Innovation Blog

12.1.07

Leading change: An interview with the CEO of Deere & Company


Leading change: An interview with the CEO of Deere & Company

Bob Lane details the steps his company took to engage the whole organization in an operational and cultural transformation.

Rodger L. Boehm

Web exclusive, December 2006


When Bob Lane became chairman and CEO of Deere & Company, in August of 2000, he inherited a leading producer of agricultural, construction, forestry, and turf care equipment that enjoyed loyal customers, a strong dealer network, and a rich heritage spanning 164 years. He also inherited a company that was, in his words, "asset heavy and margin lean," too often dissipating economic value and less prepared to compete in a changing and more demanding global environment than it could be.

Lane, at the time an 18-year veteran of the company, had held a range of operating positions (including a 2-year term as CFO) and immediately set to remedy these problems. With his leadership team, Lane created an ambitious plan to manage assets more efficiently, cut costs, and manufacture a new generation of products more in keeping with retail demand. The plan aimed to reduce Deere's vulnerability to the cyclical swings and unpredictability of the agriculture and construction markets. All salaried employees received rigorous performance goals aligned with the plan, and Deere developed efficiency targets for each point in the cycle that, if met, would deliver performance exceeding, on average, that of the company's best years.

Six years into the effort, Lane and his team have made remarkable progress. In 2006 Deere's net income topped $1.6 billion—more than double the figure in 2003. Revenues are up 48 percent over that same period. More important, shareholder value added, or SVA (essentially, the difference between operating profit and pretax cost of capital), a key metric Lane chose to guide Deere's journey, topped $1 billion in 2004—twice the company's previous best—and was $948 million in 2006.

In this interview, conducted in September 2006 at Deere's headquarters in Moline, Illinois, Rodger Boehm, a director in McKinsey's Chicago office, spoke with Lane about the role that incentives, communication, and sequencing have played in the changes at Deere; the effect of these changes on the company's culture; and the challenges that remain.

The Quarterly: When you became CEO, in 2000, what were the opportunities and challenges facing the company?

Bob Lane: In 2000 it was obvious that Deere had the benefit of a tremendous heritage, a long history of quality products, a dealer organization second to none, and dedicated and loyal employees. But while we had been recognized for many good things over the years, we hadn't been noted as often for having a great business. A good business, certainly—compliments to the dedicated and talented employees who had come before—but Deere was not yet a great business.

We were operating in a very asset-heavy way, which consumed enormous amounts of cash, and our margins were under pressure. Even in the good times, we weren't performing at particularly great levels, and in the bad times we were losing enormous amounts of economic profit. For example, we had introduced a very sophisticated combine harvester in the summer of 1999, and it was a great product, a magnificent product. But it was not a great business. In fact, even at the top of the cycle it was barely carrying its cost of capital. So our opportunity and challenge was to retain all of the good things about Deere, while at the same time recognizing that performance could be taken to a higher level worldwide.

The Quarterly: Why was Deere's operational performance less than satisfactory?

Bob Lane: We'd organized ourselves in a very decentralized way. Every factory optimized its own operations to produce at a steady, level rate. While such arrangements are very efficient for the single factory, they're not optimal for the whole business. Deere is not only in highly cyclical businesses but in highly seasonal ones as well, and level production therefore tends to lead to overproduction when markets are turning down. Moreover, there's a lot of complexity involved because our products are amazingly different in function and not that similar to one another. Combines aren't like tractors. And combines aren't like seeding equipment or forestry equipment. The result was that we had grown to be excessively asset heavy and margin lean.

The Quarterly: You chose SVA as a critical metric to address that problem. Why?

Bob Lane: We are a capital-intensive business, and yet we hadn't really focused sufficiently on tightly managing our assets. So it was clear to me, back when I first became CFO actually, that a simplified form of economic profit—focusing on the left-hand side of the balance sheet—would be just the ticket. My desire was to have something all of our operating people could embrace. I felt that the Deere employees with whom I had spent virtually my entire career would benefit from something profound but very straightforward, intuitive, and simple.

The Quarterly: Were there management challenges associated with implementing SVA?

Bob Lane: The challenge, I think, was that it was a new way to run the business. It would not be enough to have a few finance people understand what SVA meant; thousands of operating people needed to embrace it and make appropriate decisions. The question was how could I, as the chief spokesman, work together with the rest of the senior-management team to propagate this?

The Quarterly: What do you think made the difference in getting employees behind SVA?

Bob Lane: One factor was the unity of the senior team. Another factor was the simplicity of the calculation itself. Importantly, it was rooted to the left-hand side of the balance sheet, not, as is typically the case, on the right-hand side. The denominator was basically receivables, inventory, and property, plant, and equipment—things our operating people knew how to manage. And the numerator was something we already calculated and published: operating profits by division. Further, for each equipment operation we said there'd be a simple-to-understand charge for capital: 1 percent a month. Very straightforward. So if you earn 12 percent operating return on operating assets and you receive a 12 percent charge, you'd have zero economic profit.

The Quarterly: Did you make organizational changes to support the initiative?

Bob Lane: Yes, early on, with the support of the board, we divided the agricultural division into two parts: worldwide harvesting, which included things such as combine harvesters and cotton pickers, and a second part that included tractors and implements. This allowed us to focus more tightly on the underlying economics, product line by product line. This is not rocket science, but it was a very big breakthrough—to have the same financial metrics broken down for every single product line worldwide. For example, now our combine factories in Zweibrücken, Germany; Jiamusi, China; Horizontina, Brazil; and East Moline, Illinois; could all work together as one worldwide product team with common metrics.

The Quarterly: How did you get employees to align their behavior with the new goals?

Bob Lane: Simplicity and consistency. We knew we needed to raise our performance significantly, but we first had to better define, with the entire senior-management team, exactly how high the bar would be. And I think there were two concepts that unlocked it for us. One was a tool—an online performance-management system—that we implemented across the salaried workforce. Every one of our 18,000 salaried employees, top to bottom, now had to develop goals in advance that were explicitly aligned with the company's goals. Again, not rocket science, but vitally important.

The second was an upward sloping line of performance expectations that turned SVA into a meaningful, useful tool that recognized the cyclicality of our business. So to support SVA for each product line, we developed targets for operating assets and operating returns at different places in the cycle: twenty percent OROA1 at normal sales volumes, 12 percent at the bottom of the cycle, and 28 percent at the top—the key being that these targets would cause us to perform, on average, better than we had performed in our best year prior to that. This performance line was considered to be a very high bar, but it gave everybody in the organization clear goals to work on—anywhere in the world, and in any market condition.

The Quarterly: Was compensation also changed to reinforce the new goals?

Bob Lane: Yes, and that has been indispensable. What we did, under the auspices of the board, was rework the entire system to totally align compensation to SVA so that all the incentives in the short and medium term were related to economic profit. Long-term compensation for the top 1,000 is linked directly to the stock price. Compensation is certainly not the only reason to work at Deere, of course, but if you can, it's great to financially reward the people who are making these good things happen.

The Quarterly: How do the incentives work?

Bob Lane: Our short-term incentive, which applies to all salaried employees worldwide, is linked to the sales cycle. So it's now possible for individuals in a particular division to receive a very good bonus at the bottom of the cycle if the division is doing a good job and even receive a poor bonus at the top of the cycle if it is not performing adequately. Before, when business was bad out there, it was impossible, really—given the operating leverage and the heavy fixed costs of the operation—to earn a bonus.

The midterm incentive applies to around 6,000 people as one worldwide team. When we create economic value, or positive SVA, we accrue the incentive entirely in one year. However, the bonus is at risk and only paid out over four years. It can be lost if economic value is destroyed in subsequent years. In fact, anyone in the world can drain that money out—so every employee, regardless of division, has an economic interest to support other operations in the company. It's one thing to not contribute to someone else's bonus, but how about being the one that took away a bonus that was already accrued? The bonus is paid out if performance is proved sustainable. It's been an important reinforcing mechanism.

The Quarterly: How has the focus on SVA been received by Deere's union workforce?

Bob Lane: We've been very straightforward with our union colleagues and clear about what we wanted to accomplish, and they have been very involved in our thinking. In fact, when customers, board members, or other employees go out on the floor, union members will talk about product lines being SVA positive or negative. The recognition is there.

Moreover, our union colleagues have contributed to our progress. When we renegotiated the United Auto Workers' contract in 2003, we had quite a few discussions with them so they would understand how they could achieve better rewards. And their productivity, in particular, has dramatically improved: it's up about 9 percent since 2003. Without that improvement, we would need millions of additional labor hours to get our product out the door. These employees have shared in the benefits of improved productivity.

The Quarterly: What other changes—on either the cost or revenue side—did the focus on SVA necessitate?

Bob Lane: Unfortunately, we had to close a number of factories and discontinue some product lines because they weren't able to carry their weight. In addition, we did not want to overproduce, so when markets turned down we slammed our foot on the brake, which meant that earnings were suddenly hurt in the short run. This was, of course, excellent for the business but a bit painful.

The Quarterly: Looking back, what role did communications play in getting the necessary buy-in among Deere's various stakeholders?

Bob Lane: I think the key was that everybody—employees, dealers, suppliers—heard exactly the same message: we have to perform better for shareholders, and we're going to organize this company to have a great, sustainable business that delivers better shareholder returns. The economic profits have to increase. A clear and consistent message helped show our conviction. So even though the details were evolving, the direction was clear.

For example, when SVA was introduced, in December of 2000, we didn't have all of the specifics developed. In fact, during one of our management meetings early in the journey, I held up a great big meat bone in front of the group and told them that while our strategic direction and performance imperative was clear, we would put more meat on the program's bones over time. This was also true of the changes around compensation. The details came after we were already sharing with everybody how the business was going to be organized around SVA.

The Quarterly: Could you describe the role sequencing played in your approach?

Bob Lane: My original hope was that we could both dramatically improve our operating performance and grow rapidly at the same time. We quickly realized that we needed to establish a stronger operational foundation and therefore needed to improve our operating performance first. So we established two strategic imperatives early on—"Sprint North" and "Seed East." The former was focused on improving our operating efficiency in order to create the foundation for growth. The latter was focused on laying the initial seed for growth through a fairly contained and targeted set of initiatives. "Seed East" would later become "Drive East," as we established a stronger operational foundation and began to accelerate innovation and pursue global growth opportunities more aggressively.

Looking back, this desire to both grow and improve operational performance at the same time created an enormous amount of skepticism early on. And if I had it all to do over again I would be clearer and crisper at the front end about the priorities. The lesson for me was that sequencing is very important in terms of establishing the right expectations with employees and investors, and when you don't get it right it causes a lot of skepticism—legitimate skepticism.

The Quarterly: How have these changes affected Deere's culture?

Bob Lane: Trustworthiness is a vital part of Deere's heritage. For customers, that means if we say we'll make it right during the warranty period we'll make it right, even if it costs us a lot of money. For employees, it means people know where they stand. It's the same for suppliers too. One supplier told me, "You know, I wouldn't call Deere supplier friendly, but I would call Deere supplier fair." And I was pleased to hear it. As an organization, Deere aspires to be a transparent company: no smoke, no mirrors, no tricks. We're straight down the middle.

However, there were aspects of our culture that needed to change. One aspect was what you might call a "best-efforts" mind-set. If I could use an American football analogy, it was as if you could always count on Deere to move the ball at least six or seven yards. And when we got to that point, we could say "good work, good enough"—even though we hadn't reached the first-down marker. Now people are expected to have exhausted every legitimate effort to move the ball further and meet the goal, and then move the ball further again. The goal is clear.

Deere is also changing from being a family to being a high-performance team. "The John Deere family" used to be a common expression. Now that doesn't mean that in a team you don't support people when they make mistakes, but you do have to perform to high expectations. And frankly, not everybody wants to be on a high-performance team. Some people prefer to play intramurals. That's okay, but they are no longer a good fit for Deere.

The Quarterly: Have Deere's talent requirements changed as a result?

Bob Lane: In the same way that the performance bar has been raised, the skills required of our employees have gone up. Our competition is more aggressive and global in nature, and the financial demands are that much higher. And we expect our people to respond to the competition and achieve higher performance standards in a very ethical way. To respond to this challenge, there are two important institutional skills needed.

First, we need a stronger customer orientation. In the past, we probably had more of an engineering approach, versus starting with the customer need. Today it's more important than ever to understand the customer fully—maybe better than the customer understands him- or herself—and marry that understanding with innovation and technological capabilities. Second, collaborative skills will be increasingly important as we broaden our global horizons. Our strategy and performance goals require teamwork worldwide—and our culture is much more focused on enabling people to work together. This takes a different mind-set, but it's a skill that's rewarded here.

The Quarterly: You spoke of Deere's culture as being "straight down the middle." Is it difficult to balance ethics and performance, given the new demands on employees?

Bob Lane: It is a challenge, but it can be done. And we have created a new set of tests to ensure that Deere will have a high-performance culture and, at the same time, retain an environment of integrity. The emphasis is squarely on "how." It's the only word underlined in our strategy statement. So that becomes a statement to our people—how we do our business is a very important factor.

The message to our people is clear: if you get everything else done right but you don't treat people properly or you're not straightforward, you don't work here. And sometimes that hurts a lot. In fact, at our worldwide management meeting I recently announced the number of people who don't work here anymore because—even though their work was satisfactory in every other respect—how they did business was not acceptable. When I announced the number our worldwide leadership team was silent . . . silent. It got people's attention.

The Quarterly: Despite all of Deere's improvements, you have said that Deere is not yet a great business. Looking ahead, what will it take to get there?

Bob Lane: The main factor is sustainability. Delivering performance over a reasonably short period of time is insufficient evidence of sustainability. We want to be known for performance that endures. Think of our strategy as two engines. The first is sustained, exceptional operating performance, distinctively serving customers while using our assets extremely well. The second is disciplined SVA growth—proving that through innovation and invention we can expand our business and sustain that growth. A great business has both engines thrusting continuously at the same time. Those engines will flame out if you don't have the talent—the high-octane fuel to run them. So that's the third strategic component: talent from every background delivering high-performance teamwork.

Ultimately, if our business is going to be great, sustained SVA performance will contribute to human flourishing. At the end of the day, what makes profitable growth sustainable is that our exceptional operating performance delivers products and services that contribute to human advancement. Whether it's food, fiber, wood, water, wind, energy, or recreation—we'll be contributing to human flourishing.

About the Author

Rodger Boehm is a director in McKinsey's Chicago office.

9.1.07

[The cost of not innovating?] Companies will one day rue today's miserly approach to investment


The three Scrooges

Jan 4th 2007
From The Economist print edition

Companies will one day rue today's miserly approach to investment

FOR a businessman, if there is anything better than making money, it must be making more money. Profits are accounting for their biggest share of the American economy since 1950. Interest rates and bond yields are low by historical standards. It ought to be a great chance for companies to expand.

After all, the logic of capitalism is pretty clear. If returns on capital are high (and much higher than the cost of capital), businesses ought to be falling over themselves to invest. In time, that excess investment (by increasing competition) would reduce returns. Profits would return to the mean.

 

But that does not seem to be happening. Business investment has been rising steadily, rather than spectacularly. From 1993 to 2000, American non-residential fixed investment grew by less than 8% in only one year. It has beaten that mark on only one occasion since. And even that rebound (in 2005) was followed by a temporary slowdown in the second quarter of last year.

One answer to this conundrum could be that businesses in America and Europe no longer need to invest as much as they used to. They have "outsourced" their investment to India and China, which are rapidly expanding their productive capabilities and supplying Western companies as sub-contractors.

However, Henry McVey, a strategist at Morgan Stanley, says that the answer lies in a "misalignment triangle", comprising listed companies, private-equity groups and fund managers. Companies are simply not using their balance sheets effectively. They are retaining cash, rather than borrowing to exploit the gap between the returns they can achieve and the cost of finance. Indeed, Mr McVey says that many companies earn a lower return on equity than they make on their operating assets; that is a very poor deal for shareholders.

Why is this? One reason is that companies have very high hurdle rates for new projects, higher than seems justified by a world of low interest rates. But that really reformulates the puzzle in a different form; why are hurdle rates so high?

Mr McVey thinks that executives are being cautious, given the regulatory scrutiny that followed the collapses of Enron, an energy firm, and others. Executives face possible prison sentences if things go wrong; keeping a bit of cash on the balance sheet is a kind of insurance policy. Managers may also have learned a lesson from the investment splurge of the 1990s.

But this cannot be the only factor. Executives are all too happy to return cash to shareholders by buying back equity. This has the great advantage of boosting earnings per share, one of the key measures watched by investors. In turn, this supports the share price on which (thanks to options) bosses' pay often depends.

In contrast, investment in new plant and equipment may take years to recoup. Given the rapid turnover of management, executives may feel there is little point in planning for the long term, when only their successors will reap the benefits.

A similar issue affects the second point on Mr McVey's triangle; private-equity firms. They usually plan to own companies for no more than five years and the main focus is in maximising cashflow to meet interest payments and to pay down debt. Capital expenditure is a hindrance rather than a help.

But such groups are also benefiting from the caution of those they are buying from. As Mr McVey says, "Whereas in the past, [leveraged buy-out] firms actually had to know something about the business they were buying, today they can earn huge returns by merely getting rid of the excess cash on the balance sheet."

In theory, investors ought to be wise to this. They should be urging companies to borrow money to enhance returns and they should be resisting buy-outs, because they understate the potential value of the companies in question.

In practice, however, Mr McVey argues that investors, particularly fund managers, are only too happy to accept a bid premium from a private-equity group. The lift such bids give a portfolio help them to beat the index, and possibly their competitors, keeping clients happy for a while.

This is good news for stockmarkets in the short term, in that profits may remain high—or at least will not be undermined by the folly of executives. But the bad news is that underinvestment will weaken companies' long-term health. The conglomerates behind the takeover booms of the 1970s and the 1980s resembled today's private-equity groups. They aimed to use their financial expertise to improve returns across a range of industries. But they tended to run subsidiaries to maximise cashflow, and the businesses slowly deteriorated, like a poorly maintained house. Today's skinflints may do the same.