McKinsey Telecoms. RECALL No. 19 - Innovation and product development: Growth versus competition

Innovation and product development: Growth versus competition

RECALL No19

Telecommunications, Media, and Technology

Innovation and product development: Growth versus competition

RECALL No19

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Jürgen MeffertLeader of McKinsey’s EMEA Telecommunications, Media, and Technology Practice

Marc de JongLeader of McKinsey’s TMT Product Development and Innovation Service Line in EMEA

Davis LinLeader of McKinsey’s TMT Product Development and Innovation Service Line in Asia

Aaron AboagyeLeader of McKinsey’s TMT Product Development and Innovation Service Line in the Americas

Welcome ...

RECALL No 19 – Innovation and product development

… to the 19th issue of RECALL, McKinsey’s publica-tion for leaders in telecommunications, media, and high tech. The pace of change is lightning fast, driven by the consumer’s endless appetite for innovation. Anyone who has ever observed the block-wrapping lines in front of an Apple store on “release day” knows that tech consumers can never get enough. What was ground- breaking yesterday might be obsolete tomor-row. Players who can stay a step ahead and anticipate their customers’ needs will reap staggering rewards. Meeting, exceeding, and even creating these needs calls for targeted innovation and product development – the focus of this issue.

The year 2011 turned out to be disappointing in several ways. Much of the hope engendered during the after-math of the global economic crisis has been dashed as the worldwide economy stalls once again. As organi-zations across industries – in the public and private sectors alike – tighten their belts, many are making significant cuts to their innovation investments. These scale-backs may be taking the steam out of the very engine that drives growth – innovation.

Our work with telecoms, media, and high-tech organi-zations highlights the complexity of development and the importance of getting it right. New players are enter-ing the game with seemingly unbeatable price points, and a dramatic rise in applications – such as Skype and Facebook’s video-calling feature – is destroying the value of services that were once major revenue genera-tors for many telecoms incumbents.

Growing convergence adds to the complexity. From fixed to mobile, from voice to data, and from music to multimedia, traditional boundaries between services are blurring. Combined, these phenomena make it increasingly critical for industry players to abandon their “worn” strategies and adopt multidisciplinary approaches to product development.

We see a clear need for telecoms, media, and high-tech organizations to become more agile in their product development endeavors – investing in innovation, not merely waiting for it to happen. In this issue of RECALL, we discuss the need to build a professional organization around innovation that optimizes every facet of R&D. Successful innovation begins with a deep understanding of consumer insights, while sidestepping the pitfalls that can lead to misinterpretation. It also means structuring activities in ways that lead to sustained innovation – not just one-off breakthroughs – including a more thorough look at managing the innovation portfolio and the R&D teams that deliver it. These topics and a conversation with one industry leader about his quest to innovate in a time of unprecedented pressure lie in the pages ahead.

We hope the articles in this issue of RECALL inspire you to think of your organization’s commitment to and execution of research and development in new and helpful ways. As always, we welcome your feedback on these articles and ideas for topics you would like to see covered in future issues. To download a PDF copy of the articles or the entire brochure, please register at http://telecoms.mckinsey.com.

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01 Innovation-led growth: Eight essentials 9

02 IQ innovations: The future of smart 17

03 More for the money: Managing the innovation portfolio 23

04 Design to value: Consumer-driven cost control 29

05 Insight traps: Missteps in consumer research that can make products worse 35

06 A billion buyers: Product innovations for a new consumer class 41

07 Managing talent: How world-class R&D organizations do it 47

08 Lean and the software imperative: Step change in development productivity 53

09 A free-flowing pipeline: An interview with Marco Ferrero 59

Appendix 63

Contents

RECALL No 19 – Innovation and product development

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01

Enterprises that want to drive growth based on a steady stream of innovations over time need much more than great ideas. Achieving sustained “innovation at scale” requires eight essentials.

Innovation is an enduring and universal objective that inspires some and eludes many. Year after year, McKinsey surveys – in telecoms and beyond – high-light that innovation remains critically important, yet frustratingly difficult to achieve.

In McKinsey’s 2010 Global Innovation Survey, a full 90 percent of over 300 high-tech and telecoms sec-tor executives who responded said that innovation is extremely or very important to their growth strategy. Yet, only a third had well-defined strategic innovation priorities at the corporate or business unit level.

Some would argue that this is the normal course of business; after all, many believe that innovation is, by definition, not systematic. However, serendipity is not a satisfactory justification to shareholders for either good or poor innovation performance.

Even though “eureka” moments do happen, systematic innovation involves much more than hiring armies of creative people. Innovation that continuously drives success requires creativity under discipline. Shaping this framework are diverse sources of insight and rig-orous science backed by the appropriate process and structure. Built on the foundation of research and extensive work with clients, McKinsey has identified eight essentials that prove relevant to any organization pursuing innovation at scale.

1. Aspire: Innovation is fundamental to the growth vision

To be a top-performing innovative company or busi-ness unit, it is essential to describe a compelling per-formance vision that places innovation at the heart of future growth. It should answer one question: How much innovation do we need to meet our financial objectives? Many corporate executives talk up innova-tion. In reality, the underlying business either has not prioritized it or, in some cases, does not require it to meet relatively modest growth needs. Quantifying the innovation-led growth gap over time is not only possi-ble, it is essential to improving innovation performance. Companies can achieve this through the following.

Set a clear objective for innovation-led growth. Break down growth drivers and quantify the amount of inno-vation required to meet performance goals. This value gap must be substantial to incite action. If there is no gap, it might make sense to revisit business objectives. Value your current innovation pipeline. Determine if your current innovation investments are substantial enough to fill the growth gap. Be sure to account for fail-ure or underperformance from new innovations, which many companies inadvertently overlook.

Align senior leadership to innovation criticality. Secure commitment from senior leaders to take action. Allocate targets for growth from innovation to business units; include these targets in strategic planning and budget-ing. Set the right mix of financial and non-financial metrics and cascade these throughout the organization.

Innovation-led growth: Eight essentials

RECALL No 19 – Innovation and product development Innovation-led growth: Eight essentials

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Communicate an inspirational vision. This vision should align with the strategy and the growth gap. It must describe a clear path, providing employees with the opportunity to contribute. This is also a chance to introduce a common innovation vocabulary to foster broad dialog and facilitate learning and sharing.

2. Choose: Invest in the most valuable innovation spaces

The second essential is for leaders to have a sense of where the best current and future market opportuni-ties can be found and of the right time to tackle them. McKinsey calls these opportunities innovation spaces, and they should be aligned with the company’s long-term strategy, since investments in these spaces will build the foundation for future growth. An innovation space defines boundaries within which a company will search for insight to unlock new forms of value. These boundaries can be technical limits, business model parameters, or other constraints; they can be value-based or derived from market and category definitions.

Uncertainty surrounding this essential may be greatest when an industry finds itself in the throes of transi-tion. Telecoms, media, and high tech are such sectors. Examples abound of companies missing major mar-ket shifts by failing to explore innovations emerging around their core business. Only a decade ago, no one had heard of an enterprise IT manager “renting” core applications from a company on the other side of the globe, or of consumers carrying mobile devices with almost infinite functionalities. Today, pay-as-you-go cloud services are widely used IT solutions, and – as can be easily observed – numerous consumers consider smartphones with thousands of fit-for-purpose apps to be essential electronic accessories.

Identifying and selecting valuable innovation spaces is a difficult but critical capability that requires two elements. First, companies must have strong market intelligence on evolving customer trends, investment patterns in technologies, the regulatory environment, and emerging business models. Second, they must hold frequent dialogs on possible future scenarios and their implications for the company’s innovation investments. Once innovation spaces are chosen, companies should also regularly revisit their strategies to make sure their choices remain appropriate. Companies ready to take the investment lead as opposed to reacting to competi-tive pressure can take three key actions.

Develop market intelligence. Explore market signals and separate trivial shifts from the truly disruptive ones. Regularly review this intelligence with senior management, actively discuss and debate lessons learned, and incorporate the implications.

Create scenarios for key trends and possible disrup-tions. Map the ways your business will likely develop, paying close attention to factors that will change quickly and those that will change only slowly. Understand how the different scenarios impact your business. In the sce-narios, include the evolution of critical technologies and the likelihood of business model disruptions.

Select innovation spaces. The combination of market intelligence and scenario analysis will yield a selection of innovation spaces. Invest in these based on R&D, capability-building initiatives, and business develop-ment bets. Conduct disciplined, ongoing reviews of these choices and allocations.

3. Discover: Actionable and differentiated insights fuel innovation

Great innovators interpret their existing context and imagine future ones. They use a combination of obser-vation, intuition, and inspiration to work within the chosen innovation space and frame the important problems to solve. It takes experience and skill to sys-tematically bring together areas of knowledge and uncover truly differentiated, actionable insights in order to understand the specific problems that are most worth solving. Organizations should create systems that facilitate debate about market contexts – current and future – and how to best derive their implications. The three distinct “lenses” through which to view the market context are: customer, technology, and business.

The customer lens uncovers preferences – those that can be described and those that can only be discovered through careful observation of behavior. Great insights come from deciphering why behaviors result in certain contexts. The technology lens assesses feasibility and often provides benefits that can create and sustain com-petitive advantage. Technology, broadly defined, is the enabler of almost all innovative products, services, pro-cesses, and business models. In the telecoms, media, and high-tech sectors, it can also be the end product, making it all the more a critical piece of innovation. Finally, the business lens examines the competitive context, prevail-ing economics, and positioning within the value chain.

11RECALL No 19 – Innovation and product development Innovation-led growth: Eight essentials

While each lens can provide powerful knowledge, it is the combination of all three elements (in some cases, supplemented with other considerations, such as an understanding of distribution) that leads to the problem statements on which companies can focus their resourc-es to create valuable solutions. Companies with a deep understanding of their relative market position and the profit flows within their industry can better make and assess innovation investments. Unearthing these game-changing insights happens in three steps.

Uncover the “why” behind customer purchase and usage behaviors. Tap into a range of qualitative evidence, such as in-context observations, ethnographic research, and quantitative surveys, to describe what motivates con-sumers to purchase certain products and services and to see how they use them. Examine existing and emerging technologies and focus on the benefits they can offer. Consider the business dynamics in and around your cat-egory and the market position within your category.

Synthesize information into insights and describe spe-cific problems to solve. Use teams with members from different disciplines to interpret the data and develop a concise list of the activities and outcomes that custom-ers hope to achieve. Assess the relative importance of their desires, wishes, and wants. Scan existing solu-tions, no matter how simplistic they may appear. Judge how well the current solutions address articulated and unarticulated customer preferences.

Propose new solutions. Any new value proposition should identify who the target customer is, what prob-lem is being solved, and how a company will make money over time, given the anticipated competition. World-class innovators employ systematic approaches to gain this unique depth of insight and then translate it into valuable new propositions.

4. Evolve: Innovation also applies to business models

Eighty percent of global chief strategy officers recently surveyed believe their business models are at risk. Among their biggest concerns are new entrants wield-ing disruptive technologies and process innovations. In dynamic markets, product innovation alone is insufficient. A strong innovation portfolio goes beyond products; it includes other forms of innovation, encom-passing new business models and distinctive business processes that can build competitive advantage. Of all

innovations, business model innovation is known to generate the most significant long-term value.

Consider business models that you can use to deliver value to priority groups of new customers. Do not get locked into a narrow conception of your business model – have the confidence to explore broader oppor-tunities. Pilot projects and experimentation will help in making smart decisions regarding where resources can be allocated most efficiently.

Selectively invest in a diversified set of initiatives to explore innovative business models. Establish focused, cross-functional teams charged with developing suc-cessful pilots into sizeable businesses. Set understand-able and widely accepted metrics to measure perfor-mance and learn from market experiences.

5. Balance: Adjust your innovation portfolio for value, time, and risk

Venture capitalists know the challenges of successfully managing an investment portfolio. They also under-stand that more active management of the innovation portfolio can increase the expected value of the pipeline by up to 20 percent, with only a marginal increase in overall risk. However, almost 60 percent of respondents to McKinsey’s 2010 Global Innovation Survey admitted that their companies are not good at selecting the right ideas and managing a portfolio. Yet establishing an innovation portfolio, managing it well, and combining this with commercial excellence can enable companies to realize impressive performance gains.

Successful innovators demonstrate a clear advantage in portfolio management. McKinsey research revealed that over 80 percent of successful innovators have a well-understood portfolio management process in place to evaluate and prioritize projects.

These companies begin by gaining transparency regarding what people are working on. They then rigor-ously assess the expected value, timing, and associated risk. Every company should be able to understand its innovation portfolio and determine whether or not it is in line with growth requirements and risk tolerance. Companies should also consider how their portfolio balances incremental versus breakthrough projects and recalibrate as appropriate. Some companies are content to merely gain transparency, but in McKinsey’s experience, this does not suffice. Most of the value from

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a rigorous portfolio management approach comes from getting the right people to the table – people with the appropriate level of experience and relevant decision making authority – to discuss the pipeline.

The right balance can be found in portfolios of varying composition. In addition to timing, value, and risk, the portfolio should also be assessed for its competitive dynamics, technology investment needs, and the bal-ance between core and non-core investment. A company must take care not to allow the core businesses to swal-low the non-core business. Far too often, innovation pipelines become overloaded with incremental projects (not breakthrough innovations) because decision mak-ers allocate resources to their own passions, unchecked by any kind of group discussion or control. Balancing for innovation entails three leadership actions.

Generate transparency in the innovation pipeline. Comb the enterprise to find out what people are doing. Then map the innovation pipeline into a portfolio matrix using proven metrics – the anticipated size of the opportunity, the associated risk, and the probability of success within a certain time frame. For projects close to the core, historic benchmarks may provide useful guidance. For breakthrough ideas or projects beyond the core, teams may need to rely on assumption-driven “what you have to believe” scenarios to judge the risk and feasibility of success.

Align the portfolio. A company’s innovation projects should be in sync with its financial objectives and busi-ness strategy. Ensure that the set of projects and the investment allocated to them reflect the organization’s belief about where the most significant growth opportu-nities lie. Management must be confident that the port-folio will deliver on financial performance targets.

Establish an assessment and debate routine. High-risk, high-return initiatives should be managed differently than incremental, low-risk projects. Management must have a routine in place to discuss and debate the portfolio – and a mechanism to aggressively weed out low- value, low-priority projects and then reallocate resources to opportunities that generate higher value.

6. Extend: Value lies beyond company walls

For decades, organizations relied on strong internal R&D or technology functions to deliver innovation pro-grams. Many were successful. But the increased pace

of technological advancement, a globalizing economy, and lower capital barriers have resulted in an environ-ment where a university student can come up with the next multibillion-dollar innovation. Companies that extend their reach beyond their organization’s walls to find innovation partners can get greater returns on their investments. Technology now allows access to the knowledge, skills, and abilities of broad – even global – networks of external partners.

For many companies, collaborating with external partners reduces costs and speeds up time to market. Successful innovators discover they can get multiples of every dollar invested in innovation by accessing the skill and talent of others. Most companies already have strong networks in place, but they do not readily consid-er them a source of innovation. Co-creation with busi-ness partners and crowd sourcing with customers and other stakeholders yield opportunities to extract more value from innovation investments. Taking full advan-tage of the creation potential outside your company can be accomplished in three steps.

Anchor the right mindset for extending innovation net-works. The organizational culture must be ready to wel-come ideas from beyond corporate walls, with no bias against innovations developed elsewhere (to counter the “not invented here” syndrome). Even if external tech-nologies or ideas may not appear useful to a business at first glance, these should not be dismissed too quickly.

Actively manage connections. Sourcing external cre-ativity requires tightly managed interfaces with the external innovation community, then the ability to translate the creativity that is out there into something that internal development teams will not only accept but also value. While developing formal and informal partnerships, processes and resources must be devoted to managing the flow of ideas from outside the company to ensure a steady pipeline of ideas.

Use strategic networks to source new ideas. In some industries, creating relationships with other types of networks – say, universities, think tanks, and research institutes – is an effective way to bring in different perspectives and additional insights. But don’t just ask outside parties for new ideas. Use these sources to solve existing problems. Be cautious about the stage of devel-opment at which you seek an outside solution, and make sure there is a mechanism that matches what is external with the appropriate resources inside the organization.

13RECALL No 19 – Innovation and product development Innovation-led growth: Eight essentials

7. Mobilize: Organize and inspire a culture of innovation

Successful and sustainable innovation requires high levels of energy and commitment. Executives play a critical role in promoting the right culture and environ-ment to stimulate and support the sometimes long and tedious work required to make innovation successful. In fact, committed leadership is the greatest predictor of innovation success. When innovation at scale has proven extremely successful, 60 percent of senior exec-utives said they were either fully accountable or actively involved from the early stages, according to McKinsey’s 2010 Global Innovation Survey. When innovation proj-ects fell short of objectives, only 35 percent of leadership was fully accountable or actively involved early on.

In addition to commitment from the top, organizations should design structures and routines to enable specific innovation activities. Celebrating individual success stories across the company is also a powerful lever in organizational inspiration. A few activities can help mobilize a company toward innovation.

Define clear roles and responsibilities to drive the inno-vation agenda. Every person in the company should understand his or her contribution in producing valu-able innovation. While not every employee is directly involved in creating a product or new business model, those who are need meaningful incentives and rewards. Management teams must ensure that key performance indicators and targets promote the right behavior among the relevant decision makers.

Build cross-functional teams to drive innovation. While it may be necessary to hire a few talented experts, look to enable optimal performance of your current talent by teaming up individuals with complementary skills and backgrounds. Establish separate teams and groups to push for innovation beyond the core business. Use a combination of virtual and collocated teams for differ-ent types of innovation and encourage collaboration. Review team structures regularly to ensure they are aligned with the current portfolio of innovations.

Do not overemphasize organizational structure. Organizational changes may be necessary, but these will not make up the entire solution. The organization design should promote collaboration and the develop-ment of insights, but these elements cannot stem solely from a structure. Talent management needs to place

the right people in the right positions and – even more importantly – surround these people with a support-ive culture, while employing systematic approaches to deliver better innovation performance.

8. Repeat: Processes and metrics can sustain the “rhythm” of innovation

The ability to change and innovate not periodically but perpetually is a company’s “renewal capability.” According to McKinsey’s Organizational Health Index, companies with a top-quartile “renewal” score are twice as likely to outperform their peers on margins, book value, and income growth. But is it possible to system-atize innovation so that it creates value again and again? This capability, as noted earlier, is critical to successful innovation. One breakthrough innovation may provide a short-term boost to the company, but it will not lead to sustainable growth. Innovation requires a substantial infrastructure, one that supports and fuels a constant flow of new ideas and approaches.

Allow the innovation objective (aspire) to propel the annual planning process. Too often, companies estab-lish their annual budget across business units without including innovation as a key initiative. Wiring in the innovation targets and resource needs as part of the annual process is critical for repeatability.

Establish a step-by-step process to capture and combine new insights (discover and extend). Ensure that the organization evaluates and refreshes its innovation pri-orities. Embed approaches to capture and nurture fresh ideas. Encourage cross-functional, collaborative team-work that transcends the boundaries of the company.

Anchor innovation portfolio reviews (choose, evolve, and balance) in the regular business review cadence. Establish unambiguous qualitative and quantitative metrics to track the performance of innovation through-out the portfolio. Be sure to include these metrics in quarterly business reviews. Utilize these reviews to adjust resource allocations based on how well innova-tion projects perform.

Ensure that the appropriate people are in the right posi-tions backed by adequate processes (mobilize). Reward fresh ideas with systematic, non-financial incentives. Recognition, performance contracts, and the ability to do meaningful work can all prove to be powerful moti-vators for innovation talent.

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Erik Roth is a Principal in McKinsey’s Shanghai office. [email protected]

Gordon Orr is a Director in McKinsey’s Shanghai office. [email protected]

Brian Greggis a Principal in McKinsey’s San Francisco office. [email protected]

Determining the extent to which an organization pos-sesses these eight essentials is an important starting point for improving innovation performance. Do not expect (or even attempt) to perfect all eight at once; innovation excellence must be built over time, begin-ning with a strong foundation, then improved upon continually. Organizations that eventually master these eight essentials will be well positioned to consistently outperform their peers by achieving innovation at scale. Those that do not will find themselves playing a game of chance with their growth agendas.

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Smartphones have revolutionized the way consumers stay connected while on the go. Now, new technologies such as biometric sensors and traffic management are making smart devices even smarter.

Cellular technology allowed users to remain in voice contact with family, friends, and colleagues, but the 21st century brought the proliferation of unparalleled connectivity. Mobile devices now have advanced oper-ating systems that harness the combined power of the Internet, global positioning systems, gyroscopes, and image sensors, giving users (among other things) imme-diate access to a vast array of Internet-enabled tools from mobile banking and navigation to telemedicine and video on demand.

Now, new trends in the smart device landscape are laying the foundation for the next generation of these devices. Advances in technology coupled with changes in consumer behavior are bringing radical shifts to ser-vice and business models, while dramatically changing the handheld devices themselves. Innovations in smart devices will come from an understanding of the under-lying core technology and marrying this with appropri-ate business models.

Service model succession

A major game changer in the smart devices world has been the advent of the personal cloud. Cloud services are driving rapid innovation in a variety of service mod-els. One player in particular is leading the way. Apple announced its iCloud in June of 2011. This development was the response to some very specific user pain points.

First, almost as quickly as users adopted the new tech-nology, they became the owners of multiple smart devic-es, and many were frustrated by the fact that their data was spread across laptop, tablet, smartphone, and PC. They couldn’t access music downloaded on an iPhone from their iPad, and they couldn’t view a video stored on an iPad with their iPod. Second, regular updates keep Apple devices relatively bug-free, but on-the-go updat-ing hadn’t been an option for users. Having to manu-ally connect in order to update meant that users were a step behind until they were able to physically link their devices to a desktop or laptop. The creation of iCloud services enhanced user convenience by automatically synchronizing data across all devices and installing operating system updates. An added benefit has been that users have access to greater storage capacity – beyond the limits of their on-device gigabytes.

A third driver behind device integration came from the company. iCloud services would allow Apple to link user preferences across platforms. Beyond device synchro-nization, Apple is showing evidence of moving toward even greater cloud-based services. Some recent infra-structure investments indicate plans in two major areas. Their recent purchase of 12 petabytes storage from Isilon positions Apple to offer video and audio streaming. Beyond this, the acquisition of Teradata servers gives Apple unprecedented customer analytics capacity.

While at the forefront of innovation, Apple is hardly the sole player in the cloud game. Microsoft is developing a cloud-based operating system model that would make its Windows platform suite of applications even more pervasive. Amazon is looking to reinvent its sales model

02 IQ innovations: The future of smart

RECALL No 19 – Innovation and product development IQ innovations: The future of smart

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01 Future growth in tablets will stem more from B2B in the coming years

with the introduction of Amazon Cloud Drive, offering tailored pricing. Google is also seeking to drive adver-tising revenue by establishing an even larger user base through low-cost cloud services.

Making greater use of the cloud has widespread implica-tions, affecting everyone in every aspect of the game. Each player has much to gain but must also be mind-ful of several aspects. Carriers will need to determine how they will secure customer control points, while the concerns for device makers will be improving the cross-device user experience and a pricing strategy if ad-subsidized costs become the trend. Operating sys-tem players will need to devise a business-to-consumer cloud service strategy that can compete with Apple’s iCloud. The challenge for content and service providers will be securing their own content delivery channels.

B2B breakthroughs

Another area of smart devices with big changes in store is business models. The business-to-business market in particular will likely see major shifts thanks to tablet computing. Not only is the tablet market growing by leaps and bounds, but B2B’s share of this growth will be staggering (Exhibit 1). In fact, the B2B tablet market could be a USD 4 billion business by 2015.

Enterprise mobility – or applying smart device technol-ogy to business – fits into three broad categories:

� Mobile office represents the range of tablet-based applications with the largest number of current active users. Around 81.6 million professionals used on-the-go tools such as e-mail, managed Internet and intranet access, basic messaging, and dispatch functions in 2009, and that number is expected to increase to 129.4 million by 2013.

� Front office is the set of applications used mainly by a business’s field workers or sales force. These appli-cations enable remote inventory management and access to customer information. Around 29.5 mil-lion workers used these in 2009. By 2013, this figure is expected to grow to 45.4 million.

� Database integration defines the set of customized, highly specific vertical applications that offer con-stant synchronization between field and office. This has been and will likely continue to be the smallest share of users (15.5 million in 2009 and 21.2 million in 2013), largely due to its specialized nature.

A wide range of businesses is making greater use of mobile enterprise applications in these categories.

Future growth in tablets will stem more from B2B in the coming years

SOURCE: Strategic Analytics; IDC; Gartner; McKinsey

2010 2015

B2B

B2C

USD 5 billion USD 16 billion100% = CAGR

+50%

+20%

90

73

10

27

US tablet market by user typePercent

19RECALL No 19 – Innovation and product development IQ innovations: The future of smart

In the insurance industry, roving, field-based claims adjusters are a prime example of how smart devices lower costs and boost efficiency. Traditional tools for claims adjusters include an e-mail-enabled phone, a laptop computer, and a camera. Combined, this can cost the insurance company over USD 800 each year per adjuster. With smart devices, consolidation is the key. One device not only does the job better (e.g., with improved photo processing, faster booting, and longer battery life), it does so at only half the annual operating costs – and significantly lightens the adjuster toolkit.

Another example of the role smart devices play in the workplace comes from the healthcare industry. In medical settings, tablets – particularly iPads – are used to enhance patient care. First, many physicians now carry iPads as their primary device. Instant access to electronic patient records, test results, and charts means much more efficient care delivery. Second, the tablet is a convenient “port of entry” to the hospital’s Web-enabled medical resources, making for a valuable “desk reference” even when a desk is nowhere in sight. Finally, tablets enhance the physician-patient relation-ship. They are becoming a part of the conversation in ways that more actively involve the patient in his or her own care. Using electronic health records demystifies clinical matters, and patient messaging applications are facilitating the interaction between physician and patient, while breaking down some of the barriers that existed in the past.

Ultimately, for smart devices to be successful in the workplace, several stakeholders will need to act. Carriers, for instance, will have to broaden their foot-print and move from their traditional roles as band-width providers into the realm of offering end-to-end solutions. Operating system players have the opportu-nity to get in the game as well. While Apple is currently in the pole position, Windows 8 has the potential to become a viable alternative, since CIOs prefer to run PC applications for mobile and remote/virtual desktops. Finally, the necessity of confidentiality on the consumer side and data protection on the business side both mean that the entire smart device ecosystem will need to work together to tighten security.

Smart device developments

From macro to micro, the next set of developments will have a direct impact on the features and capabilities of smart devices themselves:

New form factors. Today, smart devices sport the logos of many brands, but there is little variation in their physicality. From phones to tablets, smart devices are rectangular gadgets of similar width that users hold in their hands. This predictability, however, could soon change. First, advanced materials (e.g., nanomaterials) will make for lighter, thinner, more durable, and more flexible devices. Second, developments in user inter-face and experience (UIX) models will lead to devices that recognize gestures, sense pressure, determine the immediate context, and even track the user’s retina. Next is the convergence of operating systems. The look and functionality of the Mac App Store and the iOS App Store are increasingly similar, and the tiled layout format (e.g., Metro UI) for which Windows has become known will be consistent from PC to tablet to phone. Finally, the chasm separating chipsets in computers from those in smart devices is soon to be bridged. Intel will be launching its new Medfield line of x86 proces-sors, targeting the smartphone market, and ARM is projected to capture 20 to 25 percent of the notebook market by 2015 according to iSuppli.

Combined, these innovations will open new doors to the ways users engage with their devices. More flexible form factors will enable seamless switching between all devic-es. This synergy may also give rise to an entirely new device: a phone-tablet-PC hybrid could join the tradi-tional devices by 2015. All in all, as smart devices morph in form and function and blur the boundaries between phones, tablets, and PCs, the competitive landscape will evolve accordingly. Mobile device manufacturers and PC OEMs might find themselves vying for the same custom-ers as they begin producing similar hybrid devices.

Personal data capture. With the rise of online shop-ping, social networking, and Internet search, unprec-edented amounts of personal data are being generated. Estimates show a meteoric increase in the amount of data from 1.2 zettabytes in 2010 to 7.9 in 2015. Every query, Tweet, and purchase contributes to the sea of consumer data. Alone, this would not be much more than a mass of unstructured data points. However, major investments in analytics capabilities will create order out of the growing data chaos. Apple, Facebook, Google, and Amazon are all investing in technologies that will allow them to track and analyze everything from user browsing activity to offline personal data.

The personal data explosion will not just be one of vol-ume. The types of personal data captured will also grow

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Shekhar Varanasiis an Associate Principal in McKinsey’s Chicago office. [email protected]

Richard Leeis a Principal in McKinsey’s Seoul office. [email protected]

Venkat Atluri is a Principal in McKinsey’s Chicago office. [email protected]

Umit Cakmak is an Engagement Manager in McKinsey’s Chicago office. [email protected]

as smart devices themselves become able to sense and record user information. Capturing ambient factors like altitude and temperature and biological factors such as pulse will paint an even more detailed user picture. Beyond the “what are they doing?” industry players will soon have an understanding of “who are these users?” This increase in data type, volume, and usability has the potential to disrupt a host of industries.

Advertising is but one area that will see a dramatic shift thanks to real-time, location-based promotions. In 2010, mobile advertising captured only a very small piece of the pie: about 1 percent of the USD 407 billion in revenues. By 2015, advertising revenue is projected to reach USD 554 billion – and as a channel, the share of mobile advertising is expected to skyrocket, increasing exponentially. As is the case for other industries, media players can provide a personalized gaming experience, healthcare providers can monitor vital signs to keep abreast of patient needs, and retailers can optimize product location and store layout.

Soft SIM and radio technologies. The final device-spe-cific disruptor would release users from a set of restric-tions that have defined smart device usage since their inception. New technologies will sever the tethers that have traditionally bound devices to specific infrastruc-

tures. Soft SIMs will allow users to toggle between dif-ferent carriers’ networks, and software-defined radio will enable users to switch between bands dynamically. Network operators can pursue several new business opportunities. Increased network capacity, for example, is creating a twofold trade opportunity: auction and bro-kerage. Carriers can trade spectrum real time as needed (e.g., from high-capacity to congested networks), and third parties can act as clearing houses, buying and sell-ing spectrum from and to network operators.

While the opportunities embedded within these innova-tions are significant, it will take serious consideration on the part of all players in the smart device ecosystem to fully realize the potential. All of the technology advances discussed here shift the balance of power, giving users more freedom and flexibility than they ever had before. This means that control points that operators have over their customers will become an increasingly insufficient monetizing strategy. Distribution, materials sourcing, consistent customer experience, and content delivery are strategies that carriers, device makers, OS players, and content and service providers will need to carefully consider in the new world of smart devices.

23

03

In many industries, innovation is the decisive differen-tiating factor that distinguishes winning players. Still, innovating consistently over time remains a challenge. Cross-functional governance, strategic alignment, and evaluation and selection can help organizations manage their innovation portfolios, taking breakthrough devel-opments from the serendipitous to the sustainable.

Innovation is a core element on most CEO agendas. Leaders instinctively recognize its demonstrated ability to deliver profitable growth. In fact, carefully managing an organization’s portfolio of innovations can prove to be one of the most effective tools a CEO has to drive stra-tegic change and generate superior company value. This is why Fortune 500 “growth giants” dedicate billions of dollars each year to research and development.

Innovation portfolio management focuses on the target-ed deployment of innovation resources. As McKinsey research into the performance of over 1,500 companies from 1990 to 2005 shows: players that reallocate invest-ments more actively achieve a 2.5 percent higher CAGR in total return to shareholders. In parallel, the survival rate of these active reallocators is 13 percentage points higher than of those who reallocate less (76 percent ver-sus 63 percent over a 15-year period).

Thus, the benefits of taking a structured approach to managing an innovation portfolio can be considerable. Leaders get the most out of their innovation-focused investments. A well-managed portfolio of innovations helps to support the company’s strategic objectives. The company is able to assess and manage portfolio risk levels. Plus, such an approach typically facilitates more

effective communications with investors. By adopting good portfolio management practices, one company cut 15 percent of its R&D spend and 40 percent of proj-ects without affecting its competitive position. Another shifted 20 percent of its R&D spend away from low- value, incremental innovations to higher-growth areas.

But managing an innovation portfolio well on a consis-tent basis can pose a challenge – even for companies with strong track records. In a recent McKinsey survey with over 700 senior executives, 70 percent stated that their company lacks a strong portfolio approach.

Managers often misunderstand what innovation portfolio management is all about, confusing it with execution-focused tools such as stage gating or technol-ogy road mapping. Instead, it involves actively shaping the overall allocation of innovation resources to support the company’s innovation strategy. Innovation portfolio management essentially connects the “what” of innova-tion with the “how” of execution to capture economic value, manage risk, and make sure the portfolio aligns with the company’s overall strategy. Operationally, innovation portfolio management is a question of gover-nance, strategic leadership, and decision making.

Companies struggling with portfolio management tend to stumble into some common pitfalls. In governance, they might delegate portfolio-related decisions exclu-sively to the R&D organization or fail to review projects across business units. Strategy missteps might be neglecting to align financial aspirations with the portfo-lio value or investing to play, but not to win. Evaluation pitfalls could include “not speaking a common lan-

More for the money: Managing the innovation portfolio

RECALL No 19 – Innovation and product development More for the money: Managing the innovation portfolio

24

guage” or using overly simplistic metrics. Some might rely too much on net present value (NPV) analysis or easily measurable return-on-investment calculations. Others might overlook important factors or fail to assign option values to potential breakthrough innovations. The problems that can arise are considerable. The re-sulting portfolio might be incoherent, comprising small, fragmented programs. R&D focus could be misaligned with strategy. Innovation efforts could even fail to gain real support from the business units.

Leaders might also find their investments out of sync with opportunities – underfunding high-growth areas and overinvesting in low-growth ones. They might even be pouring too much money into new areas without fully understanding the associated risks and opportunities. The bottom line: companies reap inadequate returns on their innovation investments – and investors remain unconvinced of the company’s innovation story.

Although difficult, successful innovation portfolio management is within the grasp of most companies. One CEO of an electronics giant overcame business unit silos, little coordination within the R&D organiza-tion, and a technology-driven mindset by introducing new governance processes. In another case, a specialty chemicals player reopened the floodgates on its long-term R&D pipeline by eliminating “bad” projects and identifying new candidates using a dynamic new ide-ation process. Faced with trouble finding game-chang-ing innovations, another large conglomerate overcame the challenge by redirecting top management attention toward the problem and funding a number of strategic disruptions within the organization. Each success story relied on one of three key concepts that drive successful portfolio management: cross-functional governance, strategic alignment, and evaluation and selection.

Cross-functional governance

McKinsey has identified the five elements of effective cross-functional governance:

� CEO, CTO, and business unit leaders commit the time needed and demonstrate their willingness to reach tough decisions on innovation portfolio issues.

� The organization contributes fact-based, cross-func-tional input to decision making processes involving R&D, business units, finance, and engineering.

� The company structures innovation portfolio man-agement into recurring cycles with specified mile-stones, consistent and transparent methods, and a limited number of agreed selection criteria.

� Leadership ties innovation portfolio management cycles to the organization’s normal budgeting and financial control cycles.

� The entire organization employs a cascaded approach to innovation management that is handled separately at the corporate, business unit, and product category levels. The objective is to optimize results across business units and categories, while managing the details at more granular levels.

A multinational automaker provides a compelling example of how good governance can jump-start a stall-ing innovation strategy. This company’s growth aspira-tions suggested that R&D investments were needed far beyond the budget available. Corporate leadership chal-lenged the notion that insufficient funding was available and thoroughly examined the innovation project busi-ness plans. They then set stretch cost targets based on past best practices and staffed empowered, cross-func-tional teams with members from engineering, finance, and controlling along with product line managers. This new governance approach ensured that the organization was aligned behind key strategic projects, while reduc-ing expected lifetime development costs by over 30 per-cent on a major new product platform.

Strategic alignment

Companies need to take specific actions to align innova-tion spending with overall organizational strategy and objectives. They should set expectations for new growth from innovation, determine the overall innovation spending needed to meet the growth objectives, and then size the investments by category (e.g., game chang-ers, new markets), geography, time horizon (e.g., short, medium, or long term), etc. Finally, successful compa-nies set spending limits to protect priority initiatives.

A major specialty chemical company was unable to meet its five- and ten-year growth targets because its long-term innovation pipeline was not producing the right products. Company leaders decided to rebalance the organization’s R&D portfolio, examining short-, medium-, and long-term projects and assessing them based on project NPV, risk, strategic alignment, market

25RECALL No 19 – Innovation and product development More for the money: Managing the innovation portfolio

attractiveness, competitive positioning, and likelihood of success. They introduced new idea generation pro-cesses to reinvigorate the R&D portfolio. Killing short-term projects with poor prospects – accounting for 20 percent of portfolio spending – freed up the cash and resources needed to pursue longer-term opportunities. As a result, the company was able to fill its long-term pipeline with strong new projects with a value exceed-ing USD 400 million, creating new organizational structures, metrics, and capabilities in the process, while improving its overall portfolio NPV by roughly 50 percent.

Evaluation and selection

Business leaders need effective ways to screen, rank, and optimize R&D opportunities. Effective screening ensures that projects fully align with corporate strategy, while providing a way to objectively evaluate the relative attractiveness of competing projects. Companies then prioritize projects to generate the most value possible, and finally, optimize the portfolio by introducing a sys-tem of checks and balances that eliminate ineffective efforts and identify blind spots.

One manufacturer wanted to increase the returns its projects generated. To this end, company leaders devel-oped a systematic approach to evaluating projects by creating an objective risk grid to test each project’s fun-

damental economics and market attractiveness. They quickly killed projects with economic issues, then used those resources for the remaining portfolio to increase commercialization rates and pursue new opportunities.

Another example: a telecoms company was dissatis-fied with its existing (capital) investment allocation process. Annual bottom-up selection of approximately 1,000 proposed projects made it very time-consuming. Coupled with this, R&D leaders would forecast budget overruns on existing projects halfway through the fiscal year along with projects added to the scope even after the “freeze.” This forced R&D and business leaders to review all projects again in order to reduce spend by cut-ting back scope, postponing projects to the next fiscal year, or even cancelling projects altogether. The nega-tive side effects: postponement costs (stop/start) and sinking employee morale.

The telecoms company changed its innovation selection process dramatically. It began following a top-down approach. Parallel to the business plan cycle, the overall innovation budget (excluding a contingency) was first allocated to 20 to 30 strategic topics before being broken down to a project level (see table above). This forced both R&D and business leaders to make inevitable stra-tegic trade-offs early in the process rather than at the end. The company also required any budget overruns to be corrected within the business topic grouping. Finally,

One telco selected 20 to 30 topics for top-down budget allocation

Fixed Mobile

TV Triple/quadruple play Lean supply chain Customer applications Consumer market drivenLean supply chain

Very high speed Internet Wholesale proposition Specific propositions Business market drivenFixed/mobile integration

IPv6 Mobile network upgrades (for data) Network driven

Fiber

Quality Electronic billing CRM systems Efficiency and quality driven

Licenses Testing/QA Innovation-driven network upgrades

Compliance Continuity and regu-latory driven

26

the organization performed checks of its company-wide R&D portfolio using various “lenses” to correct unin-tended imbalances of technical/commercial risk, time to market, or scarce resources.

Innovation’s link to profitable growth is undeniable, but finding success in innovation portfolio management remains a significant challenge. Companies interested in either creating or reviving an innovation portfolio management system can take a number of important actions to ensure success in terms of economic returns, strategic alignment, risk management, and investor communication. Establishing cross-functional gover-nance, ensuring strategic alignment, and developing a system of project evaluation and selection can help lead-ers produce the innovations they need in time and on a consistent and sustainable basis.

Christopher Johnsonis an Engagement Manager in McKinsey’s Philadelphia office. [email protected]

Marc de Jongis a Principal in McKinsey’s Amsterdam office. [email protected]

Hender Grievinkis an Engagement Manager in McKinsey’s Amsterdam office. [email protected]

Vanessa Chanis a Principal in McKinsey’s Philadelphia office. [email protected]

29RECALL No 19 – Innovation and product development Design to value: Consumer-driven cost control

other factors. Infrastructure operators want to mini-mize their initial deployment costs, but they are equally concerned about the need to maintain and upgrade their networks as demand evolves. Even consumers with lit-tle money to spend on a mobile handset want to be sure they will be able to access the same services enjoyed by their more affluent friends and relatives.

In this context, the most successful companies are mov-ing away from the idea of blanket cost reduction to a new approach that focuses on identifying the product attributes that customers value most, then delivering these at a cost that allows for competitive pricing while keeping margins intact. McKinsey calls this “design to value.” With it, telecoms equipment makers have deliv-ered gross margin improvements from 10 to 15 percent over a typical 18- to 24-month period. Along the way, they were able to exploit rapid savings, making such improvement projects self-funding. At the end of the process, they have stronger product development func-tions as well, with departments working together more effectively and with greater momentum in the organiza-tion for broader product and portfolio improvements.

Understanding what customers value

Design to value begins with a deeper understand-ing of exactly which product features customers want and what they are prepared to pay for them. For all but the very simplest products, purchasing decisions involve complex and subtle trade-offs between dif-ferent features. Customers can rarely articulate the value they attribute to a particular feature in isolation. Fortunately, modern market research techniques can

Tight control over product cost is becoming increasingly critical for telecoms equipment makers. Smart deci-sions must be driven by a better understanding of what customers really value.

In many important telecoms markets, being able to make products at ever-lower cost is crucial. Manufac-turers face the challenge of minimizing complexity while delivering powerful and multifunctional prod-ucts. Base station equipment must be robust but afford-able for rural use in developing economies. Handsets need to satisfy the demands of tech-savvy youth while remaining inexpensive enough for this cash-strapped segment. The “functional but affordable” imperative is on a steep future trajectory. Some of the most significant growth opportunities in the sector will rely on the avail-ability of products that are even cheaper than they are today. Even at the higher end of the market, the entry of new low-cost players providing everything from smart-phones to switches is intensifying price competition. This trend is forcing all equipment makers to focus on reducing the costs of manufacturing, selling, and sup-porting their products.

Opportunities to reduce costs arise across the entire product life cycle. While sourcing, manufacturing, and aftersales support are obvious components in a product’s lifecycle costs, these phases aren’t necessarily the most cost-intensive. Over 50 percent of a product’s lifecycle costs are determined before manufacturing even begins, during the concept and design phases (Exhibit 1).

The first two phases are also key for customer’s sense of value. Price is important to customers, but so are many

04 Design to value: Consumer-driven cost control

30

01 The largest share of product cost is determined early in its life cycle

SOURCE: McKinsey ILLUSTRATIVE

Costs impacted by product concept/design stages

SourcingManufacturing and supply chain

Aftersalessupport

Product concept Product design

Market insights Concept/indus-

trial design Target market Pricing

Features/specs definition

Detailed design

Vendor identi-fication

Negotiation and agreements

Manufacturing Supply chain

management

Customer support Product improve-

ment

4 5

Quality management6

Total

> 50

Aftersalessupport

Manufacturing and supply chain

SourcingProduct concept and design

Costs incurred (of total product lifecycle cost)Percent

1 2 3

The largest share of product cost is determined early in its life cycle

ter segment would actually place more value on a thick-er, more robust unit, even if it is cheaper to produce.

Cost-optimizing tools

Once they have built up a detailed, quantified under-standing of customer needs, equipment makers can identify opportunities to deliver on those needs at lower cost. Leading companies that have made design to value pivotal to their strategies make use of an array of tools to identify and exploit cost reduction opportunities.

Competitive teardowns involve dismantling competitor products side by side to identify cost reduction opportu-nities. Do competing products have simpler packaging? Have part counts been reduced and assembly simplified by replacing separate fasteners with molded snap fits? Teardowns are an opportunity for equipment makers to identify competitor cost-savings approaches and adapt them to their own needs as appropriate.

Platforming and modularization. Companies with complex product portfolios can frequently achieve significant savings in engineering, procurement, manu-facturing, and product support by reducing the number of components used across their product range based on platforming and modularization strategies. Building

provide a good indication of what the customer’s percep-tion of overall value comprises.

An established technique that gives companies a rich understanding of consumer needs is conjoint analysis: presenting customers with various hypothetical prod-uct configurations and price points, then asking them to choose between these. Regression techniques applied to their responses help isolate the effects of individual fea-tures on the customer’s perceived product value.

If a company understands the incremental cost of add-ing a particular feature to a product, it can use conjoint analysis results to understand not only the most impor-tant features for its customers, but also the most profit-able ones. Certain network infrastructure features like power management, for example, may prove valuable enough to add to the initial chassis design.

Similar analysis across different customer segments can also help companies plan their product portfolio: Which features should be included in all products? Which should be used to differentiate a premium offer-ing? Sometimes, distinct segments have markedly dif-ferent value perceptions. Some customers may want an ultraslim handset; others might tend to avoid such designs due to quality and durability concerns. The lat-

31RECALL No 19 – Innovation and product development Design to value: Consumer-driven cost control

multiple products for different user segments with the same basic architecture can dramatically cut costs and provide significant margin increases at the high end.

Successful modularization programs rely as much on strong governance as they do on smart engineering. Companies may rigorously measure adherence to an agreed parts list in new product development, for exam-ple, and require product teams to justify deviations from the list on a case-by-case basis.

A key part of platforming is component standardiza-tion, leading to higher purchased volumes for each component type. This typically yields cost reductions and quality improvements for every product that uses the components. The approach is not risk-free, however. If a quality issue or supply interruption does occur in a highly standardized environment, it may affect a large share of a company’s product offering. Knowing this, companies must ensure they identify strategically criti-cal component groups and focus their supplier quality assurance and risk management efforts on those.

Design for sourcing. Smarter use of external component suppliers is another area where companies can achieve significant cost reductions. Could one design-specific part be replaced with a standard one from a supplier’s portfolio? Could material specifications or surface treatment options be altered to better match supplier manufacturing capabilities? Such decisions are com-plex, requiring input from the purchasing, product design and engineering, and product management functions. They also require a detailed understanding of supplier capabilities and cost drivers. To make these decisions, the best companies engage with potential suppliers early on, before product specifications are finalized, and they hold regular cross-functional meet-ings to evaluate options.

“Clean sheet” costing. Finally, equipment makers can build detailed, bottom-up should-cost models for com-ponents and services. Using McKinsey’s proprietary tool, companies can effectively negotiate with suppliers and assess cost reduction opportunities on an ongoing basis.

Making optimization happen

Many companies start off with bold ambitions to reduce product costs dramatically, only to find that events – from fluctuations in material and component prices to last-minute requests for additional features – erode

their actual achievements. Avoiding this requires a dis-ciplined, cross-functional approach.

Some of the most successful companies establish cross-functional teams to ensure that their cost reduction efforts withstand external forces. These teams – typi-cally comprising representatives from the equipment makers’ engineering/design, sourcing, operations, and marketing functions – carry out three primary activities.

Target setting. Such a team sets cost targets for dif-ferent commodity groups. Ideally, these targets are established on a “clean sheet” basis by looking at the best practice achieved by competitors in their own and in other industries. The team then determines the gap to the company’s current performance.

Action plan design. The cross-functional team will then agree on action plans to achieve the required improve-ments in each commodity. Members meet regularly to ensure that the organization’s cost-optimizing activities are aligned with the plan.

Performance monitoring. Finally, the team is charged with assessing the actual improvements in cost perfor-mance and checking progress in this area against the targets. This assessment is carried out on a regular basis and for each of the commodity groups. Since external factors can change and progress issues may arise, the team revisits the action plan and revises it accordingly.

McKinsey’s work with equipment makers around the globe has demonstrated the undeniable power of the design-to-value approach for telecoms and other equip-ment segments, both in developed and in emerging markets. While many companies can navigate well in the familiar territory of their local markets, many of them struggle in China and other low-cost countries, where they face severe price competition with local players. The price difference is sometimes 40 to 50 percent between products with comparable levels of functionality.

A true understanding of what local customers value and how to adapt technical specifications to “local stan-dards” can deliver equipment makers with a global foot-print the winning hand in important growing markets. On the road to achieving this, design to value is not only a tool to control costs, but also a lever to open doors to new and exciting growth opportunities.

32

Abhijit Mahindroo is an Associate Principal in McKinsey’s Silicon Valley office. [email protected]

Tobias Strålin is a Principal in McKinsey’s Stockholm office. [email protected]

Dmitri Mishustin is a Principal in McKinsey’s Tokyo office. [email protected]

Aaron Aboagyeis a Principal in McKinsey’s New Jersey office. [email protected]

35

Companies already understand just how critical cus-tomer insight is to product success. What they often overlook, however, is how misguided, incomplete, or unheeded feedback can turn a technical innovation into a commercial catastrophe.

Many of today’s product companies have invested heavi-ly in the expertise, tools, and processes that allow them to create complex, high-performing designs that are easy to manufacture and which perform reliably, even under tough conditions. Usually, these achievements are completed remarkably quickly, as technologies evolve ever more rapidly and product life cycles shorten.

Too often, however, these brilliantly designed and engi-neered products have one significant flaw: they are not what customers want. Customers find the product too expensive or too complex, or the product itself lacks critical features or underperforms in important ways. Regardless of the specifics, the result of this mismatch between consumer desire and product innovation is always the same: the product fails commercially.

What is often perplexing to product companies is that they actually invested in consumer insight research before bringing the product to market. So if the needs and behaviors of customers were explored, why do these products fail? In all cases, problems arise not because the engineers and designers lack the appropriate skills, but because they are basing their design decisions on an incomplete or erroneous picture of customer needs.

McKinsey’s work with product development leaders has led to the identification of four common underlying

causes that create critical disconnects in the product development process. These are the “insight traps” that ultimately lead to commercial disappointment.

Targeting the wrong customers

It is exactly a company’s efforts to engage their custom-ers more closely that leads them into the first trap. The top 10 percent of “power” users are most likely to explore the limits of existing product designs and offer improve-ment ideas and feature requests for subsequent models. Unfortunately, these users may operate equipment in ways that bear little resemblance to the habits of most customers. This can result in products that are cost-prohibitive or too difficult to operate.

Engaged but unrepresentative user groups can take many forms. In the car industry, for example, motoring journalists, visitors to car shows, or track-day enthusi-asts might be high-profile proponents of certain aspects of vehicle design and styling, but their priorities could have little in common with the vast majority of everyday road-going users.

Similarly, some companies fall into the snare of design-ing products to suit the needs of their one or two largest clients, rather than those of the majority of customers. The pressure to do this is understandable: beyond the aspect of financial importance, companies usually spend more time talking to their top customers. But altering products to suit the requests of such a small minority can risk alienating the largest set of users and also divert development resources from improvements that might have wider appeal.

05 Insight traps: Missteps in consumer research that can make products worse

RECALL No 19 – Innovation and product development Insight traps: Missteps in consumer research that can make products worse

36

Clinical complexity: When more is less in medical product innovation

Sometimes, companies have a mistaken impression of who their real customers are. Two examples of how insight from the wrong target group can lead to lackluster sales come from the world of medical equipment manufacturers.

One company worked closely with a small num-ber of research hospitals when refining its design of an imaging machine. These users applied the machines to a wide variety of difficult tasks. Given the scope of usage, they wanted a high degree of control over the machine’s operation and data pro-cessing. When the company built devices to these specifications, they quickly learned that the appeal was not at all widespread. While the test group val-ued control, regular clinical users found the extra flexibility simply added unnecessary extra cost and made the machines harder to use. This complexity

was particularly problematic in their busy, high-pressure clinical environments where speed, sim-plicity, and reliability were much more important.

Another medical device company had focused its design efforts on the requirements of surgeons. When it observed operations and interviewed par-ticipants, however, it discovered that physician’s assistants and scrub nurses were also essential operating room team members. Plus, they needed to use this particular device during surgery. These two groups were quite influential in the hospital’s purchasing decisions, but their input wasn’t sought during the design phase. Unfortunately, their needs differed from those of surgeons in several impor-tant ways. The outcome: the final product ended up only satisfying the requirements of one-third of the operating room staff.

Companies can circumvent this trap by making sure that they engage with a truly representative customer sample as they build their understanding of user requirements. Achieving this is not difficult, but it does take a relentless push by management to ensure the tar-get customers are correctly identified. If a survey is used to gather product design information, for example, the company should be certain that it surveys a group that represents the overall market – including the customers of competitors, not just its current users.

The mistake of only targeting existing customers rather than the full range of potential customers is becoming increasingly important. In established markets, this approach risks missing out on crucial aspects of product design that may stop some users from making purchas-es. As markets expand, it may prevent companies from understanding that the requirements of some poten-tially very large user groups vastly differ from those of their established customer base.

Many Western companies have struggled to sell in high volumes in emerging markets like India and China, for example, where few customers can afford their prod-ucts. Some have overcome this issue by establishing

product development units inside emerging markets and staffing them with local employees, who can bring a deep knowledge of regional tastes and market require-ments. This approach has led to some radically differ-ent product designs, often sacrificing a relatively small amount of performance for dramatic cost reductions.

Asking the wrong questions

The second trap companies fall into as they develop the requirements for new products is asking customers what they want, rather than what they are willing to pay for. When people are asked open questions about their product requirements, they tend to ask for higher speci-fications than they currently enjoy or focus on nice-to-have features that aren’t really central to their purchase decisions or product use. Companies that build their specifications on the basis of such requests can end up with expensive, feature-laden products that customers find interesting but don’t actually want to pay extra for.

Companies can avoid this trap by making use of discrete choice modeling techniques in which customers are asked to compare different product configurations with different feature sets and to say how much they would

37RECALL No 19 – Innovation and product development Insight traps: Missteps in consumer research that can make products worse

be willing to pay for each. Such techniques allow compa-nies to understand exactly how much value customers place on specific features and compare that with the cost of implementing them. This knowledge allows them to position their products much more intelligently, find-ing sweet spots in the market where product margins are likely to be highest.

It isn’t only customer buying habits that are likely to differ from their claims in interviews. Real-world deci-sions about many other aspects of product use – from the foods we choose to eat to our adherence to mainte-nance schedules – are likely to differ markedly from what we hope we would do in ideal circumstances. To avoid the risk of designing products for customers’ ideal selves – rather than their actual selves – companies will need to ensure that they supplement interview data with information from other sources. Ethnographic research on the way products are used is helpful here, while data from field service and repair operations can reveal a great deal about the conditions products must endure when they are used under real-world circumstances.

Not acting on the available data

Even when they manage to collect rich data from appro-priate customer targets, many companies fail to give that valuable information enough importance when it comes to specifying future product design. Usually, this is because tradition, personal experience, or some other form of bias prevents decision makers from accepting the evidence that they should revise their approach.

Competitive product teardowns are good examples of this issue. Many companies carry out such teardowns, in which they compare the specifications and engineer-ing approaches used by rival products with their own. Often, however, existing product design teams run these exercises. As a result, they have a tendency to use the differences they identify as retrospective justifica-tion for their own design decisions, rather than as an opportunity to question them.

The first step in overcoming these forms of bias is sim-ply recognizing that they exist and ensuring that key assumptions are regularly questioned to be certain that the available data still supports them. An important second step is to introduce new perspectives into the discussion – by rotating design team members or bring-ing in personnel from other teams or business lines to conduct competitive teardowns and design reviews.

Failing to convert good insights into great products

The final trap that snags many companies is a failure to turn useful customer insights into real products. Sometimes, this results from a failure to translate cus-tomer requirements into clear product specifications. But just as often, we see engineering teams working with lists of specifications that they simply can’t deliver. Faced with the need to make trade-offs in order to man-ufacture a product at the required price, design teams may reach compromises that make sense to them but turn out to be far less appealing to customers.

Companies can sidestep this trap by building a better understanding of product design capabilities into the upstream concept definition phase. Some of the meth-ods described above can be used to accomplish this: discrete choice studies, for example, can yield a better understanding of what features customers consider ideal or reveal their price trade-offs. Bringing manu-facturing and sourcing specialists into teardowns can help teams decide whether the company has the internal capabilities or the external supply relationships to adopt alternative technologies or production processes.

What is also important is that development teams are transparent about the trade-offs they make during the design process. Engineers may make hundreds of such choices when developing a product, and few are subject to formal review by management. To avoid bogging down decision making in endless discussions, compa-nies can help their engineering teams by making their requirements clearer up front by, for instance, creating a rank order prioritization of proposed product features.

Manufacturing and sourcing expertise can bring tre-mendous value during the engineering process too, helping design teams ensure that they are not inadver-tently adding unnecessary cost or complexity. McKinsey has observed processes in which designs are taken to a high level of maturity before teams even review the cost implications of their decisions. One example of this was the use of expensive application-specific integrated cir-cuits in low-volume products, when a cheaper general-purpose chip could have done the same job.

All of these customer insight caveats are only useful if the product company’s culture and values support the development of products that meet consumer needs. Companies will have to ensure that their incentive

38

Dave Fedewa is a Principal in McKinsey’s Atlanta office. [email protected]

Asutosh Padhi is a Director in McKinsey’s Chicago office. [email protected]

Jim Williams is a Practice Manager in McKinsey’s Seattle office. [email protected]

systems aren’t fostering the wrong behaviors among their R&D personnel. Are employees incentivized for launching products on time and on budget, rather than for launching successful products? Or are they more likely to be rewarded for launching a weak product than abandoning it? Is a product’s success measured by sales revenue rather than profitability, encouraging teams to make expensive, feature-rich designs? In some cases, incentives are fragmented to such a degree that, while every individual is rewarded for the part they play in the product development effort, no one is truly motivated by the product’s ultimate success.

Companies sometimes find that their investment in design engineering and product innovation yields disappointing commercial returns. Such products are often doomed from the outset because they simply fall short of meeting customer needs – despite the com-pany’s commitment to consumer insights research. Organizational commitment to getting the right type of insights from the right consumer base and then turn-ing these insights into action can mean the difference between technical innovations that flop and products that consumers clamor for.

41

Emerging markets are characterized by more than just low-cost production. Economic growth is lifting mil-lions out of poverty and leading to a rise in consumer-ism. Will players in telecoms, media, and high tech be prepared to meet the specific demands of a growing middle class around the globe?

By now, most companies have heard the siren’s song of emerging market growth. Still, today’s shifting global economy may result at a scale and with implications that could indeed be more dramatic than most believe. For instance, predictions that emerging markets will collectively add more growth to the world economy over the next decade than all mature-market countries com-bined suggest that such countries could be an impor-tant component in multinational corporation (MNC) strategy. This is the first time such significance has been achieved since the industrial revolution, when the United States was itself an emerging market. Thus, hav-ing a plan to address new customers in today’s emerging markets seems more like an imperative.

China has headlined the growth story, racing from being an economic afterthought twenty years ago to its cur-rent position as the world’s second-largest economy. It has accomplished this, not merely as a manufacturer of low-cost goods, but by developing its own advanced industry base and making its way toward employing the largest population of R&D workers in the world. Companies still thinking that China only excels at man-ufacturing based on intellectual property from abroad should consider firms like Huawei. It applied for more patents than any other company in the world in 2010 – no US corporation was among the top 10 in applications.

This story, however, extends well beyond China, as countries throughout Asia, Latin America, Eastern Europe, the Middle East, and Africa play their roles in global economic rebalancing. The demographics of emerging-market demand are shifting: by 2020, 40 per-cent of the world’s population will have reached middle-class status – compared with less than 20 percent today. This means that real per capita income will double in emerging markets and unprecedented levels of new middle-class consumer demand will arise. In pursuit of sating the appetite for modern improvements arising from these new consumers, many companies are failing to recognize the essential distinguishing features of the demand they are attempting to satisfy.

The face of a new consumer

In emerging markets, there are a multitude of distinct customer groups with very different needs. These customers number in the hundreds of millions, but addressable market concentrations are distributed across many nations and scores of cultures and ethnici-ties. Geographic and societal differences are reflected in diverse consumer needs and wants. Emerging-market consumers are exhibiting extremely sophisticated and continuously evolving purchasing behaviors. They are less influenced by global brands and are no longer sat-isfied with “yester-tech” and products that have been discontinued in the mature markets. Consumer tastes and preferences in emerging markets will evolve just as rapidly – if not more so – as those of consumers in developed markets. They will demand products tailored to their needs and of the same quality as those found in more advanced economies, but at much lower price

06 A billion buyers: Product innovations for a new consumer class

RECALL No 19 – Innovation and product development A billion buyers: Product innovations for a new consumer class

42

01 Conducting R&D locally helps to achieve better local insights and to lower development costs

1 Respondents who answered “do not know” or “other” are not shown

SOURCE: 2011 McKinsey Global R&D Survey

Local innovation in emerging economiesn = 184

Global product platformsn = 211

Corporate objectives for R&D in emerging economies, by focusPercent of respondents1

Government incentives

Access to proprietary relation-ships and intellectual property

Proximity to local manufactur-ing and production

Access to larger talent pool

Better access to local con-sumer insights

Lower development costs

12

14

20

23

36

44

14

15

24

22

39

26

structures are radically reengineered. Such products are derived directly from a deep understanding of the particular needs and resources of projected end users. They span every consumer category from telecommuni-cations and high tech to durables and household goods, differing significantly from their “global” counterparts in qualitative aspects. Local, contextual insight into specific concentrations of emerging-market demand has thus become the engine that drives leading-edge innovation (Exhibit 1; see also text box).

Unilever serves as an example of such localized inno-vation success. This MNC entered emerging markets in a competitive market space with its Wheel brand laundry detergent. At first, the price points were too high: Wheel was priced 40 percent higher than the local competing product, Nirma. Unilever quickly identified the challenge and reduced the concentration of active ingredients in order to meet local requirements and the local price point. The company also innovated products to meet local out-of-pocket spending behaviors with small-sized packages. Following these initial experi-ences, Unilever significantly broadened its knowledge base for each product category.

In the area of medical devices, GE developed one of the first heavily market-tailored products by collaborating

points – as little as 30 percent of developed market prices. In this melting pot of opportunities and chal-lenges, local and global innovators will have to compete to identify the best solutions.

In the past few years, the primary competitors in most emerging-market segments transformed into local innovators. Given their understanding of local needs, they were able to gain market share with tailored prod-ucts, low price points, and broad customer reach.

By utilizing customization to meet user needs, local companies have proven to be inventive in creating new markets. Galanz, for example, decided to design and manufacture microwave ovens tailored to the domestic market. These have six different cooking programs for rice. Individual units were priced at USD 50, and the product targeted China’s newly emerging middle class – at a time when only 2 percent of Chinese households owned microwave ovens. Today, Galanz has become the world’s largest microwave oven manufacturer.

Successful product innovation

Hundreds of individual products – most of which are designed and produced within and for emerging mar-kets – are revealing a trend in which price and cost

Conducting R&D locally helps to achieve better local insights and to lower development costs

43RECALL No 19 – Innovation and product development A billion buyers: Product innovations for a new consumer class

price they can afford – and all of this at the right time and the right place. Innovations must be holistic solu-tions. Innovators need to master the overall value chain, choose the right infrastructure, and build capabilities and mindsets. In their rush to establish presence in emerging markets, even the best-performing global companies have not always considered what they needed to do to achieve sustainable success. On its many journeys with global clients, McKinsey has worked with top management to transcend conventional thinking and the static strategies responsible for early failures. In these relationships, McKinsey established numerous paths to emerging-market success.

Among the few constants of the innovation approach are granular local knowledge, substantive local input, and relentless top management commitment. Successful paths to innovation have overarching themes that can be summarized in four interconnected requirements.

Contextual insight. Clearly identify and frame the problem in context. Of particular importance is deter-mining who the consumer population is. A typical first step toward fulfilling this requirement is to granularly segment customers and compile in-context insights. McKinsey research has, for example, identified “12 Indias” and “6 Chinas,” each with distinctive local cus-tomer preferences and unmet needs. The contextual toolkit includes ethnographic studies, shop-alongs, competition scans, and in-context interviews. Some global companies have bypassed the granular analysis

with small Indian hospitals and with paramedics to design the MACi ECG device. Problem areas for the local market were the product’s dependence on electricity, its high price, its lack of durability, and poor usability for non-trained paramedics. The result: a MACi device that is battery-operated, portable, and capable of complet-ing 500 three-channel ECGs for every three hours of battery charge. At USD 500, the price is low compared with that of a “regular” ECG machine, typically costing USD 1,500. GE also innovated within the value chain, structuring financing through national banks to offer zero-interest loans. More importantly – after being suc-cessfully introduced in emerging markets – this innova-tive product was successfully launched to create a new market in developed countries.

Given the mismatch between price points and features and local needs, standardized products frequently fail to address the requirements of diverse emerging-mar-ket populations. For mature-market leaders, the reduc-tion of product cost structures by 50 percent (or more) is the key to reaching and meeting the massive new emerging-market demand. This requires breakthrough innovation – experience suggests that 30 percent is the upper limit for “cost-out” potential in existing designs.

Meeting market demand

Only groundbreaking innovation can fulfill the major-ity of emerging-market aspirations, providing new and savvy consumers with the solutions they want at a

Tailored telecoms: Indian insights and innovation

Nokia looked to India as an emerging-market labo-ratory. As the first multinational company to enter the consumer electronics market, Nokia invested heavily, establishing R&D facilities and a design studio in Bangalore and developing the first mobile phone with menus in Hindi in 2000. The team researched the needs of the rural population. The results were eye-opening.

While language is consistently a region-specific differentiator, other segment needs are often less obvious. Nokia’s research revealed the pervasive-

ness of unreliable electricity in many rural areas in India. This led to developing new features – includ-ing longer battery life and a one-touch flashlight function – all delivered at a cost of not much more than USD 10. Nokia also found out that users con-sider agricultural information very important to better equip them to negotiate with agents, but are constrained by access distance and cost. Armed with this insight, Nokia invested in services that provided agricultural market price information and weather forecasts – plus cricket match results and other local, entertainment-related information.

44

supplier partnerships can be initiated and developed. A go-to-market strategy requires innovative approaches to effectively reach fragmented distribution and remote areas. An example of such an innovative approach is the thousands of micro-entrepreneurs in India deployed so effectively by Coca-Cola and Unilever.

Organizational setup, capabilities, and mindset. Global companies are learning through experience that success demands considerable knowledge and investment – and an intense focus on emerging-market innovation. In China, for example, 1,000 multinational companies already have operating R&D centers. Manufacturing can often involve non-standard supply chains, and delivery can require assembling complex, localized dis-tribution networks. Some global leaders have hesitated to make the required investments, however, and have done so for understandable, if short-sighted, reasons.

Experience has shown that preexisting mature-market innovation organizations are inadequate for meeting the challenge. When entering emerging markets, key talent needs to be hired or trained – often within a very short time frame. New organizations must retain local top talent using a tailored model to be attractive to the local population. In India, for example, this means fast promotion cycles and a hierarchy that works in the con-text of the local culture. New structures must encourage technical and commercial functions to work together using cross-functional task teams. To effectively mobi-lize the local team, the company needs to understand and adapt to local mindsets, rather than transplanting its own mindset to the new geography.

A burgeoning global middle class is putting disposable income in the pockets of hundreds of millions of con-sumers for the very first time. Their needs, however, are just as varied as the geographies in which they live. Companies who want to take full advantage of these new emerging-market segments will abandon the one-size-fits-all mindset. The successful and sustainable approach to product innovation in these markets will consider a host of local realities such as language and culture, economics and price points, and environmental landscape and infrastructure.

that would reveal this differentiation and deployed strategies focused on introducing preexisting products to emerging markets as fast as possible. The lessons they have learned by taking such static approaches have proven costly, e.g., missing price points, failing to provide local features. In contrast, low-cost solutions that use copycat design (known as “shanzai” in China) have proven to be successful on many occasions. This is especially true if improved features and extensions have been included. The success of shanzai mobile phones – with their improved texting, dual SIM cards, and other advanced features that meet local customer needs – demonstrates that companies should consider copycat design solutions, despite the fact that these phones are often dismissed as brand name knockoffs. Holistic solutions. Use technical and commercial insights to build in profit for all stakeholders. Holistic concepts address the entire local value chain with durable and complete stakeholder-focused solutions. The overall objective of achieving extreme cost targets involves active collaboration and support in concept development from value chain partners. Product tear-downs yield key insights, robust cost benchmarks pro-vide a basis for accurate cost targets, and “should-cost” models accelerate solution development. To account for limited technology reach to emerging-market consum-ers, visual quantitative surveys and in-depth respondent orientation can replace traditional conjoint analyses.

McKinsey has observed that holistic solutions can arise from frugal local engineering, especially in financially disadvantaged emerging markets. Behind this “do-it-yourself” phenomenon is urgent consumer demand that remains otherwise unsatisfied. Dozens of small companies in China, for example, are producing electric cars at a cost of USD 2,500 to 5,000. These cars travel at slow speeds (around 50 km/h) and have limited range (100 km), but they are a dramatic step up from bicycles and they meet the needs of a large consumer base.

End-to-end systems. Sustainable performance requires an end-to-end system that covers the supply chain, the manufacturing footprint, and the go-to-market strat-egy. Key questions regarding the manufacturing foot-print are the extent to which manufacturing should be outsourced to local partners and how sustainable

45RECALL No 19 – Innovation and product development A billion buyers: Product innovations for a new consumer class

Karin Löffler is a Practice Specialist in McKinsey’s Munich office. [email protected]

Derrick Kikeris an Associate Principal in McKinsey’s Chicago office. [email protected]

47

Strategy and portfolio management are important fac-tors in research and development, but nothing shows as high a correlation with performance as the management of talent harbored within R&D teams.

Of the USD 1.2 trillion spent globally each year on R&D across corporations and academia, 40 percent – by far the largest component – pays for people. To discover what drives research productivity in labs, McKinsey recently conducted a study entitled SuccessLab to interview and survey world-class researchers. The pool of respondents comprised 4,500 researchers in 260 laboratories in academia and a range of research-based industries such as automotive, basic materials, high tech, and pharmaceuticals. The outcome was that – regardless of specialty or industry – the best R&D labs share behavioral patterns across at least six key prac-tices: talent management, strategies and roles, collabo-ration, problem solving, portfolio and project manage-ment, and business and market alignment.

Subsequent analysis then revealed which of these fac-tors had the greatest bearing on lab success. More than anything else, talent management is what the best R&D operations consistently get right. While all six practices correlate clearly with high performance, the talent fac-tor is the most important driver behind a lab’s produc-tivity. The talent management practice also shows the highest opportunity for improvement, making this a tremendously powerful lever to boost R&D productiv-ity, regardless of current levels (Exhibit 1).

Top-quartile academic labs are five times more produc-tive than bottom-quartile ones. Similar differences

exist among industrial labs. Yet many research institu-tions don’t understand how well they are doing because the people who work there wildly overestimate their own performance. The same McKinsey study revealed that 12 percent of respondents consider their own lab among the top 1 percent in R&D productivity, and 70 percent believe their lab to be in the top 25 percent. Most researchers don’t know how productive great labs are or how they become great. In fact, most labs can assess how well they do only by basic output measures. A halo effect further distorts perceptions: researchers who think that their lab performs well assume that its talent management practices are also strong.

The elements of talent management

Talent management isn’t simply about hiring the best people; not everyone can. It’s about managing talent appropriately based on selection, recruitment, develop-ment, and rewards. Just about any lab can do this, yet many don’t. SuccessLab looked at each of these areas, and while all are correlated with performance, some matter more than others (Exhibit 2).

Recruiting for potential. Managing talent starts with recruiting the right team members. In response to one SuccessLab question, the head of one top-ranked aca-demic lab explained that “the most important intrin-sic [quality] we look for is scientific curiosity.” Great labs such as this one evaluate researcher potential by appraising their basic intellectual ability, general prob-lem solving skills, and enthusiasm. They also test for cultural fit, an important factor supporting collabora-tion, which in turn drives productivity. Candidates may

07 Managing talent: How world-class R&D organizations do it

RECALL No 19 – Innovation and product development Managing talent: How world-class R&D organizations do it

48

01 Talent management is the area where labs have the greatest potential to improve

1 Defined as percentage of respondents within a lab who neither agree nor strongly agree that their lab is in line with the desired practice2 “Alignment with the needs of the business and the market” was excluded in this analysis because of insufficient data

SOURCE: McKinsey

Improvement potential1Percent of respondents

0.55 0.60 0.65 0.70 0.75 0.80

75

70

65

60

55

Correlation of practice2 with high performance r value (0 = no correlation, 1 = high positive correlation)

Effective problem solving approach

Effective project and portfolio management

Environment that promotes collaboration

Talent man-agement

Clear strate-gies and roles

spend an afternoon devising answers to a specific ques-tion or working in the lab together with the team. This approach helps labs assess a candidate’s social skills and compatibility as well. Before reaching a decision, the best labs also solicit the perspectives of team members regarding each candidate.

Average labs typically place specific technical profi-ciencies – say, the ability to use a piece of equipment or to run certain tests – at the top of their list of hiring criteria. Specific technical capabilities are sometimes required, but even when this is the recruiting focus, top labs want people who can adapt to new roles as the research evolves. Those new roles, especially in indus-trial settings, should include project management and business experience – something many labs overlook.

Nurturing people. Talent management does not stop once researchers are hired. During the course of SuccessLab research, another R&D executive said, “Many of our research leaders don’t have the capabilities they need to succeed in senior positions in the organi-zation. We are trying to give people more experience across the business to round out their future leader-ship potential.” Unlike weaker counterparts, a top lab actively supports researchers’ development throughout their careers. Senior team members, for example, spend

significant time with new researchers, mentoring them continually. Such efforts flow into year-end reviews. The most productive labs also require all researchers to draft annual personal development plans.

Recognizing success. Many researchers crave recogni-tion, and labs have a number of ways to provide this: acknowledgment in meetings, awards, and opportuni-ties to present at conferences or attend symposiums. Even more recognition comes from offering high per-formers opportunities such as larger research budgets, leadership of bigger efforts, and part-time professor-ships. Such incentives can often motivate researchers more than monetary incentives, while costing far less and lowering turnover significantly.

Although recognition is important, it’s not everything. McKinsey found that researchers also want financial rewards for superior performance. In the best labs, such incentives are transparently linked to achieve-ments – great research, publication in leading journals, milestones, or successful patent applications. One lab awards small bonuses to researchers chosen by peers for being exceptionally helpful. Another offers stock options for killing projects early to avoid wasting money on futile or low-value efforts. Many academic labs, how-ever, must rely more on non-financial motivators.

Talent management is the area where labs have the greatest potential to improve

49

02 Some talent management activities are more important for high performance than othersCorrelation with high performance for R&D labs r value (0 = no correlation, 1 = high positive correlation)

By area By activity

SOURCE: McKinsey

Recruiting for potential Talent selected to ensure cultural fit

Talent selected based on research experience

Talent selected based on intrinsic qualities

Lab members involved in decision to offer job

Nurturing people Members are supported by structured mentoring

Clear apprenticeship offered for new members

Members have personal development plan

Recognizing success Those who fail to deliver suffer consequences

Celebration of achievements is central to lab culture

Financial compensation is tied to performance

Building diversity There is turnover in the lab team

New members are from diverse professional backgrounds

0.74

0.69

0.68

0.57

0.69

0.67

0.58

0.68

0.68

0.63

0.58

0.64

RECALL No 19 – Innovation and product development Managing talent: How world-class R&D organizations do it

Not everyone succeeds in the laboratory. Obviously, fail-ure should have consequences, but often it doesn’t. In one research unit, the weakest performers were moved to another lab to initially address the issue. The best labs don’t tolerate poor performance for long. If foundering researchers don’t improve, they are asked to depart. This entails the added advantage of being able to inject the team with fresh talent and ideas.

Building diversity. Another driver of high performance is a diverse team of people with different backgrounds, specialties, and forms of expertise to help solve prob-lems. The most important aspect of building such a team is to encourage turnover. Not only does weeding out underperformers achieve this, but also fostering rotation to adjacent research areas, other geographies, different roles, or – for an industry lab – to the business side of the company. To help researchers better under-stand the needs of business and to create a greater appe-tite for career opportunities outside R&D, one commer-cial lab organizes regular presentations by former group members who have rotated into business positions.

High improvement potential – even at the top

Of the six critical practices that influence a lab’s pro-ductivity, researchers surveyed stated that talent man-

agement is the one most in need of improvement. Even the best labs can raise their game in this area, and their research productivity can improve significantly even if executives are already happy with current levels.

Since research is so important for many (if not most) companies, these matters are clearly for the C-suite, not just research managers. Top executives should start by focusing on practical, tactical actions: inquiring into diversity of backgrounds, experience, and capabilities among researchers; how the unit’s culture can foster innovation; the development support researchers get; and alignment between incentives and performance.

Research leaders who invest in great talent manage-ment will find that the related initiatives are easy to implement and have high impact. What’s more, the incremental costs are far lower than those stemming from other approaches to raise productivity such as restructuring or investing in new facilities.

Six key factors drive successful research labs. Among them, talent management shows the highest correlation with performance and has the greatest opportunity for improvement. No lab should neglect its people.

Some talent management activities are more important for high performance than others

50

This article has been adapted from an article first pub-lished by McKinsey Quarterly in May 2011.

Daniel Simonis an Engagement Manager in McKinsey’s London office. [email protected]

Marc de Jongis a Principal in McKinsey’s Amsterdam office. [email protected]

Wouter Aghinais a Principal in McKinsey’s Amsterdam office. [email protected]

53

08

RECALL No 19 – Innovation and product development Lean and the software imperative: Step change in development productivity

The value of many products is increasingly dictated by the degree to which they are enhanced by software. The capability of vendors to produce the appropriate soft-ware, however, lags behind consumer demand.

The growing importance of software in all product classes is hard to overstate. Planes, medical devices, cars, printers, and weapons systems are all surprisingly software-intensive and increasingly so. The automotive industry is only one example of this trend. According to the Institute of Electrical and Electronics Engineers, a premium car today runs around 100 million lines of code using some 70 microprocessors. Across all industries and products, sales of embedded microprocessors outnum-ber PC-based processors 35 to 1. This amounts to 3.5 bil-lion every year. Software is no longer just for computers.

The rapid rise of software-enhanced products is not going unnoticed by consumers. In fact, end user per-ception of product value is shifting toward software-dominated attributes. In mobile phones, for example, the perceived value of a device used to be rooted in the compact design, assembly quality, aesthetics, battery life, and interface simplicity. Although these attributes remain important, key differentiators today are operat-ing system capabilities and the application ecosystem richness. In other words, electronics used to be the point of differentiation; now it’s software. Some companies have adapted remarkably well to the shift toward software-intensive products. Even though there are more system software engineers in the US than mechanical, electrical, and electronics engineers combined, many companies struggle to keep up with

this trend. In fact, McKinsey regularly encounters companies that are not constrained by their ability to imagine new products or by customer interest in them, but by their ability to develop the required software for new products on time, within budget, and at appropriate productivity levels. This variation in software devel-opment capacity underlies huge performance differ-ences – of up to four times – between the most and least equipped companies (Exhibit 1).

Root causes of poor software development

McKinsey is getting to the bottom of such challenges. Based on our work with over 50 organizations, we have uncovered the areas that drive down performance. Analysis results and benchmarks point to several areas where companies struggle – and it is clear that the chal-lenge traverses processes and people (Exhibit 2).

Each problem area listed below is associated with sev-eral specific challenges that require targeted solutions. Gaps identified include:

Insufficient use of iterative and agile methods. Com-panies still adhere to waterfall methods in domains where iterative and agile methods could significantly reduce lead times and improve productivity.

Weak peer review processes. A valuable investment to catch defects early, peer review reduces quality-related costs. Still, insufficient resources are allocated for this.

Limited or non-existent testing automation. Over-reliance on manual testing cycles is time-consuming

Lean and the software imperative: Step change in development productivity

54

01 Companies ahead of the “embedded software curve” perform up to four times better than strugglers

SOURCE: McKinsey

Projects within budgetPercent

Projects on timePercent

Productivity Development hours/function point

Good performers

Mediocre performers

< 50

< 35

80

90

20

5

and a drain on resources. Automated test suites run fre-quently are an efficient way to control quality.

Immature build processes. Some companies build code too infrequently, opening the source control process to code conflicts and code instability.

Excessive “context switching.” Engineers are interrupt-ed multiple times each day by a combination of meet-ings, field tickets, technical issues, and other non-core activities (see text box on page 56).

Weak demand management. Many companies have a tenuous grasp on demand, leading to unbalanced utili-zation of their resources.

How lean can help

Companies have attempted to resolve these software development issues for years – in many cases with little success. And productivity in this area has remained rela-tively constant. There are many reasons why companies are unable to realize sustainable improvement in soft-ware and application development, but three stand out as major hurdles. First, companies often try to improve performance by setting up detailed and extensively doc-umented processes, in many cases in the context of stan-

dard certification. McKinsey’s experience shows that such processes tend to be burdensome. In many cases, process efficiency analyses reveal that as little as 15 to 25 percent of a developer’s available time is adding value in these environments. Second, organizations tend to engage in piecemeal efforts, targeting only one element at a time. This approach is blind to interdependencies between multiple elements. Third, and perhaps most important, process improvement gets relegated to spe-cial teams without sufficient buy-in from practitioners.

To address these challenges in software development, McKinsey has applied an approach that has affirmed its power in many other complex operations: lean. Over the past 15 years, the lean methodology has repeat-edly proven its value in optimizing manufacturing and service operations by eliminating waste while reduc-ing variability and inflexibility. Lean transformation is highly practical, since it invests 25 percent of the time in analysis and 75 percent in implementation. The transformation is based on an iterative learning process where new ideas are tested, feedback is gathered, and improvements are implemented immediately.

Contrary to other performance improvement method-ologies, the following lean concepts can be applied to most environments.

Companies ahead of the “embedded software curve” perform up to four times better than strugglers

55

02 When asked about their company’s performance, leaders admit to several weak spots

SOURCE: McKinsey

Sourcing and suppliers

Organization and governance

People and performance

Topic

Strategic planningProcesses and tools Budgeting

Portfolio and project management

Requirements

Software development life cycleTools

Organizational structureGovernanceSkills and capabilities

Mindsets and behaviors

People managementPerformance management

Sourcing and location

Third-party management

Architecture Architecture management

Footprint Development footprint

Average response in category

Poor Best-in-classMediocre Good

Empowering. Practitioners (not a central team) propose and test improvements. They are trained as champions to bring improvements to other areas.

Efficient. Lean is based on eliminating waste, increas-ing flexibility, and reducing rigidity. As a result, lean transformations often lead to remarkably light and simple processes with limited documentation overhead.

Flexible. Lean does not prescribe a particular software development life cycle (although it often results in approaches that incorporate many agile concepts).

Far-reaching. Lean goes beyond process improvement and tackles management systems, mindsets, and orga-nizational friction.

Continuous. Lean is not a “one-off” change program. It instills a new way of working based on continuous improvement by solving problems and removing waste.

In recent years, lean has been successfully applied to software development environments, since R&D man-agers have moved beyond their initial skepticism of yet another “process improvement methodology.” Because this approach is based on continuous improvement, the benefits achieved are lasting ones.

Applying lean to software development typically results in productivity gains exceeding 20 percent (in hours per use case, story, or function point). It goes beyond this to substantially reduce lead time (often more than 40 per-cent), thus enhancing overall post-release quality.

The keys to making a lean transformation work

While the principles of lean are battle-tested and typi-cally result in dramatic performance improvements, the organization must prepare itself in ways that lay the groundwork for success. Five organizational objectives will help companies ensure that their transformation efforts have a fighting chance and yield the improve-ments they envision.

First, the transformation objective should be clearly communicated from the top down. Senior management should support the transformation to secure backing and adoption across the organizational units affected. Successful companies design a sophisticated commu-nication plan and market the initiative in an inspiring, non-threatening way. They make it “their company’s way” of achieving operational excellence.

Next, management should set ambitious targets and create clear value realization plans. A common set of

When asked about their company’s performance, leaders admit to several weak spots

RECALL No 19 – Innovation and product development Lean and the software imperative: Step change in development productivity

56

Focusing engineers on engineering

One global high-tech company had wedged itself into a corner: they faced a rapidly increasing devel-opment backlog coupled with increasing pressure to reduce costs. After years of targeted process-related improvements, the company conducted a lean diagnostic across application development and maintenance processes.

Initial analysis revealed that only 20 percent of available engineer time was spent on core activities such as pure development. Partially overlapped work flooded into teams, which also entailed unclear prioritization and value.

In response, the company primarily became active in demand management, complexity segmentation, tool automation, and performance management. Demand management improved based on estab-

lishing a common requirements inflow function for all units to ensure filtering, removing duplicates, and devising more sophisticated activities routing. The company segmented the development process by complexity of incoming work to provide for multiple tracks with varying levels of process rigor, overhead, and support requirements. Tools rang-ing from automated build systems to requirements management were improved to reduce workload and waiting times across all teams. In general, a standardized approach to managing performance was introduced across teams – including common metrics and visual management boards.

Total potential amounted to 35 percent higher pro-ductivity and a 45 percent drop in lead times. By applying lean principles, the company freed up sig-nificant R&D resources and reduced time to market.

metrics and clear accountability among line manag-ers will help ensure that value is consistently captured. Complex and fragmented transformation organization with no value realization plans reduces transparency regarding the “leanified” unit’s performance. Freed-up time could revert back to non-value-adding tasks.

Building capabilities, management systems, and met-rics to support the effort is also a part of the groundwork an organization must do to ensure a successful lean transformation. While some have succeeded in taking the first step toward a high-performance lean develop-ment organization by removing waste in processes, generating sustainable impact requires improvements beyond the process dimension alone. This includes building the right skills, instilling accountability, anchoring performance dialogs and metrics, and establishing a culture that strives for improvement.

Management should also be mindful of the organiza-tion’s objectives, its situation, and its resources to scale the transformation accordingly. The process could range from a sequential “self-discovery” approach across development areas to a full-blown concurrent transformation, depending on the organization’s overall culture and its readiness for change.

Finally, transformation teams must be equipped with a combination of lean skills and sufficient software domain knowledge. Beyond lean skills such as process optimization, visual management systems, and perfor-mance dialogs, teams need specific software develop-ment skills to develop a lean target model. Such skills could include being able to optimize demand man-agement across maintenance and development proj-ects, to leverage agile development in pace teams to cope with different delivery horizons, and to instill standardized time estimation to support productivity point metrics.

The tricky aspect in lean transformations is frequently less technical than it is behavioral. One multinational player launched an effort to shorten the release schedule and reduce costs – only to see the effort fizzle. Their primary focus on process reengineering meant that the vital mindset shift among employees was missing. Since top management led this effort, business manag-ers assumed little accountability for the success of the program. By taking a step back and adhering to the full range of lean principles, they were finally able to make the program a success. This included a shift to a line-led rollout combined with an increased focus on changing mindsets and behaviors.

57RECALL No 19 – Innovation and product development Lean and the software imperative: Step change in development productivity

Lean can be an effective approach to improving soft-ware development performance in product companies by addressing many of the root causes behind poor software development. Companies need to ensure some specific conditions to make lean successful and strike the balance between process improvements, perfor-mance management, and mindsets and behaviors.

Santiago Comella-Dorda is an Associate Principal in McKinsey’s Boston office. [email protected]

Krish Krishnakanthan is a Principal in McKinsey’s New York office. [email protected]

Javier Garabal is an alumnus of McKinsey’s Barcelona office.

Daniel Alsénis an Associate Principal in McKinsey’s Stockholm office. [email protected]

59

Vodafone Italy is one of the country’s largest telcos. This operator earned over USD 8.7 billion in revenues in the 2011 fiscal year, serving more than 30 million active customers – in both consumer and enterprise segments with mobile and fixed business. Despite the economic crisis and price cuts driven by the country’s regulatory bodies, Vodafone Italy continues to invest in quality and innovation, working to increase broadband availability and usage to narrow Italy’s “digital divide.”

Marco Ferrero joined Vodafone Italy in 2007 as head of its wholesale unit. From 2009 to 2011, he was Head of the Consumer Product and Services Department. As part of his role, he was responsible for the opera-tor’s product development function from end to end. Mr. Ferrero is now Area Sales Director at Vodafone Italy.

McKinsey had the opportunity to speak with Mr. Ferrero in 2011 about Vodafone’s quest to develop and deliver innovations in a time of industry-wide market pressure.

McKINSEY: Why did Vodafone Italy decide to revisit how it brings new products and services to the market?

MARCO FERRERO: When I joined the Consumer Product and Services Department in 2009, there were some early signs that our product development capabili-ties were suboptimal. This stifled our innovation power. Time to market was becoming too high and almost unpredictable. We had the feeling that product devel-opment costs were increasing and the organizational effort we put into making products ready for the market was very high. And this was true across all segments

and businesses. As a company eager to constantly and successfully innovate and with an obsession for quality, we decided it was time to drastically review the way we develop products. That was the beginning of our “Make it fast” initiative.

McKINSEY: What was the objective?

MARCO FERRERO: The aim of “Make it fast” was to transform our product development infrastructure into a source of distinctiveness and competitiveness for Vodafone. The first and most important goal was to obtain a significant reduction in time to market from concept definition to market launch. We would then be able to deploy new products faster than our competitors. We aimed to reduce both concept and implementation time by 50 percent.

McKINSEY: How did the organization accommodate such a grand ambition?

MARCO FERRERO: That’s where our supporting goals came into play. From the people perspective, we also sought to dramatically reduce the fatigue everyone was feeling at that time. And on the fiscal side, our aspira-tion was to decrease costs and optimize our budget allocation to free up capacity for additional products. Together with the CEO and our senior executives, we thought that “Make it fast” was the perfect name for such a program.

McKINSEY: As the executive responsible for the initia-tive, how did you define the scope?

09 A free-flowing pipeline: An interview with Marco Ferrero Area Sales Director, Vodafone Italy

RECALL No 19 – Innovation and product development A free-flowing pipeline: An interview with Marco Ferrero

60

MARCO FERRERO: Since the objective was to change our way of developing new products end to end, we decided that the scope had to be as broad as possible, both in terms of development types and focus areas. We targeted three main development types: simple prod-ucts – such as new rate structures and promotions and maintaining existing products; new products and major innovations – like our fixed offering; and go-to-market enablers – the CRM system or the dealer station for our shops, for example.

McKINSEY: How did you decide on an implementation methodology?

MARCO FERRERO: Our product development infra-structure had been in place since 1995. That’s more than enough time for organizational and industry changes to render a finely tuned mechanism inefficient. We thought that lean methodology was the best way to fur-ther improve our performance. It enabled us to identify sources of inefficiency in the current environment and develop sustainable solutions in a bottom-up approach to gain full buy-in from the organization. Lean really helped us in the diagnostic phase to lend transparency to the real issues. At the end of the diagnostic, we count-ed ten root causes – mostly cross-functional – behind the malfunctions in our product development systems.

McKINSEY: So how exactly did you address the issues that were hindering development productivity?

MARCO FERRERO: The first step was to review and clean up our project pipeline, the enabler. The diagnos-tic phase revealed that there were too many new prod-ucts and services in our project pipeline that Marketing and the other business units were pushing without considering the overall company throughput – in my department as well as in IT and Network. We realized that this was leading to an inefficient stop-and-go working attitude within product development teams. The decision to clean it up was not easy, but there was a strong commitment from our top management to do this. In the end, we reduced the volume by 70 percent. In parallel, we focused on three key areas: the evolution of our gating process and its governance, the introduc-tion of a new cross-functional way of working, and the definition of specific KPIs to measure the health of the newly redesigned processes.

McKINSEY: Can you describe the solution design from the process perspective?

MARCO FERRERO: As a first step, we reviewed the way we size and allocate the product development budget. The key here was to preallocate funds directly to the business units. This amount was the net of strategic initiatives and a buffer for flexibility in the event of unexpected market changes. Beyond this, we extended our capital allocation perspective up to 18 or 24 months to empower business units to spend correctly within the assigned budget in the medium term as well. We also linked financial planning to operational planning, building in prioritization and trade-off mechanisms.

McKINSEY: Was redesigning the gating process as straightforward?

MARCO FERRERO: That also followed from the lean diagnostic. We structurally reviewed our gating process to further emphasize the required inputs, the expected outputs, the necessary activities, and the owners assigned to each of the four typical phases (concept, design, development, and testing). We also rethought the number and function of the gates, putting more emphasis on the “gate preparation” phases. That led us to introduce mechanisms to check product development team availability across the company before starting. The rationale here was to force a higher filtering ratio at the very beginning and to anticipate the commercial decision to pursue or not to pursue a product in the earli-est phases according to the 80/20 approach.

McKINSEY: These are all big changes to various compo-nents of product development, but how did the transfor-mation tackle the process as a whole from end to end?

MARCO FERRERO: We reviewed the entire way we work – from concept development to market launch. What we found were discontinuities across teams. We anchored more structured, cross-functional team-based approaches between Marketing, Technology, and Customer Operations. We also specified end-to-end accountabilities and reduced the number of hand-overs. To help us stay on track, we introduced a few simple KPIs to monitor the health of the new process. Indicators measured now include time to market, killing ratio at gates, and maximum difference between budget and actual cost per product. We also evaluate ex ante versus ex post business cases when we set business unit targets and evaluate people’s performance.

McKINSEY: Has Vodafone Italy begun to reap the ben-efits of this transformation?

61RECALL No 19 – Innovation and product development A free-flowing pipeline: An interview with Marco Ferrero

MARCO FERRERO: We have already exceeded our greatest expectations. Overall time to market has declined by 53 percent, and we expect to reduce it even further. We also cut our product development costs by 20 percent and succeeded in combating organizational fatigue – we spend 30 percent less of our time in meet-ings and in preparing documentation.

McKINSEY: Based on your experience, what lessons would you share with other organizations considering embarking on such a transformation?

MARCO FERRERO: First, ensure top-down sponsor-ship for the transformation. The CEO has to align top management and enlist them in the changes. Second, follow a bottom-up approach in solution design to gain strong buy-in from the key business units that will be involved in the process turnaround. Finally, make sure HR is aligned and involved to ensure people’s targets and incentives are linked to the agreed KPIs.

Marco Ferrero was interviewed by Fabrizio Pessina, an Engagement Manager in McKinsey’s Milan office.

63RECALL No 19 – Innovation and product development Appendix

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65RECALL No 19 – Innovation and product development Appendix

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