BUSINESS DYNAMICS

Maurice Glucksman and John Morecroƒt

Must all companies eventually vanish?

Ideas borrowed from evolutionary theory

can help companies survive and thrive

Maurice Glucksman is a consultant in McKinsey’s London oƒfice and John Morecroƒt is

associate professor of decision sciences at the London Business School. Copyright © 1998
McKinsey & Company. All rights reserved.

118 THE McKINSEY QUARTERLY 1998 NUMBER 2

 “…the race is not to the swiƒt, 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.”

CCLESIASTES 9:11 speaks of a puzzle that baƒfles

E 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.* 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 incon-
sequential mutations can make the diƒference be-
tween 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 neverthe-
less provides a fruitful metaphor for the way in
KEN WESTPHAL/SIS LTD 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

oƒfers a useful analogy, the fate of the dinosaurs,
seemingly wiped out by an asteroid, reminds us
that incremental shiƒts are only part of the story. A
business, like a species, might evolve successfully

≠ Most notably Arie De Geus in The Living Company, Harvard

Business School Press, Boston, Mass., 1997, and James H. Hines, as
reported by Victoria Griƒfth in Financial Times, February 26, 1997.
We would like to thank our colleagues at McKinsey and at London
Business School, especially Norman Marshall and Edoardo
Mollona, who provided invaluable reinforcing feedback.

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MANAGING METAMORPHOSIS

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.* 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.†

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 evolv-
ing. In many cases, they feed oƒf one another and grow stronger through a
virtuous self-reinforcing process. Managers oƒten 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.

≠ See, for example, B. Wernerfelt, “A resource based view of the firm,” Strategic Management Journal,
1984, Volume 5 Number 2, pp. 171–81, and I. Dierickx and K. Cool, “Asset stock accumulation and
sustainability of competitive advantage,” Management Science, 1989, Volume 35 Number 12, pp.
1504–11.
≤ Business dynamics is the application to business of system dynamics, a methodology developed
in the 1950s by Professor Jay Forrester at Massachusetts Institute of Technology. For a collection
of contemporary and classic papers in the field, see G. P. Richardson (ed.), Modeling for
Management, Dartmouth Publishers, Aldershot, Berkshire, 1996.

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ABOUT THE DYNAMIC RESOURCE SYSTEM VIEW

R
esources are “stocks” of important • They have to work together to support a
factors that a firm owns (or at least has company’s growth
reliable access to) in order to function.
• They can be built only by leveraging existing
They include tangible resources such as plant,
resources
cash, staff, and customers, and intangible
resources such as product quality, staff skills, • Rivals may emerge and challenge a
market reputation, and capabilities (or previously successful resource system
competencies).
• Unlike organisms, firms may choose to build
new resources (not just strengthen existing
Resources have a direct effect on business
ones) and connect them in novel ways.
performance:
The identification and integration of strategic
• They can help or hinder a company’s
resources into a coherent whole is the
performance
dynamic resource system view.
• To be helpful, they need to match industry
success factors

• They take time and effort to build and

See Kim Warren, “Strategic Management
maintain
and System Dynamics: A call to arms,”
• Once established, they can take time to Proceedings of the System Dynamics
deplete Conference, Istanbul, 1997.

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 Flexa-
max, 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.

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 MANAGING METAMORPHOSIS

Flexamax’s initial success rested on its superior technical performance.

Yet this didn’t explain its continued dominance, which persisted long aƒter
the basic patent had expired. Indeed, one rival, CostChem, invented a tech-
Exhibit 1
nically superior product and
WideFlux’s sustainable advantage oƒfered it at a 30 percent dis-
Resource Self-reinforcing loops
count to Flexamax, but failed
to attract much interest.
Innovator Engineer skill
reputation and knowledge
In retrospect, it is clear why
WideFlux continued to dom-
Product
Leading-edge attractiveness inate the market despite
technology
Flexamax’s higher price. It
leveraged three resources:
Learning to
Market solve urgent leading-edge products, a rep-
share problems
Profit reinvested
in R&D
utation for sustained innova-
tion, and sales engineers who
knew how to solve their cus-
tomers’ 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 aƒter 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 pro-
ducers 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

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 MANAGING METAMORPHOSIS

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 man-
agers 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 eƒforts 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 eƒfective 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
Exhibit 2
staƒf by 40 percent. It employed more engi- Recruitment of service engineers
neers than any competitor, and since its mar-
WideFlux KeenChem CostChem
ket share was falling, its service levels per 80
Service engineers

customer improved radically. But not as radi-

60
cally as KeenChem’s; that company increased
its service force fivefold, so that despite its 40

increasing market share it boasted nearly 20

three times more engineers per customer 0

1986 1988 1990 1992 1994 1996
than WideFlux.

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 MANAGING METAMORPHOSIS

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 unex-

pected way. The company did not want to cut its prices because reductions
granted to one customer ultimately had to be oƒfered to them all. It main-
tained a price premium until 1990, and was not fully competitive on price
until 1994 (Exhibit 3). Meanwhile, cost-
Exhibit 3

WideFlux’s price premium

sensitive buyers found the problem-solving
reputation of WideFlux less appealing than
$ per ton WideFlux KeenChem CostChem
8,000
the more responsive service and lower prices
of its competitors.
6,000

4,000 At first, this did not seem to be a problem for

2,000 WideFlux; aƒter all, its mission was to serve
0
high-end customers who were not sensitive
1986 1988 1990 1992 1994 1996
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 com-
petitors 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
Exhibit 4
about what its customers
KeenChem’s new sustainable advantage needed. WideFlux, meanwhile,
became less and less dis-
Resource Self-reinforcing loops
tinctive. Whether KeenChem
Customer Knowledge of
relationships customer needs knew it or not, it had hit on a
new formula for sustainable
advantage (Exhibit 4).
Product
Service attractiveness
capacity
What’s to be done?
Market By 1996, WideFlux still domi-
Learning
share opportunities
Reinvested
profit
nated the market, but Keen-
Chem was eroding its market
share at an accelerating rate.
Although the managers of WideFlux were concerned, they did not under-
stand quite how grave their predicament was.

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 MANAGING METAMORPHOSIS

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
Exhibit 5
three years. Three years aƒter that, it would Results of the simulation
be a weak second (Exhibit 5).
WideFlux KeenChem CostChem
100

Market share (%)

The simulation also showed that if WideFlux
75
cut back on research and built a service
capability distinctive from KeenChem’s, it 50

would eventually regain its dominance. But 25

it had to commit itself to a metamorphosis 0

1986 1992 1998 2004 2010
right away. If it waited as little as a year, the
value generated by the transformation would Exhibit 6

be virtually halved. A two-year delay would Value of strategic options

all but rule out the possibility of a value- $ billion

creating recovery (Exhibit 6). No change 30

Immediate policy change 75

The news was good and bad. WideFlux still One-year delay 40
Two-year delay 20
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 diƒficulty. 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 for-
mula with such a strong track record. Yet they might have acted earlier if
they had thought more seriously about the lead indicators* 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

≠ Lead indicators are drivers that act to build or deplete resources and that change more rapidly
than the resources themselves, thus giving advance warning about imminent changes in the state
of those resources. Some of the best lead indicators are the flows that build or deplete resources:
for example, R&D productivity and the rate at which products lose distinctiveness.

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MANAGING METAMORPHOSIS

Exhibit 7

WideFlux’s lead indicators

Lead indicator Resource Self-reinforcing loops

Price
premium Engineer skill
Rate at which Innovator and knowledge
products lose reputation
distinctiveness Skill of
leavers
Product
Leading-edge attractiveness
technology

R&D
productivity Market Learning to
share solve urgent
Profit reinvested problems
in R&D

Customer
churn

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 eƒfect 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 tradi-
tional 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.

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 MANAGING METAMORPHOSIS

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 suƒficient 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
Knowing the importance
how pivotal resources are built up. Fewer still
of each resource will tell you
understand the forces that could deplete
how good you are today, but
them, or know how the process of building
not where you are heading
or depleting pivotal resources is connected
to other resources, thus forming a sustain-
able self-reinforcing loop. The WideFlux managers knew that their basic
patent was a critical resource, for instance, but when it expired they mis-
takenly thought that the company could sustain its position by a reputation
for innovation, even though the stream of innovations had ceased to be
distinctive.

Look for leading indicators. Find out which pieces of information could
give the first warning of changes in the relative importance of the diƒferent
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

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 MANAGING METAMORPHOSIS

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 oƒten

be anticipated. Most resources are boosted by certain factors and under-
mined by others. We oƒten think of a shock as something that depletes
resources suddenly, but in reality a shock that
simply prevents resources from accumulating
To revive a company,
can be more important because it is harder
it is not enough to build;
to detect. The reputation of WideFlux as
destruction too is necessary
a distinctive innovator was sustained by
a steady stream of new formulations, but
ceased to grow when competitors started oƒfering a similar range of prod-
ucts. Aƒter 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 oƒfered customers cost savings rather

than the value-added services stressed by WideFlux. Each contract Keen-
Chem 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.

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 oƒten linked to a momentous dis-

continuity 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.

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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.

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