Chapter Two: The Four Zones

This post is the second in a series of posts that will eventually become a book. I am looking to improve the text by incorporating readers’ feedback before I go to print. Find out more about this project or start from the beginning.

Read the previous chapter in this series

At the core of modern businesses’ challenge to engage and absorb wave after wave of disruptive digital technology lies the problem of how best to allocate resources across three investment horizons. Each is defined in terms of when the return on that investment will be realized:

• Horizon 1: In the coming fiscal year, making it accretive to the operating plan.
• Horizon 2: In two to three years, following significant negative cash flow in the intervening period, making it dilutive to the operating plan.
• Horizon 3: In three to five years, consisting primarily of research and development that is funded so as not to be dilutive to the operating plan.

In a non-disrupted sector characterized by evolution and sustaining innovation, Horizon 3 efforts tend to be wide-ranging and exploratory, under little pressure to translate directly into major new lines of business. Horizon 2 efforts are largely taken up with developing the next generation of products to fill Horizon 1, so while they are temporarily dilutive, they are relatively low risk, and their long-term contribution is clearly in sight. Overall, therefore, there is a reasonably amicable relationship among all three horizons, funded by ongoing success in Horizon 1.

All this falls by the wayside when a major disruption strikes the sector, typically led by a venture-backed start-up with everything to gain and nothing to lose. Now the Horizon 1 business is under immediate pressure to reform, not so much from direct competitors (although they are always present) as from the new categorical displacements that threaten its very existence. A company like Kodak finds itself fighting not Fuji so much as digital photography, the Washington Post not so much the New York Times as digital media. Under such pressure, executive management turns anxiously to Horizon 3 to find next generation technology by which to engage this new business model, be that coming from the labs or from an acquisition, and then mounts an aggressive Horizon 2 effort to bring it to market.

Here, however, its methods fail. Its Horizon 3 products and teams are rarely a match for the scrappy entrepreneurs and their venture-backed start-ups with whom the company now competes, and the inside team gets little help from a Horizon 1 sales force that is still being compensated to sell the legacy offer set. In addition, the Horizon 2 initiatives are consuming cash at a fearsome rate just when Horizon 1 P&L’s are struggling to maintain margins. At some point the CFO calls a time out during which the company sadly discovers its best move is actually to retreat from Horizons 2 and 3 altogether and prop up Horizon 1 margins with some deep cost cutting. In the short term a reckoning has been deferred, but the existential threat has by no means been addressed, and the company’s power has been further eroded. The end result over time is an inexorable marginalizing of the business and its brand, ultimately culminating in a period of consolidating acquisitions among last-generation legacy franchises.

This is the norm, but it is not a desirable outcome, so it is important to note that there is another way, a way to break free from this kind of downward spiral. That is what this playbook purports to describe. At its core is a simple idea: Start-ups outperform incumbents in disrupted markets because they are not conflicted—all their enemies are outside them. Incumbent enterprises, on the other hand, are pulled in multiple directions, not just by their own economic interests and those of their shareholders but also by those of their customers and partner ecosystems as well. Torn by these forces, their efforts lack focus and prioritization, and it is no wonder they fall short of the mark.

To compete effectively, management must free itself from this bind. It needs to reconfigure its enterprise to fight independently on multiple fronts, acting in parallel but not in lock-step. Specifically, it needs to segregate investments in disruptive innovation from those in sustaining innovation, and at the same time to separate its mission-critical activities from its enabling ones. These two divisions result in four zones of management activity, each internally aligned around its own goals and objectives, each demanding a different style of leadership to achieve those ends.

The sustaining side of this model is the home of established franchises and their operating models. Their mission-critical obligation is to “make the number,” and they are supported in doing so by a variety of enabling shared services. The disruptive side, by contrast, is the domain of emerging businesses. They are gestated under a set of enabling conditions where fast failure is often a virtue, but when it is time bring a chosen one of them to scale, it becomes mission-critical.

The differences among zones in terms of investment horizon, performance metrics, and operating cadence are so great that each warrants its own local playbook, with no zone being permitted to impose its local playbook onto any of the other three. At the same time, however, all four zones do need to interoperate with each other fluidly if the overall enterprise is to win its game. Thus there does need to be an uber-playbook to govern them all, what we are calling the Zone Offense.

With all this in mind, here then is the Four Zones framework:

The Performance Zone

Beginning at twelve o’clock and proceeding clockwise, we come first to the Performance Zone. This is the engine room for operating established franchises on proven business models. The focus is on financial outcomes that are mission-critical and on innovations that are sustaining. It is run by people who pride themselves on delivering the goods—on time, on spec, and on budget—and making the number—quarter, after quarter, after quarter. They are all about the operating model, and they are all about performance.

The Performance Zone is the source of more than ninety percent of the enterprise’s revenues and well north of one hundred percent of its profits. As such it is the natural home for financial operating ratios, resource allocation hurdles, performance metrics, and the like. The return on investment focus is Horizon 1 with results being published quarterly in the company’s financial reports.

The fact that financial investors scrutinize these reports so intensely has given rise to the mistaken conclusion that quarterly performance is all shareholders care about, and that therefore Horizon 1 mandates—and by consequence the Performance Zone’s local playbook—should be prioritized above all others. Such an approach, however, leads inexorably to a slow and steady harvesting of the enterprise’s good will and brand power. As mission-critical as this zone is, therefore, it is still only one of four and must be managed to interoperate effectively with the other three for modern business success.

The Productivity Zone

The Productivity Zone is home to a suite of shared services, managed as cost centers, including Marketing, Central Engineering, Manufacturing, Supply Chain, Customer Service, HR, IT, Finance, and Administration. Simply put, any function in the corporation that does not have direct accountability for a revenue number goes here. The focus is on applying sustaining innovation to productivity-enabling initiatives targeted primarily at the Performance Zone with the bulk of the ROI expected to fall into Horizon 1. These initiatives are delivered via systems for ensuring regulatory compliance and efficient operations and programs for enabling more competitive performance.

The perennial challenge for the Productivity Zone is to manage the tensions among its three core deliverables—compliance, efficiency, and effectiveness—without subordinating any one of them to the other two. This becomes even more challenging during a period of technology disruption because the Performance Zone heightens its demands for both efficiency and effectiveness while bridling at constraints imposed in support of compliance. Shared services organizations which have gotten comfortable, not to say complacent, during a less stressful period are often bewildered by these new circumstances and wonder how much they really ought to change. Well, as Deming once said, “Change is not necessary because survival is not mandatory.” If the enterprise is going to survive a disruption to its sector, the Productivity Zone is going to need a new playbook as well.

The Incubation Zone

On the disruptive side of the ledger, the Incubation Zone plays enabling host to fast-growing offers in emerging categories and markets that are not yet of material—and therefore mission-critical—size. Its charter is a simple one: Position the enterprise to catch the next wave. This is the domain of Horizon 3, where any significant return on investment is several years out, and revenues for this zone’s portfolio are in aggregate no more than a percent or two of the enterprise’s total top line. That said, in a Fortune 500 company, this can still amount to tens to hundreds of millions of dollars, so we should not think of these as just skunk works. Rather they are simply an order of magnitude too small to participate productively in the operating model of the Performance Zone.

Surprisingly, the biggest challenge this zone faces is not what people often think—namely, being innovative enough. Instead it lies in the inability of established enterprises to scale an emerging innovation to material size. To be clear, direct responsibility for this scaling falls in the Transformation Zone, but recurrent lack of success in that quadrant creates backwash that impacts incubation management. How to keep people focused and motivated, how to fund and manage following a venture model inside a publicly held corporation, how to identify and transition the strongest candidate to the Transformation Zone, and how to manage the disposition of the many incubated businesses that do not get backed for scale—all these approaches need to be refashioned, which makes for a very interesting new playbook indeed.

The Transformation Zone

The Transformation Zone is the place in an established enterprise where a disruptive innovation goes to be scaled to material size. The goal is to create a stable, material, net new line of business, one that constitutes ten percent or more of the enterprise’s current revenues, on a growth trajectory that promises both increased size and superior profitability. This is a mission-critical undertaking because you have signaled its promise to all your key stakeholders, and they are watching. Success here will cause investors to radically revalue your stock and partners to flock to your ecosystem. It is a true game changer.

Failure, on the other hand, repositions you a rung lower on the ladder of powerful companies in your industry. Partners in your ecosystem do not desert you, but they do pull back just a bit from supporting your cause, making your next attempt to rise above just that much harder. This is not lost on investors. Increasingly it is value, not growth, investors who seek to hold your shares, and their clear mandate is to stop wasting resources on futile attempts to catch the next wave and instead optimize the businesses that are established going concerns. In effect their message is, you are mortal—deal with it!

The relevant return on investment framework for the Transformation zone is Horizon 2. This is another way of saying that transformations inevitably entail a “J-curve” wherein performance metrics go south before they turn the corner to go north. Such a trajectory is unavoidable since any disruptive business model inevitably entails engineering or reengineering the underlying operating model, which in turn mandates engineering or reengineering the supporting infrastructure model. Overall this makes for a huge change management problem. J-curves are never easy to manage, but they are exceptionally challenging for a publicly held company whose investors have grown used to steady growth from well established, profitable lines of business. This puts excruciating stress on the Performance Zone’s operating model to both make its mission-critical sustaining commitments and support a mission-critical disruption as well.

In sum, embracing disruptive innovation to transform an established enterprise is the single most unnatural act in all of business, a time when any principle of conventional management wisdom may not only be wrong but fatal. Of all the four playbooks needed to make the Four Zones model work, this is the one that requires the greatest amount of creative re-thinking.

The Zone Offense

Even from such a cursory review of these four zones, it should be clear that their individual goals, objectives, and methods are so diverse that any set of management methods creating success in one zone is likely to cause failure in the other three. That is why it is so important to keep them separate. At the same time, all four need to work in tandem to make the corporation go. Here’s what a successful Zone Offense looks like:

• The Performance Zone is the primary focus of the senior operating team, with an emphasis on steady management as opposed to bold leadership. The CEO is present and engaged, but for the most part the company is run at the next level down, following the objectives and budgets laid out in the annual operating plan, with a lot of attention paid to execution metrics. The goal is to be a well-oiled machine that produces good risk-adjusted returns with few surprises.
• The Productivity Zone spends most of its time targeting efficiencies to be gained by improving operations in the Performance Zone. Its primary goal is to extract resources from non-core work—what we call context—in order either to invest more in core tasks or take the savings to the bottom line. In a customer-focused company, for example, there are always more things you would like to do for the customer, and initiatives in this zone are designed to free up the resources to do just that.
• The Incubation Zone will have a number of things cooking at any given point in time. Each will have been funded based on its potential to become the “next big thing”—there are no resources wasted on “interesting” projects that have no clear path to scale. M&A is active and includes the onboarding of next-generation technology teams. At any given point in time, one or more of these efforts is likely to be showing signs it is ready to transition to full scale.
• The Transformation Zone is most likely to be empty. This is actually a desirable state as it means that the enterprise can have another productive year creating attractive returns at relatively low risk. Remember, you need only to succeed in one transformative initiative per decade to be world class, and transformation itself can be brutally painful.

Alternatively, the Transformation Zone may be occupied. This puts the whole enterprise on Red Alert. The CEO is at the helm, hand directly on the tiller. This is the time for bold leadership, with prudent management just having to hold on for dear life. You have put a single opportunity into the chute. All other potential disruptions have been put on hold. The entire executive team is obsessed with getting this one business past the tipping point of contributing ten percent or more of total enterprise revenue. You will not be denied.

• Overall, the Four Zones are operating in harmony. During periods of stability, the Performance Zone is funding the entire operation, with help from the Productivity Zone, paying the way for the Incubation Zone, building up whatever reserves it can for the next transformation. During periods of disruption, the Transformation Zone rules the roost, its priorities trumping all others, and all the other zones wake up every morning asking themselves, what can we do today to accelerate the transformation initiative? That isn’t just altruism. It is also pain relief.

That’s what good looks like. Unfortunately, historically it has shown up far too infrequently. So what is likely to be happening instead? Following the traditional management playbook, executive teams typically commit the following kinds of errors:

• Over-rotating to the Performance Zone. Investors scrutinize quarterly financials, and the executive compensation plan is designed to pay for performance, so it is only natural to allocate additional resources to this zone. This is fine as long as there is no transformational initiative in play. Once there is, however, it is critical to over-rotate to the Transformation Zone. Letting the Performance Zone keep to its current course and speed is a showstopper.
• Coasting in the Productivity Zone. Initiatives in this zone are for the most part neither disruptive nor mission-critical, so it is easy to get a bit complacent about performance here. Again, absent a transformational initiative, all you’re likely to be giving up are a few hundred basis points of EPS. But once a transformation is under way, you will put so much pressure on the Performance Zone, the only way you can succeed is with an exceptional contribution from your enabling initiatives. If the Productivity Zone is not up to the task, you are not going to get up to the bar.
• Mistaking the Incubation Zone for the Transformation Zone. This is one half of a classic portfolio management mistake. Anxiety about not catching the next wave causes everyone to focus on businesses in the Incubation Zone, hoping that one will bust out in all its glory and save the day. This is a fantasy. The actual path to success demands much more sacrifice, the sort of thing that can only be made possible in the Transformation Zone.
• Failing to implement a Transformation Zone. This is the other half of the portfolio management mistake. The strategy of maintaining multiple options leads inevitably to undertaking more than one transformation at a time, each under the purview of a senior executive, none specifically privileged by the CEO. The ensuing scramble for resources results in no transformational initiative getting anything like the prioritization it needs to succeed. The end result is a discouraging sequence of marginalized initiatives, each too small to make any difference to investors, each too big to just shut down and walk away from. After a painfully prolonged twilight existence, these usually end up getting tucked into one or another established line of business where they are gradually dissolved into the legacy product feature set. As Frost once wrote, it all ends “not with a bang, but a whimper.”

This is indeed a sad state of affairs. To remediate it there are three essential steps that must be taken:

1. Install a governance model that segregates these four zones from one another. In particular, do not let the methods and metrics of the Performance Zone infiltrate the governance of either the Incubation or the Transformation Zone.
2. Establish and implement best practices for each zone stand-alone (including how it interfaces with the other three). This includes declaring what offerings and initiatives are being managed within which zones, with concomitant adjustments to their goals, objectives, methods, metrics, and governance models.
3. Overlay a light-weight corporate system to oversee all four zones in parallel. All the real work is done within each of the four zones, but the annual planning and resource allocation process and the quarterly business reviews need to managed across all four, keeping each distinct from the others.

These three imperatives shape the Zone Offense playbook that follows. In each of the next four chapters we will lay out a management framework for one of the four zones and, taking a page from the “faults and fixes” segments in golf magazines, highlight some of the most common mistakes made in that zone and how best to address them. In effect, each chapter will be a local playbook for operating in that zone. Then we will close with a couple of case study examples from Salesforce and Microsoft where these principles and practices are currently being tested out. After that you will be on your own.

Read the next chapter in this series

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Geoffrey Moore | Zone to Win Book | Geoffrey Moore Twitter | Geoffrey Moore YouTube