From Optimal Hierarchy …

Although a product competes on the front line, what goes into making it competitive obviously does not happen there; corporations must bring together many resources and capabilities to create new products. Consequently, firms become complex organizations.

The traditional response to complex organizational challenges is to create hierarchy, an organizational model in which experienced, wise leaders inform themselves of the facts on the ground, reflect and consult, and then give orders to people below them, which inform the orders that those people give to people below them and so on. That’s why in every corporation, we see numerous levels above the front line. If the front line is Pantene shampoo, above Pantene is the Hair Care business, and above that is Beauty Care, and above that is Procter & Gamble.

Of course, there’s considerable variation around how hierarchy works across different national cultures, but one way or another, in most countries the assumption is that success in hierarchical organizations has traditionally been largely determined by the quality of the judgments cascading down from the people at the top because, so the logic goes, the people at the top have the best view of how the battle is going overall and where they should send their troops and with what weapons.

But in business, where competition is between products rather than companies, the line of sight between a CEO’s decisions and whether a customer will buy a product at any given time is much less clear. The individual outcomes of customers’ decisions are far from easy for executives, removed from the front line, to predict and control. This changes the power dynamics inside the corporation—who determines what is and isn’t valuable and how the rest of the organization relates to the businesses directly engaged with the company’s products and services.

… to Organizing for Value

If the judge of the value of any product or service is the customer who chooses to buy, not the provider, then it is the provider’s people at the front line, in front of the customer, who are best placed to determine what the customer values. It is up to the rest of the company to help the people in the front lines, where the revenues come in, to satisfy those customer needs. The lower level, in effect, is the customer of the level above it. And like a customer, it should expect to get more value from those services than it pays to get them. Hair Care needs to add net competitive value to Pantene, whether by doing scale-effective hair care R&D across the six major hair care brands globally or in some other way.

The same rule applies to each subsequent level of aggregation. Just as Hair Care level needs to add more value to Pantene than it costs Pantene at the front line, Beauty Care has to help Hair Care in its goal of creating more value for Pantene than it costs Pantene. Perhaps it can add value by developing proprietary understanding of beauty customers across its $13 billion beauty business that would be hard for Hair Care to develop on its own. And P&G has to help Beauty Care to help Hair Care to help Pantene. P&G can do that by making it cheaper for Beauty Care to buy advertising for Hair Care, in general, and Pantene, specifically, thanks to P&G’s huge advertising scale.

In every case, if a layer is not generating net value that ultimately helps the product win at the front line, then that layer is at best superfluous and worst makes the product less competitive. If P&G’s Beauty Care division can’t help the Hair Care help Pantene more than it costs Hair Care to support it, then P&G should consider whether to eliminate Beauty Care as a layer (which would depend on whether it’s adding value to other businesses in the lower level), or to move Hair Care to another division, or even to sell Hair Care to another owner. And if Beauty Care does not get more value from belonging to P&G than it costs to belong to, then P&G should not own and control Beauty Care. No business can compete on the front line with one hand tied behind its back by a layer above that is not creating enough value to counterbalance its cost.

A High Bar

The value that the higher layers need to provide is considerable, because having a level above the front line will automatically and unavoidably add two costs to the front line. First, there will be costs of coordination: those at the front line won’t be in a position to make important decisions on their own without checking with the next level. And that will mean potential delays and maybe not being allowed to make a decision that would be optimal for that business on its own, but not for the rest of the diversified corporation. Second, the extra level will add the direct costs of the managers or executives at that level, their support staff, their expense accounts, the extra office space and IT they will need, and a host of ancillary costs, all of which are supported by the net operating profits on sales at the front line.

So, what can the layers above do to earn their place in the chain? There are many services that higher levels in large firms provide, most of which revolve around exploiting these firms’ operational scale and scope and cumulated investment in credibility know-how.

• Operating scale. These appear most obviously in manufacturing and distribution. In distribution, for example, Frito-Lay can cost-effectively deliver Smartfood popcorn and Grandma’s Cookies directly to stores because it is already delivering Lay’s potato chips and Doritos corn-chip brands to a multitude of stores this way. (It’s worth noting that Lay’s owns four of the five biggest US chips brands, and the only other to crack the top five is Pringles, thanks to its stackable design that is robust enough to utilize cheaper warehouse distribution that regular chips are too fragile to pass through.) In R&D, Boeing can provide cost-effective new aircraft development services to its commercial aircraft business because it also has a large military aircraft business with which it can share the development costs (there is a military variant of most Boeing commercial aircraft across which those costs can be shared).
• Cumulative investment. In branding, when L’Oréal wanted to launch the Age Perfect Cosmetics line, it was able to provide a trusted beauty brand, L’Oréal Paris, and even a trusted fifty-plus sub-brand—Age Perfect from its Age Perfect Skincare line that had been launched twenty years earlier—at a much lower cost than would have been the case for the new business by itself. L’Oréal provides value to Age Perfect Cosmetics not only because of its scale but also because of its cumulated investment in establishing the credibility of the L’Oréal Paris and Age Perfect brands in the minds of customers. In addition, the company can draw on its cumulated investment in expertise at these and its other businesses in designing the new Age Perfect Cosmetics products and bringing them to market. P&G can, in a similar way, leverage its cumulated expertise in fragrances to brands as varied as Tide, Pampers, Always, Olay, Charmin, Pantene, Cascade, Dawn, and Swiffer because it currently is and has for many years been the biggest consumer of raw fragrances in the world and is furthest down the learning curve on the utilization of fragrances.

These are only examples of utilizing operating scale and cumulative investment to provide a service to the front line at a lower cost than it would cost at the front line alone. There are many others, including hiring, training and development, government relations, or regulatory compliance. But whatever type of value is added at each layer, it needs to exceed the inevitable costs that the layer imposes.

This poses two challenges. First of all, managers in the layer above have got to start treating the people below them as customers—understanding their lives and needs, stepping into their shoes. That sounds obvious, but it is surprising how remote executives become as you go up the hierarchy. For example, I worked with a major auto OEM in the mid-2000s and came to realize that every six months, each senior executive automatically had a brand-new vehicle delivered to the executive parking garage below their offices. Every day when they arrived with their car, it was cleaned, serviced, and if necessary, refueled. As a consequence, they had lost touch with what customers experienced when buying, financing, servicing, and operating their vehicles. This mindset has to change, and the change has to start from the top. How can you expect managers in the middle layers to treat those below them as customers if you don’t pay them the compliment yourself? To remedy, I had each executive, including the CEO, do in-home visits with both their own and competitor customers to familiarize themselves with life at the front line.

Smart CEOs do this instinctively. During his entire time as CEO, A.G. Lafley had a rule that whenever he visited another country, he needed the local P&G organization to set up an in-home visit with a local consumer and a store walk-through at a local retailer. His visit to the bank of a river in rural western China to speak to the village women who washed their clothes there became legendary. The message was clear: If the global CEO isn’t too busy to do in-home visits and store checks, how is it that you are?

Once they’ve ensured that managers at all levels have gotten a good understanding of their customers and what those customers need, corporate executives can start on the second challenge.

Creating a Theory for the Firm

How can the corporation add net value to all businesses in the next level of the portfolio—and how does it ensure that all businesses in that next level are capable of adding value to the subsequent level, and so on? Specifically, how does P&G make sure it adds net value to Laundry & Home Care, Baby & Feminine Care, Beauty, Grooming, Health Care, and Family Care? How does PepsiCo make sure it adds net value to Frito-Lay, Quaker Foods, and PepsiCo Beverages? How does Microsoft make sure it adds net value to Productivity & Business Processes, Intelligent Cloud, and Other Personal Computing?

Answering these questions requires thinking about both what capabilities and resources to acquire and what parts of the business really belong together. This is a classic chicken-and-egg dilemma. You can’t build value-adding capabilities until you know the portfolio members for whom you are building said value. But you can’t know what portfolio members you should have until you know that it is possible to add net value to each. This means that corporate leaders need to iterate back and forth to home in on the combination of portfolio composition and value-adding rationale(s). Let’s look at what that involves.

Because each diversified corporation already has a portfolio, the status quo is the practical place to start. The corporate level needs to develop a draft value-adding rationale for the next level. It is just like classic business unit or product strategy, in which the heart of strategy is composed of the linked where-to-play and how-to-win questions. In this case, the former question should focus on choosing in which capability domains to invest, and the latter question on choosing in what way to utilize corporate scale or cumulative investment in the chosen capabilities to make the next level net better off. With a draft value-adding rationale for the next level in place, management in each part of that level should ask the same set of questions about its draft value-adding rationale for each business in the next level. And then the next level and the next, until you get to the level directly above the front line.

This first iteration of corporate strategy from top to bottom should produce four intermediate outputs for refining in the next round. Typically, it takes two or three rounds of back-and-forth to achieve coherence across the portfolio. The four intermediate outputs are the following.