7 Powers

by Hamilton Helmer

  I have intentionally restricted this chapter’s treatment of resources. First, my treatment narrows the topic by looking only at resources which qualify as Power. The tests above are meant to help the practitioner eliminate resources that may well be notable but are not strategic in the sense that I use the term.

  Secondly, though, a more profound narrowing: this part of my book is restricted to statics of Power. The RBV figures more heavily into dynamics. When I move on to that topic in Part II, we will observe that invention is the first cause of Power. There, in exploring the endogenous determinants of invention, the concept of resources, in the broader sense used by the RBV, will feature more prominently.

  Appendix 6.2: Surplus Leader Margin for Cornered Resource

  To calibrate the intensity of Power, I ask the question “What governs profitability of the company with Power (S) when prices are such that the company with no Power (W) makes no profit at all?”

  Suppose the Cornered Resource (CR) possessed by S results in superior deliverables. This, for example, fits the Pixar case of consistently compelling movies.

  We further suppose that S realizes a per unit increase in profits from this resource of ∆. This could come from a price increase due to superior deliverables or a cost decrease. (In the Pixar case, the superior deliverables are more focused on getting higher volumes, theater attendance. One way to think about this: the ∆ that would result if pricing were such that only average volumes resulted).

  Also for simplicity, assume that there are no fixed costs to production.

  Profit ≡ π = [P – c + ∆] Q

  with

  P ≡ price

  c ≡ variable cost per unit

  Q ≡ units produced per time period

  Also suppose that the incremental cost of the CR is the fixed amount per year k. In the Pixar case this would be the extra annual compensation that would be paid to the discussed core group above what would be paid, if individuals with similar training were hired to replace them.

  So S’ profit ≡ Sπ = [WP + ∆ – c] SQ – k

  For the Surplus Leader Margin (SLM) we assess:

  C H A P T E R 7

  PROCESS POWER

  STEP BY STEP

  You have now reviewed six of the 7 Powers. This chapter will complete your tour by discussing the final type, Process Power. I save it until last because it is rare. I will use the Toyota Motor Corporation as a case.

  By the time I graduated from college in 1969, a close friend and fellow Vermont motorhead had already acquired the Toyota dealership rights for our area in Northern New England. It seemed a risky move at the time, but he considered it an investment in an extraordinary upstart. Toyota’s boxy new Corolla had none of the performance chops that usually attracted the attention and affection of our group. Instead, what impressed my friend was the sheer quality of their automobiles, which was such a contrast to those offered by the world-leading Detroit behemoths.

  Back then, Toyota hardly blipped on anyone’s radar in the US auto market: they held a .1% market share compared to General Motors’ astounding 48.5%. Even so, my friend’s investment was prescient—Toyota’s meager presence belied a deeper reality. They had already spent nearly two decades relentlessly honing a fearsome competitive asset: the Toyota Production System (TPS).

  In 1950 Eiji Toyoda, then a managing director of Toyota Motor Company, spent three months in Dearborn, Michigan studying the Ford River Rouge Plant, “the largest integrated factory in the world.”61 His earlier visit to Ford in 1929 had left him profoundly impressed by the Ford revolution in manufacturing. His reaction to the 1950 visit was quite the opposite. The Ford plant maintained deep inventories, which were used to smooth out production irregularities, but this seemed wasteful to Toyoda-san. He was more impressed by the supermarkets he saw around the city: their system of restocking only when shelves had gone empty aligned with the parsimonious nature he had developed over years of war-driven shortages. He thought he could do better than Ford, and so he set to work.62

  But developing a superior automobile manufacturing process was no fool’s errand. Even the Ford Model T, a poster child for simplicity in the car business, had 7,882 assembly steps.63 And assembly formed only a piece of the puzzle—a vast supply chain reached backwards, mirrored in its complexity by the geographically dispersed dealership distribution system that lay downstream from the point of assembly.

  But the impulse for quality and efficiency had deep roots in Toyota, stretching all the way back to Sakichi Toyoda’s 1890 invention of the Toyoda Wooden Hand Loom. So bit-by-bit, in the wake of the 1950 Ford visit, Toyota developed what would later be called the TPS. The resulting unsurpassed quality and durability of their cars met a welcome audience, many of whom were exhausted with their fragile American models and a Detroit mentality predicated on the notion of planned obsolescence, or “dynamic obsolescence” as GM’s Alfred Sloan dubbed it.64 The outcome was stunning, as seen by the chart below.

  Figure 7.1: Shares in US Automobile Market65

  From out of nowhere, by 2014 Toyota managed to pull nearly even with GM and Ford in the U.S. market. Over the same period, GM collapsed: its U.S. share plummeting from half the U.S. market to less than 20%. Worldwide, Toyota’s market share trends were even more impressive.

  The persistence of these shifts, over decades, is as notable as their magnitude. Already by 1980, the handwriting was on the wall: Toyota was soaking up market share and GM was in decline. In the 1960s GM had been looked upon as one of the best-run companies in the world, and this slow-motion collapse left the company considering whether they ought to take a page from their competitor’s playbook. And so in 1984 GM established NUMMI, a joint venture with Toyota, which would utilize Toyota production techniques to produce compact cars at a Fremont, California plant. GM accepted Toyota as the expert here, and the Fremont workers were sent to Japan for training.

  The joint venture got off to a fast start, and the low defect rates of NUMMI cars quickly approached those of Toyota in their Japanese facilities. GM had high hopes that the lessons learned from this endeavor would be readily transferable to their numerous other plants around the world.

  But it was not to be. Although Toyota offered full transparency regarding NUMMI practices, GM just couldn’t replicate the NUMMI results in its own facilities. This was not merely incompetence—the inability to mimic the TPS was shared by many, as noted in a Harvard Business Review article:

  “What’s curious is that few manufacturers have managed to imitate Toyota successfully even though the company has been extraordinarily open about its practices. Hundreds of thousands of executives from thousands of businesses have toured Toyota’s plants in Japan and the United States.”66

  This failure to transfer the NUMMI practices perpetuated the trend noted before: GM’s inexorable decline continued for decades, despite the success of NUMMI.

  So what was the underlying challenge? GM was motivated, willing and able to spend, and, with NUMMI, seemingly well positioned to acquire the needed knowledge.

  Here’s the rub: the TPS is not what it seems. On the surface, it consists of a fairly straightforward variety of interlocking procedures, such as just-in-time production, kaizen (continuous improvement), kanban (inventory control), andon cords (devices to allow workers to stop production and identify a problem so it can be fixed). Observing all this, GM workers naturally assumed you could clone TPS by copying these procedures.

  It turns out, though, that these production techniques merely manifest some deeper, more complex system, as illustrated by the frustration of Ernie Shaefer, the manager of the GM plant in Van Nuys, California:

  “…what’s different when you walk into the NUMMI plant? Well, you can see a lot of things different. But the one thing you don’t see is the system that supports the NUMMI plant. I don’t think, at that time, anybody understood the large nature of this system…. You know, they never prohibited us from walking through the plant, understanding, even asking questions
of some of their key people. I’ve often puzzled over that—why they did that. And I think they recognized, we were asking all the wrong questions. We didn’t understand this bigger picture thing. All of our questions were focused on the floor, the assembly plant, what’s happening on the line. That’s not the real issue. The issue is how do you support that system with all the other functions that have to take place in the organization?”67

  So despite best intentions, and many millions of investment dollars, achieving Toyota-like outcomes proved an elusive medium-term goal for GM. Apparently there existed a Barrier of some sort. Combine this with the twin Benefits of cost efficiency and dramatic quality improvements and there remains only one conclusion—Toyota had tapped some elusive source of Power. Their rising share price throughout these decades, graphed below and resulting in a company worth nearly $200B, serves as final indicator. But what type of Power were they wielding?

  Figure 7.2: Toyota Stock Price in US Dollars68

  Process Power

  The TPS exemplifies a rare Power type: Process Power. Let me characterize Process Power more formally using the usual Benefit and Barriers dimensions of the 7 Powers framework.

  Benefit. A company with Process Power is able to improve product attributes and/or lower costs as a result of process improvements embedded within the organization. For example, Toyota has maintained the quality increases and cost reductions of the TPS over a span of decades; these assets do not disappear as new workers are brought in and older workers retire.

  Barrier. The Barrier in Process Power is hysteresis: these process advances are difficult to replicate, and can only be achieved over a long time period of sustained evolutionary advance. This inherent speed limit in achieving the Benefit results from two factors:

  Complexity. Returning to our example: automobile production, combined with all the logistic chains which support it, entails enormous complexity. If process improvements touch many parts of these chains, as they did with Toyota, then achieving them quickly will prove challenging, if not impossible.

  Opacity. The development of TPS should tip us off to the long time constant inevitably faced by would-be imitators. The system was fashioned from the bottom up, over decades of trial and error. The fundamental tenets were never formally codified, and much of the organizational knowledge remained tacit, rather than explicit. It would not be an exaggeration to say that even Toyota did not have a full, top-down understanding of what they had created—it took fully fifteen years, for instance, before they were able to transfer TPS to their suppliers. GM’s experience with NUMMI also implies the tacit character of this knowledge: even when Toyota wanted to illuminate their work processes, they could not entirely do so.

  This Benefit/Barrier combination allows us to place Process Power on the 7 Powers chart.

  Figure 7.3: Process Power in the 7 Powers

  Which brings us to our definition of Process Power:

  Embedded company organization and activity sets which enable lower costs and/or superior product, and which can be matched only by an extended commitment.

  Process Power and the Discipline of Strategy

  Process Power has important intersections with the evolution of the discipline of Strategy.69 By characterizing these, we can better understand the nature of Process Power and why it is so rare.

  Strategy versus Operational Excellence. Professor Michael Porter of Harvard created quite a stir with his long-ago insistence that operational excellence is not strategy.70 His reason for doing so, however, completely aligns with the “No Arbitrage” assumption of this book: improvements that can be readily mimicked are not strategic, because they do not contribute to increasing m or s in the Fundamental Equation of Strategy, as these are long-term equilibrium values.

  But wait a minute. Aren’t the step-by-step improvements that drive Process Power exactly what much operational excellence is all about? Yes, they are, but this represents only the Benefit side, which brings us to an important point of caution about Process Power. The type of Benefit it cites—evolutionary bottom-up improvement—stands at the heart of operational excellence; as such, it is quite common. The rarity of Process Power results from the infrequency of the Barrier: an unyielding, long-time constant for the improvements in question. No matter how much you invest or how hard you try, the desired improvements are constrained by a boundary of potential that is tied to time, as seen in the NUMMI experience of GM.

  Perhaps the best way to think of it is this: Process Power equals operational excellence, plus hysteresis. Having said that, such hysteresis occurs so rarely that I am in strong agreement with Professor Porter’s sentiments.71

  If one were to adopt a different definition of Strategy—something like “everything that is important”—then operational excellence would be strategic. As is, though, operational excellence—while important, hard to achieve and worthy of management mind share—is not sufficient to gain competitive advantage. Professor Porter would not dispute this.

  The Experience Curve. A concept known as “The Experience Curve” loomed large in the formative years of the Boston Consulting Group and Bain & Company’s strategy practices. The Experience Curve was based on the empirical observation that many company costs seem to follow a downward trajectory that falls within a specified envelope: for each doubling of units produced (what’s meant formally by “experience”), the deflated cost per unit would be between 70% and 85% of what it had previously been prior to the doubling (referred to as “Slope”).

  This view is not naïve, as indicated by the histogram derived from data in a 1990 Science article:72

  Figure 7.4: Experience Curve Sample

  In this sample, about 60% of their 108 examples exhibited slopes in the 70–85% range.

  You might be tempted to read these data as disproving my assertion that Process Power is uncommon; rather, you might say, it is a usual business condition driven by “experience.” Unfortunately, these data simply underline the frequency of the benefits attending operational excellence. The improvements mapped above refer only to gains made over time; they tell us nothing about the relative position of multiple firms at a single point in time. For example, based on the Experience Curve, there would be no cost differences at any point in time between firms of different sizes but all firms realizing similar year-to-year gains.73

  Let’s use a simple thought experiment to clarify my assertion that the gains over time indicated by the Experience Curve are widely shared amongst firms. If the relationship between experience held across all firms at a single point in time, then one would commonly expect a firm with a 2x size advantage over its largest competitor to sustain operating margin gains of 15% to 30%. The rarity of such huge differences underscores an irony: the Experience Curve does not suggest Power, but rather it indirectly testifies to Professor Porter’s point—the ubiquity of competitive arbitrage.

  Routine. As mentioned before, while in graduate school I had the privilege of studying under Professor Richard R. Nelson. Dick is a fearlessly original thinker, and Strategy was one of the many areas to which he made seminal contributions. His book, An Evolutionary Theory of Economic Change, written with Sydney Winter, put forth the view that innovation was rarely driven by top-down purposive initiatives, but rather by the adaptive responses of “boundedly rational”74 agents. Such evolutionary innovation manifests, often tacitly, in new processes that they dubbed “routines.” This view maps well to what we saw with the TPS.

  Nelson and Winter’s book is often considered foundational to the aforementioned Resource Based View of Strategy. In Economic History, there is a notion called the “colligation problem”: how far back should you go in understanding causation?75 The RBV perspective holds that if you stop at competitive advantage, you inappropriately truncate your investigation. Rather, you might gain deeper insight by considering what more fundamental prior dispositions (“resources”) enabled the development of competitive positions in the first place. The well-disseminated notion of Core
Competencies76 is one expression of this view.

  Professors Nelson and Winter’s idea of routines provides an excellent launch pad for such inquiries. But usually such routines represent a Benefit with no Barrier; hence they do not result in Power. You might ask, then, is the RBV more revealing for operational excellence than for Strategy? This is not my view. Rich Strategy characterizations result from the RBV, but they have more to do with Dynamics, the subject of the second part of this book. Indeed, as we will see in Part II, operational excellence in general carries profound import in establishing certain types of Power.

  With this seventh Power type I am now able to finish the Competitive Position/Industry Economics roll-up that I began in Chapter 1.

  Figure 7.5: Power Intensity Determinants

  7 Powers Wrap-Up

  You are there. My goal has been all along to provide you with a strategy compass to guide you as you move forward with your business. In the Introduction I noted that to fulfill this function the 7 Powers would have to clear the high hurdle of “simple but not simplistic.” Early on, I explicitly tied my concepts back to value with the Fundamental Equation of Strategy. This gave us confidence that what followed was not simplistic. With this chapter, I have now completed the 7 Powers. I am confident from interacting with many businesspeople that this is sufficiently simple to be such a compass. I trust you will find it so as well.

  Figure 7.6: The 7 Powers

  We will now move on to Part II of this book and engage the issue of Dynamics: “How are these seven Power types developed?”

  Appendix 7.1: Process Power Surplus Leader Margin