Will Your Company's Capabilities Lead Directly to Profits? Think AgainPublished: December 04, 2002 in Knowledge@Wharton
Ask someone why the Indian software services industry has been so successful in the last decade, and you’ll likely hear responses like these: India has a large pool of talented, English-speaking engineers; the time-zone difference is beneficial for U.S. companies that need round-the-clock project work; and the labor force there is relatively inexpensive. Plus, Y2K paranoia (remember that?) spurred many firms to look to India and other offshore sites as they outsourced the tedious task of bringing their stodgy computer systems into the new century.
Simple, right? Well, not quite. In a recent study, Wharton management professor Jitendra Singh, along with Sendil Ethiraj, Prashant Kale and M.S. Krishnan from the University of Michigan Business School, make the case that such country-level advantages don’t tell the whole story.
So if it isn’t just the "India effect," what is it, exactly, that makes certain software services firms overtake the rest? "If macro labor-force factors explained everything, you would expect to see many Indian software services firms doing very well," says Kale. "But when you look closely, that’s not the case. Some 25 companies out of the 3,000 or more in that industry are doing the bulk of the work. Obviously, then, the explanation also has to take into account what individual companies have done to build relevant capabilities to compete."
Their report, based on several years’ worth of project-level data from a leading Indian software services firm, suggests that a firm’s capabilities (its core competencies) are largely context-specific, and that they should be studied both at the level of the firm and the industry. The research paper, titled "A Study of Firm Capabilities and Performance in the Software Services Industry," also demonstrates that not all capabilities are equal in their consequences – that is, some do more for a company’s bottom line than others.
Singh points out that in the past, much of the academic literature about core competencies has been theoretical, and relatively few attempts have been made to explore the link between a company’s capabilities and its performance. "Our research goes beyond past studies and provides clear-cut evidence of the fact that companies have a variety of capabilities that have different kinds of impact on their bottom-line," he explains.
Beyond the Big Picture
Just about everyone agrees that capabilities – competencies built by a firm that have the potential to generate value – can be a source of competitive advantage in the marketplace. While all firms in an industry may have access to similar resources, exactly how they use these resources can vary as a result of many factors -- company history, experience, management style, etc. -- all of which combine to make up the “secret sauce” of capabilities.
These competencies come in various flavors and vary by industry. Most airline passengers, for instance, necessarily fly on similar aircraft, usually made by Boeing, Airbus, or McDonnell-Douglas. What gives an airline competitive advantage or disadvantage, explains Singh, isn’t found in the manufacture of its wings (unless, of course, the equipment is particularly crash-prone), but rather in the way cabin crew members and customer service personnel respond to a consumer’s needs and create the unique service experience. "Once you’ve checked in and you’re on the plane, the longest contact you have with the airline is while you’re in your seat dealing with cabin crew. So for airlines, one important capability is providing a memorable experience to passengers during flight."
Identifying Key Drivers
Prior research on capabilities has shown that yes, capabilities matter; in other words, what a firm does well is indeed critical to whether the firm does well. “Companies need to identify the critical value drivers in their industry and then develop relevant capabilities to exploit these value drivers,” notes Kale. “In the software services business, a dominant capability lies in the combination of high quality and low cost, particularly in today’s environment of great cost pressures facing client firms. Therefore, software service providers need to develop this capacity in order to compete effectively on the global stage.”
As the authors note in their study, not all capabilities are equally important. If capabilities have different costs and benefits, managers will need to know how they can get the most bang for the buck.
“Our data show that not all capabilities have the same degree of impact on cost reduction. Some have more impact than others,” says Kale. “In the case of the firm we looked at, managing schedule slippage [preventing delays in the development of deliverables] is more critical than managing effort overrun [keeping clients’ changing demands from increasing a project’s workload]. Therefore, while companies may want to focus on all capabilities that are relevant in an effort to improve performance, it is more advisable to investigate the differential impact of various capabilities and to direct energies first to those that matter more.”
So if top firms’ capabilities can be tracked down and analyzed, could their competitors just copy what industry leaders do well? Not very easily, replies Singh. "Just having capabilities really doesn’t guarantee how well you will do. Having capabilities that are distinctive and difficult for others to imitate is what can give you sustainable competitive advantage. You cannot mimic only one piece of the business model that many of the top Indian software services firms are using.
"For instance, the global delivery model (GDM), used by one of the leading firms, is the foundation of its high quality-moderate cost proposition. In an effort to compete effectively, U.S.-based firms like Accenture are setting up similar operations in India. But whereas Accenture may have a few hundred people based in India out of the 75,000 employees it has worldwide, an Indian company can have several thousand based there out of, say, 10,000. Despite Accenture’s past success, it may find it difficult to quickly adopt newer business models that Indian firms can employ. Even if Accenture has an Indian operation, the firm’s economic center of gravity is not in India, and as a result, it may not be able to get its cost structure low enough."
“Companies need to invest a lot of time and money over a significant period of time to achieve the same level of capabilities as the leading firms’,” adds Kale. “Also, these capabilities are systemic in nature. Firms need to follow other practices that are consistent with the efforts required to build these capabilities (in hiring and training, culture, and so on). Replicating the entire system of activities undertaken by leading companies is generally quite challenging.”
While the study has important implications for how capabilities should be examined in the future, the authors caution readers not to apply its results indiscriminately. Although there are some generic capabilities that apply to multiple contexts, many critical capabilities are context specific. After all, running a top software services firm demands different competencies than, say, optimizing an automobile factory. “For the software services industry, the ability to manage clients and the software development process are very critical. In other industries, other capabilities would take center stage,” explains Kale. “In the pharmaceutical industry, for example, the capability to select the right R&D projects and the capability to manage them so as to get more blockbuster drugs than competitors do are critical.
“To understand the true underlying capabilities that influence performance, it is important to keep the context of the industry in mind; therefore, our results are not very easily generalized across industries,” adds Kale. He illustrates this point by contrasting software services with management consulting. “To a certain extent, the two may be similar. Developing client-specific capabilities, for instance, may be equally relevant in both industries. But software development capabilities may not be that important in consulting. While using manpower efficiently is important in certain fields such as high-end strategy consulting, it may not be equally important across all forms of consulting. Therefore, when we generalize our findings across other industries, we need to exercise a degree of caution,” he warns.
The authors hope that future research will continue to explore the differential impact of various capabilities on performance. “Not much research has been done to investigate this question in sufficient detail; our project is an attempt to push the envelope on this front,” says Kale.