MODELLING STRATEGIC ASSETS AS
A DYNAMIC SYSTEM OF ‘PRIMARY’ AND
‘DERIVATIVE’ RESOURCES
CARMINE BIANCHI
Associate Professor in Business Management
University of Bari and Palermo (Italy) - CUSA-System Dynamics Group
http://www.unipa.it/~bianchi — e-mail: bianchi @unipa.it
Abstract
Particularly in the last decade, literature on the resource-based-view of the firm has
been emphasising the relevance of strategic assets for business survival and growth.
This paper suggests a taxonomy of strategic assets in a feedback perspective. Two
main categories of strategic assets are distinguished: primary and derivative
resources. Such taxonomy may allow policy makers to better understand the
conceptual priority of some sets of resources on others, and to focus processes
leading a firm to increase or lose its strategic assets. The paper is particularly
focused on the analysis of cause-and-effect relationships between main primary and
derivative resources, delays affecting their accumulation and draining processes,
policy levers on which decision makers may act to improve them, in order to
counterbalance business or environmental forces tackling growth.
1. Introduction
What can lead a firm to excel and develop a defendable competitive advantage, in
spite of its small size and peripheral location? How sudden failures of uncontested and
leading ‘giants’ can be explained?
Quite seldom the answer can be found in official company reports. The explanation
usually lies in strategic assets (Amit R. and Schoemaker P., 1993), i.e. “firm-specific”
interdependent tangible and intangible resources which allow a business to satisfy
better than its competitors those expectations and needs emerging from different
categories of “actors” (e.g. customers, commercial partners, banks, workers). Some
examples of strategic assets are related to knowledge, image, entrepreneurial
(personal) networks, production capacity, distribution capillarity.
According to the resource-based view of the firm (Wernerfelt B., 1984; Mahoney J.
and Pandian R., 1992; Teece D. et al, 1997; Barney J., 1991), organisational rent can
be explained as a business ability to build “firm-specific” assets generating distinctive
competencies, leading to a sustainable competitive advantage and stable growth over
time. Business long term growth is strongly influenced by the aptitude of the firm to
balance the exploitation of existing resources and the development of new ones
(Penrose E., 1959; Wernerfelt B. 1984). Understanding strategic assets’ dynamics is
the key to enhance a learning-oriented business analysis and diagnosis, leading to
successful strategy formulation and implementation. This paper shows how the
system dynamics (SD) methodology can provide a useful framework on this issue.
2. The concept of ‘primary’ and ‘derivative’ resource.
A commonly used perspective of analysis for strategic assets is provided by the
distinction between resources and capabilities (i.e. services of resources) (Penrose E.,
1959). According to this approach, resources are intended as “stocks of available
factors that are owned or controlled by the firm” (Amit R. and Schoemaker P., 1993,
p. 35). They “consist of a bundle of potential services and can, for the most part, be
defined independently of their use, while services cannot be so defined, the very word
‘service’ implying a function, an activity” (Penrose E., 1959, p. 25). Some examples
of resources are related to know-how that can be traded (e.g. patents and licences),
financial or physical assets (e.g. property, plant and equipment), human capital, etc. In
contrast with resources, capabilities have been defined as “the firm’s capacity to
deploy resources, usually in combination, using organizational processes, to effect a
desired end ... Unlike resources, capabilities are based on developing, carrying, and
exchanging information through the firm’s human capital” (Amit R. and Schoemaker
P., 1993, p. 35). Main organisational capabilities have been referred to routines, tacit
knowledge and organisational memory (Nelson R. and Winter S., 1982; Polanyi M.
1962). Based on this distinction, Mahoney and Pandian assert that “resources are
stocks and capabilities (services) are flows” (1992, p. 366).
A more blurred distinction between resources and capabilities is made according to a
different approach, that defines capabilities as “a set of ‘inert’ resources that are
difficult to imitate and redeploy” (Kogut B. and Zander U., 1992, p. 385; Dierickx I.
and Cool K., 1989) !. Such an approach is based on the implicit assumption that both
resources and capabilities are stocks, whose level is affected by the rate of past
strategic expenditures (Dierickx I. and Cool K., 1989; Morecroft J., 1997). Based on
the above framework for analysis, this paper stems from three basic assumptio:
1. knowledge and capabilities are not the only factors influencing the business ability
to acquire, co-ordinate and deploy resources;
2. the concept of resource as stock of specific production factors providing the firm a
bundle of potential available services to be exploited ought to be broadened;
3. a feedback analysis of strategic assets dynamics can help decision makers to
assess the consistency of their policies.
Referring to the first point, it is possible to argue that business capabilities and
knowledge could not be enough to exploit the potential services that could be earned
from a synergetic use of available resources. In fact, the ability of the firm to acquire,
co-ordinate and deploy production factors also depends on the ‘quality’ of some other
strategic assets that (likewise capabilities) are not related to a specific resource. Such
assets mainly result from the accumulation of current internal and external business
processes, that usually give rise to slow (but significant, in the long run) changes in
many strategic soft variables. Some examples are: business image and reputation,
workers’ morale, personal networks (e.g. with banks, suppliers, customers and various
stakeholders), entrepreneurial values and business culture, which may significantly
impact on long term performance.
Financial resources are another asset that may significantly influence, in the long run,
the ability of the firm to co-ordinate all other resources. In fact, business long-term
survival and growth cannot be conceived regardless the aptitude of the firm to self-
finance, at least partially, its expansion and to maintain a balanced “debts-to-equity”
ratio. Even the most brilliant and successful business ideas, carried out by the
brightest and motivated people sharing common goals, who are able to sell a leading
product on a competitive market, are destined to fail if — at least on a medium time
! In particular, combinative capabilities have been defined as “the intersection of the capability of the
firm to exploit its knowledge and the unexplored potential of the technology” (Kogut B. and Zander
U., 1992, p. 391). Likewise, dynamic capabilities have been defined as “the firm’s ability to integrate,
build and reconfigure internal and external competences to address rapidly changing environments”
(Teece D. et al., 1997, p. 516).
horizon — the firm is not able to generate a positive income and cash flow from its
current operations. Profitability and self-financing are the two main pre-requisites for
the acquisition of other necessary resources to foster business growth ?.
Concerning the second above stated point, if we adopt a broader concept of resource,
related to “anything which could be thought of as strength or weaknesses of a given
firm [or] more formally ... (tangible and intangible) assets which are tied
semipermanently to the firm” (Wernerfelt B., 1984, p. 72), also strategic soft variables
such as competencies, business image, entrepreneurial personal contacts and values,
corporate culture, etc. can be considered — Jatu sensu — as resources, although they are
not directly related to a specified production factor or a group of them. Likewise other
resources, they are potential services that can be exploited if the firm is able to
generate a business idea whose components are consonant one another and with
relevant external variables.
Concerning the third point, a feedback perspective is likely to foster a deeper
understanding of: a) delays between adopted policies and related effects; b) short and
long term effects on strategic assets related to decisions made, c) interdependencies
between different resources affecting strategic assets, and d) internal and external
factors which may weaken or limit strategic assets’ accumulation process (Ford D.
1998). Such an approach may allow one to describe strategic assets dynamics as the
result of feedback relationships between two broad groups of production factors, i.e.:
primary and derivative resources (Coda V., 1983, p. 101). Primary resources are those
which mostly impact on the business aptitude to acquire, co-ordinate all other
resources and to exploit their potential services. Derivative resources are all other
production factors (e.g. production capacity, logistics support, organisation structure
and operative mechanisms, product portfolio, customer base, cost structure flexibility,
brand positioning) that are acquired, co-ordinated and deployed through business
primary resources. In the next sections it will be shown how both sets of resources are
mutually related in a feedback perspective.
3. ‘Primary’ and ‘derivative’ resources as strategic assets of the firm
It is opportune to differentiate primary from derivative resources as not all production
factors have the same level of importance for a firm: strategic control must selectively
assess them and support policy makers to affect their dynamics over time. A selective
approach is needed as business performance usually depends upon a limited scope of
factors which can be influenced by a bounded number of policy levers. Lack of
focusing ‘key-factors’ and related ‘policy levers’ would, at the same time, increase the
cost of information and reduce the capability of decision makers to promptly detect
the areas where to concentrate analysis and action.
Primary factors have a conceptual priority over the derivative ones, as they determine
the aptitude of the firm to improve their qualitative and quantitative profile over time.
The quality of primary resources affects the ability of the firm to acquire, co-ordinate
and deploy different production factors whose combinative worth is to be higher than
the sum of the value of single services that each of them could individually provide
(Grant R., 1991, chapt. 4, par. 4). In fact, one could theoretically introduce from
outside the firm the ‘best’ machinery, the leading products ready to be sold on the
market, the fastest and most efficient logistical systems, the most flexible and
promptest information and reporting tools, the most qualified and skilled people.
? For instance, in a firm aiming at expanding its retail sites, the only site finding capabilities could not
be enough to reinforce the virtuous process “site opening => learning => site-finding capability = site
opening” (Warren K., 1998, p.9).
However, the above resources would inevitably be wasted if the firm would lack of a
successful entrepreneur, a consistent business idea, motivated and skilled people able
to co-ordinate and deploy available resources, in order to increase business image and
reputation, organisational knowledge and financial resources. In a firm lacking of
valid organisational resources and of any kind of effort aimed to build and improve
them, all other (although valuable) production factors are destined to be lost or
wasted. The quality of the business primary resources is determinant to the attitude of
the firm to build up derivative resources. On the other hand, the accumulation of
valuable and interdependent derivative resources is a pre-condition to improve the
quality of primary resources 3. Both primary and derivative resources can be
considered as strategic assets if they correspond to a “set of difficult to trade and
imitate, scarce, appropriable and specialized” (Amit R. and Schoemaker P., 1993, p.
36) production factors that allow a firm to gain a competitive advantage. Strategic
assets can be conceived as stocks, i.e. endowments of homogeneous groups of
primary and derivative resources available in a given time. When the firm operates in
a dynamic and complex environment, it must be flexible in adapting its strategic
assets to industry evolution. It has to be able to promptly and selectively perceive
relevant information on the dominant logic (Prahalad C. and Bettis R., 1986;
Morecroft J., 1997, p. 580-581) underlying the accumulation of strategic assets in the
industry where it operates, by taking into account the changing pattern of competitors’
strategies, technologies and customer needs. In order to manage its own
metamorphosis (Glucksman M. and Morecroft J., 1998), a business has to learn, i.e.
decision makers have to open their mindsets to new possible ways of fulfilling
business activities, even though this may mean to abandon the dominant logic which
allowed the firm to be successful in the past. In managing strategic assets, decision
makers “face the daunting tasks of (1) anticipating possible futures, (2) assessing
competitive interactions within each projected future, and (3) overcoming
organizational inertia and internal dispute in order to realign the firms bundle of
strategic assets” (Amit R. and Schoemaker P., 1993, p. 40). Very often decision
making processes are made in uncertain and complex contexts, involving bias, illusion
and sub-optimality that are related to cognitive limitations in decision makers’ mental
models. Usually, bounded rationality in decision making is not related to lack of
technical knowledge or expertise of decision makers on single problem issues; it is
rather related to a poor understanding of the system structure and key-factors’
dynamics. The SD method can significantly help decision makers to understand
strategic assets building or depletion processes, through the use of both conceptual
and formal models. This paper will be more concerned on the conceptual “stock-and-
flow” modelling of strategic assets as a dynamic system of primary and derivative
resources.
4. Managing strategic assets as a system of levels and rates: modelling
how ‘primary’ resources affect (and are affected by) the accumulation
process of ‘derivative’ resources.
When a firm is started, main available resources are usually a vision of a future
business, entrepreneur’s knowledge and personal contacts (e.g. with banks, potential
customers, public administration officers), values and behavioural norms driving
decisions, financial resources to be invested as equity. Such factors are not yet
business strategic assets; in fact, they have not yet generated a working business idea
3 This concept will be analysed in the next paragraph.
and cannot be still compared with competitors’ primary resources. In order to become
strategic assets, they have to be co-ordinated and deployed by the entrepreneur. The
business idea is still to be conceptualised and focused; often it is formalised in a
written business plan that helps the entrepreneur to focus critical issues such as the
mission of the firm, products to be sold on the market, customer needs to be satisfied,
sale price and payment conditions, derivative resources to be purchased, other
primary resources (in terms of contacts, image, competencies and skills, etc.) to be
built and developed, in order to pursue desired goals over a long time horizon +. Once
the business idea has been outlined, the firm is able to build up derivative resources.
The entrepreneur’s knowledge, personal contacts and invested equity allow the firm to
gradually acquire, co-ordinate and deploy various resources (e.g., production capacity,
loans, information, human resources education, raw materials, advertising).
There are several delays affecting the accumulation of derivative resources. In fact,
beyond the time needed to outline the business idea, the accumulation process may be
delayed by the time necessary to obtain different factors (suppliers are to be
contacted, resources are to be delivered, etc.), to co-ordinate and deploy them. Both
the above delays and the likelihood of acquired resources to give rise to strategic
assets, through the synergies produced by the interaction between available factors,
are affected by the quality of primary and derivative resources that the firm will be
gradually able to build up (figure 1).
Figure 1: Primary and derivative resources Figure 2: Business knowledge building and
building processes draining processes
Figure 1 also shows how from the co-ordination and deployment of derivative
resources, through the existing stock of primary factors, the firm is able to improve
the current state of its strategic assets system. In fact, synergies developed through the
exploitation of services from different available resources may allow the firm to build
a customer base whose qualitative and quantitative profile indicates the state of the
business image and reputation on its market. Also the punctuality of business
deliveries or payments to suppliers and reliability in quality standards or post-sale
assistance may significantly contribute to build up company reputation.
Furthermore, the fulfilment of current activities usually adds new personal contacts to
those that the entrepreneur and his direct collaborators have established with different
“actors” in the competitive and social system (e.g. suppliers, competitors, banks,
4 Defining and formalising the business idea also allows the entrepreneur to evaluate its economic and
financial feasibility, as well as the profitability of capital invested.
public administration officers), leading to a change in the stock of personal networks
that constitute a valuable strategic asset especially in smaller firms.
Also learning and communication among people inside the business represent a flow
accumulating into individual, group and organisational knowledge and morale. Such
an accumulation process is triggered by an “intelligent” analysis of phenomena in
which people are involved, dialogue and debate or even formal education
programmes, on-the-job training, etc >.
A concurrent result of learning and communication accumulated into knowledge is the
generation of visions, i.e. intuitions of opportunities that may evolve into new
business ideas leading the firm to deploy its current endowment of strategic assets in
other related or unrelated strategic business areas (Norman R., 1977, chapter 7).
Income resulting from company activities is another rate accumulating into primary
resources (i.e. invested equity). Likewise for the accumulation of derivative resources,
the quality of the above commented cause-and-effect process is also affected by the
current endowment of primary resources. In fact, for instance, the higher is
reputation, the higher will be — other conditions being equal — the aptitude of the firm
to durably include a new client in its customer base.
It takes time, however, to accumulate (or deteriorate) primary resources. In fact, the
aptitude of current processes enhanced by the stock of available strategic assets to
generate a change in the primary resources endowment is affected by several delays.
This paper will particularly focus three of them, i.e.:
¢ time to learn (and lose) knowledge;
¢ time to build (and lose) image;
e time to generate income.
The reason why our analysis will particularly dwell upon such delays is due to both
the relevance of knowledge, image and equity in strategic assets building or depletion
processes, and the possibility to refer to generic conceptual models, that may allow
one to model them.
4.1. Knowledge building and depletion processes: factors influencing
‘time to learn’ and ‘time to lose knowledge’
Figure 2 depicts knowledge as a stock influenced by a learning inflow and an
‘unlearning’ outflow (Koenig U. and Membrillo A., 1998). The learning inflow
represents the rate at which the current state of knowledge is being increased in a
given time interval, as an effect of various activities performed by individuals and
groups, ranging from a careful and “intelligent” accomplishment of current tasks, to
the acquisition of new concepts/methodologies, the awareness and improvement of
mental models, sharing of insights and information among people, etc. The quality of
learning is affected by the available endowment of derivative resources that have been
accumulated by the firm through the combinative deployment of different production
factors. For instance, the bigger is the capability of the firm to create new products
(knowledge stock) the larger — other conditions being equal — will be the product
portfolio (derivative resource). Managing a larger product portfolio will be likely —
sooner or later — to generate new knowledge and capabilities (learning-by-doing),
especially if people are supported by proper organisational derivative resources °.
5 An indicator of organisation morale and feel of belonging to the firm could be referred to the total
number of workers’ strikes or resignations in a given period of time and, in small family-
owned/managed firms, to complaints from entrepreneur’s relatives involved into the business.
© e.g., learning-oriented models and tools, management control systems, education programmes and —
more generally — human capital investments. The same causal relationships could be attributed, for
However, the above learning process is tackled by a delay that could be defined as
time to learn. Such a delay is influenced by different subjective and objective (i.e.
‘environmental’) factors. Among the subjective factors, the most remarkable are
related to: a) conservative behaviour (associated to personal obstacles in changing and
adapting people’s mindset), b) lack of will and/or proper methods to foster knowledge
elicitation and sharing, c) inconsistency between declared and practised values and
beliefs, d) emotional reactions, e) individual goal seeking. Among the objective
factors, systems complexity and unpredictability are a major cause affecting time to
learn 7.
The stock of available knowledge is drained by an ‘unlearning’ outflow, whose rate
depends on the size of the stock and the average time to lose knowledge. It is possible
to distinguish three main factors affecting time to lose knowledge: 1) knowledge
obsolescence time; 2) human resources resignation time; 3) ‘time to forget’.
Knowledge obsolescence time is influenced by several phenomena involving
discontinuities in the competitive system where the firm operates. For instance, new
technologies available at a reasonable cost could force the firm to update its
competencies and capabilities in order to be able to keep abreast of competitors and/or
customer tastes. Business knowledge could also be misplaced by rivals strategies
aimed to build a competitive advantage based on different competencies and
capabilities from those which are currently hold by the firm. Another factor
influencing knowledge volatility is related to skilled human resources resignations. In
order to tackle the risk of losing its human capital, a business has to adopt human
resource policies implying proper investments in organisational assets (e.g. education,
learning-oriented programmes and tools, budgeting and reward systems, etc.) aimed to
increase employees’ loyalty as an effect of their empowerment, of a higher awareness
of their capabilities and a sense of commitment to the firm 8.
A third variable affecting time to lose knowledge may be defined as time to forget. It
represents the time it takes for individuals or groups to neglect those competencies,
skills, capabilities, experiences, etc. they have consciously, or even implicitly,
accumulated over time as a consequence of their current working, communication
activities and education. Time to forget knowledge is influenced by individual factors,
such as memory or level of attention. Likewise for the resignation time, a firm may try
to increase time to forget through proper human resource policies supporting people
to practice their knowledge, leading to a higher empowerment.
4.2. Image building and depletion processes: factors influencing time to
build and lose image.
Likewise knowledge, business image can be modelled as a stock that is influenced by
a building and a draining rate, corresponding to an inflow and outflow. In order to
example, to knowledge and capabilities generated in managing a wide customer base or delivering a
reliable product, finding new retail stores.
7 The higher they are, the longer it will take for individuals or groups to learn. In order to weaken the
above obstacles to learning, a business may act on its organisational derivative resources system, e.g.
through proper formal education programmes, or by improving task subdivision among people and the
definition of responsibility areas, by pursuing a better link among budgeting, performance evaluation
and reward fems, or even through proper models and tools supporting decision makers to better
frame systems in which they are involved.
8 Tt may also happen that the same lever could be used in a quite opposite way. For example, when a
turnaround is started, in order to build a new company knowledge base aimed to recover business
efficiency and effectiveness, it is common practice — particularly when top management is relatively
old — to foster outplacement.
understand processes related to business image dynamics, we may refer to an
example. How can a firm build a high product scope image, based on its knowledge
and capabilities to provide clients different colours, or versions of a same product at a
reasonable cost and in a short period of time? The rate at which business high product
scope image is built depends on four main factors, i.e.: 1) the stock of knowledge and
capabilities to manage production flexibility and a high product scope; 2) the
qualitative profile of a derivative resource stock, which allows the firm to build image
9; 3) the time necessary to build image; 4) the stock of accumulated high product
scope image (figure 3). The way primary resources affect derivative factors’ building
process has been previously analysed and depicted in fig. 1. The higher are derivative
resources consisting of flexibility and wide product portfolio, the higher will be the
likelihood that a firm will strengthen its product scope image (e.g. by launching new
product versions or colours). However, business reputation building rate is also
influenced by the /evel of business image accumulated by the firm in the past and the
time necessary to build it. In fact, the stronger is the stock of business image, the
easier will be for the firm to gain new customers confidence and loyalty, due to word-
of-mouth effects related to its consolidated business flexibility reputation. Moreover,
the longer is time to build image, the lower will be — other conditions being equal —
the image building rate. A main cause leading time to build image to increase is
related to competitors’ imitative strategies aimed to fill the gap between the business
and their product scope reputation. In fact, if rivals try to gain a competitive
advantage on the same critical success factor on which the firm has built in the past its
own reputation, it will be harder for it — other conditions being equal — to further
increase its own high product scope image. In order to tackle such obstacles in image
building process, the firm may improve its communication policies and promotional
strategies, based on commercial derivative resources and brand positioning, aimed to
achieve a higher and/or better potential customer base.
Business image is also affected by a draining rate, which depends on the existing
stock of current image and a time factor that is affected by three main variables, i.e.:
technological innovation, changes in customer tastes and preferences, and business
communication policies. Concerning technological innovation, discontinuities in
current available technology due to innovation, may give rise to an obsolescence of
current business knowledge and capabilities, leading to a declining image. Changes in
customer tastes may be caused by several factors. Among them, the most remarkable
are social-environmental trends and rivals strategies aimed to build a competitive
advantage based on a different critical success factor from which the firm has built its
own success. For example, competitors could aim to build competencies and image
based on product reliability, in contrast to business high product scope reputation. The
firm will be likely to lose its own image if clients will tend to appreciate competitors’
product reliability more than product scope flexibility. In order to counterbalance such
emerging threat, the firm could improve its communication and promotional policies
towards its customers and potential clients, with the aim to stress the advantages
related to a wide product scope support for them. On the contrary, if the firm could
envisage that product reliability would be in the future the main critical resource on
which to invest in order to gain a competitive advantage, it should be able to promptly
manage its own metamorphosis (Glucksman M. and Morecroft J., 1998), with the
intent to build a strong knowledge and image, based on the new critical success factor.
° In our example, production flexibility could be a strategic asset generated by technical knowledge,
leading to a proper acquisition and co-ordination of different production derivative resources (e.g.,
machinery, labour, production scheduling, plant layout).
Figure 3: Business image building and draining Figure 4: Equity and liquidity dynamics
processes
4.3. Business equity building and depletion processes: factors affecting
time to generate income.
Business equity is a third important primary resource whose accumulation process is
usually affected by a number of delays that will be here analysed.
If observed on a static perspective, equity is the difference between assets and
liabilities in a given time.
If observed on a dynamic perspective, equity can be calculated as follows:
E (t1) = E (to) + I (ti-to) — W(ti-to) + El(ti-to), where:
E(t) = Equity at period ti;
E(to) = Equity at period to;
I(ti-to) = Income (i.e. revenues minus costs) during the time interval “ti-to”;
W(ti-to) = Equity withdrawals (dividends) operated by business owners during the
time interval “ti-to”;
El(ti-to) = Equity investments operated by business owners during the time interval
“ti-to”.
Figure 4 shows that the income rate is generated from the co-ordination and
deployment of available primary and derivative resources. The higher is their
qualitative and quantitative profile, the higher — other conditions being equal — will be
income. The time needed for a firm to earn a return on invested capital (time to
generate income) mainly depends on two factors, i.e.: (1) the business and product
life-cycle stage and (2) characteristics of the industry where the firm operates. ‘Time
to generate income’ can be — other conditions being equal — higher during the early
stages of business life-cycle or in the case where the “product portfolio” is mainly
made up by new products, which tend to absorb more liquidity than they can
generate, implying also a lower profitability !°. Also industry-related factors may
significantly influence ‘time to generate income’. In fact, in the initial stages of
business life-cycle, if the industry where the firm operates is characterised by higher
proportion of fixed versus variable costs, it usually takes more time to achieve the
necessary operating volume that allows the firm to reach the break even.
Figure 4 also shows that current cash flow is affected by: a) current income gross of
non monetary costs, b) time to generate liquidity, and c) activity volumes influencing
the net working capital '!. It is crucial for a firm to properly and timely perceive
10 Tn fact, the burden of start-up costs related to various long-term investments usually extends the time
it takes for a firm to be profitable. Likewise, new products launching often requires large investments
related to R&D, production, promotion etc., whose return cannot be obtained in a short time horizon,
not only because of their considerable amount, but also owing to the low initial market demand.
!! Time to generate liquidi related to terms of payment allowed to customers and negotiated with
suppliers and to inventory cycle time (i.e. how long inventories are kept on stock before sale).
variables affecting current cash flows. Not all potential profitable growth-oriented
strategies are eventually successful, as they may not be compatible with business
liquidity. In fact, increased activity volumes and variables influencing time to generate
both income and liquidity, may give rise to negative cash flows that could seriously
prejudice business available bank credit (Bianchi C. and Bivona E., 1999). Business
operating strategies and policies are likely to generate a financial stress in two main
ways: 1) during the start-up and reorganisation stages, when long-term investments
in production capacity, R&D, promotion, distribution, organisation, etc. usually
increase the time it takes to generate income from adopted strategies and require
higher financial needs; 2) when the current endowment of available resources is
exploited by pursuing sales and market share growth, based on aggressive
commercial and production strategies !?. The concomitant effect of both the above
delays and the influence that activity volumes are likely to gradually generate on the
net working capital needs are a primary cause of system complexity and
unpredictability in understanding and managing the dynamics of equity, liquidity and
other strategic assets.
Figure 4 also shows that the acquisition of derivative resources (i.e. other derivative
resources building rate) gives rise to monetary needs if available liquidity does not
allow the firm to provide the necessary funds to finance investments !?. In order to
face such monetary needs, the firm may either negotiate loans or increase equity, or
even may opt for a combination of the above two policies. From fig. 4 it is possible to
argue that, likewise the equity increase rate, the negotiation of loans gives rise to a co-
flow that, in this case, is accumulated into the stock of total debts.
The management of equity concerns the design of policies affecting equity withdrawal
and increase rates that ought to take into account three main factors: 1) resource
acquisition monetary needs, caused by lack of available liquidity; 2) the “debts-to-
equity” ratio; 3) the extent to which business owners are willing or able to invest more
equity and reduce their periodical equity withdrawals. The above three factors are to
be systemically managed. Cause-and-effect relationships among them make more
complex equity management. In fact, the higher is the acquisition of new derivative
resources, if available assets are properly deployed, the higher income and cash flows
— other conditions being equal — will be generated on a longer time horizon. However,
in the short term, higher monetary needs caused by investments done could force the
firm to find new sources of liquidity. Such sources could be found by negotiating new
loans; nevertheless, the higher is the “debts-to-equity” ratio, the more difficult will be
for the firm to negotiate new loans at profitable interest rates and the less liquid will
be its financial position. Consequently, in order to provide the necessary monetary
resources, decision makers could — at least partially — ask business owners to increase
equity and/or reduce dividends. However, also this policy could be tackled, for
instance, by a lack of the business owning family personal assets from which to draw
liquidity to increase business equity and/or by resistance to divert resources into the
business or to give up to periodical withdrawals of profits. The consideration of the
above problems, could lead policy makers to reduce their investment programmes;
12 Quite often such strategies give rise to a net working capital increase, due to higher activity volumes
and longer terms of payment allowed to customers or even higher inventory cycle time. A higher
inventory cycle time could be caused by increased safety stocks that could be necessary to provide a
buffer in order to better pursue production and distribution flexibility, given a technology available in a
short-medium time horizon.
13 In other words, resource acquisition monetary needs = other derivative resources building rate minus
available liquidity from bank accounts.
nevertheless, if such decision could make more liquidity free in the short run, it could
deteriorate long term profitability and liquidity.
From the above analysis, it follows that managing business equity and liquidity
involves the consideration of a wider set of interconnected variables and the
assessment of effects that decisions are likely to generate over a short and long time
horizon. This is not an easy task for decision makers, not only because of limits in
available information, but also because of human cognitive flaws (Sterman J., 1994).
In fact, it may be difficult for policy makers to figure out the domain of relevant
variables, in order to outline the boundaries of the system to be explored and to
mentally process the impact that multiple cause-and-effect relationships characterised
by sequential delays are likely to generate on the stocks upon which decisions are
made.
4.4. Dynamic relationships among primary resources
In this paragraph, two examples of how dynamic relationships may be generated
among primary resources will be provided. Figure 5 shows how corporate image and
capabilities may affect workers’ morale through co-flows. In fact, the higher is the
change in image and/or learning, the higher is usually the change in workers’ morale
and motivation. Although there could be some delays between the two rates and the
change in morale, e.g. due to communication lags between the firm and its employees,
the extent to which people are satisfied and lured to work into a company strongly
depends on how they perceive the business as a potential source of learning and a
means to increase their level of self-esteem. A higher worker’s morale not only tends
to attract more people into the firm, but also reduces the average time elapsing
between when people are hired and they resign (time to leave). A lower time to leave
reduces (other conditions being equal) the rate at which skilled people resign in a
given time period and — if the hire rate is higher than the resign rate — increases the
business headcount. A higher headcount made up by motivated people is likely to
give rise — given an education investment budget — to a further increase in learning,
which strengthens motivation, leading to a self-feeding virtuous cycle.
Fig. 6 provides a different example of how primary resources may affect each other:
how error correction and detection capabilities influence company product reliability
image. The figure shows that the use of a given technology implies a normal rate of
new production defects in a given time interval, which accumulates into a stock of
total production defects. The latter increases when the firm has not developed a
knowledge base consisting of capabilities which allow employees to detect and
correct more defects than generated. However, if learning-by-doing is successfully
enhanced, the firm is able to strengthen its error detection and correction capabilities
over a longer time horizon. In fact, the more total production defects increase, the
higher variety and number of problem issues employees will face; this will increase
their skills in diagnosing and solving problems. A higher learning rate increases
capabilities, leading to a higher error detection and correction rate. Until this last
variable is lower than the rate of new production defects, the stock of total production
defects continues to grow at a decreasing pace. When the errors correction and
detection outflow becomes higher than the new errors inflow, as an effect of increased
capabilities, the net change of the total defects stock becomes negative, causing total
defects to drop.
re
Figure 5: Dynamic relationships among Figure 6: Dynamic relationships between
primary resources: co-flows affecting their primary resources: how error detection and
accumulation processes correction capabilities affect image
When a new production technology is adopted by the firm (time to, fig. 6) — e.g. in
order to reduce costs, increase flexibility and/or volumes — a discontinuance in the
business know-how is often caused. Such a phenomenon is due to the lack of
experience at the start of a new technology cycle, related to the time it usually takes to
get acquainted of new organisational and technical issues required by new production
methods. Consequently, although capabilities may have reached a relatively high level
concerning the past technology, they are not sufficient to support employees in
detecting errors related to defects caused by the new technology. As shown in the
graphs of fig. 6, if learning-by-doing is properly enhanced, an increase in production
defects rate (due to the technology leap) gives rise to a new cycle consisting of
increasing total defects that will further strengthen capabilities. Higher capabilities
will allow again the firm to progressively empty the stock of total defects.
How does the dynamics of error detection and correction capabilities affect product
reliability company image? Figure 6 shows that the stock of total production defects is
inversely related to company relative product reliability, ie. a ratio between total
competitors’ versus company’s production defects in a given time. In fact, the more
defective is production, the higher is product failure rate and the lower is reliability,
which deteriorates image. Consequently, lower production defects resulting from
higher error detection and correction capabilities, will increase relative company
product reliability. However, it is quite rare that a higher business reliability is likely
to immediately increase image. In fact, at least two variables may delay the image
building process, i.e.: the effectiveness of business communication policies and
customer preferences. The more a business is able to communicate to customers its
progress on product reliability and the relevance to them of its superior performance,
the lower will be the time to change image. However, business communication
effectiveness not only depends on the policies the firm currently adopts, but is also
affected by other factors, such as customers negative or positive
preconceptions/expectations towards the firm, which are mainly related to the image
that the company has built in the past. Another factor influencing time to change
image is related to customer preferences. This is an external variable, related to the
extent to which product reliability is perceived by customers as an important factor to
satisfy their needs.
Product reliability image is also affected by competitors policies. In fact, after a
perception delay, they could react to improvements in relative company product
reliability, by undertaking programs aimed at restoring the performance gap.
On the basis of the above remarks, it is possible to conclude that product reliability
company image will be likely to fluctuate over time as a consequence of: (1)
oscillations in business’ and competitors’ error detection/correction capabilities, (2)
delays, (3) evolutions in customer preferences.
In order to manage business image, decision makers need to understand how to affect
relevant primary resources, such as competencies, that will allow the firm to increase
its performance and — hence — to improve image. Decision makers must also
understand delays between causes and effects and outline the relevant boundaries of
the system embodying several internal and external forces generating business image
oscillations. For instance, changes in consumers’ preferences or competitors’ behavior
could significantly affect the dynamics of image over time. Understanding system
structure is the necessary step to figure out the reasons underlying its behaviour and to
set proper goals and policies to effectively pursue a stable and durable growth.
4.5. Modelling the firm as a dynamic feedback resource system.
Figure 7 provides a synopsis of processes underlying primary and derivative resources
dynamics. The above analysis has shown how a firm can be seen as a dynamic
resource stock and flow system, characterised by multiple relationships often
implying non-linear cause-and-effect relationships and delays between relevant
variables, leading to oscillating behaviour. Strategic control must support policy
makers in understanding how to manage such a dynamic system, in order to improve
qualitative and quantitative strategic assets growth over time. A main difficulty
related to the implementation of strategic control is due to the deficiencies of
traditional accounting systems in monitoring non-financial parameters and detecting
feedback loops, delays, external variables, in order to have a clearer picture of the
system on which decisions will impact in the short and long term. Measuring non-
financial parameters, such as reliability or knowledge, is not simple. In fact, applying
subjective rating scales to a given set of variables (that are often fuzzy) may lead to
inaccurate, or even wrong estimations. However, the conclusion that a higher risk of
inaccuracy ought to suggest a firm to give up control over its strategic assets system
cannot be accepted for two main reasons, i.e.: 1) also many financial evaluations may
be inaccurate (e.g. inventories or accounts receivable) or wrong; 2) the role of non-
financial evaluations is not to provide a specific, absolute, value related to a single
variable, but is instead to focus a pattern of behaviour over a given period of time,
related to a group of variables that are systematically associated one other
We believe that when the goal of business control is not measurement per se, but
instead to support decision makers’ learning, it is better to have imprecise, but
prompt, estimations rather than lacking any kind of help. If the above view of
strategic control is adopted, decision makers are helped in understanding how and
why primary resources change, they do affect derivative production factors and
results are obtained from the co-ordination and deployment of both groups of
resources, thereby affecting primary factors again. In such a perspective, the firm is
analysed and managed as a feedback system, whose present state in affected by past
decisions and affects the future state.
The awareness of feedback loops and time delays between causes and related effects
allows decision makers to better explain system dynamics, i.e. why a given state of
the business system has been achieved as an effect of results generated by our past
activities and external variables.
Figure 7: A synopsis of primary and derivative resources building and draining processes
The feedback approach goes beyond an “input-output” view of the business system
(structure > activities > results). Quite often, a non-systemic view of the firm leads
decision makers to emotionally react to those problems which seem to be as the most
urgent and compelling. As a consequence of such behaviour, short term positive
results achieved by policies aimed at “plugging” emerging crisis symptoms are offset
in a longer time horizon by unintended negative consequences which may generate
into a deeper crisis.
Another implication of emotional decision makers’ behaviour is related to limits to
growth misperception. In fact, crises may be also caused by irrational growth policies,
which do not take into account the availability of internal resources which may sustain
the expansion of business activities. “Key resource constraints include: (1) shortage of
labour or physical inputs, (2) shortage of finance; (3) lack of suitable investment
opportunities and lack of managerial capacity. Penrose considers the growth of the
firm as limited only in the long-run by its internal management resources ... In
Penrose’s theory ‘management (is) both the accelerator and the brake for the growth
process’” (Mahoney J. and Pandian J., 1992; Starbuck W., 1965). Other undetected
limits to growth may also come from external variables, such as potential market.
The SD methodology can substantially help decision makers to understand how
business strategic assets can be affected in the short and long run by their policies.
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