We would like to offer our thoughts on the current business environment for industrial companies, what the future holds, and the best course forward.
Where We Stand
Call it the age of uncertainty — this post-Great Recession environment when a weak recovery and any number of troubling signs globally cast shadows on relatively strong recent profit results. The future for industrial companies is a somewhat confusing blend.
On the plus side, industrial revenues (unadjusted for inflation) in the first nine months of 2011 topped levels last seen in the peak year of 2008, and earnings in this period were up 25 percent compared to January through September 2010. Average net profit margins at industrial firms are relatively robust again: about 6 percent now, a 6 percent improvement over last year. Emerging economies drove most of this growth, as real GDP gains in developed nations slowed to a meager 1.5 percent in 2011. In addition, the Dow Jones Industrials Index was down only 5.7 percent compared to an 11.4 percent drop in the overall stock market during that period.
The bad news, though, is that there is bad news — and it can't be easily ignored. For one thing, consumers and companies are still hesitant to spend their money — the Purchasing Managers Index tumbled in the first nine months of 2011, to 51 from 61 — and unemployment remains stubbornly high. Concerns persist that a second global recession — a double dip— is increasingly possible. Perhaps even more disconcerting, no matter what happens in the developed economies, GDP growth is already slowing in the most important emerging nations.
Given this uneven blend of trends and forecasts, it's little surprise that industrial companies have been conservative strategically. This can be seen, for example, in the pace of mergers and acquisitions. Although at the end of 2010, industrial outfits were relatively flush — cash on hand surpassed 14 percent of revenue compared to an average of about 9.5 percent during much of the past decade— the popularity of M&A has flagged recently. In the first nine months of 2011, the number of deals fell by at least 25 percent.
Instead of acquisitions, most successful industrial companies have been content to cut costs, prune their product and business unit portfolios, deleverage, and hoard cash. While that approach has perhaps put these companies in a position to navigate uncertainty, it is nonetheless a questionable tactic. Simply put, if industrial firms sit on the sidelines with their cash for too long, they may end up underinvesting in their businesses and innovation — and minimizing their growth prospects.
Over the next few years, we believe, industrial companies should view the glass as mostly half-full. They should have enough cash on hand to weather a crisis or two, but more important, they should use this time to put their money to work, particularly when many of their rivals will likely be reluctant to make bold moves. In other words, this is a perfect moment for smart industrial companies to invest in developing the capabilities, assets, and strategic intelligence that allow them to achieve and sustain competitive advantage and that prepare them to take a leading position in their industrial sectors when opportunities for growth emerge.
A Capabilities Strategy
We define capabilities as the three to six distinctive strengths your company has (or should develop) to set it apart from competitors. Each capability is built on a combination of processes, tools, knowledge, skills, talent, and organization. While we strongly believe that it is crucial for every company to make conscious choices about the capabilities that they need to develop or acquire, there are general capability guidelines for industrial companies that could be the starting point for a differentiated business model in this current dicey environment. For example, industrial companies are discovering that functional capabilities — like IT, talent development, and managing supply chains — cannot improve organizational performance in isolation, no matter how strong these functions are. Instead, the future belongs to companies that distinguish themselves by integrating and blending capabilities from their most critical functions in smart and unique ways. The following capabilities stand out as the most essential for industrial companies to develop and align:
Agile Product Development and Strong-Form Product Management
Product life cycles are decreasing as the pressure of competition and technology breakthroughs drive frequent product upgrades, if not entirely new offerings. The problem is that nearly 50 percent of all products launched fail to live up to expectations because product design tends to be a rigid, linear process, in which customer input and preferences, technology, materials, and features are virtually locked in stone up front and then a long development and planning cycle ensues. By the time the product comes out, customers may have moved on to other interests or been satiated by another company's product. Moreover, numerous design, technology, specification, and materials changes have probably added costs to the manufacturing process, which reduces margin potential.
To overcome these obstacles and radically improve the chances that product launches succeed and keep pace with rivals, agile product development is critical. Long a staple of the software industry, this approach focuses on getting more feedback from customers up front, perhaps through crowdsourcing and beta versions, and making numerous design iterations in the earlier phases, as well as having a definite idea about what the product's core attributes should be and how the product should be made before the back-end development stages actually begin. This ensures that customer preferences are met and technology and materials decisions are made more intelligently in the initial stages, thus driving down uncertainty in the latter part of product development and making that phase less costly and more efficient. Considering the role that communications technology, networking, and software play in virtually every industrial product, including cars, microwaves, and heavy equipment, borrowing a set of efficient development techniques from high-tech industries is a logical evolution.
But agile product development will be for naught if product management is given short shrift. And this is the case at too many manufacturing companies, where core product management decisions are fragmented across a variety of functions: Sales may decide which products to maintain or kill; R&D may determine when an enhanced version of a product is ready for release; and operations may have the final say in choosing suppliers. Meanwhile, product managers are little more than administrators without decision-making power; their main roles involve managing channel decisions, overseeing formulation of changes and other incremental innovations, and taking account of customer needs and preferences to fine-tune individual products and services over the course of their revenue-producing lifetimes. This siloed approach often results in wasted customer insights, slow innovation, and disappointing product profitability.
A better course is something we call strong-form product management. Under this approach, product managers are elevated to a role above the other functions and given the authority to make decisions about the timing of innovations, pricing, channel strategy, and everything else that affects the success of product portfolios. At its best, strong-form product management is an accountability model — a way of assigning responsibility for results to a single individual who can take a full portfolio or life-cycle view, rather than to a series of people without a holistic perspective. At a time when competition and customer demands have both intensified, it can be a differentiating capability, fortifying the connections to customers and increasing the odds that a company will make the right trade-offs.
Strong-form product management is also a way of ensuring that high-level strategy makes its way into the products and services that a company sells. At a company practicing strong-form management, product managers become the focal point for strategy. The product manager's job at a low-cost manufacturer is to nix new, too costly features developed by R&D that are nice but unnecessary. At a company that distinguishes itself through the experiences it provides, a strong-form product manager resists lifetime cost-savings initiatives proposed by operations if those cost savings would erode the customer's sense of exceptional service.
For many years, industrial companies have focused on cost cutting-sometimes to the detriment of their businesses. Through top-down, across-the-board budget cuts of, say, 5 percent or more a year, operational expenses may be trimmed to the bone, but to what end? Are strategically critical activities axed too deeply because they are lumped together with more wasteful overhead items that actually deserve to be slashed by 50 percent? A more logical approach is what we call cost fitness; this involves analyzing costs separately by activity, diligently determining which business operations are directly responsible for meeting the company's strategic goals, and supporting those operations with adequate budgets. There are two areas in industrial firms that have generally been victims of cost cutting in the past that deserve reassessment in light of their potential contribution to improving a firm's performance:
1. Supply Chains
Decades of relentless focus on cost cutting have left industrial supply chains vulnerable to disruptions like the earthquake and subsequent tsunami in Japan and the floods in Thailand this past year. Severe material shortages occurred primarily because Japanese, European, and American manufacturers had not diversified their supply base sufficiently to have a backup when their Japanese suppliers were forced to cease production. More than ever before, we recommend that you reevaluate your supply chain, plan better for geopolitical risks, have multiple sources for critical products and adequate backups for less essential items, and not focus solely on cutting costs.
In doing this, manufacturers should also reconsider their outsourcing/insourcing strategies. Certainly, factory capacity provided by third parties has gotten cheaper over the last few years, but China is increasingly not the best option if low wages are the key criterion. Places like Vietnam and Thailand may be better choices. Indeed, the Chinese government recently released a plan to raise the minimum wage rates for manufacturing employees by 13 percent in the next five years.
But equally important, outsourcing should be assessed through a holistic lens-that is, the decision should not be based solely on the price of labor but also on critical elements like logistics, risk, quality, scheduling, and customer preferences. For example, when customers in developed countries are willing to pay for advanced service levels or top-quality output, industrial companies are increasingly manufacturing products in their own factories in these higher-cost regions, where they can also take advantage of skilled labor, modern infrastructure, the ability to drive innovation with world-class R&D, and capabilities like new manufacturing technologies or innovative lean production systems.
2. Information Technology
In the industrial sector, IT has typically been viewed as a cost to be managed and minimized. But that's not viable anymore, as companies must begin to look at IT as a capability and not purely an ancillary or support function. For one thing, in focusing on becoming more efficient, industrial companies should realize that significant structural cost is tied up in legacy processes-processes that often vary from business unit to business unit. Consequently, standardization of business processes and consolidation of IT systems around a common enterprise solution are more and more critical. In the past, these efforts have produced only mixed success. But what appears to be different now in companies that have undertaken IT-enabled business transformations is the degree of broad senior leadership engagement. Top managers outside IT are taking lead roles in ensuring that the future-state operating model, processes, and execution road map for systems-driven transformation programs are aligned with the company's overall strategy and capability development goals. More strategic development of IT can foster a greater focus on digitization of the value chain using technology to provide a deeper level of integration with suppliers, customers, and employees.
Rapid advances in new digital technologies offer industrial companies a wide swath of tools that can be used to take advantage of new opportunities ranging from improving equipment productivity to customer data management and analysis. For example, customer service can be improved by incorporating GPS, SMS texting, and mobile Web apps in logistics systems to provide real-time freight management for product and parts distribution. Or digital sensors can be embedded in mining trucks or HVAC systems, among many other pieces of equipment, to warn of potential malfunctions before they occur and disrupt operations at customer sites. When problems are detected, these systems can automatically schedule repairs. This translates into lower cost of ownership for the user, while the industrial firm can charge a premium for the product and reap additional sales from replacement parts, which in some industrial companies can amount to 50 percent or more of total revenue. Moreover, high-quality service and maintenance can help to create enduring customer relationships that give industrial companies a leg up for the next cycle of product purchases.
But even beyond these service improvements, digitization has the potential to be the centerpiece of long-term innovative sales strategies targeted at improving customer loyalty and the potential for up-selling. This is critical because during the next few years, industrial companies will face customer markets (OEMs or end-users) that are either shrinking or growing more slowly. Consequently, manufacturers must approach customers more smartly than ever before by, for example, upgrading CRM systems to deliver useful and valuable data and insights internally. These more advanced applications should provide sales leads or real-time information about existing customers (their preferences and their needs for the immediate and longer-term future) that can be regularly reviewed by global sales teams and shared across functional silos to ensure coordination in the pursuit of customers and marketing support differentiated by types of customers.
Media mix also needs to be addressed in the context of digitization. As digital channels become more prevalent and popular, the importance of trade shows and print advertising may need to be reassessed. Even companies in a business-to-business sales environment should take advantage of social media like Facebook, Twitter, and YouTube to build product awareness and interest. Product demonstrations or interactive online sessions with engineers and designers could be powerful tools for talking directly to prospective customers and for improving productivity in sales efforts.
Winning the Talent War
Despite high unemployment rates in developed countries, the supply of skilled workers who can engineer, design, sell, and service industrial products is meager at best. In the U.S., the unemployment rate for people with a four-year college degree (or higher) is 4.3 percent. Consequently, it's critical for industrial firms to make their jobs more attractive to smarter and younger workers by, for example, offering more collaborative workplace experiences that engage workers and give them opportunity to continuously improve and seek productivity gains, or by targeting jobs to specific demographic group preferences (studies have found that members of Generation Y want more time off and are less concerned about money). In addition, manufacturers should proactively seek talented employees by participating in campus recruitment events and industry job fairs, increasing the number of college internships, forming partnerships with local colleges and universities to identify and sponsor talent, inviting students of all ages on factory tours to show that manufacturing can be a rewarding career, and partnering with other manufacturers to jointly support specialized training programs or attend far-away recruitment events.
Developing the BRIC Markets
The BRIC economies may be slowing a bit, with less than 7 percent GDP growth forecast through the end of 2012, but for many industrial companies they represent the best opportunities for growth. Still, making a substantial profit in those countries is not easy. Overcoming the impediments to profitability — which can include navigating local rules, regulations, and cultural differences; competing with government-favored domestic companies; recruiting sufficiently skilled workers; and overcoming inchoate infrastructure and logistics networks — requires building a globally effective organization and operating model with more dispersed governance structures and decision making than has been typical of industrial multinationals in the past. Manufacturers should focus on acquiring, managing, and sustaining an increasingly global and diverse talent base across multiple geographies; building practical mechanisms to support global collaboration; and driving a cost and process structure that is lean and flexible.
We hope that this letter stimulates your thinking about the capabilities your organization should develop or strengthen to compete in a period of uncertainty. We would welcome the opportunity to hear your thoughts about the year ahead and to discuss how you might create a more prosperous 2012.
For more information, visit strategyand.pwc.com