How complexity could slay your company

There’s no questioning the fact that companies today are faced with growing complexity. Environmental, political, and competitive changes conspire to create a challenging and complex operating environment.

In response to these ever evolving pressures, companies often try to mirror external complexity in their internal environments. They may respond to more sophisticated customer demands by creating tailored products and services. They may address the need for cost cutting and innovation by building matrix organizational structures. They may attempt to add new processes to address evolving market needs. In isolation, each of these responses makes sense. But in combination, they can significantly affect organisational performance.

Take BMW. At the end of 2012, the automotive giant announced new record figures for sales volume and revenues, up a whopping 12 per cent over 2011, as well as the best operating profit in the company's history. Yet despite these positive results, shares in the company were lower than they were at the beginning of the year.

How can you explain BMW’s strong top-line growth in a tough market, combined with a lower stock price? The answer lies in the fact that revenues grew significantly more than profits. In fact, profits were flat on the year, and post-tax return on sales actually dropped. BMW attributed the flat profits to an increase in personnel, higher innovation costs, and intense competition. While technically true, there is a more subtle culprit, one that underlies all these factors: higher complexity. More people, more R&D, and more products equal more complexity, which leads to higher costs, which, in turn, bring down profitability.

In the current business environment, there are several common causes of complexity: a proliferation of products and/or services, inconsistent and overlapping processes, misaligned incentives, byzantine organisational structures, and poorly articulated strategies, often in some form of combination.

In the case of BMW, the company increased its product line steadily over the past decade. As new models such as the 1 series, 6 series, and various sub-brands such as the GT and X models were added, complexity inevitably started to rise. More people were needed to design, manufacture, support, and sell all those new models and costs rose as a consequence.

How should organisations deal with complexity? The answer depends on the type of complexity being considered.

Some complexity provides competitive differentiation; this is good complexity and should be optimised. Most complexity, however, does not add value and needs to be reduced or eliminated. There are four common complexity culprits, and they can be reduced by following these steps.

Step 1

Establish a clear strategic direction. Nothing stimulates complexity more than an unclear or inconsistent strategy.

Vodafone UK was unprofitable in the mid-2000s, despite strong top-line growth. A new CEO radically simplified the strategic process, allowing each of the top 100 managers to maintain a list of no more than 5 strategic goals for each quarter, all of which had to be aligned with corporate priorities. These goals were completely transparent to the organisation’s management team. As a result of an extensive simplification program, Vodafone UK has become highly profitable in one of the world’s most competitive telecommunications markets.

Step 2

Rationalise product and service lines. In most cases, the Pareto principle applies: no more than one quarter of products or services account for more than 100% of profits.

Seen another way, three quarters of products or services actually destroy value. Firms could increase profits just by ceasing to offer products or services that do not add value. Compare RIM and Apple’s approaches to mobile phones. Apple has typically sold two generations of phones in two colours with two quantities of memory. By contrast, RIM has launched 37 versions of its Blackberry line since 2008, each with a variety of configurations.

In a statement, the company said it did not know how many models were currently on the market. Certainly, there may be strategic reasons to maintain a few promising, but as yet unprofitable lines of business. However, we maintain that firms should be impatient for profits, even from the highest potential opportunities. Interestingly, Apple has recently added to its offerings, with the iPhone 5C and iPad mini, with a corresponding increase in complexity.

Step 3

Streamline your processes - a major source of complexity.

Processes are often inefficient, non-standard, or duplicated across departments. Process simplification and standardization programs can go a long way towards reducing complexity. Nestlé went through a multi-year process of process rationalization in order to reduce value chain complexity.

Nestlé’s process was sometimes painful, and often deeply unpopular, but the results have been dramatic. Top managers now have a transparent global view of production and sales on a continuous basis. A key challenge is to balance the desire for central control with the need for local flexibility. Most processes can be standardized, while a few should be allowed to vary based on local conditions. A clear process governance framework is needed to facilitate the necessary change.

Step 4

Align personal incentives with organisational goals. A major source of complexity comes from people acting in their own interest to maximize personal gains. This self-promoting behaviour adds huge amounts of hidden complexity. A common example is incentives for growth. Many organizations reward increases in revenue, but as we can see from the BMW example, higher revenues do not always translate into higher profits. In fact, the opposite is often the case. New products need to be designed, produced, stored, shipped, maintained, serviced, and so on.

Elevated complexity is a chronic and endemic problem in today’s organizations. Like high blood pressure or elevated cholesterol, it may be hidden from view, but still dangerous. To maintain a healthy company, it’s important to have a clear direction. You should rationalize your product and service lines as well as streamline your processes. And, aligning personal incentives with organisation goals is key. Together, these four steps will help to ensure a long (and less complex) life expectancy for your organisation.

Michael Wade  is professor of innovation and strategic information management at IMD.