A perennial question for the corporate office is “How can we add value?” For many senior executives, the “Hippocratic oath” of corporate management seems to be the answer: First, do no harm. Divisional autonomy has gone from managerial principle to mantra. The corporate office is there simply to set and enforce performance targets. But in a world increasingly obsessed with private equity, the power of focus, and the discipline of debt, is there really a role for even the most mildly diversified firm and the corporate layer of management that such diversification necessarily creates?

I believe so, but only if we expand our horizons beyond merely “adding value” to including the critically important but typically overlooked problem of managing strategic uncertainty.

Why this is important, and how to do it more effectively, is what I hope to describe in this article.

Of strategies competitive and corporate

I’ve found it useful to define strategy as “how an organization creates and captures value in a specific product market.” In my experience, this definition is both sufficiently precise to have substantive content yet inclusive enough to capture what most people feel should be part of so critical a concept. Reflect for moment on what you think your organization’s strategy is in light of this definition and see if you find it consistent with your intuition.

The most significant element of this definition lies in its most easily overlooked part: that strategy is about how to create and capture value in a specific product market. This highlights the importance of defining clearly the organization and product market that are the focus of strategy.

For example, this definition makes the question “What is General Motors’ strategy” incoherent, for embedded in that question is the assumption that there is a single product market in which General Motors competes, which of course is not true: Chevy’s Corvette and GMC’s Montana mini-van are only the weakest of substitutes. Few people, when they go shopping for a car, consider the possibility of getting one instead of the other.

And so my proposed definition captures only competitive strategy, that is, the ways in which an organization competes, since competition for revenue, and hence profits, takes place ultimately at the product market level.

What, then, is corporate strategy? The most widespread view is that improving the competitive strategies of the operating units is the essence of corporate strategy. The corporate office should be focused on, for example, the identification and capture of synergies between operating units. There remains considerable debate about how best to do this. But the underlying assumption – that corporate strategy supplements competitive strategy – goes unchallenged, begging the question whether the corporate office can make any other kind of contribution.

This assumption blinds us to the other half of the value equation: uncertainty. It is indisputable that generating returns is critical, and an operating division’s competitive strategy is a description of how that unit hopes to create and capture the value required to deliver those returns. But as those familiar with financial theory and practice will know, there can be no returns without risk. Indeed, in a very real sense, accepting risk is the price of those returns, and the hope of more of the latter can only be purchased at the price of more of the former.

And so we have the opportunity to see corporate strategy not as merely a supplement to competitive strategy but also as the overlooked complement. And so a definition of corporate strategy consists of two parts: (i) capturing inter-divisional synergies – which is the extent of current thinking; and (ii) how the organization identifies and manages strategic uncertainty. It is this under-development of this second part that I hope to begin to redress.

Generating returns vs. managing uncertainty

Many leaders justly resist placing too much faith in organizational design. However, the org chart matters, because it defines how large, complex tasks are divided into manageable chunks, thereby making cooperative effort possible. After all, one cannot throw a group of people into a room and shout “get on with it.” The company’s work must be differentiated, that is, separated into sub-tasks, whilst simultaneously being integrated, that is, coordinated such that the completion of the sub-tasks cumulates to the attainment of the larger end. Organizational structure permits the achievement of these competing, but complementary, goals.

In the realm of strategy-making, however, little attention has been paid to how this same principle should be applied. In any corporation with multiple business units – that is, in any diversified company – the unquestioned dogma is that operating division managers must have the full measure of decision-making freedom, given that they are to be held accountable for their results.

General managers with full decision-making responsibility for a specific operating division – that is, a unit with a competitive strategy – must perforce decide what that strategy should be. Highly differentiated strategies, either low cost or product leadership, offer the promise of high returns, but only because they run higher strategic risk. Staking a defensible claim to a unique competitive position demands bold commitments over long periods of time to assets and capabilities that few others feel will be valuable in the future. In other words, greatness requires that companies make a significant, and largely irreversible, strategic bet. And like all bets, even when the odds are with you, you can end up losing (nearly) everything.

Take, for example, Sony’s Betamax video cassette recorder. This iconic example of strategic failure is often adduced to illustrate managerial incompetence or greed: Sony had “too short” a recording time or refused “reasonable” licensing terms to other potential manufacturers.

The full story is long and complex, but we will learn the wrong lessons from Sony’s mistake if we insist on looking at the company’s choices after the fact. The more relevant perspective is when Sony had to make its choices. And what quickly becomes clear is that Sony’s decisions were perfectly reasonable and in fact entirely consistent with the desire to dominate the market utterly.

For example, the company could have licensed its designs widely, dumbing-down its proprietary technology in the interests of acquiring greater market share faster. However, this would have compromised Sony’s ability to capture a greater share of the value it created. In other words, Sony chose a bigger slice of a smaller pie, concluding this would be more valuable than a smaller slice of a larger pie. In the event, Sony’s choice was the wrong choice, but that only became clear long after the fact. Who was to say that Sony’s “value capture” strategy – one pursued to such great effect with the Walkman or the PlayStation 2 – was going to fail this time?

It is this kinship between success and failure that defines the “strategy paradox”: precisely the same behaviors that maximize an organization’s possibility of great success also maximize its likelihood of total catastrophe. Operating divisions, forced to chose and implement a competitive strategy, face a dilemma: do they pursue high-risk, but potentially high-return strategies, or do they sacrifice any meaningful chance at greatness in exchange for reduced risk?

Empirically, most businesses opt for the security of me-too, derivative strategies over the higher-risk, but potentially higher-return strategies defined by more highly-differentiated positions. In other words, complete divisional autonomy relegates firms either to accepting strategic risk or avoiding it. What is missing is a meaningful way actively to manage it.

Managing a complex task essentially means identifying the appropriate dimension of differentiation and integration. Most organizations think of this differentiation in terms of geographic regions, functions, processes, etc. and mechanisms of integration in terms of specialist roles, cross-functional teams, etc. These concepts are so familiar as to be almost banal to anyone steeped in organizational life. What is less common, and hence less intuitive, is that to manage strategic uncertainty effectively we must similarly differentiate roles based on the strategic uncertainty decision-makers face and integrate them by way of the strategic commitments to be made. I call this organizational design principle Requisite Uncertainty. And unlike most organizational design principles, which operate essentially horizontally, Requisite Uncertainty speaks directly to the roles and responsibilities delegated to each level of the vertical hierarchy.

Perhaps the most important insights into the attributes of an effective hierarchy come to us from the late Elliott Jaques (pronounced “Jacks”), a Canadian organizational psychologist. Jaques determined that hierarchies function best when each level is separated from the others by the time horizon associated with the decisions made at that level. So, for example, the marketing manager is responsible for getting a new flavor of toothpaste into the market. He decides what the marketing mix will be, the investment in co-op advertising, which channels to focus on, and so on. Jaques’s research demonstrates that this manager will know whether or not he made good decisions within three months to a year.

The next level up in the hierarchy – say, the general manager responsible for oral health care – has a number of functions reporting to her: our marketing manager, of course, as well as product development, R&D, HR, finance, etc. Her task is different: to decide what the competitive strategy of this division will be. This requires making a commitment, at the most generic level, to a low-cost or differentiated strategy. Such commitments take time to implement and still longer for the environment to provide the feedback needed to determine their success. Jaques’ work suggests that a time horizon of three to five years is appropriate.

When coping with the tension between risk and return are assigned to the same management level, as conventional management theory demands, general managers must choose between temerity and timidity. We should not be surprised: they have no mechanisms at their disposal to manage uncertainty. It is the hierarchical equivalent of failing to separate finance from HR, and then wondering why the cash management system is breaking down and the benefits plan is a shambles.

Requisite Uncertainty separates making strategic commitments from managing the risk created by making those commitments. Operating division managers must make commitments if high achievement is to be even a possibility. It falls to corporate management, the next layer up in the hierarchy, and so responsible for a still longer time horizon, to create the strategic options needed so that divisions, if they happen to have made the wrong (even if entirely reasonable) commitments, can adapt their strategies as required.

We can see the outline of this structure at work at Microsoft over the last several decades. In the late 1980s, Microsoft had a corporate commitment to the computer software industry. There was, however, material uncertainty – strategic uncertainty – surrounding how best to compete in that space. And so the company pursued a number of different trajectories simultaneously. MS-DOS was their bread-and-butter product for both personal and corporate computing customers. Yet Microsoft was collaborating with IBM on the OS/2 graphical interface operating system, even as it was developing its own graphical Windows systems, while exploring a version of Unix targeted at commercial markets. And on the applications front, the company was writing Excel and Word for the Apple OS.

This was not diversification in defense of ignorance – the creation of a portfolio with uncorrelated fortunes and cash flows. Rather, it was a carefully constructed set of hedges against different strategic paths, some of which could prove enormously useful to each other. Some of these strategic options, like OS/2, never came “into the money” and were abandoned. Others, in particular the Windows OS and, most importantly, its complementarity with Word, Excel, and other applications, became the foundation of decades of profitability and industry dominance.

Today, Microsoft continues to build and manage a portfolio of strategic options. The Windows OS platform and Office applications suite are the company’s current bread and butter, but strategic uncertainties abound. What will the next platform, or platforms, for personal computing be? Mobile devices? Game players? What about content, search, or online services? From the perspective of the corporate office, Microsoft’s investments in Windows Mobile, Xbox, MSNBC, and MSN are strategic options that create the ability, but not the obligation, to morph the Windows division in a number of very different ways, depending on how the industry evolves over the long term – say, five to seven years. Microsoft’s corporate strategy, then, can be seen as designed to mitigate strategic risk in ways that the divisions, and shareholders, cannot replicate.

Consistent with the notion of Requisite Uncertainty, managers responsible for each of these divisions (Windows Mobile, Xbox, MSN, etc.) view the ventures they guide not as options but as commitments: each manager must choose how best to make their division as successful as possible in the medium term – say, three to five years. If these managers were forced to deal with the full flower of strategic uncertainty, they would necessarily pull in their horns, since they would be investing for both today and tomorrow, which would dilute financial resources and, more importantly, management attention. As it is, they are able to apply themselves fully to the challenges of the markets in which they compete.

And at the functional level, managers must simply “make plan”: delivering on the commitments that have been made, often years ago.

Option. Commitment. Plan. The same operating assets create value in at least three different ways simultaneously and continuously through time. Strategic options create value by reducing risk. Strategic commitments create value by besting competitors, and delivering on plan generates the cash that keeps any organization going. And different layers of the hierarchy are responsible for managing each value-generating mechanism.

Johnson & Johnson: A case study

Microsoft has accomplished this remarkable feat for more than two decades largely as a result of the very-nearly unique skills and position of Bill Gates, the founder and until recently CEO and chairman of the company. Arguably one of the few business geniuses of our generation, Gates had the insight and the influence to grapple with uncertainty head-on. As much as we might admire the substance of Microsoft’s strategy and strategy-making, at a process level it is difficult to generalize from its experience, as very few of us are likely ever to find ourselves in Bill Gates’s position.

Johnson & Johnson (J&J) provides a more illuminating case study, revealing how mere mortals can achieve results that have so far been the preserve of the admired few. A remarkable corporate success story, J&J has outperformed the general stock market for years, in part by pioneering the next wave of cutting-edge management practices. And they appear to be on the cusp of continuing that enviable tradition.

Like many other large corporations, J&J maintains a “corporate venture capital” group called Johnson & Johnson Development Corporation (JJDC). Unlike most groups of this kind, however, JJDC seems less obsessed with measuring success solely in terms of the returns on their portfolio of investments. After all, if shareholders want exposure to venture capital-like investments, there are better and more efficient mechanisms to create it — by investing in VC funds, for example. And in a $55 billion corporate like J&J, creating material returns would require a level of investment far beyond the $500 million currently under JJDC’s management – a level that would almost certainty starve the existing businesses of the investment they need to compete.

What is JJDC for, then? In short, it is the organ of the corporate office that manages the strategic risk faced by the operating companies (OpCos). Working carefully with the OpCos, JJDC determines what strategic uncertainties cloud an OpCo’s competitive future, and which of those uncertainties the OpCo is exposed to as a result of its strategic commitments. JJDC then creates the necessary strategic options so the OpCo can continue to pursue its higher-risk, higher-return strategy…without the same level of risk.

A key part of this equation is driving the OpCos to pursue higher-risk strategies in the first place. Most operating companies, whether divisions or stand-along going concerns, systematically trade returns for lower mortality rates. At J&J, however, the corporate office sets demanding performance targets. The specifics are confidential, but for example, the OpCos are responsible for delivering specified returns (e.g., 15% ROA) within specified time periods (e.g., a three-year average) with specified resources (a capital expenditure and operating budget approved by corporate). Without those targets, the OpCos would do what the majority of stand-alone business units do: drift into mediocrity.

But if all J&J were able to do with its demanding performance hurdles were trade a portfolio of low-risk, low-return OpCos for a portfolio of high-risk, high-return OpCos, it would merely have purchased a dollar for 20 nickels – creating the possibility of higher returns at the cost of higher risk. It is JJDC’s involvement that allows this portfolio to generate the returns associated with taking on greater risk without taking on the risk.

JJDC, then, does not merely seek out new growth opportunities, attempting to find “winners” that will compensate for any “losers” in the existing portfolio. Rather, it creates strategic options that make it possible for OpCos to adjust their strategies in ways they could not – at least, not without having to compromise their ability to make and deliver on the strategic commitments necessary for extraordinary competitive success.

Consider how this has played out in the Ethicon Endosurgery (EES) OpCo. EES sells, among other medical devices, a wide array of colonoscopes used for the interrogation of the colon and lower gastrointestinal tract in order to diagnose and treat a variety of pathologies, including colon cancer.

For many years, the key to continued growth and profitability in the colonoscope business has been making the devices better able to access ever-smaller body cavities, increasing the accuracy of diagnosis, and increasing the surgeon’s ability to remove ever-smaller patches of diseased tissue. The sales force in EES – the folks delivering on plan – knocks on the doors of proctologists around the world to convince them that EES has the best devices.

At the OpCo level, however, a new strategic commitment is in the making: from “better scopes” to “less discomfort.” Growth in the colonoscopy business is a function of getting more people to get colonoscopies, and an important way to do that is to reduce the pain associated with the procedure. There are at least two ways to do this. One is to increase the “intelligence” in the device so that the skill of the surgeon is less a factor that it has been historically. The kinds of investment required to deliver these improvements fall within the money, time, and performance constraints of OpCo management, and so this is a trade-off between short and medium term considerations that is rightly left in their hands.

A second pain management strategy, however, involves pharmacological solutions and very sophisticated drug/device combinations. EES has the budget to explore such solutions on its own; it is the complexity, uncertainty, and the time horizon associated with drug-based solutions that create the challenge. Exploring new drugs and new drug applications falls into the category of a strategic uncertainty for an OpCo committed to medical devices, and if EES were to get pulled in that direction, it would be violating the principle of Requisite Uncertainty, with predictable and negative results. Specifically, EES would likely be less able to execute effectively on its existing strategic commitments, thereby compromising its ability to deliver returns.

Consequently, it falls to JJDC to work with EES to identify, make, and manage the seed investments needed to manage this strategy uncertainty. EES can therefore focus on the commitments it must in order to hit the targets set for it by corporate without having merely to accept the strategic risk that would come from ignoring the risks arising from a strategic shift from “better scopes” to “less pain.”

The strategy of humility

Competitive strategy is about commitment. But commitment necessarily exposes a business to strategic risk – the possibility that it has committed reasonably, but wrongly. If corporate strategy is nothing more than the attempt to decrease the frequency of such mistakes, then we are sure to be disappointed: there’s no good reason to think corporate managers have better crystal balls than operating managers.

The new frontier in corporate strategy, I believe, is in thinking more carefully and deliberately about how to enable operating divisions to pursue outsized returns without having merely to accept the risk that has historically accompanied such boldness. Greater returns at greater risk is, frankly, meaningless. Greater returns and the same or reduced risk? Now that’s a worthwhile goal.

Making progress in this direction will require the corporate office to adopt a fundamentally different mindset. Rather than attempt to wrestle ambiguity to the ground, managing strategic uncertainty demands that we embrace our ignorance of the future, and place critical strategic unknowns at the center of the strategic conversation.

Commitment still matters – but commitments are not for corporate strategists to make. The corporate role is not to see over the horizon but rather to imagine what one might find there, and begin preparations accordingly. This frees the crew to focus its full attention on the shoals and treasures that are already in view.

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