Size is Not a Strategy

The faster big business cleans up its ethical mess, the sooner we can address the real crisis of capitalism. Giant companies dominate the landscape — from media to medicine, banking to broadband. But talented people don't want to work for them, customers hate doing business with them, and Wall Street doesn't want to invest in them. A candid appraisal of why so many big companies (even the honest ones) don't work — and some radical ideas for reform.

It is tempting to call the savage storm raging through business an overdue comeuppance for a few depraved CEOs. Or the fallout from a decade of market mania. Or the inevitable result of an accounting system that is laughably out of date. None of these are unreasonable explanations.

But the real problem is both more complex and more troubling. It is this: Big companies are broken. Nearly a century old, the modern business organization is nearing the end of its useful life. And the strategies that are being adopted by the leaders of these companies — even the honest ones — seldom get at the real issues. "The old model is dying," says Shoshana Zuboff, a high-profile professor at Harvard Business School. "It's time to invent something new."

The now-maligned startup frenzy of the 1990s was one effort at invention. For a time, big companies were terrified by the prospect of radical challenges to their power. And justifiably so, says Gary Hamel, perhaps the world's most influential strategist. "All the recipes that companies were using to prop up their share prices were running out of steam." But when the dotcoms died, old-line companies took away the wrong message: "They said, 'Silicon Valley did some cool things. But it collapsed, so we don't have to worry about it.' "

Big business has retreated to what it understands. And what it understands is getting bigger. James B. Lee Jr., vice chairman of J.P. Morgan Chase, put it this way to Institutional Investor: "Bigger is not better. Bigger is absolutely mandatory." That is the prevailing logic today: Size is not the result of success. Size is a precondition for success. Unless you are ubiquitous enough to rule at retail, muscular enough to squeeze suppliers, and global enough to operate in every corner of the world, then you do not have the resources necessary to stay in the game. And if you can't stay in the game, then you can't win.

But the logic is flawed. Economists have understood this since at least 1931, when a Frenchman named Robert Gibrat penned Inégalités Économiques. Gibrat's basic observation was that there was no relationship between a firm's size and its expected growth rate. Later research refined this conclusion. It wasn't that size had no bearing on growth. Big companies were more likely than smaller ones to survive over time. But having survived, the biggest grew the slowest.

The evidence is all around us. Start with James Lee's bank, now the country's second-largest financial-services firm. In September 2000, when Chase Manhattan announced its merger with J.P. Morgan, the company's shares were selling at $52. Today, they hover around $30, and the press is filled with reports of the company's miscues. Getting bigger has not helped Chase Manhattan get better. Nor has it helped other big companies. As the Wall Street Journal recently reported, the share prices of the 50 biggest corporate acquirers of the 1990s have fallen three times as much as the Dow Jones Industrial Average.

Sure, size counts, especially in addressing complex problems that span geographies and functions. But bigger doesn't make a company better at serving customers. Bigger isn't more rewarding to work for. Bigger doesn't innovate. Bigger, per se, isn't better. Better is better. Instead of resigning ourselves to a business world populated with plodding giants, why not imagine something more constructive?

As it happens, four of the business world's smartest thinkers have taken up that challenge. Hamel, chairman of Strategos and coauthor of Competing for the Future (Harvard Business School Press, 1994), is touting his notion of "the post-industrial organization." In The Strategy Machine: Building Your Business One Idea at a Time (HarperBusiness, 2002), consultant Larry Downes sets out an approach to strategy where information is the basis of competitive advantage. Meanwhile, Zuboff and her husband, business mogul James Maxmin, argue that the system simply can't be fixed. They propose a version of capitalism that flips the relationship between producer and consumer on its head. They call it "distributed capitalism."

The ethical storm will pass, but the bigger problem with corporate America won't. Incremental strategies, regulatory patches, or a rebound in the economy can't solve this one. Here's what might.

How Can Big Companies Innovate?
In 2000, Rajiv Laroia ran the communications-research effort at Lucent Technologies' Bell Laboratories division. Charged with optimizing 2G and 3G wireless standards for transmitting data, he and his team instead uncovered a completely different technology that delivered data much faster and more affordably.

But Lucent was wedded to existing technologies, and, as Laroia observes, "it's not easy for large companies to cannibalize their own products." So he and his team of eight engineers left the company. With $12.5 million in venture funding, they founded Flarion Technologies. "The fact that we could come up with our best work and still not have it go anywhere was a clear sign that big-company structure was not the right one for us," Laroia says. Two years later, Flarion has 150 employees, a market-trial partner in Nextel, a second round of financing, and healthy market buzz. Lucent, in free fall, has little that is healthy about it.

The question: Are giant companies such as Lucent doomed to fail at innovation? For Hamel, this is "the most exciting problem to solve today in the world." It's one that he has wrestled with for much of the last decade with the likes of IBM, Nokia, and Royal Dutch/Shell. "There will always be advantages to size and scope," Hamel says. "But the industrial company was built for optimization, not innovation."

Giant companies erect any number of barriers to innovation. They allocate resources based on what has worked in the past instead of on what could determine the future. Established hierarchies tend to minimize new threats to the existing order. Perhaps most telling, many big companies have no coherent innovation strategy. "Every CEO will at least give lip service to the idea that the world is moving faster and that we need to do a better job at being innovative," Hamel says. "But if you go into an organization and ask people to describe their innovation system, you get blank looks. They have none."

What's the best way to create a giant organization that's capable of perpetual renewal, one that's constantly innovating? Hamel proposes forming an open market for ideas, capital, and talent within the company. He suggests distributing the capability for innovation to every employee in every corner of the business. That is what Hamel imagines for the post-industrial organization — a company that combines hierarchy with markets.

The post-industrial organization doesn't dismiss hierarchy altogether. Hierarchy, Hamel argues, brings discipline and consistency to business. But traditional hierarchies are self-reinforcing: They serve the status quo. Markets, on the other hand, challenge what has worked before. They have no vested interests.

And in a market, new ideas come from everywhere. Look at what's happening at Royal Dutch/Shell. Five years ago, working with Hamel, the company's exploration-and-production division set aside 10% of its research budget for "crazy" ideas, proposals that were far removed from its existing operations. Anyone in the division could apply for the funding. And a group of four or five employees — all of them well-known mavericks and nonconformists — were charged with deciding how the money got spent. The strategy was called GameChanger.

Consider the implications. There were millions of dollars set aside for no specific purpose. The accountants hated that. The people making the funding calls weren't managers, so they weren't wedded to any existing projects. "Experience shows that in a normal hierarchy, people don't like ideas that do not support their businesses," says Leo Roodhart, innovation manager for the Shell group. "These were ideas that by definition didn't fit with current business thinking."

GameChanger creates a marketplace within Shell for ideas. Proposals are assessed within one week of application. If they are judged promising, they win seed capital and support. If early results meet expectations, the innovation is marketed within the Shell Group. So far, GameChanger has attracted hundreds of proposals. It has funded 150 projects a year, 10% of which have become commercialized.

Hamel's lesson: Innovation can happen at big companies, but only if the market conquers hierarchy. "The beauty," says Roodhart, "is that there are no managers involved. It's a bunch of renegades who like playing around. It's about the excitement and freedom of a new idea."

How Does Size Shape Strategy?
Dennis Kozlowski was an acquisition junkie. In the decade after he took over as chief executive, Tyco International spent tens of billions of dollars to buy nearly 1,000 businesses around the world. By 2001, Tyco was in fire alarms, medical products, waste-water treatment, and, well, you name it. Revenues soared from $5 billion in 1996 to $34 billion in 2001. But there was a problem: The acquisitions were masking tepid performance in the underlying businesses. Return on equity over the same period dropped to 16.3% from 17.4%. All of those deals, and the resulting mass of physical assets, had made Tyco a lesser company — and that was before Kozlowski got caught shipping empty crates to New Hampshire.

The question: In the information economy, is there a smarter way to think about the relationship between size and strategy?

In 1937, Ronald Coase, now professor emeritus at the University of Chicago Law School, wrote "The Nature of the Firm." The paper was so controversial that it took 54 years for the Nobel folks to reward Coase with the prize for economics. In his early twenties, while on a research fellowship in the United States, British-born Coase had seen that business organizations could perform some activities more efficiently than the market could. Transaction costs were lower inside the corporation. A carmaker might manufacture its own engines for less than it would cost to outsource them, for example.

But at some point, Coase wrote, "the costs of organizing additional transactions within the firm may rise." What's more, as the size and complexity of an organization grows, "the entrepreneur fails to place the factors of production in the uses where their value is greatest." Translation: Bigger is better — but only up to a point. And that point is ever changeable, a function of the marketplace.

Today, Larry Downes says, the Internet and other technologies are lowering transaction costs in the market, reducing the optimal size for most business organizations: "The focus of corporate strategy has been on maximizing physical assets. More trucks, more factories, more people. Now the focus of asset management and asset exploitation should be on data. Screw physical assets! Organize your company, your strategy, and your execution around information."

In the emerging model, which Downes calls a "strategy machine," economies of scale do create competitive advantage. But those economies are rooted entirely in information. Standardize it, repackage it, use it to gain unique market insight, and turn it into products and services. "The better the information is," Downes declares, "the better the fuel, and the more things will come out the other end."

The Enron scandal, of course, tarnished the idea of information-based strategies and intangible assets: Why own pipelines when you can create fictional transactions? But fraud shouldn't diminish genuine insight. Henry Silverman, CEO of Cendant Corp., understands the "invisible capital engine." Since the early 1990s, Cendant has acquired a string of mostly troubled businesses — Avis Rent a Car, Coldwell Banker, and the Howard Johnson hotel chain among them. They all had powerful brands. But more important, they owned great information assets: reservations systems. Listing services. Deep customer databases. Silverman spun off the hotels, the rental agencies, and the offices. But he kept the information assets and then franchised them back to the new owners of the physical assets. The more brands that Cendant collected, the more market insight Silverman had. "The firm could see overall trends," Downes says. "It could see local trends. And it could respond."

A strategy machine feeds off of market research, transaction data, and business intelligence. Early investments in information-based strategies produce new information products and services. Those, in turn, generate more ideas, which feed the next round of investment decisions. "Perhaps the most remarkable feature of the strategy machine," Downes writes, "is that the inputs and the outputs are the same. . . . Information is the input; better information is the output."

Can Big Companies Really Care About Customers?
It is late afternoon in the belly of the beast: a suburban outpost of Wal-Mart Stores, the largest company in America. All around, customers wheel big shopping carts crammed with big packages: big jugs of soda, big bags of mulch, big boxes of diapers. And it's all really, really cheap.

Indisputably, this is a big company that works brilliantly. Its throngs of customers depart contented. Not thrilled, not passionate, but satisfied. They've bought pretty much what they wanted and spent pretty much as little as possible. But is Wal-Mart the best that corporate America can offer? Or can we imagine something better?

In her landmark 1989 book, In the Age of the Smart Machine: The Future of Work and Power (Basic Books, 1989), Shoshana Zuboff predicted the enormous opportunity and risk inherent in the digital revolution. Her husband, James Maxmin, has been chief executive of Laura Ashley, Thorn Home Electronics, and Volvo UK. They are a true business-intellectual power couple. But ask for them along the winding country road in coastal Maine, where they've settled, and neighbors offer vacant looks. "Wait," says one after a moment. "You mean the people with the deer farm?"

Zuboff and Maxmin do, in fact, farm venison commercially on their property. But for the past six years, their defining preoccupation has been their new book, The Support Economy: Why Corporations Are Failing Individuals and the Next Episode of Capitalism (Viking Penguin, 2000), a daring attempt to reconceive the way that business is done.

"People," they argue, "have changed more than the commercial organizations upon which they depend. And here is the new opportunity: In that chasm that now separates individuals and organizations lies the key to a new economic order with vast opportunities for wealth creation and individual fulfillment." We have arrived, Zuboff and Maxmin believe, at a "transaction crisis." Managerial capitalism succeeded spectacularly in turning us into a nation of individuals. "It has created a new world," Zuboff says. "We have more stuff and more access to experiences. But it's having all of those things that has turned us into people who think of ourselves as individuals and who want more control."

At the same time, most big companies are focused inward. Their resources are directed toward producing goods and services and bringing them to market and on preserving their own structures and machinery. "Organizations have . . . become increasingly remote and indifferent," Zuboff and Maxmin argue. The result: "Individuals want something that modern organizations cannot give them: tangible support in leading the lives they choose."

But what if the relationship between corporation and individual were inverted? What if economic value was centered not in the goods that a business sold but in the consumers who bought those products? What if companies could realize that value only through relationships rooted in deep support?

Those principles are at the core of Zuboff and Maxmin's distributed capitalism. In this new logic, says Maxmin, "the individual is the unit of analysis. Value already exists, and it resides with individuals. And if that's where value sits, then all of the old systems and structures are no longer relevant."

The new competitors are "federated support networks," dynamic and fluid organizations that provide consumers with varying levels of deep support, along with unique aggregations of products and services. Deep support means that federations assume total responsibility and accountability for the consumption experience. It is, in fact, the new metaproduct; relationships are merely occasions of deep support.

Consider the members of the Acero family, Zuboff and Maxmin's prototypical consumers of the future. The Aceros use several federations. One fairly basic, low-cost federation automates the Aceros' routine purchases and payments. Another supports more complex needs by providing a dedicated consumption advocate. When the Aceros travel, the advocate tracks their care during the journey and monitors home oversight, communications, and cash-flow management — according to instructions from the family.

When the Aceros want to buy a new computer, a federation directs them to Web pages that provide advice and product information. With that data, the family completes a "needs analyzer," which the federation uses to offer three alternative packages. The Aceros select one, and the federation takes responsibility for the computer's delivery, any troubleshooting, and ongoing education.

Does this sound just a tad fanciful? Perhaps. But it's not difficult to imagine a Wal-Mart federation that would apply its purchasing and logistical skills to a consortium of suppliers. Maxmin argues that home-delivery pioneers such as Webvan and Kozmo, despite their unhappy fates, "had a tiny glimpse of this. They saw that you can give people back their discretionary time." What they lacked was the enterprise logic to make it happen. Deep support isn't viable without that logic.

The costs of running the basic functions replicated in every company — accounting, legal, payroll, logistics, and the like — typically chew up 25% of revenue. Under the logic of distributed capitalism, the replication of those functions would be eliminated as they migrate to a ubiquitous digital platform. The platform would capture all transactions and other relevant data while integrating processes and functions across enterprises and federations. Critically, no player in a federation would get paid until the end consumer paid — and all accounting would be rooted in cash, to reflect the consumer's preeminence.

It's a long way off, of course. The support economy, like Downes's strategy machine and Hamel's post-industrial organization, implies bold leaps. But it will also require some dramatic technological, economic, and societal advances. Exactly how might we construct the federations' massive digital backbones? How will we convince executives that information assets, unlike physical assets, are more powerful when shared? How do we measure innovation in big organizations? How do we value ideas?

Hamel, Downes, and Zuboff and Maxmin admit that they can't fill in all of the blanks. And while that is frustrating, such half-baked vagueness makes their visions all the more powerful. Because ultimately, filling in the blanks is up to all of us. "What we're talking about," says Zuboff, "is social invention. That sort of invention comes from social movement. It comes from different people coming into the ring, knocking heads, imagining, and experimenting. And that's the good part."

Keith H. Hammonds (khammonds@fastcompany.com) is a Fast Company senior editor based in New York.

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