Finally, managers increasingly believe they should dismember their companies and retain only those core activities crucial to success. But SMH is a vertically integrated fortress. It assembles all the watches it sells, and it builds most of the components for the watches it assembles.

Watches in the hotly competitive middle segment sell for between $75 and $350. This is where SMH battles most directly with Seiko and Citizen, the two Japanese giants. SMH recently acquired Blancpain, a niche producer of luxury mechanical watches that retail for $200,000 and higher. SMH has even extended its presence in watches to new product categories such as telecommunications.

Companies also hear endless advice to become niche players by focusing on ever more- narrow market segments. But SMH is everywhere. Its brash and playful Swatch (whose basic models sell for $40) has become a pop-culture phenomenon. Last year, SMH sold an estimated 27 million Swatches. The company’s flagship brand on the high end is Omega, whose models retail for anywhere between $700 and $20,000.

Conventional wisdom suggests that global companies should become “stateless.” They should seek low-cost production wherever they can find it and build operations in many national markets. Yet SMH is committed to its Swiss home base. The bulk of its technology, people, and production remain anchored in the towns and villages around the Jura mountains on Switzerland’s border with France—the traditional heart of Swiss watchmaking.

But SMH is more than a turnaround story. It is a case study of Hayek’s management philosophy and strategic thinking, both of which are strikingly at odds with the prevailing wisdom about how companies should compete in the new economy.

Nicolas Hayek has been involved with SMH from the beginning. In the early 1980s, the banks named Hayek their chief adviser on the troubled watch industry. He was already well-known as the founder and CEO of Hayek Engineering, a Zurich-based consulting firm that is something of a cross between Arthur D. Little and McKinsey & Company. In 1985, the banks proposed that Hayek buy a controlling equity stake in SMH. He assembled a group of investors, retained the single largest stake, and became CEO.

The dimensions of the turnaround are staggering. SMH took shape in 1983 when Hayek recommended that Switzerland’s banks merge the country’s two giant (and insolvent) watch manufacturers. That year, the new company generated revenues of SFr1.5 billion ($1.1 billion) and lost SFr173 million ($124 million). Last year, SMH generated revenue of about SFr3 billion ($2.1 billion) and posted profits of more than SFr400 million ($286 million).

Nicolas G. Hayek is a rare phenomenon in Europe—a genuine business celebrity. In his home country of Switzerland, and increasingly across the continent, he is an engaging presence in newspapers and magazines and on television talk shows. Hayek, 64, has earned his fame. He and his colleagues at the Swiss Corporation for Microelectronics and Watchmaking (SMH) have engineered one of the most spectacular industrial comebacks in the world—the revitalization of the Swiss watch industry.

HBR: The revitalization of SMH has generated tremendous attention across Europe. What are the most important lessons?

Nicolas Hayek: There are two main lessons. First, it is possible to build high-quality, high-value, mass-market consumer products in high-wage countries at low cost. Notice I said build, not just design and sell. A Swatch retails for 50 francs in Switzerland and $40 in the United States. The price has not changed in ten years. Yet we build all of our Swatches in Switzerland—where the most junior secretary earns more than the most senior engineer in Thailand or Malaysia.

In fact, it’s not just possible to build mass-market products in countries like Switzerland. It’s mandatory. This is a principle I am passionate about—and a principle business leaders in the United States and Europe don’t take seriously enough. We are all global companies competing in global markets. But that does not mean we owe no allegiance to our own societies and cultures.

Not so long ago, I was in the United States for a meeting with the CEO of one of your big companies. We were discussing a joint venture to produce a new product we had developed. He saw what the product could do, he reviewed the design, and he got very excited: “Great, we’ll make it in Singapore.” His people had done no research or calculations at all. It was a reflex. I said, “No, we’ll make it in Alabama.”

But I’m sure you understand the reasoning. In a global economy, companies must source wherever they can get the best people at the lowest cost. Asia is bursting with smart, well-trained workers and engineers. How can you afford not to look there for manufacturing?

We must build where we live. When a country loses the know-how and expertise to manufacture things, it loses its capacity to create wealth—its financial independence. When it loses its financial independence, it starts to lose political sovereignty.

We have to change that reflex: the instinctive reaction that if a company has a mass-market consumer product, the only place to build it is Asia or Mexico. CEOs must say to their people: “We will build this product in our country at a lower cost and with higher quality than anywhere else in the world.” Then they have to figure out how to do it.

We do this all the time. We agree on the performance specifications of a new product—a watch, a pager, a telephone. Then we assemble a project team. We present the team with some target economics: this is how much the product can sell for, not one penny more; this is the margin we need to support advertising, promotion, and so on. Thus these are the costs we can afford. Now go design a product and a production system that allows us to build it at those costs—in Switzerland.

“If labor is less than 10% of costs, there’s nothing to stop us from building a product in the most expensive country in the world.”

That means focusing on labor. If we can design a manufacturing process in which direct labor accounts for less than 10% of total costs, there is nothing to stop us from building a product in Switzerland, the most expensive country in the world. Nothing.

But you know consumer markets are fiercely competitive. How can you absorb even a modest cost disadvantage?

This is not commodity competition. Let’s say you have three similar watches. One says “Made in Japan” and sells for $100. Another says “Made in Switzerland” and sells for $110. A third says “Made in Hong Kong” and sells for $90. Which watch will consumers prefer? In Europe, between 75% and 95% of all consumers will prefer the Swiss watch—in spite of the 10% premium. In the United States, depending on which region you are talking about, between 51% and 75% of all consumers will prefer the Swiss watch. Only in Japan itself will a majority of consumers prefer the Japanese watch to the Swiss watch.

What does that mean? If you have a manufacturing process in which direct labor is less than 10% of total costs, you have eliminated those costs from the competitive equation. When we created SMH, our direct-labor costs, on average, were more than 30% of total costs. Today they are well below 10%. If we paid our workers full salaries and the Japanese paid their workers nothing, we could still compete.

This same logic applies beyond watches. CEOs must understand this point. If you can design a system in which direct-labor costs are less than 10% of total costs, it is cheaper to build mass-market consumer products in the United States than in Taiwan or Mexico.

What’s the second lesson of SMH’s comeback?

It’s related to the first. You can build mass-market products in countries like Switzerland or the United States only if you embrace the fantasy and imagination of your childhood and youth. Everywhere children believe in dreams. And they ask the same question: Why? Why does something work a certain way? Why do we behave in certain ways? We ask ourselves those questions every day.

People may laugh—the CEO of a huge Swiss company talking about fantasy. But that’s the real secret behind what we have done. It’s an unusual attitude for Switzerland—and for Europe. Too many of Europe’s large institutions—companies, governments, unions—are as rigid as prisons. They are all steel and cement and rules. We kill too many good ideas by rejecting them without thinking about them, by laughing at them.

Ten years ago, the people on the original Swatch team asked a crazy question: Why can’t we design a striking, low-cost, high-quality watch and build it in Switzerland? The bankers were skeptical. A few suppliers refused to sell us parts. They said we would ruin the industry with this crazy product. But the team overcame the resistance and got the job done.

The Swatch is based on radical innovations in design, automation, and assembly, as well as in marketing and communications. One of our plants in Grenchen makes up to 35,000 Swatches and millions of components a day. From midnight until 8 a.m., it runs practically without human intervention. Swatch is a triumph of engineering. But it is really a triumph of imagination. If you combine powerful technology with fantasy, you create something very distinct.

Let’s go back to the beginning of SMH—the dark days—and work forward to the two main lessons. It’s the early 1980s. Swiss watchmaking is on the brink. The banks call you in. What do you find?

A chaotic jungle. An absolute mess. Most people who analyze the destruction of the Swiss watch industry in the 1970s emphasize price and technology. They point to the arrival of hundreds of millions of cheap quartz watches from Japan and Hong Kong and our decision to ignore quartz, a technology we invented. But we had huge problems beyond technology. There were problems of strategy, structure, management.

The two companies that became SMH were the flagships of the Swiss industry. One was SSIH, a company that had Swiss-French origins. Omega was the crown jewel of SSIH. Up until the early 1970s, Omega was one of Switzerland’s most prestigious brands—more prestigious than even Rolex. But Omega was so successful for so long that it ruined SSIH. The company got arrogant. It also got greedy. It wanted to grow too fast, and it diluted the Omega name by selling too many watches at absurdly low prices.

SSIH had no discipline and no strategy. It had its own distribution in countries like Germany and France. It worked through agents in other countries. It even let some agents contract with outside manufacturers to build their own Omega models! It made no sense.

Then there was ASUAG, a company with Swiss-German origins. ASUAG was a manufacturing company. ASUAG owned a few brands, including Rado and Longines. But its heart and soul was an operation called Ebauches S.A., which supplied components to the whole Swiss watch industry. Ebauches was very capable. Over the years, however, as various small Swiss brands faltered, they went to ASUAG looking for a rescue package. ASUAG was the rich uncle: “Please, we are going broke. Why don’t you buy us? It won’t cost much. You can’t let us disappear.”

ASUAG felt a certain responsibility. Also, it didn’t want to lose its customer base. By the late 1970s, then, ASUAG owned much more than Rado, Longines, and Ebauches. It owned all kinds of brands. It also owned lots of little companies that made components and had run into trouble. Many of these companies had been family-owned for generations. ASUAG rescued them but left most of the family managers in place.

By 1982, ASUAG owned more than 100 separate companies—some big, some small, some modern, some backward. Most of these companies did their own marketing, their own R&D, their own assembly. It was crazy.

The banks agree to merge SSIH and ASUAG to create SMH. It’s time to sort through the jungle. Where do you begin?

We began with the products themselves. We had to understand our strategic positioning, where we stood in world markets. We made a big study, written in German, that became known as the Hayek Report. As you can imagine, the report got lots of attention in Switzerland. It was very controversial.

In the report, we drew a diagram to describe our competitive environment. It looked like a three-layer wedding cake. Back then, the world market for watches was about 500 million units per year. The low-end segment, the bottom layer of the cake, had watches with prices up to $75 or so. That layer represented 450 million units out of 500 million. The middle layer, with watches up to $400 or so, represented about 42 million units. That left 8 million watches for the top layer, with prices from $400 into the millions of dollars.

The Swiss share of the bottom layer, 450 million watches, was zero. We had nothing left. Our share of the middle layer was about 3%. Our share of the top layer was 97%.

We were cornered. The Swiss spent much of the 1970s reacting to quartz by retreating: “Why should we compete with Japan and Hong Kong? They make junk, then they give it away. We have no margin there.” Of course, as we retreated, the Japanese moved up to the next layer of the cake. Then the retreat would start again.

I decided we could retreat no longer. We had to have a broad market presence. We needed at least one profitable, growing, global brand in every segment—including the low end. That explained why we had to control and sell Swatch ourselves rather than license it or sell it through agents, as some people had proposed. It also meant we had to reinvigorate Tissot, the only global brand we had in the middle segment.

The banks studied our report and got nervous, especially about Swatch. Some of them worried that Swatch would cannibalize Tissot. Others were more emphatic: “This is not what consumers think of when they think of Switzerland. What the hell are you going to do with this piece of plastic against Japan and Hong Kong?” But we were adamant: if we did not have mass production, if we did not have a strong position in the low end, we could not control quality and costs in the other segments.

The banks thought Swatch would fail?

Not fail, necessarily. Many thought it might survive—but barely. After all, we were going to battle at the low end. Who could make real money there against people from Japan or Hong Kong? That’s when they proposed that I buy 51% of the company.

What did you see that others didn’t?

I understood that we were not just selling a consumer product, or even a branded product. We were selling an emotional product. You wear a watch on your wrist, right against your skin. You have it there for 12 hours a day, maybe 24 hours a day. It can be an important part of your self-image. It doesn’t have to be a commodity. It shouldn’t be a commodity. I knew that if we could add genuine emotion to the product, and attack the low end with a strong message, we could succeed.

How do you “emotionalize” a watch? Do you mean to say that Swatch turned something that was mundane and functional into a fashion statement?

That’s how most people describe what we did. But it’s not quite right. Fashion is important. The people at our Swatch Lab in Milan and our many other designers do beautiful work. The artists who make our Swatch special collections design wonderful watches (see the first insert, “Franco Bosisio: In the Eye of the Swatch Storm”). But take a trip to Hong Kong and look at the styles, the designs, the colors. They make pretty watches over there too.

Franco Bosisio: In the Eye of the Swatch Storm “It’s almost embarrassing. I go out to dinner, and all I see are Swatches. Swatch now accounts for 40% of the watches sold in Italy. But if you combine the watches we sell here, plus the watches Italians buy when they travel abroad, plus what they buy through auctions and ‘unofficial’ channels, our market share is even higher. “It’s incredible! And I can’t really explain it. We didn’t launch Swatch here until 1986. Italy was the last major European country to get it. That’s strange, in a way, because Italians are crazy for fashion in general and watches in particular. So people were dreaming about it: When are we going to get Swatch? When we finally made the launch, the market exploded. And it has kept growing. Our average customer in Italy owns six Swatches. “This was no brilliant strategy on our part. For years, we just weren’t happy with the distribution situation in Italy. So we decided to wait until we could do it right. Then came a series of high-profile events. For example, Sotheby’s chose Milan as the site of one of its first Swatch auctions. None of us knew what to expect. But the frenzy and the prices and the visibility were incredible. People were pushing their way in, their pockets bulging with bank notes. It was really emotional. My public relations person was in tears because it was so intense. The people from Sotheby’s were astonished. “So luck has played a big role in our success here. But of course there is more. I have always thought the appeal of Swatch rests on four pillars: design, communication in the widest sense, quality, and price. Few people appreciate how and why price has been so important. Everywhere in the world, Swatch is sold at an affordable price. But it’s also a simple price, a clean price. In the United States, $40. In Switzerland, SFr50. In Germany, DM60. In Japan, ¥7,000. “It has also been, in the first ten years, an unchanging price. Despite our incredible success in the market, despite the huge unmet demand in countries like Italy, we have never raised the price of Swatch to our dealers. And we forbid our dealers from marking up the price to their customers. Can you name another fashion product whose price has stayed exactly the same for ten years? “Price becomes a mirror for the other attributes we try to communicate. It helps set us apart from the rest of the world. A Swatch is not just affordable, it’s approachable. Buying a Swatch is an easy decision to make, an easy decision to live with. It’s provocative. But it doesn’t make you think too much. “That’s also the sensibility behind our designs. There are about 20 people in our Swatch Lab. They come from many backgrounds and from all over the world. We have had designers from Italy, Japan, Germany, France, America, Australia, many other places. A few are trained in architecture. Many are trained in industrial design. A few are right out of university. “People work with us for many reasons. Let’s face it, most people who are serious about a career in design want to spend some time in northern Italy. And they love the product, the idea that millions of people wear it. They also value the chance to interact with Alessandro Mendini, our art director. Mendini is a major figure in European styling. His work occupies a space somewhere between fine art and industrial design. He has long been known for his dramatic furniture, which he makes in very small numbers. Swatch is really his first experience with mass production. “By the way, Mendini has managed to combine both interests. He designed Lots of Dots, a special Swatch only available to members of our Swatch collectors’ club. Then he designed a ceramic armchair that is based on Lots of Dots. “We rotate people through the lab. Everyone must agree to stay for at least six months. Very few people stay for more than two years. They get tired. We get tired. This is challenging work. Lots of brilliant artists fail when they try to design for us. It’s hard to squeeze wonderful ideas into the face and band of a Swatch. In fact, we have more than 3,000 proposed designs that we have never executed. “We design two Swatch collections each year, 70 styles per collection—140 different models. We always prepare four times the number of models we need. A group in Milan selects half of those proposed designs and presents them to the management committee in Switzerland. In Switzerland, we make the final choices and decide on the collection. “Four years ago, when we established the Lab, I worried that we would run out of ideas. We asked a group of fashion experts—famous journalists, art dealers, and so on—to prepare reports for us on big themes. We worked with Oliviero Toscani, the photographer who does much of Benetton’s advertising. We hired all kinds of consultants. “We still do that—but we now do much, much more. These experts are so accomplished that they are asked to advise lots of other companies. So it was hard for us to be distinctive. We also came to realize how repetitive fashion can be. With clothing, you change the shape, the length, the fabric. But the basic design elements—the decorations and patterns—don’t change nearly as much. For us, of course, it’s the exact opposite. The size and shape of the watch stays the same. What varies is what’s on it. “We have no set routines to come up with ideas. We travel constantly, all over the world. We go to the big fashion shows—Première Vision in Paris, for example. We go to the opera, to art exhibitions. You can’t imagine how many books and magazines we read, how many painters we study. We steep ourselves in the culture of life. And then things happen. “Let me give you an example. Two of our watches in the latest Fall/Winter collection were called Fairy Tales. They grew out of some books we came across, books of images that inspired some of the great artists of the nineteenth century. On one of the watches there is a teapot, there is a man kissing the hand of a woman, and there is the face of a young woman. The holes in the bracelet look like tears. That watch tells a story. It’s like a chance encounter with people from an earlier time. “We don’t get carried away. This is only semi-serious. We want arresting images, but we also wink at the consumer. We don’t want people to think too much. We are looking for an immediate emotional reaction—spontaneity. All we can tell is that there is a man romancing a woman and that the woman is crying. Everything else is left to your imagination.”