strategic decision making

Strategic decision making in uncertain times

A McKinsey Quarterly Reader

mckinseyquarterly.com

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Strategy in a ‘structural break’Richard P. RumeltDecember 2008

During hard times, a structural break in the economyis an opportunity in disguise. To survive—and,eventually, to flourish—companies must learn toexploit it.

Dynamic management: Better decisions in uncertain timesLowell BryanDecember 2009

Companies can’t predict the future, but they can build organizations that will survive and flourish under just about any possible future.

Getting into your competitor’s headHugh Courtney, John T. Horn,and Jayanti Kar February 2009

To anticipate the moves of your rivals, you must understand how their strategists and decision makers think.

The use and abuse of scenariosCharles Roxburgh November 2009

Although it is surprisingly hard to create good ones, they help you ask the right questions and prepare for the unexpected. That is hugely valuable.

A fresh look at strategy under uncertainty: An interviewDecember 2008

Although even the highest levels of uncertainty don’t prevent businesses from analyzing predicamentsrationally, says author Hugh Courtney, the financial crisis has shown us the limits of our tools—and minds.

Rebuilding corporate reputations Sheila Bonini, David Court, and Alberto Marchir June 2009

A perfect storm has hit the standing of big business. Companies must step up their reputation-management efforts in response.

Using ‘power curves’ to assess industry dynamics Michele Zanini November 2008

A new way of looking at industry structures reveals startling patterns of inequality among even the largest companies.

Introduction

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Copyright © 2010 McKinsey & Company. All rights reserved.

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Introduction

In times of economic uncertainty, strategy becomes more

important than ever—yet harder than ever to formulate. Our new

bonus reader, with articles both by McKinsey consultants

and outside experts, not only examines the underlying principles

of strategy for these hard, confusing times but also explains

practical tools and techniques that executives can use to develop

their own strategies.

These pieces, exemplifying the Quarterly’s best traditions,

offer new ways of thinking about the challenges facing companies

and managers. They represent just a small sampling of the

knowledge and ideas available to you as a Premium Member of

McKinsey Quarterly.

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There is nothing like a crisis to clarify the mind. In suddenly volatile and different times, you must have a strategy. I don’t mean most of the things people call strategy—mission statements, audacious goals, three- to five-year budget plans. I mean a real strategy.

For many managers, the word has become a verbal tic. Business lingo has transformed marketing into marketing strategy, data processing into IT strategy, acquisitions into growth strategy. Cut prices and you have a low-price strategy. Equating strategy with success, audacity, or ambi- tion creates still more confusion. A lot of people label anything that bears the CEO’s signature as strategic—a definition based on the decider’s pay grade, not the decision.

By strategy, I mean a cohesive response to a challenge. A real strategy is neither a document nor a forecast but rather an overall approach based on a diagnosis of a challenge. The most important element of a strategy is a coherent viewpoint about the forces at work, not a plan.

What’s happening? The past year’s events have been surprising but not novel. Historically, land bubbles, easy credit, and high leverage often make a dangerous mixture. Real-estate debt triggered the first US depression, in 1819. A land mortgage boom was directly behind the 1873–77 crisis: innova-

Richard P. Rumelt

During hard times, a structural break in the economy is an opportunity in disguise. To survive—and, eventually, to flourish—companies must learn to exploit it.

Strategy in a ‘structural break’

Richard Rumelt is the Harry and Elsa Kunin professor of business and society at the Anderson School of Management, University of California at Los Angeles.

Strategy | By Invitation: Insights and opinion from outside contributors

McKinsey Quarterly 2009 Number 15

tive forms of mortgage lending in Europe and the United States generated an unsustainable boom in land prices, and a four-year global depression followed their collapse and the accompanying credit crunch. Another credit crunch, this one triggered by the failure of traded railroad notes, led to the Long Depression of 1893–97. Japan’s 1995–2004 “lost decade” followed a period of high leverage and wildly inflated land values brought to an end by a financial crash.

Leverage lies at the heart of such stories. Archimedes said, “Give me a lever long enough and a fulcrum strong enough, and I will move the world.” He didn’t add that it would take a lever many light years long to move the Earth by the width of an atom, and if the Earth twitched, the kickback from the lever would fling him far and fast. The current crisis is about kickback from leverage in two places: house- holds and financial services. Without leverage, downturns would be disappointments, but mortgages would not be foreclosed nor companies bankrupt. Leverage spreads the pain in ever-widening waves.

The way these dynamics played out is well known. US household debt started rising in the early 1980s, and its growth accelerated in 2001 (Exhibit 1). Leverage among Wall Street’s five largest broker–dealers (Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, and Morgan Stanley) rose dramatically after 2004, when the US Securi- ties and Exchange Commission exempted these firms from the long-standing 12-to-1 leverage ratio limit and let them regulate themselves. From 1990 to 2007, the whole financial-services sector expanded 2.5 times faster than overall GDP, and its profits rose from their 1947–96 average of 0.75 percent of GDP to 2.5 percent in 2007. Then falling

e x h i b i t 1

The runaway US consumer

Ratio of consumer debt to disposable income

1.4

1.2

1.0

0.8

0.6

0.4

0.2

01952 1962 1972 1982 1992 2002 2007

Source: US Bureau of Economic Analysis; US Federal Reserve

Top of sand background

Baseline for unit of measure/subtitle

e x h i b i t 1

Exhibit title

6Strategy in a ‘structural break’

home prices led to an unanticipated rise in foreclosure rates and a drop in the value of certain mortgage-backed securities. That decline quickly undid highly leveraged financial firms, whose failure spread loss and uncertainty throughout the system. US consumer spending continued at a high level through the first half of 2008 but by the third quarter had dropped at a 3.1 percent annualized rate. A recession—potentially a deep one—had arrived.

A structural break Discerning the significance of these events is harder than recounting them. I think we are looking at a structural break with the past— a phrase from econometrics, where it denotes the moment in time-series data when trends and the patterns of associations among variables change.

A corporate crisis is often a sign that the company’s business model has petered out—that the industry’s underlying structure has changed dramatically, so old ways of doing business no longer work. In the 1990s, for instance, IBM’s basic model of layering options and peri- pherals atop an integrated line of mainframe computers began to fail. Demand for computing was up, but IBM’s way of providing it was down. Likewise, newspapers are now in crisis as the Internet grabs their readers and ads. Demand for information and analysis is increasing, but traditional publishing vehicles have difficulty making money from it.

The same principle applies to the economy as a whole. In most of the recessions of the past 40 years, demand caught up with capacity and growth returned in 10 to 18 months. This recession feels different because it is hard to imagine the full-steam reexpansion of financial services or a rapid turnaround in housing. Beyond these two hot spots, there seem to be unsustainable trends in commodity prices, oil imports, the nation’s trade balance, the state of our schools, and large entitlement promises. Already, the idea that the United States can grow by borrowing money from China to finance consumption at home has begun to seem implausible. We know in our bones that the future will be different. When the business model of part or all of the economy shifts in this way, we can speak of a structural break.

Such a break often means hard times. Adjustment is neither easy nor quick. Difficult and volatile conditions wipe out some organizations—yet others prosper because they understand how to exploit the fact that old patterns vanish and new ones emerge. The first order of the day is to survive any downturns in the real economy (see sidebar, “Hard- times survival guide”), but the second is to benefit from these new patterns. A structural break is the very best time to be a strategist, for at the moment of change old sources of competitive advantage weaken and new sources appear. Afterward, upstarts can leap ahead of seemingly entrenched players.


In several industry sectors, the most recent structural break occurred in the 1980s, with the development of microprocessors, which led to much cheaper computing, personal and desktop computers, and the rise of a new kind of software industry. Those innovations begat the Internet and electronic commerce. More important for strategists, the break shifted the nature of competitive advantage dramatically. In 1985, for example, a telecom-equipment company needed sufficient scale to serve at least two of the three main continents—Asia, Europe, and North America—and skill at coordinating thousands of development engineers, manufacturing engineers, and workers. By 1995, firmware had become the primary source of advantage. Cisco Systems came out of nowhere to dominate its whole industry segment by deploying what at first was about 100,000 lines of elegant code written by a small team of talented people. That structural break allowed Silicon Valley’s small-team culture to overtake Japan’s advantages in industrial engineering and in managing a large, disciplined workforce. This shift in the logic of advantage changed the wealth of nations.

Structural breaks render obsolete many existing patterns of behavior, yet they point the way forward for some companies and at times even for whole economies. The Long Depression of 1893–97 marked the end of the railroad boom, for example, and the start of the transition to an economy based on sophisticated consumer goods. Milton Hershey built his early chocolate brand and distribution advantages in the middle of those hard times. GE was a product of the same period, for the structural break also marked the rise of a new economy based on electricity.

Although the 1930s were very hard times for the United States, not every industry or business declined. As the economy shifted massively from capital goods to consumer goods, some industries—such as steel, rubber, coal, glass, railroads, and building—suffered greatly, but consumer brands such as Kellogg’s hit their stride. Campgrounds and motels blossomed along highways. Airline passenger traffic grew robustly. Entertainment surged with the growth of the radio and movie industries, and of their audience, during the Golden Age of Hollywood.

Likewise, during the decade from 1996 to 2005, overall consumer spending remained fairly flat in Japan. Still, the economy rotated into new things. The country, for example, has more than 200 brands of soft drinks, and each of Seven-Eleven Japan’s small convenience stores carries more than 50 at any time. About 70 percent of these brands vanish each year and are replaced by new ones.

Many aspects of such structural changes will depend upon the government’s policy response. Today, nuclear power, infrastructure repair, and fiber to the home are already on the list of possible stimuli for the


economy. In examining such business opportunities, it’s important to recognize that competition for government funds is fierce. Nonetheless, the state can provide first-mover advantages in new growth areas. During Franklin Roosevelt’s New Deal, for example, the federal government vastly expanded its record keeping. Since it needed something better than handwritten or typed notes, it turned to IBM’s new-fangled punch card system. In the growth industry of aviation, Boeing lost its airline business as a result of the Air Mail Act of 1934 but also built substantial advantages by performing well on key military contracts.

The wrong way forward in a structural break during hard times is to try more of the same. The break and the hard times are sure indi- cations that an old pattern has already been pushed to its limits and is destroying value. As an example of such a pattern, consider the financial sector’s compensation incentives. Decades of careful research shows no evidence that anything but luck explains why some fund managers outperform others. Yet fund and even pension fund managers who supposedly outperform get huge pay and bonuses. Incentives are

If you can’t survive hard times, sell out early. Once you are in financial distress, you will have no bargaining power at all.

In hard times, save the core at the expense of the periphery. When times improve, recap- ture the periphery if it is still worthwhile.

Any stable source of good profits—any competitive advantage—attracts overhead, clutter, and cross-subsidies in good times. You can survive this kind of waste in such times. In hard times, you can’t and must cut it.

If hard times have a good side, it’s the pressure to cut expenses and find new efficiencies. Cuts and changes that raised interpersonal hackles in good times can be made in hard ones.

Use hard times to concentrate on and strengthen your competitive advantage. If you are confused about this concept, hard times will clarify it. Competitive advantage has two branches, both growing from the same root. You have a competitive advantage when you can take business away from another company at a profit and when your cash costs of doing business are low enough that you can survive in hard times. Take advantage of hard times to buy the assets of distressed competitors at bargain-basement prices. The best assets are competitive advantages unwisely encumbered with debt and clutter.

In hard times, many suppliers are willing to renegotiate terms. Don’t be shy.

In hard times, your buyers will want better terms. They might settle for rapid, reliable payments.

Focus on the employees and communities you will keep through the hard times. Good relations with people you have retained and helped will be repaid many times over when the good times return.

Hard-times survival guide


good in principle, but did Bear Stearns get competent risk management in return for the $4.4 billion bonus pool it distributed in 2006? Does any organization have to give its CEO a $40 million bonus to secure his services? If you pay people enough money to make any future payment beside the point, don’t be surprised when they take vast long-term risks for short-term wins. In almost any pattern, overshooting produces negative returns.

Another pattern that may generate diminished or negative returns is the baffling complexity of our business and management systems. The financial-services industry is a poster child for the costs of this kind of complexity, as well. Calls to regulate such complex systems are misguided—regulators can’t comprehend them if their creators don’t. The best regulators can do in this case is to ban certain kinds of behavior.

Complexity also manifests itself in the soaring volume of e-mail. Philip Su, a Windows Vista software engineering manager, reports that the intensity of coordination on this project created “a phenomenon by which process engenders further process, eventually becoming a self-sustaining buzz.”1 We have all experienced this unanticipated side effect of apparently cheap communications. Unfortunately, lowering the cost of sending a message dramatically increases the amount of messaging. E-mail to a group of coworkers triggers immediate

1 See Philip Su, “The world as best as I remember it,” blogs.msdn.com/philipsu.

e x h i b i t 2

The rising cost of administration

Share of selling, general, and administrative (SG&A) costs to sales, %

35

30

25

20

15

10

5

01950 1960 1970 1980 1990 2000 2007

Source: Standard & Poor’s


responses, the group of respondents expands, and responses proliferate like neutrons in a critical mass of plutonium. Messages are requests to do something, change something, or look at something. All that has a high cost. It was in the 1980s, as computing became a necessary part of the paraphernalia of management, that the percentage of pretax expenses accounted for by selling, general, and administrative costs (SG&A) began to accelerate (Exhibit 2).

In part, this rising administrative intensity shows the increasing importance of knowledge-based workers and the outsourcing of manual labor. It also reflects a more intense commitment to very complex systems comprising individual parts whose productivity is almost impossible to measure. Despite the claims of IT, marketing, and human resources that their programs generate strong returns on investment, corporations are betting on a whole approach to business, not on any one element. The risk is that in hard times, the system becomes the problem.

Consider an analogy. When oil is cheap and plentiful, we create a vast infrastructure that works well if oil remains cheap and plentiful. When it becomes expensive, we wish we had a different infrastructure. Similarly, when economic opportunities abound, we invest in a management infrastructure that harvests them very well. When the field of opportunities becomes less verdant, we must change our management infrastructure. A system that requires companies to spend at least $300,000 a year in wages, benefits, support personnel, and systems to enable one educated person to do his or her job could be unsustainable in a less luxuriant world.2

Doing things differently It’s hard to fix infrastructure when times are good and demand is growing. From 1993 to 1995, I served as director of INSEAD’s Corporate Renewal Initiative, which studied and worked with companies trying to become more competitive. As business turned up in 1996, the interests of these companies flipped, as if by a switch, from reengineering to growth.

In the years since, most companies have indeed grown. They have also spent money on increasingly complex overhead structures to address the diversity of products and geographies and the demands of employees and governments. Now, in hard times, scope and variety will be cut, but costs won’t automatically follow. The costs of managing scope and variety have been baked into the infrastructure—IT systems, sourc- ing systems, and processes for designing and marketing new products.

2 As a baseline, US elementary and secondary educational systems spend about $250,000 a year on each class of average size (23 students). Another interesting data point: the US military spends $350,000 to $700,000 a year, depending on whose figures you believe, to put one soldier on the ground in Iraq.


So during structural breaks in hard times, cutting costs isn’t enough. Things have to be done differently, and on two levels: reducing the complexity of corporate structures and transforming business models. At the corporate level, the first commandment is to simplify and simplify again. Since companies must become more modular and diverse, eliminate coordinating committees, review boards, and other mecha- nisms connecting businesses, products, or geographies. The aim of these cuts is to provide lean central and support services that don’t require business units to spend time and energy coordinating their activities. Break larger units into smaller ones to reveal cross-subsidies and to break political blockades. You may think that coordination costs will rise if you fragment the business, but you must do so to expose what ought to be streamlined.

Then start reforming individual businesses. There is a large and useful body of knowledge about how to go about doing so, and this is not the place to reprise it. In general terms, the first task is to understand how a business has survived, competed, and made money in the past. Don’t settle for PowerPoint bar charts and graphs. If the business is too complex to comprehend, break it into comprehensible parts. Once you gain this critical understanding, you can start the work of reshaping. There is no magic formula. Reforming a business always takes insight and imagination.

In ordinary hard times, the traditional moves are reducing fixed costs, scope, and variety. But in hard times accompanied by structural breaks, you must rethink the way you manage. Companies that survive and go on to prosper look beyond costs to the detailed structure of managerial work. Several new issues come to the forefront:

•How much extra work results from the way incentive and evaluation systems relentlessly pressure managers to look busy and outperform one another?

•Which information flows can you omit? Information that doesn’t inform value-creating decisions is a wasteful distraction.

•Which decisions and judgments can you standardize as policy rather than make in costly meetings and communications?

•How can you work with customers, suppliers, and the government to simplify their processes so that you can simplify yours?

Recessions are neither good for the economy nor morally uplifting. But since we are diving into a period of neck-snapping change, we had better start the process of reformation before it’s too late.


We welcome your comments on this article.Please send them to [email protected].

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D E C E M B E R 2 0 0 9

Dynamic management: Better decisions in uncertain times

Companies can’t predict the future, but they can build organizations that will survive and flourish under just about any possible future.

Lowell Bryan

s t r a t e g y p r a c t i c e

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The economic shock of 2008, and the Great Recession that followed, didn’t just create profound uncertainty over the direction of the global economy. They also shook the confidence of many business leaders in their ability to see the future well enough to take bold action.

It’s not as if we don’t know how to make good decisions under uncertainty. The US Army developed scenario planning and war gaming in the 1950s. And advanced quantitative techniques, complete with decision trees and probability-based net-present-value (NPV) calculations, have been taught to MBA students since the 1960s. These approaches are extraordinarily valuable amid today’s volatility, and many well-run companies have adopted them, over the years, for activities such as capital budgeting.

Here’s the challenge: coping with uncertainty demands more than just the thoughtful analysis generated by these approaches (which, in any event, are rarely employed for all the business decisions where they would be useful). Profound uncertainty also amplifies the importance of making decisions when the time is right—that is to say, at the moment when the fog has lifted enough to make the choice more than a crap shoot, but before things are clear to everyone, including competitors.

Over the past year or so, progressive strategists have been undertaking noble experiments (such as shorter financial-planning cycles) while dropping the pretense that they can make reasonable assumptions about the future. My sense, though, is that achieving truly dynamic management will prove elusive for most organizations until they can figure out how to get their senior leadership (say, the top 150 managers) working together in a fundamentally different way. The knowledge, skill, and experience of these leaders make them better suited than anyone else to act decisively when the time is right. Such executives are also well placed to build the organizational capabilities needed to surface critical issues early and then use the extra lead time to gather intelligence, to conduct the needed analyses, and to debate their implications.

The specifics of how companies should build these muscles will of course vary. Well-run organizations—particularly those accustomed to using stage-gate-investment approaches for activities such as oil exploration, venture capital investment, and new-product development—may find that moving toward a more dynamic management style requires a few relatively small, though collectively significant, shifts in their operating practices. Others may find the necessary changes, which include migrating away from rigid, calendar-based approaches to budgeting and planning, more wrenching. What I hope to do in this article is to lay out some core principles that will help either kind of company make the passage of time an ally rather than a challenge.

For more on strategic

planning, see “Navigating

the new normal: A

conversation with four

chief strategy officers,” on

mckinseyquarterly.com.

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Focusing on pivotal rolesA ship has a captain with a single mind. The “captain” of a large, complex modern corporation is likely to be dozens, if not hundreds, of people. Aligning those pivotal leaders so that they can steer the company in response to changing conditions is a major challenge for most organizations.

An essential first step is simply to define who occupies the pivotal roles. Some companies may have just a few; others 20, 150, or even more. On the one hand, the smaller the number, the easier it is to have the intensity of interaction needed to make critical decisions effectively and collaboratively. On the other hand, the number must be large enough so that the people involved in decision making can collectively access the full spectrum of knowledge embedded in a company’s people and its relationships with other organizations. You’ll never get perfect coverage, but if you wind up saying with any frequency, “We’re flying blind on this topic without perspective from X,” it’s a good bet that you’ve kept the group too small.

Since determining what to do under uncertainty usually requires careful debate among many people across the entire company, you need processes and protocols to determine how issues are raised, how deliberation is conducted, and how decisions are made. You also need to clearly lay out the obligations of managers, once the debate and decision making is over, to put their full weight behind making the resulting actions successful.

I wish there were one-size-fits-all protocols for getting the smart, talented people who occupy pivotal roles (and who are accustomed to making decisions through a hierarchy) to work effectively with colleagues in collectively steering the ship. But the hard truth is that what works in one organization and among one set of individuals may not work in others. Since the move toward more dynamic management changes power relationships and the prerogatives of senior executives, a company’s organizational, cultural, and political norms have a major influence on the ease of transition. (The more hierarchical and less collaborative the organization, for example, the bigger the challenge.) The best I can do is to suggest a few general approaches—whose implementation often looks quite different in different types of organizations—for helping the individuals occupying pivotal roles to work together in new ways.

Learning by doingIf you require managers to use decision-making-under-uncertainty techniques (such as scenario planning, decision trees, and stage gating) to make actual decisions, they will quickly learn how to think differently about the future. And if you have them apply these tools in teams involving executives from diverse corners of the organization, they will gain a greater appreciation for the power of collective insight in volatile times, when information, almost by definition, is fragmentary and fast moving.

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Workshop-based adult-learning techniquesExecutives can develop new mind-sets and skills, particularly to improve their ability to manage through the ambiguity and complexity inherent in today’s environment. Some companies have made progress by developing case studies based upon potential decisions they will shortly be facing and then using facilitators and friendly colleagues to get leaders used to surfacing and debating alternative courses of action. Others have found war gaming useful for illustrating the cost of basing decisions on seemingly reasonable assumptions when events are moving quickly.

Performance measurementCompanies need to hold their managers not just individually but also mutually accountable for their actions. This means evaluating how effectively executives contribute to the success of others. For example, how effective are executives at identifying the company’s critical issues, even when such issues fall outside their areas of responsibility? And how proactively do executives provide their colleagues with intelligence, knowledge, and advice? Peer-assessment techniques often are invaluable in measuring collaborative behavior.

Just-in-time decision makingMuch of the art of decision making under uncertainty is getting the timing right. If you delay too much, opportunity costs may rise, investment costs may escalate, and losses can accumulate. However, making critical decisions too early can lead to bad choices or excessive risks. And making hasty decisions under time pressure or economic duress allows little room to undertake detailed staff work or to engage in careful debate. Here are a few suggestions for companies trying to create competitive advantage from their ability to manage the passage of time decisively.

Surfacing critical issuesMost companies are accustomed to identifying major internal issues, such as whether to build a business, divest an asset, or lay off people. What’s harder—and has become increasingly important over the past year or so—is the early surfacing of opportunities and threats arising out of external events such as dramatic shifts in demand, competitive behavior, industry structure, regulation, or the macroeconomic environment.

A commonsense approach to identifying such issues early is to poll, regularly, all of the company’s top managers to get them to identify critical issues they see emerging. Each manager should provide a rationale for why any issues raised are critical. A small team of senior executives should review all such issues, designating some as critical and highlighting others for continued tracking. As time passes, some of these other issues may become critical; others may become less relevant and disappear from the list.

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One challenge: many managers are reluctant to surface emerging issues early, because they fear being perceived as someone who is weak, or who cries wolf. A well-designed performance-management system, though, can ensure that the personal risk of surfacing critical issues late is much greater than the risk of raising them too early.

Performing the necessary staff workIf a critical issue is surfaced early, there is usually time enough to use proven problem-solving approaches to making decisions under uncertainty. Decision trees, for example, help managers think about the structuring and sequencing of their decisions. Probabilistic modeling is useful for understanding the economic consequences of potential outcomes. Breaking big decisions into smaller, well-sequenced ones (the goal of stage-gate investing) helps organizations move forward without taking excessive risks. And building scenarios helps you gain perspective on your critical issues. If a particular decision produces favorable outcomes under all scenarios, it becomes a “no regrets” move justifying bold action. On the other hand, if a particular scenario is improbable, but the negative consequence (if it happens) is large, you need to build contingency plans.

If companies tried to make all or even most of their important decisions in this way, the costs could be prohibitive, and there wouldn’t be enough management bandwidth available to do anything but debate issues. Employing a materiality test, such as whether 1 or 2 percent of a company’s future earnings are at stake, is therefore vital. In a typical large company, this may mean no more than two or three dozen such issues in any given year.

Changing how decisions are madeFew companies are organized to get just-in-time managerial alignment for even a few issues a year, let alone two or three dozen. Gaining alignment among pivotal decision makers requires them to spend time together (in person, by phone, or in videoconferences) to surface emerging issues, share information, debate issues, and make timely decisions. How much time is needed for such meetings will, of course, vary with the company and its circumstances but is likely to be in the range of two to three days a month.

The only way to make this happen is to redesign the corporate calendar, along with corporate processes and protocols for how the meetings are conducted (including their length, decision-making roles, and required attendees). The redesign should encompass the creation of processes that enable the rapid surfacing and formal designation of issues considered critical. In addition, some companies have found it helpful to create a situation room—a physical place manned by support staff and connected electronically to people who can’t be physically present—to serve as a hub to mobilize the information needed to enable debate to take place in real time among the appropriate decision makers.

For more on scenario

planning, see “The use and

abuse of scenarios,” on

mckinseyquarterly.com.

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Rethinking corporate budgeting processesEverything I’ve been describing flies in the face of management practices that have proven invaluable at many companies for nearly a century. However, fixed annual planning and budget processes are antithetical to timely strategy setting and decision making.

Yet it’s important to recall why we have them: they enable the efficient delegation of authority between managers and subordinates. In return for the freedom to make decisions and allocate resources, the subordinate contracts through the budget to deliver expected results. The managers of a large company make tens of thousands of operating decisions every day, and if all of them required constant deliberations up and down the chain of command and across the organization, it would grind to a halt.

Jettisoning budgeting, therefore, is hardly an option—though it may have seemed reasonable at points over the past year, since most of the budgets produced in late 2008 for 2009 proved worthless (as did most companies’ earnings guidance to stock analysts). What this underscores is a basic problem with budgets: if developments in the marketplace are sufficiently different from the assumptions used in budgeting, managers can’t make their numbers no matter what they do. At best, by the time these developments have surfaced to the top, most of the lead time needed to address the emerging issues has been exhausted. At worst, the company faces a crisis after being weakened by the hidden costs of all of the short-term actions (such as maintenance cutbacks for manufacturers or excessive risk taking for financial institutions) undertaken by managers endeavoring to make their numbers.

So what’s the answer? Many better-run companies have already adapted the budgeting process to make it more flexible. A large number use a base case, an optimistic case, and a pessimistic case to allow for a range of outcomes. More important, a significant percentage of companies now use rolling budgets to keep their plans current. These approaches aren’t foolproof—many companies fall into the trap of using too narrow a range (such as plus or minus 5 percent), and even companies that use rolling budgets usually do so only by making small incremental adjustments, quarter to quarter, to the base case. Nonetheless, in a relatively stable environment, these approaches are a significant step forward.

But even rolling budgeting may not be enough to prepare you for a macroenvironment where you are unsure whether you will be seeing, over the next couple of years, a rapid return to global growth, an extended period of anemic growth, or a double-dip recession.

One alternative: move to a semiannual budgeting and financial-planning cycle where you make budget “contracts” for a 6-month, rather than annual, time period and undertake robust, scenario-based financial-contingency planning for the period from 6 to 24 months in the future. That approach allows companies both to continue using budgets that hold people accountable for the immediate future and to shift toward contingency budgets at

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the end of 6 months should the circumstances warrant a change of direction. I believe many companies will find that a semiannual budgeting process works better than either an annual approach, which is based upon an unrealistic year-long budget-contracting horizon, or a quarterly update, which requires almost continuous rebudgeting.

Another valuable and potentially complementary approach is to have even 6-month budgets and the results reported against them automatically adjusted for “uncontrollables.” That is, to improve accountability you can restate both budgets and results after the fact to remove, automatically, variances caused by macroeconomic uncontrollables such as interest rates, commodity prices, and currency movements. This approach can help senior leaders eliminate uncontrollable losses and windfall gains, thereby holding managers accountable for their performance in the marketplace rather than for whether the macroeconomy makes them lucky or unlucky.

Finally, many if not most companies will also find that they need to carve out discretionary budgets and staff to support just-in-time decision making. These budgets should be sufficient not just to support the needed staff work but also to provide the resources needed to begin implementing the decisions until they (and their financial implications) can be formally built into budgets.

Companies can’t control the weather, but they can design and build a ship, and equip it with a leadership team, that can navigate the ocean under all weather conditions. Organi- zations that become more flexible and skillful at making critical decisions when the timing is right have enormous opportunities to capture markets and profits from companies that persist in managing as if the future business environment is reasonably predictable.

Lowell Bryan is a director in McKinsey’s New York office. Copyright © 2009 McKinsey & Company. All right reserved.

Related articles

“Leading through uncertainty”

“Setting strategy in the new era: A conversation with Lowell Bryan and Richard Rumelt”

“How managers should approach a fragile economy”

“Strategic planning: Three tips for 2009”

20Getting into your competitor’s head

Getting into your competitor’s head

To anticipate the moves of your rivals, you must understand how their strategists and decision makers think.

Hugh Courtney, John T. Horn, and Jayanti Kar

The global financial crisis that erupted in 2008 shows, with painful clarity, that we live in an interdependent business world. In bleak times and fair, the success of a company’s strategy often depends greatly on the strategies of its competitors. In periods of financial turmoil, for instance, the prospects—and even survival—of a bank often depend on the near- term M&A of its rivals. Similarly, the ultimate success of Boeing’s new commercial jet, the 787 Dreamliner, will depend on the way Airbus positions, markets, and sells its new and competing A380 and A350. Pfizer’s ability to sustain market share and profitability in the market for cholesterol-lowering treatments will depend on the moves of the company’s branded and generic pharmaceutical competitors, to say nothing of biotech and medical-product companies developing alternative treatments.

This strategic interdependence implies that the ability to anticipate your competitors’ strategies is essential. Yet a recent survey of business executives found that the actions and reactions of potential rivals almost never play a role in, for example, decisions to introduce and price new products.1 An important reason for this neglect, we believe, is that strategic-planning tools, such as game theory and scenario planning, are of limited use unless a company can correctly define the key elements of the strategic game,

Keith

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Strategy

1 David Montgomery, Marian Chapman Moore, and Joel Urbany, “Reasoning about competitive reactions: Evidence from executives,” Marketing Science, 2005, Volume 24, Number 1, pp. 138–49.


especially the strategic options and objectives of competitors. This is no easy task. Rare is the company that truly understands what its competitors and their decision makers care about most, how they perceive their assets and capabilities, and what all this means for their strategies. A company with such insights could reverse-engineer the moves of competitors and predict what they were likely to do. In a credit crunch, for instance, such a company would be well positioned to buy financial and nonfinancial assets at attractive prices if it knew that poorly capitalized competitors would avoid new risk and therefore not bid for these assets.

Getting inside your competitor’s head is difficult because companies (and their decision makers) usually are not alike. At any time, a company has assets, resources, market positions, and capabilities it must protect, leverage, and build upon. Different endowments imply different strategies even in the same general market environment. What’s more, even a competitor with similar endowments may pursue different strategies if its owners, stakeholders, and decision makers have a different objective.

So if you want to anticipate rather than react to strategic moves, you must analyze a competitor at two levels: organizational and individual. At the organizational level, you have to think like a strategist of your competitor by searching for the perfect strategic fit between its endowments and its changing market environment. At the individual level, you have to think like the decision makers of the competitor, identifying who among them makes which decisions and the influences and incentives guiding their choices. This approach moves you beyond the data-gathering efforts of most competitive-intelligence functions, toward a thought process that helps turn competitive intelligence into competitive insights. While our approach won’t eliminate surprises, it will help you better understand your competitors and their likely moves and eliminate some of the guesswork that undermines the development of strategies in an increasingly interdependent business world.

Think like your competitor’s strategistWhen your competitor resembles you, chances are it will pursue similar strategies—what we call symmetric competition. When companies have different assets, resources, capabilities, and market positions, they will probably react to the same market opportunities and threats in different ways—what we call asymmetric competition. One of the keys to predicting a competitor’s future strategies is to understand how much or little it resembles your company.

In the fast-food industry, for example, two leading players, McDonald’s and Burger King, face the same market trends but have responded in


markedly different ways to the obesity backlash. McDonald’s has rolled out a variety of foods it promotes as healthy. Burger King has introduced high-fat, high-calorie sandwiches supported by in-your-face, politically incorrect ads. As the dominant player, McDonald’s is the lightning rod for the consumer and government backlash on obesity. It can’t afford to thumb its nose at these concerns. Smaller players like Burger King, realizing this, see an opportunity to cherry-pick share in the less health-conscious fast-food segment. Burger King competes asymmetrically.

Companies can determine whether they face symmetric or asymmetric competition by using the resource-based view of strategy: the idea that they should protect, leverage, extend, build, or acquire resources and capabilities that are valuable, rare, and inimitable and that can be successfully exploited. Resources come in three categories: tangible assets (for example, physical, technological, financial, and human resources), intangible assets (brands, reputation, and knowledge), and current market positions (access to customers, economies of scale and scope, and experience). Capabilities come in two categories: the ability both to identify and to exploit opportunities better than others do.

In the video-game-console business, the strategies of Microsoft and Sony, which are attempting to dominate next-generation systems, are largely predictable—based on each company’s tangible and intangible assets and current market position. Although the core businesses of the two competitors will be affected by video game consoles differently, both sides see them as potential digital hubs replacing some current stand-alone consumer electronic devices, such as DVD players, and interconnecting with high-definition televisions, personal computers, MP3 players, digital cameras, and so forth.

For Sony, which has valuable businesses in consumer electronics and in audio and video content, it is important to establish the PlayStation as the living-room hub, so that any cannibalization of the company’s consumer electronics businesses comes from within. After the recent victory of Sony’s Blu-ray standard over Toshiba’s HD-DVD, Sony stands to realize a huge payoff in future licensing revenues. The PlayStation, which plays only Blu- ray disks, is thus one of the company’s most important vehicles in driving demand for Blu-ray gaming, video, and audio content.

Microsoft has limited hardware and content businesses but dominates personal computers and network software. Establishing the Xbox as the living-room hub would therefore help to protect and extend its software businesses. For Microsoft, it is crucial that the “digital living room” of the future should run on Microsoft software. If an Apple product became


the hub of future “iHome” living rooms, Microsoft’s software business might suffer.

Sony and Microsoft therefore have different motives for fighting this console battle. Yet the current market positions (existing businesses and economies of scope), tangible assets (patents, cash), and intangible assets (knowledge, brands) of both companies suggest that they will compete aggressively to win. It was predictable that they would produce consoles which, so far, have been far superior technologically to previous systems and interconnect seamlessly with the Internet, computers, and a wide variety of consumer electronics devices. It was also predictable that both companies would price their consoles below cost to establish an installed base in the world’s living rooms quickly. The competition to win exclusive access to the best third-party developers’ games, as well as consumer mind- share, will also probably continue to be waged more aggressively than it was in previous console generations. For Microsoft and Sony, the resource-based view of strategy helps us to understand that this battle is about far more than dominance in the video game industry and thus to identify the aggressive strategies both are likely to follow.

Nintendo, in contrast, is largely a pure-play video game company and thus an asymmetric competitor to Microsoft and Sony. The resource-based view of strategy explains why Nintendo’s latest console, the Wii, focuses primarily on the game-playing experience and isn’t positioned as a digital hub for living rooms. The Wii’s most innovative feature is therefore a new, easy-to-use controller appealing to new and hardcore gamers alike. The Wii has few of the expensive digital-hub features built into the rival consoles and thus made its debut with a lower retail price.

Applying the resource-based view of strategy to competitors in a rigorous, systematic, and fact-based way can help you identify the options they will probably consider for any strategic issue. But if you want to gain better insight into which of those options your competitors are likeliest to choose, you have to move beyond a general analysis of their communications, behavior, assets, and capabilities and also think about the personal perceptions and incentives of their decision makers.

Think like your competitor’s decision makersSince the objectives of corporate decision makers rarely align completely with corporate objectives, companies often act in ways that seem inconsistent with their stated strategic intentions or with the unbiased assessments of outsiders about the best paths for them to follow. So if you want to predict the next moves of a competitor, you must often consider the preferences and incentives of its decision makers.


The key to getting inside the head of a competitor making any decision is first identifying who is most likely to make it and then figuring out how the objectives and incentives of that person or group may influence the competitor’s actions. In most companies, owners and top managers make divestment decisions, for example. Strategic pricing and service decisions are often made, within broad corporate guidelines, by frontline sales personnel and managers.

Owners and other important stakeholdersThe objectives of the person or group with a controlling interest in your competitor probably have a major influence on its strategy. Sometimes, personal preferences are particularly relevant: it’s likely that Virgin’s pioneering foray into the commercial space travel industry partially reflects the adventurous tastes of its charismatic founder, Sir Richard Branson. For family-owned or -controlled businesses—public or private—family values, history, and relationships may drive strategy. A competitor owned by a private-equity firm is likely to focus on near-term performance improvements to generate cash and make the company more attractive to buyers. While every private-equity firm is different, you can often forecast the tactics any given one will take by studying its history, since many such firms often repeat their successful strategies.

Other stakeholders may also profoundly influence a company’s strategy, so it often pays to get inside their heads as well. You can’t evaluate any large strategic moves GM or Ford might make without considering the interests of the United Auto Workers and how those interests might check or facilitate such moves. The importance of nonowner stakeholders in driving a company’s strategy varies by country of origin too. If you compete with a Chinese company, the Chinese government is often a critical stakeholder. In Europe, environmental organizations and other nongovernmental stakeholders exert more power over corporate decision making than they do in the United States.

Top-level managementSince the owners of companies hire top-level management to pursue the owners’ strategic objectives, a Martian might think that management’s decisions reflect those interests. Earthlings know that this may or may not be true. That’s why you must study your competitor’s top team.

First, that analysis provides another source of insight into the objectives of the company’s owners. When James McNerney arrived at 3M in 2001, for instance, he brought along his belief in GE’s “operating system,” a centralized change-management methodology that inspired GE’s successful approach to Six Sigma, globalization, and e-Business. If you were a 3M


competitor, McNerney’s history suggested that he would try to turn 3M, which had traditionally favored a fairly loose style of experimentation, into a more operationally accountable company. His hiring signaled the 3M board’s intention to focus more aggressively than before on costs and quality. It surely came as no surprise to 3M’s board or to the company’s competitors that one of McNerney’s first strategic moves was to launch a corporate Six Sigma program.

And of course, senior executives aren’t always perfect “agents” for a company’s owners, whose personal interests and incentives may differ from theirs. Such agency problems quite commonly bedevil even companies with the best governance practices, so it often pays to focus on the objectives of senior leaders as well.

The objectives of organizationsJay Barney, “Firm resources and sustained competitive advantage,” Journal of Management, 1991, Volume 17, Number 1, pp. 99–120.

David J. Collis and Cynthia A. Montgomery, “Competing on resources: Strategy in the 1990s,” Harvard Business Review, July 1995, Volume 73, Number 4, pp. 119–28.

Kevin P. Coyne, Stephen J. D. Hall, and Patricia Gorman Clifford, “Is your core competence a mirage?” mckinseyquarterly.com, February 1997.

James G. March, “Exploration and exploitation in organizational learning,” Organization Science, 1991, Volume 2, Number 1, pp. 71–87.

The objectives of decision makersMichael Jensen and Kevin J. Murphy, “CEO incentives: It’s not how much you pay, but how,” Harvard Business Review, May 1990, Volume 68, Number 3, pp. 138–53.

Paul Milgrom and John Roberts, Economics, Organization & Management, Englewood Cliffs, NJ: Prentice Hall, 1992.

Game theory, scenario planning, and simulations Hugh G. Courtney, “Games managers should play,” mckinseyquarterly.com, June 2000.

Hugh Courtney, 20/20 Foresight: Crafting Strategy in an Uncertain World, Boston, MA: Harvard Business School Press, 2001.

Anticipating business surprisesKenneth G. McGee, Heads Up: How to Anticipate Business Surprises and Seize Opportunities First, Boston, MA: Harvard Business School Press, 2004.

Recommended reading

The works below help readers learn more about the ideas and procedures discussed in this article.


General managers and frontline employeesCompetitors of a decentralized company must focus not only on the objectives of its owner and corporate leaders but also on those of business unit leaders, middle management, and even frontline staff. Until recently, for example, Ford was decentralized, with each geographic region run almost independently. Automotive competitors that wished to predict Ford’s behavior would have needed to focus on the statements and actions of each regional and brand manager, because the company’s objectives could vary from location to location and across divisions. But since Alan Mullaly took over as CEO in 2006, he has moved to coordinate some decisions and platforms across divisions and regions. Competitors must now understand what is still decided by regional managers and what by Detroit.

For certain decisions, frontline employees and managers are also important, especially if they make pricing, marketing, service, and operational decisions that significantly influence a company’s competitive advantage. Even if decision making is more centralized, the incentives of frontline employees may be misaligned with the objectives of a company’s owners or senior leaders. Agency problems may inspire the front line to undercut these objectives.

Suppose, for example, that the head of a division at one of your competitors wants its commissioned sales force to promote a new product. If the sales force is enjoying strong sales from established products, reps may hesi- tate to risk their compensation to promote the new one. A knowledge of such agency problems—which can often be detected through the chatter between your frontline sales force and the customers you share with competitors—can have great strategic importance for your company. In this case, agency problems will probably delay the point when the new product wins significant sales. You could exploit that time lag to fortify your own presence in the market and possibly to preempt the competitor’s new offering.

Reach a point of viewWhat happens once you have a better sense of the options your competitors may consider and the way they may evaluate those options?

Let’s say that your company’s market environment is relatively stable and that you have much useful information about your main competitors and their decision makers. You can then apply game theory to determine, with considerable confidence, the strategies your competitors will probably follow to maximize their objectives, as well as the way your own choices may influence those strategies. Suppose, however, that even your best efforts don’t give you a clear picture of the resources of your competitors


or their decision makers’ objectives. Then it is often best to avoid trying to predict the competition’s exact behavior and instead to use scenario planning to test your company’s strategic possibilities.

In a financial crisis, for example, even the best competitive-intelligence efforts may provide incomplete, excessively complex, or inconsistent information on the competition’s strategies and thus fail to support game theory or scenario planning. We have found that one way of generating a point of view in such situations is to conduct “war games.” In these exercises, each team, representing a specific competitor, receives a fact pack about that company and its decision makers. The teams then make key strategic decisions for the companies they represent. Through several rounds of competition, every team can act on its own strategies and react to the moves of other teams. The war game forces the players to com- bine incomplete, and perhaps inconsistent, information on competitors to develop a point of view about which moves make the most and least sense for them and are therefore the most and least likely moves for them to make.

No matter how thorough and insightful your analysis may be, two things are almost sure to happen: your competitor will make some moves you considered unlikely, and some of your data will quickly become obsolete. When a competitor acts in unexpected ways, your company has a crucial learning opportunity. Why were you wrong? Did you, say, miss an important agency problem that undermined the execution of the strategy you thought the competitor would follow? Did the market environment change, creating new threats and opportunities for the competitor? Did

Web 2008Developing competitive insightsExhibit 1 of 1Glance: Developing competitive insights must be continuous to support strategic planning and decision-making. Exhibit title: The competitor-insight loop

1 Listen to your competitor• Gather basic competitive

intelligence—what are your competitors saying?

• Use pattern recognition—do recent moves and counter-moves reveal strategy?

2 Think like a strategist for your competitor

• What are its assets, capabilities, market positions?

• How might it protect, extend, and leverage them?

4 Synthesize, learn, and repeat

• Synthesize information to a point of view about which moves make the most and least sense for your competitor

• Learn from ongoing indicators and monitoring

• Repeat

3 Think like the decision makers for your competitor

• Who is the likely decision maker?• Are the decision makers'

interests aligned with those of the company’s owners?



e x h i b i t

The competitor-insight loop

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it bring in a new chairman or CEO? You must diagnose your mistakes, learn from them, and ensure that you use the latest data to develop your point of view.

Learning from your mistakes means managing these competitive-insight activities as an ongoing process for real-time strategic planning and decision making, not as an annual or biannual event in a bureaucratic planning process. Particularly in dynamic markets, where companies have to make decisions constantly, information about competitors must be updated as soon as possible (exhibit).

One key to making this ongoing process more insightful is tapping into the latest competitive intelligence dispersed throughout the frontline workforce. An e-mail address, a blog, or a shared database could let sales reps

report on the latest pricing, promotion, negotiation, and sales tactics that competitors use with key customers or customer segments. Engineers might use such facilities to report the latest product pipeline rumors from

professional conferences. When possible, companies should also establish appropriate information-sharing arrangements with key partners; suppliers, for example, may provide the latest intelligence on future input prices. As Ken McGee argues in Heads Up, most of the information needed for sound business strategy decisions is already available. You just have to create a process to capture and synthesize it meaningfully.

Particularly today, no company is an island. Those that most accurately perceive the competitive landscape as it is and is likely to be in the future have a distinct competitive advantage. Our process—focusing on changes in the resources, decision-making structures, and compensation systems of competitors—moves beyond the usual updates on key market trends and uncertainties. Its rewards are huge: fewer surprises from competitors and more opportunities to shape markets to your own advantage. Q

Hugh Courtney is an alumnus of McKinsey’s Washington, DC, office, where John Horn is a consultant; Jayanti Kar is a consultant in the Toronto office. Copyright © 2009

McKinsey & Company. All rights reserved.

We welcome your comments on this article. Please send them to [email protected].

Related articles on mckinseyquarterly.com

How companies respond to competitors: A McKinsey Global Survey

How to improve strategic planning

Strategy’s strategist: An interview with Richard Rumelt

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N O V E M B E R 2 0 0 9

The use and abuse of scenarios

Although it is surprisingly hard to create good ones, they help you ask the right questions and prepare for the unexpected. That is hugely valuable.

Charles Roxburgh


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Scenarios are a powerful tool in the strategist’s armory. They are particularly useful in developing strategies to navigate the kinds of extreme events we have recently seen in the world economy. Scenarios enable the strategist to steer a course between the false certainty of a single forecast and the confused paralysis that often strike in troubled times. When well executed, scenarios boast a range of advantages—but they can also set traps for the unwary.

There is a significant amount of literature on scenarios: their origins in war games, their pioneering use by Shell, how to construct them, how to move from scenarios to decisions, and so on. Rather than attempt anything encyclopedic, which would require a book rather than a short article, I have put forward my personal convictions, based on experience in building scenarios over the past 25 years, about both the power and the dangers of scenarios, and how to sidestep those dangers. I close with some rules of thumb that help me—and will, I hope, help you—get the best out of scenarios.

The power of scenariosScenarios have three features that make them a particularly powerful tool for understanding uncertainty and developing strategy accordingly.

Scenarios expand your thinkingYou will think more broadly if you develop a range of possible outcomes, each backed by the sequence of events that would lead to them. The exercise is particularly valuable because of a human quirk that leads us to expect that the future will resemble the past and that change will occur only gradually. By demonstrating how—and why—things could quite quickly become much better or worse, we increase our readiness for the range of possibilities the future may hold. You are obliged to ask yourself why the past might not be a helpful guide, and you may find some surprisingly compelling answers.

This quirk, along with other factors, was most powerfully illustrated in the recent meltdown. Many financial modelers had used data going back only a few years and were therefore entirely unprepared for what we have since seen. If they had asked themselves why the recent past might not serve as a good guide to the future, they would have remembered the Asian collapse of the late 1990s, the real-estate slump of the early 1990s, the crash of October 1987, and so on. The very process of developing scenarios generates deeper insight into the underlying drivers of change. Scenarios force companies to ask,

“What would have to be true for the following outcome to emerge?” As a result, they find themselves testing a wide range of hypotheses involving changes in all sorts of underlying drivers. They learn which drivers matter and which do not—and what will actually affect those that matter enough to change the scenario.

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Scenarios uncover inevitable or near-inevitable futuresA sufficiently broad scenario-building effort yields another valuable result. As the analysis underlying each scenario proceeds, you often identify some particularly powerful drivers of change. These drivers result in outcomes that are the inevitable consequence of events that have already happened, or of trends that are already well developed. Shell, the pioneer in scenario planning, described these as “predetermined outcomes” and captured the essence of this idea with the saying, “It has rained in the mountains, so it will flood in the plains.” In developing scenarios, companies should search for predetermined outcomes—particularly unexpected ones, which are often the most powerful source of new insight uncovered in the scenario-development process.

Broadly speaking, there are four kinds of predetermined outcomes: demographic trends, economic action and reaction, the reversal of unsustainable trends, and scheduled events (which may be beyond the typical planning horizon).

• Demography is destiny. Changes in population size and structure are among the few highly predictable aspects of the future. Some uncertainties exist (potential increases in longevity, for example), but only at the margin. Sometimes, the effects of these trends are far off—as with Social Security in the United States today—so they are generally ignored. When these trends grow near, however, their effects can be powerful indeed, as when the baby boom generation is on the brink of leaving the workforce.

• “You canna change the laws of economics!” Just as Scotty the engineer could not change the laws of physics when Captain Kirk1 demanded more warp speed, so business leaders cannot assume away the laws of economics. If demand shoots up, prices will too—which will limit demand and drive increasing supply—with the result that demand, prices, or both will drop. Nothing increases in price forever, in real terms. We recently saw oil prices more than double and then sink back again by an equal amount. Price changes of this scale inevitably drive supply and demand reactions in every relevant value chain. As in physics, every economic action has a predetermined reaction. These reactions are often ignored in business strategy. If uncovered through scenario planning, however, they can generate powerful insights.

• “Trees don’t grow to the sky.” Business plans often extrapolate into the future trends that

are clearly unsustainable. Economies are fundamentally cyclical, so beware of politicians bearing tales about the end of boom and bust. Equally, do not build a strategy based on the claim that the business cycle has been tamed. Often, optimistic projections are accompanied by bold claims of a new paradigm. Strategists need to be very cautious about alleged new paradigms. The appearance of even a genuine new paradigm almost

1 For the uninitiated, Scotty and Captain Kirk are two characters from Star Trek, a famous US science fiction television series from the 1960s.

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always results in a speculative bubble. The “new economy” was a good example. More recently, securitization proved to be another sound idea that resulted in a speculative bubble. And in the past, many new, innovative technologies—railroads and radio, for example—were hailed as “new paradigms” and then promptly led to investment bubbles. A useful test is to project a trend at least 25 years out. Then ask how long can this trend really be sustained. Challenge yourself to try and prove why the shape of the future should be so fundamentally different from the more cyclical past. Chances are you won’t be able to, and this will open your eyes to the possibility of a break in the trend.

• Scheduled events may fall beyond typical planning horizons. There is also a simpler kind of predetermined outcome that does not involve any unalterable laws: scenarios must take into account scheduled events just beyond corporate planning horizons. A recent example, the results of which we have already seen, is reset dates on adjustable-rate mortgages. Well before the event, one could have predicted a spike in resets as mortgages sold in 2005 and 2006—the peak years—completed their low, three-year introductory rates. Something bad was going to happen to the economy in 2008. Right now, there is another important “timetable” to watch: the wave of large bond issues that has resulted from banks having to refinance hundreds of billions of dollars of maturing debt. Although these types of scheduled events ought to be common knowledge, they tend to be overlooked in planning exercises because they fall beyond the next 12 to 18 months. Scenarios should account for scheduled events that could have a big impact in the 24–60 month time frame.

While some errors can be avoided by recalling certain fundamental economic and demographic facts or scheduled events, problems of timing will continue to exist. Your company’s strategic planners may know that a massive dollar value of mortgages is about to reset. But when will the market actually wake up to this reality? Financial services cannot grow as a percentage of GDP forever. But at what percentage will this stop? We didn’t know before, and we still don’t know today. Still, the realization that something must happen, even if it is not clear when, leads to the inclusion of at least one scenario in which, say, financial services stop growing sooner rather than later.

Scenarios protect against ‘groupthink’Often, the power structure within companies inhibits the free flow of debate. People in meetings typically agree with whatever the most senior person in the room says. In particularly hierarchical companies, employees will wait for the most senior executive to state an opinion before venturing their own—which then magically mirrors that of the senior person. Scenarios allow companies to break out of this trap by providing a political

“safe haven” for contrarian thinking.

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Scenarios allow people to challenge conventional wisdomIn large corporations, there is typically a very strong status quo bias. After all, large sums of money, and many senior executives’ careers, have been invested in the core assumptions underpinning the current strategy—which means that challenging these assumptions can be difficult. Scenarios provide a less threatening way to lay out alternative futures in which these assumptions may no longer be true.

Avoiding the common traps in using scenariosFor all these benefits, there is a downside to scenarios. Inexperienced people and companies are prone to fall into a number of traps.

Don’t become paralyzedCreating a range of scenarios that is appropriately broad, especially in today’s uncertain climate, can paralyze a company’s leadership. The tendency to think we know what is going to happen is in some ways a survival strategy: at least it makes us confident in our choices (however misplaced that confidence may be). In the face of a wide range of possible outcomes, there is a risk of acting like the proverbial deer in the headlights: the organization becomes confused and lacking in direction, and it changes nothing in its behavior as an uncertain future bears down upon it.

The answer is to pick the scenario whose outcome seems most likely and to base a plan upon that scenario. It should be buttressed with clear contingencies if another scenario—or one that hasn’t been imagined—begins to emerge instead. Ascertain the “no regrets” moves that are sound under all scenarios or as many as possible. Ultimately, the existence of multiple possibilities should not distract a company from having a clear plan.

Don’t let scenarios muddy communicationsThe former CEO of a global industrial company once suggested that scenarios are an abdication of leadership. His point was that a leader has to set a vision for the future and persuade people to follow it. Great leaders do not paint four alternative views of the future and then say, “Follow me, although I admit I’m not sure where we are going.”

Leaders can use scenarios without abdicating their leadership responsibilities but should not communicate with the organization via scenarios. You cannot stand up in front of an organization and say, “Things will be good, bad, or terrible, but I am not sure which.” Winston Churchill’s remarks about British aims in World War II—“Victory at all costs, victory in spite of all terror, victory however long and hard the road may be”—are instructive. By insisting on only one final outcome, Churchill was not refusing to acknowledge that a wide range of conditions might exist. What he did was to set forth a goal that he regarded as what we would call “robust under different scenarios.” He was acknowledging the range of uncertainties (“however long and hard the road may be”), and he resisted overoptimism (which affected many bank CEOs early in the recent crisis).

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A chief executive, a prime minister, or a president must provide clear and inspiring leadership. That doesn’t mean these leaders should not study and prepare for a number of possibilities. Understanding the range of likely events will embolden corporate leaders to feel prepared against most eventualities and allow those leaders to communicate a single, bold goal convincingly.

One additional point about communication and scenarios is worth noting. Scenarios can help leaders avoid looking stupid. A wide range of scenarios—even if not publicly discussed—can help prevent leaders from making statements that can be proven wrong if one of the more extreme scenarios unfolds. For instance, one financial regulator boldly announced, early in the financial crisis, that its banking system was, at the time, capitalized to a level that made it bulletproof under all reasonable scenarios—only to announce, a few months later, that a further recapitalization was required. Similarly, the head of a large bank confidently suggested that the downturn was in its final phases shortly before the major indexes plummeted by 25 percent and we entered a new and even more dangerous phase of the crisis. Many CEOs have given hostages to fortune; scenarios would have helped them avoid doing so.

Don’t rely on an excessively narrow set of outcomesThe astute reader will have noticed that the above-mentioned financial regulator managed to embarrass itself even though it was using scenarios. One of the more dangerous traps of using them is that they can induce a sense of complacency, of having all your bets covered. In this regard at least, they are not so different from the value-at-risk models that left bankers feeling that all was well with their businesses—and for the same reason. Those models typically gave bankers probabilistic projections of what would happen 99 percent of the time. This induced a false sense of security about the potentially catastrophic effects of an event with a 1 percent probability. Creating scenarios that do not cover the full range of possibilities can leave you exposed exactly when scenarios provide most comfort.

One investment bank in 2001, for instance, modeled a 5 percent revenue decline as its worst case, which proved far too optimistic given the downturn that followed. Even when constructing scenarios, it is easy to be trapped by the past. We are typically too optimistic going into a downturn and too pessimistic on the way out. No one is immune to this trap, including professional builders of scenarios and the companies that use them. When the economy is heading into a downturn, pessimistic scenarios should always be pushed beyond what feels comfortable. When the economy has entered the downturn, there is a need for scenarios that may seem unreasonably optimistic.

The breadth of a scenario set can be tested by identifying extreme events—low-probability, high-impact outcomes—from the past 30 or 40 years and seeing whether the scenario set contains anything comparable. Obviously, such an event would never be a core scenario. But businesses ought to know what they would do, say, if some more virulent strain of

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avian flu were to emerge or if an unexpected geopolitical conflict exploded. Remember too that it would not take a pandemic or a terrorist attack to threaten the survival of many businesses. Sudden spikes in raw-material costs, unexpected price drops, major technological breakthroughs—any of these might take down many large businesses. Companies can’t build all possible events into their scenarios and should not spend too much time on the low-probability ones. But they must be sure of surviving high-severity outcomes, so such possibilities must be identified and kept on a watch list.

Don’t chop the tails off the distributionIn our experience, when people who are running businesses are presented with a range of scenarios, they tend to choose one or two immediately to the right and left of reality as they experience it at the time. They regard the extreme scenarios as a waste because

“they won’t happen” or, if they do happen, “all bets are off.” By ignoring the outer scenarios and spending their energy on moderate improvements or deteriorations from the present, leaders leave themselves exposed to dramatic changes—particularly on the downside.

So strategists must include “stretch” scenarios while acknowledging their low probability. Remember, risk and probability are not the same thing. Because the risk of an event is equal to its probability times its magnitude, a low-probability event can still be disastrous if its effects are large enough.

Don’t discard scenarios too quicklySometimes the most interesting and insightful scenarios are the ones that initially seem the most unlikely. This raises the question of how long companies should hold on to a scenario. Scenarios ought to be treated dynamically. Depending on the level of detail they aspire to, some might have a shelf life numbered only in months. Others may be kept and reused over a period of years. To retain some relevance, a scenario must be a living thing. Companies don’t get a scenario “right”—they keep it useful. Scenarios get better if revised over time. It is useful to add one scenario for each that is discarded; a suite of roughly the same number of scenarios should be maintained at all times.

Remember when to avoid scenarios altogetherFinally, bear in mind the one instance in which strategists will not want to use scenarios: when uncertainty is so great that they cannot be built reliably at any level of detail.2 Just as scenarios help to avoid groupthink, they can also generate a groupthink of their own. If everyone in an organization thinks the world can be categorized into four boxes on a quadrant, it may convince itself that only four outcomes or kinds of outcomes can happen. That’s very dangerous. Strategists should not think that they have all reasonable scenarios when there are quite different possibilities out there.

2 For more, see the McKinsey Quarterly’s interview with author Hugh Courtney, “A fresh look at strategy under uncertainty,” at mckinseyquarterly.com.

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Don’t use a single variableThe future is multivariate, and there are elements strategists will miss. They should therefore avoid scenarios that fall on a single spectrum (“very good,” “good,” “not so good,”

“very bad”). At least two variables should be used to construct scenarios—and the variables must not be dependent, or in reality there will be just one spectrum.

Some rules of thumbObviously, some general principles can be assembled from the points above: look for events that are certain or nearly certain to happen; make sure scenarios cover a broad range of outcomes; don’t ignore extremes; don’t discard scenarios too quickly just because short-term reality appears to refute them and never be embarrassed by a seemingly too pessimistic or optimistic scenario; understand when not enough is known to sketch out a scenario; and so on. But there are some additional rules of thumb that I have found particularly useful.

Always develop at least four scenariosA scenario set should always contain at least four alternatives. Show three and people always pick the middle one. Four forces them to discover which way they truly lean—an important input into the discussion. Two is always too few unless there is only one big swing factor affecting the situation.

Technically, of course, many scenarios can be sketched out in almost any situation. All possible combinations of just three uncertainties will create 27 scenarios. But many of them will be impossible because the variables are rarely completely independent. Usually, the possibilities can be boiled down to four or five major possible futures.

“Crunch” the quadrantsOften people use a two-by-two matrix when presenting scenarios. But it is not routinely the case that there are just two major variables. In developing scenarios, it would be typical to identify three to five critical uncertainties. How to resolve this tension? One approach is to create multiple two-by-twos using all possible combinations of the four or five critical uncertainties. It will quickly become clear that some uncertainties are highly correlated and so can be combined—and that others are not principal drivers of the various scenarios. At minimum, this will allow for simplification. Sometimes, however, it is possible to uncover a real insight when trying to describe a quadrant created by an unusual combination of uncertainties.3

There should always be a base or central caseThis point goes back to the chief executive, mentioned above, who claimed that scenarios were an abdication of responsibility. It is fine to put forward scenarios—it is, in fact, the

3 I am grateful to Pherson Associates, specifically Randy Pherson and Grace Scarborough, for bringing this technique to my attention. I have found it extremely powerful in a number of client settings.

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responsible thing to do. But those who must weigh scenarios and reach decisions based on them expect and deserve to get a specific point of view about the future. The scenario that is highest in probability should always be identified, and that ought to become the base case. If that proves impossible, it should at least be feasible to fashion a “central” case—but there must be crystal clarity about the degree of certainty attached to it, the alternatives, and the resilience of any strategy to those alternatives.

Scenarios must have catchy namesThe notion of attaching clever names to scenarios may well sound trivial. It is not. Unless scenarios become a living part of an organization, they are useless. And if they do not have snappy, memorable names, they will not enter the organization’s lexicon. Use two to four words—no more. Plays on film titles and historical events are recommended. Some names that I have used, and that appear to have stuck, are “Groundhog Day,” “the long chill,”

“perfect summer,” “end of an era,” “silver age,” and “Mexican spring.”

Avoid long, descriptive titles. No one will remember “Restrengthening world economy at a lower level of overall growth.” And avoid boring “bull, bear, and base” scenarios, even though these are used by many stock analysts. If no snappy title seems to present itself (assuming that someone creative is available), the scenario is probably too diffuse and may contain elements of two different scenarios jammed together.

Learn from being totally wrongDeveloping scenarios is an art rather than a science. People learn by experience. It is useful to look back at old scenarios and ask what, in retrospect, they missed. What could have been known at the time that would have made for better scenarios? Events will prove that some scenarios were too narrow or that one was thrown out too soon. The more comfortable an organization and its people are with mistakes and learning from them, the less likely it is to be mistaken again.

Listen to contrary voicesThis is a good corrective to groupthink. We tend to dismiss the mavericks. Scenarios are there to make room for them. Maverick scenarios have the virtue of being surprising, which makes people think. If a company’s scenarios are all completely predictable (conventionally good, conventionally bad, and somewhere in the middle), they are not going to be valuable. The best scenarios are built on a new insight—either something predetermined that others have missed or an unobvious but critical uncertainty.

On one occasion, when oil was at $120 a barrel, we presented a scenario with oil at $70. Someone asked what would happen if oil dropped to $10 a barrel. We said that was unnecessarily radical. But we probably should not have been so dismissive, as oil promptly fell below $50 a barrel. We should have been more open to the possibility of this radical price swing—after all, oil has been at $10 a barrel well within living memory. Scenarios

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should not assume a short-term time series; they should go back as far as possible. If a data series going back 300 years is available, you should consider using it (they do exist for UK interest rates and UK government debt as a percentage of GDP and these long-term data series have certainly informed current debates about the possible interest rates and sustainable debt to GDP ratios). Most variables can only be supported by data going back tens of years—but even this is much more instructive than the meager data often used and helps broaden the range of possible outcomes.

Even modest environmental changes can have enormous impactThe best example of this principle is that specialist business models fail when the business environment changes. I call this the “saber-toothed tiger” problem. The saber-toothed tiger was a specialist killing machine, its big teeth perfectly evolved to capture large mammals. When the environment changed and the large mammals became extinct, saber-toothed tigers became extinct too—those large teeth were not as good for catching small, furry mammals. By contrast, the shark is a generalist killing machine—and so has remained highly successful for hundreds of millions of years.

A specialist business model can suffer the fate of the saber-toothed tiger if the environment changes. Many winning business models are highly specialized and precisely adapted to the current business environment. Therefore no one should ever assume that today’s winners will be in an advantaged position in all possible futures (or even most of them). Therefore, scenarios should be based on creative thinking about how predicted changes in the business environment will alter the competitive landscape. If the environment changes in a scenario but the competitors remain the same, that scenario may not be imaginative enough.

None of the above is rocket science. Why, then, don’t people routinely create robust sets of scenarios, create contingency plans for each of them, watch to see which scenario is emerging, and live by it? Scenarios are in fact harder than they look—harder to conceptualize, harder to build, and uncomfortably rich in shortcomings. A good one takes time to build, and so a whole set takes a correspondingly larger investment of time and energy.

Scenarios will not provide all of the answers, but they help executives ask better questions and prepare for the unexpected. And that makes them a very valuable tool indeed.

Charles Roxburgh is a director in McKinsey’s London office. Copyright © 2009 McKinsey & Company. All rights reserved.

Related articles

“Strategic planning: Three tips for 2009”

“Hidden flaws in strategy”

“Making the most of uncertainty”

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Hugh Courtney’s book, 20/20 Foresight: Crafting Strategy in an Uncertain World, was published the day before the terrorist attacks of September 11, 2001. As the economist and former McKinsey associate principal recalls, in the following weeks interviewers often asked him,

“Does this change everything? Is this stuff still valid? The world is so much more uncertain.” Says Courtney, “The honest answer then was that the only thing that had changed was our perception of risks and uncertainties that were always there. And it’s the same answer I give today about the current global business and financial situation.”

One of Courtney’s contributions to the literature of strategy was a four-part framework to help managers determine the level of uncertainty surrounding strategic decisions. In level one, there is a clear, single view of the future; in level two, a limited set of possible future outcomes, one of which will occur; in level three, a range of possible future outcomes; and in level four, a limitless range of possible future outcomes. Courtney, an associate dean of executive programs and professor of the practice of strategy at the University of Maryland’s Robert H. Smith School of Business, discussed the relevance of this idea in a recent interview with the Quarterly.

Although even the highest levels of uncertainty don’t prevent businesses from analyzing predicaments rationally, says author Hugh Courtney, the financial crisis has shown us the limits of our tools—and minds.

A fresh look at strategy under uncertainty: An interview

Strategy

This interview was conducted by McKinsey Quarterly editors.


The Quarterly: How do you evaluate the level of business uncertainty today?

Hugh Courtney: The financial crisis has actually brought greater clarity because it has forced us to recognize that we have a lot more level three and level four situations than we would have admitted a few months ago. They probably were there all along, yet the bias was toward thinking that issues were more at level one and level two. Specifically, we have learned how interdependent our financial markets are and how systemic failure in any important node of the network can work very rapidly through the system and bring liquidity to a halt. So our scenarios about the availability of capital around the world have changed significantly.

Maybe the world and the uncertainties we face haven’t changed all that much as a result of the financial crisis, but our perception of risks has. That means there is a real opportunity to rethink the way we make strategic decisions, the way we plan under uncertainty. We should

Hugh Courtney

Fast factsRecipient of numerous MBA and executive teaching awards

Named one of five “Up and Comers” in management consulting, Consulting Magazine (December 2001)

Consults on strategic planning, decision making, and competitive dynamics under uncertainty

Has served on multiple non profit boards

Enjoys what his children enjoy: professional and collegiate athletics, hiking, and the beach

Career highlights D&E Communications (2005–present) • Chairman (2008–)

University of Maryland’s Robert H. Smith School of Business (2002–) • Associate dean of executive programs (2008–) • Professor of the practice of strategy (2007–)

McKinsey & Company (1993-2002) • Associate principal (2000-2002) • Strategy practice senior engagement manager (1998-2000)

Vital statistics Born January 12, 1963, in Boston, Massachusetts

Married, with three children

EducationGraduated with BA in economics in 1985 from Northwestern University

Earned PhD in economics in 1991 from the Massachusetts Institute of Technology

41A fresh look at strategy under uncertainty: An interview

realize that, across sectors, for most important decisions we’re actually pretty far to the right—levels three and four—in the uncertainty spectrum.

The Quarterly: What does that mean in practice for managers?

Hugh Courtney: Level four situations are, by definition, ones for which you can’t really bound the range of outcomes, because it’s anybody’s guess. I’m sure we’ve all felt a little bit of that in the last few months. So the question is, do you just have to wing it? Is that what strategic decision making comes down to? I don’t think that’s true at all, but level four does require a different mind-set.

From level one to level three, the presumption is that you can do some bottom-up analysis. You can figure out what the value drivers are and do some market research and some competitive intelligence. All this may not give you a precise forecast, but you’ll be able to bound the outcomes somehow. That’s impossible in level four situations, by definition. There’s just stuff that’s fundamentally unknowable—truly an ambiguous world.

On the other hand, that doesn’t mean you can’t be rigorous in thinking through strategic decisions in level four. It just requires you to work backward from potential strategies to what you would have to believe about the future for those strategies to succeed. The classic example would be biotech—early-stage biotech investments have always faced level four uncertainty, because you’re playing with therapies with an ultimate commercial viability that is unknown.

e x h i b i t

The four levels of residual uncertainty

True uncertainty Not even a range of possible future

outcomes

Clear enough future Single view of the future

Alternative futures Limited set of possible future outcomes,

one of which will occur

A

B

C

Range of futures Range of possible future outcomes

Level 1

Level 2

Level 3

Level 4


The Quarterly: How does that play out?

Hugh Courtney: You could ask, “What’s the return on investment of starting up a lab in this particular therapy?” The answer would be, “Who knows?” Honestly, no amount of analysis would allow you to bound the ROI. But say you told me the following: “We’re thinking about investing in a lab to work on a therapy. The lab’s going to cost $10 million. Should we do it?” Of course, I could say,

“Well, I don’t know.” But I could also work backward from that $10 million investment and reply along these lines: “Say you need a 15 percent return on that investment. I can develop a scenario about the conditions needed to achieve this—what you would have to believe about the probability of finding a viable treatment, the amount of time it would take to get to market, the physician uptake rate on that treatment, the compliance rate of patients over time, what you’d be able to price it at, for how long, and how long you’d have patent protection.” I could tell you all that. In fact, I could give you a range of scenarios, all of which will give you that 15 percent return.

Now, the reason that approach would be useful is that even though I can’t do any bottom-up analysis, I can look at analogies. There’s a whole history of drug development, and I can at least place those scenarios within the range of other outcomes in the past. Then I could tell you, for example, “We know now that this project would have to be the most successful drug launch in history to earn the return you want on that $10 million. I can’t say whether it’s going to play out that way, but are you willing to roll the dice given those odds?” Alternatively, “Hey, it only has to be as successful as the median drug-discovery process.”

In other words, you can think about a level four problem in a very structured way. It’s just that your mind-set has to change from a bottom-up analysis based on the value drivers to one based on what we know from similar situations in the past. You don’t have to wing it.

The Quarterly: Let’s say I’m a strategist for a financial-services company. How should I think about today’s uncertainty?

Hugh Courtney: This is a really interesting time because it provides unprecedented opportunities for the survivors. I think the fundamental strategic issues are whether there will continue to be benefits of scope and scale in financial services and whether there will be a big pure-play investment-banking industry in the future.

We learned very well with Glass–Steagall1 reform that the benefits of scope and scale are highly dependent on regulatory structure—that

1 The Glass-Steagall Act of 1933 established the Federal Deposit Insurance Corporation (FDIC) in the United States and separated investment and commercial banking activities. The act was repealed in 1999.


is, what you’re allowed to do with that scope and scale. For example, regulations will influence to what extent scope and scale will give you preferential access to low-cost capital, as well as how much you’re able to leverage and what you can and can’t do to hedge risks. And that’s why even the healthiest financial-services players today face tough strategic choices: they have the opportunity to make bold scope- and scale-building plays, yet the payoffs are highly reliant on future regulatory decisions that are up in the air.

The Quarterly: So what level of uncertainty does this represent?

Hugh Courtney: I imagine most of the leaders of the financial powerhouses understand the possible regulatory alternatives, and they’re well enough connected to people in Washington to see how this could play out. Potentially, it could be level two. There really are discrete alternatives, and there’s usually only a number of fairly well-defined ways to regulate any market environment. If you layer on top of this the fact that our political process tends to even out the extremes, maybe the range of alternatives is actually even narrower. So these are the sorts of things that can be bounded, and multiple scenarios can be run and quantified. The hard part for the decision makers is that even if you can define the scenarios, they have quite different implications for strategy. Still, the example illustrates why applying this kind of disciplined thinking is extremely helpful when you make such bets in uncertain times.

The Quarterly: What advice would you give to a chief strategy officer today?

Hugh Courtney: I would start with, “What were you doing in strategic planning before the financial crisis hit?” and “How well do you think it worked?” As I said, what’s changed is largely our perception of uncertainty. Most CSOs would reply, “Well, we had a pretty standard strategic-planning process. We did some industry analysis and market research and tried to do some long-term discounted cash flow on our opportunities. It was very financially driven and we felt it worked pretty well.” In the end, though, you would probably find that they were treating a lot of level three and four issues like level one and two issues and relying on the wrong tool kit.

So I would start with scenario-planning techniques—even though scenario planning has been around for decades, it’s still a niche tool in strategic-development and -planning efforts. The CSO and I would also talk about using analogies better. The basis of the analogy doesn’t have to be the exact thing you’ve done in the past, but it should be a similar space, geography, or basic business model that you can learn from. Many people today are asking what might be analogous situations, such as the Great Depression or the 1997 Asian financial crisis, and I


really understand why they are focused on them: it’s a classic example of using level four reasoning when it’s hard to use any other.

Finally, this is a good time to rethink your planning process. Have you been doing strategic planning on an annual basis as a paper-pushing exercise? That will have to change. In the months to come, you’re going to have to make decisions very quickly on fundamental opportunities that may drive your earnings performance for the next decade or more, and you’ve got to be prepared to make these decisions in real time. That requires a continuous focus on market and competitive intelligence and far more frequent conversations—daily, if necessary—among the top team about the current situation. Senior executives already may be in closer contact because of the emergency they face, but that doesn’t necessarily imply that they have the raw material and the structure to work through strategic decisions systematically. These daily conversations have to move beyond getting through that day’s crisis to more fundamental strategic issues as well, because the decisions made today may open up or close off opportunities for months and years to come.

The Quarterly: Your book discusses the shaper and adapter models. How should strategists think about shaping and adapting in these times?

Hugh Courtney: That depends on how prepared or fortunate you were going into this downturn. No one player can shape the fundamental uncertainties that are driving global capital markets. Interdependent players all over the world are making decisions. No one player—not even a Warren Buffett—can say, “You know, I feel great about things,” and change the dynamics all that much. So in some sense, everyone has to adapt to that macro uncertainty.

When it comes to fundamental strategic decisions, the paradox is that for a lot of companies in the most uncertain environments, there’s actually very little uncertainty about what they’re going to do. The situation is very clear because of the condition of their balance sheets. They really have to hunker down. They just don’t have the degrees of freedom to think about fundamental changes in their strategy.

On the other hand, there are the fortunate few that have very healthy balance sheets, aren’t so dependent on financing today, and don’t hold a lot of bad assets. They have a real interest in shaping opportunities. Again, they cannot shape the macro environment; they must adapt to that. However, they can fundamentally reshape their industry landscapes with bold M&A plays, R&D that others can’t finance, and entry into new markets. They can make bold moves that may shape the way their markets and industries play out for many years to come


by fundamentally changing the competitive dynamics or product positioning. They do have degrees of freedom and thus the opportunity to be successful shapers.

The Quarterly: Who are these fortunate few?

Hugh Courtney: They tend to be companies with business models that generate a lot of cash and don’t have much debt. That would include a lot of high-tech companies and service businesses in general, which tend to scale up through people rather than through $100 million plants. Similarly, some businesses in the energy, utilities, and telecom sectors rely on fully depreciated assets generating a lot of operating cash. So the fortunate companies are in sectors that have real cash cow businesses, even if these companies can’t completely escape the profitability and growth challenges that will be difficult for any company to avoid in the near future.

The Quarterly: Would your message be the same for companies in emerging markets like India and China?

Hugh Courtney: Yes, and in many cases the shaping opportunities are even greater. The fortunate companies are those that have healthy balance sheets and don’t need reliable, cheap financing right now, because such a reliance would put the brakes on a lot of current entrepreneurial efforts, particularly in countries like India and China. Some of the larger incumbents—the Tatas of the world—may have profound shaping opportunities in their home markets because a lot of global companies are going to retrench and pull back a little. These trends are at work in economies all around the globe, and companies with healthy balance sheets, the right capabilities, and a tolerance for risk can put together positions that could drive competitive advantage for years.

The Quarterly: How has your thinking changed since you wrote 20/20 Foresight?

Hugh Courtney: The financial crisis and 9/11 are wake-up calls to think about better management of risk and uncertainty. I find myself these days taking uncertainly more seriously. Remember, in the book I wrote that everyone should take uncertainty seriously, but day to day I fall into standard patterns that behavioral scientists have described—for example, I tend to have too much confidence in my ability to predict the future.

In the aftermath of the financial crisis, I’ve been thinking a lot about how these fundamental human cognitive biases influence everything we do in strategy development. We actually know more about the world


today than we did a few months ago, because there’s information in the meltdown. But the message behind that information is really, “You fools, remember that you’re human.” Remember the biases that lead us to be overconfident in our ability to forecast the future. Remember that the most important decisions for most companies will truly be level three and, many times, level four decisions. Our standard strategic-planning tool kits—the ones that we are most comfortable with and that we learn in MBA programs—don’t do a really good job for that.

So we ought to pay attention to this wake-up call. Embrace uncertainty. Get to know it. In uncertainty lies great opportunity. If you don’t try to understand what’s separating the known from the unknown from the unknowable, you’re really missing out. You’re just playing roulette with big money—usually other people’s money. It behooves us to take uncertainty seriously and to fundamentally rethink the way we do strategic thinking and planning.


We welcome your comments on this article.Please send them to [email protected].

J U N E 2 0 0 9

Rebuilding corporate reputations

A perfect storm has hit the standing of big business. Companies must step up their reputation-management efforts in response.

Sheila Bonini, David Court, and Alberto Marchi


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As governments respond to the financial crisis and its reverberations in the real economy, a company’s reputation has begun to matter more now than it has in decades. Companies and industries with reputation problems are more likely to incur the wrath of legislators, regulators, and the public. What’s more, the credibility of the private sector will influence its ability to weigh in on contentious issues, such as protectionism, that have serious implications for the global economy’s future.

Senior executives are acutely aware of how serious today’s reputational challenge is. Most recognize the perception that some companies in certain sectors (particularly financial services) have violated their social contract with consumers, shareholders, regulators, and taxpayers. They also know that this perception seems to have spilled over to business more broadly. In a March 2009 McKinsey Quarterly survey of senior executives around the world, 85 and 72 percent of them, respectively, said that public trust in business and commitment to free markets had deteriorated.1 According to the 2009 Edelman Trust Barometer, those executives are reading the public mind correctly: 62 percent of respondents, across 20 countries, say that they “trust corporations less now than they did a year ago.”

The breadth and depth of today’s reputational challenge is a consequence not just of the speed, severity, and unexpectedness of recent economic events but also of underlying shifts in the reputation environment that have been under way for some time. Those changes include the growing importance of Web-based participatory media, the increasing significance of nongovernmental organizations (NGOs) and other third parties, and declining trust in advertising. Together, these forces are promoting wider, faster scrutiny of companies and rendering traditional public-relations tools less effective in addressing reputational challenges.

Now more than ever, it will be action—not spin—that builds strong reputations. Organizations need to enhance their listening skills so that they are sufficiently aware of emerging issues; to reinvigorate their understanding of, and relationships with, critical stakeholders; and to go beyond traditional PR by activating a network of supporters who can influence key constituencies. Doing so effectively means stepping up both the sophistication and the internal coordination of reputation efforts. Some companies, for example, not only use cutting-edge attitudinal-segmentation techniques to better understand the concerns of stakeholders but also mobilize cross-functional teams to gather intelligence and respond quickly to far-flung reputational threats.

One key to cutting through organizational barriers that might impede such efforts is committed senior leadership, including leadership from CEOs, who have an opportunity in today’s charged environment to differentiate their companies by demonstrating real statesmanship. The stakes demand it; an energized public will expect nothing else. At a moment when capitalism seems flat on its back, CEOs have an obligation to bolster the reputations of their companies and of free markets.

A rapidly evolving reputation environmentThe financial crisis has underscored just how ill-equipped companies can be to deal with two important changes in the reputation environment. First, the influence of indirect stakeholders—

1 See “Economic Conditions Snapshot, March 2009: McKinsey Global Survey Results,” mckinseyquarterly.com, March 2009.

such as NGOs, community activists, and online networks—has grown enormously. The number of NGOs accredited by the United Nations, for instance, has grown to more than 4,000, from less than 1,000 in the early 1980s. These proliferating indirect stakeholders have tasked business with a broader set of expectations, such as making globalization more humane and combating climate change, obesity, human-rights abuses, or HIV.

Second, the proliferation of media technologies and outlets, along with the emergence of new Web-based platforms, has given individuals and organizations new tools they use to subject companies to greater and faster scrutiny. This communications revolution also means that certain issues (such as poor labor conditions) that might be acceptable in one region can be picked up by “citizen journalists” or bloggers and generate outrage in another.

As a result, what formerly were operational risks resulting from failed or inadequate processes, people, or systems now often manifest themselves as reputational risks whose costs far exceed those of the original missteps. In banking, for example, data privacy has become a reputational issue. In pharmaceutical clinical trials, Merck’s experience with Vioxx showed that anything less than full transparency can lead to disaster. And as risk-management problems in the financial sector have generated astronomical losses that taxpayers are helping bear, it’s little wonder that the reputational fallout has been enormous.

An outmoded approach to reputation managementIn this dispersed and multifaceted environment, companies must collect information about reputational threats across the organization, analyze that information in sophisticated ways, and address problems by taking action to mitigate them. That can involve developing alliances with new kinds of partners and coordinating responses from a number of parties, including governments, civil-society groups, and consumers. All this requires significant coordination and an ability to act quickly.

Many companies, though, rely primarily on small, central corporate-affairs departments that can’t monitor or examine diverse reputational threats with sufficient sophistication. Moreover, traditional PR spin can’t deal with many NGO concerns, which must often be addressed by changing business operations and conducting two-way conversations. Managers of business units have a better position for spotting potential challenges but often fail to recognize their reputational significance. Internal communication about them may be inhibited by the absence of consistent methodologies for tracking and quantifying reputational risk. Accountability for managing problems is often blurred.

As a result, responses to reputational issues can be short term, ad hoc, and defensive—a poor combination today given the intensity of public concern. And therein lies a problem that companies must solve quickly: even as reputational challenges boost the importance of good PR, companies will struggle if they rely on PR alone, with little insight into the root causes of or the facts behind their reputational problems.

A better, more integrated responseA logical starting point for companies seeking to raise their game is to put in place an effective early-warning system to make executives aware of reputational problems quickly. In our experience, most companies are quite good at tracking press mentions, and many are beginning

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50

Stanley Greenberg and Howard Paster are political consultants and public-relations experts with a long history of advising companies and individuals, including former US president Bill Clinton. Paster also formerly served as chairman and CEO of Hill & Knowlton, a PR firm owned by the WPP Group. The conversation that follows, in which the two reputation gurus reflect on the challenges facing business leaders and the steps they should take to rebuild trust, is a compilation of interviews that McKinsey’s Sheila Bonini and Allen Webb conducted separately with Greenberg and Paster in March 2009.

The Quarterly : The reputation of big business has waxed and waned over the years. Do you see anything exceptional in attitudes toward business today?

Stanley Greenberg: What’s special now is that corporate behavior is seen as being central to the most severe economic crisis since the Depression. This is being identified as a crisis produced by bad decisions and irresponsible behavior. That makes reputation issues more dramatic than in any prior period.

Howard Paster: We’ve also got a larger set of reputation issues here: trust, confidence, wondering whether unfettered capitalism is a problem.

The Quarterly : How can companies dig out?

Stanley Greenberg: Responsibility is critical. I don’t mean assigning responsibility, but people in positions of responsibility assuming responsibility. There is probably nothing more important to get right than conveying that the leaders of companies recognize this is a special moment.

I also think this is uniquely a time when the answer to the reputation problem lies less in what you are doing externally and more in what kind of company you run—the way you deal with your employees and consumers, the behavior and compensation of leaders. I don’t think you address this problem by doing more work in food banks or in neighborhoods; I think this is really about business practices. If you’re a bank, people think you have walked away from your essential functions. So you have to highlight how you are resuming business and expanding lending, if you are.

Howard Paster: The first thing you have to do if you’re in financial services is explain to people that you weren’t part of the problem, assuming you weren’t. You need to come up with specific ways to put distance between you and the bad guys. For example, the public face of a company is a big deal. Companies in trouble are wise to change their chief executives.

You’ve also got to announce, all the time, how you’re doing things differently. You have to devise ways of reiterating this again and again—preaching and living integrity internally, having codes of

conduct, having the right kinds of staff briefings, making integrity a basic premise of your operation, building it into your business. At a time when you have less money for philanthropy, for environmental initiatives, or for your employees, you’d better run a place with a lot of integrity.

The Quarterly : How important are symbolic actions, such as Goldman Sachs’s recent announcement that employees will stay at a lower-cost hotel when they go to New York?

Stanley Greenberg: I think it is a big deal. It may look like symbolism, but it is an important new tone. Executives have seemed tone deaf.

The Quarterly : What else can help?

Howard Paster: When a company gets into trouble, we always say, “Who is there that you can bring in, whose reputation is such that he or she, by virtue of being your independent auditor or your independent investigator, can become part of the cleansing process—identify problems, be believed by the media, authenticate changed behavior?” People like to use former attorneys general or someone like former senator Warren Rudman, a man of great probity: strong willed, but God he’s honest and he’ll tell you what he thinks. That’s worth a lot.

The Quarterly : One reason reputation is important is that it will influence regulations and policies. How should companies approach this debate?

Stanley Greenberg: We are going to move to re-regulating a whole range of markets as a result of all this. I think companies, understanding that the public views them as having produced a global crisis of unheard-of proportions, need to be thinking about how they reenter the debate. The perception I see among many companies is that government is overreaching. But I do not think pushing back is the best way to reenter the public discussion about the proper balance of regulation. Right now, I assume CEOs are not a very legitimate voice on how to regulate properly. One of the greater challenges will be how business gets the right voice for a momentous debate. I think responsibility is the critical piece. People are looking for responsibility to be a much stronger value on an individual, corporate, and political level. The companies that get this, that seem to be part of this, are in a much better position to have a voice in re-regulation.

Sheila Bonini is a consultant in McKinsey’s Silicon Valley office, and Allen Webb is a member of The McKinsey Quarterly ’s board of editors.

Assuming responsibility

51

to monitor the multitude of Web-based voices and NGOs, whose power is beginning to rival the mainstream media’s. However, doing these things effectively, while an important prerequisite for stepping up engagement with stakeholders, isn’t the toughest task facing organizations.

Far more of a challenge is preparing to meet serious reputational threats, whose potential frequency and cost have risen dramatically given the greater likelihood that stakeholders—including regulators and legislators—will lash out in an atmosphere that’s become less hospitable to business. These threats might take a variety of forms: issues related to a company’s business performance, like those that financial companies have recently experienced (see sidebar,

“Assuming responsibility”); unexpected shocks along the lines of Johnson & Johnson’s Tylenol scare, more than two decades ago; opposition to business moves, such as expanding operations; or long-standing, sector-specific issues, for instance climate change (industrials and oil and gas), obesity (the food and beverage industry), hidden fees (telecom providers), “e-waste” (high tech), and worker safety (mining).

To prepare for and respond to these threats, our experience suggests that companies should emphasize three priorities. First, they need to assemble enough facts—most important, perhaps, a rich understanding of key stakeholders, including consumers—and not only the product preferences but also the political attitudes of consumer groups. Second, companies should focus on the actions that matter most to stakeholders, something that may call for an exaggerated degree of transparency about corporate priorities or operations. Third, they must try to influence stakeholders through techniques that go beyond traditional PR approaches, with an emphasis on two-way dialogue. Underlying these priorities is a willingness to participate in the public debate more actively than many companies have in the past. Instead of allowing single-issue interest groups to control the conversation, companies should insist on a more complete dialogue that raises awareness of the difficult trade-offs they face.

Understanding stakeholders and their concernsCompanies should first develop a deeper understanding of the reputational issues that matter to their stakeholders and of the degree to which their products, services, operations, supply chains, and other activities affect those issues. A company trying to improve its environmental reputation, for example, needs to document, catalog, and assess its sustainability efforts and then to benchmark them against those of its competitors and industry standards. The facts should be presented objectively and, if possible, quantitatively—for example, the amount of carbon emitted or water used. Quantitative measurements promote effective comparisons and help companies avoid ignoring potential issues or performance gaps.

Such an analysis may lead a company to conclude that it has a good story that should be told more vigorously—or that it should refrain from doing so until it takes real action. The analysis also is the starting point for an objective quantification of reputational risks. The company can prioritize them and the measures needed to keep them at bay by assessing the probability and financial cost of potential reputational events, such as consumer boycotts or the forced closure of operations.

Reputations are built on perceptions, however, so issue analysis isn’t enough. Companies must also know if they are meeting the expectations of key stakeholders—those in the best position to influence sales and growth. To identify these centers of influence, companies should cast a

52

wide net, scrutinizing not just traditional stakeholders (consumers, employees, shareholders, and regulators) but also indirect ones, such as NGOs and the media, that help shape attitudes. Even for companies that don’t deal directly with consumers, it’s important to understand public opinion. People have unprecedented access to information now and may therefore concern themselves with a surprisingly wide array of issues, potentially providing the impetus for regulatory or legislative action.

Each kind of stakeholder has unique perceptions and concerns. Shareholders might ask if reputational issues will affect a company’s long-term growth prospects. Regulators could worry that the public thinks they should curb the company. The media might wonder if it could be an example of how business exploits society. There are different ways of identifying the perceptions of each kind of stakeholder and their root causes (Exhibit 1). A detailed press analysis can help companies to understand the positions of columnists and editors on key issues. Interviews with regulators can clarify their concerns. Focus groups and market research are important for understanding consumers and the wider public.

If consumer research is required, companies must understand that an analysis of how different consumers feel about them differs from typical segmentations: one for reputation management

Exhibit 1

Understanding the stakeholders

Web 2000Corporate reputationExhibit 1 of 2Glance: A company can employ methods specific to each type of stakeholder in seeking to understand its position on reputational issues.

Consumers and partners

Media, including Internet, newspapers, TV

Shareholders, analysts, investors

Regulators

Key issues • Avoiding purchases, because of negative perceptions of company

• Portraying big business issues in a negative light

• Lacking the in-depth reporting required for a balanced view of the issue

• Effect on share prices • Changing investments

• Shaping policy and regulation

• Monitoring impact on consumers, environment, and society

Key questions asked by stakeholders

• Limited; if any, probably through investment conferences

• Limited, usually through telephone discussions with investor relations unit

• Multiple in-depth meet-ings with executives at all senior leadership levels

• Follow-up conversations, if necessary, with investor relations unit

• Occasional meetings, calls with investor relations unit

• Semiannual or annual senior-management meetings

Civil society—eg, activist groups, nongovernmental organizations (NGOs), labor unions

• Advocating environmental, social, governance, and economic standards

Actions company can take

• Past financials, consensus estimates, trading informa-tion, implied valuation

• Web site, press releases, management press, sell-side analyst calls and reports, industry reports

• Past operations and unit-level information, man-agement’s future strategy and forecasts, industry outlook, management’s background

• Detailed follow-up information from company

• Quarterly updates on performance, significant changes in outlook

• Quarterly updates on performance, significant changes in outlook



Questions company should ask

• Limited; if any, probably through investment conferences

• Limited, usually through telephone discussions with investor relations unit

• Multiple in-depth meet-ings with executives at all senior leadership levels

• Follow-up conversations, if necessary, with investor relations unit





A company can employ methods specific to each type of stakeholder in seeking to understand its position on reputational issues.

e x h i b i t 1

Understanding the stakeholders

53

resembles a dissection of voters in a political campaign rather than a parsing of customers who prefer different types of products or services. There might, for example, be a group of consumers who care deeply about social issues and will weigh in aggressively on regulatory ones affecting a company’s operations. Others, such as swing voters, might be undecided about whether, or how, to become involved. Some could be uninterested and unlikely to take action. Still others may be so anti- or probusiness that their positions are set in stone. One consumer company facing regulatory challenges used this type of “social attitudinal” segmentation to analyze consumers (Exhibit 2). After identifying people who were both influential and open-minded, the company focused on addressing their needs, and the public’s attitudes toward it improved.

Transparency and actionReputations are built on a foundation not only of communications but also of deeds: stakeholders can see through PR that isn’t supported by real and consistent business activity. Consumers, our research indicates, feel that companies rely too much on lobbying and PR unsupported by action. They also fault companies for not sharing enough information about critical business issues—for manufacturers, say, the content of their products, their manufacturing processes, and their treatment of production employees. Transparency in such matters is crucial. Sometimes it highlights a mismatch between consumer expectations and a company’s performance and therefore calls for action. In other cases, transparency can convince key stakeholders that the company is headed in the right direction.

After the director of the US Food and Drug Administration voiced reservations about the side effects of the high-cholesterol treatment Crestor, for example, AstraZeneca not only placed ads in the national press to present its case but also took the unusual step of providing raw clinical-trial data on its Web site, allowing completely independent researchers to draw their own conclusions. This was a high-risk strategy, since it’s always possible to draw different statistical inferences from the same data. But the strategy reestablished public trust and stabilized Crestor’s market share.

Exhibit 2

Whom to target

Segment 7Young, uninvolved; have not yet formed opinions

Segment 6Distrustful of business; struggling to pay bills

Segment 5Angry about industry; skeptical of big business

Segment 4Knowledgeable; concerned about effect of company

Segment 1Believers in the system, its companies

Segment 2Moms who value choice for their families

Segment 3Educated, well-off;generally comfortable with company

Attitudinal segments

For disguised European consumer company

% of population

Perception of company by segments

Size of the bubble = segment size

16 1113

14

18 13

15

Positive

NegativePerc

eptio

n of

com

pany

Low

Reinforce strengths

Build relationship

Track over time

Level of participation/influence

High

1

4

6

3

7 5

2

54

Consider also the efforts of the US plastics industry to overcome a consumer and regulatory backlash, in the late 1980s, over plastic packaging’s environmental impact. The CEOs of leading companies joined forces to reframe the public debate not just through an award-winning ad campaign illustrating positive applications of plastics (in child safety, for example) but also by committing the industry to recycling and thus to solving environmental problems. The industry could do so credibly because it undertook real actions, such as spending $1.2 billion on recycling research and developing a standardized plastics-coding system.

Such actions need not take place only in response to reputational concerns; at other times, they help build goodwill that may provide some degree of cover against future bad news. A willingness to tackle climate change has helped companies like Toyota Motor and GE, for example, build strong reputations that are holding up better than those of many other major automotive and financial-services players. Sometimes, reputation-oriented actions may even have a direct impact on sales. In 2008, for instance, Best Buy began inviting customers to bring their old electronics into its stores for recycling. The program has not only generated positive press and helped position the company as an environmental leader but is also increasing foot traffic in stores.

Engaging a broad group of influencersFormal marketing and PR do play an important role in managing the reputation of a company, but when it responds to serious threats it must use many other means of spreading positive messages about its activities quickly (Exhibit 3). In general, credible third parties speaking for

Exhibit 3

No time to wastePurpose

To ensure opportunity to refute critics and deliver messages in daily news cycles

Media professionals’ war room, responsible for monitoring, responding to news

No attack left unanswered; respond to every reporter

Examples Desired outcomes

War room

To deliver messages through low-cost, high-trust channels

Speeches, events, press conferences Regularly create new stories showing company in favorable light

Free media

To deliver messages with maximum control of message and targeting

Television, print ads, brochures, Web sites, mailings

Ensure everyone hears, sees, reads message

Paid media

To develop relationships with broad set of stakeholders; listen and deliver messages to them

Meetings with politicians, organizations (eg, unions), media, other stakeholders

Wide network of influential supporters; better understanding of detractors

Networking

To reinforce messages through charitable contributions

Timberland’s charitable focus on environmental causes

Positive associations from working on good causes

Giving

To reinforce messages and reduce reputational risks through activities within business

Starbucks’s fair trade–certified coffee; Nike’s supplier policies

Seamless integration between company’s actions and reputational consequences

Operations

To gain credibility by working with others to solve industry-wide reputation issues

Labor certification standards in textile industry

More friends to help in shared reputation battles

Partnerships

To use high-credibility people to reinforce strategic messages

Placing prominent people on board, in executive positions

People with star power speaking up for the company

Surrogates

To leverage energy of current supporters

Bumper stickers, blogs, interactive Web sites

Support for company is highly visibleGrassroots

Using a number of communication channels, beyond the typical public-relations approach, can boost awareness of a company’s activities effectively.

55

the company can boost its reputation more effectively than its own PR or marketing department. Leveraging existing grassroots support—through blogs, bumper stickers, and interactive Web sites, for example—is one method. Another is to have people with high standing reinforce key strategic messages. Partnerships between the company and NGOs can be important not only because of their credibility but also because they can alert it to performance gaps early in the game. A network of positive relationships with credible third parties (such as journalists and NGOs) can also help the company get out its side of the story when crises do hit.

One company worried about what it saw as the dangerous inaccuracy of its portrayal in the press targeted opinion leaders with concise facts to dispel misunderstandings and gave regulators a scientific paper outlining the possible negative consequences of proposed regulations. A broader communication program describing recent and forthcoming changes in the company’s business practices was released to the general public. This approach was effective, but even more nuanced forms of impact are possible: influencing specific bloggers, using company blogs to start conversations with consumers (a tactic Cisco, HP, and Intel, among others, use), and reaching scientists through research discussion boards.

Increasingly, two-way dialogue is critical. Consider, for example, Chevron’s “Will you join us?” campaign, which addresses many of the oil industry’s most difficult questions, such as the developing world’s energy needs, the role of renewables, environmental protection, and the problems that will get worse if we go on using oil as we do now. The campaign not only embodies a new level of openness about the industry’s challenges but also asks the public to join the conversation on a Web site with a moderated discussion board and interactive tools providing information about conserving energy.

In this more complex world of influence strategy, no single kind of approach is likely to be sufficient to deal with fast-moving situations. Companies must instead initiate a multidisciplinary, cross-functional effort that can quickly identify reputational issues and plant responses in broader strategy, operations, and communications. The groups involved might include regulatory affairs, the general counsel, PR or corporate communications, marketing, corporate social responsibility, and investor relations.

To achieve the necessary coordination, a senior executive should be accountable for such efforts. A strong understanding of customers and marketing might make the CMO appropriate to play this role.2 But it’s the CEO who must lead a company’s overall reputation strategy, ideally with the support of a board committee focused on it. This may seem like a lot of firepower, but in today’s climate, with reputational issues threatening both shareholders and a company’s ability to achieve broader goals, that degree of high-level attention and integration is essential.

Sheila Bonini is a consultant in McKinsey’s Silicon Valley office, David Court is a director in the Dallas office, and Alberto Marchi is a principal in the Milan office. Copyright © 2009 McKinsey & Company.

All rights reserved.

Related articles

“When social issues become strategic”

“The trust gap between consumers and corporations”

“Valuing corporate social responsibility: McKinsey Global Survey Results”

“CEOs as public leaders: A McKinsey Survey”

2 See David Court, “The evolving role of the CMO,” mckinseyquarterly.com, August 2007.


Michele Zanini

Major crises and downturns often produce shakeouts that redefine industry structures. However, these crises do not fundamentally change an underlying structural trend: the increasing inequality in the size and performance of large companies. Indeed, a financial crisis—for example, the one that erupted in 2008— is likely to accelerate this intriguing long-term tendency.

The past decade has seen the rise of many “mega-institutions”—companies of unprecedented scale and scope—that have steadily pulled away from their smaller competitors.1 What has received less attention is the striking degree of inequality in the size and performance of even the mega-institutions themselves. Plotting the distribution of net income among the global top 150 corporations in 2005, for example, doesn’t yield a common bell curve, which would imply a relatively even spread of values around a mean. The result instead is a “power curve,” which, unlike normal distributions, implies that most companies are below average.

Such a curve is characterized by a short “head,” comprising a small set of companies

with extremely large incomes, and drops off quickly to a long “tail” of companies with significantly smaller incomes. This pattern, similar to those illustrating the distribution of wealth among ultrarich individuals, is described by a mathematical relationship called a “power law.”2 The relationship is simple: a variable (for example, net income) is a function of another variable (for example, rank by net income) with an exponent (for example, rank raised to a power).

Exhibit 1 shows the top 30 US banks and savings institutions in June 1994, 2007, and 2008, measured by their domestic deposits (the 2008 shares of different institutions were adjusted to reflect the surge of banking M&A in the autumn of 2008). The exhibit shows that inequality has been increasing from 1994 (when the number-ten bank was roughly 30 percent of the size of the largest one) to 2008 (when it was only 10 percent as large as the first-ranked institution). It also shows how in 2008, the financial crisis accelerated the growth of the top five compared with the other banks in the top ten as the largest financial institutions took advantage of their relatively healthy balance

Using ‘power curves’ to assess industry dynamics

Using ‘power curves’ to assess industry dynamics 57

sheets and absorbed banks in the next tier. Regulation could put a damper on this crisis-driven accelera- tion of inequality, but power curve dynamics suggest that it will not reverse the trend. Indeed, we found long-term patterns of increasing inequality in size and performance in a variety of industries and markets when we used metrics such as market value, revenues, income, and assets to plot the size of companies by rank.

Our analysis suggests that an industry’s degree of openness and competitive intensity is an important determinant of its power curve dynamics. You would expect a bigger number of competitors and consumer choices to flatten the curve, but in fact the larger the system, the larger the gap between the number-one and the median spot. As Exhibit 1 shows, after the liberalization of US interstate bank-

ing, in 1994, deposits grew significantly faster in the top-ranking banks than in the lower-ranking ones, creating a steeper power curve. Greater openness may create a more level playing field at first, but progressively greater differentiation and consolidation tend to occur over time, as they did when the United States liber- alized its telecom market.

Power curves are also promoted by intangible assets—talent, networks, brands, and intellectual property—because they can drive increasing returns to scale, generate economies of scope, and help differentiate value propositions. Exhibit 2 shows a significant degree of inequality, across the board, in the size and performance of companies in a number of sectors we researched. But the more labor- or capital-intensive sectors, such as chemicals and machinery, have flatter curves than

1Adjusted to re�ect acquisitions from June to Oct 2008.

Source: FDIC; McKinsey analysis

0

10

20

30

40

50

60

70

80

90

100

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

June 1994

June 2007

June 20081

Rank by banking deposits



e x h i b i t 1

Increasing inequality in banking

Top 30 US commercial banks and savings institutions by total domestic deposits; index: largest company = 100


intangible-rich ones, such as software and biotech.

The fact that industry structures and outcomes appear to be distributed around

“natural” values opens up an intriguing new field of research into the strategic implications. Notably, the extreme outcomes that characterize power curves suggest that strategic thrusts rather than incremental strategies are required to improve a company’s position significantly. Consider the retail mutual-fund industry, for example. The major players sitting atop this power curve (Exhibit 3) have opportunities to extend their lead over smaller players by exploiting network effects, such as cross-selling individual retirement accounts (IRAs), to a large installed base of 401(k) plan holders as they roll over their assets. The financial crisis of 2008 may well boost this opportunity further as weakened financial institutions consider placing their asset-management units on the block to raise capital.

When executives set strategy, power curves can be a useful diagnostic tool for understanding an industry’s structural dynamics. In particular, there may well be commonalities across sectors in the way these curves evolve, and that might make it possible to gain better insights— based on the experience of other industries—into an industry’s evolution. As the importance of intangible assets increases across sectors, for example, will power curves in media and insurance resemble the currently much steeper ones found in today’s intangible-rich sectors such as software and biotech? Power curves could also benchmark an industry’s performance. Curves for specific industries evolve over many years, so the appearance of large deviations from a more recent “norm” can indicate exceptional performance, on one hand, or instability in the market, on the other.

Unlike the laws of physics, power curves aren’t immutable. But their ubiquity and consistency suggest that companies

Source: Global Vantage; McKinsey analysis

100

90

80

70

60

50

40

30

20

10

021 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Distribution of market values, 2006; index: company with highest market value in each sector = 100

Rank by market value

Biotech

Insurance

Software

Machinery

Chemicals

Selected industries



e x h i b i t 2

Sector variations

Using ‘power curves’ to assess industry dynamics 59

are generally competing not only against one another but also against an industry structure that becomes progressively more unequal. For most companies, this possibility makes power curves an important piece of the strategic con- text. Senior executives must understand them and respect their implications.

Michele Zanini is an associate principal in McKinsey’s Boston office.

1 See Lowell L. Bryan and Michele Zanini, “Strategy in an era of global giants,” mckinseyquarterly.com, November 2005.2The power laws phenomenon has been explored in the recent books The Black Swan: The Impact of the Highly Improbable (Nassim Nicholas Taleb, Random House, 2007) and The Long Tail: Why the Future of Business is Selling Less of More (Chris Anderson, Hyperion, 2006).

r2 is the proportion of variance explained by a regression.

Source: Pensions & Investments; McKinsey analysis

450

500

400

350

300

250

200

150

100

50

05 10 15 20 25 300

Rank by 401(k) assets under management

US 401(k) assets under management by top 30 companies, 2006, $ billion

r2 = 0.98



e x h i b i t 3

A steep slope

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