No Need For Economies Of Scale

Illinois Tool Works revs up innovation by keeping its 665 units separate and focused

Illinois Tool Works Inc. (ITW ) might not seem like an incubator for innovation. The 93-year-old company manufactures a hodgepodge of mundane products, from automotive components and industrial fasteners to zip-strip closures for plastic bags and laminates for flooring and countertops. And its research and development outlays come to just 1% of sales, a miserly budget for even a bulk-commodities producer. Yet ITW routinely finishes among the Top 100 patent recipients in the U.S. every year, ranking 66th last year, with 301 new awards and 468 applications.

Among its newest inventions is a heater for automobile seats. It's made from conductive ink printed on a thin, flexible film of plastic, and it costs only half as much as today's toaster-coil devices. Nissan Motor Co. (NSANY ) will offer the new heater this winter in the 2006 model of its Infiniti G35 luxury sedan.

ITW owes its outsize achievements to its unorthodox business model. Like many old-line outfits, the company gets most of its growth from acquisitions; it has averaged 28 deals a year over the past decade. But management does not then merge the new units with old ones to reduce payroll and other expenses. Instead, it retains them as freestanding entities to maintain their entrepreneurial drive and keep them close to their customers. Today the $11.7 billion conglomerate operates through 665 separate businesses, each with its own profit and loss statement.

The company also practices something it calls an 80-20 philosophy. The term derives from the fact that 80% of sales and profits often come from just 20% of customers. Once this top tier has been identified, management then lavishes attention on it -- including custom-designed products -- to maximize the return from ITW's personnel and assets.

In August, David B. Speer took over as chief executive. A 27-year company veteran, Speer, 54, worked his way up through ITW's construction side after earning a bachelor's degree in industrial engineering from Iowa State University in 1973 and an MBA from Northwestern University's Kellogg School of Management in 1977. Sitting in a bare-bones conference room at ITW's headquarters in suburban Chicago, Speer talked recently with Senior Correspondent Michael Arndt. An edited transcript follows:

Let's start by talking about ITW's decentralized nature. How do you make it work?

Our business model is the antithesis of scale. To begin with, our organizations tend to be small and lean. If I were to look at combining several units, the real cost savings we would wring out would be relatively modest. Smaller, more tightly focused units also have a greater entrepreneurial spirit; there's greater participation by the employees in the business. That leads to greater intimacy with the customer and better understanding of new opportunities.

This speaks to our 80-20 approach. In many companies, you'll see a disproportionate amount of resources working on the 80% of clients that generate only 20% of results. By listening to the 20% of customers that account for 80% of sales and profits, you're in a much better position to react to their needs than if you're managing larger businesses that are more concerned about economies of scale.

How does this play out practically at ITW?

A good example is our new seat heater. We started out by looking at warranty costs from the original equipment manufacturers (OEMs) a few years ago. We discovered there was a big issue. Seat heaters often stop working, and to fix them, you generally have to remove the seat from the car. We didn't have any seat heaters at the time, but we did have this heating element we had developed almost 20 years ago for the sideview mirrors on your car. So some of our engineers said: What if we could develop this and put it into a seat? They went through a lot of iterations because this is a different application. In a seat it has to flex regularly. It has to fit contours, not like a flat piece of film behind a mirror.

The benefit to you as a passenger is that you can adjust the setting, and it will automatically regulate the temperature through the resistance in the circuit. The major advantage to the OEM is that this heater can be serviced without pulling the seat out of the car. And because it's an electrical item as opposed to an electrical-mechanical assembly, it's much simpler in design. We're excited about this because it's a patented, proprietary item that adds value and allows us to get a little more money.

Are there productivity payoffs, too?

We take the 80-20 approach and dedicate production lines and resources to high-volume products. A line will run only those three or four products, if that's the case, which represent the 80% of that business. We're able to make fewer changeovers on these lines and can increase the life of the tooling. Runs that are much longer are more efficient. By physically linking machines, we're often able to eliminate work in process and storage areas, which means a smaller footprint. And, of course, all the material handling and indirect costs are reduced. That doesn't mean we don't pay attention to the other 20% -- we just manage them separately.

Are China and India growth markets for you?

We operate with the basic philosophy that we want to produce where we sell. If I'm going to sell a product in China, I want to produce it in China. If I want to produce locally, then I have to be able to compete locally and make a decent return.

Rarely do we ever get into a geographic market through acquisitions. We usually like to get our feet on the ground and assess the market and the opportunities with our own local management team first. Today we have 21 businesses in China. Only one of those was an acquisition, and that started out as a joint venture. We've looked at a number of other acquisitions there, but frankly what's available is not attractive: A lot of it is remnants of state-owned enterprises. And in many cases, they want to do joint ventures and not sell outright. The market is not right yet for more acquisitions. In India, we have 11 businesses. Two of those started out as joint ventures that are now wholly owned. Both China and India will become more important for acquisitions.

What do you see in the economy overall?

Clearly, the auto business in North America has been trending downward with the Big Three. Europe has been disappointing. In the euro zone, I'd be surprised if growth hits 1.5% this year.

As for positive signs here, residential housing remains strong. And commercial construction is showing signs of life, for a change. Industrial production has picked up. And auto production has been trending upward with what we call the new domestics -- the Japanese, European, and Korean factories here. Our position with them has been increasing rapidly.

I don't know how oil at $60-plus is going to play out. If it stays there for long, it's going to have an impact, probably starting with the consumer. For us, I'd be pleased if our 2006 growth rates were similar to this year's. I'd be happy with 4% growth in sales from existing customers.

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