Predictable Surprises: The Disasters You Should Have Seen ComingBy Michael Watkins & Max H. Bazerman

April 29, 1995, was not a good day for Royal Dutch/Shell. That morning, a small group of Greenpeace activists boarded and occupied the Brent Spar, an obsolete oil-storage platform in the North Sea that Shell’s UK arm was planning to sink. The activists brought with them members of the European media fully equipped to publicize the drama, and announced that they were intent on blocking Shell’s decision to junk the Spar, arguing that the small amounts of low-level radioactive residues in its storage tanks would damage the environment. Greenpeace timed the operation for maximum effect—just one month before European Union environmental ministers were scheduled to meet and discuss North Sea pollution issues.

Shell rushed to court, successfully suing Greenpeace for trespassing. In the full glare of the media spotlight, the activists were forcibly removed from the platform. For weeks afterward, as the cameras continued to roll, Shell blasted Greenpeace boats with water cannons to prevent the group from reoccupying the Spar. It was a public relations nightmare, and it only got worse. Opposition to Shell’s plans—and to Shell itself—mounted throughout Europe. In Germany, a boycott of Shell gas stations was organized, and many of them were firebombed or otherwise vandalized. Pilloried in the press and criticized by governments, Shell finally retreated. It announced on June 20 that it was abandoning its plan to sink the Spar.

Shell’s uncoordinated, reactionary, and ultimately futile response to the Greenpeace protest revealed a lack of foresight and planning. The attack on the Spar had clearly come as a surprise to the company. But should it have? Shell actually had all the information it needed to predict what would transpire. The company’s own security advisers entertained the possibility that environmental activists might try to block the dumping. Other oil companies, fearing a backlash, had protested Shell’s plans when they were originally announced. Greenpeace had a history of occupying environmentally sensitive structures. And the Spar was nothing if not an obvious target: Weighing 14,500 tons, it was one of the largest offshore structures in the world and only one of a few North Sea platforms containing big storage tanks with toxic residues.

But, even with all the warning signs, Shell never saw the calamity coming. Unfortunately, its experience is all too common in the business world. Despite thoughtful managers and robust planning processes, even the best run companies are frequently caught unaware by disastrous events—events that should have been anticipated and prepared for. Such predictable surprises, as we call them, take many forms, from financial scandals to disruptions in operations, from organizational upheavals to product failures. Some result in short-term losses or distractions. Some cause damage that takes years to repair. And some are truly catastrophic—the events of September 11, 2001, are a tragic example of a predictable surprise.

The bad news is that all companies—including your own—are vulnerable to predictable surprises. In fact, if you’re like most executives, you could probably point to at least one potential crisis or disaster that hasn’t been given enough attention—a major customer that’s in financial trouble, for instance, or an overseas plant that could be a terrorist target. But there’s good news as well. In studying predictable surprises that

have taken place in business and government, we have found that organizations’ inability to prepare for them can be traced to three kinds of barriers: psychological, organizational, and political. Executives might not be able to eliminate those barriers entirely, but they can take practical steps to lower them substantially. And given the extraordinarily high stakes involved, taking those steps should be recognized as a core responsibility of every business leader.

Three Ways to Fail

It’s all too easy, of course, to play Monday-morning quarterback when things go terribly wrong. That’s not our intent here. We readily admit that many surprises are unpredictable—that some bolts out of the blue really do come out of the blue—and in those cases leaders shouldn’t be blamed for a lack of foresight. Nor should they be blamed if they’ve taken all reasonable preventive measures against a looming crisis. But if a damaging event happens that was foreseeable and preventable, no excuses should be brooked. The leaders’ feet need to be held to the fire.

So how can you tell the difference between a true surprise and one that should have been predicted? Anticipating and avoiding business disasters isn’t just a matter of doing better environmental scanning or contingency planning. It requires a number of steps, from recognizing the threat, to making it a priority in the organization, to actually mobilizing the resources required to stop it. We term this the “RPM process”: recognition, prioritization, mobilization. Failure at any of these three stages will leave a company vulnerable to potentially devastating predictable surprises. (See the sidebar “Are You to Blame?” for a further discussion of the RPM process.)

Are You to Blame?

Predictable surprises arise out of failures of recognition, prioritization, or mobilization. The best way to figure out whether a disaster could have been avoided, as the diagram at right illustrates, is to ask the following:

Did the leader recognize the threat?Some disasters can’t be foreseen. No one, for instance, could have predicted that the HIV virus would jump the species barrier to infect humans on such a vast scale. But in examining the unforeseen disasters that strike companies, we’ve found that the vast majority should have been predicted. The way to determine whether a failure of recognition occurred is to assess whether the organization’s leader marshaled resources to scan the environment for emerging threats. That includes ascertaining whether he did a reasonable job of analyzing and interpreting the data. If not, then the leader should be held accountable.

Did the leader prioritize appropriately?Predictable surprises also occur when a threat is recognized but not given priority. Failures of prioritization are particularly common, as business leaders are typically beset by many competing demands on their attention. How can they possibly distinguish the surprise that will happen from the myriad potential surprises that won’t happen? The answer is that they can’t make such distinctions with 100% accuracy. Uncertainty exists—high-probability disasters some-times do not occur, and low-probability ones sometimes do. If, therefore, a leader performs careful cost-benefit analyses and gives priority to those threats that represent the highest costs, he should not be held accountable for a failure of prioritization.

Did the leader mobilize effectively? When a threat has been deemed serious, the leader is obligated to mobilize to try to prevent it. If he takes precautionary measures commensurate with the risks involved, he should not be held accountable. Nor should he be blamed if he lacked the resources needed to mount an effective response.

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Lapses in recognition occur when leaders remain oblivious to an emerging threat or problem—a lack of attention that can plague even the most skilled executives. After European Commission regulators refused to approve General Electric’s $42 billion acquisition of Honey-well in 2001, for example, Jack Welch was quoted as saying, “You are never too old to be surprised.” Welch is a famously hard-nosed executive, and

if anyone could have been expected to do his homework, it would have been him. But was Welch correct in viewing the decision as a true surprise, an event that couldn’t have been foreseen? The evidence suggests he was not. The Economist reported at the time that there were many warning flags of the EC’s intent to scuttle the deal. For some time, the magazine pointed out, a philosophical gap had been widening between Europe and America over the regulation of mergers. And Mario Monti, the recently appointed head of the European Commission’s competition authority, was widely believed to be looking for an opportunity to assert Continental independence.

It seems the real reason Welch was surprised is that he just didn’t pay enough attention. According to the Associated Press, when GE’s CEO and his counterpart at Honey-well, Michael Bonsignore, were rushing to close the deal (United Technologies was also eager to acquire Honey-well), they “reportedly never held initial consultations with their Brussels lawyers who specialize in European competition concerns.” Welch appeared to assume that the merger would sail through the antitrust review. But while it did pass easily through the U.S. review—no doubt further reinforcing his confidence—it smashed on the rocks in Europe. Had Welch recognized the potential for a negative decision ahead of time, he almost certainly would have managed the merger negotiations and antitrust consultations differently—and Honeywell might well be a part of GE today.

Failures of prioritization arise when potential threats are recognized by leaders but not deemed sufficiently serious to warrant immediate attention. Monsanto fell into this trap in late 1999 when CEO Robert Shapiro and his advisers failed to concentrate on winning public acceptance of genetically modified foods in Europe. Betting the company on a “life sciences” vision, Shapiro had sold or spun off Monsanto’s traditional chemical businesses and moved aggressively to

acquire seed companies. Dazzled by the seemingly vast commercial opportunities of genetically modified plants, the company pressed forward with launches of GMO food products in Europe, giving far too little weight to the fact that Europeans were still reeling from the mad cow disease crisis, reports of dioxin-contaminated chicken, and numerous other food-related concerns. By focusing on technical and strategic challenges, not on the hard work of winning hearts and minds, Shapiro ultimately lost his company. He was forced to sell Monsanto to Pharmacia-Upjohn, which bought it for its pharmaceutical division, valuing the agricultural biotechnology operations at essentially zero.

Breaks in the third link in the chain—failures of mobilization—occur when leaders recognize and give adequate priority to a looming problem but fail to respond effectively. When the Securities and Exchange Commission tried to reform the U.S. accounting system—well before the collapses of Enron and WorldCom—the Big Five accounting firms fiercely lobbied Congress to block new regulations that would have limited auditors’ ability to provide consulting services. Appearing at congressional hearings in 2000, accounting firm CEOs assured legislators that no real problem existed. Joseph Berardino, then the managing partner of Arthur Andersen, stated in a written testimony that “the future of the [accounting] profession is bright and will remain bright—as long as the commission does not force us into an outdated role trapped in the old economy. Unfortunately, the proposed rule [on auditor independence] threatens to do exactly that.” The Big Five also spent millions of dollars urging members of Congress to threaten the SEC leadership with budget cuts if it imposed limits on auditor services. The lobbying worked. The SEC backed off, and the all-too-predictable accounting scandals soon began to unfold.

It’s important to note that the leadership failure here lies not just with the SEC but also with the accounting firms, which

were well aware that their addiction to consulting fees was compromising their independence as auditors. Also culpable were political leaders—Republicans and Democrats, in the executive branch and in Congress—who lacked the courage to risk political damage and take a stand on the issue.

Sometimes, leaders actually set themselves up for predictable surprises. A classic example is the 1998 decision by a coalition of 39 pharmaceutical companies to sue the government of South Africa over its attempt to reduce the cost of HIV drugs through parallel importation (buying pharmaceuticals in countries with lower prices and then importing them) and compulsory licensing (requiring patent holders to allow others to manufacture and sell their drugs at far lower cost). The companies feared that the precedent set by the South African move would undermine their control over valuable intellectual property in the developing world. But the suit sparked international outrage against the industry, prompting a very public and un-flattering look at drug firms’ profit margins and industry practices, which the press juxtaposed against the grim realities of AIDS in southern Africa. In response, governmental and nongovernmental organizations formed a coalition that ultimately won big public health exemptions on international intellectual property protection in developing countries. By mobilizing to win the narrow legal battle in South Africa, and not focusing on the broader context, the industry suffered a severe setback.

Why We’re Vulnerable

When we studied examples of predictable surprises occurring at every stage of the RPM process, we found that they share similar causes. Some of those causes are psychological—cognitive defects that leave individuals blind to approaching threats. Others are organizational—barriers within companies that impede communication and dilute accountability. Still

others are political—flaws in decision making that result from granting too much influence from special interests. Alone or in combination, these three kinds of vulnerabilities can sabotage any company at any time. All of them, as you’ll see, were apparent in Shell’s failure to anticipate the Brent Spar controversy.

Psychological Vulnerabilities.

The human mind is a notoriously imperfect instrument. Extensive research has shown that the way we process information is subject to a slew of flaws—scholars call them cognitive biases—that can lead us to ignore or underestimate approaching disasters. Here are a few of the most common:

We tend to harbor illusions that things are better than they really are. We assume that potential problems won’t actually materialize or that their consequences won’t be severe enough to merit preventive measures. “We’ll get by,” we tell ourselves.

We give great weight to evidence that supports our preconceptions and discount evidence that calls those preconceptions into question.

We pay too little heed to what other people are doing. As a result, we overlook our vulnerability to predictable surprises resulting from others’ decisions and actions.

We are creatures of the present. We try to maintain the status quo while downplaying the importance of the future, which undermines our motivation and courage to act now to prevent some distant disaster. We’d rather avoid a little pain today than a lot of pain tomorrow.

Most of us don’t feel compelled to prevent a problem that we have not personally experienced or that has not been made real to us through pictures or other vivid information. We act only after we’ve experienced significant harm or are able to graphically imagine ourselves, or those close to us, in peril.

Anticipating and avoiding business disasters requires a number of steps, from recognizing the threat, to making it a priority in the organization, to actually mobilizing the resources required to stop it.

All of these biases share something in common: They are self-serving. We tend to see the world as we’d like it to be rather than as it truly is. Much of Shell’s failure to anticipate the disastrous response to its decision to dump the Brent Spar can be traced to the self-serving biases of its people—to their unshakable belief that they were right. Shell was an engineering company run by executives trained to make decisions through rigorous technical and economic analysis. Having reviewed more than 30 independent studies and arrived at “the correct answer” about the Spar, and having received approval from the British government to sink it, executives at Shell UK were utterly confident that their decision made the most sense, and they assumed that every reasonable person would see the issue their way. They were unprepared to deal with a group of true believers who opposed any dumping on principle and who were skilled at making emotional arguments that resonated with the public. In the contest for people’s hearts and minds, emotion easily defeated analysis—much to the consternation of Shell executives. Even well after it was obvious that they were losing the battle, the leaders of Shell UK still couldn’t back away from a failing course of action.

Self-serving bias can be particularly destructive when there are conflicts of interest. Think of the many business scandals that arose after the Internet bubble burst. Although corruption certainly played a role in these disasters, the more fundamental cause was a series of biased judgments. Professional auditors distorted their accounting in ways that served the interests of their clients. Analysts on Wall Street gave overly positive assessments of companies that were clients of their firms’ investment-banking arms. Corporate

directors failed to pay enough attention to the actions of the CEOs who appointed and paid them. Many of these auditors, analysts, and board members knew that the bubble would burst, but their unconscious biases prevented them from fully acknowledging the consequences or taking preventive action. (For an in-depth discussion of how biases distort accounting results, see “Why Good Accountants Do Bad Audits,” by Max H. Bazerman, George Loewenstein, and Don A. Moore, in the November 2002 issue of HBR.)

Organizational Vulnerabilities.

The very structure of business organizations, particularly those that are large and complex, makes it difficult to anticipate predictable surprises. Because companies are usually divided into organizational silos, the information leaders need to see and assess an approaching threat is often fragmented. Various people have various pieces of the puzzle, but no one has them all. In theory, corporate management should play the role of synthesizer, bringing together the fragmented information in order to see the big picture. But the barriers to this happening are great. Information is filtered as it moves up through hierarchies—sensitive or embarrassing information is withheld or glossed over. And those at the top inevitably receive incomplete and distorted data. That’s exactly what happened in the months and years leading up to September 11. Various government agencies had pieces of information on terrorists’ methods and plans that, had they been combined, would have pointed to the type of attack that was carried out against the World Trade Center and the Pentagon. Tragically, the information remained fragmented. (For more on September 11, see the sidebar: “9/11: The Surprise That Shouldn’t Have Been.”)

9/11 The Surprise That Shouldn’t Have Been

When fanatics commandeered jetliners on September 11, 2001, and steered them into buildings full of people, it came as a horrifying shock to most of

the world. But however difficult it might have been to imagine individuals carrying out such an act, it shouldn’t have been a surprise. Portents had been building up for years. It was well known that Islamic militants were willing to become martyrs for their cause and that their hatred and aggression toward the United States had been mounting throughout the 1990s. In 1993, terrorists set off a car bomb under the World Trade Center in an attempt to destroy the building. In 1995, other terrorists hijacked an Air France plane and made an aborted attempt to fly it into the Eiffel Tower. Also in 1995, the U.S. government learned of a failed Islamic terrorist plot to simultaneously hijack 11 U.S. commercial airplanes over the Pacific Ocean and then crash a light plane filled with explosives into the CIA’s headquarters near Washington, DC. Meanwhile, dozens of federal reports, including one issued by then Vice President Al Gore’s special commission on aviation security, provided comprehensive evidence that the U.S. aviation security system was full of holes. Anyone who flew on a regular basis knew how simple it was to board an airplane with items, such as small knives, that could be used as weapons.

But despite the signals, no precautionary measures were taken. The failure can be traced to lapses in recognition, prioritization, and mobilization. Information that might have been pieced together to highlight the precise contours of the threat remained fragmented among the FBI, the CIA, and other governmental agencies. No one gave priority to plugging the security holes in the aviation system because, psychologically, the substantial and certain short-term costs of fixing the problems loomed far larger than the uncertain long-term costs of in action. And the organizations responsible for airline security, the airlines, had the wrong incentives, desiring faster, lower-cost screening to boost profitability. Inevitably, plans to fix the system fell afoul of concerted political lobbying by the airline industry.

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Organizational silos not only disperse information; they also disperse responsibility. In some cases, everyone assumes that someone else is taking responsibility, and so no one ever acts. In other cases, one part of an organization is vested with too much responsibility for a particular issue. Other parts of the organization, including those with important information or perspectives, aren’t consulted or are even actively pushed out of the decision-making process. The result? Too narrow a perspective is brought to bear on the

issue, and potential problems go unrecognized or are given too little priority.

Put another way, decision makers focus on an “impact horizon” that is too narrow, neglecting the implications for key constituencies. This sort of organizational parochialism was clearly evident within Shell. The company failed to see that sinking the Spar would set a precedent for dealing with other obsolete structures in the North Sea and that it was probably the worst structure to start with given its size and toxic residues. The company’s decentralized management structure, made up of autonomous national business units, worked well when dealing with routine problems such as customizing marketing efforts to local customers. But it worked very badly when dealing with crises that crossed national lines. The Brent Spar was located in the British part of the North Sea, so responsibility for disposing of it was naturally vested with Shell UK. Shell UK, in turn, dealt with the British government to get the necessary permissions and consulted with British environmental groups. But Greenpeace changed the game by focusing its public relations attack not in Britain but in Germany. The German Shell operating company had not been involved in the process and had no part in the decision to dump the Spar. But it became the target of most of the pressure—financial and political—from Greenpeace. Indeed, the chairman of Shell Germany, Peter Duncan, remarked publicly that he first heard about the planned sinking of the Spar “more or less from the television.” Once the crisis broke, Shell’s decentralized structure inhibited the company from coordinating crisis response activities and notifying employees of decisions and events. Senior Shell managers outside the UK publicly criticized both the disposal plans and each other through the press.

Political Vulnerabilities.

Finally, predictable surprises can emerge out of systemic flaws in decision-making processes. Imbalances of power, for example, may lead executives to overvalue the interests of one group while slighting those of other equally important groups. Such imbalances tend to be particularly damaging during the mobilization phase, when vested interests can slow or block action intended to resolve a growing problem. A case in point is the U.S. Congress, where single-interest groups, such as the National Rifle Association or the AARP, wield disproportionate influence. Through a combination of focused contributions to reelection campaigns, well-connected lobbyists, nurtured relationships with committee chairpeople and staff members, and intimate knowledge of leverage points in key processes, special-interest groups routinely stall or torpedo policy changes, even when there is a broad consensus that action is needed.

We saw this dynamic play out after Enron collapsed and WorldCom and other companies restated their financial results. Following an early burst of enthusiasm for seriously tightening corporate governance rules, Congress retreated in the face of intense lobbying by an array of business groups. In the critical area of auditing, for example, accounting industry lobbyists succeeded in watering down the Sarbanes-Oxley Act on corporate responsibility, enabling “independent” auditors to continue to provide consulting and other lucrative services to audit clients and to be rehired indefinitely by the clients, as well as allowing audit-firm staffers to take jobs with their clients. Efforts to reform pension laws to help protect workers from future Enron-like debacles were also beaten back by lobbyists representing employers. As a result, companies and investors remain vulnerable to damaging new “surprises.”

Companies are all too often oblivious to the dynamics of governmental systems. Shell, for example, failed to anticipate and shape European political responses to its Brent

Spar plan. Company officials had finalized the disposal plan after four years of study and quiet negotiations with the British government, which approved the dumping. After signing on to the Shell plan, the British government notified the other European governments with oil development and other interests in the North Sea. These governments raised no objections at that time, but the absence of objections is by no means the same as active support. As Greenpeace applied more pressure on the Continent, the German government responded by openly undercutting the UK’s decision to allow Shell to sink the Spar. Through public criticism and direct requests, Germany pressured the UK to reverse its decision. Not building a broad consensus—with governments and with other oil companies—on how to deal with aging North Sea oil rigs cost Shell dearly.

Political vulnerabilities can also crop up within companies. Sanford Weill, the chairman of Citigroup, recently came under fire for apparently using corporate resources to provide personal assistance to Jack Grubman, a star analyst at Citi’s Salomon Smith Barney. Weill allegedly helped get Grubman’s children into a prestigious day care center in return for issuing a more favorable report on AT&T, a very important client of Salomon’s investment-banking unit. But broader organizational politics also appear to have played a role in Weill’s actions. As theEconomist reported, “There is much speculation, and some e-mail evidence, that the recommendation helped to win support for Mr. Weill’s successful ousting of [Citigroup’s co-CEO, John] Reed from Michael Armstrong, AT&T’s chief executive, who also happened to sit on Citi’s board.” The resulting damage to the reputations of Weill and his company was entirely predictable.

What You Can Do

“Prediction is very difficult,” physicist Niels Bohr once said, “especially about the future.” Difficult, yes. Impossible, no. Even though many organizations are caught unprepared for disasters they should have seen coming, many have successfully recognized approaching crises and taken evasive action. In the public sector, for example, governments, corporations, and charitable organizations banded together to curtail the use of CFC refrigerants once it became clear they were damaging the ozone layer. In the business arena, leaders are today sponsoring what we call “surprise-avoidance initiatives” on topics ranging from genomics research and stem cell biology to Internet security to the reform of corporate governance.

Individual companies can learn a lot from such efforts. We have distilled from our own research a set of practical steps that managers can take to better recognize emerging problems, set appropriate priorities, and mobilize an effective preventive response. The first step is the simplest: Ask yourself and your colleagues, “What predictable surprises are currently brewing in our organization?” This may seem like an obvious question, but the fact is, it’s rarely asked. People at various levels in organizations, from the top to the bottom, are often aware of approaching storms but choose to keep silent, often out of a fear of rocking the boat or being seen as troublemakers. By actively encouraging people to speak up, executives can bring to the surface many problems that might otherwise go unmentioned.

Some threats, of course, are invisible to insiders. To ferret out these potential dangers, companies should use two proven techniques—scenario planning and risk assessment. In scenario planning, a knowledgeable and creative group of people from inside and outside the organization is convened to review company strategies, digest available information on external trends, and identify critical business drivers and potential flash points. (It’s essential to include outsiders in

this group as a counterweight to the self-serving biases of employees.) Based on this analysis, the group constructs a plausible set of scenarios for potential surprises that could emerge over, say, the coming two years. These scenarios form the basis for the design of preventive and preparatory measures. This exercise should include scenarios that, while unlikely, would have a very large impact on the organization if they occurred. A full scenario-planning exercise should be conducted annually, and formal updates of changes in the organization and its environment should be scheduled every quarter.

Rigorous risk analysis—combining a systematic assessment of the probabilities of future events and an estimation of the costs and benefits of particular outcomes—can be invaluable in overcoming the biases that afflict organizations in estimating the likelihood of unpleasant events. It can be useful not just in setting priorities but in sifting through alternative responses. During the Cuban Missile Crisis in 1962, for example, U.S. military leaders wanted to attack. Fortunately, however, President Kennedy organized a decision-making process that examined in detail the risks of available options. Two groups, each including government officials and outside experts, were organized to flesh out two particular alternatives, attack and blockade, and assess their associated risks and rewards. Based on the analysis, Kennedy eventually decided to conduct a blockade. Recently, Kennedy’s Secretary of Defense Robert McNamara made it clear that if the United States had invaded, the consequences might well have been catastrophic. Even if American forces had quickly destroyed all the weapons known to exist in Cuba, several U.S. cities could still have been struck by nuclear missiles—missiles that the military were unaware of at the time.

At its best, risk analysis combines subjective and objective evaluations. Teams of experts, like the ones Kennedy relied

on, can be organized to make regular qualitative assessments of conditions and threats. At the same time, decision analysis has developed useful techniques for helping individuals and organizations to more effectively assess the probabilities of future events and their potential consequences. (John Hammond, Ralph Keeney, and Howard Raiffa’s book Smart Choices provides a particularly good overview of this field.)

Organizational vulnerabilities are often the toughest to overcome. But while it’s rarely possible to eradicate all the internal barriers within an organization, it is possible to counter their effects by establishing cross-company systems to gather intelligence. Typically, this requires that leaders create one or more cross-functional teams responsible for collecting and synthesizing relevant information from all corners of the business. Some companies use what are called action-learning groups—teams of future leaders that meet to share data and analyze key business challenges. Also required is a change in incentives to get employees to see beyond their parochial interests and begin to share information freely. In the case of the Brent Spar fiasco, the leaders of Shell UK and Shell Germany were each focused exclusively on their own bottom lines and as a result pursued conflicting parochial interests—to the detriment of the company as a whole. Had a broader system of measures and rewards been in place, one that provided incentives to balance corporate and local interests, Shell would have been better protected against internal in-fighting and miscommunication.

Finally, executives need to build good networks—both informal advice networks and formal coalitions—for influencing political decisions. Leaders’ beliefs and impressions about the potential challenges facing their organizations are based, in large measure, on their intuition. By organizing a set of knowledgeable advisers, drawn from

both inside and outside the company, leaders can test and refine their early impressions and help counter their own unconscious biases. Hank McKinnell, the CEO of Pfizer, is a good example of a leader who routinely calls on a group of external advisers to avoid predictable surprises. One of McKinnell’s most valuable “leadership counselors” is Dan Ciampa, former CEO of Rath & Strong. By serving as both a sounding board and an adviser on key issues and decisions, Ciampa is reportedly instrumental in helping McKinnell avoid undesirable outcomes.

And when managers have to mobilize people outside their direct lines of control to confront a difficult problem—as is almost always necessary—they need to build formal coalitions. Coalition building is particularly important for getting anything done in highly politicized environments like the U.S. Congress. But it is important in business, too. Sometimes, executives have to make major organizational changes to guard against a potential disaster. Such changes always create winners and losers and generate overt and covert resistance. To prevail, leaders must be able to consolidate their supporters, neutralize their opponents, and persuade fence-sitters to back the changes. That requires, in turn, that they be good at figuring out who wields influence, inside and outside the organization, and then use that knowledge to build support and momentum for their cause.

Taking these steps will help you get an effective RPM process up and running in your company. Once the process is in place, you’ll need to shift your attention to speeding it up and making it more responsive. Events move swiftly, and they can quickly spin out of control—as Shell found out. If you’re unable to stay ahead of a potential disaster as it unfolds, you’ll be stuck in a reactive mode. You’ll become a victim of circumstances rather than a master of your own destiny.

A version of this article appeared in the April 2003 issue of Harvard Business Review.

Strategy as Simple Rules

Strategy as Simple Rules

Strategy as Simple Rules

Strategy as simple rulesBy Kathleen M. Eisenhardt & Donald Sull

Since its founding in 1994, Yahoo! has emerged as one of the blue chips of the new economy. As the Internet’s top portal, Yahoo! generates the astounding numbers we’ve come to expect from stars of the digital era—more than 100 million visits per day, annual sales growth approaching 200%, and a market capitalization that has exceeded the value of the Walt Disney Company. Yet Yahoo! also provides something we don’t generally expect from Internet companies: profits.

Everyone recognizes the unprecedented success of Yahoo!, but it’s not easily explained using traditional thinking about competitive strategy. Yahoo!’s rise can’t be attributed to an attractive industry structure, for example. In fact, the Internet portal space is a strategist’s worst nightmare: it’s characterized by intense rivalries, instant imitators, and customers who refuse to pay a cent. Worse yet, there are few barriers to entry. Nor is it possible to attribute Yahoo!’s success to unique or valuable resources—its founders had little more than a computer and a great idea when they started the company. As for strategy, many analysts would say it’s not clear that Yahoo! even has one. The company began as a catalog of Web sites, became a content aggregator, and eventually grew into a community of users. Lately it has become a broad network of media, commerce, and communication services. If Yahoo! has a strategy, it

would be very hard to pin down using traditional, textbook notions.

While the Yahoo! story is dramatic, it’s far from unique. Many other leaders of the new economy, including eBay and America On-line, also rose to prominence by pursuing constantly evolving strategies in market spaces that were considered unattractive according to traditional measures. And it’s not exclusively a new-economy phenomenon. Companies in even the oldest sectors of the economy have excelled without the advantages of superior resources or strategic positions. Consider Enron and AES in energy, Ispat International in steel, Cemex in cement, and Vodafone and Global Crossing in telecommunications.

The performance of all these companies—despite unattractive industry structures, few apparent resource advantages, and constantly evolving strategies—raises critical questions. How did they succeed? More generally, what are the sources of competitive advantage in high-velocity markets? What does strategy mean in the new economy?

The secret of companies like Yahoo! is strategy as simple rules. Managers of such companies know that the greatest opportunities for competitive advantage lie in market confusion, so they jump into chaotic markets, probe for opportunities, build on successful forays, and shift flexibly among opportunities as circumstances dictate. But they recognize the need for a few key strategic processes and a few simple rules to guide them through the chaos. As one Internet executive explained: “I have a thousand opportunities a day; strategy is deciding which 50 to do.” In traditional strategy, advantage comes from exploiting resources or stable market positions. In strategy as simple rules, by contrast, advantage comes from successfully seizing fleeting opportunities.

It’s not surprising that a young company like Yahoo! should rely on strategy as simple rules. Entrepreneurs have always used that kind of opportunity-grabbing approach because it can help them win against established competitors. What is surprising is that strategy as simple rules makes sense for all kinds of companies—large and small, old and young—in fast-moving markets like those in the new economy. That’s because, while information economics and network effects are important, the new economy’s most profound strategic implication is that companies must capture unanticipated, fleeting opportunities in order to succeed.

The new economy’s most profound strategic implication is that companies must capture unanticipated, fleeting opportunities in order to succeed.

Of course, theory is one thing, but putting it into practice is another. In fact, our recommendations reverse some prescriptions of traditional strategy. Rather than picking a position or leveraging a competence, managers should select a few key strategic processes. Rather than responding to a complicated world with elaborate strategies, they should craft a handful of simple rules. Rather than avoiding uncertainty, they should jump in.

Zeroing in on Key Processes

Companies that rely on strategy as simple rules are often accused of lacking strategies altogether. Critics have derided AOL as “the cockroach of the Internet” for scurrying from one opportunity to the next. Some analysts accuse Enron of doing the same thing. From the outside, companies like these certainly appear to be following an “if it works, anything goes” approach. But that couldn’t be further from the truth. Each company follows a disciplined strategy—otherwise, it would be paralyzed by chaos. And, as with all effective strategies, the strategy is unique to the company. But a

simple-rules strategy and its underlying logic of pursuing opportunities are harder to see than traditional approaches. (The exhibit “Three Approaches to Strategy” compares the strategies of position, resources, and simple rules.)

Three Approaches to Strategy Managers competing in business can choose among three distinct ways to fight. They can build a fortress and defend it; they can nurture and leverage unique resources; or they can flexibly pursue fleeting opportunities within simple rules. Each approach requires different skill sets and works best under different circumstances.

Managers using this strategy pick a small number of strategically significant processes and craft a few simple

rules to guide them. The key strategic processes should place the company where the flow of opportunities is swiftest and deepest. The processes might include product innovation, partnering, spinout creation, or new-market entry. For some companies, the choices are obvious—Sun Microsystems’ focus on developing new products is a good example. For other companies, the selection of key processes might require some creativity—Akamai, for instance, has developed a focus on customer care. The simple rules provide the guidelines within which managers can pursue opportunities. Strategy, then, consists of the unique set of strategically significant processes and the handful of simple rules that guide them.

Autodesk, the global leader in software for design professionals, illustrates strategy as simple rules. In the mid-1990s, Autodesk’s markets were mature, and the company dominated all of them. As a result, growth slowed to single-digit rates. CEO Carol Bartz was sure that her most-promising opportunities lay in making use of those Autodesk technologies—in areas such as wireless communications, the Internet, imaging, and global positioning—that hadn’t yet been exploited. But she wasn’t sure which new technologies and related products would be big winners. So she refocused the strategy on the product innovation process and introduced a simple, radical rule: the new-product development schedule would be shortened from a leisurely 18 to 24 months to, in some cases, a hyper-kinetic three months. That changed the pace, scale, and strategic logic with which Autodesk tackled technology opportunities.

While a strategy of accelerating product innovation helped identify opportunities more quickly, Bartz lacked the cash to commercialize all of Autodesk’s promising technologies. So she added a significant new strategy: spinouts. The first spinout, Buzzsaw.com, debuted in 1999. It allowed engineers to purchase construction materials using B2B exchange

technology. Buzzsaw.com attracted significant venture capital and benefited from Autodesk’s powerful brand and its customer relationships. Autodesk has since created a second spinout, RedSpark, and has developed simple rules for the new key process of spinning off companies.

A company’s particular combination of opportunities and constraints often dictates the processes it chooses. Cisco, Autodesk, Lego, and Yahoo! began with strategies in which product innovation was dominant, but their emphases diverged. Cisco’s new opportunities lay in the many new networking technologies that were emerging, but the company lacked the time and engineering talent to develop them all. In contrast to technology-rich and stock-price-poor Autodesk, which focused on spinouts, Cisco—with high market capitalization—found that acquisitions was the way to go. Despite its stratospheric market cap, Yahoo! went in yet another direction. The company wanted to exploit content and commerce opportunities but needed a lot of partners. Many were too big to acquire, so it created partnerships. Lego’s best opportunities were in extending its power brand and philosophy into new markets. But since the company faced less competition and operated at a slower pace than Autodesk, Cisco, or Yahoo!, managers could grow organically into new product markets such as children’s robotics, clothing, theme parks, and software.

Simple Rules for Unpredictable Markets

Most managers quickly grasp the concept of focusing on key strategic processes that will position their companies where the flow of opportunities is most promising. But because they equate processes with detailed routines, they often miss the notion of simple rules. Yet simple rules are essential. They poise the company on what’s termed in complexity theory “the edge of chaos,” providing just enough structure to allow it to capture the best opportunities. It may sound

counterintuitive, but the complicated improvisational movements that companies like AOL and Enron make as they pursue fleeting opportunities arise from simple rules.

Yahoo!’s managers initially focused their strategy on the branding and product innovation processes and lived by four product innovation rules: know the priority rank of each product in development, ensure that every engineer can work on every project, maintain the Yahoo! look in the user interface, and launch products quietly. As long as they followed the rules, developers could change products in any way they chose, come to work at any hour, wear anything, and bring along their dogs and significant others. One developer decided at midnight to build a new sports page covering the European soccer championships. Within 48 hours, it became Yahoo!’s most popular page, with more than 100,000 hits per day. Since he knew which lines he had to stay within, he was free to run with a great idea when it occurred to him. A day later, he was back on his primary project. On a bigger scale, the simple rules, in particular the requirement that every engineer be able to work on every project, allowed Yahoo! to change 50% of the code for the enormously successful My Yahoo! service four weeks before launch to adjust to the changing market.1

Over the course of studying dozens of companies in turbulent and unpredictable markets, we’ve discovered that the simple rules fall into five broad categories. (See the exhibit “Simple Rules, Summarized.”)

Simple Rules, Summarized In turbulent markets, managers should flexibly seize opportunities—but flexibility must be disciplined. Smart companies focus on key processes and simple rules. Different types of rules help executives manage different aspects of seizing opportunities.

How-to Rules.

Yahoo!’s how-to rules kept managers just organized enough to seize opportunities. Enron provides another how-to example. Its commodities-trading business focuses strategy on the risk management process with two rules: each trade must be offset by another trade that allows the company to hedge its risk, and every trader must complete a daily profit-and-loss statement. Computer giant Dell focuses on the process of rapid reorganization (or patching) around focused customer segments. A key how-to rule for this process is that

a business must be split in two when its revenue hits $1 billion.

Boundary Rules.

Sometimes simple rules delineate boundary conditions that help managers sort through many opportunities quickly. The rules might center on customers, geography, or technologies. For example, when Cisco first moved to an acquisitions-led strategy, its boundary rule was that it could acquire companies with at most 75 employees, 75% of whom were engineers. At a major pharmaceutical company, strategy centers on the drug discovery process and several boundary rules: researchers can work on any of ten molecules (no more than four at once) specified by a senior research committee, and a research project must pass a few continuation hurdles related to progress in clinical trials. Within those boundaries, researchers are free to pursue whatever looks promising. The result has been a drug pipeline that’s the envy of the industry.

Miramax—well known for artistically innovative movies such as The Crying Game, Life is Beautiful, and Pulp Fiction—has boundary rules that guide the all-important movie-picking process: first, every movie must revolve around a central human condition, such as love (The Crying Game) or envy (The Talented Mr. Ripley). Second, a movie’s main character must be appealing but deeply flawed—the hero of Shakespeare in Loveis gifted and charming but steals ideas from friends and betrays his wife. Third, movies must have a very clear story line with a beginning, middle, and end (although in Pulp Fiction the end comes first). Finally, there is a firm cap on production costs. Within the rules, there is flexibility to move quickly when a writer or director shows up with a great script. The result is an enormously creative and even surprising flow of movies and enough discipline to produce superior, consistent financial results. The English

Patient, for example, cost $27 million to make, grossed more than $200 million, and grabbed nine Oscars.

Lego provides another illustration of boundary rules. At Lego, the product market-entry process is a strategic focus because of the many opportunities to extend the Lego brand and philosophy. But while there is plenty of flexibility, not every market makes the cut. Lego has a checklist of rules. Does the proposed product have the Lego look? Will children learn while having fun? Will parents approve? Does the product maintain high quality standards? Does it stimulate creativity? If an opportunity falls short on one hurdle, the business team can proceed, but ultimately the hurdle must be cleared. Lego children’s wear, for example, met all the criteria except one: it didn’t stimulate creativity. As a result, the members of the children’s wear team worked until they figured out the answer—a line of mix-and-match clothing items that encouraged children to create their own fashion statements.

Priority Rules.

Simple rules can set priorities for resource allocation among competing opportunities. Intel realized a long time ago that it needed to allocate manufacturing capacity among its products very carefully, given the enormous costs of fabrication facilities. At a time of extreme price volatility in the mid-1980s, when Asian chip manufacturers were disrupting world markets with severe price cuts and accelerated technological improvement, Intel followed a simple rule: allocate manufacturing capacity based on a product’s gross margin. Without this rule, the company might have continued to allocate too much capacity to its traditional core memory business rather than seizing the opportunity to dominate the nascent and highly profitable microprocessor niche.2

Timing Rules.

Many companies have timing rules that set the rhythm of key strategic processes. In fact, pacing is one of the important elements that set simple-rules strategies apart from traditional strategies. Timing rules can help synchronize a company with emerging opportunities and coordinate the company’s various parts to capture them. Nortel Networks now relies on two timing rules for its strategically important product innovation process: project teams must always know when a product has to be delivered to the leading customer to win, and product development time must be less than 18 months. The first rule keeps Nortel in sync with cutting-edge customers, who represent the best opportunities. The second forces Nortel to move quickly into new opportunities while synchronizing the various parts of the corporation to do so. Together, the rules helped the company shift focus from perfecting its current products to exploiting market openings—to “go from perfection to hitting market windows,” as CEO John Roth puts it. At an Internet-based service company where we worked, globalization was the process that put the company squarely in the path of superior opportunities. Managers drove new-country expansion at the rate of one new country every two months, thus maintaining constant movement into new opportunities. Many top Silicon Valley companies set timing rules for the length of the product innovation process. When developers approach a deadline, they drop features to meet the schedule. Such rhythms maintain movement and ensure that the market and various groups within the organization—from manufacturing to marketing to engineering—are on the same beat.

Exit Rules.

Exit rules help managers pull out from yesterday’s opportunities. At the Danish hearing-aid company Oticon, executives pull the plug on a product in development if a key team member leaves for another project. Similarly, at a major high-tech multinational where creating new businesses is a

key strategic process, senior executives stop new initiatives that don’t meet certain sales and profit goals within two years. (For a look at the flip side of simple rules, see the sidebar “What Simple Rules Are Not.”)

What Simple Rules Are Not

It is impossible to dictate exactly what a company’s simple rules should be. It is possible, however, to say what they should not be.

Broad. Managers often confuse a company’s guiding principles with simple rules. The celebrated “HP way,” for example, consists of principles like “we focus on a high level of achievement and contribution” and “we encourage flexibility and innovation.” The principles are designed to apply to every activity within the company, from purchasing to product innovation. They may create a productive culture, but they provide little concrete guidance for employees trying to evaluate a partner or decide whether to enter a new market. The most effective simple rules, in contrast, are tailored to a single process.

Vague. Some rules cover a single process but are too vague to provide real guidance. One Western bank operating in Russia, for example, provided the following guideline for screening investment proposals: all investments must be currently undervalued and have potential for long-term capital appreciation. Imagine the plight of a newly hired associate who turns to that rule for guidance!

A simple screen can help managers test whether their rules are too vague. Ask: could any reasonable person argue the exact opposite of the rule? In the case of the bank in Russia, it is hard to imagine anyone suggesting that the company target overvalued companies with no potential for long-term capital appreciation. If your rules flunk this test, they are not effective.

Mindless. Companies whose simple rules have remained implicit may find upon examining them that these rules destroy rather than create value. In one company, managers listed their recent partnership relationships and then tried to figure out what rules could have produced the list. To their chagrin, they found that one rule seemed to be: always form partnerships with small, weak companies that we can control. Another was: always form partnerships with companies that are not as successful as they once were. Again, use a simple test—reverse-engineer your processes to determine your implicit simple rules. Throw out the ones that are embarrassing.

Stale. In high-velocity markets, rules can linger beyond their sell-by dates. Consider Banc One. The Columbus, Ohio-based bank grew to be the seventh-

largest bank in the United States by acquiring more than 100 regional banks. Banc One’s acquisitions followed a set of simple rules that were based on experience: Banc One must never pay so much that earnings are diluted, it must only buy successful banks with established management teams, it must never acquire a bank with assets greater than one-third of Banc One’s, and it must allow acquired banks to run as autonomous affiliates. The rules worked well until others in the banking industry consolidated operations to lower their costs substantially. Then Banc One’s loose confederation of banks was burdened with redundant operations, and it got clobbered by efficient competitors.

How do you figure out if your rules are stale? Slowing growth is a good indicator. Stock price is even better. Investors obsess about the future, while your own financials report the past. So if your share price is dropping relative to your competitors’ share prices, or if your percentage of the industry’s market value is declining, or if growth is slipping, your rules may need a refresh.

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The Number of Rules Matters

Obviously, it’s crucial to write the right rules. But it’s also important to have the optimal number of rules. Thick manuals of rules can be paralyzing. They can keep managers from seeing opportunities and moving quickly enough to capture them. We worked with a computer maker, for example, whose minutely structured process for product innovation was highly efficient but left the company no flexibility to respond to market changes. On the other hand, too few rules can also paralyze. Managers chase too many opportunities or become confused about which to pursue and which to ignore. We worked with a biotech company that lagged behind the competition in forming successful partnerships, a key strategic process in that industry. Because the company lacked guidelines, development managers brought in deal after deal, and key scientists were pulled from clinical trials over and over again to perform due diligence. Senior management ended up rejecting most of the proposals. Executives may have had implicit rules, but

nobody knew what they were. One business development manager lamented: “It would be so liberating if only I had a few guidelines about what I’m supposed to be looking for.”

Thick manuals of rules can be paralyzing. They can keep managers from seeing opportunities and moving quickly enough to capture them.

While creating the right number of rules—it’s usually somewhere between two and seven—is central, companies arrive at the optimal number from different directions. On the one hand, young companies usually have too few rules, which prevents them from executing innovative ideas effectively. They need more structure, and they often have to build their simple rules from the ground up. On the other hand, older companies usually have too many rules, which keep them from competing effectively in turbulent markets. They need to throw out massively complex procedures and start over with a few easy-to-follow directives.

The optimal number of rules for a particular company can also shift over time, depending on the nature of the business opportunities. In a period of predictability and focused opportunities, a company should have more rules in order to increase efficiency. When the landscape becomes less predictable and the opportunities more diffuse, it makes sense to have fewer rules in order to increase flexibility. When Cisco started to acquire aggressively, the “75 people, 75% engineers” rule worked extremely well—it ensured a match with Cisco’s entrepreneurial culture and left the company with lots of space to maneuver. As the company developed more clarity and focus in its home market, Cisco recognized the need for a few more rules: a target must share Cisco’s vision of where the industry is headed, it must have potential for short-term wins with current products, it must have potential for long-term wins with the follow-on product generation, it must have geographic proximity to

Cisco, and its culture must be compatible with Cisco’s. If a potential acquisition meets all five criteria, it gets a green light. If it meets four, it gets a yellow light—further consideration is required. A candidate that meets fewer than four gets a red light. CEO John Chambers believes that observing these simple rules has helped Cisco resist the temptation to make inappropriate acquisitions. More recently, Cisco has relaxed its rules (especially on proximity) to accommodate new opportunities as the company moves further afield into new technologies and toward new customers.

How Rules Are Created

We’re often asked where simple rules come from. While it’s appealing to think that they arise from clever thinking, they rarely do. More often, they grow out of experience, especially mistakes. Yahoo! and its partnership-creation rules. An exclusive joint venture with a major credit card company proved calamitous. The deal locked Yahoo! into a relationship with a particular firm, thereby limiting e-commerce opportunities. After an expensive exit, Yahoo! developed two simple rules for partnership creation: deals can’t be exclusive, and the basic service is always free.

While it’s appealing to think that simple rules arise from clever thinking, they rarely do. More often, they grow out of experience, especially mistakes.

At young companies, where there is no history to learn from, senior executives use experience gained at other companies. CEO George Conrades of Akamai, for example, drew on his decades of marketing experience to focus his company on customer service—a surprising choice of strategy for a high-tech venture. He then declared some simple rules: the company must staff the customer service group with technical gurus, every question must be answered on the first

call or e-mail, and R&D people must rotate through customer care. These how-to rules shaped customer service at Akamai but left plenty of room for employees to innovate with individual customers.

Most often, a rough outline of simple rules already exists in some implicit form. It takes an observant manager to make them explicit and then extend them as business opportunities evolve. (It’s even possible to trace a young company’s evolution by examining how its simple rules have been applied over time.) EBay, for example, started out with two strong values: egalitarianism and community—or, as one user put it, “capitalism for the rest of us.” Over time, founder and chairman Pierre Omidyar and CEO Meg Whitman made those values explicit in simple rules that helped managers predict which opportunities would work for eBay. Egalitarianism evolved into two simple how-to rules for running auctions: the number of buyers and sellers must be balanced, and transactions must be as transparent as possible. The first rule equalizes the power of buyers and sellers but does not restrict who can participate, so the eBay site is open to everyone, from individual collectors to corporations (indeed, several major retailers now use eBay as a quiet channel for their merchandise). The second rule gives all participants equal access to as much information as possible. This rule guided eBay managers into a series of moves such as creating feedback ratings on sellers, on-line galleries for expensive items, and authentication services from Lloyd’s of London.

The business meaning of community was crystallized into a few simple rules, too: product ads aren’t allowed (they compete with the community), prices for basic services must not be raised (increases hurt small members), and eBay must uphold high safety standards (a community needs to feel safe). The rules further clarified which opportunities made sense. For instance, it was okay to launch the PowerSellers

program, which offers extra services for community members who sell frequently. It was also okay to allow advertising by financial services companies and to expand into Europe, because neither move broke the rules or threatened the community. On the other hand, it was not okay to have advertising deals with companies such as CDnow whose merchandise competes with the community. Only later did the economic value of the rules become apparent: the strength of the eBay community posed a formidable entry barrier to competitors, while egalitarianism created a high level of trust and transparency among traders that effectively differentiated eBay from its competitors.

It’s entirely possible for two companies to focus on the same key process yet develop radically different simple rules to govern it. Consider Ispat International and Cisco. In the last decade, Ispat has gone from running a single steel mill in Indonesia to being the fourth-largest steel company in the world by using a new-economy strategy in an old-economy business. Founder Lakshmi Mittal’s strategy centers on the acquisition process. But Ispat’s rules for acquisitions look a whole lot different from Cisco’s for the same process.

Ispat’s rules include buying established, state-owned companies that have problems. Cisco’s rules limit its acquisitions to young, well-run, VC-backed companies. Ispat’s rules don’t include geographic restrictions, so managers search the globe—Mexico, Kazakhstan, Ireland—for ailing companies. At least initially, Cisco’s rules required exactly the opposite focus—the company stayed close to home with lots of acquisitions in Silicon Valley. Ispat focuses narrowly on two process technologies—DRI and electric arc furnaces—to drive companywide consistency. At Cisco, the whole point is to acquire new technologies. Ispat’s rules center on finding companies in which costs can be cut from current operations. Cisco’s rules gauge revenue gains from future products. The bottom line: same strategic process, same entrepreneurial

emphasis on seizing fleeting opportunities, same superior wealth creation—but with totally different simple rules.

Knowing When to Change

It’s important for companies with simple-rules strategies to follow the rules religiously—think Ten Commandments, not optional suggestions—to avoid the temptation to change them too frequently. A consistent strategy helps managers rapidly sort through all kinds of opportunities and gain short-term advantage by exploiting the attractive ones. More subtly, it can lead to patterns that build long-term advantage, such as Lego’s powerful brand position and Cisco’s interrelated networking technologies.

Although it’s unwise to churn the rules, strategies do go stale. Shifting the rules can sometimes rejuvenate strategy, but if the problems are deep, switching strategic processes may be necessary. The ability to switch to new strategic processes has been a success secret of the best new-economy companies. For example, Inktomi, a leader in Internet infrastructure software, augmented its original strategic focus on the product innovation process with a focus on the market entry process and a few boundary rules: the company must never produce a hardware product, never interface directly with end users, and always develop software for applications with many users and transactions (this exploits Inktomi’s basic technology). Company managers did not restrict the business or revenue models. The result was successful new businesses in, for example, search engines, caching, and e-commerce engines. In fact, the company’s second business, caching, is now its key growth driver. But CEO Dave Peterschmidt and his team have recently turned their attention to the sales process because corporations—a much bigger customer set than was available in their original portal market—are buying Inktomi software to manage intranets, thus opening a massive stream of new opportunities. Inktomi

is turning to this new opportunity flow and crafting fresh simple rules. Inktomi is thus accelerating growth by adding new processes before old ones falter. If managers wait until the opportunity flow dries up before shifting processes, it’s already too late. (For more details on the use of simple rules over time, see the sidebar “Enron: Simple Rules and Opportunity Logic.”)

Enron: Simple Rules and Opportunity Logic

Simple rules establish a strategic frame—not a step-by-step recipe—to help managers seize fleeting opportunities. Few companies have followed the logic of opportunity or the discipline of simple rules as consistently as Enron. Fifteen years ago, the company’s main line of business was interstate gas transmission—hardly a market space teeming with opportunities. Today, Enron makes markets in commodities ranging from pulp and paper to pollution-emission allowances. It also controls an expansive fiber-optic network, and runs an on-line exchange—EnronOnline—whose daily trading volume ranks it among the largest e-commerce sites.

Enron began its remarkable transformation by embracing uncertainty. While conventional wisdom dictates that managers avoid uncertainty, the logic of opportunity dictates that they seek it out. Like the outlaw Willie Sutton, who robbed banks because that’s where the money was, Enron managers embraced uncertainty because that’s where the juicy opportunities lay. Enron’s managers expanded from their traditional pipeline business into wholesale energy distribution, trading, and global energy. At a time when other energy executives were doggedly defending their regulatory protection, Enron CEO Ken Lay aggressively lobbied to accelerate deregulation in order to create new opportunities for Enron to exploit.

Once they had plunged into the brave new world of deregulated energy, Enron managers faced a challenge common to new-economy companies but rare among utilities—how to navigate among the overabundance of opportunities. To shift among opportunities, Enron mostly relied on small moves, which are faster and safer than large ones. Often, the moves were made from the bottom—many of Enron’s new trading businesses began as one-person operations.

The company needed to provide some structure for all this movement among opportunities. Enter key processes and simple rules. In Enron’s commodities-trading businesses, for example, strategy centers on the risk management process and two simple rules: all trades must be balanced with an offsetting trade to minimize unhedged risk, and each trader must report a

daily profit-and-loss statement. As long as they follow these how-to rules, Enron’s traders are free to pursue new opportunities. The strategy has led the company to pioneer markets for commodities that had never been traded before, including fiber-optic bandwidth, pollution-emission credits, and weather derivatives—contracts that allow companies to hedge their weather-related risk.

When it comes to strategic processes and simple rules, one size doesn’t fit all. When Enron pioneered outsourced energy-management services in 1996, every organization with a high energy bill was a potential customer. To select from the overwhelming number of opportunities, Enron managers focused on the customer-screening process and articulated a few boundary rules to identify attractive customers: a target customer must have outsourced before, energy must not be the core of its business, and contacts with Enron must already exist somewhere within the company. In addition, Enron’s salespeople must deal directly with the CEO or CFO, because only the top executives can assess the potential for companywide savings and then commit. In four years, Enron Energy Services has grown from nothing to $15 billion in sales.

When pursuing novel opportunities such as trading weather derivatives and providing outsourced energy management, it’s impossible for Enron managers to predict which initiatives will take off. Managers must be prepared, therefore, to reinforce successful moves that gain traction, even if those successes run counter to managers’ preconceived notions of what should work. Fiber-optic cable, for example, had little to do with Enron’s core energy business, but managers quickly recognized its potential and backed a winner.

In uncertain markets, not every opportunity pans out. Savvy managers respond not by making fewer moves but by cutting their losses quickly: after Enron’s acquisition of Portland General failed to work out according to plan, the company quickly put the utility back on the block. Managers at Enron also try to build on mistakes by salvaging what did work and recombining it with other resources to create new opportunities. This recombination works particularly well for large companies like Enron that have an abundance of “genetic material”—technologies, products, and expertise—for creative combinations. So while the Portland General acquisition as a whole failed to pan out, Enron managers salvaged the utility’s fledgling broadband cable business and combined it with Enron’s expertise in trading to create a host of new opportunities in buying and selling broadband capacity and running a fiber-optic network.

The Enron story also illustrates the importance of “finishing strong” when managers discover a huge opportunity. In chaotic markets, the initial move, no matter how masterful, rarely yields unambiguous success. Rather, initial

moves unearth subsequent opportunities that may prove huge, as e-commerce and broadband cable have for Enron. The key risks in pursuing uncertain opportunities are that moves may become too tentative—too prone to quick retreat—and that managers might grow overly cautious in pursuing the big opportunities that promise outsized payoffs. Enron has succeeded, in large part, because its managers finish strong. In broadband, the company reinforced early successes through moves such as delivering movies on demand in partnership with Blockbuster. Similarly, after Enron’s initial foray into Internet trading took off, top executives rapidly redeployed resources from throughout the company to scale EnronOnline.

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What Is Strategy?

Like all effective strategies, strategy as simple rules is about being different. But that difference does not arise from tightly linked activity systems or leveraged core competencies, as in traditional strategies. It arises from focusing on key strategic processes and developing simple rules that shape those processes. When a pattern emerges from the processes—a pattern that creates network effects or economies of scale or scope—the result can be a long-term competitive advantage like the ones Intel and Microsoft achieved for over a decade. More often, the competitive advantage is short term.

The more significant point, though, is that no one can predict how long an advantage will last. An executive must manage, therefore, as if it could all end tomorrow. The new economy and other chaotic markets are too uncertain to do otherwise. From newcomers like Yahoo! founder Jerry Yang, who claims, “We live on the edge,” to Dell’s Michael Dell, who famously said, “The only constant is change,” there’s almost universal recognition that the most salient feature of competitive advantage in these markets is not sustainability but unpredictability.

In stable markets, managers can rely on complicated strategies built on detailed predictions of the future. But in

complicated, fast-moving markets where significant growth and wealth creation can occur, unpredictability reigns. It makes sense to follow the lead of entrepreneurs and underdogs—seize opportunities in the here and now with a handful of rules and a few key processes. In other words, when business becomes complicated, strategy should be simple.

1. Data on the Yahoo! product launch is drawn from Marco Iansiti and Alan MacCormack, “Living on Internet Time,” HBS case no. 6-97-052, 1999.

2. Data on Intel’s exit from microprocessors is drawn from Robert A. Burgelman, Dennis L. Carter, and Raymond S. Bamford, “Intel Corporation: The Evolution of an Adaptive Organization,” Stanford Graduate School of Business case no. SM-65, 1999.

A version of this article appeared in the January 2001 issue of Harvard Business Review.

The Competitive Advantage of Nations

The Competitive Advantage of Nations

The competitive advantage of nations by Michel E. Porter

tional prosperity is created, not inherited. It does not grow out of a country’s natural endowments, its labor pool, its interest rates, or its currency’s value, as classical economics insists.

A nation’s competitiveness depends on the capacity of its industry to innovate and upgrade. Companies gain advantage against the world’s best competitors because of pressure and challenge. They benefit from having strong domestic rivals, aggressive home-based suppliers, and demanding local customers.

In a world of increasingly global competition, nations have become more, not less, important. As the basis of competition has shifted more and more to the creation and assimilation of knowledge, the role of the nation has grown. Competitive advantage is created and sustained through a highly localized process. Differences in national values, culture, economic structures, institutions, and histories all contribute to competitive success. There are striking differences in the patterns of competitiveness in every country; no nation can or will be competitive in every or even most industries. Ultimately, nations succeed in particular industries because their home environment is the most forward-looking, dynamic, and challenging.

These conclusions, the product of a four-year study of the patterns of competitive success in ten leading trading

nations, contradict the conventional wisdom that guides the thinking of many companies and national governments—and that is pervasive today in the United States. (For more about the study, see the insert “Patterns of National Competitive Success.”) According to prevailing thinking, labor costs, interest rates, exchange rates, and economies of scale are the most potent determinants of competitiveness. In companies, the words of the day are merger, alliance, strategic partnerships, collaboration, and supranational globalization. Managers are pressing for more government support for particular industries. Among governments, there is a growing tendency to experiment with various policies intended to promote national competitiveness—from efforts to manage exchange rates to new measures to manage trade to policies to relax antitrust—which usually end up only under mining it. (See the insert “What Is National Competitiveness?”)

Patterns of National Competitive Success by: Michael E. Porter

To investigate why nations gain competitive advantage in particular industries and the implications for company strategy and national economies, I conducted a four-year study of ten important trading nations: Denmark, Germany, Italy, Japan, Korea, Singapore, Sweden, Switzerland, the United Kingdom, and the United States. I was assisted by a team of more than 30 researchers, most of whom were natives of and based in the nation they studied. The researchers all used the same methodology.

Three nations—the United States, Japan, and Germany—are the world’s leading industrial powers. The other nations represent a variety of population sizes, government policies toward industry, social philosophies, geographical sizes, and locations. Together, the ten nations accounted for fully 50% of total world exports in 1985, the base year for statistical analysis.

Most previous analyses of national competitiveness have focused on single nation or bilateral comparisons. By studying nations with widely varying characteristics and circumstances, this study sought to separate the fundamental forces underlying national competitive advantage from the idiosyncratic ones.

In each nation, the study consisted of two parts. The first identified all industries in which the nation’s companies were internationally successful, using available statistical data, supplementary published sources, and field interviews. We defined a nation’s industry as internationally successful if it possessed competitive advantage relative to the best worldwide competitors. Many measures of competitive advantage, such as reported profitability, can be misleading. We chose as the best indicators the presence of substantial and sustained exports to a wide array of other nations and/or significant outbound foreign investment based on skills and assets created in the home country. A nation was considered the home base for a company if it was either a locally owned, indigenous enterprise or managed autonomously although owned by a foreign company or investors. We then created a profile of all the industries in which each nation was internationally successful at three points in time: 1971, 1978, and 1985. The pattern of competitive industries in each economy was far from random: the task was to explain it and how it had changed over time. Of particular interest were the connections or relationships among the nation’s competitive industries.

In the second part of the study, we examined the history of competition in particular industries to understand how competitive advantage was created. On the basis of national profiles, we selected over 100 industries or industry groups for detailed study; we examined many more in less detail. We went back as far as necessary to understand how and why the industry began in the nation, how it grew, when and why

companies from the nation developed international competitive advantage, and the process by which competitive advantage had been either sustained or lost. The resulting case histories fall short of the work of a good historian in their level of detail, but they do provide insight into the development of both the industry and the nation’s economy.

We chose a sample of industries for each nation that represented the most important groups of competitive industries in the economy. The industries studied accounted for a large share of total exports in each nation: more than 20% of total exports in Japan, Germany, and Switzerland, for example, and more than 40% in South Korea. We studied some of the most famous and important international success stories—German high-performance autos and chemicals, Japanese semi-conductors and VCRs, Swiss banking and pharmaceuticals, Italian footwear and textiles, U.S. commercial aircraft and motion pictures—and some relatively obscure but highly competitive industries—South Korean pianos, Italian ski boots, and British biscuits. We also added a few industries because they appeared to be paradoxes: Japanese home demand for Western-character typewriters is nearly nonexistent, for example, but Japan holds a strong export and foreign investment position in the industry. We avoided industries that were highly dependent on natural resources: such industries do not form the backbone of advanced economies, and the capacity to compete in them is more explicable using classical theory. We did, however, include a number of more technologically intensive, natural-resource-related industries such as newsprint and agricultural chemicals.

The sample of nations and industries offers a rich empirical foundation for developing and testing the new theory of how countries gain competitive advantage. The accompanying article concentrates on the determinants of competitive

advantage in individual industries and also sketches out some of the study’s overall implications for government policy and company strategy. A fuller treatment in my book, The Competitive Advantage of Nations,develops the theory and its implications in greater depth and provides many additional examples. It also contains detailed descriptions of the nations we studied and the future prospects for their economies.

 

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What Is National Competitiveness? by: Michael E. Porter

National competitiveness has become one of the central preoccupations of government and industry in every nation. Yet for all the discussion, debate, and writing on the topic, there is still no persuasive theory to explain national competitiveness. What is more, there is not even an accepted definition of the term “competitiveness” as applied to a nation. While the notion of a competitive company is clear, the notion of a competitive nation is not.

Some see national competitiveness as a macroeconomic phenomenon, driven by variables such as exchange rates, interest rates, and government deficits. But Japan, Italy, and South Korea have all enjoyed rapidly rising living standards despite budget deficits; Germany and Switzerland despite appreciating currencies; and Italy and Korea despite high interest rates.

Others argue that competitiveness is a function of cheap and abundant labor. But Germany, Switzerland, and Sweden have all prospered even with high wages and labor shortages. Besides, shouldn’t a nation seek higher wages for its workers as a goal of competitiveness?

Another view connects competitiveness with bountiful natural resources. But how, then, can one explain the success of Germany, Japan, Switzerland, Italy, and South Korea—countries with limited natural resources?

More recently, the argument has gained favor that competitiveness is driven by government policy: targeting, protection, import promotion, and subsidies have propelled Japanese and South Korean auto, steel, shipbuilding, and semiconductor industries into global preeminence. But a closer look reveals a spotty record. In Italy, government intervention has been ineffectual—but Italy has experienced a boom in world export share second only to Japan. In Germany, direct government intervention in exporting industries is rare. And even in Japan and South Korea, government’s role in such important industries as facsimile machines, copiers, robotics, and advanced materials has been modest; some of the most frequently cited examples, such as sewing machines, steel, and shipbuilding, are now quite dated.

A final popular explanation for national competitiveness is differences in management practices, including management-labor relations. The problem here, however, is that different industries require different approaches to management. The successful management practices governing small, private, and loosely organized Italian family companies in footwear, textiles, and jewelry, for example, would produce a management disaster if applied to German chemical or auto companies, Swiss pharmaceutical makers, or American aircraft producers. Nor is it possible to generalize about management-labor relations. Despite the commonly held view that powerful unions undermine competitive advantage, unions are strong in Germany and Sweden—and both countries boast internationally preeminent companies.

Clearly, none of these explanations is fully satisfactory; none is sufficient by itself to rationalize the competitive position of industries within a national border. Each contains some truth; but a broader, more complex set of forces seems to be at work.

The lack of a clear explanation signals an even more fundamental question. What is a “competitive” nation in the first place? Is a “competitive” nation one where every company or industry is competitive? No nation meets this test. Even Japan has large sectors of its economy that fall far behind the world’s best competitors.

Is a “competitive” nation one whose exchange rate makes its goods price competitive in international markets? Both Germany and Japan have enjoyed remarkable gains in their standards of living—and experienced sustained periods of strong currency and rising prices. Is a “competitive” nation one with a large positive balance of trade? Switzerland has roughly balanced trade; Italy has a chronic trade deficit—both nations enjoy strongly rising national income. Is a “competitive” nation one with low labor costs? India and Mexico both have low wages and low labor costs—but neither seems an attractive industrial model.

The only meaningful concept of competitiveness at the national level isproductivity. The principal goal of a nation is to produce a high and rising standard of living for its citizens. The ability to do so depends on the productivity with which a nation’s labor and capital are employed. Productivity is the value of the output produced by a unit of labor or capital. Productivity depends on both the quality and features of products (which determine the prices that they can command) and the efficiency with which they are produced. Productivity is the prime determinant of a nation’s long-run standard of living; it is the root cause of national per capita income. The productivity of human resources determines

employee wages; the productivity with which capital is employed determines the return it earns for its holders.

A nation’s standard of living depends on the capacity of its companies to achieve high levels of productivity—and to increase productivity over time. Sustained productivity growth requires that an economy continually upgrade itself. A nation’s companies must relentlessly improve productivity in existing industries by raising product quality, adding desirable features, improving product technology, or boosting production efficiency. They must develop the necessary capabilities to compete in more and more sophisticated industry segments, where productivity is generally high. They must finally develop the capability to compete in entirely new, sophisticated industries.

International trade and foreign investment can both improve a nation’s productivity as well as threaten it. They support rising national productivity by allowing a nation to specialize in those industries and segments of industries where its companies are more productive and to import where its companies are less productive. No nation can be competitive in everything. The ideal is to deploy the nation’s limited pool of human and other resources into the most productive uses. Even those nations with the highest standards of living have many industries in which local companies are uncompetitive.

Yet international trade and foreign investment also can threaten productivity growth. They expose a nation’s industries to the test of international standards of productivity. An industry will lose out if its productivity is not sufficiently higher than foreign rivals’ to offset any advantages in local wage rates. If a nation loses the ability to compete in a range of high-productivity/high-wage industries, its standard of living is threatened.

Defining national competitiveness as achieving a trade surplus or balanced trade per se is inappropriate. The expansion of exports because of low wages and a weak currency, at the same time that the nation imports sophisticated goods that its companies cannot produce competitively, may bring trade into balance or surplus but lowers the nation’s standard of living. Competitiveness also does not mean jobs. It’s the type of jobs, not just the ability to employ citizens at low wages, that is decisive for economic prosperity.

Seeking to explain “competitiveness” at the national level, then, is to answer the wrong question. What we must understand instead is the determinants of productivity and the rate of productivity growth. To find answers, we must focus not on the economy as a whole but onspecific industries and industry segments.We must understand how and why commercially viable skills and technology are created, which can only be fully understood at the level of particular industries. It is the outcome of the thousands of struggles for competitive advantage against foreign rivals in particular segments and industries, in which products and processes are created and improved, that underpins the process of upgrading national productivity.

When one looks closely at any national economy, there are striking differences among a nation’s industries in competitive success. International advantage is often concentrated in particular industry segments. German exports of cars are heavily skewed toward high-performance cars, while Korean exports are all compacts and subcompacts. In many industries and segments of industries, the competitors with true international competitive advantage are based in only a few nations.

Our search, then, is for the decisive characteristic of a nation that allows its companies to create and sustain competitive

advantage in particular fields—the search is for the competitive advantage of nations. We are particularly concerned with the determinants of international success in technology-and skill-intensive segments and industries, which underpin high and rising productivity.

Classical theory explains the success of nations in particular industries based on so-called factors of production such as land, labor, and natural resources. Nations gain factor-based comparative advantage in industries that make intensive use of the factors they possess in abundance. Classical theory, however, has been overshadowed in advanced industries and economies by the globalization of competition and the power of technology.

A new theory must recognize that in modern international competition, companies compete with global strategies involving not only trade but also foreign investment. What a new theory must explain is why a nation provides a favorable home base for companies that compete internationally. The home base is the nation in which the essential competitive advantages of the enterprise are created and sustained. It is where a company’s strategy is set, where the core product and process technology is created and maintained, and where the most productive jobs and most advanced skills are located. The presence of the home base in a nation has the greatest positive influence on other linked domestic industries and leads to other benefits in the nation’s economy. While the ownership of the company is often concentrated at the home base, the nationality of shareholders is secondary.

A new theory must move beyond comparative advantage to the competitive advantage of a nation. It must reflect a rich conception of competition that includes segmented markets, differentiated products, technology differences, and economies of scale. A new theory must go beyond cost and

explain why companies from some nations are better than others at creating advantages based on quality, features, and new product innovation. A new theory must begin from the premise that competition is dynamic and evolving; it must answer the questions: Why do some companies based in some nations innovate more than others? Why do some nations provide an environment that enables companies to improve and innovate faster than foreign rivals?

 

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These approaches, now much in favor in both companies and governments, are flawed. They fundamentally misperceive the true sources of competitive advantage. Pursuing them, with all their short-term appeal, will virtually guarantee that the United States—or any other advanced nation—never achieves real and sustainable competitive advantage.

We need a new perspective and new tools—an approach to competitiveness that grows directly out of an analysis of internationally successful industries, without regard for traditional ideology or current intellectual fashion. We need to know, very simply, what works and why. Then we need to apply it.

How Companies Succeed in International Markets

Around the world, companies that have achieved international leadership employ strategies that differ from each other in every respect. But while every successful company will employ its own particular strategy, the underlying mode of operation—the character and trajectory of all successful companies—is fundamentally the same.

Companies achieve competitive advantage through acts of innovation. They approach innovation in its broadest sense, including both new technologies and new ways of doing things. They perceive a new basis for competing or find better means for competing in old ways. Innovation can be manifested in a new product design, a new production process, a new marketing approach, or a new way of conducting training. Much innovation is mundane and incremental, depending more on a cumulation of small insights and advances than on a single, major technological breakthrough. It often involves ideas that are not even “new”—ideas that have been around, but never vigorously pursued. It always involves investments in skill and knowledge, as well as in physical assets and brand reputations.

Some innovations create competitive advantage by perceiving an entirely new market opportunity or by serving a market segment that others have ignored. When competitors are slow to respond, such innovation yields competitive advantage. For instance, in industries such as autos and home electronics, Japanese companies gained their initial advantage by emphasizing smaller, more compact, lower capacity models that foreign competitors disdained as less profitable, less important, and less attractive.

In international markets, innovations that yield competitive advantage anticipate both domestic and foreign needs. For example, as international concern for product safety has grown, Swedish companies like Volvo, Atlas Copco, and AGA have succeeded by anticipating the market opportunity in this area. On the other hand, innovations that respond to concerns or circumstances that are peculiar to the home market can actually retard international competitive success. The lure of the huge U.S. defense market, for instance, has diverted the attention of U.S. materials and machine-tool companies from attractive, global commercial markets.

Information plays a large role in the process of innovation and improvement—information that either is not available to competitors or that they do not seek. Sometimes it comes from simple investment in research and development or market research; more often, it comes from effort and from openness and from looking in the right place unencumbered by blinding assumptions or conventional wisdom.

This is why innovators are often outsiders from a different industry or a different country. Innovation may come from a new company, whose founder has a nontraditional background or was simply not appreciated in an older, established company. Or the capacity for innovation may come into an existing company through senior managers who are new to the particular industry and thus more able to perceive opportunities and more likely to pursue them. Or innovation may occur as a company diversifies, bringing new resources, skills, or perspectives to another industry. Or innovations may come from another nation with different circumstances or different ways of competing.

With few exceptions, innovation is the result of unusual effort. The company that successfully implements a new or better way of competing pursues its approach with dogged determination, often in the face of harsh criticism and tough obstacles. In fact, to succeed, innovation usually requires pressure, necessity, and even adversity: the fear of loss often proves more powerful than the hope of gain.

Once a company achieves competitive advantage through an innovation, it can sustain it only through relentless improvement. Almost any advantage can be imitated. Korean companies have already matched the ability of their Japanese rivals to mass-produce standard color televisions and VCRs; Brazilian companies have assembled technology and designs comparable to Italian competitors in casual leather footwear.

Competitors will eventually and inevitably overtake any company that stops improving and innovating. Sometimes early-mover advantages such as customer relationships, scale economies in existing technologies, or the loyalty of distribution channels are enough to permit a stagnant company to retain its entrenched position for years or even decades. But sooner or later, more dynamic rivals will find a way to innovate around these advantages or create a better or cheaper way of doing things. Italian appliance producers, which competed successfully on the basis of cost in selling midsize and compact appliances through large retail chains, rested too long on this initial advantage. By developing more differentiated products and creating strong brand franchises, German competitors have begun to gain ground.

Ultimately, the only way to sustain a competitive advantage is to upgrade it— to move to more sophisticated types. This is precisely what Japanese auto-makers have done. They initially penetrated foreign markets with small, inexpensive compact cars of adequate quality and competed on the basis of lower labor costs. Even while their labor-cost advantage persisted, however, the Japanese companies were upgrading. They invested aggressively to build large modern plants to reap economies of scale. Then they became innovators in process technology, pioneering just-in-time production and a host of other quality and productivity practices. These process improvements led to better product quality, better repair records, and better customer-satisfaction ratings than foreign competitors had. Most recently, Japanese automakers have advanced to the vanguard of product technology and are introducing new, premium brand names to compete with the world’s most prestigious passenger cars.

The example of the Japanese automakers also illustrates two additional prerequisites for sustaining competitive advantage. First, a company must adopt a global approach to strategy. It must sell its product worldwide, under its own

brand name, through international marketing channels that it controls. A truly global approach may even require the company to locate production or R&D facilities in other nations to take advantage of lower wage rates, to gain or improve market access, or to take advantage of foreign technology. Second, creating more sustainable advantages often means that a company must make its existing advantage obsolete—even while it is still an advantage. Japanese auto companies recognized this; either they would make their advantage obsolete, or a competitor would do it for them.

As this example suggests, innovation and change are inextricably tied together. But change is an unnatural act, particularly in successful companies; powerful forces are at work to avoid and defeat it. Past approaches become institutionalized in standard operating procedures and management controls. Training emphasizes the one correct way to do anything; the construction of specialized, dedicated facilities solidifies past practice into expensive brick and mortar; the existing strategy takes on an aura of invincibility and becomes rooted in the company culture.

Successful companies tend to develop a bias for predictability and stability; they work on defending what they have. Change is tempered by the fear that there is much to lose. The organization at all levels filters out information that would suggest new approaches, modifications, or departures from the norm. The internal environment operates like an immune system to isolate or expel “hostile” individuals who challenge current directions or established thinking. Innovation ceases; the company becomes stagnant; it is only a matter of time before aggressive competitors overtake it.

The Diamond of National Advantage

Why are certain companies based in certain nations capable of consistent innovation? Why do they ruthlessly pursue improvements, seeking an ever more sophisticated source of competitive advantage? Why are they able to overcome the substantial barriers to change and innovation that so often accompany success?

The answer lies in four broad attributes of a nation, attributes that individually and as a system constitute the diamond of national advantage, the playing field that each nation establishes and operates for its industries. These attributes are.

1. Factor Conditions. The nation’s position in factors of production, such as skilled labor or infrastructure, necessary to compete in a given industry.

2. Demand Conditions. The nature of home-market demand for the industry’s product or service.

3. Related and Supporting Industries. The presence or absence in the nation of supplier industries and other related industries that are internationally competitive.

4. Firm Strategy, Structure, and Rivalry. The conditions in the nation governing how companies are created, organized, and managed, as well as the nature of domestic rivalry.

These determinants create the national environment in which companies are born and learn how to compete. (See the diagram “Determinants of National Competitive Advantage.”) Each point on the diamond—and the diamond as a system—affects essential ingredients for achieving international competitive success: the availability of resources and skills necessary for competitive advantage in an industry; the information that shapes the opportunities that companies perceive and the directions in which they deploy their resources and skills; the goals of the owners, managers, and

individuals in companies; and most important, the pressures on companies to invest and innovate. (See the insert “How the Diamond Works: The Italian Ceramic Tile Industry.”)

Determinants of National Competitive Advantage

How the Diamond Works: The Italian Ceramic Tile Industry by: Michael J. Enright by: Paolo Tenti

In 1987, Italian companies were world leaders in the production and export of ceramic tiles, a $10 billion industry. Italian producers, concentrated in and around the small town of Sassuolo in the Emilia-Romagna region, accounted for about 30% of world production and almost 60%of world

exports. The Italian trade surplus that year in ceramic tiles was about $1.4 billion.

The development of the Italian ceramic tile industry’s competitive advantage illustrates how the diamond of national advantage works. Sassuolo’s sustainable competitive advantage in ceramic tiles grew not from any static or historical advantage but from dynamism and change. Sophisticated and demanding local buyers, strong and unique distribution channels, and intense rivalry among local companies created constant pressure for innovation. Knowledge grew quickly from continuous experimentation and cumulative production experience. Private ownership of the companies and loyalty to the community spawned intense commitment to invest in the industry.

Tile producers benefited as well from a highly developed set of local machinery suppliers and other supporting industries, producing materials, services, and infrastructure. The presence of world-class, Italian-related industries also reinforced Italian strength in tiles. Finally, the geographic concentration of the entire cluster supercharged the whole process. Today foreign companies compete against an entire subculture. The organic nature of this system represents the most sustainable advantage of Sassuolo’s ceramic tile companies.

The Origins of the Italian Industry

Tile production in Sassuolo grew out of the earthen-ware and crockery industry, whose history traces back to the thirteenth century. Immediately after World War II, there were only a handful of ceramic tile manufacturers in and around Sassuolo, all serving the local market exclusively.

Demand for ceramic tiles within Italy began to grow dramatically in the immediate postwar years, as the

reconstruction of Italy triggered a boom in building materials of all kinds. Italian demand for ceramic tiles was particularly great due to the climate, local tastes, and building techniques.

Because Sassuolo was in a relatively prosperous part of Italy, there were many who could combine the modest amount of capital and necessary organizational skills to start a tile company. In 1955, there were 14 Sassuolo area tile companies; by 1962, there were 102.

The new tile companies benefited from a local pool of mechanically trained workers. The region around Sassuolo was home to Ferrari, Maserati, Lamborghini, and other technically sophisticated companies. As the tile industry began to grow and prosper, many engineers and skilled workers gravitated to the successful companies.

The Emerging Italian Tile Cluster

Initially, Italian tile producers were dependent on foreign sources of raw materials and production technology. In the 1950s, the principal raw materials used to make tiles were kaolin (white) clays. Since there were red- but no white-clay deposits near Sassuolo, Italian producers had to import the clays from the United Kingdom. Tile-making equipment was also imported in the 1950s and 1960s: kilns from Germany, America, and France; presses for forming tiles from Germany. Sassuolo tile makers had to import even simple glazing machines.

Over time, the Italian tile producers learned how to modify imported equipment to fit local circumstances: red versus white clays, natural gas versus heavy oil. As process technicians from tile companies left to start their own equipment companies, a local machinery industry arose in Sassuolo. By 1970, Italian companies had emerged as world-

class producers of kilns and presses; the earlier situation had exactly reversed: they were exporting their red-clay equipment for foreigners to use with white clays.

The relationship between Italian tile and equipment manufacturers was a mutually supporting one, made even more so by close proximity. In the mid-1980s, there were some 200 Italian equipment manufacturers; more than 60% were located in the Sassuolo area. The equipment manufacturers competed fiercely for local business, and tile manufacturers benefited from better prices and more advanced equipment than their foreign rivals.

As the emerging tile cluster grew and concentrated in the Sassuolo region, a pool of skilled workers and technicians developed, including engineers, production specialists, maintenance workers, service technicians, and design personnel. The industry’s geographic concentration encouraged other supporting companies to form, offering molds, packaging materials, glazes, and transportation services. An array of small, specialized consulting companies emerged to give advice to tile producers on plant design, logistics, and commercial, advertising, and fiscal matters.

With its membership concentrated in the Sassuolo area, Assopiastrelle, the ceramic tile industry association, began offering services in areas of common interest: bulk purchasing, foreign-market research, and consulting on fiscal and legal matters. The growing tile cluster stimulated the formation of a new, specialized factor-creating institution: in 1976, a consortium of the University of Bologna, regional agencies, and the ceramic industry association founded the Centro Ceramico di Bologna, which conducted process research and product analysis.

Sophisticated Home Demand

By the mid-1960s, per-capita tile consumption in Italy was considerably higher than in the rest of the world. The Italian market was also the world’s most sophisticated. Italian customers, who were generally the first to adopt new designs and features, and Italian producers, who constantly innovated to improve manufacturing methods and create new designs, progressed in a mutually reinforcing process.

The uniquely sophisticated character of domestic demand also extended to retail outlets. In the 1960s, specialized tile showrooms began opening in Italy. By 1985, there were roughly 7,600 specialized showrooms handling approximately 80%of domestic sales, far more than in other nations. In 1976, the Italian company Piemme introduced tiles by famous designers to gain distribution outlets and to build brand name awareness among consumers. This innovation drew on another related industry, design services, in which Italy was world leader, with over$10 billion in exports.

Sassuolo Rivalry

The sheer number of tile companies in the Sassuolo area created intense rivalry. News of product and process innovations spread rapidly, and companies seeking technological, design, and distribution leadership had to improve constantly.

Proximity added a personal note to the intense rivalry. All of the producers were privately held, most were family run. The owners all lived in the same area, knew each other, and were the leading citizens of the same towns.

Pressures to Upgrade

In the early 1970s, faced with intense domestic rivalry, pressure from retail customers, and the shock of the 1973 energy crisis, Italian tile companies struggled to reduce gas

and labor costs. These efforts led to a technological breakthrough, the rapid single-firing process, in which the hardening process, material transformation, and glaze-fixing all occurred in one pass through the kiln. A process that took 225 employees using the double-firing method needed only 90 employees using single-firing roller kilns. Cycle time dropped from 16 to 20 hours to only 50 to 55 minutes.

The new, smaller, and lighter equipment was also easier to export. By the early 1980s, exports from Italian equipment manufacturers exceeded domestic sales; in 1988, exports represented almost 80%of total sales.

Working together, tile manufacturers and equipment manufacturers made the next important breakthrough during the mid-and late 1970s: the development of materials-handling equipment that transformed tile manufacture from a batch process to a continuous process. The innovation reduced high labor costs—which had been a substantial selective factor disadvantage facing Italian tile manufacturers.

The common perception is that Italian labor costs were lower during this period than those in the United States and Germany. In those two countries, however, different jobs had widely different wages. In Italy, wages for different skill categories were compressed, and work rules constrained manufacturers from using overtime or multiple shifts. The restriction proved costly: once cool, kilns are expensive to reheat and are best run continuously. Because of this factor disadvantage, the Italian companies were the first to develop continuous, automated production.

Internationalization

By 1970, Italian domestic demand had matured. The stagnant Italian market led companies to step up their efforts

to pursue foreign markets. The presence of related and supporting Italian industries helped in the export drive. Individual tile manufacturers began advertising in Italian and foreign home-design and architectural magazines, publications with wide global circulation among architects, designers, and consumers. This heightened awareness reinforced the quality image of Italian tiles. Tile makers were also able to capitalize on Italy’s leading world export positions in related industries like marble, building stone, sinks, washbasins, furniture, lamps, and home appliances.

Assopiastrelle, the industry association, established trade-promotion offices in the United States in 1980, in Germany in 1984, and in France in 1987. It organized elaborate trade shows in cities ranging from Bologna to Miami and ran sophisticated advertising. Between 1980 and 1987, the association spent roughly $8 million to promote Italian tiles in the United States.

 

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When a national environment permits and supports the most rapid accumulation of specialized assets and skills—sometimes simply because of greater effort and commitment—companies gain a competitive advantage. When a national environment affords better ongoing information and insight into product and process needs, companies gain a competitive advantage. Finally, when the national environment pressures companies to innovate and invest, companies both gain a competitive advantage and upgrade those advantages over time.

Factor Conditions. According to standard economic theory, factors of production—labor, land, natural resources, capital, infrastructure—will determine the flow of trade. A nation will

export those goods that make most use of the factors with which it is relatively well endowed. This doctrine, whose origins date back to Adam Smith and David Ricardo and that is embedded in classical economics, is at best incomplete and at worst incorrect.

In the sophisticated industries that form the backbone of any advanced economy, a nation does not inherit but instead creates the most important factors of production—such as skilled human resources or a scientific base. Moreover, the stock of factors that a nation enjoys at a particular time is less important than the rate and efficiency with which it creates, upgrades, and deploys them in particular industries.

The most important factors of production are those that involve sustained and heavy investment and are specialized. Basic factors, such as a pool of labor or a local raw-material source, do not constitute an advantage in knowledge-intensive industries. Companies can access them easily through a global strategy or circumvent them through technology. Contrary to conventional wisdom, simply having a general work force that is high school or even college educated represents no competitive advantage in modern international competition. To support competitive advantage, a factor must be highly specialized to an industry’s particular needs—a scientific institute specialized in optics, a pool of venture capital to fund software companies. These factors are more scarce, more difficult for foreign competitors to imitate—and they require sustained investment to create.

Nations succeed in industries where they are particularly good at factor creation. Competitive advantage results from the presence of world-class institutions that first create specialized factors and then continually work to upgrade them. Denmark has two hospitals that concentrate in studying and treating diabetes—and a world-leading export position in insulin. Holland has premier research institutes in

the cultivation, packaging, and shipping of flowers, where it is the world’s export leader.

What is not so obvious, however, is that selective disadvantages in the more basic factors can prod a company to innovate and upgrade—a disadvantage in a static model of competition can become an advantage in a dynamic one. When there is an ample supply of cheap raw materials or abundant labor, companies can simply rest on these advantages and often deploy them inefficiently. But when companies face a selective disadvantage, like high land costs, labor shortages, or the lack of local raw materials, they must innovate and upgrade to compete.

Implicit in the oft-repeated Japanese statement, “We are an island nation with no natural resources,” is the understanding that these deficiencies have only served to spur Japan’s competitive innovation. Just-in-time production, for example, economized on prohibitively expensive space. Italian steel producers in the Brescia area faced a similar set of disadvantages: high capital costs, high energy costs, and no local raw materials. Located in Northern Lombardy, these privately owned companies faced staggering logistics costs due to their distance from southern ports and the inefficiencies of the state-owned Italian transportation system. The result: they pioneered technologically advanced minimills that require only modest capital investment, use less energy, employ scrap metal as the feedstock, are efficient at small scale, and permit producers to locate close to sources of scrap and end-use customers. In other words, they converted factor disadvantages into competitive advantage.

Disadvantages can become advantages only under certain conditions. First, they must send companies proper signals about circumstances that will spread to other nations, thereby equipping them to innovate in advance of foreign

rivals. Switzerland, the nation that experienced the first labor shortages after World War II, is a case in point. Swiss companies responded to the disadvantage by upgrading labor productivity and seeking higher value, more sustainable market segments. Companies in most other parts of the world, where there were still ample workers, focused their attention on other issues, which resulted in slower upgrading.

The second condition for transforming disadvantages into advantages is favorable circumstances elsewhere in the diamond—a consideration that applies to almost all determinants. To innovate, companies must have access to people with appropriate skills and have home-demand conditions that send the right signals. They must also have active domestic rivals who create pressure to innovate. Another precondition is company goals that lead to sustained commitment to the industry. Without such a commitment and the presence of active rivalry, a company may take an easy way around a disadvantage rather than using it as a spur to innovation.

For example, U.S. consumer-electronics companies, faced with high relative labor costs, chose to leave the product and production process largely unchanged and move labor-intensive activities to Taiwan and other Asian countries. Instead of upgrading their sources of advantage, they settled for labor-cost parity. On the other hand, Japanese rivals, confronted with intense domestic competition and a mature home market, chose to eliminate labor through automation. This led to lower assembly costs, to products with fewer components and to improved quality and reliability. Soon Japanese companies were building assembly plants in the United States—the place U.S. companies had fled.

Demand Conditions. It might seem that the globalization of competition would diminish the importance of home demand. In practice, however, this is simply not the case. In fact, the

composition and character of the home market usually has a disproportionate effect on how companies perceive, interpret, and respond to buyer needs. Nations gain competitive advantage in industries where the home demand gives their companies a clearer or earlier picture of emerging buyer needs, and where demanding buyers pressure companies to innovate faster and achieve more sophisticated competitive advantages than their foreign rivals. The size of home demand proves far less significant than the character of home demand.

Home-demand conditions help build competitive advantage when a particular industry segment is larger or more visible in the domestic market than in foreign markets. The larger market segments in a nation receive the most attention from the nation’s companies; companies accord smaller or less desirable segments a lower priority. A good example is hydraulic excavators, which represent the most widely used type of construction equipment in the Japanese domestic market—but which comprise a far smaller proportion of the market in other advanced nations. This segment is one of the few where there are vigorous Japanese international competitors and where Caterpillar does not hold a substantial share of the world market.

More important than the mix of segments per se is the nature of domestic buyers. A nation’s companies gain competitive advantage if domestic buyers are the world’s most sophisticated and demanding buyers for the product or service. Sophisticated, demanding buyers provide a window into advanced customer needs; they pressure companies to meet high standards; they prod them to improve, to innovate, and to upgrade into more advanced segments. As with factor conditions, demand conditions provide advantages by forcing companies to respond to tough challenges.

Especially stringent needs arise because of local values and circumstances. For example, Japanese consumers, who live in small, tightly packed homes, must contend with hot, humid summers and high-cost electrical energy—a daunting combination of circumstances. In response, Japanese companies have pioneered compact, quiet air-conditioning units powered by energy-saving rotary compressors. In industry after industry, the tightly constrained requirements of the Japanese market have forced companies to innovate, yielding products that are kei-haku-tan-sho—light, thin, short, small—and that are internationally accepted.

Local buyers can help a nation’s companies gain advantage if their needs anticipate or even shape those of other nations—if their needs provide ongoing “early-warning indicators” of global market trends. Sometimes anticipatory needs emerge because a nation’s political values foreshadow needs that will grow elsewhere. Sweden’s long-standing concern for handicapped people has spawned an increasingly competitive industry focused on special needs. Denmark’s environmentalism has led to success for companies in water-pollution control equipment and windmills.

More generally, a nation’s companies can anticipate global trends if the nation’s values are spreading—that is, if the country is exporting its values and tastes as well as its products. The international success of U.S. companies in fast food and credit cards, for example, reflects not only the American desire for convenience but also the spread of these tastes to the rest of the world. Nations export their values and tastes through media, through training foreigners, through political influence, and through the foreign activities of their citizens and companies.

Related and Supporting Industries. The third broad determinant of national advantage is the presence in the nation of related and supporting industries that are

internationally competitive. Internationally competitive home-based suppliers create advantages in downstream industries in several ways. First, they deliver the most cost-effective inputs in an efficient, early, rapid, and sometimes preferential way. Italian gold and silver jewelry companies lead the world in that industry in part because other Italian companies supply two-thirds of the world’s jewelry-making and precious-metal recycling machinery.

Far more significant than mere access to components and machinery, however, is the advantage that home-based related and supporting industries provide in innovation and upgrading—an advantage based on close working relationships. Suppliers and end-users located near each other can take advantage of short lines of communication, quick and constant flow of information, and an ongoing exchange of ideas and innovations. Companies have the opportunity to influence their suppliers’ technical efforts and can serve as test sites for R&D work, accelerating the pace of innovation.

The illustration of “The Italian Footwear Cluster” offers a graphic example of how a group of close-by, supporting industries creates competitive advantage in a range of interconnected industries that are all internationally competitive. Shoe producers, for instance, interact regularly with leather manufacturers on new styles and manufacturing techniques and learn about new textures and colors of leather when they are still on the drawing boards. Leather manufacturers gain early insights into fashion trends, helping them to plan new products. The interaction is mutually advantageous and self-reinforcing, but it does not happen automatically: it is helped by proximity, but occurs only because companies and suppliers work at it.

The nation’s companies benefit most when the suppliers are, themselves, global competitors. It is ultimately self-defeating for a company or country to create “captive” suppliers who are totally dependent on the domestic industry and prevented from serving foreign competitors. By the same token, a nation need not be competitive in all supplier industries for its companies to gain competitive advantage. Companies can readily source from abroad materials, components, or technologies without a major effect on

innovation or performance of the industry’s products. The same is true of other generalized technologies—like electronics or software—where the industry represents a narrow application area.

Home-based competitiveness in related industries provides similar benefits: information flow and technical interchange speed the rate of innovation and upgrading. A home-based related industry also increases the likelihood that companies will embrace new skills, and it also provides a source of entrants who will bring a novel approach to competing. The Swiss success in pharmaceuticals emerged out of previous international success in the dye industry, for example; Japanese dominance in electronic musical keyboards grows out of success in acoustic instruments combined with a strong position in consumer electronics.

Firm Strategy, Structure, and Rivalry. National circumstances and context create strong tendencies in how companies are created, organized, and managed, as well as what the nature of domestic rivalry will be. In Italy, for example, successful international competitors are often small or medium-sized companies that are privately owned and operated like extended families; in Germany, in contrast, companies tend to be strictly hierarchical in organization and management practices, and top managers usually have technical backgrounds.

No one managerial system is universally appropriate—notwithstanding the current fascination with Japanese management. Competitiveness in a specific industry results from convergence of the management practices and organizational modes favored in the country and the sources of competitive advantage in the industry. In industries where Italian companies are world leaders—such as lighting, furniture, footwear, woolen fabrics, and packaging machines—a company strategy that emphasizes focus, customized

products, niche marketing, rapid change, and breathtaking flexibility fits both the dynamics of the industry and the character of the Italian management system. The German management system, in contrast, works well in technical or engineering-oriented industries—optics, chemicals, complicated machinery—where complex products demand precision manufacturing, a careful development process, after-sale service, and thus a highly disciplined management structure. German success is much rarer in consumer goods and services where image marketing and rapid new-feature and model turnover are important to competition.

Countries also differ markedly in the goals that companies and individuals seek to achieve. Company goals reflect the characteristics of national capital markets and the compensation practices for managers. For example, in Germany and Switzerland, where banks comprise a substantial part of the nation’s shareholders, most shares are held for long-term appreciation and are rarely traded. Companies do well in mature industries, where ongoing investment in R&D and new facilities is essential but returns may be only moderate. The United States is at the opposite extreme, with a large pool of risk capital but widespread trading of public companies and a strong emphasis by investors on quarterly and annual share-price appreciation. Management compensation is heavily based on annual bonuses tied to individual results. America does well in relatively new industries, like software and biotechnology, or ones where equity funding of new companies feeds active domestic rivalry, like specialty electronics and services. Strong pressures leading to underinvestment, however, plague more mature industries.

Individual motivation to work and expand skills is also important to competitive advantage. Outstanding talent is a scarce resource in any nation. A nation’s success largely depends on the types of education its talented people

choose, where they choose to work, and their commitment and effort. The goals a nation’s institutions and values set for individuals and companies, and the prestige it attaches to certain industries, guide the flow of capital and human resources—which, in turn, directly affects the competitive performance of certain industries. Nations tend to be competitive in activities that people admire or depend on—the activities from which the nation’s heroes emerge. In Switzerland, it is banking and pharmaceuticals. In Israel, the highest callings have been agriculture and defense-related fields. Sometimes it is hard to distinguish between cause and effect. Attaining international success can make an industry prestigious, reinforcing its advantage.

The presence of strong local rivals is a final, and powerful, stimulus to the creation and persistence of competitive advantage. This is true of small countries, like Switzerland, where the rivalry among its pharmaceutical companies, Hoffmann-La Roche, Ciba-Geigy, and Sandoz, contributes to a leading worldwide position. It is true in the United States in the computer and software industries. Nowhere is the role of fierce rivalry more apparent than in Japan, where there are 112 companies competing in machine tools, 34 in semiconductors, 25 in audio equipment, 15 in cameras—in fact, there are usually double figures in the industries in which Japan boasts global dominance. (See the table “Estimated Number of Japanese Rivals in Selected Industries.”) Among all the points on the diamond, domestic rivalry is arguably the most important because of the powerfully stimulating effect it has on all the others.

Estimated Number of Japanese Rivals in Selected Industries Sources: Field interviews; Nippon Kogyo Shinbun, Nippon Kogyo Nenkan, 1987; Yano Research, Market Share Jitan, 1987; researchers’ estimates.

Conventional wisdom argues that domestic competition is wasteful: it leads to duplication of effort and prevents

companies from achieving economies of scale. The “right solution” is to embrace one or two national champions, companies with the scale and strength to tackle foreign competitors, and to guarantee them the necessary resources, with the government’s blessing. In fact, however, most national champions are uncompetitive, although heavily subsidized and protected by their government. In many of the prominent industries in which there is only one national rival, such as aerospace and telecommunications, government has played a large role in distorting competition.

Static efficiency is much less important than dynamic improvement, which domestic rivalry uniquely spurs. Domestic rivalry, like any rivalry, creates pressure on companies to innovate and improve. Local rivals push each other to lower costs, improve quality and service, and create new products and processes. But unlike rivalries with foreign competitors, which tend to be analytical and distant, local rivalries often go beyond pure economic or business competition and become intensely personal. Domestic rivals engage in active feuds; they compete not only for market share but also for people, for technical excellence, and perhaps most important, for “bragging rights.” One domestic rival’s success proves to others that advancement is possible and often attracts new rivals to the industry. Companies often attribute the success of foreign rivals to “unfair” advantages. With domestic rivals, there are no excuses.

Geographic concentration magnifies the power of domestic rivalry. This pattern is strikingly common around the world: Italian jewelry companies are located around two towns, Arezzo and Valenza Po; cutlery companies in Solingen, West Germany and Seki, Japan; pharmaceutical companies in Basel, Switzerland; motorcycles and musical instruments in Hamamatsu, Japan. The more localized the rivalry, the more intense. And the more intense, the better.

Another benefit of domestic rivalry is the pressure it creates for constant upgrading of the sources of competitive advantage. The presence of domestic competitors automatically cancels the types of advantage that come from simply being in a particular nation—factor costs, access to or preference in the home market, or costs to foreign competitors who import into the market. Companies are forced to move beyond them, and as a result, gain more sustainable advantages. Moreover, competing domestic rivals will keep each other honest in obtaining government support. Companies are less likely to get hooked on the narcotic of government contracts or creeping industry protectionism. Instead, the industry will seek—and benefit from—more constructive forms of government support, such as assistance in opening foreign markets, as well as investments in focused educational institutions or other specialized factors.

Ironically, it is also vigorous domestic competition that ultimately pressures domestic companies to look at global markets and toughens them to succeed in them. Particularly when there are economies of scale, local competitors force each other to look outward to foreign markets to capture greater efficiency and higher profitability. And having been tested by fierce domestic competition, the stronger companies are well equipped to win abroad. If Digital Equipment can hold its own against IBM, Data General, Prime, and Hewlett-Packard, going up against Siemens or Machines Bull does not seem so daunting a prospect.

The Diamond as a System

Each of these four attributes defines a point on the diamond of national advantage; the effect of one point often depends on the state of others. Sophisticated buyers will not translate into advanced products, for example, unless the quality of human resources permits companies to meet buyer needs.

Selective disadvantages in factors of production will not motivate innovation unless rivalry is vigorous and company goals support sustained investment. At the broadest level, weaknesses in any one determinant will constrain an industry’s potential for advancement and upgrading.

But the points of the diamond are also self-reinforcing: they constitute a system. Two elements, domestic rivalry and geographic concentration, have especially great power to transform the diamond into a system—domestic rivalry because it promotes improvement in all the other determinants and geographic concentration because it elevates and magnifies the interaction of the four separate influences.

The role of domestic rivalry illustrates how the diamond operates as a self-reinforcing system. Vigorous domestic rivalry stimulates the development of unique pools of specialized factors, particularly if the rivals are all located in one city or region: the University of California at Davis has become the world’s leading center of wine-making research, working closely with the California wine industry. Active local rivals also upgrade domestic demand in an industry. In furniture and shoes, for example, Italian consumers have learned to expect more and better products because of the rapid pace of new product development that is driven by intense domestic rivalry among hundreds of Italian companies. Domestic rivalry also promotes the formation of related and supporting industries. Japan’s world-leading group of semiconductor producers, for instance, has spawned world-leading Japanese semiconductor-equipment manufacturers.

The effects can work in all directions: sometimes world-class suppliers become new entrants in the industry they have been supplying. Or highly sophisticated buyers may themselves enter a supplier industry, particularly when they

have relevant skills and view the new industry as strategic. In the case of the Japanese robotics industry, for example, Matsushita and Kawasaki originally designed robots for internal use before beginning to sell robots to others. Today they are strong competitors in the robotics industry. In Sweden, Sandvik moved from specialty steel into rock drills, and SKF moved from specialty steel into ball bearings.

Another effect of the diamond’s systemic nature is that nations are rarely home to just one competitive industry; rather, the diamond creates an environment that promotesclusters of competitive industries. Competitive industries are not scattered helter-skelter throughout the economy but are usually linked together through vertical (buyer-seller) or horizontal (common customers, technology, channels) relationships. Nor are clusters usually scattered physically; they tend to be concentrated geographically. One competitive industry helps to create another in a mutually reinforcing process. Japan’s strength in consumer electronics, for example, drove its success in semiconductors toward the memory chips and integrated circuits these products use. Japanese strength in laptop computers, which contrasts to limited success in other segments, reflects the base of strength in other compact, portable products and leading expertise in liquid-crystal display gained in the calculator and watch industries.

Once a cluster forms, the whole group of industries becomes mutually supporting. Benefits flow forward, backward, and horizontally. Aggressive rivalry in one industry spreads to others in the cluster, through spin-offs, through the exercise of bargaining power, and through diversification by established companies. Entry from other industries within the cluster spurs upgrading by stimulating diversity in R&D approaches and facilitating the introduction of new strategies and skills. Through the conduits of suppliers or customers who have contact with multiple competitors, information

flows freely and innovations diffuse rapidly. Interconnections within the cluster, often unanticipated, lead to perceptions of new ways of competing and new opportunities. The cluster becomes a vehicle for maintaining diversity and overcoming the inward focus, inertia, inflexibility, and accommodation among rivals that slows or blocks competitive upgrading and new entry.

The Role of Government

In the continuing debate over the competitiveness of nations, no topic engenders more argument or creates less understanding than the role of the government. Many see government as an essential helper or supporter of industry, employing a host of policies to contribute directly to the competitive performance of strategic or target industries. Others accept the “free market” view that the operation of the economy should be left to the workings of the invisible hand.

Both views are incorrect. Either, followed to its logical outcome, would lead to the permanent erosion of a country’s competitive capabilities. On one hand, advocates of government help for industry frequently propose policies that would actually hurt companies in the long run and only create the demand for more helping. On the other hand, advocates of a diminished government presence ignore the legitimate role that government plays in shaping the context and institutional structure surrounding companies and in creating an environment that stimulates companies to gain competitive advantage.

Government’s proper role is as a catalyst and challenger; it is to encourage—or even push—companies to raise their aspirations and move to higher levels of competitive performance, even though this process may be inherently unpleasant and difficult. Government cannot create

competitive industries; only companies can do that. Government plays a role that is inherently partial, that succeeds only when working in tandem with favorable underlying conditions in the diamond. Still, government’s role of transmitting and amplifying the forces of the diamond is a powerful one. Government policies that succeed are those that create an environment in which companies can gain competitive advantage rather than those that involve government directly in the process, except in nations early in the development process. It is an indirect, rather than a direct, role.

Japan’s government, at its best, understands this role better than anyone—including the point that nations pass through stages of competitive development and that government’s appropriate role shifts as the economy progresses. By stimulating early demand for advanced products, confronting industries with the need to pioneer frontier technology through symbolic cooperative projects, establishing prizes that reward quality, and pursuing other policies that magnify the forces of the diamond, the Japanese government accelerates the pace of innovation. But like government officials anywhere, at their worst Japanese bureaucrats can make the same mistakes: attempting to manage industry structure, protecting the market too long, and yielding to political pressure to insulate inefficient retailers, farmers, distributors, and industrial companies from competition.

It is not hard to understand why so many governments make the same mistakes so often in pursuit of national competitiveness: competitive time for companies and political time for governments are fundamentally at odds. It often takes more than a decade for an industry to create competitive advantage; the process entails the long upgrading of human skills, investing in products and processes, building clusters, and penetrating foreign markets. In the case of the Japanese auto industry, for instance,

companies made their first faltering steps toward exporting in the 1950s—yet did not achieve strong international positions until the 1970s.

But in politics, a decade is an eternity. Consequently, most governments favor policies that offer easily perceived short-term benefits, such as subsidies, protection, and arranged mergers—the very policies that retard innovation. Most of the policies that would make a real difference either are too slow and require too much patience for politicians or, even worse, carry with them the sting of short-term pain. Deregulating a protected industry, for example, will lead to bankruptcies sooner and to stronger, more competitive companies only later.

Policies that convey static, short-term cost advantages but that unconsciously undermine innovation and dynamism represent the most common and most profound error in government industrial policy. In a desire to help, it is all too easy for governments to adopt policies such as joint projects to avoid “wasteful” R&D that undermine dynamism and competition. Yet even a 10% cost saving through economies of scale is easily nullified through rapid product and process improvement and the pursuit of volume in global markets—something that such policies undermine.

There are some simple, basic principles that governments should embrace to play the proper supportive role for national competitiveness: encourage change, promote domestic rivalry, stimulate innovation. Some of the specific policy approaches to guide nations seeking to gain competitive advantage include the following.

Focus on specialized factor creation. Government has critical responsibilities for fundamentals like the primary and secondary education systems, basic national infrastructure, and research in areas of broad national concern such as

health care. Yet these kinds of generalized efforts at factor creation rarely produce competitive advantage. Rather, the factors that translate into competitive advantage are advanced, specialized, and tied to specific industries or industry groups. Mechanisms such as specialized apprenticeship programs, research efforts in universities connected with an industry, trade association activities, and, most important, the private investments of companies ultimately create the factors that will yield competitive advantage.

Avoid intervening in factor and currency markets. By intervening in factor and currency markets, governments hope to create lower factor costs or a favorable exchange rate that will help companies compete more effectively in international markets. Evidence from around the world indicates that these policies—such as the Reagan administration’s dollar devaluation—are often counterproductive. They work against the upgrading of industry and the search for more sustainable competitive advantage.

The contrasting case of Japan is particularly instructive, although both Germany and Switzerland have had similar experiences. Over the past 20 years, the Japanese have been rocked by the sudden Nixon currency devaluation shock, two oil shocks, and, most recently, the yen shock—all of which forced Japanese companies to upgrade their competitive advantages. The point is not that government should pursue policies that intentionally drive up factor costs or the exchange rate. Rather, when market forces create rising factor costs or a higher exchange rate, government should resist the temptation to push them back down.

Enforce strict product, safety, and environmental standards. Strict government regulations can promote competitive advantage by stimulating and upgrading

domestic demand. Stringent standards for product performance, product safety, and environmental impact pressure companies to improve quality, upgrade technology, and provide features that respond to consumer and social demands. Easing standards, however tempting, is counterproductive.

When tough regulations anticipate standards that will spread internationally, they give a nation’s companies a head start in developing products and services that will be valuable elsewhere. Sweden’s strict standards for environmental protection have promoted competitive advantage in many industries. Atlas Copco, for example, produces quiet compressors that can be used in dense urban areas with minimal disruption to residents. Strict standards, however, must be combined with a rapid and streamlined regulatory process that does not absorb resources and cause delays.

Sharply limit direct cooperation among industry rivals. The most pervasive global policy fad in the competitiveness arena today is the call for more cooperative research and industry consortia. Operating on the belief that independent research by rivals is wasteful and duplicative, that collaborative efforts achieve economies of scale, and that individual companies are likely to underinvest in R&D because they cannot reap all the benefits, governments have embraced the idea of more direct cooperation. In the United States, antitrust laws have been modified to allow more cooperative R&D; in Europe, megaprojects such as ESPRIT, an information-technology project, bring together companies from several countries. Lurking behind much of this thinking is the fascination of Western governments with—and fundamental misunderstanding of—the countless cooperative research projects sponsored by the Ministry of International Trade and Industry (MITI), projects that appear to have contributed to Japan’s competitive rise.

But a closer look at Japanese cooperative projects suggests a different story. Japanese companies participate in MITI projects to maintain good relations with MITI, to preserve their corporate images, and to hedge the risk that competitors will gain from the project—largely defensive reasons. Companies rarely contribute their best scientists and engineers to cooperative projects and usually spend much more on their own private research in the same field. Typically, the government makes only a modest financial contribution to the project.

The real value of Japanese cooperative research is to signal the importance of emerging technical areas and to stimulate proprietary company research. Cooperative projects prompt companies to explore new fields and boost internal R&D spending because companies know that their domestic rivals are investigating them.

Under certain limited conditions, cooperative research can prove beneficial. Projects should be in areas of basic product and process research, not in subjects closely connected to a company’s proprietary sources of advantage. They should constitute only a modest portion of a company’s overall research program in any given field. Cooperative research should be only indirect, channeled through independent organizations to which most industry participants have access. Organizational structures, like university labs and centers of excellence, reduce management problems and minimize the risk to rivalry. Finally, the most useful cooperative projects often involve fields that touch a number of industries and that require substantial R&D investments.

Promote goals that lead to sustained investment. Government has a vital role in shaping the goals of investors, managers, and employees through policies in various areas. The manner in which capital markets are regulated, for example, shapes the incentives of investors

and, in turn, the behavior of companies. Government should aim to encourage sustained investment in human skills, in innovation, and in physical assets. Perhaps the single most powerful tool for raising the rate of sustained investment in industry is a tax incentive for long-term (five years or more) capital gains restricted to new investment in corporate equity. Long-term capital gains incentives should also be applied to pension funds and other currently untaxed investors, who now have few reasons not to engage in rapid trading.

Deregulate competition. Regulation of competition through such policies as maintaining a state monopoly, controlling entry into an industry, or fixing prices has two strong negative consequences: it stifles rivalry and innovation as companies become preoccupied with dealing with regulators and protecting what they already have; and it makes the industry a less dynamic and less desirable buyer or supplier. Deregulation and privatization on their own, however, will not succeed without vigorous domestic rivalry—and that requires, as a corollary, a strong and consistent antitrust policy.

Enforce strong domestic antitrust policies. A strong antitrust policy—especially for horizontal mergers, alliances, and collusive behavior—is fundamental to innovation. While it is fashionable today to call for mergers and alliances in the name of globalization and the creation of national champions, these often undermine the creation of competitive advantage. Real national competitiveness requires governments to disallow mergers, acquisitions, and alliances that involve industry leaders. Furthermore, the same standards for mergers and alliances should apply to both domestic and foreign companies. Finally, government policy should favor internal entry, both domestic and international, over acquisition. Companies should, however, be allowed to acquire small companies in related industries when the move

promotes the transfer of skills that could ultimately create competitive advantage.

Reject managed trade. Managed trade represents a growing and dangerous tendency for dealing with the fallout of national competitiveness. Orderly marketing agreements, voluntary restraint agreements, or other devices that set quantitative targets to divide up markets are dangerous, ineffective, and often enormously costly to consumers. Rather than promoting innovation in a nation’s industries, managed trade guarantees a market for inefficient companies.

Government trade policy should pursue open market access in every foreign nation. To be effective, trade policy should not be a passive instrument; it cannot respond only to complaints or work only for those industries that can muster enough political clout; it should not require a long history of injury or serve only distressed industries. Trade policy should seek to open markets wherever a nation has competitive advantage and should actively address emerging industries and incipient problems.

Where government finds a trade barrier in another nation, it should concentrate its remedies on dismantling barriers, not on regulating imports or exports. In the case of Japan, for example, pressure to accelerate the already rapid growth of manufactured imports is a more effective approach than a shift to managed trade. Compensatory tariffs that punish companies for unfair trade practices are better than market quotas. Other increasingly important tools to open markets are restrictions that prevent companies in offending nations from investing in acquisitions or production facilities in the host country—thereby blocking the unfair country’s companies from using their advantage to establish a new beachhead that is immune from sanctions.

Any of these remedies, however, can backfire. It is virtually impossible to craft remedies to unfair trade practices that avoid both reducing incentives for domestic companies to innovate and export and harming domestic buyers. The aim of remedies should be adjustments that allow the remedy to disappear.

The Company Agenda

Ultimately, only companies themselves can achieve and sustain competitive advantage. To do so, they must act on the fundamentals described above. In particular, they must recognize the central role of innovation—and the uncomfortable truth that innovation grows out of pressure and challenge. It takes leadership to create a dynamic, challenging environment. And it takes leadership to recognize the all-too-easy escape routes that appear to offer a path to competitive advantage, but are actually short-cuts to failure. For example, it is tempting to rely on cooperative research and development projects to lower the cost and risk of research. But they can divert company attention and resources from proprietary research efforts and will all but eliminate the prospects for real innovation.

Competitive advantage arises from leadership that harnesses and amplifies the forces in the diamond to promote innovation and upgrading. Here are just a few of the kinds of company policies that will support that effort:

Create pressures for innovation. A company should seek out pressure and challenge, not avoid them. Part of strategy is to take advantage of the home nation to create the impetus for innovation. To do that, companies can sell to the most sophisticated and demanding buyers and channels; seek out those buyers with the most difficult needs; establish norms that exceed the toughest regulatory hurdles or product standards; source from the most advanced suppliers; treat

employees as permanent in order to stimulate upgrading of skills and productivity.

Seek out the most capable competitors as motivators. To motivate organizational change, capable competitors and respected rivals can be a common enemy. The best managers always run a little scared; they respect and study competitors. To stay dynamic, companies must make meeting challenge a part of the organization’s norms. For example, lobbying against strict product standards signals the organization that company leadership has diminished aspirations. Companies that value stability, obedient customers, dependent suppliers, and sleepy competitors are inviting inertia and, ultimately, failure.

Establish early-warning systems. Early-warning signals translate into early-mover advantages. Companies can take actions that help them see the signals of change and act on them, thereby getting a jump on the competition. For example, they can find and serve those buyers with the most anticipatory needs; investigate all emerging new buyers or channels; find places whose regulations foreshadow emerging regulations elsewhere; bring some outsiders into the management team; maintain ongoing relationships with research centers and sources of talented people.

Improve the national diamond. Companies have a vital stake in making their home environment a better platform for international success. Part of a company’s responsibility is to play an active role in forming clusters and to work with its home-nation buyers, suppliers, and channels to help them upgrade and extend their own competitive advantages. To upgrade home demand, for example, Japanese musical instrument manufacturers, led by Yamaha, Kawai, and Suzuki, have established music schools. Similarly, companies can stimulate and support local suppliers of important specialized inputs—including encouraging them to compete

globally. The health and strength of the national cluster will only enhance the company’s own rate of innovation and upgrading.

In nearly every successful competitive industry, leading companies also take explicit steps to create specialized factors like human resources, scientific knowledge, or infrastructure. In industries like wool cloth, ceramic tiles, and lighting equipment, Italian industry associations invest in market information, process technology, and common infrastructure. Companies can also speed innovation by putting their headquarters and other key operations where there are concentrations of sophisticated buyers, important suppliers, or specialized factor-creating mechanisms, such as universities or laboratories.

Welcome domestic rivalry. To compete globally, a company needs capable domestic rivals and vigorous domestic rivalry. Especially in the United States and Europe today, managers are wont to complain about excessive competition and to argue for mergers and acquisitions that will produce hoped-for economies of scale and critical mass. The complaint is only natural—but the argument is plain wrong. Vigorous domestic rivalry creates sustainable competitive advantage. Moreover, it is better to grow internationally than to dominate the domestic market. If a company wants an acquisition, a foreign one that can speed globalization and supplement home-based advantages or offset home-based disadvantages is usually far better than merging with leading domestic competitors.

Globalize to tap selective advantages in other nations. In search of “global” strategies, many companies today abandon their home diamond. To be sure, adopting a global perspective is important to creating competitive advantage. But relying on foreign activities that supplant domestic capabilities is always a second-best solution. Innovating to

offset local factor disadvantages is better than outsourcing; developing domestic suppliers and buyers is better than relying solely on foreign ones. Unless the critical underpinnings of competitiveness are present at home, companies will not sustain competitive advantage in the long run. The aim should be to upgrade home-base capabilities so that foreign activities are selective and supplemental only to over-all competitive advantage.

The correct approach to globalization is to tap selectively into sources of advantage in other nations’ diamonds. For example, identifying sophisticated buyers in other countries helps companies understand different needs and creates pressures that will stimulate a faster rate of innovation. No matter how favorable the home diamond, moreover, important research is going on in other nations. To take advantage of foreign research, companies must station high-quality people in overseas bases and mount a credible level of scientific effort. To get anything back from foreign research ventures, companies must also allow access to their own ideas—recognizing that competitive advantage comes from continuous improvement, not from protecting today’s secrets.

Use alliances only selectively. Alliances with foreign companies have become another managerial fad and cure-all: they represent a tempting solution to the problem of a company wanting the advantages of foreign enterprises or hedging against risk, without giving up independence. In reality, however, while alliances can achieve selective benefits, they always exact significant costs: they involve coordinating two separate operations, reconciling goals with an independent entity, creating a competitor, and giving up profits. These costs ultimately make most alliances short-term transitional devices, rather than stable, long-term relationships.

Most important, alliances as a broad-based strategy will only ensure a company’s mediocrity, not its international leadership. No company can rely on another outside, independent company for skills and assets that are central to its competitive advantage. Alliances are best used as a selective tool, employed on a temporary basis or involving noncore activities.

Locate the home base to support competitive advantage. Among the most important decisions for multinational companies is the nation in which to locate the home base for each distinct business. A company can have different home bases for distinct businesses or segments. Ultimately, competitive advantage is created at home: it is where strategy is set, the core product and process technology is created, and a critical mass of production takes place. The circumstances in the home nation must support innovation; otherwise the company has no choice but to move its home base to a country that stimulates innovation and that provides the best environment for global competitiveness. There are no half-measures: the management team must move as well.

The Role of Leadership

Too many companies and top managers misperceive the nature of competition and the task before them by focusing on improving financial performance, soliciting government assistance, seeking stability, and reducing risk through alliances and mergers.

Today’s competitive realities demand leadership. Leaders believe in change; they energize their organizations to innovate continuously; they recognize the importance of their home country as integral to their competitive success and work to upgrade it. Most important, leaders recognize the need for pressure and challenge. Because they are willing to

encourage appropriate—and painful—government policies and regulations, they often earn the title “statesmen,” although few see themselves that way. They are prepared to sacrifice the easy life for difficulty and, ultimately, sustained competitive advantage. That must be the goal, for both nations and companies: not just surviving, but achieving international competitiveness.

And not just once, but continuously.

A version of this article appeared in the March–April 1990 issue of Harvard Business Review.

Collaborate with Your Competitors—and Win

Collaborate with your competitors and win by Gary Hamel, Yves Doz & C.K. Prahalad

laboration between competitors is in fashion. General Motors and Toyota assemble automobiles, Siemens and Philips develop semiconductors, Canon supplies photocopiers to Kodak, France’s Thomson and Japan’s JVC manufacture videocassette recorders. But the spread of what we call “competitive collaboration”—joint ventures, outsourcing agreements, product licensings, cooperative research—has triggered unease about the long-term consequences. A strategic alliance can strengthen both companies against outsiders even as it weakens one partner vis-à-vis the other. In particular, alliances between Asian companies and Western rivals seem to work against the Western partner. Cooperation becomes a low-cost route for new competitors to gain technology and market access.1

Yet the case for collaboration is stronger than ever. It takes so much money to develop new products and to penetrate new markets that few companies can go it alone in every situation. ICL, the British computer company, could not have developed its current generation of mainframes without Fujitsu. Motorola needs Toshiba’s distribution capacity to break into the Japanese semiconductor market. Time is another critical factor. Alliances can provide shortcuts for Western companies racing to improve their production efficiency and quality control.

We have spent more than five years studying the inner workings of 15 strategic alliances and monitoring scores of

others. Our research (see the insert “About Our Research”) involves cooperative ventures between competitors from the United States and Japan, Europe and Japan, and the United States and Europe. We did not judge the success or failure of each partnership by its longevity—a common mistake when evaluating strategic alliances—but by the shifts in competitive strength on each side. We focused on how companies use competitive collaboration to enhance their internal skills and technologies while they guard against transferring competitive advantages to ambitious partners.

About Our Research

We spent more than five years studying the internal workings of 15 strategic alliances around the world. We sought answers to a series of interrelated questions. What role have strategic alliances and outsourcing agreements played in the global success of Japanese and Korean companies? How do alliances change the competitive balance between partners? Does winning at collaboration mean different things to different companies? What factors determine who gains most from collaboration?

To understand who won and who lost and why, we observed the interactions of the partners firsthand and at multiple levels in each organization. Our sample included four European-U.S. alliances, two intra-European alliances, two European-Japanese alliances, and seven U.S.-Japanese alliances. We gained access to both sides of the partnerships in about half the cases and studied each alliance for an average of three years.

Confidentiality was a paramount concern. Where we did have access to both sides, we often wound up knowing more about who was doing what to whom than either of the partners. To preserve confidentiality, our article disguises many of the alliances that were part of the study.

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There is no immutable law that strategic alliances must be a windfall for Japanese or Korean partners. Many Western companies do give away more than they gain—but that’s because they enter partnerships without knowing what it takes to win. Companies that benefit most from competitive

collaboration adhere to a set of simple but powerful principles.

Collaboration is competition in a different form.

Successful companies never forget that their new partners may be out to disarm them. They enter alliances with clear strategic objectives, and they also understand how their partners’ objectives will affect their success.

Harmony is not the most important measure of success.

Indeed, occasional conflict may be the best evidence of mutually beneficial collaboration. Few alliances remain win-win undertakings forever. A partner may be content even as it unknowingly surrenders core skills.

Cooperation has limits. Companies must defend against competitive compromise.

A strategic alliance is a constantly evolving bargain whose real terms go beyond the legal agreement or the aims of top management. What information gets traded is determined day to day, often by engineers and operating managers. Successful companies inform employees at all levels about what skills and technologies are off-limits to the partner and monitor what the partner requests and receives.

Learning from partners is paramount.

Successful companies view each alliance as a window on their partners’ broad capabilities. They use the alliance to build skills in areas outside the formal agreement and systematically diffuse new knowledge throughout their organizations.

Why Collaborate?

Using an alliance with a competitor to acquire new technologies or skills is not devious. It reflects the commitment and capacity of each partner to absorb the skills of the other. We found that in every case in which a Japanese company emerged from an alliance stronger than its Western partner, the Japanese company had made a greater effort to learn.

Strategic intent is an essential ingredient in the commitment to learning. The willingness of Asian companies to enter alliances represents a change in competitive tactics, not competitive goals. NEC, for example, has used a series of collaborative ventures to enhance its technology and product competences. NEC is the only company in the world with a leading position in telecommunications, computers, and semiconductors—despite its investing less in R&D (as a percentage of revenues) than competitors like Texas Instruments, Northern Telecom, and L.M. Ericsson. Its string of partnerships, most notably with Honeywell, allowed NEC to leverage its in-house R&D over the last two decades.

Western companies, on the other hand, often enter alliances to avoid investments. They are more interested in reducing the costs and risks of entering new businesses or markets than in acquiring new skills. A senior U.S. manager offered this analysis of his company’s venture with a Japanese rival: “We complement each other well—our distribution capability and their manufacturing skill. I see no reason to invest upstream if we can find a secure source of product. This is a comfortable relationship for us.”

An executive from this company’s Japanese partner offered a different perspective: “When it is necessary to collaborate, I go to my employees and say, ‘This is bad, I wish we had these skills ourselves. Collaboration is second best. But I will feel worse if after four years we do not know how to do what our partner knows how to do.’ We must digest their skills.”

The problem here is not that the U.S. company wants to share investment risk (its Japanese partner does too) but that the U.S. company has no ambition beyondavoidance. When the commitment to learning is so one-sided, collaboration invariably leads to competitive compromise.

Many so-called alliances between Western companies and their Asian rivals are little more than sophisticated outsourcing arrangements (see the insert “Competition for Competence”). General Motors buys cars and components from Korea’s Daewoo. Siemens buys computers from Fujitsu. Apple buys laser printer engines from Canon. The traffic is almost entirely one way. These OEM deals offer Asian partners a way to capture investment initiative from Western competitors and displace customer-competitors from value-creating activities. In many cases this goal meshes with that of the Western partner: to regain competitiveness quickly and with minimum effort.

Competition for Competence

In the article “Do You Really Have a Global Strategy?” (HBR July–August 1985), Gary Hamel and C.K. Prahalad examined one dimension of the global competitive battle: the race for brand dominance. This is the battle for control of distribution channels and global “share of mind.” Another global battle has been much less visible and has received much less management attention. This is the battle for control over key technology-based competences that fuel new business development.

Honda has built a number of businesses, including marine engines, lawn mowers, generators, motorcycles, and cars, around its engine and power train competence. Casio draws on its expertise in semiconductors and digital display in producing calculators, small-screen televisions, musical instruments, and watches. Canon relies on its imaging and microprocessor competences in its camera, copier, and laser printer businesses.

In the short run, the quality and performance of a company’s products determine its competitiveness. Over the longer term, however, what counts is the ability to build and enhance core competences—distinctive skills that spawn new generations of products. This is where many managers and commentators fear Western companies are losing. Our research helps

explain why some companies may be more likely than others to surrender core skills.

Alliance or Outsourcing?

Enticing Western companies into outsourcing agreements provides several benefits to ambitious OEM partners. Serving as a manufacturing base for a Western partner is a quick route to increased manufacturing share without the risk or expense of building brand share. The Western partners’ distribution capability allows Asian suppliers to focus all their resources on building absolute product advantage. Then OEMs can enter markets on their own and convert manufacturing share into brand share.

Serving as a sourcing platform yields more than just volume and process improvements. It also generates low-cost, low-risk market learning. The downstream (usually Western) partner typically provides information on how to tailor products to local markets. So every product design transferred to an OEM partner is also a research report on customer preferences and market needs. The OEM partner can use these insights to read the market accurately when it enters on its own.

A Ratchet Effect

Our research suggests that once a significant sourcing relationship has been established, the buyer becomes less willing and able to reemerge as a manufacturing competitor. Japanese and Korean companies are, with few exceptions, exemplary suppliers. If anything, the “soft option” of outsourcing becomes even softer as OEM suppliers routinely exceed delivery and quality expectations.

Outsourcing often begins a ratchetlike process. Relinquishing manufacturing control and paring back plant investment leads to sacrifices in product design, process technology, and, eventually, R&D budgets. Consequently, the OEM partner captures product-development as well as manufacturing initiative. Ambitious OEM partners are not content with the old formula of “You design it and we’ll make it.” The new reality is, “You design it, we’ll learn from your designs, make them more manufacturable, and launch our products alongside yours.”

Reversing the Verdict

This outcome is not inevitable. Western companies can retain control over their core competences by keeping a few simple principles in mind.

A competitive product is not the same thing as a competitive organization. While an Asian OEM partner may provide the former, it seldom provides the latter. In essence, outsourcing is a way of renting someone else’s competitiveness rather than developing a long-term solution to competitive decline.

Rethink the make-or-buy decision.Companies often treat component manufacturing operations as cost centers and transfer their output to assembly units at an arbitrarily set price. This transfer price is an accounting fiction, and it is unlikely to yield as high a return as marketing or distribution investments, which require less research money and capital. But companies seldom consider the competitive consequences of surrendering control over a key value-creating activity.

Watch out for deepening dependence.Surrender results from a series of outsourcing decisions that individually make economic sense but collectively amount to a phased exit from the business. Different managers make outsourcing decisions at different times, unaware of the cumulative impact.

Replenish core competences. Western companies must outsource some activities; the economics are just too compelling. The real issue is whether a company is adding to its stock of technologies and competences as rapidly as it is surrendering them. The question of whether to outsource should always provoke a second question: Where can we outpace our partner and other rivals in building new sources of competitive advantage?

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Consider the joint venture between Rover, the British automaker, and Honda. Some 25 years ago, Rover’s forerunners were world leaders in small car design. Honda had not even entered the automobile business. But in the mid-1970s, after failing to penetrate foreign markets, Rover turned to Honda for technology and product-development support. Rover has used the alliance to avoid investments to design and build new cars. Honda has cultivated skills in European styling and marketing as well as multinational manufacturing. There is little doubt which company will emerge stronger over the long term.

Troubled laggards like Rover often strike alliances with surging latecomers like Honda. Having fallen behind in a key

skills area (in this case, manufacturing small cars), the laggard attempts to compensate for past failures. The latecomer uses the alliance to close a specific skills gap (in this case, learning to build cars for a regional market). But a laggard that forges a partnership for short-term gain may find itself in a dependency spiral: as it contributes fewer and fewer distinctive skills, it must reveal more and more of its internal operations to keep the partner interested. For the weaker company, the issue shifts from “Should we collaborate?” to “With whom should we collaborate?” to “How do we keep our partner interested as we lose the advantages that made us attractive to them in the first place?”

There’s a certain paradox here. When both partners are equally intent on internalizing the other’s skills, distrust and conflict may spoil the alliance and threaten its very survival. That’s one reason joint ventures between Korean and Japanese companies have been few and tempestuous. Neither side wants to “open the kimono.” Alliances seem to run most smoothly when one partner is intent on learning and the other is intent on avoidance—in essence, when one partner is willing to grow dependent on the other. But running smoothly is not the point; the point is for a company to emerge from an alliance more competitive than when it entered it.

One partner does not always have to give up more than it gains to ensure the survival of an alliance. There are certain conditions under which mutual gain is possible, at least for a time:

The partners’ strategic goals converge while their competitive goals diverge.

That is, each partner allows for the other’s continued prosperity in the shared business. Philips and Du Pont collaborate to develop and manufacture compact discs, but

neither side invades the other’s market. There is a clear upstream/downstream division of effort.

The size and market power of both partners is modest compared with industry leaders.

This forces each side to accept that mutual dependence may have to continue for many years. Long-term collaboration may be so critical to both partners that neither will risk antagonizing the other by an overtly competitive bid to appropriate skills or competences. Fujitsu’s 1 to 5 size disadvantage with IBM means it will be a long time, if ever, before Fujitsu can break away from its foreign partners and go it alone.

Each partner believes it can learn from the other and at the same time limit access to proprietary skills.

JVC and Thomson, both of whom make VCRs, know that they are trading skills. But the two companies are looking for very different things. Thomson needs product technology and manufacturing prowess; JVC needs to learn how to succeed in the fragmented European market. Both sides believe there is an equitable chance for gain.

How to Build Secure Defenses

For collaboration to succeed, each partner must contribute something distinctive: basic research, product development skills, manufacturing capacity, access to distribution. The challenge is to share enough skills to create advantage vis-à-vis companies outside the alliance while preventing a wholesale transfer of core skills to the partner. This is a very thin line to walk. Companies must carefully select what skills and technologies they pass to their partners. They must develop safeguards against unintended, informal transfers of information. The goal is to limit the transparency of their operations.

The type of skill a company contributes is an important factor in how easily its partner can internalize the skills. The potential for transfer is greatest when a partner’s contribution is easily transported (in engineering drawings, on computer tapes, or in the heads of a few technical experts); easily interpreted (it can be reduced to commonly understood equations or symbols); and easily absorbed (the skill or competence is independent of any particular cultural context)

Western companies face an inherent disadvantage because their skills are generally more vulnerable to transfer. The magnet that attracts so many companies to alliances with Asian competitors is their manufacturing excellence—a competence that is less transferable than most. Just-in-time inventory systems and quality circles can be imitated, but this is like pulling a few threads out of an oriental carpet. Manufacturing excellence is a complex web of employee training, integration with suppliers, statistical process controls, employee involvement, value engineering, and design for manufacture. It is difficult to extract such a subtle competence in any way but a piecemeal fashion.

There is an important distinction between technology and competence. A discrete, stand-alone technology (for example, the design of a semiconductor chip) is more easily transferred than a process competence, which is entwined in the social fabric of a company. Asian companies often learn more from their Western partners than vice versa because they contribute difficult-to-unravel strengths, while Western partners contribute easy-to-imitate technology.

So companies must take steps to limit transparency. One approach is to limit the scope of the formal agreement. It might cover a single technology rather than an entire range of technologies; part of a product line rather than the entire line; distribution in a limited number of markets or for a

limited period of time. The objective is to circumscribe a partner’s opportunities to learn.

Moreover, agreements should establish specific performance requirements. Motorola, for example, takes an incremental, incentive-based approach to technology transfer in its venture with Toshiba. The agreement calls for Motorola to release its microprocessor technology incrementally as Toshiba delivers on its promise to increase Motorola’s penetration in the Japanese semiconductor market. The greater Motorola’s market share, the greater Toshiba’s access to Motorola’s technology.

Many of the skills that migrate between companies are not covered in the formal terms of collaboration. Top management puts together strategic alliances and sets the legal parameters for exchange. But what actually gets traded is determined by day-to-day interactions of engineers, marketers, and product developers: who says what to whom, who gets access to what facilities, who sits on what joint committees. The most important deals (“I’ll share this with you if you share that with me”) may be struck four or five organizational levels below where the deal was signed. Here lurks the greatest risk of unintended transfers of important skills.

Consider one technology-sharing alliance between European and Japanese competitors. The European company valued the partnership as a way to acquire a specific technology. The Japanese company considered it a window on its partner’s entire range of competences and interacted with a broad spectrum of its partner’s marketing and product-development staff. The company mined each contact for as much information as possible.

For example, every time the European company requested a new feature on a product being sourced from its partner, the

Japanese company asked for detailed customer and competitor analyses to justify the request. Over time, it developed a sophisticated picture of the European market that would assist its own entry strategy. The technology acquired by the European partner through the formal agreement had a useful life of three to five years. The competitive insights acquired informally by the Japanese company will probably endure longer.

Limiting unintended transfers at the operating level requires careful attention to the role of gatekeepers, the people who control what information flows to a partner. A gatekeeper can be effective only if there are a limited number of gateways through which a partner can access people and facilities. Fujitsu’s many partners all go through a single office, the “collaboration section,” to request information and assistance from different divisions. This way the company can monitor and control access to critical skills and technologies.

We studied one partnership between European and U.S. competitors that involved several divisions of each company. While the U.S. company could only access its partner through a single gateway, its partner had unfettered access to all participating divisions. The European company took advantage of its free rein. If one division refused to provide certain information, the European partner made the same request of another division. No single manager in the U.S. company could tell how much information had been transferred or was in a position to piece together patterns in the requests.

Collegiality is a prerequisite for collaborative success. But too much collegiality should set off warning bells to senior managers. CEOs or division presidents should expect occasional complaints from their counterparts about the reluctance of lower level employees to share information. That’s a sign that the gatekeepers are doing their jobs. And

senior management should regularly debrief operating personnel to find out what information the partner is requesting and what requests are being granted.

Limiting unintended transfers ultimately depends on employee loyalty and self-discipline. This was a real issue for many of the Western companies we studied. In their excitement and pride over technical achievements, engineering staffs sometimes shared information that top management considered sensitive. Japanese engineers were less likely to share proprietary information.

There are a host of cultural and professional reasons for the relative openness of Western technicians. Japanese engineers and scientists are more loyal to their company than to their profession. They are less steeped in the open give-and-take of university research since they receive much of their training from employers. They consider themselves team members more than individual scientific contributors. As one Japanese manager noted, “We don’t feel any need to reveal what we know. It is not an issue of pride for us. We’re glad to sit and listen. If we’re patient we usually learn what we want to know.”

Controlling unintended transfers may require restricting access to facilities as well as to people. Companies should declare sensitive laboratories and factories off-limits to their partners. Better yet, they might house the collaborative venture in an entirely new facility. IBM is building a special site in Japan where Fujitsu can review its forthcoming mainframe software before deciding whether to license it. IBM will be able to control exactly what Fujitsu sees and what information leaves the facility.

Finally, which country serves as “home” to the alliance affects transparency. If the collaborative team is located near one partner’s major facilities, the other partner will have

more opportunities to learn—but less control over what information gets traded. When the partner houses, feeds, and looks after engineers and operating managers, there is a danger they will “go native.” Expatriate personnel need frequent visits from headquarters as well as regular furloughs home.

Enhance the Capacity to Learn

Whether collaboration leads to competitive surrender or revitalization depends foremost on what employees believe the purpose of the alliance to be. It is self-evident: to learn, one must want to learn. Western companies won’t realize the full benefits of competitive collaboration until they overcome an arrogance borne of decades of leadership. In short, Western companies must be more receptive.

We asked a senior executive in a Japanese electronics company about the perception that Japanese companies learn more from their foreign partners than vice versa. “Our Western partners approach us with the attitude of teachers,” he told us. “We are quite happy with this, because we have the attitude of students.”

Learning begins at the top. Senior management must be committed to enhancing their companies’ skills as well as to avoiding financial risk. But most learning takes place at the lower levels of an alliance. Operating employees not only represent the front lines in an effective defense but also play a vital role in acquiring knowledge. They must be well briefed on the partner’s strengths and weaknesses and understand how acquiring particular skills will bolster their company’s competitive position.

This is already standard practice among Asian companies. We accompanied a Japanese development engineer on a tour through a partner’s factory. This engineer dutifully took notes

on plant layout, the number of production stages, the rate at which the line was running, and the number of employees. He recorded all this despite the fact that he had no manufacturing responsibility in his own company, and that the alliance didn’t encompass joint manufacturing. Such dedication greatly enhances learning.

Collaboration doesn’t always provide an opportunity to fully internalize a partner’s skills. Yet just acquiring new and more precise benchmarks of a partner’s performance can be of great value. A new benchmark can provoke a thorough review of internal performance levels and may spur a round of competitive innovation. Asking questions like, “Why do their semiconductor logic designs have fewer errors than ours?” and “Why are they investing in this technology and we’re not?” may provide the incentive for a vigorous catch-up program.

Competitive benchmarking is a tradition in most of the Japanese companies we studied. It requires many of the same skills associated with competitor analysis: systematically calibrating performance against external targets; learning to use rough estimates to determine where a competitor (or partner) is better, faster, or cheaper; translating those estimates into new internal targets; and recalibrating to establish the rate of improvement in a competitor’s performance. The great advantage of competitive collaboration is that proximity makes benchmarking easier.

Indeed, some analysts argue that one of Toyota’s motivations in collaborating with GM in the much-publicized NUMMI venture is to gauge the quality of GM’s manufacturing technology. GM’s top manufacturing people get a close look at Toyota, but the reverse is true as well. Toyota may be learning whether its giant U.S. competitor is capable of closing the productivity gap with Japan.

Competitive collaboration also provides a way of getting close enough to rivals to predict how they will behave when the alliance unravels or runs its course. How does the partner respond to price changes? How does it measure and reward executives? How does it prepare to launch a new product? By revealing a competitor’s management orthodoxies, collaboration can increase the chances of success in future head-to-head battles.

Knowledge acquired from a competitor-partner is only valuable after it is diffused through the organization. Several companies we studied had established internal clearinghouses to collect and disseminate information. The collaborations manager at one Japanese company regularly made the rounds of all employees involved in alliances. He identified what information had been collected by whom and then passed it on to appropriate departments. Another company held regular meetings where employees shared new knowledge and determined who was best positioned to acquire additional information.

Proceed with Care—But Proceed

After World War II, Japanese and Korean companies entered alliances with Western rivals from weak positions. But they worked steadfastly toward independence. In the early 1960s, NEC’s computer business was one-quarter the size of Honeywell’s, its primary foreign partner. It took only two decades for NEC to grow larger than Honeywell, which eventually sold its computer operations to an alliance between NEC and Group Bull of France. The NEC experience demonstrates that dependence on a foreign partner doesn’t automatically condemn a company to also-ran status. Collaboration may sometimes be unavoidable; surrender is not.

Managers are too often obsessed with the ownership structure of an alliance. Whether a company controls 51% or 49% of a joint venture may be much less important than the rate at which each partner learns from the other. Companies that are confident of their ability to learn may even prefer some ambiguity in the alliance’s legal structure. Ambiguity creates more potential to acquire skills and technologies. The challenge for Western companies is not to write tighter legal agreements but to become better learners.

Running away from collaboration is no answer. Even the largest Western companies can no longer outspend their global rivals. With leadership in many industries shifting toward the East, companies in the United States and Europe must become good borrowers—much like Asian companies did in the 1960s and 1970s. Competitive renewal depends on building new process capabilities and winning new product and technology battles. Collaboration can be a low-cost strategy for doing both.

1. For a vigorous warning about the perils of collaboration, see Robert B. Reich and Eric D. Mankin, “Joint Ventures with Japan Give Away Our Future,” HBR March–April 1986, p. 78.

A version of this article appeared in the January–February 1989 issue of Harvard Business Review.

Connect and Develop: Inside Procter & Gamble's New Model of Innovation By Larry Huston & Nabil Sakkab

Procter & Gamble launched a new line of Pringles potato crisps in 2004 with pictures and words—trivia questions, animal facts, jokes—printed on each crisp. They were an immediate hit. In the old days, it might have taken us two years to bring this product to market, and we would have shouldered all of the investment and risk internally. But by applying a fundamentally new approach to innovation, we were able to accelerate Pringles Prints from concept to launch in less than a year and at a fraction of what it would have otherwise cost. Here’s how we did it.

Back in 2002, as we were brainstorming about ways to make snacks more novel and fun, someone suggested that we print pop culture images on Pringles. It was a great idea, but how would we do it? One of our researchers thought we should try ink-jetting pictures onto the potato dough, and she used the printer in her office for a test run. (You can imagine her call to our computer help desk.) We quickly realized that every crisp would have to be printed as it came out of frying, when it was still at a high humidity and temperature. And somehow, we’d have to produce sharp images, in multiple colors, even as we printed thousands upon thousands of crisps each minute. Moreover, creating edible dyes that could meet these needs would require tremendous development.

Traditionally, we would have spent the bulk of our investment just on developing a workable process. An internal team would have hooked up with an ink-jet printer company that could devise the process, and then we would have entered into complex negotiations over the rights to use it.

Instead, we created a technology brief that defined the problems we needed to solve, and we circulated it throughout our global networks of individuals and institutions to discover if anyone in the world had a ready-made solution. It was through our European network that we discovered a small bakery in Bologna, Italy, run by a university professor who also manufactured baking equipment. He had invented an ink-jet method for printing edible images on cakes and cookies that we rapidly adapted to solve our problem. This innovation has helped the North America Pringles business achieve double-digit growth over the past two years.

From R&D to C&D

Most companies are still clinging to what we call the invention model, centered on a bricks-and-mortar R&D infrastructure and the idea that their innovation must principally reside within their own four walls. To be sure, these companies are increasingly trying to buttress their laboring R&D departments with acquisitions, alliances, licensing, and selective innovation outsourcing. And they’re launching Skunk Works, improving collaboration between marketing and R&D, tightening go-to-market criteria, and strengthening product portfolio management.

Most companies are still clinging to a bricks-and-mortar R&D infrastructure and the idea that their innovation must principally reside within their own four walls.

But these are incremental changes, bandages on a broken model. Strong words, perhaps, but consider the facts: Most mature companies have to create organic growth of 4% to 6% year in, year out. How are they going to do it? For P&G, that’s the equivalent of building a $4 billion business this year alone. Not long ago, when companies were smaller and the world was less competitive, firms could rely on internal R&D to drive that kind of growth. For generations, in fact,

P&G created most of its phenomenal growth by innovating from within—building global research facilities and hiring and holding on to the best talent in the world. That worked well when we were a $25 billion company; today, we’re an almost $70 billion company.

By 2000, it was clear to us that our invent-it-ourselves model was not capable of sustaining high levels of top-line growth. The explosion of new technologies was putting ever more pressure on our innovation budgets. Our R&D productivity had leveled off, and our innovation success rate—the percentage of new products that met financial objectives—had stagnated at about 35%. Squeezed by nimble competitors, flattening sales, lackluster new launches, and a quarterly earnings miss, we lost more than half our market cap when our stock slid from $118 to $52 a share. Talk about a wake-up call.

The world’s innovation landscape had changed, yet we hadn’t changed our own innovation model since the late 1980s, when we moved from a centralized approach to a globally networked internal model—what Christopher Bartlett and Sumantra Ghoshal call the transnational model in Managing Across Borders.

We discovered that important innovation was increasingly being done at small and midsize entrepreneurial companies. Even individuals were eager to license and sell their intellectual property. University and government labs had become more interested in forming industry partnerships, and they were hungry for ways to monetize their research. The Internet had opened up access to talent markets throughout the world. And a few forward-looking companies like IBM and Eli Lilly were beginning to experiment with the new concept of open innovation, leveraging one another’s (even competitors’) innovation assets—products, intellectual property, and people.

As was the case for P&G in 2000, R&D productivity at most mature, innovation-based companies today is flat while innovation costs are climbing faster than top-line growth. (Not many CEOs are going to their CTOs and saying, “Here, have some more money for innovation.”) Meanwhile, these companies are facing a growth mandate that their existing innovation models can’t possibly support. In 2000, realizing that P&G couldn’t meet its growth objectives by spending more and more on R&D for less and less payoff, our newly appointed CEO, A.G. Lafley, challenged us to reinvent the company’s innovation business model.

We knew that most of P&G’s best innovations had come from connecting ideas across internal businesses. And after studying the performance of a small number of products we’d acquired beyond our own labs, we knew that external connections could produce highly profitable innovations, too. Betting that these connections were the key to future growth, Lafley made it our goal to acquire 50% of our innovations outside the company. The strategy wasn’t to replace the capabilities of our 7,500 researchers and support staff, but to better leverage them. Half of our new products, Lafley said, would come from our own labs, and half would come through them.

It was, and still is, a radical idea. As we studied outside sources of innovation, we estimated that for every P&G researcher there were 200 scientists or engineers elsewhere in the world who were just as good—a total of perhaps 1.5 million people whose talents we could potentially use. But tapping into the creative thinking of inventors and others on the outside would require massive operational changes. We needed to move the company’s attitude from resistance to innovations “not invented here” to enthusiasm for those “proudly found elsewhere.” And we needed to change how we defined, and perceived, our R&D organization—from

7,500 people inside to 7,500 plus 1.5 million outside, with a permeable boundary between them.

It was against this backdrop that we created our connect and develop innovation model. With a clear sense of consumers’ needs, we could identify promising ideas throughout the world and apply our own R&D, manufacturing, marketing, and purchasing capabilities to them to create better and cheaper products, faster.

The model works. Today, more than 35% of our new products in market have elements that originated from outside P&G, up from about 15% in 2000. And 45% of the initiatives in our product development portfolio have key elements that were discovered externally. Through connect and develop—along with improvements in other aspects of innovation related to product cost, design, and marketing—our R&D productivity has increased by nearly 60%. Our innovation success rate has more than doubled, while the cost of innovation has fallen. R&D investment as a percentage of sales is down from 4.8% in 2000 to 3.4% today. And, in the last two years, we’ve launched more than 100 new products for which some aspect of execution came from outside the company. Five years after the company’s stock collapse in 2000, we have doubled our share price and have a portfolio of 22 billion-dollar brands.

According to a recent Conference Board survey of CEOs and board chairs, executives’ number one concern is “sustained and steady top-line growth.” CEOs understand the importance of innovation to growth, yet how many have overhauled their basic approach to innovation? Until companies realize that the innovation landscape has changed and acknowledge that their current model is unsustainable, most will find that the top-line growth they require will elude them.

Where to Play

When people first hear about connect and develop, they often think it’s the same as outsourcing innovation—contracting with outsiders to develop innovations for P&G. But it’s not. Outsourcing strategies typically just transfer work to lower-cost providers. Connect and develop, by contrast, is about finding good ideas and bringing them in to enhance and capitalize on internal capabilities.

To do this, we collaborate with organizations and individuals around the world, systematically searching for proven technologies, packages, and products that we can improve, scale up, and market, either on our own or in partnership with other companies. Among the most successful products we’ve brought to market through connect and develop are Olay Regenerist, Swiffer Dusters, and the Crest SpinBrush.

For connect and develop to work, we realized, it was crucial to know exactly what we were looking for, or where to play. If we’d set out without carefully defined targets, we’d have found loads of ideas but perhaps none that were useful to us. So we established from the start that we would seek ideas that had some degree of success already; we needed to see, at least, working products, prototypes, or technologies, and (for products) evidence of consumer interest. And we would focus on ideas and products that would benefit specifically from the application of P&G technology, marketing, distribution, or other capabilities.

Then we determined the areas in which we would look for these proven ideas. P&G is perhaps best known for its personal hygiene and household-cleaning products—brands like Crest, Charmin, Pampers, Tide, and Downy. Yet we produce more than 300 brands that span, in addition to hygiene and cleaning, snacks and beverages, pet nutrition, prescription drugs, fragrances, cosmetics, and many other

categories. And we spend almost $2 billion a year on R&D across 150 science areas, including materials, biotechnology, imaging, nutrition, veterinary medicine, and even robotics.

To focus our idea search, we directed our surveillance to three environments:

Top ten consumer needs.

Once a year, we ask our businesses what consumer needs, when addressed, will drive the growth of their brands. This may seem like an obvious question, but in most companies, researchers are working on the problems that they find interesting rather than those that might contribute to brand growth. This inquiry produces a top-ten-needs list for each business and one for the company overall. The company list, for example, includes needs such as “reduce wrinkles, improve skin texture and tone,” “improve soil repellency and restoration of hard surfaces,” “create softer paper products with lower lint and higher wet strength,” and “prevent or minimize the severity and duration of cold symptoms.”

These needs lists are then developed into science problems to be solved. The problems are often spelled out in technology briefs, like the one we sent out to find an ink-jet process for Pringles Prints. To take another example, a major laundry need is for products that clean effectively using cold water. So, in our search for relevant innovations, we’re looking for chemistry and biotechnology solutions that allow products to work well at low temperatures. Maybe the answer to our cold-water-cleaning problem is in a lab that’s studying enzymatic reactions in microbes that thrive under polar ice caps, and we need only to find the lab.

Adjacencies.

We also identify adjacencies—that is, new products or concepts that can help us take advantage of existing brand

equity. We might, for instance, ask which baby care items—such as wipes and changing pads—are adjacent to our Pampers disposable diapers, and then seek out innovative emerging products or relevant technologies in those categories. By targeting adjacencies in oral care, we’ve expanded the Crest brand beyond toothpaste to include whitening strips, power toothbrushes, and flosses.

Technology game boards.

Finally, in some areas, we use what we call technology game boards to evaluate how technology acquisition moves in one area might affect products in other categories. Conceptually, working with these planning tools is like playing a multilevel game of chess. They help us explore questions such as “Which of our key technologies do we want to strengthen?” “Which technologies do we want to acquire to help us better compete with rivals?” and “Of those that we already own, which do we want to license, sell, or codevelop further?” The answers provide an array of broad targets for our innovation searches and, as important, tell us where we shouldn’t be looking.

How to Network

Our global networks are the platform for the activities that, together, constitute the connect-and-develop strategy. But networks themselves don’t provide competitive advantage any more than the phone system does. It’s how you build and use them that matters.

Within the boundaries defined by our needs lists, adjacency maps, and technology game boards, no source of ideas is off-limits. We tap closed proprietary networks and open networks of individuals and organizations available to any company. Using these networks, we look for ideas in government and private labs, as well as academic and other research institutions; we tap suppliers, retailers, competitors,

development and trade partners, VC firms, and individual entrepreneurs.

Here are several core networks that we use to seek out new ideas. This is not an exhaustive list; rather, it is a snapshot of the networking capabilities that we’ve found most useful.

Proprietary networks.

We rely on several proprietary networks developed specifically to facilitate connect-and-develop activities. Here are two of the largest ones.

Technology entrepreneurs.

Much of the operation and momentum of connect and develop depends on our network of 70 technology entrepreneurs based around the world. These senior P&G people lead the development of our needs lists, create adjacency maps and technology game boards, and write the technology briefs that define the problems we are trying to solve. They create external connections by, for example, meeting with university and industry researchers and forming supplier networks, and they actively promote these connections to decision makers in P&G’s business units.

The technology entrepreneurs combine aggressive mining of the scientific literature, patent databases, and other data sources with physical prospecting for ideas—say, surveying the shelves of a store in Rome or combing product and technology fairs. Although it’s effective and necessary to scout for ideas electronically, it’s not sufficient. It was a technology entrepreneur who, exploring a local market in Japan, discovered what ultimately became the Mr. Clean Magic Eraser. We surely wouldn’t have found it otherwise. (See the exhibit “The Osaka Connection.”)

The Osaka Connection

In the connect-and-develop world, chance favors the prepared mind. When one of P&G’s technology entrepreneurs discovered a stain-removing sponge in a market in Osaka, Japan, he sent it to the company for evaluation. The resulting product, the Mr. Clean Magic Eraser, is now in third-generation development and has achieved double its projected revenues.

German chemical company BASF manufactures a melamine resin foam called Basotect for soundproofing and insulation in the construction and automotive industries.

LEC, a Tokyo-based consumer-products company, markets Basotect foam in Japan as a household sponge called Cleenpro.

2001

Discover

Japan-based technology entrepreneur with P&G discovers the product in an Osaka grocery store, evaluates its market performance in Japan, and establishes its fit with the P&G home-care product development and marketing criteria.

2002

Evaluate

The technology entrepreneur sends samples to R&D product researchers in Cincinnati for performance evaluation and posts a product description and evaluation of market potential on P&G’s internal “eureka catalog” network.

Market research confirms enthusiasm for the product. Product is moved into portfolio for development; P&G negotiates purchase of Basotect from BASF and terms for further collaboration.

2003

Launch

Basotect is packaged as-is and launched nationally as Mr. Clean Magic Eraser.

Mr. Clean Magic Eraser is launched in Europe.

BASF and P&G researchers collaborate in shared labs to improve Basotect’s cleaning properties, durability, and versatility.

2004

Cocreate

The first cocreated Basotect product, the Magic Eraser Duo, is launched nationally in the United States.

The cocreated Magic Eraser Wheel & Tire is launched nationally in the United States.

BASF and P&G collaborate on next-generation Magic Eraser products.

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The technology entrepreneurs work out of six connect-and-develop hubs, in China, India, Japan, Western Europe, Latin America, and the United States. Each hub focuses on finding products and technologies that, in a sense, are specialties of its region: The China hub, for example, looks in particular for new high-quality materials and cost innovations (products that exploit China’s unique ability to make things at low cost). The India hub seeks out local talent in the sciences to solve problems—in our manufacturing processes, for instance—using tools like computer modeling.

Thus far, our technology entrepreneurs have identified more than 10,000 products, product ideas, and promising technologies. Each of these discoveries has undergone a formal evaluation, as we’ll describe further on.

Suppliers.

Our top 15 suppliers have an estimated combined R&D staff of 50,000. As we built connect and develop, it didn’t take us long to realize that they represented a huge potential source of innovation. So we created a secure IT platform that would allow us to share technology briefs with our suppliers. If we’re

trying to find ways to make detergent perfume last longer after clothes come out of the dryer, for instance, one of our chemical suppliers may well have the solution. (Suppliers can’t see others’ responses, of course.) Since creating our supplier network, we’ve seen a 30% increase in innovation projects jointly staffed with P&G’s and suppliers’ researchers. In some cases, suppliers’ researchers come to work in our labs, and in others, we work in theirs—an example of what we call “cocreation,” a type of collaboration that goes well beyond typical joint development.

We also hold top-to-top meetings with suppliers so our senior leaders can interact with theirs. These meetings, along with our shared-staff arrangements, improve relationships, increase the flow of ideas, and strengthen each company’s understanding of the other’s capabilities—all of which helps us innovate.

Open networks.

A complement to our proprietary networks are open networks. The following four are particularly fruitful connect-and-develop resources.

Leading Connect and Develop

The connect-and-develop strategy requires that a senior executive have day-to-day accountability for its vision, operations, and performance. At P&G, the vice president for innovation and knowledge has this responsibility. Connect-and-develop leaders from each of the business units at P&G have dotted-line reporting relationships with the VP. The managers for our virtual R&D networks (such as NineSigma and our supplier network), the technology entrepreneur and hub network, our connect-and-develop legal resources, and our training resources report directly.

The VP oversees the development of networks and new programs, manages a corporate budget, and monitors the productivity of networks and activities. This includes tracking the performance of talent markets like NineSigma and InnoCentive as well as measuring connect-and-develop productivity by region—evaluating, for example, the costs and output (as measured by

products in market) of foreign hubs. Productivity measurements for the entire program are reported annually.

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NineSigma.

P&G helped create NineSigma, one of several firms connecting companies that have science and technology problems with companies, universities, government and private labs, and consultants that can develop solutions. Say you have a technical problem you want to crack—for P&G, as you’ll recall, one such problem is cold-temperature washing. NineSigma creates a technology brief that describes the problem, and sends this to its network of thousands of possible solution providers worldwide. Any solver can submit a nonconfidential proposal back to NineSigma, which is transmitted to the contracting company. If the company likes the proposal, NineSigma connects the company and solver, and the project proceeds from there. We’ve distributed technology briefs to more than 700,000 people through NineSigma and have as a result completed over 100 projects, with 45% of them leading to agreements for further collaboration.

InnoCentive.

Founded by Eli Lilly, InnoCentive is similar to NineSigma—but rather than connect companies with contract partners to solve broad problems across many disciplines, InnoCentive brokers solutions to more narrowly defined scientific problems. For example, we might have an industrial chemical reaction that takes five steps to accomplish and want to know if it can be done in three. We’ll put the question to InnoCentive’s 75,000 contract scientists and see what we get back. We’ve had problems solved by a graduate student in Spain, a chemist in India, a freelance chemistry consultant in the United States, and an agricultural chemist in Italy. About

a third of the problems we’ve posted through InnoCentive have been solved.

YourEncore.

In 2003, we laid the groundwork for a business called YourEncore. Now operated independently, it connects about 800 high-performing retired scientists and engineers from 150 companies with client businesses. By using YourEncore, companies can bring people with deep experience and new ways of thinking from other organizations and industries into their own.

Through YourEncore, you can contract with a retiree who has relevant experience for a specific, short-term assignment (compensation is based on the person’s preretirement salary, adjusted for inflation). For example, we might tap a former Boeing engineer with expertise in virtual aircraft design to apply his or her skills in virtual product prototyping and manufacturing design at P&G, even though our projects have nothing to do with aviation. What makes this model so powerful is that client companies can experiment at low cost and with little risk on cross-disciplinary approaches to problem solving. At any point, we might have 20 retirees from YourEncore working on P&G problems.

Yet2.com.

Six years ago, P&G joined a group of Fortune 100 companies as an initial investor in Yet2.com, an online marketplace for intellectual property exchange. Unlike NineSigma and InnoCentive, which focus on helping companies find solutions to technology problems, Yet2.com brokers technology transfer both into and out of companies, universities, and government labs. Yet2.com works with clients to write briefs describing the technology that they’re seeking or making available for license or purchase, and distributes these briefs throughout a global network of businesses, labs, and

institutions. Network members interested in posted briefs contact Yet2.com and request an introduction to the relevant client. Once introduced, the parties negotiate directly with each other. Through Yet2.com, P&G was able to license its low-cost microneedle technology to a company specializing in drug delivery. As a result of this relationship, we have ourselves licensed technology that has applications in some of our core businesses.

When to Engage

Once products and ideas are identified by our networks around the world, we need to screen them internally. All the screening methods are driven by a core understanding, pushed down through the entire organization, of what we’re looking for. It’s beyond the scope of this article to describe all of the processes we use to evaluate ideas from outside. But a look at how we might screen a new product found by a technology entrepreneur illustrates one common approach.

When our technology entrepreneurs are meeting with lab heads, scanning patents, or selecting products off store shelves, they’re conducting an initial screening in real time: Which products, technologies, or ideas meet P&G’s where-to-play criteria? Let’s assume a technology entrepreneur finds a promising product on a store shelf that passes this initial screening. His or her next step will be to log the product into our online “eureka catalog,” using a template that helps organize certain facts about the product: What is it? How does it meet our business needs? Are its patents available? What are its current sales? The catalog’s descriptions and pictures (which have a kind of Sharper Image feel) are distributed to general managers, brand managers, R&D teams, and others throughout the company worldwide, according to their interests, for evaluation.

Meanwhile, the technology entrepreneur may actively promote the product to specific managers in relevant lines of business. If an item captures the attention of, say, the director of the baby care business, she will assess its alignment with the goals of the business and subject it to a battery of practical questions—such as whether P&G has the technical infrastructure needed to develop the product—meant to identify any showstopping impediments to development. The director will also gauge the product’s business potential. If the item continues to look promising, it may be tested in consumer panels and, if the response is positive, moved into our product development portfolio. Then we’ll engage our external business development (EBD) group to contact the product’s manufacturer and begin negotiating licensing, collaboration, or other deal structures. (The EBD group is also responsible for licensing P&G’s intellectual property to third parties. Often, we find that the most profitable arrangements are ones where we both license to and license from the same company.) At this point, the product found on the outside has entered a development pipeline similar in many ways to that for any product developed in-house.

The process, of course, is more complex and rigorous than this thumbnail sketch suggests. In the end, for every 100 ideas found on the outside, only one ends up in the market.

Push the Culture

No amount of idea hunting on the outside will pay off if, internally, the organization isn’t behind the program. Once an idea gets into the development pipeline, it needs R&D, manufacturing, market research, marketing, and other functions pulling for it. But, as you know, until very recently, P&G was deeply centralized and internally focused. For connect and develop to work, we’ve had to nurture an internal culture change while developing systems for making

connections. And that has involved not only opening the company’s floodgates to ideas from the outside but actively promoting internal idea exchanges as well.

For any product development program, we tell R&D staff that they should start by finding out whether related work is being done elsewhere in the company; then they should see if an external source—a partner or supplier, for instance—has a solution. Only if those two avenues yield nothing should we consider inventing a solution from scratch. Wherever the solution comes from (inside or out), if the end product succeeds in the marketplace, the rewards for employees involved in its development are the same. In fact, to the extent that employees get recognition for the speed of product development, our reward systems actually favor innovations developed from outside ideas since, like Pringles Prints, these often move more quickly from concept to market.

Words of Warning

Procter & Gamble’s development and implementation of connect and develop has unfolded over many years. There have been some hiccups along the way, but largely it has been a methodical process of learning by doing, abandoning what doesn’t work and expanding what does. Over five years in, we’ve identified three core requirements for a successful connect-and-develop strategy.

Never assume that “ready to go” ideas found outside are truly ready to go. There will always be development work to do, including risky scale-up.

Don’t underestimate the internal resources required. You’ll need a full-time, senior executive to run any connect-and-develop initiative.

Never launch without a mandate from the CEO. Connect and develop cannot succeed if it’s cordoned off in R&D. It must be a top-down, companywide strategy.

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We have two broad goals for this reward structure. One is to make sure that the best ideas, wherever they come from, rise

to the surface. The other is to exert steady pressure on the culture, to continue to shift mind-sets away from resistance to “not invented here.” Early on, employees were anxious that connect and develop might eliminate jobs or that P&G would lose capabilities. That stands to reason, since as you increase the ideas coming in from the outside you might expect an equivalent decrease in the need for internal ideas. But with our growth objectives, there is no limit to our need for solid business-building ideas. Connect and develop has not eliminated R&D jobs, and it has actually required the company to develop new skills. There are still pockets within P&G that have not embraced connect and develop, but the trend has been toward accepting the approach, even championing it, as its benefits have accrued and people have seen that it reinforces their own work.

Adapt or Die

We believe that connect and develop will become the dominant innovation model in the twenty-first century. For most companies, as we’ve argued, the alternative invent-it-ourselves model is a sure path to diminishing returns.

To succeed, connect and develop must be driven by the top leaders in the organization. It is destined to fail if it is seen as solely an R&D strategy or isolated as an experiment in some other corner of the company. As Lafley did at P&G, the CEO of any organization must make it an explicit company strategy and priority to capture a certain amount of innovation externally. In our case, the target is a demanding—even radical—50%, but we’re well on our way to achieving it.

Don’t postpone crafting a connect-and-develop strategy, and don’t approach the process incrementally. Companies that fail to adapt to this model won’t survive the competition.

A version of this article appeared in the March 2006 issue of Harvard Business Review.

Leadership That Gets ResultsAsk any group of businesspeople the question “What do effective leaders do?” and you’ll hear a sweep of answers. Leaders set strategy; they motivate; they create a mission; they build a culture. Then ask “Whatshould leaders do?” If the group is seasoned, you’ll likely hear one response: the leader’s singular job is to get results.

But how? The mystery of what leaders can and ought to do in order to spark the best performance from their people is age-old. In recent years, that mystery has spawned an entire cottage industry: literally thousands of “leadership experts” have made careers of testing and coaching executives, all in pursuit of creating businesspeople who can turn bold objectives—be they strategic, financial, organizational, or all three—into reality.

Still, effective leadership eludes many people and organizations. One reason is that until recently, virtually no quantitative research has demonstrated which precise leadership behaviors yield positive results. Leadership experts proffer advice based on inference, experience, and instinct. Sometimes that advice is which precise leadership behaviors yield positive results. Leadership experts proffer advice based on inference, experience, and instinct. Sometimes that advice is right on target; sometimes it’s not.

But new research by the consulting firm Hay/McBer, which draws on a random sample of 3,871 executives selected from a database of more than 20,000 executives worldwide, takes much of the mystery out of effective leadership. The research found six distinct leadership styles, each springing from different components of emotional intelligence. The styles, taken individually, appear to have a direct and unique impact on the working atmosphere of a company, division, or team, and in turn, on its financial performance. And perhaps most important, the research indicates that leaders with the best results do not rely on only one leadership style; they use most of them in a given week—seamlessly and in different measure—depending on the business situation. Imagine the styles, then, as the array of clubs in a golf pro’s bag. Over the course of a game, the pro picks and chooses clubs based on the demands of the shot. Sometimes he has to ponder his selection, but usually it is automatic. The pro senses the challenge ahead, swiftly pulls out the right tool, and elegantly puts it to work. That’s how high-impact leaders operate, too.

Emotional intelligence—the ability to manage ourselves and our relationships effectively—consists of four fundamental capabilities: self-awareness, self-management, social awareness, and social skill. Each capability, in turn, is composed of specific sets of competencies. Below is a list of the capabilities and their corresponding traits.

What are the six styles of leadership? None will shock workplace veterans. Indeed, each style, by name and brief description alone, will likely resonate with anyone who leads, is led, or as is the case with most of us, does both. Coercive leaders demand immediate compliance. Authoritative leaders mobilize people toward a vision.Affiliative leaders create emotional bonds and harmony. Democratic leaders build consensus through participation. Pacesetting leaders expect excellence and self-direction. And coaching leaders develop people for the future.

Close your eyes and you can surely imagine a colleague who uses any one of these styles. You most likely use at least one yourself. What is new in this research, then, is its implications for action. First, it offers a fine-grained understanding of how different leadership styles affect performance and results. Second, it offers clear guidance on when a manager should switch between them. It also strongly suggests that switching flexibly is well advised. New, too, is the research’s finding that each leadership style springs from different components of emotional intelligence.

Measuring Leadership’s Impact

It has been more than a decade since research first linked aspects of emotional intelligence to business results. The late David McClelland, a noted Harvard University psychologist, found that leaders with strengths in a critical mass of six or more emotional intelligence competencies were far more effective than peers who lacked such strengths. For instance, when he analyzed the performance of division heads at a global food and beverage company, he found that among leaders with this critical mass of competence, 87% placed in the top third for annual salary bonuses based on their business performance. More telling, their divisions on average outperformed yearly revenue targets by 15% to 20%. Those executives who lacked emotional intelligence were rarely rated as outstanding in their annual performance reviews, and their divisions underperformed by an average of almost 20%.

Our research set out to gain a more molecular view of the links among leadership and emotional intelligence, and climate and performance. A team of McClelland’s colleagues headed by Mary Fontaine and Ruth Jacobs from Hay/McBer studied data about or observed thousands of executives, noting specific behaviors and their impact on climate.1 How did each individual motivate direct reports? Manage change initiatives? Handle crises? It was in a later phase of the research that we identified which emotional intelligence capabilities drive the six leadership styles. How does he rate in terms of self-control and social skill? Does a leader show high or low levels of empathy?

The team tested each executive’s immediate sphere of influence for its climate. “Climate” is not an amorphous term. First defined by psychologists George Litwin and Richard Stringer and later refined by McClelland and his colleagues, it refers to six key factors that influence an organization’s working environment: its flexibility—that is, how free employees feel to innovate unencumbered by red tape; their sense ofresponsibility to the organization; the level of standards that people set; the sense of accuracy about performance feedback and aptness of rewards; the clarity people have about mission and values; and finally, the level of commitment to a common purpose.

Getting Molecular : The Impact of Leadership Styles on Drivers of Climate

Our research investigated how each leadership style affected the six drivers of climate, or working atmosphere. The figures below show the correlation between each leadership style and each aspect of climate. So, for instance, if we look at the climate driver of flexibility, we see that the coercive style has a -.28 correlation while the democratic style has a .28 correlation, equally strong in the opposite direction. Focusing on the authoritative leadership style, we find that it has a .54 correlation with rewards—strongly positive—and a .21 correlation with responsibility—positive, but not as strong. In other words, the style’s correlation with rewards was more than twice that with responsibility.

According to the data, the authoritative leadership style has the most positive effect on climate, but three others—affiliative, democratic, and coaching—follow close behind. That said, the research indicates that no style should be relied on exclusively, and all have at least short-term uses.

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We found that all six leadership styles have a measurable effect on each aspect of climate. (For details, see the exhibit “Getting Molecular: The Impact of Leadership Styles on Drivers of Climate.”) Further, when we looked at the impact of climate on financial results—such as return on sales, revenue growth, efficiency, and profitability—we found a direct correlation between the two. Leaders who used styles that positively affected the climate had decidedly better financial results than those who did not. That is not to say that organizational climate is the only driver of performance. Economic conditions and competitive dynamics matter enormously. But our analysis strongly suggests that climate accounts for nearly a third of results. And that’s simply too much of an impact to ignore.

The Styles in Detail

Executives use six leadership styles, but only four of the six consistently have a positive effect on climate and results. Let’s look then at each style of leadership in detail. (For a summary of the material that follows, see the chart “The Six Leadership Styles at a Glance.”)

The Coercive Style.

The computer company was in crisis mode—its sales and profits were falling, its stock was losing value precipitously, and its shareholders were in an uproar. The board brought in a new CEO with a reputation as a turnaround artist. He set to work chopping jobs, selling off divisions, and making the tough decisions that should have been executed years before. The company was saved, at least in the short-term.

From the start, though, the CEO created a reign of terror, bullying and demeaning his executives, roaring his displeasure at the slightest misstep. The company’s top echelons were decimated not just by his erratic firings but also by defections. The CEO’s direct reports, frightened by his tendency to blame the bearer of bad news, stopped bringing him any news at all. Morale was at an all-time low—a fact reflected in another downturn in the business after the short-term recovery. The CEO was eventually fired by the board of directors.

It’s easy to understand why of all the leadership styles, the coercive one is the least effective in most situations. Consider what the style does to an organization’s climate. Flexibility is the hardest hit. The leader’s extreme top-down decision making kills new ideas on the vine. People feel so disrespected that they think, “I won’t even bring my ideas up—they’ll only be shot down.” Likewise, people’s sense of responsibility evaporates: unable to act on their own initiative, they lose their sense of ownership and feel little accountability for their performance. Some become so resentful they adopt the attitude, “I’m not going to help this bastard.”

Coercive leadership also has a damaging effect on the rewards system. Most high-performing workers are motivated by more than money—they seek the satisfaction of work well done. The coercive style erodes such pride. And finally, the style undermines one of the leader’s prime tools—motivating people by showing them how their job fits into a grand, shared mission. Such a loss, measured in terms of diminished clarity and commitment, leaves people alienated from their own jobs, wondering, “How does any of this matter?”

Given the impact of the coercive style, you might assume it should never be applied. Our research, however, uncovered a few occasions when it worked masterfully. Take the case of a division president who was brought in to change the direction of a food company that was losing money. His first act was to have the executive conference room demolished. To him, the room—with its long marble table that looked like “the deck of the Starship Enterprise”—symbolized the tradition-bound formality that was paralyzing the company. The destruction of the room, and the subsequent move to a smaller, more informal setting, sent a message no one could miss, and the division’s culture changed quickly in its wake.

That said, the coercive style should be used only with extreme caution and in the few situations when it is absolutely imperative, such as during a turnaround or when a hostile takeover is looming. In those cases, the coercive style can break failed business habits and shock people into new ways of working. It is always appropriate during a genuine emergency, like in the aftermath of an earthquake or a fire. And it can work with problem employees with whom all else has failed. But if a leader relies solely on this style or continues to use it once the emergency passes, the long-term impact of his insensitivity to the morale and feelings of those he leads will be ruinous.

The Authoritative Style.

Tom was the vice president of marketing at a floundering national restaurant chain that specialized in pizza. Needless to say, the company’s poor performance troubled the senior managers, but they were at a loss for what to do. Every Monday, they met to review recent sales, struggling to come up with fixes. To Tom, the approach didn’t make sense. “We were always trying to figure out why our sales were down last week. We had the whole company looking backward instead of figuring out what we had to do tomorrow.”

Tom saw an opportunity to change people’s way of thinking at an off-site strategy meeting. There, the conversation began with stale truisms: the company had to drive up shareholder wealth and increase return on assets. Tom believed those concepts didn’t have the power to inspire a restaurant manager to be innovative or to do better than a good-enough job.

So Tom made a bold move. In the middle of a meeting, he made an impassioned plea for his colleagues to think from the customer’s perspective. Customers want convenience, he said. The company was not in the restaurant business, it was in the business of distributing high-quality, convenient-to-get pizza. That notion—and nothing else—should drive everything the company did.

With his vibrant enthusiasm and clear vision—the hallmarks of the authoritative style—Tom filled a leadership vacuum at the company. Indeed, his concept became the core of the new mission statement. But this conceptual breakthrough was just the beginning. Tom made sure that the mission statement was built into the company’s strategic planning process as the designated driver of growth. And he ensured that the vision was articulated so that local restaurant managers understood they were the key to the company’s success and were free to find new ways to distribute pizza.

Changes came quickly. Within weeks, many local managers started guaranteeing fast, new delivery times. Even better, they started to act like entrepreneurs, finding ingenious locations to open new branches: kiosks on busy street corners and in bus and train stations, even from carts in airports and hotel lobbies.

Tom’s success was no fluke. Our research indicates that of the six leadership styles, the authoritative one is most effective, driving up every aspect of climate. Take clarity. The authoritative leader is a visionary; he motivates people by making clear to them how their work fits into a larger vision for the organization. People who work for such leaders understand that what they do matters and why. Authoritative leadership also maximizes commitment to the organization’s goals and strategy. By framing the individual tasks within a grand vision, the authoritative leader defines standards that revolve around that vision. When he gives performance feedback—whether positive or negative—the singular criterion is whether or not that performance furthers the vision. The standards for success are clear to all, as are the rewards. Finally, consider the style’s impact on flexibility. An authoritative leader states the end but generally gives people plenty of leeway to devise their own means. Authoritative leaders give people the freedom to innovate, experiment, and take calculated risks.

An authoritative leader states the end but gives people their own means.

Because of its positive impact, the authoritative style works well in almost any business situation. But it is particularly effective when a business is adrift. An authoritative leader charts a new course and sells his people on a fresh long-term vision.

The authoritative style, powerful though it may be, will not work in every situation. The approach fails, for instance, when a leader is working with a team of experts or peers who are more experienced than he is; they may see the leader as pompous or out-of-touch. Another limitation: if a manager trying to be authoritative becomes overbearing, he can undermine the egalitarian spirit of an effective team. Yet even with such caveats, leaders would be wise to grab for the authoritative “club” more often than not. It may not guarantee a hole in one, but it certainly helps with the long drive.

The Affiliative Style.

If the coercive leader demands, “Do what I say,” and the authoritative urges, “Come with me,” the affiliative leader says, “People come first.” This leadership style revolves around people—its proponents value individuals and their emotions more than tasks and goals. The affiliative leader strives to keep employees happy and to create harmony among them. He manages by building strong emotional bonds and then reaping the benefits of such an approach, namely fierce loyalty. The style also has a markedly positive effect on communication. People who like one another a lot talk a lot. They share ideas; they share inspiration. And the style drives up flexibility; friends trust one another, allowing habitual innovation and risk taking. Flexibility also rises because the affiliative leader, like a parent who adjusts household rules for a maturing adolescent, doesn’t impose unnecessary strictures on how employees get their work done. They give people the freedom to do their job in the way they think is most effective.

As for a sense of recognition and reward for work well done, the affiliative leader offers ample positive feedback. Such feedback has special potency in the workplace because it is all too rare: outside of an annual review, most people usually get no feedback on their day-to-day efforts—or only negative feedback. That makes the affiliative leader’s positive words all the more motivating. Finally, affiliative leaders are masters at building a sense of belonging. They are, for instance, likely to take their direct reports out for a meal or a drink, one-on-one, to see how they’re doing. They will bring in a cake to celebrate a group accomplishment. They are natural relationship builders.

Joe Torre, the heart and soul of the New York Yankees, is a classic affiliative leader. During the 1999 World Series, Torre tended ably to the psyches of his players as they endured the emotional pressure cooker of a pennant race. All season long, he made a special point to praise Scott Brosius, whose father had died during the season, for staying committed even as he mourned. At the celebration party after the team’s final game, Torre specifically sought out right fielder Paul O’Neill. Although he had received the news of his father’s death that morning, O’Neill chose to play in the decisive game—and he burst into tears the moment it ended. Torre made a point of acknowledging O’Neill’s personal struggle, calling him a “warrior.” Torre also used the spotlight of the victory celebration to praise two players whose return the following year was threatened by contract disputes. In doing so, he sent a clear message to the team and to the club’s owner that he valued the players immensely—too much to lose them.

Along with ministering to the emotions of his people, an affiliative leader may also tend to his own emotions openly. The year Torre’s brother was near death awaiting a heart transplant, he shared his worries with his players. He also spoke candidly with the team about his treatment for prostate cancer.

The affiliative style’s generally positive impact makes it a good all-weather approach, but leaders should employ it particularly when trying to build team harmony, increase morale, improve communication, or repair broken trust. For instance, one executive in our study was hired to replace a ruthless team leader. The former leader had taken credit for his employees’ work and had attempted to pit them against one another. His efforts ultimately failed, but the team he left behind was suspicious and weary. The new executive managed to mend the situation by unstintingly showing emotional honesty and rebuilding ties. Several months in, her leadership had created a renewed sense of commitment and energy.

Despite its benefits, the affiliative style should not be used alone. Its exclusive focus on praise can allow poor performance to go uncorrected; employees may perceive that mediocrity is tolerated. And because affiliative leaders rarely offer constructive advice on how to improve, employees must figure out how to do so on their own. When people need clear directives to navigate through complex challenges, the affiliative style leaves them rudderless. Indeed, if overly relied on, this style can actually steer a group to failure. Perhaps that is why many affiliative leaders, including Torre, use this style in close conjunction with the authoritative style. Authoritative leaders state a vision, set standards, and let people know how their work is furthering the group’s goals. Alternate that with the caring, nurturing approach of the affiliative leader, and you have a potent combination.

The Democratic Style.

Sister Mary ran a Catholic school system in a large metropolitan area. One of the schools—the only private school in an impoverished neighborhood—had been losing money for years, and the archdiocese could no longer afford to keep it open. When Sister Mary eventually got the order to shut it down, she didn’t just lock the doors. She called a meeting of all the teachers and staff at the school and explained to them the details of the financial crisis—the first time anyone working at the school had been included in the business side of the institution. She asked for their ideas on ways to keep the school open and on how to handle the closing, should it come to that. Sister Mary spent much of her time at the meeting just listening.

She did the same at later meetings for school parents and for the community and during a successive series of meetings for the school’s teachers and staff. After two months of meetings, the consensus was clear: the school would have to close. A plan was made to transfer students to other schools in the Catholic system.

The final outcome was no different than if Sister Mary had gone ahead and closed the school the day she was told to. But by allowing the school’s constituents to reach that decision collectively, Sister Mary received none of the backlash that would have accompanied such a move. People mourned the loss of the school, but they understood its inevitability. Virtually no one objected.

Compare that with the experiences of a priest in our research who headed another Catholic school. He, too, was told to shut it down. And he did—by fiat. The result was disastrous: parents filed lawsuits, teachers and parents picketed, and local newspapers ran editorials attacking his decision. It took a year to resolve the disputes before he could finally go ahead and close the school.

Sister Mary exemplifies the democratic style in action—and its benefits. By spending time getting people’s ideas and buy-in, a leader builds trust, respect, and commitment. By letting workers themselves have a say in decisions that affect their goals and how they do their work, the democratic leader drives up flexibility and responsibility. And by listening to employees’ concerns, the democratic leader learns what to do to keep morale high. Finally, because they have a say in setting their goals and the standards for evaluating success, people operating in a democratic system tend to be very realistic about what can and cannot be accomplished.

However, the democratic style has its drawbacks, which is why its impact on climate is not as high as some of the other styles. One of its more exasperating consequences can be endless meetings where ideas are mulled over, consensus remains elusive, and the only visible result is scheduling more meetings. Some democratic leaders use the style to put off making crucial decisions, hoping that enough thrashing things out will eventually yield a blinding insight. In reality, their people end up feeling confused and leaderless. Such an approach can even escalate conflicts.

When does the style work best? This approach is ideal when a leader is himself uncertain about the best direction to take and needs ideas and guidance from able employees. And even if a leader has a strong vision, the democratic style works well to generate fresh ideas for executing that vision.

The democratic style, of course, makes much less sense when employees are not competent or informed enough to offer sound advice. And it almost goes without saying that building consensus is wrongheaded in times of crisis. Take the case of a CEO whose computer company was severely threatened by changes in the market. He always sought consensus about what to do. As competitors stole customers and customers’ needs changed, he kept appointing committees to consider the situation. When the market made a sudden shift because of a new technology, the CEO froze in his tracks. The board replaced him before he could appoint yet another task force to consider the situation. The new CEO, while occasionally democratic and affiliative, relied heavily on the authoritative style, especially in his first months.

The Pacesetting Style.

Like the coercive style, the pacesetting style has its place in the leader’s repertory, but it should be used sparingly. That’s not what we expected to find. After all, the hallmarks of the pacesetting style sound admirable. The leader sets extremely high performance standards and exemplifies them himself. He is obsessive about doing things better and faster, and he asks the same of everyone around him. He quickly pinpoints poor performers and demands more from them. If they don’t rise to the occasion, he replaces them with people who can. You would think such an approach would improve results, but it doesn’t.

In fact, the pacesetting style destroys climate. Many employees feel overwhelmed by the pacesetter’s demands for excellence, and their morale drops. Guidelines for working may be clear in the leader’s head, but she does not state them clearly; she expects people to know what to do and even thinks, “If I have to tell you, you’re the wrong person for the job.” Work becomes not a matter of doing one’s best along a clear course so much as second-guessing what the leader wants. At the same time, people often feel that the pacesetter doesn’t trust them to work in their own way or to take initiative. Flexibility and responsibility evaporate; work becomes so task focused and routinized it’s boring.

As for rewards, the pacesetter either gives no feedback on how people are doing or jumps in to take over when he thinks they’re lagging. And if the leader should leave, people feel directionless—they’re so used to “the expert” setting the rules. Finally, commitment dwindles under the regime of a pacesetting leader because people have no sense of how their personal efforts fit into the big picture.

For an example of the pacesetting style, take the case of Sam, a biochemist in R&D at a large pharmaceutical company. Sam’s superb technical expertise made him an early star: he was the one everyone turned to when they needed help. Soon he was promoted to head of a team developing a new product. The other scientists on the team were as competent and self-motivated as Sam; his métier as team leader became offering himself as a model of how to do first-class scientific work under tremendous deadline pressure, pitching in when needed. His team completed its task in record time.

But then came a new assignment: Sam was put in charge of R&D for his entire division. As his tasks expanded and he had to articulate a vision, coordinate projects, delegate responsibility, and help develop others, Sam began to slip. Not trusting that his subordinates were as capable as he was, he became a micromanager, obsessed with details and taking over for others when their performance

slackened. Instead of trusting them to improve with guidance and development, Sam found himself working nights and weekends after stepping in to take over for the head of a floundering research team. Finally, his own boss suggested, to his relief, that he return to his old job as head of a product development team.

Although Sam faltered, the pacesetting style isn’t always a disaster. The approach works well when all employees are self-motivated, highly competent, and need little direction or coordination—for example, it can work for leaders of highly skilled and self-motivated professionals, like R&D groups or legal teams. And, given a talented team to lead, pace-setting does exactly that: gets work done on time or even ahead of schedule. Yet like any leadership style, pacesetting should never be used by itself.

The Coaching Style.

A product unit at a global computer company had seen sales plummet from twice as much as its competitors to only half as much. So Lawrence, the president of the manufacturing division, decided to close the unit and reassign its people and products. Upon hearing the news, James, the head of the doomed unit, decided to go over his boss’s head and plead his case to the CEO.

What did Lawrence do? Instead of blowing up at James, he sat down with his rebellious direct report and talked over not just the decision to close the division but also James’s future. He explained to James how moving to another division would help him develop new skills. It would make him a better leader and teach him more about the company’s business.

Lawrence acted more like a counselor than a traditional boss. He listened to James’s concerns and hopes, and he shared his own. He said he believed James had grown stale in his current job; it was, after all, the only place he’d worked in the company. He predicted that James would blossom in a new role.

The conversation then took a practical turn. James had not yet had his meeting with the CEO—the one he had impetuously demanded when he heard of his division’s closing. Knowing this—and also knowing that the CEO unwaveringly supported the closing—Lawrence took the time to coach James on how to present his case in that meeting. “You don’t get an audience with the CEO very often,” he noted, “let’s make sure you impress him with your thoughtfulness.” He advised James not to plead his personal case but to focus on the business unit: “If he thinks you’re in there for your own glory, he’ll throw you out faster than you walked through the door.” And he urged him to put his ideas in writing; the CEO always appreciated that.

Lawrence’s reason for coaching instead of scolding? “James is a good guy, very talented and promising,” the executive explained to us, “and I don’t want this to derail his career. I want him to stay with the company, I want him to work out, I want him to learn, I want him to benefit and grow. Just because he screwed up doesn’t mean he’s terrible.”

Lawrence’s actions illustrate the coaching style par excellence. Coaching leaders help employees identify their unique strengths and weaknesses and tie them to their personal and career aspirations. They encourage employees to establish long-term development goals and help them conceptualize a plan for

attaining them. They make agreements with their employees about their role and responsibilities in enacting development plans, and they give plentiful instruction and feedback. Coaching leaders excel at delegating; they give employees challenging assignments, even if that means the tasks won’t be accomplished quickly. In other words, these leaders are willing to put up with short-term failure if it furthers long-term learning.

Of the six styles, our research found that the coaching style is used least often. Many leaders told us they don’t have the time in this high-pressure economy for the slow and tedious work of teaching people and helping them grow. But after a first session, it takes little or no extra time. Leaders who ignore this style are passing up a powerful tool: its impact on climate and performance are markedly positive.

Admittedly, there is a paradox in coaching’s positive effect on business performance because coaching focuses primarily on personal development, not on immediate work-related tasks. Even so, coaching improves results. The reason: it requires constant dialogue, and that dialogue has a way of pushing up every driver of climate. Take flexibility. When an employee knows his boss watches him and cares about what he does, he feels free to experiment. After all, he’s sure to get quick and constructive feedback. Similarly, the ongoing dialogue of coaching guarantees that people know what is expected of them and how their work fits into a larger vision or strategy. That affects responsibility and clarity. As for commitment, coaching helps there, too, because the style’s implicit message is, “I believe in you, I’m investing in you, and I expect your best efforts.” Employees very often rise to that challenge with their heart, mind, and soul.

The coaching style works well in many business situations, but it is perhaps most effective when people on the receiving end are “up for it.” For instance, the coaching style works particularly well when employees are already aware of their weaknesses and would like to improve their performance. Similarly, the style works well when employees realize how cultivating new abilities can help them advance. In short, it works best with employees who want to be coached.

By contrast, the coaching style makes little sense when employees, for whatever reason, are resistant to learning or changing their ways. And it flops if the leader lacks the expertise to help the employee along. The fact is, many managers are unfamiliar with or simply inept at coaching, particularly when it comes to giving ongoing performance feedback that motivates rather than creates fear or apathy. Some companies have realized the positive impact of the style and are trying to make it a core competence. At some companies, a significant portion of annual bonuses are tied to an executive’s development of his or her direct reports. But many organizations have yet to take full advantage of this leadership style. Although the coaching style may not scream “bottom-line results,” it delivers them.

Leaders Need Many Styles

Many studies, including this one, have shown that the more styles a leader exhibits, the better. Leaders who have mastered four or more—especially the authoritative, democratic, affiliative, and coaching styles—have the very best climate and business performance. And the most effective leaders switch flexibly among the leadership styles as needed. Although that may sound daunting, we witnessed it

more often than you might guess, at both large corporations and tiny start-ups, by seasoned veterans who could explain exactly how and why they lead and by entrepreneurs who claim to lead by gut alone.

Leaders who have mastered four or more—especially the authoritative, democratic, affiliative, and coaching styles—have the best climate and business performance.

Such leaders don’t mechanically match their style to fit a checklist of situations—they are far more fluid. They are exquisitely sensitive to the impact they are having on others and seamlessly adjust their style to get the best results. These are leaders, for example, who can read in the first minutes of conversation that a talented but underperforming employee has been demoralized by an unsympathetic, do-it-the-way-I-tell-you manager and needs to be inspired through a reminder of why her work matters. Or that leader might choose to reenergize the employee by asking her about her dreams and aspirations and finding ways to make her job more challenging. Or that initial conversation might signal that the employee needs an ultimatum: improve or leave.

For an example of fluid leadership in action, consider Joan, the general manager of a major division at a global food and beverage company. Joan was appointed to her job while the division was in a deep crisis. It had not made its profit targets for six years; in the most recent year, it had missed by $50 million. Morale among the top management team was miserable; mistrust and resentments were rampant. Joan’s directive from above was clear: turn the division around.

Joan did so with a nimbleness in switching among leadership styles that is rare. From the start, she realized she had a short window to demonstrate effective leadership and to establish rapport and trust. She also knew that she urgently needed to be informed about what was not working, so her first task was to listen to key people.

Her first week on the job she had lunch and dinner meetings with each member of the management team. Joan sought to get each person’s understanding of the current situation. But her focus was not so much on learning how each person diagnosed the problem as on getting to know each manager as a person. Here Joan employed the affiliative style: she explored their lives, dreams, and aspirations.

She also stepped into the coaching role, looking for ways she could help the team members achieve what they wanted in their careers. For instance, one manager who had been getting feedback that he was a poor team player confided his worries to her. He thought he was a good team member, but he was plagued by persistent complaints. Recognizing that he was a talented executive and a valuable asset to the company, Joan made an agreement with him to point out (in private) when his actions undermined his goal of being seen as a team player.

She followed the one-on-one conversations with a three-day off-site meeting. Her goal here was team building, so that everyone would own whatever solution for the business problems emerged. Her initial stance at the off-site meeting was that of a democratic leader. She encouraged everyone to express freely their frustrations and complaints.

The next day, Joan had the group focus on solutions: each person made three specific proposals about what needed to be done. As Joan clustered the suggestions, a natural consensus emerged about priorities for the business, such as cutting costs. As the group came up with specific action plans, Joan got the commitment and buy-in she sought.

With that vision in place, Joan shifted into the authoritative style, assigning accountability for each follow-up step to specific executives and holding them responsible for their accomplishment. For example, the division had been dropping prices on products without increasing its volume. One obvious solution was to raise prices, but the previous VP of sales had dithered and had let the problem fester. The new VP of sales now had responsibility to adjust the price points to fix the problem.

Over the following months, Joan’s main stance was authoritative. She continually articulated the group’s new vision in a way that reminded each member of how his or her role was crucial to achieving these goals. And, especially during the first few weeks of the plan’s implementation, Joan felt that the urgency of the business crisis justified an occasional shift into the coercive style should someone fail to meet his or her responsibility. As she put it, “I had to be brutal about this follow-up and make sure this stuff happened. It was going to take discipline and focus.”

The results? Every aspect of climate improved. People were innovating. They were talking about the division’s vision and crowing about their commitment to new, clear goals. The ultimate proof of Joan’s fluid leadership style is written in black ink: after only seven months, her division exceeded its yearly profit target by $5 million.

Expanding Your Repertory

Few leaders, of course, have all six styles in their repertory, and even fewer know when and how to use them. In fact, as we have brought the findings of our research into many organizations, the most common responses have been, “But I have only two of those!” and, “I can’t use all those styles. It wouldn’t be natural.”

Such feelings are understandable, and in some cases, the antidote is relatively simple. The leader can build a team with members who employ styles she lacks. Take the case of a VP for manufacturing. She successfully ran a global factory system largely by using the affiliative style. She was on the road constantly, meeting with plant managers, attending to their pressing concerns, and letting them know how much she cared about them personally. She left the division’s strategy—extreme efficiency—to a trusted lieutenant with a keen understanding of technology, and she delegated its performance standards to a colleague who was adept at the authoritative approach. She also had a pacesetter on her team who always visited the plants with her.

An alternative approach, and one I would recommend more, is for leaders to expand their own style repertories. To do so, leaders must first understand which emotional intelligence competencies underlie the leadership styles they are lacking. They can then work assiduously to increase their quotient of them.

For instance, an affiliative leader has strengths in three emotional intelligence competencies: in empathy, in building relationships, and in communication. Empathy—sensing how people are feeling in the moment—allows the affiliative leader to respond to employees in a way that is highly congruent with that person’s emotions, thus building rapport. The affiliative leader also displays a natural ease in forming new relationships, getting to know someone as a person, and cultivating a bond. Finally, the outstanding affiliative leader has mastered the art of interpersonal communication, particularly in saying just the right thing or making the apt symbolic gesture at just the right moment.

So if you are primarily a pacesetting leader who wants to be able to use the affiliative style more often, you would need to improve your level of empathy and, perhaps, your skills at building relationships or communicating effectively. As another example, an authoritative leader who wants to add the democratic style to his repertory might need to work on the capabilities of collaboration and communication. Such advice about adding capabilities may seem simplistic—”Go change yourself”—but enhancing emotional intelligence is entirely possible with practice. (For more on how to improve emotional intelligence, see the sidebar “Growing Your Emotional Intelligence.”)

Growing Your Emotional Intelligence

Unlike IQ, which is largely genetic—it changes little from childhood—the skills of emotional intelligence can be learned at any age. It’s not easy, however. Growing your emotional intelligence takes practice and commitment. But the payoffs are well worth the investment.

Consider the case of a marketing director for a division of a global food company. Jack, as I’ll call him, was a classic pacesetter: high-energy, always striving to find better ways to get things done, and too eager to step in and take over when, say, someone seemed about to miss a deadline. Worse, Jack was prone to pounce on anyone who didn’t seem to meet his standards, flying off the handle if a person merely deviated from completing a job in the order Jack thought best.

Jack’s leadership style had a predictably disastrous impact on climate and business results. After two years of stagnant performance, Jack’s boss suggested he seek out a coach. Jack wasn’t pleased but, realizing his own job was on the line, he complied.

The coach, an expert in teaching people how to increase their emotional intelligence, began with a 360-degree evaluation of Jack. A diagnosis from multiple viewpoints is essential in improving emotional intelligence because those who need the most help usually have blind spots. In fact, our research found that top-performing leaders overestimate their strengths on, at most, one emotional intelligence ability, whereas poor performers overrate themselves on four or more. Jack was not that far off, but he did rate himself more glowingly than his direct reports, who gave him especially low grades on emotional self-control and empathy.

Initially, Jack had some trouble accepting the feedback data. But when his coach showed him how those weaknesses were tied to his inability to display leadership styles dependent on those competencies—especially the authoritative, affiliative, and coaching styles—Jack realized he had to improve if he wanted to advance in the company. Making such a connection is essential. The reason: improving

emotional intelligence isn’t done in a weekend or during a seminar—it takes diligent practice on the job, over several months. If people do not see the value of the change, they will not make that effort.

Once Jack zeroed in on areas for improvement and committed himself to making the effort, he and his coach worked up a plan to turn his day-to-day job into a learning laboratory. For instance, Jack discovered he was empathetic when things were calm, but in a crisis, he tuned out others. This tendency hampered his ability to listen to what people were telling him in the very moments he most needed to do so. Jack’s plan required him to focus on his behavior during tough situations. As soon as he felt himself tensing up, his job was to immediately step back, let the other person speak, and then ask clarifying questions. The point was to not act judgmental or hostile under pressure.

The change didn’t come easily, but with practice Jack learned to defuse his flare-ups by entering into a dialogue instead of launching a harangue. Although he didn’t always agree with them, at least he gave people a chance to make their case. At the same time, Jack also practiced giving his direct reports more positive feedback and reminding them of how their work contributed to the group’s mission. And he restrained himself from micromanaging them.

Jack met with his coach every week or two to review his progress and get advice on specific problems. For instance, occasionally Jack would find himself falling back on his old pacesetting tactics—cutting people off, jumping in to take over, and blowing up in a rage. Almost immediately, he would regret it. So he and his coach dissected those relapses to figure out what triggered the old ways and what to do the next time a similar moment arose. Such “relapse prevention” measures inoculate people against future lapses or just giving up. Over a six-month period, Jack made real improvement. His own records showed he had reduced the number of flare-ups from one or more a day at the beginning to just one or two a month. The climate had improved sharply, and the division’s numbers were starting to creep upward.

Why does improving an emotional intelligence competence take months rather than days? Because the emotional centers of the brain, not just the neocortex, are involved. The neocortex, the thinking brain that learns technical skills and purely cognitive abilities, gains knowledge very quickly, but the emotional brain does not. To master a new behavior, the emotional centers need repetition and practice. Improving your emotional intelligence, then, is akin to changing your habits. Brain circuits that carry leadership habits have to unlearn the old ones and replace them with the new. The more often a behavioral sequence is repeated, the stronger the underlying brain circuits become. At some point, the new neural pathways become the brain’s default option. When that happened, Jack was able to go through the paces of leadership effortlessly, using styles that worked for him—and the whole company.

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More Science, Less Art

Like parenthood, leadership will never be an exact science. But neither should it be a complete mystery to those who practice it. In recent years, research has helped parents understand the genetic,

psychological, and behavioral components that affect their “job performance.” With our new research, leaders, too, can get a clearer picture of what it takes to lead effectively. And perhaps as important, they can see how they can make that happen.

The business environment is continually changing, and a leader must respond in kind. Hour to hour, day to day, week to week, executives must play their leadership styles like a pro—using the right one at just the right time and in the right measure. The payoff is in the results.

1. Daniel Goleman consults with Hay/McBer on leadership development.

A version of this article appeared in the March–April 2000 issue of Harvard Business Review.

Four Models of Corporate Entrepreneurship CEOs talk about growth; markets demand it.1 But profitable organic growth is difficult. When core businesses begin to flag, research suggests that fewer than 5% of companies regain growth rates of at least 1% above gross domestic product.2 Creating new businesses, or corporate entrepreneurship, offers one increasingly potent solution. According to a recent survey, companies that put greater emphasis on creating new business models grew their operating margins faster than the competition.3

But how can established organizations build successful new businesses on an ongoing basis? Certainly, the road is littered with failures. The iPod should have been a Sony Corp. product. The Japanese corporation had the heritage, brand, technology, channels — everything. But it was Apple Inc.’s Steve Jobs who recognized that the potential of portable digital music could be unlocked only through the creation of a new business, not just a better MP3 player.

To investigate how organizations succeed at corporate entrepreneurship, we conducted a study at nearly 30 global companies (see “About the Research.”). Through that research, we were able to define four fundamental models of corporate entrepreneurship and identify factors guiding when each model should be applied. This framework of corporate entrepreneurship should help companies avoid costly trial-and-error mistakes in selecting and constructing the best program for their objectives.

About the Research

Since the late 1990s, organizations as diverse as IBM, DuPont and Cargill have been developing new approaches to corporate entrepreneurship. To make sense of such initiatives, we asked those companies and others — nearly 30 — about numerous descriptive dimensions regarding their programs for creating new businesses. These dimensions ranged from contextual factors, such as market maturity and technology intensity, to the structural and cultural characteristics of the parent company, consistent with the dimensions commonly examined in the academic business literature. Our objective was to design a framework useful for managers and, after testing various approaches, we arrived at the framework described in this article.

What is Corporate Entrepreneurship?

First, though, what exactly is corporate entrepreneurship? We define the term as the process by which teams within an established company conceive, foster, launch and manage a new business that is distinct from the parent company but leverages the parent’s assets, market position, capabilities or other resources. It differs from corporate venture capital, which predominantly pursues financial investments in external companies. Although it often involves external partners and capabilities (including acquisitions), it engages significant resources of the established company, and internal teams typically manage projects. It’s also different from spinouts, which are generally constructed as stand-

alone enterprises that do not require continuous leveraging of current business activities to realize their potential.

Corporate entrepreneurship is more than just new product development, and it can include innovations in services, channels, brands and so on.4 Traditionally, companies have added value through innovations that fit existing business functions and activities. After all, why would they develop opportunities that can’t easily be brought to market?5 Unfortunately, this approach also limits what a company is willing or even able to bring to market.6 Indeed, the failure to recognize that new products and services can require significantly different business models is often what leads to missed opportunities. Corporate entrepreneurship initiatives seek to overcome such constraints.

In the past, companies have tried to implement corporate entrepreneurship by emulating an innovation leader. Such approaches, however, often failed. It was one thing to recognize that “organizational slack” was a key factor enabling 3M Co.’s success — 3M allowed its engineers and scientists to spend 15% of their time on projects of their own design — but it was quite another to implement slack at organizations with incentives and processes that thwarted such flexibility. As Dr. Nelson Levy, a former vice president of research and development and president of various global pharmaceutical companies once quipped, “I might as well give my people 15% paid leave!”

Four Models

Clearly, what works for one company will not necessarily work for another. Through our research, we have identified two dimensions under the direct control of management that consistently differentiate how companies approach corporate entrepreneurship. The first dimension is organizational ownership: Who, if anyone, within the organization has primary ownership for the creation of new businesses? (Note: Responsibility and accountability for new business creation might be focused in a designated group or groups, or it might be diffused across the organization.) The second is resource authority: Is there a dedicated “pot of money” allocated to corporate entrepreneurship, or are new business concepts funded in an ad hoc manner through divisional or corporate budgets or “slush funds?”

FOUR MODELS

Two dimensions under the direct control of management differentiate how companies approach corporate entrepreneurship. The first is organizational ownership: Who within the company has primary ownership for the creation of new businesses? (Note: This responsibility can be focused in a designated group, or it can be diffused across the organization.) The second is resource authority: Are projects funded from a dedicated corporate pool of money or in an ad hoc manner, perhaps through business-unit budgets? Together the two dimensions generate a matrix with four dominant models: opportunist, enabler, advocate and producer.

Together the two dimensions generate a matrix with four dominant models (see “Four Models”): the opportunist (diffused ownership and ad hoc resource allocation); the enabler (diffused ownership and dedicated resources); the advocate (focused ownership and ad hoc resource allocation); and the producer (focused ownership and dedicated resources). Each model represents a distinct way of fostering corporate entrepreneurship. A closer look at the models illustrates how they help companies build corporate entrepreneurship in different ways.

The Opportunist Model

All companies begin as opportunists. Without any designated organizational ownership or resources, corporate entrepreneurship proceeds (if it does at all) based on the efforts and serendipity of intrepid “project champions” — people who toil against the odds, creating new businesses often in spite of the corporation.

Consider Zimmer Holdings Inc., a medical device company headquartered in Warsaw, Indiana.7 Zimmer has R&D organizations that undertake new product development but no formal organization or dedicated resources for corporate entrepreneurship. So when trauma surgeon Dana Mears had an idea for minimally invasive surgery for hip replacements, he presented and explored it informally with Zimmer manager Kevin Gregg. The two then got the go-ahead from top management (including CEO Ray Elliot), who approved the use of company resources for concept development and experimentation. The new medical approach required innovations in training, so the company established the Zimmer

Institute, and by 2006 more than 6,000 surgeons were being trained there in a dozen different types of minimally invasive surgical procedures. The resulting improvement in patient outcomes (and hence lower total costs) has led to some private insurers paying a premium for certain Zimmer procedures. Today, that new business has helped Zimmer achieve superior overall growth despite severe industry pricing pressure.

The opportunist model works well only in trusting corporate cultures that are open to experimentation and have diverse social networks behind the official hierarchy (in other words, places where multiple executives can say “yes”). Without this type of environment, good ideas can easily fall through organizational cracks or receive insufficient funding. Consequently, the opportunist approach is undependable for many companies. When organizations get serious about organic growth, executives realize they need more than a diffused, ad hoc approach. As a result of its past success with minimally invasive surgical procedures, Zimmer has instituted more formalized development practices for bringing new businesses to market. As such, the company has begun to evolve beyond the opportunist model.

The Enabler Model

The basic premise of the enabler model is that employees across an organization will be willing to develop new concepts if they are given adequate support. Dedicating resources and processes (but without any formal organizational ownership) enables teams to pursue opportunities on their own insofar as they fit the organization’s strategic frame. In the most evolved versions of the enabler model, companies provide the following: clear criteria for selecting which opportunities to pursue, application guidelines for funding, decision-making transparency, both recruitment and retention of entrepreneurially minded employees and, perhaps above all, active support from senior management.

Google Inc. is the poster child of the enabler model. Keval Desai, a Google program manager, describes his company in the following way: “We’re really an internal ecosystem of entrepreneurs… sort of like the [Silicon] Valley ecosystem but inside one company.” At Google, employees are allowed to spend 20% of their time to promote their ideas to colleagues, assemble teams, explore concepts and build prototypes. Project groups form on the fly, based on requirements defined by the teams themselves. An initial core team typically includes a project manager, technical lead, product marketing manager (for competitive analyses, focus groups, market targeting and so on), user-interface designer, quality-assurance specialist and an attorney (for privacy, trademark and other legal input). If the team believes it has a winner, it appeals to the Google Product Council for funding. This group, which includes the company founders, top executives and engineering team leads, provides broad strategic direction and initial resources. Successful project teams receive assistance from the Google Product Strategy Forum to formulate their business models and set milestones. Importantly, Google applies no preconceived criteria or hurdle rates to the projects. As long as a project appears to have potential and maintains the interest of Google employees, it can continue.

At any given time, Google typically supports more than 100 new business concepts in various stages of development, and information about the projects is maintained in a central, searchable database. Managers estimate that approximately 70% of the projects support the company’s core business in

some fashion, 20% represent emerging business ideas and 10% pursue speculative experiments. If a project succeeds, team members can receive substantial bonuses (called Founder’s Awards), sometimes in the millions of dollars.

Google’s entrepreneurial culture, dynamic market and extraordinary access to capital make the company difficult to replicate. Nonetheless, other organizations have had success using the enabler model. The Boeing Co. and Whirlpool Corp., for example, have found that dedicated funds for innovation combined with clear, disciplined processes for allocating those funds can go a long way toward unlocking latent entrepreneurial potential. Well-designed enabler practices also have the side benefit of exposing senior management to ambitious, innovative young employees, allowing the company to identify and nurture future leaders.

But firms should be aware that the enabler model is not just about allocating capital for corporate entrepreneurship. Personnel development and executive engagement are also critical. Google spends an extraordinary amount of time and effort on recruiting. To be hired, a program manager or senior engineering candidate might go through 20 interviews in multiple stages before the company determines whether that individual has the right combination of “entrepreneurial DNA,” broad technical talent and intellectual agility. Executive engagement is essential for people to trust that the process of corporate entrepreneurship is being taken seriously — that is, the company will indeed pursue the development and commercialization of good ideas. Without sufficient support from senior management, promising concepts can end up as casualties of conflicts with established businesses. Another danger is that the enabler model could degenerate into “bowling for dollars,” in which people apply for funds for ordinary business-unit projects or for ideas that they are not really seriously interested in pursuing.

The Advocate Model

What about cases in which funding isn’t really the issue? In the advocate model, a company assigns organizational ownership for the creation of new businesses while intentionally providing only modest budgets to the core group. Advocate organizations act as evangelists and innovation experts, facilitating corporate entrepreneurship in conjunction with business units.

Consider E.I. du Pont de Nemours and Co., the 200-year-old global conglomerate. In 1999, CEO Chad Holliday realized that the company needed some new thinking because, even though margins and returns had improved during the prior six years, growth had declined. So Holliday asked DuPont veteran Robert A. Cooper to head a small internal group that focused on company growth, and the result was the Market Driven Growth initiative.

The program provides employees with a wide range of assistance, everything from idea conceptualization through commercialization. For instance, it includes a four-day “business builder” session that helps people generate and prioritize different business concepts. After this, a team will typically spend from four to eight weeks developing a detailed business plan, including a 180-day “contract” with senior management to address major uncertainties of the proposed concept. Then the

team and a facilitator from the Market Driven Growth program will present the plan to business-unit leadership for approval.

Success within one business unit has a way of building interest from others, and over time teams like those at DuPont can become critical change agents. Although consultants can help the process, ultimately the best advocates come from a company’s veteran ranks — those who are well-known, respected and experienced in making change happen within the organization. As DuPont’s Cooper recalls, “I thought I’d spend most of my time helping design and build new businesses…. Instead, I spent at least half my time advocating.”

The core of the Market Driven Growth program is currently staffed with five full-time employees. Becoming part of this group has become a sought-after opportunity for up-and-coming managers who want to gain senior-level exposure and have a direct impact on the company’s growth. Although DuPont’s senior executives actively and openly support the program, they have never mandated its adoption by the company’s different business units. To win that support, the program worked with leaders from the business units early on to help define the mission, growth domain and criteria for opportunities they would be willing to fund. In 1999, DuPont’s corporate headquarters invested in the process development and the pilot engagements to allow the program to gain credibility, but after that each business unit had to pay its own way. Today, DuPont still doesn’t require its business units to participate, but they do so because they recognize the value of the initiative. One of the program’s early supporters was Ellen Kullman, then group vice president for DuPont’s safety and protection businesses, who has since become an enthusiastic champion of the initiative. By 2005, Kullman noted, “We have nearly a half a billion dollars of new revenues we would not have had had it not been for this program.”

The Producer Model

A few companies such as IBM, Motorola and Cargill pursue corporate entrepreneurship by establishing and supporting formal organizations with significant dedicated funds or active influence over business-unit funding. As with the enabler and advocate models, an objective is to encourage latent entrepreneurs. But the producer model also aims to protect emerging projects from turf battles, encourage cross-unit collaboration, build potentially disruptive businesses and create pathways for executives to pursue careers outside their business units.

To pursue corporate entrepreneurship, Cargill Inc., the $75 billion global agriculture products and services company based in Wayzata, Minnesota, has established its Emerging Business Accelerator.8 As David Patchen, the group’s founder and managing director, recalls, “Prior to the EBA, we lacked a clearly defined process for pursuing opportunities that fell outside of the scope of existing business units and functions…. We needed a new approach to complement our business units and Cargill Ventures [an internal venture group].”

Managers often don’t know what to do with new concepts that don’t fit an existing business, and incentives typically discourage them from absorbing near-term losses. That’s where the Emerging Business Accelerator comes in. When Cargill’s de-icing business unit identified a novel de-icing technology, the group realized it might not be well-suited to develop and commercialize the innovation.

The technology — an epoxy overlay that inhibits ice formation — was going be a high-end product that would be sold to road builders worldwide for critical applications such as bridges. But Cargill’s de-icing business unit primarily sells commodity products to transportation department agencies in North America. So the new technology was transferred to the Emerging Business Accelerator, which brought the offering to market.

Such successes have helped the Emerging Business Accelerator become a global clearinghouse for new concepts and value propositions across Cargill. The group maintains a Web site for people to submit ideas, both from inside and outside the company. When an opportunity appears promising, the Emerging Business Accelerator develops a high-level plan, performs due diligence, recruits talent and, if approved by the group’s board of directors, provides capital and monitors the project’s progress. In the early stages, project teams focus on refining their concept, business model and market offerings. To do so, they spend considerable time with potential customers to validate the market for their products or services. Projects that achieve validation from real customers graduate into either existing or new business units.

Through 2006, the Emerging Business Accelerator has evaluated dozens of opportunities, and seven significant projects have received funding of which six are ongoing. The Emerging Business Accelerator aims to generate revenues from projects within three years so that it does not become viewed merely as a source of funds for pie-in-the-sky research. It employs many development paths: greenfield investments, patent licensing, minority investments tied to business development agreements and small acquisitions. It selects, staffs and monitors — but does not operate — new business opportunities. In essence, it manages the process but not the ideas, which helps build trust and encourages collaboration among stakeholders. Cargill has found that assigning projects to managers with other profit-and-loss responsibilities does not work, so full-time teams are created.

The producer model is not without its share of challenges and risks. First, it can require significant investments over many years. Motorola’s corporate entrepreneurship group, for instance, has an annual budget in the tens of millions of dollars and a dedicated staff of more than 35 people. Second, integrating successful projects into established business units can be difficult. Project teams often become isolated and can be perceived as threats to existing business units, particularly when they have pilfered top talent. Ultimately, building credibility and trust throughout the company is critical for the producer model to succeed. Most of the corporate entrepreneurship leaders in our study said that they spend more than half their time on communications within the company, and we have found that successful producer models are generally run by senior leaders who have mastered the art of internal corporate politics.

Selecting the Right Model

Evolving from the opportunist model to any of the more deliberate forms of corporate entrepreneurship typically begins with a mandate for growth and a broad, clearly communicated vision. When a company’s vision for growth is too narrow, it will likely end up with just incremental concepts, whereas a broader vision helps everyone think outside the proverbial box. DuPont, for instance, used the phrase

“beyond the molecule” to describe its desire to go beyond traditional bulk chemicals, adding services and knowledge to its offerings.

THREE DELIBERATE APPROACHES TO CORPORATE ENTREPRENEURSHIP

After the vision is set, a company needs to delineate specific objectives. Is it seeking corporatewide cultural transformation or renovation of particular divisions to address either commoditiza-tion or disruptive threats? Or perhaps the problem is that people aren’t effective in pursuing “white space” growth platforms. In all these cases — transformation, renovation or new platforms — what is the time frame and how specific are the goals? Are immediate, bold results required to solve a particular problem, or is the objective an evolutionary program aimed at “blue ocean” discoveries? The answers to such questions will suggest the use of one model over another. (see “Three Deliberate Approaches to Corporate Entrepreneurship.”)

Enabler programs can support efforts to enhance a company’s culture. When an organization already enjoys substantial collaboration and ideation at the grassroots level, the enabler model can provide

clear channels for concepts to be considered and funded. For companies seeking cultural transformation, enabler processes in combination with new hiring criteria and staff development can result in a number of employees becoming effective change agents. The enabler model is particularly well-suited to environments in which concept development and experimentation can be pursued economically throughout the organization. At Google, for instance, a Web application prototype might require only a few engineers. In companies with self-managed communities of practice and expert networks (examples include many consultancies and technology organizations), enabler programs can accelerate the commercialization of ideas that arise from networks of knowledge workers.

For companies that want to accelerate the growth of established divisions, the advocate model might be the best option. Because of the limited resources of this model, managers must tailor their initiatives to the interests of existing lines of business, and employees have to collaborate intensively throughout the organization. This enhances the potential fit of opportunities to a company’s operations, but also requires leadership to ensure that projects do not become too incremental. Advocates exist to help business units do what they can’t accomplish on their own but should pursue in order to remain vital and relevant. Moreover, the advocate model (as well as the producer model) can prevent corporate entrepreneurship from becoming a casualty of powerful business units or competing silos.

If a company seeks to conquer new growth domains, discover breakthrough opportunities or thwart potentially disruptive competition, then it should consider the producer model.9 In general, business units are not likely to pursue disruptive concepts, and they often face strong near-term pressures that discourage investments in new growth platforms. The producer model helps overcome this, and it can provide the necessary coordination for initiatives that involve complex technologies or require the integration of certain capabilities across different business units.

With respect to resources, the enabler model can generally be maintained in a much leaner fashion than either the advocate or producer models. Simple processes communicated company-wide, arbitrated by a senior team and managed with limited staff (sometimes just a single person) can suffice. Clearly, the dedicated team and capital required by the producer model makes it a more resource-intensive choice, but even the advocate model tends to require a significant commitment. Although advocates function without a large dedicated funding pool, they can require substantial investments in the human capital and methodologies necessary to help bring new opportunities to fruition.

It should be noted that, particularly in large corporations, multiple models can be supported concurrently at different levels and functions. IBM, for instance, maintains a hybrid producer-advocate team — the Emerging Business Opportunities program — which has generated over $15 billion of new revenues as of 2005.10 Meanwhile, IBM’s Think-place and Innovation Jams encourage ideation and networking in the fashion of an advocate model. Like an enabler, IBM also supports divisional processes for corporate entrepreneurship, some of which transfer projects to the Emerging Business Opportunities program for development and scaling. And IBM is fortunate to have a corporate culture that in many ways even supports an opportunist model. Distributed power bases enable corporate entrepreneurs to find pockets of interest and resources across the corporation without any structured facilitation.

Putting the Models to Work

Successful companies typically start with a small, credible team and a mandate from top leadership (see “Getting Started”). The first task is to obtain consensus (or at least acquiescence) from senior management regarding objectives and a path forward. New leaders of corporate entrepreneurship initiatives are often surprised by how much time they spend talking with corporate and business-unit management. Nevertheless, such communication is essential, not only to build support for the new initiative but also to prevent internal stakeholders from regarding corporate entrepreneurship as a drain or threat to the company’s established operations. Building new businesses often requires contributions from people company-wide, especially during launch and scaling, so communication remains critical even after a corporate entrepreneurship program has established a proven track record.

Getting Started

For companies that are about to embark on a new program of corporate entrepreneurship, the following high-level summary of tips should provide some guidance:

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Each of the models requires different forms of leadership, processes and skill sets. An enabler model depends on establishing and communicating simple, clear processes for selecting projects, allocating funds and tracking progress, all with well-defined executive involvement. Advocate models require individuals with the instincts, access and talent to navigate the corporate culture and facilitate change. Leading advocate organizations build an arsenal of facilitation methodologies, new business design tools and networks with external capabilities. The producer model requires considerable capital and staffing and a direct line to top management. Understaffed, part-time or underfunded producer teams are set to fail.

Whatever model is selected, a set of “quick wins” will help tremendously to garner initial lessons and build credibility and momentum. If all goes well, the organization should experience a significant increase in the number of proposals, but the challenge of growth is not simply about generating compelling opportunities. When opportunity throughput increases, new bottlenecks arise as scaling field-proven new businesses and finding organizational homes within the company become all the more difficult. As Albert Manzone, president of Shelf Stable Juices at PepsiCo Inc., explains, “The more we develop, the more stress we put on our delivery mechanisms … our supply chain, channels, everything it takes to get to market and scale.” And the more distant a new concept is from the “comfort zone” of the core business, the greater the challenge.

This issue of transition and scaling is certainly not new, but it becomes increasingly vexing as companies master the front end of innovation. Unfortunately, past research offers little insight. In our study, we observed certain practices that seemed to help: considering business systems holistically and systematically up front (rather than adopting a narrow focus on technologies, products or services); selecting two or three of the core business’s focal capabilities for business system innovation and building new competencies in those areas; explicitly addressing business-unit disincentives for adopting

immature businesses; and recruiting forward-thinking “business builder” managers. But much more formal, empirical work needs to be conducted in this critical, emerging area of research.

UNLESS A COMPANY IS BLESSED with the right culture — and few are — corporate entrepreneurship won’t just happen. It needs to be nurtured and managed as a strategic, deliberate act. The traditional, isolated “skunkworks” project is no longer the primary option for companies pursuing the creation of new businesses. Indeed, as IBM, Google, DuPont and others have shown, corporate entrepreneurship does not have to rely solely on serendipity and the grassroots efforts of a few “project champions.”

In the early stages, all innovations are defined by uncertainty. If no uncertainty exists, then an organization is simply not innovating. Moreover, corporate entrepreneurs are not just creating a new product or service but changing the way a company develops, builds, markets and supports its offerings. As such, new business creation will often compel a company to incorporate capabilities and knowledge from the outside. In fact, an effective corporate entrepreneurship program can enhance a company’s ability to absorb external knowledge and opportunities, the essence of “open innovation.”

Obviously, this kind of capability can hardly be built overnight, and corporate entrepreneurship will always be a rough-and-tumble process with few guarantees. But playing it safe is hardly the answer for those companies looking to grow organically. As Mike Giersch, vice president for strategy at IBM, explains, “You’ve got to be flexible and take some risks. Some things work and some don’t. Corporate entrepreneurship is fundamentally a learning process.”