Saturday, June 9, 2007

Sometimes, It’s Not Nice to Share

I’ve worked at several companies who have had a portfolio of retail businesses and decided to centralize most of the overhead of the divisions into corporate shared services. Although each company handled it slightly differently, they tended to follow a pattern something like this:

First, someone would get the notion that if you combine division level overhead to a corporate location, the company is better off. They make a case that:

A) The quality of expertise should go up due to specialization; and
B) Costs should go down due to eliminating duplication and through economies of scale.

They win the argument, so a corporate shared services area is set up. The people running these new shared services areas get fancy new titles and increases in their salaries. To justify their position, they create a bureaucracy to interact with the divisions. The bureaucracy, of course, requires additional people to do the interacting.

Not long thereafter, the divisions make three complaints about the shared services:

1) It takes longer to get anything done.
2) More time is wasted in meetings.
3) The quality of the output from the service is not as good as before.
4) It costs a lot more money.

The complaints are investigated and found to be true in many cases. As a result, the shared service programs are scaled back significantly or eliminated altogether. Then things return pretty much back to where they were before shared services, with the divisions running much more independently.

Strategies often involve the building of a portfolio of businesses. Within such a strategy, it is common to build at least part of the portfolio via acquisitions. To help justify the high purchase prices for acquisitions, savings are factored into the financial model for the various economies of scale which are expected from combining the new business with the rest of the portfolio.

Unfortunately, it is commonly the case that after the acquisition occurs, the savings from combining the businesses turn out to be far less than what was put into the business plan. As a result, it soon becomes apparent that too much was paid for the acquisition. Now the acquiring company is faced with the reality of having of destroyed shareholder value, because they paid more for the company than they will get back in earnings/savings.

The problem is that combining certain overhead functions turns out to be counterproductive. As we saw in the story above, shared services in many cases can increase costs while reducing quality. It turns out that the number of areas which make sense to combine are far fewer than one would at first think.

Although we tell our children that “It is nice to share,” in the business world, it often makes more economic sense “not to share.” Therefore, when developing strategies, be careful not to rely too heavily on sharing of overhead to justify your tactics.

What we are really talking about here are synergies. If we overestimate synergies, we can end up with a seriously flawed strategy—maybe flawed enough to destroy a company. In order to ensure that your strategy does not come de-railed by poor assumptions on synergies, three principles should be kept in mind.

1) Resource Vs. Outsource
2) Distinctive Vs. Distractive
3) Frozen Vs. Flexible

These three principles are discussed below.

1) Resource Vs. Outsource
Often times, aggressive synergistic models are based on an assumption that divisions will outsource a number of functions to corporate. Complete outsourcing is rarely cost effective because the division gives up too much control in a complete outsource. The divisions lose control over their destiny. It is difficult enough to execute a strategy when you control your functions. If you have outsourced your functions, then it can be like fighting two wars—one against the outside marketplace and an internal war with the shared service group.

Corporate may mean well, but when the entire function is outsourced, the division tends to get stuck with too much bureaucracy, too many costs, too much wasted time, and a product not always well suited to the unique needs of the division. Divisions tend to need functional people within the division to fight for what is right for the division.

Many times, one size does not fit all. A company in the incubator stage has different needs from a rapidly growing business or a mature business. Some divisions can afford more service than others. To put them through the same process would be like telling all women that they should be wearing a size 6 dress.

Rather than “outsourcing,” one should be looking at “resourcing.” There are many resources within the portfolio which can be shared between divisions. For example, one can share access to channels of distribution, knowledge about certain customer groups, patents, vendors, sales reps, intellectual property, employees, and so on.

For example, I have a friend who used to work at 3M. He says 3M often paid a premium to acquire a company just to get access to a patent which they knew could be valuable if spread across a few of their divisions. The deals worked based on the sharing value of the patent resource rather than imaginary synergies from outsourcing.

Resourcing does not require divisions to give up control of functions. Instead, it is a means to empower a division’s function to be better off than it was before. Whereas outsourcing is primarily taking away something from a division, resourcing is primarily giving something to a division. It is like sharing gifts at Christmas.

When looking at acquisitions, one is more likely to have success in reaping benefits if the benefits are based on understanding the value of specific resources which can be shared within the portfolio, rather than difficult-to-achieve synergies through generic centralization of complete functions through outsourcing.

2) Distinctive Vs. Distractive
Certain functions are core to the success of a business. They help provide the distinctiveness which ensures strategic success at the point of implementation. In retailing, one such core function is Advertising/Marketing. Marketing is how one communicates the strategy to the customer. Advertising decisions at most retailers tend to require input from many parts of the division under very short time-frames. It is a valuable tactical tool. To lose control of advertising would be to lose control of a key determinant of strategic and operational success.

Yet, on more than one occasion, I have seen marketing/advertising outsourced from a division into a corporate shared service program. Taking away a core function from a division can make them “average” at the point where they need to be “distinctive.” We have already talked about how outsourcing can lower productivity. In certain core areas, outsourcing can also make it nearly impossible to stay on-strategy.

By contrast, some functions tend to be business distractions. For example, issuing payroll checks rarely provides competitive distinction. It is just a distraction which needs to get done. If you can take away these distractions and centralize them, the division can focus on the more critical factors.

Core strategic functions which provide distinction need to be out in the field with the division on the front lines. Functions which provide no competitive leverage (distractions) can be placed at corporate. Different businesses may have different points of distinction and distration, so one needs to examine this on a case to case basis.

3) Frozen Vs. Flexible
One of the problems with too much integration of division functions with corporate is that portfolios are not frozen. New divisions are added over time, and old divisions are divested over time. If one tries to squeeze out too many synergies by tight intertangling of the divisions with each other and corporate, it becomes more difficult to maintain flexibility when it is time to divest one of the pieces. There is value to maintaining some of that flexibility. That value can be destroyed if synergies are attempted beyond the two points already mentioned.

Instead of tight intertangling, one can get some of the same benefits with standardization. For example, if every division uses basically the same standard software systems (on non-core processes) and the same standard language to talk about business, it is easy to share resources back and forth without having to be intertangled, because standardization breaks down the barriers to working together. Yet at the same time, it makes it easier to unfreeze the portfolio and divest of pieces, because they are not so intertwined.

Making too aggressive an assumption on synergies can cause one to make the wrong strategic decisions. Subjecting divisions to overly aggressive outsourcing to corporate can end up counterproductive. To be safe, only take into account synergies regarding:

1) Resource Sharing
2) Non-Distinctive Functions
3) Those that still allow flexibility in adding to or subtracting from the portfolio.

Often, the problem with synergies is that they do not really exist in the first place. Not all business combinations make sense. Instead of 1+1=3, one can end up with 1+1=0.5. You cannot always blame the people executing the strategy when synergies to not live up to plans. Sometimes, the original design of the plan is wrong.

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