Hammer, M 2004, ‘ Deep change: how operational innovation can transform your company ’ , Harvard…

Hammer, M 2004, ‘Deep change: how operational innovation can transform
your company’, Harvard Business Review, vol. 82, no. 4, pp. 84–93.
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Breakthrough
innovations in
operationsnot just steady
innprovement-can
destroy competitors
and shake up
industries.Such
advances don’t
have to be as
rare as they are.
84 HARVARD BUSINESS REVIEW
Deep
Change
How *^
Operational
Innovation
Can Transform
Your Company
by Michael Hammer
INbase $1. 199T 3 billio d i , Progressiv n Mayfiel n in sales de Village Insurance . By 2002 , Ohio , tha , ant, figure automobil had approximatel had grow e insure n tyor
$9.5 billion. What fashionable strategies did Progressive
employ to achieve sevenfold growth in just over a decade?
Was it positioned in a high-growth industry? Hardly. Auto
insurance is a mature, ioo-year-o!d industry that grows
with GDP. Did it diversify into new businesses? No, Progressive’s business was and is overwhelmingly concentrated in consumer auto insurance. Did it go global? Again,
no. Progressive operates only in the United States.
Neither did it grow through acquisitions or clever marketing schemes. For years. Progressive did little advertising, and some of its campaigns were notably unsuccessful.
It didn’t unveil a slew of new products. Nor did it grow at
the expense of its margins, even when it set low prices.
The proof is Progressive’s combined ratio (expenses plus
claims payouts, divided by premiums), the measure of
APRIL 2004 85
How Operational Innovation Can Transform Your Company

financial performance in the insurance industry. Most
auto insurers have combined ratios that fluctuate around
102% – that is, they run a 2% loss on their underwriting
activities and recover the loss with investment income.

rest is history. Although operational innovation wasn’t
tbe sole ingredient in Wal-Mart’s success – its culture,
strategy, human resource policies, and a host of other
elements (including operational excellence) were also
critical – it was the foundation on which the
company was built.

Operational innovation is truly deep change,
affecting the very essence of a company: how
its work is done.The effects ripple outward to

all aspects of the enterprise.

three companies fundamentally rethought
bow to do work in its industry. Their oper
ational innovations dislodged some of the
mightiest corporations in the history of capitalism, in
cluding Sears, General Motors, and IBM.
These stories are well known for two reasons. First, tbe
stories are worth telling: Operational innovations fuel ex
traordinary results. But tbe stories are also repeated be
cause there are, frankly, not many of them. Operational
innovation is rare. By my estimate, no more than 10% of
large enterprises have made a serious and successful ef
fort at it. And that shouldn’t be. Executives who under
stand how operational innovation bappens-and who also
understand the cultural and organizational barriers that
prevent it from happening more often-can add to their
strategic arsenal one of the most powerful competitive
weapons in existence.

By contrast, Progressive’s combined ratio fluctuates around
96%. The company’s growth has not only been dramatic
it is now the country’s third largest auto insurer-it has
also been profitable.
The secret of Progressive’s success is maddeningly sim
ple: It outoperated its competitors. By offering lower
prices and better service than its rivals, It simply took their
customers away. And what enabled Progressive to have
better prices and service was operational innovation, the
invention and deployment of new ways of doing work.
Operational innovation should not be confused with
operational improvement or operational excellence.
Those terms refer to achieving high performance via ex
isting modes of operation: ensuring that work is done as

it ought to be to reduce errors, costs, and delays but without fundamentally changing how that work gets accomplished. Operational innovation means coming up with
entirely new ways of filling orders, developing products,
providing customer service, or doing any other activity
that an enterprise performs.
Operational innovation has been central to some of the
greatest success stories in recent business history, including Wal-Mart, Toyota, and Dell. Wal-Mart is now the largest organization in the world, and it owns one of the
world’s strongest brands. Between 1972 and 1992, WalMart went from $44 million in sales to $44 billion, powering past Sears and Kmart with faster growth, higher
profits, and lower prices. How did it score that hat trick?
Wal-Mart pioneered a great many innovations in how it
purchased and distributed goods. One of the best known
of these is cross-docking, in which goods trucked to a distribution center from suppliers are immediately transferred to trucks bound for stores – without ever being
placed into storage. Cross-docking and companion innovations led to lower inventory levels and lower operating
costs, wbich Wal-Mart translated into lower prices. The
Similar observations can be made about
Dell and Toyota, organizations whose operational innovations have become proper
nouns: the Deli Business Model and the
Toyota Production System. Each of these
Michael Hammer is the founder of Hammer and Company, a management education firm based in Cambridge,
Massachusetts. He can be reached at michael_hammer@
hammerandco.com.
The Payoffs
For most of its history. Progressive focused on high-risk
drivers, a market that it served profitably through extremely precise pricing. But in the early 1990s, the insurer
believed that much larger companies were about to enter
this niche and emulate its approach to pricing; the company’s managers realized it couldn’t compete against
larger players on a level playing fleld. So Progressive decided to win the game by changing the rules. It reinvented
claims processing to lower its costs and boost customer
satisfaction and retention.
The company introduced what it calls Immediate Response claims handling: A claimant can reach a Progressive representative by phone 24 hours a day, and the representative then schedules a time when an adjuster will
inspect the vehicle. Adjusters no longer work out of offlces from nine to five but out of mobile claims vans. Instead of taking between seven and ten days for an adjuster to see the vehicle. Progressive’s target is now just
nine bours. Tbe adjuster not only examines tbe vehicle
but also prepares an on-site estimate of the damage and,
if possible, writes a check on the spot.
This approach has many benefits. Claimants get faster
service with less hassle, which means they’re less likely to
abandon Progressive because of an unsatisfactory claims
86 HARVARD BUSINESS REVIEW
How Operational Innovation Can Transform Your Company
A Powerful Weapon
Strategic benefits
Marketplace benefits
higher customer retention
greater market share
ability to execute strategies
ability to enter new markets
Operational benefits

lower prices
greater customer satisfaction
differentiated offerings
stronger customer relationships
greater agility

gressive realized that an applicant’s credit rat
ing was a good proxy for responsible driving
behavior, it changed its application process.
Now its computer systems automatically con
tact those of a credit agency, and the appli
cant’s credit score is factored into its pricing
calculation. More accurate pricing translates
into increased underwriting profit. Put these all
together, and Progressive’s remarkable growth
becomes comprehensible.
Other companies have made similar perfor
mance gains through operational innovations.
Beginning in 1994, Eastern Electric, a UK power
utility, created a process that reduced the time
needed to initiate electrical service by 90% and
its cost by 66%. In the late 1990s, IBM invented

lower direct costs
better use of assets
faster cycle time
increased accuracy
greater customization or precision
more added value

simplified processes

Innovative operations can result in direct performance improvements
(faster cycle time and lower costs), which lead to superior market
performance (greater customer satisfaction and more highly differentiated products). And improved market performance yields a host
of strategic payoffs, from higher customer retention to the ability to
penetrate new markets.
experience. And the shortened cycle time reduced Progressive’s costs dramatically. The cost of storing a damaged
vehicle or renting a replacement car for one day-around
$28 – is roughly equal to the expected underwriting profit
on a six-month policy. It’s not hard to calculate the savings
this translates into for a company that handles more than
10,000 claims each day. Other benefits for Progressive are
an improved ability to detect fraud (because it is easier to
conduct an accident investigation before skid marks wash
away and witnesses leave the scene), lower operating
costs (because fewer people are involved in handling the
claim), and a reduction in claim payouts (because claimants often accept less money if it’s given sooner and with
less travail).
No single innovation conveys a lasting advantage, however. In addition to Immediate Response, Progressive has
also introduced a system that allows customers to call an
800 number or visit its Web site and, by providing a small amount of information, compare Progressive’s rates with those of three
competitors. (Because insurance is a regulated
industry, rates are on file with state insurance
commissioners.) This offer has attracted customers in droves.
The company has also devised even better
ways of assessing an applicant’s risk profile to
calculate the right rate to quote. When Proa new product-development process that caused
a 75% reduction in the time to develop new
products, a 45% reduction in development expenses, and a 26% increase in customer satisfaction with these new products, in 2002, Shell
Lubricants reinvented its order fulfillment process by replacing a group of people who handled different parts of an order with one individual who does it all. As a result. Shell has cut
the cycle time of turning an order into cash by
75%, reduced operating expenses by 45%, and
boosted customer satisfaction 105%-all by introducing a new way of handling orders. Time, cost, and
customer satisfaction – the dimensions of performance
shaped by operations-get major boosts from operational
innovation.
Organizational Barriers
Compared with most of the other ways that managers try
to stimulate growth – technology investments, acquisitions, major marketing campaigns, and the like – operational innovation is relatively reliable and low cost. So
why don’t more companies embrace it?
The question is particularly significant because operational innovation is needed now more than ever. Most
industries today are struggling with low-growth, even
stagnant, markets. Overcapacity is rampant, and conipetition-particuiariy giobai competition ‘s fierce. Virtually
APRIL 2004 87
How Operational Innovation Can Transform Your Company

all product and service offerings have become commodi
ties, almost no one has any pricing power, and none of
this is likely to change in the near future. In this environ
ment, the only way to grow is to take market share from
competitors by running rings around them: by operating
at lower costs that can be turned into lower prices and by
providing extraordinary levels of quality and service. In
other words, the game must now be played on the field of
operations.
Mere operational improvement is not enough to win
the game. Excellence in execution can win a close game,
but it can’t break a game wide open and turn it into a
rout. The only way to get and stay ahead of competitors
is by executing in a totally different way-that is, through
operational innovation.
But operational innovation entails a departure from fa
miliar norms and requires major changes in how depart
ments conduct their work and relate to one another. It is
truly deep change, affecting the very essence of a com
pany: how its work is done. The effects of operational in
novation ripple outward to all aspects of the enterprise,
from measurement and reward systems and job designs
to organizational structure and managerial roles. Thus,
it will never get off the ground without executive lead
ership. Yet senior managers rarely perceive operational

that the great majority of deals are unsuccessful does not
deter executives from pursuing them.
Operations simply aren’t sexy. One business school stu
dent recently observed to me, “There seems to be a hier
archy in the business world. Finance and strategy are at
the top, marketing and sales occupy the middle tier, and
operations is at the bottom.” An insurance CEO once
quipped that managers work hard at operations so they
can be promoted to the executive level, where they can
stop worrying about operations. A journalist at a promi
nent business magazine, assigned to do a story on opera
tions, confessed that he thought it boring. This is the state
of our business culture. The core, value-creating work of
enterprises has become low status.
Operations are out of sight (and out of mind-set). At
its heart, operations is a branch of engineering. It requires
a skill set and a mind-set different from those needed in
most other executive activities. Most senior managers fo
cus on strategic planning, budgeting, capital allocation,
financial management, mergers and acquisitions, person
nel issues, regulatory concerns, and other macro issues,
very different from the design work at the heart of oper
ational innovation.
Many top managers are ignorant about operations
and uninterested in learning more. They’ve ascended to
the highest levels of the enter
prise without ever getting their
hands dirty. They enter the orga

Operational innovation is by nature disruptive, so

it should be concentrated in those activities with the

egy, or marketing and build their
reputations on work in these

greatest impact on an enterprise’s strategic goals.

innovation as an important endeavor, nor do they enthu
siastically embrace it when others present it to them. Why
not? The answers hinge on some unpleasant characteris
tics of contemporary corporate leadership.
Business culture undervalues operations. I have spo
ken with thousands of managers from hundreds of com
panies about operational innovation. Overwhelmingly,
they’ve told me that their senior executives did not un
derstand, support, or encourage it. As one manager said,
“In our company, operations is not glamorous. Deals are.”
Making acquisitions, planning mergers, and buying and
selling divisions will get the company’s name and the
CEO’s picture in business magazines. Redesigning pro
curement or transforming product development will not,
even though it might be much more important to the
company’s performance. Deals are easily explained to and
understood by boards, shareholders, and the media. They
offer the prospect of nearly immediate gratification, and
the bold stroke of a deal is consistent with the modern
image of the executive as someone who focuses on grand
strategy and leaves operational details to others. The fact

managers, engineers, customer service leaders-to mind
the details of the actual work. Their role is one of super
vision, resource allocation, and direction-all vital,but all
perched precariously on a foundation not grounded in
the bedrock of the organization’s real work.
At a major semiconductor maker, for instance, a group
of middle managers who were frustrated with the com
plexity and poor performance of their order fulfillment
process decided to make a case for change to executive
management. They created a two-page diagram illustrat
ing the endless series of steps every order went through,
the redundant moves of the product between factories
and depots, the accumulations of inventory, and the enor
mous delays. When members of the company’s executive
committee saw it, they were incredulous: “We do this?”
It should not be surprising that executives without ex
perience in operations do not look there for competitive
advantage. The information they usually get does little to
focus their attention on the mechanics of operations.
How many executives receive data about order fulfill
ment cycle time, or the accuracy of customer service re

nization through finance, stratdomains. When they move into
their first general management
role, they rely on others – plant
HARVARD BUSINESS REVIEW
How Operational Innovation Can Transform Your Company
sponses, or the cost of each procurement transaction, or the percentage of parts that are reused
in new products? Indeed, in how
many organizations is such information available at all? Financial
data dominate the discourse in the
modern organization, although
operational performance is the
driver of financial results.
Nobody owns it No one holds
the title Vice President of Operational Innovation; it is organizationally homeless. It doesn’t fit
into R&D, where product innovation is based. Functional line managers are too focused on meeting
deadlines to have time for or interest in inventing new ways of
doing things. What’s more, important innovations are not limited
to individual departments but involve end-to-end processes that
cross departmental boundaries.
Normal planning and budgeting focus on investments in
new equipment, products, and services and take account
of process improvement. It’s a rare company whose budget or planning process explicitly looks for process breakthroughs. No wonder operational innovation has a hard
time gaining traction in an organization.
This is particularly problematic because operational innovation can easily founder in a sea of competing but
smaller change initiatives. It is all too common for enterprises today to have dozens – even hundreds – of operational improvement programs under way at any point in
time. Some are technologically based, such as the implementation of enterprise resource planning (ERP), customer relationship management (CRM), or supply chain
management (SCM) software systems. Others are centered on specific bodies of improvement techniques, sucb
as Six Sigma quality or lean enterprise programs. Still
others are defined in terms of outcomes, such as accelerating time to market or presenting a single face to customers, or focused on improving a particular aspect of the
enterprise (procurement or customer service, for example). Fach project typically has a narrow scope, a group of
experts dedicated to it, and a sponsor whose enthusiasm
is tolerated by his or her peers only as long as it is kept
witbin bounds.
This kind of situation can cripple operational innovation because an organization has only so much capacity
for change. If people are already juggling a great many
improvement projects, they may conclude that they can’t
handle an innovation effort as well. Indeed, in a company
consumed with improvement projects, the distinction
between improvement and innovation may be lost Improvement projects can also get in the way of innovation
efforts by appearing to address similar issues. For instance, many companies implementing ERP or SCM systems merely use them to enhance existing processes. Real
innovations in order fulfillment or supply chain management are also likely to involve these technologies, but
they may be dismissed because, people think, “we’re already doing ERP.”
Making It Work
How do operational innovation efforts begin if no one is
responsible for them and no formal channels for creating
programs exist? Most often they start as grassroots movements, fostered by people sprinkled throughout organizations who are passionately committed to finding and exploiting opportunities for operational innovation. These
catalysts take it upon themselves to find a leader who can
grasp what they have in mind and then spearhead the innovation effort. The executive must have both the imagination and the charisma needed to drive major operational change.
Then the catalysts relentlessly campaign for the causeconfronting the executive with the inadequacies of existing operations and arranging for meetings with peers
from other companies that have successfully implemented operational innovations. The campaign will be
helped immensely if catalysts can tout existing pockets of
operational innovation within their own organization.
Maybe one plant implemented a new way of scheduling
APRIL 2004 89
How Operational Innovation Can Transform Your Company

production, or a customer service center used a CRM sys
tem in a new way, or a sales team created a new way to
support customers. Examples like these will help convince
a leader that operational innovation can work.
Once the top executive is convinced that operational
innovation is worth pursuing, the organization needs to
focus its efforts. Because operational innovation is by
nature disruptive, it should be concentrated in those
activities with the greatest impact on an enterprise’s stra

just one area, most companies find it prudent to limit
their innovation programs to no more than two or three
major efforts at a time. To undertake more would proba
bly consume too many resources and create too much or
ganizational disruption.
After selecting the area for innovation, the company
must set stretch performance goals. At American Stan
dard, the goal was to triple its inventory tums; at Pro
gressive, to initiate claims within nine hours. Absent such
specific targets, innovation efforts are likely to drift or de
generate into incremental improvement projects. Only
a daunting target-clearly unattainable through existing
modes of operation-will stimulate radical thinking and
willingness to overturn tradition.
Inventing a new way of operating that achieves the tar
get need not be simply a matter of crossing your fingers
and hoping for inspiration. Following these suggestions
should accelerate your efforts.

tegic goals.

Progressive, for instance, realized that the key to its prof
itable growth is customer retention because acquiring
new customers through commission-based agents is very
expensive. And the key to customer retention is making
sure customers have rewarding interactions with the com
pany. That’s why Progressive concentrated on streamlin
ing claims; making it a more pleasant experience for
customers would directly affect overall performance.

Many auto insurers, by contrast, view
claims as a nuisance at best because
it entails paying claimants. They con
sider it to be a low-priority activity

Reimagining Processes

that doesn’t deserve attention.
Or consider how American Standard, the diversified manufacturer,
decided where to focus its innovation efforts in the early 1990s. It had
just survived a hostile takeover bid
by going through a leveraged buyout, and leaders realized that servicing the debt would consume virtually all the company’s available cash
and starve product development efforts. Because a large amount of cash
was tied up in inventories, the CEO
mandated that the company would
have to drive down its working capital and dramatically increase inventory turns. A program was instituted
to transform manufacturing from a
conventional push-based system to
one pulled by actual demand using
a system known as Demand Flow
Manufacturing. The innovation paid
off and led to a successful IPO a few
years later.
Using similar analyses, other companies have pinpointed procurement, order fulfillment, new product
development, post-sales customer
support, and even budgeting as the
place where innovation would have
the greatest effect on achieving key
strategic goals. While operational innovation need not be confined to
Dimension of work
What results
the work delivers
Who
performs the work
Where
the work is performed
When
the work is performed
Whether
the work is performed
What information
the work employs
How thoroughly
the work is performed
Example
Progressive Insurance increased market
share by informing customers of its
competitors’ rates as well as its own.
Shell Lubricants improved cycle time
by changing its order fulfillment process
so that one person handles all aspects of
an order(instead of seven peopleeach
working on one aspect).
Taco Bell cut costs by preparing ingredients
in commissaries rather than in individual
restaurants.
A major hospital responded to physician
referrals more quickly by assigning a bed
after, rather than before, agreeing to accept
a patient.
Wal-Mart cut costs by cross-docking from
truck to truck instead of storing goods in
warehouses.
A consumer packaged-goods manufacturer
reduced inventory by basing its production
scheduling on actual orders rather than on
forecasts.
Harvard Pilgrim Health Care cuts costs by
carefully analyzing patients to identify those
who need intervention before a crisis strikes.
90 HARVARD BUSINESS REVIEW
How Operational Innovation Can Transform Your Company

Look for role models outside your industry. Bench
marking within your own industry is unlikely to uncover
breakthrough concepts. But techniques used in other in
dustries with seemingly very different characteristics may
turn out to be unexpectedly applicable. For instance, in
the 1980s, Taco Bell transformed its restaurant operations
by thinking about them in manufacturing rather than in
fast-food terms. The restaurant chain reduced the amount
of on-site food preparation by outsourcing to its suppli
ers, centralizing the production of key components, and
concentrating on assembly rather than fabrication in the
restaurants. The new approach lowered Taco Bell’s costs
and increased customer satisfaction by ensuring consis
tency and by allowing restaurant personnel to focus on cus
tomers rather than production. Harvard Pilgrim Health
Care has applied techniques of market segmentation,
common in consumer goods but not in health insurance,
to identify patients most likely to have a medical crisis

customer service, and a major reduction in the total cost
of product deployment
Rethink critical dimensions of work. Designing oper
ations entails making choices in seven areas. It requires
specifying what results are to be produced and deciding
who should perform the necessary activities, where they
should be performed, and when. It also involves deter
mining under which circumstances fw/jef/jerj each of the
activities should or should not be performed, what infor
mation should be available to the performers, and how
thoroughly or intensively each activity needs to be per
formed. Managers looking to innovate should consider
changing one or more of these dimensions to create a
new operational design that delivers better performance.
(The exhibit “Reimagining Processes” shows examples of
companies that have rethought these various dimensions
of work.)

and to intervene before the crisis occurs.

Identify and defy a constraining assumption. At its
heart, every operational innovation defies an assumption
about how work should be done. Cross-docking negates
the assumption that goods need to be stored in a ware
house, build-to-order that goods should be produced
based on forecasts and destined for inventory. Zero in on
the assumption that interferes with achieving a strategic
goal.andthenfigureout how to get rid of it. A major hos
pital, for instance, recognized that to increase the number
of patients admitted for (well-reimbursed) cardiac bypass
graft operations, it needed to respond more quickly to
physicians who wanted to refer a patient. The reason for
the delay in response was the assumption that the hospi
tal first had to assign a prospective patient a bed, a sup
position that generated hours of delay and often led
physicians to send their patients somewhere else. The

Getting Implementation Right
In The Innovator’s Dilemma, Clayton Christensen ob
served that conventional market-analysis tools lead orga
nizations astray when applied to disruptive technologies.
In a similar way, conventional implementation method
ologies often lead to failure when applied to disruptive
modes of operation.
Companies that follow traditional implementation
methodologies inevitably take too long. There is so much
to be done, and so much that must be integrated with
everything else, that years can pass before the innovation
is implemented and its benefits start to flow. Further
more, because every proposed major change in operating
procedures is invariably greeted with a chorus of “it will
never work,” a lengthy implementation period gives op
ponents an extended opportunity to campaign against

solution? Send the patient to the hospital
immediately, and assign the bed while the
patient is in transit.
Make the special case into the norm.
Companies often achieve extraordinary lev
els of performance under extraordinary con
ditions; their problem is performing extraor
dinarily in normal situations. One way to

accomplish this is to turn the special-case process into the
norm. A consumer packaged-goods maker, for instance,
based its production scheduling on sales forecasts rather
than on actual customer demand. When demand for a
new product wildly exceeded forecasts, an ad hoc process
was created that gave the manufacturing division real
time information about customer demand, which in turn
allowed them to do production planning and product dis
tribution much more efficiently. After the crisis had
passed, the company decided to adopt this emergency
mode of operati