Shedding Wings

With 16 years experience at prestigious McKinsey & Co. under his belt, author John Hagel III, now at the helm of his own consultancy, has made a career out of depicting snapshots of corporate America—and offering his two cents on how things can be improved. In his latest book, The Only Sustainable Edge: Why Business Strategy Depends on Productive Friction and Dynamic Specialization (Harvard Business School Press), Hagel and co-author John Seely Brown take on the issue of outsourcing. The likelihood of gaining competitive advantage, they say, lies in executives' ability to rethink how corporations benefit from working with world-class partners.

Pharm Exec: Why do you think the traditional view of corporate capabilities is wrong-headed?

Hagel: It's not so much that it's wrong-headed. I think that what we're trying to do is add on a more dynamic component to it. Historically, strategy has been viewed in a very static way as either structural advantage, such as particular elements in the marketplace that provide enduring advantage, or competencies. If you've got a competency, you're secure, and that's your source of advantage.

By looking at how global markets are evolving, we're focused on the fact that the real source of advantage becomes the institutional capacity to build capability more rapidly than anyone else. It's all about trajectories, as opposed to any snapshot of advantage you might have at any point in time.

One of the ways you talk about getting to that point is through dynamic specialization. What's dynamic specialization as opposed to traditional specialization?

In part, [my theory on dynamic specialization] was driven by reaction. I consult a lot with senior executives at large companies and when I talk about specialization, I kind of get an allergic reaction. Something like, "Oh God, you're talking about shrinking the business and becoming smaller and lower growth." But in fact, our perspective is that specialization is increasingly becoming necessary to drive profits and sustain growth over time. What companies really have to do is choose their field of competition.

Most companies today are really three very different kinds of businesses all brought together, tightly integrated into a single corporate entity. One type of business is a customer relationship business, which has to do with getting to know a particular set of customers better and using that knowledge to bring together the right bundle of products and services to meet that customer's needs.

There's a second kind of business, which is an infrastructure management business, managing high-volume routine processing kinds of activities. It could be a manufacturing plant; it could be a logistics network—anything that's high-volume routine processing.

And then there's a third kind of business that is more of a product innovation and commercialization business—coming up with creative new products, getting them into market quickly and capitalizing on their success in the marketplace.

Those three businesses have very different economics, very different skill sets required to be successful and ultimately, even very different cultures. If you look at a focus company in any of those three businesses, they've got a totally different culture than the other two businesses. Yet most companies have these three businesses tightly brought together into a single corporate entity.

In the past, that was justified because it was much more efficient to have all these activities within one company, rather than relying on partners. Increasingly, we think that logic is less compelling and that the logic of accelerating capability building, getting better at your particular area of world-class capability, becomes the primary objective. Being able to shed these other two businesses and focus on one of the three is a prerequisite to growing more rapidly and accelerating capability. By focusing, you'll be able to move much faster and build capability much more effectively than if you're trying to do it across all three of these businesses.

From The Only Sustainable Edge, (Harvard Business Press).

So we think most executives are going to have some pretty difficult choices to make going forward. They are going to have to decide which of these businesses they are really in and how they can develop relationships with other companies to get access to the other two kinds of businesses.

If you're a pharmaceutical company, I think it's probably fairly easy to let go of some of the manufacturing. But to choose between the development of new drugs and the marketing of drugs, that's a tough choice. If anything, the industry has been moving toward integrating those two things more. Do you have advice for people who have to make that choice? Or do they even really have to make that choice? Can't they just shed some things on the side?

I think the pattern that you're seeing in the pharmaceutical industry is very consistent with the pattern being seen more broadly across many other industries. The first business that's typically shed is the high-volume routine processing kinds of activities like manufacturing and logistics. Those tend to be the first activities that get moved outside.

And in fact, there's a lot of learning that occurs as a result of moving those outside. It is quite a different management proposition to manage somebody else providing these services than it is having them within your corporation. So it's a valuable learning process. We think it sets executives up for the next set of choices, which is between these two activities—the marketing and customer relationship side, or the product innovation, commercialization side.

A lot of the recent trend in the pharmaceutical business has been towards sourcing more and more of the products from specialized third parties. [There has been an uprising] of very focused biotech companies that are developing interesting new products, and then the pharmaceutical companies are leveraging their relationships with the medical community to get those products into market quickly.

Right. In pharma, you might have to draw the line slightly differently, so that instead of innovation and commercialization, it's innovation, then commercialization and customer relationship might fit together a little bit better.

Yes. Although a lot of the testing process is a pretty high-volume, routine processing kind of activity.

And is frequently outsourced.

Exactly. So, it's an open question as to whether a pharmaceutical company really needs to have that process inside, or whether they really should be focusing much more on building effective relationships with both the physicians and the end consumers, in terms of building awareness and acceptance of their products.

Is innovation a business where scale helps a lot? Scale really has obvious advantages. With innovation, sometimes it seems like having a thousand little companies scrapping for success is a good way to innovate.

That's the interesting challenge. We often talk about these three different businesses, and two of the three businesses—the customer relationship business and infrastructure management business—have very clear economies of scale and scope, which we believe will be very large concentrated businesses over time. Typically, creative talent seeks smaller homes, if you will, to really flourish, and tends to have a much harder time surviving and thriving in very large corporate entities.

So I think the challenge for a large company that chooses to focus on product innovation is, can they really provide that home for creative talent to flourish much better than they would in more fragmented, smaller companies?

Can you think of another industry in which a company has really taken that strategy and succeeded with it?

There are relatively few companies that have made the choice to specialize in these three businesses. On the product innovation/commercialization side, the closest analogies I could come to would be companies with deep technology expertise in certain areas. There's a Japanese company, Kyocera, which is really deep into ceramics technology. They have taken this fundamental expertise in ceramics technology and spun it out into a very broad range of products that utilize ceramics technology. They've been quite successful leveraging that core expertise. You could look at Corning as an example around glass technology and the various kinds of businesses they've built based on a deep expertise in glass.

The key in those businesses has been finding a core technology that can be leveraged into multiple product categories. If you're truly trying to manage a whole series of product businesses with totally different technologies at their base, that's much more challenging.

In terms of specializing, one of the things you talk about in your book is leaving things behind. That brings up the topic of outsourcing.

It's actually one of the catalysts for writing the book. In my consulting activity, I was dealing with more and more senior executives who had been very active in outsourcing, but treating it as a very near-term operational decision, largely driven by cost reduction.

But increasingly, they were stepping back and starting to get concerned that maybe they'd been thinking too narrowly about these choices, and that they really ought to be thinking about them in strategic terms, in terms of the consequences for what kind of business they're really in.

One interesting example that's still playing out today is in the high-tech area, in computers and related kinds of technologies, where the first wave of offshoring was around contract manufacturing—in other words, taking the basic assembly activities and moving them offshore. Increasingly, they've been starting to offshore product design, which is becoming a whole vibrant industry in Taiwan.

So now, you have the design of your products off shore, done by the specialized third parties. You have the manufacturing and logistics all done by third parties. Often you don't ever touch the product as a company. The strategic question is, if they're not designing and if they're not manufacturing, what business are these high-tech companies really in?

Companies need to think very strategically about these choices and think about them less in terms of cost reduction—although certainly that is a benefit that can be derived—and much more in terms of, how are we going to access distinctive skills and capabilities and make ourselves even more attractive in the marketplace?

I often advise my clients, if they're thinking about finding an outsourcing partner, to spend a lot of time with their partner's human resource department to understand their HR policies. If they're not doing a world-class job at attracting talent, developing that talent very rapidly, and retaining that talent, you're going to live to regret that relationship. As competition intensifies, companies are going to be at a disadvantage if they're not with a world-class [outsourcing] company. Don't just focus on the bottom-line cost of the contract. Focus on the HR policies that are driving that company's success in the marketplace.

One of the things you touch on throughout the book is the way that, when two companies interact, value is exchanged and skills or capabilities are increased. So, when you use an outsourcing company, companies are—if they're smart about it—increasing their capabilities as well. But the danger is that, if you go into it like a traditional US company, just looking at the cost, the outsourced partners are not necessarily increasing your capabilities.

To really get the most benefit out of these relationships, companies have to focus on how they can push each other, as partners, to get better faster. And that actually introduces our notion of productive friction, which in part is a bit of a dig at the old dot-com kind of vision of marketplaces as being frictionless places where everything flowed freely.

Friction is an interesting phenomenon. It can be very dysfunctional and very inefficient. On the other hand, friction can be very productive. Anytime you're learning, particularly if you're learning with others, or you're bringing together people with very different experiences and skill sets and pushing each other against very aggressive performance targets, there's going to be friction. You're going to have disagreements about how to get to the performance targets you're looking for, and you're going to learn from those disagreements, as long as you have trust and respect on both sides.

A lot of the key in harnessing this productive friction is becoming much more skilled at building trust relationships where you can disagree and have friction, but end up having productive outcomes, like improving your own practice and the practice of your business partners.

One of the places where you see pretty productive friction in the pharmaceutical industry is between the industry and FDA.

That's a good analogy. I see too many executives viewing success in a partnership as having a very smooth relationship. But it's a two-edged sword. Smooth relationships may be that you're not pushing each other hard enough to get better faster, and if you are pushing each other, you're going to have some bumps along the road.

You had some ideas in the book for how to tell the difference between a functional friction, a productive friction, and unproductive friction.

A lot of it has to do with choices around the people—making sure you're bringing the right skill sets together, so you have deep skills in the relevant areas to get to a solution. Often, a lot of the unproductive friction comes because you have people who don't have the necessary skills. They become very defensive and protective, as opposed to open and willing to push each other.

Respect for each other's skills is also important. The challenge when you bring people with very different backgrounds and skill sets together is they often tend to dismiss each other's [abilities]. But you have to have respect for the other skills that are going to be required.

It's also important to have a very aggressive and tangible performance target. We talk about action points. This is the idea that the most productive friction occurs when there's a very clear outcome in a specified time period, so that you're all working towards a very clear deliverable. You can't just debate endlessly. You have to come to some kind of resolution around this.

At the same time, it's important to leave as many degrees of freedom as possible around how you get to a solution. This allows various skill sets to come together and really come up with a creative solution.

The final idea is the need for effective prototypes, ways of representing potential solutions and testing and refining them. These become critical to enhancing the friction process.

All of which leads you to the notion of strategy, which you come to in the latter part of the book. You talk about the difference between the ways that companies have looked at strategy in the past: fortress strategies as opposed to guerrilla warfare strategies. That idea of going from a static strategy to a dynamic strategy, where your plan is not just to occupy a position, but also to move over a period of time, that sounds incredibly scary. You must have people fleeing from the room when you present it to them.

It certainly makes a lot of people very uncomfortable. Anybody who has read a conventional strategy book will hear two important foundations. One is, the relevant timeframe for strategy is one to five years. The other basic principle you hear is, you need to have your strategy very clearly and tightly defined before you move into execution. Execution has to follow a strategy. You can't jump the gun.

We turn both of those basic assumptions on their heads, and argue that in very uncertain markets where there's not a lot of stability, the two most relevant timeframes for senior executives are both at a very long-term time horizon of five to 10 years, where the challenge is to develop a common view of what the market's going to look like five to 10 years from now, and what business you're going to have in order to be successful in that kind of market.

For most executives, in that five-to-ten year horizon, they say, "Give me a break. Things are just too uncertain. I couldn't possibly have a clear view of that." You need a clear view, but not a detailed view. You need to have a very high-level sense of what the market's going to look like, and what your business is going to need to look like.

The other time horizon is six to 12 months. And the real challenge for executives there is to figure out what the two or three operating initiatives are that are going to have the greatest impact in accelerating our movement towards that longer-term destination. And be very focused on making sure those two to three initiatives have adequate resources and are moving as rapidly as possible.

And at the same time, figuring out what the organizational bottlenecks are that are preventing you from moving even faster, and determining what you can do in a six-to-12 month timeframe, very tactical, very near term, to break down those bottlenecks and move even more quickly.

And then, learning by continually moving back and forth between these two time horizons; so, what are you learning in the six-to-12 month initiatives that refine your view of the longer-term destination, and how do you use that longer-term destination to focus your near-term initiatives to have even more impact?

With pharma these days, it's split—away from the middle, and toward the short and the long would be even more important. If it's taking you a dozen years to develop a new product and if the Medicare initiative threatens to completely transform the economic structure of the industry within about five or ten years, it's tough to make that kind of mid-sized plan.

Right. And my sense is the reaction to uncertainty for many companies is to kind of spread their bets even more broadly. And hedge their bets, if you will.

While it's certainly an understandable approach, it's often a very dysfunctional approach, in the sense that it breeds complacency. If you've got a lot of bets, first of all, you don't have any real sense of urgency about any of those bets. If one of them starts to unravel, the attitude is, "Well, not to worry, we've got a lot of other bets." So there's no real sense of, "I've got to make this one work." And you're spreading your resources very thin. And often the company doesn't have critical mass against any of these bets, so they're doomed to be unsuccessful, because you haven't really focused and doubled down on bets that are really going to have an impact.

What else should pharmaceutical executives be thinking about?

It's particularly important to embrace some of the newer technology that allows companies to move to more rapid incremental innovation, both around process and product. In particular, we see a lot of potential in new IT architectures. There's a new generation of architectures under the label of service-oriented architecture, which allows companies to create much more flexible connections across applications and across databases than has been feasible in the past.

One of the things that's particularly attractive about this technology is that it doesn't require companies to rip out their existing applications or databases. In fact, it starts with the assumption that you've got a pretty heterogeneous set of applications that need to be connected. This is particularly important because if you're trying to connect into business partners' applications, unless you're a huge company, you can't force your business partners to rip out their applications either. These service-oriented architectures give companies a lot more flexibility in connecting applications.

Virtualization architecture is a second set of architectures, which are really focused on creating much more flexibly accessed hardware-computing resources, networking, storage resources. The third piece is a set of tools that helps to connect people together much more effectively, and allow them to collaborate on demand. So, when they're encountering unanticipated problems or opportunities in the marketplace, they can quickly bring together the right people, give them the analytic tools to solve the problem, and access to the right kinds of data and resources that they need.

We're actually very optimistic that technology is evolving in a way that will allow this very rapid incremental innovation, and accelerate capability building not only within pharmaceutical companies, but across business partners, so that organizations can leverage the relationships they have with world-class business partners.

John Hagel III

John Hagel III is an independent management consultant and author. For sixteen years, he worked as a consultant with McKinsey & Co., where he continues to serve as senior advisor. In addition to his most recent book, The Only Sustainable Edge, co-authored with John Seely Brown, Hagel has written Net Gain: Expanding Markets Through Virtual Communities, Net Worth: Shaping Markets When Customers Make the Rules, and Out of the Box: Strategies for Achieving Profits Today and Growth Tomorrow Through Web Services.