"... the race is not to the swift, nor the battle to the strong, nor bread to the wise, nor riches to the intelligent, nor favor to the men of skill; but time and chance happen to them all."

Ecclesiastes 9:11 speaks of a puzzle that baffles the business world to this day. Why is it that companies that seem to have every advantage are overtaken by apparently weaker competitors?

Seeking a paradigm that might help explain this puzzle, some management theorists have turned to evolutionary theory.¹ Charles Darwin proposed that random mutations in the gene pool of a species are the force that drives evolution. As conditions in the environment change, a series of apparently inconsequential mutations can make the difference between adapting and flourishing on the one hand, and declining or becoming extinct on the other. So too in the business arena: as market conditions change or technology advances, a series of small changes in the culture or organization of one company will keep it healthy while another, more rigid, slowly fossilizes.

An alternative vision of evolution was put forward by Darwin’s contemporary Jean Baptiste Lamarck. Lamarck believed that capabilities acquired by one generation of a species could be transmitted in its genetic code to subsequent generations. Ultimately unpersuasive as science, Lamarck’s view nevertheless provides a fruitful metaphor for the way in which one generation of managers can build up assets and capabilities that are then passed on to the next generation.

And if the idea of evolution as gradual adaptation offers a useful analogy, the fate of the dinosaurs, seemingly wiped out by an asteroid, reminds us that incremental shifts are only part of the story. A business, like a species, might evolve successfully through the gradual transformation of its environment only to be knocked flat by the sudden impact of new technologies, deregulation, and the like.

But if thinking of companies as evolving species provides a basis for understanding why they can dominate their industry and then lose out to an apparently weaker rival, there are limits to the value of the analogy. An evolving species has no ability to predict the future; it can only react to events. Business managers, on the other hand, have a degree of control over their environment and can develop insight into how it is evolving. Though evolutionary theory may provide clues as to why individual businesses thrive or fail, it is just a beginning.

We believe managers should complement an evolutionary understanding of their business environment with insights from a related way of seeing things—the resource-based view of companies—and from business dynamics to build a "dynamic resource system view" of their business.

In the resource-based view, companies are seen as collections of resources—a parallel to the evolutionary vision in which valuable resources take the place of useful genes.² The dynamic resource system view (see panel) is an approach that makes explicit the connections between resources and why resources build up or deplete over time. Business dynamics is a rigorous analytic tool that is ideal for making these ideas operationally practical.³

Most managers know instinctively that a company’s "gene pool" is not static. In fact, the resources that make up the gene pool are constantly evolving. In many cases, they feed off one another and grow stronger through a virtuous self-reinforcing process. Managers often describe the outcome as a sustainable advantage.

Companies find themselves overtaken when rivals trump their source of sustainable advantage. This seldom happens suddenly; usually, the rivals develop new assets over time through a virtuous self-reinforcing process. Some companies manage to avoid being overtaken, remaining dominant for a very long time. In an evolving business environment, such a company must be adaptable; indeed, its resource system may change out of all recognition from one competitive era to the next. To achieve this adaptability, a company must successfully manage its own metamorphosis from dependence on one source of sustainable advantage to dependence on another.

WideFlux Chemicals, the company whose fate we discuss below, is a real enterprise, though this is not its real name or industry, and the names of its competitors have been changed. The story of WideFlux, which was almost overtaken by its rivals but arrested a steep decline and turned itself around by managing its own metamorphosis, shows how a dynamic resource system view can provide a rigorous framework that helps managers anticipate the need for change and transform their companies.

The birth of a competitive advantage

WideFlux is a specialty chemical company. In the 1970s, it patented Flexamax, a compound that revolutionized the production of fine china. Flexamax allowed ceramics factories to use raw materials of variable quality to manufacture an end product of consistently high quality. It led to dramatic reductions in inventories, raw materials costs, factory downtime, and scrap. Sales of Flexamax soared. Priced at 10 times its fully allocated costs, it spawned a phenomenally profitable business.

WideFlux went on to enjoy almost two decades of dominance in the market for ceramic additives. Though rivals introduced competing compounds, none succeeded in luring many customers away.

Flexamax’s initial success rested on its superior technical performance. Yet this didn’t explain its continued dominance, which persisted long after the basic patent had expired. Indeed, one rival, CostChem, invented a tech-nically superior product and offered it at a 30 percent discount to Flexamax, but failed to attract much interest.

In retrospect, it is clear why WideFlux continued to dominate the market despite Flexamax’s higher price. It leveraged three resources: leading-edge products, a reputation for sustained innovation, and sales engineers who knew how to solve their customers’ problems better than any competitor’s salesforce did (Exhibit 1). This combination represented a sustainable advantage because the profits from sales of Flexamax were plowed back into research and development to keep the product at the leading edge. At the same time, WideFlux’s dominant market share meant that its engineers encountered the widest possible variety of technical challenges and were thus more sophisticated than their counterparts elsewhere.

Eventually, the focus on R&D and problem solving was to be the cause of the company’s decline. Yet for many years, these strengths gave WideFlux an unassailable position.

Changing times

One key to the company’s dominance was the fact that Flexamax paid for itself many times over, so customers were not especially price sensitive. As WideFlux had met the profit targets set by its corporate parent, DivCong, year after year, there had been little pressure to run the business as a lean operation. The company paid its sales engineers the best salaries in the industry and supported a wide-ranging research program to keep up the flow of new variants on the basic Flexamax product.

Come the 1990s, however, and barriers to trade fell. Eastern European producers emerged as competitive threats, creating overcapacity and cost pressures that rippled through the economy to suppliers like WideFlux. There were other changes too. The company’s sales engineers were no longer pitching their wares to like-minded ceramic engineers; instead, purchasing departments began to wield more and more influence, and buyers imperceptibly but steadily became less technically aware and more cost conscious.

In this new climate, one competitor, KeenChem, began to enjoy some success with its Thermalease product range, which was chemically similar to Flexamax. WideFlux’s sales engineers began to discount their product to keep sales high. To meet DivCong’s annual target for profit growth, the managers of WideFlux started looking for cost savings. Their natural inclination was to do what had worked before, for they had developed a mindset that linked success with strong R&D. So they cut costs in the sales department and redoubled their research efforts in the hope of sustaining the company’s reputation as an innovator—something they regarded as essential to defending Flexamax’s market position.

Yet this was not always the message that sales engineers were getting from customers. WideFlux was still dominant in some areas, but it was doing far less well in places where KeenChem had seconded engineers to help customers optimize their consumption of Thermalease. This tactic was especially effective in regions where WideFlux’s representation was limited. It also worked well with customers whose products were aimed at the low end of the fine china market. In the mean time, KeenChem was beginning to build a reputation for reliable service that might eventually win over high-end customers as well.

KeenChem’s new sustainable advantage

Between 1986 and 1996, WideFlux’s market share fell from 84 to 56 percent. At the same time, KeenChem’s market share soared from 2 to 24 percent, and CostChem’s rose from 14 to 20 percent. Why? Technology was not the answer. WideFlux still deployed an unbeatable combination of leading-edge products and problem-solving abilities.

Service was a possible explanation, but the picture was muddled. All three competitors were hiring more service engineers (Exhibit 2). From 1992 to 1996, WideFlux increased its engineering staff by 40 percent. It employed more engineers than any competitor, and since its market share was falling, its service levels per customer improved radically. But not as radically as KeenChem’s; that company increased its service force fivefold, so that despite its increasing market share it boasted nearly three times more engineers per customer than WideFlux.

Moreover, KeenChem’s engineers were a new breed. Their technical skills were much weaker than those of their peers at WideFlux, but they were good at closing deals with cost-conscious commercial buyers. WideFlux, on the other hand, stuck with problem solvers who related well to their fellow engineers.

Price was also an important factor in WideFlux’s decline, but in an unexpected way. The company did not want to cut its prices because reductions granted to one customer ultimately had to be offered to them all. It maintained a price premium until 1990, and was not fully competitive on price until 1994 (Exhibit 3). Meanwhile, cost-sensitive buyers found the problem-solving reputation of WideFlux less appealing than the more responsive service and lower prices of its competitors.

At first, this did not seem to be a problem for WideFlux; after all, its mission was to serve high-end customers who were not sensitive to cost. The real but hidden damage caused by the company’s high prices lay in the fact that they extended a price umbrella over the whole industry, giving competitors high gross margins that helped them build two vital resources: market share and service capacity.

KeenChem exploited the gap between its own high prices and WideFlux’s even higher ones by reinvesting the extra revenue in service to customers. Having tried KeenChem’s products and services, customers came back for more. As the company’s market share grew, so did opportunities to learn about what its customers needed. WideFlux, meanwhile, became less and less distinctive. Whether KeenChem knew it or not, it had hit on a new formula for sustainable advantage (Exhibit 4).

What’s to be done?

By 1996, WideFlux still dominated the market, but KeenChem was eroding its market share at an accelerating rate. Although the managers of WideFlux were concerned, they did not understand quite how grave their predicament was.

WideFlux now developed a dynamic simulation model of competitive forces in its market. The model contained all the key resources, both new and historical, exploited by WideFlux and its competitors. It showed that if WideFlux maintained its traditional policies on R&D, service, and price, the company would cease to be dominant within three years. Three years after that, it would be a weak second (Exhibit 5).

The simulation also showed that if WideFlux cut back on research and built a service capability distinctive from KeenChem’s, it would eventually regain its dominance. But it had to commit itself to a metamorphosis right away. If it waited as little as a year, the value generated by the transformation would be virtually halved. A two-year delay would all but rule out the possibility of a value-creating recovery (Exhibit 6).

The news was good and bad. WideFlux still had a window of opportunity, but it was closing, so a dramatic cultural change would have to take place quickly. To achieve its metamorphosis, WideFlux had to build a much stronger service capability by learning from customers’ technical challenges, sharing this learning across the company, and codifying what it had learnt—yet this alone would not be enough to prevent WideFlux from reverting to its old ways at the first sign of difficulty. What the company had to do was destroy its elite research mindset by dismantling much of its prized R&D capability.

WideFlux was locked into a way of thinking that had been tremendously successful for 25 years. It wasn’t easy for managers suddenly to drop a formula with such a strong track record. Yet they might have acted earlier if they had thought more seriously about the lead indicators⁴ of the company’s historical sustainable advantages (Exhibit 7). WideFlux was aware of how it was performing in terms of most of these indicators, so management’s failure to act on them was not a matter of internal measurement.

There was, however, little publicly available information on the company’s competitors, so it was hard to maintain up-to-date information on price premiums and on such intangible resources as the reputation of the companies competing in the market and their respective service capacities. When it became clear that such information was critical, WideFlux managed to assemble it. Had it done so earlier, it might have detected the emerging challenges a bit sooner.

To act, WideFlux had to overcome its existing mindset—the embedded cultural barriers that were based on its success formula.

• The company had taught its corporate parent to expect a steady profit stream, and hadn’t anticipated having to explain why these expectations might have to be revised. This put pressure on WideFlux to maintain a price umbrella that in effect funded its competitors’ investments in service capacity.
• There was another disincentive to lowering prices: any reduction would constitute an indirect admission that the distinctive WideFlux approach to problem solving was no longer highly valued.
• The company’s long-standing focus on the engineers who were its traditional customers prevented it from appreciating the growing influence of cost-focused purchasing departments.
• Within the WideFlux organization, service was less highly regarded than R&D, so it was hard to contemplate reconfiguring the business around service.

Lessons

The WideFlux story has far-reaching implications. It illustrates the practical steps companies can take to overtake their competitors, or to avoid being overtaken themselves. The metamorphosis they must embrace involves leading a business from a historical to a future source of sustainable advantage.

Two kinds of resource can support a sustainable advantage. Tangible ones, like a gold mine or a patent, are sustainable for a time but susceptible to depletion or sudden expiry. Intangible resources, like superior gold prospecting skills or excellent R&D, are also susceptible to depletion but, unlike tangibles, can be replenished. This makes them more interesting and desirable.

A superior resource represents a sustainable advantage only when the surplus it generates is sufficient to replenish the resource faster than it is depleted—a virtuous self-reinforcing loop. Typically, but not always, several resources link together to form the self-reinforcing loop or loops.

To guide a successful metamorphosis, the managers of a company must recognize that the resources underpinning its competitive advantage are waning, and channel the residual surplus into novel resources early enough to allow new sustainable advantages to take root. When a company that has enjoyed advantages in the past fails to realize that they are ebbing away, its rivals can start building new resources and eventually overtake it. To avoid this, managers of companies threatened by changing conditions should take the following steps:

Know your resource system. Virtually all management teams know why their customers purchase their products in preference to those of other companies, and make the connection between these reasons and resources pivotal in the purchasing decision (for example, key buying factors that build up or deplete over time). Fewer manage-ment teams have a clear understanding of how pivotal resources are built up. Fewer still understand the forces that could deplete them, or know how the process of building or depleting pivotal resources is connected to other resources, thus forming a sustainable self-reinforcing loop. The WideFlux managers knew that their basic patent was a critical resource, for instance, but when it expired they mistakenly thought that the company could sustain its position by a reputation for innovation, even though the stream of innovations had ceased to be distinctive.

Knowing the importance of each resource will tell you how good you are today, but not where you are heading

Look for leading indicators. Find out which pieces of information could give the first warning of changes in the relative importance of the different resources underpinning a sustainable advantage. Measure their trajectory. Merely knowing the importance of each resource will tell you how good you are today, but not where you are heading. The WideFlux management team rightly focused on every change in market share, and became concerned about the inroads competitors were making. But one resource that started slipping away much earlier—the company’s reputation for innovation—was an early sign of bigger changes to come.

Anticipate shocks. Each resource is vulnerable to changes that can often be anticipated. Most resources are boosted by certain factors and undermined by others. We often think of a shock as something that depletes resources suddenly, but in reality a shock that simply prevents resources from accumulating can be more important because it is harder to detect. The reputation of WideFlux as a distinctive innovator was sustained by a steady stream of new formulations, but ceased to grow when competitors started offering a similar range of prod-ucts. After a while, KeenChem came to be regarded as no less innovative than WideFlux.

Identify resources that must be built to contribute to a future sustainable advantage. Companies threatened by change must build new resources—and respect the time it takes to do so. There is no way to predict with certainty which new resources will promote a future sustainable advantage, but it is possible to describe possible sources of sustainable advantage and develop the ability to build them.

By luck or design, KeenChem at first offered customers cost savings rather than the value-added services stressed by WideFlux. Each contract KeenChem won gave it a new opportunity to develop its service knowledge and improve its package of products and services. All this could be done at an attractive rate of return because WideFlux gave KeenChem a substantial price umbrella to support the upstart’s high-intensity cost-saving service and meet the profit expectations of its shareholders.

To revive a company, it is not enough to build; destruction too is necessary

Identify resources that must be destroyed. To revive a company, it is not enough to build; destruction too is necessary. KeenChem was able to create a substantial lead in cost-saving services for the low end of the market because WideFlux was culturally unsuited to nurturing a cost-saving (as opposed to technical) service function. Destroying this cultural barrier was a painful but necessary step.

Structural change in an industry is often linked to a momentous discontinuity such as deregulation or a technological breakthrough. Such discontinuities are usually the result of cumulative processes that started small: the political and social trends that lead to deregulation, say, or the pressure of demand and advancing technological capabilities that make breakthroughs more and more likely.

Any organization that wishes to take advantage of a discontinuity must have the ability to see it coming earlier and react to it more quickly than competitors. If you see a discontinuity coming, you can prepare for it by building up new sources of sustainable advantage before your rivals do. Even if you cannot see it coming, you can react and adapt quickly when it arrives if you are prepared for uncertainty.

What you see depends not only on where you look, but on what you are looking for. The dynamic resource system view can help companies see patterns emerging, and see them early and clearly. Business dynamics supports this approach with quantitative rigor and helps managers to anticipate the most powerful change levers in the face of uncertainty.