Procter Gambled & Lost

How recentralizing R&D will bring back P&G's product portfolio advantage.
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In the early 2000s, Procter and Gamble’s (P&G) CEO, A.G. Lafley, decentralized the firm’s research and development (R&D) efforts. This change – part of a larger “Organization 2005” strategy – was aimed to shift P&G’s R&D to an open innovation model. Open innovation is a model focused on gathering external knowledge from customers, suppliers, competitors, and academics. The theory is predicated on the idea that in an increasingly connected, educated, and dynamic environment, collaborative development outperforms compartmentalized R&D. The open innovation model shifted the burden of innovation from a centralized department to business units categorized by product type. This provided innovators with focus, and the success rates for new product introductions jumped from 15% to 50%.

Lafley described the paradigm shift as follows: “…we had run our own very large R&D facilities around the world and the focus had been on invention of the technology… it hadn’t really been on innovation in the sense that you take that invention into the market, it meets an unmet need and it creates a commercial success… I asked the different innovation teams to try opening up.” This differs from the traditional closed innovation mentality, which states “if we discover it ourselves, we will get it to market first.”

10 Years Later…

Fast forward to 2012, after the implementation of “Organization 2005”, and P&G’s results are troubling. Warren Buffett, a renowned value investor, has divested his US $1B stake in P&G, mirroring the sentiment of many common shareholders. Bill Ackman, an activist investor known for shaking up struggling organizations through proxy votes, has taken a $1.8B stake in the firm. Despite higher R&D as a percentage of sales, P&G’s organic growth rate has fallen to 2.0%, relative to the 5.8% and 4.0% growth rates of P&G’s great- est competitors, Unilever and Colgate-Palmolive respectively. This lacklustre performance signals the need for R&D adjustments.

P&G’s most recent “blockbusters” – Swiffer, Crest Whitestrips, and Febreze – were all developed well before the decentralization of R&D. Although the decentralization of R&D has led to in- creased product introduction success, it is clear that the business units have settled for mediocre product adjustments instead of innovative breakthroughs. Victoria Collin, an analyst at Atlantic Equities, described this process as “reformulating, not inventing”.

P&G has also successfully rebranded a number of products. This is exemplified by its modernization of the Old Spice brand, from the “deodorant your grandfather used”, to the scent used by the “man your man can [and should] smell like”. After the intro- duction of this marketing campaign, Old Spice deodorant sales increased over the previous quarter by 55%. This is despite the fact that the product itself was unchanged. It appears that P&G believes that revenue losses from slowing product development can be offset by the incremental sales developed through mar- keting campaigns. This is supported by the respective budgets of these departments – R&D as a percentage of sales has fallen by nearly 50% while the marketing budget has remained constant.

What Went Wrong?

How did an organizational shift that once held so much promise lead to anemic growth and an inability to innovate? There were flaws in both the strategy and the implementation, which ultimately led to failure.

Strategy

The open innovation strategy, which led to organizational decentralization, reduced collaboration between separate product groups within P&G. This change failed to utilize one of P&G’s competitive advantages, its conglomerate structure. For instance, Crest Whitestrips used bleaching technology from the laundry business, glue technology from the paper products business, and film technology from the food wrap department. Centralized R&D allowed these departments to work together to stimulate innovation. Today, this type of innovation would not be possible.

Implementation

The compensation structure of business unit managers also contributed to the long-term failure of the R&D reorganization. Managers were compensated based on business unit profitability, and since R&D expenditure lowered profits over the period, investment was not initiated unless it led to immediate, offsetting revenue growth. This led to the transition from high-risk, high-reward “blockbuster” products to incremental improvements of existing products. Shorter development periods and quicker return on investment became the priority.

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Turn Back the Clock

Is it too late for P&G? No. It is time it recentralize R&D, and refocus capital allocation and management compensation on new product development. The decentralized strategy has failed to deliver innovation, and the marginal improvements cannot provide a sustainable competitive advantage relative to firms such as Unilever, that continue to re-write the history of consumer goods. P&G has been able to preserve its top-line through successful marketing campaigns, but ultimately this strategy relies on a portfolio of past successes. If P&G fails to act soon, its product portfolio will slowly lose relevance, and incremental improvements will fail to sustain revenue levels. In the long-term, its current strategy is a losing one.

It is time that P&G reverse the majority of the organizational changes that have been implemented since 2005. The firm should re-establish a distinct R&D department that pools knowledge from scientists, engineers, and product developers across all of P&G’s product lines. These employees should have specific long-term targets and budgets with a significant portion of compensation derived from qualitative metrics. This system emphasizes long-term decision making through focused planning and is flexible enough to reward employees for visionary innovations. A similar compensation structure was implemented at Johnson & Johnson with great success.

P&G should also increase R&D as a percentage of revenues from the current 2.4% to 3.5%. This increase will help compensate for the void in P&G’s innovation pipeline, which will take considerable time and resources to fill. P&G should also consider partnering with external organizations to stimulate collaborative R&D. This could allow for the “cross-pollination” of technology, resulting in radical product improvements. For instance, P&G could partner with General Electric to develop laundry detergents stored within the machine, featuring an optimized release based on the cycle type and load size. P&G has the distribution and technology portfolio required to make this venture attractive to a firm like General Electric. While this strategy has some similarities to open innovation, it maintains centralized decision-making within P&G, which is vital for “blockbuster” innovations. P&G has already explored this type of collaboration through their joint venture with Teva Pharmaceuticals.

Although the proposed strategies do not provide immediate tangible benefits to P&G, they will return the firm to a sustainable state of growth by offering an improved balance between product innovation and promotion.


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