Rebuilding the Corporate Genome: Unlocking the Real Value of Your Business

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Johan C. Aurik

Gillis J. Jonk

Robert E. Willen

JOHN WILEY & SONS, INC.

R  C G

R  C G UNLOCKING THE REAL VALUE OF YOUR BUSINESS

Johan C. Aurik

Gillis J. Jonk

Robert E. Willen

JOHN WILEY & SONS, INC.

Copyright © 2003 by A. T. Kearney, Inc. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4470, or on the web at www. copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, e-mail: [email protected]. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. The publisher is not engaged in rendering professional services, and you should consult a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services please contact our Customer Care Department within the U.S. at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. ISBN 0-471-25076-7 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1

The authors wish to thank Juliette Miremont and Bethany Crawford for their support in creating this book.

Contents Figures

vii

Foreword

ix

Acknowledgments Introduction Executive Summary

xiii xv 1

SECTION I

Chapter 1:

The Corporation Breaks Down—Again

Chapter 2: Value Chains—Unchained

11 29

SECTION II

Chapter 3: Rebuilding the Corporate Genome

55

Chapter 4: Strategy: Same Hammer, New Nail

83

SECTION III

Chapter 5: Physical Capabilities: In Search of Scale

101

Chapter 6: Transaction Capabilities: Information Aggregation

115

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viii

CONTENTS

Chapter 7: Knowledge Capabilities: The Art of the Matter

131

Chapter 8: Capability Recombination: Creating a Killer Lineup

149

Chapter 9: Industries Transformed

175

SECTION IV

Chapter 10: The Next Organizational Dimension

209

Chapter 11: So What?

233

Chapter 12: Getting Set to Go

249

Epilogue

281

Notes

285

Sources

291

Glossary

295

Index

305

Figures CHAPTER 1 Figure 1.1 Figure 1.2 Figure 1.3

The Breakup of the Corporation Mapping of Industries Why Are Industries Ahead?

17 20 25

CHAPTER 2 Figure 2.1 Figure 2.2 Figure 2.3 Figure 2.4

New Forms of Interaction Air Conditioning Industry Value Chain Capabilities As Independent “Businesses” Breakdown and Delayering of the Value Chain

31 35 43 47

CHAPTER 3 Figure 3.1 Figure 3.2 Figure 3.3

Two Possible Strategies New Competition for Banks Capability Compensation Models

57 63 78

CHAPTER 4 Figure 4.1

Generic Capability Strategies

93

The Endgame for Net Markets

124

Product Value Matrix

164

CHAPTER 6 Figure 6.1 CHAPTER 8 Figure 8.1

ix

x

FIGURES

Figure 8.2 Figure 8.3

Product Life Cycle and Relative Capability Importance M&A at the Capability Level

166 171

CHAPTER 9 Figure 9.1 Figure 9.2 Figure 9.3

Oil Industry Value Drivers New Roles in the Consumer Goods Industry The Development of Value Networks in the Pharmaceutical Industry

188 195 201

CHAPTER 10 Figure 10.1 Shared Services in the SBU Model Figure 10.2 Resources and Output in the Capability Organization Figure 10.3 Dynamic Company Boundaries Figure 10.4 The Capability Organization Structure Figure 10.5 Creation of Capability-Driven Organizations

213 219 221 223 226

CHAPTER 12 Figure 12.1 Figure 12.2 Figure 12.3 Figure 12.4 Figure 12.5

The Journey to a Capability-Driven Organization The Four Steps to Set the Agenda Mapping Capabilities and Market Ventures Determining the Capability Strategies and Opportunities Establishing Capability Potential

260 261 266 271 272

Foreword The evolution of the modern corporation tends to mirror the evolution of species. Instead of taking a slow and steady path, the corporation has evolved through a series of punctuated equilibria—long periods of incremental evolution punctuated by periods of rapid development of new organizational forms in response to technological discontinuities. Two hundred years ago the industrial revolution led to dramatic improvements in the economics of production and transportation of physical goods. The industrial revolution resulted in the emergence of the modern industrial corporation, which took advantage of technology to reach new levels of scale and efficiency. As we enter the 21st century, we are at the threshold of another technological discontinuity—the information revolution. Advances in communication technology are dramatically impacting the economics of interaction. And they will inevitably give birth to the postindustrial corporation. The postindustrial corporation will not be an incremental evolution of the industrial corporation. Rather, it will be a mutant, whose form and function will be radically different from the familiar corporations of today. While the final shape of the postindustrial corporation is still unclear, some tantalizing glimpses are beginning to come into view. The agricultural equipment company John Deere is creating a services business by managing crop tracing and tracking information in the agricultural supply chain. The world’s largest conglomerate, General Electric, employs more than 10,000 people in India in an operation that provides shared services for GE companies worldwide. The upstart handheld device maker Handspring markets its handhelds without designing, manufacturing, or shipping its devices. A major bank is bidding to run the IT infrastructure xi

xii

FOREWORD

and back-office operations for a competing bank. These are all symptoms of something much larger. We may not realize this yet, but the fundamental assumptions about what corporations look like, how they operate, and how they create competitive advantage are being turned on their heads. We have traditionally thought of a corporation as an autonomous multinational entity that manages a vertically integrated value chain to produce products and services for customers. Every aspect of this definition is coming into question. Vertical integration is giving way to virtual integration. Multinational organizations are morphing into differentiated networks of entities with specialized capabilities. The value chain is evolving into networks that include suppliers, channel partners, complementors, and competitors. And instead of products and services, winning corporations are creating integrated offerings that solve complete customer problems. Integrated value chains are being deconstructed into their elemental forms and recombined in creative ways to unleash value. The basis for competition is no longer products, but creative business designs that combine capabilities of a number of actors in innovative ways. As one of my students commented, your success in the networked world of business is equal to what you know, raised to the power of who you know. The revolution in interaction costs has profound implications for the design of the corporation. Every corporation is defined in terms of two key boundaries: the geographical boundary, which determines where the firm locates its operations in physical space, and the scope boundary, which determines where the firm locates its activities in capability space. Reduced interaction costs are shifting both of these boundaries in important ways. The patterns of shifting boundaries offer deep insights into the possible contours of the postindustrial corporation. On the geographical boundary, the multinational model assumes that corporations consist of a corporate headquarters with a number of geographical subsidiaries, with an appropriately defined power balance between the two.

Foreword

xiii

Geographical subsidiaries tend to function as miniature replicas of the parent company. In the postindustrial corporation, geography is employed as the basis for comparative advantage for the entire corporation. So a company like General Electric may make its Indian operation the worldwide center of excellence for IT-enabled services, Mexico and China the worldwide centers of manufacturing, Israel and the United States the worldwide centers of R&D, and Ireland and Philippines the worldwide centers for customer call centers. These geographical entities are no longer “subsidiaries.” Rather, they will evolve into “capability clusters” that maximize comparative advantage across geographies. These capability clusters will be networked together through information technology. On the scope boundary, the old vertically integrated model assumed that corporations minimize transaction costs when they own the entire value chain and compete on scale. With the reduction in interaction costs, corporations now realize that they need to focus sharply on what they do the best and to outsource everything else to specialized partners. Instead of being a vertically integrated value chain, value is now created by a network of specialized entities that master a specific set of capabilities and combine those capabilities in flexible, yet efficient, value networks. As the authors correctly point out, capabilities will become standalone businesses in the postindustrial world. So how does one make sense of such complexity and chaos as the modern corporation transforms into a form and function that we don’t yet understand? There seems to be a bewildering array of enabling technologies, strategies, and business models to analyze. The secret is to focus on the building blocks of the corporation and not on the outcomes they result in. To take an analogy, understanding how the building blocks of a LEGO set work and interface with each other is far more insightful than trying to understand how a bridge or an airplane made from the LEGO blocks works. Similarly, to understand how a human being with billions of cells functions, the logical place to start is

xiv

FOREWORD

to understand how amino acids combine to form genes and how genes express themselves through proteins. The key to understanding complex systems is to understand that these systems consist of relatively few building blocks that can be combined in creative ways. This is the essence of the Human Genome Project. And this is the most important insight in this book. The authors correctly define capabilities as the elemental building blocks of a corporation. Just as a human being is a complex set of genes that express themselves in terms of physical form and shape, the authors view corporations as a set of capabilities deployed that express themselves in terms of value offerings. The concept of the capabilitybased organization is an insightful lens with which to view the emerging postindustrial corporation. For instance, it allows the age-old debate of integration versus specialization to be reinterpreted as competing on a narrow set of capabilities that can be leveraged across industries, or competing by integrating a diverse set of capabilities for a narrowly defined customer set. The authors demonstrate how the capability-based view of organizations can be used to gain new insights into business process outsourcing, mergers and acquisitions, and the structural transformation of industries. In unfamiliar terrain, it is very helpful to have a map in hand to navigate your way around the landscape. This book is a compelling and prescient look at the future of the modern corporation. Although the corporate genome project may be a work in progress, the authors take important steps toward the goal of understanding how corporations really work and how the corporate genome can be redesigned to exploit the full power of the information revolution. Read this book carefully because this is as close as you will get to a key for unlocking innovation and value in your industry. Mohanbir S. Sawhney McCormick Tribune Foundation Professor of Technology Kellogg School of Management

Acknowledgments We are indebted to a great many people for the insight, effort, and talent they contributed to this book. First and foremost, we are grateful to our clients, who shared with us their strategic visions and the pragmatic issues they faced in working toward them. Together, we shaped and reshaped our notions of how corporations would change in the coming decade. Their “views from the trenches” gave us a clearer understanding of the possibilities, and the realities, of corporate transformation. We also received much valuable advice and support from within A.T. Kearney. Graeme Deans, Sigurd Lilienfeldt, Dolf Balkema, Fred Alkemade, Martijn Hoogeweegen, Pieter Klapwijk, Jean-Marc Saffar, Bruce Klassen, Mike Moriarty, John Egan, and Rob Smeets offered thoughtful commentary on our ideas and our words. Henner Klein not only did that, but also put up the equivalent of seed capital by creating the right conditions for the material to be developed. Fred Steingraber, chairman emeritus of A.T. Kearney, took our message to the World Economic Forum, where many thought leaders contributed reactions that helped us refine our thoughts. David Kirkpatrick of Fortune, who wrote about our ideas after they were presented at Davos, Switzerland, summed it all up so succinctly that we borrowed his descriptions quite liberally as we worked to translate our concepts into user-friendly language. Particularly in order are thanks to Juliette Miremont, who thoughtfully and relentlessly researched and drafted many sections of the book. We are grateful as well to Bethany Crawford, Nancy Bishop, and Martha Peak, who kept a watchful eye on the story line and deftly edited xv

xvi

ACKNOWLEDGMENTS

revision upon revision. And finally, a sincere thank you to Matthew Holt and the editing team at John Wiley & Sons for taking us so ably through the difficult process of moving from thought to printed page. Johan C. Aurik Gillis J. Jonk Robert E. Willen

Introduction What if Christopher Columbus had an accurate map of the world and a global positioning system? He certainly could have conducted his explorations more efficiently and at less risk— but he would have had to hurry to keep ahead of others with the same tools. Our corporate world holds potential for exploration not unlike that of the geographic world in Columbus’s day. The competitive landscape is changing as business leaders exercise unprecedented freedom to adapt and even reinvent their corporations. This incredible flexibility is a direct result of the ability to craft strategies at increasingly lower levels of business aggregation—at the capability level, in the authors’ words. Many companies are successfully changing their business models to intensify the focus on their most lucrative elements. We no longer have to look at a whole business in our quest to drive growth and competitiveness. Rather, we can zero in on individual pieces—creating new markets and competitive dynamics in the process. In addition to this, joint ventures and alliances have become wellestablished means for value creation, complementing more traditional mergers and acquisitions. Rebuilding the Corporate Genome offers readers a number of important benefits. It details the new point of view required for setting strategy at lower levels of business aggregation. With this fresh perspective, companies can exploit new opportunities for creating competitiveness and growth and simultaneously fend off unexpected rivals. In other words, through capability lenses, new horizons and new possibilities suddenly come into focus. Industries in transition become sources of advantage rather than simply uncertainty. xvii

xviii

INTRODUCTION

The book also provides a structured approach for formulating capability strategies and identifying the resulting opportunities to increase competitiveness. It offers a methodology for companies to anticipate and address potential competition at the capability level. Finally, the authors paint a picture of how organizations will have to change to accommodate the increasingly important business capability dimension. They also describe how to prepare for the transition to a capabilitydriven organization. Rebuilding the Corporate Genome provides a map, a global positioning device, and other navigational tools to business executives. Those exposed to these tools in action will quickly recognize their value for effectively exploring how businesses can be reconfigured for new sources of growth and competitiveness. Many are already reaping the rewards. The corporate landscape has seldom changed at such a dizzying pace. To the prepared adventurer, it has never looked more inviting. Jan P. Oosterveld Member, Group Management Committee Royal Philips Electronics

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Executive Summary Imagine focusing on and nurturing the very best parts of your business—and nothing else. Coca-Cola is working toward that goal. So are Procter & Gamble and Disney. Their approaches are very different, yet they focus on a shared theme: They are dissecting their companies into tiny pieces and creating new and innovative ways to make the most of their best assets. They know—either intuitively or explicitly—that the days when one company researches, designs, makes, and sells a product or service are numbered. Why? Interaction costs have plummeted over the last several years (thanks to the Internet, but also to many other factors), making it far easier than ever before for individual pieces of a company to break free. If there are advantages to this happening—and in this book, we argue that the benefits will be substantial—the breakdown of the corporation is inevitable. This book is about the implications of this breakdown and about our vision of the new corporation. The corporation as an entity is already becoming sleeker— and far more potent. The implications are enormous: The competitive landscape will change, in some cases dramatically, necessitating new strategies for differentiation and growth. When we state that the corporation will break down, we do not mean to imply that it will atomize. Rather, strategy formulation will increasingly take place at a lower level of business aggregation, and it will become clear that large parts of the current organization are not yet shaped accordingly. This means that we will have the opportunity to recombine parts of our companies and those of others to create far more competitive entities—to take individual genes to create new strings of more powerful DNA. At this point, we should mention that this is not an 1

2

REBUILDING THE CORPORATE GENOME

empirical topic. Because this journey is just beginning, we have no database of companies to analyze. Rather, these ideas are the culmination of many discussions with thought leaders and key clients that are implementing new strategies based on a more focused corporation. We call this process rebuilding the corporate genome because of the similarities we see between a corporate capability (a single element of a value chain, like manufacturing, branding, or purchasing) and a human gene. Just as each of our genes is a piece of DNA working as an instruction manual for a particular human characteristic, each business capability is a component of the value chain that makes a unique contribution to a company’s output. The corporate genome holds the design key to what a company sells, whom it sells to, and what resources it deploys.

■ HISTORY REPEATS ITSELF The corporate genome has been renovated before—several times over. We begin our book with a review of how corporations have become increasingly focused over time, moving from conglomerates to integrated corporations to collections of business units. Now, with the phase we’re entering—the liberation of individual business capabilities—value chains undergo a transformation as well. A value chain is, after all, a set of capabilities (which we define as distinct activities that add value), many of which are purely about information. Now that product and information are less tightly linked, one value chain breaks into three distinct layers with specific characteristics: a physical value chain that consists of all the key production processes; a transaction chain that contains such information processes as ordering, scheduling, invoicing, and workflow facilitation; and a knowledge chain that encompasses the more creative elements, such as product design, branding, and assortment.

Executive Summary

3

■ NEW STRATEGIES AND OLD When businesses are brought down to the capability level, new threats and opportunities emerge. Our second section begins by looking at the major threat that has become a familiar one in recent times: Anyone could become a competitor in any capability. (Witness the ease with which Intuit’s Quicken elbowed its way into the financial services business.) This means that every capability in an organization must become world-class. Companies that remain responsible for capabilities at which they do not excel will lose ground to those that do. An insurance company that shines at marketing its policies is held back by the inefficiency of its back-office services. Conversely, an insurance company that excels at back-office services loses an opportunity to grow if it does not sell this capability. Strategies for creating a capability-driven organization fall into two main categories, and most large organizations will use both. They can focus on individual capabilities and make the most of them. Coke concentrates on leveraging its branding; Caterpillar has turned its logistics services into a subsidiary, Cat Logistics. Procter & Gamble has, since 1999, actively sought to exploit its “killer capabilities” in a number of fields. Most recently this has resulted in Emmperative, a joint venture with Worldwide Magnifi designed to make P&G’s marketing know-how available commercially to a broad corporate base. Elsewhere the company has licensed manufacturing technology and brand trademarks. The other strategy capability-driven organizations can employ is working at the value chain level, assembling the most competitive lineup of capabilities possible to create a superior product or service. Apparel company Benetton combined its branding and marketing capabilities with Imagica’s paint fabrication expertise to create a unique series of paints in colors and textures you won’t easily find elsewhere. At first glance, the number of strategic options open to

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companies willing to pursue competitiveness at the capability level appears overwhelming. Adept prioritization will be critical. When a company considers its capabilities, it will find that some are crucial to its business value—such as patents for specialty chemical firms and brands for branded goods manufacturers. The company will find that others are only beneficial or just plain necessary, but do not contribute meaningfully to business value. Performing those capabilities badly would erode their competitiveness; doing them really well would hardly provide an edge. The generic strategies now become easier to define based on how well the company performs the capabilities. The company can turn the value-producing capabilities at which it excels into businesses in their own right and leverage their strengths by selling the output to other companies. It can also explore exclusive link-ups and partnerships to leverage these strengths even further. On the other hand, if the company doesn’t excel at capabilities that produce little business value, it will have to consider how it can get the same contribution from a more competitively run capability. Pooling the capability with others in pursuit of scale is one possibility; outsourcing is another. If we look at classic strategic frameworks, we see that a capability organization complements the work of Michael Porter and C. K. Prahalad. For example, a focus on core competencies still applies—but without the restraints of current corporate boundaries. And in terms of competitive advantage, which Porter says is based on either differentiation or lower cost, it is far easier to achieve this edge in a single capability than in the entire set of capabilities that make up a traditional corporation.

■ PUTTING THE PIECES TOGETHER One key to creating a capability-driven organization is understanding how various capabilities can be optimized. In

Executive Summary

5

the third section, we return to the three value chains and discuss how the drivers behind them differ. Optimizing the physical value chain is a fairly straightforward process. Key goals of the chain include economies of scale and capital, flexibility, and a decrease in the complexity of bringing goods to market. Companies can make the most of their physical capabilities through outsourcing or carve-outs if they decide not to focus on these elements—or by insourcing (selling) capabilities they choose as a focus. The transaction value chain is in the midst of change. More and more transaction business processes are being automated and moved outside company boundaries to achieve economies of scale. The rapid rise of Net markets illustrates how transaction processes can become the core of a stand-alone business. And consider the experience of UPS: At one time it took 14 days for the company to obtain billing information for a package. After it outsourced its billing data process to a Dallas vendor, it captured the information it needed in 24 hours. The concept of optimizing knowledge assets is far less tangible—but the potential rewards are arguably the greatest. When knowledge capabilities (such as branding or design) are used creatively and effectively, companies can grow market share or charge a premium for their products. Some companies have developed innovative strategies for making the most of knowledge capabilities. Over the years, Ralph Lauren has cultivated one of the world’s most widely recognized families of consumer brands by creating a visionary concept of its “American lifestyle experience,” supported by a distinctive approach to advertising. Companies with effective knowledge capabilities will enjoy a significant competitive advantage that will be extremely difficult to replicate. Also in this section, we discuss in more detail the opportunities for optimizing the output emerging from clusters of capabilities by recombining them. We explore how prominent corporations, including GE, BMW, and GM, are already bundling business capabilities to gain an edge.

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We’ll also take the reader through the two major steps involved in recombining capabilities: pinpointing the value a company provides and choosing which capabilities to combine based on the requirements of the output. Capability optimization possibilities, of course, vary significantly by industry. We’ll look at some of the businesses at the forefront of the trend. In insurance, we discuss the transformation of back-office operations. In the oil industry, we look at optimization opportunities far upstream in the value chain (maximizing reserves and reservoir yields). In consumer goods, we assess the changes in the supply chain as the power struggle between manufacturers and retailers continues. And in pharmaceuticals, new industries are emerging: clinical research organizations and new genetic researchers. Finally, in electronics, we look at the rise of electronics manufacturing services.

■ THE TRANSFORMATION The successful capability-driven organization will be transparent, agile, and manageable. There will be a clear split between single-capability approaches and business propositions built on recombining capabilities along the value chain. Each capability or recombination will have its own leaders, markets, and customers. In the fourth section, we look at how the capability-driven organization differs from the previously integrated models and the benefits it offers. We explore the implications for strategy, organization structure, and governance as the capability organization evolves into a mixture of highly focused (but generally fewer) world-class business capabilities and a number of ventures focused on outputs. We also discuss how the market-facing nature of a capability organization ensures that companies continue—and even enhance— their focus on the customer. We then consider in more detail the implications and

Executive Summary

7

benefits of the capability-driven organization. More focused and less compromised, from leadership to culture and capital, many aspects of the corporation are affected by the shift of business to the capability level. Finally, we show how and where you can get started with the transformation by turning necessary capabilities into service businesses and finding additional ways to generate value with the most crucial and differentiating capabilities. We take you through the four key steps to setting the agenda for a capability-driven organization that can create new sources of growth and competitiveness. First, a company determines what business(es) it is really in. Second, it formulates appropriate capability and market venture strategies incorporating the full potential of individual capabilities. Third, it prioritizes capability and market venture strategies and assesses its partnering needs for those strategies. Fourth, it aligns its priorities with specific practical considerations such as resource availability. After this task, the company is ready for action.

■ HOW FAR WILL WE GO? Some have argued that we are headed toward a completely atomized corporation—a “Hollywood model” in which producers, directors, actors, and technicians come together to make a movie and then disband. This endgame is neither likely nor desirable for a number of reasons. First, competitive advantage shifts over time, forcing companies to constantly reassess which strategies to pursue and, at least as important, which strategies to invest in. Second, this readjustment of strategies is also contingent on shifts in the product life cycle: As a product matures, strategies are adapted to maintain market share. Third, it simply takes time to build efficient supply and demand. Because of the entrepreneurial risk involved in making and reassessing

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these strategic compromises, we believe the corporate center will continue to play a strong role in the capabilitydriven organization. Finally, we believe companies have little interest in ever reaching this atomized version of the endgame, where all pockets of windfall margin have flowed toward the end customer. Companies, and corporate centers in particular, will instead strive to create value chain “inefficiencies” through clever lineups, exclusive link-ups, and recombinations capable of trapping value in excess of the economic costs. Over time, this could prove to be the most challenging single task of the corporate center. What will your strategy be as the corporation changes its shape? The answer depends on your industry, the competition, your strengths, and many other variables. But if you take your business to a capability level, and redefine your strategy from there, you can find unprecedented and unexpected new sources of growth and competitive advantage.

I

Section

Introduction ■ THE CHANGING SHAPE OF THE CORPORATION Has the corporation as we know it outlived its usefulness? Companies look and act the way they do largely because outside forces have molded and shaped them over the years. Yet those external influences are themselves in the midst of dramatic change. Interaction costs have gone into freefall, nullifying much of the logic behind the current corporate structure. Value will be measured in increasingly smaller units—rendering our current definitions of the corporation obsolete.

1

Chapter

The Corporation Breaks Down—Again Corporations are built on compromise. The genetic makeup of a business—its informal (or rigid) culture, its obsession with growth (or cost controls)—will inevitably fit some areas of the company better than others. But what if smaller pieces of a corporation could be considered on their own, at the equivalent of the individual gene level? Is it not far more effective to fine-tune one specific element of a business than an entire organization? Today, many corporations are beginning to do just that. In this chapter, we: ➤ Look at historical shifts in the structure of the corporation—each toward a greater degree of focus ➤ Discuss why the current shift to a company organized around smaller units of value is possible, concentrating on falling interaction costs ➤ Present some early evidence of companies’ moving toward organizing around these individual corporate genes (which we call capabilities) ➤ Assess where certain industries fall in the level-oforganization spectrum, and why

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■ THE CORPORATE GENOME Through massive mapping efforts, we are learning how the human genome is sequenced. We can trace which individual genes in the genome determine the color of our eyes, and we are beginning to see glimmers of the links between our health and our genetic coding. Perhaps in the future we shall be able to fend off certain diseases or influence our well-being, not by changing the conditions in and around our bodies, but by affecting the very material that determines our propensity for certain conditions in the first place. Why diet if a little genetic engineering can prevent obesity? For the human genome, an aura of science fiction still surrounds such considerations. In the business world, however, it is clear that an era of corporate genetic engineering is already dawning. Rather than looking at the well-being of entire companies or business units, we can increasingly address the individual components of a business. We have called these corporate genes business capabilities. Just as each human gene is a piece of DNA working as an instruction manual for a particular human characteristic, each business capability is a component of the value chain that makes a unique contribution to a company’s output. The corporate genome holds the design key to what the company sells, whom it sells to, and what resources it deploys. In effect, it defines what products and services corporations offer. Although human genes lack the capacity to make organisms on their own, business capabilities can create the corporate equivalent. In both our client work and in recent press accounts we’ve seen that more potent versions of capabilities can be created when they are taken out of their corporate genome context—and leveraged as separate genes in new and powerful ways.


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■ INTERACTION COSTS IN FREEFALL Most new ideas are not really new; rather, they are creative extensions of existing ones. The concept of a new stage in the life of the corporation is, in large part, a new wrinkle that furthers the time-tested theories of British economist Ronald Coase. When Coase was awarded the Nobel Prize for economics in 1991, many were stunned: None of his articles contained a single equation or correlation coefficient. Yet his observations are as relevant today as they were in 1937, when he penned The Nature of the Firm. In that insightful work, Coase explored two fundamental questions: Why do firms exist, and what determines the size of a firm? Coase was the first to identify the significance of transaction costs in determining the shape of the corporation: A firm tends to expand until the costs of organizing an extra transaction within the company become equal to the costs of carrying out the same transaction on the open market. Similarly, if transaction costs were zero, theoretically there would be no firms. Search through articles in prominent business journals and reviews written in 2000, and you’ll find Coase’s name dozens of times (our Internet search yielded 98 hits). His recent surge in popularity is no coincidence; rather, it represents a consensus on one of the irrefutable benefits of the Internet: the lowering of transaction costs. Coase’s observations have clear implications for organizations: If interaction costs go down, the need to keep all business activities in-house diminishes. As transactions costs have declined, in large part because of developments in information technologies, corporations have come to function at lower levels of aggregation. This evolution validates Coase’s arguments (see sidebar: “The History of the Corporation”). The huge decline in transaction costs has been spurred by technological breakthroughs such as the telephone, television, telex, facsimile, and video conferencing, but also

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The History of the Corporation Conventional wisdom holds that the configuration of the firm has progressed through three major stages of increasing focus. The first large corporations—designed about 100 years ago—were diversified functional corporations built to achieve the efficiency and size needed to produce a limited line of goods for the growing American domestic market of the early 1900s. Firms such as DuPont, General Motors, and Ford followed this vertically integrated model. Ford not only made tires but also owned rubber plantations to supply its tire factories and ground the glass to make its windshields. As these firms started to pursue a strategy of diversification in the early 1920s, it became apparent that such a structure posed problems of coordination and control, and some (led by Alfred Sloan of General Motors) soon adopted a multidivisional structure in which each division was conceptually a distinct business with a specific market. Chevrolet, Pontiac, and Cadillac operated independently, each with its own customers and price range. By the 1960s, the diversified divisional conglomerate was the dominant form of corporation throughout the developed world. By the 1980s, the next stage had emerged. Competitive pressures forced traditional corporate giants to implement vertical disaggregation strategies (or get rid of previously integrated upstream or downstream activities) and strip down toward more focused companies, or integrated corporations. The change in strategic direction by companies like Eastman Kodak and Westinghouse, and the breakup of conglomerates like ITT, signaled this shift in the United States. In Europe, the trend toward more focused companies was slower to take hold, but soon caught up. Nokia shed businesses like paper and rubber boots; Unilever sold off its chemicals; ICI spun off its pharmaceuticals. The move away

by more physical trends such as the widespread proliferation of air travel. This drop in costs went into freefall with the radically new use of the telecom infrastructure to create the World Wide Web. The Internet has been termed “disruptive” by some because it stormed onto the scene so quickly. The infrastructure and devices required to support


15

from the conglomerate model in much of the rest of the world was—and still is—much more gradual. Witness the longevity of Korea’s once powerful chaebols (networks of companies); their demise has been only recent. The next stage is life as most of us know it: the current organization form of multiple strategic business units (SBUs) within an integrated company. As the competitive environment evolved, the integrated corporation responded by transitioning to network organization forms— a collection of business units responding to market forces rather than a chain of command. This new organization, in which business units buy and sell goods and services among themselves at prices determined in the open market, is focused, flexible, and responsive to customer needs and market requirements. Most modern companies today, from IBM to Procter & Gamble, are organized in this fashion. As defining and developing the core competence of the firm attained popularity among management researchers and practitioners, market-based definitions of businesses shifted toward more competence-based definitions. If Honda’s core competence was in small combustion engines, the domain of Honda’s activities would include any business that leverages this core competence. The typical organization today has become much more focused, but it still generally buys, makes, sells, and distributes its products largely on its own. That model is about to be turned on its head. With the advent of the Internet, we are poised at the brink of the next stage in corporate history: a modular organization that can selectively link up with other firms to utilize specific skills and capabilities. Suppliers and designers, for example, might ally with manufacturing firms to produce innovative and timely products.

it were already available. A personal computer, a phone line, and a CD-ROM from an Internet access provider will get you online in no time. And once you’re on the Internet, you can download all the software tools you need to carry out a large variety of tasks making use of the Net as an interaction medium. Contrast that with the “revolution” led

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by the advance of facsimile communication. Before it could take place, communication equipment had to be developed, manufactured, distributed, and sold. The Internet is also considered disruptive because it enables fundamental—sometimes even radical—business process improvements. From both an efficiency point of view (the ability to reduce costs) and an effectiveness point of view (the ability to reach a large audience), it is clear that the Net will bring substantial benefits. The improvement potential and the suddenness with which it has been brought about together create an instant gap between yesterday’s benchmarks and tomorrow’s possibilities for many different business processes. One day, a company is best in its class; the next day, it finds itself embarking on a journey to become state of the art. In fact, it could find that competitors are winning the race to capitalize on the newfound opportunities. One day, a company is best in its class; the next day, it finds itself embarking on a journey to become state of the art. In the end, the disruptive reduction in interaction costs introduces a new, irreversible discontinuity in our thinking about the shape of the corporation. If Coase was right, we are looking at the next split-up of the corporation, which can now be organized around separate business capabilities (see Figure 1.1). In this book, we define business capabilities as a set of value elements (built through knowledge, assets, or processes) within the value chain that lead to a specific output. For example, manufacturing is a capability, as is product design or purchasing. In essence, the individual genes of the corporation, or the business capabilities, are turned into corporate genomes themselves, with their own definitions of products, services, and customers, and with ever more focused consumption of resources. Arguably, this is the true impact of the Internet. The


Level of business aggregation

Conglomerates

17

Interaction costs

Corporations

Strategic business units Business capabilities

Connectivity and digitization Time

The breakup of conglomerates into corporations and business units has paralleled the steady decline of interaction costs. The dramatic reduction in interaction costs brought about by the Internet will accelerate the breakup to the next level of business aggregation.

Figure 1.1. The Breakup of the Corporation Source: A.T. Kearney.

Internet is not merely a means to improve efficiency and effectiveness but actually contributes to redefining business as we know it (ironically what e-commerce was expected to do before the end of the gold rush). Building a company around individual business capabilities is a far different proposition from organizing one around integrated business units. It is time to rewrite the corporate genome.

■ THE HARBINGERS OF CHANGE The organizational form of the future has been described in a number of ways, including the knowledge-creating company and the virtual organization; the contemporary economy has been termed a business ecosystem or networked economy. These labels share a common thread: They signal

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a move away from an interest in markets and hierarchies to alternative modular forms. All seem to be responses to roughly the same drivers for change: globalization, deregulation, and technological advances. Most observers believe that the new forms of technology demand that organizations restructure and adopt new ways of working—not to succeed, but to survive. The advent of modular organizations, able to link up rapidly with other firms to form larger, industrywide “constellations” of value, is an attempt to capitalize on the changes in the business environment introduced by the disruptive reduction in interaction costs. As companies are being redefined, capital markets are also showing signs of change. NASDAQ experimented during the Internet hype with the valuing of ideas or single capabilities rather than entire corporations. Indeed, dot.coms were closer to single-capability ideas than corporations: They had no customers, no assets, no profits. The willingness to value an idea that has not yet become a corporation clearly indicates that capital markets are ready to allocate resources at a level lower than the strategic business unit. The recent market corrections that affected the very companies that were based solely on ideas and not assets, customers, or profit does not invalidate these concepts.

■ THE EVE OF THE CAPABILITY ORGANIZATION The integrated corporation as we know it, typically organized around strategic business units, has outlived its usefulness. It is giving way to the rise of separate businesses, organized around the individual business capability—of which manufacturing, assembly, and distribution, as well as development, design, and branding, are all examples. Consider Motorola and Ericsson, which decided to outsource the production of their mobile phones to Celestica


19

and Flextronics, respectively. The significance of these deals is that Motorola and Ericsson have essentially defined the manufacturing of goods as a separate capability and a distinct business with its own customers and resources— and in the process have become customers in this new industry. They have also made a strategic decision to concentrate on the capabilities of design and marketing, even though the production of mobile handsets was until recently considered a key aspect of the business. By narrowing their focus, they can concentrate on the pieces of the business at which they excel and add greatest value. Think of the possibilities for a corporation that identifies the most profitable capabilities it possesses—and leaves the rest to a company that can do it better. Think of the possibilities for a corporation that identifies the most profitable capabilities it possesses— and leaves the rest to a company that can do it better.

■ THE VIEW ACROSS INDUSTRIES Clearly, some industries have captured the lead in harnessing the power of information to rebuild their corporate genomes (see Figure 1.2). While the business unit corporation dominates in most areas of business, conglomerates remain in some industries; in others, leaders are already making the move toward the capability organization. There’s a fair amount of gray area to consider, too. Businesses that might be considered conglomerates, like an ExxonMobil or a GE, actually exhibit many characteristics of a capability-focused organization (see sidebar: “A Study in Contradictions?”). In the high-tech industry, Cisco and Dell Computers are among those moving toward modular organizations. Dell (like Gateway) either buys products ready-made or pur-

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Oil and gas Utilities

Net markets

Metals Chaebols*

Industrial design Chemicals

Mining Healthcare

Insurance Banking FMCG**

Entertainment

Retail Automotive Fashion Aerospace

Conglomerates

Corporations

Strategic business units

Business capabilities

Industries are at different stages of value chain disaggregation.

Figure 1.2. Mapping of Industries Note:

*Chaebols are networks of powerful companies in Korea. **FMCG = Fast-moving consumer goods Source: A.T. Kearney.

chases all the parts from suppliers and performs only the final assembly. Established competitors—IBM, HewlettPackard, and Digital Equipment—used to produce most of their parts in-house. As a result, the smaller modular companies have outgunned their older rivals in profitability. Cisco’s forte is designing and delivering managed network solutions by efficiently outsourcing much of its manufacturing and new product development to the contract manufacturers in its network. Today Cisco advises companies on how to choreograph the key steps in value integration— just as Dell has started to advise on its Web-based integration initiative. For both of these companies, however, selling their core supply chain competency as a consulting service is only the first step toward leveraging their core capability. The next step to becoming a true modular organization will be selling their expertise directly by managing flows for other companies. In home furnishings retail, world leader IKEA has


A Study in Contradictions? With Exxon combining forces with Mobil, and British Petroleum merging with Amoco to form a new league of world oil giants, the large vertically integrated oil companies appear to be the remaining giant conglomerates. They profit from the capital power, balanced portfolios, economies of scale, and synergy savings that their shareholders demand. There is a difference, however, between these oil giants and the renowned conglomerates of the ’70s: BP-Amoco and ExxonMobil remain focused around oil and its derivatives. Earlier conglomerates such as ITT pursued a strategy of intense diversification, operating in such wide-ranging sectors as manufacturing, hotels, and insurance. Although the major oil players appear large and vertically integrated, they have actually moved quite far toward becoming capability-driven organizations. For instance, very efficient crude oil markets and oil product markets separate the upstream, sales, and chemical divisions of an oil company. The oil majors view their companies as sets of capabilities, and they work to make the most of each independently of the others. Oil concessions, for instance, are actively shared to achieve a good balance between risk and upside potential. Many of the capabilities required to drill and complete oil and gas wells have been left to the specialists such as drilling contractors, well logging contractors, cementing companies, and casing handling contractors. Maintenance of all the facilities has often been left to large engineering and maintenance firms. On an even larger scale, refineries are shared if there is no geographic justification for more than one. Shell and ExxonMobil have an equal share in the companies exploiting the oil and gas fields in the United Kingdom and the Netherlands. The oil companies have effectively optimized many capabilities of their own accord without restricting themselves to the footprint of the oil and gas they sell. In this respect, these companies represent exceptions to what today can be considered common practice. Most large companies have organized themselves in strategic business units that focus on their respective markets that control most of the resources they need to serve those markets.

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Another example of the gray area in assessing the capability shift is Fortune’s repeatedly most admired industrial company, General Electric.1 With businesses ranging from aircraft engines to television, GE is in its diversification similar to ITT before its breakup. We argue, though, that GE also employs many principles of the capability organization. One key to GE’s success is its practice of bundling, which is the business unit level variant of recombining capabilities (we talk more about both capability recombination and GE in chapter 8). The rule of thumb for many acquisitions by GE is that the acquired party must demonstrate a fit with an existing GE product or service offering. For instance, GE has acquired several companies operating in the medical industry. Rather than defining their markets restrictively (as, say, medical imaging systems or patient record-keeping software), it saw the entire spectrum of goods and services required by medical care suppliers as a single market and put together an entire suite of products and service offerings to cover almost every need. Customers get the best product and service propositions in the different fields—and from a single company that also focuses on creating propositions that combine the strengths of the different component businesses.

demonstrated the potential for building competitive advantage by redefining the relationships and organizational practices of its business and building a modular organization. In the IKEA system, each participant contributes a capability: the customer by assembling and taking home the furniture; the IKEA designers in the centralized design office in Almhult, Sweden, by working 2 to 3 years ahead of current product and carefully selecting suppliers; and the 1,800 suppliers, located in more than 50 countries around the world, by offering low-cost, high-quality products in exchange for technical assistance, leased equipment, and advice on bringing production up to quality standards that are recognized around the globe. As a result, IKEA has built an


23

integrated business system that matches the various capabilities of participants more efficiently and effectively than ever before. This organization form has enabled IKEA to keep costs and prices down while growing exponentially. Once a small Swedish mail-order furniture operation, IKEA is now the world’s largest retailer of home furnishings. The apparel industry is also well on its way toward modular organization. Nike, which has developed its own product line since 1972, has built its success on collaboration with its suppliers (which enable the company to introduce new products to market quite efficiently). Nike recognizes that its key capabilities are designing and marketing, rather than manufacturing, and relies on outside firms to make virtually all of its shoes. Nike is very much organized in a modular fashion, having disconnected manufacturing from marketing, both in space and time. It continues to keep a small domestic manufacturing facility, but for good reason: Maintaining its capability for cutting-edge design is a strategic imperative. Nike functions the most as a capability organization in its relationship with athletes. By combining its sales and marketing capabilities with Michael Jordan’s emblematic character, Nike created unique, differentiating value.

■ CONDUCIVE CONDITIONS Of course, a wide range of external factors, such as regulation, play a role in influencing which industries are ahead or behind. But for practical purposes, we focus on what we see as two main circumstances that influence how much an industry will likely be affected by the reduction in interaction costs: ➤ The information intensity of the business ➤ The congruence among a company’s capabilities

24


Products differ in their degree of information content: According to Michael Porter and Victor Millar, information intensity relates to the proportion of an organization’s market offering and/or value chain that is informationbased.2 All physical products include information about product characteristics, use, and servicing. Some have relatively low information content (such as agricultural products). Others provide customers with substantial information (package delivery firms have extensive data relating to delivery locations and times). Other products do not have a main physical component, but are information-based, such as banking, newspapers, and computer software. The notion that information-intensive businesses like banks or insurance would be more affected by reductions in interaction costs is fairly straightforward. In businesses such as the chemical or mining industry, most assets are physical. On the face of it, the Internet has less to offer them. (This is not to say that there will be no impact. Net markets and other forms of transacting electronically are already making old economy trading processes far more effective, but these processes represent little expense compared to the costs of the feedstock, the operating costs, and the capital costs.) Another factor is the effectiveness of a single capability within its current environment. The greater the compromise it must endure, the higher the chance of disaggregation as interaction costs drop. Consider, for instance, the typical small insurance company. If it is like most insurers, it still develops and services the policies it sells. Its strategies for improving marketing and branding would probably not involve seeking economies of scale—yet that’s an important goal for the servicing function of the company. This low congruence of objectives will eventually drive our small insurer apart. When it breaks into pieces, the sales and marketing entity can continue to aim for effectiveness; the policy and claims servicing will increasingly be outsourced to parties that have the right economies of scale. This dynamic in the insurance industry is acceler-


Level of capability compromise

Na tu ra ld rif t

Technology

Level of capability compromise

High

Corrective action required

High

Shift in information intensity

25

Selective capability optimization

Business model reinvention

Continuous improvement

Anticipation of discontinuities

Low

Low

Product life cycle Low

Information intensity

High

Low

Information intensity

High

The activities of corporations often tend to gradually become more information intensive and less internally aligned. The degree to which this happens will determine the appropriate corrective action.

Figure 1.3. Why Are Industries Ahead? Source: A.T. Kearney.

ated as the move toward Web-enabled systems increases the proportion of costs related to information technology (IT) relative to other expenses. As this proportion increases, so will the fixed cost component in the insurance company’s cost column, increasing the sensitivity to economies of scale in the process. Some companies, like the oil companies we mentioned earlier, have already reached a high degree of effectiveness and efficiency in their business capabilities. They will likely be affected less by the Internet. With their strategies of shared ventures and outsourcing of major processes, these companies have already reaped benefits of both scale and specialization. If left to its own devices, an industry or company will move toward increasing information intensity and a greater level of capability suboptimization (see Figure 1.3). Porter’s observations in the 1980s that the information component of products was taking on a greater importance, and that a plethora of new products based almost

26


exclusively on information were entering the marketplace, still hold true. It’s also true that many business capabilities will be affected (in various ways) by new technologies. Chances that a company can keep its capabilities near their full potential without changing its business model are slim. The Internet sets companies back in terms of optimization because suddenly more effective and efficient processes are possible—processes they haven’t yet adopted. How can companies respond? The answer depends on where a company finds itself in terms of information intensity and capability suboptimization. When both can be considered high, there is a good chance that the company will have to fundamentally rethink its business model. At the other extreme are companies that have a low information intensity and have ensured that their capabilities fit within their business definition without too much compromise. They have the (relatively) easier task of anticipating possible disruptions in their capability configuration. Companies with a high degree of information intensity, but little compromise among capabilities, must be ready to improve their capabilities in line with ever-decreasing interaction costs. Finally, companies with a high level of capability compromise that are not information intensive probably need to innovate specific capabilities to bring them back to a more effective state. It is interesting to note that as companies in the fashion industry redefine their corporate genomes, distribution maintains its role as the key capability for companies to control, given its impact on getting products to market in a timely manner. More generally, the ratio between fixed and knowledge assets is not static. As products mature and become more like commodities, differentiation tends to come from the knowledge-related components of the production process. The first car owners scrutinized the mechanical system of the car before choosing a model; today nobody buys a car without considering brand, customer service, or options offered with the vehicle. The product life cycle heavily influences how to find new sources of com-


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petitive advantage in the new corporate genome. (More on that later.)

■ THE CEO’S AGENDA While outsourcing foreshadowed the trend toward modularity (think Cisco or Nike), it is just one way in which a company can restructure its corporate genome. Carving out or spinning off departments that are not key contributors to final output are other strategies. The reciprocal aspect of this is that companies can consider selling single capabilities at which they excel to help solidify their competitive advantage. Because of the disruptive reduction in interaction costs, the role of individual business capabilities can now be more accurately identified in the total output a company creates. This transparency puts us at a lower level of aggregation than the corporate genome: Instead of the genome level we are at the individual gene level—focusing on corporate capabilities. The Human Genome Project has provided us with a catalog of tens of thousands of genes, but scientists are left with the question, What do proteins made by these genes actually do? Similarly, the shift toward the business capability (or gene) level raises two of the most basic questions any CEO can ask or be asked. Now that capabilities can contribute more independently and transparently to output, it is time once more to reconsider two very fundamental questions: “What businesses am I really in?” and “How am I going to succeed?”

■ CONCLUSION ➤ The current shape of the corporation has outlived its usefulness. The forces that help shape businesses are

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in the midst of change; transaction costs are falling dramatically. ➤ Originally vertically integrated entities built on the conglomerate model, corporations have taken on increasing levels of focus. We now see glimpses of the evolution of a new stage of the corporation: the capability organization. In this model, businesses are broken down into separate capabilities, or elements of the value chain. ➤ The corporate genome holds the design key to what the company sells; whom it sells to; and what resources it deploys. It is time to rewrite the corporate genome so the organization can focus on its key capabilities and key businesses. Focus is the key word.

2

Chapter

Value Chains—Unchained In virtual nirvana, eventually everyone will be connected—companies and key partners, companies and consumers, and units within businesses that had been stuck in their own silos before. Our ability to digitize information in any way, shape, or form enables us to better leverage lowcost connectivity, fundamentally improves how we interact, and radically changes our business definitions. Arguably, this is the true impact of the Internet. Many e-business initiatives focus on saving time, shrinking costs, streamlining processes, and enhancing product offerings. But when companies make improvements that are replicated by old rivals and new players alike, everyone ends up competing on cost. The real, sustainable exploitation of the Web will come when we change our business definitions and start organizing for real differentiation beyond firstmover advantage. The Net is far more than a means to improve effectiveness and efficiency; it actually contributes to the redefinition of business as we know it. With chains between products and information loosened, it is time to rewrite the corporate genome to make the most of this shift. In this chapter we look at how this newfound connectedness creates new dynamics in value chains, including: ➤ Why physical goods and information are now liberated from each other, and what this has meant so far for e-business 29

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➤ How the links in the value chain are dissolving and setting capabilities loose ➤ How the traditional value chain breaks down into three separate chains

■ A BRAVE NEW WORLD OF BUYING AND SELLING In its essence, the Internet represents unprecedented lowcost and wide-scale connectivity among companies, consumers, and organizations, and even among different sites of one company. New software language standards (among other things) have dramatically enhanced our ability to digitize information and allow for a far more elaborate exchange of information. As Philip Evans and Thomas Wurster tell us in Blown to Bits, we now face a far smaller trade-off between the size of the audience we reach and the quality of the information we give those recipients (see Figure 2.1).1 In the “old economy,” companies could reach a wide audience using tools like print or TV ads—or they could provide high-quality information (for instance, by conveying emotion through a salesperson). In the “new economy,” we have online communities and Web markets in which very detailed, high-quality information can be exchanged among incredibly large numbers of participants. E-commerce, or the ability to sell products over the Web, is one of the most imaginative manifestations of the new possibilities. The level of attention e-procurement has obtained is hardly surprising considering the potential benefits. Even basic forms, such as automated applications for the buying process, relieve the burden on the purchasing organization and cut administrative time and costs. Theoretically, Net markets represent another wave in the procurement revolution. Founding participants are estimated to benefit from a 60 to 80 percent reduction in

Value Chains—Unchained

New interaction opportunities

Web markets

Advertising

Communities E-commerce E-procurement

tion

iza igit

D Mailings

Size of audience reached

31

Traditional interaction trade-off

Int

ern

Process Collaboration

et

C

Exhibitions

n on

ect

ivit

y

EDI

Sales force

Quality of interaction Low-cost connectivity and digitization enable dramatic and simultaneous increases in the size of the audience reached and the quality of interaction. This development forms the basis for many new interaction opportunities.

Figure 2.1. New Forms of Interaction Sources: A.T. Kearney; “Strategy and the New Economics of Information,” by Philip B. Evans and Thomas S. Wurster, September–October 1997, Harvard Business Review, pp. 71–82.

transaction costs on common platforms, compared to traditional procurement.2 By bringing together large numbers of buyers and sellers and automating transactions, these Web-based markets expand the choices available to buyers, give sellers access to new customers, and reduce transaction costs for all. It is now clear, however, that the reality lags the theory. No Net market participant gains an advantage.

■ TAKING THE STING OUT OF ADMINISTRATIVE SERVICES The potential benefits of low-cost interaction are obvious when companies need to exchange a great deal of information with one another or with their customers—as is the

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case with many administrative and service processes. Think of the insurance industry. Online quotes can be immensely helpful in getting a consumer interested in a specific insurance product. Quotes are available—almost instantly—at the consumer’s convenience. Another major benefit: A significant part of the administrative responsibilities can be transferred from insurer to consumer. If the back-office systems and Web environment are properly linked, the task of entering policyholder data into the information system is effectively shifted from insurer to consumer, turning the consumer into an employee, and dramatically reducing data entry mistakes. Schwab.com pioneered the online trading proposition, and in the process, created a new industry segment of day trading practically overnight. Although the industry widely used low-cost phone connectivity to bring its trading services to a large audience, it was not until Schwab.com offered online trading services that the costs of the trading process plummeted. By letting clients enter the details for specific trades themselves, and by using logical algorithms to evaluate whether specific trades can be carried out or are allowed given a client’s trading status, the broker took significant costs out of the process. This was great news not only for Schwab, but for its customers, too: Accessibility had improved as dramatically as the company’s costs had. By taking the trading facilitation process to the Web, Schwab.com reduced the average cost of a trade for a consumer from US$70 to US$30. This huge improvement has allowed Schwab’s online operation to reach an enormous market share and significantly grow the number of trades it carried out. Yet a word of caution applies here. The rise of Schwab.com and the creation of the new online trading industry highlighted an important side effect—one that can manifest itself anytime the Web lies at the heart of process improvements. Although Schwab.com better than halved the average fee of a trade, competitors now offer a similar service for as low as US$7 for the average trade. This raises


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a question: Is the industry as a whole better off as a result of this innovation? An online broker must massively increase trading volumes to compensate for the annihilation of headroom for generating margins. Job cuts at Schwab.com—and many of its rivals—clearly indicate that with the birth of a new era in trade facilitation, no guaranteed vein of gold has been unearthed. Undertaking business capability improvements without a deep understanding of how all aspects of the value chain will be affected can have dire consequences. We stress this danger throughout the book, and show how this deeper understanding of the value chain will help unlock the real value of your business. Let’s take a look beneath the surface of this sobering story to see more specifically what happened. In moving the process of facilitating a trade from phone communication and data entry (handled by the company’s employees) to Web-based interaction (handled by customers), the process becomes driven heavily by economies of scale. As the cost column becomes more and more biased toward infrastructure and application costs, the need arises to achieve high volumes. Instantly, the competitive position of smaller players is threatened unless they offer differentiating accompanying services, because they are disadvantaged on price. The individual “genes” that made up the traditional business can now be isolated and turned into businesses themselves. Charles Schwab deployed this concept through its Internet trading arm. By letting users enter details about trades themselves, automating trading rights, and providing users direct access to quotes, Schwab.com halved the average trade fee, but also set a more fundamental change into motion. Because of these actions, an online broker can no longer count on the facilitation of a trade to help sell a

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multitude of other services, such as market research, portfolio advice, and stock picks. Customers will increasingly decide where to trade and where to get information for investment decisions separately. In effect, two business capabilities—that of facilitating trades and that of providing decision-making support for investments—have become disaggregated. This means that the individual “genes” that made up the traditional business have now been isolated and turned into businesses themselves; the corporate genome has been modified and new species of businesses have been created in the process.

■ A CHAIN OF CAPABILITIES To understand how the Internet will change our business definitions, we need to talk first about business boundaries. There is a certain logic to our current definitions. Traditionally a business was defined around its main output, or what it ultimately produced. Often this related to the production assets that dealt with the physical flow of goods or the delivery of services. A manufacturer was called a manufacturer because it made something; a wholesaler was called a wholesaler because it aggregated and sold products, which it kept in its warehouse and delivered as ordered. Business boundaries, and implicitly the definitions of corporate entities, have generally been drawn at places in the value chain where a scope change occurred. The output of the steel industry ends up, for instance, in cars, buildings, tools, railways, washing machines, and so on. Vertical integration for a steel manufacturer (for example, if the steel manufacturer made and sold cars) would instantly lead to an escalation of its size or cover only a small portion of its current output. Limiting this seemingly endless proliferation of scope, business boundaries typically occur between the producers of raw materials and the manufac-

Flat steel, piping, plastics, etc.

Air conditioning manufacturer

Cables, switches, heat exchangers, power supplies, electrical motors, compressors, housings, etc.

Products

Electrical installation material, heating installation material, heating systems, lighting systems, air conditioning systems, control systems, construction material, etc.

Diverging scope changes

Distribution

Installation

Operation

Building materials, labor, engineering design, architectural design, etc.

Energy, facility management, security services, etc.

Scope

Components

Scope

Material supply

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Scope

Scope

Narrowing scope changes

Scope


Scope changes in value chains are natural business boundaries at which part of the output of different industries (value chains) is combined into the specific output of the value chain step. The figure shows the high-level scope changes in the air conditioning manufacturing industry.

Figure 2.2. Air Conditioning Industry Value Chain Source: A.T. Kearney.

turers of products, or when going from products to wholesaler assortment or retail assortment. Boundaries can also occur because regulations require them or as the result of other forces outside the marketplace. At every discontinuity in the value chain, there has been a good reason to define a business boundary and as a consequence, have a transfer price. Figure 2.2 uses the extended air conditioning industry to show how the business scope changes at every step in the value chain. Upstream, the value chain converges as the goods and services traded between players in the value chain become increasingly specific to air conditioning manufacturing. Downstream toward distribution, installation, and ultimately operation of the air conditioning units, the value chain diverges to include more goods and services from related value chains, which are necessary elements in successive value chain steps. (Incidentally, one could argue that “operating” is not the last step in the

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extended value chain. It could be extended to include controlled air quality; it could even include productivity achieved by improving working conditions. In certain manufacturing environments, in fact, optimal air quality is a prerequisite to production.) Yet these boundaries will, over time, become restrictive. Companies will begin to abandon what might be called a “common denominator” viewpoint on the entire traditional business in favor of focus and alignment with the market and characteristics of each business capability. Honda’s business might be redefined around small engine technology. Companies that develop, design, brand, produce, and sell everything themselves will become endangered species. Replacing them will be companies that allow individual capabilities that draw new boundaries in a quest to become or remain best in class. If we redefine business boundaries, we need to rethink the shape of the corporation. Emerging in the place of the integrated corporation as we know it are collections of separate businesses organized around individual business capabilities. We define business capabilities as value chain elements made up of sets of activities or assets (both tangible and intangible) that make a concrete contribution to value chain output. Manufacturing, assembly, and distribution are capabilities; so are purchasing and claims processing; so are development, design, and branding.

■ SOME CAPABILITIES ARE JUST INFORMATION As we look closely at a company’s individual capabilities, we see that many of them are simply forms of information. Even in the traditional framework, the value chain is made up of a combined flow of goods and information; each element in the value chain has both an information and a physical component. The physical component is


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composed of all the physical tasks required for the activity (including supply logistics, manufacturing, packing, and distributing). The information component includes the capture, analysis, and dissemination of the data needed to perform the activity. Some activities require more information processing than others: Clearly the production of cement involves less complex information than the processing of bank mortgages. The need for information to effectively run a business has long influenced the way corporations have been organized. Some argue, for instance, that most organizations (even in the industrial age) are constructed around an information-processing goal.3 Think of offices located next to factories or a hierarchy of departments based on capturing and channeling of information flows. Information also has a role in the supply chain: In a make-and-sell production model, producers receive orders (information) that replace actual sales (physical goods). We expect changes not only to processes that deal with information in an electronic format, but to any process that involves information. For instance, insurance agents have argued that their clients want personally delivered advice on insurance and investment products, but the incredible increase in the use of the Web for obtaining such information indicates that the data can be at least partially digitized. And the trust and confidence inherent in a personal relationship can increasingly be fostered online as security concerns subside. The Internet dissolves the traditionally strong link between product and information. Consider a traditional bookseller: The underlying logistical process needed to bring the book from printing press to reader is linked to the information about the book itself (such as whether it is available). With the Internet, the information about the book (not just data like availability, but also reviews or price) can be delivered to the customer independently of the book itself. Customers no longer need to walk into a bookstore to see what is available on the shelf or to decide what book to buy.

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More and more companies have been turned on to the value of information. It is a resource that can be used, shared, exchanged, and then reused—it has no decreasing returns. Consequently the liberation of information-rich processes, which has occurred thanks to the Web, has created growth opportunities that didn’t exist until now. Managers often used information they captured on inventory, production, or logistics to help monitor or control those processes, but they rarely used it as a capability to create new value for the customer. Federal Express, in the 1980s, was one of the first to create new value for the customer by identifying and developing information as a separate capability. By allowing customers to track packages and (more recently) find out who signed for them via the Internet, Federal Express created additional value for the customer. Just as a company takes raw material and refines it into something useful—automakers, for instance, put together all those parts on their assembly lines to ultimately produce a car—a manager today collects raw information and adds value through these steps. Today, many companies offer some form of online order tracking, allowing customers to better plan their own businesses or providing them with peace of mind.

■ MAKING MONEY THE OLD-FASHIONED WAY Traditionally, a company has been compensated for the final output, or end product, of its business rather than the contribution of its individual capabilities. Consider the typical manufacturing environment. The customer pays for the end product; through this sale, the company is indirectly compensated for design, branding, manufacturing, facility management, and the other aspects of its business. Now look at a retailer. Viewed through capability glasses,


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it’s an odd sight. By basically reselling products with a markup, the retailer is actually being compensated for providing a prime location for shopping, managing the shelf spaces, providing checkout services, maintaining a loyalty program, establishing a retail brand that defines a shopping experience, and many other capabilities. In other words, the retailer is not directly compensated for any of the things at which it excels. Although Honda exhibits leadership in engine technology, the company exploits this leadership—and is compensated for it—in the automobiles, motorcycles, snowmobiles, lawn mowers, and power generators it sells. In the same fashion, an insurer that excels at reliable and speedy claims management is compensated when customers buy its policies. Under the traditional system, a business charges one price that serves as its compensation for a combination of different activities—in other words, the collective work of the corporation. The real value-added elements were typically bundled so deep into the end product that the relative contribution each step provided to the overall margin could be hard to ascertain. The development and manufacturing processes were often perceived to be closely linked, or synergistic, although product development might have been the key strength and differentiator for the company, buried in a competence center that allocated costs to the different business units. The idea that a corporation is a collection of distinct business activities has attained recognition among management researchers and practitioners. John Hagel of 12Entrepreneuring popularized this notion by identifying three businesses beneath the surface of most companies: a customer relationship business, a product innovation business, and an infrastructure business.4 Whether industrial or service-oriented, a company in essence used to charge one price for a set of capabilities or “businesses” bundled within its boundaries. But the circumstances on which this practice was based have changed.

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■ FROM CAPABILITY TO BUSINESS Now that information-rich processes are increasingly becoming footloose, they are less embedded in factories, warehouses, stores, and plants, or even the “administrative factories” of banks and insurance companies. Increasingly, business capabilities such as manufacturing, development, design, assortment, and branding are offered as standalone services; they have become businesses in their own right. In the new model, each capability has its own definition of customers, products, and services, and a new set of resources. Doing away with compromises by driving a capability as an independent entity creates powerful new sources of competitive advantage and growth opportunities for the firm. Instead of competing in a single market, a company can turn itself into several capability businesses, fueling growth by serving several markets. Consider an insurance company that invests in (Webenabled) back-office processes to improve claim management efficiency. The insurer could try to recoup some of its costs by offering this new capability to smaller insurance companies that cannot make the same substantial investments. This practice would decrease the burden of the investment costs for the insurance company and allow the smaller players to continue going after their more focused market segments. The insurance company becomes active in two markets: It sells insurance to consumers and backoffice services to insurance companies. Traditionally, the insurance company could grow only by penetrating more insurance markets and achieving higher levels of cross-selling. Under a capability-focused approach, the insurer can sell these competitive administrative services directly to another insurer. This is especially interesting considering the inherent compromises in a corporation that sells the output of a portfolio of capabilities. Offering policies to consumers requires companies to develop products, brand them, and sell them—and all these


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capabilities can potentially dilute the competitiveness of its administrative machine if they are plagued by compromise. But let’s move past the hypothetical examples to some real-world industry leaders. Procter & Gamble is among those companies at the forefront of the shift to a business capability perspective. In the early 1990s, the company considered trade secrets to be a competitive advantage. Today, it is ready to sell at least some of its technical expertise, including what it calls its “reliability engineering,” to other companies. This toolbox of technical and statistical innovation—which predicts why an assembly line fails and how to minimize breakdowns—is credited with saving the company billions of dollars since 1990.5 This efficiency tool is now up for sale, as a product ready for licensing, priced according to the savings it represents for the buyer. Another industry leader selling a capability is the Walt Disney Company, which inked a long-term agreement with Coca-Cola to market children’s beverages (produced by Coke) globally under the Disney brand. The companies market juices, punches, and smoothies from Minute Maid, the flagship of Coca-Cola’s fruit beverage business. Colorfully packaged offerings, including Disney Xtreme! Coolers, come in flavors like Tropical Waveboard and All Out Apple. In this agreement, Disney’s brand becomes a capability in its own right and is sold as “a unique way to bring Disney magic to children worldwide.”6 In this example of companies bringing their marketing efforts together to sell the products, Coca-Cola does the heavy lifting necessary to roll out the beverages, while Disney lends its characters that have long enticed children around the world. And those who relish the compelling mix of tropical beaches and sports know the virtues of Hawaiian Tropic sunscreen products. For many, its hallmark coconut scent conjures memories of sun-drenched holidays well into the winter months. Yet for a long time, even the people at Hawaiian Tropic shared parents’ struggles to get their kids to wear sunscreen. Now, Hawaiian Tropic and Mattell have collaborated to

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produce the Hawaiian Tropic C Barbie™ line of sunscreen products, making protection from the sun fun for little girls on holiday. Needless to say, this product line brings together the best of both companies to create a powerful proposition for a new segment. Parents are no doubt hoping for an Action Man version in jungle camouflage packaging. Internet sweethearts Dell and Cisco are exploring similar routes to get more direct compensation for their leadership in demand fulfillment. They have started offering consulting services related to their competence in managing complicated demand flows. The next step might actually be to sell demand fulfillment management services outright and start managing demand flows for other companies that could benefit from Dell and Cisco’s capabilities. In all of these examples, the breakup of the value chain frees capabilities to search for their own means of efficiency and effectiveness outside current business definitions (see Figure 2.3). In the traditional aggregated model, suboptimization of capabilities is unavoidable. Consider, for instance, a typical multinational firm with many business units that service several different global and regional markets. To ensure the units achieve sufficient impact in the markets they serve, they are given considerable autonomy. Unfortunately, there is a downside to this approach: Many capabilities are shaped according to the footprint the business units have in the market. This footprint reflects how the company is doing with the products and services it is currently providing. It does not necessarily reflect the optimal scope or scale for the other capabilities in the lineup, such as enterprise resource planning (ERP) support; indirect goods and services sourcing; finance and accounting support; research and development; and manufacturing. The breakup of value chains into capabilities causes some interesting side effects. Take, for instance, the commercial assortments offered by different players in the value chain. A manufacturer might have an assortment of electrical cable, which it offers primarily to wholesalers. The wholesalers, in turn, have an assortment of electrotechnical


Old economy

New economy

Information flows Design/ development

Branding

Process control

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Design/ development

Assortment

Branding

Assortment

Transaction

Process control management

Transaction facilitation

Component manufacturing

Product manufacturing

Physical flow Component manufacturing

Product manufacturing

Traditionally value chains have broken down into smaller value chain steps. More recently, the value chain has also split into layers, effectively turning individual capabilities into businesses in their own right.

Figure 2.3. Capabilities As Independent “Businesses” Source: A.T. Kearney.

products—which includes the cables as well as complementary switches, tubing, light fixtures, switch boards, and lamps. The building contractors, in turn, will combine this assortment with that of a building construction material wholesaler and with design and building services. At each step of the value chain the size of the assortment increases. At each stage, the assortment is closely linked to the underlying physical processes. But when we look at a disaggregated value chain, the three levels of assortment suddenly find themselves next to each other. This is your worst channel-conflict nightmare. The consequences are easy to predict: At least one assortment will be disintermediated because the three layers do not add much value. After all, the various product suppliers can get together to create a virtual offering combining the assortment of a set of complementary suppliers. In the process, the wholesaler is likely to be reduced to a logistical service provider (see sidebar: “Shedding a New Light on Disintermediation”).

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Shedding a New Light on Disintermediation With the advent of the Internet, many players faced the threat of disintermediation—losing the key role they played in the value chain by being bypassed altogether. A typical example is the wholesaler, which historically has bridged the chasm between fragmented buyers that require an assortment and suppliers that did not have the scope to provide it. In essence, the wholesaler bundled several different services into one offering. It provided a physical service in the form of warehousing and distribution. The batches produced and supplied by the different manufacturers had to be broken down into lot sizes the customer could handle. At the same time, the goods had to be stored in a way that made it possible to pick the mixed orders of the customers. In addition, the wholesalers provided an information service by creating an assortment with terms and conditions as well as facilitating the transaction. In the latter, the wholesaler effectively takes care of the credit risk of the many different customers for the suppliers. Providing an attractive assortment with the right terms and conditions is an interesting capability or service. In principle, the suppliers themselves provide all the parts of this assortment. The wholesaler adds significantly to the final assortment only if it engages in significant value-added services. The wholesaler is (or was) allowed to aggregate the different assortments of the suppliers into one because the information demands of bringing together a fragmented manufacturer base with a similarly fragmented customer base have traditionally been absolutely prohibitive. In addition, the wholesaler fulfilled the physical distribution role. The assortment the wholesaler offered simply reflected what the company had in stock in its warehouses or could order on relatively short notice. Lower interaction costs make it increasingly possible to treat these service components as two separate businesses, each with its own means of optimization. Simply put, the information challenge of putting together the assortments


of different manufacturers has subsided, potentially reducing the wholesaler to a logistical extension of the different groups of manufacturers or customers. The threat to the wholesaler doesn’t stop here. In some industries, the physical role of the distributor becomes endangered once it is disentangled from the assortment and transaction facilitation role. In the semiconductor industry, companies like FedEx already handle a considerable portion of the physical distribution. The very high specificity of putting together an electronics components assortment has allowed wholesalers to maintain a strong link between the commercial assortment and the physical wholesale role. If the wholesalers are loosening their grip on the commercial assortment, however (for instance, through the rise of Net market initiatives), they may find parties such as FedEx better positioned to carry out physical distribution activities. The typical wholesaler thus faces the risk of being disintermediated as new forms of assortment aggregation develop. To succeed in this environment, the wholesaler has little choice but to evolve toward increasing levels of customer focus. By recognizing and acting on its participation in the knowledge value chain, the wholesaler can protect itself against disintermediation. Consider the opportunities in important knowledge capabilities, such as translating the customer’s need into a product or service choice. In lighting, air conditioning, and other industries, manufacturers actively work the market by helping customers determine which products best fit their requirements. These services are often extended to all who influence the buying decision, such as architects and engineers. The agenda, of course, is to plant a bias toward a particular product in the customer’s mind to boost sales. The Web is the perfect place to conduct this informationdriven process—and a forward-thinking wholesaler (which has the added advantage of being able to pit manufacturers against one another) can beat the manufacturer to the opportunity.

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■ DISAGGREGATION: THE THREE LAYERS When information flows detach themselves from their physical envelopes, the liberated capabilities can be grouped into three layers: the physical value chain, the transaction value chain (which focuses on transaction and control), and the knowledge value chain (which focuses on creative elements such as product design, branding, customer need translation, and assortment). (See Figure 2.4.)

➤ The Physical Value Chain Business capabilities in the physical value chain are the individual processes of the typical production chain: raw material supply, component manufacturing, product assembly, distribution, and warehousing, to name a few. As production-oriented as these activities are, they do not apply only to industrial companies. For a retailer, the physical chain consists of building and maintaining outlets, as well as the logistics of getting the goods to the stores and onto the shelves. Even an information and content business like a newspaper has a physical value chain—in this case, the printing and distribution activities. In a traditional bank, the physical presence of the bank is the vehicle for receiving, storing, and delivering money. In many instances, these physical capabilities are strongly linked to the capital tied up in the balance sheet. Businesses that focus on physical goods thus tend to require capital-intensive facilities, which also means that they have high fixed costs. As a result, economies of scale and economies of capital are key drivers of these businesses. For a bank or a newspaper, the physical component involves an extra dimension. Arguably neither the newspapers nor the dollars are the real goods flowing through the value chain. Rather, it is the news printed on the newspaper and the value represented by the money that flows. Since both news and the value of money can be digitized, in those


Manufacturer Design

Product branding

Wholesaler Assortment

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Retailer Assortment

Retail branding

Knowledge layer Process control

Transaction

Process control

Process control

Transaction

Transaction layer

Manufacturing

Wholesale distribution

Fine distribution

Physical layer When value chains break down into smaller value chain steps and split into layers at the same time, the emerging capabilities can be reconfigured into new businesses. Three distinct value chain layers will emerge, each with specific characteristics.

Traditional business definitions New business definitions

Figure 2.4. Breakdown and Delayering of the Value Chain Source: A.T. Kearney.

industries the real value chain can be isolated as the information breaks free from the physical process. In fact, many people already receive their tailored selections of news and do their banking from the comfort of their PCs. The scope of a vertically integrated firm is defined by what it can sell in the markets in which it is active. This means that its market share will be the key driver in determining whether it can reach competitive levels of economic scale. It could be argued, for instance, that for effective mobile phone manufacturing (separated from other processes such as sales and marketing) a company needs a certain minimum global market share of perhaps 30 percent. This is the minimum scale required to provide a platform for innovation, keep efficient production lines running, and maintain leverage over key suppliers. Anything less will erode the company’s competitive edge. Some of the key structural innovations introduced to

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mitigate the perceived shortcomings of the vertically integrated firm were aimed at improving asset productivity to gain economies of scale. Outsourcing—which searches for economies of scale outside a company’s walls—is part of this drive toward increased efficiency. Many businesses have chosen to outsource their logistics operations (including warehousing and distribution) to enjoy the cost reductions that higher economies of scale and density can bring. More recently, production companies have considered outsourcing their manufacturing operations, seeing this activity as a purely physical process that does not create real value (which lies in brand names, service levels, and so forth).

➤ The Transaction Value Chain The term transaction flow applies to any business capability pertaining to the transaction and control process, in manufacturing activities as well as services. In an industrial company, transactions include such processes as ordering, production scheduling, and invoicing. In an insurance company, transactions include the handling of claims, the processing of payments, and the gathering of customer data. Often driven by the basic economics of information technology, the transaction processes tend to follow the same economic drivers as the physical flow of assets by searching for economies of scale. It is no coincidence, for instance, that huge corporations are the ones that can afford comprehensive ERP systems. It is also no surprise that companies making products with the highest information component—think of newspapers, banks, or insurance— were the first to use data processing technologies while capitalizing on (even more) scale. As soon as technology allowed it, quests to increase information economies of scale beyond company boundaries began via initiatives such as Net markets and trading platforms. Being able to share a transaction platform, and


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Footloose or Loose-Footed? When the Internet made its debut, there were great expectations of its ability to make many information-rich processes and activities completely footloose. Knowledge and information were supposed to travel freely in digitized form, making use of unprecedented levels of connectivity. As a consequence, they could search for the most optimal configurations for making their contribution. Since then, we have witnessed collaborative design efforts, marketplaces providing transactional support from a distance, virtual assortments, and many more examples of what we have called knowledge and transaction capabilities looking for optimization. The physical capabilities generated less buzz for two reasons. First, they were not expected to benefit in the same way. Second, many people anticipated that the informationrich capabilities would tear themselves away from the stronghold the often asset-intensive physical capabilities seemed to have had on them. But there is more to this story: Although the physical assets are not likely to start moving about freely themselves, they can be made footloose indirectly (perhaps we should say “loose-footed”) by changing the characteristics of the actual goods flow within the assets with the help of Internetenabled technologies. A factory, for instance, can be transformed to allow it to handle manufacturing tasks for the goods flows of several different companies. Information technology will allow manufacturers to interact with the enterprise resource planning (ERP) systems of the different companies for which they provide manufacturing services. In other words, physical assets can increasingly cater to a mixed ownership goods flow and achieve better economies of scale and performance in the process.

standardizing it at the same time, yields impressive economies of scale. In the dark ages, several thousand companies each had their own ordering and invoicing applications; now Net markets are working to offer new economies of scale by consolidating these processes. Identifying the

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transaction flow as a distinct value chain has driven new Net markets to focus on the transaction processes exclusively in order to create a new business with far narrower business boundaries. While many Net markets have gone from promise to extinction in only 2 short years, it is likely that a single Net market per industry will survive to provide this standardized transaction platform. In the dark ages, several thousand companies each had their own ordering and invoicing applications; now Net markets are working to offer new economies of scale by consolidating these processes.

➤ The Knowledge Value Chain In the 1980s, observers noted that companies were using information technology for accounting and record-keeping functions (with computers automating such functions as order processing), and they hinted that the actual effect was greater because “by bundling more information with the physical product package sold to the buyer, the new technology affects a company’s ability to differentiate itself.”7 Capabilities such as branding, design, product development, and commercial assortment are potentially even more powerful means of differentiation. They are the components of the knowledge value chain. Economies of scale are seldom the secret to success for these knowledge capabilities. Effectiveness—which relates more to attributes such as scope, speed, type of focus, market impact, and segments—is far more important. Smaller companies are traditionally more successful at capabilities that require uniqueness, flexibility, innovation, and creativity to be effective—an important observation in our discussion of how companies can find new avenues for growth by focusing on newly liberated business capabilities. For several reasons, the knowledge flow is the most in-


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teresting layer of the value chain to look at for better value growth. First, this layer is highly vulnerable to change imposed by the introduction of the Web, as the capabilities in essence all represent some form of information. Second, in many companies and even industries, the knowledge layer has played second fiddle to the physical layer, and to a lesser extent, the transaction layer (as is true in the banking industry). Motivated by demands for sufficient returns on capital, many companies have optimized their physical goods flow assets at the expense of knowledge assets. This means that when given the freedom to fulfill their own key success factors, they are likely to jump ship or follow a different line than the physical assets. Most important, however, through intangible processes such as branding, product development, assortment, and design, companies enhance their value proposition and thus their ability to extract margin from the market through premium prices. Knowledge capabilities anchored in patents, or the ones able to create a strong emotional link with the customer, can be especially powerful sources of value. At the same time, knowledge capabilities are also the most challenging to optimize. Finding the right brand positioning, for example, is more art than science. More and more companies are competing on intangible assets such as knowledge because they have become absolutely critical resources. When Ralph Larsen, the chairman of Johnson & Johnson, states, “We are not in the product business; we are in the knowledge business,” we start to see how far companies are going in order to redefine their business boundaries.8 Once we recognize the distinct value chains at work in our business activities, and the specific capabilities they harbor, we can adjust our strategies to the realities of the digital economy. As physical objects, books are expensive and don’t sell quickly. But the more you can display, and the more information you can offer, the more you can sell. Of course, the principle of turning capabilities into businesses is not new (think logistics). What is new, however,

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is that turning capabilities into businesses can increasingly be considered for the information-rich capabilities from the transaction and knowledge value chains, thanks to the low-cost connectivity offered by the Web.

■ CONCLUSION ➤ Each value chain is actually a grouping of single capabilities, and the rebuilding of the corporate genome will take place at the capability level. ➤ Thanks to the connectivity the Internet has enabled, physical goods and information are no longer tightly linked within a value chain. ➤ What was once a single value chain now splits into three: a physical flow, a transaction flow, and a knowledge flow. The significance of this is that for each of the three chains, strategies to improve efficiency and effectiveness differ.

II

Section

Introduction ■ NEW THREATS AND OLD What happens when anyone can compete with you in any capability? Your only defense: Make every capability in your organization world-class. Does this mean you need a new strategy? Yes. Do you throw the classic strategic frameworks out the window? No!

3

Chapter

Rebuilding the Corporate Genome Just like the human genome, the corporate genome holds a design key—in this case, to what a company does, with whom it interacts, and with what resources. When business capabilities become free agents, it becomes possible to radically redefine the genome. When new genomes emerge, they are built around single capabilities rather than entire sets of them. The corporation takes on a sleeker, less rigid shape. Just like business boundaries, sources of competitive advantage shift over time as the underlying factors change. Economies of scale and scope, vertical integration or lack of it, and core competencies have all, at some point, been hailed as winning characteristics of the companies that possess them. Now that the disruption caused by the Internet has thrown us into a new phase of business aggregation, the question of competitive advantage comes back with a vengeance. In this chapter, we discuss how rebuilding your corporate genome around business capabilities can affect where your company stands in an industry. More specifically, we: ➤ Outline how companies can either boost the effectiveness of an individual capability or recombine multiple capabilities to create superior output 55

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➤ Point out the implications of the competitive threat that arises from organizing around capabilities: Rivals could outdo you in specific areas ➤ Discuss how the genetic makeup of your corporation and the balance of power in your value chain determine your best course of action

■ CAPABILITY-DRIVEN STRATEGIES When individual capabilities are seen as businesses in their own right—with their own markets, customers, products and services, and resources—it follows that a capability-level strategy will be more effective. The freshly liberated capabilities, after all, will create their own opportunities for new sources of competitiveness, and will therefore attract the attention of companies seeking growth and business improvement opportunities. Two basic types of strategies can be developed at the capability level (see Figure 3.1): ➤ Strategies that focus on a single piece of a business to create a killer capability ➤ Strategies that focus on the combination of capabilities along the value chain to produce a killer lineup The strategies focused on single capabilities aim to either leverage strong elements of a business or to find ways to boost the contribution a particular element makes to output, or both. The former equates to leveraging capabilities by turning them into businesses in their own right and selling their output outside the company. Companies such as Cisco and Dell Computers, as well as companies like IKEA, could consider selling demand fulfillment management services to other companies and thus capitalize on what is arguably their strongest capability. Both Cisco and

Rebuilding the Corporate Genome

Single-capability-focused strategies

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Value-chain-focused capability strategies

Companies

$ $

$ $

“Killer capability”

“Killer lineup”

• Maximize the competitiveness of individual capabilities by reconfiguring them across companies • Leverage competitive capabilities by selling capability output outside company boundaries • Leverage capabilities upstream or downstream in the value chain

• Maximize the competitiveness of the “business” output or “chain” output of sets of capabilities regardless of whether they reside within own company boundaries

Two main types of capability strategies can be pursued: single-capability-focused strategies and value-chain-focused strategies (which are output focused).

Figure 3.1. Two Possible Strategies Source: A.T. Kearney.

Dell have made the first steps in this direction by selling related consulting services. The latter option is a bolder approach to maximizing the competitiveness of a single capability. If capabilities can increasingly be nurtured independently, it becomes easier to create a new and improved capability by looking outside company boundaries. Here’s a simple example: the manufacturing operations of several companies, all of which have global plants. Although the global plants enjoy sufficient economies of scale, shipping all the goods around the globe incurs logistical costs that could have been avoided by using regional manufacturing sites. To address the situation, a subset of industry players with complementary market positions exclusively pool their manufacturing capability. They create a single manufacturing company with a truly global footprint—saving considerably on the logistics costs without sacrificing economies of scale. They could even sell capacity to other

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parties, creating a new additional revenue stream for the partnership. The manufacturers could take this concept further by extending the pooling arrangement to include players from other industries that require similar manufacturing capabilities, reducing potential conflicts of interest. Such a pooling setup could, of course, be emulated by the remaining players in the industry, potentially nullifying the competitive benefits in the process. There is, however, a distinct advantage in being able to select the most suitable partners. Once the optimal partnership has been created, the remaining players are left with the second-best choices, potentially putting them at a nearly insurmountable disadvantage compared to the first-mover pooling partnership. In other words, if this can be done, there will be a good chance that it will be done eventually. There is an important twist to selling the output of single capabilities that were previously embedded in a product or service. Whatever the capability produces does not necessarily have to be sold to the existing customers or to others that use the output for the same applications. Being able to sell the output of one capability independently from the business end product allows a company to reassess where the capability output can add the most value—and therefore potentially yield the greatest return. Enzyme manufacturers, for instance, spend considerable research and development efforts on creating patentable enzymes that perform better (for instance, in sugar extraction for fruit juice manufacturing processes). An enzyme with a 5 percent better performance might obtain a premium in the market. This premium, however, is likely to be only a fraction of the savings in terms of raw fruit and process costs. It could be more attractive, therefore, to try to “sell” the R&D expertise downstream in the value chain through partnerships at the processing level. Another example is the quest to develop ever more energy-conserving fluorescent lighting. The compact fluorescent lamps in the home environment and the electronic


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ballasts in offices are widely used. They save considerable energy, but since the makers are locked in fierce competition with each other, they capture relatively little of the value of the energy saved. Could new business models be defined that leverage the R&D knowledge differently to better capture some of that value? It’s a question worth investigating. Another way of looking at this issue is to assess what really drives the money made or lost in downstream steps of the value chain. Saving energy is clearly a worthwhile cause, but in monetary terms it is even more important to influence energy consumption over time. The price of electricity during the day is not constant; in many developed countries there is a considerable difference in the spot price between peak and off-peak hours. The reason: Electricity generation is a megascale process. It uses huge generators that do not lend themselves well to being switched on and off depending on the need for electricity. The result: The ability to influence electricity consumption proactively could yield considerable benefits. Being able to dim all secondary lighting (perhaps to 70 percent during the heaviest peak hours) would provide a nice return. (This concept mirrors current practices in deep-freeze warehouses, which are brought to minus 26 degrees centigrade during the night and allowed to gradually go up to minus 20 degrees during the two peak periods in the day.) To capitalize on research and development efforts in this direction, fluorescent light manufacturers will need new business models, possibly with complementary partners. It would be difficult to capture this value through the sale of a bulb. The strategies we’ve just described focus on creating and exploiting capabilities with a new level of competitiveness, or what you might call “killer capabilities.” Enterprises can also use their newfound capability freedom to improve the lineup of capabilities creating specific output, resulting in what might be termed “killer lineups.” The strategies focusing on the combination of capabilities along the value chain revolve around creating more

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competitive, or even new, value chain output. Such strategies aim to capitalize on the increasing potential for creating “virtual” value chains by aligning the output of capabilities with different owners. One recombination possibility: Selected players that hold a key world-class capability get together and create a venture aimed at exploiting this accumulation of superior capabilities. This route to riches could be far shorter than each of the partners would travel working individually to bring its entire organization up to world-class standards.

The strategies focusing on the combination of capabilities along the value chain revolve around creating more competitive, or even new, value chain output.

Coca-Cola optimized a single capability when it began licensing its brand—which was named number one in the world by BusinessWeek in August 2001.1 Recently the company began orchestrating clusters of capabilities with other industry leaders (including Procter & Gamble, Disney, and Nestlé) to seek competitive advantage outside the carbonated drinks business.

■ NEW LEVELS OF RIVALRY When competitive advantage is won or lost at the capability level, companies become vulnerable to attack in unexpected places. If a company cannot execute a particular capability effectively, it risks being outperformed by another that excels in that same area. In other words, competitors can beat you by going after a small piece of your business: one of your suboptimized capabilities. These competitors often come from within the indus-


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try. In many countries, the contact lens business is being split increasingly into a contact lens fitting service and a contact lens sales business. Contact lenses are ideally suited to online sales once consumers know just what they need. Consumers can buy well-known brands and be confident that they will receive quality products. At the same time, contact lens specifications are highly standardized, allowing customers to order exactly the type of contact lens they require. Perhaps most important, contact lenses represent relatively high value in small and light packages that fit easily in a mailbox, making them the ideal candidate for home delivery. Many traditional contact lens stores that provide a full service of contact lens fitting and inspection as well as sales are on the defensive; their bread-and-butter sales are being attacked by Web-based competitors. The ability to sell the related services together with the contact lens (in other words, to use the contact lens as a price carrier) will gradually erode. The capability of facilitating contact lens ordering and payment is dramatically improved by going online rather than to a physical location. Based on this innovation, a new and competitive proposition is formulated by adding other complementary capabilities, such as branding contact lenses and providing fine distribution. Competition can also come from outside the industry. For example, in recent years financial management software such as Intuit’s Quicken has made it possible for customers to access and integrate financial information in fundamentally new ways. Users can directly access their bank accounts through the Web and actively manage their financial affairs. Many banks enable customers to conduct real-time interactive banking, reconcile all their financial data from bills, balance checkbooks, and view bank statements online. Intuit takes this concept much further. It allows consumers to do all this with many different financial institutions, and for many different types of transactions and information, such as on mortgages, insurance, investments, and stock trading. For consumers, switching banks

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or brokers is a snap, because they can continue working through an interface they know. By providing this facilitation service, Intuit becomes a direct competitor to the banks. Because the bank no longer controls what the customer sees on the screen, it runs a serious risk of deterioration in its customer relationships. Not only that, its ability to provide valuable advice based on consumers’ finances will be significantly reduced. The wealth of financial information consumers have at their own disposal, reaching far beyond the scope of a single bank, also allows them to obtain financial advice far more easily from other sources. Rather than handing over shoeboxes full of bank statements and other financial information, consumers can now give access to their financial software to a financial planner or use online analysis tools. A direct implication is that banks and other financial institutions will be increasingly judged on their brands and assortment of financial products: Most of the information differentiators have been absorbed by a company dwarfed by the sheer size of the consolidated banks. This example highlights the innovation and new competition created by the breakdown of a business into capabilities. Companies that fail to face these issues head-on will lose their lead the same way the banks are losing control of customer relationships (see Figure 3.2). A few years ago, banks did not consider software companies to be competitors. Many industry experts believe the emergence of these financial services intermediaries foreshadows a shift in retail banking. Quicken, they say, is just the beginning. The adoption of standards will bridge the gap between personal financial software and bank Web sites, making it far easier for customers to switch from one provider to another. The music industry offers a highly publicized example of how new competitors are emerging in the market space made viable by the disruptive reduction in interaction costs. Even before the Napster controversy, groups such as the Internet Underground Music Archive (IUMA) started


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Statements Bank “service”

Knowledge value chain

Customer need translation

Transaction value chain Physical value chain

Digitization and low-cost connectivity fundamentally change the role of the bank statement from an extension of the bank account to an integral part of an overall personal financial administration scheme that incorporates input from many different financial institutions. This aggregation of information allows financial advisors, or even software, to provide advice on the financial services a customer requires—a service traditionally offered by banks and other financial institutions.

Figure 3.2. New Competition for Banks Source: A.T. Kearney.

posting digital audio tracks from unknown artists on the Web, potentially subverting the role that record labels play. New technology allows musicians to record and edit material inexpensively themselves, and to distribute and promote it over networks such as the Web or commercial online services. It also allows them to test consumers’ reactions to their music, build an audience for their recorded performances, and even distribute their products digitally. The capability of bringing music to market has traditionally occurred in the physical world, but today labels are facing competition from players that neither produce, record, nor distribute recordings in the traditional sense. Another area in which the competitive scene is being rearranged by the opportunities of low-cost interaction is that of customer need translation, or the service of helping customers define their needs. For many different products and services ranging from financial products to highly

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technical items (such as air conditioning systems), customers need help deciding which product or configuration is best for them. In many technical environments, such as construction, marine equipment, and professional audio equipment, translation of a customer need into a technical specification plays a key role in the value chain. Traditionally, this task was divided into application advice provided by engineering bureaus, architects, or the like, and technical advice provided by the manufacturers. Manufacturers’ intimate knowledge of their products allowed them to provide valuable advice on which engine, control system, or appliance was best for their customers. In fact, such advice plays an important role in being able to “specify” products, which as a result of the advice become locked in as a customer’s choice. Increasingly, however, the application–advice providers can use specification information on products (which is now often digitized) in their application advice. In many cases, the specification data can even be incorporated in software design tools. For the end customer nothing much changes, except that design turnaround times are often shorter. The relative contribution by the manufacturers and decision influencers, however, changes in favor of the decision influencers. As the manufacturers’ relative contribution erodes, so does their ability to use this contribution to help lock in demand for their products. In other words, customer need translation capability is optimized in a way that reduces their control over the final output. The nature of the competition the manufacturers face changes as well. Instead of being able to rely on specification efforts to secure business, they will have to focus entirely on creating a product range that can compete on specification and price, and hopefully on other factors such as the brand. New competitors aren’t the only problem. Companies can shoot themselves in the foot by “dragging along” or retaining control of a suboptimized capability—making the business as a whole less efficient. Think of the food industry, in which innovation and new product introduction are


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the key drivers of value. While many companies have invested in their manufacturing capabilities (to respond to growing competition), these companies are actually dragging along inflexible technology that is ill-suited to today’s short product life cycle. Reciprocally, manufacturing companies have started to shift from making their products to concentrating more and more on knowledge capabilities, such as branding and product development. These companies have optimized their manufacturing beyond company boundaries (by outsourcing or contract manufacturing) and are in a better position than their integrated competitors to invest capital and management resources in the very capabilities that yield market share: new product introduction, marketing, and brand management.

■ THE DEFENSE: A GOOD OFFENSE The reorganization of businesses around capabilities can be viewed as a threat—or a powerful new competitive tool. Innovators that recognize and organize for the opportunity created by this trend can tap into additional revenue streams and differentiate themselves in novel ways. When companies bring competitive advantage down to the capability level, they enjoy an opportunity to grow by directly selling the output of their best performing capabilities. We’ve mentioned that in the insurance industry, a company can profit from its investment in a Web-enabled back office not only through efficiency improvements, but by selling back-office services to other insurers. The challenge is to take this line of thinking and to extend it to the firm’s less tangible, yet more differentiating, elements. We can imagine, for instance, that a company like CocaCola could seek out new growth opportunities by capitalizing on what it does best—achieving brand recognition and merchandising—as a stand-alone area of expertise. Innovators like that will turn their star capabilities into separate

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businesses with their own genomes. They will have an opportunity to carve out separate businesses by selling capabilities directly as modules that other companies can purchase and plug into their own operations. That individual capabilities can be seen as independent businesses is not by itself shifting the source of competitive advantage. The real driver is the break from traditional business definitions that, as we have seen, often harbor compromises inherent in the molding of capabilities into one business. The cost of compromise is the underperformance of those capabilities that have been shaped in line with the leading capabilities—especially once competition takes place at the capability level. Doing away with such compromises for single capabilities—by driving a capability as an independent business—creates powerful new sources of competitive advantage for the firm.

■ ORGANIZATION AROUND INFORMATION Of course, a company’s ability to focus on and make the most of increasingly independent subbusinesses is neither new nor triggered by the Internet. Many corporations, for example, have already stacked up their own logistics services against those available from specialized third-party logistics providers. For those whose in-house operations came up short, outsourcing of the entire logistical service package was often an easy decision. Other well-established examples of capability optimization in the physical value chain also exist, such as assigning parts of the supply chain to contract manufacturers. The automotive industry’s use of modular manufacturing (car components are made at different sites and then brought together for final assembly) is one example of capability optimization in the physical value chain. In a fiercely competitive environment, carmakers need to slash


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costs through economies of scale, which in turn prompts them to push more manufacturing complexities upstream to their suppliers. The suppliers, seeing the opportunity to take on this additional business, have made the most of the capabilities that were transferred to them. Today, Delphi Automotive Systems’ expertise and experience in developing and supplying batteries has translated into producing applications for multiple industries, including heavy-duty truck, automotive, marine, electric/hybrid vehicles, and standby battery energy storage systems. While these examples show that the ability to organize around capabilities was clearly not triggered by the Internet, we contend that information technology will spark an explosion in this sort of cooperation and reshuffling. Companies can make the most of interactions in existing relationships, but also seek entirely new ones with best-in-class owners of complementary capabilities. And conversely, the owners of those best-in-class capabilities can look for new applications and partners that are willing to pay for them. The Internet will trigger the ability to organize around capabilities—not just in physical areas such as logistics and manufacturing, but also in less tangible categories such as product design, commercial assortment, and customer need translation. Since fewer assets are involved with information capabilities, the speed and flexibility with which these capabilities can be optimized or put into new configurations should be an order of magnitude higher than was the case with physical capabilities in the past. Managers have often used information they have captured on inventory, production, or logistics to help monitor or control those processes. Until recently, though, they have rarely used information itself to create new value for the organization. The first information subbusiness to be considered for optimization outside a company’s boundaries is transaction facilitation. Direct competitors have, for example, come together to share supply chain platforms by forming consortia like Covisint (in the automobile

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industry), Envera (in the chemicals industry), and Transora (in the packaged goods industry). Since they’re IT-driven, transactions become more efficient as economies of scale increase. And the sharing of Internet-based business infrastructures (along with the necessary standardization) enables huge economies of scale. Instead of several thousand companies using their own ordering and invoicing applications, a Net market searches for new levels of scale by consolidating these processes. But it is by optimizing knowledge assets (including development, design, branding, and assortment management) that a company can charge a premium or increase market share as a source of value. Optimization of these assets has been slow, but a few examples demonstrate the potential. Ford Motor Company is one. The company has recently strengthened its commitment to its “ultimate goal of being the premier design organization in the world” by opening a new design house with 30 designers located in a vibrant area of London. In essence, Ford realized that the best-in-class designers it needed to dream up hot cars would be more likely to flock to Soho, London, than Dearborn, Michigan.

■ RECOMBINING CAPABILITIES Mohanbir S. Sawhney, a professor at Northwestern’s Kellogg Graduate School of Management, says of the networked economy: “Instead of one big monolithic entity, companies start to look like clusters of distributed capabilities. It’s the way the movie industry works.”2 One way to seek competitive advantage in today’s disaggregated world of business capabilities is indeed to recombine or cluster with other companies’ capabilities. Companies combining (parts of ) their capabilities can work toward creating the super capability, or a truly dominating gene. Just as certain genes play a leading role in determining whether our eyes


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are brown or blue, differentiating capabilities in a company have a strong influence on its output. And while we are rapidly moving toward the ability to mix and match individual genes within the human genome, the good news for business is that we are already there: Companies can already assemble an optimized corporate genome through the creation of killer lineups. Just as certain genes play a leading role in determining whether our eyes are brown or blue, differentiating capabilities in a company have a strong influence on its output.

■ CREATING DOMINANT GENES— THE KILLER CAPABILITY Companies that recombine their capabilities can work within an industry or across different value chains. Collaborative design in the consumer electronics industry illustrates how recombination can sharpen a company’s competitive edge. Yesterday, the production of mobile handsets was considered a key to the mobile phone business. Today, the global leaders of this business, Ericsson and Motorola, have made a strategic decision to concentrate on the capabilities of design and marketing while assigning the task of manufacturing mobile phones to another company. Tomorrow, through collaborative design with chip manufacturers, we can imagine that these leaders will be compensated according to “time to market,” or the speed with which they can introduce new mobile phones. In the process, they will redefine the basis for competition. Are the mobile phone companies really interested in the microprocessors themselves, those dark little components with tiny metal pins sticking out? What they really want is to

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beat their competitors to the market with the coolest new phones. If they can get there through means other than collaborative design with semiconductor manufacturers, they will. Both semiconductor firms and electronic component firms will have to determine whether the current setup through collaborative design of the semiconductor itself is really the smartest way to achieve short times to market. If it’s not, they could lose out as other configurations that shorten time to market hijack the scene. For a cross-industry example of recombination in search of new sources of competitive advantage from a single capability, let’s look at Philips Domestic Appliances & Personal Care, which manufactures coffee machines, among other products. Philips allied with coffee seller Douwe-Egberts, a division of Sara Lee, to create Senseo Crema, a unique nonespresso “coffee experience.” The sleek and fashionable appliance Philips offers might best be described as a hybrid between a traditional drip machine and an expensive espresso maker; it was developed to produce superior coffee with a distinctive layer of creamy foam. The machine represents a collaborative effort with Douwe-Egberts, which developed coffee sachets specifically for the machine to satisfy consumers’ demand for fast and easy beverages. The coffee machine and coffee pouch work together to create the right taste, the creamy layer of froth, and the convenience of coffee by the cup. These two companies have combined their key development capabilities to offer a unique value to the customer. Like the taste of the coffee? You’ll have to buy the coffee machine and coffee together to get it. Consider also the somewhat mundane business of bathroom renovation. If you’ve ever remodeled a bathroom, you’re familiar with the coordination required to find products that are both available and complementary from a design standpoint. You go to a ceramics manufacturer for the bathtub and sink, a tile manufacturer for the bathroom tiles, the paint manufacturer for the waterproof paint, and maybe a curtain manufacturer for window treatments.


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Only five years ago, it would have been a major effort for the different manufacturers to come together to create a few bathroom lines that were truly integrated in terms of color and style. Such alignment between the different elements that go into a new bathroom would alleviate the need for consumers to shop around for matching materials and finishes. However, for the manufacturers involved, the bathroom products represent only a small part of their total output, making it too much trouble to create such product lines. Now the Internet, through the collaborative design and project management tools it supports, makes it possible for several best-in-class manufacturers to get together to ensure that the decorative line on the bathtub and sink matches the ones on the tiles, and that the color of the tiles and bathtub is complemented by several shades of paint and coordinating patterns in the curtains. Similarly, their marketing counterparts can create the necessary supporting material and campaigns with other collaboration software applications. This simple example illustrates how competitive benefits can be achieved at much lower aggregation levels than before. A facsimile would simply not support the level of sophistication required in collaborative design and branding efforts. The implications are profound. Rather than going through time-consuming mergers or acquisitions (which would not make much sense in this case because only a small part of the companies’ output and a subset of the capabilities are involved), the companies can get together at a much lower level of business aggregation. In fact, they create just the sort of combination of capabilities that generates maximum impact. Careful selection of partners can further enhance the strength of the concept by complementing this combination of capabilities with combined brand power. Given the price pressure that do-it-yourself stores like Home Depot and B&Q have put on many home furnishings manufacturers, the manufacturers have a lot to

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gain by creating a counterbalance and strengthening their grip on consumers through a combination of design and branding power. Keep this good news in mind: The companies in these examples did not have to change all their processes and operations, nor did they have to go through massive merger and acquisition exercises. They only got together to recombine specific capabilities to increase their overall competitiveness.

■ A KILLER LINEUP Another way to exploit newfound capability freedom is to line up a potentially invincible set of capabilities to create a highly competitive product or service. Until now, most companies have attempted to achieve this in-house. IKEA has done a stellar job of ensuring that each capability is optimized in its own right around the goal of producing economically priced, well-designed, cheery furniture. And it has made sure that each single capability contributing to this overall objective is the best you can get. Assembling furniture? Leave that to the customers; they don’t want to pay a premium to have it put together. Creating the right buying environment? Go for low-cost locations with lots of parking space, with open layouts so that customers can look at all the furniture available. Warehousing? Maintain sufficient stock of all furniture and let the customers do most of the order picking. Customer need translation? Provide plenty of instruction material, helpful tips, calculation examples, and configuration assistance so the customers can do a large part themselves. Manufacturing? Ensure flexibility by developing a network of third-party furniture manufacturers, each contributing a small part to the total assortment. Design? Cultivate a core design team to ensure the IKEA family feel, and use external designers to inject a trendy look into the furniture.


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Although the IKEA proposition might not appeal to everybody, its huge success is a tribute to the mastery of its individual key capabilities. Unfortunately for competitors, there appears to be little room to further improve even one of the required capabilities, so that IKEA’s market share advantage seems nearly insurmountable. Although IKEA may not have left much leeway for competitors, there is no IKEA yet in many other industries, no company that has so effectively aligned the dominating genes in its corporate genome. In those situations, there is ample room for recombining capabilities along the value chain. Another important consideration is that for many capabilities, the large reduction of interaction costs has radically altered the potential of some dominant genes. In other words, the Internet allows new shapes and forms of capabilities—and they’ll be vastly more competitive than their pre-Web variants. To demonstrate the difference between singlecapability-focused recombination and chain-focused recombination, let’s look at Tapestria, an online sourcing site for designers and architects, which went live online in spring 2000. Textile manufacturing for furniture and curtains is a fragmented business, with different mills and designers each making a contribution to what can be considered the global decorating textile industry. Because every mill has a small and specific assortment, wholesalers can play a vital role in assembling offerings that appeal to interior designers and architects. The mills have had no choice but to allow the wholesalers to act as intermediaries; by themselves they would not be able to create an attractive assortment. The whole supply chain for such fabrics is cumbersome. Because assortment is offered in the form of sample books, it is extremely susceptible to becoming outdated. Textiles ordered are often out of stock, which creates all sorts of planning difficulties for interior designers and decorators. Tapestria has transformed textile assortment. By creating a digitized offering complemented by high-quality

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Drawing Boundaries Around Capabilities As capabilities become businesses in their own right, a new business dimension emerges in the organization that is more or less perpendicular to the traditional strategic business unit. The question of how to proportion the new capability businesses now arises. Much has been written about how to define business units and how to segment markets. The consensus calls for ensuring the highest level of strategic homogeneity practical. Ideally, business unit managers can enjoy focus in their management tasks, avoiding (for instance) the need to handle commodity products in the morning and highly differentiated, high-margin goods in the afternoon. The focus will continue to narrow until other factors (such as customer requirements) prevent further segmentation of the business, or until the resulting impracticalities of everyday management discourage a further breakdown. Every capability will require such analysis. Companies will need to decide what level of detail each capability requires to achieve the desired focus, as well as how much detail can effectively be supported by the managerial infrastructure that now benefits from vastly reduced interaction costs. If key characteristics of a capability conflict, the capability needs to be more narrowly defined. Even if for practi-

pictures displaying not only the colors but also textures, the site enables designers to quickly search large numbers of samples online. They can even sort by color, pattern, texture, mill, or designer. The assortment, of course, is kept up to date with no need to send out new sample books. So far more than 40 mills have brought their assortments together in this way. The opportunities for improving the process even further are substantial. The Web link also allows for easier communication between interior designers and textile designers, making custom designs significantly easier to obtain. The different mills represented by Tapes-


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cal reasons a capability cannot become a separate business entity, it might still be desirable to make it independently measurable so that it can be managed in a focused way. Segmenting the corporation in the capability dimension will be a gradual process. New opportunities to interact with outside entities will gradually facilitate a greater focus within the company, but there is a balance to be sought between the benefits and the increased complexity and costs of managing the lower aggregation level. We can be certain, however, that new interaction opportunities will support much higher levels of business focus in both the capability and market venture dimension than we are used to today. The definition of capabilities will be dynamic, in part because of the continuously improving ability to manage in a focused way. In addition, the requirements and characteristics of capabilities will shift over time. Technological advances, environmental changes, and product life cycles will alter the strategic demands placed on capabilities—and therefore their very definition. All in all, companies will have to continuously balance the benefits and need for focus with the increased managerial load this will bring. This will, in fact, be somewhat similar to reassessing customer and market segmentations to ensure business units are still aligned with their respective markets. The difference, once again, is that this needs to take place at the capability level.

tria have created a “super assortment,” which is even more effective because it is available online. In itself, the textile assortment on the Web would be relatively useless without a facility to order the textiles (or samples) and have them delivered. Traditionally, the textile wholesalers carry out this task. Here’s where the valuechain-focused capability recombination comes into play. Hunter Douglas, a maker of window treatments and cofounder of Tapestria, has a global distribution system serving interior designers and decorators, as well as the trades. In the Tapestria venture, Hunter Douglas brings in its

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distribution system to complement the assortment. This setup is potentially a winning combination. If interior designers and decorators can be persuaded to use the online assortment rather than the sample books at wholesalers, the efficiency of the process will be tough to match. The benefits are compelling: The participating mills can get much closer to their real customers and become more responsive, and Hunter Douglas can better utilize its distribution network and enhance the service it provides to customers.

■ WHAT’S YOUR GENETIC PREFERENCE? Companies considering capability-driven strategies face a choice: Should they focus on individual capabilities or on the alignment of capabilities in the value chain? An even more basic question is whether a company is in a position to lead the recombination of capabilities. A company is free, of course, to decide whether to become the best in class in one capability or the best integrator of several and sell the output of the combined set of capabilities. However, each company exhibits a genetic preference. There is potentially good value in becoming a Cisco-like orchestrator (coordinating a cluster of chip manufacturers, contract manufacturers, component distributors, systems integrators, employees, and customers)—if coordination happens to be important to the total output. In addition, a company will have to assess whether coordination can become its competitive advantage—that is, whether coordination is one of the dominating genes. It is highly likely that companies that own the capabilities most critical to value chain output are in the best position to lead recombination efforts, or if they have no interest in doing so, to delegate these efforts. If value is concentrated on the physical parts of the value chain, as in manufacturing, companies with the highest economies of


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scale stand to make their mark on potential recombination efforts. On the other hand, if a coordination capability, such as supply chain management, plays a dominant role in the value chain, the company that most effectively integrates the different activities is more apt to extract value. Generally, the more fragmented value chains are, the more important the role of the integrating capability will be. In the computer industry, the value in the value chains has shifted upstream as well as downstream. Companies able to integrate components best and combine them with their brand and customer service proposition have extracted significant value by assembling competitive combinations of different capabilities. At the same time, companies with significant economies of scale and specialization have become dominant suppliers of key components. Today there are many PC manufacturers. The number of hard disk manufacturers, DVD drive manufacturers, and monitor manufacturers has been greatly reduced through consolidation. Intel is, of course, the leader of the pack in terms of key component markets. Manufacturing itself has become a less significant capability. On the other hand, in businesses such as chemicals, coordination has little impact on the output. Instead, economies of scale and subsequent asset utilization play an important role. In the fine chemicals markets, research and development is highly influential. The role of the integrator is far less dominant in determining the competitiveness of the output. Facilitation of transactions and coordination will, therefore, not become an industry-shaping force. The chemical industry will adopt Net markets, but only because doing so makes the buying and selling process more efficient. Thus the role of integrating has value only when the coordination capability plays an important role in the output.

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Compensation for Innovation When companies innovate their business capabilities, they have two basic options for getting compensated for them (see Figure 3.3): Indirect compensation model $

Direct compensation model

Products/ services

World-class capability

Products/ services Potential “sell” in parallel value chains

$

$ World-class capability

Potential “sell” upstream or downstream in value chain

Companies can get compensated directly for their world-class capabilities by selling the output as a separate service. Traditionally, they get compensated indirectly, by incorporating the output of the capability into a final product or service, which is sold to the end customer.

Figure 3.3. Capability Compensation Models Source: A.T. Kearney.

➤ Directly, by selling the capability as a service to other businesses ➤ Indirectly, by complementing it with other capabilities and selling the total output Both of these compensation models present specific challenges.

Challenges of Direct Compensation Selling a capability directly to businesses implies that companies have to search for a market for their innovated capability. For example, information-driven capabilities sensitive to economies of scale, such as transaction facili-


tation, often lend themselves to the direct compensation model. Among the most notable examples of direct compensation models are the Net markets, which became en vogue when the Internet hype shifted from B2C (business to consumer) to B2B (business to business). The concept of a Net market is straightforward. Rather than having thousands of companies developing and implementing their own ordering and invoicing systems, it makes more sense to create a few open, standardized transaction platforms to be used by everyone for a fee. The standardization and universality of the transaction platform can also build the foundation for all sorts of additional services that would not have been possible otherwise. But as the B2B shakeout so dramatically demonstrated, selling a capability such as transaction facilitation depends directly on the ability to find enough customers for the new service. For transaction facilitation services, potential customers need to transform themselves internally in order to use the transaction platform. Such transformation often requires sweeping change management programs. Needless to say, this creates numerous difficulties for aspiring transaction facilitators. First, the value of their service stays rather limited for a period of time, during which too few trading partners are hooked up to the platform to make it attractive. At the same time, the long ramp-up period allows plenty of opportunity for competitors to set up shop. The proliferation of Net markets, despite the slowly developing demand for these services, is a clear example of this dynamic. In theory, all direct compensation models face this downside, especially if the capability they offer has not traditionally been outsourced (as is often the case for Web initiatives). The direct compensation model does not limit itself to selling services in the traditional way. Instead, the new service provider can seek compensation by bringing its service into a new venture in return for a stake in the venture. In this case, the capability innovator (the company selling a business capability) combines its innovated capability with those of others for a share in the venture. Compensation then comes in the form of dividends rather than revenue. Setting up a new venture, which combines complementary

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capabilities between companies, could also be an alternative to putting a capability directly on the market.

Challenges of Indirect Compensation Seeking compensation indirectly by integrating the innovative capability into an integrated business poses the challenge of finding complementary capabilities. Many Web initiatives have followed this indirect route. Think of Amazon.com, which has achieved a remarkable feat in its dramatic innovation in the assortment and transaction capability. But Amazon chose to build an entire business with many different business capabilities (at which it did not particularly excel) to exploit its Web innovation—and in the process integrate bricks-and-mortar capabilities. Amazon rapidly built a globally recognized brand—quite a feat compared with the achievements of corporations like CocaCola, which have built their brand equity over the course of a century. Amazon also had to figure out how to get the books into consumers’ homes. This proved to be a major hurdle, especially in cost terms. In a way, by tying their innovative capability to an integrated business, many such Web initiatives are reproducing the “old-fashioned” model in which traditional companies are indirectly compensated for what they do best (think Honda)—and thus have not yet been able to grasp the full benefit of their capability initiatives.

■ CONCLUSION As Clayton Christensen points out, “Today’s competitive advantage may become tomorrow’s albatross.”3 As businesses move toward lower levels of aggregation, any business’s competitive advantage is tenuous at best. We believe that as companies begin to organize around more narrowly defined business capabilities, the following will hold true: ➤ Competitive advantage will be won or lost at the capability level. If one element of a business is not op-


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erating at its best, that element is likely to hold the organization as a whole back. ➤ With competitive advantage being defined at the business capability level, firms can hold two competitive positions: being the best in class in one capability or creating the best lineup of capabilities. Which of those strategies a company chooses should depend on the company’s existing strengths and where value resides in the value chain. ➤ Companies can be compensated for their competitive advantage in two ways: They can sell a capability they excel at directly or indirectly by bundling it with other capabilities.

4

Chapter

Strategy Same Hammer, New Nail

Under fire from global competition? Time for a new strategy. Reeling in the wake of technological advances? Time for a new strategy. At every critical juncture in the competitive landscape, companies form and re-form their plans. Today, the disruptive reduction in interaction costs changes business definitions once again and sets forth new possibilities: single-capability strategies aimed at maximizing the contribution of resources and assets, and value chain strategies aimed at putting together the most competitive lineup of capabilities possible to create superior output. Either capability-level strategy means that the strategic frameworks we used in the “old” economy will likely undergo an adaptation phase. The key difference today is not a new concept or framework of strategy per se, but rather the new level at which it’s applied. In this chapter we: ➤ Consider the traditional strategic frameworks designed in a world in which companies sold collective sets of capabilities ➤ Show how these frameworks apply to a world in which each capability becomes a business in its own right ➤ Discuss how a businesses can regard its capabilities as a portfolio and formulate strategy in much the same way as one would address any portfolio of businesses 83

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■ “OLD” STRATEGIC FRAMEWORKS The Internet is far more than a means of improving effectiveness and efficiency; it actually contributes to the redefinition of business as we know it. With chains between products and information loosened, business boundaries are being redesigned to bring out the true potential of a company’s capabilities. A widespread change in business boundaries calls for new strategies—but also reinforces key frameworks that have brought rigor and legitimacy to the field of strategy at both the business unit and the corporate level. Two decades ago, Harvard professor Michael Porter’s book Competitive Advantage gave executives new strategy tools based on economic theories.1 Porter avers that the structure of an industry determines the state of competition within it and sets the context for companies’ strategies. In the strategic framework of competitive advantage, companies are forced to make strategic choices when deciding to exploit one of two types of competitive advantage: “lower cost than rivals and the ability to differentiate and command a premium price that exceeds the extra cost of doing so.” If companies pursue both low cost and differentiation simultaneously, Porter contends, they will be beaten by rivals that focus on just one strategy. Competitive advantage, Porter says, can ultimately be attributed to the ownership of a valuable resource that enables the company to perform activities better or more cheaply than competitors. Companies achieve cost leadership via the most effective use of resources; therefore cost leadership is desirable for activities that consume a relatively large amount of resources (such as component manufacturing). Differentiation focuses on the top-line side of businesses; companies with a unique offering can charge a premium price and enjoy some relief from the need to produce their goods or services cheaply. When the physical and information components of the

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value chain become unlinked, Porter’s argument becomes more powerful than ever. As we touched on before, the capabilities grouped in the three resulting value chains (physical, transaction, and knowledge) respond to very different drivers of competitive advantage. While the physical (including component manufacturing and assembly) and the transaction (including invoicing, processing, and control) capabilities lend themselves well to low-cost strategies, the knowledge capabilities (including design, development, and branding) are natural differentiators and are focused on effectiveness. Keeping all of these capabilities together within the same company boundaries can stunt growth. When they’re treated separately, each is free to travel on the straightest path to competitive advantage. In the early 1990s, the increasing recognition of the importance of “core competence”2 and “competing on capabilities”3 in determining business definitions led to a move away from market-based definitions of businesses and toward more competence-based definitions—moving strategy from outside to inside the company. After 10 years of downsizing, companies began to focus on how to grow. C. K. Prahalad introduced the notion that if you excel at one competency (your “core competency”), you should focus your business activities on it. If Honda’s core competence is the small combustion engine, he argued, Honda should define and develop the business in which this core competence finds an application. (Think of Cisco, which bought 40 companies to exploit its leadership in demand fulfillment.) This approach emphasizes the skills and collective learning embedded in an organization, as well as management’s ability to marshal them. Certain key characteristics define a core competency: It provides potential access to a wide variety of markets; it makes a significant contribution to the perceived customer benefits of the end product; and it should be difficult for competitors to imitate. In this framework, “core products” are the physical

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incarnation of one or more core competencies. Thinking in terms of core products forces a company to distinguish between the brand share it achieves in end product markets (for example, 20 percent of the automobile market) and the manufacturing share it achieves in any particular core product (40 percent of the small engine market). By identifying competition on these different planes, an inherent compromise between distinct value-added activities and end products becomes readily apparent. Although it is a useful strategic tool for making firms more responsive to the market, the competence-based definition of business does not free firms from a huge compromise. Compensation remains tied to the total output of a firm—not to a single activity that adds value. Prahalad also points out that certain companies—like 3M, Black & Decker, NEC, and Citicorp—have developed a myriad of products as a way to capitalize on their core competence in the race for global brand dominance. The proliferation of products built around their core competence has allowed their individual businesses to build image, customer loyalty, and access to distribution channels. We believe that seeking compensation from a core competency by building these global brand umbrellas may still be a cumbersome way of creating growth in that it still necessitates indirect compensation for a firm’s most valuable capability. “Old” business definitions often harbor compromises inherent in the molding of different capabilities into one business. The resulting opportunity cost is the underperformance of those capabilities that have been shaped in line with the leading, or scope-defining, capabilities. The profit-making parts subsidize the money-losers, the capabilities at which the company’s performance is below par. Here, many of the limits found in strategic business units, and already identified by Prahalad and Hamel for their core competence framework, ring true in our argument for the capability organization: underinvestment (by capability managers who do not feel responsible for building leadership in a particular capability); imprisoned resources

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(talented people who are withheld from working on key capabilities); and bounded innovation (the pursuit of marginal innovations in the absence of recognized dominating capabilities). The profit-making parts subsidize the money-losers, the capabilities at which the company’s performance is below par. A clarification is necessary at this point. While Prahalad refers to competencies as the “collective learning in the organization,” for the purpose of this book we define business capabilities as any set of value elements within the value chain that make a unique contribution to output. Our definition is therefore broader and more flexible; these value elements built up through knowledge, assets, or processes can be as specific as owning patents or as broad as the manufacturing capability of a whole factory. In addition, the term capability, as we define it, signifies a value element that makes a unique contribution to the value chain—but does not reflect the competence the company displays in this value element (a company can outsource a capability if it performs below par). In order to avoid suboptimization or at least difficult strategic choices, companies should try to obtain compensation from single capabilities rather than the entire output produced.

■ “NEW” STRATEGIC FRAMEWORKS A direct consequence of regarding capabilities as businesses in their own right is that previous strategic frameworks must now be applied at the capability, rather than the company, level. When we look at Porter’s competitive advantage framework, we see that it not only remains valid at the capability

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level, but gains strength when the value chain breaks into business capabilities. Porter’s two strategies for seeking competitive advantage—low cost and differentiation—entail making some rather difficult choices. By applying the framework at the capability level, companies mitigate the trade-offs. In the previous business definition, companies sold the output of a set of capabilities and had to opt for either cost leadership or differentiation for all capabilities simultaneously. But once capabilities within the company are footloose, these decisions are made at the capability level. If the insurance company with competitive administrative procedures sells its claims management capability, it can aggressively pursue cost leadership in its back-office administrative services, and try to differentiate in its policy-selling business with flexible product configurations and consistently high service levels. In the same way, a company selling its manufacturing capability as a separate business will be liberated from compromises imposed by other parts of the firm (for instance, its market share in end products) and can likely achieve both flexibility and low-cost strategic targets. Flextronics, the company that took over the manufacturing of mobile handsets from Ericsson, is more apt to achieve these targets than Ericsson, which has to balance them with the requirements of design, product development, and marketing—and, not the least important, its mobile phone global market share. Now let’s consider the core competency framework. Adopting a capability perspective on businesses does not make this line of reasoning invalid. On the contrary, the Web opens up possibilities to leverage core competencies on a much wider scale. Thanks to the shift of business definitions to the capability level, companies can focus on what they do best, without compromising their other lines of business. In the near future it is conceivable that companies such as Cisco and Dell will sell demand fulfillment services directly by having the essential information

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routed to them. That way they can directly leverage their core competencies without entering new markets. The end of the 20th century saw the emergence of other strategic concepts, including business ecosystems, to help bridge the gap between these seemingly disparate approaches. Closing the line of reasoning around strategic alliances and virtual organization, the business ecosystem approach views a company not as a member of a single industry but as a part of a business ecosystem that crosses a variety of industries. In this framework, companies create networks of relationships with customers, suppliers, and rivals to gain greater competitive advantage. James Moore, who coined the term, explains that companies in an ecosystem “work cooperatively and competitively to support new products, satisfy customer needs, and eventually incorporate the next round of innovations.”4 Like other strategic frameworks, Moore’s ecosystem finds its validity in the new level of business aggregation. Whether investing in state-of-the-art technology, signing on suppliers to expand a growing business, developing crucial elements of value to maintain leadership, or incorporating innovations to fend off obsolescence, the network of relationships can be woven at the capability, rather than the company, level. One company can participate in several ecosystems at the same time.

■ “IT IS A PORTFOLIO, JIM, BUT NOT AS WE KNOW IT” The newfound freedom to optimize capabilities rather than entire businesses gives rise to significant opportunity, but it can also be a bit cumbersome in everyday use because of the vast number of permutations possible. Organizations need an approach that focuses their efforts to make business capabilities work better for them.

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This approach can be relatively simple. Strategic frameworks designed in the age of business units can also be applied to business capabilities; likewise, frameworks for dealing with portfolios of businesses or business units can also be used on sets of capabilities that make up a business. Just as we can describe parts of a business portfolio as “bleeders,” “stars,” and “cash cows,” we can label business capabilities drag-alongs, exploitable, or leverageable. In other words, we still have a portfolio—but not as we know it. One could argue that the portfolio of business capabilities is even easier to address than a portfolio of businesses. After all, a set of business capabilities shares a very clearly defined common goal: that of delivering the most competitive product or service offering. The objectives of a portfolio of businesses, on the other hand, are often less well defined, except for financial performance.

➤ The Relative Capability Contribution Since the objective of a set of business capabilities is to deliver a competitive product or service, it follows that strategies for capabilities should be driven in part by how heavily they contribute to that goal. Capabilities vary in their relative contribution to the value of the end product; we’ll classify them as crucial, beneficial, or necessary. Capabilities that fall under the crucial designation are key to output value. Obtaining patents for specialty chemical firms, branding for branded fast-moving consumer goods manufacturers, manufacturing volume for commodity suppliers, and commercial assortment for wholesalers are examples. In some instances, the capabilities contributing most to overall output value of the business do not stay the same over time. In the cyclical semiconductor industry, for instance, the capability of providing foundry capacity will be crucial to output value in an upturn since access to foundry capacity allows semiconductor firms to produce silicon wafers. But when the cycle turns down, the capability power balance changes completely. The ability

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to lock in volume through effective design boosts the utilization of the assets that required such heavy investments. It is clear that these capabilities, which are crucial to output value, justify a company’s existence in a certain business. If performance lags in these important capabilities, it will be difficult to compensate via the remaining capabilities, since they contribute less to overall output value. Companies that are strong in key capabilities have the ability to control, or delegate control, in their markets. Consequently, they will be the natural orchestrators of the capability lineup if these capabilities do not all reside within one company. Another group of capabilities are beneficial, but not decisive, in terms of generating business value. The capabilities that fall into this category vary by type of business. What they share is that they contribute more to overall output value than the capabilities that are necessary only from an overall output value perspective. These capabilities could include manufacturing, bill of material sourcing, enterprise resource planning (ERP) facilitation, process technology development, maintenance operations, quality management, logistics, supply chain management, and many others. Individual circumstances dictate where they fall on the spectrum: Dell would argue, for instance, that it counts extended supply chain management as a crucial capability. This last group—necessary capabilities—can reduce output value if their performance is substandard, but their contribution to the offering lies in their cost-effectiveness. Many capabilities related to support functions, such as finance and accounting, procurement facilitation, indirect sourcing, facility management, and IT support, often (but not always) fall in this category of capabilities.

➤ The Relative Capability Performance Capabilities can also be classified by their performance. Procter & Gamble has achieved world-class performance in

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ERP facilitation; after years of standardization P&G can basically funnel all of its turnover through one ERP system. Theoretically, this equates to best-in-class standards for IT support and maintenance costs per dollar of turnover compared to similar businesses that maintain different ERP systems for their various business units or geographies. We can similarly compare the relative brand strengths of companies, patent portfolios, the degree to which sourcing strategies have been implemented and adhered to, the level of volume concentration compared to the number of stock keeping units (SKUs), and so forth.

➤ Generic Capability Strategies Capabilities can thus be mapped by plotting their relative contribution to overall output value and their relative performance against what will be considered world class in the future for a specific business or business unit (see Figure 4.1). The positioning of these two characteristics determines the generic strategies that could or should be considered for the individual capabilities. The first target for closer scrutiny is often the capabilities with low scores in both business value and performance. These capabilities are eroding the company’s competitiveness in the market. After all, rivals making use of better performing “necessary” and partly “beneficial” capabilities will enjoy higher margins. As a result, they have more room to reinvest in the business or to channel resources to capabilities that are strong contributors to overall business output value. A key reason for eyeing these capabilities first is politics. No fundamental strategic discussions on the direction of the firm are required. When the fate of crucial, valueadding capabilities is considered, heated strategic debates often ensue. Crucial capabilities are solidly anchored inside the business units. Even though they probably hold the biggest leverage in terms of business value they are often far less accessible than support functions.

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Capability mapping World class

Consider insourcing and leverage

Consider exclusive leverage and lineups

Capability performance Consider outsourcing or pooling Laggard

Necessary

Beneficial

Crucial

Importance for business value Companies can assess their capabilities on relative performance and contribution to overall business value. Generic capability strategies can be determined based on where capabilities are positioned on these two dimensions.

Figure 4.1. Generic Capability Strategies Source: A.T. Kearney.

The generic strategy in these instances will be to either outsource the capability or pool it with selected and suitable partners to get the capability up to, or closer to, worldclass standards. Because the capabilities are not key to value production, outsourcing or sharing should not represent a fundamental problem. A relatively small player relying on its extraordinary brand strength will never achieve world-class performance in-house in areas like procurement, finance, and accounting because its larger competitors will generally be able to leverage their volumes better. If the small player decides to outsource, and thus allow for a margin for the outsourcing partner, it still wins as long as the outsourcing partner generates sufficient economies of scale. Several recent initiatives, ranging from Net markets to procurement utilities to application service providers, fit in this model. In mid-2001 Sara Lee and ICG Commerce announced one of the first cross-border comprehensive

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e-procurement initiatives in Europe. If the deal is completed, Sara Lee will outsource its procurement of indirect goods and services, allowing volumes to be pooled with other European companies and providing Sara Lee with access to ICG Commerce’s procurement tools and applications. The arrangement will allow the participating business units of Sara Lee to tap into a capability performance they would never enjoy on their own. Another group of capabilities worthy of attention are solid performers that aren’t crucial to overall business output value. For instance, effective ERP facilitation might help specialty chemical manufacturers manage performance by controlling process costs, feedstocks, and product flows. This contribution is highly beneficial—but will never be crucial because the real value lies in the patents that protect the firm’s products. If the firm has invested considerable money and resources in setting up an effective end-to-end ERP facilitation, it could consider leveraging this competitive capability by turning it into a business in its own right, selling the output to different (perhaps smaller) players, who would also gain from the efficiencies good ERP facilitation brings. The proceeds could then be used to create business around new patents—the capability that really matters. Capabilities that are not crucial, but nevertheless competitive, can therefore potentially be leveraged outside the company’s boundaries, and in many cases, across different business units.

➤ The New Utility Businesses Many of the capabilities in the necessary category have the potential to be turned into businesses themselves. Providing IT infrastructure support, for instance, has been turned into a business in its own right. Several different companies, such as EDS and IBM, offer these services at rates that would be unattainable for their clients. Increasingly, more complex capabilities are following suit. Some insurance companies are combining transaction capability and IT

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support into one business, creating a utility that provides back-office services to several insurance companies. The interesting thing is that when a capability such as accounting support services is turned into a business, capabilities such as record keeping become crucial to the output value of the newly formed accounting support business. This is not surprising, as this now has become the core of this new business. Procurement of indirect goods and services, however, remains a necessary capability for the new business.

➤ Leveraging the Real Value of Your Business Perhaps most interesting are the capabilities that are crucial to output value and are performing really well. It is becoming increasingly important to understand the best way to exploit the potential value these capabilities harbor. In many cases, opportunities exist outside the lineup of capabilities in the business units or the business. Many opportunities are already being tapped: Some companies brand products that are not produced in-house; others sell patents that cannot be brought to fruition inside company boundaries. Where does a capability add the most value in the extended value chain? This question is not always addressed with the same rigor. Research and development efforts are often linked to the products (or services) the company supplies. This allows the company to make better products that potentially sell at a premium. However, that is not necessarily the best possible use of a company’s R&D expertise. Consider Philips’s coffee maker designed to work with specific coffee pouches. Philips realized that there is only so much premium to be obtained selling coffee machines. Yet the coffee market, driven by emotions and brands, represents a far greater premium potential. By linking up with a coffee producer, it was able to gain a far higher return on its development resources than it could selling machines.

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➤ Optimizing the Portfolio of Business Capabilities All in all, a similar approach to business portfolio optimization can be adopted to make the most of sets of capabilities. Bleeders are great candidates for outsourcing or pooling. Nonstrategic but ably performing parts of the portfolio will have to be evaluated to determine the most appropriate owner of these businesses. Capabilities that are both highly strategic and world-class performers demand a carefully orchestrated strategy focused on extracting maximum value—whether through the rest of the portfolio or alone.

■ BEYOND STRATEGY At A.T. Kearney, we believe that the leaders of the future will be those who recognize that new business boundaries are springing up within their corporations. This means that instead of being in a single traditional business, they may well find themselves in several—each with differing characteristics. Strategy will have to be adapted to the company’s individual businesses rather than its “portfolios of businesses.” Applying known strategic frameworks to those new businesses will also allow them to gain the insight required to compete, possibly even by stepping outside traditional boundaries. A gradual shift from a business unit focus to a capability focus is not without risk. Under old business definitions, a corporation could be successful even though some of its capabilities were not best in class—perhaps not even close. When competitiveness is determined at the aggregate level, companies can apply the rule that the sum is more than the parts. In most industries, the presence of a few weak functions has been forgiven to some extent; only in highly competitive industries would these shortcomings erode a company’s edge. The more competitive advantage

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counts at the individual capability level, the stronger the need to have all capabilities optimized. The reverse is also true: Companies dragging along suboptimal capabilities risk being ambushed when competitors outside their traditional markets introduce focused new offerings. The more competitive advantage counts at the individual capability level, the stronger the need to have all capabilities optimized. In a capability world, each capability must portray stand-alone differentiation or cost leadership. Competitiveness for each individual capability will have to be achieved in-house or with outsourcing solutions (to take advantage of higher economies of scale or higher effectiveness). The challenge is to take this line of thinking about stand-alone capabilities beyond the ultra-adaptive logistics providers or low-cost manufacturing contractors, and to extend it to the more intangible—and more lucrative—capabilities a firm has to offer. For instance, how does a company ensure its branding, development, or assortment efforts survive in the market? But selling a capability in its own right also means that you dramatically change what you sell, whom you sell to, and what resources you deploy. As we have seen, online marketplaces were an early attempt to capitalize on the transaction capabilities liberated by the reduction in interaction costs. Building, implementing, and integrating the technology needed to operate these electronic marketplaces has been more complex than originally anticipated; extensive change management programs were required to effectively reduce transaction costs in the Net market customers’ organizations. As companies are discovering, bringing an individual capability to market implies major shifts in business processes—and in customers as well. Industry procurement initiatives on the Web depend heavily on the capacity (and willingness) of suppliers to develop e-catalogs for their products and specifications. To be

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successful at rebuilding their corporate genomes around business capabilities, companies will have to adopt a holistic view that encompasses all of these implications. Finally, organizing for change in the face of this disruption means bringing management focus from the business unit level down to the capability level. Shaping the new organization in this way involves taking steps that will allow a company to behave as a set of multiple businesses. Enabling management of capabilities in their own right has profound implications for the company’s resources, culture, organization structure, capital requirements, and leadership. All need to become more capability-specific. We consider these implications in more detail in the last section of the book when we take a closer look at the characteristics of the capability organization.

■ CONCLUSION ➤ The narrowing of focus to the capability level has implications for strategy, which will be adapted to a company’s individual businesses (that is, its capabilities) rather than to its portfolio of businesses. ➤ By applying the competitive advantage framework at the capability level, companies free themselves from difficult strategic choices between cost leadership and differentiation. ➤ The Internet opens up possibilities for leveraging core competencies on a much wider scale: With business definitions at the capability level, companies can now focus on what they do best, without compromising their other lines of business. ➤ To achieve this focus, companies will have to address their businesses as portfolios of capabilities, which can be evaluated in much the same way as we now assess a business portfolio.

III Section

Introduction ■ VALUE CHAIN VARIABLES How can you make the most of a value chain? That depends. Physical value chains are fairly straightforward, and can be maximized primarily via economies of scale and capital. Ditto (to some degree) the transaction value chain. Maximizing knowledge value chains is a less precise endeavor—but the potential rewards are arguably the greatest. Want to take optimization to its heights? Start by understanding the characteristics of your chosen value chain.

5

Chapter

Physical Capabilities In Search of Scale

It’s a trend that once would have bordered on heretical: Many companies are outsourcing a greater portion of their most important physical processes. In some cases, the activity the company hands off today would have been considered a key source of differentiation just a few years ago (such as Motorola’s outsourcing of cellular handset production). Low returns relative to services, high capital intensity, and low flexibility are among the culprits. Dramatic increases in scale and efficiency are consistently among the benefits. The providers that are taking over the reins offer a new and improved version of the production process. This practice, of course, has been de rigueur for some processes for quite some time. But new forms of optimization have become increasingly easy—like partnering outside an organization to leverage a key capability. In this chapter we: ➤ Look at well-established examples of optimization in the physical value chain and assess its drivers ➤ Discuss several options for maximizing the effectiveness and efficiency of the physical value chain ➤ Consider the impact of the Internet on physical capability optimization and offer our predictions for the future 101

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■ A WEALTH OF WELL-ESTABLISHED EXAMPLES Many examples of optimization are already well established in the physical value chain. As companies handed off growing portions of production, an entire industry emerged that promised to manage these processes more effectively. The simplest form of this concept, outsourcing, gives the company control over the process, but the provider ownership of the assets. Contract manufacturing goes a little further in that companies have less control over the process. Through outsourcing, companies can take advantage of increased economies of scale and more sophisticated process expertise of the service providers they rely on. This enables them to offer higher quality products at lower cost; it buys executives more time to focus on the company’s core processes; and it allows companies to convert their fixed capital investments and human resources into a variable cost, thereby enabling them to manage business cycles more effectively. Because logistics for many companies is an important process—but rarely a differentiating capability—many companies have found that moving their logistics outside company boundaries has produced impressive results. In fact, what began as the business of providing pure transportation services has evolved into an industry with logistics services attached to transport. Target stores, which outsource their transportation needs to Ryder Integrated Logistics, rely on Ryder for next-day deliveries and streamlined billing processes, thereby decreasing their need for massive, in-store inventory. Chrysler has cut its parts delivery time in half by relying on Exel Logistics. With the same partner, DuPont managed to shorten its product turnaround time from 3 days to within 1 hour—and still cut labor and costs. Increasingly, providers are intervening in the planning stages of product or service design and delivery to maximize those capabilities.

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In addition to logistics, manufacturing capabilities have been subject to similar efficiency-driven movements outside company boundaries. Many of today’s corporate strategy stars have identified manufacturing as a distinct capability to leave in the hands of others. Nike built its success on designing and marketing shoes rather than actually making them. The company focuses on what it does best, enlisting outside firms for virtually all manufacturing activities. In the same way, Cisco has concentrated on designing and delivering managed network solutions by assigning much of its manufacturing and new product development to the contract manufacturers in its network. Many of today’s corporate strategy stars have identified manufacturing as a distinct capability to leave in the hands of others. Outsourcing, formerly the offloading of auxiliary activities like data processing or catering services, is a different animal today. It may now entail shifting responsibility for what are—or once were—thought to be a business’s core activities. The restructuring of the automotive supply chain illustrates how optimization has led suppliers to take on greater complexity in the manufacture and delivery of cars. Acknowledging the necessity of economies of scale (which are, of course, tough to achieve within a single company), original equipment manufacturers, or OEMs, now require suppliers to take on additional capabilities within the automotive supply chain. And the suppliers have stepped up to the plate, mastering additional product integration tasks. Today, instead of delivering parts, a supplier may manage design, quality, and efficiency. It often fills the roles of systems integrator and value-added parts supplier. Today, OEMs are increasingly serving as final integrators, focusing mainly on strategic systems capabilities. The result: The major players in vehicle manufacturing are increasing modular

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sourcing (between 30 and 40 percent of vehicles are supplied in modular form). TRW is pushing for an expanded supplier role by developing in-house capabilities and designing fully integrated chassis modules.1 Soon, GM will make just the outside and underbodies of its cars and trucks, leaving various auto supply companies in charge of the interior of each of its vehicles. This trend has even led to some experiments with comanufacturing. Volkswagen and Ford, for example, share a van-manufacturing platform in Portugal. While most optimization examples in the physical value chain come in the form of providers (and suppliers) maximizing the competitiveness of single capabilities in place of their previous owners (as we have seen in logistics and manufacturing), companies can also restructure their corporate genome by looking inside. The flip side of outsourcing is that companies can consider leveraging single capabilities at which they excel by optimizing them to help solidify their competitive advantage. Consider the global passenger airline industry. Wild swings in profitability over the past 25 years have pushed major players to find new sources of growth outside the traditional passenger business. At Singapore Airlines and Cathay Pacific, cargo is run as a separate profit center to exploit the advantage their home base positions offer—you might call it their “site provision” capability. Indeed, Hong Kong and Singapore have traditionally been Asia’s main gateways for exports and represent a potentially very profitable base for the airlines’ cargo business. A company can also leverage a nondifferentiating capability by selling it in third-party markets, thereby opening up new growth opportunities. Again in the airline industry, Lufthansa and the former SAir Group both chose to transfer their internal support capabilities (such as maintenance, repair, and operations [MRO], catering, ground handling, and IT) to profit centers and venture into thirdparty markets. For both carriers, former support functions are now managed as separate ventures, each with the goal


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of positioning itself as a first-rate player within the relevant market. LSG Sky Chef and Gate Gourmet are today’s global leaders in the in-flight services market, sharing some 60 percent of total revenue volume. Carving out or spinning off capabilities that are not key contributors to final output and selling them directly as modules that other companies can plug into their own operations—what we call insourcing—is another way to optimize capabilities beyond company boundaries. In the airline industry, SAir Group and Lufthansa went one step further than Cathay and Singapore Airlines with their cargo business by spinning them off into separate businesses. The quest to take a single capability to greater levels of effectiveness and efficiency can lead to the creation of new ventures. Many first-tier automotive suppliers, such as Visteon (spun off from Ford in 2000) and Delphi (spun off from GM in 1999), represent efforts to leverage capabilities outside company boundaries. Today, these ventures’ bestin-class expertise and experience have translated into developing and supplying parts to industries other than those in their historical niche. While many companies enjoy the benefits of outsourcing their logistics, others are leveraging this capability by creating new ventures. Consider the Caterpillar subsidiary Cat Logistics, created to market inventory management and distribution expertise to other manufacturers. Today Cat Logistics serves such industry leaders as DaimlerChrysler, BMW Group, Honeywell, and Ericsson. The two primary factors that determine the success of a new venture created to leverage best-in-class capabilities are the readiness of the parent company itself and the readiness of the supply market (for example, a third-party logistics provider industry must exist in order for companies to outsource logistics). Other factors include the breadth of the potential customer base (there must be a real and sizeable need for the product outside the current industry) and the uniqueness of the offering. If these

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conditions are fulfilled, the creation of a new venture that exploits a best-in-class capability can lead to strong value creation: Since its inception, Cat Logistics has experienced rapid growth.

■ OPTIMIZING KEY DRIVERS The physical value chain lends itself well to optimization because it is driven by the requirements of scale, flexibility, and complexity. As a result, improvement is easier to measure (and optimization is more likely to be sought) than it is in knowledge assets, which are generally driven by such intangible factors as uniqueness or fit. In addition to this added transparency, products are also easier to value than knowledge assets: How can you put an accurate price tag on a brand? As we have seen, a company’s physical capabilities (such as product assembly, component manufacturing, or warehousing) are strongly linked to the capital tied up in the balance sheet. Businesses that focus on physical goods tend to require capital-intensive facilities, which also means they have high fixed costs. As a result, economies of scale and economies of capital are key drivers of these businesses—which is why optimization of physical capabilities often points you beyond your own company boundaries. In the electronics industry, firms on the other end of the outsourcing trend (also known as electronics manufacturing service or EMS companies) have made manufacturing their dominating capability and usually have the scale to do it more cheaply than their customers. With worldwide assembly operations in low-cost regional bases such as China, Mexico, and Hungary, firms like Solectron, Flextronics, or Celestica can also supply multinationals’ global markets. Another key driver in the physical value chain is flexibility. Again, companies that have made manufacturing


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their dominating capability are better equipped to win. Electronics manufacturing service companies are, for instance, honing measures of manufacturing efficiency— such as inventory turns, asset intensity, and demand-flow technology—to a science. While Ericsson has a limited product range in its factories, Flextronics spreads risk by serving multiple customers from one plant. The manufacturers profit from optimized common process management interfaces, which make them highly flexible and able to produce with information limited to design specification, product origin, and destination. Companies that outsource manufacturing also shift the activity from a fixedcost to a variable-cost structure, enabling them to better respond to a shift in demand. Previously integrated firms can handle the manufacturing challenge of short product life cycles more flexibly and focus on their more differentiating capabilities of design, sales, and brand management. More and more, manufacturers face the increasing complexity of bringing products to market. Fifteen years ago Ericsson was still designing and manufacturing the screws that went into its wireless phones. “Nobody would imagine doing anything like that today,” asserts Bjorn Bostrom, Ericsson’s senior vice president of supply and data processing.2 Given that time to market has become so short, companies cannot afford to be held back by the like of screws. Complexities of production cycles are also an issue for today’s global players; the manufacturing and design cycles clearly do not work in sync. It’s harder than ever for mobile phone giants to stay ahead of the game by coming out with innovative and differentiating handsets before their competitors do. The drivers of a company’s physical capabilities—scale, flexibility, and increased complexity—bring innovators well outside company boundaries. As we have seen, many businesses have chosen to outsource their logistics and part of their manufacturing to enjoy the savings that higher economies of scale and density bring. Consequently,

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interaction costs have a strong impact. While the notion that companies can optimize increasingly independent subbusinesses is not new, disruptively low interaction costs bring optimization to an unprecedented level. More important, optimization ceases to be an option; it becomes a requirement.

■ FROM PHYSICAL TO VIRTUAL When we look at just how lower interaction costs make management processes more efficient, we think of the opportunities that emerge for real-time information exchange between customer and supplier. By connecting the customer and back office electronically, insourcing and outsourcing initiatives become viable alternatives to inhouse solutions. Since the Web enables increased collaboration and communication across functions within the organization and across several tiers of suppliers and customers, supply chain efficiency rises. Supply chain management software solutions provided by companies like i2 Technologies and Manugistics could not improve process management before the Net. Customers of Federal Express and UPS could not track packages all the way to the doorstep. The one-to-one interaction of electronic data interchange (EDI) between companies has given way to the many-to-many-to-many possibilities of the Internet. Just 15 months after Handspring was founded, it launched the Visor personal digital assistant to go head-tohead against the Palm Pilot. How’s this for leveraging the Internet? With no factories and none of its employees having any physical contact with the product, Handspring receives orders for the Visor through its Web site, which is hosted by a partner company. The order is then channeled to a fulfillment partner (which holds the inventory) and sent off to contract manufacturers (incidentally Flextronics and Solectron—which were involved in the design


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phase as well), which package and ship the Visor to the consumer.3 The reduction in interaction costs also enables companies to address the increasing complexity of bringing goods to market. Consumer goods companies can now handle more individualized products for more customers because of the disruptive reduction in interaction costs. By providing a gateway to individual customers, the Internet enables these firms to develop and design products that respond to individual needs. Although the Web was initially thought of as a tool to handle simple products, experience is showing that on the contrary, complex products can increasingly be handled effectively on the Web. How customized can you get? Take a look at Procter & Gamble’s Reflect.com, a Web site that offers personal care products. Customers cocreate their own products by answering a series of questions about themselves and their preferences. Each order, from mascara to shampoo, is tailored to the information the customer supplies. Low-cost interaction also enables unparalleled flexibility. For instance, factories can handle different concurrent product flows for different customers. Because interaction costs have dropped, companies can now manage and charge for these flows independently, even though the output may be going to a range of customers. Thanks to this, companies can allocate their overhead in a more meaningful way and avoid cross-subsidizing products. Just as FedEx knows exactly how much an individual package costs to ship, companies can now price their physical capabilities according to the market (an important step for transforming into a fully optimized capability organization). Aligning capabilities to the market does not necessarily signify doing away with all physical capabilities. Some processes—such as strategic manufacturing—will be kept in-house during optimization. In the fashion industry, for example, getting products to market quickly is considered a strategic aspect of the business, and most companies choose to keep the distribution capability in-house.

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■ WHAT DOES THIS MEAN FOR THE FUTURE? Clearly, the opportunities created by the Web will have a major impact on top-line growth by developing new channels to go to market. Today consumer goods or even pharmaceutical firms that traditionally have worked through wholesalers can go to market directly. The Internet provides them with the necessary infrastructure to manage a new form of distribution that could not have been manageable otherwise. In this process, distribution is becoming an increasingly key capability—set to play a strategic role alongside R&D. The Web will also enable far more elaborate optimization. For instance, distribution, picking, and packing can be made more efficient through multi-industry pooling. To fight low utilization in an assembly capability, companies often try to standardize packaging and centralize assembly lines regionally. But volume remains limited by company boundaries—or in the example of the beer industry, the size of the bottle. With collaborative tools, companies from different industries will share assembly lines and distribution capabilities. Companies that agree to share certain packaging standards (say, the diameter and height of a bottle) could pool their assembly and distribution capabilities across industries. Such a practice induces economies of scale without incurring extra transportation costs, and results in smaller delivery areas, lower total costs, and higher growth. Similar tactics have long been used by the oil industry, which shares refineries for the same reason.4 With collaborative tools, companies from different industries will share assembly lines and distribution capabilities. Although they could dramatically increase their efficiency, most companies don’t consider creating multi-


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industry pools. They believe assembly is a differentiating capability, and the complexities of pooling are too difficult to manage. We would argue it is more likely that the increased complexity of customer segmenting and the fragmentation of products and services will make costs prohibitive for companies that do not optimize at least some key elements of their physical value chains. What will physical value chains look like 10 years from now? Once the impact of the disruption in interaction costs is established, we can expect more pooling as companies seek the ultimate economies of scale. We also anticipate that highly specialized assembly service offerings will emerge that incorporate more standardization and simultaneously enable more individualization as the number of modules increases. Many of these developments are intertwined; as processes become more specialized, they also become easier to package into modules. One good example of how specialization drives the emergence of new service offerings is the electronic circuit board manufacturing process. Until recently, most assembly operations of electronic circuit boards (such as the ones used in televisions, stereo equipment, facsimile machines, telephones, and portable CD players) amounted to soldering lots of components in the right places on etched circuit boards. The mechanics of the operations allowed for automation at even relatively modest scales. As integrated circuits became commonplace and miniaturization became a fact of life, ever more complex components needed to be stuck on ever smaller areas of circuit board. Moreover, the boards could be made to suit an even wider range of applications. Circuit board manufacturing technology advanced in parallel and a variety of new technologies and methods were introduced, such as multilayering, surface mounting and (under environmental pressure) lead-free solder. These new developments made the manufacturing process far more specialized and considerably more capital intensive, effectively putting it out of

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The Next-Generation Supply Chain and Manufacturing Network New information technology solutions can vastly improve the performance of supply chains by establishing integral control and planning. The latest advanced planning system applications by companies such as i2 Technologies and Manugistics offer unprecedented support in managing the different parts of the supply chain in concerted fashion and even in extending the reach of the supply chain control input. Of course, significant changes will have to be made to the business processes to move to such new levels of supply chain control. New areas of accountability will have to be defined, and the way of working between sales and marketing and the industrial side of the corporation will be strongly dictated by the supply chain control needs. In essence, the new technologies centralize control over the supply chain. The possibilities do not end here, though. Leaders will see central supply chain control as a necessary step that will eventually enable the mixing of supply chains, or parts of supply chains, with other complementary players. If goods flows are merged, densities will increase and create the opportunity for changing the stock points and crossdocking points in the supply chain. Instead of optimizing via central supply chain control, we can now positively move into supply chain reconfiguration on an unprecedented scale by creating far higher goods flow densities.

reach of even medium-sized electronics firms for cost reasons. These circumstances gave rise to a new industry: providing circuit board manufacturing services. Other areas that will be affected by low-cost connectivity and digitization are capital and competitive advantage. Today leaders in the consumer goods industries own their plants and machinery. Tomorrow these companies will participate in pooled manufacturing solutions—but to whom will the assets belong? The emergence of asset management services is one possible strategic route for these companies.


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An immediate benefit will be that goods flows can be directed toward the market premixed with goods of complementary partners. Complementary manufacturers sharing national warehouses, for instance, can premix the goods flows and tailor them to the retailers or wholesalers. This allows them to increase the drop frequency and reduce the drop size, thus increasing service levels toward their customers. In the second instance they can deploy their newfound service level toward direct customers as well, making use of the ability to deliver smaller drops. The latter prospect can be especially powerful if use is made of cross-docking stations closer to the market than the distribution centers of the retailers, wholesalers, or manufacturers themselves. Needless to say, such new supply chain configurations do not just reflect optimization discussions. The relative power balance in the value chain will influence the competitive dynamics in the near future as these scenarios unfold. The overriding question will be, who can benefit most from such supply chain reconfiguration activity? Perhaps the benefits can in fact be achieved only from a total industry perspective, if other business models are changed as well. It is clear that when such new supply chain models are combined with, say, a change in the retailer’s business model from selling consumer products to consumers to selling shelf space to consortia of manufacturers, maximum benefits can be obtained for both parties, as well as the consumer.

The impact on competitive advantage is profound. Companies whose flexibility has put them ahead of the pack will likely see their edge dissipate as increased interactivity makes all firms more flexible. But there are ways to maintain—or gain—the lead. A firm that has great flexibility in its manufacturing process can sell that capability in its own right. A low-cost manufacturer can maintain its advantage by sustaining the largest market share. Preserving cost competitiveness in the physical value chain is a necessity in the face of increased complexity of customer

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demands—and only innovators will learn how to capture the growth opportunities that emerge.

■ CONCLUSION ➤ The physical value chain lends itself well to optimization because it is driven by the requirements of scale, flexibility, and complexity. As a result, the impact of optimization is easier to measure (and optimization more likely to be sought) for physical assets than for other capabilities. ➤ The provider industry born of outsourcing, traditionally an option for enhancing physical capabilities such as logistics or auxiliary services, has moved into processes once thought to be a business’s core activities. ➤ While most optimization examples in the physical value chain represent the offloading of auxiliary activities to a company that can perform them better, companies can also restructure their corporate genomes by looking inside for strong capabilities they can leverage. ➤ The Internet brings optimization of physical capabilities to a new level and makes new forms of optimization possible. In the future, the Web will spur more elaborate optimization—in the form of increased specialization in manufacturing and the pooling of capabilities among different companies, for example.

6

Chapter

Transaction Capabilities Information Aggregation

Given the explosion in connectivity and the ability to digitize so much information, transaction chain capabilities are poised to undergo major transformation. These capabilities are, after all, synonymous with the interaction and the exchange of data. They often are facilitating or enabling in character; they often are not key determinants of business unit output. They are sensitive to economies of scale, and thus benefit from efforts to optimize them beyond company boundaries. For all of these reasons, transaction value chain capabilities are prime candidates for optimization by being funneled into separate businesses or recombined across companies. Business-to-business (B2B) Net markets found favor because they efficiently and effectively aggregate the transaction information that passes between the buyer and seller. The battle for control of this space has many dimensions: the dot.coms versus the dot.corps, vertical versus horizontal, public versus private Net markets, and so forth. Yet in any form, the function remains the same: improving the transaction process. Although transaction activities can be grouped into a value chain, they encompass a diverse range of capabilities, from billing to employee benefits selection to purely administrative processes such as

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insurance policy administration. Each capability has its own solution for optimization. In this chapter, we: ➤ Discuss the trend toward relinquishing control over increasingly IT-dependent processes in the transaction value chain ➤ Look at how the Internet dramatically affects the optimization landscape for a company’s transaction and control capabilities ➤ Take a peek at what might be in store for the whole transaction arena once the euphoria over efficiency gains wears off and more sophisticated forms of optimization are pursued

■ THE EARLY OPTIMIZERS A transaction flow is the collection of transaction and control processes in both manufacturing activities and services. In an industrial company, transactions include such tasks as order taking, production scheduling, and invoicing. In a service company, transactions might include the handling of claims (in insurance), the processing of payments, and the gathering of customer data. Over the last decade, companies have begun to relinquish control over their transaction and process control capabilities as they become increasingly dependent on advances in information technology. Today, these capabilities are prime candidates for optimization as they migrate toward amorphous IT platforms being managed by an industry still in the making. Consequently, more and more business processes within the transaction value chain are being automated and moved outside company boundaries to exploit economies of scale and specialization. Because these information-rich processes are enabled by information technology (or can be transformed by IT),

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and because IT is rarely a core competency, most firms have determined that the gains of delegating the responsibility to others outweigh the benefits of retaining control over them. Indeed, over the past 30 years, thanks to computer power and volume bundling, the cost per MIPS (million instructions per second) has been reduced by half annually: In 1979, the first IBM PC processed 0.33 MIPS; in 1999, the Pentium III processed 1,000 MIPS.1 This speed of technological change gives companies a good incentive to leave the technology learning curve to others. As technology advances faster than ever, it is inconceivable that a company will be able to keep up if technology is not a key contributor to the products or services it produces. Cost is a major consideration, too. A company that outsources responsibility for its technology can profit from the vendor’s capacity to perform the task at a lower cost because of economies of scale, more cutting-edge technology, and better control of the process. This speed of technological change gives companies a good incentive to leave the technology learning curve to others. The opportunities for specialization and economies of scale have already spurred an abundance of new service businesses to which companies can outsource the capabilities that do not directly influence their business output. Areas such as payroll and credit card processing are regarded as mature service industries (payroll, of course, is one of the oldest outsourcing niches around). Service providers have also started taking on those business processes that are more central to a company’s operations. Consider UPS, which delivers 3 million packages a day. While the delivery company skillfully managed its enormous fleet of brown trucks and the location of its packages, it had difficulty capturing the related billing data. It took 14 days for the company to obtain the billing information for any

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package. This 2-week delay in the accounts receivable process was too long; UPS decided to outsource its billing data processing to a Dallas-based vendor, which set up an intricate satellite transmission system that made capture of the billing information faster and cheaper. Today, UPS gets its billing information in 24 hours—from a company with no physical goods (other than IT and telecom equipment).2 In addition, the vendor has the opportunity to leverage the infrastructure put in place for UPS more broadly—creating additional growth channels and tapping into economies of scale. Procurement is another prime candidate for optimization initiatives and an example of where company control has been relinquished to gain productivity and scale. This trend began before the Internet (think of all the intermediaries at work in a company’s buying process, from real estate agents to travel agents to MRO providers). However, low transaction costs and process efficiencies have taken procurement optimization to new heights and have enabled the debut of procurement service providers. Enlisting an outside provider is not the only element of the optimization repertoire for the transaction value chain. Dramatic change can also be realized by making transaction capabilities work harder or smarter. Initiatives such as vendor-managed inventory (VMI), for example, help companies better manage their supply chain. The objective of VMI is to integrate the supply chain and empower suppliers to manage the replenishment process (within preagreed specifications) by giving them more operational control and full access to operational and strategic information. In the longer term, VMI will create a truly responsive and cost-effective supply chain by integrating formerly separate pieces of the supply chain. Today, supply chain optimization, aimed at improving the partnerships between buyers and suppliers in a comanaged process of shared information, is evolving from simple VMI to broader initiatives such as collaborative planning, forecasting, and replenishment (CPFR). As optimization of the


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supply chain becomes more about information than processes, CPFR will replace earlier forms of inventory management. Over the years, optimization in the transaction value chain has branched out from its traditional strongholds of data processing and payroll processing to new areas, such as human resources and process control. Human resources executives are seeking improvement by turning to outsourcing partners that can effectively manage their companies’ day-to-day human resources functions. Currently, the HR functions outsourced most frequently include compensation planning, benefits administration, recruiting and outplacement services, 401(k) savings plans and retirement plans, management development, and training programs. But a total package of outsourcing services, where many different functions are bundled together, is rapidly gaining popularity. The benefits are compelling: Companies get more integrated and coordinated solutions at a lower cost. In an effort to revamp its human resources operations and technology, the Canadian Imperial Bank of Commerce (CIBC) recently turned to EDS to take on many of its human resources functions, including payroll, pension, and benefits administration. EDS will essentially create a human resources portal for CIBC to enable employees and managers to help themselves. By supplying self-service tools, such as systems and records, and managing them effectively, EDS contributes to productivity enhancements at CIBC by allowing employees to input their own status changes, view compensation statements online, and take advantage of retirement planning tools.

■ THE INTERNET’S IMPACT Because transaction capabilities are entirely about interaction (internal or external), they are likely to be dramatically affected by the introduction of the Internet. The

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Internet revamps a company’s transaction and control capabilities by automating labor-intensive processes and enabling a level of scale that was once unthinkable. Activities that were previously managed via faxes and phone calls and company-performed data entry, from procurement to accounts payable, are being digitized. In the process, new levels of optimization are emerging. Online bookseller Amazon, for instance, has recognized that in addition to selling books online, its online “retail services” capability is an asset in itself and can be optimized outside company boundaries. When it sells retail services to other companies Amazon will also take over such capabilities as order management (which determines how many widgets are to be shipped to which warehouse with which bar code). Order management has now become an automated (and therefore further optimized) capability that other companies can leverage directly—enabling them to focus on more value-added capabilities such as account management. While transformed by the dramatic reduction in interaction costs, transaction capabilities become far more ITdriven and thus depend on economies of scale and standardization. As a result, the Internet has introduced a myriad of new optimization possibilities in the transaction value chain. Before the Internet, only large organizations were able to afford comprehensive ERP (enterprise resource planning) systems and data processing technologies. As technology shot forward, the quests for increasing scale beyond company boundaries spurred such initiatives as Net markets and trading platforms. Traditionally, each company had its own ordering and invoicing application—hardly a cost-efficient process. Now businesses can share Internet-based business infrastructures in the form of Net markets (contingent on standardization), allowing large economies of scale to be achieved. Instead of several thousand companies having their own ordering and invoicing applications, a Net market maker searches for new levels of scale by consolidating these processes.


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New service offerings have been created around those emerging platforms. For instance, several banks are setting up small to medium enterprise (SME) service portals through which tailored services are offered to specific branches of companies. Without Internet-based transaction platforms, such tailored service offerings would have been difficult to bring to market; most branches of the banks were for practical reasons focused by region rather than industry type. The emerging platforms allow the economies of scale that make investments in tailored offerings pay off. Internally, the banks can increasingly support such offerings and decentralize knowledge through intranets. Another issue facing many small to medium enterprises is the enormous duplication in all sorts of administrative processes. Basic information about company employees, for instance, is keyed in or filled out many times. It may be given to tax authorities, retirement plans, health insurance, special benefits programs, payroll, the chamber of commerce, job-related risk insurance and government agencies—all of which have their own information needs. The optimal solution would be to build a single standardized information platform, from which permission to use relevant information could be granted to different parties as appropriate. The main body of information would be maintained in one place, creating significant new efficiencies in information management.

■ THE FUTURE OF THE TRANSACTION Keeping transaction capabilities within company boundaries is no longer a competitive option for companies. The weakening of the link between the transaction and the actual process, combined with the emergence of Net markets, has brought a new transaction business into existence. We anticipate that all departments dealing with transactional activities (such as EDI payments) will eventually cease to

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exist. The reciprocal result will be the rise of specialized players in business process management that cover functions from human resources to office management—and that offer enticing economies of scale. We also expect more aligning of processes. The optimization landscape for the transaction value chain is evolving—but the pace of change depends on the players’ readiness. To benefit from the opportunities at hand, companies must do some housekeeping as a prerequisite to standardization. Just as one company cannot purchase its office supplies through a marketplace if facility services and procurement have not aligned their processes, another company cannot offer a self-service HR platform to employees if benefits and payroll do not communicate. The optimization landscape for the transaction value chain is evolving—but the pace of change depends on the players’ readiness. In the future, we expect standards to become far more prevalent and comprehensive. Taxpayers filing their taxes online in the United States using Intuit’s user-friendly interface, Turbotax, can already link directly with the financial institutions managing their funds or obtain more information on opening accounts with these institutions. One can easily imagine how the next few years could bring the materialization of one back-end platform linking employees to their benefits elections, but also to the financial institutions managing their accounts, and to the tax authorities to which they are liable. While the Web opened up opportunities for companies to transact more effectively via Net markets, these online markets have in many cases narrowed their focus. Companies want to profit from the economies of scale a Net market brings to the transaction process without sharing sensitive information with competitors. Companies are limiting their participation in public Net markets and


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leveraging the Net market model as an internal initiative, at least for the purchase of direct materials. DaimlerChrysler, Toyota, and Volkswagen, for example, are all attempting to improve business results using private online marketplaces for collaboration internally and with their trading partners. With its online FastCar initiative, DaimlerChrysler intends to save billions of dollars in development and new vehicle launch costs and reduce time to market by interconnecting the company’s design, engineering, manufacturing, procurement, and other activities (while also participating in a shared initiative, Covisint, with other leading car manufacturers). Toyota intends to use its marketplace to better control inventory through improved forecasting and enhanced planning, deployment, and replenishment of inventory. Finally, with the help of the alliance partners, Volkswagen is building its own B2B marketplace to improve relationships with suppliers through better collaboration and visibility. By tightening their transaction value chains with the help of private online marketplaces, the carmakers can more often have the right parts available, at the right time, at a highly competitive cost. The shift toward more private marketplaces highlights the challenge encountered when companies first tried to seize the opportunities offered by the Internet. The promise of marketplaces hinges on the participating companies’ capacity to streamline their processes and align their organizations with the new system. The success of improving transaction capabilities by setting up marketplaces— whether public or private—depends on a certain level of readiness of the players involved. The level of alignment of internal processes (such as payment and procurement) affects the readiness of a company. And it is the lack of alignment that explains why so many marketplaces have failed to produce the promised results—or have grown more slowly than originally anticipated. We’ve said that further optimization opportunities in the transaction value chain depend heavily on progress in the establishment of truly standardized platforms. Some

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The Endgame What is the endgame for transaction optimization through Net markets? To answer that question, one must consider the two distinct types of benefits Net markets offer: the efficiency gained by reducing transaction costs between buyer and seller, and the value of enhancing the product or service offering. Current developments point to an evolution toward a set of wide-ranging and independent transaction and communication platforms (see Figure 6.1). They will Selling (e.g., consortium, MRO goods)

Transaction platform/ exchange

Sellers

Internet market connectivity

Buyers

Buying consortium (e.g., for indirect goods)

Exclusive collaboration (e.g., supply chain pooling)

Net market activities will be superimposed and derive their shape from their key strategic objectives. Transaction platforms will be large, standardized third-party platforms. Selling and buying consortia will be exclusive and focused, creating benefits only for the partners involved.

Figure 6.1. The Endgame for Net Markets Source: A.T. Kearney.

industry-specific standardization initiatives are already in place. One is UCCnet, a universal foundation for electronic commerce spanning all industries and geographies. In time UCCnet (established by the Uniform Code Council, the founders of the bar code) will provide a universal infrastructure of compliant data regardless of how companies identify their products. RosettaNet is a nonprofit organization developing XML standards for data exchange within the


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likely form the necessary foundation on which most transaction-oriented commerce will be conducted. Ultimately, these will become global, standards-based e-marketplaces that provide little opportunity for competitive differentiation (or materialization of the value benefit) but offer maximum efficiency in facilitating transactions. To address the lack of benefit on the value side, numerous differentiating value networks will emerge, making full use of the standardized transaction platforms. Several complementary companies might come together, for instance, to create a truly competitive offering with terms and conditions that favor one-stop shopping from their assortment. Factoring services might be offered over the transaction platform, compensating companies for a percentage of the deal. It is unlikely that all these services will be bundled with the transaction service itself—but on the other hand, the factoring services cannot exist without the platform. The factoring service could be country-specific and offered by a company that has invested in the local market intelligence to be able to offer very competitive rates.

technology supply chain—connecting component manufacturers, distributors, resellers, and purchasers. And Global Commerce Initiative (GCI) is a joint effort of 40 of the world’s leading manufacturers and retailers working together to create the first global standards for Internet trading in the consumer goods industry. However, beyond these industry-specific efforts, no single standard or standards organization has emerged as the front-runner—and given the effort involved, one is not expected to for several years.3

■ NEXT-GENERATION OPTIMIZATION The developments we’ve discussed revolve primarily around optimizing the transactions that take place in value chains as we know them today. Clearly the benefits will be

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substantial, and progress therefore unstoppable, but it is not always clear how more value will be generated out of more interaction efficiency. Yes, many customers will find products and services that better fit their needs, but the question of whether they will be willing to pay more remains. Continuous business optimization is in many industries a requirement to play rather than a sustainable source of added value. What we really need to know, then, is how more efficient transactions can contribute to, or support the creation of, lasting value. A number of opportunities are emerging that illustrate what might be possible. They share a common theme: They try to capture the upside of new ways of interaction by looking at what more can be done in addition to what can be done better. In other words, the opportunities extend beyond gaining efficiencies and reducing costs to finding new ways of doing business. Let’s look at some examples.

➤ New Supply Chain Management Consider the supply chain optimization and procurement examples we discussed earlier. The creation of central control of the interactions between the parts of a company’s supply chain requires a common internal transaction platform, which often consists of the enterprise resource planning (ERP) and advanced planning systems. Through this platform central control can suggest what to transact between the different supply chain elements. In supply chain management, this means that the physical carrying cost of shelf space can increasingly be isolated from the transaction of moving goods and acting on the information. Proprietary information in vendor-managed inventory (VMI) arrangements begins to vanish as VMI is replaced by Webenabled, many-to-many solutions. This sets the scene for next-generation supply chain optimization, in which industry leaders band together in joint ownership of warehouses. The internal transaction platforms have not only


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improved business processes; they have enabled structural reform of supply chain management capabilities.

➤ Virtual Consolidation The unprecedented levels of scale introduced by the Internet make it possible to take procurement management to new levels. ICG Commerce will leverage its e-procurement services (built around a flexible Internet-based platform) to electronically pool and aggregate Sara Lee’s purchasing with that of other companies across Europe. Together, these companies will tap common suppliers across multiple countries to secure the best pricing possible on indirect and direct goods and services. As a result, Sara Lee will not only benefit from the freedom to focus on more strategic purchasing and activities, but will enjoy easy access to lower priced indirect goods. By adopting Web-based platforms that allow companies to aggregate pricing for such diverse services as couriers, utilities, office supplies, and telecommunication, the efficiency and effectiveness of procurement capabilities can be maximized.

➤ Prepackaging Service Propositions In newer areas of transaction outsourcing, such as human resources, the low-cost connectivity introduced by the Internet is also changing the optimization landscape. Without a platform of shared information, complete HR packages could not be implemented. The drop in interaction costs also makes self-service possible; employees can update their benefits elections, retirement contributions, and payroll deductions with interactive voice response technology and the Internet. Not only is this technology more efficient for employees, who get timely and accurate information; it reduces the company’s costs as well. Once all the HR-related interactions have been migrated to efficient transaction platforms, new service offerings come within reach. Employees of a firm generally

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have in common the company’s policies on pensions, employee benefits, and so forth; yet they also have many differences, including family circumstances, age differences, interests, and level within the firm. Once an efficient transaction platform has been established for all HR matters, employees can potentially hook up to “service centers” that cut right across company boundaries and serve the interests of specific employee groups—such as single professionals, single parents, married couples, and families—in a focused manner. Such services would be too costly and cumbersome for single companies to set up and maintain, but they could be established on top of efficient transaction platforms since the necessary information can easily be made available.

➤ Selling Solutions Many companies are upgrading their offering from selling products or services to selling “solutions.” Why sell air transport if customers really want their package to go from point A to point B? A car if customers want mobility? Lightbulbs if customers want light? Jet engines if customers need thrust? It is not uncommon for companies to search for partnerships in which they create the ultimate solution to offer to their customers. Such partnerships do not necessarily work. Many mergers and acquisitions undertaken in the name of complementary service offerings have been seriously disappointing (the only safe conclusion we can draw is that the complementary service offerings at least didn’t hinder each other). We propose a strategy to make these solutions work: Scrutinize the elements that make up the solution and ensure that the most commodity-like ones can be incorporated in the solution as if they really were commodities. In other words, you can’t afford to let nondifferentiating elements even slightly hinder the creation of the solution. In moving goods, some transport modalities are effectively like commodities and sold as capacity. Including this


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modality in the exclusive lineup for the solution would only hinder integral scheduling efficiency without adding any value. Here’s the catch: Although many products and services are effectively behaving as commodities, they can’t yet be included in solutions, because there are no efficient markets through which these products or services can be obtained. Here lies an opportunity for transaction platforms. They can facilitate the true commoditization of the products and services required in value-adding solutions. This may sound harsh at first, but remember that in many cases, prevention really only delays the inevitable. It might make more sense to identify the real drivers for sustainable competitive advantage instead. In commodity markets, being twice the size of your biggest competitor, and reaping the associated scale advantages, would certainly help.

➤ The Internal Transaction Platform Internal transaction facilitation will be one of the really new areas where the newfound interaction opportunities will have impact. As companies progress toward capabilitydriven organizations, they will have to manage parts of their organizations that are currently embedded in the different business units as if they were separate businesses with products or services, customers, and resources. This means that interactions among the different parts of a company will have to be brought to a new level of professionalism, with upfront agreements and consequences for performance issues. In general, management information will have to be made even more suitable for inclusion in service level agreements and performance measurement for contract follow-up. This need to capture a mix of formal and informal intracompany interaction in businesslike contracts, which can also be followed up on, might open up a whole new application space, especially if companies want to leverage their resources beyond their own businesses and business

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units. If transactions take place around business boundaries, what better place to start a business than where new boundaries are created?

■ CONCLUSION ➤ Because transaction capabilities are about interaction and the exchange of information, they are likely to be dramatically affected by the Internet. Because they depend on information technology, transaction capabilities are prime candidates for optimization initiatives in search of scale and efficiency. ➤ Many new service businesses have emerged that offer specialization and economies of scale. For capabilities that do not directly influence a company’s business output, these new firms offer significant benefits. ➤ Over the years, optimization of transaction capabilities has branched out from its traditional strongholds (such as billing and payroll) to new areas of process control (such as supply chain management and employee benefits elections) as companies trade control over these processes for increased efficiencies. We expect a rise in the number of specialized players in business process management as well as further standardization of processes and platforms—without which optimization in the transaction value chain may stall. ➤ A fundamental question is, what business opportunities can an increase in interaction bring about now that this increase can be obtained at lower costs? The benefits will not fall to the party facilitating the transaction, but to the entities in the best position to make use of it.

7

Chapter

Knowledge Capabilities The Art of the Matter

The trouble with most optimization trends is that your competitors waste little time jumping on the bandwagon. Once your rivals copy your strategy, your first- or smartmover advantage fades fast. But when you turn your attention to knowledge capabilities, you’ll see tremendous opportunities for differentiation that are far harder to replicate. Envision a world where groups of knowledge workers apply and augment their expertise without being tied to the constraints of the company’s traditional end product. Imagine the infinite possibilities in creating a convenient assortment of the best products available or a buying experience that is highly tailored to the consumer. Think about the potential of a powerful brand when both management and creative staff can concentrate fully on its development, free of the distractions of buying raw materials costeffectively or delivering the goods reliably. Many companies are already moving in this direction. Looking forward, we expect to see an explosion of this activity as ventures focus on the creativity and breakthrough potential for differentiation based on knowledge. In this chapter we: ➤ Look at early examples of optimization in the knowledge value chain 131

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➤ Discuss the drivers behind knowledge capabilities and how to make the most of them ➤ Assess the impact of disruptive change on the knowledge value chain and predict what it means for the future

■ THE EARLY MOVERS The knowledge flow is the collection of the creative elements of the value chain. Development, design, branding, assortment management (the coordination of the product choices offered to a customer), and customer need translation (the process of guiding customers to the product that best meets their needs) are all intangible processes that help companies enhance their value propositions. Each capability encapsulates some information about the product or service. A company that maximizes its knowledge assets can differentiate itself, and therefore charge a premium or increase its market share. A company with a trusted brand, for example, commands a higher price than its less-known competitors that offer a similar product. But optimizing knowledge capabilities is not always as easy as improving capabilities in the physical and transaction value chains because the impact is difficult to measure. It’s harder for other reasons, too: It involves more creativity and less science to optimize a brand than a manufacturing process. Despite the challenges, some industries are already creating winning strategies for making the most of their knowledge capabilities.

➤ Design and Development These days, customers sit squarely in the driver’s seat. Many companies are revamping their design and development capabilities to give the people what they want. The

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supply chain restructuring in the automotive industry is one example. As we mentioned earlier, suppliers are taking on more and more upstream responsibilities from the carmakers. Design modules are in some cases supplanting the more traditional manufacturing modules, enabling automakers to reduce costs and to profit from added flexibility. From TRW’s development of in-house capabilities that enable it to design fully integrated chassis modules, to Magna’s assumption of total responsibility for the development of GM’s Cadillac Catera’s new interior, to Ford Motor Company’s establishment of a design house in vibrant Soho, London, the automotive industry is shifting toward optimizing its product design capabilities. Engineer-to-engineer collaborative design, or “E2E collaboration,” is also thriving, opening up exciting opportunities for carmakers to enhance their development capability outside their company boundaries. In 2000, three teams of automotive designers and engineers on three continents developed the European Roadster Challenge (EUROC) race car in just 7 days. Collaborating over the Internet, a team in Europe designed the chassis while a team in Japan designed the body and a United States–based group created the power train.1 This impressive feat is just the tip of the proverbial iceberg when it comes to maximizing knowledge capabilities. In 2000, three teams of automotive designers and engineers on three continents developed the European Roadster Challenge (EUROC) race car in just 7 days. Another striking example of this trend in design and development transformation can be found in the pharmaceutical industry. Knowledge capabilities such as research and development (including basic research and clinical trials) and product innovation have always been crucial competitive differentiators. Today, the major pharmaceuticals have the opportunity to outsource much of their basic

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research to independent biotech firms, and a good portion of their clinical trials and field monitoring to clinical research organizations (CROs), which have deep knowledge of patients and medical service providers; in short, the entire pharmaceutical industry is radically restructuring. (See chapter 9 for a detailed analysis of changes in the pharmaceutical industry.) New large-scale independent collaborative efforts, such as the Human Genome Project, also demonstrate how optimization of the pharmaceutical knowledge value chain takes companies that want to be ahead of the pack beyond traditional company boundaries. The differentiating capability for pharmaceutical firms in this context appears to be the skillful orchestration of all of the players in the value chain, as well as sales and marketing.2 En route, they have even found a way to get computer processing power under very attractive conditions of the supporting software by tapping into unused CPU capacity of millions of PC users supportive of the general cause. Finally, Motorola, seeing the market share of its semiconductors plunge with its share of the cell phone market, recently decided to sell its chip sets to other cell phone manufacturers. With this decision, Motorola will make its technology and design available to direct competitors in the cell phone market (perhaps not Nokia, but other smaller players). Some see in this decision a risk that the company will erode its competitive edge. But the recent slowdown in the semiconductor market and the growth potential in chip sales persuaded Motorola to act. In reality, for a large segment of the market the design of chip sets is now considered secondary to imaginative new styles incorporating changeable phone color faceplates and other accessories consumers clamor for. By selling its chip set design capability to other players on the market, Motorola plans to make a play for the US$12 billion market, which it expects to grow to US$35 billion worldwide by 2004.3


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➤ Branding Of course, you are probably not going to outsource your branding—but you can still optimize it. Look at Coca-Cola. For years, the beverage giant has enjoyed high returns on capital by outsourcing its machinery-intensive bottling work to others and meanwhile has leveraged its brand to the hilt via licensing agreements around the world. Recently, Fotoball USA (a leading souvenir and promotional products marketing company) and Coca-Cola agreed to produce licensed footballs, basketballs, and other sporting goods brandishing the Coca-Cola trademark. In this example, the Coca-Cola brand is a capability treated almost as a separate business; the company receives direct compensation without selling a single Coke. The fashion industry has crafted an interesting strategy for extracting maximum value from its brand. Among the masters is Ralph Lauren, a global leader in the design, marketing, and distribution of premium lifestyle products. For more than 30 years, the reputation and distinctive image of its Polo brand have been developed across an expanding number of products, brands, and international markets. It is now active in four major areas: apparel, home, accessories, and fragrances. Over the years, Ralph Lauren has created a visionary concept of its “American lifestyle experience” (supported by a distinctive approach to advertising) and now holds one of the world’s most widely recognized families of consumer brands. The company, through a joint venture with NBC, is now finding new media through which to expand its brands, including Internet, broadcast, cable, and print. While focusing on and enhancing its brands as its differentiating capability, the company leaves other activities—such as manufacturing and the majority of retailing— in the hands of others, developing an extensive licensing business to support this strategy. The licensing agreements cover a broad range of businesses (from fashion accessories to home products, including paint and furniture) and play

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a key role in diversifying the designer’s product while providing a continuous stream of income. While Ralph Lauren’s international licensing partners operate 111 freestanding Polo stores in more than 60 countries around the world, the company is regaining control of its distribution channels by opening up more retail outlets and revamping its merchandising strategy.4 These activities do not buck the trend: By opening new outlets, the company can operate in high-margin areas specifically because of its strong capabilities (premium brand and retail assortment). Further, by controlling distribution, Ralph Lauren keeps a tight rein on time to market—a critical aspect of its business. We said earlier that you are probably not going to outsource your branding. This statement needs some qualification, however. It is fairly safe to say that if the brand represents a substantial part of the value generated by the company—for instance, via substantial price premiums— then outsourcing is not likely. There are, however, industries where the brand is necessary to provide a measure of buying comfort, but will never really generate a substantial premium. Large-volume white goods would fall into this category. Instead, other capabilities are crucial to the value created by the company, such as industrial leverage or access to trade channels. In such instances, outsourcing branding can be an option, but it will be carried out indirectly through the leverage of other capabilities. A white goods manufacturer could, for instance, sell its products in B2B fashion to another white goods firm in another geography where it is not present. Leveraging its industrial base can make much more sense than trying to enter a new market.

➤ Customer Need Translation The activity of guiding customers to the product or service that best meets their needs (often called demand translation or customer need translation services) also holds great potential for optimization. Consider how Dell Computers


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transformed its customer need translation capability. Dell outsources all design and innovation for components and nonassembly production, but focuses on (and invests heavily in) translating customer needs (which it receives from its Web site) into logistics and component integration. Actually, any Web site that offers a keyword search and interprets searches to suggest other products also focuses on this capability. The risk for traditional players is that customer need translation is moving across suppliers and brands. The interactive search engines that help users “translate demand” are even more powerful and competitive if they offer a wider assortment (across brands) in response to the customer’s need.

➤ Assortment Management Companies like Amazon.com credit their existence to their deft handling of assortment management, or the process of choosing which products to offer to consumers and how. Rather than driving to a bookstore, you can visit Amazon.com and search for a book by typing in keywords— from any location, at any time. You can check out reviews from other readers and even switch to browsing CDs or DVDs. Amazon has built its success on the dramatic improvement in the way assortment can be brought to us. Unfortunately, judging by the number of people who use Amazon for book searches but do not purchase the book online, Amazon has not achieved a similar degree of improvement in its transaction or distribution capabilities. In a similar vein, consider the experience of a group of typically fragmented business-to-business commodity manufacturers, which traditionally have been obliged to sell products through consolidated wholesalers. Since they couldn’t consolidate to fight increasing price pressure because of tight antitrust regulations, the manufacturers of luminaries, wires, switches, and outlets got together with complementary commodity suppliers via a common wholesaler that offered assortment to the end customer.

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Today, with the tools provided by the Internet, complementary best-in-class manufacturers of each commodity product can easily set up a virtual assortment of goods while relying on a logistics company to set up a warehouse and deliver the products directly to the end customers. By coming together on the Internet, the commodity suppliers are able to search for competitiveness outside their company boundaries to offer customers a more exhaustive array of products in a searchable, convenient format. There is an interesting dynamic at play in the assortment game. Because margin flows more easily downstream in a value chain than upstream—the reason why price erosion is cited more often than price appreciation in most industries—the creation of a virtual assortment is easier for buyers than sellers. When customers pool their buying needs, and thus create a demand-based assortment, they clearly can gain from their strengthened positions. Better prices and conditions can be obtained through such forms of leverage. There is little downside. If the arrangement doesn’t work out, they can fall back to their original positions. The reverse is true for assortments that face downstream, or selling assortments. Getting together complementary manufacturers to create a “super assortment” to increase their power versus the wholesalers they serve, for instance, will require a substantial amount of discipline. The partners cannot give in to wholesalers’ attempts to break the coalition by selling outside the consortium. The wholesalers will inevitably test the stamina of the selling consortium, exerting considerable pressure and causing major disruption to the business of the consortium partners.

➤ Market Intelligence Market intelligence has long been recognized in certain industries as a powerful potential source of top-line impact. Yield management is one example of market intelligence


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optimization. Yield management systems (also known as revenue management systems) were put in place by airlines in the early 1980s to maximize seat sales at the optimal price, improving revenue return from each flight. Similar systems were then widely adopted in the hotel, car rental, shipping, and advertising industries. All have perishable products to sell (if a hotel room or advertising space is not used at a given date, it is lost). Yield management enables companies to segment business into micromarkets, each with its own price and value proposition. Different segments of the market, of course, have varying appetites for different products at different prices (far-in-advance booking requirements or stopovers may be acceptable to the budget traveler, but inconceivable to the time-pressed business traveler). The goal is to charge a price as close as possible to what each customer will pay (not necessarily the highest) to maximize revenue; the result is that no two seats on a plane have the same price tag.

■ KNOWLEDGE CAPABILITY DRIVERS In his work on outsourcing innovation, James Brian Quinn, emeritus professor of management at the Amos Tuck School, points to four forces driving the innovation revolution: the rise in global demand, which creates new markets for innovation; the supply of knowledge workers and tools such as software, which lowers research risk and cost; the increased interaction between technologies; and greater incentives for innovation.5 Whatever the causes, the innovation revolution has led many firms to search for ways to optimize their knowledge capabilities—the very capabilities that lie beneath a company’s capacity to innovate. Advances in information technology (IT) affect almost all knowledge capabilities. Today, no research and development department can predict or cover all possible designs

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or competitive positions given the opportunities generated by advances in software, electronics, and market-reading tools. Consider how these advances might affect product development in the automotive industry. Since the 1970s, carmakers have steadily adopted tools such as product development management software and computer-aided design, manufacturing, and engineering systems. These tools have helped companies cut the time it takes to bring a new model to the market from 5 years to 3. As the Internet grows bigger and more robust, companies are beginning to link their diverse product development systems together. As these connections take root, communication will speed across the automotive value chain, beginning with the designer and ending with the customer. Industry watchers predict that the time needed to develop a new model can be slashed to a year or less. That’s because communication will flow upward from the marketplace as rapidly as it travels downstream to the production line—opening up new opportunities for collaboration in the design and development capabilities between manufacturer and supplier, as well as manufacturer and distributor. One can imagine that customized models could be quickly delivered to the dealer, or large fleet owners (like Hertz or Avis) could participate directly in the design of their vehicles. Virtual design is at the heart of this process, and global automakers are scrambling to get their programs to run securely over the Web. When General Motors inked a deal with Unigraphics Solutions, Ford with Structural Dynamics Research, and DaimlerChrysler with France’s Dassault Systemes, all acknowledged the criticality of computeraided 3D interactive platforms for collaborative design. Once all the systems are connected, teams of engineers around the world will be able to communicate by voice while viewing a part—or an entire car—on their computer screens. Each will be able to make changes that their colleagues can see in real time. These designs will be tested in virtual cars on virtual tracks and achieve far higher levels


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of fit with customer needs. Specifications for the parts will be sent directly to the parts supplier, which will be part of the team. It is the reduction in interaction costs that allows companies to organize for these virtual clusters, which would previously have been impossible to manage. Another capability for which the Internet and other advances in technology have had a top-line impact is yield management. Because data is more readily available today, companies can further optimize their yield management capability. Airlines use computer-based yield management systems and sophisticated mathematical formulas to forecast demand for seats, taking into account historical data and seasonal variables. The private data networks currently in place (such as British Airways’ COBRA system) enable more efficient seat sales and more flexibility in the range of fares. The Internet enables an additional layer of optimization, as this information leaves the proprietary networks of airlines and becomes available to customers in real time (think Expedia or Orbitz). Yield management optimization and the corollary price transparency will inevitably lead to a redefinition of the travel industry. Just as airlines are seizing top-line growth opportunities by relying on data management systems, development of third-generation mobile telephony depends on progress in chip data capacity, and innovation in the food industry is strongly linked to progress in flavor enhancements and weather predictions that help predict agricultural product prices. In this context, optimizing knowledge capabilities often means tapping into capabilities of external leaders, not just for best-in-class products and services, but also for the continuous innovation and evolution of ideas.6 Optimizing knowledge-related activities is a far different exercise than improving physical and transaction activities. Rather than being driven by scale, flexibility, and complexity, knowledge capabilities are influenced more by such factors as effectiveness (extracting high margins), speed (decreasing time to market), fit (matching customer needs), and uniqueness (rendering the ability to charge a

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premium), in addition to efficiency (performing better, faster, and at lower cost). Shifting product development and design outside company boundaries, for example, can speed up the development process (time to market) and help companies better match their customers’ needs (fit). By outsourcing clinical studies to clinical research organizations, pharmaceutical firms collect data faster, speeding new product introduction. When automakers collaborate with their suppliers to create design modules, they can introduce new products that are more attuned to customer demand. In addition to shaving time to market and responding more accurately to customer needs, moving design and development outside the company can mitigate delays in hiring or in infrastructure development, and circumvent internal resistance to new ideas. Large companies that transfer responsibilities to smaller ones realize an additional benefit: Smaller firms are generally more flexible and have put innovation at the heart of their value proposition.

Most giants of the luxury goods industry focus on optimizing one driver of the knowledge value chain— uniqueness. Most giants of the luxury goods industry focus on optimizing one driver of the knowledge value chain—uniqueness—which gives them the capacity to charge a significant premium on their products. This characteristic is the formula for success for companies such as Ralph Lauren, Gucci, and Armani. Then there’s Nike, which designs for fit and uniqueness. All of these companies use their brand (a capability they excel at) as the focus for improvement efforts in order to achieve their goals of uniqueness and fit, while leaving most other capabilities to partners.


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Creating a Context for Innovation Striving to meet customer needs to achieve better fit must not prevent a company from creating the very context for innovation at which small firms excel. According to Clayton M. Christensen,1 this context is created by building distance between the company and its customers—as a company that’s performing well will tend to devote resources to what it knows customers want. These solid performers find it difficult to allocate resources toward disruptive technologies (lower margin opportunities that their customers don’t want) until their customers ask for them. “By then,” he points out, “it’s too late.” The reasoning is similar for investors: Innovation, which can be viewed as the optimization of knowledge capabilities, is a long-term investment that may contradict shareholder value objectives. Thus the only way to direct adequate resources toward innovation is to create the necessary distance from investors.

➤ The Real Promise It is clearly attractive to make knowledge capabilities even more effective and leverage them outside traditional company boundaries. There are many examples that demonstrate the virtues of doing so. In specific cases, however, a potentially more rewarding strategy has become possible with the liberation of knowledge capabilities from their physical and other counterparts. It is now possible to deploy the contribution of the capability at a new location in the value chain—where potentially far more value is residing. In chapter 4 we discussed the example of Philips Domestic Appliances, which leveraged its development capability by collaborating with a coffee manufacturer to create a superior coffee experience. In doing so, it exploited its development capability far more effectively that it ever could have in developing coffee makers on its own. Tapping into pools of value upstream or downstream in the value chain is not straightforward. Several rather

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stringent requirements will have to be met. Consider, for example, energy-saving fluorescent lights. All major manufacturers have invested considerable money and resources in developing bulbs and ballasts that give off quality light while using only a fraction of the energy. In many cases energy cost is reduced to 20 percent of that of regular lights. This means that the lamp manufacturers add considerable value to the processes of their customers—their energy bill is potentially cut by 80 percent, a savings that far surpasses the marginal increase in purchase price that the energy-saving bulb represents over its lifetime. However, the light manufacturers have not been able to effectively tap into this pool of value. Unfortunately, at the time there was no real alternative to getting compensated for their brilliant development work by selling these advanced lights to their customers. This means that their fortunes are not determined by how much value is generated in the value chain of their customers, but by how competitive the energy savings lamp market is. As it happens, this market has turned quite competitive quite quickly. Chinese companies began selling energy-saving bulbs that looked nearly the same, although the specifications were not as stringent. Prices eroded, leaving the major lamp manufacturers in a challenging situation. One of the next frontiers is probably miniaturizing the energy-saving fluorescent lights to make them completely interchangeable with regular lightbulbs. Low-cost imitators will find this technological feat harder to copy; the electronics must work reliably in a very harsh environment of energy conversion and heat buildup. This challenge should provide the manufacturers the opportunity to sell the miniaturized energy-saving lamp as a differentiated product and charge a premium price—for a while. Alternatively, they might search for business models that allow them to replace ordinary lightbulbs with the new energy-saving ones and get a share in the energy savings by selling the light output rather than the device: In other words, they might be able to tap into the value created for


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their customers by leveraging their developmental capability in the lighting market much as the coffee maker developers did in the coffee market. Given the location of many ordinary light bulbs—private homes—this might prove very difficult. Questions that must be answered to determine whether a knowledge capability can be leveraged at a different point in the value chain include: ➤ Can a business model be defined around the capability to capture the value? ➤ Can the business model be made sustainable through protective measures? Suppose that the aviation solutions division of GE decides to create an offering of selling hours of thrust for a jet engine. (In other words, the user would pay for the hours the engine is actively used rather than paying for ownership of the engine.) The offering could differentiate hours of takeoff thrust, cruising thrust, and idle running, perhaps establishing a minimum number of monthly hours. GE could make this happen by combining all its resources from financing and applying them to the maintenance of jet engines. If it did this for a new generation of jet engines—preferably one that is more reliable, easier to maintain, and more energy efficient—it could potentially tap into the savings the engine will generate for the operators of aircraft. The benefit of selling thrust by the hour is potentially much larger than for sale of the engine itself. Years of proven performance statistics would be required to demonstrate that GE’s engines warrant a premium price. But even if this could be proved, the premium would likely be a lot smaller than the continuous benefit obtained during the lifetime of the jet engine. In selling what it calls “power by the hour,” GE can thus benefit immediately from its development progress.

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The copying and printing industry underwent a similar move downstream in the value chain, albeit on less favorable terms. In the mainstream segments, manufacturers ran out of features to put into their machines to boost sales or command premium pricing. Most business users already had copiers and printers covering their needs several times over in terms of both quantity and quality. Manufacturers can earn a return on their development efforts only in niche segments such as color printing and wideformat printing. It didn’t take long for the market to recognize the need for a shift in the value chain. Rather than buying copiers and printers, businesses started to buy printed pages, leaving the worries about spare parts, toners, paper, and other supplies to Kinko’s and the like. Suddenly the whole business model was turned upside-down. The consumables became a cost burden rather then a source of revenue and good margins. Instead of selling as many copiers and printers for as high a price possible, it became necessary to sell as many printed pages with as few copiers and printers as possible. This is quite a startling notion if you make copiers and high-end printers! GE’s power-by-the-hour offering has a sustainable business model as long as GE’s jet engines are more energy efficient and more reliable than those of the competition. Philips’ coffee maker and the coffee pouches are linked through a two-way patent, creating the foundation for a robust business model. Theoretically, we can assess for all knowledge capabilities whether it is possible to tap into pockets of value upstream or downstream in the value chain.

■ A LOOK TO THE FUTURE Given the huge rise in connectivity the Internet has bestowed upon us, we can expect an explosion in collaborative and knowledge management tools. We have seen that a


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number of industries—automotive, pharmaceutical, and fashion, to cite just a few—have begun to optimize their design functions. These improvements affect the key drivers behind design (speed, effectiveness, efficiency, fit, and uniqueness) to increase market share or extract a higher margin from the product. As collaborative tools, such as online design portals, become more popular, additional opportunities emerge. Rather than relocating all of its designers to Soho, London, Ford might consider developing a design portal to achieve the same amount of innovative interaction—or more. Design portals could also play a useful role in industries where a rigorous feedback loop is necessary, such as aerospace. Assortment management is also likely to be affected by the rise of collaborative tools. Consider commodities that are needed by many industries, such as those that fall into the category of maintenance, repair, and operations (MRO). On one hand, MRO providers are losing power because of the consolidation of customers (accelerated by the Web). On the other, customers typically need more than the output of one MRO supplier, and the service level required is quite high. Thanks to the Web, several MRO suppliers can come together as a single entity offering an assortment that matches the needs of customers for a variety of products and facilitates such processes as delivery and invoicing. Grainger.com, a grouping of MRO suppliers that provide an integrated online catalog, is one example. The Web enables manufacturers to bypass the wholesaler in its traditional role—and avoid the wholesaler’s margins in the process. Finally, the Internet also offers tremendous opportunity for customer need translation. Consider the construction of a building, which requires the knowledge of many different trades (such as masonry, plumbing, and lighting). Manufacturers of the products involved ( bricks, pipes, lightbulbs) can actively work the market by helping builders match products with their requirements. These services are often extended to all who influence the buying

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decision, such as architects and engineers. In addition to the boost in sales, greater collaboration of knowledge processes is also expected. Thanks to the tools that lower interaction costs make available, the builders can set up an online design support service that contractors can tap into once for all their design needs.

■ CONCLUSION As these knowledge assets become increasingly footloose from their physical counterparts, they can more freely search for the best means to improve efficiency and effectiveness. Specifically: ➤ Companies in industries including automotive, pharmaceuticals, consumer goods, and fashion have started to optimize the creative elements of their value chains (such as branding, design, and assortment) in an attempt to enhance differentiation and ultimately increase growth. ➤ The revolution in information technology has led many firms to explore opportunities to optimize their knowledge capabilities—the very capabilities behind a company’s capacity to innovate. The exploration opportunities do not limit themselves to a specific industry or market but potentially extend along the value chain or in parallel value chains. ➤ Thanks to low interaction costs, firms can achieve higher levels of effectiveness, efficiency, speed, fit, and uniqueness, which are all drivers of knowledge capabilities.

8

Chapter

Capability Recombination Creating a Killer Lineup

When does the sum of the parts equal more than the whole? We argue that this is the case when companies grasp the tremendous opportunity emerging from their individual capabilities. This is also true when several world-class entities look along the value chain and combine the best of their abilities to create sustainable, disproportionate value. While many companies already package related products and services together, this concept goes far beyond that. It’s about companies that recombine the capability they excel at with the star capabilities of other companies (within an industry or across several) to create new competitive goods or services—and dominate their value chains. In this chapter we: ➤ Examine the characteristics of “recombination” at the capability level and explain how it differs from the current practice of selling related products and services together ➤ Look at the different forms of capability recombination: ➤ Its aim can be to create better products and services, or entirely new products and services

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➤ It can be accomplished through supplier-customer relationships, or through exclusive link-ups between companies ➤ Take you through the two major steps involved in recombining capabilities: determining which capabilities are candidates for recombination based on their contribution to output, and assessing the requirements of the recombination ➤ Discuss the implications that new forms of recombination at the capability level have on old business definitions and strategies

■ TRADITIONAL PACKAGING: THE TOTAL EXPERIENCE Over the past few years, companies have responded to the challenges of the product life cycle by bundling an array of services together with their traditional product offerings. While this clustering of products and services does open up new markets for companies, recombination at the business capability level can be an even more powerful strategy, and certainly creates a whole new playing field from which advantage can be taken. (We will explain the differences between traditional packaging of products and services and the newer concept of recombination in a moment.) Recombination of business capabilities beyond company boundaries offers businesses the potential to generate sustainable value by differentiating the venture and making it difficult to replicate, and often also by increasing switching costs. To explain what’s new about recombination, let’s look first at some traditional examples of packaging products and services. Many firms discovered that if you bundled complementary goods and services, provided that they were already successful in their own right, the result would

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be an offering that would be more attractive than the sum of all parts. The bundling tactic has proven less successful as a means of making mediocre products and services more competitive. This means that if none of the components of the combined offering is really desirable on its own, it will be more difficult to create a sustainable competitive advantage through the bundling efforts. Financial services firms have enjoyed considerable success in bundling products and services to gain an edge over their competitors. As a diversified services, technology, and manufacturing company, General Electric is a classic example (see sidebar: “Bundling Versus Recombination: Where Does GE Fit In?”). In fact, GE created its financial services arm to allow customers to buy GE’s large industrial products. Today, the GE Financial Network family of companies offers a wide range of products and services to meet the financial needs of its customers: mortgages, mutual funds, dental plans, credit cards, and financial training, to name a few. More widely, large nontraditional players in many sectors have taken advantage of their strong brand names and relationships with their customers to enter the financial services arena. Increasingly, large retail chain stores are entering the business of personal financial services. British retail store chains Sainsbury and Tesco have allied themselves with financial services providers. Boots, a large medical retail chain in the United Kingdom, has started its own bank and insurance company. This trend extends far beyond retail. British Airways recently teamed up with Royal Bank of Canada to offer banking services to its globetrotting high fliers, and BMW started its own bank to provide financing and insurance for every BMW car sold. Sony of Japan has applied for a banking license as well, while Ford Motors announced recently that it was establishing “private label financing” for brands such as Land Rover, Jaguar, and Mazda in an effort to expand its financial services operations. All of these examples illustrate how companies are increasingly

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Bundling Versus Recombination: Where Does GE Fit In? It’s easy enough to say that the business world is gradually disaggregating toward the capability level and cite plenty of examples to support the claim. It is much harder to assess whether a highly successful company like GE bucks the trend. As GE links with one company after another, it shows few signs of disaggregation. Yet GE’s success can be at least partly attributed to the practice of bundling, which is the business unit level variant of capability recombination. Look at GE’s incredible performance in the stock market, and two drivers become apparent. GE has an exceptionally strong culture backed by values that include a passion for quality through the six sigma program and a thirst for embracing change as an improvement opportunity rather than a threat. Companies under the GE umbrella refuse to accept third or fourth place in an industry. Leaders push relentlessly until they have achieved industry leadership, and use the position to leverage strengths even further. It is no surprise that the stock market loves such practices. After all, growth and the creation of barriers to competition are powerful drivers of shareholder value. One powerful tactic GE employs can be termed product and service bundling. A simple principle guides many acquisitions by GE: The acquired party must demonstrate some fit with a current GE product or service offering. GE has, for instance, acquired several companies operating in the medical industry. Rather than defining their markets restrictively (as medical imaging devices or patient recordkeeping software), it sees the entire spectrum of goods and services required by medical care suppliers as a single market and carefully assembles an entire suite of products and service offerings. Mediocre players could employ such tactics to compensate for competitive deficiencies in one or more of their businesses. But when industry leaders use this strategy, the combination can become very powerful. Not only will customers get the best product and service propositions in the different fields, they get them from a single company that


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also combines the strengths of the different component businesses. Competitors face a formidable challenge. Copying GE will not be easy. In many industries, the company has a head start in assembling a best-in-class portfolio of businesses. Becoming the best player in a single market has also become more challenging. Being the best in a specific product or service market is no longer enough; a company must now also battle the perceived benefit of providing an entire suite of complementary products and services. A customer will often be inclined to use GE financing for an aircraft engine unless the non-GE financing service is demonstrably better. Since GE can bundle its aircraft engines, its maintenance services, and its financing services into selling hours of thrust, for instance, its offering is tough to beat. Does this mean that GE’s competitors face an endless uphill battle? Not necessarily. First, GE’s bundling success was established when bundling products and services for the customer saved a considerable amount on interaction costs. As these expenses fall and markets for GE’s products and services become more transparent, it will be easier for customers to put together their own preferred combinations. This means that although it might be convenient to use one integrated supplier, the need to do so will gradually lessen. Cost and effort will no longer deter a customer from using an alternative supplier for a specific piece of what once was a package. Financing services, for instance, have become considerably more accessible as information on performance and risks becomes more sophisticated. The in-house advantage erodes. Just as with business capabilities contributing to a specific business unit output, all elements in the bundled product or service offering must become world-class to fend off substitution by rivals. For GE, this means redoubling its emphasis on its corporate values to ensure that all its businesses become dominant players in their fields. In addition, competitors have new entrée into very specific and more sophisticated partnerships without incurring prohibitive partnership management costs. Bundled product and service offerings can be created without

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acquiring entire companies or business units. The less time a company spends on acquisitions, the more time it can devote to making the bundled product or service offering work for its targeted customers. Corporate matchmaking will shift from the business level to that of product and service offerings, offering companies far greater options for successful combinations. Potential GE competitors can also take heart in the notion that bundling entire businesses or business units can increasingly be complemented (or if not done carefully, undermined) by capability recombination. Since the typical merger involves putting together entire sets of business capabilities, which are not necessarily all complementary, even GE faces the struggle of integrating them all. Companies that recombine at the capability level can avoid the integration hassle of business units altogether. When there is an opportunity for effective capability recombination, a strong unbundling force will be the result. After all, customers will increasingly desire a more “menu-driven” approach for their goods and services if they know that other sources provide better value for certain parts of a package. The dynamics of bundling and capability recombination are similar. Companies operating in industries where GE is pursuing a bundling strategy can consider emulating GE. They might, however, be more effective if they recombine capabilities to create “bundle breakers.” We’re talking about businesses with such a substantial competitive edge that customers cannot ignore the benefits, or about specific partnerships that offer specific groups of customers something so targeted that GE cannot follow suit because it serves the interests of a broader business segment. Recent history offers a highly practical reason why capability recombination beats bundling. In July 2001, the European Commission blocked GE from acquiring Honeywell, precisely because it feared that by bundling together engines, electrical components, and trade financing, the firm would increasingly dominate the aircraft-manufacturing business. Providing discounts to customers that bought a package of components and services, the commission argued, would yield an unfair advantage to a merged GEHoneywell over competitors offering unbundled products.


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Antitrust barriers can be an even more powerful argument against bundling via acquisitions than synergy concerns or partnership management costs. Whether proven or not, the economic argument against bundling—first used by the American Supreme Court in the 1940s1—exists and will likely be used against mergers again. Recombining strategies at the capability level spares companies from such regulatory pressures. Would a recombination of bestin-class capabilities with Honeywell—perhaps more clearly benefiting the customer—have received as much attention from the antitrust authorities? Of course, GE won’t wait to be steamrollered. It will constantly be on the lookout for potential bundle breakers through initiatives such as DestroyYourBusiness.com and will create ever more focused product and service offerings. Most important, however, GE is continuously nurturing and pushing its dominant genes so that they top the list in any bundling activity. It is also likely that the company will gradually adjust its definition of a gene from a business to an individual business capability—which might also preclude further run-ins with Brussels. Perhaps if capability thinking had been recognized and accepted a few years ago, Jack Welsh would have postponed his retirement.

packaging services with their traditional product offerings based on customer needs and capitalizing on the cachet of their brand to do so. Companies are increasingly packaging services with their traditional product offerings based on customer needs and capitalizing on the cachet of their brand to do so. With the advent of telematics—the automotive computer systems that combine wireless communications with global positioning technology—the automotive industry is also experiencing its share of product and service cluster-

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ing. General Motors began the telematics age in 1996 when it formed OnStar to offer safety services to owners of luxury vehicles for a monthly fee. A few years later, GM announced that its OnStar system would be factory installed in 1 million of its vehicles; Mercedes-Benz and Ford’s Lincoln soon followed suit with similar systems. Drivers of GM cars can now communicate with OnStar staff anytime over a dedicated cellular network using a hands-free microphone and three-button system. With the premium service package, drivers get unlimited emergency assistance (summoned by air bag deployment), theft notification, remote door unlock, route planning, and other services. This suite of services, powered by wireless communications, global positioning systems (GPS), and onboard electronics, represents an entirely new source of revenue for automobile manufacturers.2 In fact, the service can represent a significant part of the total profit made on the sale of the car. Whether we’re talking about financial services providers teaming up with airlines, or high-tech start-ups cozying up to the large automobile giants, the key common element is the packaging of goods and services together to give the product a competitive nudge as it reaches maturity in its life cycle. The concept of shifting product value can alter the balance of power in the value chain (as is shown in the next section), but a business capability level focus and lower interaction costs introduce completely new forms of recombination beyond this packaging.

■ CAPABILITY RECOMBINATION: LINING UP THE BEST OF THE BREED Capability recombination comes in different forms. The most basic type involves lining up a set of best available capabilities to create a superior end result. Recombination of capabilities can have either of the following objectives:


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➤ Creating better products and services ➤ Creating new products and services Another way to distinguish between different forms of capability recombination is to consider the exclusivity of capabilities involved in the recombination. When suppliers sell a good or service to customers, which use it to create better products and services, the relationships involved are often not exclusive. Any company that wants to use the output of the capability can do so, provided it is willing to pay the price. There are also recombinations in which two or more companies link together exclusively in such a way that the fortunes of all parties ride on the success of the recombination’s collective output. We’ll share several examples that highlight these differences.

➤ Creating a Better Experience Recombination to create a better product or service is prevalent in markets that have both a significant high-end segment and a type of product or service that can carry substantial price premiums. In such cases, the effort involved in recombination can pay off, even when transaction costs are still to be reckoned with. Consider, for instance, the outdoor sports and leisure gear industry. W.L. Gore & Associates invented a membrane several decades ago with micropores that keep moisture out, but let air through. The membranes can be laminated onto material and used to produce foul-weather gear like waterproof pants and jackets that don’t have that dreaded clammy feeling. The membranes have become known under their own brand, Gore-Tex. Many well-known brands of outdoor garments, such as The North Face, Berghaus, and Mammut, incorporate Gore-Tex in their ranges, creating a dual-branded, highly desirable proposition for their customers. Hiking boots represent another great example of multiple recombination to create the best proposition for

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consumers. Many decades ago, an Italian mountain climber started to develop soles for mountain boots after several people died in an alpine accident at least partly attributable to poor equipment and footwear. The soles Vitale Bramani created have gradually evolved into the de facto standard in mountain climbing. Every self-respecting mountaineer about to cross a glacier or leave the tree line well behind is highly likely to choose mountain boots equipped with Vibram soles. Interestingly enough, companies such as Meindl and Lowa, both manufacturers of hiking and mountain boots, offer products that combine their own shoe design and manufacturing prowess with the superior Vibram soles and even a Gore-Tex lining to make the shoes waterproof and comfortable at the same time, by allowing them to breathe. Vibram S.p.A. Italy is following capability strategies in more ways than one. Not only does the firm specialize and excel in a single component, which it sells to many different shoe manufacturers, it also exploits its leadership by licensing the Vibram brand and technology to the Quabaug Corporation, which exclusively serves the needs of the American market. Such combinations of capabilities create a superior product for the consumer, but their only exclusivity lies in the fact that both the Vibram soles and the Gore-Tex fabrics are quite expensive, certainly when matched with the best branded outdoor gear manufacturers can put together. Arguably, the relationship between W.L. Gore and Vibram and their customers is similar to the relationship Intel has with the major personal computer manufacturers. Exclusive recombinations could be seen as a step up from the preceding examples. These recombinations require stronger strategic alignment, and importantly, a higher degree of discipline from the different partners. Unsurprisingly, there are fewer of them—again, mainly in high-end markets with premium potential. The expectation is that as interaction costs fall, that other segments and markets will have to follow suit to remain competitive.


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A common practice in several consumer industries is to create high-end product ranges in some sort of partnership or recombination of capabilities. In domestic appliances, the high-end range can be designed by a specialized firm and the highly aesthetic stainless steel housing manufactured by a specialized firm. The functional parts, assembly, sales, and distribution can be handled by the domestic appliances firm that also handles the mid- to low-end ranges. Siemens has Porsche-designed stainless steel coffee makers and water kettles. They certainly look the part, and they benefit from the unique Porsche design and brand image. Such practices can also be found in exclusive car segments. Companies like BMW and Alpina, and Mercedes and AMG, have long-standing working relationships to take the already-exclusive cars produced by BMW and Mercedes one step further in terms of performance and looks.

➤ Creating a New Experience Here’s another variation on the theme: Recombining business capabilities along the value chain creates a unique product or service that previously did not exist. When two or more companies put together their differentiating genes, they can create disproportionate value by offering something new or better to the market. This is exactly what home appliance maker Whirlpool is attempting to do by allying with Procter & Gamble in a recent deal to roll out the Personal Valet, a cabinet-sized clothes refresher made by Whirlpool that removes odors and wrinkles using a chemical formula developed by P&G.3 When Whirlpool first recognized the market need for ironing solutions (to reduce dry cleaning bills and to develop an alternative to the ironing chore), its engineers built a simple prototype of the Valet. But Whirlpool soon realized that it could achieve greater competitive advantage by venturing beyond company boundaries. Whirlpool approached P&G, which was creating a product to remove odors from fabric and refresh dry-clean-only clothes. In the

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end, the two companies joined their development capabilities. P&G contributed its new clothes-freshening formula, and Whirlpool its home appliance and ability to distribute the chemical evenly. In this recombination, the companies create a new product with a unique value proposition for the market. It’s a great idea, but success is not a given. Will customers accept this high-margin machine that requires a significant change in customer habits? And is the venture a distracting detour, as some analysts have suggested?4 We would argue that this recombination of knowledge capabilities is far from a distraction. After all, it capitalizes on what both companies do best—in other words, on their differentiating capabilities. The second characteristic of recombination at the capability level is that company or industry barriers do not limit the possibilities. We’ve mentioned that the Coca-Cola Company strives not only to optimize its brand as a single capability, but also to create winning combinations with other companies. One example is its deal to brand Coke’s Minute Maid drinks with Disney characters to leverage its strengths in noncarbonated drinks through a proposition appealing to younger age groups. Coca-Cola embarked on similar efforts by creating a new company with Nestlé to chase market share in readyto-drink tea and coffee and by considering a joint venture with P&G (which eventually unraveled) to market juices and snacks. From the volume-focused strategy of the past, in which distribution was the key driver (ensuring “a Coke within reach” of every thirsty customer), Coca-Cola is seeking new growth avenues by building new, niche-oriented value propositions with other capability providers. In these instances, Coca-Cola is able to create a differentiating new venture by aligning its strongest capabilities with those of its partners—and this greatly enhances the value proposition and growth potential of everyone involved. In the P&G example, the two food and drink giants were originally looking to become global leaders in non-


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carbonated drinks and snacks. Coca-Cola would have brought its know-how in worldwide distribution, merchandising, and customer marketing of noncarbonated beverages (a rapidly growing business) to the table, and P&G its research and development skills related to healthconscious trends. Another P&G effort involves licensing deals to move brands into new territory—without investing in production. The company licensed the Cover Girl brand to Marcolin for eyewear. It also bought Jean Patou perfumes and signed a licensing agreement with Chemise Lacoste to sell its perfumes and beauty products. Procter & Gamble has projected that its licensing deal flow will rise by about 30 percent, with revenue per transaction increasing by 50 percent, over the next 4 years. Another example of cross-industry recombination can be found in a business that already functions in a modular fashion: the apparel industry. Following Ralph Lauren’s lead, Benetton, the clothing company famous for its outrageous advertising, has branched out into ultrahip paints. Its Paint Colors and Effect Finishes range is aimed at fashion-conscious homemakers who like to change the colors on their walls nearly as often as the contents of their wardrobes. Benetton transferred the denim from our legs onto our walls when it teamed up with Imagica, a United Kingdom–based supplier of architectural coatings. Imagica has been looking to expand its product lines with extended color options and unique features to woo the growing number of female shoppers who are looking for specific color tones. In this venture, Benetton (recognized for its textures and colors) recombines its branding and marketing capabilities with Imagica’s paint fabrication expertise to create a unique output of colors and effect finishes. Needless to say, the combination really stands out in contrast with traditional paint offerings on the displays in do-it-yourself stores. Another characteristic of recombination at the capability level is that it takes place along the value chain.

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Rather than aiming to maximize the contribution of a single capability, recombination puts together the best of what companies have to offer at any point in the value chain for a more competitive end result. Reorganizing to improve collaboration, a trend that is under way in a number of technologically advanced industries, is an example of recombination. In the pharmaceutical industry, small research institutes and biotech firms have captured increasing responsibility for the research function. To capitalize on promising technology and the best assets of the nimbler small firms and to speed development, large pharmaceuticals have scrambled to recombine their strong branding and marketing expertise with the skills of key partners that are taking over parts of the value chain. Eli Lilly, for instance, espouses a strategy of “discovery without walls.” The company has formed several dozen research alliances with a wide variety of biotech firms, ranging from start-ups to more established companies. At the same time, the traditional companies are leveraging their own strengths: Merck has innumerable licensing agreements, as well as arrangements to manufacture, market, and sell pharmaceuticals for smaller companies. (See chapter 9 for a discussion of the emergence of value networks in biopharmaceuticals.)

■ RECOMBINATION: THE HOW-TO MANUAL Recombining one company’s best-in-class capabilities with another’s can potentially create disproportionate value for all involved. But not all capabilities are candidates for recombination; the best suited are those that significantly contribute to the output a value chain produces. Whether they excel at branding, product design, product development, or assortment capabilities, the Coca-Colas and Mercks of the world all display different “genetic predispo-


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The Recombination Trigger: Standardization Recombination has long been possible at a limited level, but the dramatic drop in interaction costs makes it possible for this concept to really take off. Businesses can now recombine their capabilities more easily, and in totally new ways. One key contributor to falling interaction costs is standardization, which brings cross-industry and cross–value chain collaborative design to a new level. Think of two people communicating: They (ideally) talk to each other in the same language. The same concept holds true for business processes: The only way for ERP systems or design processes, for instance, to talk to one another is with the help of a predefined “translation” or, even better, through a commonly available language. Extensible markup language (XML), a system for organizing and tagging elements of a Web document, has become a de facto standard in the Internet world for conducting transactions and exchanging information. Imagine the opportunities when an XML-type standardization takes off in architectural, engineering, and construction companies and introduces the ability to manage the whole process from conception and design to a building’s commission.

sitions” toward recombination. These companies have identified their differentiating capabilities and worked beyond company boundaries to push them to their limits. A successful recombination at the capability level entails determining where the value lies in the value chain and which differentiating genes (which have a natural tendency to shift over time) have the most impact on output. We need some sort of framework to address this task effectively. As we’ve mentioned before, companies are increasingly focusing not on the physical product itself, but on the whole package of activities involved in transferring that product to the consumer in the appropriate manner. Our A.T. Kearney colleague Pieter Klapwijk, in his work on global economic networks, put it this way: “A complete

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Invariable

Tangible

Intangible

Variable

What it does

How it gets to you

• Technical specifications

• Right time, place, and quantity

What it identifies with

How it is transferred

• Brand image

• Transaction location and environment

The product value matrix provides a framework for classifying the different value attributes of products and services.

Figure 8.1. Product Value Matrix Source: A.T. Kearney.

picture of product value includes production, marketing, distribution, retailing and services.”5 In other words, all capabilities in the value chain contribute in some way, shape, or form to the value of the offering to the customer. Companies should therefore consider all of these aspects of their business when trying to determine their differentiating capabilities. For these purposes, the product value matrix (PVM) is a useful framework for discussing the different value attributes of a product (see Figure 8.1).6 Each quadrant of the matrix describes a fundamental attribute of product value. Two attributes are related to the product itself. The technical specifications determine its functional benefit, or what the product does. The product’s emotional benefit refers to its contribution to the identity or image of the owner, such as status or a particular lifestyle, as the result of branding and other marketing tools. The other two value attributes relate to how the consumer buys the product. One is the availability of the product within the right time frame and in the right quantity—a conse-


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quence of good distribution and logistics. The other is the environment and ease of the transaction, or where and how easily the purchase takes place. This matrix can help determine a company’s recombination agenda because it provides a grouping framework for many of the capabilities in the value chain and a guide toward defining the different “businesses” a company can be involved in. For instance, the business of providing a positive buying experience typically occupies the bottom right quadrant, and involves such capabilities as maintaining the buying environment, which can fall anywhere on the spectrum from a physical location (such as a shop or wholesaler desk) to a Web site. The business of translating customer requirements into product and service specifications also takes up the bottom right quadrant for products and services further along in their life cycles. For new products and services, though, the translation capability will fall closer to the top left quadrant due to the importance of product specification. Not surprisingly, the manufacturer’s domain is in the left quadrants, while the typical retailer and wholesaler are more to the right. The life cycle determines which party can best help the customer translate its need into a concrete product or service specification (see also Figure 8.2). Usually, one company does not produce all the value attributes of a product, and the different players (such as manufacturers, retailers, and logistics providers) vie for power in the value chain. The end customer’s preferences determine which value attribute dominates (or which capability differentiates). Over time, the dominating gene tends to shift from the technical specifications to the quality of logistics, and finally to the end service. To use Klapwijk’s example, when the first video recorders came out, the functional benefit of the recorder constituted the main part of the value proposition. Now that video recorders have become commodities to the average consumer in the Western world—offering similar technical specifications— consumers’ preferences have shifted to the right side of the


Value

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Manufacturer power

Growth

Retailer/ wholesaler power

Maturation

Decline

Time

What it does

What it identifies with

How it is transferred

Technology development, component development, product development, component manufacturing, product assembly, testing, application knowledge, customer requirement translation

Brand development, product design, application design, market intelligence

Retail brand development, commercial assortment, buying environment provision, customer requirement translation, order intake, invoicing, payment facilitation, order status information

How it gets to you Warehousing, distribution, fine distribution, order picking, packaging, shelf positioning

Different attributes, and therefore different capabilities, are important depending on where a product (or service) is in its life cycle. Generally speaking, the life cycle starts with what the product does and can end in how it is transferred.

Figure 8.2. Product Life Cycle and Relative Capability Importance Source: A.T. Kearney.

product value matrix. An extended warranty plan or attractive financing options will generally matter more than the recorder’s features. The shifting nature of the differentiating gene extends far beyond retail. Consider, for instance, the evolution of value in the computer industry. Ten years ago, it resided in putting the parts together (which set Compaq apart from the crowd); now it centers on how well a company manages the supply chain (the source of Dell’s competitive advantage). The differentiating gene is shifting in the pharmaceutical industry as well. Several years ago, patent holders (in most cases, large pharmaceuticals) ruled the value chain; today power has shifted to researchers. The process of obtaining a patent is changing as industry leaders combine capabilities with biotechnology firms and increasingly rely on them for research and development. The competitive requirement dictating whether to optimize individual capabilities or to recombine with others is highly


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dynamic—a company needs to frequently reassess the appropriate strategies to pursue. To make matters even more complicated, many companies are often involved in several subbusinesses with very different capability needs because they are at different stages of the product or service life cycle. This often means that a company will have to simultaneously manage both a commodity business (in which the power resides largely with the retailer or wholesaler) and more early life cycle products for which the manufacturers are still well in control. Not only will this produce tension in the customer relationship, it will also create very different partnership needs and capability priorities. Significant business risk can result from insufficiently addressing these different capability needs, especially as competitive advantage is increasingly determined at the capability level.

■ CAPABILITY RECOMBINATION REQUIREMENTS One observation derives from the preceding picture: It is unnecessary for one company to excel at all four quadrants. On the contrary, a company is better off identifying and fostering (through optimization or recombination) those capabilities at which it excels. It should take into account how the customer feels about different attributes. If a capability no longer contributes significantly to the output and ceases to matter to the consumer, the company must release it—by outsourcing, insourcing, or carving out whole departments. Naturally, this also affects any recombination strategies the company pursues with others. Nike would find little value in recombining its rubber R&D capabilities with best-in-class textile manufacturers if all the customer cares about is the Nike “swoosh.” Finally, companies are free to decide whether to become best in class in one capability or to focus on aligning

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a best-in-class set of capabilities—but each business exhibits its own genetic preference. There is huge value in becoming a Cisco-like orchestrator—if coordination happens to be both an important capability in your output and a significant source of value in the industry. But be attentive to changes in the competitive environment and wary of getting too comfortable in the integrator role: The value of a capability recombination can erode over time as products mature and new technology hits the market. Companies are free to decide whether to become best in class in one capability or to focus on aligning a best-in-class set of capabilities—but each business exhibits its own genetic preference.

■ “ASSETLESS” MERGERS Whether they create clusters (such as the design function in the automotive industry) or new ventures (such as the Whirlpool/P&G Personal Valet), companies now have alternatives to traditional mergers and acquisitions. Instead of merging or acquiring entire businesses, companies can now opt to merge or pool selected capabilities to go after synergies or improved competitiveness in a very focused manner. Such capability recombination is akin to an “assetless” merger, freeing companies from the pitfalls of costly corporate marriages, which until now had been the predominant means of acquiring or finding synergies with other companies’ capabilities. We expect to see a wave of new ventures constructed around best-in-class capabilities as an alternative to mergers and their inherent risks (see sidebar: “New Views on the Successes and Failures of M&A Activities”). Although it exposes companies to far fewer risks than traditional mergers, recombination requires a certain


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amount of synergy between partners. First, aligning bestin-class capabilities to create a “virtual value chain” that creates competitive output works best in an environment of trust. Flexibility works in an alliance; constant changing of the rules on either side does not. Most important, however, is the need to be able to create a new and independent business model for the capability recombination, with as few links to the existing business as possible. If the benefits of a capability recombination will come in the form of increased volumes in existing businesses, for instance, there will be a serious risk that the businesses of the different partners will not develop equally well, which might quickly lead to tensions in the alliance. On the other hand, a business model that is independent from existing business (for instance, one in which benefits are generated inside the capability recombination) offers potential for a more robust alliance. In addition, there must be fit between the partners with respect to scale and scope. Venturing benefits and profit sharing are often built into recombination strategies: CocaCola can, for instance, negotiate a share from each Disney character drink sold because each party is contributing equally. On the other hand, Coca-Cola came close to handing over some of its most promising brands to a joint venture with Procter & Gamble—but then reconsidered in light of inequities in the performance of the brands involved. Coke’s Minute Maid grew more than 10 percent in the first quarter of 2001, while Sunny Delight sales fell by about the same amount.8 In the same vein, Procter & Gamble might find it difficult to request an equity participation in each Personal Valet unit sold if the amount of its clothes-freshening formula used is insignificant compared to the price of each unit sold.

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New Views on the Successes and Failures of M&A Activities Research conducted by A.T. Kearney has found that many newly merged companies fail to live up to initial expectations: Only 42 percent of mergers create substantial returns for shareholders, and 58 percent actually destroy value.7 Not only do they miss the mark when it comes to increasing shareholder value, in some cases mergers actually hurt shareholders. After 3 years, profitability of new companies drops on average by 10 percent. Within 4 years, 50 percent of all alliances in the United States are deemed failures. Although not all mergers fail (some in the study increased shareholder wealth by 25 percent), the research ties success to factors that can be difficult to achieve—such as experience gained from previous mergers. Flaws in the strategic assumptions leading up to the merger play an important, although not dominant, role in failures. If we look at mergers from a capability perspective, we gain new insights as to why some work better than others. The major difficulty in classic merger and acquisition (M&A) activity is that it often involves merging entire businesses—or in other words, it brings together two complete sets of capabilities (see Figure 8.3). This notion alone creates the suspicion that merger partners probably couldn’t complement each other in all capabilities. It is also highly unlikely that simply putting the different capabilities together can move them meaningfully toward the desired endgame. In reality, mergers are meant to make the most of a small subset of capabilities. The gains in the leading capability postmerger are expected to outweigh the negative effect on others. In many instances, companies display a bias toward business capabilities that put a large claim on capital employed. The urge to optimize these capabilities is often strong—and unfortunately diverts attention away from maximizing competitive advantage via knowledge capabilities, which often are less capital intensive. The transformation required to consummate an asset-intensive merger is often considerable, involving physical assets and many personnel. Knowledge capabilities can be put together more nimbly and flexibly, and therefore hasten the journey to increased competitiveness.


Business optimization in the traditional economy

Design/ development

Assortment

Design/ development

Branding

Assortment

Branding

M&A Process control


Process control



Product assembly


Product assembly

Business definitions and optimization in the new economy Design/development

Application 1

Application 2


Assortment

Branding

Commodity-type products


Segment 1

Segment 2

Product assembly

Insource 3rd party

Ordering, invoicing, inventory management

Old manufacturer

Component categories

Finished products network

New business alliance partners

Traditionally, merger and acquisition activity involved entire businesses or business units. Increasingly, focused M&A activities can take place at the capability level, creating synergies where they add value and avoiding integration that does not.

Figure 8.3. M&A at the Capability Level Source: A.T. Kearney.

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■ NEW BUSINESS SEGMENTATION If business output becomes the result of capability combinations, we face profound changes in how we should define business segments. Rather than relying on dimensions such as customers, geography, and products, we now also need to consider different combinations of required capabilities as sources of segmentation and drivers for business structures. The needs of these different combinations of capabilities are fundamentally different. The contact lens business represents a good example. Today, we can identify two types of contact lens businesses. One is the traditional model, where a professional measures the patient’s eyes and then sells him or her the appropriate lenses. The much newer type sells contact lenses according to the specifications (including brand and prescription) provided by the patient. The former business requires a measuring and examining capability; the latter does not. This does not change a thing in terms of contact lens need, spending power, geographic lens-wearing spread, users’ preference over glasses, and other typical market considerations. But it does create a powerful opportunity to segment from a capability standpoint as the additional costs of the measuring and examining capability will have to be recouped. If the competitiveness of a capability recombination lies in making the most of its individual capabilities, a business boundary will emerge where one capability trades places with another. This becomes especially relevant when the individual contributing capabilities have different owners, since new businesses are effectively created.


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■ CONCLUSION ➤ By recombining key capabilities, businesses can create new and more competitive output, enabling them to extract disproportionate value from the market. ➤ Recombination of business capabilities can take several forms: ➤ It can be aimed at creating better products and services, or entirely new products and services ➤ It can be achieved through supplier-customer relationships, or through exclusive link-ups between companies ➤ The most far-reaching recombinations share the following characteristics: They create unique output that previously did not exist; they are confined by neither company nor industry barriers; they are exclusive (which makes the venture difficult to replicate); and they take place along the value chain (rather than around a single capability). ➤ Not all capabilities make good candidates for recombination. The relative power in the value chain determines which capabilities are best suited to recombination strategies.

9

Chapter

Industries Transformed Take the challenges of fending off the emerging competition in one capability, and multiply those by the number of capabilities in your industry. Do you sense the potential for a revolution? In this chapter, we look more closely at how entire industries are changing as businesses take on a capability perspective. Any company that wants to see how capability thinking affects its business can begin by exploring industry dynamics at a high level. From this exercise, most senior executives will quickly recognize the importance of looking at their companies as a set of fundamental capabilities in a systematic and rigorous way. In this chapter, we present our views on how a business capability approach is emerging in five industries and what this means for companies’ corporate genomes. We’ll take you through the following trends: ➤ The breakup of the insurance industry value chain ➤ New business definitions in the upstream oil and gas industry ➤ Supply chain optimization in the fast-moving consumer goods industry ➤ Value networks in the biopharmaceutical industry ➤ Contract manufacturing in the electronics industry

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In each of these, pressures are building that are sparking profound change as organizations focus on very specific aspects of their businesses.

■ BREAKUP OF THE INSURANCE INDUSTRY VALUE CHAIN Many insurance companies, from life to liability, have experienced firsthand what lower interaction costs can do to an industry. Because the insurance business is fairly information intensive, virtually all of its processes are affected by lower interaction costs and the introduction of the Internet. Companies will witness significant change whether they operate through distributors or as direct insurers. Case in point: Consumers are increasingly searching for information on insurance products on the Internet. They can turn to sites such as Insweb.com or Quotesmith. com for background on different insurance products— and to quickly compare the products and prices of different insurance companies. Recent research1 indicates that for every 10 percent increase in the use of the Net in a particular population, prices erode by as much as 5 percent. Clearly, the migration to the Web does not instantly translate to newfound riches. But comparison Web sites are not alone in reshaping the insurance industry. Insurers are also addressing how the Internet can enhance the information exchange between the company and its customers, for instance by letting the customer, rather than the employees of the insurance company, do most of the data entry. Many are reducing claims-related expenses by virtually pooling and leveraging their buying power. Auto repair networks represent one of the most common examples. Although the endgames for various sectors of the insurance industry are not fully clear, we do know that they will operate at far lower cost levels than today as “e” transforms

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many of the core processes in the insurance industry. The insurance value chain is beginning to break up. Most insurers, acknowledging the need to adapt, have embarked on transformation journeys whose destinations are not yet fully determined. A capability perspective on the insurance business can be helpful in assessing the specific strategic challenges and possible endgames for key parts of the business. Although we won’t presume to predict the next-generation insurance business model with great accuracy, these capability discussions can provide the building blocks for setting the strategy. The typical insurance company is involved in the following activities: ➤ Branding ➤ Customer need translation (helping customers choose what they need) ➤ Assortment ➤ Product development ➤ Underwriting ➤ Policy administration (including risk analysis, pricing, and maintenance) ➤ Claims administration ➤ Claims settlement This list is not complete, but it provides a good starting point for exploring the new strategic options available to an integrated insurance company now that interaction costs have dropped dramatically. Let’s look at possibilities for some of the more important capabilities.

➤ Policy Administration As an information-intensive aspect of the business, the insurance company back office will clearly be affected by

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falling interaction costs. Think of the activities involved: They range from capturing information on the customer to providing quotes to sending policy renewal notices. Whether or not an agent is part of the process, myriad forms shuttle back and forth and data is entered and often reentered. The high degree of manual work involved has meant that the costs of the policy administration process were relatively variable: More policies required more employees to handle the flow of information. Although there were IT system investments to be made, they would still be considerably less than the costs associated with handling the flow of information. All this will change radically if the process is truly Webenabled, or in fact becomes Web-based. The customer will capture a great deal of the data and drive most of the administration process. The relative amount of fixed versus variable costs in the administrative process will rise as companies invest in the technology needed to transition toward the Web and the need for insurance company employees to process information declines. The policy administration process can then benefit from economies of scale. While in the traditional model smaller insurance companies could have their own back offices, the new economies of scale requirements will force them to search for such administrative services outside. They may turn to large insurers that can leverage size and investments even further and reduce costs. In the process, the large insurers will create additional business-to-business (B2B) revenues as they turn their capability into a business. Web enablement also facilitates virtual back offices by directing electronic information flows.

➤ Providing an Assortment of Products The rise of insurance comparison Web sites clearly demonstrates the fundamental changes in the way insurance products are offered. Assortments have been based on


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channels (for instance, they were tailored for use by agents or for direct sales to consumers), but are becoming more theme specific. Car insurance, second-hand car sales, and financing are increasingly offered together, and insurance for homes is offered along with property sales and mortgage offerings. Assortments are also becoming more focused on specific target customer groups, such as high net worth individuals, second-home owners, home office workers, and consultants. The transition from channel-focused assortments to a wider range of combinations based on target groups or themes is hardly surprising, since many insurance products cover things or events that are specific for different customer groups. The notion of defining an assortment of insurance products by the insurance company (or brand) that offers them is becoming increasingly outdated. Also driving this transition to theme or target group assortments is the reduction of geographic restrictions. Traditionally, insurance agents operated in a specific geography. No agent could become too focused or specialized, as that would mean quickly running out of target customers in the territory. Although these physical restrictions have not changed, new uses of information technology have made it possible to efficiently create and deliver to agents “virtual” specialization and product prepackaging. This way, the investments required to create a focused product offering can be leveraged over all the potential customers, rather than just those in a specific geography. The role of the agent will no doubt change in the coming years, as prepackaging of not only insurance products but also financial products will increase. Agents will still provide personal interaction and peace of mind for customers, but they will play a smaller role in product selection and adoption. Buyers are in luck: Products and services will be developed with a stronger focus on the particular needs of specific customer groupings. All this affects product development as well. Insurers

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will have to come up with new products quickly and cheaply, and the products must be easy to tailor in terms of pricing and selected special conditions.

➤ Customer Need Translation As the assortment dynamics change, so will the needs for translating customer requirements. Traditionally, customers have needed help in determining which products are most suitable for them since the products have traditionally been designed for distribution channels rather than specific groups. Given this fact, insurers often believed that products sold over the Web had to be simple and easy to understand. Now we see that the opposite is probably true: Complex products can likely be handled more cost-effectively by eliminating the human interface. Mistakes and misinterpretations, and the significant costs of correcting them, can be avoided. Of course, products will need to be more tailored toward specific customer groups or themes. Building more of the customer need translation services into the products themselves or adding automated self-help applications will not automatically eliminate the agent’s role in the value chain. Many customers will continue to appreciate personal contact. The value the agent adds in translating the actual customer requirement, however, will erode as the use of tailored products rises. Insurers often believed that products sold over the Web had to be simple and easy to understand. Now we see that the opposite is probably true. What will change is the ability to accommodate the compensation for the agents’ services in the price of the insurance product. As the market becomes more transparent and starts to make use of more prepackaged product and service offerings, the differences between the agent chan-


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nel and direct channels will become blurred, making price differences more conspicuous.

➤ Insurance Product Development Insurance product development will be affected by the requirements of other capabilities, such as assortment and back-office services. Both assortment and back office will increasingly require a larger scale product development effort. On one hand, the product basics will have to be modular enough to be aligned with a large-scale administration process that serves several insurers. On the other hand, assortment tailoring will have to be cost-effective. A modular product concept, together with sufficient scale, should make this possible.

➤ Claims Settlement As administrative processes become increasingly IT driven and product assortments are tailored toward specific customer profiles, new sources of differentiation will become critical. Claims settlement may be one. Many property and loss insurers are already leveraging purchasing power to simultaneously reduce claims expenses and increase the service provided to their customers. A customer who has a damaged car, for instance, often has to get the damage assessed, arrange the paperwork, obtain approval, and then have the car repaired. If, however, the insurance company refers the customer to a network of repair shops with which it has a volume deal instead of paying for the repair, the customer avoids the paperwork or hassle associated with the traditional process. Such an arrangement is inconceivable if the information exchange between insurance company and repair shop network cannot be handled effectively. Sufficient scale is also a requirement—insurers might pool repair volumes with selected partners, such as fleet owners. This activity can even be turned into a business in its own right. A

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large insurer with a good repair deal can decide to offer this service to smaller insurance companies to leverage its position even further and make a profit in the process. The latter will be a welcome addition, given the challenge of making a solid underwriting profit.

➤ Branding A brand is all about its effectiveness, or in other words, the sales or premium it commands relative to the investment made in it. In principle, it would be more logical to maintain two different brands with a different positioning than a single brand if this is more cost-effective. Stretching the single brand to the same volume as two individual brands might be more costly than maintaining two more focused brands. This means that insurance companies may be free to deploy brands as they require without the need to create duplicate back-office, underwriting, and product development operations. In fact, some insurance companies with strong brands but insufficient scale could focus entirely on exploiting their brand equity. Strong regional players, for instance, could buy back-office services from a large national player that acknowledges that building its own brand in that region would not be cost-effective.

➤ The New Insurance Business Models Given these considerations around individual business capabilities, we can draw some conclusions about business models. Policy administration services companies are emerging, offering their services to different insurance companies. In many cases, these companies are either carve-outs from the larger insurance companies able to make the necessary investments, or they are smaller insurance firms grabbing first-mover advantage. For more complicated products, a further evolution of this model could also be expected. Enter the white-label in-


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surer: a company that provides one-stop shopping to anybody with preferred access to groups of customers. A retail chain might want to leverage its shops and brand name by selling private-label insurance. It does not want to actually take on the risk, so it turns to white-label insurers that provide everything from product design to the complete administration and claims administration. It would, in turn, buy the services of a call center and claims fulfillment services company. The white-label insurer could even maintain a strategic sales and marketing group that sells the insurance services through assortment alliances. Products could be grouped by theme, by customer niches, or through comparison sites under the old brand. Clearly, a much broader mindset will be required when thinking about the new definition of an insurance company.

■ IS UPSTREAM OIL WHAT IT APPEARS TO BE? When most people think about major oil companies and their upstream (exploration and production) activities, they have a highly integrated image in their heads. This is understandable; much of our oil has typically come from hard-to-get-to places like scorching deserts or dense and inhospitable jungles. In the early oil days, such challenges were significant, and even production took place in what might be called “expedition” mode. The entire operation had to be self-supporting. Later, the major oil companies really gave meaning to the term vertically integrated by doing everything from searching for oil and gas to refining gasoline and selling it to consumers. At first sight, the oil companies’ journey to a capability-driven perspective looks to be a long one—but is it? If we begin a hypothetical stint on a drilling and production platform in the North Sea, we’ll see that the major oil companies have deployed

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capability thinking on a large scale and have created many new “service” industries in the process: It all starts at 6:20 a.m., when you take a private taxi to the helicopter terminal—there is no company transport. The helicopter flying you to the platform is from a large charter company that efficiently deploys helicopters across the entire North Sea. The medic who welcomes you on the platform and gives you your safety instruction, location of the muster points, and cabin assignment is from an agency. You dump your gear in your cabin and make your way over to the mess room, where a catering company provides four warm meals a day. You recognize the uniform the caterer is wearing: It is the same as that of the person you saw cleaning the corridor on your way up to the mess room. When you venture outside after donning your safety gear, you bump into quite a few people dressed in coveralls that do not match the company colors. They are from the maintenance and engineering company, which not only maintains the entire production installation on a contract basis, but also carries out the modifications to the gas compressor module now that it has completed the engineering design. Making your way to the drill floor, you confront yet another color of coveralls—this time from the drilling contractor, which provides the entire drilling crew on a time incentive contract. After returning to the safety of the drilling office, you review the binder of one of the first wells drilled from the platform about 14 years ago. On all the reports of measurements carried out in this well, the names of the two major well logging companies keep appearing, as well as the different names on the casing running report, the cementing reports, the drilling mud reports, and directional drilling reports. When you take out a more recent file, you find the same, except that many of the different companies now


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appear to be owned by either the drilling contractor or the major well logging company. Clearly, the major oil companies have turned many capabilities required in the exploration and production of oil into businesses in their own right over the past decades. This transition has been driven by several factors: ➤ An incredible range of different capabilities is required to find and produce oil, which creates a need to focus. ➤ Significant specialization, and therefore scale, is required for those capabilities. ➤ The size of the major oil company balance sheets requires a highly efficient and effective operation. The continued consolidation of oil companies over the past few decades appears to be driven primarily by the desire to run a more efficient operation. The major oil companies have devoted the lion’s share of their attention to owning and operating large, capital-intensive production assets and have outsourced most of the related capabilities. These two capabilities put a massive mark on an oil company, tying up most of the considerable capital on its balance sheet and keeping the majority of employees busy. Since a few points’ improvement in performance can represent significant value, the degree of attention the two capabilities get is logical. Scale and asset productivity (via the effective purchase and coordination of the required services) are strong drivers of success.

➤ The Real Upstream Oil Businesses When we step back and examine the major capabilities an upstream oil company is involved in, we find the following three businesses, the output of which is ultimately “sold” through the (share of) produced oil and gas:

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➤ Owning and operating production assets ➤ Trading exploration rights and concessions ➤ Maximizing reserves and reservoir yields Most oil companies recognize that the first two are businesses in their own right and have allowed them to develop different footprints. Many concessions have several different owners; one is usually appointed as the “operator” of the field in question. Some companies, such as Shell and ExxonMobil, have equal stakes in the businesses that develop and exploit the fields in the North Sea.

➤ The Next-Generation Oil Company? When it comes to maximizing (proven) reserves and reservoir yields, however, the freedom to develop this capability on its own has been elusive, creating the potential for a fundamental industry game change. Those in the industry may calculate this will happen “when hell freezes over,” but we don’t wait for prolonged periods of subfreezing temperatures before hearing us out on our capability argument. The capability of maximizing reserves and reservoir yields has effectively been split and integrally linked to the two other main capabilities. Maximizing proven reserves through exploration drilling and seismic surveys is an integral part of the exploration rights and concessionstrading business. Reservoir yield optimization over the lifetime of a field is often integrated in business units looking after those fields and operating the production assets. The oil companies optimize these capabilities by ensuring that knowledge is shared between the different fields, often by actively transferring people among operating units all over the world. For both the asset-operating business and the concessions business, the footprint can easily be established. An oil company might have, for instance, a global share in the rights to proven reserves, a global share in oil that it can


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sell, and a (probably larger) global share of operating fields since many national oil companies leave this to the majors. This is all very well, but what if those are not the most value-adding capabilities? What if maximizing reserves and reservoir yields actually contributes more? The graphs in Figure 9.1 show correlations between total shareholder returns and two factors: average reserves added per well drilled and total capital productivity. The first correlation is an expression of how well a company is able to find oil; the second, of how well it uses its capital. The graphs show a correlation between total shareholder returns and average reserves added per well and no correlation with total capital productivity. Statistics are often accused of being used to prove anything, but let’s assume that this finding is true. If it is, companies that limit their share of the reserve and reservoir yield maximization capability to that of the concessions business and assetoperating business leave a large potential source of value generation untapped. The real measure of effectiveness would instead be the share of the reserves and reservoirs for which we perform our maximization services. The only condition, of course, is the ability to define a satisfactory business model around this capability—an issue that is now implicitly addressed in that both subcapabilities are linked to the concessions portfolio and the involvement in operating fields. Several oil service industry companies have attempted to set up businesses that provide reserve and reservoir yield services. But the oil majors hold a huge knowledge advantage over the service industry. The abundance of data gathered over the entire lifetime of reservoirs, together with the wealth of information ranging from seismic profiles to production characteristics, provides an experience base that is essential to providing world-class reserve and reservoir yield services. Given this requirement for a critical mass of knowledge in both scale and scope, the lead time required to gather this information, and the likely deployment issues, it is

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Total shareholder returns

350%

R2 = 0.7777

300% 250% 200% 150% 100% 50% 0% 0

2,000

4,000

6,000

Average reserves added per well drilled Reserve additions per well drilled excluding purchases and sales1

Total shareholder returns

350%

R2 = 0.2048

300% 250% 200% 150% 100% 50% 0% 0%

50%

100%

150%

Gross total capacity productivity Total capacity productivity as sales/economic capital (%) 2

The correlation between total shareholder returns of oil companies and the average reserves added per well drilled is significantly better than the correlation between total shareholder returns and total capital productivity.

Figure 9.1. Oil Industry Value Drivers Notes:

1

Includes revisions, recovery, extensions, and discoveries. Economic capital is the sum of property, plant, and equipment (PP&E), working capital, and other capital. Other capital is primarily capitalization of unsuccessful exploration and development (dry hole costs). Peer group includes: ARCO, BP, Exxon, Royal Dutch/Shell, Texaco, Phillips, Chevron, and Amoco. Sources: 1999 company financial statements; Compustat; US Oil & Gas Company Performance Report, Penwell Publishing; A.T. Kearney analysis. 2


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quite conceivable that this capability will show the largest spread between world class and laggards. Successfully leveraging this capability, therefore, could be the secret to success in outperforming the oil company peer index. Who would be in the best position to leverage this capability? Arguably it would be the major oil companies, which have the most knowledge and experience that could be leveraged beyond their own operations. If they could find customers in the national oil companies and smaller oil firms, they could sell their most value-adding capability directly for a share in the upside potential of exploration and development activities. Selling reserve maximization and reservoir yield services immediately poses a strategic trade-off, however. Increasing the industrywide impact of this capability by leveraging the best-in-class players’ strengths will raise total (potential) oil production and lower overall production costs. In essence, the major oil companies will hurt their own upstream oil-producing and -selling business by leveraging their most value-adding capability and making other businesses more successful—or, in other words, making the upstream oil industry more competitive. The strategic trade-off involves choosing between, say, a 5 percent share in global oil production (a publicly traded, highly assetintensive commodity business) and a 15 percent share in the exploitation of the most value-contributing capability—but also lower oil prices that affect the business of owning and operating production assets. Interestingly enough, the companies in the best position to leverage their reserve and reservoir service are the major oil companies, whose downstream operations would likely benefit from the lower oil prices. In other words, the oil company faces an identity crisis: Will it be an oil company or the ultimate service company—the “Intel inside” of the oil industry? We have, for the sake of discussion, conveniently left out all sorts of complicating matters such as the role of OPEC, the political and economic considerations around

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oil as a key strategic commodity, and the huge amount of capital tied up in the existing industry structure. Our intent is simply to run a “what if?” capability scenario on a well-established and mature industry. The oil company faces an identity crisis: Will it be an oil company or the ultimate service company—the “Intel inside” of the oil industry?

■ STREAMLINING THE CONSUMER GOODS SUPPLY CHAIN In the fast-moving consumer goods industry, efforts have been under way for years to streamline the value chain, increase collaboration, and as a result improve both efficiency and margin for all. Most notably, considerable time and energy have been spent on efficient consumer response (ECR) initiatives, which unfortunately yielded little tangible benefit. Recently, the consumer products industry has witnessed tremendous activity in electronic marketplaces. The large exchanges—Transora, WorldWide Retail Exchange (WWRE), GlobalNetXchange (GNX), and CPGmarket—have made a splash with their size, speed, and high participation rate. Interestingly, however, these exchanges make many of the same promises of ECR (such as streamlining the supply chain and increasing collaboration). One would not be alone in thinking that the industry has been through this before! The very big difference today is the disruptive reduction in interaction costs. Many dreams and speculations look more realistic given the basic foundation of information technology. This is not to say that the large electronic marketplaces will provide all the answers—and we feel strongly that they won’t—but that low interaction costs and


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the consequent emergence of business capabilities will profoundly and irreversibly affect consumer goods companies. Perhaps more important, a more strict focus on business capabilities may spark the growth that has long eluded the industry. The move toward focused capabilities is already causing or at least supporting several industrywide trends. Let’s look at the most prominent ones.

➤ Retailers Gaining Power Retailers have gained the upper hand in their power struggle with manufacturers. The shopping experience and fine distribution of goods (two distinct capabilities currently dominated by retailers) have become more important than most branded goods themselves. The best example is Wal-Mart, which has gained a disproportionate share of the margin and influence in the value chain of delivering consumer goods (certainly, at least, from the manufacturer’s perspective). You can also see evidence in the growth of private-label goods by most large U.K. retailers, like Tesco, Sainsbury, and Asda (a Wal-Mart affiliate). As shoppers get more comfortable with the store, its format, and the products it sells, their loyalty to branded goods deteriorates. The tide has turned for a number of reasons. For one, many retailers have gone through massive consolidation, which has produced “shopping experience” brands of equal or larger stature than many consumer product brands. In addition, the manufacturers have created differentiated and branded propositions commanding premium prices. These propositions create the umbrella under which retailers can optimize their mix of product sold by blending in private-label goods. But more fundamentally, perhaps the power shift is also occurring because many consumer product segments are moving down the product life cycle. This will gradually favor capabilities that influence how the product is transferred—capabilities typically mastered

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by the retailers. The evidence is all around us. You can buy a lot of good stuff in most developed countries, and products from most retailers seldom fail to satisfy. So people act logically: They begin to gravitate toward the buying experience that suits them rather than chase after particular brands. In other words, manufacturers’ past successes in creating innovative products are now used against them. We are not implying that life is easy for the retailers. There are plenty to choose from in most developed countries—all sporting the most essential product brands to lure the customers into their “superior buying environment.” Consolidation is not just a competitive strategy; it has become a matter of survival for most retail groups. One could even argue that the only real winners are the consumers that scoop up increasingly attractive offerings at lower and lower prices. Ironically, the branding and product innovation success of the leading manufacturers forces all the leading retailers to carry the most coveted brands. This creates the basis for transparency and fierce competition between the retailers, and in the bargain forces the retailers to wield the power they have over the manufacturers. What a strange business model the retailer has from a capability perspective! If it provides prime shopping locations, an attractively maintained store, a solid retail brand, exquisite loyalty schemes, flawless distribution, effective buying power, and good customer service, it can sell Abrand products with a markup in direct competition with several other retailers and throw in a few private-label products to capture some margin from under the price umbrella provided by the A-brands. The retailer is compensated only indirectly for the capabilities at which it excels. This is far from a satisfactory situation. It would be reasonable, therefore, for retailers and manufacturers to experiment (for selected categories) with business models that provide direct compensation—for instance, in the form of a guaranteed margin per meter of shelf space—to the retailer for its capabilities. That leaves the top-line worries on the shelves to the manufacturer or groups of manufacturers. Over time,


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the most successful manufacturers will be able to offer the highest compensation to the most successful retailers, creating a self-reinforcing feedback loop in which both parties can provide maximum value to the market—and extract it as well. For now, the consumer goods manufacturers and retailers are typically warring with each other and competing in capabilities dominated by the other. Manufacturers look for alternative channels for their products; retailers create and promote private labels that erode the branded goods’ profit margins. The manufacturer is challenged to continue to provide real differentiation in the products the consumer wants most. In addition, the brand remains a critical weapon in reestablishing loyalty and providing an umbrella for growth around a successful proposition.

➤ Shifting Supply Chain Complexity One key source of retailers’ power is that goods flows often have to be mixed to get them to markets effectively. For most categories, no manufacturer could even dream of cost-effectively supplying all the stores at which its products are sold since retailers have a better system for sending mixed flows of goods to their outlets. (The manufacturer might want to consider it, though, for top-line, shelf management reasons.) So, many retailers become more demanding in terms of distribution requirements, and in many cases they effectively shift stock upstream in the supply chain toward the manufacturers. Then the manufacturers have to reduce cost in the supply chain, increase service levels, and improve supply chain performance. But what if the supply chain moved outside today’s company boundaries? Suppose that it is no longer necessary to “own” a goods flow to be able to control it? Currently, the flow of mixed goods that the retailers direct toward their stores is controlled by their own information systems or control systems. What if several manufacturers used a single control system that allowed them to direct combined

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flows of goods deep into the market? They could serve not just one retail format in a geographic area, but all, perhaps even besting the density of the retailers’ flow of goods. And what if they went one step further, assigning to new manufacturing service companies all of the manufacturing that is not strategic or closely linked to innovation? They could reduce the total flow of goods by linking manufacturing closer to geographic needs. Such “fourth” parties will be instrumental in allowing the entire industry to focus more on what it does best. The manufacturers can focus squarely on product innovation and branding; the retailers can ensure they provide the best buying environment in the broadest sense of the word—for instance, by taking loyalty schemes way beyond their current scope—and the new “fourth” parties can provide fulfillment more effectively than the retailers previously could. One could argue that this would pose a threat to the retailers. This is absolutely true—if the retailers stick to their current business model. Adept retailers will follow similar capability leverage strategies to compensate for the inevitable erosion of their current business footprints. They will, for instance, leverage their brand or their loyalty programs into the new routes to market, or set up true customer relationship management across a multitude of channels for different parties. In other words, they will no longer limit their revenue generation efforts to selling products with a markup. Such a scenario clearly represents major changes to the ownership of assets and resources in the consumer goods value chain. This will probably slow the transition even if it appears inevitable given the endgame considerations. It will also raise the stakes as to who will drive the transition. The winners will be the visionaries that position themselves early to benefit most from transition. Figure 9.2 shows a capability view of the consumer goods value chain and the new roles that will be fulfilled in the future.


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Knowledge value chain Product innovation

Product development

Product branding

Services

Innovator

Buying experience

• Loyalty program

• Location • Assortment • Transaction

Distribution and cross-dock

Shelf stock/ pick & pack

Transaction value chain

Retail branding

Service provider

Physical value chain Raw material supply

Manufacture

Inbound logistics

Warehouse

Fine distribution

Fulfillers In the consumer goods industry, manufacturers and retailers can focus more on their key roles when different business models are pursued and product fulfillment is optimized through new “fourth” parties or fulfillers.

Figure 9.2. New Roles in the Consumer Goods Industry Source: A.T. Kearney.

➤ Positioning for Growth The challenges just described certainly affect the manufacturers, which have lost more in the struggle in recent times. Most large manufacturers (such as Procter & Gamble, Nestlé, and Unilever) are having chronic difficulties in growing year-on-year. Yet the burden is squarely on their shoulders to develop innovative new products and consumer propositions. They’ve enjoyed some success with singularly strong brands and global brand extensions (for instance, Unilever with its popular Dove brand and the reputation for moisturizing qualities). We’ve also witnessed efforts to recombine capabilities with other companies to dominate a category or to change the assortment of goods offered. These successes are rare, however; the large manufacturers need more of these stories (and more broadly, they need to shore up their branding capabilities) to grow both revenues and profits.

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When the manufacturers can regard themselves as two different companies—a consumer goods manufacturer and a consumer goods brander and developer—they can line themselves up to pursue growth through differentiation in a far more focused fashion. Conversations about growth in consumer goods rarely continue for more than a few minutes before settling on the ability to meet customer needs, wants, and desires. Without question, the retailers have done a better job of relating to consumers than the manufacturers of branded products. Of course, the retailers are simply more intimate with the people who spend their hard-earned money for basic goods, and this ultimately translates into greater control of the value chain. Let’s assume that the consumer goods company can leave much of its manufacturing and distribution to a new “fourth-party” fulfiller that gives it far more access to markets and channels than ever before. The consumer goods company becomes free to search for every advantage in product innovation, branding opportunities, and new service concepts. The former “manufacturer” will enjoy much more freedom in organizing for this across company boundaries. New link-ups can be established with a plethora of potential partners to boost service propositions, brand leverage, and product development in unprecedented freedom. Combine this with a newfound freedom in routes to market new growth, and opportunities will certainly emerge. At the end of the day, we expect to see greater clarity in the roles of consumer goods industry participants as capabilities drive competition and focus. Business models will be evaluated for their effectiveness, and where necessary reconfigured around new sets of business capabilities. A new sector will also emerge, concentrating on the physical processes in manufacturing and distributing consumer goods. Companies will be forced into one of the three roles depicted in Figure 9.2.


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■ BIOPHARMACEUTICAL “VALUE NETWORKS” Typical biopharmaceutical firms are heavily integrated, with all of the capabilities along the value chain handled in-house: research (created originally or by leveraging academic discoveries in the field), development of chemical compounds, manufacturing the newly developed compounds, marketing (to penetrate the medical community), and sales. While integration has guaranteed biopharmaceutical giants double-digit annual growth rates for more than 20 years, two factors are contributing to a change: ➤ Biopharmaceutical revenues will flatten unless companies become truly innovative. While drug consumption is bound to increase in volume (given demographics and increasing effectiveness of drugs), most countries will find it increasingly difficult to maintain current healthcare expenditure growth rates. Biopharmaceutical products represent a huge chunk of healthcare spending. Faced with the necessity of managing costs, it is likely a premium will be placed on new drugs that add significant value to existing therapeutic strategies—thereby reducing the incentive to develop “me too” drugs. ➤ R&D costs will skyrocket unless biopharmaceutical companies improve their processes. The premium the market places on the development of new drugs means increasing investment in R&D at two levels: in late-stage development (to reduce the development cycle) and most recently, in early-stage development (to identify new targets and the molecules that will affect them). Investing is essential to secure the benefits the market can offer for innovation: high levels of reimbursement and longer patent protection.

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Faced with the prospect of lower revenues and higher costs, biopharmaceuticals have no choice but to reduce their development cycles and boost innovation. Today, these firms can consider each step in the pharmaceutical value chain as a distinct business capability that can be optimized, leveraged, or recombined outside company boundaries. The biopharmaceuticals can rebuild their corporate genomes in search of new sources of value. Until recently, these traditional integrated biopharmaceutical companies defined the entire biopharmaceutical R&D landscape. Today, two young industries are helping to deconstruct and reshape it: clinical research organizations (CROs) and the new biology industry, defined as a genebased industry. Biopharmaceuticals can consider these businesses as new forms of competition—or they can form “value networks” (powered by the Internet) with the nascent industries and ultimately extract disproportionate value.

➤ Clinical Research Organizations CROs were originally developed by executives who spun off these entities from the large biopharmaceutical firms. As pharmaceutical giants transferred more of their development capabilities to the CROs in an attempt to transform fixed costs into variable ones and reduce drug development cycle time, they began to consolidate. Ultimately, the CRO value chain started closely mirroring the pharmaceuticals firms themselves—albeit without a product. While CROs offer more flexibility and a stronger focus on knowledge capabilities, inefficiencies in their partnership with the pharma giants remained, due primarily to ineffective knowledge and data transfers. Today, the Internet puts an end to the inefficiencies in the existing partnership between CROs and biopharmaceutical firms. It dissolves the link between the previously aggregated capabilities in both organizations, setting the scene for improved forms of cooperation. Faced with new opportunities for collaboration, pharmaceutical firms and


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CROs are forced to ask themselves fundamental questions about their business, examining their knowledge capabilities through a microscope. By forming a bio value network that recombines capabilities from both sides, the pharmaceuticals can leave the task of development to more flexible and focused players, and the CROs can leverage the capability they excel at: drug development. The likely result is a far more competitive, shorter development cycle for drugs and faster time to market. Once bio value networks are formed, specialized clinical labs can be leveraged by CROs outside their boundaries, or in another network to service other biopharmaceutical firms. Biopharmaceutical phase 1 drug development centers might also become independent but virtually integrated to a value network whose mission is the reduction of the drug development cycle time.

➤ “New Biology” Players The past few years have seen the emergence of “new biology” or gene-based life sciences disciplines enabled by the rapid development of computing power and information systems. As life sciences researchers leveraged this rapidly expanding computing power to explore the human genome, new disciplines (such as functional genomics or SNPs—single nucleotide polymorphisms) and new sciences (such as proteomics, meteomics, and bioinformatics) emerged. These breakthroughs in biology have shifted the drug discovery paradigm from an empirical approach to a systematic approach and pose a challenge to the biopharmaceutical giants. These firms have no choice but to integrate the benefits of these emerging disciplines into their own research process in order to maintain their innovative edge. However, while failing to invest in these new biology platforms would come close to a death sentence for these firms, the investment in capital and human resources can also be prohibitively high. As with CROs, one way for these firms to secure access to new biology platforms and breakthrough innovation, while not bearing the costs, is through

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the development of value networks in which each party combines their best-of-breed capabilities.

➤ The Biopharmaceutical Differentiating Capability The large biopharmaceutical firms are genetically disposed toward coordination of capabilities. While both CROs and biology firms are likely to bring best-in-class development capabilities that greatly reduce the drug development cycle, biopharmaceutical firms will find their niche in these networks by leveraging their excellence in such capabilities as clinical development network design, network management, or clinical trial design. The value in the pharmaceutical value chain is shifting. Companies that are adept at orchestrating the players involved in developing and marketing drugs will dominate the chain and maximize value from a specific network. (An organization that cannot do this is better served by focusing on a single capability.) By possessing the differentiating network management capability, a firm can engender significant reductions in drug development cycle time, drive future drug revenues, or design incentive schemes to allocate these future revenues adequately between players. As they do when they cooperate with CROs, pharmaceuticals will leverage their new biology network design, network evaluation, or option-based portfolio management capabilities in combination with the research and development capabilities of the smaller, more nimble biotechnology firms.

■ NEW PLAYERS IN THE ELECTRONICS INDUSTRY Many industries in which knowledge capabilities drive strong profit margins have started to migrate from traditional to virtually integrated operating models. They can


Biotech

Licensing

Universities

Drug production

CRO1

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Effective industry R&D contribution

Investigators

Value chain steps

Research

Development

Manufacturing

Sales and marketing

Capabilities

Knowledge value chain

• Patent portfolio • Basic research • Licensing

Transaction • Collaborative development value chain facilitation

Physical value chain

• Facilities

• Trial design • Results interpretation • Trial management • File preparation

• Process design • Process piloting • Process management • Raw material sourcing

• Branding • Demand generation • Channel management

• Trial data capture • Trial data processing

• Process control • Procurement facilitation

• Transaction facilitation

• Patient pools

• Manufacturing

• Warehousing • Distribution

By building complementary capabilities into a value network, the pharmaceutical R&D process can be improved dramatically. The constant pressure to discover and develop new drugs will drive the industry to form such links.

Figure 9.3. The Development of Value Networks in the Pharmaceutical Industry Note: 1CRO = Clinical research organizations. Source: A.T. Kearney.

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then leverage differentiating capabilities (namely innovation and product development) while simultaneously improving asset productivity. The semiconductor and pharmaceutical industries are, for example, rapidly moving to a virtual operating model, employing contract manufacturing for many products. Consumer products and food processing firms generally wish to maintain a higher degree of control over operating assets, but are also embracing contract manufacturing and asset management. Oil and gas and chemical companies have identified many activities that don’t add value, but are just beginning to move toward a virtual operating model. Companies in all these sectors are moving from traditionally integrated to virtually integrated using supplier partners for anything from support services to auxiliary operations to production. An A.T. Kearney study of large OEMs (original equipment manufacturers) in the computer, telecommunications, and consumer electronics industries confirmed the progress in the trend toward a virtual operating model in the electronics industry. An entirely new class of players called electronics manufacturing services (EMSs) has become a key player in the “de-verticalization” of the industry’s physical processes (see Figure 9.3). Through our ongoing research on these industries, we have identified a number of de-verticalization drivers: ➤ Shortening product life cycles ➤ Increasing technological product complexity ➤ Advancing manufacturing technology and capital requirements ➤ Increasing need for specialization and scale in manufacturing processes ➤ Brand erosion ➤ Rapid market globalization ➤ Pressure to increase shareholder value


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Asset Management Services A company’s willingness to relinquish control dictates how far down the outsourcing spectrum, from support services to product-related activities, it will move. A major obstacle to establishing virtually integrated operating models is the availability of acceptable supplier partners to perform the targeted activities. As a result, asset management services have sprung up to service the operations component of this need. Packaged food leaders can, for instance, give up the operations of their assets to a new entity that will operate the current plants (with the current employees) with a strong focus on improving operational productivity. The asset manager’s offering is designed to enable clients to outsource existing operations-related activities, but enables companies to retain a higher degree of control than contract manufacturing (facilities management, engineering, maintenance). In addition, a long-term outsourcing relationship allows the supplier to recoup its investments in ongoing improvement of infrastructure and processes. Outsourcers can take underinvested processes, build economies of scale, and leverage their process expertise and supply chain management, thus improving operations and reducing costs. This cannot be achieved with traditional contract manufacturing, whose thin margins and transitory relationships make no room for process improvement and R&D funding. Asset management solutions provide a framework for companies to leverage differentiating capabilities and value drivers (such as R&D, sales and marketing, product development, and brand development) while improving operating performance (productivity gains are driven by reducing asset base and operating costs and minimizing capital investments). Potential benefits from increasing the productivity of an underperforming asset network are significant. Consequently, this strategy makes industries more competitive at the capability level.

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As in all outsourcing decisions, though, the decision to break down into capabilities must achieve a benefit beyond simply shifting assets off the balance sheet. In the electronics industry, it would be easy to assume that the objective is increasing the efficiency of the physical process. But, as usual, it is more complicated than that. It is important to understand the critical role the stage in a product’s life cycle plays: De-verticalization typically occurs well after the introduction and growth stages of a product, when physical process efficiencies outweigh innovation and new product development. As outsourcing or de-verticalization of physical processes continues to increase, capability thinking provides a clear and rational explanation for a company faced with these decisions. Of course, outsourcing of manufacturing is a highly strategic issue with many detailed implications (for product design, time to market, and so forth). And companies are deciding to retain certain physical processes even when an entire industry is in the midst of shifting: Witness Nokia’s retention of mobile handset final assembly as both Ericsson and Motorola have given up the capabilities of the physical process completely. As we discuss in the chapters that follow, an organization should go through some fundamental exercises to understand the business it is really in and the strategic decisions that implies.

■ CONCLUSION Many industries are facing massive change as they focus more on business capabilities. In most industries, the likely changes include the following: ➤ Individual companies are exhibiting far greater focus around a specific differentiating capability. Clearly, this implies a general trend toward a smaller company (in terms of assets and people) as well.


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➤ Carve-outs and spin-offs of big corporations are beginning, where the new entity is seeking the scale it needs to become world class. ➤ New companies are rapidly emerging to fill previously unidentified gaps in the value chain. Most likely, these will come from capability carve-outs of big firms.

IV Section

Introduction ■ THE JOURNEY TOWARD THE ENDGAME The capability-driven organization: It’s not your father’s SBU. As the organization evolves into highly focused worldclass business capabilities and market ventures, strategy, organization structure, and governance will need to change, too. Before you make major changes, you’ll need to strategize, prioritize—and understand your limitations.

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The Next Organizational Dimension If you narrow the focus of your business to the capability level, you can create powerful new sources of competitive advantage. Some companies may succeed by strengthening a particular capability through a one-time initiative—but that’s a fleeting victory. The key to rebuilding your corporate genome, and elevating your competitive standing over time, is aligning your entire organization to foster the capability approach. This chapter answers two fundamental questions: How does the capability-driven organization differ from the previous integrated models? And what are its benefits? Specifically, we explore: ➤ The evolution from the integrated corporation, organized around strategic business units (SBUs), to the emerging capability-driven organization ➤ The characteristics of the capability-driven organization, particularly in the areas of strategy, organization structure, and governance

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■ BEYOND THE SBU In an integrated corporation organized around strategic business units, capabilities that affect the output of the business directly are often dedicated to a particular unit. This means that one management team often gets full control—and perhaps as important, full ownership—of all resources relevant to that business unit. The fact that those capabilities could be exploited laterally is implicitly considered to be of secondary importance to the pursuit of each business unit’s primary markets. When the units of a company don’t share critical capabilities, though, the company misses out on business opportunities. Fortunately, the competition is generally organized in the same fashion—and therefore cannot leverage capabilities in this way, either. Experience shows that if one company treats a capability differently, others may soon jump on the bandwagon. Once the first corporations started to outsource logistics services, for instance, the others had to follow suit to remain competitive. This brings us back to a key theme of our book: Corporations have to take increasing notice of business capabilities if they want to keep ahead of their rivals. Otherwise, new, more nimble competitors will show them how it’s done. As interaction costs go down, a company can overcome the compromises inherent in tending to an entire organization and liberate individual capabilities to search for their own specific business optimization. As the hegemony of the SBU erodes in favor of business capabilities, organizations will ineluctably follow suit—organizing accordingly. The emerging capability-driven organization is certainly not a return to the functional model. That would discard three decades of progress and development in thinking about corporate organization. While we contend that the strict SBU model has outlived its usefulness, we also

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acknowledge that its market-facing features established strong guidelines around market orientation and competitiveness for all future organization forms. The emerging organizational form recognizes the virtues of the strategic business unit’s focus on the market—and adds the benefits of deploying best-in-class business capabilities. This unique combination can manifest itself in the two sources of competitive advantage we outlined before: optimization of best-in-class capabilities and recombination of complementary capabilities to generate better or new products or services. The entire organization will become more market-focused. First of all, the SBUs will have better and more differentiating capabilities at their disposal, allowing them to create more competitive and more fitting propositions toward their customers. The increased flexibility and agility will allow them to focus on smaller market segments with a better alignment of capabilities. Needless to say, this will unlock a powerful source of new growth opportunities for many existing business units. Instead of transforming a company’s design capability to meet a large variety of design needs, why not focus that capability on the applications it masters best and hire specialized design companies to complete the portfolio? The emerging organizational form recognizes the virtues of the strategic business unit’s focus on the market—and adds the benefits of deploying best-inclass business capabilities. Second, the capabilities themselves will become customer-focused as they start looking for external buyers for their services. Many companies have created “competence centers” to better capture and deploy knowledge. These competence centers have created internal customers out of the business units that use them. However, it is not until they start selling their services externally that they become true businesses in their own right.

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➤ Shared Services for SBUs Many corporations have significantly reduced the costs and increased the effectiveness of certain internal functions by creating a shared services approach. Strategic business units “buy” services such as finance and administration, human resource management, and facility management from the internal departments responsible for those functions. Having developed as a support system for the firm’s business units, these departments migrated easily to being considered potential businesses in their own right—first via service level agreements (SLAs) to internal customers, then at arm’s length with external customers. Firms such as EDS, and many others in the information technology industry, owe their creation and success to this evolution. Other capabilities followed, and business processes needed by several business units became prime targets for consolidation into services centers. Think of the umbrella call centers that are often shared among several business units. They offer a twofold advantage: Each individual unit invests less, and customers get faster service since call load peaks and valleys become more level. In fact, once the units agree with the center’s specific service level, the unit manager need no longer be involved in the management of and information about the calls. Further consolidation may take place by outsourcing the center’s services to a third party—increasing economies of scale and flexibility, as well as service levels and competitiveness, simultaneously. The organization structure that results when SBUs and shared services (produced in-house or by a third party) coexist is depicted in Figure 10.1. The strategic business units preside over the propositions toward the markets, the shared capabilities within the company boundaries, and the logistics services (which are often already outsourced).


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Figure 10.1. Shared Services in the SBU Model Source: A.T. Kearney.

➤ The Right Conditions Two important observations are necessary at this stage. First, the less critical (or relevant) a capability is for a business unit’s market proposition, the more likely it will fall prey to such forms of optimization. Since these functions do not directly influence the business unit’s performance, they are purely cost-driven (and susceptible to cost efficiencies) and generally enjoy more operating freedom from the business unit’s central planners. For these reasons, noncritical capabilities are more likely to go their own way as they seek more cost-effective approaches. Although well-run logistics services are desirable and necessary for the competitiveness of many businesses, they only represent sources of competitive edge or add a premium to the product in specific industries. Companies that want to make the most of these capabilities will do so by searching

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for economies of scale, whether it is best obtained inside or outside company boundaries. Second, the more measurable a service’s performance, the lower the hurdle for setting up a shared approach—an observation that is directly linked to the level of interaction costs. Call centers are prime candidates for shared services because the information systems supporting the call center operators both facilitate the service processes and make the center’s performance highly measurable. When a center receives a call from a customer, a wealth of information is gathered. Because the customer and order database are closely linked, the caller’s telephone number provides enough information to automatically retrieve that customer’s file, while information concerning the call (such as duration and request characteristics) is automatically logged for later analysis by the center’s management and clients. Finally, difficult requests and inquiries can efficiently be passed on to the most appropriate people, who can be instantly brought up-to-date on the customer’s profile. Because call centers are supported by an infrastructure enabling such information-rich processes, business unit managers no longer need their own order or service desks to capture valuable customer data. The availability of the information provides them with a similar sense of control as if they owned the capability themselves. In other words, the business unit managers can obtain the output of those capabilities through enforceable contracts or service level agreements. Shared call centers can tailor service level agreements to individual quality requirements, thanks to the information processing facilitated by the IT backbone. More important, because they can get customer data and servicing statistics, business managers can effectively benchmark call centers against each other and may go outside company boundaries for better service. This represents a level of choice and quality that was not available before shared centers. Measurability is, in fact, extremely important. Many or-


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ganizations, for instance in insurance and banking, have set up shared customer service centers to achieve economies of scale and share the investment burden. Without the appropriate information systems support, however, business unit managers are robbed of two important optimization tools: the ability to enhance the customer proposition and to assess the center’s competitiveness. Without a reliable information loop, service center costs are simply allocated between the different business units (not reflecting actual costs incurred), and no customer information feeds back to the unit manager. Lack of measurability is also detrimental to the service center itself. The service center manager has no tools for assessing what is (or is not) really required, and what costs are incurred to service the business unit versus what costs derive from inefficient management. Following this line of reasoning, we believe that as measurability increases, business unit managers will become increasingly open to buying capabilities from both internal and external suppliers if it helps them create a more competitive market proposition. When we think about the ability to measure a service center’s performance, we come to an important conclusion. It appears that the disruptive reduction in interaction costs does not just bring competitiveness further down to the capability level—it also allows companies to organize for it. Let’s pause here for an observation. While we fully expect that business unit managers will become increasingly comfortable with buying capabilities from external suppliers, we also realize that some will (rightly) be suspicious of buying capabilities from their direct competitors. If Procter & Gamble sold its marketing capability directly as a consulting service, would archrival Unilever be the first to sign up? Reciprocally, market leaders may be wary of divulging information that represents the very source of their competitive advantage to their immediate competition. The challenge for them is to identify which capabilities they do not want to share—a decision which, as we will see, falls increasingly on the corporate center. In reality, while such

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capability optimization is possible between industry leaders, it is more likely that a company will sell its key capabilities to a smaller competitor rather than one against which it is in direct competition. Cross-industry opportunities for sharing capabilities are also significant (and perhaps more likely) in mitigating these competitive concerns.

■ TO EACH CAPABILITY ITS OWN STRATEGY Finding the right strategy in line with the scope of a global multinational corporation is not an easy task (to put it mildly). As early as the mid-1970s, C. K. Prahalad identified the shortcomings of the global matrix organization in terms of formulating and implementing robust strategic objectives. While the matrix should help in the strategic decision-making process by introducing geographic, product, and functional perspectives, “such a structure, as it provides representation of multiple views and interests, also has a built-in tendency to impede the development of a strategic focus,” he wrote.1 Unfortunately, the matrix structure does not mitigate the two major sources of complexity at stake in global business: the diversity of the nature of competition and markets, and the need to coordinate the company’s activities worldwide. In the traditional setting, executives are forced to make tough choices as they decide how to exploit competitive advantage. Prahalad concludes, “Executives tend to trade diversity in the environment for the degree of coordination they desire in worldwide operations.” Yet when each capability becomes a business in its own right, it creates its own definition of customers, products, and services, and it manages its own resources. A capability-focused organization is more transparent, agile, and manageable. Each capability within the company adopts its own tailored strategy, rather than a plan geared toward the corporation’s portfolio of businesses.


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Think of the potential benefits of this shift. Managers who feel responsible for building leadership in a particular capability will make additional, more targeted investments. Resources will be better allocated since talented people will have the incentive to migrate to key capabilities. And innovation will abound because compensation will no longer be limited to company boundaries or fixed revenue. Ultimately, the capability organization is more efficient: at the business unit level as business unit managers focus completely on satisfying their own demands, and at the capability level, because it is more market-facing.

➤ Two Possible Roads Two managerial dimensions exist in the capability-driven organization: a market venture dimension, which aligns a set of capabilities to produce superior output, and a capability dimension, which leverages capabilities. The dimensions are not exclusive, and companies can choose to emphasize one or the other. Larger companies will most likely be involved in both dimensions, and will be built around a set of best-in-class capabilities that can be leveraged through their key market ventures. The market ventures in a company are effectively virtual business units. Compared to today’s situation, the market ventures ensure the output of best-in-class capabilities to serve their markets best. A company will preferably obtain those capabilities inhouse, but if it has to go outside, it will. The market ventures will determine what capabilities are needed to be differentiating. Capabilities, on the other hand, will ask themselves to which market ventures they can add most value—and thus position themselves to receive the largest compensation for their services. The capability organization eradicates the three management levels traditionally found in companies built on the strategic business unit model—functional, product, and geographic—by creating multiple independent businesses within the old integrated one.

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■ DOING AWAY WITH THE MATRIX ORGANIZATION? Although some matrix organizations function effectively, the matrix is commonly seen as a rather awkward organizational form with limited transparency of responsibilities and accountability. In the matrix, employees answer to two or more bosses: a functional boss, who ensures that the quality of the work meets the standards of the company; and one or more business unit (or regional/function/ product group) boss(es) with specific requirements for their business. You are probably familiar with the difficulties this overlap presents: Setting priorities is complicated, and excessive internal preoccupations push conflicts up to the corporate level. When resources are scarce or market conditions challenging, the issues become all the more pronounced. The trade-offs that result between capabilities and market propositions are out of touch with the marketplace. Indeed, business units previously had full control over capabilities (in the traditional integrated model) for good reason: to ensure that the people who had in-depth knowledge of the market and the capabilities at their disposal set the unit’s priorities. As we pointed out earlier, companies need to be competitive not just in terms of what they have traditionally offered to the end consumer, but also at the more narrow capability level. This means that we need to make the matrix organization work. Fortunately, the same forces that create the need to be competitive in both dimensions also facilitate organizing for such dual competitiveness. We can use our enhanced interaction capabilities to scale up the approach for support capabilities, such as finance and administration and call centers. In other words, the dramatic reduction in interaction costs can be deployed to make the traditional matrix organization more transparent, measurable, and as a result, more unambiguously accountable.


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Figure 10.2. Resources and Output in the Capability Organization Source: A.T. Kearney.

In the new structure, multiple reporting lines for key capabilities are effectively replaced by one reporting line and several “contracts” or SLAs that commit to a specific contribution. What does this new type of matrix organization look like? The new economy has often been described as a network of players getting together to create and deliver value to customers, or as value webs. The capabilitydriven organization can be compared to a value web—but one in which capabilities and SBUs (rather than individual companies) link up to create the most competitive output. A traditional organization is structured around resources that come in (assets, human capital), are transformed into the firm’s capabilities, and then turned into output that is funneled through its different business units (see Figure 10.2). A capability organization adds two further options, based on two fundamental questions that emerge:

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➤ To whom can I sell a capability at which I excel? ➤ Which capability can I buy to produce additional output? What happens to the organization structure when a company plays out these two options? Let’s start with the example of a company (think Caterpillar) that has turned its logistics capability into a logistics services business unit (think Caterpillar Logistics) to leverage one of its capabilities. The single logistics capability becomes a business unit in its own right, made up of a new set of capabilities (such as warehousing, fleet, and information technology) and business units (such as small parcels and value-added services). Here’s the difference: The new logistics services business unit now has a wider range of customers. In the old days, the only customers for the logistics capability were in-company business units. In this case, there are also implications for capital allocation, as “old” companies can share a stake in the new market venture. The logistics single capability can also be leveraged within company boundaries—the “old” capability director would become the director of the logistics services business unit. The reciprocal example is a business unit director meeting the unit’s needs by purchasing IT services from a third party with large processing centers and high customer service standards rather than maintaining in-house capabilities (see Figure 10.3).

■ STRUCTURE: FLEXIBILITY AND ACCOUNTABILITY The capability-driven organization adopts a far more flexible stance toward company boundaries. Although in traditional business practices, business boundaries were relatively fixed, changing primarily though mergers and


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Figure 10.3. Dynamic Company Boundaries Source: A.T. Kearney.

acquisitions, a capability environment is much less rigidly defined. Under this structure, companies will shift toward creating new businesses out of their own capabilities and those of other, complementary companies. They will form alliances, joint ventures, and other partnerships. If the company believes that a particular capability cannot offer a world-class proposition, then it should consider outsourcing the capability altogether. Similar considerations apply to the market venture dimension in the company. In certain situations, the company can consider setting up alliances or joint ventures that make use of both its own capabilities and those of selected partners. In that case, a special venture can be set up in which the selected partners have a stake. If the capabilities of the company do not warrant it a position in the market venture, then it can still sell the capability as services to external ventures.

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The capability-driven corporation will have two new types of directors: the market venture director and the capability director. Market venture directors buy their services directly from the appropriate capability directors— who, in turn, will most likely sell these services outside their company boundaries as well. The capability director will assess opportunities to deploy capability resources. Ideally this search is not only for volume for the resources, but also for opportunities to deploy resources in such a way that they become more valuable to as many strategic business units as possible. There is a conceptual difference between the current responsibilities of functional or operational managers and the responsibilities of the new capability directors. Think of a large domestic appliances manufacturer producing washing machines, refrigerators, cooking stations, and so forth. Such a company often produces partly in-house and partly through contract manufacturers. Typically, the marketing department and the product development department together draw up product specifications. Then, manufacturing searches for the best way of making the products, whether in-house, through contract manufacturers, or increasingly through OEM suppliers, which can provide even further economies of scale. The new capability director will oversee all these tasks, but in addition, will assess how manufacturing as a business in itself can be made more effective. This involves examining market opportunities for selling the output of the capability to other companies’ business units—perhaps in countries where the company is not present to avoid conflicts of interest. There could be a point at which a company might find more value in leveraging capabilities than through a venture. The Sabre Corporation is a case in point. A business that grew from American Airlines’ process automation capability and evolved over 25 years, its market capitalization in spring 2002 was more than 150 percent that of its market venture parent American Airlines! When a company strips


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Figure 10.4. The Capability Organization Structure Source: A.T. Kearney.

itself of its weaker capabilities, it might actually end up with a set of best-in-class capabilities that have more value than the market ventures in which it is involved. If the value of finding oil is the key capability for the oil industry, should a company like Shell continue to sell oil or sell its exploration and development capability to others? In the same way, as soon as Nike starts to sell its branding capability as a business, it kills itself—unless it stops selling shoes. As both capability directors and market venture directors line up resources, an organizational configuration will have to be created for the most important capabilities and market ventures (see Figure 10.4). The capabilities will be able to sell outside company boundaries through contracts or service level agreements, effectively becoming separate businesses. In much the same way, the market ventures can now “buy” from their internal capability suppliers. The process will propel strategic trade-offs to the surface: Costs

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will no longer be allocated at the end of the year to the different business units; they will be “incurred” or invoiced according to contracts between the capability directors and market venture directors. This will place the risk of going after market opportunities where it should be: with the market director rather than the capability director. Similarly, the capability director can seek capital to invest in more competitive capability contributions and ensure future use of assets and resources. The transition to such a capability-driven organizational configuration should really start with the most relevant capabilities and market ventures. Capabilities should not be turned into individual businesses simply for the sake of change. One could argue that the drive toward shared services units for HR, accounting, IT, and others, although making formidable contributions to overall cost level improvements, does little to strengthen real strategic competitiveness by improving the way core capabilities are deployed through the key market ventures. With that said, however, it is generally more feasible politically to begin with necessary capabilities that are underperforming. After all, changes to these capabilities do not require long and heated discussions about the firm’s strategic direction.

■ A COMPLETELY ATOMIZED ENDGAME? One might ask whether the capability-driven organization is just a working matrix equivalent of today’s strategic business unit organization. The answer is a profound no. As companies start to create capability businesses, they will find out which of their capabilities are strong enough to lead their markets. If the capability businesses fail to impress their most immediate customers, the old business units turned ventures, they will be replaced by stronger capability businesses outside the firm. In other words, they will be outsourced. A company could also spot an opportu-


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nity to combine its own capability with parts of other companies, perhaps in a joint venture or other form of alliance. Whatever the configuration, the number of capabilities a company will be active in will likely be less, rather than more. In fact, the company is likely to retain only those capabilities at which it really excels and that it can leverage through one or more of its key business ventures. A similar consideration will take place in the venture dimension. If a firm cannot get access to the output of a capability that is key for a specific venture, it might consider pulling out or creating a partnership with others that have necessary and complementary capabilities. All in all, the corporation will be distilled to its essence: the key capabilities at which it excels and the core ventures through which it can leverage them. The strategic combination of both gives the corporation the ability to add value—and thereby its permission to exist. The corporation will be distilled to its essence: the key capabilities at which it excels and the core ventures through which it can leverage them. Does this mean the corporation becomes smaller? That’s debatable. On one hand, a company is likely to give up full ownership of some capabilities, for instance by outsourcing noncore functions. But on the other hand, certain strategies—like optimizing physical capabilities—will demand size since economies of scale are critical. In addition, a company’s footprint will likely grow through alliances, partnerships, joint ventures, and even contracts as it increases its involvement in related capability businesses and ventures (see Figure 10.5). The mobile telephone business of Philips Electronics NV is a case in point. For several years it suffered from not having achieved sufficient market share to be truly competitive in the marketplace. To improve its fortunes, it rearranged its capabilities in the mobile phone business in

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Figure 10.5. Creation of Capability-Driven Organizations Source: A.T. Kearney.

summer 2001. It formed a joint venture (JV) with a Chinese electronics firm that could develop, design, and manufacture mobile telephones. Philips redirected its involvement with the mobile phone business to exploiting its access to markets through its sales and marketing units, while its footprint included a share in the industrially focused JV. The targeted result was, of course, that its market share in mobile phone sales would no longer impede its industrial prowess but would let it search for its own optimization. Earlier, Motorola and Ericsson followed similar, but less far-reaching, routes by outsourcing their manufacturing operations. Motorola went further with its semiconductor business. Seeing the market share of its semiconductors plunge with its share of the cell phone market, Motorola made the recent decision to sell its chip sets to any mobile company—including direct competitors (perhaps not Nokia) in the cell phone market. No longer fearing that exploiting its semiconductor business outside company boundaries could erode its competitive edge, Motorola has


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increased its footprint in a market likely to represent US$35 billion by 2004.2 Much has been written about the modular value chain, or the atomized corporation. The concept assumes that single units of customer needs will be served by an optimal and specific combination of value chain elements, and that for each component of the customer need, the most ideal resource is selected to fulfill that need. The implication is that an organization might as well completely focus on its capabilities, since it gains little by creating predefined and exclusive combinations of capabilities. In other words, there will be little value for corporations. We disagree. First, we are not in such a situation today— and a long journey toward becoming modular lies ahead. Fortunes will be made and lost on that road. More important, however, are several factors that essentially preclude the emergence of a completely atomized value chain. Scope differences, innovation cycles, emotional (and irrational) consumer behavior, and learning curves will create room for entrepreneurship, and as a consequence, also for corporations. Companies will become more focused (more agile, with only a few ventures and capabilities)—but not completely atomized.

■ GOVERNANCE: A STRONGER CORPORATE CENTER In the capability-driven organization, business unit directors and capability directors focus on optimizing their own businesses. As a result, the corporate center will have to make the trade-off between favoring a capability business or a market venture (see sidebar: “The Role of the Corporate Center”). A CEO might, for instance, have to choose between selling a technology in the marketplace or keeping the exclusivity for the company’s own brands for a certain

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The Role of the Corporate Center June 10, 2002 Gavin M. McAllister Chief Executive Officer Holding Corp. 123 Capability Avenue Company Town, NY 45678 Re: The new role for the corporate center Dear Gavin, I understand you would like to know more about the changing role of the corporate center in a company like Holding Corp. We believe the corporate center will take on stronger importance as your business shifts to a capability perspective; this letter offers our initial thinking as to why. Generally, a holding company engages in either of two types of relationships with its businesses portfolio: a strategic holding relationship or a financial holding relationship. We believe a holding company does not necessarily have to choose between the two. It can manage a mix of strategic and financial holding relationships with its different businesses, as long as it adopts the right relationship under the appropriate conditions. The strategic holding relationship is based on the presumption that there are interdependencies between the different businesses in the portfolio, which—if exploited effectively—can create greater value than the businesses can achieve individually. The four businesses that use the Holding Corp. brand, for instance, enjoy higher recognition via one brand rather than four. In this case, the holding company or corporate center has a natural role: It sets the strategy for making the most of this interdependency. In other words, it makes compromises for the greater good of the entire firm rather than granting the individual business the freedom to use the brand as it sees fit. (Needless to say, the value generated by exploiting interdependencies should outweigh the value lost through the compromise.)


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If interdependencies or synergies cannot be exploited successfully, either because they don’t exist, or because the capital market is not sufficiently convinced that they do, then a financial holding relationship becomes necessary. This changes the setting: The holding company will now have to justify having a stake in the different businesses—or it runs the risk of an overall stock price discount. The best reason is typically that the businesses in the portfolio are first in their respective markets, or well on their way to the top. Of course, if there is an owner for those businesses with the potential for an effective strategic holding relationship, or if no leadership positions appear attainable, then a divestiture must be considered. Obviously the role of the holding company will reflect this reality. It must ensure that the businesses it has a financial holding relationship with are deploying the right strategies to expand their leadership positions. Compared to a strategic holding relationship, the financial holding businesses have more strategic freedom to achieve their leadership positions. In return, however, they will be measured only against this leadership benchmark. This goes much further than ensuring that returns fall in line with what the group has promised the market. At least two businesses in the Holding Corp. group (both industrial divisions) would have to step up their pace considerably to justify their position in the overall portfolio and to relieve you from having to explain repeatedly to market analysts why you keep them. The same principles apply in a capability-driven organization. The corporate center determines which capability businesses and market venture businesses it should maintain strategic relationships with to maximize the companies’ strengths. It may decide not to sell the output of a highly competitive capability to the market, but to exploit it through its own market ventures instead, perhaps compromising the volume of the capability business. In the same way, it can ask market ventures to use the in-house capabilities for a period of time to get to world-class performance levels. If strategic trade-offs between the capability businesses and market venture businesses aren’t needed, the corporate

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center will have to adopt a financial relationship, in which it ensures that its capabilities and market ventures position themselves for building or expanding leadership positions. The corporate center will also determine which capabilities to move outside the corporation. Compared to a holding company, these relationships will be more dynamic, and will change between strategic and financial with higher frequencies. At the start of a product life cycle, for instance, the need for strategic trade-offs may be strong, whereas toward the end, all capabilities require straightforward optimization. One key role of the corporate center will be, therefore, to manage such time-sensitive trade-offs as investments in new technologies or markets. Careful management of opportunities and compromises will play a vital role in building the leadership positions of the future. In summary, we believe that the role of the corporate center will not diminish in a capability-driven organization. Corporate centers have shrunk generally over the last decades, outsourcing staff functions and delegating increasingly to the business units. The size of yesteryear is unlikely to return, but its role in making strategic trade-off decisions, and the core entrepreneurial initiatives, will increase markedly. The key question will be whether it is able to play this role. I believe it was Voltaire who wrote, “My apologies for the length of this letter; I did not have time to make it shorter.” I hope this provides some food for thought, and I look forward to a fruitful discussion next week. Kind regards,

Jay Schrader Vice President A.T. Kearney, Inc.


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period of time. In this case, the business unit would bid for a period of exclusivity for the “technology development” capability’s innovation. While capabilities and business units will tend to give business to each other, there are tough decisions to make when an in-house capability or business unit is not best in class. Suppose a company’s brand name is not strong enough to leverage a breakthrough technology. The technology might be sold to a competing brand to reap the benefits of higher volumes and margins (due to better positioning). In this case, the corporate center can make the arbitrage to keep the technology inhouse and bear the cost to avoid stifling innovation in the future. If, on the contrary, a capability is so strong that it surpasses the benefit of the market venture, it is up to the corporate center to make the tough decision to shift strategies—and close down a market venture. In the early 1990s, C. K. Prahalad and Gary Hamel introduced the notion that a company should try to get into businesses that require a strong contribution from its core competency. In this framework, a company is forced to distinguish between the brand share it achieves in end product markets (for example, 20 percent of the automobile market) and the manufacturing share it achieves in any particular core product (40 percent of the small engine market). In a similar fashion, in a capability-driven model, the corporate center will distinguish between the two objectives of becoming world class in capabilities and in market ventures. All in all, the corporate center is responsible for assessing the potential impact in terms of growth. It must define the theoretical chance of becoming world class versus the practical chance—and make the necessary decisions. Not all trade-offs will be concrete. Thus, the company’s governance mechanisms should ensure that capabilities with less tangible—but highly significant—benefits are taken into account and that all trade-offs are made explicitly. Finally, the new multicapability corporation will likely build on a myriad of partnerships and various forms

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of supplier relationships that will become more complex to manage and increasingly require new forms of governance. In short, the governance function is responsible for strategy and organization.

■ CONCLUSION ➤ Capabilities that are not critical to market propositions (and whose performance is easily measured) are frequently optimized in a shared services approach. As interaction costs go down and measurability increases, business unit managers are more inclined to buy noncritical capabilities, either from an internal or external supplier. ➤ The capability organization emerges as a mixture of highly focused (but generally fewer) world-class business capabilities and market ventures focused on outputs. ➤ There are two dimensions the capability-driven organization can take: a market venture dimension and a capability dimension. In many cases, companies will mix both approaches. The capability organization requires a stronger corporate center to manage the trade-offs between these strategies. ➤ In a world where competitive advantage inexorably changes, a company’s corporate center will have to make the strategic trade-offs necessary to remain competitive—and constantly readjust its decisions when new technology emerges. ➤ Because there is value in making these trade-offs, companies will become more focused (more agile, with only a few market ventures and capabilities)— but not completely atomized.

11

Chapter

So What? Focus. Agility. Strength. These are a few of the themes that repeat themselves in our discussion of the capabilitydriven organization. This chapter offers our top 10 takeaways emerging from the transformation to the capabilitydriven organization (see sidebar: “A Capability Snapshot”). This list is not exhaustive, but it is intended to reinforce the benefits of a capability focus. In this chapter: ➤ We review the strategic implications of becoming a capability-driven organization. ➤ We discuss what it means for the people of the corporation, from the top down. 1. The capability-driven organization creates new markets and growth opportunities through its capability businesses. When businesses define their strategies at the capability level, they can focus precisely on what it will take to position each capability or venture for increased competitiveness, faster growth, and better prices. The more narrowly they define their customers, the more focused and effective capability businesses can be in their quest to meet customer needs. The first objective of the capability-driven organization is to create value for the customer and then growth, which is a direct result of the ability to increase value. Differentiation and innovation, the driving forces behind the 233

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A Capability Snapshot Dimensions

Before

Now

Growth

Dependent on growth of existing market

Increased through differentiation, innovation, and more narrowly focused value propositions

Competitiveness Defined at the strategic Defined at the capability business unit level level; all capabilities must become world-class Strategy

Compromised by the requirements of the strategic business unit level

Formulated and deployed at the capability level

Pricing strategy

Fixed price carrier per product-service bundle

Flexible price carrier is a tool for the company to manipulate

Mergers and acquisitions

Capability synergies difficult to exploit because of heavy implementation requirements

Capability recombination through JVs, new ventures and alliances

Capital

Suboptimized allocation of capital around lowest performing capabilities

More effective allocation of capital to best performing capabilities

Culture

Single global culture imposed from center

Culture develops naturally around capabilities and center maintains loose culture

Leadership

Strong cross-functional More focused knowledge expertise of single capabilities

Network management

Static relationships

Flexibility to manage and change network easily

Measurement

Difficult to enforce

More effective measurement indicators

So What?

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capability organization’s growth, are by-products of both capability strategies. Think of a company’s strategy to optimize a single capability like design by turning it into a separate business. That company can now sell its design expertise to new customers outside the firm. Growth also stems from value chain strategies aimed at putting together the most competitive lineup of capabilities to create superior output, as we saw with IKEA. A company can create additional growth opportunities by matching key capabilities with its core businesses to leverage the companies’ respective competitive strengths. The capability-driven organization can also engender the development of new markets by allowing for more narrowly defined value propositions (through the identification of microsegments). When capabilities become businesses, each has its own customers and its own opportunities for segmenting. Compared to customer segmentation at the business unit level, the capability structure allows for a more focused customer view: There are as many capabilities and market ventures as there are potential customers. 2. Because the entire corporation becomes market-facing, the entire organization must be brought to world-class standards. Once capabilities are liberated from their straitjackets, they are free to become world class. The downside of this good news is that if they don’t, others will. Competition takes place at a new level, and achieving best-of-breed status becomes mandatory. Yesterday, Delphi and Visteon operated under the umbrella of parent companies GM and Ford; today they sell to any carmaker. They can do so because they leverage their world-class expertise in the manufacturing of auto parts. In models that emphasize competitiveness at the business unit level, units can buy and sell goods and services among themselves at prices determined in the open market. This model is focused, flexible, and responsive to

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customer needs and market requirements—yet it does not allow for competitiveness at the capability level. Business capabilities need their own customers, and their performance should be assessed vis-à-vis the market independently of whether or not they are sold within company boundaries. 3. The capability-driven organization enjoys more focused and more powerful strategy formulation and deployment. Capability thinking reduces the compromise inherent in business unit strategies. Single business unit strategies are replaced by capability strategies, venture strategies, or a mixture of the two. Giving each business its own identity naturally enables it to best fulfill its own needs. For instance, businesses in the knowledge value chain share a need for speed, as time to market becomes instrumental in gaining market share or extracting a premium for a product or service. These businesses are better off if they do not accommodate the longer business cycle in action in the firm’s factories. Apart from the improved quality of the strategy content, one of the benefits the capability-driven organization can bring is increased effectiveness in strategy deployment. The capability-driven organization can anchor strategies more firmly in the organization, and can better measure results and follow up when necessary. First of all, the different types of strategies can be given their own owners, which can be held accountable for their deployment. At the same time, because the strategies are so tightly aligned with the capability and venture businesses strategies themselves, feedback on the strategies’ effectiveness is far more direct. 4. An appropriate pricing strategy is needed at the capability level. As we have seen, companies confronted with extremely complex consumer demands are increasingly focusing not only on the physical product itself, but also on the whole

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package of activities or services involved in transferring that product to the consumer. The technical specifications of the product itself, as well as such services as maintenance, warranty, and financing, are all diverse elements of value that can find their way into the single price of a product. A complete picture of product value, therefore, must include all the aspects of value involved in one product (and one price). The price carrier—the value element that has the most influence on determining the price of the final product—is determined by the requirements of the value chain’s ultimate customer in combination with the key capability contributing to the output. The capability-driven organization creates multiple businesses within the formerly integrated business or business unit. As it reevaluates what it sells and to whom (in other words, as it rebuilds its genome), the capabilitydriven organization will also need to revisit the price carriers in each of its product and service bundles. It will need to carefully gear its pricing strategy to reflect the company’s new—and most likely more focused—product and service offering. The pricing strategy at the capability level is important for two reasons: ➤ The gradual disaggregation of businesses is likely to create changes in which product or service (or capability) can serve as the price carrier. ➤ The price carrier is in a good position to anchor the venture businesses, as it is the part of the business collecting the sales from the ultimate customer. The price carrier in the value chain is also key in determining the relative power position among the different players in the chain. As corporate leaders rethink their business definitions, they may find opportunities to sell the output of their capabilities to other companies. They may also find, however, that a price carrier will no longer be able

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to collect compensation for some of the capabilities that contribute to the final product. For instance, we considered earlier how Schwab.com pioneered online trading by taking trading facilitation to the Web and reducing the average cost of a trade from US$70 down to US$30. In the process, trade facilitation became more driven by economies of scale. Now that customers distinguish between carrying out a trade and obtaining quality information for their investment decisions, the trade facilitation process in itself can no longer play the role of price carrier for a bundle of services such as market research, portfolio advice, and stock picks. Today, traditional players recognized for their expertise in advising clients about their stock choices have lost their power in the value chain to higher volume players. 5. Mergers and acquisitions can take place at the capability level. Research shows that many newly merged companies fail to live up to initial expectations. Soft issues such as corporate cultures around communication, performance measurement, or control systems are often cited as the highest unanticipated cost of a merger. That is because, as we have pointed out, most mergers in reality only optimize a subset of a company’s capabilities. Adopting a capabilitydriven organization clearly could help avoid common M&A pitfalls. Capability mergers and acquisitions can take many shapes and forms. A group of companies can, for instance, decide to pool their assets into a new company that sells the services back to them, as well as to other companies. The founders in this case would not try to get the services for lower prices, but rather would create an additional revenue stream from the dividends of the new service company. Another possibility is a joint venture between selected players to create a more competitive capability. Several insurance companies have set up or are considering product develop-

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ment joint ventures to more cost-effectively complement their back-office integration and utility proposition. Adopting a capability-driven organization clearly could help avoid common M&A pitfalls. Alliances will become an even more prevalent method of improving competitiveness as the capability recombination opportunities run out of steam (at a certain point acquiring and divesting ever-smaller parts of the company will become more and more difficult) and the need to leverage capabilities increases. 6. Capital is allocated more effectively and more measures for success are built in. When “old” business definitions harbor compromises that result in the underperformance of some capabilities, the profit-making parts subsidize the money-losers. This compromise ultimately cuts into capital effectiveness; the economic return of the firm as a whole reflects the underperformance of the suboptimized capabilities. In a multicapability organization, one can imagine each capability will be able to seek at least part of its capital on its own—which results in a sharper profile in capital effectiveness than the traditional organization with aggregated capital needs. If a manufacturing capability manager wants to raise capital to invest in next-generation circuit boards, the cost of capital for this venture will not necessarily be the same as that for the whole firm. The implication is that this arrangement achieves the ultimate separation of capabilities with a more advantageous capital return than the firm as a whole experiences. As a consequence, risk management now plays out at the level of the market venture director, not at the level of the organization. Thus the capability organization has the opportunity to sharpen capital effectiveness—capital requirements of

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asset-intensive companies, after all, are radically different from the requirements for information-focused companies. But the leader of a typical integrated insurance company is also measured by different success criteria than the leader of a world-class insurance back-office services firm or an insurance product development firm. So, in addition to better allocation of capital, venturing capabilities will be built in once capabilities are managed in a competitive environment. Traditionally, companies received indirect compensation for value-added activities by charging one transfer price for their total output. Now venturing can be built in at the capability level. 7. The corporate culture becomes less compromised and more focused. The capability-driven organization allows corporate cultures to align themselves more closely to the characteristics of their resources. In traditional organizations, the character of the business unit, or perhaps the aggregation of business unit characteristics, determined the guiding culture of all the different types of resources. Naturally, a manufacturing environment will gravitate to a different culture than that of a sales organization. By allowing capabilities to search for their own cultures, a better fit may be achieved. A manufacturing capability could consider becoming the most competitive commodity manufacturer. It will search for customers in need of large volumes at low prices, and it will develop a culture focused on cost consciousness. This was more difficult in the old model when commodity, mid-range, and high-end manufacturing were all part of one unit. The core requirement for the capability organization in terms of culture is to allow for greater focus, linked to core capabilities and to the organization of business. However, mapping the corporate culture to the capability level starkly contrasts with the predominant vision that a strong global culture plays a fundamental role in the transfer of

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critical capabilities among geographically dispersed multinationals. For example, ABB, a global technology company that employs about 160,000 people in more than 100 countries, believes that using multicultural top management teams in its global propositions throughout the world helps managers around the globe share the same values. It is safe to assume that such a global corporate culture will be threatened when allowed to develop at the individual capability level. At the other extreme, when asked during the World Economic Forum meeting in Davos, Switzerland, to characterize the culture of his company, Softbank President Masayoshi Son declared, “Softbank has no culture. The only culture is the culture of its parts.” When it comes to culture, a multicapability company can choose from three paths: attempt to maintain its single global culture regardless of the threat (à la ABB); allow the parts to inevitably have their own individual culture with the center holding nothing (Softbank); or allow the culture to develop on its own around the newly created businesses while maintaining a loose umbrella brand. Most companies that have developed a strong lifestyle brand (like Virgin or Ralph Lauren) achieve the last, and probably most desirable, alternative. In the case of Virgin, the red Virgin logo (and to some extent the character of Richard Branson himself) is what keeps cola and airplanes together under the same umbrella. Ralph Lauren can comfortably develop its range of products from fashion to home furnishings and media—while relying on outside providers for most of the capabilities needed to develop these products, and allowing those partners to develop the cultures conducive to creating competitive output from their capabilities. When a best-in-class recombination of capabilities occurs, the congruency of cultures and trust will play an important role in the choice of partners and the success of business units. Consider the cultural differences at stake between the academic community populating the clinical

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research organizations and executives manning the forprofit pharmaceutical and chemical industries. One is driven by the desire to be recognized for its research and the other by the urgency of translating research into real dollars. We believe that such differences can be increasingly accommodated when specific capabilities are aligned through contracts or virtual ventures, avoiding the actual merger of identities and businesses. It is also not difficult to reason that this accommodation will play a strong role in enabling greater levels and degrees of cooperation between capabilities. Given the sensitivity of mergers and acquisitions to corporate culture, there is a strong business case for working with others that have world-class capabilities since such collaboration doesn’t require forcing two distinct cultures together and there is less need to merge assets. 8. Leadership is more focused, is held more accountable, and has greater incentive to succeed. Because the capability-driven organization is a more focused entity, its leaders can be more focused as well. Market venture directors concentrate on their capability recombinations. They take on the role of integration managers, purchasing their services from several capability managers. They assess in-house capabilities against those outside company boundaries. In this sense, the venture director is still responsible for the business risk, but should be seen more as a coordinator, who at each step reexamines the available capabilities and has the opportunity to go outside the company to purchase them. The capability director will search for opportunities to deploy the resources associated with his capability. Ideally he looks not only for volume, but also for opportunities to deploy his resources in a way that makes them more valuable to as many strategic business units as possible. The rationale is simple: The more competitive his resources are, the more he can charge for them and the more he can grow his resource pool. Like the market venture director, he will

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not confine his search for opportunities to company boundaries. He can even act as an intermediary by combining his resources and those of other companies to provide optimal service to the business units of the company. Capability directors negotiate directly with market venture directors (in or outside the company) and need different skill sets, depending on what they are selling. For example, directors in the knowledge value chain will be required above all to demonstrate innovation and ability to get products to market in a timely manner. These managers will have an extra incentive to pursue innovation goals because of potentially higher return on their investment: Innovation draws in more customers (not limited by a company’s business units), and rewards can be made even more attractive through forms of risk-sharing arrangements. Similarly, the component manufacturing director will have the incentive to develop the next-generation circuit board–manufacturing process (for the same reasons of remuneration) or improve utilization of assets. In more traditional organizational forms, functional managers were much further from the market and often very budgetdriven, underexposing them to such entrepreneurial incentives. In the traditional business environment, heads of manufacturing would search for the best way of making products. That might be in-house, through contract manufacturers, or increasingly through OEM suppliers, which can provide even further economies of scale. The new capability director will do all of that, but in addition, will assess how manufacturing as a business in itself can be made more effective. He will examine market opportunities for selling the output of the capability to other companies’ business units—perhaps in countries where his company is not present to avoid conflicts of interest. Many European manufacturers in different industries have, for instance, a limited presence in the U.S. market. Strong competition, coupled with a lack of brand position and limited access to distribution networks, has effectively

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relegated them to opportunistic market approaches. In principle, nothing should stop a European capability director from penetrating the U.S. market at the capability level and leveraging her product portfolio by selling manufacturing to an American player. This way, she will effectively produce under a different brand name. In addition to making a (small) margin on the products sold to the U.S. company, the European manufacturer leverages its own industrial base and brings costs down for the individual business units. Dyson, the U.K. vacuum cleaner company, is one example. By licensing its unique vacuum cleaner concept and design that incorporates its cyclone-based dust air separation technology to Canadian company Fantom, Dyson gained access to distribution and to a brand that matches the positioning of Dyson in Europe. 9. Flexible network management is a key success factor for the capability-driven organization. Another key characteristic of the capability-driven organization is the increased agility that results from the elimination of fixed costs and the development of networks. Capability-driven organizations can easily change what they sell, to whom, and with what resources. The corporation’s skill in managing and changing its relationships with outside players could be termed flexible network management. This concept also involves managing the interaction with other capability or market venture providers through service level agreements or other forms of contractual relationships. First, an entrepreneurial spirit needs to be instilled in supplier relationships, both internally and externally, for the main capabilities affecting the value chain output. Relationships will shift from budget-focused deals to forms of risk sharing—suppliers becoming more like coinvestors in the success of the capability lineup. Capability directors and market venture directors will, for example, agree to each invest a certain number of days into the development of a product. While the market venture manager will profit

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from a steady revenue stream from the sale of the product once it is developed, the design capability manager has a “technology window of opportunity” that can be sold only once (while one patent can take several months to develop). Because it is in essence possible to sell this idea only once, the design capability manager will seek equity in the deal in order to capture part of the revenue stream that will be generated in the future. In other words, if knowledge applies to future products and services, compensation should be made for that knowledge via equity. Relationships will shift from budget-focused deals to forms of risk sharing—suppliers becoming more like coinvestors in the success of the capability lineup. Perhaps more important, having the ability to manage a network also means having the capacity to change it. The capability-driven organization must be able to redefine its contractual relationships in a way that traditionally integrated firms cannot. Employee contracts, performance measurements, and joint venture agreements and alliance contracts need to be easily revisited and redefined. Such flexibility also includes changing the boundaries of the network itself. As cumbersome as it is for an integrated corporation to shed factories or other production units, the capability organization will find it relatively easy to sign new joint venture agreements with other capability or business market venture providers. This competence for nimble network management will be apparent at the corporate center level (where tradeoffs are made for the whole organization) as well as at the single-capability and business market venture level. 10. New measurement opportunities will drive organizational agility. Another key to organizational agility is measurement. Since businesses can now interact in more cost-effective and more elaborate ways, they can create the measurement

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capability needed to make the somewhat problematic traditional matrix organization work. First, measurement ability can be deployed to create enforceable contracts—a must if companies want to sell the output of single capabilities to other parties. The service will have to be priced and assessed on its profitability and value generation. For many companies this means beefing up cost allocation structures and financial reporting measures. Second, more enforceable and measurable contracts to link resources to specific ventures will lead to more straightforward relationships. This has some important benefits. Many organizations need to balance functional and business unit interests. Especially in stressful situations, such as during fast-paced growth or a contraction in the market, such matrix setups become less robust. The gap between business policies and resource allocation can be substantial at times. When such matrix relationships are replaced by enforceable contractual relationships (between the business ventures and the main capabilities, for instance), such clashes can be better avoided. The matrix resources with several reporting lines (functional, regional, and business lines, for instance) are effectively replaced by capabilities with several contractual relationships. The contracts will specify priorities. Finally, the reduction in interaction costs affects performance measurement—which needs to be aligned. The matrix model based performance on local profit and product introduction; now performance will be measured on the capability or on venturing. As we discussed earlier, Procter & Gamble has recently shifted its strategy by recombining certain capabilities with a number of market leaders (of the likes of Coca-Cola and Whirlpool) in an attempt to explore new growth avenues and play a leading role in technology innovation. As a prerequisite to creating such agreements—which generally include product codevelopment—P&G underwent some changes in underlying structure toward modifying performance measurements in a way that focused on individual capabilities.

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These changes created a more transparent, agile corporation. The first step toward making its capabilities more visible can be traced back to July 1999, when P&G changed its internal accounting to reflect the shift of business definitions to the capability level. Instead of crediting the sale of a license to a general corporate fund, the division that developed the technology was allowed to record the revenue. Another change required that all patents in use be made available for licensing 3 years after the product went to market or 5 years after a patent was awarded. With the new accounting rule, business capabilities were de facto able to receive direct compensation for their innovations. Indeed, these policies encouraged parts of the company to offer technology for licensing, and several divisions began discussions with other companies about possible partnerships.

■ CONCLUSION If we had to distill our discussion of the capability-driven organization into just a few sentences, they would include the following: ➤ The capability-driven organization is more focused and more powerful. ➤ It is more transparent and agile. ➤ Companies that want to focus on capabilities face a long but productive journey.

12

Chapter

Getting Set to Go The transformation involved in changing the shape of a company is nothing short of massive. The undertaking will affect a firm’s resources, its business processes, it culture, and its people. We believe it will occupy business leaders over much of this decade. For them, the crucial starting point will be adopting the mindset of the corporate raider, stripping the company to its essence and viewing it as a portfolio of businesses capabilities, each with its own unique makeup and business potential. All this will have to be done while considering the strategic needs of the businesses that have harbored the business capabilities until now. A capability-driven approach has important advantages over current methods of crafting strategies. The biggest is that many trade-offs involved in developing strategies for an entire business will be resolved. Because single business capabilities have specific key success factors, strategy development tends to be far less ambiguous. The downside is, of course, that strategies will have to be developed for all relevant capabilities as well as output businesses, which will increase the number of business entities that require strategic attention. Capability strategies are often straightforward in nature. The same strategic principles that have been used for decades still apply—but now at a lower level of business aggregation. So why isn’t capability thinking put into practice 249

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on a wide scale already? As we initiate clients, colleagues, students, and others in capability thinking concepts, we see firsthand the challenge of changing a collective mindset. Everyday business remains locked into the strategic business unit mold. Even if business leaders adopt the new mindset, they are often still forced to dedicate a considerable part of their time to running businesses in these traditional configurations. Fortunately, capability thinking itself offers a solution. In this chapter we suggest an itinerary for a journey to a capability-driven organization. We are not aware of a single company that has completed this journey, but several companies have embarked on different legs of it, and many more are casting off the moorings to get under way. In this chapter, we also take you through our recommendations on planning for this transformation. The steps we outline are based on many discussions with client executives and colleagues about the search for sustainable value in the face of disruptively low interaction costs: ➤ Determine the businesses you are really in. ➤ Formulate capability and market venture strategies. ➤ Establish strategic prioritization and partnering needs. ➤ Determine company priorities and restrictions, and plan for action.

■ THE CAPABILITY JOURNEY If we want to exploit the opportunities that capability strategies offer us, we will not only have to create a new strategic mindset, we will also have to create the right conditions for capability strategies to prosper. Since capability strategies are often of an “I-could-have-thought-of-that”

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nature, but at the same time are not widely adopted, there must be obstacles to the exploitation of such strategies. In fact, the obstacles appear formidable. In 1999 C. K. Prahalad and Jan P. Oosterveld observed that “many senior managers in multinational organizations have little knowledge of, or experience with, alternate models of managing and responding to new customer expectations.”1 They added that there is a natural “tendency to seek administrative clarity, even if it comes at the expense of strategic clarity.” Considering that capability strategies bring not only new customer expectations but also entirely new definitions of customers, the size of this obstacle can be fully appreciated. It also means that the current administrative model will have to be transformed into one that better aligns with capability strategies, as the existing one makes organizations hold on to prevailing business unit strategies. We argue that the organizational structures and governance structures in place in many large multinational organizations are holding those organizations in a strong business unit grip. Annual budget cycles, quarterly targets, accounting structures, organizational structures, and strategic reviews all work toward establishing the business unit as the most important fiber throughout the corporation. And while this business unit grip helps companies focus effectively on their markets and line up the resources within their business units, it is not conducive to fostering real capability strategies. There is an ironic twist to this situation: Business unit managers are forced to spend considerable time on managing several capabilities, but they are often restricted to the boundaries of their own business units. It’s an inefficient process, and neither the market ventures nor the capabilities get a fair deal. The market ventures (business units) do not receive the attention and contribution from their capability lineups they deserve, and the capabilities are managed against an intrinsically irrelevant benchmark of

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business unit sales! Could this be why many mature businesses wrestle with finding new sources of growth and are forced to continuously cut costs? Let’s look at some of the underlying drivers for this organizational dynamic.

➤ A Passion for Managing the Boring Bits Although businesses and business units often derive their name from the markets they sell in, business managers can’t devote themselves to ensuring that those markets are served with the best possible lineup of capabilities required. They have often spent considerable time working those same capabilities into a shape that serves the purpose. With changing market conditions and increasing competition, this can be a considerable task: After all, costs have to be reduced, productivities improved, and growth realized. Given that industrial operations, for instance, can represent a significant part of the resource pool, workforce, and asset base (in many industries), the center of attention can easily gravitate toward the performance of these capabilities rather than the markets being served. The threat is most prevalent in mature industries where cost control has become paramount. More human factors could also be at play in the propensity of businesses to keep together resource- and assetintensive capabilities. Perhaps there is a certain kind of satisfaction in knowing that one manages a business with tens of thousands of people, all working in concerted fashion toward a common goal. Managing the exploitation of patents through license fees with a handful of lawyers might rake in the same sort of net profits, but probably does not wield the same sort of respect. If you accept this premise, then you won’t be surprised if business managers or business unit managers will not readily concede control over capabilities to others, even if doing so would enable them make a more effective contribution to their business undertakings. If there is no natural tendency to want to cede control

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over capabilities, then people will find all sorts of reasons for keeping the capability in-house for exclusive use. In our discussions with business managers over the last few years, the chicken-and-egg dilemma was invariably raised as one of the first reservations. In many instances, there will not yet be markets on which the output of specific capabilities can be bought and sold. This makes it difficult to view a capability as a business in its own right with markets, competition, growth potential, and—above all—a price reference. This is understandable. After all, it was a long and gradual process when companies began to outsource logistics and certain manufacturing processes. Now the electronics manufacturing service and third-party logistics services industries are well established. Capabilities such as call centers, back-office administrative processes, and IT infrastructure are well on their way to following suit. Still, it is clear that a lot of water will have to pass under the bridge before the next—and arguably more interesting— wave of capabilities has reached this stage. Another huge stumbling block for relinquishing control over a capability is that this shift often makes business unit managers less confident of achieving their targets. Unfortunately, a number of outsourcing deals have (from the business unit’s perspective) gone spectacularly wrong for both parties. You may have read the books about what happened and how to avoid such difficulties in the future, but remember that the entire business world is the best example showing that the principle of the free market works. Trillions of dollars worth of products and services are exchanged between millions of companies every day on the principle that the better the products and services delivered, the greater the chance to grow and create shareholder value. There is no reason to believe that if we stretched our business definitions, this concept would shatter. Increasing the contribution from the main tool for achieving control—relevant management information—is key to combating fears when making the transition toward capability businesses.

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Outsourced call centers are a prime example. In many cases, the outsourcing partner has better systems that allow far more management information to be generated and used than would be possible in-house. The sense of control will increase, rather than decrease, as the clarity of contract relationships is combined with follow-up measurements.

➤ The Market Venture Manager Who Manages Capabilities The reluctance to widely adopt capability-driven strategies and organizations leads to a peculiar situation. We end up with market venture directors (business [unit] managers) who spend most of their time managing some of the capabilities that soak up the most resources and assets inside their businesses. That’s not bad per se, but if these managers limit their capability efforts to the objectives of the business units they are responsible for, they concoct a recipe for suboptimization. If the most resource- and assetintensive capabilities are not also most crucial to the output value of the business, they will consume a disproportionate amount of management attention.

➤ Accelerating and Focusing Management Control What are the chances that a university graduate in a large organization’s IT support department will join the board of executive directors? A quick survey of the résumés of board members of large corporations indicates that other functions, such as manufacturing or sales and marketing, are more likely to gain favor. This holds true for many industries, but not for companies that have made IT their core business (such as EDS, IBM, and Accenture). In other words, a little function called IT support in one company is the raison d’être in another. This does not imply that every company with its own IT support is making a judgment error. Many circumstances

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justify the need for in-house IT support. Systems that were developed in-house, and are highly industry- and company-specific, often need internal IT support. In other cases, there might be a strong need to mix IT and industry specialists for optimal results—which might be harder to achieve if the IT specialists come from outside. Yet in the long run, will this situation continue to be justifiable? Companies will have to assess when and how to begin to transfer capabilities or subcapabilities to parties better positioned to carry out those tasks. They will also have to create the appropriate organizational “pull” in this direction at the right time. Leaving this to independent business units will not naturally create the necessary convergence across multiple units.

■ THE TRANSFORMATION RECIPE Two important observations serve as the starting point for the transformation to a capability-driven organization: ➤ Business managers spend a disproportionate amount of time on capabilities that are not crucial to overall business value. ➤ To ensure that necessary convergence materializes in time, organizational “pull” will have to be established to look after interests that run across business units and optimization. Generic transformation recipes should be as practical as possible, and based on endgames that enable individual capabilities to avoid “retransformation” efforts as much as possible. To draft the road map, let us first group capabilities into three distinct clusters and the strategies best suited to them. We briefly discussed in chapter 4 a system for classifying

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capabilities according to their contribution to overall business value. The level of business aggregation plays an important role in this exercise. Although IT infrastructure can generally be classified as a necessary capability, businesses built on outsourcing of IT infrastructure will consider the capability to be crucial. (This is, of course, generally true for any business built around a single capability; performance in that specific area will be the most crucial contributor to business value.) The ranking of capabilities is highly business dependent. Large shifts in capability classifications can be expected, for instance, between commodity businesses and differentiated goods businesses. If a company cannot classify its capabilities, it is probably because two or more subbusinesses with different characteristics are hiding inside the business.

➤ The “Necessary” Capabilities The first group of capabilities consists of those that are “necessary” for generating business output. Capabilities in this cluster can include finance and accounting, procurement facilitation, sourcing of indirect material, HR management, employee benefits management, IT support, ERP (enterprise resource facilitation) support, and similar areas. They are all characterized by their relatively generic nature and their potential for benefiting from economies of scale. In principle, these capabilities will eventually be turned into businesses in their own right, leveraging knowledge, resources, and assets over many different businesses or business units. Many initiatives over the past few years have validated this general direction. Turning such capabilities into a separate business can at first take the shape of a shared services center, but ultimately, the business will likely be spun off or taken over by an outsourcing partner. The biggest hurdle in all this is insufficient standardization. Many large corporations that explore the idea of

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shared services centers are put off by the sheer amount of transformation (read investment) required to standardize processes enough to reap substantial benefits. Only straightforward transactional processes are “easy” enough to consolidate, and sometimes even to move to low-wage countries. Consider the following analogy. People on a mountain plateau at 4,000 meters might know that the reduced level of oxygen at this altitude impairs their physical performance and hampers their breathing efficiency. But if the only way down to sea level is over a pass of 6,500 meters, the risk of passing out and not making it at all outweighs the prolonged discomfort of staying put. In essence, the best options are to wait until better equipment becomes available or to make preparations that minimize the risk of not making it over the mountain pass. In business, the tools that facilitate the standardization and consolidation of processes are rapidly becoming more robust and deployable. The transformation hurdle is therefore gradually eroding, and companies will have to decide when the time is ripe to break through to the other side. If the “big bang” effect of turning necessary capabilities into businesses in their own right seems unpalatable, a more gradual process can be developed in which subcapabilities are consolidated in sequence of suitability and transformation hurdle. Information technology infrastructure and data processing can, for instance, be the first subcapabilities to be consolidated within IT, to be gradually followed by applications and maintenance. In finance and accounting, subcapabilities such as accounts receivable (and payable) can probably be consolidated first. Providing management information will probably be one of the later subcapabilities to be consolidated. A strong business and organizational “pull” must first be established to trigger and drive the standardization and consolidation. The chance that businesses or business units will spontaneously start to consolidate their necessary capabilities is negligible.

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➤ The “Crucial” Capabilities At the other end of the spectrum are capabilities that are key to overall business value or have potentially differentiating powers. Product (or service) development, research, branding, yield management, patents, and assortment—in short, many of the capabilities from the knowledge value chain layer—fall into this group. The relative importance of the capabilities in this group will be far more industry specific than the necessary capabilities. Consequently, an assessment will be required to identify which capabilities fall into the crucial group for a specific industry. The key driver for these capabilities is seldom economies of scale; fit and effectiveness are more likely candidates. Drafting strategies for these capabilities will require a search along the value chain to determine where they can potentially add the most value. After that, business models for capturing this value need to be explored. Lining up the organization to leverage crucial capabilities requires less transformation effort. The capabilities are likely to find a far better anchoring inside business units since they are not driven by economies of scale. In addition, since they are often knowledge capabilities, they can be more easily recombined or differently deployed without running into a massive transformation hurdle. Probably the only requirement is to free up business management time to focus more on leveraging the major contributors— which (coincidentally) can be supported by turning the “necessary” capabilities into businesses in their own right to be managed by dedicated directors.

➤ The “Beneficial” Capabilities We’re now left with a group of capabilities that contribute more to overall business value than the necessary capabilities, but are not exactly crucial either. There are also capabilities that benefit from economies of scale, but are

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nevertheless so specific that it’s tough to leverage them across company boundaries and value chains (of course, the flip side is that the upward potential will also be less). For this group of in-between capabilities, which we call beneficial, there is no prefabricated strategy or approach. Each capability will require an assessment to determine the most appropriate strategy. Capabilities that might fall into this category include manufacturing, bill of material sourcing, ERP facilitation, process technology development, maintenance operations, quality management, logistics, and supply chain management. Weighing the trade-off between keeping a best-in-class capability exclusive and leveraging it to other players is likely to be a recurring task in the assessment efforts.

■ PUTTING THE TRANSFORMATION RECIPE TOGETHER The characteristics of the three groups of capabilities suggest a framework for the transition toward a capabilitydriven organization. The framework contains the following components: ➤ The necessary capabilities, such as finance and accounting, human resources, information technology support, facility management, and possibly basic manufacturing, are turned into businesses in their own right as soon as is practically feasible. A transition model via shared services centers to a separate business or outsourced activity can be adopted. A gradual process broken into subcapabilities appears the most attractive. This will free up valuable management time of the business units (market ventures).

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When capabilities are gradually turned into businesses in their own right, perhaps through the intermediate step of setting up shared services centers, business units will be able to focus themselves more and more on developing their markets without being distracted by having to manage all required capabilities.

Figure 12.1. The Journey to a Capability-Driven Organization Source: A.T. Kearney.

➤ The crucial capabilities probably reside within the strategic business units, which will have to assess how and where to best exploit them. ➤ The beneficial capabilities will be addressed by the business units (market ventures) with functional support to ensure that pan-business-unit considerations are sufficiently addressed. All in all, this leads to an organization in which dedicated management teams take care of the necessary capabilities. The business unit directors (who now become true market venture directors) will be free to focus on the capabilities that really matter for them. Figure 12.1 illustrates how such a change might take shape. This proposed transition journey assumes that some capability knowledge of the industry under consideration is available. Although many companies have elements of capability strategies in place, we recommend that each com-

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Four steps can be used to create the agenda for the transition to a capability-driven firm. The first step will identify the different capabilities and market ventures the firm participates in and how they relate to each other. The second step involves a strategic assessment to determine the appropriate strategies for the business capabilities and market ventures. In the next step, the potential impact of capability strategies and market venture strategies is quantified, the competitive context assessed, and partnering needs identified. In the final step, the firm’s specific characteristics influence priorities and a feasible plan for action.

Figure 12.2. The Four Steps to Set the Agenda Source: A.T. Kearney.

pany assess the potential of capability strategies in a structured fashion. The following sections propose a four-step approach for setting the capability agenda (see Figure 12.2).

■ STEP 1: DETERMINE THE BUSINESSES YOU ARE REALLY IN The move toward a lower level of aggregation of the corporation forces CEOs to set their corporations beneath a microscope. Now that capabilities can contribute more transparently to output, CEOs must ask themselves once again: “What businesses am I really in?” Many companies failed to ask themselves this question while caught up in the early euphoria brought on by the Internet; others have asked, but lack the models or experience to deal with the

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challenges the answer bestows upon them. Characterizing new business definitions is the starting point in our approach. This step should literally be the first (and all other steps performed sequentially), as strategy should precede structure. The particular risk involved in not taking these steps in order is to strategize at the company level and not at the capability level. In other words, strategizing at the total company or business unit level will not sufficiently address the needs and possibilities of the individual business capabilities. To pin down new business definitions in the face of disruptively low interaction costs, you need to define which capabilities and outputs you participate in and how they link together. This requires dissecting the business into two dimensions. First, the business must be broken down into single capabilities. You can, in essence, unbundle2 the business into a market-facing entity, a production entity, and a development entity and gradually move to greater detail in terms of distinct business capabilities. A set of generic capabilities can serve as a starting point for this task. This set can serve both as a checklist and as a basis for tailoring the capabilities to the industry. Physical capabilities Transaction capabilities Knowledge capabilities Material supply Component manufacturing Subassembly manufacturing Product manufacturing Warehousing Distribution Picking and packing Fine distribution Site provision Logistics

Ordering facilitation Invoicing Process control Inventory management Forecasting Claims handling Payment processing Billing Benefits administration Procurement Compensation planning

Product design Product development Application development Product branding Buying experience branding Service branding Customer need translation Commercial assortment Status information Market intelligence

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Some of the capabilities from the checklist need to be very specific. For instance, the capability of making a commercial assortment available often takes place at several stages of the value chain. Raw materials such as oil products are sold on oil product exchanges; some are further processed and turned into raw material for plastics and are subsequently offered commercially in the assortment of bulk plastic granulate producers. Part of their output is bought by wholesalers and made available together with associated materials to small production firms producing and selling (for instance) plastic containers. The plastic containers are, in turn, sold to the public at large through the assortment made available by the retailers. Strategizing at the total company or business unit level will not sufficiently address the needs and possibilities around the individual business capabilities. Identifying all stages of specific capabilities helps illustrate how the definition of capabilities might change if they are freed from old business definitions. It is also critical to rethink what a capability really stands for, or what real business is hiding behind what appears to be a small capability within a single firm. Doing this is a little like looking at an M. C. Escher print: You see the real picture only if you change your perspective. Suddenly, when you’re looking at a flight of birds, you see a school of fish in their midst.

➤ The Capability Tree We’ve had lots of discussions over the aggregation level at which capabilities need to be defined. Unfortunately, there is no single answer; the best aggregation level will ultimately depend on the objective. For business modeling purposes, for instance, a higher aggregation level will be used to make models accessible and to allow the organization

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to absorb them if the strategies are deployed. To determine capability strategies, however, a greater level of detail will be required to get to unambiguous economic drivers, and thus relevant strategies, for the capabilities. For communication purposes even greater levels of detail are useful. This level, which can arguably be called the level of subcapabilities, illustrates the nature of capabilities and explains what is included in them. It can be useful to construct a capability tree and roll up or drill down into levels of detail depending on the need at hand. It will also help place capabilities in the value chain layer they belong to: physical, transaction, or knowledge. It is also possible to map the different market ventures in which a company participates or has interests. This map appears to be more closely aligned with typical business unit structures existing in many larger organizations today. The business unit structure can serve as a starting point for mapping the market ventures. One word of caution: There is a significant risk of missing out on critical insights if existing business unit structures feature too prominently in determining the company’s market ventures. This is because in many organizations, the business units are not really leading in setting the company boundaries. The cross-section of the products a company can produce, and the markets they can be sold in, provide the basis for business unit definitions. In other words, a certain market opportunity does not determine company boundaries—rather, the industrial capability sets the boundaries of the company’s activities. This distinction is not merely academic. Business units are often defined around major product groups or technologies because this provides a straightforward, measurable segmentation of the business. The way in which business is conducted, however, is often strategically more important in business segmentation, albeit less easily measurable. Many business-to-business manufacturing environments include a wholesaler/replenishment segment that has typical commodity characteristics. Price, availability,

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and service level rule. The products might belong to a far larger range, including really differentiating designs and specifications, yet they are often managed by the same business units. Perhaps in such cases it makes sense to define business units around the type of business conducted, each with its own specific requirements in terms of capability mix and partnering needs. Instead of having several product-denominated business units, the company could set up a replenishment business unit with its own key success factors, processes all geared toward availability, price, and service level, and perhaps with complementary partners outside the company. This commodity business unit could be complemented with several smaller business units focusing on the products sold in specification fashion to customers. Such a setup would probably also require reducing the level of vertical integration by creating an OEM/ ODM (original equipment manufacturing/original design manufacturing) business serving all business units. Dissecting the company output also helps identify potential breakups of the total offering—those propositions in which the existing capability-based price carrier may lose its ability to collect compensation for the integral offering. The areas to focus on are those in which a company holds onto a business capability that cannot stand up to its direct competition at the capability level. You can also draw a map that shows how various capabilities contribute to the different types of output (see Figure 12.3).

■ STEP 2: FORMULATE CAPABILITY AND MARKET VENTURE STRATEGIES The second step, formulating capability and market venture strategies, entails determining the key drivers for each capability and what it produces and envisioning how to optimize the capability businesses and market ventures. In

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Figure 12.3. Mapping Capabilities and Market Ventures Source: A.T. Kearney.

the second instance, a gap assessment can be a useful tool for determining how the company and its competitors are positioned vis-à-vis the expected endgames. The starting point for this step is to understand how individual capabilities would develop based on their own success factors or business drivers. Each business capability has the potential to reach an optimal configuration via economies of scale or scope, flexibility, effectiveness, and so forth. Whether it reaches this configuration and how it will look depends on a number of factors. (For a discussion of geography and capability strategies, see sidebar: “Taking Care of the Geographical Dimension.”) One important factor will be how low interaction costs might affect the specific capability aside from allowing it to search for its own level of optimization. Information-rich capabilities, such as those in the knowledge value chain, have significant potential to be transformed as companies exploit low-cost connectivity and the ability to digitize information.

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Taking Care of the Geographical Dimension In many large enterprises, geography plays an important role in organizational design. Business units and country or regional organizations have engaged in countless power struggles. How will a capability-driven organization affect this dynamic? The answer holds a contradiction: Geography will become much more important, but increasingly irrelevant from an organizational point of view. It will be less influential in organizational but more so in business design. It will also be considered at a lower level of business aggregation. In traditional organizations geography comes up when it is time to decide how to cut the organizational cake. What’s best—a business unit structure or a regional structure? A product structure or a channel structure? Or some form of matrix to serve multiple dimensions without too much compromise? Each method of slicing will benefit some capabilities—and compromise others. Traditional organizational design, therefore, devotes considerable time to determining which dimension (such as geography, function, or product group) should lead, and which should be addressed in different ways (for instance, through focused measurement). This task is an arduous one. Because most businesses harbor several subbusinesses, each of which has its own characteristics and resulting needs, the demands placed on specific capabilities vary as well. For instance, consider the requirements for a large chemicals firm. If it makes commodity chemicals, the manufacturing plant must be an optimal size and run very efficiently to keep costs low enough to compete. The processing capability (plant operations) will be key. If the chemicals firm attempts to raise margins by also producing specialty chemicals, different capabilities will become key—such as research and development, process piloting, and design-in capabilities. At the same time, the plant must now be capable of more sophisticated process control and able to produce smaller batches of different chemicals. Clearly, the needs of the specialty business are at odds with those of the commodity business. Even the geographical requirements differ. Because of the premium potential,

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and the closer fit with customer requirements, the specialty chemicals can probably travel further than the commodity chemicals, which have to be produced as close to the market as possible to save on transportation costs. A company must make the tough choice between becoming a cost leader or differentiator if it is to make a clear-cut organizational design choice. How does the capability perspective make this easier? The capability and market characteristics determine the most logical choices. Let’s look at two possible options for the chemical company: a 400-kiloton commodity plant focused on efficiency, or a 200-kiloton specialty plant that can manage more complex production processes in shorter runs. Geography now becomes a business design parameter. The commodity plant would have to serve a major industrial area (in Europe, it could be the Ruhr area in Germany) to keep transport costs in check. The specialty plant could cover most of Europe since transport costs represent a smaller percentage of total product costs and price. It is fairly simple to draw this big picture. Now let’s look at a serious challenge for our chemical firm: It decides to go the specialty route, but its market share is too small to run the plant at peak efficiency, forcing it to also produce commodity chemicals at the specialized plant. These chemicals are sold at a loss (since they are produced at a plant that is highly sophisticated, small, and expensive), dragging down the potential of the specialty chemicals business. If the company wants to optimize its processing capability, the only logical conclusion is this: The processing business will have to either sell its services outside company boundaries to build volume, or assess whether it can pool volume with other businesses in a new processing company that excels in research and development, process piloting, and design-in capabilities. This example illustrates just how difficult it can be to manage all of a company’s compromises effectively. The organizational design challenge this presents could be compared to cutting a cake for several demanding 4-year-olds while the cherries constantly change position, the layers change places, and the icing changes color!

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The example also shows that when we start creating businesses out of (sets of) capabilities, fewer demands have to be met simultaneously. The number of organizational permutations suitable for a single-capability business is, in most cases, very limited. The characteristics of the capability will clearly favor certain business configurations—and therefore certain organizational configurations—over others. Geography will be an integral part of the optimal business configuration, and as such becomes a business design parameter. In other words, many organizational compromises existing in today’s companies will be resolved when they move toward a capability-driven organization. When P&G announced its intention to create three regional service centers for a number of its support functions, and that it might outsource parts of them, it introduced a lot of organizational clarity. When viewed in isolation from all the other considerations affecting sales, marketing, production, and innovation, it appeared to make a lot of sense to set up three centers in the main regions where P&G operated. The regional specifics were significant enough to preclude a further consolidation in a single global service center.

Current conditions also influence the endgame. For instance, the number of players involved in each step of the value chain can significantly affect the future direction of capabilities. The power dynamics between the players and the concentration of value in the chain wield influence as well. For example, if the value resides in the physical layer of the value chain, say in manufacturing, companies with the highest economies of capital can potentially put their mark on the value chain. The required strategy will then be consolidation around that capability. On the other hand, if the coordination capability plays a dominant role in the value chain of the future, the company that excels at integration is more apt to extract value. In this case, the likely endgame will favor the dominance of integrators—a phenomenon of increasing importance when markets are

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fragmented and high-end capabilities such as innovation and design command a premium. (The value chain power dynamics will play an important role in the third step, establishing strategic priorities.) The endgame developments are also heavily influenced by which value chain perspective the market maker chooses to adopt: an upstream view, where the focus generally rests on getting more value at lower cost, or a downstream view, where the focus rests on bringing more value to customers. The downstream perspective is more challenging; it succeeds only when a company also creates value for other players in the chain, and is able to “bribe” itself into a better position. At the capability level, the upstream perspective chosen by the market makers may bypass some players.

➤ Generic Capability Strategies In chapter 4, we discussed creating generic strategies for capabilities by plotting them against their contribution to overall business value and their performance against competitors. Complement this effort with a vision for the potential endgame for the individual capabilities, and you get a sense of where the company stands, both against its direct competitors and in the journey toward the goal. A capability’s contribution to output value cannot be established directly, nor will its context be completely fixed or clear. For instance, suppose you want to assess performance against the endgame for optimizing ordering and invoicing through a third-party transaction platform. First, you’d need to evaluate which industries are likely to use the different platforms, and for what part of their transaction needs. However, the fact that the contribution to output value cannot be determined exactly is not so relevant. The important thing is to prioritize and assess the risks and opportunities you derive from strategizing at the capability level.

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Importance for business value The main capabilities of a specialty chemical firm are plotted against their relative importance to business value. In this case, value comes mainly from the patent portfolio and the ability to take processes from the laboratory to full-scale chemical processes, and from relative capability performance. The company in this example has strengths in the important capabilities for this industry, but appears to offset this with its lackluster performance in the necessary capabilities. The company had recently invested considerably in an end-to-end ERP system, which is now state-of-the-art but could benefit further from increased scale.

Figure 12.4. Determining the Capability Strategies and Opportunities Source: A.T. Kearney.

To get a first indication of how capabilities contribute to overall business value, compare players achieving varied success in an industry and assess the differences between those players at the capability level. What patterns can be found between capability strengths and overall strengths? Figure 12.4 gives an example of a high-level capability analysis for a specialty chemical company. For a single capability, two criteria will drive the ability to shape the endgame: the relative position as benchmarked against the (cross) industry competition at the capability level and the relative innovation opportunity against what can be considered the endgame. The stronger the company is in a specific capability, the greater the likelihood it can drive the progression toward the goal. However, the larger the gap between the current capability configuration and the endgame, the less important the relative position of different players becomes. The longer the

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Figure 12.5. Establishing Capability Potential Source: A.T. Kearney.

journey, the less relevant the starting point and the more room players have to innovate. And the larger the capability’s contribution to the endgame, the more urgent optimization becomes. Companies will look first at capabilities that bring the most to value chain output as they seek to control the value chain and create more value within their own companies. The result of this step will be a set of strategies for all the major capabilities. Figure 12.5 illustrates how such a strategy might be developed for a single capability—in this case ERP facilitation. The example company is a multinational, multi-business-unit company, which has assessed its capability to provide effective ERP facilitation. Because it is organized in a strong business unit configuration, it has delegated ERP facilitation to those units. The result: Each of the 30 business units has developed and implemented its own ERP system, tailored to its own needs. At first sight, this appears to be an attractive proposi-

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tion. After all, each business unit has an ERP system that fulfills its specific requirements. But look closer. Most business units represent a mix of different channels and customer segments, as well as various extended supply chain concepts, such as make-to-stock and make-to-order. Since the business units could not afford to create several parallel ERP solutions, most opted for a hybrid solution that would cater to the different needs. Needless to say, the resulting solutions are quite complex and fail to excel in terms of functionality because of the compromises required. Compared to a company that has achieved standardization across business units and selected a single ERP flavor for its entire business, our company has a clear disadvantage in terms of leverage and maintenance costs. So our company considers strategies to improve the contribution from its ERP facilitation efforts. It might first focus on internal standardization, perhaps by creating a restrictive menu of several ERP flavors the business units can select from in order to meet their requirements. It might also seek external leverage if the internal potential is considered to be insufficient, or perhaps too difficult to unlock.

➤ The Extended Value Chain Another important tool is a map that shows the location of various players along the extended value chain and their business models. Such a map can also assist in determining the respective market sizes and market attractiveness. This value chain mapping can facilitate the assessment of where in the value chain the capabilities of a specific company might have the highest return. Development efforts to make a fuel-efficient automobile will save the user considerable operating costs over the lifetime of the car. Unless the car manufacturer can implement a business model that taps into these fuel savings directly, the fuel efficiency must generate a price premium when the car is sold—well before new owner benefits. There is a risk that the customer segments that are attracted by fuel efficiency are also the

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ones that buy strongly on economic grounds. The premiumpaying customer groups may flock to gas-guzzling but status-enhancing models, shunning the micro and costefficient cars. So despite the demonstrable fuel efficiency benefits, the return on the development efforts is a ticket to play rather than a powerful source of premium prices.

➤ Assessing the Impact on the Market Ventures Going through the capability strategies and using the capability–market venture map, companies can assess how the strategic opportunities for the capabilities might affect the competitiveness of the market ventures. This will allow them to adjust strategies for the market ventures (the old business units) accordingly, tap into new opportunities, and counter emerging threats.

■ STEP 3: ASSESS STRATEGIC PRIORITIES AND PARTNERING NEEDS The third step involves ranking and prioritizing the strategic options. The following criteria are key to this process: ➤ Potential of the (capability) strategy: The bigger and more attractive the strategic option appears in value creation terms, the more pursuit will seem a necessity. ➤ Urgency from a competitive dynamics perspective: The competitive dynamics and power balance in the extended value chain can favor or work against the successful deployment of specific capability strategies. ➤ Urgency from a partnership perspective: Only one company gets the dream partnership. When that seat is taken, an alternate plan will have to be deployed.

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➤ The Capability Strategy Potential There is a risk that the second step (formulating capability and market venture strategies) will yield a plethora of strategic options and threats, which could bog down strategy deployment. It is important, therefore, to screen the strategies to quantify their attractiveness, considering the secondary benefits a capability strategy might have in the market ventures that use the capability. Leveraging the industrial base of a packaged consumer goods company by selling in OEM fashion to competitors with complementary geographic footprints will reduce the cost of goods sold due to better leverage of fixed industrial costs and development efforts. It will also yield a small margin on the products sold to the complementary partner, and boost its own sales by using the headroom created by the lower costs of goods sold to work the market more intensively. The strategic potential can be quantified or assessed with essentially the same tools used for evaluating regular business unit strategies.

➤ Urgency from a Competitive Dynamics Perspective Next in determining the strategic priorities is to assess how likely it is that certain strategies can—or in some cases, must—be successfully deployed to fight off new competitive threats. A company serving a fragmented market, for instance, should keep in mind that buyers will eventually start using new interaction opportunities to virtually increase their relative power in the value chain. A simple way to gain insight into the likely competitive dynamics is to expand the representation of the extended value chain developed in the previous step to include the three value chain layers—physical, transaction, and knowledge—and map the different players and their relative sizes on these value chains. It is important to address scope changes in the value chain at this stage, and to look

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at the most important parallel value chains to determine how important the industry is for the next step in the value chain. Car insurance, for instance, is a typical secondary product, its market heavily influenced by trends in areas like car ownership and financing.

➤ Urgency from a Partnership Perspective The third step is to determine your partnering needs to get to the endgame, as partners are more likely than ever to be a part of the most promising strategies. We use the word partner in its broadest sense: A partnership can range from an agreement to an outright sale or purchase. Any optimization strategy that takes you outside company boundaries involves carefully choosing the other players. Whether you optimize your manufacturing or logistics capabilities by assigning them to an outside vendor, leverage your back-office operations by selling them to proposition directors from other firms, or recombine your design capability with best-in-class product developers, you will require partners. In the latter situation, where partners create exclusive recombination strategies, the bestin-class partners are available only once. After that, availability is restricted to the second tier in quality—at best. Any optimization strategy that takes you outside company boundaries involves carefully choosing the other players. Identifying the most appropriate candidates to fill the gaps in creating superior output or to optimize individual business capabilities is a critical task. Given the importance of selecting the right partner for successful recombination scenarios, carefully assessing your needs and thoroughly screening candidates are essential steps.

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Two basic factors determine partner suitability from a capability perspective.3 The first is the extent to which a potential partner can help move you toward capability endgames, and thus the ability to achieve competitive advantage at the capability level. The second is the degree to which the different capabilities of potential partners complement each other—or in other words, how far alliance partners can move toward the endgames of multiple business capabilities. The joint venture launched in July 2001 by Philips Electronics of the Netherlands and LG Electronics of South Korea to serve the global CRT monitor business makes a lot of sense from the perspective of several capabilities. Industrially, the two partners are quite complementary, having a specific focus on the CRT monitor range. Their material needs complement each other beautifully; they become even stronger buyers of glass, plastics, and components. To make the proposition even stronger, Philips and LG complement each other at the sales and marketing level as well, given their positions in the different geographic regions of the world. Thus the partnership allows Philips and LG electronics to leverage several capabilities in a single partnering effort. Such examples, however, are likely to be the exception rather than the norm. The chances are higher that the partnering needs will become very capabilityspecific, and that multiple partners will be required to get to the most competitive value chain output. Partners need to be grouped and treated in differentiated ways based on the nature of the relationship. We can divide them into two broad groupings: strategic partnerships and nonstrategic partnerships (such as vendor relationships). The more important the relationship is for either party in providing a key capability or a venture, the more strategic or exclusive it is. If we include resources that remain part of the company, we can define three basic levels: core internal capabilities and ventures, strategic partnerships, and external buyer/supplier relationships.

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■ STEP 4: DETERMINE COMPANY PRIORITIES AND PLAN FOR ACTION At the end of step 3 we have a neatly prioritized set of capability and market venture strategies ready for implementation. For many of the strategies, deployment will mean the development of a business case to validate the opportunity and a detailed rollout plan. Depending on the type of opportunity, the business case development is likely to be followed by a design and initiation phase, after which the deployment can start. One last thing: The company perspective will have to be used as the ultimate screening criterion. What level of effort can the company support? Which issues need to be addressed regardless of new strategic opportunities? What market expectations have to be met in the short term? What political sensitivities need to be accommodated to maintain organizational stability? There are many other considerations in this vein. One of the first tasks in the last step in setting the agenda for change, therefore, is to determine the most pressing considerations and restrictions the company faces and assess the likely organizational impact of the most attractive capability strategies. Only when this vital input has been collected can a workable plan for action be drafted.

■ CONCLUSION The outcome of these four steps will be a prioritized set of offensive and defensive strategies, including timing and valuation, tailored toward the individual business: ➤ The first step is to determine the businesses you are really in by identifying the capabilities and outputs you participate in and by characterizing the makeup of the value chain.

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➤ The second step is to determine the suitable capability and market venture strategies given their existing characteristics and drivers. This step entails determining the key drivers for each capability and market venture, shaping the likely scenarios, and conducting a gap assessment. ➤ The third step is to prioritize the output of the previous step against three criteria: ➤ Capability strategy potential ➤ Value chain competitive dynamics and power balance impact ➤ Partnering needs and opportunities ➤ The last step is to think through how the possible strategies affect the organization, how they relate to the company’s priorities at this moment, and what’s going to be the most successful plan for action. Successful implementation depends on a company’s ability to comprehensively transform itself. In this process, many interfaces, systems, and requirements will radically change. Entire processes will become obsolete, be subcontracted, dramatically increase in importance, or generate returns through radically new business models. Redefining business boundaries implies major transformation— deeply affecting your company’s capabilities, assets, people, and culture. The challenge is heightened by the fact that change will increasingly be needed not just in one company, but across all key partners.

Epilogue Based on our many discussions with executives, colleagues, and subject matter experts, we believe the following observations capture the reality of the business environment in the years to come: ➤ Competitiveness and growth opportunities will increasingly be defined at lower business aggregation levels due to ever-decreasing interaction costs. ➤ The dramatic drop in interaction costs can be considered disruptive. It creates instant opportunities to redefine businesses, which must be addressed to create new growth opportunities or avoid new threats. ➤ Many examples of the new cycle of business practices already exist in various industries, but the disruptive nature of the change means that many of the scenarios we envision today may actually materialize in different ways. ➤ The possible endgames for capabilities based on physical assets and driven by economies of scale appear relatively straightforward. Learning to develop and deploy strategies for knowledge capabilities will be the real challenge ahead. But now what? When the fascination for business-to-consumer (B2C) concepts dwindled in the latter days of the Internet hype, business-to-business (B2B) was hailed as the real promise and true opportunity brought about by the Internet. With hindsight this appears more logical, albeit for different reasons than originally anticipated. The new interaction opportunities B2B brings to old companies will create 281

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entirely new industries, such as trade facilitation and a variety of procurement services businesses. However, B2B will also exert a far more fundamental influence: An abundance of new services and businesses can be defined once capabilities are treated as businesses in their own right. Consumers will still buy cars, televisions, houses, and cleaning services; the real difference will be that many more “businesses” will have participated in creating the end result, exchanging products and rendering services among them in the process. The redefinition of business may lead to some receding of company boundaries (a reduction in what is 100 percent owned by the company). But the footprint of the corporation, because of its growing involvement in new partnership forms, is actually likely to increase. The strategies deployed also affect size. For instance, the scale required to optimize a manufacturing process is irrelevant for capabilities in the knowledge value chain, which depend on the right customer fit. More focused, the capability-driven organization will be armed to face the benefits and challenges of the shift of competitive advantage to the capability level. We are clearly facing a disruption, and any discontinuity instantly creates improvement potential. Some of the opportunity is really greenfield in nature; it was a key driver behind the frenzied activity during the Internet hype. But just as with the old economy gold rushes in Alaska and California, the expectations of instant wealth were grossly exaggerated, and the number of diggers led to serious dilution of the proceeds (except for a company complementing needle and thread with rivets in trouser manufacturing). As we have argued throughout the book, the highest quality gold is not buried in such greenfield opportunities, but in the reconfiguration of what already exists. By exploiting and leveraging existing production assets, brand equities, skills, customer relationships, resources, and knowledge in fresh configurations, new sources of value can unlocked.

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This brings us to an interesting conclusion. Apparently, a company’s capabilities are like options on value creation opportunities. We should, therefore, not only value a company on the likely success it will have in its current markets, but also on the potential new capability-related markets it could be active in if it decided to do so. At least as long as we are transitioning toward lower levels of business aggregation, the valuation of a company should include not only the expectations around the markets it is active in, but also the value of the options of entering (and reconfiguring for) completely new markets related to its capabilities. Obviously we shall have to adapt our valuation spreadsheets for the years to come to accommodate a version of real option pricing of capabilities. The implications are quite profound. Today we value companies on their activities in markets matching the current level of business aggregation. Arguably, these valuations will look quite different when performed at the business capability level. This topic, however, is worth a book in itself. Our aim in this book is to provide executives with the perspective needed to adapt to the fundamental shift in the business environment. Old frameworks prevail, but they can be applied in radically new ways. The capabilitydriven organization will create tremendous new sources of growth and competitiveness for those who take their strongest capabilities and market ventures to even higher ground.

Notes CHAPTER 1 1. David Kirkpatrick, “From Davos, Talk of Death,” Fortune, March 5, 2001, p. 180. 2. Michael E. Porter and Victor E. Millar, “How Information Gives You Competitive Advantage,” Harvard Business Review, July/ August 1985, pp. 149–160. CHAPTER 2 1. Philip B. Evans and Thomas S. Wurster, “Strategy and the New Economics of Information,” Harvard Business Review, September–October 1997, pp. 71–82. 2. A.T. Kearney analysis, based on interviews with clients. 3. “Every Business is an Information Business,” Financial Times, February 1, 1999, p. 3. 4. John Hagel III and Marc Singer. “Unbundling the Corporation,” Harvard Business Review, March–April 1999, pp. 133–141. 5. Julian E. Barnes, “Procter & Gamble Seeks Partners as Part of a New Image,” New York Times Online Edition, March 16, 2001. Retrieved March 16, 2001, from http://www.nytimes.com. 6. Quote by Andy Mooney, president of Disney Consumer Products Worldwide, in a Coca-Cola press release, February 28, 2001. 7. Michael E. Porter and Victor E. Millar, “How Information Gives You Competitive Advantage,” Harvard Business Review, July/August 1985, pp. 149–160. 8. “Every Business Is an Information Business,” Financial Times, February 1, 1999, p. 3. CHAPTER 3 1. Gerry Kermouch, Stanley Holmes, and Moon Ihlwan. “The Best Global Brands,” BusinessWeek, August 6, 2001, p. 50. 2. David Kirkpatrick, “From Davos, Talk of Death,” Fortune, March 5, 2001, p. 180.

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3. Clayton M. Christensen, “The Past and Future of Competitive Advantage,” MIT Sloan Management Review, Winter 2001, pp. 105–109. CHAPTER 4 1. Michael E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New York: Free Press, 1985). 2. C. K. Prahalad and Gary Hamel, “The Core Competence of the Corporation,” Harvard Business Review, May–June 1990, pp. 79–91. 3. G. P. Stalk, P. Evans, and L. Shuman, “Competing on Capabilities: The New Rules of Corporate Strategy,” Harvard Business Review, March–April 1992, pp. 57–70. 4. James F. Moore, The Death of Competition: Leadership and Strategy in the Age of Business Ecosystems (New York: HarperBusiness, 1996). CHAPTER 5 1. A.T. Kearney Automotive Industry Analysis (June 1998). Chicago: A.T. Kearney. 2. Kerry A. Dolan and Robyn Meredith, “Ghost Cars, Ghost Brand,” Forbes, April 30, 2001, p. 106. 3. Ibid. 4. Pieter Klapwijk, Global Economic Networks (Amsterdam: Klapwijk Holding N.V., 1996), p. 75 CHAPTER 6 1. Intel Microprocessor Quick Reference Guide, (n.d.), http:// www.intel.com. Retrieved July 1, 2002, from http://www.intel. com/pressroom/kits/quickreffam.htm. 2. Beth Ellyn Rosenthal, “You Can’t Be Good at Everything,” OutsourcingJournal.com, March 2001. Retrieved July 1, 2002, from http://www.outsourcingjournal.com/issues/mar2001/ insights4.html. 3. For more information on standards, see Mike Moriarty and Bruce Klassen, Power Play: The Beginning of the Endgame in Net Markets (New York: Wiley, 2001).

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CHAPTER 7 1. Alan Hall, “How the Web is retooling Detroit,” BusinessWeek, November 27, 2000, p. 194–196. 2. See the section Biopharmaceutical “Value Networks” in chapter 9. 3. Rob Kaiser, “Motorola Chips Set Free,” Chicago Tribune, July 23, 2001, p. 3. 4. “Growth Strategies,” Ralph Lauren Annual Report, 2000, pp. 9–16. 5. James Brian Quinn, “Outsourcing Innovation: The New Engine of Growth,” Sloan Management Review, Summer 2000, pp. 13–28. 6. Ibid.

CHAPTER 8 1. “In the 1940s, America’s Supreme Court concluded that, ‘tying agreements serve hardly any purpose beyond the suppression of competition.’ Economists have long challenged that absolutism. Many now think that, though there are exceptions, selling bundles of goods together as a package can be a source of economic efficiency.” From F. T. McCarthy, “A Bundle of Trouble,” The Economist, July 7, 2001. 2. Jon Maples, “Will Telematics Drive the Industry to Distraction?” Red Herring, April 4, 2001. Retrieved April 4, 2001, from http://www.redherring.com/mag/issue95/360018636. 3. Julian Barnes, “Whirlpool to Change Consumer Habits,” New York Times, March 16, 2001, p. 1. 4. Ibid. 5. Pieter Klapwijk, Global Economic Networks (Amsterdam: Klapwijk Holding N.V., 1996). 6. Ibid. The PVM was originally formulated by Klapwijk and colleagues in the early 1990s in the context of a product strategy assignment carried out by A.T. Kearney. The model subsequently has been used in a number of assignments across industries. 7. Corporate Marriage: Blight or Bliss? Chicago: A.T. Kearney, 1999. 8. Sales figures from press releases; media coverage of deal includes Reuters, September 26, 2001.

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CHAPTER 9 1. Jeffrey R. Brown and Austan Goolsbee, Does the Internet Make Markets More Competitive? Evidence from the Life Insurance Industry, NBER Working Paper 79962000 (Cambridge, MA: National Bureau of Economic Research, 2000). CHAPTER 10 1. C. K. Prahalad, “Strategic Choices in Diversified MNCs,” Harvard Business Review, July/August 1976, pp. 67–78. 2. Motorola company sources, cited in Rob Kaiser, “Motorola Chips Set Free,” Chicago Tribune, July 23, 2001. CHAPTER 12 1. C. K. Prahalad and Jan P. Oosterveld, “Transforming Internal Governance: The Challenge for Multinationals,” MIT Sloan Management Review, spring 1999, pp. 31–39. 2. John Hagel III and Marc Singer, “Unbundling the Corporation,” Harvard Business Review, March–April 1999, pp. 133–141. 3. There are, of course, myriad factors to consider in a partner-screening process, and many publications have addressed these. One is Romil Bahl and Jimmy Livingston, “Tying the Knot,” Executive Agenda (published by A.T. Kearney), Fourth Quarter 2000, p. 5. GLOSSARY 1. James F. Moore, “Predators and Prey: A New Ecology of Competition,” Harvard Business Review, May–June 1993, pp. 75–86. 2. Michael E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New York: Free Press, 1985). 3. C. K. Prahalad and Gary K. Hamel, “The Core Competence of the Corporation,” Harvard Business Review, May–June 1990, pp. 79–91. 4. Michael E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New York: Free Press, 1985). 5. Clayton M. Christensen, The Innovator’s Dilemma (Boston: Harvard Business School Press, 1997). 6. Michael E. Porter and Victor E. Millar, “How Information Gives You Competitive Advantage,” Harvard Business Review, July– August 1985, pp. 149–160.

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7. C. Handy, The Age of Unreason (Boston: Harvard Business School Press, 1989). 8. Daniel F. Burton Jr., “The Brave New Wired World: Emergence of a Networked Economy,” Foreign Policy, no. 106 (March 22, 1997), p. 22. 9. Pieter Klapwijk, Global Economic Networks (Amsterdam: Klapwijk Holding N.V., 1996) p. 75. The PVM was originally formulated by Klapwijk in 1999 in the context of a product strategy assignment carried out by A.T. Kearney. The model subsequently has been used in a number of assignments across industries. 10. Michael E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New York: Free Press, 1985). 11. J. Byrne, “The Virtual Corporation,” BusinessWeek, February 8, 1993, pp. 99–103.

Sources After the gold rush. (2001, February). (A.T. Kearney discussion paper). Chicago: A.T. Kearney. Andrews, Kenneth. (1987). The concept of corporate strategy (Rev. ed.). New York: Irwin. A.T. Kearney automotive industry analysis. (1998, June). Chicago: A.T. Kearney. Baldwin, Carliss Y., & Clark, Kim B. (1997, September–October). Managing in the age of modularity. Harvard Business Review, pp. 84–93. Barnes, Julian. (2001, March 16). Whirlpool to change consumer habits. New York Times, p 1. Barnes, Julian E. (2001, March 16). Procter & Gamble seeks partners as part of a new image. New York Times Online Edition. Retrieved March 16, 2001, from http://www.nytimes.com. Barney, Jay B. (1999, March 22). How a firm’s capabilities affect boundary decisions. Sloan Management Review, p. 137. Blackman, T. (1999, May 6). Trading in options. People Management, p. 42. Byrne, J. (1993, February 8). The virtual corporation. BusinessWeek, pp. 99–103. Chandler, A. D., Jr. (1962). Strategy and structure: Chapters in the history of the American industrial enterprise. Cambridge, MA: MIT Press. Christensen, Clayton M. (1997). The innovator’s dilemma. Boston: Harvard Business School Press. Christensen, Clayton M. (2001, Winter) The past and future of competitive advantage. MIT Sloan Management Review, p. 105. Coase, Ronald. (1937). The nature of the firm. Econimica, 4, 386– 405. Collis, David J., & Montgomery, Cynthia A. (1995, July–August). Competing on resources: Strategy in the 1990s. Harvard Business Review, p. 118. Corporate marriage: Blight or bliss? (1999). Chicago: A.T. Kearney. Diba, Ahmad, & Munoz, Lisa. (2001, February 19). America’s most admired companies. Fortune, p. 64. 291

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Dolan, Kerry A., & Meredith, Robyn. (2001, April 30). Ghost cars, ghost brand. Forbes, p. 106. Dupin, Chris. (2001, May 14). Logistics as a profit center. Journal of Commerce, p. 11. Evans, Philip, & Wurster, Thomas S. (2000). Blown to bits. Boston: Harvard Business School Press. Every business is an information business (Survey on mastering information management). (1999, February 1). Financial Times, p. 3. Hagel, John, III, & Singer, Marc. (1999, March–April). Unbundling the corporation. Harvard Business Review, pp. 133–140. Hall, Alan. (2000, November 27). How the Web is retooling Detroit. Business Week, pp. 194–196. Hamel, Gary, & Prahalad, C. K. (1993, March–April). Strategy as stretch and leverage. Harvard Business Review, pp. 75–84. Hamel, Gary, & Prahalad, C. K. (1994, July–August). Competing for the future. Harvard Business Review, pp. 122–128. Kermouch, Gerry, Holmes, Stanley, & Ihlwan, Moon. (2001, August 6). The best global brands. BusinessWeek, p. 50. Kirkpatrick, David. (2001, March 5). From Davos, talk of death. Fortune, p. 180. Klapwijk, Pieter. (1996). Global economic networks. Amsterdam: Klapwijk Holding N.V. Maples, Jon. (2001, April 4). Will telematics drive the industry to distraction? Red Herring. Miles, R. E., & Snow, C. C. (1986, Spring). Organizations: New concepts for new forms. California Management Review, p. 62. Miles, R. E., & Snow, C. C. (1992, Summer). Causes of failure in network organizations. California Management Review, p. 53. Moore, James F. (1996). The death of competition: Leadership and strategy in the age of business ecosystems. New York: HarperBusiness. Moriarty, Mike, & Klassen, Bruce. (2001). Power play: The beginning of the endgame in Net markets. New York: Wiley. Nonaka, I., & Takeuchi, H. (1995). The knowledge-creating company: How Japanese companies create the dynamics of innovation. New York: Oxford University Press. Porter, Michael E. (1985). Competitive advantage: Creating and sustaining superior performance. New York: Free Press. Porter, Michael E., & Millar, Victor E. (1985, July–August). How

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information gives you competitive advantage. Harvard Business Review, pp. 149–160. Prahalad, C. K. (1976, July–August). Strategic choices in diversified MNCs. Harvard Business Review, pp. 67–78. Prahalad, C. K., & Hamel, Gary. (1990, May–June). The core competence of the corporation. Harvard Business Review, pp. 79–91. Prahalad, C. K., & Oosterveld, Jan P. (1999, spring). Transforming internal governance: The challenge for multinationals. MIT Sloan Management Review, pp. 31–39. Quinn, James Brian. (2000, Summer). Outsourcing innovation: The new engine of growth. Sloan Management Review, pp. 13–28. Rosenthal, Beth Ellyn. (2001, March). You can’t be good at everything. OutsourcingJournal.com. Retrieved July 1, 2002, from http://www.outsourcingjournal.com/issues/mar2001/ insights4.html. Smeltzer, Larry R., & Carter, Joseph R. (2001, March). How to build an e-procurement strategy—Part 2. Supply Chain Management Review, p. 76. Stalk, G. P., Evans, P., & Shuman, L. (1992, March–April). Competing on capabilities: The new rules of corporate strategy. Harvard Business Review, pp. 57–70. Tapscott, Don, Ticoll, David, & Lowy, Alex. (2000). Digital capital: Harnessing the power of business webs. Boston: Harvard Business School Press. Tulley, S. (1993, February 8). The modular corporation. Fortune, p. 106. Williamson, O. (1981, December). The modern corporation: Origin, evolution, attributes. Journal of Economic Literature, p. 1537.

Glossary Many of the terms in this glossary have slightly different meanings depending on the context. This glossary offers definitions of terms as they are used in this book. Asset management. An industrial company’s practice of handing over the responsibility for running its operations to a third-party asset manager. Companies retain a higher degree of control than traditional contract manufacturing or outsourcing because they continue to own the assets involved. Assortment. A capability that involves presenting products or services, as well as the terms and conditions under which they can be acquired, to the customer in logical groups. When a company provides a powerful assortment, it creates an effective fit between the products and services offered, the specific customer needs, and the appropriate terms and conditions. In retail shops, the products on the shelf serve a dual purpose: providing an assortment to choose from and a warehousing function allowing the consumers to do their own order picking (and packing after checkout). The assortment capability falls within the knowledge value chain. Best in class. At the top of the performance range in a group of peers given a state of technological advancement. Best of breed. See best in class. Bio value network. A collection of biopharmaceutical players (such as biopharmaceutical firms, biotech firms, and clinical research organizations) that combine their capabilities to create value and solidify competitive advantage. Business ecosystem. An environment in which companies create networks of relationships with customers, suppliers, and rivals to gain greater competitive advantage.1 Capability. A set of value elements (built through knowledge, assets, or processes) within the value chain that lead to a specific output. For example, manufacturing is a capability, as is design or purchasing.

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Capability director. In the capability-driven organization, the capability director assesses how a particular capability can be made more effective by searching for the best way of deploying resources. This will require addressing whether resources should be deployed in-house or outside company boundaries, but also whether the resources can be made far more effective by recombining them with those of other players inside or outside the industry. Along with the market venture director, the capability director is one of the cornerstones of the capabilitydriven organization. Capability-driven organization. A corporation that is organized around its business capabilities. The capability-driven organization is emerging as the next step in the historical breakup of the corporation, which is enabled largely by the disruptive reduction in interaction costs. Carve out. To leverage a single capability (or set of capabilities) a company excels at by taking it outside the company boundaries and creating a new market venture around it. Traditionally done with business units serving multiple markets. Collaborative design. In our framework, a collaborative process is one carried out across current business boundaries, most likely supported by some sort of software application. For design activities this is an established practice, but it also has been given an enormous boost lately due to the vastly improved opportunities for software-supported design efforts and project management efforts. Collaborative efforts can point to a horizontal joining of forces with other designers or a vertical link-up with other steps in the value chain for which closer (exclusive) integration adds value. Collaborative planning, forecasting, and replenishment (CPFR). A form of supply chain optimization in which buyers and suppliers comanage and share information in order to better predict and prepare for changes in demand. Competitive advantage. A company’s edge over its rivals. The principal reference is Michael E. Porter’s classic book: Competitive Advantage: Creating and Sustaining Superior Performance.2 In that book, Porter contends that a company can achieve competitive advantage through either cost leadership or differentiation.

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Contract manufacturing. For industrial companies, a form of outsourcing manufacturing activities. Contract manufacturing often goes further than merely outsourcing of the manufacturing capability itself by allowing the contract manufacturer to search for procurement advantages and other economies of scale. Core competence. Core competence is the collective learning in the organization, especially the capacity to coordinate diverse production skills and integrate streams of technologies, according to C. K. Prahalad and Gary Hamel.3 Prahalad and Hamel state that at least three tests can be used to identify core competence: It offers potential access to a variety of markets; it contributes significantly to the perceived benefits of the end product; and it is tough for others to imitate. Corporate genome. The corporate genome is the set of instructions for building a company. It holds the design key to what the company sells, whom it sells to, and what resources it deploys. In effect, it defines not only what products and services corporations offer, but the shape of the corporation. Cost leadership. A source of competitive advantage according to Michael Porter, who says it is achieved by using resources effectively and should be pursued for capabilities that consume a relatively large amount of resources (such as component manufacturing). Cost leadership will result in superior margins or growth in market share. Customer need translation or demand translation. The process of helping customers determine suitable product or service choices based on their specifications. This capability can range from providing background information to a full-fledged effort in working with the customer to determine its needs. Entire industries such as architectural design and industrial engineering are extensions of customer need translation efforts. Deconstruction. A term generally used for breaking something down in order to rebuild it in a different format. For instance, several insurance companies could decide to break down their organizations into a commercial entity and an administrative back-office entity, after which the different back-office parts can be recombined into a larger back-office firm enjoying economies of scale beyond that of the individual “donor” companies.

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Demand fulfillment management. A company’s capability (within the knowledge value chain) to provide fast, accurate, and reliable delivery-date responses to customer orders by managing the entire flow of components and subcomponents from suppliers and second-tier suppliers as well as the assembly activities required in the process. It generally includes activities such as choice management, order and order line capturing, customer verification, order confirmation, and of course, the actual fulfillment of the order by managing the upstream part of the supply chain. Demand translation. See customer need translation. Differentiating capability or dominant capability. The capability that really determines the competitiveness of the output. Just as a differentiating human gene may determine the color of one’s eyes, differentiating capabilities have a strong influence on the output of a company. Differentiation. One of two sources of competitive advantage, according to Michael Porter.4 Differentiation focuses on the top-line side of businesses by searching for differentiators that effectively support a premium price (or market share growth) and somewhat relieve a company from the need to produce at the lowest cost. Direct compensation model. In our framework, the model in which companies seek compensation for a capability at which they excel by selling its output directly as a service to other businesses. Disaggregation. In this book, we refer to disaggregation as the process of dissolving a company’s value chain into its component parts. Disaggregation is driven largely by the disruptive reduction in interaction costs. Disaggregation works in two dimensions: It breaks up the value chain and also splits it into a physical layer, a transaction layer, and a knowledge layer. Disruptive. Interrupting the normal course of corporate history. The Internet is disruptive for two reasons: the suddenness of its introduction and the improvement potential it represents. Disruptive technologies. Technologies that bring to market a value proposition that had been available previously but had rendered low profitability margins. The opposite of “sustain-

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ing technologies,” which foster improved performance of existing products.5 Dominant capability. See differentiating capability. Downstream perspective. The vantage point of those close to the customer on the value chain. From a downstream perspective, the potential of the Web revolves around bringing more value to customers. Effectiveness. Having the desired effect. In our framework, effectiveness is a driver pertaining to the knowledge value chain that enables a company to extract high margins. Efficiency. A company’s ability to work better, faster, and at lower cost. In our framework, efficiency is a driver pertaining to the knowledge value chain. Electronics manufacturing service (EMS). A type of company that provides advanced electronics design, manufacturing, and related services to original equipment manufacturers (OEMs). E2E collaboration. Engineer-to-engineer collaborative design. Fit. A company’s ability to match its products or services with customer needs. In our framework, fit is typically an effectiveness driver pertaining to the knowledge value chain. Goods or services cluster. A complete picture of a company’s product and/or services, which includes the whole package of activities involved in transferring that product to the consumer (such as production, marketing, distribution, retailing, and associated services). Indirect compensation model. In our framework, the model in which companies are compensated by complementing capabilities at which they excel with other capabilities in order to be able to sell the final output. Information intensity. According to Michael Porter and Victor Millar, information intensity pertains to the proportion of an organization’s market offering and/or value chain that is information-based.6 Insourcing. Selling a company’s capabilities directly as modules that other companies can purchase and plug into their own operations. The reciprocal aspect of outsourcing. Integrated corporation. A corporation that generally buys, makes, sells, and distributes its products largely on its own.

300

GLOSSARY

Interaction costs. In our framework, a broader term for transaction costs as defined by Ronald Coase. For instance, interaction costs can include all dealings between marketing people, product developers, and the engineering department as they prepare for a new product launch. The total “interaction” taking place will thus be both formal and informal, and will encompass the exchange of information that would be needed if the relationship were external. Knowledge value chain. One of the three layers within the traditional value chain. The knowledge chain involves the creative elements of a company’s value chain. Development, design, branding, assortment management, and demand translation services are all examples of capabilities that encapsulate some information about a product or service and pertain to this layer of a company’s value chain. Market venture director. An integration manager who purchases services from several capability managers. Compared to an SBU director, the market venture director has the added responsibility of testing in-house capabilities on their output and the option of going outside company boundaries to optimize output. Along with the capability director, the market venture director is one of the cornerstones of the capabilitydriven organization. Matrix organization. An organization form developed in the 1970s characterized by three management levels of reporting: functional, product, and geographic. Traditionally found in companies organized around strategic business units. Million instructions per second (MIPS). The accepted unit used to measure the cost of computing. Modular company. The modular company is generally referred to as a company whose major functions act as self-managed units. The term is commonly used to describe the disaggregating effect of lower interaction costs on organizations.7 Modular manufacturing. The process of manufacturing components at different sites and bringing them together for final assembly. Modular manufacturing involves structuring the supply chain in “production modules,” which are delegated to many separate suppliers. Need translation. See customer need translation.

Glossary

301

Networked economy. An economy in which computing and communications converge to create an electronic marketplace that is utterly dependent on powerful information networks. The “network” consists of computing power, software, and telecommunications infrastructure.8 Network organization. A collection of business “modules” dynamically responding to demand in the market through combining the appropriate resources for specific demands. As such it does not follow a specific chain of command. OEM (original equipment manufacturer). An OEM is a company that designs, develops, manufactures, and sells products. Optimization. In our framework, the process of bringing business capabilities closer to their full potential. Optimized capabilities are not compromised; they are effective and efficient given their specific optimization dimension and opportunities created through new technologies. Outsourcing. The strategic use of outside resources to perform activities traditionally handled by internal staff and resources. Outsourcing transfers major, noncore functions to specialized, efficient service providers, and enables a firm to restructure around its core competencies. Physical value chain. One of the three layers of the traditional value chain. The physical value chain constitutes the tangible capabilities contained in the production chain of an industrial process (raw material supply, component manufacturing, product assembly, distribution, warehousing), as well as in services (in retail: building and maintaining outlets, getting the goods to the outlet) and in information businesses (in banking: the branches; in news: print and press). Pooling. Exclusive sharing of resources to serve a common purpose. Price carrier. The value element that has the most influence in determining the price of the final product as determined by the buying behavior of the value chain’s ultimate customer. Product life cycle. Traditionally, the range of stages of a product’s increasing maturity: introduction, growth, maturity, and decline. As products reach maturity, they are frequently packaged with service elements to preserve or gain a competitive edge.

302

GLOSSARY

Product value matrix. A framework for discussing the different value attributes of a product. Each quadrant of the matrix describes a fundamental attribute of product value. Two attributes are related to the product itself (what it does, what it identifies with). The other two value attributes relate to how the consumer buys the product (how it gets to you, how it is transferred).9 Recombination. In our framework, the orchestration of a cluster of capabilities in order to produce a new specific and competitive output or the combining of different parts of companies to create a new and more competitive capability. Scope. The breadth of a company’s activities or the breadth of a specific stage in the value chain. Suboptimized. Not optimized; compromised. In the traditional integrated corporation, some capabilities are suboptimized because they are treated in basically the same manner as the company’s leading and scope-determining capabilities. Transaction costs. The expenses associated with measurement, information, bargaining, contracting, and enforcing and policing agreements. Transaction cost economics dates back to Ronald Coase’s 1937 classic work, The Nature of the Firm, in which Coase claimed in essence that the size of the firm would shrink as transaction costs fell. Transaction value chain. One of the three layers of the traditional value chain. The transaction value chain includes any capability pertaining to the transaction and control process. In a manufacturing company, transactions include such processes as ordering, production scheduling, and invoicing. In an insurance company, transactions include the handling of claims, the processing of payments, and the gathering of customer data. Uniqueness. A company’s ability to make differentiated products that render a premium.10 In our framework, uniqueness is a driver pertaining to the knowledge value chain. Upstream perspective. The vantage point of those close to the raw material on the value chain. In our framework, those with an upstream perspective generally exploit the Web to lower costs. Value chain. A collection of distinct activities, each of which adds value, that culminates in a product or service.

Glossary

303

Vendor-managed inventory (VMI). The concept of transferring responsibility for maintaining inventory to the vendor. Through VMI, companies can better manage their supply chain because both parties have improved access to operational and strategic information. Virtual organization/corporation/company. The virtual organization consists of a grouping of units of different firms (suppliers, customers, even competitors) that have joined in an alliance that is more “virtual” (or electronic) than physical to exploit complementary skills in pursuing common strategic goals.11 Yield management. Yield management enables companies to segment business into micromarkets, each of which has its own price and value proposition. The goal is to charge a price as close as possible to what each customer will pay (not necessarily the highest) to maximize revenue.

Index Numbers in italics indicate figures. 3M, 86 ABB, 241 Accenture, 254 Air conditioning industry: value chains in, 35–36 diagram of, 35 Alpina, 159 Amazon.com, 80, 120, 137 American Airlines, 222 AMG, 159 Armani, 142 Asda. See Wal-Mart, Asda Asset management, 203, 285 Assortment capability, 285 Assortment management, 137– 138, 147 Atomized corporations, 1, 7–8, 227. See also Capabilitydriven organizations; Modular value chain; Strategic business units (SBUs) Automotive industry: knowledge value chain in, 66–68 See also individual companies Avis, 140 B&Q, 70–71 Benetton, 3, 161

Berghaus, 157 Biopharmaceutical industry: clinical research organizations (see Clinical research organizations [CROs]) integration of business capabilities in, 197–201 “new biology,” 198, 199–201 value chains in, 200 Black & Decker, 86 Blown to Bits, 30 BMW Group, 105, 151, 159. See also Automotive industry Boots, 151 Bostrom, Bjorn, 107. See also Ericsson Boundaries, corporate: in capability-driven organizations, 74–75, 220–224 defined, 282 geographical, viii–ix scope, viii–ix, 34–36, 47, 292 transaction capability in, 121– 125 BP-Amoco, 21 Bramani, Vitale, 158 Branding: in insurance industry, 177, 178– 180, 182 knowledge value chain, 135– 136 Branson, Richard, 241 British Airways, 151 COBRA system, 141

305

306

INDEX

Bundling. See Capability-driven organizations; General Electric (GE) Canadian Imperial Bank of Commerce (CIBC), 119 Capabilities: defined, x, 16, 285 grouping beneficial, 91, 258–261 crucial, 90–91, 258, 259–261 necessary, 91, 94–95, 256–257, 259–261 as independent entities, 40–45, 94–95 knowledge (see Knowledge value chain) physical (see Physical value chain) product vs. information, 36–38 transaction (see Transaction value chain) value chain, as components of, 12 See also Capability-driven organizations; Capabilitydriven strategies Capability-driven organizations: agenda setting steps (four), 7, 261–278 summary, 278–279 into atomized corporations, 227 benefits (ten), 233–247 boundaries, 220–224 compensation direct, 78–80, 288 indirect, 78, 80, 289 corporate center, 227–232, 266 defined, 286

distribution (see Distribution capability) effect on industry (see individual industries) endgame, 7–8, 224–227 geographical dimension, 267– 269 managerial dimensions (two), 217–218 management capability director, 222–224, 242–244, 252–255, 286 corporate center, 227–232 market venture director, 222– 224, 242–244, 252–255, 290 in matrix organizations, 218– 220 organization of, 223 recombination of capabilities, 6, 76–78, 68–69, 149–173 in assetless mergers, 168–171 defined, 292 in mergers and acquisitions, 170–171, 238–239 requirements, 167–168 standardization, 163 vs. traditional (bundling) methods, 150–156 relative performance of, 91–92 rivalry, 60–65 setting boundaries for, 74–75 vs. strategic business units, 209–232, 236 strategies (see Capability-driven strategies) vs. traditional methods, 28–45, 47, 96–98 Capability-driven strategies, 249– 279

Index

choosing a strategy, 76–77, 216– 217 core competence, 85–89, 287 determining business identity, 261–265 formulating strategies, 265– 274 generic strategies, 92–94, 270– 273 new frameworks, 87–89 business ecosystems, 89, 285 old frameworks, 84–87 pricing strategy, 236–238 priority assessment, 274–278 types of (two), 56–60 (see also Killer capability; Killer lineup) Cat Logistics, 3, 105, 106, 220 Caterpillar, 3, 105, 220 Cathay Pacific, 104, 105 Celestica, 18–19, 106 Chaebols, 15, 20 Chain-focused capability strategies, 57. See also Killer lineup Charles Schwab, 32–34 Chemise Lacoste, 161 Chevrolet, 14. See also Automotive industry Christensen, Clayton M., 80, 143 Chrysler. See DaimlerChrysler CIBC. See Canadian Imperial Bank of Commerce (CIBC) Cisco, 19–20, 42, 56–57, 103 Citicorp, 86 Clinical research organizations (CROs), 134, 198–199 Coase, Ronald, 13 COBRA system. See British Airways, COBRA system

307

Coca-Cola, 1, 3, 41, 60, 135, 160– 161, 246 Collaborative planning, forecasting, and replenishment (CPFR), 118–119, 286 Company boundaries. See Boundaries, corporate Compaq, 166 Competitive Advantage, 84, 286 Conglomerates, breakup of, 17, 19, 21–22. See also Corporations; Oil industry; Vertically-integrated corporations Consumer goods industry: integration of business capabilities into, 190–196 transaction costs in, 190–191 value chains in, 6, 195 See also individual companies Coordination capability, 76–77 Core competence, 85–89, 287 Corporate boundaries. See Boundaries, corporate Corporate genes. See Capabilities Corporate genomes: as business capabilities, 12 CEO’s agenda, 27 defined, 2, 287 rebuilding, 55–81 Corporations: breakup of, 11–28 diagram of, 17 future forms of, 17–19 history of, 14–15 Cover Girl, 161 Covisint, 67–68, 123 CPFR. See Collaborative planning, forecasting, and replenishment (CPFR)

308

INDEX

CPGmarket, 190. See also Consumer goods industry CROs. See Clinical research organizations (CROs) Customer need translation, 64– 65, 136–137, 147–148 defined, 287 See also Insurance industry, customer need translation DaimlerChrysler, 102, 105, 123. See also Automotive industry Dell Computers, 19–20, 42, 56–57, 91, 136–137, 166 Delphi, 105, 235 Demand translation. See Customer need translation DestroyYourBusiness.com. See General Electric (GE), DestroyYourBusiness.com. Digital Equipment, 20 Disintermediation, 44–45 Distribution capability, 109–114 Douwe-Egberts, 70 DuPont, 14, 102 Dyson, 244 Eastman Kodak, 14 E-commerce, 30. See also Net markets ECR. See Efficient consumer response (ECR) EDI. See Electronic data interchange (EDI) EDS, 94, 119, 212, 254 Efficient consumer response (ECR), 190 Electronic data interchange (EDI), 108

Electronics industry: integration of business capabilities into, 200–204 value chains in, 201–204 See also individual companies Electronics manufacturing service (EMS), 106–107, 202, 289 Eli Lilly, 162 Emmperative. See Proctor & Gamble (P&G), Emmperative EMS. See Electronics manufacturing service (EMS) Enterprise resource planning (ERP), 91, 94, 120, 126, 163, 272–273 Envera, 68 ERP. See Enterprise resource planning (ERP) Ericsson, 18–19, 69–70, 88, 105, 107, 204, 226. See also Electronics industry European Roadster Challenge (EUROC), 133 Evans, Philip, 30 Exel Logistics, 102 Expedia, 141 Extensible markup language (XML), 163 ExxonMobil, 19, 21, 186 Fantom, 244 FastCar. See DaimlerChrysler Federal Express (FedEx), 38, 45, 108, 109 Flexible network management, 244–245 Flextronics, 19, 88, 106, 107, 108– 109

Index

Ford Motor Company, 14, 68, 104, 105, 133, 151, 154, 235. See also Automotive industry Fotoball USA, 135 Gate Gourmet, 105 Gateway, 19 GCI. See Global Commerce Initiative (GCI) General Electric (GE), vii, ix, 5, 19, 22, 151–155 DestroyYourBusiness.com, 155 GE Financial Network, 151 product and service bundling, 152–155 See also Electronics industry General Motors (GM), 5, 14, 104, 105, 133, 235 OnStar, 156 See also Automotive industry Global Commerce Initiative (GCI), 125 GlobalNetExchange (GNX), 190. See also Consumer goods industry GoreTex, 157–158 Grainger.com, 147 Gucci, 142 Hagel, John, 39 Hamel, Gary, 231, 287 Handspring, vii, 108–109 Hawaiian Tropic, 41–42 Hertz, 140 Hewlett-Packard, 20 Home Depot, 71–72 Honda, 39 Honeywell, 105, 154–155 Human Genome Project, x Hunter Douglas, 75–76

309

i2Entrepreneuring, 108, 112–113. See also Hagel, John IBM, 15, 20, 94, 254 ICG Commerce, 93–94, 127 ICI, 14 IKEA, 20–23, 56, 72–73 Imagica, 3, 161 Insourcing, 105, 167, 289 Insurance industry: branding (see Branding) customer need translation, 180–181 effect of capability-driven strategy on, 175–183 interaction costs in, 32, 176– 178 Internet’s effect on, 32, 40–41, 176–178 value chains in, 176–183 Insweb.com, 176 Intel, 77 Interaction costs, 1, 13–17, 108– 109, 210, 281 congruence among capabilities, 23–27 defined, 290 effect on consumer goods industry (see Consumer goods industry) insurance industry (see Insurance industry) Internet impact on, 16 information intensity, 23–27, 289 performance management, 246–247 See also Customer need translation; Internet Internal transaction platform, 129–130

310

INDEX

Internet: as disruptive, 14–17, 288–289 effect on corporations, 11–28, 30–31 insurance industry (see Insurance industry) interaction costs, 16, 31–34, interaction forms, 30–31 knowledge value chain (see Knowledge value chain) music industry, 62–63 oil industry, 25 (see also Oil industry) supply chain management (see Supply chain management) transaction costs, 13–17, 30– 31, 49–50 transaction flow, 49–50 transaction value chain (see Transaction value chain) value chains (see Value chains) yield management (see Yield management) information capability, 37–38 markets (see Net markets) Internet Underground Music Archive (IUMA), 62–63 Intuit, 3, 61–62, 122 ITT, 14, 21 IUMA. See Internet Underground Music Archive (IUMA) Jean Patou, 161 John Deere, vii Johnson & Johnson. See Larsen, Ralph Killer capability, 56–60, 69–72 diagram of, 57

Killer lineup, 56–60, 72–73, 149– 173 diagram of, 57 Klapwijk, Pieter, 163–164, 165 Knowledge flow. See Knowledge value chain, flow Knowledge value chain, 2, 5, 36– 38, 46, 50–52, 131–148 assortment management, 137– 138 branding (see Branding) breakdown of, 47 checklist, 262 customer need translation, 136–137 defined, 290 design and development, 132– 133 flow, 132 Internet’s effect on, 146–148 market intelligence, 138–139 vs. physical value chain, 46–48 vs. transaction value chain, 48– 50 See also Biopharmaceutical industry; Consumer goods industry Larsen, Ralph, 51 LG Electronics, 277. See also Electronics industry Lowa, 158 LSG Sky Chef, 105 Lufthansa, 104, 105 Magna, 133 Maintenance, repair, and operations (MRO), 147 Mammut, 157 Manugistics, 108, 112–113 Marcolin, 161

Index

Matrix organization, 216–217, 218–220 defined, 290 See also Capability-driven organizations; Product value matrix (PVM); Strategic business units (SBUs) Mattell, 41–42 Meindl, 158 Mercedes-Benz, 156, 159. See also Automotive industry Millar, Victor, 24, 289 Modular company, 18, 19–23, 290 Modular manufacturing, 66–67, 290 Modular value chain, 227 Moore, James, 89 Motorola, 18–19, 69–70, 101, 134, 204, 226–227. See also Electronics industry MRO. See Maintenance, repair, and operations (MRO) NASDAQ, 18 The Nature of the Firm, 13, 292 NBC, 135 NEC, 86 Need translation. See Customer need translation Nestlé, 160, 195. See also Consumer goods industry Net markets, 24, 30–31, 48–50, 79– 80, 115, 119–125 endgame of, 124–125 Nike, 23, 103, 142, 167 Nokia, 14, 134, 204, 226. See also Electronics industry The North Face, 157 OEMs. See Original equipment manufacturers (OEMs)

311

Oil industry: integration of business capabilities into, 183–190 value chains in, 6, 183–190 as vertically-integrated corporations, 183 See also BP-Amoco; ExxonMobil; Shell OnStar. See General Motors (GE), OnStar Oosterveld, Jan P., 251 Orbitz, 141 Order management, 120 Original equipment manufacturers (OEMs), 103–104, 202, 291 Outsourcing, 48, 94 asset management and, 203 business management and, 253–254 capability organization and, 18–19 capability recombination and, 167, 204 customer need translation and, 136–137 defined, 291 knowledge capabilities and, 139–142 physical capabilities and, 102– 106 transaction capabilities and, 117–119, 127–128 P&G. See Procter & Gamble Personal Valet. See Proctor & Gamble (P&G), Personal Valet; Whirlpool, Personal Valet Pharmaceutical industry. See Biopharmaceutical industry

312

INDEX

Philips, 70, 95, 143, 225–226, 277. See also Electronics industry Physical value chain, 2, 5, 46–48, 101–114 in automotive industry, 66–68 breakdown of, 47 checklist, 262 defined, 291 vs. knowledge value chain, 50–52 optimizing key drivers of, 106– 108 vs. transaction value chain, 48–50 See also Biopharmaceutical industry; Capabilities; Consumer goods industry; Modular company; Modular manufacturing; Modular value chain Pontiac, 14. See also Automotive industry Porsche, 159. See also Automotive industry Porter, Michael, 4, 24–25, 84–86, 288, 289 Postindustrial corporation, vii Prahalad, C. K., 4, 85–87, 216–217, 231, 251, 287 Procter & Gamble (P&G), 1, 3, 15, 41, 91–92, 159–161, 195, 246–247, 269 Emmperative, 3 Personal Valet, 159 Reflect.com, 109 See also Consumer goods industry Product value matrix (PVM), 164– 166, 292 Punctuated equilibria, vii

PVM. See Product value matrix (PVM) Quabaug Corporation, 158 Quinn, James Brian, 139 Quotesmith.com, 176 Ralph Lauren, 5, 135–136, 142, 241 Reflect.com. See Proctor & Gamble (P&G), Reflect.com Revenue management. See Yield management RosettaNet, 124–125 Royal Bank of Canada, 151 Ryder Integrated Logistics, 102 Sabre Corporation, 222 Sainsbury, 151, 191. See also Consumer goods industry SAir Group, 104, 105 Sara Lee, 93–94, 127 Sawhney, Mohanbir, 68 SBUs. See Strategic business units (SBUs) Schwab.com. See Charles Schwab Service level agreements (SLAs), 212 Shell, 21, 186 Siemens, 159 Singapore Airlines, 104, 105 Single-capability-focused strategies, 57, 83–98. See also Killer capability SLAs. See Service level agreements (SLAs) Sloan, Alfred, 14 Small to medium enterprises (SMEs), 121 Softbank, 241 Solectron, 106, 108–109 Son, Masayoshi, 241

Index

Sony, 151. See also Electronics industry Strategic business units (SBUs), 15 into capability-driven organizations, 209–211 shared services, 212–216 call centers, 212, 214 strategy, 216–217 Supply chain management, 126– 127, 133 Internet’s effect on, 108–114 See also Transaction value chain Tapestria, 73–76 Target stores, 102. See also Consumer goods industry Telematics, 155–156 Tesco, 151, 191. See also Consumer goods industry Toyota, 123. See also Automotive industry Transaction flow. See Transaction value chain, flow Transaction value chain, 2, 5, 36– 38, 46 breakdown of, 47 checklist, 262 costs, 13, 77, 292 defined, 292 flow, 48–50 internal platform, 129–130 Internet’s effect on, 119–121 vs. knowledge value chain, 50–52 next-generation optimization, 125–130 optimization of, 115–119 vs. physical value chain, 46–48 See also Biopharmaceutical industry; Consumer goods industry

313

Transora, 68, 190. See also Consumer goods industry TRW, 104, 133 UCCnet, 124 Uniform Code Council, 124 Unilever, 14, 195. See also Consumer goods industry United Postal Service (UPS), 5, 108, 117–118 Value chains, 29–54 breakup of, 42–43 defined, 2, 292 disaggregation, 20, 43, 46–52, 288 diagram of, 47 disintermediation, 43–45 evolution of, viii in industry (see individual industries) Internet’s effect on, 29–31, 37–38 knowledge (see Knowledge value chain) mapping, 273–274 modular, 227 physical (see Physical value chain) as strategy, 3–4 transaction (see Transaction value chain) Vendor-managed inventory (VMI), 118, 126–127, 293 Vertically-integrated corporations: history of, 14–15 (see also Conglomerates) oil industry (see Oil industry) value chains in, viii–x Vibram soles, 158

314

INDEX

Vibram S.p.A. Italy, 158 Virgin, 241 Virtual design, 140–141 Visteon, 105, 235 VMI. See Vendor-managed inventory (VMI) Volkswagen, 104, 123. See also Automotive industry Voltaire, 230 Wal-Mart, 191 Asda, 191 See also Consumer goods industry Walt Disney Company, 1, 41 Westinghouse, 14 Whirlpool, 159–160, 246

Personal Valet, 159 See also Electronics industry W.L. Gore & Associates, 157–158 Worldwide Magnifi, 3 Worldwide Retail Exchange (WWRE), 190. See also Consumer goods industry Wurster, Thomas, 30 WWRE. See Worldwide Retail Exchange (WWRE) XML. See Extensible markup language (XML) Yield management, 138–139 defined, 293 Internet’s effect on, 141

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