Building an Innovation Culture - Mastering the Seven Truths of Innovation and Transforming LEGO - Brick by brick: How LEGO Rewrote the Rules of Innovation and Conquered the Global Toy Industry - BusinessNews Publishing

Brick by brick: How LEGO Rewrote the Rules of Innovation and Conquered the Global Toy Industry - BusinessNews Publishing (2014)

Part II. Mastering the Seven Truths of Innovation and Transforming LEGO

Chapter 4. Building an Innovation Culture

The Return to Core Values

We wanted to break the back of the culture.

—Jørgen Vig Knudstorp, CEO, the LEGO Group

ALTHOUGH KNUDSTORP, IN HIS PRESENTATIONS TO THE LEGO Group’s board of directors, was prescient in predicting the company’s near collapse, the first few months of 2004 found him struggling to diagnose why the company had fallen so far so fast. He knew he couldn’t return LEGO to profitable growth if he first didn’t understand the root causes of how such a creative powerhouse had so decisively lost its way.

The conundrum gnawed at him as he boarded an overnight flight from New York to Amsterdam. On the plane he happened to sit next to Chris Zook, a partner at the strategy consultancy Bain & Company and the author of Profit from the Core. In his book, Zook argued that sustained, profitable growth comes when companies focus on core products for a clearly defined segment of customers. He warned that companies must exercise careful planning and great care when they expand into related or “adjacent” areas, such as significantly new channels, value chains, technologies, or product lines. If they diversify too much in too short a span, the results probably will be ugly.

As Zook explained his thesis, Knudstorp reflected on the kaleidoscopic array of new businesses that LEGO had taken on in just the past decade: software (computer games and LEGO MovieMaker), learning concepts (LEGO Education), lifestyle products (LEGO kids’ wear), girls’ toys (LEGO dolls), media (books, magazines, television), three more theme parks, and the goal of three hundred more retail stores. Despite all of that effort, expansion, and experimentation, far too many of those ventures ended up in the red. In fact, the rate at which the LEGO Group dove into new markets roughly corresponded to the rate at which it racked up losses.

Thinking back on the company’s many disparate ventures, it occurred to Knudstorp that the root cause of the LEGO Group’s problems resided in the simple fact that its approach to creating distinctive, desirable offerings was far too aggressive. “Chris said his research showed that if a company has a strong core business, it can move into one adjacency every five years,” Knudstorp recalled. “As he was saying this, I was thinking we read the book the other way around. We did five adjacencies every year. Suddenly we had to manage a lot of businesses that we just didn’t understand. We didn’t have the capabilities and we couldn’t keep up the pace.

“It’s fine to experiment and diversify,” he continued. “But behind the scenes, there’s a management system that needs to keep its integrity. And there was no overall guidance of the innovation process.”

Knudstorp knew that if LEGO was to pull back from the abyss, the company’s culture—its goals, beliefs, habits, and ways of working—would have to value discipline and focus as much as creativity. Only then could the company consistently invent something new while keeping it LEGO. The goal was to foster a culture where developers and marketers were highly empowered to reimagine what was possible for LEGO but also highly accountable for the results—where they’d have both the flexibility to do the right thing for kids and the stimulus to do the right thing for profits.

At least in the near term, rebuilding a company culture where profitable, sustained innovation flourished would be an exceedingly difficult challenge. For starters, an unwieldy triumvirate consisting of Kristiansen, Knudstorp, and Jesper Ovesen would lead LEGO in its all-or-nothing effort to get back in the black. In January 2004, under the terse headline “Plougmann and Ciccolella Are Leaving the Company,” the LEGO Group announced sweeping changes at the top of the organization. In its press release, the company stated, “As a consequence of the LEGO Company’s expected deficit in the order of DKK 1.4 billion” ($225 million), Kjeld Kirk Kristiansen would resume day-to-day responsibilities for managing the organization, “assisted” by Knudstorp and Ovesen. If LEGO had been rudderless during the Plougmann era, with innovation efforts spiraling out in every direction, it was difficult to see how the company would once again rebuild its culture when there’d be three different hands at the helm.

Surprisingly, even though LEGO was in a death spiral, many staffers greeted the leadership shake-up with unmitigated joy.

Poul Plougmann was less than loved at the time of his departure. Unfairly or not, his Nordic complexion and shock of white hair, along with his having axed one thousand employees in 1998, had led some LEGO staffers to bequeath him the sobriquet “Mr. Death.” The grandson of the LEGO Group’s founder, on the other hand, was hailed as the company’s savior. Upon hearing news of the changes, an elated designer Photoshopped an image of Kristiansen’s face onto a poster for the movie The Lord of the Rings: The Return of the King. Within a few hours of the announcement, copies of the doctored poster were plastered all over the hallways of the LEGO Group’s headquarters. At a town hall meeting later that day, staffers cheered Kristiansen’s homecoming. But although the king had reclaimed his throne, his court was nevertheless riddled with angst over the company’s benighted future. People’s apprehension sprang out of three questions that reside at the epicenter of almost every turnaround effort: Would the company make it? Who was really in charge? And what was the strategy?

The new management team’s real-world answers to those questions were honest and direct.

Would the company make it? As 2003 wound down and the bleeding accelerated, Plougmann described the company’s predicament, in an interview with the Danish newspaper Boersen, as “unexpectedly bad, nearly catastrophic.”13 If anything, the LEGO Group’s plight was even worse than Plougmann admitted. The company was in the midst of a meltdown.

By the end of 2003, the LEGO Group’s sales had plunged by 30 percent compared to the previous year and it had lost its leadership position atop all of its core markets. LEGO was running a negative cash flow of DKK 1 billion ($160 million) and had racked up debt of DKK 5 billion ($800 million). Although 2003 brought the biggest deficit in the LEGO Group’s history, 2004 was forecast to be even worse, as the company’s net loss was expected to double to DKK 1.9 billion (about $300 million).

At least over the short term, there was no possibility that LEGO might grow its way out of the debacle. In early 2004, an internal survey of the company’s entire product portfolio revealed that 94 percent of LEGO sets were unprofitable. Only Star Wars and Bionicle kits were making money. Not only had LEGO sustained the largest losses, on a percentage basis, among toy makers, but it was by far the industry’s least profitable brand.

As news of the brick maker’s crash spread beyond Billund, analysts predicted that with toy industry heavyweights and private equity firms closing in, LEGO would probably be broken up and sold off in pieces. The Financial Times reported the LEGO Group’s “financial independence” was at stake. The British newspaper the Independent cited “growing speculation that LEGO cannot survive alone.” In a headline, the London Telegraph flatly declared, “Family Likely to Lose Control of the LEGO Set.”

Kristiansen was determined to keep LEGO in the family, but the headlines weren’t just hype. The company’s financial health was so dire, Ovesen had at least one discussion with Mattel about acquiring LEGO, just in case the turnaround foundered. His blunt assessment of the company’s dilemma: “We didn’t know if we would make it through the year.”

Who was really in charge? Although the message to both the LEGO organization and the outside world was that Kristiansen was back in the driver’s seat, he was not about to steer the company’s day-to-day operations. Having led LEGO for the better part of a quarter century, Kristiansen believed the challenge of reinventing the company required a new chief. But who?

Ovesen had the acumen and the throw weight to take on the financial restructuring, but he was a CFO lifer who had no desire to become CEO. Knudstorp had the right long-term vision for LEGO, as well as impressive people skills, but the board of directors fretted that he was too inexperienced to shepherd the organization at such a decisive moment. The board wanted to recruit a turnaround expert from some other organization, but Kristiansen concluded that after Plougmann’s volatile tenure, another outsider would be too great a shock to the LEGO Group’s system.

In the end, the board decided the best way forward was to settle for the aforementioned triumvirate, with Kristiansen as the face of the organization, Ovesen as the financial overseer, and Knudstorp as the master strategist and CEO-in-waiting. Although there was a certain “make our weakness our strength” logic to the arrangement, it hardly inspired confidence. Because Knudstorp wasn’t the company’s officially designated leader, he lacked a clear mandate to make big changes.

“It was not a super construction, because the company was in a real critical situation,” he conceded. “I just didn’t have enough formal authority. We needed to make decisions at a pretty high pace. When you’re running a turnaround, you don’t want confusion.”

What was the strategy? Having been assigned the knotty task of devising a turnaround strategy, Knudstorp found that clarity proved elusive. Any instinct he might have had for choosing the best way forward was consumed by a swirl of confusing choices.

In announcing Plougmann’s firing, the LEGO Group’s press release declared that the company’s future strategy would put renewed emphasis on its “core products.” Kristiansen told the Telegraph that new product lines “did not give the expected results. We will now focus on profitability, especially the attractive potential of our core products.”14 In an interview with the Financial Times, he opined that the LEGO Group’s fall was the result of chasing too many fads and neglecting the construction toys that had once made it great. “We have simply not had enough focus on our core products,” he averred. “Too much of our growth has been generated by licensed products.”15 Again and again, the word core figured prominently in nearly every account of the company’s plan for reviving growth.

At first glance, the road to growth seemed remarkably straightforward: go back to making and selling millions of LEGO bricks and let kids’ imaginations take over. Trouble was, that strategy had flatlined in the mid-1990s as simple plastic building blocks lost their luster and more kids shifted to video games and electronic toys. Plougmann had been brought in precisely because LEGO needed to shake up its complacent, inward-looking culture, break out of its rapidly narrowing niche, and seek new pathways to growth. And that was exactly what he had done.

When LEGO tied into the Harry Potter and Star Wars franchises and those deals yielded blockbuster sales, few complained that the Danish family firm had abandoned its core. Had the company shunned Star Wars and thereby let Hasbro grab the deal—at the time, a very real possibility—LEGO would have been roundly criticized for relying overmuch on its aging, brick-based product lines and missing out on a promising growth opportunity to a more innovative rival. If, five years later, Star Wars wasn’t “core” to LEGO, as Kristiansen implied in the Financial Times piece, it certainly was core to the brick maker’s balance sheet.

And what of some of those other big growth initiatives? Were amusement parks and retail stores really so very far removed from the company’s roots? Disney had made parks spectacularly successful for its businesses, as Apple had done with stores. Why shouldn’t LEGO?

With Plougmann out and his reinvention strategy having been deemed a failure, Knudstorp was expected to reverse course once again and take LEGO back to basics. But which core pathway should he follow? Bricks and minifigs, by themselves, couldn’t put LEGO ahead of its competitors. As for licensed lines, LEGO was already overly reliant on them. And with the exception of LEGOLAND Billund, it was losing millions on its parks and most of its stores; at least over the near term, using those vehicles to exploit the power of the brand was not a viable option. Try as he might to discover the one true avenue that was rooted in the past and yet would deliver LEGO to a bright, shiny future, Knudstorp found himself running down one dead end after another.

Night after night, the former McKinsey consultant would meet with the seasoned CFO for dinner at the LEGOLAND Hotel, where he focus-tested his strategies for improving the business. “I had something like eight proposals on what to do about operations, seven proposals on what to do about innovation, and probably another seven proposals for market actions and so forth,” exclaimed Knudstorp. “In all, I must have proposed fifty or sixty actions. And Jesper just looked at me and said, ‘The way you describe the company and the way I understand the situation, your plan is too complex. It’s never going to happen.’ ”

Ovesen’s advice was as direct as it was taut: Forget strategy. The company needed an action plan for its survival.

In cutting through Knudstorp’s strategic scenarios and homing in on a plan for survival, Ovesen sought to give people a window into what needed to happen next. A survival plan comes with a list of priorities that aim to restore the organization’s fiscal health and competitiveness. When management communicates and follows up on those actions—when it says what it’s going to do and then does it—its credibility starts to grow and people begin to move along with the new leadership. “Jesper’s clarity was just what I needed,” said Knudstorp. “But it was also just what the organization needed.”

Putting a survival plan ahead of a growth plan was challenging, given that people were clamoring for the strategy—a road map for reviving profits and returning LEGO to the top of the toy industry. At a gathering of the company’s sixty top executives, one of them stood up and said what many were thinking: “We need to get clear on the strategy and the mission.” But Knudstorp deliberately refused to deliver one. “Right now, our mission is just to survive,” he told the group. “To cut costs, sell businesses, and restore our competitiveness.”

Knudstorp and Ovesen’s decision not to spell out a big, overarching strategy served a dual purpose. First, they needed to fully focus people’s energy, experience, and talent on the treacherous task that lay before them. If they didn’t raise cash, secure new lines of credit, and stop selling money-losing products, LEGO wouldn’t get to launch a grand strategy because it wouldn’t survive 2004 as an independent organization. Second, they were determined to remake the company’s mind-set, which in their view was far too complacent. Knudstorp recalled how Ovesen couldn’t get over the fact that his previous employer, Danske Bank, was among the most successful financial institutions in Scandinavia, “and yet everyone came to work grumpy and angry. Then Jesper arrives at LEGO, and he tells me, ‘I have never seen so much shit in my life. Everything is broken. You’re not making any money. You can’t even forecast your sales, and people are so happy—I can’t believe it.’ ”

To Remake the Company’s Culture, Begin by Breaking It

All throughout the late 1990s, when LEGO was destroying economic value on a daily basis, Danish business executives had voted it the most admired company in Denmark. And, of course, in 2000 both Fortune and the British Association of Toy Retailers had proclaimed the LEGO brick the twentieth century’s greatest toy. Although the LEGO Group’s steep decline had alarmed some staffers, there remained a bright residue of optimism that ran through the organization—a sanguine belief among too many managers and associates that the storm would pass and better days would soon return. Knudstorp and Ovesen concluded that before LEGO could even begin to reignite a sense of what was possible for LEGO, they first had to persuade people that decades of unfettered growth offered no assurance that the company would ever get its groove back. So rather than follow the example of most leaders in a turnaround, which is to fabricate an inspiring plan that would rally people to a better and brighter future, Knudstorp and Ovesen instead decided to begin by stamping out the last vestiges of overconfidence and deliver a dose of hard realism.

“We wanted to break the back of the culture,” said Knudstorp. “We had to go through a one-year, painful process of beating ourselves up and saying, ‘You know what? There’s no reason to be so enthusiastic. We’re not such a world-class brand, as we go around telling ourselves. We say we do a lot for child development, but we’re not selling a lot, so how can we be?’

“This was a company that was always very enthusiastic about grand strategies and nurturing the child of all ages,” he continued. “Our message was, ‘forget [for now] about the visionary, child-development stuff. Let’s get more operational and execution oriented. Let’s get stuff done.’ ”

Remaking the LEGO culture—altering people’s behaviors and beliefs so that they focused less on grandiose ideas and strategies and more on “getting stuff done”—was really a matter of reconnecting with the bedrock values that had sustained LEGO since its inception.

An organization’s values signal what its leaders and associates care about and what they stand for. Values not only serve to bind people to a set of shared assumptions about where the business can and should be going. They also define what’s possible for associates, customers, and partners. By reanimating its values, the LEGO Group’s leaders stood a better chance of giving people a shared sense of purpose, one that would once again set the company apart from much of the me-too thinking that dominates the toy industry.

Caught up as he was with trying to wrangle the whirlwind of events that engulfed LEGO during 2004, Knudstorp had little time to reflect on how he might map out a return to the values that had guided LEGO for so many decades. Acting mostly on instinct, he concluded that for LEGO to get back to making core products (whatever they turned out to be) for core customers, it had to revive the core set of founding principles that Ole and Godtfred Kirk Christiansen had established so many years ago: that the LEGO play experience is founded not on products but on the brick and the building system, that tightening designers’ focus leads to more profitable innovation, that LEGO must return to acting authentically, and that the road to profitability starts with the retailers. Taken together, those essential values, established more than half a century earlier, stood the best chance of preparing LEGO for an increasingly challenging future.

To build a culture where sustained value creation thrived once again, Knudstorp’s overriding challenge was to remake the LEGO Group’s core values in a contemporary way. As the author and Copenhagen Business School professor Majken Schultz later told Knudstorp, he “used LEGO’s history to create a new cultural identity.” Knudstorp agreed, although his way of putting it was decidedly unvarnished: “It was not something we were very deliberate about,” he mused. “But essentially, we stole from our past to interpret our future.”

Here’s what they did.

First the Stores, Then the Kids

Although the LEGO Group’s mission is to “inspire and develop the builders of tomorrow,” its leaders long understood that to nurture kids, it had to forge tight, profitable partnerships with retailers. But those alliances deteriorated badly during the Plougmann era, when chains such as Walmart and Toys “R” Us were whipsawed by such rash LEGO moves as dumping DUPLO and failing to forecast the fall-off in sales of Star Wars kits in a year without a new movie. Seeking to repair the damage, Kristiansen and Knudstorp, soon after they took over from Plougmann, took a lap around the world and met with key partners. It was a brutal trip, as the recent years’ frustrations with the LEGO Group’s mismanagement of its key account relationships finally erupted.

In a February 2004 stop at New York’s Toy Fair, the year’s largest gathering of North America’s biggest toy sellers, Kristiansen and Knudstorp sat down with a disgruntled team of senior buyers from Toys “R” Us. The Toys “R” Us team delivered a blistering brief on the LEGO Group’s performance. “They told us, ‘We love and understand the LEGO brand better than you guys do,’ ” Knudstorp recalled. “It was a shocking statement, especially coming from a retailer.” Howard Roffman, Lucasfilm’s licensing chief and the point man for LEGO Star Wars, tendered an unsettlingly similar appraisal, telling Kristiansen: “You’ve lost your grip on the business. You’re not on top of your game.”

From the partners’ perspective, the LEGO Group’s sins were numerous. The company’s leaders had lost sight of the deep-seated DNA that had made the brand great, and they were clueless about how to keep it vibrant in a rapidly changing world. Its marketers were aloof and slow to respond to retailers’ needs. Worst of all, LEGO had grown stunningly inept at forecasting demand and managing its supply chain. It had overwhelmed retailers’ inventory with lackluster kits. At the same time, in the United States, there was an unforgivable lapse: LEGO had failed to deliver sufficient quantities of its two best-selling Bionicle products in the run-up to Christmas. At a time when LEGO had suffered the worst loss in its history, it had created robust demand for Bionicle and then couldn’t fulfill it.

Those forthright conversations drove home the notion that senior management must restore not only the LEGO Group’s profitability but retailers’ profitability as well. Upon his return to Billund, Knudstorp pushed to once again put the retailer ahead of the customer, as LEGO had throughout its most successful decades. But that notion proved anathema to some of the company’s executives.

“The company’s mission statement was to nurture the child of all ages, and I spent the next nine months debating with people in top management whether we were now neglecting the children,” he said. “We literally told people to forget about the children for now, because if we don’t serve the retailer, we’ll never reach the child.

“It just goes to show how incredibly hard it is to change habits and cultures,” Knudstorp continued. “Some of those top people had spent so much of their careers dedicating themselves to another strategic direction. In the end, you can only change by letting some of them go.”

After a seminar at the Swiss business school IMD (where Kristiansen had received his MBA), the management team identified a set of “must-win battles” for 2004—immediate, do-or-die efforts that aimed to return LEGO to a safe harbor. Chief among those battles was the declaration that LEGO would “restore competitiveness by focusing on our retail customers.” That meant working to improve retailers’ margins, delivering to store shelves the right kits in the right volumes at the right time, and creating a “balanced” (read: not overly dependent on one hit toy) product portfolio that tapped into kids’ desires.

If people are going to follow a leader into the future, they need to know precisely whom they’re trying to please. By firing managers who wouldn’t change and asserting unequivocally that improving retailers’ LEGO sales was crucial for the company’s survival, Knudstorp made clear that retailers would be the ultimate judges of the LEGO Group’s performance. That might not have been enough to change the hearts of those LEGO staffers who still believed the company should put kids before retailers. So be it. By spotlighting which constituency LEGO must serve, Knudstorp stood a better chance of changing more minds. Such clarity began to infuse staffers with enough confidence to face the future.

Tighter Focus Leads to Profitable Innovation

In the 1950s, when the son of the LEGO Group’s founder decided to bet entirely on the plastic brick and cease production of wooden toys, he demonstrated that channeling people’s creativity into one specific area could generate an outpouring of profitable products. In the decades that followed, even as LEGO spun out new product lines such as DUPLO for preschoolers and Technic for advanced builders, each of those platforms was rooted in the LEGO building system. By consistently doing more of what it had done before, LEGO improved its chances of making successful products.

But the company lost much of its focus and discipline while pursuing every conceivable adjacency—to use Zook’s term—in its bid to become the world’s strongest brand among families with children by 2005. Francesco Ciccolella, in his rebranding of the brick, had proclaimed that LEGO was “an idea-based—not a category-based—business.” The notion that LEGO was not a toy but an idea—and an undefined idea at that—was so opaque, it opened the way for designers to create products that were far removed from the very real qualities that had defined LEGO in the minds of customers. And his declaration that “the LEGO idea [will] transcend traditional category boundaries” ensured that LEGO would venture into such uncharted terrain as lifestyle products, branded stores, theme parks, and beyond.

Knudstorp understood the logic behind Plougmann’s decision to rapidly expand the LEGO Group’s product portfolio, pursue untapped markets, and diversify the ranks of its designers and developers. Problem was, the company’s zealous desire to boost innovation had taken it in so many directions, it couldn’t manage all of its many initiatives. Ovesen had come to the same conclusion. Citing Apple and its legendary perfectionism, secrecy, and attention to detail, he argued that “the world’s most innovative companies are also the most disciplined. You have to have great control over all the basics; only then can you start to be truly innovative.”

As they huddled over dinner during the first nights of 2004, Knudstorp and Ovesen began to map out how they’d wage another must-win battle for the company’s survival: “Set a crisp and clear direction and change the way we do business.” Above all, that meant getting a better grasp on where LEGO was making money and putting people’s efforts behind those products that showed the most promise. By jettisoning the businesses that were bleeding money, Knudstorp and Ovesen began to reveal the profitable product lines that were truly core to LEGO.

They were an unlikely but complementary pairing: the mathematically minded CFO who “saw a number behind every person” and the young, humanistic CEO-in-waiting who “saw a person behind every number.” But the combination proved effective.

Ovesen plunged into every LEGO business unit and delivered triage reports that made the case for eliminating product lines that were deep in the red, restructuring lines that showed signs of life, and expanding the few that were profitable. The pair’s reports back to Kristiansen and the board led to the decision to cut out 30 percent of the product portfolio, curtail the LEGO stores initiative, and jettison the company’s theme parks and computer games businesses. The moves were not without controversy. LEGO video games held great promise, but after the Darwin debacle, it was felt the company lacked the resources and the management know-how to successfully commercialize the effort. The theme parks were even more problematic. Because his father had launched LEGOLAND Billund, Kristiansen was deeply reluctant to sell off the business. It would be another year before he rendered his decision.

In the meantime, Knudstorp and Ovesen’s most significant move was to immediately halt production of LEGO Explore and revive DUPLO. Restoring DUPLO’s primacy signaled to the designers of preschool toys that the line would be a core part of the company’s future. “There was a lot of cheering when we got the [DUPLO logo] red rabbit back,” recalled Allan Steen Larsen, one of the designers who had worked on Explore. “We felt we were back on the right track.”

Following quickly on the DUPLO rebirth was a refocus on other tried-and-true product lines that had sustained LEGO since the brick’s earliest days. The World City line, which consisted of futuristic buildings and flying cars, was quickly restructured to realistically reflect the world that kids saw all around them, just as the LEGO town sets of the 1950s had done. The Jack Stone and fanciful Orient Express lines were replaced with updated themes from the 1970s and ’80s, such as a Pirates line and Knights of the Kingdom, both of which were reboots of previously successful play themes.

Ovesen also inaugurated a near-term, measurable goal that consisted solely of a number: 13½ percent. He established a financial tracking system dubbed Consumer Product Profitability (CPP), which measured the return on sales of individual products and markets. CPP gave LEGO an unimpeded view into where it was losing and making money. To survive, any existing or proposed product should demonstrate that its return on sales would meet or surpass that 13½ percent benchmark, which was based on the company’s analysis of its competitors’ earnings and its expectation of what a premium toy brand should deliver.

Of course, most of the toys in the LEGO Group’s 2004 portfolio would fail to clear that bar; some product lines were given a temporary reprieve and allowed to slip under it, with 6 percent set as an absolute minimum. But 13½ percent gave managers, when they were considering the prospects of products that were still in development, a vivid reality check. No matter how passionate designers were about a toy in the making, if they couldn’t convincingly forecast a 13½ percent return, the product would never see the market. The new standard also communicated to everyone in the organization that, moving forward, they should focus solely on innovations that would yield real profits.

“In town hall meetings, emails, on the factory floors—13½ percent was talked about everywhere, all the time,” said senior vice president Poul Schou, who oversees most of the company’s product development. “It was a huge ambition in those days to make a number like that, but it gave us something to aim for. When I sat down with my product lines and looked out over all of my markets, we always had to ask the question, ‘Where do we hit 13½ percent?’ It was an incredibly clear way to set priorities.”

Not a Product but a System

All throughout 2004, Knudstorp had extensive conversations with Kristiansen about the nature and continuing relevance of the LEGO System of Play. Knudstorp was reminded that LEGO owed its decades of unbroken success to Godtfred Kirk Christiansen’s insight that if every LEGO piece clicked with every other piece—and every LEGO kit was an integral part of a larger LEGO universe—LEGO could offer kids more possibilities for continuous play. And with continuous play came (nearly) limitless sales.

For children and their parents, the benefits of a play system were obvious: combining bricks in almost any way they wanted fired kids’ creativity and imagination and delivered a singularly unique building experience. But for Knudstorp, his eureka moment came when he realized the LEGO System is not just a play system, it’s also a business system. After all, it had been a retailer who suggested to Godtfred, on that ferry trip to England, that instead of following the industry norm of striving to come up with one-hit wonders, LEGO should create a coherent, expandable universe of toys. A LEGO system of toys, the retailer reasoned, would build familiarity and a sense of community around LEGO and thereby would generate repeat sales.

“The system grew out of a retailer’s request,” Knudstorp recalled. “And it proved to be of real advantage to retailers.”

More than anything, the LEGO System’s greatest value resided in its benefit to manufacturing, for it shielded LEGO from much of the rapid shifts in kids’ tastes. The toy industry was and continues to be enormously fickle—even certified phenomena, such as Beanie Babies and Tickle Me Elmo in the 1990s, eventually ran their course and were replaced by the next hot property. Thus, toy companies have had to constantly scramble to conceive and produce this year’s “must-have,” knowing that next year they’ll most likely have to retrofit their factories for something different.

Thanks to the LEGO System, however, the company’s forecasters understood that no matter what kits kids lusted for—LEGO City, Star Wars, or something entirely new—it could still produce bricks, minifigs, wheels, windows, and thousands of other components, every day of every year, just as it had done for decades. The sets and themes would change, but many of the components remained the same. Because most components were compatible across so many different kits, LEGO could reap enormous cost savings by not having to dramatically change its manufacturing operations from year to year. Knudstorp knew this intuitively, but his conversations with Kristiansen brought into sharper focus the notion that the LEGO System is an all-encompassing business system.

“Near the end of 2004, I started to understand that we have a customer base, a retailer base, and a manufacturing base that loves the System,” he recalled. “I realized that our job was to take what made the LEGO System so successful in the 1970s and 1980s and remake it for the twenty-first century.”

As a first step in making the System a centerpiece of the company’s survival plan, Knudstorp accelerated an effort that had begun in the summer of 2002: restore the Design Lab’s authority. From the System of Play’s earliest days, no new LEGO color or piece, whether it be a brighter shade of yellow or a fire engine’s windshield, could see the light of day without Godtfred’s personal approval. In the years following Godtfred’s retirement, the Design Lab continued to impose his strict, authoritarian rule over the universe of LEGO components.

Comprising some of the company’s most experienced designers and developers, the Design Lab functioned as an unyielding final arbiter whose foremost goal was to tightly corral the LEGO color palette and tamp down the total number of LEGO elements in the company’s inventory, especially one-of-a-kind elements, such as an Indiana Jones whip, that worked in just one particular set.

Until the early 1990s, the Lab had been a critical force for driving down costs. But then the Lab lost its sway. As LEGO launched a bevy of wildly divergent products in the hopes that something, anything, might capture the malleable minds of its young customers, designers began to openly circumvent the Lab. They conjured models requiring whole new phalanxes of components—variations of arms, boats, cones, doors, and much, much more, in colors that ranged from aqua to speckled silver. They even immortalized themselves in the models they built, replicating their own faces on minifigs. They were, quite literally, out of control.

The total number of different elements that LEGO produced each year (measured at the end of each year). The number peaked at 14,200 in 2004.

In just seven years, from 1997 to 2004, the number of elements in the company’s inventory exploded, ascending from slightly more than 6,000 to more than 14,200. So did its range of colors, which climbed from the original six (red, yellow, blue, green, black, and white) to more than fifty. As the number of components and colors mounted, soaring supply and production costs plundered the company’s bottom line. Here’s why.

A standard brick with two rows of four studs delivers a profit to LEGO that is orders of magnitude greater than any specialized element, all because the brick is what LEGO calls a “universal” or “evergreen” element that can be used in so many different sets. A one-of-a-kind, specialized piece, however, generally works in just one or a few sets. Moreover, the cost of molding a standard brick is orders of magnitude cheaper than producing a specialized piece.

A mold for a standard LEGO piece costs anywhere from $50,000 to $80,000; over its lifetime, it will spit out some sixty million bricks. The cost of making the mold, spread out over all those bricks, is essentially zero. But when designers concoct a specialized piece and LEGO manufactures just fifty thousand of them, the molding cost rises to as high as $1 per piece. Including just a few of these specialized pieces, as LEGO did with unrelenting frequency during the Plougmann era, can potentially kill a LEGO set’s profit potential.

This is not to suggest that specialized pieces are bad. Far from it. LEGO Indiana Jones would never feel real without Indy’s whip; LEGO Board Games would never spring to life without their unique dice. But there’s no denying that specialized pieces are costly to produce, and their proliferation was a prime reason why the LEGO Group’s profits plummeted through much of the 1990s, despite steady sales.*

A LEGO brick mold.

Having launched a painstaking review of each of those 14,200 pieces in the LEGO universe, the Design Lab found that 90 percent of new elements were developed and used just once. And many components were duplicates. Among the dupes were eight minifig police officers and six minifig chefs, with barely decipherable differences between them. The Lab dealt with the redundancies by slashing the total number of components by more than 50 percent. When it reduced the product portfolio’s minifig chef population from six to one, designers protested and longtime fans howled. To calm the fans, LEGO tried humor: it held a mock online memorial service for the “dead chefs.”

Redundant police and chef minifigs symbolized the out-of-control, outside-the-box innovation efforts that had almost put LEGO out of business. So in 2004, the company’s new management team responded by restarting a practice that LEGO had once abandoned: putting strict cost limits around its products.

Beginning in the late 1980s, every LEGO development team, when it began work on a new project, was assigned a full manufacturing cost (FMC) for producing the set. The FMC totaled the entire spectrum of the set’s costs—acquiring the raw materials, molding the bricks and other pieces, producing building instructions, packing and packaging the assortment of pieces, even the injection molding machine’s depreciation. No development team was permitted to exceed its FMC; if it had, it would have eaten into the company’s margins.

In the go-go years of the late 1990s, however, the LEGO Group’s management allowed developers to untether themselves from the FMC’s limits. The consequences were disastrous. Freed from the FMC’s constraints, designers concocted more and more of those specialized pieces. Designers didn’t simply decide to go wild. They were spurred by management’s insistence that they devise increasingly esoteric models, such as Galidor, Jack Stone, and LEGO Explore, which required radically different components. Although there might have been good reasons to justify the creation of individual specialized pieces, their cumulative effect was to make the LEGO Group’s operations increasingly complex. The costs of purchasing new molds to produce each of those specialized pieces rapidly compounded; so did the costs associated with managing the manufacture and packaging of those specialized components. The ironic result was that LEGO, by dramatically ramping up its pace of innovation, plundered its profits.

Beginning in 2004, while marketing managers were pushed to reach the 13½ percent profit targets, development teams were given equally challenging FMC cost targets. A LEGO City team that was designing a new police station would be assigned a specific cost; failing to meet that target would come back to haunt the designers at their annual review. “You had to stay within your FMC model,” said Henrik Weis Aalbaek, who helped champion the framework’s return. “Otherwise, you were dead.”

At the same time, designers had free rein to create, so long as they kept within the FMC’s parameters. In a very real sense, they were forced to innovate inside the box. It was expected that designers would devise pieces that required new molds, since those elements would make, say, a LEGO City police station fresh and exciting. But such specialized pieces had to be really special—something that would light up the entire set. At the same time, the FMC frame ensured that designers would tamp down the desire to create lots of cool-for-cool’s-sake pieces and instead find creative ways to make more out of universal pieces. As a result, on average, at least 70 percent of every LEGO set, whether it’s a LEGO City box or a new play theme such as Ninjago, is now made up of standard, universal bricks. Or to put it another way, 70 percent of the bricks in a City line are used in radically different sets such as Ninjago, and vice versa. This allows LEGO to reap enormous cost savings by not having to produce more molds for “uncommon” elements.

As for the designers, they gradually discovered they were more creative with a smaller inventory. Though the idea runs counter to the notion that great design requires maximum freedom, LEGO designers found that the tighter range of components gave them even more definition and sufficient direction to come up with successful ideas. Apple’s designers made a similar discovery when Steve Jobs insisted that the iPhone needed only a single, minimalist control button. Jobs’ obsession with simplicity forced his designers to overcome complexity and innovate with less, which resulted in one of the past decade’s most iconic designs.

Concluded Knudstorp: “Innovation flourishes when the space available for it is limited. Less is more.”

Ultimately, the FMC framework, by putting distinctive cost constraints in place, delivered a sharper sense of direction to designers. “When designers chose a color or a certain element, they could see the costs of their decisions,” said Aalbaek. Such knowledge, in turn, increased the odds that they’d create money-making toys.

Make It Authentic

From the 1930s to the early 1990s, authenticity was one of the core strands of the LEGO Group’s DNA. Recall that with kits such as LEGO City, kids could re-create the streetscapes, fire stations, and ambulances of their real-world lives. Even a fantasy theme such as LEGO Castle included telling details, such as the knights’ movable visors and armor breastplates, that helped make the medieval era as “real as real” for kids.

Over the years, as the company’s universe of product lines expanded, the brand’s legions of fans came to recognize the essential features that were authentic to LEGO itself: the brick, the System, and the building experience. But as we’ve seen, those qualities began to bleed out of LEGO during the Plougmann era. Fearing that the brick was passé, LEGO diluted the building experience and frequently violated the System’s integrity. As a result, the newer kits didn’t feel like they were authentically, classically LEGO.

In 2004, as Knudstorp and Ovesen swiftly moved to shut down money-losing product lines, they also began to strip away much of what was pseudo-LEGO. In killing off Explore, Galidor, and Jack Stone and elevating such foundational LEGO play experiences as DUPLO and City, the pair began to make LEGO a little less ersatz for those true-believing fans who loved to build. At the same time, Knudstorp understood that it wasn’t enough to make the LEGO play experience more authentic. He had to do the same with the LEGO work experience.

Authenticity is really about integrity. It comes to leaders who do what they say they’re going to do. When the story that leaders tell through their actions aligns with the story they tell through their communications, people sense that the story is true, and authenticity sets in. Knudstorp knew that words weren’t enough to truly instill the company’s culture with a renewed sense of discipline, focus, and accountability. Authentic leadership requires action. Borrowing a line from Millard Fuller, the founder of Habitat for Humanity, Knudstorp argued that for LEGO to reset its compass and authentically return to its core, “you don’t think yourself into a new way of acting, you act yourself into a new way of thinking.”

“As McKinsey consultants, we believed that thinking is paramount—that thought turns into action,” he reasoned. “But it’s actually the opposite. When you act your way into a new habit, the habit becomes your opinion about how you should do things, and that opinion becomes your character as a person or as an organization. So we started to take some actions that would make us change our behavior.”

To build a culture of ownership and accountability, Knudstorp set out to track the company’s progress. He created a war room to monitor the supply chain and measure product quality and delivery performance. He also built key performance indicators, or KPIs, into people’s performance reviews, to ensure they were helping to fuel the company’s return to the core. An essential KPI for some senior managers, for example, set goals for cutting the number of LEGO elements.

At every step, Knudstorp changed many of the artifacts—facilities, offices, tangible awards, and recognition—that together constituted the most visible aspects of the company’s cultural fabric. That meant creating physical changes that held people accountable for their results and the organization’s performance. After a first round of layoffs in 2004, he shuttered offices and moved the remaining associates into far tighter quarters. His reasoning: half-empty office space gave people a sense of abundance. At a time when LEGO was bleeding losses and starving for resources, he wanted people to have a sense of scarcity. To that end, he also sold off the LEGO Group’s head office in Billund, with its posh executive suites, and moved himself and other senior managers to a building that also housed the packing plant. And he eschewed the kind of luxe wheels that most European executives drive, such as a BMW 7 Series, and instead took to commuting to Billund in a far humbler 2001 Citroën C5, a car similar to the Volkswagen Passat or Ford Mondeo.

Knudstorp also changed some of the company’s rituals. Instead of managers holding sway over minions, colleagues held colleagues accountable for their results. At the war room meetings, where executives ran through weekly sales results, he insisted that the heads of product lines post their numbers on a whiteboard. “We could have done it in SAP or some other IT system, but the point was to do it personally,” he explained. “Here’s a group of eight leaders. You step up. ‘Sorry, guys, I didn’t make it this week. Here’s the corrective action I’m taking.’ ” The idea was to use peer pressure, rather than pressure from some corporate overlord, to change behavior.

Looking back at the events that transpired during 2004, Knudstorp recalled that a significant part of his job that year was to “break down the confidence of the organization, because we had been overconfident and we needed to come back to reality.” His constant reminders that LEGO was resting on a “burning platform” and his insistence that the company needed a survival plan instead of a strategy certainly deflated people’s sense of entitlement. So did the blizzard of pink slips that befell the LEGO Group. The Financial Times later reported that during the restructuring, Knudstorp and Ovesen ran LEGO “like a ruthless private equity firm,” and that’s about right. The pair cut twelve hundred jobs, nearly a third of the company’s workforce at the time. By shuttering costly factories and unprofitable product lines and selling off real estate, they cut the LEGO Group’s cost base by $600 million over two years. “When we announced the layoffs and sell-offs and cost-cutting and all the rest of it, you can imagine the mood in the organization was not exactly optimistic,” Knudstorp concluded drily. Nevertheless, he had gotten people’s attention.

Knudstorp had also begun to position people for success. By restoring the company’s fundamental values, he laid the foundation for an innovation culture that put the retailer first; that focused designers as well as managers on creating only those toys that stood an odds-on chance of generating substantial profits; that revived the enduring LEGO product lines that appealed to kids who loved to build; that championed inside-the-box creativity; that challenged people to do more with less; and that pushed people to act authentically by showing instead of telling. Even so, it would take at least a year before any of those actions would reap real rewards.

On a sun-splashed day in June 2004, Knudstorp stepped before a gathering in Billund’s LEGOLAND Hotel of sixty of the LEGO Group’s top managers. Although it had not yet been made official, this was his coming-out as the company’s new chief.

Knudstorp’s first words had nothing to do with the LEGO Group’s dire financial predicament, nor even with LEGO itself. Instead, he spoke about his love for the Scandinavian summer. By revealing his “passion for this place we’re in, this culture,” he hoped to summon the sense of unity and shared purpose they would need to face the difficult challenges confronting LEGO, of which there remained many: limited cash, increasing price pressure, high fixed costs, the shift away from traditional play, dreadfully few products that were actually profitable.

After Knudstorp was finished with his remarks, there was a smattering of applause. Though it was plain that Kristiansen had tapped Knudstorp as his heir apparent, more than a few executives might well have wondered whether he was the man for the job. The company had survived the year and staffers were beginning to brace themselves for a difficult future. But a return to profitability still seemed like a pipe dream, and Knudstorp had yet to reveal a long-range strategy for turning the company around. In fact, it’s safe to assume that some in that room believed they should have been given the CEO job. After dinner that night, just one executive called to congratulate him.

Four months later, after forecasting the company’s record loss for 2004, Kristiansen announced he was stepping aside. Knudstorp would be just the second outsider to head LEGO since its founding. In Billund, some wondered how long Knudstorp would last. At the supermarket and other gathering places, conventional wisdom held that the new chief would never be the LEGO Group’s real leader until he convinced Kristiansen to divest the company of the LEGOLAND parks. And so far that hadn’t happened. It was still very much an open-ended question whether seventy-two-year-old LEGO would keep its independence intact, and whether its thirty-four-year-old CEO would keep his job.

* Our back-of-the-envelope analysis found that DKK 1 million of sales per element is a magic number for LEGO. If sales fall or element counts rise—and the ratio between the two drops below one million—LEGO slides into a loss. As the ratio rises, however, profits increase exponentially.

FMC is the cost part of the CPP system we discussed earlier. FMC cost numbers are combined with sales revenues to give the profitability numbers in the CPP system.