Do not let this crisis go to waste
Understanding industry architecture (especially in financial services) can also help us to understand both the causes of and remedy for our malaise, showing us how some companies manage industry architectures to their advantage and how some industries are dangerously unstable. With these insights, the current recession could become a golden opportunity to reshape companies and even sectors, argues Michael G Jacobides.
Industry architectures consist of the roles played by companies in a sector and the rules (standards, regulations and conventions) that connect them. The rules shape the ways in which money is made (companies' business models). They influence "who does what" (strategic choices and what each role is in the industry) - which, in turn, determines "who takes what" (revenues, market share, competitive advantage and profit). However, the rules are not static - they change substantially over time.
For example, looking at the financial services industry over the past decade, we have seen new instruments (securitized loans and, later, collateralized debt obligations), new rules (often promoted by the companies and individuals who stood to benefit from them) and new models (varying types of hedge funds). These changes transformed the way money was made and created new winners: Securitizers in the beginning of the decade, hedge funds and private equity shortly thereafter and (until the collapse) all their employees.
Industry architectures often change without us noticing; indeed, I only helped coin the term "industry architecture" in 2006. Since nobody is meant to monitor them, industry architectures can lead to boom or bust - or both. If one could take a step back and get a sense of the entire system, he or she might see the risks and opportunities; but if no one does, a meltdown can result. Thus, each successive change in financial services was eminently sensible in isolation, but their cumulative impact was disastrous; and, ideally, someone would have foreseen it.
Dramatic change
Many sectors have changed dramatically during the past few years, reducing leaders to laggards and turning newcomers into giants. Consider the early days of computing, when the industry unbundled, vertically disintegrating, changing the competitive dynamics and even the identity of the sector. IBM outsourced too much during the 1980s, giving up critical business functions. Meanwhile, the Apple of the late 1980s was too integrated and closed, losing the battle for personal computing and allowing previously unknown companies to capture key parts of its value proposition. Both organisations came close to failure.
Microsoft, by contrast, used shrewd agreements to maintain its position as a "bottleneck", retaining the key parts of the computing value-added process and guaranteeing a foothold in the critical areas of graphical user interface, operating system and pre-installed software. Companies such as this do not just work in a sector - they work on it - shaping the sector and ensuring that the future of the industry will fit their capabilities.
IBM and Apple's more recent history suggests that they too are becoming more savvy managers of their sector's architecture. IBM's rebirth in the 1990s was based on an open, flexible model that focused on keeping the critical parts of customer handling and higher value-added sectors, while exiting the commoditised parts of the business.
Apple's return to dominance through the iPod was the result of a cleverly designed ecosystem: By controlling iTunes, design, the brand and pricing, Apple ensured it ruled the environment without needing to integrate most parts of the value chain. In other words, it turned itself into a bottleneck. Because its supplier relationships are so well designed, Apple does not need to manufacture any of the components of an iPod. It also fosters competition between the different "complementors" (makers of speakers and iPod accessories) who agree to play by Apple's rules and create an installed base of compatible products. Thus, the company's success stems, in large part, from its ability to build a new industry architecture.
Even when no one company dominates a sector, profits migrate as industry architectures change. Consider the increasingly untenable position of large telecommunications operators, which have been challenged by new ways of making money and having to reposition themselves constantly vis-à-vis content providers, handset manufacturers and service providers. Or consider health care, in which traditional pharmaceutical companies need to change their value-adding activities as demands for personalised medicine and more advanced care change the landscape. The new winners will be companies that manage to adapt, changing the way they make money. In every industry, success flows from the ability to adapt to (or reshape) industry architecture and the company's role within it.
Transformative recessions
As downturn becomes recession and credit evaporates, other industry architectures are up for grabs. Recessions cause transformations in the way we do business. The 1970s downturn caused European and US manufacturers to change their practices and reorganise their supply chains. The early 1990s recession helped spur the growth of outsourcing, and the IT slump at the start of this decade ushered in a new type of networked organisation and flexible workers.
When sectors are growing, everyone is busy making money. They carry on as they have always done, even if it is inefficient, and nobody wants to voice any doubts or change the sector. But when the going gets tough, companies are willing to consider entirely new ways of doing business, and established leaders may be unable to prevent changes in the structure of their sector.
Crisis means new industry architectures. That means new opportunities for those who can adapt and challenges for those who think that a downturn can only mean lower output, redundancies and retrenchment. Customer needs are different in a downturn: Consumption shifts from an aspirational, image-driven model to an emphasis on thrift and value, as we can see from the spike in sales of low-price retail chains such as ALDI, Lidl or Wal-Mart over the Christmas period in Europe and the US.
Business-to-business relationships are redrawn, shifting the focus from growth to preserving cash. Capital markets are preoccupied with risk. And regulators are aiming for corporate survival at all costs, where once they sought competition. This is why downturns are associated with rapid changes in a sector's pecking order - a threat for those at the top and an opportunity for those hungry for success. So what should companies do?
No mean feat
Adapting to a new reality, changing the way you do business or reshaping your industry's architecture is no mean feat.
First, you need to work out how you can add value in the new environment. This requires realigning what the company does in order to match emerging needs. It means reconsidering how the organisation is structured, and how its financial and capital structure translates success into results.
To do this, you must clearly express why and how your company can add value as well as explain how it can continue doing so as the downturn deepens and conditions change. You have to decide how to reposition the company in the sector, distinguishing between temporary lulls and profound cyclical changes, and consider what could be tenable in the future. You need to plan for the worst while plotting your course to emerge stronger from this difficult period.
You must also leverage the needs of other companies to gain a strategic and architectural advantage for tomorrow. As economic conditions change, companies that you deal with will develop new priorities; they will be less concerned about structuring their long-term plans or positions than about preserving cash or addressing immediate needs. So, in exchange for accommodating their short-term requirements, you could build a relationship to enhance your long-term prospects. And consider how you can capitalise on cheap resources available today: Most of the technology-based companies that were hiring in the wake of the 2001 stock market crash reaped handsome returns from the exceptional talent they could afford to lock in. Strategic recruiting of bright graduates now could lead to a formidable strength in a few years.
You might also seek to occupy the niches that other companies are being forced to leave (especially in emerging markets). This is one of the reasons why some companies grow dramatically during downturns and why established leaders are vulnerable, even if they appear immune to going under. Most of today's giants initially positioned themselves as allies of existing players, but they carved new business models, reshaped industry architectures and gradually improved their positions. They shaped their own long-term future by understanding and meeting the short-term needs of the companies around them.
Consider Velti, an upstart in the interface between mobile communications and advertising. It reshapes the nature of the sector around it by updating its business model as the sector evolves, and shifting its compensation model to a results-driven structure, to preserve cash for its clients and reduce their perception of risk in a technology venture. Or consider more established players that capitalise on growth opportunities caused by the downturn, such as the hedge funds and private equity groups with plenty of cash that are starting to replace functions traditionally performed by investment banks.
Redefine yourself
It is essential to redefine yourself as needs change. But many companies do find themselves in crisis management mode. In order to move forward, they need to address the causes of diminished performance, not the symptoms. This, alas, does not come easy. In a crisis, organisations often resort to fire-fighting or papering over the cracks. They try to cut costs to deal with declining revenues, often spreading the pain equally across lines of business or functional divisions. Worse still, they might eliminate the areas that appear "easy to cut" in the short term, cashing in every investment regardless of its medium-term prospects.
Instead, companies and their leaders need to recognise that changes in customers and markets require a wholesale rethinking of their value proposition, business model or financial structure. Focusing on the basic questions of how value is added can help companies save themselves from a spiral of cost-cutting and redundancies.
Thinking about industry architectures can also help to dispel the gloomy introspection that accompanies downturns. In tough times, everyone looks inward, obsessing over redundancies, politics and reorganisation - losing touch with customers and the market just when they can least afford to. Finding a way to refocus on value, on what lies behind the financial results, could help to combat this dangerous tendency. It could be just the challenge you need to energise and awaken the talent in your business and restructure your company and your sector.
Companies that have courage do much more than manage their operations and costs to return to profitability. They identify which parts of their business are viable and which are not, using the crisis as an opportunity to take a strategic look at their future and that of their sector.
We know that companies do not change unless they are forced to, and that managers have used "burning platforms" as an opportunity to reorganise from time immemorial. The good news is that no one needs convincing that the platform is burning. The flames are around our ears. What is important now is not to let a good crisis go to waste.
Michael G. Jacobides (mjacobides@london.edu) is Associate Professor of Strategic and International Management at London Business School and also the Sumantra Ghoshal Fellow at the Advanced Institute of Management.
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