As Western companies duke it out for a piece of the developing-market pie, Procter & Gamble is going deeper — courting not just the newly rich but also the very poor. The company’s vaunted R&D operation is turning up surprises.

We are a long, long way from Cincinnati. Getting here required a 15-hour flight to Beijing, followed by a nearly three-hour flight to Lanzhou, an industrial city on the Yellow River in China’s midsection, and, finally, a bumpy, two-hour drive deep into treeless hills the color of dried clay. Our destination, in a pinprick of a town called Shahe, is a small cinder-block house framed by Szechuan pepper trees, its primary decoration a poster of Chairman Mao. Eight of us — a reporter, a photographer, two local “fixers,” a translator, and three executives from Procter & Gamble — have come here so that we can watch a 29-year-old corn and potato farmer named Wei Xiao Yan wash her hair.

And she washes it with gusto, especially considering that she is doing it in front of a crowd while standing in the doorway of her kitchen, using a small metal basin with no more than three cups of water. Water scarcity is the rule here; the family stores rainwater in a well and must pay a private company for anything more. After trying to work up some lather with a tiny bit of Rejoice — P&G’s cheapest local offering, which costs about 10 renminbi ($1.50) a bottle — Wei Xiao Yan does a cursory rinse, then forces the family comb through her tangles. “The shampoo puts nutrients in my hair,” she says, noting that it is her first bottle of real shampoo after a lifetime of using laundry soap flakes, which made her hair oily. I make the error of asking her if it might not be more practical to cut her nearly waist-length hair. She looks at me with disdain. “As a woman, you should have long hair,” she snaps. “And my husband likes it.”

Cindy Graulty, principal R&D scientist for P&G, and Melisa Liu, principal R&D researcher, give each other knowing looks. My blunder led to the kind of insight that P&G is seeking as it tries to learn how best to make products for the underserved — what the company calls the “$2 a day” consumer, based on average income. Wei Xiao Yan’s tart response explodes the assumption by some marketers that what poor consumers look for is the most practical, cheapest solution. Wei may live on 900 renminbi a year ($135) and have so little water that her washing machine — a wedding gift — is rusting in the courtyard. But that does not mean she won’t make the effort to look pretty for her husband. “It’s a myth to say poor people only want function,” says Graulty, who has headed P&G’s $2-a-day initiative since October 2009. “They care about beauty. Just like us.”

Obvious, right? Yet despite the growing belief that the billions of poor — what the late management thinker C.K. Prahalad termed the “bottom of the pyramid” — can actually make up a viable economic market, most attempts to harness it have failed. Procter & Gamble PG , a $79 billion (in sales) company better known for its middle- and upper-middle-class brands than for its low-end offerings, thinks there’s another way to reach those consumers. So it has quietly launched a skunkworks, populated mostly by technical folks rather than market researchers, to approach the $2-a-day consumer from a new perspective. Rather than try to invent products first or rely on market research alone, the group spends days or weeks in the field, visiting homes in Brazil, China, India, and elsewhere. It’s the same approach the company uses in developed markets but requires much more effort, without the obvious potential payoff from consumers with disposable income. “Our innovation strategy is not just diluting the top-tier product for the lower-end consumer,” says Robert McDonald, P&G’s CEO and chairman. “You have to discretely innovate for every one of those consumers on that economic curve, and if you don’t do that, you’ll fail.”

Some wonder why P&G bothers. The holy grail for companies in developing markets has always been the emerging middle class, and P&G is no exception. “Knowing how [Wei] shampoos is great,” says Bill Schmitz, a managing director at Deutsche Bank Securities who covers P&G. “But she probably won’t be a profitable consumer for a decade.” Indeed, the company, present in 180 countries, remains committed to “mass prestige” — delivering high-quality brands such as Olay, Crest, Tide, and Pampers to the middle and upper classes at a premium price. Even as P&G has focused more on developing markets, with sales there rising to 34% from 20% in 2000, its target customer is still the Shanghai bank manager we also visited. She lives in a new high-rise, dines out, and favors P&G’s SK-II skin-care products, which retail for up to $374.

It is this woman, not Wei, who is the focus of the old saying “If every one of the 2.5 billion Chinese and Indians just bought one [Coke or package of Pampers or bar of Dove soap or insert product here] a [day, week, month], we would [double, triple, quadruple] our sales.” Yet P&G, realizing that its future success lies in the developing world, has concluded that it must compete at the lower end of the spectrum as aggressively as it does at the higher one. For too long, says P&G director Scott Cook, founder of Intuit, the company ceded ground. “There was debate at the board level,” he says. “It pushed them to stop being only premium and not to give competitors a safe harbor.”

For P&G the stakes are high, in part because of some harsh new realities. Start with the fact that the global recession put a dent in P&G’s up-the-curve strategy. Then there is the simple paradox of growth: For a giant company to grow at the levels it has in the past — and satisfy its investors, as its stock is about where it was five years ago — P&G must expand aggressively, even if it means moving away from its core strength. P&G says developing markets are growing at 6% to 8% annually, compared with 1% to 2% in the developed world. The market for the poor remains largely untapped.

“We’re late to those markets,” says McDonald, who spent much of his career overseas, including in Japan and the Philippines. “As a result, we’ve got to do things smarter.” He’s not exaggerating. In Brazil, which many think is poised to exhibit China-type growth, Colgate-Palmolive CL has a 71% market share in toothpaste; P&G wasn’t even in the category until 18 months ago. Unilever UL , with its Anglo-Dutch colonial heritage, already gets more than 50% of its sales from developing markets. “P&G is still very U.S.-centric,” says Paul Polman, Unilever’s CEO (and until 2006 a P&G exec). “What Bob is doing is not wrong, but it will take some time. Emerging markets are in the DNA of our company.”

Throwing down the gauntlet, McDonald has set a hugely ambitious goal of 800 million new customers by 2015 and says he is shifting the company’s emphasis from the West to Asia and Africa. Even in China, a notable success story for P&G since it entered a joint venture with Hutchison Whampoa in 1988, per capita spending on P&G products is just $3 a year, vs. nearly $100 in the U.S.? McDonald wants to raise the average expenditure globally from $11.50 in the next few years. “The move of the center of gravity is critical,” he says.

To communicate that approach, he has changed the strategy of the company to “Touching and improving more lives, in more parts of the world, more completely.” What he calls “purpose-inspired growth” is meant to help his employees believe that they are not merely pushers of deodorant and dryer sheets, but instead helping improve people’s daily existence. “It’s more than a noble idea,” McDonald proclaimed at the company’s Dec. 16 analyst meeting. “It’s a game-changing growth strategy and a powerful source of competitive advantage.” Certainly when aimed at the $2-a-day customer, the idea of improving lives allows people like Graulty to feel that her project has meaning. “It’s almost like you don’t even have to pay us to do this,” she says. “Don’t tell our managers that.”

Going local on R&D

Beautiful Chinese women wearing red cheongsams are striking drums that seem to be made of water. A dragon with smoldering eyes undulates on the stage as P&G CEO McDonald and CTO Bruce Brown nod to various local dignitaries, including China’s vice minister of commerce. You’ve seen this movie before; it’s yet another ribbon cutting for a Western company expanding in China — this time for P&G’s Beijing Innovation Center (BJIC), a sparkling $70 million home for the company’s regional R&D efforts. Already the company has invested more than $1 billion in China, and McDonald says it will spend another $1 billion in the next five years.

Yet leaving all the hoopla aside, the center is particularly important when it comes to P&G’s shifting priorities. Though the company has 25 R&D centers all over the world, BJIC is an attempt to research, source, and develop products for China and the rest of Asia without having to rely on the company’s headquarters in Cincinnati.

One of the most important reasons for that is the masses of high-caliber talent coming out of Chinese universities. The hope is that all that brainpower will lead to innovations that will also work in the developed world. P&G is, amazingly, one of the top three choices among Chinese university graduates looking for jobs. And the place is pulsing with the energy of young people who want to make it big; as a raucous karaoke party shows, they seem to have both right- and left-brain abilities. The campus feels a bit like being at a Silicon Valley startup — except that it’s a unit of a 173-year-old company.

For most of its history P&G, which puts a whopping $2 billion annually into R&D, succeeded by inventing technically superior products at home, then pushing them out to the market in a command-and-control fashion. Only over the past decade, as former CEO A.G. Lafley pried open the company to ideas from the outside, did things change. The Swiffer and the Mr. Clean Magic Eraser — both hits for P&G — came about through partnerships with outside product developers.

BJIC is the only tech center in the developing world that operates across all the company’s global business units, or GBUs, as P&Gers, acronym lovers all, tag it. Similar to the company’s baby playrooms and fake supermarkets in Ohio, here a simulated hutong (a typical Chinese home) lets researchers observe consumers as they brush their teeth or change a diaper, then make immediate changes to prototypes. “Now we can do end-to-end product innovation,” says Brown.

Even before the new center opened last August, several new products came out of China. They included Tide Naturals, a skin-sensitive detergent for women who wash clothing by hand, and Crest Pro Health toothpaste, a premium brand whose main researcher, Wang Xiaoli, cracked a 50-year chemistry problem by finding a way for stannous fluoride — a stronger form of fluoride — to stabilize in water. Wang, who won a companywide innovation award, says she came to P&G because “I didn’t want what I learned to be published in 100 years.”

The key, says McDonald, is making sure that technical development and testing are done locally. That’s something P&G’s Gillette unit learned the hard way before P&G bought it in 2005, when it developed a razor specifically for Indian men. Since many of them shave only a couple of times a week, often using a basin, they have longer facial hair than most Western men. Rather than testing in India, Boston-based Gillette decided to try out the razor on Indian men who were studying at MIT. They loved it, so the company went ahead with a launch in India. It flopped — because the MIT students, unlike much of the Indian market, had access to running water. Lesson learned, P&G retrenched, tested locally, and last October launched Gillette Guard, a razor that is easier to rinse.

New uses for old ideas

The most valuable consumer insights for P&G’s $2-a-day explorers are transnational ones. That’s why Liu, a young Chinese woman who has worked in the research division of P&G for six years, has spent much of the past one trekking through the jungles of Brazil, the slums of India, and farming villages in rural China. She is bringing what she learns back to Beijing — and hoping that the knowledge will lead to wins elsewhere. Back at Wei’s home, she pulls out a plastic bag full of products — some new prototypes, some off the shelf — for her to sample. Wei relies on a washcloth and a scrap of soap to clean her body, and she never undresses completely — not because of water concerns, but because of privacy issues. There is no bathroom, her father-in-law lives in the home, and she feels she has no place to go.

Out of the bag comes an unmarked bottle with a body cleanser formulated to clean without much water. It’s kind of like Purell — except that it generates foam, which can be easily wiped away, instead of lather. The technology comes from an existing hair-color product, which means that it’s a potential win-win for P&G, a new use for an old idea. “We just have so much stuff,” says Graulty. “Our job is finding the right match.” Liu pulls out a bottle of Febreze — an air freshener for relatively affluent customers — and shows Wei its use as a spray to improve the smell of clothing that can’t be washed often.

She likes it, but not as much as the leave-in conditioner they try next; the look on her face when she touches her hair is one of deep desire. I can’t help but wonder whether this experience is touching and improving her life, or tantalizing her by introducing her to something she can’t have. The item Wei likes most, though, is one that P&G doesn’t even make: an off-the-shelf camping shower, basically a large plastic bag that hangs on a line or a tree and lets you shower with sun-heated water. For her it is a breakthrough product — she can wash in private.

Does that mean, I ask, that P&G should go into the camping-shower business? No, says Graulty; certainly the company might try partnering with a producer to sell, say, cleanser with one, but the real insight is privacy. Graulty’s project has uncovered other misconceptions about poor consumers, including the notion that they always want the simplest product (they don’t), and that they are not as aspirational as the more well-to-do (they are). They need more skin-care products because they spend so much more time outside. And though P&G never contemplated selling hair dye to poor customers, Graulty has learned that in those parts of the world, dye is very much in demand. “It’s a paradigm shift,” she says. “We say, ‘Why would they buy that? It’s not like food, clothing, and shelter.’ But to get a good job, to be presentable, they have to have beauty.” The R&D folks are now working on a colorant that uses little water — and is priced appropriately for a $2-a-day customer.

To be sure, it will be a while before any of this research helps P&G make real headway. In the meantime, the company is relying on classic tactics like price cuts and advertising to gain share. “Promotions win quarters,” McDonald told the analysts. “Innovation takes decades.” His message may be working. After a few years of skepticism, P&G is gaining fans like Goldman Sachs’s Andrew Sawyer, who upgraded the stock in December largely on the company’s emerging-market strategy.

Though no product has been launched yet from the $2-a-day project, Brown says several are in the works, including a hair-care product beginning formal testing in India. Last fall the group of about 100 met for the first-ever $2-a-day confab. (Ironically, the meeting took place not in Africa or Asia, but in Cincinnati — “The logistics were better,” Brown says, apologetically.) One move McDonald has not made so far is to form a formal business unit. That’s the type of thing the company might have done immediately in the past — but management now believes would be better handled locally, across silos. “If there were a $2-a-day division,” director Cook says, “everyone else would wash their hands of it.”

Now, if everyone else would simply begin to wash his hands with P&G products, the company might get somewhere.

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