Stratevolve Blog

On 2nd February, 2010, we learnt that Kraft Foods had sealed its takeover of Cadbury. Following a four month long hostile takeover battle, the UK chocolate manufacturer said it had received valid acceptances of the offer from investors of the firm. Positive statements about the acquisition were forthcoming from Kraft Chief Executive Irene Rosenfeld who said, “I warmly welcome Cadbury employees into the Kraft Foods family.” Ms Rosenfeld added, “This combined company has a phenomenal future, and I firmly believe it will deliver outstanding returns to our shareholders”.

However, there were some other parties that remained concerned. Most notably, Warren Buffett, Kraft’s largest shareholder, thought the $US19.6 billion acquisition was not a good deal. Buffett also questioned how Rosenfeld chose to pay for it – a reference to Kraft selling its fast-growing pizza business in a move to raise cash for the Cadbury deal. Meanwhile, analysts observed that the integration of Cadbury and meeting cost-cutting and revenue growth targets will be the key going forward.

The local unions were also concerned about the deal, anticipating that Kraft would need to cut costs to repay its debt. The unions were proved right on this score. Six days after the bid had been accepted, Kraft confirmed the closure of a factory in Somerdale, near Bristol, with a loss of 400 jobs. And it’s understood that Kraft are currently critically reviewing management structures, personnel, plant, production and workforce for further cost savings.

Like many entities, Kraft is now under pressure to cut costs, but its important to avoid the common pitfall of easy cost reduction that destroy long term organisational value. The operation of a ‘rule’ imposed from the top that is determined by the need to cut costs and the need for speed leads to a random set of actions that can have huge unanticipated consequences.

The problem with these types of cost cutting measures from the standpoint of the firm’s future viability is they are almost ‘unmanaged’ cost cuts. These measures are little better than knee-jerk responses. They will no doubt have an impact on cost flows, but the problem is they will also inflict random damage to the value creation processes within the business.

So what’s the alternative? The alternative is Intelligent Cost Reduction. This approach avoids the most severe effects of random cost cutting. To engage in intelligent cost reduction requires an insight into the value creation processes within the business.

A relatively recent development in strategic thinking, the resource-based view of the firm, can help us to approach cost reduction in an intelligent, rather than knee-jerk way. Techniques like cause mapping and asset auditing can help us uncover subtle sources of competitive advantage and differential value-creation in the business. Working with our clients, our research reveals that enduring competitive advantages often derive from complex processes and assets e.g. tacit knowledge, collective routines, relationships with key clients, personal reputations, and complex interactions between different types of know-how. These enduring sources of advantage need to be fully recognised as they form the strategic asset base of the firm.

Once we have built deep insights into the strategic asset base we can then approach cost reduction in an informed manner. A shared understanding of the core value activities and those who perform them enables us to differentiate between staff. We can distinguish critical value activities from those that are less critical. Armed with these insights we can identify areas of the business where cost reductions would be highly damaging to revenue creation, and those areas where cost reductions would have only peripheral impact.

Throughout January 2010, the dominant news story in both the financial and general press concerns the appropriateness of banker bonuses. Many banks released their results in January, which in other circumstances would be hailed as great successes: Goldman Sachs reported $13.4 billion net profit for 2009 (up from $2.3 billion net profit in 2008); JP Morgan Chase reported $11.7 billion net profit for the year just ended; Bank of America made $6.3 billion net profit, and so on.

Of course, the point of contention is not the high level of bank profits per se, but the associated high level of banker bonuses. Goldman Sachs stated they’ll pay $16.2 billion in compensations and benefits (up 48% over 2008) which is estimated to equate to $500,000 per head at the bank. At JP Morgan Chase, investment bankers earned $9.3 billion in pay and bonuses. You get the drift.

On both sides of the Atlantic, the level of these bonuses has become a source of public interest (to say the least!). The question often put about in the press is: can these bonuses be justified after these banks received preferential treatment through Government bail-outs to survive them through the recession?

This question, in substance, was recently put to the RBS Chief Executive by MPs on the Treasury Select Committee. He replied that RBS bonuses (speculated to be £1.5 billion) would be based on the financial performance achieved, and market rates for bankers. This explanation however has not satisfied all shareholders, including some indirect shareholders (certain high profile tax payers), who take the view that if they own 84% of the bank they should be able to dictate a change in the bank’s bonus culture.

The RBS case study to date surfaces a strategic issue that perhaps gets at the heart of the matter – that in a firm there are different forms of stakeholder value. A common way of viewing a firm is that it consists of a number of stakeholders who form a coalition of interests. Although each stakeholder (i.e. customer, funder, suppliers, executives, and society at large) have different interests, the firm nevertheless acts as a vehicle for different stakeholders to interact in pursuit of their own agendas and needs.

However, we would take the view that some stakeholder interests are in direct conflict with those of other stakeholders and therefore actions by the firm which benefit one group of stakeholders can only be possible if other stakeholder groups are disadvantaged. This is not to suggest that the coalition that is the firm is a zero sum game; there may well be strategies that benefit all stakeholder groups. Taking into account the interests of all stakeholder groups is a monumentally difficult task. It is highly unlikely that a strategy will add value to one stakeholder group without necessarily impacting others. It is also highly unlikely that a strategy will add value incrementally to all stakeholder groups simultaneously. There will inevitably be tradeoffs. Navigating these trades offs is one of the major strategic challenges that Governments, Regulatory Authorities and Banks now face.

Over the last few weeks or so, the topic of bankers’ bonuses has featured heavily in the press in two different contexts. Firstly, the British Chancellor, Alistair Darling, levied a one-off tax on bankers’ bonuses of 50 percent in his pre-budget report. This tax applies to banks operating in Britain and to their British-based employers. Bonuses of £25,000 (approximately $40,000 US Dollars) or more are to be put into a pot for each bank and that part will be taxed at 50 percent.

Secondly, the topic of bankers’ bonuses was featured in a proposal by the Basel Committee on Banking Supervision. This committee is reviewing the rules governing bank’s strengths and is proposing that banks will be blocked from paying dividends or bonuses if their capital levels fall below a minimum threshold.

Bankers are crying “unfair” and accusing the Government of being short-sighted, whereas Alistair Darling received widespread public support for his banker tax. The level of public angst is high due to footing an enormous bill for bankers’ excessive risk taking. According to the National Audit Office figures, the Government (aka the tax payer) has so far spent £117 billion pounds (approximately $189 billion US Dollars) to rescue the banks.

From a strategic point of view, this fractious relationship between bankers and Government requires addressing in order to avoid future cycles of banker punishment (the equivalent of a public flogging, cheered on by the crowds!), and banker resentment, followed by banker inventiveness to escape intended financial levies. And it seems that there are many different views between Government and the Banking community that need to be reconciled covering bank lending policy, capital reserve levels, splitting out retail banking, basis for remuneration etc.

So what might help? Well, in situations with multiple and conflicting views a useful starting point is to step back and seek strategic clarity of organisational purpose, from which measures of success can then be derived. This starts with identifying the main beneficiaries, and potentially several types of beneficiaries. Once there is agreement about who the beneficiaries are, the next step is to identify what they want or what they value from the organisation. Guided by clarity about who the beneficiaries are, and what they value from the organisation, we can then try to work out the role of other “stakeholders” in delivering beneficiary value. Note this is quite different from an approach which tries to incorporate all stakeholders and their interests in decision making. More often than not, identifying several types of beneficiaries implies that the organisation should be restructured so that each sub-unit can focus on just one beneficiary group.

Adopting the above approach may at least help to surface the fundamental issues in the banking sector concerning core purpose, and what banks should be delivering. Strategic clarity should enable individuals to take on the complex task of strategic leadership, and help today in choosing among alternatives courses of action. Without strategic clarity, there is unlikely to be agreement among the key parties on benchmarks for performance linked to justifiable banker bonuses for some time to come.

On November 10th, 2009, Lloyds Banking Group controversially announced 5,000 job cuts. Lloyd’s management marked the occasion as “another important step in bringing our business together” i.e. integrating HBOS which Lloyds bought at the peak of the financial crisis.

However, the union didn’t see this step in the same light! They said that the job losses demonstrated “the depth of corporate arrogance within the tax payer supported bank.” The Lloyd job cuts come just days after Royal Bank of Scotland, also government supported, announced thousands of job losses.

Arguably, these divergent views between management and employees reflect a failure of strategy. That is, a failure of strategy to appreciate the complexities created by a new hybrid entity – part private, and part public.

Consider firstly the private sector view. Traditionally, life is tough for CEOs in the private sector. Their performance is scrutinised by analysts and shareholders and if their companies don’t deliver sufficient growth and profit, their days are numbered. So life’s tough but oddly it’s also straight forward. A clear profit goal provides clarity throughout the organisation and helps in making strategic decisions. Put simply, when faced with choices between alternative courses of action the profit goal kicks in: will option A deliver more profit than option B?

In the public sector, the challenge is fundamentally different. There is rarely a clear, single objective and organisations are characterised by multiple stakeholders with different and often competing interests. Added to this, governmental goals posts are being moved! Against this backdrop CEOs are required to be leaders not just of their organisations, but of the places and beneficiaries they serve.

In a hybrid entity – part private, part public – there is a need to reconsider our concepts of strategy and leadership. From a private sector perspective, a shake up to reduce costs is clearly in shareholder’s interests. While from a public sector point of view, initiating the redundancy of thousands of jobs implies an organisational failure and a high social cost. The situation in the case of taxpayer owned banks is additionally complicated as they remain nominally independent of the government, and hence less sensitive to broader public goals; a frustrating situation for bank employees who are part owners by virtue of their tax payer status!

Because of the multiple interests to take into account, Strategy for Taxpayer Owned banks is very complicated. An initial challenge for the leaders of these institutions is to make sense of the complexity and re-set the purpose of the organisation, focusing on the beneficiaries, and not just the shareholders. By doing so, they can provide the security of purpose that enables the organisation to coalesce and more forward purposefully.

The current economic environment is highly uncertain for most organisations. This level of uncertainty affects how we develop strategy, in particular how we answer questions about where and how we compete and the type of capabilities we need to develop in uncertain environments.

Analysing Your Way to a Strategy

Textbooks on strategic management emphasize an analytical approach to formulating strategy. Executives should decide on objectives, analyse the firm’s competitive environment, assess the firm’s strengths and weaknesses, and decide upon a plan for the future. Ideally, the plan should spell out answers to the following questions:

• What markets should we compete in?
• How will we compete?
• What assets and capabilities do we need to do this?

Uncertain Environments

However, analysis can only focus on the past. It is not possible to analyse what is happening now, because the information is not instantly available, and it is impossible to analyse the future, as it is unknowable. There are no ‘facts’ about the future that could be predicted and incorporated into any analysis. Where analytical approaches to strategy making have been used the implicit assumption underpinning the process is that analysing the past will help us predict the future. This might have been the case in highly stable environments, but even in these instances unanticipated shocks would inevitably have disrupted the implementation of even the most carefully crafted plan.

Clearly in the current uncertain and unstable environment it’s almost impossible to anticipate what will happen next week, let alone predict the state of the world five years ahead. But the need to set some direction or ‘strategy’ still remains, in spite of this uncertainty. So how can we satisfactorily answer the three questions set out above, where we face unpredictable environments.

Strategy in Uncertain Environments

Our argument is that in stable environments we should be able to specify answers to all three questions. So we could state the target market segments we wish to operate within, we would be clear about customer needs, and what products and product features we need to provide to these customers. We can also be clear about the capabilities, processes, systems, equipment, know-how, skills etc we would need to deliver these products efficiently.

So in stable environments we can specify the core value creation processes required to deliver efficient customer value. Where there is incremental change in the environment we should be able to specify the core value creation processes in outline, but we would recognise that these processes would need to evolve with the environment over time. Hence we would need to, and be able to, specify the ‘refinement’ capabilities and activities that will deliver continual improvements to the core value processes e.g. just-in-time, six sigma etc.
Where we face faster paced change, and where this change is largely predictable, we are less able to specify the nature of the core value processes, but we can be clear about how to innovate and in what general directions we should be looking to innovate. We can specify and establish research programmes, development projects etc, and we should be able to identify the kinds of systems, structures, and capabilities and culture we need to deliver and incorporate a stream of valuable innovations. Thus where we face fast-paced but largely predictable change we should still be able to determine where we compete and how we compete, but we might be less clear about the specific products we might need to produce and the processes we might need to produce them.

At the extreme end of environmental uncertainty we face almost unpredictable futures. All we can be certain about is that changes will happen, and they may be disruptive. We cannot predict what these might be, or when they might occur. So what can we specify as strategies when facing this level of uncertainty? In uncertain environments we might just be able to specify what markets we are intending to compete in; how we compete and what capabilities are required in the core value creating processes is difficult to specify. What we can decide is that we need to build adaptive capabilities into the firm, to enable us to react to unforeseen problems or opportunities.

The need for strategy in extreme uncertainty doesn’t disappear. What changes is its focus. Rather than looking to specify the required core processes and capabilities, instead we need to specify the adaptive capabilities the firm will need. These might include ensuring we have the ability to sense the environment properly and that we are able to tap into diverse sources of information that we can detect and accurately interpret subtle but small signals of likely future changes. We might also choose to build in a capability to adapt and flex our activities, so we can respond rapidly and appropriately to market shifts. This might include extending the skill set of employees, breaking down rigid silos and hierarchies, decentralising decision making, building extensive informal external networks, and shifting the culture to one that encourages experimentation and risk-taking.

Conclusion

The degree of uncertainty we face should affect what our ‘strategy’ specifies. Stable environments allow us to be quite precise in our answers to the three questions. The more uncertainty we face the less specific we can be about a) how we might compete and b) exactly what assets and capabilities we will need in the core value creation processes. But what we can specify are the change or ‘dynamic’ capabilities we need to enable us to adjust to the emerging environment.