-refer to the Added file for thorough instructions

198 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Porter views cost leadership and differentiation as mutually exclusive strategies. A firm that attempts to pursue both is “stuck in the middle”:

The firm stuck in the middle is almost guaranteed low profitability. It either loses the high-volume customers who demand low prices or must bid away its profits to get this business from the low-cost firms. Yet it also loses high-margin business— the cream—to the firms who are focused on high-margin targets or have achieved differentiation overall. The firm that is stuck in the middle also probably suffers from a blurred corporate culture and a conflicting set of organizational arrange- ments and motivation system.60

The metal container industry is a highly competitive, low-

growth, low-profit industry. Cans lack much potential for

differentiation, and buyers (especially beverage and food

canning companies) are very powerful. Cost efficiency is

essential, but can we also identify opportunities for prof-

itable differentiation? Following the procedure outlined

above, we can construct a value chain for a firm and its

customers, and then identify linkages between the two.

Figure 7.14 identifies five such linkages:

1 Distinctive can designs (e.g., Sapporo’s beer can)

can support the customer’s efforts to differentiate

its product.

2 Manufacturing cans to high tolerances can mini-

mize breakdowns on customers’ canning lines.

3 Reliable, punctual can deliveries allow canners to

economize on their can inventories.

4 An efficient order-processing system reduces

canners’ ordering costs.

5 Speedy, proficient technical support allows cus-

tomers to operate their canning lines with high-

capacity utilization.

STRATEGY CAPSULE 7.8

Using the Value Chain to Identify Differentiation Opportunities for a Manufacturer of Metal Containers

FIGURE 7.14 Identifying differentiation opportunities by linking the firm’s value chain to that of the customer

Su p

p lies o

f steel an

d alu

m in

u m

Pu rch

asin g

In ven

to ry h

o ld

in g

D esig

n en

g in

eerin g

M an

u factu

rin g

In ven

to ry h

o ld

in g

D istrib

u tio

n

Sales

Service an d

tech n

ical su p

p o

rt

Pu rch

asin g

In ven

to ry h

o ld

in g

Pro cessin

g

C an

n in

g

M arketin

g

D istrib

u tio

n

1

2 3 4

5

CANMAKER CANNER

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 199

TABLE 7.1 Features of cost leadership and differentiation strategies

Generic strategy Key strategy elements Organizational requirements

Cost leadership Scale-efficient plants

Maximizing labor productivity

Design for manufacture

Control of overheads

Process innovation

Outsourcing

Avoid marginal customering accounts

Access to capital

Division of labor with incentives linked to quantitative performance targets

Product design coordinated with manufacture

Tight cost controls

Process engineering skills

Benchmarking

Measuring profit per customer

Differentiation Emphasis on branding, advertising, design, customer service, quality, and new product development

Marketing abilities

Product engineering skills

Cross-functional coordination

Creativity

Research capability

Incentives linked to qualitative perfor- mance targets

In practice, few firms are faced with such stark alternatives. Differentiation is not simply an issue of “to differentiate or not to differentiate.” All firms must make decisions as to which customer requirements to focus on and where to position their product or service in the market. A cost leadership strategy typically implies limited-feature, standardized offerings, but this does not necessarily imply that the product or service is an undifferentiated commodity. Southwest Airlines and AirAsia are budget airlines with a no-frills offering yet have clear market positions with unique brand images. The VW Beetle shows that a utilitarian, mass-market product can achieve cult status.

In most industries, market leadership is held by a firm that maximizes cus- tomer appeal by reconciling effective differentiation with low cost—Toyota in cars, McDonald’s in fast food, Nike in athletic shoes. The simultaneous pursuit of cost efficiency, quality, innovation, and brand building was a feature of Japanese suppli- ers of cars, motorcycles, consumer electronics, and musical instruments during the late 20th century. In many industries, the cost leader is not the market leader but a smaller competitor with minimal overheads, non-union labor and cheaply acquired assets. In oil refining, the cost leaders tend to be independent refining companies rather than integrated giants such as ExxonMobil or Shell. In car rental, the cost leader is more likely to be Rent-A-Wreck (a subsidiary of J. J. F. Management, Inc.) rather than Hertz or Avis. Reconciling cost efficiency with differentiation has been facilitated by new management techniques: total quality management has repudi- ated perceived tradeoff between quality and cost; flexible manufacturing systems have reconciled scale economies with variety.

200 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Self-Study Questions 1. Figure 7.1 implies that stable industries, where firms have similar resources and capa-

bilities, offer less opportunity for competitive advantage than industries where change is rapid and firms are heterogeneous. On the basis of these considerations, among the fol- lowing industries, in which do you predict that inter-firm differences in profitability will

Summary

Making money in business requires establishing and sustaining competitive advantage. Identifying opportunities for competitive advantage requires insight into the nature and process of competition within a market. Our analysis of the imperfections of the com- petitive process takes us back to the resources and capabilities needed to compete in a particular market and conditions under which these are available. Similarly, the isolating mechanisms that sustain competitive advantage are dependent primarily upon the ability of rivals to access the resources and capabilities needed for imitation.

Competitive advantage has two primary dimensions: cost advantage and differentia- tion advantage. The first of these, cost advantage, is the outcome of seven primary cost drivers. We showed that by applying these cost drivers and by disaggregating the firm into a value chain of linked activities we can appraise a firm’s cost position relative to competi- tors and identify opportunities for cost reduction. The principal message of this section is the need to look behind cost accounting data and beyond simplistic approaches to cost efficiency, and to analyze the factors that drive relative unit costs in each of the firm’s activities in a systematic and comprehensive manner.

The appeal of differentiation is that it offers multiple opportunities for competitive advantage with a greater potential for sustainability than does cost advantage. The vast realm of differentiation opportunity extends beyond marketing and design to encompass all aspects of a firm’s interactions with its customers. Achieving a differentiation advantage requires the firm to match its own capacity for creating uniqueness to the requirements and preferences of customers. The value chain offers firms a useful framework for identify- ing how they can create value for their customers by combining demand-side and supply- side sources of differentiation.

Finally, the basis of a firm’s competitive advantage has important implications not just for the design of its strategy but for the design of its organizational structure and systems. Typically, companies that are focused on cost leadership design their orga- nizations differently from those that pursue differentiation. However, the implications of competitive strategy for organizational design are complicated by the fact that, for most firms, cost efficiency and differentiation are not mutually exclusive—in today’s

intensely competitive markets, firms have little choice but to pursue both.

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 201

1. Richard Rumelt argues that competitive advantage lacks a clear and consistent definition (“What in the World is Competitive Advantage?” Policy Working Paper 2003- 105, Anderson School, UCLA, August, 2003).

2. K. Ferdows, M. A. Lewis, and J. Machuca, “Rapid-Fire Fulfillment,” Harvard Business Review (November 2004): 104–110.

3. G. Stalk Jr., “Time: The Next Source of Competitive Advantage,” Harvard Business Review ( July/August, 1988): 41–51.

4. See, for example: Y. Doz and M. Kosonen, “Embedding Strategic Agility: A Leadership Agenda for Accelerating Business Model Renewal,” Long Range Planning, 43 (April

2010): 370–382; and S. Fourné, J. Jansen, and T. Mom, “Strategic Agility in MNEs: Managing Tensions to Capture Opportunities across Emerging and Established Markets,” California Management Review, 56 (Spring 2014)

5. J. A. Schumpeter, Capitalism, Socialism and Democracy (London: Routledge, 1994, first published 1942): 82–83.

6. C. Kim and R. Mauborgne, “Blue Ocean Strategy,” Harvard Business Review (October 2004). A similar approach to analyzing strategic innovation is McKinsey’s new game strategies. See: R. Buaron, “New Game Strategies,” McKinsey Quarterly Anthology (2000 ): 34–36.

7. G. Hamel, “The Why, What, and How of Management Innovation,” Harvard Business Review (February 2006).

be small and in which will they be wide: retail banking, video games, wireless hand- sets, insurance, supermarkets, and semiconductors?

2. Since 2009, Apple has been the world’s most profitable supplier of wireless handsets by a large margin. Can Apple sustain its competitive advantage in this market?

3. Illy, the Italian-based supplier of quality coffee and coffee-making equipment, is launch- ing an international chain of gourmet coffee shops. What advice would you offer Illy for how it can best build competitive advantage in the face of Starbucks’ market leadership?

4. Which drivers of cost advantage (Figure 7.7) did Sears exploit in order to offer its Sears Motor Buggy “at a price within the reach of all”? (See quotation that opens this chapter.)

5. Target (the US discount retailer), H&M (the Swedish fashion clothing chain), and Primark (the UK discount clothing chain) have pioneered cheap chic—combining dis- count store prices with fashion appeal. What are the principal challenges of designing and implementing a cheap chic strategy? Design a cheap chic strategy for a company entering another market e.g., restaurants, sports shoes, cosmetics, or office furniture.

6. To what extent are the seven cost drivers shown in Figure 7.7 relevant in analyzing the costs per student at your business school or educational institution? What recommen- dations would you make to your dean for improving the cost efficiency of your school?

7. Bottled water sells at least 200 times the price of tap water, with substantial price dif- ferentials between different brands. What are the key differentiation variables that determine the price premium that can be obtained for bottled water?

8. Advise a chain of movie theaters on a differentiation strategy to restore its flagging profitability. Use the value chain framework outlined in Strategy Capsule 7.8 to iden- tify potential linkages between the company’s value chain and that of its customers in order to identify differentiation opportunities.

Notes

202 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

8. R. P. Rumelt, “Toward a Strategic Theory of the Firm,” in R. Lamb (ed.), Competitive Strategic Management (Englewood Cliffs, NJ: Prentice Hall, 1984): 556–570.

9. R. Jacobsen, “The Persistence of Abnormal Returns,”Strategic Management Journal 9 (1988): 415–430; R. R. Wiggins and T. W. Ruefli, “Schumpeter’s Ghost: Is Hypercompetition Making the Best of Times Shorter?” Strategic Management Journal 26 (2005): 887–911.

10. G. Stalk, “Curveball: Strategies to Fool the Competition,” Harvard Business Review (September 2006): 114–122.

11. The film was based on the book by B. Traven, The Treasure of the Sierra Madre (New York: Knopf, 1947).

12. Monopolies and Mergers Commission, Cat and Dog Foods (London: Her Majesty’s Stationery Office, 1977).

13. D. Besanko, D. Dranove, S. Schaefer, and M. Shanley, Economics of Strategy, 6th edn. (Hoboken, NJ: John Wiley & Sons, Inc., 2013): section on “Limit Pricing,” pp. 207–211.

14. T. C. Schelling, The Strategy of Conflict, 2nd edn (Cambridge, MA: Harvard University Press, 1980): 35–41.

15. A. Brandenburger and B. Nalebuff, Co-opetition (New York: Doubleday, 1996): 72–80.

16. R. Schmalensee, “Entry Deterrence in the Ready-to-Eat Breakfast Cereal Industry,” Bell Journal of Economics 9 (1978): 305–327.

17. Monopolies and Mergers Commission, Indirect Electrostatic Reprographic Equipment (London: Her Majesty’s Stationery Office, 1976): 37, 56.

18. S. A. Lippman and R. P. Rumelt, “Uncertain Imitability: An Analysis of Interfirm Differences in Efficiency under Competition,”Bell Journal of Economics 13 (1982): 418–438. See also: R. Reed and R. DeFillippi, “Causal Ambiguity, Barriers to Imitation, and Sustainable Competitive Advantage,” Academy of Management Review 15 (1990): 88–102.

19. P. R. Milgrom and J. Roberts, “Complementarities and Fit: Strategy, Structure and Organizational Change in Manufacturing,” Journal of Accounting and Economics 19 (1995): 179–208.

20. J. W. Rivkin, “Imitation of Complex Strategies,” Management Science 46 (2000): 824–844.

21. M. E. Porter and N. Siggelkow, “Contextuality within Activity Systems and Sustainable Competitive Advantage,”Academy of Management Perspectives 22 (May 2008): 34–56.

22. M. E. Porter, Competitive Advantage (New York: Free Press, 1985): 13.

23. Ibid.,: 120. 24. M. Venzin, Building an International Financial Services

Firm: How Successful Firms Design and Execute Cross- border Strategies (Oxford: Oxford University Press, 2009).

25. R. P. McAfee and J. McMillan, “Organizational Diseconomies of Scale,” Journal of Economics and Management Strategy 4 (1996): 399–426.

26. L. Rapping, “Learning and World War II Production Functions,” Review of Economics and Statistics (February 1965): 81–86.

27. L. Argote, S. L. Beckman, and D. Epple, “The Persistence and Transfer of Learning in Industrial Settings,”Management Science 36 (1990): 140–154; M. Zollo and S. G. Winter, “Deliberate Learning and the Evolution of Dynamic Capabilities,” Organization Science 13 (2002): 339–351.

28. J. Womack and D. T. Jones, “From Lean Production to Lean Enterprise,” Harvard Business Review (March/April 1994); J. Womack and D. T. Jones, “Beyond Toyota: How to Root Out Waste and Pursue Perfection,” Harvard Business Review (September/ October, 1996).

29. M. Hammer and J. Champy, Re-engineering the Corporation: A Manifesto for Business Revolution (New York: HarperBusiness, 1993): 32.

30. V. Glover and M. L. Marcus, “Business Process Transformation,” Advances in Management Information Systems 9 (M. E. Sharpe, March 2008); R. Merrifield, J. Calhoun, and D. Stevens, “The Next Revolution in Productivity,” Harvard Business Review (November 2006): 72–79.

31 F. X. Frei, “Breaking the Tradeoff between Efficiency and Service,” Harvard Business Review (November 2006): 92–103.

32. “Caterpillar to Cut 20,000 Jobs as Downturn Worsens,” Wall Street Journal ( January 28, 2009).

33. Bureau of Labor Statistics, http://www.bls.gov/iag/tgs/ iagauto.htm, accessed July 20, 2015.

34. “Buying Power of Multiproduct Retailers,” OECD Journal of Competition Law and Policy 2 (March, 2000).

35. P. Krugman, “Amazon’s Monopsony Is Not O.K.,” New York Times (October 19, 2014).

36. R. Cyert and J. March, A Behavioral Theory of the Firm (Englewood Cliffs, NJ: Prentice Hall, 1963).

37. H. Leibenstein, “Allocative Efficiency versus X-Efficiency,” American Economic Review 54 ( June 1966): 392–415.

38. “Fighting the Flab,” Economist (March 22, 2014). 39. K. Kase, F. J. Saez, and H. Riquelme, The New Samurais

of Japanese Industry (Cheltenham: Edward Elgar, 2006). 40. M. E. Porter, Competitive Advantage (New York: Free

Press, 1985): 87; and R. S. Kaplan and S. R. Anderson, “Time-Driven Activity-based Costing,” Harvard Business Review (November 2004): 131–138.

41. M. E. Porter, Competitive Advantage (New York: Free Press, 1985): 120.

42. T. Peters, Thriving on Chaos (New York: Knopf, 1987): 56. 43. “Cemex: Cementing a Global Strategy,” Insead Case No.

307-233-1 (2007). 44. The distinction between segmentation and differentia-

tion is discussed in P. R. Dickson and J. L. Ginter, “Market Segmentation, Product Differentiation and Marketing Strategy,” Journal of Marketing 51 (April 1987): 1–10.

45. S. Schiffman, M. Reynolds, and F. Young, Introduction to Multidimensional Scaling: Theory, Methods, and Applications (Cambridge, MA: Academic Press, 1981).

46. F.-J. Lapointe and P. Legendre, “A Classification of Pure Malt Scotch Whiskies,” Applied Statistics 43 (1994): 237– 257. On the principles of MDS, see I. Borg and

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 203

P. Groenen, Modern Multidimensional Scaling: Theory and Application (New York: Springer-Verlag, 1997).

47. P. Cattin and D. R. Wittink, “Commercial Use of Conjoint Analysis: A Survey,” Journal of Marketing 46 (Summer 1982): 44–53.

48. K. Lancaster, Consumer Demand: A New Approach (New York: Columbia University Press, 1971).

49. P. Nicolaides and C. Baden-Fuller, Price Discrimination and Product Differentiation in the European Domestic Appliance Market (London: Center for Business Strategy, London Business School, 1987).

50. A. Maslow, “A Theory of Human Motivation,” Psychological Review 50 (1943): 370–396.

51. “Coke Lore: The Real Story of New Coke,” www.theco- cacolacompany.com/heritage/cokelore_newcoke.html, accessed July 20, 2015.

52. S. Zadek, “The Path to Corporate Responsibility,” Harvard Business Review, 82 (December, 2004): 125–129.

53. Porter, Competitive Advantage, op. cit.,124–125. 54. S. Mathur, “Competitive Industrial Marketing Strategies,”

Long Range Planning 17 (1984): 102–109. 55. K. R. Tuli, A. K. Kohli, and S. G. Bharadwaj, “Rethinking

Customer Solutions: From Product Bundles to Relational Processes,” Journal of Marketing 71, (2007): 1–17.

56. K. Clark and T. Fujimoto, Product Development Performance (Boston: Harvard Business School Press, 1991): 29–30.

57. K. B. Clark and T. Fujimoto, “The Power of Product Integrity,” Harvard Business Review (November/ December, 1990): 107–118.

58. “The Madoff Affair: Going Down Quietly,” Economist (March 14, 2009).

59. D. J. Watts and J. Peretti, “Viral Marketing for the Real World,” Harvard Business Review (May 2007): 22–23.

60. M. E. Porter, Competitive Strategy (New York: Free Press, 1980): 42.

8 Industry Evolution and Strategic Change

No company ever stops changing . . . Each new generation must meet changes—in the automotive market, in the general administration of the enterprise, and in the involvement of the corporation in a changing world. The work of creating goes on.

ALFRED P. SLOAN JR., PRESIDENT OF GENERAL

MOTORS 192337, CHAIRMAN 193756

It is not the strongest of the species that survive, nor the most intelligent, but the one that is most responsive to change.

CHARLES DARWIN

You keep same-ing when you ought to be changing.

LEE HAZLEWOOD, THESE BOOTS ARE MADE FOR WALKING,

RECORDED BY NANCY SINATRA, 1966

O U T L I N E

◆ Introduction and Objectives

◆ The Industry Life Cycle

● Demand Growth

● Creation and Diffusion of Knowledge

● How General Is the Life-Cycle Pattern?

● Implications of the Life Cycle for Competition and Strategy

◆ The Challenge of Organizational Adaptation and Strategic Change

● Why is Change so Difficult? The Sources of Organizational Inertia

● Organizational Adaptation and Industry Evolution

● Coping with Technological Change

◆ Managing Strategic Change

● Dual Strategies and Organizational Ambidexterity

● Combatting Organizational Inertia

● Developing New Capabilities

● Dynamic Capabilities

● Using Knowledge Management to Develop Organizational Capability

◆ Summary

◆ Self-Study Questions

◆ Notes

206 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Introduction and Objectives

Everything is in a state of constant change—the business environment especially. One of the great- est challenges of strategic management is to ensure that the firm keeps pace with changes occur- ring within its environment.

Change in the industry environment is driven by the forces of technology, consumer needs, politics, economic development, and a host of other influences. In some industries, these forces for change combine to create massive, unpredictable changes. In telecommunications new digital and wireless technologies combined with regulatory changes have resulted in an industry which in 2015 is almost unrecognizable from that which existed 25 years ago. In other industries—food processing, railroads, and car rental—change is more gradual and more predictable. Change is not just the result of external forces: the competitive strategies of firms are key drivers of change—industries are being continually recreated by competition.

The purpose of this chapter is to help us to understand and manage change. To do this we shall explore the forces that drive change and look for patterns that can help us to predict how industries are likely to evolve over time. While each industry follows a unique development path, there are common drivers of change that give rise to similar patterns of change, thereby allowing us to identify opportunities for competitive advantage.

Understanding, even predicting, change in an industry’s environment is difficult. But an even greater challenge is adapting to change. For individuals change is disruptive, costly, and uncom- fortable. For organizations the forces of inertia are even stronger. As a result, the life cycles of firms tend to be much shorter than the life cycles of industries: changes at the industry level tend to occur through the death of existing firms and the birth of new firms rather than through continuous adaptation by a constant population of firms. We need to understand these sources of inertia in organizations in order to overcome them. We also need to look beyond adaptation to see the poten- tial for a firm to initiate change. What determines the ability of some firms to become game-chang- ers in their industries?

Whether adapting to or initiating change, competing in a changing world requires the develop- ment of new capabilities. How difficult can this be? The short answer is “Very.” We will look not just at the challenges of building new capabilities but also at the approaches that organizations can take to overcome these difficulties.

By the time you have completed this chapter, you will be able to:

◆ Recognize the different stages of industry development and understand the factors that drive the process of industry evolution.

◆ Identify the key success factors associated with industries at different stages of their devel- opment and recommend strategies, organizational structures, and management systems appropriate to these stages.

◆ Appreciate the sources of organizational inertia, the challenges of managing strategic change, and be familiar with different approaches to strategic change—including the use of scenario analysis and the quest for ambidexterity.

CHAPTER 8 INDUSTRY EVOLUTION AND STRATEGIC CHANGE 207

The Industry Life Cycle

One of the best-known and most enduring marketing concepts is the product life cycle.1 Products are born, their sales grow, they reach maturity, they go into decline, and they ultimately die. If products have life cycles, so the industries that produce them experience an industry life cycle. To the extent that an industry produces multiple generations of a product, the industry life cycle is likely to be of longer duration than that of a single product.

The life cycle comprises four phases: introduction (or emergence), growth, matu- rity, and decline (Figure 8.1). Let us first examine the forces that drive industry evolution, and then look at the features of each of these stages. Two forces are fun- damental: demand growth and the production and diffusion of knowledge.

Demand Growth The life cycle and the stages within it are defined primarily by changes in an indus- try’s growth rate over time. The characteristic profile is an S-shaped growth curve.

● In the introduction stage, sales are small and the rate of market penetration is low because the industry’s products are little known and customers are few. The novelty of the technology, small scale of production, and lack of experience mean high costs and low quality. Customers for new products tend to be affluent, innovation-oriented, and risk-tolerant.

◆ Become familiar with the different approaches that firms have taken in developing orga- nizational capabilities—and the merits and pitfalls of each.

◆ Recognize the principal tools of knowledge management and the roles they can play in developing organizational capability.

FIGURE 8.1 The industry life cycle

INTRODUCTION

GROWTH

MATURITY

DECLINE

In du

st ry

S al

es

Time

208 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

● The growth stage is characterized by accelerating market penetration as tech- nical improvements and increased efficiency open up the mass market.

● Increasing market saturation causes the onset of the maturity stage. Once saturation is reached, demand is wholly for replacement.

● Finally, as the industry becomes challenged by new industries that produce tech- nologically superior substitute products, the industry enters its decline stage.

Creation and Diffusion of Knowledge The second driver of the industry life cycle is knowledge. New knowledge in the form of product innovation is responsible for an industry’s birth, and the dual pro- cesses of knowledge creation and knowledge diffusion exert a major influence on industry evolution.

In the introduction stage, product technology advances rapidly. There is no domi- nant product technology, and rival technologies compete for attention. Competition is primarily between alternative technologies and design configurations:

● The first 30 years of steam ships featured competition between paddles and propellers, wooden hulls and iron hulls, and, eventually, between coal and oil.

● The beginnings of the home computer industry during 1978–1982 saw com- petition between different data storage systems (audiotapes versus floppy disks), visual displays (TV receivers versus dedicated monitors), operating systems (CPM versus DOS versus Apple II), and microprocessors.

Dominant Designs and Technical Standards The outcome of competition between rival designs and technologies is usually convergence by the industry around a dominant design—a product architecture that defines the look, functional ity, and production method for the product and becomes accepted by the industry as a whole. Dominant designs have included:

● The Underwood Model 5 introduced in 1899 established the basic architec- ture and main features of typewriters for the 20th century: a moving carriage, the ability to see the characters being typed, a shift function for upper-case characters, and a replaceable inked ribbon.2

● Leica’s Ur-Leica camera launched in Germany in 1924 established key fea- tures of the 35 mm camera, though it was not until Canon began mass-pro- ducing cameras based on the Leica original that this design of 35 mm camera came to dominate still photography.

● When Ray Kroc opened his first McDonald’s hamburger restaurant in Illinois in 1955, he established what would soon become a dominant design for the fast-food restaurant industry: a limited menu, no waiter service, eat-in and take-out options, roadside locations for motorized customers, and a franchis- ing model of business system licensing.

The concepts of dominant design and technical standard are related but distinct. Dominant design refers to the overall configuration of a product or system.

CHAPTER 8 INDUSTRY EVOLUTION AND STRATEGIC CHANGE 209

A technical standard is a technology or specification that is important for compat- ibility. While technical standards typically embody intellectual property in the form of patents or copyright, dominant designs usually do not. A dominant design may or may not embody a technical standard. IBM’s PC established both a dominant design for personal computers and the “Wintel” standard. Conversely, the Boeing 707 was a dominant design for large passenger jets but did not set industry standards in aerospace technology that would dominate subsequent generations of airplanes. Technical standards emerge where there are network effects—the need for users to connect in some way with one another. Network effects cause each customer to choose the same technology as everyone else to avoid being stranded. Unlike a pro- prietary technical standard, which is typically embodied in patents or copyrights, a firm that sets a dominant design does not normally own intellectual property in that design. Hence, except for some early-mover advantage, there is not necessarily any profit advantage from setting a dominant design.

Dominant designs also exist in processes. In the flat glass industry there has been a succession of dominant process designs from glass cylinder blowing to continuous ribbon drawing to float glass.3 Dominant designs are present, too, in business models. In many new markets, competition is between rival business models. In home gro- cery delivery, e-commerce start-ups such as Webvan and Peapod soon succumbed to competition from “bricks and clicks” retailers such as Giant, and Walmart (and Tesco in the UK).

From Product to Process Innovation The emergence of a dominant design marks a critical juncture in an industry’s evolution. Once the industry coalesces around a leading product design, there’s a shift from radical to incremental product innovation. This transition helps inaugurate the industry’s growth phase: greater standardization reduces risks to customers and encourages firms to invest in production capacity. The shift in emphasis from design to manufacture triggers process innovation as firms seek to reduce costs and increase product reliability through large-scale production methods (Figure 8.2). The combination of process improvements, design modifications, and scale economies results in falling costs and greater availability, which in turn drive rapidly increasing market penetration.

FIGURE 8.2 Product and process innovation over time

Time

Product Innovation

Process Innovation

Ra te

o f I

n n

ov at

io n

210 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Strategy Capsule 8.1 uses the history of the automobile industry to illustrate these patterns of development.

Knowledge diffusion is also important on the customer side. Over the course of the life cycle, customers become increasingly informed. As they become more knowledgeable about the performance attributes of rival manufacturers’ prod- ucts, so they are better able to judge value for money and become more price sensitive.

The period 1890–1912 was one of rapid product inno-

vation in the auto industry. After 1886, when Karl Benz

received a patent on his three-wheel motor carriage,

a flurry of technical advances occurred in Germany,

France, the US, and the UK. Developments included:

◆ the first four-cylinder four-stroke engine (by Karl

Benz in 1890);

◆ the honeycomb radiator (by Daimler in 1890);

◆ the manual gearbox (Panhard and Levassor in

1895);

◆ automatic transmission (by Packard in 1904);

◆ electric headlamps (by General Motors in 1908);

◆ the all-steel body (adopted by General Motors in

1912).

Ford’s Model T, introduced in 1908, with its front-

mounted, water-cooled engine and transmission with

a gearbox, wet clutch, and rear-wheel drive, acted

as a dominant design for the industry. During the

remainder of the 20th century, automotive technol-

ogy and design converged. A key indicator of this was

the gradual elimination of alternative technologies

and designs. Volkswagen’s Beetle was the last mass-

produced car with a rear-mounted, air-cooled engine.

Citroen abandoned its distinctive suspension and brak-

ing systems. Four-stroke engines with four or six inline

cylinders became dominant. Distinctive national dif-

ferences eroded as American cars became smaller and

Japanese and Italian cars became bigger. The fall of

the Iron Curtain extinguished the last outposts of non-

conformity: by the mid-1990s, East German two-stroke

Wartburgs and Trabants were collectors’ items.

As product innovation slowed, so process innova-

tion took off. In October 1913, Ford opened its Highland

Park Assembly Plant, with its revolutionary production

methods based on interchangeable parts and a mov-

ing assembly line. Radical productivity improvement

resulted in the price of the Model T falling from $628 in

1908 to $260 in 1924. By 1927, 15 million Model T’s had

been produced.

The second major process innovation in automo-

biles was Toyota’s system of lean production, involving a

tightly integrated “pull” system of production embody-

ing just-in-time scheduling, team-based production,

flexible manufacturing, and total quality management.

During the 1970s and 1980s, lean production diffused

throughout the world’s vehicle industry in the same

way that Ford’s mass-production system had trans-

formed the industry half a century before.

However, by 2015 this period of technological sta-

bility was threatened by two developments: electric

cars and driverless cars.

Sources: www.ford.com; http://en.wikipedia.org/wiki/ History_of_the_automobile.

STRATEGY CAPSULE 8.1

Evolution of the Automobile Industry

CHAPTER 8 INDUSTRY EVOLUTION AND STRATEGIC CHANGE 211

How General Is the Life-Cycle Pattern? To what extent do industries conform to this life-cycle pattern? To begin with, the duration of the life cycle varies greatly from industry to industry:

● The hotel industry has its origins over two millennia ago. In year 1 AD, the baby Jesus was born in a stable in Bethlehem because, according to Luke’s Gospel, “there was no room at the inn.” In the US, hotels (as distinct from inns) were established in the late 18th century. After World War II, the indus- try grew rapidly with expanding tourism and business travel. However, dur- ing the 21st century the industry began making the transition from maturity to decline with the growth of videoconferencing and advent of residential sharing services such as Airbnb.

● The introduction phase of the US railroad industry extended from the build- ing of the first railroad, the Baltimore and Ohio in 1827, to the growth phase of the 1870s. With the growth of road transport, the industry entered its decline phase during the late 1950s.

● In personal computers, the introduction phase lasted a mere four years before growth took off in 1978. Between 1978 and 1983, a flood of new and established firms entered the industry. During the 1990s, growth slowed, excess capacity emerged, and the industry began to consolidate around fewer companies. In 2011, global sales of PCs peaked and the industry entered its decline phase.

● Digital audio players (MP3 players) were first introduced by Seehan Information Systems and Diamond Multimedia in 1997. With the launch of Apple’s iPod in 2001, the industry entered its growth phase. After reaching a peak in 2009, global sales of MP3 players, including the iPod, went into steep decline. By 2015, dedicated MP3 players were widely viewed as obsolete.

Over time, industry life cycles have become increasingly compressed. This is especially evident in e-commerce. The speed of diffusion of online gambling, online taxi services, and social networking have reduced the time from initial introduc- tion to maturity to a few years. The implication is that “competing on internet time” requires a radical rethink of strategies and management processes.4

Patterns of evolution also differ. Industries supplying basic necessities such as res- idential construction, food processing and clothing may never enter a decline phase because obsolescence is unlikely for such needs. Some industries may experience a rejuvenation of their life cycle. The market for TV receivers has experienced mul- tiple revivals: color TVs, portable TVs, flat-screen TVs, and HDTVs. Similar waves of innovation have revitalized retailing (Figure 8.3).

An industry is likely to be at different stages of its life cycle in different countries. Although the automobile markets of the EU, Japan, and the US are in their decline phase, those of Asia and Latin America are in their growth phase. Multinational companies can exploit such differences: developing new products and introducing them into the advanced industrial countries, then shifting attention to other growth markets once maturity sets in.

A further feature of industry evolution is shifting industry boundaries—some industries converge (cell phones, portable game players, cameras, and calculators);

212 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

other industries, (banking, medical services) fragment. To understand the dynamics of industry change, we may need to look at clusters of related industries.5

Implications of the Life Cycle for Competition and Strategy Changes in demand growth and technology over the cycle have implications for industry structure, the population of firms, and competition. Table 8.1 summarizes the principal features of each stage of the industry life cycle.

Product Differentiation The introduction stage typically features a wide variety of product types that reflect the diversity of technologies and designs—and the lack of consensus over customer requirements. Convergence around a dominant design is often followed by commoditization during the mature phase unless pro- ducers develop new dimensions for differentiation. Personal computers, credit cards, online financial services, wireless communication services, and internet access have all become commodity items which buyers select primarily on price. However, the trend toward commoditization also creates incentives for firms to create novel approaches to differentiation.

Organizational Demographics and Industry Structure The number of firms in an industry changes substantially over the life cycle. The field of organizational ecology, founded by Michael Hannan, John Freeman, and Glen Carroll, analyzes the population of industries and the processes of founding and selection that determine entry and exit.6 Some of the main findings of the organizational ecologists in relation to industry evolution are:

● The number of firms in an industry increases rapidly during the early stages of an industry’s life. Initially, an industry may be pioneered by a few firms. However, as the industry gains legitimacy, failure rates decline and the rate of new firm foundings increases. The US automobile industry comprised 272 manufacturers in 1909,7 while in TV receivers there were 92 companies in

FIGURE 8.3 Innovation and renewal in the industry life cycle: Retailing

Mail Order, Catalogue Retailers e.g., Sears Roebuck,

Montgomery Ward

Chain Stores

e.g., A&P, Woolworth’s,

WHSmith

Warehouse Clubs

e.g., Price Club Sam’s Club

Department Stores

e.g., Le Bon Marché, Macy’s, Harrods

Discount Stores

e.g., K-Mart Walmart

Category Killers

e.g., Toys “R” Us, Home

Depot

Internet Retailers

e.g., Amazon, Alibaba

Pop-Up Stores

2000 1980196019401920190018801840

CHAPTER 8 INDUSTRY EVOLUTION AND STRATEGIC CHANGE 213

1951.8 New entrants have very different origins. Some are start-up compa- nies (de novo entrants); others are established firms diversifying from related industries (de alio entrants).

● With the onset of maturity, the number of firms begins to fall. Very often, industries go through one or more shakeout phases during which the rate of firm failure increases sharply. After this point, rates of entry and exit decline and the survival rate for incumbents increases substantially.9 The shakeout phase of intensive acquisition, merger, and exit occurs, on aver- age, 29 years into the life cycle and results in the number of producers being halved.10 In the US tire industry, the number of firms grew from one (Goodrich) in 1896 to 274 in 1922 before shakeout reduced the industry to 49 firms in 1936.11

● As industries become increasingly concentrated and the leading firms focus on the mass market, so a new phase of entry may take place as new firms create niche positions in the market. An example of this resource partitioning

TABLE 8.1 The evolution of industry structure and competition over the life cycle

Introduction Growth Maturity Decline

Demand Limited to early adopters: high-income, avant-garde

Rapidly increasing market penetration

Mass market, replacement/ repeat buying. Customers knowledgeable and price sensitive

Obsolescence

Technology Competing technolo- gies, rapid product innovation

Standardization around dominant technology, rapid process innovation

Well-diffused technical know-how: quest for technological improvements.

Little product or pro- cess innovation

Products Poor quality, wide variety of features and technologies, frequent design changes

Design and quality improve, emer- gence of dominant design

Trend to commoditization. Attempts to differentiate by branding, quality, and bundling

Commodities the norm: differentia- tion difficult and unprofitable

Manufacturing and distribution

Short production runs, high-skilled labor content, spe- cialized distribution channels

Capacity shortages, mass production, competition for distribution

Emergence of overcapacity, deskilling of production, long production runs, distributors carry fewer lines

Chronic overcapacity, reemergence of specialty channels

Trade Producers and consumers in advanced countries

Exports from advanced countries to rest of world

Production shifts to newly industrializing then devel- oping countries

Exports from coun- tries with lowest labor costs

Competition Few companies Entry, mergers, and exits

Shakeout, price competition increases

Price wars, exits

Key success factors

Product innovation, establishing cred- ible image of firm and product

Design for manu- facture, access to distribution, brand building, fast prod- uct development, process innovation

Cost efficiency through capital intensity, scale efficiency, and low input costs

Low overheads, buyer selection, signaling commit- ment, rationalizing capacity

214 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

is the US brewing industry: as the mass market became dominated by a handful of national brewers, so opportunities arose for new types of brewing companies—microbreweries and brew pubs—to establish themselves in spe- cialist niches.12

However, in different industries structural change follows very different paths. In most industries maturity is associated with increasing concentration, but where scale economies are unimportant and entry barriers are low, maturity and commoditization may cause concentration to decline (as in credit cards, television broadcasting, and processed foods).

Location and International Trade Industries migrate internationally dur- ing their life cycles. New industries begin in the advanced industrial countries because of the presence of affluent consumers and the availability of technical and scientific resources. As demand grows in other countries, they are serviced initially by exports, but a reduced need for sophisticated labor skills makes pro- duction attractive in newly industrialized countries. The advanced industrialized countries begin to import. With maturity, commoditization, and deskilling of pro- duction processes, production eventually shifts to developing countries where labor costs are lowest.

At the beginning of the 1990s, the production of wireless handsets was concen- trated in the US, Japan, Finland, and Germany. By the end of the 1990s, South Korea had joined this leading group. In 2014, almost 75% of the world’s mobile phones were produced in China.

The Nature and Intensity of Competition These changes in industry struc- ture over the life cycle—commoditization, new entry, and international diffusion of production—have implications for competition: first, a shift from non-price competition to price competition; second, margins shrink as the intensity of com- petition grows.

During the introduction stage, the battle for technological leadership means that price competition may be weak, but heavy investments in innovation and market development depress profitability. The growth phase is more conducive to prof- itability as market demand outstrips industry capacity, especially if incumbents are protected by barriers to entry. With the onset of maturity, increased product standardization and excess capacity stimulate price competition, especially during shakeout. How intense this is depends a great deal on the balance between capacity and demand and the extent of international competition. In food retailing, airlines, motor vehicles, metals, and insurance, maturity was associated with strong price competition and slender profitability. In household detergents, breakfast cereals, cosmetics, and cigarettes, high seller concentration and strong brands have limited price rivalry and supported high margins. The decline phase is almost always associ- ated with strong price competition (often degenerating into destructive price wars) and dismal profit performance.

Key Success Factors and Industry Evolution These same changes in structure together with changes in demand and technology over the industry life cycle also have important implications for the sources of competitive advantage at each stage of industry evolution:

CHAPTER 8 INDUSTRY EVOLUTION AND STRATEGIC CHANGE 215

1 During the introductory stage, product innovation is the basis for initial entry and for subsequent success. Soon, other requirements for success emerge: grow- ing investment requirements necessitate increased financial resources; product development needs to be supported by capabilities in manufacturing, market- ing, and distribution.

2 Once the growth stage is reached, the key challenge is scaling up. As the mar- ket expands, product design and manufacturing must adapt to the needs of large-scale production. As Figure 8.4 shows, investment in R & D, plant and equipment, and sales tends to be high during the growth phase. Increased manufacturing must be matched by widening distribution.

3 With the maturity stage, competitive advantage is increasingly a quest for effi- ciency, particularly in industries that tend toward commoditization. Cost efficiency through scale economies, low wages, and low overheads becomes the key suc- cess factor. Figure 8.4 shows that R & D, capital investment, and marketing are lower in maturity than during the growth phase.

4 The transition to decline intensifies pressures for cost cutting. It also requires maintaining stability by encouraging the orderly exit of industry capacity and capturing residual market demand. We consider the strategic issues presented by mature and declining industries more fully in Chapter 10.

FIGURE 8.4 Differences in strategy and performance between businesses at different stages of the industry life cycle

12

10

8

6

4

2

0

R O

I

V al

u e

A d

d ed

/R ev

en u

e

Te ch

n ic

al C

h an

g e

N ew

P ro

d u

ct s

% S

al es

fr o

m N

ew Pr

o d

u ct

s

Pr o

d u

ct R

& D

/S al

es

A g

e o

f P la

n t

an d

Eq u

ip m

en t

In ve

st m

en t/

Sa le

s

A d

ve rt

is in

g /S

al es

Growth

Maturity

Decline

Note: The figure shows standardized means for each variable for businesses at each stage of the life cycle. Source: C. Anderson and C. Zeithaml, “Stage of the Product Life Cycle, Business Strategy and Business Performance,” Academy of Management Journal 27 (1984): 5–24.

216 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

The Challenge of Organizational Adaptation and Strategic Change

We have established that industries change. But what about the companies within them? Let us turn our attention to business enterprises and consider both the impedi- ments to change and the means by which change takes place.

Why is Change so Difficult? The Sources of Organizational Inertia At the heart of all approaches to change management is the recognition that organi- zations find change difficult. Why is this so? Different theories of organizational and industrial change emphasize different barriers to change:

● Organizational routines: Evolutionary economists emphasize the fact that capabilities are based on organizational routines—patterns of coordinated interaction among organizational members that develop through continual repetition. The more highly developed are an organization’s routines, the more difficult it is to develop new routines. Hence, organizations get caught in competency traps13 where “core capabilities become core rigidities.”14

● Social and political structures: Organizations are both social systems and political systems. As social systems, organizations develop patterns of interaction that make organizational change stressful and disruptive.15 As political systems, organizations develop stable distributions of power; change represents a threat to the power of those in positions of authority. Hence, both as social systems and political systems, organizations tend to resist change.

● Conformity: Institutional sociologists emphasize the propensity of firms to imitate one another in order to gain legitimacy. The process of institutional isomorphism locks organizations into common structures and strategies that make it difficult for them to adapt to change.16 The pressures for confor- mity can be external—governments, investment analysts, banks, and other resource providers encourage the adoption of similar strategies and structures. Isomorphism also results from voluntary imitation—risk aversion encourages companies to adopt similar strategies and structures to their peers.17

● Limited search: The Carnegie School of organizational theory (associated with Herbert Simon, Jim March, and Richard Cyert) views search as the primary driver of organizational change. Organizations tend to limit search to areas close to their existing activities—they prefer exploitation of existing knowl- edge over exploration for new opportunities.18 Limited search is reinforced, first, by bounded rationality—human beings have limited information pro- cessing capacity, which constrains the set of choices they can consider and, second, by satisficing—the propensity for individuals (and organizations) to terminate the search for better solutions when they reach a satisfactory level of performance rather than to pursue optimal performance. The implication is that organizational change is triggered by declining performance.

● Complementarities between strategy, structure, and systems: The notion of fit is a core principle of management. Chapter 1 discussed the need for strat- egy to fit with the firm’s external environment and its internal resources

CHAPTER 8 INDUSTRY EVOLUTION AND STRATEGIC CHANGE 217

and capabilities, and observed that strategy is manifest as an activity system. Chapter 6 referred to contingency theory: the idea that an organization’s opti- mal design is determined by its environment and strategy. Ultimately, all the features of an organization—strategy, structure, systems, culture, goals, and employee skills—are complementary.19 Organizations establish complex, idio- syncratic combinations of multiple characteristics during their early phases of development in order to match the conditions of their business environment. However, once established, this complex configuration becomes a barrier to change. To respond to a change in its external environment, it is not enough to make incremental changes in a few dimensions of strategy—it is likely that the firm will need to find a new configuration that involves a comprehensive set of changes (Strategy Capsule 8.2).20 The implication is that organizations

During the 1980s, Liz Claiborne became a highly suc-

cessful designer, manufacturer, and retailer of clothes for

professional women. Liz Claiborne’s success was based

upon a strategy that combined a number of closely

linked choices concerning functions and activities.

◆ Design was based around a “color by numbers”

approach involving “concept groups” of different

garments that could be mixed and matched.

◆ Department stores were encouraged to provide

dedicated space to present Liz Claiborne’s concept

collections. Liz Claiborne consultants visited depart-

ment stores to train their sales staff and to ensure

that the collections were being displayed correctly.

◆ Retailers could not purchase individual garment

lines; they were required to purchase the entire

concept group and had to submit a single order

for each season—they could not reorder.

◆ Most manufacturing was contracted out to gar-

ment makers in SE Asia.

◆ To create close contact with customers, Liz Claiborne

offered fashion shows at department stores, “break-

fast clinics” where potential customers could see the

latest collection, and tracked customer preferences

through point-of-sale data collection.

◆ Rather than the conventional four-season product

cycle, Liz Claiborne operated a six-season cycle.

During the 1990s, Liz Claiborne’s performance

went into a sharp decline. The key problem was the

trend toward more casual clothes in the workplace.

Moreover, financial pressures on department stores

made them less willing to buy complete collections.

As a result Liz Claiborne allowed reordering by retailers.

However, once retailers could split orders into smaller,

more frequent orders, the entire Liz Claiborne system

began to break down: it could not adapt to the quick-

response, fast-cycle model that was increasingly domi-

nant within the garment trade. In 1994, Liz Claiborne

appointed a new CEO who systematically rebuilt the

business around a more casual look more flexibility

within its collections (although still with a common

“color card”), and a shorter supply chain, with most pro-

duction in North and Central America.

Source: N. Siggelkow, “Change in the Presence of Fit: The Rise, the Fall, and the Renaissance of Liz Claiborne,” Academy of Management Journal 44 (2001): 838–57.

STRATEGY CAPSULE 8.2

A Tight-Fitting Business System Makes Change Perilous: The Liz Claiborne Story

218 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

tend to evolve through a process of punctuated equilibrium, involving long periods of stability during which the widening misalignment between the organization and its environment ultimately forces radical and comprehensive change on the company.21 This typically requires a change in leadership.

Organizational Adaptation and Industry Evolution Thinking about industrial and organizational change has been strongly influenced by ideas from evolutionary biology. Evolutionary change is viewed as an adaptive process that involves variation, selection, and retention.22 The key issue is the level at which these evolutionary processes occur:

● Organizational ecology has been discussed in relation to changes in the number of firms in an industry over time. However, organizational ecology is a broader theory of economic change based on the assumption of organi- zational inertia. As a result, industry evolution occurs through changes in the population of firms rather than by adaptation of firms themselves. Industries develop and grow through new entry spurred by the imitation of initial suc- cessful entrants. The competitive process is a selection mechanism, in which organizations whose characteristics match the requirements of their environ- ment can attract resources; those that do not are eliminated.23

● Evolutionary economics focuses upon individual organizations as the primary agents of change. The process of variation, selection, and retention takes place at the level of the organizational routine—unsuccessful routines are abandoned; successful routines are retained and replicated within the organi- zation.24 As we discussed in Chapter 5, these patterns of coordinated activity are the basis for organizational capability. While evolutionary theorists view firms as adapting to external change through the search for new rou- tines, replication of successful routines, and abandonment of unsuccessful routines, such adaptation is neither fast nor costless.

Empirical evidence points to the importance of both processes. The ability of some companies to adapt is indicated by the fact that many have been leaders in their industries for a century or more—BASF, the world’s largest chemical company, has been a leader in chemicals since it was founded in 1865 as a producer of syn- thetic dyes. Exxon and Shell have led the world’s petroleum industry since the late 19th century.25 Budweiser Budvar, the Czech beer company (that has a long-running trademark dispute with Anheuser-Busch) traces its origins to 1785. Mitsui Group, a Japanese conglomerate, is even older—its first business, a retail store, was estab- lished in 1673.

Yet these companies are exceptions. Among the companies forming the original Dow Jones Industrial Average in 1896, only General Electric remains in the index today. Of the world’s 12 biggest companies in 1912, just two were in the top 12 by 2015 (Table 8.2). And life spans are shortening: the average period in which compa- nies remained in the S&P 500 was 90 years in 1935; in 1958 it was 61 years; by 2011 it was down to 18 years.

The demise of great companies partly reflects the rise of new industries—notably the information and communications technology (ICT) sector, but also the failure of established firms to adapt successfully to the life cycles of their own industries.

CHAPTER 8 INDUSTRY EVOLUTION AND STRATEGIC CHANGE 219

Even though the industry life cycle involves changes that are largely predictable, changing key success factors implies that the different stages of the life cycle require different resources and capabilities. The innovators that pioneer the creation of a new industry are typically different companies from the “consolidators” that develop it:

The fact that the firms that create new product and service markets are rarely the ones that scale them into mass markets has serious implications for the modern corporation. Our research points to a simple reason for this phenomenon: the skills, mind-sets, and competences needed for discovery and invention are not only different from those needed for commercialization; they conflict with the needed characteristics. This means that the firms good at invention are unlikely to be good at commercialization and vice versa.26

The typical pattern is that technology-based start-ups that pioneer new areas of business are acquired by companies that are well established in closely related industries, and these established incumbents offer the financial resources and func- tional capabilities needed to grow the start-up. In plant biotechnology, the pioneers were start-ups such as Calgene, Cetus Corporation, DNA Plant Technologies, and Mycogen; by 2015, the leading suppliers of genetically modified seeds were DuPont, Monsanto, Syngenta, and Dow Chemical—all long-established chemical firms. Of course, some start-ups do survive industry shakeouts and acquisition to become industry leaders: Google, Cisco Systems, and Facebook are examples. Geoffrey Moore describes the transition from a start-up serving early adopters to an estab- lished business serving mainstream customers as “crossing the chasm.”27

In most new industries we find a mixture of start-up companies (de novo entrants) and established companies that have diversified from other sectors (de alio entrants). Which are likely to be more successful? The basic issue is whether the flexibility and entrepreneurial advantages of start-ups outweigh the superior resources and

TABLE 8.2 World’s biggest companies in terms of market capitalization, 1912 and 2015

1912 $billion 2015 $billion

US Steel 0.74 Apple 637 Standard Oil NJ (Exxon) 0.39 ExxonMobil 393 J&P Coates 0.29 Microsoft 385 Pullman 0.20 Johnson & Johnson 292 Royal Dutch Shell 0.19 Wells Fargo 282 Anaconda 0.18 Walmart 277 General Electric 0.17 Novartis 252 Singer 0.17 General Electric 249 American Brands 0.17 China Mobile 240 Navistar 0.16 Nestlé 237 British American Tobacco 0.16 Chevron 213 De Beers 0.16 China Construction Bank 201

Sources: L. Hannah “Marshall’s ‘Trees’ and the Global ‘Forest’: Were ‘Giant Redwoods’ Different?” in N. Lamoreaux, D. Raff, and P. Temin (eds), Learning by Doing in Markets, Firms and Nations, Chicago: University of Chicago Press, 1999: 253–94; Financial Times (January 3, 2015).

220 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

capabilities of established firms. This further depends upon whether the resources and capabilities required in the new industry are similar to those present in an exist- ing industry. Where these linkages are close, de alio entrants are at an advantage: in automobiles, former bicycle, carriage, and engine manufacturers tended to be the best performers;28 television production was dominated by former producers of radios.29

Many start-up ventures also draw resources and capabilities from established firms. A high proportion of new ventures are established by former employees of existing firms within that sector. In Silicon Valley most of the leading semiconductor firms, including Intel, trace their origins to Shockley Semiconductor Laboratories, the pioneer of integrated circuits.30 Established companies are often important investors in new ventures. Investors in Uber include the Chinese internet giant Baidu and the founders of Amazon, Napster, and Yelp.

Coping with Technological Change Competition between new start-ups and established firms is not just a feature of the early phases of an industry’s life cycle: it is ongoing. The greatest threat that new- comers pose to established firms is during periods of technological change. New technology is especially challenging to incumbents when it is “competence destroy- ing,” when it is “architectural,” and when it is “disruptive.”

Competence enhancing and competence destroying technological change Some technological changes undermine the resources and capabilities of estab- lished firms—according to Tushman and Anderson, they are “competence destroy- ing.” Other changes are “competence enhancing”—they preserve, even strengthen, the resources add capabilities of incumbent firms.31 The quartz watch radically undermined the competence base of mechanical watchmakers. Conversely, the tur- bofan, a major advance in jet engine technology, reinforced the capability base of existing aero engine manufacturers. The key issue is how the new technology influ- ences the strategic importance of resources and capabilities possessed by estab- lished firms. In the typesetting industry, the ability of incumbent firms to withstand the transition to radically new technologies rested upon the continuing importance of certain key resources: customer relationships, sales and service networks, and font libraries.32

Architectural and Component Innovation The ease with which established firms adapt to technological change depends upon whether the innovation occurs at the component or the architectural level. Henderson and Clark argue that innova- tions which change the overall architecture of a product create great difficulties for established firms because an architectural innovation requires a major reconfigura- tion of a company’s strategy and activity system.33 In automobiles, the hybrid engine was an important innovation but did not require a major reconfiguration of car design and engineering. The battery-powered electric motor is an architectural innovation— it requires redesign of the entire car and involves carmakers in creating systems for recharging. In many sectors of e-commerce—online grocery purchases and online banking—the internet involved innovation at the component level (it provided a new channel of distribution for existing products). Hence, existing supermarket chains and established retail banks with their clicks and bricks business models have dominated

CHAPTER 8 INDUSTRY EVOLUTION AND STRATEGIC CHANGE 221

online groceries and online financial services.The rise of Boeing during the 1960s to become the world’s leading producer of passenger aircraft was primarily because of its recognition that the jet engine was an architectural innovation that necessitated a major redesign of airplanes.34

Disruptive Technologies Clay Christiansen distinguishes between new technol- ogy that is sustaining—it augments existing performance attributes—and new tech- nology that is disruptive—it incorporates different performance attributes than the existing technology.35

Steam-powered ships were initially slower, more expensive, and less reliable than sailing ships. The leading shipbuilders failed to make the transition to steam power because their leading customers, the transoceanic shipping companies, remained loyal to sail until after the turn of the 20th century. Steam power was used mainly for inland waters, which lacked constant winds. After several decades of gradual development for these niche markets, stream-powered ships were able to outper- form sailing ships on ocean routes.

In the disk-drive industry, some technological innovations—such as thin-film heads and more finely dispersed ferrous oxide coatings—enhanced the dominant perfor- mance criterion, recording density, reinforcing the market positions of established industry leaders. Other disk-drive technologies, notably new product generations with smaller diameters, were disruptive: established companies lagged behind newcom- ers in launching the new disk sizes and typically lost their industry leadership.36 They stored less data and were resisted by major customers. Thus, the 3.5-inch disk was intro- duced by Connor Peripherals (mainly for use in laptop computers), but was initially rejected by industry leader, Seagate. Within three years the rapid development of the 3.5-inch disk had rendered the 5.25-inch disk obsolete.37

Managing Strategic Change

Given the many barriers to organizational change and the difficulties that companies experience in coping with disruptive technologies and architectural innovation, how can companies adapt to changes in their environment?

Just as the sources of organizational inertia are many, so too are the theo- ries and methods of organizational change. Until the 1980s, most approaches to organizational change were based upon the behavioral sciences and emphasized bottom-up, decentralized initiatives. Socio-technical systems emphasized the need for social systems to adapt to the requirements of new technologies,38 while orga- nizational development (OD) emphasized group dynamics and the role of “change agents.”39

More recently, managing change has become a central topic within strategic management practice and research. In this section we review four approaches to managing strategic change. We begin with the dual challenge of manag- ing for today while preparing for tomorrow and discuss the potential for organizational ambidexterity. Second, we examine management tools for counteracting organizational inertia. Third, we explore the means by which companies develop new capabilities. Finally, we address the role and nature of dynamic capabilities.

222 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Dual Strategies and Organizational Ambidexterity In Chapter 1 we learned that strategy has two major dimensions: positioning for the present and adapting to the future. As we observed then, reconciling the two is diffi- cult. Derek Abell argued that “managing with dual strategies” is the most challenging dilemma that senior managers face:

Running a successful business requires a clear strategy in terms of defining target mar- kets and lavishing attention on those factors which are critical to success; changing a business in anticipation of the future requires a vision of how the future will look and a strategy for how the organization will have to adapt to meet future challenges.40

Abell argues that dual strategies require dual planning systems: short-term planning that focuses on strategic fit and performance over a one- or two-year period; and longer-term planning to develop vision, reshape the corporate port- folio, redefine and reposition individual businesses, develop new capabilities, and redesign organizational structures over periods of five years or more. This challenge of reconciling “competing for today” with “preparing for tomorrow” is closely related to the tradeoff between exploitation and exploration that we discussed in relation to organizational inertia. The observation we made then, concerning the propensity of organizations to favor exploitation over exploration, applies equally to strategy: competing for the present tends to take precedence over preparing for the future.

The capacity to reconcile the two is what Charles O’Reilly and Michael Tushman refer to as “organizational ambidexterity.” The ambidextrous firm is “capable of simultaneously exploiting existing competences and exploring new opportuni- ties.”41 Two types of organizational ambidexterity have been identified: structural and contextual.

Structural Ambidexterity is where exploration and exploitation are undertaken in separate organizational units, on the basis that it is usually easier to foster change initiatives in new organizational units rather in existing ones. For example, faced with the challenge of disruptive technologies, Christensen and Overdorf suggest that established companies develop products and businesses that embody the new technologies in organizationally separate units.42 For example:

● IBM developed its PC in a separate unit in Florida—far from IBM’s corporate headquarters in New York. Its leader, Bill Lowe, claimed that this separation was critical to creating a business system that was radically different from IBM’s core mainframe business.43

● Shell’s GameChanger program was established to develop new avenues for future growth by exploiting innovations and entrepreneurial initiatives that would otherwise be stifled by Shell’s financial system and organizational structure.44 The key challenge is whether the initiatives fostered within the “exploration” unit will lead change within the organization as a whole. Xerox’s Palo Alto Research Center developed many of the innovations that drove the microcomputer revolution of the 1980s and 1990s, but few of these innovations were exploited by Xerox itself. Similarly, the innovative business system established by General Motors’ Saturn division did little to turn GM into “a new kind of car company.”45

CHAPTER 8 INDUSTRY EVOLUTION AND STRATEGIC CHANGE 223

Contextual ambidexterity involves the same organizational units and the same organizational members pursuing both exploratory and exploitative activities. At Oticon, the Danish hearing aid company, employees were encouraged to sustain existing products while pursuing innovation and creativity.46 Under the slogan “Innovation from Everyone, Everywhere” Whirlpool sought to embed innovation throughout its existing organization: “Innovation had been the responsibility of a couple of groups, engineering and marketing. Now, you have thousands of people involved.”47 The problem of contextual ambidexterity is that the management sys- tems and the individual behaviors required for efficient exploitation are incompat- ible with these needed for exploration.

Combatting Organizational Inertia If organizational change follows a process of punctuated equilibrium in which periods of stability are interspersed by periods of intense upheaval, what precipitates these episodes of transformational change? Most large companies exhibit periodic restructur- ing, involving simultaneous changes in strategy, structure, management systems, and top management personnel. Such restructuring typically follows declining performance caused either by a major external shock or by a growing misalignment between the firm and its external environment. For example, the oil and gas majors underwent far- reaching restructuring during 1986–1992 following the oil price decline of 1986.48 If sustained, the oil price decline of 2014 may also trigger far-reaching strategic changes. A challenge for top management is to undertake large-scale change before being pres- sured by declining performance.This may require managers to let go of the beliefs that wed them to the prevailing strategy. Polaroid’s failure to adapt to digital imaging despite developing leading-edge digital-imaging capabilities can be attributed to top manage- ment’s unchanging system of beliefs regarding the company and its strategy.49

Creating Perceptions of Crisis Crises create the conditions for strategic change by loosening the organization’s attachment to the status quo. The problem is that by the time the organization is engulfed in crisis it may already be too late. Hence, a use- ful tool for leaders of change is to create the perception of impending crisis so that necessary changes can be implemented well before a real crisis emerges. At General Electric, even when the company was reporting record profits, Jack Welch was able to convince employees of the need for change in order to defend against emerging threats. Andy Grove’s dictum “Only the paranoid survive” helped Intel to maintain a continual striving for improvement and development despite its dominance of the market for PC microprocessors.

Establishing Stretch Targets Another approach to weakening the powers of organizational inertia is to continually pressure the organizations by means of ambi- tious performance targets. The idea is that performance targets that are achievable but only with an extension of employee effort can motivate creativity and initiative while attacking complacency. Stretch targets are normally associated with short- and medium-term performance goals for individuals and organizational units. However, they also relate to long-term strategic goals. A key role of vision statements and ambitious strategic intent is to create a sustained sense of ambition and organiza- tional purpose. These ideas are exemplified by Collins and Porras’ notion of “Big Hairy Ambitious Goals” that I discussed in Chapter 1. Apple’s success in introducing

224 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

“insanely great” new products owes much to Steve Jobs imposing seemingly impos- sible goals on his product development teams. For the iPod he insisted that it should store thousands of songs, have a battery life exceeding four hours, and be smaller and thinner than any existing mp3 player.50

Organizational Initiatives as Catalysts of Change Chief executives are lim- ited in their ability to initiate and implement organization-wide change. However, by a combination of authoritative and charismatic leadership, they may be able to pioneer specific initiatives with a surprisingly extensive impact. Corporate ini- tiatives sponsored by the CEO are effective for disseminating strategic changes, best practices, and management innovations. At General Electric Jack Welch was an especially effective exponent of using corporate initiatives to drive organizational change. These were built around communicable and compelling slogans such as “Be number 1 or number 2 in your industry,” “GE’s growth engine,” “boundarylessness,” “six-sigma quality,” and “destroy-your-business-dot-com.” Leaders can also have a profound impact through symbolic actions. A key incident in the transformation of the Qingdao Refrigerator Plant into Haier, one of the world’s biggest appliance companies, was when the CEO, Zhang Ruimin, took a sledgehammer to defective refrigerators in front of the assembled workforce.51

Reorganizing Company Structure By reorganizing the structure top manage- ment can redistribute power, reshuffle top management, and introduce new blood. One of the last major actions of CEO Steve Ballmer before retiring in August 2013 was to reorganize Microsoft’s divisional structure in order to break down estab- lished power centers and facilitate the transition to a more integrated company. At General Electric, Jeff Immelt’s quest for a more flexible, collaborative company was supported by five major divisional reorganizations between 2002 and 2014. Periodic changes in organizational structure can stimulate decentralized search and local initiatives while encouraging more effective exploitation of the outcomes of such search.52 Reconciling the benefits of integration and flexibility may require organiza- tions to oscillate between periods of decentralization and periods of centralization.53

New Leadership If strategic change is hampered by management’s adher- ence to outmoded beliefs or if the existing team lacks the diversity of opinion and outlook for new strategic thinking then an outsider may be needed to lead change. Evidence of the relative performance of internal and external CEOs is mixed. However, if an organization is performing poorly, an external CEO tends to be more effective at leading change than an internal appointment.54 Certainly, this was the case of IBM under Lou Gerstner and 3M under Jim McNerney. Organizational change is also stimulated by recruiting new managers from out- side the organization.

Scenario Analysis Adapting to change requires anticipating change. Yet pre- dicting the future is hazardous, if not impossible. “Only a fool would make predic- tions especially about the future,” remarked movie mogul Samuel Goldwyn. But the inability to predict does not preclude preparing for change. Scenario analysis is a systematic way of thinking about how the future might unfold. Scenario analysis is not a forecasting technique, but a process for thinking about and analyzing the future by drawing upon a broad range of information and expertise.

CHAPTER 8 INDUSTRY EVOLUTION AND STRATEGIC CHANGE 225

Herman Kahn, who pioneered their use first at the Rand Corporation, defined sce- narios as “hypothetical sequences of events constructed for the purpose of focusing attention on causal process and decision points.”55 The multiple-scenario approach constructs several distinct, internally consistent views of how the future may look five to 50 years ahead. Its key value is in combining the interrelated impacts of a wide range of economic, technological, demographic, and political factors into a few distinct alternative stories of how the future might unfold. Scenario analysis can be either qualitative or quantitative or a combination of the two. Quantitative scenario analysis builds simulation models to identify likely outcomes. Qualitative scenarios typically take the form of narratives and can be particularly useful in engaging the insight and imagination of decision makers.

Scenario analysis is used to explore paths of industry evolution, the develop- ment of particular countries, and the impact of new technology. However, as with most strategy techniques, the value of scenario analysis is not in the results but in the process. Scenario analysis is a powerful tool for communicating different ideas and insights, surfacing deeply held beliefs and assumptions, identifying possible threats and opportunities, generating and evaluating alternative strategies, encourag- ing more flexible thinking, and building consensus. Evaluating different strategies under different scenarios can help identify which strategies are most robust and force managers to address “what if?” questions. Strategy Capsule 8.3 outlines the use of scenarios at Shell.

Developing New Capabilities Ultimately, adapting to a changing world requires developing the capabilities needed to renew competitive advantage. To recognize the challenges this presents, we need to ask, Where do capabilities come from?

The Origins of Organizational Capability: Early Experiences and Path Dependency Distinctive capabilities can often be traced back to the circumstances which prevailed during companies’ founding and early development. They are subject to path dependency—a company’s capabilities today are the result of its history.56 For example:

● How did Walmart, develop its outstanding capability in supply chain logistics? This super-efficient system of warehousing, distribution, and vendor relation- ships was not the result of careful planning and design; it evolved from the cir- cumstances that Walmart faced during its early years of existence. Its small-town locations in Arkansas and Oklahoma resulted in unreliable delivery from its suppliers; consequently, Walmart established its own distribution system. What about the other capabilities that contribute to Walmart’s remarkable cost effi- ciency? These too can be traced back to Walmart’s origins in rural Arkansas and the values of its founder, Sam Walton.

● Despite a common competitive environment and similar strategies, the world’s leading oil and gas majors display very different capability profiles (Table 8.3). Industry leaders ExxonMobil and Royal Dutch Shell exemplify these differences. ExxonMobil is known for its outstanding financial manage- ment which can be traced back to its role (as Standard Oil New Jersey) in providing overall financial management for Rockefeller’s Standard Oil Trust.

226 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Royal Dutch Shell has used scenarios as a basis for long-

term strategic planning since 1967, Mike Pocock, Shell’s

former chairman, observed: “We believe in basing plan-

ning not on single forecasts, but on deep thought that

identifies a coherent pattern of economic, political, and

social development.”

Shell‘s scenarios are critical to the transition of

its planning function from producing plans to lead-

ing a process of dialogue and learning, the outcome

of which is improved decision making by managers.

This involves continually challenging current thinking

within the group, encouraging a wider look at external

influences on the business, and forging coordination

among Shell’s 200-odd subsidiaries.

Shell’s global scenarios are prepared every four or

five years by a team comprising corporate planning

staff, executives, and outside experts. Economic,

political, technological, and demographic trends

are analyzed up to 50 years into the future. In 2014,

Shell identified two global scenarios for the period

to 2060:

◆ Mountains: A world where current elites retain their

power, manage for stability, and “unlock resources

steadily and cautiously, not solely dictated by

immediate market forces. The resulting rigidity

within the system dampens economic dynamism

and stifles social mobility.”

◆ Oceans: A world of devolved power where “com-

peting interests are accommodated and compro-

mise is king. Economic productivity surges on a

huge wave of reforms, yet social cohesion is some-

times eroded and politics destabilized … giving

immediate market forces greater prominence.”

Once approved by top management, the scenarios

are disseminated by reports, presentations, and work-

shops, where they form the basis for long-term strategy

discussion by business sectors and operating companies.

Shell is adamant that its scenarios are not forecasts.

They represent carefully thought-out stories of how the

various forces shaping the global energy environment

of the future might play out. Their value is in stimulat-

ing the social and cognitive processes through which

managers envisage the future “They are designed to

stretch management to consider even events that may

be only remotely possible.”. According to former CEO

Jeroen van der Veer: “the imperative is to use this tool

to gain deeper insights into our global business envi-

ronment and to achieve the cultural change that is at

the heart of our group strategy.”

Sources: A. de Geus, “Planning as Learning,” Harvard Business Review (March/April 1988): 70–4; P. Schoemacher, “Multiple Scenario Development: Its Conceptual and Behavioral Foundation,” Strategic Management Journal 14 (1993): 193– 214; Royal Dutch Shell, New Lens Scenarios: A Shift in Perspective for a World in Transition (2014).

STRATEGY CAPSULE 8.3

Multiple-Scenario Development at Shell

Royal Dutch Shell is known for its decentralized, international management capability, which allows it to become an “insider” wherever it does business. Shell was established to ship Russian oil in China while Royal Dutch was cre- ated to exploit Indonesian oil reserves. With head offices thousands of miles away in Europe, both parts of the group developed a decentralized, adapt- able management style.

These observations are troubling for managers in established companies: if a firm’s capabilities are determined during the early stages of its life, is it really possible to

CHAPTER 8 INDUSTRY EVOLUTION AND STRATEGIC CHANGE 227

develop the new capabilities needed to adapt to changes? Established capabilities embedded within organizational structure and culture present formidable barriers to building new capabilities. Indeed, the more highly developed a firm’s organizational capabilities, the greater the barrier they create. Because Dell Computer’s direct sales model was so highly developed, Dell found it difficult to adapt to selling through retail outlets as well. Hence the argument that core capabilities are simultaneously core rigidities.57

Integrating Resources to Create Capability To understand how to develop new capabilities let us look once more at the structure of organizational capability. In Chapter 5 (Strategy Capsule 5.5) we observed that organizational capability results from the combination of different resources, particularly the skills of different organizational members. This integration requires suitable processes, an appropriate organizational structure, motivation, and overall organizational alignment, especially with the organi- zation’s culture.

These components form the building blocks for new capabilities:

● Processes: Without processes, organizational capability will be completely dependent on individual skills. With processes (or organizational routines) we can ensure that task performance is efficient, repeatable, and reliable. When Whirlpool launched its innovation drive, the emphasis was on creating pro- cesses: processes for training employees in the tools of innovation, processes for idea generation, and processes for idea selection and development.58 Once processes are in place they are developed through routinization and learning— essential to capability development is the creation of mechanisms that facilitate learning-by-doing and ensure the retention and sharing of learning.

TABLE 8.3 Distinctive capabilities as a consequence of childhood experiences: The oil majors

Company Distinctive capability Early history

ExxonMobil Financial management ExxonMobil’s predecessor, Standard Oil (NJ), was the holding company for Rockefeller’s Standard Oil Trust

Royal Dutch Shell Coordinating a decentralized global network of 200 operating companies

Shell Transport & Trading headquartered in London and founded to sell Russian oil in China and the Far East

Royal Dutch Petroleum headquartered in The Hague; founded to exploit Indonesian reserves

BP Elephant hunting Discovered huge Persian reserves, went on to find Forties field (North Sea) and Prudhoe Bay (Alaska)

ENI Deal making in politicized environments

The Enrico Mattei legacy; the challenge of managing government relations in post- war Italy

Mobil Lubricants Vacuum Oil Co. founded in 1866 to supply patented petroleum lubricants

228 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

● Structure: The people and processes that contribute to an organizational capability need to be located within the same organizational unit if they are to achieve the coordination needed to ensure a high performance capability. When McKinsey & Company wanted to develop specialized consulting capabili- ties in relation to different sectors and different management functions, it cre- ated a matrix structure comprising industry practices and functional practices. The need for the organizational structure to be aligned with capabilities means capabilities that span different organizational units tend to be underdeveloped. When European and US automakers adopted cross-functional product develop- ment teams to replace the previous sequential system that spanned multiple functions, their product development became faster and smoother.59

● Motivation: Without motivation not only will individuals give less than their best but equally important, they will not set aside their personal preferences and prejudices to integrate as a team. Creating the motivation that drives outstanding team capabilities—be it Bayern Munich football team, the Royal Air Force’s aerobatic team (the Red Arrows), or the Simon Bolivar Youth Orchestra—involves a combination of leadership skills that, as yet, are poorly understood. Which is why outstanding former sports coaches are able to command huge fees on the corporate lecture circuit.

● Organizational alignment: Finally, there is the issue of fit. Exceptional per- formance requires that all the components of a capability fit with one another and with the broader organizational context. Following the 1989 Exxon Valdez oil spill, safety became a priority for ExxonMobil. The development of ExxonMobil’s HSE (health, safety, and environment) capability has been the result of a multifaceted program of training, process redesign, incentives, and penalties that are articulated in its Operations Integrity Management System. A safety-first culture was inculcated by an obsession with accident preven- tion that required the reporting of paper cuts and other trivial injuries, strict rules on parking practices in company car parks, and the requirement that all meetings begin with a “safety minute.”60 Conversely, BP’s dismal safety record during 2000–2010 reflects weaknesses in safety processes, a lack of account- ability by middle managers for safety performance, and a management sys- tem dominated by short- and medium-term financial targets.61

Developing Capabilities Sequentially Developing new capabilities requires a systematic and long-term process of development that integrates the four compo- nents described above. For most organizations, the key challenge is not obtaining the underlying resources—indeed, many examples of outstanding capabilities have resulted from the pressures of resource shortage. Toyota’s lean production capability was born during a period of acute resource shortage in Japan.

If the key challenge is integrating resources through establishing and develop- ing processes through routinization and learning, building structure, motivating the people involved, and aligning the new capability with other aspects of the organiza- tion, the demands upon management are considerable. Hence, an organization must limit the number and scope of the capabilities that it is attempting to create at any point in time. This implies that capabilities need to be developed sequentially rather than all at once.

CHAPTER 8 INDUSTRY EVOLUTION AND STRATEGIC CHANGE 229

The task is further complicated by the fact that we have limited knowledge about how to manage capability development. Hence, it may be helpful to focus not on the organizational capabilities themselves but on developing and supplying the products that use those capabilities. A trajectory through time of related, increasingly sophisticated products allows a firm to develop the “integrative knowledge” that is at the heart of organizational capability.62 Consider Panasonic’s approach to developing manufacturing capabilities in new markets:

In every country batteries are a necessity, so they sell well. As long as we bring a few advanced automated pieces of equipment for the processes vital to final product quality, even unskilled labor can produce good products. As they work on this rather simple product, the workers get trained, and this increased skill level then permits us to gradually expand production to items with increasingly higher technology levels, first radios, then televisions.63

The key to such a sequential approach is for each stage of development to be linked not just to a specific product (or part of a product) but also to a clearly defined set of capabilities. Strategy Capsule 8.4 outlines Hyundai’s sequential approach to capability development.

Dynamic Capabilities The ability of some firms (e.g., IBM, General Electric, 3M, Toyota, and Tata Group) to repeatedly adapt to new circumstances while others stagnate and die suggests that the capacity for change is itself an organizational capability. David Teece and his colleagues introduced the term dynamic capabilities to refer to a “firm’s ability to integrate, build, and reconfigure internal and external competences to address rapidly changing environments.”64

Despite a lack of consensus over definition, common to almost all conceptions of dynamic capabilities is that they are “higher order” capabilities that orchestrate change among lower-level “ordinary” or “operational” capabilities. However, specify- ing, in precise terms, the definition and nature of dynamic capabilities has proved elusive. Teece proposes that “dynamic capabilities can be disaggregated into the capacity (1) to sense and shape opportunities and threats, (2) to seize opportuni- ties, and (3) to maintain competitiveness through enhancing, combining, protecting, and, when necessary, reconfiguring the business enterprise’s intangible and tangible assets.”65 However, this does not help us much when trying to identify the dynamic capabilities a company possesses or in distinguishing dynamic from ordinary capa- bilities. To facilitate the identification of dynamic capabilities, it is therefore useful to equate dynamic capabilities with “specific and identifiable processes”66 and “pat- terned and routine”67 behavior (as opposed to ad hoc problem solving).

IBM offers an example of how management processes can build higher-level dynamic capabilities. Under the leadership of three CEOs—Lou Gerstner, Sam Palmisano, and Ginni Rometty—IBM’s Strategic Leadership Model comprised a num- ber of processes designed to sense new business opportunities and then fund their development into new business initiatives. Strategy Capsule 14.3 in Chapter 14 out- lines IBM’s strategic management system.68

230 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Hyundai’s emergence as a world-class automobile pro-

ducer is a remarkable example of capability develop-

ment over a sequence of compressed phases (Figure 8.5).

Each phase of the development process was character-

ized by a clear objective in terms of product outcome,

a tight time deadline, an empowered development

team, a clear recognition of the capabilities that needed

to be developed in each phase, and an atmosphere of

impending crisis should the project not succeed. The

first phase was the construction of an assembly plant

in the unprecedented time of 18 months in order to

build Hyundai’s first car—a Ford Cortina imported in

semi-knocked down (SKD) form. Subsequent phases

involved products of increasing sophistication and the

development of more advanced capabilities.

STRATEGY CAPSULE 8.4

Hyundai Motor: Developing Capabilities through Product Sequencing

Source: Draws upon L. Kim, “Crisis construction and organizational learning: Capability building and catch- ing up at Hyundai Motor,” Organizational Science 9 (1998): 506–21.

FIGURE 8.5 Phased development at Hyundai Motor, 1968–1995

1970 1974 1985 1994–95

Large-scale design integration

Global logistics Lifecycle engineering

Assembly Production

engineering Local

marketing

Hydrodynamics Thermodynamics Fuel engineering Emission control Lubrication Kinetics and vibration Ceramics Electronic control

systems

CAPABILITIES

PRODUCTS

Accent Avante Sonata

Auto styling and design

Casting and forging

Chassis design

Tooling Body

production Export

marketing

FWD engineering

CAD/CAM Assembly

control systems Advanced

component handling

1968

SKD/CKD Ford Cortina

Pony ”Alpha” engine

Excel

Gary Hamel and Management Revolution For Gary Hamel the idea that dynamic capability can be built on processes and routines is anathema. Change requires breaking away from existing management practice: “escaping the gravi- tational pull of the current paradigm.”69 According to Gary Hamel, in an era of nonlinear change, “the company that is evolving slowly is already on its way to extinction.”70 Revolution must be met by revolution. In books, articles, talks, and

CHAPTER 8 INDUSTRY EVOLUTION AND STRATEGIC CHANGE 231

blogs over two decades, Hamel has expounded the kinds of changes needed for managers to cast off the status quo and reconceptualize the structural, psychologi- cal, and sociological norms of organizations. The Management Innovation Exchange (MIX) cofounded by Hamel has the premise: “To thrive in the 21st century, organi- zations must be adaptable, innovative, inspiring and socially accountable. That will require a genuine revolution in management principles and practice” and that “while modern management is one of humankind’s most important inventions, it is now a mature technology that must be reinvented for a new age.”71

Despite the enthusiasm for dynamic capabilities, new business models, manage- ment reinvention, and new organizational forms, the fact remains that successful transformations by large, established organizations are few—and those that undergo multiple transformations are exceedingly rare. The risks inherent in radical trans- formation are evident in the demise of several of the most prominent exponents of strategic metamorphosis and innovative business models:

● Enron’s transformation from a utility and pipeline company to a trader and market-maker in energy futures and derivatives ended in its demise in 2001;

● Vivendi’s transformation from a French water and waste utility into a leading global multimedia empire fell apart in 2002;

● Skandia, the Swedish insurance company, pioneered knowledge-based inno- vation but was overtaken by management scandal and was acquired by Old Mutual.

Using Knowledge Management to Develop Organizational Capability Since the early 1990s, the development of capabilities by organizations has been profoundly influenced by a set of concepts and practices referred to as knowledge management. Knowledge management comprises a range of management organi- zational processes and practices whose common feature is their goal of generating value from knowledge.72 Knowledge management includes many long-established organizational functions such as R & D, management information systems, employee training, and managing intellectual property, even strategic planning; however, at its core it comprises:

● The application of information technology to management processes—espe- cially the use of databases, intranets, expert systems, and groupware for stor- ing, analyzing, and disseminating information.

● The promotion of organizational learning—including best practices trans- fer, “lessons learned” from ongoing activities, and processes for sharing know-how.

These two areas of knowledge management correspond to the two principal types of knowledge—knowing about and knowing how:73

● Knowing about is explicit: it comprises facts, theories, and sets of instruc- tions. Explicit knowledge can be communicated at negligible marginal cost

232 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

between individuals and across space and time. This ability to disseminate knowledge such that any one person’s use does not limit anyone else’s access to the same knowledge means that explicit knowledge has the characteristic of a public good: once created, it can be replicated among innumerable users at low cost. Information and communication technolo- gies play a major role in storing, analyzing, and disseminating explicit knowledge.

● Know-how is tacit in nature: it involves skills that are expressed through their performance (riding a bicycle, playing the piano). Such tacit knowledge can- not be directly articulated or codified. It can only be observed through its application and acquired through practice. Its management requires socially embedded person-to-person processes.

If explicit knowledge can be transferred so easily, it is seldom the foundation of sustainable competitive advantage. It is only secure from rivals when it is protected, either by intellectual property rights (patents, copyrights, trade secrets) or by secrecy (“The formula for Coca-Cola will be kept in a safe in the vault of our Atlanta head- quarters guarded by heavily-armed Coca-Cola personnel.”). The challenge of tacit knowledge is the opposite. The Roca brothers’ Catalan restaurant, El Celler de Can Roca, has been declared the world’s best restaurant. If their culinary skills have been acquired through intuition and learning-by-doing, how do they transfer this know- how to the chefs and managers of their new restaurant in Barcelona’s Hotel Omm? To build organizational capability, individual know-how must be shared within the organization. Replicating knowledge in a new location requires making know-how explicit. This systematization is the basis of McDonald’s incredible growth, but is more difficult for a Michelin three-starred restaurant. Moreover, while systematization per- mits internal replication, it also facilitates imitation by rivals. For consulting companies, the distinction between tacit (personalized) and explicit (systematized) knowledge defines their business model and is a central determinant of their strategy. 74 The result is a “paradox of replication.” In order to utilize knowledge to build organizational capability we need to replicate it; and replication is much easier if the knowledge is in explicit form.75

Knowledge Management Activities that Contribute to Capability Development Knowledge management can be represented as a series of activities that contribute to capability development by building, retaining, accessing, transferring, and integrating knowledge. Table 8.4 lists several knowledge-management practices.

However, the contribution of knowledge management to capability develop- ment in organizations may be less about specific techniques and more about the insight that the knowledge-based view of the firm has given to organizational performance and the role of management. For example, Ikujiro Nonaka’s model of knowledge creation offers penetrating insights into the organizational processes through which knowledge is created and value is created from knowledge (Strategy Capsule 8.5).

CHAPTER 8 INDUSTRY EVOLUTION AND STRATEGIC CHANGE 233

TABLE 8.4 Knowledge-management practices

Knowledge process Contributing activities Explanation and examples

Knowledge identification Intellectual property management

Firms are devoting increased effort to identifying and protect- ing their intellectual property, and patents especially

Corporate yellow pages BP’s Connect comprises personnel data that allows each employee to identify the skills and experience of other employees in the organization

Knowledge measurement Intellectual capital accounting

Skandia’s intellectual capital accounting system pioneered the measurement and valuation of a firm’s stock of knowledge. Dow Chemical uses intellectual capital metrics to link its pat- ent portfolio to shareholder value

Knowledge retention Lessons learned The US Army’s Center for Lessons Learned distils the results of maneuvers, simulated battles, and actual operations into tactical guidelines and recommended procedures. Most consulting firms have post-project reviews to capture the knowledge gained from each project

Knowledge transfer and sharing

Databases Project-based organizations typically store knowledge gener- ated by client assignments in searchable databases

Communities-of-practice Communities of practice are informal, self-organizing networks for transferring experiential knowledge among employees who share the same professional interests

Best practice transfer Where operations are geographically dispersed, different units are likely to develop local innovations and improvements. Best practice methodology aims to identify then transfer superior practices

Data analysis Big data “Big data” refers to the collation and analysis of huge data sets such as Walmart’s more than one million customer transac- tions each hour and UPS’s tracking of its 16.3 million pack- ages per day and telematic data for its 46,000 vehicles.

STRATEGY CAPSULE 8.5

Knowledge Conversion and Knowledge Replication

Ikujiro Nonaka’s theory of knowledge creation argues

that knowledge conversion between tacit and explicit

forms and between individual and organizational levels

produces a “knowledge spiral” in which the organization’s

stock of knowledge broadens and deepens. For example,

explicit knowledge is internalized into tacit knowledge

in the form of intuition, know-how, and routines, while

tacit knowledge is externalized into explicit knowledge

through articulation and codification. Knowledge also

moves between levels: individual knowledge is com-

bined into organizational knowledge; individual knowl-

edge is socialized into organizational knowledge.

Knowledge conversion lies at the heart of a key

stage of business development: the transition from the

234 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

FIGURE 8.6 Knowledge conversion

Source: Based upon I. Nonaka, “A Dynamic Theory of Organizational Knowledge Creation,” Organization Science 5 (1994): 14–37.

Individual Organization

Explicit

Tacit

Skills, Know-how

Organizational routines

T yp

es o

f K n

o w

le d

g e

Levels of knowledge

Facts, Information, Scientif ic kn.

Databases, Rules, Systems, IP

Internalization

Externalization

CRAFT ENTERPRISES

INDUSTRIAL ENTERPRISES

Combination

Socialization

Routinization

Sys tem

ati zat

ion

craft enterprise based upon individual, tacit knowledge,

to the industrial enterprise based upon explicit, organiza-

tional knowledge. This transition is depicted in Figure 8.6

and is illustrated by the following examples:

◆ Henry Ford’s Model T was initially produced on

a small scale by skilled workers. Ford’s assembly

line mass-production technology systematized

that individual, tacit knowledge and built it into

machines and processes. Ford’s industrial system

was no longer dependent upon skilled craftsmen:

the assembly lines could be operated by former

farm workers and new immigrants.

◆ When Ray Kroc discovered the McDonald broth-

ers’ hamburger stand in Riversdale, California, he

recognized the potential for systematizing and

replicating their process. McDonald’s business

model was replicated through operating manuals

and training programs. Now 400,000 employees,

most of whom lack the most rudimentary culinary

skills, serve 68 million customers daily. The relevant

knowledge is embedded within McDonald’s busi-

ness system.

This systematization of knowledge offers massive

potential for value creation through replication and

deskilling. This systematization has transformed the

service sector: with the replacement of individual pro-

prietorships by international chains in hotels (Marriott),

car rental (Hertz), coffee shops (Starbucks), and tax

preparation (H&R Block).

CHAPTER 8 INDUSTRY EVOLUTION AND STRATEGIC CHANGE 235

Summary

A vital task of strategic management is to navigate the crosscurrents of change. But predicting and adapting to change are huge challenges for businesses and their leaders.

The life-cycle model allows us to understand the forces driving industry evolution and to antici- pate their impact on industry structure and the basis of competitive advantage.

But, identifying regularities in the patterns of industry evolution is of little use if firms are unable to adapt to these changes. The challenge of adaptation is huge: the presence of organizational inertia means that industry evolution occurs more through the birth of new firms and the death of old ones rather than through adaptation by established firms. Even flexible, innovative companies experience problems in coping with new technologies—especially those that are “competence destroying,” “dis- ruptive,” or embody “architectural innovation.”

Managing change requires managers to operate in two time zones: they must optimize for today while preparing the organization for the future. The concept of the ambidextrous organization is an approach to resolving this dilemma. Other tools for managing strategic change include: creat- ing perceptions of crisis, establishing stretch targets, corporate-wide initiatives, recruiting external managerial talent, dynamic capabilities, and scenario planning.

Whatever approach or tools are adopted to manage change, strategic change requires build- ing new capabilities. To the extent that an organization’s capabilities are a product of its entire his- tory, building new capabilities is a formidable challenge. To understand how organizations build capability we need to understand how resources are integrated into capability—in particular, the role of processes, structure, motivation, and alignment. The complexities of capability development and our limited understanding of how capabilities are built point to the advantages of sequential approaches to developing capabilities.

Ultimately, capability building is about harnessing the knowledge which exists within the orga- nization. For this purpose knowledge management offers considerable potential for increasing the effectiveness of capability development. In addition to specific techniques for identifying, retaining, sharing, and replicating knowledge, the knowledge-based view of the firm offers pen- etrating insights into the challenges of and potential for the creation and exploitation of knowl- edge by firms.

In the next two chapters, we discuss strategy formulation and strategy implementation in indus- tries at different stages of their development: emerging industries, which are characterized by rapid change and technology-based competition, and mature industries.

236 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Self-Study Questions 1. Consider the changes that have occurred in a comparatively new industry (e.g., wireless

telecommunications, smartphones, video game consoles, online brokerage services, fit- ness clubs). To what extent has the evolution of the industry followed the pattern pre- dicted by the industry life-cycle model? What are the features of the industry that have influenced its pattern of evolution? At what stage of development is the industry today? How is the industry likely to evolve in the future?

2. Select a product that has become a dominant design for its industry (e.g., the IBM PC in personal computers, McDonald’s in fast food, Harvard Business School in MBA educa- tion, Southwest in budget airlines). What factors caused one firm’s product architecture to become dominant? Why did other firms imitate this dominant design? How did the emergence of the dominant design influence the evolution of the industry?

3. The resource partitioning model argues that as industries become dominated by a few major companies with similar strategies and products so opportunities open for new entrants to build specialist niches. Identify an opportunity for establishing a specialist new business in an industry currently dominated by mass-market giants.

4. Choose an industry that faces significant change over the next ten years. Identify the main drivers of change and construct two scenarios of how these changes might play out. In relation to one of the leading firms in the industry, what are the implications of the two scenarios, and what strategy options should the firm consider?

5. Identify two sports teams: one that is rich in resources (such as talented players) but whose capabilities (as indicated by performance) have been poor; one that is resource- poor but has displayed strong team capabilities. What clues can you offer as to the deter- minants of capabilities among sports teams?

6. The market leaders in video games for mobile devices during 2012–14 were start-up com- panies such as DeNA, GungHo Online, Supercell, King, and Rovio. Why have start-ups outperformed established video game giants such as Electronic Arts, Rock Star Games, and Activision Blizzard in this market?

7. The dean of your business school wishes to upgrade the school’s educational capabilities in order to better equip its graduates for success in their careers and in their lives. Advise your dean on what tools and systems of knowledge management might be deployed in order to support these goals.

CHAPTER 8 INDUSTRY EVOLUTION AND STRATEGIC CHANGE 237

1. T. Levitt, “Exploit the Product Life Cycle,” Harvard Business Review (November/December 1965): 81–94; G. Day, “The Product Life Cycle: Analysis and Applications,” Journal of Marketing 45 (Autumn 1981): 60–67.

2. F. F. Suárez and J. M. Utterback, “Dominant Designs and the Survival of Firms,” Strategic Management Journal 16 (1995): 415–430.

3. P. Anderson and M. L. Tushman, “Technological Discontinuities and Dominant Designs,” Administrative Science Quarterly 35 (1990): 604–633.

4. M. A. Cusumano and D. B. Yoffie, Competing on Internet Time: Lessons from Netscape and Its Battle with Microsoft (New York: Free Press, 1998).

5. M. G. Jacobides, “Industry Change through Vertical Disintegration: How and Why Markets Emerged in Mortgage Banking,” Academy of Management Journal 48 (2005): 465–498; M. G. Jacobides, C. Y. Baldwin, and R. Dizaji, “From the Structure of the Value Chain to the Strategic Dynamics of Industry Sectors,” Academy of Management Presentation (Philadelphia, August 7, 2007).

6. G. Carroll and M. Hannan, The Demography of Corporations and Industries (Princeton, MA: Princeton University Press, 2000). For a survey see J. Baum, “Organizational Ecology,” in S. R. Clegg, C. Hardy, and W. R. Nord (eds), The SAGE Handbook of Organizational Studies (Thousand Oaks, CA: SAGE Publications, 1996); and D. Barron, “Evolutionary Theory,” in D. O. Faulkner and A. Campbell (eds), The Oxford Handbook of Strategy (Oxford: Oxford University Press, 2003), vol. 1: 74–97.

7. G. R. Carroll, L. S. Bigelow, M.-D. Seidel, and B. Tsai, “The Fates of de novo and de alio Producers in the American Automobile Industry, 1885–1981,” Strategic Management Journal 17 (Summer 1996): 117–137.

8. S. Klepper and K. L. Simons, “Dominance by Birthright: Entry of Prior Radio Producers and Competitive Ramifications in the US Television Receiver Industry,” Strategic Management Journal 21 (2000): 997–1016.

9. High rates of entry and exit may continue well into maturity. See T. Dunne, M. J. Roberts, and L. Samuelson, “Patterns of Firm Entry and Exit in US Manufacturing Industries,” Rand Journal of Economics 19 (1988): 495–515.

10. S. Klepper and E. Grady, “The Evolution of New Industries and the Determinants of Industry Structure,” Rand Journal of Economics 21 (1990): 27–44.

11. S. Klepper and K. Simons, “The Making of an Oligopoly: Firm Survival and Technological Change in the Evolution of the US Tire Industry,” Journal of Political Economy 108 (2000): 728–760.

12. G. Carroll and A. Swaminathan, “Why the Microbrewery Movement? Organizational Dynamics of Resource Partitioning in the American Brewing Industry,” American Journal of Sociology 106 (2000): 715–762.

13. B. Levitt and J. G. March, “Organizational Learning,” Annual Review of Sociology 14 (1988): 319–340.

14. D. Leonard-Barton, “Core Capabilities and Core Rigidities: A Paradox in Managing New Product Development,” Strategic Management Journal 13 (Summer 1992): 111–125.

15. M. T. Hannan, L. Polos, and G. R. Carroll, “Structural Inertia and Organizational Change Revisited III: The Evolution of Organizational Inertia,” Stanford GSB Research Paper 1734 (April 2002).

16. P. J. DiMaggio and W. Powell, “The Iron Cage Revisited: Institutional Isomorphism and Collective Rationality in Organizational Fields,” American Sociological Review 48 (1983): 147–160.

17. J.-C. Spender, Industry Recipes (Oxford: Blackwell Publishing, 1989).

18. J. G. March, “Exploration and Exploitation in Organizational Learning,” Organizational Science 2 (1991): 71–87.

19. The concept of fit is common to several disci- plines within management including: organiza- tional economics (e.g., P. R. Milgrom and J. Roberts, “Complementarities and Fit: Strategy, Structure, and Organizational Change in Manufacturing,” Journal of Accounting and Economics 19 (1995): 179–208); socio- technical systems (e.g., E. Trist, “The Sociotechnical Perspective,” in A. H. Van de Ven and W. H. Joyce (eds), Perspectives on Organization Design and Behavior (New York: John Wiley & Sons, Inc., 1984); and complexity theory (e.g. J. W. Rivkin, “Imitation of Complex Strategies,” Management Science 46 (2000): 824–844).

20. M. E. Porter and N. Siggelkow, “Contextual Interactions within Activity Systems,” Academy of Management Perspectives 22 (May 2008): 34–56.

21. E. Romanelli and M. L. Tushman, “Organizational Transformation as Punctuated Equilibrium: An Empirical Test,” Academy of Management Journal 37 (1994): 1141–1166.

22. H. E. Aldrich, Organizations and Environments (Stanford, CA: Stanford University Press, 2007).

23. For an introduction to organizational ecology, see M. T. Hannan and G. R. Carroll, “An introduction to organiza- tional ecology,” in G. R. Carroll and M. T. Hannan (eds), Organizations in Industry (Oxford: Oxford University Press, 1995): 17–31.

24. For a survey of evolutionary approaches, see R. R. Nelson, “Recent Evolutionary Theorizing about Economic Change,” Journal of Economic Literature 33 (March 1995): 48–90.

25. R. Foster, “Creative Destruction Whips through Corporate America,” Innosight Executive Briefing (Winter 2012).

Notes

238 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

26. C. Markides and P. Geroski, “Colonizers and Consolidators: The Two Cultures of Corporate Strategy,” Strategy and Business 32 (Fall 2003).

27. G. A. Moore, Crossing the Chasm (New York: HarperCollins, 1991).

28. S. Klepper, “The Capabilities of New Firms and the Evolution of the US Automobile Industry,” Industrial and Corporate Change 11 (2002): 645–666.

29. S. Klepper and K. L. Simons, “Dominance by Birthright: Entry of Prior Radio Producers and Competitive Ramifications in the US Television Receiver Industry,” Strategic Management Journal 21 (2000): 997–1016.

30. D. A. Kaplan, The Silicon Boys and Their Valley of Dreams (New York: Morrow, 1999).

31. M. L. Tushman and P. Anderson, “Technological Discontinuities and Organizational Environments,” Administrative Science Quarterly 31 (1986): 439–465.

32. M. Tripsas, “Unravelling the Process of Creative Destruction: Complementary Assets and Incumbent Survival in the Typesetter Industry,” Strategic Management Journal 18 (Summer 1997): 119–142.

33. R. M. Henderson and K. B. Clark, “Architectural Innovation: The Reconfiguration of Existing Systems and the Failure of Established Firms,” Administrative Science Quarterly (1990): 9–30.

34. Ibid, page 17. 35. J. Bower and C. M. Christensen, “Disruptive

Technologies: Catching the Wave,” Harvard Business Review ( January/February 1995): 43–53.

36. C. M. Christensen, The Innovator’s Dilemma (Boston: Harvard Business School Press, 1997).

37. Ibid. 38. W. A. Pasmore, Designing Effective Organizations: The

Sociotechnical Systems Perspective (New York: John Wiley & Sons, Inc., 1988).

39. W. G. Bennis, Organization Development: Its Nature, Origins, and Prospects (New York: Addison-Wesley, 1969).

40. D. F. Abell, Managing with Dual Strategies (New York: Free Press, 1993): 3.

41. C. A. O’Reilly and M. L. Tushman, “The Ambidextrous Organization,” Harvard Business Review (April 2004): 74–81.

42. C. M. Christensen and M. Overdorf, “Meeting the Challenge of Disruptive Change,” Harvard Business Review (March/April 2000): 66–76.

43. T. Elder, “Lessons from Xerox and IBM,” Harvard Business Review ( July/August 1989): 66–71.

44. “Shell GameChanger: A Safe Place to Get Crazy Ideas Started,” http://www.managementexchange.com, Management Innovation eXchange ( January 7, 2013), www.managementexchange.com/story/shell-game- changer, accessed July 20, 2015.

45. See “Lab Inventors: Xerox PARC and its Innovation Machine,” in A. Rao and P. Scaruffi, A History of Silicon Valley, 2nd edn (Omniware, 2013); and “Saturn: Why One of Detroit’s Brightest Hopes Failed,” Christian Science Monitor (October 1, 2009).

46. G. Verona and D. Ravasi, “Unbundling dynamic capa- bilities: An exploratory study of continuous product innovation,” Industrial and Corporate Change 12 (2002): 577–606.

47. Interview with Nancy Snyder, Whirlpool’s vice- president of leadership and strategic competency development, Business Week (March 6, 2006), http:// www.businessweek.com/innovate/content/mar2006/ id20060306_287425.htm?.

48. R. Cibin and R. M. Grant, “Restructuring among the World’s Leading Oil Companies,” British Journal of Management 7 (1996): 283–308.

49. M. Tripsas and G. Gavetti, “Capabilities, Cognition and Inertia: Evidence from Digital Imaging,” Strategic Management Journal 21 (2000): 1147–1161.

50. H. Y. Howard, “Decoding Leadership: How Steve Jobs Transformed Apple to Spearhead a Technological Informal Economy,” Journal of Business and Management 19 (2013): 33–44.

51. “Haier: Taking a Chinese Company Global in 2011,” Harvard Business School Case No. 712408-PDF-ENG (August 2011).

52. N. Siggelkow and D. A. Levinthal, “Escaping Real (Non- benign) Competency Traps: Linking the Dynamics of Organizational Structure to the Dynamics of Search,” Strategic Organization 3 (2005): 85–115.

53. J. Nickerson and T. Zenger, “Being Efficiently Fickle: A Dynamic Theory of Organizational Choice,” Organization Science 13 (September/October 2002): 547–567.

54. A. Karaevli and E. Zajac, “When is an Outsider CEO a Good Choice?” MIT Sloan Management Review (Summer 2013); A. Falato and D. Kadyrzhanova, “CEO Successions and Firm Performance in the US Financial Industry,” Finance and Economics Discussion Series (Federal Reserve Board, 2012).

55. H. Kahn, The Next 200 Years: A Scenario for America and the World (New York: William Morrow, 1976). For a guide to the use of scenarios in strategy making, see K. van der Heijden, Scenarios: The Art of Strategic Conversation (Chichester: John Wiley & Sons, Ltd, 2005).

56. B. Wernerfelt, “Why Do Firms Tend to Become Different?” in C. E. Helfat (ed.), Handbook of Organizational Capabilities (Oxford: Blackwell, 2006): 121–133.

57. D. Leonard-Barton, “Core Capabilities and Core Rigidities,” Strategic Management Journal 13 (Summer 1992): 111–126.

58. N. T. Snyder and D. L. Duarte, Unleashing Innovation: How Whirlpool Transformed an Industry (San Francisco: Jossey-Bass, 2008).

59. K. B. Clark and T. Fujimoto, Product Development Performance: Strategy, Organization, and Management in the World Auto Industry (Boston: HBS Press, 1991).

60. S Coll, Private Empire: ExxonMobil and American Power (New York: Penguin, 2012).

61. The Report of the BP U.S. Refineries Independent Safety Review Panel ( January 2007).

CHAPTER 8 INDUSTRY EVOLUTION AND STRATEGIC CHANGE 239

62. C. E. Helfat and R. S. Raubitschek, “Product Sequencing: Co-evolution of Knowledge, Capabilities and Products,” Strategic Management Journal 21 (2000): 961–979. The parallel development of capabilities and products has also been referred to as “dynamic resource fit.” See: H. Itami, Mobilizing Invisible Assets (Boston: Harvard University Press, 1987): 125.

63. A. Takahashi, What I Learned from Konosuke Matsushita (Tokyo: Jitsugyo no Nihonsha, 1980); in Japanese, quoted by H. Itami, Mobilizing Invisible Assets (Boston: Harvard University Press, 1987): 25.

64. D. J. Teece, G. Pisano, and A. Shuen, “Dynamic Capabilities and Strategic Management,” Strategic Management Journal 18 (1997): 509–533.

65. D. J. Teece, “Explicating Dynamic Capabilities: The Nature and Microfoundations of (Sustainable) Enterprise Performance,” Strategic Management Journal 28 (2007): 1319.

66. K. M. Eisenhardt and J. Martin, “Dynamic Capabilities: What Are They?” Strategic Management Journal 21 (2000): 1105–1121.

67. S. G. Winter, “Understanding Dynamic Capabilities,” Strategic Management Journal 24 (2003): 991–995.

68. J. B. Harreld, C. A. O’Reilly and M. L. Tushman, “Dynamic Capabilities at IBM: Driving Strategy into Action,” California Management Review 49 (2007): 21–43.

69. http://www.strategos.com/category-creators-reach- escape-velocity/, accessed July 20, 2015.

70. G. Hamel, Leading the Revolution (Boston: Harvard Business School Press, 2000): 5.

71. http://www.managementexchange.com/about-the-mix, accessed July 20, 2015.

72. K. Dalkir, Knowledge Management in Theory and Practice, 2nd edn (Cambridge, MA: MIT Press, 2011).

73. R. M. Grant, “Toward a Knowledge-Based Theory of the Firm,” Strategic Management Journal 17 (Winter Special Issue, 1996): 109-122.

74. M. Hansen, N. Nohria, and T. Tierney, “What’s Your Strategy for Managing Knowledge?” Harvard Business Review (March 1999): 106–116.

75. J. Rivkin, “Reproducing Knowledge: Replication with- out Imitation at Moderate Complexity,” Organization Science 12 (2001): 274–293.

9 Technology-based Industries and the Management of Innovation

Whereas a calculator on the ENIAC is equipped with 18,000 vacuum tubes and weighs 30 tons, computers in the future may have only 1000 vacuum tubes and perhaps weigh only 1.5 tons.

POPULAR MECHANICS, MARCH 1949

There’s no chance that the iPhone is going to get any significant market share.

STEVE BALLMER, CEO, MICROSOFT, APRIL 30, 2007

O U T L I N E

◆ Introduction and Objectives

◆ Competitive Advantage in Technology-intensive Industries

● The Innovation Process

● Capturing Value from Innovation

● Which Mechanisms Are Effective at Protecting Innovation?

◆ Strategies to Exploit Innovation: How and When to Enter

● Alternative Strategies to Exploit Innovation

● Timing Innovation: To Lead or to Follow?

● Managing Risks

◆ Standards, Platforms, and Network Externalities

● Types of Standard

● The Role of Network Externalities

◆ Platform-based Markets

● Competing for Standards

◆ Implementing Technology Strategies: Creating the Conditions for Innovation

● Fostering Creativity

◆ Accessing External Sources of Innovation

● Customers as Sources of Innovation

● Open Innovation

● Buying Innovation

● Organizing for Innovation

◆ Summary

◆ Self-Study Questions

◆ Notes

242 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Introduction and Objectives

In the previous chapter we saw that technology is the primary force that creates new industries and transforms existing ones. New industries include wireless telephony, biotechnology, photovoltaic power, fiber optics, robotics, and social networking. Industries transformed by new technologies include photography, recorded music, pharmaceuticals, and securities trading. New technology is a source of opportunity, especially for new businesses but, as we saw in the previous chapter, it presents major problems for many established companies.

This chapter focuses on business environments where technology is a key driver of change and an important source of competitive advantage. These technology-intensive industries include both emerging industries (those in the introductory and growth phases of their life cycle) and established industries where technology continues to drive competition. The issues we examine, however, are also relevant to all industries where technology has the potential to create competitive advantage including those which may be revolutionized by new technology such as healthcare and education .

In the last chapter, we viewed technology as an external driver of industrial change. In this chap- ter our primary concern will be the use of technology as a tool of competitive strategy. How can an enterprise best exploit technology to establish a competitive advantage?

The chapter is organized around these four learning objectives. First, we examine the links between technology and competition and the potential for innovation to establish sustainable com- petitive advantage. Second, we discuss key issues in the design of technology strategies, including alternative strategies for exploiting an innovation, timing, and managing risk. Third, we discuss net- work externalities and setting industry standards. Fourth, we look at how firms are extending their innovation processes beyond their organizational boundaries. Finally, we examine how technology- based strategies can best be implemented.

By the time you have completed this chapter, you will be able to:

◆ Identify the factors that determine the returns to innovation, and evaluate the potential for an innovation to establish competitive advantage.

◆ Formulate strategies for exploiting innovation and managing technology, including:

● identifying and evaluating strategic options for exploiting innovation;

● assessing the relative advantages of being a leader or a follower in innovation;

● managing risk;

● Formulate strategies to exploit network effects and win standards wars.

◆ Understand why companies are widening their quest for innovation, including the adoption of open innovation.

◆ Implement strategies in technology-based industries by designing the organizational struc- tures and systems that foster innovation and new product development.

CHAPTER 9 TECHNOLOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 243

Competitive Advantage in Technology-intensive Industries

Innovation forms the key link between technology and competitive advantage. The quest for competitive advantage stimulates the search for innovation and successful innovations allow some firms to dominate their industries. To explore the conditions under which innovation creates competitive advantage, let us begin by examining the innovation process.

The Innovation Process Invention is the creation of new products and processes through the development of new knowledge or from new combinations of existing knowledge. Most inven- tions are the result of novel applications of existing knowledge. Samuel Morse’s telegraph, patented in 1840, was based on several decades of research into electro- magnetism from Ben Franklin to Ørsted, Ampère, and Sturgeon. The compact disk embodies knowledge about lasers developed several decades previously.

Innovation is the initial commercialization of invention by producing and mar- keting a new good or service or by using a new method of production. Once introduced, innovation diffuses: on the demand side, through customers purchasing the good or service; on the supply side, through imitation by competitors. An inno- vation may be the result of a single invention (most product innovations in chemi- cals and pharmaceuticals involve discoveries of new chemical compounds) or it may combine many inventions. The first automobile, introduced by Karl Benz in 1885, embodied a multitude of inventions, from the wheel, invented some 5000 years previously, to the internal combustion engine, invented nine years earlier. Not all invention progresses into innovation: among the patent portfolios of most technology-intensive firms are inventions that have yet to find a viable commercial application. Conversely, innovations may involve little or no new technology: the personal computer was a new configuration of existing technologies; most new types of packaging, including the vast array of tamper-proof packages, involve novel designs but no new technology.

Figure 9.1 shows the pattern of development from knowledge creation to inven- tion and innovation. Historically, the lags between knowledge creation and innova- tion have been long:

● Chester F. Carlson invented xerography in 1938 by combining established knowledge about electrostatics and printing. The first patents were awarded in 1940. Xerox purchased the patent rights and launched its first office copier in 1958. By 1974, the first competitive machines were introduced by IBM, Kodak, Ricoh, and Canon.

● The jet engine, employing Newtonian principles, was patented by Frank Whittle in 1930. The first commercial jet airliner, the De Havilland Comet, flew in 1957, followed two years later by the Boeing 707.

Recently, the innovation cycle has speeded up:

● The use of satellite radio signals for global positioning was developed by physicists at Johns Hopkins University in late 1950s. An experimental GPS satellite was launched by the US Air Force in 1978 and the GPS system was

244 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

fully operational by 1995. Commercial applications began in the 1990s: Garmin launched its car sat-nav system in 1998 followed by TomTom in 2002.

● MP3, the audio file compression software, was developed at the Fraunhofer Institute in Germany in 1987; by the mid-1990s, the swapping of MP3 music files had taken off in US college campuses, and in 1998 the first MP3 player, Diamond Multimedia’s Rio, was launched. Apple’s iPod was introduced in 2001.

The lag between new knowledge and its commercial application depends on the motivation behind the initial research. A key distinction is between basic research motivated by pure science (e.g., Niels Bohr’s research into atomic physics) and basic research motivated by practical needs (e.g., Louis Pasteur’s research into microbiol- ogy.)1 The huge, and rapid, commercial impact of the research undertaken by the US Department of Defense’s Advanced Research Projects Agency—GPS satellites, the internet, RISC computing, motion-sensing devices—underlines the potential of basic research inspired by practical needs.2

Capturing Value from Innovation “If a man can . . . make a better mousetrap than his neighbor, though he build his house in the woods, the world will make a beaten path to his door,” claimed Emerson. Yet the inventors of new mousetraps, and other gadgets too, are more likely to be found at the bankruptcy courts than in the millionaires’ playgrounds of the Caribbean. Certainly, innovation is no guarantor of fame and fortune, either for indi- viduals or for companies. There is no consistent evidence that either R & D intensity or frequency of new-product introductions is positively associated with profitability.3

The profitability of an innovation to the innovator depends on the value created by the innovation and the share of that value that the innovator is able to capture. As Strategy Capsule 9.1 shows, different innovations result in very different distribu- tions of value. In the case of aspartame, the innovator G. D. Searle with NutraSweet was the primary beneficiary. In the case of the personal computer, suppliers and consumers were the primary beneficiaries. In the case of smartphones, followers have appropriated most of the value.

Invention Innovation Dif fusion

ADOPTION

IMITATION

Supply side

Demand side

Basic Knowledge

FIGURE 9.1 The development of technology: From knowledge creation to diffusion

CHAPTER 9 TECHNOLOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 245

The value created by an innovation is distributed

among a number of different parties (Figure 9.2).

◆ Aspartame: Aspartame, the artificial sweetener,

was discovered in 1965 by the drug company G.

D. Searle & Co. (later acquired by Monsanto) and

launched in 1981 as NutraSweet. The patent on

aspartame expired in 1992, after which competi-

tion grew. However, Searle/Monsanto, successfully

appropriated a major part of the value created.

◆ Personal computers: The innovators—MITS,

Tandy, Apple, and Xerox—earned modest

profits from their innovation. The followers—

IBM, Dell, Compaq, Acer, Toshiba, and a host of

later entrants—did somewhat better, but their

returns were overshadowed by the huge profits

earned by the suppliers to the industr y, espe -

cially : Intel in microprocessors and Microsoft

in operating systems Complementors, notably

the suppliers of applications software, also

did well. However, intense price competition

meant that the primar y beneficiaries from the

PC were consumers, who typically paid prices

for their PCs that were a fraction of the value

they derived.

◆ Smartphones: The first were the IBM Simon (1993)

and the Nokia 9000 series (1996). Followers—

notably RIM, Apple, and Samsung—have earned

huge profits from smartphones. Several suppliers

have also been big winners (e.g., microprocessor

supplier, ARM); also complementors, notably app

suppliers.

STRATEGY CAPSULE 9.1

How the Returns on Innovation Are Shared

FIGURE 9.2 Appropriating of value: Who gets the benefits from innovation?

Customers Customers

Followers

Followers

Complementors Complementors

Suppliers

Suppliers

Innovator Innovator ASPARTAME

Customers

Followers

Suppliers Innovator

SMARTPHONESPERSONAL COMPUTERS

The term regime of appropriability is used to describe the conditions that influence the distribution of the value created by innovation. In a strong regime of appropriability, the innovator is able to capture a substantial share of that value: Pilkington’s float glass process, Pfizer’s Viagra, and Dyson’s dual-cyclone vacuum cleaner—like Searle’s NutraSweet—all generated huge profits for their owners. In a weak regime of appropriability, other parties derive most of the value. E-book

246 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

readers, and online brokerage services, are similar to personal computers: a lack of proprietary technology results in fierce price competition and most of the value created goes to consumers.

The regime of appropriability comprises four key components which determine the innovator’s ability to profit from innovation: property rights, the tacitness and complexity of the technology, lead time, and complementary resources.

Property Rights in Innovation Capturing the returns to innovation depends, to a great extent, on the ability to establish property rights in the innovation. It was the desire to protect the returns to inventors that prompted the English Parliament to pass the 1623 Statute of Monopolies, which established the basis of patent law. Since then, the law has been extended to several areas of intellectual property, including:

● Patents: Exclusive rights to a new and useful product, process, substance, or design. Obtaining a patent requires that the invention is novel, useful, and not excessively obvious. Patent law varies from country to country. In the US, a patent is valid for 17 years (14 for a design).

● Copyrights: Exclusive production, publication, or sales rights to the creators of artistic, literary, dramatic, or musical works. Examples include articles, books, drawings, maps, photographs, and musical compositions.

● Trademarks: Words, symbols, or other marks used to distinguish the goods or services supplied by a firm. In the US and the UK, they are registered with the Patent Office. Trademarks provide the basis for brand identification.

● Trade secrets: Offer a modest degree of legal protection for recipes, formu- lae, industrial processes, customer lists, and other knowledge acquired in the course of business.

The effectiveness of intellectual property law depends on the type of innova- tion being protected. For new chemical products (a new drug or plastic), patents can provide effective protection. For products that involve new configurations of existing components or new manufacturing processes, patents may fail to prevent rivals from innovating around them. The scope of the patent law has been extended to include computer software, business methods, and genetically engineered life forms. Business method patents have generated considerable controversy, espe- cially Amazon’s patent on “one-click-to-buy” internet purchasing.4 While patents and copyright establish property rights, their disadvantage (from the inventor’s view- point) is that they make information public. Hence, companies often prefer secrecy to patenting as a means of protecting innovations.

In recent decades, companies have devoted increasing attention to protect- ing and exploiting the economic value of their intellectual property. When Texas Instruments began exploiting its patent portfolio as a revenue source during the 1980s, the technology sector as a whole woke up to the value of its knowledge assets. During the 1990s, TI’s royalty income exceeded its operating income from other sources. One outcome has been an upsurge in patenting. The US Patent and Trademark Office granted 302,948 patents in 2013; during 1980–1985 it averaged 67,000 annually.

CHAPTER 9 TECHNOLOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 247

Tacitness and Complexity of the Technology In the absence of effective legal protection the extent to which an innovation can be imitated by a competitor depends on the ease with which the technology can be comprehended and rep- licated. This depends, first, on the extent to which the technical knowledge is codifiable. Codifiable knowledge, by definition, is that which can be written down. Hence, if it is not effectively protected by patents or copyright, diffusion is likely to be rapid and the competitive advantage not sustainable. Financial innovations such as mortgage-backed securities and credit default swaps embody readily codi- fiable knowledge that can be copied very quickly. Similarly, Coca-Cola’s recipe is codifiable and, in the absence of trade-secret protection, is easily copied. Intel’s designs for advanced microprocessors are codified and can be copied; however, the processes for manufacturing these integrated circuits are based on deeply tacit knowledge.

The second key factor is complexity. Every new fashion, from the Mary Quant miniskirt of 1962 to Burberry’s blanket coat of fall 2014 involves simple, easy-to- copy ideas. Conversely, Airbus’s A380 and Intel’s Core M processor based upon its 14-nanometer technology present entirely different challenges for the would-be imitator.

Lead Time Tacitness and complexity do not provide lasting barriers to imitation, but they do offer the innovator time. Innovation creates a temporary competitive advantage that offers a window of opportunity for the innovator to build on the initial advantage.

The innovator’s lead time is the time it will take followers to catch up. The challenge for the innovator is to use initial lead-time advantages to build the capabilities and market position to entrench industry leadership. Intel in micro- processors, Cisco Systems in routers, and Canon in inkjet printers were brilliant at exploiting lead time to build advantages in efficient manufacture, quality, and market presence. Conversely, innovative British companies are notorious for hav- ing squandered their lead-time advantage in jet planes, radars, CT scanners, and genomics.

Lead time allows a firm to move down its learning curve ahead of followers. In new generations of microprocessors, Intel has traditionally been first to market, allowing it to move quickly down its experience curve, cut prices, and so pressuring the profit margins of its rival, AMD.

Complementary Resources Bringing new products and processes to market requires not just invention; it also requires the diverse resources and capabilities needed to finance, produce, and market the innovation. These are referred to as complementary resources (Figure 9.3). Chester Carlson invented xerography but was unable for many years to bring his product to market because he lacked the comple- mentary resources needed to develop, manufacture, market, distribute, and service his invention. Conversely, Searle (and its later parent, Monsanto) was able to provide almost all the development, manufacturing, marketing, and distribution resources needed to exploit its NutraSweet innovation. As a result, Carlson was able to appro- priate only a tiny part of the value created by his invention of the plain-paper Xerox copier, whereas Searle/Monsanto was successful in appropriating a major part of the value created by its new artificial sweetener.

248 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Complementary resources may be accessed through alliances with other firms, for example biotech firms ally with large pharmaceutical companies for clinical trials, manufacture, and marketing.5 When an innovation and the complementary resources that support it are supplied by different firms, the division of value between them depends on their relative power. A key determinant of this is whether the complementary resources are specialized or unspecialized. Fuel cells may eventually displace both internal combustion engines and battery-powered electric motors in most of the world’s automobiles. However, the problem for the developers of fuel cells is that their success depends on automobile manufacturers making specialized investments in designing a whole new range of cars, service station owners providing specialized refueling facilities, and repair firms investing in training and new equipment. For fuel cells to be widely adopted will require that the benefits of the innovation are shared widely with the different providers of these complementary resources. Where complementary resources are generic, the innovator is in a much stronger position to capture value. Because Adobe Systems’ Acrobat Portable Document Format (PDF) works with files created in almost any software application, Adobe is well positioned to capture most of the value created by its innovatory software product. However, one advantage of co-specialized complementary resources is that they raise barriers to imitation. Consider the threat that Linux presents to Microsoft Window’s dominance of PC operating systems. Intel has adapted its microprocessors to the needs of Windows and most applications software is written to run on Windows, so the challenge for the Linux community is not just to develop a workable operating system but also to encourage the development of applications software and hardware that are compatible with the Linux operating system.

FIGURE 9.3 Complementary resources

Distribution

Customer service capability

Marketing capability

Financial resources

Complementary technologies

Supplier relationships

Brand

Manufacturing capability

Innovation and core

technological know-how

CHAPTER 9 TECHNOLOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 249

Which Mechanisms Are Effective at Protecting Innovation? How effective are these different mechanisms in protecting innovations? Table 9.1 shows that, despite considerable variation across industries, patent protection is of limited effectiveness as compared with lead time, secrecy, and complemen- tary manufacturing and sales/service resources. Indeed, since the late 1980s, the effectiveness of patents appeared to have declined despite the strengthening of patent law. Although patents are effective in increasing the lead time before competitors are able to bring imitative products to market, these gains tend to be small. The great majority of patented products and processes are duplicated within three years.6

Given the limited effectiveness of patents, why do firms continue to engage in patenting? Figure 9.4 shows that, while protection from imitation is the principal motive, several others are also very important. In particular, much patenting activ- ity appears to be strategic; it is directed toward blocking the innovation efforts of other companies and establishing property rights in technologies that can then be used in bargaining with other companies for access to their proprietary technologies. In semiconductors and electronics, cross-licensing arrangements— where one company gives access to its patents across a field of technology in exchange for access to another company’s patents—are critical in permitting “freedom to design”: the ability to design products that draw on technologies owned by different companies.7

TABLE 9.1 The effectiveness of different mechanisms for protecting innovation

Secrecy (%)

Patents (%)

Lead-time (%)

Sales/service (%)

Manufacturing (%)

Product innovations Food 59 18 53 40 51 Drugs 54 50 50 33 49 Electronic components 34 21 46 50 51 Telecom equipment 47 26 66 42 41 Medical equipment 51 55 58 52 49 All industries 51 35 53 43 46 Process innovations Food 56 16 42 30 47 Drugs 68 36 36 25 44 Electronic components 47 15 43 42 56 Telecom equipment 35 15 43 34 41 Medical equipment 49 34 45 32 50 All industries 51 23 38 31 43

Note: These data show the percentage of companies reporting that the particular mechanism, their sales and service, and their manufacturing capabilities were effective in protecting their innovations. Source: W. M. Cohen, R. R. Nelson, and J. P. Walsh, “Protecting Their Intellectual Assets: Appropriability Conditions and Why US Manufacturing Firms Patent (Or Not),” NBER Working Paper No. W7552 (February 2000). © 2000. Reprinted by permission of the authors.

250 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Strategies to Exploit Innovation: How and When to Enter

Having established some of the key factors that determine the returns to innovation, let us consider some of the main questions concerning the formulation of strategies to manage technology and exploit innovation.

Alternative Strategies to Exploit Innovation How should a firm maximize the returns to its innovation? A number of alternative strategies are available. Figure 9.5 orders them according to the size of the com- mitment of resources that each requires. Thus, licensing requires little involvement by the innovator in subsequent commercialization, hence is a limited investment. Internal commercialization, possibly through creating a new enterprise or business unit, involves a much greater investment of resources and capabilities. In between there are various opportunities for collaboration with other companies—joint ven- tures, strategic alliances, and outsourcing that allow resource sharing between companies.

A firm’s choice of exploitation mode depends on two sets of factors: the charac- teristics of the innovation and the resources and capabilities of the firm.

Characteristics of the Innovation The extent to which a firm can establish clear property rights in an innovation is a critical determinant of its innovation strategy. Licensing is only viable where ownership in the innovation is protected by patent or copyrights. Thus, in pharmaceuticals, licensing is widespread because patents are clear and defensible. Many biotech companies engage only in R & D and license their drug discoveries to large pharmaceutical companies that possess the necessary

0 10 20 30 40 50 60 70 80 90 100

To prevent copying

For licensing revenue

To prevent lawsuits

To block others

For use in negotiations

To enhance reputation

To measure performance Process innovations Product innovations

FIGURE 9.4 Why do companies patent? (Responses by 674 US companies)

Source: W. M. Cohen, R. R. Nelson, and J. P. Walsh, “Protecting Their Intellectual Assets: Appropriability Conditions and Why US Manufacturing Firms Patent (Or Not),” NBER Working Paper No. W7552 (February 2000). © 2000. Reprinted by permission of the authors.

CHAPTER 9 TECHNOLOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 251

complementary resources. Royalties from licensing its sound-reduction technologies accounted for 82% of Dolby Laboratories’ 2014 revenues. Conversely, when Steve Jobs and Steve Wozniak developed their Apple I and Apple II computers, they had little option other than to go into business themselves: the absence of proprietary technology ruled out licensing as an option.

The advantages of licensing are, first, that it relieves the company of the need to acquire the complementary resources and capabilities needed for commercialization and, second, that it can allow the innovation to be commercialized quickly. If the lead time offered by the innovation is short, multiple licensing can allow for a fast global rollout. The problem, however, is that the success of the innovation in the market is totally dependent on the commitment and effectiveness of the licensees. James Dyson, the British inventor of the dual cyclone vacuum cleaner, created his own company to manufacture and market his vacuum cleaners after failing to interest any major appli- ance company in licensing his technology.

Resources and Capabilities of the Firm As Figure 9.5 shows, different strategies require very different resources and capabilities. Hence, the choice of how to exploit an innovation depends critically upon the resources and capabilities that the innova- tor brings to the party. Start-up firms possess few of the complementary resources and capabilities needed to commercialize their innovations. Inevitably, they will be attracted to licensing or to accessing the resources of larger firms through outsourc- ing, alliances, or joint ventures. As we noted in the previous chapter, new industries often follow a two-stage evolution where “innovators” do the pioneering and “con- solidators” with their complementary resources do the developing.

Certain large, resource-rich corporations such as DuPont, Siemens, Hitachi, and IBM have strong traditions of pursuing basic research, then internally developing the

FIGURE 9.5 Alternative strategies for exploiting innovation

Licensing Outsourcing

certain functions

Strategic alliance

Joint venture

Internal commercialization

Little investment risk but returns also limited. Risk that the licensee either lacks motivation or steals the innovation

Risk and return

Limits capital investment, but may create dependence on suppliers/partners

Benef its of f lexibility. Risks of informal structure

Shares investment and risk. Risk of partner disagreement and culture clash

Biggest investment requirement and corresponding risks. Benef its of control

Legal protection Capability in managing outsourced activities

Pooling of the resources and capabilities of multiple f irms requires collaborative capability

Full set of complementary resources and capabilities

ARM plc licenses its microprocessor technology to over 200 semiconductor companies; Stanford University earns over $100m annually from licensing its inventions

Apple designs its iPhones and Nvidia designs its graphics processing units, but both outsource manufacturing

Nike and Apple’s alliance to develop wearable devices was followed in 2014 by Samsung and Under Armour forming a similar alliance

Panasonic and Tesla Motors formed a joint venture in 2014 to develop a gigafactory to produce lithium ion batteries

Larry Page and Sergey Brin established Google Inc. to develop and market their internet search technology

Resource requirements

Examples

252 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

innovations that arise. However, even these companies have been forced into more technological collaborations with other companies. Ron Adner observes that innova- tion increasingly requires coordinated responses by multiple companies. Innovating firms need to identify and map their innovation ecosystem, then manage the inter- dependencies within it. The long delay in the introduction of HDTV can be attrib- uted to inadequate coor dination among TV manufacturers, production studios, and broadcasters.8 We shall return to the challenges of managing innovation ecosystems when we look closer at platform-based competition.

Timing Innovation: To Lead or to Follow? To gain competitive advantage in emerging and technologically intensive industries, is it better to be a leader or a follower in innovation? As Table 9.2 shows, the evidence is mixed: in some products the leader has been the first to grab the prize; in oth- ers, the leader has succumbed to the risks and costs of pioneering. Optimal timing of entry into an emerging industry and the introduction of new technology are complex issues. The advantage of being an early mover depends on the following factors:

● The extent to which innovation can be protected by property rights or lead- time advantages: If an innovation is appropriable through a patent, copy- right, or lead-time advantage, there is advantage in being an early mover. This is especially the case where patent protection is important, as in

TABLE 9.2 Leaders, followers, and success in emerging industries

Product Innovator Follower The winner

Jet airliner De Havilland (Comet) Boeing (707) Follower Float glass Pilkington Corning Leader X-ray scanner EMI General Electric Follower Office PC Xerox IBM Follower VCRs Ampex/Sony Matsushita Follower Instant camera Polaroid Kodak Leader Microwave oven Raytheon Samsung Follower Video games player Atari Nintendo/Sony Followers Disposable diaper Procter & Gamble Kimberley-Clark Leader Compact disk Sony/Philips Matsushita, Pioneer Leader Web browser Netscape Microsoft Follower Web search engine Lycos Google Follower MP3 music players Diamond Multimedia Apple (iPod) Follower Operating systems for

mobile devices Symbian, Palm OS Microsoft, Apple,

Google Followers

Laser printer Xerox, IBM Canon Follower Flash memory Toshiba Samsung, Intel Followers E-book reader Sony (Digital Reader) Amazon (Kindle) Follower Social networking SixDegrees.com Facebook Follower

Source: Updated from D. Teece, The Competitive Challenge: Strategies for Industrial Innovation and Renewal (Cambridge: Ballinger, 1987): 186–8.

CHAPTER 9 TECHNOLOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 253

pharmaceuticals. Notable patent races include that between Alexander Bell and Elisha Gray to patent the telephone (Bell got to the Patent Office a few hours before Gray),9 and between Celera Inc. and the National Institutes of Health to patent the sequence of the human genome.10

● The importance of complementary resources: The more important comple- mentary resources are in exploiting an innovation, the greater the costs and risks of pioneering. Prior to Tesla Motors, just abut every company that tried to pioneer an all-electric car failed miserably. The problem for the pioneer is that the development costs are huge because of the need, not just to orches- trate multiple technologies but also to establish an entire infrastructure for distribution, service, and recharging. Where the need for complementary resources is great, followers are also favored by the fact that, as an indus- try develops, specialist firms emerge to supply complements. Thus, in pio- neering electric cars, a key challenge for Tesla Motors—especially in major overseas markets such as China—is establishing chains of charging stations. Later entrants into electric cars will be able to rely upon an established infrastructure.

● The potential to establish a standard: As we shall see later in this chapter, some markets converge toward a technical standard. The greater the impor- tance of technical standards, the greater the advantages of being an early mover in order to influence those standards and gain the market momen- tum needed to establish leadership. Once a standard has been set, displac- ing it becomes exceptionally difficult. IBM was responsible for establishing Microsoft’s MS-DOS as the dominant operating system for personal comput- ers. However, when in 1987 IBM launched its OS/2 operating system, it had little success against the entrenched position of Microsoft. Only by offering their products for free have Linux and Google’s Chrome been able to take market share from Microsoft’s Windows.

The implication is that optimal timing depends on the resources and capabilities that a firm has at its disposal. Hence, different firms have different strategic windows— periods in time when their resources and capabilities are aligned with the opportu- nities available in the market. A small, technology-based firm may have no choice but to pioneer innovation: its opportunity is to grab first-mover advantage and then develop the necessary complementary resources before more powerful rivals appear. For the large, established firm with financial resources and strong production, mar- keting, and distribution capabilities, the strategic window is likely to be both longer and later. The risks of pioneering are greater for an established firm with a reputation and brands to protect, while to exploit its complementary resources effectively typi- cally requires a more developed market. Consider the following examples:

● In the early days of personal computers, Apple was a pioneer, IBM a fol- lower. The timing of entry was probably optimal for each. Apple’s resources comprised the vision of Steve Jobs and the technical genius of Steve Wozniak; only by pioneering could it hope to be successful. IBM had enor- mous strengths in manufacturing, distribution, and reputation. It could build competitive advantage even without technological leadership. The key for IBM was to delay its entry until the time when the market had developed to the point where IBM’s strengths could have their maximum impact.

254 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

● In the browser war between Netscape and Microsoft, Microsoft had the luxury of being able to follow the pioneer, Netscape. Microsoft’s huge product development, marketing, and distribution capabilities, and, most important, its vast installed base of the Windows operating system allowed it to overhaul Netscape’s initial lead.

● EMI, the British music and electronics company, introduced the world’s first CT scanner in 1972. Despite a four-year lead, General Electric’s vast technological and commercial capabilities within medical electronics allowed it to drive EMI out of the market.11

Followers are especially effective in initiating a new product’s transition from niche mar- ket to mass market. According to Markides and Geroski, successful first movers pioneer new products that embody new technologies and new functionality.12 The opportunity for the fast-second entrant is to grow the niche market into a mass market by lowering cost and increasing quality. Timing is critical. Don Sull argues that a successful follower strategy requires “active waiting”: a company needs to monitor market developments and assemble resources and capabilities while it prepares for large-scale market entry.13

Managing Risks Emerging industries are risky. There are two main sources of uncertainty:

● Technological uncertainty arises from the unpredictability of technological evo- lution and the complex dynamics through which technical standards and domi- nant designs are selected. Hindsight is always 20/20, but ex ante it is difficult to predict how technologies and the industries that deploy them will evolve.

● Market uncertainty relates to the size and growth rates of the markets for new products. When Xerox introduced its first plain-paper copier in 1959, Apple its first personal computer in 1977, or Sony its Walkman in 1979, none had any idea of the size of the potential market. Similarly with Facebook: when Mark Zuckerberg launched it from his Harvard dorm in February 2004, there was little indication that it would grow from a college website into a global social net- work with over one billion active users. Forecasting demand for new products is hazardous—most forecasting techniques are based on past data. Demand forecasts for new products tend to rely either on analogies14 or expert opinion— e.g., combining expert insight and experience using the Delphi technique.15

If managers are unable to forecast technology and demand, then to manage risk they must be alert to emerging trends while limiting their exposure to risk through avoiding large-scale commitments. Useful strategies for limiting risk include:

● Cooperating with lead users: During the early phases of industry develop- ment, careful monitoring of and response to market trends and customer requirements is essential to avoid major errors in technology and design. Von Hippel argues that lead users provide a source of leading market indicators, can assist in developing new products and processes, and offer an early cash flow to fund development expenditures.16 In computer software, beta ver- sions are released to computer enthusiasts for testing. Nike has two sets of lead users: professional athletes who are trendsetters for athletic footwear

CHAPTER 9 TECHNOLOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 255

and hip-hop artists who are at the leading edge of urban fashion trends. In communications and aerospace, government defense contracts play a crucial role in developing new technologies.17

● Limiting risk exposure: The financial risks of emerging industries can be miti- gated by financial and operational practices that minimize a firm’s exposure to adversity. By avoiding debt and keeping fixed costs low, a firm can lower its financial and operational gearing. Outsourcing and strategic alliance can also hold down capital investment and fixed costs.

● Flexibility: Uncertainty necessitates rapid responses to unpredicted events. Achieving such flexibility means keeping options open and delaying commit- ment to a specific technology until its potential becomes clear. Twitter—origi- nally Odeo—was founded to develop a podcasting platform. Once Apple added a podcasting facility to iTunes, Odeo redirected itself toward a plat- form for internet-hosted text messages.

● Multiple strategies: Eric Beinhocker of McKinsey & Company argues that uncertainty favors multiple strategies over a single focused strategy—what he refers to as “robust, adaptive strategies.” Faced with technological uncer- tainty, well-resourced companies—such as IBM, Microsoft, and Google—have the luxury of simultaneously investing in a variety of technological options. For Microsoft this has meant a number of prominent failures—MP3 players (Zune), smartphones (Kin), tablet computers (Surface), and social networking (Yammer). Nevertheless, Microsoft’s multiplicity of investments has allowed it to build leadership positions in several new fields, including online gaming and cloud computing.18 Large, well-resourced companies have the luxury of pursuing multiple strategic options.

Standards, Platforms, and Network Externalities

In the previous chapter, we noted that the establishment of a standard can be a key event in an industry’s development and growth. In the digital, networked economy, more and more markets are subject to standards which play a vital role in ensuring compatibility between users. For companies, owning a standard can be an impor- tant source of competitive advantage with the potential to offer returns that are unmatched by any other type of competitive advantage. Table 9.3 lists several com- panies which own key technical standards within a particular product category. A characteristic of most of these companies is the fact that these standards have gener- ated considerable profits and shareholder value.

Types of Standard A standard is a format, an interface, or a system that allows interoperability. Adhering to standards allows us to browse millions of different web pages, ensures the light bulbs made by any manufacturer will fit any manufacturer’s lamps, and keeps the traffic moving in Los Angeles (most of the time). Standards can be public or private.

● Public (or open) standards are those that are available to all either free or for a nominal charge. Typically, they do not involve any privately owned

256 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

intellectual property, or the intellectual-property owners make access free (such as Linux). Public standards may be mandatory standards set by government and backed by the force of law (these relate mainly to safety, environmental, and consumer protection standards) or they are volun- tary standards set by industry associations of standards bodies such as the International Organization for Standardization (ISO), the American National Standards Institute, or the British Standards Institute. Thus, the GSM mobile phone standard was set by the European Telecom Standards Institute. Internet protocols (standards governing internet addressing and routing) are mostly public. They are governed by several international bodies, including the Internet Engineering Task Force.

● Private (proprietary) standards are those where the technologies and designs are owned by companies or individuals. If I own the technology that becomes a standard, I can embody the technology in a product that others buy or license the technology to others who wish to use it. Thus, in smartphones the major rival standards are Apple’s iOS and Google’s Android. Apple’s iOS is used only in Apple’s mobile devices; Android is licensed widely. Android also represents another variant on technical standards: it is open source; it is freely available; and it can be used, adapted, and devel- oped by anyone. Most private standards are de facto standards: they emerge through voluntary adoption by producers and consumers. Table 9.3 gives examples.

A problem with de facto standards is that they may take a long time to emerge, resulting in a duplication of investments and delaying the development of the mar- ket. It was 40 years before a standard railroad gauge was agreed in the US.19 A man- dated, public standard can avoid much of this uncertainty. Europe’s mandating of standards for wireless telephony as compared with the US’s market-based approach

TABLE 9.3 Examples of companies that own de facto industry standards

Company Product category Standard

Microsoft PC operating systems Windows Intel PC microprocessors x86 series Sony/Philips Compact disks CD-ROM format ARM (Holdings) Microprocessors for mobile devices ARM architecture Oracle Corporation Programming language for web apps Java Qualcomm Digital cellular wireless communication CDMA Adobe Systems Common file format for creating and

viewing documents Acrobat Portable

Document Format Adobe Systems Web page animation Adobe Flash Adobe Systems Page description language for document printing Post Script Bosch Antilock braking systems ABS and TCS (Traction

Control System) IMAX Corporation Motion picture filming and projection system IMAX Apple Music downloading system iTunes/iPod Sony High definition DVD Blu-ray NTT DOCOMO Mobile phone payment system in Japan Osaifu-Keitai

CHAPTER 9 TECHNOLOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 257

resulted in Europe making the transition to 2G much quicker than the US. However, with 4G the situation has reversed: it is Europe that is the laggard.20 Delayed emer- gence of a standard may kill the technology altogether. The failure of quadraphonic sound to displace stereophonic sound during the 1970s resulted from incompatible technical standards, which inhibited audio manufacturers, record companies, and consumers from investing in the technology.21

The Role of Network Externalities Standards emerge in markets that are subject to network externalities. A net- work externality exists whenever the value of a product to an individual customer depends on the number of other users of that product. The classic example of net- work externality is the telephone. Since there is little satisfaction to be gained from talking to oneself on the telephone, the value of a telephone to each user depends on the number of other users connected to the same network. This is different from most products. When I pour myself a glass of Glenlivet after a couple of exhaust- ing MBA classes, my enjoyment is independent of how many other people in the world are drinking whiskey. Indeed, some products may have negative network externalities—the value of the product is less if many other people purchase the same product. If I spend $3000 on an Armani silver lamé tuxedo and find that half my colleagues at the faculty Christmas party are wearing the same jacket, my satis- faction is lessened.

Networks require technical standards to ensure connection to the network. This does not require everyone to use the same product or even the same technology, but rather that the different products are compatible with one another through some form of common interface. In the case of wireless telephone service, it doesn’t mat- ter (as far as network access is concerned) whether I purchase service from AT&T, Verizon, or T-Mobile: technical standards ensure compatibility between each net- work which allows connectivity. Similarly with railroads: if I am transporting coal from Wyoming to Boston, my choice of railroad company is not critical. Unlike in the 1870s, every railroad company now uses a standard gauge and is required to give “common carrier” access to other companies’ rolling stock.

Network externalities arise from several sources:

● Products where users are linked to a network: Telephones, railroad systems, and email instant messaging groups are networks where users are linked together. Applications software, whether spreadsheet programs or video games, also links users—they can share files and play games interactively. User-level externalities may also arise through social identification. I watch Game of Thrones and the Hollywood Oscar presentations on TV not because I enjoy them but so that I have something to talk to my colleagues about in the faculty common room.22

● Availability of complementary products and services: Where products are consumed as systems, the availability of complementary products and ser- vices depends on the number of customers for that system. Microsoft’s key problem in the smartphone market is that Windows’ 3% market share results in an acute shortage of third-party apps for the Windows Phone. Similarly, I choose to own a Ford Focus rather than a Ferrari Testarossa, not only because I’m a lousy driver but also because I know that, should I break

258 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

down 200 miles from Bismarck, North Dakota, spare parts and a repair ser- vice will be more readily available.

● Economizing on switching costs: By purchasing the product or system that is most widely used, there is less chance that I shall have to bear the costs of switching. By using Microsoft PowerPoint rather than an alternative presenta- tion software such as SlideRocket or Prezi, it is more likely that I will avoid the costs of retraining and file conversion when I become a visiting professor at another university.

Network externalities create positive feedback. Once a technology or system gains market leadership, it attracts more and more users. Conversely, once market leadership is lost, a downward spiral is likely. This process is called tipping: once a certain threshold is reached, cumulative forces become unstoppable—the result is a winner-takes-all mar- ket.23 Those markets subject to significant network externalities tend to be dominated by a single supplier (e.g., Microsoft in PC operating systems and office applications, eBay in internet auctions, and Airbnb in residential accommodation sharing).

Once established, technical and design standards tend to be highly resilient. Standards are difficult to displace due to learning effects and collective lock-in. Learning effects cause the dominant technology and design to be continually improved and refined. Even where the existing standard is inherently inferior, switching to a superior technology may not occur because of collective lock in. The classic case is the QWERTY typewriter layout. Its 1873 design was based on the need to slow the speed of typing to prevent typewriter keys from jamming. Although the jamming problem was soon solved, the QWERTY layout has persisted, despite the availability of the faster Dvorak Simplified Keyboard (DSK).24

Platform-based Markets

Digital technologies together with internet or wireless connectivity have created markets where network externalities arise both from user connections and from the availability of complements. These platform-based markets are also referred to as two-sided (or even multi-sided) markets because they form an interface between two groups of users: customers and the suppliers of complementary products.

Operating systems are the quintessential platforms: Microsoft’s Windows, Apple’s iOS, and Google’s Android create network externalities among users (direct exter- nalities) and among the suppliers of applications (indirect externalities). Each of these platforms is central to an ecosystem comprising thousands of interdependent companies that coevolve. Thus, the Android ecosystem comprises over 100 smart- phone manufacturers, thousands of app developers, suppliers of hardware com- ponents, accessory providers, and many other types of player. As Strategy Capsule 4.1 in Chapter 4 describes in relation to smartphones, competition between rival platforms for market dominance is often intense.

However, platforms are not restricted to digital markets, and nor do the net- works necessarily require technical standards. A shopping mall is a platform: the mall developer creates a two-sided market comprising the retailers who lease the individual stores and the customers who do the shopping—network externalities operate on both sides.

CHAPTER 9 TECHNOLOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 259

Deciding whether to pursue a product strategy or a platform strategy is a key strategic issue. Google and Facebook both began with product strategies but soon recognized the potential for their products—Google’s search engine and Facebook’s social network—to become platforms. Many department stores have undertaken a similar transition: abandoning retailing in favor of managing an infrastructure that hosts multiple concession stores. The success of the Apple Macintosh between 1984 and 2004 was limited by Apple’s pursuit of a product rather than a platform strategy. We look further at platform strategies in Strategy Capsule 9.2.

Competing for Standards In markets subject to network externalities, control over standards is the primary basis for competitive advantage. Owning a proprietary standard can be the basis for market domination—and, as in the case of the Wintel standard for personal computers—a source of massive profits. What do we know about designing winning strategies in markets subject to network externalities?

The first key issue is to determine whether we are competing in a market that will converge around a single technical standard. This requires a careful analysis of the presence and sources of network externalities.

The second strategic issue in standards setting is recognizing the role of positive feed- back: the technology that can establish early leadership will rapidly gain momentum. Building a “bigger bandwagon” according to Shapiro and Varian25 requires the following:

● Before you go to war, assemble allies: You’ll need the support of consumers, suppliers of complements, even your competitors. Not even the strongest companies can afford to go it alone in a standards war.

● Preempt the market: Enter early, achieve fast-cycle product development, make early deals with key customers, and adopt penetration pricing.

● Manage expectations: The key to managing positive feedback is to convince customers, suppliers, and the producers of complementary goods that you will emerge as the victor. These expectations become a self-fulfilling prophecy. The massive pre-launch promotion and publicity built up by Sony prior to the American and European launch of PlayStation 2 in October 2000 was an effort to convince consumers, retailers, and game developers that the product would be the blockbuster consumer electronics product of the new decade, thereby stymieing Sega’s and Nintendo’s efforts to establish their rival systems.

A great deal has been learned from the standards battles of the past four decades, particularly those involving competing platforms. Strategy Capsule 9.2 outlines the lessons from past platform wars. If a company attempts to appropriate too great a share of the value created, it may well fail to build a big enough bandwagon to gain market leadership. Thus, most recent standards battles have involved broad alliances, which comprise multiple ecosystem members. In the 2006–2008 struggle between Sony (Blu-ray) and Toshiba (HD-DVD), each camp recruited movie studios, software firms, and producers of computers and consumer electronics using various inducements, including direct cash payments. The defection of Warner Brothers to the Sony camp was critical to the market tipping suddenly in Sony’s favor. However, it appears that all the financial gains from owning the winning standard were dis- sipated by the costs of the war.26

260 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Past competitive battles between rival platforms have

exercised a powerful influence over current thinking

about designing strategies for markets subject to network

externalities. None has been more influential than the

competitive battles of the late 1970 and 1980s in video-

cassette recorders (VCRs) and personal computers (PCs).

In neither case was technical superiority the key—

indeed, in both instances it could be argued that the

superior technology lost. The key factor was managing

the dynamics of market penetration in order to build

market leadership:

◆ In VCRs, Sony kept tight proprietary control of its

Betamax system; JVC licensed its VHS system to

Sharp, Philips, GE, RCA, and others, fueling market

penetration.

◆ In computers, IBM’s PC platform became domi-

nant because access to its product specifications

and the availability of the core technologies—

notably Microsoft’s operating system and Intel’s

microprocessors—allowed a multitude of “clone

makers” to enter the market. The problem for IBM

was that it established the dominant platform

but Intel and Microsoft appropriated most of the

value. For Apple, the situation was the reverse: by

keeping tight control over its Macintosh operating

system and product architecture, it earned high

margins, but it forfeited the opportunity for market

dominance.

This tradeoff between penetrating the market

and appropriating the returns to platform ownership

is shown in Figure 9.6. Learning from these two epic

contests, platform owners have relinquished more

and more value to complementors, competitors, and

customers in order to build a bigger bandwagon than

their rivals. In some cases this has meant foregoing all

possible profits. In the browser war of 1995–1998, both

Netscape (Navigator) and Microsoft (Explorer) ended

up giving away their products.

Finding a better balance between market penetra-

tion and value appropriation has resulted in new pric-

ing models. Adobe (and many other software suppliers)

follows a “freemium” model—Acrobat Reader is avail-

able free of charge, but to create or convert PDF files,

the necessary Acrobat software must be purchased.

STRATEGY CAPSULE 9.2

Winning Platform Wars

Achieving compatibility with existing products is a critical issue in standards bat- tles. Advantage typically goes to the competitor that adopts an evolutionary strategy (i.e., offers backward compatibility) rather than one that adopts a revolutionary strat- egy.27 A key advantage of the Sony PlayStation 2 over Microsoft Xbox and Nintendo Cube was its compatibility with the PlayStation 1. However, the limited compatibility of PlayStation 3 with PlayStation 2 was one of the many problems that limited the success of PlayStation 3.

What are the key resources needed to win a standards war? Shapiro and Varian emphasize the following:

● control over an installed base of customers; ● owning intellectual property rights in the new technology;

CHAPTER 9 TECHNOLOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 261

FIGURE 9.6 Platform wars in videocassette recorders and personal computers

Maximizing market

penetration

Maximizing value

appropriation

VHS Betamax

IBM PC

Personal computers

Apple Mac

VCRs

Other platform battles have indicated that winning

platform wars is not only about building market momen-

tum through maximizing the numbers of complemen-

tors and customers. Customers are, typically, not buying

a platform; they are buying a system, and the attractive-

ness of that system is not determined exclusively by

the number of users and the number of complements

available. Consider two exceptionally profitable platform

owners: Nintendo in video game consoles during 1988–

1996 and Apple in smartphones during 2008–2015. In

both cases the success of the platforms—the Nintendo

Entertainment System (NES) and the iPhone—was

determined by the overall quality of the system, not

just the hardware but the applications software as well.

Both Nintendo and Apple exercised tight control over

application developers imposing quality standards and

ensuring overall system integration.

Sources: A. Gawer and M. A. Cusumano, “How Companies Become Platform Leaders,” MIT Sloan Management Review 49 (2008): 28–35; C. Cennamo and J. Santal, “Platform Competition: Strategic Trade-offs in Platform Markets,” Strategic Management Journal 34 (2013): 133150.

● the ability to innovate in order to extend and adapt the initial technological advance;

● early-mover advantage; ● strength in complements (e.g., Intel has preserved its standard in micropro-

cessors by promoting standards in buses, chipsets, graphics controllers, and interfaces between motherboards and CPUs);

● reputation and brand name.28

However, the dynamics of standards wars are complex and we are far from being able to propose general strategy principles. As Strategy Capsule 9.2 shows, in platform-based competition it is not always the case that “the biggest bandwagon

262 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

wins”—issues of quality and brand differentiation are also important. Nor does plat- form leadership necessarily translate into the platform owner’s ability to capture value. Finally, it is often unclear whether a market will converge around a single platform (e.g., eBay in online auctions) or multiple platforms (e.g., video game con- soles and smartphones.)29

Implementing Technology Strategies: Creating the Conditions for Innovation

As we have noted previously, strategy formulation cannot be separated from its implementation. Nowhere is this more evident than in technology-intensive businesses.

Our analysis so far has taught us about the potential for generating competitive advantage from innovation and about the design of technology-based strategies but has said little about the conditions under which innovation is achieved. Incisive strategic analysis of how to make money out of innovation is of little use if we can- not generate innovation in the first place. We know that innovation requires certain resources—people, facilities, information, and time—but, like other capabilities, the relationship between R & D input and innovation output is weak—indeed under some circumstances lack of resources may act as a spur to innovation.30 The produc- tivity of R & D depends critically on the organizational conditions that foster innova- tion. What are these conditions and how do we create them?

Let’s begin with the critical distinction between invention and innovation. While these activities are complementary, they require different resources and differ- ent organizational conditions. While invention depends on creativity, innovation requires collaboration and cross-functional integration.

Fostering Creativity The Conditions for Creativity Invention is an act of creativity requiring knowl- edge and imagination. The creativity that drives invention is typically an individual act that establishes a meaningful relationship between concepts or objects that had not previously been related. This reconceptualization can be triggered by accidents: an apple falling on Isaac Newton’s head or James Watt observing a kettle boiling. Creativity is associated with particular personality traits. Creative people tend to be curious, imaginative, adventurous, assertive, playful, self-confident, risk taking, reflective, and uninhibited.31

Individual creativity also depends on the organizational environment in which they work—this is as true for the researchers and engineers at Amgen and Google as it was for the painters and sculptors of the Florentine and Venetian schools. Few great works of art or outstanding inventions are the products of solitary geniuses. Creativity is stimulated by human interaction: the productivity of R & D laboratories depends critically on the communication networks that the engineers and scientists establish.32 An important catalyst of interaction is play, which creates an environment of inquiry, liberates thought from conven- tional constraints, and provides the opportunity to establish new relationships

CHAPTER 9 TECHNOLOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 263

by rearranging ideas and structures at a safe distance from reality. The essence of play is that it permits unconstrained forms of experimentation.33 The potential for low-cost experimentation has expanded vastly thanks to advances in com- puter modeling and simulation that permit prototyping and market research to be undertaken speedily and virtually.34

Organizing for Creativity Creativity requires management systems that are quite different from those that are appropriate for efficiency—we observed in Chapter 8, when discussing the challenge of ambidexterity, exploration needs to be managed very differently from exploitation. In particular, creatively oriented people tend to be responsive to distinctive types of incentive. They desire to work in an egalitarian culture with enough space and resources to provide the opportunity to be spontane- ous, experience freedom, and have fun in the performance of a task that, they feel, makes a difference to the performance of their organization (and, possibly, to the world as a whole). Praise, recognition, and opportunities for education and profes- sional growth are also more important than assuming managerial responsibilities.35 Evidence from open-source projects shows that people will devote time and effort to creative activities even in the absence of financial rewards.36 Nurturing the drive to create may require a degree of freedom and flexibility that conflicts with conven- tional HR practices. At many technology-based companies, including Google and W. L. Gore & Associates, engineers choose which projects they wish to join.

Organizational environments conducive to creativity tend to be both nurturing and competitive. Creativity requires a work context that is secure but not cozy. Dorothy Leonard points to the merits of creative abrasion within innovative teams— fostering innovation through the interaction of different personalities and perspec- tives. Managers must resist the temptation to clone in favor of embracing diversity of cognitive and behavioral characteristics within work groups—creating whole brain teams.37 Exploiting diversity may require constructive conflict. Microsoft’s develop- ment team meetings are renowned for open criticism and intense disagreement. Such conflict can spur progress toward better solutions.

Table 9.4 contrasts some characteristics of innovative organizations compared with those designed for operational efficiency.

Accessing External Sources of Innovation

Internal creativity is not the sole source of innovation: innovation can be accessed beyond an organization’s boundaries. A major trend in innovation management has been a shift in focus away from firms’ internal R & D toward accessing ideas and knowledge from the wider world. New tools of information and communications technology have reinforced this trend.

Customers as Sources of Innovation We observed earlier in this chapter that research directed toward practical needs is more likely to lead to innovation than that motivated toward scientific discovery. Few important inventions have been spontaneous creations by technologists—most have resulted from grappling with practical problems. The invention of the Xerox

264 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

copying process (xerography) by Chester Carlson, a patent attorney, was inspired by his frustration with the tedious task of making multiple copies of patent applica- tions. Joseph Lister, a British surgeon, developed sterile surgery in response to the appalling fatality rate from surgery in the Victorian era.

The old adage that “necessity is the mother of invention” explains why customers are such fertile sources of innovation—they are most acutely involved with match- ing existing products and services to their needs. However, listening to customers is typically a weak inspiration and guide for innovation. As Henry Ford remarked: “If I had asked people what they wanted, they would have said faster horses!” Moreover, as studies of disruptive innovation have shown, major customers are likely to be dismissive of radical innovation.

According to Adrian Slywotzky, the key is “Creating What People Love Before They Know They Want It.” This requires focusing not on what customers want but on their sources of dissatisfaction. He advocates creating a “hassle map”: a sequence of customers’ frustrations and negative emotions that can guide new approaches to creating customer value.38

Eric von Hippel advocates making customers part of the innovation process.39 Companies can induce and exploit customer initiated innovation by identifying leading- edge customers, supplying them with easy-to-use design tools, and ensuring flexibility in production processes so that customers’ innovations can be effectively exploited.40

Open Innovation Involving customers (and suppliers, too) in innovation may be seen as an inter- mediate stage in opening the innovation processes. As innovation increasingly

TABLE 9.4 The characteristics of “operating” and “innovating” organizations

Operating organization Innovating organization

Structure Bureaucratic Specialization and division of labor Hierarchical control Defined organizational boundaries

Flat organization without hierarchical control

Task-oriented project teams Fuzzy organizational boundaries

Processes Emphasis on eliminating variation (e.g., six-sigma)

Top-down control Tight financial controls

Emphasis on enhancing variation Loose controls to foster idea

generation Flexible strategic planning and financial

control

Reward systems Financial compensation Promotion up the hierarchy Power and status symbols

Autonomy Recognition Equity participation in new ventures

People Recruitment and selection based on the needs of the organization structure for specific skills: functional and staff specialists, general managers, and operatives

Key need is for idea generators who combine required technical knowl- edge with creative personality traits

Managers must act as sponsors and orchestrators.

Source: Adapted from J. K. Galbraith and R. K. Kazanjian, Strategy Implementation: Structure, Systems and Processes, 2nd edn (St. Paul, MN: West, 1986).

CHAPTER 9 TECHNOLOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 265

requires integrating multiple technologies—often from traditionally separate sci- entific areas—so firms have been forced to look more widely in sourcing technol- ogy and sharing know-how. The evidence that interpersonal interaction stimulates innovation is overwhelming. This is true whether we are considering R & D teams within organizations, inter-firm alliances, interpersonal networks, or clusters of firms concentrated within industrial districts.41 Building on the principle that the gains to collaborative knowledge sharing outweigh the risks of one’s proprie- tary knowledge being expropriated, an increasing number of firms are adopting open innovation—an approach to innovation that seeks, exploits, and applies knowledge both from inside and outside the organization. According to Henry Chesbrough: “Open innovation is fundamentally about operating in a world of abundant knowledge, where not all the smart people work for you, so you’d bet- ter go find them, connect to them, and build upon what they can do.”42 While the pioneers of open innovation have been open-source software communities and networks of small and medium-sized firms, some of its leading exponents are giant corporations (Strategy Capsule 9.3).

Buying Innovation For all the exhortations by business leaders and management consultants to cultivate innovation, the fact remains that small, technology-intensive start-ups have advan- tages over large corporations in the early stages of the innovation process. Hence, the major source of innovation for many large companies is to buy it through licens- ing, outright purchase of patents, or acquiring young, technology-based companies. Pharmaceutical companies have been especially prominent in this outsourcing of innovation, especially within biotechnology. In addition to licensing drug patents and signing collaborative agreements, outright acquisitions of specialist biotech firms (these include Alios BioPharma by Johnson & Johnson in 2014, Genentech by Roche in 2009, ICOS by Eli Lily in 2007, and Chiron by Novartis in 2006).43 We shall look more closely at mergers, acquisitions, and alliances in Chapter 15.

Organizing for Innovation For creativity to create value, both for the company and for society, it must be directed and harnessed. Balancing creative freedom with commercial discipline is a challenge for all innovative companies. The problem is not restricted to technol- ogy-based companies but also affects fashion and media companies: “The two cul- tures—of the ponytail and the suit—are a world apart, and combustible together.”44 Many innovative companies have been formed by frustrated inventors leaving established companies. The success of Google in internet-based software, Apple in digital mobile devices, Disney in animated movies, and HBO with its succession of award-winning TV series reveals a remarkable ability to mesh creativity with commercial acuity.

Reconciling creativity with commercial effectiveness is a major challenge for organizational design—as Table 9.4 shows, the organizational requirements of the two are very different. The organizational solution (as we explored in Chapter 6) comes from reconciling differentiation and integration. The creative and opera- tional functions of the organization need different structures and systems. Yet, the

266 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

key to successful innovation is in integrating creativity and technological expertise with capabilities in production, marketing, finance, distribution, and customer sup- port. Achieving such integration is difficult. Tension between the operating and the innovating parts of organizations is inevitable. Innovation upsets established rou- tines and threatens the status quo. The more stable the operating and administrative side of the organization, the greater the resistance to innovation. The opposition of the US naval establishment to continuous-aim firing, an innovation offering huge improvements in gunnery accuracy, illuminates this resistance to innovation.45

As innovation has become an increasing priority for established corporations, so chief executives have sought to emulate the flexibility, creativity, and entrepreneurial spirit of technology-based start-ups. Organizational initiatives aimed at stimulating new product development and the exploitation of new technologies include the following:

● Cross-functional Product Development Teams: These have proven highly effective mechanisms for integrating creativity with functional effective- ness. Conventional approaches to new product development involved

PROCTER & GAMBLE’S CONNECT AND DEVELOP

P&G’s Connect and Develop innovation process seeks

to “identify promising ideas throughout the world

and apply our own R & D, manufacturing, marketing,

and purchasing capabilities to them to create bet-

ter and cheaper products, faster.” The program was

a response to the realization that, despite a research

staff of 7500, P&G was not generating the new prod-

ucts needed to meet its growth targets. For each of

its own research scientists, P&G estimated there were

at least 200 outside the company with the potential

to contribute to its development efforts. To focus its

search, each business was asked to identify its top

ten customer needs (e.g., reduce wrinkles, improve

skin texture, softer paper products with higher wet

strength) which were translated into specific techni-

cal requirements (e.g., biotechnology solutions that

permit detergents to perform well at low tempera-

tures). The initiatives were prioritized according to

their fit with P&G’s existing areas of brand and tech-

nological strength.

The Connect and Develop process involved:

◆ Seventy technology entrepreneurs within P&G

responsible for developing external contacts and

exploring for innovation in particular localities and

with a focus around particular product or technol-

ogy areas.

◆ Suppliers with whom P&G shared technology

briefs and engaged in regular meetings with senior

P&G executives to explore mutual development

opportunities.

◆ Technology brokering networks such as NineSigma

linking companies with universities, government

bodies, consultants, and other solutions providers;

Innocentive, which brokers solutions to science-

based problems; YourEncore, a network of retired

scientists and engineers; and Yet2.com, an online

marketplace for intellectual capital.

STRATEGY CAPSULE 9.3

Open Innovation at Procter & Gamble and IBM

CHAPTER 9 TECHNOLOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 267

a sequential process that began in the corporate research lab then went “over the wall” to engineering, manufacturing, finance, and so on. Japanese companies pioneered autonomous product development teams staffed by specialists seconded from different departments with leadership from a “heavyweight” team manager who was able to pro- tect the team from undue corporate influence.46 Such teams have proven effective in deploying a broad range of specialist knowledge and, most importantly, integrating that knowledge flexibility and quickly, for exam- ple through rapid prototyping and concurrent engineering.47

● Product champions: These provide a means, first, for incorporating indi- vidual creativity within organizational processes and, second, for linking invention to subsequent commercialization. The key is to permit the indi- viduals who are sources of creative ideas to lead the teams which develop those ideas—but also to allow this leadership to continue through into the commercialization phases. Companies that are consistently success- ful in innovation have the ability to design organizational processes that

The resulting flow of suggestions and proposals are

screened and disseminated through P&G’s Eureka online

catalog. It is then up to executives within the business

groups to identify interesting proposals, to pursue

these with the external provider through P&G’s External

Business Development group, and to then move the

initiative into their own product development process.

By 2005, 35% of P&G’s new product launches had

their origins outside the company. These included

Swiffer cleaning cloths, Olay Regeneration, and Crest

Spinbrush.

IBM’S INNOVATION JAM

IBM’s Innovation Jam is one element of IBM’s exten-

sive collaborative innovation network. It is a massive

online brainstorming process to generate, select, and

develop new business ideas. The 2006 Jam was based

upon an initial identification of 25 technology clusters

grouped into six broad categories. Websites were built

for each technology cluster and, for a 72-hour period,

IBM employees, their families and friends, suppliers,

customers, and individual scientists and engineers

from all around the world were invited to contribute

ideas for innovations based on these technologies. The

150,000 participants generated vast and diverse sug-

gestions that were subject to text mining software and

review by 50 senior executives and technical specialists

who worked in nine separate teams to identify prom-

ising ideas. The next phase of the Jam subjected the

selected innovation ideas to comments and review by

the online community. This was followed by a further

review process in which the ten best proposals were

selected and a budget of $100 million was allocated

to their development. The selected business ideas

included a real-time foreign language translation ser-

vice, smart healthcare payment systems, IT applica-

tions to environmental projects, and 3-D internet. The

new businesses were begun as incubator projects and

were then transferred to one or other of IBM’s business

groups. As well as divisional links, the new ventures

were also subject to monthly review by IBM’s corpo-

rate top management. IBM has since extended its jam

methodology to address a widening array of issues.

Sources: www.pgconnectdevelop.com; L. Huston and N. Sakkab, “Connect and Develop: Inside Procter & Gamble’s New Model for Innovation,” Harvard Business Review (March 2006): 58–66; www.collaborationjam.com; O. M. Bjelland and R. C. Wood, “An Inside View of IBM’s Innovation Jam,” MIT Sloan Management Review (Fall 2008): 32–43.

268 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

capture, direct, and exploit individuals’ drive for achievement and success and their commitment to their innovations. The rationale for creating product champions is that these committed individuals can overcome resistance to change within the organization and generate the enthusiasm that attracts the involvement of others and forges cross-functional integra- tion. Schön’s study of 15 major innovations concludes that: “the new idea either finds a champion or dies.”48 A British study of 43 matched pairs of successful and unsuccessful innovations similarly concluded that a key factor distinguishing successful innovation was the presence of a “busi- ness innovator” to exert entrepreneurial leadership.49 3M Corporation has a long tradition of using product champions to develop new product ideas and grow them into new businesses (Strategy Capsule 9.4).

● Corporate incubators: These are business development units that fund and nurture new businesses based upon technologies that have been developed internally but have limited applications within a company’s established busi- nesses. Corporate incubators became very popular during the IT boom at the end of the 1990s, when companies saw the potential to generate substantial value from establishing then spinning off new tech-based ventures.50 Despite a sound strategic and organizational logic, few major companies have achieved sustained success from the incubator units that they established and among the successful ones many have been sold to venture capital firms. A key problem, according to Hamel and Prahalad, is that: “Many corporate incubators became orphanages for unloved ideas that had no internal sup- port or in-house sponsorship.”51 Despite their uneven track record, several leading companies have experienced considerable success in introducing company-wide processes for developing new businesses based upon inter- nally generated innovations. Cisco Systems created its Emerging Technology Business Group (EMTG) in 2006 to detect emerging market trends, conceive of opportunities to exploit them, and organically grow new ventures inside the company. Within 18 months, 400 ideas for new businesses had been posted on the Cisco wiki and several were under development, including TelePresence, a video surveillance security system that later became a busi- ness unit. A key feature of Cisco’s incubator is its close linkage with the rest of the company—especially with senior management.52

CHAPTER 9 TECHNOLOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 269

START LITTLE AND BUILD

We don’t look to the president or the vice-president for

R & D to say, all right, on Monday morning 3M is going

to get into such-and-such a business. Rather, we prefer

to see someone in one of our laboratories, or market-

ing, or manufacturing units bring forward a new idea

that he’s been thinking about. Then, when he can con-

vince people around him, including his supervisor, that

he’s got something interesting, we’ll make him what we

call a “project manager” with a small budget of money

and talent, and let him run with it. Throughout all our

60 years of history here, that has been the mark of suc-

cess. Did you develop a new business? (Bob Adams,

Vice-President for R & D, 3M Corporation)

SCOTCHLITE

Someone asked the question, “Why didn’t 3M make glass

beads, because glass beads were going to find increas-

ing use on the highways?” . . . I had done a little work on

trying to color glass beads and had learned a little about

their reflecting properties. And, as a little extra-curricular

activity, I’d been trying to make luminous house numbers.

Well, this question and my free-time lab project

combined to stimulate me to search out where glass

beads were being used on the highway. We found a

place where beads had been sprinkled on the high-

way and we saw that they did provide a more visible

line at night . . . From there, it was only natural for us

to conclude that, since we were a coating company,

and probably knew more than anyone else about

putting particles onto a web, we ought to be able to

coat glass beads very accurately on a piece of paper.

So, that’s what we did. The first reflective tape we

made was simply a double-coated tape—glass beads

sprinkled on one side and an adhesive on the other.

We took some out here in St. Paul and, with the coop-

eration of the highway department, put some down.

After the first frost came, and then a thaw, we found

we didn’t know as much about adhesives under all

weather conditions as we thought . . .

We looked around inside the company for skills in

related areas. We tapped knowledge that existed in our

sandpaper business on how to make waterproof sand-

paper. We drew on the expertise of our roofing people

who knew something about exposure. We reached

into our adhesive and tape division to see how we

could make the tape stick to the highway better.

The resulting product became known as “Scotchlite.”

Its principal application was in reflective signs; only later

did 3M develop the market for highway marking. The

originator of the product, Harry Heltzer, interested the

head of the New Products Division in the product, and

he encouraged Heltzer to go out and sell it. Scotchlite

was a success and Heltzer became the general man-

ager of the division set up to produce and market it.

Source: “The Technical Strategy of 3M: Start More Little Businesses and More Little Businesses,” Innovation 5 (1969).

STRATEGY CAPSULE 9.4

Innovation at 3M: The Role of the Product Champion

Summary

In emerging and technology-based industries, nurturing and exploiting innovation is the fundamental source of competitive advantage and the focus of strategy formulation. Yet the fundamental strate- gic issues in these industries—the dynamics of competition, the role of the resources and capabili- ties in establishing competitive advantage, and the design of structures and systems to implement strategy—are ones we have already encountered and require us to apply our basic strategy toolkit.

270 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Yet, the unpredictability and instability of these industries mean that strategic decisions in technology-driven industries have a very special character. The remarkable dynamics of these indus- tries mean that the difference between massive value creation and total failure may be the result of small differences in timing or technological choices.

The speed and unpredictability of change in these markets means that sound strategic deci- sion making can never guarantee success. Yet, managing effectively amidst such uncertainty is only possible with a strategy based upon understanding technological change and its implications for competitive advantage.

In this chapter I have distilled what we have learned in recent decades—about strategies to suc- cessfully manage innovation and technological change. The key lessons learned relate to:

◆ how the value created by innovation is shared among the different players in a market, includ- ing the roles of intellectual property, tacitness and complexity of the technology, lead time, and complementary resources;

◆ the design of innovation strategies, including whether to be an early mover or a follower; whether to exploit an innovation through licensing, an alliance, a joint venture, or internal development; and how to manage risk;

◆ competing for standards and platform leadership in markets subject to network externalities;

◆ how to implement strategies for innovation, including organizing to stimulate creativity, access innovation from outside, and developing new products.

Many of the themes we have dealt with—such as appropriating value from innovation and rec- onciling creativity with commercial discipline—are general issues in the strategic management of technology. Ultimately, however, the design and implementation of strategies in industries where innovation is a key success factor requires strategy to be closely tailored to the characteristics of tech- nology, market demand, and industry structure. BCG’s list of the world’s most innovative companies includes among its top ten Apple, Samsung, Amazon, Toyota, and Facebook. While all these compa- nies have been highly successful in using innovation to build competitive advantage, the strategies each has deployed have been closely tailored to their individual circumstances.

Self-Study Questions 1. Trevor Baylis, a British inventor, submitted a patent application in November 1992 for a wind-

up radio for use in Africa in areas where there was no electricity supply and people were too poor to afford batteries. He was excited by the prospects for radio broadcasts as a means of disseminating health education in areas of Africa devastated by AIDS. After appearances on British and South African TV, Baylis attracted a number of entrepreneurs and companies inter- ested in manufacturing and marketing his clockwork radio. However, Baylis was concerned by the fact that his patent provided only limited protection for his invention: most of the main components—a clockwork generator and transistor radio—were long-established technolo- gies. What advice would you offer Baylis as to how he can best exploit his invention?

2. Table 9.1 shows that:

CHAPTER 9 TECHNOLOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 271

a. patents have been more effective in protecting product innovations in drugs and medical equipment than in food or electronic components;

b. patents are more effective in protecting product innovations than process innovations. Can you suggest reasons why?

3. Page 251 refers to James Dyson’s difficulties in licensing his innovative vacuum cleaner (see http://www.cdf.org/issue_journal/dyson_fills_a_vacuum.html for further informa- tion). What lessons would you draw from Dyson’s experience concerning the use of licensing by small firms to exploit innovation?

4. From the evidence presented in Table 9.2, what conclusions can you draw regarding the factors that determine whether leaders or followers win out in the markets for new products?

5. In the market for ride sharing services, Uber is the market leader, followed by Lyft, Curb, and Sidecar. In each overseas country where Uber operates, it faces local competitors: UK rivals include BlaBlaCar, Carpooling.com, and Hailo. What are the sources of network externalities in this market? Do they operate at the city, national, or global level? Does the strength of these network effects mean that Uber’s competitors are doomed to failure?

Notes

1. D. Stokes, Pasteur’s Quadrant: Basic Science and Technological Innovation (Washington, DC: Brookings Institution Press, 1997).

2. R. E. Dugan and K. J. Gabriel, “Special Forces Innovation: How DARPA Attacks Problems,” Harvard Business Review (October 2013).

3. In the US, the return on R & D spending was estimated at between 3.7% and 5.5%. See M. Warusawitharana, “Research and Development, Profits and Firm Value: A Structural Estimation,” Discussion Paper (Washington, DC: Federal Reserve Board, September, 2008). See also: K. W. Artz, P. M. Norman, D. E. Hatfield, and L. B. Cardinal, “A Longitudinal Study of the Impact of R&D, Patents, and Product Innovation on Firm Performance.” Journal of Product Innovation Management 27 (2010): 725–740.

4. “Amazon Loses 1-Click Patent,” Forbes ( July 7, 2011); “Justices Deny Patent to Business Methods,” New York Times ( June 19, 2014).

5. F. T. Rothermael, “Incumbent Advantage through Exploiting Complementary Assets via Interfirm Cooperation,” Strategic Management Journal 22 (2001): 687–699.

6. R. C. Levin, A. K. Klevorick, R. R. Nelson, and S. G. Winter, “Appropriating the Returns from Industrial Research and Development,” Brookings Papers on Economic Activity 18, no. 3 (1987): 783–832.

7. P. Grindley and D. J. Teece, “Managing Intellectual Capital: Licensing and Cross-Licensing in Semiconductors and Electronics,” California Management Review 39 (Winter 1997): 8–41.

8. R. Adner, “Match your Innovation Strategy to your Innovation Ecosystem,” Harvard Business Review (April 2006): 17–37.

9. S. Shulman, The Telephone Gambit (New York: Norton, 2008).

10. “The Human Genome Race,” Scientific American (April 24, 2000).

11. “EMI and the CT Scanner,” Harvard Business School Case No. 383-194 ( June 1983).

12. C. Markides and P. A. Geroski, Fast Second (San Francisco: Jossey-Bass, 2005).

13. D. Sull, “Strategy as Active Waiting,” Harvard Business Review (September 2005): 120–129.

14. For example, data on penetration rates for electric toothbrushes and CD players were used to fore- cast the market demand for HDTVs in the United States (B. L. Bayus, “High-Definition Television: Assessing Demand Forecasts for the Next Generation Consumer Durable,” Management Science 39 (1993): 1319–1333).

15. G. Rowe and G. Wright “The Delphi Technique as a Forecasting Tool: Issues and Analysis,” International Journal of Forecasting 15 (1999) 353–375.

16. E. Von Hippel, “Lead Users: A Source of Novel Product Concepts,” Management Science 32 ( July, 1986).

17. In electronic instruments, customers’ ideas initiated most of the successful new products introduced by manufacturers. See E. Von Hippel, “Users as Innovators,” Technology Review 5 (1976): 212–239.

18. E. D. Beinhocker, “Robust Adaptive Strategies,” Sloan Management Review (Spring 1999): 95–106; E. D. Beinhocker, “Strategy at the Edge of Chaos,” McKinsey Quarterly (Winter 1997).

19. A. Friedlander, The Growth of Railroads (Arlington, VA: CNRI, 1995).

272 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

20. “Europe Is Losing the 4G Race,” Wall Street Journal ( June 3, 2013).

21. S. Postrel, “Competing Networks and Proprietary Standards: The Case of Quadraphonic Sound,” Journal of Industrial Economics 24 (December 1990): 169–186.

22. S. J. Liebowitz and S. E. Margolis (“Network Externality: An Uncommon Tragedy,” Journal of Economic Perspectives 8 (Spring 1994): 133–150) refer to these user-to-user externalities as direct externalities.

23. M. Gladwell, The Tipping Point (Boston: Little, Brown and Company, 2000).

24. P. David, “Clio and the Economics of QWERTY,” American Economic Review 75 (May 1985): 332–337; S. J. Gould, “The Panda’s Thumb of Technology,” Natural History 96, no. 1 (1986): 14–23. For an alternative view see S. J. Liebowitz and S. Margolis, “The Fable of the Keys,” Journal of Law and Economics 33 (1990): 1–26.

25. C. Shapiro and H. R. Varian, “The Art of Standards Wars,” California Management Review 41 (Winter 1999): 8–32.

26. R. M. Grant “The DVD War of 2006–8: Blu-Ray vs. HD-DVD,” Cases to Accompany Contemporary Strategy Analysis, 7th edn (Chichester: John Wiley & Sons, Ltd, 2010).

27. C. Shapiro and H. R. Varian, “The Art of Standards Wars,” California Management Review 41 (Winter 1999): 15–16.

28. C. Shapiro and H. R. Varian, “The Art of Standards Wars,” California Management Review 41 (Winter 1999): 16–18.

29. For recent research into competitive advantage and net- work effects see: D. P. McIntyre and M. Subramaniam, “Strategy in Network Industries: A Review and Research Agenda,” Journal of Management 35 (2009): 1494–1517; A. Afuah, “Are Network Effects Really About Size? The Role of Structure and Conduct,” Strategic Management Journal 34 (2013): 257–273; K. J. Boudreau and L. B. Jeppesen, “Unpaid Crowd Complementors: The Platform Network Effect Mirage,” Strategic Management Journal 36 (2015) forthcoming.

30. R. Katila and S. Shane, “When Does Lack of Resources Make New Firms Innovative?” Academy of Management Journal 48 (2005): 814–829.

31. J. M. George, “Creativity in Organizations,” Academy of Management Annals 1 (2007): 439–477.

32. M. L. Tushman, “Managing Communication Networks in R & D Laboratories,” Sloan Management Review 20 (Winter 1979): 37–49.

33. D. Dougherty and C. H. Takacs, “Team Play: Heedful Interrelating as the Boundary for Innovation,” Long Range Planning 37 (December 2004): 569–590.

34. S. Thomke, “Enlightened Experimentation: The New Imperative for Innovation,” Harvard Business Review (February 2001): 66–75.

35. R. Florida and J. Goodnight, “Managing for Creativity,” Harvard Business Review ( July/August 2005): 124–131.

36. G. von Krogh, S. Haefliger, S. Spaeth, M. W. Wallin, “Carrots and Rainbows: Motivation and Social Practice in Open Source Software Development,” MIS Quarterly 36 (2012): 649–676.

37. D. Leonard and S. Straus, “Putting Your Company’s Whole Brain to Work,” Harvard Business Review (August

1997): 111–121; D. Leonard and P. Swap, When Sparks Fly: Igniting Creativity in Groups (Boston: Harvard Business School Press, 1999).

38. A. J. Slywotzky, Demand: Creating What People Love Before They Know They Want It (Paris: Hachette, 2012).

39. E. Von Hippel (The Sources of Innovation, New York: Oxford University Press, 1988).

40. S. Thomke and E. von Hippel, “Customers as Innovators: A New Way to Create Value,” Harvard Business Review (April 2002).

41. M. Dodgson, “Technological Collaboration and Innovation,” in M. Dodgson and R. Rothwell (eds.), The Handbook of Industrial Innovation (Cheltenham: Edward Elgar, 1994); A. Arora, A. Fosfur, and A. Gambardella, Markets for Technology (Cambridge, MA: MIT Press, 2001); S. Breschi and F. Malerba, Clusters, Networks and Innovation (Oxford: Oxford University Press, 2005 ).

42. H. Chesbrough, Open Innovation: The New Imperative for Creating and Profiting from Technology (Boston: Harvard Business School Press, 2003). See also, B. Cassiman and G. Valentini, “What is Open Innovation, Really?” Bocconi University working paper (2014).

43. P. M. Danzon, A. Epstein, and S. Nicholson, “Mergers and Acquisitions in the Pharmaceutical and Biotech Industries,” NBER Working Paper No. 10536 (Washington DC, June 2004).

44. “How to Manage a Dream Factory,” Economist ( January 16, 2003).

45. E. Morrison, “Gunfire at Sea: A Case Study of Innovation,” in M. Tushman and W. L. Moore (eds), Readings in the Management of Innovation (Cambridge, MA: Ballinger, 1988): 165–178.

46. K. Clark and T. Fujimoto, Product Development Performance: Strategy, Organization, and Management in the World Auto Industry (Boston: Harvard Business School Press, 1991).

47. K. Imai, I. Nonaka, and H. Takeuchi, “Managing the New Product Development Process: How Japanese Companies Learn and Unlearn,” in K. Clark, R. Hayes, and C. Lorenz (eds), The Uneasy Alliance (Boston: Harvard Business School Press, 1985).

48. D. A. Schön, “Champions for Radical New Inventions,” Harvard Business Review (March/April, 1963): 84.

49. R. Rothwell, C. Freeman, A. Horlsey, V. T. Jervis, A. B. Robertson, and J. Townsend, “SAPPHO Updated: Project SAPPHO Phase II,” Research Policy 3 (1974): 258–291.

50. M. T. Hansen, H. W. Chesborough, N. Nohria and D. N. Sull, “Networked Incubators: Hothouse of the New Economy,” Harvard Business Review (September/ October 2000): 74–88; “How to Make the Most of a Brilliant Idea,” Financial Times (December 6, 2000): 21.

51. G. Hamel and C. K. Prahalad, “Nurturing Creativity: Putting Passions to Work,” Shell World (Royal Dutch Shell, September 14, 2007): 1–12.

52. “Cisco: Emerging Markets technology Group,” www. benzinga.com/life/entrepreneurship/10/12/656767/ cisco-emerging-markets-technology-group, accessed July 20, 2015.

10 Competitive Advantage in Mature Industries

We are a true “penny profit” business. That means that it takes hard work and atten- tion to detail to be financially successful—it is far from being a sure thing. Our store managers must do two things well: control costs and increase sales. Cost control cannot be done by compromising product quality, customer service, or restaurant cleanliness, but rather by consistent monitoring of the “vital signs” of the busi- ness through observation, reports, and analysis. Portion control is a critical part of our business. For example, each Filet-O-Fish sandwich receives 1 fluid ounce of tartar sauce and 0.5 ounces of cheese. Our raw materials are fabricated to exact- ing tolerances, and our managers check them on an ongoing basis. Our written specification for lettuce is over two typewritten pages long. Our French fries must meet standards for potato type, solid and moisture content, and distribution of strand lengths.

EDWARD H. RENSI, PRESIDENT AND CHIEF OPERATING OFFICER, MCDONALD’S USA1

O U T L I N E

◆ Introduction and Objectives

◆ Competitive Advantage in Mature Industries

● Cost Advantage

● Segment and Customer Selection

● The Quest for Differentiation

● Innovation

◆ Strategy Implementation in Mature Industries: Structure, Systems, and Style

● Efficiency through Bureaucracy

● Trends in Strategy Implementation among Mature Businesses

◆ Strategies for Declining Industries

● Adjusting Capacity to Declining Demand

● Strategy Alternatives for Declining Industries

◆ Summary

◆ Self-Study Questions

◆ Notes

274 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Competitive Advantage in Mature Industries

Our analysis of the industry life cycle (Chapter 8) suggests that maturity undermines profitability in two ways. First, overcapacity and commoditization increase competi- tive pressure. Second, competitive advantage is more difficult to establish and sus- tain as a result of:

● Less scope for differentiation advantage resulting from better informed buyers, product standardization, and lack of technological change.

● Diffusion of process technology means that cost advantages are difficult to obtain and sustain. Once a cost advantage is established, it is vulnerable

Introduction and Objectives

Despite the infatuation of both the media and the stock market with technology-based companies such as Google, Facebook, and Twitter, the fact remains that industries where most of us earn our living and spend most of our income are comparatively mature. Of the world’s 20 biggest compa- nies (in terms of sales), 18 are in petroleum, retailing, automobiles, financial services, mining, and electricity: industries that have existed for more than a century. (The other two, Apple and Samsung Electronics, represent new, technology-based industries.)2

Despite their heterogeneity—they range from beauty parlors to steel—mature industries pres- ent several similarities from a strategic perspective. The purpose of this chapter is to explore these characteristics of mature industries, identify strategies through which competitive advantage can be established within them, and recognize the implications of these strategies for structure, systems, and leadership style. As we shall see, maturity does not imply lack of opportunity. Companies such as H&M (fashion clothing), AirAsia (airlines), Starbucks (coffee shops), and Nucor (steel) have suc- cessfully deployed innovative strategies within mature sectors. Neither does maturity imply sluggish performance: Coca-Cola, ExxonMobil, and Daimler were founded in the 19th century, yet, over the past two decades, have achieved combinations of profitability and growth that would make most high-tech companies envious. Nor does maturity mean lack of innovation: as we shall see, many mature industries have been transformed by new technologies and new strategies.

By the time you have completed this chapter, you will be able to:

◆ Recognize the principal strategic characteristics of mature industries.

◆ Identify key success factors within mature industries and formulate strategies directed toward their exploitation.

◆ Design organizational structures and management systems that can effectively imple- ment such strategies.

◆ Recognize the characteristics of declining industries, the opportunities for profit they may offer, and the strategy options available to firms.

CHAPTER 10 COMPETITIVE ADVANTAGE IN MATURE INDUSTRIES 275

to exchange rate movements and the emergence of low-cost overseas competitors.

● A highly developed industry infrastructure together with the presence of pow- erful distributors makes it easier for new entrants to attack established firms.

Warren Buffett, The Sage of Omaha, uses different words to convey a simi- lar idea. He categorizes businesses into “franchises” and “businesses” and views maturity as a process of value destruction in which franchises degenerate into businesses:

An economic franchise arises from a product or service that (1) is needed or desired; (2) is thought by customers to have no close substitute; and (3) is not subject to price regulation. Franchises earn high rates of return on capital . . . [and] can tolerate mismanagement . . . In contrast, “a business” earns exceptional profits only if it is a low-cost operator or if supply of its product or service is tight. And a business, unlike a franchise, can be killed by poor management.3

Cost Advantage Commoditization implies that cost efficiency is the primary basis for competitive advantage in many mature industries. Three cost drivers tend to be especially important:

● Economies of scale: In capital-intensive industries, or where advertising, distribution, or new product development is an important element of total cost, economies of scale are important sources of interfirm cost differences. The increased standardization that accompanies maturity greatly assists the exploitation of such scale economies. In automobiles, as with many other manufacturing industries, industry evolution has been driven by the quest for scale economies. The significance of scale economies in mature industries is indicated by the fact that the association between return on investment and market share is stronger in mature industries than in emerging industries.4

● Low-cost inputs: The quest for low-cost inputs explains the migration of maturing industries from the advanced to the newly industrializing countries of the world. But accessing low-cost inputs does not necessarily mean estab- lishing operations in India or Vietnam. Established firms can become locked into high salaries and benefits, inefficient working practices, and bloated overheads inherited from more prosperous times. New entrants into mature industries may gain cost advantages by acquiring plant and equipment at bar- gain-basement levels and by cutting labor costs. Valero Energy Corporation is the largest oil refiner in the US: it acquired loss-making refineries from the majors at below-book prices then operated them with rigorous cost effi- ciency. Convenience stores throughout North America and Western Europe are increasingly owned and operated by immigrants whose family-based operation offers cost and flexibility advantages.

● Low overheads: Some of the most profitable companies in mature industries are those able to minimize overhead costs. In discount retailing, Walmart is famous for its parsimonious approach to costs. Among the oil majors, Exxon

276 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

is known for its rigorous control of overhead costs. Exxon’s headquarters cost (relative to netassets) was about one-quarter that of Mobil’s.5 When Exxon merged with Mobil, it was able to extract huge cost savings from Mobil. In newspaper and magazine publishing, newcomers such as EMAP in the UK and Media News Group in the US (run by “Lean” Dean Singleton) have deployed a strategy of acquiring titles then pruning overheads.

As cost inefficiencies tend to become institutionalized within mature enterprises, cost reduction may require drastic interventions. Corporate restructuring—inten- sive periods of structural and strategic change—typically involves cost reduction through outsourcing, headcount reduction, and downsizing, especially at corporate headquarters.6 Successful turnaround strategies in mature industries typically involve aggressive cost cutting together with measures to boost productivity and prune assets.7

Segment and Customer Selection Sluggish demand growth, lack of product differentiation, and international compe- tition tend to depress the profitability of mature industries. Yet, even unattractive industries may offer attractive niche markets with strong growth of demand, few competitors, and abundant potential for differentiation. As a result, segment selec- tion can be a key determinant of differences in the performance of companies within the same industry. Walmart’s profitability was boosted by locating its stores in small and medium-sized towns where it faced little competition. In the auto industry, there is a constant quest to escape the intense competition of most market segments with “crossover” vehicles that span existing segments. The propensity for market leaders to focus on the mass market, creates opportunities for smaller players to carve out new market niches by supplying underserved customer needs—what Chapter 8 refers to as “resource partitioning.”8

The logic of segment focus implies further disaggregation of markets—down to the level of the individual customer. Information technology permits new approaches to customer relationship management (CRM), making it possible to analyze individual characteristics and preferences, identify individual customers’ profit contribution to the firm, and organize marketing around individualized, inte- grated approaches to customers. In the same way that Las Vegas casinos have long recognized that the major part of their profits derives from a tiny minority of custom- ers—the “high rollers”—so banks, supermarkets, credit card companies, and hotels increasingly use transaction data to identify their most attractive customers, and those that are a drag on profitability.

The next stage in this process is to go beyond customer selection to actively target more attractive customers and transform less valuable customers into more valuable customers. For example, credit card issuer Capital One uses data warehous- ing, experimentation, simulation, and sophisticated statistical modeling to estimate the lifetime profitability of each customer and adjust the terms and features of its credit card offers to the preferences, characteristics, and profit potential of individual customers. “Big data” is transforming companies’ ability to individualize marketing. McKinsey & Company points to the potential for big data and other information and communications technologies to usher in an era of “on-demand marketing.”9

CHAPTER 10 COMPETITIVE ADVANTAGE IN MATURE INDUSTRIES 277

The Quest for Differentiation Cost leadership, as we noted in Chapter 7, is difficult to sustain, particularly in the face of international competition. Hence, differentiating to attain some insulation from the rigors of price competition is particularly attractive in mature industries. The problem is that the trend toward commoditization narrows the scope for dif- ferentiation and reduces customer willingness to pay a premium for differentiation:

● In tires and domestic appliances, companies’ investments in differentiation through product innovation, quality, and brand reputation have generated disappointing returns. Vigorous competition, price-sensitive customers, and strong, aggressive retailers have limited the price premium that differentiation will support.

● Attempts by airlines to gain competitive advantage through offering more legroom, providing superior in-flight entertainment, and achieving superior punctuality have met little market response from consumers. The only effec- tive differentiators appear to be frequent-flier programs and services offered to first- and business-class travelers.

Standardization of the physical attributes of a product and convergence of con- sumer preferences constrains, but does not eliminate, opportunities for meaningful and profitable differentiation. Product standardization is frequently accompanied by increased differentiation of complementary services—financing terms, leasing arrangements, warranties, after-sales services and the like. In consumer goods, maturity often means a shift from physical differentiation to image differentiation. Entrenched consumer loyalties to specific brands of cola or cigarettes are a tribute to the capacity of brand promotion over long periods to create distinct images among near-identical products.

The intensely competitive retail sector produces particularly interesting examples of differentiation strategies. The dismal profitability earned by many retail chains (Toys “R” Us, Foot Locker, Radio Shack, and J. C. Penny in the US; Carrefour, Metro, and Dixons in Europe) contrasts sharply with the sales growth and profitability of stores that have established clear differentiation through variety, style, and ambi- ance (Wholefoods, TJX, Limited Brands, and Bed, Bath & Beyond in the US; Inditex, H&M, Sephora, and IKEA from Europe). A further lesson from highly competitive mature sectors such as retailing is that competitive advantage is difficult to sustain. Most of the outstandingly successful retailers of the previous decade—Best Buy, Body Shop, Tesco, and Marks & Spencer—have slipped into mediocrity.

Innovation We have characterized mature industries as industries where the pace of technical change is slow. In many mature industries—steel, textiles, food processing, insur- ance, and hotels—R & D expenditure is below 1% of sales revenue, while in US manufacturing as a whole just three sectors—computers and electronics, pharma- ceuticals, and aerospace—account for 65% of R & D spending.10 Yet, measured by patenting activity, some mature industries are as innovative as emerging industries.11 Among BCG’s list of the world’s 50 most innovative companies, three are consumer goods companies (Procter & Gamble, Nestlé, and Unilever), two are conglomerates

278 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

(GE and Tata Group), and six are automobile producers.12 Even in mature low-tech products such as tires, brassieres, and fishing rods, continuing inventiveness is indi- cated by a steady flow of new patents (Strategy Capsule 10.1).

Despite an increased pace of technological change in many mature industries, most opportunities for establishing competitive advantage are likely to arise from strategic innovation—including new game strategies and blue-ocean strategies that we discussed in Chapter 7. Indeed, as identified in Chapter 8, it may be that strategic innovation constitutes a third phase of innovation that becomes prominent once product and process innovation slacken. In addition to the value chain reconfigu- ration approach discussed in Chapter 7,13 firms can seek strategic innovation by redefining markets and market segments. This may involve:

● Embracing new customer groups: Harley-Davidson has created a market for expensive motorcycles among the middle-aged, while in the maturing mar- ket for video game consoles Nintendo achieved remarkable success with its Wii by appealing to consumers outside the core market of young males. The most rapidly growing churches—for example Jehovah’s Witnesses in Russia and Amway Christian Fellowship in America—tend to be those that recruit among non-church-going social and demographic groups.

Women have used fabric to bind and support their

breasts for at least two millennia, but it was not until

the late 19th century that the term brassiere was used

to refer to such undergarments. In 1913, the first US

patent for a brassiere was issued to Mary Phelps Jacob.

Since then, the technological quest for a better bra has

continued—between 2005 and 2014 228 US patents

relating to brassieres were issued. Design innovations

include:

◆ Wonderbra (owned by Sara Lee) introduced a

“variable cleavage” bra equipped with a system of

pulleys;

◆ the Airotic bra designed by Gossard (also owned

by Sara Lee) featured “twin air bags as standard”;

◆ Charnos’s Bioform bra replaced underwiring with

soft molded polypropylene around a rigid ring—a

design inspired by the Frisbee and engineered

by Ove Arup (who also engineered London’s

Millennium Bridge which had to be closed

because of excessive wobbling);

◆ Japan’s Triumph lingerie company introduced a

“Close Sister Bra”: inspired by Disney’s Frozen movie,

the matched bras change color simultaneously;

◆ Recent “smart bras” include University of

Wollongong’s sports bra that adjusts for breast

movement during exercise and Microsoft’s bra

that embodies sensors that collect EKG activity

and sends messages concerning the wearer’s emo-

tional state to a smartphone.

Source: “Bra Wars,” Economist (December 2, 2000): 112; USTPO Patent Database; “The Physics of Bras,” Discover Magazine (November 2005) ; “Microsoft Developed a ‘Smart’ Bra,” CNN (December 4, 2013).

STRATEGY CAPSULE 10.1

Innovation in Mature Industries: Brassiere Technology

CHAPTER 10 COMPETITIVE ADVANTAGE IN MATURE INDUSTRIES 279

● Augmenting, bundling, and theming: Some of the most successful approaches to differentiation in mature industries involve bundling additional products or services with the core offering. In book retailing, Barnes & Noble offers not only a wide range of titles but also Starbucks coffee shops within its stores. Neighborhood bookstores that have survived competition from the megastores and Amazon.com are often those that have added poetry readings, live music, and other recreational services. This augmenting and bundling of the product offering may extend to involve the customer in an entire experience. Theming by retail stores (such as Disney Stores and American Girl) and restaurants (such as Hard Rock Café and Rainforest Café) reflects the desire to involve cus- tomers in an experience that goes beyond the products being sold.14

● Customer solutions: Another approach to differentiation through bundling products and services is to offer customer solutions—an integrated bundle of products and support services that are offered as a customized package. For example, Alstom’s rail transport division has transitioned from “being a supplier of goods to a system and service provider”: rather than supplying locomotives, rolling stock, and signaling systems as standalone items, it offers “complete transport solutions for train availability during the life cycle of the product.”15 However, as a senior manager from the Italian engineering firm, Bonfiglioli, explained to me: “Supplying customer solutions is an appealing strategy, but execution is far from easy. Once we had sales representatives who visited customers carrying a product directory. Now the sales represen- tative has to visit the customer with a team comprising product and mainte- nance engineers and a financial analyst.”

● Liberation from the maturity mindset: The ability to create competitive advan- tage requires managers to free themselves from the cognitive limits associated with notions of maturity. Baden-Fuller and Stopford argue that maturity is a state of mind, not a state of the business—every enterprise has the potential for rejuvenation. The key to strategic innovation is for managers to prevent indus- try conventions from imprisoning their companies into conventional thinking about strategy. This means cultivating an entrepreneurial organization where middle managers are encouraged to experiment and learn.16

Costas Markides identifies several firms that have successfully broken away from conventional wisdom to establish a unique positioning within mature industries:

● Edward Jones, with 2000 offices, mostly in the US but also in Canada and the UK, has rejected the conventional wisdom that successful brokerage firms require scale economies, product diversification, e-commerce, and integration with investment banks. Each Edward Jones’ office has just one investment adviser who is motivated to grow local business through face- to-face relationships; there are no proprietary investment products and no online investing.

● Enterprise Rent-A-Car has adopted a location strategy that is quite differ- ent from its major competitors, Hertz and Avis. Rather than concentrate on serving the business traveler through locating at airports and downtown, Enterprise concentrates on suburban locations, where it caters primarily to the consumer market.17

280 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

How do companies break away from the pack and achieve strategic innova- tion? The problem is that breaking with industry conventions requires confronting industry-wide systems of belief—what J.-C. Spender refers to as industry recipes.”18 This is likely to require that managers find ways of altering their cognitive maps— the mental frameworks through which they perceive and understand their industry environments.19 This may explain why strategic innovation in mature industries is so often associated with firms that are either outsiders or peripheral players.

Gary Hamel proposes fostering strategic innovation through reorganizing the strategy-making process. This means breaking top management’s monopoly over strategy formulation, bringing in younger people from further down the organiza- tion, and gaining involvement from those on the periphery of the organization.20

Strategy Implementation in Mature Industries: Structure, Systems, and Style

Across most mature industries, the primary basis for competitive advantage is opera- tional efficiency; however, as we have seen, cost efficiency must be reconciled with innovation and customer responsiveness. What kinds of organizational structures, management systems, and leadership styles do mature businesses need to adopt in order to achieve these multiple performance goals?

Efficiency through Bureaucracy As we observed in Chapter 6, the conventional prescription for stable environments was mechanistic organizations characterized by centralization, precisely defined roles, and predominantly vertical communication.21 Henry Mintzberg describes this formalized type of organization dedicated to the pursuit of efficiency as the machine bureaucracy.22 Efficiency is achieved through standardized routines, division of labor, and close management control based on bureaucratic principles. Division of labor extends to management as well as operatives—high levels of vertical and horizontal specialization are typical among managers. Vertical specialization is evident in the concentration of strategy formulation at the apex of the hierarchy, while middle and junior management supervise and administer through the application of standardized rules and procedures. Horizontal specialization takes the form of functional structures.

The machine bureaucracy as described by Mintzberg is a caricature of actual organizations—probably the closest approximations are found in government departments performing highly routine administrative duties (e.g., the Internal Revenue Service or departments of motor vehicle licensing). However, in most mature industries, the features of mechanistic organizations are evident in highly routinized operations controlled by detailed rules and procedures. McDonald’s is far from being a typical bureaucracy—in particular, the majority of outlets are fran- chises operated by independent companies—however, the cost efficiency and con- sistency that characterizes its performance is achieved through highly standardized and detailed operating procedures that govern virtually every aspect of how it does business (see the quotation that introduces this chapter). Similarly, in Marriott Hotels, HSBC, Toyota Motor Company, and Walmart the ability of these huge organi- zations to achieve efficiency and consistent high quality is the result of management

CHAPTER 10 COMPETITIVE ADVANTAGE IN MATURE INDUSTRIES 281

systems that draw heavily upon the principles of bureaucracy. The key features of these mature organizations are summarized in Table 10.1.

Trends in Strategy Implementation among Mature Businesses When competitive advantage in mature industries was all about cost advantage through scale and division of labor, management practices based upon standard- ized processes, elaborately defined rules, hierarchical control, quantitative perfor- mance targets, and incentives closely linked to individual performance work well. However, as we have discussed, the requirements for success in mature industries and the strategies needed to achieve success given these requirements have become much more complex. In terms of cost efficiency, scale advantages have become less important than the flexibility to exploit low-cost inputs and to outsource to low-cost specialists, and creating an organizational environment that constantly strives to eliminate waste and discover new sources of efficiency.

TABLE 10.1 Strategy implementation in mature industries: The conventional model

STRATEGY The primary goal is cost advantage through economies of scale and capital- intensive production of standardized products/services

Strategy formulation primarily the realm of top managers Middle managers responsible for strategy implementation

STRUCTURE Functional departments (e.g., production, marketing, customer service, distribution)

Distinction between line and staff Clearly defined job roles with strong vertical reporting/delegation

relationships

CONTROLS Performance targets are primarily quantitative and short term and are speci- fied for all members of the organization

Performance is closely monitored by well-established, centralized manage- ment information systems and formalized reporting requirements

Financial controls through budgets and profit targets particularly important

INCENTIVES Incentives are based on achievement of individual targets and take the form of financial rewards and promotion up the hierarchy

Penalties exist for failure to attain quantitative targets, for failure to adhere to the rules, and for lack of conformity to company norms

COMMUNICATION Primarily vertical for the purposes of delegation and reporting Lateral communication limited, often achieved through interdepartmental

committees

LEADERSHIP Primary functions of top management: control and strategic direction Typical CEO profiles include the administrator, who guides the organization

through establishing and operating organizational systems and principles and building consensus (e.g., Alfred Sloan Jr. of General Motors); the auto- crat, who uses top-down decision making and leads through centraliza- tion of power and force of personality (Lee Iacocca of Chrysler and Steve Jobs at Apple); and the strategic leader, who combines clear strategic direction with considerable decentralization of decision making (Sam Palmisano at IBM, Carlos Ghosn at Renault-Nissan, Jeff Immelt at GE).

282 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

The efficiency leaders in mature industries are not necessarily the biggest firms that are able to exploit scale benefits to the maximum: they are more likely to be companies that have dedicated themselves to efficiency through implement- ing performance-oriented management systems. Top-performing companies in mature businesses—UPS in delivery services, Walmart in discount retailing, Nucor in steel, ExxonMobil in petroleum—have integrated management systems where performance goals are the centerpiece of strategy and these goals are implemented through financial controls, HR policies, and operating practices which are closely tailored to these goals.

Unifying an organization around the pursuit of efficiency requires management systems that allow disaggregation of company-wide goals into specific performance targets for departments and individuals—the balanced scorecard is one of the most widely used techniques for achieving this (see Chapter 2). Most important, however, is embedding performance goals within the company’s organizational culture:

● Central to UPS’s performance-driven management style is a corporate culture that simultaneously embraces high levels of employee autonomy and the company’s “obsessive-compulsive personality.”23

● Walmart’s culture of frugality reflects the values of founder Sam Walton. According to Walmart executive Ron Loveless: “Sam valued every penny. People say that Walmart is making $10 billion a year, or whatever. But that’s not how people within the company think of it. If you spent a dollar, the question was: ‘How many dollars of merchandise would you need to sell to make that dollar?’”24

● Ryanair has mastered the art of managing for cost efficiency. From a simple strategic goal of being Europe’s lowest-cost airline, Ryanair’s route struc- ture, choice of airports, fleet, ticketing system, and HR practices are meticu- lously aligned to cost minimization. Ryanair’s obsession with cost cutting is reflected in the large proportion of employees that are on temporary con- tracts, the requirement that crews pay for their own uniforms and training, and a heavy emphasis on incentive pay (cabin crew receive a commission on inflight sales).25

Reconciling differentiation and innovation with a relentless drive for cost efficiency creates difficult challenges for designing management systems that promote these goals without blunting the imperatives for cost minimization. The conventional model for reconciling efficiency with innovation in mature companies is internal differentia- tion: innovation and entrepreneurship are the responsibility of specialist R & D, new product development, and business development units. However, some established companies in mature industries, including Toyota and Whirlpool, have embraced dis- persed innovation, encouraging initiative and ideas from all employees.26

Strategies for Declining Industries

The transition from maturity to decline can be a result of technological substitution (typewriters, photographic film), changes in consumer preferences (canned food, men’s suits), demographic shifts (children’s toys in Europe), or foreign competition

CHAPTER 10 COMPETITIVE ADVANTAGE IN MATURE INDUSTRIES 283

(textiles in the advanced industrialized countries). Shrinking market demand gives rise to acute strategic issues. Among the key features of declining industries are:

● excess capacity; ● lack of technical change (reflected in a lack of new product introduction and

stability of process technology); ● a declining number of competitors, but some entry as new firms acquire the

assets of exiting firms cheaply; ● high average age of both physical and human resources; ● aggressive price competition.

Despite the inhospitable environment offered by declining industries, research by Kathryn Harrigan has uncovered declining industries where at least some par- ticipants earned surprisingly high profits. These included electronic vacuum tubes, cigars, and leather tanning. However, elsewhere—notably in prepared baby foods, rayon, and meat processing—decline was accompanied by aggressive price compe- tition, company failures, and instability.27

What determines whether or not a declining industry becomes a competitive bloodbath? Two factors are critical: the balance between capacity and output, and the nature of the demand for the product.

Adjusting Capacity to Declining Demand The smooth adjustment of industry capacity to declining demand is the key to sta- bility and profitability during the decline phase. In industries where capacity exits from the industry in an orderly fashion, decline can occur without trauma. Where substantial excess capacity persists, as has occurred among the oil refineries of America and Europe, in the bakery industry, in coal mining, and in long-haul bus transportation, the potential exists for destructive competition. The ease with which capacity adjusts to declining demand depends on the following factors:

● The predictability of decline: If decline can be forecast, it is more likely that firms can plan for it. The decline of traditional photography with the advent of digital imaging was anticipated and planned for. Conversely, the decline in sales of personal computers which began in 2011 was largely unexpected. The more cyclical and volatile the demand, the more difficult it is for firms to perceive the trend of demand, even after the onset of decline.

● Barriers to exit: Barriers to exit impede the exit of capacity from an industry. The major barriers are: ○ Durable and specialized assets. Just as capital requirements impose a bar-

rier to entry into an industry, those same investments also discourage exit. The longer they last and the fewer the opportunities for using those assets in another industry are, the more companies are tied to that particular industry.

○ Costs incurred in plant closure. Apart from the accounting costs of writing off assets, substantial cash costs may be incurred in redundancy payments to employees, compensation for broken contacts with

284 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

customers and suppliers, decommissioning the plant, and environmental cleanup.

○ Managerial commitment. In addition to financial considerations, firms may be reluctant to close plants for a variety of emotional and moral reasons. Resistance to plant closure and divestment arises from pride in company traditions and reputation, managers’ unwillingness to accept failure, and loyalties to employees and the local community.

● The strategies of the surviving firms: Smooth exit of capacity ultimately depends on the willingness of the industry players to close plants and divest assets. The sooner companies recognize and address the problem, the more likely it is that independent and collective action can achieve capacity reduc- tion. In European gasoline retailing, for example, the problem of excess capacity was partially solved by bilateral exchanges of service stations among the major oil companies. Stronger firms in the industry can facilitate the exit of weaker firms by offering to acquire their plants and take over their after-sales service commitments. A key strategy among private equity firms has been initiating roll-ups in declining industries—consolidating multiple acquisitions. Clear Channel Communications rolled up the US market for radio stations, eventually owning more than 900. Felix Salmon argues that the financial news industry is also ripe for a roll up: merging Forbes Media with online financial news sites The Street, Business Insider, and Seeking Alpha to create a major rival to Bloomberg and Reuters.28

Strategy Alternatives for Declining Industries Conventional strategy recommendations for declining industries are either to divest or to harvest (i.e., to generate the maximum cash flow from existing investments without reinvesting). However, these strategies assume that declining industries are inherently unprofitable. If profit potential exists, then other strategies may be attrac- tive. Harrigan and Porter identify four strategies that can profitably be pursued either individually or sequentially in declining industries:29

● Leadership: By gaining leadership, a firm is well placed to outstay competi- tors and play a dominant role in the final stages of an industry’s life cycle. Once leadership is attained, the firm is in a good position to switch to a harvest strategy and enjoy a strong profit stream from its market position. Establishing leadership can be done by acquiring competitors, but a cheaper way is to encourage competitors to exit (and then acquire their plants). Inducements to competitors to exit may include showing commitment to the industry, helping to lower their exit costs, releasing pessimistic forecasts of the industry’s future, and raising the stakes, for example by supporting more stringent environmental controls that make it costly for them to stay in business.

● Niche: Identify a segment that is likely to maintain a stable demand and that other firms are unlikely to invade, then pursue a leadership strategy to estab- lish dominance within the segment. The most attractive niches are those that

CHAPTER 10 COMPETITIVE ADVANTAGE IN MATURE INDUSTRIES 285

offer the greatest prospects for stability and where demand is most inelastic. In products facing technological obsolescence, established firms have often been successful in cultivating a lucrative high-price, high-quality segment. For example, Richemont has created a very profitable business based upon mechanical watches (Lange & Söhne, Baume et Mercier, Cartier, Piaget, Vacheron Constantin) and luxury fountain pens (Montblanc).

● Harvest: By harvesting, a firm maximizes its cash flow from existing assets, while avoiding further investment. A harvesting strategy seeks to boost mar- gins wherever possible through raising prices and cutting costs by rational- izing the number of models, number of channels, and number of customers. Note, however, that a harvest strategy can be difficult to implement. In the face of strong competition, harvesting may accelerate decline, particularly if employee morale is adversely affected by a strategy that offers no long-term future for the business.

● Divest: If the future looks bleak, the best strategy may be to divest the busi- ness in the early stages of decline before a consensus has developed as to the inevitability of decline. Once industry decline is well established, it may be extremely difficult to find buyers.

Choosing the most appropriate strategy requires a careful assessment both of the profit potential of the industry and the competitive position of the firm. Harrigan and Porter pose four key questions:

● Can the structure of the industry support a hospitable, potentially profitable decline phase?

● What are the exit barriers that each significant competitor faces? ● Do your company strengths fit the remaining pockets of demand? ● What are your competitors’ strengths in these pockets? How can their exit

barriers be overcome?

Selecting an appropriate strategy requires matching the opportunities remaining in the industry to the company’s competitive position. Figure 10.1 shows a simple framework for strategy choice.

FIGURE 10.1 Strategic alternatives for declining industries

INDUSTRY STRUCTURE

Favorable to decline

Strengths in remaining demand pockets

Lacks strength in remaining demand pockets

COMPANY’S COMPETITIVE POSITION

Unfavorable to decline

LEADERSHIP or

NICHE

NICHE or

HARVEST

HARVEST or

DIVEST

DIVEST QUICKLY

286 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Summary

Mature industries present challenging environments for the formulation and implementation of business strategies. Competition—price competition in particular—is usually strong, and competi- tive advantage is often difficult to build and sustain: cost advantages are vulnerable to imitation; differentiation opportunities are limited by the trend to standardization.

Stable positions of competitive advantage in mature industries are traditionally associated with cost advantage from economies of scale or experience, with selecting the most attractive market segments and customers to serve, with creating differentiation advantage, and with pursuing tech- nological and strategic innovation.

Implementing these strategies, especially those associated with rigorous cost efficiency, typi- cally requires management systems based upon standardized processes and relentless performance management. However, as mature industries become increasingly complex and turbulent, so the pursuit of cost efficiency needs to be matched with flexibility, responsiveness, and innovation. Companies such as Walmart, Coca-Cola, McDonald’s, Hyundai and UPS show remarkable capacity to reconcile vigorous cost efficiency with adaptability.

Declining industries present special challenges to companies: typically, they are associated with intense competition and low margins. However, such environments also present profitable oppor- tunities for those firms that can orchestrate orderly decline from a position of leadership, establish a niche, or generate cash from harvesting assets.

Self-Study Questions 1. Consider Table 3.1 in Chapter 3. Most of the least profitable US industries are mature

industries. Yet at the top of the table are tobacco, personal and household products, and food consumer products, all mature industries. What is it about this latter group of indus- tries that has allowed them to escape the intense price competition and low profitability often associated with mature sectors?

2. Established airlines are cutting costs to compete with the increasing number of budget airlines. Yet, it is unlikely that they will ever match the costs of Southwest, Ryanair, or AirAsia. Which, if any, of the strategies outlined in this chapter offers the best opportu- nity for the established airlines to improve their competitive position vis-à-vis the budget airlines?

3. Department stores (e.g., Macy’s and Sears in the US, Selfridges and House of Fraser in the UK) face increasing competition from specialized chain retailers and discount stores. What innovative strategies might department stores adopt to revitalize their competitiveness?

4. Book retailing is in decline. From the strategy options identified in the section “Strategy Alternatives for Declining Industries,” what recommendations would you offer to (a) Barnes & Noble and (b) an independent book retailer located in your vicinity?

CHAPTER 10 COMPETITIVE ADVANTAGE IN MATURE INDUSTRIES 287

Notes

1. E. H. Rensi, “Computers at McDonald’s,” in J. F. McLimore and L. Larwood (eds), Strategies, Successes: Senior Executives Speak Out (New York: Harper & Row, 1988): 159–160.

2. Fortune Global 500, 2014. 3. Letter to Shareholders, Annual Report of Berkshire

Hathaway Inc., 1991. 4. R. D. Buzzell and B. T. Gale, The PIMS Principles (New

York: Free Press, 1987): 279. 5. T. Copeland, T. Koller, and J. Murrin, Valuation:

Measuring and Managing the Value of Companies, 3rd edn (New York: John Wiley & Sons, Inc., 2000): 305.

6. R. Cibin and R. M. Grant, “Restructuring among the World’s Leading Oil Companies,” British Journal of Management 7 (December 1996): 283–308.

7. D. C. Hambrick and S. M. Schecter, “Turnaround Strategies for Mature Industrial-Product Business Units,” Academy of Management Journal 26 (1983): 231–248; J. L. Morrow, Jr., Richard A. Johnson and Lowell W. Busenitz, “The Effects of Cost and Asset Retrenchment on Firm Performance: The Overlooked Role of a Firm’s Competitive Environment,” Journal of Management 30 (2004): 189.

8. G. R. Carroll and A. Swaminathan, “Why the Microbrewery Movement? Organizational Dynamics of Resource Partitioning in the American Brewing Industry,” American Journal of Sociology 106 (2000): 715–762; C. Boone, G. R. Carroll, and A. van Witteloostuijn, “Resource Distributions and Market Partitioning: Dutch Daily Newspapers 1964–1994,” American Sociological Review 67 (2002): 408–431.

9. Capital One Financial Corporation, Harvard Business School Case No. 9-700-124 (2000).

10. National Science Foundation, Research and Development in Industry: 2002 (www.nsf.gov/statistics/industry).

11. A. M. McGahan and B. S. Silverman, “How Does Innovative Activity Change as Industries Mature?” International Journal of Industrial Organization 19 (2001): 1141–1160.

12. “Innovation in 2014,” BCG Perspectives (October 28, 2014).

13. See section entitled: “Internal Sources of Change: Competitive Advantage from Innovation,” Chapter 7.

14. B. J. Pine and J. Gilmore, “Welcome to the Experience Economy,” Harvard Business Review ( July/August 1998): 97–105.

15. A. Davies, T. Brady, and M. Hobday, “Organizing for Solutions: System Seller vs. System Integrator,” Industrial Marketing Management 36 (2007): 183–193.

16. C. Baden-Fuller and J. Stopford, Rejuvenating the Mature Business (Boston: HBS Press, 1994): especially Chapters 3 and 4.

17. C. C. Markides, All the Right Moves (Boston: Harvard Business School Press, 1999).

18. J.-C. Spender, Industry Recipes: The Nature and Sources of Managerial Judgment (Oxford: Blackwell Publishing, 1989). On a similar theme, see also A. S. Huff, “Industry Influences on Strategy Reformulation,” Strategic Management Journal 3 (1982): 119–131.

19. P. S. Barr, J. L. Stimpert, and A. S. Huff, “Cognitive Change, Strategic Action, and Organizational Renewal,” Strategic Management Journal 13 (Summer 1992): 15–36.

20. G. Hamel, “Strategy as Revolution,” Harvard Business Review 96 ( July/August 1996): 69–82.

21. T. Burns and G. M. Stalker, The Management of Innovation (London: Tavistock Institute, 1961).

22. H. Mintzberg, Structure in Fives: Designing Effective Organizations (Englewood Cliffs, NJ: Prentice Hall, 1983): Chapter 9.

23. G. Nieman, Big Brown: The Untold Story of UPS (Chichester: John Wiley & Sons, Ltd, 2007): 70.

24. C. Fishman, The Wal-Mart Effect: The High Cost of Everyday Low Prices (Harmondsworth: Penguin, 2006).

25. Ryanair: Defying Gravity, IMD Case No. 3-1633 (2007). Available from www.ecch.com.

26. “How Whirlpool Defines Innovation,” Business Week (March 6, 2006).

27. K. R. Harrigan, Strategies for Declining Businesses (Lexington, MA: D. C. Heath, 1980).

28. F. Salmon, “The Financial Media Rollup Strategy,” (November 15, 2013), http://blogs.reuters.com/felix- salmon/2013/11/15/the-financial-media-rollup-strategy/, accessed July 20, 2015.

29. K. R. Harrigan and M. E. Porter, “End-Game Strategies for Declining Industries,” Harvard Business Review ( July/August 1983): 111–120.

IV CORPORATE STRATEGY

11 Vertical Integration and the Scope of the Firm

12 Global Strategy and the Multinational Corporation

13 Diversification Strategy

14 Implementing Corporate Strategy: Managing the Multibusiness Firm

15 External Growth Strategies: Mergers, Acquisitions, and Alliances

16 Current Trends in Strategic Management

11 Vertical Integration and the Scope of the Firm

The idea of vertical integration is anathema to an increasing number of companies. Most of yesterday’s highly integrated giants are working overtime at splitting into more manageable, more energetic units—i.e., de-integrating. Then they are turn- ing around and re-integrating—not by acquisitions but via alliances with all sorts of partners of all shapes and sizes.

TOM PETERS, LIBERATION MANAGEMENT

Bath Fitter has control of the product from raw material to installation. This control allows them to better guarantee the quality by knowing exactly how it is made, not outsourcing it to someone that could take shortcuts to manufacture the product with- out Bath Fitter knowing. Also, they control the measuring, installation, and customer facing representative. By doing this, Bath Fitter would be able to get accurate and fast feedback about how the product is being used, quality issues, or the ease of installation.

“BATH FIT TER HAS VERTICAL INTEGRATION,” HT TP://BEYONDLEAN.WORDPRESS.COM/2011/08/29/

O U T L I N E

◆ Introduction and Objectives

◆ Transaction Costs and the Scope of the Firm

◆ The Benefits and Costs of Vertical Integration

◆ The Benefits from Vertical Integration

● Technical Economies from the Physical Integration of Processes

● Avoiding Transaction Costs in Vertical Exchanges

◆ The Costs of Vertical Integration

● Differences in Optimal Scale between Different Stages of Production

● The Need to Develop Distinctive Capabilities

● Problems of Managing Strategically Different Businesses

● Incentive Problems

● Competitive Effects

● Flexibility

● Investing in an Unattractive Business

● Compounding Risk

◆ Applying the Criteria: Deciding Whether to Make or Buy

◆ Designing Vertical Relationships

◆ Different Types of Vertical Relationship

◆ Choosing Among Alternative Vertical Relationships

◆ Recent Trends

◆ Summary

◆ Self-Study Questions

◆ Notes

292 PART IV CORPORATE STRATEGY

Introduction and Objectives

Chapter 1 introduced the distinction between corporate strategy and business strategy. Corporate strategy is concerned with decisions over the scope of the firm’s activities, including:

◆ Product scope: How specialized should the firm be in terms of the range of products it supplies? Coca-Cola (soft drinks), SABMiller (beer), Gap (fashion retailing), and SAP (software) are engaged in a single industry sector; Sony, Berkshire Hathaway, and Tata Group are diversified across mul- tiple industries.

◆ Geographical scope: What is the optimal geographical spread of activities for the firm? In the choc- olate industry Hershey are heavily focused on North America; Nestlé operates globally.

◆ Vertical scope: What range of vertically linked activities should the firm encompass? Walt Disney is vertically integrated from the production of movies and TV shows, through movie distribution and TV networks (ABC, Disney Channel, ESPN), to exploiting its movies’ characters in its Disney stores and theme parks. Nike is more vertically specialized: it designs and markets footwear and apparel but outsources most activities in its value chain, including manufacturing, distribution, and retailing.

The distinction between corporate and business strategy may be summarized as follows: cor- porate strategy is concerned with where a firm competes; business strategy is concerned with how a firm competes within a particular area of business.1 So far, the primary focus of the book has been business strategy. In this final part, we shift our attention to corporate strategy: decisions that define the scope of the firm. I devote separate chapters to the different dimensions of scope—vertical scope (vertical integration), geographical scope (multinationality), and product scope (diversification). However, as we shall discover, the key underlying concepts for analyzing these different dimen- sions—economies of scope in resources and capabilities, transaction costs, and costs of corporate complexity—are common to all three.

In this chapter we begin by considering the overall scope of the firm. We then focus specifically on vertical integration. This takes us to the core factors that determine firm boundaries, in particular, the role of transaction costs. As we shall discover, vertical integration has been a hot topic in corpo- rate strategy. Opportunities for outsourcing, alliances, and electronic commerce have caused com- panies to rethink which of their activities should remain within their organizational boundaries.

By the time you have completed this chapter, you will be able to:

◆ Appreciate the role of firms and markets in organizing economic activity and apply the principles of transaction cost economics to explain why boundaries between firms and mar- kets shift over time.

◆ Understand the relative advantages of vertical integration and outsourcing in organizing vertically related activities, and apply this understanding to decisions over whether a par- ticular activity should be undertaken internally or outsourced.

◆ Identify alternative ways of organizing vertical transactions and, given the characteristics and circumstances of a transaction, recommend the most suitable transaction mode.

CHAPTER 11 VERTICAL INTEGRATION AND THE SCOPE OF THE FIRM 293

Transaction Costs and the Scope of the Firm

In Chapter 6 (Strategy Capsule 6.1), we traced the development of the business corporation. Firms came into existence because of their efficiency advantages in organizing production. Let us explore this issue further and clarify its implications for the boundaries of the firm.

Although the capitalist economy is frequently referred to as a “market economy,” it actually comprises two forms of economic organization. One is the market mecha- nism, where individuals and firms, guided by market prices, make independent deci- sions to buy and sell goods and services. The other is the administrative mechanism of firms, where decisions concerning production and resource allocation are made by managers and carried out through hierarchies. The market mechanism was character- ized by Adam Smith as the “invisible hand” because its coordinating role does not require conscious planning. Alfred Chandler referred to the administrative mechanism of firms as the “visible hand” because it involves active planning and direction.2

Firms and markets may be viewed as alternative institutions for organizing pro- duction. Firms are distinguished by the fact they comprise a number of individuals bound by employment contracts with a central contracting authority. But production can also be organized through market transactions. When I remodeled my base- ment, I contracted a self-employed builder to undertake the work. He in turn sub- contracted parts of the work to a plumber, an electrician, a joiner, a drywall installer, and a painter. Although the job involved the coordinated activity of several individu- als, these self-employed specialists were not linked by employment relations but by market contracts (“$4000 to install wiring, lights, and power outlets”).

The relative roles of firms and markets vary in different areas of business. Compare the supply of mainframe computers with that of personal computers. IBM’s System z mainframe computers are assembled by IBM using IBM microprocessors and IBM’s z/OS operating system, and run IBM applications software. IBM also undertakes distribution, marketing, and customer support. HP’s laptop computers are manu- factured by Flextronics, Quanta, and other companies using components produced by firms such as Intel, Seagate, Nvidia, and Samsung. Customer support is also out- sourced to companies located in India and South-East Asia.

What determines which activities are undertaken within a firm and which through market contracts? Ronald Coase’s answer was the relative cost of organizing within firms as compared to organizing across markets.3 Markets are not costless: the transaction costs of markets include the costs of search, negotiation, drawing up contracts, and monitoring and enforcing contracts (including the costs of litigation should a dispute arise). Conversely, if an activity is internalized within a firm, then the firm incurs certain administrative costs. If the transaction costs of organizing an activity through the market are more than the administrative costs of organizing it within a firm, we can expect that activity to be encompassed within a firm.

Consider the packaging business (Figure 11.1). With regard to vertical scope, which is more efficient: three independent companies—one producing raw mate- rials (e.g., bauxite), the next producing semi-finished packaging materials (e.g., aluminum foil), and the third producing finished packaging (e.g., aluminum cans)—or having all three stages undertaken by a single company? In the case of product scope, should aluminum cans, plastic containers, and paper cartons be produced by three separate companies or are there efficiencies from merging all

294 PART IV CORPORATE STRATEGY

FIGURE 11.1 The scope of the firm: Specialization versus integration in the packaging industry

Bauxite

Cans

US EUBrazil

Aluminum

Specialized f irms linked by markets

Single integrated f irm

Vertical Scope

Cans Cartons

Bottles

Product Scope

US EUBrazil

Geographical Scope

Bauxite

Cans Aluminum

CartonsBottlesCans

FIGURE 11.2 The shifting roles of firms and markets in the US economy, 1800 to 2010

0

2

4

6

8

10

12

14

16

18

20

18 00

18 10

18 20

18 30

18 40

18 50

18 60

18 70

18 80

18 90

19 00

19 10

19 20

19 30

19 40

19 50

19 60

19 70

19 80

19 90

20 00

20 10

20 14

First Industrial Revolution: Mechanization and the factory system more suited to organizing workers as employees than as self-employed contractors.

Railways and Telegraph expand firms’ geographical reach

Second Industrial Revolution: Systematic approaches to management, organizational innovations, and the telephone reduce the costs of organizing within firms.

Expanding Size and Scope of Corporations:

operational, and human resource management

internal administration

op 100 companies as % of total private sector employment

Restructuring, Refocusing, and Downsizing among Large Corporations:

the efficiency of large, hierarchically organized firms

technologies give individual and small firms the same technological opportunities as large organizations

Source: Author’s estimates based upon various sources including: L. J. White, “Trends in Aggregate Concentration in the United States,” Journal of Economic Perspectives 16 (Fall 2002): 137–60; A. Chandler Jr., The Visible Hand (Cambridge, MA: MIT Press, 1977); S. Kim “The Growth of Modern Business Enterprises in the Twentieth Century,” Research in Economic History 19 (1999): 75–110.

three into a single company? In the case of geographical scope, which is more efficient: three independent companies producing cans in the US, Brazil, and the European Union, or a single multinational company owning can-making plants in all three countries?

The relative roles of firms and markets in organizing production have experi- enced major shifts over the past 200 years. As Figure 11.2 shows, these shifts can be

CHAPTER 11 VERTICAL INTEGRATION AND THE SCOPE OF THE FIRM 295

linked to technological changes, including innovation in management and organiza- tion favored large firms. Around the mid-1970s, the trend toward growing corporate size and scope went into reverse: a more turbulent business environment and new information and communications technologies favored more focused enterprises coordinated through markets.

The Benefits and Costs of Vertical Integration

So far we have considered the overall scope of the firm. Let us focus now on just one dimension of corporate scope: vertical integration. The question we seek to answer is this: Is it better to be vertically integrated or vertically specialized? With regard to a specific activity, this translates into: To make or to buy? First, we must be clear what we mean by vertical integration.

Vertical integration is a firm’s ownership and control of multiple vertical stages in the supply of a product. The extent of a firm’s vertical integration is indicated by the number of stages of the industry’s value chain that it spans, and can be measured by the ratio of its value added to sales revenue.4

Vertical integration can be either backward (or upstream) into its suppliers’ activi- ties or forward (or downstream) into its customers’ activities. Vertical integration may also be full or partial. Some California wineries are fully integrated: they pro- duce wine only from the grapes they grow, and sell it all through direct distribu- tion. Most are partially integrated: their homegrown grapes are supplemented with purchased grapes; they sell some wine through their own tasting rooms but most through independent distributors.

Strategies toward vertical integration have been subject to shifting fashions. For most of the 20th century the prevailing wisdom was that vertical integration was beneficial because it allowed superior coordination and reduced risk. In the 1960s, J. K. Galbraith predicted the triumph of corporate capitalism: only huge, integrated companies offered the security needed to develop and com- mercialize new technologies.5 Yet, the past 30 years have witnessed a profound change of opinion: outsourcing, it is claimed, enhances flexibility and allows firms to concentrate on those activities where they possess superior capa- bilities. Moreover, many of the coordination benefits associated with vertical integration can be achieved through collaboration between vertically related companies.

However, as in other areas of management, fashion is fickle. Strategy Capsule 11.1 describes vertical integration in the entertainment and media sector, where inte- gration between content producers and distribution allows the coordinated devel- opment and distribution of new content (e.g., Disney’s Frozen), yet multichannel commercial exploitation can also be achieved through licensing contracts with mul- tiple firms (e.g., J. K. Rowling’s Harry Potter).

Our task is to go beyond fads and fashions to uncover the factors that determine whether vertical integration enhances or weakens performance.

296 PART IV CORPORATE STRATEGY

Over the past two decades integration between con-

tent producers (film studios, music publishing) and dis-

tribution companies (theaters, TV broadcasting, cable

companies, satellite TV, digital streaming) has reshaped

the entertainment industry. Key players include:

◆ Time Warner Inc. (Warner Bros. Studios, New Line

Cinema, Castle Rock, Time magazines, Warner Cable,

HBO, Turner Broadcasting, Cartoon Network, CNN)

◆ 21st Century Fox (20th Century Fox, Fox Broadcasting,

Sky TV, MySpace)

◆ Comcast Corp. (Universal Pictures, NBC, Telemundo,

Comcast Cable, Universal Parks and Resorts)

◆ Viacom (Paramount Pictures, MTV, BET, Nickelodeon,

Comedy Central)

◆ Walt Disney (Walt Disney Studios, Pixar, Disney Theatrical

Productions, Walt Disney Records, Walt Disney Pictures,

ABC, ESPN, Disney Channel, Disney Online).

The mergers creating these integrated production

and distribution companies have not all been success-

ful: AOL’s 2000 merger with Time Warner and the acqui-

sition spree that transformed Compagnie Générale des

Eaux into Vivendi Universal were disasters.

To illustrate the relative merits of vertical integration

and market-based contracts, consider the commercial

exploitation of the fictional characters from Harry Potter

with those of Frozen.

HARRY POTTER

◆ Seven Harry Potter novels written by J. K. Rowling

were published by Bloomsbury in the UK and

Scholastic Press in the US between 1997 and 2007

with total sales of 240 million (to 2014).

◆ Film rights were acquired by Warner Bros., which

produced eight movies generating $7.7 billion in

box office receipts.

◆ 11 Harry Potter video games were produced by

Electronic Arts.

◆ A Harry Potter attraction opened at Comcast’s

Universal Orlando Resort in 2010, while a Warner Bros.

Harry Potter studio tour opened in the UK in 2012.

◆ Harry Potter copyrights and trademarks have been

licensed to Mattel, Coca-Cola, Lego, Hasbro, Gund,

Tonner Doll Company, Whirlwood Magic Wands,

and other companies for the production of toys,

clothing, and other products.

FROZEN

Frozen is a computer-animated film inspired by Hans

Christian Andersen’s The Snow Queen, produced by

Walt Disney Animation Studios, and released by Walt

Disney Pictures in 2013. Within eight months it gen-

erated $1.2 billion in worldwide box office revenue.

Prior to release, Frozen was promoted heavily at Disney

theme parks. Commercial spinoffs from the movie and

its lead characters, Elsa and Anna, include:

◆ a range of merchandise including dolls, costumes

and “home décor, bath, textile, footwear, sporting

goods, consumer electronics, and pool and sum-

mer toys” developed by Disney Consumer Products

and sold through Disney Stores and independent

channels;

◆ DVD and Blu-ray releases by Walt Disney Studios

Home Entertainment;

◆ a video game launched by Disney Mobile for hand-

held devices;

◆ a Broadway stage musical adaptation by Disney

Theatrical (under development in 2014);

◆ temporary Anna and Elsa attractions introduced

in Disney theme parks during 2014; a larger scale

Frozen ride was under consideration.

STRATEGY CAPSULE 11.1

Vertical Integration in the Entertainment Industry: Frozen versus Harry Potter

CHAPTER 11 VERTICAL INTEGRATION AND THE SCOPE OF THE FIRM 297

The Benefits from Vertical Integration

Technical Economies from the Physical Integration of Processes Proponents of vertical integration have often emphasized the technical economies it offers: cost savings that arise from the physical integration of processes. Thus, most steel sheet is produced by integrated producers in plants that first produce steel and then roll hot steel into sheet. Linking the two stages of production at a single location reduces transportation and energy costs. Similar technical economies arise in integrating pulp and paper production and from linking oil refining with petro- chemical production.

However, although these considerations explain the need for the co-location of plants, they do not explain why vertical integration in terms of common ownership is necessary. Why can’t steel and steel strip production or pulp and paper produc- tion be undertaken by separate firms that own facilities which are physically inte- grated with one another? To answer this question, we must look beyond technical economies and consider the implications of linked processes for transaction costs.6

Avoiding Transaction Costs in Vertical Exchanges Consider the value chain for steel cans which extends from mining iron ore to the use of cans by food-processing companies (Figure 11.3). There is vertical integration between some stages; other stages are linked by market contracts between specialist firms. In the final linkage—between can producing and canning—most cans are produced by specialist packaging companies (such as Crown Holdings and Ball Corporation).7 An analysis of transaction costs can explain these different arrangements.

The predominance of market contracts between the producers of steel strip and the producers of cans reflects low transaction costs in the market for steel strip: there are many buyers and sellers, information is readily available, and the switching costs for buyers and suppliers are low. The same is true for many other commodity products: few jewelry companies own gold mines; flour-milling companies seldom own wheat farms.

FIGURE 11.3 The value chain for steel cans

Steel strip production

Can- making

Steel production

Iron ore mining

Canning of food, drink,

oil, etc.

MARKET CONTRACTS

VERTICAL INTEGRATION

MARKET CONTRACTS

VERTICAL INTEGRATION AND MARKET CONTRACTS

298 PART IV CORPORATE STRATEGY

To understand why vertical integration predominates across steel production and steel strip production, let us see what would happen if the two stages were owned by separate companies. Because there are technical economies from hot-rolling steel as soon as it is poured from the furnace, steel makers and strip producers must invest in integrated facilities. A competitive market between the two stages is impos- sible; each steel strip producer is tied to its adjacent steel producer. In other words, the market becomes a series of bilateral monopolies.

The reason these relationships between steel producers and strip producers are problematic in that each steel supplier negotiates with a single buyer; there is no market price: it all depends on relative bargaining power. Such bargaining is costly: the mutual dependency of the two parties encourages opportunism and strategic misrepresentation as each company seeks to enhance and exploit its bargaining power at the expense of the other. Thus, once we move from a competitive market situation to one where individual buyers and sellers are locked together in close bilateral relationships, the efficiencies of competitive markets are lost.

The culprits in this situation are transaction-specific investments. When a can- maker buys steel strip, neither the steel strip producer nor the can-maker needs to invest in equipment or technology that is specific to the needs of the other party. In the case of the steel producer and the steel roller, each company’s plant is built to match the other party’s plant. Once built, the plant’s value depends upon the avail- ability of the other party’s complementary facilities—each seller is tied to a single buyer, which gives each the potential to hold up the other (i.e., each party can threaten the other with withholding business).

If the future were predictable, these issues could be resolved in advance. However, in an uncertain world it is impossible to write a complete contract that covers every possible eventuality over the entire life span of the capital investments being made.

Empirical research confirms the tendency for transaction-specific investments to encourage vertical integration:8

● Among automakers, specialized components are more likely to be manu- factured in-house than commodity items such as tires and spark plugs.9 Similarly, in aerospace, company-specific components are more likely to be produced in-house rather than purchased externally.10

● In semiconductors, integration across design and fabrication is more likely for the technically complex integrated circuits (such as those produced by Intel and STMicroelectronics) than for simpler chips. The more complex the chip, the greater the need for the designer and fabricator to invest in close techni- cal collaboration.11

The Costs of Vertical Integration

The presence of transaction costs in intermediate markets is not sufficient justifica- tion for vertical integration. While vertical integration avoids the transaction costs of using the market, it imposes an administrative cost. The extent of these costs depends on several factors.

CHAPTER 11 VERTICAL INTEGRATION AND THE SCOPE OF THE FIRM 299

Differences in Optimal Scale between Different Stages of Production UPS’s delivery vans are manufactured to its own specifications by Morgan Olson in Sturgis, Michigan. Should UPS build its own vans and trucks? Almost certainly not: the transaction costs avoided by UPS will be trivial compared with the inefficiencies incurred in manufacturing its own vans: the 20,000 vans UPS purchases each year are well below the minimum efficient scale of an assembly plant. Similarly, specialist brewers such as Anchor Brewing of San Francisco or Adnams of Suffolk, England do not make their own containers (as do Anheuser-Busch InBev and SABMiller). Small brewers simply lack the scale needed for the low-cost manufacture of cans and bottles.

The Need to Develop Distinctive Capabilities Another reason for UPS not making its own vans is that it is likely to be a poor vehicle manufacturer. A key advantage of a company specializing in a few activities is its ability to develop distinctive capabilities in those activities. Even large, technol- ogy-based companies such as Xerox, Sony, and Philips cannot maintain IT capabili- ties that match those of IT services specialists such as IBM, TCS, and Accenture. A major advantage of these IT specialists is the learning they gain from working with multiple clients. If Sony’s IT department only serves the in-house needs of Sony, this limits the development of its IT capabilities.

However, this assumes that capabilities in different vertical activities are inde- pendent of one another and the required capabilities are generic rather than highly customized. Where one capability is closely integrated with capabilities in adjacent activities, vertical integration may help develop these integrated, system-wide capa- bilities. Thus, Walmart keeps its IT in-house. The reason is that real-time information is central to Walmart’s supply chain management, in-store operations, and upper- level managerial decision making. Walmart’s need for tightly integrated informa- tion and communication services customized to meet its unique business systems inclines it toward in-sourcing.

Problems of Managing Strategically Different Businesses These problems of differences in optimal scale and developing distinctive capabilities may be viewed as part of a wider set of problems—that of managing vertically related businesses that are strategically very different. A major disadvantage of UPS owning a truck-manufacturing company is that the management systems and organizational capabilities required for truck manufacturing are very different from those required for express delivery. These considerations explain the lack of vertical integration between manufacturing and retailing. Firms that are integrated across design, manufacturing, and retailing, such as Zara (Inditex S.A.) and Gucci (Kering S.A.), are unusual. Most of the world’s leading retailers—Walmart, Gap, Carrefour—do not manufacture. Similarly, few manufacturing companies retail their own products. Not only do manufacturing and retailing require very different organizational capabilities, they also require differ- ent strategic planning systems, different approaches to control and human resource management, and different top-management styles and skills.

300 PART IV CORPORATE STRATEGY

These strategic dissimilarities are a key factor in the trend to vertically de- integrate. Marriott’s split into two separate companies, Marriott International and Host Marriott, was influenced by the belief that owning hotels is a strategically dif- ferent business from operating hotels. Similarly, the Coca-Cola Company spun off its bottling activities as Coca-Cola Enterprises Inc. partly because managing local bottling and distribution operations is very different from managing the global Coca- Cola brand and producing and distributing concentrates.

Incentive Problems Vertical integration changes the incentives between vertically related businesses. Where a market interface exists between a buyer and a seller, profit incentives ensure that the buyer is motivated to secure the best possible deal and the seller is motivated to pursue efficiency and service in order to attract and retain the buyer—these are termed high-powered incentives. With vertical integration, internal supplier–customer relationships are subject to low-powered incentives. When my office computer malfunctions, I call the university’s IT department. The incentives for the in-house technicians to respond promptly to my email and voice messages are weak. If I were free to use an outside IT specialist, that specialist would only get the business if they were able to offer same-day service and would only get paid once the problem was resolved.

One approach to creating stronger performance incentives within vertically inte- grated companies is to open internal divisions to external competition. As we shall examine more fully in Chapter 14, many large corporations have created shared service organizations, where internal suppliers of corporate services—such as IT, training, and engineering—compete with external suppliers of the same services to serve internal operating divisions.

Competitive Effects For a monopolist, one of the supposed benefits of vertical integration is to extend a monopoly position at one stage of an industry’s value chain to adjacent stages. Classic cases of this are Standard Oil and Alcoa. However, economists have shown that there is no additional monopoly profit to be extracted by extending a monopoly to adjacent stages of the value chain.12

For a firm that is not monopolist, vertical integration risks damaging its competi- tive position in its core business. If it forward integrates it becomes a competitor of its customers (or, if it backwards integrates, a competitor of its suppliers), potentially damaging its attractiveness as a business partner. When Google acquired Motorola, a major risk was that other handset makers that were customers for its Android operat- ing system (Samsung in particular) might regard Google as a less reliable supplier and be inclined to find an alternative operating system to Android.13

Flexibility Both vertical integration and market transactions can claim advantage with regard to different types of flexibility. Where the required flexibility is rapid responsiveness to uncertain demand, there may be advantages in market transactions. The lack of ver- tical integration in the construction industry reflects, in part, the need for flexibility

CHAPTER 11 VERTICAL INTEGRATION AND THE SCOPE OF THE FIRM 301

in adjusting both to cyclical patterns of demand and to the different requirements of each project.14 Vertical integration may also be disadvantageous in responding quickly to new product development opportunities that require new combinations of technical capabilities. Some of the most successful new electronic products of recent years—Apple’s iPod, Microsoft’s Xbox, Dell’s range of notebook computers— have been produced by contract manufacturers. Extensive outsourcing has been a key feature of fast-cycle product development throughout the electronics sector.

Yet, where system-wide flexibility is required, vertical integration may allow for speed and coordination in achieving simultaneous adjustment throughout the verti- cal chain. American Apparel is a rare example of a successful US manufacturer of apparel. Its tightly coordinated vertical integration from its Los Angeles design and manufacturing base to its 160 retail stores across ten countries allows a super-fast design-to-distribution cycle. Figure 11.4 shows an advertisement for American Apparel.

FIGURE 11.4 An American Apparel advertisement

The downtown LA vertically integrated paradigm by American Apparel. Now involving 5000 people.

American Apparel Made in Downtown LA Vertically Integrated Manufacturing www.americanapparel.net

Wholesale Sales

$Finance

Designing

Dyeing

Fabric Storage

Retailing in 10 Countries

Warehousing Distribution

People

Marketing

Knitting

Cutting

Sewing

Source: American Apparel Inc.

302 PART IV CORPORATE STRATEGY

Investing in an Unattractive Business Finally, one of the biggest disadvantages of vertical integration is that it may involve investing in an inherently unattractive industry. Irrespective of transaction costs and coordination benefits, McDonald’s chooses not to backward integrate into beef rais- ing and potato growing, because agriculture is a low-margin industry.

Compounding Risk To the extent that it ties a company to its internal suppliers and internal customers, vertical integration represents a compounding of risk: problems at any one stage of production threaten production and profitability at all other stages. When union workers at a General Motors brake plant went on strike in 1998, GM’s 24 US assem- bly plants were soon brought to a halt. If Disney animation studios fail to produce blockbuster animation movies that introduce new characters, then the knock-on effects are felt through plummeting DVD sales, lack of spin-off shows on the Disney Channel, reduction of merchandise sales in Disney Stores, and a shortage of new attractions at Disney theme parks.

Applying the Criteria: Deciding Whether to Make or Buy

Vertical integration is neither good nor bad. As with most questions of strategy, it all depends upon the specific context. The value of our analysis is that we can identify the factors that determine the relative advantages of the market transactions versus internalization. Figure 11.5 summarizes some of the key criteria.

However, our analysis is not yet complete; we must consider some additional factors that influence the choice of vertical strategy, and in particular the fact that vertical relationships are not limited to the simple choice of make or buy.

Designing Vertical Relationships

Our discussion so far has compared vertical integration with arm’s-length market contracts. In practice, the adjacent stages in a value chain can be linked through a variety of relationships. Figure 11.6 shows a number of different types of rela- tionship between buyers and sellers. These relationships may be classified in rela- tion to two characteristics. First, the extent to which the buyer and seller commit resources to the relationship: arm’s-length, spot contracts involve no resource commitment beyond the single deal; vertical integration typically involves a sub- stantial investment. Second, the formality of the relationship: long-term contracts and franchises are formalized by the complex written agreements they entail; spot contracts typically involve little or no documentation and are governed by common law; collaborative agreements between buyers and sellers are usually informal—they are trust based; vertical integration allows management discretion to replace legal formality.

CHAPTER 11 VERTICAL INTEGRATION AND THE SCOPE OF THE FIRM 303

FIGURE 11.5 Vertical integration (VI) versus outsourcing: Key considerations

The greater the number of f irms, the less advantageous is VI How many f irms are in the vertically adjacent activity?

The greater the need for transaction-specif ic investments, the greater the advantages of VI

Do transaction-specif ic investments need to be made by either party?

The greater are information asymmetries, the more likely is opportunistic behavior and the greater the advantages of VI

How evenly distributed is information between the f irms at each stage?

How great is uncertainty over the period of the relationship?

The greater the uncertainty, the more incomplete is the contract and the greater the advantages of VI

How critical is the continual upgrading of capabilities in the adjacent activity?

The greater the need for capability development, the greater the disadvantages of VI

How important are prof it incentives to performance in the adjacent activity?

The greater the need for high-powered incentives, the greater the disadvantages of VI

How uncertain is market demand? The more unpredictable is demand, the less advantageous is VI

Does VI transmit risk between stages? The greater are risks at each stage, the more VI compounds risk

How similar are two stages in terms of the optimal scale of the operation?

The greater the dissimilarity, the less advantageous is VI

How strategically similar are the stages?

Characteristics of the vertical relationship

Implication

304 PART IV CORPORATE STRATEGY

Different Types of Vertical Relationship

Different vertical relationships offer different combinations of advantages and disadvantages. For example:

● Long-term contracts: Market transactions can be either spot contracts— buying a cargo of crude oil on the Rotterdam petroleum market—or long- term contracts—a series of transactions over a period of time that specify the terms of sales and the responsibilities of each party. Spot transactions work well under competitive conditions (many buyers and sellers and a standard product) where there is no need for transaction-specific investments by either party. Where closer supplier–customer ties are needed, particularly when one or both parties need to make transaction-specific investments, a longer- term contract can help avoid opportunism and provide the security needed to make the necessary investment. However, long-term contracts face the problem of anticipating the circumstances that may arise during the life of the contract: either they are too restrictive or so loose that they give rise to opportunism and conflicting interpretation. Long-term contracts often include provisions for the arbitration of contract disputes.

● Vertical partnerships: The greater the difficulties of specifying complete con- tracts for long-term supplier–customer deals, the greater the advantage of vertical relationships based on trust and mutual understanding. Such relation- ships can provide the security needed to support transaction-specific invest- ments, the flexibility to meet changing circumstances, and the incentives to avoid opportunism. Such arrangements may be entirely relational contracts, with no written contract at all. The model for vendor partnerships has been the close collaborative relationships that many Japanese companies have with their suppliers. Japanese automakers have been much less backward inte- grated than their US or European counterparts but have also achieved close

FIGURE 11.6 Different types of vertical relationship

High

Fo rm

al iz

at io

n

Low

Spot sales/ purchases

Low HighDegree of Commitment

Long-term contracts

Agency agreements

Franchises

Joint ventures

Vertical integration

Informal supplier/ customer

relationships

Value adding vertical

partnerships