Mastering Strategy: Resource Based Strategy

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The resource based view of strategy has a coherence and integrative role that places it well ahead of other mechanisms of strategic decision making. After thirty years or so, the subject of strategy is genuinely acquiring what can be described as a paradigm – to use the most overworked and abused term in the study of management.

It is the early 1960’s. Robert Macnamara, recruited from the Ford, the US carmaker to run the Department of Defense, is managing the first stages of the Vietnam War on computers in the Pentagon. John Kenneth Galbraith, detesting the world Macnamara represents, writes of the New Industrial State, in which giant mechanistic corporations run our lives.

The Soviet Union is ahead in the space race and while most of the West loathes the Russian empire they do not dispute the claims made for its economic success. Every newly independent colonial territory looks forward to the realisation of its development plan. Harold Wilson talks of the white heat of the technological revolution: George Brown gives Britain its first, and only, national plan.

It is in this environment that the idea of business strategy is created. The early texts are by Igor Ansoff and Ken Andrews (see further reading). Its principal journal is called Long Range Planning. It is founded on an illusion of rationality and the possibilities of control.

It is a world that will soon fall apart. Macnamara will be translated to the World Bank, but history will note the failure of each of his careers – CEO, Secretary of State, international statesman. Half a million hippies will gather at Woodstock to celebrate the demise of the New Industrial State – and – although few people saw it then – the Soviet Union is on an unstoppable path from totalitarianism to disintegration.

Yet the delusion of control has continued to define the subject of business strategy. In the heady 1960’s, no major firm was without its strategic plan. Few are without them today, although few devote the resources to them they once did. They contain numbers, neither targets nor forecasts, which purport to describe the evolution of the company’s affairs over the next five years.

But planning and strategy are no longer conflated. The delusion of control has changed its form if not its nature. What matters are vision and mission. Charismatic CEO’s can transcend the boundaries of the firm. Their achievements, and those of the companies they inspired, could be restricted only by the limitations of their executive imagination.

But companies are not restrained only by imagination. They are limited by their own capabilities, by technology, by competition, and by the demands of their customers. So visionary strategy has been succeeded by an era in which the cliché – ‘formulation is easy, it is implementation that’s the problem’ holds sway. If strategising consists of having visions, it is obvious that formulation is easy and implementation the problem: all substantive issues of strategy have been redefined as issues of implementation.

As organisations stubbornly fail to conform to the visions of their senior executives, we should not be surprised that organisational transformation has become one of the most popular branches of consultancy.

Or perhaps the CEO’s vision is of the external environment, rather than the internal capabilities of the firm. The future belongs to those who see it first, or most clearly. But this is rarely so. It is not just that forecasting is hard – although that difficulty should not be underestimated. Even if you do see the future correctly, its timing is hard to predict and its implications are uncertain.

AT & T, the US telecoms carrier, understood that the convergence of telecommunications and computing would transform not only the company’s own markets but much of business life. It was a perceptive vision, not widely shared. But the company failed to see – how could it have? – that the internet was the specific vehicle through which the vision would be realised, or that its merger with NCR, the US business machines manufacturer, was an irrelevant and inappropriate response. While there are many examples – take General Motors or International Business Machines – of companies which suffered from failing to see the future even after it had arrived, there are almost none of companies building sustainable competitive advantages from superior forecasting abilities.

Thoughtful strategy, then, is not about crystal balls, or grand designs and visions. The attempt to formulate these at the level of national economies is now seen to have been at best risible and at worst disastrous – as with Soviet economic planning, Mao’s Cultural Revolution, or the improvement strategies of almost all developing countries. What has been true of states is true also in companies. No one has, or could hope to have, the knowledge necessary to construct these transformational plans. Nor, however totalitarian the structures they introduce – in governments or corporations – does anyone truly enjoy the power to implement them.

The subject of strategy

Business strategy is concerned with the match between the internal capabilities of the company and its external environment. Although there is much disagreement of substance among those who write about strategy, most agree this is the issue.

The methods of strategy, and its central questions, follow from that definition. The methods require analysis of the characteristics of the company and the industries and markets in which it operates. The questions are two fold. What are the origins and characteristics of the successful fit between characteristics and environment – Why do companies succeed? How can companies and their managers make that fit more effective. How will companies succeed?

I once thought that these core questions of strategy – the positive question of understanding the processes through which effective strategies had been arrived at, the normative question of what effective strategy should be – were quite separate. I now believe they are barely worth distinguishing, and that the conventional emphasis on the vision is the product of the illusion of control.

Strategy is not planning, visioning or forecasting – all remnants of the belief that one can control the future by superior insight and superior will. The modern subject of business strategy is a set of analytic techniques for understanding better, and so influencing, a company’s position in its actual and potential marketplace.

Evolving modern theory

Strategy, as I have defined it, is a subject of application, rather than a discipline – rather as, say, geriatrics is to underlying disciplines of pharmacology or cell biology – and the obvious underpinning disciplines for strategy are economics and organisational sociology. Still, this is not how the subject developed in practice.

When the content of strategy was first set out thirty years ago, industrial economics was dominated by the structure – conduct – performance paradigm, which emphasised how market structure – the number of competitors and the degree of rivalry between them – was the principal influence on a company’s behaviour.

Market structure was determined partly by external conditions of supply and demand, and partly (unless anti-trust-agencies intervened) by the attempts of firms to influence the intensity of competition.

This was a view of markets aimed at public policy, not business policy. It was correctly seen as having little relevance to the basic issues of business strategy. The neglect of the internal characteristics of companies is obvious and explicit. While some of the strategic tools developed by consultants in the 1970’s – such as the experience curve and the portfolio matrix – might advantageously have had an economic basis, in practice microeconomic theory was largely ignored.

Not until 1980, with the publication of Michael Porter’s Competitive Strategy, did economists attempt to recapture the field of strategy. But this was ultimately to prove a false move. Porter’s work – essentially a translation of the structure-conduct-performance paradigm into language more appropriate for a business audience – suffered from the limitations of the material on which it was based. Porter’s ‘five forces’ and value chain are usefully descriptive of industry structure, but shed no light on the central strategic issue: why different firms, facing the same environment, perform differently.

Much of the organisational sociology of the 1960’s addressed strategic issues. Chandler’s magisterial Strategy and Structure, or the empirical work of Tom Burns and G. M. Stalker, addressed directly the relationships between organisational form and the technological and market environment. But academic sociology was largely captured by people hostile to the very concept of capitalist organisation. The subject drifted into abstraction, and further away from the day to day concerns of those in business.

More recent insights into the nature of organisations have come either from economics or from the accumulated practical wisdom of which Charles Handy and Henry Mintzberg are, in different ways, effective exponents. Porter’s attention ultimately reverted to the public policy concerns of his former mentors in the Harvard economics department, as in The Competitive Advantage of Nations.

Strategy today – rents and capabilities

At about the same time as Porter first wrote about strategy, the Strategic Management Journal, today the leading journal in the field, was established. The currently dominant view of strategy – resource-based theory – has been principally set out in its pages. It also has an economic base, but has found its inspiration in different places and further back in history. It draws on the Ricardian approach to the determination of economic rent, and the view of the firm as a collection of capabilities described by Edith Penrose and George Richardson.

Economic rent is what firms earn over and above the cost of the capital employed in their business. The terminology is unfortunate. It is used because the central framework was set out by David Ricardo in the early part of the 19th century, when agriculture was the dominant form of economic activity. Economic rent has been variously called economic profit, super-normal-profit and excess profit – terms which lack appeal for modern business people. Most recently Stern Stewart, a consultancy, has had some success marketing the concept under the term economic value added. The problem here is that value added – the value added that is taxed – means something different. Nor does my own attempt to call it added value help. Perhaps economic rent is best. The title doesn’t matter. The concept does.

The objective of a firm is to increase its economic rent, rather than its profit as such. A firm which increases its profits but not its economic rent – as through investments or acquisitions which yield less than the cost of capital – destroys value.

In a contestable market – one in which entry by new firms is relatively early and exit by failing firms is relatively quick – firms which are only just successful enough to survive will earn the industry cost of capital on the replacement cost of their assets. Economic rent is the measure of the competitive advantage which effective established firms enjoy, and competitive advantage is the only means by which companies in contestable markets can earn economic rents.

The opportunity for companies to sustain these competitive advantages is determined by their capabilities. The capabilities of a company are of many kinds. For the purposes of strategy the key distinction is between distinctive capabilities and reproducible capabilities. Distinctive capabilities are those characteristics of a firm which cannot be replicated by competitors, or can only be replicated with great difficulty, even after these competitors realise the benefits which they yield for the originating company.

Distinctive capabilities can be of many kinds. Government licences, statutory monopolies, or effective patents and copyrights, are particularly stark examples of distinctive capabilities. But equally powerful idiosyncratic characteristics have been built by companies in competitive markets. These include strong brands, patterns of supplier or customer relationships, and skills, knowledge and routines which are embedded in teams.

Reproducible capabilities can be bought or created by any firm with reasonable management skills, diligence and financial resources. Most technical capabilities are of this kind. Marketing capabilities are sometimes distinctive, sometimes reproducible.

The importance of the distinction for strategy is this. Only distinctive capabilities can be the basis of sustainable competitive advantage. Collections of reproducible capabilities can and will be established by others and therefore cannot generate rents in a competitive or contestable market.

Matching capabilities to markets

So the strategist must first look inward. The strategist must identify the distinctive capabilities of the organisation and seek to surround these with a collection of reproducible capabilities, or complementary assets, which enable the firm to sell its distinctive capabilities in the market in which it operates.

While this is easier said than done, it defines a structure in which the processes of strategy formulation and its implementation are bound together. The resource based view of strategy – which emphasises rent creation through distinctive capabilities – has found its most widely accepted popularisation in the core competences approach of C. K. Prahalad and Gary Hamel. But that application has been made problematic by the absence of sharp criteria for distinguishing core and other competencies, which allows the wishful thinking characteristic of vision and mission- based strategising. Core competencies become pretty much what the senior management of the corporation wants them to be.

The perspective of economic rent – which forces the question ‘why can’t competitors do that?’ into every discussion – cuts through much of this haziness.

Characteristics such as size, strategic vision, market share and market positioning – all commonly seen as sources of competitive advantage, but all ultimately reproducible by firms with competitive advantages of their own – can be seen clearly as the result, rather than the origin, of competitive advantage.

Strategic analysis then turns outward, to identify those markets in which the company’s capabilities can yield competitive advantage. The emphasis here is again on distinctive capabilities, since only these can be a source of economic rent, but distinctive capabilities need to be supported by an appropriate set of complementary reproducible capabilities.

Markets have product geographic dimensions, and different capabilities each have their own implications for the boundaries of the appropriate market. Reputations and brands are typically effective in relation to a specific customer group, and may be valuable in selling other related products to that group. Innovation based competitive advantages will typically have a narrower product focus but may transcend national boundaries in ways that reputations cannot. Distinctive capabilities may dictate market position as well as market choice. Those based on supplier relationships, may be most appropriately deployed at the top of the market, while the effectiveness of brands is defined by the customer group which identifies with the brand.

Since distinctive capabilities are at the heart of competitive advantage, every firm asks how it can create distinctive capabilities. Yet the question contains an inherent contradiction. If irreproducible characteristics could be created, they would cease to be irreproducible. What is truly irreproducible has three primary sources: market structure which limits entry; firm history which by its very nature requires extended time to replicate; tacitness in relationships – routines and behaviour of “uncertain imitability” which cannot be replicated because no-one, not even the participants themselves, fully comprehend their nature.

So companies do well to begin by looking at the distinctive capabilities they have rather than at those they would like to have. And established, successful companies will not usually enjoy that position if they do not enjoy some distinctive capability. Again, it is easy to overestimate the effect of conscious design in the development of firms and market structures.

The evolution of capabilities and environment

Strategy, with its emphasis on the fit between characteristics and environment links naturally to an evolutionary perspective on organisation. Processes which provide favourable feedback for characteristics which are well adapted to their environment – and these include both biological evolution and competitive market economies – produce organisms, or companies, which have capabilities matched to their requirement.

Recent understanding of evolutionary processes emphasises how little intentionality is required to produce that result. Successful companies are not necessarily there because (except with hindsight) anyone had superior insight in organisational design or strategic fit. Rather there were many different views of the firm capabilities a particular activity required: and it was the market, rather than the visionary executive, which chose the match that was most effective. Distinctive capabilities were established , rather than designed.

This view is supported by detached business history. Andrew Pettigrew’s description of ICI shows an organisation whose path was largely fixed – both for good and for bad – by its own past. The scope and opportunity for effective management strategic choice – both for good and bad – was necessarily limited by the past. This is not to be pessimistic about the potential for strategic direction or the ability of executives to make important differences, but to reiterate the absurdity and irrelevance of using the blank sheet of paper approach to corporate strategy.

New paradigm

The resource based view of strategy has a coherence and integrative role that places it well ahead of other mechanisms of strategic decision making. I have little doubt that for the foreseeable future major contributions to ways of strategic thinking will either form part of that framework or represent development of that framework. After thirty years or so, the subject of strategy is genuinely acquiring what can be described as a paradigm – to use the most overworked and abused term in the study of management.

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