Why old tools won't work in the "new"knowledge economy

Norman T. Sheehan

Norman T, Sheehan, B,Comm,MBA, PhD, CMA is an AssociateProfessor in the College otCommerce at the University ofSaskatchewan. He teaches,publishes and advises in theareas of strategy formuiation,strategy implementation/performance measurement, andmanagement of knowiedge-intensive firms (Sheehan®commerce.usask.ca).

Introduction

Firms in the knowledge economy are significant drivers of economic growth, both for theclients they help and for themselves as witnessed by the fact that their revenues haveincreased tenfold in the past twenty years. Despite the meteoric rise of knowledge-intensivefirms, we know very little about their business models and even less about how to improvetheir profitability. While we have many tools to analyze and improve the performance ofindustrial firms, we have few toois for knowledge-intensive firms. Porter's (1998) strategytools[1] are intended for industrial firms, suoh as Ford Motor Company, Deli, Coca-Cola,Caterpillar, Anheuser-Busch, and Nucor, not knowledge-intensive firms such as Accentureand McKinsey in consulting, Deloitte and KPMG in auditing, Clifford Chance and WatchellLipton in legai, Kleiner Perkins and Bain Capital in venture capital, and BBDO Worldwi(de andMcCann Erickson in advertising. Aithough Porter's tools may provide some strategicinsights, managers of knowledge economy firms run the risk of applying misleading advice.If we want valid, trustworthy insights from Porter's key strategy tools - five forces, genericstrategies, and value chain - they need to be sharpened and modified for use inknowledge-intensive firms.

Many knowledge-intensive firms recently experienced shock in the aftermath of the dot.commeltdown, 9/11, economic recession, and the implosion of Arthur Andersen. These eventsleft managers scrambling to unearth new ways of increasing their firm's profitability. Thispaper examines the business models of knowledge-intensive firms using a sharper lens andoffers three options to improve performance:

1. increase value capture by using insights from a modified five forces anaiysis;

2. improve value created by choosing a business modei that best fits a firm'sproblem-solving expertise, clients targeted, and desired risk ievel; and

3. identify competitive niches by evaluating which problem-solving activities shoul(J beperformed in-house versus ieft to clients or outsourced.

Value capture in knowledge-intensive industries

Firms fight to retain and capture vaiue from actors in and around their industry. Porter's fiveforces analysis tells a story of who captures the most value: Is it rivals, who by competing forcustomers force the firm to reduce prices or incur additional expenses that increase thevalue offered? Is it buyers with high bargaining power who force the firm to accept lowerprices? Is it suppliers with high bargaining power that cause the firm to pay higher prices forinputs? Is it attractive substitutes who limit the price consumers will pay for the firm'sproduct? Or is it potential new entrants who force the firm to reduce its price to discouragetheir entry into the market (see Figure 1)?

DOI 10.1108;02756660510608567 VOL 2e NO. 4 2005, pp, 53-60, S' Emerald Group Publishing Limited. ISSN 0275-6668 JOURNAL OF BUSINESS STRATEGY PAGE 53

Figure 1 Porter's five forces for industrial firms

Suppliers Buyers

Substitutes

If the industry is favorable, such as the pharmaceutical industry, then all firms in thepharmaceutical industry wilt enjoy superior performance. If the industry is unfavorable, suchas the airline industry, then all firms suffer For example, United and Delta are struggling dueto high industry rivalry, low cost entrants such as Jet Blue, high bargaining power of keysuppliers such as airline pilots, and an increasing attractiveness of substitutes such asvideoconferencing.

Knowledge-intensive firms create value by soiving their clients' problems through the directapplication of knowledge. Whereas knowledge plays a role in all firms, its role is distinctive inknowledge-intensive firms. Rather than being embodied in the process or product,knowledge resides in experts and its application is customized in real time based on clients'needs. The way knowledge-intensive firms create value critically impacts Porter's story ofwho captures the value in a number of ways: First, knowledge-intensive firms competedifferently - they fight vigorously to win the best experts and best projects (Maister, 1992)[2],but thereafter cooperate with their rivals. Knowledge-intensive firms routinely refer projectsto rival firms better suited to solving the problem or they may even cooperate by sharingwork on larger projects. For example, law firms may refer clients to other law firms orsub-contract work for large legal cases. Knowledge- intensive firms may also cooperate toadvance the professional or industry association through conferences, common trainingprograms, or setting common standards (see Figure 2).

Second, first-mover advantages play a decidedly smaller role in knowledge-intensiveindustries due to the rapid commoditization of ideas and processes. Although the first firm tointroduce new ideas may "cream off" a disproportionate share of new business, theadvantage is typically temporary. In the early 1990s, CSC Index used its head start inbusiness process re-engineering to build a lead over its competitors, but as CSC Index soonlearned, this advantage was fleeting due to the ease with which their processes andsolutions were imitated by rivals.

Third, experts, who are the main suppliers to knowledge-intensive firms may have highbargaining power if their clients are tied to the expert rather than to the firm. For example, ifclients approach the firm because they want specific consultants, then those consultantshave leverage that they may apply to appropriate higher salaries. However, if the clientapproaches the firm and will take any qualified consultant, their bargaining power is muted.

" Knowledge-intensive firms compete differently - they fightvigorously to win the best experts and best projects, butthereafter cooperate with their rivals."

';>i

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Figure 2 A modified five forces for knowledge-intensive industries

Experts

New Entrants

OO

oCooperation

ORivalry C )

OReferrals

OClients

Substitutes

Fourth, the bargaining power of clients is reduoed due to a knowledge gap between expertsand their clients. Clients may not be able to view the problem-solving activities or thecontingencies experts operate under that often make it difficult for clients to ascertain thequality of the solution, even after the fact (Lowendahl, 1997)[3], In some cases, once thesolution is implemented it may be irreversible - think of a lawyer trying a legai case or kneesurgery. A client's bargaining position is further weakened if the solution is very important tothe client. One reason some clients pay such a high price for expertise is that the cost ofignorance may be even higher (Fjeldstad and Andersen, 2003).

Finally, while there is a minimal cost to set-up a new knowledge-intensive firm, reputationacts as a deterrent. Established experts have an easier time if they are known to clients, butnew entrants are hindered by their newness - not having a track record makes it difficult towin clients. Industrial firms can lure customers to try new products by reducing their prices,but this is risky for knowledge-intensive firms because it may be seen as cutting quality.Think whether you would be comfortable going to trial with a law firm that advertises "BoxingDay divorce specials" or "Easter break-and-enter specials."

After completing a five forces analysis managers can try the following tactics to capturemore value: Reduce the bargaining power of its experts by tying clients to the firm instead ofto the expert. Accenture and McKinsey have a clear "one firm" policy, which is partiallyintended to "tie" the client to the firm rather than to one particular consultant. If it is netfeasible (or desirable) to reduce ties between individual experts and clients, another way topersuade experts to accept less than full market value for their services is to offer a menu of(future) rewards such as competence building, enhanced legitimacy, and an opportunity tobecome partner (Fjeldstad and Andersen, 2003). Some clients may try to reduce thebargaining power cf firms by hiring their own experts. Many corporations have in-house legalcounsel. Can managers of knowledge-intensive firms introduce flexible client arrangementsand pricing structures to make this option less attractive for current and potential clients?

Reputation plays a key role in deciding who hires your firm, who partners with your firm, andwho refers clients to your firm. Is there room to proactively improve the firm's reputationalstatus by increasing involvement in the profession, monitoring and measuring reputation, orpartnering with firms with better reputations?

Business models for knowledge-intensive firms

Business models for knowledge-intensive firms should outline a strategy in terms of whichclients they will target, what problems they will solve, and how they plan to do this efficientlyand effectively. In making these strategic choices, knowledge-intensive firms face a different

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competitive lancJscape from industriai firms. For example, knowledge-intensive firms focusmore on value enhancement than cost reduction, "Cars, despite heroic attempts atbranding, are still more or less interchangeable and sold on price - hence the car industry'sfixation on costs. But each new class of drug is usually unlike anything else that came before.Moreover, few patients will buy second-best heart pills just to save a few dollars . . . " {TtieEconomist. 1998). Cost is important in knowledge-intensive firms, but it is not the definingcharacteristic - the defining characteristic is adding the most value by healing the sickestpatients, winning the toughest court cases or designing the most aestheticaliy pleasingbuildings. Further, competing on being the lowest cost/iowest prioe in any segment is riskybecause it may be equated with being tow quality in the clients' mind. This is not to say firmscannot offer iower priced services - knowledge-intensive firms routinely targetprioe-sensitive ciients with lower priced services. FDS' own consultants sell projects tomid- and lower-end clients, while AT Kearney targets high-end clients who can affordhigher-priced engagements. But competing with a lowest price strategy is less appealing forknowledge-intensive firms because in the absence of other information clients mayassociate price paid with the quality of the solution.

Aside from the potentially damaging signal a low cost/low price strategy may send,knowledge-intensive firms also face significant challenges implementing a low cost strategydue to their cost structures. Fxpert salaries are typically a knowledge-intensive firm's largestexpense item and there is less room to reduce salaries. Knowledge-intensive firms also lackscale economies. Larger scale may allow a firm to offer services to global clients, to solve"larger" problems, and tc provide additional opportunities to balance the workload ofexperts (Stabell and Fjeldstad, 1998; Starbuck, 1992)[4]. However, these advantages aremore than offset by the costs associated with coordinating experts and the need toreconfigure for unique cases. Although some larger firms such as McKinsey enjoy success,smaller knowledge-intensive firms typically earn higher revenues per expert than largerfirms.

Porter argues that the only way for firms to achieve above average profitability is by basingtheir business model on being lowest cost or differentiated. However, a low cost strategy isnot strategically attractive for knowledge-intensive firms. Instead we suggest that a keytrade-off for knowledge-intensive firms is the breadth of their problem domain, which definesproblems to be solved and clients targeted by the firm (Fjeldstad and Haanes, 2001;L0wendahl et al., 2001; Stabell, 2001 )[5]. Knowledge-intensive firms can choose to begeneralists and solve a broad range of problems or they may choose to be specialists byfocusing on a narrow range of problems.

A second key positioning choice for knowledge-intensive firms is the level of knowledgere-use (Hansen etat., 1999; L0wendahl etai, 2001; Maister, 1993; Mintzberg, 1979), giventhat expertise directly impacts client value and firm cost (see Table I). At one end of theknowledge re-use spectrum, firms such as Deloitte Consulting and Acoenture sell mainlypre-packaged or "off the shelf" solutions. These firms are efficient, as they have solved thesetypes of problems before, but they may be less effective if new problems do not call for oldsolutions. Maister (1993)[6] labels this type of firm "grey hairs", which is appropriate as itimplies depth of knowledge but less adaptability in its application. At the other end of theknowledge re-use spectrum, we see firms that sell tailor-made solutions such as Deka, whichinvented the Segway. These firms typically approach each problem as a blank sheet ofpaper with the aim of arriving at a customized solution and are more effective solving clientproblems but less efficient.

Placing the two dimensions together gives a range of business models forknowledge-intensive firms (see Table !).

Managers need to analyze their firm's knowledge re-use and desired risk levels beforepicking a business model that best fits their expertise, target clients, and aspirations.Knowledge-intensive firms choosing a broad problem domain and "off the shelf" solutions,whioh we label General Stores, typically earn lower client fees but incur lower expenses insolving their problems. Their main risk is that their expertise becomes obsolete, although by

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Table I Business models for knowledge-intensive firms

Sells packaged solutions Sells tailor-made solutions

Broad problem domain

Narrow problem domain

General stores (Deloitte Consulting, IBMConsulting)Specialty shop (Balanced ScorecardCollaborative, Marakon)

Idea labs (Boston Consulting Group, DeanKamens firm - DEKA)Boutiques (Gary Hamel's Innovation Lab)

diversifying into a broad range of problems they have a lower obsolescence risk comparedto firms suoh as Specialty Shops, which have narrower specializations. Specialty Shops areexperts at solving one type of problem. They typically charge lower fees, but should beefficient as long as clients' projects fit their expertise profile. Firms that choose broadproblem domains and customization, which we label Idea Labs, typically earn higher feesbut run the risk of having costs exceed revenues due to an unclear probiem definition andscope. Firms with narrow problem domains and customization, which we label Boutiques,earn higher fees but also face obsolescence and efficiency issues. On the positive side,though, Boutiques and Specialty Shops have reduoed their complexity and thus risk byfocusing on narrower problem domains (L0wendahl and Revang, 2004). Lastly, Boutiquesand Idea Labs face a longer-term risk: as they gain a reputation for successfully solvingcertain types of problems, new clients may request old solutions. While profitable in the shortterm, this may gradually lead to a "success trap"[7] as their old knowledge loses its marketrelevance.

Activity scope for knowledge-intensive firms

Firms can use activities as an analytical tool to improve the effectiveness and efficiency oftheir operations. Porter argues we cannot understand a firm's competitive potential bylooking at the firm as a whole; rather its competitive position is determined by the activities itundertakes, such as receiving, manufacturing, storing, transporting, hiring, training,purchasing, and marketing (Porter, 1998)[8]. To assist managers to understand andimplement a low cost or differentiation strategy using activities. Porter outlines the valuechain (see Figure 3). The value chain is a generic activity template that can be used todecompose the firm into the individual activities it undertakes to oreate value for thecustomer.

Knowledge-intensive firms create value by solving problems in contrast to industrial firms,which create value by transforming inputs into outputs. This different value-creating logicdemands a new activity framework. Stabell and Fjeldstad propose a value shop activitytemplate as a tool to model value creation in knowledge-intensive firms (Stabell andFjeldstad, 1998)[9].

Knowledge-intensive firms create value for their clients by performing one or more of thegeneric problem-solving activities:

• problem finding, which includes acquiring clients and defining their problems;

• problem solving, which includes alternative generation and evaluation;

Figure 3 The value chain

SupportActivities

PrimaryActivities

\ Firm Infrastructure\ Human Resource Management\ Technology Development/ Procurement/ Inbound/ Logistics

Operation OutboundLogistics

Marketing& Sates

\\

\/

After-Sales /Service /

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choice of an alternative;

implementation of an alternative; and

follow up and control to see if the alternative selected resolves the problem.

In the graphic model for the value shop, the primary problem-solving activities, rather thanbeing linear as in the value chain, are shown as "wheels within wheels" in order toemphasize a cyciical and iterative value creation logic (see Figure 4). As with the valuechain, the value shop has a corresponding set of support activities that play an indirect rolein creating value for their clients. The main difference is that senior experts typioaily performtraining and technology development activities along with their primary problem-solvingactivities.

Once the knowledge-intensive firm has been divided into its key value-creating activities,managers can pursue two lines of strategic analysis: They can compare their activity set tothat of competitors - are they performing them better or differently? This analysis usuallyprovides insights into areas that need to be improved. For example, are all activities creatingvalue in the clients' eyes? Can we eliminate or reduce some activities? Are competitorsundertaking different activities and adding more value at lower cost? A second line of inquiryfocuses on the scope of the business model - which activities should be completedin-house versus having the client perform them.

A general building contractor is an example of a knowledge-intensive firm that performs onlythe first aotivity, problem finding. A general contractor wins the engagement and thencontracts the actual construction work out to various trades. However, it is more common thatknowledge-intensive firms, such as consultants and architects, perform problem finding andproblem defining activities. These firms win the engagement, outline a set ofrecommendations, and then leave the remaining activities (choosing the solution,implementation, and follow up) in the hands of the client. Some knowledge-intensivefirms, suoh as cosmetic surgeons and lawyers, oomplete the full cycle of activities. They winthe work, recommend and choose a solution, implement by doing the surgery or trying thecase, and then follow up. On the other hand, some knowledge-intensive firms perform onlyimplementation and follow-up activities, relying on referrals from other knowledge-intensivefirms for their clients.

Focusing on activities provides managers with another lens to differentiate themselves.Choosing different activity sets leads to the formation and (potentially) domination of new

Figure 4 The value shop

SupportActivities

Firm Infrastructure

Human Resources Management

Technology Development

Procurement

Primary /Activities '

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Business models for knowledge-intensive firms shouldoutline a strategy in terms of which clients they will target,what problems they will solve, and how they plan to do thisefficiently and effectively."

I

Keywords:Knowledge organizations,Performance measures,Business excellence,Knowledge management,Activity based management

competitive niches: Acoenture found a new strategic niche in this manner. Once a pureproblem finder and definer, Accenture now performs implementation and follow-up activitiesfor clients (i.e. back office procedures like payroll and accounting). Some architectural firmsare moving beyond delivering drawings to managing the construction of buildings they havedesigned.

Maister suggests a new business model for consulting firms (Ttie Economist. 2001), whichhe labels "pnme contractors". He proposes that these firms should act as generalcontractors by coordinating the work of boutique and specialty shops, which are hiredbecause they are the "best of breed."

Summary

Applying "old" tools to "new" knowledge-intensive firms seldom provides the strategic edgemanagers are looking for. Managers of knowledge-intensive firms need to use the old tools innew ways, if they are to improve their business models and ultimately increase theirprofitability.

Notes

1. Discusses five forces analysis, generic strategies and the value chain.

2. Discusses how professional service firms compete for professional talent and client projects.

3. Discusses how information issues impact professional service firms.

4. Discusses scale economies in knowledge-intensive firms.

5. Discusses how the scope of the problem domain is a key strategic choice.

6. Discusses "grey hairs" in professional service firms.

7. Mintzberg (1979) was first to note this risk, but see also Fjeldstad and Haanes (2001) who build onJim March's work on exploration versus exploitation.

8. Describes how to use activities to improve efficiency and effectiveness.

9. Discusses the strategic implications of the value shop.

References

(The) Economisl {}998), "New drugs for rare diseases", Ttie Economist, 28 May p. 78.

(The) Economist (2001), "Spoilt for choice", Ttie Economist, 7 July p. 66.

Fjeldstad, 0. and Andersen, E. (2003), "Casting off the chains: value shops and value networks",European Business Forum, Vol. 14, pp. 47-53.

Fjeldstad, 0. and Haanes, K. (2001), "Strategy tradeoffs in the knowledge and network economy".Business Strategy Review. Vol. 12 No. 1, pp. 1-10.

Hansen, M., Nohria, N. and Tierney, T (1999), "What's your strategy for managing knowledge". HarvardBusiness Review, March/April, pp. 2-12.

Lewendahl, B. (1997), Strategic Management of the Professional Service Firm. HandelshojskolensForlag, Copenhagen.

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Lawendahl, B. and Revang, 0. (2004), "Achieving results in an after modern context: thoughts on therole of strategizing and organizing", European Management Review, Vol. 1 No. 1, pp, 49-54.

Lewendahl, B., Revang, 0. and Fosstenl0kken, S. (2001), "Knowiedge and vaiue creation inprofessionai service firms: a framework for analysis". Human Relations, Vol. 54 No. 7, pp. 911-31.

Maister, D. (1993), Managing the Prolessional Service Firm, The Free Press, New York, NY.

Mintzberg, H. (1979), The Structure of Organizations, Prentice-Hall, Englewood Cliffs, NJ.

Porter, M. (1998), Competitive Advantage, The Free Press, New York, NY.

Sfabell, C. (2001), "New models for vaiue creation and competitive advantage in the petroleumindustry", research report 1/2001, Norwegian School of Management, Oslo.

Stabeli, C. and Fjeldstad, 0. (1998), "Configuring value for competitive advantage: on chains, shopsand networks". Strategic Management Journal, Voi. 19 No. 5, pp. 413-37.

Starbuck, W. (1992), "Learning by knowiedge-intensive firms". Journal of Management Studies. Vol 29No. 6, pp. 713-40.

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