The Mission Statement Is Dead! Long Live the Mission Narrative!

The idea for this piece was rattling around in the back of my brain when I came across an interesting blog post on the Association for Talent Development’s site: “Why I Hate Mission Statements—But Love Missions.” The writer, Brad Federman, lays out many legitimate complaints about typical declarations: They have been wordsmithed into frothy blather, are too long to be remembered, and have little use beyond adorning the lobby wall. But Federman also argues, correctly, that a compelling mission has the power to shape a workplace and inform strategic and operational decisions. So what accounts for the disconnect? More importantly, how can it be bridged?

The primary fault lies not in the “mission” but in the “statement.” A statement is a one-time aspirational exercise, which is usually crafted by an elite group of marketers or executives for customers or clients. Everyone involved feels good about the honeyed prose. And there are, of course, good mission statements. The best are crisp and straightforward—more Hemingway than Faulkner. I like Patagonia’s: “Build the best product, cause no unnecessary harm, use business to inspire, and implement solutions to the environmental crisis.”

Too often, however, the statement becomes an end in itself, disconnected from job descriptions, leadership competencies, operational policies, and the other activities that comprise the day-to-day reality of the organization. Making that connection takes work and commitment. And that’s where mission narratives come in.

The narrative is a bottom-up method for ratifying the relevance and strength of the company’s purpose while also unearthing examples, hidden best practices, and unacknowledged obstacles to success. In a healthy culture, names can be attached to the narrative because telling truth to power is not a career-ending move. In companies that are more toxic, they can be written anonymously. People who are intimidated by writing can invest in some voice recognition software that allows them to capture the narrative orally.

The mission narrative should be short and explicit—the story of how a company’s mission is actually achieved. The quality of the writing is secondary, even tertiary, to spirit and specificity. It can be half a page, a page, or even two pages. It can be written by the people who actually do the work, and it can take one of many forms, depending on who’s writing it. Here are some examples of what a team leader might write:

  • To realize our mission, I do A, B, and C as a retail team leader to build a group that delivers X, Y, and Z. An example of where we performed at our peak in the past six months is… and an example of where we fell short is… I was most proud of my team when we…
  • The criteria I use for hiring are 1, 2, and 3. The formal and informal methods that I use for development are 4, 5, and 6.
  • The policies, procedures, and tools that help me most are… and here’s why. Here are those that get most in the way… and here’s why. The changes I would make tomorrow if I could are… and here’s why.
  • Here’s what I have done over the past six months to make our store and its people embody the mission of this organization…
  • If I were to hire my replacement, I would look for these qualities and/or experiences that are not in the current job description… Here’s why they would be important for his or her success…

A product manager might write about how the company’s mission informs the way suppliers are chosen or components approved for inclusion in a product. A designer or architect could write about how materials are specified. The list goes on.

Emphasizing examples, evidence, and underlying reasoning (“Here’s why…”) bring genuine experiences to light. Storytelling—the oldest, most enduring, and one of the most powerful forms of human communication—helps individuals from the shop floor to the boardroom distill concrete meaning and expression of the company’s overarching focus. Meaning drives engagement and motivation. Meaning cannot be crafted from afar; each person must find it and feel it themselves. The narrative exercise provides a channel for that exploration.

Be careful, however, not to turn the narrative into a corporate history. This is not about memorializing the distant past but rather an opportunity to chronicle the present and co-create the future. The narratives should be part of an ongoing, open-ended dialog through which members of the enterprise learn more about themselves and the work they do while also sharing to create community.

As a collective body of knowledge, the mission narratives can inform everything from organizational structure, to reward-and-recognition programs or basic policies. The exercise can embed purpose, values, and performance measures deep into an organization (and reveal where improvements must be made). Alignment up and down within organizational units and across organizational boundaries improves when people clearly articulate why they are doing what they are doing. Interdependencies are revealed. Resilience is enhanced.

Are there companies that do this well? John Hagel has cited Nike and Appleas examples of corporate narratives that hit the mark, with their “Just do it” and “Think different” messages, respectively. These slogans are not merely catchy mission statements meant to be used as marketing tools, but they begin narratives that encapsulate a larger story at the institutional level. I’m advocating something even more holistic and expansive in its creation and iteration. Like Rob Goffee and Gareth Jones, who wrote about how to create the best workplace on Earth but who could find no company that followed all of the principles, I am still searching for the organization that takes full advantage of the power of mission narratives. If you know of one or are part of an organization that would like to try, please get in touch. In a future post, I’ll share some of the best.

Originally published at strategy + business

People analytics: ‘Moneyball’ for human resources

Lord knows it’s expensive and time consuming, and even when they get it, it’s not clear how much students actually learn. But the one thing you could always say about a college degree was that it led to better jobs because it served as a reliable and invaluable signal to employers about a job applicant’s intelligence and persistence.

Or maybe not. Michael Rosenbaum knows from fancy degrees — he’s got a BA and law degree from Harvard, along with a master’s from the London School of Economics. But at the two software companies he has founded in Baltimore, 40 percent of the programmers have no college degrees, and half of the others got theirs from community colleges. The reason is simple: Statistically speaking, a degree from a fancy college has zero correlation with success in writing software.

Such are the insights from “people analytics,” a hot new area in human resource management that aims to bring “big data” to the task of corporate hiring and promotion. What “moneyball” did for baseball, people analytics promises to do for human resources, replacing intuition, old-boy networks and outmoded rules of thumb with computerized tests, database searches and quantifiable performance metrics.

Given the time and money companies sink into hiring and recruitment, the results are decidedly mediocre. According to a survey conducted by Arlington-based Corporate Executive Board, nearly a quarter of all new hires leave within a year, while Gallup reports that half of those who do stay reported being “not engaged. The resulting drag on profits and productivity represent a multibillion dollar opportunity for firms such as Rosenbaum’s Pegged Software, which helps hospitals and nursing homes reduce turnover of entry-level workers by putting the right people in the right jobs.

What’s surprising isn’t that companies are beginning to use more objective techniques to make personnel decisions, says Peter Cappelli, a professor at the University of Pennsylvania’s Wharton School of Management. “What’s surprising is that, for the last 20 years, they’ve been going with their gut.”

In the early versions of “people analytics,” companies asked managers to identify their best-performing employees and then tried to find patterns in each group based on biographical information, work history and their answers to computerized personality and intelligence tests. Job applicants were then “scored” based on how closely their background and test answers matched those high-performing employees.

Rosenbaum says the problem with the early efforts is that the results tended to correlate less with the actual strengths of the job candidates than with their cleverness in taking the tests. And by relying on the managers’ rating of current employees, the process reintroduced a high degree of bias and subjectivity into the scoring system.

See entire article at:  Moneyball

 

Brad Federman Interviewed by Business Interviews

“In terms of a unique tool or technique used to help create a more sensitive or respective workplace environment nothing beats one-on-one connections and conversations.”

Brad Federman

Brad Federman
F&H Solutions Group
COO

F&H Solutions Group (FHSG) is a national consulting firm specializing in human resources and labor relations matters. Their HR consultants have unmatched expertise and experience in working with all types and sizes of organizations in different industries in both the private and public sectors.

FHSG provides solutions for a better workplace. Clients value their ability to develop strategies that have a positive impact on their organization and save them time and money.

F & H Solutions Group

BusinessInterviews.com: What are some trends in the human resources industry that you’re excited about?

Brad: I’m excited about several trends in the Human Resource industry. One of the first things I find exciting are the millennials. We have such great diversity in terms of generational differences in the workplace. It has opportunity to cause a lot of conflict, yet it also has an opportunity to create change. We have so many tools out there that promote networking and connections that are no longer hierarchical and yet we live in organizations that make it difficult to utilize those platforms in a productive manner because they are focused on hierarchy and outdated policies. When organizations catch up to where society is you have moments when things really work, where people truly connect at a unique level and a great deal of innovation occurs. I think this next generation is going to drive that, they are going to make that happen. They believe in workplace balance, being treated as an adult, jumping in and participating on the frontend. They want to put their imprint on what they create which means that our workplace needs to begin to represent that in the way that we establish our structures, our policies and procedures, etc.

The second trend I really am excited about is globalization. While that trend has being going on for a long time, what’s unique and different is that it is continuing to infiltrate every aspect of business. It doesn’t matter whether you work for a large company such as Microsoft, or you work for a small mom and pop shop, at some point the concept of diversity, globalization and dealing with different cultures is going to impact your business. I know small firms with one or two people in them that work across the globe and respond to clients of different backgrounds and nationalities. This presents a real challenge for a lot of miscommunication, etc. However, what is exciting is that people are getting better at understanding differences, embracing differences, learning about different cultures. We are becoming more mature in the way we view people around the globe.

The last trend is technology in HR. Now, I am not excited about the technology per se, I am excited about what possibilities it presents. You see, the history of HR is it’s an outgrowth of the legal profession so it’s been focused on risks and compliance. The truth is that in today’s world with everything becoming more and more transparent due to technology and because of the type of worker in place it is imperative that HR is focused more on building a strong culture and relationships that drive business success and performance. Focusing on risks and compliance doesn’t allow HR to do that. The idea of risks and compliance are going to go away would be foolish and unrealistic. However, with the amount of technology that is coming into play and the ability to outsource so many of these compliance functions to organizations that specialize in these areas allows HR an opportunity to shed what does not add value to the company and focus their activities on what does. That is exciting.

BusinessInterviews.com: Can you provide an example of a unique tool or technique that you’ve used to help encourage a more sensitive, respectful workplace environment?

Brad: In terms of a unique tool or technique used to help create a more sensitive or respective workplace environment nothing beats one-on-one connections and conversations. People are always more respectful and sensitive to those they understand, that they know personally. They are also more respectful and sensitive to those that they really listen to. So one activity that we do to encourage this kind of situation is called “rant and rave.” We have them stick two flipcharts up in the workplace for their team. One is rant, “What makes you rant about this place?” “What drives you crazy on a day to day basis?” And the other one is rave. “What makes you want to cheer?” “What makes you excited about working here?” And the leader gives people time to write things upon on those flip charts privately and when they are finished we encourage the leader of that team to have a conversation with their team about what is on those two flipcharts. The conversation is centered on two things (1) how do we remove, eliminate or reduce the things that drive us crazy, that make us rant; and (2) how do we increase or keep the things that make us rave, that we love? The wording is key because it is not how can I as the leader do it, it is how can “we” as a “team” do it? This should not be about the leader it should be about the group.

The second technique is that we create interviews for leaders to foster interesting conversations with their employees such as specific questions that we know will generate a conversation centered on personal things. In working with a major retailer, we had them take two or three questions that we supplied them and asked them to incorporate these questions into conversations with their people. They were shocked at what they found out. They learned about hardships and about the fact that many of their people are struggling financially. They realized that some of the things that they did as a leadership team actually caused their people to be frustrated or disengaged even though they had good intent. When they had this new information about their employees they were able to respond in kind and change the way people viewed them in the workplace. Because of this knowledge changes were made to make the workplace more respect oriented and fun. Ultimately it was all because they understood who their employees were and what they were going through.

BusinessInterviews.com: What are some common obstacles you see top-level managers encountering and how can they be avoided?

Brad: Top level managers are encountering a lot of obstacles in their daily work. One of the biggest obstacles that people face is their pace of work. Since technology follows us wherever we go managers struggle to be more efficient and one way is to multi-task. Unfortunately, when we try to get more done more efficiently the quality of our work and ability to problem solve goes down because we need space and time to really reflect. Also, when we multi-task we know that things actually take longer, the quality of our work drops and we wind up sending a message to the people around us that they are not valued because doing things like answering emails while having conversations. Leaders who do a great job of handling this issue do it by knowing what to say “no” to. They do that to free up time and space to tackle complex challenges and problems. Problems that need buy in from different stake holders. The ability to say “no” to different things is what gives you an opportunity to truly say “yes” and commit to others.

The second obstacle that top level mangers encounter is forgetting what it is like to be an employee, a worker on the line, or in an entry level position in today’s work world. They don’t know their employee’s concerns and don’t realize that employees struggle just to make their rent or pay the gas to get to work. They become further removed from their employees by only hanging out with other leaders, creating separate dining rooms, separate bathrooms, putting themselves on separate floors and creating environments where they sit up high and watch over the staff. This creates barriers between themselves and the people with who they work. When those barriers exist even with the best intent we take actions that cause people to disengage and promote significant distance between us and those with who we work. The best way we can avoid making this mistake is reducing those barriers by promoting cross-pollination between different levels of people so people can talk openly and freely and encourage people to build connections with each other, not just professional connections, but to get to know each other personally. The client I referenced earlier, where we had them ask two or three questions of each employee is a good example. One of the “aha’s” they had was they had a lot of people who were struggling monetarily in their company. They had made a decision in some of the charity work they were doing to stop crediting people with giving their time and asking people just to give money. Some of the people they were asking to give money to a food bank were actually spending their time at the food bank because they needed food. The idea that their manager asked them to give money to the very same food bank that they have to go to so they can eat was emotionally distressing. When these leaders realized what they were doing to their people they had a very different perspective about their charitable efforts in the office. They had a very different perspective about the reaction employees had to the charitable efforts in their office and they would never had a sense of humility and a sense of empathy towards their employees if they had never asked such questions.

BusinessInterviews.com: Do you ever find that time-management is over looked as an important component to building a strong leadership foundation?

Brad: I think time management is actually not only over looked, I think it is misunderstood. There are some things you can tack with basic time management such as keeping meetings short, putting some rules in place not to waste time, but time management is a subset of something bigger which I would call choice management. Every day we walk into work and we make choices. Where will we spend or not spend our time and how will we spend our time? I believe it is about choice management not time management. People look at time management as a date book, as scheduling in Outlook and it really is about priorities. The way we spend our time is a reflection of our priorities. Those people that struggle with time management are really struggling with priorities. Being a leader means understanding what has the most impact and then spending time and resources on those impactful activities. That’s our core effort. Anything else either needs to be outsourced or removed, or managed efficiently using a system. The tasks that deserve our time, our efforts, that are truly core and important, those are our priorities and that is where our time and energy should be spent.

BusinessInterviews.com: What advice would you pass onto a manager who has been experiencing a long-term, high volume of staff absences?

Brad: The advice that I would give to a manager that is experiencing long-term, high volume of staff absences is to first look at them self and ask them self, what am I doing or not doing that is inherently contributing to the absences? Your team is a reflection of you. We create a shadow that we cast on our departments, our groups, our teams, based on our own behavior. Second they should look at how they are recruiting, hiring, and on-boarding new employees. Are they hiring for job and culture fit, not just skill set? People need to be good, but they also need to feel good (about what they are doing).

BusinessInterviews.com: Can you share with our readers why this is such an exciting time to be working for F&H Solutions Group?

Brad: When you ask me why it is such an exciting time to work at F&H Solutions Group, the reason has a lot to do with the trends in the human resource industry going on now. The complexity, challenges, excitement of the change that is happening in our organizations, and in the HR industry as a whole, makes working here fun. We are on the preface of significant shift in the way we operate, the way we think about human behavior and the way we interact with organizations. To me this is an thrilling moment in time and because the transformation in the workplace is creating some stimulating projects and a lot of growth. After all we like to learn and be challenge ourselves.

F&H Solutions Group is a creative, innovative organization that is reflecting today’s organizational needs. I would much rather work for this firm because a lot of firms have not moved forward and are basically are stuck in the 80’s and 90’s workplace and mindset.

Freedom is not free, and neither is engagement.

man-free-signThe 4th of July – Independence day.  It is the day we commemorate the adoption of the Declaration of Independence.  From there, The United States of America went on to form a government and agree to a constitution.

However, the Declaration of Independence and The Constitution by themselves are just pieces of paper.  Many other countries that suffer from coups, military control, and sectarian violence have had similar pieces of paper.  If you look beyond the documents and think about history the real work and tests were in the political upheavals and wars such as the American Revolution and the Civil War.  And we are retested throughout our history.

We paid highly for our freedoms.  We paid dearly for those pieces of paper.  And in the end the spirit of “One Nation” won out.  Those pieces of paper reflect work, pain, sacrifice and the choice to rise above oneself or a particular group.

Engagement is no different.  Survey time –  It is the day we commemorate the adoption of the idea that our employees are valued.  Here is the difference between American History and corporate history.  Too many organizations, leaders, and managers see the survey as the work, the pain, the cost.  We are interested in results and fixing items, or as I like to call it, treating symptoms.

The real work and the significant investment come after a survey.  Most companies spend 80 cents on the survey and 20 cents on follow up.  That concept needs to be turned upside down.  An easy way to test my theory out is to look at survey results of companies.  One of the lowest scoring items on any engagement survey is…

“I had an opportunity to discuss the previous organizational survey results with a member of management.”

In fact, in a recent survey we just completed only 21% of employees felt that they had a real opportunity to discuss the previous results with a member of management.  If a company cannot even meet this threshold there is no way they are supporting an engaged culture.

Let’s put a stake in the ground and change our approach to engagement.

  • Start a conversation.  A conversation is a two way dialogue.  Engagement follow ups and action planning needs to be a conversation.  Unfortunately, most managers are held accountable for having a plan not engaging their employees.  Managers comb through the results, diagnose the issues without really understanding them, create an action plan on how to fix engagement levels, and then share that plan and work with their employees.  Employees bless the plan because they do not want to be seen as questioning their manager’s thought process and ideas.  Hey, they are not stupid, and the employees feel less engaged after the survey follow up process then before.
  • Fix the problem.  One reason we talk with our employees or hold focus groups is to better understand the “Why” behind the ratings.  If employees don’t feel recognized it could be for any number of reasons.  Maybe the recognition is not specific.  Maybe you rely too much on programs rather than making it personal.  It could be that you are not providing enough recognition.  Or it could be that you are counteracting the recognition by your ability to find things wrong more than you do right.  I could go on.  The point is, knowing the “Why” is what helps you move forward.
  • Execute a strategic, disciplined approach.  If you want employees to believe that the company truly cares about employee engagement then make sure you have a plan.  When will they hear about the overall results?  How? Will they receive anything in writing?  When will they hear directly about their team or department?  This effort should be run like a military campaign from the top down.  It should be as transparent as possible and ensure that everyone receives the same or similar messaging.
  • Make the invisible visible.  You will not get credit for actions your employees cannot see or connect to the survey feedback.  It is critically important to tie an organization’s, department’s or manager’s decision and actions back to the survey feedback.  Too many times organizations make positive changes, but do not get credit for them.  Marketing is a part of responding.
  • Create a culture.  What happens after 2-3 months when the action plans are finished?  Back to business as usual.  And all that progress is lost because employees see the survey and action planning as an event.  But nothing really changes.  Creating an engaged environment is more about creating a culture that breeds trust, reduces fear, creates connections between employees and the organization, promotes the ability to focus on the right things in the right way and to work with pride toward something that has meaning.  In order to create that culture and maintain it everything changes.  The way we talk, behave, our meeting structure, our organizational structure, who we hire, who we promote, how we hire and promote, the things we measure, the stories we tell and so on.

Surveys tell us how well we did last year at creating and maintaining that culture.  In the end, responding to the survey is not the answer.  Why?  Because those survey results reflect the work, pain, sacrifice and the choice to rise above oneself or a particular group, or our inability to do so.  It is not the paper that matters.    It is price we paid for that culture.

 

 

 

 

 

 

 

 

HR skills inadequate? Research details challenges for 21st century employers

Few would deny that the human resources department has its hands full. With change bombarding the workplace at an ever-increasing pace, HR professionals feel the heat. Now, a new study examining 21st century workplace trends concludes that HR is at risk of getting burned.

The Deloitte Global Human Capital Trends 2014 report sounds a dire warning. The report, which brings together 15 years of research along with the views of more than 2,500 business and HR leaders in 94 countries, goes so far as to say HR is “playing catch up,” and there’s a need to “reskill” the HR function. In fact, reskilling HR was one of the top three concerns identified in the study.

Seventy-seven percent of the study’s participants see the need for HR to develop new skills. They say today’s HR professionals lack the skills and data they need in the modern work environment. More than a third (34 percent) of respondents said their HR and talent programs are just “getting by” or even “underperforming.”

“Critical mission”
“There’s no doubt that human capital strategies are now a major factor in business growth,” says Jason Geller, national managing director for U.S. human capital consulting at Deloitte Consulting LLP. “Yet, today’s HR departments are not equipped to face the challenges of this new role. When you add to this the rapidly changing landscape of HR technologies, such as cloud and big data, and their impact on attracting, retaining, and developing talent, it becomes clear that reskilling HR teams is arguably the most critical mission for organizations today.”

“Playing catch up”? A need to “reskill HR”? The Deloitte report uses tough words and highlights big challenges for the profession. Jerry Glass and Brad Federman of F&H Solutions Group, a national human resources consulting firm, are on the front lines of the changing workplace, and they have ideas about how HR should respond.

Creativity versus compliance is one area HR needs to examine, Glass and Federman say. Glass, the firm’s president, says the HR function often is still largely risk averse, and “anything you want to do in HR still gets run by legal.”

Federman, F&H’s chief operating officer, agrees. “The joke goes if you have an idea you want to kill, bring it to HR or the legal team,” he says. “If you come up with a fantastic idea, something that’s not been done before, most business people will say, ‘Fantastic, how do we make it work?’ but HR will pick apart the idea. It won’t get off the ground. HR can sometimes hold an organization back from doing good things.”

Glass says reskilling HR includes teaching the brain to act differently. “When you have a great idea, the easiest thing to do is to say why it won’t work,” he says. But he wants to train people to explore how to say yes instead of automatically saying no.

Federman says he sees HR professionals struggling to figure out how to administer the Family and Medical Leave Act and other compliance issues when they can outsource those tasks and focus on what’s going to add value to the organization.

Paradigm shift on engagement, recruitment
Retention and engagement, along with leadership development, were other concerns explored in the Deloitte study, and Federman says a paradigm shift is needed. Surveying employees is good, he says, but too often more money is put into conducting the survey than is invested in dealing with what’s learned from it. Engagement shouldn’t just be thought of in terms of a two- or three-month action plan.

Not only do managers need to focus on engagement of their employees, they also need to think about their own engagement, Federman says. “If I’m disengaged, my employees will be disengaged, guaranteed,” he says.

Federman says organizations need to encourage the concept of accountability and individual responsibility among employees. He says surveys show that most employees say their coworkers have as much or more impact on their engagement as their managers, but it’s the managers who get blamed.

The challenge to attract top talent is mentioned in the Deloitte study as a serious competitive issue, and Glass says finding the right talent has been difficult for a long time. He says talented individuals are always going to want a challenge. So the employer needs to focus on employees’ career paths as a way to keep them interested.

Federman says organizations need to support career growth by giving employees the ability to manage their careers. When that happens, people will want to stay with their organization and when they do change employers it will be for the right reasons.

Trust and transparency play a role along with an organization’s values, Federman says. When organizations get involved in community charitable events for more than just public relations reasons, employees have a sense of pride that their employer is supporting their value system.

Millennial challenge
The change the Millennial generation is bringing to the workplace is another challenge for HR. Glass says HR needs to learn how to get the Millennial workers engaged and understanding the employer’s mission and objectives when the forms of communicating HR is used to aren’t working.

Glass says he recently spoke to a group of 35 Millennials and asked how many of them regularly read a print newspaper. Only three raised their hands. Most get their news online and may not even click to read an entire article.

Federman says when employees are just picking up snippets and doing a lot of things at the same time, two things happen: They make decisions based on limited information, and because they’re so tied to technology, they don’t shut down. That leads to burnout as well as communicating via technology on things that need to be communicated in person.

HR’s ability to set ground rules for effectively managing communication with the youngest members of the workforce will be key to success, Glass says.

Originally Published by Tammy Binford in HRhero

Remaking the industrial economy

A regenerative economic model—the circular economy—is starting to help companies create more value while reducing their dependence on scarce resources.

Visualize, for a moment, the industrial economy as a massive system of conveyor belts—one that directs materials and energy from resource-rich countries to manufacturing powerhouses, such as China, and then spirits the resulting products onward to the United States, Europe, and other destinations, where they are used, discarded, and replaced. While this image is an exaggeration, it does capture the essence of the linear, one-way production model that has dominated global manufacturing since the onset of the Industrial Revolution.

Increasingly, however, the linear approach to industrialization has come under strain. Some three billion consumers from the developing world will enter the middle class by 2030. The unprecedented size and impact of this shift is squeezing companies between rising and less predictable commodity prices, on the one hand, and blistering competition and unpredictable demand, on the other. The turn of the millennium marked the point when a rise in the real prices of natural resources began erasing a century’s worth of real-price declines. The biggest economic downturn since the Great Depression briefly dampened demand, but since 2009, resource prices have rebounded faster than global economic output (Exhibit 1). Clearly, the era of largely ignoring resource costs is over.

Exhibit 1

Since 2009, resource prices have rebounded more quickly than global economic output.

In light of volatile markets for resources, and even worries about their depletion, the call for a new economic model is getting louder. In response, some companies are questioning the assumptions that underpin how they make and sell products. In an effort to keep control over valuable natural resources, these companies are finding novel ways to reuse products and components. Their success provokes bolder questions. Could economic growth be decoupled from resource constraints? Could an industrial system that is regenerative by design—a “circular economy,” which restores material, energy, and labor inputs—be good for both society and business? If the experience of global automaker Renault is any indicator, the answer appears to be yes.

  • Renault’s plant in Choisy-le-Roi, near Paris, remanufactures automotive engines, transmissions, injection pumps, and other components for resale. The plant’s remanufacturing operations use 80 percent less energy and almost 90 percent less water (as well as generate about 70 percent less oil and detergent waste) than comparable new production does. And the plant delivers higher operating margins than Renault as a whole can boast.
  • More broadly, the company redesigns certain components to make them easier to disassemble and use again. It also targets components for closed-loop reuse, essentially converting materials and components from worn-out vehicles into inputs for new ones. To support these efforts, Renault formed joint ventures with a steel recycler and a waste-management company to bring end-of-use expertise into product design. Together, these moves help Renault save money by maintaining tighter control of its raw materials throughout its vehicles’ life cycles—or use cycles.
  • Renault also works with suppliers to identify “circular benefits” that distribute value across its supply chain. For example, the company helped its provider of cutting fluids (a coolant and lubricant used in machining) to shift from a sales- to a performance-based model. By changing the relationship’s nature and terms, Renault motivated the supplier to redesign the fluid and surrounding processes for greater efficiency. The result was a 90 percent reduction in the volume of waste discharge. This new arrangement benefits both companies: the supplier is moving up the value chain so that it can be more profitable, while Renault’s total cost of ownership for cutting fluids fell by about 20 percent.

Renault’s experience is just one data point in a growing body of evidence suggesting that the business opportunities in a circular economy are real—and large. In this article, we’ll explore the concept of such an economy, examine the arguments and economics underpinning it, and discuss the challenges that must be overcome to make it a reality. The work, which draws on McKinsey’s recent collaboration with the Ellen MacArthur Foundation and the World Economic Forum1 1. This work is summarized in three reports: Towards the Circular Economy: Accelerating the scale-up across global supply chains, World Economic Forum, January 2014; Towards the circular economy: Economic and business rationale for an accelerated transition, Ellen MacArthur Foundation, January 2012; and Towards the circular economy: Opportunities for the consumer goods sector, Ellen MacArthur Foundation, January 2013. 

Circular thinking

A circular economy replaces one assumption—disposability—with another: restoration. At the core, it aims to move away from the “take, make, and dispose” system by designing and optimizing products for multiple cycles of disassembly and reuse.2 2.For readers interested in learning more about circular economies and the thinking behind them, we recommend two seminal books: Michael Braungart and William McDonough, Cradle to Cradle: Remaking the Way We Make Things, first edition, New York, NY: North Point Press, 2002; and Walter R. Stahel, The Performance Economy, second edition, Basingstoke, Hampshire: Palgrave Macmillan, 2010. This effort starts with materials, which are viewed as valuable stock to be used again, not as elements that flow through the economy once. For a sense of the scale involved, consider the fast-moving consumer-goods industry: about 80 percent of the $3.2 trillion worth of materials it uses each year is not recovered.

The circular economy aims to eradicate waste—not just from manufacturing processes, as lean management aspires to do, but systematically, throughout the various life cycles and uses of products and their components. (Often, what might otherwise be called waste becomes valuable feedstock for successive usage steps.) Indeed, tight component and product cycles of use and reuse, aided by product design, help define the concept of a circular economy and distinguish it from recycling, which loses large amounts of embedded energy and labor.

Moreover, a circular system introduces a strict differentiation between a product’s consumable and durable components. Manufacturers in a traditional economy often don’t distinguish between the two. In a circular economy, the goal for consumables is to use nontoxic and pure components, so they can eventually be returned to the biosphere, where they could have a replenishing effect. The goal for durable components (metals and most plastics, for instance) is to reuse or upgrade them for other productive applications through as many cycles as possible (Exhibit 2). This approach contrasts sharply with the mind-set embedded in most of today’s industrial operations, where even the terminology—value chain, supply chain, end user—expresses a linear view.

Exhibit 2

In a circular economy, products are designed to enable cycles of disassembly and reuse, thus reducing or eliminating waste. View a slideshow of this exhibit, narrated by McKinsey alumnus Markus Zils.

Since restoration is the default assumption in a circular economy, the role of consumer is replaced by that of user. For companies, this change requires a different way of thinking about their implicit contract with customers. For example, in a buy-and-consume economy, the goal is to sell the product. In a circular economy, the aspiration might be to rent it out to ensure that its materials were returned for reuse. When products must be sold, companies would create incentives to guarantee their return and reuse. While all this might sound rather utopian, a number of companies are starting to pull four (often mutually reinforcing) levers to convert theory into hard-hitting practice.

1. The power of the inner circle

Ricoh, a global maker of office machines, designed its GreenLine brand of office copiers and printers to maximize the reusability of products and components, while minimizing the use of virgin materials. Products returning from their leasing contracts are inspected, dismantled, and taken through an extensive refurbishing process that includes replacing components and updating software before the machines reenter the market. By designing the components to be reused or recycled in Ricoh facilities, the company reduces the need for new materials in production and creates a tight “inner circle” of use that allows it to employ less material, labor, energy, and capital. GreenLine products are now offered in six major European markets, where they account for 10 to 20 percent of Ricoh’s sales by volume and earn margins that are as much as two times higher than those of the company’s comparable new products—without a reduction in quality.

For products that can’t be remanufactured, refurbished, or upgraded, Ricoh harvests the components and recycles them at local facilities. The company is currently considering a plan to return some recycled materials to its manufacturing plants in Asia for use in making new components. After factoring in the price differences between virgin and recycled materials (polypropylene, for example) and the cost of Asia-bound container shipping, Ricoh estimates it could save up to 30 percent on the cost of materials for these components. Overall, the company says, it’s on track to reduce the input of new resources in its products by 25 percent below their 2007 levels no later than 2020.

2. The power of circling longer

A closely related way companies can benefit from a circular economy is to maximize the number of consecutive product cycles (cycles of reuse, repair, or remanufacture), the time products spend in each of them, or both. If designed appropriately, each additional cycle eliminates some measure of the net material, energy, and labor costs of creating a new product or component. For example, Renault leases batteries for electric cars, in large part to recover them more easily so they can be reengineered or recycled for additional duty. Keeping close control over the process helps ensure the product’s quality and gives Renault a chance to strengthen its ties to customers.

Leasing isn’t new in the automotive industry, of course: tire-maker Michelin leased automobile tires in the 1920s. In 2011, Michelin Fleet Solutions had 290,000 vehicles under contract in more than 20 European countries. The group offers tire upgrades, maintenance, and replacement to optimize the performance of trucking fleets and to lower their total cost of ownership. By maintaining control over the tires, Michelin can collect them when they wear out and can extend their technical utility by retreading or regrooving them for resale. The company estimates that retreads, for example, require half of the raw materials new tires do but deliver up to 90 percent of the performance.

Meanwhile, in a few stores, the UK-based retailer B&Q is piloting a take-back program for its power tools. Customers can exchange used ones either for cash or a charity donation. The company plans to refurbish the tools it collects in Europe for resale locally or to recycle them and thus recover raw materials that could be used to make new power tools in the company’s facilities in China. Our research suggests that the margin-improvement potential, primarily resulting from savings in the cost of materials, could be as high as ten percentage points.

3. The power of cascaded use

Another source of value creation is to take a product or component and diversify its reuse more widely across the value chain, redistributing the materials so they can substitute for inflows of virgin ones somewhere else. For example, the Australian property and infrastructure company Lend Lease uses scrapped-wood chips from timber mills to create cross-laminated timber panels for construction.

Global apparel retailer H&M launched an in-store collection program encouraging customers to bring in old clothes in exchange for discount vouchers on new H&M clothing. The company partners with I:CO, a reverse-logistics provider, to sort the clothes for a range of subsequent “cascaded” uses.3 3.Cascading is the process of putting materials and components to use, across value streams and industries, after their end of life. The majority of items collected are dispatched to the global secondhand-apparel market. Clothes that are no longer suitable to wear are used as substitutes for virgin materials in other applications—for example, as cleaning cloths and textile yarns or as inputs for damping and insulation materials in the auto industry or for pipe insulation in the construction industry. When all other options are exhausted, the remaining textiles (1 to 3 percent, according to I:CO estimates) become fuel to produce electricity.

H&M executives view the program as a way to increase in-store traffic and customer loyalty. It is also the first step in the company’s longer-term goal of recycling all of its textile fibers for additional purposes and using yarns made from collected textiles in its new products—a move that would bring greater arbitrage opportunities.

4. The power of pure inputs

The final way companies can benefit from the principles of a circular economy is by designing products and components so they are easier to separate into consumable and durable elements later on, thus helping to ensure the purity and nontoxicity of materials along the manufacturing process. Greater ease of separation also increases the efficiency of collection and redistribution while maintaining the quality of the materials—a crucial economic consideration and often a substantial challenge. In the United States, for example, less than one-third of the rubble generated during the construction and demolition of buildings is recycled or reused, though it contains high concentrations of recyclable steel, wood, and concrete.4 4. Buildings and Their Impact on the Environment: A Statistical Summary, revised April 22, 2009, US Environmental Protection Agency, epa.gov. Even in paper recycling (where the inputs are generally considered “pure” and recycling rates approach 80 percent in Europe), the difficulty of removing inks, fillers, and coatings from paper without degrading it results in a loss of materials worth $32 billion a year.

In some cases, companies work with their supply partners to create ecosystems that support circular product designs. For example, Desso, a Dutch manufacturer of carpets, operates a take-back program that collects end-of-use carpet tiles to recover their materials for further production or for sale to secondary materials suppliers. The carpet-backing material can be fully recycled in the company’s own production processes; Desso’s supplier, Aquafil, converts the Nylon 6–based top yarn back into new yarn. Because the nylon inputs are pure, they can be reused over and over again without degradation. In general, designing a product to use the purest materials possible helps maintain their residual value and supports recycling and reuse.

Squaring the circle

Given the potential of the circular economy to replace untapped value through resource arbitrage, why isn’t it taking off faster? Three barriers have slowed the realization of that potential; each holds clues about moves companies can make to convert themselves from linear to circular economics.

Geographic dispersion

The most tangible barrier for corporate decision makers is all around them, in the extensive supply and manufacturing footprints that companies have created to thrive in the linear economy. This problem is evident even in seemingly simple products. For example, B&Q estimates that its cordless drills contain up to 80 components derived from 14 raw materials sourced in as many as seven countries. A product such as a car is significantly more complex. Understandably, closing product and component loops for most products is difficult, despite attractive arbitrage opportunities.

Moreover, good standards for reusable materials require global support, which is not always present. Whether companies attempt to create closed global loops (like Ricoh) or geographically open cascades (as H&M and I:CO are attempting to do in the apparel industry), there is always a risk that an efficient and effective collection, reuse, and recycling process will break down. That is particularly true in developing countries, where the collection and recycling of valuable end-of-use materials frequently falls to the informal sector. In China, for example, the formal sector covers only about 20 percent of the “e-waste” collected.5 5. Euromonitor; expert interviews. Without adequate standards, reprocessing is inefficient and, worse, creates health and safety hazards for the workers involved.

To get a handle on the challenge of geographic dispersion, senior executives must start thinking as hard about reverse-network activities (moving from products to components to materials) as they do about the traditional inbound ones. They will have to deal with a host of thorny trade-offs. Should refurbishment take place in the region of manufacture or of usage? When is it more economical to reduce components to their constituent materials and sell them on global markets? How cost effective would it be to establish postusage loops with business partners as opposed to making new components with virgin materials?

Developing a clear picture of the economics will be crucial, as will the ability to create “win–win” partnerships. For example, in exchange for lower prices and guaranteed access to supplies, Philips Healthcare returns used components to its suppliers and lets them decide whether to reuse the components for new builds and service parts or to sell them to raw-materials suppliers as high-quality, recyclable (or even ready-to-use) feedstock. (See, “Toward a circular economy: Philips CEO Frans van Houten,” available on mckinsey.com, on February 7.)

Reverse-logistics skills (such as collection, sorting, remanufacturing, and refurbishment) will be critical. One of the success factors in Ricoh’s GreenLine operations is the company’s “take-back” system, which optimizes supply and demand for remanufactured machines. This system requires sophisticated reverse-network-management capabilities, such as tracking the location and condition of used devices and components, as well as storing bill-of-materials information.

Complex materials

The second point of leakage involves the sheer complexity and proliferation of modern product formulations, which are rarely labeled or made public and are therefore devilishly difficult to identify after the fact, even for manufacturers. In the world of plastics, for example, companies have broadened the spectrum of materials used, in creative and complex ways. Most innovations in polymer-materials science have come courtesy of new additives that act, for example, as heat stabilizers, flame retardants, pigments, or antimicrobial agents.

In addition, the proliferation of materials can come from sheer habit or even management inattention. Companies, for example, often add materials to cut costs or innovate and then later fail to revisit these decisions; in their purchasing practices, say, they might introduce 16 plastics, where 4 would cover all functional specifications and application needs. These problems have exponentially increased the complexity of materials, while making it hard to classify and collect them on the scale required to create arbitrage opportunities or to demonstrate the returns needed to attract investors.

Moreover, companies often have no cost-efficient way of using chemical or physical processes to extract embedded raw materials without degrading the product, so most of the original value is lost in current, smelter-based recycling processes. For example, only $3 worth of gold, silver, and palladium can currently be extracted from a mobile phone that, when new, contains $16 worth of raw materials.

Despite the difficulties, some companies are making progress. Veolia’s Magpie materials-sorting system, for example, uses infrared and laser technologies to sort some plastics quickly. The company’s facility in Rainham, in the United Kingdom, can separate nine grades of plastics while processing 50,000 metric tons of them a year. Nonetheless, current technologies still depend on accurate (and often manual) presorting, which must meet minimum purity requirements to ensure an economically viable yield.

As Veolia’s example suggests, tackling the problem of complex materials will ultimately come down to extracting them at scale, so that they have a marketable value. This will in turn require companies to cooperate in the precompetitive sphere. Arbitrage opportunities already exist across the value chain—from raw-materials suppliers to product manufacturers, players in end-of-use management, and suppliers of the enabling information technologies. Successful first movers could capture significant economic benefits, including an outsized influence on global standards or on the design of products and supply chains.

The curse of the status quo

The final barrier against a circular economy is the sheer difficulty of breaking ingrained habits. Many aspects of the current system reflect decisions made long ago. While some are relatively innocuous (for instance, QWERTY keyboards and the shape of power plugs), others incur higher costs.

Misaligned incentives dot the industrial landscape, making it hard to create, capture, and redistribute value. Customers, for instance, are used to evaluating the expense of products only at the point of sale, even if costlier but longer-lasting products would be more economical in the long term. Leasing models are unheard of in many industries, though they would benefit both customers and companies. Research from the Ellen MacArthur Foundation suggests, for example, that leasing high-end home washing machines would lower the cost of use for customers by one-third over five years. During that time, manufacturers would earn roughly one-third more in profits because they could lease their fleets of machines multiple times before refurbishment.6 6. For more, see Towards the circular economy: Economic and business rationale for an accelerated transition, Ellen MacArthur Foundation, January 2012, ellenmacarthurfoundation.org.

Ingrained habits within companies also thwart change. Senior executives rightly worry about the higher levels of capital needed to change products, as well as the friction of moving from familiar sales- to usage-based approaches. One of the biggest concerns for Ricoh’s executives before launching GreenLine, for example, was that it might cannibalize new products. Only after creating a control plan to monitor sales of GreenLine and other offerings was the company confident that it could guarantee strong coverage across different customer segments while not cannibalizing its products.

Misaligned incentives also exist between companies. Dividing the gains from optimized designs of more circular products or processes is tricky given the different motivations involved. For example, in the European beer industry, the closed-loop model for returnable bottles is well established. Yet in some markets, the share of bottles completing the circle back to the manufacturer dropped to one-third, from one-half, between 2007 and 2012. The reason: store owners preferred to dispose of the empty bottles themselves because that maximized the sales space available to promote new products. Addressing such challenges requires companies to develop profit-sharing models across their value chains. They should also learn how to spot “moments of truth” when it might be easier to break with the status quo—for example, when companies enter new markets, renegotiate agreements with suppliers and service providers, or face choices about big capital investments.

Toward a circular economy

Ultimately, the systemic nature of the barriers means that individual corporate actions, while necessary, won’t suffice to create a circular economy at scale. The real payoff will come only when multiple players across the business and research communities, supported by policy makers and investors, come together to reconceive key manufacturing processes and flows of materials and products. Should that happen, our research finds, the benefits would be huge. They include:

  • Net materials savings. On a global scale, the net savings from materials could reach $1 trillion a year. In the European Union alone, the annual savings for durable products with moderate lifespans could reach $630 billion. The benefits would be highest in the automotive sector ($200 billion a year), followed by machinery and equipment.
  • Mitigated supply risks. If applied to steel consumption in the automotive, machining, and transport sectors, a circular transformation could achieve global net materials savings equivalent to between 110 million and 170 million metric tons of iron ore a year in 2025. Such a shift could reduce demand-driven volatility in these industries.
  • Innovation potential. Redesigning materials, systems, and products for circular use is a fundamental requirement of a circular economy and therefore represents a giant opportunity for companies, even in product categories that aren’t normally considered innovative, such as the carpet industry.
  • Job creation. By some estimates, the remanufacturing and recycling industries already account for about one million jobs in Europe and the United States.7 7.According to the Automotive Parts Remanufacturers Association (United States) and SITA (the waste-management arm of Suez Environnement).The effects of a more circular industrial model on the structure and vitality of labor markets still need to be explored. Yet we see signs that a circular economy would—under the right circumstances—increase local employment, especially in entry-level and semiskilled jobs, thus addressing a serious issue facing many developed countries. Ricoh’s remanufacturing plant, for instance, employs more than 300 people.

Focusing a collective effort on the leverage points that would have a systemic impact is the key to unlocking this potential. Our research suggests that the place to start is materials flows, as they represent the most universal industrial assets. The ultimate objective is to close materials loops on a global level and to achieve tipping points that would bring major streams of materials back into the system, at high volume and quality levels, through established markets. Creating pure-materials stocks for companies would help jump-start that process while giving companies strong incentives to innovate.

The ubiquitous PET8 8.Polyethylene terephthalate. provides a useful analogy for how this could happen. The polymer’s strong adoption as the basic input for bottles in the beverage industry created a recycled-PET market that extended beyond bottles. This in turn created a stable platform for beverage companies to use PET for their own innovative purposes. Innovation therefore shifted from materials (new additives harder to isolate and later remove) and toward products and processes (for example, novel shapes for sports-drink bottles, new process innovations that allow hot drinks to be injected into bottles, and thinner-walled water bottles requiring lower amounts of materials to create).

Establishing de-facto standards for other materials would act as a catalyst for further action. Our research identified four types of materials, each at a different stage of maturity in its evolution toward the circular economy. These four thus represent realistic starting points where pilot projects would make the greatest difference right away (Exhibit 3).

Exhibit 3

A large-scale transformation would focus on four types of materials at different stages of maturity.

Mobilizing multiple stakeholders is always challenging, of course, and could take several forms, including industry partnerships and consortia. Nonprofits and nongovernmental organizations will also play a vital convening role.9 9.For example, the Ellen MacArthur Foundation’s Circular Economy 100 program aims to bring companies and innovators together across regions to help develop and accelerate various commercial opportunities. Similarly, the World Economic Forum has created a number of initiatives focused on circular-economy issues.Regardless of the route companies choose, by joining forces they can begin using existing science to develop the projects and enabling mechanisms that could trigger a self-reinforcing virtuous cycle. That would in turn ultimately benefit stakeholders on every level—customers, businesses, and society as a whole.

The “take, make, and dispose” model of production has long relied on cheap resources to maintain growth and stability. That world no longer exists. By applying the principles of a circular economy—a system that is regenerative by design—forward-looking companies can seize growth opportunities while laying the groundwork for a new industrial era that benefits companies and economies alike. Capitalizing on the opportunities will require new ways of working, but the benefits are well worth the cost.

Originally Published in full in McKinsey – Insights and Publications

Next-shoring: A CEO’s guide

Proximity to demand and innovative supply ecosystems will trump labor costs as technology transforms operations in the years ahead.

When offshoring entered the popular lexicon, in the 1990s, it became shorthand for efforts to arbitrage labor costs by using lower-wage workers in developing nations. But savvy manufacturing leaders saw it as more: a decisive change in globalization, made possible by a wave of liberalization in countries such as China and India, a steady improvement in the capabilities of emerging-market suppliers and workers, a growing ability to transfer proven management processes to new locales, and increasingly favorable transportation and communications economics.

Something of equal moment is occurring today. As we settle into a “new normal” catalyzed by the global financial crisis, the ensuing recession, and an uneven global recovery, traditional arbitrage models seem increasingly outmoded.1 1. See Ian Davis, “The new normal,” McKinsey Quarterly, March 2009. For some products, low labor costs still furnish a decisive competitive edge, of course. But as wages and purchasing power rise in emerging markets, their relative importance as centers of demand, not just supply, is growing.

Global energy dynamics too are evolving—not just the now-familiar shale-gas revolution in the United States, but also rising levels of innovation in areas such as battery storage and renewables—potentially reframing manufacturers’ strategic options. Simultaneously, advances stemming from the expanding Internet of Things, the next wave of robotics, and other disruptive technologies are enabling radical operational innovations while boosting the importance of new workforce skills.

Rather than focus on offshoring or even “reshoring”—a term used to describe the return of manufacturing to developed markets as wages rise in emerging ones—today’s manufacturing strategies need to concentrate on what’s coming next. A next-shoring perspective emphasizes proximity to demand and proximity to innovation. Both are crucial in a world where evolving demand from new markets places a premium on the ability to adapt products to different regions and where emerging technologies that could disrupt costs and processes are making new supply ecosystems a differentiator. Next-shoring strategies encompass elements such as a diverse and agile set of production locations, a rich network of innovation-oriented partnerships, and a strong focus on technical skills.

In this article, we’ll describe the economic forces sweeping across the manufacturing landscape and examine technologies coming to the fore. Then we’ll suggest some principles for executives operating in this new world. The picture we’re painting is of necessity impressionistic: next-shoring is still taking shape and no doubt will evolve in unexpected ways. What’s increasingly clear, though, is that the assumptions underlying its predecessor, offshoring, are giving way to something new.

Economic fundamentals

The case for next-shoring starts with the economic fundamentals of demand (since the importance of local factors is growing) and supply (as the dynamics of labor and energy costs evolve).

The importance of local demand factors

More than two-thirds of global manufacturing activity takes place in industries that tend to locate close to demand. This simple fact helps explain why manufacturing output and employment have recently risen—not only in Europe and North America, but also in emerging markets, such as China—since demand bottomed out during the recession following the financial crisis of 2008.

Regional demand looms large in sectors such as automobiles, machinery, food and beverages, and fabricated metals. In the United States, about 85 percent of the industrial rebound (half a million jobs since 2010) can be explained just by output growth in automobiles, machinery, and oil and gas—along with the linkages between these sectors and locally oriented suppliers of fabricated metals, rubber, and plastics (Exhibit 1).2 2. See Manufacturing the future: The next era of global growth and innovation, McKinsey Global Institute, November 2012, for an in-depth analysis of the economics and trends surrounding five types of manufacturing industries: global technologies (for instance, electronics) that are R&D intensive and highly traded, global innovation for local markets (autos, machinery) that are R&D intensive but tend to produce adjacent to demand, labor-intensive regional processors (food, fabricated metals) that are highly localized and locate adjacent to demand, resource-intensive commodities (metals, paper and pulp) that are energy intensive and locate near demand or resources, and labor-intensive tradables (apparel, footwear) that are highly traded and locate where labor is cheap. The automotive, machinery, and oil and gas industries consume nearly 80 percent of US metals output, for example.

Exhibit 1

In the recent US industrial rebound, about 85 percent of the job growth in manufacturing occurred in automobiles, machinery, and regional-supplier industries.

In China too, locally oriented manufacturers have contributed significantly to rising regional investment and employment. The country has, for example, emerged as the world’s largest market and producer for the automotive industry, and many rapidly growing manufacturing sectors there have deep ties to it. As automotive OEMs expand their capacity in emerging markets to serve regional demand, their suppliers have followed; the number of automotive-supplier plants in Asia has tripled in just the past decade.

The emerging markets’ share of global demand is steadily climbing, from roughly 40 percent in 2008 to an expected 66 percent by 2025 (Exhibit 2). As that share rises, it also is fragmenting into many product varieties, feature and quality levels, price points, service needs, and marketing channels. The regional, ethnic, income, and cultural diversity of markets such as Africa, Brazil, China, and India (where some local segments exceed the size of entire markets in developed nations) is raising the ante for meeting local demand. In the automobile industry, for example, fragmenting customer demand has led to a 30 to 50 percent increase in the number of models. Ninety percent of recent capital expenditures in the automotive sector have involved product derivatives worldwide and capacity expansions in new markets.

Exhibit 2

Emerging markets’ share of global demand is expected to reach 66 percent by 2025.

The limits of labor-cost arbitrage

Surging local demand helps explain why rapid wage growth in China hasn’t choked off manufacturing expansion there. Wages have nearly doubled since 2008, partly as a result of domestic minimum-wage policies.3 3. Measured in nominal dollars. (The country’s 2011 five-year plan called for 13 percent average annual minimum-wage increases, a rate some provinces have already exceeded.) True, in a few labor-intensive, trade-oriented industries, such as apparel production and consumer electronics, labor-cost changes do tend to tip the balance between different geographic regions; manufacturing employment in Bangladesh and Vietnam, for instance, has benefited from China’s wage surge, even as Chinese manufacturers are seeking to raise productivity.

But these are far from the only implications of rising wages. Just as Henry Ford’s $5 day helped create a new consuming class, so higher wages in China are increasing local demand, thus reinforcing the local-investment choices of OEMs and suppliers. At the same time, there is little evidence of a zero-sum game between China and advanced economies, such as the United States. Rather, the narrowing labor-cost gap reinforces the importance of local demand factors in driving manufacturing employment. Indeed, factor costs often have the greatest impact on location decisions within a region—for example, Airbus moving to Alabama instead of Texas or North Carolina. These costs interact with policy factors, such as infrastructure spending and tax incentives, to shape a region’s overall economic attractiveness.

The impact of energy costs

The price of natural gas in the United States has fallen by two-thirds as gas production from shale deposits rose by 50 percent annually since 2007. A narrow range of sectors—gas-intensive manufacturing, such as the production of petrochemicals, fertilizer, and steel—are benefiting most directly. Some downstream players in the energy value chain have begun shifting investments. Dow Chemical, BASF, and Methanex, for example, have announced plans for new US manufacturing capacity to take advantage of cheaper, abundant energy supplies.

These moves are important for such companies and subsectors; McKinsey Global Institute (MGI) research suggests that by 2020, lower-cost energy could boost US GDP by somewhere between $400 billion and $700 billion.4 4. For more, see the full McKinsey Global Institute report, Game changers: Five opportunities for US growth and renewal, July 2013. But do they presage a dramatic rebalancing of global manufacturing activity? Electricity costs were already lower in the United States than in many countries, including China—which, along with others, also has opportunities to boost its own energy output through hydraulic fracturing. And fossil fuels aren’t the only area where the energy-supply picture is morphing.

Consider, for example, the potential impact of energy-storage technologies, especially lithium-ion batteries and fuel cells, which are becoming more capable and less costly. At the same time, the improving economics of renewable-energy production—particularly solar and wind power—offers manufacturers an expanding range of future supply options. In some developing regions where power grids are unreliable or nonexistent, factory complexes served by distributed solar power may be feasible. Distributed generation is also growing in combined heat–power (CHP) plants, which use heat created in the production process to run steam turbines and generate electricity locally.

None of these is a silver bullet today. But as advances continue over time, more and more companies may become able to ask themselves where they would place major strategic bets if the availability and price of energy were lesser concerns. That too will probably lead back to a focus on local demand patterns. Interestingly, the country representing the greatest source of future demand growth—China—also is actively stimulating the development of a range of new energy sources and storage technologies through a focus on new strategic industries in its five-year plans.5 5. See Guangyu Li and Jonathan Woetzel, “What China’s five-year plan means for business,” July 2011.

Technology disruption ahead

Technology is affecting far more than energy dynamics. Advanced robotics, 3-D printers, and the large-scale digitization of operations are poised to alter fundamental assumptions about manufacturing costs and footprints.6 6. For more, see Disruptive technologies: Advances that will transform life, business, and the global economy, McKinsey Global Institute, May 2013. To derive value from these shifts, companies will have to make significant investments and ensure access to hubs of innovation, capable suppliers, and highly skilled workers.

Advanced robotics

Investments in industrial robots have increased by nearly 50 percent since 2008—even in emerging nations such as China—as a new generation of advanced systems develops, with greater dexterity and ability to process information. These robots can perform an expanding array of factory tasks—for instance, manipulating small electronic parts, and picking and packing individual products. They can work side by side with humans and be trained by factory-floor operators rather than programmed by teams of highly paid engineers. Improved economics and capabilities eventually may yield productivity gains that are unforeseen today, as well as better products and faster speed to market. As that happens, companies will be able to retool their manufacturing systems to provide new roles for these mechanical “workers.”

Cheaper, more proficient robots that can substitute for a wider variety of human tasks are another reason companies may locate more manufacturing closer to major demand markets, even where wage rates are higher. In developing nations, robots could speed up rates of automation and help bridge shortages of some production skills. MGI research suggests that 15 to 25 percent of the tasks of industrial workers in developed countries and 5 to 15 percent of those in developing countries could be automated by 2025.

Further out, highly robotized factories also equipped with other information technologies might shift competition to areas such as the ownership of customer networks, which should become increasingly valuable as information embedded in them starts guiding production priorities and flows. Flexible, intelligent assembly robots also should enable contract manufacturers to serve an increasingly diverse range of customers, creating new opportunities for attackers to target attractive microsegments.

3-D printing

The economics of 3-D printing are improving rapidly, as well. While still only a sliver of value in the manufacturing sector (0.02 percent), sales of 3-D printers are set to double, to $4 billion, by 2015, and prices for the equipment are declining swiftly.7 7. Wohlers Report 2013: Additive Manufacturing and 3D Printing State of the Industry, Wohlers Associates, May 2013, wohlersassociates.com. Also, 3-D printers open up the possibility of more distributed production networks and radical customization. In early manufacturing applications, some companies are using the devices to accelerate product development, since they eliminate wait times for prototyping by faraway specialists. Companies will be able to consider new supply-chain models and, in some cases, replace traditional suppliers of parts with targeted usage of in-house printers.

These printers won’t replace traditional high-volume modes of production, such as die casting and stamping. For more specialized goods, though, it’s easy to imagine the emergence of service businesses—the equivalent of copy or print shops—that would manufacture items based on design specifications provided by B2B or B2C customers. Crowdsourcing networks for new-product ideas could one day complement traditional R&D activities for some manufacturers. (For more on 3-D printing, see “3-D printing takes shape,” available on mckinsey.com, on January 31.)

Digitized operations

Significant as advanced robotics and 3-D printers are, they represent just two plot lines in a much bigger story about the digitization of operations. Cloud computing, mobile communications, and the Internet of Things8 8.The growing collection of sensors and actuators embedded in products and equipment. are beginning to combine with advanced analytics to create threads of intelligent data that link assets and stakeholders as never before. Increasingly, products will communicate with each other, with robots and advanced machines inside factories, and with customers and suppliers. Digital “DNA” for parts (including the materials, equipment, and time required to make them) will also be increasingly available.

The implication is that we are approaching a day when manufacturers will have unprecedented global visibility into who makes what, where, and how well. They’ll be able to run virtual operations “war rooms” on their phones. They’ll have new opportunities to solve plant-floor optimization problems as intelligent machines interface with each other and with people on the line. In the near future, manufacturers also will exploit opportunities for crowdsourced design and on-demand production. These opportunities will extend well beyond goods made by 3-D printers; manufacturers will pursue the buying and selling of previously underutilized production lines “by the hour” and will rely on dynamic databases to determine what every part should cost. And new forms of technology-enabled collaboration, such as the three-dimensional virtual assembly and testing of vehicles, will redefine what it means to be proximate to innovation—which may be locally generated or accessed via broadband.

Digital operations aren’t a far-off fantasy. GE already has a 400-person industrial Internet software team and its employees use iPads to run an advanced battery factory in New York State. Amazon.com is employing growing numbers of smart warehouse robots. Fiat has reduced the number of physical prototypes needed to introduce a new product; Alcoa has compressed prototyping time and costs for some products; and an auto supplier recently slashed an eight-month prototyping process to one week.

Next-shoring

Although these forces are still gathering strength, they’re already pointing toward two defining priorities for manufacturing strategy in the era of next-shoring: proximity to demand and proximity to innovation, particularly an innovative base of suppliers. In developed and emerging markets alike, both ingredients will be critical. Next-shoring isn’t about the shift of manufacturing from one place to another but about adapting to, and preparing for, the changing nature of manufacturing everywhere.

Optimizing location decisions

Being close to demand is particularly important at a time when consumption in emerging markets is growing rapidly, boosting with it the diversity of the regional preferences that manufacturers must contend with. In a 2012 interview with McKinsey, Timken CEO James Griffith explained his company’s approach: “Over the last ten years, we’ve added a very strong Eastern European, Indian, and Chinese manufacturing base,” not because wages are low there “but because those were the markets that were growing.” This expansion has been accompanied by a strategic shift away from a focus on automotive parts—“we could make a car last for a million miles, but nobody cares.” The new emphasis is on fast-growing mining, trucking, steelmaking, and cement-making customers in emerging markets. For them, Timken’s reliability is a decisive asset.9 9. See “Manufacturing’s new era: A conversation with Timken CEO James Griffith,” December 2012.

Locating manufacturing close to demand makes it easier to identify and meet local needs. It’s a delicate balancing act, though, to create an efficient global manufacturing footprint that embraces a wide range of local tastes, since economies of scale still matter in many industries. Volkswagen has coped by moving from vehicle platforms to more modular architectures that provide greater flexibility for manufacturing several product variants or derivatives.

New products, market segments, and consumer preferences are combining with perennial risks (such as seasonal variations in demand and fluctuations in wages and currency rates) to boost uncertainty in manufacturing and supply networks. That uncertainty places a premium on operational agility—the ability to adapt design, production, and supply chains rapidly to fluctuating conditions.10 10.For more on operational agility, see Mike Doheny, Venu Nagali, and Florian Weig, “Agile operations for volatile times,” McKinsey Quarterly, May 2012. This too may play into location decisions.

Take the experience of a consumer-products company that had relied on one plant to supply its major market. When the company began experiencing unaccustomed spikes in regional and seasonal purchasing patterns, shortages and lost sales ensued. To accommodate rising variations in demand, the company built a second plant, with similar cost characteristics, in a different region. This additional capacity helped ensure supplies to the prime market, where the problems were most acute, while also allowing the company to meet growing demand opportunistically in several new markets close to the new plant. Although the investment was considerable, it lowered the company’s risk exposure, eliminated damaging stockouts, and improved the bottom line.

Building supplier ecosystems

New combinations of technical expertise and local domain knowledge will become the basis for powerful new product strategies. Responsive, collaborative, and tech-savvy supplier ecosystems will therefore be increasingly important competitive assets in a growing number of regional markets. To keep up with the opportunities afforded by technological change, for example, a major manufacturer that until recently had relied on a low-cost supplier in Mexico for parts has begun working with a new supplier that has cutting-edge 3-D printing capabilities. The new relationship has lowered stocking costs (since parts are made on demand), while providing avenues for developing prototypes more quickly.

Examples like this are just a start. As information flows among partners become more robust, they will usher in a range of improvements, from surer logistics to better payment systems. These will create a virtuous cycle of collaborative benefits. The supply bases of many manufacturers thus may soon need significant upgrades and capital investments to create joint competencies in areas such as robotics. Collaboration and management investment in skill-development programs could be necessary as well. In some cases, it may be valuable to collaborate with local or national governments to create the conditions in which the manufacturing ecosystems of the future can flourish. Tighter supply networks also will foster production systems that reduce the need for virgin natural resources, a topic addressed in more detail by our colleagues in “Remaking the industrial economy,” available on mckinsey.com on February 5.

A failure to develop innovative supply ecosystems will have growing competitive implications for countries as well as companies. The competitive challenges facing the United States sometimes look more like a system failure than an economic one. US investment in advanced robotics, for example, often lags behind that of other developed economies, with trade deficits prevailing even in sectors where wage-rate differentials aren’t a big influence on location decisions.

Developing people and skills

All this will place a premium on manufacturing talent, creating a range of regional challenges. In Europe and the United States, educational institutions aren’t producing workers with the technical skills advanced manufacturers need. In developing economies, such as China, the millions of lower-cost production associates who are well adapted to routine manufacturing may find it difficult to climb to the next level. Line supervisors—often fresh out of regional universities—struggle to manage baseline operations and to coordinate teams. Organizations will need to invest more in formal training and on-the-job coaching to bridge the gaps. They must also cast a wider net, supporting local community colleges and technical institutes to shape curricula and gain access to new talent streams.

A related challenge is the need for new management muscle. As it gets harder to hide behind labor-cost arbitrage, regional manufacturing executives and midlevel managers will need to become both better at running a tight operational ship and more versatile. They should be able to grasp the productivity potential of a range of new technologies and have enough ground-level knowledge of local markets to influence product strategies and investment trade-offs. The ability to build external relationships—with suppliers, education partners, and local-government officials who can influence the development of vibrant, sophisticated supply ecosystems—will also be a source of competitive advantage.

Next-shoring will look different in different locales, of course. Europe and the United States have impressive advantages in areas such as biopharmaceuticals, automotive engineering, and advanced materials. China, meanwhile, is quickly climbing the expertise curve, with increasingly sophisticated corporate and university research facilities and growing experience in advanced processes and emerging industries.11 11.See Gordon Orr and Erik Roth, “The CEO’s guide to innovation in China,” McKinsey Quarterly, February 2012; and “China’s innovation engine picks up speed,” McKinsey Quarterly, June 2013. In the world we’re entering, the question won’t be whether to produce in one market for another but how to tailor product strategies for each and how to match local needs with the latest veins of manufacturing know-how and digital expertise. While the road map for every company, industry, and location will be different, we believe that the principles we’ve laid out here should be useful for all.

Originally Published by McKinsey & Company

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