Brake problems. A fuel leak. A cracked windshield. One electrical fire. Then another. An emergency landing in Japan. A safety investigation imposed by the FAA. Then two premier customers—Japan’s two main airlines, ANA and JAL, ground their fleet of Boeing [BA] 787s. Then the FAA grounds all 787s used by the only American carrier. Now other regulators around the world follow suit, grounding all 50 of the 787s delivered so far. The regulatory grounding of an entire fleet is unusual—the first since 1979—and relates to a key to the plane’s claimed energy-efficiency: the novel use of lithium ion batteries, which have shown a propensity to overheat and lead to fires—fires that generate oxygen and hence are difficult to put out.

And keep in mind: Boeing’s 787 project is already billions of dollars over budget. The delivery schedule has been pushed back at least seven times. The first planes were delivered over three years late. In fact, out of a total of 848 planes sold, only 6 percent have been delivered.

Yet grave as these issues seem, they are merely symptoms of a deeper disease that has been gnawing at the US economy for decades: flawed offshoring decisions by the C-suite. Offshoring is not some menial matter to be left to accountants in the backroom or high-priced consultants armed with spreadsheets, promising quick profits. It raises mission-critical issues potentially affecting the survival of entire firms, whole industries and ultimately the economy.

Not just Boeing: an economy-wide problem

Thus Boeing is hardly alone in making flawed offshoring decisions. Boeing is just the latest and most spectacular example of an economy-wide problem.

“Many companies that offshored manufacturing didn’t really do the math,” Harry Moser, an MIT-trained engineer and founder of the Reshoring Initiative told me. As many as 60 percent of the decisions were based on miscalculations.

As noted by Gary Pisano and Willy Shih in their classic article, “Restoring American Competitiveness” (Harvard Business Review, July-August 2009), offshoring has been devastating whole US industries, stunting innovation, and crippling capacity to compete long-term.

Pisano and Shih write: “The decline of manufacturing in a region sets off a chain reaction. Once manufacturing is outsourced, process-engineering expertise can’t be maintained, since it depends on daily interactions with manufacturing. Without process-engineering capabilities, companies find it increasingly difficult to conduct advanced research on next-generation process technologies. Without the ability to develop such new processes, they find they can no longer develop new products. In the long term, then, an economy that lacks an infrastructure for advanced process engineering and manufacturing will lose its ability to innovate.”

Pisano and Shih have a frighteningly long list of industries that are “already lost” to the USA, including: compact fluorescent lighting; LCDs for monitors, TVs and handheld devices like mobile phones; electrophoretic displays; lithium ion, lithium polymer and NiMH batteries; advanced rechargeable batteries for hybrid vehicles; crystalline and polycrystalline silicon solar cells, inverters and power semiconductors for solar panels; desktop, notebook and netbook PCs; low-end servers; hard-disk drives; consumer networking gear such as routers, access points, and home set-top boxes; advanced composite used in sporting goods and other consumer gear; advanced ceramics and integrated circuit packaging.

The list of industries “at risk” is even longer and more worrisome.

Now unless Boeing can quickly fix the technical issues afflicting the 787, its entire airline business will also be “at risk”. Manufacturing airplanes could even become an addition to the list of industries “already lost.”

These issues are a wakeup call not just to Boeing but to every CEO whose firm or whose suppliers have been or will be involved in offshoring. Every CEO must learn seven lessons.

1.      Use the right metrics to evaluate offshoring

In analyzing offshoring, firms must get beyond rudimentary cost calculations focused on short-term profit,, such as the cost of labor or the ex-factory cost and incorporate the total cost and risk of extended international supply chains. This is easily done with the help of the Reshoring Initiative, whose website includes an analytical tool enabling companies to calculate the full risks and costs of offshoring. It’s called the Total Cost of Ownership Estimator[TM]. And the price is right. It doesn’t require hiring high-priced consultants: it’s free.

The Estimator poses a series of questions. What’s the price of the part from each of the destinations? How far is it away? How often are you going to travel to see the supplier? How much intellectual property risk is there? How long do you think you are going to make it? It uses the answers to calculate twenty-five different costs. When they are added up, that’s the Total Cost of Ownership.

Most companies have tended to make their sourcing decisions based on the wage rate or the ex-works price or the landed cost, and leave out another twenty cost categories. The Estimator makes it easy for the company to calculate the other twenty costs.

“Often what firms find,” says Moser, “is that whereas the offshoring price is perhaps 30 percent less than the US price, all these other costs add up to more than 30 percent. If they are willing to recognize all of them, then they can see that it may be profitable to bring the work back.”

“For instance,” says Moser, “I took the last 27 cases where users compared China to the US. On average, the US price was 69 percent higher than the production price in China. It turned out that the US total cost of ownership was 4 percent lower. So it made a huge difference to make that calculation. That’s an indication that a substantial portion of the work that has been offshored would come back if people would use the right metrics.”

2.      Review whether earlier outsourcing decisions made sense

Let’s back up a bit and note that Boeing’s problems have been visible for some time. In August 2011, my article drew attention to the perilous offshoring course on which Boeing was embarked.

In December 2012, fellow Forbes contributor Jonathan Salem Baskin wrote: “The company was convinced by one or more management consulting firms to outsource design and production of the 787’s components. While this idea might make sense for sourcing coffeemakers, it was a nonsense approach to assembling perhaps the most complicated and potentially dangerous machines shy of nuclear reactors. I’m sure blather from Harvard Business Review supported the idea that distances between factories in Seattle and Outer Mongolia were no farther than a VOIP chat, but the reality was a mess. Parts didn’t fit together with others. Some suppliers subcontracted work to their suppliers and then shrugged at problems with assembly. When one part wasn’t available, the next one that depended on it couldn’t be attached and the global supply chain all but seized up. Boeing had to spend $1 billion in 2009 to buy one of the worst offenders and bring the work back in-house.”

“The grounding — an unusual action for a new plane — focuses on one of the more risky design choices made by Boeing, namely to make extensive use of lithium ion batteries aboard its airplanes for the first time,” write Christopher Drew, Jad Mouawad and Matthew Wald in the New York Times: “The 787’s problems could jeopardize one of its major features, its ability to fly long distances at a cheaper cost… The maker of the 787’s batteries, Japan’s GS Yuasa, has declined to comment on the problems so far. “

What was Boeing thinking when they opted to embrace such extensive offshoring? Moser believes the error lay in using the wrong measure of the impact of offshoring on earnings. “Many companies that offshored manufacturing didn’t really do the math,” Harry Moser, an MIT-trained engineer and founder of the Reshoring Initiative told me. “A study the consulting company, Archstone,  showed that 60 percent of offshoring decisions used only rudimentary cost calculations, maybe just price or labor costs rather than something holistic like total cost. Most of the true risks and cost of offshoring were hidden.”

For many companies, it’s time to redo the math, and then verify whether they still have the expertise to bring manufacturing back.

3.      Don’t outsource mission-critical components

“Boeing has acknowledged, says Moser, “that its biggest problem was in outsourcing not only manufacturing but also a lot of the engineering. There were multiple tiers of outsourced companies who were supposed to be making their designs consistent so that the parts fit together. And they didn’t fit together. If Boeing had taken full responsibility for the engineering and then had jobbed the parts out and gotten them made to print, their problems would have been a lot less severe. It seems like they had this brilliant idea of outsourcing a lot of engineering with the manufacturing. There’s almost nothing as complicated as a Dreamliner.

“For example, an iPhone isn’t nearly as complicated. The downside risk isn’t as great. Apple has succeeded with outsourcing almost everything to Foxconn, mainly because they first completely manufacture the new product in the US. They make sure it’s right, while Foxconn is working in parallel with them, developing their tooling and whatever. So Apple has a finished product and they say to Foxconn: make it just like this! What Apple has done has worked amazingly well, because they have the capability to do the perfect prototype here, before it gets offshored to Foxconn. Most companies don’t have that.

“Thus Boeing didn’t have a finished product. So there were all kinds of risks of things not coming together. The tendency is too often for companies to try to do the engineering over here and the manufacturing over there. Eventually the innovation declines and the risk increases, as outlined by Pisano and Shih.”

4.      Bring some manufacturing back

Moser estimates that when the total costs are included, around 25 percent of manufacturing that is currently outsourced could be profitably brought home, if the manufacturing expertise still exists. Looking ahead, changes in relative economics are likely to increase that percentage.

It is important to take into account rapid changes in relative costs. Oil prices are three times what they were in 2000. Natural gas in the US is a quarter of what it is in Asia. Chinese wages are five times what they were in 2000 and are expected to keep rising rapidly. And in any event labor is a steadily decreasing percentage of the cost of manufacturing.

Reshoring is already happening to a limited extent. Apple [AAPL] announced recently that it will resume manufacturing of one of the existing Mac lines in the US next year. GE [GE] is spending some $800 million to re-establish manufacturing in its giant facility—until recently, almost defunct—at Appliance Park, in Louisville, Kentucky. Whirlpool [WHR] is bringing mixer-making back from China to Ohio. Otis is bringing elevator production back from Mexico to South Carolina. And Wham-O Toys is bringing Frisbee-molding back from China to California. Based on the reshoring articles in the ReshoreNow Library, Moser calculates that at least 50,000 manufacturing jobs have recently been reshored in the last three years.

Where companies see that it could be profitable to bring manufacturing back, they will need to ensure that they either have or can rebuild the necessary expertise—sometimes a daunting challenge.

5.      Adequately assess the risk factors of offshoring

In Boeing’s case, as  Jonathan Salem Baskin notes: “It didn’t help that the outsourcing plan included skipping the detailed blueprints the company would have normally prepared, and allowing vendors to come up with their own. Delivered components arrived with instructions and notes written in Chinese, Italian, and other languages. Oh, and they decided to build the airplane out of plastic along with other novel materials and technologies, so it would have been a big experiment even if Boeing approached manufacturing like it always had.”

Clearly firms have underestimated the risk of having extended international supply chains. I asked Moser whether Total Cost of Ownership Estimator can help firms get a better handle on that risk.

“The TCO Estimator assigns no factor values apart from freight,” says Moser. “The user assigns all the factors. The user answers questions about the delivery time, and the price. That enables the Estimator’s algorithm to assess the inventory and the inventory carrying costs. There’s a section on opportunity cost. If the firm will lose orders because it can’t deliver, then put a value on that. There are sections on natural disaster risk and political risk. “

If Boeing had been using this earlier what would be the implications? If they underestimated the delay risk or the technical risk as low, the Estimator would have reflected the underestimation of the risk.

“The Estimator would have encouraged them to try to estimate each of the risks,” says Moser. “When you have twenty-five of them, you only have to put in 1 percent in each to balance the savings you might get from going offshore.

“If you are buying pencils, not much intellectual property risk; if you can’t get it from this source, you can get it from somewhere else. The margins aren’t big, so you don’t lose so much. You don’t have much image to lose. But when you are making airplanes, there’s a lot of risk. Instead of having one size fit all, the Estimator lets you adapt for each product, each market, and make a more holistic and informed decision.

“The Reshoring Initiative site also offers resources. Library contains articles about transportation industry and equipment, and firms can understand where production was reshored and why. They might conclude: ‘Looks like a lot of companies are having problems with these things. Maybe we should increase our risk levels?’

“The Initiative also has information on what other users have found on the distribution of average costs. If they look at that, they might realize that some costs and risks have been underestimated. So the Estimator can help them make better decisions.”

   6.  Adequately value the role of innovation

Much of the offshoring that has taken place has assumed that the outsourced items are “little do-hickeys” with low value and so didn’t really matter much in the overall scheme of things. The little do-hickeys are worth pennies or less and have next-to-no margin. While those “little do-hickeys” might seem cheap in themselves, the lessons to be learned in improving their manufacture in the end can turn out to be highly valuable. (In cost accounting and economics, which usually don’t explicitly value knowledge, this loss is invisible and so doesn’t get taken into account.)

Firms often haven’t thought through how often they are going to redesign this product. “If it’s a bracket and you’re not going to redesign it for 30 years, it doesn’t matter very much,” says Moser. These days however there are very few components that are good for another thirty years. “If it is something that you are updating every six months or every year, then that becomes a lot more important. It’s the difference between a commodity and something that’s design-driven. The result of answering those questions is an ‘innovation cost of being at a distance.’ The Reshoring Initiative has resources so that firms can develop the understanding to make better decisions.“

The opportunity cost of lost innovation can be significant. Thus when GE decided to bring manufacturing of its innovative GeoSpring water heater back from the “cheap” Chinese factory to the “expensive” Kentucky factory, the cost of production went down. “The material cost went down. The labor required to make it went down. The quality went up. Even the energy efficiency went up. GE wasn’t just able to hold the retail sticker to the ‘China price.’ It beat that price by nearly 20 percent. The China-made GeoSpring retailed for $1,599. The Louisville-made GeoSpring retails for $1,299.

GE’s water heater as originally designed for manufacture in China had a tangle of copper tubing that was difficult to weld together. In the past, GE had been shipping the design to China and telling them to “make it”. Confronted with making the water heater themselves, they discovered that “in terms of manufacturability, it was terrible.” So GE’s designers got together with the welders and redesigned the heater so that it was easier and cheaper to make. They eliminated the tangle of tubing that couldn’t be easily welded. By having those workers right at the table with the designers, the work hours necessary to assemble the water heater went from 10 hours in China to two hours in Louisville.

“For years,” Charles Fishman writes in a great article in The Atlantic, “too many American companies have treated the actual manufacturing of their products as incidental—a generic, interchangeable, relatively low-value part of their business. If you spec’d the item closely enough—if you created a good design, and your drawings had precision; if you hired a cheap factory and inspected for quality—who cared what language the factory workers spoke? … It was like writing a cookbook without ever cooking…. there is an inherent understanding that moves out when you move the manufacturing out. And you never get it back.”

What is only now dawning on the smart American companies, Lou Lenzi, head of design for GE appliances says, is that when you outsource the making of the products, “your whole business goes with the outsourcing.”

7.      Get to the root of the problem: maximizing shareholder value

While several decades of outsourcing were under way, why didn’t these smart managers think about the importance of innovating and protecting intellectual property? Why didn’t these well-educated managers realize that it was important to have designers, engineers, and assembly-line workers talk to each other? Why didn’t these MBA graduates realize that outsourcing might be mortgaging the future of their firms?

“There was a herd mentality to the offshoring,” John Shook, the CEO of the Lean Enterprise Institute, in Cambridge, Massachusetts. “And there was some bullshit. But it was also the inability to see the total costs—the engineers in the U.S. and factory managers in China who can’t talk to each other; the management hours and money flying to Asia to find out why the quality they wanted wasn’t being delivered. The cost of all that is huge.”

When managers manage with a spreadsheet rather than real-world knowledge about what is actually going on in the factory and what were its possibilities, they overlook hidden costs of the erosion of skills, the loss of quality and constraints on innovation. They also missed the potential added value to customers that could be generated by designing and manufacturing things differently. They also missed the costs and risks of an international supply chain, which is increasingly out of step with the shorter, faster product cycles.

Why did all these smart, highly educated people make all these mistakes? The root cause of these errors is a focus on the dumbest idea in the world: maximizing shareholder value. Focusing on short-term shareholder value ended up destroying vast quantities of long-term shareholder value.

A focus on maximizing shareholder value leads the firm to do things that detract from maximizing long-term shareholder value, such as offshoring, favoring cost-cutting over innovation, and pursuit of “corner cutting” and “bad profits” that destroy brand equity. The net result can be seen in the disastrously declining ROA and ROIC over the last four decades in large US firms as documented by Deloitte’s Shift Index.

The errors of offshoring are thus not isolated events. They are the result of the underlying philosophy of shareholder value, rather than the true purpose of every firm: create value for customers. The resurrection of American manufacturing will require more than simply bringing back production to America. Global manufacturing is at the cusp of a massive transformation as the new economics of energy and labor plays out and a set of new technologies—robotics, artificial intelligence, 3D printing, and nanotechnology—are advancing rapidly. Together these developments will spark a radical transformation of manufacturing around the world over the next decade. The winners in the rapidly changing world of manufacturing will be those firms that have mastered the agility needed to generate rapid and continuous customer-based innovation.

Success in this new world of manufacturing will require a radically different kind of management from the hierarchical bureaucracy focused on shareholder value that is now prevalent. It will require a different goal (adding value for customers), a different role for managers (enabling self-organizing teams), a different way of coordinating work (dynamic linking), different values (continuous improvement and radical transparency) and different communications (horizontal conversations). Merely shifting the locus of production is not enough. Companies need systemic change—a new management paradigm.

Pursuit of maximizing shareholder value at Boeing led to offshoring that has caused massive damage to shareholder value. The eventual scale of the damage can only be guessed at today. The remedy lies not in pointing fingers at Boeing’s management, but rather in treating the economy-wide disease that caused the problem.

And read also:

Why Amazon Can’t Make A Kindle In The USA

Dont’s Diss The Paradigm Shift In Management

How Manufacturing Can Learn from Software To Become Agile

The dumbest idea in the world: maximizing shareholder value

The five big surprises of radical management

________________________

Steve Denning’s most recent book is: The Leader’s Guide to Radical Management (Jossey-Bass, 2010).

Follow Steve Denning on Twitter @stevedenning

 

Never doubt that a small group of thoughtful, committed citizens can change the world. Indeed, it is the only thing that ever has.

Margaret Mead

Just over a year ago, some colleagues and I decided to find out whether Margaret Mead was right. Could a small group of thoughtful, committed citizens actually change the world? Jurgen Appelo, Franz Röösli, and Peter Stevens and I got together to see whether we could help spark a revolution in the way organizations around the world are led and managed. Fat chance, right?

Well, our plan was even more far-fetched. We invited 17 others to come to Stoos, Switzerland – a tiny alpine village accessible only by rail or cable car.

The first positive sign was that the twenty-one invitees actually showed up. They traveled from four continents to the Alps of central Switzerland with the quixotic goal facilitating a complete transformation of leadership and management in the global business landscape.

The second good sign was that the day-and-a-half meeting resulted in the group of strong-minded individuals with significant differences in point of view reaching broad agreement on what was wrong and committing to work together to fix it. They issued a simple communique that among other things described the complexity and seriousness of the problem and urged organizations to become “learning networks of individuals creating value and that the role of leaders should include the stewardship of the living rather than the management of the machine.”

The third nice sign was even more important: the advocates of different approaches to creating and sustaining these “learning networks of individuals creating value through stewardship of the living” were able to set aside their differences and get behind a common goal that reflected the commonalities of their viewpoints. The Stoos 21 declined to specify the ‘right way’ to lead or manage or any particular roadmap to success. Instead they invited others to join the movement and help make the transformation happen.

In one year, 1,500+ join the Stoos Network

The next good sign was that the invitation got an immediate and strong response. Over the twelve months since the initial Stoos gathering, more than 1,500 people have answered the call and joined what has become known as the Stoos Network.

Want to join: go here!

And follow the lively discussion about the Stoos Network on Twitter with  the hashtag is #stoos.

A number of Stoos “satellites” have sprung up around the world, including six in the US, thirteen in Europe and three in Asia-Pacific. Along with several major gatherings during the year, there have been countless numbers of meetings in the satellites. So much activity has been generated that it has in fact been difficult to keep track, let along take stock, of what has been happening. These developments are really rather remarkable, given that it has all happened spontaneously without central direction.

The next step: Stoos Connect on January 25

Now a new milestone is imminent. Stoos Connect is a six-hour online event that will take place on Friday 25 January 2013, informally also known as World Stoos Day. Stoos Connect offers a chance to take stock of what has happened, to evaluate the extent of the progress, to lay plans for enlarging the movement and make the tipping point actually happen.

The center of Stoos Connect is in the De Balie (Salon), Leidseplein, Amsterdam, and features a great speaker lineup, including Roger Martin (dean of the Rotman School of Business), Dan Pink (author of Drive), Jurgen Appelo (Management 3.0) and Lisa Earle McLeod  (author of Selling With Noble Purpose). Over twenty satellites around the world will participate.

Stoos Connect will be a live broadcast via the Internet. Unlike many any other online events, the broadcast is intended not only for individuals. The organizers are encouraging satellites to set up physical sites where locals can gather together to participate in the event as a group. Some twenty sites have been set up. More contact information for each site below.

Our understanding of the problem has deepened

Stoos Connect will be an opportunity to recognize that over the course of the year the global understanding of the problem that we are dealing with has broadened and deepened, both within and beyond the Stoos movement.

Thus there are finally signs that the hegemony of the dumbest idea in the world—maximizing shareholder value –is coming to an end. Despite rearguard efforts from The Economist to defend the indefensible, the Drucker Forum in November 2012 came out strongly to put this noxious idea behind us.

Another standby of 20^th Century management thinking—sustainable competitive advantage—also had a rough time during the year. Today, there is a growing recognition that in the 21^st Century the only comparative advantage is temporary. The forthcoming book by Professor Rita McGrath of Columbia Business School, The End of Competitive Advantage, should further drive home the point.

During 2012, we also started to see signs of reversing the most short-sighted decision in the world: international out-sourcing.

While the scariest story in the world–big banks and derivatives—got a whole lot scarier, we now have a clearer and deeper understanding of what’s wrong and how to fix it.

Meanwhile Harvard Business Review helped expose the most overpaid people in the world—the C-suite—and an important book by Ellen Schultz detailed the shocking heist of workers’ retirement funds. This is a problem in itself–i.e. HBR calls “the financial incentives bubble”–as well as being a major constraint on getting positive change.

Overall, by year’s end, there was a much sharper and wider awareness that we are in a phase change to a different and more creative kind of economy. It’s good to see that more and more companies, like Whole Foods, are exemplifying the paradigm shift in management and urging others to join them.

So although we’re not yet at the tipping point, during the year we saw important signs that we are getting there. There is a growing awareness that the shift is a shift in the management paradigm, not just about adopting some new  tools or processes. The shift is as transformational as the shift from the medieval view that the sun revolves around the earth to the view that earth and the other planets revolve around the sun. It is a fundamental transition in world-view. Once people make this shift, everything is different.

Next for Stoos: a movement of movements?

Different speakers at Stoos Connect will present their views on where to from here. My own talk will highlight the need for the Stoos movement to go beyond being a unique large-scale global movement on its own (already a significant accomplishment) and in addition catalyze “a movement of movements”.

Thus the Stoos movement is not alone in pushing for a shift in the leadership and management paradigm. Other movements that are genuinely dedicated to achieving a paradigm shift in leadership and management include the Management Innovation Exchange, the Drucker Society Global Network, the Beyond Budgeting Roundtable, the Scrum Alliance, the Agile Alliance, the Society for Organisational Learning and the Daedalus Trust.

The movements have more in common with each other and Stoos than they have significant differences.

The type of leadership and management they are all referring to is radically different from the management mindset of most of the Global 1000, from the management practices usually advocated by leading consulting and private equity firms, and from the management practices taught in the majority of courses in today’s business schools and celebrated endlessly in some management journals.

Recognizing and working together with these other movements will be the key to accelerating the transformation and getting to the tipping point.

Join Stoos Connect!

If you too would like to be a ‘steward of the living’ than “a manager of the machine’, please join one of the Stoos Connect satellites below and participate in this global event on January 25:

• De Balie, Amsterdam, The Netherlands: Main Venue
• Munich, Germany [munich@stoosconnect.nl]
• Berlin, Germany [team@intrinsify.me]
• Barcelona, Spain [barcelona@stoosconnect.nl]
• Madrid, Spain [josem_zamarron@solspain.org]
• Hamburg, Germany (external link, will open in new window)
• Melbourne, Australia (external link)
• Bordeaux, France (external link)
• New Haven, CT, USA (external link) [newhaven@stoosconnect.nl]
• Oslo, Norway (by Oslo Lean Meetup group) (external link)
• Sao Paulo, Brazil (external link) [amagno@adaptworks.com.br]
• Upper Silesia – Oberschlesien, Poland [silesia@stoosconnect.nl]
• Ottawa, Ontario, Canada [gschaadt@deltapartners.ca]
• Zürich, Switzerland [zurich@stoosconnect.nl]
• Vilnius, Lithuania (Adform) [vilnius@stoosconnect.nl]
• Skopje, Macedonia (private company event) [skopje@stoosconnect.nl]
• Chicago, IL, USA (exact location t.b.d.) [chicago@stoosconnect.nl]
• Geneva, Switzerland (exact location t.b.d.) [geneva@stoosconnect.nl]
• Research Triangle Park, NC, USA (exact location t.b.d.) [rtp@stoosconnect.nl]
• Denver, CO, USA (Oppenheimerfunds) [denver@stoosconnect.nl]

And read also:

Facilitating a tipping point for organizations

The phase change to a creative economy

The key missing ingredient in leadership today

The new management paradigm and John Mackey’s Whole Foods

The five surprises of radical management

____________

Steve Denning‘s most recent book is: The Leader’s Guide to Radical Management (Jossey-Bass, 2010).

Follow Steve Denning on Twitter @stevedenning

On the face of it, shareholder value is the dumbest idea in the world.

Jack Welch, 2009

What on earth is going on with Procter & Gamble [PG] and Unilever [UL]? In the period 2000-2009, during which A.G.Lafley was CEO, P&G was universally perceived as a winner and Lafley was regarded as one of the very best performing CEOs of his generation. His successor at P&G in 2009, Bob McDonald, was appointed from within P&G, in order to continue the strong track record of success. By contrast, in that period, the performance of P&G’s competitor, Unilever, was widely regarded as poor: its board was forced to look outside the firm for a new CEO and eventually found one in 2009 with a somewhat surprising pedigree: long-time rival P&G.

Yet in recent months, perceptions in the business press have suddenly reversed. Both The Economist and Fortune have both published scathing articles about P&G’s performance, suggesting that P&G management is failing, while making unfavorable comparisons to Unilever. Unilever is now being hailed as a winner and P&G is now being depicted as a dog.

Hedge fund activist, William Ackman of Pershing Square Capital Management purchased $1.8 billion in P&G shares, and reportedly asked for McDonald’s resignation. P&G’s CEO Bob McDonald now finds himself under siege: recently the Board felt it necessary to issue a public statement in his support.

How did P&G go so swiftly from being a “winner” to being a “loser”? How did Bob McDonald become a dunce so quickly, while Paul Polman, CEO of Unilever, has abruptly become a star? To try to make sense of all this, I consulted Roger Martin, Dean of the Rotman School of Management at the University of Toronto and the guru of customer capitalism, to find out what on earth is going on.

SD: Roger, are you in a position to shed some light what’s going on with the topsy-turvy evaluations of P&G and Unilever and their CEOs?

ROGER MARTIN: I know both companies and both CEOs well. I have consulted to P&G leadership for the past 27 years. Paul Polman came from P&G. He and I worked intensively together on strategy at P&G in the 1990s during his formative years there as a general manager. And I also worked lots with Bob McDonald in that period and I advise him today. I have praised Paul’s work at Unilever in my recent article in BusinessWeek: basically I love what he is doing there.

SD: So what do you make of the current discussion of the performance of P&G and Unilever and their CEOs?

ROGER MARTIN: Frankly, the current narrative in the capital markets about Paul Polman versus Bob McDonald drives me nuts. I admit I have low expectations of Wall Street analysis to begin with, but the thinking and logic here are so lame that they surprise even me. The overwhelming narrative now is that Paul is a genius and Bob is a dummy, based on the “fabulous” stock performance of Unilever and the “terrible” performance of P&G under their respective leadership.

SD: So what’s really going on?

ROGER MARTIN: Let’s look the data behind the story. You may recall we had a little problem in 2008 with a bit of a stock market meltdown. And that was preceded with a big run up in stock values. This was ubiquitous and influenced most all big companies. The S&P 500 hit its all-time high of 1561.80 on October 12, 2007 and then cratered to 43% of its high when it bottomed at 676.53 on March 9, 2009. Then it gradually worked its way up to 1472.12 as of close of trading yesterday, 94% of its all-time high and 218% of the bottom.

Both P&G and Unilever experienced the same wild ride at almost the exact same times. P&G hit its all-time high of $74.40 a couple of months after the S&P on December 13, 2007 and then cratered to 59% of its high when it bottomed at $44.18 on March 1, 2009 (a week away from the S&P bottom) and then worked its way up to yesterday’s closing of $69.27, which is 93% of its all-time high and 157% of the bottom.

Unilever hit its all-time high of $37.95 two weeks after P&G on December 28, 2007 and then cratered to 59% of its high when it bottomed at $17.04 on March 9, 2009 (same day as the S&P bottom) and then worked its way up to yesterday’s closing of $38.73, 102% of its all-time high and 227% of the bottom.

SD: How does this relate to CEO performance at the respective companies?

ROGER MARTIN: Both Paul and Bob took over their current positions in close proximity to the bottom of the S&P and both of their stocks – Paul on January 1, 2009 and Bob on July 1, 2009. I think it is fair to say that neither one of them had a thing to do with the fact that the global capital markets had tanked nor that their respective stocks were right there with it. And it is hard to argue that there would have be a whit of difference had they switched start dates. Basically, they both inherited a company near the bottom of a stock market and economic crisis and both have had 3-4 years to work on their way out of that mess.

SD: What conclusions should an analyst draw?

ROGER MARTIN: First, there is no escape from the expectations market for a single company. P&G and Unilever peaked with the bull market and crashed with the bear market and recovered from the trough with the market. Expectations swung wildly for everyone involved.

Second, the biggest difference between the stock market performances of Paul and Bob over this boom-bust-recovery period between late 2007 and the end of 2012 is that Unilever crashed as much as the market (S&P – down to 43% of peak; Unilever – 45%) and P&G managed to crash a lot less (59% of peak). This makes Unilever’s recovery from the trough (227%) much more impressive than P&G’s (157%) and since P&G dropped less than the S&P, P&G looks like it lags the S&P (218%).

Third, if you ask how these two men fared in restoring their stock prices to their previous glory – the pre-crash high – there isn’t much of a story. By the end of 2012, the S&P was back to 94% of its pre-crash high. P&G, despite its ‘terrible’ performance, was also at 93%. Unilever was 102%.

So what does it come down to? Paul is a genius and Bob is a dummy because of those nine percentage points in the market’s expectations about the future of Unilever versus P&G? Nine percentage points in stock price appreciation defines the range between genius and dummy? So if the stock price of Unilever would be $34.53 rather than $38.73, Paul would be a dummy. And if P&G would be $75.89 rather than $69.27, Bob would be a genius.

SD: Are the markets saying that Paul did a better job than Bob in digging Unilever out of a deeper stock price trough?

ROGER MARTIN: That’s the kind of classically lame argument that often comes out of capital markets. The depth of the trough is a function of expectations, not reality. Investors put themselves into and out of troughs of their own volition.

SD: So how should we evaluate the performance of the two firms and their CEOs?

ROGER MARTIN: For me the most compelling argument is the following. Who was in charge of P&G when it hit its all-time high? It was A.G. Lafley, who is rightly lauded as one of the world’s best CEOs of his generation. By the mid-2000s, he had turned around P&G and had it humming on literally all its cylinders.

How about Unilever? Well the board was sufficiently displeased with the performance of the company and its existing management team that it found it necessary to go outside for the first time in history to appoint a CEO – Paul Polman. I think that accounts more than anything else for the relatively modest 11-point difference in relative expectation from pre-crash peak to current for these two companies.

SD: So why are capital market heavyweights now calling for Bob McDonald’s ouster?

ROGER MARTIN: Apparently they want to enforce the following rule on public companies: “We will bid up the price of your stock to whatever in our wildest expectation fantasies we imagine that it is worth and then hold you accountable for earning a sparkling return on that value, and if you don’t do it immediately we will savage you and the stock price and get somebody else to bring it back up to where it was when we started haranguing you.” And we wonder why America’s economy seems terminally screwed up!

And read also:

The Dumbest Idea In The World: Maximizing Shareholder Value

Q&A With Roger Martin: Fighting The Kool-Aid Of Stock-Based Compensation

How Do You Fix Bad Habits?

Solving the innovation enigma

Bureaucracy, anarchy and innovation amnesia

____________

Steve Denning’s most recent book is: The Leader’s Guide to Radical Management (Jossey-Bass, 2010).

Follow Steve Denning on Twitter @stevedenning

 

Remember Jaws? In 1975, the small town of Amity was on the eve of the Fourth of July weekend, a time of celebration of the founding of this marvelous country. But just before the celebration was about to begin, a vicious shark attack occurs. Concerned about losing the money from the holiday tourist trade, the mayor and townsfolk ignore the warnings to keep people out of the water. But then after another shark attack, and yet another, the town’s leadership finally grasps the peril, but not before more disasters occurred.

Jaws, writes John Whitehead, wasn’t just a simple story about sharks. Instead, it was a social commentary about how a love of money can blind us to averting preventable disasters.

Fast forward to the financial meltdown of 2008 and what do we see? America again was celebrating. The economy was booming. Everyone seemed to be getting wealthier, even though the warning signs were everywhere: too much borrowing, foolish investments, greedy banks, regulators asleep at the wheel, politicians eager to promote home-ownership for those who couldn’t afford it, and distinguished analysts openly predicting this could only end badly. And then, when Lehman Bros fell, the financial system froze and world economy almost collapsed. Why?

The root cause wasn’t just the reckless lending and the excessive risk taking. The problem at the core was a lack of transparency. After Lehman’s collapse, no one could understand any particular bank’s risks from derivative trading and so no bank wanted to lend to or trade with any other bank. Because all the big banks’ had been involved to an unknown degree in risky derivative trading, no one could tell whether any particular financial institution might suddenly implode.

Since then, massive efforts have been made to clean up the banks, and put in place regulations aimed at restoring trust and confidence in the financial system. But the result in terms of dealing with the basic problem, according to a terrific article by Frank Partnoy and Jesse Eisinger in The Atlantic entitled “What’s Inside America’s Banks?” is failure.

Another global financial crisis is on the way

Financial reform didn’t work. Banks today are bigger and more opaque than ever, and they continue to trade in derivatives in many of the same ways they did before the crash, but on a larger scale and with precisely the same unknown risks.

Ignoring warning signs has inevitable consequences. We ignored them before and we saw what happened. We can say this with virtual certainty: if we continue as now and ignore them again, the great white shark of a global financial meltdown will gobble up the meager economic recovery and make 2008 look like a hiccup.

We can’t say when this will happen. We can’t say which bank or which particular instrument will trigger the debacle. What we can say with virtual certainty is that if we continue as now is that it will happen. Because the scale of the trading is larger, and because the depleted government treasures are not well placed for another huge bailout, the impact will be worse than 2008.

Today’s financial scandals are mere sideshows

Thus the biggest risk we face is not the stories of repeated wrongdoing by the banks that are still making headlines, such as:

• Trading gone awry: JPMorgan’s [JPM] loss of $6 billion from trading activities of which CEO Jamie Dimon was blissfully unaware.
• Price fixing at LIBOR. “Many of the biggest banks now stand accused of manipulating the world’s most popular benchmark interest rate, the London Interbank Offered Rate (LIBOR).
• Foreclosure abuses. Just this week, big banks agreed two settlements totaling $20.15 billion for foreclosure abuses.
• Money laundering: Accusations of illegal, clandestine bank activities are also proliferating. Large global banks have been accused by U.S. government officials of helping Mexican drug dealers launder money (HSBC), and of funneling cash to Iran (Standard Chartered).
• Tax evasion: Two Swiss banks were involved in Switzerland-based. In 2009, UBS [UBS] helped 20,000 U.S. taxpayers with assets of about $20 billion hide their identities from the IRS. Now, the oldest Swiss bank, Wegelin & Co. has been indicted on criminal charges for helping U.S. taxpayers avoid taxes on at least $1.2 billion for a nearly ten years.
• Misleading clients with worthless securities: Only after the financial crisis of 2008 did people learn that banks routinely misled clients, sold them securities known to be garbage, and even, in some cases, secretly bet against them to profit from their ignorance.

The world’s scariest story: trading in derivatives

Bad as these scandals are and vast as the money involved in them is by any normal standard, they are mere blips on the screen, compared to the risk that is still staring us in the face: the lack of transparency in derivative trading that now totals in notional amount more than $700 trillion. That is more than ten times the size of the entire world economy. Yet incredibly, we have little information about it or its implications for the financial strength of any of the big banks.

Moreover the derivatives market is steadily growing. “The total notional value, or face value, of the global derivatives market when the housing bubble popped in 2007 stood at around $500 trillion… The Over-The-Counter derivatives market alone had grown to a notional value of at least $648 trillion as of the end of 2011… the market is likely worth closer to $707 trillion and perhaps more,” writes analyst Jenny Walsh in The Paper Boat.

“The market has grown so unfathomably vast, the global economy is at risk of massive damage should even a small percentage of contracts go sour.  Its size and potential influence are difficult just to comprehend, let alone assess.”

The bulk of this derivative trading is conducted by the big banks. Bankers generally assume that the likely risk of gain or loss on derivatives is much smaller than their “notional amount.” Wells Fargo for instance says the concept “is not, when viewed in isolation, a meaningful measure of the risk profile of the instruments” and “many of its derivatives offset each other”.

However as we learned in 2008, it is possible to lose a large portion of the “notional amount” of a derivatives trade if the bet goes terribly wrong, particularly if the bet is linked to other bets, resulting in losses by other organizations occurring at the same time. The ripple effects can be massive and unpredictable.

Banks don’t tell investors how much of the “notional amount” that they could lose in a worst-case scenario, nor are they required to. Even a savvy investor who reads the footnotes can only guess at what a bank’s potential risk exposure from the complicated interactions of derivatives might be. And when experts can’t assess risk, and large bets go wrong simultaneously, the whole financial system can freeze and lead to a global financial meltdown.

In 2008, governments had enough resources to avert total calamity. Today’s cash-strapped governments are in no position to cope with another massive bailout.

Wells Fargo: is this good bank “extremely safe”?

The article in The Atlantic clarifies what’s going on by exploring what’s going on inside what is arguably the safest and most conservative bank: Wells Fargo [WFC].

Last year, I had written an article about the case for considering Wells Fargo as a “a good bank”.

Wells does what banks are supposed to do: take deposits  and then lend the money back out. Interest margin drives half its revenues. Fees from mortgages, investment accounts and credit cards generate the other half. ‘I couldn’t care less about league tables,’ says Wells CEO Stumpf. ‘I’m more interested in kitchen tables and conference room tables.’ By operating a bank like a bank, the article says, Stumpf has at once made Wells exceedingly profitable—for 2011 the bank’s net income jumped 28% to $15.9 billion, on $81 billion in revenue—and extremely safe. The value of Wells Fargo’s shares is now the highest of any U.S. bank: $173 billion as of early December 2012.

Wells Fargo: large scale trading in derivatives

But among the startling disclosures in the article in The Atlantic from examining the footnotes in its most recent annual report are:

• The sheer volume of proprietary trading at Wells Fargo suggests that this bank is not what it seems.
• A large part of that trading is not in safe conservative things like equities or bonds but in derivatives—the things that almost blew up the economy in 2008.
• These derivatives are hidden under seemingly the benign headings.
• The scale of this trading is breath-taking.
• The benignly labeled activity “customer accommodations” has derivatives on its books with notional risk of $2 trillion. That number, assuming it is accurate, can make any particular trading loss appear minuscule.

A lower circle of financial hell: “special purpose entities” redux

Ever heard of “variable interest entities” aka VIEs? If not, you are not alone. They are phenomena that reside in what The Atlantic calls “an even lower circle of financial hell” than proprietary trading. They are basically a new label for “special-purpose entities” i.e. the infamous accounting devices that Enron employed to hide its debts. These deals were called ‘off-balance-sheet’ transactions, because they did not appear on Enron’s balance sheet.

The article likens variable interest entities to “a horror film, which the special-purpose entity has been reanimated… The problem is especially worrisome at banks: every major bank has substantial positions in VIEs.”

As of the end of 2011, Wells Fargo, the “extremely safe bank”, reported “significant continuing involvement” with variable-interest entities that had total assets of about $1.5 trillion. The ‘maximum exposure to loss’ that it reports is much smaller, but still substantial: just over $60 billion, more than 40 percent of its capital reserves. The bank says the likelihood of such a loss is ‘extremely remote.’ As The Atlantic comments: “We can hope.”

Worse: “Wells Fargo… excludes some VIEs from consideration, for many of the same reasons Enron excluded its special-purpose entities: the bank says that its continuing involvement is not significant, that its investment is temporary or small, or that it did not design or operate these deals. (Wells Fargo isn’t alone; other major banks also follow this Enron-like approach to disclosure.)… The presence of VIEs on Wells Fargo’s balance sheet ‘is a signal that there is $1.5 trillion of exposure to complete unknowns.’”

Other banks are even riskier

Thus it turns out that Wells Fargo isn’t so much an “extremely safe” bank in absolute terms but rather a bank that isn’t doing as much risky stuff as the other big banks. “One reason Wells Fargo is trusted more than other big banks is that its notional amount of derivatives is comparatively small… It’s just somewhat less involved in derivatives than other banks.” The amount of its ‘notional involvement’ in proprietary trading in derivatives amounts to “only” about half the size of the entire US economy.

By contrast, at the end of the third quarter of 2012, JPMorgan had $72 trillion in notional amount on its books—almost five times the size of the U.S. economy, or about the size of the entire world economy.

But even at the lower levels of trading by Wells Fargo, the numbers are so large that they put Wells Fargo’s seemingly immense capital reserves—$148 billion—as a mere drop in an ocean of potential losses.

Wells Fargo declined to answer questions from the journalists from The Atlantic. Their response to requests for clarification was to suggest re-reading the unhelpful sections of the annual report. They also declined to answer: “How much money would Wells Fargo lose from these trades under various scenarios?”

Ironically, Jamie Dimon has been proven right when he made light of the $6 billion trading loss at JPMorgan last year. Compared to the scale of these potential losses, and the financial crisis that lies ahead, a loss of $6 billion is merely a “tempest in a teacup.”

How does Wells Fargo make money?

The Atlantic also finds worrying issues in how Wells Fargo does make money. Scouring through Wells Fargo’s annual report, seemingly safe conservative categories turn out to involve proprietary trading:

• Almost $1.5 billion of the seemingly safe “interest income” comes from “trading assets”;
• Another $9.1 billion results from “securities available for sale.”
• One billion dollars of the bank’s seemingly safe “non-interest income” are “net gains from trading activities.”
• Up and down the ledger, abstruse, all-embracing categories appear: “other fees earned from related activities,” “other interest income,” and just plain “other.” The income statement’s “other” catchalls collectively amounted to $6.6 billion of Wells Fargo’s income in 2011.

Meanwhile in this world of shell games and mind-boggling numbers, big losses can go unremarked. Buried in a footnote on page 164 of Wells Fargo’s annual report is the admission of a trading loss of $377 million loss on trading derivatives related to certain CDOs,” or collateralized debt obligations went unremarked, because of bigger losses for instance at JPMorgan. “Wells Fargo’s massive CDO-derivatives loss was a multi-hundred-million-dollar tree falling silently in the financial forest. To paraphrase the late Senator Everett Dirksen, $377 million here and $377 million there, and pretty soon you’re talking about serious money.”

Specialists and hedge funds as much in the dark as the public

Public confidence in banks is now at a record low. According to Gallup, in the late 1970s, around 60 percent of Americans said they trusted big banks “a great deal” or “quite a lot.” In June 2012, less than 25 percent of respondents told Gallup they had faith in big banks.

But it’s not just public confidence. Specialists are equally bewildered. The Atlantic cites:

• Ed Trott, a former Financial Accounting Standards Board member, when asked whether he trusted bank accounting, he said, simply, “Absolutely not.”
• Several financial executives told The Atlantic that they see the large banks as “complete black boxes.”
• A chief executive of one of the nation’s largest financial institutions considers banks “uninvestable,” a Wall Street neologism for “untouchable.”
• Paul Singer, who runs the influential investment fund Elliott Associates, wrote to his partners this summer, “There is no major financial institution today whose financial statements provide a meaningful clue” about its risks.
• Arthur Levitt, the former chairman of the SEC, lamented to us in November that none of the post-2008 remedies has “significantly diminished the likelihood of financial crises.”
• A recent survey by Barclays Capital found that more than half of institutional investors did not trust how banks measure the riskiness of their assets.
• When hedge-fund managers were asked how trustworthy they find “risk weightings”—the numbers that banks use to calculate how much capital they should set aside as a safety cushion in case of a business downturn—about 60 percent of those managers answered 1 or 2 on a five-point scale, with 1 being “not trustworthy at all.” None of them gave banks a 5.
• A disturbing number of former bankers have recently declared that the banking industry is broken, including Herbert Allison, the ex-president of Merrill Lynch and former head of the Obama administration’s Troubled Asset Relief Program, Philip Purcell (ex-CEO of Morgan Stanley Dean Witter), Sallie Krawcheck (ex-CFO of Citigroup), David Komansky (ex-CEO of Merrill Lynch), and John Reed (former co-CEO of Citigroup) and Sandy Weill, another ex-CEO of Citigroup. The Atlantic notes that “this newfound clarity typically follows their passage from financial titan to rich retiree.”
• Bill Ackman, one of the nation’s highest-profile and most successful investors, lost almost $400 million betting on the recovery of Citigroup [C]. Last spring, Pershing Square sold its entire stake in Citigroup, as the bank’s strategy drifted, at a loss approaching $400 million.

Wall Street doesn’t trust big banks

Wall Street already reflects its distrust of the big banks. Even after a run-up in the price of bank stocks this fall, many remain below “book value,” which means that the banks are worth less than the stated value of the assets on their books. This indicates that investors don’t believe the stated value, or don’t believe the banks will be profitable in the future—or both.

The reality is that even an ostensibly simple and “extremely safe” bank like Wells Fargo impossible to understand. Every major bank’s financial statements have some or all of these problems; many banks are much worse.

Regulation hasn’t worked

In the wake of the recent financial crisis, the government has moved to give new powers to the regulators who oversee the markets. But the net result of the effort to regulate the big banks is almost as stupefying as the amounts of money involved. Draft Basel III regulations total 616 pages. Quarterly reporting to the Fed required a spreadsheet with 2,271 columns. 2010’s Dodd-Frank law was 848 pages and required regulators to create so many new rules (not fully defined by the legislation itself) that it could amount to 30,000 pages of legal minutiae when fully codified. What human mind can possibly comprehend all this?

Complex accounting rules have thus made the problem worse. Clever bankers, aided by their lawyers and accountants, find ways around the intentions of the regulations while remaining within the letter of the law. Because these rules have grown ever more detailed and lawyerly—while still failing to cover every possible circumstance—they have had the perverse effect of allowing banks to avoid giving investors the information needed to gauge the value and risk of a bank’s portfolio.

What to do: more clarity and actual sanctions

Some experts propose that the banking system needs more capital. Others call for a return to Glass-Steagall or a full-scale breakup of the big banks. These reforms could help, but none squarely addresses the problem of opacity, or the mischief that opacity enables.

The Atlantic suggests that a starting point is “to rebuild the twin pillars of regulation that Congress built in 1933 and 1934, in the aftermath of the 1929 crash. First, there must be a straightforward standard of disclosure for Wells Fargo and its banking brethren to follow: describe risks in commonsense terms that an investor can understand. Second, there must be a real risk of punishment for bank executives who mislead investors, or otherwise perpetrate fraud and abuse.”

The Atlantic argues that these two pillars don’t require massively complicated regulation. The straightforward disclosure regime that prevailed for decades starting in the 1930s didn’t require extensive legal rules. Nor did vigorous prosecution of financial crime.

However it does require political will-power. The decision not to prosecute UBS for criminal tax fraud in 2009, when a smaller bank was so prosecuted, sends a clear signal that the large banks are not only too big to fail and too complex to manage. They are also too big to punish.

The Atlantic suggests a grand bargain: “simpler rules and streamlined regulation if they subject themselves to real enforcement.”

A paradigm shift in banking

Rules and penalties can only take us so far. Nothing significant is likely to change until the dynamic of the financial sector changes. The SEC and the courts can pursue the banks with court cases and penalties, but they will always be confronted with time-wasting legal defenses, as well as time lags between the invention of new ways to fleece customers and the discovery and proof of those methods.

The financial sector is in effect an extreme example of the shareholder value theory run amok. Pursuit of profit not only undermines the banks themselves and ultimately the global economy as a whole.

Regulation and enforcement will only work if it is accompanied by a paradigm shift in the banking sector that changes the context in which banks operate and the way they are run, so that banks shift their goal from making money to adding value to stakeholders, particularly customers. This would require action from the legislature, the SEC, the stock market and the business schools, as well as of course the banks themselves.

Ultimately, change is for the banks’ own good. Without it, investors will continue to worry about which bank will be the next Lehman Brothers, while the rest of us can only brace ourselves for the next inevitable financial cataclysm.

And read also:

The new management paradigm and John Mackey’s Whole Foods

Lest We Forget: Why We Had A Financial Crisis

Does Wells Fargo practice radical management?

What shall we do with the big bad banks?

Big bad banks: The science of changing pathologically asocial behavior

_________

Steve Denning’s most recent book is: The Leader’s Guide to Radical Management (Jossey-Bass, 2010).

Follow Steve Denning on Twitter @stevedenning

Imagine a business that is born out of a dream about how the world could be and should be…

Picture a business built on love and care rather than stress and fear, whose team members are passionate and committed to their work…

Think of a business that cares profoundly about the well-being of its customers, seeing them not as consumers but as flesh-and-blood human beings whom it is privileged to serve…

Envision a business that embraces outsiders as insiders, inviting its suppliers into the family circle and treating them with the same love and care it showers on its customers and team members.

Imagine a business that is a committed and caring citizen of every community it inhabits, elevating its civic life and contributing in multiple ways to its betterment….

Imagine a business that exercises great care in whom it hires, where hardly anyone ever leaves once he or she joins…

See in your mind’s eye a business that chooses and promotes leaders because of their wisdom and capacity for love and care…

Imagine a business that exists in a virtuous cycle of multifaceted value creation… while also delivering superior financial results year after year, decade after decade…

Unreal?

Not so, say John Mackey, Co-CEO of Whole Foods Markets [WFM] and co-founder of the conscious capitalism movement and Raj Sisodia in their brilliant new book, Conscious Capitalism: Liberating the Heroic Spirit of Business (Harvard Business Review Press, January 2013): a great start to the new year!

Such businesses, say Mackey and Sisodia—suffused with higher purpose, leavened with authentic caring, influential and inspirational, egalitarian and committed to excellence, trustworthy and transparent, admired and emulated, loved and respected—are not imaginary entities in some fictional utopia. The prime example that they offer is of course Whole Foods itself, but there are other firms which also implement the principles. “They exist in the real world, by the dozens today but soon to be by the hundreds and thousands.”

A paradigm shift in management

The book is a hymn of praise to the emerging new paradigm of management as well as a guide on how to implement it. The book isn’t just talking about a few management techniques or tools. It’s presenting a different way of thinking and speaking and acting in the workplace.

Mackey and Sisodia are of course not alone in arguing that a shift in the management paradigm is under way. They join other thought leaders, including Alan W. Brown, John Seely Brown, Rod Collins, Bill George, Ranjay Gulati, John Hagel, Gary Hamel, Umair Haque, Vlatka Hlupic, Roger Martin, Lisa Earle McLeod, Vineet Nayar, Franz Roeoesli, Fred Reichheld and Jeff Sutherland.

Mackey and Sisodia call their particular flavor of the paradigm shift “conscious capitalism”. Other writers use different terms, including “customer capitalism”, “stakeholder capitalism”, “management 2.0”, “reorganizing for resilience”, “the power of pull”, “employees first”, the “net promoter system”, “wiki-management” or “radical management”.

Whatever it is called, it is radically different from the management mindset of most of the Global 1000, from the management practices usually advocated by leading consulting and private equity firms, and from the management practices taught in the majority of courses in today’s business schools and celebrated endlessly in some management journals.

The shift in management paradigm is as transformational as the shift from the medieval view that the sun revolves around the earth to the view that earth and the other planets revolve around the sun. It is a fundamental transition in world-view. Once you make this shift, everything is different.

The book cites as examples of companies today that exemplify the new management paradigm: Whole Foods Market [WFM], The Container Store, Patagonia, Eaton [ETN], the Tata Group, Google [GOOG], Panera Bread [PNRA], Southwest Airlines [LUV], Bright Horizons, Starbucks [SBUX], UPS [UPS], Costco [COST], Wegmans, REI, Twitter, and POSCO [PKX]. In his foreword, Bill George throws the net even wider and includes: IBM, Apple, Novartis, Wells Fargo, and General Mills.

Whether all of these firms now exhibit all of the characteristics of conscious capitalism deserves further examination. Even in Whole Foods itself, of which I’m the biggest fan, performance varies considerably from store to store. And let’s be honest: it’s as easy to find a disengaged checkout clerk there as it is in any supermarket (why no self-checkouts?)

And IBM? It’s a stretch to suggest that IBM is “suffused with higher purpose” and “leavened with authentic caring”. Or “egalitarian” and “a business built on love”? Give me a break! Although parts of IBM implement some of what the book is talking about, much of IBM is firmly entrenched in management practices aimed at extracting money from customers.

But most of the firms that Mackey and Sisodia cite are at least aspiring to move towards the principles of the new management paradigm that the authors articulate. And as the superior financial results of firms that genuinely practice the new management paradigm become apparent, its ultimate triumph is inevitable.

The ten-year share price of most of the publicly owned companies cited by the authors are doing significantly better than the S&P 500.

S&P 500                                +51%
Whole Foods                     +250%
Eaton Corporation            +182%
Google                                 +740%
Southwest Airlines               -30%
Starbucks                            +420%
UPS                                         +20%
Costco                                  +260%
POSCO                                +230%

REI is consumer cooperative that appears to be profitable.  We don’t know the profitability of the firms that are privately owned: Wegmans, The Container Store, Patagonia, the Tata Group and Twitter. It seems that privately owned firms find it easier to practice conscious capitalism than those subjected to the pressures of the stock market.

Bright Horizons is a widely admired child care provider. It was acquired by a private equity firm in 2008. Given the explicit objective of private equity (i.e. making more money quickly), one has to wonder whether love and trust in that firm will survive the “turnaround”.

Strengths of the book

The book is nevertheless a welcome addition to the growing literature on the new management paradigm. It is particularly strong on:

• A brilliant exposition of the values and thought-patterns of the new management paradigm.
• A devastating critique of the current dominant management paradigm
• New insights on how to weave all the stakeholders, the community and the environment into the management of a firm that still makes a lot of money.
• How the new paradigm differs from mere tweaks or facelifts to the current paradigm, such as corporate and social responsibility or Michael Porter’s shared value.

Capitalism has been its own worst enemy

The book accepts harsh criticism of the current practices of capitalism: “exploiting workers, cheating consumers, causing inequality by benefiting the rich but not the poor, homogenizing society, fragmenting communities, and destroying the environment. Entrepreneurs and other businesspeople are accused of being motivated primarily by selfishness and greed.” Mackey and Sisodia agree:

1. Businesspeople have allowed the ethical basis of free-enterprise capitalism to be hijacked intellectually by economists and critics who have foisted on it a narrow, self-serving, and inaccurate identity devoid of its inherent ethical justification…
2. Too many businesses have operated with a low level of consciousness about their true purpose and overall impact on the world.
3. In recent years, maximization of profits has taken root in academia as well as among business leaders.
4. Crony capitalism is restricting competition in favor of politically well-connected businesses.

The book argues that the heart of the problem is that businesses today view their purpose as profit maximization and treat all participants in the system as means to that end. These firms may succeed in creating material prosperity in the short term, but the resultant price tag of long-term systemic problems is increasingly unacceptable and unaffordable, both for the firm itself and for society. Shareholder capitalism simply doesn’t work, even on its own terms.

Mackey and Sisodia note that symptoms of dysfunction and disaffection abound in the corporate world.

• The average level of engagement that American team members have with their work has remained at 30 percent or less for the past ten years, and almost as many people are hostile to their employers.
• Top executives at the helm of many major corporations have rigged the game to enrich themselves at the expense of the company and its stakeholders. According to the Institute for Policy Studies, the ratio between CEO pay and average pay was 42: 1 in 1980, 107: 1 in 1990, and 525: 1 in 2000. It has fluctuated in recent years, standing at 325: 1 in 2010.
• Crony capitalists and governments have become locked in an unholy embrace, elevating the narrow, self-serving interests of the few over the well-being of the many. They use the coercive power of government to secure advantages not enjoyed by others: regulations that favor them but hinder competitors, laws that prevent market entry, and government-sanctioned cartels.
• The dominant narrative about business is that it is greedy, exploitative, manipulative and corrupt. The majority of human beings on the planet thus experience themselves as furthering and supporting greed, exploitation, manipulation and corruption. When people experience themselves that way, they actually begin to become that way.

The biggest sin of capitalism as practiced today however is that it doesn’t work even on its own terms. It is making less and less money.

Conscious capitalism makes more money

Enter the new management paradigm. In addition to creating social, cultural, intellectual, physical, ecological, emotional, and spiritual value for all stakeholders, conscious businesses excel at delivering exceptional financial performance over the long term. For example, a representative sample of conscious firms outperformed the overall stock market by a ratio of 10.5: 1 over a fifteen-year period, delivering more than 1,600 percent total returns when the market was up just over 150 percent for the same period.

• Conscious businesses win, but they do so in a way that is far richer and more multifaceted than the traditional definition of winning, in which others must lose for someone to win.
• Conscious businesses believe that right actions undertaken for the right reasons generally lead to good outcomes over time.
• Traditional businesses give their managers hard targets for metrics like market share, profit margins, and earnings per share. Such metrics confuse cause and effect. To achieve those numbers— which are just abstractions— managers often knowingly undertake actions that are harmful to stakeholders, including, ultimately, shareholders. For example, managers might squeeze their team members or their suppliers. These actions may deliver the desired numbers in the next quarter, but they also plant the seeds for much bigger problems in the future.

The myth of profit maximization

The book argues that for capitalism to succeed, it has to shed the foundational belief that profit maximization is the sole purpose of business. This myth has done enormous damage to the reputation of capitalism and the legitimacy of business in society. Conscious capitalism aims to recapture the narrative and restore its true essence: the purpose of business is to improve our lives and to create value for stakeholders.

The authors envisage a heroic story of free-enterprise capitalism in which entrepreneurs use their dreams and passion as fuel to create extraordinary value for customers, team members, suppliers, society, and investors.

The thesis of conscious capitalism is that business is good because it creates value, it is ethical because it is based on voluntary exchange, it is noble because it can elevate our existence, and it is heroic because it lifts people out of poverty and creates prosperity. It is grounded in an ethical system based on value creation for all stakeholders. Money is one measure of value, but it is not the only measure.

A new management paradigm for a new chapter in human history

Mackey and Sisodia argue that the new management paradigm is necessary in part because the landscape for business has been transformed. People today care about different things and are better informed, better educated, and better connected than in the past; their expectations from businesses in their roles as customers, team members, suppliers, investors, and community members are rapidly changing. Unfortunately, most companies have not evolved to keep pace with all these changes and are still doing business using mind-sets and practices that were appropriate for a very different world. It is now time to change that.

These changes are challenging. They also offer great business opportunities which however cannot be effectively addressed if we use the same mental models we have operated with in the past. “Business as usual” will not work anymore. We need a new philosophy to lead and work by.

Conscious capitalism is not about being virtuous or doing well by doing good. It is a way of thinking about business that is more conscious of its higher purpose, its impacts on the world, and the relationships it has with its various constituencies and stakeholders. It reflects a deeper consciousness about why businesses exist and how they can create more value.

Conscious capitalism has four tenets: higher purpose, stakeholder integration, conscious leadership, and conscious culture and management. The four are interconnected and mutually reinforcing. The tenets are foundational; they are not tactics or strategies. They represent the essential elements of an integrated business philosophy that must be understood holistically to be effectively manifested.

As the figure shows, higher purpose and core values are central to a conscious business; all the other tenets connect back to these foundational ideas.

Stakeholder Integration

Stakeholders are all the entities that impact or are impacted by a business. Conscious businesses recognize that each of their stakeholders is important and all are connected and interdependent, and that the business must seek to optimize value creation for all of them. All the stakeholders of a conscious business are motivated by a shared sense of purpose and core values. When conflicts and potential trade-offs arise between major stakeholders, conscious businesses engage the limitless power of human creativity to create win-win-win-win-win-win solutions that transcend those conflicts and create a harmony of interests among the interdependent stakeholders.

Conscious Leadership

Conscious business requires conscious leadership. Conscious leaders are motivated primarily by service to the firm’s higher purpose and creating value for all stakeholders. They reject a zero-sum, trade-off-oriented view of business and look for creative, synergistic win-win-win approaches that deliver multiple kinds of value simultaneously.

Conscious culture and management

Conscious cultures naturally evolve from the enterprise’s commitments to higher purpose, stakeholder interdependence, and conscious leadership. They usually share many traits, such as trust, accountability, transparency, integrity, loyalty, egalitarianism, fairness, personal growth, and love and care.

Conscious businesses use an approach to management that is consistent with their culture and is based on decentralization, empowerment, and collaboration. This amplifies the organization’s ability to innovate continually and create multiple kinds of value for all stakeholders.

Conscious Capitalism provides an ethical foundation that is essential but has been largely lacking in business. The larger the company, the greater its footprint and therefore its responsibility to the world.

Conscious capitalism is not corporate and social responsibility

A good business doesn’t need to do anything special to be socially responsible. When it creates value for its major stakeholders, it is acting in a socially responsible way. The whole idea of corporate social responsibility (CSR) is based on the fallacy that the underlying structure of business is either tainted or at best ethically neutral.

Conscious capitalism is not shared value

Bill George’s foreword misleadingly suggests that conscious capitalism “dovetails perfectly” with the shared value idea of Harvard Business School guru, Michael Porter. Mackey and Sisodia take a different tack. Conscious capitalism focuses on shared human values, not just shared economic value. Shared value lacks the intangible but critical emotional and spiritual motivators that give conscious capitalism its extraordinary power. They say that shared value “feels more like a tactical readjustment rather than the kind of fundamental rethinking that is required today.”

Profits are best pursued indirectly

The book argues that profits are like happiness. The more directly you pursue happiness, the less likely you are to achieve it. While profits are an essential and desirable outcome for business. profits are best achieved by not making them the primary goal of the business. They are the outcome when companies do business with a sense of higher purpose.

The fact that many businesses make money by aiming to make money doesn’t disprove the book’s thesis: these businesses are currently simply competing against other similar businesses that are organized and managed with the same overall values and goals— maximizing profits. The real question is, how does a traditional profit-centered business fare when it competes against a stakeholder-centered business? Based on the data presented in Appendix A of the book, these firms won’t survive when competing with firms pursuing conscious capitalism: conscious businesses significantly outperform traditional businesses over the long run.

Thus business leaders need to become more aware that their business is not a machine but part of a complex, interdependent, and evolving system with multiple constituencies. From this perspective, they will see that profit is one of the important purposes of the business, but not the sole purpose. They will also see that the best way to maximize long-term profits is to create value for the entire interdependent business system. Once enough business leaders come to understand and accept this new business paradigm, conscious capitalism will reach a take-off point and the hostility toward business will start to dissipate.

Wide-ranging insights

The book has profound insights on a wide range of subjects, including:

Educating customers:  At times, the book has two quite different personas: one is John Mackey, the uncompromisingly moralistic preacher of healthier living and the other is John Mackey, the practical businessman. The two personas come together when the book discusses why Whole Foods still carries a certain amount of junk food in addition to its predominantly healthy food: “The answer is that our company is in a never-ending dialogue internally and with our customers, trying to strike the right balance between being so restrictive that we no longer have a viable business and so permissive that we are no longer true to our core value concerning healthy eating. We have not found the right answer, once and for all. Ultimately, our customers ‘vote with their money’ every time they shop. Just as, over time, they have voted for more and more organic foods, we hope they will gradually vote the unhealthiest foods out of our stores by choosing not to buy them.”

Continuous innovation: Competition forces organizations to continuously improve, innovate, and to be more creative— or be left behind. To thrive, they have to offer customers new products, services, and value that their competitors don’t. What makes it even more challenging is that customer expectations about quality and value rise continuously.

Competition: If Whole Foods Market, for example, had to compete with Walmart strictly on the basis of supply chain efficiency or distribution economies of scale, it would be impossible for it to win. But what Whole Foods can do is be more nimble, more creative, and more innovative and provide higher-quality service while creating a better store environment. By the time Walmart figures out what Whole Foods is doing, Whole Foods will have moved on to newer and better innovations that create new value for its ever-evolving customers.

Marketing: Whole Foods thinks of marketing as enhancing the quality of its relationship with its customers. Everything that develops and deepens the relationship and builds trust is good marketing. Anything that detracts from that is bad marketing. As Trader Joe’s former president, Doug Rauch, puts it: “Since conscious businesses are purpose-driven organizations that are aligned with their stakeholders, they do not need to use marketing as a way to stimulate or create interest that otherwise wouldn’t be there. They can honestly share what’s true about their product or service. They don’t try to create demand artificially and temporarily; they just authentically communicate and connect with people around their common values.”

Genuine teams: Teams make their own decisions regarding hiring, the selection of many products, merchandising, and even compensation. Teams have profit responsibilities as well. Most of our incentive programs are team-based, not individual. For example, gain-sharing bonuses are awarded according to team performance. There is total transparency in the firm on compensation.

The firm is more than the sum of its parts: Analytical thinking can be a form of reductionism— it ignores the relationships stakeholders have with the business and with each other. No complex, evolving, and self-adapting organization can be adequately understood merely through analyzing its parts and ignoring the full system. A business is more than just the sum of the individual stakeholders.

Three types of corporate cancer: (a) The most common type of corporate cancer in business results from a focus on maximizing shareholder value and profits. When the investor is seen as the only stakeholder that matters, and the interdependency and the intrinsic value of the other stakeholders are denied, the business is at high risk of creating and growing a cancer that may one day destroy it. (b) The second stakeholder cancer threat comes from senior management teams that seek to maximize their own compensation without creating commensurate value. In many cases, executives simply pay themselves too much, with little concern for internal equity or connection with overall performance. In some companies, executive compensation is so high that it has a major impact on profits. (c) The third common cause of stakeholder cancer is team members who become selfish, damaging the whole business system of which they are part. Some organizations that are not strongly subject to market discipline develop a culture of entitlement.

Conscious Management is an organic whole: The four tenets of Conscious Capitalism comprise an organic whole; they are interconnected and interdependent. All the elements need to be in harmony and support each other. It is important, then, that the approach to management in a conscious business be consistent with the other tenets of Conscious Capitalism. In particular, the emotional and spiritual elements that define a conscious culture call for a particular kind of management approach so they can be fully expressed and reinforced.

Conscious management is a virtuous circle: it seeks to focus these creative energies in the most effective way possible by creating a virtuous cycle of reinforcing organizational practices. Decentralization, combined with empowerment, fosters innovation. Through collaboration, these innovations are shared, improved upon, and diffused throughout the organization, multiplying their effect and helping the company grow, evolve, and prosper. As discussed earlier, conscious businesses are largely self-organizing, self-motivating, and self-healing organizations. The most evolved ones are largely self-managing as well. Of course, this does not happen automatically; it requires a kind of “intelligent design” to create an operating system that is in harmony with the culture of a conscious organization and the fundamentals of human nature.

Quibbles

Conscious Capitalism is thus a major contribution to the literature of the new management paradigm. With a book that has so many virtues, it may seem churlish to criticize. But areas where the book is less strong include:

• Who is the most important stakeholder? The book rightly values all stakeholders and argues that if the firm does the right thing by all stakeholders, the customer will like it. In recent years, this assumption has worked out for Whole Foods, since Mackey’s passion for better food happens to coincide with a growing interest in the marketplace in the US for better food. But it’s a matter of fact in each case. In many other fields, customers are not so enlightened. In the end, the customer is the primary stakeholder. As Peter Drucker enunciated back in 1973, the only valid purpose of a firm is to create a customer.
• How do you measure progress in a firm practicing conscious capitalism on a daily basis? The idea that if the firm has the right values, everything will work out for the best is a view born more of hope than experience. The insights of Fred Reichheld on the net promoter system could have helped here.
• Agile and Scrum: How do you focus the work of teams on adding value rather than making money? Giving them P&L responsibilities runs significant risks. The discoveries of Agile and Scrum would help here.
• A tendency to over-statement. Not all the firms cited as practitioners of conscious capitalism actually implement the principles of conscious capitalism all the time. For instance, is Disney’s current purpose: “To use our imaginations to bring happiness to millions”? That might once have been a goal of Walt Disney the individual, but it hardly reflects the goal or practices of the global conglomerate that is Disney today.
• The history of shareholder value: The book tends to overlook the fact that the current single-minded obsession with shareholder value is largely a phenomenon of the last four decades, not something that has characterized business for centuries. In the overall scheme of things, the total focus on money and short-term profits is quite recent. To some extent, we don’t need to reinvent the future. We can recover from a relatively brief period of collective dementia by rediscovering values that we always had, but somehow forgot.

Making the paradigm shift happen

We are thus in the midst of a historic transition where it is becoming clear that the old paradigm no longer works and people’s minds are open to new possibilities. The great challenges and exciting opportunities of our era demand visionary thought and bold action.

Resistance to change may be lower, but it still exists. Experience shows that dominant paradigms die hard. When a new paradigm, even a clearly compelling one, is put forward, it encounters resistance from those with entrenched worldviews and much invested in the status quo. As the logical and empirical support for the new paradigm mounts, its opponents begin to attack it, often viciously. The next phase is usually an uneasy coexistence between the two paradigms. Eventually, the weight of accumulated evidence creates a tipping point in favor of the new paradigm.

Some leaders and established companies are responding to the philosophy of Conscious Capitalism and are taking tentative steps in this direction. The book sees the millennial generation (those born between approximately 1980 and 2000) that is coming of age right now as a key force for change.

The authors might also look to another potential driver of change: collaboration with other change movements. Thus while the book is right to differentiate conscious capitalism from mere management facelifts like shared value, it overlooks the commonalities that it shares with other movements genuinely dedicated to achieving a paradigm shift in management, such as the Management Innovation Exchange, the Stoos Network, the Drucker Society Global Network, the Beyond Budgeting Roundtable, the Scrum Alliance, the Agile Alliance, the Society for Organisational Learning and the Daedalus Trust. Recognizing and working together with these movements will lead to faster progress towards transformation than going it alone.

No one can doubt the authors’ passion for change. They find critically reassessing all of our mental models, assumptions, and theories for their continued accuracy and relevance to be scary but also exhilarating. There are so many new possibilities. For them, this is the best possible time to be alive, when almost everything you thought you knew is wrong.

Conscious Capitalism is a wonderful book, full of fiery passion and incisive insights. So buy it. Read it. Implement it. It’s a true guide to future.

And read also:

Whole Foods & the triumph of customer capitalism

Why we don’t yet see a Whole Foods economy

The dumbest idea in the world: maximizing shareholder value

Don’t diss the paradigm shift: it’s happening

Why the paradigm shift in management is so difficult

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Steve Denning’s most recent book is: The Leader’s Guide to Radical Management (Jossey-Bass, 2010).

Follow Steve Denning on Twitter @stevedenning