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Why old tools won't work in the "new" knowledge economy

Norman T. Sheehan

Norman T, Sheehan, B,Comm, MBA, PhD, CMA is an Associate Professor in the College ot Commerce at the University of Saskatchewan. He teaches, publishes and advises in the areas of strategy formuiation, strategy implementation/ performance measurement, and management of knowiedgeintensive firms (Sheehan commerce.usask.ca).

Introduction
Firms in the knowledge economy are significant drivers of economic growth, both for the clients they help and for themselves as witnessed by the fact that their revenues have increased tenfold in the past twenty years. Despite the meteoric rise of knowledge-intensive firms, we know very little about their business models and even less about how to improve their profitability. While we have many tools to analyze and improve the performance of industrial firms, we have few toois for knowledge-intensive firms. Porter's (1998) strategy tools[1] are intended for industrial firms, suoh as Ford Motor Company, Deli, Coca-Cola, Caterpillar, Anheuser-Busch, and Nucor, not knowledge-intensive firms such as Accenture and McKinsey in consulting, Deloitte and KPMG in auditing, Clifford Chance and Watchell Lipton in legai, Kleiner Perkins and Bain Capital in venture capital, and BBDO Worldwi(de and McCann Erickson in advertising. Aithough Porter's tools may provide some strategic insights, managers of knowledge economy firms run the risk of applying misleading advice. If we want valid, trustworthy insights from Porter's key strategy tools - five forces, generic strategies, and value chain - they need to be sharpened and modified for use in knowledge-intensive firms. Many knowledge-intensive firms recently experienced shock in the aftermath of the dot.com meltdown, 9/11, economic recession, and the implosion of Arthur Andersen. These events left managers scrambling to unearth new ways of increasing their firm's profitability. This paper examines the business models of knowledge-intensive firms using a sharper lens and offers three options to improve performance: 1. increase value capture by using insights from a modified five forces anaiysis; 2. improve value created by choosing a business modei that best fits a firm's problem-solving expertise, clients targeted, and desired risk ievel; and 3. identify competitive niches by evaluating which problem-solving activities shoul(J be performed in-house versus ieft to clients or outsourced.

Value capture in knowledge-intensive industries


Firms fight to retain and capture vaiue from actors in and around their industry. Porter's five forces analysis tells a story of who captures the most value: Is it rivals, who by competing for customers force the firm to reduce prices or incur additional expenses that increase the value offered? Is it buyers with high bargaining power who force the firm to accept lower prices? Is it suppliers with high bargaining power that cause the firm to pay higher prices for inputs? Is it attractive substitutes who limit the price consumers will pay for the firm's product? Or is it potential new entrants who force the firm to reduce its price to discourage their entry into the market (see Figure 1)?

DOI 10.1108;02756660510608567

VOL 2e NO. 4 2005, pp, 53-60, S' Emerald Group Publishing Limited. ISSN 0275-6668

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Figure 1 Porter's five forces for industrial firms

Suppliers

Buyers

Substitutes

If the industry is favorable, such as the pharmaceutical industry, then all firms in the pharmaceutical industry wilt enjoy superior performance. If the industry is unfavorable, such as the airline industry, then all firms suffer For example, United and Delta are struggling due to high industry rivalry, low cost entrants such as Jet Blue, high bargaining power of key suppliers such as airline pilots, and an increasing attractiveness of substitutes such as videoconferencing. Knowledge-intensive firms create value by soiving their clients' problems through the direct application of knowledge. Whereas knowledge plays a role in all firms, its role is distinctive in knowledge-intensive firms. Rather than being embodied in the process or product, knowledge resides in experts and its application is customized in real time based on clients' needs. The way knowledge-intensive firms create value critically impacts Porter's story of who captures the value in a number of ways: First, knowledge-intensive firms compete differently - they fight vigorously to win the best experts and best projects (Maister, 1992)[2], but thereafter cooperate with their rivals. Knowledge-intensive firms routinely refer projects to rival firms better suited to solving the problem or they may even cooperate by sharing work on larger projects. For example, law firms may refer clients to other law firms or sub-contract work for large legal cases. Knowledge- intensive firms may also cooperate to advance the professional or industry association through conferences, common training programs, or setting common standards (see Figure 2). Second, first-mover advantages play a decidedly smaller role in knowledge-intensive industries due to the rapid commoditization of ideas and processes. Although the first firm to introduce new ideas may "cream off" a disproportionate share of new business, the advantage is typically temporary. In the early 1990s, CSC Index used its head start in business process re-engineering to build a lead over its competitors, but as CSC Index soon learned, this advantage was fleeting due to the ease with which their processes and solutions were imitated by rivals. Third, experts, who are the main suppliers to knowledge-intensive firms may have high bargaining power if their clients are tied to the expert rather than to the firm. For example, if clients approach the firm because they want specific consultants, then those consultants have leverage that they may apply to appropriate higher salaries. However, if the client approaches the firm and will take any qualified consultant, their bargaining power is muted.

" Knowledge-intensive firms compete differently - they fight vigorously to win the best experts and best projects, but thereafter cooperate with their rivals."

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Figure 2 A modified five forces for knowledge-intensive industries

New Entrants

OO
Experts

OC O O Referrals
Rivalry

Cooperation

Clients

Substitutes

Fourth, the bargaining power of clients is reduoed due to a knowledge gap between experts and their clients. Clients may not be able to view the problem-solving activities or the contingencies experts operate under that often make it difficult for clients to ascertain the quality of the solution, even after the fact (Lowendahl, 1997)[3], In some cases, once the solution is implemented it may be irreversible - think of a lawyer trying a legai case or knee surgery. A client's bargaining position is further weakened if the solution is very important to the client. One reason some clients pay such a high price for expertise is that the cost of ignorance may be even higher (Fjeldstad and Andersen, 2003). Finally, while there is a minimal cost to set-up a new knowledge-intensive firm, reputation acts as a deterrent. Established experts have an easier time if they are known to clients, but new entrants are hindered by their newness - not having a track record makes it difficult to win clients. Industrial firms can lure customers to try new products by reducing their prices, but this is risky for knowledge-intensive firms because it may be seen as cutting quality. Think whether you would be comfortable going to trial with a law firm that advertises "Boxing Day divorce specials" or "Easter break-and-enter specials." After completing a five forces analysis managers can try the following tactics to capture more value: Reduce the bargaining power of its experts by tying clients to the firm instead of to the expert. Accenture and McKinsey have a clear "one firm" policy, which is partially intended to "tie" the client to the firm rather than to one particular consultant. If it is net feasible (or desirable) to reduce ties between individual experts and clients, another way to persuade experts to accept less than full market value for their services is to offer a menu of (future) rewards such as competence building, enhanced legitimacy, and an opportunity to become partner (Fjeldstad and Andersen, 2003). Some clients may try to reduce the bargaining power cf firms by hiring their own experts. Many corporations have in-house legal counsel. Can managers of knowledge-intensive firms introduce flexible client arrangements and pricing structures to make this option less attractive for current and potential clients? Reputation plays a key role in deciding who hires your firm, who partners with your firm, and who refers clients to your firm. Is there room to proactively improve the firm's reputational status by increasing involvement in the profession, monitoring and measuring reputation, or partnering with firms with better reputations? Business models for knowledge-intensive firms Business models for knowledge-intensive firms should outline a strategy in terms of which clients they will target, what problems they will solve, and how they plan to do this efficiently and effectively. In making these strategic choices, knowledge-intensive firms face a different

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competitive lancJscape from industriai firms. For example, knowledge-intensive firms focus more on value enhancement than cost reduction, "Cars, despite heroic attempts at branding, are still more or less interchangeable and sold on price - hence the car industry's fixation on costs. But each new class of drug is usually unlike anything else that came before. Moreover, few patients will buy second-best heart pills just to save a few dollars . . . " {Ttie Economist. 1998). Cost is important in knowledge-intensive firms, but it is not the defining characteristic - the defining characteristic is adding the most value by healing the sickest patients, winning the toughest court cases or designing the most aestheticaliy pleasing buildings. Further, competing on being the lowest cost/iowest prioe in any segment is risky because it may be equated with being tow quality in the clients' mind. This is not to say firms cannot offer iower priced services - knowledge-intensive firms routinely target prioe-sensitive ciients with lower priced services. FDS' own consultants sell projects to mid- and lower-end clients, while AT Kearney targets high-end clients who can afford higher-priced engagements. But competing with a lowest price strategy is less appealing for knowledge-intensive firms because in the absence of other information clients may associate price paid with the quality of the solution. Aside from the potentially damaging signal a low cost/low price strategy may send, knowledge-intensive firms also face significant challenges implementing a low cost strategy due to their cost structures. Fxpert salaries are typically a knowledge-intensive firm's largest expense item and there is less room to reduce salaries. Knowledge-intensive firms also lack scale economies. Larger scale may allow a firm to offer services to global clients, to solve "larger" problems, and tc provide additional opportunities to balance the workload of experts (Stabell and Fjeldstad, 1998; Starbuck, 1992)[4]. However, these advantages are more than offset by the costs associated with coordinating experts and the need to reconfigure for unique cases. Although some larger firms such as McKinsey enjoy success, smaller knowledge-intensive firms typically earn higher revenues per expert than larger firms. Porter argues that the only way for firms to achieve above average profitability is by basing their business model on being lowest cost or differentiated. However, a low cost strategy is not strategically attractive for knowledge-intensive firms. Instead we suggest that a key trade-off for knowledge-intensive firms is the breadth of their problem domain, which defines problems to be solved and clients targeted by the firm (Fjeldstad and Haanes, 2001; L0wendahl et al., 2001; Stabell, 2001 )[5]. Knowledge-intensive firms can choose to be generalists and solve a broad range of problems or they may choose to be specialists by focusing on a narrow range of problems. A second key positioning choice for knowledge-intensive firms is the level of knowledge re-use (Hansen etat., 1999; L0wendahl etai, 2001; Maister, 1993; Mintzberg, 1979), given that expertise directly impacts client value and firm cost (see Table I). At one end of the knowledge re-use spectrum, firms such as Deloitte Consulting and Acoenture sell mainly pre-packaged or "off the shelf" solutions. These firms are efficient, as they have solved these types of problems before, but they may be less effective if new problems do not call for old solutions. Maister (1993)[6] labels this type of firm "grey hairs", which is appropriate as it implies depth of knowledge but less adaptability in its application. At the other end of the knowledge re-use spectrum, we see firms that sell tailor-made solutions such as Deka, which invented the Segway. These firms typically approach each problem as a blank sheet of paper with the aim of arriving at a customized solution and are more effective solving client problems but less efficient. Placing the two dimensions together gives a range of business models for knowledge-intensive firms (see Table !). Managers need to analyze their firm's knowledge re-use and desired risk levels before picking a business model that best fits their expertise, target clients, and aspirations. Knowledge-intensive firms choosing a broad problem domain and "off the shelf" solutions, whioh we label General Stores, typically earn lower client fees but incur lower expenses in solving their problems. Their main risk is that their expertise becomes obsolete, although by

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Table I Business models for knowledge-intensive firms


Sells packaged solutions Broad problem domain Narrow problem domain General stores (Deloitte Consulting, IBM Consulting) Specialty shop (Balanced Scorecard Collaborative, Marakon) Sells tailor-made solutions Idea labs (Boston Consulting Group, Dean Kamens firm - DEKA) Boutiques (Gary Hamel's Innovation Lab)

diversifying into a broad range of problems they have a lower obsolescence risk compared to firms suoh as Specialty Shops, which have narrower specializations. Specialty Shops are experts at solving one type of problem. They typically charge lower fees, but should be efficient as long as clients' projects fit their expertise profile. Firms that choose broad problem domains and customization, which we label Idea Labs, typically earn higher fees but run the risk of having costs exceed revenues due to an unclear probiem definition and scope. Firms with narrow problem domains and customization, which we label Boutiques, earn higher fees but also face obsolescence and efficiency issues. On the positive side, though, Boutiques and Specialty Shops have reduoed their complexity and thus risk by focusing on narrower problem domains (L0wendahl and Revang, 2004). Lastly, Boutiques and Idea Labs face a longer-term risk: as they gain a reputation for successfully solving certain types of problems, new clients may request old solutions. While profitable in the short term, this may gradually lead to a "success trap"[7] as their old knowledge loses its market relevance.

Activity scope for knowledge-intensive firms


Firms can use activities as an analytical tool to improve the effectiveness and efficiency of their operations. Porter argues we cannot understand a firm's competitive potential by looking at the firm as a whole; rather its competitive position is determined by the activities it undertakes, such as receiving, manufacturing, storing, transporting, hiring, training, purchasing, and marketing (Porter, 1998)[8]. To assist managers to understand and implement a low cost or differentiation strategy using activities. Porter outlines the value chain (see Figure 3). The value chain is a generic activity template that can be used to decompose the firm into the individual activities it undertakes to oreate value for the customer. Knowledge-intensive firms create value by solving problems in contrast to industrial firms, which create value by transforming inputs into outputs. This different value-creating logic demands a new activity framework. Stabell and Fjeldstad propose a value shop activity template as a tool to model value creation in knowledge-intensive firms (Stabell and Fjeldstad, 1998)[9]. Knowledge-intensive firms create value for their clients by performing one or more of the generic problem-solving activities: problem finding, which includes acquiring clients and defining their problems;

problem solving, which includes alternative generation and evaluation;

Figure 3 The value chain


\
Support Activities Primary Activities

Firm Infrastructure \ \ Human Resource Management \ \ Technology Development \ / Procurement / / Inbound Operation Outbound Marketing After-Sales / / Logistics Logistics & Sates Service /

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choice of an alternative; implementation of an alternative; and follow up and control to see if the alternative selected resolves the problem.

In the graphic model for the value shop, the primary problem-solving activities, rather than being linear as in the value chain, are shown as "wheels within wheels" in order to emphasize a cyciical and iterative value creation logic (see Figure 4). As with the value chain, the value shop has a corresponding set of support activities that play an indirect role in creating value for their clients. The main difference is that senior experts typioaily perform training and technology development activities along with their primary problem-solving activities. Once the knowledge-intensive firm has been divided into its key value-creating activities, managers can pursue two lines of strategic analysis: They can compare their activity set to that of competitors - are they performing them better or differently? This analysis usually provides insights into areas that need to be improved. For example, are all activities creating value in the clients' eyes? Can we eliminate or reduce some activities? Are competitors undertaking different activities and adding more value at lower cost? A second line of inquiry focuses on the scope of the business model - which activities should be completed in-house versus having the client perform them. A general building contractor is an example of a knowledge-intensive firm that performs only the first aotivity, problem finding. A general contractor wins the engagement and then contracts the actual construction work out to various trades. However, it is more common that knowledge-intensive firms, such as consultants and architects, perform problem finding and problem defining activities. These firms win the engagement, outline a set of recommendations, and then leave the remaining activities (choosing the solution, implementation, and follow up) in the hands of the client. Some knowledge-intensive firms, suoh as cosmetic surgeons and lawyers, oomplete the full cycle of activities. They win the work, recommend and choose a solution, implement by doing the surgery or trying the case, and then follow up. On the other hand, some knowledge-intensive firms perform only implementation and follow-up activities, relying on referrals from other knowledge-intensive firms for their clients. Focusing on activities provides managers with another lens to differentiate themselves. Choosing different activity sets leads to the formation and (potentially) domination of new

Figure 4 The value shop

Support Activities

Firm Infrastructure Human Resources Management Technology Development Procurement

Primary / Activities '

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Business models for knowledge-intensive firms should outline a strategy in terms of which clients they will target, what problems they will solve, and how they plan to do this efficiently and effectively."

competitive niches: Acoenture found a new strategic niche in this manner. Once a pure problem finder and definer, Accenture now performs implementation and follow-up activities for clients (i.e. back office procedures like payroll and accounting). Some architectural firms are moving beyond delivering drawings to managing the construction of buildings they have designed. Maister suggests a new business model for consulting firms (Ttie Economist. 2001), which he labels "pnme contractors". He proposes that these firms should act as general contractors by coordinating the work of boutique and specialty shops, which are hired because they are the "best of breed."
Keywords: Knowledge organizations, Performance measures,

Summary Applying "old" tools to "new" knowledge-intensive firms seldom provides the strategic edge managers are looking for. Managers of knowledge-intensive firms need to use the old tools in new ways, if they are to improve their business models and ultimately increase their profitability.

Business excellence, Knowledge management, Activity based management

Notes
1. Discusses five forces analysis, generic strategies and the value chain. 2. Discusses how professional service firms compete for professional talent and client projects. 3. Discusses how information issues impact professional service firms. 4. Discusses scale economies in knowledge-intensive firms. 5. Discusses how the scope of the problem domain is a key strategic choice. 6. Discusses "grey hairs" in professional service firms. 7. Mintzberg (1979) was first to note this risk, but see also Fjeldstad and Haanes (2001) who build on Jim March's work on exploration versus exploitation. 8. Describes how to use activities to improve efficiency and effectiveness. 9. Discusses the strategic implications of the value shop.

References
(The) Economisl {}998), "New drugs for rare diseases", Ttie Economist, 28 May p. 78. (The) Economist (2001), "Spoilt for choice", Ttie Economist, 7 July p. 66. Fjeldstad, 0. and Andersen, E. (2003), "Casting off the chains: value shops and value networks", European Business Forum, Vol. 14, pp. 47-53. Fjeldstad, 0 . and Haanes, K. (2001), "Strategy tradeoffs in the knowledge and network economy". Business Strategy Review. Vol. 12 No. 1, pp. 1-10. Hansen, M., Nohria, N. and Tierney, T (1999), "What's your strategy for managing knowledge". Harvard Business Review, March/April, pp. 2-12. Lewendahl, B. (1997), Strategic Management of the Professional Service Firm. Handelshojskolens Forlag, Copenhagen.

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Lawendahl, B. and Revang, 0 . (2004), "Achieving results in an after modern context: thoughts on the role of strategizing and organizing", European Management Review, Vol. 1 No. 1, pp, 49-54. Lewendahl, B., Revang, 0. and Fosstenl0kken, S. (2001), "Knowiedge and vaiue creation in professionai service firms: a framework for analysis". Human Relations, Vol. 54 No. 7, pp. 911-31. Maister, D. (1993), Managing the Prolessional Service Firm, The Free Press, New York, NY. Mintzberg, H. (1979), The Structure of Organizations, Prentice-Hall, Englewood Cliffs, NJ. Porter, M. (1998), Competitive Advantage, The Free Press, New York, NY. Sfabell, C. (2001), "New models for vaiue creation and competitive advantage in the petroleum industry", research report 1/2001, Norwegian School of Management, Oslo. Stabeli, C. and Fjeldstad, 0. (1998), "Configuring value for competitive advantage: on chains, shops and networks". Strategic Management Journal, Voi. 19 No. 5, pp. 413-37. Starbuck, W. (1992), "Learning by knowiedge-intensive firms". Journal of Management Studies. Vol 29 No. 6, pp. 713-40.

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