1. Achieving Decentralization and Near Decomposability 

Every system comprises subsystems (elements) that are to some extent interdependent and independent. However, as discussed earlier, enterprises are unlikely  to  be  continuously  responsive to customers and new technologies absent a high degree of decentralization. With decentralized decision making, different managers observe different information and control different deci- sions, but there is not the need for communication to a single central decision-maker, and hence no comprehensive “roll-up” of information is required. Decentralization must be pursued as enterprises expand, otherwise flexibility and responsiveness will erode.

One well-documented restructuring that is widely adopted as enterprises grow is the adoption of the  multidivisional  form. This involves decomposition and the devolution of decision rights to quasi-independent profit centers. The abandonment of func- tional structures in favor of the multidivisional form has been analyzed by Chandler (1962), Williamson (1975), and many others. The basic rationale of this reconfiguration was to achieve greater accountability of managerial decisions so that the recogni- tion of opportunities and threats could proceed more thoroughly and expeditiously. With functional internal structures, day-to-day problems tend to distract management from long-run strategic issues. Studies showed that decentralization along product or market lines with independent profit centers led to performance improvements in many industries, at least during the period in which these organizational innovations were diffusing (Armour and Teece, 1978; Teece, 1980b). More recent scholarship has sug- gested that even further decentralization and decomposition in large organizations may be beneficial (Bartlett and Ghoshal, 1993).

There is also some evidence that “modern” human resource management techniques—involving delayering, decentralization of decision rights, teamwork, flexible task responsibilities and performance-based rewards—also improve performance (Jan- tunen, 2005).

Of course, achieving decentralization can compromise the orga- nization’s ability to achieve integration. There is little harm and much benefit from decentralization when the customer does not benefit from an integrated product offering, or when sourcing and other inputs do not benefit from integration and/or aggrega- tion. If customer and supply considerations allow decomposabil- ity (because the required integration between units is less than within units), then management’s ability to identify and implement decomposable subunits should enhance performance. However, if firm-specific economies of scale and scope are available, they must be captured—otherwise the enterprise is tantamount to a conglom- erate. This tension can be managed through a collaborative non- hierarchical management style assisted by establishing councils and other integration forums. Middle management can also play a criti- cal role when such forums are established. They can also design and implement tight financial controls and performance-based reward systems. Since intangibles are key drivers of performance, their enhancement and protection must become a managerial priority.

The open innovation model of Chesbrough (2003) also recog- nizes the benefits of relying on a distributed model of innovation where the enterprise reaches out beyond its own boundaries to access and integrate technology developed by others. By way of example, Henderson and Cockburn (1994) found that an enter- prise’s ability to integrate knowledge from external sources— their “architectural competence”—was positively associated with research productivity, as measured by patent counts. Likewise, Iansiti and Clark (1994) found that “integration capability” in the automobile industry and in the computer industry was associ- ated with positive enterprise performance, again demonstrating the importance of knowledge integration skills. In the end, it appears that in fast-paced environments organizational units must have considerable autonomy (to make decisions rapidly) but remain connected to activities that must be coordinated. Achieving this delicate balance is what Simon (2002) called “near decompos- ability” and implementing it is an important microfoundation of dynamic capabilities.

2. Managing Cospecialization

The field of strategic management and the dynamic capabilities framework recognizes that “strategic fit” needs to be continuously achieved. However, unless the concept is operationalized it has lim- ited utility. The key dimension of “fit” emphasized in the dynamic capabilities framework is that of “cospecialization”. The concept of cospecialization, introduced in Teece (1986a) and discussed in the “Managing Complements and ‘Platforms’ ” section above, opera- tionalizes at least one dimension of the otherwise rather vague concept of organizational adaptation and “fit”. Cospecialization can be of one asset to another, or of strategy to structure, or of strategy to process. It is important to both seizing and reconfiguration. In environments of rapid change, there is a need for continuous or at least semi-continuous realignment.

In many ways, much of the traditional literature on organiza- tional adaptation and “fit” (e.g. Miles and Snow, 1994) is consistent with dynamic capabilities. In particular, both the strategy and orga- nizational behavior literature emphasize fit between and amongst strategy, structure, and processes. While it is not central to his framework, Michael Porter does note that:

[S]trategic fit among many activities is fundamental not only to competi- tive advantage but also to sustainability of that advantage. It is harder for a rival to match an array of interlocked activities than it is merely to imitate a particular sales force approach, match a process technology, or replicate a set of product features. (Porter, 1996: 73)

Despite Porter’s clear recognition of the concept of “fit”, nei- ther complementarities nor cospecialization are recognized in the Five Forces framework. However, complementarities and cospe- cialization are recognized in various ways in the literature (Teece, 1986a), Brandenburger and Nalebuff (1996), and Santoro and McGill (2005). Economic historians (Rosenberg, 1982; Hughes, 1983) have  also  noted  the  phenomenon  at  a  general  level; but in most analyses of competition and  competitive  advan- tage, it is common to stress that various innovations are sub- stitutes, rather than complements that may be cospecialized to each other. Indeed, Schumpeter (1934) stressed that successful innovations/enterprises are threatened by swarms of imitators, all striving to produce “me-too” substitutes.22 He completely neglected complementarities.

However, complementary innovation and complementary assets are of great significance, particularly in industries in which inno- vation might be characterized as cumulative, and/or where indus- try “platforms” exist or are needed. Examples of complementary innovation are ubiquitous. In the enterprise software industry, business applications can be especially valuable to users if they can somehow be integrated into a single program, or into a tightly integrated suite. The development of gyroscopic stabilizers made imaging devices such as video cameras and binoculars easier to use by minimizing the impact of camera shake, and enhanced the product, especially when the new feature was able to be introduced at low cost. Likewise, better high-energy recharge- able batteries enable laptop computers and cell phones to operate for longer times. Situations of complementarities where there is also cospecialization between technologies, and between technolo- gies and other parts of the value chain, are common, yet until recently poorly analyzed in economic analysis and in strategy formulation.

Cospecialized assets are a particular class of  complementary assets where the value of an asset is a function of its use in conjunction with other particular assets.23 With cospecialization, joint use is value enhancing.24 Cospecialization results in “thin” markets; that is, the assets in question are idiosyncratic and can- not be readily bought and sold in a market. Capturing cospecial- ization benefits may require integrated operations (Teece, 2000). Cospecialization allows differentiated product offerings or unique cost savings. The inherent “thin” market environment surrounding specific assets means that competitors are not able to rapidly assem- ble the same assets by acquisition, and hence cannot offer the same products/services at competing price points.

Management’s ability to identify, develop, and utilize in com- bination specialized  and  cospecialized  assets  built  or  bought  is an important dynamic capability, but it is not always present in enterprise settings. Special value can be created (and potentially appropriated by another party) through asset combinations, par- ticularly when an  asset  owner  is  not  cognizant  of  the  value  of its assets to another party that owns assets whose value will be enhanced through combination.25  This  arises  because  the  mar- kets for cospecialized assets are necessarily thin or nonexistent. Langlois (1992) highlights the case of the diesel-electric loco- motive where, in the 1920s, Charles Kettering had developed advanced lightweight diesel technology at the GM labs. The ear- liest use was in  submarines.  Alfred  P.  Sloan,  GM’s  chairman, saw the possibility of applying the technology to make diesel- electric locomotives—steam power was, at the time, completely dominant. To accomplish this, GM needed capabilities resident in the locomotive manufacturers and at Westinghouse Electric. As Langlois (1992: 115) notes, the three sets  of  capabilities  might have been combined by some kind of contract or joint venture, but the steam  manufacturers—Alco,  Baldwin,  and  Lima—failed to  cooperate.26   In  short,  both  innovation  and  reconfiguration may necessitate cospecialized assets being combined by manage- ment in order for  (systemic)  innovation27  to  proceed.  Managers do not always succeed in doing so, sometimes because they do not sense the need or  the  opportunity,  and  sometimes  because they do but they are unable to effectuate the integration. If the assets cannot be procured externally, they will need to be built internally.

The ability of management to identify needs and opportunities to “invest” in cospecialized assets (through its own development or astute purchase) is fundamental to dynamic capabilities. Mere “horse-trading” skills (which market agents possess) will not suf- fice to build sustainable competitive advantage, and decisions on when and how to invest—whether and when to build or buy cospecialized assets—will depend upon many factors, including transaction costs. In particular, they will depend on management’s entrepreneurial capacities with respect to matching up and inte- grating relevant cospecialized assets.

It is apparent that cospecialization involves “lock-in” and is a particular form of complementarity that exists when technologies and other assets need to be part of a tightly integrated system to achieve the performance that customers want. Business success in such circumstances requires the coordination of R&D investment and alliance activity. The manner and timing with which such coor- dination needs to be accomplished is important to success (Teece, 1986a; Mitchell, 1991). Common ownership of the parts facilitates system-wide innovation and economic performance (Teece, 2000) and protects against opportunism (Williamson, 1975).

To summarize, entrepreneurs and managers can create spe- cial value by combining cospecialized assets inside the enterprise (Teece, 2007). This may require investments to create the necessary cospecialized technologies—as illustrated by Thomas Edison and the creation of electric power as a system. It is not uncommon in technology-based industries to find that certain technologies are worth more to some market participants than to others, based on the technology they already have, and their technology and product strategy.

3. Learning, Knowledge Management, and Corporate Governance

With intangible assets being critical to enterprise success, the gov- ernance and incentive structures designed to enable learning and the generation of new knowledge become salient. There are many types of learning—including experiential, vicarious, individual, and organizational—and a large literature that explores each type. Also “sensing” requires learning about the environment and about new technological capabilities. R&D was seen as one way that the enterprise could promote such learning. However, in the context of the dynamic capability discussed in this section, the ability to integrate and combine assets, including knowledge, is a core skill (Kogut and Zander, 1992; Grant, 1996). The combination of know-how within the enterprise, and between the enterprise and organizations external to it (e.g. other enterprises, universities), is important.

Integrating know-how from outside as well as within the enter- prise is especially important to success when “systems” and “net- works” are present. Good incentive design and the creation of learning, knowledge-sharing, and knowledge-integrating proced- ures are likely to be critical to business performance, and a key (micro)foundation of dynamic capabilities (Nonaka and Takeuchi, 1995; Chesbrough, 2003). Of equal importance are monitoring and managing the “leakage”, misappropriation, and misuse of know- how, trade secrets, and other intellectual property. Of course, tacit know-how is difficult to imitate and has a certain amount of “natural” protection. However, much know-how does leak out. Innovating business enterprises with limited experience have been known to inadvertently compromise or lose their intellectual prop- erty rights. Failure to proactively monitor and protect know-how and intellectual property is common.

The outsourcing of production and the proliferation of joint development activities likewise create requirements that enter- prises develop governance procedures to monitor the transfer of technology and intellectual property. Technology transfer activi- ties, which hitherto took place inside the enterprise, increasingly take place across enterprise boundaries. The development of gov- ernance mechanisms to assist the flow of technology while protect- ing intellectual property rights from misappropriation and misuse are foundational to dynamic capabilities in many sectors today. Figure 1.3 summarizes the microfoundations of this third class of dynamic capability.

There are also several other “governance” issues relevant to dynamic capabilities. At one level there are governance and busi- ness model issues associated with an enterprise’s ability to achieve asset “combinations” and reconfiguration. As noted earlier, there is a continuous need to modify product offerings, business models, enterprise boundaries, and organizational structures. Decentralized structures that facilitate near decomposability are likely to assist in achieving reconfiguration.

Fig. 1.3. Combination, reconfiguration, and asset protection skills

One class of governance issues relate to incentive alignment. The microfoundations of incentive issues are embedded in an understanding of agency and incentive design issues, also discussed earlier. Agency theory has long emphasized that the separation of ownership from control creates interest alignment problems, particularly around management compensation and the allocation of corporate perquisites. The abuse of discretion and the use of corporate assets for private purposes can occur absent appropri- ate accountability/oversight. These issues become more severe as an enterprise grows and the separation between ownership and management widens. Recent corporate governance scandals in the USA, Europe, and Japan indicate the need for continued vigilance. However, increasing the mix of independent and “inside” directors will not necessarily ameliorate problems associated with strategic “malfeasance”.

There are likely to be benefits associated with participation at the board level by individuals who can calibrate whether the top management team is sufficiently “dynamic”. The replacement of the CEO and other members of the top management team, if they demonstrate weak sensing, seizing, and reconfiguration capabilities (strategic “malfeasance”), is important to effectuate. That is not to say that guarding against financial malfeasance is unimportant. It will always remain as an important corporate  governance  func- tion; but its significance is likely to pale next to strategic “malfea- sance”, which is harder to detect and evaluate. The current wave of governance reforms in the USA—with its strong emphasis on accounting controls and systems integrity—may inadvertently lead to much bigger “strategic” performance failures by management. Boards stacked with inexperienced “independent” board members may not have the requisite talents to properly diagnose strategic “malfeasance” and respond accordingly.

A related literature in economics has stressed how  poorly designed incentives can produce tensions between the actions of employees and the actions needed to achieve profitable perform- ance. Dysfunctional behavior, such as activity that generates influence costs, has received considerable attention (Teece, 2003). Also, through use of collective bargaining, employees in industries insulated from global competition have been able to appropriate economic surplus. Above-market wages—which characterized, and to some extent still characterize, certain enterprises in the auto, steel, and airline industries in the USA—are a case in point. These conditions can extend to managerial ranks as well. Restructuring may then require the judicious use of bankruptcy laws to rewrite uncompetitive supply contracts that are the product of unrealistic collective bargaining actions in an earlier period. The ability of some enterprises to craft work specifications, attract and retain more committed talent, design reward systems, develop corporate cultures, and blunt the formation of coalitions that extract quasi- rents through threatening to withhold participation, is an import- ant managerial capacity.

The design and creation of mechanisms inside the enterprise to prevent the dissipation of rents by interest groups (both man- agement and employees) would also appear to be very relevant to dynamic capabilities, but has not been high on the agenda of strategy researchers. One exception is Gottschalg and Zollo (2007), who point out that the capacity to continuously achieve incen- tive alignment is an important performance-enhancing (and rent- protecting) dynamic capability.

Many of the issues discussed here have, in the past, fallen under the rubric of  human  resource  management;  a  closer  connection of these issues to strategic management issues would appear to be warranted. The reason is that strategic management is focused not only on how to generate rent streams, but also on how to pre- vent them from being dissipated or captured by various entities or groups inside and outside the enterprise. For instance, the concepts of the “appropriability regime” and “isolating mechanisms” were developed by strategic management scholars to help explain how rents from innovation and other sources of superior performance can be protected  and  guarded  from  dissipation  by  competitors and others. However, the earlier focus on markets or “external” competition did not address internal appropriation by  interest groups.

Source: Teece David J. (2009), Dynamic Capabilities and Strategic Management: Organizing for Innovation and Growth, Oxford University Press; 1st edition.

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