text:
Discover everything Scribd has to offer, including books and audiobooks from major publishers.
N I N T H E d iti o n es io Cas Ed nd
n a it xt TeC o n te m po r a r y S t r ate gy A na lys i s T ex t a n d Ca s e sC o ntemporary Strategy An alysis T e xt a n d ca se s
Ninth Edition
Robert M. GrantCopyright © 2016, 2013, 2010 Robert M. Grant
All effort has been made to trace and acknowledge ownership of copyright. The publisher would be gladto hear from any copyright holders whom it has not been possible to contact.
Registered officeJohn Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom
For details of our global editorial offices, for customer services and for information about how to applyfor permission to reuse the copyright material in this book please see our website at www.wiley.com.
The right of Robert M. Grant to be identified as the author of this work has been asserted in accordancewith the UK Copyright, Designs and Patents Act 1988.
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmit-ted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except aspermitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher.
Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some materialincluded with standard print versions of this book may not be included in e-books or in print-on-demand.If this book refers to media such as a CD or DVD that is not included in the version you purchased, youmay download this material at http://booksupport.wiley.com. For more information about Wiley prod-ucts, visit www.wiley.com.
Designations used by companies to distinguish their products are often claimed as trademarks. All brandnames and product names used in this book are trade names, service marks, trademarks or registeredtrademarks of their respective owners. The publisher is not associated with any product or vendor men-tioned in this book. This publication is designed to provide accurate and authoritative information inregard to the subject matter covered. It is sold on the understanding that the publisher is not engaged inrendering professional services. If professional advice or other expert assistance is required, the servicesof a competent professional should be sought.
A catalogue record for this book is available from the British Library.
Glossary 727 Index 735 CONTENTS
Summary 386 Self-Study Questions 386 Notes 387
Introduction 410 The New Environment of Business 410 New Directions in Strategic Thinking 415 Redesigning Organizations 419 The Changing Role of Managers 422 Summary 424 Notes 424
15 New York Times: The Search for a New Business Model 598
Glossary 727 Index 735 Pr eface t o ninth E dition
Strategy is the great work of the organization. In situations of life or death, it is the Tao of survival or extinction. Its study cannot be neglected. —SUN TZU, THE ART OF WAR
◆◆ The Basic Framework for Strategy Analysis ◆◆ How Is Strategy Made? The Strategy Process
By the time you have completed this chapter, you will be able to: ◆◆ Appreciate the contribution that strategy can make to successful performance, both for individuals and for organizations, and recognize the key characteristics of an effective strategy. ◆◆ Comprehend the basic framework of strategy analysis that underlies this book. ◆◆ Recognize how strategic management has evolved over the past 60 years. ◆◆ Identify and describe the strategy of a business enterprise. ◆◆ Understand how strategy is made within organizations. ◆◆ Recognize the distinctive features of strategic management among not-for-profit organizations.
Since the purpose of strategy is to help us to win, we start by looking at the role of strategy in success.
Strategy Capsules 1.1 and 1.2 describe the careers of two individuals, Queen Elizabeth II and Lady Gaga, who have been outstandingly successful in leading their organiza- tions. Although these two remarkable women operate within vastly different arenas, can their success be attributed to any common factors? For neither of these successful women can success be attributed to overwhelm- ingly superior resources. For all of Queen Elizabeth's formal status as head of state, she has very little real power and, in most respects, is a servant of the democratically elected British government. Lady Gaga is clearly a creative and capable entertainer, but few would claim that she has outstanding talents as a vocalist, musician, or songwriter. Nor can their success be attributed either exclusively or primarily to luck. Indeed, Queen Elizabeth has experienced a succession of difficulties and tragedies, while Lady Gaga has experienced setbacks (e.g. the cancelation of her first recording chapter 1 The Concept of Strategy 5
contract and various health problems). Central to their success has been their abilityto respond to events—whether positive or negative—with flexibility and clarity ofdirection. My contention is that common to both the 60-year successful reign of QueenElizabeth II and the short but stellar career of Lady Gaga is the presence of a soundlyformulated and effectively implemented strategy. While these strategies did not existas explicit plans, for both Queen Elizabeth and Lady Gaga we can discern a consis-tency of direction based clear goals and a keen awareness of how to maneuver intoa position of advantage. Elizabeth Windsor's strategy as queen of the UK and the Commonwealth countriesmay be seen in the role she has created for herself in relation to her people. As queenshe is figurehead for the nation, an embodiment of the stability and continuity of thenation, a symbol of British family and cultural life, and an exemplar of service andprofessional dedication. Lady Gaga's remarkable success during 2008-15 reflects a career strategy that usesmusic as her gateway, upon which she has built a celebrity status by combining thegeneric tools of star creation—shock value, fashion leadership, and media presence—with a uniquely differentiated image that has captured the imagination and affectionof teenagers and young adults throughout the world. What do these two examples tell us about the characteristics of a strategy that areconducive to success? In both stories, four common factors stand out (Figure 1.1):
●● Goals that are consistent and long term: Both Queen Elizabeth and Lady Gaga display a focused commitment to career goals that they have pursued steadfastly. ●● Profound understanding of the competitive environment: The ways in which both Elizabeth II and Gaga define their roles and pursue their careers reveal a deep and insightful appreciation of the external environments in which they operate. Queen Elizabeth has been alert both to the changing political environment in which the monarchy is situated and to the mood and needs of the British people. Lady Gaga's business model and strategic positioning show a keen awareness of the changing economics of the music business, the marketing potential of social networking, and the needs of Generation Y. ●● Objective appraisal of resources: Both Queen Elizabeth and Lady Gaga have been adept at recognizing and deploying the resources at their disposal. Both, too, have been aware of the limits of those resources and drawn upon the resources of others—Queen Elizabeth through her family, the royal household, and a network of loyal supporters; Lady Gaga upon the variety of talents in her Haus of Gaga. ●● Effective implementation: Without effective implementation, the best-laid strategies are of little use. Critical to the success of Queen Elizabeth and Lady Gaga has been their effectiveness as leaders and the creation of loyal, supportive organizations to provide decision support and operational implementation.
These observations about the role of strategy in success can be made in relationto most fields of human endeavor. Whether we look at warfare, chess, politics, sport,or business, the success of individuals and organizations is seldom the outcome6 Part I introduction
By late 2015, Elizabeth Windsor had been queen for Head of Nation" where she "acts as a focus for national 63 years—longer than any of her predecessors. identity, unity and pride; gives a sense of stability and At her birth on April 21, 1926, hereditary monar- continuity; officially recognises success and excel- chies were common throughout the world. Apart from lence; and supports the ideal of voluntary service" the British Empire, 45 countries had this form of gov- (www.royal.gov.uk). ernment. By 2015, the forces of democracy, modernity, How has Queen Elizabeth been able to retain not and reform had reduced these to 26—mostly small just the formal position of the monarchy but also its autocracies such as Bahrain, Qatar, Oman, Kuwait, status, influence, and wealth despite the challenges of Bhutan, and Lesotho. Monarchies had also survived the past 60 years? These challenges include the social in Denmark, Sweden, Norway, the Netherlands, and and political changes which have swept away most of Belgium, but these royal families had lost most of their the privileges conferred by hereditary status (including wealth and privileges. the exclusion of most hereditary lords from the House By contrast, the British royal family retains consid- of Lords, Britain's upper chamber of Parliament) and erable wealth—the Queen's personal net worth was the internal challenges presented by such a famously estimated by Forbes magazine at $500 million—not dysfunctional family—including the failed marriages of including the $10 billion worth of palaces and other most of her family members and the controversy that real estate owned by the nation but used by her and surrounded the life and death of her daughter-in-law, her family. Queen Elizabeth's formal status is head of Diana, Princess of Wales. state of the UK and 15 other Commonwealth coun- At the heart of Elizabeth's sustaining of the British tries (including Canada and Australia), head of the monarchy has been her single-minded devotion to Church of England, and head of the British armed what she regards as her duties to the monarchy and forces. Yet none of these positions confers any deci- to the nation. Throughout her 60-year reign she has sion making power—her influence comes from cultivated the role of leader of her nation—a role that the informal role she has established for herself. she has not compromised by pursuit of personal or According to her website, she "has a less formal role as family interests. In pursing this role she has recognized
the need for political neutrality—even when she has relations strategy has been carefully managed by apersonally disagreed with her prime ministers (notably group of top professionals who report to her privatewith Margaret Thatcher's "socially divisive" policies and secretary.Tony Blair's commitment of British troops to Iraq and While respecting tradition and protocol, sheAfghanistan). adapts in the face of pressing circumstances. The Through her outreach activities she has played a death of her daughter-in-law, Diana, created difficultmajor role in promoting British influence, British cul- tensions between her responsibilities as a grand-ture, and British values within the wider world. She has mother and her need to show leadership to a griev-made multiple visits to each of the 54 Commonwealth ing nation. In responding to this time of crisis shenations, including 26 to Canada and 16 to Australia. departed from several established traditions: includ- Maintaining her popularity with the British people ing bowing to the coffin of her ex-daughter-in-law ashas required adaptation to the wrenching changes it passed the palace.of her era. Recognizing the growing unacceptability Elizabeth has made effective use of the resourcesof hereditary privilege and the traditional British class available to her. First and foremost of these has beensystem, she has repositioned the royal family from the underlying desire of the British people for conti-being the leader of the ruling class to an embodiment nuity and their inherent distrust of their political lead-of the nation as a whole. To make her and her family ers. By positioning herself above the political fray andmore inclusive and less socially stereotyped she culti- emphasizing her lineage—including the prominentvated involvement with popular culture, with ordinary public roles of her mother and her children and grand-people engaged in social service and charitable work, children—she reinforces the legitimacy of herself, herand, most recently, endorsing the marriage of her family, and the institution they represent. She has alsograndson William to Kate Middleton—the first mem- exploited her powers of patronage, using her formalber of the royal family to marry outside the ranks of the position to cultivate informal relationships with botharistocracy. political and cultural leaders. Elizabeth has been adept at exploiting new media. The success of Elizabeth's 63-year reign is indicatedTelevision has provided an especially powerful medium by the popular support for her personally and forfor communicating both with her subjects and with the institution of the monarchy. Outside of Northerna wider global audience. Her web page appeared Ireland, the UK lacks any significant republican move-in 1997, in 2009 she joined Twitter, and in 2010 ment; republicanism is also weak in Canada andFacebook. Throughout her reign, her press and public Australia.
and reconciling. They know the environments within which they play and tend to be fast learners in terms of recognizing the paths to advancement. They know themselves well in terms of both strengths and weaknesses. Finally, they imple- ment their career strategies with commitment, consistency, and determination. As the late Peter Drucker observed: "we must learn how to be the CEO of our own careers."1 There is a downside, however. Focusing on a single goal may lead to outstand- ing success but may be matched by dismal failure in other areas of life. Many people who have reached the pinnacles of their careers have led lives scarred by poor relationships with friends and families and stunted personal development. These include Howard Hughes and Jean Paul Getty in business, Richard Nixon and8 Part I introduction
Stefani Joanne Angelina Germanotta, better known as However, music is only one element in the Lady Lady Gaga, is one of the most successful popular enter- Gaga phenomenon—her achievement is not so much tainers to emerge in the 21st century. Since releasing her as a singer or songwriter as in establishing a persona first album, The Fame, in 2008 she has certified album which transcends pop music. Like David Bowie and sales of 27 million, swept leading music awards including Madonna before her, Lady Gaga is famous for being Grammy, MTV, and Billboards, topped Forbes Celebrity 100 Lady Gaga. To do this requires a multi-media, multi- list, and generated $382 million in ticket sales for her 2012 faceted offering that comprises an integrated array "Born this Way" tour. Her 79 concerts during her 2014 of components including music, visual appearance, "Artrave: The Artpop Ball" tour generated $271 million. newsworthy events, a distinctive attitude and person- Since dropping out of NYU's Tisch School of the Arts ality, and a set of values with which fans can identify. in 2005, Germanotta has shown total commitment to Key among these is visual impact and theatricality. advancing her musical career, first as a songwriter, and Her hit records were heavily promoted by the visu- then developing her Lady Gaga persona. Her debut ally stunning music videos that accompanied them. album, The Fame, and its follow up, The Fame Monster, Paparazzi and Bad Romance each won best video yielded a succession of number-one hits during 2009 awards at the 2009 and 2010 Grammies; the latter is and 2010. the second-most-downloaded YouTube video of all Gaga's music is a catchy mix of pop and dance, well time. Most striking of all has been Lady Gaga's dress suited to dance clubs and radio airplay. It features good and overall appearance, which have set new stan- melodies, Gaga's capable singing voice, and her reflec- dards in eccentricity, innovation, and impact. Individual tions on society and life, but it is hardly exceptional or outfits—her plastic bubble dress, meat dress, and innovative: music critic Simon Reynolds described it "decapitated-corpse dress"—together with weird hair- as: "ruthlessly catchy, naughties pop glazed with Auto- dos, extravagant hats, and extreme footwear (she met Tune and undergirded with R&B-ish beats." President Obama in 16-inch heels)—are as well-known
Successful strategy
as her hit songs. The range of visual images she projects more as social statements of non-conformity thanis so varied that her every appearance creates a buzz of as fashion statements. In communicating her expe-anticipation as to her latest incarnation. riences of alienation and bullying at school and her More than any other star, Lady Gaga has developed a values of individuality, sexual freedom, and accep-business model that recognizes the realities of the post- tance of differences—reinforced through her involve-digital world of entertainment. Like Web 2.0 pioneers such ment in charities and gay rights events—she has builtas Facebook and Twitter, Gaga has followed the model: a global fan base that is unusual in its loyalty andfirst build market presence, and then think about mon- commitment. The sense of belonging is reinforcedetizing that presence. Her record releases are accompa- by gestures and symbols such as the "Monster Claw"nied, sometimes preceded, by music videos on YouTube. greeting and the "Manifesto of Little Monsters." AsWith 45 million Facebook fans, 15.8 m illion Twitter fol- "Mother Monster," Gaga is spokesperson and guru forlowers, and 1.9 billion YouTube views (as of November this community.16, 2011), Famecount crowned her "most popular liv- Lady Gaga's most outstanding talents are her show-ing musician online." Her networking with fans includes manship and theatricality. Modeled on Andy Warhol'sGagaville, an interactive game developed by Zynga, and "Factory," The Haus of Gaga is her creative workshopThe Backplane, a music-based social network. and augments her own capabilities. It includes man- Her emphasis on visual imagery reflects the ways ager Troy Carter, choreographer and creative directorin which her fame is converted into revenues. While Laurieann Gibson, fashion director Nicola Formichetti,music royalties are important, concerts are her primary hair stylist Frederic Aspiras, stylist and designer Annarevenue source. Other revenue sources—endorse- Trevelyan, fashion photographer Nick Night, makeupments, product placement in videos and concerts, artist Tara Savelo, marketing director Bobby Campbell,merchandizing deals, and media appearances—also and others involved in designing and producing songs,link closely with her visual presence. videos, concert sets, photo shoots, and the whole A distinctive feature of Gaga's market presence range of Gaga's public appearances.is her relationship with her fans. The devotion of her Sources: M. Sala, "The Strategy of Lady Gaga," BSc thesis Bocconifans—her "Little Monsters"—is based less on their University, Milan, June 2011; http://www.statisticbrain.com/desire to emulate her look as upon empathy with her lady-gaga-career-statistics, accessed July 20, 2015; http://values and attitudes. They recognize Gaga's images en.wikipedia.org/wiki/Lady_Gaga, accessed July 20, 2015.
Joseph Stalin in politics, Elvis Presley and Marilyn Monroe in entertainment, Mike Tyson and O. J. Simpson in sport, and Bobby Fischer in chess. Fulfillment in our personal lives is likely to require broad-based lifetime strategies.2 These same ingredients of successful strategies—clear goals, understanding the competitive environment, resource appraisal, and effective implementation—form the key components of our analysis of business strategy.
Figure 1.2 shows the basic framework for strategy analysis that we shall use through- out the book. The four elements of a successful strategy shown in Figure 1.1 are recast into two groups—the firm and the industry environment—with strategy10 Part I introduction
Figure 1.2 The basic framework: Strategy as a link between the firm and its environment
forming a link between the two. The firm embodies three of these elements: goals and values ("simple, consistent, long-term goals"), resources and capabilities ("objec- tive appraisal of resources"), and structure and systems ("effective implementation"). The industry environment embodies the fourth ("profound understanding of the competitive environment") and is defined by the firm's relationships with competi- tors, customers, and suppliers. This view of strategy as a link between the firm and its industry environment has close similarities with the widely used SWOT framework. However, as I explain in Strategy Capsule 1.3, a two-way classification of internal and external forces is superior to the four-way SWOT framework. The task of business strategy, then, is to determine how the firm will deploy its resources within its environment and so satisfy its long-term goals, and how it will organize itself to implement that strategy.
Strategic Fit Fundamental to this view of strategy as a link between the firm and its external environment is the notion of strategic fit. This refers to the consistency of a firm's strategy, first, with the firm's external environment and, second, with its internal environment, especially with its goals and values and resources and capabilities. A major reason for the decline and failure of some companies comes from their having a strategy that lacks consistency with either the internal or the external environment. The decline of Nokia (which lost over 90% of its stock market value in the four years up to July 2012) may be attributed to a strategy which failed to take account of a major change in its external environment: the growing consumer demand for smartphones. Other companies struggle to align their strategies to their internal resources and capabilities. A critical issue for Nintendo will be whether it possesses the financial and technological resources to continue to compete head-to-head with Sony and Microsoft in the market for video game consoles. The concept of strategic fit also relates to the internal consistency among the different elements of a firm's strategy. Effective strategies are ones where functional strategies and individual decisions are aligned with one another to create a con- sistent strategic position and direction of development. This notion of internal fit is central to Michael Porter's conceptualization of the firm as an activity system. chapter 1 The Concept of Strategy 11
Distinguishing between the external and the inter- and who may intimidate his younger team members,nal environment of the firm is common to most he is a weakness.approaches to strategy analysis. The best-known Is global warming a threat or an opportunity for theand most widely used of these approaches is the world's automobile producers? By encouraging higher"SWOT" framework, which classifies the various taxes on motor fuels and restrictions on car use, it isinfluences on a firm's strategy into four categories: a threat. By encouraging consumers to switch to fuel-Strengths, Weaknesses, Opportunities, and Threats. efficient and electric cars, it offers an opportunity forThe first two—strengths and weaknesses—relate new sales.to the internal environment of the firm, primar- The lesson here is that classifying external factorsily its resources and capabilities; the last two— into opportunities and threats, and internal factors intoopportunities and threats—relate to the external strengths and weaknesses, is arbitrary. What is impor-environment. tant is to carefully identify the external and internal Which is better, a two-way distinction between forces that impact the firm, and then analyze theirinternal and external influences or the four-way SWOT implications.taxonomy? The key issue is whether it is sensible and In this book I will follow a simple two-way classi-worthwhile to classify internal factors into strengths fication of internal and external factors and avoid anyand weaknesses and external factors into opportu- superficial categorization into strengths or weaknesses,nities and threats. In practice, such distinctions are and opportunities or threats.difficult. Is LeBron James a strength or a weakness for the Note: For more on SWOT see: T. Hill and R. Westbrook, "SWOT Analysis: It's Time For A Product Recall," Long Range Planning,Cleveland Cavaliers? As one of the NBA's most accom- 30 (February 1997): 46–52; and M. Venzin, "SWOT Analysis:plished and acclaimed players he is a strength. As a Such a Waste of Time?" (February 2015) http://ideas.30-year-old player whose best days are behind him sdabocconi.it/strategy/archives/3405.
Porter states that "Strategy is the creation of a unique and differentiated position involving a different set of activities."3 The key is how these activities fit together to form a consistent, mutually reinforcing system. Ryanair's strategic position is as Europe's lowest-cost airline providing no-frills flights to budget-conscious travelers. This is achieved by a set of activities which fit together to support that positioning (Figure 1.3). The concept of strategic fit is one component of a set of ideas known as contingency theory. Contingency theory postulates that there is no single best way of organizing or managing. The best way to design, manage, and lead an organization depends upon circumstances—in particular the characteristics of that organization's environment.412 Part I introduction
Job High labor f lexibility High aircraft No-frills product utilization offering productivity Boeing Direct 737s only Single class; no sales 25-min. reserved seating Low prices; only turnaround separate charging for additional No baggage Point-to-point routes Internet-only services transfer check-in
Secondary airports
Many of the principles of military strategy have been applied to business situ- ations. These include the relative strengths of offensive and defensive strategies; the merits of outflanking over frontal assault; the roles of graduated responses to aggressive initiatives; the benefits of surprise; and the potential for deception, envelopment, escalation, and attrition.6 At the same time, there are major differ- ences between business competition and military conflict. The objective of war is (usually) to defeat the enemy. The purpose of business rivalry is seldom so aggressive: most business enterprises seek to coexist with their rivals rather than to destroy them. chapter 1 The Concept of Strategy 13
The tendency for the principles of military and business strategy to develop alongseparate paths indicates the absence of a general theory of strategy. The publicationof Von Neumann and Morgenstern's Theory of Games in 1944 gave rise to the hopethat a general theory of competitive behavior would emerge. During the subsequentsix decades, game theory has revolutionized the study of competitive interaction,not just in business but in politics, military conflict, and international relations aswell. Yet, as we shall see in Chapter 4, game theory has achieved only limited suc-cess as a broadly applicable general theory of strategy.7
The first step in developing long-range plans was to corporation and various district engineers. Alternative forecast the product demand for future years. After plans for achieving company goals were also devel- calculating the tonnage needed in each sales district oped for some areas, and investment proposals were to provide the "target" fraction of the total forecast formulated after considering the amount of available demand, the optimal production level for each area capital and the company debt policy. The vice presi- was determined. A computer program that incor- dent who was responsible for long-range planning porated the projected demand, existing production recommended certain plans to the president and, after capacity, freight costs, etc. was used for this purpose. the top executives and the board of directors reviewed When the optimum production rate in each area alternative plans, they made the necessary decisions was found, the additional facilities needed to produce about future activities. the desired tonnage were specified. Then the capi- Source: H. W. Henry, Long Range Planning Processes in 45 tal costs for the necessary equipment, buildings, and Industrial Companies (Englewood Cliffs, NJ: Prentice-Hall, layout were estimated by the chief engineer of the 1967): 65.
During the 1990s, the focus of strategy analysis shifted from the sources of profit in the external environment to the sources of profit within the firm. Increasingly the resources and capabilities of the firm became regarded as the main source of com- petitive advantage and the primary basis for formulating strategy.12 This emphasis on what has been called the resource-based view of the firm represented a sub- stantial shift in thinking about strategy. While the quest for attractive industries and market leadership encouraged firms to adopt similar strategies, emphasis on internal resources and capabilities has encouraged firms to identify how they are different from their competitors and design strategies that exploit these differences. During the 21st century, new challenges have continued to shape the principles and practice of strategy. Digital technologies have had a massive impact on the com- petitive dynamics of many industries, creating winner-take-all markets and standards wars.13 Disruptive technologies14 and accelerating rates of change have meant that strategy has become less and less about plans and more about creating options of the future,15 fostering strategic innovation,16 and seeking the "blue oceans" of uncon- tested market space.17 The complexity of these challenges have meant that being self-sufficient is no longer viable for most firms—alliances and other forms of col- laboration are an increasingly common feature of firms' strategies. The 2008–2009 financial crisis triggered new thinking about the strategy and pur- pose of business. Disillusion with the excesses and unfairness of market capitalism has renewed interest in corporate social responsibility, ethics, sustainability, and the role of legitimacy in long-term corporate success.18 Figure 1.4 summarizes the main developments in strategic management since the mid-20th century. chapter 1 The Concept of Strategy 15
Financial Budgeting:
1950 • Operational budgeting • DCF capital budgeting
1960 Corporate Planning: • Corporate plans based on medium-term economic forecasts
1970 Emergence of Strategic Management: • Industry analysis and competitive positioning
1980 The Quest for Competitive Advantage: • Emphasis on resources and capabilities
1990 • Shareholder value maximization • Refocusing, outsourcing, delayering, cost cutting
2000 Adapting to Turbulence: • Adapting to and exploiting digital technology • The quest for flexibility and strategic innovation
2015 • Strategic alliances • Social and environmental responsibility
Strategy Today
What Is Strategy?In its broadest sense, strategy is the means by which individuals or organizationsachieve their objectives. Table 1.1 presents a number of definitions of the term strat-egy. Common to most definitions is the notion that strategy is focused on achievingcertain goals; that it involves allocating resources; and that it implies some consis-tency, integration, or cohesiveness of decisions and actions. Yet, as we have seen, the conception of firm strategy has changed greatly overthe past half-century. As the business environment has become more unstable andunpredictable, so strategy has become less concerned with detailed plans and moreabout guidelines for success. This is consistent with the examples that began thischapter. Neither Queen Elizabeth nor Lady Gaga appears to have articulated anyexplicit strategic plan, but the consistency we discern in their actions suggests bothpossessed clear ideas of what they wanted to achieve and how they would achieveit. This shift in emphasis from strategy as plan to strategy as direction does not implyany downgrading of the role of strategy. The more turbulent the environment, themore must strategy embrace flexibility and responsiveness. But it is precisely inthese conditions that strategy becomes more, rather than less, important. When thefirm is buffeted by unforeseen threats and where new opportunities are constantly16 Part I introduction
●● Strategy: a plan, method, or series of actions designed to achieve a specific goal or effect. —Wordsmyth Dictionary (http://www.wordsmyth.net) ●● T he determination of the long-run goals and objectives of an enterprise, and the adoption of courses of action and the allocation of resources necessary for carrying out these goals. —Alfred Chandler, Strategy and Structure (Cambridge, MA: MIT Press, 1962) ●● Strategy: "a cohesive response to an important challenge." —Richard Rumelt, Good Strategy/Bad Strategy (New York: Crown Business, 2011): 6. ●● Lost Boy: "Injuns! Let's go get 'em!" John Darling: "Hold on a minute. First we must have a strategy." Lost Boy: "Uhh? What's a strategy?" John Darling: "It's, er . . . it's a plan of attack." —Walt Disney's Peter Pan
appearing, then strategy becomes the compass that can navigate the firm through stormy seas.
●● Where is the company investing its money? Notes to financial statements pro- vide detailed breakdowns of capital expenditure by region and by business segment. ●● What technologies is the company developing? Identifying the patents that a company has filed (using the online databases of the US and EU patent offices) indicates the technological trajectory it is pursuing. ●● What new products have been released, major investment projects initi- ated, and top management hired? These strategic decisions are typically announced in press releases and reported in trade journals.
●● Where to compete? ●● How to compete?
The answers to these questions define the two major areas of a firm's strategy: corporate strategy and business strategy. Corporate strategy defines the scope of the firm in terms of the industries and markets in which it competes. Corporate strategy decisions include choices over diversification, vertical integration, acquisitions, and new ventures, and the alloca- tion of resources between the different businesses of the firm. chapter 1 The Concept of Strategy 19
Business strategy is concerned with how the firm competes within a particular industry or market. If the firm is to prosper within an industry, it must establish a competitive advantage over its rivals. Hence, this area of strategy is also referred to as competitive strategy. The distinction between corporate strategy and business strategy corresponds to the organizational structure of most large companies. Corporate strategy is the responsibility of corporate top management. Business strategy is primarily the responsibility of the senior managers of divisions and subsidiaries. This distinction between corporate and business strategy also corresponds to the primary sources of superior profit for a firm. As we have noted, the purpose of strategy is to achieve superior performance. Basic to this is the need to survive and prosper, which in turn requires that over the long term the firm earn a rate of return on its capital that exceeds its cost of capital. There are two possible ways of achiev- ing this. First, by choosing to locate within industries where overall rates of return are attractive (corporate strategy). Second, by attaining a position of advantage vis- à-vis competitors within an industry, allowing it to earn a return that exceeds the industry average (Figure 1.5). This distinction may be expressed in even simpler terms. The basic ques- tion facing the firm is "How do we make money?" The answer to this ques- tion corresponds to the two basic strategic choices we identified above: "Where to compete?" ("In which industries and markets should we be?") and "How to compete?" As an integrated approach to firm strategy, this book deals with both business and corporate strategy. However, my primary emphasis will be on business strategy. This is because the critical requirement for a company's success is its ability to establish competitive advantage. Hence, issues of business strategy precede those of corpo- rate strategy. At the same time, these two dimensions of strategy are intertwined: the scope of a firm's business has implications for the sources of competitive advantage, and the nature of a firm's competitive advantage determines the industries and mar- kets it can be successful in.
INDUSTRY ATTRACTIVENESS CORPORATE STRATEGY RATE OF PROFIT Where to compete? ABOVE THE COST OF CAPITAL
How do we make money? COMPETITIVE ADVANTAGE BUSINESS STRATEGY How to compete? chapter 1 The Concept of Strategy 21
Figure 1.6 Describing firm strategy: Competing in the present, preparing forthe future
Describing StrategyThese same two questions—"Where is the firm competing?" and "How is it compet-ing?"—also provide the basis upon which we can describe the strategy that a firm ispursuing. The where question has multiple dimensions. It relates to the products thefirm supplies, the customers it serves, the countries and localities where it operates,and the vertical range of activities it undertakes. However, strategy is not simply about "competing for today"; it is also concernedwith "competing for tomorrow." This dynamic aspect of strategy involves establishingobjectives for the future and determining how they will be achieved. Future objec-tives relate to the overall purpose of the firm (mission), what it seeks to become(vision), and how it will meet specific performance targets. These two dimensions of strategy—the static and the dynamic—are depictedin Figure 1.6 and are illustrated by the Coca-Cola Company. As we shall seein Chapter 8, reconciling these two dimensions of strategy—what Derek Abellcalls "competing with dual strategies"—is one of the central dilemmas of strategicmanagement.26
How companies make strategy and how they should make strategy are among themost hotly debated issues in strategic management. The corporate planning under-taken by large companies during the 1960s was a highly formalized approach tostrategy making. Strategy may also be made informally: emerging through adap-tation to circumstances. In our opening discussion of Queen Elizabeth and LadyGaga, I discerned a consistency and pattern to their career decisions that I identifiedas strategy, even though there is no evidence that either of them engaged in anysystematic process of strategy formulation. Similarly, most successful companies arenot products of grand designs. The rise of Apple Inc. to become the world's most22 Part I introduction
valuable company (in terms of stock market capitalization) has often been attributed to a brilliant strategy of integrating hardware, software, and aesthetics to create con- sumer electronic products that offered a unique consumer experience. Yet, there is little evidence that Apple's incredible success since 2004 was the result of any grand design. Dick Rumelt reports when Steve Jobs was reappointed as Apple's CEO in 1997, his first actions were to cut costs, slash investment spending, and prune the product range. When asked in 1998 about his strategy for Apple, he replied: "I'm going to wait for the next big thing."27 Clearly, Apple's remarkable success since 2001 with its iPod, iPhone, and iPad was not the result of a preconceived plan. It was the outcome of a set of strategic decisions that combined penetrating insight into consumer preferences and tech- nological trends with Apple's own design and development capabilities, and astute responses to unfolding circumstances. So, what does this mean for strategy making by companies and other organiza- tions? Should managers seek to formulate strategy through a rational systematic process, or is the best approach in a turbulent world to respond to events while maintaining some sense of direction in the form of goals and guidelines?
managers made almost every conceivable mistake until the market finally hit themover the head with the right formula."33 In practice, strategy making involves both thought and action: "Strategy existsin the cognition of managers but also is reified in what companies do."34 This istypically through a process in which top-down rational design is combined withdecentralized adaptation. The design aspect of strategy comprises a number of orga-nizational processes through which strategy is deliberated, discussed, and decided.In larger companies these include board meetings and a formalized process of stra-tegic planning supplemented by more broadly participative events, such as strategyworkshops. I will discuss processes of strategic planning more fully in Chapter 6. At the same time, strategy is being continually enacted through decisions that aremade by every member of the organization—by middle managers especially. Thedecentralized, bottom-up process of strategy emergence often precedes more for-malized top-down strategy formulation. Intel's historic decision to abandon memorychips and concentrate on microprocessors was initiated in the decisions taken bybusiness unit and plant managers that were subsequently promulgated by top man-agement as strategy.35 In all the companies I am familiar with, strategy making combines design andemergence—a process that I have referred to as "planned emergence."36 The bal-ance between the two depends greatly upon the stability and predictability of theorganization's business environment. The Roman Catholic Church and La Poste,the French postal service, inhabit relatively stable environments; they can plan activ-ities and resource allocations in some detail quite far into the future. For WikiLeaks,Credit Bank of Iraq, or Somali pirate gangs, strategic planning will inevitably berestricted to a few guidelines; most strategic decisions must be responses to unfold-ing circumstances. As the business environment becomes more turbulent and less predictable, sostrategy making becomes less about detailed decisions and more about guidelinesand general direction. Bain & Company advocates the use of strategic principles—"pithy, memorable distillations of strategy that guide and empower employees"—tocombine consistent focus with adaptability and responsiveness.37 McDonald's strategystatement in Strategy Capsule 1.5 is an example of such strategic principles. Similarly,Southwest Airlines encapsulates its strategy in a simple statement: "Meet customers'short-haul travel needs at fares competitive with the cost of automobile travel." Forfast-moving businesses, strategy may be little more than a set of "simple rules." Forexample, Lego evaluates new product proposals by applying a checklist of rules:"Does the product have the Lego look?" "Will children learn while having fun?" "Doesit stimulate creativity?"38 We shall return to the role of rules and principles to guide an organization's evo-lution and coordination in our final chapter, where we explore some of the implica-tions of complexity theory for strategic management.
whether strategies are deliberate or emergent, systematic analysis is a vital input into the strategy process. Without analysis, strategic decisions are susceptible to power battles, individual whims, fads, and wishful thinking. Concepts, theories, and analytic tools are complements of, and not substitutes for, intuition and creativity. Their role is to provide frameworks for organizing discussion, processing information, and devel- oping consensus. This is not to endorse current approaches to strategy analysis. Strategic manage- ment is still a young field and the existing toolbox of concepts and techniques remains woefully inadequate. Our challenge is to do better. If existing analytical techniques do not adequately address the problems of strategy making and strategy implementation under conditions of uncertainty, technological change, and complexity, we need to augment and extend our strategy toolkits. In the course of this book, you will encoun- ter concepts such as real options, tacit knowledge, hypercompetition, complementarity, and complexity that will help you address more effectively the challenges that firms are facing in today's turbulent business environment. We must also recognize the role and the limitations of strategy analysis. Unlike many of the analytical techniques in accounting, finance, market research, or production management, strategy analysis does not generate solutions to problems. It does not offer algorithms or formulae that tell us the optimal strategy to adopt. The strategic questions that companies face (like those that we face in our own careers and lives) are simply too complex to be programmed. The purpose of strategy analysis is not to provide answers but to help us understand the issues. Most of the analytic techniques introduced in this book are frameworks that allow us to identify, classify, and understand the principal factors relevant to strategic decisions. Such frameworks are invaluable in allowing us to come to terms with the complexities of strategy decisions. In some instances, the most useful contribution may be in assisting us to make a start on the problem. By guiding us to the questions we need to answer and by providing a framework for organizing the information gathered, strategy analysis places us in a supe- rior position to a manager who relies exclusively on experience and intuition. Finally, analytic frameworks and techniques can improve our flexibility as man- agers. The concepts and frameworks we shall cover are not specific to particular industries, companies, or situations. Hence, they can help increase our confidence and effectiveness in understanding and responding to new situations and new circumstances.
Industry analysis Identify the Appraise Diagnose Formulate Implement current performance performance strategy strategy strategy Analysis of resources and capabilities
1 Identify the current strategy. Assuming we are dealing with an existing busi- ness, as opposed to a new venture, the first task is to identify the current strat- egy of the business (drawing upon the sections above on "Where do We Find Strategy?" and "Describing Strategy"). 2 Appraise performance. How well is the current strategy performing? In the next chapter we shall consider the use of financial analysis to measure firm performance. 3 Diagnose performance. Having determined the level and trend of the firm's performance, the next challenge is diagnosis: in the case of poor performance, can we use a combination of financial and strategic analysis to determine the sources of unsatisfactory performance? In the case of good performance, can we identify the factors driving this? As Dick Rumelt observes, the core question in most strategy situations is: "What's going on here?"40 Chapter 2 offers guidance on such diagnosis. 4 Industry analysis. Analyzing the fit between strategy and the firm's industry environment is a fundamental input into both diagnosing recent performance and generating future strategic options. Chapters 3 and 4 address industry analysis. 5 Analysis of resources and capabilities. Equivalently, analyzing the fit between strategy and the firm's resources and capabilities is a fundamental input into both diagnosing recent performance and generating future strategic options. Chapter 5 describes the analysis of resources and capabilities. 6 Formulate strategy. Performance diagnosis, industry analysis, and the analysis of resources and capabilities provide a basis for generating strategic options for the future, the most promising of which can be developed into a recommended strategy. Chapter 7 outlines how the intersection of internal strengths and exter- nal success factors combine to offer a basis for competitive advantage. 7 Implement strategy. Executing the chosen strategy requires linking the strat- egy to performance goals and resource allocations and establishing appropriate organizational structure and management systems. Chapter 6 outlines how this can be done.
When strategic management meant top-down, long-range planning, there was littledistinction between business corporations and not-for-profit organizations: the26 Part I introduction
Table 1.2 The applicability of the concepts and tools of strategic analysis to different types of not-for-profit organizations
Organizations Organizations in competitive in competitive environments that environments that Organizations sheltered charge users provide free services from competition Examples Royal Opera House Salvation Army UK Ministry of Defence Guggenheim Museum Habitat for Humanity European Central Bank Stanford University Greenpeace New York Police Department Linux World Health Organization Analysis of goals and Identification of mission, goals, and performance indicators and establishing consistency performance between them is a critical area of strategy analysis for all not-for-profits Analysis of the competitive Main tools of competitive Main arena for competition Not important. However, environment analysis are the same as for and competitive strategy is there is interagency com for-profit firms the market for funding petition for public funding Analysis of resources and Identifying and exploiting distinctive resources and Analysis of resources and capabilities capabilities critical to designing strategies that confer capabilities essential for competitive advantage determining priorities and designing strategies Strategy implementation The basic principles of organizational design, performance management, and leadership are common to all organizational types chapter 1 The Concept of Strategy 27
Among the tools of strategy analysis that are applicable to all types of not-for- profit organizations, those which relate to the role of strategy in specifying orga- nizational goals and linking goals to resource-allocation decisions are especially important. For businesses, profit is always a key goal since it ensures survival and fuels development. But for not-for-profits, goals are typically complex. The mis- sion of Harvard University is to "create knowledge, to open the minds of students to that knowledge, and to enable students to take best advantage of their educa- tional opportunities." But how are these multiple objectives to be reconciled in practice? How should Harvard's budget be allocated between research and finan- cial aid for students? Is Harvard's mission better served by investing in graduate or undergraduate education? The strategic planning process of not-for-profits needs to be designed so that mission, goals, resource allocation, and performance targets are closely aligned. Strategy Capsule 1.6 shows the strategic planning framework for the US State Department.
SG 5: Modernize the way we do diplomacy and Source: US Department of State and US Agency for International development Development, Strategic Plan for Fiscal Years 2014–2018.28 Part I introduction
Summary This chapter has covered a great deal of ground—I hope that you are not suffering from indigestion. If you are feeling a little overwhelmed, not to worry: we shall be returning to the themes and issues raised in this chapter in the subsequent chapters of this book. The key lessons from this chapter are: ◆◆ Strategy is a key ingredient of success both for individuals and organizations. A sound strategy cannot guarantee success, but it can improve the odds. Successful strategies tend to embody four elements: clear, long-term goals; profound understanding of the external environment; astute appraisal of internal resources and capabilities; and effective implementation. ◆◆ The above four elements form the primary components of strategy analysis: goals, industry analy- sis, analysis of resources and capabilities, and strategy implementation through the design of structures and systems. ◆◆ Strategy is no longer concerned with detailed planning based upon forecasts; it is increasingly about direction, identity, and exploiting the sources of superior profitability. ◆◆ To describe the strategy of a firm (or any other type of organization) we need to recognize where the firm is competing, how it is competing, and the direction in which it is developing. ◆◆ Developing a strategy for an organization requires a combination of purpose-led planning (ratio- nal design) and a flexible response to changing circumstances (emergence). chapter 1 The Concept of Strategy 29
◆◆ The principles and tools of strategic management have been developed primarily for business enterprises; however, they are also applicable to the strategic management of not-for-profit orga- nizations, especially those that inhabit competitive environments.
Our next stage is to delve further into the basic strategy framework shown in Figure 1.2. The elements of this framework—goals and values, the industry environment, resources and capabili- ties, and structure and systems—are the subjects of the five chapters that form Part II of the book. We then deploy these tools to analyze the quest for competitive advantages in different industry contexts (Part III), and then in the development of corporate strategy (Part IV). Figure 1.8 shows the framework for the book.
I. INTRODUCTION Ch. 1 The Concept of Strategy
Self-Study Questions1. In relation to the four characteristics of successful strategies in Figure 1.1, assess the US government's Middle East strategy during 2009–2015.2. The discussion of the evolution of business strategy (see the section "From Corporate Planning to Strategic Management") established that the characteristics of a firm's strategic plans and its30 Part I introduction
strategic planning process are strongly influenced by the volatility and unpredictability of its external environment. On this basis, what differences would you expect in the strategic plans and strategic planning processes of Coca-Cola Company and Uber Technologies Inc.? 3. I have noted that a firm's strategy can be described in terms of the answers to two questions: "Where are we competing?" and "How are we competing?" Applying these two questions, provide a concise description of Lady Gaga's career strategy (see Strategy Capsule 1.2). 4. Using the framework of Figure 1.6, describe the strategy of the university or school you attend. 5. What is your career strategy for the next five years? To what extent does your strategy fit with your long-term goals, the characteristics of the external environment, and your own strengths and weaknesses?
1. P. F. Drucker, "Managing Oneself," Harvard Business 10. M. E. Porter, Competitive Strategy (New York: Free Press, Review (March/April 1999): 65–74. 1980). 2. Stephen Covey (in The Seven Habits of Highly Effective 11. See Boston Consulting Group, Perspectives on People, New York: Simon & Schuster, 1989) recommends Experience (Boston: Boston Consulting Group, 1978) that we develop lifetime mission statements based on and studies using the PIMS (Profit Impact of Market the multiple roles that we occupy: in relation to our Strategy) database, for example R. D. Buzzell and B. T. careers, our partners, our family members, our friends, Gale, The PIMS Principles (New York: Free Press, 1987). and our spiritual lives. 12. R. M. Grant, "The Resource-based Theory of Competitive 3. M. E. Porter, "What is Strategy?" Harvard Business Advantage: Implications for Strategy Formulation," Review (November/December 1996): 61–78. California Management Review 33 (Spring 1991): 4. See A. H. Van De Ven and R. Drazin,' "The concept of 114–135; D. J. Collis and C. Montgomery, "Competing fit in contingency theory" Research in Organizational on Resources: Strategy in the 1990s," Harvard Business Behavior 7 (1985): 333–365. Review ( July/August 1995): 119–128. 5. Sun Tzu, The Art of Strategy: A New Translation of Sun 13. E. Lee, J. Lee, and J. Lee, "Reconsideration of the Tzu's Classic "The Art of War," trans. R. L. Wing (New Winner-Take-All Hypothesis: Complex Networks and York: Doubleday, 1988). Local Bias," Management Science 52 (December 2006): 6. See R. Evered, "So What Is Strategy?" Long Range 1838–1848; C. Shapiro and H. R. Varian, Information Planning 16, no. 3 ( June 1983): 57–72; and E. Clemons Rules (Boston: Harvard Business School Press, 1998). and J. Santamaria, "Maneuver Warfare," Harvard 14. C. Christensen, The Innovator's Dilemma (Boston: Business Review (April 2002): 46–53. Harvard Business School Press, 1997). 7. On the contribution of game theory to business strategy 15. P. J. Williamson, "Strategy as options on the future," analysis, see F. M. Fisher, "Games Economists Play: A Sloan Management Review 40(March 1999): 117–126. Non-cooperative View," RAND Journal of Economics 20 16. C. Markides, "Strategic innovation in established compa- (Spring 1989): 113–124; C. F. Camerer, "Does Strategy nies," Sloan Management Review ( June 1998): 31–42. Research Need Game Theory?" Strategic Management 17. W. C. Kim and R. Mauborgne, "Creating new market Journal 12 (Winter 1991): 137–152; A. K. Dixit and B. J. space," Harvard Business Review ( January/February Nalebuff, The Art of Strategy: A Game Theorist's Guide to 1999): 83–93. Success in Business and Life (New York: W. W. Norton, 18. See, for example, N. Koehn, "The Brain—and Soul—of 2008). Capitalism." Harvard Business Review, November 2013; 8. For example, D. W. Ewing, "Looking Around: Long- and T. Piketty, Capital in the Twenty-First Century range Business Planning," Harvard Business Review (Cambridge, MA: Harvard University Press, 2014). ( July/August 1956): 135–146; and B. Payne, "Steps in 19. "Strategic Intensity: A Conversation with Garry Long-range Planning," Harvard Business Review (March/ Kasparov," Harvard Business Review (April 2005): April 1957): 95–101. 105–113. 9. H. I. Ansoff, "Strategies for diversification," Harvard 20. The concept of bounded rationality was developed Business Review (September/October, 1957): 113–124. by Herbert Simon ("A Behavioral Model of Rational chapter 1 The Concept of Strategy 31
Choice," Quarterly Journal of Economics 69 (1955): 31. Boston Consulting Group, Strategy Alternatives for the 99–118. British Motorcycle Industry (London: Her Majesty's 21. G. Hamel and C. K. Prahalad, "Strategic Intent," Harvard Stationery Office, 1975). Business Review (May/June 1989): 63–77. 32. R. T. Pascale, "Perspective on Strategy: The Real Story 22. G. Hamel and C. K. Prahalad, "Strategy as Stretch and Behind Honda's Success," California Management Leverage," Harvard Business Review (March/April 1993): Review 26, no. 3 (Spring 1984): 47–72. 75–84. 33. H. Mintzberg, "Crafting Strategy," Harvard Business 23. J. C. Collins and J. I. Porras, Built to Last: Successful Review ( July/August 1987): 70. Habits of Visionary Companies (New York: 34. G. Gavetti and J. Rivkin, "On the origin of strategy: HarperCollins, 1995). Action and cognition over time." Organization Science, 24. R. Rumelt, Good Strategy/Bad Strategy: The Difference and 18, 420–439. Why it Matters (New York: Crown Business, 2011): 5–6. 35. R. A. Burgelman and A. Grove, "Strategic Dissonance," 25. D. J. Collis and M. G. Rukstad, "Can You Say What Your California Management Review 38 (Winter 1996): Strategy Is?" Harvard Business Review (April 2008): 8–28. 63–73. 36. R. M. Grant, "Strategic Planning in a Turbulent 26. D. F. Abell, Managing with Dual Strategies (New York: Environment: Evidence from the Oil and Gas Majors," Free Press, 1993). Strategic Management Journal 14 ( June 2003): 491–517. 27. Rumelt, op cit.: 14. 37. O. Gadiesh and J. Gilbert, "Transforming Corner-office 28. H. Mintzberg, "Patterns of Strategy Formulation," Strategy into Frontline Action," Harvard Business Review Management Science 24 (1978): 934–948; "Of Strategies: (May 2001): 73–80. Deliberate and Emergent," Strategic Management 38. K. M. Eisenhardt and D. N. Sull, "Strategy as Simple Journal 6 (1985): 257–272. Rules," Harvard Business Review ( January 2001): 29. H. Mintzberg, "The Fall and Rise of Strategic Planning," 107–116. Harvard Business Review ( January/February 1994): 39. A similar, but more detailed, approach is proposed 107–114. by Markus Venzin. See M. Venzin, C. Rasner, and V. 30. The two views of Honda are captured in two Harvard Mahnke, The Strategy Process: A Practical Handbook for cases: Honda [A] and [B] (Boston: Harvard Business Implementation in Business (Cyan, 2005). School, Cases 384049 and 384050, 1989). 40. Rumelt, op cit., 79. II THE TOOLSOF STRATEGY ANALYSIS
The strategic aim of a business is to earn a return on capital, and if in any particular case the return in the long run is not satisfactory, then the deficiency should be corrected or the activity abandoned for a more favorable one. —ALFRED P. SLOAN JR., PRESIDENT AND THEN CHAIRMAN OF GENERAL MOTORS, 1923 TO 1956.1
Profits are to business as breathing is to life. Breathing is essential to life, but is not the purpose for living. Similarly, profits are essential for the existence of the corpo- ration, but they are not the reason for its existence. —DENNIS BAKKE, FOUNDER AND FORMER CEO, AES CORPORATION
By the time you have completed this chapter, you will be able to: ◆◆ Recognize that, while every firm has a distinct purpose, the common goal for all firms is creating value, and appreciate how the debate over shareholder versus stakeholder goals involves different definitions of value creation. ◆◆ Understand how profit, cash flow, and enterprise value relate to one another. ◆◆ Use the tools of financial analysis to appraise firm performance, diagnose the sources of performance problems, and set performance targets. ◆◆ Appreciate how a firm's values, principles, and pursuit of corporate social responsibility can help define its strategy and support its creation of value. ◆◆ Understand how real options contribute to firm value and how options thinking can contribute to strategy analysis. chapter 2 Goals, Values, and Performance 37
There is more to business than making money. For the entrepreneurs who createbusiness enterprises, personal wealth appears to be a less important motivationthan the wish for autonomy, the desire for achievement, and lust for excitement.Over 80 years ago, the economist Joseph Schumpeter observed: "The entrepreneur–innovator's motivation includes such aspects as the dream to found a private king-dom, the will to conquer and to succeed for the sake of success itself, and the joyof creating and getting things done."2 Business enterprises are creative organizationswhich offer individuals unsurpassed opportunity to make a difference in the world.Certainly, making money was not the goal that inspired Henry Ford to build a busi-ness that precipitated a social revolution:
I will build a motor car for the great multitude … It will be so low in price that no man making good wages will be unable to own one and to enjoy with his family the blessing of hours of pleasure in God's great open spaces … When I'm through, everyone will be able to afford one, and everyone will have one.3
●● Google's mission is "to organize the world's information and make it univer- sally accessible and useful." ●● "The IKEA vision is to create a better everyday life for the many people. We make this possible by offering a wide range of well-designed, functional home furnishing products at prices so low that as many people as possible will be able to afford them." ●● The Lego Group's mission is "To inspire and develop the builders of tomorrow."
and locations where they are more valued. Similarly, speculation involves transfer- ring products from a point in time where a product is valued less to a point in time where it is valued more. Thus, commerce creates value through arbitrage across time and space.5 How can this value creation be measured? Value added—the difference between the value of a firm's output and the cost of its material inputs—is one measure. Value added is equal to the sum of all the income paid to the suppliers of factors of production. Thus:
To simplify our analysis of strategy formulation I make the assumption that theprimary goal of strategy is to maximize the value of the enterprise through seek-ing to maximize profits over the long term. Having extolled the virtues of businessenterprises as creative institutions, how can I rationalize this unedifying focus onmoney making? I have three justifications:
Hence, the issue of whether firms should operate in the interests of shareholdersor of all stakeholders matters more in principle than in practice. According to Jensen:40 Part II THE TOOLS OF STRATEGY ANALYSIS
What Is Profit? Thus far, I have referred to firms' quest for profit in general terms. It is time to look more carefully at what we mean by profit and how it relates to value creation. Profit is the surplus of revenues over costs available for distribution to the owners of the firm. But if profit maximization is to be a realistic goal, the firm must know what profit is and how to measure it; otherwise, instructing managers to maximize profit offers little guidance. What is the firm to maximize: total profit or rate of profit? Over what period? With what kind of adjustment for risk? And what is profit any- way—accounting profit, cash flow, or economic profit? These ambiguities become apparent once we compare the profit performance of companies. Table 2.1 shows that ranking companies by profitability depends critically on what profitability mea- sure is used.
TABLE 2.1 Profitability measures for some of the world's largest companies, 2014
Market Return to capitalizationa Net income ROSb ROEc ROAd shareholderse Company ($ billion) ($ billion) (%) (%) (%) (%) Apple 750 14.0 29.7 35.2 24.5 +68.5 ExxonMobil 354 30.5 12.5 27.6 17.6 –6.9 Wal-Mart Stores, Inc. 278 16.0 5.5 20.4 13.1 +2.6 Industrial & Commercial 270 22.9 56.6 20.5 1.6 +12.3 Bank of China General Electric 254 15.2 12.1 11.9 2.7 –3.4 JPMorgan Chase 222 21.8 31.6 9.8 1.2 +2.7 Volkswagen 118 11.8 6.3 12.3 3.6 +8.4 Notes: a Shares outstanding × closing price of shares on February 18, 2015. b Return on sales = Operating profit as a percentage of sales revenues. c Return on equity = Net income as a percentage of year-end shareholder equity. d Return on assets = Operating income as a percentage of year-end total assets. e Dividend + share price appreciation during 2014. chapter 2 Goals, Values, and Performance 41
At Guinness-to-Johnny-Walker drinks giant Diageo, they took measures to reduce their capital bases andEVA transformed the way in which Diageo measured make their assets work harder. At Diageo's Pillsbury foodits performance, allocated its capital and advertising business, the economic profit of every product andexpenditures, and evaluated its managers. every major customer was scrutinized. The result was Taking account of the costs of the capital tied up the elimination of many products and efforts to makein slow-maturing, vintage drinks such as Talisker and marginal customers more profitable. Ultimately, EVALagavulin malt whisky, Hennessey cognac, and Dom analysis resulted in Diageo selling Pillsbury to GeneralPerignon champagne showed that these high-margin Foods. This was followed by the sale of Diageo's Burgerdrinks were often not as profitable as the company King chain to Texas Pacific, a private equity group.had believed. The result was that Diageo's advertising Value-based management was extended throughoutexpenditures were reallocated toward Smirnoff vodka, the organization by making EVA the primary determinantGordon's gin, Baileys, and other drinks that could be of the incentive pay earned by 1400 Diageo managers.sold within weeks of distillation. Sources: John McGrath, "Tracking Down Value," Financial Once managers had to report profits after deduc- Times Mastering Management Review (December 1998);tion of the cost of the capital tied up in their businesses, www.diageo.com.
value (NPV) of the returns that the asset generates. The relevant returns are the cash flows to the firm. Hence, firms are valued using the same discounted cash flow (DCF) methodology that we apply to the valuation of investment projects. Thus, the value of an enterprise (V) is the sum of its free cash flows (C) in each year t, discounted at the enterprise's cost of capital.14 The relevant cost of capital is the weighted average cost of capital (WACC) that averages the cost of equity and the cost of debt:
∑ (1 + WACC) Ct V = t t
Therefore, for the equity financed firm, maximizing the present value of the firm's profits over its lifetime also means maximizing the firm's current market capitalization. If maximizing profits over the life of the firm also means maximizing the stock market value of the firm, why is it that shareholder value maximization has attracted chapter 2 Goals, Values, and Performance 43
so much criticism in recent years? The problems arise from the fact that the stockmarket cannot see the future with much clarity, hence its valuations of companiesare strongly influenced by short-term and psychological factors. This then creates thepossibility for a top management to boost their firm's stock market value by meansother than increasing profits over the lifetime of the firm. For example, if stock mar-kets are myopic, management may be encouraged to maximize short-term profitsto the detriment of long-run profitability. This in turn may tempt top managementto boost short-term earnings through financial manipulation rather than by growingthe firm's operating profits. Such manipulation may include adjustments to financialstructure, earnings smoothing, and the use of asset sales to flatter reported profits. To avoid some of the criticisms that shareholder value maximization has attracted,my emphasis will be on maximizing enterprise value rather than on maximizingshareholder value. This is partly for convenience: distinguishing debt from equityis not always straightforward, due to the presence of preference stock and convert-ible debt, while junk bonds share the characteristics of both equity and debt. Moreimportantly, focusing on the value of the enterprise as a whole supports our empha-sis of the fundamental drivers of firm value in preference to the distractions anddistortions that result from a preoccupation with stock market value.
Our discussion so far has established that every business enterprise has a distinctpurpose. Yet, for all businesses, the profits earned over the life of the business—enterprise value—are a sound indicator of a business's success in creating value.They also offer a sound criterion for selecting the strategies to achieve that businesspurpose. So, how do we apply these principles to appraise and develop business strate-gies? There are four key areas where our analysis of profit performance can guidestrategy: first, in appraising a firm's (or business unit's) performance; second, in diag-nosing the sources of poor performance; third, in selecting strategies on the basis oftheir profit prospects; and, finally, setting performance targets.
Notes: a Market capitalization + Book value of long-term debt. b Percentage increase in share price + Dividend yield. c Operating income/Sales revenue. d Net income/Shareholders' equity. e Operating income/(Shareholders' equity + long-term debt). f Operating income/Total assets.
of a firm in value creation we can compare the change in the market value of the firm relative to that of competitors over a period (preferably several years). At the end of 2014, United Parcel Services, Inc. (UPS) had a market capitalization of $96.0 billion (enterprise value $105.8 bn.), compared to $48.5 billion for FedEx Corp. (enterprise value $53.2 bn). This indicates that UPS is expected to generate almost twice as much value as FedEx in the future. Table 2.2 shows that, from 2010 to 2014, UPS generated a total shareholder return of 104.3% compared to 110.7% for FedEx, indicating that the two companies have been similarly effective in value creation over the past five years. Clearly, stock market valuation is an imperfect performance indicator—particularly in terms of its sensitivity to new information and its vulner- ability to market psychology and disequilibrium—but it is the best indictor we have of intrinsic value.
Operating Operating profit Operating margin and net margin measure a firm's ability margin Sales to extract profit from its sales, but for appraising firm per- formance, these ratios reveal little because margins varyNet margin Net income greatly between sectors according to capital intensity. Sales Margins are useful to compare the performance of firms within the same industry, but are not useful for comparing firms in different industries because margins depend on an industry's capital intensity (see Table 2.1).
Notes:Few accounting ratios have standard definitions, hence, it is advisable to be explicit about how you have calculated the ratio you are using.
A general guideline for rate of return ratios is that the numerator should be the profits that are available to remunerate the owners of the
assets, equity, and capital employed should to be averaged between the beginning and end of the period.
Performance Diagnosis If profit performance is unsatisfactory, we need to identify the sources of poor perfor- mance so that management can take corrective action. The main tool of diagnosis is disaggregation of return on capital in order to identify the fundamental value drivers. A starting point is to apply the Du Pont Formula to disaggregate return on invested46 Part II THE TOOLS OF STRATEGY ANALYSIS
SGA expense/Sales
ROCE Fixed Asset Turnover (Sales/PPE)
Inventory Turnover (Sales/Inventories) Sales/Capital Employed Creditor Turnover (Sales/Accounts receivable)
Notes: ROCE: Return on capital employed. COGS: Cost of goods sold. PPE: Property, plant, and equipment. For further discussion, see T. Koller et al., Valuation, 5th edn (Chichester: John Wiley & Sons, Ltd, 2010).
capital into sales margin and capital turnover. We can then further disaggregate both sales margin and capital productivity into their component items (Figure 2.1). This points us toward the specific activities that are the sources of poor performance. Strategy Capsule 2.2 disaggregates the return on assets for UPS and FedEx so that we can begin to pinpoint the sources of UPS's superior profitability. If we combine the financial data with the qualitative data on the two companies' business strate- gies, operations, and organization together with information on conditions within the industry in which the two companies compete, we can begin to diagnose why UPS has outperformed FedEx.
Between 2010 and 2014, United Parcel Service (UPS) FedEx has higher costs of fuel, maintenance, depreciation,has earned more than double the return on assets as its and "other." UPS's higher capital turnover is mainly due toclosest rival, FedEx Corporation. What insights can finan- its higher turnover of fixed assets (property, plant, andcial analysis offer into the sources of this performance equipment).differential? These differences reflect the different composition Disaggregating the companies' return on capital of the two companies' businesses. UPS is more heav-employed into operating margin and capital turnover ily involved in ground transportation (UPS has 103,000shows that differences in ROCE are due to UPS's supe- vehicles; FedEx has 55,000), which tends to be more laborrior operating margin and higher capital turnover. See intensive. FedEx is more oriented toward air transporta-Figure 2.2. tion (UPS has 620 aircraft; FedEx has 650). Express delivery Probing UPS's higher operating margin highlights services tend to be less profitable than ground delivery.major differences in the cost structure of the two compa- However, the differences in business mix do not appearnies: UPS is more labor intensive with a much higher ratio to completely explain the wide discrepancy in fuel, main-of employee costs to sales (however, UPS's average com- tenance, and other costs between FedEx and UPS. Thepensation per employee is much lower than FedEx's). likelihood is that UPS has superior operational efficiency.
Figure 2.2 Analyzing why UPS earns a higher return on capital employed (ROCE) than FedEx
Labor costs/Sales U: 54.8% F: 37.0%
Fuel costs/Sales U: 7.5% F: 10.7% Operating margin U: 10.1% Maintenance/Sales F: 6.5% U: 2.3% F: 4.3%
Depreciation/Sales U: 3.4% F: 5.3%
PPE turnover U: 3.02 F: 2.36 Sales/Capital U = UPS Employed Receivables turnover F = FedEx U: 3.28 U: 10.23 F: 8.59 F: 2.34
Cash turnover U: 9.51 F: 11.5248 Part II THE TOOLS OF STRATEGY ANALYSIS
greater the need to concentrate on the short term. For companies teetering on the brink of bankruptcy long-term strategy takes a back seat; survival is the domi- nant concern. For companies that are performing well, financial analysis allows us to under- stand the sources of superior performance so that strategy can protect and enhance these determinants of success. For example, in the case of UPS (see Strategy Capsule 2.2), financial analysis points to the efficiency benefits that arise from being the US's biggest package delivery company and having an integrated system of collection and delivery that optimizes operational efficiency. The superior profitability of UPS's international business points to its ability to successfully enter foreign markets and integrate overseas operations within its global system. However, analyzing the past only takes us so far. The world of business is one of constant change and the role of strategy is to help the firm to adapt to change. The challenge is to look into the future and identify factors that threaten perfor- mance or create new opportunities for profit. In making strategy recommendations to UPS, our financial analysis can tell us some of the reasons why UPS has been doing well up until now, but the key to sustaining UPS's performance is to recognize how its industry environment will be changing in terms of customer requirements, competition, technology, and energy costs and to assess UPS's capacity to adapt to these new conditions. While financial analysis is inevitably backward looking, stra- tegic analysis allows us to look forward and understand some of the critical factors impacting a firm's success in the future.
The dilemma with any system of performance management is that the perfor-mance goals are long term (e.g., maximizing profits over the lifetime of the com-pany), but to act as an effective control mechanism performance targets need to bemonitored over the short term. For financial targets the problem is that their short-term pursuit may undermine long-term profit maximization.
Strategic Profit Drivers Financial value drivers and balanced scorecards are sys-tematic techniques of performance management based upon the assumption that,if overall goals can be disaggregated into precise, quantitative, time-specific targets,each member of the organization knows what is expected of him or her and ismotivated toward achieving the targets set. However, a mounting body of evidencepoints to the unintended consequences of managing through performance targets. Performance targets create two types of problem. The first problem is the one weacknowledged in relation to profit maximization: targeting the goal itself may under-mine that goal's attainment. Thus, many of the firms that are most successful at creat-ing shareholder value are those which emphasize purpose over profit. Conversely,many of the firms most committed to maximizing shareholder value—Enron, forexample—have been spectacularly unsuccessful in achieving that goal.20 The experi-ences of Boeing illustrate this problem (see Strategy Capsule 2.3).2150 Part II THE TOOLS OF STRATEGY ANALYSIS
Boeing was one of the most financially successful team of Harry Stonecipher and Phil Condit took over. members of the Dow Jones Industrial Index between Mr Condit proudly talked of taking the company into 1960 and 1990. Yet Boeing gave little attention to "a value-based environment where unit cost, return on financial management. CEO Bill Allen was interested investment, and shareholder return are the measures in building great planes and leading the world market by which you'll be judged." with them: "Boeing is always reaching out for tomor- The result was lack of investment in major new civil row. This can only be accomplished by people who live, aviation projects and diversification into defense and breathe, eat and sleep what they are doing." At a board satellites. Under Condit, Boeing relinquished market meeting to approve Boeing's biggest ever investment, leadership in passenger aircraft to Airbus, while falter- the 747, Allen was asked by non-executive director ing as a defense contractor due partly to ethical lapses Crawford Greenwalt for Boeing's financial projections by key executives. When Condit resigned on December on the project. In response to Allen's vague reply, 1, 2003, Boeing's stock price was 20% lower than when Greenwalt buried his head in his hands. "My God," he he was appointed. muttered, "these guys don't even know what the return Sources: John Kay, "Forget How the Crow Flies," Financial on investment will be on this thing." Times Magazine (January 17, 2004): 17–27; R. Perlstein, The The change came in the mid-1990s when Boeing Stock Ticker and the Superjumbo (Prickly Paradigm Press, acquired McDonnell Douglas and a new management 2005). chapter 2 Goals, Values, and Performance 51
The alternative to making the goal the target is to disaggregate the goal into spe-cific quantitative targets (e.g., using value drivers or a balanced scorecard). However,this presents our second problem: the means by which the targets are attained con-flict with the desired goal. The problem is vividly illustrated by the problems of per-formance targets in the public sector. In Soviet shoe factories, quantitative monthlytargets would be met by producing low-quality shoes of a single size.22 In the BritishNational Health Service the target of eight-minute ambulance response times wasachieved by substituting single paramedics in cars and partially trained volunteersfor regular ambulance crews.23 Given these challenges, the approach we shall adopt in this book is to focus onthe strategic factors that drive long-run profitability. Once we have identified theprimary sources of profit available to the firm we have a basis, first, for formulating astrategy to exploit these sources of profit and, second, for implementing that strategythrough performance guidelines and targets based upon those strategic variables.This notion that pursuing profitability requires focusing upon the fundamental stra-tegic drivers of profit can also bring clarity to the complex and contentious issue ofthe social responsibilities of business firms.
At the beginning of this chapter, I argued that, while every company has a distinctorganizational purpose, a common goal for every business enterprise is to createvalue, and the best indicator of value creation is profit over the lifetime of the com-pany—or, equivalently, maximizing enterprise value. Although the corporate scandalsof the 21st century—from Enron in 2001 to Lehman Brothers in 2008—have discred-ited the pursuit of profit and shareholder value maximization, I have justified long-runprofit maximization as an appropriate and practical goal for the strategic managementof firms. This justification was based largely on the alignment which I perceived, first,between profits and the interests of society as a whole (reflecting Adam Smith's prin-ciple of the "invisible hand" which guides self-interest toward the common good)and, second, between the pursuit of stakeholder and shareholder interests (bothare reliant on the firm earning profit over the long-term). But what about when thepursuit of profit conflicts with the social good or with widely held ethical principles?How are such inconsistencies and conflicts to be managed? Is it sufficient to followMilton Friedman's dictum that:
There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engage in open and free competition without deception or fraud.24
the law, and pursue strategies that are explicitly oriented toward the interests of society. Let us discuss each of these areas in turn.
Since its inception, Accenture has been governed by relationships by being responsive and relevant and its core values. They shape the culture and define the by consistently delivering value. character of our company. They guide how we behave ◆◆ One Global Network Leveraging the power of and make decisions. global insight, relationships, collaboration and learning to deliver exceptional service to clients ◆◆ Stewardship Fulfilling our obligation of building wherever they do business. a better, stronger and more durable company for future generations, protecting the Accenture ◆◆ Respect for the Individual Valuing diversity and brand, meeting our commitments to stakeholders, unique contributions, fostering a trusting, open acting with an owner mentality, developing our and inclusive environment and treating each people and helping improve communities and the person in a manner that reflects Accenture's global environment. values.
◆◆ Best People Attracting, developing and retaining the ◆◆ Integrity Being ethically unyielding and hon- best talent for our business, challenging our people, est and inspiring trust by saying what we mean, demonstrating a "can-do" attitude and fostering a col- matching our behaviors to our words and taking laborative and mutually supportive environment. responsibility for our actions.
So far, we have identified the value of the firm with the net present value (NPV) of its profit earnings (or, equivalently, free cash flows). But NPV is not the only source of chapter 2 Goals, Values, and Performance 55
Since launching its Sustainable Living Plan in McKinsey and Company, Polman noted that the bene-November 2010, Unilever—the Anglo-Dutch mul- fits to Unilever included improved access to raw mate-tinational supplying over 400 brands of food, per- rials, greater employee commitment, a stronger drivesonal care, and household products—has become toward innovation throughout the company, greatlyestablished as a world leader in environment sus- increased numbers of applications for jobs at Unilever,tainability and, according to the Economist, Unilever and improvement in efficiency in Unilever plants and"reckoned to have the most comprehensive strategy throughout its supply chain. Shareholders appear toof enlightened capitalism of any global firm." The have benefitted as well: in the five years following theprogram—with its goals of reducing Unilever's envi- launch of the Sustainable Living Plan, Unilever's shareronmental footprint, increasing its positive social price rose by 40%, well ahead of rivals Procter & Gambleimpact, doubling sales, and increasing long-term and Nestlé.profitability—has been the centerpiece of CEO Paul However, when Polman announced, en route forPolman's strategy for the company. More than most the January 2015 Davos meetings, that he planned toother companies, Unilever has embedded its sustain- "use the size and scale of Unilever" to lobby global lead-ability program within its strategic, operational, and ers for a binding agreement on climate change andhuman resource management: the plan is overseen poverty eradication, some wondered whether he wasby the board and incentive bonuses are linked to its putting global interests ahead of Unilever's—especiallyquantitative targets for improvements in emissions, given Unilever's disappointing sales performance dur-waste reduction, and energy and water conservation. ing 2014. While Polman emphasizes that Unilever's commit- Sources: McKinsey & Company, "Committing to sustainability:ment to sustainability is because it is "the right thing An interview with Unilever's Paul Polman," http://www. mckinsey.com/videos/video?vid=3564008886001&plyrid=to do" he is also clear that the primary motivation is 2399849255001&Height=270&Width=480, accessed July 20,the fact that the Sustainable Living Plan is in the long- 2015; "Unilever: In search of the good business," Economist,term interests of Unilever itself. In an interview with August 9, 2014.
value available to the firm. The simple idea that an option—the choice of whether to do something or not—has value has important implications for how we value firms. In recent years, the principles of option pricing have been extended from valuing financial securities to valuing investment projects and companies. The resulting field of real option analysis has emerged as one of the most important developments in finan- cial theory over the past decade, with far-reaching implications for strategy analysis. The technical details of valuing real options are complex. However, the underlying principles are intuitive. Let me outline the basic ideas of real options theory and what they mean for strategy analysis. Consider the investments that Royal Dutch Shell is making in joint-venture devel- opment projects to produce hydrogen for use in fuel cells. The large-scale use of56 Part II THE TOOLS OF STRATEGY ANALYSIS
fuel cells in transportation vehicles or for power generation seems unlikely within the foreseeable future. Shell's expenditure on these projects is small, but almost cer- tainly these funds would generate a higher return if they were used in Shell's core oil and gas business. So, how can these investments—indeed, all of Shell's investments in renewable energy—be consistent with shareholder interests? The answer lies in the option value of these investments. Shell is not developing a full-scale fuel cell business, and nor is it developing commercial-scale hydrogen production plants: it is developing technologies that could be used to produce hydrogen if fuel cells become widely used. By building know-how and intellectual property in this technology, Shell has created an option. If economic, environmental, or political factors restrict hydrocarbon use and if fuel cells advance to the point of technical and commercial viability, then Shell could exercise that option by investing much larger amounts in commercial-scale hydrogen production. In a world of uncertainty, where investments, once made, are irreversible, flex- ibility is valuable. Instead of committing to an entire project, there is virtue in break- ing the project into a number of phases, where the decision of whether and how to embark on the next phase can be made in the light of prevailing circumstances and the learning gained from the previous stage of the project. Most large companies have a "phases and gates" approach to product development in which the develop- ment process is split into distinct "phases," at the end of which the project is reas- sessed before being allowed through the "gate." Such a phased approach creates the options to continue the project, to abandon it, to amend it, or to wait. Venture capitalists clearly recognize the value of growth options. In November 2014, Kik, a Toronto-based start-up, received $38.3 million in venture capital financing. Kik is a free mobile chat service that targets 13- to 15-year-olds and has 200 million users, but almost no revenues. For its investors, Kik offers an option. Their funding is just to take Kik to its next level of development where it can add a browser and links to other mobile applications which can make Kik into a broader-based user platform together with the potential to carry paid advertising.33 The emphasis that venture capitalists place on scalability—the potential to scale up or replicate a business should the initial launch be successful—similarly acknowledges the value of growth options. Strategy Capsule 2.6 addresses the calculation of real option values.
Application of real option value to investment projects technique offers a more intuitive appreciation of theand strategies has been limited by the complexity of sources of option value. The analysis involves two mainthe valuation techniques. Yet, even without getting stages:into the mathematics needed to quantify option val-ues, we can use the basic principles involved to under- 1 Create an event tree that shows the value of thestand the factors that determine option values and to project at each development period under tworecognize how projects and strategies can be designed different scenarios.in order to maximize their option values. 2 Convert the event tree into a decision tree by iden- The early work on real option valuation adapted the tifying the key decision points on the event tree,Black–Scholes option-pricing formula developed for typically the points where commitments of newvaluing financial options to the valuation of real invest- funds to the project are required or where therement projects.a Black–Scholes comprises six determi- is the option to defer development. Incrementalnants of option value, each of which has an analogy in project values at each stage can then be calcu-the valuation of a real option: lated for each decision point by working back from the final nodes of the decision tree (using a1 Stock price: The NPV of the project: a higher NPV discount factor based upon the replicating port- increases option value. folio technique). If the incremental project value2 Exercise price: Investment cost: the higher the at the initial stage exceeds the initial investment, cost, the lower the option value. proceed with the first phase, and similarly for each3 Uncertainty: for both financial and real options, subsequent phase.c uncertainty increases option value. Notes:4 Time to expiry: for both financial and real options, a See: F. Black and M. Scholes, "The Pricing of Options and the longer the option lasts, the greater its value. Corporate Liabilities," Journal of Political Economy 81 (1993):5 Dividends: Decrease in the value of the invest- 637–54.
In developing strategy, our main concern is with growth options. These might include:
Summary Chapter 1 introduced a framework for strategy analysis that provides the structure for Part II of this book. This chapter has explored the first component of that framework—the goals, values, and per- formance of the firm. We have explored in some depth the difficult, and still contentious, issue of the appropriate goals for the firm. While each firm has a specific business purpose, common to all firms is the desire, and the necessity, to create value. How that value is defined and measured distinguishes those who argue that the firms should operate primarily in the interests of owners (shareholders) from those who argue for a stakeholder approach. Our approach is pragmatic: shareholder and stakeholder interests tend to converge and, where they diverge, the pressure of competition limits the scope for pursuing stakeholder interests at the expense of profit, hence my conclusion that long-run profit— or its equivalent, enterprise value—is appropriate both as an indicator of firm performance and as a guide to strategy formulation. We explored the relationships between value, profit, and cash flow and saw how the failings of shareholder value maximization resulted more from its misapplication than from any inherent flaw. chapter 2 Goals, Values, and Performance 59
The application of financial analysis to the assessment of firm performance is an essential compo- nent of strategic analysis. Financial analysis creates a basis for strategy formulation, first, by appraising overall firm performance and, second, by diagnosing the sources of unsatisfactory performance. Combining financial analysis and strategic analysis allows us to establish performance targets for companies and their business units. Finally, we looked beyond the limits of our useful, yet simplistic, profit-oriented approach to firm performance and business strategy. We looked, first, at how the principles of corporate social respon- sibility can be incorporated within a firm's strategy to enhance its creation of both social and share- holder value. Second, we extended our analysis of value maximization to take account of the fact that strategy creates enterprise value not only by generating profit but also by creating real options.
Self-Study Questions1. Table 2.1 compares companies according to different profitability measures. a. Which two of the six performance measures do you think are the most useful indica- tors of how well a company is being managed? b. Is return on sales or return on equity a better basis on which to compare the perfor- mance of the companies listed? c. Several companies are highly profitable yet delivered very low returns to their share- holders during 2014. How is this possible?2. India's Tata Group is a diversified group. Some of its largest companies are: Tata Steel, Tata Motors, Tata Consultancy Services (IT), Tata Power (electricity generation), Tata Chemicals, Tata Tea, Indian Hotels, and Tata Communications. How do you think Tata Group's recent adoption of EVA as a performance management tool is likely to influence the way in which it allocates investment among the companies listed above?3. With regard to Strategy Capsule 2.2, what additional data would you seek and what addi- tional analysis would you undertake to investigate further the reasons for UPS's superior profitability to FedEx?4. The CEO of a chain of pizza restaurants wishes to initiate a program of CSR to be funded by a 5% levy on the company's operating profit. The board of directors, fearing a nega- tive shareholder reaction, is opposed to the plan. What arguments might the CEO use to persuade the board that CSR might be in the interests of shareholders, and what types of CSR initiatives might the program include to ensure that this was the case?5. Nike, a supplier of sports footwear and apparel, is interested in the idea that it could increase its stock market value by creating options for itself. What actions might Nike take that might generate option value?60 Part II THE TOOLS OF STRATEGY ANALYSIS
1. A. P. Sloan, My Years at General Motors (New York: 15. T. Koller, M. Goedhart, D. Wessels, Valuation: Doubleday, 1963). Measuring and Managing the Value of Companies, 5th 2. J. A. Schumpeter, The Theory of Economic Development edn (Hoboken, NJ: John Wiley & Sons, Inc., 2010). (Cambridge, MA: Harvard University Press 1934). 16. F. Modigliani and M. H. Miller, "The Cost of Capital, 3. "Henry Ford: The Man Who Taught America to Drive," Corporation Finance, and the Theory of Investments," Entrepreneur (October 8, 2008), www.entrepreneur. American Economic Review 48 (1958): 261–297. com/article/197524, accessed July 20, 2015. 17. Some calculations of enterprise value deduct the bal- 4. C. A. Montgomery, "Putting Leadership Back into ance sheet value of a firm's cash and marketable secu- Strategy," Harvard Business Review (January 2008): 54–60. rities from the market value of its equity and debt in 5. In this chapter, I use the term value in two distinct order to value only the business itself. senses. Here I am referring to economic value, which 18. J. A. Kay and C. Meyer, "On the Application of is worth as measured in monetary units. I shall also be Accounting Rates of Return," Economic Journal 96 discussing values as moral principles or standards of (1986): 199–207. behavior. 19. R. S. Kaplan and D. P. Norton, "The Balanced Scorecard: 6. T. Donaldson and L. E. Preston, "The stakeholder theory Measures that Drive Performance," Harvard Business of the corporation," Academy of Management Review 20 Review ( January/February 1992): 71–9; R. S. Kaplan (1995): 65–91. and D. P. Norton, "Using the Balanced Scorecard as a 7. In several countries, company law has been amended Strategic Management System," Harvard Business Review to allow companies to pursue explicit social goals. In ( January/February 1996): 75–85. the US, these "benefit corporations" (or B-corporations) 20. S. Chatterjee, "Enron's Incremental Descent into include the outdoor apparel company, Patagonia. See J. Bankruptcy: A Strategic and Organizational Analysis," Surowiecki, "Companies with Benefits," The New Yorker, Long Range Planning 36 (2003): 133–149. August 4, 2014. 21. The general principle here is that of obliquity: it is often 8. See M. B. Lieberman, N. Balasubramanian, and R. better to pursue our goals indirectly rather than directly. García-Castro "Value Creation and Appropriation See: J. Kay, Obliquity (London: Profile Books, 2010). in Firms: Conceptual Review and a Method for 22. P. C. Roberts and K. LaFollett Meltdown: Inside the Soviet Measurement," ( June 10, 2013, available at SSRN: Economy (Washington, DC: Cato Institut, 1990). http://ssrn.com/abstract=2381801) for an approach to 23. G. Bevan and C. Hood, "What's Measured Is What estimating. Matters: Targets and Gaming in the English Public 9. M. C. Jensen, "Value Maximization, Stakeholder Theory, Health Care System," Public Administration 84 (2006): and the Corporate Objective Function," Journal of 517–538. Applied Corporate Finance 22 (Winter 2010): 34. 24. M. Friedman, Capitalism and Freedom (Chicago: 10. J. Helwege, V. Intintoli, and A. Zhang, "Voting with Their University of Chicago Press, 1963). Feet or Activism? Institutional Investors' Impact on CEO 25. L. Bryan, "Enduring Ideas: The 7-S Framework," Turnover," Journal of Corporate Finance Vol. 18 (2012): McKinsey Quarterly (March 2008). 22–37. 26. J. Collins and J. Porras, "Building Your Company's 11. T. M. Jones, "Instrumental Stakeholder Theory: A Vision," Harvard Business Review (September/October Synthesis of Ethics and Economics," Academy of 1996): 65–77. Management Review 20 (1995): 404–37. 27. W. T. Allen, "Our Schizophrenic Conception of the 12. M. Orlitzky, F. L. Schmidt, and S. L. Rynes, "Corporate Business Corporation," Cardozo Law Review 14 (1992): Social and Financial Performance: A Meta-Analysis," 261–281. Organization Studies 24 (Summer 2003): 403–441. 28. A. Smith, An Inquiry into the Nature and Causes of the 13. See www.sternstewart.com. See also J. L. Grant, Wealth of Nations, 5th edn (London: Methuen & Co., Foundations of Economic Value Added, 2nd edn (New 1905), Chapter 2. York: John Wiley & Sons, Ltd, 2003). 29. A. de Geus, "The Living Company," Harvard Business 14. The cost of equity capital is calculated using the capital Review (March/April 1997): 51–59. asset pricing model: Firm X's cost of equity ∙ the risk- 30. M. E. Porter and M. R. Kramer, "Strategy and Society: free rate of interest + a risk premium. The risk premium The Link between Competitive Advantage and is the excess of the stock market rate of return over the Corporate Social Responsibility," Harvard Business risk-free rate multiplied by Firm X's beta coefficient (its Review (December 2006): 78–92. measure of systematic risk). See T. Koller, M. Goedhart, 31. M. E. Porter and M. R. Kramer, "Creating Shared Value," and D. Wessels, Valuation: Measuring and Managing Harvard Business Review ( January 2011): 62–77. the Value of Companies, 5th edn (Hoboken, NJ: John 32. C. K. Prahalad and S. L. Hart, "The Fortune at the Bottom Wiley & Sons, Inc., 2010), Chapter 11. of the Pyramid," strategy + business 26 (2002): 54–67; chapter 2 Goals, Values, and Performance 61
T. London and S. L. Hart, "Reinventing Strategies for 36. A. Gower and M. A. Cusamano, "How Companies Emerging Markets: Beyond the Transnational Model," Become Platform Leaders," Sloan Management Review Journal of International Business Studies 35 (2004): 350–370. (Winter 2008): 28–35. 33. "Kik Teen Chat App Draws Venture Capital," Financial 37. T. Chi, "Option to Acquire or Divest a Joint Times (November 19, 2014). Venture," Strategic Management Journal 21 (2000) 34. N. Nichols, "Scientific Management at Merck: An 665–687. Interview with CFO Judy Lewent," Harvard Business 38. B. Kogut and N. Kulatilaka, "Capabilities as Real Review ( January/February 1994): 89–105. Options," Organization Science 12 (2001) 744–758; 35. B. Kogut and N. Kulatilaka, "Options Thinking and R. G. McGrath, W. Furrier, and A. Mendel, "Real Options Platform Investments: Investing in Opportunity," California as Engines of Choice and Heterogeneity," Academy of Management Review (Winter 1994): 52–69. Management Review 29 (2004): 86–101. 3 Industry Analysis: The Fundamentals
When a management with a reputation for brilliance tackles a business with a rep- utation for poor fundamental economics, it is the reputation of the business that remains intact. —WARREN BUFFETT, CHAIRMAN, BERKSHIRE HATHAWAY
The reinsurance business has the defect of being too attractive-looking to new entrants for its own good and will therefore always tend to be the opposite of, say, the old business of gathering and rendering dead horses that always tended to contain few and prosperous participants. —CHARLES T. MUNGER, CHAIRMAN, WESCO FINANCIAL CORP
By the time you have completed this chapter, you will be able to: ◆◆ Appreciate that the firm's industry forms the core of its external environment and understand that its characteristics and dynamics are essential components of strategy analysis. ◆◆ Recognize the main structural features of an industry and understand how they impact the intensity of competition and overall level of profitability in the industry. ◆◆ Apply industry analysis to explain the level of profitability in an industry and predict how profitability is likely to change in the future. ◆◆ Develop strategies that (a) position the firm most favorably in relation to competition and (b) influence industry structure in order to enhance industry attractiveness. ◆◆ Define the boundaries of the industry within which a firm is located. ◆◆ Identify opportunities for competitive advantage within an industry (key success factors).
The business environment of the firm consists of all the external influences that impact its decisions and its performance. Given the vast number of external influ- ences, how can managers hope to monitor, let alone analyze, environmental con- ditions? The starting point is some kind of system or framework for organizing information. Environmental influences can be classified by source, for example, into political, economic, social, and technological factors—what is known as PEST chapter 3 Industry Analysis: The Fundamentals 65
does not necessarily yield profit. The value created is distributed between custom- ers and producers by the forces of competition. The stronger competition is among producers, the more value is received by customers as consumer surplus (the differ- ence between the price they actually pay and the maximum price they would have been willing to pay) and the less is received by producers (as producer surplus or economic rent). A single supplier of umbrellas outside the Gare de Lyon on a wet Parisian morning can charge a price that fully exploits commuters' desire to keep dry. As more and more umbrella sellers arrive, so the price of umbrellas will be pushed closer to the wholesale cost. However, the profit earned by Parisian umbrella sellers, or any other industry, does not just depend on the competition between them. It also depends upon their suppliers. If an industry has a powerful supplier—a single wholesaler of cheap, imported umbrellas—that supplier may be able to capture a major part of the value created in the local umbrella market. Hence, the profits earned by the firms in an industry are determined by three factors:
Industry analysis brings all three factors into a single analytic framework.
Table 3.1 shows the profitability of different US industries. Some industries consis- tently earn high rates of profit; others fail to cover their cost of capital. The basic premise that underlies industry analysis is that the level of industry profitability is neither random nor the result of entirely industry-specific influences: it is deter- mined by the systematic influences of the industry's structure. The underlying theory of how industry structure drives competitive behavior and determines industry profitability is provided by industrial organization (IO) economics. The two reference points are the theory of monopoly and the theory of perfect competition. In a monopoly a single firm is protected by high barriers to entry. In perfect competition many firms supply a homogeneous product and there are no entry barriers; these form end points of the spectrum of industry structures. While a monopolist can appropriate in profit the full amount of the value it creates, under perfect competition the rate of profit falls to a level that just covers firms' cost of capital. In the real world, industries fall between these two extremes. During 1996–2002, Microsoft's near monopoly of the market for PC operating systems allowed it to earn a return on equity of almost 30%. In the close-to-perfectly competitive, US farm sector, the long-run return on equity is 3.0%—below the cost of capital. However, most manufacturing and service indus- tries are somewhere in between: they are oligopolies—industries dominated by a small number of major companies. Small markets can offer good profit opportuni- ties if they can be dominated by a single firm. Strategy Capsule 3.1 gives examples of such niche markets. chapter 3 Industry Analysis: The Fundamentals 67
US Smokeless Tobacco Company earned an operat- casing to suit all product types." Its overall world market ing margin of 55% during 2011–2013, making a major share is around 60%. During 2010–2013, it earned a contribution to the 102% return on equity earned by return on equity of 25%—about three times its cost its parent, Altria Inc., over the same period. What's the of equity. secret of USSTC's profitability? It accounts for 55% of International Game Technology (IGT) based in the US market for smokeless tobacco, and its long- Reno, Nevada is the world's dominant manufacturer of established brands (including Skoal, Copenhagen, and slot machines for casinos. IGT maintains its 70% US mar- Red Seal), its distribution through thousands of small ket share through close relations with casino operators retail outlets, and government restrictions on adver- and a continuous flow of new products. With heavy tising tobacco products create formidable barriers to investment in R & D (it holds over 6,000 patents), and a entry to would-be competitors. policy of leasing rather than selling machines, IGT limits Devro plc, based in the Scottish village of rivals' market opportunities. Despite heavy investment Moodiesburn, is the world's leading supplier of col- in new technologies and new products, IGT earned an lagen sausage skins ("casings"). "From the British ROE of 21% from 2011 to 2013. 'Banger' to the Chinese Lap Cheong, from the French Merguez to the South American Chorizo, Devro has a Sources: www.altria.com, www.devro.com, and www.igt.com.
Rivalry among existing f irms
SUPPLIER POWER • Buyers' price sensitivity • Relative bargaining power (See Buyer Power for detail)
BUYER POWER Price sensitivity Bargaining power • Cost of product • Size and concentration relative to total cost of buyers relative to producers • Product • Buyers' switching costs dif ferentiation • Buyers' information • Competition • Buyers' ability to between buyers backward integrate70 Part II THE TOOLS OF STRATEGY ANALYSIS
provided a new source of substitute competition that has proved devastating for a number of established industries. Travel agencies, newspapers, and telecommunica- tion providers have all suffered severe competition from internet-based substitutes. The extent to which substitutes depress prices and profits depends on the pro- pensity of buyers to substitute between alternatives. This, in turn, depends on their price-performance characteristics. If city-center to city-center travel between Washington and New York is 50 minutes quicker by air than by train and the average traveler values time at $30 an hour, the implication is that the train will be competi- tive at fares of $25 below those charged by the airlines. The more complex a product and the more differentiated are buyers' preferences, the lower the extent of substitu- tion by customers on the basis of price differences.
Threat of Entry If an industry earns a return on capital in excess of its cost of capital, it will attract entry from new firms and firms diversifying from other industries. If entry is unre- stricted, profitability will fall toward its competitive level. In both the UK and the US, the popularity of craft beers and the low capital cost of small-batch beer production have meant a flood of new entrants into the beer markets of both countries. Between 1990 and 2014, the number of breweries increased from 284 to 2822 in the US and from 241 to 1285 in the UK, despite the fact that overall beer production declined in both countries.2 Wage differences between occupations are also influenced by entry barriers.Why is it that my wife, a psychotherapist, earns much less than our niece, a recently qualified medical doctor? In psychotherapy there are multiple accrediting bodies and less restrictive government licensing than in medicine, hence there are much lower barriers to entry. Threat of entry rather than actual entry may be sufficient to ensure that established firms constrain their prices to the competitive level. An industry where no barriers to entry or exit exist is contestable: prices and profits tend toward the competitive level, regardless of the number of firms within the industry.3 Contestability depends on the absence of sunk costs—investments whose value cannot be recovered on exit. With no sunk costs, an industry is vulnerable to "hit and run" entry whenever established firms raise their prices above the competitive level. In most industries, however, new entrants cannot enter on equal terms with those of established firms. A barrier to entry is any disadvantage that new entrants face relative to established firms. The size of this disadvantage determines the height of a barrier to entry. The principal sources of barriers to entry are as follows.
Economies of Scale Industries with high capital requirements for new entrants are also subject to economies of scale. Thus, large, indivisible investments in chapter 3 Industry Analysis: The Fundamentals 71
Absolute Cost Advantages Established firms may have a unit cost advantageover entrants, irrespective of scale. Absolute cost advantages often result from theownership of low-cost sources of raw materials. Established oil and gas producers,such as Saudi Aramco and Gazprom, which have access to the world's biggest andmost accessible reserves, have an unassailable cost advantage over more recententrants such as Cairn Energy and BG Group. Absolute cost advantages may alsoresult from economies of learning. Intel's dominance of the market for advancedmicroprocessors arises in part from the efficiency benefits it derives from its wealthof experience.
Governmental and Legal Barriers Some economists claim that the only trulyeffective barriers to entry are those created by government. In taxicabs, banking,telecommunications, and broadcasting, entry usually requires a license from a publicauthority. Since medieval times favored businesses have benefitted from govern-ments granting them an exclusive right to ply a particular trade. Today, patents,copyrights, and trademarks protect the creators of intellectual property from imita-tors. Regulatory requirements and environmental and safety standards often put newentrants at a disadvantage in comparison with established firms because compliancecosts tend to weigh more heavily on newcomers.72 Part II THE TOOLS OF STRATEGY ANALYSIS
operators favor mergers that would reduce the number of competitors to three ineach market.12 However, despite the frequent observation that the exit of a com-petitor reduces price competition, while the entry of a new competitor stimulatesit, there is little systematic evidence that seller concentration increases profitability."The relation, if any, between seller concentration and profitability is weak statisti-cally and the estimated effect is usually small."13
Product Differentiation The more similar the offerings among rival firms, themore willing are customers to switch between them and the greater is the inducementfor firms to cut prices to boost sales. Where the products of rival firms are virtuallyindistinguishable, the product is a commodity and price is the sole basis for competi-tion. By contrast, in industries where products are highly differentiated (perfumes,pharmaceuticals, restaurants, management consulting services), competition tends tofocus on quality, brand promotion, and customer service rather than price.
Excess Capacity and Exit Barriers Why, especially in commodity industries, doesindustry profitability tend to fall so drastically during periods of recession? The key isthe balance between demand and capacity. Unused capacity encourages firms to offerprice cuts to attract new business. Excess capacity may be cyclical (e.g., the boom–bustcycle in the semiconductor industry); it may also be part of a structural problem result-ing from overinvestment and declining demand. In this latter situation, the key issue iswhether excess capacity will leave the industry. Barriers to exit are costs associatedwith capacity leaving an industry. Where resources are durable and specialized, andwhere employees are entitled to job protection, barriers to exit may be substantial.14In the European auto industry, excess capacity together with high exit barriers havedevastated industry profitability. Conversely, demand growth creates capacity shortagesthat boost margins. Rising production of shale oil in North America during 2012–2015created an acute shortage of pipeline capacity, greatly increasing the profitability of thepipeline companies. On average, companies in growing industries earn higher profitsthan companies in slow-growing or declining industries (Figure 3.4).
–1.5 –6% –4% –2% 0% 2% 4% 6% 8% 10% 12% Rate of market growth (in real terms)
Source: Based upon the PIMS multiple regression equation. See R.M. Grant Contemporary Strategy Analysis, 5th edition (Blackwell, 2005): 491.
airlines to offer heavily discounted tickets on flights with low bookings reflects the very low variable costs of filling empty seats. "Cyclical" stocks are characterized not only by cyclical demand but also by a high ratio of fixed to variable costs, which means that fluctuations in revenues are amplified into much bigger fluctuations in profits. Scale economies may also encourage companies to compete aggressively on price in order to gain the cost benefits of greater volume. If scale efficiency in the auto industry means producing six million cars a year, a level that is currently achieved by only seven companies, the outcome is a battle for market share as each firm tries to achieve critical mass.
Buyers' Price Sensitivity The extent to which buyers are sensitive to the prices charged by the firms in an industry depends on the following.
●● The greater the importance of an item as a proportion of total cost, the more sensitive buyers will be about the price they pay. Beverage manufacturers are highly sensitive to the costs of aluminum cans because this is one of their largest single cost items. Conversely, most companies are not sensitive to the fees charged by their auditors, since auditing costs are a tiny fraction of total company expenses. ●● The less differentiated the products of the supplying industry, the more will- ing the buyer is to switch suppliers on the basis of price. The manufacturers chapter 3 Industry Analysis: The Fundamentals 75
of T-shirts and light bulbs have much more to fear from Walmart's buying power than have the suppliers of cosmetics. ●● The more intense the competition among buyers, the greater their eagerness for price reductions from their sellers. As competition in the world automo- bile industry has intensified, so component suppliers face greater pressures for lower prices. ●● The more critical an industry's product to the quality of the buyer's product or service, the less sensitive are buyers to the prices they are charged. The buying power of personal computer manufacturers relative to the manufac- turers of microprocessors (Intel and AMD) is limited by the vital importance of these components to the functionality of PCs.
●● Size and concentration of buyers relative to suppliers. The smaller the num- ber of buyers and the bigger their purchases, the greater the cost of losing one. Because of their size, health maintenance organizations can purchase healthcare from hospitals and doctors at much lower costs than can individ- ual patients. Empirical studies show that buyer concentration lowers prices and profits in the supplying industry.16 ●● Buyers' information. The better-informed buyers are about suppliers and their prices and costs, the better they are able to bargain. Doctors and lawyers do not normally display the prices they charge, nor do traders in the bazaars of Marrakesh or Chennai. Keeping customers ignorant of relative prices is an effective constraint on their buying power. But knowing prices is of little value if the quality of the product is unknown. In the markets for haircuts, interior design, and management consulting, the ability of buyers to bargain over price is limited by uncertainty over the precise attributes of the product they are buying. ●● Capacity for vertical integration. In refusing to deal with the other party, the alternative to finding another supplier or buyer is to do it yourself. Large beer companies have reduced their dependence on the manufacturers of alu- minum cans by manufacturing their own. Large retail chains introduce their own label brands to compete with those of their suppliers. Backward integra- tion need not necessarily occur—a credible threat may suffice.
the suppliers. Again, the relevant factors are the ease with which the firms in the industry can switch between different input suppliers and the relative bargaining power of each party. The suppliers of commodities tend to lack bargaining power relative to their customers, hence they may use cartels to boost their influence over prices (e.g., OPEC, the International Coffee Organization, and farmers' marketing coopera- tives). Conversely, the suppliers of complex, technically sophisticated components may be able to exert considerable bargaining power. The dismal profitability of the personal computer industry may be attributed to the power exercised by the suppliers of key components (processors, disk drives, LCD screens) and the dominant supplier of operating systems (Microsoft). The profitability of the wire- less telecommunications carriers also suffers from the presence of a powerful supplier: the monopoly position of national governments which auction spectrum licenses. Labor unions are important sources of supplier power. US industries where over 60% of employees are unionized (such as automobiles, steel, and airlines) earned a return on investment that was five percentage points lower than industries where less than 35% of employees were unionized.17
1 Examine how the industry's current and recent levels of competition and profit- ability are a consequence of its present structure. 2 Identify the trends that are changing the industry's structure. Is the industry consolidating? Are new players seeking to enter? Are the industry's products becoming more differentiated or more commoditized? Will additions to industry capacity outstrip growth of demand? Is technological innovation causing new substitutes to appear? 3 Identify how these structural changes will affect the five forces of competi- tion and resulting profitability of the industry. Will the changes in indus- try structure cause competition to intensify or to weaken? Rarely do all the structural changes move competition in a consistent direction, typically some will exacerbate competitive intensity; others will cause it to abate. Hence, determining the overall impact on profitability tends to be a matter of judgment.
Strategy Capsule 3.2 discusses the outlook for profitability in the wireless handsetindustry.
Wireless telephony has been one of the greatest growth Huawei, and Xiaomi—introduced branded phones. As industries of the past two decades—and almost as mature markets became saturated, so excess capacity lucrative for the handset makers as for the service pro- emerged throughout the industry, which, in turn, rein- viders. During the 1990s, growth of handset sales in forced the buying power of the major distributors of North America, Europe, and Japan averaged close to phones, the wireless service companies. 50% each year and generated massive profits and share- During 2016–2020, competition and profitability holder value for the early leaders, Motorola and Nokia. will be affected by several factors: During 2005–2015, there have been profound changes in competition and margins. Despite contin- ◆◆ New entry seems likely to continue. In the smart- ued demand growth (especially in emerging markets), phone market, the availability of the Android plat- profitability has fallen. During 2000–2005, the industry form making it easy for contract manufacturers to leaders—Nokia, Motorola, Sony-Ericsson, Samsung, LG, design and brand their own phones will increase and Siemens—earned an average operating margin the number of firms competing in this segment. of 23% on their sales of mobile devices. By 2014, the ◆◆ Most emerging markets, including China and India, top seven suppliers (Samsung, Apple, Lenovo, Huawei, are likely to become saturated. Nokia, LG, and Xiaomi) were earning an average operat- ing margin of 4% (with Apple and Samsung account- ◆◆ Product differentiation will decline. In smartphones, ing for almost all the combined profit). the Apple and Android platforms offer increasingly The structural changes undermining industry similar functionality and most of the same apps. profitability included new entry; several Chinese and ◆◆ Mergers among telecom service providers will Taiwanese contact manufacturers—including HTC, increase their buying power.
●● Between 2000 and 2006, a wave of mergers and acquisitions among the world's iron ore miners resulted in three companies—Vale, Rio Tinto, and BHP Billiton—controlling 75% of global iron ore exports. The growing power of the iron ore producers relative to their customers, the steel makers, con- tributed to the 400% rise in iron ore prices between 2004 and 2010.18 chapter 3 Industry Analysis: The Fundamentals 79
The idea of firms reshaping their industries to their own advantage has beendeveloped by Michael Jacobides. He begins with the premise that industries are in astate of continual evolution and that all firms, even quite small ones, have the poten-tial to influence the development of industry structure to suit their own interests—thereby achieving what he calls architectural advantage. Jacobides encouragesfirms to look broadly at their industry—to see their entire value chain and linkswith firms producing complementary goods and services. The key is then to identify"bottlenecks"—activities where scarcity and the potential for control offer superioropportunities for profit.21 Architectural advantages results from three sources:
streaming. Yet not all segments of the recorded music business have been equally affected. The old are less inclined to new technology than younger listeners are, hence classical music, country, and golden oldies have become comparatively more attractive than pop and hip hop genres. Porter describes the success of US truck-maker Paccar in sheltering itself from the bargaining power of fleet buyers. By focusing on the preferences of independent owner-operators (e.g., by providing superior sleeping cabins, higher-specification seats, a roadside assistance program) Paccar has consistently been able to earn the highest rate of return in the industry.22 Effective positioning requires the firm to anticipate changes in the competitive forces likely to affect the industry. Traditional book retailing has been devastated by online retailers such as Amazon and e-books. The survivors are those that have positioned themselves to avoid these powerful competitive forces, for example by creating new revenue sources such as cafes and events for which admission is charged.
The central issue in defining industries and markets is to establish who is competingwith whom. To do this we need to draw upon the principle of substitutability. Thereare two dimensions to this: substitutability on the demand side and substitutabilityon the supply side. Let us consider once more the industry within which Ferrari competes. Startingwith the demand side, if customers are willing to substitute only between Ferrarisand other sports-car brands brands on the basis of price differentials, then Ferrari ispart of the performance car industry. If, on the other hand, customers are willing tosubstitute Ferraris for other mass-market brands, then Ferrari is part of the broaderautomobile industry. But this fails to take account of substitutability on the supply side. If volumecar producers such as Ford and Hyundai are able to apply their production facili-ties and distribution networks to supply sports cars, then, on the basis of supply-side substitutability, we could regard Ferrari as part of the broader automobileindustry. The same logic can be used to define the major domestic appliances asan industry. Although consumers are unwilling to substitute between refrigeratorsand dishwashers, manufacturers can use the same plants and distribution channelsfor different appliances. Similar considerations apply to geographical boundaries. Should Ferrari viewitself as competing in a single global market or in a series of separate national orregional markets? The criterion here again is substitutability. If customers are willingand able to substitute cars available on different national markets, or if manufac-turers are willing and able to divert their output among different countries to takeaccount of differences in margins, then a market is global. The key test of the geo-graphical boundaries of a market is price: if price differences for the same productbetween different locations tend to be eroded by demand-side and supply-sidesubstitution, then these locations lie within a single market. In practice, drawing the boundaries of markets and industries is a matter of judg-ment that depends on the purposes and context of the analysis. Decisions regardingpricing and market positioning will require a micro-level approach to market andindustry definition. Decisions over investments in technology, new plants, and newproducts require a wider view of the relevant market and industry. The boundaries of a market or industry are seldom clear-cut. A firm's competi-tive environment is a continuum rather than a bounded space. Thus, we may viewthe competitive market of Disneyland, Hong Kong as a set of concentric circles.82 Part II THE TOOLS OF STRATEGY ANALYSIS
The closest competitors are nearby theme parks Ocean Park and Ma Wan Park. Slightly more distant are Shenzhen Happy Valley, Shenzhen Window of the World, and Splendid China. Further still are Disneyland parks in Tokyo and Shanghai and alternative forms of entertainment, e.g., a trip to Macau or to a beach resort such as Sanya on Hainan Island. For the purposes of applying the five forces framework, industry definition is seldom critical. Thus, we may define the "box" within which industry rivals com- pete quite narrowly, but because we take account of competitive forces outside the industry box, we can view nearby competitors as the suppliers of substitutes and potential entrants. Hence, the precise boundaries of the industry box are not greatly important.23
To answer the first question we need to look more closely at customers of the industry and to view them not as a source of buying power and a threat to profit- ability but as the raison d'être of the industry and its underlying source of profit. This requires that we inquire: Who are our customers? What are their needs? How do they choose between competing offerings? Once we recognize the basis upon which customers' choose between rival offerings, we can identify the factors that confer success upon the individual firm. For example, if travelers choose airlines primarily on price, then cost efficiency is the primary basis for competitive advan- tage in the airline industry and the key success factors are the determinants of relative cost. The second question requires that we examine the nature of competition in the industry. How intense is competition and what are its key dimensions? Thus, in airlines, it is not enough to offer low fares. To survive intense competition during chapter 3 Industry Analysis: The Fundamentals 83
As a consultant faced with an unfamiliar business He replied: "The rate of tree growth is the keyor industry, I make a point of first asking the special- variable. As a rule, two factors promote growth: theists in the business, "What is the secret of success in amount of sunshine and the amount of water. Ourthis industry?" Needless to say, I seldom get an immedi- company doesn't have many forests with enough ofate answer and so I pursue the inquiry by asking other both. In Arizona and Utah, for example, we get morequestions from a variety of angles in order to establish than enough sunshine but too little water and so treeas quickly as possible some reasonable hypotheses as growth is very low. Now, if we could give the trees into key factors for success. In the course of these inter- those states enough water, they'd be ready in less thanviews it usually becomes quite obvious what analyses 15 years instead of the 30 it takes now. The most impor-will be required in order to prove or disprove these tant project we have in hand at the moment is aimedhypotheses. By first identifying the probable key factors at finding out how to do this."for success and then screening them by proof or dis- Impressed that this director knew how to work outproof, it is often possible for the strategist to penetrate a key factor strategy for his business, I offered my ownvery quickly to the core of a problem. contribution: "Then under the opposite conditions, Traveling in the US last year, I found myself on one where there is plenty of water but too little sunshine—occasion sitting in a plane next to a director of one of for example, around the lower reaches of the Columbiathe biggest lumber companies in the country. Thinking River—the key factors should be fertilizers to speed upI might learn something useful in the course of the the growth and the choice of tree varieties that don'tfive-hour flight, I asked him, "What are the key factors need so much sunshine."for success in the lumber industry?" To my surprise, Having established in a few minutes the generalhis reply was immediate: "Owning large forests and framework of what we were going to talk about, Imaximizing the yield from them." The first of these key spent the rest of the long flight very profitably hearingfactors is a relatively simple matter: purchase of forest- from him in detail how each of these factors was beingland. But his second point required further explanation. applied.Accordingly, my next question was: "What variable or Source: Kenichi Ohmae, The Mind of the Strategist (New York:variables do you control in order to maximize the yield McGraw-Hill, 1982): 85 © The McGraw-Hill Companies Inc.,from a given tract?" reproduced with permission.
recessionary periods an airline requires financial strength; it may also require good relations with regulators and suppliers. A basic framework for identifying key success factors is presented in Figure 3.5. Application of the framework to identify key success factors in three industries is outlined in Table 3.2. Key success factors can also be identified through the direct modeling of profit- ability. In the same way that the five forces analysis models the determinants of84 Part II THE TOOLS OF STRATEGY ANALYSIS
Table 3.2 Identifying key success factors: Steel, fashion clothing, and supermarkets
_____ ASMs RPMs × _____ ASMs − ________ ASMs vidual flights. Some of the main determinants of each of thesecomponent ratios are the following: ◆◆ Expenses/ASMs ●● wage rates and benefit levels◆◆ Revenue/RPMs ●● fuel efficiency of aircraft ●● intensity of competition on routes flown ●● productivity of employees (determined partly ●● effective yield management to permit quick by their job flexibility) price adjustment to changing market conditions ●● load factors ●● ability to attract business customers ●● level of administrative cost. ●● superior customer service.86 Part II THE TOOLS OF STRATEGY ANALYSIS
Summary In Chapter 1 we established that a profound understanding of the competitive environment is a critical ingredient of a successful strategy. Despite the vast number of external influences that affect every business enterprise, our focus is the firm's industry environment which we analyze in order to evaluate the industry's profit potential and to identify the sources of competitive advantage. The centerpiece of our approach is Porter's five forces of competition framework, which links the structure of an industry to the competitive intensity within it and to the profitability that it realizes. The Porter framework offers a simple yet powerful organizing framework for identifying the relevant features of an industry's structure and predicting their implications for competitive behavior. The primary application for the Porter five forces framework is in predicting how changes in an industry's structure are likely to affect its profitability. Once we understand the drivers of industry profitability, we can identify strategies through which a firm can improve industry attractiveness and position itself in relation to these different competitive forces. As with most of the tools for strategy analysis that we shall consider in this book, the Porter five forces framework is easy to comprehend. However, real learning about industry analysis and about the Porter framework in particular derives from its application. It is only when we apply the Porter framework to analyzing competition and diagnosing the causes of high or low profitability in an industry that we are forced to confront the complexities and subtleties of the model. A key issue is identifying the industry within which a firm competes and recognizing its boundaries. By employing the principles of substitutability and relevance, we can delineate meaningful industry boundaries. Finally, our industry analysis allows us to make a first approach at identifying the sources of com- petitive advantage through recognizing key success factors in an industry. I urge you to put the tools of industry analysis to work—not just in your strategic management coursework but also in interpreting everyday business events. The value of the Porter framework is as a practical tool—in helping us to understand the disparities in profitability between industries, whether an industry will sustain its profitability into the future, and which start-up companies have the best potential for making money. Through practical applications, you will also become aware of the limitations of the Porter framework. In the next chapter we will see how we can extend our analysis of industry and competition. chapter 3 Industry Analysis: The Fundamentals 87
Self-Study Questions 1. From Table 3.1, select a high-profit industry and a low-profit industry. From what you know of the structure of your selected industry, use the five forces framework to explain why profitability has been high in one industry and low in the other. 2. With reference to Strategy Capsule 3.1, use the five forces framework to explain why profitability has been so high in the US market for smokeless tobacco. 3. The major forces shaping the business environment of the fixed-line telecom industry are technology and government policy. The industry has been influenced by fiber optics (greatly increasing transmission capacity), new modes of telecommunication (wireless and internet telephony), the convergence of telecom and cable TV, and regulatory change (including the opening of fixed-line infrastructures to "virtual operators"). Using the five forces of competition framework, show how each of these developments has influenced competition and profitability in the fixed-line telecom industry. 4. By March 2015, the online travel agency industry had consolidated around two lead- ers: Expedia (which had acquired Travelocity, Lastminute.com, and Orbitz) and Priceline (which owned booking.com, Kayak and OpenTable). These two market leaders competed with numerous smaller online travel agents (e.g., TripAdvisor, Travelzoo), with traditional travel agencies (e.g., Carlson Wagonlit, TUI, American Express—all of which had adopted a "bricks 'n' clicks" business model), and with direct online sales by airlines, hotel chains, and car rental companies. Amazon and Google were both viewed as likely entrants to the market. The online travel agents are dependent upon computerized airline reservation systems such as Sabre, Amadeus, and Travelport. Use Porter's five forces framework to predict the likely profitability of the online travel agency industry over the next ten years. 5. Walmart (like Carrefour, Ahold, and Tesco) competes in several countries of the world, yet most shoppers choose between retailers within a radius of a few miles. For the purposes of analyzing profitability and competitive strategy, should Walmart consider the discount retailing industry to be global, national, or local? 6. What do you think are key success factors in: a. the pizza delivery industry? b. the credit card industry (where the world's biggest issuers are: Bank of America, JPMorgan Chase, Citigroup, American Express, Capital One, HSBC, and Discover)?
Notes 1. M. E. Porter, "The Five Competitive Forces that Shape York: Harcourt Brace Jovanovich, 1982). See also M. Strategy," Harvard Business Review 57 (January 2008): 57–71. Spence, "Contestable Markets and the Theory of Industry 2. Brewers Association, "Historical U.S. Brewery Count," Structure: A Review Article," Journal of Economic http://www.brewersassociation.org/statistics/number-of- Literature 21 (1983): 981–990. breweries/; "Good Beer Guide 2015 Shows UK has Most 4. "Annual Franchise 500," Entrepreneur ( January 2014). Breweries," Guardian (September 11, 2014). 5. "Brand Keys Customer Loyalty 2013," http://brandkeys. 3. W. J. Baumol, J. C. Panzar, and R. D. Willig, Contestable com/wp-content/uploads/2013/02/2013-CLEI-Press- Markets and the Theory of Industry Structure (New Release-FINAL-Overall.pdf, accessed July 20, 2015.88 Part II THE TOOLS OF STRATEGY ANALYSIS
6. R. D. Buzzell and P. W. Farris, "Marketing Costs in 16. T. Kelly and M. L. Gosman, "Increased Buyer Consumer Goods Industries," in H. Thorelli (ed.), Concentration and its Effects on Profitability in Strategy + Structure = Performance (Bloomington, IN: the Manufacturing Sector," Review of Industrial Indiana University Press, 1977): 128–129. Organization 17 (2000): 41–59. 7. In October 1999, the Department of Justice alleged that 17. R. D. Buzzell and B. T. Gale, The PIMS Principles (New American Airlines was using unfair means in attempting to York: Free Press, 1987): 67. monopolize air traffic out of Dallas/Fort Worth, http:// 18. "Iron Ore Companies Consolidated," International openjurist.org/743/f2d/1114/united-states-v-american- Resource Journal (October 2014). airlines-inc-l, accessed July 20, 2015. 19. J. Bower, When Markets Quake (Boston: Harvard 8. M. Lieberman ("Excess Capacity as a Barrier to Entry," Business School Press, 1986). Journal of Industrial Economics 35, 1987: 607–627) 20. M. Carnall, S. Berry, and P. Spiller, "Airline Hubbing, argues that, to be credible, the threat of retaliation Costs and Demand," in D. Lee (ed.), Advances in Airline needs to be supported by incumbents investing in Economics, vol. 1 (Amsterdam: Elsevier, 2006). excess capacity so that they have the potential to flood 21. M. G. Jacobides, "Strategy Bottlenecks: How TME the market. Players Can Shape and Win Control of Their Industry 9. See, for example, J. S. Bain, Barriers to New Competition Architecture," Insights, 9 (2011): 84–91; M. G. Jacobides (Cambridge, MA: Harvard University Press, 1956); and and J. P. MacDuffie, "How to Drive Value Your Way," H. M. Mann, "Seller Concentration, Entry Barriers, Harvard Business Review, 91 ( July/August 2013): and Rates of Return in Thirty Industries," Review of 92–100. Economics and Statistics 48 (1966): 296–307. 22. M. E. Porter, "The Five Competitive Forces that Shape 10. J. L. Siegfried and L. B. Evans, "Empirical Studies of Strategy," Harvard Business Review 57 ( January 2008): Entry and Exit: A Survey of the Evidence," Review 57–71. of Industrial Organization 9 (1994): 121–155. 23. For a concise discussion of market definition see Office 11. G. S. Yip, "Gateways to Entry," Harvard Business Review of Fair Trading, Market Definition (London: December 60 (September/October1982): 85–93. 2004), especially pp. 7–17. 12. "Mobile Telecoms: Four is a Magic Number," Economist 24. The term was coined by Chuck Hofer and Dan (March 15, 2014): 64. Schendel (Strategy Formulation: Analytical Concepts, 13. R. Schmalensee, "Inter-Industry Studies of Structure St Paul: West Publishing, 1977: 77). They define key and Performance," in R. Schmalensee and R. D. Willig success factors as "those variables that management (eds), Handbook of Industrial Organization, 2nd edn can influence through its decisions and that can affect (Amsterdam: North Holland, 1988): 976. significantly the overall competitive positions of the 14. C. Baden-Fuller (ed.), Strategic Management of Excess firms in an industry." Capacity (Oxford: Basil Blackwell, 1990). 25. P. Ghemawat, Commitment: The Dynamic of Strategy 15. "Dry bulk shipping rates approach all-time low," (New York: Free Press, 1991): 11. Financial Times (November 27, 2008). 4 Further Topics in Industry and Competitive Analysis
By the time you have completed this chapter, you will be able to: ◆◆ Recognize the limits of the Porter five forces framework, and extend the framework to include the role of complements as well as substitutes. ◆◆ Acknowledge competition as a dynamic process that changes industry structures, appreci- ate the insights that game theory offers into the dynamics of rivalry, and use competitor analysis to predict the competitive moves by rivals. ◆◆ Segment an industry into its constituent markets, appraise the relative attractiveness of different segments and apply strategic group analysis to classify firms according to their strategic types.
Schmalensee (1985)
Rumelt (1991)
0 10 20 30 40 50 60 70 80 90 100Sources: R. Schmalensee, "Do markets differ much?" American Economic Review 75 (1985): 341–51; R. P. Rumelt,"How much does industry matter?" Strategic Management Journal 12 (1991): 167–85; A. M. McGahan andM. E. Porter, "How much does industry matter, really?" Strategic Management Journal 18 (1997): 15–30; G.Hawawini, V. Subramanian, and P. Verdin, "Is Performance Driven by Industry or Firm-Specific Factors? A New Lookat the Evidence," Strategic Management Journal 24 (2003): 1–16; J. A. Roquebert, R. L. Phillips, and P. A. Westfall,"Markets vs. Management: What 'Drives' Profitability?" Strategic Management Journal 17 (1996): 653–64;V. F. Misangyi, H. Elms, T. Greckhamer, and J. A. Lepine, "A New Perspective on a Fundamental Debate: A MultilevelApproach to Industry, Corporate and Business Unit Effects," Strategic Management Journal 27 (2006): 571–90.
However, the usefulness of industry analysis is not conditional upon the rela-tive importance of inter-industry and intra-industry profitability differences. Industryanalysis is important because, without a deep understanding of their competitiveenvironment, firms cannot make sound strategic decisions. Industry analysis is notrelevant just to choosing which industries to locate within, it is also important foridentifying attractive segments and the sources of competitive advantage within anindustry. If our industry analysis is to fulfill its potential, it needs to go beyond the confinesof the Porter five forces framework. We need to go further in understanding thedeterminants of competitive behavior between companies, in particular using morerigorous approaches to analyze the relationship between market structure and com-petition. We need to disaggregate broad industry sectors to examine competitionwithin particular segments and among particular groups of firms. But let's begin byconsidering the potential to extend the Porter framework.
SUPPLIERS The suppliers of complements create value for the industry Bargaining power of suppliers and can exercise bargaining power
INDUSTRY COMPETITORS COMPLEMENTS POTENTIAL Threat of ENTRANTS new entrants Threat of SUBSTITUTES Rivalry among substitutes existing firms
very different situation from video games, where hardware suppliers keep propri-etary control over their operating systems. Where two products complement one another, profit will accrue to the supplierthat builds the stronger market position and reduces the value contributed by theother. How is this done? The key is to achieve monopolization, differentiation, andshortage of supply in one's own product, while encouraging competition, com-moditization, and excess capacity in the production of the complementary product.This is the same principle of creating a bottleneck that we discussed in the last chap-ter. Google has pioneered Android and Chrome as open-source operating systems inorder to counter Apple's dominance of mobile devices and Microsoft's dominance ofpersonal computers systems. As the above examples suggest, products based on digital technologies presentsome interesting issues in relation to competition and the quest for profit. In digitalmarkets users typically require systems that comprise hardware, an operating sys-tem, application software, and probably internet connection as well. In these mar-kets, competition tends to be among rival platforms—the interfaces that link thecomponent parts of the system. Both the users and the suppliers of applications tendto congregate around the market-leading platform—a phenomenon we call networkexternality. The result is the creation of winner-takes-all markets where a mar-ket share leader accounts for most industry sales and scoops most, if not all, of theindustry's profit pool. Strategy Capsule 4.1 discusses competition between differentsmartphone platforms. In winner-takes-all markets, the whole notion of industry attractiveness becomesmeaningless: the industry is only attractive to the firm that attains market leader-ship. In smartphones the situation is slightly different because the leading platform,Android, is open source. It is the #2 platform owner, Apple, that scoops most of theindustry's profit—in 2014 the other leading suppliers (Samsung, Sony, LG, Lenovo,and HTC) either made losses or earned a thin margin.4 We return to the role ofnetwork externalities in Chapter 9, when we discuss strategy in technology-basedindustries.
HypercompetitionThe Porter five forces framework is based upon the assumption that industry struc-ture determines competitive behavior, which in turn determines industry profitabil-ity. But competition also unleashes the forces of innovation and entrepreneurshipthat transform industry structures. Joseph Schumpeter viewed competition as a"perennial gale of creative destruction" in which market-dominating incumbents arechallenged, and often unseated, by rivals' innovations.5 This view of Schumpeter (and the "Austrian school" of economics) that com-petition is a dynamic process in which industry structure is constantly changingraises the issue of whether competitive behavior should be seen as an outcome ofindustry structure or a determinant of industry structure.6 The issue is the speedof structural change in the industry—if structural transformation is rapid, then the94 Part II the tools of strategy analysis
A key feature of the relationship between complemen- The early market leader in smartphone operat- tary products in digital markets is that they tend to be ing systems was Symbian, which was jointly owned co-specialized. Video games are adapted to play on a by Nokia, Sony-Ericsson, and Motorola. However, the specific video game console; video game consoles launch of Apple's iPhone in 2007 with its proprietary need to be designed to accommodate the character- iOS system, quickly displaced Symbian. While the iOS istics of the games they will play. This is different from was exclusive to Apple, apps could be created by the relationship between automobiles and gasoline: third-party developers who purchased Apple's soft- Shell gasoline will power any gasoline-fueled internal ware development kit and offered their apps through combustion engine; a Ford Focus will run on any brand Apple's App Store. Revenues were split 30% for Apple of gasoline. and 70% for the developer. Co-specialization creates network externalities. The introduction of Google's Android OS proved Network externalities arise when the value of a product to be a game-changer. Android was not only available to a user depends upon the number of other users of to any manufacturer, it was also open-source, which the product. The availability of complementary prod- meant that it was free. The first Android smartphone ucts is a major source of network externalities in digital was launched by HTC in October 2008. At the end of markets—the outcome tends to be winner-takes-all 2014, there were more than 50 firms supplying Android markets. smartphones. Moreover, there were 1.43 million apps Consider the market for smartphones. The attrac- on offer at Google Play—the app store for Android tiveness of a particular smartphone to a user depends applications—compared with 1.21 million at Apple's upon the number and quality of applications ("apps") App Store. available. App developers will target those platforms The operation of network externalities in the mar- with the greatest number of users. Migration by users ket is evident in the growing dominance of Android and developers from platforms with a low market share and Apple's iOS in smartphones. Between 2011 and to those with a high market share creates the "winner- 2014, the combined market share of Microsoft Phone, takes-all" effect. Blackberry OS, and Symbian declined from 46 to 4%. By Like many other digital markets, the market contrast, Android rose from 37 to 84%, while Apple iOS for smartphones is a two-sided market where the declined from 18 to 12%. platform—the operating system—forms an interface Sources: C. Cennamo and J. Santalo, "Platform Competition: between the two sides. The two sides are the two types Strategic Trade-offs in Platform Markets." Strategic of customer for operating systems: the consumers who Management Journal, 34 (2013): 1331–1350; GSMA buy smartphones and the developers who develop Intelligence, Analysis: Mobile Platform Wars (London: February 2014). applications and pay for access. chapter 4 Further Topics in Industry and Competitive Analysis 95
five forces framework does not offer a stable basis on which to predict competitionand profitability. In most industries, Schumpeter's process of "creative destruction" tends to bemore of a breeze than a gale. In established industries entry occurs so slowly thatprofits are undermined only gradually,7 while changes in industrial concentrationtend to be slow.8 One survey observed: "the picture of the competitive process …is, to say the least, sluggish in the extreme."9 As a result, both at the firm and theindustry level, profits tend to be highly persistent in the long run.10 But what about recent trends? Has accelerating technological change and inten-sifying international competition reinforced the processes of "creative destruction"?Rich D'Aveni argues that a general feature of industries today is hypercompetition:"intense and rapid competitive moves, in which competitors must move quicklyto build [new] advantages and erode the advantages of their rivals."11 If indus-tries are hypercompetitive, their structures are likely to be less stable than in thepast, and competitive advantage will be temporary.12 According to Rita McGrath,"Transient advantage is the new normal."13 Despite everyday observations that markets are becoming more volatile and mar-ket leadership more tenuous, research findings are inconsistent. One large-scalestatistical study conclude: "The heterogeneity and volatility of competitive advantagein US manufacturing industries has steadily and astonishingly increased since 1950.These results suggest that a shift toward hypercompetition has indeed occurred."14Another study found that this increased volatility extended well beyond technology-intensive industries but also extended beyond manufacturing industries.15 However,another study found a "lack of widespread evidence … that markets are more unsta-ble now than in the recent past."16
●● It permits the framing of strategic decisions. Apart from its predictive value, game theory provides a structure, a set of concepts, and a terminology that allows us to describe and structure a competitive situation in terms of: ○○ identity of the players;
Game theory has been used to analyze a wide variety of competitive situa- tions. These include the Cuban missile crisis of 1962,22 rivalry between Boeing and Airbus,23 NASCAR race tactics,24 auctions of airwave spectrum,25 the 2008 financial crisis,26 and the reasons why evolution has conferred such magnificent tails upon male peacocks.27 In terms of applications to competition among business enter- prises, game theory points to five aspects of strategic behavior through which a firm can influence competitive outcomes: cooperation, deterrence, commitment, chang- ing the structure of the game being played, and signaling.
Cooperation One of the key merits of game theory is its ability to encompass both competition and cooperation. A key deficiency of the five forces framework is in viewing interfirm relations as exclusively competitive in nature. Central to Adam Brandenburger and Barry Nalebuff's concept of co-opetition is recognition of the competitive/cooperative duality of business relationships.28 While some relationships are predominantly competitive (Coca-Cola and Pepsi) and others are predominantly cooperative (Intel and Microsoft), there is no simple dichotomy between competi- tion and cooperation: all business relationships combine elements of both. For all their intense rivalry, Coca-Cola and Pepsi cooperate on multiple fronts, including common policies on sales of soda drinks within schools, environmental issues, and health concerns. They may also coordinate their pricing and product introductions.29 Exxon and Shell have competed for leadership of the world's petroleum industry for over a century; at the same time they cooperate in a number of joint ventures. The desire of competitors to cluster together—antique dealers in London's Bermondsey Market or movie studios in Hollywood—points to the common interests of com- peting firms in growing the size of their market and developing its infrastructure. Typically, competition results in inferior outcomes for participants than cooperation. The prisoners' dilemma game analyzes this predicament, but also points to the stra- tegic initiatives through which a player can transform the game in order to reach a cooperative outcome (Strategy Capsule 4.2).
The classic prisoners' dilemma game involves a pair of of the incentives for cheating—a constant problem forcrime suspects who are arrested and interrogated sep- OPEC, where the member countries agree quotas butarately. The dilemma is that each will rat on the other then cheat on them.with the result that both end up in jail despite the fact How can a firm escape from such prisoners' dilem-that if both had remained silent they would have been mas? One answer is to change a one-period gamereleased for lack of evidence. (single transaction) into a repeated game. In the above The dilemma arises in almost all competitive example of competition in advertising, a multi-periodsituations—everyone could be better off with collu- perspective allows the companies to recognize thesion. Consider competition between Coca-Cola and futility of advertising campaigns that merely cancelPepsi in Ecuador, where each has the choice of spend- one another out. In the case of supplier–buyer rela-ing big or small on advertising. Figure 4.3 shows the tions, where the typical equilibrium is a low-qualitypayoffs to each firm. product at a low price, moving from a spot-transaction Clearly, the best solution for both firms is for them to to a long-term vendor relationship gives the suppliereach restrain their advertising expenditure (the upper the incentive to offer a better-quality product and theleft cell). However, in the absence of cooperation, the buyer to offer a price that reflects the preferred quality.outcome for both firms is to adopt big budgets (the A second solution is to change the payoffs throughlower right cell)—the reason being that each will fear deterrence. In the classic prisoners' dilemma, the Mafiathat any restraint will be countered by the rival seeking shifts the equilibrium from the suspects both confess-advantage by shifting to a big advertising budget. The ing to their both remaining silent by using draconianresulting maxi-min choice of strategies (each company reprisals to enforce its "code of silence." Similarly, if bothchooses the strategy that maximizes the minimum Coca-Cola and Pepsi were to threaten one anotherpayoff ) is a Nash equilibrium: no player can increase with aggressive price cuts should the other seek advan-his/her payoff by a unilateral change in strategy. Even if tage through a big advertising budget, this could shiftcollusion can be achieved, it will be unstable because the equilibrium to the top-left cell.
potential new entrant with a price war, such a threat will lack credibility if such a price war would inflict more damage on the incumbent than on the new entrant. Investing in excess capacity can be an effective means of discouraging entry. Prior to the expiration of its NutraSweet patents, Monsanto invested heavily in unneeded plant capacity to deter manufacturers of generic aspartame.30 Conversely, in compact disks, the reluctance of the dominant firm (Philips) to invest heavily in new capacity to meet growing demand encouraged a wave of new entrants.31 However, deterrence only works when the adversaries can be deterred. A central weakness of President George W. Bush's "war on terror" was that ideologically moti- vated terrorists are not susceptible to deterrence.32
Changing the Structure of the Game Creative strategies can change the struc- ture of the competitive game. A company may seek to change the structure of the industry within which it is competing in order to increase the profit potential of the industry or to appropriate a greater share of the available profit. Thus, establish- ing alliances and agreements with competitors can increase the value of the game by increasing the size of the market and building joint strength against possible entrants. There may be many opportunities for converting win–lose (or even lose– lose) games into win–win games by rivals designing cooperative solutions. In some cases, it may be advantageous for a firm to assist its competitors. When in June 2014, Tesla Motors offered to make available its patents to competitors, it was betting that any loss in its own competitive advantage would be offset by the ben- efits of expanding the market for electric vehicles and encouraging the wider adop- tion of its own technologies with regard to battery design and battery recharging chapter 4 Further Topics in Industry and Competitive Analysis 99
systems. As we shall see in Chapter 9, standards battles often involve the deliberatesacrificing of potential monopoly positions by the main contestants.37
STRATEGY How is the firm competing?
OBJECTIVES What are competitor's current goals? PREDICTIONS Is performance meeting these goals? • What strategy changes How are its goals likely to change? will the competitor initiate? • How will the competitor ASSUMPTIONS respond to our strategic What assumptions does the competitor initiatives? hold about the industry and itself?
●● Competitor's current strategy: To predict how a rival will behave in the future, we must understand how that rival is competing at present. As we noted in Chapter 1, identifying a firm's strategy requires looking at what the company says and what it does (see "Where Do We Find Strategy?" in Chapter 1). The key is to link the content of top management communication (with investors, the media, and financial analysts) with the evidence of strategic actions, par- ticularly those that involve a commitment of resources. For both sources of information, company websites are invaluable.102 Part II the tools of strategy analysis
Segmentation Analysis50 In Chapter 3 we noted the difficulty of drawing industry boundaries and the need to define industries both broadly and narrowly according to the types of question we are seeking to answer. Initially, it may be convenient to define industries broadly, chapter 4 Further Topics in Industry and Competitive Analysis 103
During the 1960s, lightweight Japanese motorcycles Basically, we do not believe in the lightweightbegan to flood Britain and North America. The chair- market. We believe that motorcycles are sportsman of BSA, Eric Turner, was dismissive of this competi- vehicles, not transportation vehicles. Even if ative challenge to the dominant position of his Triumph man says he bought a motorcycle for transporta-and BSA brands: tion, it's generally for leisure time use. The light- weight motorcycle is only supplemental. Back The success of Honda, Suzuki, and Yamaha has around World War I, a number of companies been jolly good for us. People start out by buy- came out with lightweight bikes. We came out ing one of the low-priced Japanese jobs. They with one ourselves. We came out with another get to enjoy the fun and exhilaration of the in 1947 and it just didn't go anywhere. We have open road and they frequently end up buy- seen what happens to these small sizes. ing one of our more powerful and expensive (American Motor Cycle, September 15, 1966) machines. (Advertising Age, December 27, 1965) By 1980, BSA and Triumph had ceased production and Harley-Davidson was struggling for survival. The Similar complacency was expressed by William world motorcycle industry, including the heavyweightDavidson, president of Harley-Davidson: segment, was dominated by the Japanese.
but for a more detailed analysis of competition we need to focus on markets that are drawn more narrowly in terms of both products and geography. This process of disaggregating industries into specific markets we call segmentation. Segmentation is particularly important if competition varies across the different submarkets within an industry such that some are more attractive than others. While Sony and Microsoft battled for dominance for leadership among so-called hard-core gamers with their technologically advanced PS3 and Xbox 360 consoles, Nintendo's Wii became a surprise market share leader by focusing on a large and underserved market segment: casual and older video game players. In the cutthroat tire industry, Pirelli has achieved superior margins by investing heavily in technology and focus- ing on high-performance tires for sports and luxury cars.51 The purpose of segmentation analysis is to identify attractive segments, to select strategies for different segments, and to determine how many segments to serve. The analysis proceeds in five stages (see Strategy Capsule 4.4 for an application; Strategy Capsule 4.5 looks at vertical segmentation).
Figure 4.5 The basis for segmentation: The characteristics of buyers and products
• Size Industrial • Technical buyers sophistication • OEM/replacement
Characteristics Household • Demographics of the Buyers buyers • Lifestyle • Purchase occasion Distribution channel • Size • Distributor/broker • Exclusive/nonexclusive Opportunities for Geographical • General/specialist Dif ferentiation location
• Physical size • Price level Characteristics • Product features of the Product • Technology design • Inputs used (e.g., raw materials) • Performance characteristics • Pre-sales and post-sales services
which customers to serve and what to offer them: hence segmentation vari- ables relate to the characteristics of customers and the product (Figure 4.5). The most appropriate segmentation variables are those that partition the mar- ket most distinctly in terms of limits to substitution by customers (demand- side substitutability) and by producers (supply-side substitutability). Price differentials are good indicators of market segments: distinct market segments tend to display sustained price differentials. Typically, segmentation analysis generates far too many segmentation variables and too many categories for each variable. For our analysis to be manageable and useful, we need to reduce these to two or three. To do this we need to (a) identify the most strategically significant segmentation variables and (b) combine segmentation variables that are closely correlated. For example, in the restaurant industry, price level, service level (waiter service/self-service), cuisine (fast-food/full meals), and alcohol license (wine served/soft drinks only) are likely to be closely related. We could use a single variable, restaurant type, with three categories—full-service restaurants, cafés, and fast-food outlets—as a proxy for all of these variables. 2 Construct a Segmentation Matrix: Once the segmentation variables have been selected and discrete categories determined for each, the individual chapter 4 Further Topics in Industry and Competitive Analysis 105
1 Identify key segmentation variables and catego- compared with the saturated, excess capacity ries. Possible segmentation variables include: price, laden markets of Europe and North America. In size, engine power, body style, buyer type (retail these mature markets, the hybrid and electric car versus fleet), and geographical market. We can segments may be attractive due to fewer com- reduce the number of segmentation variables—in petitors and lack of excess capacity. particular, price, size, and engine power tend to be 4 Identify KSFs in each segment. In sports cars, tech- closely correlated. Other variables clearly define nology and design aesthetics are likely to be key distinct markets (e.g., geographical regions and differentiators. In luxury cars, quality and interior individual national markets). design are likely to be essential. In family compact 2 Construct a segmentation matrix. The segmen- and mini-cars, low cost is the primary basis for tation matrix in Figure 4.6 shows geographical competitive advantage. regions (columns) and product types (rows). These 5 Analyze attractions of broad versus narrow seg- product types combine multiple segmentation ment scope. Because of the potential to share tech- variables: price, size, design, and fuel type. nology, design, and components across models, all 3 Analyze segment attractiveness. Applying five product segments are dominated by full-range forces analysis to individual segments points to mass-manufactures. In terms of geographical the attractiveness of the growth markets of Asia segments, only in the biggest markets (primarily and Latin America (especially for luxury cars) as China) have nationally focused producers survived.
Full-size cars
P Mid-size cars R O Small cars D U Station wagons C T Minivans S Sports cars
Sport utility
Pickup trucks
Hybrids chapter 4 Further Topics in Industry and Competitive Analysis 107
Segmentation is usually horizontal: markets are dis- using company financial data to estimate the profit ataggregated according to products, geography, and each stage of the value chain. Figure 4.7 shows the dis-customer groups. We can also segment an industry ver- tribution of value in the US automobile sector. The area oftically by identifying different value chain activities. Bain each segment's rectangle corresponds to the total profit& Company's profit pool analysis offers one approach to for that activity. Alternatively, stock market capitalizationmapping profitability differences between different verti- can be used to identify which groups of firms within acal activities. Bain's profit pool mapping involves, first, esti- sector are most successful at appropriating value. In themating the industry's total profit by applying the average computer sector, the market value of hardware compa-margin earned by a sample of companies in the industry nies has declined sharply in relation to that of softwareto an estimate of the industry's total revenues and, second, and semiconductor companies.
20 Operating margin
0 0 Share of industry revenue 100%
Source: Reprinted by permission of Harvard Business Review. From "Profit Pools: A Fresh Look at Strategy," O. Gadiesh and J. L. Gilbert, May/June 1998, p. 142, Copyright © 1998 by the Harvard Business School Publishing Corporation; all rights reserved.108 Part II the tools of strategy analysis
Upstream INTERNATIONAL EXPLORATION AND PRODUCTION COMPANIES NATIONAL e.g., Conoco, Apache, Occidental, PRODUCTION Marathon Oil COMPANIES e.g., Saudi Aramco, Kuwait Vertical Balance
Petroleum, Qatar Integrated
Petroleum SUPER MAJORS INTEGRATED INTEGRATED e.g., ExxonMobil, Shell, NATIONAL OIL COMPANIES INTERNATIONAL BP, Chevron, Total e.g., Petrobras, PDVSA, CNPC, MAJORS Indian Oil, Pemex e.g., ENI, Repsol, PetroCanada DOMESTIC-FOCUSED Downstream
DOWWNSTREAM COMPANIES e.g., Valero, Nippon Oil, Phillips 66
National Global Geographical Scope
Strategic Groups Whereas segmentation analysis concentrates on the characteristics of markets as the basis for disaggregating industries, strategic group analysis segments an industry on the basis of the strategies of the member firms. A strategic group is "the group of firms in an industry following the same or a similar strategy along the strategic dimensions."54 These strategic dimensions might include product range, geographical breadth, choice of distribution channels, level of product quality, degree of vertical integration, choice of technology, and so on. By selecting the most important stra- tegic dimensions and locating each firm in the industry along them, it is possible to identify groups of companies that have adopted more or less similar approaches to competing within the industry. In some industries strategic groups are readily observable, for example airlines fall into two broad strategic groups: "legacy carri- ers" (such as American, JAL, and British Airways) and "low-cost carriers" (such as Ryanair, Easyjet, and Southwest). Other industries are more complex: Figure 4.8 shows strategic groups within the petroleum industry.55 Most of the empirical research into strategic groups has been concerned with competition and profitability between groups—the basic argument being that mobil- ity barriers between strategic groups permit some groups of firms to be persistently more profitable than other groups.56 In general, the proposition that profitability dif- ferences within strategic groups are less than differences between strategic groups has not received robust empirical support.57 This may reflect the fact that the mem- bers of a strategic group, although pursuing similar strategies, are not necessarily in competition with one another. For example, within the European airline industry, the low-cost carriers pursue similar strategies, but do not, for the most part, com- pete on the same routes. Hence, the main usefulness of strategic group analysis is in understanding strategic positioning, recognizing patterns of competition, and iden- tifying strategic niches; it is less useful as a tool for analyzing interfirm profitability differences.58 chapter 4 Further Topics in Industry and Competitive Analysis 109
Summary The purpose of this chapter has been to go beyond the basic analysis of industry structure, competi- tion, and profitability presented in Chapter 3 to consider the dynamics of competitive rivalry and the internal complexities of industries. In terms of industry and competitive analysis, we have extended our strategy toolkit in several directions: ◆◆ We have recognized the potential for complementary products to add value and noted the importance of strategies that can exploit this source of value. Such complementary relationships are especially important in industries based upon digital technologies. Here complementarities between hardware and software and between operating systems and applications have given rise to platform-based competition and winner-takes-all markets. We shall explore these competi- tive dynamics further in Chapter 9. ◆◆ We have noted the importance of competitive interactions between close rivals and learned a structured approach to analyzing competitors and predicting their behavior. At a more sophis- ticated theoretical level, we have recognized how game theory offers insights into competition, bargaining, and the design of winning strategies. ◆◆ We examined the microstructure of industries and markets and the value of segmentation analy- sis and strategic group analysis in understanding industries at a more detailed level and in select- ing an advantageous strategic position within an industry.
Self-Study Questions1. HP, Canon, Epson, and other manufacturers of inkjet printers make most of their profits from their ink cartridges. Why are cartridges more profitable than printers? Would the situ- ation be different: a. if cartridges were manufactured by different firms from those which make printers? b. if cartridges were interchangeable between different printers? c. if patent and copyright restrictions did not prevent other firms from supplying ink cartridges that could be used in the leading brands of printer?2. In July 2015, Microsoft announced its write-off of its Nokia handset business (acquired a year earlier) and its withdrawal from the smartphone market. Its Windows Phone oper- ating system had a 1% share of the smartphone market and there were about 290,000 Windows Phone apps (compared to 1.6 million for Android and 1.3 million for the Apple iPhone). How do the dynamics of platform-based competition (see Strategy Capsule 4.1) help explain Microsoft's failure in the market for smartphones?3. In November 2005, six of Paris's most luxurious hotels—including George V, Le Bristol, the Ritz, and Hotel de Crillon—were fined for colluding on room rates. Regular guests showed little concern—noting that, whatever the listed rack rate, it was always possible110 Part II the tools of strategy analysis
to negotiate substantial discounts. Using the prisoners' dilemma model, can you explain why the hotels were able to collude over their listed rates but not over discounts? 4. During 2015, Netflix and Amazon were battling for leadership in the video streaming markets of North America and Europe. Both offered a fixed-price subscription, the main difference being that Amazon Prime's annual subscription bundled video streaming of movies and TV shows with the free delivery of goods from amazon.com. Netflix's appre- hension about Amazon stemmed from Amazon's huge revenue stream (16 times that of Netflix), its willingness to diversify into related businesses (Amazon supplied its own hardware for viewing video, the Kindle Fire, and was producing its own original video content) and its willingness to endure losses in the quest for market leadership through aggressive price cutting. How might Netflix use the competitor analysis framework out- lined in Figure 4.4 to predict Amazon's competitive strategy in the market for streamed video content? 5. How would you segment the restaurant market in your hometown? How would you advise someone thinking of starting a new restaurant which segments might be most attractive in terms of profit potential? 6. Consider either the North American or European markets for air travel. Can these markets be segmented? If so, by what variables and into which categories? Can an airline be finan- cially viable by specializing in certain segments or must airlines seek to compete across all (or most) segments?
12. R. A. D'Aveni, G. B. Dagnino, and K. G. Smith, "The 29. T. Dhar, J.-P. Chatas, R. W. Collerill, and B. W. Gould, Age of Temporary Advantage," Strategic Management "Strategic Pricing between Coca-Cola Company and Journal 31 (2010): 1371–1385. PepsiCo," Journal of Economics and Management 13. R. G. McGrath, "Transient Advantage," Harvard Business Strategy 14 (2005): 905–931. Review 91 ( June 2013). 30. Bitter Competition: Holland Sweetener vs. NutraSweet (A) 14. L. G. Thomas and R. D'Aveni, "The Rise of (Harvard Business School Case No. 9-794-079, 1994). Hypercompetition in the US Manufacturing Sector, 31. A. M. McGahan, "The Incentive not to Invest: Capacity 1950–2002." Tuck School of Business, Dartmouth Commitments in the Compact Disk Introduction," in College, Working Paper No. 2004-11 (2004). R. A. Burgelman and R. S. Rosenbloom (eds), Research 15. R. R. Wiggins and T. W. Ruefli, "Schumpeter's Ghost: Is on Technological Innovation Management and Policy, Hypercompetition Making the Best of Times Shorter?" vol. 5 (Greenwich, CT: JAI Press, 1994). Strategic Management Journal 26 (2005): 887–911. 32. D. K. Levine and R. A. Levine, "Deterrence in the 16. G. McNamara, P. M. Vaaler, and C. Devers, "Same As Cold War and the War on Terror," Defence and Peace It Ever Was: The Search for Evidence of Increasing Economics 17 (2006): 605–617. Hypercompetition," Strategic Management Journal 24 33. D. N. Sull, "Managing by Commitments," Harvard (2003): 261–278. Business Review ( June 2003): 82–91. 17. K. Weigelt and C. F. Camerer, "Reputation and Corporate 34. Games where price is the primary decision variable are Strategy: A Review of Recent Theory and Applications," called Bertrand models after the 19th century French Strategic Management Journal 9 (1988): 137–142. economist Joseph Bertrand. 18. A. K. Dixit, "The Role of Investment in Entry Deterrence," 35. Games where quantity is the primary decision variable Economic Journal 90 (1980): 95–106; P. Milgrom and J. are called Cournot models after the 19th century French Roberts, "Informational Asymmetries, Strategic Behavior economist Antoine Augustin Cournot. and Industrial Organization," American Economic Review 36. F. Scott Morton, "Strategic Complements and 77, no. 2 (May 1987): 184–189. Substitutes," Financial Times Mastering Strategy 19. P. Milgrom and J. Roberts, "Informational Asymmetries, Supplement (November 8, 1999): 10–13. Strategic Behavior and Industrial Organization," 37. R.M. Grant, "Tesla Motors: Disrupting the Auto Industry," American Economic Review 77, no. 2 (May 1987): in Contemporary Strategy Analysis: Text and Cases, 9th 184–9. edn. (Wiley, 2016). 20. P. Ghemawat, Commitment: The Dynamic of Strategy 38. For a review of research on competitive signaling, (New York: Free Press, 1991). see O. Heil and T. S. Robertson, "Toward a Theory of 21. See, for example: A. K. Dixit and B. J. Nalebuff, Competitive Market Signaling: A Research Agenda," Thinking Strategically: The Competitive Edge in Business, Strategic Management Journal 12 (1991): 403–418. Politics, and Everyday Life (New York: W. W. Norton, 39. B. Macintyre, Operation Mincemeat: The True Spy Story 1991); and J. McMillan, Games, Strategies, and Managers that Changed the Course of World War II (London: (New York: Oxford University Press, 1992). Bloomsbury, 2010). 22. G. T. Allison and P. Zelikow, Essence of Decision: 40. For a survey of the strategic role of reputation, see Explaining the Cuban Missile Crisis, 2nd edn (Boston: K. Weigelt and C. Camerer, "Reputation and Corporate Little, Brown and Company, 1999). Strategy: A Review of Recent Theory and Applications," 23. B. C. Esty and P. Ghemawat, "Airbus vs. Boeing in Strategic Management Journal 9 (1988): 443–454. Superjumbos: A Case of Failed Preemption," Harvard 41. P. Milgrom and J. Roberts, "Predation, Reputation, and Business School Working Paper No. 02-061 (2002). Entry Deterrence," Journal of Economic Theory 27 24. D. Ronfelt, "Social Science at 190 mph on NASCAR's (1982): 280–312. Biggest Superspeedways," First Monday 5 (February 7, 42. R. M. Grant, "Pricing Behavior in the UK Wholesale 2000). Market for Petrol," Journal of Industrial Economics 30 25. July 17, 2014 202-408-7500, firstname.lastname@example.com (1982): 271–292; L. Miller, "The Provocative Practice of "Economists Behind the FCC's Spectrum Auctions Price Signaling: Collusion versus Cooperation," Business to Receive Golden Goose Award" ( July 17, 2014), Horizons ( July/August 1993). http://www.goldengooseaward.org/wp-content/ 43. On the ability of game theory to predict almost any uploads/2014/07/Wilson-Milgrom-McAfee-to-Receive- equilibrium solution (the Pandora's Box Problem) Golden-Goose-Awards-7-17-14.pdf, accessed November see C. F. Camerer, "Does Strategy Research Need Game 15, 2014. Theory?" Strategic Management Journal, Special Issue 26. John Cassidy "Rational Irrationality," New Yorker 12 (Winter 1991): 137–152; F. M. Fisher, "The Games (October 5, 2009). Economists Play: A Noncooperative View," Rand 27. J. Maynard Smith, "Sexual Selection and the Handicap Journal of Economics 20 (Spring 1989): 113–124; and Principle," Journal of Theoretical Biology 57 (1976): Steve Postrel illustrates the point with a game, S. Postrel, 239–242. "Burning Your Britches behind You: Can Policy Scholars 28. A. Brandenburger and B. Nalebuff, Co-opetition (New Bank on Game Theory?" Strategic Management Journal, York: Doubleday, 1996). Special Issue 12 (Winter 1991): 153–155.112 Part II the tools of strategy analysis
44. G. F. Rose and M. Lloyd, "The Failure of FCC Influences on Strategy Reformulation," Strategic Spectrum Auctions," (Washington DC: Center for Management Journal 3 (1982): 119–131. American Progress, May 2006); P. Klemperer, "How 50. This section draws heavily on M. E. Porter, Competitive not to Run Auctions: The European 3G Mobile Advantage (New York: Free Press, 1985): Chapter 7. Telecom Auctions. European Economic Review 46 51. "Pirelli's Bet on High-performance Tires," International (2002): 829–845. Herald Tribune (April 2, 2005). 45. Strategic and Competitive Intelligence Professionals; the 52. R. E. Caves and M. E. Porter, "From Entry Barriers to Institute for Competitive Intelligence. Mobility Barriers: Conjectural Decisions and Contrived 46. For example, J. D. Underwood, Competitive Intelligence Deterrence to New Competition," Quarterly Journal of For Dummies (Chichester: John Wiley & Sons, Ltd, Economics 91 (1977): 241–262. 2014); L. M. Fuld, The Secret Language of Competitive 53. W. C. Kim and R. Mauborgne, "Blue Ocean Strategy: Intelligence (Indianapolis: Dog Ear Publishing, 2010); From Theory to Practice," California Management M. Ioia, The New Rules of Competitive Intelligence Review 47 (Spring 2005): 105–121. (Bloomington, IN: Xlibris, 2014). 54. M. E. Porter, Competitive Strategy (New York: Free Press, 47. "McLaren Docked F1 Points for Spying," Financial 1980): 129. Times (September 14, 2007); "Kolon Loses $920 Million 55. For more on strategic groups, see J. McGee and H. Thomas, Verdict to DuPont in Trial Over Kevlar," Washington Post "Strategic Groups: Theory, Research, and Taxonomy," (September 15, 2011). Strategic Management Journal 7 (1986): 141–160. 48. Office of the National Counterintelligence Executive, 56. A. Feigenbaum and H. Thomas, "Strategic Groups and Foreign Spies Stealing US Economic Secrets in Performance: The US Insurance Industry," Strategic Cyberspace: Report to Congress on Foreign Economic Management Journal 11 (1990): 197–215. Collection and Industrial Espionage, 2009–2011 57. K. Cool and I. Dierickx, "Rivalry, Strategic Groups, and (October 2011). Firm Profitability," Strategic Management Journal 14 49. J.-C. Spender, Industry Recipes: The Nature and Sources (1993): 47–59. of Managerial Judgment (Oxford: Blackwell, 1989). How 58. K. Smith, C. Grimm, and S. Wally, "Strategic Groups social interaction promotes convergence of percep- and Rivalrous Firm Behavior: Toward a Reconciliation," tions and beliefs is discussed by Anne Huff in "Industry Strategic Management Journal 18 (1997): 149–157. 5 Analyzing Resources and Capabilities
One gets paid only for strengths; one does not get paid for weaknesses. The ques- tion, therefore, is first: What are our specific strengths? And then: Are they the right strengths? Are they the strengths that fit the opportunities of tomorrow, or are they the strengths that fitted those of yesterday? Are we deploying our strengths where the opportunities no longer are, or perhaps never were? And finally, what additional strengths do we have to acquire? — PETER DRUCKER1
By the time you have completed this chapter, you will be able to: ◆◆ Appreciate the role of a firm's resources and capabilities as a basis for formulating strategy. ◆◆ Identify the resources and capabilities of a firm. ◆◆ Evaluate the potential for a firm's resources and capabilities to confer sustainable competi- tive advantage. ◆◆ Formulate strategies that exploit internal strengths while defending against internal weaknesses.
We begin by explaining why a company's resources and capabilities are so important to its strategy.
Strategy is concerned with matching a firm's resources and capabilities to the opportu- nities that arise in the external environment. So far, the emphasis of the book has been on the identification of profit opportunities in the external environment of the firm. In this chapter, our emphasis shifts from the interface between strategy and the external environment toward the interface between strategy and the internal environment of the firm—more specifically, with the resources and capabilities of the firm (Figure 5.1). There is nothing new in the idea that strategy should exploit the resource and capability strengths of a person or an organization. The biblical tale of David and Goliath can be interpreted from this perspective (Strategy Capsule 5.1). The growing emphasis on the role of resources and capabilities as the basis for strategy is the result of two factors. First, as firms' industry environments have become more unstable, so internal resources and capabilities rather than external market focus have been viewed as comprising a more secure base for formulating strategy. Second, it has become increasingly apparent that competitive advantage rather than industry attractiveness is the primary source of superior profitability. Let us consider each of these factors.
The The Firm–Strategy Environment–Strategy Interface Interface
To understand why the resource-based view has had a major impact on strategy thinking, let us go back to the starting point for strategy formulation: the underlying purpose of the firm which can be answered by posing the question: "What is our business?" Conventionally, this question has been answered in terms of the market being served: "Who are our customers?" and "Which of their needs are we seeking to serve?" However, in a world where customer preferences are volatile and the identity of customers and the technologies for serving them are changing, a market-focused strategy may not provide the stability and constancy of direction needed to guide strategy over the long term. When the external environment is in a state of flux, the
In about 1000 bc, David, an Israeli shepherd boy, took the battle line to meet him. Reaching into his bag andup the challenge of meeting Goliath, the champion of taking out a stone, he slung it and struck the Philistinethe Philistines in single combat. Goliath's "height was on the forehead. The stone sank into his forehead, andsix cubits and a span [three meters]. He had a bronze he fell facedown on the ground."helmet on his head and wore a coat of scale armor of David's victory over Goliath reflects a strategy basedbronze weighing five thousand shekels [58 kg]; on his upon exploiting three core strengths: David's courage andlegs he wore bronze greaves, and a bronze javelin was self-confidence, his speed and mobility, and his expertiseslung on his back." King Saul of the Israelites offered with a sling. This strategy allowed him to negate Goliath'sDavid armor and a helmet, but David discarded them: core strengths: his size, his advanced offensive and defen-"'I cannot go in these,' he said to Saul, 'because I am sive equipment, and his combat experience. Had he fol-not used to them.' … Then he took his staff in his hand, lowed King Saul's advice and adopted a conventionalchose five smooth stones from the stream, put them in strategy for armed single combat, the outcome wouldthe pouch of his shepherd's bag and, with his sling in almost certainly have been very different.his hand, approached the Philistine… As the Philistine Source: Holy Bible (New International Version): 1 Samuel 17:moved closer to attack him, David ran quickly toward 39–49.116 Part II the tools of strategy analysis
firm itself, in terms of the bundle of resources and capabilities it possesses, may be a much more stable basis on which to define its identity. This emphasis on resources and capabilities as the foundation of firm strategy was popularized by C. K. Prahalad and Gary Hamel in their 1990 landmark paper "The Core Competence of the Corporation."3 The potential for capabilities to be the "roots of competitiveness," the sources of new products, and the foundation for strategy is exemplified by Honda and 3M, among other companies (Strategy Capsule 5.2). In general, the greater the rate of change in a firm's external environment, the more likely it is that internal resources and capabilities rather than external mar- ket focus will provide a secure foundation for long-term strategy. In fast-moving, technology-based industries, basing strategy upon capabilities can help firms to outlive the life-cycles of their initial products. Microsoft's initial success was the result of its MS-DOS operating system for the IBM PC. However, by building its software development, marketing, and partnering capabilities Microsoft has success- fully expanded from other operating systems to applications software (e.g., Office), internet services (e.g., Xbox Live), and cloud-based computing services. Similarly, Apple's ability to combine hardware, software, ergonomics, and aesthetics to cre- ate products with superior functionality, design, and ease of use has allowed it to expand beyond desktop and notebook computers into MP3 players (iPod), smart- phones (iPhone), tablet computers (iPad), and watches. Conversely, those companies that attempted to maintain their market focus in the face of radical technological change have often experienced huge difficulties in building the new technological capabilities needed to serve their customers. The saga of Eastman Kodak is a classic example. Its dominance of the world market for photographic products was threatened by digital imaging. Kodak invested billions of dollars developing digital technologies and digital imaging products. Yet, in January 2012, Kodak was forced into bankruptcy. Might Kodak have been better off by stick- ing with its chemical know-how, allowing its photographic business to decline while developing its interests in specialty chemicals, pharmaceuticals, and healthcare?4 Typewriter and office equipment makers Olivetti and Smith Corona offer similar cautionary tales. Despite their investments in microelectronics, both failed as sup- pliers of personal computers. Might Olivetti and Smith Corona have been better advised to deploy their existing electrical and precision engineering know-how in other products?5 This pattern of established firms failing to adjust to disruptive tech- nological change within their own industries is well documented—in typesetting and in disk drive manufacturing, successive technological waves have caused market leaders to falter and have allowed new entrants to prosper.6
Honda Motor Company has never defined itself over 55,000 industrial, office, medical, and householdeither as a motorcycle or an automobile company. As products. Is it a conglomerate?Figure 5.2 shows, since its founding in 1948, its devel- Certainly not, claims 3M. Its vast product range restsopment of expertise in designing and manufacturing on a cluster of technological capabilities that it has sys-engines has taken it from motorcycles to a wide range tematically developed for over more than a centuryof internal engine products. (Figure 5.3). 3M Corporation (originally Minnesota Mining andManufacturing) has expanded from sandpaper into
Marine engines, Honda Portable Variable generators, pumps, Technical generator Cylinder chainsaws, snow- Research Management blowers, ground tillers, Institute 405cc N360 founded motor- minicar Home co-generation Fuel Model A cycle system cell car Honda Honda clip-on 50cc Civic business jet bicycle Super- 4-cylinder engine 1000cc cub 750cc Civic Production Goldwing GE- motorcycle Hybrid of diesel motorcycle Honda 98cc, engines 2-stroke Enters Enters turbofan Dream motorcycle Formula 1 Acura Car Enters Indy engine motorcycle racing racing division car racing
Floppy disks and data storage Road signs and products LED lighting markings Drug delivery systems Audio tape Videotape Sandpaper Insulation products PRODUCTS Acetate Post-it notes Pharmaceuticals Display screens film Carborundum Scotch- Surgical tapes Anticorrosion coatings mining tape and dressings Homecare/kitchen products 1902 2015 Abrasives Adhesives Materials sciences Flexible Nanotechnology electronics TECHNICAL Coatings and thin-film Microreplication CAPABILITIES technologies Surface modification Sensors Health sciences118 Part II the tools of strategy analysis
distinctions between different types of profit (or rent). The profits arising from mar- ket power are referred to as monopoly rents; those arising from superior resources are Ricardian rents, after the 19th century British economist David Ricardo. Ricardo showed that, in a competitive wheat market, when land at the margin of cultivation earned a negligible return, fertile land would yield high returns. Ricardian rent is the return earned by a scarce resource over and above the cost of using the resource.7 Most of the $879 million of royalties earned in 2014 by Dolby Laboratories from licensing its sound reduction technologies comprises Ricardian rents, as does most of the $56.2 million earned in 2014 by tennis player Roger Federer. Distinguishing between profit arising from market power and profit arising from resource superiority is less clear in practice than in principle. A closer look at Porter's five forces framework suggests that industry attractiveness often derives from the ownership of strategic resources. Barriers to entry, for example, are typically the result of patents, brands, know-how, or distribution channels, learning, or some other resource possessed by incumbent firms. Monopoly is usually based on the ownership of a key resource such as a technical standard or government license. The resource-based approach has profound implications for companies' strategy for- mulation. When the primary concern of strategy was industry selection and positioning, companies tended to adopt similar strategies. The resource-based view, by contrast, recognizes that each company possesses a unique collection of resources and capabili- ties; the key to profitability is not doing the same as other firms but rather exploiting differences. Establishing competitive advantage involves formulating and implementing a strategy that exploits a firm's unique strengths. The remainder of this chapter outlines a resource-based approach to strategy for- mulation. Fundamental to this approach is a thorough and profound understanding of the resources and capabilities of a firm. Such understanding provides a basis for selecting a strategy that exploits the key resource and capabilities of an organization. While our emphasis is on firm strategy, the same principles can be applied to guid- ing our own careers. A sound career strategy is one that, like David against Goliath, recognizes and exploits one's strengths while minimizing vulnerability to one's weak- nesses—see Strategy Capsule 5.3 for an example. For both individuals and organiza- tions the starting point is to identify the available resources and capabilities.
Let us begin by distinguishing between the resources and the capabilities of the firm. Resources are the productive assets owned by the firm; capabilities are what the firm can do. On their own, individual resources do not confer competitive advan- tage; they must work together to create organizational capability. Organizational capability, when applied through an appropriate strategy, provides the foundation for competitive advantage. Figure 5.4 shows the relationships between resources, capabilities, and competitive advantage.
Identifying Resources Drawing up an inventory of a firm's resources can be surprisingly difficult. No such document exists within the accounting or management information systems of most organizations. The balance sheet provides only a partial view of a firm's resources—it comprises mainly financial and physical resources. Our broader view chapter 5 Analyzing Resources and Capabilities 119
The year 2001 was disastrous for Mariah Carey. Her first have this magnificent voice and you write such com-movie, Glitter, was a flop, the soundtrack was Carey's pelling songs, why are you dressing like that, why areworst selling album in years, she was dropped by EMI, you using all these collaborations [with other artistsand suffered a nervous breakdown. and other songwriters]? Why? It's like driving a Ferrari in Lyor Cohen, the workaholic chief executive of first—you won't see what that Ferrari will do until youIsland Def Jam records was quick to spot an opportu- get into sixth gear."nity: "I cold-called her on the day of her release from Cohen signed Carey in May 2002. Under UniversalEMI and I said, I think you are an unbelievable artist and Music's Island Def Jam Records, Carey returned to heryou should hold your head up high. What I said stuck versatile voice, song-writing talents, and ballad style.on her and she ended up signing with us." Her next album, The Emancipation of Mimi, was the His strategic analysis of Carey's situation was con- biggest-selling album of 2005, and in 2006 she won acise: "I said to her, what's your competitive advantage? Grammy award.A great voice, of course. And what else? You write everyone of your songs—you're a great writer. So why did Source: "Rap's Unlikely Mogul," Financial Times (August 5,you stray from your competitive advantage? If you 2002). © The Financial Times, reproduced with permission.
In 1984, Michael Eisner became CEO of the Walt Disney packages of movies to TV networks. To put Disney's Company. Between 1984 and 1988, Disney's net income underutilized movie studios to work, Eisner doubled increased from $98 million to $570 million, and its stock the number of movies in production and made Disney market valuation from $1.8 billion to $10.3 billion. a major producer of TV programs. The key to the Disney turnaround was the mobiliza- Supporting the exploitation of these tangible tion of Disney's considerable resource base. With the resources was Disney's critically important intangible acquisition of Arvida, a real estate development com- resource: the enduring affection of millions of people pany, Disney's land holdings in Florida were developed across generations and throughout the world for Disney into hotels, convention facilities, residential housing, and its characters. As a result, Disney's new management and a new theme park, the Disney-MGM Studio Tour. was able to boost theme park admission charges, launch To exploit its huge film library, Disney began sell- a chain of Disney Stores to push sales of Disney merchan- ing the Disney classics on videocassette and licensing dise, and replicate Disney theme parks in Europe and Asia.
Tangible Resources Tangible resources are the easiest to identify and value: financial resources and physical assets are valued in the firm's balance sheet. Yet, accounting conventions—especially historic cost valuation—typically result in tan- gible resources being misvalued. The Walt Disney Company's annual accounts for 2014 valued its entire movie library—based on production cost less amortization—at a mere $1.4 billion and its total land assets (including its 28,000 acres in Florida) at a paltry $1.2 billion.8 However, the primary goal of resource analysis is not to value a company's tangi- ble resources but to understand their potential for generating profit. This requires not just balance sheet valuation but information on their composition and characteristics. With that information we can explore two main routes to create additional value from a firm's tangible resources: ●● What opportunities exist for economizing on their use? Can we use fewer resources to support the same level of business or use the existing resources to support a larger volume of business? ● Can existing assets be deployed more profitably? Strategy Capsule 5.4 discusses how Michael Eisner's turnaround of Walt Disney during the mid-1980s used both these approaches.
TABLE 5.1 Large companies with the highest valuation ratios, December 12, 2014
divergence between companies' balance-sheet valuations (or book values) and theirstock-market valuations (Table 5.1). Among the most important of these underval-ued or unvalued intangible resources are brands (Table 5.2). Interbrand values theWalt Disney brand at $32 billion; yet in Disney's balance sheet, all its trademarksare valued at $1.2 billion. Trademarks provide the legal basis for brand ownership. Trademarks are onetype of intellectual property. Other types of intellectual property are patents, copy-rights, and trade secrets which form the proprietary knowledge assets of the firm.The growing importance of proprietary technology as a strategic resource is appar-ent from the efforts companies make to protect their innovations with patents andenforce their patents through litigation. As the economy becomes increasingly knowl-edge-based, so patents and copyrights become increasingly important resources.For companies such as Qualcomm, a leader in CDMA digital wireless telephony,ARM, the world's leading designer of microprocessors for mobile devices, and W. L.Gore Associates, the manufacturer of Gore-Tex and other high-tech fabrics, patentsare their most valuable resources. A firm's relationships can also be considered resources. They provide a firm withaccess to information, know-how, inputs, and a wide range of other resources thatlie beyond the firm's boundaries. Being embedded within an inter-firm networkalso conveys legitimacy upon a firm, which can enhance its survival capacity. Theseinter-firm relationships have been referred to as "network resources."9122 Part II the tools of strategy analysis
Human Resources Human resources comprise the skills and productive effort offered by an organization's employees. Human resources do not appear on the firm's balance sheet—the firm does not own its employees; it purchases their ser- vices under employment contacts. However, the stability of employment relation- ships allows us to consider human resources as part of the resources of the firm. In the US the average length of time an employee stays with an employer is 4.6 years, in Europe it is longer—9.5 years in Great Britain, 12.3 in France and 11.7 in Germany; in Japan it is 16.2 years.12 Organizations devote considerable effort to analyzing their human resources: both in hiring new employees and in appraising their performance and planning their development. Human resource appraisal has become far more systematic and sophis- ticated. Many organizations have established assessment centers to measure employ- ees' skills and attributes using indicators that research has identified as predictors of superior job performance. Competency modeling involves identifying the set of skills, content knowledge, attitudes, and values associated with superior performers within chapter 5 Analyzing Resources and Capabilities 123
a particular job category, then assessing each employee against that profile.13 A keyresearch finding is the importance of psychological and social aptitudes in determin-ing superior work performance—recent interest in emotional and social intelligencereflects this.14 These findings explain the growing trend among companies to "hirefor attitude; train for skills."
products of unrivaled ease of use and customer appeal results from its combining technical capability with penetrating market insight. This capability is not readily apparent from either a functional or a value chain analysis. To look beyond generic capabilities to uncover those that are unique requires insight and judgment. A care- ful examination of an organization's history can be especially revealing. In reviewing an organization's successes and failures over time, do patterns emerge and what do these patterns tell us about the capabilities that the organization possesses? At the basis of every organizational capability is coordinated behavior among organizational members. This is what distinguishes an organizational capability from an individual skill. Routines and processes play a critical role in integrating individual actions to create organizational capabilities (see Strategy Capsule 5.5). Integration is also important among organizational capabilities. The capabilities of an organization may be viewed as a hierarchical system in which lower-level capa- bilities are integrated to form higher-level capabilities. For oil and gas companies, a key requirement for success is the ability to find oil and gas. Figure 5.6 shows that exploration capability comprises a number of component capabilities, which, in turn, can be further disaggregated into even more specialized capabilities. For most companies it is these higher-level capabilities that constitute the "core competences" described by Prahalad and Hamel. Thus, Toyota's "lean production" capability integrates multiple capabilities that relate to just-in-time scheduling, total quality management, statistical process control, flexible manufacturing, and continu- ous improvement. These higher-level capabilities tend to be cross-functional. For example, new product development capability is an upper-level capability that integrates techno- logical development, marketing, design, product engineering, process engineering, and finance. Some writers have proposed that at the highest level of the capability hierarchy are dynamic capabilities—capabilities that allow the modification and adaptation of lower-level operational and functional capabilities.20 We shall look more closely at dynamic capabilities in Chapter 8. chapter 5 Analyzing Resources and Capabilities 125
Resources are combined to create organizational capa- coordination. The same organization may find it diffi-bilities; however, an organization's capabilities are not cult to respond to novel situations.simply an outcome of the resources upon which they Organizational capabilities do not simply emerge:are based. they must be created through management action: In sport, resource-rich teams are often outplayed hence in this book we shall focus on processes ratherby teams that create strong capabilities from mod- than routines. Processes are coordinated sequencesest resources. In European soccer, star-studded teams of actions through which specific productive tasks are(e.g., Chelsea, Real Madrid, and Manchester City) performed. Not only is the term process well under-are frequently humbled by those built from limited stood by managers, the tools for designing, mapping,means (e.g., Borussia Dortmund, Arsenal, and Athletico and improving business processes are well developed.bMadrid). In business too we see upstarts with mod- However, creating and developing organizationalest resources outcompeting established giants: Dyson capabilities is not only about putting in place pro-against Electrolux in domestic appliances, Hyundai cesses. Processes need to be located within appro-against Toyota in automobiles, Cisco Systems against priately designed organizational units, the individualsEricsson in telecom equipment, ARM against Intel in involved need to motivated, and the resources, pro-microprocessors. Clearly, there is more to organizational cesses, structures, and management systems need tocapability than just resources. be aligned with one another.c In Chapter 8 we shall The academic literature views organizational capa- address in greater detail the challenge that companiesbility as based upon organizational routines. These face in developing organizational capabilities."regular and predictable behavioral patterns [com- Notes:prising] repetitive patterns of activity"a are viewed by a R. R. Nelson and S. G. Winter, An Evolutionary Theory ofevolutionary economists as determining what firms Economic Change (Cambridge, MA: Belknap, 1982).do, who they are, and how they develop and grow. b T. W. Malone, K. Crowston, J. Lee, and B. Pentland, "Tools for Inventing Organizations: Toward a Handbook of OrganizationalLike individual skills, organizational routines develop Processes," Management Science 45 (1999): 425–43.through learning by doing—and, if not used, they c T. Felin, N. J. Foss, K. H. Heimeriks, and T. L. Madsen,wither. Hence, there is a tradeoff between efficiency "Microfoundations of Routines and Capabilities: Individuals,and flexibility. A limited repertoire of routines can Processes, and Structure," Journal of Management Studies, 49be performed highly efficiently with near-perfect (2012): 1351–1374.
Relevance ESTABLISHING A COMPETITIVE ADVANTAGE Scarcity
THE PROFIT-EARNING SUSTAINING A POTENTIAL COMPETITIVE Transferability OF A RESOURCE OR ADVANTAGE CAPABILITY
Property rights
APPROPRIATING A COMPETITIVE Relative ADVANTAGE bargaining power
●● Durability: The more durable a resource, the greater its ability to support a competitive advantage over the long term. For most resources, including capital equipment and proprietary technology, the quickening pace of tech- nological innovation is shortening their life spans. Brands, on the other hand, can show remarkable resilience to time. Heinz sauces, Kellogg's cereals, Guinness stout, Burberry raincoats, and Coca-Cola have been market leaders for over a century. ●● Transferability: Competitive advantage is undermined by competitive imi- tation. If resources and capabilities are transferable between firms—i.e., if they can be bought and sold—then any competitive advantage that is based upon them will be eroded. Most resources—including most human resources—can be bought and sold with little difficulty. Other resources and most capabilities are immobile and not easily transferred. Some resources are specific to certain locations and cannot be relocated. A competitive advantage of the Laphroaig distillery and its 10-year-old, single malt whis- key is its water spring on the Isle of Islay, which supplies water flavored by peat and sea spray. Capabilities, because they combine multiple resources embedded in an organization's management systems, are also difficult to move from one firm to another. Another barrier to transferability is limited information regarding resource quality. In the case of human resources, hir- ing decisions are typically based on very little knowledge of how the new employee will perform. Sellers of resources have better information about128 Part II the tools of strategy analysis
Investment banks are a fascinating arena to view the contributed to Disney's 2013 net income of $7.4 billion asconflict between employees and owners to appropriate compared with that of Disney's other 180,000 employeesthe returns to organizational capability. Goldman Sachs is unknown.possesses outstanding capabilities in merger and acqui- The more organizational performance can be iden-sition services, underwriting and proprietary trading. tified with the expertise of an individual employee, theThese capabilities combine employee skills, IT infrastruc- more mobile is that employee, and the more likely thatture, corporate reputation, and the company's systems the employee's skills can be deployed with anotherand culture. All but the first of these are owned by the firm, then the stronger is the bargaining position ofcompany. However, the division of returns between that employee.employees and owners suggests that employees have Hence, the emphasis that many investment banks,the upper hand in appropriating rents (Table 5. 3). advertising agencies, and other professional service Similarly in professional sport: star players are well firms give to team-based rather than individual skills.positioned to exploit the full value of their contribution "We believe our strength lies in . . . our unique team-to their teams' performance. The $23.5 million salary based approach," declares audit firm Grant Thornton.paid to Kobe Bryant for the 2014/15 NBA season seems However, employees can reassert their bargain-likely to fully exploit his value to the Los Angeles Lakers. ing power through emphasizing team mobility: in So too CEOs: Disney's CEO, Robert Iger, was paid September 2010, most of UBS's energy team moved$34.3 million in 2014. But determining how much Iger to Citi.
future, and their own wishful thinking. The tendency toward hubris among compa- nies, and their senior managers, means that business success often sows the seeds of its own destruction.25 Royal Bank of Scotland's successful acquisition of NatWest Bank was followed by an acquisition binge culminating in the disastrous takeover of ABN Amro in 2007.26 Benchmarking—the process of comparing one's processes and performance to those of other companies—offers an objective and quantitative way for a firm to assess its resources and capabilities relative to its competitors'.27 The results can be salutary: Xerox Corporation, a pioneer of benchmarking during the 1980s, observed the massive superiority of its Japanese competitors in cost efficiency, quality, and130 Part II the tools of strategy analysis
The approach outlined in this chapter for apprais- developed by Jay Barney. Let me compare the two ing the strategic importance of resources is an approaches so that their similarities and differences alternative to the more widely used VRIO framework are apparent.
new-product development. More recent evidence shows wide gaps in most indus- tries between average practices and best practices.28 My own experience with companies points to the need for benchmarking to be supplemented by more reflective approaches to recognizing strengths and weak- nesses. As I indicated in relation to the earlier discussion of "Identifying Organizational Capabilities," it can be highly instructive to get groups of managers together to ask them to identify things that the company has done well in recent years and things that it has done badly, then to ask whether any patterns emerge.
High Superfluous Strengths Key Strengths
RELATIVE STRENGTH Low Zone of lrrelevance Key Weaknesses
Low High STRATEGIC IMPORTANCE
Our key focus is on the two right-hand quadrants of Figure 5.8. How do weexploit our key strengths most effectively? How can we address our key weaknessesin terms of both reducing our vulnerability to them and correcting them? Finally,what about our "inconsequential" strengths: are these really superfluous or are thereways in which we can deploy them to greater effect? Let me offer a few suggestions.
converting weakness into strength is likely to be a long-term task for most compa- nies. In the short to medium term, a company is likely to be stuck with the resources and capabilities that it has inherited. The most decisive, and often most successful, solution to weaknesses in key functions is to outsource. Thus, in the automobile industry, companies have become increasingly selective in the activities they perform internally. The trend toward ver- tical deintegration is the result of companies concentrating on their key strengths and outsourcing other activities. Across a range of activities specialist suppliers have more highly developed capabilities than most companies. Hence the out- sourcing of IT (to Accenture, IBM, Capgemini), logistics (to Exel, Kuehne + Nagle, UPS), and food service (to Compass, Sodexo). Some companies may be present in relatively few activities within their value chains. In athletic shoes and clothing, Nike undertakes product design, market- ing, and overall "systems integration," but manufacturing, logistics, and many other functions are contracted out. We shall consider the vertical scope of the firm in greater depth in Chapter 11. Clever strategy formulation can allow a firm to negate its vulnerability to key weaknesses. Consider once more Harley-Davidson. It cannot compete with Honda, Yamaha, and BMW on technology. The solution? It has made a virtue out of its outmoded technology and traditional designs. Harley-Davidson's old-fashioned, push-rod engines, and recycled designs have become central to its retro-look authenticity.
heritage is not an obvious source of competitive advantage for its MBA programs.Yet, the Jesuit approach to education is about developing the whole person; thisfits well with an emphasis on developing the values, integrity, and emotional intel-ligence necessary to be a successful business leader. Similarly, Dartmouth College'slocation in the woods of New Hampshire far from any major business center is notan obvious benefit to its business programs. However, Dartmouth's Tuck BusinessSchool has used the isolation and natural beauty of its locale to create an MBAprogram that features unparalleled community and social involvement that fosterspersonal development and close network ties.
If the key success factor in the airline business is pro- as a tourist destination and (b) compete on North viding safe, reliable transportation between city pairs Atlantic routes between European and North American at a competitive price, we can begin by identifying the cities. For (b) to be viable, Icelandair needs to make resources and capabilities needed to achieve that goal. routes that involve a stopover at its Reykjavik hub com- We can then use the value chain to fill out more system- petitive with the point-to-point routes offered by the atically this list of resources and capabilities. Table 5.4 major US and European airlines. This requires (a) using and Figure 5.9 show the major resources and capabilities Icelandair's operational efficiency to undercut other required in the airline business and assess Icelandair's airlines on price and (b) exploiting Icelandair's opera- position relative to a peer group of competitors. tional and customer service capabilities, its human In terms of strategy implications, a key resource that resource strengths, and the appeal of Reykjavik/Iceland distinguishes Icelandair is location: Iceland's popula- as a stopover to establish a differentiation advantage. tion of 326,000 offers a passenger and freight market Icelandair's strategy is encapsulated in its vision state- that Icelandair can easily dominate, but is too small to ment: "To unlock Iceland's potential as a year-round support an international airline. Hence, to achieve effi- destination, to strengthen Iceland's position as a con- cient scale, Icelandair must (a) collaborate with other necting hub and to maintain our focus on flexibility firms and the Icelandic government to develop Iceland and experience."
Key Strengths Superfluous Strengths General management Human resources Marketing RELATIVE STRENGTH
Financial resources Maintenance Cabin services Flight operations
Brand Landing slots Location Fleet /Route network Low
Summary We have shifted the focus of our attention from the external environment of the firm to its internal environment. We have observed that internal resources and capabilities offer a sound basis for build- ing strategy. Indeed, when a firm's external environment is in a state of flux, internal strengths are likely to provide the primary basis upon which it can define its identity and its strategy. In this chapter we have followed a systematic approach to identifying the resources and capabili- ties that an organization has access to and then have appraised these resources and capabilities in terms of their potential to offer a sustainable competitive advantage and, ultimately, to generate profit. Having built a picture of an organization's key resources and capabilities and having identified areas of strength and weakness, we can then devise strategies through which the organization can exploit its strengths and minimize its vulnerability to its weaknesses. Figure 5.10 summarizes the main stages of our analysis. In the course of the chapter, we have encountered a number of theoretical concepts and relation- ships; however, the basic issues of resource and capability analysis are intensely practical. At its core, resource and capability analysis asks what is distinctive about a firm in terms of what it can do better than its competitors and what it cannot. This involves not only analysis of balance sheets, employee competencies, and benchmarking data, but also insight into the values, ambitions, and traditions of a company that shape its priorities and identity.
RESOURCES chapter 5 Analyzing Resources and Capabilities 137
Because the resources and capabilities of the firm form the foundation for building competitive advantage, we shall return again and again to the concepts of this chapter. In the next chapter we shall consider the organizational structure and management systems through which resources and capabilities are deployed. In Chapter 7 we shall look more closely at the competitive advantages that arise when resource and capability strengths intersect with key success factors. In Chapter 8 we shall consider how companies build the capabilities needed to deal with the challenges of the future.
Self-Study Questions1. Since it was founded in 1994, Amazon has expanded its business from online book sales, to online general retailing, to audio and video streaming, to e-readers and tablet comput- ers, to cloud computing. Is Amazon's strategy based primarily upon serving a market need or primarily on exploiting its resources and capabilities?2. The world's leading typewriter manufacturers in the 1970s included Olivetti, Underwood, IBM, Olympia, Remington, Smith Corona, and Brother Industries. While IBM and Brother adapted to the microelectronics revolution, most of the others failed. What strategies might these companies have pursued rather than entering the personal computer and electronic work processing market?3. I have argued that the part of discrepancy between firms' stock market value and their book value reflects the fact than intangible resources are typically undervalued or not valued at all in their balance sheets. For the companies listed in Table 5.1, which types of resource are likely to be absent or undervalued in the firms' balance sheets?4. Many companies announce in their corporate communications: "Our people are our great- est resource." In terms of the criteria listed in Figure 5.7, can employees be considered of the utmost strategic importance? For Walmart, McDonald's, and McKinsey & Company, how important are employees to their competitive advantages?5. The chapter argues that Apple's key capabilities are product design and product develop- ment which combine hardware technology, software engineering, aesthetics, ergonomics, and cognitive awareness to create products with a superior user interface and unrivalled market appeal. How easy would it be for Samsung to replicate these capabilities of Apple?6. Given the profile of Icelandair's resources and capabilities outlined in Strategic Capsule 5.8, how might Icelandair best exploit its resources and capabilities to (a) expand passenger numbers traveling to and from Iceland and (b) profitably grow its share of the North Atlantic market?7. Apply resource and capability analysis to your own business school. Begin by identifying the resources and capabilities relevant to success in the market for business education, appraise the resources and capabilities of your school, and then make strategy recommen- dations regarding such matters as the programs to be offered and the overall positioning and differentiation of the school and its offerings.138 Part II the tools of strategy analysis
Notes 1. P. F. Drucker, Managing in Turbulent Times (New York: 14. D. Goleman, Emotional Intelligence (New York: Bantam, Harper & Row, 1990). 1995); D. Goleman, Social Intelligence (New York: 2. The resource-based view is described in J. B.Barney, Bantam, 2006). "Firm Resources and Sustained Competitive Advantage," 15. C. E. Helfat and M. Lieberman, "The Birth of Capabilities: Journal of Management 17 (1991): 99–120; J. Mahoney Market Entry and the Importance of Prehistory," and J. R. Pandian, "The Resource-Based View within Industrial and Corporate Change 12 (2002) 725–760. the Conversation of Strategic Management," Strategic 16. P. Selznick, Leadership in Administration: A Sociological Management Journal 13 (1992): 363–380; M. A. Peterlaf, Interpretation (New York: Harper & Row, 1957). "The Cornerstones of Competitive Advantage: A 17. C. K. Prahalad and G. Hamel, "The Core Competence of Resource-Based View," Strategic Management Journal the Corporation," Harvard Business Review (May/June 14 (1993): 179–192; and R. M. Grant, "The Resource- 1990): 79–91. based Theory of Competitive Advantage," California 18. G. Hamel and C. K. Prahalad state: "the distinction between Management Review 33 (1991): 114–135. competencies and capabilities is purely semantic" (letter, 3. C. K. Prahalad and G. Hamel, "The Core Competence Harvard Business Review, May/June 1992: 164–165). of the Corporation," Harvard Business Review (May/ 19. M. E. Porter, Competitive Advantage (New York: Free June1990): 79–91. Press, 1984). 4. "Eastman Kodak: Failing to Meet the Digital Challenge," 20. D. J. Teece, G. Pisano, and A. Shuen, "Dynamic in R. M. Grant, Cases to Accompany Contemporary Capabilities and Strategic Management," Strategic Strategy Analysis 8th edn (Oxford: Blackwell, 2013). Management Journal 18 (1997): 509–533. 5. E. Danneels, "Trying to Become a Different Type of 21. P. Leinwand and C. Mainardi, "The Coherence Premium", Company: Dynamic Capability at Smith Corona", Strategic Harvard Business Review 88 ( June 2010): 86–92. Management Journal 32 (2011): 1–31. E. Danneels, 22. Adverse selection refers to the propensity for a market B. Provera, and G. Verona, "(De-)Institutionalizing to be dominated by low-quality or risky offerings as Organizational Competence: Olivetti's Transition a result of information asymmetry. This is also known from Mechanical to Electronic Technology", Bocconi as the lemons problem. See G. Akerlof, "The Market University, Milan, 2012. for Lemons: Qualitative Uncertainty and the Market 6. M. Tripsas, "Unraveling the Process of Creative Mechanism," Quarterly Journal of Economics 84 (1970): Destruction: Complementary Assets and Incumbent 488–500. Survival in the Typesetter Industry," Strategic 23. J. B. Barney, "Strategic Factor Markets: Expectations, Luck Management Journal 18 (Summer 1997): 119–142; J. and Business Strategy," Management Science 32 (October Bower and C. M. Christensen, "Disruptive Technologies: 1986): 1231–1241. Catching the Wave," Harvard Business Review ( January/ 24. I. Dierickx and K. Cool ("Asset Stock Accumulation and February 1995): 43–53. Sustainability of Competitive Advantage," Management 7. A. Madhok, S. Li, and R. L. Priem, "The Resource-Based View Science 35 (1989): 1504–1513) point to two major dis- Revisited: Comparative Firm Advantage, Willingness-Based advantages of imitation. They are subject to asset mass Isolating Mechanisms and Competitive Heterogeneity", efficiencies (the incumbent's strong initial resource European Management Review 7 (2010): 91–100. position facilitates the subsequent accumulation of 8. Walt Disney Company, 10-K report, 2014. these resources) and time compression diseconomies 9. R. Gulati, "Network Location and Learning: The Influence (additional costs incurred by an imitator when seeking to of Network Resources and Firm Capabilities on Alliance rapidly accumulate a resource or capability e.g., "crash Formation," Strategic Management Journal, 20 (1999): programs" of R & D and "blitz" advertising 397–420. campaigns tend to be costly and unproductive). 10. S. Green, "Understanding Corporate Culture and Its 25. D. Miller, The Icarus Paradox: How Exceptional Relationship to Strategy," International Studies of Companies Bring About Their Own Downfall (New York: Management and Organization, 18 (Summer 1988): 6–28. Harper-Business, 1990). 11. J. Barney, "Organizational Culture: Can It Be a Source 26. I. Martin, Making It Happen: Fred Goodwin, RBS and the of Sustained Competitive Advantage?" Academy of Men Who Blew up the British Economy (London: Simon & Management Review, 11 1986): 656–665. Schuster, 2013). 12. OECD data for 2013. http://stats.oecd.org/Index. 27. "What is Benchmarking?" Benchnet: The Benchmarking aspx?DatasetCode=TENURE_AVE. Exchange, www.benchnet.com, accessed July 20, 2015. 13. E. Lawler, "From Job-Based to Competency-Based 28. "N. Nicholas and J. Van Reenen, "Why Do Management Organizations," Journal of Organizational Behavior 15 Practices Differ across Firms and Countries?" Journal of (1994): 3–15; L. Spencer and S. Spencer, Competence at Economic Perspectives 24 (2010): 203–224. Work: Models for Superior Performance (New York: John 29. C. Markides, All the Right Moves (Boston: Harvard Wiley & Sons, Inc., 1993). Business School Press, 1999). 6 Organization Structure and Management Systems: The Fundamentals of Strategy Implementation Ultimately, there may be no long-term sustainable advantage other than the ability to organize and manage. —JAY GALBRAITH AND ED LAWLER
I'd rather have first-rate execution and second-rate strategy anytime than brilliant ideas and mediocre management. —JAMIE DIMON, CEO, JPMORGAN CHASE & CO.
Many people regard execution as detail work that's beneath the dignity of a business leader. That's wrong. To the contrary, it's a leader's most important job. —LARRY BOSSIDY, FORMER CEO, HONEYWELL
By the time you have completed this chapter, you will be able to: ◆◆ Understand how strategic planning links to operational planning, performance manage- ment, and resource allocation in implementing strategy. ◆◆ Appreciate the basic principles that determine the structural characteristics of complex human organizations. ◆◆ Select the organizational structure best suited to a particular business context. ◆◆ Recognize how companies have been changing their organizational structures in recent years and the forces driving these changes. chapter 6 organization Structure and Management Systems 141
The Annual Strategic Planning Cycle Most large companies have a regular (normally annual, sometimes bi-annual) strategic planning process that results in a document that is endorsed by the board of directors and provides a development plan for the company for the next three to five years. The strategic planning process is a systematized approach that assembles information, shares perceptions, conducts analysis, reaches decisions, ensures consistency among those decisions, and com- mits managers to courses of action and performance targets. Strategic planning processes vary between organizations. At some it is highly centralized. Even after an entrepreneurial start-up has grown into a large com- pany, strategy making may remain the preserve of the chief executive. At MCI Communications, former CEO Orville Wright observed: "We do it strictly top- down at MCI."5 However, at most large companies, the strategic planning process involves a combination of top-down direction and bottom-up initiatives.6 Figure 6.1 shows a typical strategic planning cycle. The principal stages are:
1. Setting the context: guidelines, forecasts, assumptions. The CEO typically initi- ates the process by indicating strategic priorities—these will be influenced by the outcome of the previous performance reviews. In addition, the strategic planning unit may provide assumptions or forecasts that offer a common basis for strategic planning by different units within the organization. For example, the 2014–2017 strategic plan of the Italian oil and gas company Eni was built upon (a) the goal of increasing free cash flow by expanding petroleum produc- tion and rationalizing downstream activities and (b) assumptions that the price of crude would average $90 per barrel and the dollar/euro exchange rate would average 1.3.7
Approval by Draft Discussions Revised Board Corporate Business with Business Guidelines Plans Corporate Plans
Corporate Forecasts/ Plan Scenarios/ Planning Assumptions
Performance Review chapter 6 organization Structure and Management Systems 143
2. Business plans. On the basis of these priorities and planning assumptions, the different organizational units—product divisions, functional departments, and geographical units—create strategic plans which are then presented for com- ment and discussion to top management. This dialogue represents a critically important feature of the strategy system: it provides a process for sharing knowl- edge, communicating ideas, and reaching consensus. This process may be more important than the strategic plans that are created. As General (later President) Dwight Eisenhower observed: "Plans are nothing; planning is everything." At Eni, business plans were created for each of Eni's major divisions: exploration and production, gas and power, and refining and marketing. 3. The corporate plan. Once agreed, the business plans are then integrated to cre- ate the corporate strategic plan that is then presented to the board for approval. 4. Capital expenditure budgets. Capital expenditure budgets link strategy to resource allocation. They are established through both top-down and bottom- up initiatives. When organizational units prepare their business plans, they will indicate the major projects they plan to undertake during the strategic planning period and the capital expenditures involved. When top management aggre- gates business plans to create the corporate plan, it establishes capital expendi- ture budgets both for the company as a whole and for the individual businesses. The businesses then submit capital expenditure requests for specific projects that are evaluated through standard appraisal methodologies, typically using risk-adjusted discounted cash flow analysis. Capital expenditure approvals take place at different levels of a company according to their size. Projects of up to $5 million might be approved by a business unit head; projects of up to $25 million might be approved by divisional top management; larger projects might need to be approved by the top management committee; the biggest projects may require approval by the board of directors. Eni's strategic plan for 2014–2017 established a capital expenditure budget of €54 billion, of which €44.4 billion would go to exploration and production. 5. Operational plans and performance targets. Implementing strategy requires breaking down strategic plans into a series of shorter-term plans that provide a focus for action and a basis for performance monitoring. At the basis of the annual operating plan are a set of performance targets derived from the stra- tegic plan. These performance targets are both financial (sales growth, mar- gins, return on capital) and operational (inventory turns, defect rates, number of new outlets opened). In the section on "Setting Performance Targets" in Chapter 2, I outlined the basic cascading logic for goal setting: overall goals of the organization are disaggregated into more specific performance goals as we move down the organization. As Chapter 2 shows, this can use either a simple financial disaggregation or the balanced scorecard methodology. There is nothing new about this approach: management by objectives (the pro- cess of participative goal setting) was proposed by Peter Drucker in 1954.8 Performance targets can be built into the annual operating budget. The oper- ating budget is a pro forma profit-and-loss statement for the company as a whole and for individual divisions and business units for the upcoming year. It is usually divided into quarters and months to permit continual monitoring and the early identification of variances. The operating budget is part forecast and part target. Each business typically prepares an operating budget for the144 Part II THE TOOLS OF STRATEGY ANALYSIS
following year that is then discussed with the top management committee and, if acceptable, approved. In some organizations the budgeting process is part of the strategic planning system: the operating budget is the first year of the strategic plans; in others, budgeting follows strategic planning. Operational planning is more than setting performance targets and agreeing budgets; it also involves planning specific activities. As Bossidy and Charan explain: "An operating plan includes the programs your business is going to complete within one year … Among these programs are product launches; the market- ing plan; a sales plan that takes advantage of market opportunities; a manu- facturing plan that stipulates production outputs; and a productivity plan that improves efficiency."9
Implementing strategy is not just about strategic planning processes and linking them to goal setting, operational activities, and resource allocation. Strategy imple- mentation encompasses the entire design of the organization. How a firm is orga- nized determines its capacity for action. We saw in the previous chapter that the design of processes and structures is fundamental to organizational capabilities. The same is true in war: from the conquests of the Roman legions, to the one-sided out- come of the Franco-Prussian War (1871) and the Israeli victories in the Six-Day War (1967) and Yom Kippur War (1973), organizational superiority has played a critical role in military success. Business enterprises come in many shapes and sizes. Samsung Corporation and Louie's Sandwich Bar on 32nd Street, New York share few organizational com- monalities. When we include social enterprises, we expand the range of organiza- tions even further. Yet, almost all organizations begin as tiny start-ups that involve merely the ambition and efforts of an individual or a small group of people. Strategy Capsule 6.1 summarizes some of the key developments in the development of the business corporation. Despite their diversity, all business enterprises face the same challenge of design- ing structures and systems that match the particular circumstances of their own situ- ation. In the same way that strategic management is a quest for unique solutions to the matching of internal resources and capabilities to external business opportunity, so organizational design is about selecting structures, systems, and management styles that can best implement such strategies. To establish principles, guidelines, and criteria for designing business organizations we need to consider the fundamen- tal challenges of organizing. To design a firm we must first recognize what it is supposed to do. According to Henry Mintzberg:
One man draws out the wire, another straightens it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the papers.11
Smith's pin makers produced about 4800 pins per person each day. "But if theyhad all wrought separately and independently, and without any of them having beeneducated to this peculiar business, they certainly could not each have made 20, per-haps not one pin, in a day." Henry Ford's assembly-line system introduced in 1913was based on the same principle. Between the end of 1912 and early 1914 the timetaken to assemble a Model T fell from 106 hours to six hours. But specialization comes at a cost. The more a production process is dividedbetween different specialists, the more complex is the challenge of integratingtheir separate efforts. The more volatile and unstable the external environment,the greater the number of decisions that need to be made and the greater are thecoordination costs. Hence, the more stable the environment, the greater the optimaldivision of labor. This is true both for firms and for entire societies. Civilizations arebuilt on an increased division of labor, which is only possible through stability. Asthe recent histories of Somalia, Syria, and the Congo have demonstrated so tragically,once chaos reigns, societies regress toward subsistence mode, where each familyunit must be self-sufficient.
The large corporation, the dominant feature of the administrative headquarters. "Line" employees advanced capitalist economy, is of recent origin. At the were engaged in operational tasks within oper- beginning of the 19th century, most production, even ating units; "staff" comprised administrators and in Britain, the most industrially advanced economy of functional specialists located at head office. These the time, was undertaken by individuals and by fami- simple line-and-staff structures developed into lies working in their own homes. In the US, the biggest more complex functional structures; companies business organizations in the mid-19th century were such as Sears Roebuck & Co. and Shell Transport family-owned farms, especially some of the large plan- and Trading managed numerous operating units tations of the South.a The business corporation, one of with large functionally specialized headquarters. the greatest innovations of modern society, resulted ◆◆ The holding company was a financial structure cre- from two main sources: legal development and orga- ated by a parent company acquiring controlling nizational innovation. equity stakes in a number of subsidiary companies. A corporation is an enterprise that has a legal iden- Its management structures were simple: the parent tity: it can own property, enter into contracts, sue, and appointed the board of directors of the subsidiar- be sued. The first corporations were created by royal ies and received dividends, but otherwise there decree, notably the colonial trading companies: the was little integration or overall managerial control. British East India Company (1600), the Dutch East India The holding company structure allows entrepre- Company (1602), and Hudson's Bay Company (1670). neurs such as Richard Branson and families such The introduction of limited liability during the mid-19th as the Tata family of India to control large business century, protected shareholders from corporate debts empires without the need for either the capital or thereby pemitting large-scale equity financing.b the management structure required by an inte- During the 19th century, most ideas about orga- grated corporation. nization and management derived from the biggest ◆◆ The multidivisional corporation: During the 1920s, the organizations of that time: European armies. General multidivisional form began to replace both central- von Moltke's organization of the Prussian army into divi- ized, functional structures and loose-knit holding sions and general staff functions during the 1860s pro- companies. At DuPont, increasing size and a widen- vided the basic model for large industrial corporations.c ing product range strained the functional structure However, toward the end of the 19th century organiza- and overloaded top management. The solution tional developments in the US encouraged new think- devised by Pierre Du Pont was to decentralize: 10 ing about business administration which would form product divisions were created, each with their own the basis of "the second industrial revolution": sales, R & D, and support activities. The corporate ◆◆ Line-and-Staff Structure: Lack of transportation head office headed by an executive committee and communication meant that most companies took responsibility for coordination, strategy, and operated in just one place. The railroad and the resource allocation.d Soon after, General Motors, telegraph changed all that. In the US, the railroad a loose holding company built by acquisition, companies were the first to create geographi- adopted a similar structure to solve its problems of cally separate operating units managed by an weak financial control and a confused product line. chapter 6 organization Structure and Management Systems 147
Board of Directors
Canadian Division
Source: A. P. Sloan, My Years with General Motors (Orbit Publishing, 1972): 57. © 1963 by Alfred P. Sloan. © renewed 1991,Alfred P. Sloan Foundation. Reproduced with Permission.
The new structure (shown in Figure 6.2) divided firms and individual proprietorships; partnerships pre- decision making between the division heads, each dominate in professional service industries such as law; responsible for their division's operations and per- cooperatives are prominent in some sectors, especially formance, and the president, as head of the general agriculture; despite the privatization trend of the 1990s, office and responsible for the corporation's devel- state-owned enterprises are highly influential. Saudi opment and control.e During the next 50 years, the Aramco, Indian Railways, China Mobile, China National multidivisional structure became the dominant Petroleum, and Royal Bank of Scotland are all industry organizational form for large corporations. leaders that are majority state-owned.
Corporate culture comprises the beliefs, values, and and a dedication to the public good, but without abehavioral norms of the company, which influence strong sense of customer focus.chow employees think and behave. It is manifest in a Cultures take a long time to develop and can-symbols, ceremonies, social practices, rites, vocabulary, not easily be changed. As the external environmentand dress. While shared values are effective in align- changes, a highly effective culture may become dys-ing the goals of organizational members, culture as a functional. The police forces of many US cities havewhole exercises a wider influence on an organization's developed cultures of professionalism and militarism,capacity for purposeful action. Organizational culture is which increased their effectiveness in fighting crime,a complex phenomenon. It is influenced by the exter- but also contributed to problems of isolation and unre-nal environment—in particular the national and ethnic sponsiveness to community needs.dcultures within which the firm is embedded. It may also Culture is probably the single most powerful deter-be influenced by the social and professional cultures minant of how an organization behaves—according toof organizational members. Most of all, it is a product of Peter Drucker, "Culture eats strategy for breakfast!"e Yet,the organization's history: the founder's personality and culture is far from being a flexible management tool atbeliefs tend to be especially influential. For example, the the disposal of chief executives. Culture is a propertycorporate culture of Walt Disney Company continues to of the organization as a whole, which is not amenablereflect the values, aspirations, and personal style of Walt to top management manipulation. CEOs inherit ratherDisney. A corporate culture is seldom homogeneous: than create the culture of their organizations. The keydifferent cultures may be evident in the research lab, in issue is to recognize the culture of the organizationsales, and within the accounting department. and to ensure that structure and systems work with Culture can facilitate both cooperation and coor- the culture and not against it. Where organizationaldination. In companies such as Starbucks, Shell, culture supports strategy, it can be very valuable. First,Nintendo, and Google, strong corporate cultures cre- it is cheap: as a control device it saves on the costs ofate a sense of identity among employees that supports monitoring and financial incentives; second, it permitscommunication and organizational routines. However, flexibility: when individuals internalize the goals andculture can also impede strategy implementation. principles of the organization, they can be allowed toCultures can also be divisive and dysfunctional. At the use their initiative and creativity in their work.British bank NatWest during the 1990s, John Weeksidentified a "culture of complaining" which was a barrier Notes: a E. H. Schein, "Organizational Culture," American Psychologist 45to top-down strategy initiatives. A culture is likely to b (1990): 109–19.support some types of corporate action but handicap b J. Weeks, Unpopular Culture: The Ritual of Complaint in a Britishothers. Salomon Brothers (now part of Citigroup) was Bank (Chicago: University of Chicago Press, 2004).renowned for its individualistic, internally competitive T. Burns, The BBC: Public Institution and Private World (London: c
culture that reinforced drive and individual effort but Macmillan, 1977).did little to support cooperation. The culture of the d "Policing: Don't Shoot," Economist (December 13, 2014): 37.British Broadcasting Corporation (BBC) reflects internal J. Weeks, "On Management: Culture Eats Strategy," Manage e
to drop the baton. Unless individuals can find ways of coordinating their efforts, pro- duction doesn't happen. As we have already seen in our discussion of organizational capabilities, the exceptional performance of Walmart, the Cirque du Soleil, and the US Marine Corps Band derives less from the skills of the individual members as from superb coordination between them. Among the mechanism for coordination, the fol- lowing can be found in all firms:
●● Rules and directives: A basic feature of the firm is the existence of general employment contracts under which individuals agree to perform a range of duties as required by their employer. This allows managers to exercise authority by means of general rules ("Secret agents on overseas missions will have essential expenses reimbursed only on production of original receipts") and specific directives ("Miss Moneypenny, show Mr Bond his new tooth- brush with 4G communication and a concealed death ray"). ●● Routines: Where activities are performed recurrently, coordination based on mutual adjustment and rules becomes institutionalized within organizational routines. As we noted in the previous chapter, these "regular and predict- able sequences of coordinated actions by individuals" are fundamental to the operation of organizational processes and provide the foundation of organizational capability. If organizations are to perform complex activi- ties efficiently and reliably, rules, directives, and mutual adjustments are not enough—coordination must become embedded in routines. ●● Mutual adjustment: The simplest form of coordination involves the mutual adjustment of individuals engaged in related tasks. In soccer or doubles tennis, players coordinate their actions spontaneously without direction or established routines. Such mutual adjustment occurs in leaderless teams and is especially suited to novel tasks where routinization is not feasible.
The relative roles of these different coordination devices depend on the types of activity being performed and the intensity of collaboration required. Rules are highly efficient for activities where standardized outcomes are required—most quality-control procedures involve the application of simple rules. Routines are essential for activities where close interdependence exists between individuals, be the activity a basic production task (supplying customers at Starbucks) or more complex (performing a heart bypass operation). Mutual adjustment works best for non-standardized tasks (such as problem solving) where those involved are well informed of the actions of their co-workers, either because they are in close visual contact (a chef de cuisine and his/her sous chefs) or because of informa- tion exchange (designers using interactive CAD software).
●● The human body comprises subsystems such as the respiratory system, ner- vous system, and digestive system, each of which consists of organs, each of which is made up of individual cells. ●● The physical universe is hierarchy with galaxies at the top, below them are solar systems and we can continue down all the way to atoms and further to of subatomic particles. ●● Social systems comprise individuals, families, communities, and nations. ●● A novel is organized by chapters, paragraphs, sentences, words, and letters.
Task definition Rigid and highly specialized Flexible and broadly definedCoordination and control Rules and directives vertically imposed Mutual adjustment, common cultureCommunication Vertical Vertical and horizontalKnowledge Centralized DispersedCommitment and loyalty To immediate superior To the organization and its goalsEnvironmental context Stable with low technological Dynamic with significant technological uncertainty uncertainty and ambiguity
Source: Adapted from Richard Butler, Designing Organizations: A Decision-Making Perspective (London: Routledge, 1991): 76, by permissionof Cengage Learning.
Stalker found that firms in stable environments had mechanistic forms, characterized by bureaucracy; those in less stable markets had organic forms that were less formal and more flexible.23 Table 6.1 contrasts key characteristics of the two forms. By the 1970s, contingency theory—the idea there was no one best way to orga- nize; it depended upon the strategy being pursued, the technology employed, and the surrounding environment—had become widely accepted.24 Although Google and McDonald's are of similar sizes in terms of revenue, their structures and systems are very different. McDonald's is highly bureaucratized: high levels of job special- ization, formal systems, and a strong emphasis on rules and procedures. Google emphasizes informality, low job specialization, horizontal communication, and the importance of principles over rules. These differences reflect differences in strategy, technology, human resources, and the dynamism of the business environments that each firm occupies. In general, the more standardized goods or services (beverage cans, blood tests, or haircuts for army inductees) are and the more stable the envi- ronment is, the greater are the efficiency advantages of the bureaucratic model with its standard operating procedures and high levels of specialization. Once markets become turbulent, or innovation becomes desirable, or buyers require customized products—then the bureaucratic model breaks down. These contingency factors also cause functions within companies to be orga- nized differently. Stable, standardized activities such as payroll, treasury, taxation, customer support, and purchasing activities tend to operate well when organized along bureaucratic principles; research, new product development, marketing, and strategic planning require more organic modes of organization. As the business environment has become increasingly turbulent, the trend has been toward organic approaches to organizing, which have tended to displace more bureaucratic approaches. Since the mid-1980s, almost all large companies have made strenuous efforts to restructure and reorganize in order to achieve greater flex- ibility and responsiveness. Within their multidivisional structures, companies have decentralized decision making, reduced their number of hierarchical layers, shrunk headquarters staffs, emphasized horizontal rather than vertical communication, and shifted the emphasis of control from supervision to accountability. However, the trend has not been one way. The financial crisis of 2008 and its after- math have caused many companies to reimpose top-down control. Greater aware- ness of the need to manage financial, environmental, and political risks in sectors such as financial services, petroleum, and mining have also reinforced centralized154 Part II THE TOOLS OF STRATEGY ANALYSIS
control and reliance on rules. It is possible that the cycles of centralization and decentralization that many companies exhibit are a means by which they balance the tradeoff between integration and flexible responsiveness.25 Developments in ICT have worked in different directions. In some cases the auto- mation of processes has permitted their centralization and bureaucratization (think of the customer service activities of your bank or telecom supplier). In other areas, ICT has encouraged informal approaches to coordination. The huge leaps in the avail- ability of information available to organizational members and the ease with which they can communicate with one another has increased vastly the capacity for mutual adjustment without the need for intensive hierarchical guidance and leadership.
In this section we will tackle these two central issues of organizational design. First, on what basis should individuals be grouped into organizational units? Second, how should organizational units be configured into overall organizational structures?
●● When John Scully became CEO of Apple in 1984, the company was orga- nized by product: Apple II, Apple III, Lisa, and Macintosh. Cross-functional coordination within each product was strong, but there was little integration across products: each had a different operating system, applications were incompatible, and scale economies in purchasing, manufacturing, and dis- tributions could not be exploited. Scully's response was to reorganize Apple along functional lines to gain control, reduce costs, and achieve a more coherent product strategy. ●● General Motors, a pioneer of the multidivisional structure, moved toward a more functional structure. As cost efficiency became its strategic priority, it maintained its brand names (Cadillac, Chevrolet, Buick) but merged these separate divisions into a more functionally based structure to exploit scale economies and foster the development and transfer of know-how (compare Figure 6.4 with Figure 6.2).
GM Europe
GM China
Matrix Structures Whatever the primary basis for grouping, all companiesthat embrace multiple products, multiple functions, and multiple locations must
Corporate Staff • Business Development • Legal • Commercial and Public Relations • Global Research • Human Resources • Finance
M PA NI ES Research Public Affairs on Planning gi Re Human Resources an a, ric
ric and Organization Af
Af ne
d Health, Safety, an ho
re and Environment te Asia cop
he sia
h an
isp la
Materials ra
ut Fr
m st
So t, pe
Legal Au
d Eas o S
rn d
Information Computing ur ON
an e an
dl E GI
es st
Finance RE
Eu Ea
SECTOR Upstream (Oil and Gas) Natural Gas Downstream Supply Marketing Oil Marine Manufacturing Trading Chemicals Coal Metals Others chapter 6 organization Structure and Management Systems 159
making is not as fast as it should be with everyone looking over their shoul- der for approval … The objective is to redesign job content more meaning- fully. The purpose is to rejuvenate the organization by defining richer jobs with fewer hierarchical layers of reporting.29 ●● Adhocracy and team-based organization: Adhocracies, according to Henry Mintzberg, are organizations that feature shared values, high levels of partici- pation, flexible communication, and spontaneous coordination. Hierarchy, authority, and control mechanisms are largely absent.30 Adhocracies tend to exist where problem solving and other non-routine activities predominate and where expertise is prized. Individual teams involved in research, consult- ing, engineering, entertainment, and crisis response tend to be adhocracies. At a larger organizational scale, companies such as Google, W. L. Gore & Associates, and some advertising agencies have adopted team-based struc- tures with many of the features of adhocracies. ●● Project-based organizations: Closely related to team-based organizations are project-based organizations. A key feature of the project-based organization is recognition that work assignments are for a finite duration, hence the orga- nization structure needs to be dynamically flexible. Project-based organiza- tions are common in sectors such as construction, consulting, oil exploration, and engineering. Because every project is different and involves a sequence of phases, each project needs to be undertaken by a closely interacting team that is able to draw upon the know-how of previous and parallel project teams. As cycle times become compressed across more and more activities, companies are introducing project-based organization into their conventional divisional and functional structures—for example new product development, change management, knowledge management, and research are increasingly organized into projects. ●● Network structures: A common feature of new approaches to company orga- nization is an emphasis on the informal over formal aspects of organizational structure. The main approach to describing and analyzing this informal struc- ture is from the perspective of a social network—the pattern of interactions among organizational members (which can also be extended to those outside the organization). Social network analysis offers insight into how informa- tion and know-how move within organizations, how power and influence are determined, and how organizations adapt. The importance of social networks to the behavior and performance of organizations has led several management thinkers to recommend that these informal social structures be the primary basis for organizational structure and supplant traditional, formal structures. Thus, Gunnar Hedlund and Bartlett and Ghoshal have proposed network- based models of the multinational corporation.31 This emphasis on patterns of communication and interaction rather than the formal relationships puts emphasis on the informal mechanisms through which coordination occurs and work gets done within organizations. Advances in information and communi- cations technology have greatly increased the scope for coordination to occur outside of the formal structure, leading many observes to advocate the disman- tling of much of the formal structures that firms have inherited. ●● Permeable organizational boundaries: Network relationships exist between firms as well as between individuals. As firms specialize around their core chapter 6 organization Structure and Management Systems 161
SummaryStrategy formulation and strategy implementation are closely interdependent. The formulation ofstrategy needs to take account of an organization's capacity for implementation; at the same time,the implementation process inevitably involves creating strategy. If an organization's strategic man-agement process is to be effective then its strategic planning system must be linked to actions, com-mitments and their monitoring, and the allocation of resources. Hence, operational plans and capitalexpenditure budgets are critical components of a firm's strategic management system. Strategy implementation involves the entire design of the organization. By understanding theneed to reconcile specialization with cooperation and coordination, we are able to appreciatethe fundamental principles of organizational design. Applying these principles, we can determine how best to allocate individuals to organizationalunits and how to combine these organizational units into broader groupings—in particular thechoice between basic organizational forms such as functional, divisional, or matrix organizations.162 Part II THE TOOLS OF STRATEGY ANALYSIS
We have also seen how company's organizational structures have been changing in recent years, influenced both by the demands of their external environments and the opportunities made avail- able by advances in information and communication technologies. The chapters that follow will have more to say on the organizational structures and manage- ment systems appropriate to different strategies and different business contexts. In the final chapter (Chapter 16) we shall explore some of the new trends and new ideas that are reshaping our thinking about organizational design.
Self-Study Questions 1. Jack Dorsey, the CEO of Twitter, Inc., has asked for your help in designing a strategic planning system for the company. Would you recommend a formal strategic planning sys- tem with an annual cycle such as that outlined in "The Strategic Planning System: Linking Strategy to Action" and Figure 6.1? (Note: Twitter's strategy is summarized in Strategy Capsule 1.5 in Chapter 1.) 2. Referring to Strategy Capsule 6.1, as DuPont expanded its product range (from explosives into paints, dyes, plastics, and synthetic fibers) why do you think the functional structure (organized around manufacturing plants and other functions such as sales, finance, and R & D) became unwieldy? Why did the multidivisional structure based on product groups improve management effectiveness? 3. Within your own organization (whether a university, company, or not-for-profit organiza- tion), which departments or activities are organized mechanistically and which organ- ically? To what extent does the mode of organization fit the different environmental contexts and technologies of the different departments or activities? 4. In 2008, Citigroup announced that its Consumer business would be split into Consumer Banking, which would continue to operate through individual national banks, and Global Cards, which would form a single global business (similar to Citi's Global Wealth Management division). On the basis of the arguments relating to the "Defining Organizational Units" section above, why should credit cards be organized as a global unit and all other consumer banking services as national units? 5. The examples of Apple and General Motors (see "Functional Structure" section above) point to the evolution of organizational structures over the industry life-cycle. During the growth phase, many companies adopt multidivisional structures; during maturity and decline, many companies revert to functional structures. Why might this be? (Note: you may wish to refer to Chapter 8, which outlines the main features of the life-cycle model.) 6. Draw an organizational chart for a business school that you are familiar with. Does the school operate with a matrix structure (for instance, are there functional/discipline-based departments together with units managing individual programs)? Which dimension of the matrix is more powerful, and how effectively do the two dimensions coordinate? How would you reorganize the structure to make the school more efficient and effective? chapter 6 organization Structure and Management Systems 163
1. L. Bossidy and R. Charan, Execution: The Discipline of 20. J. D. Orton and K. E. Weick, "Loosely Coupled Systems: Getting Things Done (New York: Random House, A Reconceptualization," Academy of Management 2002): 71. Review 15 (1990): 203–223. 2. H. Mintzberg, "Patterns of Strategy Formulation," 21. On organizational modularity, see R. Sanchez and Management Science 24 (1978): 934–48; "Of Strategies: J. T. Mahoney, "Modularity, Flexibility, and Knowledge Deliberate and Emergent," Strategic Management Management in Product and Organizational Design," Journal 6 (1985): 257–272. Strategic Management Journal 17 (Winter 1996): 3. T. J. Peters, "Strategy Follows Structure: Developing 63–76; C. Baldwin and K. Clark, "Managing in an Age Distinctive Skills," California Management Review, 26 of Modularity," Harvard Business Review (September/ (Spring 1984): 111-128. October 1997): 84–93. 4. Apple Computer: Preliminary Confidential Offering 22. "Idea: Theories X and Y," The Economist online extra Memorandum, 1978. http://www.computerhistory.org/ (October 6, 2008), www.economist.com/node/12370445, collections/catalog/102712693. accessed July 20, 2015. 5. MCI Communications: Planning for the 1990s (Harvard 23. T. Burns and G. M. Stalker, The Management of Business School Case No. 9-190-136, 1990): 1. Innovation (London: Tavistock, 1961). 6. For a description of the strategic planning systems 24. L. Donaldson, "Contingency Theory (Structural)," in of the world's leading oil and gas majors, see: R. M. R. Thorpe and R. Holt (eds.), The Sage Dictionary of Grant, "Strategic Planning in a Turbulent Environment: Qualitative Management Research (London: Sage, 2008). Evidence from the Oil Majors," Strategic Management 25. J. Nickerson and T. Zenger refer to this as structural Journal 24 (2003): 491–518. modulation: "Being Efficiently Fickle: A Dynamic 7. "Eni 2014–2017 Strategic Plan" (Rome: Eni, February 13, Theory of Organizational Choice," Organization Science 2014). 13 (2002): 547–567. 8. P. F. Drucker, The Practice of Management (New York: 26. J. D. Thompson, Organizations in Action (New York: Harper, 1954). McGraw-Hill, 1967). The nature of interdependence in 9. L. Bossidy and R. Charan, Execution: The Discipline organizational processes is revisited in T. W. Malone, of Getting Things Done (New York: Random House, K. Crowston, J. Lee, and B. Pentland, "Tools for 2002): 227. Inventing Organizations: Toward a Handbook of 10. H. Mintzberg, Structure in Fives: Designing Effective Organizational Processes," Management Science 45 Organizations (Englewood Cliffs, NJ: Prentice Hall, (March 1999): 489–504. 1993): 2. 27. C. A. Bartlett and S. Ghoshal, "Matrix Management: Not 11. A. Smith, The Wealth of Nations (London: Dent, 1910): 5. a Structure, a Frame of Mind," Harvard Business Review 12. K. Eisenhardt, "Agency Theory: An Assessment and ( July/August 1990): 138–145. Reviews," Academy of Management Review 14 (1989): 28. R. Daft and A. Lewin, "Where are the theories for the 57–74. new organizational forms?" Organization Science 3 13. L. A. Bebchuk and J. M. Fried, "Pay without (1993): 1–6. Performance: Overview of the Issues." Academy of 29. R. Kumar, "De-Layering at Tata Steel," Journal of Management Perspectives 20 (2006): 5–24. Organizational Behavior Education 1 (2006): 37–56. 14. T. Peters and R. Waterman, In Search of Excellence 30. H. Mintzberg, Structure in Fives: Designing Effective (New York: Harper & Row, 1982). Organizations (Englewood Cliffs, NJ: Prentice Hall, 15. J.-C. Spender, Business Strategy: Managing Uncertainty, 1993): Chapter 12. Opportunity, and Enterprise (Oxford: Oxford University 31. G. Hedlund, "The Hypermodern MNC: A Heterarchy?" Press, 2014). Human Resource Management 25 (1986): 9–35; C. 16. M. Weber, Economy and Society: An Outline of Bartlett and S. Ghoshal, Managing across Borders: The Interpretive Sociology (Berkeley, CA: University Transnational Solution, 2nd edn (Boston, Harvard of California Press, 1968). Business School, 1998). 17. T. Burns and G. M. Stalker, The Management of 32. M. H. Lazerson and G. Lorenzoni, "The Firms that Innovation (London: Tavistock Institute, 1961). Feed Industrial Districts: A Return to the Italian Source," 18. H. Mintzberg, Structure in Fives: Designing Effective Industrial and Corporate Change 8 (1999): 235–266; Organizations (Englewood Cliffs: Prentice Hall, 1993): A. Grandori, Interfirm Networks (London: Routledge, Chapter 9. 1999). 19. H. A. Simon, "The Architecture of Complexity," 33. R. J. DeFilippi and M. B. Arthur, "Paradox in Project- Proceedings of the American Philosophical Society 106 based Enterprise: The Case of Film Making," California (1962): 467–482. Management Review 42 (1998): 186–191. III BUSINESSSTRATEGY ANDTHE QUEST FOR COMPETITIVE ADVANTAGE
If the three keys to selling real estate are location, location, location, then the three keys of selling consumer products are differentiation, differentiation, differentiation. —ROBERT GOIZUETA, FORMER CHAIRMAN, COCA-COLA COMPANY
◆◆ How Competitive Advantage Is Established and ●● The Nature and Significance of Differentiation Sustained ●● Analyzing Differentiation: The Demand Side ●● Establishing Competitive Advantage ●● Analyzing Differentiation: The Supply Side ●● Sustaining Competitive Advantage ●● Bringing It All Together: The Value Chain in◆◆ Types of Competitive Advantage: Cost and Differentiation Analysis Differentiation ◆◆ Implementing Cost and Differentiation Strategies◆◆ Cost Analysis ◆◆ Summary ●● The Sources of Cost Advantage ◆◆ Self-Study Questions ●● Using the Value Chain to Analyze Costs ◆◆ Notes168 Part IIi BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
By the time you have completed this chapter, you will be able to: ◆◆ Identify the circumstances in which a firm can create and sustain competitive advan- tage over a rival and recognize how resource conditions create imperfections in the competitive process that offer opportunities for competitive advantage. ◆◆ Distinguish the two primary types of competitive advantage: cost advantage and dif- ferentiation advantage. ◆◆ Identify the sources of cost advantage in an industry, apply cost analysis to assess a firm's relative cost position, and recommend strategies to enhance cost competitiveness. ◆◆ Appreciate the potential for differentiation to create competitive advantage, ana- lyze the sources of differentiation, and formulate strategies that create differentiation advantage.
firms compete within the same market, one firm possesses a competitive advantageover its rivals when it earns (or has the potential to earn) a persistently higherrate of profit. The problem here is that if we identify competitive advantage with superior prof-itability, why do we need the concept of competitive advantage at all? A key distinc-tion is that competitive advantage may not be revealed in higher profitability—a firmmay forgo current profit in favor of investing in market share, technology, customerloyalty, or executive perks.1 In viewing competitive advantage as the result of matching internal strengths toexternal success factors, I may have conveyed the notion of competitive advantageas something static and stable. In fact, as we observed in Chapter 4 when discuss-ing competition as a process of "creative destruction," competitive advantage is adisequilibrium phenomenon: it is created by change and, once established, it sets inmotion the competitive process that leads to its destruction.
Some f irms Resource heterogeneity Some f irms are faster have greater creative among f irms creates and more effective and innovative winners and losers in exploiting change capability170 Part IIi BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
among the firms within an industry. The world's tobacco industry has a relatively stable external environment and the leading firms pursue similar strategies with similar resources and capabilities: differences in profitability among firms tend to be small. The toy industry, on the other hand, comprises a heterogeneous group of firms that experience unpredictable shifts in consumer preferences and technology. As a result, profitability differences are wide and variable. The competitive advantage that arises from external change also depends on firms' ability to respond to change. Any external change creates entrepreneurial opportunities that will accrue to the firms that exploit these opportunities most effectively. Entrepreneurial responsiveness involves one of two key capabilities:
Among business buzzwords, the term business model Strategic innovation through new business modelsis one of the most loosely defined. According to Joan has the capacity to revolutionize established industries.Magretta, business models are simply "stories that This was certainly the case with the low-cost carrierexplain how enterprises work." In doing so they address model pioneered by Southwest. It is also true of fran-the fundamental questions of "How do we make chising, a business model first adopted by the Singermoney in this business?" and "What is the underlying sewing machine company for its dealers, but perfectedeconomic logic that explains how we deliver value to and popularized by McDonald's.customers and at an appropriate cost?"a Subsequent Recent interest in business models has beendefinitions have extended the concept of the business closely associated with the rise of e-commerce,model to encompass not only the core logic of how the where the strategic challenge for new businesses hasbusiness creates and captures value but also the broader been devising business models that permit the mon-business system through which that value creation and etization of their innovations.c Thus, newspapers havecapture occurs. Thus, Zott et al. define the business adopted a variety of business models in their questmodel as "depicting the content, structure, and gover- to generate revenues from their online content, thesenance of transactions designed to create value through include:the exploitation of business opportunities."b Although the terms business model and strategy are ◆◆ free access with paid third-party advertising;often used synonymously, if "business model" is to be a ◆◆ user subscriptions;useful concept, it needs to be distinguished from "strat- ◆◆ metered access with limited free access;egy." While "business model" describes the overall con- ◆◆ "freemium" models with some content offered freefiguration of a firm's business system, "strategy" describes but more valuable content only available throughthe specifics of how that business model fits a firm's subscription.particular market context and its resource and capabil-ity endowments. Thus, Southwest Airlines developed anew business model involving minimal passenger ser- Notes: a J. Magretta, "Why Business Models Matter," Harvard Businessvices and point-to-point routes using a single model of Review (May 2002): 86–92.aircraft. This low-cost carrier model has been imitated by b C. Zott, R. Amit, and L. Massa, "The Business Model: Recentstart-up airlines throughout the world. Yet, Southwest, Developments and Future Research," Journal of Management, 37 (July 2011): 1019–1042.Ryanair, EasyJet, and AirAsia each have distinct strategies c "The Search for a New Business Model," Pew Journalismin terms of the routes they fly and variations in how they Research Project (March 4, 2012). http://www.journalism.apply the basic business model. org/2012/03/05/search-new-business-model/.
Kim and Mauborgne argue that the best value- e.g., Dell's integrated system for ordering, assem- creating opportunities for business lie not in existing bling, and distributing PCs, which permitted unprec- industries following conventional approaches to com- edented customer choice and speed of fulfilment. peting (what they refer to as "red oceans") but seeking uncontested market space. These "blue oceans" may be The strategy canvas is a framework for developing entirely new industries created by technological inno- blue ocean strategies. The horizontal axis shows the vation (such as wireless telephony and biotechnology) different product characteristics along which the firms but are more likely to be the creation of new market in the industry compete; the vertical axis shows the space within existing industries using existing tech- amount of each characteristic a firm offers its custom- nologies. This may involve: ers. Starting with the value line showing the industry's existing offerings, the challenge is to identify a strategy ◆◆ New customer segments for existing products, e.g., that can provide a novel combination of attributes. This Apple Computer's recognition of the potential of involves four types of choice: the use of microcomputers in homes and schools. ◆◆ Reconceptualization of existing products, e.g., ◆◆ Raise: What factors should be raised well above the Cirque du Soleil's reinvention of the circus as a mul- industry's standard? timedia, theatrical experience. ◆◆ Eliminate: Which factors that the industry has long
reconfigurations of established value chains that ◆◆ Reduce: Which factors should be reduced well establish new positions of competitive advantage, below the industry's standard?
◆◆ Create: Which factors should be created that the Source: Based upon W. C. Kim and R. Mauborgne, Blue Ocean industry has never offered? Strategy: How to Create Uncontested Market Space and Make the Competition Irrelevant (Boston: Harvard Business School Figure 7.2 compares value lines for Cirque du Soleil Press, 2005).and a traditional circus.
FIGURE 7.2 The Strategy Canvas: Value lines for Cirque du Soleil and the traditional circus
Cirque du Soleil Traditional circus Low
Diagnosis • Use multiple sources of competitive advantages to create causal ambiguity
Urban Outfitters Inc. was founded in Philadelphia in urban-bohemian-styled product mix, which includes 1976. By 2014, its three main chains—Urban Outfitters, clothing, furnishings, and gift items, is displayed within Anthropologie, and Free People—comprised over 500 bazaar-like stores, each of which has a unique design. stores in ten countries. The company describes itself as To encourage frequent customer visits, the layout of targeting well-educated, urban-minded, young adults each store is changed every two weeks, creating a aged 18 to 30 through its unique merchandise mix and new shopping experience whenever customers return. compelling store environment: "We create a unified Emphasizing community with its customers, it forgoes environment in our stores that establishes an emo- traditional forms of advertising in favor of blogs and tional bond with the customer. Every element of the word-of-mouth transmission. Each practice makes environment is tailored to the aesthetic preferences of little sense on its own, but together they represent a our target customers. Through creative design, much distinctive, integrated strategy. Attempts to imitate of the existing retail space is modified to incorporate Urban Outfitters' competitive advantage would most a mosaic of fixtures, finishes and revealed architectural likely fail because of the difficulty of replicating every details. In our stores, merchandise is integrated into a aspect of the strategy before integrating them in the variety of creative vignettes and displays designed to right manner. offer our customers an entire look at a distinct lifestyle." Source: Urban Outfitters Inc. 10-K Report to January 31, 2014; According to Michael Porter and Nicolaj Siggelkow, M. E. Porter and N. Siggelkow, "Contextuality within Activity Urban Outfitters offers a set of management practices Systems and Sustainable Competitive Advantage," Academy of that is both distinctive and highly interdependent. The Management Perspectives 22 (May 2008): 34–56.
Competitive advantage arises where there are managed funds. Vanguard´s S&P 500 Index fundimperfections in the competitive process, which in with administrative costs of 0.5% annually has out-turn result from the conditions under which essen- performed 90% of US equity mutual funds.tial resources and capabilities are available. Hence, ◆◆ If markets are subject to systematic behavioralby analyzing imperfections of competition, we can trends (e.g., the small firm effect or the Januaryidentify the sources of competitive advantage in dif- effect), competitive advantage accrues to tradersferent types of market. The key distinction is between with superior knowledge of market psychology orthe two types of value-creating activity: trading and of systematic price patterns (chart analysis). If mar-production. kets are subject to bandwagon effects, competi- In trading markets the limiting case is efficient mar- tive advantage can be gained in the short term bykets, which correspond closely to perfectly competitive following the herd (momentum trading) and lon-markets (examples include the markets for securities, ger term by a contrarian strategy. Warren Buffett isforeign exchange, and commodity futures). If prices a contrarian who is "fearful when others are greedy,reflect all available information and adjust instanta- and greedy when others are fearful."neously to newly available information, no markettrader can expect to earn more than any other. It is not In production markets the potential for competitivepossible to beat the market on any consistent basis— advantage is much greater because of the complexin other words competitive advantage is absent. This combinations of the resources and capabilities required,absence of competitive advantage reflects the con- the highly differentiated nature of these resourcesditions of resource availability. Both of the resources and capabilities, and the imperfections in their sup-needed to compete—finance and information—are ply. Within an industry, the more heterogeneous areequally available to all traders. firms' endowments of resources and capabilities, the Competitive advantage in trading markets requires greater the potential for competitive advantage. In theimperfections in the competitive process: European electricity-generating industry, the growing diversity of players—utilities (EDF, ENEL), gas distribu-◆◆ Where there is an imperfect availability of informa- tors (Gaz de France, Centrica), petroleum majors (Shell, tion, competitive advantage results from supe- ENI), independent power producers (AES, E.ON), and rior access to information—hence the criminal wind generators—has expanded opportunities for penalties for insider trading in most advanced competitive advantage and widened the profit differ- economies. entials between them.◆◆ Where transaction costs are present, competitive Differences in resource endowments also influence advantage accrues to the traders with the lowest the erosion of competitive advantage: the more similar transaction costs, hence the superior returns to are competitors' resources and capabilities, the easier low-cost index mutual funds over professionally is imitation.178 Part IIi BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
A firm can achieve a higher rate of profit (or potential profit) over a rival in one of two ways: either it can supply an identical product or service at a lower cost or it can sup- ply a product or service that is differentiated in such a way that the customer is willing to pay a price premium that exceeds the additional cost of the differentiation. In the former case, the firm possesses a cost advantage; in the latter, a differentiation advan- tage. In pursuing cost advantage, the goal of the firm is to become the cost leader in its industry or industry segment. Cost leadership requires the firm to "find and exploit all sources of cost advantage [and] sell a standard, no-frills product."22 Differentiation by a firm from its competitors is achieved "when it provides something unique that is valuable to buyers beyond simply offering a low price."23 Figure 7.4 illustrates these two types of advantage. By combining the two types of competitive advantage with the firm's choice of scope—broad market versus narrow segment—Michael Porter has defined three generic strategies: cost leadership, differentiation, and focus (Figure 7.5).
Cost Analysis
Historically, strategic management has emphasized cost advantage as the primary basis for competitive advantage in an industry. This focus on cost reflected the traditional emphasis by economists on price as the principal medium of competition. It also reflected the quest by large industrial corporations during the last century to exploit economies of
COST t ADVANTAGE duc l ar pro i Sim cost wer COMPETITIVE at lo ADVANTAGE Pric from e pr emi uniq um ue p rod uct DIFFERENTIATION ADVANTAGE
COST Industry-wide DIFFERENTIATION LEADERSHIP COMPETITIVE SCOPE Single segment FOCUS chapter 7 The Sources and Dimensions of Competitive Advantage 179
scale and scope through investments in mass production and mass distribution. Duringthe 1970s and 1980s, this preoccupation with cost advantage was reflected in the wide-spread interest in the experience curve as a tool of strategy analysis (Strategy Capsule 7.5). In recent decades, companies have been forced to think more broadly andradically about cost efficiency. Growing competition from emerging market coun-tries has created intense cost pressures for Western and Japanese firms, resultingin novel approaches to cost reduction, including outsourcing, offshoring, processre-engineering, lean production, and organizational delayering.
The experience curve has its basis in the systematic motorcycles as an exemplar of this strategy.b The quest reduction in the time taken to build airplanes and Liberty for market share was supported by numerous studies ships during World War II. In a series of studies, ranging confirming a positive relationship between profitabil- from bottle caps and refrigerators to long-distance calls ity and market share.c However, association does not and insurance policies, the Boston Consulting Group imply causation—it seems likely that market share and (BCG) observed a remarkable regularity in the reduc- profitability are both outcomes of some other source of tions in unit costs with increased cumulative output. Its competitive advantage—product innovation, or supe- law of experience states: the unit cost of value added to rior marketing.d a standard product declines by a constant percentage The weaknesses of the experience curve as a strategy (typically between 15 and 30%) each time cumulative tool are, first, it fails to distinguish several sources of cost output doubles. (Where "unit cost of value added" is the reduction (learning, scale, process innovation); second, unit cost of production less the unit cost of bought-in it presumes that cost reductions from experience are components and materials). aFigure 7.6 shows the expe- automatic—the reality is that they must be managed. rience curve for Ford's Model T. The experience curve has important implications Notes: Boston Consulting Group, Perspectives on Experience (Boston: a for strategy. If a firm can expand its output faster than BCG, 1970). its competitors can, it can move down the experience Boston Consulting Group, Strategy Alternatives for the British b
curve more rapidly and open up a widening cost dif- Motorcycle Industry (London: HMSO, 1975). R. Jacobsen and D. Aaker, "Is Market Share All That It's Cracked c ferential. BCG concluded that a firm's primary strate- Up To Be?" Journal of Marketing, 49 (Fall 1985 ): 11–22. gic goal should be driving volume growth through R. Wensley , "PIMS and BCG: New Horizons or False Dawn?" d
maximizing market share. BCG identified Honda in Strategic Management Journal, 3 ( 1982): 147–58.
$4000 1909 $3500
$3000 1910 Unit cost (1958)
$2500 1911 $2000 1912 1913 $1500 1914 1915 1918 1920 $1000
$0 0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0 2.2 2.4 2.6 2.8 3.0 3.2 3.4 3.6 3.8 4.0 Cumulative units of production (millions)
Note: The figure shows an 85% experience curve, i.e., unit costs declined by approximately 15% with each doubling of cumulative volume. chapter 7 The Sources and Dimensions of Competitive Advantage 181
ECONOMIES OF LEARNING • Increased individual skills • Improved organizational routines
PRODUCTION TECHNIQUES • Process innovation • Re-engineering of business processes
PRODUCT DESIGN • Standardization of designs and components • Design for manufacture
• Location advantages INPUT COSTS • Ownership of low-cost inputs • Nonunion labor • Bargaining power
CAPACITY UTILIZATION • Ratio of fixed to variable costs • Fast and flexible capacity adjustment
• Organizational slack/X-inefficiency RESIDUAL EFFICIENCY • Motivation and organizational culture • Managerial effectiveness
Cost per unit of output
Units of output per period Minimum Ef ficient Plant Size
Figure 7.9 shows how soft drink brands with the greatest sales volume tend to havethe lowest unit advertising costs. In other industries—especially aerospace, automo-biles, software, and telecommunications—the need to amortize the huge costs ofnew product development has forced consolidation. Where product development is182 Part IIi BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
very costly, volume is essential to profitability. The Boeing 747 was hugely profitable because 1508 were built between 1970 and 2014. The challenge for the Airbus A380 is whether there is sufficient worldwide demand to cover its $18 billion develop- ment cost. Yet, even in industries where scale economies are important, small and medium- sized companies continue to survive and prosper in competition with much bigger rivals. In automobiles, BMW, Jaguar Land Rover, and Hyundai have been more prof- itable than Toyota, Ford, and GM. In commercial banking, there is no evidence that big banks outperform smaller players either on profitability or costs.24 How do small and medium-sized firms offset the disadvantages of small scale? First, by exploit- ing superior flexibility; second, by outsourcing activities where scale is critical to efficiency (e.g., specialist car makers typically license technologies and designs and buy in engines); third, by avoiding the motivational and coordination problems that often afflict large organizations.25
Service offerings, too, can be designed for ease and efficiency of production. Motel6, cost leader in US budget motels, carefully designs its product to keep operatingcosts low. Its motels occupy low-cost, out-of-town locations; it uses standard moteldesigns; it avoids facilities such as pools and restaurants; and it designs rooms to facili-tate easy cleaning and low maintenance. However, efficiency in service design is com-promised by the tendency of customers to request deviations from standard offerings("I'd like my hamburger with the bun toasted on one side only, please"). This requiresa clear strategy to manage variability either through accommodation or restriction.31
Capacity Utilization Over the short and medium terms, plant capacity ismore or less fixed and variations in output cause capacity utilization to rise orfall. Underutilization raises unit costs because fixed costs must be spread over184 Part IIi BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Michel Hammer and James Champy describe how busi- financing request and walked it through all five steps. ness process re-engineering resulted in IBM reducing They discovered that all five stages could be com- the time taken to approve requests by sales personnel pleted within 90 minutes! for new customer credit approval from six days to four The problem was that the process had been hours. Under the old system, five stages were involved: designed for the most complex credit requests that IBM received, whereas in the vast majority of cases no 1 an IBM salesperson telephoned a request for specialist judgment was called for: all that was needed financing, which was logged on a piece of paper; was to check credit ratings and to plug numbers into 2 the request was sent to the credit department, standard algorithms. The credit approval process was which checked the customer's creditworthiness; redesigned by replacing the specialists (credit check- 3 the request and credit check were sent to the ers, pricers, and so on) with generalists who undertook business practices department where a loan cov- all five processes. Only where the request was non- enant was drawn up; standard or unusually complex were specialists called in. Not only was processing time reduced by 94%, 4 the paperwork was passed to a pricer, who deter- but the number of employees involved was reduced mined the interest rate; and the total number of customer approvals greatly 5 the clerical group prepared a quote letter that increased. was sent to the salesperson. Source: Adapted from M. Hammer and J. Champy, Frustrated by the delays and resulting lost sales, Re-engineering the Corporation: A Manifesto for Business two managers undertook an experiment. They took a Revolution (New York: HarperBusiness, 1993): 36–9.
fewer units of production; pushing output beyond normal full capacity also cre- ates inefficiencies. Boeing's efforts to boost output during 2006–2011 resulted in increased unit costs due to overtime pay, premiums for night and weekend shifts, increased defects, and higher levels of maintenance. Hence, the ability to speedily adjust capacity to downturns in demand can be a major source of cost advantage. During the 2008–2009 recession, survival in hard-hit sectors such as house building, construction equipment, and retailing required fast response to declining demand: Caterpillar announced it was cutting 20,000 jobs on January 28, 2008, the same day it reported a downturn in its quarterly sales.32
Input Costs The firms in an industry do not necessarily pay the same price for identical inputs. There are several sources of lower input costs:
● Locational differences in input prices: The prices of inputs, and wage rates in particular, vary between locations. In the US, software engineers earned an average of $82,000 in 2014. In India, the average was $11,000. In auto chapter 7 The Sources and Dimensions of Competitive Advantage 185
assembly the hourly rate in Chinese plants was about $3.50 an hour in 2014 compared with $28 in the US (not including benefits).33 ● Ownership of low-cost sources of supply: In raw-material-intensive industries, ownership of low-cost sources of material can offer a mas- sive cost advantage. In petroleum, lifting costs for the three "supermajors" (ExxonMobil, Royal Dutch Shell, and BP) were about $18 per barrel in 2013; for Saudi Aramco they were about $5. ● Non-union labor: Labor unions result in higher levels of pay and benefits and work rules that can lower productivity. In the US airline industry, non-union Virgin America had average salary and benefit cost per employee of $79,161 in 2013 compared with $98,300 for United (80% unionized). ● Bargaining power: The ability to negotiate preferential prices and discounts can be a major source of cost advantage for industry leaders, especially in retailing.34 Amazon's growing dominance of book retailing allows it to demand discounts from publishers of up to 60%.35
Residual Efficiency Even after taking account of the basic cost drivers—scale,technology, product and process design, input costs, and capacity utilization—unexplained cost differences between firms typically remain. These residual efficien-cies relate to the extent to which the firm approaches its efficiency frontier of optimaloperation which depends on the firm's ability to eliminate "organizational slack"36or "X-inefficiency."37 These excess costs have a propensity to accumulate within cor-porate headquarters—where they become targets for activist investors.38 Eliminatingthese excess costs often requires a threat to a company's survival—in his first year asCEO, Carlos Ghosn cut Nissan Motor's operating costs by 20%.39 At Walmart, Ryanair,and Amazon, high levels of residual efficiency are the result of management systemsand company values that are intolerant of unnecessary costs and glorify frugality.
A value chain analysis of a firm's cost position comprises the following stages:
1 Disaggregate the firm into separate activities: Determining the appropriate value chain activities is a matter of judgment. It requires identifying which activities186 Part IIi BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
are separate from one another, which are most important in terms of cost, and their dissimilarity in terms of cost drivers. 2 Estimate the cost that each activity contributes to total costs. Michael Porter suggests the detailed assignment of operating costs and assets to each value activity; however, even with activity-based costing, detailed cost allocation can be a major exercise.40 3 Identify cost drivers: For each activity, what factors determine the level of unit cost relative to other firms? For some activities, cost drivers can be deduced simply from the nature of the activity and the types of cost incurred. For activities with large fixed costs such as new product development or marketing, the principal cost driver is likely to be the ability to amortize costs over a large volume of sales. For labor-intensive activities, key cost drivers tend to be wage rates, process design, and defect rates. 4 Identify linkages: The costs of one activity may be determined, in part, by the way in which other activities are performed. Xerox discovered that its high ser- vice costs relative to competitors' reflected the complexity of design of its copi- ers, which required 30 different interrelated adjustments. 5 Identify opportunities for reducing costs: By identifying areas of comparative inefficiency and the cost drivers for each, opportunities for cost reduction become evident. If scale economies are a key cost driver, can volume be increased? If wage costs are excessive, will employees accept productivity-increasing mea- sures; alternatively, can production be relocated? If an activity cannot be per- formed efficiently within the firm, can it be outsourced?
Figure 7.10 shows how the application of the value chain to automobile manu- facture can identify possible cost reductions.
Differentiation Analysis
A firm differentiates itself from its competitors "when it provides something unique that is valuable to buyers beyond simply offering a lower price."41 Differentiation advantage occurs when a firm is able to obtain from its differentiation a price pre- mium that exceeds the cost of providing the differentiation. Every firm has opportunities for differentiating its offering to customers, although the range of differentiation opportunities depends on the characteristics of the product. An automobile or a restaurant offers greater potential for differentiation than cement, wheat, or memory chips. These latter products are called commodities precisely because they lack physical differentiation. Yet, according to Tom Peters, "Anything can be turned into a value-added product or service."42 Consider the following:
● Cement is the ultimate commodity product, yet Cemex, based in Mexico, has become a leading worldwide supplier of cement and ready-mix concrete through emphasizing "building solutions"—one aspect of which is ensuring that 98% of its deliveries are on time (compared to 34% for the industry as a whole).43 chapter 7 The Sources and Dimensions of Competitive Advantage 187
Figure 7.10 Using the value chain in cost analysis: An automobile manufacturer SEQUENCE OF ANALYSIS VALUE CHAIN COST DRIVER
The lesson is this: differentiation is not simply about offering different product features; it is about identifying and understanding every possible interaction between the firm and its customers and asking how these interactions can be enhanced or changed in order to deliver additional value to the customer. This requires looking at both the firm (the supply side) and its customers (the demand side). While supply- side analysis identifies the firm's potential to create uniqueness, the critical issue is whether such differentiation creates value for customers and whether the value cre- ated exceeds the cost of the differentiation. Only by understanding what customers want, how they choose, and what motivates them can we identify opportunities for profitable differentiation. Thus, differentiation strategies are not about pursuing uniqueness for its own sake. Differentiation is about understanding customers and how to best meet their needs. To this extent, the quest for differentiation advantage takes us to the heart of business strategy. The fundamental issues of differentiation are also the fundamental issues of business strategy: Who are our customers? How do we create value for them? And how do we do it more effectively and efficiently than anyone else? Because differentiation is about uniqueness, establishing differentiation advantage requires creativity: it cannot be achieved simply through applying standardized frame- works and techniques. This is not to say that differentiation advantage is not ame- nable to systematic analysis. As we have observed, there are two requirements for creating profitable differentiation. On the supply side, the firm must be aware of the resources and capabilities through which it can create uniqueness (and do it better than competitors). On the demand side, the key is insight into customers and their needs and preferences. These two sides form the major components of our analysis of differentiation.
differentiation includes every aspect of the way in which a company relates to itscustomers. Starbucks' ability to charge up to $5 for a cup of coffee (compared to a USaverage price of $1.38) rests not just on the characteristics of the coffee but also on theoverall "Starbucks Experience" which encompasses the retail environment, the senseof community in which customers participate, and the values that Starbucks projects.Differentiation activities are not specific to particular functions such as design andmarketing; they infuse all aspects of the relationship between an organization and itscustomers, including the identity and culture of a company. Differentiation includes both tangible and intangible dimensions. Tangible dif-ferentiation is concerned with the observable characteristics of a product or servicethat are relevant to customers' preferences and choice processes, for example size,shape, color, weight, design, material, and performance attributes such as reliability,consistency, taste, speed, durability, and safety. Tangible differentiation also extendsto products and services that complement the product in question: delivery, after-sales services, and accessories. Opportunities for intangible differentiation arise because the value that cus-tomers perceive in a product is seldom determined solely by observable productfeatures or objective performance criteria. Social, emotional, psychological, andesthetic considerations are present in most customer choices. For consumer goodsand services the desire for status, exclusivity, individuality, security, and communityare powerful motivational forces. Where a product or service is meeting complexcustomer needs, differentiation choices involve the overall image of the firm andits offering. Image differentiation is especially important for those products andservices whose qualities and performance are difficult to ascertain at the time ofpurchase (so-called experience goods). These include cosmetics, medical services,and education.
Getting back to strategy means getting back to a at all . . . We discovered next that grain distributiondeep understanding of what a product is about. Some and the time between grinding the beans and pouringtime ago, for example, a Japanese home appliance in the water were crucial. As a result we began to thinkcompany was trying to develop a coffee percolator. about the product and its necessary features in a newShould it be a General Electric-type percolator, execu- way. It had to have a built-in dechlorinating function. Ittives wondered? Should it be the same drip type that had to have a built-in grinder. All the customer shouldPhilips makes? Larger? Smaller? I urged them to ask a have to do is pour in water and beans . . .different kind of question: Why do people drink coffee? To start you have to ask the right questions and setWhat are they looking for when they do? If your objec- the right kinds of strategic goals. If your only concerntive is to serve the customer better, then shouldn't you is that General Electric has just brought out a percola-understand why that customer drinks coffee in the first tor that brews coffee in 10 minutes, you will get yourplace? Then you would know what kind of percolator engineers to design one that brews it in seven minutes.to make. And if you stick to that logic, market research will tell The answer came back: good taste. Then I asked you that instant coffee is the way to go . . . Conventionalthe company's engineers what they were doing to marketing approaches won't solve the problem. If youhelp the consumer enjoy good taste in a cup of coffee. ask people whether they want their coffee in 10 min-They said they were trying to design a good percola- utes or seven, they will say seven, of course. But it's stilltor. I asked them what influences the taste in a cup of the wrong question. And you end up back where youcoffee. No one knew. That became the next question started, trying to beat the competition at its own game.we had to answer. It turns out that lots of things can If your primary focus is on the competition, you willaffect taste—the beans, the temperature, the water. never step back and ask what the customers' inherentWe did our homework and discovered all the things needs are, and what the product really is about.that affect taste . . . Of all the factors, water quality, we learned, made Source: Reprinted by permission of Harvard Business Review. From "Getting Back to Strategy," Kenichi Ohmae, November/the greatest difference. The percolator in design at the December 1988, p. 154, Copyright © 1988 by the Harvardtime, however, didn't take water quality into account Business School Publishing Corporation; all rights reserved.
of "New Coke" in 1985 was the result of Coca-Cola giving precedence to tangi- ble differentiation (taste preferences) over intangible differentiation (authenticity).51 Harley-Davidson harbors no such illusions: it recognizes quite clearly that it is in the business of selling lifestyle, not transportation. If the dominant customer needs that a product satisfies are identity and social affiliation, the implications for differentiation are far reaching. In particular, to identify profitable differentiation opportunities requires that we analyze not only the prod- uct and its characteristics but also customers, their lifestyles and aspirations, and the relationship of the product to those lifestyles and aspirations. Market research that focuses upon traditional demographic and socioeconomic factors may be less useful than a deep understanding of consumers' relationships with a product. As consumers192 Part IIi BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Low High
Buf ferin EFFECTIVENESS Bayer
Private- label Anacin Excedrin aspirin
become increasingly sensitive to the activities of companies that supply their goods and services, so companies are drawn toward corporate social responsibility as a means of protecting and augmenting the value of their brands.52 Figure 7.12 summarizes the key points of this discussion by posing some basic questions that explore the potential for demand-side differentiation.
● A perfume can be sampled prior to purchase and its fragrance assessed, but its ability to augment the identity of the wearer and attract attention remains uncertain. Hence, the key role of branding, packaging, advertising, and lavish promotional events in establishing the perfume's identity and performance credentials. ● In financial services, the customer cannot easily assess the honesty, finan- cial security, or competence of the supplier. Hence, financial service com- panies emphasize symbols of security and stability: imposing head offices, conservative office decor, smartly dressed employees, and trademarks such as Prudential's rock and Travelers' red umbrella. Bernie Madoff's multibil- lion investment swindle was sustained by his close association with leading figures among New York's Jewish community, his prominent role in cultural and charitable organizations, and the aura of exclusivity around his invest- ment firm.
Brands Brands fulfill multiple roles. At its most basic level, a brand providesa guarantee of the quality of a product simply by identifying the producer of aproduct, thereby ensuring the producer is legally accountable for the products sup-plied. Further, the brand represents an investment that provides an incentive tomaintain quality and customer satisfaction. It is a credible signal of quality becauseof the disincentive of its owner to devalue it. As a result, a brand acts as a guaranteeto the customer that reduces uncertainty and search costs. The more difficult it is todiscern quality on inspection, and the greater the cost to the customer of purchasinga defective product, the greater the value of a brand: a trusted brand name is moreimportant to us when we purchase mountaineering equipment than when we buya pair of socks. This role of the brand as a guarantor of reliability is particularly significant ine-commerce. Internet transactions are characterized by the anonymity of buyers andsellers and lack of government regulation. As a result, well-established players ine-commerce—Amazon, Microsoft, eBay, and Yahoo!—can use their brand to reduceconsumers' perceived risk. By contrast, the value conferred by consumer brands such as Red Bull, Harley-Davidson, Mercedes-Benz, Gucci, Virgin, and American Express is less a guarantee ofreliability and more an embodiment of identity and lifestyle. Traditionally, advertisinghas been the primary means of influencing and reinforcing customer perceptions.Increasingly, however, consumer goods companies are seeking new approaches tobrand development that focus less on product characteristics and more on "brand196 Part IIi BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Value Chain Analysis of Producer Goods Using the value chain to identify opportunities for differentiation advantage involves three principal stages:
1 Construct a value chain for the firm and its customer. It may be useful to con- sider not just the immediate customer but also firms further downstream in the value chain. If the firm supplies different types of customers, it's useful to draw separate value chains for each major category of customer. 2 Identify the drivers of uniqueness in each activity of the firm's value chain. Figure 7.13 identifies some possible sources of differentiation within Porter's generic value chain. 3 Locate linkages between the value chain of the firm and that of the buyer. What can the firm do with its own value chain activities that can reduce the cost or enhance the differentiation potential of the customer's value chain activities? The amount of additional value that the firm creates for its customers through exploit- ing these linkages represents the potential price premium the firm can charge for its differentiation. Strategy Capsule 7.8 demonstrates the identification of differen- tiation opportunities by lining the value chains of a firm and its customers.
Figure 7.13 Using the value chain to identify differentiation potential on thesupply side
Customer technical Quality of Defect-free Fast delivery. Building support. Consumer components products. Ef f icient order brand credit. Availability and materials Wide variety processing reputation of spares
The metal container industry is a highly competitive, low- 2 Manufacturing cans to high tolerances can mini- growth, low-profit industry. Cans lack much potential for mize breakdowns on customers' canning lines. differentiation, and buyers (especially beverage and food 3 Reliable, punctual can deliveries allow canners to canning companies) are very powerful. Cost efficiency is economize on their can inventories. essential, but can we also identify opportunities for prof- 4 An efficient order-processing system reduces itable differentiation? Following the procedure outlined canners' ordering costs. above, we can construct a value chain for a firm and its customers, and then identify linkages between the two. 5 Speedy, proficient technical support allows cus-
Figure 7.14 identifies five such linkages: tomers to operate their canning lines with high- capacity utilization. 1 Distinctive can designs (e.g., Sapporo's beer can) can support the customer's efforts to differentiate its product.
Figure 7.14 Identifying differentiation opportunities by linking the firm's value chain to that of the customer
1 5 2 3 4 Inventory holding Inventory holding
Inventory holding
technical support Supplies of steel
Manufacturing and aluminum
Distribution engineering
Purchasing Service and
Processing Purchasing
Marketing Canning Design
The firm stuck in the middle is almost guaranteed low profitability. It either loses the high-volume customers who demand low prices or must bid away its profits to get this business from the low-cost firms. Yet it also loses high-margin business— the cream—to the firms who are focused on high-margin targets or have achieved differentiation overall. The firm that is stuck in the middle also probably suffers from a blurred corporate culture and a conflicting set of organizational arrange- ments and motivation system.60 chapter 7 The Sources and Dimensions of Competitive Advantage 199
In practice, few firms are faced with such stark alternatives. Differentiation isnot simply an issue of "to differentiate or not to differentiate." All firms must makedecisions as to which customer requirements to focus on and where to positiontheir product or service in the market. A cost leadership strategy typically implieslimited-feature, standardized offerings, but this does not necessarily imply that theproduct or service is an undifferentiated commodity. Southwest Airlines and AirAsiaare budget airlines with a no-frills offering yet have clear market positions withunique brand images. The VW Beetle shows that a utilitarian, mass-market productcan achieve cult status. In most industries, market leadership is held by a firm that maximizes cus-tomer appeal by reconciling effective differentiation with low cost—Toyota in cars,McDonald's in fast food, Nike in athletic shoes. The simultaneous pursuit of costefficiency, quality, innovation, and brand building was a feature of Japanese suppli-ers of cars, motorcycles, consumer electronics, and musical instruments during thelate 20th century. In many industries, the cost leader is not the market leader but asmaller competitor with minimal overheads, non-union labor and cheaply acquiredassets. In oil refining, the cost leaders tend to be independent refining companiesrather than integrated giants such as ExxonMobil or Shell. In car rental, the costleader is more likely to be Rent-A-Wreck (a subsidiary of J. J. F. Management, Inc.)rather than Hertz or Avis. Reconciling cost efficiency with differentiation has beenfacilitated by new management techniques: total quality management has repudi-ated perceived tradeoff between quality and cost; flexible manufacturing systemshave reconciled scale economies with variety.200 Part IIi BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Summary Making money in business requires establishing and sustaining competitive advantage. Identifying opportunities for competitive advantage requires insight into the nature and process of competition within a market. Our analysis of the imperfections of the com- petitive process takes us back to the resources and capabilities needed to compete in a particular market and conditions under which these are available. Similarly, the isolating mechanisms that sustain competitive advantage are dependent primarily upon the ability of rivals to access the resources and capabilities needed for imitation. Competitive advantage has two primary dimensions: cost advantage and differentia- tion advantage. The first of these, cost advantage, is the outcome of seven primary cost drivers. We showed that by applying these cost drivers and by disaggregating the firm into a value chain of linked activities we can appraise a firm's cost position relative to competi- tors and identify opportunities for cost reduction. The principal message of this section is the need to look behind cost accounting data and beyond simplistic approaches to cost efficiency, and to analyze the factors that drive relative unit costs in each of the firm's activities in a systematic and comprehensive manner. The appeal of differentiation is that it offers multiple opportunities for competitive advantage with a greater potential for sustainability than does cost advantage. The vast realm of differentiation opportunity extends beyond marketing and design to encompass all aspects of a firm's interactions with its customers. Achieving a differentiation advantage requires the firm to match its own capacity for creating uniqueness to the requirements and preferences of customers. The value chain offers firms a useful framework for identify- ing how they can create value for their customers by combining demand-side and supply- side sources of differentiation. Finally, the basis of a firm's competitive advantage has important implications not just for the design of its strategy but for the design of its organizational structure and systems. Typically, companies that are focused on cost leadership design their orga- nizations differently from those that pursue differentiation. However, the implications of competitive strategy for organizational design are complicated by the fact that, for most firms, cost efficiency and differentiation are not mutually exclusive—in today's intensely competitive markets, firms have little choice but to pursue both.
Self-Study Questions 1. Figure 7.1 implies that stable industries, where firms have similar resources and capa- bilities, offer less opportunity for competitive advantage than industries where change is rapid and firms are heterogeneous. On the basis of these considerations, among the fol- lowing industries, in which do you predict that inter-firm differences in profitability will chapter 7 The Sources and Dimensions of Competitive Advantage 201
be small and in which will they be wide: retail banking, video games, wireless hand- sets, insurance, supermarkets, and semiconductors? 2. Since 2009, Apple has been the world's most profitable supplier of wireless handsets by a large margin. Can Apple sustain its competitive advantage in this market? 3. Illy, the Italian-based supplier of quality coffee and coffee-making equipment, is launch- ing an international chain of gourmet coffee shops. What advice would you offer Illy for how it can best build competitive advantage in the face of Starbucks' market leadership? 4. Which drivers of cost advantage (Figure 7.7) did Sears exploit in order to offer its Sears Motor Buggy "at a price within the reach of all"? (See quotation that opens this chapter.) 5. Target (the US discount retailer), H&M (the Swedish fashion clothing chain), and Primark (the UK discount clothing chain) have pioneered cheap chic—combining dis- count store prices with fashion appeal. What are the principal challenges of designing and implementing a cheap chic strategy? Design a cheap chic strategy for a company entering another market e.g., restaurants, sports shoes, cosmetics, or office furniture. 6. To what extent are the seven cost drivers shown in Figure 7.7 relevant in analyzing the costs per student at your business school or educational institution? What recommen- dations would you make to your dean for improving the cost efficiency of your school? 7. Bottled water sells at least 200 times the price of tap water, with substantial price dif- ferentials between different brands. What are the key differentiation variables that determine the price premium that can be obtained for bottled water? 8. Advise a chain of movie theaters on a differentiation strategy to restore its flagging profitability. Use the value chain framework outlined in Strategy Capsule 7.8 to iden- tify potential linkages between the company's value chain and that of its customers in order to identify differentiation opportunities.
1. Richard Rumelt argues that competitive advantage lacks 2010): 370–382; and S. Fourné, J. Jansen, and a clear and consistent definition ("What in the World is T. Mom, "Strategic Agility in MNEs: Managing Tensions to Competitive Advantage?" Policy Working Paper 2003- Capture Opportunities across Emerging and Established 105, Anderson School, UCLA, August, 2003). Markets," California Management Review, 56 (Spring 2014) 2. K. Ferdows, M. A. Lewis, and J. Machuca, "Rapid-Fire 5. J. A. Schumpeter, Capitalism, Socialism and Democracy Fulfillment," Harvard Business Review (November 2004): (London: Routledge, 1994, first published 1942): 82–83. 104–110. 6. C. Kim and R. Mauborgne, "Blue Ocean Strategy," 3. G. Stalk Jr., "Time: The Next Source of Competitive Harvard Business Review (October 2004). A similar Advantage," Harvard Business Review ( July/August, approach to analyzing strategic innovation is McKinsey's 1988): 41–51. new game strategies. See: R. Buaron, "New Game 4. See, for example: Y. Doz and M. Kosonen, "Embedding Strategies," McKinsey Quarterly Anthology (2000 ): 34–36. Strategic Agility: A Leadership Agenda for Accelerating 7. G. Hamel, "The Why, What, and How of Management Business Model Renewal," Long Range Planning, 43 (April Innovation," Harvard Business Review (February 2006).202 Part IIi BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
8. R. P. Rumelt, "Toward a Strategic Theory of the Firm," 27. L. Argote, S. L. Beckman, and D. Epple, "The in R. Lamb (ed.), Competitive Strategic Management Persistence and Transfer of Learning in Industrial (Englewood Cliffs, NJ: Prentice Hall, 1984): 556–570. Settings,"Management Science 36 (1990): 140–154; 9. R. Jacobsen, "The Persistence of Abnormal M. Zollo and S. G. Winter, "Deliberate Learning and Returns,"Strategic Management Journal 9 (1988): the Evolution of Dynamic Capabilities," Organization 415–430; R. R. Wiggins and T. W. Ruefli, "Schumpeter's Science 13 (2002): 339–351. Ghost: Is Hypercompetition Making the Best of Times 28. J. Womack and D. T. Jones, "From Lean Production Shorter?" Strategic Management Journal 26 (2005): 887–911. to Lean Enterprise," Harvard Business Review 10. G. Stalk, "Curveball: Strategies to Fool the Competition," (March/April 1994); J. Womack and D. T. Jones, Harvard Business Review (September 2006): 114–122. "Beyond Toyota: How to Root Out Waste and Pursue 11. The film was based on the book by B. Traven, Perfection," Harvard Business Review (September/ The Treasure of the Sierra Madre (New York: October, 1996). Knopf, 1947). 29. M. Hammer and J. Champy, Re-engineering the 12. Monopolies and Mergers Commission, Cat and Dog Corporation: A Manifesto for Business Revolution (New Foods (London: Her Majesty's Stationery Office, 1977). York: HarperBusiness, 1993): 32. 13. D. Besanko, D. Dranove, S. Schaefer, and M. Shanley, 30. V. Glover and M. L. Marcus, "Business Process Economics of Strategy, 6th edn. (Hoboken, NJ: John Transformation," Advances in Management Information Wiley & Sons, Inc., 2013): section on "Limit Pricing," pp. Systems 9 (M. E. Sharpe, March 2008); R. Merrifield, 207–211. J. Calhoun, and D. Stevens, "The Next Revolution in 14. T. C. Schelling, The Strategy of Conflict, 2nd edn Productivity," Harvard Business Review (November (Cambridge, MA: Harvard University Press, 1980): 35–41. 2006): 72–79. 15. A. Brandenburger and B. Nalebuff, Co-opetition (New 31 F. X. Frei, "Breaking the Tradeoff between Efficiency and York: Doubleday, 1996): 72–80. Service," Harvard Business Review (November 2006): 16. R. Schmalensee, "Entry Deterrence in the Ready-to-Eat 92–103. Breakfast Cereal Industry," Bell Journal of Economics 9 32. "Caterpillar to Cut 20,000 Jobs as Downturn Worsens," (1978): 305–327. Wall Street Journal ( January 28, 2009). 17. Monopolies and Mergers Commission, Indirect 33. Bureau of Labor Statistics, http://www.bls.gov/iag/tgs/ Electrostatic Reprographic Equipment (London: Her iagauto.htm, accessed July 20, 2015. Majesty's Stationery Office, 1976): 37, 56. 34. "Buying Power of Multiproduct Retailers," OECD Journal 18. S. A. Lippman and R. P. Rumelt, "Uncertain Imitability: of Competition Law and Policy 2 (March, 2000). An Analysis of Interfirm Differences in Efficiency under 35. P. Krugman, "Amazon's Monopsony Is Not O.K.," New Competition,"Bell Journal of Economics 13 (1982): York Times (October 19, 2014). 418–438. See also: R. Reed and R. DeFillippi, "Causal 36. R. Cyert and J. March, A Behavioral Theory of the Firm Ambiguity, Barriers to Imitation, and Sustainable (Englewood Cliffs, NJ: Prentice Hall, 1963). Competitive Advantage," Academy of Management 37. H. Leibenstein, "Allocative Efficiency versus X-Efficiency," Review 15 (1990): 88–102. American Economic Review 54 ( June 1966): 392–415. 19. P. R. Milgrom and J. Roberts, "Complementarities and 38. "Fighting the Flab," Economist (March 22, 2014). Fit: Strategy, Structure and Organizational Change in 39. K. Kase, F. J. Saez, and H. Riquelme, The New Samurais Manufacturing," Journal of Accounting and Economics of Japanese Industry (Cheltenham: Edward Elgar, 2006). 19 (1995): 179–208. 40. M. E. Porter, Competitive Advantage (New York: Free 20. J. W. Rivkin, "Imitation of Complex Strategies," Press, 1985): 87; and R. S. Kaplan and S. R. Anderson, Management Science 46 (2000): 824–844. "Time-Driven Activity-based Costing," Harvard Business 21. M. E. Porter and N. Siggelkow, "Contextuality Review (November 2004): 131–138. within Activity Systems and Sustainable Competitive 41. M. E. Porter, Competitive Advantage (New York: Free Advantage,"Academy of Management Perspectives 22 (May Press, 1985): 120. 2008): 34–56. 42. T. Peters, Thriving on Chaos (New York: Knopf, 1987): 56. 22. M. E. Porter, Competitive Advantage (New York: Free 43. "Cemex: Cementing a Global Strategy," Insead Case No. Press, 1985): 13. 307-233-1 (2007). 23. Ibid.,: 120. 44. The distinction between segmentation and differentia- 24. M. Venzin, Building an International Financial Services tion is discussed in P. R. Dickson and J. L. Ginter, "Market Firm: How Successful Firms Design and Execute Cross- Segmentation, Product Differentiation and Marketing border Strategies (Oxford: Oxford University Press, 2009). Strategy," Journal of Marketing 51 (April 1987): 1–10. 25. R. P. McAfee and J. McMillan, "Organizational 45. S. Schiffman, M. Reynolds, and F. Young, Introduction Diseconomies of Scale," Journal of Economics and to Multidimensional Scaling: Theory, Methods, and Management Strategy 4 (1996): 399–426. Applications (Cambridge, MA: Academic Press, 1981). 26. L. Rapping, "Learning and World War II Production 46. F.-J. Lapointe and P. Legendre, "A Classification of Pure Functions," Review of Economics and Statistics (February Malt Scotch Whiskies," Applied Statistics 43 (1994): 237– 1965): 81–86. 257. On the principles of MDS, see I. Borg and chapter 7 The Sources and Dimensions of Competitive Advantage 203
P. Groenen, Modern Multidimensional Scaling: Theory 53. Porter, Competitive Advantage, op. cit.,124–125. and Application (New York: Springer-Verlag, 1997). 54. S. Mathur, "Competitive Industrial Marketing Strategies," 47. P. Cattin and D. R. Wittink, "Commercial Use of Conjoint Long Range Planning 17 (1984): 102–109. Analysis: A Survey," Journal of Marketing 46 (Summer 55. K. R. Tuli, A. K. Kohli, and S. G. Bharadwaj, "Rethinking 1982): 44–53. Customer Solutions: From Product Bundles to Relational 48. K. Lancaster, Consumer Demand: A New Approach Processes," Journal of Marketing 71, (2007): 1–17. (New York: Columbia University Press, 1971). 56. K. Clark and T. Fujimoto, Product Development 49. P. Nicolaides and C. Baden-Fuller, Price Discrimination Performance (Boston: Harvard Business School Press, and Product Differentiation in the European Domestic 1991): 29–30. Appliance Market (London: Center for Business Strategy, 57. K. B. Clark and T. Fujimoto, "The Power of Product London Business School, 1987). Integrity," Harvard Business Review (November/ 50. A. Maslow, "A Theory of Human Motivation," December, 1990): 107–118. Psychological Review 50 (1943): 370–396. 58. "The Madoff Affair: Going Down Quietly," Economist 51. "Coke Lore: The Real Story of New Coke," www.theco- (March 14, 2009). cacolacompany.com/heritage/cokelore_newcoke.html, 59. D. J. Watts and J. Peretti, "Viral Marketing for the Real accessed July 20, 2015. World," Harvard Business Review (May 2007): 22–23. 52. S. Zadek, "The Path to Corporate Responsibility," 60. M. E. Porter, Competitive Strategy (New York: Free Press, Harvard Business Review, 82 (December, 2004): 125–129. 1980): 42. 8 I ndustry Evolution and Strategic Change
No company ever stops changing . . . Each new generation must meet changes—in the automotive market, in the general administration of the enterprise, and in the involvement of the corporation in a changing world. The work of creating goes on. —ALFRED P. SLOAN JR., PRESIDENT OF GENERAL MOTORS 1923–37, CHAIRMAN 1937–56
It is not the strongest of the species that survive, nor the most intelligent, but the one that is most responsive to change. —CHARLES DARWIN
By the time you have completed this chapter, you will be able to: ◆◆ Recognize the different stages of industry development and understand the factors that drive the process of industry evolution. ◆◆ Identify the key success factors associated with industries at different stages of their devel- opment and recommend strategies, organizational structures, and management systems appropriate to these stages. ◆◆ Appreciate the sources of organizational inertia, the challenges of managing strategic change, and be familiar with different approaches to strategic change—including the use of scenario analysis and the quest for ambidexterity. chapter 8 Industry Evolution and Strategic Change 207
◆◆ Become familiar with the different approaches that firms have taken in developing orga- nizational capabilities—and the merits and pitfalls of each. ◆◆ Recognize the principal tools of knowledge management and the roles they can play in developing organizational capability.
One of the best-known and most enduring marketing concepts is the product lifecycle.1 Products are born, their sales grow, they reach maturity, they go into decline,and they ultimately die. If products have life cycles, so the industries that producethem experience an industry life cycle. To the extent that an industry producesmultiple generations of a product, the industry life cycle is likely to be of longerduration than that of a single product. The life cycle comprises four phases: introduction (or emergence), growth, matu-rity, and decline (Figure 8.1). Let us first examine the forces that drive industryevolution, and then look at the features of each of these stages. Two forces are fun-damental: demand growth and the production and diffusion of knowledge.
Demand GrowthThe life cycle and the stages within it are defined primarily by changes in an indus-try's growth rate over time. The characteristic profile is an S-shaped growth curve.
● In the introduction stage, sales are small and the rate of market penetration is low because the industry's products are little known and customers are few. The novelty of the technology, small scale of production, and lack of experience mean high costs and low quality. Customers for new products tend to be affluent, innovation-oriented, and risk-tolerant.
MATURITY Industry Sales
INTRODUCTION Time208 Part III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
● The first 30 years of steam ships featured competition between paddles and propellers, wooden hulls and iron hulls, and, eventually, between coal and oil. ● The beginnings of the home computer industry during 1978–1982 saw com- petition between different data storage systems (audiotapes versus floppy disks), visual displays (TV receivers versus dedicated monitors), operating systems (CPM versus DOS versus Apple II), and microprocessors.
The concepts of dominant design and technical standard are related but distinct. Dominant design refers to the overall configuration of a product or system. chapter 8 Industry Evolution and Strategic Change 209
Process Innovation
Product Innovation
Time210 Part III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Strategy Capsule 8.1 uses the history of the automobile industry to illustrate these patterns of development. Knowledge diffusion is also important on the customer side. Over the course of the life cycle, customers become increasingly informed. As they become more knowledgeable about the performance attributes of rival manufacturers' prod- ucts, so they are better able to judge value for money and become more price sensitive.
The period 1890–1912 was one of rapid product inno- cylinders became dominant. Distinctive national dif- vation in the auto industry. After 1886, when Karl Benz ferences eroded as American cars became smaller and received a patent on his three-wheel motor carriage, Japanese and Italian cars became bigger. The fall of a flurry of technical advances occurred in Germany, the Iron Curtain extinguished the last outposts of non- France, the US, and the UK. Developments included: conformity: by the mid-1990s, East German two-stroke Wartburgs and Trabants were collectors' items. ◆◆ the first four-cylinder four-stroke engine (by Karl As product innovation slowed, so process innova- Benz in 1890); tion took off. In October 1913, Ford opened its Highland ◆◆ the honeycomb radiator (by Daimler in 1890); Park Assembly Plant, with its revolutionary production methods based on interchangeable parts and a mov- ◆◆ the manual gearbox (Panhard and Levassor in ing assembly line. Radical productivity improvement 1895); resulted in the price of the Model T falling from $628 in ◆◆ automatic transmission (by Packard in 1904); 1908 to $260 in 1924. By 1927, 15 million Model T's had ◆◆ electric headlamps (by General Motors in 1908); been produced. ◆◆ the all-steel body (adopted by General Motors in The second major process innovation in automo- 1912). biles was Toyota's system of lean production, involving a tightly integrated "pull" system of production embody- Ford's Model T, introduced in 1908, with its front- ing just-in-time scheduling, team-based production, mounted, water-cooled engine and transmission with flexible manufacturing, and total quality management. a gearbox, wet clutch, and rear-wheel drive, acted During the 1970s and 1980s, lean production diffused as a dominant design for the industry. During the throughout the world's vehicle industry in the same remainder of the 20th century, automotive technol- way that Ford's mass-production system had trans- ogy and design converged. A key indicator of this was formed the industry half a century before. the gradual elimination of alternative technologies However, by 2015 this period of technological sta- and designs. Volkswagen's Beetle was the last mass- bility was threatened by two developments: electric produced car with a rear-mounted, air-cooled engine. cars and driverless cars. Citroen abandoned its distinctive suspension and brak- Sources: www.ford.com; http://en.wikipedia.org/wiki/ ing systems. Four-stroke engines with four or six inline History_of_the_automobile. chapter 8 Industry Evolution and Strategic Change 211
● The hotel industry has its origins over two millennia ago. In year 1 ad, the baby Jesus was born in a stable in Bethlehem because, according to Luke's Gospel, "there was no room at the inn." In the US, hotels (as distinct from inns) were established in the late 18th century. After World War II, the indus- try grew rapidly with expanding tourism and business travel. However, dur- ing the 21st century the industry began making the transition from maturity to decline with the growth of videoconferencing and advent of residential sharing services such as Airbnb. ● The introduction phase of the US railroad industry extended from the build- ing of the first railroad, the Baltimore and Ohio in 1827, to the growth phase of the 1870s. With the growth of road transport, the industry entered its decline phase during the late 1950s. ● In personal computers, the introduction phase lasted a mere four years before growth took off in 1978. Between 1978 and 1983, a flood of new and established firms entered the industry. During the 1990s, growth slowed, excess capacity emerged, and the industry began to consolidate around fewer companies. In 2011, global sales of PCs peaked and the industry entered its decline phase. ●● Digital audio players (MP3 players) were first introduced by Seehan Information Systems and Diamond Multimedia in 1997. With the launch of Apple's iPod in 2001, the industry entered its growth phase. After reaching a peak in 2009, global sales of MP3 players, including the iPod, went into steep decline. By 2015, dedicated MP3 players were widely viewed as obsolete.
Over time, industry life cycles have become increasingly compressed. This isespecially evident in e-commerce. The speed of diffusion of online gambling, onlinetaxi services, and social networking have reduced the time from initial introduc-tion to maturity to a few years. The implication is that "competing on internet time"requires a radical rethink of strategies and management processes.4 Patterns of evolution also differ. Industries supplying basic necessities such as res-idential construction, food processing and clothing may never enter a decline phasebecause obsolescence is unlikely for such needs. Some industries may experiencea rejuvenation of their life cycle. The market for TV receivers has experienced mul-tiple revivals: color TVs, portable TVs, flat-screen TVs, and HDTVs. Similar waves ofinnovation have revitalized retailing (Figure 8.3). An industry is likely to be at different stages of its life cycle in different countries.Although the automobile markets of the EU, Japan, and the US are in their declinephase, those of Asia and Latin America are in their growth phase. Multinationalcompanies can exploit such differences: developing new products and introducingthem into the advanced industrial countries, then shifting attention to other growthmarkets once maturity sets in. A further feature of industry evolution is shifting industry boundaries—someindustries converge (cell phones, portable game players, cameras, and calculators);212 Part III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Figure 8.3 Innovation and renewal in the industry life cycle: Retailing
● The number of firms in an industry increases rapidly during the early stages of an industry's life. Initially, an industry may be pioneered by a few firms. However, as the industry gains legitimacy, failure rates decline and the rate of new firm foundings increases. The US automobile industry comprised 272 manufacturers in 1909,7 while in TV receivers there were 92 companies in chapter 8 Industry Evolution and Strategic Change 213
Table 8.1 The evolution of industry structure and competition over the life cycle Introduction Growth Maturity DeclineDemand Limited to early Rapidly increasing Mass market, replacement/ Obsolescence adopters: market penetration repeat buying. Customers high-income, knowledgeable and price avant-garde sensitiveTechnology Competing technolo- Standardization Well-diffused technical Little product or pro- gies, rapid product around dominant know-how: quest for cess innovation innovation technology, rapid technological process innovation improvements.Products Poor quality, wide Design and quality Trend to commoditization. Commodities the variety of features improve, emer- Attempts to differentiate norm: differentia- and technologies, gence of dominant by branding, quality, and tion difficult and frequent design design bundling unprofitable changesManufacturing Short production Capacity shortages, Emergence of overcapacity, Chronic overcapacity, and runs, high-skilled mass production, deskilling of production, reemergence of distribution labor content, spe- competition for long production runs, specialty channels cialized distribution distribution distributors carry fewer channels linesTrade Producers and Exports from Production shifts to newly Exports from coun- consumers in advanced countries industrializing then devel- tries with lowest advanced countries to rest of world oping countries labor costsCompetition Few companies Entry, mergers, and Shakeout, price Price wars, exits exits competition increasesKey success Product innovation, Design for manu- Cost efficiency through Low overheads, factors establishing cred- facture, access to capital intensity, scale buyer selection, ible image of firm distribution, brand efficiency, and low input signaling commit- and product building, fast prod- costs ment, rationalizing uct development, capacity process innovation
1951.8 New entrants have very different origins. Some are start-up compa- nies (de novo entrants); others are established firms diversifying from related industries (de alio entrants). ● With the onset of maturity, the number of firms begins to fall. Very often, industries go through one or more shakeout phases during which the rate of firm failure increases sharply. After this point, rates of entry and exit decline and the survival rate for incumbents increases substantially.9 The shakeout phase of intensive acquisition, merger, and exit occurs, on aver- age, 29 years into the life cycle and results in the number of producers being halved.10 In the US tire industry, the number of firms grew from one (Goodrich) in 1896 to 274 in 1922 before shakeout reduced the industry to 49 firms in 1936.11 ●● As industries become increasingly concentrated and the leading firms focus on the mass market, so a new phase of entry may take place as new firms create niche positions in the market. An example of this resource partitioning214 Part III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Key Success Factors and Industry Evolution These same changes in structure together with changes in demand and technology over the industry life cycle also have important implications for the sources of competitive advantage at each stage of industry evolution: chapter 8 Industry Evolution and Strategic Change 215
Growth 6 Maturity Decline
Value Added/Revenue
Technical Change
New Products
Advertising/SalesNote: The figure shows standardized means for each variable for businesses at each stage of the life cycle.Source: C. Anderson and C. Zeithaml, "Stage of the Product Life Cycle, Business Strategy and BusinessPerformance," Academy of Management Journal 27 (1984): 5–24.
1 During the introductory stage, product innovation is the basis for initial entry and for subsequent success. Soon, other requirements for success emerge: grow- ing investment requirements necessitate increased financial resources; product development needs to be supported by capabilities in manufacturing, market- ing, and distribution. 2 Once the growth stage is reached, the key challenge is scaling up. As the mar- ket expands, product design and manufacturing must adapt to the needs of large-scale production. As Figure 8.4 shows, investment in R & D, plant and equipment, and sales tends to be high during the growth phase. Increased manufacturing must be matched by widening distribution. 3 With the maturity stage, competitive advantage is increasingly a quest for effi- ciency, particularly in industries that tend toward commoditization. Cost efficiency through scale economies, low wages, and low overheads becomes the key suc- cess factor. Figure 8.4 shows that R & D, capital investment, and marketing are lower in maturity than during the growth phase. 4 The transition to decline intensifies pressures for cost cutting. It also requires maintaining stability by encouraging the orderly exit of industry capacity and capturing residual market demand. We consider the strategic issues presented by mature and declining industries more fully in Chapter 10.216 Part III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
We have established that industries change. But what about the companies within them? Let us turn our attention to business enterprises and consider both the impedi- ments to change and the means by which change takes place.
During the 1980s, Liz Claiborne became a highly suc- latest collection, and tracked customer preferencescessful designer, manufacturer, and retailer of clothes for through point-of-sale data collection.professional women. Liz Claiborne's success was based ◆◆ Rather than the conventional four-season productupon a strategy that combined a number of closely cycle, Liz Claiborne operated a six-season cycle.linked choices concerning functions and activities. During the 1990s, Liz Claiborne's performance◆◆ Design was based around a "color by numbers" went into a sharp decline. The key problem was the approach involving "concept groups" of different trend toward more casual clothes in the workplace. garments that could be mixed and matched. Moreover, financial pressures on department stores
◆◆ Department stores were encouraged to provide made them less willing to buy complete collections.
dedicated space to present Liz Claiborne's concept As a result Liz Claiborne allowed reordering by retailers.
collections. Liz Claiborne consultants visited depart- However, once retailers could split orders into smaller,
ment stores to train their sales staff and to ensure more frequent orders, the entire Liz Claiborne system
that the collections were being displayed correctly. began to break down: it could not adapt to the quick- response, fast-cycle model that was increasingly domi-◆◆ Retailers could not purchase individual garment nant within the garment trade. In 1994, Liz Claiborne lines; they were required to purchase the entire appointed a new CEO who systematically rebuilt the concept group and had to submit a single order business around a more casual look more flexibility for each season—they could not reorder. within its collections (although still with a common◆◆ Most manufacturing was contracted out to gar- "color card"), and a shorter supply chain, with most pro- ment makers in SE Asia. duction in North and Central America.◆◆ To create close contact with customers, Liz Claiborne Source: N. Siggelkow, "Change in the Presence of Fit: The Rise, offered fashion shows at department stores, "break- the Fall, and the Renaissance of Liz Claiborne," Academy of fast clinics" where potential customers could see the Management Journal 44 (2001): 838–57.218 Part III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Sources: L. Hannah "Marshall's 'Trees' and the Global 'Forest': Were 'Giant Redwoods' Different?" in N. Lamoreaux,D. Raff, and P. Temin (eds), Learning by Doing in Markets, Firms and Nations, Chicago: University of Chicago Press,1999: 253–94; Financial Times (January 3, 2015).
Even though the industry life cycle involves changes that are largely predictable,changing key success factors implies that the different stages of the life cycle requiredifferent resources and capabilities. The innovators that pioneer the creation of a newindustry are typically different companies from the "consolidators" that develop it:
The fact that the firms that create new product and service markets are rarely the ones that scale them into mass markets has serious implications for the modern corporation. Our research points to a simple reason for this phenomenon: the skills, mind-sets, and competences needed for discovery and invention are not only different from those needed for commercialization; they conflict with the needed characteristics. This means that the firms good at invention are unlikely to be good at commercialization and vice versa.26
The typical pattern is that technology-based start-ups that pioneer new areasof business are acquired by companies that are well established in closely relatedindustries, and these established incumbents offer the financial resources and func-tional capabilities needed to grow the start-up. In plant biotechnology, the pioneerswere start-ups such as Calgene, Cetus Corporation, DNA Plant Technologies, andMycogen; by 2015, the leading suppliers of genetically modified seeds were DuPont,Monsanto, Syngenta, and Dow Chemical—all long-established chemical firms. Ofcourse, some start-ups do survive industry shakeouts and acquisition to becomeindustry leaders: Google, Cisco Systems, and Facebook are examples. GeoffreyMoore describes the transition from a start-up serving early adopters to an estab-lished business serving mainstream customers as "crossing the chasm."27 In most new industries we find a mixture of start-up companies (de novo entrants)and established companies that have diversified from other sectors (de alio entrants).Which are likely to be more successful? The basic issue is whether the flexibilityand entrepreneurial advantages of start-ups outweigh the superior resources and220 Part III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
capabilities of established firms. This further depends upon whether the resources and capabilities required in the new industry are similar to those present in an exist- ing industry. Where these linkages are close, de alio entrants are at an advantage: in automobiles, former bicycle, carriage, and engine manufacturers tended to be the best performers;28 television production was dominated by former producers of radios.29 Many start-up ventures also draw resources and capabilities from established firms. A high proportion of new ventures are established by former employees of existing firms within that sector. In Silicon Valley most of the leading semiconductor firms, including Intel, trace their origins to Shockley Semiconductor Laboratories, the pioneer of integrated circuits.30 Established companies are often important investors in new ventures. Investors in Uber include the Chinese internet giant Baidu and the founders of Amazon, Napster, and Yelp.