Chapter 3
Look From the Top Down

4 types of capabilities
Cut and build
Eliminate unnecessary capabilities
Acquire needed capabilities
What to use when


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Chapter 3

Look From the Top Down

Excerpt from Rethinking the Corporation

By Robert M. Tomasko




How can you identify your company's key capabilities? When consultants help their clients identify the technologies that drive their businesses they ask key employees from a variety of functions and organizational levels to complete this sentence:

"We know best how to _____________________" , or

"Our ability to ___________________ really sets us apart from our competitors."

The thought process in which the consultant is trying to engage the client is a sequential look back at everything of significance that goes on within the company. This reflective process is a bit like peeling an onion. Outer layers are successively discarded until the useful central core is found, by considering, in turn:

- What do we do?

- What do we do well?

- What do we do exceptionally well?

- What do we do exceptionally well that adds
value that our customers perceive?

- What do we do exceptionally well that our customers
perceive adds more value than that provided by our

Activities that remain on the list after this last question is answered are the ones most worthy of organizing around. The answers to questions such as these are usually varied and come in different degrees of resolution. But patterns and common themes eventually emerge, especially when the same questions are rephrased and asked of the company's customers.

Not by introspection alone
Differences between the internal and the customer views about what value the company is adding should be carefully reconciled. It's not uncommon for an inward-oriented company to rate a particular capability highly, and then find that the users of the products this capability creates feel it adds minimal value. This sort of collective self-delusion can be dangerous. A.T.& T. lost time and a great deal of money in the computer business, thinking it had a stronger position than it actually did. Likewise, when Sears, Roebuck and Co. compares it retailing prowess Home Depot in providing tools for house owner remodeling projects and Circuit City in consumer electronics, it may identify significant instances of capability slippage.

At times, the opposite may be true. A capability the company feels is mundane may actually provide (in its customer's eyes) a useful source of differentiation of its products from those of its competitors. Don't assume you know more about how your customers are making use of what you produce than they do. Look and ask.

Customer perception, or misperception, can be more significant than sheer technical excellence. Several years ago the Olympia Brewing Company made a significantly investment in a new beer formulation. Their goal was to develop a better tasting product than the category leader, one that would build on Olympia's superior brewing capabilities. And in blind taste tests their target customers agreed and overwhelmingly preferred the new product. But when the tests were rerun and the brews were identified by name, the market leader easily won. The brand image of the established product was so strong it overcame the sensory preferences of most consumers. Perhaps Olympia had taken a too narrow view of the capabilities needed to establish a winning market position

What capabilities really count?
For professors C.K. Prahalad and Gary Hamel, the bottom line of their research on global competitiveness research is simply put: "An organization's capacity to improve existing skills and learn new ones is the most defensible competitive advantage of all." Very true, but not all competences and skills are created equal. Not all are worth improving; resource and time constraints limit how many new ones can be acquired. Companies, even small and medium size ones, have hundreds of capabilities. Some have thousands. Which ones really count and should be the basis for organizing and resizing, and which can be safely deemphasized or ignored?

Answering these questions requires disaggregation of the competences concept. If competences are to be a useful guide to resizing, it is necessary to analyze a company's capabilities beyond deciding which are "core" and which are not. A useful way to do this is to use criticality to the customer as the yardstick.

Least critical to the customer, as well as least noticed, are the competences, called complementary capabilities, that underlie a business's internal support services. These include the administrative activities performed by groups such as the personnel department, the mail room, the materials management function, the accountants who prepare monthly financial reports, and so on. Necessary as most of these services may be, they are instances of the company doing business with itself, rather than with paying outsiders. Often the most important direct impact of these activities on customers is their cost, which is reflected in the company's overhead and passed along in its prices.

For many manufacturers, delivery of the completed product is of secondary importance to compared production. Their outbound logistics are among their complementary capabilities and are frequently provided by contractors. Not so for Domino's Pizza. Receiving a fresh-baked pizza within thirty minutes of placing an order is a key value perceived by Domino's customers. This delivery capability is central to Domino's part-production, part-service business.

Competences that directly make possible the products or services customers buy are more important than those that just support or complement their provision. There are two types of such competences. Core capabilities, in this terminology, are those that are vital to what is being done but that are not unique to any one company. At Domino's, the generic ability to produce pizzas quickly is such a capability. For an airline, these competences may include the abilities to fly planes and to keep them well maintained. They are competences that are often noticed only by their absence-the tray table that never managed to stay latched on your recent flight aboard a financially troubled air carrier, or the pizza that arrived soggy or undercooked.

Critical capabilities are more noticeable, in a positive sense. In fact, they are the keys to achieving competitive distinction. While core capabilities are mature and ordinary, critical capabilities are novel and sources of growth. To paraphrase Alan Kay, Apple Computer's visionary product planner: Critical capabilities are what weren't around when you started your career. You do not take them for granted. At your airline seat, they are the personal video screens that allow you to select whatever combination of movies and video games will best provide diversion on a long flight to Tokyo. At home, it's the appearance of a fresh, hot pizza in less than half an hour from the time you ordered it. In the hands of a Frito-Lay delivery person restocking potato chips in a supermarket, it's the information power available in the hand-held computer that analyzes past purchasing patterns and suggests how many of each flavor of chip to leave behind to maximize next week's sales.

Most critical to future customer needs are the capabilities resident in a business but nascent in the marketplace. These cutting-edge capabilities will be embedded in tomorrow's products. Today they may be in the R&D labs, scattered throughout the business, or forgotten in a subsidiary or branch office. Or they may be hard at work in another company in another industry, awaiting transfer to yours. All of which is not to say they are unimportant, just often unrecognized sources of tomorrow's advantage.

Capabilities as Dynamic Properties
Capabilities are not static possessions. What might be a critical capability at one point in time, such as Pan American's jet-powered transatlantic fleet was in the 1960s, may lose its differentiating ability as it is imitated by others. Some capabilities, like the mix of factors that contribute to Delta Airline's legendary reputation for friendly and attentive customer service, are harder to imitate. In Delta's case, they result from a blend of competences in employee relations, cross-training, internal communications, staffing from within, and ongoing maintenance of a one- family culture. These are part of a carefully orchestrated management system, self-reinforcing, and built up over a long period of time. It is difficult for a competitor to extract and duplicate any one element of it and expect to rival Delta's overall performance in this area.

What may have been a complementary capability in the past-as information and data processing systems were for airlines when they operated in a completely regulated marketplace-can gain critical importance as the business environment changes. In the deregulated U.S. airline industry, as many as 10,000 fares may change each day. For an air carrier, keeping up with competitors' prices and adjusting its own to maximize the number of seats sold are competitive necessities; these complementary capabilities have become critical.

The identification and the classification of a corporation's capabilities are not ends in themselves, but a platform for creative insight into ways the business might grow.

Cutting and building
The most useful way to initially envision a company, from the viewpoint of an organizational architect, is from the outside in. And to think about it as a portfolio of reinforcing capabilities, varying in importance. When resizing a business, four key questions then arise:

- What capabilities are now present?

- Of these: which do we really need?

- Which are diverting our focus?

- Which others do we need to acquire or rebuild?

Most resizings based on these answers follow the "cut and build," not the "slash and burn" pattern. Their objective is strengthening competitiveness, not reducing size. Changes are driven by analysis of competence gaps and the requirements for strategic focus, not by the attractiveness of the last deal offered or the trendiness of the current quick management fix.

A number of resizing tools are available. Most have received widespread use worldwide, though not always in the situations where they were most appropriate. Think about these as if they form a continuum ranging from complete elimination of a capability, and the organization and assets supporting it, to the acquisition of ones that are essentially "ready-to-wear".

Eliminating unnecessary capabilities
On the "cutting" side the most severe change is the abandonment or total shut down of an intact business. This usually makes sense only when bankruptcy threatens and no buyer is available, though Federal Express made effective use of this tactic when its high quality fax network (Zap Mail) failed as a business. Chrysler's exit from its overseas marketplaces is another example. It is a drastic measure but one that, if necessary, can bring quick focus to what remains. It is frequently kept in reserve, and then applied only when losses in one business threaten the survival of others.

Piecemeal shutdowns are more common. Most, such as the major plant closings announced by General Motors, are not aimed at capability focus as much as capacity reduction. At times these shutdowns have been likened to slow-motion suicide, as in Pan American Airway's decade-long sales of it capabilities in the hotel and airplane service businesses. Funds from these sales were used to support the provision of Pan Am's core product, rather than reinvested to develop new critical competences, and only served to put off the inevitable shutdown of the air carrier.

Spinoffs, selling an intact set of capabilities to someone who can make better use of them have become increasingly popular. Popular during the deal-driven 1980s, this tactic still has utility as a focus-promoting tool. Corporate wall destruction is a central theme of this book. But some walls are better left up, and even strengthened. These are the barriers between a company and the capabilities that do little for the business but clutter or distort its focus. These are the capabilities to sell-off, to separate as intact, free-standing businesses when possible.

This is the first move John MacKay makes when assuming leadership of a business badly in need of restructuring. His career included positions as chief executive or chief operating officer of three major Canadian corporations. MacKay, now president of the company that built the retractable roof on Toronto's sky dome, early on sorts out the "keepers" from the "castoffs." Then his talents, as one of Canada's leading corporate reshapers, can focus on the operations that can make best use of them. MacKay's only regret, though, with this approach is that he did not keep some residual ownership in the businesses he spun off. Several that he sold to their employees, and liberated from a distracted headquarter's umbrella, have emerged as star performers in their focused market segments.

Partial spinoffs then can make even more sense. They directly address MacKay's concern. They make sure the parent company keeps a financial stake in the venture being spun-off. Long popular in technology driven companies that are likely to develop more useful technologies than their focus will allow them to pursue, this mechanism has been used with success at Xerox, 3M and Alcan Aluminum. IBM has also used a partial spin-off to exit from the typewriter and laser printer businesses. With the aid of some operationally-oriented investment bankers, it set up a new company, Lexmark International, to take over these product lines. IBM retained 10% ownership of Lexmark, which is now free to develop what had become sideline competences at IBM.

Dis-integration is another way of capability-focusing with great promise. It is especially useful for vertically integrated companies. It says: look hard at all the interrelated businesses you are in. Examine the economics of each closely. Then decouple them. For example, Royal Dutch Shell is involved in all phases of the oil business. They discover it, produce it, move it, refine it and sell it. But Shell discovered that operating its shipping fleet only to carry its own oil wasted a good bit of its transport capability. The head of its marine division, Ian McGrath, said: "If I sit around in port for five days waiting for company cargo, that makes me a cost." Instead, he wants to run a profit-making capability, so McGrath's ships frequently carry crude oil for their competitors. And Shell's own oil is transported by whomever makes the most sense - at one point 80% of it was riding in ships independent from Shell.

In the Prato region of central Italy the textile business was threatened with near extinction. High production costs, falling market prices, and increasingly aggressive Asian competitors forced the owners of the large, vertically integrated mills to rethink the basics of their businesses. Their solution was to subdivide these mammoths into many smaller businesses, each competing for a specialized segment of the textile business. Some became designers, some experts at color mixing, others focused at producing high quality knits for women's' dresses. Work is contracted-out to whichever unit can best meet the market needs of the moment. The plan worked, productivity increased, inventory dropped, and overall production doubled while the textile business in the rest of Europe suffered a major decline. Later chapters of this book will examine the management systems that kept this loosely-coupled network so well focused.

Pruning, also called downsizing, rightsizing, streamlining and a variety of other euphemisms, characterizes the less drastic cutbacks that virtually all major North American and European businesses have made over the past few years.

Swapping - trading one business for another - is a less common but potentially useful tool. Several years ago General Electric and the French electronics group, Thompson, exchanged businesses to allow each to focus capabilities in areas of greatest relative strength. G.E. received Thompson's medical equipment business, adding to its own strong presence in this industry, while giving up a consumer electronics division that helped make Thompson more of a global player.

Swapping is a way to simultaneously cut and build. The need to add new capabilities, or reinforce existing needed but weak ones, seldom occurs in exact symmetry with the requirement to cut. But there are a variety of mechanisms that can be used to build-in competences.

Acquiring new capabilities
Renting them is sometimes the quickest. Outsourcing has become a boom business in many areas. Both workers and executives are available on a temporary lease rather than "permanent" hire basis. So are many types of professionals and middle managers. Increasingly common is the outsourcing of corporate internal service functions; less common, but of more potential significance are moves such as Apple Computer's to tap into the miniaturization capabilities of the Sony Corporation to build its first PowerBook notebook-sized Macintoshes. Sony engineers had little experience making personal computers, but they were masters at skills that had eluded Apple's in-house talent: making something very small, and making it very quickly. Apple was already two years late in the laptop marketplace, a key reason it was willing, for the first time, to put its logo on a computer made by another company.

Renting a capability, even on a long term lease, is a way to get use of it. But it does not make it your own. To have that degree of control you frequently must make an enabling acquisition. Microsoft propelled its rapid rise to dominance in the software industry through its early core product, MS-DOS, the operating system software used by all IBM and IBM-compatible personal computers. But it did not invent it from scratch; it purchased it for $50,000 from a tiny company called Seattle Computer Products. Microsoft then rewrote, revised, renamed and licensed it to IBM. Microsoft knew what its market, IBM, needed. It knew what its internal capabilities were, and it knew how this acquisition of a capability would mesh with these. It really purchased a capability, not a company.

Most acquisitions are not as strategically successful, mainly because most attention is given to buying the company, not acquiring its competences. The results of research studies of the aftermath of acquisitions indicates that the value they add is a subject of controversy, at best. The acquired firm's owners usually gain from its sale, but the extra value from acquisitions for the shareholders of the acquiring firms averages close to zero. One study that looked into this situation found that about one-third of the firms bought were later sold.

From a capability building point of view, the way to avoid the pitfalls of acquisition assimilation is to develop it internally. While this is often the most desirable course to take, it too is often fraught with difficulty. In most companies - at least in those that have not undertaken a major wall removal campaign - the biggest obstacle to the innovation of new capabilities is the existence of the currently successful old ones. This creates a difficult catch-22 for successful internal development. When the existing business is doing well, and funds are potentially most available for capability-expansion, the motivation to do so is usually at a low point, especially if the new competence might threaten the old. But when a crisis occurs, and yesterday's critical capability becomes today's easily available commodity, neither the time or money are around to reinvent the future.

The middle ground between these extremes are occupied by the trendy array of joint ventures, partnerships, and alliances that are crisscrossing the business landscape. Their emergence is significantly reshaping the way new products and markets are being developed. They are important wall-lowering tools, and their impact on the corporate organization chart will be considered at several points in the chapters that follow.

What to use when
The toolkit is large. Which tools are most useful to resize which capabilities?

The low value directly added to customers by complimentary capabilities has resulted in their being common targets for pruning and cutting back. This relative "expendability" is seldom appropriate across-the-board, and can be counterproductive. Depending on the how the needs of your customer's are evolving, today's overhead activity might become tomorrow's critical capability.

Outsourcing is often a more useful sizing approach to take with regard to complimentary skills that are expected to remain complimentary. When and how to do this will be considered in later chapters.

Analysis of dis-integration opportunities is often a good tool to use to help uncover possibilities for sharpening focus through outsourcing and spinning-off. It is useful for both complimentary and core capabilities.

The proper sizing of core capabilities also poses a number of challenges. While these areas of a firm's operations add relatively little to distinguish them from its competitors, without them it would be impossible to remain in business. At times they also represent barriers to entry for other competitors - barriers your company may want to keep strong. Some can be contracted-out, but only with great care less your supplier become a competitor. These are very appropriate targets for ongoing streamlining, and careful monitoring to spot the point where the capability is so much of a commodity that it is a spin-off candidate. While complete divestiture of a core capability (disparaging called "hollowing-out" by some business critics) is a move seldom warranted, some might be amenable to partial-spin-off.

Critical capabilities require even more delicacy. Because of the difficulties and risks inherent in creating new capabilities from scratch, many companies have looked to joint ventures and partnerships as ways to acquire them. This can be a dangerous path when the capability is central (or hoped to be central) to the reason you want customers to prefer you. This is a lesson American Telephone and Telegraph Co. learned after a several year partnership with Olivetti failed to propel them into the ranks of the world's leading computer makers. For this a greater commitment was necessary: the subsequent purchase of an already well established information systems firm, National Cash Register.

Enabling acquisitions are a good way to expand the repertoire of critical capabilities. They can work best when the competence being acquired is portable, ready-to-wear, or self-contained - the way the skills of Investors Diversified Services were when purchased by American Express. When it needs a great deal of customization to pay-off, includes too much excess baggage, or is highly dependent on a unique hard-to-replicate organization culture, the likelihood of capability-assimilation by acquisition is limited.

By definition, the competences critically important to delivering value to your customer should not be among the targets for cutting back. But, in many companies, these have become entangled in company-wide downsizings and some lost in piecemeal shutdowns and spinoffs. This first line of defense is awareness. Know what capabilities are critical, and which are core or complimentary. Then act accordingly. Drive resizing with these in mind. Changes based on considerations of costs or financial assets alone can leave a business strategically stunted.

Sizing decisions about cutting-edge capabilities can be made more easily. Some companies invent their own, though there can be many a slip between the skunkworks and the customer. It is becoming increasingly common to obtain them through alliances and joint ventures with others who may be farther along in their development. One company's mundane core capability might be for you, in a different market serving different customers, a valuable addition to your future competitiveness. These close, knowledge sharing, partnerships can be effective when you are clear about exactly what capability you hope to acquire from them. Outsourcing is a less likely way to build cutting-edge capabilities - it's awfully hard to rent your future.

© Robert M. Tomasko 2002

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