This Document Contains Chapters 3 to 4 Chapter 3 The Internal Organization: Resources, Capabilities, Core Competencies, and Competitive Advantages LEARNING OBJECTIVES 1. Explain why firms need to study and understand their internal organization. 2. Define value and discuss its importance. 3. Describe the differences between tangible and intangible resources. 4. Define capabilities and discuss their development. 5. Describe four criteria used to determine whether resources and capabilities are core competencies. 6. Explain how firms analyze their value chain for the purpose of determining where they are able to create value when using their resources, capabilities, and core competencies. 7. Define outsourcing and discuss reasons for its use. 8. Discuss the importance of identifying internal strengths and weaknesses. 9. Discuss the importance of avoiding core rigidities. CHAPTER OUTLINE Opening Case Zara: The Capabilities Behind the Spanish “Fast Fashion” Retail Giant ANALYZING THE INTERNAL ORGANIZATION The Context of Internal Analysis Creating Value The Challenge of Analyzing the Internal Organization Resources, Capabilities, Core Competencies Strategic Focus Emphasis on Value Creation through Tangibile (Kinder Morgan) and Intangible (Coca-Cola Inc.) Resources Strategic Focus Samsung Bests Apple in Smartphone Sales by Its Imitation Capability Building Core Competencies Value Chain Analysis Outsourcing Competencies, Strengths, Weaknesses, and Strategic Decisions SUMMARY REVIEW QUESTIONS EXPERIENTIAL EXERCISES VIDEO CASE This Document Contains Chapters 3 to 4 LECTURE NOTES Chapter Introduction: As indicated in Chapter 1, firms follow two competing models to generate the inputs needed to formulate and implement strategies. Chapter 2 focused on the external environment, which is the foundation of the I/O model. The emphasis in Chapter 3 is on internal resources and their potential to create competitive advantage for the firm, which falls in line with the resource-based model. This orientation is perhaps best captured by the elements of Figure 3.1, which should be emphasized. However, it should also be emphasized that no competitive advantage lasts forever and, over time, any firm’s value-creating strategy can be duplicated. OPENING CASE Zara: The Capabilities behind the Spanish “Fast Fashion” Retail Giant Zara has established itself as the world’s largest fashion retailer through the use of branded products and company-owned stores. It opened its six thousandth store in London in 2012. Zara uses its resources and capabilities as the foundation for its core competencies. Two rules guide the company: Give customers what they want, and get it to them faster than anyone else. To do this Zara has developed several capabilities including the ability to design quickly, collect timely information on customer tastes and habits, and manage its supply chain more efficiently than competitors. Customers appreciate the rapid inventory turnover which encourages them to visit the stores frequently. In addition, the rarity of individual pieces gives customers a sense of individuality and has created a large online following. Zara owns most of its stores and has developed long-term relationships with suppliers. Many of the garments it sells are manufactured in its own factories which improves quality control. Teaching Note: Zara is an interesting company in a turbulent, low margin industry. They have developed a unique strategic position and, as evidenced by their impressive growth, gained a large and loyal following. Ask students to describe how Zara has developed capabilities that give it a competitive advantage. Ask them to relate these sources of competitive advantage back to the two basic rules that shape Zara’s strategic position. Students should realize that Zara has intentionally developed capabilities that set it apart from its competitors. Teaching Note: Numerous firms such as Coca-Cola, McDonald’s, Campbell Soup, and Subway have implemented value-creating strategies using their unique resources, capabilities, and core competencies. In particular, they have developed unique capabilities related to the management of their brands. • The ultimate goal of such strategies is for the firms to achieve a sustainable competitive advantage that will enable them to earn above-average returns. • To achieve strategic competitiveness and earn above-average returns, firms must leverage their core competencies to exploit opportunities in the external environment. • However, a competitive advantage does not always last, because value- creating strategies may be successfully imitated or duplicated by competitors. Several features of the global economy, such as technological changes, can result in the erosion of the competitive advantage of established competitors. For example, the Internet is undermining the competitive advantage of brick-and-mortar rivals. Competitive advantages are often strongly related to the resources firms hold and how they are managed. Resources are the foundation for strategy and these can generate competitive advantages leading to wealth creation when they are bundled together uniquely. People are an especially critical resource for producing innovation and gaining a competitive advantage. Even if they are not as critical in some industries, they are necessary for the development and implementation of firms’ strategies. The sustainability of a competitive advantage is a function of three factors: • The obsolescence of a core competence—the basis of value creation—as a result of environmental changes • The availability of substitutes for the core competence (or the extent to which competitors can use different core competencies to overcome value created by the original core competence) • The imitability of the core competence (or the abilities of competitors to develop the same core competence) To sustain a competitive advantage, firms must manage current core competencies while simultaneously developing new competencies. In other words, strategists must continuously make investments that will enhance the value of current competencies while striving to develop new ones (discussed further in Chapter 5). This chapter represents the next phase in the strategy development process: what a firm can do. It is linked to the understanding that managers gain by assessing the external environment to determine what the firm might do, or to identify opportunities that might be pursued. Teaching Note: It is important to stress that the outcomes of the external and internal analyses of a firm's environment must be linked. Analyzing the external environment enables strategists to identify opportunities that the firm can choose to pursue if it is capable of doing so. This capability is determined by a careful analysis of the firm's internal environment, or by determining whether or not it has the resources, capabilities, and core competencies that will enable it to successfully implement value-creating strategies that fit with its vision and mission (previously discussed in Chapter 1). 1 Explain the need for organizations to study and understand thei internal organization. ANALYZING THE INTERNAL ORGANIZATION The Context of Internal Analysis In the global economy, traditional factors such as labor costs, access to financial resources and raw materials, and protected or regulated markets continue to be sources of competitive advantage, but to a lesser degree (mostly because the advantages created by these more traditional sources can be overcome by competitors through an international strategy and by the flow of resources throughout the global economy). Increasingly, those analyzing their firm’s internal environment should use a global mind-set (i.e., the ability to study an internal environment in ways that are not dependent on the assumptions of a single country, culture, or context). Analysis of the firm’s internal environment requires that evaluators examine the firm’s portfolio of resources and the bundles of heterogeneous resources and capabilities managers have created. Understanding how to leverage the firm’s unique bundle of resources and capabilities is a key outcome decision makers seek when analyzing the internal environment. Teaching Note: It might be appropriate at this point in the discussion to remind students of the primary differences between the I/O and resource- based models. The I/O model presumes that resources and capabilities are distributed homogeneously among firms and freely move between them; the primary determining factor is how firms react to changes in the external environment. The resource-based model presumes a heterogeneous distribution of resources and capabilities and assumes that they do not move freely between firms. By using or exploiting their core competencies, firms are in a position to develop and perform value-creating strategies better than their competitors or to create and perform value- creating strategies that competitors either are unable or unwilling to imitate. Teaching Note: Although it will be discussed in detail in Chapter 4, it is appropriate to provide students with some introductory remarks on value at this point. Value represents a concept of the relationship between a product's features (such as quality) and its price relative to those offered by competitors. As will be discussed in Chapter 4, value can be provided by low cost, high differentiation of product features, or a combination of low cost and differentiated features. Figure Note: Relationships between the components of an internal strategic analysis—resources, capabilities, and core competencies—and a sustainable competitive advantage and strategic competitiveness are illustrated in Figure 3.1. This is a very helpful figure as it ties together much of the material in the chapter. FIGURE 3.1 Components of Internal Analysis Leading to Competitive Advantage and Strategic Competitiveness As illustrated in Figure 3.1: • A firm's tangible and intangible resources (for example, its facilities and corporate culture, respectively) represent sources of capabilities • These capabilities (teams or bundles of resources) represent sources of core competencies • When exploited and nurtured (and valuable, costly to imitate, rare, and non-substitutable), core competencies are potential sources of competitive advantage • If a firm is able to use its core competencies to achieve a competitive advantage, it will achieve strategic competitiveness and earn above-average returns so long as competitors are unable or unwilling to imitate them successfully Teaching Note: The importance of a firm's internal characteristics— represented by its resources and capabilities—highlights a shift in the priorities and prescriptions of strategic management research. The field has evolved or developed from a position that understanding industry characteristics and then positioning the firm to take advantage of industry characteristics relative to competitors was of primary importance to recognizing that it is a firm's resources and capabilities (which represent sources of core competencies) that should serve as the foundation for firm strategy. This shift recognizes that industry attractiveness is not dependent only on industry characteristics. Industry attractiveness is ultimately determined by both industry characteristics (which can be translated into opportunities and threats) or what a firm might do and its internal strengths (its resources, capabilities, and core competencies) which determine what a firm is capable of doing to take advantage of (or exploit) external opportunities. 2 Define value and discuss its importance. Creating Value Some thoughts on “value”: • Firms create value by exploiting core competencies and meeting the standards of global competition. • Value is measured by the product’s performance and by its attributes for which customers are willing to pay. • Firms must provide value to customers that is superior to the value provided by competitors in order to create a competitive advantage. • Customers perceive higher value in global rather than domestic-only brands. • Firms create value by innovatively bundling and leveraging their resources and capabilities. • Ultimately, value is the foundation for earning above-average profits. • Core competencies, combined with product-market positions, are the most important sources of advantage. • The core competencies of a firm, in addition to analysis of its general, industry, and competitor environments, should drive its selection of strategies. The Challenge of Analyzing the Internal Organization Correctly identifying, developing, deploying, and protecting firm resources, capabilities, and core competencies requires managers to make difficult decisions. In part, these challenges are a result of characteristics of both the internal and external environments of the firm. This challenge is multiplied because of three conditions that characterize important strategic decisions—uncertainty, complexity, and intraorganizational conflict. Figure Note: Suggest that students refer to Figure 3.2 during your discussion of the three conditions that characterize important strategic decisions. FIGURE 3.2 Conditions Affecting Managerial Decisions about Resources, Capabilities, and Core Competencies The conditions or decision characteristics presented in Figure 3.2 are: • Uncertainty regarding the assessment of the general and industry environments, assessments, and predictability of competitive actions, and customer preferences. Strategic leaders need to be aware of how biases affect decisions about how to cope with uncertainty and how to manage resources and capabilities to form core competencies. • Complexity regarding the nature of any interrelatedness of the causes of change in the environment and how the environments are perceived, especially regarding decisions as to which of the firm’s resources and capabilities might serve as the foundation for competitive advantage. • Intraorganizational conflicts among managers making decisions about which core competencies are to be nurtured and about how the nurturing should take place. Teaching Note: The descriptions of uncertainty, complexity, and intraorganizational conflict (see below) expand on the material presented in the text. This should help you explain these concepts in greater depth, if you should choose to do so. Uncertainty is present because of the inherent difficulty in identifying, assessing, and predicting changes and trends in characteristics of the external environment. Among these characteristics are correctly predicting the extent, direction, and timing of changes in the general environment, such as those resulting from societal values, political and economic conditions, customer preferences, and emerging technologies from other industries (and how they might ultimately affect the firm). Complexity is increased because of the uncertain nature of interrelationships among the characteristics of the external environment and the related challenge regarding how to assess the effects of changes in one set of characteristics on other characteristics. The issue becomes more complex when managers must relate the complex external environment to their assessment of the firm's internal environment and thus affects decisions regarding the firm's resources, capabilities, and core competencies, and their relationship to opportunities in the external environment that can be exploited successfully to achieve a competitive advantage. Intraorganizational conflicts often develop as a result of uncertainty and complexity. When managers make decisions regarding the identification of the firm's capabilities and choose to nurture them (with resources) to develop core competencies that can be exploited to achieve a competitive advantage, they must make these important decisions without absolute certainty that the decision is correct. And, such decisions may result in changes or shifts in power and interrelationships among individuals and groups within the firm. When this occurs, there may be conflict as those who are affected adversely—or perceive that they will be so affected—may resist these changes. In some cases, managers faced with decisions that may have unpleasant consequences or are uncomfortable often experience denial, an unconscious coping mechanism used to block out and not initiate major changes that may have some pain associated with them. Thus, managers that must make decisions under conditions of uncertainty, complexity, and intraorganizational conflict must exercise judgment, a capacity for making a successful decision in a timely manner when no correct model is available or when relevant data are unreliable or incomplete. When exercising judgment, decision makers often take intelligent risks. In the current competitive landscape, executive judgment can be a particularly important source of competitive advantage. One reason is that over time, effective judgment allows a firm to build a strong reputation and retain the loyalty of stakeholders whose support is linked to above-average returns. Significant changes in the value-creating potential of a firm’s resources and capabilities can occur in a rapidly changing global economy. Because these changes affect a company’s power and social structure, inertia or resistance to change may surface. Even though these reactions may happen, decision makers should not deny the changes needed to assure the firm’s strategic competitiveness. By denying the need for change, difficult experiences can be avoided in the short run. 3 Describe the differences between tangible and intangible resources. RESOURCES, CAPABILITIES, AND CORE COMPETENCIES This section develops the background and relationships among resources, capabilities, and core competencies that represent potential sources on which a firm can build the foundation for a competitive advantage. Resources Resources represent inputs into a firm's production process, such as capital equipment, the skills of individual employees, brand names, financial resources, and talented managers. By themselves—or individually—resources generally will not enable a firm to achieve a competitive advantage. They must be combined or integrated with other firm resources to establish a capability. When these capabilities are identified and nurtured, they can result in core competencies, which may lead to a competitive advantage. A firm's resources can be classified either as tangible or intangible. STRATEGIC FOCUS Emphasis on Value Creation through Tangible (Kinder Morgan) and Intangible (Coca-Cola Inc.) Resources The Stratgic Focus profiles two companies, Kinder Morgan and Coca-Cola, and describes some of the ways in which they have used resources to create value for customers. Kinder-Morgan’s focus is on tangible resources – pipe and pipeline networks, storage terminals, liquid transportation assets, and financial assets (derived from creative tax approaches to earnings distributions and cash). Coca-Cola has a number of both tangible and intangible resources that it uses to create value. Intangible resources include a strong brand (based on well-managed image from marketing capabilities) that spans its product line. Tangible resources include financial capabilities and massive storage tanks that support its growing juice business and its advanced distribution system. Teaching Note: The point should be obvious that competitive advantage can be achieved through a number of different means. Rather than focusing strictly on the two companies mentioned in the Strategic Focus, ask students to identify other companies and how they have been able to develop capabilities from either tangible or intangible resources. Tangible Resources Tangible resources are assets that can be seen or quantified, such as a firm's physical assets (e.g., its plant and equipment). Tangible resources are classified in one of four ways, as illustrated in Table 3.1. TABLE 3.1 Tangible Resources A firm's tangible resources generally can be placed into one of four categories: • Financial resources, such as borrowing capacity • Organizational resources, such as its formal reporting structure and systems • Physical resources, such as location • Technological resources, such as patents and trademarks Teaching Note: One statement made in the chapter deserves special attention. Paraphrased slightly, the authors declare that the value of tangible resources is constrained because they are difficult to leverage: it is hard to derive more business or additional value from a tangible resource. For example, an airplane is a tangible resource or asset, but it can only be used on one route at a time, and it is equally impossible to put the same crew on five different routes at the same time. This is also true for the financial investment made in the airplane, but intangible assets such as a new innovation in manufacturing processes can be applied to many assembly lines. These dynamics are considered next. Intangible Resources A firm's intangible resources may be less visible, but they are no less important. In fact, they may be more important as a source of core competencies. Intangible resources range from innovation resources, such as knowledge, trust, and organizational routines, to the firm's people-dependent or subjective resources of know-how, networks, organizational culture, to the firm's reputation for its goods and services and the way it interacts with others (such as employees, suppliers, or customers). Teaching Note: It is interesting to note that tangible resources may be less valuable today than they were in the past. To support this conclusion, economist John Kendrick has found that intangible assets have contributed increasingly to US economic growth since the early 1900s. The ratio of intangible business capital to tangible business capital in 1929 was 30 percent to 70 percent, but that ratio was 63 percent to 37 percent in 1990. Table Note: Three classifications of intangible resources are presented in Table 3.2. TABLE 3.2 Intangible Resources A firm's intangible resources can be classified as: • Human resources, such as knowledge, trust, and managerial capabilities • Innovation resources, such as scientific capabilities and capacity to innovate • Reputational resources, such as the firm's reputation with customers or suppliers Because tangible resources are those that can be seen (such as plants), touched (such as equipment), documented (such as contracts with suppliers of raw materials), or quantified (such as the value of a specific asset), they generally do not, by themselves, represent capabilities that serve as sources of core competencies. However, they still have value and will contribute to the development of capabilities and core competencies. Teaching Note: Remind students of the relationships illustrated in Figure 3.2. Resources are the source of firm capabilities, capabilities are the source of core competencies, and core competencies are the foundation for achieving a competitive advantage and strategic competitiveness. Because they cannot be quantified, touched, or seen, and are more difficult to explain, intangible resources are more likely to be sources of sustainable competitive advantage. And, if they also are difficult for competitors to identify and/or understand, they also may represent the most likely source(s) of a firm's capabilities, core competencies, and sustained competitive advantage. Teaching Note: One can report to the class that two surveys asked managers to identify the source of their firms' competitive advantage or overall success. In both instances, one intangible asset was identified as the most important: Company Reputation/Reputation for Quality. As time permits, you may want to have the class discuss what makes a company's reputation. This also can be assigned as a "thought-provoking" question for an outside assignment or for future class discussion. The Value of Brands: A Mini-Lecture One intangible resource that may enable a firm to create a reputation and serve as a source of competitive advantage is a brand name. Specifically, what a brand name communicates to customers about the performance characteristics or attributes of a firm's product(s) represents a direct link to a firm's reputation with its customers. When the brand name communicates positive characteristics of a product (for example, superior performance, high quality, or superior value), consumers will tend to purchase the brand name product rather than similar products offered by competing firms. Thus, it is important that companies with strong brand names nurture the core competencies that provide the brand name with value and continually communicate that value through consistent advertising messages. When a firm has a brand name that serves as a foundation for competitive advantage, the firm often will try to leverage the power of that brand name. Using an example in the chapter, Harley-Davidson's name now adorns a limited edition Barbie doll, a popular restaurant in New York City, and a line of L’Oreal cologne. Moreover, Harley-Davidson Motorclothes generates over $100 million in revenue for the firm each year, and the Harley brand adorns many clothing items, from black leather jackets to fashions for tots. The value of a brand name can be lessened or reduced by competitive actions that the firm either does not recognize or to which it fails to respond. In the consumer goods segment, national brands are under attack by private label store brands. And some appear to be losing the battle as customer preferences are shifting toward private labels that may be perceived as providing more value than the national brands. In many cases, national brands have reacted to such threats by cutting prices. However, cost-cutting is not the only strategy that can be used to safeguard a brand. • For companies whose brand names are expected to thrive and continue to provide a competitive advantage (such as Nike or Hanes), their challenge is to nurture and exploit the resources, capabilities, and core competencies that are the source of competitive advantage. • For companies whose brands are under fire (such as Marlboro or Budweiser), the challenge is to re-establish the value of the brand. They must reconfigure their existing bundle of resources, capabilities, and core competencies to renew them as sources of competitive advantage. • For companies whose brands are troubled, because the brands are no longer a source of competitive advantage, the challenge is even greater: they must identify and develop new bundles of resources and capabilities and nurture them to establish a new source of competitive advantage. • Firms also may choose to package their brand as a way to differentiate themselves from competitors, as Century 21 Real Estate has done by using technology to make its offices virtual home stores by offering many discounted home services, including cable service, appliances, insurance, and mortgages. • Other firms (e.g., Procter & Gamble, General Motors, and Philip Morris) support their brand-name products through heavy advertising expenditures. Note: It is important to remember that resources—both tangible and intangible—represent the primary sources that enable a firm to establish capabilities, the capacity for a set or bundle of unique resources to perform a task or activity integratively. In other words, individual resources alone, while they may have value, will contribute to the development of capabilities only when they are put together in unique combinations to provide the foundation for core competencies and the establishment of competitive advantage. Examples include a firm’s information-based tangible resources (Table 3.1) and/or its intangible resources (Table 3.2). 4 Define capabilities and discuss their development. Capabilities As implied in the definition, a firm’s capabilities represent its capacity to integrate individual firm resources to achieve a desired objective, though this ability does not emerge overnight. Capabilities develop over time as a result of complex interactions that take advantage of the interrelationships between a firm’s tangible and intangible resources that are based on the development, transmission, and exchange or sharing of information and knowledge as carried out by the firm’s employees (its human capital). A firm’s ability to achieve a competitive advantage is thus reflected in its knowledge base and the ability of its human capital to successfully exploit firm capabilities. Thus, human capital is of significant value in the firm’s ability to develop capabilities and core competencies to achieve strategic competitiveness. Teaching Note: As discussed in the chapter, the strategic value of resources is increased when they are integrated or combined. Unique combinations of the firm’s tangible and intangible resources can be molded into capabilities— what the firm can do when it deploys teams of resources working together. You can use a firm like Microsoft to illustrate this point. The knowledge possessed by the firm’s human capital may be one of the most significant sources of a firm’s competitive advantage because it represents everything that the firm has learned, and thus everything that it knows about successfully linking or bundling sets of individual resources to develop capabilities as a foundation for developing core competencies and, ultimately, to achieve a competitive advantage. Teaching Note: A number of firms have gone so far as to hire a Chief Learning Officer (CLO) to find ways for the organization to acquire, internalize, and share knowledge in competitively relevant ways. Managing knowledge is critical since enterprises view this as their primary source of competitive advantage and believe it should be used in ways that will create value for customers. Establishing and nurturing the skills and abilities of the workforce is of critical importance to a firm’s ability not only to establish, but to sustain a competitive advantage by acquiring new knowledge and developing new skills that will enhance existing capabilities and core competencies, as well as aid in the development of new ones. Teaching Note: Firms use a variety of methods to nurture the value of their human capital. For example, Microsoft contends its best asset is the intellectual potential of its employees. To support the trend, the firm strives to hire people who are more talented than the current set of employees in hopes of defending and extending the domain of its intellectual property. It is not uncommon for prospective employees to be asked questions like, “Why are manhole covers round?” (The answer: A round cover cannot fall into the hole no matter which way it is turned.) Such questions may seem silly, but the goal is to identify people with powerful reasoning skills, and thus (conceivably) the capacity to generate outstanding software solutions. Firms also have functional area capabilities they have nurtured and are now considered as core competencies. As a result, these core competencies provide the foundation for the firm’s competitive advantage. Table Note: Table 3.3 illustrates the value-creating potential of functional areas for a broad array of firms in a variety of industries. Rather than going over the table item by item, students should be asked to discuss why a particular firm’s capabilities serve as a source of competitive advantage. In other words, involve students in a discussion of why one firm’s functional activity is being performed better than that of its competitors. For example, ask students to compare and contrast the marketing approaches of Procter & Gamble and Polo Ralph Lauren Company or the manufacturing capabilities of Komatsu and Sony. TABLE 3.3 Examples of Firms’ Capabilities Table 3.3 provides examples of functional areas, capabilities, and firm examples across a variety of industries. It indicates that a number of functional area capabilities have the potential to serve as the foundation for a firm’s competitive advantage. STRATEGIC FOCUS Samsung Bests Apple in Smartphone Sales by Its Imitation CapabilitySamsung is a large diversified South Korean business group. Its largest business is Samsung Electronics, which has experienced impressive growth. In fact, it overtook Apple in 2012 in sales of smartphones. Based largely in its history as a component manufacturer, Samsung is able to produce many of the parts that go into its phones, giving it a significant advantage. Its entry into the smartphone market was predicated on a ‘copycat’ imitation strategy of the Apple iPhone. As part of its business model, Samsung not only produces components for its own phones, but also components that its competitors need. While it cannot steal competitors’ intellectual property, this does give them a good glimpse into the future by seeing where competitors are pushing the industry. Most students will be familiar with many of Samsung’s electronic products, as well as those of its competitors. Ask students to comments on innovation in some of the product lines in which Samsung competes and to argue either for, or against, the ‘copycat’ strategy that Samsung uses. Ask them to identify the ethical issues that are involved with this approach and where they would draw the line in terms of acceptable business practice. 5 Describe four criteria used to determine whether resources and capabilities are core competencies. Core Competencies Once a firm has identified its resources and capabilities, it is ready to identify its core competencies, the resources and capabilities that are a source of competitive advantage for the firm over its competitors. Core competencies emerge over time through an organizational process of accumulating and learning how to deploy different resources and capabilities. As the capacity to take action, core competencies are the “crown jewels of a company,” the activities the company performs especially well compared with competitors and through which the firm adds unique value to its goods or services over a long period. Teaching Note: Remember, resources and capabilities serve as the foundation on which firms formulate and implement value-creating strategies so that the firm can achieve strategic competitiveness and earn above- average returns. However, if a firm has a deficiency in some of its resources, it may not be able to achieve strategic competitiveness. For example, insufficient financial resources may prevent a firm from implementing the processes or integrating the activities required to add superior value by limiting its ability to hire workers with the necessary skills or to invest in the capital assets (facilities and equipment) that are needed. Thus, firms not only are challenged to scan the external environment to identify opportunities that can be exploited, but also to have an in-depth understanding of their resources and capabilities. This enables the firm to develop strategies to exploit external opportunities while it also avoids competing in areas where the firm's resources and capabilities are inadequate. Not all of a firm’s resources and capabilities are strategic assets—that is, assets that have competitive value and the potential to serve as a source of competitive advantage. Some resources and capabilities may result in incompetence, because they represent competitive areas in which the firm is weak compared to competitors. Thus, some resources or capabilities may stifle or prevent the development of a core competence. When the firm's resources and capabilities result in a core competence, the firm will be able to produce goods or services with features and characteristics that are valued by customers. This implies that firms can implement value-creating strategies only when its capabilities and resources can be combined to form core competencies. The question is asked: “How many core competencies are required for a competitive advantage?” McKinsey & Company recommends that firms identify 3 or 4 competencies around which to frame their strategic actions. BUILDING CORE COMPETENCIES This section discusses two conceptual tools/frameworks firms can use to identify competitive advantages: • Four criteria determine which of the firm’s resources and capabilities are core competencies. • Value chain analysis, a tool for determining which value-creating competencies should be maintained, upgraded, and developed and which should be outsourced. Four Criteria for Sustainable Competitive Advantage Four criteria should be used to determine whether or not a firm’s capabilities are core competencies and can be a source of competitive advantage. Table Note: Table 3.4 describes the four criteria for determining strategic capabilities. These criteria are discussed in more detail following the table. TABLE 3.4 The Four Criteria of Sustainable Strategic Capabilities Before they can be sources of competitive advantage, capabilities must be: • valuable • rare • costly-to-imitate • nonsubstitutable It is important to understand that a firm’s capabilities must meet all four of the criteria noted earlier before they can be core competencies and enable the firm to achieve a sustainable competitive advantage. However, a short-term competitive advantage is available when firm capabilities are valuable, rare, and non-substitutable. The length of time that a firm possessing such capabilities can expect to sustain a competitive advantage depends on how long it takes for competitors to successfully imitate the value-creating activity or process, or reproduce valued features or characteristics of the product or service. Thus, the ability to sustain a competitive advantage is dependent on firm capabilities being valuable, rare, non-substitutable, and costly to imitate. Valuable Capabilities that are valuable help a firm exploit opportunities and/or neutralize threats in the external environment. Valuable capabilities allow a firm to develop and implement strategies that create customer value. Rare Capabilities are rare when they are possessed by few, if any, current or potential competitors. If many firms have the same capabilities, the same value-creating strategies will be selected. As a result, none of the firms will be able to achieve a sustainable competitive advantage. A competitive advantage will be achieved by firms that develop and exploit capabilities that are different from those held by other firms. Costly to Imitate Capabilities are costly to imitate when other firms are unable to develop them except at a cost disadvantage relative to firms that already have them. This usually is a result of one or a combination of three conditions: 1. Unique historical conditions can make duplication of capabilities costly. For example, establishing facilities in a key location that can preempt competition when no other locations have similar value-related characteristics or developing a unique organizational culture in the early stages of the organization's life may not be cheap to duplicate by firms that are developing theirs at a different time. A unique culture may not only serve as a source of competitive advantage, but also can be a source of competitive disadvantage. The latter may be the case when a firm's culture prevents it from recognizing or successfully adapting to changes in a turbulent environment. Teaching Note: This may explain why such companies as IBM and General Motors, whose cultures developed early in each company's history—and during relatively calm or stable environments—were able to rely on formal controls and multiple approvals of strategies and be successful. However, their respective cultures, grounded in rigidity and bureaucracy, may have prevented them from successfully adapting to rapid environmental change in a fast-paced global environment. 2. Causal ambiguity also may prevent competitors from perfectly imitating a competency if the link between a firm's capabilities and core competencies is not identified or understood. Competitors may not be able to identify or determine how a firm uses its competencies to achieve a sustainable competitive advantage. 3. Social complexity means that a firm's capabilities are the product of complex social phenomena such as interpersonal relationships within the firm (e.g., how managers and subordinates at Hewlett-Packard work with each other) or a firm’s reputation with its customers and suppliers. Nonsubstitutable A firm's capabilities are nonsubstitutable when they do not have strategic equivalents. Firm resources are strategically equivalent when each can be separately exploited to implement the same strategies. If capabilities are invisible, it is even more difficult for competitors to identify viable substitutes. Examples of capabilities that can be difficult to identify or to find suitable substitutes include firm-specific knowledge and trust-based working relationships. Table Note: Table 3.5 summarizes the relationship between the characteristics of firm capabilities, sustainability of competitive advantage, and performance implications. Rather than repeating the table in a lecture, students should be advised to refer to it as needed. TABLE 3.5 Outcomes from Combinations of the Criteria for Sustainable Competitive Advantage Highlights from Table 3.5 are: • Resources and capabilities that are neither valuable, rare, costly to imitate, nor nonsubstitutable mean that the firm will be at a competitive disadvantage and will earn below-average returns. • Resources and capabilities that are valuable, but are neither rare nor costly to imitate and may or may not be nonsubstitutable mean that the firm can achieve competitive parity and earn average returns. • Resources and capabilities that are both valuable and rare, but are not costly to imitate and may or may not be nonsubstitutable, may enable the firm to achieve a temporary competitive advantage and will earn above-average to average returns. • Resources and capabilities that are valuable, rare, costly to imitate, and nonsubstitutable will enable the firm to achieve a sustainable competitive disadvantage and earn above- average returns. Teaching Note: Given the criteria for the sustainability of a competitive advantage, ask students if The Gap’s Old Navy concept (or another case with which they are likely to be personally familiar) represents a source of competitive advantage that can be sustained over time. One likely interpretation using the criteria set out in Table 3.5 is that The Gap’s competitive advantage in the Old Navy concept can only be sustained until competitors successfully imitate or duplicate the value created. Thus, the Old Navy concept represents a temporary competitive advantage. This will enable The Gap to earn above-average returns until the value created is successfully imitated by competitors. 6 Explain how value-chain analysis is used to identify and evaluate resources and capabilities. Value Chain Analysis A framework that firms can use to identify and evaluate the ways in which their resources and capabilities can add value is value chain analysis. This framework is useful because it enables firms to understand which parts of their operations or activities create value by segmenting the value chain into primary and secondary activities as illustrated in Figure 3.3. Figure Note: Students should refer to Figure 3.3 and Tables 3.6 and 3.7 during your explanation of the value chain concept. Tables 3.6 and 3.7 develop the criteria for examining the value-creating potential of the firm's primary and secondary activities, respectively, after these terms are introduced in Figure 3.3. FIGURE 3.3 A Model of the Value Chain Figure 3.3 illustrates how the value-creating activities performed by the firm can be separated into value chain activities and support functions. Value chain activities represent traditional line activities such as supply chain management, operations, distribution, marketing, and follow-up service. Support functions are represented by a firm's staff activities and include its financial infrastructure, human resource management practices, and management information systems activities. FIGURE 3.4 Creating Value Through Value Chain Activities Figure 3.4 illustrates the link between the value chain activities and customer value. All areas of the value chain can help firms deliver value to customers. Supply-chain management consists of activities including sourcing, procurement, conversion, and logistics management that are necessary for the firm to receive raw materials and convert them into final products. Operations consists of activities necessary to efficiently change raw materials into finished products. Developing employees’ work schedules, designing production processes and physical layout of the operations’ facilities, determining production capacity needs, and selecting and maintaining production equipment are examples of specific operations activities. Distribution consists of activities related to getting the final product to the customer. Efficiently handling customers’ orders, choosing the optimal delivery channel, and working with the finance support function to arrange for customers’ payments for delivered goods are examples of these activities. Marketing (including sales) consists of activities taken for the purpose of segmenting target customers on the basis of their unique needs, satisfying customers’ needs, retaining customers, and locating additional customers. Advertising campaigns, developing and managing product brands, determining appropriate pricing strategies, and training and supporting a sales force are specific examples of these activities. Follow-up service consists of activities taken to increase a product’s value for customers. Surveys to receive feedback about the customer’s satisfaction, offering technical support after the sale, and fully complying with a product’s warranty are examples of these activities. FIGURE 3.5 Creating Value Through Support Functions Figure 3.5 illustrates the link between the support functions a company performs and customer value. All support functions can help firms deliver value to customers. Finance consists of activities associated with effectively acquring and managing financial resources. Securing adequate financial capital, investing in organizational functions in ways that will support the firm’s efforts to produce and distribute its products in the short- and long-term, and managing relationships with those providing financial capital to the firm are specific examples of these activities. Human Resource consists of activities associated with managing the firm’s human capital. Selecting, training, retaining, and compensating human resources in ways that create a capability and hopefully a core competence are specific examples of these activities. Management Information Systems consists of activities taken to obtain and manage information and knowledge throughout the firm. Identifying and utilizing sophisticated technologies, determining optimal ways to collect and distribute knowledge, and linking relevant information and knowledge to organizational functions are activities associated with this support function. Using the value chain framework enables managers to study the firm’s resources and capabilities in relationship to the primary and support activities performed to design, manufacture, and distribute products, and to assess them relative to competitors’ capabilities. For these activities to be sources of competitive advantage, a firm must be able to: • Perform primary or support activities in a manner superior to the ways that competitors perform them • Perform a primary or support activity that no competitor is able to perform to create superior value for customers and achieve a competitive advantage This implies that, given that individual firms comprise unique or heterogeneous bundles of activities, reconfiguring the value chain—or rebundling resources and capabilities—may enable a firm to develop unique value-creating activities. The managerial challenge is that the value-creation process is difficult and there is no one best way to assess a firm’s primary and support activities or to evaluate the value-creating potential of those activities either within the firm or relative to competitors, because of incomplete or ambiguous data. By being objective, managers may be able to use the value chain framework to identify new, unique ways to combine resources and capabilities to create value that are difficult for competitors to recognize, understand, or imitate. The longer a firm is able to keep competitors “in the dark” as to how resources and capabilities have been combined to create value, the longer a firm will be able to sustain a competitive advantage. Firms can use outsourcing as an alternative to identify primary or support activities for which its resources and capabilities are not core competencies and do not enable the firm to add superior value and achieve competitive advantage. 7 Define outsourcing and discuss the reasons for its use. OUTSOURCING Outsourcing describes a firm's decision to purchase a value-creating activity from an external supplier. Outsourcing has become important—and may become more important in the future—for two reasons: • There are limits to the abilities of firms to possess all of the bundles of resources and capabilities that are required to achieve superior performance (relative to competitors) in all its primary and support activities. • With limited resources and capabilities, firms can increase their ability to develop resources and capabilities to form core competencies and achieve competitive advantage by nurturing a few core competencies. Firms engaging in outsourcing can increase their flexibility, mitigate risks, and reduce their capital investment. Teaching Note: When outsourcing, a firm seeks the greatest value. In other words, a company wants to outsource only to firms possessing a core competence in terms of performing the primary or support activity that is being outsourced. Other research suggests that outsourcing does not work effectively without extensive internal capabilities to coordinate external sourcing as well as core competencies. To ensure that the appropriate primary and support activities are outsourced, four skills are essential for managers involved in outsourcing programs: • Strategic thinking – understanding whether/how outsourcing creates competitive advantage within the company • Deal making – ability to secure rights from external providers that can be fully used by internal managers • Partnership governance – ability to oversee and govern appropriately the relationship with the company to which the services were outsourced • Change management – because outsourcing can significantly change how an organization operates, managers administering these programs must also be able to manage that change, including resolving employee resistance that accompanies any significant change effort Teaching Note: Outsourcing can take several forms, depending on a firm's strategic objectives. Examples of outsourcing strategies that, while different, enable outsourcing firms to achieve their strategic objectives while changing the face of college campuses include: • Universities and colleges outsourcing the management of college bookstores to Follett College Stores and Barnes & Noble • Food Service management companies such as ARA and Marriott licensing with Burger King to establish national chain restaurants on college campuses • Colleges in the US contracting with private firms to manage or build on- campus housing 8, 9 Discuss the importance of identifying internal strengths and weaknesses; Discuss the importance of avoiding core rigidities. COMPETENCIES, STRENGTHS, WEAKNESSES, AND STRATEGIC DECISIONS Tools such as outsourcing help the firm focus on its core competencies as the source of its competitive advantages. However, evidence shows that the value-creating ability of core competencies should never be taken for granted. Moreover, the ability of a core competence to be a permanent competitive advantage can’t be assumed. All core competencies have the potential to become core rigidities. As Leslie Wexner, CEO of The Limited, Inc., says: “Success doesn’t beget success. Success begets failure because the more that you know a thing works, the less likely you are to think that it won’t work. When you’ve had a long string of victories, it’s harder to foresee your own vulnerabilities.” Thus, each competence is a strength and a weakness—a strength because it is the source of competitive advantage and, hence, strategic competitiveness, and a weakness because, if emphasized when it is no longer competitively relevant, it can sow the seeds of organizational inertia. Events occurring in the firm’s external environment create conditions through which core competencies can become core rigidities, generate inertia, and stifle innovation. According to one observer, “Often the flip side, the dark side, of core capabilities is revealed due to external events when new competitors figure out a better way to serve the firm’s customers, when new technologies emerge, or when political or social events shift the ground underneath.” In the final analysis, changes in the external environment do not cause core competencies to become core rigidities; rather, strategic myopia and inflexibility on the part of managers are the cause. Thus, nurturing existing competencies must be balanced by efforts to encourage the development of new competencies. Chapter 4 Business-Level Strategy LEARNING OBJECTIVES 1. Define business-level strategy. 2. Discuss the relationship between customers and business-level strategies in terms of who, what, and how. 3. Explain the differences among business-level strategies. 4. Use the five forces of competition model to explain how above-average returns can be earned through each business-level strategy. 5. Describe the risks of using each of the business-level strategies. CHAPTER OUTLINE Opening Case Is J.C. Penney Killing Itself with a Failed Strategy? CUSTOMERS: THEIR RELATIONSHIP WITH BUSINESS-LEVEL STRATEGIES Effectively Managing Relationships with Customers Reach, Richness, and Affiliation Who: Determining the Customers to Serve What: Determining Which Customer Needs to Satisfy How: Determining Core Competencies Necessary to Satisfy Customer Needs Strategic Focus Continuously Innovating to Satisfy Customers’ Needs THE PURPOSE OF A BUSINESS-LEVEL STRATEGY TYPES OF BUSINESS-LEVEL STRATEGIES Cost Leadership Strategy Differentiation Strategy Strategic Focus Apple vs. Samsung: Apple Differentiates and Samsung Imperfectly Imitates Focus Strategies Integrated Cost Leadership/Differentiation Strategy SUMMARY REVIEW QUESTIONS EXPERIENTIAL EXERCISES VIDEO CASE LECTURE NOTES Chapter Introduction: Firms that perform well, even in very competitive industries, will follow some pattern of decision-making and execution that is internally consistent. That is, the firm will line up its resource commitments in a way that reinforces the direction of the enterprise. If these decisions are inconsistent, the outcome will be resource commitments that work against one another and hinder the progress of the business. This chapter lays out the basic strategy patterns that can lead to competitive advantage. Knowing these will help students understand how to make the most of the firm’s potential. OPENING CASE Is J.C. Penney Killing Itself with a Failed Strategy? In 2012, J.C. Penney CEO Ron Johnson announced a new strategy for the company. The strategy involved a a remake of the retail stores to create shops focused on specific brands (i.e., Levi’s, izod, Liz Claiborne) and types of goods within each store. The strategy also incorporated a new pricing system that promoted a new customer-value approach across all products (and eliminate special high discounts on selected products). However, this strategy overlooked current JCP customers that had come to expect regular discounts. First year performance (both sales and stock price) was disappointing. In addition, the implementation of the strategy was poorly executed. As a result, Johnson’s understanding of the business was called into question as was JCP’s ability to rebound from this apparent misstep. After performance declines, layoffs, and partial backtracking on the everyday customer value approach, Johnson was fired in April 2013. Teaching Note: Ask students to evaluate JCP’s ‘new’ strategy and what they would have done differently to implement it. Ask them to identify JCP’s competitors and how these companies differentiate themselves from one another. Aside from the dimensions listed in the Opening Case, ask students to identify other ways that JCP achieves differentiation. Students should come to realize that JCP and its competitors have differentiated themselves on several dimensions and that to grow in a saturated and highly competitive industry they need to offer value that exceeds that of its competition. Ask students to identify other firms with a strong competitive advantage that changed strategy to attract customers and ended up alienating their core customers. 1 Define business-level strategy. Business-level strategies represent integrated and coordinated sets of actions that are taken to exploit core competencies and gain a competitive advantage. To be more specific, strategies are purposeful, precede the taking of actions to which they apply, and demonstrate a shared understanding of the firm’s vision and mission. An effectively formulated strategy marshals, integrates, and allocates the firm’s resources, capabilities, and competencies so that it will be properly aligned with its external environment. A properly developed strategy also rationalizes the firm’s vision and mission along with the actions taken to achieve them. Determining the businesses in which the firm will compete is a question of corporate-level strategy and is discussed in Chapter 6. Competition in individual product markets is a question of business-level strategy. The firm’s core competencies should be focused on satisfying customer needs or preferences through business-level strategies, which detail actions taken to provide value to customers and gain a competitive advantage by exploiting core competencies in specific, individual product or service markets. In other words, business-level strategies are developed based on a firm’s core competencies and indicate how an organization chooses to compete in a particular market to gain a competitive advantage over competitors. A customer focus requires that firms simultaneously evaluate or consider • Whom to serve, • What customer needs will be satisfied, and • How those needs will be satisfied through the strategy selected. 2 Discuss the relationship between customers and business- level strategies in terms of who, what, and how. CUSTOMERS: THEIR RELATIONSHIP WITH BUSINESS-LEVEL STRATEGIES Returns earned from relationships with customers (current and/or new) are the lifeblood of all firms. To survive and achieve strategic competitiveness in the contemporary competitive landscape, firms must: • Identify who their customers are • Determine customer needs or preferences • Focus on satisfying the needs of some group of customers • Determine how to compete (select a strategy) that enables them to satisfy customer needs The firm’s relationships with its customers are strengthened when it delivers superior value to them. Effectively Managing Relationships with Customers Teaching Note: A number of companies have become skilled at managing all aspects of their relationship with their customers. For example, Amazon.com is known for the quality of information it maintains about its customers, the service it renders, and its ability to anticipate customers’ needs. Cemex uses the Internet to link its customers, cement plants, and main control room, allowing the firm to automate orders and optimize truck deliveries in highly congested Mexico City. Reach, Richness, and Affiliation In the Internet age, firms can maintain competitive advantage by: • Thinking continuously about accessing and connecting with customers (reach) • Maintaining information with depth and detail for (and from) customers (richness) • Facilitating useful interactions with customer (affiliation) Who: Determining the Customers to Serve The first step is to identify customers based on differences in needs or preferences (often called market segmentation). This enables the firm to have a better grasp on what might be important to customers because of the lack of any in-depth insights relevant for decision making that are provided by central tendencies (averages) of the market in general. Table Note: It might be interesting to ask students which of the dimensions in this table help identify the most promising market segments for which type of business. TABLE 4.1 Basis for Customer Segmentation Dimensions that can be used to identify potential customers include the following factors: For consumer markets: • Demographic factors • Socioeconomic factors • Geographic factors • Psychological factors • Consumption patterns • Perceptual factors For industrial markets: • End-use segments • Product segments • Geographic segments • Common buying factor segments • Customer size segments It is imperative that firms pay careful attention to differences in customer needs among customer groups and not arbitrarily “lump” them together because: • Almost any identifiable human or organizational characteristic can be used to sub-divide a market into segments that differ from one another on a given characteristic. • Customer characteristics are often combined to segment markets into specific groups that have unique needs. • Demographic factors can also be used to segment markets into generations with unique interests and needs. Teaching Note: In the US, the teenage market segment is a competitively relevant customer group. Generate discussion by asking students about their assessments of the size, growth, and spending-related characteristics of this market segment. What: Determining Which Customer Needs to Satisfy As noted in Chapter 3, one challenge for firms is to identify ways in which they can bundle their resources and capabilities to create value for customers, because given the choice, customers are most interested in purchasing products that both satisfy their needs and provide value. After the firm decides whom it will serve, it must identify the targeted customer group’s needs that its goods or services can satisfy. This is important in that successful firms learn how to deliver to customers what they want and when they want it. In a general sense, needs (wants) are related to a product’s benefits and features. Having close and frequent interactions with both current and potential customers helps the firm identify those individuals’ and groups’ current and future needs. From a strategic perspective, a basic need of all customers is to buy products that create value for them. The most effective firms continuously strive to anticipate changes in customers’ needs. Failure to do this results in the loss of customers to competitors who are offering greater value in terms of product features and functionalities. In any given industry, there is great variety among consumers in terms of their needs, e.g., high-quality, lower-cost with acceptable quality, quick delivery. Diversified food and soft-drink producer PepsiCo believes that “any one consumer has different needs at different times of the day.” How: Determining Core Competencies Necessary to Satisfy Customers’ Needs As explained in Chapters 1 and 3, core competencies are resources and capabilities that serve as a source of competitive advantage for the firm over its rivals. Firms use core competencies (how) to implement value-creating strategies and thereby satisfy customers’ needs. Only those firms with the capacity to continuously improve, innovate, and upgrade their competencies can expect to meet and hopefully exceed customers’ expectations across time. STRATEGIC FOCUS Continuously Innovating to Satisfy Customers’ Needs The Strategic Focus makes the point that in many industries firms must continually innovate to provide superior value to customers. However, many firms are slow to innovate for fear of losing current customers (this is known as the “innovator’s dilemma”). This allows new entrants in the industry to introduce innovations that capture customers served by incumbent firms. Several firms in the Strategic Focus (L’Oreal, Alaska Airlines, Amazon.com. Dell) have come to understand that innovation provides a way forward that improves their strategic position by creating superior customer value. Underlying these efforts is encouraging employees to take risks and experiment with new ideas. Teaching Note: Students will undoubtedly be familiar with most of the companies profiled in the Strategic Focus. Ask students to speculate about what information the innovation decisions were based on? Ask them to identify other companies’ innovations and speculate about what drove these innovations. The discussion should address how conditions in the external environment created opportunities to provide customer value. 3 Explain the differences among business-level strategies. 4 Use the five forces of competition model to explain how above-average returns can be earned through each business- level strategy. 5 Describe the risks of using each of the business-level strategies. Teaching Note: The next section of the chapter describes generic business-level strategies that can be implemented to provide customers with distinctive products that meet customer needs and enable the firm to achieve a competitive advantage and earn above-average returns. Indicate that the business-level strategies are considered generic because they generally apply across industries, products, and the public and private sectors. TYPES OF BUSINESS-LEVEL STRATEGIES Business-level strategy is concerned with a firm’s position in an industry, relative to competitors. Firms are challenged to select business-level strategies to position themselves favorably by performing activities differently or performing different activities as compared to its rivals. Thus, the firm’s business-level strategy is a deliberate choice about how it will perform the value chain’s primary and support activities in ways that create unique value. Figure Note: As illustrated in Figure 4.1, firms select their business-level strategies based on a combination of competitive (market) scope and competitive advantage (product uniqueness or low cost). FIGURE 4.1 Five Business-Level Strategies Firms can choose one of five strategies from the generic strategy matrix based on the source of competitive advantage—uniqueness or cost—and breadth of competitive scope—broad or narrow. A firm choosing to compete across a broad market determines that it should compete in a number of customer segments. Competitive advantage is achieved either by offering unique products—a differentiation strategy—or by establishing a low-cost position and providing standardized products at the lowest competitive price—a cost leadership strategy. Firms that choose to compete in narrow customer segments select a focus strategy, which may be either a focused differentiation strategy (few segments, unique products) or a focused cost leadership strategy (narrow segment, standardized products at the lowest competitive price). An integrated cost leadership/differentiation incorporates both of these emphases. None of the five business-level strategies shown in Figure 4.1 is inherently or universally superior to the others. The effectiveness of each strategy is contingent both on the opportunities and threats in a firm’s external environment and on the possibilities provided by the firm’s unique resources, capabilities, and core competencies. It is critical, therefore, for the firm to select a business-level strategy that is based on a match between the opportunities and threats in its external environment and the strengths of its internal environment as shown by its core competencies. Cost Leadership Strategy The cost leadership strategy is an integrated set of actions taken to produce goods or services with features that are acceptable to customers at the lowest cost, relative to that of competitors. Firms that choose a cost-leadership strategy generally offer relatively standardized products with characteristics or features that typical customers accept (but with competitive levels of differentiation) at the lowest competitive price. Firms that wish to be successful by following a cost-leadership strategy must maintain constant efforts aimed at lowering costs (relative to rivals’ costs) and creating value for customers. Cost-reduction strategies can include: • Building efficient-scale facilities • Establishing tight control of production and overhead costs • Minimizing the costs of sales, product research and development, and service • Investing in state-of-the-art manufacturing technologies Implementing and maintaining a cost leadership strategy means that a firm must consider its value chain of primary and secondary activities (as discussed in Chapter 3) and effectively link those activities, if it is to be successful (as illustrated in Figure 4.2). As primary activities, inbound logistics and outbound logistics often account for much of the total cost to produce some goods and services. Research suggests that a competitive advantage in logistics creates more value with cost leadership strategies than with differentiation strategies, prompting cost leaders to focus on these primary activities. Cost leaders also carefully examine all support activities to find additional sources of potential cost reductions. Figure Note: Figure 4.2 points out that the critical focus in successfully implementing a cost leadership strategy is on efficiency and cost reduction throughout the value delivery system. FIGURE 4.2 Examples of Value-Creating Activities Associated with the Cost Leadership Strategy As suggested in Figure 4.2, the firm’s focus throughout each of its value chain activities and support functions is on the following: • Simplification of processes and procedures • Achieving efficiency and effectiveness • Reducing costs • Monitoring costs of activities provided by others that interface with the firm’s inbound or outbound logistics A firm that successfully implements a cost leadership strategy can earn above-average returns even when the five competitive forces are strong. Rivalry with Existing Competitors Achieving the lowest cost position means that a firm’s rivals will hesitate to compete based on price because, in a price war, the low cost firm will still earn profits even after its competitors compete away all profits. Having the low-cost position is a valuable defense against rivals. For example, Walmart controls and reduces costs so well that rivals cannot compete against it based on price. To build its cost position, the discount retailer achieves strict cost control in several ways. Kmart’s decision to compete against Walmart on the basis of cost contributed to the firm’s failure and subsequent bankruptcy filing. Its inferior distribution system—an inefficient and high-cost system compared to Walmart’s—is one of the factors that prevented Kmart from having a competitive cost structure relative to Walmart. Bargaining Power of Buyers (Customers) Achieving the low cost position provides some protection against powerful customers who attempt to drive down prices. If customers attempt to drive prices below the cost of the next most efficient firm, that firm might choose to exit the market (rather than remain and earn below average profits), leaving the low cost firm with a monopoly position. If that happens, customers would lose any bargaining power as the monopoly firm would be in a position to raise prices. Bargaining Power of Suppliers Because they have achieved the lowest cost position in the industry, the cost leadership strategy enables a firm to absorb a greater amount of cost increases from powerful suppliers before it must raise prices charged to customers. This may enable the firm to be alone among its competitors in earning above-average returns. In addition, a low-cost leader that also has a dominant market share may be in a position to force suppliers to reduce prices or to hold down the level of price increases, and thus reduce the power of suppliers. Again, Walmart is a good example of a firm that follows this pattern. Potential Entrants Firms successfully following cost leadership strategies generally must produce and sell in large volumes to earn above-average returns. And with a continuous focus on efficiency and reducing costs, cost leadership firms create barriers to entry. New entrants must either enter the industry at a large scale (large enough to achieve the same economies of scale as the next lowest cost firm) or be satisfied with average profits until they move sufficiently far down the experience curve to match the efficiencies of the low-cost leader. Product Substitutes The cost leader is in a more attractive position relative to substitute products than are other firms in the industry. To retain customers, the cost leader can more easily reduce prices to maintain the price-value relationship and retain customers. Competitive Risks of the Cost Leadership Strategy Despite the attractiveness of the cost leadership strategy, it is accompanied by risks such as the following: • Technological innovations by competitors could eliminate the cost leader’s cost advantage. • Overly focusing on process efficiency may cause the cost leader to overlook needed differentiation features. • Competitors may successfully imitate the low-cost leader’s value chain configuration. In the event of any of the above, the low-cost leader is challenged to increase value to customers. This may mean reducing prices or adding product features without raising prices. However, if prices are reduced too low, it may be difficult for the firm to earn satisfactory margins and customers may resist any price increases. Differentiation Strategy In contrast to the cost leadership strategy, implementation of a differentiation strategy means that value is provided to customers through the unique features and characteristics of a firm’s products rather than by the lowest price. Because differentiated products satisfy customers’ unique needs or preferences, firms can charge a premium price for differentiated products. But the premium cannot exceed what customers are willing to pay. For the firm to be able to outperform its competitors and earn above-average returns, the price charged for the differentiated product must exceed the cost of differentiation. In other words, the price charged must exceed total product cost. Because of this, the differentiated product’s premium prices generally exceed the low price of the standard product. Firms that follow a differentiation strategy concentrate or focus on product innovation and developing product features that customers value rather than on maintaining the lowest competitive price (the case for cost leadership strategy). Often this strategy seeks to differentiate the product/service on as many dimensions as possible. Products can be differentiated in a number of ways so that they stand apart from standardized products: • Superior quality • Unusual or unique features • More responsive customer service • Rapid product innovation • Advanced technological features • Engineering design and performance • Additional features • An image of prestige or status Some examples of differentiation strategies include the following: • Ralph Lauren differentiates its clothing lines through image. • Lexus cars are differentiated by prestige and image. • Apple (iPod and iPhone) are differentiated by innovative design. • McKinsey and Company offers differentiated consulting services. Successfully implementing (and maintaining) a differentiation strategy requires a firm to consider its value chain of primary and secondary activities and effectively link those activities as illustrated in Figure 4.3. Figure Note: Use Figure 4.3 to show that the critical focus in a successful differentiation strategy is on quality and product innovation, regardless of the value-creating activity. FIGURE 4.3 Examples of Value-Creating Activities Associated with the Differentiation Strategy As suggested in Figure 4.3, the firm’s focus in its value chain activities and support functions is on • Establishing the importance of quality • Accuracy, speed, and responsiveness • Understanding and meeting customers’ unique preferences • Monitoring the speed, reliability, and quality of activities provided by others that interface with the firm’s inbound and outbound logistics Teaching Note: The chapter mentions that firms following differentiation strategies cannot completely ignore costs and the need for minimal spending on process-related innovations. Porter refers to this as maintaining “parity” on the alternative dimension. When speaking of cost leadership strategies, a useful example of “differentiation parity” comes from the automobile manufacturing industry. Hyundai has been able to compete based on cost, but it still produces a car that is “in the ballpark” on differentiation. Failed manufacturer Yugo offered a very inexpensive car (introduced at a mere $1995 in the early 1980s), but these were of such poor quality that buyers refused to purchase them once news of their reliability problems got out. A car that will not run is not a value, even if it sells for only a fraction of the price of all other available models! In a similar way, a company that competes on differentiation must maintain “cost parity” so that the differentiated features that customers want are not beyond the reach of their pocketbooks. Consumers recognize the superior quality of Sony televisions, but the premium charged is justifiable, given the quality of the product. Obviously, controlling costs plays an important part in pricing possibilities. STRATEGIC FOCUS Apple vs. Samsung: Apple Differentiates and Samsung Imperfectly Imitates Apple is a successful product innovator that creates new markets and then dominates them as a first mover. Samsung has become a successful challenger to Apple by imitating Apple’s innovations as a fast second mover. Using this strategic approach Samsung imitates desirable Apple features (with some changes) and improves on some in ways that customers value. The cycle of innovation/imitation occurs in multiple product groups. Even though Samsung appears to be an imitator, it invests about three times as much money in R&D than Apple (5.4% of sales vs 2.2%). Teaching Note: Students will undoubtedly be familiar with products of both companies profiled in the Strategic Focus. Ask students to speculate about the future battles involving Apple and Samsung? Based on information in the Strategic Focus, do they think Samsung is destined to be a perpetual second mover, or will it’s R&D investments overtake Apple’s leadership position. Ask them to identify other companies that are locked into similar cycles of innovation and imitation. A firm that successfully implements a differentiation strategy can earn above-average returns even when the five competitive forces are strong. Rivalry with Existing Competitors Achieving customer loyalty means differentiating products in ways that are meaningful to customers. Brand loyalty means that customers will be less sensitive to price increases. As long as the firm satisfies the differentiated needs of loyal customers, it may be insulated from price-based competition. Bargaining Power of Buyers (Customers) Through meaningful differentiation, firms develop products that are considered unique. This uniqueness may insulate the firm from competitive rivalry and reduce customer sensitivity to price increases (similar to the insulation from rivalry with existing competitors). By satisfying customer preferences in ways that no competitor can, firms also are able to charge higher prices (because there are no comparable product alternatives). Bargaining Power of Suppliers Because of the differentiator’s focus on product quality and responsiveness to customer preferences, suppliers also may be forced to provide differentiators with higher quality materials, components, or services, which can drive up the firm’s per-unit costs. Since the differentiator charges premium prices, they are somewhat insulated from suppliers’ price increases (as the differentiator can absorb a greater level of cost increases from powerful suppliers through its higher margins). Alternatively, because of lower price sensitivity by customers, differentiators may be able to raise prices to cover increased supplier-related costs. Potential Entrants The principal barrier to entry is customers’ loyalty to the uniquely differentiated brand. This means that a potential entrant must either overcome (or surpass) the uniqueness of existing products or provide similarly differentiated products at a lower price to increase customer value. Product Substitutes Brand loyalty may insulate differentiated products from substitutes. Without brand loyalty, customers may switch to substitutes that offer similar features at a lower price or to products with more attractive features at the same price. Competitive Risks of the Differentiation Strategy Like the cost leadership strategy, the differentiation strategy also carries risks such as the following: • Customers may decide that the cost of uniqueness is too high. In other words, the price differential between the standardized and differentiated product is too high. Perhaps the firm provides a greater level of uniqueness than customers are willing to pay for. • The firm’s means of differentiation no longer provides value to customers. For instance, what is the value of prestige or exclusivity? And, how long will they last as customers become more sophisticated? • Customer learning may reduce the customer’s perception of the value of the firm’s differentiation. Through experience, customers may learn that the extra price for a differentiated good is no longer a value. Teaching Note: This loss of value through customer learning or changes in customer perceptions can be illustrated by the experiences of IBM. Initially, the IBM name on a personal computer signaled value to customers; however, clones soon challenged IBM’s preeminent position in the PC market. As customers learned that the clone machines offered similar features at lower prices, the value attached to the IBM brand name diminished and IBM’s sales suffered. • A fourth risk is concerned with counterfeiting. Increasingly, counterfeit goods (products that attempt to convey differentiated features to customers at significantly reduced prices) are a concern for many firms using the differentiated strategy. In the event of any of the above, differentiators are challenged to increase value to customers. This may mean reducing prices, adding product features without raising prices, or developing new efficiencies in its value chain of primary and secondary activities. Focus Strategies By implementing a cost leadership or differentiation strategy, firms choose to compete by exploiting their core competencies on an industry-wide basis and adopt a broad competitive reach. Alternatively, firms can choose to follow a focus strategy by seeking to use their core competencies to serve the needs of a particular customer group in an industry. In other words, firms focus on specific, smaller segments (or niches) of customers rather than across the entire market. Markets can be segmented by: • Particular buyer group (e.g., youths or senior citizens) • Different segments of a product line (e.g., products for professionals or “do-it- yourselfers”) • Different geographic market (e.g., the eastern or western United States) Firms may choose to follow a focus strategy because: • They can serve a narrow segment more effectively than competitors that choose to compete industry wide • The narrow segment’s needs are so special that industry-wide competitors choose not to meet them • Certain narrow segments are being poorly served by industry-wide competitors Note: Emphasize again that focus strategies can be based either on cost leadership or differentiation. Focused Cost Leadership Strategy Firms that compete by following cost leadership strategies to serve narrow market niches generally target the smallest buyers in an industry (those who purchase in such small quantities that industry-wide competitors cannot serve them at the same low cost). Global furniture retailer IKEA provides customers with “good design and function at low prices” through use of the focused cost leadership strategy. IKEA does this by offering low- cost, modular furniture (assembled by customers), using self-service as an alternative to having sales associates follow and pressure customers to buy. IKEA displays its products in room-like settings so that customers can view different combinations of furniture, eliminating the need for assistance from sales associates or decorators to visualize the setting and reducing employee costs. Customers also pick up their own purchases to reduce the firm’s costs. However, the company also differentiates somewhat. For example, stores address the needs of shoppers (e.g., extended hours and in-store childcare) while they shop. Focused Differentiation Strategy Firms following focused differentiation strategies produce customized products for small market segments. They can be successful when either the quantities involved are too small for industry-wide competitors to handle economically, or when the extent of customization (or differentiation) requested is beyond the capabilities of the industry-wide differentiator. The text uses the new generation of lunch trucks offering high-end fare prepared by highly trained chefs and often owned by well-known restaurants to illustrate this strategy. Teaching Note: Other examples of focused differentiators include: • Upscale apartment buildings in various locations are being designed to serve the needs of technologically savvy city dwellers, offering differentiated features such as high-speed digital Internet access and other sophisticated telecommunications services. • Manufacturers such as Ferrari, Aston Martin, and Lamborghini compete in the tiny supercar category with prices starting at $150,000 and running as high as $600,000. These cars are more than just transportation. Just as was noted for industry-wide differentiators and low-cost producers, firms choosing to focus must be particularly adept at completing primary and secondary value chain activities in a superior way. Issues related to the five competitive forces are similar to those discussed for the differentiation and cost leadership strategies; however, the competitive scope of the focus is on a narrow segment rather than the industry. Students should review Figures 4.3 and 4.4 (Value-Creating Activities) as well as the earlier discussion of the five competitive forces for the cost leadership and differentiation strategies. Competitive Risks of Focus Strategies The competitive risks of focus firms are similar to those previously noted for the cost leadership and differentiation strategies with the following additions: • Competitors may successfully focus on an even smaller segment of the market, “outfocusing” the focuser, or focus only on the most profitable slice of the focuser’s chosen segment. Teaching Note: For example, Confederate Motor Co. is producing a highly differentiated motorcycle that might appeal to some of Harley-Davidson’s customers. Obsessed with making a “fiercely American motorcycle” (one that is even more American than are Harley’s products), Confederate’s motorcycles are produced entirely by hand labor. In fact, a full week is required to make a single bike. Digital technology is used to design Confederate’s products, which have a radical appearance. At a price of $62,000 or more, the firm’s products will appeal only to customers wanting to buy a truly differentiated product such as the F113 Hellcat (which is receiving “rave reviews in the motorcycling press”). • An industry-wide competitor may recognize the attractiveness of the segment served by the focuser and mobilize its superior resources to better serve the segment’s needs. • Preferences and needs of the narrow segment may become more similar to the broader market, reducing or eliminating the advantages of focusing. Integrated Cost Leadership/Differentiation Strategy This hybrid strategy may become even more important—and more popular—as global competition rises. Compared to firms relying on a single generic strategy, firms that integrate the generic strategies may position themselves to improve their ability to adapt quickly to environmental changes. Successfully pursuing the cost leadership and differentiation strategies simultaneously yields additive benefits: • Differentiation enables the firm to charge premium prices. • Cost leadership enables the firm to charge the lowest competitive price. • The firm is thus able to achieve a competitive advantage by delivering value to customers based on both product features and low price. • A variety of other factors also may enable firms to gain a competitive advantage and earn above-average returns from an integrated cost leadership/differentiation strategy. Flexible Manufacturing Systems A flexible manufacturing system is a computer-controlled process used to produce a variety of products in moderate, flexible quantities. It enables firms to achieve the flexibility necessary to simultaneously respond to changes in customer needs and preferences while maintaining the low-cost advantages of large-scale manufacturing. This increases a firm’s ability to engage in an integrated low-cost/differentiation strategy. Information Networks Information networks enable a firm to coordinate interdependencies between internally and externally performed value-creating activities to increase flexibility and responsiveness. Examples include real-time linkages between manufacturers and suppliers or subcontractors, or between retailers and suppliers. These linkages can improve time-to-market of new products by coordinating design and production activities and reduce out-of-stock occurrences by shortening the order-restock cycle. Customer relationship management (CRM) is one form of an information-based network process that firms use to better understand customers and their needs. An effective CRM system provides a 360-degree view of the company’s relationship with customers, encompassing all contact points, involving all business processes, and incorporating all communication media and sales channels. The firm can then use this information to determine the trade-offs its customers are willing to make between differentiated features and low cost, which is vital for companies using the integrated cost leadership/differentiation strategy. Enterprise Resource Planning Systems: A Mini-Lecture Enterprise Resource Planning is an information system used to identify and plan the resources required across the firm to receive, record, produce, and ship customer orders. For example, salespeople for aircraft parts distributor Aviall use handheld equipment to scan barcode labels on bins in customers’ facilities to determine when parts need to be restocked. Data gathered through this procedure are uploaded via the Web to the Aviall back-end replenishment and ERP system, allowing the order fulfillment process to begin within minutes of scanning. Growth in ERP applications such as the one used at Aviall has been significant. Full installations of an ERP system are expensive, running into the tens of millions of dollars for large-scale applications. Improving efficiency on a company-wide basis is a primary objective of using an ERP system. Efficiency improvements result from the use of systems through which financial and operational data are moved rapidly from one department to another. The transfer of sales data from Aviall salespeople to the order entry point at the firm’s manufacturing facility demonstrates the rapid movement of information from one function to another. Integrating data across parties that are involved with detailing product specifications and then manufacturing those products and distributing them in ways that are consistent with customers’ unique needs enable the firm to respond with flexibility to customer preferences relative to cost and differentiation. Total Quality Management Systems These systems have been established to improve product quality (from a customer perspective) and to improve productivity in the performance of the internal value-creating activities. Firms develop and use TQM systems in order to (1) increase customer satisfaction, (2) cut costs, and (3) reduce the amount of time required to introduce innovative products to the marketplace. Improving product quality focuses on product reliability, performance, and utility, and enables the firm to differentiate its products and charge higher prices, while lowering the costs of manufacturing and service. Teaching Note: The following are the key assumptions on which total quality management (TQM) systems are based: • The costs of poor quality exceed the costs of developing processes that produce high quality products and services (in other words, it is less costly to do things right the first time). • Employees care about their work and will take the initiative to improve it (but only if the firm provides the resources, tools, and training necessary and management listens to their ideas). • Since organizations are systems of highly interdependent parts, decision processes must be integrated and include participation from all affected functional areas. • Responsibility for effective TQM rests with top-level managers who must support TQM processes and appropriately design the firm so that employees can function effectively. Competitive Risks of the Integrated Cost Leadership/Differentiation Strategy This is a risky strategy, as it is difficult for firms to perform primary and support activities in ways that allow them to produce relatively inexpensive products with levels of differentiation that create value for the target customers. Moreover, to properly use this strategy across time, firms must be able to simultaneously reduce costs incurred to produce products (as required by the cost leadership strategy) while increasing products’ differentiation (as required by the differentiation strategy). Being “stuck-in-the-middle” implies that the firm will not be able to manage successfully the five competitive forces and will not achieve strategic competitiveness. In fact, these firms can only earn average profits when industry structure is favorable or when other firms in the industry also are “stuck-in-the-middle.” Instructor Manual for Strategic Management: Concepts and Cases: Competitiveness and Globalization Michael A. Hitt, R. Duane Ireland, Robert E. Hoskisson 9781285425184, 9781285425177, 9780538753098, 9781133495239, 9780357033838, 9781305502208, 9781305502147
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