Resource and capability considerations in firm boundary decisions

Only three apparently minor additions to traditional transactions cost logic lead to the conclusion that resources and capabilities can be an impor- tant determinant of a firm’s boundary; and hence its vertical integration strategy. First, it must sometimes be the case that a firm does not possess all the resources and capabilities it needs to be competitively successful. Second, it must be very difficult (i.e. costly) for a firm without a particular resource or capability that it needs to be successful to create that resource or capability on its own. Third, it must be very difficult (i.e. costly) for a firm without a resource or capability that it needs to be successful to gain access to that resource or capability by acquiring a firm that already has it. When these three conditions hold, the application of traditional transactions cost logic will lead managers to make boundary decisions that put the competitive success of their firm at risk. In these settings, resource- based theory suggests very different governance choices than transactions cost theory. In particular, in these settings, firms may find it necessary to adopt nonhierarchical forms of governance to gain access to resources and capabilities they need to be successful—but resources and capabilities they cannot create on their own and that they cannot gain access to by acquiring another firm—even though such forms of governance might subject a firm to high levels of opportunism.

1. RESOURCE AND CAPABILITY DIFFERENCES ACROSS FIRMS

It is self-evident that firms can vary in the resources and capabilities they possess. Over time, firms, even if they are operating in the same industry, make different choices in strategy, technology, geographic location, and so forth. These differences in choice can exist for a wide variety of reasons, including the personal preferences of managers in a firm, uncertainty in the competitive environment facing firms, the financial constraints a par- ticular firm faces at a particular time, and so forth. Many of these choices can create important resource and capability differences across firms—the condition of resource heterogeneity first discussed in Chapter 3.

Consider, for example, Toyota and GM. Both these firms operate in the global automobile industry. And yet, even the most casual observer can document important differences in the resources and capabilities of these two firms. Toyota has well-documented resources and capabilities in lean production (Womack, Jones, and Roos 1990). It is, on average, able to manufacture very high-quality cars at very low cost. Despite years of effort, most observers agree that GM—at least that part of GM that is not the Saturn Division or the NUMMI joint venture with Toyota—still has not fully developed this lean production capability.

This is not to suggest that GM does not possess resources and capa- bilities, resources and capabilities that even Toyota does not possess. For example, GM has developed a very extensive distribution system in North America, a capability that Toyota does not have (but would probably like to have).

Numerous examples could be cited at this point in the discussion. This is because it is so common for firms, even firms in the same industry, to differ significantly in the resources and capabilities they possess. Suffice it to say that, if anything, important capability differences across firms, even firms in the same industry, are the rule, not the exception to the rule. Indeed, in general, the only time that capability differences across firms in an industry are not likely to exist is when the structure of an industry completely determines strategic choices of firms in that industry (Bain 1968). In this setting, surviving firms will all have made the same, or at least strategically equivalent, choices over time—choices that, in the long run, should lead these firms to develop the same sets of resources and capa- bilities. However, research in industrial economics suggests that industry structure completely determines firm strategy only rarely, and thus firms in an industry should have identical sets of resources and capabilities only occasionally (Scherer 1980).

Implicitly, TCE acknowledges that firms may have significant capability differences. For without significant capability differences, there would be no potential gains from trade. With no potential gains from trade, it would not be necessary for firms to engage in exchanges that, in turn, would have to be governed. Thus, a theory about governance choices made by firms implicitly assumes that firms must differ in the resources and capabilities they possess. Thus, technically speaking, observing that firms can vary sig- nificantly in their resources and capabilities does not change the exchange conditions traditionally studied by TCE. However, capability differences are discussed here both as a matter of logical completeness and as a matter of emphasis. While it is true that capability differences are implicitly part of any transactions cost analysis, these differences generally do not receive the attention that they often should.

Moreover, not only can firms differ in their resources and capabilities, but it can sometimes be the case that, in order for a firm to be competitively successful, it must have access to resources and capabilities that it does not currently possess. In this setting, a firm with a capability disadvantage has three basic choices: it can gain access to these resources and capabilities by cooperating with firms that already possess them (either through market or intermediate forms of governance), it can create these resources and capabilities on its own (a form of hierarchical governance), or it can gain access to them by acquiring a firm that already possesses them (another form of hierarchical governance).2 The difficulties that can sometimes attend the two hierarchical governance solutions to a firm not possessing all the resources and capabilities it needs to be successful are discussed below.

2. COSTLY TO CREATE RESOURCES AND CAPABILITIES

Not only can there be significant capability differences across firms, even if firms are operating in the same industry, but these capability differences can last for long periods. Capability differences can last for long periods because it can be very costly for firms without a capability to create that capability. Indeed, as long as the cost of creating a capability is greater than any benefit that could be obtained from possessing a capability, a firm will find it in its rational self-interest to not create that capability. This can be true even if possessing a capability would be very beneficial, as long as the cost of creating a capability is very high. This is the assumption of resource immobility first mentioned in Chapter 3.

There are numerous reasons why it might be very costly for a firm to create a particular capability on its own (Dierickx and Cool 1989; Barney 1991b). Four of these reasons, originally described in Chapter 3 and par- ticularly important in the case of vertical integration are: (a) the ability to create a capability in a cost-effective way may depend on unique historical conditions that no longer exist, (b) the creation of a capability may be path-dependent, (c ) a capability may be socially complex and thus costly to create, and (d) the actions a firm would need to take to create a capability may not be fully known.

The role of history

Sometimes, the ability of a firm to create resources and capabilities in a cost-effective way may depend on a firm being in the ‘right place at the right time’ in history. As history moves on, these opportunities can only be recreated at very high (perhaps infinitely high) cost. A firm that did not happen to be in the right place at the right time may find it to be essentially impossible to create a particular capability in a cost-effective manner. This was the case for Caterpillar, originally described in Chapter 3.

Path dependence

Sometimes, in order to create a particular capability, a firm must go through a long and difficult learning process. When there is no way to ‘short circuit’ this learning process, it is said to be path dependent. When learning processes are path dependent, decisions made early on in the creation of a capability can have profound impacts on the capability that is actually created in a firm. While other firms may want to create this partic- ular capability for themselves, if they have made decisions that have already put them on another capability creation path, they will need to undo those decisions, and change their trajectory to the path that will ultimately lead to the creation of the capability they wish to possess. However, all these efforts can take time and can be very costly. Thus, in general, when resources and capabilities are path dependent, they are likely to be very costly to create.

Consider, for example, the capability that some Japanese firms have to work cooperatively with their suppliers. Many US manufacturers have coveted these resources and capabilities, in order to gain access to the low-cost, high-quality supplies that seem to be available to at least some Japanese firms (Dyer and Ouchi 1993). However, quick creation of these resources and capabilities among many US manufacturers has been elusive. This difficulty is understandable when it is recognized that many Japanese firms have been working with the same network of suppliers for over 500 years. The experience that develops over 500 years is costly to create in a short period.

Social complexity

In addition to the role of history and path dependence, sometimes it will be very costly for a firm to create a particular capability because that capability is socially complex in nature. Examples of these socially complex firm resources and capabilities might include a firm’s culture (see Chapter 4), its reputation among customers and suppliers (Klein, Crawford, and Alchian 1978), its trustworthiness (see Chapter 5), and so forth. These kinds of resources and capabilities can enable a firm to pursue valuable business and corporate strategies. Firms without these resources and capa- bilities may find it difficult to conceive of, let alone implement, these same strategies.

However, even though the value of these socially complex resources and capabilities in enabling a firm to pursue valuable economic opportuni- ties may be known, it may still be very difficult for a firm without these resources and capabilities to create them. Socially complex resources and capabilities are generally beyond the ability of managers to change in the short term (Porras and Berg 1978a, 1978b). Rather, these socially complex resources and capabilities evolve and change slowly over time.3 It is difficult to buy and sell trust, friendship, and teamwork. A firm without these kinds of socially complex resources and capabilities may find it very difficult to create them on their own.

Consider, for example, the economic performance of the set of ‘vision- ary’ firms identified by Collins and Porras (1997) in their book, Built to Last. These well-known firms—including General Electric, Hewlett- Packard, Johnson & Johnson, Merck, Sony, Wal-Mart, and Disney—are all organized around unique visions of their roles in the economy, their responsibilities to their customers and suppliers, and their commitment to their employees. These socially complex visions have had a profound effect on the decisions these firms have made and the strategies they have pursued. Moreover, over the long run, these firms have provided a much higher return to shareholders than competing firms that are not organized around these socially complex sets of values and commitments.4 Despite the well-documented success of these visionary firms over many decades, many of their direct competitors have simply been unable to create their own unique visions and thus have been unable to generate the same level of economic performance. When resources and capabilities are socially complex—as the visions of these high performing firms are—it can be very difficult to create them.

Causal ambiguity

Finally, sometimes it is simply not clear what actions a firm should take to create a particular capability. When the relationship between actions a firm takes and the resources and capabilities it creates is causally ambiguous, it can be very difficult to create a particular set of resources and capabilities. Causal ambiguity about how to create a particular set of resources and capabilities exists whenever multiple competing hypotheses about how to create a particular set of resources and capabilities exist and when these hypotheses cannot be rigorously tested. These conditions are particularly likely when the sources of a firm’s resources and capabilities are taken- for-granted, unspoken, and tacit attributes of a firm (Reed and DeFillippi 1990). Such organizational attributes have been described as ‘invisible assets’ (Itami 1987), and can include an organization’s culture (Barney 1986b) and its unwritten operational routines (Nelson and Winter 1982).

Clearly, possessing some kinds of invisible assets may enable a firm to create certain kinds of resources and capabilities. However, when the assets needed to create resources and capabilities are invisible, it can be very difficult for firms seeking to create these resources and capabilities to know what they should do to create them. As long as there are multiple competing hypotheses about what a firm needs to do to create a particular set of resources and capabilities, a condition of causal ambiguity obtains, and firms cannot be sure about what they must do to create them. Not knowing what to do to create a set of resources and capabilities clearly increases the difficulty of creating them.

Thus, in some situations, firms without certain resources and capa- bilities will find it very difficult and costly to create these resources and capabilities on their own. Whenever the creation of a capability depends on history or is path dependent, whenever a capability is socially complex, or whenever its creation is causally ambiguous, it may be very difficult for firms without a capability to create it on their own.

3. COSTLY TO ACQUIRE RESOURCES AND CAPABILITIES

If firms cannot create resources and capabilities on their own, they can still use hierarchical governance to obtain access to those resources and capabilities by acquiring other firms that already possess them. However, when it is very costly to acquire firms that already possess these resources and capabilities, this approach to gaining access to them can be foreclosed. Stated more precisely, whenever the cost of acquiring another firm in order to gain access to important resources and capabilities it possesses is greater than the benefit that can be gained through this acquisition, acquiring another firm to solve a firm’s capability disadvantages will not be chosen.

It is well known that acquiring firms must usually pay a premium in order to acquire a target firm (Barney 1997). However, paying a premium, per se, to acquire a firm does not necessarily mean that a firm has imple- mented a foolish strategy. This is especially true when the acquired firm possesses resources and capabilities that are essential to an acquiring firm’s competitive success and cannot be created by the acquiring firm on its own in a cost-effective way.

However, there may be other liabilities associated with using an acqui- sition to gain access to another firm’s resources and capabilities that may drive the cost of acquisition up to the point that it is greater than any value that could have been created by gaining access to resources and capabilities. These other liabilities raise the effective cost of acquiring a firm, and fall into several categories: (a) legal constraints on acquisitions, (b) the inter- ests of a target firm’s owners, (c ) the impact of an acquisition on the value of a target firm’s resources and capabilities, (d) market uncertainty and the lack of strategic flexibility associated with an acquisition, (e) how broadly applicable the acquired capability would be in the acquiring firm, ( f ) the acquisition of unwanted ‘baggage’ in the target firm, and (g ) the difficulty of leveraging acquired resources and capabilities throughout an acquiring firm.

Legal constraints on acquisitions

Most obviously, sometimes one firm may want to acquire another, in order to gain access to resources and capabilities possessed by this other firm, only to discover that important legal barriers to that acquisition exist. These barriers can be of at least two types: antitrust barriers to acquisition and local ownership barriers to acquisition.

Microsoft, for example, several years ago concluded that it wanted to purchase Intuit, the firm that had developed and marketed the most suc- cessful home accounting software on the market—Quicken. There was little doubt that such an acquisition would have benefitted Microsoft— assuming a reasonable price for Intuit could have been negotiated. Not only would Microsoft have gained access to Intuit’s programming capability, they would also have gained access to its installed base of users and to its reputation in this home accounting software market. However, this acqui- sition did not pass antitrust scrutiny, and Microsoft had to find another approach for entering this software application market.5

Countries, for their own political reasons, can place ownership restric- tions on domestic firms, thereby making it illegal for a nondomestic firm to acquire a domestic firm. Obviously, this represents a significant barrier to completing an acquisition. If a domestic firm possesses resources and capabilities that a nondomestic firm needs, and if a nondomestic firm is unable to develop these resources and capabilities on its own, it will have to find some alternative to acquisition to gain access to those resources and capabilities.

Interests of a target firm’s owners

Sometimes, the owners of a firm that possesses valuable resources and capabilities may not want to sell that firm. This is especially common for privately held, or closely held, firms. In this setting, firm owners often per- ceive important nonpecuniary benefits from ownership, including social status in a geographic region, the maintenance of an important family tradition, personal loyalty to employees, and so forth. In these settings, a reluctance to sell will have the effect of driving the price of an acquisition up, often to the point that it is no longer economically viable. When this occurs, a firm seeking access to resources and capabilities possessed by this other firm will have to find an alternative to acquisition to gain this access.

For example, Publicis SA is one of the largest advertising agencies in Europe. Founded by Marcel Bleustein-Blanchet in 1926 in Paris, Publicis has grown from a small French operation to a large integrated network of agencies providing a broad range of advertising, communications, and public relations services throughout Europe. In the midst of the consoli- dation of the global advertising market characterized by numerous merg- ers and acquisitions, Publicis consistently resisted being acquired. Indeed, Bleustein-Blanchet once turned down an acquisition offer from Saatchi & Saatchi by saying, ‘Not even for 100 million francs would I sell Publicis.’ Still independent, Publicis entered into a strategic alliance with the US advertising firm Foote, Cone & Belding (FCB). However, for FCB to gain access to Publicis’ resources and capabilities, it had to find an alternative to acquisition (Kanter 1993). This alternative was a joint venture.

The impact of acquisition on resource value

Sometimes, the acquisition of a firm can reduce the value of the resources and capabilities an acquiring firm is seeking in the acquired firm. Consider, once again, Publicis. One of this firm’s greatest assets was its long-term contracts with several large French companies, many of which were at least partially owned by the French government. However, these French clients strongly preferred working with a French advertising agency. If Publicis had been acquired by, say, a US advertising agency, the very thing that the US agency was trying to purchase—Publicis’ relationship with large French companies—would have been put in jeopardy. In this context, a firm inter- ested in gaining access to Publicis’ resources and capabilities would simply have to find an alternative to acquisition, since the act of acquiring Publicis would have destroyed the resources and capabilities being sought (Kanter 1993).

Strategic flexibility and uncertainty

Under conditions of high market uncertainty, it may not be possible for a firm to know, with certainty, what resources and capabilities it will need to successfully compete in the long run. In this setting, a firm has a strong incentive to retain its flexibility, to move as quickly as possi- ble to create the required resources and capabilities when uncertainty is resolved.

In this highly uncertain environment, acquiring another firm in order to gain access to its resources and capabilities is a less flexible governance choice than, say, using intermediate or market governance to gain access to that capability. If one firm acquires another in order to gain access to a particular capability, only to discover that this capability turns out to not be valuable, this firm will have to sell off the firm it originally acquired, since the capability it purchased when it bought this firm has turned out to not be valuable. On the other hand, if a firm uses intermediate or market governance to gain access to a particular capability, only to find that that capability is not economically valuable, the costs of withdrawing from that form of governance are generally much lower than the costs of selling a previously acquired firm.

Indeed, there is strong empirical support that suggests that, under con- ditions of high market uncertainty, firms prefer gaining access to the resources and capabilities of other firms through various forms of strate- gic alliances (as forms of intermediate governance) rather than through acquisitions (Kogut 1991). Only after the market uncertainty facing a firm is resolved do firms use acquisitions to gain access to these resources and capabilities. In the meantime, firms prefer to remain flexible in order to avoid the costs associated with acquiring firms only to discover that the resources and capabilities thus acquired turn out to not be economically valuable.

How broadly applicable a capability is in the acquiring firm

Another reason why acquiring another firm to gain access to its resources and capabilities may be very costly is that the capability that is being acquired, while essential, is only applicable in a narrow range of activities in the acquiring firm or for a very short period in the acquiring firm. This could happen, for example, if the required resources and capabilities are only relevant in a small number of stages of the value chain of the firm contemplating an acquisition. Once this stage of the value chain is com- pleted, the resources and capabilities of the firm it acquired may no longer be needed, and this firm should be sold off—a process we have already seen can be more costly than withdrawing from a market or intermediate forms of governance.

Consider, for example, a firm developing a new product. Suppose that this new product requires the use of some specialized technology resources and capabilities that are not required in any of this firm’s other products. A very reasonable way for this firm to gain access to these resources and capa- bilities would be for it to enter into some form of market or intermediate governance relationship with a firm that already possessed these specific technical resources and capabilities. Then, when the development of this product was complete, the relationship between these two firms could be severed at low cost.

Acquiring the firm with these specialized technical resources and capa- bilities is a much more costly solution. Certainly, acquiring this firm might facilitate the use of these technical resources and capabilities in the devel- opment of the new product, since using a hierarchical form of governance should be able to solve any transaction-specific investment problems that might arise between these two firms if nonhierarchical forms of governance were used to manage this exchange. However, the cost of dismantling this hierarchical form of governance would be much higher than the cost of dis- mantling nonhierarchical forms of governance. And since the firm needing access to these technical resources and capabilities knows that it only needs them for the development of a particular product for a relatively short period, this firm knows that it will almost certainly want to divest itself of this firm once this specific product is developed. To avoid these almost certain costs, a firm may opt for less hierarchical forms of governance, even if those forms of governance do not fully protect it from potential opportunistic actions of its exchange partner.

The acquisition of unwanted baggage and diffused resources and capabilities

Also, acquiring another firm almost always involves acquiring resources and capabilities that the acquiring firm does not need or want (Hennart 1988; Kogut 1988). Firms are bundles of resources and capabilities that are often difficult to disentangle. A particular capability may not be con- veniently located in a single division, or a single group, in another firm. Rather, that capability may be spread across multiple individuals, divisions, and groups around the world in another firm. These kinds of diffused resources and capabilities cannot be easily separated from the firm where they are operating. In this setting, a firm seeking to gain access to the diffused resources and capabilities of another firm may have to acquire the entire firm to do so.

Whenever an entire firm is acquired, both desirable and undesirable resources and capabilities are acquired. Moreover, an acquiring firm must pay for both the resources and capabilities it desires, and the resources and capabilities it does not desire—because some other firm may desire precisely the same resources and capabilities that this firm finds undesir- able. If the desirable resources and capabilities can be separated from the undesirable resources and capabilities in the acquired firm, the problem of acquiring unwanted capability baggage in an acquisition can be solved by simply spinning off those parts of the acquired firm that are not important to the acquiring firm. While there may be some costs associated with selling off these unwanted parts of the firm (costs that increase the effective cost of using acquisitions as a way to gain access to another firm’s resources and capabilities), at least the firm can gain access to just those parts of another firm that are strategically most relevant.

However, when a firm’s resources and capabilities are diffused through- out its organization, it may be impossible to separate the desirable from the undesirable, the core from the baggage. In this setting, acquiring the bag- gage in order to gain access to some important resources and capabilities significantly increases the cost of acquisition. Indeed, the effective cost of the acquisition can rise to the point that it is greater than whatever benefit would have been created by gaining access to an acquired firm’s resources and capabilities.

Leveraging an acquired firm’s resources and capabilities

Even if none of the other problems with acquiring another firm to gain access to its resources and capabilities exists, such an acquisition can still be very costly. This is because it is often difficult to leverage the acquired resources and capabilities across the relevant parts of the acquiring firm’s operations.

Research indicates that many acquisitions fail (Porter 1987). By far, the most important reason for this failure is the inability of acquiring firms to take full advantage of the resources and capabilities of the firms they have acquired (Haspeslagh and Jemison 1987). These difficulties in inte- gration stem from differences in culture, systems, approach, and so forth. Such differences can significantly raise the effective price of an acquisition designed to provide a firm the resources and capabilities it needs to be competitively successful. Thus, even if a firm knows that another firm has the resources and capabilities needed to be competitively successful, it does not follow that this firm will always be able to acquire this other firm to gain access to its resources and capabilities. Even if an acquisition occurs, diffi- cult leveraging problems can emerge, preventing a firm from gaining the capability access it needs. Of course, these integration difficulties increase dramatically if an acquisition is in any sense unfriendly.

Source: Barney Jay B., Clark Delwyn N. (2007), Resource-Based Theory: Creating and Sustaining Competitive Advantage, Oxford University Press; Illustrated edition.

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