CHAPTER FIVE

THE CAPABILITIES SYSTEM

When Jeff Bezos launched Amazon.com as “the world’s biggest bookstore” in 1995, people took that slogan at face value. Here was a great new way to buy printed reading material. But Bezos knew that books were just an initial proof-point. Music CDs came next, and then Amazon suddenly became a clothing store, a pharmacy, a bicycle shop, an electronics outlet, and a gourmet food emporium—all rolled into one and reachable through your computer. Not everything worked; Amazon’s foray into online auctions faltered. But with a culture that tolerated failure as long as it came with learning, Amazon has kept on trying and has succeeded far more often than it has failed. It is an excellent example of a world-class capabilities system as the engine of success.

Amazon’s way to play revolves around its role as an experience provider and a superaggregator of vendors and customers, giving people a compelling, one-stop online shopping experience with easy access to products from around the world, information about those products supplied by millions of other customers, and friction-free product delivery. To make this work, Amazon must be perceived as the most trusted location on the Internet and the most central hub for electronic commerce—the hub that everyone thinks of first. In short, Bezos and the Amazon leadership team have updated the mission of the original nineteenth-century department store: vast comparability of items in a wide variety of shopping categories.

Amazon’s way to play thus represents an ingenious application of the economic concept of increasing returns, also known as the network effect.¹ The greater the number of suppliers and customers that use Amazon as their marketplace of choice, and the more they participate by rating and commenting on each other’s wares, the greater the number of new people who are drawn in, thereby making the marketplace even more valuable.

Finally, the way to play also takes account of the reasons people shop in the first place. As Bezos put it, Amazon’s customers want “selection, low prices, and fast delivery . . . I can’t imagine that ten years from now they are going to say, ‘I love Amazon, but if only they could deliver my products a little more slowly’ . . . ‘Or I wish their prices were a little higher.’”² Put together, these features more than compensate for the most challenging aspect of electronic retailing: that consumers can’t physically touch merchandise and walk away with it immediately.

A system of five key integrated capabilities supports this complex and highly effective way to play:

Retail interface design: From its earliest days, when it pioneered the inclusion of customer recommendations and in-depth product information on its Web site, Amazon has excelled at retail interface design. The elegant, seamless qualities of the Amazon site—full of detail, but not cluttered, and with highly sophisticated search, comment, linking, and online payment features—have turned the site into an international information utility. It is the free, de facto repository of record for data on the books, media items, and other products that it carries and (increasingly) on the people who create and purchase them. This interface design capability was also tapped for Amazon’s Kindle electronic reading device, the first such device to be successful.

Back-end supply chain: This online retailer has also painstakingly developed a back-end supply chain capability that even the operations department at Walmart might envy. It handles massive numbers of products through networks of specialized warehouses and the supply chains of many of its partners. This means that as part of its supply-chain management, Amazon must be able to manage its vendors, to keep customers from being disappointed if the suppliers don’t deliver with the same accuracy and speed. That is one reason Amazon also makes its in-house logistics available to its independent suppliers, who get, on average, a 70 percent lift in sales and a 30 percent reduction in returns by switching to the “Fulfilled by Amazon” program. The supply chain is linked closely to the Web site, so that customers can reroute orders on the fly or cancel them until the last moment, with no questions asked.

Merchandising: This capability is Amazon’s hidden source of value. Like Target, another consummate merchandiser, Amazon doesn’t always have the absolutely best price, but it maintains trust by keeping its average prices lower than those of most other vendors, while managing their assortment of featured items aggressively. Amazon purchasing agents identify attractive products rapidly and work closely with producers to display them in exclusive ways. The Flip Ultra video camera, for example, appeared prominently and profitably on Amazon.com in time for the 2007 Christmas season, because of the online store’s proficiency. After a meeting at Amazon’s Seattle headquarters, the marketers flew home; when they arrived a few hours later, Amazon already had a live prototype of the Web pages ready, showing images of wedding and baby videos.

Customer-relationship management: Amazon’s customer-relationship management capability and the robust analytics underlying it are well known. Visitors rapidly learn about affinities—to others who liked the same product or to other products that they might like themselves—without feeling that their privacy has been broached. This capability also allows Amazon to understand its customers superlatively, for example, to solve customer dissatisfaction issues before they occur, because of its knowledge of what customers have needed in the past. Thus, this capability helps Amazon avoid a reliance on reactive and expensive customer service. Amazon’s premium service, called Amazon Prime, gives frequent users steep discounts on fast shipping in exchange for an annual fee and even more intensive analytics and relationship-building.

Technological innovation: A final capability is rapid, experimental, and pragmatic technological innovation, often operating behind the scenes. This capability enabled many of Amazon’s leading-edge features and offerings, including the Kindle, the “one-click” instant-ordering system, and its cloud computer services, which were originally designed for Amazon’s internal use but have since been extended to customers. Because these computer services can be listed in Amazon’s online structure, delivered with little extra expense, and managed with little service or support, Amazon can offer them online to customers in ways that build on and expand its way to play. For example, Amazon’s Mechanical Turk brokerage service allows people to post help-wanted notices for very small tasks—such as programming, editing, sorting, or entering comments in social media sites—that others can execute from their computers and get paid for through Amazon. By the time you read this paragraph, the details here may be obsolete, because Amazon will have introduced newly innovated services and features by then.

The strength of these capabilities, as always, is most powerful in the way they come together as a system. Amazon is known for its proficiency at upselling—drawing customers to purchase more products per transaction (or online basket) than just about any other company. That’s because each transaction combines analytics (identifying the right products of interest for a given consumer) with superior merchandising (delivering those right items at the right prices), with customer management and interface design (coalescing that massive complexity into a simple point-of-purchase opportunity) and supply-chain excellence (delivering on its promise for speed and reliability) to reinforce the moment of truth, when a consumer adds to a purchase. Without any one of those capabilities at world-class levels, Amazon could not have posted its consistent growth rates; even during the 2008–2009 recession, the retailer grew more than 20 percent each quarter. It did this while maintaining gross margins of 18 to 20 percent and offering extremely low prices on many items.

Note that Amazon.com has never built or bought its own brick-and-mortar stores, not even experimentally. Most other companies would have been tempted, but Bezos and his executive team are apparently aware that this would require coming up to speed with a whole new incompatible system of complex capabilities, against a host of more experienced and capable competitors. This way, when brick-and-mortar retail chains build their Web sites, they enter Amazon’s turf, where it is already the most coherent, capable player by far.

Amazon’s capabilities system has been under development steadily since the mid-1990s. Back in 1999, at the height of the dot-com boom, we recall seeing a television segment about Amazon. The Christmas selling season had begun, and there was Jeff Bezos, standing in a distribution center, wearing a hard hat and discussing the automatic sort, pick, and pack machines that his company had started using. At a time when other dot-com executives were talking about “eyeballs” and “frictionless commerce,” Bezos’s priorities seemed startlingly un-“e”-like. But in the years since, as our Amazon orders have arrived when we expected, with never a mistake, and as Amazon’s revenue has grown by a factor of ten, we’ve often been reminded of the clarity of his thinking.

Amazon continues to develop all its capabilities—both organically and through acquisitions. (In chapter 8, we’ll look more closely at Amazon’s capabilities-driven acquisition of Zappos, the online apparel store.) One of the most telling examples is Amazon’s launch of same-day delivery in ten major U.S. cities during the summer of 2010. Having made some online supermarket acquisitions, the retailer discovered the value of local delivery fleets and rapidly integrated those with the rest of its logistics. This also enables extra features, such as Saturday delivery, that can attract new Amazon Prime members. The company is now using its well-honed analytics to decide where to offer what types of same-day delivery, and to whom. Other companies, like Webvan (which Amazon purchased after its 2001 bankruptcy), have failed spectacularly in this field, but Amazon may well succeed.

The Distinctive Capability

As we explained earlier, a capability is not simply a function or practice. It is the ability to reliably and consistently deliver a specified outcome, in support of your way to play. This capability is ensured through the right combination of processes, tools, knowledge, skills, and organization, all focused on meeting the desired result. The most important capabilities are distinctive: each of them represents an extraordinary competence that few others can master.

When they hear the word capabilities, many businesspeople think of intangible assets: employees’ skill sets or the quality of work done by a corporate function such as R&D or supply chain. Others associate it with the competency models administered by human resources departments or with learning and development efforts. But we use the term in a more specific and strategy-related way: capabilities are the defining strengths that your company must have to help it compete.

Gary Hamel and C. K. Prahalad amplify that definition usefully in their book Competing for the Future. Using the term core competence, they define a capability as a “bundle of skills and technologies that enables a company to provide a particular benefit to customers.”³ To Hamel and Prahalad, a core competence has a clear, customer-perceived benefit and a competitive advantage, and it can be extended to other products and markets. They argue—correctly, in our view—that it falls to senior management to identify the core competencies of a company, to continue to strengthen those competencies, and to invest in new ones. Senior management must also make sure that core competencies don’t get trapped in the silos of business units.

As the experience of companies like Amazon suggests, a single capability can take years to develop, drawing upon a range of people (and their skills and knowledge), as well as embodying processes, technologies, and practices. The more distinctive that capability and the more related to your way to play, the more valuable it is.

Capabilities can include anything a company does with distinction to realize its way to play. They need not be directly visible to outsiders: Amazon’s behind-the-scenes merchandising capability, which is critical to its success, is hardly noted by most observers. Capabilities don’t have to be private-sector-specific. For an employment agency with public-sector clients, recruiting and developing people for government work may be a critical capability. For a protected utility, a state-owned enterprise, or an organization competing in some developing economies, managing government relationships could matter more than any kind of specific marketing acumen.

The way you think about capabilities is important because it can shape the way you conceive of and build them. For example, some executives look at capabilities so vaguely (e.g., thinking of quality, innovation, consumer insight, or supply-chain management as capabilities) that investments in these capabilities can mean almost anything. These are generally important functions; every large company invests in them. But there are dozens of ways to excel at innovation, and many of them are specific to particular product categories, industries, and even regions. A new motor-vehicle launch program would require very different skills and supply-chain methods depending on whether it’s a truck or a microcar; a gasoline- or electric-powered vehicle; or a launch in India, China, Europe, or the United States. If you don’t have a clear sense of what types of innovation are included in your capability and what types are not, then you haven’t defined it rigorously enough.

Capabilities Versus Assets

Many corporate leaders assign insufficient weight to their differentiating capabilities in developing strategy. Instead, they base their strategy on an assessment of their assets—their patents, brands, land, facilities, machinery, supplier and customer connections, and cash. Guided in part by this “asset-forward” view of the world, they tend to compete most heavily wherever they have assets at sufficient scale.

That’s shortsighted. If assets were the primary factor underlying success, then any company in an industry could win by adopting the same strategy, as long as it had enough capital to buy the assets it needed. Moreover, assets tend to depreciate in value and can diminish unexpectedly. For example, the value of patents expires, and in many sectors, it has become easier to manage around them.

A capability, by contrast, is yours. It can’t be stolen or easily bought by competitors; by the time they copy what you know how to do, you will already have evolved the capability further. Even if they duplicate some of your methods, they will not be able to make use of them as you do.

Honeywell realized this in its operations in China several years ago, when it successfully introduced a new line of thermostats and control devices for Chinese buildings and industries. Other technology manufacturers, entering China with the assets of their technologies (and, in some cases, their patents), had been confronted by Chinese knockoff producers, which essentially counterfeited their devices and sold them at lower cost. Instead, Honeywell opened a new R&D center in Shanghai, employing two thousand, to develop its subsequent products for the Chinese market—and to back up those products with support and services that no knockoff producer could easily duplicate. Within three years, the company tripled its revenues in China.⁴

Fixed assets are more difficult to apply across many products, services, and businesses than are capabilities, which further limits fixed assets’ value. Moreover, even the most valuable and long-lived assets are, increasingly, table stakes in most competitive industries. Everyone in the game has to have them, but they are rarely the basis of sustainable differentiation, because anyone with capital can acquire them.

Time favors the capabilities-driven strategy over the asset-driven strategy. While assets depreciate, the value of a capability tends to grow as it is used and improved. Consider the difference between an oil company strategy based on exploiting the oil fields it already owns (its assets), versus a strategy aimed at expanding the ability to safely discover and develop new fields (a capability that generates new assets). Many types of capabilities can also be used to develop new assets. An improved innovation capability will lead a company to hold more patents (and more profitable patents). A strong marketing capability sustains the viability of a brand.

We do not suggest that you ignore assets; they play a major role in how you go to market. But the power of an effective capability can surprise you. We recall a conversation with leaders of a large European food company, in which they talked about the distribution network that they used to deliver prepared meats. Suddenly, one of the top executives looked up and said, “I didn’t realize this before. But nobody else understands how to transport a sausage to the shelf this way.” Sausage distribution, hardly the company’s main business, had always seemed trivial, but suddenly the executives realized that this specific distribution capability could be applied to a wide range of other food products, where local tastes and freshness were important customer requirements. If they invested in it properly and applied it more broadly, it could lead to some entirely new growth opportunities.

The Capabilities System

A capabilities system consists of the three to six capabilities that distinguish a company and that the company invests in; these capabilities reinforce one another in the service of the company’s way to play. To put it more broadly, the capabilities system is the integrated group of activities that enables a company to create value in the path it has chosen. Every great company, we believe, is supported by a well-established, well-supported, and focused system of capabilities.

The value of a capabilities system has not always been recognized by business thinkers as it should be. One who did recognize it was the eminent strategy writer and business historian Alfred D. Chandler, Jr. “The competitive strengths of industrial firms rest on learned organizational capabilities . . .,” he wrote. “Once a new enterprise’s competitive power has been tested, its set of integrated organizational capabilities becomes a learning base for improving existing products and processes and for developing new ones.”⁵ The most successful companies, he added, were those that continued to reinvest their earnings in improving their capabilities, bringing them together, and deploying them against competitors.⁶

As Chandler acknowledged in an interview in 2001, this concept summed up his lifelong effort to understand why some enterprises were influential in shaping their industry, while others withered. Born in 1918 into the du Pont and Poor (of Standard & Poor’s) families, he had grown up in the heart of emergent business culture, and he had begun his quest as a teenager, poring over old railroad expense records that he had found in his great-aunt’s attic. Along the way he wrote a series of seminal books, including Strategy and Structure: Chapters in the History of the American Industrial Enterprise (1962), the first to lay out a concept of business strategy as a long-term group of goals and objectives, and The Visible Hand: The Managerial Revolution in American Business (1977), which was the first business book to win the Pulitzer Prize.⁷ He also founded the academic field of business history, as a professor at Harvard University.

But it wasn’t until his last two books—Inventing the Electronic Century (2001), on consumer and computer electronics, and Shaping the Industrial Century (2005), on chemicals and pharmaceuticals—that Chandler came to feel that he had cracked the code of business success, and the evolution of industries as well. In these books, both published shortly before he died in 2007, he followed story after story of business competition. The company that reinvested in its own capabilities invariably won the market. One of many examples was IBM versus Sperry Rand in 1953, both making the transition from tabulating machines to computers. Sperry Rand had a three-year head start, but according to Chandler, its teams squabbled, its sales force had little interest in the new products from R&D, and its leadership was reluctant to invest in either technology or human skills. IBM, led by Thomas Watson, Sr., focused intently on building and applying its capabilities in hardware and software. It applied its experience with punch card tabulators, for example, to design peripherals for its new computers. The 650 mainframe, launched in 1954 and later dubbed “computing’s Model T” by Watson himself, was the source of immense revenue, which the company plowed back into furthering both its technical and its sales capabilities.⁸ Chandler argued that the “integrated learning base” (his phrase for a capabilities system) created enough of an advantage to enable companies to outperform competitors for decades—or until they stopped reinvesting in it.

In a coherent company, a capabilities system is the chosen vehicle for channeling investment. It establishes a new form of scale by deploying capabilities more broadly. As we’ve seen with Pfizer Consumer Healthcare, JCI, and the food company described in chapter 4, designing a capabilities system also serves as a natural way to align people’s thinking. It was not just the capabilities individually that were essential, but how they operated in a system. Each capabilities system, in fact, requires capabilities that are well matched—just as a high-performance sports car requires a high-performance engine, transmission, and tires that are very different from those you would install on a pickup truck. A capabilities system must also be well matched to your way to play; it provides a powerful basis for choosing a successful way to play for your company.

Companies that combine capabilities into a system gain tremendous advantage over their competitors. Another good example is Inditex, the Spanish fashion manufacturer and retailer, better known by its main brand name, Zara. Zara’s remarkable success depends on combining seemingly unrelated capabilities in customer insight, rapid-response manufacturing innovation, logistics, and nimble fashion design. These all come together in a very specific way.

If you walk into a Zara retail store, you’ll find some “classic” garments, which change infrequently; these are outsourced to manufacturers from low-wage countries like Sri Lanka and Malaysia. Seasonal and fashion-forward clothes are produced at Zara’s own factories and suppliers in Europe, where the company has built the remarkable capability of redesigning clothes quickly in response to analysis and insight. Kaj Grichnik and Conrad Winkler describe this rapid process in their book Make or Break:

Zara’s full price is often 15 percent below the full prices of specialty competitors, and its assortment is well-managed. Because its purposefully changing inventory and everyday lower prices attract customers, it does not need to discount as heavily as other retailers do. Day by day, it sells a higher proportion of its clothing than do competitors at regular prices—and about 20 percent more units per square foot of retail space. This provides more value to the consumer than the traditional method of marking down items for discounts when they are no longer new, with a much more profitable cost structure for the company. In fact, it’s a mutually reinforcing benefit. The more the capabilities system provides the right assortment in the right quantities, the more Zara can pass that value (in lower working capital, fewer markdowns, and less written-off inventory) to customers. This in turn provides more scale for the capabilities system, as consumers come back more often, looking for the next iteration of style. Even when other clothing manufacturers and retailers have struggled with shrinking profit margins, Zara reports consistent growth in earnings. Moreover, because of the close alignment among its capabilities, the system is almost impossible to copy.

Another example is Frito-Lay, the snack division of PepsiCo. Three basic integrated capabilities, involving human and physical capital, fit within its system. The first is direct store delivery (DSD). On several continents, Frito-Lay, rather than relying on a third-party distributor, has its own fleets of trucks with skilled and motivated drivers who are known for their ability to build relations with store owners, commandeer shelf space, and even offer stores credit. (The DSD network provides limited banking services in some markets.) Frito-Lay actually invented the handheld computer to enable its DSD capability.

To be sure, DSD is not considered a highly differentiated capability today. Many consumer packaged-goods companies distribute merchandise this way. But in its use of information technology, training, and skilled global management, Frito-Lay still maintains a clear, distinct advantage in getting the right product to the right place at the right time. More importantly, Frito-Lay parlays it in combination with two other distinctive capabilities: the continuous innovation of new products (particularly new flavors), and a proficiency with local consumer marketing programs that reinforce demand.

Like Zara, Frito-Lay has built a value chain that would be very difficult for another company to replicate, because these three capabilities work so well together. For example, it deploys them to rapidly and broadly test new products in the market. Most consumer packaged-goods companies struggle with market tests of new products, because they rely on retailers to stock the shelves; the associated slotting fees can add up to $1 to $2 million for a new product in the United States. But Frito-Lay stocks its own products. This gives it tremendous cost savings and the flexibility to launch and test new products. If the products don’t attract customers, Frito-Lay can withdraw them quickly. If the products are hits, that’s even better; because it “owns the shelf,” there’s a direct link back to innovation and marketing. It can rapidly build demand, which reinforces the relationship with retail grocers.

Closing the Capabilities Gap

In chapter 10, we’ll discuss the design of a capabilities system and its continual refinement over time. But even at the very first stages, one question should be at the heart of your thinking: what is the gap between the capabilities you will need and the capabilities you already have?

Your way to play should largely be developed in light of the capabilities you already have. It should take into account everything you’re great at. But inevitably, given the incoherence of the past and the ambitions of the present, there will be gaps you’ll have to fill. Indeed, the gaps may sometimes be so great that you will find it challenging to earn a right to win. You may even need to reconsider your chosen way to play. (In chapter 10, we’ll discuss how to evaluate these gaps in light of your competitors.)

Several snack companies are now facing this type of dilemma. Health and wellness are widespread trends, and many food manufacturers are investing heavily in innovative, health-based new products. But within these companies, there’s a backlash of people who are quite reasonably asking if the companies can fulfill their promises. These companies have well-honed capabilities bringing to market the salty, sugary snacks that trigger emotional connections with people. As the companies add healthier food products to the mix, they are having difficulty creating value. They are trying to support two ways to play at one time, each way requiring a very different type of R&D and marketing, and their capabilities systems may not be up to the challenge.

In similar circumstances, you don’t necessarily have to settle for incoherence. You do need to be more explicit about the stretch required to accomplish your new way to play. Look closely at the companies that have the greatest right to win in that new business. What capabilities are they bringing to bear?

Then assess your own capabilities in the light of your distinction. What could you do better than anyone else in this arena? Conversely, what would it take to develop or acquire the capabilities you need to win in this new way to play? Would you need to acquire technology? Train and develop people in new ways? Invest in R&D differently? Build new types of practices and create new policies? Where does the expertise related to these capabilities exist—inside your firm or outside, or both?

In assessing your capabilities gap, look at the capabilities that you aren’t using fully. For example, you may have invested heavily in a supply chain or legal capability that has only paid off in one or two product lines. These should either be extended to your full company (if they prove valuable there), or the investment should be reconsidered.

Also consider the measures required to deploy the same capabilities against many parts of your business. Will the staff and processes involved be the same? If not, how do they interact? Will the handoff from one capability to the next be designed by a single team? Or do you want people within the relevant functions and business practices to conceive and develop their parts of it cross-functionally?

The relevance of your capabilities to your business, of course, is not just an operational issue. The next chapter focuses on this third strategic element: the lineup of products and services in your company, and the degree to which they fit with both your capabilities system and your way to play.