joining the new economy

Journal of Applied Corporate Finance F A L L 2 0 0 0 V O L U M E 1 3 . 3

Joining the New Economy by David Glassman, Stern Stewart & Co.

116BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE

JOINING THE NEWECONOMY

by David Glassman,Stern Stewart & Co.

We are at the dawn of a new industrial order. We are leaving behind a world in

which scale, efficiency, and replication were everything. We are taking our first

tentative steps into a world where imagination, experimentation and agility are,

if not everything, at least the essential catalysts for wealth creation.1

With coordination among multiple firms madeeasier and cheaper, Coase’s theory, presented in1937, is being validated daily. Wal-Mart pioneeredelectronic linkages with suppliers back in the1980s by investing heavily in information technol-ogy and Electronic Data Interchange (EDI). Thiswas the beginning of inter-firm, real-time informa-tion exchanges. The new connections enabledsuppliers to monitor and automatically replenishinventory in Wal-Mart’s stores and distributioncenters. Shipments were made daily instead ofweekly, freeing up store space for merchandisingand reducing inventory in the system. Manufac-turers also were able to use the better informationabout Wal-Mart to improve efficiencies in produc-tion scheduling. Despite the pressure from Wal-Mart to reduce prices, the improved connectivitybenefited suppliers. Efficiency, EVA, and valueincreased for the entire system. And Wal-Martovertook Sears and Kmart to become the leadingretailer in the U.S.

Dell Computer and Cisco Systems have usedInternet connections to create a new type of “busi-ness model” for organizing activities, the “virtualintegration” approach. Up to 50% of Dell’s ordersnow come in through its Web site, about $40 millionper day. Cisco takes over 80% of its orders, andreceives over 80% of customer inquiries, via theWeb. Costs are significantly lower because custom-ers configure the orders themselves; human inter-vention is not required.

1. Gary Hamel, “Bringing Silicon Valley Inside,” Harvard Business Review,September-October, 1999; p. 83.

2. Economica, November 1937.

ust after 1900, Henry Ford ushered in aneconomy dominated by physical assets,manufacturing processes, and new meth-

ods of organization. Ford revolutionized the auto-motive industry, first by standardizing components,and then by developing the moving assembly line.His mass production model required a command-and-control structure in which activities were coor-dinated internally by centralized decision-makingbodies. To ensure a reliable source of supplies, Fordbecame the first truly vertically integrated company,manufacturing all the components, and even man-aging a rubber plantation in South America toprovide raw material for the tire factories. Manage-ment was hierarchical, and production was gearedtoward building-to-forecasts.

Now, almost 100 years later, our economy isbeing transformed anew by advances in communi-cations. Technology is enabling new ways of con-necting, making for easier and faster exchanges ofinformation. The transformation is unfolding at abreathtaking pace, yet the impact is familiar. Profes-sor Ronald Coase, in his pathbreaking article on “TheNature of the Firm,”2 noted that as “transactionscosts” fall, companies will change the scale andscope of activities they choose to perform internally.Transactions costs can be thought of as the costs ofcontracting in the market for products and services,including monitoring quality, ensuring on-time de-livery, and coordinating procurement, manufactur-ing, distribution, and the like.

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117VOLUME 13 NUMBER 3 FALL 2000

Once received, the order is transmitted “realtime” to Dell’s third-party manufacturing partners.They ship the necessary components to Dell’s as-sembly plant, where activities are coordinated insuch a way as to require an inventory buffer of onlyfour hours. Dell performs testing and quality con-trol at the assembly site and then ships the ordervia Airborne Express. If the customer has a prob-lem, service is provided by another third party.Cisco has even initiated a customer “chat room” onits Web site. The customer network provides timelyassistance, reducing the need for Cisco to providethe service. Again, lower costs without sacrificingcustomer satisfaction.

Michael Dell’s model, which features build-to-order, real-time information sharing and order-to-delivery as fast as five days, is every bit asrevolutionary as Henry Ford’s. At Dell’s OptiPlexfacility in Austin, Texas, 84% of orders are built,customized, and shipped within eight hours. Al-though the concept of transaction costs may seemmundane, the dramatic reduction in such costs hashad a profound impact. Consider the following:

Dell’s Cash Conversion Cycle—defined as thesum of Receivable and Inventory days-on-handless Accounts Payable days—has fallen over thelast five years from +40 days to -18 days. WorkingCapital has switched from a use of funds to asource of cash. Meanwhile, Compaq Computer, aclose competitor, has a Cash Conversion Cycle of50 days.

Dell’s Operating Margin—Operating Income-to-Revenues—was 9.8% in 1999; Compaq’s was 1.6%.

Dell generated $4.4 in Sales for every dollarinvested in Assets (excluding Cash and equivalents),versus $1.8 for Compaq.

Dell’s Economic Value Added (EVA ) was $1.7billion in 1999, Compaq’s EVA was –$200 million.

This latter comparison, based on EVA, is par-ticularly important. EVA has become a popularperformance measure because it measures acompany’s economic profit. It is calculated as theoperating profit for a business minus a charge for thecapital invested. Because it takes into account thecost of capital, EVA is more closely aligned withvalue than the more familiar accounting measures,especially when evaluating performance in aneconomy based on connections.

Much of the benefit in coordinating activitiesacross firms appears on the Balance Sheet, not theIncome Statement. The leveraging of assets con-serves capital, and adds to the cash flow that can bedistributed to shareholders or reinvested in otherprofitable growth opportunities. Focusing on tradi-tional measures of earnings fails to reveal the truebenefits of Dell’s virtual integration approach. Bytaking into account the cost of capital, EVA does.

Dell’s approach provides a package of comple-mentary capabilities—notably, speed, scalability,and flexibility—that sets it apart from Compaq andothers in the industry. None of these competitiveadvantages could be obtained with a traditionalorganizational model. As Michael Dell says:

If you’ve got an operation that builds a compo-nent, the cost to communicate with that operation inan information sense, if it is done electronically, goesto zero…That enables you to scale more quickly, givesyou more flexibility, you can manage supplier net-works in more dynamic fashion, and get things offyour balance sheet that aren’t your specialty—andcompanies can really home in on something thatthey’re really great at.

We have roughly 30,000 employees now, and$26 billion in revenue. If we were vertically inte-grated, I don’t know how many employees we’d have,but it would be some huge number. And we wouldn’tbe a 15-year old company. There’s no way you couldbuild a company like that in 15 years if you had todo it all yourself.3

LOWER TRANSACTIONS COSTS GIVE RISE TONEW MARKETS

More recently eBay, FreeMarkets, and VerticalNethave deployed the power of connections to createnew virtual markets. They bring together buyers andsellers, adding liquidity to markets to make themmore efficient for businesses and consumers alike.They in turn capture a share of the value by charginga small percent of every transaction. When appliedin a business-to-business environment, auction sitesallow companies to reduce procurement costs througha more competitive bidding process. Similarly, com-panies selling excess inventory can obtain moreattractive prices.

3. The Wall Street Journal, December 1, 1999.

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118JOURNAL OF APPLIED CORPORATE FINANCE

But achieving and sustaining success does notcome cheap. It requires investments in new forms ofcapital. Wal-Mart, Dell, Cisco, eBay, FreeMarkets,and VerticalNet could not have achieved their con-nections without investing heavily in informationtechnology (IT). Their IT capabilities represent (in-tangible) capital that enables real-time communica-tions. But the investment appears largely as anexpense on the income statement. Only the equip-ment is capitalized and depreciated over multipleyears, but this is a relatively small part of theinvestment. Project development, training, docu-mentation, and maintenance are substantial and theypenalize accounting measures of earnings immedi-ately. Similarly, investments in customers—market-ing, promotions, advertising, and profiling—createintangible capital, but the outlays are expensed inthe year incurred. Expenditures to build and nurturebrands are treated the same. All of these contributeto something even more important—building trustwith suppliers and customers.

These shortcomings of GAAP accounting aremore than academic problems. In many cases,executive concerns about quarterly earnings disclo-sures override strategic investments. And, becauseincentive compensation is often tied to accountingresults, executives are further discouraged from“doing the right thing.” Instead, they may defervalue-creating investments.

And it’s not just accounting that impedes suc-cess in this new environment. Many companies arealso hamstrung by a “legacy culture” that is at oddswith the connections and capital investment neces-sary for success in today’s marketplace. Executiveswith a traditional mindset tend to view the companyas a self-contained entity; they prefer to perform allfunctions inside instead of seeking out partners thatcontribute superior supplies or services outside ofmanagement’s expertise. Managers often believethey need to own an activity in order to controlquality, scheduling, and coordination with otheractivities. But control does not require ownership;paradoxically, ownership can even weaken controlbecause direct market feedback, and the account-ability that results from it, is lost.

Market feedback is the most powerful source ofdiscipline on management. Customer choices in-form managers and employees about their collective

performance and motivate them to seek continuousimprovement. And technology offers real-time infor-mation exchanges that make coordination acrossfirm boundaries easy. A further benefit of third-partycollaboration is the ease with which a company canrespond to changes in technology or markets: in-stead of having to replace obsolete plants andmachines, the company can simply change suppli-ers. Thus, for a variety of reasons, if an activity is nota distinctive capability, management can upgradequality, employ less capital, and reduce risk byteaming up with a best-in-class partner. Recognizingthe need to reduce transactions costs is the first step.

Creating new business models, and investing inintangible capital, clearly present new challenges fortraditional companies, but these can be overcome.It begins with a culture that focuses on the creationof enduring shareholder value. Many companies paylip service to this worthy goal, but continue to aimat the wrong target—short-term measures of earn-ings and EPS. Instead, management must substituteeconomic performance measures like EVA. EVA iswell established in the business community, hasbeen embraced by many Wall Street analysts, and issupported by major investors like the CaliforniaPension Retirement System (CalPERS), the largestsingle investor in the U.S. capital markets.

EVA makes adjustments to earnings wherenecessary. For example, EVA capitalizes outlays thatare recorded as accounting expenses if they reflectlong-term investments. Such outlays include R&D,brand advertising, IT infrastructure, training, and thelike. And by charging the cost of capital against thecapitalized items, EVA ensures accountability forearning economic returns over the long term, butwithout penalizing executives in the short run. EVAalso provides a common language for a company (oralliance partners) to build and communicate a busi-ness case, allocate resources, and share rewards.

Herman Miller, the second largest manufacturer ofoffice furniture and a committed user of EVA in itsbusiness practices, invested $500 million to createInternet connections linking order entry with (internaland external) production planning and shipping. Theinvestment in capabilities and IT infrastructure wasscrutinized in detail by the Board of Directors, becauseas CEO Mike Volkema says, “As a manufacturer, you’reused to investments that produce goods.”4 Over the last

4. “Reinventing Herman Miller,” Business Week, April 3, 2000.


five years, the company’s investment in technology hasdoubled as a percent of revenues, from 2.4% to almost5%. Inventory turns at its pilot division are over 40, ascompared to 27 for the total company and less than 20for the overall industry. In the twelve months toSeptember 30, 2000, Herman Miller’s stock price wasup 30%, relative to 21% for Hon and 23% for Steelcase,its two closest competitors. Herman Miller has alsooutperformed both peers over the last three- and five-year periods.

In sum, new tools, new accounting, and a newmindset are necessary to promote the kinds of capitalinvestments—in software, capabilities, customers,people, and brands—that create value in today’smarketplace. Share values will fluctuate, bubblesmay burst, but technology will continue to affectmarkets profoundly. The question for traditionalcompanies is not whether to initiate change, butwhere to begin. The rest of this discussion focuseson a set of actions (listed below) that are aimed atimproving competitive capabilities of traditional“old economy” firms.

Imperatives for the New Economy

1. Strengthen IT Governance2. Connect to Networks3. Formulate an Alliance Management System4. Reward Sharing of Best Practices and Nurturing

of “Disruptive” Innovation5. Invest in Business Literacy and Other Forms of

Human Capital6. Strengthen Performance Measures and Analysis

Tools7. Leverage Brands8. Eliminate Distractions9. Strengthen Sales Force Capabilities

Let’s begin with the first imperative and discusseach in turn.

IMPERATIVE #1: STRENGTHEN GOVERNANCEOF THE IT FUNCTION

[CFOs] must step up as a kind of “value arbiter”of IT investments. Bad IT decisions are going to drivedown a company’s multiple…The insightful investorwill buy stock in companies that have an effective ITinvestment process.5

Over 50% of capital spending in the U.S. isdirected to information technology.6 Informationtechnology strengthens and extends corporatecapabilities, supports and accelerates executionof strategy, enables management to extend itsstrategy to new markets, and can even sow theseeds for new business strategies that were previ-ously impractical. At the same time, communica-tions technology has made information less ex-pensive to generate and more practical to dissemi-nate, a development that will continue to haveprofound consequences for business strategiesand structures.

But if technology has great potential, poormanagement of technology resources can inflictlasting damage on supplier and customer relations,and on shareholder value. CEOs can point to numer-ous experiences with ERP and other initiatives wherepromises were great, spending was substantial, butwhere benefits have not been realized. IT initiativesfrequently bypass the financial rigor required ofmore traditional capital expenditures, accountabilitysystems are weak, and IT managers are generallyisolated from business managers confronting thechallenges of the marketplace.

Because of IT’s central role in building competi-tive capabilities, firms must shore up their IT gover-nance process. IT governance is concerned withissues such as:

Information technology’s role—capabilities, re-sources, and spending—in supporting strategy andbusiness plans;

How scarce IT resources are allocated to promisinggrowth areas;

Demonstrating the financial benefits of IT invest-ments, ranking opportunities, and monitoring projectsin progress;

Performance measurement, goal setting, and in-centive compensation of IT managers; and

Managing IT project risks by staging commitments,modularizing applications, and building contingencyplans.

Of special importance is the process by whichbusiness unit executives communicate and collabo-rate with IT to identify, evaluate, and establishpriorities for incorporating new applications intotheir marketing, manufacturing, logistics, and ser-vices areas.

5. Thornton May, Cambridge Technology Partners, quoted in CFO, January,2000.

6. Department of Commerce.

Executives with a traditional mindset tend to view the company as a self-containedentity; they prefer to perform all functions inside instead of seeking out partnersthat contribute superior supplies or services outside of management’s expertise.


Many companies would like to quantify IT’scontribution to overall value, but approach theexercise incorrectly. Instead of viewing it as avaluation problem—one that leads to unresolvablearguments about assumptions—it is better ap-proached as a governance problem. This involvescreating an internal market for scarce IT resources,charging the going market rate for the use of suchresources, and measuring profitability at the end ofthe year. IT’s EVA is the best measure of its contri-bution to value.

In essence, IT should be converted from a costcenter—with contentious allocations made to thebusiness units—to an EVA center.7 As an EVA center,IT would be asked to market solutions to businessmanagers, develop a project scope with associatedtimelines and milestones, mobilize resources, andnegotiate fees. In other words, IT would be managedas a business with its EVA measured and used toestablish goals, and award incentive bonuses. Mar-ket pressures will operate on IT managers, requiringthem to develop a level of intimacy with the businessunits that is currently rare in major companies. ITwould also be able to attract and retain skilledmanagers more easily if they see themselves as partof an entrepreneurial business with an attractivebonus opportunity.

These issues apply not just to IT, but to all keyprocesses—logistics, shared services, and supplychain management, to name just a few. I begin withIT because the stakes are highest, the expendituresand risks are large, and the current metrics andaccountability systems are unusually weak.

IMPERATIVE #2: CONNECT TO NETWORKS

Traditionally, IT investments have been in-ward-looking, concentrated on making each en-terprise more efficient in isolation. By contrast, theInternet is all about communicating, connecting,and transacting with the outside world...No longercan any business see itself as a more-or-less freestanding entity. It must become part of an e-businessecosystem.8

Among other things, the Internet allows compa-nies to eliminate distributors and sell direct tocustomers. Economists call this disintermediation;

the middlemen call it death. But the Internet alsooffers opportunity for this threatened species. Takethe case of Home Depot. As of the end of 1999, thecompany ranked #18 among U.S. firms in MarketValue Added, with $81 billion of wealth creation. Asmall builder can go to Home Depot’s Web site, enterthe details of his project, and receive advice on thematerials needed, how to schedule the work, andpitfalls to navigate. The Web site will offer to deliverthe materials all at once, or on a just-in-time basis. If thebuilder needs a plumber or electrician, Home Depotwill help by posting on its site the details of the job.

Home Depot is at the hub of an electronicnetwork linking its suppliers and customers. It is notjust selling hardware; it is providing solutions. Andby offering value-added services, Home Depot isstrengthening customer relationships. Builders willreturn to the site when they next have a job.Plumbers and electricians will return looking forwork. Home Depot is not high tech, but they havefigured out how to use technology to their advantage.

General Electric Medical Systems also performsas an information intermediary. The company sellsmedical equipment to hospitals throughout theworld, and it tracks performance and productivitydata. GE uses the data to benchmark the perfor-mance of customers to best-in-class peers. GE thenoffers a consulting service aimed at process changesto increase productivity.

Intermediaries are often in an excellent positionto gather, organize, and distribute specialized infor-mation to industry participants. They have thereputation, relationships, and industry knowledge toprovide a trustworthy one-stop-shopping source ofinformation and advice.

Networks are particularly compelling becausethey have the potential to generate increasing re-turns for the sponsor. As each user joins, thenetwork grows in value to all other participants.And it becomes more compelling for non-users tosign up. This is the draw of AOL’s instant messagingservice. The company’s aggressive marketing cam-paigns of the mid-to-late 1990s paid off by creatinga network, especially among teens. With friends onthe network, others are sure to sign on. As oneobserver put it, “Teenage chat and drivel enabledAOL to buy the most powerful media company[Time-Warner] in the world.”

7. For a discussion of EVA centers, see the article in this issue by Marc Hodak,“The Viable EVA Center (Or, How to Slice a Company So It Doesn’t Bleed).”

8. The dot.com Imperative, The World in 2000, The Economist Publications,1999, pp. 94, 96.


There is nothing particularly new about net-works; Visa and Mastercard created networksconnecting merchants and consumers decadesago. But new technology has made their forma-tion easier and cheaper, even for small start-upcompanies. Once again, the decline in transac-tions costs has had a profound impact on businessstructures.

Networks offer opportunities to gain sustain-able competitive advantage for the developer. Theindustry-focused business-to-business exchanges

now sprouting up are the latest examples of networkeconomics. The traditional companies are sponsor-ing the formation and start-up activities with an eyeto spinning them off in the public marketplace. Thesponsoring companies benefit in several ways: theelectronic network makes the market more efficient,thus reducing costs, working capital, and cycle time;and the sponsoring companies capture the valuecreated through their equity ownership in the enter-prise. Venture capitalists typically do not participatein the capital structure.

NETWORKING IN THE NEW ECONOMY

Partnering and collaborating to bring more andbetter services to customers is the modus operandi ofthe New Economy. Even competitors are collaborating:IBM in 1999 agreed to a $16 billion arrangement tosupply Dell Computer with key components such asdisk drives, chips, network attachments, and monitorsThe seven-year agreement is the largest supply dealinvolving two computer companies.

Or consider the strategic alliance betweenAmazon.com and Toyrus.com. The 1999 holiday sea-

from the increased scale of the merchandise offering;and Toysrus.com benefits from increasing the scale ofits fulfillment capability.

The financial arrangement requires Toysrus.com topay an annual fixed fee to Amazon; a (single digit)percent of annual revenue; and a fixed dollar amountper transaction. Importantly, Amazon also has anopportunity to invest in Toysrus.com. As part of thearrangement, Amazon receives warrants enabling itpurchase up to 5% of the company.

9. Research Report, August 10, 2000.

son was difficult forToyrus.com; it was oneof the most popularWeb-sites (measured by“hits”) but fulfillmentwas unsatisfactory. Ascompensation, they of-fered $100 coupons tocustomers receivingpackages late. Mean-while, Amazon’s fulfill-ment was excellent butits merchandise offering in the toys category waslimited; in fact, they were forced to write off inventoryafter the holiday season.

In August, the two companies announced a ten-year alliance that will enable customers to shop on-lineat a co-branded Web site. Each firm will focus on whatit does best. Toysrus.com will be responsible for themerchandise selection, procurement, and inventory;Amazon.com will take charge of fulfillment.

Strategically, the value proposition seems compel-ling. Both companies benefit from the combined brandstrength each brings to the venture; Amazon benefits

At the time of the pub-lic press release announc-ing the alliance, investorsreacted favorably. Mea-sured from two weeksbefore to two weeks afterthe announcementAmazon’s price increasedby almost 20% (after ad-justing for an increase inthe overall market), whileToys ‘R’ Us (the parent of

Toysrus.com) gained 11%. The extraordinary gain forAmazon may reflect more than this single alliance.Investors are perhaps taking the view that this is the firstin a series of transactions in which Amazon leverages itsfulfillment capability in similar alliances with other firms.Merrill Lynch observed that:

“Strategically, the move signals a shift away fromend-to-end vertical integration, in which Amazon ownseverything and competes with all other major retailers,toward one in which Amazon acts as a full-serviceshopping portal—similar to AOL or Yahoo! Shopping,but with fulfillment included.”9

Investments in customers—marketing, promotions, advertising, and profiling—create intangible capital, but the outlays are expensed in the year incurred.

Expenditures to build and nurture brands are treated the same.

+30%

–20%

–10%

0%

+10%

+20%19.8%

11.3%

–10 days +10 daysPress Release (8/10/00)

SHARE PRICE PERFORMANCEAMZN

TOY

S&P 500


IMPERATIVE #3: FORMULATE AN ALLIANCEMANAGEMENT SYSTEM

Corporate alliances are exploding in numberand value. The typical large company manages 30 ormore alliances, which account for anywhere fromsix percent to 15 percent of its market value. Yet 61percent are underperforming.10

Alliance governance must define the processby which decisions are made and resources allo-cated, the measures and metrics used to gaugeperformance, and the way in which value creationwill be shared.

Partnerships between companies with comple-mentary capabilities obviously can create substantialvalue, but they also raise thorny questions. Trust forone. How does each party know that the others areoperating for the benefit of the partnership? Are theinterests of all participants aligned? How is thismonitored? No collaboration will endure unless itoffers a “win” to all participants.

Within any single organization it is enormouslydifficult to align incentives; procurement, manufac-turing, distribution, sales, and service all tend to havedifferent performance measures. And as each groupseeks to maximize their local measures, they fre-quently act to undermine the global interests of thecompany. If these problems exist within a singlecompany, then crafting a governance system thatoperates across multiple companies would appear tobe a formidable task.

Part of the coordination problem is the lack ofa standard measure. If one firm is aiming at short-term earnings, another at long-term cash flow, anda third at sales growth, there is virtually no chancefor a consensus. Different agendas reign, and mis-trust surely follows. It happens inside companiesevery day. The collaborating parties must adopt aconsistent standard to use when allocating resources,measuring performance, setting goals, communicat-ing with managers, and establishing compensationarrangements. This ensures that the interests ofparticipants are aligned.

EVA can help. Vendors often describe theirvalue proposition in EVA terms. This makes it easierto communicate with companies evaluating theinitiative, because more and more senior executives

are focused on economic performance. EVA enablessuppliers to document for customers their true costs,including the cost of capital, thus facilitating an opendiscussion of compensation terms.

Speaking the same language enables the part-ners in a collaboration to measure, for example, thetotal benefits available from tightening the supplychain through collaborative planning, continuousreplenishment, and the like. While the benefits willgenerally not be divided equally, the company thatwins the most will ensure that all the other partici-pants win something. Each will enjoy an increase inEVA. Structuring an arrangement that is in eachparty’s best interest is the most promising way topromote coordination, trust, and an enduring value-creating venture.

This is also true of more traditional outsourcingarrangements. The contract structure raises thesame governance questions—how are decisionscoordinated, what are the measures used to evalu-ate performance, and how should compensationbe earned. GE Aircraft’s contract arrangementswith the airlines provides a good model. GE ispaid a fixed fee for each hour the aircraft is flying.The agreement is simple, unambiguous, and in-centives are clearly aligned.

IMPERATIVE #4: REWARD SHARING OF BESTPRACTICES AND ENCOURAGE “DISRUPTIVE”INNOVATION

Recent experience suggests it takes little morethan two years for a start-up to formulate aninnovative business idea, establish a Web presenceand begin to dominate its chosen sector. By thenit may be too late for slow-moving traditionalbusinesses to respond.11

There is little question that success demandsswift innovation and fast response times to volatileand unpredictable developments in the market.Rapid response places a premium on communica-tion across activities, functions, and geographies tocoordinate innovative activity. But communication isnot a strength of most large companies. Managerstend to focus on their immediate environment—theirdaily tasks, the products they oversee, the countriesin which they manage—and overlook how their

10. “Dispelling the Myths of Alliances,” a survey conducted by AndersenConsulting.

11. “Business and the Internet,” The Economist, June 26, 1999, p. 6.


actions affect other activities. This “silo” mindset canbe addressed partly by technology, but mostlythrough leadership.12

Technologically, intranets can support knowl-edge sharing across the firm, but only if the CEOchampions its use. At General Electric, for ex-ample, “boundaryless” behavior—the sharing ofbest practices—is one component of incentivepay for the top 3,000 managers at the company.Executives boast of what they learn from otherunits. When one business unit president told JackWelch that he was being tutored about the Internetby a subordinate, Welch immediately instituted anew program requiring the top 600 managers tobe mentored in Internet applications.

Of course, not everyone is Jack Welch. Chang-ing the culture is difficult, time consuming, and notalways supported by management. Top executivesthat have spent long careers in the old economy failto appreciate how profoundly new technologyinfluences their environment. The following state-ment by the 57-year-old head of Merrill Lynch’s retailbusiness is a classic example: “the do-it-yourself modelof investing, based on Internet trading, should beregarded as a serious threat to Americans’ financiallives.” The retail group resisted offering online tradinguntil proponents inside Merrill Lynch proposed creat-ing a separate operation. Online training, at $29.95 pertrade, is now available through Merrill’s retail group.

Missed opportunities also extend to “disrup-tive” innovation. Clay Christenson of the HarvardBusiness School has documented numerous cases inwhich well managed companies failed to developtechnology that was not immediately applicable totheir market, but which ended up cutting into theirbusiness. Merrill Lynch’s experience with onlinetrading is just one example. The company served thehigh-end customer interested in advice and re-search, not the discount trading market served byCharles Schwab. Only when customers began de-fecting did Merrill Lynch change its strategy.

Similarly, Wang Laboratories, Prime Computer,Data General, and Digital Equipment—all successfulminicomputer firms—failed to develop a competitivedesktop personal computer product. When the desk-top emerged, it did not have nearly enough capacityor speed to interest minicomputer customers. Thecompanies in this market regarded it as more or less

irrelevant—that is, until performance improved enoughto be competitive with minicomputers.

Digital Equipment made four different attemptsto introduce a desktop computer between 1983 and1995 and failed each time. At Digital, the personalcomputer was unable to compete for the time,energy, funding, and other resources necessary forsuccess. The company’s structure and culture wasgeared to minicomputers; moving down to thedesktop market meant a drop in profit margin.Instead, executives were eyeing the mainframesegment, which commanded higher margins thanminicomputers. Making a commitment to the PCmarket would have required eliminating costs thatwere necessary to support the minicomputer andmainframe initiatives. That management was unableto justify this led to an ironic outcome: Digital wasacquired by Compaq in the mid-1990s.

As Christenson notes, Digital Equipment wouldhave been better off moving the PC initiative into aseparate company, one that could establish a com-petitive cost structure and culture committed to theproduct’s success. Further, the separate businesscould provide strong incentives—based on operat-ing and, perhaps, stock price performance—that arehighly focused on the success of the enterprise.

IMPERATIVE #5: INVEST IN BUSINESSLITERACY AND OTHER FORMS OF HUMANCAPITAL

No market is unaffected by new technology—neither the business, the financial, nor the humancapital markets. From business school graduates tosenior executives, we have witnessed a migration toSilicon Valley start-ups. While the trend is reversing,the experience proves that people are attracted toentrepreneurial opportunities where the upside isunlimited. A small organization, stock options, andthe prospect for an IPO were and remain big draws.And in a market where the scarcest resource is skilledpeople, large companies must revise their humanresource policies accordingly. It would be a mistaketo allow complacency to set in just because of adownturn in technology stocks.

Most companies resist pay practices that createlarge differentials between managers in the samepay grade. The entitlement structure means that

12. This point is emphasized elsewhere in this issue by C.K. Prahalad and YvesDoz, “The CEO: A Visible Hand in Wealth Creation?”.

EVA capitalizes outlays that are recorded as accounting expenses if they reflectlong-term investments, including outlays for R&D, brand advertising,

IT infrastructure, and training. And by charging the cost of capital againstthe capitalized items, EVA ensures accountability for earning economic

returns over the long term, but without penalizing executives in the short run.


outstanding individuals in effect subsidize mediocreones. In a strong market the exceptional performerswill be the first to leave.

Companies that have implemented an EVAmanagement program—as distinguished from asimple EVA measurement system—offer incentivecompensation that provides uncapped opportuni-ties. The result is not just stronger incentives, but amore focused work effort and a desire amongparticipants at all levels to upgrade skills. HermanMiller, an EVA company since 1996, writes in its 2000Annual Report: “Making EVA such an important partof our overall compensation structure has driven amuch higher level of business literacy throughoutour workforce, providing better decision-makingthroughout the company.”

GE also actively manages its pool of humancapital. To be sure, it often loses top managers, inlarge part because it is a recruiting ground forcompanies in the market for CEOs. Still, GE growsreplacements; its system produces a depth of man-agement unprecedented in the U.S. Part of the GEprocess involves each year dividing its 85,000 pro-fessionals and managers into five groups. The top10% receives substantial stock options; the fifthgroup, the bottom 10%, is culled. As The Economistdescribes the process:

Mr. Welch’s working year revolves around per-sonnel. He teaches each month at Crotonville…A fairchunk of April and May is spent going through theannual “Session-C” appraisals of GE’s top 3,000managers. Each January there is an annual meetingof the top 500 managers.13

In recent years, companies have made substan-tial progress in improving capital management.Metrics (e.g., EVA) are more powerful, and account-ability is stronger. Similar progress must be made inthe management of the firm’s human capital. We livein a world of free agency; talented people will moveto opportunities that are economically and intellec-tually stimulating. Staid corporate bureaucracies willnot attract these resources. Instead, the companymust develop a fluid and flexible environment, onethat encourages experimentation, allows people to

gain a diverse set of experiences, and enablesindividuals to have a sense that they can make adifference. Stock options are only part of the solu-tion; good management must provide the rest.

IMPERATIVE #6: STRENGTHEN PERFORMANCEMEASURES AND ANALYSIS TOOLS

Our current dual-entry accounting system wasdeveloped roughly 500 years ago. It was largely builtto track the movement of physical goods for thebenefit of creditors. In a world dominated by tangiblecapital, our currently employed accounting systemworked fine. As the source of value creation shifts tointangible capital, however, the system becomes lessand less reflective of economic reality…Investors mustbe aware that the financial score for the InformationRevolution is kept with an outdated system.14

During the 1990s, many companies applied theEVA concepts to implement shareholder value mea-sures and metrics. In practice, there are importantadvantages in using the traditional accounting sys-tem as the point of departure for calculating EVA.While flawed, it is at least familiar. And the distortionsin performance measurement arising from account-ing principles can, in most instances, be remediedwith minor adjustments.15

However, for New Economy companies invest-ing in intangibles, the shortcomings of the account-ing system are more severe. Expenditures on R&D,IT, brand building (advertising) and customer acqui-sitions, and general capabilities enhancement aregenerally all considered expenses for reportingpurposes—even though payoffs are expected fromthese investments in future years. These categoriesof expenditure should be recorded as investments,and reflected in the company’s capital base.

The common observation that Internet compa-nies do not make profits says more about ouraccounting system than about the profitability of thecompanies. When developing a standard and creat-ing a network is the strategic objective, the businessplan must be to invest aggressively to acquirecustomers. The losses stemming from advertising andpromotions obscure profits from those companies

13. September 18, 1999.14. “The Triumph of Bits,” Michael J. Mauboussin, U.S. Chief Investment

Strategist Credit Suisse First Boston. Published in Equity Research, December10, 1999.

15. Common examples include capitalizing operating leases; ignoring non-cash write-downs, offsetting extraordinary items, capitalizing long-term strategicinvestments, applying cash instead of accrual of reserves; employing purchaseaccounting instead of pooling in the treatment of acquisitions, and so on.


that have achieved the scale necessary to be gener-ating income and EVA from current operations.

Using measures that make sense is critical topromote the right behaviors. Expensing intangiblescauses managers to underinvest in critical capabili-ties just to produce short-term earnings.

IMPERATIVE #7: LEVERAGE BRANDS

Brand management will continue to be animportant feature of the business landscape. Brandsdifferentiate products with information. Quality,trust, and esteem all drive brand equity values.Investments in brands, product development, andadvertising are part of the value building equation.When measuring EVA for the brand, these expendi-tures should be considered part of capital, notwritten off immediately against earnings.

Managing brands to record attractive account-ing results is a mistake, and can end up reducing thebrand’s value. In the late 1980s and early 1990s manyconsumer product companies were overly aggres-sive in raising prices. Rubbermaid, for example, settargets for double-digit annual sales growth. Withinflation declining over this period, achievement ofthe goal became more difficult. Their price increasesalso came just as competitors were raising productquality. Market share and value losses followed. Theprice differential was unsustainable and Rubbermaid’sstock price, $38 in 1991, dropped to the low $20s in1998. The company was sold to Newell in 1999 at avalue in the mid-$30s.

In sum, executives must manage brand values,not current earnings. Linking consumer perceptionsof brands to financial results—EVA and value—willenable companies to develop credible metrics toassess the benefits of building and strengtheningspecific elements of the brand portfolio. Resourcesallocated to the portfolio should be based on soundfinancial analysis of the potential value created.Year-over-year accretion in brand value should bemeasured and incorporated in the incentive mix formarketing executives. Acquisition and divestiturestrategies should also consider brand economics.Part of the value lies in the strategic options gener-ated by successful development of a brand. Brandvaluation metrics often fail to take this into account, yetit can be a sizable component of the investment’s value.

IMPERATIVE #8: ELIMINATE DISTRACTIONS

With the development of new means ofcommunication…It is much easier for people to con-tract out and obtain supplies from other firms, whichsuggests that firms are going to get smaller. On theother hand, one of the things that limited a firm’sgrowth in the past was doing many things for whichit was ill-equipped. Now, by contracting out, it canexpand its core business without taking on addi-tional tasks related to the expansion.

—Ronald Coase, Nobel Prize economist16

As discussed earlier, Dell Computer is one of theleading companies of our time; Compaq is not. Dellexploits information: to coordinate its build-to-ordermodel with key partners, to track orders movingthrough the system, and to gather intelligence oncustomer trends. In effect, Dell substitutes informa-tion for inventory. Compaq, by contrast, still buildsto forecast, feeding inventory to its retail channels.

Ford Motor, the pioneer of the vertically inte-grated mass production model, is consulting withMichael Dell, the pioneer of virtual integration. Fordis considering outsourcing all manufacturing opera-tions to focus on the essentials: product develop-ment, brand management and customer service.Ford has already completed the spinoff of VisteonAutomotive Systems, an $18 billion auto parts manu-facturing company.

The source of wealth creation is sustainablecompetitive advantage. Its achievement requires theleveraging of capabilities that are distinctive. Throughthe 1980s and 1990s, a massive and largely successfuleffort has been made to improve efficiency andeliminate waste. The last several decades were alsoa period in which companies divested unrelatedbusinesses, the legacy of a failed diversificationstrategy. The unwinding of diversification is com-plete, but the momentum for focus continues. It nowinvolves eliminating distractions, time and scarceresources spent on activities outside of management’sdistinctive expertise. For Dell, its competitive ad-vantage is not manufacturing. Ford seems to bedrawing the same conclusion. IT advances makepossible, and competitive challenges make im-perative, contracting outside for critical, but non-strategic services.

16. The Wall Street Journal, January 1, 2000, p. B36.

Outsourcing enables the company to focus on leveraging its distinctive capabilitieswhile benefiting from the knowledge and specialization of the partner.


And it’s not just in manufacturing. Informationtechnology is another area where outsourcing isflourishing. Outsourcing enables the company tofocus on leveraging its distinctive capabilities whilebenefiting from the knowledge and specialization ofthe partner. In addition, in an environment that ischanging rapidly and unpredictably, outsourcingreduces risk. Committing to large capital outlays fortalent and equipment can lead to write-offs in futureyears if technology changes or the needs of thecompany shift. An IT specialist, by contrast, hasalready invested in diverse skills and equipment. Thepartner can more easily tailor the skills to the needsof any particular customer, and transfer those notrequired to another. The outsourcing arrangementbrings flexibility and agility, ensuring that IT sup-ports the swift execution of strategy.

IMPERATIVE #9: STRENGTHEN SALES FORCECAPABILITIES

One of the messages of stock market valuationsis that software is more valuable than hardware,intellectual capital is more prized than equipment.Yet the sales forces of many traditional companiescontinue to focus on the sale of equipment. Seniormanagement may have decided on a strategy to sellvalue-added solutions, but pronouncements havelittle impact in the field. The reason is that salescommissions can be earned in several ways; theeasiest is to make the same familiar pitch salespeoplehave made in the past. If this focuses on the low-margin product so be it.

Instead of impeding change, the sales force canhelp to drive change. It has become platitudinous toidentify speed as a competitive advantage. Theimportant question is “How do we get faster?” Thesales force can help. The sales force is the first-linecontact with customers; they see before anyone elsethe shifting market trends. They can identify needs,communicate with the rest of the team, and sell thenew proposition to customers.

Converting the sales force from a liability to astrategic asset is a big step. First, to change behaviormanagement must adjust the compensation programto reward the high margin sale. But more must bedone. The business and financial literacy of the salesforce must be upgraded. Although this does not

mean taking accounting courses, it does involvegaining some awareness of what drives EVA andvalue. The sales force can intuitively understand theconcepts of growing profit while controlling the useof capital. They can understand the customer’s valueproposition and explain how their product helps thecustomer succeed. Coupled with easy-to-use tools,their presentation can document the financial valueproposition to key decision makers at the customer.This is a necessary step in engaging candidates in adialogue that can lead to a strong value addedrelationship for both parties.

Compensation and capabilities can improveeffectiveness. But for the sales force to become atrue strategic asset, the company’s organizationalarchitecture must also change. Communicationchannels must be open to take advantage of theknowledge residing in the sales force. The com-pany must have flexible manufacturing and otherprocesses to evaluate and respond to the informa-tion that comes in. People must be committed notto any particular product, but to adding value. Inshort, the culture must embrace change, valueentrepreneurism, be willing to experiment, andreward people for success.

SUMMING UP: THE OPEN ARCHITECTURE

Change was once seen as an issue of organiza-tional structure…with structure following strategy.This view reflected a belief in the possibility of control-ling the firm and its environment, of creating a long-term structure and a strategy that would need onlyfine-tuning in the future…The language of businessnow is about how to plan when you can’t predict,how to be adaptable, and how to handle thediscontinuities of change.17

The decline in the costs of communicating,coordinating, and collaborating across firms in thevalue chain has led to the emergence of newbusiness models—virtually integrated companies,retail “bricks and clicks” organizations, and net-works like AOL and eBay—to exploit new opportu-nities. With these new organizations comes a needfor new governance practices—ones that permitswifter decisions, best practice sharing, and morefocused operations.

17. Peter Keen, The Process Edge, Harvard Business School Press, 1997,p. 11.


Improvements in governance must focus, at aminimum, on the following:

Organization structures that leverage external alli-ances while improving internal collaboration. Thisinvolves gaining acceptance and support for acommon aspiration across the company—to deployfinancial and human resources, complemented bytechnology, to build shareholder wealth.

Performance measures that encourage managersto make long-term investments in capabilities evenwhen accounting measures penalize earnings in theshort term. This requires more than a change tointernal measures that capitalize the spending; it alsonecessitates a more open dialogue with the invest-ment community. Analysts and investors must un-derstand the potential returns from such investmentsand generally need some help from management.(Credibility is raised if management also indicates thatthe company’s incentive program holds executivesaccountable for realizing those potential returns.)

Human resource policies that strengthen businessliteracy, reward collaboration, attract and retainentrepreneurs, and align objectives across thecompany’s regions, functions, and product lines.

Building a culture that embraces the opportuni-ties brought by change, and accommodates thepartnerships and collaborations required of abusiness ecosystem.

In sum, extracting and capturing value frominformation, investing in the new forms of capital,and making the right connections are today’s criticalvalue drivers. Companies that get it right get re-warded in the stock market. Their success keepstalented executives in place and enables them toattract more human capital. Success also buildsanother form of capital—credibility in the financialmarketplace. Having gained the trust of investors,management is given more room to pursue long-term investments even when returns are not forth-coming in the short-run. Gaining credibility requiresprocesses that apply economic discipline to deci-sion-making, resource allocation, performance mea-surement, and incentive compensation.

In this sense, achieving success in today’seconomy is much the same as in days past. Technol-ogy changes the environment and creates the oppor-tunities. Good management will attract the financialand human capital to seize them.

DAVID GLASSMAN

is one of the founding partners of Stern Stewart & Co., and leadsthe firm’s advisory services for the New Economy.

Most companies resist pay practices that create large differentials between managersin the same pay grade. The entitlement structure means that outstanding individuals

in effect subsidize mediocre ones. In a strong market the exceptional performerswill be the first to leave.

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