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Building superior capabilities for strategic sourcing

Purchased materials and services often make up 60 to 80 percent of a product’s cost. Companies that don’t invest in the purchasing team’s capabilities are throwing away value.

Jack Welch once notoriously said that “engineers who can’t add, operators who can’t run their equipment, and accountants who can’t foot numbers become purchasing professionals.” Hyperbole aside, General Electric’s legendary boss was reflecting a common perception: the purchasing function is little more than a necessary evil in business. No surprise, then, that many companies underinvest in the purchasing team’s capabilities and leave sourcing out of strategic decision-making processes in favor of functions, such as manufacturing and sales, that drive revenue.

Over time, of course, a negative compounding effect sets in: up-and-coming talent flows to the higher-status functions, often exacerbating the capabilities mismatch when difficult sourcing negotiations come up. If a supplier’s heavily supported sales team squares off against an underdeveloped purchasing team, the result, like that of a football match between Fiji and Brazil, is fairly predictable.

Yet purchased materials and services make up 60 to 80 percent of a product’s total cost in many industries. As a result, companies that do not invest appropriately in the purchasing team’s capabilities and culture are throwing away more value than they realize. Organizations that employ leading-edge purchasing practices achieve almost double the margins of companies with below-average purchasing departments (20.2 percent versus 10.9 percent, respectively). Among the dimensions that affect purchasing’s success, capabilities and culture were correlated 1.5 to 2.2 times more strongly with a company’s financial performance than the others we studied (exhibit).


Capabilities and culture are key to purchasing success.

We have developed an approach that emphasizes speed and scale to build and institutionalize capabilities, so that performance improves rapidly and continues to get better over the long term. When applied to purchasing, the approach helps to raise the function’s profile and to give high-performing procurement professionals more leadership-development opportunities and exposure to senior management. In our experience, companies that employ this program in purchasing are able to attract and retain better purchasing talent and capture the financial impact more quickly and sustainably. This article will discuss how the approach has improved the performance of purchasing organizations and helped several of them realize their goals.

Identifying and building capabilities

To turn the purchasing function into a high-functioning strategic asset, an organization must first identify the specific capabilities that will create the most value. They vary by company but may include technical skills such as the ability to reverse-engineer a supplier’s cost structure accurately or to conduct a thorough supply-market analysis that produces insights leading to a competitive advantage. Leadership capabilities—such as the ability to navigate complex cross-functional interests, to manage the trade-offs required to meet competing needs, and to identify alternatives with perspicacity and tact—may also be important.

A company can figure out which capabilities have the greatest potential to contribute to performance by conducting a bottom-up assessment of its technical and leadership capabilities and comparing them with relevant benchmarks. For one leading chemical company, this type of assessment revealed a need to improve advanced “should-cost” analytics (that is, clean-sheet modeling) and cross-functional leadership. The company created a tailored capability-building program to build these specific skills. One year later, it was routinely convening cross-functional sourcing teams and using clean-sheet-based negotiations to capture savings that ranged from 10 to 20 percent for many categories.

Beyond building individual employees’ skills, an organization must embed them in its processes, systems, and tools. For example, after completing an initial phase of capability building for individuals, a leading basic-materials company took the next step. This effort included the implementation of an improved organizational structure to place a greater focus on value-generating priorities: transactional activities, such as purchase-order processing, were organizationally separated from strategic activities, such as category management. Data-collection tools and clear processes were instituted to support a more strategic kind of category management. The company also worked to ensure that the right individuals were placed in the right roles. Finally, performance-management systems were put in place to measure and provide incentives for total-cost-of-ownership savings and continuous improvement.

Use real work and adult-learning principles

According to our research, the traditional method of providing corporate training, through infrequent classroom sessions, is one of the least effective ways to build capabilities. Adults retain new ones more successfully if learning occurs through shorter, more frequent interventions in which the content is delivered “just in time.” That is, when training is tied to real work and the specific activities an individual must complete, trainees get immediate practice in incremental new skills that directly affect their day-to-day responsibilities. Over time, these new skills build on each other and develop into a complete set of improved capabilities.

One of the most effective ways to act on these adult-learning principles and scale new capabilities quickly is the “train the trainer” approach. In this technique, a small number of highly skilled and motivated change agents go through a structured “field and forum” program covering technical and leadership capabilities. While these change agents are in this program, they are expected to transfer their newly acquired capabilities to others by acting as mentors for a cohort of key purchasing employees going through an actual category-sourcing process. These purchasing staffers, with some further training, then go on to become coaches and mentors themselves. Through this approach, a combination of coaching and on-the-job training creates an organizational-talent engine that scales up new capabilities rapidly.

The global chemical company mentioned above followed this approach for its purchasing-transformation program. The company’s purchasing leaders identified a core set of trainers, who were 100 percent dedicated to driving change in the organization. Every week, these trainers received seven hours of technical and leadership training, and in tandem each of them co-led a cross-functional category-sourcing team. Over the course of 16 weeks, the trainers led their teams through the full sourcing process while also receiving regular coaching, training, and mentoring from their leaders. At the end of the period, the trainers unanimously declared that this experience had been the most transformative time in their careers, both professionally and personally, and that it helped improve their own skills and mind-sets, as well as the attitudes and capabilities of their colleagues. The trainers went on to train others independently and to become highly respected leaders in the organization. Many were recognized by C-level executives for their achievements.

Scale up and institutionalize

After the first phase of individual and institutional capability building, a company must focus on scaling, across the entire organization, the new way of doing business, so that it is sustainable over the long term. For example, at the basic-materials company mentioned above, this scale-up was accomplished by first setting an austere goal of 7 percent cost reductions across the entire third-party spending base and creating a clear action plan to reach that level in two years. This plan involved a sequence of category-sourcing efforts, with assigned team members and a center of excellence of core trainers and leaders to provide category teams with the necessary capabilities and expertise. A robust mechanism reported results to the whole organization to build excitement and credibility for the cost reductions. Two years later, the organization is well on its way to achieving what many thought a nearly impossible goal.

The final important piece in the capability-building effort relates to culture: creating an environment in which purchasing professionals are proud of the value they add to the organization and have the confidence to take a leadership role in finding and delivering new sources of value. Such cultural change is the bedrock of a sustainable transformation in a purchasing organization. Companies can push this change by creating highly visible senior role models who act out the new culture. These companies do so in several ways: instituting joint purchasing councils with responsibility for ensuring cross-functional collaboration and making use of the right forums to publicize successes throughout the organization and build excitement. Continuing to measure the attitudes and mind-sets of the staff carefully (using employee questionnaires and focus groups, for example) and then making targeted interventions to address challenges are important as well.

For example, at one leading global chemical company, a “victim” mind-set predominated in the purchasing function. Professionals within the group felt directionless and disheartened by an environment in which key sourcing decisions were often made without their involvement. To change this attitude, the company made sure senior leadership was involved in redesigning the purchasing organization, developing and institutionalizing a formal sourcing process, and implementing new databases and tools. Executives participated in weekly stakeholder meetings and periodic gatherings to address concerns as they arose. The company also made a significant effort to communicate the project’s successes to the whole organization. Eighteen months after launch, the purchasing transformation was on track to exceed some radical savings goals in many categories. The transformation was recognized as one of the most significant efforts the company had ever undertaken, not only because of the bottom-line impact, but also because the project fundamentally changed the way the organization operated.

Companies that have invested in developing best-in-class purchasing capabilities have nearly double the margins of those that have not. By identifying the capabilities that will drive value, building them in real work situations using adult-learning principles, and institutionalizing them, a company can create sustainable performance improvements that enhance the bottom line.
Printed from McKinsey & Company

Applying global trends: A look at China’s auto industry

Strategists can challenge conventional wisdom and better prepare for uncertainty by analyzing the complex and not-so-obvious ways global trends interact in their industries.

Predicting the future is arguably the most important and hardest task facing strategists. One way of loading the dice in their favor: scrutinizing the demographic, technological, environmental, macroeconomic, and other long-term forces constantly shaping the global economy. The most eye-opening implications typically lurk at the intersections where multiple trends (and dozens or more subtrends) interact with one another, often in complex and not-so-obvious ways. Moreover, to analyze trends successfully, executives must develop a fine-grained understanding of the potential impact for specific geographies and industries.

Only a dozen years ago, for example, authoritative predictions for the coming decade envisioned no more than a few million mobile-phone users throughout Africa. Local income, consumption, technology, infrastructure, and regulatory conditions seemed to hold little promise for significant growth. Less than ten years later, though, Nigeria alone had 42 million mobile subscribers—80 times more than initial forecasts predicted—as growth skyrocketed, largely as a result of the interaction between just two trends: improved income levels and cheaper handsets. This was a massive growth opportunity that global telcos missed but African and Middle Eastern players captured, to the tune of more than $100 billion, by developing low-cost business models.

How can company strategists spot the next big opportunity or looming threat in their industries before it’s apparent to everyone? In this article, we’ll describe a four-step methodology for making global trends part of a scenario-based strategic-planning process. By bringing together trends and their interactions, industry-specific insights, and problem-solving techniques, this approach helps create quantitative, actionable, and unbiased scenarios for what might happen in the next five to ten years. Better scenarios, in turn, can help companies challenge conventional wisdom, pressure-test existing business models, identify market opportunities, and develop more innovative products and services.

To illustrate our thinking, we’ll look at an intriguing example—how Chinese automakers could defy conventional wisdom and steal a march on competitors in developed markets by succeeding there much more quickly than expected in a future characterized by natural-resource constraints, unceasing innovation, a growing role for governments, and a shift of economic growth and power to emerging markets.

1. Establish the reference frame

The right frame of reference—a specific problem statement and a clear sense of the industry context for long-term shifts—is a critical starting point. For example: “What share of the car market in developed countries is Chinese auto manufacturers likely to capture by 2020, and what impact could they have on global profit pools?” This might be a timely question for the planning team at a European or US automaker. After all, Chinese automakers enjoy a 35 percent cost advantage over those in developed markets, and Chinese OEMs have supersized ambitions. BusinessWeek reported in July 2008, for instance, that Geely Automobile “intends to sell 2 million cars [in the US market] by 2015, and [the CEO is] confident he can thrive against global competition.” The company’s March 2010 acquisition of Sweden’s Volvo Cars suggests that these ambitions aren’t just cheap talk.

Still, China’s light-vehicle manufacturers haven’t entered European or US markets at any scale, nor are they expected to do so soon. IHS Global Insight recently forecast that China’s share of these markets would double, from 0.1 percent today to a still-marginal 0.2 percent by 2020. Chinese cars also suffer from poor consumer perceptions of their quality and safety. Evaluations by the China New Car Assessment Program (C-NCAP, a government-supported agency) give the country’s automakers a quality index score of around 30, versus 45 for automakers in developed markets.

Hyundai provides a memorable and recent example of an Asian automaker that entered the US market (in the late 1980s) with quality problems and with volumes comparable to those of some smaller Chinese OEMs now. Though quite successful today, it took the company nearly two decades to establish a meaningful presence in developed markets by competing on price and slowly building out its sales network while improving its quality and brand image. Interestingly, the low market share numbers some forecasters expect for China’s automakers seem to imply a trajectory similar to Hyundai’s in the late 1980s.

But how relevant is this example for today’s Chinese automakers? The vast difference in scale between China’s domestic auto markets and South Korea’s is obvious. But Chinese market penetration might be similarly measured if certain conditions held sway—such as the absence of major technological breakthroughs in engine technology, continued quality problems for Chinese automakers, and a need for the slow, steady development of a sales network.

2. Expand the solution space

Having carefully defined the problem and the industry context surrounding it, the challenge for strategists is to broaden the potential solution space by challenging conventional wisdom through the lens of global trends. Most companies have a broad range of experts who can help, yet these people are often tucked away in organizational silos that make it difficult for them to connect the dots. Automakers in the developed world are very good at gathering rich trend data and perspectives on topics such as regulation, macroeconomics, and demand. But regulatory analysts in car companies may spend more time developing strategies for government relations and lobbying than they do working with internal economists forecasting future demand. Those economists, in turn, rarely interact with engineers who focus on future game-changing technological possibilities.

When companies overcome these and other strategic and organizational barriers, they can begin developing a rigorous and more nuanced picture of how trends and subtrends might influence their industries. In the auto industry, for instance, could the developing world’s rising economic influence, the increasing scarcity of resources, and the spread of “green” technologies combine to affect the market, with unexpected results?

While events could play out in many ways, Chinese carmakers could well leapfrog current engine technology and develop a significant competitive advantage in electric vehicles or other clean technologies; the Chinese player BYD Auto appears to be moving in this direction already. For one thing, global resource constraints are prompting China to reduce its dependence on foreign oil, as well as pollution and greenhouse gas emissions. With large funds available through an economic-stimulus package, the Chinese government is already investing significantly in R&D for alternative technologies.

In parallel, China’s massive buildup of new infrastructure might spark an entirely novel green automotive infrastructure, without the massive replacement costs developed nations would incur. This infrastructure could include service networks and promote incentives for clean-tech cars (say, special traffic lanes and preferential parking). Such moves might inspire a large-scale consumer preference for alternative-technology vehicles, allowing Chinese automakers to achieve the required scale to begin mass production; China, remember, is a homogenous automotive market—as well as the world’s largest and fastest-growing one. This, in turn, would give China’s carmakers a cost and knowledge advantage that might help them pass over competitors in the developed world.

Likewise, Chinese cars could rapidly exceed minimum quality and safety standards if the government’s appetite for technology and management know-how drove it to support the acquisition of a major automaker in a developed market (say, one of the top five). This move would speed the transfer of best practices to local Chinese companies, thus helping them to move rapidly up the learning curve, to improve their brand image, and to develop a more sophisticated understanding of consumer needs. Alternately, the Chinese government might raise safety, emission, and quality standards in response to consumer demands while simultaneously subsidizing local players so that they could meet the more stringent requirements.

Finally, natural-resource constraints and environmental concerns might persuade consumers in developed markets to adopt cost-effective clean-tech vehicles more quickly than expected, creating a large market that Chinese auto players would be poised to supply.

3. Define scenarios

In broadening the solution space by highlighting the way trends may interact to challenge conventional wisdom, we’ve emphasized two variables that seem quite uncertain and will probably have a major impact on the industry’s evolution: first, whether Chinese manufacturers can achieve a scale advantage in clean technology and, second, whether they will acquire a large, leading Western auto brand. We can use these two variables to generate a handful of scenarios, each with a compelling but distinct narrative. A methodology called “quadrant crunching,” which the US Central Intelligence Agency developed in recent years, allows planners to generate extreme but plausible scenarios quickly by reversing their underlying assumptions to arrive at a number of very different potential states of the world. This approach can help business strategists combine uncertainties to provide a basis for robust, quantitative, and therefore actionable scenarios, such as the following for our Chinese automotive example (exhibit):


  • A perfect storm. China’s government aggressively promotes its carmakers by creating the conditions for a domestic clean-tech market to flourish and by helping a Chinese company buy a major automotive business in a developed market in order to facilitate rapid market entry.
  • The clean-tech advantage. China’s market for clean-tech vehicles flourishes, allowing domestic automakers to develop competitive advantages to compete head-on in developed markets, but without acquiring a brand in any of them.
  • A helping hand. A Chinese acquisition of a top auto player (one much larger than Volvo) in a developed market combines established brands and quality perceptions with access to a large sales network, as well as a homegrown cost advantage in traditional vehicles powered by combustion engines.
  • Follow in Hyundai’s footsteps. Chinese auto players use their existing brands or create new ones, leveraging their factor cost advantage to produce inexpensive traditional cars that compete head-on with the cars of incumbents in developed markets.

4. Quantify industry impact

A systematic forecasting method developed in the 1940s, this method draws on the knowledge of a panel of experts with diverse, incomplete information to generate predictions on which future scenarios can be based.

The Delphi technique

Design Quality control Run the poll Synthesize
Stages Design the panel, choose the questions, and identify the panelists. Double-check the panel’s composition and scrutinize questions. Poll, aggregate responses, repoll. Aggregate the final estimates.
Imperatives Ask the panelists for estimates, justification, and level of confidence in their estimate.

Choose panelists with a general background but with knowledge spike.

Be sure the panel is balanced.

Do a dry run with team members or colleagues to be sure questions are clear.

Group the justifications and aggregate predictions.

Repoll until the estimates don’t change (2–3 times should be enough).

Look for the story between the justifications and the estimates.

Weigh the estimates by self-assessed confidence levels.

Caveats Avoid ambiguous questions, which confuse panelists and result in unusable answers. Avoid a preponderance of like-minded panelists by including external experts. Homogeneity among panelists may lend a perception of rigor to a biased estimate. Results will often cluster around scenarios. Don’t allow the story to be effaced, but do average the results. Don’t report on the precision of the forecast (eg, confidence intervals); rather, include average confidence of each group of panelists.




Such scenarios are important because they provide strategic clarity, and they become even more powerful when accompanied by probabilities and financial estimates that help clarify their implications. One classic approach involves the Delphi technique—a systematic forecasting method, developed in the 1940s, that draws on the knowledge of a panel of experts with diverse, incomplete information. By keeping individual predictions anonymous and using an iterative process to converge on a limited set of outcomes, this method minimizes “groupthink” and helps experts to get comfortable with high levels of uncertainty (see sidebar, “The Delphi technique”).

We used the Delphi method with a panel of McKinsey auto industry experts after briefing them extensively on the scenarios. The outcome? The panelists saw only a 40 percent likelihood that the scenario based on conventional wisdom would be realized. In this scenario, Chinese automotive companies would capture, at most, $1 billion of the profit pool in developed markets by 2020.

By contrast, the panel saw a 60 percent likelihood of an aggressive entry by China into developed markets, with Chinese players capturing a 3 to 15 percent market share. One scenario gave Chinese players a 10 to 15 percent chance of entering the developed world with the benefits of both a clean-tech cost advantage and a major acquisition. Subsequently, we estimated that this scenario implies that Chinese automakers would capture a whopping $4 billion to $7 billion share of the global profit pool.

To be sure, much would have to happen for this most aggressive scenario to play out, but it is plausible enough—and the stakes are high enough—to demand more serious attention from auto strategists in developed markets. Indeed, if this scenario came to pass, the implications would be significant: developed-market players would likely see a big profit erosion that could put their viability in question, thus propelling a large-scale restructuring of the industry.

Uncertainty isn’t limited to the auto sector. A wider range of actionable scenarios based on a granular understanding of global trends and their interactions can help strategists in any industry see opportunities where others see only uncertainty. Armed with a more robust outlook, executives can define the appropriate strategic postures, identify no-regrets moves and steps to mitigate risk, and spot the potential big bets—insights that together underpin a long-term strategic plan. By reassessing scenarios over time, companies can prepare to seize opportunities before their competitors do.

The coming era of ‘on-demand’ marketing

Emerging technologies are poised to personalize the consumer experience radically—in real time and almost everywhere. It’s not too early to prepare.

Digital marketing is about to enter more challenging territory. Building on the vast increase in consumer power brought on by the digital age, marketing is headed toward being on demand—not just always “on,” but also always relevant, responsive to the consumer’s desire for marketing that cuts through the noise with pinpoint delivery.

What’s fueling on-demand marketing is the continued, symbiotic evolution of technology and consumer expectations. Already, search technologies have made product information ubiquitous; social media encourages consumers to share, compare, and rate experiences; and mobile devices add a “wherever” dimension to the digital environment. Executives encounter this empowerment daily when, for example, cable customers push for video programming on any device at any time or travelers expect a few taps on a smartphone app to deliver a full complement of airline services.

Remarkably, all this is starting to seem common and routine. Most leading marketers know how to think through customer-search needs, and optimizing search positioning has become one of the biggest media outlays. Companies have ramped up their publishing and monitoring activities on social channels, hoping to create positive media experiences customers will share. They are even “engineering” advocacy by creating easy, automatic ways for consumers to post favorable reviews or to describe their engagement with brands.

But we’re just getting started. The developments pushing marketing experiences even further include the growth of mobile connectivity, better-designed online spaces created with the powerful new HTML5 Web language, the activation of the Internet of Things in many devices through inexpensive communications tags and microtransmitters, and advances in handling “big data.” Consumers may soon be able to search by image, voice, and gesture; automatically participate with others by taking pictures or making transactions; and discover new opportunities with devices that augment reality in their field of vision (think Google glasses).

As these digital capabilities multiply, consumer demands will rise in four areas:

1. Now: Consumers will want to interact anywhere at any time.

2. Can I: They will want to do truly new things as disparate kinds of information (from financial accounts to data on physical activity) are deployed more effectively in ways that create value for them.

3. For me: They will expect all data stored about them to be targeted precisely to their needs or used to personalize what they experience.

4. Simply: They will expect all interactions to be easy.

This article seeks to paint a picture of this new world and its implications for leaders across the enterprise. One thing is clear: the consumer’s experiences with brands and categories are set to become even more intense and defining. That matters profoundly because such experiences drive two-thirds of the decisions customers make, according to research by our colleagues; prices often drive the rest.

It’s also apparent that each company as a whole must mobilize to deliver high-quality experiences across sales, service, product use, and marketing. Few companies can execute at this level today. As interactions multiply, companies will want to use techniques such as design thinking to shape consumer experiences. They also will need to be familiar with emerging tools for gathering the right data across the consumer decision journey. Finally, the marketing organization’s structure will need to be rethought as collaboration across functions and businesses becomes ever more essential.

What to expect in 2020

Over the next several years, we’re likely to see the consumer experience radically integrated across the physical and virtual environment. Most of the technologies needed to make this scenario happen are available now. One that’s gaining particular traction is near-field communication (NFC): embedded chips in phones exchange data on contact with objects that have NFC tags. The price of such tags is already as low as 15 cents, and new research could make them even cheaper, so more companies could build them into almost any device, generating a massive expansion of new interactive experiences. To understand that near future, follow a hypothetical, tech-enabled consumer, Diane, who purchases an audio headset.
on demand info graphic

Taken together, the scenes from Diane’s consumer journey illustrate the four emerging areas of consumer demands we touched on above.


Marketers have gotten a foretaste of the consumer’s desire for more urgency and ubiquity. Bank balances running low? Send the consumer an alert on her cell phone. A question about fees shows up on the bank’s Twitter handle? Post an immediate response. An executive of one major bank believes that the immediacy of smartphone apps has already made brick-and-mortar contact unnecessary for many young consumers, who use a range of mobile services to manage their accounts and rarely interact with the brand physically. Yet having an entire bank in your phone may be only a baseline for the experiences on the horizon. Consider one European beverage company’s beta test of beer coasters embedded with NFC technology. A club patron contemplating a new brew can tap a coaster with a cell phone and get a history of the beer, bars where it is served, upcoming promotions, and a list of friends who have given it a thumbs-up.

In this environment, a marketer’s “publishing” extends to virtualized media such as the coaster or Diane’s headphones, which become touch points for considering and evaluating products and services. Digital information technologies, operating behind the scenes to integrate data on all interactions a consumer has across the decision journey, will provide insights into the best influence pathways for companies, while also triggering new personalized experiences for consumers.

Can I

Most first-wave digital capabilities helped people access things they already did—shopping, banking, finding information. Consumers must often settle for compromises in their digital experiences. Yet robust programming, data-access, and interface possibilities now available could make every digital interaction an opportunity to deliver something exceptional.

Consider Commonwealth Bank of Australia’s new smartphone app, which changes the house-hunting experience. A prospective home buyer begins by taking a picture of a house he or she likes. Using image-recognition software and location-based technologies, the app identifies the house and provides the list price, taxes, and other information. It then connects with the buyer’s personal financial data and (with further links to lender databases) determines whether the buyer can be preapproved for a mortgage (and, if so, in what amount). This nearly instantaneous series of interactions cuts through the hassle of searching real-estate agents’ sites for houses and then connecting with the agents or with mortgage brokers for financing, which might take a week.

The mortgage app shows how the digital environment is now integrating disparate sources of information, at low cost and at scale, for many new domains. The challenge for companies is to look beyond today’s interfaces and interactions and to see that moving past compromises will require a rethinking of aspects of packaging, pricing, delivery, and products.

For me

Some online marketers already use features in devices such as cameras and touch screens to help consumers see what apparel and accessories may actually look like when worn. Web retailer Warby Parker, for example, offers hundreds of customized views of eyeglasses overlaid on a Webcam picture of the consumer.

In the future, demands for more personalized experiences will intensify. A phone tap, a click, or a stylus jot will instantly personalize offers, using information captured on “likes,” recent travel, income, what friends are doing or like, and much more. With each interaction, the consumer will be creating new data footprints and streams that complement existing digital portraits, sharpening their potential impact. Facebook will eventually be able to mine the world’s largest database of photographs, linking individual people to their activities. Smartphones have rich data on every place where you have traveled with one in your pocket. This is just a start, and the privacy, security, and general trust implications are staggering. Yet consumers consistently show a desire to provide more data when companies use captured information to provide truly helpful feedback (you’re over budget or you are doing well in your exercise program) or to offer recommendations, services, and customization tools rather than just push what might appear to be intrusive (and creepy) messaging.


The quest for simplicity led Amazon to create a subscriber model for delivering bulky repeat-buy items (such as diapers) and Starbucks to adopt a tap-and-go approach to mobile payments. Yet many interactions remain complex and fragmented: to name just a few, finding, organizing, and redeeming online coupons; turning weekly meal plans into online delivery orders; tracking your monthly cash flow; and staying on top of your health-insurance bills and reimbursements.

Evolving technologies and consumer behavior should make it easier to redesign many complex experiences. For example, companies offering inherently complicated products or services could overlay a game interface on certain Web pages, to let consumers play at trading off different options and prices. Visual-recognition technology could allow you to scan health-care bills, receipts, statements, and appointments into one integrated calendar and cash-management system. Already, start-ups in travel, expense, and sales-force management are experimenting with approaches that streamline processes and make interactions more inviting—using touch and swipe to make changes, gestures to activate large displays, and data in phones to recognize consumers and automatically customize interfaces.

Setting strategies and building capabilities

Consumers will soon make these demands of every interaction they have with companies. Although the marketing function may often be the best conduit to get customer input and to drive decisions about how to distinguish brands, coordinated efforts across the enterprise will be needed on three levels.

Designing interactions across the consumer decision journey

Today, many companies have successfully defined and addressed customer interactions across a few channels. What they need to be designing, however, is the entire story of how individuals encounter a brand and the steps they take to evaluate, purchase, and relate to it across the decision journey. Marketing or customer research can’t do this alone. At one apparel retailer, managers from multiple functions go together into the field to do deep ethnographic research— watching how customers shop, going into their homes, and uncovering the triggers and motivations that drive behavior. These managers look for the compromises that people face as they try to get things done, probing for their higher aspirations. And the managers watch how customers react as they interact with brands.

Among the findings, the managers identified seven key “use cases”—customer situations that lead to satisfaction along different decision journeys. They found a wide range of trigger points for choosing an “outfit solution” for a social occasion, learning that shoppers became frustrated, especially online, when they couldn’t see how items would look together. Customers wanted to drag and drop items on an on-screen model or to see great combinations in advance. But that required different merchants to work collectively and the stores to bring items together on sales floors.

Cross-functional teams also came together in workshops. With third parties such as fashion bloggers and thought leaders from online-media companies, they mapped out new ways to influence the decision journeys of customers with different attitudes toward the retailer’s brand or different kinds of spending behavior. One of the most valuable outcomes was clarity on how the store’s brand positioning could guide the design of new experiences. The teams knew that their story would always be “better value than the shopper expected, delivered in a friendly way.” That meant warm visuals and messaging on the company’s Web site and across various media to reinforce the story of value to the customer. And the teams explored new ways social media could help customers show off the value they received.

Out of the work came not only a shared, company-wide sense of the decision journeys of consumers but also immediate buy-in to a wide range of initiatives that could boost market share. These initiatives are on track to provide an 8 percent sales lift above what the existing plan envisioned and were implemented more quickly because of the management team’s shared sense of engagement.

Making data and discovery a nonstop cycle

To win over on-demand customers, you must know them, what they expect, and what works with them, and then have the ability to reach them with the right kind of interaction. Data lie at the heart of efforts to build that understanding—data to define and contextualize trends, data to measure the effectiveness of activities and investments at key points in the consumer decision journey, and data to understand how and why individuals move along those journeys. To realize that potential, companies need three distinct data lenses.

Telescope. A clear view of the broad trends in your market, category, and brand is essential. Digital sources that track what people are looking for (search), what people are saying (social monitoring), and what people are doing (tracking online, mobile, and in-store activities) represent rivers of input providing constant warning signs of trouble or signals of latent opportunity. Many companies are drowning in reports from vendors providing these types of information tools, yet few have much clarity on which things they need to look for and who needs to know what.

One packaged-goods company got a jump on competitors when it saw a spike in online conversations about the lack of natural ingredients in shampoos and then recognized a corresponding rise in search inquiries on the subject. A new line of natural hair care products, launched at record-breaking speed, has become a successful early mover in a growing segment. A telecommunications company has become similarly plugged in: it now has a war room to track every online comment anywhere. Besides being better able to address—in an open, friendly, and fast way—problems that could escalate, it now has a great frontline source of line-outage signals that trigger repair crews and increases in call-center capacity.

Binoculars. Against this backdrop of market activity, few companies have a complete, integrated picture of where they spend their money, which interactions actually happen, and what their outcomes are. Most direct-sales companies (retailers, banks, travel services) measure the performance of their spending through isolated last-attribution analyses that look narrowly at what consumers do after confronting a search link, an e-mail, or an advertisement. Branded-goods companies try to throw all of their media spending together into an econometric model assessing the effects of their media mix. In the world of on-demand marketing, where multiple interactions take place along multiple journeys, last-action attribution explains only part of the impact of media spending, and media-mix models fail to account for touches and costs outside of paid channels.

What’s next? Deploying tools that rapidly assemble databases of every customer contact with a brand, companies will need to push every customer-facing function to work together and form an integrated view of consumer decision journeys. With longitudinal pictures of customers’ touches and their outcomes, companies can model total costs per action, find the most effective decision-journey patterns, and spot points of leakage. As more contacts become digitized—and they will—the data will gradually get easier to create. Getting a head start can help companies build ongoing test labs where they tune the ability to create and analyze the right data and immediately learn where to add investments. One bank has already realized millions of dollars in added value from the knowledge that weak points in the customer on-boarding process were undermining major marketing programs. Only when branches, call centers, and marketing worked together could the bank find the right fixes, improve customer satisfaction, and raise marketing’s return on investment.

Microscope. Trust is essential, and personalization can show customers they matter. They expect a brand to be a good steward and user of data about them and, increasingly, have high expectations for what a brand should know. In the example described earlier, data about Diane powers the brand’s ability to make it easy for her to share photographs, to buy a headset, to set up and manage a free Spotify subscription, to receive information about a local event, to be recognized at it, and to get additional special offers. Information about Diane is the thread that keeps all of her brand interactions immediate (now), valuable (can I), relevant (for me), and easy (simply).

Yet given the laser focus on getting programs into the market to improve performance, few marketers (or even line executives) have stepped back and pulled their teams together to work through the scenarios and customer-data models they will now need to build. Even fewer have a strong sense of what the current plans of the company’s IT department will deliver in which time frame. One company that addressed these issues has identified over 20 types of consumer decision journeys as archetypes of experiences it must support over the next three years. From those decision journeys, it has derived a core set of information capabilities it will need to build and is well down a tight road map of development that has already enabled it to launch products in breakthrough ways.

Delivering with new skills and processes

To deliver these new experiences, executive teams must rethink the role and structure of the marketing organization and how it engages with other functions. The changes are likely to cut deeply, transforming the way companies manage campaigns and communities, measure performance, provide customer support, and interact with outside agencies. It’s still early days, but consider the breadth of recent efforts.

Raising a consumer-packaged-goods company’s digital game. A European CPG company started by creating a digital-analytics group with worldwide operations. Rather than sprinkle digital experts across the globe, the company developed a unified structure with common standards for roles, common training, and digital career tracks to build an arsenal of future talent. The analytics team is part of a broader digital center of excellence that provides service support to the business units and drives major upgrades in IT capabilities. Defined commitments from managers in finance, legal, and HR help the center deal with challenges that arise as it seeks to offer customers a richer digital experience.

The company also reviewed all of its e-commerce trade accounts and decided that it needed a much more granular approach to serving customers. Says one executive, “It is not just an issue of managing our relationship with pure-play e-commerce sellers versus our traditional channels; it also is an issue of managing the online versus brick-and-mortar sides of the same traditional partner.” A new e-commerce trade team with added digital-analytic support is helping both to enhance the online-merchandising mix and to improve the placement of the company’s products in the search engines of e-commerce providers.

Finally, marketing leaders established a novel customer-relationship-management (CRM) team because they realized that the growth of the company’s mobile services, coupon programs, sampling, and social communities was finally enabling it to gather huge amounts of direct data about how people interacted with its brands. (That information had previously been available only to retailers.) These structural and talent changes led the company to realize that it needed to reshuffle its agency relationships, replacing a single brand-and-ad agency with two agencies—one for brand programs, the other for digital and CRM direct marketing. The company also brought more media and digital analytics in-house.

Reorienting a bank. At one institution, a new understanding of emerging brand challenges led to a radical change in the status of the CMO. Marketing had earlier ranked low in this sales-driven organization, where the function’s leaders focused mostly on corporate communications and brand campaigns. Now, a new CMO, much closer to her peers on the executive board, has been charged with directing the full consumer experience.

Each month, the bank’s business-unit leaders gather to talk about their progress in improving different consumer decision journeys. As new products and campaigns are launched, these executives place a laminated card of such a journey at the center of a conference-room table. They discuss assumptions across the whole flow of the journey for different consumer segments and how various groups across functions should contribute to the campaign. Where should customer data be captured and reused later? How will the campaign flow from mass media to social media and to the bank’s Web site? What is the follow-up experience once a customer sets up an account?

The bank has created a corporate center of excellence for digital marketing to give the strategy a forward tilt and to plan for needed capabilities. It has also appointed a new team of full-time executives who focus on mobile and social technologies—executives who have become evangelists, helping business units to raise their digital game along a range of consumer interactions. The first wave of fixes and new programs has already generated tens of millions of dollars in the first six months, and the bank expects these efforts to add more than $100 million to its annual margins.

The forces enabling consumers to expect fulfillment on demand are unstoppable. Across the entire consumer decision journey, every touch is a brand experience, and those touches just keep multiplying in number. To mobilize for the on-demand challenges ahead, companies must:

  • bring managers together from across the business to understand consumers’ decision journeys, to speculate about where they may lead, and to design experiences that will meet the consumer’s demands (NowCan IFor me, andSimply)
  • align the executive team around an explicit end-to-end data strategy across trends, performance, and people
  • challenge the delivery processes behind every touch point—are the processes making the best use of your data and interaction opportunities and are they appropriately tailored to the speed required and to expectations about your brand?

Executive recruiters tell us that corporate boards are looking for more people who can challenge and improve a company’s approach to social media, big data, and the customer experience. Staying ahead of the design, data, and delivery requirements of on-demand customers is much more than a marketing issue—it will be a crucial basis for future competitive advantage.

Interview: How militaries learn and adapt: An interview with Major General H. R. McMaster

An experienced combat commander and leading expert on training and doctrine assesses recent military history and its implications for the future.

Major General Herbert Raymond (H. R.) McMaster is the commander of the US Army Maneuver Center of Excellence at Fort Benning, Georgia. A facility for military training, doctrine, and leadership development, the center works with forces that specialize in defeating enemies through a combination of fire, maneuver, and combat and then conducting security operations to consolidate those gains. In a December 2012 interview with McKinsey’s Andrew Erdmann, General McMaster talks about how the US Army has evolved, how war itself has—or hasn’t—changed, what we have learned from the wars in Afghanistan and Iraq, and what the Army must do to prepare the next generation of leaders and soldiers for warfare in the future.

McKinsey on Government: Your experience in combat has ranged from the last great tank battle of the 20th century—the Battle of 73 Easting in February 1991—to counterinsurgency in Tal Afar, Iraq, to fighting corruption in Afghanistan with Combined Joint Interagency Task Force Shafafiyat from 2010 to 2012. Looking back on nearly 30 years in the military, what has changed, and how have you adapted?

H. R. McMaster: I think the biggest surprise has been the broadening of the range of conflicts we’ve found ourselves in since I first entered the Army in the 1980s. Obviously, there was a lot of instability during the Cold War, but there was also a certain degree of predictability. The primary mission of our armed forces at that time was to deter aggression by the Soviet Union and its allies. Today, that’s no longer the case. We now need a much wider range of capabilities, including the ability to operate in complex conflicts that require the close integration of military, political, and economic-development efforts.

One great feature of the Army is that it gives us the opportunity not only to have very intense formative experiences but also, consistent with the adult-learning model, to reflect on those experiences and prepare for the next level of responsibility. This type of learning is what helps us gain the breadth and depth of knowledge that allows us to adapt to unforeseen challenges and circumstances.

McKinsey on Government: You are a scholar of military history. How has your study of military history influenced your career?

H. R. McMaster: I think the study of military history has been the most important preparation for every position I’ve had in the last 12 years or so. It’s important to study and understand your responsibilities within any profession, but it’s particularly important for military officers to read, think, discuss, and write about the problem of war and warfare so they can understand not just the changes in the character of warfare but also the continuities. That type of understanding is what helps you adapt.

I think the American tendency—and I’m sure this is often the case in business as well—is to emphasize change over continuity. We’re so enamored of technological advancements that we fail to think about how to best apply those technologies to what we’re trying to achieve. This can mask some very important continuities in the nature of war and their implications for our responsibilities as officers.

The study of military history helps identify not only these continuities but also their application to the current and future problems of war and warfare. This type of study helps us make a grounded projection into the future based on an understanding of the past. It helps us reason by historical analogy while also understanding the complexity and uniqueness of historical events and circumstances. This is what Carl von Clausewitz believed: that military theory will serve its purpose when it allows us to take what seems fused and break it down into its constituent elements.

As one of my favorite military historians, Sir Michael Howard, suggested, you have to study history to get its analytic power in width, in depth, and in context: in width, to see change over time; in depth, by looking at specific campaigns and battles to understand the complex causality of events that created them; and then in the context of politics, policy, and diplomacy. Studying history is invaluable in preparing our officers for their future responsibilities.

McKinsey on Government: You mentioned the continuities of war. What are some examples of things that remain unchanged?

H. R. McMaster: First, war is still an extension of politics and policy. I think we saw that both in Iraq and Afghanistan; we initially failed to think through a sustainable political outcome that would be consistent with our vital interests, and it complicated both of those wars.

Second, war is an inherently human endeavor. In the 1990s, everyone was quoting Moore’s law and thought it would revolutionize war. We saw this in some of the language associated with the “revolution in military affairs” and “defense transformation.” We assumed that advances in information, surveillance technology, technical-intelligence collection, automated decision-making tools, and so on were going to make war fast, cheap, efficient, and relatively risk free—that technology would lift the fog of war and make warfare essentially a targeting exercise, in which we gain visibility on enemy organizations and strike those organizations from a safe distance. But that’s not true, of course.

This links closely to another continuity of war—war is not linear, and chance plays a large role.

One other continuity is that war is a contest of wills between determined enemies. We often operate effectively on the physical battleground but not on the psychological battleground. We fail to communicate our resolve. I think, for example, the reason the Taliban regime collapsed in 2001 is largely because every Afghan was convinced it was inevitable. But much of what we have done since then—at least, as perceived by Afghans—raises doubts about our long-term intentions. This is not a criticism of policy. Rather, it highlights the need for us to be cognizant that war is a contest of wills.

Finally, we often start by determining the resources we want to commit or what is palatable from a political standpoint. We confuse activity with progress, and that’s always dangerous, especially in war. In reality, we should first define the objective, compare it with the current state, and then work backward: what is the nature of this conflict? What are the obstacles to progress, and how do we overcome them? What are the opportunities, and how do we exploit them? What resources do we need to accomplish our goals? The confusion of activity with progress is one final continuity in the nature of warfare that we must always remember.

McKinsey on Government: What have been the Army’s greatest successes in organizational adaptation during the past 25 years? What are some of the enduring challenges, and how might those be overcome?

H. R. McMaster: The wars in Iraq and Afghanistan were not at all what we had anticipated—they weren’t fast, cheap, or efficient. They were extremely complicated politically, and they demanded sustained commitment, as well as the integration of multiple elements of national power. But I think once we confronted the realities of those wars and realized the kinds of mistakes we had made, we adapted very well from the bottom up. That goes against what has emerged as the conventional wisdom about the war, but I think it’s true.

The challenge now is to get better at deep institutional learning. This is what you’ll hear people in the US military call DOTMLPF, meaning changes in doctrine, organization, training, material, leadership and education, personnel, and facilities. We need the kinds of integrated solutions that acknowledge the complex nature of the environments in which we are working and that take into account the determined, adaptive, and often brutal nature of our enemies. In this context, our doctrine is still catching up. We have the counterinsurgency manual, the stability-operations manual, and the security-force-assistance manual, but I don’t think we have put the politics at the center of those manuals.1 So, for example, we assume in our doctrine that the challenges associated with developing indigenous security forces are mainly about building capacity, when, in fact, they’re about trying to develop institutions that can survive and that will operate in a way that is at least congruent with our interests.

What’s going to be really important for the Army, and for our military in general, is what we’ve learned from the past 12 years of war. We need to use what we’ve learned to make a grounded projection into the near future and to inform our understanding of the problem of future armed conflict. Once we understand that problem, we then need to reshape our doctrine, educate our leaders, conduct the necessary training, develop combat capabilities, and design the right evolutions within our organization. To do so, we need to put aside narrow, parochial interests and avoid slipping back into our enamorment with exclusively technological solutions to the problem of future war.

McKinsey on Government: How do you think our land forces will evolve, and what do you see as the greatest challenges to the US Army’s future success?

H. R. McMaster: There’s no single greatest challenge to the Army’s future success. We are facing a broad range of challenges and emerging enemy capabilities, which will increasingly involve technological countermeasures. Our enemies will try to disrupt our ability to communicate by going after our networks, for example. We have to be prepared to counter those types of attacks, and we have to build redundancy into our forces so that we can operate if our capabilities are degraded.

Ultimately, all the threats to our national security are land based. We therefore have to be prepared to operate in a broad range of physical environments and terrains. To do that, we need to retain combined-arms capabilities and indirect-fire capabilities, as well as access to our Air Force, Navy, and our engineers—together, they give us freedom of movement and action.

One challenge we are seeing more frequently is state support for proxy forces, or nonstate organizations that have many of the capabilities that were once associated only with nation-states. For example, Hezbollah has antitank capabilities, mines, and roadside bombs. It has missiles and rockets, and it has weaponized unmanned aerial vehicles. We will need to continue to defeat nations that threaten our interests, but more and more, we also have to deal with proxy forces or networked enemy organizations that have the kinds of advanced capabilities once held only by nation-states.

But rather than picking certain countries or certain areas, we have to look more broadly at our enemies’ emerging capabilities. We know that our enemies are going to employ traditional countermeasures: dispersion, concealment, intermingling with civilian populations, deception. We know that the application of nanotechnologies is going to reduce the signature of these forces, which means we’re going to have to fight for information in close contact with enemy organizations and with civilian populations. The enemy can’t beat us on the open battleground, so they’re going to operate in restrictive terrain or urban areas. How we fight in cities is going to be important. We’re going to need to maintain our mobility, our engineer capability, and our ability to defeat shoulder-fired antiaircraft weapon systems. We also see emerging longer-range rocket and missile capabilities, as well as chemical weapons and other weapons of mass destruction.

McKinsey on Government: The US Army today has a deeply experienced, battle-tested corps of officers and noncommissioned officers. What are the essential qualities of Army leaders in the next 10 to 20 years?

H. R. McMaster: At the Maneuver Center, we’re working on a strategy that identifies what competencies our leaders need and then looks at how, where, and at what point in their careers we train and educate them. The “how” increasingly involves cutting-edge technologies that allow us to offer more effective distance learning and collaboration between leaders. We also want to cultivate within our leaders a desire for lifelong learning and to provide them with the tools necessary for informal self-study and collaborative study across their careers. (For more, see sidebar, “A reading list for military professionals.”)

First and foremost, we need leaders who can adapt and innovate. As Sir Michael Howard has said—and I’m paraphrasing—we’re never going to get the problem of future war precisely right. The key is to not be so far off the mark that you can’t adapt once the real demands of combat reveal themselves, and you need leaders who can adapt rapidly to unforeseen circumstances. They need to be able retain the initiative as well as sustain the types of campaigns that require a broad range of capabilities—rule of law, development of indigenous forces, and military support for governance, for example.

The human dimension of war is immensely important for the Army as well; we need leaders who are morally, ethically, and psychologically prepared for combat and who understand why breakdowns in morals and ethics occur. In The Face of Battle, John Keegan said that “it is towards the disintegration of human groups that battle is directed.”2 So how do you protect organizations against that kind of disintegration? I think there are usually four causes of breakdowns in moral character—ignorance, uncertainty, fear, or combat trauma. It is important to understand the effects of those four factors on an organization and then educate soldiers about what we expect of them. We need leaders who have physical and mental courage on the battlefield, of course, but also the courage to speak their minds and offer respectful and candid feedback to their superiors. Our leaders can’t feel compelled to tell their bosses what they want to hear.

McKinsey on Government: What about our soldiers? How are we helping them learn?

H. R. McMaster: What’s great about soldiers who join the Army is that they expect it to be hard, and they’re disappointed if it’s not. They want to be challenged. This is a self-selecting, highly motivated group of people. Soldiers tend to define themselves based on other people’s expectations of them, and we have to keep those expectations high.

As with our leaders, we need our soldiers to be able to adapt. At the Maneuver Center, we immerse our soldiers in complex environments, and as we train them on fundamentals, we also test their ability to observe changes in the environment and to adjust as necessary so they can accomplish their mission. We call this “outcome-based training and evaluation.” Rather than using a checklist of individual capabilities, we are evaluating them on their ability to innovate and adapt to unforeseen conditions. We’re trying to build into our training the kinds of things soldiers encounter in combat—uncertainty, bad information, and casualties, for example. Before we would say, “Go to point A and wait for instructions.” Now we’ll say, “You have to get to five or six points in the amount of time you have available—you pick which order you want to do it in.” This means they have to analyze the terrain, the routes between the points, and the sequencing of the points themselves.

In addition to the fundamentals of combat, our soldiers really have to live the Army’s professional ethics and values. They must be committed to selfless service, to their fellow soldiers, to their mission, and to our nation. That also involves, obviously, respect for and protection of our Constitution and understanding their role in that context. They also need to understand the environments they’re operating in. For example, we’re dealing with a wartime narcotics economy, essentially, in Afghanistan; that’s a big driver of the conflict there. We need to educate our soldiers about the nature of the microconflicts they are a part of and ensure that they understand the social, cultural, and political dynamics at work within the populations where these wars are fought.

Our soldiers also have to recognize how being in persistent danger can affect organizations and be able to identify warning signs. They have to be good at grief work and be able to support one another when they lose a fellow soldier. This can’t be achieved through standard training alone—this has to be done through reading, thinking, and discussing as well.

McKinsey on Government: When you think about future conflict, how does the ability to work well with allies and partners fit into the equation?

H. R. McMaster: I think it’s immensely important that we’re adept at working as part of multinational teams. Transnational terrorist organizations use mass murder of innocent people as their principal tactic, and so they are a threat to all civilized people; we have to work together to defeat those threats. Terrorist organizations use the complex cultural-political dynamics of microlocal conflicts to their benefit. They use ignorance to foment hatred, and then they use that hatred to justify violence against innocent people. They pit communities against one another, and then they portray themselves as patrons and protectors of one of the parties in the conflict. You can see it in Mali, in northern Nigeria, and in Yemen. And you certainly see it in Syria, in what is becoming a humanitarian crisis of colossal scale. You can also see it along the border between the predominantly Kurdish and Arab regions in Iraq, in Afghanistan, and in portions of Pakistan.

I think we’re always going to have to operate as part of a multinational force. To do so, we have to understand the history and the culture of each of these conflicts and of the microconflicts in each subregion. Obviously, our multinational partners are invaluable for their perspectives, but we also need strong partnerships with indigenous leaders. As in business, we need negotiation competencies and the ability to map stakeholder interests in particular. When we’re partnering with somebody we need to understand several things: their interests, how they align with our interests, how to build relationships based on mutual trust and common purpose, and how to use those relationships to work together to accomplish the mission.

Printed with permission from McKinsey Insights & Publications

Strategy, scenarios, and the global shift in defense power

As the strategic landscape shifts, an economic-scenario approach can help defense organizations grapple with uncertainty.

The art of strategy, in defense as elsewhere, involves understanding possible futures to inform present decisions. Change, volatility, and uncertainty are perennial challenges to the defense strategist and are likely to increase in the coming years. Formulating strategy in these conditions will test planners in the public and private sectors alike.

To succeed, decision makers should look behind the headlines of the day to ask the right questions about what will affect their organization in the future. This requires considering the deeper underlying trends that will reshape the strategic landscape in the years ahead. Foremost among them is the shift in global economic power. Although often commented upon by economists and pundits, many strategists focused on defense issues have not fully internalized this historic shift and its implications.

Here we offer a perspective on how strategists in defense organizations and aerospace and defense companies should approach this challenge. First, we describe how the profound shift in economic power since the end of the Cold War has already reshaped the world’s strategic landscape, including the distribution of global defense spending. The potential evolution of these economic dynamics is fundamental to strategy. Predicting their future is, of course, impossible. Instead, we offer something more modest and practical: a new approach to scenario planning that is rooted in a deep understanding of global economics. Such an understanding reveals the potential for unexpected scale and pace in the shift of defense spending from the United States and its treaty allies to emerging economies.

The strategic landscape reshaped, 1991-2012

The past 20 years saw dramatic changes on the battlefield, even as some features endured, and the beginnings of an equally dramatic shift in economic power. In combination, these movements have altered the strategic landscape, and provide a glimpse into the future.

Continuity and change in military operations

For the world’s defense and security organizations, history certainly did not end with the collapse of the Soviet Union and the cessation of the Cold War in 1991. We have since seen conflict on almost every continent, from the last major tank battle of the 20th century at 73 Easting in the Gulf War to numerous wars, clashes, and insurgencies in Europe, Asia, Africa, and the Americas. Since the attacks of September 11, 2001, attention has focused on the greater Middle East—Afghanistan, Iraq, and, increasingly, the struggles for control and influence in the aftermath of the Arab Spring.

The tempo of military operations has been relentless. Since 1991, for instance, the United States has embarked upon a new military intervention roughly every two years. North Atlantic Treaty Organization (NATO) forces have been at war in Afghanistan for over a decade. South Korean and Japanese forces have deployed for the first time to the Middle East. Meanwhile, the United Nations has launched a new peacekeeping operation every six months. Moreover, the duration of most of these operations has increased to five to ten years.

Innovations in military technology and operations have marked these past two decades of conflict. Precision-guided munitions have evolved and demonstrated their effectiveness in conflicts beginning with the Gulf War and continuing in Kosovo, Afghanistan, and most recently NATO’s Operation Unified Protector in Libya in 2011. Advanced missiles now pose particular threats to capital ships and fixed bases. Unmanned aerial vehicles (or remotely piloted air systems) are now standard components in many militaries’ intelligence, surveillance, and reconnaissance (ISR) tool kits, and they increasingly serve as weapons platforms as well. Harnessing big data and employing advanced analytic techniques are other features of 21st century ISR. Cyberwarfare has moved from theory to practice.

Militaries today confront adversaries who employ a full spectrum of tactics, from conventional to irregular and even criminal (“hybrid war”). Modern navies, for instance, cope with traditional and unconventional foes, including Somali pirates and asymmetrical threats such as terrorist suicide speedboats. Air forces are investing in fifth-generation fighters even as they continue to provide workhorse logistical support for operations in the field. And for foot soldiers, despite the numerous technical advances in communications and equipment, the past decade has been largely spent relearning the lessons of counterinsurgency: “Walk. Stop by, don’t drive by. . . .Situational awareness can only be gained by interacting face-to-face, not separated by ballistic glass or Oakleys.” Plus ça change, plus c’est la même chose.

The power shift begins

Concurrent with these tactical and operational developments, tectonic plates moved at a deeper strategic level. A profound shift in economic power began during this period—one that has already manifested itself in the distribution of traditional “hard” military power among the great powers. This shift will continue to reshape the strategic landscape in the years ahead.

Future historians will likely point to 2007–08 as an inflection point in global history. For the first time in over two centuries—since the start of the Industrial Revolution—the majority of the world’s economic growth took place in the developing world, driven in large part by China, India, and other Asian economies. In addition to favorable demographics and reforms to open emerging economies, increasing urbanization—especially in China—drove much of this growth. Significantly, 2008 was also the first time ever that a majority of people lived in cities. The pace of urbanization is staggering. More than 1.3 million people migrate every week to urban areas. And this historic migration will likely continue unabated for the next two decades, mainly in the emerging economies of Asia, Latin America, and, increasingly, Africa. The global economic crisis that began in 2008 accelerated this shift in economic power from developing to emerging economies, as the BRIC countries (Brazil, Russia, India, and China) weathered the storm well and the developed economies of the United States, Europe, and Japan suffered and remain vulnerable more than four years later. Between 2009 and 2012, China’s economy grew over 30 percent and India’s 22 percent in real terms, whereas Germany’s grew 7.9 percent and the United States’s 7.1 percent. And in 2008, for the first time, a Chinese company led the world in international patent applications.

Taken together, economic and demographic forces drove the most rapid shift in human history in what the McKinsey Global Institute (MGI) calls the “economic center of gravity”—the geographic midpoint of global economic activity (Exhibit 1). MGI projects this movement to continue, at a slightly slower pace, for the next 15 years or so, when, by this measure, most of the regional imbalances ushered in by the Industrial Revolution will have been erased.

Exhibit 1

The ten years from 2000 to 2010 saw the fastest-ever shift in the world’s economic center of gravity.

These economic trends have already started to reshape the global landscape of defense spending. To be sure, a nation’s assessment of its security threats plays a critical role in shaping its defense spending in the near term. That said, a major country’s military power flows in large part from its underlying economic strength over the medium to long term: the faster a country’s economy grows, the more likely its defense spending will increase as well. Despite widely different geopolitical complexities and economic dynamics, the countries with the largest defense budgets, which account for the vast majority of the world’s defense expenditures, have fit this pattern since 1991 (Exhibit 2).

Exhibit 2

Growth in military spending and GDP are correlated over the long term.

Other more subtle shifts in national power were also taking place between 1991 and 2011. R&D expenditures in all major economies nearly doubled in constant 2011 dollar terms, rising from roughly $740 billion in 1991 to $1.5 trillion in 2011. But just as we saw in defense spending, countries’ R&D investments mirrored trends in their overall economic growth. Europe and Japan’s combined share of global R&D expenditures declined by 11 percent in the 20 years after 1991. Meanwhile, China increased its share of global spending to 9 percent from 1 percent during the same period. Developing countries are thus emerging as true competitors to the developed economies not only with regard to their economies’ sheer scale but also their innovation and technical prowess. R&D spending matters: a country’s R&D investments are strongly correlated with the quality of the military’s equipment 25 years later. This suggests that in the future, developing countries will narrow the gap in quality between their military equipment and that of developed countries.

Glimpses of the future

We have seen these dynamics play out around the world since 1991. Sustained operations and the increasing costs of modern weapons platforms have proved too much for many Western governments and their publics as they manage the aftermath of the global economic crisis and structural strains in their aging societies. For example, the United Kingdom’s 2010 Defence and Security Review declared bluntly that its “inherited defense spending plans… [are] completely unaffordable” and that it needs to “confront the legacy of overstretch.” France’s earlier national-security review analyzed the changing strategic context and new priorities and thus, through a different logic, reached similar conclusions. The US Department of Defense (DOD), under Secretary of Defense Robert Gates, launched its own efficiencies campaign, which has accelerated under his successors. The planned reductions in the US defense budget in the next decade are literally on the scale of some countries’ GDPs. Other Western militaries are undergoing similar retrenchments. At the same time, however, China, other East Asian countries, India, Brazil, and other emerging economies have continued to increase not only their defense expenditures in real terms, as shown in Exhibit 3, but also, in many cases, the sophistication of their own defense industries.


Exhibit 3

Developing countries have closed the gap in defense spending since the end of the Cold War.


Today, the United States remains the world’s preeminent military power in scale, sophistication, battle-tested experience, and global reach. US defense spending in 2011 was more than five times that of the next highest defense spender, China. America’s traditional allies also occupy important positions in the global defense landscape. Japan, France, and the United Kingdom ranked third, fourth, and fifth in defense spending in 2011. The momentum, however, is unmistakable: emerging economies are positioned to displace the other developed economies in the top tier of defense spenders. China’s rise in defense spending is starkest. In 2011 it spent $126 billion, more than twice as much as the countries that are the next largest spenders: Japan, France, the United Kingdom, and Russia. Chinese authorities announced in March 2013 that they plan to increase defense spending another 10.7 percent in 2013.

The direction is clear. Developed economies—and the world’s leading military establishments historically—have experienced relative decline vis-à-vis the major developing economies since 1991. Yet the scale, scope, and pace of change of the shift in economic power cannot be simply extrapolated from the recent past to understand the future. Instead, strategists will require a new approach to manage this era’s particular strategic uncertainties.

An economic-scenario approach

Scenario planning is an established tool for business and defense strategists. Done right, scenario planning accounts for the major variables or drivers that could shape the future, in sufficient depth and vividness to enable strategists to draw out potential implications for the strategy and plans of their organizations. Scenarios are not meant to be predictive or comprehensive, covering all possible futures. Rather, the goals are to define a range of possibilities and identify important continuities among them, as well as significant uncertainties or risks that a strategy should address. Such an analysis, in turn, helps to frame critical questions and generate strategic insights that then shape the strategic decisions of today and adaptation tomorrow.

Today, defense scenarios typically start with geopolitical, security, or more operational assumptions or with a statement of guiding objectives (such as “Counter violent extremism, deter and defeat aggression, strengthen international and regional security, and shape the future force”; “US forces must be prepared to fight ‘two and a half’ wars simultaneously”; or “Blue Force must be ready to counter Red Force in country X”). For example, the US DOD’s recent strategy documents—the February 2010 Quadrennial Defense Review Report and the February 2011 National Military Strategy of the United States—briefly review the changing strategic environment but do not offer alternative scenarios. The importance of this era’s economic forces, however, suggests that a different approach, one with a more explicit grounding in these new economic realities, is needed. National-security strategies typically do not explore the full implications of the shift in economic power now under way. The approach outlined here is designed to address this gap. The development of rich, sophisticated scenarios for the future course of the global economy provides its starting point. These scenarios, in turn, enable the mapping of changes in countries’ economic power in relative and absolute terms. The trends most immediately relevant for defense and security organizations—especially levels of defense spending and R&D investment—are then built upon these economic foundations.

We use a set of economic scenarios for the next decade built with McKinsey’s Global Growth Model (GGM) to illustrate this approach. The GGM is a database and modeling tool that supports the construction of detailed economic scenarios down to the country level. Its variables span GDP and more than 100 others, including demographics, education levels, public debt, R&D investments, and urbanization rates.

The baseline economic scenarios employed here are predicated on the assumption that major developed and emerging economies will develop with different growth rates—namely, developing economies will tend to grow at a significantly higher rate than developed economies. We emphasize these different outcomes and groups because, broadly speaking, the challenges faced by countries in each group are similar. Generally, advanced economies have struggled not only with the aftermath of the 2008 downturn but also with meeting their aging populations’ multifaceted challenges. Meanwhile, emerging markets have tried to sustain or accelerate growth through export promotion, the allocation of capital, continued economic reform, urbanization and industrialization, and other tactics.

The relative performance of these different groups of economies thus describes a range of four principal scenarios. The GGM scenarios are bounded by emerging markets’ growth rates (between 3 and 7 percent per year from 2013 to 2022) and advanced economies’ growth at 1 to 3 percent annually. These growth rates define four broad-based scenarios shown in Exhibit 4: Global Growth Renewed, Advanced Economies Rebound, Emerging Economies Lead, and Global Lost Decade.


Exhibit 4

Four scenarios describe possible paths for the global economy from 2013 to 2022.


Together, these scenarios portray different potential future international landscapes and balances of economic power among the major economies. They make clear that the stakes are extraordinarily high for the health of the entire global economy. While growth continues across all scenarios, the difference in total global real GDP between the most favorable scenario ($100 trillion, under Global Growth Renewed) and the least favorable one ($84.5 trillion, under Global Lost Decade) is a staggering $15 trillion per year in 2022. That is roughly equivalent to the US economy today.

The scenarios also have quite different outcomes for the relative distribution of economic power among countries. Across all scenarios, the US economy remains the world’s largest economy. China’s rapid growth continues, but by 2022, it still does not equal the size of the US economy today. The absolute gap between the two narrows more or less depending on the scenario. The other major developing economies follow a similar pattern; Europe and Japan experience steady growth in the most favorable scenarios and stagnation in those that are less favorable.

Defense-spending scenarios to 2022

The four baseline economic scenarios paint very different possible futures for the world’s major economies—and thus for their self-confidence, internal political stability, and the vision of their roles internationally. Geopolitical relations (for example, strains among past allies over burden sharing or opportunities for new alignments among rising powers) would also vary under the different scenarios.

To understand these implications, we analyzed global defense spending under the economic scenarios. We focus our analysis on the top 15 defense spenders in 2011. These countries account for the lion’s share of global defense spending under any scenario (that is, nearly 85 percent in 2011) for the sake of simplicity. As mentioned, growth in countries’ defense spending is strongly correlated (r-squared equals 0.84) with their underlying economic growth over longer periods of time. Therefore, we use each scenario’s estimate of countries’ real GDP and a country-specific correlation between defense spending and GDP to derive the percentage of each nation’s real GDP devoted to defense spending in 2022 under each scenario.

The likely changes in countries’ relative share of global defense spending between 2011 and 2022 are striking (Exhibit 5). If we divide the 15 countries studied into the United States and its 9 treaty allies, and the emerging BRIC countries and Saudi Arabia, we see that while the US and its allies still account for the majority of defense spending in all scenarios in 2022, their relative advantage is eroded in all scenarios by emerging markets’ higher rates of economic growth. Most dramatically, in the Emerging Economies Lead scenario, the United States and its treaty allies’ relative advantage in global share of defense spending falls by 23 percentage points in a decade, dropping to 55 percent by 2022.

Exhibit 5

A substantial share of global defense spending will shift away from the United States and its traditional allies.

The scenarios likewise suggest dramatic shifts in defense spending in absolute terms. Defense spending in the BRIC countries and Saudi Arabia will increase significantly in all scenarios—from roughly $290 billion in 2011 to between approximately $550 billion and $830 billion by 2022 (in constant 2011 dollars). The fate of the United States and its major treaty allies’ defense spending is mixed, however. When the major developed economies fare well, their combined defense spending increases from a little over $1 trillion in 2011 to more than $1.4 trillion in 2022; when they fare poorly, in the Global Lost Decade and Emerging Economies Lead scenarios, their combined defense spending falls below $1 trillion by 2022.

Exploring these scenarios for individual countries again shows shifts in defense spending away from the developed economies. Consider the top five defense spenders in each scenario (Exhibit 6). The United States and China maintain their one-two positions in total defense spending in all scenarios. In those scenarios in which US economic growth remains sluggish throughout the coming decade, its defense spending falls more than 15 percent in real terms. The United States’s relative advantage in defense spending over China, however, declines significantly from 5.4x in 2011 to between 3.2x and 1.6x in 2022. India enters the ranks of the world’s top five defense spenders in all scenarios (see “A bright future for India’s defense industry?” [PDF–417KB]). Russia and Saudi Arabia round out the top five defense spenders in three of the four scenarios. Only in the Advanced Economies Rebound scenario do France and the United Kingdom—two of the US treaty partners—remain in the top five.

Exhibit 6

The difference between the two biggest defense spenders varies widely by scenario.

Considering total R&D investments across the different countries provides a rough measure of the dynamism of high-technology industries and innovation, and, as noted above, an indication of long-term trends in the quality of the military equipment the country makes (Exhibit 7).


Exhibit 7

The combined European, Japanese, and US share of global R&D investment will shrink in any scenario.


Our scenarios show overall R&D investments tracking the trends seen in defense spending but at different rates. The United States retains its leadership position but by less than before, as emerging economies gain ground on the United States and its traditional allies. Most important, China’s investments in R&D accelerate in the next ten years; in all scenarios, China more than doubles its share of global R&D investment. In the coming decade, we should expect China to place second only to the United States in total R&D investments, just as it became the world’s second-biggest defense spender in the previous decade. China’s rise in R&D is stunning: in all scenarios, it will increase its share of global R&D from roughly $1 of every $100 in 1991 to $1 of $5 spent in 2022. In doing so, it surpasses both Europe and Japan; their investments grow slowly in all scenarios. That said, Europe and Japan will remain major centers of global R&D into the 2020s because of their relatively robust starting point. Meanwhile, Brazil, India, and Russia also gain share, though at a much slower pace than China, and they will continue to lag behind Europe and Japan by a significant margin in 2022 (for example, Japan’s R&D spending will remain roughly five times India’s across the scenarios).

This economic-scenario approach enables strategists to assess other underlying factors should a particular analysis require it. These include public-debt burdens (for instance, high for most developed economies, with exceptions such as Australia), subtle variations among some countries’ relative performance (for example, South Korea consistently punches above its weight with regard to defense spending and R&D), education levels (for instance, other countries continue to narrow the US lead in average number of years of education per person), and demographic trends.

From using scenarios to framing the right question

Decision makers in ministries of defense and corporate boardrooms require analytic tools to help them manage uncertainties. Without them, they risk falling prey to misguided confidence in a single, clear, but almost certainly erroneous prediction of the future, or they will be forced to rely on their gut. The economic-scenario approach outlined here is one such tool for the strategist’s tool kit.

The economic-scenario approach highlights how the global strategic landscape may change in the coming decade. Such scenarios can help organizations identify the specific potential opportunities, risks, trade-offs, and outcomes that their strategies should consider. From a defense official’s perspective, such questions could include the following:

  • What does it mean for the United States when the defense spending of its traditional treaty allies will continue to decline in relative, and perhaps absolute, terms? What capabilities might these allies be able to deploy in the future? What new security relationships might be needed to manage the shifting balance of defense power? What might be the implications of such shifts for US force structure, overseas basing, and diplomacy?
  • What does it mean for European countries’ role in the world as their relative share of defense power shrinks? Will NATO’s role in the world correspondingly retract? Will NATO’s “out of area” operations become a thing of the past? Will individual European countries have effective expeditionary forces in the 2020s, or will limitations force them to decide among increased dependence on US support (for example, logistical and lift support), increased defense cooperation within Europe, and disengagement from traditional areas of influence such as Africa? What might be the implications of these different scenarios for the future affordability of independent nuclear-deterrence forces in France and the United Kingdom?
  • What does the wide range of possibilities for US defense spending in 2022 mean for Asian countries? How will such uncertainties shape their defense postures and diplomacy toward the United States, and one another?
  • What does it mean for emerging countries that for the next decade the United States will remain the global leader in military spending and R&D investments despite those countries’ rapid growth? How relevant will European powers be in their strategic calculus? What security relationships should they prioritize to cope with the shifting strategic landscape?

From an aerospace and defense executive’s perspective, such questions could include the following:

  • Which markets will matter most for a company’s growth in the next ten years? What should be the relative balance among developed and developing markets in its portfolio?
  • What does the possible emergence of India and Saudi Arabia among the world’s top five defense spenders suggest for a company’s strategic priorities?
  • How should a company manage the diversity of regulations and laws related to technology transfer, intellectual property, and local content provisions as it seeks to expand into specific developing markets? How should it manage its defense and civilian aerospace businesses in such markets in light of other diplomatic and commercial considerations? What innovative joint ventures, mergers, or other collaborations will fuel growth among aerospace and defense companies based in different countries?
  • How should a company leverage the continued robust R&D base in Europe, Japan, and the United States to serve both developed and developing aerospace and defense markets?
  • How will developing countries’ aerospace and defense industries “go global” and compete directly against more established Western players in defense markets around the world in the coming decade? What are the implications for Western companies’ strategies, operations, and costs if many systems are produced for emerging markets?
  • What should be a company’s global manufacturing footprint in light of these trends and uncertainties in the coming decade?
  • What skills and talent will a company need to succeed in the changed global defense landscape?

Asking the right questions is the starting point for any strategy. We are now living through an unprecedented shift in global economic power. No one can predict precisely what this means for our future. Robust economic scenarios, however, can help strategists frame the right questions and trade-offs for their organizations, which is more helpful than aspiring to predict that which defies prediction.

Printed with permission from McKinsey Insights & Publications.

Beyond Korean style: Shaping a new growth formula

Beginning in the 1960s, South Korea has set economic-development records with a growth formula that focused on heavy-industry and manufactured exports. GDP has tripled in just the past 20 years, and South Korea became the first nation to go from being a recipient of aid from the Organisation for Economic Co-operation and Development to being a member of its donor committee. South Korea is the leading supplier of LCD screens, memory chips, and mobile phones and is the world’s number-five automaker.

Yet the nation’s GDP growth is increasingly decoupled from the lives of its middle- income citizens. The number of middle-income households—earning 50 to 150 percent of median income—has fallen from 75.4 percent of the population to 67.5 percent since 1990, and more than half of middle-income households are cashflow constrained when the full costs of housing payments are counted. The squeeze contributes to trends that could affect future growth, including a plummeting personal-saving rate and one of the world’s lowest fertility rates. Beyond Korean style: Shaping a new growth formula, a new report from the McKinsey Global Institute (MGI), explores the causes of these economic challenges and makes specific recommendations for combatting them. Among the report’s findings:

  • South Korea’s largest industrial corporations have continued to grow rapidly, but mostly in new global markets; their domestic employment has fallen by 2 percent annually for 15 years, leaving job creation to small and medium-sized enterprises (SMEs) and Korea’s underdeveloped service sector, where wages are just 55 percent of manufacturing pay.
  • Spending on housing and education have soared (exhibit). The median price for a home in South Korea is 7.7 times the median annual income—more than twice the US multiple. South Koreans also pay much more to finance their home purchases because low loan-to-value limits often force homebuyers to seek supplemental, high-interest loans. Spending on private education is extremely high as well (around 9 percent of GDP) because South Koreans believe admission to a top university is the only path to success for their children.



Beyond Korean Style - exhibit


But South Korea can take specific steps to strengthen its middle-income households, increase domestic demand, and build a more balanced economy. Namely:

  • Reduce housing payments. By switching to mortgages with looser loan-to-value limits, MGI estimates that South Korean homeowners could save $8 billion annually in payments. South Korea can also encourage more investment in rental housing and can consider shared ownership programs.
  • End the education “arms race.” Even though Koreans continue to sacrifice to prepare their children for university, unemployment rates are higher for South Korean college graduates than for graduates of vocational high schools. And when costs are factored in, the net present value of the lifetime earnings of a privately educated college graduate is lower than those for a graduate of vocational high school. To help parents consider alternatives to a university education, MGI suggests higher investment in vocational education and expansion of the Meister school program, in which employers collaborate with schools to create job-relevant curricula. A dual-track system would enable students to continue on to college degrees as they progress in their careers.
  • Build up services and SMEs. South Korean services are dominated by low value-added enterprises, particularly local services (for example, restaurants, real-estate sales, transportation). South Korea can build on the success of sectors that are already globally competitive, such as construction engineering, and help expand sectors such as health care, tourism, and financial services.
  • Create an entrepreneurial SME sector. Most SMEs are very small, and few mid-sized enterprises become large companies. Structural problems are partly to blame, but South Korea also lacks an entrepreneurial tradition and offers limited support for innovative risk-takers. South Korea can work to expand access to capital, increase intellectual-property protections, teach entrepreneurism, and update bankruptcy regulations. These initiatives will take a concerted effort by policy makers, business leaders, and South Korean citizens. But the result could be a new growth formula that complements the current model, reverses the erosion of middle-income households, and builds a sustainable future for all South Koreans.

Printed with permission from McKinsey Global Institute

Manufacturing the future: The next era of global growth and innovation

The global manufacturing sector has undergone a tumultuous decade:

Large developing economies leaped into the first tier of manufacturing nations, a severe recession choked off demand, and manufacturing employment fell at an accelerated rate in advanced economies. Still, manufacturing remains critically important to both the developing and the advanced world. In the former, it continues to provide a pathway from subsistence agriculture to rising incomes and living standards. In the latter, it remains a vital source of innovation and competitiveness, making outsized contributions to research and development, exports, and productivity growth. But the manufacturing sector has changed—bringing both opportunities and challenges—and neither business leaders nor policymakers can rely on old responses in the new manufacturing environment.

Manufacturing the future:

The next era of global growth and innovation, a major report from the McKinsey Global Institute, presents a clear view of how manufacturing contributes to the global economy today and how it will probably evolve over the coming decade. Our findings include the following points:

  • Manufacturing’s role is changing. The way it contributes to the economy shifts as nations mature: in today’s advanced economies, manufacturing promotes innovation, productivity, and trade more than growth and employment. In these countries, manufacturing also has begun to consume more services and to rely more heavily on them to operate.
  • Manufacturing is not monolithic. It is a diverse sector with five distinct groups of industries, each with specific drivers of success.
  • Manufacturing is entering a dynamic new phase. As a new global consuming class emerges in developing nations, and innovations spark additional demand, global manufacturers will have substantial new opportunities—but in a much more uncertain environment.

Manufacturing’s role is changing:

Globally, manufacturing continues to grow. It now accounts for approximately 16 percent of global GDP and 14 percent of employment. But the manufacturing sector’s relative size in an economy varies with its stage of development. We find that when economies industrialize, manufacturing employment and output both rise rapidly, but once manufacturing’s share of GDP peaks—at 20 to 35 percent of GDP—it falls in an inverted U pattern, along with its share of employment. The reason is that as wages rise, consumers have more money to spend on services, and that sector’s growth accelerates, making it more important than manufacturing as a source of growth and employment.

The sector is also evolving in ways that make the traditional view—that manufacturing and services are completely separate and fundamentally different sectors—outdated. Service inputs (everything from logistics to advertising) make up an increasing amount of manufacturing activity. In the United States, every dollar of manufacturing output requires 19 cents of services. And in some manufacturing industries, more than half of all employees work in service roles, such as R&D engineers and office-support staff.

As advanced economies recover from the Great Recession, hiring in manufacturing may accelerate, and some nations may even raise net exports. Manufacturers will continue to hire workers, both in production and nonproduction roles (such as design and after-sales service). But in the long run, manufacturing’s share of employment will remain under pressure as a result of ongoing productivity improvements, faster growth in services, and the force of global competition, which pushes advanced economies to specialize in activities requiring more skill (Exhibit 1).

Exhibit 1

Manufacturing is not monolithic. No two manufacturing industries are exactly alike; some are more labor- or more knowledge-intensive. Some rely heavily on transportation, while for others, proximity to customers is the critical issue. We have identified five broad manufacturing segments and analyzed how different production factors influence where they build factories, carry out R&D, and go to market.

The largest segment by output (gross value added) includes industries such as autos, chemicals, and pharmaceuticals. These industries depend heavily on global innovation for local markets—they are highly R&D intensive—and also require close proximity to markets. The second-largest segment is regional processing, which includes industries such as printing and food and beverages. The smallest segment, with just 7 percent of global manufacturing value-added, produces labor-intensive tradables (Exhibit 2).

Exhibit 2

Manufacturing is diverse: We identify five broad groups with very different characteristics and requirements

Manufacturing is entering a dynamic new phase. By 2025, a new global consuming class will have emerged, and the majority of consumption will take place in developing economies. This will create rich new market opportunities. Meanwhile, in established markets, demand is fragmenting as customers ask for greater variation and more types of after-sales service. A rich pipeline of innovations in materials and processes—from nanomaterials to 3-D printing to advanced robotics—also promises to create fresh demand and drive further productivity gains across manufacturing industries and geographies.

These opportunities arise in an extremely challenging environment. In some low-cost labor markets, wage rates are rising rapidly. Volatile resource prices, a looming shortage of highly skilled talent, and heightened supply-chain and regulatory risks create an environment that is far more uncertain than it was before the Great Recession.

Manufacturers and policy makers need new approaches and capabilities. Companies must develop a highly detailed understanding of specific emerging markets, as well as the needs of their existing customers. They will also require agile approaches to the development of strategy—using scenario planning rather than point forecasts, for example. And they will have to make big bets on long-range opportunities, such as tapping new markets in developing economies or switching to new materials, but must do so in ways that minimize risk.

A critical challenge for manufacturers will be to approach footprint decisions in a more nuanced way. Labor-intensive industries will almost always follow the path of low wages, but others, with more complex needs, must weigh factors such as access to low-cost transportation, to consumer insights, or to skilled employees. The result could very well be a new kind of global manufacturing company—a networked enterprise that uses “big data” and analytics to respond quickly and decisively to changing conditions and can also pursue long-term opportunities.

For policymakers, supporting manufacturing industries and competing globally means that policy must be grounded in a comprehensive understanding of the diverse industry segments in a national or regional economy, as well as the wider trends affecting them. For example, shapers of energy policy need to consider which segments will be affected by higher or lower energy costs, how great the impact is likely to be, and what magnitude of difference will trigger a location decision. Policymakers should also recognize that their long-term goals for growth, innovation, and exports are best served by supporting critical enablers for manufacturers (such as investing in modern infrastructure) and by helping them forge the connections they will need to access rapidly growing emerging markets.

Two key priorities for both governments and businesses are education and the development of skills. Companies have to build their R&D capabilities, as well as expertise in data analytics and product design. They will need qualified, computer-savvy factory workers and agile managers for complex global supply chains. In addition to supporting ongoing efforts to improve public education—particularly the teaching of math and analytical skills—policy makers must work with industry and educational institutions to ensure that skills learned in school fit the needs of employers.

Urban World: A new iPad app for exploring an unprecedented wave of urbanization

The growth of cities in emerging markets is driving the most significant economic transformation in history. The McKinsey Global Institute’s new iPad app, Urban World, offers a sense of how economic power will move as this urban expansion takes place. The app offers previously unavailable data from a proprietary MGI database of more than 2,600 cities around the world.

The app also places urbanization in a historical context, using a view from space of the global nighttime distribution of light as a proxy for the global distribution of economic activity. Users can visualize the world’s shifting center of economic gravity during the past two millennia, to 2025. The app serves a purpose similar to a 16th-century map—a rough but helpful tool to help navigate the evolving urban world.

Corporate strategists, urban planners, economic historians, and geography buffs alike can use the app’s interactive map to compare individual cities on their GDP, population, and income levels in 2010 and one scenario for 2025.

The growth of some urban markets can exceed that of entire nations, which is why cities matter for strategy. Companies can use the data to compare the economic growth from different cities. For example, Vienna had roughly the same GDP in 2010 as Istanbul. By 2025, the scenario presented in the app shows that the GDP of Istanbul will be comparable to the entire country of Austria. Auckland (New Zealand) had roughly the same GDP in 2010 as New Delhi but, by 2025, the GDP of New Delhi will be almost as great as the GDP of the entire country of New Zealand.

MGI research finds that the annual consumption of citizens in emerging markets will reach $30 trillion by 2025, and the GDP of these markets will exceed that of developed countries. Business leaders recognize that emerging markets hold the key to long-term success—but that they also pose daunting challenges. Many companies’ financial results reflect that ambivalence. In 2010, 100 of the world’s largest companies headquartered in developed economies derived just 17 percent of revenue from emerging markets—despite the fact that those markets account for 36 percent of global GDP. Companies that neglect these new markets risk missing out as much as 70 percent of global GDP growth between now and 2025.

iPad screenshot

Urban World: A new iPad app - image3

The big-data revolution in US health care: Accelerating value and innovation

Big data could transform the health-care sector, but the industry must undergo fundamental changes before stakeholders can capture its full value.

A big-data revolution is under way in health care. Start with the vastly increased supply of information. Over the last decade, pharmaceutical companies have been aggregating years of research and development data into medical databases, while payors and providers have digitized their patient records. Meanwhile, the US federal government and other public stakeholders have been opening their vast stores of health-care knowledge, including data from clinical trials and information on patients covered under public insurance programs. In parallel, recent technical advances have made it easier to collect and analyze information from multiple sources—a major benefit in health care, since data for a single patient may come from various payors, hospitals, laboratories, and physician offices.

Fiscal concerns, perhaps more than any other factor, are driving the demand for big-data applications. After more than 20 years of steady increases, health-care expenses now represent 17.6 percent of GDP—nearly $600 billion more than the expected benchmark for a nation of the United States’s size and wealth.1 To discourage overutilization, many payors have shifted from fee-for-service compensation, which rewards physicians for treatment volume, to risk-sharing arrangements that prioritize outcomes. Under the new schemes, when treatments deliver the desired results, provider compensation may be less than before. Payors are also entering similar agreements with pharmaceutical companies and basing reimbursement on a drug’s ability to improve patient health. In this new environment, health-care stakeholders have greater incentives to compile and exchange information.

While health-care costs may be paramount in big data’s rise, clinical trends also play a role. Physicians have traditionally used their judgment when making treatment decisions, but in the last few years there has been a move toward evidence-based medicine, which involves systematically reviewing clinical data and making treatment decisions based on the best available information. Aggregating individual data sets into big-data algorithms often provides the most robust evidence, since nuances in subpopulations (such as the presence of patients with gluten allergies) may be so rare that they are not readily apparent in small samples.

Although the health-care industry has lagged behind sectors like retail and banking in the use of big data—partly because of concerns about patient confidentiality—it could soon catch up. First movers in the data sphere are already achieving positive results, which is prompting other stakeholders to take action, lest they be left behind. These developments are encouraging, but they also raise an important question: is the health-care industry prepared to capture big data’s full potential, or are there roadblocks that will hamper its use? (In a related video, McKinsey director Nicolaus Henke explains how analytics is transforming the practice of medicine.)

A new value framework

Health-care stakeholders are well versed in capturing value and have developed many levers to assist with this goal. But traditional tools do not always take complete advantage of the insights that big data can provide. Unit-price discounts, for instance, are based primarily on contracting and negotiating leverage. And like most other well-established health-care value levers, they focus solely on reducing costs rather than improving patient outcomes. Although these tools will continue to play an important role, stakeholders will only benefit from big data if they take a more holistic, patient-centered approach to value, one that focuses equally on health-care spending and treatment outcomes. We have created five pathways to assist them in redefining value and identifying tools that are appropriate for the new era. They focus on the following concepts:

  • Right living. Patients must be encouraged to play an active role in their own health by making the right choices about diet, exercise, preventive care, and other lifestyle factors.
  • Right care. Patients must receive the most timely, appropriate treatment available. In addition to relying heavily on protocols, right care requires a coordinated approach, with all caregivers having access to the same information and working toward the same goal to avoid duplication of effort and suboptimal treatment strategies.
  • Right provider. Any professionals who treat patients must have strong performance records and be capable of achieving the best outcomes. They should also be selected based on their skill sets and abilities rather than their job titles. For instance, nurses or physicians’ assistants may perform many tasks that do not require a doctor.
  • Right value. Providers and payors should continually look for ways to improve value while preserving or improving health-care quality. For example, they could develop a system in which provider reimbursement is tied to patient outcomes or undertake programs designed to eliminate wasteful spending.
  • Right innovation. Stakeholders must focus on identifying new therapies and approaches to health-care delivery. They should also try to improve the innovation engines themselves—for instance, by advancing medicine and boosting R&D productivity.

The value pathways evolve as new data become available, fostering a feedback loop. The concept of right care, for instance, could change if new data suggest that the standard protocol for a particular disease does not produce optimal results. And a change in one pathway could spur changes in others, since they are interdependent. An investigation into right value, for example, could reveal that patients are most likely to suffer costly complications after an appendectomy if their physician performs few of these operations. This finding could influence opinions not only about value but about the right provider to perform an appendectomy.

The pathways in action

Some health-care leaders have already captured value from big data by focusing on the concepts outlined in our pathways or have set the groundwork for doing so. Consider a few examples:

  • Kaiser Permanente has fully implemented a new computer system, HealthConnect, to ensure data exchange across all medical facilities and promote the use of electronic health records. The integrated system has improved outcomes in cardiovascular disease and achieved an estimated $1 billion in savings from reduced office visits and lab tests.
  • Blue Shield of California, in partnership with NantHealth, is improving health-care delivery and patient outcomes by developing an integrated technology system that will allow doctors, hospitals, and health plans to deliver evidence-based care that is more coordinated and personalized. This will help improve performance in a number of areas, including prevention and care coordination.
  • AstraZeneca established a four-year partnership with WellPoint’s data and analytics subsidiary, HealthCore, to conduct real-world studies to determine the most effective and economical treatments for some chronic illnesses and common diseases. AstraZeneca will use HealthCore data, together with its own clinical-trial data, to guide R&D investment decisions. The company is also in talks with payors about providing coverage for drugs already on the market, again using HealthCore data as evidence.

During a recent scan of the industry, we found that interest in big data is not confined to traditional players. Since 2010, more than 200 new businesses have developed innovative health-care applications. About 40 percent of these were aimed at direct health interventions or predictive capabilities. That’s a powerful new frontier for health-data applications, which historically focused more on data management and retrospective data analysis (exhibit).


Many innovative US health-care data applications move beyond retroactive reporting to interventions and predictive capabilities.

Some devices take patient monitoring to a new level. For instance, Asthmapolis has created a GPS-enabled tracker that records inhaler usage by asthmatics. The information is ported to a central database and used to identify individual, group, and population-based trends. The data are then merged with Centers for Disease Control and Prevention information about known asthma catalysts (such as high pollen counts in the Northeast or volcanic fog in Hawaii). Together, the information helps physicians develop personalized treatment plans and spot prevention opportunities.

Another company,, offers a mobile application in which patients with select conditions agree, in conjunction with their providers, to be tracked through their mobile phones and assisted with behavioral-health therapies. The app records data about calls, texts, geographic location, and even physical movements. Patients also respond to surveys delivered over their smartphones. The application integrates patient data with public research on behavioral health from the National Institutes of Health and other sources. The insights obtained can be revealing—for instance, a lack of movement or other activity could signal that a patient feels physically unwell, and irregular sleep patterns (revealed through late-night calls or texts) may signal that an anxiety attack is imminent.

Improvement at scale: What is the potential?

To determine the opportunity of the new value pathways, we evaluated a range of health-care initiatives and assessed their potential impact as total annual cost savings, holding outcomes constant, using a 2011 baseline. If these early successes were scaled up to create systemwide impact, we estimate that the pathways could account for $300 billion to $450 billion in reduced health-care spending, or 12 to 17 percent of the $2.6 trillion baseline in US health-care costs.

Even a few simple interventions can have an enormous impact when scaled up. In the “right living” pathway, for instance, we estimate that aspirin use by those at risk for coronary heart disease, combined with early cholesterol screening and smoking cessation, could reduce the total cost of their care by more than $30 billion. While these actions have been encouraged for some time, big data now enables faster identification of high-risk patients, more effective interventions, and closer monitoring.

Our estimate of $300 billion to $450 billion in reduced health-care spending could be conservative, as many insights and innovations are still ahead. We have yet to fully understand subpopulation efficacy of cancer therapies and the predictive indicators of relapse, for example, and we believe the big-data revolution will uncover many new learning opportunities in these areas.

A few caveats

Although we are optimistic about big data’s potential to transform health care, some structural issues may pose obstacles. The move away from fee-for-service care—already well under way—must continue. Similarly, traditional medical-management techniques must change, since they pit payors and providers against each other, framing benefit plans with respect to what is and is not covered rather than what is and is not most effective. And all stakeholders must recognize the value of big data and be willing to act on its insights, a fundamental mind-set shift for many and one that may prove difficult to achieve. Patients will not benefit from research on exercise, for example, if they persist in their sedentary lifestyles. And physicians may not improve patient outcomes if they refuse to follow treatment protocols based on big data and instead rely solely on their own judgment.

Privacy issues will continue to be a major concern. Although new computer programs can readily remove names and other personal information from records being transported into large databases, stakeholders across the industry must be vigilant and watch for potential problems as more information becomes public.

Finally, health care will need to learn from other data-driven revolutions. All too often, players have taken advantage of data transparency by pursuing objectives that create value only for themselves, and this could also occur in the health-care sector. For instance, owners of MRI machines, looking to amortize fixed costs across more patients, might choose to use big data only to identify underserved patients and disease areas. If they convincingly market their services, patients may receive unnecessary MRIs—a situation that would increase costs without necessarily improving outcomes.

Reprinted with permission from McKinsey Global Institute

Leadership and the art of plate spinning

Senior executives will better balance people and priorities by embracing the paradoxes of organizational life.

I often ask business leaders three simple questions. What are your company’s ten most exciting value-creation opportunities? Who are your ten best people? How many of your ten best people are working on your ten most exciting opportunities? It’s a rough and ready exercise, to be sure. But the answer to the last question—typically, no more than six—is usually expressed with ill-disguised frustration that demonstrates how difficult it is for senior executives to achieve organizational alignment.

What makes this problem particularly challenging is a number of paradoxes, many of them rooted in the eccentricity and unpredictability of human behavior, about how organizations really tick. Appealing as it is to believe that the workplace is economically rational, in reality it is not. As my colleague Scott Keller and I explained in our 2011 book, Beyond Performance,1 a decade’s worth of data derived from more than 700 companies strongly suggests that the rational way to achieve superior performance—focusing on its financial and operational manifestations by pursuing multiple short-term revenue-generating initiatives and meeting tough individual targets—may not be the most effective one.

Rather, our research shows that the most successful organizations, over the long term, consistently focus on “enabling” things (leadership, purpose, employee motivation) whose immediate benefits aren’t always clear. These healthy organizations, as we call them, are internally aligned around a clear vision and strategy; can execute to a high quality thanks to strong capabilities, management processes, and employee motivation; and renew themselves more effectively than their rivals do. In short, health today drives performance tomorrow.

Many CEOs instinctively understand the paradox of performance and health, though few have expressed or acted upon it better than John Mackey, founder and CEO of Whole Foods. “We have not achieved our tremendous increase in shareholder value,” he once observed, “by making shareholder value the only purpose of our business.”

In this article, I want to focus on three other paradoxes that, in my experience, are both particularly striking and quite difficult to reconcile. The first is that change comes about more easily and more quickly in organizations that keep some things stable. The second is that organizations are more likely to succeed if they simultaneously control and empower their employees. And the third is that business cultures that rightly encourage consistency (say, in the quality of services and products) must also allow for the sort of variability—and even failure—that goes with innovation and experimentation.

Coming to grips with these paradoxes will be invaluable for executives trying to keep their people and priorities in balance at a time when cultural and leadership change sometimes seems an existential imperative. Just as a circus performer deftly spins plates or bowls to keep them moving and upright, so must senior executives constantly intervene to encourage the sorts of behavior that align an organization with its top priorities.

Change and stability

Organizational change, obviously, is often imperative in response to emerging customer demands, new regulations, and fresh competitive threats. But constant or sudden change is unsettling and destabilizing for companies and individuals alike. Just as human beings tend to freeze when confronted with too many new things in their lives—a divorce, a house move, and a change of job, for example—so will organizations overwhelmed by change resist and frustrate transformation-minded chief executives set on radically overturning the established order. Burning platforms grab attention but do little to motivate creativity. Paradoxically, therefore, change leaders should try to promote a sense of stability at their company’s core and, where possible, make changes seem relatively small, incremental, or even peripheral, while cumulatively achieving the transformation needed to drive high performance.

A large universal bank provides a case in point. Given the tumult in the financial-services sector in recent years, it needs to change, and change profoundly. But the cry of “let’s change everything” will be counterproductive in an organization where staff members are mostly hard-working, committed people operating processes that involve millions of transactions per hour.

One large automotive company I’m familiar with, buffeted by three different owners and five different CEOs in the last decade, has recently embraced this paradox with a new management model dubbed “balance,” a word loaded with meaning in the automotive industry because of its association with reducing drag and increasing speed. The simple idea behind the model is that any changes to a company’s systems, structures, and processes should always be introduced in a consistent way, typically quarterly, as part of an explicit change package. If a proposed change isn’t ready in time for one of these regular releases, it is either deferred to the next one or abandoned.

Previously, leaders of each of the company’s functions had been inclined to introduce, on their own, changes they thought might generate value—for example, finance would launch a program to make costs variable, HR would announce an initiative to shake up performance management and compensation, and manufacturing would bring in new vendor-management systems. Hapless middle managers found themselves in a blizzard of change that made it difficult to focus on the organization’s top priorities. Now, before change programs are rolled out more broadly, all of them are integrated, and the resulting complexities are addressed at the top of the organization.

In this way, the company’s underlying operating model has remained more stable than it would otherwise have been, and more stable than it used to be when changes were announced in an uncoordinated fashion. Managers now understand and accept the rhythm of change, while managers and employees alike have gained new confidence that the different elements in the releases will be complementary and coherent.

The result is that a well-intentioned but disjointed flow of unending change has been converted into a well-structured one. Moreover, after years of lagging behind industry peers, the company has shortened its product-development cycles and increased the quality of its products. And it is running much more smoothly, with 20 percent fewer managers.

Control and empowerment

All organizations need at least a thread of control to link those who own the business to those charged with implementing its objectives. Companies that neglect mechanisms that enforce discipline, common standards, or compliance with external regulation do so at their peril. The share price of one global energy group, for example, collapsed when it came to light that poor oversight had allowed internal analysts to develop metrics based on optimistic assumptions and to overstate the company’s oil and gas reserves substantially.

Yet excessive control, paradoxically, tends to drive dysfunctional behavior, to undermine people’s sense of purpose, and to harm motivation by hemming employees into a corporate straitjacket. The trick for the CEO-cum-plate-spinner is to get the balance right in light of shifting corporate and market contexts. In general, a company will probably need more control when it must actually change direction and more empowerment when it is set on the new course.

The story of how a major global technology company recovered from a crisis four years ago is instructive. Forced to write off more than $2 billion of unmanageable contracts—and facing insolvency—a new management team took drastic and decisive action to strip out costs, renegotiate old agreements, change established practices, and impose stringent new controls. The company (with more than 100,000 employees) was saved but in the process found that it had lost the ability to deliver on its top priority: creative new ideas that would fuel organic growth. That’s because an unintended consequence of the much-needed cost reductions had been the emergence of a “parent–child” relationship between the company’s top team and middle managers. These managers had become so used to being told what to do, and had been given so little room to maneuver, that they eventually lost the ability to experiment. The “tree” of top management had grown so large that nothing could grow in its shade.

This company’s solution was to introduce an “envelope” leadership approach, which first involved defining a set of borders. Employees could not go beyond them, but within them there was almost complete freedom to innovate and grow. Other businesses have attempted to copy the envelope idea but few have had the success of this global technology company, whose approach had real teeth. The flame of empowerment was fanned by first identifying some 600 leaders with the best capabilities and then rotating them around different businesses, with a mandate to shake things up. Meanwhile, the company’s purpose, vision, mission, and values were all rewritten and drilled into leaders. Its “signature processes” (five core ones, where it aspired to be truly differentiated) were fundamentally reimagined. And evaluation and reward mechanisms were dramatically tightened to reward stars and actively manage people who seemed to be struggling. As the company added a greater degree of empowerment to the stricter controls—plates both balanced and spinning—its performance improved. Sales are growing again, and fresh energy is palpable throughout the organization.

Consistency and variability

Producing high-quality products and delivering them to customers on time and with the same level of consistency at every point in the value chain is critical to success in most industries. Variability is wasteful and time consuming, not to mention potentially alienating for customers. Most organizations therefore applaud behavior that attacks and eliminates it.

Yet in human terms, consistency too often hardens into rigid mind-sets characterized by fear of personal and organizational failure. It’s been shown that we feel the pain of failure twice as much as we do the joy of success, so employees naturally tend to protect themselves and their teams, behavior that can inadvertently hamper innovation and calculated risk taking. After all, mistakes—from Edison’s countless failed filaments to 3M’s accidental creation of the adhesive behind Post-it notes—can sometimes be the mother of invention; as they say in the mountains, “If you’re not falling, you’re not skiing.”

It’s hard to think of a sector where it’s more important to get the balance between consistency and variability right than it is in pharmaceuticals. Lives are at stake, and the development and launch costs of a new compound often run to billions of dollars. Faced with the approaching expiration of many licenses, one of the world’s biggest pharma companies found that its tradition of reliability and consistency had become a limiting mind-set. Although it desperately needed to make new discoveries, a status quo bias took hold of the organization, which froze around a complex bundle of assurance, governance, and controls. Fear of failure and an obsession with getting these things right produced defensive 100-page PowerPoint presentations in abundance, but little meaningful product-development progress.

Behavioral problems didn’t help, of course. An excessive “telling” rather than “listening” culture had degenerated into bullying; some senior executives literally shouted at their underlings. On one notorious “away day,” a number of exercises revolved around cage fighting, a sport (dubbed “human cockfighting”) that combines boxing, wrestling, and martial arts. The signal this sent from the top was that the culture really was dog eat dog.

Things came to a head when two scientists, frustrated by the time needed to get approvals, left to set up their own successful research business and were openly lauded by colleagues for breaking free of a stifling bureaucracy and dictatorial culture. The morale of those left behind suffered further, and energy drained out of the organization.

The solution the company devised combined building “slack” (additional people) into its resourcing—a bold move in austere times—with a direct attack on negative behavior. The worst offenders were removed, and it was made clear that cage-fighting attitudes were unacceptable.

Steps were taken to bump up the innovation rate by investing in smart people, but the top team went further. It set out fundamentally to alter what it called the organization’s “social architecture” by building worldwide communities of scientists and encouraging exchanges between them across geographical boundaries and industry disciplines.

Successful experiments, to be sure, were more highly valued than failures, but both had their place in the company’s culture. An emphasis in communications on “our wealth of ideas” promoted the simple notion that wealth (economic progress) arises from ideas (experimentation and innovation) and showed how carefully crafted language can help drive change. The result was an increase in the pipeline of products and, over time, a resumption of profit growth.

Embracing the paradoxes described in this article can be uncomfortable: it’s counterintuitive to stimulate change by grounding it in sources of reassuring stability or to focus on boundaries and control when a company wants to stir up new ideas. Yet the act of trying to reconcile these tensions helps leaders keep their eyes on all their spinning plates and identify when interventions are needed to keep the organization lined up with its top priorities. Last, this approach makes it possible to avoid the frustration of many executives I’ve encountered, who pick an extreme: either they try to stifle complex behavior by building powerful and rigid top-down structures, or they express puzzlement and disappointment when looser, more laissez-faire styles of management expose the messy realities of human endeavor. Far more centered and high performing, in my experience, are those leaders who welcome the inconvenient contradictions of organizational life.

Printed with permission from McKinsey Quarterly.