How to seize the upside of the downturn

By Donald Sull Professor of Management Practice, London Business School

In the midst of a downturn, most managers fixate on the abundant bad news: Demand is down, prices falling, credit scarce, and layoffs likely. Obsessing over threats obscures a surprising but crucial truth about downturns — the worst of times for the economy as a whole can be the best of times for individual firms to create value for the long term.

In past downturns, some firms including Toyota, Nokia, Cisco, Samsung, and Emirates Airline emerged from an economic crisis stronger than when they entered. Like the ancient Greek wrestler Antaeus who regained strength when thrown to the ground, these companies derived strength from economic hard times. Many of their competitors, in contrast, languished or failed. Part of the difference results from managers understanding of how to create value in a downturn, as well as their effectiveness in acting on these insights.

Every downturn opens a window of opportunity to adjust the status quo, and astute managers push through necessary changes while the window is open. An economic crisis marks a sharp break with the past, and observing the break, employees recognize that a firm can not do more of what worked in the past. The downturn lowers their resistance to change and cuts through complacency that might impede action in fat times. A downturn often brings latent challenges to a head, and savvy managers can harness the resulting energy to infuse the organization with a sense of urgency in fixing these problems.

A downturn provides a ready-made external rationale to justify painful decisions that would appear extreme in better times. Finally, an economic crisis provides managers with an air cover to make decisions that incur short-term financial pain for long-term gain, such as pruning products, “firing” unprofitable customers, or exiting money-losing businesses. Investors, boards and bosses are typically more forgiving of short-term dips in sales and earnings during a downturn when all competitors are suffering, than they would be during a boom when everyone else is doing well.

Managers can harness a downturn to make any number of possible changes, but three actions in particular are likely to create long-term value: Managers can build processes that instill ongoing cost discipline, force hard choices that they avoided during the boom times, and accelerate transformational change within the organization. In addition, they should also remain alert to the golden opportunities that often emerge during a downturn.

Instill ongoing cost discipline
During the boom, many managers thought their objective was to grow revenues through innovation. It is not. Companies exist to create economic value, which is the difference between revenues and the opportunity cost of all inputs (including capital). Good managers keep their hands on both levers at all times, looking for growth opportunities during downturns while maintaining cost discipline while the good times roll.

Unfortunately, best practice is not common practice. Many companies instead veer between periods of undisciplined growth and brutal cost cutting. During a boom, they press on the gas pedal to grow revenues. When the economic cycle turns, however, they slam on the brakes, abandon growth, and focus on slashing expenses to free cash flow. Once the economy picks up again, they abandon their newfound cost discipline to pursue revenue growth.

This stop-go approach is a mistake. Golden opportunities to increase sales often emerge in downturns, a topic discussed in greater detail below. The best opportunities to cut costs often arise in good times. During a boom, managers tend to overlook the inefficiencies that sprout like weeds throughout the organization, sapping resources from more productive uses. During a downturn, good managers weed their overgrown garden, but great ones build processes to nip these costs in the bud as they crop up in the future.

Everyone knows that Toyota Motors overtook its Detroit rivals in large part through its “lean” production system. which continuously reduces costs by identifying and eliminating activities or materials that do not add value for end users. Toyota pioneered these processes not in benign markets, but in the midst of a deep downturn that depressed automobile demand and forced Japanese automakers into the red.

Toyota managers did not ask what to cut, but addressed the more fundamental question of how to systematically identify and eliminate waste on an ongoing basis. Teams of managers studied Ford’s manufacturing process, but were unimpressed by the large stocks of work-in-progress inventory and frequent quality problems. They also benchmarked best practices within Toyota, and discovered an experimental process within the company’s own machine shop, where successive work stations took only the parts or materials they needed at that point in time. This early “just in time” process minimized inventories, and also quickly surfaced problems along the assembly line, to avoid costly rework.

In instilling these processes, Toyota did several things well. First, Toyota’s managers looked both outside the company for ideas, neither ignoring external ideas nor slavishly following the latest management fad. Second, they continued to refine their processes, added complementary practices including visual signals to pull more inventory and a system that allowed workers to stop the assembly line when they detected a problem.

Third, they used the downturn to negotiate changes in work practices. The Toyota system required workers to man more machines, provide constant suggestions for improvement, and move among stations as workflow dictated. The downturn helped convince workers that these changes were necessary. Fourth, Toyota managers recognized that no company is an island, but is embedded in an ecosystem of suppliers and distributors, and they extended these practices to their suppliers. Finally, Toyota managers did not lose their discipline when the market picked up, but continued to use and improve their processes after demand picked up again.

Managers can look for ways build ongoing discipline into resource allocation processes. In many companies, the budgeting process takes the previous year’s expenditures as given, and then incrementally augments or decreases them to calculate the next year’s budget. Facing a deep recession in Brazil, retailer Lojas Americanas introduced Zero Based budgeting, that required managers to develop their budget from scratch and justify each budget item anew.

To instill ongoing cost discipline, managers should ask themselves a few questions: What processes do we currently have in place to systematically identify and eliminate waste? Could we improve these procedures? Are there promising best practices in part of our organization that we could disseminate more widely throughout the organization?

Force hard choices
Good times produce ample resources, which blunt the need to make hard tradeoffs. During a boom, managers tend to spread resources evenly—like peanut butter on bread—to preserve a sense of fairness and minimize conflict. Even in the best of times, this egalitarian approach to resource allocation ensures that promising opportunities secure fewer resources than they need, while less attractive units receive more than they deserve.

In the worst of times, this egalitarian approach to resource allocation is even more dangerous, dissipating scarce cash. Unfortunately, many managers try to spread the pain of downsizing evenly, demanding an identical percentage reduction in head count or expenditure of all units, for example, regardless of their merits.
 
A downturn provides the ideal opportunity to force hard choices. Consider Nokia. After the Soviet Union crumbled, Finland suffered one of the worst recessions in its history, and Nokia, then a diversified conglomerate, faced financial distress. Rather than spreading cuts evenly, Nokia’s executives made the hard call to focus on the fledgling telecommunications business, while exiting other businesses that accounted for nearly 90% of Nokia’s revenues.

The Nokia example illustrates important points about making hard choices during a downturn. First, managers must be willing to reverse their previous decisions. During the 1980s, Nokia executives invested heavily in consumer electronics, but when that bet did not pay off, the top team was willing to cut their losses and focus on the much smaller mobile phone business. Second, Nokia’s executives recognized that betting on telecommunications reduced the group’s diversification, and exposed the focused firm to greater risk. They offset the lost diversification with other risk management tools, including diversification within telecommunications (e.g., handsets and infrastructure), spreading across geographic markets, and achieving economies of scale.

A downturn provides an occasion to make hard choices not only in the C-Suite, but throughout the entire organization. After the dot.com bubble burst in 2001, Cisco suffered a sharp decline in sales. Cisco’s leadership responded by forcing hard choices at every level in the organization, including consolidating suppliers from 1,300 to 420, halving the number of channel partners, culling the bottom third of products, streamlining research and development projects, and sharply reducing acquisitions.

During the boom, Cisco middle managers enjoyed wide latitude to acquire start-ups, with the company snapping up two dozen in 2000 alone. During the downturn, Cisco tightened up the process, by creating an investment review board that met monthly to vet acquisition targets. Managers proposing acquisitions were required to draw up detailed integration plans and personally commit to hitting sales and earnings targets for the new business.

Companies can also harness a downturn to prioritize which corporate initiatives really matter. Corporate “priorities” tend to proliferate during a boom. Middle managers in one European engineering group counted more than 50 so-called “strategic priorities” that had rained down on them from headquarters over the preceding two years. This excess of objectives consumes not only cash, but also diverts managerial attention from what truly matters.

In a downturn, senior executives should consolidate their major initiatives into a single list and make the hard choices to select a handful that are truly critical. To ensure everyone gets the message, they should communicate the key priorities throughout the entire organization including a list of initiatives that are no longer key objectives, to ensure people do not waste resources on unimportant matters. Senior executives can give these priorities teeth by eliminating key performance indicators linked to less critical initiatives, and link the bonus of key managers to corporate objectives.

To force hard choices, managers can ask themselves a series of questions. What initiatives, businesses, products, markets, etc. have a call on our scarce resources? Can we rank order them in terms of value creation potential? Where should we draw the line that marks the truly critical from the nice to have?

Accelerate fundamental changes
Prior to the current downturn, many organizations embarked upon large-scale change programs. Common examples include shifting from selling products to services, fostering greater collaboration across organizational silos, or building a more entrepreneurial culture. Major change efforts are difficult in the best of times, and many executives worry that a downturn will halt future progress or reverse any gains made to date. Indeed in a downturn, managers too often scurry from fighting one fire to the next, and thereby lose sight of the longer transformation effort.

Nothing could be further from the truth. Large-scale change initiatives typically require eight to ten years to complete, and often run out of steam along the way. Downturns provide an ideal opportunity to reinvigorate an ongoing transformation. Managers can harness a downturn to renew a sense of urgency, justify unpopular decisions, and overcome complacency or resistance to change, as the Samsung case illustrates.

After succeeding his father as chairman of the Samsung Group in 1987, Lee Kun Hee kicked off a program to transform the conglomerate from a good Korean competitor to a great global company. Fifteen years later, the group’s flagship business—Samsung Electronics—had largely achieved the chairman’s ambition—leading in technological innovation, market share of key products, brand awareness, and financial returns. A careful analysis of Samsung’s transformation reveals that most of the critical decisions that propelled the group to global leadership were concentrated during two downturns.

After a promising start in the mid-1980s, Samsung’s transformation was running out of steam. Lee used the global recession the early 1990s to force through a series of difficult changes in short order: He divested businesses, such as sugar and paper processing, that were profitable and long-standing place in the group’s portfolio, because they could not achieve leadership in global markets.

Lee concentrated research and development and advertising expenditures on a handful of businesses deemed capable of competing globally, while curtailing expenditures in other businesses. Lee insisted that subsidiaries measure performance against global leaders, rather than benchmark other Korean companies, and instituted manufacturing processes to produce world-class quality. Finally, Lee bucked the Korean tradition of basing promotions strictly on seniority, to advance a large number of young executives based on their performance and global outlook.

By the mid-1990s, Lee again worried that the transformation was losing traction. While other Korean executives bemoaned the Asian Economic crisis beginning in 1997, Lee embraced it as another opportunity to reinvigorate Samsung’s transformation. He divested additional units and led a further round of headcount reductions. The chairman also increased the autonomy of the remaining businesses by eliminating cross-business subsidies, loan guarantees, and below-market transfer prices. These changes, which marked a sharp break from traditional business practices in Korea, freed the businesses to compete more effectively in global markets.

As they enter the fray of short-term retrenchment, managers should ask themselves a series of questions to keep sight of long-term transformation. Which large-scale changes did we start prior to the downturn? Which do we still consider critical to our long-term success? What changes would we have to make even if this crisis had never occurred? How can we harness the crisis to accelerate these changes?

Seize golden opportunities
Golden opportunities refer to occasions when a firm can create value significantly in excess of the cost of the resources required to seize the opportunity. Typical examples include acquisitions at bargain basement prices (think Banco Santander’s acquisition of Alliance & Leicester and Bradford & Bingley); innovative products, like the iPod, that create and dominate a new sector; expanding in emerging markets; or acquiring valuable resources on the cheap.

Golden opportunities do not come along every day, and most managers look for them when the good times are rolling. This is a mistake. The surprising reality, is that the best opportunities often arise during downturns for several reasons. Distressed sellers must offload valuable assets at bargain basement prices—recall how ING Direct snapped up the deposits unloaded by failing Icelandic banks. To conserve cash, companies may be forced to retreat from attractive opportunities, thereby creating an opportunity for rivals. In the face of the recession, Adobe Systems may scale back its ambitions in web-design software, creating an opening for a deep-pocket competitor like Microsoft to exploit. Competitors may have to pass on new opportunities to conserve cash. Airbus launched its A380 into the industry downturn following September 11th when few airlines had the wherewithal to buy the new plane despite its greater range, size, and fuel efficiency. Emirates, in contrast, pounced.

Sometimes seizing the opportunity requires a creative deal to help ease another company’s pain. When the Korean Won collapsed during the Asian crisis in the late 1990s, Korean producers flooded the European market with cheap microwaves, driving European appliance makers near bankruptcy. The Chinese company Guangdong Galanz negotiated a novel agreement with European white goods companies. The Europeans moved their state-of-the-art production lines to China, where Galanz manufactured microwaves for half the cost, and secured the right to use the spare manufacturing capacity to make its microwaves for sale in Asia. Galanz thereby secured cutting-edge manufacturing technology, economies of scale, and exposure to leading companies’ product design, which allowed it to quickly emerge as the world’s largest producer of microwave ovens.

In the midst of a downturn it is very easy for managers to focus exclusively on managing threats, and thereby lose sight of golden opportunities that might arise. To counterbalance this tendency, they should ask themselves the following questions. Are competitors retreating from attractive opportunities that we can seize? Should we double down in growth markets, such as BRIC economies, rather than retrenching to our core? Does our customers’ or competitors’ pain create an opportunity for us? Can we snap up key resources at bargain basement prices?

All the economic bad news can eclipse the crucial reality that every downturn has an upside. To seize that upside, managers must recognize the opportunities in hard times, and muster the courage to seize them.

Professor Donald Sull teaches on the Senior Executive Programme and Achieving Strategic Agility programme at London Business School.

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