The Rules of James Farrell's Game


When a company plans an acquisition these days, the role model typically is General Electric. For good reason. GE has the merger game down pat. It begins by homing in on core operations. Then, to achieve unsurpassed economies of scale, it buys market share to solidify the No. 1 or 2 spot in its chosen fields, preferably on a global scale. All the while, GE is ruthless in cost-cutting. The company consolidates everything it can into centralized operations, enabling it to do away with scads of jobs at each of its new acquisitions.

No offense, Jack Welch, but W. James Farrell thinks his formula for business-building may be even better. Since becoming chief executive of Illinois Tool Works in 1995, Farrell has snapped up more than 200 companies. The spree has helped ITW almost double its net income and sales during Farrell's tenure.

Although the economy is dragging down this year's numbers, ITW posted a record $958 million profit in 2000, on revenue of $10 billion. The Glenview (Ill.)-based manufacturer now operates in 43 countries and employs 55,000 people.

NO CONSOLIDATION. While GE and others insist on industry dominance, ITW prefers to meander wherever its scouts see an opportunity. Example: The company purchased Premark International in late 1999, which moved ITW into the commercial food-equipment business. Farrell put together the $3.4 billion deal even though ITW had no expertise in that arena. His staff saw many ways to redesign Premark's meat slicers and dishwashers, and thus boost sales.

Just a few months later, ITW was invited to buy Hussmann International, which makes refrigerators for food retailers and restaurants. Farrell took a pass. The reason? He couldn't see any way to make a better refrigerator.

Farrell's Rules: When ITW takes in a business, the company doesn't consolidate. Instead, ITW typically breaks up the acquisition into even smaller units. That way, the business managers stay close to their customers. Farrell also gives them nearly complete autonomy, encouraging them to act like entrepreneurs.

If they see a takeover opportunity that would boost sales, these unit managers flag their boss, who, in turn, reports directly to Farrell. Often, the deal's done within six months. Today, ITW has roughly 600 separate businesses.

ONTO SOMETHING. From the outside, the whole setup looks horribly inefficient -- six hundred departments, yikes! But ITW's numbers prove Farrell is onto something. On average, when ITW buys a new entity, it has an operating margin of 9%. Within five years, that margin jumps to 19% on average, besting almost all of its peers.

Farrell's secret? In addition to decentralizing authority, the chairman and CEO instills what ITW calls the 80/20 process at each unit. What this means is focusing exclusively on the 20% of customers or products that provide 80% of sales, and letting go of the peripherals. The sorting process aids managers, giving them a simple tool to judge which customers and products are essential and which are only distractions.

Despite ITW's track record and overall heft, the industrial conglomerate is hardly a household word. But its products are virtually everywhere, ranging from the plastic rings that hold together beverage six-packs to the pressure seals on zip-style plastic bags, as well as industrial paint sprayers, the holograms that accent credit cards, plastic rails for computer motherboards, and printers that stamp "use by" dates on milk cartons.

Recently, Farrell sat down with BusinessWeek correspondent Michael Arndt in a no-frills conference room at ITW's headquarters in suburban Chicago to talk about his growth strategy. What follows is an edited transcript of the conversation.

Q: You've got 600 companies or business units at this point. But the trend in the business world is toward consolidation for the sake of efficiency or synergy. That way you don't need 600 units with duplicate functions. Why do it your way?

A: There are two reasons for it. One...is hereditary. Since ITW was formed close to 90 years ago, we've been creating divisions within the company. It was the way the company got started....That's one reason why we think small.

The second reason is: Especially in the last 15 or 20 years, we have been doing our 80/20 analysis, which leads us to the conclusion that if you simplify things, you can do those things much more efficiently than the common consolidation route. You may think you're consolidating two divisions together, ending up with one sales force instead of two sales forces. But we'll split things up and end up with two sales forces, but with fewer salesmen than the business that consolidates and has one sales force.

Q: But isn't there a risk that you do end up with a lot of duplication, that you are repeating a lot of work throughout 600 units?

A: People say this is crazy. You can't have 600 divisions. You'll have more overhead and duplication of costs, blah, blah, blah. The real test of this is to give you a report that adds everything up. Our annual report takes all 600 divisions and adds it all up: Here's what our sales are. Here's what our SG&A [selling, general, and administrative] costs are. And our SG&A costs are lower than 75% of the companies out there. So something is happening. We're not hiding that cost anywhere. We're competitive in the marketplace. So run your consolidated model. It seems to me my costs are lower than yours with my decentralized model.

Q: Let's talk about your 80/20 thinking. You're concentrating on that core base that provides 80% of your business. Don't you risk getting comfortable or lazy? After all, you've got that core base that buys 80% of your stuff. What is the incentive to innovate, because you've already got those customers?

A: Because if you don't grow, you die....I don't care if you're an individual or a family or a business. If you...stand still...you're history. And there's more than focusing on the 20% that [accounts for] 80% of your business. In that process, we ask, "Do we have all of their business?" And the answer is no. Who ever has 100% of a market?

So the question then becomes, "What does it take to get 100% of their business?" Is it a new product? Is it new features on our current product? Is it price? Is it delivery? Is it service? What are the things we're lacking that prevent us from getting more business? Those things that are lacking become the future plans to change yourself to get that business. So really focusing on that select set of customers really drives growth. And we're clearly after growth.

Q: Now one of the things that a lot of companies do when they go out and acquire a company is wipe out 10%, 20%, 30% of a labor force as soon as they go in. Great way to reduce costs. What do you do?

A: Probably the same thing, but it takes five years to do it. Because what do we know? We know we just acquired a company, but we're not intimate with what everybody does and how they do it. So we spend time with the people in the company to do this 80/20 process and begin to separate things.

And a lot of this reduction in workforce, if you will, is retirements and attrition. So we don't have to go in there and announce big layoffs. Which is why we become a very attractive acquirer to people selling their businesses, because they know we don't go in there and wildly disrupt the organization.

Q: Do you find that other companies come to you and ask for your advice on how you do this?

A: All the time.

Q: Do you see any other companies that are following your model now?

A: No. It took us 10 years to develop this process. We didn't sit down and say, "Hey, let's do 80/20." And then after we really got going on it, it took us another five years to really get most of our existing businesses thinking this way. It's a tough discipline.

Intellectually, it's easy to understand. But it's very difficult to put into practice. Because your organization starts to fight with you Day 1. They say: "You can't think about getting rid of these products over here because we have to have a complete product line in order to sell to our customers. And you can't do this in the factory because we need this volume to absorb the burden of our fixed costs." And on and on and on. You get arguments up the wazoo.

Most people when they start hearing that from their organization, they stop. They do things that are easy, but that's as far as they go.


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