December 1998 Operations research that achieves a sustainable, competitive advantage shakes up the corporate world By Peter C. Bell Investing in OR/MS has now emerged as a successful corporate strategy. The roller-coaster ride that has been our history is reaching new heights as OR/MS captures the attention of chief executives and boards of directors. It is time for OR/MS professionals to seize the moment and begin talking about a redefinition of "strategic OR/MS." Early corporate OR/MS groups were largely efficiency experts or cost cutters, and many struggled to deliver the benefits required to fund their continuation. Early OR/MS was project oriented; OR/MS groups performed "studies." The installation of massive computing power on the desktop of almost every executive has changed our world and provided OR/MS with direct access to management. Leading-edge OR/MS groups are now key players in the day-to-day management of major corporations. Over the last decade, leading practitioners recognized that a corporation that was good at OR/MS could achieve a sustainable cost advantage over others that were not. A leading exponent of this view was Thomas M. Cook, president of Sabre Decision Technologies (SDT, formerly American Airlines Decision Technologies), who in 1991 stated that "the things we are doing are designed to create a competitive advantage" [1]. There is good evidence that the OR/MS work at SDT has catalyzed massive change not only at American Airlines, but throughout the airline industry and in other industries where SDT has sold its services. Along with industrial restructuring, SDT has been credited with causing competitor bankruptcies while providing a competitive advantage of hundreds of millions of dollars annually to its parent company, sustained over a significant period of time. In summary, SDT's work has had a strategic impact. Unfortunately, most OR/MS researchers have been slow to recognize the "strategic" value of their work. When we have linked OR/MS and corporate strategy we have talked about the application of OR/MS tools to very high-level ("strategic level") decisions. SDT has shown that OR/MS work can be "strategic" while addressing operational level problems. There is now an opportunity for OR/MS to redefine "strategic OR/MS." A Role for OR/MS in Corporate Strategy Strategy guru, consultant and author Michael Porter defined "corporate strategy" as determining what business the corporation should be in and how best to manage the array of business units [2]. The firm defines its competitive strategy to create a competitive advantage at the level of the strategic business units. In assessing its competitive strategy, the firm must determine those products that its customers value, which the firm is capable of delivering better than others, and which competitors cannot easily replicate. A successful competitive strategy is one that leads to a sustainable competitive advantage. To execute a successful competitive strategy, the corporation must possess distinctive competencies. Distinctive competencies are the internal skills, knowledge and organizational structures that cross functional boundaries, and are not easily replicated. Distinctive competencies (which cannot usually be outsourced or purchased) make a significant contribution to the value the customer attaches to the product, and provide the corporation with the ability to compete in several markets. Distinctive competencies provide the foundation of a successful competitive and corporate strategy; they enable a corporation to execute strategy more effectively than other companies that might have the same or a similar strategy. The example of Federal Express (FedEx) should help tie these ideas together: FedEx's corporate strategy is to be a major player in the international, overnight package business. FedEx's competitive strategy includes "absolutely, positively" overnight; guaranteed on-time delivery, with friendly staff and low prices. FedEx brings a variety of distinctive competencies into this competitive strategy, including its aircraft fleet, its hubs and package handling systems, its package tracking and customer support functions, and its logistics support. IT and Distinctive Competence The use of information technology provides a competitive advantage for many globally competitive firms, and has become a distinctive competence for these organizations. Porter and Millar recognized the strategic value of IT in 1985 when they wrote in the Harvard Business Review that, "Until recently, most managers treated information technology as a support service and delegated it to EDP departments. Now, however, every company must understand the broad effects and implications of the new technology and how it can create substantial and sustainable competitive advantage. ... Information technology is changing the way companies operate [3]." In that same article, Porter and Millar recognized OR/MS as a key component of IT: "Today IT must be conceived of broadly to encompass the information that businesses create and use as well as a wide spectrum of ... technologies that process the information" [3]. The strategic importance of IT is evident through the existence of senior appointments in many major corporations, including many vice presidential-level chief information officers (CIOs). The average CIO, however, is an information systems professional who has emerged from the data processing department, and most CIOs pay more attention to hardware and software management, and how data is collected, than how the data is used to achieve a sustainable competitive advantage. Managers of OR/MS activities remain well down the organization structure in most corporations. There are, however, a growing number of corporations which manage their OR/MS activities extremely well, and, in doing so, have created a sustainable competitive advantage through investing in OR/MS. Senior management of these firms recognize OR/MS as a distinctive competence, and consider their OR/MS skills to be a strategically important asset. Redefining "Strategic OR/MS" We define the term "strategic OR/MS" as OR/MS that achieves a sustainable competitive advantage. Strategic OR/MS is, therefore, a body of work that forms the basis of a distinct competence in OR/MS. Does "strategic OR/MS" exist? Can we find examples of firms that are achieving a sustainable competitive advantage from a distinctive competence in OR/MS? Evidence of a sustainable competitive advantage from any source is rarely directly observable, but instead, the existence of strategic OR/MS activities can be inferred from secondary evidence. If OR/MS is a distinctive competence for a firm, then: the chief executive officer (CEO) of the firm will know about the firm's OR/MS work and of its importance, there will be OR/MS work being done which constitutes the "strategic asset," and this work should be identifiable, a firm with an OR/MS group that has achieved strategic success will provide them with a certain status, and will involve the group on a regular basis on other major decisions, the firm's competitors should know about, and probably respond to, the successful strategic OR/MS work, perhaps by attempting to copy it, there will be evidence that industrial restructuring has occurred, motivated by one firm's successful strategic use of OR/MS, and new businesses will appear which serve industries where OR/MS has achieved strategic success in the industry. The OR/MS literature contains many applications that provide this evidence. There is not the space to list them all here (more extensive details are available in Bell [4], [5]), but here are a few quotes from CEOs talking about the importance of their OR/MS to their respective firms: R. E. Howson, chairman of the board and chief executive officer, McDermott International, Inc.: "OR plays an important part of our ability to manage our diverse businesses. ... As we look to the future, OR will continue to be a vital and necessary part of our organization and our goal to remain a world-class company, capable of competing against all comers" [6]. Francisco Eizmendi Jr., president, San Miguel Corporation: "OR/MS plays a big role in the five-year ... approximately one billion dollar expansion and modernization program that we launched in 1987. Under the program we have built 22 manufacturing plants — we would not have dared to undertake the expansion at all without OR/MS. ... San Miguel's senior management appreciates the vital role of MS in attaining our corporate goals, and in implementing the strategies that enable us to achieve adequate growth and satisfactory returns for our various stakeholders" [7]. Frederick W. Smith, chairman, CEO and founder of FedEx, who is well known for his close ties to the company's OR/MS department: "Employing OR techniques and modeling skills, the OR department has played a role in the development of long-range plans for the past 17 years. Every major system change ... (was) modeled by OR several years in advance of the actual system change. This enabled the company to grow smoothly... By modeling various alternatives for future system design, FedEx has, in effect, made its mistakes on paper. Computer modeling works; it allows us to examine many different alternatives and it forces the examination of the entire problem." [1] There are many examples of OR/MS work that have produced handsome returns. Few can match the example of KeyCorp (a U.S. bank holding company with assets of $66.8 billion and equity of $4.7 billion) which spent less than $500,000 on an OR/MS project beginning in 1991 [8]. The project reduced expenses by $98 million over five years. While the cost reduction is impressive, it cannot be considered "strategic" unless there is evidence that it is sustainable. Firms with strategic OR/MS activities have the ability to address very large, complex problems where an optimum solution is not currently obtainable [4]. These firms address these problems by constraining them to a size that can be solved in real time at the leading edge of available technique and technology, and invest significant OR/MS resources into improving the solutions. This investment yields increasingly lower costs as the solution procedures are developed over a substantial period of time. The cost advantage is further sustainable if management intervention is required to implement the improved solutions as they are developed. Sustainability of the competitive advantage, therefore, arises from two sources. First, the OR/MS group has developed skills and knowledge (and perhaps hardware, databases and code) that a competitor starting work on the same problem cannot easily replicate. Second, management has adapted the firm's structure and operations to take maximum advantage of the low cost solutions being developed. These structural changes may involve contracts, labor relations or facilities design; consequently, a competitor attempting to replicate the MS/OR work may not be able to implement the solutions, or may obtain much smaller cost savings on implementation. One such problem is the "optimum dynamic pricing" problem. Algorithms which address this problem form a key part of American Airlines' yield management system. Robert Crandall, former chairman, president and CEO of American Airlines, stated: "I believe that yield management is the single most important technical development in transportation management since we entered the era of airline deregulation in 1979. ... (Dynamic pricing) creates a pricing structure which responds to demand on a flight-by-flight basis. As a result, we can more effectively match our demand to supply" [9]. National Car Rental was essentially bankrupt when it introduced optimal dynamic pricing in its new revenue management system. The impact was dramatic: "(OR) basically saved National Car Renal. And you can go from the CEO of National on down, and they will all say (that) just applying these MS models made the life or death difference for this company" [10]. The extent of management intervention that was required to successfully implement the OR/MS work at National was provided by company vice president Ernest Johnson, who stated: "We got (senior management) to commit to educating the company. In fact, we got them to agree to conduct seminars themselves once the system had been devised. We got them to tour the country and talk to rental agents at all locations, and talk to every reservation agent to explain the differences that they would see in the way pricing and inventory were now going to be handled. ... We had to change the culture of the organization" [10]. Reaction to Successful OR/MS One would expect that the opinions of a management science group that has scored a strategic success should be regularly sought on important decision issues. Federal Express has had a successful OR/MS group for many years, and the group has historically been involved in major decisions. Joe Hinson, general manager of OR at FedEx, chaired the corporate strategic planning committee and reported directly and regularly to CEO Fred Smith. "When you know that you'll be listened to, the weight of your work becomes a little bit heavier and more satisfying," Hinson said. "It's nice to know that the answer that you come up with will not be muddled by the time it reaches the top" [1]. Hinson went on to discuss how deeply his OR/MS group is ingrained in the activities of FedEx: "An OR/MS department's effectiveness doesn't necessarily have to be measured by the one big home run that saves the company millions of dollars, but rather by giving out lots of good results, providing answers to lots of questions every day and every week of the year, year after year" [1]. Mason, et. al, writing in Interfaces, concluded that "FedEx is an archetype of a company that has succeeded by applying the scientific methods to its operations. Models and analysis have informed many of (FedEx's) crucial, business-shaping decisions. In cases in which OR wasn't used ... the company performed poorly" [11]. Successful strategic OR/MS provides a competitive advantage over a period of time that should be noticeable. In some cases, the advantage is so devastating that it drives the competition out of business. Consider the case of People Express Airlines. Stressing customer service and cheap fares, PE quickly became a highly successful, rapidly growing airline in the early 1980s [12]. The strategy paid off: PE's annual revenues soared to almost $1 billion by 1985. Contemporary writings suggested that PE had some problems, but no one anticipated that the airline would be facing bankruptcy by the end of 1986. The rapid deployment of OR/MS by American Airlines was not seen as a significant competitive threat at the time. After the fact, however, it was generally agreed that innovative operations research and management science work at SDT drove People Express out of business in just a few months. Donald Burr, founder and CEO of People Express, later conceded that the use of computer programs by major carriers to immediately match or undercut his prices ultimately killed PE [13]. An independent assessment by Loveman and Beer agreed, suggesting that "the major carriers met People Express's pricing structure ... and used their reservations systems to achieve optimal pricing and yield management. PE's performance, in essentially all dimensions, immediately declined. ... The end was swift" [13]. At the time, many other airlines faced severe competitive pressures. American Airlines reacted to the pressure by investing heavily in OR/MS and it proved to be a successful strategy. Others that followed different strategies were less successful and did not survive or survived only in a diminished form. The North American airline industry has gone through major restructuring during the period following deregulation in December 1981. There is broad recognition that OR/MS work is now a critical part of airline operations. As Loveman and Beer noted in 1991, "It is worth emphasizing that a reservations system, with its yield management capacity, is arguably the single most important strategic asset of an airline" [14]. There are many other examples of industrial restructuring as a result of strategic OR/MS. For example: ABB was a recent entrant into the electrical transformer market which collapsed from about 3,300 units in 1974 to less than 1,000 units in 1975. Industrial giants Westinghouse, General Electric, McGraw-Edison and the fledgling ABB were left to fight for a share of a downsized market. By 1988, ABB had 40 percent of this shrunken market, and Westinghouse and General Electric no longer made industrial transformers. Between 1974 and 1988, ABB undertook a series of innovative and sophisticated OR/MS projects which transformed the company and its markets. While many factors contributed to ABB's success, president Daniel Elwing observed in a statement at the 1988 board of directors meeting — when ABB sales had grown to exceed $100 million — that "without the insights from our marketing models, it is unlikely we would have current sales of $25 million; in fact, without the use of these models, it is unlikely we would be here at all" [15]. Another form of market restructuring is the "turnaround." The National Car Rental case described above appears particularly compelling since the OR/MS work was a direct order from the CEO. The company was told that it faced liquidation by its parent company (General Motors) if National did not become profitable. Harris Corporation's Semiconductor division is another example of an OR/MS-induced turnaround. Starting in 1992, Harris Semiconductor invested $3.8 million starting in IMPReSS, an OR/MS-based project which used state-of-the-art optimization to set all production, delivery and inventory levels in 22 manufacturing plants worldwide [16]. In announcing the OR/MS effort on company television, Jon Cornell, divisional president, emphasized how close to the brink the semiconductor division was: "(The division) will not survive unless we solve our delivery problem. If IMPReSS succeeds, we can succeed. If it fails, we will surely fail." After installation, Phil Farmer, president and CEO, talked about the dramatic nature of the turnaround: "Our on-time delivery was running about 75 percent, which was not acceptable. IMPReSS raised our on-time delivery to 95 percent. Significantly 75 percent represented the worst performance in the industry, while 95 percent represented about the best. The financial consequences were that a loss of $100 million during 1989-91 was turned into steadily increasing profits." The bottom line: Successful practitioners have provided operations research with the opportunity to define "strategic OR/MS" and position operations research as a corporate competitive weapon. If the profession can fully exploit the opportunity that's available and continue to build on the successes, the future of OR/MS will be very bright indeed. References P. Horner (1991), "Eyes on the Prize," OR/MS Today, Vol. 18, No. 4. M. E. Porter (1990), "From Competitive Advantage to Corporate Strategy," Harvard Business Review. M.E. Porter and V. E. Millar (1985), "How Information Gives You Competitive Advantage," Harvard Business Review. P.C. Bell (1998), "Strategic Operational Research," Journal of Operational Research, Vol. 49, No. 4. P.C. Bell (1999), "Management Science/Operations Research: A Strategic Perspective," South-Western College Publishing, Cincinnati. R.E. Howson (1995), Plenary Speech to the INFORMS Conference, New Orleans, October. E. Del Rosario (1994), "MS Brews Success for San Miguel," OR/MS Today, Vol. 21, No. 5. S.K. Kotha, M.P. Barnum and D.A. Brown (1996), "Keycorp Service Excellence Management System," Interfaces, Vol. 26, No. 1. B.C. Smith, J.F. Leimkuhler and R.M. Darrow (1992), "Yield Management at American Airlines, Interfaces, Vol. 22, No. No. 1. M.K. Geraghty and E. Johnson. (1997), "Revenue Management Saves National Car Rental," Interfaces, Vol. 27, No. 1. R.O. Mason, J.L. McKenney, W. Carlson, and D. C. Copeland. (1996), "Absolutely, Positively Operations Research: the Federal Express Story," Interfaces, Vol. 27, No. 2. "People Express Airlines: Rise And Decline," (1993) Harvard Business School 9-490-012, People Express (March 1984) (1986), Harvard Business School 9-487-043, People Express (May 1985) (1986), Harvard Business School 9-487-044, People Express Update 1/89 (1989), Harvard Business School 9-489-022 People Express (A) (1995) Harvard Business School 9-483-103 J.A. Bryan (1989), "Donald Burr May Be Ready To Take To The Skies Again," Business Week, January 16. G. Loveman and M. Beer (1991), "People Express Airlines: Rise And Decline," Teaching Note, Harvard Business School 5-491-080. D.H. Gensch, N. Aversa and S. P. Momse (1990), "A Choice-Modeling Market Information System That Enabled ABB Electric To Expand Its Market Share," Interfaces, Vol. 20, No. 1. R. C. Leachman, R. F. Benson, C. Liu and D. J. Raar (1996), "IMPReSS: An Automated Production-Planning And Delivery-Quotation System At Harris Corporation - Semiconductor Sector," Interfaces, Vol. 26, No. 1. Peter Bell is a professor of Management Science & Information Systems at the Richard Ivey School of Business, University of Western Ontario. He is also the immediate past president of IFORS, the International Federation of Operational Research Societies. Table of Contents OR/MS Today Home Page OR/MS Today copyright © 1998 by the Institute for Operations Research and the Management Sciences. All rights reserved. Lionheart Publishing, Inc. 506 Roswell Street, Suite 220, Marietta, GA 30060, USA Phone: 770-431-0867 | Fax: 770-432-6969 E-mail: lpi@lionhrtpub.com URL: http://www.lionhrtpub.com Web Site © Copyright 1998 by Lionheart Publishing, Inc. All rights reserved.