mckinseynotes

The next generation of in-house software development - How leading-edge companies are streamlining applications development.

2006-07-29T11:08:00.000-07:00

Most companies recognize the many advantages of buying software applications off the shelf rather than developing them in-house. By purchasing packaged applications (such as those from Microsoft, Oracle, SAP, and other vendors) or by using applications that vendors create, host, and make available over the Web (for example, those from SalesForce.com), companies can acquire effective business solutions with the benefits of standardization. In this way, they can keep up with of the innovations created by focused specialists.

In spite of those advantages, custom-built applications are still very much a part of the IT landscape. Companies in many sectors spend well over half their applications budgets on custom software, used largely to enhance, support, and operate customized systems. For large companies in competitive, fast-moving industries such as telecommunications, financial services, high tech, pharmaceuticals, and media, those outlays can run into hundreds of millions of dollars. Banks, for instance, frequently build custom applications to support new financial products or to manage risk. Pharmaceutical companies regularly build custom applications to support R&D and marketing activities.

Even when a company uses off-the-shelf applications, it frequently customizes them, typically by adding modules that provide a distinctive capability. A high-tech company, for example, installed a suite of packaged enterprise-resource-planning applications but also built a customized cash-management application to supplement the ERP product's plain-vanilla finance functionality. Unfortunately, even a little customization here and there quickly adds up. Worse, when companies must revise systems to meet new business needs, changing interconnected, customized applications can be difficult and costly, and upgrades to customized applications usually cost more than those to packaged software.

Nevertheless, some pioneering companies have found a way to capture the benefits of packaged software in a customized-applications environment. They have adopted the approach of software vendors, which package and sell applications aimed at the common needs of many customers rather than of individuals, by writing an application once and then selling it many times. In this way, pioneering banks and media and pharmaceutical companies have reduced the complexity and cost of managing applications and speeded up the deployment of new or updated ones.

An approach some companies have used to turn elements of custom-applications support into packaged activities involves standardizing the maintenance, support, and software-management activities that groups of applications share. Applications that support field service work, for instance, may undertake similar functions (such as call planning) or incorporate similar types of tools (such as calculators, diagnostics, or checklists for customers). A company can define the management of common elements among applications as standardized "products" designed to provide for the needs of many applications rather than one. Similarly, it can assemble new, custom-built applications from common, internally built modules of functionality and then reuse services developed by its teams to undertake common tasks such as authenticating users or accessing attributes of customers or products. Like software vendors, such a company writes the code once but uses it frequently—a tactic made possible by creating application interfaces that incorporate broadly accepted standards such as those from the Web Services Interoperability Organization.

The upside of this approach is now quite clear. One company that adopted these support and maintenance principles reduced spending on applications maintenance by 30 percent—amounting to 60 percent of the entire applications budget—and speeded up the deployment of new applications, thereby completing in two to three weeks what once took two to three months.

Focusing in-house applications management on such products can be challenging and clearly isn't right for all companies. The payback will be greatest in fast-moving sectors. Companies prepared to try will be tempted to seek solutions for the problems of today's applications portfolios rather than those of tomorrow's—problems that are inevitably harder to pinpoint and understand. But treating support services as products is all about building for the future. Companies will need to change how they organize support resources, perhaps even overhauling IT governance structures to ensure the appropriate funding, oversight, and accountability of a very different applications environment.

Turning applications management into a product

To understand what the leading companies are doing, it's worth dividing the expenditures for custom-made applications into two parts, each requiring a different strategy. One part is identifying and codifying into software the business rules that give a company its competitive edge—rules like "If a physician is unaware of our product, give her the benefits message" or "If patient compliance is an issue, discuss tools for improving compliance." This is a development task.

The second part of spending on custom applications—accounting for 50 to 70 percent of their total costs—involves managing them over their lifetime. This task includes selecting the applications tools to use, determining the service levels users require, rolling out applications, operating them at target service levels, maintaining them, providing ongoing user support for them, and eventually retiring them.

In most companies today, the IT and business teams involved in developing a custom application decide independently on the type and version of the applications tools and deployment environment it will use—the server, the database, the portal, and so on. Decisions about service levels (such as availability) and policies on data storage also are made ad hoc. Such applications end up as complex beasts to manage, typically requiring a host of maintenance and support processes as customized as the applications themselves. There will be differences—sometimes major—in how they meet the demand for split-second response times or what must be done to change the reports that they produce.

More companies are setting standard levels for infrastructure services—including standards for server availability, storage capacity, and network performance. Yet the way teams manage end-user enhancements, maintenance, and support for applications still varies widely. These variations lead to spotty utilization, reduce productivity, delay the rollout of new applications, and impair the ability to meet user expectations consistently.

In response to such problems, companies have tried to reduce labor costs by, for instance, offshoring the maintenance of applications and consolidating them in shared service centers. Consolidation improves utilization (fewer machines and people are needed) but rarely raises the productivity of IT maintenance, because the diversity of maintenance and support activities doesn't go away. Similarly, offshoring can reduce per-hour labor costs, but companies (either in their captive offshore centers or their outsourcing vendors) typically do little to reduce the underlying diversity in the maintenance processes for applications. Indeed, without investment in a level of on-site support or strict adherence to processes, geographic separation may only exacerbate the problem.

But these processes can be standardized, as some leading companies are demonstrating. A company may have thousands of applications, but we've found that, for most organizations, they can be clustered into fewer than a dozen archetypes—our term for applications grouped by their key commonalities. Archetypes naturally vary by company, but broadly speaking they can include applications that support a large number of customers primarily on the Web, provide data-intensive analytical support, track performance and provide dashboard summaries for senior executives, or offer highly regulated transaction support.

The important point is that, within these archetypes, the requirements for applications management are strikingly similar, so maintenance and support can be standardized. All "road warrior" applications, for example, need tools that support offline work, the offline-online synchronization of data, PDA form factors, and early-morning and late-evening technical assistance. Companies essentially need to standardize these processes into products, designed once and then used over and over again for different applications, within a particular archetype. When a company needs a new customized application, the team that develops it chooses a product that determines how it will be deployed, maintained, operated, supported, and even priced for internal users. This approach draws on the model used by software vendors and application service providers such as SalesForce.com.

Considerable standardization may be involved. One company, for instance, defined five such products that address the management challenges of each application archetype and are designed to derive the maximum benefit from standardization (exhibit). Together, the five addressed 60 percent of the company's applications, accounting for 80 percent of its applications budget. This company didn't attempt to squeeze all existing applications into the new model. Instead, it has looked forward: IT managers estimate that over 90 percent of all its new applications-development projects will take advantage of one of the five models from the beginning.

Companies that took this path have found several benefits of standardizing applications-management activities as products:

Reduced work for application "owners" (such as business units) and developers in sorting through management issues
Reduced costs and enhanced cost transparency derived from per-seat, per-application prices
Standardized, fine-tuned processes for applications of the same archetype
Dramatically higher resource utilization
Increased manageability of service levels
Concentration of skills around fewer technologies, leading to better training and development
Full value for companies that consolidate applications in shared services¹

Turning business functionality into products

Several leading companies are at the stage of defining archetypes to reduce spending on applications management. Some of these companies have begun to experiment with applying the lessons of packaged software—write once, sell to many—to the development of customized applications as well (see sidebar, "The development and delivery process").

In essence, such companies have taken the writing of reusable code, an idea as old as computing, into a new era. The task is to create software that performs a particular function—calculating an interest rate or targeting a customer, say—and then to reuse it in any new application that might need this functionality. In the past, locating such code and deciding how best to use it were difficult because this knowledge could be shared effectively only within a tightly knit team.

Today companies bring some order and standardization to the process by using Internet-based service-oriented-architecture (SOA) standards.² These IT advances help companies to codify business functionality in ready-to-use software building blocks much more easily and quickly, to scale up the kinds of functionality suitable for reuse in applications, and to ensure that such building blocks are employed more effectively across project teams and organizations—and maintained in a more standard fashion after an application has been deployed.

Consider the problem these companies are solving: because the applications that support old ways of working are difficult to change, many companies have found it hard to adapt their business capabilities to keep up with market developments. One health insurance company, for example, has a different claims engine for each of its three lines of business. When the applications were developed, making each one unique was logical because these businesses had very different needs. But that uniqueness has become a drag on innovation. When the insurer began to introduce more consumer-directed health plans, it had to change all three systems—and alter them again when it later introduced a new marketing approach that involved different methods for tracking customers and promotions. Each change was difficult, expensive, and time consuming.

In a company with reusable components of business functionality, such changes are a lot easier. A major bank created a library of reusable modules—essentially off-the-shelf products—that codified business functions for analytic modeling. The bank uses these products repeatedly in applications that support the trading of a wide range of financial instruments, such as equities, bonds, derivatives, and foreign exchange.

Other companies are following suit. A leading media business defined ways to codify elements (including customer profiles, lifetime value analyses, promotions, and campaign management) so that the software for them could be built once and reused. Naturally, this approach saves time and therefore money. For early adopters, the benefit that really counts is a reduction in the time needed to develop an application: they are finding that they can roll one out 20 to 40 percent faster when they use common applications products. Furthermore, the reduced expense could eventually allow companies to leverage the advantages by using easy-to-assemble applications to test new business strategies. If the strategies work, the companies can scale up the applications; if they don't, little has been lost, because such applications are inexpensive to build and easy to discard.

It is still early to make definitive predictions. But internal, off-the-shelf components of business functionality might allow IT to deliver its true promise: promoting business innovations instead of being the boat anchor holding them back.

Lessons from early adopters

As we noted earlier, this approach isn't suitable for all companies. Those that must roll out new applications quickly and constantly—banks and media companies, for instance—will benefit from it. But those in slow-moving sectors may have little need. If applications don't have to change much, writing them once is good enough—it's not worth all the work required to standardize custom activities. For businesses that can benefit from product-oriented approaches, we offer the following lessons from early adopters:

Build the products "prospectively," mindful not just of the existing base of applications but also of future needs.
Organize groups to deliver products effectively against business needs and not just technology outcomes.
Pay attention to organizational factors that will ensure proper governance and realize the business benefits.

Build the right products prospectively

Defining the right products to manage applications begins with analyzing how they cluster according to common needs. It is then more fruitful to focus on applications in the pipeline rather than those already in place. In fast-moving sectors, the useful shelf life of most applications is typically less than five years. By focusing on the future, companies in these sectors avoid putting effort into applications near retirement; thus, within three years, as much as 90 percent of the portfolio of custom applications can be standardized.

Admittedly, it is possible to standardize the support and maintenance of existing applications so as to reduce costs. Further, it is easier for a company to see concrete ways of reengineering existing support processes (a remediation project) than to plan the organization of support and maintenance for new applications that haven't yet been clearly defined, because budgets, risks, and organizing principles are unclear. Nevertheless, our analyses suggest that it isn't worth recalibrating the management of most existing applications. Significant effort is necessary to reengineer processes and to help people accept and abide by new standards. Since the applications portfolio turns over quickly, the costs of reengineering are barely recovered, if at all. Reengineering applications with a longer life cycle can make sense, but only a few of them exist in the portfolios of companies in fast-moving businesses.

Similarly, the best way to identify the components of common business functionality is to look at requirements prospectively rather than retrospectively. In particular, companies should focus on specific areas (such as the way prospective customers are valued) where there is a strong business interest in standardizing operations or rules across groups. This approach not only helps a company get to the truly reusable business rules but also piques the business's interest in using these products, thereby making it easier to secure ongoing support for standardizing such processes.

Organize to deliver products effectively

To define and deliver applications-management products, early adopters are carving out a single, separate applications organization from the multiple existing ones. As this delivery organization proves itself, companies mandate adherence to the new, standardized approach. Typically, the organization is global, focused on standardizing activities of the applications that support products globally. After all, there are more common elements within product groupings than in applications that are grouped geographically.

The pioneers are also forming groups to manage business functionality products, organizing them in close relation to business domains—that is, end-to-end business processes (such as order to cash or R&D). The developers become steeped in the business groups' activities and can see more clearly how to capture functionality in code. Also, business leaders can act as sponsors of these product groups, an approach that can put them on an equal footing with traditional applications-development teams. In some cases, these groups can even provide leadership in driving business process standards—leaving traditional teams to assemble solutions from the reusable code.

Pay attention to organizational factors

Turning support and maintenance into standardized applications-management products is one thing; getting the organizational elements right to make the most of those products is another. Companies must pay attention to three immediate constituencies: vendors, internal "buyers," and those who finance the budget for applications development.

Vendors have to understand what the company is trying to accomplish by standardizing support and maintenance, development, or both. A vendor's specialized software offerings or hardware should be incorporated appropriately into a prospective customized application. These technologies must therefore comply with the standards chosen for the management product supporting the application or be compatible with the modules assembled to make a new application. To achieve this goal, one company uses an architecture review process—looking at an application's technical design before launching development—as a way of forcing vendors to comply with its standardization efforts. Another company encourages compliance by certifying vendors, providing awareness education, and offering price incentives and vendor performance reviews.

A company must also persuade those who own an application internally (and across the global business) to look for and use off-the-shelf business functionality, captured in code either inside or outside the company. One way to do so is to create markets for these products. Goldman Sachs, for example, built a Web portal that allows developers around the world to share software components and documentation, both internally and with certified systems integration vendors.

Finally, those financing new applications must favor standardized business functionality products (on the development side) and management products (on the support side). People should be held accountable for moving toward these new, common approaches. Costs for developing functionality and management products are ascribed to a single applications project, but subsequent applications can reuse them, and this possibility has implications for the way projects are measured and their performance is graded. Companies may find it necessary to finance standardization efforts separately from other development projects and to establish pricing mechanisms for recouping the investment from business users of the applications. Funding must take into account both efficiency and relevance, and pricing should balance recovering the investment with encouraging greater use.

Companies that live or die by how quickly they can roll out new, innovative business capabilities to their customers can benefit from making their customized applications more like products.

The development and delivery process

Old

• The infrastructure staff and development vendor must design an infrastructure platform for every application.

• Dealing with exceptions to current processes (such as the needs of machines, remote access, and root privileges for the vendor) creates unnecessary overhead.

• Delays caused by procurement snags or infrastructure configuration issues typically run five to six weeks.

• Because the company has to pay vendors on a time-and-materials basis—and scale is limited—expenses mount.

• External resources are needed for routine operations such as database administration support.

• Time and attention are wasted on coordinating activities such as reboots and updates with other groups sharing infrastructure.

• Ad hoc systems upgrades and reboots often cause unplanned application downtime.

New

• Predefined product options greatly reduce the time spent designing the infrastructure for the most common applications.

• A standardized process that can also handle exceptions creates a single point of ownership and accountability.

• An inventory of infrastructure options that comply with the reference architecture eliminates procurement delays.

• Leveraging vendor contracts gives the company a pool of resources at attractive rates.

• Routine tasks that were formerly undertaken by the vendor are coordinated, eliminating redundancy in the process.

• Applications operations are managed, freeing time to focus on more critical business tasks.

• Accountability for service levels helps the company identify key areas to improve processes.

Return to reference

About the Authors

Sam Marwaha and Ranjit Tinaikar are principals in McKinsey's global IT practice. Sam is a coleader of the IT governance and organization practice and leads the US pharmaceutical-IT practice. Ranjit, a coleader of the IT strategy practice, specializes in retail-banking and consumer credit operations. Samir Patil, an associate principal, is a leader in the IT governance and organization practice. All three are based in New York.

This article was first published in the Spring 2006 issue of McKinsey on IT.

Notes

¹Managing applications support in this way is very similar to the approach other companies are taking to manage their infrastructure more efficiently and effectively. For more on this topic, see James M. Kaplan, Markus Löffler, and Roger P. Roberts, "Managing next-generation IT infrastructure," McKinsey on IT, Number 3, Winter 2004, pp. 2-9.

²Service-oriented architectures allow applications to be highly interoperable across a network by making it possible to access standardized computing or application services in a standardized way.

Ten trends to watch in 2006

2006-07-29T11:05:00.000-07:00

Web exclusive, January 2006

Those who say that business success is all about execution are wrong. The right product markets, technology, and geography are critical components of long-term economic performance. Bad industries usually trump good management, however: in sectors such as banking, telecommunications, and technology, almost two-thirds of the organic growth of listed Western companies can be attributed to being in the right markets and geographies. Companies that ride the currents succeed; those that swim against them usually struggle. Identifying these currents and developing strategies to navigate them are vital to corporate success.

What are the currents that will make the world of 2015 a very different place to do business from the world of today? Predicting short-term changes or shocks is often a fool's errand. But forecasting long-term directional change is possible by identifying trends through an analysis of deep history rather than of the shallow past. Even the Internet took more than 30 years to become an overnight phenomenon.

Macroeconomic trends

We would highlight ten trends that will change the business landscape. First, we have identified three macroeconomic trends that will deeply transform the underlying global economy.

1. Centers of economic activity will shift profoundly, not just globally, but also regionally. As a consequence of economic liberalization, technological advances, capital market developments, and demographic shifts, the world has embarked on a massive realignment of economic activity. Although there will undoubtedly be shocks and setbacks, this realignment will persist. Today, Asia (excluding Japan) accounts for 13 percent of world GDP, while Western Europe accounts for more than 30 percent. Within the next 20 years the two will nearly converge. Some industries and functions—manufacturing and IT services, for example—will shift even more dramatically. The story is not simply the march to Asia. Shifts within regions are as significant as those occurring across regions. The United States will still account for the largest share of absolute economic growth in the next two decades.

Further reading:
China and India: The race to growth
Mapping the global capital markets

2. Public-sector activities will balloon, making productivity gains essential. The unprecedented aging of populations across the developed world will call for new levels of efficiency and creativity from the public sector. Without clear productivity gains, the pension and health care burden will drive taxes to stifling proportions.

Nor is the problem confined to the developed economies. Many emerging-market governments will have to decide what level of social services to provide to citizens who increasingly demand state-provided protections such as health care and retirement security. The adoption of proven private-sector approaches will likely become pervasive in the provision of social services in both the developed and the developing worlds.

Further reading:
The demographic deficit: How aging will reduce global wealth
Boosting government productivity

3. The consumer landscape will change and expand significantly. Almost a billion new consumers will enter the global marketplace in the next decade as economic growth in emerging markets pushes them beyond the threshold level of $5,000 in annual household income—a point when people generally begin to spend on discretionary goods. From now to 2015, the consumer's spending power in emerging economies will increase from $4 trillion to more than $9 trillion—nearly the current spending power of Western Europe.

Shifts within consumer segments in developed economies will also be profound. Populations are not only aging, of course, but changing in other ways too: for example, by 2015 the Hispanic population in the United States will have spending power equivalent to that of 60 percent of all Chinese consumers. And consumers, wherever they live, will increasingly have information about and access to the same products and brands.

Further reading:
Premium marketing to the masses: An interview with LG Electronics India's managing director
New strategies for consumer goods

Social and environmental trends

Next, we have identified four social and environmental trends. Although they are less predictable and their impact on the business world is less certain, they will fundamentally change how we live and work.

4. Technological connectivity will transform the way people live and interact. The technology revolution has been just that. Yet we are at the early, not mature, stage of this revolution. Individuals, public sectors, and businesses are learning how to make the best use of IT in designing processes and in developing and accessing knowledge. New developments in fields such as biotechnology, laser technology, and nanotechnology are moving well beyond the realm of products and services.

More transformational than technology itself is the shift in behavior that it enables. We work not just globally but also instantaneously. We are forming communities and relationships in new ways (indeed, 12 percent of US newlyweds last year met online). More than two billion people now use cell phones. We send nine trillion e-mails a year. We do a billion Google searches a day, more than half in languages other than English. For perhaps the first time in history, geography is not the primary constraint on the limits of social and economic organization.

Further reading:
The next revolution in interactions
The McKinsey Global Survey of Business Executives, July 2005

5. The battlefield for talent will shift. Ongoing shifts in labor and talent will be far more profound than the widely observed migration of jobs to low-wage countries. The shift to knowledge-intensive industries highlights the importance and scarcity of well-trained talent. The increasing integration of global labor markets, however, is opening up vast new talent sources. The 33 million university-educated young professionals in developing countries is more than double the number in developed ones. For many companies and governments, global labor and talent strategies will become as important as global sourcing and manufacturing strategies.

Further reading:
China's looming talent shortage
Sizing the emerging global labor market

6. The role and behavior of big business will come under increasingly sharp scrutiny. As businesses expand their global reach, and as the economic demands on the environment intensify, the level of societal suspicion about big business is likely to increase. The tenets of current global business ideology—for example, shareholder value, free trade, intellectual-property rights, and profit repatriation—are not understood, let alone accepted, in many parts of the world. Scandals and environmental mishaps seem as inevitable as the likelihood that these incidents will be subsequently blown out of proportion, thereby fueling resentment and creating a political and regulatory backlash. This trend is not just of the past 5 years but of the past 250 years. The increasing pace and extent of global business, and the emergence of truly giant global corporations, will exacerbate the pressures over the next 10 years.

Business, particularly big business, will never be loved. It can, however, be more appreciated. Business leaders need to argue and demonstrate more forcefully the intellectual, social, and economic case for business in society and the massive contributions business makes to social welfare.

Further reading:
What is the business of business?
The role of regulation in strategy

7. Demand for natural resources will grow, as will the strain on the environment. As economic growth accelerates—particularly in emerging markets—we are using natural resources at unprecedented rates. Oil demand is projected to grow by 50 percent in the next two decades, and without large new discoveries or radical innovations supply is unlikely to keep up. We are seeing similar surges in demand across a broad range of commodities. In China, for example, demand for copper, steel, and aluminum has nearly tripled in the past decade.

The world's resources are increasingly constrained. Water shortages will be the key constraint to growth in many countries. And one of our scarcest natural resources—the atmosphere—will require dramatic shifts in human behavior to keep it from being depleted further. Innovation in technology, regulation, and the use of resources will be central to creating a world that can both drive robust economic growth and sustain environmental demands.

Further reading:
Preparing for a low-carbon future
What's next for Big Oil?

Business and industry trends

Finally, we have identified a third set of trends: business and industry trends, which are driving change at the company level.

8. New global industry structures are emerging. In response to changing market regulation and the advent of new technologies, nontraditional business models are flourishing, often coexisting in the same market and sector space.

In many industries, a barbell-like structure is appearing, with a few giants on top, a narrow middle, and then a flourish of smaller, fast-moving players on the bottom. Similarly, corporate borders are becoming blurrier as interlinked "ecosystems" of suppliers, producers, and customers emerge. Even basic structural assumptions are being upended: for example, the emergence of robust private equity financing is changing corporate ownership, life cycles, and performance expectations. Winning companies, using efficiencies gained by new structural possibilities, will capitalize on these transformations.

Further reading:
Strategy in an era of global giants
Loosening up: How process networks unlock the power of specialization

9. Management will go from art to science. Bigger, more complex companies demand new tools to run and manage them. Indeed, improved technology and statistical-control tools have given rise to new management approaches that make even mega-institutions viable.

Long gone is the day of the "gut instinct" management style. Today's business leaders are adopting algorithmic decision-making techniques and using highly sophisticated software to run their organizations. Scientific management is moving from a skill that creates competitive advantage to an ante that gives companies the right to play the game.

Further reading:
Do you know who your experts are?
Matching people and jobs

10. Ubiquitous access to information is changing the economics of knowledge. Knowledge is increasingly available and, at the same time, increasingly specialized. The most obvious manifestation of this trend is the rise of search engines (such as Google), which make an almost infinite amount of information available instantaneously. Access to knowledge has become almost universal. Yet the transformation is much more profound than simply broad access.

New models of knowledge production, access, distribution, and ownership are emerging. We are seeing the rise of open-source approaches to knowledge development as communities, not individuals, become responsible for innovations. Knowledge production itself is growing: worldwide patent applications, for example, rose from 1990 to 2004 at a rate of 20 percent annually. Companies will need to learn how to leverage this new knowledge universe—or risk drowning in a flood of too much information.

Further reading:
The 21st-century organization
Making a market in knowledge

Companies need to understand the implications of these trends alongside customer needs and competitive developments. Executives who align their company's strategy with these factors will be the best placed to succeed. Reflecting on these trends will be time well spent.

About the Authors

Ian Davis is worldwide managing director of McKinsey & Company and Elizabeth Stephenson is a consultant in McKinsey's San Francisco office. A shorter version of this article was published in the Financial Times on January 13, 2006.

Moving IT infrastructure labor offshore

2006-07-27T08:17:00.000-07:00

Moving IT infrastructure labor offshore

The offshoring of IT infrastructure—machines and networks and the people who manage them—has been relatively slow to develop. But this is changing as leaders show how to offshore it effectively and vendors step up to meet a growing opportunity.

Kishore Kanakamedala, James M. Kaplan, and Gary L. Moe

Web exclusive, June 2006

Half of the people in corporate IT departments manage and support infrastructure rather than develop and maintain applications, yet infrastructure represents only a tiny percentage of the IT labor offshored to low-cost locations so far. One reason is that managers have been hesitant to send such mission-critical operations too far from home. If an application-development project bogs down in Budapest or Bangalore, the roll out of a new feature may be delayed; if a server crashes or a network goes down, the business consequences can be far more serious. These concerns—as well as the cost and unreliability of telecommunications in some developing markets, the limited availability of key infrastructure skills there, and a history of locating hardware and labor at end-user sites—have made CIOs reluctant to pull the offshoring lever to reduce infrastructure costs.

In the past two years, however, constraints on the offshoring of infrastructure have started to ease, and the market appears poised to follow the growth trajectory of other IT-offshoring segments (Exhibit 1). Offshore vendors have started to invest aggressively both in infrastructure talent and redundant networks from the United States and Western Europe. From 2003 to 2005, the number of offshore vendors (the global talent pool of people who can handle infrastructure tasks) tripled, to 15,000, from 5,000. At the same time, automation tools, more effective processes, and onshore consolidation efforts have made corporate IT departments increasingly comfortable with locating more of their infrastructure labor remotely from assets and users.

Most senior IT executives have already learned valuable lessons from offshoring their application-development projects, but they will have to learn new skills to offshore infrastructure successfully. The split between onshore and offshore resources requires a careful design based on the need for proximity to application developers, end users, and infrastructure assets. The necessary skills imply that different mixes of locations and commercial models (vendor or captive) will be required, and the real-time nature of infrastructure typically calls for substantial changes to key processes and organizational structures.

Leading-edge companies that began moving labor to India two to three years ago have already achieved savings of as much as 60 percent

The benefits of offshoring labor

IT departments send their infrastructure labor offshore primarily to take advantage of lower labor costs, but there are other advantages too. The offshoring of infrastructure labor can spur operational improvements and the implementation of a global operating model that provides far more uniform support to applications and users, no matter where they work.

Hiring people with the necessary skills is getting easier in places such as India, Malaysia, the Philippines, and Eastern Europe. Some IT infrastructure technologies are easier to offshore than others: depending on the task, companies may be able to offshore from 40 to 50 percent of the staff in certain areas (Exhibit 2). Leading-edge companies that began moving their internal IT help desk operations and UNIX server monitoring, management, and support work to India two to three years ago have already achieved savings in unit labor costs of as much as 60 percent—though 20 percent is more typical—after an initial investment period (Exhibit 3). Seeing this opportunity, vendors and captives have ramped up their skills, and a lot of them now offer a broad range of network, help desk, distribution, and application integration capabilities.

Many companies house their infrastructure in local or regional operations. For this reason, technologies, processes, and services are scattered around the world, so it is hard for infrastructure organizations to support increasingly global business processes and applications. The opportunity to consolidate labor in a low-cost offshore center can act as a forcing mechanism to consolidate infrastructure operations and thus raise service levels for applications and users—for example, by providing affordable 24/7 support.

In addition, some companies that have already moved some of their application-development and business operations offshore find that moving their infrastructure staffs as well offers economies of scale for facilities, data communications, and training. One manufacturer offshored all of its server support and help desk work to the Indian vendor that already developed its applications. Thanks to shared facilities, administration, and training, it achieved savings of 10 to 30 percent on those infrastructure tasks.

Assessing the opportunity

Most IT executives already understand some of the basic planning requirements for offshoring the development of applications. Deciding which infrastructure activities can be offshored is a bit different, partly because the reliability of infrastructure affects business operations directly (and often immediately) and because people who play infrastructure roles work so closely with other functions (such as operations) and third-party vendors. Given these constraints, managers planning a move must evaluate whether the jobs under consideration require proximity to senior management, application designers, vendors, or machines. Obviously, any function requiring close access to any of these onshore resources is a poor candidate for offshoring. What's more, in some countries and industries, regulations limit cross-border access to customer data, so any role requiring such access would not be wholly transferable.

Moving infrastructure labor offshore is just one way to make better use of IT resources. See "Managing next-generation IT infrastructure."

Companies that view offshoring from this perspective report that about half of all infrastructure labor can be offshored, depending on how well grooved their IT processes are. A retailer with thoroughly understood business processes, stable IT budgets, a conservative stance on introducing new applications and technologies, and very limited regulatory requirements, for example, might offshore more than half of its infrastructure labor, because those roles are easy to standardize and manage remotely. By contrast, an investment bank, which could have a very different IT environment, might be able to offshore slightly less, because more of its roles require closer management or greater flexibility.

Planning the move

As with application development, the right place, time, and model are key decisions. Reengineering roles, transferring knowledge, and monitoring operations in real time are even more critical.

Location

Labor skills and costs vary by region. Singapore, given its political stability, advanced skills, pervasive use of English, robust infrastructure, and (for many IT organizations) existing footprint, is the least risky labor-offshoring option. Singapore's labor costs are several times India's, however, and with a population of only four million its labor market is shallow.

India (followed by Eastern Europe, Malaysia, and possibly China) is on the rise as an offshore provider of infrastructure services. While infrastructure offshoring is still relatively new to India, it has vast amounts of low-cost, English-speaking labor in almost every infrastructure area except mainframes. As labor costs rise there, however, many IT organizations will look to Malaysia as an alternative source of English-speaking infrastructure labor or to several Eastern European countries that can provide support in French and German. Although China is not a realistic option for companies that need English-language support, several IT organizations are looking at the region around the Chinese city of Dalian as a location for Japanese infrastructure operations.

Captive or vendor?

Captives and contractors are among the range of available options. Almost all full-service Indian offshore vendors are investing heavily in infrastructure capabilities, though most of the deals these companies have signed to date are relatively small. In infrastructure as in other services, they plan to leverage their proven advantages over captive operations in recruiting and retaining personnel. But very early data indicate that the offshoring of infrastructure may involve a more even balance between captive and sourced operations than application development did, because companies want to retain more control over what are largely real-time processes.

Sequencing and prioritization

When companies offshore infrastructure labor, tasks that involve the least interaction with the onshore business should be moved first if the talent pools in the offshore location can supply the right staff—mainframe operators, for example, are still hard to find offshore. A typical strategy would be to move monitoring and some problem resolution responsibilities first, followed by more sophisticated roles, such as system and database administration.

Remote management and automation

If only jobs (and not machines) are moving offshore, remote monitoring and administration become critical. Engineers in Asia or Eastern Europe may be keeping an eye on machines in North America or Western Europe and performing necessary services, such as rebooting servers, backing up data, balancing loads, and tuning performance.

During the past few years, tools to perform these tasks have advanced significantly. The remote-monitoring and -diagnostic capabilities of the leading system-management tools have improved; remote system updates, patch management, and automated server provisioning have become more common. In addition, the troubleshooting capabilities of network-management tools are more robust; end-to-end trouble-ticket generation, routing, and management are now widespread.

To capture the full potential of infrastructure offshoring, IT managers must determine which roles can be undertaken at a distance

Role and process redesign

Even with such substantial advances in remote management and automation, many onshore infrastructure workers still perform a mix of activities. Some tasks require these workers to be physically close to machines, developers, and top managers; others don't. Looking only at roles in the current model will probably mean that fewer of them can be offshored than might be the case if they were reengineered. To capture the full potential of infrastructure offshoring, IT managers must determine which roles can be undertaken at a distance from onshore machines and personnel and then have roles and processes redesigned to segregate such functions from those that need proximity.

This is a substantial process of change. Several organizations that have undertaken it concluded that they had to augment their traditional, technology-centric processes and structures with functionally aligned processes and structures. One organization, for example, ifs transferring a number of operational responsibilities from its onshore server, storage, and end-user organizations to offshore centers of excellence aligned by function.

Training and knowledge transfer

Every company's IT setup is unique. New offshore workers must be trained to understand the legacy systems, service requirements, and businesses they will support. Ongoing exchanges are needed to transfer knowledge in both directions; a leading manufacturer, for instance, rotates its offshore staff through its US back-office and IT operations. That approach gives these employees enough hands-on experience to understand the company's unique needs (such as the way a proprietary manufacturing process affects procurement, now partly undertaken offshore), as well as the performance tuning and optimization required by its server configuration. Good training and professional development are also valuable tools for recruitment and retention in low-cost regions that experience an offshoring boom. This manufacturer reports that it has a much lower attrition rate among offshore workers than peer companies do.

Unique governance challenges

The real-time nature of IT infrastructure means that it can't be governed in the same way as the offshoring of application development. Companies must clearly determine who has the authority to resolve conflicts and processes, since engineers and managers may have to react in minutes rather than hours or days. In addition, it's common to have employees with similar titles and tasks sitting in a number of locations—a recipe for confusion unless roles and responsibilities are plainly defined. In view of these greater risks, it would be a mistake to leave the details of governance to data center managers. CIOs and senior business executives must take a direct interest in setting up the proper governance, for the success of the venture will depend on it.

In addition to all the usual benchmarks of good governance—clearly delineated reporting structures and decision-making rights, as well as processes for approving projects, resolving conflicts, and handling exceptions—three governance principles are essential for offshoring infrastructure. First, to reduce the chance of miscommunication, offshore teams must be aligned with the onshore organization at all levels, from senior managers through engineers and operators.

Second, because onshore and offshore teams work together more closely in running the IT infrastructure, it's critical to establish a good relationship between them by encouraging informal collaboration and camaraderie. It helps if the offshore leader has strong credibility with the onshore leadership, but even managers at more junior levels should come together periodically through training events and regular job rotations.

Third, companies should align their performance metrics for managers with the new offshore strategy. A common mistake is to set performance targets for offshore operations without giving onshore managers incentives to send more work their way. An electronics company trying to ramp up its offshore data center operations, for example, was still asking the head of its onshore center to keep it running with 99.99 percent uptime for all applications. There were no incentives for cost savings. The offshore operation was staffed up, but its utilization remained low because the onshore manager received no encouragement to send it work. As a result, the company saw no benefit from its offshore data center investment until IT and business managers gave the head of the onshore data center an incentive to cut costs through offshoring.

CIOs are just beginning to discover the large value creation opportunity that IT infrastructure offshoring affords. First movers will not only cut costs but also get the first pick of the talent pool, develop better innovations thanks to the new global business and operating models, and gain a deeper understanding of the offshore services landscape.

About the Authors

Kishore Kanakamedala, James Kaplan, and Gary Moe are members of McKinsey's global IT practice. Kishore, a consultant, is an expert in IT management and is the practice manager for IT infrastructure. He is based in Silicon Valley. James, a principal, leads the IT infrastructure practice. He is based in New York. Gary, a principal, is among the leaders of the outsourcing and offshoring practice. He is based in Silicon Valley.

The authors wish to acknowledge the contributions of Asen Angelov, Jeff Cohen, Abhijit Dubey, William Forrest, Kevin Gu, Michael Rosenthal, and Allen Weinberg.

This article was first published in the Summer 2006 issue of McKinsey on IT.

Measuring performance in services

2006-05-08T18:50:00.000-07:00

Measuring performance in services

Services are more difficult to measure and monitor than manufacturing processes are, but executives can rein in variance and boost productivity—if they implement rigorous metrics.

Eric Harmon, Scott C. Hensel, and Timothy E. Lukes

2006 Number 1

Faced with stiffening competition, increasingly demanding customers, high labor costs, and, in some markets, slowing growth, service businesses around the world are trying to boost their productivity. But whereas manufacturing businesses can raise it by monitoring and reducing waste and variance in their relatively homogeneous production and distribution processes, service businesses find that improving performance is trickier: their customers, activities, and deals vary too widely. Moreover, services are highly customizable, and people—the basic unit of productivity in services—bring unpredictable differences in experience, skills, and motivation to the job.

Such seemingly uncontrollable factors cause many executives to accept a high level of variance—and a great deal of waste and inefficiency—in service costs. Executives may be hiring more staff than they need to support the widest degree of variance and also forgoing opportunities to write and price service contracts more effectively and to deliver services more productively.

As with any task or operation, to improve the productivity of services, you must apply the lessons of experience. Consequently, measuring and monitoring performance (and its variance) is a fundamental prerequisite for identifying efficiencies and best practices and for spreading them throughout the organization. Although some variance in services is inescapable, much of what executives consider unmanageable can be controlled if companies properly account for differences in the size and type of customers they serve and in the service agreements they reach with those customers and then define and collect data uniformly across different service environments. To do so, it is necessary to bear in mind a few essential principles of service measurement.

First, service companies need to compare themselves against their own performance rather than against poorly defined external measures. Using external benchmarks only compounds the difficulties that service companies face in getting comparable measurements from different parts of the organization.
Service companies must look deeper than their financial costs in order to discover and monitor the root causes of those expenses. This point may seem self-evident, yet many companies fail to understand these causes fully.
Finally, service companies must set up broad cost-measurement systems to report and compare all expenses across the functional silos common to service delivery organizations. The goal is to improve the service companies' grasp of the cross-functional trade-offs that must be made to rein in total costs.

None of these principles is easy to implement. Top executives are likely to face resistance from managers and frontline personnel who insist that services are inherently random and that service situations are unique. Managers who have grown used to the protection that lax measurement affords may be reluctant to view their operations through a more powerful lens. But only by adopting these principles and implementing rigorous measurement systems throughout the organization can service executives begin to identify reducible variance and take the first steps toward bringing down costs and improving the pricing and delivery of services.

Why variance is difficult to measure

Executives who launch variance-measurement programs in a service business are often surprised at the level of difference they discover among similar sites and groups within their own organization, let alone when they compare one company with another. In general, a company's metrics are not uniform across its business units, so that, for example, one group in a call center may regard all calls on a given issue as a single case, while another logs every call separately. A top executive with a background in consumer goods (where items are similar and thus comparable) assumed control of a service business and was shocked to find that the variance of key metrics among similar sites ranged from a factor of 2 to 30. Site managers explained this vast range by asserting that every site was different—and, according to their metrics, they were right.

Services are different

To make meaningful comparisons, companies have to identify the sources of difference in their businesses and devise metrics that compare these businesses meaningfully. The considerations that show up frequently include the most obvious differences among jobs and groups, such as regional variations in labor costs, local geographies and difficulties in reaching accounts, the workload mix (for example, repairs versus installation), and differences in the use of capital (whether equipment is owned or leased by the company or owned by the customer). Several other major issues come into play as well.

Service-level agreements. The more types of services a business offers, the more variability it can expect in its agreements. The metrics for a help desk that provides customer support for 5,000 users in a 9-to-5 office are very different from those for a help desk that supports logistics in a round-the-clock industrial environment. Even when offerings are similar, variance can be introduced locally through the way contracts are interpreted. In one IT-outsourcing company, two desktop support accounts with service-level agreements that specified an eight-hour response time had very different cost metrics. When asked why, the manager of the poorly performing account said that, despite the contract's limits, "If we don't answer within the hour, our client goes ballistic." The written service-level agreement had been trumped by an unwritten one that was costing real money.

Environment, equipment, and infrastructure. Each customer's environment has unique aspects that are difficult to measure. A logistics provider will see huge differences between managing a big, automated warehouse and a small, simple one. Field services that support industrial systems must contend with many generations of equipment and upgrades at customer sites. Some clients have their own on-site staff to support service, while others may be difficult even to reach. Given the range of possibilities, it's usually not very helpful simply to measure the average cost of a service call.

Work volume. Size is a major reason for the wide variance among accounts and business units. Interestingly, managers of both small and large accounts claim that size makes their particular metrics worse. Both have a point: large accounts should benefit from scale, but in general they are also more complex, and that drives costs back up. Volume needs to be considered, but only in tandem with other patterns (including scale benefits and the breadth of work) that help explain costs.

The data problem

Underlying all of these problems is an inability to identify what must be measured and how to normalize data across different environments. Even when companies know what to measure, they struggle to achieve accuracy. Data are rarely defined or collected uniformly across an organization's environments. A service call involving the installation of two elevators, for example, could be measured as a single installation in one part of a company and as two in another.

Contributing to this ambiguity is the fact that data collection is usually driven by the requirements of financial cost reporting, which often fails to shed light on ways of boosting performance. Accountants for an IT services company may need to know the cost of each server, for instance, but an executive looking to reduce variance would also need to know the number of service incidents by server type and the time spent on each incident. Variance in demand drivers is also important: did the number of calls to a help desk rise because more users bought a product, for example, or because it changed? Financial metrics might fail to detect this important distinction.

Principles of service measurement

Many executives don't understand how to measure and manage what appear to be unique activities, and they confuse correctable performance variance with irreducible environmental variance. Embracing three principles that identify variance and allow for meaningful comparisons can help executives overcome these difficulties.

Use internal benchmarks

While a company must know what its peers are achieving, it's a mistake to measure its performance against the competition: these benchmarks are typically just samples of data with little explanation behind them. Companies that use external benchmarks are often frustrated to find themselves off by a factor of five to ten, positively or negatively.

Using external benchmarks compounds the internal difficulties that service companies face in normalizing activities and the data that define them. Consider a measure such as costs per unit of information processed: some companies include allocated costs, such as corporate overhead and salaries; others don't.

Internal benchmarks deliver more detailed metrics, allowing a company to find its own best practices and to see where and how they are achieved. It can then have access to all relevant information to assess differences among business units and accounts. In defining internal benchmarks, for example, a company can determine which costs are included or how asset costs are allocated—details that get lost in external benchmarking. A company can see what's really possible within the organization by using its own benchmarks.

A cost tree with detailed metrics is an important tool to help companies define internal benchmarks (exhibit below). External metrics might deliver numbers on the top level of the tree, but only by developing internal trees for each service line can a company begin to understand its true cost drivers. A tree allows a manager to compare the performance of different accounts against similar metrics and also to calculate which improvements will have the most impact on the top-level figure. Once a team has gathered cost data throughout the tree, for example, it could target opportunities to cut costs and calculate which efforts would have the most impact on the bottom line. Creating cost trees can also help companies write better service agreements that exclude unprofitable activities or generate more revenue where service costs warrant it.

Measure cost drivers

Even after service companies begin to define and capture the detail that lies beneath the top level of the cost tree, they still need to discover the underlying cause of each expense. Measuring only the cost of repair calls, for instance, probably wouldn't reveal whether they all stem from a single poorly built product, which could be improved or sourced differently for less than the cost of the repairs, or from factors such as variability in the performance of repair teams. Better measurements look at cost drivers, such as cost per employee (a resource metric), incidents per employee per day (a productivity metric), or—in a product-based service business—the number of incidents per product (a volume metric).

Of course, companies must also omit allocated costs, which can confuse the issue. A business unit's support infrastructure, for example, could include human resources, physical plant, and product engineering, all of which must be considered from a financial point of view. But such costs do little to determine productivity and are something of an obstruction when companies try to spot variance and waste. Once these obstacles are removed, managers can stop trying to cut costs that may be beyond their control and instead address the drivers they can improve. Before measuring the financial costs, it's often helpful to measure the items and events that drive costs, such as people, machines, incidents, service calls, and change orders.

Measure deep and broad

When service companies try to measure only their selected costs—rather than taking a comprehensive approach—they are often surprised to see that their teams hit every budget target while still losing money. That's because services are fungible, and it's easy to measure the wrong things or to shift costs, intentionally or not, to unmeasured areas.

Consider the case of a cable company that was trying to reduce the resolution times of its help desk and service calls. After setting goals, managers saw resolution times shrink, but total service costs were rising. In this case, help desk representatives, eager to meet their goals, spent less time trying to resolve problems remotely. After asking only a few questions, these employees referred cases to field service reps, who were happy to have a series of fast and easy calls to boost their own metrics. Unfortunately, the number of field service calls, which are far more expensive than help desk calls, rose dramatically. To resolve this problem, management combined call centers and field services into a single cost tree and monitored the percentage of calls passed from the one to the other, as well as the time spent on each type of call. Managers then encouraged the call center reps to spend more time trying to resolve difficult calls before passing them along to field services, thereby increasing the average call time but helping to reduce total costs. Thus a critical purpose of any cost tree is to yield insights about how better (or worse) performance in one area of the tree might affect another.

Setting up measurement systems

With these principles in mind, executives can begin to define their metrics, collect data, and implement processes that will drive their efforts forward.

Build the tree and choose your metrics

Cost trees should be detailed enough to spot efficiency problems and broad enough to be comparable across operating units. Once companies have identified the allocated costs and cost drivers, they can begin to build the cost tree. Broad input from the field (line managers, engineers, field and service reps) is vital, along with input from senior executives, who are generally better able to focus on the total costs required to deliver a service to customers. In this way, the tree captures all the costs of (and details on) the most important cost drivers. The tree should also be constructed to compare key metrics across a range of environments—for example, all call centers, whether they operate 24 hours a day or 9.

As the data arrive, management will want to monitor the top level of the tree as well as the key metrics below. In most cases, we find, three to five metrics monitor 80 percent of the variance in costs.

Collect with care

Without clearly defined metrics and knowledgeable people to support the gathering of data throughout the organization, companies can spend too much time cleaning up messy data. Training and improved processes can alleviate this problem.

Managers should review the data collection rules and templates with the people who develop them—usually employees from different regions or accounts. Even with new procedures in place, however, there will be much room for interpretation. It's therefore helpful to show not only how data should be collected and entered but also how users occasionally misinterpreted these processes in the past—an approach that sheds light on gray areas the rules might not address. Guidelines for identifying problems early on can save time later. It's also important to establish boundaries beyond which suspect metrics should be investigated. One service company, whose teams handled from two to five service calls a day, wondered why one of its teams was reporting an average of only a single call. It found a good reason: the account belonged to a prison system, where security procedures made each visit a daylong affair.

Reviewing data collection in the early stages of implementation can help to ensure that procedures are followed. Equally, sharing reports with regional and account leaders gives them an early view of their standing and can help identify unusual patterns in the data.

Institutionalize measurement

Managers accustomed to tracking costs in accordance with accounting needs will have to understand these new metrics and make them consistent throughout all levels of the organization. Periodic reviews, whose frequency should be based on the availability and shelf life of data, are essential for individuals and work groups. Visible interest from senior management—such as sending an executive vice president to attend a regional metrics review—promotes a strong message to everyone that a company is intent on identifying variance and improving service performance. Compensation should be tied to these metrics.

What's measured can be managed

For tools managers can use to price and manage service contracts, see "How to make after-sales services pay off."

Once executives have learned to measure the variance inherent in service companies, they can begin to manage processes to eliminate waste, to improve the delivery of services, to price services more accurately, and to write better contracts. Although a company can do many things to control the variance of its service delivery, most of them fall into three main areas: managing demand, standardizing environments, and applying appropriate resources to tasks.

Managing demand offers the biggest potential for improvement. Cost trees help managers identify the sources of demand for services—sources that might include faulty products, poorly performing service units, or any number of other causes. Some fixes must be made within the organization (better training, better products, automated-response systems); others depend on shaping the behavior of customers (for instance, by offering tools and guidance to help them resolve problems themselves).

Standardizing operating environments requires the most discipline, since salespeople are strongly tempted to sell as much customization as a client wants. Standardization can yield enormous results: in addition to raising productivity, it helps the workforce become more flexible because people can transfer with less retraining. Where possible, companies should standardize not only service product lines and tasks but also the work environments of employees and the equipment they use to deliver services. Scripted routines help eliminate errors and allow employees to emulate high performers. Furthermore, clearly defined programs limit overdelivery, a common problem in service companies.

What's more, identifying cost variances can help companies allocate their human resources more effectively. In general, it's more productive to handle problems with the least expensive resources that can resolve them: calling in experts or sending out field technicians increases costs and slows response times—and therefore makes customers less satisfied. Metrics on costs per call or device demonstrate the benefits of using less expensive labor, thus encouraging companies to keep requests upstream and to place first responders (often a call center) in less costly regions to further increase savings and productivity.

Finally, companies that have a better picture of where costs are incurred can price services more accurately to avoid losing revenue on unprofitable activities. They can write better contracts that take into account cost drivers hitherto written off as inescapable variance.

As services become an ever larger part of the global economy, managers are rightly looking for ways to improve productivity and efficiency. Services may be more difficult to measure and standardize than the manufacture of products, but executives should not abandon hope. Adopting the principles set forth in this article will help companies improve the delivery, pricing, and sales and marketing of services.

About the Authors

Eric Harmon is an associate principal in McKinsey's Dallas office, Scott Hensel is an associate principal in the Stamford office, and Tim Lukes is a consultant in the Miami office.

The authors would like to thank Byron Auguste, Ken Davis, Travis Fagan, Ozan Gursel, and Greg Neubecker for their contributions to this article.

The untapped market for offshore services

2006-04-18T10:34:00.000-07:00

The untapped market for offshore services

Business processes and traditionally outsourced—but not offshored—IT services will be the main drivers of offshoring growth in the near future.

Sujit K. Chakrabarty, Prashant Gandhi, and Noshir Kaka

2006 Number 2

The global market for offshored IT services and business processes has nearly tripled since 2001. However, a study finds that service providers have so far captured only 10 percent of a $300 billion opportunity. Over the next five years, the market will grow by an additional $80 billion.

Our study, which includes a comprehensive analysis of the addressable market for offshoring, also highlights ways in which this market may yet evolve.¹ It found that the drivers of future growth are likely to shift somewhat in IT-outsourcing services but will remain largely the same in business processes. Despite a significant slowdown in IT spending, the global offshoring market for IT services has grown by 21 percent a year since 2001. To date, this growth has come largely from applications development and maintenance and from R&D services—segments where we estimate that offshoring has reached about 30 percent of its potential. In R&D, new growth opportunities are opening up in increasingly advanced services. The John F. Welch Technology Centre, in Bangalore, for example, is conducting R&D in technologies such as propulsion systems for aircraft engines and in this way contributing significantly to the design of GE's latest jet engine. Nevertheless, our analysis suggests that, during the next five years, more traditionally outsourced—though not offshored—IT services, such as hardware and software maintenance, network administration, and help desk services, will account for 47 percent of the addressable market for offshored IT services (Exhibit 1).²

The global market for business process offshoring has grown by 49 percent a year since 2001 and appears likely to continue outpacing the market for offshored IT services. Banking and insurance account for nearly half of the addressable business process market, but companies have captured less than 10 percent of it thus far (Exhibit 2). In the next five years, the lion's share of growth is likely to come from these two industries: there are opportunities worth $23 billion to $25 billion, for example, in the offshoring of retail-banking activities associated with deposits and lending, $9 billion to $11 billion in credit card processing, and $3 billion to $4 billion in mortgage processing. Among cross-industry functions, human resources (HR) and finance and accounting appear set to fuel growth.

While the global addressable market for offshoring is a stunning $300 billion, the pace of adoption will be shaped by the interplay of three forces: supply (the capacity and quality of offshore locations), demand (the rate at which companies adopt offshoring), and the actions of industry players. We built a model to study this interplay and to evaluate various scenarios for different industries. Our analysis indicates that approximately 35 percent of the work that could potentially be offshored, worth $110 billion and divided equally between IT services and business processes, actually will be offshored by 2010. We believe that India's offshoring industry, which has captured two-thirds of the current global market for offshored IT services and almost half of the global market for offshored business processes, can maintain its leadership position. But to do so the industry, together with India's central and state governments, must address a few key issues, such as bridging a potential shortfall of nearly half a million qualified workers and improving the country's infrastructure.

The potential expansion of the markets that offshoring can address—say, through new models that go beyond the simple replication of onshore activities—is hard to forecast, since precedents are few and the potential varies greatly among industries. Still, companies can start by looking for ways in which offshoring would allow them to increase their revenues, to avoid or reduce costs, and to improve their utilization of capital.

One leading US bank, for instance, saved $100 million by using offshore staff to detect fraud in low-value transactions that could not be scrutinized profitably onshore. Lower processing costs have even allowed banks to create new products, such as subprime lending to previously unviable customer segments. As for the pharmaceutical industry, it could double the value it creates from offshoring (Exhibit 3), through new or redesigned processes and services that would improve compliance and the quality of its trial data, enhance its analytical capabilities, and help it develop products for consumer microsegments.

About the Authors

Sujit Chakrabarty is a consultant and Noshir Kaka is a principal in McKinsey's Mumbai office; Prashant Gandhi is an associate principal in the Delhi office.

Notes

¹ The study—Extending India's Leadership in the Global IT and BPO Industries, published in December 2005—was conducted jointly by India's National Association of Software and Service Companies (Nasscom) and McKinsey, and is available for purchase at Nasscom's Web site. The markets discussed in this article are those we consider "addressable," meaning that they can be served using a delivery model based primarily on offshore work. (Indian IT companies typically perform 25 to 30 percent of their work in the client's country and the rest offshore.) Our market estimates are limited to industries that are currently offshoring on a significant scale.

² The size of the addressable offshore IT market was determined using a three-step methodology. First, we examined spending on IT services in developed countries. Then, in a detailed analysis involving primary as well as secondary research, we applied to each service the six key factors (including labor intensity, business risk, and the complexity of interactions) that affect the decision to offshore tasks. Finally, we estimated the offshore cost savings for individual activities.

2006-02-12T09:50:00.000-08:00

Reducing risks in offshoring projects

Identifying and tracking risks throughout the life of a relocation effort can greatly improve the odds that it will succeed.

Michael Bloch and Christoph Jans

2005 Number 3

Executives know that transferring business or IT processes to low-cost locations can save a bundle. Yet such moves frequently fail to create the expected value,¹ often because managers underestimate or misunderstand the risks involved. Our analysis indicates that by systematically identifying, assessing, and tracking risks throughout the life of an offshoring effort, a company can lower its costs as well as increase the odds that the effort will succeed.

Before beginning an offshoring project, a successful company examines, among other factors, the risks associated with its business case for the move, its assets (including intellectual property), and the knowledge and skill levels of those involved. Such a comprehensive approach can yield surprises. One company, after cataloging the risks of a particular offshoring effort and then using a simple visualization tool (exhibit), found that the most likely—and most severe—risks came from the organization's own employees: a high rate of turnover threatened the transfer of knowledge to the new location. By addressing these and other risks early, the company completed the offshoring effort three months ahead of schedule and, by our estimates, saved €5 million to €7 million in costs.

enlarge exhibit

About the Authors

Michael Bloch is a principal in McKinsey's Geneva office, and Christoph Jans is an associate principal in the Zurich office.

Notes

¹David Craig and Paul Willmott, "Outsourcing grows up," The McKinsey Quarterly, Web exclusive, February 2005.

When IT's customers are external

2006-02-03T11:56:00.000-08:00

IT organizations can minimize the risks of customer-facing projects by adopting the approach of software product companies.

Simon P. MacGibbon, Jeffrey R. Schumacher, Ranjit S. Tinaikar

Web exclusive, January 2006

Managing a large IT implementation is challenging for any company, but the risks increase when the end users are external customers and the price of failure is damage to the bottom line. Careful planning of the design and rollout is thus crucial. No one knows this better than software product companies, such as Microsoft and Oracle, which live or die by how well they introduce products that both meet their customers' needs and keep their cost base competitive. They realize the importance of understanding what customers want, of market research and customer support, and of maximizing value by striking a balance between satisfying buyers and controlling costs.

In these respects, software product companies have much to teach internal IT organizations, whose project-management practices usually fall short when it comes to developing and executing customer-facing systems. Too often the IT organization assumes that someone in marketing or sales has done the up-front market research or that budget-busting modifications to the features of systems are customer driven and absolutely essential. Such faulty assumptions can have serious consequences: whereas internal customers usually have no choice but to adopt a new solution—even a poorly designed one—external customers can go elsewhere. During the recent refinancing boom, for example, one mortgage company had to forgo 10 to 20 percent in potential extra revenues because its loan origination system couldn't handle the necessary volume. Rather than deal with a slow, unwieldy system, the company's "customers," namely, the real-estate brokers who sold its loans, simply used other lenders.

A market-oriented approach

Traditional project management focuses on prioritizing, scheduling, and deploying a well-defined set of system capabilities using standard processes and tools. These are vital steps, but they must be adapted to the special needs of customer-facing projects.

The market-oriented approach of software product companies differs in two ways. First, these companies focus on customers, using market research and follow-up support to ensure that users will like and adopt a new product because they find that it meets their needs. Second, the companies sell to highly competitive markets, so they must keep their costs in line. They therefore design products simple enough to ensure that development and maintenance costs can be controlled, yet sufficiently comprehensive to meet their customers' requirements. This balancing act ensures that products are not overcustomized and that solutions target the highest-value buyers.

Researching customers and usage

Since customer satisfaction and the adoption of products are tightly linked, product companies invest heavily in market research to gain a detailed understanding not just of functional needs but also of how the solution will fit in with adjacent systems and environments.

This research can uncover potential problems early on. A large vendor of customer-relationship-management (CRM) systems, for example, assumed that few of its target customers used a certain type of integration platform. Research showed the opposite—the platform was disproportionately dominant. In response, the vendor developed connectors to enable customers using that platform to integrate its CRM system, averting a potential disaster.

The failure to anticipate such external dependencies is common among IT organizations, even though fixing the mismatch can require costly upgrades or product modifications. A product company such as Siebel Systems, by contrast, employs marketing specialists and has an explicit process to establish an understanding of the broader environments where its products are going to be used. The design stage incorporates not just the basic functional requirements of a product but also the features and capabilities that will help customers integrate it into their suite of systems to create a solution. Another effective approach is to give beta versions of software to customers with the aim of eliciting feedback and an early buy-in before the launch of the main product.

Market research must be a continuing rather than a one-off effort. Successful product companies monitor customer adoption trends across the entire life cycle of a product and adjust development plans accordingly. Without up-to-date information, an IT project can miss the mark. One financial-services company successfully navigated through two system releases for institutional customers without hiccups, but with the third release the system ground to a halt, overwhelmed by unexpected levels of usage that exceeded its capacity. Investigation revealed that the customer adoption group had raised its forecast of transaction volumes but that, somehow, this vital piece of information hadn't made it to the system-development and testing teams, which continued working with the original forecast assumptions. The company fixed the problem by establishing an explicit communication link between the customer adoption people and the development and testing teams at the highest level of the project-management hierarchy.

Balancing costs with customization

Most projects carried out by internal IT organizations suffer from budget overruns that occur for two reasons: excessive customization and changing requirements. In an effort to keep external customers—especially big, powerful ones—happy, many IT groups end up overcustomizing solutions and adding needless costs and complexity. One large consumer credit company almost doubled the time and money originally allocated to a new platform for institutional customers by trying to satisfy all of their operational and technology needs.

Product companies avoid this problem and keep their costs competitive by identifying common customer needs and then developing a basic product around a standard menu of features and functions. Additional options are bundled into a tiered offering aimed at a few higher-value customers and those willing to pay a premium. The mortgage company mentioned earlier started with ambitious plans for its new loan origination platform. Ideally, it would have supported a wide range of products (mortgages, home equity lines, and personal loans) and distribution channels (wholesale, branch, and direct). But faced with escalating costs and development time as the project team struggled to reconcile these competing priorities, the CEO imposed a financial cap. This move helped to get the project done by forcing the IT group to narrow its focus to the product and channel that had the highest growth potential and the greatest current volume, respectively.

At one database company, the reuse of components is so central that it gives an award to whichever team "stole the most code"

Unplanned or changing requirements should be accommodated by instilling process discipline. To reduce the number of changes ordered, many product companies use process-improvement methodologies, such as the capability maturity model (CMM), a set of process standards widely adopted by the software-development industry to improve the quality and productivity of the development process. Leading providers of offshore software-development services, for example, must have attained CMM Level 5—the highest—to be competitive. They also increase their flexibility by designing components for reuse. Eontec, for instance, has a product for retail banks that reuses services such as check reorders and fund transfers across channels. Most of the large providers of enterprise-resource-planning solutions, such as SAP and Oracle, draw on inherent commonalities of service (such as invoice generation) to develop standard but flexible packages that can be adapted to different customer situations. In Secrets of Software Success, the authors report that at one provider of database products, the reuse of components is so integral to the corporate culture that an award for "the team that stole the most code" is given at the company's annual developer conference.1 The financial-services company mentioned earlier, aiming to support a range of home-financing products and their complex contracts flexibly and cost effectively, created a set of reusable modules for common products and contracts.

Providing follow-up customer support

High-quality solutions and strong customer support win the customers' trust, as product companies know. They reap the dividends in the form of wider adoption of their products, increased customer satisfaction, and future repurchases or upgrades.

Trust can be built in a number of ways. Siebel uses extensive beta testing to improve its products' usability and quality before releasing them. Intuit's TurboTax, a tool for calculating and submitting taxes, includes context-sensitive feedback options in its product in order to collect market reactions online. Netscape distributes free beta versions of its Web browser to gain critical mass for new releases. Companies that manage postmerger IT integration ramp up their help desk support when they first roll out customer-facing components, such as branch teller and call-center applications for retail banks.

The mortgage company took a test-and-learn approach to implementing its loan origination platform. Two pilot groups in one geographic location tested the platform under real market conditions to see which features and functions delivered measurable benefits to customers. Meanwhile, taking another page from the release models of software product companies, the mortgage company forecast how the new platform would affect call-center volumes and beefed up support correspondingly so that customers would come away satisfied with their experience and the solution.

Most new software solutions require a level of process change and "re-skilling" on the customer's part. Large IT projects typically bring customers up to speed with training documents, user manuals, and perhaps formal training programs. Software companies go further and see the postsales period as an opportunity to strengthen the relationship and build trust by offering on-site consultants, specialized help desks, Web-based communities, deployment managers, and feedback channels. Few IT projects—even customer-facing ones—approach follow-up and support with the degree of discipline shown by product companies.

Making it work

Like a product company's R&D group, an IT organization must collaborate with marketing and sales to make sure that a solution offers value to customers. To do so in a disciplined way and to keep the focus unremittingly on the customer, it's necessary to reengineer the traditional software-development steps of project initiation, design, coding, testing, and deployment.

A customer-facing project is best initiated and sponsored not by IT but by the business unit that "owns" the customer relationship. It is also essential for marketing and sales to be involved in researching customer needs and for the IT organization to allow enough time—up to three or four months—to gather this intelligence during the project initiation phase. At this point, as well, the project team should identify the company's highest-value customers and their vital requirements, which will then form the core of a set of standard features. This approach keeps costs down by minimizing customization. In addition, detailed research helps IT to prioritize its development efforts and to make the right trade-offs in the subsequent design phase. Research carried out by a large asset manager, for instance, revealed that the company's inflexible approach to record keeping was a source of dissatisfaction for its largest, most profitable customers, leaving it vulnerable to competitors. Armed with this information, the company made upgrading its record-keeping platform a priority.

During the design phase, it is standard IT practice to involve the end user—difficult enough for internal projects but even more so for customer-facing ones, where end users cannot be strong-armed into cooperating. Project teams thus must secure the customers' involvement by using methods ranging from formal contractual agreements to informal advisory boards. One provider of global payment services formed a group of key-customer banks to help develop and roll out a payment-messaging technology. An auto-financing company with a strong culture of dealer-centered service and sales formed a dealer advisory board to test ideas for online loan origination and to win advance buy-in for new features. When a few large customers account for the bulk of a company's revenue, it is usually wise to have them participate even more actively in the design phase. Specific controls should also be introduced at this point to ensure that the marketing group or salespeople on a project team get written design approval from these customers before development starts.

The focus on the customer must be sustained into the coding and testing phases, when the development team should survey the technology environment of leading customers and work with their IT departments to ensure that the new system will integrate well. This concern is a vital one if customers have to send or receive information through financial or administrative systems that tie into the solution. An agency that buys, pools, and securitizes loans from lending institutions, for instance, must download detailed product and contract information from these business partners, a requirement that obliges the agency to integrate its systems with theirs. Final tests should include simulations to show how well a system handles specific transaction types or volumes, with customers verifying the correct conditions to test.

At the deployment stage, the project team should ensure that operations run smoothly by dispatching specialized deployment engineers (from IT) and relationship managers (from marketing) to customers' sites. A help desk is also vital during the first few months. After that, a formal satisfaction-and-review process will gather feedback for future releases.

Risky and challenging though customer-facing IT projects might be, they also offer opportunities to deepen and strengthen relationships with customers. By adopting a market-oriented approach and maintaining a strong customer focus throughout the development cycle, the IT organization can greatly increase its chances of success.
About the Authors

Simon MacGibbon, a consultant in McKinsey's global sales and marketing practice, specializes in customer life cycle management and the telecommunications industry. He is based in San Francisco. Jeff Schumacher, an associate principal, leads McKinsey's customer life cycle management technology practice in San Francisco, where he is based. He specializes in sales and marketing. Ranjit Tinaikar, a principal, coleads McKinsey's global IT strategy practice and credit operations practice. He is based in New York.

This article was first published in the Winter 2005 issue of McKinsey IT.
Notes

1 Detlev J. Hoch, Cyriac R. Roeding, Gert Purkert, Sandro K. Kindner, and Ralph Müller, Secrets of Software Success: Management Insights from 100 Software Firms around the World, Boston: Harvard Business School Press, 1999, p. 118.

What IT leaders do

2005-11-24T08:39:00.000-08:00

Companies that rely on IT governance systems alone will come up short.

Eric Monnoyer and Paul Willmott

Web exclusive, August 2005

Something's gone very wrong with the structures, processes, and policies that govern how a business makes IT decisions and who within the organization makes them. Most companies have such frameworks—commonly referred to as IT governance—in place today. In the best cases these systems help IT and business managers work together to make smarter IT investments that deliver real value.

Despite these well-defined rules, IT and the business too often lack a common understanding of the company's basic objectives and have conflicting opinions about technology options and priorities. A good deal of research shows that this misalignment usually results in failed IT initiatives and high costs.¹

The problem is that IT governance systems have become a substitute for real leadership. Companies are relying on tightly scripted meetings, analyses, and decision frameworks to unite CIOs and business executives around a common vision for IT. But committee meetings and processes are poor stand-ins for executives who can forge a clear agreement among their peers about IT investment choices and drive the senior-level conversations needed to make tough trade-offs.

For several reasons, leadership can achieve what governance systems by themselves cannot. First, IT leaders earn the trust of their business colleagues, often by demonstrating that they understand the company in business terms, by examining IT options as business investments (rather than as technology solutions), and by managing the IT function as a business—using business metrics to quantify results, for example.

Trusted, credible leaders articulate a vision for IT's role in the company and ensure that this vision is clearly understood by managers throughout the organization. They inspire other executives to pursue new IT-enabled business opportunities and have enough clout to keep managers focused on the right issues and on making the most effective decisions.

Governance systems by their nature lack the focus, energy, and high-level attention that an individual leader can provide. Meetings and rules can't make executives trust each other—trust is built at a personal level. Processes can't command the attention executives give to trusted peers. In some companies, for instance, business leaders send delegates to technology committee meetings; they would never shrug off a meeting with a respected colleague, however. Systems alone don't forge common visions or inspire action; without a leader, governance systems are like a vehicle without an engine.

In companies with strong IT leaders, governance constitutes a much more flexible set of managerial activities, involves fewer people and fewer meetings, and is typically tailored to fit the IT leader's style, much as executive committee activities often reflect a CEO's leadership approach.

As companies turn their attention to growth and place bets on new IT investments, they can no longer allow systems to substitute for strong IT leadership. The executive team must be more creative about identifying leaders, helping them succeed, and redesigning governance systems to support these leaders rather than to compensate for their absence.

A tale of two banks

Consider the case of one large European bank: the effectiveness of its IT strategy was being undermined by a leadership vacuum. The head of retail banking was pushing hard for new systems and processes to improve customer relationships, the CEO wanted to consolidate operations across organizational boundaries, and the CIO's top priority was to renew the bank's core applications and systems.

The bank had a clearly defined IT governance structure in place for resolving exactly this kind of alignment issue. A committee of business and functional executives followed a step-by-step process for analyzing and reviewing IT options and setting priorities. But the bank still lacked a clear vision for IT's role in supporting the bank's overall strategy. The committee weighed the relative merits of the options against one another rather than using a common understanding of general priorities to assess each initiative. The committee was simply not capable of becoming the driving force in resolving these conflicting senior agendas. How could it be? It would be like asking a nation's legislative body to act as a leader. In the end, the CIO hijacked the process to push his IT agenda forward.

In stark contrast, at another European bank competing agendas are resolved by an IT leader (in this case, the CIO) with the clout to get executives to discuss options and reach a consensus—even if it isn't the decision they would make on their own. More important, the bank has fewer major conflicts over IT investments, because the CIO has effectively integrated a common vision for technology with the corporate strategy, thus avoiding lengthy debates about which investments are desirable.

The CIO has clout because he earned it. He is regarded as a peer by the other executives; he understands the bank's businesses and thinks about them in the same way the other executives do; he uses their language; he thinks about initiatives as business options (not technology ones) and assesses them with the appropriate metrics; and he understands the constraints of the businesses and works within them. For instance, he's careful to plan, sequence, and finance necessary investments within the constraints of the bottom line of each business unit.

At this second bank, IT governance is less formal and therefore far more effective than at the first one. Because the CIO has excellent working relationships with the business leaders, they use personal discussions to make quick decisions collectively rather than resorting to formal meetings. This approach has enabled the CIO and his executive colleagues to consolidate several committees at different management levels into a single executive IT council that understands the bank's IT strategy and makes investment decisions accordingly.

Our analysis of the IT decisions at these two banks highlights a very clear message. The bank with an IT leader makes business-focused IT decisions that have helped increase its earnings each quarter and are supporting revenue growth in core businesses. In contrast, the bank relying on governance processes to act as a "ghost leader" has stalled; costs are high and transformation is slow.

Lead IT governance—don't be led by it

In companies with strong IT leaders, the IT governance structures are more efficient and streamlined and less bureaucratic than in companies without such leaders. Over time, leaders figure out what tasks can be achieved through relationships and what must be accomplished through more formalized assessment and decision-making processes. The balance varies, of course, depending on the leader's style, the top team's chemistry, and the specific processes required to get things done.

An efficient process typically gives the executive IT committee the space to solve higher-value problems. One company's executive council, for instance, focuses on detailed analyses of how to implement new investments with maximum speed in order to reap the expected benefits as soon as possible. In particular, the council examines how to communicate its IT decisions to employees throughout the organization's business and IT-management ranks.

Some companies streamline IT governance even further, by integrating it with existing business governance processes. At one European insurance company, the executive committee that makes most of the major business decisions also handles IT. The executive team believes this approach is more effective because IT choices aren't viewed as separate and parallel to business decisions but as one aspect of them.

Unfortunately, many other companies try to solve the problems that stem from a lack of leadership—incoherent IT strategies, competing agendas, missed opportunities for the businesses to leverage IT, misalignment and miscommunication between IT and business managers—by ladling on more governance. These companies assume that greater alignment and better IT decisions would result from clearer rules, more meetings, different people at the meetings, more rigorous analysis of business cases, or more forms and checklists.

They are wrong; additional IT governance measures don't work and instead often exacerbate the problems. When one European financial-services company tightened its governance procedures, for instance, business executives became even more disaffected and participation plummeted. At another company, governance has evolved into a mammoth system of checks and balances, involving long, arduous meetings and multiple committees—a process intended to allow managers to question or defend the business case for new investments aggressively.

IT governance can always improve, but never enough to compensate for a lack of IT leadership; there is no substitute for the sheer power of having leaders who trust and respect each other. Indeed, IT leaders trump governance alone in three other important respects.

Leaders address issues that governance misses

Companies structure their governance systems to decide whether to increase or cut investments in technology. They rarely use these processes to examine the broader questions regarding IT value that leaders routinely confront: what is the role of IT? How do we measure and improve the impact of IT on the business? What innovations should we be exploring? What strategies are our competitors pursuing? And what constitutes best practice?

Leaders accommodate different executive styles; governance doesn't

Some business leaders prepare for IT committee meetings by getting input and advice from their own managers and by reflecting on how they operate in their own domains. Others prefer going over issues and potential options with the CIO. Some executives delegate responsibilities to trusted subordinates; others wish to exert total control by conducting personal reviews after the official IT committee has met and then making a decision. Leaders understand these stylistic differences and accommodate them. In many companies, however, governance is a process that doesn't allow for much flexibility—rules restrict when and how decisions are made, and business leaders are expected to fall into line.

Leaders are accountable

Executives routinely accuse IT of managing projects poorly or of failing to translate business needs into IT solutions. IT, for its part, often blames business for a lack of involvement and quality input. Leaders must be accountable where governance isn't; the buck stops with them.

The way forward

True IT leadership is rare. It results only from a deliberate effort by the executive team—and often in reaction to specific circumstances. At one company that had grown through serial acquisitions, for instance, the top team concluded that strong IT leadership was needed to bring coherence to the company's fragmented systems. In other cases, IT leaders emerged at companies that depended increasingly on performance outside their home market or where the CEO integrated IT into the company's management culture.

The common denominator is that the executive team must take responsibility for finding an IT leader and then commit to making that person successful. Three lessons emerge.

1. Hire creatively

Too often, CEOs and their top teams rely on stereotypes about who should lead IT. Finding the right person with the necessary skills isn't easy, since the role is fraught with paradox. An IT leader must be a businessperson who understands IT: an executive—like the CEO—who can create change but who individually may not have the clout within the organization to make things happen, and who is a peer of business leaders yet respected as "one of us" by the IT staff.

CEOs sell their companies short by searching solely for CIOs to fill this role. Banks in North America and Europe have asked chief financial officers or chief operating officers to lead IT. One large global energy company rotates business executives into the role for a set period to ensure both that someone with business skills runs IT and that the business units are then seeded with IT-savvy managers.

2. Help IT leaders succeed

The IT leader must be part of the executive team to get results and to build the necessary relationships and credibility within the company. CIOs who are perceived to be operating managers—not leaders—rarely sit on the management committee and often report to executives other than the CEO. The solution isn't to clear space at the table for an operating manager; instead companies should search for an IT leader who adds value to the management team.

Obviously, the IT leader needs the right resources to succeed, but an explicit mandate within the company—including a role in the decision-making process—is equally important. The management team may opt, for example, to give the IT leader veto rights over any project that isn't compatible with the company's IT architecture. One European telecommunications company made the IT leader its process architect. Business and functional leaders still operate the processes but must convince the IT leader in order to change them.

3. Create the conditions for aligning IT and business

Alignment won't come about simply from discussions between IT and business units. Instead, clear frameworks for decision making and alignment must be forged within these boundaries. The company's strategy should be specific enough for IT and business leaders to discuss trade-offs rather than debate what the strategy means, for example.

In some cases, performance frameworks help to align business and IT. One telecommunications company, for instance, uses business rather than technology metrics to review and compensate its IT leader.

The difference between companies with strong IT leaders and those that use governance as a substitute for leadership is striking (exhibit). Executive teams with a strong IT leader make better, faster decisions about technology than do companies that rely solely on a governance system—no matter how effective it is.

enlarge exhibit

About the Authors

Eric Monnoyer is a principal and leads McKinsey's IT practice in France. He specializes in IT performance management and is based in Paris. Paul Willmott is a principal in McKinsey's global IT practice and specializes in IT organization and governance. He is based in London.

This article was first published in the Fall 2005 issue of McKinsey on IT.

Notes

¹Andrew M. Appel, Amit Dhadwal, and Wayne E. Pietraszek, "More bang for the IT buck," The McKinsey Quarterly, 2003 Number 2, pp. 130–41.

Building stronger IT vendor relationships

2005-11-24T08:34:00.000-08:00

Our research indicates that although a majority of technology executives want to have stronger relationships with their IT suppliers, they often act in ways that undermine that goal. In fact, many corporate customers lose out on the potential benefit of a closer relationship by engaging in value-destroying or inconsistent behavior—too much emphasis on costs, say—when they interact with vendors.

McKinsey interviewed IT executives at 23 companies representing a wide range of industries to learn about technology-purchasing patterns, criteria, and priorities over the next 12 to 36 months. We found not only a number of factors that subvert effective buyer-vendor relationships but also ways for both parties to increase the value they deliver and receive.

The benefits of partnership
Although 20 percent of the executives we interviewed regard costs—not added value—as the top priority, 70 percent said that they want to move away from purely transactional relationships by establishing stronger partnerships with a smaller number of preferred IT suppliers. These relationship-seeking customers want vendors that better understand their specific technical environment, offer ongoing advice, help them manage aggressive technology upgrade-and-innovation cycles, and provide solutions for their most pressing business problems. As one buyer explained, "We're looking for a vendor that can bring real insight to our business by tying together industry knowledge, technical knowledge, and knowledge of us as a customer—vendors get to see what my peers are doing and should be able to use this information to help me make better decisions." Another noted, "I want my supplier to approach my account like a good financial planner—to review my status and recent transactions, then engage me in a rich discussion around my emerging needs, market trends, and relevant new-product offerings."

Buyers and vendors alike stand to gain from a smaller number of more committed relationships. Consider the case of a telecommunications company that used tough tactics with one of its vendors when it negotiated the contract for a customer-relationship-management system. Despite the size and clout of the company, the resulting arm's-length relationship meant that when it wanted additional features, it had to invest a great deal of time and money to customize the software in house. After the company committed itself to a higher-value relationship, however, it began meeting with the vendor's CEO, sharing its development plans, and suggesting features that could minimize the need for customization—suggestions the vendor started to take.

Another case: a travel company was launching a new online system, which required a significant infrastructure upgrade involving a number of vendors. At first, the company took a very tough stance with each of them on price, but it became clear that cutting the project's implementation time was a priority and that protracted negotiations were putting it at risk. A new CIO therefore decided to enter into more open and relationship-based negotiations with a set of core vendors. This approach not only enabled the joint team to meet the project's schedule at minimal additional cost but also created the right environment for these vendors to become strategic partners over the long term, bringing new ideas and insights to the CIO. Since relationship-based negotiations with all vendors would not have been practical, it was essential to identify those that were crucial to the project's success and could be of value on a longer-run basis.

Such companies are in the minority, however. Of the 70 percent of respondents who say that they want to have close relationships with vendors, only 30 percent actually do. The rest continue to think and act in a transactional way, and many blindly seek the lowest total cost of ownership (TCO) from their vendors in all circumstances—typically by negotiating hard at the bargaining table. When an IT product is vital, however, TCO analysis is often too narrow. The cost of downtime when a hotel's reservation system crashes or when a store can't meet its inventory requirements because of IT snafus surely outweighs any incremental IT savings from tough negotiations.

Companies aspiring to better relationships with their vendors should approach the challenge on two fronts. First they must analyze their portfolios of IT vendors to determine which ones are the best candidates for closer partnerships. Then they must change their behavior to close the gap between themselves and their vendors.

Analyzing the vendor portfolio
If only because resources are limited, no company can afford to have strong relationships with all of its IT vendors. To decide which of them are most important, the company should begin by breaking down its portfolio into critical and noncritical vendors and focus its efforts accordingly.

A critical vendor provides the integral products that support crucial technology needs or the noncommodity products that eat up a large part of a company's IT budget. These are the vendors for tight relationships. Storage products, for example, are a big-ticket purchase for telecom companies, which must log data on every call placed or received, for both legal and operational (billing) reasons. Thus, storage vendors would be on the critical list. A hotel's most critical vendor might provide and support the mainframe that runs the core reservation system.

For noncritical vendors, which supply more standard products (such as ordinary desktop systems), transactional relationships are fine. Companies can treat these products as commodities, shop for the best price, seek bids from more than one supplier, and use a standard TCO approach to purchasing.

Once a company has ranked its vendors, it should compare the skills of the critical ones with those of its internal IT organization to see how well the two complement each other and which capabilities of which vendors it might further leverage to meet its needs. Ask yourself what you hope to achieve through each critical vendor. Many companies, for instance, want insights into the way competitors use the products of a certain vendor; others may want a larger say in its R&D or engineering function to ensure that its products better suit their needs.

Next, explore which vendors have the skills and commitment to exert the greatest impact on your company. Consider, for example, the value that a vendor now delivers as reflected in the quality of its products, its responsiveness, its knowledge, and its expertise. How well does the vendor understand your business and how do its offerings fit your needs? Is the vendor willing to commit extra resources to ensure your company's success? Since a critical vendor may fall short on one or more of these dimensions, it's important to consider vendors you don't currently use.

The next step is to identify the gaps between your current and desired vendor relationships. Since a mix of transactional and high-impact ones is usually the goal, this analysis will show where your company is over- or underinvesting in its vendors; thus it may choose to pull away from some and move closer to others (exhibit). Focus time and resources on undercapitalized yet critical relationships.

enlarge exhibit
Close the gaps
Our research shows that to achieve higher-value relationships, most companies must change their behavior and the way they communicate with vendors. Certain kinds of behavior on the customer's part—focusing conversations on TCO, for instance, or using a vendor's openness about potential product defects as a negotiating weapon—promote transactional relationships, and vendors may respond by committing fewer resources and engaging less fully. Other companies sabotage their relationships with vendors by withholding information and regular feedback and by behaving inconsistently—in effect, sending mixed messages about the type of relationship they desire. The following forms of behavior promote closer relationships.

Be explicit about expectations. A good portfolio analysis helps companies identify what, specifically, they want from their key vendor relationships. A company's needs—tactical knowledge about competitors, influence over a vendor's R&D, a high degree of responsiveness or expertise in specific areas—must be communicated clearly, and the vendor must explicitly agree to meet them. Be clear, too, about what your company is willing to pay for added services; although higher value doesn't necessarily come at a higher cost, trade-offs are often necessary. Finally, make sure that the vendor shares your desire for a closer relationship.
Involve senior management. Assigning an executive sponsor (such as the CIO or the chief marketing officer) to build, monitor, and sustain ties with a vendor tells it that its relationship with your company is important. Yet even when sponsors are on board, they may not spend enough time with key vendors. An executive sponsor should hold quarterly meetings with their top managers.
Share information. When a company shares details about its IT infrastructure, business plans, priorities, or technology road map, its vendors can provide more effective solutions and insights. Moreover, the sharing of information often allows companies to leverage their vendors' R&D and can thereby prevent major customization expenses. Clearly, withholding information is counterproductive.
Provide regular feedback. Constructive, systematic feedback demonstrates a high level of commitment and provides a forum for resolving issues. Companies should stick to fact-based evaluations and avoid off-the-cuff or anecdotal criticism.
Building higher-value relationships is a two-way street, of course, and the actions of vendors are equally important. Those that are open about product issues build trust and provide insights that can guide the purchasing decisions of buyers; sharing information about a forthcoming product can, for example, help buyers better plan their own IT architectures. Moreover, vendors that listen to what key customers need and then respond accordingly may spare them the high costs of correction and customization—and make them less likely to stray.

To get more from IT investments, companies must understand the types of relationships they seek from their vendors, decide which vendors can offer those relationships, and then act on this evaluation. By avoiding value-destroying behavior, companies and their vendors can build a foundation of trust—and closer relationships that deliver a far greater impact than mere transactional ones.

Next-generation CIOs

2005-03-18T21:17:00.000-08:00

Many chief information officers do an excellent job of overseeing IT operations, but very few lead their companies' efforts to get real business benefits from IT investments. A new style of leader is needed—one who can find ways for IT to change the company, not just run it. Are CIOs up to the challenge?

Case in point: The CIO of a large European bank instilled discipline and focus in the IT organization, reduced IT costs, streamlined and upgraded the infrastructure, and showed the business units that IT mattered. From an enterprise perspective, however, the CIO's performance was not so impressive. First, the IT budget focused on maintaining bank operations, not on innovating to add business value. Second, technology operations and investments were not aligned with the bank's business strategies.

The bank's CFO proposed an alliance. The two executives would involve business-unit leaders in defining the bank's IT agenda. They would begin, the CFO suggested, by helping the business leaders see the impact of their decisions on IT costs. At the CFO's behest, IT reports on operating costs and reliability were replaced with reports focusing on IT-driven business and financial metrics, such as business-process errors. The CFO also sold the bank on a new decision-making process for technology investments—one requiring greater business-unit involvement. Over time, persuaded by facts, influence, and deal making, the business-unit leaders became more deeply engaged in initiatives to reduce IT costs stemming from business complexity.1 Today these executives are making smarter decisions about IT investments and are more accountable for the outcomes.

Who was the real IT leader at the bank—the CIO or the CFO? The answer is obvious: the CFO drove efforts to take IT to the next level. While some CIOs may be content to manage their IT organizations efficiently, those who aspire to a greater role will need to make a choice in the next few years: step up to the new responsibilities required of an IT leader or watch as another executive does.

At many companies in Europe and North America, CIOs have been optimizing IT assets successfully. But at a growing number of these businesses, CEOs say they are disappointed that IT hasn't done more to improve corporate performance (see sidebar, "What CEOs really think about IT" ). CEOs and many CIOs agree on the components needed to manage IT for value—including more business-unit involvement in technology-investment decisions, greater business accountability for realizing the benefits of those investments, and an increased emphasis on using IT to change the company rather than just to run it. The missing ingredient is the leadership needed to make these changes real.

Let's be clear: this article is not suggesting—as many have, for many years—that CIOs should have a seat at the strategy-making table. That advice is good, but simplistic. There are CIOs who can provide savvy ideas about new business applications but can't drive the kind of business value that the European bank's CFO in our example did. Whether IT leadership ends up in the hands of the CIO or another executive depends on multiple factors, including ability, reputation, corporate culture, and a company's perception of the role of IT. In a recent survey,2 few senior executives placed a high degree of importance on guidance in IT matters from the CIO: their top priority was getting business value from IT.

Some CIOs have taken on the leadership mantle. From our ongoing research on CIO relationships in French companies—as well as discussions with other European and US CIOs, CEOs, and business-unit leaders3—it is clear that this transition requires a new focus plus new skills. CIOs need to direct their attention away from managing IT supply and toward managing IT demand, and they must fine-tune their executive-leadership skills.
From supply to demand

Think of supply and demand, in this context, as a clarifying analogy. CIO responsibilities span a spectrum of managerial tasks, with one end of the spectrum involving supply—the delivery of IT resources and services to support business functions. The other end of the spectrum is demand—the task of helping the business innovate through its use of technology. CIOs who accept the new responsibilities of IT leadership are delegating or even shedding some operational duties and spending more time helping business leaders identify and use technologies that matter. This challenge includes persuading business leaders to be better owners of the technology they leverage. To achieve this goal, CIOs are redefining their roles and changing the way they communicate and lead.

In truth, most CIOs struggle to balance the supply and demand roles. Managing IT supply—keeping the engine running cost-efficiently and reliably—is the heart of the job. Basic systems must be operating smoothly before the CIO can take on broader leadership responsibilities. Most CIOs also spend considerable time with business-unit leaders and other executives in the company and talk to customers, suppliers, and business partners.

But many CIOs admit that managing supply tends to trump shaping demand. Although in survey after survey they say that aligning IT and business strategies remains one of their most significant challenges, they don't have enough time for effective strategic planning.4 They feel demand-side pressures but are hard-pressed to meet them.

While CIOs do spend time with business-unit leaders, numerous executives say that the time is not well spent. They tell us that their CIOs aren't up to speed on issues confronting the businesses and can't think through the implications of systems trade-offs, on a business-unit level, for planned implementations or proposed IT investments. Moreover, business leaders often tell us that their CIOs are not proactively bringing them new ideas about how technology can help them compete more effectively.

Part of the problem stems from the inherent conflict of managing supply and shaping demand. CIOs often must meet requirements to reduce total IT spending, for instance, while making investments to support future scenarios—even though these upgrades will increase IT operating costs. By trying to be both a cost cutter and an innovator, the CIO sometimes compromises one role. At a financial-services company, the CIO slashed IT supply costs to meet corporate objectives, and now the organization's aging legacy systems fail to provide competitive functionality. The company's business leaders don't understand why IT spending must rise or why it will take a long time to implement needed new functionality.

CIOs who seek a broader demand role also face many organizational challenges. They alone can't drive change in parts of the organization that are under the control of other executives. Business-unit leaders want more IT leadership, but they are wary of CIOs who don't tread carefully along business leaders' boundaries.

Ironically, as business leaders have gained a greater understanding of technology's strategic impact—indeed, during the dot-com years, some even led Internet channel initiatives—they are more likely to engage in battles over ownership of and accountability for IT. Tempers can flare especially vividly during decisions about business-applications investments. At a US-based financial-services company, business-unit leaders went to war with the CIO, one of its top executives, when he attempted to take greater responsibility for IT applications and technology investments at the business-unit level and to make business leaders shoulder more accountability for getting returns from IT.
Leadership agenda

At a growing number of companies for which IT is part of the very fabric of the business, the next IT objective clearly is to make improvements on the demand side. Leadership in this area awaits CIOs or other executives who will step up to the challenge. What does demand-side leadership consist of? In companies where executives have begun to ensure that the organization captures greater value from IT investments, we see three critical hallmarks of success:

1. Key business executives in the organization—as well as the CIO—have a clear financial understanding of IT costs and potential investments. Business and IT managers who discuss IT in a common, business-focused language make smarter and faster decisions.

2. There is widespread business accountability for IT. Executives who possess a financial understanding of IT are more willing to take responsibility for generating value from IT investments.

3. Business and IT managers seriously study how new technology investments can help a company become more productive and competitive. In other words, they seek innovations that will help them change the business.

For a majority of companies, IT leadership is a vacuum. The CIO should view each of the three markers of success as an opportunity. By taking the lead in making improvements in any one—or all three—of these areas, a CIO can help the organization get significantly greater value out of its IT spending and, in the process, gain credibility to take on even more significant leadership tasks.
Financial language of IT

At companies where business executives are involved in technology-investment decisions, IT leaders aren't generating reports about how many person-days it will take to build functionality into a particular system. Instead they frame IT costs in financial terms. At one company, for instance, the CIO compared the IT capital expenditures of a proposed new system with ratios and returns on other kinds of capital outlays made by companies in the sector. Another CIO routinely groups costs or investments in tangible categories—such as equipment and people—and breaks out how specific changes in the business unit can lower costs or improve an investment's impact.

At a handful of companies, CFOs are starting to push aggressively for changes in the way IT and the business evaluate and measure information technology. Smart CIOs could forge alliances with their CFOs to sell these changes throughout the organization.
Business accountability

Most executives recognize that active involvement by business leaders in setting the agenda for IT investments improves the company's ability to get the greatest benefit from them.5 But involving business executives in investment decisions—much less getting them to take responsibility for realizing the benefits of new systems—has been difficult. There is considerable room for improvement. In a 2003 McKinsey survey, 64 percent of CIOs reported that their IT budgets were set at the beginning of the year and that they didn't have to compete with business units or other functions for resources. Also, 68 percent of these companies had no process for auditing the performance of their IT projects. An additional 14 percent said that while their companies did have a postimplementation audit process, outcomes weren't tied to budgets or bonuses (see "Tech spending is up, but who's doing the buying?" McKinsey on IT, Number 2, Spring 2004, pp. 9–12).

Despite these organizational constraints, CIOs can drive changes in accountability. At a basic level, many CIOs can do postimplementation audits themselves. More generally, a few CIOs have led broad change initiatives—restructuring global IT organizations, for example—that have prompted businesses to take on greater responsibility for IT decisions. (For a look at how one CIO achieved this result, see "Deutsche Bank's IT revolution," McKinsey on IT, Number 2, Spring 2004, pp. 18–22.)
Innovation

Business-unit leaders we spoke with worry that they don't have a good grasp of which new technologies to scrutinize and which to ignore. Are any emerging technologies potentially disruptive—that is, could they help a company change the competitive game? And how, specifically, might the business units take advantage of new technology?

Charlie Feld, the former CIO of Frito-Lay, Delta Airlines, and First Data Resources, argues that CIOs must be able to cut through complex tangles of business and technology signals to see—as an innovator would—patterns and meaning and to distinguish opportunities from fads.6 That vision is one of the skills required for demand-side leadership.

The CIO of a large European construction company says that his role within the organization is to be the "chief innovation officer." He spends considerable time studying the use of technology by European and North American companies in order to find new solutions—for example, ways that technologies used in other sectors can be recast to pioneer trends in building and construction.
Making the transition

CIOs who drive improvements in one or all three of these areas will need to focus less on operational issues and more on becoming business leaders. In our discussions with CIOs, business-unit leaders, and executives, we have identified a few important practices that can help CIOs succeed at this challenge.
Ensure that IT is efficient and then make the transition to effectiveness

For some CIOs, the first step in the transition from supply-side to demand-side leadership is to verify that the IT department is in good financial and operational order. As a North American energy company CIO put it, "If you can't keep basic systems up and running, you can't talk about strategy."

The dilemma for CIOs is that ensuring efficiency requires one set of management approaches and focusing on effectiveness quite another, so new skills are needed and very different priorities must be set. In mastering efficiency, CIOs are often pushed to be project oriented and to concentrate on the short-term actions needed to make targeted improvements or to put out fires. Communication with business units often emphasizes action plans and progress.

When the IT engine is running smoothly and the CIO turns his or her attention from supply to demand, the required management capabilities change—from operational skills to strategic ones, from short-term horizons to longer-term ones, from IT communications to business communications. CIOs need to know not only what the differences are but also how to time the shift; move too soon or too late and credibility with business leaders will suffer.

To be sure, some CIOs won't make the transition successfully. Those who do will spend less time managing core operations, be better able to describe the performance of the infrastructure in business terms, and spend more time creating real business value from IT.
Reengineer relationships with business leaders

For CIOs who have efficiency in order, the first step toward effectiveness is to build strong relationships with business leaders. The current supply-side model of IT leadership doesn't help CIOs forge these connections. In many companies, IT staff undertake discussions with business units about their requirements while the CIO largely stays at home managing supply. The reverse needs to happen.

Even CIOs who spend time talking with business leaders often need to digest the experience. Each discussion is an opportunity to forge a common financial understanding of IT. Successful demand-side CIOs leave IT measures and operating reports at the door; they know that providing business leaders with unwanted information only reinforces negative opinions about IT. Instead they ask about the business—and they listen. Executives have different opinions about the level of information they want, and smart CIOs figure out how to accommodate these differences within a common financial language.

As part of these discussions, CIOs should provide insights about how technology can help the business develop new capabilities. A few CIOs who do this well sometimes frame these discussions around what their competitors are doing—they have become adept at business intelligence. The CIO at one bank, for instance, routinely interviewed managers who were newly hired from competing banks about technology and business issues.
Invest a business committee with technology oversight

A few leading companies have disbanded their technology committees—typically staffed by business managers and IT staff—and are asking senior-executive committees to take responsibility for IT-investment decisions. They found that technology committees had limited usefulness. Indeed, business managers often sent delegates in their place, thus undermining the group's continuity and typically shifting the perspective toward IT.

Instead these companies ask existing top-executive committees to add technology to their agendas. (At two such companies, the CIO has earned membership; at others, the CIO is an invitee.) Over the years, these executive committees have worked to make effective decisions quickly. As they learn about technology, they apply the same decision-making process. Executives at companies with such a committee don't send substitutes to meetings, and all decisions about IT projects go through it. Using this structure avoids the problems (such as encroaching on the space of other committees and making conflicting decisions about IT) that companies have when multiple committees are responsible for different aspects of technology investments.

Ultimately, some CIOs may need to shed—partly or wholly—their supply responsibilities. The CIO of a European industrial company is beginning to outsource most of its supply-side organization so that the remaining IT managers can focus on demand-side activities. One European insurance company recently replaced a supply-oriented CIO with a new one who sits on the company's executive committee and has no responsibility for supply.

The pressing need to get better business value from IT calls for technologically savvy business leaders. Now is the time for CIOs to step up to the role—the challenges are many, but the opportunity has never been more ripe.
What CEOs really think about IT

Most large companies in the United States and Europe have long struggled with the need for tighter relationships between IT and business managers. This perennial management problem is echoed once again in a recent study of how French CEOs and CIOs view the performance of information systems within their organizations.1 Insights from the study suggest that CEOs are growing keener to find a solution—and that both CIOs and the leaders of business units may soon be held more accountable for business ownership of IT.

In the survey, CEOs say that IT isn't meeting their (admittedly high) performance expectations, particularly in providing systems and tools to support managerial decision making and in gaining the scale advantages of deploying common systems and processes across business units. CEOs attribute the gap between expected and actual performance mainly to the insufficient involvement of business units in IT projects, to the weak oversight and management of these projects, and to IT's inadequate understanding of their business requirements. As one CEO commented, "Because the businesspeople are uninterested in information systems, the information systems people have the power."

CEOs have high expectations that business units will be strongly involved with information systems projects throughout their whole life cycle. Around 90 percent of the CEOs expect business units to identify the IT investments needed to implement their strategies; to support, monitor, and assess important IT projects; and to help make IT-investment and budget decisions as well as the process and organizational changes that technology implementations require. But the actual involvement of business units is far below expectations: fewer than 10 percent of the CEOs feel that businesses really assess the benefits of IT projects, for example (exhibit).
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enlarge exhibit

Moreover, CEOs acknowledge that the governance of IT emphasizes checks and balances more than the strategic use of IT to create value. In most of the companies questioned, the business units allocate resources to information systems on a case-by-case basis. Projects are often run by steering committees that oversee joint teams consisting of managers of business units and IT. Few business units have a permanent sense of responsibility for IT, and the interaction between CIOs and business units is often confined to a few strategic IT committee meetings a year. In half of the companies, the CIO isn't involved in drawing up business-unit strategies, and in most companies, information systems aren't discussed at the board level.

But the most important blind spot is the assessment and monitoring of IT's benefits. The survey reveals that only major projects are subjected to business-case assessments before launch, that only half of the companies monitor the expected benefits, and that the business units are not accountable for realizing them in nine companies out of ten.

The survey does, however, suggest that some CEOs are starting to make business managers more accountable for getting business value from IT. One approach is to give business units ambitious progress objectives, which encourage managers to seek ways of using information systems to meet them. A CEO said, "I try to empower the BUs [business units] and have them make commitments. We monitor them and apply pressure through benchmarks. For finance [the cost of financial processes], for example, the benchmark was set at 0.8 percent of total income and we gave them 18 months to achieve it....The division bosses weren't the least bit interested, but they realized that they couldn't achieve their continuous-progress objectives if their division wasn't equipped with performing information systems. In less than six months, we saw a genuine change."

Other approaches used by CEOs to get business managers more involved in IT decision making include putting information systems issues on the agendas of executive committees and initiating the development of master plans for integrating the strategies of information technology and business units.
Notes

1 The study—conducted jointly in 2002 by McKinsey and Club Informatique des Grandes Entreprises Françaises (Cigref), to which a majority of the largest companies in France belong—was based on interviews with or questionnaires from the CEOs and CIOs of more than 70 leading French corporations.

Return to reference
About the Authors

David Mark is a director in McKinsey's Silicon Valley office, and Eric Monnoyer is a principal in the Paris office.

This article was first published in the Spring 2004 issue of McKinsey on IT.
Notes

1 See Frank Mattern, Stephan Schönwälder, and Wolfram Stein, "Fighting complexity in IT," The McKinsey Quarterly, 2003 Number 1, pp. 56–65.

2 GartnerG2 and Forbes.com, "Key business issues survey: What keeps CEOs up at night?" The analysis of the survey, released in February 2004 on Forbes.com, focused on the responses of 462 senior business executives from large companies around the world.

3 In a follow-up to a 2002 survey by McKinsey and Club Informatique des Grandes Entreprises Françaises (Cigref) of CIOs and CEOs at more than 70 leading French companies, we are conducting in-depth interviews with business-unit leaders at a subset of these companies.

4 The most recent survey is "State of the CIO survey," CIO, April 1, 2003.

5 Dan Lohmeyer, Sofya Pogreb, and Scott Robinson, "Who's accountable for IT?" The McKinsey Quarterly, 2002 special edition: Technology after the bubble, pp. 38–47; and Jed Dempsey, Robert E. Dvorak, Endre Holen, David Mark, and William F. Meehan, "Escaping the IT abyss," The McKinsey Quarterly, 1997 Number 4, pp. 80–91.

6 Charlie Feld, "IT leadership in 2010," CIO, December 15, 2003.

The Paris guide to IT architecture

2005-03-18T20:53:00.000-08:00

The Paris guide to IT architecture

City planners try to preserve viable old assets, to replace outmoded assets, and to add new assets—all in the context of an infrastructure linking them coherently. IT developers have a good deal to learn from that approach.

Jürgen Laartz, Ernst Sonderegger, and Johan Vinckier

The McKinsey Quarterly, 2000 Number 3

Companies that want to gain a competitive edge, whether by being the first into a market with new products or by launching an electronic-commerce channel, know how much they depend on information technology architectures to achieve their aims. Usually, though, the architecture is a costly and aging maze of applications, hardware systems, and networks. Far from making it possible to achieve strategic goals, it can make a mockery of them. But by looking at the evolution of another complicated set of systems—those that make up a modern city—senior managers can begin to understand more fully how the controlled and rational development of an IT architecture can enhance the ability to compete.

Stories about companies that stumbled because their IT architectures couldn't accommodate rapid and drastic change are legion. Fast-growing companies are liable to hit a wall when their architectures fail to expand quickly enough to serve new customers cost-efficiently. Long-established companies can lose market share if their architectures lack the flexibility to move products to market as quickly as their competitors do.

A leading international bank discovered this problem the hard way. Its strategy involved launching an Internet channel that included an on-line securities brokerage, but its deadlines were so tight that there was no time to integrate the customer interface with the back-end systems where transactions were to be processed. The bank's back-office staff therefore had to input each one by hand, an error-prone process feasible only in the early days of e-brokerage, when volumes were tiny.

How could the bank's IT managers have allowed the systems they supervised to undermine rather than advance a strategic goal? The design decisions that had shaped the systems landscape over the years were, individually, sound. The people responsible had focused on delivering the required functionality on time and within budget. But no one had kept an eye on the big picture. The overall systems landscape thus became too complicated, extremely costly, hard to manage, and incapable of responding flexibly to the bank's business needs.

Whether chief executives wish to undertake new e-commerce or customer-relationship-management (CRM) initiatives or to replace existing IT systems, they can learn from the way modern cities adapt to the needs of residents and businesses. For, in the same way, a properly conceived and administered IT architecture adapts itself to the diverse and changing needs of the company that deploys it.

We could use several cities to make the analogy between city planning and IT architectures, but Paris seems particularly apt. When you walk around Paris, you see a wonderful variety of buildings dating from many centuries; a closer look reveals that a majority of these structures went up in the past hundred years. The infrastructure of Paris, such as its network of roads and bridges, unites these buildings, defining the cityscape and setting the terms in which it has evolved.

When Baron Georges-Eugène Haussmann was commissioned by Napoléon III to create a new plan for parts of Paris, in the 1850s, he cut boulevards through the existing pattern of streets to facilitate commerce and the movement of troops. Since then, Paris has carefully planned the redevelopment of sections of the city, so that neighborhoods and districts have distinctive social or economic roles. Most office towers, for example, are located outside the historic borders. As a result, the Paris of today, with its Beaubourg and La Défense, is a modern and highly efficient but unmistakable patchwork of many eras. City planners try to preserve and renovate those old assets that are still viable while replacing others and adding new ones in a coherent way. Finally, a city like Paris makes sure that a good infrastructure binds all these assets together for the long term.

This city-planning analogy can help established companies avoid IT architecture problems. A company might believe that major chunks of its applications are so unfit for current needs that they might as well have come from the Middle Ages. At the same time, IT departments are repeatedly asked to add new functions and to integrate business units and allied companies. This ceaseless growth in automation has made it less and less feasible to replace all systems completely. The challenge is to stay abreast of the different life cycles of a given IT system's components so that the architecture as a whole doesn't become obsolete (see sidebar, "Case study: A leading international bank").

The planning of cities like Paris has taught us four lessons that can help companies manage the evolution of their IT architectures to further their strategic initiatives.

1. Define a long-term plan

Most cities have zoning codes that designate some areas as residential, some as industrial, and some as parks. While mixed use (shops with apartments upstairs, for example) is permitted in some districts, certain functions are incompatible with each other: a responsible planning board would not, for example, permit a smelting plant to be located next to a hospital.

Similarly, good IT architectures break down complicated applications landscapes into coherent, manageable parts often known as domains. Typically, each domain performs a discrete function. An insurance company, for instance, would have domains such as product systems for life or automobile insurance and channel systems for call centers or physical branches.

This scheme permits IT functions to be built in one domain and then made available to other domains that need them. A product-pricing algorithm, for instance, could be built in the product domain and then made available to all channels. But a call center and an e-commerce channel that each built its own product-pricing algorithm would be needlessly duplicating each other's IT effort. There would also be a serious risk of inconsistencies—conflicting price quotations, for example—even if two channels sold the same product under the same brand.

IT architectures that are opaque and tangled should be broken down into clearer domains. Within a financial institution, this effort might involve disaggregating

a system providing both channel functions and product functions. By contrast, IT functions that are identical but dispersed across an architecture—databases containing different bits of information about the same customers, for example—should be grouped into a single domain. Exhibit 1 depicts one bank's vision of what its IT architecture ought to be.

2. Build a stable interface infrastructure

To offer neighborhoods standard services such as power and water, a city needs a stable infrastructure. The infrastructure must serve prospective as well as existing needs and have uniform interfaces—including the same types of outlets, plugs, and voltages—so that business can be carried out not just among neighborhoods but across an entire country.

Similarly, the interface infrastructure of an IT architecture makes it possible for domains to exchange information and instructions—what IT specialists refer to as "services"—with middleware functioning as the transporting technology. A customer information system, for example, should provide a standard service (name, address, customer number, birth date, and family members) regardless of whether it is requested by a salesperson's application or the company's Web site.

Ideally, all interfaces between domains pass through a limited set of stable and standard services. If they should lack stability, a change to any one of them would require all domains using it to go through a maintenance cycle. When a database of customers is migrated from an older mainframe to, say, a newer UNIX server, channel applications need not be affected as long as the customer's profile service hasn't changed.

Services also drastically limit the number of access routes to a domain. Once upon a time, all developers might have been able to blaze their own trails in search of the information they needed in other domains, but services force all developers to access domains in a standard way. Just as each city resident uses the same type of plug to draw a standard type of voltage, a channel system or a customer-billing system should retrieve a customer's profile with a standard service. Some financial institutions have set themselves the goal of gradually replacing the tens of thousands of differently tailored interfaces among their domains with a set of 500 or so services.

3. Appoint a zoning board

Many cities have created zoning boards to draw up and carry out long-term plans that both reflect and help shape evolving patterns of public use and the general preferences of elected officials. Similarly, a company needs its own zoning board, usually a separate group within the IT organization, to manage the evolution of an IT architecture.

The board's role is to define the discrete domains and the functionality belonging to each. Domains can be defined according to which kinds of functionality and data belong together, the de facto standards that software packages set for them, and which part of the business should manage them. To achieve IT efficiencies, the board should also identify the technologies and software development tools to be used in the domains. Finally, the board must ensure that the company builds and manages a strong and highly stable service infrastructure.

A bank's zoning board might, for example, decide that certain kinds of software belong in the call-center domain: the software that generates the scripts telephone operators read when customers call, the software that integrates the computers of those operators and their telephones, and the software that generates reports on call-center performance indicators. The board might also adopt UNIX as the system's platform and require all interfaces with software in domains other than the call center to pass through the standard services.

Occasionally, managers seek an exception to the rules—in city-planning jargon, a "variance." If, say, company X offered a delayed-payment function, which allows a bill to be paid on a specific date at the customer's direction, the managers of company Y, a competitor, might ask to have a similar function built into their own call-center application if the payments domain couldn't accommodate the new feature immediately.

Normally, deviations of this nature aren't allowed, since they deny other channels easy access to the function. But in specific cases, the zoning board, adopting an overall business perspective, will choose to weigh trade-offs: waiting until the payment domain can deliver the feature, allowing the call-center domain to deliver it temporarily, or delivering a quick fix by writing an add-on program in the payment domain. The last option is generally the preferable one, since the people in charge of the payment domain would then be responsible for turning an improvised solution into a well-engineered feature of that domain.

4. Make the most of what you have

Before making new investments, good municipal leaders ensure they have made the most of existing assets. Cities, for example, would generally try to add bandwidth to existing copper wire before submitting themselves to the disruptions of laying fiber-optic lines.

Likewise, companies that contemplate building new systems should first try to get what they can out of their current applications, however messy. Such companies might, for instance, be able to build adapters on to existing applications—a practice known as "wrapping"—so that they can be hooked up to a standardized service infrastructure. Wrapping permits a company to deliver a clean and stable customer profile service, for example, to an important new e-commerce domain even when the data are drawn from a variety of existing systems (Exhibit 2). A data warehouse that serves the purpose of supplying background for a CRM initiative could be added in the same way. Under this approach, new applications and domains such as e-commerce can be insulated from the problems of an existing IT architecture even while it is being renovated or replaced.

Companies reviewing their architectures will probably discover a multitude of past "city-planning" mistakes—the IT equivalent of putting a smelting plant next to a hospital. In general, companies can't justify correcting all of these mistakes, but new business initiatives can provide the occasion for doing so.

When an IT architecture embodies decades of ad hoc decisions and short-term projects, it can be no less disorderly than Bangkok or Mexico City. But even planners in those cities look for evolutionary ways to exploit important assets. Tearing them down and beginning again or building a brand-new city next door to the old one is rarely a serious possibility.

Instead, cities adopt change programs. They typically start by mapping the roles of existing zones and the capacity of the transportation infrastructure. Then they calculate how much growth to expect in particular areas within a given time frame and how much infrastructure must be added or restored to support that growth. Finally, public undertakings are put out to tender, and private proposals that are not "as of right'' are submitted to the approval process. Often, public-private partnerships—such as New York City's Lincoln Center, built in the 1960s on the site of slums—have a transforming effect on the surrounding neighborhood and beyond.

Similarly, an IT program starts by determining the extent of problems such as duplication. If the company's goal is to become a multiproduct, multichannel financial institution, for example, it must organize domains around those key areas of functionality. A first step toward implementing this architecture will usually be the construction of services that wrap current applications; these services can then offer the existing capabilities of legacy systems to new applications in a stable, standardized way. Once a service infrastructure of this type is established, applications can coexist with new kinds of functionality, such as e-commerce. Gradually, the IT architecture becomes an evolving asset, with applications in each domain—all bound together by a stable service infrastructure—added, enhanced, renovated, and replaced along different time lines.

Our four lessons from city planners have helped companies begin redesigning their IT architectures in order to get products and services to market more quickly and to improve their returns on IT assets. Even chief executives who believe that their companies' IT architectures resemble Mumbai rather than Paris are likely to find that an approach taking into account the existing fabric while laying the groundwork for growth will turn their IT assets into virtual cities of light.

Case study: A leading international bank

Senior managers of a large international bank developed a strategy to get products to market faster, offer more customized services, and reach larger numbers of customers through new channels. To execute the strategy, the bank had to redesign its information technology architecture, and it decided to do so with an approach incorporating lessons about how cities grow. Three possibilities were considered: a greenfield approach, with each division building a new platform tailored to its requirements; migration to a banking software package using a modern IT architecture; and the transformation of existing systems according to an IT architectural master plan—something akin to a long-term city plan. The third approach would have to permit the immediate addition of new kinds of functionality, such as electronic commerce, in parallel with a thoroughgoing renovation (or even replacement) of some core systems.

The first option was rejected because the costs of the new system and the time required to build it would have been excessive. The second option was tempting in theory, but banking packages capable of handling the bank's product breadth and high volumes were not available. The third option had three important advantages. It could be introduced gradually, starting with the existing application portfolio. It would continue to use existing applications as they evolved, thus reducing the payback period on the investment to a year. Finally, it would spare the bank the need to spend at least five years developing and maintaining the old and new architectures in parallel.

1. Define a long-term plan

The bank's IT architecture left much to be desired. The customer database held payment information—an arrangement resulting in unnecessary interactions between software engineers from the bank's customer side and software engineers from the product side. The deposits system was so closely woven into the securities and customer information system that several attempts to replace it with a more modern version had failed. And the Internet channel systems offered access to the back-office systems only through an aging interface, a problem that became a performance bottleneck delaying new software releases and jeopardizing levels of service.

To resolve these issues, management designed an IT architecture: the long-term city plan. It laid out the components—that is, the "city's" zones (the securities domain, the customer information domain, the credit domain, and so on), the data they should contain, and the way they were to communicate with other systems. This set of rules was intended to transform the systems landscape into a more modular environment where particular systems could be altered or exchanged to minimize the impact on other systems.

2. Build a stable interface infrastructure

Just as streets usually have a longer life than do individual buildings, so too the communications infrastructure and interfaces between systems tend to remain in place longer than the systems themselves. One challenge in making the bank's IT architecture work was to design and implement communications and data exchanges between the separate domains. To do so, the IT department had to master new technology and application design skills. Most difficult, groups of software developers pursuing the city-planning approach could no longer make private arrangements among themselves about how to integrate their applications.

3. Appoint a zoning board

Both to ensure that the systems developers adhered to the rules of the IT architecture and to get a long-term plan adopted, the bank's chief information officer created and chaired a steering committee. Every deviation from the rules had to be reported to the committee, which granted approval, at best, on a temporary basis—and then only on condition that there was a clear plan to make the system architecturally compliant.

4. Make the most of what you have

It was clear from the outset that the bank had no practical chance of eliminating its legacy systems in the near future and that, in any case, doing so would be uneconomical. On the positive side, so many functions had been built into the systems over the years that the bank could offer a wide array of customized services (such as tax statements for customers in different countries) and an extremely broad set of products. Even Russian government bonds from the pre-Communist era could be processed in securities accounts.

The bank thus began renovating its legacy systems to reduce their complexity while maintaining their broad functionality. To permit the almost round-the-clock use demanded by e-commerce applications, the bank overhauled applications monopolized at night by accounting batch runs. This approach extended the life of existing systems and in this way lowered the amount of new investment needed, while the systems' reduced complexity brought down IT operations costs.

Overall, the bank found that its evolutionary approach addressed its changing IT needs in an economical and low-risk way that enabled it to respond properly to urgent business priorities, such as e-commerce, while resolving fundamental problems in its systems. The bank expects the effectiveness of its IT architecture to improve so much that it will recoup the substantial investment it made—an average of 20 percent of its annual IT development budget for three years—within a year of finishing the project.

Return to reference

About the Authors

Jürgen Laartz is a principal in McKinsey's Frankfurt office; Ernst Sonderegger is a principal in the Zurich office; Johan Vinckier is a principal in the London office.

The right passage to India

2005-03-18T13:19:00.000-08:00

The right passage to India
Companies attracted to the country’s potential must do more than merely transplant products and systems that have succeeded elsewhere.
Kuldeep P. Jain, Nigel A. S. Manson, and Shirish Sankhe
The McKinsey Quarterly, Web exclusive, February 2005
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India, for some time now the focal point of the global trend toward strategic offshoring, has simultaneously become appealing as a market in its own right. With GDP growth more than double that of the United States and the United Kingdom during the past decade, and with forecast continued real annual growth of almost 7 percent,1 India is one of the world's most promising and fastest-growing economies, and multinational companies are eagerly investing there.
Yet the performance of the multinationals that have tried to exploit this opportunity has been decidedly mixed. Many of those notable for their strong performance elsewhere have yet to achieve significant market positions (or even average industry profitability) in India, despite a significant investment of time and capital in its industries.2 Why? Perhaps because the market entry strategies that have worked so well for these companies elsewhere—bringing in tried and tested products and business models from other countries, leveraging capabilities and skills from core markets, and forming joint ventures to tap into local expertise and share start-up costs—are less successful in India. Our research3 suggests that the most successful multinationals in India have been those that did not merely tailor their existing strategy to an intriguing local market but instead cut a strategy from whole cloth. In short, they have resisted the instinct to transplant to India the best of what they do elsewhere, even going so far as to treat the country as a bottom-up development opportunity.
With less of a focus on the initial entry and with a longer-term view of what a thriving Indian business would look like, the more successful companies have invested time and resources to understand local consumers and business conditions: tailoring product offers to the entire market, from the high-end to the middle and lower-end segments; reengineering supply chains; and even skipping the joint-venture route. The reward for this effort? Of the 50-plus multinational companies with a significant presence in India, the 9 market leaders, including British American Tobacco (BAT), Hyundai Motor, Suzuki Motor, and Unilever, have an average return on capital employed of around 48 percent. Even the next 26 have an average ROCE of 36 percent (exhibit).
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Getting local in India
India's per capita income is half of China's and one-fourth of Brazil's, and as much as 80 percent of Indian demand for any industry's products will be in the middle or lower segments. As a result, multinationals must resist the temptation merely to replicate their global product offerings; the products and price points that are competitive in India are often considerably different from those that work well in other countries. In particular, in India companies must reach into the middle and lower-end segments or they may end up as niche high-end players, with insignificant revenues and profits.
Multinationals that understand the Indian consumer's expectations and price sensitivities can tap into what is often a large and promising market, but they shouldn't assume that the lowest price tag will always lead it. Indian consumers, even in the lower-end segments, will pay a premium if the value of superior features and quality is seen to far outweigh their cost. LG Electronics, for example, reengineered its TV product specifications in order to develop three offerings specifically for India, including a no-frills one to expand the market at the low end and a premium 21-inch flat TV for the middle segment. By keeping the price of the latter offering to within 10 percent of the price of TVs with conventional screens, LGE persuaded many consumers to buy it. These innovations have led the company to a top-three position in the country's consumer durable-goods and electronics market in a little over three years, with revenues of nearly a billion dollars in India. And Toyota Motor captured nearly a third of the multi-utility-vehicle (MUV) market by offering a significantly superior product at a limited price premium.
Very often, however, companies need to develop completely new products to compete at target price points set by local competitors, as Hindustan Lever Limited (HLL), a part of the multinational Unilever, did with its low-priced detergent brand, Wheel. Responding to local competition, HLL lowered the active detergent content of its existing product, decreased the oil-to-water ratio, and then launched the new detergent at a 30 percent discount to the price points of the company's more traditional detergents. Today, Wheel accounts for 45 percent of HLL's detergent business in India and for 8 percent of total HLL sales.
In other cases, companies must significantly localize their product offerings to meet Indian consumer preferences. Hyundai, for example, spent several months customizing its small-car offering, Santro. Because Indian consumers attach significant importance to lifetime ownership costs, Hyundai reduced the engine output of the Santro to keep its fuel efficiency high, priced its spare parts reasonably, and made more than a dozen changes to the product specifications to suit Indian market conditions. In contrast, other global automakers entered the market with vehicles that had low gas mileage and high repair rates and after-sales service costs.
Companies can bolster their profitability by reengineering their supply chains. Hyundai, for instance—in contrast to other global auto manufacturers in India, which source only about 60 to 70 percent4 of their components locally—buys 90 percent of its components from cheaper Indian suppliers rather than importing more expensive parts from its usual suppliers elsewhere. Multinational pharmaceutical companies outsource a large share of their production to third-party manufacturers within India—an uncommon practice for major pharma companies elsewhere in the world. And both Hyundai and LGE have built global-scale manufacturing facilities to capture economies, making India a global manufacturing hub that can serve other markets as the local market develops.
Using extensive third-party distribution also helps. In India, organized retail distribution systems reach less than 2 percent of the market, so there is considerable pressure to find innovative ways of reaching retail consumers. This third-party distribution system is crucial to capturing demand created by the superior price-to-value offerings available in smaller cities and rural areas, which make up a large share of the Indian market. In fact, successful multinationals—such as Castrol (acquired by BP in 2000), LG Electronics, and Unilever—have built deep third-party distribution networks that serve second-tier cities and villages. Here again, a local strategy is crucial. One multinational company, for instance, used to own its entire worldwide distribution infrastructure, including warehouses and trucks. Applying that business system in India, where large companies face high labor and overhead costs, made it impossible to attain nationwide reach. Moving to a third-party distribution system employing a network of dealers and agents proved very successful.
Finally, in contrast to companies that rotate expatriate managers in and out of the country every two or three years—often a recipe for failure—most successful multinationals, such as Citibank, GlaxoSmithKline, and Unilever, have an Indian CEO in their local operations. Given the need to tailor products, supply chains, and distribution systems to local markets, local managers tend to be more effective. If the CEO is an expatriate, combining longer postings with a strong local second in command, as in the case of the South Korean giant Hyundai, seems to be crucial to success. In addition, multinationals such as Castrol have benefited from strong local boards to counsel, challenge, and help local operations.
Skipping the joint venture
Multinationals entering new markets have traditionally struck up joint ventures with local partners for a variety of reasons, including their ability to influence public policy, to bring into the venture existing products as well as marketing and sales capabilities, and to comply with regulatory requirements when foreign participation was restricted to less than 50 percent of a business.
While joint ventures are still crucial to gaining access to privileged assets in some industries—metals and mining, for example, and oil and gas—our research shows that, where possible, multinationals are better off going it alone. Of the 25 major joint ventures established from 1993 to 2003, only 3 survive. Most foundered because the local partner couldn't invest enough resources to enlarge the business as quickly as the multinational had hoped. As a result, most of the multinationals that initially entered the market through joint ventures have exited them and pursued independent operations. Multinationals, such as Hyundai and LGE, that have achieved real success in India have bypassed joint ventures entirely, and newcomers are increasingly entering the market on their own. Even when a joint venture is unavoidable, successful multinationals ensure from the outset that they retain management control and have a clear path to eventual full ownership.
Participating in the regulatory process
Multinationals in deregulating industries often need to be flexible and patient during the natural process of regulatory evolution. Regulations governing the mobile-telephony sector, for example, have been amended several times since 1994 as it has grown; it had two licensed operators per region back then and now has as many as six. Although most multinationals left the sector when the regulations governing it changed, Hutchison Whampoa continued to invest in India. Ten years later, Hutchison Essar is one of the top three telcos in the country (as reckoned by market share), and interviews with industry experts suggest that the company enjoys strong profitability.5
If regulations are a crucial factor for an industry, the CEO needs to spend a lot of time managing them. The most successful multinationals haven't relied on third-party legislation managers or joint-venture partners to address regulatory issues; instead they have invested much time and energy to identify and understand the key policy makers, to formulate robust positions for investment, and even to suggest regulatory changes. In addition, these companies have garnered support from constituencies such as state governments, which compete for investments, and industry associations that lobby for similar regulatory changes.
Clearly, any entry into a new market requires a certain degree of tailoring to its specific needs and conditions. But for some companies, the entry into India has forced a fundamental rethinking of product offers, cost structures, distribution systems, and management teams. Companies that successfully tap into the promising Indian market often ignore conventional wisdom, including the need for joint ventures.
About the Authors
Kuldeep Jain is a consultant and Shirish Sankhe is a partner in McKinsey's Mumbai office, and Nigel Manson is an associate principal in the London office.
This article was first published in the Winter 2005 issue of McKinsey on Finance.
Notes
1The Economist Intelligence Unit forecasts 6.9 percent real GDP growth from 2003 to 2008.
2Based on McKinsey analysis of the Centre for Monitoring Indian Economy's Prowess financial database for average industry profitability. The database, built on CMIE's understanding of disclosures in India on around 8,000 companies, is highly normalized.
3We reviewed the performance in India of more than 100 multinationals, conducting detailed case studies of 15 that have had varying degrees of success and interviewing 30 experts, company managers, analysts, and current or retired CEOs of leading multinationals.
4The Automotive Components Manufacturers Association (ACMA) of India.
5Since it is unlisted, actual numbers aren't available.

Managing CEO transitions

2005-03-14T15:41:00.000-08:00

Managing CEO transitions
A leader’s best chance to lock in new organizational norms is usually during the first few months on the job.

TSUN-YAN HSIEH AND STEPHEN BEAR

The McKinsey Quarterly, 1994 Number 2

A new manager brought in from the outside. A key retirement. An executive waiting in the wings who finally gets his or her chance. The splitting of the Chairman/CEO role into two separate positions. The departure of unsuccessful contenders. Beyond their obvious effects on individual careers, such changes are also opportunities—often not fully exploited—to bring about significant organizational change. Never more so than when the change takes place at the very top with the appearance of a new CEO. These "appearances" are becoming increasingly common as more industries face discontinuities and more stakeholders assert their rights. Indeed, nearly a quarter of the CEOs of Business Week's top 1,000 companies have turned over during the past two years. How can companies—and new incumbents—better leverage these stressful periods of transition to break out of the performance-limiting aspects of the established order?

Perhaps an oil company president put it best: "This place has had three presidents in five years. My predecessors all made the mistake of trying too hard to get things back to normal. The organization took it as an endorsement of business-as-usual when a lot had to be changed. When I came in, the place felt rudderless. They were watching me to see if I would break them out of this rut. I did." Appropriately so. CEO transitions offer a natural, albeit brief, opportunity to shake up the status quo and change it fundamentally.

Make no mistake, even in the most flexible organizations, an entrenched status quo rapidly develops. Everyone knows what is important; who has influence; what success really means; which roles have prestige; which protocol must be followed to get things done; what constitutes a career-limiting move. On the positive side, this shared knowledge, when replicated all the way down the line, promotes a certain efficiency. It is clear whom to call; how reports should be done; which meetings to attend; what is kosher to ask; and where the land mines really are.

CEO transitions disrupt the efficiencies of the "status quo" and sever the web of familiar practice
CEO transitions disrupt these efficiencies and sever the web of familiar practice. Connections are broken; intelligence flows stop; secure power bases are thrown up for grabs; uncertainty takes the place of continuity; and what was once an easy and standard route to follow becomes a voyage into uncharted waters. Within 100 days or so, however, a new order usually gets established and things settle down again. Or, in the absence of strong leadership, the old order reasserts itself. Either way, such periods of genuine transition—the time when all is in flux, nothing is fixed, the status quo is interrupted, and an organization buzzes with the expectation of change—are painfully short.

But they are also—if properly grasped and managed—a unique opportunity to reset a company's rhythms to the requirements of the future. The general readiness to listen, learn, and act is at its height. So is the willingness, during this honeymoon phase, to defer judgment and give new incumbents the benefit of the doubt. These are, then, times of fluidity during which new performance expectations can be established more easily and new organizational norms are cast. They are also when the foundation stones get laid upon which a CEO's legacy will be built.

From a series of discussions with CEOs who have undergone such periods of transition and from our and our colleagues' work with public- and private-sector leaders around the world, we have distilled six lessons about how to make the best use of these periods of fluidity.

1. Start with where you want to end up
Sprinters are trained to keep their eyes on the finish line, but it is easy to be distracted by all the excitement as a race gets under way. CEOs who are new to their jobs can also get distracted by the day-to-day urgencies of running their business and by their felt need to hit the ground running. Everyone tells them, "When in doubt, do something." But looking back years later, they often regret this peremptory action bias. As the CEO of one media company acknowledges, "I expended a lot of my—and my organization's—energy on areas that should not have been priorities."

In retrospect, many corporate leaders wish they had started with a much clearer sense of where they wanted to end up
In retrospect, many corporate leaders wish they had started with a much clearer sense of where they wanted to end up. The lesson is painful. "I've learned," one reports, "that you have to be very clear about your end goals because, without that clarity, you waste a lot of time, money, and goodwill taking detours, making mid-course corrections, and reversing your earlier decisions." Some do not survive such reversals or corrections. As a CEO who lost his job after only 18 months put it, "For a while, I thought I had traction by attacking the most urgent issues a couple at a time. But I was soon consumed by the fire that I was trying to put out."

A focus on legacy
Executives who do make the transition successfully often focus, from the very beginning, on the kind of legacy they want to leave behind as a way of setting their sights on the finish line. When they think about their potential legacy, many CEOs first look to business goals: "I want to have downsized the company and focused it more on the core business before I leave"; "I want to restore share prices to pre-1987 levels"; "I want to build a management team that can—and will—take this company forward." Others dwell on personal considerations: "I'd like to get invited to stay on for another three years"; "I'd like to have developed a second pursuit by the time I am 55."

All these aspirations are legitimate. By themselves, however, they—and many like them—do not go far enough, do not cover enough ground. They address underlying cultural issues much too infrequently. As one CEO reflected, "There is nothing more important than to leave behind an organization that feels confident of its future and feels like a winner."

A legacy goes well beyond aspirations for financial or market position. It deals with perceptions in the minds of the leader's many constituencies
We have found that an effective way of thinking about a legacy includes: the condition of the organization at the time a leader departs; the prevailing focus of its people; what the leader personally stood for; and the organizational climate that grew out of the leader's style and actions. Thus defined, a legacy goes well beyond aspirations for financial or market position. It deals, as well, with perceptions in the minds of the leader's many and varied constituencies. And like all issues of perception, it deals with things that are more black-and-white than reality.

The CEO of a large US industrial corporation had created a record of major improvements by concentrating primarily on downsizing and defending against further market share erosion. However, the company still lagged world-class industry leaders and the climate left behind was perceived as being riddled with uncertainty and shaken confidence. By contrast, when Sam Walton of Wal-Mart died in 1991, he left behind the most successful retail operation in the United States, a personal reputation for thrift and attention to detail, and an organization marked by high energy, a strong performance orientation, and great confidence in its continuing success.

A fair test of legacy-related aspirations is to ask, "What would be my number one regret if I had to leave without achieving it?"
A fair test of legacy-related aspirations is to ask, "What would be my number one regret if I had to leave without achieving it?" Due diligence, however, requires asking as well, "What is the number one thing that could derail what I hope to achieve?" Is there, for example, a capable next generation of leaders to carry on—and build on—the present leader's accomplishments?

At the same time, of course, a new CEO must take into account any personal considerations that will impinge on the time and energy available for business pursuits. Here the questions can get quite personal. At this stage of my life, how much sacrifice on the personal front am I willing to make? How much time must I carve out for personal health or physical conditioning? For specific family members? For community service? For outside activities like involvement in regional economic development forums, special government taskforces, or CEO roundtables that might also, even if indirectly, benefit the stakeholders of the corporation? The challenge is to make these personal aspirations explicit and think through how they interact with all the other elements of a hoped-for legacy.

2. Get clear on the lay of the land
There are many unwritten realities that add up to the unique landscape that characterizes each organization. Who belongs to the power cliques? Who has credibility and why? How do the subterranean communication channels really work? What do people hold dear? How do decisions really get made? Which are the constraining scarce resources? How do they get allocated?

Most new CEOs instinctively know they must explore the organizational terrain for unexploded land mines. Few, however, delve deeply enough into how the organization really works or how different people will react to different leadership actions. Even fewer develop the full range of insight needed to use all of an organization's dynamics to achieve greater impact.

"It is dangerous to just find out where the land mines used to be. That doesn't tell you where the new booby-traps are planted"
This, of course, can be treacherous ground. According to the new CEO of a manufacturing business, "It is dangerous just to find out what people's strengths and weaknesses are and where the land mines used to be. That doesn't tell you how things really work or where the new booby-traps are planted. I had to get a sense of whether—today—a particular move would trigger a dynamic chain reaction that might blow the place up."

Chain reactions, started by new leaders, can also have beneficial effects. Another new CEO, for example, went to work early every day during his first three weeks at a transportation company. His intent was to start the day early enough to read up on the company's business before staff members showed up at 9.00am. Coming in around 7.00am meant that he literally had to turn on the lights. By the second week, he noticed that more and more people were coming in early. By week 3, someone always arrived before he did and turned on all the lights.

These chains of influence mean that there are possible economies of effort in changing an organization's dynamics. When the new CEO of a large US railroad took over the reins, he wanted to move immediately to make the indulgent corporate culture far more people- and performance-centered. Among the first things he did was close the executive dining-room and kick executive offices out of their prime ground-floor space so they could be replaced with a fitness center. By the time he announced that one-third of corporate staff would be cut, the organization had already gotten the message: change was real and more was coming.

"You never find out where all the skeletons are from the inside"
Surprisingly, it is not difficult to build a good working model of these dynamics—if a new leader systematically explores the landscape, talks to a representative cross-section of people both inside and outside the organization, and asks the right questions. As a new division president of a paper company told us, "You never find out where all the skeletons are from the inside. I often get more insights into the culture and politics of an organization by talking to customers and suppliers."

An army major we know always made it a point to take a week of personal time to visit, unofficially, his next posting before he actually assumed command. That way, he found out in advance not only what the morale of the troops was, but also what they really held dear—things like better rations and avoidance of extra weekend duties. He also found out the strengths and weaknesses of all the officers in that command, as well as the one whom the troops respected the most. On the first day of his official command, he would ask for that officer to be his second-in-command. He would also promise his troops (and then deliver) better rations and duty-free weekends in return for playing by his rules. He got his following.

3. Select which expectations to change, which to honor, and which to defend
New CEOs face the daunting challenge of balancing multiple expectations. Every stakeholder group has expectations, and available time, money, and other resources seldom, if ever, match aggregate demands. These expectations, moreover, often clash, and conflicts of interests arise. Worse still is the discovery that promises have been made or special deals agreed to by predecessors. Never mind the fine print, there is the implicit spirit of the "contract" to contend with.

"The trouble I had was with expectations. They were there, they were real, and would have come back to haunt me if I had pretended that they were not"
"It was easy enough to see what the formal obligations were," said a CEO of his transition. "The trouble I had was with expectations. They were seldom written down, and my senior managers were not close enough to the troops to know what they were. Even when I ferreted them out, my managers would deny that they were legitimate. But believe me, they were there, they were real, and they would have come back to haunt me if I had pretended that they were not."

New CEOs often have a hard time separating legitimate obligations from ingrained but unbridled expectations
Somewhere along the line, these unchecked expectations can easily turn into obligations. Whether it is a promise of job security for employees, the promotion prospects or role definition of particular executives, or the size of this year's bonus packages, new CEOs often have a hard time separating legitimate obligations from ingrained but unbridled expectations. One CEO explained how hard this is. "The expectations that I was given by my predecessor and the board were terribly vague. 'You should be able to turn it around in a year or so,' they told me. And 'be sure not to give in to union demands.' I really had to dig hard to find out what caused them to believe that these expectations could be satisfied."

Further, transitions inevitably give rise to new expectations as well as to questions about existing ones. "Profits are down and they just fired the CEO. Is my job secure with the new CEO?" "He brought in a new VP Marketing from the outside. When is the next shoe going to drop on the rest of the marketing department?" "This guy [the in-coming CEO] is notorious for cost-cutting. What will happen to our tradition of paying workers at the 75th percentile of the industry?"

Recognizing the uncertainties created by the fact of transition at the top, many CEOs feel compelled to move quickly to clarify and address the expectations people have of them. At times like these, however, they need to be aware of two kinds of problems that can haunt the rest of their tenure, if not damage their legacy altogether.

The first has to do with the indiscriminate upholding of expectations. In the perfectly understandable interest of assuaging fears and removing uncertainty, some new CEOs treat all existing expectations as obligations and vow to uphold them across the board. In so doing, however, they squander a unique opportunity to reset expectations at a point when employee anticipation of—and likely acceptance of—change is highest. This, of course, locks in the status quo.

The CEO of a medium-size enterprise with three related businesses lamented about the missed opportunity to reset expectations when he was first appointed. The old order was that divisional presidents were left alone to run the business. Synergies across the businesses were rarely exploited because the three divisions operated as fiefdoms. Without thinking through future needs, the new CEO reaffirmed the divisions' independence. Two years later, he was still trying to get divisional managers to focus on potential synergies—long after competitors had pulled ahead by dint of their integrated strategies.

CEOs in transition often feel compelled to make early promises on which they ultimately cannot deliver
The second problem, which often follows the first, is unkept promises. CEOs in transition often feel compelled to make early promises on which they ultimately cannot deliver. Why? They bow to the sentiment of the people around them at the time. Wanting to be liked and accepted, they let good intentions cloud their business judgment.

The CEO of a North American company felt it was urgent to allay employee anxieties following a merger with a major competitor. He quickly announced that no one from either company would lose a job as a result of the merger—a promise that was irreconcilable with harsh industry realities and, therefore, clearly unrealistic. Three recessionary years later, he had to face up to two years of downsizing that eliminated thousands of jobs. Employees who had lived with an expectation of "life-long" employment, which was strongly reenforced by the CEO's promise of no firing, were traumatized. The CEO retired shortly after without ever recovering from the stigma of his "broken contract."

4. Get your real team together
Every new leader has to start with inherited players and their hidden agendas, uncertain aspirations, possible mistrust, and questionable loyalty
Each transition begins with an inherited team. Like it or not, a new leader has to start with inherited players and their hidden agendas, uncertain aspirations, possible mistrust, and questionable loyalty, as well as the history of relations among them and between each of them and the rest of the organization. Sorting out these dynamics early is never easy but always essential. As one CEO observed, "People knew that I had to get board approval to change the top team and that the board was going to question why we had to move so quickly. So my power to institute a new agenda was limited until I had key board members on my side. That took me damn near six months."

Assessing the players and the team
Naturally, the first challenge is to gather a perspective on each of the players and on overall team dynamics. Beyond probing for each person's competence, aspiration, credibility, and the like, a new leader must assess the personal impact each has on the team and on the rest of the organization. Is she a positive influence on the people she works with? Is his concern for self-interest in balance with his concern for the collective good? Does she nourish or merely exploit her peers and subordinates? Do his actions, not just his words, uphold the values I hold dear? Is she a good role model for the kind of leadership this company needs?

Questions also need to be asked about the team and the way it works. Does it provide the complementary skills I need? Is it small enough to function effectively? Does it have common aspirations about performance? How does it work together? Beyond the immediate group, who else is very much a part of the team? Who should be?

Making people choices
People choices are often the most dramatic—and arguably the most important—decisions a leader in transition has to make. Though full of difficult tradeoffs and rife with emotions, even the toughest calls are better made during the transition, when the situation is still fluid, than later. Much better to start with the right slate: the opportunity costs of having to change horses in mid-journey are too high.

All leaders have their own approaches to making people judgments. The raw ingredients, however, are similar: the person's strengths and weaknesses, the impact of each choice on the team and the organization, and the requirements of the business. There is no magic here, just a series of three basic questions: Which configuration comes closest to putting the right people in the right places? Combining which roles into which leadership positions will maximize the company's leadership capacity? And, of course, what personal role should I play?

Effective new CEOs concentrate on roles that leverage their proven strengths. Otherwise, they can silently fall prey to the roles that others expect them to play. "I need to cover government relations," said one newly-appointed CEO, "because my predecessor has always done it." This sounds logical, but his predecessor had had the savvy and stature to be an industry statesman. Not him. New leaders may find it difficult to define what their true strengths are for a role to which they have not previously been exposed. It may be easier to ask: What am I not good at doing? This kind of soul-searching can also help them put in place managers able to compensate for their particular weaknesses.

New CEOs seldom have the luxury to move as many people as they want as quickly as they would like
Although the freedom they enjoy to carry out major people and role changes will vary by situation, new CEOs seldom have the luxury to move as many people as they want as quickly as they would like. In the short term at least, they often have to make compromises on which people ought to go in which places. This is tolerable—as long as these compromises boost overall leadership capacity. The only caveat is that these compromises should not be forgotten down the road as lower-level talent matures and outside candidates become available.

A newly-installed CEO at a financial services firm responded to this problem by privately classifying his executive team, through careful assessment, into three categories: keepers, watchers, and goners. "Keepers" were clearly major assets whom he quickly informed of their status even before their formal roles were decided. This reduced their anxiety and minimized the risk of losing them. "Goners" were major liabilities, who subtracted from the overall leadership capacity. Though painful, visibly—and quickly—removing them would unleash frustrated energy in the organization. Finally, "watchers" were people who could become major assets if they could address one or two deficiencies within a reasonable time, say 12 to 18 months. Meanwhile, they represented a net addition to the overall capacity of the team.

But what if a new CEO has no flexibility to move on the problem cases? What if the team is still too large and unwieldy? In such cases, leaders often underestimate the power of informal devices like the use of forums and teams to improve overall effectiveness. It may help, for example, to change the established practice on when and with whom the CEO meets one-on-one, what the agenda is when the whole group meets, and when subgroups of two or three get asked to address specific issues.

This latter point may be especially valuable if a new CEO wants to avoid the appearance of setting up an exclusive inner circle. This is most likely to happen when there are only two circles: either you are part of the preferred inner circle, or you are not. Using multiple, issue-specific teams—each made up of different permutations and combinations of the larger group—circumvents this problem and boosts the whole group's effective capacity. A CEO who got really excited by this approach went a step further: "Mix them up and throw in a few young tigers and whipper-snappers as chasers. Then get out of the way and watch it go."

Communicating people choices
As important as making tough people choices is the decision about when and how to communicate them. Should I do it sooner rather than later? Should I leave people to read the tea leaves and figure it out? Should I have explicit, face-to-face conversations with the individuals affected?

"Explicit and sooner" is usually better than "implicit and later"
Again, there is no one right answer. One CEO even told us, "Sure, you've got to think quickly about your people. But that doesn't mean you have to act immediately on everyone. The most urgent need is to move on those you'll need to bring in." Our experience, however, is that "explicit and sooner" is usually better than "implicit and later." Anxious people during transitions are quick to read meanings, often not intended, into subtle shifts in role or resource allocation. Who is in favor? Who is down and on the way out? Left fuzzy, these signals will evoke political jockeying, whip the rumor mill into a frenzy, and tie up a lot of otherwise productive energy in an endless guessing game.

The financial services CEO described above moved swiftly—within 30 days of his appointment—to reassure the "keepers." He acted on all the "goners," as individual decisions got made, within the first 60 days. At the same time, he told all the "watchers" why they were on probation and what they had to work on and by when. Each had the chance to buy into the challenge or take an exit package instead. At first blush, his approach may appear blunt, almost brutal. But even those executives who were terminated thought he was firm but fair and actually appreciated his explicitness.

5. Focus on a few themes
"If everything is a priority, then nothing is a priority. It may sound trite. But we do it to ourselves all the time. At times, there seemed to be 200 'critical' things to do. Even when I pared the list down to 30, I still felt swamped." The sentiment is familiar. But so is the appropriate response, even during the hectic days of a corporate transition: the best directions are simple directions. When things get overly complicated, it is easy to get lost—and to lose others.

When organizations are provided with a clear and simple road-map, they can move with purpose and focus, leaving room for individual imagination and experience to fill in the details. But when they are deluged with long lists of priorities and complex tactics dressed up in fancy words, people's eyes glaze over and confusion reigns. It does not have to be this way. "I gave up a lot of important-looking things and erred on the side of being brutally simple," observed the paper company president. "I focused on only two themes—quality and throughput. Everyone knew what was important, and that made our energy productive and kept us in the game."

Moving quickly to articulate a few simple themes feeds an organization's hunger for a sense of what the new order might entail
During transitions, moving quickly to articulate a few simple themes feeds an organization's hunger for a sense of what the new order might entail, which frees it to respond positively to the new direction. It also provides an overall context so that people can come to grips with everything that is going on. In short, it provides a beacon of stability in a sea of change.

But what makes a good theme? How is it different from a slogan? First, of course, it must convey the essence of the rational case for the new order. But it must also be emotionally compelling. If it is not, it will not last both through the transition period and through the three to five years it will take to reach the implied organizational goals. The life of a slogan, by contrast, can be measured in days or months, not years.

Effective themes meet the "rule of 3 and 300": three simple but compelling themes can legitimize and sustain up to 300 organizational initiatives
More importantly, a theme finds its richest meaning as it energizes—and gets enriched and energized by—the ongoing, day-to-day actions of a broad cross-section of people. In fact, one CEO described effective themes as meeting the "rule of 3 and 300": three simple but compelling themes can legitimize and sustain up to 300 separate but consistent organizational initiatives.

Not surprisingly, the themes best able to mobilize large numbers of people tend to be value-laden. The new CEO of a natural resources company, for example, captured the imagination of his people when he enunciated the dual themes of "velocity" and "business-like thinking." Both readily developed personal meaning for everyone in the organization. Front-line people recognized in them an endorsement of rapid decisions that sensibly tried to balance economic gains among employees, shareholders, and the communities in which the company operated. Staffers recognized a clarion call to cut red tape and move with greater and more purposeful speed. The essence of the new order became clear: we must become fast-moving, tough-minded, and responsible businesspeople to stay ahead of the game.

Within 60 days of his appointment, the new CEO of an industrial company called on his people to become more "performance-oriented, bottom-line accountable people" who relied on "simplified business processes" and "strong implementation skills." They responded well initially, but never broke out of their old ways of doing things. The reason? Key initiatives were underled, and expectations remained unclear on how far or how fast to change. As a result, promising themes soon turned into hollow slogans.

6. Balance between short and long term
Transitions are always hectic, challenging times. The pace is intense. Everything demands attention. Daily calendars are filled with countless urgent and immediate tasks. In such an environment, it is not surprising that important long-term priorities often slip out of focus. Even with the best intentions in the world, it is not always easy to tell what must be done now and what can be done later. It is hard to strike the right balance. Indeed, a common refrain from many new CEOs is "There were so many opportunities to add value, that my biggest mistake was immediately to turn the place upside down based on flawed knowledge."

Most new CEOs gravitate to near-term urgencies, soaking up precious time trying to keep the wheels from falling off
Few new CEOs get the balance right. Most gravitate to near-term urgencies, soaking up precious time trying to keep the wheels from falling off. This is perfectly understandable. A few deliberately take off for the mountains to ruminate on paths to the future, leaving the organization to wonder what might eventually come down on them. This is understandable, too. As is the focus of still others, who embark on cost-cutting campaigns, believing that the organization should do—and think about—nothing else before it takes out a big chunk of costs. This, of course, leaves everyone to worry about what will be at the end of the rainbow once the raging storm of downsizing has finally subsided.

Balance, however, is important—and possible. Two simple principles might help. First, people will be more enthusiastic about near-term sacrifices if they know that a better future lies ahead. New leaders must take the time to spell out, even if only thematically, what constitutes that better future. If they are clear about the kinds of capabilities required in the new order, their people will be better able to avoid cutting out muscle along with the fat. The previously mentioned financial services CEO, for example, employed three themes during his transition: "Low-cost producer," "Best marketer of financial services for selected target customers," and "Superior branch network." The first signalled the need for retrenchment and aggressive cost reduction in those businesses in which they could be the low-cost producer. The second and third provided the uplift, the redeployment opportunity for people's energy.

The second principle is that movement creates opportunity. Some CEOs focus on a single cost or restructuring theme because they cannot see any other controllable actions they can take. Even in this unfortunate circumstance, however, it is vital for them to communicate the future-building experiments being undertaken. No guarantees are needed, just openness about what is being explored. Investigating a strategic alliance, contemplating an industry restructuring, or reexamining fundamentals of a business generates movement forward that, in turn, may open new possibilities not imagined before. This is not an argument in favor of movement for the sake of movement. Only a reminder that there is an upside to living in a turbulent world: there are always new possibilities—and new opportunities—to explore.

"We may our ends by our beginnings know," wrote Sir John Denham nearly four centuries ago. He might just as easily have been writing about today's CEO transition.

About the Authors
Tsun-yan Hsieh is a director and Steve Bear is a principal in McKinsey's Toronto office.

How private equity firms can play in China

2005-03-04T09:37:00.000-08:00

Given the difficulties of doing business there, direct investment in Chinese companies isn’t always the best option.
Gordon Orr
The McKinsey Quarterly, Web exclusive, February 2005
International private equity houses are stepping up their efforts to invest in China in the next few years, reflecting a gold rush mentality that could leave some investors disappointed.
Private equity funds with good connections and deep insights account for the bulk of recent investments. But some new entrants have relatively untested China investment teams.
The influx of new money reflects the pulling power of the "China story," which suggests that there are opportunities that investors cannot afford to miss. Supporters of this contention point to a handful of pioneers who have made big profits by listing their portfolio companies on overseas stock exchanges such as the Nasdaq.
In practice, however, most investors will continue to struggle to pull off successful deals in China as investment conditions worsen. Many private equity investors might be better served by investing their funds in overseas companies that will benefit from China's economic boom. Those who are willing to make a bet on the growing pool of Chinese companies will face a number of challenges.
First, an oversupply of capital is placing more negotiating power in the hands of the target companies, possibly limiting potential investment returns. It could also be increasingly difficult for investors to conduct due diligence, as companies may feel able to withhold information.
Second, inexperienced investment teams might find it hard to keep tabs on the management of Chinese portfolio companies. For example, we recently saw a fund that has been seriously hit by its "remote-controlled" approach to investing in China. The fund's local representative—a junior staff member—was so intimidated by his US-based partners that he simply told them what he thought they wanted to hear and disregarded the underlying downward spiral. And it did not help that the local representative was seen as a lightweight by the Chinese portfolio company, which chose to ignore his presence.
Third, some private equity investors may struggle to secure domestic debt financing because many local banks remain wary of what they regard as foreign predators. In general, private equity companies can expect little help from the Chinese operations of international banks, which have limited capacity for lending local currency. Some funds have opted for a partial solution: obtaining specific guarantees of bank financing before the investment.
Access to financing is particularly tricky for portfolio companies seeking to expand overseas through mergers and acquisitions. While big companies—such as state-owned China Netcom and the privately held computer manufacturer Lenovo—can readily get access to foreign currency, smaller private companies may find it much harder to build up a war chest for foreign expansion.
The average time needed to line up foreign currency has fallen dramatically—from years to months. The precise timing, however, remains unpredictable, creating uncertainty among investors over their ability to pursue a strategy.
Finally, the path to a profitable exit remains uncertain. Despite China's decision to lift a six-month moratorium on initial public offerings, there is no guarantee of getting a timely spot in the IPO queue.
Trade sales, which are another potential exit, are likely to become less common, because foreign multinational groups increasingly focus on organic growth rather than acquisitions.
Given these challenges, we believe a number of private equity funds can find better China-related opportunities closer to home. For example, although Fortune 500 companies have the scale and international scope to move operations and sourcing to China, many midsize US companies have yet to follow suit. Some of these companies are held back by their lack of expertise in the region, while others are reluctant to change their traditional way of working.
There may be an opportunity for private equity groups to invest in these midsize US manufacturing companies because, while they are struggling to keep up with the Chinese competition, they retain substantial brand value, sales channels, and intellectual property. Through investment, private equity funds can inject the management talent to help a company shift operations and sourcing to China—which can lead to substantial cost reductions. Our experience suggests that there is tremendous room for such deals because there is little competition to invest in midsize US manufacturing companies.
The key is to develop a management team that can repeat these restructurings. To recoup their investment, private equity firms might want to sell these companies to Chinese rivals looking to expand overseas. Given the relative inexperience of the potential Chinese trade buyers, astute sellers may well be able to strike a very attractive deal.
About the Authors
Gordon Orr is a director in McKinsey's Shanghai office. This article was published as "Gold rush may be a mirage" in the Financial Times on February 23, 2005.

China and India: The race to growth

2004-10-31T16:43:00.000-08:00

China and India: The race to growth

The world’s two biggest developing countries are taking different paths to economic prosperity. Which is the better one?

Diana Farrell, Tarun Khanna, Jayant Sinha, and Jonathan R. Woetzel

The McKinsey Quarterly, 2004 Special Edition : China today

First it was China. The rest of the world looked on in disbelief, then awe, as the Chinese economy began to take off in the 1980s at what seemed like lightning speed and the country positioned itself as a global economic power. GDP growth, driven largely by manufacturing, rose to 9 percent in 2003 after reaching 8 percent in 2002. China used its vast reservoirs of domestic savings to build an impressive infrastructure and sucked in huge amounts of foreign money to build factories and to acquire the expertise it needed. In 2003 it received $53 billion in foreign direct investment, or 8.2 percent¹ of the world's total—more than any other country.

India began its economic transformation almost a decade after China did but has recently grabbed just as much attention, prompted largely by the number of jobs transferred to it from the West. At the same time, the country is rapidly creating world-class businesses in knowledge-based industries such as software, IT services, and pharmaceuticals. These companies, which emerged with little government assistance, have helped propel the economy: GDP growth stood at 8.3 percent in 2003, up from 4.3 percent in 2002. But India's level of foreign direct investment—$4.7 billion in 2003, up from $3 billion in 2002—is a fraction of China's.

Both countries still have serious problems: India has poor roads and insufficient water and electricity supplies, all of which could thwart its development; China has massive bad bank loans that will have to be accounted for. The contrasting ways in which China and India are developing, and the particular difficulties each still faces, prompt debate about whether one country has a better approach to economic development and will eventually emerge as the stronger. We recently asked three leading experts for their views on the subject; their essays may be accessed on the pages that follow or by clicking on the titles below.

—Jayant Sinha

About the Authors

Jayant Sinha is a principal in McKinsey's Delhi office. Tarun Khanna is the Jorge Paulo Lemann professor at the Harvard Business School. Jonathan Woetzel is a director in McKinsey's Shanghai office. Diana Farrell is the director of the McKinsey Global Institute.

Notes

¹ The United Nations Conference on Trade and Development (UNCTAD) database on foreign direct investment.

India's entrepreneurial advantage

China has shackled its independent businesspeople. India has empowered them.

Tarun Khanna

China and India have followed radically different approaches to economic development. China's resulted from a conscious decision; India more or less happened upon its course. Is one way better than the other? There is no gainsaying the fact that China's growth has rocketed ahead of India's, but the conventional view that the Chinese model is unambiguously the better of the two is wrong in many ways; each has its advantages. And it is far from clear which will deliver the more sustainable growth.

Together with Yasheng Huang, of the Sloan School of Management, at the Massachusetts Institute of Technology (MIT), I have argued that these approaches differ on two dimensions. First, the Chinese government nurtures and directs economic activity more than the Indian government does. It invests heavily in physical infrastructure and often decides which companies—not necessarily the best—receive government resources and listings on local stock markets. By contrast, since the mid-1980s the Indian government has become less and less interventionist. The second dimension is foreign direct investment. China has embraced it; India remains cautious.

These differences have an impact on the types of companies that succeed and, I would argue, on entrepreneurialism. Let's look first at what kinds of companies thrive. China trumps India when it comes to industries that rely on "hard" infrastructure (roads, ports, power) and will do so for the foreseeable future. But when it comes to "soft" infrastructure businesses—those in which intangible assets matter more—India tends to come out ahead, be it in software, biotechnology, or creative industries such as advertising.

Thus manufacturing companies whose just-in-time production processes rely on efficient road and transport networks fare poorly in India. But businesses that are unconstrained by shortages of generators and roads flourish. Soft assets underpin even the Indian car industry. Unlike China's car sector, which has expanded as a result of big capital investments from multinational companies, India's has succeeded on the back of clever designs that make it possible to produce cheap indigenous models. India actually sends China high-value-added mechanized and electronic components whose production depends more on know-how than on infrastructure.

Moreover, many hard-asset companies in China exist because the government funnels money to them. The government can do this because it intervenes in domestic capital markets. In India there is no such government intervention. Hence successful companies tend to cluster in industries where capital constraints are less of an issue. You don't need a deep reservoir of capital to start a software company; you do for a big steel plant.

The Indian government's lower level of intervention in capital markets and its decision not to regulate industries that lack tangible assets (software, biotech, media) have created room for entrepreneurs. Entrepreneurial activity is fueled both by incumbent (often family-owned) enterprises and by new entrants. The former use cash flows from diverse existing businesses to invest in newer ventures. In biotechnology, however, Biocon emerged from pure entrepreneurial effort, as did Infosys Technologies in software. Similarly, hundreds of smaller versions of companies such as Infosys and Wipro Technologies have no government links, unlike so many of China's successful companies.

Although India's stock and bond markets are hardly perfect, they do on the whole support private enterprise. Here too, entrepreneurialism has played a part, even improving India's institutional framework. Take the Bombay Stock Exchange (BSE), founded about 130 years ago and until recently the most inefficient entity imaginable. It has become radically more efficient in the past decade as a result of the competing efforts of an enterprising former bureaucrat named R. H. Patil. With technological inputs from around the world and some fancy footwork to dodge entrenched interests at the BSE, in 1994 he started a rival institution, the state-of-the-art National Stock Exchange of India, which now has more business. In China, by contrast, the government tries to make stock markets successful by command, with predictably little to show for its efforts. There has been little competition indeed between the Shanghai and Shenzhen exchanges.

Good hard infrastructure and the Chinese government's decision to welcome foreign investment make it reasonably easy for multinationals to do business in China, and since they bring their own capital and senior talent, they do not have to rely heavily on local institutions. China has no shortage of homegrown entrepreneurial talent. But indigenous companies have a much tougher time, hindered as they are by inefficient capital markets, a banking system notorious for bad loans, and the fact that local officials rather than market forces largely decide who receives funding.

The pros and cons of these two models should be studied, and it is fair to ask whether China's will hamper its economic development

China and India both have the ability to keep growing in their own very different ways for a decade or so. The Chinese government's intervention in the economy—including the decision to welcome foreign direct investment—has brought a material improvement in the standard of living that India hasn't enjoyed. It may also be that each country has chosen the path best suited to its own historical circumstances. But the pros and cons of these two development models should be studied, and it is fair to ask whether China's approach will hamper its future economic development.

Huang and I believe that the presence of so many self-reliant multi-national companies has partly relieved the Chinese government of pressure to develop or reform the institutions that support free enterprise and economic growth. And the fact that many domestic investments still are not allocated through sensible pricing mechanisms means that China wastes many of its resources. Productivity and long-term economic growth, as we all know, thrive on competition, which is all too often stifled by government intervention.

When the two countries are compared, it is easy to forget that India began its economic reforms more than a decade later than China did. As India opens up further to foreign direct investment, we might well discover that the country's more laissez-faire approach has nurtured the conditions that will enable free enterprise and economic growth to flourish more easily in the long run.

About the Author

Tarun Khanna is the Jorge Paulo Lemann professor at the Harvard Business School.

China: The best of all possible models

In an efficient market, the private sector is better than governments at allocating investment funds. But China isn't an efficient market, and India has relatively little investment funding.

Jonathan R. Woetzel

Finding fault with China's approach to economic development is easy: cyclical overcapacity, state-influenced resource allocation, and growing social inequalities are just a few of its shortcomings. But it's hard to see how any other model could have given the economy such a powerful kick start.

The Chinese government manages the development of enterprises with a view to driving economic growth. You can be a small entrepreneur in China, but if you want to be big you will have to get money from a government-affiliated source at some point. Government officials essentially have the power to decide which companies grow.

In achieving the objective of growth, this policy has been tremendously successful. China has quickly built industries large enough to drive its economy. Take the auto industry, now an important contributor to the manufacturing sector. Only 20 years ago, China had no auto industry to speak of; there were a few manufacturers of trucks but none of passenger cars. To get started, the government decided that in a high-scale, high-tech industry, some foreign company—in this case, Volkswagen—had to come in and show local ones what to do. Because most local companies were state-owned 20 years ago, Volkswagen was hooked up with a state-owned company.

You might argue that this development model has thwarted entrepreneurship. But there weren't any entrepreneurs in the industry at the time. There were no private companies that could partner with Volkswagen, let alone compete with it. The government simply said, "We want China to modernize. We want the Chinese economy to grow. We don't have the companies we need to make that happen, so we're prepared to do what it takes to create them."

The capital-intensive auto plants built with foreign partners in China as a result of its development policy may have no particular productivity advantage over the plants they might have built at home. But all of the spending by the big car companies has paid off.

Moreover, local, privately owned automakers such as Chery Automotive and Geely Automotive are beginning to thrive. A generation of entrepreneurs has put to good advantage the skills and training that the foreigners provided, so that Chinese companies now put together cars of reasonable quality much more cheaply than foreign automakers can. At present, domestic players benefit from the price umbrella that the foreign ones provide. But these smaller fry are now making cars for $2,000, which means that any company that has high cost structures will eventually suffer. With lower tariffs on the way because of China's accession to the World Trade Organization, and with new competitors proliferating, the automotive industry is heading into a classic price war that only the fittest will survive. This is precisely what happened in the consumer electronics industry, where competition led to the emergence of successful Chinese companies that operate globally. I think that in five or ten years' time, at least a third of the Chinese auto industry will be completely private—nothing to do with the current state players. And this will all have started with the state saying, "We want to build a car industry."

Looking at industry more broadly, inefficiencies and cyclicality have resulted from the fact that many funding decisions are driven at the local-government level. Local officials have GDP growth as a political-performance target, so many of them look for the biggest investments they can make to push along the regional economy. Like stock market investors pursuing the latest speculative fad, they have created a lemming effect, with lots of unsound investments, whether in aluminum smelters, residential real estate, or TV factories. The outcome tends to be waves of overcapacity as investments are made right up to—and sometimes way beyond—the point where it is patently obvious that the economics cannot justify them.

But remember that the essential mechanism of economic reform in China has been the encouragement of competition among provinces and municipalities. Until the 1980s there was no such thing in China as a national company. Everything was local. There was no single legal entity that operated more than five kilometers (about 3.1 miles) from its headquarters. With the removal of internal trade barriers, local entrepreneurs and their government backers invested to build scale and attack neighboring markets. Yes, this does lead to overcapacity and price wars. But over time—and relatively short periods of time, too—all that cyclicality also leads to shakeouts that the most competitive enterprises survive. These enterprises, thanks to their national scale and real competitive advantages, no longer depend on local-government funding and can now start to compete for the long term, both domestically and internationally.

That has certainly been the story in consumer electronics, where the top three players in personal computers control 50 percent of the domestic market, and in beer, where the top ten own 30 percent. It is starting to be the story in heavy industries, where companies such as China Qianjiang own 40 percent of the motorcycle market and Wanxiang dominates its niche in automotive components (see "Supplying auto parts to the world," available on mckinseyquarterly.com on September 16). Interestingly, it is not the foreign companies but the locals that tend to be the winners of the consolidation wars. The beer industry is a case in point: most foreign brewers, unprepared for tough domestic competition and rapid consolidation, entered and exited in the 1990s.

The government is fixing the banks through tough higher reserve margins, branch-level changes, and more flexible risk-based pricing

Moreover, I don't believe that foreign direct investment is linked to the development of China's capital markets or to a reform of the banking system. Multinationals account for only 15 percent of fixed-asset investment, so they don't drive the economy to a very great extent. China must rely on its own domestic financial resources to finance growth. As a result, the country's capital markets are being developed. And the government is fixing the banks through tough higher reserve margins, branch-level changes in performance management and incentives, and more flexible risk-based pricing.

As for the oft-stated view that China is trying to create global state-owned champions, it is at least partly a myth. The government does want to develop strong Chinese companies, but it does not expect them to be state enterprises, which are inefficient by definition. Indeed, it is now telling them that if they want to grow, they will have to get listed on the stock market. The government's policy for the first 20 years of its reform program was, "Let's do what's needed to establish markets." Its policy for the next 20 years will be, "Let's get out of those markets." The global Chinese companies of tomorrow will be competitive, mostly listed, and entirely commercial in their aims and purposes.

Ultimately, you have to ask whether the inefficiencies of the Chinese approach outweigh what it has achieved for the economy overall. The answer, I think, is no. The government still controls most of the country's financial resources and has been reasonably good at allocating them—that's why the economy has grown so fast. Compared with the private sector in an efficient market, the government is no doubt worse at allocating funds. But China is not an efficient market, and the Indian model—essentially one with relatively little investment funding, whether by the government or the private sector—could not have achieved as much growth for the Chinese economy as the approach China's government actually took. The Indian model might not be adequate for India's economy either: the country's family-owned businesses and other private investors may be good at deciding what makes a sound investment for them, but they have not spent enough money to drive the kind of growth seen in China. It would not surprise me at all to see investment in India rise dramatically as foreign and domestic investors alike begin to recognize its potential going forward.

About the Author

Jonathan Woetzel is a director in McKinsey's Shanghai office.

Sector by sector

The strength of the Chinese and Indian economies will actually be decided at the industry level.

Diana Farrell

The answer to the question, "Which is the better approach to economic development?" is not to be found at the national level. You have to look at what's going on in individual industries. And when you do, you find that supportive government policies that encourage competition drive good performance. Both China and India have some sluggish, inefficient industries that are heavily regulated and lack competitive dynamism. But both countries also have successful industries that thrive unfettered by poor regulation.

The McKinsey Global Institute has long argued that the key to high economic growth is productivity and that the main barrier to productivity gains is the raft of microlevel government regulations that hinder competition. This idea is well illustrated in the case of India.

At the high end of India's productivity spectrum is the information technology, software, and business-process-outsourcing sector. It's a big success story, having created hundreds of thousands of jobs and billions of dollars' worth of exports. As a new sector—and one whose potential the government, in my view, failed to recognize early on—it has avoided stifling regulation. IT, software, and outsourcing companies are exempt from the labor regulations that govern working hours and overtime in other sectors, and they have been allowed to receive foreign direct investment, which is prohibited in retailing, for example. Without this foreign money, it is debatable whether the sector could have taken off. By 2002 it already accounted for 15 percent of all foreign direct investment in India.

In the middle of the spectrum is the auto industry, which has seen dramatic change since the government began to liberalize it in the 1980s. By 1992 most of the barriers to foreign investment had been lifted, and this made it possible for output and labor productivity to soar. Prices have fallen and, even as the industry has consolidated, employment levels have held steady thanks to robust demand. Nonetheless, with tariffs on finished cars still relatively high, automakers remain sheltered from global competition and the sector is less efficient than it could be.

At the low end of the spectrum is the consumer electronics sector, which, despite the lifting of foreign-investment restrictions in the early 1990s, is still burdened by tariffs, taxes, and regulations. As a result, Indian consumer electronics goods can't compete internationally and prices for local consumers are unnecessarily high. The performance of India's food-retailing industry is even worse. Partly as a result of a total ban on foreign investment, labor productivity is just 6 percent of US levels.

Now look at China, which also has some reasonably liberalized and highly competitive industries, including consumer electronics, in which labor productivity is double that of its Indian counterpart. Over the past 20 years, the industry has become globally competitive through a combination of foreign direct investment and intense competition among domestic companies. It is also remarkable for the relatively liberal approach the government has taken to regulation—probably because of a failure to see its growth potential. Today China makes $60 billion worth of consumer electronics goods a year.

The performance of China's auto industry—which was considered a strategic one and remains tightly regulated because of the government's desire to bring in technology and investment—is less clear-cut. The market has been opened up to foreign automakers, consumer demand has grown enormously, and prices have dropped. Yet the sector shows how government intervention can thwart the potential of foreign direct investment. Foreign automakers can invest only in joint ventures, they have to buy components from local suppliers, and tariffs shield the market from imports. Competition is beginning to increase as private companies grow stronger. But for the time being, the productivity of foreign joint ventures in China is low compared with that of plants in Japan or the United States—astounding given China's low labor costs.

Since there are such big differences in the performance of different sectors within the same country, it makes sense to compare the performance of India and China at the sector rather than the national level. In IT and business-process outsourcing, India is so far ahead of the game that China can't do anything during the next 10 or 15 years that would bring it close to catching up. In consumer electronics, however, China dominates, and India won't provide serious competition during the next 10 years.

The auto sector is a toss-up. India's competitive forces have driven an enormous amount of innovation in the sector. Low-cost labor has been used instead of expensive automation, and local engineering talent has developed innovative new products such as the Scorpio—a sport utility vehicle that sells for a fraction of the price of an equivalent car in the United States. In China, large amounts of foreign direct investment have built a big industry, but regulation has so far limited its competitive potential.

It is far from clear which economy will emerge as the stronger one. The foundations of robust, sustainable economic growth must be built at the industry level, on the back of high productivity, which is achieved when governments ensure a level playing field through sound regulation and remove the barriers that stifle competition. Both China and India still have ample opportunity to help their industries and economies thrive.

About the Author

Diana Farrell is the director of the McKinsey Global Institute.

Impact On Global Industry Restructuring & Implications For Companies

2004-10-31T16:39:00.000-08:00

Several powerful factors, from liberalized foreign investment policies to a drop in the costs associated with global operations, are making a convincing case for building truly worldwide businesses. Multinational companies in the auto sector, for example, can find greater profits through savings and revenues that represent roughly 27 percent of the US$ 1.2 billion industry.

Thanks to an increasingly mobile and connected world, global corporations stand to simultaneously increase efficiency and lower costs by taking full advantage of the growing expertise and specialization in emerging economies.

Five Horizons for Global Success
With the lifting of restrictions and regulations, a number of nations have seen thriving sectors as a result of MNC entry, and building particular skills and expertise that continue to make them competitive in the global marketplace.

For MNCs to take advantage of these opportunities, they need to recognize what aspects of their industry best lend themselves to globalization. As a result, five horizons of industry structuring have emerged:

Market entry: The predominant form of global expansion allows companies to mine new markets for their products in much the same way they do at home.
Product specialization: Certain countries or regions take over the entire production process of a particular product.
Value chain disaggregation: Each portion of the supply chain is located in a separate area with relevant expertise within a region. Parts are then assembled in yet another location.
Value chain reengineering: After relocating an activity to a new location, production process can be tweaked by adjusting capital/labor ratio to capture further savings.
New market creation: Successful global value chain management leads to the creation of better products at lower prices, which in turn can be introduced to whole new markets.

No Blueprints
While the opportunities and the benefits are significant, there is no one correct approach to managing global optimization. Global expansion alone does not ensure success. Just as high-performing companies in developed countries exhibit a broad range of successful management approaches, so do large developing economies.

Companies must balance global resources with local knowledge. That includes aligning management incentives globally but tailoring them to local conditions. In Mexico's retail banking, for example, successful approaches ranged from BBV's top-down direction to Citigroup's management coaching of the executives.

And companies must recognize that there is no single blueprint that works for every sector in every country. Each situation is different and those managers that can recognize them and build performance around them will be the ones who succeed.

Information Technology/Business Process Outsourcing (IT/BPO) Case Study

2004-10-31T16:38:00.000-08:00

Companies are moving critical IT (information technology) and BPO (business processes operations) to offshore locations, particularly in India.

India, with its English speaking, educated, and technically proficient workforce, offshoring is growing at 30 percent per year and is projected to grow to more than US$ 200 billion by 2008.

Despite widespread concerns that offshoring eliminates jobs at home, in reality the revenue saved through offshoring is being reinvested at home.

Information Technology (IT)
As the largest global supplier of offshore IT, India accounts for roughly a quarter of the global market for IT talent. India has added hundreds of thousands of high tech jobs though, relative to the economy overall, the impact to date has been small. Because many of the IT facilities tapped for offshoring already existed, FDI impact has been on increasing employment and bringing higher value-added functions to India.

Business Process Outsourcing (BPO)
Facilities and infrastructure for BPO, unlike IT, have been created entirely through FDI. The Indian government offers lucrative incentives to attract MNCs but without significant positive effect since MNCs are already committed to establishing BPO functions in India. Government funds lost through tax incentives would be better used to improve the country’s infrastructure. Lack of reliable power, for example, poses a major threat to BPO growth.

Conclusions
Offshoring of IT and BPO has been a boon for India, and the sector is expected to grow in the years ahead. Numerous new jobs have been created, and higher value-added functions have been brought to India. As international companies enter India, increased competition is beginning to drive sector productivity.

Offshoring and beyond

2004-10-31T16:30:00.000-08:00

Offshoring and beyond

Cheap labor is the beginning, not the end.

Vivek Agrawal, Diana Farrell, and Jaana K. Remes

The McKinsey Quarterly, 2003 Special Edition: Global directions

The enticement to companies of a worker who earns $2 an hour in India as against ten times that amount for a worker in the United States is obvious. For years, such wage differentials have attracted leading manufacturing companies to low-wage nations. More recently, businesses of all kinds have also exported back-office functions such as data entry, payroll processing, and call centers. Business-process offshoring is all the rage, and the hundreds of companies that have taken this route often cut their costs by as much as half.

Yet as impressive as these achievements may appear, new research by the McKinsey Global Institute (MGI) finds that companies are leaving billions of dollars in savings behind when they offshore back-office functions and service jobs.¹ Such companies are merely replicating what they do at home, where labor is expensive and capital is relatively cheap, in countries in which the reverse is true. What is needed? Nothing less than a total transformation of business processes to harness the new environment’s potential. And by undertaking such a transformation, many companies will find that the resulting lower cost structure releases massive new revenue opportunities even more valuable than the savings.

Halfway to global

The first wave of globalization began a hundred or more years ago, when companies were lured abroad by the prospect of new markets. Even today, we estimate, the age-old motivation of reaching vast new customer pools explains perhaps 80 percent of cross-border investments. Many of them, such as Wal-Mart Stores’ operations in Mexico and HSBC’s in Malaysia, are in service sectors that require a local presence by definition. Others are in industries such as automotive, in which high tariffs and other trade barriers effectively force foreign companies to set up shop locally if they want to do business.

Despite the fits and starts of progress in world trade talks, the policy barriers that limit foreign investment and trade have fallen significantly over the past ten years. The result has been a second wave of globalization, in which companies from North America, Europe, and Japan build plants in low-wage countries to take advantage of enormous wage differentials and then export the finished goods back to the home market. These companies have substantially cut their costs for a variety of products, particularly labor-intensive ones such as textiles and toys, even taking into account the extra expense of transportation and overseas management and training.

Companies in a few industries have gone further, specializing in component production and final assembly in the countries or regions with the strongest comparative advantage. Nowhere is this third wave of globalization more evident than in consumer electronics (see sidebar, "How far can it go?"). Business-process offshoring, made possible by the dramatic fall in telecommunications costs and the ability to transform paper-based activities into digital ones requiring only a telephone and a computer, is just the next logical step. A broad range of service jobs and back-office functions can now be performed remotely in India, for example, or in the Philippines. Low-skill work such as data entry and transaction processing, real-time customer support, and research services are obvious candidates. But even high-skill activities such as customized software development, the design of automotive and aerospace components (CAD/CAM), and pharmaceutical research are increasingly undertaken outside the United States.

Many of the jobs sent offshore may be considered undesirable and lacking in prestige in developed countries yet are highly attractive in developing ones. So offshore workers not only cost far less but also are often more highly motivated, which means that they perform better. One British bank’s call-center agents in India, for instance, process 20 percent more transactions, with 3 percent more accuracy, than their counterparts do in the United Kingdom. Some companies set up their own "captive" operations in offshore locations to take advantage of these benefits, while others outsource to local companies, particularly in India.

Companies in the United States and Britain account for roughly 70 percent of the business-process-offshoring market. Relatively liberal employment and labor laws give such companies flexibility in reassigning their activities and eliminating jobs, and they can take advantage of the sizable English-speaking populations in many low-wage countries, such as India, Ireland, the Philippines, and South Africa. With a shared language, errors are far less likely and functions that require voice interaction or text-based work are straightforward. The opportunities for Continental European and Japanese companies are thus more limited.

Business-process offshoring is still a nascent industry. By our estimates, in 2002 it was worth $32 billion to $35 billion, just 1 percent of the $3 trillion worth of business functions that could be performed remotely. Because of the significant benefits already being realized through offshoring, the market is projected to grow by 30 to 40 percent annually over the next five years.² This prospect may cause consternation over job losses in the United States (see Vivek Agrawal and Diana Farrell, "Who wins in offshoring," The McKinsey Quarterly, 2003 Number 4 Global directions, pp. 36–41), but it will make offshoring an industry with well over $100 billion in annual revenues by 2008.

Getting more from offshoring

Merely replicating processes developed at home, however, is not the way to realize offshoring’s full potential. Wages represent 70 percent of call-center costs in the United States, for instance, so these operations are designed to minimize labor by using all available technology. But in low-wage India, that makes little sense, since wages represent only 30 percent of costs, and capital equipment (to provide telecom bandwidth, for example) is often more expensive than it is at home.

The way to reduce the cost of offshore operations even further (Exhibit 1) is to reorganize and reengineer operations to take full advantage of these differences. In a low-wage country, the capital infrastructure—including office space, telecommunications lines, and computer hardware and software—should be used as intensively as possible. For a call center, this approach can reduce costs by an additional 30 to 40 percent, boosting total savings to as much as 70 percent of the cost of onshore operations (Exhibit 2). The potential value for other offshored functions, like data entry, payroll processing, and financial accounting, is similar.

Companies can boost their capital productivity in low-wage environments in three ways:

Round-the-clock shifts. The most obvious way to use the capital infrastructure more intensively is to run round-the-clock shifts, even if they mean higher wages for odd hours. This option simply wouldn’t exist in a high-wage environment, where wage premiums offset any capital savings. We estimate that just by increasing the number of shifts, companies can reduce their operating costs by 30 to 44 percent for many types of offshore work, including financial accounting, procurement, call centers, transaction processing, and more complex functions such as knowledge services and R&D (Exhibit 3). But in India, we found that even the most efficient third-party providers run only two shifts a day, and most of the captive operations set up by multinational corporations are running only one.
Cheaper capital equipment. Some service providers in India are using cheap local labor to develop their own software instead of purchasing more expensive branded products from the global software giants. American Express, for instance, hired programmers to write software to reconcile accounts, and the software now reconciles over three-quarters of them, or more than half a million every day. The company, which paid only $5,000 to develop this solution, estimates that licensing more sophisticated database software would have cost several million dollars. The Indian carmaker Maruti Udyog developed its own robots for its assembly lines; the robots, on average, cost a small fraction of what similar ones cost its partner Suzuki in Japan. In this way, companies maintain the level of automation that prevails in high-wage countries, but at a distinctly lower capital cost.
Reduced automation. Some companies have gone a step further and used workers for tasks that would normally be automated at home. A payments processor, for example, might employ people to input checks manually into a computer system instead of using expensive imaging software. A telemarketing firm that would use expensive automatic dialers in a high-wage country might have workers make their own calls instead.

Manufacturers too can use this approach. Certain automotive original-equipment manufacturers (OEMs) in China use robots for only 30 percent of the welding in car assembly, as compared with 90 percent or more in US or European operations. (BMW’s plant in South Africa employs the same line of attack.) In India, domestic car companies have reduced the need for automation throughout the manufacturing process: they use more manual labor to load and change dies in pressing, body welding, materials handling, and other functions—while suffering no discernible loss of quality in the finished product. In this way, these companies manage to cut their assembly costs by 4 to 5 percent or even more and save themselves millions of dollars annually.

Ultimately, companies might completely redesign the sequence in which tasks are performed, in order to leverage the opportunities above more fully. Consider the simple example of a call-center agent who manages customer accounts. In high-wage countries, each customer call is routed to an agent who listens to the request, opens up a computer database, and updates the account in real time. Neither the computer nor the telephone is used efficiently, since the agent is either talking or typing but not both.

Offshore, an agent equipped with only a telephone could write the customer request by hand into a tracking log and move on to the next call. Telecom costs are reduced because the agent spends less time on calls and customers less time on hold. Another agent, working at a computer station used around the clock, could enter the information into the database. While the new process requires more agents to handle requests, expensive computer hardware and software and telephone lines are used more intensively. Added wages are more than offset by savings on computers, software licenses, and telephone connections (Exhibit 4). The economics of an Indian call center suggest that this simple change could actually boost current profit margins for offshoring vendors by as much as 50 percent.

Reengineering offshore functions makes sense only if wages stay low. Over time, they will rise and technology costs will continue to fall. As this happens, companies can adjust their operations to reflect changing factor costs. But in most low-wage countries, labor is so cheap and the labor pool so large that rising wages are unlikely to be a problem for decades. India each year produces 2,000,000 college graduates—more than 80 percent of them English speakers—while China produces 850,000, though with minimal English skills. Even a small country like the Philippines annually produces 290,000 college graduates, all English speakers.

Beyond cost savings

By reaping offshoring’s full potential, companies will find that their new, lower-cost structures open up a variety of opportunities to boost revenue growth. These opportunities will often far exceed the annual cost savings.

Some companies, for instance, can now chase delinquent accounts receivable they formerly had to ignore: one airline carrier is capturing $75 million in previously lost receivables on top of the $50 million it saves each year by operating its accounts-receivable department in India. Meanwhile, a leading US personal-computer manufacturer created telephone- and e-mail-based customer service centers in India to provide technical support. In addition to saving more than $100 million annually, it has significantly increased the proportion of customer problems it resolves. The company thereby reduces the number of follow-up calls it receives and the amount of merchandise it must replace while simultaneously boosting its customer satisfaction levels. And a financial-services firm has extended to customers with lower account balances services previously limited to high-net-worth clients, thus opening up large new customer segments in its home market.

The new cost position can also be used to develop cheaper products for consumers in emerging markets. Consider the experience of one of their own local companies. The Indian automaker Tata Motors (formerly Telco) designed the low-cost Indica car for the domestic market. The Indica sells for roughly 10 percent less than cars from global OEMs and breaks even on a volume of 150,000 units, a fraction of the number global companies need. That Indicas have fewer features accounts for a small part of the cost savings. Most of the savings come from a lower level of automation in assembly, a reengineered process, and the use of very low cost local labor to develop the car (at a quarter of what a global OEM would have spent to develop something similar). As a result, the company has grown from virtually nothing to capture a quarter of the Indian market in its segment during the past four years—displacing Suzuki Motor, Hyundai, and other global brands—and is now under contract to export 100,000 Indicas to the United Kingdom and Continental Europe.

As companies go further down the road to globalization, the potential to create new markets and redefine industries is enormous. Consider how the dramatic price reductions made possible by globalizing production have changed the market for televisions in the United States. Just 25 years ago, almost a quarter of US households had no color TV. Since then, prices have declined by roughly 40 percent in real terms. Now 98 percent of US households have at least one, and many families have three or more. At the new price point, color televisions have been transformed from luxury items into nearly disposable goods that most of the population considers a necessity. And as color TVs have proliferated, they have given rise to an industry that produces television content and television-based games worth more than $30 billion. Although the detractors of globalization fear that it has already gone too far, we believe that it has barely begun.

How far can it go?

The personal computer on your desk today may have been designed in Taiwan and assembled in Mexico, with memory chips from South Korea, a motherboard from China, and a hard drive from Thailand. Not surprisingly, the value of world trade in consumer electronics components and final goods is 180 percent of the value of industry sales each year, and the industry has been completely restructured. Many companies around the world are now specializing in quite narrow segments of the value chain—for example, as innovators and designers of goods, low-cost producers, specialized assemblers, or marketers and distributors.

Countries too are starting to specialize: Mexico and Eastern Europe take advantage of their location to assemble goods destined for the United States and Europe, respectively, and China uses its huge labor pool to become a global base for low-cost manufacturing. Although companies have benefited from lower costs and consumers have enjoyed dramatically lower prices and more choice, few nonmanufacturing industries have moved so decisively.

Clearly, not every industry could go as far as consumer electronics along the road to globalization: steel, for instance, is heavy and bulky to transport, while services such as retailing, banking, and entertainment must of necessity remain largely local. The interplay between the physical nature of any industry, its organizational environment, and the legal, regulatory, and policy barriers to its globalization determines its potential for restructuring.

The barriers to globalization are real, and many may not come down. But as an experiment, we looked at how much value could be created in the automotive industry if they did. We found that it could capture a staggering $150 billion annually in cost savings and an additional $170 billion annually in new revenues—a combination that would boost industry revenues by more than 25 percent from current levels. What stands in the way of achieving this increase?

Most people think that the industry is already global, largely because of the popularity of foreign cars. Few realize that of the 55 million vehicles produced each year, more than 90 percent are sold where they are made. Although the leading OEMs have all built plants in low-wage countries, these facilities were built to meet local or regional demand. Very few cars move from one geographic region to another, and until very recently only about 100,000 cars produced in low-wage countries were subsequently exported to high-wage ones.¹

Yet there are few good reasons for this pattern. After all, it costs only $500 and takes only three weeks to ship an automobile anywhere in the world, and both the cost and the time are diminishing. More important, cars can be produced in low-wage countries for at least 20 percent less than in high-wage ones, even after shipping costs and tariffs are factored in (exhibit). The resulting boon to the world’s consumers could be enormous.

Furthermore, experience has shown that quality standards can be maintained in low-wage countries. BMW’s South African plant, which exports to Europe and North America, is even slightly better than the German plant.² Volkswagen produces all of its popular New Beetles in Mexico. Operating in these countries often requires extra training for workers—BMW spends three to five times more on training in South Africa than it does in its other plants—but wage differences more than offset that cost.

Moreover, many analysts believe that overcapacity in the global automotive industry is now 30 percent or even higher. Much of the overcapacity is in emerging markets, where governments granted lucrative incentives to global OEMs during the 1990s but local demand failed to materialize. These factories could be supplying developed countries with lower-cost cars. Confronted by idle plants in countries from Thailand to Brazil, a few OEMs are now moving in this direction.

The barriers to globalization are government policies and some of the industry’s organizational features. Apart from Japan, virtually every country has car tariffs, which range from 2.5 percent in the United States to 10 percent in Europe and to over 100 percent in some developing countries. What’s more, strong unions mount stiff resistance to moving production offshore. Many auto parts are proprietary and there is very little standardization across manufacturers. So the complex supply chain—which can include hundreds of direct suppliers, each relying on hundreds of subsuppliers—is still relatively fragmented despite current perceptions of rampant consolidation. And since assembly plants can cost up to half a billion dollars to build, OEMs have enormous sunk costs in their existing manufacturing facilities.

If the industry found ways to overcome these barriers, it could capture up to $320 billion annually in cost savings and new revenues. The first step would be to use existing plants in low-wage countries more efficiently. By cutting the current overcapacity in half, the industry could reap $10 billion annually.³ By building all additional production capacity in low-wage countries, it could save a further $40 billion annually after five years. Over time, if OEMs migrated 70 percent of their assembly and components sourcing in high-wage countries to low-wage ones, they could realize savings in the neighborhood of $150 billion a year. (For most OEMs, as much as 30 percent of demand is variable and 70 percent stable and predictable. Moving 70 percent offshore is thus potentially feasible without making consumers wait longer to get their cars or building large inventories to compensate for fluctuating demand.)

But the benefits don’t stop at cost savings. By taking advantage of low-cost labor and disaggregating supply chains, automakers could produce cars at least 20 to 25 percent more cheaply. If tariffs on parts were also to fall, these companies could, by conservative estimates, cut prices by 30 percent and unleash massive new demand. In emerging markets, where consumers are highly price sensitive and there is significant unmet demand for low-cost cars, we estimate that the industry could increase its sales by up to $100 billion a year.

In developed countries, where most consumers already own cars, cutting the price of the lowest-cost models by 30 percent (to $7,000, from $10,500) could produce roughly $70 billion in additional sales. Some of this demand would come from low-income households that currently don’t own cars. But part of the opportunity would be generated by changing the way consumers view them: instead of having only one or two, households might opt for three or four, with some purchased just for fun. Parents might be more inclined to buy cars for their children, and young people might enter the market as well.

The potential value at stake in the auto industry is eye-popping but hardly unique. As the barriers to globalization continue to erode, many other industries could be restructured and capture similar value.

Notes

¹This estimate doesn’t include production within the countries adhering to the North American Free Trade Agreement (NAFTA).

²"Two-way street: Automakers get even more mileage from the Third World," Wall Street Journal, July 31, 2002.

³For details on these calculations, see the October 2003 MGI report New Horizons: Multinational Company Investment in Developing Economies, available free of charge.

Return to reference

About the Authors

Vivek Agrawal is a consultant in McKinsey’s Minneapolis office; Diana Farrell, the director of the McKinsey Global Institute, is a principal in the San Francisco office, where Jaana Remes is a consultant.

The authors would like to acknowledge the many MGI fellows who participated in the project and the partners around the world who helped make it possible: Nelly Aguilera, Dino Asvaintra, Angelique Augereau, Vivek Bansal, Dan Devroye, Maggie Durant, Heinz-Peter Elstrodt, Antonio Farini, Thomas-Anton Heinzl, Lan Kang, Ashish Kotecha, Martha Laboissiere, Enrique Lopez, Maria McClay, Glenn Mercer, Gordon Orr, Vincent Palmade, Ranjit Pandit, Antonio Puron, Julio Rodriguez, Jaeson Rosenfeld, Rodrigo Rubio, and Heiner Schulz. We also wish to acknowledge members of the McKinsey initiative on business-process outsourcing and offshoring, including Detlev Hoch, Noshir Kaka, Anil Kumar, Sunish Sharma, Stefan Spang, Sanoke Viswanathan, and Patrick Woetzel. Their work contributed significantly to our understanding of the software- and business-process-offshoring sectors.

Notes

¹See the October 2003 MGI report New Horizons: Multinational Company Investment in Developing Economies, available free of charge. During the yearlong research project leading up to this report, we conducted in-depth case studies of foreign direct investment in five sectors (automotive, consumer electronics, retail banking, retailing, and the offshoring of information technology and business processes) in four major developing economies (Brazil, China, India, and Mexico). These cases generated the basis of our findings and conclusions.

²Consensus estimates of the market research firms Aberdeen Group, Gartner, and IDC.

Managing the cost of real estate

2004-08-22T06:33:00.000-07:00

Managing the cost of real estate

To cut real-estate expenses, corporations must learn to calculate their true occupancy cost and to measure their performance.

Bonnie Stone Sellers and Scott A. Thomas

The McKinsey Quarterly, 2004 Number 4

Real estate can account for up to 15 percent of total operating expenses for many companies. Yet a study of real-estate-management practices shows that a significant number of corporations fail to control their occupancy cost—though opportunities for savings abound.

Despite the trillions of dollars real estate consumes, we found that for most companies this area is chronically undermanaged, to the extent that basic business tools—guidelines for when to acquire new space, whether to buy or lease, and how much to spend—are frequently absent. In fact, many corporations actually outsource these vital decisions or assign employees to deal with them only on a part-time basis. The result is often a patchwork of excess locations and costs.

The companies most adept at real-estate management, our study found, assign employees with skills in property, finance, legal, and workplace design to manage corporate real estate on a full-time basis. Even with clear guidelines and best practices, many companies still fall short when deciding how much to spend on occupancy and how to manage real-estate portfolios. Two measures can help improve management and control costs.

First, companies should use a broader definition of occupancy cost than just rent, since the failure to account for operating costs, depreciation, and the cost of capital yields an incomplete picture and doesn't reveal the areas that might be improved. Calculating the total occupancy cost focuses attention on space and site management as well as external factors, such as the impact of changes in financing options and in the market value of real estate (Exhibit 1). Reducing certain components of the occupancy cost—eliminating excess space by liquidating assets or by changing financial structures, for example—might take several years to accomplish.

By contrast, site-management agreements, including maintenance, cleaning, and service contracts, are easier to control, and competing vendors can bid on them annually. A large engineering company, for example, found that its true total occupancy cost was $9.9 million more than it had calculated for rent and related operating expenses alone. The company's efforts to reduce its occupancy cost by controlling entire categories of unmanaged expenses it had previously considered insignificant generated annual savings of $2 million.

Second, companies must use internal and industry norms to benchmark their performance systematically, with the intention of highlighting potential opportunities for improvement. With these calculations in hand, managers are far better equipped to set reasonable spending targets and to find opportunities for cutting costs. Before setting annual spending targets, companies should benchmark to uncover inefficiencies and to calculate potential savings. The first step is to gather comprehensive, current data—a difficult task, since information on the real-estate market is often out-of-date and resides in many dispersed sources. For these reasons, it is important to develop a plan to find the most recent information and keep it current.

The metrics most commonly used to gauge occupancy are density, cost as a percentage of revenue, and cost per full-time employee. In our view, density—which is the only metric not affected by market pricing and currency exchange rates and isn't related to other performance measures, such as revenue—provides the best indication of how well a company manages its real estate. The optimal density of office space, taking into account all other uses for it, ranges from 150 to 200 square feet per full-time employee, which represents the minimum amount of space a person needs to work efficiently. Raising density is usually the most effective way to save money; one regional bank with a total occupancy cost of $87 million identified more than $16 million in annual savings—$11 million of it solely from this source (Exhibit 2).

Companies that determine their true occupancy cost and measure their performance can align real-estate decisions with their business strategy while supporting larger corporate goals, such as growth, making employees more effective, and improving return on equity.

About the Authors

Bonnie Stone Sellers is a principal and Scott Thomas is a consultant in McKinsey's New York office.