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Chapter 2

Firm-level analysis: Resources, Capabilities and Core Competencies

In this chapter, we cover how organizations achieve and sustain competitive advantage. One approach is the ‘internal view of strategy’, also referred to as the micro-foundations of strategic advantage. Extensive research on ‘micro-foundations of strategic advantage’ has led to several hypotheses, which are largely categorized into three groups:

1. The Resource-based view (RBV) hypothesis, originating in the works of Penrose (1959) and Wernerfelt (1984).

1. The Knowledge-based view (KBV) hypothesis, originating in the inter-related theories of evolutionary economics (Nelson and Winter, 1982), organizational learning (Senge, 1990) and increasing returns (Arthur, 1994).

1. The Core competence view (CCV) hypothesis, originating in the work of Prahalad and Hamel (1990).

The key ingredient to the Resource-based view (RBV) is the assumption of isolating mechanisms – that is, the resources of a firm are difficult to substitute or imitate by other firms. RBV considers isolating mechanisms a key factor in the ability of a firm to outperform its competitors. Isolating mechanisms make the resources of a firm difficult to substitute or imitate by other firms. Thus firms are able to generate above-average returns from its unique resources, and gain a dominant position in its chosen marketplace.

Whilst RBV is holistic in nature, the knowledge-based view (KBV) focuses on the process of development of knowledge resources as a special factor contributing to isolating mechanisms. The KBV hypothesis contends that different firms follow a different path of experience to develop knowledge resources over their history. These different paths of experience generate varying bundles of resources and varied ways of combining and customizing these resources for specific deployments. Firms look to secure and sustain their competitive advantage in different ways by ‘codifying’ their experiences churning out knowledge.

The core competence view (CCV) stresses on the core coordination, communication and integration abilities of a firm to be able to synthesize technologies and skills into something insightful that may have a range of applications and customer benefits; it is through this aggregation, a firm is able to secure a higher market share and thereby growth. However, market dynamics may at times reduce the value of a specific aggregation, which would then call for significant changes in the core competencies.

The Resource-based View Hypothesis

The resource-based view (RBV) focuses on a firm’s internal characteristics; it identifies its unique resources and accounts for how they might have been created and maintained (Penrose, 1959; Wernerfelt, 1984). However, the two main limitations of RBV are as follows:

• RBV does not address how future resources may be created, and is therefore a static theory (Priem & Butler, 2001).

• RBV primarily focuses on sustaining competitive advantage of specific business units, and not on how business units in themselves are able to survive and maintain their strategic advantage for the corporation (Bowman & Ambrosini, 2003).

Barney’s (1991) VRIN (Valuable, Rare, Inimitable and Non-substitutable) framework is the practical approach to RBV: it helps us recognize that valuable resources generate superior value, and are rare, because they are difficult to imitate and substitute (Priem and Butler, 2001; Hoopes, Madsen and Walker, 2003).

Given the inherent tautology in the above, the four factors in VRIN network are best operationalized as NIRV instead, wherein at the outset executives should identify key difficult-to-substitute resource portfolios and constituent resources that are also difficult-to-imitate or copy. Then validate the value by affirming that deployment of those resources does yield the firm a unique (rare) advantage in the market (i.e. it is profitable and able to secure desired market share and reputation). If not, then that might indicate that other firms have been able to substitute its resource portfolio, and/or imitate its constituent resources.

Overall, RBV seeks to explain why some firms might continually have a stable, competitive edge in an extremely aggressive but stable environment Figure 2.x illustrates the RBV hypothesis stating that “isolating mechanisms” mitigate (almost to the point of eliminate) the threat of corporate erosions and thereby enable sustainable competitive advantage.

Figure 2.x: The RBV Hypothesis

Isolating Mechanisms

Isolating mechanisms are factors that allow firms to prevent attrition and disintegration of resources, and thereby remain competitive. Three major isolating mechanisms encompass RBV: causal ambiguity, path dependency, and competitive exclusivity.

Causal ambiguity –is not being able to find the specific reason of success of a practice or performance as there are multiple possibilities, which could affect the system holistically; e.g. a firm sustaining profit quarter on quarter could have various reasons contributing it. The rationale for causal ambiguity may be further divided in the form of “social complexity”, “asset specificity”, and “tacitness”.

• Social complexity arises from informal and formal communications among social networks of a firm, which cannot be easily replicated in other firms even if the nature of business of the firm is the same. E.g. in a hospital, post handling a critical patient, the surgeon and the accompanying team discuss and analyze the case, which in turn creates an internal knowledge base, but is difficult to replicate in other hospitals as they may not have a similar team facing a similar situation. Thus the situation and the team are rare to be duplicated even in a similar social context and/or setting.

• Asset specificity focuses on a particular resource which is more valuable to the specific firm. Asset specificity may be of several types: human asset specificity (e.g. highly specialized human skills), material asset specificity (e.g. highly specialized materials), machinery asset specificity (e.g. highly specialized machinery), and method asset specificity (e.g. highly specialized software or procedure). For instance, diagnosis and treatment of a rare ailment requires specialized doctors, equipment and methods extremely specific to that ailment per se and therefore there may be a specialized hospital catering to only patients of that ailment or hospitals within a region may have specialized units among others catering to that particular ailment. Thus, the resources of the hospital are highly asset-specific, because their value outside of this hospital among those that lack similarly specialized doctors, equipment, and methods, is much less (Boseley & Duffy, 2012).

• Tacitness arises when resources within a firm per se are accumulated over time using processes and systems that are unique to that firm. Tacit resources could be cognitive or emotive or include relational skills, beliefs, and practices. For example, rare immunotherapy treatment requires careful monitoring of the patient condition on a range of factors and the understanding of which comes only with experience of handling such cases. Therefore, this knowledge gained is more than just theoretical knowledge gathered from written materials and therefore may not be easily copied.

Path dependency – A firm’s future path is dependent on its prior relationships, experience and reputation in relation to its resource portfolios, and is the source of its advantage over the others. The path of their future actions is dependent on and limited by the path they have taken to reach the present state (Teece, Pisano and Shuen, 1997). For instance, while Apple has developed a leading market position for its iphones in the Western markets, Samsung is the market leader in the emerging markets with its Galaxy smartphones. Samsung has built its success around a path of reputation in smart devices, including smart televisions and watches; and around relationships and experience that allow it to offer a diverse portfolio of smart phones, in different sizes, colors, and of different functionality, at low costs.

Competitive exclusivity – is marked by firms actively impeding sharing of resources with potential competitors, often by legally binding documents, such as nondisclosure agreements/exclusive supply agreements. The goal is to secure and enforce intellectual property rights, making it virtually impossible for other firms to duplicate or develop any alternative.

Limitations of the Isolating Mechanisms

Isolating mechanisms despite their importance under the RBV context have their limitations in dynamic environments, where the power of these mechanisms tends to be much weaker (Ferdinand et al, 2004). Thus, the three major mechanisms encompassing RBV, i.e. causal ambiguity, path dependency, and competitive exclusivity are often compromised.

The causal ambiguity assumption lies in the fact that while resources specific to a firm may have causal ambiguity, other firms may still construct functionally equivalent, yet different, set of resources focusing on alternative market niches. For example, large foreign banks usually lack local knowledge and experience. Therefore, they rely on their global relationships, knowledge, and reputation to target foreign and larger domestic clients, who have a stronger global awareness and need for global experiences. Local firms in Brazil, Russia, China, India and South Africa (BRICS) have been quite successful in leveraging their local relationships, knowledge and reputation to target individual and small and medium enterprise clients.

The path dependency assumption: Although a firm’s own future possibilities are dependent on its historical path of relationships, experiences and reputation, other firms may also accumulate a high possibility resource portfolio from different points and along different paths. For instance, China's early high speed trains were imported or built under technology transfer agreements with foreign train-makers including Siemens, Bombardier and Kawasaki Heavy Industries. Chinese engineers then redesigned key parts and improvised upon foreign designs to build indigenous trains that can reach operational speeds of up to 240 mph. The Chinese government supported these through several “speed up” campaigns during the late 1990s and 2000s for modernizing existing rail lines.

The lacuna with the competitive exclusivity assumption lies in the fact that although a firm’s resources may be exclusive in its own rights, that alone is not sufficient to achieve long-term exclusive competitive advantage for the firm within dynamic environments. Let us take the example of Finland-based Nokia, which was the second largest mobile phone maker during the 2000s. But it lost out on its competitive edge over time as it wasn’t able to successfully migrate to smartphones and android-based mobile devices, which by then had caught the imagination of people worldwide. By 2012, Nokia’s market share plummeted and the company was compelled to sell off its global mobile business division to Microsoft in 2013 for US$7.17 billion.

The Knowledge-based View Hypothesis

The Knowledge-based View (KBV) distinguishes between resources and capabilities (Amit & Schoemaker, 1993). The former is tradable and non-specific to a firm, i.e. it may be purchased and thereby be shared/distributed to other firms. The latter deploys and engages resources raising their productivity. Capabilities include tools (e.g. subject skills for solving problems and for social judgments, and objects that automate these skills such as computer systems), codes (e.g. processes, routines, software, and language to transfer capabilities over time and across firm boundaries), and theories (e.g. cultural values and practices). The KBV therefore is an important reformulation of RBV in the context of the modern industrial economy where knowledge workers produce an estimated 55% of the world’s GDP (Cavalcanti, 2003; using 1998 data).

The KBV hypothesis states that each firm has its own “unique” trajectory or path of capability development, which gives rise to divergent resources and ways of combining and customizing these resources for specific deployments. The KBV builds on three important organizational theories, as illustrated in Exhibit 2.x.

Exhibit 2.x: The KBV Hypothesis

The Evolutionary theory: according to KBV, the path is unique to each firm because the knowledge development is a local, evolutionary process (Nelson & Winter, 1982). In the evolutionary theory, knowledge is internal gained from various processes used by a firm during the course of its operations and from various experiences and interactions. The story of Patanjali Ayurveda, the fastest growing consumer goods firm in India during 2010s, is illustrative.

The Organizational Leaning theory is another key ingredient to the KBV (Senge, 1990). This theory emphasizes both learning-by-doing (how knowledge is created and accumulated) as well as learning-by-using (how knowledge is used and deployed), and suggests that these processes generate differential competencies across firms.

Learning-by-doing has four types of knowledge processes (Håkanson, 2010): articulation, replication, integration and combination. Articulation and replication involve cooperative efforts within specific expert communities, while integration and combination involve coordination of specialized knowledge across such communities.

Articulation occurs in the form of codes, such as standard operating processes (SOPs). Replication is critical for achieving growth through knowledge; therefore, replication of articulated knowledge may occur simply by transmission of codes. To replicate less articulated knowledge, firms need to foster human interactions, like for example apprenticeship training.

Integration requires firms to promote empathy or ‘perspective taking’ among each expert community – i.e. taking the perspective of another community as part of its own way of knowledge development (Boland and Tenkasi, 1995, p. 356). For example: a consulting firm does not need to internalize hardware and software engineering skills in order to integrate the use of computer systems in its consulting services.

Combination calls for innovations involving closer cooperation and new perspectives. The goal of combination is to foster interaction among different expert communities with regard to their less articulated knowledge. To do so, firms need to offer enabling and motivational conditions. One way firms do so is through ‘organizational culture’, which facilitates dialog among members of otherwise different specialization frames. Another way is by investing in tools such as computer systems that offer dedicated support for interactions among members.

In addition to learning-by-doing for creating and developing knowledge, KBV also emphasizes on ‘learning-by-using’ for securing competitive advantage. Firms need to appropriately deploy their knowledge in the form of value-generating strategies. Learning-by-using takes time, and it might be difficult for other firms to accelerate their learning and develop similar knowledge just by making investments (Zack, 1999). The firms may accelerate learning-by-using by designing knowledge maps as aids to prioritize and focus learning use, and systematically categorizing and benchmarking organizational knowledge for "critical learning mass" around particular strategic areas of knowledge (Zack, 1999). As also evidenced by the case of Patanjali Ayurveda, Randall (2013) found that in a transitional economy facing competition from foreign multinational enterprises (MNE), domestic firms that exploited their indigenous knowledge by using a ‘made in’ strategy and a ‘umbrella’ strategy to successfully position different products under an umbrella brand, reported significantly better performance, as compared to those who did not. The foreign MNEs often face long lead times in effectively using local knowledge, unless they have a possibility of acquiring local firms in emerging markets.

The Increasing Returns theory: As illustrated by the use of indigenous knowledge to generate rapid growth by Patanjali Ayurveda, the KBV puts an emphasis on managing knowledge transfers for achieving increasing returns from a given knowledge base (Grant, 2002). Unlike physical resources that are consumed as they are used, providing decreasing returns over time; knowledge offers the possibility of yielding increasing returns as it is used because the initial creation of the knowledge base is often costlier than its subsequent replication. Thus, the more knowledge is used (the scale of application), the more valuable it might become – thus yielding what is called “economies of scale”. Similarly, the more areas it is applied (the scope of application), the more valuable it becomes – thus yielding what is called “economies of scope”. Economies of scale and scope, together with the complementarity of knowledge processes (i.e. articulation, replication, integration and combination), imply increasing returns from knowledge-based initiatives, which are fundamental to the ‘new economy’ (Arthur, 1994).

KBV under dynamic environments

In dynamic environments, the assumptions of the three constituent theories of the KBV – evolutionary theory, organizational learning theory, and increasing returns theory – are often compromised, and require a different perspective.

The evolutionary theory: Though in stable environments different firms are likely to develop distinct heterogeneous evolutionary paths and heterogeneous portfolio of resources using their unique knowledge base, in dynamic environments, organizational survival depends on having a diversity of knowledge and resources (Nannen, van den Bergh & Eiben, 2013). Diversity of knowledge and innovative initiatives gives flexibility to a firm to adapt and influence the changing market needs. It is important to understand that just being local doesn’t guarantee survival and sustaining an advantage over competitors. For instance, when the Indian firm Mahindra and Mahindra was successfully able to compete against the larger MNEs in the tractor industry by focusing on low power tractors targeted at small and mid-sized farmers, Punjab Motors – the erstwhile market leader in India, failed to survive during the 1990s because its focus was on the higher power tractors targeted at more affluent and larger farmers. Thus, Punjab Motors being the local brand ‘lost out’ on competition and became the direct target of attack from many foreign MNEs, who used preferential credit terms and aggressive advertising tactics to cut out its market.

The organizational learning theory: In stable environments, knowledge creation and application processes are based largely on how knowledge as an object is acquired and used, but in dynamic environments, the subjective forms of knowledge become more important. Knowledge, as an object is essentially a commodity: as long as firms garner experiences, articulate their experiences into scalable knowledge, integrate and combine their knowledge into more complex sell-able objects, they are able to capture and sustain a competitive advantage. Whereas, in dynamic environments, the value of objective knowledge is subject to rapid erosion, as the complex objects based on that knowledge are commoditized. For instance, Nokia’s phones became a commodity that lacked any special value, once Apple launched its smartphones. Traditionally, research and development (R&D) is a key driver of organizational learning, but with brisk changes, firms often find it difficult to sustain large investments in R&D. Therefore, in many markets, firms specialized in R&D have emerged victorious as they excel in translating their knowledge objects into patents and other forms of intellectual property rights. They also use this knowledge base to offer training and other forms of more subjective knowledge transfers.

As markets for complex knowledge objects have developed, it is not sufficient for firms to focus just on learning how to acquire and apply these traded objects. Local influences on learning imply that knowledge is situated in specific contexts, making it difficult for the knowledge and the learning system to migrate from one context to another. Thus, context dependency in its essence signifies that knowledge which is meaningful and valuable in a social context may not necessarily have the same connotation in another context. For instance, Xerox invented Windows systems at its research center, but did not consider it valuable for its photocopier equipment. It was Apple who recognized the value of Windows for computers after its scientists visited the research center of Xerox. It was then Bill Gates who decided to adopt the same for Microsoft operating system, and the rest as they say is history.

Thus, in dynamic environments, organizational success is dependent on mechanisms for constructing shared meanings and cooperating within specialized communities, each with their own learning paradigms. For MNEs, cross-cultural factors and organizational inertia complicate such mechanisms, as diverse societal cultures differ dramatically in their meaning-making practices and inertia impedes the willingness to accept alternative practices. For instance, in the West, members may decide to use a new technology for high-end products targeted at affluent customers; but in emerging markets, members may seek to apply the same technology to offer mass luxuries in less affluent markets. While on the one hand, the Western members perceive mass luxury applications as devaluing their corporate identity, on the other, emerging market members tend to perceive premium luxury applications as irresponsible exuberance.

The increasing returns theory: In stable environments, investments are made to generate increasing returns through economies of scale and scope, aided by articulation and codification of knowledge into sharable and replicable information. For dynamic environments in contrast, the value of information tends to depreciate quickly. Therefore, in order to increase returns, firms must seek new intra and inter organizational sources that offer knowledge, using which they could augment their existing knowledge base, which otherwise was at risk of being irrelevant. In today’s network economy, innovations and returns are no more a linear model for creating knowledge within a firm. Rather firms prefer to collaborate with outside partners on building economies of scale and scope for new products, processes and services.

In dynamic environments, new technologies, ideas, and opportunities may emerge in many different and unconventional organizations, communities, and geographies. Firms may source knowledge through interactions and network connections with newly discovered geographies, customer segments, vendor groups, scientific laboratories, partners, competitors, and communities. This enables them to spread themselves and thus reduce overall costs, risks, and the time of knowledge creation. This process is therefore not linear, but interactive; it requires considerable communication and collaboration among different units within a firm and among different organizations.

The Core Competence View Hypothesis

The Core competence view (CCV) – first articulated by Prahlad and Hamel (1990) -- makes a distinction between the knowledge processes of articulation and replication, referred to as competencies, and knowledge processes of integration and combination, referred to as core competencies. Unlike RBV, the concept of core competence is conceived at the corporate level. Core competencies are deemed as the root of a corporate’s distinctive qualities, and therefore sometimes also characterized as ‘distinctive competencies”. Prahalad and Hamel (1990) note:

“Core competencies are the collective learning in the organization, especially how to co-ordinate diverse production skills and integrate multiple streams of technologies...core competence is communication, involvement and a deep commitment to working across organizational boundaries...core competence does not diminish with use. Unlike physical assets, which do deteriorate over time, competencies are enhanced as they are applied and shared.”

Wang and Ahmed (2007) elaborate that core competencies are a bundle of a firm’s resources and capabilities that are strategically important to its competitive advantage. For example, the success of the European firm, Zara, in the fast changing fashion industry relies on its core competence in responsiveness to customers, which in turn is derived from a bundle of capabilities including swift copy of catwalk design, advanced information systems, just-in-time production and shop-floor led stock control that combine together for success. Therefore, the emphasis of core competencies is on creative ‘integration’ and innovative ‘combination’ of resources and capabilities in light of a firm’s strategic direction.

According to Prahalad and Hamel (1990), core competencies help corporates leverage their diverse competencies into core products, based on the creative integration and innovative combinations of multiple streams of technology and production skills. Core products can be used by constituent firms – i.e. multiple business units, to develop multiple end products.

Core competencies are intrinsically linked to an organization’s vision, values and core business. During the 1990s, CCV was very popular among strategy consultants to help guide diversification and outsourcing decisions of firms. In stable environments, a focus on the corporate-wide core competencies allows constituent firms to avoid dispersing their limited resources into too many diverse areas, and to be able to pursue an internally coherent strategy. All investments in improving core competencies generate increasing returns from superior core products and several end products. On the other hand, outsourcing activities that are tied to the core competencies hurt a firm by weakening the development of core products. Prahalad and Hamel (1990) recommended three tests for identifying core competencies of any corporation:

1. A core competence is difficult for competitors to imitate or trade because it is a complex harmonization of individual technologies and production skills.

2. A core competence provides potential access to a wide variety of markets.

3. A core competence makes a significant contribution to the perceived customer benefits of the end product.

The first test is related to the concept of social complexity discussed under the isolating mechanisms for RBV. The second is connected to the concept of economies of scope discussed under the increasing returns theory for KBV. In addition, the CCV emphasizes the role of perceived customer benefits. Prahalad and Hamel (1990) emphasized how Japanese firms widely used the CCV to offer the benefits that customers in the U.S. and other markets valued, and attributed their strategic advantage during the 1980s to this view. For instance, Honda’s core competence was using different technologies and skills to make powerful engines (a core product), which it then used in a variety of markets including trucks, cars, and motorcycles (end products) and the customers identified its innovative engines as a key factor in their preference for Honda.

Exhibit 2.x: The CCV Hypothesis

CCV under Dynamic Environments

The CCV has come under scanner, partly because the Japanese firms identified as exemplars by Prahalad and Hamel (1990) have fallen behind and seen dramatic falls in their global market shares since the 1990s. The shift in the fortunes of Japanese firms is related with a rapid appreciation in Japanese currency yen, particularly during the early 1990s. Yen appreciation made Japan-based knowledge combination and integration processes extremely costly from a global standpoint. On the other hand, processes of knowledge articulation and replication based in the overseas factories and investment networks of the Japanese firms became dramatically more cost-effective. Japanese firms have been reluctant to situate their complex knowledge combination and integration processes overseas, because of a fear that such offshoring will result in further, possible complete, hollowing out of the Japanese advantage. In the interim, more cost-effective combination and integration processes have allowed American firms to regain advantage in electronics, automotive, and other sectors, and to create new areas of advantage in biotechnology, energy and other areas.

In dynamic environments, it is not sufficient to compete solely on the basis of corporate-wide efforts to combine, integrate diverse skills and technologies into core products, and to find applications for them. Firms need to effectively respond to market changes, which are often compiled of complex sequences of several processes (also known as ‘meta-processes’), such as sensing the environmental change, seizing the right opportunities for change, and realigning the firm’s competencies using new combinations and integrations, and new interpretations of previously articulated and widely replicated competencies. The ‘meta-processes’ need to be connected with the social context and experiences of the firm, so that micro dynamics of the habitual responses of members may be redirected (Hutchins, 1993); this helps firms not only to generate new learning, but also discover ways of advanced learning in the course of organizational practice – manifested as practice-based knowing and discovery.

Practice-based knowing and discovery addresses another lacuna in CCV – research shows that too much and too long focus on a specific set of core competencies, based on a specific set of skills and technologies, will actually make a firm’s core competencies a ‘core rigidity’ (Leonard-Barton, 1992). In other words, a firm’s insistence to stick to a previously successful combination and integration might put it in a ‘competency trap’ (Wang & Ahmed, 2007). This could block the firm’s capacity to adapt quickly to market dynamism reducing drastically its competitive advantage. For instance, Honda has traditionally focused on gasoline-run engines. In India, diesel is cheaper than gasoline because of government subsidies, and that is why it is widely used by the poor farmers. While Honda has adapted to diesel engines in the passenger car segment, it has gained a strategic advantage on fuel economy; however, Hyundai’s fleet is preferred by the public because of its superior engine performance. In comparison to Hyundai’s engine, the engine of Honda City has a lower displacement and is therefore less powerful. The peak power and torque ratings for Honda city are also lower than Hyundai. Additionally, Hyundai’s engine is more refined and quieter, while Honda’s is pretty audible inside the cabin (Singh, 2014).