Marina Gorbis's Blog, page 1504

Countries Full of Mistrustful People Are Less Entrepreneurial

Interpersonal trust has a substantial impact on a country’s level of entrepreneurship and, therefore, economic growth, according to an analysis of survey data from thousands of respondents by Byung-Yeon Kim of Seoul National University and Youngho Kang of Samsung Economic Research Institute, both in South Korea. For example, a 1-standard-deviation, or 16.4%, increase in a population’s trust in strangers would increase the proportion of entrepreneurs in the workforce by 34.8%. High levels of interpersonal trust within a population reduce the uncertainties associated with engaging in entrepreneurial business activities.

Is Your Next Great CEO a Management Consultant?

There are a variety of places where corporations and boards look for potential CEOs, but the leagues of management consulting generally isn’t one of them. However, new unreleased research from Spencer Stuart, a global executive search firm, suggests that we’re giving this sector short shift: There may be specific cases when a consulting background can actually boost company performance, even more so than a more traditional candidate.

Below is an edited exchange I had with a team at Spencer Stuart, led by consultants Janine Ames and Jim Citrin, who describe what they’ve uncovered about this topic — and what they’re still learning about consultants-as-CEOs.

So why should a company consider hiring a management consultant to be their CEO?

While former management consultants are not frequently chosen as CEOs — our research noted 28 former management consultants with five-plus years of consulting experience out of a total of 541 CEO transitions between 2004 and 2010 — the evidence we’ve uncovered here would suggest that, as a class, they are fully worthy of consideration. When they did take the helm of a company, they tended to improve the condition of the company over the course of their tenure more often than other leaders — 71% of the time versus 42% for those without management consulting backgrounds.

In the subset of cases where the company’s condition was classified as “Crisis” or “Challenged,” a similar difference was also evident, moving the companies to the “Stable” or “Growth” category 92% of the time, versus 70% for non-management consultants.

Leadership choices depend on many factors, of course, and need to be incredibly nuanced. But this evidence perhaps further legitimizes the option.

It can’t be the case that any old consultant should lead up a company. Did you find any characteristics that set effective consultants-to-CEOs apart?

Not every consultant is an appropriate CEO-level leader, just as is true in the broader executive population.  The nature of consulting suggests some particular factors to consider. And it certainly is possible for a person to be a highly successful consultant but not succeed in a CEO role.

For instance, consultants who are gifted at analyzing complex problems and identifying a range of possible solutions, but don’t have the drive to implement those solutions, do not make strong chief executives.  Even strong “people leadership” in a consulting context may not necessarily translate — leading teams of highly educated, motivated MBAs in the “up or out” environment of most management consulting firms is quite different from leading an employee population with a mixed set of skills and backgrounds.

Finally, it is less risky to advise than it is take direct action — those consultants with the courage to be the decider and accept the personal risk of those decisions are more likely to be great CEOs.

In terms of other specific characteristics within the study, leaders who have worked at the partner level for a top strategy firm appear more likely to succeed.  This makes sense given that they have probably worked most directly for CEOs of client companies and therefore appreciate the issues and levers of the top executive.  They also are likely to have had deeper experience tackling some of the most complex and important challenges organizations face.

Does it matter if the consultant has done work for the company doing the hiring?

No, we did not see that relationship.  There are certain industries where deep knowledge and expertise are needed, and consultants working in the industry are therefore more compelling candidates.  However, it was not the case that consultants simply crossed over from serving a specific client to being that company’s top executive.

You found that management consultants were better able to turn poorly performing companies around. Since that’s often the job of a consultant to begin with, should we be surprised?

No, probably not.  Consultants are trained to analyze and address problems, and focus on improving the value of a company over a short time frame — exactly what is needed in many turnaround situations.  They are often adept at connecting the dots between complex sets of issues and crafting phased, comprehensive programs of attack — targeting the initiatives that are most likely to deliver impact.

And what happens after the turnaround — do consultants have the skills to lead companies during good times as well as bad?

Our study did not answer this question specifically, but we have no reason to expect that they did not perform at least as well as their non-consulting peers.  Given the growing complexities of businesses today — in terms of global footprint, changing business models, more complicated constituency networks, risk management, digital technology forces, evolving competitors and other societal shifts — any company in good times is still facing a pretty daunting array of potential challenges.

What can CEOs who don’t have consulting backgrounds learn from those who do?

The main thing to learn is the urgency with which consultants naturally operate.  Having been in project settings where the clock is ticking on delivering value, consultants are often able to analyze the situation and quickly focus on the levers that matter most.

The other message is around the importance of clear and transparent communication — management consultants are trained in communicating complex ideas simply, creating a story that can be followed and remembered, and tying recommended actions back to a central strategic framework that clarifies where the company is headed.  This skill in communication is becoming more important in the transparent, multi-constituent world in which we now live.

Are there any dangers in hiring a consultant to run your company?

There are dangers in any leadership decision, and all people decisions are complicated.  The stakes are enormous and not all the evidence is visible to the naked eye. On top of that, any set of leadership requirements is going to be highly dependent on the company, its situation, strategy, business model, condition, and scores of other factors.

Beyond that, there are certainly dangers in hiring the wrong kind of consultant.  As mentioned above, not every highly successful consultant will make a great CEO.  Careful assessment of the person’s executional drive, well-rounded leadership ability and risk tolerance are important to ensure that a particular consultant will potentially be a capable CEO.  Then there are all the other factors to assess.

What unanswered questions are you still looking into?

One thing we would like to investigate further is whether the trend of choosing former management consultants as CEO is one that is accelerating.  There are some early indications that that could be the case, but we don’t yet have the sample size to prove that.

Our interest in this area is largely about continually evolving our understanding of the characteristics of high-performing CEOs, so we will continue to explore how the valuable skills or competencies that consultants have may be found in, or cultivated in, the corporate environment.

We’re also interested in expanding our research in order to understand the performance of management consultants in a number of other roles — not just as a CEO. 

Taking Over from an Incompetent Team Leader

Becoming the leader of an existing team can be challenging, but taking over from an incompetent leader is more difficult. Incompetent leaders are not only ineffective at achieving the team’s goals. They think and act in ways that detract from and undermine the team’s performance, working relationships, and well-being. Consequently, in addition to forging agreement on the normal issues of mission, goals, and roles, incoming leaders often find their new team in disarray, dealing with conflict and stress. Building a stronger team means addressing these emotionally-laden issues.

There are several steps leaders facing this situation can take:

Tell team members what you know. Your new direct reports want to know what you understand about the leadership deficit they have faced and how it has affected the team. Your purpose isn’t to criticize the previous leader or to be omniscient; it’s to show the team that you have some understanding and appreciation – however limited – of the challenges they have faced and the effects it has had on the organization, the team and them. By telling people what you know, you also model transparency, a value that may have been lacking in the previous leader.

Be curious about what the team has experienced. If you know only a little about what the team has been through, say so. But even if you have worked with the team or been a team member, get curious and ask about the challenges they have faced and what concerns they have. Incompetent leaders leave behind disarray, conflict, and stress. By understanding what they have experienced, you develop a more complete picture of the issues that you and your team will need to address to move forward. Your curiosity also shows that you are interested in their well-being, another value that may have been lacking in the previous leader.

Temporarily suspend judgment about whether team members are resisting changes to improve team functioning and accountability. Teams that have been led by incompetent leaders often have insufficient or stifling structures, processes and accountability. Team members have received mixed messages about what is expected of them and they have often been treated poorly, without regard to their well-being. It’s easy to think that because you are increasing predictability and psychological safety, team members will quickly and enthusiastically embrace your changes. But team members may welcome the changes and have concerns about effects of the changes. They may worry that you will use the increased accountability punitively or that the changes in expectations will reveal their weaknesses, which will put their jobs at risk. As a result, they may not fully implement the changes. It’s easy to infer that these members are simply resisting change. If instead, if you get curious and understand they concerns, you can design team changes in a way that address the concerns at the same time it achieves the results the team needs.

Be careful about assessing team members’ knowledge and skills based on their initial performance. Similarly, if team members aren’t performing their jobs adequately, it’s easy to infer incorrectly that members can’t perform their jobs. But, sometimes it’s more complex than that. Team members’ knowledge and skills may be masked by the dysfunctional structures, processes, and expectations that the previous leader created and within which team members operate. Until you start to change these conditions, it can be difficult to tell if team members have what it takes to do the job.

Explain your behavior; don’t make team members guess. As you assess the current team’s functioning and work with the team to make changes, don’t assume that you can allay members’ concerns simply by acting effectively. Team members’ anxieties about the previous leader can easily lead them to misinterpret your comments and behaviors. To reduce this possibility, consistently explain why you are doing what you’re doing and why you are saying what you’re saying. This also enables you to share your leadership philosophy and set expectations for how you want others to lead.

You may be thinking that you don’t have the time to follow these steps; you need to get some team results fast. There is a paradox here. If you start by quickly changing team structures, overall it will take more time to get better team results than if you spend more time to understand, appreciate, and respond to team members’ needs and concerns before making changes. Smart leaders practice what systems thinkers long ago learned: Go slow to go fast.

Strategic Humor: Cartoons from the December 2013 Issue

Enjoy these cartoons from the December issue of HBR, and test your management wit in the HBR Cartoon Caption Contest at the bottom of this post. If we choose your caption as the winner, you will be featured in next month’s magazine and win a free Harvard Business Review Press book.

“I think we’ve all heard enough debate about the chair budget, Vickers. Now, are there any other areas where we can trim some fat?”

 

Paul Gilligan


“One man’s cubicle is another man’s fort.”

  Teresa Burns Parkhurst

“Printer-gatherer.”

  Ken Krimstein

“This economy has been especially hard on sidekicks.”

  Kaamran Hafeez

“These dinners with the boss can be so awkward.”

  Paula Pratt

And congratulations to our November caption contest winner, Dale Stout of Colorado Springs, Colorado. Here’s his winning caption:

“How’s this 360-degree feedback working?”

Cartoonist: Susan Camilleri Konar

NEW CAPTION CONTEST

Enter your own caption for this cartoon in the comments field below — you could be featured in next month’s magazine and win a free book. To be considered for the prize, please submit your caption by January 14, 2014.

Cartoonist: Paula Pratt

Five Ways the Advertising Industry Is About to Transform

Technology has prompted tremendous change in the advertising industry—change that would have been inconceivable even a decade ago. People are accessing, consuming, and sharing content in more varied ways than ever, and marketers have scores of new opportunities to understand, reach, and engage with consumers. But at the same time the ecosystem of technologies that supports online advertising has become so complicated and cumbersome that it actually makes it harder for advertisers to invest more money to market effectively, putting the industry’s growth at risk.

The next evolution in digital advertising must be driven by innovative platforms that more effectively help marketers move their businesses forward.  Technology will only be able to deliver on its promise of moving TV dollars online if it creates greater process efficiencies, drives more commerce, and enables deeper engagement with consumers.

Fortunately, there are some encouraging trends.  Here are the changes I expect we’ll see in the next year or so:

1. Automation will take hold. As automated, or programmatic, advertising technologies replace unwieldy manual media planning and buying processes that eat up too much time and overlook critical consumer data, more (human) resources can be directed toward the creative side of the house, and toward engaging and effective advertising that drives commerce, for example, native advertising, sponsorships, take-overs and other strategic initiatives.

Automation is a win for web publishers as well.  Programmatic advertising does not mean publishers need to put their inventory up to the highest bidder.  It simply means they can make it accessible via a technology platform that makes it easier for buyers to access it while still setting premium pricing.  Programmatic advertising is about automation, not auctions.

Bottom line: sophisticated technologies will serve to complement and enhance the creative talents of humans by freeing up their time that has – to a great degree – been occupied by rote tasks such as completing insertion orders for ad buys.  Projections put about 22% of all digital media being automated next year – up from just 4% in 2010.

2. Open ecosystems will succeed. Both Wall Street and Madison Avenue have run out of patience for niche ad technologies that are product features masquerading as point solution companies. Look no further than the massive sell-off last week of stock from specialized ad tech vendors. For too long, the industry has asked marketers to manage multiple relationships with up to 40 vendors to execute online advertising.  This is a significant deterrent for digital investment as it creates more work than value for already resource-strapped agencies and marketers. These closed systems that force marketers to stitch together a patchwork of feature companies will lose, and a small number of open ecosystems that these feature companies can plug into will emerge to streamline agency and marketer workload. We’ll see industry consolidation continue in 2014 and witness the rise of open platforms that will make media planning and buying a whole lot simpler for all involved.

3. Mobile will drive sales for marketers. 2014 will be the year that marketers demand device agnostic advertising. Desktop display growth has been leapfrogged by the smartphone and tablet, moving multi-screen advertising into the spotlight. The Association of National Advertisers and Nielsen just reported that by 2016, about 50% of digital advertising will be multi-screen.  We see this trend already in our business with about 45% of all clients running multi-screen advertising. Innovations and technologies – such as new targeting capabilities and new uses of data that empower marketers to gain a single view of the customer across all screens are leading this movement, because ultimately, a cross-screen strategy will drive the highest return for marketers.

4. Premium advertising will get more premium. 2014 will be the year when immersive advertising experiences that tie directly to a transaction will begin to flourish on the Web. As automation kicks in and time is given back to agencies and marketers to be more creative, we will see an industry call for more premium opportunities that goes beyond banners and gets much more sophisticated and customizable. Whether it’s a new live advertising execution (think Oreos response during the 2013 Super Bowl blackout) or a commerce campaign that drives sales through location based content, digital advertising will be remarkable, unique and experience-based.

5. Operational convergence will drive strategy. Technologists, creative art directors, and content producers can no longer operate in separate silos.  With more consumer data being generated than ever before, marketing, data, and technology must be aligned. As this convergence accelerates, more holistic and integrated businesses will emerge and outperform their competition.

I’m confident that these big shifts in the industry will result in relationships between brands and consumers that are more transparent and based on the exchange of real value.

Reverse Innovation Starts with Education

Historically, multinationals innovated in rich countries and sold those products in poor countries. Reverse innovation is doing exactly the opposite. It is about innovating in poor countries and selling those products in rich countries. Since two-thirds of world’s growth in GDP is likely come from poor countries, reverse innovation is an important phenomenon. Reverse innovation is also a significant learning opportunity for students in engineering.

Engineering graduates are good at solving problems. Once given a problem, they tackle it rigorously. But what if these individuals weren’t handed problems and instead sought them out? Engineers have an opportunity to reframe the problem space and identify a whole new set of problems if they ask this question: How do we engineer and design products to solve the world’s toughest challenges?

Some schools have already started thinking in this way. Earlier this year, I received an invitation on behalf of the Tata Center for Technology and Design and the Department of Mechanical Engineering to speak at MIT about my work on reverse innovation. The students and faculty affiliated with the Tata Center, which focuses on creating solutions for resource-constrained communities in India through academic research, are currently pursuing theses on emerging market challenges and strive to create high-performance and low-cost technologies that will be globally relevant.

On a similar note, last week, I gave a keynote speech on reverse innovation to students at University of Alabama in the Science, Technology, Engineering, and Math (STEM) disciplines. These students — majoring in fields such as engineering, biology, chemistry, and other technology-oriented areas — read my book, Reverse Innovation, over the summer. Throughout the school year, students work in teams to innovate new business models and products for problems faced by the poor. I was inspired after interacting with the smart young STEM majors. They didn’t just listen; they wanted to act. One student told me, “Your work has inspired me to change my mind-set to problems. I look forward to implementing it by visiting emerging economies.” Of all the keynotes I gave this year, the one I gave to University of Alabama STEM students is the highlight. (The fact that I got to watch the Alabama–LSU game was icing on the cake!)

The issues these two groups are studying are pressing, and other universities need to follow their lead. Out of the earth’s population, about 2 billion can afford good products whereas the remaining 5 billion are poor and are therefore nonconsumers. Innovating to solve the problems of the 5 billion poor represents the biggest opportunity for corporations. However, this also presents some of the hardest technical challenges for humanity, where we cannot simply adapt solutions used in wealthy markets. We have to innovate anew. The constraints posed by serving the poor will push innovations toward high-performance, low-cost products that have the potential to transform everyone’s life — including customers in rich countries.

Consider the following examples. The U.S.-based Harman International Industries, known for ultrasophisticated dashboard audiovisual systems for high-end automobiles, engineered a radically simpler and cheaper auto infotainment system for mid-price and entry-level cars in emerging markets. The company subsequently migrated the low-cost platform to serve the needs of luxury cars as well. General Electric engineered an $800 portable, battery-operated, easy-to-use electro-cardiogram (ECG) machine for rural India at a time when they were selling very powerful $10,000 ECG machines in the U.S. The $800 ECG platform is now sold in wealthy countries as well, creating new applications and additional growth for the company.

To solve poor-world problems, engineers must create technologies that meet or exceed the performance of their wealthy equivalents, but for a fraction of the price. The constraints one faces in poor countries will force them to create fundamentally new technologies; modifications to existing technologies cannot achieve the performance/price combination we need. Opportunities exist to push the price/performance paradigm in several areas including health care, energy, housing, education, clean water, and transportation, among others. Once we have created these new technologies, we can reverse innovate to modify the technology for the American context, adding features and functionality for what America demands and can support. Reverse innovation will be a catalyst for new ideas and a valuable design tool for engineers striving to create technologies that have global impact.

America is at a crossroads. We can either eke out 1 or 2 percentage points of growth by restricting ourselves to the needs of the 2 billion rich, or play the pioneering role we have played in the past by bringing the other 5 billion into the fold and ensuring a future with strong growth and indelible impact. Clearly, I would vote for the latter. American universities should offer programs where engineering students can play a big part in designing and engineering products that address the needs of people in emerging economies.

The Politics of China’s Economic Adjustment

After many years of spectacular economic growth and of what seemed — on the surface at least — like remarkable cohesion within China’s political elite, the past two years have involved what to many analysts has been an astonishing amount of turmoil at the highest levels of the Chinese political establishment. There are many precedents in recent history for China’s 30 years of rapid, investment-led growth. However, these precedents suggest that we should not have been surprised by the recent turmoil.

In every case on record, the adjustment period following the growth “miracle” was a period of difficult economic adjustment — and it is perhaps worth noting that the adjustment period has always been far more difficult than even the pessimists predicted. But, we must remember that the adjustment period was also always a time of political difficulty, of fractious political disputes, and in some cases, of political transformation. In fact, excluding a few, very unique cases, the adjustment period has always been even more striking as a period of political change than as a period of economic change.

And it should not be hard to see why. When a country’s governance is structured in such a way that incentives for the political elite are aligned with the economic interests of the country, the country is likely to grow rapidly and in a healthy way, and with minimal political disruption. When they are misaligned, however, there are likely to be significant strains and pressures that resolve themselves through political conflict.

What does this have to do with China? In the early 1980s, when China’s reforms began, the country was seriously underinvested and urgently needed to improve its infrastructure, its manufacturing capacity, and housing and education. As the country’s leaders engaged in a massive program of investment, there were many opportunities for the state and for the political elite to benefit directly from transforming the country’s capital stock, by controlling access to cheap credit. One consequence was that while the lives of ordinary Chinese improved at a pace perhaps unmatched in human history, the share of China’s GDP retained by the state sector and the political elite actually increased more, as they benefited disproportionately from Chinese growth.

But every country that has experienced a growth miracle has also developed imbalances that had to be reversed. The adjustment process is simply the process by which these imbalances are reversed. China is no exception. In order to rebalance the Chinese economy after three decades during which ordinary Chinese households retained an ever-smaller share of the rapidly growing Chinese economy (doing nonetheless very well in the process), China must now shift to a period in which they receive an ever-rising share of a more slowly growing Chinese economy. This, in fact, is almost the very definition of rebalancing in the Chinese context.

China’s economic adjustment necessarily involves, in other words, a sharp reduction in the rate at which the state and the political elite have been able to benefit from the growth of the past thirty years. What’s more, Beijing must implement legal, financial and government reforms that are likely to undermine the ability of the elite to control access to credit and initiate large-scale investment projects. China’s old economic model — which rewarded both the country and the elite very handsomely — must now be transformed into a model that will continue to reward the country, but at the relative expense of the elite. This was the challenge faced by every country as it adjusted from its period of rapid, investment-led growth, and it has always been a politically challenging process.

Beijing has already demonstrated sufficient foresight and ability to have managed the growth period successfully, and we have every reason to hope that China’s top policymakers will manage the adjustment process equally well. But there should be little doubt that thirty years of astonishing growth was the relatively easier part. Today, President Xi Jinping and Premier Li Keqiang face a far greater challenge than that faced by their predecessors. The recent political turmoil in China is not an accident, and it has not ended. History makes it very clear that the next ten years will be a political challenge for China even more than it will be an economic one.

China’s Next Great Transition

An HBR Insight Center




China Needs a New Generation of Dreamers (and New Dreams)
Understanding Chinese Consumers
China’s Bad Bet on the Environment
Jack Ma on Taking Back China’s Blue Skies

Microsoft’s Next CEO: How the Board Can Get It Right

Let’s face facts: Most boards invest heavily in executive assessments, exposing chief-executive candidates to C-suite responsibilities and checking their P&L performance — while simultaneously scanning outside prospects.  Yet less attention is given to one of the most important determining factors of all:  Whether directors who have actually served as CEOs are driving the process.  It takes one, in our view, to really know one.  If the succession and search are not driven by those who have already run another firm, the company is, in our experience, less likely to end up with a CEO who can run this one.

Look at Microsoft’s current search for a successor to chief executive Steve Balmer, who has run the show since 2000.  John W. Thompson, the former CEO of Symantec, leads its search committee, and he is joined by Steve J. Luczo, chairman and CEO of Seagate, and Charles H. Noski, former CFO of Bank of America.  All have served at or near the pinnacle of company power, and they now bring that experience to judging who has the requisite skill-set to lead the world’s largest software maker in a fast-morphing market.  They will likely decide among three major options, and here is where that prior executive experience will prove critical in picking among them:

1. Stay inside or consider an “outside-in” candidate.  Thompson and his colleagues have up-for- consideration several long-term Microsoft managers and a former executive, Stephen Elop,   recently reacquired when Microsoft purchased much of Nokia.  Their prior question here is sure to be the company’s long-term strategy.  Should Microsoft reinvent itself or stay the course?  Most insiders are likely to play to the latter since they have been deeply responsible for executing the departing CEO’s agenda.  This is the default—most Fortune 100 CEOs have been home grown—but it comes with a downside: other top talent may decamp to corner offices elsewhere.

2.  Go outside for a tech-savvy executive with a proven record and who is of an age to run the company for the next ten to fifteen years.  This option opens the way for a much larger gear shift, but it also comes with the same hitch.  The inside talent that is passed over may quickly head out the door, as happened at Boeing when it brought in James McNerney from 3M— only to lose its own Alan Mulally to Ford.

3. Go outside for a more experienced outside CEO of a major enterprise who could further develop Microsoft’s top talent and then be ready to step aside in five or six years.  This brings the advantages of holding off on anointing an internal executive who may not be quite ready—but at the same time retaining the top contestants and allowing for a strategic redirection.  This is no doubt one reason that Ford’s Mullaly is under active consideration.

Regardless of the choice, we believe that Microsoft search committee will better be able to assess these options and their candidates given its members’ own C-suite experience.  Since they have been there and done what they are looking for before, that should improve the likelihood that they and the board will reach the right outcome in the biggest decision that the directors will ever face.

From observation and experience with many boards in the U.S. and abroad, we have come to conclude that too much of the debate around CEO succession misses one of the most important determinants of success or failure.  And that is a matter of creating the right social architecture in the boardroom — including composing the search committee — that can optimize finding the right executive given the company’s challenges at hand.

We also believe that current and former chief executives, or those who have been close to the throne, are more likely to bring the right insight and instinct to the board’s decision.  Having already made so many executive selections of their own, and knowing personally what is required of those who carry ultimate responsibility, they bring the confidence and know-how of the seasoned veteran.  They are less likely to hand-off the process to a search firm, more likely to make company strategy the first criterion in narrowing the field, and more likely to discern who would constitute the best strategic fit.

Company boards think a lot these days about downside risks, as they obviously should and have learned to do in the wake of the financial crisis.  Directors worry about bad acquisitions, bad operating procedures, bad safety measures, and bad multinational expansions that can kill results.  But in our view the greatest such hazard is picking the wrong CEO who can drive the company in the ground.  And to guard against that ultimate risk, the best protection is to bring great performers onto the board who know how to run companies for having done it — and then to place the best of the best on the search committee when it really counts.

Ram Charan, Dennis Carey, and Michael Useem are authors of Boards That Lead: When to Take Charge, When to Partner, and When to Stay Out of the Way, 2014.

When M&A Is Not the Best Option for Hospitals

Historically, larger scale has offered hospital systems a number of advantages, including increased referral volumes, better access to capital, stronger pricing power, and classic cost economies. For instance, larger scale has enabled many hospital systems to lower their per-patient operating costs significantly.

However, reform and other market changes are altering the scale equation for hospital systems, so some of the traditional advantages that larger scale has traditionally brought them may no longer apply. For example, hospital systems’ ability to receive premium prices for higher quality and more consistent care in a market is now being limited by greater consumer and employer price sensitivity, increased scrutiny on industry profits, and regulatory concerns about hospital mergers.

In addition, creating value through M&A deals always is challenging, and all M&A activity involves a certain amount of value destruction. (Many hospitals system executives underestimate the cost of both pursuing an acquisition and managing the post-merger integration.)

So while hospital systems must respond to growing pressure on their margins and some M&A opportunities should still be pursued, their executives should ask themselves two questions before taking the plunge: What other — perhaps new — advantages might scale bring that would enable them to overcome the inevitable value destruction associated with M&A? Are there other affiliation models beyond M&A that would allow them to capture these advantages with less risk and at a lower cost?

These questions are the heart of a new, smarter scale equation (PDF) that can help leaders of hospital systems to address the challenges ahead.

Advantages of scale

The advantages that hospital systems can derive from scale fall into four groups:

Classic economies of scale focus on lowering the cost per unit of care delivered (e.g., by spreading fixed costs across a larger volume of patients, consolidating administrative functions, or enabling a provider to negotiate lower prices for major cost categories).

Economies of scope can allow hospital systems to leverage their scale to develop new revenue streams. For example, Tenet Healthcare launched Conifer Health Solutions in 2008, and its technology-enabled services now help its more than 600 clients throughout the United States manage patient revenues, financial risk, and patient communication and engagement and support their efforts in accountable care and population health management. It currently assists these clients in managing $25 billion in annual patient revenues and provides services that support population health management for more than 4 million people.

Economies of structure can be captured by hospital systems that have a structural advantage in some of the local markets they serve. For instance, structural advantage can be gained if a hospital is a market share leader or has a large physician network, an extensive out-of-hospital footprint, or unique or differentiated services (such as being the only facility in a region that can provide advanced oncology services). A hospital system that can strengthen its structural position within a market is apt to have a more favorable negotiating position with its partners. It is also likely to be better able to take on risk pooling for population health management and improve its retention of patients.

Economies of skill can permit hospital systems to share or build best practices at a comparatively low cost. For instance, greater value can be created when a system with a strongly disciplined approach to operations shares this skill with another system than when the operations of two moderately disciplined systems are merged. In addition to operational excellence, other economies of skill include stronger physician alignment (on issues such as how to minimize waste and implement emerging value-based models), greater capacity for innovating on where and how medicine is practiced (e.g., through the adoption of evidence-based care pathways and care delivery in lower-cost settings), more effective IT deployment (to enable standardization and integration of care), and better management of financial risk. In many cases, it may be skill economies that best enable providers to create value in the next few years.

Affiliation models

Once a hospital system has determined which economies it wants to pursue, it can then determine which approach would be best for capturing them. A range of different models should be considered:

Inorganic scale can be purchased through a traditional asset-consolidation transaction — for instance, the merger of two hospitals operating in the same region, the absorption of one or more hospitals into a larger health system, or the merger of two systems on a regional or national scale. Deals such of these often result in considerable economies of scale and skill but at a high cost and with significant implementation risk.

Virtual hospital integration can allow a hospital system to capture certain benefits of scale without requiring it to directly control another organization or commit to a long-term relationship. This type of deal may involve the co-provision or outsourcing of shared services or the joint creation of knowledge and innovation. As a result, the health system can obtain some economies of scale and/or skill without the high upfront investment or risk associated with M&A.

Horizontal organic scale develops when a hospital system extends its footprint across the care continuum (e.g., by acquiring physician practices or outpatient facilities). This approach often strengthens the system’s reputation in the community, facilitates referral growth, and paves the way toward population health management. However, it offers only limited economies of scale.

Vertical organic scale requires a hospital system to build direct relationships with payers, employers, or both to enable it to capture greater patient volume. This may be accomplished through network design or risk-sharing arrangements with payers, or direct-to-employer strategies, such as onsite workplace clinics or “centers of excellence” that provide leading care for all employees of an organization. (For example, the retailer Lowe’s contracted directly with the Cleveland Clinic to carry out best-in-class heart procedures for all its employees). This option has the potential to create high value by enhancing the health system’s structural position. In addition, it can be pursued in parallel with horizontal expansion, particularly when the payer–provider collaboration aims to establish new care or payment methods with a care-management focus.

The Smarter Scale Equation

When deciding which affiliation model best captures the desired economies of scale, hospital system executives should consider the following questions: How much potential value creation is available with each model — and at what cost? And does the proposed model complement the system’s strengths, weaknesses, and objectives?

Answering these questions requires executives to shift their thinking away from the traditional scale approach and toward a more complex equation that evaluates the risks and costs of hospital integration, as well as the difficulty of actually capturing the potential upside value. This broader approach will enable them to achieve their desired outcomes at appropriate levels of risk and investment.

An expanded version of this article can be found on the website for publications of McKinsey’s Healthcare Systems and Services Practice.

Follow the Leading Health Care Innovation insight center on Twitter @HBRhealth. E-mail us at healtheditors@hbr.org, and sign up to receive updates here.

Leading Health Care Innovation

From the Editors of Harvard Business Review and the New England Journal of Medicine




The Big Barrier to High-Value Health Care: Destructive Self-Interest
A Framework for Reducing Suffering in Health Care
Fix the Handful of U.S. Hospitals Responsible for Out–of–Control Costs
Saving Academic Medicine from Obsolescence

When Selling Digital Content, Let the Customer Set the Price

The newspaper industry is a good example of just how difficult it can be to thrive when business goes digital, especially if that business is chronically resistant to change. David Carr, at The New York Times, summarized the industry’s precarious position as follows:

“Producing serious news is an expensive enterprise with a beleaguered business model, one that remains tied to the tracks as a locomotive of splintered audiences and declining advertising hurtles toward it.” (The New York Times; October 20, 2013)

Yet, there may well be a light at the end of this tunnel, and it comes in the form of Jeff Bezos, founder of Amazon, who recently purchased The Washington Post, and Pierre Omidyar, founder of eBay, who shortly after pledged $250 million to create a new general-interest news site. The surprising investments of these giants of the digital age have certainly made disbelievers sit up and take notice. But Bezos was quick to pinpoint the key challenge ahead:

“The Post is famous for its investigative journalism. It pours energy and investment and sweat and dollars into uncovering important stories. And then a bunch of Web sites summarize that [work] in about four minutes and readers can access that news for free. One question is: How do you make a living in that kind of environment?” (The Washington Post; September 3, 2013)

Bezos’ question certainly resonates with us, as it embodies a fundamental problem that many businesses—sellers of newspapers, music, movies, videogames, software, etc.—are struggling to deal with. It is also a question that the two of us have studied closely, independently or together, for some time. Indeed, the shift of content to the digital domain has forced organizations to rethink their attitude to value creation, at times backtracking to the very issue of what “value” actually means. Despite this, the way companies convert digital anything into cash seems to be stuck in time, obeying rules that may have worked in the context of a physical product but make far less sense today. To be sure, some visionaries spotted this inconsistency and posited that “free” (and the hybrid “freemium”) is the clever way forward. Unfortunately, the idea of giving stuff away today in the hope of a hefty payday tomorrow has caused new problems that are not straightforward to solve. Meanwhile, other visionaries preach hard lines of “pay walls” or softer versions with metering. The goal here is to set one or few rigid prices. This tends to be favored approach of traditional content providers. But if you consider the possibility of infinite variety that comes with a digital platform, not to mention the low or non-existent marginal costs, this model is probably leaving good money on the table. How can business make money from digital content, then? We believe that monetizing digital needs a fresh approach. In particular, we propose an architecture for pricing digital goods that is intended to move the exchange between seller and buyer from the transactional to the relational. This architecture reflects three key ingredients of today’s social marketplaces:

Empowerment. Companies are embracing the idea of delegating activities to their customers. We see this in marketing with product development and advertising, mostly. But what about monetization? How about letting customers participate—at least to some controlled extent—in price setting to raise their level of engagement?
Dialog. Gaining customer feedback is intuitive. But how often does the seller get involved and create a true dialog? And, even if there is discussion, how often is it tied directly to the pricing process? Modern e-commerce systems can enable rich automated value-focused interactions, but this capability is underused.
Reputation. Integrate the idea of social capital in the monetization approach. You can do this by creating a reputation score that relates directly to customers’ conscious use of the pricing power granted in point 1 above. Importantly, this score evolves over the course of multiple transactions.

We see these as general, flexible building blocks. One specific configuration is something we call FairPay. Here is how it plays out:

Empowerment. We take an extreme view: buyers first experience the product and then have the power to pay whatever they wish, including zero. The timing matters because (a) customers should know the product they are asked to sacrifice money for, and (b) it fosters reciprocity, a strong social norm. Moreover, there is a constraint in place to avoid freeriding: companies retain the right to make future FairPay offers (i.e., they can take away a customer’s price-setting privilege).
Dialog. Firms suggest reference prices to anchor a customer’s price offer and can provide reports to remind people of the value received. Customers are asked to justify the prices paid by indicating their reasons. Firms respond with counterarguments. Importantly, this dialog is structured for scalability and personalization through the use of modern choice architectures. The technology is there.
Reputation. Customers have a fairness rating. Choice architectures are then applied to segment customers in terms of fairness (and other attributes) and apply “carrots” (relating to product tiers, perks, etc.) to improve profitability or “sticks” (the threat to remove a customer’s price-setting privilege) to at least sustain it.

Our FairPay approach is only one application of the principles outlined above. No doubt different organizations can leverage this framework in different ways, not all of which will go so far as to allow users to pay what they want. Indeed, such experimentation is necessary to overcome the challenges businesses face in monetizing digital content. The key, however, is to move beyond the debate over free vs. fee to focus on empowering and communicating with customers, and finding ways to reward those who opt to pay.