by: Atul Teckchandani

Years ago, the most successful firms were vertically integrated. If you go way back – to the 1930s – there was Ford’s River Rouge plant, which made everything that went into the automobiles it ultimately manufactured. The plant had a steel furnace, a tool and die plant, a tire-making facility, and a paper mill. It even had its own power plant and railroad. Even back in the 1980s, many technology firms such as Apple and HP did not just design personal computers, they also manufactured them.

Over time, this strategy has given way to one that emphasizes keeping your core competencies in house and outsourcing the rest. A core competency is something that a business sees as being central to its success. Prahalad and Hamel (Harvard Business Review, 1990) say that a core competency can be identified using the following three criteria:

1. It provides access to a wide variety of markets.
2. It significantly affects the perceived customer benefits of the final product or service.
3. It should be difficult for others to imitate.

The article cites the example of Honda, whose core competency is its expertise in building engines. This fits all three of the criteria. First, this expertise has allowed them to build lawn mowers and motorcycles in addition to automobiles. Second, many consumers purchased Hondas because of its reliable and fuel efficient engines. Third, engines are arguably the most critical and complex components in automobiles and any advances in engine technology are not easy to imitate.

As companies have focused on their core competencies, they have become less vertically integrated. It no longer makes sense for Apple and HP to manufacture their electronic gadgets. Not only is manufacturing not one of their core competencies, there are other companies that can do it much better. Analogously, many companies no longer manage their own information technology resources – instead they hire a firm like IBM to do it for them.

For a firm, the consequences of deviating too far from its core competencies can be disastrous, if not fatal. For example, Cisco went on a spending spree in the last decade, spending billions buying firms such as Scientific-Atlanta (maker of the set-top boxes given to consumers by their cable providers), Linksys (maker of consumer networking equipment), and Pure Digital (maker of the Flip cameras). All of these acquisitions were intended to help Cisco get a foothold in the consumer space for network-related products. But the problem was that they did not fit with Cisco’s core competency, which is expertise in corporate networking. The result was that Cisco ended up shutting down its Flip division two years after it purchased it and its Scientific-Atlanta division has undergone many layoffs. While Cisco was once a Wall Street favorite, this strategy of acquiring firms that were only loosely connected to its core businesses was widely hammered by its investors and resulted in many profit warnings from the firm. Cisco finally relented and announced that it was going to refocus on its networking businesses.

What is interesting is that firms continue to deviate from their core competencies. Apple Computer recently acquired a firm (PA Semi) that designs processors. Since acquiring the firm in 2008, PA Semi’s processors have been designed into iPhones and iPads. But why would Apple want to get into the processor business? Many firms, such as Intel, Qualcomm, and NVIDIA specialize in making processors for many types of devices. In contrast, Apple’s core competencies have little to do with processor design. Apple is much better at building user-friendly software and aesthetically-pleasing hardware. These competencies have allowed Apple to enter the consumer electronics space, which has become a larger revenue generator than the firm’s computer business.

Another culprit is Amazon, who has been on an acquisition binge. They own numerous other e-retailers, such as zappos.com, diapers.com, drugstore.com and pets.com. They own firms that offer and distribute content, such as imdb.com and audible.com. They have also been launching their own subsidiaries, such as Amazon Local (which offers Groupon-type deals), A9 (which builds a search engine), Lab126 (which builds the Kindle) and endless.com (which is an online shoe retailer). Recently, they announced their intent to buy Kiva Systems, which makes robots that can be used to automate warehouses. Their acquisition strategy is virtually impossible to understand. Many of the online retailers they have acquired remain independent and continue to operate. Yet Amazon continues to let its own amazon.com site compete with them directly and even launches its own subsidiaries to further increase competition. The need to create another search engine seems highly questionable when consumers have few complaints with the current leaders in that space. And Amazon is definitely not in the robotics business. Many of these acquisitions seem to be of products and services that Amazon uses heavily. Kiva’s robots are used in Amazon’s warehouses. Imdb.com’s movie content is linked to amazon.com’s movie pages. But why purchase them outright rather than just purchase their products or services? More importantly, does Amazon have the ability to continue to allow these acquired firms to grow and thrive? Only time will tell. Amazon’s core competency used to be in e-commerce. But they have moved to become a content provider as well. Those are two core competencies that have little in common. Couple that with becoming a hardware provider and industrial equipment provider, and the result is significant lack of clarity as to what Amazon does well, which could be a sign of trouble ahead for the firm.

And herein lies the lesson for entrepreneurs: know what your core competencies are and focus on them. This means that a firm should have no more than a few core competencies. Build the capabilities to develop, nurture and enhance these competencies internally while outsourcing the rest. That is a business model strategy that has proven to work for all firms, big or small.

Dr. Atul Teckchandani is an Assistant Professor of Management at the Mihaylo College of Business and Economics, California State University, Fullerton. He teaches courses in entrepreneurship, provides student advising and is involved with the Center for Entrepreneurship within Mihaylo College. He has a PhD in Business Administration (Management of Organizations) from the Haas School of Business at the University of California, Berkeley, as well as an MBA from the McCombs School of Business at the University of Texas, Austin.