Does the Term “Core Competence” Destroy Value?

CoreCompSoul1The term “core competence” has taken hold in the business world. Not many academic terms break through to common usage so this might be viewed as a tremendous success. Unfortunately, it isn’t clear that it is particularly useful with the modified practitioner definition. As it is commonly used, it seems to mean “stuff the firm is pretty good at.” Unlike Prahalad and Hamel’s original article, common usage does not suggest that these capabilities: necessarily confer value in the eyes of customers over what rivals can produce, are hard to imitate, or that they are especially relevant in a corporate (multi-business) context.

Stripped of these defining characteristics, is the term useful?

As it is commonly used, the term can help firms distinguish what they are relatively good at from things that they are not. This is akin to a simple business unit-level internal analysis that identifies strengths and weaknesses. While it is important for firms to be aware of their strengths and weaknesses, by not comparing the strengths to rivals, we cannot infer whether the firm has a competitive advantage or how long such an advantage might last. It could even reflect a competitive disadvantage if rivals are superior in those areas. As a mode of internal analysis, the common usage doesn’t really go beyond SWOT analysis, which itself is woefully inadequate as a form of analysis.

When practitioners use the term core competence, it is often preceded by the words “stick to your…” That is, the firm should understand what they are good at and avoid straying from strengths. Of course, acquiring a new competence should be an important strategic decision – not to be taken lightly. However, the traditional advice seems to miss the mark if it implies that firms should avoid such decisions altogether. Classic examples of railroads, radio broadcasting, or, more recently, Toys ‘R’ Us illustrate how sticking to one’s knitting is not always the best strategy.

In short, as an internal analysis tool, the common usage of the term core competence does not add much value – certainly not relative to other internal analysis tools like value chain and VRIO analysis.

How do multi-business firms create value?  Corporate/multi-business strategy is a rather squishy topic. Practitioners often make poor decisions about the scope of a firm’s businesses because the tools tend to be imprecise. I have yet to hear a cogent explanation from an analyst for why Amazon might create value in the grocery business. After a few sentences of enthusiastic hand waving, things get really squishy with respect to new cash flows that might justify the 30% bid premium. Core competence can add value to this discussion so long as it adds clarity as opposed to making the topic even murkier.

Operational Economies of Scope are the drivers of most corporate strategies. This involves integrating elements of business unit value chains to either lower costs or increase revenue over what could be achieved without the integration. For example, integrating similar production processes may create more scale or purchasing power that lowers costs (e.g., Samsung’s scale in producing different types of memory chips). Similarly, coordinating sales efforts may result in cross-selling gains and integrating distribution may create better routes to market that enhance revenue. Apple leverages customer service through their genius bars to differentiate their products. Any element of the value chain could conceivably be integrated to create operational economies.

Then we would need to weigh whether the cost of integration exceeds the potential gains. This discussion could be relatively concrete. Ideally, we understand where the cash flows would come from. What revenue would increase or costs would decrease. The coordination costs are harder to quantify. What opportunities cannot be pursued due to organizational constraints? Ultimately, it must be clear that, if the businesses were sold off, the integration would typically cease and some value would be lost. Of course, the coordination costs would also be eliminated.

Core Competence as sustained corporate advantage. Building on Prahalad & Hamel, core competence might be used to identify whether a firm has a sustained competitive advantage through its corporate strategy. With this in mind, core competence can be defined as a VRIO resource that is leveraged across business units. Certainly firm-level assets such as corporate R&D or brand can be leveraged across multiple businesses and, in some cases, these may be VRIO such that they are unavailable to rivals. Here, the headquarters must be providing access to unique assets that the business units would lack if they were sold off. Presumably, they would be worth less without access to these assets.

One might think of core competencies as augmented operational economies such that rivals cannot effectively imitate or substitute the resource. In other words, it is an explanation of competitive advantage on the corporate level where operational economies are sustained over time. Even if a business unit were acquired by another firm with a similar business portfolio, the value could not be created through similar integration of value chain elements because another firm would lack VRIO resources.

A point of confusion tends to arise around support functions that are centralized at the corporate headquarters (finance, accounting, HR, etc.). A key reason to share these value chain elements is to reduce costs. In this sense, the firm could be creating value through such centralized home office functions. That would not suggest that the firm has a core competence in these areas so much as operational economies can be achieved when performing them at a larger scale. Even if they are not VRIO, the units might face higher costs if they were spun out and became less efficient in these functional areas (e.g., at a smaller scale).

What type of integration is needed? The distinction of what type of integration is required seems especially important. Integration generates ongoing coordination costs and it is important to assess whether the gains exceed these costs. While all operational economies require some integration, the extent and nature of the integration varies widely. If integration affects only one value chain element, and doesn’t force costly compromises or inefficiencies in other areas, the costs can be relatively low. The same would be true for core competencies. Extending the parent firm’s VRIO brand in marketing efforts may require relatively little coordination. In contrast, extending corporate R&D to generate new products may require more costly integration on a day-to-day basis (See 3M’s technology portfolio).

Some forms of corporate value creation require little to no integration. For example, “Discipline” takes place when a poorly performing target is acquired for the purpose of improving its stand-alone value. This is a key mechanism for Private Equity firms. Of course, they need expertise to understand what the problems are and how to fix them. However, the acquired firm need not be integrated and can be sold off once the problems have been fixed.

Because effective coordination is costly and difficult to achieve, this may be a central component in determining whether a given corporate strategy will create value. The ability to implement effective coordination structures and mechanisms may, itself, be part of a VRIO capability. That is, firms may excel at achieving specific types of coordination links across units. It is important to understand what types of coordination the firm can achieve since such capabilities cannot be effective in all contexts (e.g., across different functions in very different industries with distinct cultures) – what are the boundaries on the ability to coordinate?

So, in the end, maybe core competence isn’t so useful… Given the high bar (a leveraged VRIO resource), one might anticipate that core competence is quite rare. There are likely very few firms that can accurately claim to have a core competence. The term seems to steer managers away from the more concrete discussion of operational economies. In this respect, it is hard to conclude that it warrants the time and effort to try and correct the broad misuse of the term.

Time is probably better spent understanding “temporary” corporate advantages and setting aside whether they will be sustained or imitated. Operational economies of scope may be less rare but they are still quite a challenge to realize – especially while limiting coordination costs. Ultimately, such organizational innovations tend to be harder to imitate than scholars anticipate anyway.

Contributed by Russ Coff

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