’re not in financial trouble. The practice started in the early 1980s, when economic slowdown more or less forced firms into it, but proved to not be a passing trend when in the ensuing decades many firms continued to engage in systematic workforce reductions.

Of course firms engage in downsizing hoping to boost their profitability. But does it work? It has obvious advantages – waving the hatchet tends to lower headcount quite effectively, which obviously leaves you with lower labour expenses – but also some potential disadvantages – such as lower commitment and loyalty among the survivors. It is not immediately clear whether the positives will outweigh the negatives, or vice versa.

Therefore, Professors James Guthrie, from the University of Kansas, and Deepak Datta, from the University of Texas at Arlington, decided to research the issue in a systematic way. They managed to obtain in-depth data on 122 firms that had engaged in downsizing and performed various statistical techniques to examine whether the programme had improved their profitability. The answer was a plain “no”.

Beforehand, James and Deepak had thought that downsizing would likely be harmful for firms that rely heavily on people (such as firms in industries in which R&D is very important; firms with low capital intensity) and firms that are in growth industries (since it would be more difficult to justify mass lay-offs there). And they were right; in those type of businesses, downsizing programmes significantly reduced firms’ subsequent profitability.

However, they had also expected the reverse to be true; that firms in industries in which people were less central to companies’ competitive advantage (firms in industries with low R&D; firms with high capital intensity) and firms in low-growth industries would be able to get away with downsizing programmes, and increase their profitability as a result. Yet, there they proved to be wrong. Even in such businesses, downsizing didn’t help a single bit, and usually lowered performance. In fact, they couldn’t find a single business in which downsizing proved beneficial for firms.

Of course, firms in trouble need to do something. However, simply reducing your head-count won’t do the trick. As Fortune Magazine observed, most firms that downsize, “rather than becoming lean and mean, often end up lean and lame”.

Wanna play Strategy? Get a board game

I agree strategy is simple, but not that simple!

It continues to surprise me what people sometimes pro-claim is their business strategy. Take for instance the principles I often hear people suggest form the basis of their acquisition strategy.

When a particular transaction is being considered, executives have to go out and explain the logic for the deal to directors, investors, and analysts. Regularly, however, a strategic rationale is only being drawn up after it has been decided by management that the deal is “desirable”. Quite often, this logic will appear contrived, overly complex or simply made to fit the acquisition rather than that the deal results from a well thought through strategy in the first place.

For example, I’ve often heard the logic behind a transaction being explained in terms of complementarities; “it is a perfect match because their geographic spread perfectly matches ours” or “their product portfolio complements ours”, and so forth. Yet, just as often I would hear the logic being explained exactly the other way around; in terms of perfect overlap, for instance “it is a perfect match because they are active in the exact same markets as we are”.

Just the fact that you “complement” each other does not constitute a strategy. It might be worthwhile to combine forces, but first you’d need an argument to explain why this would enable you to create extra value. Without such logic, it’s hollow and meaningless. Similarly, just because you have perfect overlap doesn’t automatically imply it’s a good strategy. Why does adding it up enable you to do something you could not do before?

Yet, the one that always gets me is “the matrix”. Yep, really a matrix. On the horizontal axis, one places countries (in which the company is active). On the vertical axis, one places business lines (in which the company is active). Then, on the intersections, one ticks boxes (with a decisive “X”) indicating in which countries we have which line of business. And our strategy is: We fill the boxes. As many as possible.

“This acquisition is expensive, but it enables us to immediately tick six boxes!” Wow, yes, surely this warrants an 80% take-over premium – well done indeed; six boxes! We’re doing well, aren’t we?”

But strategy is really not the same as a game of Risk, placing pawns on a map of the world. Sure, perhaps it can be advantageous to own multiple business lines in that particular set of countries, but without a thorough explanation about why it’s these countries (and not some others), and these lines of business (and not some others), and why it is beneficial to have them all, that’s what it is; an oversized game of Risk. But with real money, and real people.

Your expectations manage you

I’ve ranted about self-fulfilling prophecies in management before. Another study along these lines was conducted in the 1970s by Albert King – at the time a professor of management and industrial relations Kansas State University.

Albert conducted an experiment in four different plants owned by one and the same company. The managers of plants 1 and 2 were told, by the company’s director of manufacturing, to experiment with “job enlargement” practices, in which machine crews had to both set up their machines and inspect their own finished work. The other two plants, 3 and 4, were asked to implement “job rotation” practices, in which workers switched tasks at scheduled intervals. Thus, Albert’s experiment appeared to be comparing the results of job enlargement with those of job rotation.*

Then Albert did a cunning thing: he lied. Because he introduced one other crucial difference between the plants. The managers of plants 1 and 3 were told that past research implied that the job changes would raise productivity, while the managers of plants 2 and 4 were led to believe that past research implied that the job changes would improve “industrial relations” (which should result in lower absenteeism).

Subsequently, for a period of 12 months, Albert measured both productivity and absenteeism levels at the four plants. Analysing the data, it turned out that where the plant managers had been told to expect higher productivity, productivity became 6 percent higher; where the plant managers had been told to expect better industrial relations, absenteeism was 12 percent lower, regardless of whether they implemented job-enlargement or job-rotation practices!

The changes in workers’ actual activities really had no influence; productivity at the two job-enlargement plants hardly differed at all, nor did absenteeism at the two job-rotation plants. It were the plant managers’ expectations that caused all the effects.

Albert stopped short of telling the people at the plants that the job changes would enable them to sing like Pavarotti because you’re starting to believe they would have brought the house down. People somehow achieve what they (are led to) believe will happen, regardless of the actual changes to the organisation. As Albert wrote “the results provide evidence that managerial expectations concerning performance may serve as a self-fulfilling prophecy”.

* this paragraph has been adapted from a chapter in a book by Bill Starbuck (2006)

When acquisitions take over

Firms are expected to base the price and hence the premium they are willing to pay for a transaction on their calculations of how much synergy the deal would be able to generate. Although long-term value creation is always difficult to quantify with any certainty, firms usually do the best they can and then determine the target’s maximum price.

However, once executives have their mind firmly set on acquiring a particular target but are outbid by a rival, this may be difficult to swallow. Often, it seems to awaken the warrior in them; they go back to their people and instruct them to “find me another 100 million or so in synergies” in the target’s books, which enables them to up the bid. For instance, we saw indications of this when Mittal was bidding for Arcelor, and it is hardly a sporadic event.

Clearly, this is a dangerous phase in a bidding process. Copious research, for instance on “escalation of commitment” in M&A deals, has indicated that overexcited executives have a tendency to not walk away from a deal when they should, mysteriously uncovering extra value in a transaction when a firm’s rivals are starting to outbid.

But I guess this bit is only human. It is the part that comes after that which always gets me. The company that ultimately “wins” the bidding war is declared the winner – in newspapers, business magazines, etc. They pop the champagne and celebrate, while the loser pouts and has a crisis meeting.

But are we sure that you are the “winner” when you just paid 300 million for a company you originally calculated was worth half of that…? And are you sure you really are the loser when you just made your competitor pay 150 million more than the darn thing is worth…? Somehow, I am not so sure, no matter what the newspapers say.

Seeds and fertiliser – how to build a firm

American visitor: “How come you got such a gorgeous lawn?”
Lord: “Well, the quality of the soil is, I dare say, of the utmost importance”.
American visitor: “No problem”.
Lord: “Furthermore, one does need the finest quality seed and fertilisers”.
American visitor: “Big deal”.
Lord: “Of course, daily watering and weekly mowing are jolly important”.
American visitor: “No sweat, just leave it to me!”
Lord: “That’s it”.
American visitor: “No kidding?! That’s it?!”
Lord: “Oh, absolutely. There is nothing to it, old boy, just keep it up for five centuries”.

What many firms, trying to grow fast or add scores of acquisitions, often fail to realise: Organisations work much the same way as a lawn. You can buy the machinery, lease the building, hire the people, acquire the assets pretty quickly and relatively easily, and put them together. But this does not mean that you will have a working organisation.

An effective firm requires that the various elements of its organisation - both the "hard" factors (such as its structure, incentive system, etc.) and the "soft" elements (such as the culture of the place, informal communication patterns, etc.) - are fine-tuned, interact and reinforce one another. Building such an organisation implies more than just "owning the parts"; it takes continued dedication, hard work and, most of all, it simply takes time.