Once you understand the industry forces, your competitors’ choices in customer outcome and strategy, have chosen your own customer outcomes, have built your strategy around your core capabilities, and have seen success in your business, you may choose to grow through diversification. But carefully note the risks in growing through this diversification, and pay attention to the lessons of history. I have referred to Enron in an earlier blog, and the choices of their leaders present another solid lesson here about diversification. In my opinion, and in the opinion of many scholars, the initial mistake of CEO Mark Frevert and his team was one of trying to grow without recognizing Enron’s true core capabilities. This attempt resulted in growth into areas not congruent with its capabilities, or its ability to present a competitive advantage and add value.
Before its financial collapse in September of 2004, Enron’s core capability (simplified) was developing and managing the financial vehicles to understand and own a market while maintaining an asset-light position. In 1998, Frevert stated that capability in this way: “….[Enron has] a trading capability in a market, which gives us a better insight into the market and is a precondition for investment in physical assets”. If they had to invest in physical assets at all, they tended over time to sell those assets and then focus on the financial vehicles of “swapping” and “hedging” to make their money. This tactic was their core capability.
But in the rush to continue growth for the company, Enron distributed and delegated the responsibility for growth without a clear message to the responsible middle managers to grow through this core capability. The result was growth into areas that seemed adjacent, but didn’t capitalize on this capability. For example, to the outside observer Enron had presumably dealt with the delivery of natural gas to various customers. So wouldn’t the delivery of water be a similar business? Enron moved into the business of setting up water delivery facilities in various parts of the world. But what many employees of Enron failed to recognize is that Enron’s value was not in the delivery of natural gas. It was in the financial mechanisms to power this market. And the delivery of water did not take advantage of these core capabilities. In fact, the first move in this market was the outlay of large amounts of capital for fixed assets. As a result, Enron had no competitive advantage in this new area, and in fact lost a lot of money. Ultimately, forays into other markets in a similar manner caused Enron to be less competitive and over-extend itself. The rest is written in the history books. The fact that Enron’s management turned to fraud to hide its failing business results is another matter.
You must fully understand what has made you successful before you can repeat this success. You may think that what has made you successful is your set of core competencies. Recall that this is not the same as your core capabilities. Core competencies are those “point focused” skills like “designing microwave thin film circuits above 40 GHz” that are elements of your success, but may be “purchasable” by your competition by finding the right resources. But core capabilities are different. They are the holistic sum total of your processes throughout your value chain that deliver a unique customer outcome. For instance, the customer outcome of “delivering first-to-market cutting edge communications solutions” is the result of a set of business processes from R/D to sales and customer service that need to be integrated with this goal in mind. It may or may not require the core competency stated above.
If you have relied solely on your core competencies as a differentiator, as the reason for your success, your business may be in some jeopardy over time. More likely, you have an unstated core capability that is responsible for your success, such as “a value chain that delivers fast-follower solutions with much higher quality and lower price”. In order to diversify with greater probability of success, you should clearly identify your core capabilities and diversify around them.
Diversifying around your core capabilities is not the only way to succeed, but it will likely deliver a more solid and defensible position. Some companies diversify around a given core competency. This strategy is dangerous because your core competency may not be yours for long, or may not be needed by your customers for long. Famous examples of companies that made this strategic mistake include Kodak (film) and Post Versalog (sliderules). If you create a flexible delivery system (delivery to a wide range of customer types, flexible marketing and sales force), this diversification around your core competency can create a business strategy that is valuable and defensible for a time. Be on guard though, since at any time your market can shift, or your competitors can buy this core competency and strain your business model significantly. The danger of a competitor copying or nullifying your core capabilities, or needing a wholesale revamp of your capabilities is much less likely.
I worked in a company that started a new division to satisfy a specific and unique customer base. We designed a set of business processes that gave customizable solutions to a set of very few and very powerful customers in order to target their most significant measurement issues. The core capabilities we set up (the business processes integrated across our value chain) were designed to produce a customer outcome that could be stated as “a dependable and key measurement partner for the largest customers in this industry, there to help immediately solve the toughest problems”. These core capabilities could be stated as “business processes that deliver rapid solutions in hardware, software and services that solve unique customer problems requiring customizability around a platform base.” The required activities and resources were: rapid time-to-market product development, significant deployment of application engineers and large investments in inbound marketing, sales and service. Initially we were focused on hardware/software hybrid solutions for our customers’ businesses. Diversification consistent with this set of business processes included services for competitive analysis, software for efficient deployment of scarce and expensive capital resources, and service for repair of infrastructure. These new areas of diversification required developing some new core competencies, but they were consistent with our core capability. As a result, the advantage that we held compared to our competition with this core capability continued and grew as we diversified into delivering new products and services.
We could just as well have used these core capabilities to expand with greater diversity. For instance, we may have chosen to serve a new set of customers, as long as our core capabilities delivered a powerful outcome that was valued in this new customer set. Thinking in this way about diversification allows you to expand into new business spaces with confidence that what you offer is differentiated and highly competitive.
In this blog, I have argued that your diversification should be supported by, in fact stem from, your core capabilities. Once you have seen success in your business from your well-honed business practices, your diversification should be into areas where your core capabilities can be parlayed into a competitive advantage. Diversify around your core capabilities.