Capability Reputation

Capabilities are generally defined as a firm’s ability to use and combine resources to do something valuable or useful, such as produce a product or develop an innovation. Because stakeholders, whether they are customers, investors, suppliers, competitors, or someone else, do not have access to perfect information about a firm and its capabilities, they must instead use direct and vicarious observations of the firm’s actions and outcomes to make inferences about what its underlying capabilities are. Based on these inferences, stakeholders form beliefs about a firm’s skill sets and performance characteristics, such as its ability to innovate, produce high-quality products or services, provide quality management, and have strong financial performance, in addition to other aspects about what a firm can do or what it is likely to be able to accomplish.

These stakeholder group–specific beliefs are referred to as capability reputations, and a firm may have numerous capability reputations that can vary depending on the specific aspects being evaluated. For example, it may be viewed as being able to produce high-quality products and being able to meet the expectations of the financial markets, but not for being particularly innovative or having very high-quality managers. These capability judgments are then used by stakeholders to make decisions about whether and how to interact with a particular firm. The rest of this entry briefly reviews the history of capability reputation research, how capability reputations are built or lost, and the implications of having a good or bad capability reputation.

The research on capability reputations traces its roots to the signaling literature in economics. Because the focus of these studies was often on firm performance, most references to reputations in these literatures, when not otherwise specified, seem to refer implicitly to capability reputations of some sort. For example, many studies on reputation in the management literature used the well-known Fortune’s “Most Admired Companies” list, which appears to represent the perceptions that executives, directors, and analysts have regarding the ability of the firms to have continued financial performance, and hence can be thought of as a measure of the capability reputation of a firm for those specific audiences.

Building and Losing a Good Capability Reputation

A firm can build a positive reputation for possessing particular capabilities over time by consistently meeting or exceeding the expectations of stakeholders along the relevant dimension being evaluated, whether it’s financial performance, research and development output, or something else. Similarly, consistent violations of stakeholder expectations (e.g., negative earnings surprises, product failures) may lead to the erosion or degradation of a firm’s capability reputation.

Capability reputations may not take that much time and effort to build because there tends to be a positivity bias when making judgments about abilities. That is, positive indicators and accomplishments are weighted heavier and given more credence when making inferences about capability. If so, capability reputations may be fairly robust and difficult to lose once built up. However, the processes surrounding judgments of individuals’ capabilities may be very different from how stakeholders make judgments about an organization’s capabilities. Exactly how long it might take to develop capabilities, when stakeholders will give the organization credit for possessing those capabilities, and how quickly they may be lost is still not known.

What Are the Implications of a Good or Bad Capability Reputation?

A good capability reputation means that the firm is viewed as highly skilled and/or capable of creating value along the dimension being evaluated by the stakeholder group. For example, Berkshire Hathaway may be viewed by investors as being able to generate strong financial market performance, while Apple might be viewed as being able to develop innovative but easy-to-use products. On the other hand, a bad capability reputation would mean that the stakeholder group would view the firm as being particularly inept or unskilled at creating value in a particular dimension. Many major American airlines, for example, are often cited by customers as being unable to provide good customer service or comfortable travel experiences in comparison with European or Asian carriers.

Having a good capability reputation can benefit a firm in numerous ways. A strong capability reputation can help a firm charge and earn premiums on its products from customers and thereby gain greater market dominance, be viewed as a more attractive partner for joint ventures by other firms, and be perceived as a less risky investment by the financial markets. In a related vein, although it is rarely referred to as an assessment of a company’s capability reputation, perceptions about a rival firm’s capabilities influence the degree to which a firm would attack, retaliate, or otherwise engage in direct competitive interactions with that rival.

Conversely, firms with a bad capability reputation are likely to have difficulty in attracting and retaining customers or clients, may have to offer price discounts relative to competitors with similar product quality, may be underpriced in the stock market, and may be generally viewed as less attractive by stakeholders. In addition, competitors are also more likely to view firms with a bad capability reputation as being less able to defend themselves and thus may be more likely to attack those firms. At the same time, however, good capability reputations may not always lead to positive outcomes for the firm, and by the same token, a bad capability reputation may not always lead to bad outcomes for the firm either.

Although good capability reputations bring tremendous benefits to a firm, there is some evidence that there may be downsides to having a good capability reputation as well. For example, automobile firms with a stronger reputation lost more market share following a severe automobile recall than firms with a weaker reputation. In a different vein, strong performance tends to lead to unrealistically high expectations from both investors and analysts. Likewise, these types of pressures might lead some firms to engage in illegal activities in order to try to avoid a potential letdown. Moreover, activists might be more likely to target firms with a good reputation because such firms make a better symbolic target and are likely to have greater media coverage.

Conclusion

Capability reputations can influence firms in many different ways, and there may be both benefits and drawbacks to having a good capability reputation. Exactly how capability reputations are built, maintained, or lost, as well as the complex influences that they can have on firms, varies and warrants further study.