McKinsey - Preserving combat power when defense budgets are falling - May 2013

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McKinsey - Preserving combat power when defense budgets are falling - May 2013

McKinsey - Preserving combat power when defense budgets are falling - May 2013

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  • 1. 1David Chinn Preserving combat power whendefense budgets are fallingAcross the Western world, defense budgetsare undergoing substantial and far-reaching cuts.In most countries, the approach taken toeffect these cuts has been to reduce the capa-bilities of armed forces: fewer militarypersonnel, fewer weapons systems, and delayedmodernization. But another approach,increasing productivity in defense, could achievethe substantial savings needed while alsoprotecting combat power.This article outlines the extent of recent defensebudget cuts across the developed world andthe challenge of making these cuts: as budgetshave large fixed costs, even relatively smallreductions lead to sizable cuts to military capa-Defense ministries can cope with austerity. Here’s how.bility. The article presents a potential solutionthrough which governments can increase defenseproductivity to reduce costs without cuttingcapability, using three primary levers: ensuringthat forces are aligned with national militarystrategy, capturing functional efficiencies in allareas of spend, and reducing noncombatpersonnel. Collectively, these opportunities couldpotentially save 10 to 20 percent of totalmilitary budgets (excluding pension costs)—without reducing capability.Austerity and its impact ondefense budgetsIn managing their budgets, even in times ofplenty, defense ministries face two parallelNeil Webbp u b l i c s e c t o r p r a c t i c eA P R I L 2 0 1 3
  • 2. 2tensions: the need to enhance military capabilitydespite the state’s competing needs to meetsocial and fiscal priorities, and the rapid inflationrate of the already high cost of modernmilitary technology.Added to these perennial tensions is a new chal-lenge: governments have to reduce spending tobalance budgets, reduce debt, and address risinghealth and welfare costs as populations ageduring a prolonged period of low growth, if notExhibit 1 From 2009 to 2011, NATO countries1have slashed budgets.McKinsey on Defense 2013Defense austerityExhibit 1 of 32011 defense spending,$ billionChange2 in defense budget,2009–11, %United StatesUnited KingdomNetherlandsCzech RepublicCroatiaHungarySlovakiaBulgariaSloveniaEstoniaRomaniaLithuaniaLatviaAlbaniaPortugalGermanyCanadaFranceItalySpainTurkeyBelgiumPolandDenmarkNorwayGreece1–10–2–57–8–18–14–15–6–5–25–23–14–17–22–22–21–1484–15–79–29771163634755221611110.40.30.30.2352518151210881North Atlantic Treaty Organization; excludes Iceland and Luxembourg due to lack of data.2Constant 2010 dollars.Source: Stockholm International Peace Research Institute
  • 3. 3theater while denying the objectives of—or imposing unacceptable costs on—an oppor-tunistic aggressor in a second theater.• Reducing numbers of combat formations. TheUnited Kingdom has reduced its surface fleet of23 destroyers and frigates to 19, and plans toreduce its army by one-fifth to 82,000 personnel;Germany plans to reduce its armed forcesfrom 250,000 to 185,000.• Canceling new-equipment programs. Germanyhas indicated that it will cancel its order oftranche 3B Eurofighter jets; the United Stateshas cut some planned equipment programs,including those for the Medium Extended AirDefense System and the high-mobilitymultipurpose wheeled vehicle, or Humvee.Other programs, including the GroundCombat Vehicle, will likely be restructured.• Retrenching from forward outposts. TheUnited States has indicated that it willdramatically reduce troops in Europe, includinga 25 percent reduction in Army personnel;the United Kingdom will recall its armoreddivision from Germany.To be sure, this is not the first time that budgetshave been slashed: US defense spending, forPrevious periods of austerity came in times ofpeace. This time, we have austerity withoutpeace, with conflicts hot and cold continuingin many parts of the world.outright recession. Across the Western world,governments are grappling with the challenges ofdebt overhang, recession, and changingpriorities—with recent economic news suggestingthat full recovery is still elusive.Governments facing budget challenges haveuniversally responded to the challenge of austerityby cutting defense budgets, among others. Forexample, two-thirds of European countries havecut their defense spending since 2008, manyby 10 percent or more. Regardless of the outcomeof sequestration, committed US defense cutsof $487 billion over the next ten years representan 8 percent reduction in spending.Exhibit 1 shows the scale of the cuts that havealready been made by the United States and otherNorth Atlantic Treaty Organization (NATO)countries. The US budget is essentially flat, whilethe rest of NATO is down 6 percent fromthe peak—and there are more reductions to come.Countries are undertaking a range of actionsto address the funding gap:• Realigning defense strategy with economiccapacity. The United States has reducedits aspiration from being able to fight two majorwars simultaneously to being capableof defeating a major act of aggression in one
  • 4. 4example, has been fairly cyclical, with roughly20 years between peak and trough (see “Managinga downturn: How the US defense industrycan learn from its past,” on mckinsey.com). Butone new feature is worth noting. Previousperiods of austerity came in times of peace—theend of the Korean War, the end of the VietnamWar, the end of the Cold War. This time, we haveausterity without peace; the withdrawalsfrom Iraq and Afghanistan are not accompaniedby peace, conflicts hot and cold continue inmany parts of the world (for example, in theKorean peninsula), and new conflagrations flareup routinely (as in Mali and Syria). For mili-taries around the world, this is not austerity ofchoice, or the austerity that comes withrecuperation after outsize commitments areended; in fact, there is a massive need toinvest to reinstate equipment worn out fromIraq and Afghanistan. Instead it is austeritydriven by national financial imperatives.When budgets are cut, there is a proportionatelygreater reduction in investment, resulting fromthe underlying structure of defense budgeting andthe flexibility available to achieve reductions.McKinsey’s analysis of defense spending acrossmore than 30 countries shows that defensebudgets commonly have a large fixed component(Exhibit 2), with only one quarter of the budgetflexible in the short term—typically the costs oftraining and spare parts. When governmentsneed to save money, they naturally and instinc-tively look first at these short-term variablecosts, and then at reductions in force structureand cancellations of equipment programs.Both seem straightforward and guaranteed tosave money.Exhibit 2 Only a small portion of defense spending isvariable in the short term.McKinsey on Defense 2013Defense austerityExhibit 2 of 3Typical components of defense budget, %TotalExamplesSource: McKinsey global defense benchmarks• Salaries for militarypersonnel• Depreciation• Fuel• Munitions• Overtime• Other consumables• Salaries for civilianpersonnel100Fixed or variable longterm (>3 years)50Variable mediumterm (1–3 years)25Variable shortterm (<1 year)25
  • 5. 5However, cuts in training and maintenancetend to be ineffective; there isn’t enough spendingto deliver the savings, and the cuts result in aforce that is less effective than it was before. Overthe long term, such cuts “hollow out” a force,leaving it incapable of delivering combat powerwhen needed.And cutting force structures is inefficient.Although cutting a unit typically saves the cost ofpersonnel, their training, and their equipmentmaintenance, there is substantial investment ininfrastructure and equipment that is simplylost. While it is possible to sell unwanted militaryequipment, the returns are often small. It isalso typically the case that the headquarters andsupport functions shrink more slowly thanthe frontline units—partly due to organizationalinertia (the people deciding on cuts are rarelythose at the front line) and partly due to the loss ofgenuine economies of scale.Similarly, canceling or reducing the scope ofequipment projects once they are under way doesnot save as much as governments hope. Thecost of a combat aircraft, such as an F-22, includesthe one-time development costs spread acrossall of the aircraft to be purchased. For the UnitedStates, the total R&D costs of the F-22 cameto about $32 billion. If the program is canceledExhibit 3+189%–71%Cuts in volume lead to higher costs, which lead tocanceled orders—the infamous ‘death spiral.’McKinsey on Defense 2013Defense austerityExhibit 3 of 3Over the past 20 years, F-22 unit costshave risen dramatically...Rising unit costsOrder reductionsF-22 unit cost, $ million, constant 2010 Number of planned F-22s, aircraft... leading to order reductions thatfurther drive up costs30035040025020015010050050060070040030020010001990 1995 2000 2005 2010 2015 1990 1995 2000 2005 2010 2015Source: Teal Group Corporation; Defense Industry Daily; selected acquisition reports,US Government Accountability Office; press search
  • 6. 6prior to full production that money is lost entirely.If the number of aircraft is reduced, developmentcosts are spread across fewer aircraft, therebyincreasing the cost per plane. This is the infamous“death spiral” that afflicts military-equipmentacquisition. Exhibit 3 shows how the rising costsof F-22 aircraft since the early 1990s led toreductions in orders, which in turn further droveup unit costs.Simply cutting frontline units is, paradoxically,a costly way of cutting costs. But there is abetter way. McKinsey’s work on defense budgetingand understanding the cost of militarycapabilities, on achieving efficiencies in supportactivities, and on military restructuringshows that there is a broader range of choices. Ourbenchmarking1 reveals huge differences inefficiency and effectiveness across armed forces,and this in turn suggests that there are manyoptions available to political and military leadersbeyond cutting force structure.Defense ministries and armed forces have foundthat savings of 10 percent of the total budget(excluding pensions) are achievable, and in somecases the opportunity can exceed 20 percent.Furthermore, the benefit is double: because theyfocus on eliminating waste and complexity,these types of savings, rather than reducing combatpower, actually improve readiness, flexibility,and military capability. This is a message that allstakeholders want to hear: more effective,more responsive, less expensive military capabil-ities are possible, if defense ministries workthrough a series of approaches to realize savingsbefore they cut essentials like training,maintenance, and especially combat power.The rest of this article will examine three sourcesof potential savings, looking at examples fromseveral countries: strategic realignment (whichin the most extreme cases can save 50 percent ofoperating costs for affected equipment),functional efficiency (which can save from10 to 30 percent of relevant spending),and noncombat-personnel reduction (which istypically 15 to 20 percent).Realign strategiesIn addition to resetting strategy, shrinkingforces, and canceling programs, governmentshave been redefining what they want fromtheir military forces by lowering the demandson the remaining forces. But too often forceshave not adjusted to these changed requirementsquickly enough. Simply put, having forcesthat are more capable or more ready than policyguidance demands is wasteful and comesat the cost of force structure, investment,or readiness.Clarifying the true requirement of the military.As noted, as countries redefine what their armedforces are expected to be ready for, they arereexamining their strategic posture. Thisreexamination typically happens following majorgeopolitical changes, such as after the end ofthe Cold War and again after 9/11—for example,in the United Kingdom, with the StrategicDefence Review (SDR) in 1998 and SDR: A NewChapter in 2002. Most recently, the UnitedKingdom conducted the Strategic Defence andSecurity Review in 2010. Other countries,such as the United States, examine their require-ments on a regular cycle (as in the QuadrennialDefense Review) but also look more broadly whencircumstances require it, such as in the USdefense department’s defense strategy review in2012.2 Likewise, France is revisiting its whitepaper on national defense and security, which waslast reviewed by the government of President
  • 7. 7Nicolas Sarkozy after his election in 2007, andGermany has recently completed a comprehensivereview of its defense strategy.However, change in broad government policyoften takes far too long before it is translated intodetailed expectations for individual units.For instance, the layout of military bases in someEuropean countries is still designed forredundancy in case of attack by the erstwhileSoviet Union. One example of adapting tochanged requirements came about when theUnited Kingdom moved to prepare for “mostlikely” rather than “worst case” scenarios. Thisreduced its need for dispersed airbases,allowing it to scale back its aircraft supportinfrastructure. “Depth repairs” are nowconducted at a single location—Royal Air Force(RAF) Marham for Tornado aircraft andRAF Cottesmore for Harrier aircraft—and nowonly “forward repairs” are made at opera-tional squadrons.3 As a result, along with a numberof other changes, the cost of operating Tornadoaircraft was halved. But many countries have notmade the adjustment across all areas to adaptto new requirements and policies.Adapting forces to the changing demands ofgovernment policy requires first ensuringthat the strategic direction is clear, and then con-verting the strategic direction into specificand detailed requirements for personnel training,equipment, logistics support, maintenance,stock holdings, and infrastructure at the level ofindividual units. Based on this, a plan can bedeveloped for adapting each capability and for theforce as a whole, thereby releasing no-longer-needed resources.Moving to different readiness profiles. Budgetingfor defense is a real challenge for both min-istries of defense and treasuries, as it is hard toconnect budget levels to military outputs—to a large extent because it is hard to quantifymilitary outputs. Individual capabilities(for example, antisubmarine warfare) are oftenconsidered to be all or nothing: either youmaintain the capability or you abandon it com-pletely. However this is not truly the case:militaries can adopt any of several readinessprofiles, from very high readiness (forexample, deployable in minutes or hours) tocomplete mothballing, with years requiredto return to full readiness.By creating defined readiness levels and under-standing in detail the implications of movingfrom one level to another for each force element, itis possible to create a much more open debateand a much more flexible defense budget. In themost extreme case, countries such as Switzerlandand Israel that depend heavily on reservesfor the bulk of their combat power are able tomake personnel flexible while reducingthe life-cycle cost of equipment by keeping it inhumidity-controlled storage (thus avoidingrust and slowing down the frequency with whichit needs to be maintained). The UnitedKingdom has adopted a variant of this approachcalled whole-fleet management, in whichtraining and operational fleets are separated,with the operational fleet maintained asa reserve fleet.Unlocking cross-service efficiencies. Procure-ment, logistics, IT, and administrative supportshare many commonalities, across theservices. To benefit from these commonalitiesmany militaries have moved to create singlecross-service organizations. Prominent examplesinclude the Defense Logistics Agency in theUnited States, Defence Equipment and Support in
  • 8. 8the United Kingdom, the Defence Acquisitionand Logistics Organization in Denmark, and theDefence Materiel Organisation in Australia.The benefits of these cross-service groups stem notonly from economies of scale but also fromeconomies of skill—more capable and specializedfunctions are often both more efficient andmore effective. Some countries have not taken suchsteps yet—sometimes from fear of change orinertia, sometimes because high levels of threatand military activity make it hard to take therisk of such major change, and sometimes becausethe funding and authority structure createspowerful incentives for keeping fully integratedindividual services.The scale of the opportunity is enormous. The UKDefence Logistics Organisation set a goalto reduce costs by 20 percent while maintainingoutput, a target reached as promised withinfive years. However, in this case as in others, simplycreating a combined organization did notdeliver all of the savings. It required concertedeffort to rationalize processes, develop skills,and drive out duplication.Improve functional efficiencyArmed forces have many support functions similarto those in commercial companies, and many ofthe tools of operational excellence developed inthe private sector are both applicable andproven in the military arena. Three of these arediscussed below.Improving non-equipment procurement. Anearlier article, in McKinsey on Government’s firstspecial issue on defense,4 added up the “bigsavings from little things” and explained howdefense ministries can save up to 20 per-cent in non-equipment procurement—a categorythat typically accounts for 25 to 40 percentof the whole budget. Thus, better procurement ofthese items can provide up to 3 to 4 percentsavings on the total budget.Keeping the forces supplied with food, water, andfuel, paying rent and utilities costs, andcarrying out maintenance and similar activitiesconsumes the majority of the procurementspending of most armed forces. Those forces thathave made a substantial effort to manage thisspending while maintaining quality have achievedsavings of between 12 and 20 percent. Evenmore important, these savings can be achievedwithout substantial personnel changes ordisruption and often within, or with relativelysmall changes to, the existing organiza-tional structures.
  • 9. 9One best practice in defense ministries and armedforces is to move away from a narrow viewof procurement focused on commercial contractnegotiation and toward a “category management”approach that encompasses all aspects ofthe management of a group of similar purchasedgoods. In Israel, the Israeli Defense Forcesand the Israeli Ministry of Defense have recentlybegun to work in integrated procurementteams, with each team taking full accountabilityfor a category.The work of category managers is driven frominitial requirements and addresses five aspects ofmanaging the category: detailed specifications—often the best way to achieve savings is by reducing“gold plating”; quantity—for example, manyministries buy too many high-end personal weap-ons compared with the numbers of troopseligible to receive them, as basic weapons willsuffice for many troops; order size—manyministries err by buying multiple small batchesrather than the true required number for ayear or multiple years; negotiations with supplierson price and contract terms; and the managementof stocks, storage, and distribution afterpurchase. In many cases, category managementalso involves make-versus-buy decisions.In Israel, the defense ministry’s procurementinitiative has targeted annual savings of 2 percentof the defense budget. Its cross-functionalcategory-management teams are structured toensure that best practices are embedded,and the teams are held accountable to the chain ofcommand, so that improvement is sustainedover time. Implementation is under way and hasalready delivered substantial savings.Streamlining end-to-end logistics. The supportof equipment and personnel, through supplychains and maintenance capabilities, is an area ofsubstantial cost that presents a significantopportunity for efficiency improvements.Logistics often have a complex mixture of third-party arrangements for support, alongwith military and civilian staff. The field is alsocomplicated by the increasing technologicalcomplexity of much military equipment, and theconcomitant rise in costs to maintain it.Many militaries have made substantial changesto their forces and how they operate, whilethe logistics to support those forces has remainedlargely unchanged. Others have highly inefficientmaintenance processes and suboptimal stockmanagement, warehousing, and distribution. Yetothers have made commercial arrangementsfor maintenance that deliver neither the qualityand timeliness of output required nor theexpected cost savings.Actions that can be taken to streamline logisticsinclude the wholesale reconfiguration of facilitiesand processes, which typically reduces thenumber of echelons and facilities and increasesindustrial involvement. Some forces haveseen substantial improvements in productivity—up to 30 percent in a few months—fromadopting comprehensive end-to-end processredesign, looking “from foxhole to factory”to eliminate waste and optimize the flow of repairprocesses. This typically shortens cycle times,increases quality, and substantially reduces man-power. This approach therefore delivers moreand better military output at a lower cost.One success story, documented by the UK NationalAudit Office, is the transformation of the UKMinistry of Defence’s Tornado and Harrier fleets.In the case of Tornado, the Ministry of Defencewas able, over the course of five years, to reduce
  • 10. 10the cost per flying hour by half, while main-taining the same level of operational and trainingactivity. While not all militaries can enjoythis kind of improvement, the opportunitiesare substantial.However, militaries are at a disadvantage insustaining these types of savings when comparedwith commercial organizations. Militariestypically have high levels of staff turnover con-nected with job rotations—staff officers oftenhave two-year postings, which is long enough tolearn the job and start a change process butnot long enough to build capabilities, embedchange, and ensure it is sustained. Also, thereare typically poor or no incentives to createefficiency; incentives often focus on short-termperformance and immediate availabilityrather than turnaround time and cost reduction.Too often, military-improvement projectsdeliver prize-winning results in the short term,only to degrade to similar or worse performancewithin a few years. The results that are sus-tained are the ones that come from improvementsembedded into the operations, training, andleadership culture before success is declared.Improving life-cycle support models. There isincreasing interest in contracted supportfor military equipment. In both commercial andmilitary settings, it is common to buy aircraftengines with a “power by the hour”–type arrange-ment, in which a fixed annual payment ismade based on the number of flying hours ratherthan paying for maintenance and spare partswhen required. This can include the provisionof replacement engines when an engine issent for repair. The most comprehensive formof contracted support is sometimes calledavailability contracting, in which the contractorcommits to deliver a specific output, say,a certain number of flight hours per year. In itsmost sophisticated form, contractors deliveravailable equipment as the output. The UnitedKingdom presents two recent examples:the Air Tanker Ltd. consortium commits toprovide a number of flying hours to thegovernment customer, and KBR—the USThe results that are sustained are the ones thatcome from improvements embedded intothe operations, training, and leadership culturebefore success is declared.
  • 11. 11engineering, construction, and private-military-contracting company, which owns and operatesa fleet of heavy-equipment transporters (HETs)—provides the British Army with deliveredvehicles, both at home and for overseas operations.HET drivers are reservists; KBR trains themfor military roles such that when deployed theybecome uniformed personnel.At their best, these arrangements provideministries of defense (MODs) with access to best-practice industrial capabilities, dependableequipment, and good value for money. But thesegood results are not common. Inevitably, overthe 25-to-40-year life of military platforms, therequirements will change. Through a poorunderstanding of these requirements and aninsufficient understanding of the under-lying costs, an MOD can lock itself into rigidcontracts in which suppliers’ incentives aremisaligned with the MOD’s. For example, in theUnited States, a 2008 Government AccountabilityOffice review of performance-based logistics(PBL)—another term for these types of contractedsupport arrangements—found that while inalmost all cases performance was at or above thecontracted level, the evidence for cost savingswas unclear, and in some cases the PBL had costmore. The Department of Defense confirmedthis in two studies in 2011 and 2012 and is takingsteps to collect more comprehensive dataon costs.Some MODs have seen substantial improvementsin the life-cycle costs of modern platformsthrough detailed and sophisticated cost modelingagainst a reliable baseline, an energeticchallenge of assumptions, redesign of supportrequirements and arrangements, and carefulalignment of incentives with suppliers. This needsto be sustained with adequate ongoing contractmanagement and an ongoing focus on rigorousanalysis and regular renegotiation.Reduce administrative, support, andheadquarters personnelAs militaries change their structures and reducethe number of combat units over time, asall Western countries have done since the end ofthe Cold War, administrative functions tendnot to be pared down at the same speed. Indeed,McKinsey’s benchmarking analysis5 demon-strates substantial variance in the ratio of combatpersonnel to noncombat personnel (oftencalled the tooth-to-tail ratio), with clear room forimprovement in most countries. But this ratiomust be interpreted with care. It is appropriate tocompare only those countries with similarstrategic postures; expeditionary forces will needlevels of support that are different from staticdefensive forces.Some of the changes that enable reduction inadministrative, support, and HQ personnelare well-known: outsourcing of support functions,introduction of modern IT systems to automatefinancial- and personnel-management activities,and combining similar functions into central-ized and more efficient shared services. Manyarmed forces have been successful in introducingthese. However, in some cases, the promisedbenefits are not realized.
  • 12. 12HQ and administrative activities often includea fair amount of low-value work. Over time,elaborate and sometimes unnecessary procedurestend to accumulate, culminating in unreadreports and duplicated staff work. When HQ costsare cut, often the number of staff is reducedbut the amount of work to be done remains thesame. When this is the case, the pressureto increase staff numbers will be hard to resistover time. Through a disciplined process ofactivity-value analysis, which identifiesand eliminates unnecessary activity, substantialtime can be freed up for redeployment orcost reduction.One example of this is in Denmark, wherethe military was reorganized from 2005 to 2009to move from a static, defensive posture to onethat could support expeditionary missions abroad.While Denmark’s ministry of defense hadalready started down the road of unlocking cross-service efficiencies (a topic discussed above),it extended this journey dramatically, creatingfurther tri-service organizations for bothgeneral support functions (HR, accounting, IT,communications) and military supportfunctions (logistics and maintenance). Thetransformation reduced support costs bya third, shifting the balance between spending onoperational activities and spending on supportfunctions from 40–60 before the transformationto 60–40 after it.Even where manpower numbers have beenreduced, the cost of providing personneland veterans with the health care and pensionsthey have earned through their national servicehas become a major element of defense budgets.When he was US secretary of defense, RobertGates said that “health-care costs are eating thedefense department alive.” He was referringto the tripling of those costs since 2001 to a totalof roughly $50 billion in 2011—more than thedefense budget of France. If governments don’t getthese costs under control while continuingto fulfill their obligations to active personnel andveterans, it is likely that the scale of budgetaryreductions required will be hard to achieve insome countries.The pressure on national budgets is severe, andit is unlikely to lessen over the next decade.Armed forces will likely continue to be required toreduce budgets even while demands on theircombat readiness remain high. But there are waysto reduce spending while maintaining or evenincreasing combat readiness—ways that arein keeping with the traditional military values ofingenuity and pragmatism.David Chinn is a director in McKinsey’s London office. Copyright © 2013 McKinsey & Company. All rights reserved. 1 Scott Gebicke and Samuel Magid, “Lessons from around theworld: Benchmarking performance in defense,” mckinsey.com,March 2010. 2 Sustaining US Global Leadership: Priorities for 21st CenturyDefense, US Department of Defense, January 2012. 3 Transforming Logistics Support for Fast Jets, UK NationalAudit Office, July 17, 2007. 4 Hans Arnum et al., “Big savings from little things:Non-equipment procurement,” mckinsey.com, March 2010. 5 Gebicke and Magid, “Lessons from around the world.”