Sunday, October 17, 2010

Mandelbrot’s Legacy: Strategy in Extremistan

By Dr. Suhaib Riaz.

Benoit Mandelbrot passed away at the age of 85 a few days ago (Oct 14, 2010). He epitomized the cross-disciplinary and relevance-focused scholar like few others. While Mandelbrot’s work has had applications across the sciences and social sciences, the implications of his ideas for the field of Strategic Management are rarely considered.

One exception is the work of his co-author and protégé, Nassem Nicholas Taleb, who gives due credit to Mandelbrot for shaping his own thinking. Taleb’s extension of Mandelbrot’s ideas has several implications for us. Central to these is the contention that the social science world is not Mediocristan, i.e. one that can be captured by Gaussian probability distribution, but rather Extremistan, where more Mandelbrotian ideas of fat-tails and fractals apply.

Taleb’s is perhaps the only recent work to take Mandelbrot’s ideas close to Strategy scholars, as close indeed as an article in a recent Harvard Business Review issue. To get a feel of the Extremistan we are talking about, where most of Strategy operates, look at Taleb’s examples in the HBR article, which are also reported in the “On Robustness and Fragility” section added to the new paperback edition of his book, The Black Swan. What exactly does Extremistan mean and what does it do:

“It causes winner-take-all effects that have severe consequences. Less than 0.25% of all the companies listed in the world represent around half the market capitalization, less than 0.2% of books account for approximately half their sales, less than 0.1% of drugs generate a little more than half the pharmaceutical industry’s sales – and less than 0.1% of risky events will cause at least half your losses.” 
Note the implications of this for (organizational) performance, which is core to the very definition of the Strategic Management field:
“Because of socioeconomic randomness, there’s no such thing as a “typical” failure or a “typical” success. There are typical heights and weights, but there’s no such thing as a typical victory or catastrophe.” 

This is something Strategy scholars should sit up and take notice of. The dominant methods in Strategy research are still based on the Gaussian assumptions relevant only to Mediocristan. The majority of strategy scholars rely on regressions, which originated in fields of study where all phenomena approximated (or were heavily assumed to follow) Gaussian distributions. Simply put, our tools are not up to the phenomena our field deals with.

I believe this means that Strategy has to be looked at afresh as a field, not confined to Mediocristan, but rather like several other social and economic phenomena, from Extremistan. The lack of recognition of these issues is not just a problem in the world of academia, but also in industry, where current practices and organizational structures typically don’t apply Extremistan ideas:
“Such disparagement of negative advice makes companies treat risk management as distinct from profit making and as an after thought. Instead, corporations should integrate risk-management activities into profit centers and treat them as profit generating activities, particularly if the companies are susceptible to Black Swan events.” 
Recent events related to the global financial crisis have given Mandelbrot’s ideas a new life, even as he himself passes away leaving us a rich legacy. His maverick nature, cross-disciplinary work, and focus on relevance also meant that his home base remained in practice and it was not till his last decade in life that he actually took on a full time professorial appointment!

This is perhaps an opportune time for fresh thinking on how his ideas might apply further to Strategic Management, both in academia and practice.

Thursday, October 7, 2010

Revisiting Basics: Differentiation

By Dr. Glenn Rowe

You have a great idea! You’ve found a supportive supplier and you think there are customers who will buy your product/service. You’ve assessed there will be no substitutes for your product/service in the foreseeable future, that you can protect your product/service development and delivery systems and there will be no price wars in the next few years. So, what strategy should you pursue?

An appropriate strategy is differentiation – this means that you have a product/service that will be very different in many ways and you can charge a premium price that customers will pay. Supporting a differentiation strategy will increase expenses but that increase will be more than offset by your premium price.

There are many sources of differentiation and they are limited only by the creativity of those working with you. The first is product features which are easily copied. A second group consists of product mix, linkages with other firms, product customization, product complexity, and consumer marketing. These are less easily copied but can be copied over time. The third group, and hardest to imitate, are location, reputation, distribution channels, linkages among functions within your firm, timing of launch and service and support. Most of this last group involves relationships between people and takes time to develop.

The next question is: do you have the resources to support a differentiation strategy? Frankly, do you have the creative and innovative people to drive a strategy that develops a perception in the minds of customers that your product/service is more valuable? If your resources are mostly about “squeezing blood from a stone” you may have a mismatch between your resources and strategy.

A thorough analysis of your firm’s value chain can help assess this. You need to consider primary and secondary activities. The primary activities start with controlling and appropriately inventorying raw materials. Next, are the operational elements (e.g., effectiveness of production control systems to improve quality and reduce costs and efficiency of layout and work-flow design) required to add value to the raw materials going into the product/service. Then, effective outbound logistics are needed to ensure timely/effective delivery of your service/product. Further, you need effective marketing and sales to develop brand loyalty among targeted customers. Finally, you need to effectively service customers that will be more of a revenue benefit than a cost to you. All these activities need support from secondary activities such as an effective procurement system, a supportive Human Resource Management system, efficient and appropriate technology and a senior management team that can effectively integrate activities across the value chain.

The next step is to examine the structure, control systems and reward systems needed to support differentiation. Structurally, consider cross-functional linkages, a willingness to explore new structures to exploit new opportunities, and allowing isolated pockets of intense creative efforts. Controls should allow flexibility in controlling activities, tolerance for creative people and an ability to learn from innovative failures. Compensation needs to reward risk taking - not punish failure plus it needs to reward creative flair and allow subjective performance measurement.

leadership and preferences should always be top of mind. Are you a strategic, visionary or managerial leader? What type of culture do you want to develop? One that supports a differentiation strategy is assumed! Are you the leader to do this? Do you have what it takes to support creative people as well as account for the cash flow in and out of your firm? What are the preferences of your major stakeholders/investors? Are they supportive of the development of a differentiation strategy?

These are a few questions to get you going. In another instalment we will examine what it takes to pursue a cost leadership strategy.

*Dr. Glenn Rowe is the Director of the Executive MBA Program at the Richard Ivey School of Business, Canada. He is an Associate Professor of Strategic Management and holds the Paul MacPherson Chair in Strategic Leadership.