Business leaders are living in challenging times. More than ever, we find ourselves walking a fine line between significant value creation and disastrous value destruction. One small misstep and what looked like an irresistible opportunity rapidly becomes an inescapable trap.
We search for a road map to guide us, but we fail to realize that the lenses we use to survey our surroundings will make the real difference in the success of our journey. What we need is the ability to survey a whole panorama of developments - distinct, but largely interconnected and mutually reinforcing - and to understand how they are combining to challenge some of our most basic ideas about how to structure and run an enterprise.
We know in general terms what these developments are, but we often find it hard to look past the executive summaries and discern their deeper significance - let alone their combined impact. There is, first of all, the burgeoning of business opportunity on what we call "the edge," a term that takes in the periphery of enterprises and industries as well as the large developing economies and some important demographic trends. There is the dynamism of the financial markets, where performance is rewarded and underperformance punished, where private equity investors catalyze more and more corporate restructuring and where venture capitalists fund more and more innovation and competition. There is the rise of connectivity and the fall of interaction costs produced by modern information technology. And there are the trends toward offshoring, outsourcing and increasingly flexible and adaptive collaborations among companies.
There is a strong case to be made that these developments, taken together, are pushing us toward a fundamental reformulation of the firm itself, and a world in which companies will find themselves choosing which of three basic business types they are best suited to become. Enormous value stands to be unlocked in this process, especially by early movers - as we can see by looking at several of these phenomena in greater depth.
Let's start with the concept of the edge, which is where we have the richest opportunities for value creation - and the best protection against value destruction. What do we mean by edge? First, we mean the edge of the enterprise. Second, the edge also refers to the boundaries of industries. Third, there are geographic edges - in the sense of large, emerging economies, especially in China and India. Finally, edge also points to the younger, emerging, generations of consumers and employees who, shaped by a world of pervasive information technology, are evolving different ways of learning, consuming and relating to each other. The large, emerging economies of China and India are demographically heavily weighted toward younger generations of consumers, making them especially rich arenas for innovation and value creation.
Of course, we cannot divert our attention completely from the core of our businesses. We need to learn how to pay attention to both the core and the edge at the same time, without letting one distract us from the other. When we do pay attention, we begin to see something remarkable: the edge will reshape and eventually transform the core.
When we focus on the edge of the enterprise, the boundaries of our industries and the large, emerging economies, we begin to see how events in these arenas spill back into the core, both challenging us and creating opportunities for innovation. The challenge comes at the enterprise level, where the core capabilities that determine our business success are being redefined. More profoundly, it comes at a macro level, with the developed economies of the U.S., Western Europe and Japan also forced to rethink their global roles.
This gives rise to a new business strategy. Companies need to tap more effectively into the rapidly developing resources and opportunities emerging on the edge in order to amplify their own capabilities and create powerful new engines for innovation and growth. But to accomplish this, companies will need to undergo a fundamental transformation, deploying global business and technology architectures that spill beyond their own boundaries and span a growing number of companies across the globe.
The rationale for the firm
Some context is in order here. In thinking about why firms exist, academics (and, through them, executives) have long been influenced by a seminal essay, "The Nature of the Firm," published in 1937 by economist Ronald Coase, who later went on to win a Nobel Prize. Put simply, Coase argued that firms exist to economize on market transactions. All economic activity incurs transaction or interaction costs - the costs (and time) required to find resources, get relevant information about them, negotiate to gain access, monitor their use and switch from one source to another if needs are not being met. Coase simply and powerfully argued that, under certain circumstances, firms provided a more efficient mechanism to access and use resources relative to open-market transactions. In this view, efficiency was the primary motivation for the rise of firms. It certainly seemed to explain the rise of modern industrial firms as described in such classics as Alfred Chandler's "Strategy and Structure."
But as information technology systematically reduces interaction costs both within the firm and across firms more broadly, perhaps it is time to reassess the continuing rationale for the firm. We hasten to add that we are not in the camp arguing for the dissolution of the firm. Firms, albeit in somewhat different forms, will continue to play the critical role in economic value creation. But the rationale for the firm is shifting in a fundamental way: from efficiency considerations to capability building and to creating systemic innovation.
In this perspective, the primary role of the firm should be to accelerate knowledge building and capability building. This is a much more dynamic view of the firm, since it broadens attention from the tasks of allocating existing resources to the tasks of deepening knowledge and capability in an increasingly uncertain environment.
Of course, executives are entitled to be skeptical at this point. Isn't it common sense that all companies would want to build capability faster? In practice, this has proven very difficult. In part, this is why accelerating capability building is such a powerful edge. Few companies do it well. But new mechanisms will help companies to build capability faster. These new mechanisms collectively will require profound institutional transformation, so they will not be easy to deploy, but the rewards will be significant for the companies that are able to master them.
Process outsourcing and offshoring
We are witnessing a rapid growth of both process outsourcing and offshoring. Early waves of process outsourcing were limited to administrative processes like finance and administration or human resource management. Over the past decade, the focus has shifted to outsourcing and offshoring of core operating processes of the firm - manufacturing, logistics, product development and elements of customer-relationship management.
The result is that these choices can no longer be conceived of as narrow operational decisions focused on delivering near-term operating savings. When the choices involve the core activities required to deliver value to the customer, operating savings are only one part of the equation. Companies must seek out outsourcing providers that can provide world-class capabilities. We are moving from wage arbitrage to skill arbitrage.
But that is just the beginning. If the rationale for the firm is to get better faster, then we need to change how we assess our business partners. The skills and capabilities these partners have today are important. Even more important, however, is the ability of the business partners to get better faster - have they themselves mastered the management techniques and built the business relationships required to do this?
Shedding core operating processes and relying on world-class outsourcing partners to provide these capabilities only works if executives have a clear view of their own distinctive capabilities - and a commitment to get better faster in these areas. Process outsourcing gives executives a valuable opportunity to focus on building these distinctive capabilities.
Within the enterprise, executives have developed hard-wired approaches to business process management. Activities across the business process are specified in great detail and standardized to deliver greater operating efficiency. These techniques work very well within the firm when the primary goal is to deliver operating savings.
But once we start trying to tap into the capabilities of other companies, we face a challenge. Our hard-wired approaches to business process management begin to fall apart. This is why some companies are beginning to develop a much more modular, loosely coupled approach to orchestrating business processes extending across hundreds, if not thousands, of enterprises. Early pioneers of this approach include Li & Fung Ltd. (the Hong Kong-listed apparel giant) and Nike Inc. in supply-chain operations, Chinese original design manufacturers, or ODMs, like Compal Electronics Inc. and Asustek Computer Inc. in product design and Cisco Systems Corp. in the customer-relationship management processes. These companies are building global process networks that provide much more flexible access to specialized resources.
Productive friction
Accessing a broader range of specialized resources is only part of the story. The real opportunity is to build long-term relationships with business partners that push each other to get better faster. If the relationship were to end tomorrow, the question is: would all parties perform better on a standalone basis as a result of having been in the relationship? This is a much higher bar than asking whether the relationship produced a return on investment.
Productive friction increases the potential for innovation, learning and capability building by bringing people from relevant specializations together around difficult problems in settings that enhance creative problem solving. When people with different backgrounds, experiences and skill sets engage with each other on real problems, there is usually considerable friction - misunderstandings occur, arguments arise and time is consumed - before resolution and learning occurs. Often, this friction becomes dysfunctional as misunderstanding hardens into mistrust. Yet, properly harnessed, friction can become very productive, accelerating learning, generating innovation and building trust across diverse participants.
Having tapped the power of productive friction, the pioneering global process networks built by the likes of Cisco and Nike are pointing the way toward a new wave of specialization for companies. Many executives will ask: haven't we already specialized? Relative to the conglomerates that have largely fallen from favor, we certainly have. But there is much more focusing to be done, and offshoring (and related outsourcing) trends are already driving this next wave of initiatives forward. These initiatives will be organized along business types that generally (but not entirely) correspond to the core operating processes of the firm - infrastructure management businesses, product innovation and commercialization businesses and customer relationship businesses.
Broadly speaking, a number of industries, most notably financial services, pharmaceuticals and the computer industry, have already begun to restructure along these lines. In the credit card industry, for example, specialized transaction processing companies handle the back office processing, retail banks take on the role of product innovation and commercialization and a variety of companies ranging from Intuit Inc. to UAL Corp.'s United Airlines are offering affinity credit cards as part of their efforts to develop deeper relationships with their customers. In the pharmaceutical business, specialized biotechnology companies are taking on more of the research and development activities while the large pharmaceutical companies are focusing more on scale-intensive manufacturing and distribution roles. Offshoring is simply another trend that will reinforce and accelerate this unbundling.
Let's look at these three business types in a little more detail. Infrastructure management businesses focus on relatively routine, high-volume business activities, like managing logistics operations, high-volume commodity manufacturing or call center operations. Examples of companies specialized in this area are United Parcel Service Inc. in logistics, Solectron Corp. in computer manufacturing and Convergys Corp. in call center operations. Product innovation and commercialization businesses focus on the task of developing innovative new products or services and accelerating their penetration into target markets. Early examples of this kind of business focus span the spectrum from design firms in the fashion industry to fabless semiconductor design firms in the electronics industry. Finally, customer-relationship businesses concentrate on identifying a target customer segment, getting to know that segment extremely well and using this knowledge to more effectively mobilize the right bundles of third-party products and services to address the needs of their customers. In consumer markets, examples of these kinds of businesses include general practice physicians and independent financial advisers. In business markets, examples include Accenture Ltd. in information technology and commercial brokers in real estate.
While we can point to examples of companies already focusing on one of these three business types, most companies today still have these three business types tightly bundled together within their enterprise walls. This is the case even though each of these three business types requires very different economics, skills and even cultures to be successful. By tightly bundling these three businesses together, companies inevitably limit the performance of one or more of these business types. They therefore become vulnerable to more focused competitors.
Many of the offshoring service providers have chosen to focus on one of these three business types - particularly in infrastructure management businesses, although interesting examples of the other two business types are also represented offshore. These providers are rapidly establishing world-class capabilities. More diversified companies that choose to retain these activities within the enterprise will face increasingly severe competition from companies accessing world-class capabilities from focused providers. At the same time, shedding these activities is no easy choice. It means losing the opportunity to differentiate in the outsourced functions and choosing other areas in which to develop world-class capabilities of their own.
Companies are likely to find it useful to think in terms of these three business types as they make their specialization choices. If they make the right choices, they will continue to create significant value of their own and will be able to amplify this value by accessing specialized capabilities of other companies, many of them located offshore. If they make the wrong choices and either try to do too much or pick areas where they truly cannot differentiate themselves, they will destroy significant value.
Within these three business types, further specialization choices are likely to be necessary. Infrastructure management businesses are likely to specialize in a particular category of routine, high volume business activities - for example, operation of logistics networks versus operation of telecommunication networks. Customer relationship businesses will generally specialize in specific customer segments. Product innovation and commercialization businesses in contrast will tend to specialize in certain technology or design segments.
As this unbundling of corporations proceeds, we will see the insights of Adam Smith regarding the virtues of specialization taken to another level. Dynamic specialization will reshape the business landscape, generating significant productivity improvement in the process. This isn't to say that the future will belong to small companies. At least two of the business types we have discussed (infrastructure management businesses and customer relationship businesses) have compelling economies of scale and scope that will lead to significant concentration among large, focused enterprises. Furthermore, the real opportunity for value creation will come from creative approaches to rebundling specialized firms in flexible process networks that help participants to work together to get better faster.
Financial markets as catalysts
Global financial markets are becoming ever more demanding regarding corporate performance. At one level, the growing focus of investors on quarterly earnings growth tends to reinforce the near-term operating savings mindset of senior executives. On the other hand, as companies begin to experience the diminishing returns from round after round of cost-cutting, financial markets are also forcing executives to rethink their business strategies at a more fundamental level.
If public companies can't find ways to drive innovation and growth, private equity firms stand ready to move in and unbundle enterprises that fail to perform. A growing number of PE firms are looking at the opportunities to take midtier manufacturing firms private, outsource the core manufacturing operations to China and refocus the companies on either product innovation or customer-relationship management.
On the other side, venture capital firms are fueling the formation of new waves of innovative companies that can add value to larger, established companies. As performance pressures mount, we will need to increasingly challenge the most basic assumptions that shape our enterprises. What is the role of the firm going forward? What business are we really in? How do we more effectively build relationships that help us to access complementary capabilities but also force each side to get better faster? How can we more effectively leverage financial markets to accelerate the process of restructuring?
One thing is certain. The relationships we build with business partners, often viewed as secondary and peripheral to the enterprise, are becoming ever more central to business performance. While executives talk freely of "strategic" partnerships, these relationships have tended to be conceived and executed within a relatively narrow and near-term operational context.
We are on the cusp of a profound restructuring of global business. The winners in this restructuring process will be those who use business relationships in a much more strategic fashion to get better faster by working with others. Restructuring creates enormous opportunity for value creation, especially by those who understand the new structures, relationships and practices required to extract value. - John Hagel and John Brown
John Hagel III and John Seely Brown are co-authors of the new book, "The Only Sustainable Edge: Why Business Strategy Depends on Productive Friction and Dynamic Specialization." Hagel is an independent management consultant who spent 16 years with McKinsey and Co. He can be reached at john@johnhagel.com. Brown, the former chief scientist at Xerox Corp., is now a visiting scholar at the University of Southern California. He can be reached at jsb@johnseelybrown.com.
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