Capabilities as Real Options
Author(s): Bruce Kogut and Nalin Kulatilaka
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Source: Organization Science, Vol. 12, No. 6 (Nov. - Dec., 2001), pp. 744-758
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Capabilitiesas Real Options
Bruce Kogut * Nalin Kulatilaka
WhartonSchool, University
ofPennsylvania,Philadelphia,Pennsylvania19104
Boston,Massachusetts02215
Avenue,Boston University,
School ofManagement,595 Commonwealth
upenn.edu * nalink@bu.edu
kogut@wharton.
Abstract
Strategyresearchconsistsof a balance betweenpositiveand
heurisnormativetheory.Normativetheoriessuggestparticular
to findappropriatesolutions.
tics,or cognitiverepresentations,
Heuristicspermitfastersolutionsto real-timeproblems;they
to inapproalso sufferfromthe potentialof negativetransfer
priateapplications.
The theoryof real optionsprovidestheappropriate
heuristic
of competenciesand exploratory
search.A realoptions
framing
approachmarriesthetheoryof financialoptionstofoundational
ideas in strategy,
organizationaltheory,and complexsystems.
We join these approachesto identifythreepairs of concepts:
scarce factorand the underlying
asset in optiontheory,inertia
and irreversibility,
and theruggednessof landscapeand option
values. Strategictheoriesof resourceslargelydefinea core
In doingso, thisdefcompetenceas uniqueand nonimmutable.
initionhas wronglyforgotten
Barney'sinitialinsightintoscarce
the valuationof a competitive
factormarketsas determining
asset. Financial theoryof real optionsderivesits heuristicsof
searchby inferring
investingin exploratory
futurevalue of tofrommarketprices.
day's investments
We applythethreeconceptualpairsto theevaluationof capabilitiesas real optionsthrougha formaldescriptivemodel.
The valuationof core capabilitiesis derivedfromobservingthe
pricedynamicsof correlatedstrategicfactorsin themarket.Because of inertia,managerscannoteasilyadjustthewrongsetof
organizationalcapabilitiesto the emergenceof marketopportunities.However,firmsthathave made investments
in capabilitiesappropriateto theseopportunities
are able to respond.
Fromthisdescription,
we definecore competenceas thechoice
of capabilitiesthatpermitsthe firmto make thebest response
to marketopportunities.
The heuristicframing
of capabilitiesas
real optionsguidesthenormativeevaluationof thebalance betweenexploitationand exploration.
(Strategy; Options; Capabilities; Heuristics; Irreversibility;Landscapes)
Strategizing is the application of heuristic frames to analyze the world and to generate normativeevaluations of
potential avenues of implementation. Strategy research
reflectscompeting ideas about how the world looks, or
ORGANIZATION SCIENCE, ? 2001 INFORMS
Vol. 12, No. 6, November-December2001, pp. 744-758
whattheworldneeds.However,liketheircounterparts
in
engineeringor architecture,
strategyresearchersdistinto
guishthemselvesfrompractitioners
by theirattention
an articulation
of theoryand evidence.It is thisserious
of
concernforthedesignof practiceby an investigation
the appropriatetheoreticalframingthatis the markof
appliedsciencesin professionalschools (Simon 1969).
researchbetween
Thereis currently
debatein strategy
fora firmto "position"itselfin themarket
theimportance
or to own unique resources.Ned Bowman (1995) made
thedistinction
betweenstrategiesthatlook in themirror
and thosethatlook throughthelookingglass. In theparlance of contemporary
strategyresearch,resourceand
knowledge theoriesof the firmare inward looking,
whereasmarketpositioningand industry
analysisareoutwardlooking.
It is not surprising
thatduringa timeof restructuring
and reengineering,
strategyresearchersshould shiftthe
emphasisfromindustry
analysisto theinternalsourcesof
competitiveadvantage.The current
emphasison looking
in themirrorbegs thequestionof how to choose among
alternatives.
The resource-basedand knowledgetheories
view theuniquecapabilitiesofthefirmas thecornerstone
of sustainablerents.These approachessharethecommon
insightthata chosen strategy
presumesthecapabilityof
thevision.A heuristicappropriate
implementing
to identifying
capabilitiesrequiredto supporta strategy
is provided by thenotionof core competence,as proposedby
Hamel and Prahalad (1994). And yet,it is oftenoverlookedthatHamel and Prahalad(1994) essentiallyinvert
the framingof a resource-basedview of strategy
by arguingforthe analysisof whitespaces in themarkettopographyof existingbusinessesto identify
valuable avenues of exploration.
The ideas of core competenceand whitespaces share
strongparallelswiththeheuristicapplicationof real optiontheoryto strategy,
wherebyinvestments
in exploration create capabilitiesto address futureopportunities
(Bowman and Hurry1993). In thisregard,a real option
is strongly
reminiscent
of thedistinction
betweenexploitation and exploration(Hedlund and Rolander 1990,
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BRUCE KOGUT AND NALIN KULATILAKA
Capabilitiesas Real Options
March 1991). A real optionis theinvestment
in physical
andhumanassetsthatprovidestheopportunity
torespond
to futurecontingentevents.A good example of a real
optionis theinvestment
in a sales operationin a developingcountrythatloses moneybutprovideslearningof
theenvironment
thatwill providethefuturecapabilityto
expandifthecountryshouldgrow.Firmsas adaptivesystemsstrikea balancebetweenrefinements
ofexistingprocesses and explorationsof variationson new techniques
and new markets.The staticanalysisof decidingto allocate effort
to each of theseactivitiesis especiallycomplicated,because currentefforts
resultin short-term
efficiencies that can overwhelm long-termeffortsof
exploration(March 1991). Thus,thedynamicsby which
capabilitiesinteractand are learnedpose a complexcombinatorialproblem.
Organizationaltheoryhas been slow to embracethe
idea thatorganizationscan proactivelyexploitriskrather
thanjust absorbit.Yet iffirmsand theirenvironment
are
engagedin a coevolutionary
dynamicLewinet al. (1998),
thenit is usefulfora firmto ponderthematchbetween
its futurecapabilitiesand futureenvironments.
We propose thatthetheoryof real optionsprovidesan appropriate theoretical
foundation
fortheheuristicframesto identifyand value capabilities and exploratoryactivities.
Because capabilitiesare platformsthatcreatea generic
in futureopset of resources,theyrepresent
investments
In
and
Kulatilaka
portunities
(Kogut
1994a). effect,real
view withinoptionvaluationmarriestheresource-based
dustrypositioningby discipliningthe analysis of the
value of capabilitiesby a markettest.
We proceedby firstcharacterizing
thevalue and limitationsof heuristics.We thendeveloptheuse of real optionsas a heuristicand show how it is groundedin, and
resourceof strategy:
throwslighton,threelinesofthought
based view of thefirm,traditional
organizational
theory,
and complexadaptivesystems.A centralconceptin organizationaltheoryis inertia.Its allied notionin financial
is criticalto thedefinition
economicsof "irreversibility"
of a real option.The argumentthatwe develop is that
because ofthe
irreversible
investments
capabilitiesreflect
the organizational
costliness of rapidly transforming
knowledgein a firm.This knowledgeis composedof the
set of technologicaland organizationalcomplements,
The
verymuchin thespiritofthesociotechnicaltradition.
in compledifficulty
facinga firmis thatimprovements
mentsprovidea competitiveadvantage,while also generatinga highlevel of inertiathatinhibitsthefirmfrom
radicalchange.
We examinetheseideas througha stylizedmathematical descriptionof the problem of adopting radical
clarifiesthatthe benefitof a
change.Our formalization
real optionsheuristicis theimpositionof a markettestto
derivethe valuationof capabilities.It also allows fora
of a core competenceas derivedfrom
precisedefinition
thevaluationof inertresourcesgiventheenvironment.
Strategyas Heuristic
Following distinctionsmade in cognitivescience, we
separatea heuristicintoits cognitiveframeand therules
of search.A cognitive(or heuristic)framerefersto the
of theproblemand solutionspace. The
"representation"
by whichsoheuristicrulesof searchare thealgorithms
solutionspace.'
lutionsare foundin therepresented
Simon(1969) introduced
bothoftheseelementsbydeto the
finingheuristicsas proceduralsearchin distinction
substantiverationality
of economics and operationsresearch.Simonnotedthatthesolutionsto manyproblems
are notcomputable;thatis, the searchalgorithmcannot
theoptimalanswer.The problem
in finitetimedetermine
by thetraveling
of computationis classicallyillustrated
salesmanproblemin whichtheobjectiveis to minimize
thetravelcostsof a salespersonwho has to visit50 cities.
The 50! calculationis computable,but not withinany
reasonablehorizon.For this reason,manyheuristicalgorithmshave been proposedto provide"satisfactory,"
butnotclearlyoptimal,solutionsto thisproblem.
Strategyoftenhas this level of complexityand also
theoptimalchoice.
oftenlacks a methodof determining
In orderto knowwhethera firmshouldenterintoa parto understandthe costs
ticularbusiness,it is important
andqualityoftheproductor servicethatcan be delivered.
It is also important,
consequently,to understandthereto thecompetitiveentryof an insponse of competitors
novationand its embedded bundle of attributes(e.g.,
price, quality). There are, then, two embedded decithe capabilities,the otherthe
sions-one determining
The dimensionalproblemof identifying
marketstrategy.
theirinteractions
all these elementsand understanding
quickly defies a declarativeanalysis (i.e., net present
value) or an exhaustiveproceduralsearchacrossall combinations.
somecogHeuristicshave theadvantageof countering
nitivebiases, but at a cost. In some cases, the heuristic
will lead to nonoptimaldecisions. In a studyon plant
scheduling,Bowman (1963) foundthatmanagerswould
do betterif theyused linearestimatesfromtheirexperience ratherthantriedto optimizein responseto each situation.The implicationis thatmanagerswould do better
heuristicsthanseek to optimize
to relyupon experiential
each situation.In real time,the searchforoptimalstratbyrecency
egiescan be toocostlyorliabletobe influenced
2001
ORGANIZATIONSCIENCENol. 12, No. 6, November-December
745
BRUCE KOGUT AND NALIN KULATILAKA
Capabilitiesas Real Options
effects(e.g., thearrivalof new information).
Kunreuther
(1969) modifiedthesefindings
thatrulescued to selective
environmental
information
improveactual decisionmaking. This findingimpliesthattheremay be certainmetaheuristics
thatidentify
theenvironment
and therebyindicatetheapplicationofless robust,butmoreappropriate,
decisionrules.
The meritof a heuristicis its real-timeutility.One of
of evolutionary
thecornerstones
organizationaltheoryis
March and Simon's (1958) notionof routines,whichis
an organizational
ofheuristicproblemsolving.
enactment
Nelson
and
Winter
(See
1982.) Studies on innovation
show remarkabletrade-offs
betweencosts and timefor
innovations(Scherer1967,Mansfield1988; see Midler's
1993 discussion). Consequently,because the developmentand use of heuristicsare situatedin particularcontextsthatare onlypartiallyunderstood,
theycan be misapplied. The Cohen and Bacdayan (1994) experiments
illustratethese trade-offs
betweenroutinesas heuristics
and misapplications.
Theirstudyof theemergent
rulesin
a simplecardgame showedthatsimpleheuristics
routines
guided the behaviorof play. Betterroutines,of course,
were associated withbetteroutcomes.When the game
changed,theplayerstendedto engagein "negativetranstheacquiredheuristics
fer,"thatis, theytransferred
to the
new game even thoughinappropriate.
Strategizingis, then,theapplicationof imperfect
heuristicsto problemsolvingand implementation.
Unlikethe
implicitheuristicsthatrepresent
whatArgyrisand Schon
(1978) call "theoriesin use," formalstrategizing
applies
explicitschemasto searchforappropriate
decisions.Nevertheless,the underlyingtheoriesto theseheuristicsare
oftenonly implicit.Even explicitheuristicsare liable to
be appliedto theinappropriate
settingif hiddenassumptionsprove to be wrong.Because complex interactions
markorganizational
choice,thepotentialforthecognitive
misrepresentation
of the problemis large. Thus, an imfeatureofanyframework
portant
is a processofdiscovery
and experimentation.
It is thisprocess thatthe heuristicof real optionsattemptsto impose and evaluate.If strategyis seen as the
choice of capabilitiesthatprovidethe appropriateflexibilityfora stochasticallychanginglandscape,thenit is
criticalto tryto inferthevalue of designand investment
thatprovidesthe flexibility
to respondto opportunities.
An organizationcannot,however,expend all of its resourceson search,norcan itsimplyignoretheimportance
of changeand evolution.A real optionheuristicis a way
to discernthevalue of particularpathsof explorationin
evolvingenvironments.
Moreover,as we developbelow,
it is a heuristicthatis groundedin theoriesof strategy,
organizationalecology,and complexsystems.
746
Strategyand Real Options
The corecompetenceconceptarosein thelate 1980s duringtheheightofreengineering,
propelledby acquisitions
and new information
technologies.It is a directresponse
to thereputedfinancialpressuresfromfinancialmarkets
The
dominatedforthefirsttimebyinstitutional
investors.
formulation
by Hamel and Prahalad(1994) suggeststhat
the initialdata are in the spiritof understanding
the inof thefirm,whichshouldbe groundedin
tendedstrategy
a distinctivecompetence,an idea that dates back to
Selznick(1957).
The theoreticalfoundationsto this view are several,
fromthereasoningaboutwhyknowledgeis hardto imitateto theevolutionary
theoriesof firmgrowth.Froma
decision-theoretic
thecorecompetenceframperspective,
A
ing readilylends itselfto a real optioninterpretation.
real optionis technicallydefinedby an investment
decision thatis characterized
theprovisionof
by uncertainty,
futuremanagerialdiscretionto exerciseat theappropriate
time,and irreversibility.
These threeelementsarejointlyrequiredfortheappliAn optionhas valueonly
cationofa realoptionsheuristic.
ifthereis uncertainty,
therelevantsource
thoughdefining
of theuncertainty
is nottrivial.An operationally
importantelementof designis theprovisionof discretion,
such
as thestagingofan R&D projectto correspond
to discrete
pointsof go-nogo decisions.
is an easily overlookedfeatureand sigIrreversibility
nifiesthe inabilityto costlesslyrevisitan investment
or
decision. Irreversibility
is a subtleidea thatcarriesthe
notionof the arrowof time.2For example,thedecision
to make an investment
todaybears the riskthatthe investedassetscan onlybe sold laterat a discount.In this
is the inabilityto recoverthe incontext,irreversibility
vestment
costsalreadyexpendedfortheproductdivision.
is accentuatedif the divestingof an inIrreversibility
vestmentalso engages costs attachedto the unbundling
of integrated
and coupled assets.
The conceptof irreversibility
is criticalto whyinertia
of organizational
capabilitiesis thesourceof thevalue of
real options.Irreversibility
does notmeanthatfirmscannotchange,orthattransformation
is notpossible.Clearly,
if a firmhad no competitivepressure,it could gradually
implementthe transformation
process.It is because the
benefitsof transformation
decline as competitors
themselves adoptnew capabilitiesthata firmfaces a problem
ofirreversibility
in thiscase. A delaymaylowerthecosts,
buttransformation
comes too late.
Because timehas an arrow,thedecisionto delaymakin knowledgeneededto entera newmaringinvestments
kethas a timesubscript.The value of thisdecisionwill
be different
ifit is considerednextyear;otherfirmsmay
ORGANIZATIONSCIENCE/Vol.
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Capabilitiesas Real Options
have enteredand theearlyrentsare now dissipated.Beentailsa decisionto investin capabilities
cause strategy
foregoingthis investment
to sustaina marketstrategy,
means thatthe firmdoes not have the optionto launch
the strategyif the marketbecomes favorable.However,
The failureof a firm
not all capabilitiesare irreversible.
technologiesat one pointof time
to investin information
outforsuch servicesin the
does notprecludecontracting
to investdiminishes
future.More likely,theopportunity
over timeas otherscome to acquirethenecessarycapaa time dimensionbetween
bilities.There is, therefore,
makinga decisionto investand itsactualimplementation
will change.
duringwhichthevalue of theinvestment
impliesthattheasset shouldbe "scarce"
Irreversibility
and difficult
to replicatein a timelyway in orderto supporta strategyat a particulartime.If, throughimitation
and substitution,
thisfactorwill be moreabundantin the
futureand its value will be less, theoptionvalue is only
to exploittranrealized throughthe currentinvestment
To Barney (1986), the creationof
sientopportunities.3
rentsis fortuitous.
Ifmanagersunderstood
entrepreneurial
the value creationprocess,the knowledgethroughimitationwould lead to theerosionof theserents.
Consequently,a core competenceis a scarce factoras
Barney (1986) definesit, thatembeds complex options
The importantdifferencebeon futureopportunities.
of theresource-basedview of
tweenthisearlystatement
thefirmand core competenceis thelatter'sinsistenceon
thevalue of a resourceas derivedfromitsfuturebutuncertainuse. In thesensethatBarneyrelieson marketvalofuniqueassets,he
uationsto back intohis identification
is consistentwiththeview thatthemarketvalues theuse
to theirpotentialuse by firms
of theseassetsin reference
biddingfortheirownership.Dierickx and Cool (1989)
note thatBarneymakes theincompleteinferenceby iginforFirmsmusthave differential
noringirreversibility.
mationby factorof the arrowof time(or whattheycall
"timecompression").Because it takestimeto build and
absorbcapabilities,a firmcannotspontaneously
replicate
scarce assets. Consequently,some firmswill discover
profitableprojectswherethe "excess rents"are earned
not
through their organizational complementarities,
throughsuperiorinformation.
This conclusionemphasizesthatthescarcityof a core
competenceshouldbe reflectedin equilibriumfinancial
prices,evenifa firmcannotearnexcessrentsbybuyingthis
competencein themarket.This pointis exactlyBarney's
thata marketforscarcefactorsforcesexternal
contention
value oftheinternal
thepresentandfuture
pricesto reflect
to value thescarcityof these
assets.The marketattempts
currentand futurecash flowsgiven
assets forgenerating
a firm'spositionin the market.In otherwords,scarcity
thevalue of a competence.It is
itselfdoes notdetermine
condition.Rather,scarcity
a necessarybut not sufficient
ifthecompetencepermitsa firmto achieve
is interesting
positionin themarketplace.
a competitive
Some writersfail to make thisobservationaltogether.
For example,Teece et al. (1997, p. 516) writethat"core
competencesmust accordinglybe derived by looking
products
acrosstherangeof a firm's (and itscompetitors)
and services."This statementis, however,seriouslyincomplete.The missingelementin this analysis is, of
course,thescarcefactormarket.A firmmaybe well ento
forcompetitors
dowed withpatentsmakingit difficult
these
questionis whether
imitate.However,theimportant
whichwe mightalso call moregenerically
endowments,
theknowledgeof thefirm,is usefulnotonlyto current,
but also to futureapplications.This questionis not answeredby a notionof dynamiccapabilities,or of comcriterion
is the
binativecapabilities,unlessthenormative
in core competencein refidentification
and investment
must
bydefinition,
erencetopotentialuses. Thiscriterion,
considerthe marketand the positionof the firm.This
objectionis notpetty,foritis easy to imaginethatwithout
marketdisciplineon theanalysis,thepotentialcandidates
forcore competencequicklymultiply.
Thereis anotherway to thinkaboutthisproblem,sugalong
gestedby Winter(1987), as a broaderformulation
the lines of optimalcontrol.Winter(1987, p. 180-181)
theorycomes the idea thata
states,"Fromevolutionary
statedescriptionmay includeorganizationalbehavioral
orroutinesthatarenotamenabletorapidchange,
patterns
definedassets.It is by
as well as ... moreconventionally
thatfallunder
thisroutethata varietyof considerations
therubricsknowledgeandcompetencemayenterthestraoptimalcontrol
Conventionally,
tegicstatedescription."4
and
of theenvironment
describesthestatecharacteristics
allows thedecisionmakerdiscretionover a few control
variables,e.g., technologiesor output.Winter'ssuggesof caand opportunities
tionis to capturetheconstraints
pabilitiesthrougha richerdescriptionof the statevariables. It is thisinsightthatwe use below in our formal
treatment.
The OrganizationalEcology of
IrreversibleInvestments
The conceptof core capabilitiesas embodyingexplorato hedgethefuturerunscounterto some
toryinvestments
streamsof thoughton organizationaldesign. Organizaas threathas vieweduncertainty
tionaltheoryhistorically
ofthetechnicalcoreofan organization.
eningthestability
avoidance,"March
By proposingtheidea of "uncertainty
2001
ORGANIZATIONSCIENCE/Vol. 12, No. 6, November-December
747
BRUCE KOGUT AND NALIN KULATILAKA
Capabilitiesas Real Options
and Simon(1958) suggestedthatan organization'sdesign
ofeliminating
servesthefunction
variance.Thisidea also
appearsin Thompson's(1967) landmarkbook thatanalyzes the manyways thatfirmsbufferthemselvesfrom
uncertainty.
Similarly,Pfefferand Salancik (1978) motivatethetheoryof resourcedependencyas thecreation
of organizationalmechanismsto reduceuncertainty.
The contribution
of organizationalecology is to formulatemoreexplicitlytherelationship
betweenenvironmentaluncertainty
and organizationalstrategiesin a dynamicsetting.In particular,
Hannanand Freeman(1977)
thatchange smoothly
distinguishbetweenenvironments
fromthose whose change is granular,i.e., moreabrupt.
This distinction
betweentwokindsofuncertainty-adistinctionthatwe exploitmathematically
below-implies
thatin granularand uncertainenvironments,
generalists
will do betterthanspecialists.This notionof generalists
is definedoperationallyin theirempiricalworkas organizationswhosecompetencecorrespondsto a broadarray
of possibleenvironmental
outcomes.
Givenits stresson inertia,itis no doubtsurprising
that
organizationalecology implies option thinking.In the
framingof options,generalistsare organizationswhose
competenciesare robustacross manyfuturestatesof the
world. The formulationby Tuma and Hannan (1984)
makes the analogybetweenoptionsand survivalstrategies moreexplicit.They notethata hazardmodel is the
probabilityof hittinga lower boundaryin a stochastic
diffusionprocesswhichgovernsthegrowthof theorganization.Indeed,theconditionalprobability
ofexercising
theoptionis also thehazardof hittingtheboundaryof a
diffusionprocess. The differencebetweenthe two approaches,of course,is thata real optionmodeltypically
considersthe upperboundary,thatis, theprobabilityof
increasinggrowthby exercise ratherthan the implied
in organizational
strategy
ecologyof minimizing
thehazardof death.5The inertialqualitiesof an organization
are
consequentlycentralto understanding
the value of a
firm'sassetsforfuturedeployment
giventheuncertainty
and graininessof the environment.
Indeed, it is exactly
because of McKelvey's (1999) contentionthattheenvironmentchanges more rapidlythan organizationsthat
thereis value in investingassets to respondto future
changes.
The boundaryproblemin organizationalecology is
based on the same presumptionas for real options,
namely,thatan organizationconsistsof a reservoirof
inertand irreversibleresources.Organizationecology,
like organizationaltheoryin general,has soughtto separate out featuresof the organizationthatcan be easily
changedand henceperipheralfromthose thatare inert
748
and hence core. FollowingThompson,thecore has frequentlybeen regardedas technical,a pointof view also
adoptedby Scott(1995).
Core andperiphery
implya dimensionofdistance.This
notionof distancein core and peripheryis one of the
hardestconceptsin organizationalscience,and yetit is
also foundin thefundamental
organizational
conceptsof
local versus exploratorylearningand radical or incrementalinnovation.These conceptsshare the idea that
firmscan be mappedontoa multidimensional
space repof technologicaland orresenting
different
combinations
ganizationalpractices.(In the next section,we turnto
this space as rugged.)To simplifythese
understanding
dimensions,considera two-dimensional
space withthe
coordinatesrepresenting
a combinationof a technology
and organizationalpractices.The notionof inertiaposes
the questionof whetherit is easier to move along the
technologicalor organizationaldimensionsif one wants
to change.
on innovation
The organizational
literature
has implied
thatthetechnologicaldimensionis especiallyproblematic
betweenincremental
and
by emphasizingthe difference
radical innovation.The dimensionof organizationapTushman
pears as independentfromthisconsideration.
and Anderson(1986) have offeredtheinsightthatinnovationscan be characterizedas radical or incremental,
dependinguponwhethertheydestroyor enhancea firm's
competence.(See also Henderson1993.) This reasoning
thattheradicalness
ultimately
leads to theconsideration
of an innovationhas less to do withthe noveltyof the
withexistingknowledge
technologythanits conformity
of thefirm,
i.e., thewaysby whichworkis organizedand
Because theway workis organized
poweris distributed.
will varyby firms,
thentheradicalnessof a technological
innovationcannotbe determined
of a particindependent
ularorganizational
context.Switching,or adoption,costs
are stronglycontingenton the currentorganizationof
work.
One of themostperplexingquestionsin organizational
behavioris thefailureto identify
clear matchesbetween
technologiesand organizationalstructures.
(See the review givenin Dosi and Kogut 1993,and thesummary
of
the workcomparingU.S. and Japaneseorganizationsin
Lincoln 1993.) Dosi and Kogut(1993) proposedthatthe
failureto findrobustrelationshipshas been due to the
tendencyto theorizeelement-to-element
correspondence,
such as highvolumeproductionwithverticalhierarchy.6
The empiricalresultsdo notshowthattheseare complementswhen otherfactorsare controlled.Alternatively,
Dosi and Kogut suggestthatthe correspondence
might
be setto set,wherea setof organizational
practicesmaps
ontoa set of technologies.The data mightnotrevealthat
ORGANIZATIONSCIENCE/VOl. 12, No. 6, November-December
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BRUCE KOGUT AND NALIN KULATILAKA
Capabilitiesas Real Options
A and B existas complements;all we observeis A and
need not be unique
C and D and B. Complementarities
but they
betweenany giventechnologyor organization,
stillshouldbe relationallybounded.The recentfindings
by MacDuffie(1996) on "bundles" of humanresource
practicesin autoplantsindicatethatthereis a logic which
relatesorganizingpracticesto each otherand to technologies. The experienceof GeneralMotorsand othercar
is thatadoptingthe new capabilitiesof
manufacturers
flexibility
and speed requireschangesin automationand
organization.Between these two sets, thereare many
equivalentcomplements,but thereare no
functionally
correspondences.
uniqueelement-to-element
This descriptionalso capturesDosi and Kogut's idea
of coevolutionof technologyand organizationthrough
two key features.First,technologyand organizationdo
nor is theircoupling
notrepresentrandomassignments,
simplyat thediscretionof managers.Rather,thematches
of a technologyand organizingprincipleare constrained
However,within
correspondence.
to reasonableset-to-set
intechimprovements
constraints,
"developmental"
these
nology and organizationare correlatedthroughexperiofmechanentiallearning.For example,theintroduction
ical equipmentto move thechassis fromone line to the
next requiredthe organizationalinnovationto increase
the "tightness"of the couplingof serial workprocesses
in thefactory.In otherwords,technologyand organizationare dynamicallycoupled in theirevolution.
The costs of alteringtightlycoupled componentsof
technologyand organizationimplythatfirmswill persist
of thenet
in theirold ways beyondtherecommendation
presentvalue. This persistencedefinesa rangeof inertia,
or what is called a hysteresisband. Because organizamanandhencediscontinuous,
tionalchangeis disruptive
their
organizations,
agers hesitateto radically change
hopingperhapsthatfuturestatesof theworldwouldproto the
Thus,contrary
vide moreappealingenvironments.
normativevalue in respondingflexibly,inertiais rationifchange
allyencouragedin highlyvolatileenvironments
is granular.
is costlyand theenvironment
of thispoint.A
Figure 1 providesa simpleillustration
systems,
firmcan choose betweentwo complementary
called low and high variety.The importantissue is
whetherthe relativevalue of gainingthe capabilityof
varietyis enough to offsetthe costs of discontinuous
change.The choice of capabilitiesis, as we depictit,derivedfromthe marketprice placed on variety.Because
over theevolutionof thevalue of variety
of uncertainty
and the costs of adoption,managersrationallymight
techniquesbeforetheyare
choose to persistwithinferior
offuture
Inertia,then,is notsimconfident
developments.
of stickiness,butreflectsexpectationsreply a property
gardingthe value and costs of change.Inertiaincreases
hesitant
because managersarerationally
withuncertainty,
to incurthe cost of change to capabilitiesthatmay berevertsto its
come easily worthlessif the environment
previousstate.(Clearly,inertiacan also stemfromconsiderationsof loss aversionor statusquo bias of managers.)
In a normativevein,it standsto reasonfromthepoint
of view of an organizationalecology thata firmshould
experimentin activitiesthatpromoteits futuresurvival
(Lewin and Volderba 1999). In thissense,organizational
bias of
ecologyoffersan escape fromtheinward-looking
Forenhancingfuture
view of strategy.
theresource-based
thatcorrespond
survival,a firmshouldinvestin platforms
to expectationsregardingthe evolutionof the external
Platformsare technologicaland organizaenvironment.
thatpermita firmto enterintoa wide
tionalinvestments
menu of futuremarkets.Firmsthatbuild generalplatformsare more likely to surviveand grow (Kim and
Kogut 1996). It is exactlythe evaluationof this correspondencebetweenexplorationof new capabilitiesand
thatis provided
theevolutionof themarketenvironment
by theapplicationof a real optionsheuristic.
ComplexAdaptiveSystemsand Option
Theory7
A hallmarkfeatureof complexsystemsis therecognition
change is markedby sharpnonlinethatenvironmental
arity(Lewin and Volderba 1999). An optionis defined,
on
thatare nonlinearand contingent
of course,by returns
is
not
it
surprising
thestochasticstateoftheworld.Hence,
in complexand nonthatoptionvaluationis appropriate
linearenvironments.
To avoid confusion,we distinguishbetweenexperimentationand marketexploration.Search is the applicationof productsand servicesto new marketsand landis thelearningofnewtechniques
scapes.Experimentation
and combinationsof technicaland organizationalelements.In practice,themarketsearchand experimentation
it is confusing
are likelyto be linked,and,consequently,
is
It
on theirseparation. nevertheless
to insisttoo strongly
usefulto rememberthatnew ways of doing thingsand
addressingnew marketsare notthesame. To understand
whatinnovationstreamto choose and whatkindsof flexibilityto develop requiresan evaluationof the implicaand marketexplorationforthecontionsof experiments
toursof the innovativelandscape. For this,we need to
of theenvironment
matchmorecloselythe stochasticity
of organizational
new
combinations
of
to experiments
elements.
and technological
contourgeneratedby
A landscapeis theperformance
2001
ORGANIZATIONSCIENCE/Vol. 12, No. 6, November-December
749
BRUCE KOGUT AND NALIN KULATILAKA
Figure 1
Capabilitiesas Real Options
The Implications of Hysteresis on the Choice of
New Techniques
Variety
Hysteresis
Band
.
.......-...i
B
Method
ofOrganizing
A:
B:
A
Time
Mass Production
Toyotaism
theaggregationof each firm'spositionin a multidimenofresources.Withsionalspace givenbyitsconfiguration
it represents
distance
out imposinga core and periphery,
among organizationaland technicalfeaturesin a multias "there"or
dimensionalspace. (If featuresare identified
"notthere,"thenthemeasureof proximity
is theEuclidean hammingdistancein a multidimensional
space.) The
ruggednessofthelandscapeimplies,muchlikethetheory
of strategicgroups,thatfirmscompetearounddiscrete
combinationsof resourceswhichcorrespondto different
marketniches,or whichprovidefunctionally
equivalent
methodsof production.Movingfromone to theotheris
problematicbecause competenciesare scarce(thatis, difficultto imitate)and also because a landscapecoevolves
throughcompetitiveinteractions.
A usefulheuristicin thiskind of representation
is to
know the value of directionalchange in the landscape.
The value of changingresourcesand hencechangingpositionin thislandscaperequiresan evaluationof thecost
of change against the futureunknownreward.This is
whatoptiontheorydoes; itputsa value on theinvestment
in thecapabilityto changepositionin thelandscapecontingenton the environmental
outcome.It does this by
inferring
fromtoday's marketvaluationsthe expected
value ofchangingpositionin thefuture.
Unlikethefitness
landscapesfoundin organizationalecology and biology,
real optionslooks at thevalue of a position,wherecontourscorrespondto different
valuationsplaced on theassets of an organization.
Complexadaptivesystemthinking
has founditdifficult
to give heuristicadvice otherthantheimportanceof creatinga processby whichto respondto uncertainty.
In his
thoughtful
conclusionto a special issue on complexity,
Cohen (1999, p. 375) concludesthataimofrecent"efforts
is not so mucha theorythatpredictswhata givencomplex systemwill do, butrathera framework."
However,
750
needs to providedecisionheuultimately,
a framework
risticsto evaluatechoices.
in organizational
The normativeliterature
theory(e.g.,
Tushman and O'Reilly 1997, Brown and Eisenhardt
1998) has in recentyearsrecognizedthevalue of flexible
as an organizational
caresponsesto radicaluncertainty
Brownand Eisenhardt
pabilityin complexenvironments.
(1998, p. 151) explicitlyconnectprobes with options
If thefutureevolutionof opportunities
was obthinking.
ofchangein one
vious,thena firmcould focustheefforts
direction.However,because the directionof change is
unknown,itpays to investin probing.But clearly,a heuristicto choose theprobesis required.
ofprobesas options
It is usefulto marrytheperspective
withthe idea of a ruggedlandscape,an idea thatoriginates in biologybut thathas usefulapplicationsto untheperformance
derstanding
implicationsof complexinteractionsamong complements.(See Kauffman1993,
Levinthal1997,McKelvey 1999.) Considera firmthatis
conlocated neara local peak. Holdingits environment
stant,probingconsistsof learningaboutsuperiorwaysto
combineits technologicaland organizationalelements.
By learning,we implya notionof knowledgethatis incompleteand notentirelyexplicitlyunderstood.It is incomplete,as suggestedby theobservationthatfirmsinto improveexistingpractices.It is
novateincrementally
partlytacit;or else firmswould easily convergeto best
to theset-to-set
discussionin Dosi and
practice.To return
Kogut (1993), local learningis thediscoveryof thecorrespondencebetweennew elementsin theexistingsetof
techniques.
The case oflocal learningis different
thanmovingfrom
one peak to another.Moving to a new peak impliesan
architectural
change in the language of Hendersonand
Clark (1990). Such changeis no longerexperimentation
aroundindividualmodules,but requiresa complex redesign aroundnew sets of technicaland organizational
elements. Normally, radical architecturalchange is
viewedas incurring
catastrophic
risksbecause of,forexample,a competitor'sintroduction
of a productthatrequiresa majorchangein a firm'scapabilities.But in fact,
suchchangecan be orchestrated
through
explorationand
experimentation
thateffectively
builds ridges between
peaks.
Baldwin and Clark (2000) proposea real optionsapproach for understanding
the choice of modules when
outcomesare unknown.The explicitvaluperformance
ationof theactivityof experimentation
raisesan importantissue of the design of the firm.It would seem, arguably,thatthe best designforexplorationis based on
modularity,
wherebya firmcan pick and choose thebest
components.Since modulesmightbe viewedas independentexperiments,
a reasonableinferenceis thatthefirm,
ORGANIZATIONSCIENCE/Vol. 12, No. 6, November-December
2001
BRUCE KOGUT AND NALIN KULATILAKA
Capabilitiesas Real Options
like a market,should be designed aroundindependent
teams.This argument
is, in fact,congruouswithSimon's
(1969) argumentof the social decompositionof organiunits.
zationsintorelativelyindependent
of Baldwinand Clark(2000)
The heuristicframework
cannot,however,be applied to thecase of radicalarchiproblem
tectural
change.Thisis no longera mix-and-match
of modules,but represents
the switchfromone conjoint
set of technologicaland organizationalcorrespondences
to a new set. In thisenvironment,
a firmcannotexploit
its path dependence.It rathermustevaluate the distant
contoursof the value landscape and decide the optimal
timingto switchnew capabilities.As we will show,this
problemis, in fact,less severethancommonlyportrayed
because explorationpermitsthe buildingof ridgesbetweenvalue peaks.
LookingOutsidetheFirm:
MarketPricing
in new capabilities?
How shouldwe value an investment
Clearly,thevalue of a capabilitydependsnotonlyon the
internalassets,butalso on how thoseassetsaredeployed,
and on theexternalmarketconditions.Thus,thepriceof
a correlatedasset in therelevant"scarce factor"market
representsthe initialpointof departure.The value of a
capabilityis theninferredfromthe observedprice dynamicswhichreplicatethepayoffto therealoption.This
whichmarketdiscipline
replicationis thedevice through
and selectionof core cais imposedon theidentification
pabilities.It is notthestaticcomparisonof thecapability
and strategicfactorthatmatters,but rathertheinformationthatis gleanedin thechangesin pricesovertime.
consideragain theframing
To elucidatethe intuition,
of a real optionsproblem.The organizationalassetsof a
A FormalDescription
firmprovidean optionto spenda fixedamountto procure
To grounda heuristicof real optionsin positivetheory, a new capabilitybypurchasinga physicalassetat theend
we have indicatedthe commonalitiesin strategy,
orga- of one year.If theoptionis exercised,thentheresulting
nizationalecology,and complexsystemsbypairingthree projectvalue has the risk characteristics
of an existing
asset,irre- tradedfirm.For example,a pharmaceuticalfirmis conconceptsof scarcefactorsand theunderlying
versibility
and inertia,and thelandscaperuggednessand
has a
sideringan entryintobiotechnology.It currently
optionvalues.To makethesepairingsexplicit,we present strongcapabilityin conventionaldrugdevelopmentthat
below a formaldescriptionthatgroundstheheuristicsof
providesan optionto enterintobiotechnologyat an esrealoptionsin organizational
theory.We makeuse ofthe timatedcost.This cost is idiosyncratic
to thisfirm.Howfollowingthreeprincipalideas. First,thestickinessofor- ever,once it entersintothemarket,itsnew businesscarganizationaland technologicalcombinationsrequiresa
ries a marketrisk similarto otherbiotechnologyfirms.
as indicatedby
notionof time,thatis, of irreversibility
whythepriceofotherfirmsdoes
This exampleillustrates
the dynamicmarketvaluationof organizationalassets. notgivethevalue of thecore capability,because thecost
(There are, of course, start-upand transactioncosts, of entryis idiosyncratic
to each firm.However,theprice
intoswitchingcosts.) Second,that dynamicsof otherfirmsprovideinformation
whichwe incorporate
on thefacdistancein discretecombinationsresultsin a radicaldif- tors(e.g., risk)thatdrivethevalue of theoptionto enter
of modules in thismarket.
ferencebetweenlearningand recombination
withina familyof organizationand technicalelements,
The value of a financialoptiondependson thecurrent
can be
as opposed to betweenfamilies.Last, uncertainty
shareprice.Because thesourceof thisexogenousuncertradedmarket
decomposed into continuousand granularmeasuresof
taintyis the marketprice of a frequently
financial
change.
share
of
options
stock),
financialsecurity(the
We seek below to offerthe theoreticalunderpinnings can be dynamicallyreplicatedwitha portfolioof stocks
to understanding
As a result,derivativescan be
capabilitiesas an option,not to value
investments.
and risk-free
a realoption.(DixitandPindyck1994andAmram valued withoutknowledgeof theexpectedreturnearned
explicitly
financialasset.
and Kulatilaka 1999 provide a thoroughcollectionof
by theunderlying
suchapplications.)For manyapplications,thereexistreaFor a special but important
case, Black and Scholes
has
sonableavenuesof valuation.The formaldescription
(1973) derivedthisvalue throughan optionpricingfortheimportant
mula. The simplebut criticalinnovationwas theirevenadvantageof clearlydefininga core comthatbycomposinga replicating
portfolio,
tualrecognition
petence in referenceto a marketvaluation,as well as
between the value of the optioncould be perfectlytrackedby a
providinga clear statementof the trade-offs
learningand exploitation,on the one hand,and experi- leveredpositionin the tradedstock.It is, however,unreplicatedwith
mentationand explorationon the other.The graphs, likelythatreal optionscan be perfectly
the
functions
and par- tradedassets.The replicationmayrequire use ofprodwhichare drawnbased on linearprofit
uct or factorprices.Even whenwidelytraded,theprices
and
ticularparametervalues, illustratesthesetrade-offs
of such real assets need not appreciateat a rateequal to
switchingpoints.
ORGANIZATIONSCIENCENVol.
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Capabilitiesas Real Options
its equilibriumrisk-adjustedreturn.Instead,ownersof
real assetswill reap variousconveniencebenefitsand incur carryingcosts thataffectthe total returns.In such
cases, valuationrequiresknowledgeof the actual price
dynamicsof the factorprice and the equilibriumriskadjustedreturn.
As an initialproposal,we suggestthatthetheoretically
mostinteresting
theappropriate
wayto identify
correlated
asset is to decompose the marketprice into a bundleof
attributes
thatpiercestherevenueveil of thefirmto see
the underlyingassets. Whereasthis analysisis unquestionablyhard,it should be recalled thatit is consistent
bothwiththefinancialmarketpressuretounderstand
(i.e.,
strip)assets and thegrowthof derivativesto hedge specific componentsof a firm'srisk.From this angle, the
value of thecapabilitydependson its contribution
to the
priceof productor factorpriceswhose riskis spannedby
tradedassetsin theeconomy.The value of thecapability
is thusobtainedby explicitlyspecifyingtheprofitfunctionusingthesepricesas an argument.
To identifyand value a core competence,we must
specifytheevolutionofthequality-adjusted
pricethatwe
call 0. A simpleexampleis a microprocessor,
wherebya
quality-adjusted
price can be expressedas the ratio of
price to the processingspeed (or "mips" formillionsof
instructions
persecond).Since we cannotdirectly
observe
thisprice,we can choose the stockprice of a firmspecializingin microprocessors
to give theestimatesforthe
volatility.However,because 0 is nota puresecuritybut
is theobservedpriceof a scarce factor,its pricecharacteristicsneed notnecessarilyevolve accordingto itsequilibriumrisk characteristics.Local supply-and-demand
conditionsand technologicalinnovationdeterminethe
evolutionof 0. We want to sortout smoothlyevolving
fromdiscretegranularshocks.We assume 0
uncertainty
to be exogenouslydeterminedand characterizeits evolutionby stochasticprocess
technicalchange.For example,an increasein oil prices
would lead consumersto prefercars whichsave in fuel
As longas thesechangesarefairlysmooth,
consumption.
in volatilit seems reasonableto capturethisuncertainty
in theenvironity.This termrepresentstheuncertainty
mentaroundthelocal peak.
Otherchangesmaybe moreradicaland appearas discontinuousPoissonjumps,such as thearrivalof new orand is a measureof thegranuganizationalinnovations,
These changeswould appear
larityof the environment.
as a suddenjump in priceto a firm.
The qualityadjustedpriceapproachto buildinga valuation model faces potentialproblems.The argument
hingeson thepremisethattheriskprofileof thevalue of
the innovationis spanned by quality-adjustedprices.
However, the quality-adjusted
price is derivedfroma
model of the industrypricingbehaviorand can suffer
from"modelingerror."Furthermore,
thequality-adjusted
pricemaynotperfectly
trackthevalue of theinnovation
and may introducea "trackingerror."This erroris akin
to basis riskin commoditymarketswherethepriceof a
commodityis specificto itslocation.Finally,notbeinga
securityprice, the quality-adjusted
price can embed a
conveniencevalue thatis not easily observedor estimated. For the arbitrage-basedvaluationapproach to
work,theerrorcomponentsmustbe independent
of each
otherand have no systematic
risk.Hence,expertopinion
may providea superiormethodto formprobability
distributions
ofpossiblefuture
marketconditionsforthenew
businessin radicallynew landscapes.
Looking Inside the Firm: CapabilitySets
Even iftwofirmsare competingin thesame industry
and
market,movementin pricesof the strategicasset influences differently
theirvalue because of the relationship
betweenthecapabilitiesof thefirmand theprofitopportunities.To describethisformally,we make use of the
~
+
(O t) At
Ato =
notionof distance-which we showedto be a common
assumptionin strategy,
organizational
ecology,and comDeterministic
Growth
plex systems-betweendiscretecombinationsof technologyand organizationalelementsthatdefinea capa+
Kdq
G3(Ot, t) AZt
bility.We firstdevelopthenotionof a capabilitysetand
Smoothly
evolvinguncertainty Discreteinnovations thendefinetheprofitfunctionof a firmin relationto its
set of organizationaland technologicalpractices.
where,uis theexpectedgrowthrateof 0, 6 is its instanFor convenience,we considerthecase of an automotaneousvolatility,
dq
bile producerchoosingto staywithinthe currentset of
AZ, is standardNormaldistributed,
is a Poisson processwithintensity
parameterX,and K iS
mass productionor switchingto new high-performance
therandompercentage
jump amplitudeconditionalon the combinationscalled lean production(See MacDuffie
Poisson eventoccurring(Merton1976).
1996). A firmhas the set of capabilitiesc, wherec E C
Changes in the quality-adjusted
price may reflectun- is the set of all feasiblecapabilities.In our case, C conpredictableshiftsin consumerpreferences
or incremental tains "mass" and "lean" productionfamilieswiththeir
752
ORGANIZATIONSCIENCE/Vol. 12, No. 6, November-December
2001
BRUCE KOGUT AND NALIN KULATILAKA
Capabilitiesas Real Options
associatedorganizationalstructures.
Each familyof productiontechniquescan containmanydistincttechnologies. They are, however,coupled withthe same organizational structure.
Hence, a technologyfamilyrefersto
all technologiesthatcan be operatedwithina singleorganization.
Suppose thefirmis currently
employingtechnologyin
the "mass" productionfamily,i.e., cmE CmE C. The
firm'sproblemis to decidewhatcapabilitiesitshoulduse
in thecurrent
period.Specifically,
itschoicesare (a) continueusingci , (b) continuein thesame familybutmake
incremental
technologicalimprovements
by employinga
bettermass productiontechnique,c4,j or (c) make a discontinuousorganizationalswitchand employlean productiontechnique,c 1. Choices a and b reflect
"as is" evaluations; only c involves a "could be" alternative.We
capturetheidea of inertiathroughthereorganizing
costs
incurredby switchingfromone capabilityto another,be
it frommass intolean, or conventionalpharmaceutics
to
biotechnology.We denote these large organizational
costsof switchingas Aiy.
For example,thecostof switching fromcn(mass production)to cl (lean production)can
be denotedas Aml.In practice,switchingbetweencapabilitieswill consumetime,as Dierickxand Cool (1989)
note.Our model assumesthatthereis an inversemonotonicrelationshp
betweencost of switchingand thetime
to
taken switch.Hence,a switchthattakesmoretimewill
be represented
by a higherswitchingcosts.
Withinan organizationalcapability,switchingcosts
betweenmodulesare small,but notinsignificant.
At the
withinthesame familyenablesthe
same time,continuing
firmto capitalize on local learningeffects.If the firm
continuesin cmor moves to a bettermass techniqueci,
then it will subsequentlylearn by doing. However,
switchingfromthe ith to thejth technologymay still
incurtechnologicalcosts. We definethe local learning
benefitsin mass productionas -6 mm
and technological
switchingcosts 6ii.
To summarizethe magnitudeof switchingcosts betweenall combinationsof capabilitiesand technologies,
we denotethecost of switchingfromcmcapabilityto c4
as:
6m1i
iml =Tij
Technologicalchange
+
Qml
Organizationallearning
where
cost
technological
Ti -
if i 0 j
if i = j
-bij
6ii
technologicallearning
organizationalcost
Oml
Omm
if m = I
if m = 1.
organizationallearning
We can now writedownthefirm'sobjective.Each set
of capabilitiescm has an accompanyingprofitfunction
whichis obtainedby solvingtheusual profit-maximizationproblem:
H(O, c')
=
max O.y
YECM
inputand output
where0 is a vectorof quality-adjusted
pricesand y is thevectorof inputand outputlevels that
are determined
by thecapabilityset.This simpleexpression indicatesthatthe firm'sabilityto choose the best
on its organizationalresources.
is contingent
strategy
DynamicValuationoftheCritical
CapabilitySet
thecurrent
Whenfuturevalues of 0 evolve stochastically,
decision influencesall futuredecisionsas well. The decision by a mass producerof cars to investin flexible
runstheriskthatthe
usinglean production
manufacturing
Americanmarketsuddenlydecides to buy large recreational vehicles made best by standardmass production
techniques.But now theyface theproblemthattheyare
and cannoteasily switch
investedin lean manufacturing
back. The tightcouplingof organizationand technology
why capabilitiesradically
is essentialto understanding
of strategyas not only the
change the understanding
choice of enteringmarkets,but also as the selectionof
competence.
The way to fullyanalyzetheimplicationsof inertiais
to writeout explicitlytheproblemovertime.To do this,
butinwe no longerworkdirectlywithprofitfunctions,
steadwitha value function.While technicallythisprobis bothintuitive
lem is oftenhardto solve,itsformulation
treats
At a pointin timet,thisformulation
and insightful.
thepresentvalue of all futurebenefitsgivenoptimalfuture behavior, as representedby the value function
2001
ORGANIZATIONSCIENCE/Vol. 12, No. 6, November-December
753
BRUCE KOGUT AND NALIN KULATILAKA
Capabilitiesas Real Options
V(Ot,cl ). The value functionis thesolutionof thewellknownBellmanequation:
V(Ot,Cl)
=
Figure 2
Static and Dynamic Hysteresis
Profits
0.80
max
0.6006'capability
r(H(Ot, ci)
6alJ) +
-
0.50
pEt[V(Qt+,,
c1')I,
--r
c** = argmax L(H(Ot, cl)
-
65ij) +
pEt[V(Ot+1, cl)].
-
2 givenI'
.capability
.
- '-+
"capability1 given2"
Breacevenpoint:
"swtchfrom2 to 1n
iBreacevenpoint.
0.10
0.00
r
" capability.
-
0.30
0.20
2
,
0.40
wherecl is thecurrent
capabilitycAchosenfromtheset
of feasibletechnologiesand organizationsat timet + 1.
This formulation
is Winter'soptimalcontrolsuggestion
whichincludesorganizational
knowledge,orcapabilities,
as a statevariable.
The Bellmanequationhas an intuitively
appealingformulation,forit directlyevaluatestheexploitationof the
choice of currentcapabilities(the firsttermin brackets)
withthevalue ofpersisting
or switchingin thefuture(the
second term).This equationindicatesthatin each period
theproducercontemplatesswitchingintoa new capability. If it chooses capabilityc4, it realizes benefitsof
costsof6 ml, andthenarrives
HI(Ot,c4),butpays switching
at thefollowingperiodwithvalue functionV(Ot+
1,cJ).
This value dependson thecapabilitychosen,ci, as well
as on the value of the statevariable nextperiod,Ot+1.
? was stillunknownat timet, we take exBecause Ot+
pectations;we also discountat ratep. (See Pindyck1991
and Kulatilakaand Marcus 1994 fora moreexplicittreatmentof systematic
risk.)
In each periodtheproducerchooses thecapabilitycl,
thatmaximizesthevalue of theproject.This choice can
be interpreted
as definingthedynamiccapabilityas
c4
Band .............. .Dynamic
Hysteresis
-
0.70
"witcllfromI to2"
0.00
0.20
0.40
0.60
0.80
1.00
Quality Adjusted Price (0)
a criticalconceptbecause it shows thatinertianeed not
be the consequenceof myopiabut is itselfsensitiveto
environmental
turbulenceand to a firm'scompetence.A
morecompetentfirmis, ironically,moresubjectto inertia.
The band betweenthe switchingcosts is underestinet
breakevenprofits,
matedby comparingsingle-period
of switchingcosts,underthetwocapabilities.Because of
thepossibilitythat0 mayrevertback to previousvalues
(e.g., because of a suddendropin oil pricesfavoringgasguzzlingcars), the firmpersistsin its currentmode and
waits to see how prices evolve in the future.At some
point,however,0 takeson values thatjustifynotonlythe
one-time switching costs but also the probabilityweightedcosts attachedto switchingback. If a firmis
unable to choose the optimalresponse,theseconditions
lead to a competency
trapthatis expressedbya hysteresis
band. In Figure2, theprofitfunctionsfortwo capability
setsand theresultinghysteresis
band is graphed.
In the absence of switchingcosts,the solutionto this
optimizationproblemis simple: Choose in each period
Traps and Learning
thecapabilitycl thatmaximizesHl(Ot,cl) in thatperiod. Competency
This is the static critical capabilitydiscussed earlier. to Learn
Because of thebenefitsof learningby doing,simplyexHowever, the presence of switchingcosts makes a
forward-looking
analysisnecessary.In thecase of costly ploitingcurrentcapabilitiesleads to cumulativeand inIn effect,theprofit
function
can
reorganization,the probabilitydistributionof future crementalimprovement.
outwardovertime.By stayingin
prices affectsthe currentchoice of technologyand or- be describedas shifting
itscurrent
activities,thefirmbecomesincreasingly
more
ganization.
Techniquesof mass production
are expressed
This definition
of a dynamiccapabilitydefinesourre- competent.
routinesthatcouple technologyand
of a "core competence."Core competence in well-understood
interpretation
people throughknownorganizingprinciplesof work.
is thecapabilityset(i.e., combinationof organization
and
The dangerremains,of course,that0 will suddenly
technologyelements)thatpermitsthefirmtodynamically
in whichthe
choose the optimalstrategy
fora givenpricerealization jump to a rangeor crossa criticalthreshold
firm'scompetenceis no longerprofitable.
In a sense,its
of thestrategicfactor.
accumulatedlearningin theold techniquesis a "competencytrap." (See thediscussionin March 1991.) Yet, as
Hysteresisand Inertia
a consequence,byimproving
in massproduction,
itis less
Withtheabove concepts,we can now analyzemorefully attractive
to changeorganizational
capabilities.Hence, a
thehysteresisband firstgiven in Figure 1. Hysteresisis
firmmightrationallypreserveits way of doing things
754
ORGANIZATIONSCIENCE/VOl. 12, No. 6, November-December
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Capabilitiesas Real Options
because it has become so good at doingthe(now) wrong
thing.Dougherty(1995) has labeled this "core incompetence."Exploitationofcurrent
knowledgedriveslearning by doing;thepitfallis thatthislearningincreasesthe
rigidityof thefirm.
To speed itstransition
to new techniques,thefirmmay
decide proactivelyto allocate fundingto explorationby
experimenting
withnew techniques.This diversionofresourcesslows downitsaccumulationof learningwiththe
currenttechnology.At the same time,it increasesthe
value of theoptionto switchto new capabilitiesby loweringthe costs of switching.To characterizethiswider
menuof choices,Figure3 depictsthedecisionof a firm
thathas accumulateda particularbreadthof knowledge
in thecurrent
productiontechniques,as well as in learningderivedfromexperiments
withnewmethods.(We can
thinkoftheseexperiments
as 'joint ventures,"
suchas the
NummiventurebetweenGeneralMotorsand Toyota.)
The neteffectsof learningare ambiguousand depend
upontherateby whichnew knowledgeis gainedthrough
In Figure
learningby doing relativeto experimentation.
4, this comparisonis graphedby showingthe upward
change in profitfunctionsover time due to these two
learningeffects.By construction,
we show the gains to
experimentation
dominatinglearningby doing. Thus,
whileitis a truismthatfirmsneedto balanceexploitation
and exploration,the possibilityfor local learningmay
driveout distantsearch(Levinthaland March 1993).
Thereis a moreimportant
insightprovidedby theinvestmentsin exploration,namely,thatthe literature
on
innovationoveremphasizesthe difficulty
posed by discontinuouschange.In morecontemporary
parlance,the
prospectsof successfulradicalchangeare viewedas poor
because the chance of jumping fromone performance
peak to a distantpeak is consideredimprobable.But exploratoryinvestments
permitthe buildingof ridgesbetweenpeaks. By exploringthecurrentassetsthatcan be
Figure3
ExpandedCapabilitySets
Familyi+1
Familyi
Timet
- - -
Familyi+2
_
Experimental
leaming
Producton
knowledge
inFamily;
Continue
Time t+1
Producton
knowledge
Experimental
leaming
toFamily
i+1
Switch
Production
knowledge
ORGANIZATIONSCIENCE/Vol.
Experimental
leaming
Figure4
Effectsof Learning
Profits
"Lean ProductionFamily"
t+2
-.
5.
-
."Mass
.
.
,2
,
-
-.
.
t.
Production amly
-f
.
QualityAdjusted
.'
ice (0)
price increases
:Crsitcalwsitching
wsith
increasedlearning
recombinedand coupledwithnew ones,a firmis able to
reduce the risks of falsely choosing new capabilities.
explorationreducestheorganiThroughrecombination,
zationalcosts to successfullyadoptradicalchangein its
capabilities.
Discussion:How Good a Heuristic?
Real optiontheoryprovidescomplexheuristicsto apply,
thoughthereare reasonableways to simplifythe application (Bowman and Moskowitz 1997). Equally importantis thatthereal optionsheuristiccarriesthedangerof
situations.A particuto inappropriate
negativetransfer
larlytroublingcomplicationforreal optionsanalysisis
and
interactions
of competitive
theexplicitconsideration
endogenizethedypositioning.Competitiveinteractions
namicsof the externalmarketprice.The valuationof a
of a market
strategicoption requiresan identification
priceby whichto derivethe replicateof theunderlying
asset. In financialmarkets,thisprice is easily givenby
and reasonableasstockor futureprices.An important
sumptionis thatexercisingtheoptiondoes notinfluence
portfolio.
thevalue of thereplicating
This assumptiondoes notalways hold forreal options
fortwo reasons.First,by exercisingan optionto entera
market,a firmofteninfluencespricesthroughincreasing
supply.Second, by entering(or exiting)a market,competitorswill altertheirbehavior.As a result,themarket
price is endogenousto the decision whetherto exercise
theoption.
This problemis partlyresolvedby recognizingthatthe
value of thetareflectsthe assessmenton entry.But this
assumptionhardlyprovidesinsightinto the identityof
behavior.A structural
and theirstrategic
possibleentrants
approachis explicitregardingthe natureof futurecompetition.Kulatilaka and Perotti(1998) follow this approachby evaluatingthedecisionto launcha new technology in the contextof differentconjecturesabout
strucThis solutionmarriestheindustry
marketstructure.
tureanalysisto core competence,but throughthe stipuratherthanfolationthattheanalysisis forwardlooking
marketstructure.
cused on current
2001
12,No. 6, November-December
755
BRUCE KOGUT AND NALIN KULATILAKA
Capabilitiesas Real Options
Endnotes
Conclusions
Real optionanalysisprovidesthetheoretical
foundations 'See Minsky(1985, pp. 243-253) foran example.
2Georgescu-Roegen(1971, p. 196) providesan explicitand earlydisto theuse of heuristicsforderivingcapabilities.Through
cussionof irreversibility,
hysteresis(as discussedlater),and thearrow
an understanding
of competencein relation of time.The arrowof timeand evolutionare centralthemesin Prigogine
conditioning
to a markettest(e.g., Barney'snotionof a strategic
factor and Stengers(1984). A volumeof essays on irreversibility
(withlittle
market),it identifiesthe coupling of organizationand
closureon definition)
is editedby Boyeret al. (1991).
technologyas the leading explanationforthe iffeversi- 3For a discussion,see Kogut and Zander (1992) on knowledgeand
in capabilities.In a naffowsense,it
bilityof investments
combinativecapabilitiesas options,and Zanderand Kogut(1995) and
faultsdiscountedcash flowanalysisas theprincipaltool
Szulanski (1995) forempiricalstudiesthatmeasureinimitableas tacthe value of a firm.But more pro- itness.
of understanding
4Winter(1987) suggestsnet presentvalue as a measurewhichis apfoundly,the recognitionthatthecouplingof people and
Most surveyson theuse of
technologyis a source of optionvalue challengessim- propriateforthecase withoutuncertainty.
plisticnotionsof firmsas "pure asset plays." In thisre- capitalbudgetingtechniquesshow thatalmostall largecorporatefirms
use netpresentvalue calculationsforinvestment
decisions.See Kogut
the argumentthata firm'smostenspect,it strengthens
and
and
Kulatilaka
(1992)
and
Baldwin
Clark
(1992,
1994) fora disduringadvantage lies in its human resources(Pfeffer
in capabilitiesis nota netpresentvalue of
cussionof whyinvestment
1994).
cash flows,buta real optionvaluati.
Ironically,then,thederivationoftheoptionvalue from
5Howard Kunreutherpointsout to us thata strategyof minimizing
theembeddedknowledgein organizational
assetsdeflects
deathresultsin suboptimalbehavior,as shownin an extantliterature
a purelyfinancialevaluationof the firm.Because orga- in thedecision sciences. Still,thereis a technicalcorrespondencebenizationsconsistofcoupledsystems,thevalue ofthefirm tweenevaluatingthe value of the firmat eitherboundary.As Black
in thepresentvalue ofitsconstituent
is notreflected
parts, and Scholes (1973) notedearlyin thedevelopmentof optionpricing,
but in the combinativepotentialof deployingthesecacan be used to value the stock.
the boundarydefinedby bankruptcy
pabilitiesfor innovationin existingmarketsor for adNote also Tuma and Hannan's (1984) acknowledgement
ofthenonlindressingnew markets.It suggeststhatfirmsare dynamic ear and stochasticprocessthatgovernsfirmgrowthin theirChapters
systemsconsistingofthecomplexcouplingoftechnology 12 and 15 discussionof stochasticcalculus.
ofMilgromandRoberts
and people throughorganizationaldesign.The paradox- 6Thispointis implicitin thelatticeformulation
ical conclusionto the sustainedapplicationof financial (1990), wherea firm'schoice is constrainedby technicalcomplemenas a combinatorial
modelingto firmsis that,in the end, the fundamental tarities.See Levinthal(1997) forcomplementarities
in
problem
organizational
space.
basis of the value of the firmis its organizationalcapabilityto exploitcurrentassets and explorefutureoppor- 7We thankArie Lewin forencouragingthe developmentof the ideas
below.
tunities.
The recentefforts
in organizationaltheoryto embrace
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