A telco executive needs to make a $1 billion yes or no decision as to whether to invest in a new network technology to provide new servide to customers. One best-practice market research survey predicts a return on investment of 25 per cent; a second, equally valid, forecasts minus 25 percent. What should that executive do?
How should executives at a software firm deal with a large customer that is also their chief competitor and one of their biggest suppliers?
How should the CEO of a credit card company think strategically about positioning, when segments and value propositions come and go every six months?
A large regional bank recognizes that to achieve its aspirations in retail banking, it must shape the nature of competition by discovering huge but as yet unrecognized customer needs, and stimulating other players to follow its bold lead. How can item bark on such a strategy?
All these cases lie outside the conditions for which the traditional model of strategy was designed. In fact, our work suggests that up to 50 per cent of the strategy situations faced by large companies lie outside of those conditions. Equally, no single one of the new frameworks can address them all.
Therefore, it is time for a new approach to strategy. The past twenty years have seen a wider range of business situations emerge than ever before. No
single strategy prescription can be appropriate in each one of them. Whats needed is a more robust model of business that can
handle a much borader set of
circumstances and suggest when and how we should use specific theories.
The shortcomings of the traditional approach:
At the heart of the traditional strategy framework lies a microeconomic model of industry. Exhibit 1 illustrates its popularised form, the Porter model. This model combines exogenous forces acting on an industry (such as technology and regulation) with endogenous ones. More importantly, it makes three tacit but crucial assumptions. First, that an industry consists of a set of unrelated buyers, sellers, substitutes, and competitors that interact at arms length. Second, that wealth will accrue to players that are able to erect barriers against competitors and potential entrants; in other words, that the source of value is structural advantage. Third, that uncertainty is sufficiently low that you can accurately predict participants behavior and choose a strategy accordingly. Even if the odds of each assumption being individually correct is moderate, the combined chances of at least one of these being wrong is high. So, lets examine the validity of these assumptions.
Industry structure
The traditional microeconomic model is based on a rational industrial structure where each player competes at arms length not only with its rivals, but also with customers and suppliers for control of the economic rents. However, at least two other industry structures are commonly found today. In both these structures, conduct differs from that prescribed by the traditional model and anyone blindly applying the standard microeconomic rules will get into trouble.
Co-dependent systems are cross-industry structures such as alliances, networks, and economic webs. The most novel and increasingly widespread of these is the economic web. Webs are sets of companies that use a common architecture to deliver independent elements of an overall value proposition that grows stronger as more companies join the set (for example, the Wintel and Apple webs in the computer industry).* the fortunes of any player in a web depend both on the success of the web as a whole, and on how well that player uses its own position of influence within the web. The strategic challenge is to strike the right balance between the prosperity of the web and that of individual participants; greedy players can harm themselves as well as wreck the web. Thus, an arms length fight to grab economic rents could be highly counterproductive.
High-tech industries such as computers, telecommunications, software, and multimedia are migrating toward web structures, but evidence of webs can also be seen in order sectors such as automobiles, health care, forest products, and financial services.
Privileged relationships are structures within which firms single out other firms in the same market for special treatment because of financial interest (Korean chaebols, Mexican grupos, Japanese keiretsus), friendship, trust, or ethnic loyalty. Governments create similar business relationships in the name of national defense of pride.
Consider also the Indian and overseas Chinese, who have networks of family - owned corporations where relationships between members are clearly privileged. In such situations, network members actions need to be understood in the light of not just their firms strategies, but also the strategy of the whole network, and the individual members positions in the family hierarchy.
Source of Advantage
The traditional microeconomic model assumes that wealth will accure to businesses that possess structural advantages over competitors and potential industry entratants. In major sectors of the economy - telecommunications, basic materials, transportation - this is still true. But competitive advantage can also be built on two other foundations:
Front-line execution. Companies in some industries win by consistently outperforming competitors in the execution of day-to-day tasks. In commercial lines property/casualty insurance, for instance, a few players have demonstrated that superior
underwriting and claims handling can overwhelm any structural advantage.
Insight/foresight. Some firms create wealth by possessing knowledge of having insights that others lack. The knowledge may lie in scientific or technical expertise (Hewlett-Packards continuing superiority in printers), pattern recognition (the ability of some banks to make consistent profits by taking short-term positions in foreign exchange), or sheet creativity (Disneys unmatched success in animated films).
If the three (that is, one old and two new) sources of competitive advantage are brought together with the three (again, one old and two new) industry structures mentioned earlier, the result is a new model that better reflects the rich strategic possibilities of todays industrial landscape (Exhibit2).
Level of uncertainty
The traditional model assumes that uncertainty is sufficiently low in an industry that you can make reasonably accurate predictions on which to base your strategy. In reality, however, the future is usually much harder to foretell. When faced with uncertainty, executives tend to leap to extremes. Some simply pretend the uncertainty does not exist; others see it, but in
paralyzes them.
What should strategists do when the true results (at least in part) of their situation analysis is I dont know, and no amount of good analysis will tell me? Certainly, they should not just apply scenario planning and recommend options. Rather, the secret of devising successful strategies under high uncertainty lies in ascertaining just how uncertain the environment relly is, and tailoring strategy to that degree of uncertainty. Four levels of uncertainty can be identified:
At level 1, the traditional incro economic model still holds, and strategists are able to develop a single useful prediction of the future. This does not mean that there is no uncertainty, but rather that analysis will be sufficiently robust to allow a clear strategic direction to emerge. Appropriate sensitivity analysis can be performed after a course of action has been determined. Consider the fast-food industry, where change over the past decade has been evolutionary, allowing companies to base their strategy on a prediction.
At level 2, analysis shows that the future will follow one of a few discrete scenarios, though it cannot predict which one. In late 1995, for example, the outline of the pending telecom legislation in the United States was clear; what was not clear was whether it would pass Congress. In this case, strategy could be built around two possible scenarios. Generally speaking, since the number of scenarios is usually small at this level of uncertainty, strategy can be determined analytically.
At level 3, continuous uncertainty prevails. Though there are only a few dimensions of uncertainty, analysis is unable to reduce the future to a limited number of discrete scenarios. Instead, the reality might lie anywhere alone a continuum for each dimension. Many new technologies, for instance, face uncertainty over the rate of market acceptance. It is not just a matter of fast or slow acceptance; it could be anything in between.
At level 4, there is true ambiguity: multiple dimensions of continuous uncertainty. Consider the case of a multinational deciding whether to invest in Russia in 1992. In addition to an unusual degree of uncertainty over demand, the company would have faced uncertainty about the laws that would govern contracts, about who would have the power to enter contracts, and even about whether current suppliers and
distributors would remain in
business.
These graduated levels of uncertainty govern the type of situation analysis a strategist should perform. At level 1, traditional frameworks are entirely appropriate. At level 2, scenario planning, quantitative game theory, and options pricing frameworks will be needed to help determine strategy. At levels 3 and 4, qualitative game theory, latent demand analysis, and evolutionary models will be required.
When this concept of uncertainty is combined with the new industry model illustrated in Exhibit 2, the result is a new approach to situation analysis (Exhibit2, the result is a new approach to situation analysis (Exhibit 3) It takes account of the varying levels of uncertainty about the external forces acting on an industry, the effect of these forces on that industry, and the industrys interactions with itself. It also shows that the level of uncertainty can rise and fall
over time.
A new definition of strategy.
Traditionally, strategy was defined as an integrated st of actions that leads to a sustainable competitive advantage. This definition continues to work well in traditional industry structures characterized by low uncertainty. Beyond this limited context, however, we believe a broader definition is needed. For example, in high uncertainty situations strategy is likely to call for more than a single integrated set of actions. It will probably require investment in a variety of options, small bets, and so on. The new definition is that strategy is the handful of
decisions that:
ldrive shape most of a companys subsequent actions,
lare not easily changed once made, and
lhave the greatest impact on whether the companys strategic objectives are met.
To be specific, the handful of decisions are:
selecting the companys strategic posture
identifying the source(s) of competitive advantage
developing the business concept
developing the business concept
constructing tailored value delivery systems.
Lets look at each of these decisions in detail.
Strategic posture:
Depending on the extent of its ambition, a company can adopt one of three strategic postures: adapting, shaping, or reserving the right to play.
Adapting is the most common choice. A company analyzes its environment, then commits to a set of actions that conform to that environment. Though different levels of uncertainty might require different actions, the mind set is always one of accepting the world as it is - seizing known opportunities and responding to know threats.
Shaping consists of attempting to change the environment in a direction that would benefit the firm. Shapers invent entirely new products for which demand is only atent, or alter the basic structure of their industry, or develop entirely new ways to compete. They believe they can influence the world to such an extent that a detailed analysis of their current environment is scarcely relevant. This belief may rest on the power of an idea or on consistently suerior capabilities. Either way, shapers depend on their own
ability to change their external circumstances.
Shaping turns out to be attractive in some pretty counterintuitive cases. In highly uncertain envrionments, for instance, one would normally be tempted to hedge and avoid commitment. Yet for some strong players, this might actually be the best time for a bold move. Imagine a group of frightened children, lost in a forest. The best strategy might be for the biggest kid to shout, I know the way. Follow me! Even if that kid didnt really know the way, and it took hours to get out of the forest, the group would still stay together. Similarly, if there is uncertainty over industry direction, a bold shaping posture may be the best option.
That said, shaping isnt always avisable. It offers the highest reward, but also the highest risk, of the three postures. It is difficult to create massive wealth without being a shaper; think of the steel and railroad barons of the nineteenth century, Thomas Edison, Microsoft, and Netscape. But at the opposite end of the spectrum, think too of Zap Mail, Microsoft Network, Betamax, and the English Channel Tunnel.
Reserving the right to play is a noncommittal posture. It consists of doing the minimum required to keep open the possibility to become a strong player later. It is not the same as taking no action at all; rather, it is an investment in learning.*
Underlying these three postures are fundamental differences in mindset. However, it would be wrong to oversimplify; companies like Microsoft seem to be able to blend elements of all three, and a companys choice of posturemay change as conditions alter. In general, though, most companies should aim to develop a single cominant posture.
Competitive advantage
Earlier, we noted three different bases of competitive advantage: structural advantage, frontline execution, and insight/foresight. There are, of course, many subvariatns of each, such as core competences, time-based competition, and hustle. And new sources of competitive advantage may well emerge in the future. Though companies have many tools for selecting a source of advantage, they seldom realize how this choice canlock them in in unexpected ways.
Structural advantage results from a tight congruence between a companys value proposition and a structural reason why competitors cannot copy it. This necessarily locks the company in a particular set of customers or needs. If these change, the strategy may become obsolete.
Frontline execution strategies are usually even more locked in, committing an entire organization to adhere to a set pattern of performance. One companys program to build execution skills incorporated 65 separate subprograms to change organization structure and hiring and pay
practices, and introduce new information systems, policies, and procedures. Not surprisingly, the company had little flexibility to adjust its strategy if conditions changed.
Insight/foresight might appear to be a more flexible basis for competitive advantage, as it does not entail locking into a single value proposition interms of product or market. However, there is often lock-in at the input level. When a company is dependent on the source of insight, it can be vulnerable if that source becomes less valuable. Moreover, companies can only create wealth if enough customers buy their goods or services. Therefore, insight/ foresight usually has to be combined with structural advantage or frontline execution if it is to create value.
Business concept
There is more to translating postures and sources of advantage into specific strategic decisions than simply choosing your positioning. Any complex business concept will probably be constructed from fourtypes of building blocks: big bets, Real and financial options, no regrets moves, and safety nets.
Big bets are major commitments to a course of action that may pay off handsomely in some situations, but produce dismal results in others. Real and
financial options give a company flexibility, either financially or operationally.
Financial options are well understood. Real options are investments in tangible capital goods or operating expenses that are made in order to learn or create flexibility (for instance, installing machinery that can work on a variety of raw materials). No regrets moves are actions that make sense no matter what eventually happens. And safety nets are options that are specifically designed to protect against a big bet going bad.
Consider the case of a large specialty chemical company that faced uncertainty over which of two new technologies its industry would accept. If it had decided to make a major investments in one of the two, it might have been able to convince other players that its choice was superior, and so shape the industrys technology base. This constituted a big bet: if the company failed to convince others, its plant would be stranded. It could have complemented the bet with no regrets initiatives, such as cost reduction and sales improvement programs, and added a safety net provision by planning to retrofit the second technology if its bet proved wrong.
In practice, management at this company chose a strategy consisting of several real options. The company formed an alliance with a new entrant using one of the new technologies, while retrofitting several of its own small plants with the other technology. In addition, it took several no regrets measures, but it did not need a safety net.
Tailored value delivery system.
Big bets, rel options, and so on are the building blocks from which new strategiesare assembled. For each of these building blocks, companies need to construct a separate value delivery system. Imagine that a company faced with a choice between two technologies elects to buy real options to cover both of them. Real options, unlike financial options, are investments in organizations and people. When these options turn out not to be valuable there is a significant human and organizational cost attached to unwinding them. (Do you fire the R&D team whose solution you do not use?) Thus, strategies capable of dealing with the complexities of todays business environment are likely to call for the ability to create, grow, and manage multiple value delivery systems
simultaneously.
Evolving strategy
As well making the four strategic decisions outlined above, managers must also learn to recognize the dynamics inherent in every situation and manage the building blocks of strategy effectively
over time.
Traditionally, strategic management has ment little more than staying the course. Today, however, it means actively managing the way in which strategy unforlds, month after month, year after year. That might entail drawing up contingent road maps in which reaching specific milestones will clarify the right strategy; it might equally mean recognizing that strategy will have to evolve as industry
conditions alter.
Just the new framework changes what is required of strategy, so it changes the strategy development process - especially in terms of who actually develops strategy, and when they do it. In situations where there is little uncertainty and structural advantage is critical (for instance, capacity decisions in the chemical industry), a traditional strategy development process, led by senior line management and conducted annually, could continue to work well. In industries with low uncertainty where frontline execution is the source of differentiation, bottom-up processes could be the right choice.
On the other hand, where uncertainty is high, where web-like structures are in the ascendant, or where a company spires to be a shaper, the strategy development process will probably need to be totally revamped. In fact, it might not be a separate process at all. Instead, direction setting by the CEO or business leader would be combined with extremely short communication lines to the workers in the marketplace, and real-time rather than periodic adjustment of the strategy.
The broader picture
How does this new approach to strategy relate to concepts that have been proposed by others? We believe that, like the traditional model, most of these concepts are appropriate only in specific situations within the broader picture (Exhibit 4). The customer retention framework, for example, is really only valid in frontline execution industries with limited uncertainty. If companies base their strategy on it anywhere else, they will be focusing on minute improvements to a value proposition that could be blown away by competitors if the environment were to change.
We have examined over 25 separate strategy concepts proposed over the past few years. Close examination of any of these reveals how their underlying assumptions limit the circumstances in which they can be used. Consequently, strategists should be familiar with all of these concepts, but not baised toward any of them.
They should narrow their focus to a specific submodel only after they have determined which one is most propitiate to their situation. In todays diverse business world, they must take into account a wider range of industry structures and bases of competitive advantage, and a higher degree of uncertainty. Admittedly, this is more complex than looking for keys under a gurus lamppost. But if any area of business
deserves the extra effort, surely it is strategy.n
Reprinted with permission
from McKinsey Quarterly.
