5

Cut Costs to Grow Stronger

Ever been to the Danaher Open? Watched the Danaher 500 on TV? No, you haven’t. Industrial conglomerate Danaher doesn’t sponsor big-time sporting events. That’s not who they are. Nor does it conduct corporate or image advertising of any sort, and its PR is handled by investor relations. It also does without some other things you might expect to find at a company its size—like expensive office furnishings, even for its top executives.

Danaher doesn’t bother with activities that don’t directly support its unique value proposition—its “way to play”—in the market. Instead, it invests where its identity is, as a science and technology leader comprised of well-run businesses in selected specialized industries. It pours money, time, and management attention into building up its differentiating capabilities. For example, incoming executives, whether recruited from the outside or joining as part of an acquisition, go through an extensive onboarding program, including an elaborate introduction to the Danaher Business System and stints in several businesses within the Danaher system. This onboarding can last several months—a significant investment, especially when multiplied across many new leaders. But it ensures that when they finally take the reins of part of a business, they are equipped to handle it in Danaher’s way.

Outside of its capabilities system, Danaher watches its funds carefully. It spends only what is necessary to compete in the industry sectors where it does business: scientific and technical devices, instruments, life sciences equipment, and industrial tools and components. (As we noted earlier, Danaher announced that it is spinning off this latter line of business to a separate company in 2016.) And it spends even less on everything else.

Danaher’s thoughtful, disciplined use of resources is ingrained in everything it does. Like IKEA’s executives, Danaher’s executives treat the company’s money as a precious resource over which they have stewardship. This will likely strike you as something all companies do, and of course, most companies recognize that cash is a precious resource, and most companies strive constantly for cash savings. But they manage costs separately from strategy. In fact, only rarely does a company link its expense tracking and budget process directly to its value proposition or consider the budget’s effect on distinctive capabilities. If your costs are not fully driving your strategy, then what chance will you have to execute it successfully?

The answer is to place intensive interest in differentiating the costs that don’t matter from the costs that do. This important distinction is a way of life in most of the companies we looked at closely. Amazon, Apple, Frito-Lay, Inditex, Lego, and Starbucks have all garnered comments about the tightfistedness of their top management. Yet all of them are willing to spend money if they think it will distinguish them. And all of them have prospered as a result.

To close the gap between strategy and execution, you need to learn to allocate costs in a different way than you have in the past. Making this transition will often be a game-changing, breakthrough experience for you. To be sure, it may be triggered by desperation. You might be in financial trouble; if you don’t rapidly stem the bleeing, your survival could be in doubt. But it might also be triggered by an aspiration. You might sense that your company could do something powerful, something that you’ve never done before, if you deploy your cash more deliberately.

Danaher’s Identity Profile

With headquarters in Washington, D.C., Danaher is a group of companies that produce industrial components, instruments, and other devices for scientific and technological industries, including life sciences. Since 1980, its annualized returns to shareholders are three times higher than that of the S&P Industrials Index.

In 2015, Danaher announced a forthcoming split into two companies: a focused science and technology company (which will retain the Danaher name) and a diversified industrial growth company.

Value Proposition: As a “company that builds companies,” this consolidator adds value through M&A and operational excellence. These capabilities enable its member companies to be B2B category leaders, consistently offering high-quality, reliable products and solutions in what otherwise would be a diverse group of professional, medical, industrial, and commercial enterprises.

Capabilities System

Portfolio of Products and Services: Danaher has grown since the mid-1980s into a conglomerate with almost $20 billion in annual revenues and forty-one businesses spanning five manufacturing sectors: dental; environmental; industrial technologies; life sciences and diagnostics; and testing and measurement.

Either way, you are probably already aware of the dangers of across-the-board cuts. You have seen first-hand how they weaken companies. This time will be different. Instead of seeing growth and frugality as opposing imperatives, where cutting costs means giving up the chance to grow, you will treat every cut as an opportunity to channel investment toward building advantage.

You now begin an exercise in strategy and cost management that will empower you to bring your capabilities system to life. You will judge the value of each business, function, or project according to how it lines up with your company’s value proposition and capabilities system. Distinctive capabilities will get the resources they need to realize their full potential. Everything else is up for reconsideration, as if it’s a new expense. You’ll gain an in-depth awareness of the expense of building, maintaining, and extending distinctive capabilities systems. You’ll pay for them by taking the money from everything else. Cutting costs to grow stronger will become an essential part of your company’s culture. Aligning your internal investments with your strategy will help you overcome the habits of mind built into your existing budgets, and to build up your critical capabilities, even as many of your competitors weaken themselves by cutting costs across the board.

During this exercise, you’ll assemble working teams from every part of the company to identify the expenses that need to be cut. They will appreciate that they are freeing up money for reinvestment. But no working team should have the authority at this stage to spend that money. A central steering committee will be needed to oversee the decisions. The executive committee or the CEO will need to approve them, on behalf of the capabilities system of the whole company. Investment capital is precious, and there will never be enough to go around. The organization must make the best use of its funds as a whole, and that can only be done from the core.

This exercise will give your enterprise the freedom to make the right choices over the long term, choices that are required to close the gap between strategy and execution. You will make a transition from pro forma annual budgeting to strategic resource allocation. This may not be easy for you—it is very difficult for many companies. But it can be done—and the rewards are immense.

How Frito-Lay Found Funds for Growth

When Roger Enrico took the helm as CEO of Frito-Lay in 1991, the company was still developing its remarkable capabilities system, including the innovative and distinctive approach to direct store delivery that we described in chapter 2.¹ At the same time, however, its growth had stalled and it was facing strong competitive threats. Eagle Snacks, after ten years of efforts to compete with Frito-Lay, was steadily gaining market share and approaching profitability. They had just launched a successful knockoff of Doritos, one of Frito-Lay’s most profitable brands. Eagle Snacks had also poached some of Frito-Lay’s sales executives and was beginning to leap forward in its merchandising skill and its own effective distribution system.

Worst of all, other Eagle Snacks products were, for the first time, outperforming their Frito-Lay counterparts in blind taste tests.² Some observers saw this as a slap in Enrico’s face. He had been the PepsiCo executive who had pioneered blind taste tests to beat Coca-Cola under the banner of “The Pepsi Challenge.” He may have seen it the same way; in any case, he reacted decisively. He temporarily shut down a poorly performing plant to demonstrate how seriously he took quality issues. Like Zhang Ruimin’s refrigerator-smashing at Haier (see chapter 2), this was a symbolic gesture, to make sure everyone at Frito-Lay understood that the company’s reputation was at stake.

Enrico explicitly stated how the company would regain its dominant position in the industry. First, Frito-Lay would “make quality a reality”: it would invest in brand-building and improving the value of its products. It would also “take back the streets”: use its DSD capability to outmaneuver Eagle, stopping it in its tracks. And the company would “empower the front lines,” reconfiguring the field organization to aim directly at Eagle Snacks and its nascent relationships with distributors.

But how would Frito-Lay fund the expansion of its capabilities system to do this? Enrico resolved to start by cutting US$100 million in annual general and administrative costs. This cut represented 40 percent of the expenses in these functions. Several external cost-cutting experts were invited to help, and each said that this plan was impossible. Cuts of 15 to 20 percent would be more realistic, they said. Enrico shook his head and decided that Frito-Lay would do the cuts itself. Indeed, to ensure that everyone at the company understood how serious he was, he put Charlie Feld, the developer of the merchandising handheld computer and a company hero, in charge of the effort.

As part of the cost reductions, the company laid off eighteen hundred managerial and professional people in just one day. The transition was, of course, highly traumatic for everyone involved, including those who stayed.³ But it was also liberating for the company. The cost reduction wasn’t just a layoff exercise; it removed layers of management and many unnecessary practices—enablers of incoherence—and led to a much higher level of responsiveness and effectiveness. The action also freed up money to invest in Frito-Lay’s distinctive capabilities: its direct store delivery, rapid-cycle flavor innovation, consumer marketing, and high-quality manufacturing, all of which needed continuous upgrading and development.

One marketing executive from that era remembers helping a brand manager, just before the layoffs, try to make a case for adding a new factory to make Rold Gold pretzels. The category was growing and there were product shortages: “The [brand manager’s proposal] for new capacity was a no-brainer. Even the guys in the finance department thought so.” A meeting seeking the necessary approval from about a dozen managers went smoothly, with no questions asked. Yet the next day, the proposal was rejected, apparently for purely bureaucratic reasons. It contradicted the established schedule for new factory construction, which was laid out years in advance.

After the layoffs, the brand manager convened a repeat meeting, inviting the same group. Only a handful were left at the company. The approval processes were instantly streamlined. The request sailed through.

“While the transition felt terrifying,” the marketing executive recalls, “we were all blown away, not by how little went wrong after that, but by how much went right. Eliminating ‘sacred cow’ initiatives was suddenly easy. Nobody had the time or the people to do anything except the top strategic priorities.” Another big change was directly related to empowering the front lines; suddenly, Frito-Lay could tailor programs to specific markets and work with store managers much more easily. “We had all been held back by our own controls. Those were replaced with a sense of purpose and freedom that no one will ever forget.”

Within two years, Frito-Lay’s quality was back at the top of the sector, its brand equity scores were climbing exponentially, and Eagle Snacks was on its way to oblivion. Frito-Lay’s other leading competitors were also hurt: Borden was forced into liquidation and Keebler withdrew from the salty-snacks category. In 1996, with no other competitor willing to buy them, Anheuser-Busch sold four out of its five Eagle Snack manufacturing plants to Frito-Lay for a fraction of their investment.⁴ Frito-Lay grew its US market share from about 50 percent in 1992 to more than 60 percent in 2000, a share it has maintained or exceeded to this day. None of that would have been possible with the old cost structures, and the incoherent management practices they engendered, in place.

Where to Find Funds

Having made the important decision to connect cost to strategy, you now begin to rethink your investments in capabilities. These were probably hidden in the past within an array of functional budgets. You need to unravel those costs and sort out the implications of your current spending patterns. That is the purpose of what we call the “parking-lot” exercise. In this exercise, you list all the expenses related to the activities of your enterprise. You move them to a metaphorical parking lot. One by one, you’re going to decide whether or not to let them back into the building.

As shown in figure 5-1, this spending should be broken down into four categories, depending on the type of activity and its relationship to your distinctive capabilities system.⁵

Because this analysis divides your cost by capability, rather than by division or function, it allows you to see how closely your spending is tied to your strategy. The analysis will not be easy, because most conventional expense-tracking systems don’t assign costs to capabilities. Your new approach will probably raise some cultural and operational issues that, as we’ll see throughout this chapter, require direct leadership attention.

The first of the four categories is differentiating capabilities. All these activities are related to the few things you must do better than anyone else to excel at your value proposition. They should get as much investment as they need—enough to fund the point interventions, capabilities innovation, and acquisitions needed to build them, and to fund the costs of scaling them up across the organization as we

Sometimes this high level of resource allocation doesn’t seem fair to other parts of the company. But such outsized investment is justified by the strategic importance of differentiating capabilities. Inditex, for example, sometimes pays to air-ship its clothes to stores in line with its capability in rapid-response manufacturing and operations. CEMEX, in the midst of a financial crisis after the meltdown of the global housing market, still invested in its knowledge-sharing platform to support operational efficiency, sustainability, and innovation. And as discussed earlier, Frito-Lay’s entire direct-store delivery system is much more expensive than traditional distribution methods for consumer packaged goods. But all these expenses are more than paid back in revenue and profit growth.

And then there’s Starbucks. It invests in the well-being of its partners (employees) because it sees the company’s relationship with them as a differentiator. Indeed, recruiting and managing a cadre of dedicated employees is one of its distinctive capabilities; it ensures that the high turnover and inattentive indifference of other retail chains will not be evident at Starbucks stores. “Why didn’t every company work that way?” Michael Gill asks in his memoir about working as a Starbucks barista after losing his job as a J. Walter Thompson executive. “Because, I had to admit, it cost money. Most companies didn’t want to really give their people decent health benefits … It cost too much money. No other company I knew gave part-time people such incredible benefits. And stock … The company’s respect was backed up by costly investments in me and every [employee].” He says that because he didn’t want to risk losing his job, he would not treat his work at Starbucks casually. The interest the company takes is an investment paid back by most of the people there.

The second category, table stakes (sometimes called competitive necessities), includes the activities that aren’t related to your differentiating capabilities, but that you need to stay viable in your industry. Every industry has its own table stakes, which are recognized by insiders and are often unseen by outsiders. In the auto industry, if you’re not already proficient in lean manufacturing production and the implementation of digital features, even in the least expensive vehicles, you won’t survive. In the chemical industry, sophisticated prowess in sourcing and procuring raw materials is a condition for entry. The same is true for specialized recruiting in the oil and gas industries, where there are recurring cycles of oversupply and undersupply of petroleum engineers.⁶ User interfaces that work seamlessly across multiple platforms constitute the table stakes in the media industry, whose audiences routinely tune in through mobile phones and tablets. In health care, the table stakes include the ability to forecast demand, as the number of people needing medical attention fluctuates with various factors. Appendix D describes table-stakes capabilities in more detail for the biopharmaceutical, retail, and technology industries.

When thinking about table-stakes allocations, make sure you target the right level of proficiency: All too often, companies underinvest in some table-stakes capabilities and overinvest in others. There is always a temptation to overspend in some of these areas because your competitors do or because you always have. But while table stakes get you in the game, they do not differentiate you. Don’t assume you have to spend as much as your competitors spend. Your goal is to increase efficiency and stay in the game without draining investment or attention from your differentiating capabilities.

Starbucks’ Identity Profile

Based in Seattle, Starbucks is a coffee roaster and a retailer of coffee and other beverages, known for the ambience in its retail stores.

Value Proposition: Purveyor of the “third place” for conviviality—a center for human activity after home and work—this experience provider and category leader has one of the world’s most iconic brands.

Capabilities System

Portfolio of Products and Services: Starbucks manages retail stores; sells coffee, tea, and related food and beverages in a variety of forms; and continually innovates new products for its own stores and for groceries.

This temptation is especially difficult to resist in rapidly evolving industries, where the list of potential table-stake activities continually grows longer as companies compete. They get caught up in an arms-race-like melee, trying to match each other’s investments and prowess. In these industries, all companies start to look the same.

When Qualcomm first began to develop its CDMA technology for licensing, the company ran up against a table-stake requirement. Without semiconductor design and manufacturing capabilities (which its leaders called infrastructure), it could not sell its platform. At that time, in the 1980s, the existing computer industry was not equipped for outsourced manufacturing. So the company built its own fabrication plants, making the specialized integrated circuits needed to connect to CDMA, thus demonstrating that the manufacturing was feasible. A few years later, Qualcomm built additional factories to make handsets for digital mobile phones.

“Qualcomm essentially had to bootstrap its own industry,” Dave Mock says in his book about the company, “hoping that at some point in the future, partners or joint ventures would relieve it of this necessity.”⁷ The company increased its factory footprint from seventy thousand square feet in 1994 to more than two million square feet in 1996.⁸ The costs came directly out of earnings growth—which undermined shareholder confidence.

There were benefits, to be sure—Qualcomm controlled the product, learned from production, and got its wares quickly to the phone companies—and the company leaders considered establishing a permanent manufacturing capability. But other companies that were better equipped for this job were now emerging. The pace of change in fabrication was exhausting, and Qualcomm began losing bids to manufacturers that could handle the fabrication better. Thus, in 1998, Qualcomm’s leaders decided to spin off manufacturing altogether. They sold off the last factories, which made handsets, to Kyocera in 1999.

Thereafter, Qualcomm invested in manufacturing when it had to, but always with an exit strategy. As with any table-stake activity, the company’s goal was always to make the transaction as cleanly and inexpensively as possible, saving the greatest investment for capabilities that mattered more.

The third category is lights-on activities. These basic business costs are required simply to operate. Legal, administrative, and facilities costs often fall in this category. Lights-on activities should receive just enough cash to keep things going (which will typically be less than competitors spend and proportionately less than table stakes). These costs should be subject to strict scrutiny, constant pruning, and a continuous search for greater efficiency.

The final category is simply costs that are not required. These costs do not contribute to the business in any tangible way, but nonetheless show up on the income statement. There is generally more in this category than you’d expect. In extreme cases, we have seen such spending constitute as much as 40 percent of a company’s budget. Almost every company will have some obvious candidates for this list: a layer of management that was once important, an internal approval process that is no longer needed, upkeep on several buildings in a country where no one is willing to decide which offices to close, or an underused corporate jet.

There may also be an array of legacy functional projects that are often created with great intentions and backed up with elaborate IT infrastructure but that no longer serve any clear purpose except perpetuating themselves. They may have come into existence to support a part of the business that required different capabilities from the rest. These initiatives may have been funded for years, fostering incoherence. This analysis gives you an opportunity to reclaim those funds for more strategic purposes.

The not-required costs are pernicious enemies of success and growth. Not only do they drain financial resources, but they also fund activity that distracts from the core work of the company and drives a wedge between strategy and execution. Realistically, no enterprise, not even the most coherent, will reduce this category to zero, but you should reduce it as much as possible. The only way to do that is to go back to your identity—and test whether each set of costs will further any part of your strategy. If the answer is no, then you may have to let go of a part of the enterprise, even if it has historic or sentimental value.

Out of the Parking Lot

The parking-lot exercise allows you to break free of the budgetary practices of the past. Year after year, in many companies, annual budgets are determined in relation to those of the previous year. They typically represent the same trajectory as in past spending, with only slight variations. Now all this is going to change. You are using this exercise to rethink your costs from a capabilities perspective, in light of your strategic priorities.

Conduct this exercise at the business unit level. In many companies, you’ll need to divide the costs into subgroups, ideally organized according to the broad capability the costs seem to fit best. Assign a working team to each group, with the mandate to develop a rationale for each expense in light of its strategic relevance. Until all the working teams have made their recommendations, the senior core team can’t create a holistic picture of the investments being allocated and their larger impact on capabilities. If you are a member of one of these teams, you will have to challenge everything based on your understanding of the overall company’s identity and strategy, not the priorities of your part of the company. Is the activity critical to your company’s value proposition and capabilities system? If so, it’s part of a distinctive capability. If not, do you have to be somewhat proficient at this activity, given your industry (a table-stakes capability) or business necessities (a lights-on capability)? And if not (a capability that is not required), how close can you come to zero spending on it?

Take the time to come to an accurate view of the connections between these expenses and your strategy. Adidas’ old museum of discarded shoe experiments might have seemed superfluous, but it was critical, as we saw in chapter 3, to the company’s revitalization. Putting it in the not-required category might have been disastrous. On the other hand, we’ve seen projects occasionally defended as critical to a company’s distinctive capabilities; but when examined closely, the link turns out to be mostly wishful thinking.

After cataloging all the expenses related to your differentiating capabilities, you’ll bring them back in from the metaphorical parking lot and begin developing plans for their further development (like the blueprints in chapter 3). You’ll usually find that your capability-building efforts have been starving for investment because so many resources have been channeled elsewhere. Then look at your table stakes. Ensure they are at necessary levels only and nothing more. Do the same for the lights-on activities. Everything remaining in the parking lot is not required: it is subject to dismissal or, at least, significant rethinking.

Occasionally, one of the table-stake or lights-on activities—and the costs that go with it—could suddenly acquire strategic importance; for instance, a telecommunications company moving into providing internet service might suddenly find that regulatory relationships demand much more attention and investment. No matter what investment you assign, however, the basic principle remains the same: the largest percentage of spending should be on your differentiating capabilities.

Coming to a final set of recommendations will undoubtedly take a bit of iteration. Each working team in turn must be prepared to help the members of the central steering committee (the core team) understand the risk or trade-offs of their cost-cutting recommendations. This information will also help the core team understand the benefits (or disadvantages) to the whole. The core team keeps track of all the ideas, maps them against the capabilities the firm needs, and makes adjustments accordingly. For example, if one working team suggests an investment in the marketing capabilities for the Far East region, the core team asks whether the company can take advantage of the scale of that capability for all product lines and perhaps for other places around the world.

Your old conversations about cost cutting were probably only loosely connected to strategy and largely focused on being fair. Your top executives worried about distributing the cuts evenly across the board so that no single group would have to change dramatically. Big cuts were made only under duress, and usually in the most visible (or immediately addressable) areas rather than the areas where there was a strategic rationale.

Now there are explicit conversations about relevance and purpose. You understand why each investment adds value, and you can thus look at all your expenses holistically and free up capital in a way you never could before. The tool “Spending Alignment” offers specific questions to help you close the gap between your company’s strategy and its budgetary practices.

The parking-lot exercise has other, perhaps unexpected benefits. First, it provides a tremendous release of emotional energy. Many business leaders dread the discussion of “not required” costs, but such a discussion can create much new energy. As in the Frito-Lay story earlier in this chapter, people experience the release as an escape from bureaucratic shackles and unnecessary constraints. By tackling these costs head-on and explicitly guaranteeing that you will reinvest the money in the capabilities system that you need most, you make it clear that you are not just making cuts. You are making it easier to create sustainable value.

To be sure, you’ll probably spark emotionally laden resistance from the organization at first. Some executives will have to consciously stretch their comfort zones as you go through this cost-analysis process. After all, nearly every activity, whether strategically relevant or not, has a rationale behind it. Some of these sessions represent a first step in a major overhaul that could lead to the departure of colleagues.

Yet executives also recognize the value of freeing up cash. When you raise awareness of the potential of investing more in distinctive capabilities, you can catalyze a massive change of attitude. We have seen increased awareness foster a climate of mutual accountability of the sort we described in chapter 4. People become willing to look anew at reducing costs, because they know a fresh assessment will enable a more effective strategy and make the entire enterprise feel like a better place to work.

One CEO opened a parking-lot exercise by putting up a slide and saying, “Look at all these departments that are not essential to executing our strategy. Many of you are in those groups, and I’m sorry about that, but we have to be clear minded and clear thinking in what we’re about to do. You can still be a hero, if you’re in one of these less important groups, by creating the leanest operations possible.”⁹

Another benefit of this exercise is the movement of cost allocation from functions to capabilities. As you decide where one activity ends and another begins, think outside your functional definitions. That in itself brings clarity to your decision making. When costs are tied to established functional areas, then functional leaders have an incentive to treat any cost management as a challenge to their department’s value. Who can argue with sales costs, marketing costs, or costs for ensuring quality? The trade-offs between expense and strategic value are almost invisible in the functional context, and the true value of each expense is masked.

For example, in many companies, all of the investment in improving employees’ skills and proficiency is consolidated within a single budget line called learning and development, which is attached to the human capital function. Seeing training as a single cost center in this way will make it hard for you to differentiate between the training that really matters to your capabilities and training that is less important. If you allocate those costs by capability, you’ll know which training deserves the attention of senior leaders. They may get directly involved, as Danaher’s top executives do in the company’s Danaher Business System training. Other training, such as that of support staff in how to use ERP software, will be relegated to the lights-on category.

You will find that this new approach is ultimately much better for functional leaders as well. It takes them out of the familiar budgetary trap common to incoherent companies, where the leaders never get enough cash to provide what the businesses ask of them, yet don’t have the time, capital, or support to innovate capabilities in the way that the business requires. In chapter 3, we described the trade-offs that functions must make in this situation, trying to meet multiple demands. Now, instead of forcing the functions into this impossible situation, the enterprise can have an open discussion about priorities, gaining insight into the way incoherence drives complexity in their company. These conversations can provide a huge relief for functional leaders who previously had to manage this problem on their own.

The parking-lot approach also replaces the conventional practice of pitting functions against each other in a pro forma way. In some companies, budget exercises routinely shortchange internally focused functions like HR while giving market-facing functions money according to last year’s results. With the parking-lot exercise, there is more opportunity for mutual accountability. The rationale for cost allocation is clearer; it is expressly articulated by the management team with the overall strategy in mind. Whatever is needed to create value is more likely to gain support.

This exercise may also prompt you to look at outsourcing in a new light. Outsourcing becomes a strategic vehicle for rationalizing (and often improving) your table-stakes and lights-on expenses. In make-or-buy decisions after you’ve conducted the parking-lot exercise, you’re not just looking for cost reductions; you’re looking for a long-term relationship that will enable you to deliver these functions more effectively. When it comes to distinctive capabilities, outsourcing can still play an important role if access to talent, knowledge, or tools will be easier to gain that way. However, if you have proprietary advantages in this area, make sure your distinctive capabilities are carefully managed and protected.

Finally, the parking-lot exercise makes some use of benchmarking. In chapter 3, we discussed the perils of benchmarking. When you benchmark what other companies are doing, you risk setting yourself up to borrow practices and processes that erode your differentiation. But once you have divided your activities into these four categories (differentiating, table-stakes, lights-on, and “not required” capabilities), benchmarking becomes helpful. You can learn a great deal from the experience of other enterprises that have reduced the costs of table-stakes and lights-on activities. In particular, look for examples from companies that, like Frito-Lay, reduced their operational expenses dramatically under stress while becoming stronger in the process.

Benchmarking may also be useful for targeting where each category of costs should land financially. With differentiating capabilities, either there should be no similar examples in your industry at all or they should fall near the high end of the cost range—unless you’ve found your own way to deliver the capability at lower cost. Table-stake capabilities should cost no more than the industry average and hopefully less. And of course, lights-on capabilities should be at the bottom end of the cost range. Since few companies classify expenses according to their capabilities (which is why traditional benchmarks can be so misleading), it’s unlikely that your competitors do. Your benchmarks will come back with functional classifications, dividing the expenses related to a single capability among, say, marketing, operations, sales, and R&D. You’ll have to recategorize them so that you can translate those costs into the capabilities meaningful to you, or close-enough proxies.

A New Way of Life at Lego

There are plenty of examples of this kind of parking-lot exercise among companies that have closed the strategy-to-execution gap. One compelling example was Lego’s war room, which we described earlier in the book. CEO Jørgen Vig Knudstorp set up the room in 2002, and he and a group of top managers met there daily to work through issues, redesign their operations, and figure out ways to cut costs. The give-and-take was instrumental in putting Lego on a profitable course.

One important factor was the decision to suspend growth plans until the managers had rethought their expenses. “Many of us found it very difficult,” Knudstorp told Bloomberg reporter David Tweed, “but I thought it was fantastic because growth is like a sugarcoating on your problems. You don’t see them so well when you’re growing. When you’re not growing you really have to drive productivity.”¹⁰

The Lego story is worth exploring in more detail because it shows how many costs have become habitual over time and how a bit of awareness can revitalize a company. The account that follows comes from a close observation of the Lego case by our colleagues Keith Oliver, Edouard Samakh, and Peter Heckmann.¹¹ (Oliver is also known for being the operations expert who coined the term “supply chain management.”)

There were indeed costs directly related to Lego’s superior capabilities. The costs included the “Kitchen,” the company’s product development lab and a point of corporate pride. But not every aspect of product development was distinctive; in fact, the most costly aspects of product design were detracting from Lego’s differentiation.

As a pilot program to show the value of sharp cost management, the company started with sourcing. This was linked to a distinctive capability, but primarily as a means to an end. Customers recognized the quality of Lego bricks, but did not care where the resins came from. More importantly, sourcing was not managed strategically.

As Oliver, Samakh, and Heckmann describe, chief financial officer Jesper Ovesen took charge of the sourcing pilot project:

Once the benefits of the sourcing change were clear, then the new initiative had credibility, and Lego moved to a more fundamental issue: raising the creativity of product design through awareness of cost trade-offs. Designers were encouraged to recognize that extra features had to be considered part of the cost of the overall package. “Yes, you can give sparkling amber eyes to your new Bionicle space alien action figure,” Oliver, Samakh, and Heckmann write, “but it may limit your choices on its claws.” The new proficiency in navigating cost trade-offs was a major change for the company’s product development center (the Kitchen) and was treated as a great source of pride. It was also accepted as a strategic move. Designers began to use existing elements in new ways, rather than devising new elements requiring new molds and colors.

Added interoperability in toy design now became one of Lego’s distinctive features. “The best cooks are not the ones who have all the ingredients in front of them,” a senior manager wrote in a memo to the Kitchen. “They’re the ones who go into whatever kitchen and work with whatever they have.”¹² Knudstorp says that the Lego designers “initially saw reducing complexity as pure pain, but gradually they realized that what they had seen at first as a new set of constraints could in fact enable them to become even more creative.”¹³

Previously, the manufacturing function had been considered sacrosanct; its chaos was seen as part of the company’s history. Oliver and his coauthors say that Lego had previously run “one of the largest injection-molding operations in the world, with more than 800 machines, in its Danish factory, yet the production teams operated as hundreds of independent toy shops. The teams placed their orders haphazardly and changed them frequently, preventing operations from piecing together a reliable picture of demand needs, supply capabilities, and inventory levels. This murkiness led to overall capacity utilization of just 70 percent.” Now, however, manufacturing was treated as a table-stakes activity: essential but not distinctive. With the teams rationalizing production cycles, reorganizing the assembly lines, and outsourcing some production, the results were immense cost savings and improved manufacturing effectiveness.

Distribution was even more of a table-stakes activity—or in some cases, a liability. Lego’s sales were moving online, and its delivery priorities were outmoded. Oliver, Samakh, and Heckmann explain: “The company spent a disproportionate amount of time and effort serving small shops, which drove up the costs of fulfillment substantially. Sixty-seven percent of all orders consisted of less than a full carton—an incredibly costly proposition that demands labor-intensive ‘pick-packing’ at the distribution center.” The company cut the number of its logistics providers, immediately saving 10 percent of its transportation costs. It standardized its contracts with retailers, provided discounts for early orders, and refused to ship partial cartons.

In retrospect, all of this may seem like an obvious set of moves, but at the time, it represented a remarkable exercise in collective change: moving an entire resistant organization to a better operating model. It took tremendous management attention, and a willingness on everyone’s part to confront the realities of their cost structure. The company had no choice; it had to shrink costs in these areas or it could not survive, let alone win.

Many of Lego’s most innovative moves since then were made possible by these changes. Cost savings aside, the company could never have developed its Lego community or narrative skills if its leaders were still struggling with logistics and sourcing. The new approach “allowed us to again focus on developing the business, on innovation, and on developing our organization to become a much more creative place to work,” says Knudstorp. “Those are luxuries we didn’t have when we didn’t make money and we had a supply chain that was ten to fifteen years behind the times.”¹⁴

Rethinking Next Year’s Budget

Once you’ve gone through the parking-lot exercise and done the blueprinting described in chapter 3, you’re now set for the next quarter or the year. But you have to look to the long term as well: you need to reconsider how your enterprise conducts its annual planning and budgeting.

Within most big companies, few things are as universally loathed as the annual budgeting process. Every year, each business unit and function adjusts the previous year’s budget by a few percentage points, up or down, across the board. People think about the best practices they are trying to develop and the selling, general, and administrative overhead that they need. Their efforts are not integrated into the strategy, and people typically give little or no thought to the capabilities that span functional boundaries.

Finance typically approves the budget—or doesn’t—according to revenue and profit projections, not according to strategic priorities. The result of the exercise is the assignment of a percentage increase or decrease for the firm as a whole. The company might adjust the figures by taking into account new projects or imperatives, but essentially everyone uses last year’s budget as a baseline. Every business unit and department thus has an incentive to show that it deserves the same budget it had before, and sometimes more. This budgeting approach orients the whole company toward repeating (or at best making incremental changes to) the often distorted spending patterns of the previous year.

Our parking-lot exercise, in itself, frees you from the tyrannical mind-set of the end-of-year budget. In that sense, it is similar to the management trend of zero-based budgeting, in which every allocation must be evaluated every year and not just carried over from the past. But zero-based analysis considers costs only in terms of functional or short-term relevance, which, as we noted earlier, can often be misleading. It doesn’t distinguish distinctive capabilities from other activities, and it may shortchange critically important expenses that might take more than a year or two to come to full fruition.

Our exercise goes further. It links annual budgeting directly, and transparently, to your value proposition and capabilities system. You reconsider your funding, every year, in light of how your priorities need to change, how your teams are innovating what they need to do, and as we’ll see in the next chapter, what new funding you might need in order to shape your future.

Start this process well before the usual period—perhaps halfway through the fiscal year. Instead of asking for the usual projections and adjustments from each budget from each business unit and function, ask the groups to conduct an exercise similar to the parking-lot exercise. In this version, ask them to look closely at each line in the budget. How does this activity contribute to the company’s distinctive capabilities? How does it contribute to table-stakes or lights-on activities? To what extent is the activity draining resources?

Then look ahead: How will this business unit realize its growth aspirations this year? Which capabilities will it require most? Where are the gaps between the capabilities that already exist and the capabilities it needs? What risks would the business run if it made the cuts and other changes you are suggesting?

If a capabilities-oriented budget exercise is conducted with skill and proper attention, it can often put 20 to 40 percent of a department’s general and administrative costs back into play for redeployment. (You may want to target that level of savings, as Frito-Lay did, to fund your capabilities system.) It also leads each team to prioritize its activities and costs—and to drop or diminish activities that take up people’s time without adding much value. Finally, the top team should consider all the requests and prioritize investments accordingly, just as they did with the original parking-lot exercise.

Over time, as you regularly conduct this exercise, it becomes a habitual aspect of your company’s continuous improvement. You may want to explicitly say that the budget for each department will depend, as it never has before, on strategic alignment; therefore, if people can make a case for funding their activities as contributing to distinctive capabilities, their budget may actually increase. But they must also demonstrate how they expect to deliver. In some companies that have closed the strategy-to-execution gap, executive bonuses are tied to their ability to design, defend, and execute these investments.

You can use these budgets as guidelines for executing necessary changes. Continue to operate with your new focused mind-set, with senior team members as ambassadors throughout the rest of the enterprise. They will need to explain the rationale for cuts (and for reinvestment where that is taking place) and to listen to concerns and suggestions. You will undoubtedly continue to be challenged by events; every plan will require adaptation to meet changing realities. But those changes in allocation will henceforth be made in the context of a clear identity and rationale. You are cutting costs to grow stronger, holding and building the capabilities that support your right to win, and creating and supporting a more coherent portfolio. You start to see all your costs as investments in your future.

With facility in cost management, you have more room to maneuver. You can open the door to greater aspirations—and begin taking your company to new, more proficient levels. That’s the subject of the next chapter.