CHAPTER ONE

Rethinking Networks

Strategy is becoming, to an increasing extent, the art of managing assets that one does not own.
For many years, Kmart and Wal-Mart reigned as the flagships of the U.S. retail industry, with little to distinguish them in the eyes of most consumers and practitioners but matters of style. But Kmart filed for Chapter 11 protection in January 2002, whereas Wal-Mart continues to thrive as the most successful retailer of all time. Colorful and sinister theories accounting for Wal-Mart’s spectacular success abound: Accounts have mentioned everything from predatory pricing to employee culture and from Sam Walton’s overalls to his knack for identifying productive store locations. However, an examination of Wal-Mart’s relationship with its vast network of business partners highlights a very different driver of its success: Wal-Mart, like Microsoft, is successful because it figured out how to create, manage, and evolve an incredibly powerful business ecosystem.
Over the years, Wal-Mart took advantage of its ability to gather consumer information to coordinate the distributed assets of its vast network of suppliers. You can almost think of it as a single enormous operation, made up of thousands of companies. Through a combination of technology, capabilities, and policies, Wal-Mart wove the fabric that organized this massive network of organizations into a collective force that worked to provide customers with the products they needed at the time they needed them, at the lowest possible cost. This strategy proved remarkably effective, resulting in dramatic performance advantages in cost, operating margin, and sales per square foot—a gap that Wal-Mart has sustained and even widened over time.
Wal-Mart’s approach evolved over a long period. But even early in its history, Wal-Mart made a point of tracking demand information in real time. The key was that it decided to share this information with its supplier network. It introduced Retail Link, the system that still delivers the most accurate real-time sales information in the industry to Wal-Mart partners. Wal-Mart was unique in the retail space in offering this kind of service, turning Retail Link into a critical supply chain hub that now connects the information systems of thousands of manufacturers, including the likes of Tyson Foods, Gillette, and Procter & Gamble. Moreover, through the software and hardware it disseminated, Wal-Mart provided the tools and technological components that enabled its network partners to make Retail Link an integral element in their respective supply chains, further amplifying the impact of the consumer information it provided. In this way, thousands of individual firms have been able to share in the value created by Wal-Mart’s information infrastructure, and have built their own technology and business processes to leverage Wal-Mart’s information assets.
By sharing sales data, as well as through other contributions, such as sharing the massive scale economies of its stores and centralizing the structure of its supply network, Wal-Mart effectively provided a low-cost, high-efficiency, and information-rich platform for the distribution of an enormous variety of products. This was valuable to Wal-Mart’s many suppliers, which in turn reflected on Wal-Mart’s own position and advantage. Ultimately, Wal-Mart was successful because it made use of its unique position in its network of suppliers and shared the value that was created by being a network hub.
Like Wal-Mart, the dramatic success of Microsoft is also frequently ascribed to simplistic theories, ranging from conspiracy to luck. But looking carefully at how Microsoft managed its network of business partners over time yields an intriguing explanation: that like Wal-Mart, Microsoft created and actively maintained a platform that a vast number of firms could leverage to increase productivity, enhance stability, and use as the building blocks for innovation.
From the earliest days of the microcomputer industry, Microsoft focused on designing programming tools and technologies that were used by thousands of organizations and millions of developers. Indeed, Microsoft’s first product was not an application or an operating system, but the first popular version of BASIC to run on microcomputers—effectively a tool that enabled developers to more easily create software that would run on a large number of machines. Since the early 1980s, Microsoft has been offering operating systems, such as MS-DOS and Windows, that included standard interfaces for writing application programs. These technologies evolved further during the late 1980s and 1990s to include a powerful combination of operating systems, reusable programming components, and tools. These elements increased developer productivity and innovation, enabling this community to create a variety of applications without having to worry about hardware-specific details. Thus, like Wal-Mart, Microsoft simplified the challenge of connecting a very large and distributed network of companies for its customers. Like Wal-Mart, Microsoft acted as a crucial hub in a vast and diverse business ecosystem.
Both Wal-Mart and Microsoft deliberately chose to shape the collective performance of the networks of firms that depend on them by offering platforms on which others could build. Both firms were successful because they appreciated the impact these platforms could have on these business networks and took steps to realize this impact by creating real opportunities for other firms. These firms in turn made investments in leveraging these platforms and began to depend on them for their success. This created a virtuous cycle in their respective industries through which a broad variety of firms achieved high levels of productivity, stability, and innovativeness. This in turn led to outstanding operating performance for both Microsoft and Wal-Mart, sustained over decades.
Despite their drastically different settings, the two firms’ success stories share a number of critical factors. Like Wal-Mart, Microsoft’s performance is linked to that of its vast network of business partners, numbering in the tens of thousands. Like Wal-Mart, Microsoft has worked hard to organize the behavior of these business partners, creating opportunities for growth and innovation. And like Wal-Mart, Microsoft is only strong if this business community is large, healthy, and growing. This does not mean that all members of these communities are always happy with Microsoft’s or Wal-Mart’s behavior, since both firms frequently adopt aggressive positions in negotiations. Regardless of the intensity of individual encounters, however, both firms understand that they can only win if they continue to sustain the collective health of their vast networks of business partners.
In essence, both of these firms understand that their fate is shared with that of the other members of their business network. Rather than focusing primarily on their internal capabilities (as many of their competitors did), they emphasize the collective properties of the business networks in which they participate, and treat these more like organic ecosystems than traditional supply chain partners. They understand their individual impact on the health of these ecosystems and the respective impact of ecosystem health on their own performance.
Ultimately Wal-Mart and Microsoft were successful because they played the role of a keystone in their respective ecosystems. Drawn from biology, the term describes a pattern of behavior that improves the performance of an ecosystem and, in doing so, improves individual performance. This kind of keystone strategy is the focus of this book. As will become increasingly clear, this approach to strategy challenges many prevailing views about how critical firms such as Wal-Mart and Microsoft work, and calls into question much conventional wisdom about the management practices of firms as diverse and varied as eBay, Enron, Charles Schwab, and IBM.

Business Networks

Wal-Mart and Microsoft are by no means alone in operating within business networks. Business networks are ubiquitous in our economy. Dozens of organizations collaborate to bring electricity into our homes. Hundreds of organizations join forces to manufacture and distribute a personal computer. Thousands of companies coordinate with each other to provide the rich foundation of applications necessary to make a software operating system successful. This pervasive networked nature of our business environment has triggered a significant evolution in the design of business operations and in the role of managers. For an increasing portion of our business leaders, the fundamental challenge they now face is the management of assets that are not directly owned by their own firms.
Business networks did not start with the Internet. Networks are now more widespread in our economy than ever before, but their pervasiveness is the result of an evolution in social, economic, political, and technological systems that has stretched over the last few centuries. For hundreds of years, the Italian apparel industry (originating in the Prato region) has been organized as a loosely connected network of many organizations, many as small as one person. The local autonomy of this system enabled the kind of focus, flexibility, and quick reaction that ensured strong performance in a highly turbulent environment. At the same time, organizations evolved to coordinate the network. Starting with the impannatore of Renaissance Italy, these organizations orchestrated an integrated production and distribution system from the individual parts of the distributed network. To do this, they developed a range of processes and technologies connecting their network partners to each other and coordinating their collective response. This combination of autonomy and coordination enabled the Italian apparel network to become robust enough to survive hundreds of years of technology and market changes, achieving enough productivity and innovation to triumph over competitive systems. Even now, the Italian apparel network is a remarkably distributed operation in which a small number of organizations, such as Benetton, function as keystones to help coordinate network behavior.
Despite the rich and deep roots of our networked economy, the nature of business challenges evolved significantly during the second half of the twentieth century. During much of the 1900s, the mantra of most modern businesses was still vertical integration, as organizations such as DuPont, Ford, and IBM evolved as juggernauts that directly owned the vast majority of the assets necessary for their daily operation. Creating distributed business networks was too difficult and costly, and the advantages of vertical integration dominated in most environments. But during the last decades of the twentieth century significant changes in our legal, managerial, and technological capabilities made it much easier for companies to collaborate and distribute operations over many organizations. In industries as different as personal computers and personal care products, companies leveraged multiple organizations in distributed supply chains, integrated technological components from a variety of business alliances, collaborated with a number of channel partners to distribute their products, and leveraged complementary services from banks, insurance providers, or retailers. This pushed many of our industries toward a fully networked structure, in which even the simplest product or service is now the result of collaboration among many different organizations.
Business networks thus emerged in industries as different as automobiles and fast foods. The auto industry evolved to exhibit a widely distributed structure, with more than half of the value of any individual car being contributed by an increasingly extensive supplier base. Companies such as Ford and Chrysler found themselves at the hubs of increasingly complex and global networks, which motivated the development of new capabilities, processes, and technologies. During the same time period, food service institutions such as McDonald’s and Burger King were built on top of extensive supplier bases and developed massive networks of franchisees.
During the second half of the twentieth century, large, distributed business networks became the established way of doing business in the modern economy. They can be identified in industries ranging from biotechnology to insurance, and from banking to software. Just because they are ubiquitous, however, does not mean that they are easy to manage.

Network Challenges

In the last ten years, the combination of readily available technology and capital has made the creation of business networks easy. Despite being simple to create, business networks are still poorly understood and most often poorly managed. In the boom years of the Internet, there was an almost universal euphoria about the power of networks. Business networks would enable unforeseen efficiencies in operations and innovation. New network technologies would disrupt traditional companies and create unprecedented opportunities for new company growth and innovation. Network “effects” would create enormous value and large barriers to entry in businesses as different as enterprise software and grocery delivery. But things were not so easy.
The implosion of the Internet bubble made it obvious that network members share a common fate, which means that they can both rise and fall together. And although many had predicted that the bubble could not last, the sharpness, suddenness, and violence of the fall surprised a lot of people. The stunning reversal of the virtuous cycle that seemed to automatically drive endless growth left many questioning the very foundation of their faith in the power of business networks. But the Internet was by no means alone in generating business network failures. The effective coordination of distributed operating assets has eluded managers in organizations as different as Enron and the State of California, and in industries as different as electricity and software.
Behind these failures is a school of management thinking that focuses primarily on the internal operations of the firm and tells us little about how to manage vast networks of firms. The majority of books on our management bookshelves tell us to build internal capabilities, focus on our core competencies, create small, dedicated teams, and ward off disruptive technologies by spinning off small, focused, dedicated ventures. Prevailing management theories all too often advise the operating manager to create small, isolated units to fight problems and leverage opportunity. Given their emphasis on understanding focused, tightly coupled systems, these theories have a difficult time dealing with a huge, unfocused, unbounded, amorphous, and constantly evolving network like the Internet. They can’t tell us how to manage a network of business partners that is one thousand times the size of the firm, as is the case in industries as different as apparel and software. They don’t tell us why IBM’s innovation strategy is more dependent on influencing the behavior of the millions of free software developers scattered outside its organizational boundaries than on the hundreds located in its internal Thomas J. Watson Research Center. And they can’t explain why Microsoft and Wal-Mart have been able to sustain unprecedented growth in revenues and profits by leveraging their networks of business partners.
When the Internet took off and business networks became ubiquitous, our understanding of management and strategy simply did not keep up. Consultants and academics rushed to propound new theories, but often without a solid foundation in research or experience. The executives who ran new Internet ventures or attempted to modify the operating models of established firms were thus often flying blind, attempting new business models and structures without solid foundations. The results are now all too obvious.
As our economy recovers and evolves, it is essential that we finally develop a solid understanding of how networks and key firms within them support or inhibit innovation, how they can enhance or damage operational productivity, and how they can provide healthy, sustainable environments for the creation of new firms and products. This, in essence, is the objective of this book.

Business Networks as Ecosystems

The collapse of the Internet economy—the few successes, the many failures, and the many lessons drawn from the evolution of traditional firms—provides the perfect opportunity to reflect on, research, and finally learn how to manage complex networks of firms. This motivated us to launch research programs involving dozens of firms across a variety of industry sectors. Over the last few ye...