(FORTUNE Magazine) – AS ANNUAL MEETINGS go, Procter & Gamble's promised to be pleasantly uneventful. Sales and profits were up; ditto the stock price and the outlook for the future. Even the animal-rights activists waving signs outside P&G's sleekly squat postmodern headquarters in Cincinnati seemed routine. Which is why CEO John Smale's announcement a few minutes into the noon meeting that he was retiring at the end of the year to be replaced by vice chairman Edwin Artzt, 59, had the force of a grenade lobbed into the crowded auditorium. So impregnable is P&G that no word of Smale's plans had leaked beforehand. Indeed, a month earlier, the dark-haired, jowly 62-year-old had denied twice that he had any intention of stepping down. P&G insiders took the appointment of Artzt as a sign that P&G was continuing with the most radical restructuring in its recent history. The man responsible for turning around Procter's international division, Artzt is known within the company for his aggressive style. Says he: ''I feel most of the major things going on here have a lot of my blood and sweat already on them. I'm committed to the program, which is just about to blossom.'' The transfer at the top shows that Smale, after overseeing two years of wrenching change, feels confident enough to let Artzt guide a new P&G through its completion. A new P&G? Yes. The peerless promoter that practically created modern marketing is re-creating it, profoundly altering the way consumer packaged goods are made and sold. Says Smale: ''We've made watershed changes at P&G, the most significant changes since the Second World War. They will bear fruit well into the next decade.'' More balderdash from the big office? Hardly. Listen to consultant John Luther of Marketing Corp. of America, an adviser to scores of consumer products companies: ''Procter is reinventing the packaged goods industry for the year 2000 and beyond.'' In the process, the company is providing American business with a case study of how a large and bureaucratic organization can change internally without totally destroying the culture that made it great. Says Smale: ''We're not ancestor worshippers, but we do believe this company's culture is rooted very much in its past.'' Procter is taking the best of its past -- a willingness to stay with long-term projects, job security, and a history of promotion from within -- and grafting on to it a management style that calls for pushing authority down, speeding up decisions, and getting closer to the customer. Some examples: -- P&G now treats retailers -- once considered tough, penny-pinching adversaries -- as partners and assigns special teams to help big customers like Wal-Mart and Kroger improve inventory, distribution, and sales promotion. (For more on how manufacturers are teaming up with their distributors, see Other Voices.) -- Into its famous brand management system, P&G has inserted a new level, called category manager. The supra-brand managers have the spending power and decision-making authority to respond to fast-changing markets. -- Another new position, the product supply manager, works with representatives from manufacturing, engineering, distribution, and purchasing to cut product development time. This middle-level manager has the authority to make decisions on the spot. -- To crack overseas markets, P&G is going native, spending heavily to learn what consumers from Oslo to Osaka want. Make no mistake: These are sweeping changes. In the first two years of restructuring, Procter has reorganized marketing, sales, manufacturing, and distribution. Bonuses are now based on individual performance rather than corporate results, and head count in the U.S. is down by 2,000, to 43,600. Over one-third of the company's top 20 managers have been replaced since 1984. DRIVING the reorganization is Smale's long-term strategy to be the market leader in each of P&G's 39 product categories. So far the company, which makes such household names as Crest, Ivory soap, Head & Shoulders, Pampers, Tide, NyQuil, Pepto-Bismol, and Folgers coffee, is first in 22 categories, up from 17 four years ago. In September the company announced the $1.3 billion purchase of Noxell, the manufacturer of Noxema skin cream and Cover Girl makeup, which will make P&G the largest mass-marketer of cosmetics in the U.S. Says Smale: ''The money is made by those manufacturers that have major share.'' Hercules Segalas, head of the consumer products group at Paine Webber, estimates that best-selling Crest, for instance, enjoys a 75% profit margin. The reorganization has already produced some sprightly numbers. After a string of dismal years, earnings in fiscal 1989 (which ended in June) jumped 18% to $1.2 billion on sales of $21.4 billion. Unit volume growth, chugging along at 5% in 1985, is now rising at an average annual rate of 7%, a remarkable pace for a large company operating in mature markets. Wall Street has not overlooked the new sparkle: Over the past year, P&G's stock has bubbled up 48% to a recent price of $120.75 a share. Says Morgan Stanley security analyst Brenda Lee Landry, who cites P&G's manageable debt, growing cash flow, and $1.6 billion in cash: ''This large, stodgy company has been revitalized.'' True enough. But change has its costs, and the long, drawn-out variety may be the most expensive kind. P&G's process of stretching its reorganization over years has proved demoralizing for some employees and even customers. Says a manager of a grocery chain, who anxiously awaits some sign of the new, improved P&G: ''We hear a lot about the focus on Wal-Mart, and we want to know more about it.'' Because Smale has been streamlining the company by attrition rather than layoffs, pockets of hardheaded, change-resistant bureaucrats remain. In some divisions and departments, the mix of old and new management levels makes for unnecessary confusion. Reporting lines in sales, for instance, are particularly unclear. An ex-P&Ger observes: ''It's a nightmare right now.'' Though the company claims turnover is low, a headhunter who says he used to get five or ten calls a week from P&G people is now getting 30. Says he: ''They're losing some of their best and brightest.'' The company's rigid adherence to gradual promotion from within has prevented it from solving pressing problems in the food and beverage businesses. In the infamous soft-cookie wars of the early 1980s, Procter's Duncan Hines division got burned by Nabisco. Orange Crush soft drinks never came close to the Coke and Pepsi league and were finally sold last spring. P&G remains reluctant to hire outside food and beverage experts. Says a former high-level employee: ''The biggest hang-up is that they don't let a lot of light in the window.'' Though P&G plays down the turmoil, the selection of Artzt suggests that the company may be stepping up the pace of reorganization. Says an ex-P&G manager: ''I think Ed will look at plans and timetables and force people to move them up. He will also reduce head count.'' For example, in the early 1980s, Artzt cut P&G's British work force 13%.

In guiding P&G's restructuring to its conclusion, Artzt has an advantage that managers in similar situations should envy: supportive shareholders. Thanks to a century-old profit-sharing plan and a brand-new employee stock ownership program, current and retired employees control 28% of the shares. Not only do workers have a stake in making the reorganization a success, but so much control in presumably friendly hands should discourage raiders. Restructuring came to Cincinnati none too soon. In the mid-1980s, P&G's margins and earnings were eroding, and flagship products like Crest and Pampers were losing market share. The feeling among financial analysts and corporate customers was that P&G had become a corporate Kremlin: bureaucratic, risk averse, and arrogant. Says Leslie Dietzman, an executive vice president at Ames Department Stores and one of P&G's major customers: ''It was do it P& G's way or hit the highway.'' A manager at a large Midwestern supermarket chain, for instance, recalls how < P&G once told him he would get his promotion money (funds the manufacturers give retailers to pay for special sales, coupons, and ad campaigns) only if he ran a two-column-inch newspaper ad on Tide. Recalls the retailer: ''The P&G salesman would come into the store, measure the ad and say, 'Nope, it's only 1.9 inches, you won't get the money.' '' MANY COMPETITORS like Colgate-Palmolive and Campbell Soup were already restructuring, and Smale realized that if he didn't do some heavy lifting, P&G would be left behind. Turning over such a huge boulder would be a hard job, but Smale, a 37-year veteran with an almost encyclopedic knowledge of the company, was the right man. In 1954, when he was the brand manager for what was then a little-known toothpaste called Crest, he asked the American Dental Association to endorse it. Six years later they did, giving Crest a leg up on the competition that it has never lost. A high-ranking manager who recently left the company describes Smale as ''a tough, pragmatic man with a great command of the business. He can keep his hands on a lot of balls.'' Though pleasant in social settings, Smale is considered aloof by colleagues. His lieutenant John Pepper, the company's president, is much warmer, and P&G security analysts, employees, and former employees tabbed him as the next CEO. When Artzt got the call, the speculation was that Pepper, at 51, needed more seasoning -- an opinion that was reinforced when he was made the head of international, Artzt's old territory. Nonetheless, he remains the heir apparent. Known as a listener and consensus builder, Pepper invites managers on the spur of the moment for informal lunches. He represents a new generation at P&G hip to the latest in management thought who toss around buzzwords like ''self-directed'' and ''empowerment.'' Not that he's exactly Silicon Valley: Employees still talk about the time he worked Christmas day. In the summer of 1987, the company began organizing its 4,000-strong sales force to do something pretty obvious: focus more on the customer -- in this case, supermarkets and department stores. Under the old system P&G had 11 national sales forces, each hawking a product line such as detergents or foods. Retailers were faced with numerous P&G salesmen pushing 11 different product lines with all sorts of different promotions. For years P&G got away with this awkward system. Says Paine Webber's Segalas: ''Retailers hated P&G, but they needed it. It dominated the trade.'' Then the balance of power shifted from big manufacturers like P&G to the retailers. What tipped the scales was consolidation among supermarket and drugstore chains and the widespread use of scanners at the checkout counter. As a result of industry mergers, 100 chains now account for some 80% of P&G's U.S. grocery sales, vs. 15% about 20 years ago. Electronic bar coding helped retailers gather their own sales data. P&G could no longer bully its way into the stores, waving figures a retailer couldn't dispute that showed Tide was outselling All and was therefore entitled to more shelf space. Slowly P&G realized that it would have to start fussing over these power- punching retailers. Says Mike Milligan, one of P&G's top sales executives: ''We're switching from a product to a customer approach.'' Now teams of people from finance, distribution, manufacturing, and other functions are assigned to cover the big retailers. Says an executive at a large supermarket chain: ''We can call the shots now. If we want to run a Duncan Hines ad, P&G has given its local sales managers the autonomy to say, 'We'll give you $20,000 for it.' '' A TEAM OF A DOZEN or so attends solely to the needs of Wal-Mart. Working with the crew from P&G, the discount giant has set up a just-in-time ordering and delivery system for Pampers and Luvs disposable diapers. When the diapers run low in a store, a computer sends an order by satellite to a P&G factory, which in turn automatically ships more diapers directly to the outlet. As a result, Wal-Mart can maintain smaller inventories and cut the number of times it runs out of Pampers. Says Smale: ''This is what people refer to as a win- win situation. Our costs go lower and their costs go lower. Our objectives and the objectives of our customers are going to be much more aligned.'' Here's another example of working with -- rather than against -- the retailers. P&G through a joint venture has installed a state-of-the-art checkout system called Visions in a Dahl's supermarket in Des Moines, Iowa. A Dahl's customer gets an electronic card that he inserts in a black box hooked to the register to call up his account. Let's say the customer buys Downy on sale. When the clerk scans the bottle of fabric softener, a color monitor at the counter shows a video of a woman holding Downy and purring, ''You've saved 50 cents on Downy.'' That amount is deducted from the tab. Visions also automatically tallies points for certain products -- 50 for Downy. When the . customer accrues enough points, he or she gets a prize, perhaps a watch (4,745 points) or a VCR (22,035). Not only is Visions attracting customers to Dahl's stores, but it is also giving both Dahl's and P&G valuable market data about consumer spending. Once Smale tackled sales, he turned to the heart of P&G, the vaunted brand management system. The company doesn't know for sure how many brand managers it has -- one inside source stopped counting at 92. Some shepherd $700-million or $800-million-a-year businesses. Only one of every three new hires makes it to brand manager, a process that usually takes four years. Those who do earn between $60,000 and $77,000. They are responsible for every aspect of their brands -- marketing, advertising, sales, and development. The rub: To get a major decision, brand managers often had to go through three or four layers of management. With up to 14 brand managers in each division, getting the attention of the division chief wasn't easy. One manager recalls waiting a year for an OK on a simple package design change. Another difficulty: Brand managers were so focused on a single product that they lost sight of the marketplace, even of what their colleagues were doing. Says one who left P&G: ''The brand managers were butting heads. There was a lot of cannibalization. You'd issue coupons at the same time for P&G's liquid and powdered detergents.'' That's why Smale, in late 1987, created the category management system, a move which promises to revolutionize consumer marketing much as brand management did nearly 60 years ago. He broke the company into 39 product categories and named 26 category managers (some have more than one category). Brand managers report to the category manager, who is like a small businessman. He has total profit-and-loss responsibility for an entire product line -- all laundry detergents, for example, which would include such competing brands as Tide, Cheer, and Ivory Flakes. The idea is to have someone who thinks in terms of product groups and who will make sure the brand managers aren't sabotaging each other. Now the brand managers can go directly to the category manager, who has the authority to make quick decisions and to back them up with as much as $1 million per project. Says Smale: ''The creation of these category profit centers was really a continuation of the basic philosophy that small is good, that you bring focus to a specific business when you create a stand-alone operation.'' - Last year's severe drought in the Midwest put the new system to the test. The price of soybeans, a crucial ingredient in Puritan and Crisco oils, started to shoot up. What to do? Buy now or wait? Under the old system, says category manager Neil DeFeo, ''We'd write a lengthy memo with exhibits and send it to senior management for agreement.'' Instead, DeFeo gave an OK on the spot to the purchasing agent to buy more soybeans and avoided a pounding on escalating prices. Critics of the category management system say that P&G is moving in the right direction but not far enough or fast enough. For the most part the company has not eliminated any of the division vice presidents or other executives whose authority is being usurped by the category managers. Observes one ex-P&Ger: ''You've got these vice presidents, all with their corporate jets, who make a lot of money and have been there forever. It's not easy to get rid of them.'' WHEN HE LAUNCHES a new product or repositions an old one, the category manager forms a small team made up of the brand manager plus people from sales, finance, and manufacturing. Key to P&G's success here is another new position called the product supply manager, who reports to the category manager but has broad responsibility over every aspect of manufacturing, engineering, purchasing, and distribution. Says Smale: ''I have the growing conviction that the product supply concept is perhaps the single most important thing that can influence our profit performance over the next several years.'' He estimates that the creation of product supply managers will slash costs by $1 billion over the next two years. At the old P&G a brand manager would come up with a new concept for a product or package. The idea, usually traveling in memo form, would be tossed over the transom to engineering, then to manufacturing, and then maybe to distribution. Progress was slow and awkward. The product supply manager has changed all that. This spring, for example, the category manager for dishwashing detergent wanted a new cap for liquid Cascade. Though the cap in use was childproof, it was also somewhat adultproof. The team got together, and the product supply manager, as its leader, was able to get everyone to work out all the cost, design, and manufacturing problems. The cap went into production without any glitches after only nine months, nearly twice as fast as under the old system. TO INSTILL a sense of what P&G calls ''total quality,'' the company spreads tales like this one as well as other corporate heroics. In a war story making the rounds this fall, the company's Hatboro, Pennsylvania, plant was gearing up to launch a new children's NyQuil cough syrup in time for the winter cold season. Just days before the line was to start rolling, the factory received from a supplier three million NyQuil boxes printed upside down. If the faulty boxes were run through the machine that inserted the bottles, the tops of the bottles would end up at the bottom of the boxes, and the packages would be unstable on the store shelves. Without enough time to bring in engineers or have new parts designed, two mechanics, George Rowan and Ed Scott, worked around the clock for three days, missing the plant's annual picnic. The pair came up with a system of springs and brushes that turned the boxes around and kept them open so NyQuil bottles could be inserted properly. Amen. And how about this for getting really close to the customer? At the Duncan Hines angel food cake factory in Jackson, Tennessee, the line workers are given letters from customers who have problems with the product. One factory hand called up a customer whose angel food cake didn't rise, and helped figure out why by asking such questions as ''How long did you beat the mix?'' and ''At what temperature did you bake it?'' Says Smale: ''What we've said to the workers is, this is the only place we make angel food cake, and you're responsible for it, and if you want to talk to the consumer, we'd like you to talk to the consumer.'' The quality quest explains the $652 million P&G allocated to R&D in fiscal 1988. As a percent of sales, that amount represents half again as much as such competitors as Unilever and Colgate-Palmolive spend developing packaged goods (see chart). Even so, P&G has had few megahits since it launched disposable diapers in the 1960s. But olestra, the fake fat now undergoing Food and Drug Administration testing, may be that long-awaited home run. OLESTRA is sugar and vegetable oil chemically combined so that its molecule is too large for the stomach to digest; so it never enters the bloodstream, where it can clog arteries and veins. The body simply excretes it. Olestra rolls over the tongue much like fat but without the calories or cholesterol. It can be used to replace the silky consistency fat gives ice cream or to fry fat-free French fries, potato chips, and donuts. At Procter's R&D labs, this FORTUNE writer dined on steak with wine sauce, sauteed zucchini, and apple tart, all cooked in vegetable oil cut with olestra. The meal tasted just as good as food cooked in regular vegetable oil. Potato chips fried in olestra, however, flunked a blind taste test; they lacked the delightfully greasy aftertaste of the real thing. The FDA is expected to rule on olestra's safety within the next two years. If approved for sale, olestra will likely be used initially as an additive in Crisco and Puritan vegetable oils. Nutritionists are concerned that if P&G marketed a 100% olestra product, some Americans would scarf down ice cream and French fries until scurvy got them. Estimates of how much money olestra will make for P&G range wildly. Some financial analysts believe the fake fat will add $1 billion to sales over the first few years; others a few hundred million. Even Smale can't guess, but he firmly believes olestra heralds a change in the American diet. Want to know how P&G's restructuring will play out? Take a look at the international division. During his nine-year tenure as its head, Artzt helped P&G expand rapidly overseas. In 1986 the international business -- P&G peddles its products in 140 foreign countries -- represented 29% of sales; now it is 40%. Nearly 35% of earnings in fiscal 1989 came from offshore, up from 23% three years ago. In fiscal 1989 international's profits shot up 37% from the year earlier. Feeding the growth spurt is P&G's entry into new business categories overseas, such as feminine protection products. Always is now marketed in the Far East, where it's called Whisper and is the biggest selling sanitary napkin in Japan. The acquisition of Richardson-Vicks, the maker of NyQuil cough syrup and Oil of Olay skin creams, has provided P&G with strong international distribution channels in Australia, New Zealand, Singapore, and Hong Kong. But perhaps the most important element in P&G's overseas success is its new willingness to go native, and nothing illustrates this better than the company's experience in Japan. Smale predicts that -- after 16 years of struggle -- sales in Japan will top $1 billion in 1990. In the next three years Japan should replace West Germany as P&G's biggest foreign market. The key to cracking Japan: realizing that the company would have to fine-tune its ''world products'' -- defined by P&G as the best you can buy anywhere -- to the Japanese market. Not such a revelation, you say. Well, remember that P&G once truly believed its marketing prowess could ignore cultural differences. That attitude is changing. Says Artzt: ''We need to develop the ability to deliver globally what we do well regionally. We have to adapt to overseas markets.'' For example, a Camay soap commercial showed a Japanese husband in the room while his wife was bathing, an invasion of privacy the Japanese found distasteful. After P&G switched to a more abstract commercial, sales improved. In the early 1980s, P&G was getting soaked in the Japanese diaper market. After years of painstaking market research, the company finally realized that Japanese parents are very concerned with keeping their babies clean, and changed their kids' diapers far more often than Americans do. In response, P&G devised Ultra Pampers, a more absorbent diaper that keeps the tyke drier and makes frequent changing a less messy task. P&G also discovered that in land- starved Japan, shelf and closet space is almost as precious to housewives as their kids. It made the diapers thinner so the same number fit in a much smaller box. The popularity of the new diapers spread like a baby's rash, and today Ultra Pampers is the market leader. P&G sells a total of 20 products in Japan, including Colac, the leading laxative. To keep the momentum going, in September the company announced a new $215 million R&D center to be built in Osaka Bay in the early 1990s. The company has also made some inroads into the Japanese distribution system, whose arcane network of mom and pop wholesalers has frustrated many American firms. Procter's executives in Japan try to establish an unofficial partnership with the Japanese distributors the same way that the Japanese companies do, by showing a keen personal interest in their lives, inside and outside work. Not only do top executives help the distributors run their businesses, but they also hold elaborate lunches for the them and, in some cases, even attend their weddings and funerals. WHAT'S TRULY AMAZING about P&G's historic restructuring is that it is a response to the consumer market, not the stock market. No raider has the company in his cross hairs -- at least not yet. So P&G can rewrite the rules of marketing in its own deliberate way, continuing to pour money into R&D and toughing out a turnaround for businesses like Citrus Hill orange juice despite years of losses. After all, taking the long view paid off for Folgers coffee, which took 25 years to become the best-selling java in the U.S. A new management structure, a fresh global approach, an enduring corporate culture, and a commitment to the long term: Sounds like P&G is just about ready for the year 2000.

BOX: WHERE P&G IS NO. 1 Detergent U.S. Deodorant U.S. Diapers FRANCE Coffee U.S. Cleanser U.S. Stomach remedy U.S. Toilet paper U.S. Cough syrup U.S. Toothpaste W. GERMANY Dishwasher soap U.S. Peanut butter U.S. Fabric softener W. GERMANY Shortening U.S. Fabric softener U.S.

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