Playing To Win
The Precision Modern Company
Last week, I had a conversation with a CEO client on the best way to think about outsourcing, and that caused me to recall a memo that I wrote on the topic to another CEO 21 years ago. When I went back to find and reread the memo, my reaction was that it made even more sense today than two decades ago. For that reason, I decided to tackle the subject as my 51st Year II Playing to Win/Practitioner Insights (PTW/PI) piece, The Precision Modern Company: Shaping it to Focus & Motivate Your Talent. You can find the previous 103 PTW/PI here.
The Super Sizing of Companies
Companies had already gotten huge by the time I wrote that 2001 memo, having grown monumentally in the second half of the 20th century. For example, in 1960, General Motors (GM), was the biggest private sector company on the planet at a revenue of only $11 billion. But it was $189 billion by 2000 — four times bigger in real terms. Since then, companies have gotten still huger. The Fortune 10 companies have grown real revenues by 64% since 2001. And the median employee count for those companies is 225,000, which is equivalent to a Top 100 US city, approximately the size of Richmond, Virginia.
To understand why we have the companies we do, we need to go back to Ronald Coase’s landmark 1937 article, The Nature of the Firm (which would win him a Nobel Prize many years later). Coase asserted that the reason why companies exist and choose to engage in activities inside their bounds rather than outside is transactions costs. The company could do many of the things it does inside through contracts with outside firms, but it would incur prohibitively high transactions costs — including contracting costs, monitoring costs, and dispute resolution costs. Hence it chooses vertical and horizontal integration to avoid the transactions costs. Coasian transactions costs logic drove companies to assume that until otherwise proven, activities should be performed internally, which spurred their massive growth in size and staffing.
A Counterpoint to the Logic
However, since Coase made his external transactions cost argument, we have come to understand that there are internal transactions costs too. This was pointed out in 1976 in the legendary Michael Jensen and William Meckling article, Theory of the firm: Managerial Behavior, Agency Costs and Ownership Structure. It documented how problems of imperfect agency — i.e., managers whose incentives for action are not aligned with the interests of the firm and its shareholders — create massive inefficiencies inside companies. And these agency problems grow with the size and complexity of organizations.
Many business leaders see the fight against the resultant internal bureaucracy to be one of their biggest challenges. Hence business leaders are now more likely to consider the tradeoff between internal transactions costs and external transactions costs instead of focusing in isolation on the magnitude of external transactions costs.
Meanwhile, external transactions costs have fallen systematically over the 85 years since Coase’s article. The monumental increases in the power of information technology have made the costs of coordinating with outside actors much lower. Additionally, globalization has allowed the development of suppliers who have world scale in narrow niches, and they have become attractive candidates for activities previously carried out internally, such as software development with giant India-based low-cost outsourcers.
But as of 2022, the most compelling logic for me in rethinking the boundaries of companies is the war for talent. High-end talent is demanding a more robust sense of meaning in their jobs. They want to feel that they are making an important contribution to a company about which they care deeply. But in a firm as big as a medium-sized city, it is hard to ensure the meaning in jobs when there is a huge disparity in the true importance of their jobs to their company.
There are activities that fulfil table stakes and others that are integral to advantage. And it is difficult to motivate and compensate talent in both those disparate activities in a way that contributes to competitive advantage. Companies tend to average across the two activities. They pay too much for table stakes activities and too little for activities integral to advantage. They set standards of performance too high for the former and too low for the latter. Both make it difficult to attract, retain and motivate top talent and to achieve the strongest competitive position.
Becoming a More Precise Company
I believe that modern companies must work hard to overcome the counterproductive averaging to become more precise and competitive companies.
Determining the Activities that are Integral to Advantage
The effort begins with determining the activities that are integral to advantage. Note that I focus on activities, not entire functions. People think of P&G as a marketing-driven company, so they would assume that everything done within the marketing (they call it ‘advertising’) function must be critical to advantage. Yes, and no. Aspects of that function most certainly are. But P&G fully outsources its advertising copy creation to outside advertising agencies. Every P&G ad that you see online or on TV has been outsourced. However, all the marketing strategy work leading up to providing a brief to the agency is critical to advantage and done internally. All the copy testing and subsequent work is proprietary and critical to advantage — and is done internally. In this case, P&G is precise by activity — not broad brush by function.
It is a set of these activities across the array of functions that produces the How to Win at the heart of your strategy choice. To be a precise company, these activities integral to advantage require very careful definition.
Activities Outside Those Integral to Advantage
For all activities outside the set of advantage-producing activities, the goal should be to outsource them if feasible. It won’t be feasible in all cases because to successfully outsource an activity, three features need to be present. First, you need to be able to define the activity precisely enough to specify the desired outputs in a service level agreement (SLA). If the definition is fuzzy, it will be impossible to define an SLA that is workable and enforceable. Second, the transactions costs of creating and managing the outsource relationship need to be sufficiently low for the outsourcing to make sense. Third, outsourced suppliers must be available. If there isn’t a relatively robust set of suppliers from which to choose, outsourcing could put the company in the hands of a monopoly supplier who is able to extract disproportionate benefits from the relationship. To the extent that an activity has these three features, it should be contracted to be done outside the boundaries of the company, not inside.
Activities that Appear to be Integral to Advantage
For the activities that appear to be critical to advantage, they should be thin-sliced as with P&G marketing above. At first blush, ad copy creation might well have seemed like an activity critical to P&G’s branding advantage. But with further assessment it was clear that the activity could be specified well enough to define an SLA, the transactions costs were manageable, and there are a host of ad agency suppliers — and P&G could create proprietary advantage in other aspects of branding.
However, for activities critical to advantage, a fourth criteria needs to be added: can an outsource partner provide superior performance on the activity in question? In the case of ad copy development, I suspect P&G recognizes that its culture and operating environment is not as conducive to producing great copy developers as the culture and operating environments of the great ad agencies of the world. Their professionals can work on a wider variety of projects than can P&G marketing personnel and can choose to live in ad agency hubs such as Manhattan and Chicago rather than Cincinnati. Plus, these agencies have the scale and cumulative experience in ad copy creation that P&G could never replicate. If outsource partners can perform an activity better than you, yet you keep it inside, you can bet your competitors will outsource for an advantage over you.
Herman Miller (MillerKnoll since a 2021 merger with Knoll) is another example of thin-slicing to outsource a key activity in order to improve performance. It is the most lauded and honored office furniture designer of all time, with arguably the best understanding of office furniture design of any firm in its industry. However, virtually all its most successful furniture has been designed by outside designers, in stark contrast to its major competitors like Steelcase and Haworth. Why? Because Herman Miller has long believed that the greatest furniture designers are industrial designers who spend a goodly portion of their life designing things other than office furniture. Such great designers won’t want to be cooped up in an office furniture manufacturing company. They will want to be in an industrial design firm. Hence, Herman Miller, though it is fabulous in design, would not be able to create as favorable culture and operating environment inside for design as other alternatives — e.g., private design boutiques — so it outsources design, which is close to the heart of its competitive advantage. But it keeps inside setting the design brief, managing the design process, ensuring design for manufacturability, among other activities flanking the industrial design itself.
The goal of a precision company should be to place each activity with an organization in which the jobs involved are critical to their competitive advantage. The creatives in ad agencies are central to the competitive advantage of ad agencies. The designers in industrial design firms are central to their competitive advantage. That talent will produce at its best when it is in a place that values their talent at the highest level.
Some years ago, I was involved in a major outsourcing at a client. As part of the deal, my client reserved the right to survey its employees who transferred to the outsource partner for 5 years after the closing. The results were striking. While my client had been accused of selling loyal employees into indentured servitude, the average job satisfaction of the transferred employees was statistically significantly higher, and they enjoyed a superior compensation and promotion trajectory than prior to transfer. Why? They were more important in their new company, which specialized in doing the sort of work for which my client contracted, than they had been at my client.
The overarching goal isn’t to make companies smaller. Some will become smaller, and some will become bigger. The goal is to reshuffle talent and tasks so that each company has a far greater proportion of its talent working on activities that are central to its competitive advantage. That would result in more businesses like Shopify, ADP and AWS. That will produce happier workers and higher productivity in the business sector overall.
In an economy in which must-have talent in expressing its power to work where it wants and how it wants, it has become imperative for companies to create an environment in which the highest possible proportion of its talent is working on activities that are integral to its advantage. That is what will enable companies to pay and treat talent in a way that attracts and motivates the talent that companies need to achieve and maintain advantage.
That means being aggressive on partnering for as many activities for which you need only to match performance standards of your competitors. And it means thin-slicing activities that appear integral to advantage to enable outsourcing pieces of those activities that could be performed better by a partner.
This effort shouldn’t be limited to those at the top of your company. At every level, managers should seek to have their operation engage only in activities that are truly integral to competitive advantage. Conserve every internal slot for talent that can help you build your competitive advantage. When you do, your unit, whether tiny or large, will perform at its best.