Ghemawat - Commitment

Commitmentversus Flexibility?

Pankaj GhemawatPatricio del Sol

Companies must frequently choose between commilment to com-peting in a particular way and the flexibility to compete effectivelyin a variety of ways. Strategists display a substantial amount of dis-sonance in this regard. Some assert that that commitment to a

particular strategic thrust Is the prerequisite to sustained superior performancein most competitive situations. Others argue that the flexibility to change tackon relatively short notice and at low cost—in order to adapt to or to take advan-tage of uncertainty—may be the key to success in these turbulent times.

Like many other points of contention in contemporary business strategy,this one has antecedents in military strategy. Two contrasting examples fromsixteenth-century Spanish military history offer the best Illustration. Consider,first of all. the situation faced by the Spanish Conquistador, Hernan Cortes, afterhe managed to land several hundred men, traveling on 12 ships, on the eastcoast of Mexico in 1519. Since Ihe loot there was limited, he decided to mounta bold, if not reckless, expedition to the Aztec capital Tenochtitlan (the site ofpresent-day Mexico City), with the aim of capturing or killing the emperorMontezuma.

Cortes' troops were less than totally enthusiastic about this expeditionsince they realized that they were heavily outnumbered and would face death-through-evisceration if captured. Revolt soon became a possibility. In particular.

The authors Are grateful to David Collis. Benjamin EstyTarun Khanna, and three anonymous refereesfor their suggestions and insightful comments.This article was prepared while del Sol was a ResearchFellow at the Harvard Bustness School fnsm September 1995 to August 1996. Ghemawat's researchon tinis article was supported by the Division of Research at the Harvard Business School and del Sol'sresearch by the Fulbnght Program, the Pontificia Universidad Catolica de Chile, and the Chilean com-panies Codigas, Cruz Blanca, Derco, and Endesa.

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Commitment versus Flexibility?

F I G U R E I . Burning One's Bridges

Army I ^ Bridge Island Bridge -* Army 2

one group of men plotted lo steal one of the ships and sail back to their homesin Cuba. Cortes dealt harshly with ilic conspirators, having two of the leadersexecuted. He then quelled any lingering discontent by ordering nine of his 12ships to be beached. This decisive move was hailed by the Conquistador's sup-porters, for it was believed that otherwise many of his men would have refused10 join the expedition into the Mexican interior.' In this and many otherinstances, Cortes showed totai commitment lo his ultimate objective.

The logic of Cortc's' commitment is depicted in stylized form in Figure 1.Assume ihai ihere are two armies, each ol which would like to occupy an islandbut would rather retreat than fight the other for it. If Army I occupies the islandfirst and burns the bridge behind it. Army 2 has no option than to cede theisland because it knows that Army I is committed to fighting if Army 2 attacks.Army 1 has tfierefore costiessly secured the island by restricting its own flexibil-ity to retreat!

Of course, things can sometimes go better with flexibility and worse withcommitment. Consider, as an advertisement for flexibility, the cautionary tale ofthe Spanish Armada, a Heel sent by King Philip II of Spain to invade England inI 588. The resources Spain committed to ihe Armada were more than an orderof magnitude greater than the resources it committed to Cortes's Mexicanadventure: the Armada involved more than 120 ships carrying nearly 30,000men—an endeavor that significantly depleted the Spanish national treasury.

The Armada arrived in the English Channel laden with large stocks ofammunition as well as troops since it was supposed to launch a ground invasionof England. However, the extra weight put the Armada at a tactical disadvantageagainst the English fleet, whose ships were generally faster and mure maneuver-able. The English ships were smaller and did not have to carry heavy cargo intobattle since they were operating close to home ports.' In addition, the Spaniardsalso found that they could not reload their artillery as fast as the English, whohad developed bciier gun carriages.

The English used their superior flexibility—in terms of speed, maneuver-ability, and weapons technology—to pound the Spanish Armada in a number ofengagements. They struck their decisive blow with the guerilla-lactic of setting

CALIFORNIA MANAGEMENT REVIEW VOL. 40, NO, 4 SUMMER 1998 27


small boats on fire and setting them adrift amt)ng the Spanish llect when ilwas anchored off Calais. This sowed panic among the top-heavy, clumsy shipsto which the Spanish had (over)committed. The Armada finally broke forma-tion, had to retreat, and ran into heavy weatber that led to further losses. Onlyslightly more than half of ihe ships that had left Spain ullimately made it backhome. This defeat marked a turning point in the colonization of the rest of theworid by European powers: Spain lost its ascendancy, and England registeredthe biggest gains.

Taken together, the examples of Cones' successful commiltnent to theconquest of Mexico and tbe Spanish Armada's failed commitment to the con-quest of England suggest that there is no simple, one-slze-fits-all solution to thequestion of commitment versus flexibility. In response, one could simply citethe need ti) balance the two fas one ol ihe present authors proposed more ihana decade ago).* This article clarifies the relationship between commitment andflexibility.

Commitment, Flexibility, and Resource-Specificity

The best way to understand the relationship between commitinent andflexibility is by examining a firm's resources, meaning all the durable factors,assets, or capabilities the firm uses lo produce its goods or services. Tbis defini-tion is deliberately broad: it includes plant and equipmeni, real estate, mineraldeposits, patents, brand names, information systems, the experience and skillsof employees, incentive schemes, trust relationships between managementand workers, and organizational culture. Note that not all resources need beacquired by conscious investment. Luck or historical accident may play a roleas well.

Resources can be categorized in terms of whether they are specific orflexible (nonspecific). Resource-specificity, in turn, can arise in one of two dif-ferent ways: resources can be specific either to the firm employing them or lo aparticular use or application—a productive activity, a product, or a physical loca-tion. Technically, a resource is specific to a firm if its value to the firm exceeds itsprice in the factor market, i.e., if its value lo one firm exceeds its value to anyother firm. A resource is specific to a usage if its value decreases when a firmapplies it differently. Consider these two dimensions of specificity in some detail.

Firm-specific resources tend to be "sticky" in the sense ihal there are sig-nificant costs to separating them from the firm ihal possesses tbem. The decisionto invest, or disinvest, in them implies an irreversible commitment by tbe firm.For example, the advertising expenses needed to develop a brand name aregenerally sunk or nonrecoverable, making tbe brand name a siicky or firm-specific resource."^ The cost of abandoning such firni-specilic resources createsa tendency toward persistence or commitmenl in a company's strategy that isabsent when resources are firm-flexible: in the latter case, ihe firm retains ihe

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FIGURE 2. Resource Specificity Matrix

Firm-FlexibleResource

Firm-SpecificResource

[T 3• 0

uIE*UV

a•,• ?

Sv*^ Commitment ^ 3

option of realizing (most of) the value of resources by selling them in factormarkets.

Usage-specific resources tend to restrict a firm's ability to change the waythat it is positioned in its product markets. To see bow they do so, it is useful tocompare them with usage-flexible resources tbat can enhatice a firm's ability: toincrease or decrease produaion volume in response lo fluctuations in demand,to change from one product to another, to alter the allrifiutes of or inputs toexisting products, or lo introduce new products. Note, however, that usage-specific resources may or may not imply commitment to a particular strategy onthe part of the firm that possesses them: that depends on whether they are alsofirm-specific. More generally, specificity/flexibility along the usage dimensionneed not be lightly correlated with specificity/tlexibiliiy along the linndimension.

The Resource Specificity Matrix

Juxtaposing the two dimensions of specificity/fiexibility yields iheresource specificity matrix depicted in Figure 2. Flexibility of some sort is inher-ent in all the quadrants of this matrix except the one in which resources arebotb firm- and usage-specific (quadrant D of the matrix). Commitment, on the

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Commrtment versus Flexibility?

Olher hand, is a feature ol both quadranis on the riglu-hand side of ihc matrix(quadrants B aud D).

This two-by-iwo tnatrix is ohviously an idealization, for two separatereasons. First, the difference between specificity and llexibility is a matter ofdci ree rather than a clear dicholomy. Second, firms generally possess a bundleot resources that diller In terms of where ihey should be placed along these twodimensions. Nevertheless, the matrix is useful in classifying situations becauseprior research on commitment and flexibility has implicitly tended to focus oncases that cluster in the shaded quadrants of the matrix (A and D). It has tendedto miss out on the many examples that can be classified in the unshaded quad-rants of the matrix, particularly quadrant B, in wliich lhe resource is firm-spe-cific hut usa^f-fiexihle and in which, therefore, both commitment and flexibilityis obtained.

Firm- and Usage-Flexible Resources (Quadrant A)

Some resources are specific neither to a firm nor to a product marketapplication. Cash is probably the most fiexibie resource a company can havebecause it can lie used by any firm for any purpose. Another resource that pos-sesses some flexibility along both dimensions is the large investment that manycompanies are making in information technology—an investment that in manyindustries now exceeds investments in conventional physical capital (i.e., plantand equipment). Much of the off-the-shelf hardware component of such invest-ments is, in principle, neither specific to a particular fimi nor to a particularproduct market application.

Firm- and Usage-Specific Resources (Quadrant D)

In contrast to generic information Icthriology resources, specialized plantscan be resources that are both specific to a fimi and to a tisage. Consider, forexample, the plant that Nucor buill in the second-halt of the 1980s to producefiat-rolled sheet metal by casting steel in very thin slabs."* This plant was clearlyspecific to a particular product market application. It was also fimi-specific inthe sense that while ihin-slab casting technology was ostensibly avaiiabie onequal terms to all steelmakers frotn the key equipment supplier, other steelmak-ers lacked the capabilities required to start-up a thin-slab caster cost-effectivelyand to wring continuii"ig productivity improvements out of it. As a result, it tookcompetitors until 1995 to imitate Nucor's move—by which time it was well onits way to its avowed goal ol becoming the largest steelmaker in tfie UnitedStates.

Another example is Gillette's investment in developitig and manufac-turing the Sensor shaving system.'' While antitrust concerns prompted Gilletteto quickly license its patents on the Sensor to its largest competitor, Schick,Schick has refrained from imitating this demonstrably superior shaving systembecause it lacks the manufacturing capabilities required to assemble this highly-engineered product at sufficiently low costs. So the investment in the Sensor

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was specific to Gillette (in the sense of being worth more to it than to its com-petitors) as well as being specific to a particular product market application.

Firm-Specific and Usat^e-Flexible Resources (Quadrant B)

The brand name Disney is a good example of a resource that is specificto a particular company but quite flexible in its product-market uses. It is specificto the Walt Disney company because it complements many of Disney's otherresources such as its management systems and culture, its expertise in cartoonand film production, the talents and creativity of its people, its theme parks, andits cartoon characters such as Mickey Mouse. On the other hand, this brandname is not specific to a narrowly defined product market. Since October 1984,when Michael Eisner was named Disney's chairman and chief executive officer,Disney has successfully used this and other resources to build its presence inareas as diverse as resort hotels, television programming, cable television, televi-sion stations, books, records, consumer products, direct marketing, and retailstores. As a result, Disney is one of the very few companies that has (nearly)met, for more than a decade, its very ambitious targets of 20% compoundannual earnings growth and a 20% return on stockholders' equity.^

Another example of reliance on a usage-flexible resource to support aneven broader diversification strategy is supplied by the highly diversified groups,often controlled by families tbat dominate business in East and South Asia (aswell as many other parts of the world). These groups, some of which have beenvery successful, base their corporate strategies as much as anything else on rela-tionships—what China hands refer to a^ t^uanxi—w'wh governments, suppliers,customers, foreign partners, and each other. These relationships are not veryspecific in any product-market sense, but given their personal basis, are veryfirm-specific.

Firm-Flexible and Usage-Specific Resources (Quadrant C)

Finally, il is also possible to think of resources that are specific to a partic-ular usage but not to a particular firm. Taxicab medallions supply a classic exam-ple. To operate a cab in Manhattan, an individual driver or a firm must first buyor rent a medallion from someone who already owns one because the totalnumber of medallions issued by the city's Taxi & Limousine Commission has notchanged very much since 1937, when this system was instituted. This resource isnot very firtn-specific because it is independent of the oiher resources requiredto compete effectively in the taxicab business and because there is an active sec-ondary market in medallions. However, a medallion is clearly usage-specificbecause it can only be used to operate a yellow cab in a particular city.

Many natural resource investments have similar characleristics. In nattiralgas, for instance, Enron has used medium- and long-term trading contracts toachieve above-average returns with below-average risk. Other companies havesuccessfully followed similar strategies in the oil and gold businesses by buying

CALIFORNIA MANAGEMENT REVIEW VOL. 40. NO, 4 SUMMER 1998 31


and selling deposits rather than developing new ones. These strategics wouldnot be workable if the underlying natural resources were very firm-specific.

Summarizing this section, our examples suggest that while the firm-specificity and the usage-specificity of resources is sometimes correlated, some-times it is not

Flexible Management of Commitments

In recent years, strategists have urged managers to develop and commu-nicate a clear vision not only of their products, but also of their resources." Also,managers must learn to distinguish between resources specific to a firm, whichcannot be separated from it, and resources specific to a usage, which cannot beused to produce different types or volumes of products via different processes orcombinations of inputs. The distinction between tfiese two dimensions of speci-ficity has important implications for managers,

Implications of the Firm-Flexible/Specific DimensionThe most strategic dimension of the matrix showed in Figure 2 is the

horizontal one of firm-fiexibility/specificity. This is because firms wishing toobtain sustainable superior returns cannot avoid committing to at least somefirm-specific resources. Such commitments are highly strategic because invest-ments in firm-specific resources are very costly to reverse.

Sustainable Superior Returns RequireCommitment to Some Firm-Specific Resources

A strategy can provide a sustainable competitive advantage only if it isbased on some firm-specific resources; otherwise, competitors can easily imitatethe strategy, eroding any unique advantages. As noted above, the value of afirm-fiexible resource does not exceed its price in the factor market. Competitorscan easily imitate strategies that require only firm-flexible resources by acquir-ing them in this market. Thus, while companies may invest in firm-fiexibleresources to reduce their exit barriers, the trouble is that this kind of investmentis also likely to reduce entry barriers." In a hypothetical situation where thereare no entry or exit barriers—a situation described by economists as perfectlycontestable—any advantage would be ironed out in the twinkling of an eye.'"

Therefore, businesses aspiring to sustainable superior returns must buildtheir product market positions around commitments to some firm-specificresources, hivestments in firm-flexible resources may be easier to reverse, butcome at the cost of sustainability. Competition, and, more specifically, imitation,means that firms using only firm-flexible resources will probably generatemediocre returns.

Consider, as a cautionary example, IBM's entry into the personal com-puter market in 1981 from the perspective of imitation. In order to enter the

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Commitment versus Flexibiltty?

market quickly and catch up with the pioneer, Apple Computer, IBM abandonedlong-standing polices of internal development practice by outsourcing micro-processors from hitel and the operating system from Microsoft. Also, in order toencourage programmers tt) write application software for the PC, IBM pursuedan open architecture policy. The simultaneous implementation of outsourcingand open architecture was a major mistake because it let hundreds of competingfirms "clone" the PC by using the same peripherals, operating system, andprocessor architecture as IBM. As a result, Intel and Microsoft have, in recentyears, been able to make several times as much money as the entire personalcomputer industry combined. We would argue that IBM failed to invest suffi-ciently in firm-specific resources and paid the price for this serious strategicmistake.

Another example that is still unfolding is the leveraged buyout (LBO)industry that was born in the 1980s. Typically, an LBO association acquires acompany or division with the help of a substantial amount of debt financing.It then puts in place a high-powered management compensation system and aset of sophisticated legal contracts to help improve management incentivesand, therefore, firm performance. And once the improvetnent targets are met,it cashes out by selling the company. Traditionally, LBO associations have beenvery fiexible—some would say opportunistic—in their choice of acquisitions,and they have therefore looked like highly diversified conglomerates in termsof their business portfolit)s. However, the high returns obtained by LBO associ-ations in the past—as reflected in annualized returns that frequently exceeded50%—have encouraged a host of imitators. As a result, the supply of fundsfor such transactions in the United States is now several times as large as thedeal vokime to which those funds can be applied. Imitation has been possiblebecause the resources on which this industry has been based have historicallynot been very firm-specific. In response, many LBO associations are nowattempting to become more specialized by limiting the number of industriesin which they operate and by developing specific organizational expertise atoperating in those industries.

These examples suggest that firms that employ only firm-flexibleresources are unlikely to earn sustainable superior returns irrespective ofwhether those resources are specific in a product-market sense or not. That isbecause of the tautology that the value of a fimi-llexible resource cannot exceedits price in the relevant factor market. The implications can be illustrated withthe taxicab example cited earlier. Taxicab participants in local markets do notseem to earn substantial returns, despite their use of medallions that are usage-specific, scarce resources, because their returns must be calculated net of eitherthe cost of acquiring a medallion or the opportunity cost of not selling one.

Furthermore, firm-specific resources are necessary but not sufficientto deter imitation. Even in the extreme case in which imitation is unprofitable,for example, competitors might suffer a "coordination failure" and invest in thesame firm-specific resources, ensuring imitation.

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Commitment versus Flexibilrty?

Choices Concerning More Firm-Specific Resources Are More Strategic

Choices concerning the acquisition and liquidation of firm-flexibleresources do not require a very deep look into the future: if they lurn out to besuboptimal, they can, by definition, be reversed relatively quickly and cheaply.This was first pointed out three decades ago by tbe Nobei-laureate economist,Kenneth Arrow, who noted that in the absence of tbe sort of commitmentimplied by firm-specific resources, "The decision as to the stock of capital to beheld at any time is myopic, being independent of future developments in tech-nology, demand, or anything else; forecasts for only the tnost immediate futureare needed, and then only as to capital goods prices."" For example, assumethat you buy a medallion to work as a taxi driver in Manhattan but find a bet-ter work opportunity afterwards. In all likelihood, you will be able to sell themedallion without much loss, so that the decision to buy the medallion in thefirst place will be significantly less strategic than ihe initial outlays on it mightseem to imply.

However, choices concerning investment or disinvestment in resourcesthat are more firm-specific tend to be less reversible and should therefore beregarded as more strategic. These choices create a need to look beyond the pre-sent to the future, to tbink through things ahead of time. Managers should focuson such choices not only because they are dilficult to make, but also becausethey can be counted to have a disproportionately iarge, long-lived Impact—forbetter or worse—on the performance of tbe organization.

The upside of commitments to firm-specific resources was illustratedby the examples, cited earlier, of Nucor's investment in thin-slab casting andGillette's investment in Sensor. Both companies parleyed an initial investmentof several hundred million dollars into increases in market value thai were morethan ten times as large. For another dramatic example involving a less tangibleresource, consider De Beers, the orchestralor ol the most successful naturalresource cartel of modern times, in the diamond industry.'^ De Beers' mostimportant resource, arguably, is the firm-specific reputation it has cultivatedsince the 1920s for mopping up diamonds from the countries that produce themso as to preserve tbeir prices and image of scarcity downstream. This strategywas seriously challenged at the beginning of the 1980s by an explosion in thesupply of rough diamonds and a general economic downturn that induced adrop in the consumer demand for them, a drop which was magnified by pipelineeffects as it got transmitted back upstream to rough diamond buyers and suppli-ers. De Beers had to decide whether to spend more than a billion dollars stock-piling rough diamonds in order to perpetuate its strategy. It recognized that thisstockpile probably could not be worked off in the next few years, but also reck-oned thai it risked destroying its business by not stockpiling because that couldshatter the perception that diamonds represented safe stores of value. De Beerswent ahead and invested in stockpiling, Fifteen years later, the cartel persists,and continues to deliver cashfiows to De Beers that have more than compen-sated it for its investment.

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Ol course, commitments to firm-specific resources are no panaceabecause they may imply irreversible losses as well as sustainable superiorreturns. For an illustration of the downside of such commitments, considerGannetl's launch of USA Today in 1981.'^ Gannett went ahead with the launch,despite the weak financials projected for the paper, because of the impetus thatits CEO Al Neuharth supplied to the project. It persisted with the paper, despitecirculation and advertising revenues that proved even worse than expected, forthe same reason. Ten years later, Gannett bad invested $800 tiiillion iti the paper(rather than the maximum cumulative cash outflow of $130 million that hadbeen envisaged) and was still recording operating losses. According to Gannett'streasurer, Jimmy Thomas, while USA Today's operating returns may look goodsomeday, "It never will be a good financial idea because of the $800 millionsunk into that thing, and the foregone income that's there."

To summarize, distinguishing between the firm-specificity and the usage-specificity of resources can help managers allocate their limited capacity for in-depth analysis among the choices that they confront. Because firm-specificresources are, by their very nature, more strategic, choices concerning suchresources are the ones that need to be analyzed in particular depth. And com-mitments to some such resources are a necessary (but not sufficient) conditionfor sustained superior performance.

Implications of the Usage-Flexible/Specific DimensionStrategies that employ usage-flexible resources may or may not be

the rigbt ones, and the benefit of delaying commitment is reduced when theresources are more usage-flexible.

Investing in Usage-Flexible Resources May or May Not Be the Right Strategy

As noted, managers have no alternative but to commit lo some firm-specific resources. In contrast, the level of usage-specificity of the resources is amatter of choice. If fiexibility were free, a firm would generally prefer to benefitfrom both commitment and fiexibility, i.e., to own resources that are firm-spe-cific but usage-fiexible, like the Disney brand name. However, in most casesflexibifity is not free: it often leads to higher production costs or lower productquality. It is only in such cases, where there are important trade-offs, that usage-flexibility poses a choice problem.

Any attempt to make such trade-offs appropriately must focus on thepositioning of the firm's products—the difference between the benefits that theproducts provide to their users and the total costs incurred in making {and deliv-ering) them. In an uncertain world, usage-flexible resources have the advantageof making it possible to revise the positioning of a firm's products as new infor-mation is obtained. From a conceptual perspective, determining whether thisadvantage is compelling involves estimating products' positioning in possiblestates of the world, or scenarios, after ihe revision opporlunities afforded bythe underlying resources have been optimally exploited. Abstracting away from

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Commitment versus Flexibilfty?

considerations of sustainability and risk-aversion, a firm should choose the alter-native that maximizes expected positioning value. Real options analysis is ofgreat help in valuing usage-flexible resources in this way: it provides a languagethat lets managers to talk with some precision about flexibility, and it can some-times even be used to quantify Uexibility values."

For an illustration, consider the tradeoffs involved in building fiexibilityinto the manufacture of uncoated fine paper. Flexibility in this sense permits aplant to produce more j^rades of paper by shortening the changeover times andlowering the costs associated with switching between grades. This flexibility isvaluable because the prices of alternative paper grades differ, in ways that varyover time. Specifically, more fiexible pilants can obtain higher average pricesbecause they can change the grades ihat they mainilacture more easily. Adetailed study of 61 North American plants by Upton indicates that the impactcan be very large: the most flexible plants in his sample were capable of produc-ing a range of paper grades 30 times as wide as the least flexible plants."

Upton's study also indicates, however, that such flexibility is not free. Inparticular, product range flexibility bore a strong negative relation in his sampleto machine width, which is widely used as a surrogate for scale-related operatitigcost efficiencies in paper manufacture. And while he did not explicitly look atthe implications of product range flexibility for investment efficiency, industryobservers generally regard increased flexibility as requiring elevated levels ofcapital investment—an effect that is potentially very important in a very capital-intensive business. Overall, it is far from clear that opting for maximal productrange flexibility is the optimal choice in manufacturing uncoated fine paper.

Finally and somewhat unexpectedly, Upton's study suggests that manage-ment has a significant impact on the improvement of product flexibility, regard-less of the technology and infrastructure in place. This is consistent with theresuhs of other studies of manufacturing flexibility such as Jaikumar's compara-tive investigation of flexible tnanulacturitig systems (FMS) in the machine toolindustry in ihe United States and Japan."^ The U.S. companies in Jaikumar'ssample spent as much if not more than their Japanese counterparts on FMSs,bui produced a significantly narrower range of prodticts on average. In Japan,the average types of parts made by an FMS was 9 times greater than in U.S., theannual volume per part was 7 times lower, the number of new parts introducedper year was 22 times greater, and the utilization rate was 84% (versus 52% inthe United States).

Our own sense from these studies is that usage-flexibility has been over-emphasized in the literature on manufacturing/operations at the expense offirm-specificity. Consider companies that manage to attain more manufacturingflexibility than their lechnology, infrastructure, or cost efficiency would leadone to expect. They presumably do so not because they have privileged accessto manufacturing technology and techniques that tend to be firm-flexible (i.e.,generic) as well as usage-dexible, hut because they have built up superior firm-specific capabilities for taking advantage of the possibilities for usage-flexibility

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altorded by modern manufacturing. Once again, firm-spedfic resources arethe ones that seem to be strategically salient. Or to make the same point inanother way, firms that are exemplars in terms of exploiting flexibility in theirmanufacturing processes seetn to have made firm-specific commitments tousage-flexibility.

The significance of this point extends well beyond manufacturing to oiherimportant processes, such as product development. 3M is perhaps the prototypeof a company that has achieved success on the basis of the scope and speed of itsproduct development efforts.'^ The scope of product development efforts al 3Mis underscored by ibe fact that il currently manages over 100 core technologieswhich il leverages into 60,000 products that are sold around the world (includ-ing abrasives, adhesives, coatings, tapes, films, microfiltns, laser image systems,other photographic and graphic products, and health care products). 3M'semphasis on speed in product development is evident in the long-standingcorporate objective of generating at least 25% of total sales from products intro-duced within the pasl five years. To achieve this target, 3M has to introducerougbly 3,000 new products per year.

3M has gotten to where it is because of ihe way in which it is organized.The norm that "products belong to divisions, but technologies belong to thecompany" favors sharing knowledge and expertise. A policy that encouragesresearchers to spend up to 15% of their time pursuing projects of personalinterest to them protuotes individual entrepreneurship. Systems for defining,selecting, and funding projects enhance efficiency in implementation. Theseorganizational arrangements, which drive 3M's fiexibility in terms of the productmarkets that it serves, ct)nstitute a firm-specific resource given how hard itwould be lo graft them onto a "representative" firm with very diflererii admin-istrative traditions. We have, once again, a case of commitment lo flexibility.'"

Firms Should Have Less Incentive to Delay InvestmentWhen the Resources are More Usage-Flexible

Unbundling the firm-specificity and the usage-specificity of resources alsoprovides new insights on the optimal timing of investment under uncertainty.First, timing decisions concerning firm-llexible resources should be relativelystraightforward lor the reason specified by Arrow and cited earlier: "Forecastsfor only the niosi immediate future are needed, and tben only as lo capitalgoods [resource] prices." Standard discounting techniques, which make theimplicit assumption that investment processes are reversible, are adequate forthis purpose.

Second, firms should have less incentive to delay investment when theresources involved are more usage-fiexible. Tbis second insight has been fleshedout by financial economists and other researchers who have developetl o]nion-theoretic techniques for making irreversible investments under uncertainty.Option theory highlights a logic for delaying commitment until key uncertaintieshave been resolved and the scenario that will prevail in the future is more


Commrtment versus Flexibility?

SpecificResources

FlexibleResources

State of the World

F I G U R E 3. Usage-Flexible versus ^^^^^.^^ j ^ quantitative terms, theUsage-Specific Resources , r . i •

* " value of delaying commitment^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ~ depends on the possibility of reducing

the probability of incorrect choice bywaiting as well as the penalty associ-ated with making the wrong choice.

Usage-flexibility matters in thisregard because it reduces the penaltyassociated with making "wrong"choices: downside exposure to unfa-vorable scenarios is limited by thepossibility of revising the ways inwhich usage-llexible resources actuallyare used after key uncertainties areresolved. To use quantitative termsonce again, the value of usage-fiexibleresources has lower variance than thatof usage-specific ones (see Figure 3).This lower variance also lowers thevalue of delaying commitment.

In summary, the importance of timing decisions seems to increase as wemove from firm-flexible resources (quadrants A and C of the matrix in Figure 2)to resources that are firm-specific but usage-flexible {quadrant B) to resourcesthat are both firm- and usage-speciEic (quadrant D). In ihe last case, timing deci-sions may well be of strategic, rather than tactical, importance.

For an illustration, consider New England Power's choice about whetherto retire or to invest in two coal-fired power generating units at Salem Harbor.From an operating cost perspective, the two coal-fired units looked attractivedespite their age and small size: coal offered a cost advantage at the time overother fuels and even though fuels' relative cosl positions were apt to ffuctuate,management felt that there was additional (flexibility) value to maintainingsome diversity in fuel-usage in a system that was dominated by fuels other thancoal. But from a capital cost perspective, the two coal-fired units would requiresubstantial investments in scrubbing systems to comply with the Phase 11 limitsset by the Environmental Protection Agency (EPA), and even more for compli-ance with Phase III limits, which had yet to be promulgated.

A simple analysis tbat compared the economics of retiring the two unitsright away versus investing in them to make their emissions levels consistentwith expected Phase III limits favored their retirement—an act that would beirreversible given the impracticality of restarting the units if they were shutdown. But New England Power's management realized that they could, givenregulatory timetables, defer investments in complying with Phase II limitsuntil Phase III limits and compliance costs became clear. Tbe sophisticatedquantitative analysis they commissioned indicated tbat the possibility of delaying

CALIFORNIA MANAGEMENT REVIEW VOL 40, NO. 4 SUMMER 1998

Commitment versus Flexibilfty?

investments in reducing emissions added about $fOO million in flexibility valueto the option of continuing to operate the coal-fired units (at least for severalyears), making it the preferred choice.

However, delaying commitment to resources that are both firm- andusage- specific isn't always the optimal response to the problem of investingunder conditions of uncertainty. Companies that refuse to lock in to investmentsuntil key uncertainties are resolved risk being locked out by competitors thatmove before they do. Such lock-out risks loom particularly large when there aresignificant early-mover advantages such as size economies, early-movers' advan-tageous access to customers or to the resources required to serve them, crediblethreats by early-movers (whose resources are relatively sunk) to retaliate againstinterlopers, and response lags.''' As in ihe burning bridges example in Figure 1,the risk to army 1 of delaying commitment is that army 2 may burn its bridgefirst and win the island.'"

Integration of Commitment and Flexihility

Most of the strategic choices that managers have to make in today'shighly uncertain and competitive markets imply both commitmeui and flexibil-ity. Management influences the extent to which the flexibility value inherent incommitment processes actually is realized. More specifically, the flexible man-agement of commitments involves either adaptation of the planned course ofaction to the feedback received about it or, if the news is sufficiently grim, itsabandonment.

The possibility of adapting a planned course of action to feedback isvaluable because few commitments seem to succeed exactly as planned. It isadaptation that often spells the difference between success and failure. "LittleShort Cake Fingers" were a dismal failure until they were renamed "Twinkies."Honda's entry into the U.S. market for motorcycles, the first successful penetra-tion of this sort by a Japanese manufacturer, stalled until it stumbled on andstarted to satisfy an unexpectedly large pool of demand for lightweight motor-cycles. Clarence Birdseye founded the precursor to General Foods to sell frozenfoods in 192f, but experienced losses for more than a decade until the companycommenced targeting institutional as well as retail buyers. Raytheon began tomarket microwave ovens in the early f950s; by the early f 960s, microwaveshad become the biggest consumer product failure in the company's history; bythe early 1970s, they had become by far the mosi successful one after radical,Japanese-aided reengineering. This list could be stretched to include many, per-haps most, business successes.

The value of being able to abandon a commitment program is perhapsless obvious, even tfiough it was implicit in some of the earlier examples (e.g.,of USA Today and New England Power). The U.S. venture capital industry illus-trates abandonment value in direct, dramatic fashion. The typical venture capi-tal firm receives thousands of investment proposals each year, pursues a fewhundred of these leads in some depth, and ultimately commits its capita! to a


Commitmenf versus Flexibility?

handful of them. For all lhe care that goes into selecting them, however, thefunded few generate disappointing returns more often than not: the industry'srule-of-thumb seems to be that only 10 to 15% of the ventures in the typicalportfolio turn out to be clear winners.

Venture capitalists deal with these long odds by infusing capital into anew venture in several stages instead of committing to it all up front. Each newstage is generally linked to some significant development in the history of theventure, such as completion of design, pilot production, or operating break-even. While the amounts disbursed are dictated by business requirements, theytend to increase substantially from one stage to the next //the venture capitalistcontinues to supply capital. Staged capital commitment ol this sort is valuable—indeed vita!—to venture capitalists because it preserves the possibility of aban-doning the venture at a later stage. Note that it is the possibility of receiving badnews about a venture that makes the flexibility afforded by commitment valu-able. That is because if the information received about the venture were not bad,there would be no reason to revise support for the venture and therefore novalue to commitment in stages as opposed to ali at once.

To summarize, far to<i many companies squander the potential for flexi-bility value that is inherent in most commitments by treating commitment as anact that predetermines an entire course of action: as a go/no-go decision madeonce and for all time. It is better to think of commitment rather differently, as aprocess that can be adapted to or abandoned in light of feedhack received aboutits prospects. Management matters for adaptation and abandonment as well asfor analysis.

Conclusions

We have tried to cut through the debate about commitment versus flex-ibility by distinguishing between specificity (versus llexibility) of resources toa particular firm as opposed to a particular usage. Usage-flexible resources easethe problem of commitment under conditions of uncertainty, btit their effectiveexploitation seems lo rest, in part, on commitments to firm-specific resources.Thus, commituient and flexibility are not two opposed sources of value: evenstrategies for flexibility require some sort of commitment to deter imitation. Ourexperience with a number of companies suggests that even though these distinc-tions are important, ihey are still poorly understood by most managers.

How might managers incorporate these insights into resource investmentand disinvestment decisions? We suggest a six-step process for managers to fol-low in making such decisions.

• Begin by classifying the resources to be added or subtracted in terms ofthe four quadrants of Figure 2. While some decisions will involve multi-ple types of resources, it is nevertheless helpful to separate resources inthese terms.

40 CAUFORNIA MANAGEMENT REVIEW VOL. 40, NO. 4 SUMMER 1998

Commftment versus Flexibility?

Focus only a limited amount of attention on firm-flexible resources(those in quadrants A and C). Choices concerning such resources arenot strategic because they can be reversed by the firm and imitated bythe competition.

Focus more attention on investment and disinvestment in Brm-specificresources (quadrants B and D). Choices concerning such resources arestrategic because the commitments impiicit in them underpin the possi-bility of sustainable superior returns or irreversible losses.

Evaluate choices concerning firm-specific resources differently dependingon whether they are usage-specific (quadrant D) or usage-flexible (quad-rant B). The valuation of usage-flexible resources, in particular, should tryto account for tbe value of being able to reposition after new informationis obtained; only then can the trade-off between usage-flexibility andusage-specificity be tnade appropriately.

Analyze the impact of tbe timing of investment (or disinvestment) inusage and firm-specific resources (quadrant D). Such resources often con-front managers with choices about whether to delay commitment untilkey uncertainties have been resolved or to "lock in" and thereby "lockout" competitors.

Build management routines and systems to actually be able to takeadvantage of the flexibility inherent in commitment processes. Otherwise,flexibility value will remain unrealized.

Notes

1. H. Thomas, Conquest: Moniezuma, Cones and ihe Full Lff Old Mexico (New York, NY:Simon and Schuster, 1993), pp. 221-224.

2. See F. Fernandez-Arnu'sto, The Spanish Armada: The Experience of War in 1588(Oxford: Oxford Univfrsity Prfss, 1988), pp. 135-180.

3. P. Ghemawat, "Sustainable Advantage," Har\/ard Business Review. 64/5 (Septem-ber/October 1986): 53-58.

4. Conversely, note that brand names are not always firm-specific. There are exam-ples of brand names that have been sold.

5. Sec P. Ghemawat, "Nucor at Cross Roads," Harvard Business Schooi Case, 1993.6. See P. Ghemawat, "Gillette's Launch of Sensor," Harvard Business School Case,

1992.7. See D.J. Collis. "The Wall Disney Company," Harvard Business School Case Series

A-C, 1995; and P Ghemawat, "Walt Disney: 1988-1996," Harvard Business SchoolCase, 1996.

8. See, for example, B. Wcrncrfi-It, "A Resource-Based View of the Firm," StrategicManagement Journal. 5 (1984): 171-180.

9. For example. Caves and Porter observe, "each source of entry barriers identifiedby Bain can also erect a barrier to exit." R.E. Caves, and M.E. Porter, "Barriers toExit," in R, Masson and P. Quails, eds.. Essays in Industrial Organization in Honor ofJoe S. Bain (Cambridge, MA: Ballinger, 1976), p. 44.

10. W.J. Baumol, .I.C. Panzar, and R.D. WiUig, Caniestable Markets and the Theory ofIndusiry Structure (New York, NY: Harcourt Brace Jovanovich, Inc., 1982).

CALIFORNIA MANAGEMENT REVIEW VOL40.NO,4 SUMMER 1998 41


11. K.J. Arrow. "Optimal Capital Policy with Irreversible Investment," in .I.N. Wolfe.ed.. Value, Caplhil, and Growth (Edinburgh: Edinburgb University Press. 1968).

12. See P. Gbemawat. "De Beers Consolidated Mines Ltd. (A)." Harvard BusinessSchool Case, 1990.

13. See P. Gbcmawat, "USA Today Decision: Making Headlines Across the Nation,"Harvard Business Scbooi Case. 1991.

14. See, [or example, A.K. Dixit and R.S. Pindyck. Inveslmeni under Uncertainty(Princeton, NJ: Princeton University Press, 1994); S.C. Myers, "Finance Tbeoryand Financial Siratt'gy," Interfaces. 14/1 (1984): 126-137.

15. For more details, consuli D.M. Upton. "Tbc Management of ManufacturingFlexibility," California Management Review. (Winter 1994): 72-89; and D.M. Upton,"What Really Makes Factories Flexible?" Harvard Business Review. 73/4(July/August 1995): 74-84.

16. See R. Jaikumar. "Postinduslrial Manufacturing." Harvard Business Review, 64/6(Nnvember/December 1986): 69-76.

17. See C.A. Bartleti, "3M: Profile of an Innovating Company," Harvard BusinessSchool Case. 1995.

18. Nole that in the introductory example of the Spanish Armada, itu- English were ascommitted to a particular strategy as the Spanish. We wuiild cite the English strat-egy as anotber example ol successful commitment to tlexibility.

19. For additionai discussion, see Ghemawat (1986), op. cit, and P. Ghemawat, Com-tnitmenl: The Dynamic of Strategy {>iew \ork, NY: Free Press, 1991), pp. 86-88.

20. As a referee pointed out, a sirategy ol making a small Hrm-speciiic investment tocreate an option on a larger one can probably capture only the preemptive valueof the smaller investmeni.

42 CALIFORNIA MANAGEMENT REVIEW VOL. 40, NO. 4 SUMMER 1998

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Ghemawat - Commitment