T

here'€™s no questioning the fact that companies today are faced with growing complexity. Environmental, political and competitive changes conspire to create a challenging and complex operating environment.

In response to these ever evolving pressures, companies often try to mirror external complexity in their internal environments. For example, they may respond to more sophisticated customer demands by creating tailored products and services. They may address the need for cost cutting and innovation by building matrix organizational structures. They may attempt to add new processes to address evolving market needs. In isolation, each of these responses makes sense, but in combination, they can significantly affect organizational performance.

Take BMW for example. At the end of 2012, the company recorded a 12 percent increase in sales volume and revenues in 2011, as well as the best operating profit in the company'€™s history. Despite these positive results, shares in the company were lower than they were at the beginning of the year.

How can you explain BMW'€™s strong top-line growth in a tough market, combined with a lower stock price? The answer lies in the fact that revenues grew significantly more than profits. In fact, profits were flat on the year, and post-tax return on sales actually dropped.

BMW attributed the flat profits to an increase in personnel, higher innovation costs, and intense competition. While technically true, there is a subtler culprit, one that underlies all these factors: higher complexity. More people, more R&D, and more products equal more complexity, which leads to higher costs, which, in turn, bring down profitability.

There are several common causes of complexity: a proliferation of products and/or services, inconsistent and overlapping processes, misaligned incentives, byzantine organizational structures, and poorly articulated strategies, often in some form of combination.

How should organizations deal with complexity? The answer depends on the type of complexity being considered. Some types of complexity provide competitive differentiation, which is good complexity and should be optimized. Most types of complexity, however, do not add value and need to be reduced or eliminated. There are four common complexity culprits, and they can be reduced by following these steps.

Step 1: Establish a clear strategic direction. Nothing stimulates complexity more than an unclear or inconsistent strategy. Vodafone UK was unprofitable in the mid-2000s, despite strong top-line growth. A new CEO radically simplified the strategic process, allowing each of the top 100 managers to maintain a list of no more than 5 strategic goals for each quarter, all of which had to be aligned with corporate priorities. These goals were completely transparent to the organization'€™s management team. As a result of an extensive simplification program, Vodafone UK has become highly profitable in one of the world'€™s most competitive telecommunications markets.

Step 2: Rationalize product and service lines. In most cases, the Pareto principle applies '€“ no more than one quarter of products or services account for more than 100 percent of profits. Seen another way, three quarters of products or services actually destroy value. Firms could increase profits just by ceasing to offer products or services that do not add value. Compare RIM and Apple'€™s approaches to mobile phones. Apple has typically sold much fewer variants than BlackBerry. RIM, in a statement, said it did not know how many models were currently on the market. Certainly, there may be strategic reasons to maintain a few promising, but as yet unprofitable lines of business. However, we maintain that firms should be impatient for profits, even from the highest potential opportunities.

Step 3: Streamline your processes - a major source of complexity. Processes are often inefficient, non-standard, or duplicated across departments. Process simplification and standardization programs can go a long way toward reducing complexity. Nestlé went through a multi-year process of rationalization to reduce value chain complexity. Nestlé'€™s process was sometimes painful, and often deeply unpopular, but the results have been dramatic. Top managers now have a transparent global view of production and sales. A key challenge is to balance the desire for central control with the need for local flexibility. Most processes can be standardized, while a few should be allowed to vary based on local conditions.

Step 4: Align personal incentives with organizational goals. A major source of complexity comes from people acting in their own interest to maximize personal gains. This self-promoting behavior adds huge amounts of hidden complexity. A common example is incentives for growth. Many organizations reward increases in revenue, but as we can see from the BMW example, higher revenues do not always translate into higher profits. In fact the opposite is often the case. New products need to be designed, produced, stored, shipped, maintained, serviced, and so on.

Elevated complexity is a chronic and endemic problem in today'€™s organizations. Like high blood pressure, it may be hidden from view, but still dangerous. To maintain a healthy company, you should rationalize your product and service lines. Aligning personal incentives with organization goals is key. Together, these four steps will help to ensure a long life expectancy for your organization.

The writer is professor of innovation and strategic information management at IMD.