What Is Business Strategy?
01
© MARIO ANZUONI/Reuters /Corbis
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1
Define business strategy, including the importance of
competitive advantage, the four choices that are critical to
strategy formulation, and the strategic management process.
2
Summarize the information that the company’s mission and
thorough external and internal analysis provide to guide strategy.
3
Discuss how strategies are formulated and implemented in
order to achieve objectives.
4
Explain who is responsible for, and who benefits from, good
business strategy.
[3]
01
I
Strategy at Apple
n 2000, Apple computer held a loyal customer base but
was limping along as a relatively minor player in the
personal computer market. Launched by Steve Jobs
and Steve Wozniak, Apple was one of the pioneers in the
industry. Unlike other PC makers that relied on Microsoft’s
operating system and application software, Apple wrote its
own operating system software and much of its application
software, which was known as being easy to use. In fact,
Apple was the first to introduce software on a low cost
personal computer with drop-down menus and a graphical
user interface that allowed customers to easily complete
a task—like drag a file to the trash to delete it. However,
Apple’s investment in unique software led to high-priced
computers and created files that were originally incompatible
with those of Microsoft’s Windows operating system and
Office software suite. As a result, Apple rarely achieved more
than about a 5 percent share of the computer market.1
These advantages helped iPod quickly move to industry
leadership, despite the fact that an iPod cost 15 to 25 percent
more than a Rio.3 At the time the iPod was launched, it
was difficult for most consumers to legally access digital
downloads of songs. Initially, the iPod was only snapped up
by a relatively small group of users, mostly teenagers and
college students, who were illegally downloading songs
through Napster and other free downloading sites.
Apple recognized that in order to grow the market for
iPods, it needed to help consumers legally access songs to
play on their iPods. As a result, Apple developed software
called iTunes, allowing customers to legally download songs.
One main reason iTunes was able to provide legal downloads
before its competitors was because Steve Jobs, as CEO of both
Apple and Pixar (the animation movie production company),
understood that music companies, like movie companies,
were concerned about people pirating their products. So
Apple worked with the music
companies to sell songs that had
CUSTOMERS NOW COULD EASILY AND LEGALLY ACCESS SONGS SIMPLY BY
been digitized using software
CONNECTING THEIR iPODS TO THEIR COMPUTERS AND LETTING THE SOFTWARE DO
that prevented customers from
TO THE REST. EVEN A TECHNOLOGY-CHALLENGED GRANDPARENT COULD DO IT.
copying the songs to more than
a few computers. iTunes was
designed to be easy to use with the iPod. Customers now could
That all changed in 2001, however, when Apple entered
easily and legally access songs simply by connecting their
an entirely new market with the launch of an MP3 portable
iPods to their computers and letting the software do to the rest.
music player called the iPod. Apple’s MP3 player was not
Even a technology-challenged grandparent could do it.4
the first on the market. A company called Rio had offered an
MP3 player for a couple of years before iPod’s entry into the
But Apple wasn’t done with its music player strategy.
market. But iPod quickly took market share from the Rio, for
Apple’s experience in the computer business was that
three primary reasons:
other companies could make similar products, often
at lower prices. Indeed, while Apple and IBM were the
1. iPod had a mini hard drive that allowed it to hold 500
pioneers of the personal computer industry and dominated
songs, as opposed to the roughly 15 songs the Rio
it during the early years, lower-priced competitors like
could hold using flash memory.
Dell, Hewlett-Packard, Lenovo, and ASUS, eventually
2. iPod was the first to introduce a “fly wheel” navigacame to dominate the market. Apple realized it needed to
tion button—the round button that was easy to use and
prevent easy imitation of its music offering. So it created
allowed users to quickly scroll through menus and songs.
proprietary software called Fairplay that restricted the use
3. iPod was backed with Apple’s name and an innovative
of music downloaded from iTunes to iPods only. That meant
design.2
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[5]
WHAT IS BUSINESS STRATEGY?
consumers couldn’t buy a lower-priced MP3 player and use
it with iTunes because it was incompatible. If they wanted to
use a different MP3 player, they would have to download and
pay for music a second time.5
To top it off, Apple did something that no other maker of
computers, music players, or any other electronic device
company had done. It opened its own stores to sell Apple
products. This required that Apple learn how to operate retail
stores. The Apple Stores helped Apple create a direct link to
its customers, making it easier for consumers to learn about
and try out Apple products—and get their products serviced.
As a result of Apple’s strategic initiatives, it has built
a very secure market position in music players, currently
holding over 70 percent of that market.6 But the battle isn’t
over. Amazon has entered the industry, offering music
buyers unrestricted use of its songs. Moreover, competitors
e-Music, Rhapsody.com, and Spotify are offering music via
subscription. Users can listen to any song they want for a
monthly subscription fee. And Pandora, a free online radio
service, offers similar unlimited access to songs. The $17
billion music industry is so large that it will continue to
attract new competitors who want to dethrone Apple.
ì
How did Apple enter the music industry and within 10 years become the dominant seller of
both songs and music players? Why is Pandora, a start-up, succeeding in the music industry
while former giant Sony (maker of the Walkman and Discman) is struggling? For that matter, why is any company successful? Understanding the series of actions taken by Apple to
achieve a dominant position in the online music business will go a long way toward understanding business strategy—a company’s plan to gain, and sustain, competitive advantage in
its markets. In this chapter, we’ll help you get started by answering some basic questions. We
begin with the most obvious: “What is a business strategy?”
WHAT IS BUSINESS STRATEGY?
The word strategy comes from the Greek word strategos, meaning, “the art of the general.”
In other words, the origin of strategy comes from the art of war, and, specifically, the role of
a general in a war. In fact, there is a famous treatise titled The Art of War that is said to have
been authored by Sun Tzu, a legendary Chinese general. In the art of war, the goal is to win—
but that is not the strategy. Can you imagine the great general Hannibal saying something
like, “Our strategy is to beat Rome!” No, Hannibal’s goal was to defeat Rome. His strategy was
to bring hidden strengths against the weaknesses of his enemy at the point of attack—which
he did when he crossed the Alps to attack in a way that his enemies did not believe he could.
He achieved an advantage through his strategy.
In similar fashion, a company’s business strategy is defined as a company’s plan to gain,
and sustain competitive advantage in the marketplace. This plan is based on the theory its
leaders have about how to succeed in a particular market. This theory involves predictions
of which markets are attractive and how a company can offer unique value to customers
in those markets in a way that won’t be easily imitated by competitors. This theory then
gets translated into a plan to gain competitive advantage. Apple’s theory of how to gain a
competitive advantage in music download business was to create cool and easy-to-use MP3
players that could easily—and legally—download digital songs from a computer through
the iTunes store. Apple sought to sustain its advantage by making it impossible for competitor MP3 players to download songs from the iTunes store. The Apple Stores contributed to
Apple’s advantage by providing a direct physical link to customers that competitors couldn’t
match. In this particular instance, Apple’s plan to gain, and sustain, competitive advantage
worked. But there have been other times, such as with the Apple Newton Message Pad (the
first handheld computer that Apple sold as a personal digital assistant) that Apple’s theory
about how to gain and sustain competitive advantage did not work. Sometimes strategies
are successful and sometimes they are not.
Strategies are more likely to be successful when the plan explicitly takes into account
four factors:
1. the attractiveness of a market
2. how to offer unique value relative to the competition
business strategy A plan to
achieve competitive advantage
that involves making four strategic
choices: (1) markets to compete
in; (2) unique value the firm will
offer in those markets; (3) the
resources and capabilities required
to offer that unique value better
than competitors; and (4) ways to
sustain the advantage by preventing
imitation.
competitive advantage When
a firm generates higher profits
compared to its competitors.
market The industry and
geographic area that a company
competes in.
unique value The reason a firm
wins with customers or the value
proposition it offers to customers,
such as a low cost advantage or
differentiation advantage.
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3. what resources or capabilities are necessary to deliver that unique value
4. how to sustain a competitive advantage once it has been achieved.
The goal of the strategic plan is to create competitive advantage. First, let’s examine the goal.
Competitive Advantage
What exactly do we mean when we use the term competitive advantage? 7 In the sports world,
it is usually obvious when a team has a competitive advantage over another team: The better team wins the game by having a higher score. The ability to consistently win is based on
attracting and developing better players and coaches, and by employing strategies to exploit
the weaknesses of opponents. In the business world, the scoring is measured by looking
at the profits (as a percentage of invested capital) generated by each firm. We describe the
S T R AT E GY I N P R A CT I C E
Measuring American Home Products’
Competitive Advantage
T
o see which firms in an industry are most successful,
we typically compare their return on assets (ROA), a
calculation of operating profits divided by total assets, or
their return on equity (ROE), which is operating profits divided
by total stockholders’ equity. The company that consistently
generates the highest returns for its investors, in terms of ROA
or ROE, wins the game. For example, from 1971 to 2000, the
pharmaceutical company American Home Products averaged
19 percent ROA, compared to competitor American Cyanamid’s
7 percent. American Home Products’ ROA was higher than
American Cyanamid’s every year for 30 years. This is evidence
that during this time period, American Home Products had a
competitive advantage over American Cyanamid.8 American
Home Products’ advantage over American Cyanamid
frequently has been attributed to its ability to develop more
blockbuster drugs (through more effective research and
development) and to quickly get those drugs to market through
a larger and more effective sales force.
Profitability of Different Firms in the Pharmaceutical Industry
20
18
Operating Profit (ROA %)
16
14
12
10
8
6
4
2
Source: Annual reports; 1973–1992
American
Cyanamid
Pfizer
Upjohn
Schering Plough
Eli Lilly
Bristol Myers
Squibb
Merck
American Home
Products
0
WHAT IS BUSINESS STRATEGY?
most common ways of measuring profits in Strategy in Practice: Measuring American Home
Products’ Competitive Advantage.
Just as in sports, where an inferior team may outscore a superior team on a given day,
it may be possible for an inferior company to outscore a superior company in a particular
quarter, or perhaps even a year. Competitive advantage requires that a firm consistently outperform its rivals in generating above-average profits. A firm has a competitive advantage
when it can consistently generate above-average profits through a strategy that competitors
are unable to imitate or find too costly to imitate. Above-average profits are profit returns
in excess of what an investor expects from other investments with a similar amount of risk.
Risk is an investor’s uncertainty about the profits or losses that will result from a particular
investment. For example, investors suffer a lot of uncertainty (and, hence, risk) when they
put their money into a start-up company that is trying to launch products based on a new
technology, such as a solar power company. There is much less risk in investing in a stable
firm with a long history of profitability, such as a utility company that supplies power to
customers who have few, if any, alternative sources of power.9
Many organizations work to achieve objectives other than profit. For example, universities, many hospitals, government agencies, not-for-profit organizations, and social entrepreneurs play important roles in making our economy work and our society a better place to
live. These organizations do not measure their success in terms of profit rates, but they still
use many of the tools of strategic management to help them succeed (see Chapter 14). For
these organizations, success might be measured using tangible outcomes such as the number of degrees granted, patient health and satisfaction measures, people served, or some
other measure of an improved society.
The primary source of a company’s competitive advantage can come from several areas
of its operations. For example, the diamond company De Beers has an advantage that comes
from paying lower costs for its diamonds than other companies do, because De Beers owns
its own diamond mines. Competitive advantage can also come from different functional areas
within the company. Biotechnology pioneer Genentech’s advantage comes primarily from
research and development that has produced several blockbuster drugs; Toyota’s advantage in
automobiles comes primarily from its operations (known as the Toyota Production System);
Procter & Gamble’s advantage in household products comes largely from its sales and marketing, and Nordstrom’s advantage as a retailer comes largely from its merchandising and service.
[7]
above-average profits Returns in
excess of what an investor expects
from other investments with a
similar amount of risk.
The Strategic Management Process
The processes that firms use to develop a strategy can differ dramatically across firms. In
some cases, executives do not spend significant time on strategy formulation and strategies
are often based only on recent experience and limited information. However, we propose
that a better approach to the formulation of strategy is the strategic management process
outlined in Figure 1.1. The strategic management process for formulating and implementing
strategy involves thorough external analysis and internal analysis. Only after conducting
an analysis of the company’s external environment and its internal resources and capabilities are a firm’s executives and managers able to identify the most attractive business opportunities and to formulate a strategy for achieving competitive advantage.
The central task of the strategy formulation process is specifying the high-level plan and
set of actions the company will take in its quest to achieve competitive advantage. Once the
plan for creating competitive advantage is created, the final step is to develop a detailed plan
to effectively implement, or put into action, the firm’s strategy through specific activities.
The focus of the strategic management process should be to make four key strategic
choices, as shown in Figure 1.2
1. Which markets the company will pursue. A company’s markets include both the industries in which it competes and its geographic markets.
2. What unique value to offer the customer in those markets. This is the firm’s value proposition, the reason the company wins with a set of customers.10
3. What resources and capabilities are required? What does the company need to have
and know how to do so that it can deliver its unique value better than competitors, and
exactly how will the company deliver its unique value?11
strategic management
process The process by which
organizations formulate a plan
and allocate resources to achieve
competitive advantage that involves
making four strategic choices:
(1) markets to compete in; (2)
unique value the firm will offer in
those markets; (3) the resources
and capabilities required to offer
that unique value better than
competitors; and (4) ways to
sustain the advantage by preventing
imitation.
external analysis Examining
the forces that influence industry
attractiveness, including
opportunities and threats that exist
in the environment.
internal analysis The analysis of
a firm’s resources and capabilities
to assess how effectively the firm
is able to deliver the unique value
(value proposition) that it hopes to
provide to customers.
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[ Figure 1.1 ] The Strategic Management Process
Mission
External Analysis
Internal Analysis
Strategy Formulation
Business Level
Strategies
Strategy
Vehicles
Corporate
Strategy
[Chapter 6]
Dynamic
Strategic Actions
Cost
Advantage
[Chapter 4]
Differentiation
Advantage
[Chapter 5]
Vertical
Integration
[Chapter 7]
Strategic
Alliances
[Chapter 8]
Disruptive
Business
Models
[Chapter 10]
Competitor
Interaction/
Game Theory
[Chapter 11]
International
Strategy
[Chapter 9]
Strategy Implementation
Strategy
Implementation
[Chapter 12]
Governance
and Ethics
[Chapter 13]
Social Value
Organizations
[Chapter 14]
4. How the company will capture value and sustain a competitive advantage over time.
Firms need to create barriers to imitation to keep other companies from delivering the
same value.
Markets. One of the first decisions a company must make is which markets it will serve.
Leaders must choose the industries a company competes in and the product and service
markets within those industries. For example, before iPod, Apple only competed in the
computer industry. Its product markets included desktop and laptop computers. Launching
iPod and iTunes took Apple into the music industry. Later, when Apple launched the iPhone,
it entered the cell phone business.
It is also important to select geographic markets to serve. Apple competes on a worldwide
basis, which allows it to spread heavy research and development costs across its many geographic markets. By contrast, Walmart started by focusing on rural markets, which allowed
it to offer lower prices than the “mom and pop” retail stores in small towns.12
Unique Value. After a company chooses the markets in which to compete, it then
attempts to offer unique value in those markets. This is often referred to as a company’s
value proposition, or the value that it proposes to offer to customers. Companies typically
try to achieve a competitive advantage by choosing between one of two generic strategies
WHAT IS BUSINESS STRATEGY?
[9]
[ Figure 1.2 ] Four Key Strategic Choices in Strategic
Management
Markets to
Pursue
Unique Value to
Offer
Resources and
Capabilities to
Develop
Sustaining
Advantage
for offering unique value: low cost or differentiation. Companies such as Walmart, Ryanair,
Taco Bell, and Kia attract customers by being cost leaders, offering products or services
that are priced lower than competitor offerings. A firm that chooses a low-cost strategy
(the focus of Chapter 4) focuses on reducing its costs below those of its competitors. Key
sources of cost advantage include economies of scale, lower-cost inputs, or proprietary
production know-how.
A firm that chooses a differentiation strategy (the focus of Chapter 5) focuses on offering features, quality, convenience, or image that customers cannot get from competitors.
Apple’s unique value is offering iPods (music players), iPhones (smart phones), and iPads
(tablets) that are well designed, innovative, easy to use, and have features that competing
products don’t have (“there’s an App for that”). In similar fashion, Starbucks wins through
differentiation by offering multiple blends of high-quality coffee in convenient locations.
Resources and Capabilities. Delivering unique value requires developing resources and
capabilities that will allow the company to perform activities better than competitors.
Indeed, perhaps the most critical role of the strategist is to figure out how to build or acquire the
resources and capabilities necessary to deliver unique value.
Resources refer to assets that the firm accumulates over time, such as plants, equipment,
land, brands, patents, cash, and people. Steve Jobs was a key resource for Apple because he
had the uncanny ability to figure out what customers wanted before even they knew.
Capabilities refers to processes (or recipes) the firm develops to coordinate human activity to achieve specific goals. To illustrate, Starbucks has key resources that allow it to succeed
through differentiation, include its Starbucks brand, its retail store locations, its recipes to
produce different coffee blends, and even some patents to protect those recipes. Its capabilities include its processes to roast coffee beans for the best flavor, create new coffee blends,
design stores with great atmosphere, and find optimal store locations. These resources and
capabilities have allowed Starbucks to deliver unique value to customers, thereby helping
the company outperform other coffee shops within the coffee retailing industry.
Sustaining Advantage. By being the first to offer music downloads through its easy-to-use
iTunes software, Apple encouraged its customers to store their entire music libraries on
iTunes. Designing iTunes so that it wouldn’t download songs to other music players helped
Apple to prevent competing MP3 players from taking market share from iPod. Of course,
Apple’s brand image and its Apple Stores also prevent competitors from easily imitating its
products and services. These actions helped Apple capture the value it created.
cost advantage An advantage that
a firm has over its competitors
in the activities associated with
producing a product or service,
thereby allowing it to produce the
same product at lower cost.
differentiation advantage An
advantage a firm has over its
competitors by making a product
more attractive by offering unique
qualities in the form of features,
reliability, and convenience that
distinguishes it from competing
products.
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WHAT INFORMATION AND ANALYSIS GUIDES
STRATEGY FORMULATION?
As Figure 1.1 shows, the earliest steps in the strategic management process involve analyses
and choices that later result in the formulation and implementation of a company’s strategy.
These choices are made within the context of the company’s mission and only after an analysis of the external environment and internal organization.
Mission
mission A company’s primary
purpose that often specifies the
business or businesses in which
the firm intends to compete—or
the customers it intends to serve.
A company’s mission outlines the company’s primary purpose and often specifies the business or businesses in which the firm intends to compete—or the customers it intends to
serve. People in business often use the terms mission, vision, or purpose somewhat interchangeably. For our purposes in this book, we will use the term mission to refer to the primary purpose of the organization.
Most business firms start with a mission, even if it isn’t formally stated. For example,
Starbucks founder Howard Schultz got the idea to introduce coffee bars to America when
he visited Italy and experienced the great coffee and convenience of Italian espresso bars.
His external analysis of the coffee shop industry in the United States led him to believe
that there was an opportunity to bring an exceptional coffee experience to America. Schultz
once said American coffee was so bad it tasted like “swill.” He discovered café latte when
visiting an espresso bar in Verona, Italy, and thought, “I have to take this to America.”13 So
he launched Starbucks, a company that offered higher-quality coffee than traditional coffee
shops, and included many varieties at a premium price. In essence, Starbucks started with a
mission to bring high-quality coffee to the masses in the United States.
As companies grow and develop formal mission statements, these statements often
define the core values that a firm espouses, and are often written to inspire employees to
behave in particular ways. Starbucks formalized its mission as follows:
Our mission: to nurture and inspire the human spirit—one person, one cup, and one
neighborhood at a time.14
It then proceeds with the statement: Here are the principles of how we live that every day—
which is followed by a set of principles or values designed to guide employee behaviors. Even
after it has been formalized, however, a company’s mission is still open to interpretation, as
Strategy in Practice: Apple’s Evolving Mission shows.
External Analysis
SWOT analysis Strategic
planning method used to evaluate
the strengths, weaknesses,
opportunities, and threats involved
in a business.
External analysis is critical for addressing the first strategic choice: Where should we compete? External analysis involves: (1) an examination of the competition and the forces that
shape industry competition and profitability; and (2) customer analysis to understand what
customers really want. The combined results of external analysis with internal analysis of
the firm are often summarized as a SWOT analysis. SWOT is an acronym for Strengths,
Weaknesses, Opportunities, and Threats.15 External analysis is particularly useful for shedding light on the latter two: opportunities and threats.
Industry Analysis. One of the central questions for the strategist is to determine which
markets or industries to compete in. The fact of the matter is that all industries are not
created equal. To illustrate, between 1992 and 2006, the average return on invested capital
in U.S. industries ranged from as low as zero to more than 50 percent.16 The most profitable
industries include prepackaged software, soft drinks, and pharmaceuticals. These industries
are more than five times as profitable as the least profitable industries, which include airlines,
hotels, and steel. This does not mean that a steel or airline company cannot be successful or
profitable (Southwest Airlines has been quite profitable17), but it does mean that the average
profitability of all firms in these industries is low compared to other industries. This makes
the challenge of making money in these low-profit industries even greater.
WHAT INFORMATION AND ANALYSIS GUIDES STRATEGY FORMULATION?
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S T R AT E GY I N P R A CT I C E
Apple’s Evolving Mission
W
hen Steve Jobs and Steve Wozniak launched Apple in
1976, their primary purpose was to make great computers
that people loved to use. Twenty-four years later, Apple was still
essentially a computer company when it launched the iPod, a
device that took the company into the music industry.
But did you know that Apple was not the first computer
company to make a small, handheld MP3 player with a minihard drive that could store your entire music library? That honor
goes to Compaq (later acquired by HP). Compaq developed an
MP3 player before Apple, but the company decided this was
not an industry and product market that it wanted to enter.
Compaq decided not to pursue the MP3 business because it
saw its mission as being a computer maker, and music players
fell outside of that mission. Instead of refining the design and
launching its MP3 player on the market, Compaq sold the
technology to a Korean company. In contrast, Apple decided that
this product market was not outside its mission.
Apple’s decision was influenced by its external analysis.
Apple looked at the multibillion-dollar music business and
quickly realized that no company was offering legal digital
downloads—so the market was wide open because of the
challenges of protecting the files from easily being copied.
Apple’s leaders also considered its internal capabilities.
Unlike Compaq—which only made computer hardware but
not software—Apple had vast experience at writing software
for Apple computers. It also had far greater design expertise
than Compaq. In fact, the company had long been hailed for
the cutting-edge designs of the iMac and some of its other
computers. Apple decided to channel its internal capabilities
at writing software to navigate an MP3 player. Apple’s
software engineers came up with the innovative “flywheel”
design for navigating the iPod. Likewise, it channeled its
design capabilities toward designing a product that was
elegant and small enough to fit in your pocket.
As a result of formulating a strategy to enter the MP3
player market—and subsequently the iPhone and iPad
markets—Apple’s mission has broadened. The company no
longer focuses on just being a computer maker. In fact, in
2007 it changed its name from Apple Computer Inc. to Apple
Inc. to reflect this change in its mission.
Why are some industries more profitable than others? Strategy professor Michael Porter
developed a model for conducting industry analysis called the Five Forces that Shape Industry Competition.18 Understanding the five forces that shape industry competition is one of
the starting points for developing strategy, and will be discussed in detail in Chapter 2. This
framework helps managers think about what the company can do to increase its power over
suppliers and buyers, create barriers to other firms looking to enter the market, reduce the
threat of substitute products or services, and reduce rivalry with competitors.
Customer Analysis. External analysis also involves an analysis of customers or potential
customers, notably an analysis of their needs and price sensitivity. In particular, the
strategist can make better decisions about how to offer unique value by considering groups
of customers who all have similar needs. This is called customer segmentation analysis.19
For example, in the automobile industry, some customers want cars that are very stylish,
powerful, luxurious, and packed with technology and gadgets. These customers are the
focus of companies such as Porsche, Mercedes Benz, BMW, and Lexus. Others want trucks
with the capacity to haul heavy items and move easily over rough terrain. These customers
are the focus of the truck divisions of Chevy and Ford. Still others want economy cars for
basic transportation—the focus of Hyundai and Kia.
External analysis should enlighten managers about the competitive forces that influence
the profitability of particular markets and industries, as well as opportunities and threats. In
addition, it should shed light on what customers want and what they are willing to pay to
have their needs met.
Internal Analysis
Whereas external analysis focuses on a company’s industry, customers, and competitors, internal analysis focuses on the company itself. Internal analysis completes the SWOT by focusing
price sensitivity The degree
to which the price of a product
or service affects consumers’
willingness to purchase the product
or service.
segmentation analysis Dividing up
customers into groups or segments
based on similar needs or wants.
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resource-based review of firm
Determining the strategic
resources available to a company.
on strengths and weaknesses. More formally, internal analysis involves an analysis of the company’s set of resources and capabilities that can be deployed—or should be developed—to
deliver unique value to customers. We discuss internal analysis in greater detail in Chapter 3.
In the 1980s, the resource-based view of the firm, also known as the resource-based
model, was developed to explain why some firms outperform other firms within the same
industry.20 Why does Nucor make money in the steel business when most of its U.S. competitors do not? Why does Southwest fly high in the air travel business while most of its
competitors are ( financially) grounded? The resource-based model assumes that each company is a collection of resources and capabilities (also referred to as competencies) that are
deployed to deliver unique value.21
Firms that don’t have the resources and capabilities that are necessary to implement the
strategies they are contemplating, may need to improve, change, or possibly create them
in order to offer unique value to their customers. This is where resource allocation becomes
an important dimension of strategy. Once a company decides how it hopes to offer unique
value, it must allocate the resources necessary to build those resources or capabilities. For
example, once Target realized that it could not compete directly on prices with Walmart,
it allocated additional resources to move “upmarket.” This involved investing heavily in a
trends department, a new mix of higher-quality products, relationships with designers, more
expensive suburban retail locations, and significant TV advertising to get the message out
to customers.
HOW ARE STRATEGIES FORMULATED?
corporate strategy Decisions
about what markets to compete
in, made by executives at the
corporate level of an organization.
business unit strategy Decisions
about how to gain and sustain
advantage, made at the manager
level for each standalone
business unit within a company.
functional strategy Decisions
about how to effectively implement
the business unit strategy within
functional areas like finance,
product development, operations,
information technology, sales and
marketing, and customer service.
strategy vehicles Activities and
strategic choices—such as make
versus buy, acquisitions, and
strategic alliances—that influence
a firm’s ability to enter particular
markets, deliver unique value to
customers, or create barriers to
imitating its product.
Formulating a strategy involves selecting which actions the company will take to gain and
sustain competitive advantage. Remember, competitive advantage requires that the company do all of the following:
ì Provide unique value to a set of customers in the appropriate markets.
ì Develop a set of resources and capabilities that allow the company to deliver that
unique value to customers better than competitors.
ì Sustain the competitive advantage by figuring out how to prevent imitation of the
chosen strategy.
A company will also need to formulate, and then implement, strategy at three different
levels of the organization: corporate, business unit (product), and functional.
Corporate strategy refers to decisions that are made by senior corporate executives about where to compete in terms of industries and markets. For example, Amazon’s
corporate executives made the decision to enter the electronic reader/tablet business with
the Kindle where it would face new competitors like Apple. Similarly, Amazon’s launch of
Amazon Web Services—a business that provides web hosting, cloud storage, and marketplace software—was made at corporate headquarters by the corporate management team.
Business unit strategy is made at the level of the strategic business unit—standalone business units in a company that typically have their own profit and loss responsibility. Amazon’s
online discount business would be considered one business unit, whereas Kindle and Amazon Web Services would be different business units. The general manager of each business
unit addresses the questions we’ve identified regarding how to gain and sustain advantage
in that particular market. Finally, within each business unit are different functions such as
finance, product development, operations, information technology, sales and marketing,
and customer service. A functional strategy should align with the overall business unit
strategies to effectively implement the business unit strategy (see Figure 1.3).
Strategy Vehicles for Achieving Strategic Objectives
In many instances, firms rely on a few key strategy vehicles to help them enter attractive
markets and build the resources and capabilities necessary to deliver unique value. These
strategy vehicles include such things as diversification, acquisitions, alliances, vertical
HOW ARE STRATEGIES FORMULATED?
[ 13 ]
[ Figure 1.3 ] Multiple Levels of Strategic Analysis
Multiple Levels of Strategic Analysis
Corporate
Strategy
(Where to compete)
Business Unit 1
Strategy
(How to compete)
R&D
Strategy
(How to
implement)
Business Unit 2
Strategy
(How to compete)
Operations
Strategy
(How to
implement)
Marketing
Strategy
(How to
implement)
Identifies where to
compete in terms of
industries and
markets.
Identifies what unique
value to offer (cost or
differentiation) and
how to deliver it
Provides guidance for
managing and allocating
resources to distinct
business units
Provides a plan
to achieve competitive
advantage
H.R.
Strategy
(How to
implement)
Strategies and tactics of the functional areas should
align with and implement the overall business unit strategy.
integration, and international expansion. In some cases, a firm may choose to grow by diversifying, adding to its products or opening a new line of business. Acquisition is a strategy
vehicle used for growth and diversification or to acquire key resources.
For example, when Apple acquired NeXT Computing, the late Steve Jobs’s start-up, Apple
acquired the operating system that became OSX—and the acquisition brought Steve Jobs
back to Apple.22 More recently, Apple acquired SIRI, a company that made voice recognition
and search software that was the technology behind SIRI (pronounced sir’-ee), Apple’s personal assistant on the iPhone.
Sometimes companies decide to access new resources and capabilities through a strategic alliance—an exclusive relationship with another firm—rather than through acquisition.
For example, Apple teamed up with AT&T in an alliance to launch the iPhone in the United
States. AT&T put huge promotional dollars behind the iPhone—and paid Apple 10 percent
of their revenues from each iPhone subscriber—in order to be the exclusive distributor of
iPhones for the first five years.
Vertical integration, or the make-buy decision, is also a vehicle for achieving objectives.23
For example, when Apple decided to move into retailing by establishing Apple Stores, the
company made a decision to “make” stores that sold their own products, rather than simply
“buy” the retailing services of stores run by other companies, like Best Buy or Walmart. Finally,
companies may use international expansion as a vehicle to achieve economies of scale, access
key resources, or learn new skills. Indeed, some companies use international expansion as
a primary source of competitive advantage. These strategy vehicles—discussed in detail in
Chapters 6 to 9—are important tools that strategists use to achieve key strategic objectives.
Strategy Implementation
The final step in the strategic management process is to implement the strategy that was
chosen during the strategy formulation phase. Strategy implementation occurs when a
company adopts a set of organizational processes that enable it to effectively carry out its
strategy. Effective implementation typically requires the following:
1. The functional strategies within the company—research and development, operations,
sales and marketing, human resource management—are well aligned with delivering
the unique value identified in the overall strategy. Implementation is generally more
successful when a company can measure how effectively functional activities are being
performed to support the overall strategy.
strategy implementation The
translation of a chosen strategy
into organizational action so
as to effectively implement the
activities required to achieve
strategic goals and objectives.
[ 14 ]
CH01
ì WHAT IS BUSINESS STRATEGY?
S T R AT E GY I N P R A CT I C E
Walmart Functional Strategies Implement
the Overall Strategy
W
hen a company has a clear strategy regarding how it
plans to offer unique value, or “win” with customers,
this helps guide the implementation of the overall strategy
within each of the different business functions. As we’ve
discussed, Walmart’s strategy is to win by being a cost
leader in its markets. Walmart’s functional areas support
that strategy in a number of ways:24
ì Walmart’s human resource management strategy focuses
on keeping labor costs as low as possible. Walmart pays
relatively low wages and has few layers of management, which minimizes labor costs. Walmart also has
a nonunion stance and once even closed a store in
Canada when the workers tried to unionize.25 Managers have small offices with inexpensive furniture, and
when they travel, they stay at inexpensive hotels and
frequently share a room.
ì Walmart’s information technology and operations areas
also focus attention on cost reduction. Walmart has
invested in information technology to lower the costs
of communicating with thousands of suppliers and to
provide suppliers with real-time data on what products
are selling, at what price, in what store.
ì Walmart purchasing department negotiates aggressively
with suppliers. Walmart uses its tremendous buying
power to get the lowest prices on products from its
suppliers. It also offers a product mix that appeals to
price-sensitive customers.
ì Marketing does price checks at competitors. The
goal of the marketing staff is to ensure that
Walmart’s prices are always as low, if not lower,
than competitors.
2. The organization’s structure, systems, staff, skills, style (culture), and shared values are
designed to facilitate the execution of the strategy. This is the McKinsey 7-S framework,
which is useful for creating the alignment necessary to ensure effective implementation.
We discuss how companies can effectively create alignment with their strategy—or
change the organization to align with a new strategy—in Chapter 12. The Strategy in Practice: Walmart Functional Strategies Implement the Overall Strategy feature describes some of
the actions that Walmart has taken to ensure that its functional activities align with and
implement the overall business unit strategy.
To ensure successful implementation, the organization should have clear metrics, or ways
to measure whether or not the plan is being implemented. In Chapter 12, we provide a strategy tool, our version of the balanced scorecard, which suggests some useful metrics that
functional area leaders, and the CEO and top management team, can use to determine how
effectively strategies are being implemented.26
WHO IS RESPONSIBLE FOR BUSINESS STRATEGY?
strategic leaders Organizational
leaders charged with formulating
and implementing a strategy with
the objective of ensuring the survival
and success of an organization.
deliberate strategy A plan or
pattern of action that is formulated
through a deliberate planning
process that is then carried out to
achieve the mission or goals of an
organization.
Strategic leaders are typically the leaders of an organization who develop strategy through
the strategic management process. These leaders are responsible for not only formulating
strategy, but also for explaining the strategy in a way that employees will understand—and
in a way that will motivate employees to execute it. Chapter 13 explains the role the board
of directors and the top management team play in formulating and implementing strategy.
Theorist Henry Mintzberg refers to strategies that are developed by management, using the
strategic management process shown in Figure 1.1, as “intended” or “deliberate” strategies.27
Deliberate strategies are implemented as a result of careful analysis of markets, customers,
competitors, and a firm’s resources and capabilities. Target’s move to upscale discount retailing came after it concluded that it could not compete with Walmart on costs and prices. So
WHO IS RESPONSIBLE FOR BUSINESS STRATEGY?
ETHICS
[ 15 ]
A N D ST R AT E GY
The Price Companies Pay to Stay Competitive
O
ne of the central ethical challenges facing the strategist
is making decisions designed to deliver unique value
to customers. A decision could, for example, focus on low
cost and how it might result in reduced value for specific
stakeholder groups.
Over the past few years, an increasing number of US
companies have shut down US facilities and fired American
workers as they have shifted their activities overseas to save
money. For example, IBM laid off over 1,200 employees in
New York and Vermont because their jobs could be done
more cost effectively in “Brazil, India, and now China.”31
In similar fashion, HP announced layoffs of 500 customer
service workers in Arkansas due to global restructuring,
the term often used to describe a company’s plan to fire
workers and move activities from one location to another.32
And Eaton, a 101-year-old Cleveland-based manufacturer
of electronic components, moved its corporate address to
Ireland, where the top corporate tax rate is 12.5 percent
versus 35 percent in the United States. These are only a
few of the many examples of organizations making difficult
decisions in order to stay competitive. But at what price?
In each of these instances, the company’s leaders
are responding to customer demands (lower prices) and
shareholder demands (higher profit returns). But in doing
so, they are neglecting employee demands (job retention)
and community demands (taxes provide community
benefits). Some may question whether it is ethical to fire
employees and avoid US taxes in order to better meet
the desires of customers and shareholders. Others will
argue that if the company does not keep its customers
and shareholders happy, employees will eventually lose
their jobs anyway because the company will not be cost
competitive, and companies that go bankrupt cannot pay
taxes. The challenge of meeting the sometimes-competing
needs of various stakeholder groups is one that is
constantly faced by a company’s leaders. A typical response
is to prioritize stakeholders’ needs—with customers and
shareholders needs coming first—and take strategic
actions that best meet their needs. But actions that take
unduly from employees and communities to compensate
customers and shareholders are viewed by many as
unethical.
it created a trends department, created partnerships with high-end fashion designers (e.g.,
Oscar de la Renta) and stores (Neiman Marcus), offered a higher-end mix of products, and
built stores in more affluent suburban areas as opposed to rural towns. Target’s strategy to
become Tarzhay was the result of a deliberate strategic plan.
Emergent strategy is a strategy that was not expressly intended in the original planning
of strategy. Strategies that emerge when leaders recognize and act on unexpected opportunities that occur through serendipity, such as ideas from people within the organization, are
called emergent strategies.28 Apple’s transformation from a computer company to a company known mostly for its music players and cell phones was the result of a strategy that
emerged after the introduction of the iPod. The iPod opened up opportunities—such as the
iPhone and iPad—that the company’s senior executives did not necessarily foresee.
Successful companies typically have strategies that are partly deliberate, due to effective
strategic planning processes, and partly emergent, due to a willingness to respond to ideas
that come from within the organization. In a successful company, everyone in the organization has some responsibility for understanding the company’s strategy and for offering ideas
to improve the company’s strategic position.
emergent strategy A plan or
pattern of action that develops
and emerges over time in an
organization despite a mission or
goals.
Who Benefits from a Good Business Strategy?
Every organization has a set of stakeholders to whom it is accountable—and who therefore
can influence business strategy. Organizations have four primary stakeholder groups:
1. Capital market stakeholders (shareholders, banks, etc.)
2. Product market stakeholders (customers, suppliers)
3. Organizational stakeholders (employees)
4. Community stakeholders (communities, government bodies, community activists).29
stakeholders Those who have
a share or an interest in the
activities and performance of an
organization.
[ 16 ]
CH01
ì WHAT IS BUSINESS STRATEGY?
shareholders Owners of a
company.
There is a lively debate that will be discussed in Chapter 13 about which of these four
stakeholder groups is the most important and should be the primary beneficiaries of successful business strategies. Some people believe that shareholders (owners of the company)
are the most important. Others make the case that customers, employees, governments, or
communities should be the primary beneficiaries of business activity. In the United States,
shareholders typically receive highest priority, but each stakeholder group can influence the
strategic decisions that are made by a company.
Sometimes, different stakeholder groups have conflicting views as to the appropriateness of different strategic decisions. Imagine that your company can lower its product costs
by closing down your plants in the United States and moving production to China, where
labor is cheaper. This will require firing many of your U.S. employees. Both the employee
stakeholder group and community stakeholder groups in the cities where your plants are
located will perceive this move as negative, and they will try to stop the company from making this decision. However, shareholders and customer stakeholder groups may applaud
this decision. It could increase profits for shareholders and lower prices for customers, or
both. Because of conflicts like this, companies need to make sure their strategic actions follow accepted ethical standards for business activity. In the ideal situation, a firm has such
an effective business strategy that it generates above-average profit returns. Above-average
returns allow companies to not only meet the expectations of shareholders, but also satisfy
the expectations of other suppliers of capital, product-market, organizational, and community stakeholders. Since stakeholders influence, and are influenced by, strategic decisions
made by a company’s management team, it is important to understand and consider the
needs of different stakeholder groups when making strategic decisions.30
Why You Need to Know Business Strategy
Understanding business strategy and the strategic management process is important for at
least two reasons:
1. When you start your own company or are the president or general manager of a
department or division within a company, your primary job will be to formulate and
implement an effective business strategy. Even as a junior person in your company, by
understanding basic strategy principles you will be more effective at developing and
implementing ideas that are consistent with, and support, your business unit’s overall
strategy. Being able to understand and contribute to your firm’s strategy may lead to
earlier promotions as you stand out from your peers.
2. Understanding strategy will help you evaluate the strategy of companies you choose to
work for. Effective strategy can give a company competitive advantage over its rivals. Companies with competitive advantage typically provide superior advancement opportunities,
higher pay, and greater job security than companies without any competitive advantage.
In summary, understanding the strategic management process—as well as the concepts
that are fundamental to the formulation, and implementation, of strategy—will likely be
very helpful as you pursue a successful career in business.
SUMMARY
ì A company’s business strategy is defined as a plan to achieve competitive advantage. Formulating a strategy involves making four key choices: (1) what markets or industries the
company will pursue; (2) what unique value to offer the customer in those markets; (3)
what resources and capabilities will allow the firm to deliver that unique value better
than competitors; and (4) how the company will sustain its advantage and prevent imitation of its strategy by competitors.
ì The strategic management process involves the selection of a company mission as well as
external and internal analyses that contribute to the formulation of a company’s strategy. A
company’s mission outlines the company’s primary purpose and scope of activity. External
Analysis of the
External Environment:
Opportunities and Threats
02
LLUIS GENE/AFP / Getty Images
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1
Explain the importance of correctly identifying and choosing a
firm’s industries and markets.
2
Identify and measure the five major forces that shape average
firm profitability within industries to evaluate the overall
attractiveness of an industry.
3
Discuss how understanding the five forces that shape industry
competition is useful as a starting point for developing strategy.
4
Identify the factors in the general environment that affect firm
and industry profitability.
[ 21 ]
02
Nokia and the
Smartphone Industry
market share of cell phones, the company commanded
only 2 percent of the emerging smartphone market in
North American. Nokia’s profits had plunged 68 percent,
from nearly €8 million in 2007 to only €3.3 million in 2009.
Moreover, the firm’s stock also tumbled, falling 86 percent
from a high of $39.57 a share in October 2007 to $7.15 a
share in April 2014.
What happened? To a large extent, Nokia was caught off
guard by fundamental changes in the mobile phone industry
from 2003 to the present. Before the introduction of 3G (third
generation) smart phones, the cell phone manufacturing
industry had power over its suppliers, the makers of chips,
and other parts for cell phones. Software wasn’t a big part
of the picture and most handset makers programmed their
own software. The firm that could make the most attractive
phone with the best hardware features at the lowest cost
outperformed others in the industry. For years, Nokia had
offered unique value to its customers by having the latest
and best hardware.
With the advent of 3G smart
NOKIA FAILED, HOWEVER, TO LOOK MORE BROADLY AT WHAT THE CELL
phones, however, software became
PHONE MARKET WAS BECOMING AND WHO MIGHT BECOME ITS NEW
the central differentiator. Today, most
COMPETITORS IN THAT EMERGING MARKET. IT WASN’T PREPARED TO
people buy a phone based on its
COMPETE WITH THEM AND COULDN’T SUSTAIN ITS COMPETITIVE ADVANTAGE.
operating system and the applications
the operating system can run. Nokia
did see the change coming and poured Research and
(N-Gage) that tapped into the entertainment and media
Development (R&D) dollars into its own Symbian operating
markets, and owned Symbian, the leading operating system
system, focusing on building the resources and capabilities
for the new generation of multifunctional 3G phones. In all,
necessary to compete in software. In 2003, 80 percent of all
Nokia had nine divisions producing products for a variety of
3G phones—the first ones able to surf the Internet—were
industries, each with separate profit and loss accountability.1
sold by companies that had licensed Nokia’s Symbian
As late as 2003, Nokia appeared to have a competitive
operating system. In contrast, Microsoft, Nokia’s major
advantage in cell phones in the same way that Microsoft had
competitor at the time, had great difficulty with the early
an advantage in PC operating system software and Intel in
launch of Windows Mobile operating system for 3G smart
microprocessors.
phones. Several of Microsoft’s partners abandoned Windows
By 2010, however, Nokia had taken a nose dive. Although
Mobile for Nokia’s Symbian system.2
it still held a reasonable 32 percent of the worldwide
N
okia, a long-time leader in the telecommunications
equipment and mobile phone industry, got its start
in that industry in 1981 when it acquired a 51 percent
stake in a Finnish telecommunication firm. Since that time,
Nokia has sold more mobile phones than any other company.
The firm has been the world leader in market share since
the mid-1980s. By 2008, Nokia’s worldwide market share
had reached 40 percent, more than double the approximately
18 percent market share of Samsung, its nearest rival. The
Nokia brand was a top seller everywhere, including the
United States, China, Latin America, and Africa.
Not only was Nokia the leader in handset manufacturing,
offering value to its customers by manufacturing a full line
of phones from the lowest end of the price range to the most
expensive, the company also manufactured some of its own
cell-phone components, such as cameras and accessories.
In addition, Nokia designed and manufactured network
infrastructure equipment, launched a gaming device
[ 22 ]
DETERMINING THE RIGHT LANDSCAPE: DEFINING A FIRM’S INDUSTRY
Nokia failed, however, to look more broadly at what the
cell phone market was becoming and who might become
its new competitors in that emerging market. It wasn’t
prepared to compete with them and couldn’t sustain its
competitive advantage. With the introduction of Apple’s
iPhone and Google’s Android operating system, Nokia’s
share of operating systems plummeted so far that the
company eventually teamed up with its old rival, Microsoft,
to offer Windows Mobile 7 on Nokia phones.3 But this did
little to stop the onslaught from Apple and Samsung, who
sold phones using Google’s Android system. In the first
quarter of 2011, Nokia sold 108.5 million handsets for a
total of $9.4 billion. Apple, in contrast, sold only 18.6 million
iPhones but made $11.9 billion.4 Nokia had clearly lost the
market for high-end phones to Apple and other phones
[ 23 ]
running the Android operating system. In addition, Nokia’s
low-end handsets were under pressure from new Asian
manufacturers. Indeed, thousands of new low-cost Shanzhai
manufacturers, small Chinese firms focused on creating
knockoff products, now make phones with names such as
“Nckia.” The Shanzhai manufacturers flooded the markets
in China, India, the Middle East, and Africa, threatening to
erode Nokia’s market share in the remaining markets where
Nokia was still dominant.5
Indeed, Nokia’s position in cell phones became so
stark that in 2013 it sold its entire cell phone business,
the cornerstone of its previous success, to Microsoft. Not
only did Nokia have to sell, but it did so at a shockingly low
price of only 5.5 billion euros, off from the highest market
capitalization of 110 billion euros during its glory days.6
As described in Chapter 1, strategy involves crafting a plan to create competitive
advantage—and superior profitability—in particular markets. This plan, however, is shaped
by the landscape in which the firm competes. A firm’s external environment provides both
opportunities—ways of taking advantage of conditions in the environment to become more
profitable—and threats—conditions in the competitive environment that endanger the
profitability of the firm.7 Successful firms have a deep understanding of their environment
and constantly scan the horizon to see opportunities and threats as they emerge.8
One of the key threats a strategist must understand and cope with is competition.
Often, however, managers define competition too narrowly, as if it occurred only among
today’s direct competitors. Nokia was so focused on Microsoft as its key competitor in
the 3G operating system industry, and Motorola and Ericsson as its cell phone competitors, that it failed to effectively prepare for Apple’s entry into the industry. Competition
for profits goes beyond established industry competitors to include four other forces that
shape industry attractiveness and profitability: customers, suppliers, potential entrants,
and substitute products. Together, all five forces define an industry’s structure and shape
the competitive interactions—and profitability—of companies within that industry.
Even though industries might appear to differ significantly, the principles that determine
the underlying drivers of profitability are often the same. The global cell phone industry,
for instance, appears to have nothing in common with the highly profitable soft drink
industry or the low-cost airline industry (i.e., Southwest and JetBlue). But to understand
industry competition and profitability in these and other industries we must analyze the
same five forces.
This chapter will help you to recognize the major threats and opportunities that make up
the competitive landscape, both the industry forces and general macroeconomic forces that
drive industry attractiveness—and profitability.
DETERMINING THE RIGHT LANDSCAPE: DEFINING A
FIRM’S INDUSTRY
The first strategic decision that most firms must make is to select the industry, and markets,
in which it will compete. The Strategy in Practice feature discusses the U.S. government’s
classification of industries.
A firm’s industry also determines which customers and which competitors will be part
of the firm’s landscape. The landscape is typically defined by: (1) the industry (or industries)
in which a firm competes, and (2) the product and geographic markets within that industry that the firm targets. For example, Nokia competes primarily in the cellular telephone
ì
[ 24 ]
CH02
ì ANALYSIS OF THE EXTERNAL ENVIRONMENT: OPPORTUNITIES AND THREATS
S T R AT E GY I N P R A CT I C E
How the U.S. Government Defines Industries
O
ne tool that helps to define industries is the NAICS
(North American Industry Classification System), a
series of codes generated by the U.S. government.9 These
codes (formerly referred to as SIC codes, for Standard
Industrial Classification) vary from two to seven digits,
becoming more narrow with increasing numbers of digits.
Table 2.1 provides the NAICS codes for the cell phone
handset manufacturing and mobile operating system
industries. In Nokia’s early years, it competed primarily in
category 334220, cell phones. As cell phones became more
sophisticated, Nokia also began to compete in category
511210, operating systems.
NAICS codes can be useful not just for helping to define
an industry but also for determining who the primary
competitors are, although in fast-changing industries, the
NAICS can sometimes lag behind changing technologies or
changing customer demands. As we’ve seen, Nokia failed
to seriously update its definition of its industry to include
all the companies competing under its new classification
code.
The choice of industries is important because not all
industries are created equal. The profits of an average
firm in some industries are substantially higher than
profits of an average firm in other industries. Figure 2.1
shows the return on equity for a variety of industries over
a ten-year period. As you can see, the industry in which a
firm competes has a direct bearing on the profits earned
by that firm.
[ Table 2.1 ] NAICS Codes for Nokia
HANDSET HARDWARE BUSINESS
HANDSET SOFTWARE BUSINESS
Code
Classification
Code
Classification
33
Manufacturing
51
Information
334
Computer and Electronic Product Manufacturing
511
Publishing Industries
3342
Communication Equipment Manufacturers
5112
Software Publishers
33422
Wireless Communication Equipment Manufacturers
51121
Software Publishers
334220
Cellular Telephone Manufacturers
511210
Operating Systems Software Publishers
[ Figure 2.1 ] Varying Attractiveness of U.S. Industries 2000–2010
RETURN ON EQUITY
16%
14%
12%
10%
8%
6%
4%
2%
Source: Troy’s Almanac
Auto Manufacturing
Telecommunications
Investment Banking
Oil and Gas
Industry Average ROE
Software
Steel
Airline
General
Merchandise
Stores
Computer
Hardware
Pharmaceuticals
Soft Drinks
0%
FIVE FORCES THAT SHAPE AVERAGE PROFITABILITY WITHIN INDUSTRIES
[ 25 ]
manufacturing and operating system industries. Within the cellular telephone manufacturing industry, Nokia targets multiple product markets by selling a range of handsets, from
high-end smart phones to inexpensive basic phones. The company also targets multiple
geographic markets, focusing mainly on Europe and developing economies in the Middle
East and Africa.
Be careful about assuming that it is obvious which industry a company competes in. For
example, it seems obvious that Barnes & Noble competes in the book retailing industry and
Microsoft competes in the computer software industry. However, it may be less obvious that
those aren’t their only industries. In addition to operating systems, Microsoft also makes the
X-Box gaming system, so it competes in the gaming console industry as well as the PC operating system industry. Barnes & Noble sells an e-reader, the Nook that combines electronic
books with computer hardware. Amazon.com, Barnes & Nobles’ main book retailing competitor, not only sells books and the Kindle e-Reader, but also sells web services competing
with Microsoft and a wide range of products online as a discount retailer competing with
Walmart. Firms must choose which markets to compete in, with many large firms choosing
to compete in several at the same time.
If managers do not properly define and understand their industry, they may be vulnerable to unseen competitors. For example, Nokia defined itself primarily as a mobile
handset manufacturer. As a result, managers failed to see computer hardware companies
like Apple and web search companies like Google becoming potential competitors—or
potential partners. Their focus on preventing Microsoft from creating a dominant position
in the mobile operating system industry caused them to overlook Apple, a company that
has consistently been the leader in innovative, user-friendly operating systems for a variety
of platforms.10
Truly understanding an industry often begins by taking a customer-oriented view.
Rather than identifying the industry based on the product or service they produce (such
as cell phone handsets), firms should think carefully about the job that products do for customers. What need does a product fill? Understanding customer needs can be very helpful
in defining the boundaries of an industry. If two firms have products that do the same job
for customers—they meet similar customer needs—then those two firms can be considered
part of the same industry. For instance, companies that meet the need for communication
by manufacturing mobile handsets, as opposed to mobile ham radios (long-range walkie
talkies), compete in the same industry.11 In the case of cell phones, changing customer
needs broadened the boundaries of the industry, from primarily hardware manufacturing to
include mobile operating systems and applications that allowed phones to do far more jobs
for customers than just place a phone call. This led to new competitors for Nokia, including
Apple and Google.
FIVE FORCES THAT SHAPE AVERAGE PROFITABILITY
WITHIN INDUSTRIES
Michael Porter, a well-known strategy professor at Harvard, identified five forces that
shape the profit-making potential of the average firm in an industry. As shown in Figure 2.2, those five forces are: (1) rivalry, (2) buyer power, (3) supplier power, (4) threat of
new entrants, and (5) threat of substitute products. The strength of each of these five forces
(known as Porter’s Five Forces12) varies widely from industry to industry. For instance, in
the semiconductor industry, the threat of substitutes is almost nonexistent, while in the
carbonated soft drink industry it is a significant threat. A careful analysis of the five forces
is a powerful way for firms to discover the threats and opportunities in their environments. We provide a tool at the end of this chapter to help you conduct a careful analysis
of an industry’s five forces.
There are three basic steps involved in using the five forces analysis tool:
ìStep 1: Identify the specific factors relevant to each of the five major forces. We
describe the factors that contribute to each of the five forces in the next five sections
of this chapter.
rivalry Competition among firms
within an industry. Typically this
involves firms putting pressure on
each other and limiting each other’s
profit potential by attempting to
steal profits and/or market share.
substitute A product that is
fundamentally different yet serves
the same function or purpose as
another product.
threats Conditions in the
competitive environment that
endanger the profitability of a firm.
opportunities Ways of taking
advantage of conditions in the
environment to become more
profitable.
[ 26 ]
CH02
ì ANALYSIS OF THE EXTERNAL ENVIRONMENT: OPPORTUNITIES AND THREATS
[ Figure 2.2 ] Analyzing Major Threats: The Five Forces Industry Analysis Tool
NEW
ENTRANTS
BUYER
POWER
COMPETITOR
RIVALRY
SUPPLIER
POWER
SUBSTITUTES
Source: Adapted from Michael E. Porter, “How Competitive Forces Shape Strategy,” Harvard Business Review 86,
1 (January 2008), pp. 80–86.
attractiveness of an industry The
degree to which an average firm in
the industry can earn good profits.
ìStep 2: Analyze the strength of each force. To what extent is it shaping the industry’s
attractiveness? The appendix at the end of the book lists several sources where you
might find the data you need to analyze each of the five forces.
ìStep 3: Estimate the overall strength of the combined five forces to determine the
general attractiveness of the industry, the profit potential for an average firm in the
industry.
Instructions for steps 2 and 3 are at the end of the chapter. Step 1, the factors relevant to
each of the five forces, is discussed next.
Rivalry: Competition among Established Companies
Competition in an industry is sometimes referred to as war, with each company deploying as
many weapons in its arsenal as possible to gain greater profits. Because there are typically a limited number of buyers, each firm’s profits often come at the expense of other firms in the industry. Each move by a firm provokes countermoves among competitors, resulting in a constantly
shifting competitive landscape populated by winners and losers. (Chapter 11 explores how successful firms manage that shifting landscape by planning for the countermoves of their rivals.)
Firms’ moves and countermoves can take many forms, including sales and promotions,
better quality or service, a wider variety of products, or lower prices. Not surprisingly, these
types of moves increase rivalry—the intensity with which companies compete with each
other for customers—which tends to squeeze the profit margins of most firms in an industry. Rivalry among firms in an industry—for either rational or irrational reasons—is such an
important driver of profitability that it is shown at the center of Figure 2.2.
The following seven factors are critical to understanding the intensity of rivalry in an industry:
1. The number and size of competitors
2. Standardization of products
3. Costs to buyers of switching to another product
4. Growth in demand for products
FIVE FORCES THAT SHAPE AVERAGE PROFITABILITY WITHIN INDUSTRIES
[ 27 ]
5. Levels of unused production capacity
6. High fixed costs and highly perishable products
7. The difficulty for firms of leaving the industry
The Number and Relative Size of Competitors. The more competitors in an industry, the
more likely that one or more of them will take action to gain profits at the expense of others.
Economists call an industry with a lot of competitors a fragmented industry. In a fragmented
industry, it is difficult to keep track of the pricing and competitive moves of multiple players.
The large number of firms responding to one another tends to create intense rivalry. The
same is true of the relative sizes of competitors. If firms are approximately the same size,
they tend to be able to respond, or retaliate, strongly to moves by rival firms.
Industries that are concentrated, as opposed to fragmented, have far fewer competitors
and tend to be dominated by a few large firms. In these industries, rivalry is typically much
less intense. Smaller competitors do not have the capability to respond to actions taken by
large firms, and the few large competitors are more aware of each other and less likely to risk
actions that may result in price wars.
Relatively Standardized Products. Differentiated products, ones that boast different features
or better quality, tend to engender loyalty in customers because they meet customer needs
in unique ways. When products are standardized, or commodity-like, buyers are less loyal to
a particular brand and it is easier to convince them to switch brands. A rider may be fiercely
loyal to his or her Harley-Davidson motorcycle, for example, but willing to buy several different
brands of gas for the Harley. Firms that sell standardized products—manufactured products
or materials that are interchangeable regardless of who makes them like bolts and nuts,
rubber, plastics or commodities such as coal, crude oil, salt, or sugar—often have to compete
by offering sales, rebates, or lowering prices. Price wars increase rivalry and decrease profits.
Low Switching Costs for Buyers. Switching costs include any cost to the customer
for changing brands. Switching costs for buyers are related to the degree of product
standardization. For a computer user, changing operating system or word processing
software would entail considerable switching costs because the user would need to:
(1) convert files to the new software, and (2) learn how to use the new software. Switching
from an iPod to another MP3 player might require music lovers to move all of their music
files from iTunes to a different music software. In contrast, most of us can change our brand
of gum or candy bar without any switching costs. The lower the switching costs, the easier it
is for competitors to poach customers, thereby increasing industry rivalry.
Switching costs are a fundamental part of not just rivalry but also the other four forces:
1. Buyer power. If customers, or buyers, can easily switch firms, then buyers have increased
power.
2. Supplier power. If firms can’t switch suppliers easily, then suppliers have increased
power.
3. New entrants. If buyers can easily switch to new companies attempting to enter the
industry, there is a greater threat of new entrants.
4. Substitutes. If buyers can switch to substitute products without much difficulty, firms
face an increased threat from those substitutes.
Slow Growth in Demand for Products or Services. When demand is increasing rapidly,
most firms can grow without taking existing customers from competitors. When growth
slows, however, firms can become desperate. They may try to increase their sales volume by
attracting customers from their competitors through sales promotions, price discounts, or
other tactics.13 Of course, competitors then respond with their own sales promotions and
price cuts, thereby increasing industry rivalry. Consider the flat-screen television industry.
When large, flat-panel displays were first introduced, prices were high. They remained that
way for years while industry growth exploded. As flat-panel manufacturers anticipated
slower growth, from 18 percent in 2010 to 4 percent in the first half of 2011, they dropped
prices by more than 25 percent in the last quarter of 2010 in a bid to gain what market share
they could from their competitors.14
switching costs Barriers that
help keep buyers using the same
supplier by imposing extra costs for
switching suppliers.
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CH02
ì ANALYSIS OF THE EXTERNAL ENVIRONMENT: OPPORTUNITIES AND THREATS
High Levels of Unused Production Capacity. Unused production capacity is expensive. Firms
typically try to produce at or near their full production capacity so that they can spread
the fixed cost of factories, machinery, and other means of production across more units. In
fact, they may try to produce more product than the market demands, in order to use their
capacity completely. However, when more is produced than is demanded in the market,
firms often have to drop their price or risk having unsold product. This has frequently been
the case in the automobile industry. During an economic downturn, automakers offer
price cuts, rebates, and special sales incentives to buyers so that they don’t have significant
unused production capacity.
High Fixed Costs, Highly Perishable Products, High Storage Costs. Industries that produce
or serve products in these three categories sometimes find themselves with a supply of
products that they have to sell quickly or take large losses on. For example, airlines operate
with high fixed costs. Most of the cost of a flight is in the airplane, the fuel, and the pilot
and flight attendants. It is not in the cost of serving an additional passenger. The marginal
cost of adding an additional passenger is truly only peanuts (and a drink). If it appears that
a scheduled flight is going to have few passengers, an airline may be tempted to discount
steeply in order to fill as many seats as possible. The variable cost of an additional passenger
is very little, so selling a seat for less would not cost the airline money, but leaving it empty
would mean the airline has fewer passengers over whom to spread its fixed costs.
Firms that sell highly perishable products, such as fruits or vegetables, face similar problems. As food nears the date when produce will spoil, grocery chains often steeply discount
it rather than lose the sale completely. Products with high storage costs exhibit the same
characteristics. If firms have an oversupply and are forced to store the product, they may discount the price to avoid storage costs. In all three cases, steep discounting leads to increased
rivalry as competitors are forced to respond with discounts of their own, or be left with
losses while others recoup their production costs.
High Exit Barriers. In some industries, companies don’t exit even when they aren’t making
a lot of money. Most often, they stay because they have made investments in specialized
equipment that can’t be used in any other industry. For example, steel blast furnaces are very
expensive and cannot be used in any industry other than steelmaking. If the firm exits the
steel industry, its blast furnaces lose most of their value. Another barrier to exit is labor or
government agreements that make it difficult to close a plant. Emotional ties to employees
or a business can also lead to less than rational decisions by top management to stay in
business.
Buyer Power: Bargaining Power and Price Sensitivity
supplier A firm that provides
products that are inputs to another
firm’s production process.
When buyers have sufficient power, they can demand either lower prices or better products
from their suppliers, thereby hurting average profitability of firms in the supplier industry. The two primary situations in which buyers have high power are when buyers hold a
stronger bargaining position than sellers and when buyers are price-sensitive. The strength
of a buyer’s bargaining power or price sensitivity can be affected by a number of factors.
When firms understand what causes buyers to have power over their industry, they have a
better chance of countering that power.
Buyer Bargaining Power. Four key factors influence the degree to which buyers have
bargaining power over their suppliers. We already discussed two of these factors—buyers’
switching costs and demand—because they are also factors in rivalry among firms. The two
remaining factors are the concentration and size of buyers and the threat that buyers can
backward integrate:
ì Number, or concentration, and size of buyers. Buyer concentration reflects the law of
supply and demand. If there are few buyers but many sellers, then the sellers must
compete more strongly for buyer business. Sellers in this situation are likely to give
concessions to make the sale. Likewise, the larger the buyers, compared to sellers,
the more likely sellers are to increase the level of competition in order to gain buyers’ business. For example, farmers, as suppliers to the frozen-food industry, are not
very concentrated. The three largest farmers account for only about 1 percent of all
FIVE FORCES THAT SHAPE AVERAGE PROFITABILITY WITHIN INDUSTRIES
food produced and sold. Frozen food makers, however, are concentrated. The top four
(Nestlé, Schwan, ConAgra, and HJ Heinz) accounted for nearly half (48.6 percent) of
total market share in their industry in 2010.15 This means that frozen-food manufacturers, as buyers, have a great deal of power over farmers. A farmer who needs the business of the big four frozen-food makers in order to sell this year’s crop may be willing
to accept a lower price in order to secure their business.
Credible
threat of backward integration. In some cases, a buyer can exert pressure over
ì
suppliers by threatening them with backward integration, meaning they will make the
product themselves. For example, one way Walmart keeps prices low for consumers is
by threatening to expand its Sam’s Choice store brand products into additional categories if manufacturers of other branded products don’t meet Walmart’s pricing demands.
Buyer Price Sensitivity. In general, when buyers are more price-sensitive, they are more
likely to exert pressure on suppliers to keep prices low. Buyers exert pressure not just through
price negotiation but also through more comparison-shopping and a greater willingness to
switch suppliers. Buyer price sensitivity tends to increase in the following situations:
ì Buyers are struggling financially. When companies are struggling financially, they are
more likely to be price-conscious and to look for ways to get less expensive sources of
supply. If many of an industry’s buyers are in the same situation, there is a cap on what
suppliers can charge.
ì Product is significant proportion of buyer’s costs. Buyers tend to care more about getting
a good price when the product they are buying creates a large part of the costs of their
own production (or their budget, if the buyers are the end consumers). If the product
is only a small part of their cost structure, buyers are less likely to bother negotiating
or comparison-shopping. For instance, end consumers are less likely to do extensive
comparison-shopping for a gallon of milk than they are for a home or car. Likewise,
auto manufacturers are less likely to pressure suppliers of electrical wiring for price
cuts than suppliers of steel or engine components.
ì Buyers purchase in large volumes. When buyers purchase in large volumes, they typically expect to get breaks in price. In essence, the buyer is taking a risk by being willing
to buy large amounts at once rather than smaller amounts over time.
ì Product doesn’t affect buyers’ performance very much. If a product is very important to
the quality of the buyers’ end product, then buyers tend not to be very price conscious.
For instance, when Nokia had the most innovative handsets on the market, many cellular phone carriers, like Verizon and T-Mobile, were willing to pay whatever Nokia
charged in order to be able offer Nokia phones to their customers. However, if suppliers’ products don’t affect buyers’ quality or performance very much, then buyers are
much more likely to be price conscious. For instance, the plastic casing on tablet or
laptop computers doesn’t enhance the performance of the computers very much; it
doesn’t drive sales to the end consumer. As a consequence, PC manufacturers are likely
to shop around for price discounts on plastic casings in ways that they might not for
the microprocessors that run the computers.
ì Product doesn’t save buyers money. If a product saves buyers money, they tend not to be
very price conscious when purchasing it. These types of products can be anything from
machinery in manufacturing industries that replaces highly skilled, costly labor to
inexpensive, overseas labor that replaces more expensive labor or machinery in countries such as the United States. If a product does not save buyers money, however, buyers are as likely to be price conscious as they are with other types of products they buy.
Supplier Bargaining Power
The factors that increase the bargaining power of suppliers are very similar to those that
increase the bargaining power of buyers. In this case, however, the firms are not customers,
but suppliers, those from whom your industry purchases inputs. When supplier industries
have strong bargaining power, they can charge higher prices, which tend to decrease average
profitability in an industry. As firms understand the factors that give suppliers power, they
may be able to make decisions that decrease that power.
[ 29 ]
backward integration A firm
purchases one or more of its
suppliers in order to make a
product itself rather than buying it
from another firm.
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CH02
ì ANALYSIS OF THE EXTERNAL ENVIRONMENT: OPPORTUNITIES AND THREATS
Number, or Concentration, and Size of Suppliers. As with buyer concentration, supplier
concentration follows the law of supply and demand. If there are few sellers, but lots of
buyers in an industry, then the buyers have to compete to get the products that they want,
often paying higher prices to get sufficient supply. Likewise, the larger the number of sellers
compared to the buyers, the less likely buyers are to pay the price that sellers are demanding.
For instance, ARM, a designer of semiconductor chips for smart phones, controls more
than 95 percent of the market for its product,16 resulting in a highly concentrated supplier
industry dominated by one large firm. As a consequence, Nokia, or any other smart phone
handset manufacturer that wants a sufficient supply of chips, and wants the high-quality
chips that won ARM its market share in the first place, has to buy from chip manufacturers
who license from ARM. ARM has sufficient power that it can, to a large degree, set the price
for its product. Suppliers who charge more often squeeze the profits of buyers, who may not
be able to pass additional costs through to their customers. In fact, ARM’s rise to power in
the mobile semiconductor chip industry is a major contributor to Nokia’s current difficulties. Nokia cannot charge enough for its low-cost handsets to make a good profit after paying for expensive ARM chips.
Credible Threat of Forward Integration. In some cases, a supplier can exert pressure over
forward integration A firm goes
into the business of its former
buyers, rather than continuing to
sell to them.
its buyers by threatening them with forward integration, doing what its buyers do, if the
buyers don’t offer price concessions. A good example of this is Google and its decision to
forward integrate in the smart phone handset industry by manufacturing its own phones.17
Google also licenses its Android operating system to other handset makers, such as HTC
and Samsung. Google’s ability to forward integrate gives Google power over those handset
makers. When there is a credible threat of forward integration, buyers are often willing to
take a cut in profit by paying higher prices, rather than risk losing the supply altogether and
creating a new rival (if the supplier hasn’t already forward integrated).
Threat of New Entrants
barriers to entry The way
organizations make it more difficult
for potential entrants to get a
foothold in the industry.
As previously shown in Figure 2.1, not all industries are created equal. Industries in which
the average firm is making good profits can often be targets, enticing firms from outside
those industries to enter. Likewise, quickly growing industries are often attractive, which
increases the incentive for outside firms to enter those industries. One of the important
tasks for strategists is to identify firms that might enter their industries. New entrants pose a
double hazard. First, they typically are anxious to gain market share.18 Unless the industry is
growing quickly, that market share must come at the expense of existing firms. Second, new
entrants bring new production capacity, which tends to drive prices down unless demand is
growing faster than the increase in supply.
New entrants mean greater rivalry, so existing firms often try to discourage new entrants
by building barriers to entry. The higher the barriers to entry, the more difficult it is for
potential entrants to get a foothold in the industry, and the more likely that they are to quit
or choose to not enter in the first place. Likewise, incumbent firms, those already in the
industry, often signal new entrants that they are likely to retaliate by slashing prices, increasing advertising, or other competitive moves that help the established firms hold on to their
market share. If the threats of retaliation are perceived as credible, potential entrants might
decide to stay away.
It is essential for firms to understand the barriers to entry that already exist in their
industry and to consider ways of increasing them. Existing firms may also want to build new
barriers. Firms that are considering going into an industry can use an analysis of the barriers
to entry in the target industry to help them determine how likely they are to succeed.
Economies of Scale, Experience, or Learning. These types of economies occur when the cost
per unit of production (the cost for producing each individual product or service) decreases
as a firm produces more. Typically, these economies come from mass manufacturing
methods, discounts through purchasing in high volumes, employees becoming quicker and
better at production, and being able to spread the fixed costs of production machinery, R&D,
advertising, and marketing across more units.19 Chapter 4 will explore these three types of
cost advantages in greater detail. In essence, lower costs allow the firm either to lower its
FIVE FORCES THAT SHAPE AVERAGE PROFITABILITY WITHIN INDUSTRIES
price, perhaps in retaliation for a new firm entering the market, or to maintain its price while
earning more profits than competitors.
When economies of scale, experience, or learning exist in an industry, new firms will be
at a cost disadvantage. New firms are not likely to have as much market share as existing
firms, so they will not produce as much and can’t achieve the same economies as existing
firms. Some firms may not be able to lower their prices sufficiently to match incumbent firms’
prices. Other new entrants may match incumbent prices, but earn smaller profit margins
than the incumbents. The higher the economies of scale, the greater the barrier to entry and
the easier it is for the larger incumbent to pose a credible threat of retaliation.
If conditions change so that cost savings from these economies become smaller, the
barrier diminishes. For example, from the late 1980s until the early 2000s, the cell phone
handset manufacturing industry possessed high economies of scale. Nokia produced millions of handsets per year during this time and had the lowest costs of its competitors.
Consequently, the number of firms in the industry was relatively stable during this period.
However, the invention of flexible manufacturing processes, coupled with the rise of lowcost, highly-skilled labor in China in the mid-2000s, lowered the cost savings that could be
achieved from high levels of production and allowed thousands of new Shanzhai manufacturers to successfully enter the industry.
Other Cost Advantages Not Related to Scale. Incumbent firms might have cost advantages
relative to new entrants for a variety of reasons besides economies of scale. These include
the following:
1. Patents or proprietary technology such as those that exist in the pharmaceutical
industry
2. Better locations (a deterrent to firms wishing to enter markets where Starbucks is
dominant, for example)
3. Economies of scope—less expensive costs per unit created by bundling different types
of products. For example, Procter & Gamble has low-cost marketing and distribution
costs, compared to firms that manufacture only one type of product, because P&G
ships dozens of different types of products to the same retailers. (See Chapter 4 for a
more detailed explanation of economies of scope.)
4. Preferential access to critical resources, such as raw materials or access to distribution networks. For example, Chinese makers of lithium ion batteries have governmentprotected access to sources of rare earth elements, raw materials that are necessary
for battery production. In many industries, new entrants face high barriers in the cost
of building a dealer network or recruiting retailers to sell their products. With a limited
number of potential dealers and retailers, new entrants often find themselves having
to cut prices, and profit margins as well, to secure access to distribution.
As with economies of scale, it is important for firms to track whether barriers are rising
or falling. An expiring patent or the advent of an innovative distribution channel, such as
the Internet, has the potential to radically change the strength of barriers related to cost
advantages.
Capital Requirements. It costs money to enter a new industry. Not only do potential entrants
often need capital to build a factory or store, but they may also have to invest in R&D to
generate viable products, build inventory, undertake sufficient advertising and marketing
to take market share from incumbent firms, and have sufficient cash on hand to cover
customer credit. Anything that increases the start-up costs will reduce the pool of possible
entrants. For instance, the computer semiconductor chip industry, dominated by Intel,
makes a very complex product. New entrants would need to spend years of R&D before they
had a viable product and could make their first sale. The high capital requirements needed
for long periods of R&D limit the number of entrants to those with enough financial or
other resources to enter. However, firms that already have made R&D investments in similar
products, such as semiconductor chips for mobile phones, could lower the capital costs
associated with entering the computer semiconductor industry. It is likely no coincidence
that ARM, the maker of mobile semiconductor chips, is one of only a few successful entrants
into Intel’s industry in the last 30 or more years.
[ 31 ]
[ 32 ]
CH02
ì ANALYSIS OF THE EXTERNAL ENVIRONMENT: OPPORTUNITIES AND THREATS
Network Effects. In some industries, network effects increase the switching costs for
network effects Growth in demand
for a firm’s product that results
from a growth in the number of
existing customers.
customers, making it more difficult for new entrants to steal business from incumbent
firms. When network effects are in operation, the greater the number of people using
products from a given firm, the greater the demand grows for that firm’s product. For
example, the more people who use a particular social networking site, the more customers
want to continue to use the site, and the more new customers are likely to try it. A new
entrant wanting to compete with Facebook is at a distinct disadvantage, because most of
their potential customers’ “friends” are likely to be on Facebook, making it less likely that
they will be willing to switch to a new social media site.
Government Policy Restrictions. Finally, government policies may make it more difficult
to enter a market or even restrict a market completely to new entrants. For instance,
governments often raise the costs of entry by requiring bonding, licenses, insurance,
or environmental studies before a firm can enter an industry. New entrants will have to
use capital that might have been used for R&D, production, or advertising to meet those
requirements. When competing across international borders, additional regulations, such
as trade restrictions and local content requirements, may be applied to try to limit foreign
competition. In some industries, such as hairstyling, the requirements might be fairly
minimal, but in others, such as oil refining, they can become so onerous that most new
firms cannot overcome the barrier.
Threat of Substitute Products
A substitute is a product that is fundamentally different yet serves the same basic function
or purpose as another product. One of the primary problems for the strategist in assessing
substitutes is determining what is a substitute and what isn’t. It involves determining the
boundaries of an industry, as we addressed earlier in the chapter, and then scanning other
industries to find products that might serve the same basic functions. For instance, e-mail
is a substitute for telephone messages, faxed documents, or documents delivered via the
post office. All four are ways of delivering messages. Similarly, fruit juice is a substitute for
any number of other drink products, including coffee, wine, and soda. Generally, something
can be considered a substitute if it serves the same function, such as quenching thirst, but
does so with a different set of characteristics. If the product has the same basic characteristics and is made using the same general set of inputs, it would be considered part of rivalry,
rather than a substitute. For instance, competitor brands serving the same basic need, such
as Apples iPhone and Samsung smart phones running Google’s Android operating system,
are rivals, not substitutes.
In general, substitutes put downward pressure on the price that firms in an industry can
charge. For instance, streaming video across the Internet is a substitute for watching movies in the theater. Even if you had the only movie theater in an area, you could not charge
whatever price you wanted to. As your price rose, more customers would switch to streaming video. If the price difference is enough, customers will stream even though the quality
is lower and they have to wait weeks or months before the movie leaves the theater and is
available online. For some industries, such as newspapers, the low price of the substitute—
in this case, free news on the Internet—can be disastrous, creating such a low cap on the
prices they can charge that many firms go out of business. The factors that determine the
intensity of a threat of substitutes include the awareness and availability of substitutes and
their price and performance compared to an industry’s products.
Awareness and Availability. Sometimes customers aren’t readily aware that substitutes
exist. The threat increases when substitute products are well known. This is particularly
true if there are strong brands among the substitute products. Likewise, if the substitute
product is just as easy for customers to obtain as another industry’s products are, it is more
of a threat. If the substitute is difficult to find or acquire, the threat is diminished.
Price and Performance. A significant part of the customer decision to switch to substitutes
will concern the price and performance trade-offs. As we discussed earlier in the chapter,
customers are more likely to switch to a substitute if the costs of switching are low. The
OVERALL INDUSTRY ATTRACTIVENESS
price of the substitute, itself, also factors into customers’ decisions. If substitutes are cheaper
than products from another industry, the threat is higher. Likewise, if the performance
of substitutes is similar or better, the threat is higher. The closer the substitute is in
performance, the less flexible a seller can be with price. For instance, many newspapers
have seen steep declines in circulation as Internet news has gained in quality. The Wall Street
Journal, however, has not declined in circulation over the same time period because online
substitutes for serious business news have not increased in quality nearly as fast as for other
types of news.
OVERALL INDUSTRY ATTRACTIVENESS
Understanding the five forces that shape industry competition is useful as a starting point
for developing strategy. Indeed, managers often define competition too narrowly, as if it
occurred only among direct competitors. Yet competition for profits goes beyond direct
rivals to include buyers, suppliers, potential entrants, and substitute products. The extended
rivalry that results from all five forces defines an industry’s structure and shapes the nature
of competitive interaction within an industry. Every company should know what the average profitability of its industry is and how that has been changing over time. The five forces
help explain why industry profitability is what it is—and why it might be changing. Attractive (profitable) industries are those where firms have created power over buyers and suppliers, created barriers to entry to reduce the threat of new entrants, and minimized the threat
of substitutes while keeping rivalry to a minimum. Even inefficient, relatively poorly run
companies can earn superior profits under such conditions.
At the other extreme, are unattractive industries. Firms in these industries are consistently pressured by buyers and suppliers alike. They face high rivalry, easy entrance for
new competitors, and many well-positioned substitute products. Under these conditions,
only the most efficient, well-run companies are able to turn a profit. Each of the five forces
can be analyzed to determine the degree to which, and how, it contributes to industry
attractiveness.
We provide a strategy tool at the end of this chapter for analyzing each force. After doing
an analysis of each force, these can be combined to develop a detailed picture of what is driving the overall profitability—the attractiveness—of the industry.
Few industries will rate high (attractive) or low (unattractive) on all forces. A significant
threat from just one or two of the five forces is often sufficient to destroy the attractiveness
of an industry. For example, many firms in the auto industry have struggled to be profitable
over the last decade. This industry, however, has relatively low buyer and supplier power, no
real threat of substitutes, and a moderate threat of new entrants. Rivalry, however, has been
fierce, with constant excess production capacity and price discounting. Sometimes, it only
takes one of the five forces to be unattractive to make an industry struggle. When many of
the five forces are unattractive, firms face great challenges maintaining profitability. However, understanding each force and how it is influencing profitability helps managers know
where to focus in dealing with those challenges. Moreover, a company strategist who understands that competition extends well beyond existing rivals will perceive wider competitive
threats and be better prepared to address them. At the same time, thinking comprehensively about an industry’s structure can uncover opportunities to improve performance on
each of the five forces, thereby becoming the basis for distinct strategies that yield superior
performance.
One thing to keep in mind is that the five forces are subject to change. Each of the five
forces can be altered by actions taken by firms within or without the industry. For instance,
Google built the Android operating system, even though it gives it away for free, to increase
the number of suppliers for its search engine, thus decreasing the supplier power that Apple
might have had had it been able to dominate the smartphone industry. A good strategist
always has her eye on actions and trends that might change any of the five forces in her
industry. Not all of those trends come from actions taken by firms close to the industry.
Some come from the general environment. These are discussed in the next section.
[ 33 ]
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CH02
ì ANALYSIS OF THE EXTERNAL ENVIRONMENT: OPPORTUNITIES AND THREATS
HOW THE GENERAL ENVIRONMENT SHAPES
FIRM AND INDUSTRY PROFITABILITY
To determine the landscape that a firm competes in, it isn’t enough to only understand the
five forces that directly affect an industry. The general environment also needs to be understood. The general environment can affect firms in a variety of ways,20 including affecting the
shape of each of the five industry forces. A simple way to think about the general environment is to break it down into eight categories. Strategic managers in the best companies are
focused on each of these categories, looking for trends that might lead to new opportunities
or threats. This is illustrated in Figure 2.3:
ì Complementary products or services
ì Technological change
ì General economic conditions
ì Population demographics
ì Ecological/natural environment
ì Global competitive forces
ì Political, legal, and regulatory forces
ì Social/cultural forces
[ Figure 2.3 ] Trends in Opportunities and Threats in the General Environment
THE GENERAL ENVIRONMENT
Complimentary
Products/Services
NEW
ENTRANTS
Social/Cultural Forces
Political/ Legal/
Regulatory
Forces
Global Forces
BUYER
POWER
COMPETITOR
RIVALRY
SUBSTITUTES
Ecological/Natural
Environment
Technology Change
SUPPLIER
POWER
General
Economic
Conditions
Demographics
HOW THE GENERAL ENVIRONMENT SHAPES FIRM AND INDUSTRY PROFITABILITY
[ 35 ]
Developments in each of the eight categories shown in the outer ring have the potential to shape and change the general landscape for any specific industry. Each category can
affect an industry’s dynamics, which are shown by the area within the center circle, altering
any or all of the five forces. You should always keep in mind that an industry’s five forces are
not static. The five forces are subject to change and may change, even radically, if elements
of the general environment change. When you are examining the general environment, it is
important, then, to not just get a picture of what things look like today but to analyze trends,
the direction each category is headed toward tomorrow. Remember, as well, that this analysis is industry specific. You want to know how each of the eight categories is going to affect
the industry you are studying.
The relative importance of each of the general environmental factors differs from industry to industry. In the fast-food industry, social forces, such as a shift toward healthier eating,
are likely to alter the threat of substitutes, but technological change doesn’t play as a large
a role. In the motorcycle manufacturing industry, demographics play a key role, as many
industrialized nations experience an upward trend in the average age of the population, but
changes in societal perceptions of motorcycles don’t appear to be shifting quickly, resulting
in fewer people riding motorcycles because they are perceived to be transportation for the
young. Managers need to develop a deep sense of which environmental factors are strategically relevant to their own industries.21 Managers need to understand not only which factors have the largest impact on their industry right now, but also which factors are likely to
change in the future, so that they can adapt their firms’ strategies to changing conditions.
Complementary Products or Services
Complementary products or services are those that can be used in tandem with those in
another industry. For example, video gaming hardware and software, or smartphone operating systems and apps, are complementary sets of products. When two complements are
used together, they are worth more than when they are used apart. Complementary pairs
or groups (also called ecosystems) of products can be found in many places, not just in the
technology sector.22 Gas stations and roads are complements to automobiles, and piping
is a complementary product to natural gas. Trends in complementary industries have the
potential to radically alter—for better or worse—the landscape in which firms compete.
Take the rise of application software (apps), for instance. In the 1990s, Microsoft created
tools for software designers. By doing so, Microsoft lowered the barriers to entry in the application software industry, a complementary industry to operating systems. Apple made it
even easier to enter the app industry by releasing segments of its operating system code, creating even more new entrants and sparking the rise of single-purpose, inexpensive apps for
mobile computing devices. Now, customers at Apple’s app store can choose from hundreds
of thousands of apps for their iPhones.
The number of new entrants in the app industry is actually increasing the barriers to
entry in the smartphone operating system industry. It would be difficult for a new mobile
operating system to come on the scene and compete with Apple or Android. Even powerful
Microsoft has experienced challenges entering the mobile operating system business.23 For
many industries, changes in complementary products are one of the most important trends
to keep an eye on. Some consider them significant enough that they even refer to them as a
sixth force among the five industry forces.24
Technological Change
Technological change within an industry has the potential to radically reshape a firm’s landscape, and sometimes society with it. Technological changes can include new products,
such as smart phones; new processes, such as hydraulic fracturing ( fracking), which has
dramatically increased the output of the natural gas industry; or new materials, such as
lithium batteries, which make electric automobiles possible. In many industries, the pace
of technological change has accelerated over the last couple of decades.25 Managers find
it increasingly important to consistently scan the environment to locate potential new
complementary products or
services Products or services that
can be used in tandem with those
from another industry.
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ì ANALYSIS OF THE EXTERNAL ENVIRONMENT: OPPORTUNITIES AND THREATS
technologies that might affect their industries.26 Early adopters are often able to gain greater
market share and earn higher profit margins than those who are late to adopt, suggesting
the importance of incorporating new technologies early.
Not only can technology change the nature of rivalry in an industry by giving some firms
an upper hand in gaining market share, but it can sometimes lower barriers to entry. For
instance, flexible manufacturing processes have allowed Shanzhai handset makers to nearly
match Nokia’s cost of manufacturing cell phones. Even in low-technology industries such
as steel, new technology can sometimes pave the way for new entrants. In the 1970s, a new
technology for smelting steel called the electric arc oven allowed new firms, such as Nucor,
to enter the industry with only one-tenth the capital investment that would have been
needed to start a traditional steel firm. Perhaps the technological change that has affected
the threat of new entrants in the greatest number of industries in the last 20 years is the
Internet. Some have suggested that the next giant wave of technology change, one we are
in the middle of experiencing is wireless communication, like smart phones, which allow
individuals to connect from and to anywhere and anyone at any time.27
General Economic Conditions
Changing macroeconomic forces can also have a large impact on industries. The state of an
economy can affect a region or nation and, subsequently, the ability of the average firm in an
industry to be profitable. Analyzing the economic environment typically involves measuring
the economic growth rate, interest rates, currency exchange rates, and the rate of inflation
or deflation. The appendix provides a list of sources where you can find information on
these economic indicators.
Economic Growth. How quickly, or slowly, an economy is growing has a direct impact on
most firms’ bottom line. Economic expansion tends to improve customer balance sheets,
lower price sensitivity, and increase the growth rate in an industry, as customers purchase
more, easing rivalry. For example, a number of African nations, such as Nigeria and Kenya,
have experienced solid levels of economic growth in the last few years.28 As a consequence,
a growing percentage of the population has sufficient disposable income to afford products
like automobiles and cell phones. Companies providing products like these in Africa have
experienced a boom in customer demand.29 The reverse is also true. When an economy
slows down, industry growth rates slow, customers are more price sensitive, and suppliers
are also likely to be struggling and pursuing ways of increasing profits—at the expense of
firms in your industry, if they have the power to do so.
Interest Rates. Interest rates mostly can affect rivalry by increasing or decreasing the
demand for an industry’s products. This is true for expensive items like housing, cars, and
even education, which often requires customers to take out loans to purchase. For example,
the housing boom experienced in the United States and Europe in the early 2000s was fueled
by low-interest-rate loans, sometimes below 4 percent, when the average mortgage interest
rate in the previous decade had been above 6 percent. When interest rates are low, industry
growth rates increase and rivalry decreases. When interest rates are high, the opposite
can occur. In addition, interest rates affect the cost of capital. When interest rates are low,
many firms can afford to invest in new assets. As interest rates increase, new investments
become more difficult. As a result, firms sometimes engage in price wars as a strategy for
gaining market share when rates are high, rather than investing in R&D and new product
development.
Currency Exchange Rates. Currency exchange rates reflect the value of one country’s
currency in relation to the currency from another country. Exchange rates can have a large
impact on the prices that customers pay for products from firms in other countries, directly
affecting profitability for those firms. For instance, from mid-2010 to mid-2011, the Swiss
franc appreciated 65 percent against the U.S. dollar, making Swiss products 65 percent more
costly in the United States, even though the cost of production hadn’t changed at all. Nestlé,
a Swiss firm, was particularly hard hit. It either had to decrease its profit margin to cover the
extra cost or increase its prices substantially, risking fewer customers buying its products.
HOW THE GENERAL ENVIRONMENT SHAPES FIRM AND INDUSTRY PROFITABILITY
Inflation. A significant, consistent rise in prices, known as inflation, can create many
problems for firms. Inflation, or the opposite, deflation, means that the value of the dollar
doesn’t stay constant. Today, a product may cost $1. If inflation is at 2 percent a year, then
next year that product will cost $1.02. Inflation or deflation, if they are high enough, can make
it hard for firms to plan investments. Inflation tends to decrease overall economic growth,
increasing rivalry and possibly buyer and supplier power and the threat of substitutes. When
firms can’t predict what price they will be able to get for a particular product, investments
in new product development become riskier. When inflation is high, many industries
experience increases in price competition, rather than development, as a means of gaining
market share.
Demographic Forces
Demographic forces involve changes in the basic characteristics of a population, including changes in the overall number of people, the average age, the number of each gender
or ethnicity, or the income distribution of the population.30 Because demographic changes
involve basic shifts in the product and geographic markets that firm’s target, demographic
changes are always accompanied by opportunities and threats. Even though demographics
often change slowly, they fundamentally reshape the landscape, so good strategic managers
have a firm understanding of demographic trends. The appendix contains a list of readily
available sources for demographic information. Some sources, such as the World Bank, contain hundreds of demographic indicators.
Over the last 50 years, the size the world’s population has more than doubled, from
around 3 billion to more than 7 billion people. Projections suggest that the Earth’s population could reach 9 billion by 2040.31 Each new individual is a potential new consumer, suggesting that growth rates of many industries will increase over time. However, increases in
consumption resulting from population growth also mean that supplies of raw materials
(such as the rare-earth metals terbium and europium currently used in flat-panel displays32)
are likely to decrease. Furthermore, the world population isn’t spread evenly over all nations.
The enormous populations of China and India account, to a large degree, for the number of
firms that have set up operations in those countries.
The average age of the population within a nation can also have a tremendous effect
on some industries. In Japan, for instance, more than 20 percent of the population is over
age 65. In the United States, this won’t occur until around 2040.33 The robotics industry
has already felt this shift. Japanese companies like Honda have invested tens of millions
of dollars in robots for home use, including walk-assist robots that help elderly people
with weakened muscles remain ambulatory when they would otherwise need to use a
wheelchair.34
Ecological/Natural Environment
The natural environment can also be a source of change for many industries. In some cases,
this involves changes to the physical environment such as increasing shortages of key inputs
like rare earth metals or fluctuations in the amount and cost of energy (i.e., oil and gas).
More often, though, current trends in the natural environment involve changes in the public’s perception of how business affects the environment. From global warming to clean air
and water, the public in many countries—including developing economies like China—are
demanding that firms be more proactive in protecting the environment. Many firms have
responded by implementing green initiatives. Although some of these may be for public
relations purposes only many firms have established serious goals. For instance, Procter &
Gamble has goals to use 30 percent renewable energy to power its plants by 2020. By 2014,
7.5 percent of its energy needs were already met by renewable energy. They have also promised to reduce their energy consumption, water usage, greenhouse gas emissions and waste
by 20 percent by 2020. They have already reduced them by 8 percent by 2014.35 If consumers
truly care about the environment, then actions like these increase rivalry as competitors are
forced to respond in kind.
[ 37 ]
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ì ANALYSIS OF THE EXTERNAL ENVIRONMENT: OPPORTUNITIES AND THREATS
Global Forces
Global forces also play a large role in shaping many industries. Over the last 50 years,
as communications and transportation technologies have undergone a revolution, trade
barriers among nations have fallen dramatically. Many countries, from South Korea and
Taiwan, to China and India, to Brazil and South Africa, have enjoyed remarkable economic growth and a rising standard of living. These changes have caused firms from many
countries to expand operations and begin producing and selling across national borders.
We will examine global forces and strategies for capitalizing on them in greater detail in
Chapter 9.
Political, Legal, and Regulatory Forces
Political, legal, and regulatory forces are those that arise from the use of government. When
new laws are passed, they may alter the shape of an industry and influence the strategic
actions that firms might take.36 For example, the federal Affordable Health Care Act, enacted
in 2009, mandates that health insurers cover everyone, including those with preexisting
conditions. This may change the cost structure of the industry, potentially resulting in consolidation and less rivalry, as inefficient firms either go out of business or are acquired by
more viable firms. In the United States following the Great Recession of 2008–2009, the
Federal Reserve required banks to keep larger amounts of cash on hand to cover potential
mortgage-related losses. One consequence of this regulation was less lending to small
businesses, erecting entry barriers in many industries and changing the nature of rivalry in
industries with many small firms.
Because political processes, laws, and regulations have the potential to shape and constrain industries, managers should analyze and understand the impact of new laws and regulations and decide how to respond. The Affordable Health Care Act, for example, requires
firms with over 50 employees to provide health insurance for their workers, or face fines.
Because the law also provides for health insurance exchanges through which uninsured
people can buy their own insurance, many firms are considering dropping employee health
insurance as a benefit. Their managers have determined that the fines their companies face
would be cheaper than the current premiums for health insurance.
Of course, laws often provide opportunities, as well as threats. For instance, laws in many
countries and states in the United States that require electricity providers to obtain a percentage of their electricity from renewable sources have resulted in a boom in demand for
wind turbines and solar panels. Because of the potentially far-ranging effect of laws and
regulations, many firms and industries strategically lobby government in an attempt to
influence the lawmakers to enact legislations favorable to those industries.
Social/Cultural Forces
Social forces refer to society’s cultural values and norms, or attitudes. Values and attitudes
are so fundamental that they often affect the other six general environmental forces, shaping the overall landscape in which firms compete. For instance, changing cultural norms
about health have resulted in laws against sodas being sold in schools and lawsuits against
fast-food retailers such as McDonald’s for marketing “unhealthy” food to children.
Like the other environmental forces, however, social forces can create opportunities if a
firm happens to be among the first to act on changes in values and attitudes. For instance,
Facebook helped to change social norms about connecting to friends and family. It reaped
enormous profits for being among the first to capitalize on the change in social networking.
Social forces are different, sometimes radically so, in different countries. Firms that compete in a global industry must understand differences among consumers in each country
they serve. For example, the collectivist orientation of many people in China results in a
general belief that the well-being of the group is more important than that of the individual
and a related norm of open information sharing.37 This open-sharing norm allows a greater
acceptance of product knockoffs and software pirating than many people are comfortable
with in countries that tend to have individualist orientations, such as the United States.
Internal Analysis:
Strengths, Weaknesses,
and Competitive Advantage
03
WALT DISNEY PICTURES / Album / Album / SuperStock
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1
Identify the steps in the value chain a firm uses to create
competitive advantage.
2
Distinguish among the core concepts of strengths, weaknesses,
resources, capabilities, and priorities.
3
Evaluate the strength and sustainability of internally generated
competitive advantages using the VRIO model.
4
Analyze a company and identify its strengths or weaknesses,
resources, capabilities, and priorities using the company
diamond tool.
[ 47 ]
03
Disney: No Mickey Mouse
Company
little things; they could do anything. I asked him what he
was going to call the character. “Mortimer Mouse,” he said.
I said, “That doesn’t sound very good,’ and then I came up
with ‘Mickey Mouse.’”4 That mouse, conceived in adversity,
would soon lead his creator to prosperity.
Mickey’s public debut in Steamboat Willie in late 1928
introduced not only a memorable mouse performing
laughable antics, but also a company that incorporated the
latest technology to bring its stories to life. Sound was just
beginning to make inroads in Hollywood, and Steamboat
Willie represented the first synchronous sound movie.
Mickey’s motions and voice were perfectly timed with the
music and audio in the cartoon, a major advance in motion
pictures. The public, and critics, loved it, and the Disneys
were on their way to lasting success.
Walt and Roy Disney learned well from Charles Mintz
the importance of owning, not just creating, characters.
Ownership of their most important resources allowed the
brothers to control the use of characters by licensing the
images to others. Walt entered his first licensing agreement
in 1929 with a stationary company that
EVERYONE KNOWS MICKEY, BUT FEW KNOW THE STORY OF HOW MICKEY’S
produced Mickey Mouse emblazoned
ARRIVAL IN 1928 SET OFF A CHAIN OF EVENTS THAT CONTINUES TO DRIVE
notecards. By the time WWII broke out in
1942, Disney was earning 10 percent of its
PROFITS FOR DISNEY MORE THAN 85 YEARS LATER.
revenue from licensing.5
Oswald quickly gained popularity, due in large part to
The cartoons featuring the lovable Mickey Mouse, and
the Disneys’ insistence on quality drawing and animation
cutting-edge technology became a Disney hallmark. The
sequences that came to be described as the “illusion of
company pioneered a series of firsts:
life,” which enabled characters to move smoothly, like
ì Technicolor was used for the first time in a film in
real humans.3 In 1928, Walt and his wife, Lilly, headed
1938’s Snow White and the Seven Dwarfs.
east to negotiate with Mintz for more money to expand the
ì A multi-plane camera enhanced the illusion-of-life
successful series. The negotiations did not go well for the
artistry.
Disneys. Not only would Mintz not pay more, he fired Walt!
ì In 1940, Fantasia introduced a precursor to modern
Mintz held the rights to the Oswald character, and he set out
surround-sound technology. This innovative technolto produce Oswald without the Disney brothers.
ogy would not spread industry-wide for another two
Crushed at the loss of their main character and income
decades. 6
source, Walt and Lilly boarded the cross-country train to
W
hen most of us think of the Disney Company, we
think of Mickey Mouse, Disney’s oldest and most
important in a long line of memorable characters.
As the company’s spokesman, he appears prominently
on the Walt Disney Company’s home page (http://
thewaltdisneycompany.com/about-disney.)1 Everyone knows
Mickey, but few know the story of how Mickey’s arrival in
1928 set off a chain of events that continues to drive profits
for Disney more than 85 years later.
In 1923, Walt Disney and his brother Roy settled in
Burbank, California. They created the Disney Brothers
Cartoon Studio to capitalize on a series of Laugh-O-Gram
animations Walt had produced in their hometown of Kansas
City, Missouri. Later that year, movie distributor Margaret
Winkler contracted with the new studio to produce a series
of single-reel cartoons based on a character from Walt’s
first movie, Alice’s Wonderland.2 After 56 successful episodes
of the Alice Comedies, Winkler’s husband, Charles Mintz,
contracted with the Disneys in 1927 to produce a new
character, Oswald the Lucky Rabbit.
return to Hollywood. Lilly recalled, “Walt showed me some
of his sketches on the train coming home. They were cute
[ 48 ]
Walt’s capability to innovate continued throughout his
career. He realized the potential of television in its infancy.
THE VALUE CHAIN
The first Disney television broadcast in 1950 was One Hour
in Wonderland, a program Walt created to help promote
his upcoming film Alice in Wonderland. And on October 27,
1954, the first episode of Disneyland aired. The show would
later become Walt Disney’s Wonderful World of Color to
capitalize on the potential of color television. And, it would
last. In some version, new Disney programming, from
the original Mickey Mouse Club to today’s popular Disney
Channel, has been on weekly network television for more
than 60 years.
Walt entered the world of television in order to fund his
grandest innovation of all: The country’s first destination
[ 49 ]
theme park. Disneyland opened in July of 1955 on 270
acres of land in Orange County, California.7 Disneyland
defied all skeptics and proved to be a huge success from
the day it opened. The park combined the company’s skills
in engineering and entertainment. Walt even called his
designers “imagineers.” Walt’s focus on creating a clean
setting also helped to set Disneyland apart from other
amusement parks. Ferris wheels and roller coasters were
no substitute for Magic Mountain or the Tea Cups, and the
spotless and inviting atmosphere proved a huge draw for
families across the country. Disneyland became one of
America’s first destination resorts.
ì
The Disney brothers chose to compete in a difficult industry. Their studio survived and eventually flourished in spite of a harsh industry environment and intense competition. The film industry featured several large studios such as Metro Goldwyn Mayer (MGM) and United Artists.
These industry powerhouses had access to the best actors and writers, and they had distribution networks to ensure that their films played in theaters across the United States. Competition
in the industry was fierce—the industry produced over 800 films a year throughout the 1920s.8
The Disney story, from a strategic perspective, captures the essence and power of a firm’s
internal abilities—the resources and capabilities that can create and sustain a competitive
advantage. The concepts and tools in this chapter will help you to evaluate a firm’s internal
abilities in order to answer the question, “How can a firm succeed, even in a very difficult
industry environment?” The first section of the chapter explains how firms create competitive advantages over rivals, and the second section discusses the sustainability of those
advantages over time. Internal analysis seeks to allow informed and meaningful judgments
about a company’s ability to win in its market, both in time (during any year or product cycle)
and over time (as long as a decade or longer).9 Winning in time means that a firm has a competitive advantage; winning over time requires that advantage to be sustainable. We end the
chapter by describing how to use a tool called the Company Diamond to create a meaningful
visual model of the internal attributes that are the basis for a firm’s competitive advantages.
As we’ve mentioned, strategists assume that firms differ. How can we describe those differences in a clear way that highlight how they contribute to the overall strategy? The value
chain provides a logical way to divide the firm into important strategic activities.
THE VALUE CHAIN
Figure 3.1 displays the value chain, or the steps in the process it takes to transform raw inputs
into finished outputs. Developed by Michael Porter, the value chain is a way to depict and
evaluate the activities a company performs. The horizontal elements in Figure 3.1 capture the
production process that a firm uses to acquire and import raw materials, transform them
into valuable outputs, and put them in the hands of customers. The vertical axis represents
four administrative elements—firm infrastructure, human resource management, technology
development, and procurement—that span all of the firm’s economic activities. Porter’s value
chain not only provides a framework to describe the activities a company performs, it also can
help to identify which activities represent the firm’s competitive strengths and weaknesses.
Walmart’s sophisticated information system shows how technology development adds
value by creating critical firm infrastructure. Its information systems give Walmart strength
in inbound logistics because it can find low-cost ways to move products from its suppliers to
warehouses, and in outbound logistics, when it uses the same systems to move products at low
cost to its retail stores. High-end retailer Nordstrom’s legendary return policy is part of its core
activities in marketing and sales as well as after-sales service. The ability to return virtually any
Nordstrom item with no receipt and no questions asked creates unique value for customers.
value chain A visual description
of the steps required to turn raw
materials into finished products
and/or services. The value chain
also describes key functions of
the firm linked to each stage and
functions that span the productive
activities of the firm.
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ì INTERNAL ANALYSIS: STRENGTHS, WEAKNESSES, AND COMPETITIVE ADVANTAGE
[ Figure 3.1 ] The Value Chain
Firm
Infrastructure
Support
(Enabling)
Activities
Human
Resource
Management
Technology
Development
M
a
Procurement
r
g
i
n
Inbound
Logistics
Operations
Outbound
Logistics
Marketing
and Sales
After-Sales
Services
Primary (Core)
Activities
Source: Adapted from Michael Porter, Competitive Advantage, 1985
Apple’s dominance in its markets can be traced to its strengths in the support activities
of technology development and procurement. For example, the original iPhone featured a
very unique raw material, Corning’s ultra-strong Gorilla Glass.10 Apple’s iTunes website and
Apple Stores showcase its strengths in operations. The company is also well-known for its
strong marketing and sales efforts, including its sleek logo and advertising campaigns that
have made Apple products a “must have” product for billions across the globe.
Disney’s early strength, as the opening case indicated, came in operations, by way of its
illusion-of-life cartooning process and innovative film production, both of which were enabled by the company’s technological development. The company used its stable of memorable and unique characters such as Mickey Mouse, Snow White, and the Little Mermaid to
create and sustain its brand identity in filmed and theme park entertainment. That identity
contributes to Disney’s strength in marketing and sales, in theaters, theme parks, and retail
operations such as the Disney Store.
The value chain helps managers identify areas in which a firm has an absolute strength,
but provides no guidance about strength relative to competitors. So, the value chain can
be used to answer the important question, “What is a firm good at?” However, it can’t be
used to answer the critical question, “What is the firm better at than relevant competitors?” The second question can be answered through two processes. First, we’ll define a set
of concepts—resources, capabilities, and priorities—to help in understanding the sources of
a firm’s strengths. Second, VRIO thinking will be introduced, which is a way of measuring the
magnitude and durability of a firm’s strengths versus competitive rivals.
THE RESOURCE-BASED VIEW
resources All assets, capabilities,
organizational processes, firm
attributes, information, knowledge,
and so on, controlled by a firm that
enable the firm to conceive of and
implement strategies that improve
its efficiency and effectiveness.
capabilities The procedures,
processes, and routines firms
employ in their activities.
priorities A firm’s values and
rankings of what is most important.
Resources, capabilities, and priorities can be thought of as answers to basic questions that
firms face. Resources are what a firm employs to create value and competitive advantage.
Capabilities represent how firms do things—the processes they use. Priorities explain why
firms allocate critical resources to achieve key objectives.11
Resources
Resources provide the answer to the question, “What creates the firm’s strengths?” One
definition states that “resources include all assets, capabilities, organizational processes,
firm attributes, information, knowledge, etc. controlled by a firm that enables the firm to
THE RESOURCE-BASED VIEW
conceive of and implement strategies that improve its efficiency and effectiveness.”12 This
definition clearly identifies what could be a resource, but its breadth makes it difficult to
identify and limit what types of things count as a resource.
Most resources are, or could be, counted and quantified on a firm’s balance sheet as
assets. Accountants classify resources as tangible or intangible assets. Tangible resources
are those with physical presence, such as land, factories, machinery, equipment, or cash.
Intangible resources are economically valuable assets that “do not have physical presence,”
and include brands, licenses patents, knowledge, and reputation.13
Four categories of resources are important contributors to competitive advantage:
1. Physical resources, such as plant or equipment
2. Financial resources, such as free cash flow
3. Human resources, including employee and management skills and talents
4. Intangible resources, the intangible assets held by firms, such as brands and patents
These four types of resources enable both the core operational and important support/
administrative activities in the value chain. Nordstrom could not operate without the physical resources of stores or a website for customers to visit, or without the financial resources of
cash or credit to purchase inventory. Similarly, without the human resources of salespeople
and the intangible resource of a strong brand, there would be no customer service, which
gives Nordstrom its strength in marketing and sales. Finally, without the intangible resource
of Nordstrom’s culture contributing to the firm’s infrastructure, and the human resource of
its training programs, the shopping experience would provide little of the satisfaction that
customers have come to expect.
[ 51 ]
assets Tangible or intangible
resources or factors of production
that create economic value for the
firm when employed. This chapter
focuses on physical, financial,
human, and intangible assets.
Capabilities
Capabilities are processes that the firm has developed to coordinate human activity in order
to achieve specific goals. McDonald’s corporation holds a commanding 24 percent market
share in the U.S. fast-food industry, nearly four times as large as rival Wendy’s.14 McDonald’s
operates more than 34,000 stores worldwide, many of them in highly accessible locations,
such as freeway off-ramps, towns, and mall locations. Although the stores themselves are
resources, McDonald’s has also developed a set of operating capabilities, or processes, that
are implemented in each of these stores. The process of filling customers’ orders at industry-leading speed is a capability at the heart of what makes McDonald’s successful. Speedy
customer service involves several steps: procuring customer orders accurately and quickly,
communicating the orders to the cooks, cooking the food, packaging it, and delivering it to
the customer. This process is repeated hundreds of times a day at all 34,000 individual store
locations, leading to high store-level capability for fast-food turnaround.
Competitive advantage relies on a strong set of operating capabilities. A firm’s advantage becomes stronger if it develops dynamic capabilities, processes that are designed to
continuously expand existing resources or to improve or modify operating capabilities.15
Dynamic capabilities are practiced and refined over time and through repetition. For example, Procter & Gamble (P&G) has many brand resources, such as Crest, Tide, Pampers, Pantene, and Febreeze. But it also has been through the process of creating a new brand many
times. Through repetition, P&G has refined its capability to create new brands to the point
that it now has a dynamic capability that can help it expand its existing brand resources
with new additions, such as the Olay Pro-X skin cleaning system.
Dynamic capabilities can help firms modify and evolve processes to keep pace with
environmental changes such as new competitors, shifting demographics, or new technologies. They can also enable firms to incorporate learning into their processes. For
example, Toyota follows a method of continuous improvement of its processes, known as
kaizen, in which ideas from many different sources are used to eliminate waste of effort
or materials.
Companies with strong dynamic capabilities have a more secure foundation for competitive advantage than those without them, for two reasons. First, dynamic capabilities
entail complex connections and coordination among different internal units within the
firm. For example, finding the optimal site for a restaurant requires input from marketing
operating capabilities Procedures,
processes, or routines for
delivering value to customers,
employees, suppliers, or investors.
dynamic capabilities Procedures,
processes, and routines that
continuously expand existing
resources or improve operating
capabilities.
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ì INTERNAL ANALYSIS: STRENGTHS, WEAKNESSES, AND COMPETITIVE ADVANTAGE
S T R AT E GY I N P R A CT I C E
Preserving Disney’s Capabilities: Don’t Mess
with the Mouse!
W
alt and Roy Disney learned early on about the
importance of copyrighting characters, and over the
years, his company developed a set of dynamic capabilities
to protect those resources.17 Steamboat Willie, also known
as Mickey Mouse, debuted on the screen in 1928. Under
existing copyright law, Disney’s copyright protection on
the fabled mouse would expire in 2003, 75 years after
the character’s origination. In 1988, Disney led a group
of Hollywood studios, music labels, and other content
owners in the entertainment business to successfully lobby
Congress to extend the copyright protection on Mickey
Mouse, and other characters created between 1923 and
1978, for another 20 years.18
With so much riding on the mouse and his friends,
Disney makes every effort to safeguard its property. The rise
of YouTube and other user-generated content (UGC) sites
has presented yet another challenge in the copyright wars.
Users can upload content to these sites without rights or
permission to the material. Disney recognized this threat
early and realized the resulting legal battle would be global,
long-running, and very, very expensive. Rather than threaten
YouTube and other technology providers, Disney General
Counsel Alan Braverman decided on a different strategy:
Disney would agree not to sue UGC sites as long as those
sites worked to remove copyrighted content on their own.19
The negotiations were delicate and took over a year, but
industry giants Disney, Microsoft, Viacom, Myspace, NBC,
Dailymotion, and Chinese UGC site Youku.com agreed to a
set of rules to protect content copyrights.
Critics complain that Disney’s efforts to protect its
copyrights stifle creativity and innovation in film and
entertainment, often at the expense of small, independent
filmmakers or retailers. The company maintains its legal
right to protect its brands and properties through copyright
law. Its actions around UGC, however, have allowed sites like
YouTube, Pinterest, and Facebook to grow without the threat
of costly and continuous lawsuits from content providers
such as Disney.20
about demographic information and target customer segments; the corporate counsel
about sales contracts and local regulations; and real estate professionals skilled at identifying, negotiating, and closing on properties. Companies that have developed strong coordination processes are likely to also gain the competitive advantage of good restaurant
locations.
Second, dynamic capabilities take time to develop and require significant learning. Processes or routines represent deeply engrained habits of behavior that take years for companies to perfect. As firms and their managers master the ongoing process of learning and
adjusting in the face of competitor, customer, or market changes, they develop a formidable
set of dynamic capabilities.16 Read more about one of Disney’s critical dynamic capabilities,
the ability to protect its intellectual property, in the Strategy in Practice feature.
Priorities
Resources and capabilities help firms create and deliver unique value. So what drives the
choices of which resources and capabilities a firm should invest money and time in? The
answer is priorities, which are a firm’s ranking of what is most important. Priorities are
driven by a company’s underlying values, its leaders’ beliefs about what is right and wrong,
good and bad, desirable and undesirable.
Management guru Peter Drucker described values as the ultimate test for action.21
Drucker noted that corporate decisions about hiring from the inside or outside, a company’s
stance about the importance of R&D, marketing, or any other functions look like technical
questions of strategy; however, they are really questions about what companies and their
leaders truly value.
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[ 53 ]
S T R AT E GY I N P R A CT I C E
Values and Priorities at Pixar
W
hen Steve Jobs bought Pixar Animation Studios in 1986,
he refocused the company away from its founding focus
on high-tech hardware, toward creating computer-generated
animated movies that people would flock to. The refocus
was critically, as well as financially, successful and resulted
in box-office hits such as Toy Story 1, 2 and 3, A Bug’s Life,
Monster’s Inc., Finding Nemo, Cars, and Up.22
Jobs valued innovation and creativity, and he felt they
were the keys to Pixar’s success. Jobs also believed that
innovation is sparked when individual creative people
spontaneously get together and share ideas. Jobs oversaw
the design of the Pixar Studios building and made sure that
the architecture itself would reinforce his values, by making
interaction among employees a design priority. As Jobs’s
biographer Walter Isaacson recounts:
Because Jobs was fanatic about these unplanned
collaborations, he envisioned a campus where these
encounters could take place, and his design included
a great atrium space that acts as a central hub for the
campus.
Brad Bird, director of The Incredibles and
Ratatouille, said of the space, “The atrium initially
might seem like a waste of space . . .But Steve
realized that when people run into each other, when
they make eye contact, things happen.”
And did it work? “Steve’s theory worked from day one,”
said John Lasseter, Pixar’s chief creative officer “…I’ve
never seen a building that promoted collaboration and
creativity as well as this one.”23
At Pixar, values favoring creative collaborations led to
a design priority: interaction. Building a workspace that
promoted these interactions maintains and enhances Pixar’s
rich capabilities for innovation in both technical design and
storytelling.
Values lead to priorities that help executives, managers, and employees make decisions.
Priorities drive the creation of resources and capabilities in two ways. First, priorities guide
resource allocation processes such as capital investment, human capital acquisition and
training, and brand development. Second, priorities maintain those allocations over time
when things get tough. Read in the Strategy in Practice feature how priorities influenced the
design of a new headquarters building for Pixar Studios, a Disney subsidiary.
CREATING A SUSTAINABLE COMPETITIVE
ADVANTAGE: THE VRIO MODEL OF SUSTAINABILITY
Walt Disney’s experiences with Oswald the Rabbit illustrate the difference between having
a competitive advantage and sustaining that advantage through time. Although the first
cartoons were both profitable and promising of a strong future, the Oswald advantage
was unsustainable because Disney didn’t own the rights to the character. Charles Mintz
proved unable to sustain the character Oswald because Mintz lacked the capability to keep
Oswald “alive” the way Disney kept Mickey Mouse alive through products, TV shows, and
theme park. Oswald’s life on film ended as Mintz’s team ran out of new ideas for the character in 1943, shortly after Disney created to Bambi, Dumbo, and Pinocchio.24 Walt Disney
lost a valuable competitive asset when Mintz enforced his ownership of the copyright on
Walt’s fateful trip to New York, but Mintz lacked the capability to sustain the character he
had captured.
Competitive advantages arise when resources or capabilities possess two attributes:
Value and rarity. Two other principles determine the durability, or sustainability, of
competitive advantage: Inimitability, the characteristics that make a resource or capability
difficult to imitate, and an organization’s ability to exploit profit returns generated by its
value Worth or utility.
rarity To be uncommon, or not
available to other competitors.
inimitability An attribute of a
resource that describes the degree
of difficulty a competitor would face
in copying, imitating, or mimicking
the value of that resource.
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ì INTERNAL ANALYSIS: STRENGTHS, WEAKNESSES, AND COMPETITIVE ADVANTAGE
unique and valuable resources. Together, these four characteristics—value, rarity, inimitability, and organization to exploit profits—are often abbreviated as VRIO. We’ll examine each
one in turn.
Value
Mickey Mouse earned returns for Disney and allowed the company to grow because this
character created value for film distributors and viewers. Value denotes worth for customers. A resource creates value if its contributions allow a company to produce a product
or service that is of worth to end users. Products or services have value when they create
direct pleasure, satisfaction, or happiness for the end user, or when they create indirect
opportunities that for users to experience produce pleasure and satisfaction. Users won’t
pay for products or services unless they create value in their lives. In fact, a fundamental
premise of our economic system holds that the price someone will pay for a good depends
on the value that good produces. The higher the value, the higher the price that buyers are
willing to pay.
Although not an absolute rule, resources and capabilities that provide firms with the
opportunity to produce and sell at lower costs than their rivals create value for customers. Low cost itself may produce some direct pleasure for users, but its benefits are mostly
indirect, as purchasing products and services at a low cost usually leave users with more
money to spend on other things that provide them pleasure or satisfaction. Similarly, unique
products or services often create direct pleasure or satisfaction for customers. Resources
that help a firm bring such differentiated products and services to the market create value
for customers. Of course, those resources also create economic value for the firm, defined as
profits. Chapter 4 includes a discussion of how firms can create cost leadership strategies
and Chapter 5 considers differentiation.
Rarity
To be rare is to be uncommon, or not available to other competitors. Unique is often used
as a synonym for rare. McDonald’s tries to find unique locations for its restaurants, such
as being the only restaurant at a freeway exit, or the closest to the on-ramp, or its presence
as the sole dining option inside many Walmart stores. Rare or unique resources create
competitive advantage through a basic principle of economics—scarcity. When products
or services are scarce, users are often willing to pay a higher price for them than they would
be if the same products or services were more commonly available, leading to higher company profits.
Inimitability
Inimitability is the extent to which competitors cannot easily reproduce a product by
employing equal, or equivalent, sources of value in their own products and services. Think
about attending a Major League Baseball, an NBA, or NFL game. The histories of the teams,
the star players, the amenities of professional stadiums, and the rules adopted by each league
to govern play mean that other leagues simply can’t imitate the experience these leagues
provide. In fact, the last successful rival competitive league was the American Basketball
Association (ABA), and it merged with the NBA in 1976. Several factors drive inimitability,
thereby acting as barriers to imitation. We’ll describe each one below.
Path Dependence. Path dependence means that the process through which a resource
or capability came into being may make it difficult for competitors to imitate. During
World War II, British aerospace companies focused on building small fighter planes
while Boeing, an American company, built many large bombers and tankers. After the
war, Boeing leveraged its learning and investments in large aircraft to introduce the first
successful commercial jetliner, the 707, in late 1957.25 A British company, De Havilland,
actually developed the first commercial jet aircraft, the Comet. However, the Comet failed
because De Havilland wasn’t as far along the learning curve on designing or building
CREATING A SUSTAINABLE COMPETITIVE ADVANTAGE: THE VRIO MODEL OF SUSTAINABILITY
ETHICS
[ 55 ]
A N D S T R AT E GY
Ethics & Strategy: Nondisclosure, Noncompete,
and Resource Protection
M
any companies have competitive resources in the form
of proprietary business practices. These proprietary
resources, also known as trade secrets, may be a “formula,
pattern, compilation, program, device, method, technique, or
process”26 that has been developed within a firm for its own
use. One common trade secret is the detailed information
about the purchase preferences of customers learned
by salespeople over time. This leads to manufacturing
companies, for example, customizing machines or tools to
fit their own unique production demands. Similarly, many
firms develop unique software code that adapts “off the shelf”
software packages such as SAP or Microsoft Office to perform
functions unique to the firm. Trade secrets improve a firm’s
ability to create a differentiated offering or to lower costs.
These trade secrets do not qualify for legal protection through
patents, copyrights, or trademarks, however, and challenges
arise when other organizations gain access to these “secrets.”
Trade secrets that create value for customers or other
stakeholders, and are unique to the firm can be a source
of a sustained advantage, as long as they do not “leak out”
and become common knowledge available to competitors.
Companies use two legal contracts to protect trade secrets:
nondisclosure agreements and noncompete agreements.
Nondisclosure agreements, often referred to as NDAs,
prohibit employees, suppliers, investors, or others who have
knowledge of a trade secret from sharing it with others.
Noncompete agreements prohibit employees from leaving
the company and taking a job with a firm that could exploit
an employee’s knowledge of trade secrets. A noncompete
agreement usually covers employee movement to firms
that compete directly, but could also include key suppliers
or customers as well. The use of NDAs and noncompetes
raises ethical issues for strategic managers.
From the firm’s perspective, these contracts offer protection
against the leakage of its valuable knowledge, processes, and
skills. Managers can, however, write NDAs so tightly that those
who sign them would be prohibited from using any knowledge,
skill, or process that is even remotely related to the actual trade
secret. Some entrepreneurs use the NDA as a weapon to keep
suppliers, customers, or investors from working on products
or projects that may be only loosely related to the trade secret.
NDAs that prohibit disclosure of particular lines of software
code, or particular programming languages, for example, may
stifle competition instead of protecting intellectual property.
Ironically, many venture capitalists, suppliers, and large
customers routinely refuse to sign NDAs in order to avoid
any restrictions on their ability to pursue their own interests.
Managers must balance their economic interests in protecting
their trade secrets with stakeholders’ ethical rights to pursue
their own goals without violating a contract.
Similarly, noncompete agreements can be written so
broadly that they unfairly penalize employees in their search
for new employment. First, noncompetes may be written in
a way that extends far beyond direct competitors, suppliers,
or customers and includes firms only distantly affected by
the firm’s trade secrets. Second, noncompetes may be of
such a long duration that even after a trade secret becomes
obsolete it still prevents employees from working for a
competitor. Managers, in their zeal to protect trade secrets,
can create agreements that restrict employees from using
even their generalized skills to find other employment.
Managers must strike an appropriate balance between
the strategic need of the firm to protect its valuable
trade-secret-based resources and the legitimate needs
of other stakeholders to interact with the firm and still
pursue their own interests.
large aircraft that could safely fly passengers. Path dependence helps to block imitation
when resources or capabilities follow a sequential development path—for example,
when previous investments enable later ones, or when significant learning underlies the
resource or capability.
Tacit Knowledge. For many processes, such as cooking French fries at McDonald’s, the
actions needed to imitate the sequence can be codified, or written down, and easily learned
by others. Such easy-to-codify-and-learn knowledge is referred to as explicit knowledge. Tacit
knowledge is just the opposite. Many valuable skills and processes, such as Walt Disney’s
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ì INTERNAL ANALYSIS: STRENGTHS, WEAKNESSES, AND COMPETITIVE ADVANTAGE
ability to choose good stories or Steve Jobs’s ability to spot great design in a product, can’t be
learned easily, if they can be learned at all.27 These skills are difficult, maybe even impossible,
to learn, teach, or coach, because they are based on tacit knowledge. Tacit knowledge is
sticky, or immobile, and difficult to imitate by competitors.
Causal Ambiguity. Causality refers to the notion that one thing causes another: A leads to B.
Sometimes, however, the causal relationship is unclear or ambiguous, and the relationship
between variable A and outcome B is difficult to disentangle.28 You may have learned in
statistics courses that correlation does not equal causation, and just because A and B
appear together does not mean that A causes B. One example is Steve Jobs, who studied
calligraphy at Reed College and yogic meditation from gurus in India. Jobs credited these
two experiences as highly influential in his aesthetic abilities, but most entrepreneurs will
not find that calligraphy classes or meditation trips to India bestow upon them the same
aesthetic abilities that Jobs possessed. In similar fashion, General Motors tried to imitate
Toyota’s production methods—the Toyota Production System—to produce cars at the same
cost and quality. But even after its engineers spent weeks and months watching Toyota
build cars in a joint-venture plant, GM still wasn’t able to achieve equal productivity. The
cause of Toyota’s productivity was not easy to determine because it was spread throughout
the organization, including the hiring and training systems, the layout of its plants, and
fundamental priorities and culture of the company.
Complexity. Resources, capabilities, and priorities become difficult for competitors to
imitate when they span the organization or contain many interrelated elements and exhibit
substantial complexity. Creating synchronous sound for Steamboat Willie, for example,
proved a complex task in 1927. Walt Disney learned that the key was to time the cartoon
framing and motion with the beat of the music (12 frames and beats per minute). Today,
much of Disney’s competitive advantage rests on the complex interplay between film
production, distribution in theaters and television, branding, merchandising, and theme
park management. NBC Universal has similar resources, but its profit rate is only about
one-fourth of Disney’s. Disney mastered the complex art of managing multiple, interrelated
business over several decades, while NBC Universal combined these resources through a
merger and has yet to prove the same ability to manage a complex and interrelated set of
business processes.
Time Compression Diseconomies. Diseconomies happen when an action increases, rather
than decreases, cost and efficiency. Timing is crucial in the development or deployment of
many resources, capabilities, or priorities and can become a diseconomy in many cases.29 If
a project requires a $20 million investment a year for the next two years, time compression
diseconomies mean that you can’t get the same results by spending $40 million in one year.
Resources that come from natural or physical processes, such as biological growth limits in
biotechnology, pharmaceutical research, or forestry, cannot be rushed. Similarly, resources
that come from differences in individual or organizational abilities to learn require adequate
time for lessons to be deciphered and processed.30
positive network externalities:
When the value of a product
increases with the number of
users.
virtuous circle When more sellers
attract more buyers, who, in turn,
attract more sellers.
Network Effects and First-Mover Advantages. Recall from Chapter 2 that much of the
reason eBay is so successful has to do with network effects, which economists call positive
network externalities. eBay wins because of its network effect. If you want to sell your
old stuff, where do you want to sell? Some place where there are lots of potential buyers.
If you want to buy stuff, where would you look? In a place with lots of sellers! More sellers
attract more buyers, who in turn attract more sellers. It’s a virtuous circle. As eBay grows
in popularity, other online auction sites such as Yahoo! have a hard time competing because
it’s difficult to attract buyers and sellers. Everyone wants to be where they have the greatest
exposure or selection.
Network effects represent a specific form of a first-mover advantage.31 For example,
eBay has been able to lock up the best sellers and most active buyers for its site because
it was the first mover in the market. Being the second to enter is difficult, as eBay learned
in Japan, where it exited the market because Yahoo!’s auction site had captured the firstmover advantage.32 First movers establish a number of advantages. In addition to customers, they can lock up other resources such as locations, patents, or scarce raw material
CREATING A SUSTAINABLE COMPETITIVE ADVANTAGE: THE VRIO MODEL OF SUSTAINABILITY
[ 57 ]
inputs. They can also establish long-term contracts with customers and set industry standards that favor their products. These actions make it difficult for rivals to profitably imitate
the first mover.
Organized to Exploit
A firm may employ valuable, rare, and difficult-to-imitate resources and yet still lack a
sustainable competitive advantage because the firm may not be organized to exploit
or have the contracts and systems in place to capture the profits that resources create.33
Consider National Football League (NFL) players. Revenues paid to the NFL from television
networks for the exclusive right to broadcast NFL games have grown from $47 million per
year in 1970 to just over $4 billion each year in 2012, a compound annual growth rate of an
impressive 12 percent. Over that same period, the players’ share of revenue has jumped from
35 percent in 1970 to 57 percent in 2011.34 How were players able to increase their share of
the pie by over 60 percent?
Before 1970, the NFL Players Association (NFLPA) had been a weak collection of player
representatives. During the 1970s, however, the NFLPA emerged as a true, well-organized
union, capable of engaging owners in meaningful contract negotiations backed up by
credible threats of strikes and legal action. The contracts that the NFLPA negotiated for
its members have garnered an increasing percentage of the NFL’s growing revenue. The
NFLPA’s stronger organization enhanced its legal standing and administrative abilities,
allowing players to capture the Ricardian Rents from their valuable, rare, and inimitable
resources.
organized to exploit The degree
to which the legal, administrative,
and operating structure of the
firm allows it to capture the rents
generated by resources.
Assessing Competitive Advantage with VRIO
Figure 3.2 shows the relationships between VRIO attributes of resources or capabilities
and competitive advantage. You can assess the strength and durability of a company’s
position by answering a yes or no question for each element in the matrix. Both resources
and capabilities should be subjected to the VRIO questions to determine the strength of a
company’s competitive advantage.
As Figure 3.2 shows, in the real world, firms that can’t create value for their stakeholders
don’t survive. These businesses experience competitive failure. Many companies, especially
new start-ups, introduce valuable products that are also unique and rare and enjoy a period
competitive failure When firms
that can’t create value for their
stakeholders don’t survive.
[ Figure 3.2 ] Resources and Competitive Advantage
Is the resource
valuable?
Is the resource
rare?
Is the resource
inimitable?
Is the company
organized to
exploit?
Competitive
Failure
No
No
No
No
Competitive
Parity
Yes
No
No
No
Competitive
Advantage
Yes
Yes
No
No
Durable
Competitive
Advantage
Yes
Yes
Yes
No
Sustained
Competitive
Advantage
Yes
Yes
Yes
Yes
Source: Adapted from Jay Barnery, “Firm Resources and Sustained Competitive Advantage,” Journal of Management 17,
no. 1 (March 1, 1991): 99–120.
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ì INTERNAL ANALYSIS: STRENGTHS, WEAKNESSES, AND COMPETITIVE ADVANTAGE
competitive parity When a
company survives but has no real
competitive advantage over rivals.
sustained competitive
advantage When firms combine
the legal elements, intellectual
property rights, administrative
elements, and cultural elements,
allowing them to capture high
profits that come from their
valuable, rare, and inimitable
resources, capabilities, or priorities.
of competitive advantage. The combination of value and uniqueness creates a short-run
competitive advantage in time for a firm. Over time, however, competitors can imitate these
resources and create competitive parity in the industry. Parity means that a company
survives but has no real competitive advantage over rivals.
To create competitive advantage in the long run—an advantage that endures over several
years—a firm must create barriers to imitation. Barriers make it difficult for competitors to
offer similar products or services, drive prices down, and dissipate the firm’s superior profits.
Barriers to imitation provide a durable competitive advantage, one a company is able to
sustain. Durable advantages dissipate over time, and moving from durable to sustainable
potential advantage into an actual one requires an organizational structure and design
that captures the value from resources and capabilities. Companies that realize sustained
competitive advantage combine the legal elements, such as contracts or intellectual property rights; administrative elements, including organizational structure; and cultural elements, such as norms regarding rewards and what constitutes equity that allow them to
capture high profits that come from their valuable, rare and inimitable resources, capabilities, or priorities.
Managers may work hard to create resources and capabilities that are VRIO, only to then
witness changes in technology, consumer tastes and preferences, government regulations,
or other forces that imperil their source of competitive advantage. The Strategy in Practice
feature describes how Disney responded when a new technology for cartooning presented a
threat to its sources of competitive advantage.
S T R AT E GY I N P R A CT I C E
Disney Responds to a Competitive Threat
D
isney’s initial competitive advantage arose from the
company’s ability to combine illusion-of-life animation
and the latest technological advances with classic stories in
the 1920s. Steamboat Willie, which pioneered synchronoussound, Fantasia, which debuted Technicolor, and Snow White,
the first full-length animated feature film, all still stand as
classics. Modern classics, including The Little Mermaid, The
Lion King, and Beauty and the Beast, built on and reinforced
Disney’s valuable, rare, and difficult-to-imitate brand and
character resources, as well as its storytelling capabilities.
Eventually, however, a leapfrog technological innovation
threatened Disney’s core source of competitive advantage.
In 1986, Pixar Animation Studios secured its first Oscar
nomination for its animated short film, Luxo, Jr. The
wonderful, family-friendly story of a small lamp signaled
that computer-generated animation (CGA), coupled with a
great story line, could prove a viable competitor to Disney’s
illusion-of-life capability.
With the development of its RenderMan software in
1987,35 Pixar, “could produce settings that looked absolutely
real,” said Pixar director John Lasseter.36 Pixar used this
new technology to produce a series of blockbuster hits,
including Toy Story, Toy Story 2, Monsters Inc., The Incredibles,
and Wall-E. Wired magazine would later peg Lasseter as
“the next Walt Disney.”37 Disney had used CGA since the
production of Tron in 1982, but only as a complement to,
never a substitute for, hand-drawn animation.
Disney lacked the in-house skill or software to compete
with Pixar. The company also found itself boxed in
strategically. Mickey Mouse turned 60 in 1987, and the Disney
brand evoked images of family-oriented entertainment but
not cutting-edge technology. Furthermore, the look and feel
of its animated character family appealed more to children
than to teenagers or adults. CGA posed a threat to Disney’s
brand, character resources, and to its illusion-of-life and
storytelling capabilities.
How did Disney respond? At first, the company partnered
with Pixar and provided distribution for Pixar films, as well
as financial resources for production and marketing. In
return, Disney received a percentage of the films’ profits.
The partnership prospered through six movies, including
Ratatouille, Up, Toy Story 3, and Monsters University.
During the time it partnered with Pixar, Disney’s own films,
built around its illusion-of-life animation, such as Treasure
Planet, were mostly unsuccessful. Eventually, Disney decided
it needed to own Pixar’s cutting-edge CGA capabilities. In
2006, Disney bought Pixar for $7.5 billion, adding Pixar’s
capabilities to its own pool of Disney capabilities.
THE COMPANY DIAMOND: A TOOL FOR ASSESSING COMPETITIVE ADVANTAGE
THE COMPANY DIAMOND: A TOOL FOR ASSESSING
COMPETITIVE ADVANTAGE
We’ve introduced some important concepts to help you understand how a company’s internal resources and capabilities may allow it to deliver unique value and achieve superior
performance. Internal analysis depends on more than concepts, however, and so now we
present an analytical process and tool that allow you to identify and catalog a firm’s potential for sustained competitive advantage. The company diamond tool will help you in the
academic work of this course, but it will prove even more valuable as you decide whether
to invest in or work for a particular company. You can also use the company diamond after
you take a job, when you work on teams assigned to create strategy for your company or
to understand the strategic strengths of your competitors. This tool will prove particularly
helpful should you want to start your own company.
The diamond also invokes a powerful metaphor about internal sources of competitive
advantage. Diamonds are valuable, but the creation of that value depends on the actions
of people and organizations. The diamonds you see in a jewelry store have been taken from
their original, raw state and cut, shaped, and graded to increase their value. Companies create sustainable competitive advantages by taking raw factors or production and molding
them into VRIO resources and capabilities.
Figure 3.3 illustrates the company diamond. The diamond shape helps you to integrate
the different internal elements that create layers of competitive advantage. 38 In the top
layer are the activities that create strengths and weaknesses. Resources and capabilities
lie below, in the center layer, because they lay the foundation for and fuel the activities
in the top layer. The bottom of the diamond—the deepest driver of competitive advantage—captures the values and priorities that guide the development of resources and
capabilities.
The numbered questions can be answered in order to help you move down the diamond
to discover the different sources of competitive advantage for a company. When you are
finished gathering and analyzing data to answer them, you should be able to draw a diamond or create a table for the company that provides a robust and detailed picture of the
company’s strategic advantages.
[ Figure 3.3 ] The Company Diamond
Source of Advantage
1. What is the company good at?
2. How does this create value?
3. What resources and capabilities drive those
activities?
4. What values support and sustain
resources and capabilities
Strengths &
Weeknesses
(Activities)
Resources
&
Capabilities
Durability of advantage
1. Is the element rare?
2. Is the element inimitable?
3. Is the organization able to exploit?
Priorities
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ì INTERNAL ANALYSIS: STRENGTHS, WEAKNESSES, AND COMPETITIVE ADVANTAGE
Gathering Data for Company Diamond Analysis
Data to complete a diamond profile come from a number of sources. You can use three main
types of data:
1. Archival data: Written or numeric information can be found in the library or on the
Internet.
2. Interviews: Interviews can range from personal questions to impersonal surveys.
3. Observation: Your own experiences, such as visits or use of products or services, are
also valuable.
If you want to create a diamond profile for a private company, you may find very little archival data, but it might be simpler to locate people willing to grant interviews or to
directly observe the company. For public companies, the reverse often proves true. Abundant archival data exist, but companies often create barriers, or firewalls, that make interviews difficult. The size of the company means that observations provide only a limited view
of the company. The appendix at the end of the book helps you know what to look for as you
perform a diamond analysis, and describes in detail different data sources you can use to
do the analysis.
As you gather data and use the questions to sort and categorize the information you
find, remember the GIGO principle from computer programming: Garbage in, garbage out.
Stated more elegantly, the more attention you pay to gathering, verifying, and comparing the
data, the richer, more robust, and more insightful your finished product will be. You should
always rely on at least two types of data (e.g., archival records and interviews), and use multiple sources of data within each type. For each strength, weakness, resource, capability, value,
or priority that you identify, include the source from which you drew your data. If your data
all come from a single source such as a website, Bloomberg Businessweek, Fortune, or Wall
Street Journal article, then your diamond will be weaker than if the information is drawn
from multiple sources. Tapping other data sources, such as doing an interview or scheduling
a plant visit, may seem daunting, but doing so will pay great dividends in creating a richer,
more complete profile of the company.
Be very careful to balance your data sources. Don’t rely exclusively on data provided by
the company or solely on data that come from the company’s detractors. Both have a point
of view that differs from the real company. If you are thinking about accepting a job with a
company, or one of its competitors, you’ll want to dedicate significant time and energy to
developing the richest diamond you can.
Using the Company Diamond
You can use the diamond to focus on a company’s strengths or its weaknesses. It is often
simpler to create a separate analysis for strengths and weaknesses as a first step.
Table 3.1 shows the results of a simple diamond analysis to compare the strengths of two
national retailers: Walmart and Nordstrom. As you can see from the table, both Walmart
and Nordstrom have clearly identifiable strengths that customers, suppliers, and others can
readily see.
What if you wanted to create a diamond profile to focus on a company’s weaknesses?
Consider Sears Holdings, the company created by the 2004 merger of Sears and Kmart.
Kmart began operations in the late nineteenth century and was a competitor of Walmart
until Walmart drove them into bankruptcy. Sears opened its first retail store in 1925 and
enjoyed a run as America’s largest retailer through most of the twentieth century.
A visit to a Sears store would allow you to observe both the company’s strengths and
weaknesses. Sears boasts a broad line of major national brands and some well-known house
brands, including Kenmore appliances and Craftsman tools. Sears offers its goods at multiple price points.39 However, while you would see a broad selection, you would also likely see
a store with outmoded lighting, worn carpeting or tile, and a merchandising and product
mix that lacks excitement. Articles in the popular press indicate that the company’s strategy
centers on store closings and layoffs, rather than on investing in new capabilities.40
THE COMPANY DIAMOND: A TOOL FOR ASSESSING COMPETITIVE ADVANTAGE
[ 61 ]
[ Table 3.1 ] Using the Diamond Model to Identify Strengths
COMPANY
Questions
Walmart
Nordstrom
What is the company good at?
Low prices
Customer service
What resources and capabilities
create those strengths?
Stores located in rural areas
Posh stores
Number of stores
Talented staff
Logistics, planning
In-store merchandising
Distribution centers
Selection and retention of staff
IT systems
Pricing policies
How does the company create value
for customers?
Low prices that enable customers to
purchase more total items
Pleasure and satisfaction through the
shopping experience and the goods
purchased
What priorities support/ sustain those
resources and capabilities?
Frugality
Outstanding service
Striving for excellence
Empowered employees
Rare?
Yes—size and scale
Yes—reputation/brand
Inimitable?
Yes—complexity
Yes—causal ambiguity
Organized to exploit?
Yes—centralized
Yes—decentralized
Competitive Advantage
Sources: Author interviews with selected organizational members, store visits and tours, various articles in popular press such as the New
York Times, Wall Street Journal, Bloomberg Businessweek, Fortune, and Forbes.
A read of Sears Holdings 2011 Annual Report or its 10-K filings, financial reports required
by the Securities and Exchange Commission (SEC), would reveal a company with a 2011 loss
of over $3 billion and cash resources that declined from $1.3 billion to $754 million over the
same period.41
The mission and values statements featured on the company’s website focus on building
lifetime relationships with customers, quality products, and positive energy. You may notice,
however, that these values don’t translate into priorities that connect with the company’s
strategy of selling off its assets, which the Wall Street Journal termed the “early stages of
liquidation.”42
If you use the VRIO process described in Figure 3.2, you would see that the rareness of
Sears’s resources diminishes with each sale of a valuable set of assets, a brand, or a retail
operation. Specialty retailers, such as local appliance stores or dedicated tool shops, not only
imitate Sears’ broad selection of products, they often exceed it and provide more knowledgeable service and support. Discount and big-box retailers such as Sam’s Club, Costco, or The
Home Depot match any price advantage Sears offers. Finally, you might notice that, as of
2012, Sears seems to be organized to sell, rather than grow, any superior profit returns from
its resources and capabilities. Table 3.2 summarizes the Sears situation based a company
diamond analysis.
The diamond profiles for Walmart, Nordstrom, and Sears Holdings should help you
understand the variety of strategies available to retailers. Company diamond analysis also
reveals how the strengths, resources, capabilities, and values work together at winning companies Walmart and Nordstrom, and how they don’t work together at Sears Holdings. The
profiles will help you have a better understanding as to why Walmart and Nordstrom generate superior returns for their shareholders and why Sears loses money.
[ 62 ]
CH03
ì INTERNAL ANALYSIS: STRENGTHS, WEAKNESSES, AND COMPETITIVE ADVANTAGE
[ Table 3.2 ] Using the Company Diamond to Identify Weaknesses in Sears Holdings
Questions
What is company good at?
Broad selection of goods
Appliances, tools
What are the company’s weaknesses?
Outmoded stores
Poor merchandizing
Unmotivated employees
What resources and capabilities are lacking
and contribute to those weaknesses?
Lack of financial resources for reinvestment
How does the company create value?
Better value can be had through specialty stores or
discounters, such as Walmart or Home Depot
What values support/sustain those resources
and capabilities?
Stated values and goals not consistent with current actions
Lack of strategic consistency to support training,
merchandizing
Priority seems to be survival
Competitive Advantage
Rare?
Diminishing through asset sales
Inimitable?
No. Specialty retailers offer better products, services and
low-cost retailers offer better prices
Organized to exploit?
No. Corporate focus is on creating cash flow through asset
sales
SUMMARY
rStrategy tools can be used to understand better how companies create and sustain comr
r
r
r
petitive advantages through their own efforts, as opposed to merely relying on the industry’s structure.
The value chain provides a broad and comprehensive roadmap for identifying the sources
of a firm’s strengths and weaknesses among its different value-creating functions and
infrastructure elements.
The factors of production that a firm uses to create competitive advantages can be
divided into three categories: resources, capabilities, and priorities. Priorities support the
development of capabilities, and they enable the creation and deployment of unique and
valuable resources.
Valuable and rare resources and capabilities create competitive advantages for firms. The
durability or sustainability of those resources depends on inimitability—how difficult it
would be for a competitor to imitate the resource. Finally, the firm must be organized in
legal and administrative ways that capture the returns created by those resources.
The company diamond is a tool to help identify, categorize, and assess the overall strategic advantages of a firm. The company diamond allows depth of analysis and understanding about the root causes of a firm’s competitive advantages.
Cost Advantage
04
© travelib envilronment / Alamy
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1
Differentiate between economies of scale and scope and
describe how both produce cost advantages.
2
Describe what an experience curve is and how it can be used to
make effective business decisions.
3
Discuss sources of lower input costs and how they provide the
basis of a cost advantage strategy.
4
Explain two changes in a firm’s business model that can enable
a cost advantage strategy.
[ 67 ]
04
The World’s Cheapest Car
rear-mounted 35-horsepower engine. Yes, that’s not a typo;
only 35 horsepower.2 Compare that to the 170 horsepower
standard engine in the base-model Honda Accord, or even
the 70 horsepower engine in a tiny U.S. Smart car. The Nano
also sported numerous innovations (including 34 inventions
for which Tata filed patent applications) that made it India’s
Car of the Year in 2010.3
Beyond designing a car that could be manufactured at
low cost, Tata also thought about how these cars could
be distributed at low cost. The Nano is designed to be
assembled from kits at dealerships, much like motorcycles
are in the United States. This approach alone could disrupt
the entire automobile distribution system in India. Tata
needed a way to reach customers in the smaller villages in
India, where Indians primarily drove scooters.
To be able sell its cars as inexpensively as possible in
the smaller villages in India, Tata decided against building
dealerships; there simply wasn’t a large enough market.
Instead Tata imitated the strategy of companies that sold
scooters. Scooter dealers arrived on
Sunday at farmers’ markets or flea
PRICED AT $2,500, NANO WAS LAUNCHED AS THE WORLD’S CHEAPEST CAR.
markets with big trucks filled with
scooters and set out the scooters in
wheel vehicle made of scooter parts?”1 Tata gathered a
rows for people to buy immediately. The Tata team brought
40 Nanos at a time to each open-air market and provided
small group of engineers to design a low-cost vehicle with
services so customers could see the car, learn how to
four wheels. The initial design had two soft doors with vinyl
operate it, get a license, buy insurance, and drive it home
windows, a cloth roof, and a metal bar as a safety measure.
the same day. This approach allowed Tata to eliminate the
But after seeing the initial designs, Tata and his group
typical dealership overhead costs required to sell cars—
concluded that the market wouldn’t want a “half car.” So
savings it could then pass on to its customers.4
Tata and his team spent the next several years designing a
“real” car that would use the least expensive materials and
The Tata Nano case illustrates how a company can
the least expensive components, and could be assembled
clearly define its unique value as being low cost, after
with minimal skill in the fewest possible labor hours.
which it then develops the resources and capabilities to
Tata’s dream became a reality in 2009, with the launch of
deliver its product at the lowest possible cost. During the
the Tata Nano. Priced at $2,500, Nano was launched as the
first few months after launching the Nano Tata received
world’s cheapest car. Designed to only weigh 1,320 pounds
orders for almost 200,000 units—a solid start for an all new
and get 50 miles per gallon, the Nano is powered by a
model.
P
riced at $2,500, Nano was launched as the world’s
cheapest car.
One rainy day in Mumbai, India, in 2003, Ratan Tata,
former chairman of the Tata Group, noticed a man riding
a scooter with an older child standing in the front, behind
the handlebars. The man’s wife sat sidesaddle on the back
of the scooter with another child on her lap. All four were
soaked to the bone. As Tata watched, he asked himself,
“Why can’t this family own a car and avoid the rain?” Then
he realized that, like over 700 million Indians who made
less than $10,000 a year, they probably couldn’t afford one.
Tata could not get the sight of that family out of his mind. He
began to dwell on the possibility of creating an affordable
“people’s car.”
“The two-wheeler observation [with the family of four
piled on the scooter] got me thinking that we needed to
create a safer form of transport,” Tata recalls. “My first
doodle was to rebuild cars around the scooter, so that those
using them could be safer if it fell. Could there be a four-
ì
[ 68 ]
ECONOMIES OF SCALE AND SCOPE
[ 69 ]
Companies typically choose between one of two “generic” strategies for offering unique value to
customers: cost advantage or differentiation advantage (the focus of Chapter 5). By designing cars
to be manufactured at the lowest cost possible, and by designing a distribution system to get the
cars to customers at the lowest cost possible, Tata has a cost advantage over every other carmaker in India, which allows it to sell the Nano at the lowest price. Like Tata, a firm that chooses
a cost advantage strategy wins with customers by reducing its prices below all of its competitors,
thereby allowing it to gain market share. Alternatively, a firm with a cost advantage may choose
the same price as competitors, which results in greater profits rather than higher market share.
Adopting a cost advantage strategy does not mean that the company focuses on cost to
the exclusion of everything else. Having a single-minded focus on making a low-cost product or service can result in an offering that no one wants to buy. Although Tata wins with
customers primarily because it sells a car that is cheaper than competitor offerings, it must
still worry about producing a car that works and is at least somewhat reliable. In fact, some
of the early Nanos caught fire, which scared off many buyers until Tata fixed the problem by
beefing up the heat shield in the exhaust system.
However, a company that wins by providing low-cost products or services must focus
most of its resources and capabilities on keeping its costs as low as possible. In this chapter,
we’ll explore the five potential sources of cost advantage summarized in Table 4.1: economies of scale or scope, learning or experience effects, proprietary know-how, lower-cost
inputs, and using a different business model.
[ Table 4.1 ] Sources of Cost Advantage
Economies of Scale or Scope
Greater unit volume allows firms to have lower costs by:
ì spreading fixed costs across more units
ì specialization of equipment and people
Learning and Experience
Greater cumulative volume drives cost differences due to greater learning and experience within companies with more
cumulative experience in production.
Proprietary Knowledge
Some companies develop proprietary knowledge in the production of their product or service, which leads to a
cost advantage.
Input Costs
Some companies may have lower input costs than others due to:
ì greater bargaining power over suppliers or labor
ì superior cooperation with suppliers (including lower transaction costs)
ì sourcing from low-cost locations (e.g., country comparative advantage)
ì preferred access to inputs
Different Business Model
Eliminating activities or steps in the value chain or using a different set of activities altogether may allow a firm to deliver
a product or service at lower cost.
ECONOMIES OF SCALE AND SCOPE
One of the primary reasons large companies dominate many manufacturing and service
industries is because of economies of scale. Economies of scale exist when an increase in
company size (measured as volume of production) lowers the company’s average cost per
unit produced.5 For example, if Tata can sell a volume of 100,000 cars instead of 10,000 cars,
the cost to produce each car will fall as the total volume or scale of production increases.
When there are significant economies of scale in manufacturing, research and development,
marketing, distribution, or service, large firms have a cost advantage over smaller firms.
economies of scale A reduction
in costs per unit due to increases
in efficiency of production as the
number of goods being produced
increases.
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CH04
ì COST ADVANTAGE
Economies of scale arise from four principle sources: the ability to spread fixed costs
of production, the ability to spread nonproduction costs, specialization of equipment, and
specialization of people.
Ability to Spread Fixed Costs of Production
fixed cost of production Costs
such as plant and equipment,
which are relatively fixed, meaning
that they do not increase with an
increase in the number of units
produced.
High volumes of production enable firms to spread the fixed cost of production, the costs of
plant and equipment, thereby lowering their cost per unit. A simple way to think about this is
to imagine two roommates who decide to share the $3,000 cost of purchasing a big-screen TV.
In this case, the cost per roommate is $1,500. If, however, another roommate joins in on the
purchase, the cost per roommate will decrease to $1,000, because there are now three roommates. If there were five roommates, the cost would drop still more, to $600 per roommate. The
more roommates over which to spread the cost of the TV, the lower the cost per roommate.
In similar fashion, companies can spread the costs of their plant and equipment when
they have more customers to share the cost. For example, it might cost a company $1 million to purchase equipment and a plant with the capacity to produce one thousand units of
a particular product; but it might cost that company only $2 million to build a plant with the
capacity to produce five thousand units. This happens because, in many activities, increases
in output do not require proportionate increases in input. For example, building an auto plant
that can produce 100,000 cars does not cost Tata five times the cost of a 20,000-car plant. The
larger plant would typically only cost two to three times as much as the smaller one.6
Ability to Spread Nonproduction Costs
High volumes of production also enable firms to spread the cost of nonproduction functions across
more units, thereby lowering the cost per unit. Large volumes enable companies to spread the
cost of research and development (R&D), advertising, and general and administrative expenses.
Research and Development. Firms that incur high R&D expenses—such as in the pharmaceutical
industry—have a strong incentive to expand operations globally to as many customers as
possible. Once a pharmaceutical company has made the R&D investment to develop a new drug,
those costs essentially become a fixed cost to spread across as many consumers as possible. In
fact, some research has shown that the best predictor of whether an industry is global (meaning
that firms in the industry expand to compete on a global basis) is the company’s R&D costs as
a percentage of sales. The higher a firm’s R&D costs as a percentage of sales, the more incentive
the firm has to expand globally to spread those costs across more customers.7
Advertising. In similar fashion, advertising is also subject to economies of scale. The fixed
cost of putting an advertisement in the local city newspaper is the same for a grocery chain
with one store in a particular market as it is for a chain with three stores in the same market.
By spreading the advertising cost across three stores, the larger chain will have one-third the
advertising costs per store, with the same level of advertising.
general and administrative costs
(G&A) Expenses and taxes that
are directly related to the general
operation of the company, and
executive salaries, general support,
and taxes related to the overall
administration of the company.
General and Administrative Costs. General and administrative costs (G&A) include the
costs of accounting, finance, human resource management, and the chief executive and her
staff. A company with high sales volume can spread its G&A costs across more units, thereby
creating a cost advantage. Walmart’s general and administrative costs are only about 0.5
percent of sales, for example. This is a much lower proportion than its competitor Sears
Holding Company, which has G&A costs of roughly 2 percent of sales.8 Walmart actually
spends, on an absolute basis, more than three times as much on G&A as Sears Holding
Company does. It is because Walmart’s sales volume is 10 times greater that G&A is much
smaller as a percentage of its sales.9
Specialization of Machines and Equipment
Companies with large volumes are also able to produce at low cost because they can invest in
specialized machines and equipment. A firm that has high volumes of production is often able
to purchase and use specialized equipment or tools that small firms simply cannot afford, due to
their lower production volumes. For example, in the ball bearing industry, the lowest-cost way to
produce fewer than 100 rings is to do it on general-purpose lathes. Producing between 100 and 1
ECONOMIES OF SCALE AND SCOPE
[ 71 ]
million rings is done most efficiently with a specialized screw machine. Companies that produce
more than 1 million rings can afford to purchase an even more specialized high-speed, continuous-process machine that further lowers the cost per unit. As volumes increase, firms have the
ability to use specialized (often automated) machines to do work at lower cost per unit.10
Specialization of Tasks and People
High volumes of production also permit greater task specialization, thereby leading to
greater employee specialization.
Task Specialization. When work tasks are specialized, workers can become more and
more efficient at the particular task and avoid the loss of time that occurs from workers
switching between jobs. For example, Henry Ford’s big breakthrough in the mass production
in automobiles involved breaking down the production process into a series of separate
tasks that could be performed by highly trained and specialized workers. Some workers
specialized on design, others on specific parts, and others on testing.
task specialization Breaking a
large process into smaller tasks
that require specialized knowledge.
employee specialization Increased
efficiency that results when
employees perform a narrow
range of tasks over and over again,
leading them to acquire specialized
knowledge that helps them
complete the task more efficiently.
Employee Specialization. Employees who specialize in accomplishing a particular task,
such as accounting, legal, or tax work, often bring high levels of skills to their tasks. The
value of employee specialization occurs not just in manufacturing environments, but also
in knowledge industries such as management consulting, investment banking, and the legal
profession, where specialization of labor permits larger firms to offer a wider range and
depth of expertise to potential clients.
Smaller firms often do not have the volume necessary to justify high levels of employee
specialization—and when they do hire specialized employees, there might not be enough
work to keep them busy all of the time. This is why small firms are more likely to have
employees who are required to perform multiple business functions and why they often
outsource to subcontractors specialized work, such as accounting, legal, or taxes.
Evaluating Economies of Scale: The Scale Curve
As we’ve seen, due to economies of scale, we expect cost per unit of output to decrease as
unit volumes increase. This relationship can be shown in a graph, the scale curve pictured
in Figure 4.1. Service businesses do not produce “units” of products like manufacturing businesses. Instead, in most cases, companies use some version of “number of customers served”
as their unit of analysis. Service companies can typically create scale curves that show how
the cost to serve customers decreases as the number of customers served increases.
At some point, however, the costs per unit no longer decrease with increases in volume.
This point, shown at Q1 in Figure 4.1, is called the minimum efficient scale. It is the optimal
quantity for a company to produce.
Cost per Unit of Production
[ Figure 4.1 ] Economies of Scale
Economies of Scale
Minimum Efficient Scale
(optimal quantity)
Diseconomies of Scale
Q1
High
Low
Volume of Production
scale curve A graphic
representation of the relationship
between cost per unit and scale
(volume) of production in a given
time period.
minimum efficient scale The
smallest level of output (unit
volume) that a plant or firm can
produce to minimize its longrun average costs. In a graphic
presentation of output/unit volume
(x-axis) and cost per unit (y-axis), it
is the output level where costs per
unit flatten and no longer continue
going down with increased output.
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CH04
ì COST ADVANTAGE
S T R AT E GY
I N P R A CT I C E
The Downside of Size and Scale
in the Airline Industry
A
fter the terrorist attacks on September 11, 2001, airlines
in the United States experienced a dramatic decrease
in passengers because people were worried about flying.11
During the prior 10-year period, American, Delta, and
Northwest—the largest carriers in the United States—had
been among the most profitable, in large part because of
their economies of scale. But during the three-year period
immediately following 9/11, these three airlines were among
the least profitable.
So how did being a large airline become a liability? There
were many contributing factors. One of the most important
reasons was that these large airlines had heavy fixed costs.
diseconomies of scale An increase
in marginal cost when output is
increased.
Prior to the attacks, they had spread those costs across
a lot of passengers. After the attacks, American, Delta,
and Northwest still had the same fixed costs, but they had
a much smaller volume of passengers. These airlines
suddenly had too many planes, too many gates, and too many
employees for the smaller number of passengers they were
serving. Combined with the economic downturn following
9/11, the airlines’ inability to spread their fixed costs over a
large number of passengers cut deeply into their profits.
Although economies of scale can be an advantage during
an economic boom, they can be an anchor weight during an
economic bust.
If a company continues to increase its volume beyond the minimum efficient scale, the
cost per unit actually starts to increase, due to diseconomies of scale. In large organizations, diseconomies of scale can happen because large plants become very complex to
manage. This increase in size and complexity tends to lead to increased waste and lower
employee motivation, which, in turn, leads to increased supervision costs.
Moreover, while large firms typically have an advantage in economic upturns, they are
sometimes at a disadvantage during downturns because they have more difficulty spreading
fixed costs when demand declines, as described in Strategy in Practice: The Downside of Size
and Scale in the Airline Industry.
Some firms with heavy fixed costs have moved to reduce the risks of large fixed costs by
shifting more of their cost structure from fixed cost to variable cost. One way they do this is by
outsourcing more of their activities, which will be discussed in depth in Chapter 7. For example, rather than invest in information technology personnel or equipment, they may outsource
these services to a low-cost provider, perhaps in India. For these firms, the cost of information
technology now varies according to how much the firm uses the subcontractor’s services. During a downturn, the company does not have to continue paying for people or equipment it is
not using. Another way they may convert fixed to variable costs is by leasing equipment on a
short-term basis, allowing them to turn equipment back to the lessor if demand is low. The key
point to remember is that size and scale do not always guarantee a cost advantage.
Economies of scale are more relevant in some industries than others, meaning that costs
per unit fall more rapidly with increases in volume in those industries. Scale curve slopes in
these industries are described as “steeper” than those in other industries. One such industry
is the mobile (cell) phone service industry. Figure 4.2 shows data for a wireless carrier, which
estimates a scale curve. This scale curve suggests that costs per subscriber (shown on the
vertical axis) drop by roughly 18 percent with each doubling of the number of subscribers (shown on the horizontal axis). For mobile phone companies, volume brings significant
benefits. The relatively steep scale curve of the mobile phone service industry is a primary
reason for mergers and acquisitions in that industry, as companies try to grow larger and
get more subscribers. Today, a small number of large companies dominate the market. For
AT&T, Verizon, and Sprint, the fixed costs per subscriber drop by 10 to 25 percent with every
doubling of the number of subscribers, because these companies can spread across more
LEARNING AND EXPERIENCE
[ 73 ]
[ Figure 4.2 ] Wireless Scale Curve
Average Cost per Subscriber
(Constant Dollars)
$40.00
$35.00
$30.00
$25.00
$20.00
$15.00
5,000,000
15,000,000 25,000,000 35,000,000 45,000,000 55,000,000 65,000,000
Number of Subscribers
Scale Curve: y = 3184.8x–0.271
Average Slope: 2a = 2(–0.272) = 0.83
Cost per subscriber falls (1 – 0.83) = 17 percent with each doubling of cumulative subscribers.
Source: Wireless Experience Curve (Constant Dollars)
subscribers the fixed costs of the cell phone towers required to route calls and the retail
stores required to serve customers across more subscribers.
Economies of Scope
Economies of scope differ from economies of scale in that the company does not reduce
costs by increasing the volume of a specific activity but by expanding the scope of its operations to related activities, so that some costs can be shared.12 Economies of scope exist when
the cost of conducting two business activities within the same company is less than the
cost of those same two businesses operated separately. To illustrate, when The Limited Inc.
opens up a Limited store selling women’s clothing, a Victoria’s Secret store, and a Bath and
Body Works store all in the same shopping mall, the company is looking for economies of
scope. Each of these stores sells different kinds of products and therefore they perform very
different activities in terms of product design, product mix, suppliers and marketing. However, the activities required to run these three separate stores are not completely unrelated.
All three stores need to find—and sign leases for—optimal locations in the shopping mall.
All three stores also need to have their products shipped to the mall.
When these stores are part of the same company, the company can lower the costs of
securing retail space by: (1) using the same people to identify, and negotiate the lease for, all
three stores, and (2) using the bargaining power of leasing space for three stores rather than
one to negotiate a better deal. The Limited can also lower distribution and shipping costs by
using the same warehouses and trucks to ship products to the shopping mall. The company
might engage in joint store promotions to boost sales, perhaps distributing promotional
offers good for Bath and Body Works at the Victoria Secret stores, or vice versa.
The greater scope of its operations is what allows The Limited to share some of the costs
of operation across its three stores. We discuss economies of scope in greater depth in
Chapter 6: Corporate Strategies.
economies of scope The
average total cost of production
decreases as a result of increasing
the number of different goods
produced.
LEARNING AND EXPERIENCE
Some companies use the basic premise of “practice makes perfect” to help them pursue
a cost advantage strategy. These companies are relying on the fact that humans can
perform tasks more efficiently—more quickly, with greater dexterity—the more a task is
cost advantage strategy A strategy
in which the unique value offered to
customers is lower-priced products
or services.
[ 74 ]
CH04
ì COST ADVANTAGE
repeated. Doing a task a lot of times also often helps people become more effective, that is,
they find better ways to complete the task. Researchers and strategists measure the effects
of learning and experience using the learning curve and the experience curve.
The Learning Curve
learning curve The concept that
labor costs per unit decrease
with increases in volume due to
learning. New skills or knowledge
can be quickly acquired initially,
but subsequent learning becomes
much slower.
The learning curve is a tool that managers can use to determine the contribution of
human learning on the part of employees to reductions in costs per unit. During World
War II, researchers first noticed that labor costs per unit decrease with an increase in
cumulative output. The researchers studied an aircraft manufacturing firm. They calculated that the number of labor hours required to build each aircraft fell by roughly 20 percent each time the cumulative volume of production doubled.13 Since that initial discovery,
a similar pattern has been found in many other industries, including the manufacture of
ships, computers, and TVs.14
Learning curve advantages are also relevant in service industries such as accounting,
consulting, legal services, and even personal services like hair styling. As an accountant
completes a greater number of tax returns, she learns how to do it more quickly. The same
can be said for a lawyer who repeatedly handles divorces or hair stylists repeatedly giving
clients a particular hairstyle.
The learning curve is more complex than a scale curve to calculate because it requires
gathering data on the cumulative volume of a given product or service produced, the total
amount since the company started making the product or providing the service. In contrast, the scale curve, described earlier in this chapter, shows how costs per unit change
with increases of volume of production during a given time period, such as a quarter,
half-year, or year. It is easier for companies to obtain cost information from specific time
periods.
The Experience Curve
experience curve A representation
of the relationship between
cumulative volume and product
cost.
In 1968, the Boston Consulting Group (BCG) generalized the concept of the learning curve
to encompass not just direct labor hours but all costs incurred to produce a product or service.15 BCG conducted a series of studies on a variety of products and services ranging from
bottle caps to refrigerators to long-distance telephone calls, and they found that costs per
unit (and prices) fall in a predictable way with increases in cumulative volume. Costs drop
with increases in cumulative volume due to a combination of factors, including economies
of scale, but also due to learning.
The experience curve shows how costs per unit change with increases in cumulative
volume produced. Like the learning curve, calculating an experience curve requires cumulative volume data. An experience curve does a better job of capturing learning effects than
a scale curve, because it is based on cumulative volume, like the learning curve. But, it also
does a better job of capturing the effects of economies of scale than a learning curve does,
because it includes all costs, not just labor. However, if data from the same time period are
used to calculate a scale curve and experience curve, both analyses produce the same result.
For detailed instructions on how to calculate a scale or experience curve using Microsoft
Excel, see the Strategy Tool at the end of the chapter.
Like scale curves, experience curves are applicable to service, as well as manufacturing, industries. Recall that, for service industries, the unit of analysis is generally “number
of people served.” For example, the authors of this book consulted with a bank that was
providing credit card services (a store-brand credit card) to Fry’s Electronics, a retail chain
that competes with Best Buy. The bank was trying to decide whether to invest more money
in marketing to convince more of Fry’s customers to apply for, and use, a Fry’s credit card.
Our question to the company was: How much do your costs decrease as you add credit
card subscribers? What is the slope of your experience curve? By understanding how much
costs would decrease if the company doubled their number of credit card subscribers, the
company would know how much they could afford to spend in marketing to get additional
customers.
LEARNING AND EXPERIENCE
[ 75 ]
[ Figure 4.3 ] Semiconductor Industry Experience Curve
Cost Per Unit of Production ($)
60.00
Average Slope = 0.798
Average Decrease in Cost with Doubling
of Volume = 20.2%
50.00
40.00
30.00
20.00
10.00
1,
00
0,
00
0
1,
50
0,
00
0
2,
00
0,
00
0
2,
50
0,
00
0
3,
00
0,
00
0
3,
50
0,
00
0
4,
00
0,
00
0
4,
50
0,
00
0
5,
00
0,
00
0
0
50
0,
00
0
0.00
Cumulative Volume of Production (units)
Since BCG’s early studies, literally hundreds of studies have shown that production costs
usually decline by 10 to 30 percent with each doubling of cumulative output. All of this
research is summarized in the law of experience:
The cost per unit of a standard product or service declines by a constant percentage
(typically between 10 and 30 percent) each time cumulative output doubles.16
Although the law of experience is phrased in terms of cost reductions, the slope of an
experience curve is described according to the percentage of costs that remain after doubling cumulative volume, rather than by the reduction in costs. For example, Figure 4.3
shows an 80 percent experience curve slope for semiconductors. This means that with each
doubling of cumulative volume, the cost has dropped by 20 percent, or that costs are 80 percent of what they were before volume doubled. If the thousandth semiconductor produced
costs a company $100 to make, then the two-thousandth semiconductor costs $80, and the
four-thousandth semiconductor will cost $64, or 80 percent of $80.
Learning and experience curve slopes tend to be steeper in the early stages of production
because learning occurs more rapidly in the early stages of production. This is because the
most obvious opportunities to reduce costs will present themselves early in the experience
of a company, but after those easy changes are adopted, gains from learning come in smaller
increments. Both scale curves and experience curves tend to be steeper in manufacturing industries than they are in service businesses—which means volume tends to be more
important for success in manufacturing industries.
Experience Curves and Market Share
To a strategist, the logic of the experience curve suggests that the company with the highest
volume in an industry—the highest share of an industry’s output—will also be the lowest-cost
producer. In fact, early work by the Boston Consulting Group showed that a company’s relative market share was a key indicator of competitive advantage and profit performance.17 This
finding was corroborated by the PIMS studies (an acronym for Profit Impact of Market share
Studies), which showed a consistent positive correlation between a company’s market share
and its profitability in most industries.18 As discussed in Strategy in Practice: The Relationship
between Market Share and Profitability in Retail Industries, the correlation can sometimes be
seen in retail as well as manufacturing industries. The logic was as follows: the higher the
company’s volume (its market share), the lower the costs per unit, and the better the profit
performance. A company’s market share was seen as a key driver of firm profitability.
law of experience Costs per
unit decrease with increases in
cumulative volume of production.
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ì COST ADVANTAGE
S T R AT E GY
I N P R A CT I C E
The Relationship Between Market Share
and Profitability in Retail Industries
F
ood retailers like Albertsons and Pathmark sell
thousands of products, as do home improvement
retailers like The Home Depot and Lowe’s. In retail
industries, where companies sell multiple products, it is not
possible to analyze an experience curve, because retailers
do not have a “cost per unit,” as manufacturers do.
Another way for firms in these industries to answer
the question, “Do I need to be big to be profitable?” is to
plot each company’s market share (its share of industry
revenues) on the x-axis and each company’s profit margins
(operating profit as a percent of revenues) on the y-axis.
Figure 4.4 shows an example of such a graph for the home
improvement industry. This graph shows a clear positive
relationship between national market share and profit
margins. The Home Depot and Lowe’s have high market
share in the United States and are much more profitable
than Sears, Ace Hardware, or True Value hardware. In this
particular industry, it appears that national market share
contributes to lower costs and higher profitability.
However, we conducted this same analysis in the food
retailing industry, using companies such as Albertsons,
Kroger, Safeway, Pathmark, A&P, Giant Food, Wegmans, and
Food Lion. That graph showed that national market share
was not a good predictor of firm profit margins. Many regional
supermarket chains, including Wegmans and Giant Food, were
more profitable than larger national chains, such as Albertsons
and Safeway. We can conclude that it is not critical to have high
national market share to be successful in food retailing.
[ Figure 4.4 ] The Market Share-Profit Relationship: Home Improvement Retailing
8.0%
7.0%
Home Depot
Lowe’s
Net Profit Margin
6.0%
5.0%
4.0%
Walmart
3.0%
2.0%
True Value
1.0%
Sears
Ace Hardware
0.0%
2.0%
4.0%
0.0%
6.0%
8.0%
10.0%
12.0%
Market Share in Revenue
14.0%
16.0%
18.0%
Note: Market share figures are for 2004; profit figures are an average of 2000–2005.
The initial conclusion from studies on the market share/profitability relationship was
that if a company wants to increase its profitability, it should increase its market share. This
had a clear implication for pricing strategy: A company should set its price based on its
anticipated costs per unit (at the higher market share), not at current costs per unit. This
kind of anticipatory pricing strategy would presumably trigger actual increases in market
share, along with lower costs, per unit, and higher overall profitability.
Does this strategy work? Not usually, and here’s why: Imagine that you compete in an
industry with five other companies who all hold the view that market share is the key to
profitability. To acquire market share from each other, each organization will have to drop its
prices or increase its advertising and marketing costs. If all companies in a market adopt this
approach, it seems clear that none of the firms will be particularly successful at either gaining
LEARNING AND EXPERIENCE
[ 77 ]
market share or increasing profitability.19 The general consensus of strategists now is that market share cannot be easily purchased. Rather, it is most often earned, through a low-cost strategy or by offering a superior product. For example, Air Asia is currently the low-cost airline in
Asia—and perhaps the world—because it has very low labor costs and provides fewer amenities to customers than its competitors do.20 In fact, to keep costs low it doesn’t even rent gates
at airports, but instead buses its passengers out to the tarmac where they board the plane. Air
Asia consistently prices lower than competitors who realize they cannot afford to match the
low prices. As a result, Air Asia is rapidly growing its market share by offering lower prices.
Most strategists today acknowledge that there is a correlation between market share and
profitability and appreciate that greater market share will lead to lower costs per unit. As
Air Asia grows its market share in the airline industry, for example, its cost per unit will
decrease, which will further improve Air Asia’s profitability. However, in most cases the cause
of both market share and profitability is some common underlying factor, such as a lowercost method of production or an innovative product that allows a firm to simultaneously
grow market share and profitability. In Air Asia’s case, its low-cost position is what allows
it to grow market share and profitability simultaneously. In the case of Apple, its ability to
simultaneously grow market share in music players (with iPod) and phones (with iPhone)
while increasing profits is due to its ability to create an innovative product.
How Strategists Use the Scale and Experience Curves
to Make Decisions
Scale and experience curves are useful tools for making practical strategic decisions about
growth and investment strategies; pricing strategies; strategies for managing costs; and
acquisition strategies.
Growth/Investment Strategy. As we’ve mentioned, experience curves tend to be steeper
in fast-growing industries. A scale or experience curve slope in a particular industry that
is quite steep (a slope less than 85 percent is quite steep, meaning that with each doubling
of volume, costs drop by 15 percent or more) indicates that first movers in a fast-growing
market will secure a widening cost advantage. Firms in an industry with a steep curve
have an imperative to grow as fast, or faster, than their rivals, so they do not end up at a
cost disadvantage. Moreover, a steep curve also suggests that a firm should take whatever
action is necessary to become a market-share leader. General Electric was known to have its
business units follow the philosophy, “Be #1 or #2, or exit,” presumably because GE operated
mainly in industries with steep experience curves, where it was difficult to be profitable if
the business unit was not #1 or #2 in unit volume.21
Pricing Strategy. A scale or experience curve can also be useful as a basis for pricing strategy.
A company can use the curve to anticipate future costs at different levels of volume. If higher
unit volumes will produce lower costs per unit, the company may want to price its product
or service aggressively low now, so that it can gain enough market share to reach those higher
volumes, and make more money. For example, Hyundai has been described as a company
that is pricing very aggressively to gain market share in order to lower its future costs per
unit.22 The strategy seems to be working, as evidenced by the fact that share has tripled in
the United States in the last 10 years. Of course, as we pointed out earlier, if all firms in an
industry attempt to price for market-share gains without a sustainable cost advantage, the
strategy may not work for any of them.
Cost-Management Strategy. A scale or experience curve can also be used as way to assess
a company’s relative cost position. For example, it is possible to plot scale or experience
curves for a company and for its competitors, allowing company leaders to assess how well
each company is managing its costs. For many years, General Motors produced more cars
than any other automaker in the world. An industry-wide analysis of several companies’
cost per unit produced (each car) showed, however, that while General Motors produced the
most units, it did not have the lowest cost per unit.23 Toyota, Honda, and Hyundai all had
lower costs per unit. This type of analysis suggests that General Motors was not managing
its costs well. Given its high production volumes, it should have lower costs per car. There
relative cost The costs incurred
by one company compared to the
costs paid by a competitor.
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ì COST ADVANTAGE
[ Figure 4.5 ] The Value of Scale in Delivering Internet Service to Hotel Rooms
$0.80
Total Operating Cost Per Room Per Day
$0.75
$0.70
Guest Tek costs fall by
an average of 29
percent with every
doubling of room count1
$0.65
$0.60
$0.55
$0.50
$0.45
$0.40
$0.35
$0.30
$0.25
Acquisition of
Golden Tree
(200,000 rooms)
$0.20
$0.15
$0.10
0
70,000
140,000
210,000
280,000
350,000
420,000
490,000
560,000
Number of Rooms (Installed Base)
1Power
function (based on trend-fit) is C = 154.13 Q–.4955. Doubling volume (2–0.4955) delivers a
cost that is 71 percent of previous level.
Note: Guest Tek Operating Cost per Room, 2003–2006
is probably much GM can learn from its lower-cost competitors. For example, Tata doesn’t
have significant economies of scale in production like General Motors has, but Tata has
developed proprietary designs and patents that allow it to produce cars at low cost.
Acquisition Strategy. Finally, a scale curve can be useful to predict cost synergies: the amount
by which costs will likely decrease if two firms combine their volume/scale. For example, Guest
Tek, a company that delivers Internet service to hotel rooms, saw an opportunity to lower its
cost per room with the purchase of its competitor Golden Tree. Guest Tek had a volume of
200,000 rooms, and Golden Tree also provided Internet service to roughly 200,000 rooms.
Acquisitions are often based on such synergies, which is why acquiring firms must pay a
premium to the shareholders of the target firm. How much was Golden Tree worth to Guest
Tek? An experience curve analysis allowed Guest Tek to see that its total operating cost per
room per day was decreasing by 29 percent with each doubling of rooms (a 71 percent slope,
as shown in Figure 4.5). The acquisition of Golden Tree would almost double the number of
rooms serviced, so Guest Tek could expect costs to drop by close to 29 percent. The actual
drop would probably be somewhat less, due to the costs associated with integrating the operations of the two separate companies, but at least Guest Tek had some idea of the cost synergies that it would likely generate as the result of acquiring Golden Tree. Guest Tek went ahead
with the acquisition and achieved the expected cost synergies, leading to record profits.
In summary, scale curve or experience curve analysis can be an extremely useful tool for
the strategist in making a number of key strategic decisions.
Proprietary Knowledge
proprietary knowledge
Information that is not public and
that is viewed as the property of
the holder.
In some cases companies are able to achieve a cost advantage due to proprietary
knowledge that is independent of scale or output. As described in the opening case, Tata
designed the Nano in a unique way, for example, using a specially designed 35-horsepower,
rear-mounted engine. Tata developed some important proprietary knowledge in designing the low-cost vehicle, some of which is protected by the 34 patents it applied for when
it completed the design.24 Patents are often important sources of proprietary intellectual
property. Another auto manufacturer, Toyota, has long been known to have lower production costs than its U.S. competitors in the auto industry—GM, Ford, and Chrysler—because
it has pioneered flexible production techniques (sometimes called the Toyota Production
System, or TPS), while U.S. firms have historically used mass production techniques.25 These
techniques are not protected by patents but by trade secrets.
LOWER INPUT COSTS
[ 79 ]
The architect of the Toyota Production System was Taiichi Ohno, a Toyota engineer who
realized that Toyota simply didn’t have the volume of production required to compete with
U.S. automakers on the basis of economies of scale. So, Ohno invented a set of processes
that allowed Toyota the flexibility to make three to four different car models within the
same plant. U.S. automakers, in comparison, could typically only make one or two different
car models within the same plant. A key principle of the Toyota Production System is “justin-time” delivery of components, both from outside suppliers and from different manufacturing stations within the plant. Delivering components close to the time they will be used
keeps inventories at plants low and minimizes waste.
Studies have shown that the Toyota Production System comprises roughly 30 key processes, including their “just-in-time” delivery. Although U.S. automakers have tried to imitate many of the practices of TPS, they have been relatively unsuccessful at understanding
the full proprietary system and how it works. As a result, Toyota has been able to maintain a
cost advantage and quality advantage over many competitors.
LOWER INPUT COSTS
Inputs are any purchases that are made by a firm in the course of conducting business
activities. The term inputs is broad. It includes raw materials, supplies, parts, and equipment. Inputs also include labor, capital, and land. When companies in a particular industry
purchase their inputs as commodities from the same competitive input markets, we can
expect every company to pay the same price for identical inputs.
In some situations, however, companies can achieve a cost advantage through lowercost inputs. There are four primary ways that companies achieve cost advantage through
lower-cost inputs: (1) exercising strong bargaining power over suppliers, (2) cooperating
especially well with suppliers, (3) getting inputs from low-cost locations, and (4) arranging
better access to inputs than other companies have.
Bargaining Power over Suppliers
Perhaps the most important way that companies get lower-cost inputs is by having greater
bargaining power over suppliers than their competitors do. There are two main sources of
bargaining power: buying a lot from the supplier and using successful negotiating tactics.
Purchasing Volume. Perhaps not surprisingly, suppliers can be expected to drop prices
when buyers increase their volume of purchases. Indeed, as a rule of thumb, suppliers are
known to drop prices by 5 to 10 percent with a doubling of purchased volume. At high
volumes, suppliers experience economies of scale and the law of experience, so they can
lower their prices. Walmart, for example, is known to get lower cost per unit prices from
suppliers because it can guarantee significantly higher volumes than its major competitors,
Target and Sears Holding Company.
Purchasing and Negotiating Tactics. Even when two firms purchase similar volumes of
inputs, one of the firms may have negotiation skills and purchasing tactics that allow it to
get inputs at lower prices. Once again, Walmart is well-known for its purchasing strategy
and tough negotiating tactics. Walmart spreads its purchases across numerous suppliers, so
that no one supplier has a dominant market share in any particular product category. The
company’s willingness to drop a supplier’s product if another supplier comes in with a lower
price is widely known. These practices let suppliers know that they are expendable, which
creates an incentive for suppliers to always give Walmart their lowest prices.26
Cooperation with Suppliers
Rather than strong-arm suppliers into offering lower prices as a result of bargaining power,
some companies achieve cost advantages by working cooperatively with suppliers. Toyota is
known for working cooperatively with suppliers to get lower-cost and higher-quality inputs.
Rather than spread purchases across multiple suppliers, Toyota has a two-vendor policy;
it typically only works with two partner suppliers of a particular input. By working with a
inputs Resources such as people,
raw materials, energy, information,
or financing that are put into a
system (such as an economy,
manufacturing plant, computer
system, etc.) to obtain a desired
output.
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CH04
ì COST ADVANTAGE
smaller number of suppliers, Toyota is able to devote resources to make sure it coordinates
very effectively with these particular suppliers.27 Toyota will even send its own engineers,
who are manufacturing experts in TPS, to help suppliers implement more efficient manufacturing processes to lower their costs. As a result of their close, highly cooperative relationship with Toyota, many suppliers will build their manufacturing plants close to Toyota’s
automobile assembly plants, thereby lowering the costs of transportation, logistics, and
face-to-face communications. Toyota is often able to get lower input costs from suppliers by
developing relationships that are highly cooperative.
Location Advantages
Another way to achieve cost advantage through low-cost inputs is to source inputs from the
lowest-cost location or country. The price of inputs can vary significantly between locations
because of differences in wage rates, exchange rates, or raw material or energy costs.
Wage rates. When Nike entered the athletic footwear industry in the late 1970s, Adidas was the world leader. Adidas produced high-quality shoes primarily in Europe,
where labor rates were quite high. Textile workers were paid approximately $20 per
hour in 1990. Nike decided to source all of its shoes from Asia, starting in Korea (where
wage rates were roughly $2.50 per hour in 1990) and then later mainly in China and
Indonesia (where wage rates were roughly $0.50 an hour in 1990).28 Because high-quality athletic shoes require a lot of hand-stitching labor, Nike was able to get shoes at far
lower cost than Adidas. Nike used these cost savings to invest in marketing, athlete
endorsers, and shoe design—a strategy of differentiation.
Exchange rates. In the late 1990s, the value of the Indonesian rupiah fell from 4,000
rupiah per dollar to over 10,000 rupiah per dollar. This meant that Nike could buy more
rupiahs with each dollar. It also meant Nike could buy shoes manufactured in Indonesia for less than it could purchase shoes made in countries, such as China, where the
currency had more value compared to the dollar.
Raw material and energy costs. The production of aluminum requires significant
energy, which is why much of the production is done in countries with low-cost hydroelectric power, such as Canada.29 Pulp and paper producers have typically come from countries
such as Canada and Scandinavia that have access to forests and hydroelectric power.30
r
r
r
Preferred Access to Inputs
In some instances, a company may have a cost advantage because it has preferred access
to particular inputs—it can get them more easily than other companies can. For example,
drilling oil in Saudi Arabia requires only the simplest drilling technologies, because drilling is
less complicated in the desert and oil is more frequently found relatively close to the surface.
For this reason, Saudi Arabian oil companies can access oil more cheaply than most oil companies in the world can. In similar fashion, the diamond company De Beers has historically
had preferred access to diamonds because De Beers owns and controls the output of a large
percentage of the world’s diamond mines.31
Companies only gain a cost advantage through preferred access to inputs when those
inputs are raw materials (such as oil or diamonds) that are rare and difficult to imitate.
business model The plan and
set of activities implemented by a
company to offer unique value and
generate revenue and make a profit
from operations.
value chain The sequence of all
activities that are performed by
a firm to turn raw materials into
the finished product that is sold
to a buyer.
DIFFERENT BUSINESS MODEL OR VALUE CHAIN
A final way to achieve a cost advantage is to use an entirely different business model, or
set of activities, to deliver a product or service. There are two basic ways to create a new
business model: to eliminate activities or steps in the value chain or to perform different
activities altogether.32 The value chain refers to the sequence of all activities that are performed by a firm to turn raw materials into the finished product that is sold to a buyer.33
Each activity is designed to add value to the prior activity, which is why it is referred to as
the value chain.
SUMMARY
Eliminating Steps in the Value Chain
One reason Ryanair has a cost advantage over other airlines in Europe is because it does not
offer any in-flight meals, pillows, blankets, or even air-sick bags. By not offering these items,
Ryanair not only doesn’t have to purchase the items itself, but also is able to significantly
reduce the labor costs associated with getting meals on and off its airplanes or laundering
blankets and pillows.
In similar fashion, Panasonic has long had a cost advantage over competitor Sony,
because it opts to spend only one-half as much as Sony spends for research and development each year. Rather than lead in product development, Panasonic follows, largely by
imitating Sony’s technologies. Panasonic also spends less than Sony does on advertising,
because it does not lead in launching new product designs. Eliminating some R&D and
advertising allows Panasonic to have lower costs, and lower prices, for comparable products
sold in electronics stores.
Performing Completely New Activities
Book retailer Barnes and Noble sells books through large superstores. Each store costs millions
of dollars to build. The company also has thousands of employees working in those bookstores
and millions of dollars of books on its store shelves. In 1995, Amazon.com began to sell books
in a completely different way—over the Internet. It was much cheaper for Amazon to build a
few large warehouses, take orders online, and ship books directly to the customers’ homes than
to do the things Barnes and Noble was doing: building superstores, hiring employees to staff
the stores, and buying and storing inventory.34 We provide a more comprehensive treatment of
strategies based on different business models and disruptive innovations in Chapter 10. Some
firms like Ryanair and Amazon achieve a cost advantage by deploying a different business
model, meaning that they either eliminate activities or steps in the value chain, or they deliver
their product or services using entirely different activities than their competitors do.
Revisiting Tata
At the beginning of the chapter, we described how Tata entered the motor vehicle industry with
the Tata Nano, which was heralded as “the world’s cheapest car.” Indeed, the Tata Nano was
the lowest-priced car in the world and was expected to appeal to very price-sensitive Indian
customers. Yet it hasn’t sold as expected. Between 2009 and 2013, Tata sold 229,000 vehicles—a
number far lower than expected. So what happened? Most observers point to the fact that the
Nano was marketed as the most affordable car available. But in the Indian market where car
purchases are hugely aspirational, people don’t want to buy “the world’s cheapest car.” Purchasing a Nano makes the Indian consumer feel cheap and doesn’t give the impression that they
want to give to friends and family. Says Haritha Saranga, a professor at the Indian Institute of
Management in Bangalore, “It is important to change the current image of Nano as a cheap
car.”35 So Tata represents a cautionary tale about how you position a low-cost product. For some
products that are hard to differentiate, like sugar, salt, wheat, oil, coal, and aluminum, offering
the lowest price may be all you need to win customer business. However, for many other products, like a car, customers consider a broader set of factors beyond price. In Chapter 5, we turn
our attention to the ways that firms differentiate their offerings in ways other than price.
SUMMARY
rCompanies that consistently offer lower prices due to lower costs rely on one or more of
r
five primary sources of cost advantage: economies of scale or scope, learning and experience, proprietary knowledge, low cost inputs, or a different business model.
Economies of scale produce cost advantages by allowing firms to: (a) better spread the
fixed costs of production across more units, (b) spread nonfixed costs across more units,
[ 81 ]
Differentiation Advantage
05
© Erkan Mehmet / Ala
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1
Define product differentiation.
2
Describe the four major categories or sources of product or
service differentiation.
3
Explain how to find sources of product differentiation.
4
Discuss how to build the resources and capabilities to
differentiate.
[ 87 ]
05
The Rise of Facebook
create online friendships, but decreased security. Numerous
news stories exposed sexual predators who sought out
victims through MySpace, and many parents would not allow
their children to use MySpace due to safety concerns.3
In addition to enhancing real-world friendships, Facebook
was the first social media site to offer a “relationship status”
option, allowing users to link their profiles to those of significant
others. Although this feature was later easily replicated by other
social media sites, Facebook was the first to offer it.
Facebook also had a different approach to customization.
MySpace offered a high degree of customizability, allowing
users to change the color and layout of their page. In contrast,
Facebook had a simple, clean, and standard appearance.
Interestingly, most users of social network sites reported that
Facebook was much easier to navigate because it didn’t allow
the customizability of MySpace.4 The standard appearance
made it easier to find the information they were looking for.
A final key difference between MySpace and Facebook was
that MySpace had several advertisements on each page,
which cluttered the website and increased the wait time for
the page to load. Mark Zuckerberg insisted
WHEN FACEBOOK FIRST LAUNCHED, IT WASN’T CLEAR THAT IT WOULD
that Facebook have no advertisements, thereby
BE SUCCESSFUL AT COMPETING WITH THESE [TWO] SOCIAL MEDIA SITES, adding to the minimalist appearance of the site.
AND THEIR ALREADY-LARGE NETWORKS OF USERS. HOWEVER, IT DIDN’T This approach made it quicker and easier for
users to navigate the site.
TAKE LONG BEFORE IT BECAME CLEAR THAT FACEBOOK WAS OFFERING
These differences quickly propelled Facebook
USERS THINGS THEY COULD NOT GET ON MYSPACE OR FRIENDSTER, AND
past both MySpace and Friendster. By 2010,
THAT THOSE THINGS WOULD MAKE IT EXTRAORDINARILY SUCCESSFUL.
Facebook had more than 400 million total
was later expanded to anyone with an .edu email address,
users, and on any given day, 125 million of them used the
Facebook’s exclusivity created a sense of privacy, security,
site.5 MySpace, on the other hand, had only 125 million users,
2
and elitism. Like Friendster, Facebook was not necessarily
52 million of whom used MySpace daily.6 Friendster trailed
intended to build new friendships online, but rather, to
far behind at 8.2 million users. Facebook’s unique features
perpetuate real-world friendships through the Internet. It
allowed it to change the face of the Internet and become the
required its users to request friends and wait for a friendship
largest social networking site in the United States.
confirmation. Only after a friendship had been established
Facebook was launched at the same price as MySpace
could a user view another person’s information and photos.
and Friendster: Free. Thus, it wasn’t possible for Facebook
MySpace, on the other hand, had a significantly more
to succeed through a low-cost strategy. Instead, Facebook
open interface, allowing greater access to information and
needed to offer something different—a product differentiation
photos of MySpace users. This increased the user’s ability to
strategy—to attract users.
I
n 2004, it seemed that the social media niche had been
filled. The two largest social networks were MySpace, with
86 million users, and Friendster, with fewer than 10 million
users.1 MySpace was open to anybody over the age of 13, while
Friendster was open to those 18 years or older. MySpace, in
particular, was growing rapidly and was designed to be easily
customizable to the interests of its users. It followed the example
of Friendster by having user profiles, blogs, and friendship
connections, but it also made it easy to share music and videos
and was particularly popular with emerging music performers.
When Facebook first launched, it wasn’t clear that it would be
successful at competing with these two social media sites, and
their already-large networks of users. However, it didn’t take
long before it became clear that Facebook was offering users
things they could not get on MySpace or Friendster, and that
those things would make it extraordinarily successful.
Facebook was launched by Mark Zuckerberg and his
computer science roommates at Harvard, Eduardo Saverin,
Dustin Moskowitz, and Dustin Hughes. Access to Facebook
was initially limited to Harvard students. Although membership
ì
[ 88 ]
SOURCES OF PRODUCT DIFFERENTIATION
[ 89 ]
Why did users flock to Facebook over other social networks? The primary reasons were that
Facebook offered greater exclusivity, privacy, and simplicity, the ability to share relationship
status, and zero advertising. These were features that simply weren’t available on the other
social networking sites. These features allowed Facebook to offer unique value in a way that
the other sites did not.
Professor Clayton Christensen has argued that customers—people and companies—
have “jobs” that arise regularly that need to get done. When customers become aware of a
job that they need to get done in their lives, they look around for a product or service that
they can “hire” to get the job done. As well-known marketing professor Theodore Levitt once
observed, “People don’t want to buy a quarter-inch drill. They want a quarter-inch hole!”7 A
drill is one way to do that job. Customers hire movies, concerts, or Cirque du Soleil tickets
to provide an entertainment experience. They hire an iron and ironing board to help them
iron the wrinkles out of clothing, but they could also purchase clothing with wrinkle-free
fabric to do the same job. When customers go to purchase a product (or service—we will
use “product” in this chapter to refer to both products and services) to get a job done, they
tend to consider two factors:
1. The way a product is differentiated from other products to perform the job (or jobs)
they want done;
2. The price of the product.
WHAT IS PRODUCT DIFFERENTIATION?
Some companies decide to offer customers low-priced products and thus pursue a low-cost
strategy as described in Chapter 4. In effect, they don’t try to do a different job from competing
products; they just try to do the same job at a lower price. Other companies, such as Facebook,
choose a product differentiation strategy. Product differentiation is a strategy whereby companies attempt to gain competitive advantage by offering value that is not available in other
products or services or that other products don’t do as well.8 This value may come in the form
of different product features, product quality or reliability, convenience, or brand image.
It is important to remember that product differentiation is always a matter of customer
perception.9 The actual products of two different companies may be similar in terms of technical features, but if one product is perceived as being different in a way that is valued by
customers, then product differentiation exists. Not surprisingly, when the perceived value
of the product increases in the mind of the customer, it also increases the customer’s willingness to pay a higher price. Thus, companies that invest resources to create unique features in their products often charge a premium price. A higher price is typically necessary
because attempts to differentiate products usually require companies to invest resources
that increase the cost of their offering.
Apple virtually always charges higher prices for its products because it invests heavily in
R&D and design in order to develop products that “wow” customers by offering unique features. However, even Apple must keep its cost structure under control so that it can offer its
differentiated products at a competitive price. If the price of an iPhone or iPad were $1,000,
there would be far fewer customers willing to buy an iPhone. Thus, there is a clear trade-off
companies must make between cost and differentiation. Greater differentiation typically
requires greater costs. So, in order to make a differentiation strategy successful, customers
must be willing to pay for greater product differentiation.
SOURCES OF PRODUCT DIFFERENTIATION
Identifying the sources of product differentiation is challenging. It seems as though
there are dozens of ways that products or services are differentiated from each other
to offer unique value. However, we have found four major categories of differentiation.
product differentiation A strategy
whereby companies attempt to gain
competitive advantage by offering
value that is not available in other
products or services or that other
products don’t do as well.
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As shown in Figure 5.1, products typically offer unique value because they offer: (1) different product/service features, (2) superior quality or reliability, (3) convenience, or
(4) brand image.10
Different Product/Service Features
Offering different product features is perhaps the most frequently used source of differentiation. We have found that it is useful to think about offering different product features in
three ways:
1. The product does a “better job” of meeting a customer need on existing product
features.
2. The product does “more jobs” for the customer than other products.
3. The product does a “unique job” that nothing else does.
Does a Better Job on Existing Features. Some companies differentiate their products by
focusing on one particular feature and doing a better job than other products of providing
value on that particular feature. For example, Dyson vacuums have gained market share
by claiming that the CycloneTM technology in their vacuums provides better “sucking”
capability. Dyson’s tagline: “The strongest suction at the cleaner head.” It doesn’t necessarily
claim that its vacuums are more reliable or lighter and easier to use—other features that
customers might care about. The key differentiator is suction capability, which is supposed
to do a better job of getting carpets clean.
Before 2001, when Apple launched the iPod, Sony was the market leader11 in portable
music players, based on the success of its portable cassette-tape player, the Walkman, and
the follow-up portable CD player, the Discman. The Apple iPod beat Sony Discman on two
key features. The iPod, which customers could fit into a pocket, was more portable than
the Discman, a key feature that many customers were looking for. Not only was the iPod
more portable, but it also had the feature of being able to store and play 500 songs, far
more than the number of songs got from the Discman, which could only play one CD at
a time. By providing better performance on key features—portability and menu of songs
available to listen to—iPod quickly came to dominate the market. Companies can identify
key features by identifying customer needs and the “jobs” that customers are hiring products to do for them.
Some companies succeed by doing a better job providing service to customers. Of
course, every company must provide service to customers, but some just figure out ways
[ Figure 5.1 ] Sources of Differentiation Advantage
Does a better job on existing
features
Superior Product
Features
Does more “jobs” than other
products
Does a “unique” job that nothing else
does
Better
Quality/Reliability
What is the source of
differentiation
advantage?
More convenient to
find, purchase, use
Brand/Image
SOURCES OF PRODUCT DIFFERENTIATION
[ 91 ]
to exceed customer expectations. Nordstrom is an example of a company that is often
lauded by customers for providing exceptional customer service. One of the most wellknown Nordstrom customer service stories is about a man who went into the Nordstrom
in Anchorage, Alaska, to return a set of tires. Nordstrom does not sell tires. But to be
responsive, the Nordstrom store manager still decided to allow the customer to return
the tires there.12 In another instance, a member of the housekeeping staff at a Nordstrom
in Connecticut noticed a customer had left her bags, along with her receipt and a flight
itinerary, in the parking lot. After Nordstrom was unsuccessful at contacting the customer
by phone, the employee drove to the airport, paged the customer, and returned her bags.13
Nordstrom provides extensive training to employees on how to provide great customer
service, and these stories serve to create a culture that encourages extraordinary customer service.
Does More Jobs. In some cases, a product might not do a better job on existing features
but simply does more jobs, or meets more needs, for customers than competitor offerings.
For example, Facebook did a job that the other social networking sites did not do when it
gave users the ability to alert their friends about their “relationship status,” a particularly
important piece of information for teenagers and college students.
When Apple launched the iPhone, the differentiating factor was not that the iPhone
made it easier to do the same jobs as other phones, such as place a phone call or get good
reception. In fact, many users say that the iPhone is a worse “phone” than competing products. Instead, Apple differentiated the iPhone by having it do more “jobs” for customers,
beyond making calls. iPhone users are able to easily make video calls and use their phone
to take HD videos. A second camera is built in to make it easy for users to take self-portraits
in front of the White House or Eiffel Tower. The many apps that were available only on the
iPhone (“there’s an App for that”) did a host of other jobs for users that no other phones had
the capability to perform.14
In similar fashion, 35-millimeter cameras lost the market to digital cameras because
digital cameras could do more jobs for customers. According to most professional photographers, the early digital cameras were technologically limited and actually took pictures
that were not as clear as pictures taken by 35-millimeter cameras. However, clarity in the
photo was only one dimension of getting a “good” picture. Consumers also wanted to see
the picture at the moment it was taken to know whether it had turned out the way they
liked. Digital cameras made it possible to instantly see the picture. Because the picture
was captured on a digital file, it was much easier to post a picture on your Facebook page,
or e-mail it to friends and family. Finally, a digital camera lowered the cost of taking each
picture because customers only printed the pictures that they liked and wanted to use—as
opposed to having to print the whole roll of film. Digital cameras ultimately came to dominate the market because they simply did more jobs for customers than their 35-millimeter
predecessors.
Does a Unique Job. Some products do a completely unique job that other products simply
do not do. Rather than simply doing existing jobs better or doing more of jobs than other
products, they offer a completely new feature to the market. For example, Propecia was the
first pharmaceutical pill that was clinically proven to grow hair. No other pill could do that
unique job. Disney theme parks are the only places you can go to see Mickey Mouse or ride
the Pirates of the Caribbean to see Captain Jack Sparrow.
Products that are designed to be customizable by customers do a unique job because
they can be created expressly to meet one particular customer’s unique need. In many cases,
the customer does the customization. For example, Nike allows customers to design their
own ID athletic shoes by selecting from a variety of design, color, and print options. Similarly, Timbuk2 allows buyers to customize their bag or purse by selecting from a variety of
modules or options. One of the most successful companies of this type is Build-a-Bear, a
company that allows you to “build” your own stuffed animal. You choose what the animal
looks like and then select various sounds that your animal can make. They also have a variety of different types of clothes that you can put on your animal. This approach has often
been referred to as mass customization, meaning that a company mass-produces the various modules of the product and then allows the customer to select which modules will be
mass customization When a
company mass-produces the
various modules of the product and
then allows the customer to select
which modules will be combined
together.
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combined together.15 Companies that choose this approach must develop the resources and
capabilities necessary to create their products in modules and to accurately combine those
modules as customer’s request.
Quality or Reliability
Some products are differentiated because of the quality or reliability of the product. The
product doesn’t necessarily do a better job as far as performance on existing features. It
doesn’t do more jobs than other products, and it doesn’t do a unique job. It simply lasts
longer.
Of course, it is possible to argue that a product with superior reliability actually does do a
better job on an existing feature, as already suggested. However, it is important to note that a
product differentiated based on quality or reliability offers essentially the same features and
functionality of other products, but lasts longer. Unlike the Dyson vacuum, a product that
wins due to superior reliability would not offer “better sucking power.” Instead, the vacuum
may suck just as much, but continue to display the same sucking power for months or years
longer. A music player might not offer better portability, as was the case with the Apple iPod,
but it might be more durable. For customers who don’t like the hassle of products breaking
down, this can be an important differentiator.
Historically, Honda and Toyota have succeeded, and differentiated their products, based
on superior reliability. Their vehicles are always at the top of various quality ratings because
they have the fewest defects. Customers don’t necessarily snap up Honda or Toyota vehicles
due to superior styling, more comfortable seats, or more power. They buy them because they
last and don’t often break down.16 This is particularly important to people or families who
have only one car, or do not have alternative transportation or a support system available to
help them when their car breaks down.
For years, appliance maker Maytag differentiated its products based on quality. It ran
commercials featuring the “lonely Maytag repairman” who sat around the office with
nowhere to go, because Maytag products presumably never broke down. The “Energizer
bunny” is another advertising character created to promote reliability. Energizer batteries
don’t do anything different from other batteries, so Energizer has emphasized their reliability, with its claim that they “last, and last, and last.”
Convenience
Another differentiator used by companies is making their products more convenient to
find and purchase.17 The product itself might actually be identical to other products on
the market, but the seller has figured out a way to make it easier for customers to buy.
Starbucks is an example of a company that succeeds, in part, through convenience. Starbucks does attempt to differentiate its coffee through branding and by offering different
blends and taste. But perhaps just as important, the company makes its coffees very easy
to find. Go into downtown Seattle or San Francisco and it seems you will find a Starbucks
on every other corner. When you have a hankering for coffee, Starbucks makes it convenient to find. Convenience is also one of the reasons why Coke and Pepsi are so successful.
Although brand image (described in the next section) is their most important differentiator, by investing in enormous vending machine networks, they ensure that when you are
thirsty, there is likely to be a Coke or Pepsi product nearby. We often buy Coke or Pepsi
products because it less convenient to go find another place that offers a wider array of
beverages.
Convenience also includes making a product easier to purchase. Amazon.com was the
pioneer of one-click purchase on the Internet, differentiating its services and contributing to its ability to outsell other Internet retailers. In related fashion, because Amazon
provides such a broad array of products, it essentially provides a “one-stop shop” for customers looking to buy products on the Internet. In the brick-and-mortar world, Walmart
provides convenience in its stores by offering a broad array of products from groceries
to electronics, to flowers and shrubs in the nursery. Beyond offering low prices, Walmart
SOURCES OF PRODUCT DIFFERENTIATION
makes it more convenient for customers to purchase what they want by putting it all
under one roof.
A special case of convenience involves the size of the network or ecosystem of the firm
offering a product or service. Some products or services are more convenient to use because
there is a large network of other users; these products benefit from network effects.18 Now
that Facebook is the largest social network site, it is more convenient for new users to join
Facebook to connect with friends than to choose another site, because most friends probably already have a profile on Facebook. This advantage keeps users going to Facebook, even
though competitors may have imitated many of Facebook’s other features. In similar fashion, eBay dominates the online auction market because buyers find it more convenient to go
ETHICS
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network effects When some
products or services are more
convenient to use because there is
a large network of other users.
A N D S T R AT E GY
At What Point Does Marketing Become Lying?
T
he shoe company Skechers claims that its rocker-bottom
Shape-ups sneakers help tone and shape your body. Hall
of Fame quarterback Joe Montana said they improved his
strength and posture, and celebrity Kim Kardashian boasted
that they allowed her to ditch her personal trainer. Olay
Regenerist, a line of anti-aging products made by Procter
& Gamble, claims that its creams will reduce wrinkles and
helps you look younger. And then there is Dannon, claiming
that its Activa and DanActive yogurts have health benefits,
including boosting immunity and regulating digestion. Are
these claims true? Can companies advertise these benefits if
they haven’t been proven?
Companies that pursue a differentiation strategy are
motivated to accentuate the features of their products and
services that provide unique value. Indeed, that is the job
of the marketing function—to create advertisements and
promotional materials that differentiate a product in the
minds of customers. This can create challenges for leaders
in companies because they have an incentive to exaggerate
product claims in an attempt to convince customers that
their product offers specific benefits.
To illustrate the fine line that marketers often walk,
consider the case of Kirstie Alley, the actress who touted
the benefits of the Organic Liaison weight loss program
that resulted in her dramatic weight loss as she prepared
to participate in Dancing with the Stars. But according
to a “false and misleading advertising” lawsuit filed by
Marina Abramyan, a dieter that used the program, Alley
didn’t achieve all of her weight loss by using the Organic
Liaison program. Abramyan’s suit against both Alley and
Organic Liaison claims that the celebrity’s weight loss was
augmented with an extreme diet and exercise regimen. Now
it is up to the court to decide if the Organic Liaison program
works as advertised.
To avoid these types of lawsuits, companies have become
increasingly cautious and are making sure their claims
are backed by data. For example, if Verizon claims it is
“America’s most reliable network,” or AT&T says that it
has “more bars in more places,” the companies must use
specific measures of “reliability” or “bars in more places”
to back the companies’ statements. Of course, it’s possible
that the data supporting Verizon or AT&T’s claims may be
technically correct but are actually misleading. For example,
if a company’s network is most “reliable” for a very limited
time period—say, a week or month—is it misleading to
use the most reliable label all the time? These are just a
few examples of issues and decisions that pose ethical
dilemmas for the strategist.
One clear standard of wrongdoing is whether or not
claims will be supported in a court of law. In the case
of Skechers and Dannon, the answer appears to be no.
Skechers was forced to pay $50 million and Dannon $35
million to settle claims of false advertising when it was
determined in a court of law that their product claims
didn’t hold up. Olay Regenerist is still awaiting judgment
after a woman filed a suit claiming the product’s antiaging claims were false. These lawsuits show that false
product claims can be very costly—and they highlight the
importance of making sure that product claims that can be
verified. Moreover, even if a company’s claims are partially
true but misleading, this can lead to negative publicity that
can tarnish a company’s brand. The bottom line is that
differentiators must be careful to ensure that the claimed
benefits actually exist.
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to an auction website where there are more sellers and, thus, a broader selection of goods.
Interestingly, while eBay is the dominant auction site in the United States, Yahoo! is the
dominant auction site in Japan. Yahoo! launched in Japan before eBay, and network effects
(e.g., more sellers attract more buyers) allowed it quickly to became the largest auction site
in Japan.
As a final example, one reason people use Microsoft’s operating system or Office suite of
products is because there is a large network of other individuals using the same products.
Using the same software makes it more convenient for users to trade and exchange files,
because the files are compatible.
Brand Image
brand image When products are
differentiated through marketing,
via advertisements, promotions,
and other marketing activities.
prestige brands When products
are differentiated by being
associated with positive qualities in
the minds of customers.
A final source of differentiation advantage is brand image.19 Companies often turn to this
source of advantage when they have difficulty differentiating their products based upon
features, reliability, or convenience. Brand image is typically developed through marketing, via advertisements, promotions, and other marketing activities. Interestingly, numerous studies have shown that the more people are exposed to something, be it a brand,
company, or product, the more they come to trust it.20 Indeed, the “mere exposure effect”
is a psychological phenomenon by which people tend to develop a preference for things
merely because they are familiar with them.21 In social psychology, this effect is sometimes called the “familiarity principle.” Studies of interpersonal attraction suggest that the
more often we see a person, the more pleasing and likeable that person appears to us.22
To fully appreciate and understand the value of brand image, consider the following questions: Is Jell-O really better than other gelatins? Is Kleenex really better than other tissues?
These brands are extremely well-known because they essentially pioneered their product
categories. We have been exposed to these brands many times over many years, through
commercials and other forms of marketing. Consequently, when we reach out to buy gelatin
or tissue, we tend to reach for the brands with the best brand image—even if it isn’t clear
that the product is different in features, reliability, or convenience.
Beyond mere exposure, companies also attempt to actively associate their products with
positive qualities in the minds of customers. This is a particularly important source of differentiation for products we consider as prestige brands.23 Sometimes, the job we hire a product to do is to help us feel part of an elite group or “club.” For example, this is why many people
hire a brand such as Louis Vuitton, Versace, Rolex, or Chanel even when functionally equivalent products can be purchased at a much lower price. Customers may choose to purchase
a Lexus or Infiniti even when a functionally equivalent Toyota or Nissan is available with the
same or longer warranty. In fact, Toyota makes Lexus and manufactures both Toyota and
Lexus brand cars in the same manufacturing plants with the same workers. The same is true
for Nissan, which produces Infiniti vehicles. But brand doesn’t have to signal prestige. The
Toyota Prius is a brand that appeals to the environmentally conscious. People may want to
be associated with a brand that differentiates itself as low-brow, environmentally conscious,
manly, or some other distinguishing characteristic. There are a variety of ways that brand
image can be a powerful source of differentiation in the mind of the customer.24
HOW TO FIND SOURCES OF PRODUCT DIFFERENTIATION
There are two major ways that companies attempt to find sources of product differentiation—customer segmentation and mapping the consumption chain. We’ll discuss some of
the details of each method.
Customer Segmentation
As mentioned earlier in the chapter, customers hire products or services to do jobs for
them—to satisfy particular needs or wants. Individual customers have different needs that
they want satisfied. They also differ in the amount of money they have to purchase products
HOW TO FIND SOURCES OF PRODUCT DIFFERENTIATION
or services to satisfy those needs. For example, some car buyers want power, speed, and
torque in a car so that it can go from zero to 60 miles per hour in 3 or 4 seconds. They look
for turbo-charged vehicles with lots of horsepower. Those buyers who like power but are
more price-sensitive look at turbo charged vehicles that sell for less than $30,000, such as the
Mitsubishi Evo, Subaru STI, or Hyundai Genesis Coupe. Buyers looking for power who have
more financial resources will look to the Porsche 911, BMW M-6, or Mercedes McLaren—or
an even higher-priced Ferrari or Lamborghini. These cars are all designed to do the job of
providing speed and excitement to buyers.
Other car buyers need a car that can comfortably seat five people when they carpool or
carry their kids and friends to the soccer match. These buyers look for roomy vehicles that
are easy to get in and out of, such as minivans. Still other car buyers are simply looking for
reliable transportation—a car that isn’t expensive but won’t break down and if it does is relatively cheap to fix. Those buyers will tend to opt for vehicles like the Hyundai Elantra, Honda
Civic, or Toyota Corolla that are specifically designed for that job.
Companies are more successful when they can offer the exact value that each customer
is looking for. However, the cost of designing a specific product for each customer is usually
prohibitively high. The next best solution is to group customers based on similar needs and
then create products that meet the needs of a particular group. This process of grouping
customers based on similar needs is often called customer segmentation. Customer segments are groups of people who share similar needs and thus are likely to desire the same
features in a product.
Along with defining customer segments, a company must choose which segments are
actually in its target market. Strategy involves making trade-offs, and companies often
have to make decisions about where to deploy scarce resources to get their best return.
This means they often have to decide which customer segments they think they can best
serve—and which segments deserve little (or no) attention. Facebook started by focusing
on the college student segment because the founders—as college students themselves—
had a deep understanding of the needs of college students and designed Facebook to meet
their needs.
Companies find customer segmentation extremely helpful if they can define segments
appropriately. When companies do not effectively segment customers into similar needbased groups, then they are likely to run into one of two problems. The first problem is that
they may add features, and costs, to their products that some groups of customers don’t
really want and don’t want to pay for. The second problem is that they may not add features
that certain groups care about and would be willing to pay for, potentially losing market
share to rival firms that do offer those features.
The marketing function within companies is typically charged with the challenge of market segmentation. Marketers typically segment markets in one of three ways:
1. Based on various attributes or the price of products
2. Based on attributes of the individuals or companies who are customers, including
demographics or psychographics
3. Based on the job-to-be-done view, an alternative way of segmenting customers that
has emerged recently
Product Attributes. One way to segment customers is based on product attributes. For
example, customers looking to buy motorcycles may place different value on different
attributes, such as power (speed), reliability, and ease of handling, gas consumption, or
customizability. By assessing the relative importance that customers put on different
attributes, and grouping customers based on what they want in those attributes, it may
be possible to design products to meet the needs of that customer segment. For example,
Honda tends to design motorcycles that appeal to customers who want reliable, easy-tohandle transportation vehicles. In contrast, Harley-Davidson designs rugged motorcycles
that are loud, showy, and highly customizable. Customizability is an important attribute
for customers who prefer Harley-Davidson; the average Harley-Davidson buyer spends
an additional 50 percent over the price of the motorcycle to make it completely unique.
Discovering groups of customers who want similar product attributes has enabled Honda
and Harley to design their products to better meet the needs of those customer segments.
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customer segmentation Grouping
customers based on similar needs.
customer segments Groups of
people who share similar needs
and thus are likely to desire the
same features in a product.
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Demographics/Customer Attributes. Another way to segment customers is based on the
demographics of customers. Popular ways to segment the consumer market include by age,
socioeconomic status (e.g., income), education, profession, and ethnic group. For example,
teenagers might be considered one segment of the market because they are viewed to be
similar in terms of what they want from certain types of products or services. Their needs
and wants are often quite different from college students, 30- to 50-year-old parents, and
retired people. Not surprisingly, high-income, middle-income, and low-income families are
often put into different segments, as are people with differing levels of education.
A popular way to segment the business market is based on size of companies, as measured in revenues, assets, or employees. Large companies are often perceived to have needs
that differ considerably from those of small companies and, consequently, businesses that
sell to large companies view them as a different customer segment.
Segmenting based on demographics has the advantage25 that it is relatively easy to do,
once you have data to place customers into different demographic categories. The disadvantage is that not all individuals (or companies) within a particular demographic category
share the same needs and wants.
Job To Be Done. As we’ve mentioned, Clayton Christensen suggests that customers “hire”
products to do “jobs” for them. He further argues that, “What this means is that the job,
not the customer or the product, should be the fundamental unit of market segmentation
analysis.”26 When people have a “job” to do, they set out to hire something or someone to do
the job as effectively, conveniently, and inexpensively as possible. Observing someone in a
particular circumstance can lead to insights about a job to be done—and a better way to do
the job.
According to Christensen, every job has a functional, a social, and an emotional dimension. The relative importance of these dimensions varies from job to job. For example, “I
need to feel like I belong to an elite, exclusive group” is a job for which luxury brand products
such as Gucci and Versace are hired. In this case, the functional dimension of the job isn’t
nearly as important as its social and emotional dimensions. In contrast, the jobs for which a
delivery truck might be hired are dominated by functional requirements, such as the size of
the truck or ease of loading.
Understanding the functional, social, and emotional dimensions of a “job to be done” can
be quite complex—but might be key to differentiating your product or service. For example, Harley-Davidson customers often purchase a Harley-Davidson motorcycle because
they view themselves as rugged individualists. This is one reason why customizability is
so important—each Harley rider wants the motorcycle to reflect his or her unique identity
and not be like anyone else’s. Beyond that, they want to find others with a similar life view
that they can ride with, which is why the Harley Owners Group (H.O.G.) is important to
many riders. Thus, for most Harley-Davidson buyers, the job to be done goes well beyond
providing a particular type of ride on a motorcycle. The job to be done is related to helping
the buyer express his or her identity and be part of an elite group of rugged individualists.
Segmenting a market in different ways can provide different insights as to how to differentiate a product. Table 5.1 shows all three ways of segmenting the mobile handheld
device market.27 Each segmentation approach might lead a company to develop different
features and consider different competitors. For example, a company that segments the
market using the product attribute view may focus on providing the best camera, best
phone features, best organizer, and so on. A company that takes a demographic approach
to segmenting the handheld market might use occupation as a way to segment customers.
Such a company might conclude that traveling sales representatives want different things in
a handheld device than college students do. A company that uses the job-to-be-done view
might discover that one segment sees the job to be done as using small snippets of time
productively. That segment might be different from those who “hire” their handheld device
to provide entertainment. When most companies in an industry segment customers in a
particular way, there may be an opportunity for a company to segment the market in a different way, thereby identifying groups of customers whose needs are not met by the typical
method of segmentation. This might allow a company to offer a different value proposition,
thereby creating a competitive advantage with a particular group of customers.
HOW TO FIND SOURCES OF PRODUCT DIFFERENTIATION
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[ Table 5.1. ] How You Segment the Market for Handheld Devices Will Influence the Product Features
You Consider to Be Relevant
PRODUCT ATTRIBUTE VIEW
DEMOGRAPHIC VIEW
JOB-TO-BE-DONE VIEW
Market Definition
Market Definition
Market Definition
The handheld wireless device
The traveling salesman
Use small snippets of time
productively
Competitors
Competitors
Competitors
Palm Pilot, Handspring Treo,
Sony Clié, HP Jordana, Compaq
I-Paq, wireless phone
Notebook computers, wireline Internet
access, wireless and wireline telephones
Wireless telephones, Wall Street
Journal, CNN Airport News,
listening to boring presentations,
doing nothing
Features to consider
Features to consider
Features to consider
Digital camera
Wireless Internet access; bandwidth for data
E-mail
Word
Downloadable CRM data/functionality
Voice mail
Excel
Wireless access to online travel agencies
Voice phone
Outlook
Online stock trading
Headline news, frequent updates
Voice phone
E-book and e-technical manuals
Simple, single-player games
Organizer
E-mail
Entertaining “top-ten“ lists
Handwriting recognition
Voice
Always on
Source: Adapted from Christensen and Raynor, The Innovator’s Solution, p. 83.
Mapping the Consumption Chain
Another process that can be used to look for differentiation opportunities is to map the
consumption chain, which involves tracing your customer’s entire experience with your
product or service.28 Professors Ian McMillan and Rita McGrath, who developed and
advocate the technique, suggest that companies perform this exercise for each important customer segment. Mapping the consumption chain involves identifying all the
steps through which customers pass from the time they first become aware of your product to the time when they finally have to dispose of it or discontinue using it, as shown
in Table 5.2. Although products or services may have somewhat different consumption
chains, a few activities are common to most chains. To understand the consumption
chain, MacMillan and McGrath suggest asking the following questions, in the following
order.
How Do Consumers Become Aware of Their Need for a Product or Service? The first
step in the consumption chain occurs when customers become aware that they need
a product or service. A company may be able to differentiate its product if it can find
a unique way to make consumers aware of a need. For example, consider the problem
of differentiating an everyday consumer product, such as a toothbrush. For most of us,
brushing is an everyday ritual to which we pay relatively little attention. As a result,
many people use a toothbrush for too long, until its bristles become worn and no longer
effective at cleaning teeth.
Toothbrush maker Oral-B discovered a way to capitalize on this widespread habit by
inventing a way for the toothbrush to communicate to the customer that it needs to be
replaced. Oral-B introduced a patented blue dye in the center bristles of its toothbrushes.
They dye gradually fades as the brush is used. When the dye completely disappears, it signals
the user that the brush is no longer effective and needs to be replaced. Thus, customers are
made aware of a need that previously had gone unrecognized. One could imagine that makers of tires or other products that wear out could create a similar advantage. By providing
mapping the consumption
chain Identifying all the steps
through which customers pass,
from the time they first become
aware of your product to the time
when they finally have to dispose of
it or discontinue using it.
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ì DIFFERENTIATION ADVANTAGE
[ Table 5.2 ] Mapping the Consumption Chain
How do consumers become aware of a need for your product/service?
How do consumers find your offering?
How do consumers make their final selections (priority of attributes)
How do consumers order and purchase your product?
How is your product/service delivered?
How is your product/service paid for?
How is your product stored/moved around?
What do consumers need help with when they use the product?
What if customers aren’t satisfied and need to return or exchange?
How is your product repaired, service, disposed of?
Source: MacMillan and McGrath, “Discovering New Sources of Differentiation.”
a way to make customers aware that they may need a particular product, companies can
find a way to differentiate their product.
How Do Consumers Find Your Offering? Once potential customers are aware that they have
a need for a product, they then need to find it. Companies can differentiate their offering if
they can make the search process easier for customers by making it less complicated, more
convenient, or less expensive. Starbucks has made finding high-quality coffee simpler by
opening up so many stores that a latte is nearly always within easy reach. Many companies
help consumers find their product by paying to be at the top of a Google search. For example,
if a consumer types “snowboard” in a Google search, sporting goods retailer REI pops to the
top of the list because they pay Google for that premium space. Convenient placement of
REI’s listing makes it easier for consumers to find, and eventually buy, snowboards from
REI. Other ways to make a product easier to find include making it available when others
are not, as companies that have 24-hour telephone-order lines do, or offering it in places
where competitors do not offer theirs. For example, some credit card companies set up
booths on college campuses to put credit cards within easy reach of college students. In
similar fashion, Coke puts vending machines in university buildings, public schools are often
banning soft drink vendors]at gymnasiums, and in workplaces to make it easy for someone
to find a Coke. Thus, some companies can differentiate their offering simply by making it
easier to find.
How Do Consumers Make Their Final Selections? After a consumer has narrowed down
the possibilities, he or she must make a choice. This is the time when product attributes
typically dominate, and it is critical to ensure that consumers are aware of features that may
differentiate a product. Some companies assist in product selection by providing customers
with side-by-side comparisons of their products with those of competitors. A comparison
list makes it easier for consumers to see which product has more features, or has the features
they care about the most. Alternatively, a company can select the one feature that customers
might care about and trumpet how their product beats others on that particular feature.
Bose does this with its “noise canceling” headphones, emphasizing that their headphones
cancel out more noise and give you better sound quality than other headphones. Anything
that can be done to make the product selection process more comfortable, less irritating, or
more convenient has the potential to be a differentiator.
How Do Customers Order and Purchase Your Product or Service? Another way to
differentiate a product is to make the process of ordering and purchasing more convenient.
Amazon.com has made the process of purchasing a product online easier by storing all
of your relevant personal and credit information and allowing you to use their “one-click”
HOW TO FIND SOURCES OF PRODUCT DIFFERENTIATION
purchase option. In similar fashion, Starbucks has created a “Starbucks Card” that is
essentially like a credit or debit card that allows you to quickly swipe your way to a coffee. In
addition to buying the coffee faster, customers who use a Starbucks Card also accumulate
points that be applied to future purchases at Starbucks.
American Hospital Supply revolutionized how disposable medical products, such as
bandages, tongue depressors, syringes, and disinfectants, are sold to hospitals by simplifying
the ordering and restocking process. The company did this by installing computer terminals
for purchasing their products at each of its customer hospitals. The terminals connected
those customers directly to the company’s system, allowing direct-drop shipment and automatic restocking whenever supplies fell below a certain level.
One potential benefit of making your product more convenient to order is your company can create a switching cost, especially for repeat customers. Once customers have
signed on to a purchasing system such as American Hospital Supply’s terminals, it can be
costly or inconvenient for them to switch to another supplier. As we described in Chapter 2,
switching costs create a barrier that can prevent competitors from getting access to your
customers.
How Is Your Product or Service Delivered and/or Installed? Customers sometimes need
to have products that they purchase delivered, installed, or assembled. Transporting and
assembling products are stumbling blocks for customers, so these services can be a source
of differentiation. RC Willey, a successful retailer of furniture, appliances, and televisions,
guarantees delivery within 48 hours for those who want it. Quick delivery is especially
important to customers whose refrigerator has quit working or who need a new bed.
If a product requires assembly or installation, companies may differentiate themselves
by making it easier to install. For example, before software was downloaded via the Internet, Apple let your computer software self-install. All you had to do was insert a disc it into
the computer and everything else was taken care of. When consumers need to install parts
or equipment, some companies try to make installation easier by providing a poster with
the product that clearly illustrates the installation steps. Color-coding cords and cables or
other devices involved in an installation can further simplify the process and make a product easier to set up and use.
How Is Your Product Stored? When it is expensive, inconvenient, or even dangerous
for customers to have a product simply sitting around, a company has the potential to
differentiate the product by providing better or easier storage options. Air Products and
Chemicals, a maker of industrial gasses, became the leader in its market segments by
addressing the problem of storage. Air Products realized that most of its customers—
chemical companies—would rather avoid the burden of having to store vast quantities of
high-pressure gasses. So it built small industrial-gas plants next to its customers’ sites. This
created an important differentiator by making gas storage more convenient. Even better,
once an Air Products plant was built next to a customer, competitors had little opportunity
to move in.
In similar fashion, NordicTrack, a maker of workout equipment including cross-country
ski machines and treadmills, has designed many of its workout machines to easily fold up
and slide under a bed or into a closet. Customers with little room for a workout machine,
but a strong desire to work out at home, have been attracted to NordicTrack’s easy-to-store
machines.
What Do Customers Need Help with When They Use Your Product? Sometimes a customer
will need assistance when using a product or service. A company can differentiate on that
dimension if it understands what kind of help customers and can provide that assistance
more effectively than other companies. For example, each year during Thanksgiving in the
United States, millions of home chefs cook a turkey. Many of these people are making a
turkey for the first time and have questions about the process. Butterball’s 24-hour Turkey
Talk-Line fields questions from thousands of these customers every Thanksgiving. Butterball
also has a turkey-cooking guide that its customers can download. One frequent, and very
important, question people ask when cooking a turkey is how to tell when it is done. Poultry
must reach a certain internal temperature to be safe to eat. Nobody wants to give their family
[ 99 ]
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CH05
ì DIFFERENTIATION ADVANTAGE
and friends food poisoning on Thanksgiving. To answer this question easily and definitively
for cooks who don’t have or have trouble reading a food thermometer, Butterball (and some
other turkey providers) install a “pop-up button” on the turkey that springs outward when
the turkey is done. Its help line and pop-up signals help differentiate Butterball as the best
turkey choice for inexperienced cooks.
What If Customers Aren’t Satisfied and Need a Return or Exchange? While many companies
focus on the customer through the sale and installation of a product, others realize that
long-term loyalty requires attention to customers’ needs throughout their experience with a
product. Handling problems well when the product doesn’t work out for a customer can be
as important as meeting the need that motivated the initial purchase.
Nordstrom is an excellent example of a company that has focused on succeeding through
superior service—including after-sale service. As previously described, Nordstrom captured
national publicity when one of its store managers “took back” a set of tires from a customer
despite the fact that Nordstrom did not sell tires. By focusing on and aggressively promoting
its no-questions-asked return policy, Nordstrom has developed a reputation as a company
that provides unique customer service. Customers may be unhappy with a particular product that they return, but they are not unhappy with the store if it does everything possible to
make sure that the return is easy to do.
How Is Your Product Repaired, Serviced, or Disposed Of? As many users of technologically
sophisticated products will attest, repair experiences—both good and bad—can influence a
lifetime of subsequent purchases. This is particularly true if you are highly inconvenienced
because the product fails to work properly, as is the case in an elevator (nobody wants to get
stuck in an elevator). Otis Elevator uses remote diagnostics to prevent service interruptions
on its elevators. In high-traffic office buildings, where servicing elevators is a major
inconvenience to occupants and visitors alike, Otis uses its remote-diagnostic capabilities
to predict possible service interruptions. It also sends employees to carry out preventive
maintenance in the evening, when traffic is light. Thus, companies can find opportunities to
differentiate by ensuring that products are quickly and easily repaired when they fail to work
properly.
Finally, customers might find the need to dispose of a product when it is no longer usable.
Most people don’t have a truck—or enough time and interest--to haul an old mattress or
oven off to a dump or recycling center. But, RC Willey, a successful seller of mattresses and
appliances, will haul away your old mattress or oven for free when you buy a new one. By
disposing of obsolete or broken appliances, mattresses, and furniture for customers when
they purchase a product, RC Willey meets a customer need that may be unrelated to the
new product, but still differentiates the product because it comes with a service that makes
the customer’s life easier.
In summary, by analyzing the consumption chain—the series of steps experienced by
a customer from becoming aware of a need for a product to disposing of it—companies
can find opportunities to differentiate. Once an opportunity to offer unique value has been
identified, the company must then figure out how to deliver that unique value better than
its competitors can.
BUILDING THE RESOURCES AND CAPABILITIES
TO DIFFERENTIATE
Customer segmentation and mapping the consumption chain are useful tools for identifying what unique value to offer a customer. However, it is just as important for a company to
figure out how to deliver that unique value.29 For example, how does a company consistently
offer different features in its products? How does a company deliver high quality and reliability? How does a company build a brand image?
Building the capacity to deliver unique value requires acquiring and allocating resources.
For example, as discussed in Chapter 1, Howard Schultz, founder of Starbucks, got the idea
for Starbucks Coffee Bars during a visit to Italy. There, he observed “espresso bars” that
BUILDING THE RESOURCES AND CAPABILITIES TO DIFFERENTIATE
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S T R AT E GY I N P R A CT I C E
How Starbucks Built the Resources to Differentiate
S
tarbucks’s ability to deliver on a differentiation strategy
of offering high-quality coffee at convenient locations
required that the company build its resources and capabilities.
One capability that proved essential in order for
Starbucks to differentiate itself with high-quality coffee
and multiple blends was the ability to roast and blend
coffee beans. Most coffee shops in the United States did
not roast their own coffee beans and therefore couldn’t
match the quality of coffee that Starbucks offered. Roasting
its own beans also allowed Starbucks to create signature
blends, experimenting with different beans and different
ways of roasting to offer a variety of flavors. Then, it built
capabilities to highly train baristas to peddle its gourmet
blends in a way that added to the feeling that Starbucks was
a trendy hangout.
Starbucks also learned—through analysis and trial and
error—to identify the optimal locations within a city in order
to make each shop as conveniently accessible to as many
customers as possible. To prevent imitation of its coffee
shops, Starbucks built stores as quickly as possible so that
would-be imitators would find that the best locations for
similar coffee shops within a city already were taken.
As we examined in Chapter 3, there are numerous
types of resources and capabilities that a firm can
build and deploy to deliver unique value better than
competitors. For Starbucks, two of the key capabilities
have been the ability to effectively roast and blend coffee
beans and the ability to identify optimal store locations
and quickly fill those locations with Starbucks shops and
highly trained baristas.
offered customers their choice among multiple blends of coffees—far more than the typical
coffee shop in the United States—and were conveniently located at several places throughout major cities.
Schultz also realized that many people in the United States would also want to purchase
high-quality coffee at convenient locations where they could sit and enjoy their drinks with
friends in a comfortable atmosphere. Schultz had identified a unique value. Now, he needed
to build the resources and capabilities to deliver that value, as described in the Strategy in
Practice box.
Assessing Differentiation Performance
We have heard many executives ask, “What metric can I use to assess how well my differentiation strategy is working?” According to consultant and researcher Fred Reichheld, the
answer to that question lies in whether you can satisfy customers to such a degree that they
are willing to recommend your company (or product) to a friend or colleague.30 Companies that
do an exceptional job of providing unique value to customers get their customers to promote the product to others. In effect, they turn their customers into salespeople. Naturally,
this has a dramatic, positive effect on a company’s growth.
Reichheld and his colleagues at Bain & Company conducted a great deal of research, surveying consumers across multiple industries, to find a way to measure how much companies inspire their customers to promote them. Their research resulted in the Net Promoter
Score, a useful tool for assessing customer satisfaction (see the Appendix for a description
of how to calculate a Net Promoter score). Reichheld claims that tracking net promoters is a
powerful way to measure customer loyalty.
We compared the net promoter scores of the iPhone versus the Blackberry among a
sample of college students during the spring of 2011. In this sample, the iPhone had a net
promoter score of over 70 percent. Most students who used an iPhone ranked it a 9 or 10,
and few ranked it at 6 or below. In contrast, the Blackberry had a net promoter score of
only 10 percent, with almost as many detractors as promoters. Not surprisingly, sales of the
iPhone have grown much faster than those of the Blackberry among college students.
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CH05
ì DIFFERENTIATION ADVANTAGE
Our informal net promoter score survey highlights an important dimension of any analysis using the net promoter score or any other customer satisfaction metric: You must have a
representative sample of customers. If we had sampled a different customer segment, such
as business people, we might have seen very different net promoter scores for the iPhone
and Blackberry. To get an overall picture of a company or product’s net promoter score,
choose a customer sample that represents all of the company or products different the market segments. To gather targeted information about how well a product or service is differentiated to meet the needs of customers in a particular segment, your sample should
include only customers in that segment of the market.
SUMMARY
ì In this chapter, we examined differentiation as an alternative to low cost as a way to offer
unique value to a customer. Product differentiation is a strategy whereby companies
attempt to gain competitive advantage by offering value that is not available in other
products or services.
ì Companies have four main options for creating product differentiation:
Different features. The product does a better job on features available in other products,
does more “jobs” than other products, or does a “unique job” not done by any other
product.
Quality or reliability. The product does the same job as other products, but does it for
longer.
Convenience. The product is easily available when the customer needs or wants it.
Brand image. The product gives customers a certain feeling or idea.
ì Strategists often use two tools to discover differentiation opportunities: customer segmentation and mapping the consumption chain. Customer segmentation is a process
used to segment the market into customer groups who share similar needs. The consumption chain is the set of activities a customer goes through in the process of realizing
a need and then acting on it to purchase a product or service. Each step in the chain can
present ways to differentiate a product or service.
ì Discovering sources of differentiation is just one half of the equation. In order for a differentiation strategy to be successful, a company must then develop or acquire the resources
and capabilities to deliver that unique value better than competitors.
ì The net promoter score is a tool that can be used to assess how well a differentiation strategy is working to turn customers into promoters of a company’s offering.
KEY TERMS
brand image (p. 94)
customer segmentation
(p. 95)
customer segments
(p. 95)
mapping the consumption
chain (p. 97)
mass customization
(p. 91)
network effects (p. 93)
prestige brands (p. 94)
product differentiation
(p. 89)
Corporate Strategy
06
© Ed Kashi/VII / Corb
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1
Describe how a corporate strategy differs from a business unit
level strategy.
2
Identify the six ways in which a company may create value
through diversification, and the advantages of each source. Be
able to evaluate a diversified company’s ability to create value
using one or more of these sources.
3
Use a portfolio management tool to characterize a company’s
different business units and to evaluate how well a company
manages its portfolio.
4
Explain how a company would choose whether to diversify by
greenfield entry or by acquisition. Explain how a company should
decide how tightly to integrate an acquisition into its current
business portfolio.
[ 107 ]
06
Cisco Systems: Growth
through Diversification
and Acquisition
emerging market of networked PCs. CEO John Morgridge
touted the acquisitions ability to, “permit us even greater
responsiveness” to customer needs.4 Over the next three
years, Cisco would make a dozen acquisitions, each
designed to help the company enter new product and
customer segments or to expand and solidify its presence
in existing markets. In 1997, Cisco entered the training and
education market by opening 64 “network academies” to
train high school and college students to design, install, and
maintain computer networks.5
1998 was a watershed year for Cisco. The company,
using a mix of acquired and internally developed technology,
entered the telephone market and introduced Voice over
Internet Protocol (VOIP)
communications. The
THE HUSBAND AND WIFE TEAM DECIDED TO COMMERCIALIZE THEIR INVENTION, THE AGS
fast-growing company
ROUTER, AND, DURING A DRIVE OVER SAN FRANCISCO’S GOLDEN GATE BRIDGE, THEY
realized revenue of
CHOSE TO NAME THE COMPANY CISCO SYSTEMS.
$8.5 billion and saw its
market capitalization
rise to $100 billion. Since going public, revenue had grown
Cisco entered the market just as Apple Computer
almost 1,200 percent and its market cap had grown almost
introduced the Macintosh and the personal computer
450 percent! The company’s acquisition capabilities grew
industry began to grow rapidly. Cisco’s initial customers
as well, Cisco completed nine acquisitions that year, or one
were large corporations with multiple, extensive computer
every six weeks. Cisco also expanded its training academies
networks. By 1989, Cisco had one patent, three products
to a total of 580 locations.
on the market, 11 employees, and $27 million in revenue.2
Cisco’s growth continued over the next two years. The
The company went public in 1990 (ticker symbol CSCO) with
company entered a new market for its products and services
revenue of $69 million, and an initial market capitalization
in 1999: the home computer and consumer market. By
of $224 million. By 1992, sales had grown 550 percent to
late 1999, 42 percent of American homes had Internet
$381 million and Cisco began to enter new markets for its
connections, up from almost none five years earlier. The
products and services; Cisco expanded into the market for
3
company quickened its acquisition pace, announcing 18
networked servers and began writing and selling software.
deals—a deal every three weeks. In 2000, Cisco bought 23
In 1993, the company made its first acquisition, a $94.5
companies, two a month. The market for Internet connectivity
million all-stock deal for Crescendo Communications,
and computer networking continued to evolve, and Cisco’s
a manufacturer of desktop computing workgroup
products enabled that growth and evolution. Research and
solutions. The acquisition broadened Cisco’s product
development efforts resulted in patents and products that
line and expanded its resources and capabilities in the
I
n 1984, Len Bosack managed the computer science
department at Stanford University, and his wife, Sandra
Lerner, worked with the computer network at the Graduate
School of Business, located 500 yards from her husband’s
building. The two wanted to connect the computer networks
of their respective departments. Because the networks
used different protocols (commands and languages), the
two developed the first multi-protocol router, a device that
lets different networks communicate and share data. The
husband and wife team decided to commercialize their
invention, the AGS router, and, during a drive over San
Francisco’s Golden Gate Bridge, they chose to name the
company Cisco Systems.1
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CORPORATE VERSUS BUSINESS UNIT STRATEGY
established Cisco in wireless network technology, a major
growth sector of the industry during the early twenty-first
century. On March 27, 2000, Cisco became the world’s most
valuable company, with a market capitalization of $569 billion.6
With 46 acquisitions completed since 1993, Cisco had
developed a clear and consistent process for bringing
acquisitions into the Cisco family.7 The process began with
the identification of attractive targets, typically companies
with new and emerging technologies or ones whose products
would enhance Cisco’s current offerings to customers. The
newly acquired company’s products would appear in the Cisco
catalog—with Cisco part numbers—the day the acquisition
closed. This ensured immediate revenue and profit growth
from the acquisition. Integration specialists from Cisco
worked onsite with the newly acquired company during the
first 90 days after the deal closed. These specialists helped
the new organization to adapt to and navigate within Cisco’s
internal systems; they also introduced new members to the
Cisco culture. Other integration specialists installed Cisco
accounting and purchasing systems.
[ 109 ]
Cisco fell from its perch as America’s most valuable
company when the Internet stock bubble burst in 2002.
That didn’t stop the company from pursuing its strategy
of acquisition and diversification to maintain and enhance
its status as the backbone of the internet. At the end of
the new century’s first decade, Cisco held leading market
positions in most router and networking categories,
including over 30 percent of the market for routers and
switchers.8 That year, the company shipped its 30 millionth
IP phones to customers around the world.9 Internal growth
and acquisitions helped Cisco maintain and extend its lead
in cutting edge communication and network markets. Cisco
received 913 patents during 2010. With the December 2010
purchase of Linesider Technologies, a maker of network
products for cloud computing applications represented
Cisco’s 145th acquisition. As the second decade of the
twenty-first century began, Cisco seemed well positioned to
lead in all of its existing markets, and the company would
continue to provide the backbone for new, emerging Internet
markets.
ì
Cisco Systems is a leading business in the new, technologically based economy of the
twenty-first century. The company uses its intellectual property and brand resources, along
with its innovation and acquisition capabilities, to create competitive advantages through
the methods you’ve learned about in previous chapters. The concepts and models discussed
in Chapters 2 through 5 presume that a company operates in one definable industry, such as
health care or home appliances.
CORPORATE VERSUS BUSINESS UNIT STRATEGY
The tools of industry analysis, low cost or differentiation strategies, and innovation help
managers devise business unit strategy, or an approach for creating competitive advantage
within a single industry, market, or line of business. Cisco, when viewed as a collection or
portfolio of businesses, competes in a different, but related way than its individual business
units. Cisco managers have a clear corporate strategy, or an approach for creating value and
competitive advantages through participation in several different industries and markets.
Corporate strategy entails competing in a core industry or business and also operating in
adjacent businesses or markets. When those adjacent markets can be mapped along the value
chain, then a firm vertically integrates. For example, when Apple made the decision in the
early 1980s to develop its own computer operating system in-house, it vertically integrated
backward by producing the inputs to its computers. Vertical integration represents such an
important and unique form of diversification that Chapter 7 deals specifically with this topic.
When a firm moves to an adjacent business or market enters a new industry value chain,
it engages in horizontal diversification, most commonly referred to simply as diversification. The adjacent market may mean selling the firm’s existing products to new customer
groups, bringing new products and services to existing customers, or selling new products
and services to new customers. Managers diversify their firms through one of three methods: greenfield or organic entry, alliance, or acquisition. Alliances, like vertical integration,
present the firm with a unique set of opportunities and challenges, so we’ll discuss them
separately in Chapter 8. This chapter describes both greenfield entry and acquisition as
mechanisms of diversification.
business unit strategy The search
for competitive advantage within a
single industry, market, or line of
business.
corporate strategy The search for
value and competitive advantages
through participation in several
different industries and markets.
vertical integration Movement into
adjacent markets by a firm along
its own value chain. Movement in
the direction of raw materials is
backward integration. Movement
in the direction of sales, service,
or warranty operations is forward
integration.
horizontal diversification The
movement into an adjacent, or
unrelated, market that is not along
a firm’s own value chain.
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CH06
ì CORPORATE STRATEGY
In this chapter, you’ll learn how companies can create value by competing in several
industries instead of just one, and how companies can diversify through greenfield entry or
acquisition. Should a company choose to diversify through acquisition, you’ll learn about
the process of acquisition and understand how tightly a newly acquired business should be
integrated into the company.
CREATING VALUE THROUGH DIVERSIFICATION
Early research by strategy scholars into corporate diversification identified an inverted
curvilinear (an upside-down, U-shaped) relationship between corporate diversification
and profitability. Firms that compete in a few, related industries or markets outperform
firms focused on a single industry. More is not always better, however, because firms that
compete in many, unrelated industries perform worse than those in a few, related ones. A
number of studies over the last three decades have come to the same general conclusion:
Moderate diversification pays off but very high levels of diversification lead to lower levels
of performance.10
Levels of Diversification
single business A firm earning
more than 95 percent of the
revenues from a single line of
business.
dominant vertical business A
firm that earns more than 70
percent of its revenue from its
main line of business and the rest
from businesses located along
the value chain.
dominant business A firm that
earns more than 70 percent of
revenue from its main line of
business and the remainder from
other lines across different value
chains.
related-constrained
diversification A firm that earns
less than 70 percent of its revenue
from its main line of business
and its other lines of business
share product, technological, and
distribution linkages with the main
business.
related-linked diversification A
firm that operates in related
markets, but fewer linkages exist
between the new and existing
markets than the elements create
separately.
unrelated diversified
firm Competes in product
categories and markets with few, if
any, links between them.
Firms have several choices about how to diversify, and they have a range of options
about how much to diversify. Strategy scholar Richard Rumelt created a continuum of
diversification strategies based on the product market similarity of the firm’s businesses.
Firms range from related to unrelated diversifiers.11 A single business is one where more
than 95 percent of the revenues come from a single line of business, most often measured in
terms of the four-digit NAICS codes you learned about in Chapter 2. The dominant vertical
business earns more than 70 percent of its revenue from its main line of business and the
rest from businesses located along the value chain, either upstream (backward integration)
or downstream ( forward integration) from the core activity. A dominant business earns
more than 70 percent of revenue from its main line of business and the remainder from
other lines across different value chains.
A related-constrained firm earns less than 70 percent of its revenue from its main line
of business and its other lines of business share product, technological, and distribution
linkages with the main business. Amazon marketplace represents related-constrained
diversification; marketplace sells a similar product (used rather than new books) and uses
the same technology (the amazon website) and distribution network (UPS) as the parent
company. Related-linked diversification occurs when the businesses are still related but
fewer linkages exist between the new and existing business. Amazon Fresh, started in 2007,
sells groceries (a different product group) over the web (same technology) for rapid home
delivery (but not through UPS).
Finally, an unrelated diversified firm competes in product categories and markets with
few, if any, links between them. Unrelated firms are also called conglomerates and include
firms such as General Electric and the 3M Company, also known as Minnesota Mining and
Manufacturing. You might recognize 3M for its famous Post-It Notes and line of tapes, but
the company sells products from A to Z, from surgical materials for abdominal support to
its dental restorative product ESPE Z100.12
For diversification to add value in the real world, managers must answer the following
questions: (1) Why will the existing businesses be more valuable because we’ve entered an
adjacent business? and (2) Why will the new business activity be more valuable inside our
corporation than operating alone? The simplest answers to these questions are the same
as the answers to the fundamental strategy questions we raised in Chapter 1. Diversification adds value when it allows the combined businesses to deliver greater value and utility
to new or existing customers than the firm could without being diversified. Diversification also adds value if the combined businesses reduce the firm’s overall cost of producing
goods or services.
CREATING VALUE THROUGH DIVERSIFICATION
Value Creation: Exploit and Expand Resources and Capabilities
Diversification adds value when expansion into an adjacent business either exploits the
firm’s core and valuable resources and capabilities or diversification enhances and grows
the resource base. To provide more clarity to the notion of exploiting and expanding, you
can divide a firm’s resources and capabilities into two broad categories: a “front end” or
customer-facing resources and capabilities and a technological and operational “back end.”
Procter & Gamble’s resources such as brands, product lines, distribution channels, and its
capabilities in uncovering deep customer needs represent the customer-facing part of the
business. Walmart’s resources in terms of regional distribution centers and information systems and its capabilities in global supply chain management and cost reduction belong in
the “back-end” group.
Diversification allows companies to exploit their existing customer-facing resources by
adding new operational resources and capabilities. General Electric‘s entry into the finance
business in the early part of the twentieth century allowed it to solve a core problem for
cities and towns: how to defray the huge upfront costs of electrification. Similarly, a business
can exploit its existing technological and operational strengths to reach out to new customer groups. General Electric used its original skills in light bulb and electrical equipment
manufacturing to enter a new, high-technology market at the end of the nineteenth century:
X-ray machines. GE leveraged its knowledge and skill toward a new set of customers, doctors, hospitals, and patients.
Diversification also creates value when it helps a company expand its existing set of
resources and capabilities or diversification enables it to prepare for the future. Cisco makes a
number of acquisitions designed to expand both its technology platforms and product lines.
Cisco introduced its first Internet Protocol (IP) phone in 1998. In 1999, the company made
three acquisitions, Sentient Networks, GeoTel Communications, and Amteva Technologies,
that brought patents and products that Cisco needed to expand its business.13 Figure 6.1
illustrates the basic logic of value creation through exploiting or expanding resources and
from either front- or back-end resources or capabilities.
The logic of exploiting or expanding resources and capabilities provides you with a deeper
understanding of what it means for a firm to enter an adjacent market. Adjacent means “next
to,” and we might think of adjacent markets as ones with products or services right next to
each other. Starbucks sells food and mugs along with its premium coffee, but the company
also sells CDs or other products. Food and mugs are naturally adjacent to coffee (people eat
[ Figure 6.1 ] Adding Value Through Diversification
Value through
Exploiting
Resources
'
“Front-end”, customerfacing part of the business
Value From
“Back-end” operational
parts of the business
xpand customer
base
Enhancing
Resources
'
ain new market
knowledge
' Better serve
existing customers
through more,
better products
' Add new brands
' Identify new
trends earlier
' Create economies
of scope or
increased scale
' Improve quality,
productivity, or
other best
practices
' Broaden existing
production
capacity
' Adopt new
technology
platforms
' Access innovative
process or product
technologies
' Enhance R&D
capabilities or
outputs
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ì CORPORATE STRATEGY
adjacent market A market or
industry that is closely related
to markets or industries a firm
currently competes in.
food with coffee and drink coffee in mugs), but music isn’t. When we speak of an adjacent
market, we mean a closely related market for creating value and utility for customers. Starbucks provides customers with a cup of coffee but also a relaxing place to hang out or meet
up with others. Part of that environment entails music to set the mood. Starbucks captures
the value of that music by offering CDs and other ambience products to customers.
The notions of expanding and exploiting resources help you understand why companies
can create sustainable competitive advantages. In the next section, you’ll learn how
companies actually create competitive advantage and business value through diversification.
The Six Ss
Exploiting and/or expanding the resources and capabilities usually come through one of six
mechanisms. To help you remember these important elements, we’ve created a mnemonic
device, the six Ss: employing slack, creating synergy, leveraging shared knowledge, utilizing
similar models for success, spreading human and financial capital to its best use, or providing a stepping stone for the company to a completely new business sector. As you read
through each S, try to think about how each would help a company exploit or expand its
resources and capabilities. Each of the Ss can work through the customer-facing front end
of the business or the operational and technological back end.
slack Unused resource capacity.
economy of scope Activities where
the average cost of producing two
different products is less when
delivered together than separately.
management skill The individual
and collective abilities of a firm’s
management team to engage in
value-creating activities.
synergy Action between different
elements of a system that creates
more value together than the
elements create separately.
Employing Slack. Slack means unused resource capacity. Delta Airlines generated almost
$37.7 billion in revenue in 2012 through its combined operation, almost $1 billion carrying
cargo and freight.14 Why would Delta, whose primary customers are people, be involved in
the back-end freight business? The top half of the aircraft carries people, the bottom half
carries the luggage. There’s often extra room in the bottom of the plane that Delta can fill
with freight cargo at almost no cost! Transporting cargo adds value because it captures slack
in the form of an economy of scope. An economy of scope arises when the average cost of
producing two different products is less when delivered together than separately.
Management skill often represents another unused resource. Firms can only grow as
fast as they have knowledgeable and skilled managers to guide that growth.15 This has an
important corollary: As managers learn their jobs and develop skill, they are able to effectively handle an increased number of activities. Marriott, the upscale hotel operator, competed for many years to service business travelers in hotels noted for excellent service. In
the late 1980s, the company started its economy chain of Fairfield Inns and the extendedstay Marriott Suites hotel. Marriott became the first major hotelier to offer a portfolio of
brands.16 In the mid-1990s, Marriott moved into the adjacent but upscale hotel segment
with its purchase of the fabled Ritz-Carlton brand.17 Employing slack usually creates value
through exploitation although sometimes during an acquisition a company may acquire
redundant resources that expand slack.18
Creating Synergy. Synergy occurs when different elements of a system interact in a way
that creates more value together than the elements create separately. Simply put, the whole
exceeds the sum of its parts.
Disney competes in two adjacent entertainment markets, films and theme parks. The
two businesses create more brand value for Disney together than either would separately.
For example, customers’ emotional connection with Disney deepens when they interact
with the same characters at a distance in movies and then up close through attractions at
the parks. Procter & Gamble gains operational leverage with retailers when it negotiates for
shelf space because the company offers retailers a portfolio of important products and can
bundle different products to maximize potential revenue for retailers. P&G saves on distribution and logistics costs as trucks carry multiple products to each retail location. Synergy
clearly exploits the resources and capabilities to offer customers better products and services. Synergy also increases the number and ways a company interacts with its customers,
and that can expand its capabilities to meet customer needs in the future.
Shared Knowledge. Think of a diversified company as a tree: the leaves, twigs, and
branches represent different product markets and industries, but the competitive
advantage comes from the common roots, processes, or knowledge. These roots are often
CREATING VALUE THROUGH DIVERSIFICATION
called core competencies, “the collective learning in the organization, especially how to
coordinate diverse production skills and integrate multiple streams of technologies.”19 Core
competencies represent a set of resources or capabilities at the center of the diversified
corporation that are distributed to individual businesses to adapt for their particular
markets. Honda parlays operational and technological knowledge and ability in engine
design and performance into several diverse downstream markets, including automobiles,
lawnmowers, and consumer generators. ESPN’s ability to extend its brand and reputation
for serious and engaging sports coverage creates competitive advantage across its 70
different brand platforms.20 These include the flagship broadcast properties and websites,
as well as the magazine, apparel, and restaurant businesses. Honda’s core competencies at
high-quality engine design attract a broad set of customers to its products, while ESPN’s
core competencies (or shared knowledge) allow the company to service sports fans over a
variety of technological platforms. Shared knowledge helps you understand why some very
unrelated product markets can represent valuable adjacent markets.
Similar Business Models. A business model is a method for enabling value to be created and
exchanged between companies and their customers. General Motors’ business model involves
transforming raw materials such as steel, rubber, and plastic into automobiles, all done at very
large scale. eBay’s business model is to provide an electronic venue, or market, where buyers
and sellers can come together. Strategy scholars note that some business models have common
elements or keys to success. They describe these commonalities as a dominant logic or “the
[ 113 ]
core competencies (or shared
knowledge) Collective knowledge
that can be distributed throughout
the organization to create value.
business model A method to
enable the creation and exchange
of value between companies and
their customers.
dominant logic A conceptualization
of a business, or a set of rules
for competition, that applies to
seemingly unrelated product
markets or industries.
S T R AT E GY I N P R A CT I C E
Creating Value at Newell Rubbermaid
N
ewell Rubbermaid (Symbol NWL, 2012 Revenues: $5.90
billion) traces its origin to 1903, when Edgar A. Newell
purchased the assets of curtain rod manufacturer W. F.
Linton. Newell’s original focus lay in improving curtain rods
through technology, production improvements, and cost
reduction. In 1912, the company began selling its products
through mass merchandizer Woolworth, and business
took off. As the company grew over the years, it broadened
the product line to include other low-technology window
treatment products such as extension rods, drapery pin
hooks, and curtain holdbacks.22
In 1965, new CEO Dan Ferguson decided on a new
strategy; rather than focus solely on window treatments, the
company would use mergers and acquisitions to become a
major player in housewares and hardware goods, specifically
low-technology products marketed through mass retailers.
Increasing the product line would create better leverage with
the company’s target customers: chains such as Woolworth
and K-Mart. With the purchase of the EZ Paintr Corporation
in 1974, the company made its first substantial jump outside
its traditional markets. Ferguson would make 70 acquisitions
during his 30-year tenure as CEO, including glass maker
Anchor Hocking, cookware manufacturer WearEver, and
later Calphalon, and Levelor window blinds.
Newell’s acquisition formula exhibits a dominant logic.
Each of the target companies mass produce relatively lowtechnology consumer goods in different grades (good, better,
best), and each company distributes its products through
mass retailers.
After taking control of its targets, the company follows
a rigorous process of “Newellizing” its new acquisition.23
Newell uses its deep and extensive knowledge of its
customer, mass retailers, to help its acquisitions reconfigure
product lines and categories to satisfy the needs of its
customers. Newell eliminates duplicate product lines and
makes sure that the company’s offerings fit into the “good,
better, best” quality logic that lies at the core of its success.
Newell creates back-end synergies by eliminating
duplicate functions such as separate sales staffs or
headquarters expenses, as well as sharing production
technologies and processes. Newell uses its dominant logic
knowledge to help the new company reduce costs, improve
manufacturing to find efficiencies, improve financial controls
and metrics, and improve cash flow.
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ì CORPORATE STRATEGY
way managers conceptualize the business and make critical resource allocation decisions—
be it in technologies, product development, distribution, advertising, or human resource
management.”21 A dominant logic implies that some businesses may look very different at the
level of products or services but may share a set of management principles and skills, such as
managing a workforce filled with skilled labor, or be subject to the same economic processes
such as stage in the life cycle, similar barriers to entry, or economies of scale.
The Japanese company Sumitomo Heavy Industries competes in a number of different
industries. The company has business divisions in power generation, plastics machinery
(like injection molding tools and dyes) industrial equipment, precision instruments (such as
extreme cryogenic refrigeration), defense systems, ship building, and others. These don’t seem
adjacent at all, but a closer look reveals that each business shares two back-end commonalities: advanced engineering and huge fixed costs. Success in each business area depends on
the ability to attract and retain scientific talent that will drive innovation and managing a set
of very sophisticated physical assets that require substantial capital investments. The Strategy in Practice feature details a company with a customer facing dominant logic.
internal capital market The
movement of funds, talent, or
knowledge from unit to unit
directed by the leaders of the firm.
Spreading Capital. Some companies create value through diversification by acting as an
internal capital market.24 They create value across business units by moving funds, talent,
or knowledge from unit to unit. Rather than leaving resources within a business unit for its
own growth, these strategic investments work to increase the corporate value by investing
in business units with greater potential growth in the future.
Spreading capital depends on detailed performance information for each unit, as well as
an intuitive sense about the value of future investments. As a consequence, these managers
can fund business growth at a lower cost of capital than if units relied on external sources
such as banks or capital markets.25 Companies creating value through an internal capital
market look like the definition of conglomerates—business units with little in common in
the products or processes. Executives keep these businesses as separate units in order to
accurately assess and reward performance. Since there is no sharing of resources, managers have no other divisions to blame if their units perform poorly. Keeping business units
separate also allows corporate executives to sell units to willing buyers. Spreading capital
S T R AT E GY I N P R A CT I C E
The Challenges of a Conglomerate: ITT Industries
T
he company that would become ITT industries began
in 1920 when two brothers, Sosthenes and Hernand
Behn, started to build the world’s system of interconnected
telephone lines. They succeeded, and over the next four
decades, their company became a provider of international
telephone services and the switching equipment that
powered large networks.26
Harold Geneen became the CEO of ITT in 1959, and over
the next 17 years he would transform the company from
$750 million in annual sales to $17 billion in annual sales.
How did he do it? Through diversification! Geneen’s ITT
acquired more than 350 companies—at one point closing one
deal per week—and the company expanded operations into
2,000 business units. ITT epitomized the term conglomerate,
or a group of companies cobbled together simply to grow
revenues and earnings. ITT owned businesses as diverse
as the Sheraton Hotel chain, Avis Rent-A-Car, the Hartford
Insurance Company, and the maker of Wonder Bread.
Geneen referred to his company as a “unified-management,
multi-product company.”27
The problem for ITT was, however, managing 2,000 different
businesses, most of them quite unrelated. By the end of
Geneen’s tenure, the board and his successor realized that
the company’s portfolio of businesses destroyed value for
shareholders. ITT split itself into three companies, a group
of industrial companies driven by synergies and similar
processes, the insurance and financial services businesses,
and a group that contained all the rest of the businesses.
With highly efficient markets for financial capital,
equipment, and physical capital, and labor markets that
move human capital, the job of allocating scarce and
valuable resources is better accomplished through the
market. The conglomerate form fell out of favor, but the logic
of spreading capital still makes sense in emerging markets,
where sophisticated and transparent markets for financial
and human capital do not yet exist.28
CREATING VALUE THROUGH DIVERSIFICATION
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exploits the management team’s unique abilities to invest for value, and each new investment enhances the team’s collective learning. The next Strategy in Practice feature describes
the challenges of the spreading capital strategy.
Provide a Stepping Stone to a New Industry. While the other five Ss all exploit a company’s
current resources and capabilities, the stepping stone mechanism explicitly works to
enhance capabilities. Executives may survey the landscape of the industry and its future
trends and decide that their competitive position will not be sustainable and their money
would be best invested in some other business segment.
Successfully shifting the firm’s position through diversification usually entails migration, creating a path so the company can avoid “long leaps” from its core into a segment where its resources
and capabilities create little value. The path involves a set of “short leaps” executed over time that
allows the company to acquire new resources and capabilities. Adjacent markets have two characteristics: (1) they allow the firm to exploit some of its resources and capabilities to create value; and
(2) they allow the firm to acquire related resources and capabilities to prepare for the next step.29
Consider the case of Safeguard Scientific in the 1990s.30 In 1991, the company’s major
line of business was computer peripherals, an industry that includes keyboards, printers,
and storage devices. By 2003, the company had shifted its major line of business to the optical instruments business, products such as advanced lenses, scopes, and optical scanning
equipment. Safeguard didn’t just jump from keyboards to scientific equipment; it migrated
through adjacent industries to acquire skills and capabilities. In 1993, the company moved
into producing telephone equipment, and then, in 1995, into electrical instruments. The
company exited computer peripherals in 1996, the same year it entered optical instruments.
It exited the telephone business in 1999.
Instead of one “long leap” from computer equipment to optical devices, Safeguard took
a number of “short hops” through industries where it could leverage existing capabilities
and build new ones. The stepping-stone path allowed the company to acquire a new set of
back-end operational skills and technology. The company also had to acquire a new set of
customer-facing elements, as well.
Destroying Value Through Diversification
The six Ss show how and where managers can create value for shareholders of a diversified
firm; however, one relatively robust finding from scholars in corporate finance is that diversified firms often trade at a discount versus undiversified rivals and that increasing diversification (entering additional new lines of business) tends to destroy shareholder value.31
If you think of the acid test for value we presented, diversification destroys value when
the new line of business fails to exploit or expand the company’s resources and capabilities in meaningful ways. Value usually gets destroyed in one of five ways: excessive pride;
sunk cost fallacy; imitative diversification; poor governance and incentives; or the lack of
resource commonality between the lines of business.
Hubris. Managers may diversify based on their own beliefs about the potential of their
company’s ability to create value in the adjacent market. Hubris is an ancient Greek word
for excessive pride, arrogance, or overconfidence.32 Managers act with hubris when they
diversify or make acquisitions based on their own experience or their “gut feelings” rather
than on solid data and research. Researchers have argued for, and demonstrated, the hubris
hypothesis as an explanation for the poor performance of so many acquisitions.33
Sunk Cost Fallacy. Closely related to hubris as a reason why diversification fails is the sunk
cost fallacy, whereby managers believe that their investment in a failed acquisition just
needs more incremental investment in order to succeed. Executives are often reluctant
to abandon a project in which they have already invested so much time and capital; they
often move forward under the assumption that “things will turn around with a little more
investment.” The sunk cost fallacy leads managers on a path of escalating commitment to
invest resources in failed, or failing, diversification efforts.
Imitation. Managers sometimes feel pressure to diversify their corporation when a
competitor diversifies first. The competitor has done due diligence and selected an attractive
target for acquisition, or made a greenfield entry after careful research and planning. Caught
hubris Excessive pride, arrogance,
or overconfidence.
sunk cost fallacy The belief of
managers that investment in a
failed acquisition must continue
because significant amounts have
already been invested.
CH06
ì CORPORATE STRATEGY
off-guard, a firm might quickly look for a similar acquisition target or hurry to create a
similar line of business. In their rush to respond, managers fail to consider how attractive
the target really is, or if they have the resources and capabilities that make the new market a
value adding adjacency. In 2001, shipping leader UPS bought Mailboxes, Etc. for $191 million
to give the company 4,300 new drop-off locations. FedEx responded by paying $2.4 billion for
1,200 Kinko’s copy centers. FedEx bought fewer stores for more money and had to figure out
how to incorporate Kinko’s huge copy business into its operations.34 While both companies
sought to expand into an attractive adjacent market, by being the first mover UPS found the
more attractive target. FedEx struggled because it had to integrate a set of resources that
aligned poorly with the company’s core. Kinko’s resources and capabilities were not oriented
to truly exploit FedEx’s.
Poor Governance and Incentives. Managers receive compensation based on how their
companies perform. The threat of failure and the thrill of profit-based rewards create a
set of high-powered incentives for managers to run their businesses effectively.35 When
they become part of a diversified corporation, however, those managers sometimes move
to salary-based compensation that divorces their pay from their performance. Further,
within a diversified firm, managers’ decisions must account for internal politics, resource
allocation constraints, or mandatory transfers with other divisions. The division becomes
less valuable inside the corporation because managers have weak incentives to focus on
exploiting and expanding resources and capabilities and stronger incentives to focus their
energy in other areas.
Poor Management. How do managers, given their limited time, energy, and mental
resources, guide, and direct the diversified firm? Sometimes they use models that relegate
their different investments to simplified categories and then provide a management rule for
each category. The Boston Consulting Group’s growth share matrix represents one such tool.
Figure 6.2 illustrates the growth share matrix.
In the growth share matrix, units contribute to corporate value creation in one of two
ways, they either serve as engines of revenue growth or they generate cash flows for the firm
to reinvest or distribute to shareholders. Executives classified business units as high or low
on each dimension and applied a set of rules for managing each different quadrant. Cash
cows have high share but low growth and can generate large cash flows that can be used
to fund growth businesses. Companies typically like to minimize investments in cash cows
because the goal is to milk the cow. Stars combine high share with high growth and smart
managers should invest heavily in these units to maintain or improve their position over
time. These businesses typically represent the future of the company. Question marks, as
their name implies, truly present a conundrum for management because they require significant investment and effective strategic management if they are to become stars. But if not
managed correctly, the significant investments may not move them into the star quadrant
[ Figure 6.2 ] The BCG Matrix
High
Growth Rate
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Low
Low
High
Relative Market Share
METHODS OF DIVERSIFICATION
[ 117 ]
and instead they may move into the dog quadrant when growth slows. Dogs have low share
and low growth and add little profitability to a company’s overall portfolio businesses. The
general rule is to divest the dogs.
As you can easily see, the growth share matrix says almost nothing about whether cash
cows, dogs, question marks, or stars help the corporation exploit or expand a company’s
resources and capabilities. Companies that slavishly follow tools such as this will often miss
important sources of value available in their portfolio. For example, a dog business may have
low growth because it competes in an emerging industry using cutting edge technology.
Divesting the dog may prevent the company from understanding a new technology platform
at its inception.
Lack of Resources. Think back to our feature on ITT. A single management system that
operates 2,000 different business units relies on very high level financial measures, such as
return on invested capital, to make decisions about which businesses will grow and which
will stagnate. What ITT lacked, and why it eventually broke itself apart, was the ability to
understand and respond to the unique strategic needs of each market, customer group,
and line of business. Most of ITT’s business units would offer very negative answers to the
questions of value at the beginning of the chapter. Each business gained little of value by
membership in the corporation and each added little value in return.
In this section, you’ve learned why and when diversification adds value. In the next section, we’ll introduce a set of tools that strategic managers can use to evaluate the different
business units in their portfolio.
METHODS OF DIVERSIFICATION
Once firms decide to diversify their operations, the next question they must answer concerns how to diversify: Should they use greenfield entry by opening their own operations,
or should they acquire a company already in the target market or industry? Moreover, if they
do decide to enter via acquisition, how do they select a target, get the deal done, and successfully integrate the new company into the portfolio?
Table 6.1 displays some criteria that managers should consider when choosing their
mode of entry. The table aids analysis by dividing resources into front- and back-end categories, and also includes the important criteria of scale-based advantages and timing issues for
market entry. Greenfield entry makes sense, first and foremost, when companies have the
front-end and back-end resources and capabilities they can immediately exploit to create
value. For example, GE’s entry into medical products in the early 1900s drew on its core technical expertise in designing and manufacturing electrical equipment. GE opened its own
finance unit to effectively exploit its deep knowledge of the buying process for electrification
systems and customer characteristics.
Greenfield also makes sense when companies can afford to enter new arenas slowly and
at small to moderate investment. Conversely, acquisition, the outright purchase of another
company, becomes the preferred mode of entry when the firm needs to quickly expand its
own resources and capabilities to effectively compete. Acquisitions make sense when delay
proves costly. In many technology businesses with sophisticated technologies and long lead
times for development, companies that enter through greenfield may be too far behind to
ever catch up. Acquisition also makes sense if the industry favors competitors with large
scale or is characterized by a steep learning or experience curve.
You may be tempted to think that greenfield entry represents value through exploitation and acquisitions through expansion. That oversimplifies the analysis; acquisition may
prove the preferred choice when any one of the target markets meets any one of the criteria outlined above. GE’s 2012 purchase of Italian aerospace company Avio may look like
just another addition to a large conglomerate, but as previously described, this acquisition
both exploited and enabled GE’s position in the aircraft industry.36 Once managers decide
to acquire another business, firms that have developed an acquisition capability initiate a
greenfield entry Entry into an
adjacent market by a firm that
opens its own operation.
acquisition The purchase of
another company, or its assets.
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ì CORPORATE STRATEGY
[ Table 6.1 ] Greenfield Entry versus Acquisition
COMPETITIVE DIMENSION
GREENFIELD ENTRY
ACQUISITION
Brands
Brands well-known in the new markets and little advertising needed
Brands not well-known in the new
market and heavy advertising will be
required
Customers
Customers in new market similar to
existing customers
Customers in new market very
different from existing ones
Channels
Many channels available that the firm
can easily access
Few channels available or access to
channels difficult and expensive
Human Capital
Standardized knowledge and skills
that can be easily gained
Unique or tacit knowledge and skill
Technology
New technology integrates easily with
existing processes
New technology does not integrate
easily with existing processes
Scale
Economies of scale add few, if any,
advantages
Significant economies of scale or
learning effects that confer strategic
advantage
Speed
Slow, deliberate entry enables growth
of solid market position
Rapid entry needed to capture
opportunity
Front End Resources
Back-End Resources
well-defined process to examine, purchase, and then bring the new entity into the corporate
fold. In this section we’ll explain the four essential steps in that process: identifying potential
targets, selecting which of these to purchase, doing the deal, and integrating the acquisition
after the deal closes.
THE ACQUISITION AND INTEGRATION PROCESS
Acquisitions represent an opportunity to create, or destroy, value for the firm. In 2013, for
example, the American economy witnessed over 8,000 mergers or acquisitions, valued at
$980 billion.37 In spite of its prevalence in the U.S. economy, most mergers or acquisitions fail
to create value for shareholders. Estimates vary, but between 70 percent and 90 percent of
mergers don’t work out.38
Making the Acquisition
due diligence The process
whereby managers closely examine
the target firm to understand its
core processes, strengths, and
weaknesses.
Before searching for a firm to purchase, managers must understand the real, value-creating
need behind the move. Good reasons to diversify center on both the acquiring and target
firm’s resources and capabilities. Value creating acquisitions will either exploit the value of
a firm’s current stock of resources or the acquisition will enhance the firm’s resources and
capabilities. Poor reasons for acquisitions include simply adding top line revenue growth
or doing a deal just because a competitor recently did one. These reasons make clear how
the acquisition makes the current corporation more valuable; however, managers must also
answer other questions: Why and how will the target firm be more valuable because we own
it? The answer to these questions comes from the six Ss above. The best acquisitions create
value for both the acquiring and acquired firm.
After making a list of potential targets that pass the first screen, the next phase requires
the firm to perform a due diligence audit on each potential target. Due diligence means to
closely examine the target firm to understand its core processes, strengths, and weaknesses.
THE ACQUISITION AND INTEGRATION PROCESS
[ 119 ]
Newell Corporation’s 1999 purchase of Rubbermaid illustrates the problems that inattention to due diligence can create. Newell essentially bought Rubbermaid’s revenues and
profits; it had little to offer Rubbermaid in terms of resources and capabilities and the same
held true for Rubbermaid.39 Newell rushed its financial due diligence and failed to see that,
within legal bounds, Rubbermaid created a picture of a business in better condition than the
actual corporation. Rubbermaid proved to be, what one analyst termed, “a perfumed pig”
and Newell overpaid as a result. Newell Chairman Daniel Ferguson stated, “We should have
paid $31 per share but we paid $38.”40 Failure to follow these steps required Newell to write
off $500 million of merger-related goodwill in 2002.
Once a potential candidate passes the value screen and survives the due diligence process, managers at the acquiring firm must decide how much they are willing to pay for the
target. A number of tools exist to help with the valuation; firms often hire investment bankers or advisors to help them.41
Acquirers must pay a premium to acquire a target; the premium represents a bet by the
acquirer on its ability to create value through the acquisition. In the United States, the average premium that the acquiring firm pays for a target firm is roughly 30 percent. For example,
Newell originally offered just over $34/share for Rubbermaid, which was then trading at about
$26/share, but eventually paid $38 per share.42 The process of acquisition plays an important
strategic role for firms, and it represents a source of ethical challenges for managers and executives. Our Ethics and Strategy feature invites you to think through one such dilemma.
Integrating the Target
The acquisition premium creates two challenges for the acquiring firm. First, the larger the
premium, the more value they must actually create to justify the acquisition. Second, given the
time value of money, the larger the premium, the quicker the acquirer must create that value.
For example, a hefty premium, coupled with large debt to close the deal, strongly encourages
( forces) managers of the acquiring firm to create real value in order to pay off the debt.45 Strategy and management researchers suggest that acquisition represents a risky strategy for value
creation with failure rates as high as 90 percent in some industries.46 Acquisitions may fail to
create value because of poor strategic fit, incomplete due diligence, or a high acquisition price,
but also because the acquiring firm fails to properly integrate the firm into its portfolio.
Proper integration, like everything else depends on the firm’s overall strategy and, more
specifically on which of the six Ss the corporation uses to create value through diversification. Integration means the degree to which the two companies share facilities, operating
procedures, compensation systems, organizational structures, and even cultural norms.
Sometimes, an acquiring firm will need to tightly integrate the acquired firm into its own
organization, but other strategies require the two firms to operate relatively (or completely)
separate. Figure 6.3 illustrates the link between the degree of integration and the source of
value creation.
Managers in the firm tasked with integrating the new acquisition must decide which
activities or operations to integrate and how completely or tightly coupled the target and
company will be linked together. The tighter the degree of integration, the more the combined entity looks and acts like a single firm. Conversely, loose integration allows each company autonomy in its business operations. Firms may follow one of four general integration
strategies: They can bury the target through complete integration, build a brand new entity
with the combined entities through tight integration, blend in the target to the corporation
using best practices from each, or bolt on the target to the existing company only where it
makes sense. Table 6.2 summarizes each approach; we will describe each in more detail.
Bury. Another term for bury is takeover, where the acquiring firm breaks up the target
firm and weaves its individual elements (e.g., product lines, employees, manufacturing
facilities) into the fabric of the acquiring firm. The target’s brand, culture, and identity
all disappear; both the back-end operations and customer-facing aspects of the acquirer
remain unchanged, although supplemented by the addition of the target’s assets. Apple’s
acquisitions of more than 40 start-up firms have followed this pattern, including NeXT,
eMagic, and Siri (yes, it used the Siri name for the personal digital assistant on the iPhone).
takeover An acquisition where the
acquiring firm absorbs the target
firm. The target firm ceases to
exist.
[ 120 ]
CH06
ETHICS
ì CORPORATE STRATEGY
A N D S T R AT E GY
Transparency During the Acquisition Process
W
hen a company makes an acquisition, how much
should it disclose about its true intentions to the
employees of the acquired firm? Cisco Systems CEO
John Chambers talks about the importance of treating
employees of the acquired firm well, as he believes “you’re
only acquiring employees.”43 Cisco has acquired over 150
companies, and its core values reflect Chambers’s concern
for employees: integrity, respect for individuals, and open
communication. These core values have led to many
successful acquisitions by Cisco as target companies have
been successfully integrated into the Cisco family.
Open communication and respect for individuals seem
to be straightforward values, but each of these raise ethical
issues for strategic managers during the integration
process. Strategists usually have several objectives in mind
when making an acquisition. The firm might buy the ability to
offer certain products or services, it may purchase another
firm for access to production processes, plants, or favorable
locations, managers may target intellectual property such
as patents and trademarks in an acquisition, or strategists
may seek to lock up unique and valuable human capital.
The point is that when an acquiring firm considers a target,
it might have multiple objectives in mind. The firm might
fully integrate some divisions or elements, allow others
to run as a separate business, and close down or sell off
others. The ethical issue involves the trade-off between the
acquirer’s desires to move efficiently and effectively versus
stakeholders’ (primarily employees but also customers and
suppliers) needs for information in making their own plan.
Here’s an example. Consider two regional nursing home
operators, Blue Heron and White Swan.44 Each company
uses acquisitions to grow and expand into new regions. In
this case, Blue Heron and White Swan each purchased a
family-owned, local set of nursing homes to gain entry into
the Southwestern region of the United States. Both acquirers
follow a prescribed list of 90-day objectives integration
plan to bury the acquired firm. The objectives include
implementing the corporate technology platform, migrating
purchases to the acquirer’s preferred vendors, assessing the
need for capital investments in the newly acquired units, and
training employees on Blue Heron or White Swan procedures
and protocols. At the end of the 90 days, both acquirers
always replace the unit’s existing general manager to bring
in their own staff who are familiar with the existing culture,
processes, and strategies.
The ethical challenge for Blue Heron and White Swan
is that during the 90-day transition period, the acquired
unit’s manager-in-place can play a key role in the efficiency
and effectiveness of the transition. How much information
should leaders of the acquiring firm share with the unit
managers about their ultimate plans? If they tell the
managers of their impending termination, they run the risk
of losing a valuable player during the transition process.
However, withholding that information raises fairness
concerns for the unit managers; they could have used that
90-day period to find and secure new employment. How
would you resolve this dilemma?
Blue Heron operates as a business first and foremost.
Its belief is that the most important goal is to ensure
efficiency and effectiveness during the transition. Managers
are interchangeable, and Blue Heron does not disclose
its true intentions to the unit managers until they receive
termination notices at the end of the 90 days. White Swan,
also deeply committed to creating value for shareholders,
opts for a different, open approach. Its managers sit down
with the unit managers at the beginning of the process
and disclose their ultimate plans. White Swan offers those
managers increased pay and a bonus for the transition
period, outplacement help in finding a new position, and the
promise of a very positive reference if the job is well done.
White Swan refuses to trade off its obligations to owners
and employees. The owners get a smooth and effective
transition, and employees are treated with dignity, fairness,
and respect.
THE ACQUISITION AND INTEGRATION PROCESS
[ 121 ]
[ Figure 6.3 ] Determining the Proper Degree of Integration
Source of
value
creation
Employing
Slack
Creating
Synergy
Stepping
Stones
Shared
Knowledge
Similar
Models
Spread
Capital
Degree of
Integration
Tightly
integrated
Well
integrated
Integrated
Moderately
integrated
Loosely
integrated
Not
integrated
Best exploit
economies of
scope,
knowledge,
and skills.
Cost sharing
requires
integrated
operations
Building new
knowledge
and skill
requires close
proximity and
exchange but
also freedom
of action by
the acquired
firm
Sharing
overlapping
knowledge,
but allowing
each business
to exploit
unique
knowledge
Only those
areas with
common
model will
gain
through
shared
practices.
Keep units
separate to
monitor
performance
and create
accountability
Reason
Innovation
builds on
common
resources
The target firm ceases to exist as Apple assimilates and disperses the valuable elements of
the firm throughout its existing organization.47
Build. The traditional term merger represents what companies do when they build one new firm
from the components of the two. The degree of integration is not as high as in the bury strategy,
but a new identity, culture, and corporate brand emerges when the deal closes. Back-end and
customer-facing aspects of the business use the best in class processes of either company.
In 1998, auto giants Daimler-Benz and Chrysler merged, resulting in DaimlerChrysler
AG, with a stated goal of increasing global customer share by sharing best operating practices between the two businesses. This bold strategy required the companies to truly build a
new organization, on both the customer front-end and operational back-end. Unfortunately,
the companies split in 2007 after it became apparent that the “merger of equals” was really
an acquisition of Chrysler by Daimler. Building a new company may be the hardest integration strategy of all.
merger An acquisition with the
goal of creating a new firm from
the components of the two preacquisition firms.
Blend. A blended acquisition results in a moderate degree of integration. The target firm
retains its own identity, brand, and much of its culture and operating autonomy. Acquirers
may transfer many back-end practices to the acquired firm, as Newell does when it
“Newellizes” an acquisition; the company may choose to share fewer processes and
practices, such as GE’s management of many of its acquisitions. Customer-facing aspects
of the business remain largely separate to capitalize on the strength of each company in
its market. When companies add value through synergy, shared knowledge, or similar
processes, a blending strategy helps create new value while preserving the strengths of
each company.
[ Table 6.2 ] General Integration Strategies
ELEMENT/
STRATEGY
BURY
BUILD
BLEND
BOLT ON
Integration
Complete
Tight
Moderate—loose
None
Brand and Identity
Acquirer maintains,
Target loses
New, combined
Target maintains
front end
Target retains
Back-End Operations
Acquirer imposed
Best of breed
Acquirer dominates
Separate
Customer Facing
Operations
Acquirer imposed
Combined, Best of
Breed
Separate
Separate
[ 122 ]
CH06
ì CORPORATE STRATEGY
Bolt On. The metaphor of bolting on an acquisition implies two separate entities joined at
integration team A group of
individuals from different functional
areas of an acquiring firm that
coordinate and manage the
integration of the target company
after the acquisition has closed.
a single point through a very strong link. In a bolt-on acquisition, the two entities remain
deliberately separate in order to monitor the performance of each unit. The link between
the two businesses usually lies in the transfer of cash between divisions, either in the form
of capital investment from the acquirer to the acquired or the payment of a dividend in the
reverse direction.
ITT exemplifies the bolt-on model; each business unit is connected with the corporate
center only through financial reporting. Because the goal of each unit was to contribute
cash and operating profit rather than knowledge or strategically valuable assets, the bolt-on
model was the only appropriate integration choice for ITT to create any value. The different
business units could make no excuses that achieving larger corporate goals had influenced
their individual earnings; the bolt-on model preserved operating transparency among the
many different businesses.
Regardless of the integration template managers in the acquiring firm choose, attention to a number integration processes work to create a smooth and successful acquisition.
These processes begin with the creation of a dedicated integration team as soon as the deal
is announced.
The most successful integration teams are jointly led by high-profile executives from both
the acquiring and acquired firm; the credibility and authority of these teams helps break
down barriers to change and integration in both companies. The team should be composed
of subject area experts within each business function, such as human resources, marketing, operations, and finance/accounting.48 Each element of the new business that will be
integrated needs its own specialist on the integration team to lead and monitor the effort.
Finally, members of the best integrations work full time in these roles. Full-time status
allows these individuals to supplement their functional knowledge with expertise specific
to the acquisition process.
This team makes several key decisions that create a successful acquisition. The first decision involves which company culture will dominate the new entity. Culture, norms, and values that define “how things are done around here” are the most important elements in the
process. The acquiring firm usually wants its culture to dominate the new company, but
people in the acquired firm often want their culture to persist. The resulting cultural clash
can sabotage the entire integration process. A more difficult option entails building a new
culture that combines the best elements of each company’s culture.49
Speed matters in the integration process. When people see that the new company
creates value for its stakeholders, including themselves, they become willing to change
their own behaviors and truly join the new organization. The quicker the integration team
can create clear successes, the more quickly members of the acquired firm dedicate their
energy to making the venture succeed. This principle underlies Cisco’s practice of having the acquired company’s products for sale by Cisco employees on day 1 of the new
relationship.
The team decides which tactical elements and operational functions of the two firms
will be integrated and implements whichever strategic integration template the firm
chooses. Several other processes ensure that the merger, once finalized, creates value as
soon as possible. These include determining a clear day-1 set of priorities and tasks to realize
immediate value from the deal, establishing a clear set of measures or key performance
indicators (KPIs) to monitor progress, a clear path for implementing new systems in
operations, marketing, or information systems, and a commitment to clearly communicate,
in fact overcommunicate, the rationale and goals for the acquisition and the measureable
progress toward those goals. We close this chapter by looking at General Electric to see how
the company has mastered the acquisition integration process.
SUMMARY
[ 123 ]
S T R AT E GY I N P R A CT I C E
How GE Integrates Acquisitions50
G
eneral Electric’s financial services unit, GE Capital, made
over 100 acquisitions in a five-year period. With acquisition
such an essential element of the unit’s strategy and the sheer
number of acquisitions to integrate into an already-diverse
portfolio, GE managers used this period of intense activity to
perfect a system for integrating new acquisitions. The process
worked very well, resulting in a systematic framework that the
unit—and other companies—could use to improve the odds of
success in an inherently difficult enterprise.
GE’s system builds on four powerful lessons they learned
through experience:
1. Acquisition is a process, not an event. Acquisition begins
long before the deal closes and ends long after. Work
done before the deal closes improves the integration
success, and monitoring for a sustained period allows
the new entity to “settle in” to the GE portfolio. Acquiring a company most often represents a long-term
commitment; the integration process should have a
similar goal of long-term value creation.
2. Successful integration requires a committed team of
talented professionals whose only job is integration.
Integration managers, just like product or brand
managers, create value for the business and require
their own set of dedicated skills to succeed. Asking
people to work on an integration team in addition to
their already-full plates usually ends up with integration becoming a lower priority, which, in turn, jeopardizes the overall success of the acquisition.
3. Communication about important matters such as who
will lose their jobs and how compensation systems will
change must be clear, forceful, and immediate. People care a lot about their own future. Until they know
where they stand, it’s hard for them to commit to making the acquisition a true success. Only after people
know WIFM (what’s in it for me) will they attend to the
strategic rationale for the move.
4. Real and significant integration happens best when people work together on real, mission critical tasks. Things
like company picnics, “getting to know you” days, or
other feel-good activities prove far less effective than
assigning people to work on business-related, profitgenerating activities. Working on real projects brings
people together and helps the company show the success of the acquisition more quickly.
SUMMARY
ì Diversification creates value when firms exploit or enhance their resource base by entering a new line of business, market, or industry. Managers should ask two questions when
considering entering a new line of business: (1) Why will the existing businesses be more
valuable because we’ve entered an adjacent business? and (2) Why will the new business
activity be more valuable inside our corporation than operating alone? When managers
choose to diversify, they face a choice about whether to enter a new line of business through
greenfield entry or through acquisition. Greenfield entry proves a preferred strategy when
the firm can readily exploit its existing resources and capabilities, is not pressed for speed,
and can enter a new line of business at a small or moderate scale. Diversification through
acquisition becomes the preferred strategy when firms must expand their resources and
capabilities to compete effectively, enter a market quickly, or operate at large scale.
Vertical Integration
and Outsourcing
07
Ed Lallo/Bloomberg via Getty Imag
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1
Define vertical integration, forward vertical integration, and
backward integration.
2
Describe the three Cs that represent the primary reasons that firms
may choose to vertically integrate (make) and perform an activity
internally versus outsource (buy) the activity to (from) a supplier.
3
Describe the two Fs, which examine the potential dangers of
vertical integration.
4
Explain the advantages of outsourcing and the conditions under
which it might be advantageous to outsource an activity to an
external supplier.
5
Discuss the actions a manager could take to prevent a
subcontractor from becoming a competitor.
[ 129 ]
07
Dell and ASUS:
A Tale of Two Companies
products and services. Both Dell and Wall Street loved the
change. As Dell moved upmarket selling more powerful
PCs and servers, it continued to outsource more of its
lower-value components and processes, mostly to suppliers
in China. Eventually, Dell outsourced the management of
much of its supply chain, and more of the final assembly
of the entire computer.4 It got to the point where some
Dell computers were almost completely designed and
manufactured by other companies.
Although Dell outsourced to increase efficiency and
improve its performance, other companies in the industry
chose the opposite approach. ASUS, a Chinese company
that was the recipient of much of Dell’s outsourcing, began
making circuits and motherboards for Dell (and other PC
manufacturers) cheaper than Dell could. ASUS had a cost
advantage from manufacturing circuits and motherboards in
China and soon became the world’s largest manufacturer of
PC motherboards.5
As ASUS produced more and more of Dell’s
components, it increased both sales and profits. Over
time, ASUS continued to build new
WHAT STARTED IN MICHAEL DELL’S DORM ROOM AT THE UNIVERSITY
manufacturing knowledge and
OF TEXAS, AUSTIN, GREW TO A FORTUNE 500 COMPANY IN LESS THAN A
capabilities, moving upmarket behind
Dell, from circuits and motherboards to
DECADE.
supply chain management, computer
assembly, and computer design. Eventually, in 2007
sales and distribution, and service. Over time, Dell
ASUS launched its own inexpensive Eee PC in Taiwan at
streamlined its business model by outsourcing more and
a price tag of $340, and the computer quickly sold out.
more of its low-value manufacturing operations, eliminating
ASUS stock increased by 4.9 percent the day it launched.6
expensive equipment and competencies. For example, by
outsourcing motherboards and the final assembly of its
This led to a worldwide launch of the Eee PC, which is
computers, Dell cut the cost of those activities by roughly
now sold through BestBuy and Amazon.com. Analysts
20 percent.3
appreciated ASUS’s vertical integration strategy (bringing
more activities inside the firm), just as they appreciated
Outsourcing low-value-added manufacturing tasks
Dell’s outsourcing strategy (sending more activities to
reduced assets on Dell’s balance sheet and allowed the
suppliers).
organization the freedom to focus on higher-profit-margin
D
ell began in 1984 with a simple idea in mind: create
and deliver custom personal computers (PCs)
directly to customers within 48 hours. What started in
Michael Dell’s dorm room at the University of Texas, Austin,
grew to a Fortune 500 company in less than a decade.1
Moving inventory quickly without the costs of storefronts
or distributors made these computers affordable, and also
provided customers with the latest technology within days.
The company became a powerful player in the PC market in
just a few years.
From the early 1990s until 2006, Dell was a darling of
stock analysts. In fact, Dell’s market value (market cap)
jumped from $2.5 billion in 1995 to $100 billion in 2005.2
Dell was rewarded by Wall Street with a higher stock price
for its growth and ability to generate high profits with
relatively few assets. The company’s ability to generate
high profits with only a few assets was possible because
it outsourced most of the components and operations
associated with making its PCs to outside suppliers. This
allowed it to focus on computer design, final assembly,
ì
[ 130 ]
WHAT IS VERTICAL INTEGRATION
[ 131 ]
Dell and ASUS prospered with opposite strategies: one outsourcing, the other integrating.
Dell improved its profit returns on net assets (RONA) by outsourcing manufacturing processes and their associated physical assets while focusing on higher-value-added activities
such as design, marketing, and service.7 ASUS increased revenues and profits by moving
upmarket behind Dell, gradually developing more sophisticated manufacturing capabilities
and eventually launching its own PC. Dell and ASUS’s successes raise the following questions: How can two companies in the same industry each find success with opposite vertical
integration strategies? Are both strategies appropriate, or did analysts overlook weaknesses
in one or both of these strategies? Finally, did Dell or ASUS management set up their respective companies for greater future success or failure?
WHAT IS VERTICAL INTEGRATION?
Dell and ASUS made different decisions about the extent to which they wanted to perform
activities related to developing, designing, manufacturing, selling, and servicing their computers. Dell decided to outsource some of the activities that it had previously conducted
internally to ASUS and other suppliers. Outsourcing refers to a firm contracting out a business process or activity to an external supplier.
Dell’s leaders made this decision because they felt that other firms could perform these
activities more efficiently than Dell could. So they outsourced what they perceived as lower
value-added activities—or those activities on which they made lower profit margins. At
the same time, ASUS decided to enter into an increasing number of activities related to
making a computer—from making components and motherboards to fully designing and
manufacturing its own Eee personal computer. This is referred to as vertical integration
(or insourcing)—bringing business processes or activities previously conducted by outside
companies in-house. ASUS developed the capabilities to perform these additional functions
efficiently and improved the company’s overall performance. Moreover, by adding activities,
ASUS’s leaders felt that they could build additional manufacturing capabilities for the company that would be useful in the future.
This case illustrates the classic “make” (ASUS) versus “buy” (Dell) choice that leaders
face as they try to offer unique value to the market. Two firms can look at the same activity and one might decide that it makes sense to make it, or conduct the function internally
within the firm, while another firm might decide to outsource the same activity. As shown
in the Dell–ASUS case, this choice can have real impact on a firm’s ability to succeed. Consequently, it is important to understand when to make and when to buy.
This chapter will cover why companies choose to conduct an activity within the firm; the
benefits of outsourcing, and the conditions when it might be advantageous; and the dangers
of outsourcing as well as the risks of vertical integration. In the Strategy Tool at the end of
the chapter, we provide a tool, the “Make vs. Buy Assessment,” that can be used to decide
whether to make versus buy.
outsourcing The process where
a firm contracts out a business
process or activity to an external
supplier.
vertical integration (or insourcing)
Bringing business processes or
activities previously conducted by
outside companies in-house.
The Value Chain
The different aspects of the value chain have been covered in earlier chapters but they warrant a more in-depth discussion here as a clear understanding of the value chain is critical to
the “make versus buy” decision. The value chain for an industry is the sequence of activities
that transform raw materials into finished products. Each key activity “adds value” to the
prior activity—hence the term value chain.8
To illustrate, let’s walk through the industry value chain for gasoline. To get gasoline to
the consumer, we first need to explore for crude, then drill, then pump, then ship, then refine
the crude into gasoline, then ship again, then finally sell gasoline to the end consumer, as
outlined in Figure 7.1.
Companies have their own value chains that are usually distinct from an industry value
chain. Companies that participate in many or all stages of the industry value chain from
exploration to final sale are highly vertically integrated.9 Companies that participate in only
value chain The sequence of all
activities that are performed by a
firm to turn raw materials into the
finished product that is sold to a
buyer.
[ 132 ]
CH07
ì VERTICAL INTEGRATION AND OUTSOURCING
[ Figure 7.1 ] The Oil Industry Value Chain
Exploring for Crude Oil
Drilling for Crude Oil
Shipping Crude Oil
Refining Crude Oil
Shipping Refined Products
Selling Refined Products to Final Customer
one activity (such as shipping crude oil) are vertically specialized.10 Activities closer to the
beginning of the industry value chain, or the raw materials used to create a product, are
referred to as upstream activities and those towards the end, or final products that consumers purchase, are downstream activities.11
Forward Integration and Backward Integration
If a company wants to grow by moving forward in the value chain—that is, downstream—
we say that company engages in forward integration.12 This might be an oil-refining company that wants to open its own gas stations to sell gas. Or it might be an oil-exploration
company that decides to refine the crude oil that it finds. In contrast, if a company wants
to grow by moving backward in the value chain—that is, upstream—we say that company
is backward integrating.13 This might be a drilling or refining company that wants to do its
own exploration.
For any given activity in the value chain, an organization’s leaders must answer this key
question: Do we make it or do we buy it? In other words, do we do it ourselves, or do we have
some other company do it? The answer to this question hinges on whether the firm can
build a capability that will allow it to do a better job of offering unique value by conducting
the activity itself rather than having another company do it.
In some cases, a firm’s leaders will decide that being vertically integrated into more activities will allow it to better deliver either a low-cost or differentiated product to the customer.
In other cases, a firm may feel like it is better off by being vertically specialized.
To illustrate, Walt Disney is vertically integrated into many vertically linked activities in
the value chain. It produces its own movies and TV shows with its own studio and its wholly
owned subsidiary Pixar. Disney also distributes its TV shows and movies through its own
TV networks (ABC and Disney Channel) and to movie theaters through a worldwide distribution network. Disney doesn’t own movie theaters, but many years ago most of the movie
studios like Paramount and Fox owned their own theaters.14
In contrast, Nike is much more vertically specialized than Disney. Nike designs and markets its athletic footwear, equipment, and apparel, but outsources many other activities in
its value chain.15 It does not manufacture its shoes, equipment, or apparel, and for the most
part, it sells its products through stores owned by other companies, such as Foot Locker.
When Nike started selling its shoes and apparel through its own Niketown stores, it forward
integrated by conducting activities within the firm that are downstream and closer to the end
customer. Likewise, ASUS engaged in forward integration as it continued to take on more
activities for Dell in the final assembly of a computer. If Nike were to start to manufacture
THREE KEY REASONS TO VERTICALLY INTEGRATE
[ 133 ]
its own shoes or apparel, it would be engaging in backward integration by incorporating
more activities that combine materials and components into a final product. When Netflix
started to create its own originally produced shows—such as political drama House of Cards
and comedy Arrested Development—this was a form of backward integration designed to
allow it to differentiate its service from competitors.
The success of firms such as Nike, Disney, Netflix, and ASUS has been strongly influenced
by the choices of organizational leaders regarding which activities along the value chain
should be conducted within the firm and developed as core competencies, and which activities should be outsourced to other companies. This choice of whether to “make” or “buy”
hinges on a variety of factors that we address in the next section.
THREE KEY REASONS TO VERTICALLY INTEGRATE
There are three primary reasons that companies choose to make versus buy. We refer to
these reasons as the three Cs of vertical integration: capabilities, coordination, and control,
as outlined in Table 7.1.
Capabilities
The first C is capabilities, which refers to the question of whether the firm has—or can
build—the capabilities to perform the activity better than other firms.16 The firm’s leaders
should ask this question: To what extent are we, or could we be, the best in the world at
conducting this activity?
If the firm can be one of the best in the world, then it is probably an activity it should do.
But, if it cannot be one of the best in the world, then the firm is probably better off by outsourcing the function to a company that has stronger capabilities.17
To illustrate, Nike designs and markets its own shoes, but outsources the manufacturing of its shoes to other companies. Suppliers that manufacture shoes for Nike and other
athletic shoe companies have developed capabilities to manufacture shoes at very low cost.
This requires managing low-wage workers in emerging economies, such as China and Indonesia where the majority of the world’s athletic shoes are manufactured. Since Nike differentiates its shoes based on its internal activities of design and marketing, it is content to let
suppliers manufacture its products.
Nike understands that low-cost manufacturing capabilities are very different from design
and marketing capabilities and has decided that it doesn’t need to manufacture its own
shoes in order to differentiate them in the marketplace. It saves considerable capital investment by not having to invest in large manufacturing plants and building manufacturing
capabilities. This allows Nike to focus its capital and full attention on building a capability to
design athletic shoes that deliver the best performance possible.
Nike also focuses on developing the world’s best marketing capabilities to build a brand
that will differentiate its products.
Finally, through its design and marketing capabilities Nike creates barriers to imitation to
prevent subcontractors of its shoes from becoming competitors (see Strategy in Practice:
How to Prevent a Subcontractor from Becoming a Competitor).
subcontractor A supplier that
provides an input to a local firm;
the term subcontractor is often
used to describe suppliers that are
contracted to create customized
inputs for a firm.
[ Table 7.1 ] 3-C Reasons to Vertically Integrate
Capabilities
Conduct the activity internally when the firm has or can develop better capabilities to perform it than
other firms.
Coordination
Conduct the activity internally when effective coordination and tight integration of the activity with
other firm activities provides performance advantages—such as speed to market or improved quality.
Control
Conduct the activity internally to control scarce inputs or inputs created through specialized assets in
order to reduce transaction costs.
[ 134 ]
CH07
ì VERTICAL INTEGRATION AND OUTSOURCING
Coordination
The second C is coordination, which refers to the question of whether a firm is better able to
effectively coordinate the activity with other activities in the firm when both are conducted
internally. In this case, the firm isn’t necessarily more capable at performing a particular
activity, but it lowers the coordination costs associated with two interdependent activities.
A firm’s leaders should ask: To what extent will we improve our ability to coordinate our
business activities—and offer unique value—by conducting this activity ourselves?
The fact of the matter is that some activities or tasks require more coordination than
others to be successful because of greater interdependence with other activities. The
greater the interdependence between activities, the more it makes sense to vertically integrate
and have these done within a company where the team members can effectively coordinate
their work.18
For example, Apple’s integration of chip design activities illustrates a company vertically
integrating to achieve better coordination.19 For years, Apple outsourced the design and
manufacture of most of the microprocessors (chips) used to power its products to companies like Motorola, Intel, and AMD. However, Apple executives decided that they could
better coordinate product development activities if Apple designed its own chips.20 They
believed that doing so—even if they didn’t have better chip development capabilities than
Intel or AMD—would lower coordination costs and enhance the speed of new product
development. Additionally, designing their own chips would make it more difficult for competitors to imitate Apple technology because competitors wouldn’t have access to Appledesigned chips. So, Apple hired chip experts, some who had worked for AMD and Intel,21 and
now designs many of the chips that power its products. Being able to better coordinate all of
the activities associated with developing new products was a key reason that Apple decided
to backward integrate and bring chip design in house.
So how do managers know if two activities require high levels of coordination and
therefore are better conducted within the firm? The answer is to understand the nature of
the interdependence of the activities—with less interdependent activities being outsourced
and more interdependent activities being conducted within the firm.
We will now describe three types of interdependence—modular, sequential, and
reciprocal—and how they influence the make versus buy decision as outlined in Figure 7.2.
Modular Interdependence. Some activities require low levels of coordination because the
activities are modular in nature. This means the results are pooled together but the individual
activities can be conducted without coordinating with other activities.
To illustrate modular interdependence, consider the activities that are important to the
performance of a golf team. Members of a golf team may share information about the golf
course with each other, but in the final analysis, play is by the individual performer. In this
case, team performance is based on individual performances or activities that are pooled
together. This is typically referred to as modular or pooled interdependence,22 which means
that the degree of coordination required is relatively low.
[ Figure 7.2 ] How Interdependence Influences Vertical Integration and Outsourcing
Low Teamwork
(Modular
Interdependence)
Low
Moderate Teamwork
(Sequential
Interdependence)
High Teamwork
(Reciprocal
Interdependence)
Medium
Outsourcing
High
Vertical
Integration
THREE KEY REASONS TO VERTICALLY INTEGRATE
In similar fashion, when an automaker purchases certain standardized nuts and bolts to
assemble its cars, everything else in the car can be designed without regard for the nuts and
bolts. As a result, automakers feel no need to make their own nuts and bolts because while
these inputs are necessary they don’t require a high level of coordination with other inputs.
The task of designing and manufacturing nuts and bolts is completely independent of the
tasks of designing and manufacturing other automobile components. Moreover, nuts and
bolts do not differentiate the final product. The same is true for other automotive inputs,
such as batteries and oil filters, which are fairly standard across vehicles and are therefore
characterized by modular interdependence.
Sequential Interdependence.23 Activities are sequentially interdependent when one firm
(or set of individuals) cannot perform its (their) tasks until another firm has completed its
tasks and passed on the results. Under these circumstances, team members must meet
together more regularly and consistently to coordinate their work.
A baseball team is an example of a team that requires a moderate amount of coordination. All nine players must be on the field at once, but the players are not involved in every
play. However, whether a batter bunts or tries to hit to the opposite field depends on what
the previous hitters have done. Relay throws from outfield to shortstop to home base, and
double plays from the third baseman to second to first, are activities that require sequential
coordination.
Likewise, with an automobile, whoever creates the air conditioning system cannot
design it until the overall vehicle has been designed. In contrast, bolts and nuts can be produced without regard for the car design. Before the activity of creating an air conditioning
system can begin, the amount of geometric space allocated for the air conditioning system
in the dashboard must be identified. Moreover, the location of the vents in the vehicle and
lines for carrying air to the vents must also be designed. The work of designing and manufacturing an air conditioning system cannot begin until the vehicle body and geometric
dimensions of the car have been designed, which means these activities are characterized
by sequential interdependence. As a result, automakers either make the air conditioning
system internally or work closely with a supplier—often in partnership fashion—to achieve
the coordination required.
Reciprocal Interdependence. Some activities or tasks require a high degree of coordination
because tasks are reciprocally interdependent. In these activities, good performance is
achieved through work done in a simultaneous and repetitive process in which each
individual must work in close coordination with other team members because they can
complete their tasks only through a process of iterative knowledge sharing.24 Individuals
performing certain activities must communicate their own requirements frequently and be
responsive to the needs of those performing related activities.
To illustrate, members of a basketball team must coordinate constantly as they run
their offensive plays and play “team” defense. Every member interacts with every other
member. It could be predicted that a basketball team would suffer more from the lack of
teamwork (coordination) than would a golf team or a baseball team. Indeed, this seems to
be the case, as evidenced by the fact that major league baseball teams that acquire a few
free agent stars will occasionally come from a low ranking the prior year to win the World
Series. For example, the 2012 Boston Red Sox placed last in their division—and third worst
in the American League—but went to the World Series in 2013. This rarely happens with
NBA basketball teams, which must learn how to coordinate and work together to be successful. Experience has shown that even having the best individual basketball talent on
one team is no guarantee of team success. The United States basketball team experienced
a historic failure when it failed to win the 2004 Olympics and the 2006 World championships with players like Tim Duncan, Dwayne Wade, and Carmelo Anthony. The need for
better teamwork prompted the United States to require a three-year commitment from
NBA players so that they could learn to work together as a team. Since then, the U.S. basketball team has won every world championship, including gold medals at the 2008 and
2012 Olympics.25
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Product development teams for complex products such as automobiles, aircraft, robotics, consumer electronics, and so on, work together in a reciprocally interdependent fashion.
For example, the design of an engine for an automobile is reciprocally interdependent with
many of the other activities of designing and creating an automobile. The engine design
must change along with modifications in the vehicle’s overall body design because a heavier
or lighter vehicle requires different engine requirements. The engine also influences, and is
influenced by, the transmission system in the vehicle. Because of all of these reciprocal interdependencies between the engine, overall vehicle design and other key vehicle systems like
the transmission, automakers almost always make their own engines rather than outsourcing them to suppliers. The need to coordinate these activities effectively leads to vertical
integration of these activities.
Control
transaction-specific asset An
asset, such as equipment (oil
pipeline) or facility (bowling alley),
that is customized or specialized to
a particular use. Assets are more
specialized when the value of the
asset in its current or intended
use is high compared to its next
best use.
The third C is control, which refers to a firm’s desire to maintain control over a valuable activity or input in the value chain. In other words, an organization’s leaders must ask: To what
extent should we maintain control over a crucial step in the value chain by conducting this
activity ourselves?
A company may want to vertically integrate in order to control some scarce and valuable
resource, particularly if it is a differentiator of its final product.26 The choice to backward
integrate may be made in order to control access to important raw materials or inputs that
are highly customized to downstream activities. Some producers of aluminum have purchased land that is rich in bauxite—a key raw material that is necessary to make aluminum.
They want to ensure that they have control of that key input so they developed bauxitemining operations.
In a similar vein, it might make sense to maintain control over investments in assets or
equipment that provide key inputs at lower cost. For example, suppose that crude oil is best
shipped to an oil refinery through a pipeline. Let’s say the cost of shipping a barrel of crude
oil by truck is $1.00 per barrel whereas transporting by pipeline would only be $0.50 per
barrel. Once built, the owner of the pipeline could opportunistically raise the shipping price
up to $0.99 since the only real alternative is to ship the crude in trucks. Likewise, the owner
of the refinery could refuse to pay a fair price to the pipeline owner—or any price, for that
matter—if there is no other alternative use for the pipeline.
In this case, the pipeline is a transaction-specific asset, meaning it is specialized
or customized to a particular transaction (transporting oil to the refinery) and has little value when redeployed to its next best use.27 In fact, a technique that can be used
to determine if an asset is specialized is to estimate the value of an asset (equipment,
process, etc.) in its current (or intended) use divided by the value of the asset/process
in its next best use. What is the “next best use” of a pipeline? Is it redeployable to other
uses without a loss in value? While it might be fun to think that it could be used as an
underground waterslide, practically speaking, it has little value if it isn’t transporting oil.
The value of a pipeline in its intended use as a pipeline is high, but in its “next best use”
the value is very low. In contrast, trucks used to transport oil could be used to transport
things other than oil, such as chemicals or natural gas. It is a far less specialized asset
than a pipeline.
Managers ultimately want to control assets or inputs that are specialized to each other.
By doing so, they avoid the transaction costs associated with negotiating and writing a legal
contract to ensure that the transaction takes place.28 The cost of hold-up, which is what can
happen when one firm tries to take advantage of a firm that has made a transaction-specific
investment like a pipeline, is also avoided.29 The refinery could “hold up” the pipeline firm by
failing to pay a fair price because the pipeline has no alternative use.
In the previous example, the pipeline only has high value if it is transporting oil to the
refinery; so the same firm would want to own both the pipeline and refinery. This way, the
firm avoids the possibility of one firm trying to hold up another firm, and it also reduces
transaction costs. This is the same reason homeowners like to own the land that surrounds
their home. If they didn’t, the person owning the land could charge an unfair price to cross
the land to access the home. This would be another example of hold-up.
DANGERS OF VERTICAL INTEGRATION
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S T R AT E GY I N P R A CT I C E
A Classic “Make vs. Buy” Mistake
I
magine that you work for a company that makes a kitchen
appliance product that costs $50 to manufacture. You have
to decide whether to make or buy a component that is an
input for the product. Your analysis shows that, based on
the estimated volume of parts, your costs to manufacture
the part internally will be $0.98 per unit. A quick bid in the
market suggests that you can buy the same part from two
suppliers for $1.00 (another supplier bid $1.01). There are
no real quality differences between what you can make and
what you can buy from suppliers. What should you do? Make
the part for $0.98 or buy it for $1.00?
For many, the answer seems easy. Of course you make
the part for $0.98 because it will save you $0.02 per unit
over buying it from an outside supplier. But this is typically
the wrong answer—and here’s why. You want to conduct
an activity internally if you can do it at lower cost or with
better quality than the competition. In this case, it appears
that your costs per unit are lower than the competition.
However, the price of the part from the supplier includes a
profit margin—and profit margins for most products sold are
typically in the 10 to 20 percent range or higher. This means
that the supplier’s cost to produce the part is likely to be 10
to 20 cents less per unit than your company’s costs.
In fact, you don’t have an absolute cost advantage in
making this part. There are multiple suppliers producing this
same component and offering a similar price. This means
you might have some bargaining power over these suppliers
and could get at least one of them to drop their price to
$0.98 or lower. In addition, outsourcing will allow you to
focus the company’s capital resources and the attention of
the management team on higher-value activities. A part that
costs $1.00 out of $50.00 total is not a significant contributor
to cost. Even if you save $0.02 per unit, it won’t contribute
much to your cost advantage. Of course, if this part allows
you to differentiate your product—or if you could make it with
higher quality—then you still might want to do it internally.
But in this case, there are no real quality differences
between the product that you can make internally and the
one you can buy from a supplier.
The bottom line is that a classic mistake with make vs.
buy is assuming that you are better off making a part or
conducting an activity internally when the internal cost is equal
to—or even slightly lower—than the price from a supplier. You
need to compare your costs with the supplier costs (not the
supplier’s price) to know whether or not your capabilities at
conducting the activity are really better than a supplier’s. Of
course, if you have the capabilities to produce a higher-quality
input, or there are advantages associated with having better
coordination or control, you still might want to conduct the
activity internally even if your costs are higher. For guidance in
making the “make versus buy” decision, see the Strategy Tool:
Make versus Buy Assessment at the end of the chapter.
DANGERS OF VERTICAL INTEGRATION
Even though there are some very good reasons to vertically integrate, there are two important dangers—a loss of flexibility and loss of focus—the two Fs.
Loss of Flexibility
First, when many activities are managed in the value chain, the flexibility to quickly make
changes to the business is lost.30 This might be important when there are major technological changes. In fact, research has shown that companies that are more vertically integrated
take a bigger hit to performance when there is a technological change.31
This happened to computer workstation manufacturers DEC and Data General—
companies that had vertically integrated into making CISC microprocessors that powered
the workstation—when the faster and simpler RISC microprocessors were introduced.
Competitor Silicon Graphics did not make its own CISC microprocessors, so it was able to
quickly move to RISC microprocessors, which gave it an advantage in the marketplace. Silicon
Graphics also didn’t need to sell off the now obsolete CISC microprocessor manufacturing
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equipment. Similar things happened to the more vertically integrated makers of CD players and Discman—like Sony and Panasonic—when MP3 players hit the market. Companies
simply have greater flexibility to switch to another supplier when they outsource than they
do when the activity is conducted internally.
Having more flexibility—that is, being less vertically integrated—is particularly valuable
when new technologies are being developed or if the cost to perform an activity can change
quickly. For example, one of the reasons that Nike chooses to outsource the production of its
shoes is because it likes the ability to switch suppliers depending on which supplier is lowest
cost at the moment.
To illustrate, in the late 1990s, the Asian financial crises had a dramatic effect on the currencies and exchange rates on some Asian countries, but not others. Indonesia’s currency, the
rupiah, was trading at roughly 4,000 to the dollar before the crises, but a dollar would fetch
more than 10,000 rupiahs at the height of the crises. This meant that Nike could buy shoes
from Indonesian subcontractors for less than half the prices they were paying before the
change in exchange rates. At the same time, China decided to keep its currency stable with
the dollar so Nike’s prices on shoes from Chinese shoe suppliers didn’t change much. Because
Nike didn’t own any of the manufacturing plants, it had the flexibility to shift production to
the low-cost location—which, for a period of time, favored Indonesia over China. As a result
of changing wages and exchange rates across countries where shoes are produced, Nike likes
the flexibility to source the manufacturing of its new products to the lowest cost producer.
Loss of Focus
A loss of focus refers to the fact that the more different types of activities a firm needs to
manage, the harder it is to be world class in all of those activities. It is just too difficult for
managers to focus on many different activities at once and be world class at all of them.
To illustrate, for many years General Motors (GM) made almost 70 percent of its parts
internally including spark plugs, batteries, brakes, and a host of other automotive parts. In
contrast, Toyota only makes about 25 percent of its parts. Toyota outsources to companies
that specialize in various parts—like spark plugs, batteries, and brakes—and therefore, provides the best possible parts at reasonable costs. While GM made its own brakes, Toyota
outsourced them to companies like Akebono and Kayabe Brake that specialized in brakes.
General Motors cars have been higher cost than Toyota’s, in part because it just couldn’t
make parts cheaper than Toyota could buy them.
Why did General Motors have higher costs for producing automotive components such as
spark plugs, batteries, and brakes? The primary reason was a lack of focus—suppliers were able
to have lower costs by focusing on a narrow product line and producing those products in
large scale for multiple automakers. Akebono Brake made braking systems not only for Toyota
but also for Nissan and many other automakers. This allowed Akebono to produce products
in larger volumes and with greater economies of scale, thereby lowering costs per unit. GM’s
lack of focus made it difficult for their internal brake divisions to compete with these focused
suppliers. Moreover, even though GM could buy cheaper brakes from outside suppliers such as
Akebono and Kayabe, it refused to do so because GM didn’t want to incur the costs to fire its
union workers and close its plants. Both a lack of focus and flexibility hurt GM’s overall performance. General Motors finally realized that too much vertical integration was a liability, and it
eventually created an automotive components division it spun off as a separate company that
would have to compete on its own. Now GM has more flexibility to buy from other suppliers
and only buys from its former in-house suppliers if they offer the best product at the lowest cost.
There is one more dimension to focus that is worth mentioning. When firms are vertically
specialized, they only stay in business when they can focus on making profits. If they can’t
make enough profits, they go out of business. However, when an activity is conducted within
a firm, it can often stay in business even if it isn’t performing well and making profits—just
like some of GM’s automotive parts divisions. This is possible because it gets subsidized by
other parts of a company’s business that are profitable. Sometimes you lose the discipline
of the marketplace and a focus on making profits when you conduct an activity internally.
Keeping employees motivated to perform is critical if an organization hopes to be world
class in any activity.
ADVANTAGES OF OUTSOURCING
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ADVANTAGES OF OUTSOURCING
The two Fs, as already described, are dangers of vertical integration—which also means they
are advantages to outsourcing. Outsourcing does give firms more flexibility to quickly move
activities to whatever company is the best at performing that particular activity. As previously mentioned, Nike has the flexibility to move its shoe production to the world’s lowestcost supplier, whoever that may be. This flexibility is particularly valuable when there are
rapidly changing economic conditions or technologies. When there is high technological
uncertainty in an industry with lots of new leapfrog technologies being developed, flexibility
is valuable, and outsourcing is often preferred to vertical integration.
Outsourcing also allows firms to focus their attention on being good at a narrower range of
activities. Along with this benefit, outsourcing also minimizes the capital investment required
to grow. Nike would have needed to raise a lot more capital during its rapid growth phase of the
1980s and 1990s if it had not outsourced the manufacturing of its shoes. The cost of building and
running new plants would have been significant. Instead, it was able to focus its attention on
the capabilities that were most critical to differentiating its shoes: shoe design and marketing.32
There is one final advantage of outsourcing. Imagine that Nike had decided to build
plants to manufacture its athletic shoes. In order to achieve greater economies of scale,
Nike’s manufacturing plants would have to be able to acquire shoe-manufacturing contracts
from other shoe companies—like Adidas, Reebok, New Balance, or Skechers. Do you think
Adidas would let a Nike manufacturing plant produce its shoes? Probably not. Adidas would
not want to share its designs or help Nike in any way. Without those economies of scale, Nike
shoes manufactured by a Nike manufacturing plant would cost substantially more to make
than they do in outsourced manufacturing plants.
ETHICS
A N D ST R AT E GY
Should You Outsource to Subcontractors
that Use Child Labor?
T
he CEO of a popular clothing business discovers that two
of her company’s sewing subcontractors in Bangladesh
are using child labor. She also learns that if the child
workers lose their jobs, most of them will just find work with
another company—or worse, some may turn to prostitution
to survive. What’s the right thing to do? Lay the children off
and live with the fact that you’ve eliminated a viable option
for their survival, or keep them working in the factory? This
is the type of ethical dilemma faced by many companies that
outsource jobs to subcontractors.
When Levi Strauss & Co., an organization that outsources
the production of its products to subcontractors, confronted
this problem, it came up with an innovative solution: Take
the children out of the factory; continue paying their wages
on the condition they attend school full time; and guarantee
them employment in the factory when they are 14 years old,
the local age of maturity. Since the pay of these underageworkers was less than $0.40 per hour, the cost to Levi and the
subcontractors was relatively low. The benefit was a cadre of
more educated and productive—and more loyal—workers.
Levi’s approach to this difficult situation earned the
praise of Bangladeshi and U.S. government officials and
several nongovernmental organizations (NGOs). Not only
did Levi help meet the needs of factory workers, but it did so
without necessarily sacrificing returns to its shareholders.
Subsequently, the Bangladesh Garment Manufacturers and
Exporters Association, along with other groups, set aside
more than $1 million for the education of approximately
75,000 underage girls who had previously worked in
Bangladesh factories. Levi’s initiative shows that an innovative
solution can solve even the most challenging problems.
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S T R AT E GY I N P R A CT I C E
Outsourcing via Crowdsourcing
C
ompanies are increasingly turning over outsourcing
tasks to crowds—individuals or organizations outside the
company who may be better suited to perform a particular
task. Crowdsourcing refers to the phenomenon of outsourcing
tasks to individuals or organizations that are outside of your
organization.33 One example is Wikipedia.34 Rather than
follow Encyclopedia Britannica’s model of hiring experts to
provide all of the information necessary for an encyclopedia,
Wikipedia enlists crowds of individual contributors. Wikipedia
is the product of thousands and thousands of individuals
contributing their knowledge and information. Unlike most
cases of crowdsourcing, Wikipedia contributors don’t get
paid but are energized by intrinsic motivations, such as the
desire to learn or build a reputation for being an expert in a
community of peers. In most cases, however, the crowd is
paid to perform a task for the company.
While crowdsourcing is the term used to refer to the practice
of outsourcing tasks to a crowd outside the organization,
there are actually several types of crowdsourcing, including
crowdtasking, crowdvoting, crowdcreating, and crowdinnovation.
Crowdtasking refers to enlisting a crowd to complete a
simple, repetitive task. For example, CardMunch, founded in
2009 by a group of Carnegie Mellon University engineering
graduates, has a simple mission—storage of business cards
and how they are managed. Using the company’s free app,
customers start by taking a picture of a business card. For a
small fee, the content is digitized by a crowd of individuals, put
into the user’s contacts, and then CardMunch reaches out to
the contact via e-mail or a LinkedIn request.35
CardMunch can vary the amount they pay for data input
depending on the supply of workers—which can be quite
large since they can tap into large pools of labor in India
willing to work for very low wages. They also use a different
member of the crowd to compare the information on the
business card with what was input into CardMunch. Another
example is Amazon, which has turned crowdtasking into a
business with its Mechanical Turk, an online marketplace for
work. Companies that want to crowdsource tasks can go to
Mechanical Turk to request workers for human intelligence
tasks (HIT), and individuals can go to Mechanical Turk to
find a task to work on. Crowdtasking works particularly well
for tasks that don’t take a lot of specialized skill and can be
accomplished by people sitting at their computer.
Crowdcreating refers to turning to the crowd to create
content or complete a task that requires specific knowledge
or expertise on the part of the crowd member. Threadless, an
online community of artists and an e-commerce website, is a
company that uses crowd-creating. Rather than hire T-shirt
designers, Threadless enlists members to submit ideas for
T-shirt slogans and designs.36 This allows it to constantly
tap into new artists and ideas, and sell its T-shirts without
professional designers, advertising, modeling agencies,
photographers, a salesforce, or retail distribution.37 The
company typically pays $2,000 for a T-shirt design that it takes
to market and has sold T-shirts from more than 1,500 different
designers.38 Threadless uses another form of crowdsourcing—
called crowdvoting—to select the designs to take to market.
Crowdvoting or crowdsorting refers to using a crowd to
evaluate an offering or to make predictions about uncertain
events. Crowdvoting is particularly good for gathering lots of
information about the market that is widely dispersed. For
example, after Threadless receives submissions for T-shirt
designs it goes to a crowd of customers and designers and
asks for their vote on which T-shirt designs they like the
best. By using the crowd to choose the winners of the design
contests, Threadless is able to better predict which T-shirts
will sell. Threadless has developed an enviable track record
of having never produced a flop—every T-shirt it has ever
produced has sold out.39
Crowdinnovation refers to using the crowd to solve a
challenging problem that requires an innovative solution. For
example, Netflix offered a $1 million prize to the software
programmer(s) who could create an algorithm that would
provide the best recommendations on movies for specific
customers. Netflix provided a dataset of over 100 million movie
ratings from users to the crowd to analyze. In explaining why
Netflix chose to go this route, Netflix CEO Reed Hastings said
they wanted to get hundreds—if not thousands—of software
programmers to work on the algorithm. “You’re getting PhDs
[to work on your problem] for a dollar an hour,” says Hastings.40
Netflix got their best movie ranking algorithm from the BelKor
Pragmatic Chaos team—a group of software programmers
who worked on complex programming problems for AT&T
wireless.41 Crowd-innovation using contests works well when
it isn’t obvious what combination of skills or technologies will
lead to the best solution to a problem.
The bottom line is that new digital technologies have
turbocharged crowdsourcing as a way to outsource activities
to a crowd. And crowdsourcing has resulted in companies
outsourcing more activities than ever before.
DANGERS OF OUTSOURCING
In a similar vein, during the time period that General Motors made most of its own
automotive parts, its in-house suppliers were limited in their total volumes because GM’s
competitors would not buy parts from GM’s in-house parts suppliers. In fact, Ford had an
explicit policy prohibiting it. Outside suppliers can often produce at much greater scale
than in-house suppliers because in-house suppliers often have difficulty getting outside
customers.
DANGERS OF OUTSOURCING
While outsourcing has its advantages, it also has its dangers. There are two major dangers of outsourcing: a loss of capabilities (particularly the capability to innovate) and
a lack of control over critical assets or activities. Dell’s experience of outsourcing the
majority of components, supply chain management, and final assembly of its computers
is instructive. Although Dell’s outsourcing strategy lowered its asset base and increased
its profits in the short run, it also resulted in Dell having fewer capabilities to innovate
and create competitive advantage in the future. Dell’s market value soared to a high of
$103 billion in 2005, but at the beginning of 2012, Dell’s market value had dropped to $26
billion. One reason for Dell’s fall is the emergence of new, low-cost PC makers such as
ASUS—a competitor that Dell helped create (see Strategy in Practice: How to Prevent a
Subcontractor from Becoming a Competitor). However, and perhaps more importantly,
Dell has had a difficult time designing and building differentiated PCs, laptops, and tablets to compete effectively with Apple. More vertically integrated than Dell, Apple makes
much of the software that runs its products as well as some of the key components. By
having a larger portfolio of capabilities, Apple is better able to innovate and create new
products. Outsourcing can also be dangerous because it can lead to a loss of capabilities
to do new things.42
In addition to leading to a loss of innovation capabilities, outsourcing can lead to a loss of
control as suppliers that provide key inputs gain bargaining power. To illustrate, when IBM
first launched a micro-computer—the PC—it decided to outsource two of the key components of the computer: the microprocessor (to Intel) and the operating system (to Microsoft). The microprocessor was the single most expensive component of the PC, and the DOS
operating system was the software that users had to learn in order to navigate the computer.
IBM felt that if the PC turned out to be successful, it would eventually make its own microprocessors and create its own operating system.
As it turned out, IBM PCs were very successful, and so the company decided to make
its own microprocessors and operating systems. However, Intel launched the “Intel Inside”
campaign, telling customers that the microprocessor was the “heart” of the computer and
alerting customers to look for “Intel Inside.” As a result, IBM was not successful at getting customers to buy IBM PCs that didn’t have Intel chips in them. In fact, in the halls
of IBM’s headquarters, some of the executives were heard asking the question: “Who let
Intel Inside?”43 Many felt that IBM should have purchased Intel early on or should have
launched the first PC with an IBsM-built microprocessor because it was a key input that
they should have controlled. IBM had traded speed to market ( flexibility) for control of a
critical input.
In similar fashion, IBM decided that it no longer wanted to rely on Microsoft for the
operating system, so it launched its own OS/2 operating system and tried to get customers to switch. Microsoft responded with its Windows 3 operating system. IBM’s customers were so well acquainted with Microsoft’s operating system that they didn’t want to
switch to OS/2. IBM eventually abandoned OS/2 in 2004. At the end of the day, IBM had
outsourced the two key components that it later realized it wanted to control. Without making its own operating system or microprocessor, IBM had few options for differentiating its PCs. IBM eventually sold off its PC division to Chinese firm Lenovo in
2004. IBM and Dell’s experiences provide a cautionary tale for companies that choose to
outsource.
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S T R AT E GY I N P R A CT I C E
How to Prevent a Subcontractor from
Becoming a Competitor
C
ompanies that outsource face a substantial challenge.
They must make sure that they don’t end up creating
a competitor—which was essentially what Dell did by
outsourcing so much to ASUS. What steps can companies
take to prevent this from happening?
1. Build barriers to imitation. One of the most important
things a company can do to prevent a supplier from
becoming a competitor is to build barriers to imitation.
As described in Chapter 2, a barrier to entry prevents
new entrants from easily entering a particular industry.
A barrier to imitation is something that prevents other
companies from imitating what a particular company
can do.
To illustrate, Nike outsources the manufacturing of its
athletic shoes to subcontractors—so they know how
to make Nike-quality shoes. Why don’t these suppliers enter the athletic footwear business and compete
with Nike? The answer is that Nike has built a number
of barriers to imitation that make reproduction of their
footwear difficult. The first barrier is brand. Nike’s
brand is so well known that a no-name brand will have
a hard time competing, even if it is good quality. But
beyond that, Nike’s shoes go through annual design
changes. This means suppliers would soon be developing shoes using “old” design technology. Of course,
Nike also writes contracts with suppliers that prohibit
them from making shoes based on Nike’s designs or
intellectual property. These practices all make it difficult for suppliers to become a competitor to Nike.
2. Limit knowledge of the full product. Another way to stop
a supplier from becoming a competitor is by preventing
the supplier from knowing everything about making a
product. Some companies will outsource some of the
components of a product to suppliers but will manufacture one or more key components internally and
manage final assembly of the product internally. That
way, no one supplier has all of the knowledge necessary to easily produce a competing product.
3. Take an equity stake in the supplier. A final way to prevent a supplier from becoming a competitor—or from
becoming too powerful—is by taking an equity stake
in the supplier. For example, when IBM launched its
PC, back in the early 1980s, it could have looked at its
key suppliers—for example, Intel and Microsoft—and
decided to take an equity stake in those suppliers. If
IBM had taken an equity stake in Intel and Microsoft it
would have given them more control over their activities. Moreover, IBM would have at least been rewarded
for helping Intel and Microsoft grow and become
powerful suppliers in the industry. Imagine how much
more successful IBM would be today if it had only
thought to take a 40 percent equity stake in Intel and
Microsoft—something it could have easily done when it
launched the first IBM PC.
SUMMARY
ì Vertical integration is defined as a decision of whether to conduct an activity internally
within the firm (make) or outsource it to an outside supplier (buy).
ì Companies choose to conduct an activity within the firm and use the 3-C framework as a
way to evaluate whether it makes sense to make versus buy.
ì Firms want to conduct an activity internally if they think they have, or can develop, the
capabilities necessary to be among the best in the world at conducting that activity.
Firms also choose to conduct an activity internally if they believe it will help them better
Strategic Alliances
08
imago stock&people / Newsco
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1
Differentiate among strategic alliances, vertical integration, and
arm’s-length supplier relationships.
2
Explain the different types of strategic alliances, how they are
governed and the conditions under which each type is preferred.
3
Describe the different ways value is created in alliances.
4
Discuss the two potential dangers of strategic alliances and
three ways that firms can protect themselves against these
dangers.
5
Describe the importance of building an alliance management
capability.
[ 147 ]
08
Tokyo Disneyland
form a strategic alliance and make the Tokyo Disney dream
a reality. OL had what Disney did not: 115 acres of open real
estate on the outskirts of Tokyo, financial resources, and
knowledge of Japanese and Asian culture that could make
the venture a success. Disney had its brand, park design and
management capabilities, and a host of movie characters
that people would pay just to stand next to and snap a photo
as outlined in Table 8.1.
A Disney resort in Japan seemed to make sense, given
that Japanese tourists flocked to Disneyland in the United
States. Furthermore, since there are almost no imports or
exports between foreign markets in the leisure industry,
there would be none of the negative side effects typically
associated with Japanese-American licensing agreements.
But there were still risks involved. Would Japanese and
other Asians want to go to a Disneyland that wasn’t in
America? Would a
DESPITE ALL APPEARANCES, THE INTERESTING THING ABOUT TOKYO DISNEYLAND IS THAT
theme park work in
THE WALT DISNEY COMPANY IS NOT INVOLVED IN THE DAY-TO-DAY OPERATIONS OF THE
Tokyo’s cold, humid,
PARK. IT SIMPLY COLLECTS A LICENSING FEE FROM ORIENTAL LANDS COMPANY (OL), A
rainy climate?
Disney’s two U.S.
JAPANESE REAL ESTATE FIRM.
parks in Florida and
southern California were both “vacation destination” parks
collects a licensing fee from Oriental Lands Company (OL), a
with warm weather.
Japanese real estate firm that financed, built, and runs both
Moreover, back in the late 1970s, Disney was hurting
Tokyo Disneyland and its neighboring park, Tokyo DisneySea.
financially. It didn’t have the capital to make the investment
Walt Disney and Oriental Lands came together in 1979 to
E
xcited tourists who enter Tokyo Disneyland are
immediately transported into a uniquely American
dream world. Nearly everything at Tokyo Disneyland is
a replica of the original Disneyland in Anaheim, California,
from Sleeping Beauty’s castle to Disneyland’s famous
“Main Street” attraction. Signs are printed in English, with
only small Japanese subtitles. When the park opened
in 1984, only 2 of its 27 restaurants even sold Japanese
foods.1 Instead, visitors snacked on hot dogs, popcorn,
and “spaceburgers” between rides. The only observable
Japanese touch is an enormous roof-covering over Main
Street, a symbol reminding visitors that they truly are in
Japan, rainy season included.
Despite all appearances, the interesting thing about
Tokyo Disneyland is that the Walt Disney Company is not
involved in the day-to-day operations of the park. It simply
[ Table 8.1 ] Disney-Oriental Land Co. Alliance
Disney Resources and Capabilities
OLC Resources and Capabilities
ì Disney brand
ì Land for the park near Tokyo
ì Disney theme park rides and designs
ì Financial resources to build the park
ì Park management processes
ì Relationships with construction firms to build the park
ì Ongoing stream of Disney characters from movies
ì Knowledge of Japanese culture and how to
manage Japanese workers
ì Disney consumer products to sell at the park
[ 148 ]
WHAT IS A STRATEGIC ALLIANCE?
needed to build a park in Japan. Disney received more
than 20 offers from Japanese firms vying for the chance
to become its partner in building and running the park. So
Disney did its due diligence of potential partners in Japan
and eventually decided that OL would be the best partner.
Forming the partnership was not necessarily a walk in
the park. Negotiating a satisfactory partnership agreement
required that both sides overcome cultural barriers and
major disagreements. OL wanted Disney to contribute funds
to build the park, but Disney refused to contribute in any way
toward the initial investment. Disney also required a 50-year
contract, a time commitment that frightened OL when there
remained so many unknowns. Moreover, Disney demanded
a high licensing fee of 10 percent of all gross revenues; OL
wanted to pay 5 percent. OL initially called Disney’s terms
a “servile agreement,”2 and it took more than 4 years of
negotiating for the two to reach common ground in 1979.
[ 149 ]
In the end, Disney paid a sum of less than 1 percent of the
initial investment and received a license fee of 10 percent
of gate receipts, but did lower its license fee to 5 percent on
nongate receipt sales.3
Despite the difficult negotiations, Tokyo Disneyland has
been a smashing success. Even though it had to pay high
interest costs from the $1.53 billion upfront investment
required to build the park, as well the average 7.5 percent
license fee to Disney, OL was able to make the project
profitable in just four years after the park opened in 1983.
The firms continued their partnership, working together
to build Tokyo DisneySea in 2001.Together with Tokyo
Disneyland and a number of Disney-branded hotels, the
two parks make up the Tokyo Disney Resort. Disney’s
Imagineering unit continues to design and develop new
theme concepts and attractions for the parks. OL, in turn,
markets and operates the entire Tokyo Disney Resort.
ì
All in all, Disney’s support through providing its image, know-how, and design skills has
been invaluable, and Oriental Land’s management and execution is unparalleled by Disney’s
other international partnerships. The Tokyo Disney Resort has received more than a half
billion total visitors since Tokyo Disneyland opened in 1983, with more visitors each year
than either of Disney’s U.S. parks. The annual number of visitors has never dropped below 10
million, and it reached a high of 17 million visitors in 1997. OL, which runs few destinations
other than the Tokyo Disney parks, is now ranked as the second-largest tourism-leisure firm
in the world, just behind Disney itself.4 In one recent year, Tokyo Disney Resort generated
revenues of approximately U.S.$4.15 billion. That translated to about U.S.$690 million in
operating profits for OL. Disney received about $300 million from its licensing fees, a sum
that is basically pure profits for Disney, since it has negligible costs associated with Tokyo
Disneyland and no investment in assets.
There are currently no plans for a third park in Japan, but Disney has confirmed that if
another park was planned, Disney would be happy to work with Oriental Lands to make it
a success.5
WHAT IS A STRATEGIC ALLIANCE?
The Walt Disney–Oriental Land Company alliance illustrates how strategic alliances can
be a vehicle for achieving important strategic objectives—such as lowering costs, creating
new sources of differentiation or entering new markets. A strategic alliance—sometimes
referred to as a partnership between firms—is a cooperative arrangement in which two or
more firms combine their resources and capabilities to create new value.6 Strategy scholars
sometimes refer to these types of arrangements, in which firms cooperate to create competitive advantage through their collaboration, as cooperative strategy or a relational advantage.7
Strategic alliances have grown dramatically in importance over the past 25 years. Strategic alliances accounted for only about 5 percent of the revenues of Fortune 1000 companies
back in 1980, but by 2010 it is estimated that they accounted for almost one-third of the
revenues of Fortune 1000 companies. In Walt Disney’s case, Tokyo Disneyland contributed
almost 20 percent of Disney’s total theme park profits in 2011.8
Today, many companies are increasingly using alliances to achieve strategic objectives.
The basic logic for alliances can be summed up in the adage, “Two heads are better than
strategic alliance A cooperative
arrangement in which two or more
firms combine their resources
and capabilities to create new
value, sometimes referred to as a
partnership.
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CH08
ì STRATEGIC ALLIANCES
one.” Sometimes it just makes sense to combine the resources and capabilities of two companies to solve certain problems or achieve particular objectives.
Companies may choose to cooperate at any stage along the value chain, from research
and development to manufacturing to the marketing, sales, or service of products or services. For example, BMW and Toyota are doing R&D together to develop new fuel-cell technology to increase fuel efficiency.9 Intel and Micron have teamed up to manufacture flash
memory together.10 Target and Neiman Marcus have partnered to sell affordable luxury
brands.11 In these instances, firms collaborate to improve their performance at common
stages of the value chain. In other instances, a firm may team up with a firm at a different
stage of the value chain. For example, Apple and AT&T teamed up to sell the iPhone—Apple
provided the phones and AT&T provided the cellular network.12 Although there are different ways to categorize alliances, perhaps the most common way to distinguish one type of
alliance from another is by the mechanism used to govern the alliance. We explain these
different types of alliances in the next section.
Choosing an Alliance
Companies have three choices—summarized as make, buy, or ally—when it comes to
conducting any particular activity that needs to be done to offer a product or service to a
customer.
ì First, they can make, or conduct the activity themselves within the firm.
ì Second, they can buy, or purchase, the activity or input from another firm, using an
“arm’s-length relationship,” in which the buyer purchases an input with no obligation
to have a long-term relationship with the supplier. Companies that send out a “bid” to
numerous suppliers and then buy from the supplier that offers the lowest price have an
arm’s-length relationship with those suppliers. The winner of the bid this month may
lose next month.
ì Finally, they can ally, or acquire, the activity or input from another firm, using an exclusive partnership relationship with that firm.
As discussed in Chapter 7, companies want to conduct those activities internally that are
most important to delivering the unique value they hope to offer. Disney prefers to create
its own stories and characters for its movies, make its own movies, and run its own stores.
These activities are most important to its success with customers and therefore it wants to
have control over those activities.
However, companies can’t do everything, so they buy many inputs from other companies
using an arm’s-length relationship. Arm’s-length relationships work just fine for purchasing
commodities, inputs that aren’t differentiated on anything but price. For example, Disney
doesn’t have a partnership with suppliers that provide fabric for its character’s costumes or
hot dogs and buns for its theme park restaurants. It can purchase those inputs from whatever supplier offers the lower price. Similarly, automakers need to purchase basic inputs like
fasteners such as nuts and bolts from suppliers to put their cars together, but they usually
don’t have a partnership with those suppliers.
Other inputs or activities require a partnership, a long-term relationship in which both
parties work closely to create new value together. Four kinds of inputs and activities might
qualify as “strategic” inputs that merit forming an alliance relationship.
1. Inputs that can differentiate your product in the minds of customers. Automakers are
much more likely to want to partner with a supplier that provides important engine
or drivetrain components that influence engine performance or reliability than one
that provides fasteners. For example, truck manufacturers often partner with Cummins, a respected maker of truck engines and components, in the manufacture of
their trucks.
2. Inputs that influence your brand or reputation. Volvo, a Swedish manufacturer of cars
and trucks, has tried to develop a reputation on the safety of its cars. Consequently,
it has worked closely with key suppliers, including Autoliv, a Swedish supplier of seat
belts and airbags, to put pioneering safety technology into its vehicles.
WHAT IS A STRATEGIC ALLIANCE?
[ 151 ]
S T R AT E GY I N P R A CT I C E
Walt Disney and Oriental Land: Why Ally?
O
ne might reasonably ask why Disney didn’t just build
Tokyo Disneyland on its own. Disney obviously knew how
to run a theme park. It owned and operated two theme parks
in the United States without the involvement of a partner.
Disney could have captured the $690 million that went to the
Oriental Land Company in a recent year, as well as the $300
million it did get. Why share the profits with a partner?
The first question that Disney certainly must have asked
with regard to Tokyo Disneyland was whether it could “make”
another park: Do we have the resources and capabilities
to build Tokyo Disneyland on our own? The answer to that
question was not entirely straightforward. Building a theme
park in a new, foreign environment came with a host of risks.
Tokyo is not a warm-weather “vacation destination,” like
California or Florida. Disney had absolutely no experience in
hiring, training, and managing a Japanese workforce. Would
Oriental Land Company have sold Disney the 115 acres of
land required for the park? If so, at what price? Did Disney
have the $2.0 billion investment required to buy the land and
build the park? If it chose to make the investment in Japan,
what other opportunities would it have to forgo? Finally, and
maybe most importantly, how confident was Disney that
Tokyo Disneyland would succeed?
When companies face an opportunity that comes with
risks, they may look to a partner to share or mitigate the
risks. In this particular case, Disney solved most of its
problems by partnering with OL. OL provided high-value
resources; it owned the land and took virtually all of the
investment risk. Disney didn’t have to risk much capital
investment and was able to deploy its capital elsewhere. OL
runs the park, so Disney didn’t have to learn how to manage
a Japanese workforce. Disney gets 10 percent return on gate
receipts regardless of the profitability of the park. The two
companies are able to share ideas on how to best localize
the Disneyland park within the Japanese environment.
In the end, the park proved successful, and both OL and
Disney received value from the partnership. It is possible
that Disney might have been just as successful if it had
built and run the park on its own. But it’s also possible
that, without OL as a partner, Disney might have made
different decisions about how to build or run the park
that would have hurt performance. Indeed, when Disney
built EuroDisney, located outside of Paris, it experienced
a host of problems and the park struggled for years.13 In
particular, Disney didn’t take into account important local
preferences like serving wine with meals in the park,
and the marketing was described as “too Americanized”
and not tailored to the needs of customers in individual
European countries.14 The alliance with OL clearly
mitigated many of the risks associated with the venture,
and OL’s resources and capabilities likely increased the
probability of success.
3. High value inputs or activities that make up a high percentage of your total costs. Companies that make refrigerators are more likely to partner with the supplier who provides
the compressor—the component that costs the most and cools the refrigerator—than
with the suppliers of plastic trays or fixtures.
4. Inputs or activities that require significant coordination in order to achieve the desired fit,
quality, or performance. Whenever you need to coordinate closely with another firm
to get the desired performance from their input or activity, you probably want a partnership relationship. For example, automakers must typically work closely with the
supplier that provides the HVAC system (heating, ventilation, and air conditioning)
for a vehicle, because the supplier must know the geometric constraints in the dashboard, as well as where to run the lines to the vents throughout the car, and because
the HVAC system influences, and is influenced by, the catalytic converter and other
engine components.
The Strategy in Practice feature explores the factors that helped Disney make the “make,
buy, or ally” decision about Tokyo Disneyland.
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ì STRATEGIC ALLIANCES
TYPES OF ALLIANCES
As Figure 8.1 shows, there are three basic types of alliances. Each is governed in a different
way, in order to split the gains from the alliance and protect each partner’s interests.
Nonequity or Contractual Alliance
contractual or nonequity
alliance Two or more firms
write a contract to govern their
relationship. There is ownership
shared between the companies.
The first type is a contractual or nonequity alliance, in which two or more firms write a
contract to govern their relationship.15 The contract specifies what each party is to do in the
alliance—and what each party should receive if it fulfills its duty in the alliance. For example,
when Disney wants to promote the characters from a new movie, it will often create promotional materials such as figurines or games and partner with McDonalds to put them into
Happy Meals for kids. Then Disney and McDonalds jointly pay for TV commercials to advertise the movie and the Happy Meal promotional materials. Combining meals and toys creates value for both Disney and McDonalds, who create a contract to govern the relationship.
Different types of nonequity alliances include:
ì Licensing agreements, in which one firm receives a license, or permission to use a
resource, such as a brand or a patent, from another firm in return for a percentage of
the revenues or profits16
ì Supply agreements, in which a supplier may agree to develop certain customized inputs
for a customer
ì Distribution agreements, in which a distributor or retailer may agree to provide certain
customized services in order to help sell a product17
As the name nonequity alliance suggests, companies do not take equity positions in each
other. They also do not form a joint venture. Companies tend to choose nonequity alliances
when it is easy to specify what each party is supposed to do in the relationship, as well as
the rewards that should come from meeting those obligations. Nonequity alliances tend to
be less complex and to require less interdependence and coordination between the companies than alliances that involve equity. When an alliance requires the joint creation of new
resources and capabilities by the partners, companies often tend to opt for equity alliances
or joint ventures.
[ Figure 8.1 ] Types of Strategic Alliances
Types of Strategic Alliances
Contractual Alliance
Equity Alliance
Joint Venture
Cooperation between firms
is managed directly through
contracts, without crossequity holdings or an
independent firm being
created.
Cooperative contracts are
supplemented by equity
investments by one partner
in the other partner.
Sometimes these equity
investments are
reciprocated.
Cooperating firms combine
resources to form an
independent firm in which
they invest. Profits from this
independent firm
compensate partners for
this investment.
Preferred When:
& Interdependence
between partners is
low (e.g., pooled)
& It is easy to measure
the contributions of
each partner and write
it in a contract.
& Interdependence between & Interdependence
between firms is very high
firms is moderate (e.g.,
(e.g., reciprocal).
sequential).
& Firms bring knowledge or & Firms bring knowledge or
difficult-to-measure
difficult-to-measure
contributions that must
contributions but each can
be combined into a single
perform their roles
organization to coordinate
separately.
effectively.
TYPES OF ALLIANCES
[ 153 ]
Equity Alliance
In an equity alliance, the collaborating firms often supplement contracts with equity holdings in their alliance partners.18 For example, Toyota owns between 5 and 49 percent of the
equity of its 10 largest Japanese suppliers, who all work very closely with Toyota in the development and production of its automobiles.19 The fact that Toyota owns some equity in these
suppliers aligns their incentives with Toyota’s needs and encourages the suppliers to make
investments that benefit Toyota. For example, Toyota’s equity investments encourage its
suppliers to locate their manufacturing plants next to Toyota’s assembly plants to reduce
the costs of shipping and inventory.
In situations where the parties to an alliance need incentives to bring their best resources
to the alliance, equity is often preferred to contracts as a way to align the incentives of partners. For example, many large pharmaceutical companies, such as Eli Lilly, Merck, and Pfizer
own equity positions in start-up biotechnology companies. The large pharmaceutical firms’
equity positions give them the option to be part owners of new biotechnology drugs the
start-ups develop. This option of owning a stake of a potentially profitable new drug creates
incentives for companies such as Eli Lilly to provide financial resources to help develop a
drug, as well any other support that may increase its probability of success. For instance, if a
new drug looks promising, Lilly will use its sales force and distribution channels to sell the
new drug around the world.20
equity alliance The collaborating
firms in an alliance supplement
contract with equity holdings in
their alliance partners.
Joint Venture
The final form of alliance, a joint venture, is an alliance in which collaborating firms create
and jointly own a legally independent company. The new company is created from resources
and assets contributed by the “parent” firms.21 The “parent” firms jointly exercise control
over the new venture and consequently share revenues, expenses, and profits.
Joint ventures are preferred when firms need to combine their resources and capabilities in order to create a competitive advantage that is substantially different from any
they possess individually. For example, Intel makes microprocessors and Micron makes
advanced semiconductors, but both companies saw an opportunity in flash memory, the
type of memory used in flash drives and increasingly used in mobile devices such as MP3
players and smart phones. Both companies had some relevant skills and assets, so they
decided to each put in $1.2 billion in cash and assets and create IM Flash, a new company
jointly owned by Intel and Micron.22 The new company focused on the flash memory
market and didn’t deflect the attention of Intel and Micron from their core businesses.
In similar fashion, when GM wanted to enter the Chinese market, it teamed up with
SAIC, a Shanghai-based automobile company, to create Shanghai-GM, a joint venture that
brings together GM’s expertise and technology for making cars with Shanghai’s knowledge
of the Chinese market and experience managing a Chinese workforce.23
Typically, partners in a joint venture own equal percentages and contribute equally to the
venture’s operations, as was the case with IM Flash. However, in some cases one party might
bring more resources to the venture, which will lead to a higher equity stake. Moreover, over
time, a firm’s priorities may change, which can lead to one partner purchasing the equity
stake of the partner. For example, in 2012 Intel decided that IM Flash was less of a priority so
it sold $600 million of its stake in the company to Micron.24 Many joint ventures end with one
partner selling some or its entire ownership stake in the joint venture to the other partner.
joint venture An alliance in which
collaborating firms create and
jointly own a legally independent
company.
Vertical and Horizontal Alliances
In addition to distinguishing alliances by the type of governance arrangement (e.g., nonequity, equity, joint venture), alliances are sometimes categorized as either vertical alliances or
horizontal alliances.
A vertical alliance is an alliance between firms who are positioned at different stages
along the value chain, such as a supplier and a buyer.25 Toyota’s relationships with its top 10
suppliers are considered vertical alliances—the output of one of the firms in the relationship
is the input of the other. Vertical alliances are usually formed to combine unique resources,
create new alliance-specific resources, or lower transaction costs between two companies
vertical alliance An alliance
between firms who are positioned
at different stages along the value
chain, such as a supplier and a
buyer.
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ì STRATEGIC ALLIANCES
S T R AT E GY I N P R A CT I C E
Bose: Working with Suppliers in Vertical Alliances
B
chase orders, monitoring materials requirements, and
assisting with manufacturing planning. Bose interviews
and approves the “in-plant rep” and essentially treats
the rep as a Bose employee—the “in-plant” has access
to Bose facilities, personnel, and computer systems,
and even gets a performance review.
ose Corporation, known for its sound systems and
pioneering innovations in acoustic technology, has
also been a pioneer in establishing what it calls “JIT II
Partnerships” with some of its suppliers. A JIT II partnership
(named after Toyota’s Just-In-Time delivery practice with
suppliers) is a relationship with a supplier that involves the
following characteristics:26
ì Bose selects a supplier that it believes has the best
capabilities to meet its needs and agrees to give that
supplier all of its business.
ì The supplier must give Bose its best pricing on products. Bose can bid a product on the market if it doesn’t
think it is getting the best prices.
ì Bose gives the supplier an “evergreen” contract, meaning that as long as the supplier performs according to
expectations, the contract rolls over for another year.
ì The supplier agrees to provide at least one “in-plant
representative” who will work at Bose for 30 to 40
hours per week. This person replaces the Bose buyer
and production planner and essentially works for Bose
procurement and logistics. Duties involve placing pur-
Lance Dixon, Bose director of procurement and logistics,
initiated JIT II partnerships when he realized that by working
more closely with key suppliers, both Bose and the suppliers
could reduce costs. Says Dixon, “Suppliers are normally
outside of your company trying to see through the window
into what you are doing. We open the door and let them in to
do the work together.”27
G&F industries, a Bose supplier of plastic components for
Bose Speakers, has been a JIT II supplier for 20 years. G&F’s
“in-plant rep” Chris Labonte says that working inside Bose
every day gives him the information he needs to help G&F
better meet Bose’s needs. “Being here onsite at Bose allows
me to get the right jobs running at the right times with the
right quantities,” says Labonte, “It’s a real positive, open,
trusting, and nonadversarial, yet direct, relationship.”28
How JIT II Partnerships Create Value at Bose Corp.
BOSE ORGANIZATION
Traditional
Process
Bose
Design
Engineer
Bose
Materials
Planner
SUPPLIER ORGANIZATION
Bose
Buyer
Bose
Production
Planner
JIT II
Partnership
Process
Bose
Design
Engineer
Bose
Production
Planner
Supplier
“In-plant”
Representative
Supplier
Salesperson
Supplier
Production
and
Engineering
Personnel
Supplier
Production and
Engineering
Personnel
“The major advantage isn’t having a customer rep. at our location -- rather it’s that the
customer rep is ‘empowered’ to use our system-thereby replacing the planner, buyer and
salesman.”
Sherwin Greenblatt, President, Boss Corp.
JIT partnerships have lowered Bose’s administrative costs
by more than 20 percent. Bose simply doesn’t have to hire
as many people, because its supplier partners do the work
that employees previously did. Bose claims it also reduced
inventory and logistics costs by more than 25 percent as
a result of its JIT II partnerships, due to better planning
and increased supplier efficiency, with suppliers delivering
components exactly when Bose needs them. Suppliers
enjoy having a partnership with Bose because they have
guaranteed sales and they can plan more effectively for their
own production runs. Both Bose and its partner suppliers are
better off, which is the primary goal of an effective partnership.
WAYS TO CREATE VALUE IN ALLIANCES
who are already transacting. The Strategy in Practice feature describes the details of how
Bose handles vertical alliances with its suppliers.
In contrast, a horizontal alliance is between two firms that do not have a supplier-buyer
relationship and are typically positioned at a common stage of the value chain (e.g., competitors). The Shanghai-GM partnership is a horizontal alliance. The partners conduct activities at a common stage along the value chain, which means they conduct similar activities
internally. In this case, both of them manufacture automobiles. Horizontal alliances can also
occur between companies who don’t do the same activities but do complementary ones,
such as Electronic Arts developing games for the Sony PlayStation. Horizontal alliances are
often created to pool similar resources, or to combine complementary knowledge. We discuss these different ways to create value in alliances in the next section.
WAYS TO CREATE VALUE IN ALLIANCES
Alliances are a vehicle that allows a company to access the resources and capabilities of
another firm in order to create value by either lowering its costs or differentiating its offerings.
How can managers determine if accessing the resources and capabilities of a partner really
will help their company create value? Alliances create value if they do any these four things:29
1. Combine unique resources
2. Pool similar resources
3. Create new alliance-specific resources
4. Lower transaction costs
We will examine each of these different ways to create value in partnerships, in turn, but it
is worth noting that these are not mutually exclusive ways for creating value in an alliance.
Alliance partners may use several of these ways of creating value in a single alliance.
Combine Unique Resources
The first way that firms create value through an alliance is by combining unique resources to
create an even more powerful offering. This is what Pixar and Disney did to dominate computer-animated films.30 As described in Chapter 3, Pixar contributed computer-generated
animation (CGA) and story-writing skills that brought to life unique stories in films such as
Toy Story, Finding Nemo, Cars, and The Incredibles. Disney contributed worldwide film distribution to the partnership and sold products involving Pixar’s movie characters—such as
Woody and Buzz Lightyear—at its Disney stores and theme parks. No other film distributor
could bring to Pixar stores or theme parks like Disney’s that could be used to make money
off of memorable movie characters. By combining their unique resources, Pixar and Disney
created synergy that increased profits for both firms. In fact, Disney eventually acquired
Pixar in order to gain full control over Pixar’s unique resources.31
In similar fashion, Target decided to team up first with high-end designer Missoni, and
later with Neiman Marcus, in contractual alliances to bring high-end fashion to the masses.
Target had long been playing a unique tune among box-store discounters, differentiating
itself from Walmart as a place for the younger generation to get affordable fashion. It hoped
that partnerships with designers could boost the image of “Tar-zhay,” as more upscale consumers like to call Target. When first teamed with Missoni in 2011 to offer a line of Missonidesigned products through its 1,700-plus stores,32 the demand for Missoni products at Target
quickly swept up every available item, leaving many customers disappointed that they had
missed out. The sheer volume of traffic online caused the Target website to crash for nearly a
whole day.33 This led to a similar partnership with high-end retailer Neiman Marcus in July of
2012—with the idea to bring a larger number of designers to the masses through Target. Target brought size, scale, and distribution to these partnership relationships, and Missoni and
Neiman Marcus brought a chic factor that Target simply could not replicate on its own.34
Companies typically combine unique resources to create new products, enter new
markets, or to avoid the costs of entering different stages of the value chain. For example,
[ 155 ]
horizontal alliance An alliance
between two firms that do not
have a supplier-buyer relationship
and are typically positioned at a
common stage of the value chain.
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S T R AT E GY I N P R A CT I C E
General Motors’ Learning Alliance with Toyota
I
n the early 1980s, General Motors was being trounced
in the small car marketplace by Toyota. Toyota had
pioneered the “Toyota Production System,” also called lean
manufacturing. Unlike the mass production techniques
used by General Motors, the Toyota Production System was
particularly good for small production runs and building
multiple models in the same plant. GM wanted to learn more
about the Toyota Production System so it could build small
cars more profitably. But what would entice Toyota to share
this knowledge with GM?
As it turns out, in the early 1980s, the U.S. government
started to put quotas on automobiles imported from Japan.
This meant that Toyota could only sell a limited number of
vehicles in the United States. If it wanted to sell more, it would
have to manufacture cars in the United States. Toyota had
never tried to build cars with American workers, and it wasn’t
sure how well its production system would work in the United
States. So it agreed to form an alliance with GM—called New
United Motor Manufacturing, Inc. (NUMMI)—to manufacture
small cars for GM and Toyota in the United States. GM had
an idle plant in Fremont, California, that it brought to the
alliance, as well as many automobile workers and managers.
Toyota agreed to take full responsibility for the manufacturing
process, including using former GM employees to install and
operate the Toyota Production System.
The alliance lasted more than 25 years. GM learned
manufacturing processes that it took to its other plants, and
Toyota learned the practices involved in managing a U.S.
workforce, which it took to four plants that it subsequently
built in the United States.
Pixar decided not to invest in movie distribution, instead relying on the distribution resources
and capabilities that Disney had already built.
Sometimes, the unique resources that the partners combine are intangible resources in
the form of knowledge. Such “learning alliances” are increasingly popular. The goal is for
each alliance partner to learn something that it believes will be a valuable addition to its
capabilities in the future. The Strategy in Practice feature describes one early example of a
learning alliance.
In a similar fashion, when Visa wanted to learn about how to bring financial literacy,
and credit cards, to a younger crowd, it turned to an unlikely partner—Marvel Comics. Visa
and Marvel jointly developed a unique comic book addressing money-management issues,
starring Marvel characters The Avengers and Spiderman. Imagine Spiderman and Hulk discussing different options for financing Spiderman’s new big-screen TV! That will grab the
attention of teenagers. Through the partnership, Marvel learned to use its comic books for
educational purposes, and Visa learned about a unique way to educate potential customers. This was a case where both partners also brought unique resources to the relationship.
Pool Similar Resources
A second way that alliances create value is by pooling similar resources to achieve economies of scale that neither firm could achieve on its own. For example, as described earlier,
Intel and Micron wanted to get into manufacturing flash memory—a business that required
billions of dollars of investment in plant and equipment. So they decided to create IMFlash,
a joint venture designed to produce flash memory products. By splitting the cost of the plant
and equipment, the two companies were able to build a much larger plant and, through
economies of scale, produce flash memory at a lower cost per unit.35 This value didn’t necessarily require combining unique resources, just the pooling of total resources to achieve
economies of scale in the R&D and production of flash memory.
In addition to achieving economies of scale, another reason firms pool similar resources
is to share the risks associated with conducting a particular activity. BP and Statoil formed
a joint venture, pooling their financial resources and knowledge to share the expense
and lower the risks associated with costly international oil exploration and production
WAYS TO CREATE VALUE IN ALLIANCES
activities.36 By sharing the costs of the drilling equipment and the other fixed assets, the two
firms were each able to lower their fixed costs per barrel of oil.
Create New, Alliance-Specific Resources
A third way alliances create value is by creating new, alliance-specific resources. Alliancespecific resources are those that are created specifically to help the partners achieve the
alliance objectives. Alliance-specific resources can be owned by one partner, or jointly held.
Firms typically create alliance-specific resources to increase the efficiency of doing business
together or to expand the available resources of all the partners.
The alliance between Toyota Boshoku and Toyota is an example of building new
resources in order to improve efficiency, the ability of the partners to coordinate their joint
work. Toyota Boshoku, which supplies automobile seats to Toyota, built its factory next
door to Toyota’s assembly factory.37 Because seats are bulky and costly to ship, building the
plant nearby lowered Toyota Boshoku’s costs of inventory and shipping to Toyota. Then,
to further reduce shipping costs, Boshoku decided to build a conveyer belt to take seats
directly from its factory into Toyota’s. The factory plant and the conveyor belt were both new
resources that were created to support Boshoku’s transactions with Toyota. These investments substantially lowered transportation costs, inventory costs, and the costs associated
with having face-to-face meetings. In comparison, General Motors does not have alliance
relationships with its seat suppliers. As a result, the suppliers have not built their factories
nearby. Not surprisingly, GM and its seat suppliers had higher inventory and transportation
costs, which give Toyota and Boshoku a cost advantage over GM and its suppliers.38
Visa represents an example of alliance partners creating a jointly held alliance-specific
resource that could expand the resources available to all the partners. In the 1970s, Bank
of America and a group of other financial institutions decided to form a joint venture company with the purpose of building a credit card business. Credit cards were new at the time,
and the banks were hoping to get customers to widely use them. The new joint venture
company was named “Visa,” and the company then built the Visa brand with customers
through marketing and advertising. The Visa brand was perhaps the most valuable resource
created through the alliance, because it allowed member banks to issue credit cards that
were immediately recognizable to customers. Over time, many other banks and financial
institutions wanted the benefits of issuing a Visa credit card, so they joined the private
membership association that owned Visa. Visa finally became a public company in 2007,
but its primary owners are still the banks that were part of the original private membership
association that established Visa.39
Lower Transaction Costs
A fourth way that alliances create value is by lowering transaction costs. Alliances that
create value through lower transaction costs are primarily trying to increase efficiency and
lower the costs between transactors in the value chain: buyers and suppliers.
By transaction costs, we mean all of the costs associated with making a transaction
happen.40 In most companies, purchasing personnel, sales personnel, and attorneys have
primary responsibility to find and negotiate agreements with suppliers of inputs and buyers of outputs. If alliance partners can create relationships with suppliers or buyers based
on mutual trust, then they don’t have to employ as many purchasing or sales personnel.
They also don’t have to employ as many lawyers to write costly contracts to protect their
interests.41
One study of Toyota and General Motors found that Toyota’s procurement and legal costs
were half those of General Motors. 42 The study concluded that General Motors and its suppliers had higher transaction costs because they didn’t trust each other; so they spent a lot
of time negotiating agreements and writing legal contracts. In contrast, Toyota had developed relationships with its supplier partners that were based on mutual trust. One thing
that Toyota did to build trusting relationships with some suppliers was to purchase a minority stock ownership stake in the supplier. Because Toyota owned part of the suppliers’ stock,
suppliers felt that Toyota would behave in a trustworthy manner.
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THE RISKS OF ALLIANCES
The issue of protecting one’s interest in an alliance is real—alliances are not without risks.43
When a company agrees to an alliance, it loses some of its independence. It must rely on its
partner to produce and perform as expected. Just as there are incentives to cooperate in alliances, there are also incentives for companies to act opportunistically, to take advantage of
a partner if the situation presents itself. So managers need to be aware of the two major ways
that a partner can take advantage of one another in an alliance: hold-up and misrepresentation. (You can remember these two forms of opportunism as H&M.)
Hold-Up
hold-up When one partner tries
to exploit the alliance-specific
investments made by another
partner.
Hold-up occurs when one partner tries to exploit the alliance-specific investments made
by another partner.44 In the case where Toyota Boshoku built its factory next to Toyota’s, this
created an opportunity for Toyota to “hold-up” Boshoku by opportunistically renegotiating
lower prices after Boshuku made the investment. Once Toyota Boshoku built its factory
next door to Toyota, it was highly committed to Toyota; its investments could not be easily
redeployed to serve other customers. It was important for Boshuku to make sure that Toyota
would be trustworthy and not try to negotiate lower prices after Boshoku built its factory
next door. So it created an equity alliance with Toyota, in which Toyota owned 49 percent of
Toyota Boshoku’s stock.45
Managers must be aware that whenever they make investments in equipment, facilities,
or processes that are customized to a partner—and therefore not easily redeployable to
other uses—there is the potential for the partner to hold up their company.
Misrepresentation
misrepresentation When one
partner in an alliance creates false
expectations about the resources it
brings to the relationship or fails to
deliver what it originally promised.
Misrepresentation occurs when one partner in an alliance creates false expectations about
the resources it brings to the relationship or fails to deliver what it originally promised.46
For example, suppose a start-up biotechnology company is developing a new drug to fight
Alzheimer’s disease. It needs additional resources to conduct clinical trials in order to get
approval for this new drug. To convince a pharmaceutical company to provide the necessary
resources, the biotech start-up could misrepresent how far along the drug is in the development pipeline. Or it could overstate the effectiveness of the drug in initial clinical trials.
A company that considers entering into an alliance with a firm that brings intangible
resources to an alliance—such as local market knowledge or relationships with key political
figures—needs to research its partner thoroughly to guard against this form of opportunism.
Ultimately, however, misrepresentation is a hazard that firms faces when doing business
with others of questionable moral character. The only true way to protect against misrepresentation is to partner with trustworthy individuals and firms.
Building Trust to Lower the Risks of Alliances
The bottom line is that, while alliances have the potential to create value, they are also
fraught with challenges and risks. Alliances cause independent firms to become interdependent, which means they must work effectively together to succeed. This may explain
why some studies of alliances have found that trust between partners is the most important
ingredient for alliance success. Next we examine four ways that companies attempt to protect themselves from opportunism and build trust with their alliance partners.
Personal Trust. The first way to prevent against opportunism by a partner is to only initiate
partnerships with people who you know to be trustworthy. These would likely be individuals
you have known for a long time, such as family, friends, classmates, or others within your
THE RISKS OF ALLIANCES
ETHICS
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A N D S T R AT E GY
The Blame Game in Strategic Alliances
O
n April 20, 2010, disaster struck on a BP oil rig in
the Gulf of Mexico. An explosion claimed 11 lives and
resulted in a sea-floor gusher that flowed for 87 days—
spilling 210 million gallons of oil into the Gulf. BP took
a thrashing in the press and agreed to a record setting
fine of $4.5 billion. But not long after agreeing to the fine,
BP decided to go on the offensive with multibillion-dollar
lawsuits seeking to shift the blame to its partners—
Transocean, owner of the ill-fated rig, and Halliburton,
the company that supplied the cement that didn’t hold.
BP sued rig-owner Transocean for more than $40 billion
because of failures in the rig’s safety system. That’s a
remarkable figure because it comes close to what BP
estimates will be its entire liability for paying claims and
cleaning up in the wake of the spill. BP has also sued
Halliburton for an estimated $10 billion, contending that
Halliburton’s “unstable” cement job failed to block the spill.
BP also accused Halliburton of destroying post-spill test
results to cover up the cement contractor’s culpability. In
response, Transocean and Halliburton each filed lawsuits
of their own. Transocean claims that BP jeopardized the
rig through risky cost-saving moves and Halliburton said
its work on the rig was done, “under BP’s direction and
according to their plan.” However, Halliburton eventually
admitted that it did destroy critical post-spill test results
in the aftermath of the 2010 Gulf of Mexico oil spill. BP and
Halliburton are now spending millions pointing the finger at
each other.
The now defunct partnership between BP, Transocean,
and Halliburton highlights a key ethical dilemma in strategic
alliances. The dilemma has to do with the fact that alliance
partners are interdependent—which means they must trust
and rely on each other to accomplish key objectives. When
things go wrong, partners have strong incentives to blame
the other party—even if it may be their fault—because the
interdependencies between the two parties make it difficult
to assign blame. The blame game is clearly going on with
BP and its partners. When this happens parties often have
strong incentives to misrepresent or hide information to
avoid blame. This is a key ethical dilemma faced by BP and
its partners as they now look to the courts to divvy up their
financial responsibility for the spill.
social network. Of course, you need to know them well enough to be able to judge their
character—and you need to be accurate at evaluating their character. This type of trust is
sometimes called goodwill trust, because you are relying on the goodwill of the other party
to protect your interests.
Some research has shown that compared to U.S. firms, Japanese firms are much more
likely to rely on personal trust to govern their alliances.47 As a result, managers often partake in a long “honeymoon” period of meetings, dinners, and even activities such as singing
karaoke, to get to know individuals in the other firm before deciding whether they think
they can trust the firm enough to enter into a partnership. This is often frustrating for U.S.
firms who are more willing to write contracts to govern their alliances than to rely on personal trust.
Legal Contracts. In most cases, when firms initiate a partnership, they write a legal contract
to protect their interests. Legal contracts are usually used to help protect the interests of
alliance partners and to spell out the obligations and expectations of the partners.
A contract is a substitute for personal trust. If someone violates personal trust, there is
no real economic recourse other than ending your friendship or relationship. But if someone
violates a contract, you can sue the other party in court to get some economic recourse.
This threat of a lawsuit can be an important incentive for partners to perform according
to legally established obligations and expectations. As detailed in Table 8.2, most contracts
have clauses that clarify three categories of issues:
1. Governance issues, such as how decisions will be made, how profits will be split and
how disputes will be resolved
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[ Table 8.2 ] Common Clauses in Alliance Contracts
Governance Clauses
Residual rights clauses
In contractual alliances, parties often specify how the profits or assets created from the
alliance are to be split among the partners.
Equity/ownership clauses
Equity alliances or joint ventures must specify what percentage of equity is owned by each
of the partners.
Voting rights clauses
Specify the number of votes for decision making assigned to each partner in an alliance. In
equity alliances, voting rights usually correspond to equity ownership.
Minority protection
clauses
Specify the kinds of decisions that can be vetoed, if any, by firms with a minority interest in
the alliance.
Dispute resolution
clauses
Specify the process by which disputes among partners will be resolved.
Operating clauses
Performance clauses
Specify the specific duties and obligations of each of the partners, including warranties and
minimum performance levels required to satisfy the contract.
Noncompete clauses
Specify product markets or businesses that partners are restricted from entering.
Intellectual property right
protection clauses
Specify intellectual property or confidential information brought to the alliance by the partners that is not to be used by other partners or shared outside of the alliance without the
partner’s written consent.
Intellectual property right
creation clauses
Specify ownership rights to intellectual property (such as patents) created as a result of the
alliance.
Exit/Termination Clauses
Preemption rights clauses
Specify that if one partner wishes to sell its equity, it must first offer to sell the equity to the
other partner.
Initial public offering (IPO)
clauses
Specify conditions under which partners in equity alliances or a joint venture will pursue an
initial public stock offering.
Call/put option clauses
Specify the conditions under which one partner can force another partner to sell (or buy) its
shares and at what price.
Termination clauses
Specify under what conditions the contract can be terminated and the consequences of
termination for each partner.
2. Operating issues, such as what performance is expected, and how intellectual property
will be shared and protected
3. Exit/termination issues, including the conditions under which partners can exit the
alliance or the contract can be terminated
Shared Ownership/Financial Collateral Bonds. When one partner owns a financial stake
in another partner, as Toyota does with some of its supplier partners, it has an incentive to
cooperatively help the partner be as financially successful as possible because it shares in
the partner’s profits. By having your partner purchase a stake in your organization, you align
the incentives of both partners to work together.
Another way to align incentives and build trust is by having a partner post a financial collateral bond that it will lose if it doesn’t perform according to a specified contract. For example, fast-food chains such as McDonald’s will often partner with franchisees, individuals who
purchase a franchise from McDonald’s that gives them the right to operate a McDonald’s
outlet at a particular location. The franchise fee is essentially put into something like an
escrow account, while McDonald’s monitors the franchisee to ensure that it operates the
outlet according to McDonald’s guidelines. If the outlet fails to provide McDonald’s quality
food or service (which McDonald’s checks by sending in inspectors), McDonald’s can keep
the franchise fee and take away the franchise.
BUILDING AN ALLIANCE MANAGEMENT CAPABILITY
BUILDING AN ALLIANCE MANAGEMENT CAPABILITY
Strategic alliances have become a fast and flexible way to access complementary resources
and capabilities that reside in other firms. They are also profitable. One study found that a
company’s stock price jumped roughly 1 percent, on average, with each announcement of
a new alliance, which translated into an average increase in market value of $54 million per
alliance.48 Yet, as we’ve seen, alliances are fraught with risks. Indeed, almost half of them
fail.49 In such an environment, the ability to form and manage alliances more effectively than
competitors can itself become an important source of competitive advantage. In Chapter 3,
we discussed the importance of a firm building internal resources and capabilities, which
can be used to accomplish key strategic objectives. One of those capabilities is an alliance
capability—the focus of the final section of this chapter.
How do some firms develop a capability for successfully forming and managing alliances? Professors Jeff Dyer, Prashant Kale, and Harbir Singh conducted an in-depth study
of 200 corporations and their 1,572 alliances to learn how firms can systematically manage
alliances to maximize success.50 Although all companies seem to generate some value from
alliances, some companies—such as Eli Lilly, Oracle, and Hewlett-Packard—systematically
generate much more than other firms.
How do they do it? By building a dedicated strategic alliance function within the company. Companies like these appoint a vice president or director of strategic alliances with
his or her own staff and resources. The dedicated function coordinates all alliance-related
activity within the firm and is charged with creating processes to share and leverage prior
alliance management experience. Companies with such an alliance function achieved a
25 percent higher long-term success rate with alliances than companies that did not have
a dedicated function. They also generated almost four times as much market wealth whenever they announced the formation of a new alliance.
The research showed that an effective dedicated alliance function develops a firm’s capability
to perform four key functions: It improves knowledge management efforts, increases external visibility, provides internal coordination, and eliminates accountability and intervention problems.51
Improves Knowledge Management
A dedicated function acts as a focal point for learning, helping the company leverage lessons
and feedback from prior and ongoing alliances. It systematically establishes a series of routine processes to articulate, document, codify, and share know-how about the key phases
of the alliance lifecycle. Many companies with dedicated alliance functions have codified
explicit alliance-management knowledge by creating guidelines and manuals to help them
manage specific aspects of the alliance lifecycle, such as partner selection and alliance negotiation and contracting. For example, Hewlett-Packard has developed 60 different tools and
templates, included in a 300-page manual that can be used to guide decision making in
specific alliance situations. The manual includes such tools as a template for making the
business case for an alliance, a partner evaluation form, a negotiations template outlining
the roles and responsibilities of different departments, a list of ways to measure alliance
performance, and an alliance termination checklist. Figure 8.2 lists more of the guidelines
and tools companies have developed.
Increases External Visibility
A dedicated alliance function can keep the market appraised of new alliances and about
successful events in ongoing alliances. Such external visibility can enhance the reputation of
the company in the marketplace and create the perception that alliances are adding value.
The creation of a dedicated alliance function sends a signal to the marketplace that the company is committed to its alliances and to managing them effectively.
In addition, when a potential partner wants to contact a company about a potential alliance, a dedicated alliance function makes an easy, highly visible point of contact. The alliance function typically screens potential partners, and brings in the appropriate internal
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ì STRATEGIC ALLIANCES
[ Figure 8.2 ] Example of Tools to Use Across the Alliance Lifecycle
* Needs Analysis
Checklist
* Partner
Screening Form
* Negotiations
Guidelines
* Make vs. Buy vs.
Ally analysis
* Technology and
patent domain
maps
* Needs v/s
wants Checklist
* List of Possible
Alliance Partners
with Resources to
Meet Needs.
* Cultural Fit
Evaluation
Form
* Due Diligence
Team
Alliance
Business
Case
Partner
Assessment &
Selection
* Alliance
Contract
Template
* Alliance Structure
Guidelines
* Alliance Metrics
Framework
Alliance
Negotiation &
Governance
* Decision
Making
Template
* Relationship
Evaluation
Form
* Trust-building
Worksheet
* Yearly Status
Report
* Work planning
Worksheet
* Termination
Checklist
* Alliance
Communication
Infrastructure
* Termination
Planning
Worksheet
Alliance
Management
Assessment
&
Termination
ALLIANCE LIFECYCLE
parties if a partnership looks attractive. For instance, Oracle has an “Alliance Online”
website that actually puts the partnering process online. Oracle describes the terms and
conditions of different “tiers” of partnership on its website, allowing potential partners to
choose which level fits them best. Alliance Online has emerged as Oracle’s primary vehicle for recruiting and developing partnerships, with more than 7,000 tier I partners. It has
also conserved human resources, allowing Oracle’s strategic alliance function to focus the
majority of its human resources on its 12 higher-profile and more strategically important
tier III partners.
Provides Internal Coordination
One reason alliances fail is because of the inability of one partner or another to mobilize
internal resources to support the alliance initiative. Visionary alliance leaders may lack the
power or organizational authority to access key resources that may be necessary to ensure
alliance success. One alliance executive at a firm without a dedicated alliance function
explained, “We have a difficult time in supporting our alliance initiatives because many
times the various resources and skills needed to support a particular alliance are located
in different functions around the company. You have to go begging to each unit and hope
that they will support you. But that’s time consuming, and we don’t always get the support
we should.”
A dedicated alliance function helps solve this problem in two ways. First, it has the
organizational legitimacy to reach across business units and request the resources necessary to support the alliance. If a particular business unit is not responsive, it can quickly
elevate the issue to a senior executive. Second, over time, individuals within the alliance
function develop networks of contacts throughout the organization. These networks
engender a degree of trust between alliance managers and employees throughout the
organization, thereby allowing them to engage in reciprocal exchanges in support of alliance initiatives.
Facilitates Intervention and Accountability
Alliance failure is the culmination of a chain of escalating events. Signs of distress are often
visible early on. If alliances are adequately monitored, the alliance function can step in and
intervene appropriately—much like a marriage counselor. However, only 50 percent of all
KEY TERMS
companies that form alliances have any kind of formal metrics in place to assess how well
the alliance performs. In contrast, 76 percent, of companies with a dedicated alliance function have formal alliance metrics to keep tabs on how the alliance is performing.52
To illustrate, Eli Lilly’s alliance function does an annual “health check” of its key alliances, surveying both Lilly employees and the partner’s alliance managers. After the survey, an alliance manager sits down with the leader of a particular alliance to discuss the
results and offer suggestions for improvement. When serious conflicts arise, the alliance
function can help resolve the dispute. In some cases, Lilly found that it needed to replace
its alliance leader. One executive at Lilly commented, “Sometimes an alliance has lived
beyond its useful life. You need someone to step in and either pull the plug or push it in
new directions.”53
The bottom line is that developing processes to effectively form and manage alliances
builds a capability for generating value through strategic alliances.
SUMMARY
ì A strategic alliance is a cooperative arrangement in which two or more firms combine
their resources and capabilities to create new value.
ì There are three basic types of alliances each structured differently to split the gains from the
alliance and protect each partner’s interests. The first type is a nonequity or contractual alliance, in which the firms write a contract to govern the relationship. The second type is an
equity alliance, in which collaborating firms often supplement contracts with equity holdings
in their alliance partners. In situations where alliance parties need incentives to bring their
best resources to an alliance, equity is often preferred to contracts as a way to align the incentives of partners. The third type is a joint venture, an alliance in which the collaborating or “parent” firms combine their resources to create a jointly owned but legally independent company.
ì The primary strategic objective of firms is to offer unique value to customers, either
through low cost or differentiation. Alliances are a vehicle for accessing the resources and
capabilities of another firm that will help you lower costs or differentiate your offering.
ì There are four primary ways to create value with an alliance partner:
1. Combine unique resources
2. Pool similar resources
3. Create new alliance-specific resources
4. Lower transaction costs
ì As partners work together to create new value, they have to build trust to ensure that they
cooperate effectively. There are four primary ways that partners build trust in alliance
relationships: (1) personal trust, (2) legal contracts, (3) shared equity/financial collateral
bonds, or (4) reputation. The ability to build trust with a partner has often been viewed as
the single most important contributor to alliance success.
KEY TERMS
contractual or nonequity
alliance (p. 152)
equity alliance (p. 153)
hold-up (p. 158)
horizontal alliance (p. 155)
joint venture (p. 153)
misrepresentation (p. 158)
strategic alliance (p. 149)
vertical alliance (p. 153)
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International Strategy
09
© AzureRepublicPhotography /Alamy
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1
Discuss the globalization of business.
2
Explain why firms choose to expand internationally.
3
Describe different kinds of distance and how they affect
successful international expansion and how this affects the
choice of where firms should go when they expand.
4
Explain the three primary types of international strategy and
be able to use the international strategy triangle to determine
which international strategy is right for a specific firm.
5
Explain when a firm should use each of four major ways to enter
a foreign market.
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09
L
Lincoln Electric
Learns Some Difficult Lessons
incoln Electric is one of the most celebrated companies
in U.S. history. Business schools across the entire
world have made it the number one case study on
how companies manage their workforces. At first glance,
it seems odd that Lincoln Electric should be so famous.
Unlike Apple or Exxon, it doesn’t have the highest market
capitalization. Unlike Facebook or Google, it isn’t in an
industry that is fashionable or that innovates quickly. Lincoln
makes welding machinery and the sticks of metal that
welders melt to bond two objects together, known as welding
consumables. Yet, in the last 20 years, Lincoln Electric
captured the majority market share in the United States
competing against such big-name firms as GE. It then went
on to capture the largest share of the welding equipment and
consumables market in the entire world. Lincoln currently
manufactures in 20 countries and has distributors and
Lincoln Electric’s success story has not been free of
trials. In fact, the first time Lincoln Electric decided to
expand internationally, it nearly killed the company. From
the mid-1940s until 1986, Lincoln Electric was primarily
a U.S. firm. Nearly all production occurred in Cleveland.
The company had opened plants in Canada, Australia,
and France shortly after World War II, but these were
mostly autonomous units. However, from 1986 to 1992,
the company—fearing a slowdown in the U.S. market and
seeing foreign competitors grabbing market share in the
United States—embarked on a period of rapid international
expansion.
During those six years, Lincoln Electric went from
little international presence to buying or building three
overseas plants a year. Lincoln acquired and built a plant
in Venezuela, acquired existing plants in Mexico, Brazil,
Scotland, Norway, the
LINCOLN ELECTRIC’S SUCCESS STORY HAS NOT BEEN FREE OF TRIALS. IN FACT, THE FIRST
United Kingdom, the
TIME LINCOLN ELECTRIC DECIDED TO EXPAND INTERNATIONALLY IT NEARLY KILLED THE
Netherlands, Spain,
and Germany, and
COMPANY.
built a plant in Brazil
and three in Japan, among others—a total of 17 plants in 15
sales offices in over 160 countries worldwide.1 Not bad for a
countries. None of the top management team, however, had
Cleveland, Ohio-based manufacturing company.
any international experience. They bought plants intending
Lincoln’s success is often attributed to the way it pays
to rely on the existing plant managers’ local knowledge.
its workers. Management believes that the way they
Lincoln also decided to use the local brands of the plants
compensate their workers maximizes their incentives to
it bought, because local managers had assured Lincoln’s
be productive. The three cornerstones of the company’s
executives that Europeans, in particular, would not buy U.S.
compensation policy are:
2
branded products.
1. Piecework: Workers’ pay is based on the number of
Lincoln’s leaders had hoped to install the renowned
pieces they produce rather than the number of hours
Lincoln Electric incentive system in each of its new
they work.
international plants. However, none of the foreign units
2. Year-end bonuses: Big bonuses at the end of the year,
implemented the system. Lincoln’s managers were not
based on personal evaluations and company perforaware that many local laws forbid parts of the Lincoln
mance, can often double workers’ yearly earnings.
system. In some locations, local management and workers
3. Guaranteed employment:3 Since 1951, Lincoln Electric
didn’t see its value. None of the foreign units except
has promised not to lay off employees, no matter how
Canada and Australia, the older ones, turned out to be
difficult things become, a promise the company has
profitable.
kept to this day.4
[ 170 ]
THE GLOBALIZATION OF BUSINESS
[ 171 ]
[ Table 9.1 ] Lincoln Electric Income (in U.S. $millions)
1987
1988
1989
1990
1991
1992
1993
1994
49.9
55.9
53.0
28.2
30.8
24.9
42.6
71.7
Europe
1.5
3.1
4.4
2.1
–14.4
–52.8
–68.9
3.9
Other Regions
1.3
2.0
–0.6
–6.8
–2.9
–7.2
–22.9
5.5
52.7
61.0
56.8
23.5
13.5
–35.1
–49.2
81.1
United States
Total
Top management in Cleveland knew that the foreign
units were struggling but, not having experience running
a multinational company, they used a hands-off policy
and weren’t aware of exactly why things weren’t working.
When Lincoln’s CEO retired in 1992, the new CEO was
handed the reins to a company in which losses in the
foreign units had become so huge that Lincoln Electric
had to borrow money for the first time in its history. The
company then nearly defaulted on its bank loans—twice—
only surviving by begging the banks for more generous
terms. Twice, Lincoln had to borrow money to pay the
year-end bonuses that were so critical to its competitive
advantage.
To fix the foreign operations, the new CEO moved to the
United Kingdom and spent more than a year personally
overseeing the plants in Europe. He broke local unwritten
cultural rules about taking market share from other local
companies by aggressively selling Lincoln Electric U.S.
branded products at trade shows and in every other venue
he could introduce them. He also broke a long-standing
Lincoln Electric policy of promoting managers from within
the company. Instead, he worked to lure key managers
from other U.S. firms that had significant international
experience. He led the company to close plants in Germany
and Japan—despite having just bought or built them—and
rationalized production in the remaining plants, so that
each was manufacturing a different product, rather than
competing with other Lincoln plants.
By the middle of 1994, Lincoln had turned things around.
Its foreign operations had become profitable as outlined
in Table 9.1.5 Since then, the lessons the company learned
have been applied over and over, with great success, leading
to Lincoln’s current position as market leader in many
countries around the world.
ì
This chapter will help you to answer three critical questions concerning international
strategy: Why, Where, and How. Carefully researched and thoughtful responses to those
three questions can make the difference between a successful expansion effort and failure,
or near failure, like Lincoln experienced.
THE GLOBALIZATION OF BUSINESS
Over the last 50 years, the scope of business has changed for most organizations. Companies used to compete primarily within their own country. Technological advancements in
communications and transportation, along with falling trade barriers, have changed that
for most firms. Over that period of time the average tariff, the tax on goods imported into a
country, dropped from over 40 percent to an average of 4 percent in developed nations. At
the same time, countries across the globe repealed regulations that kept foreign firms from
buying local companies and building plants and stores in their markets. As a consequence,
the volume of international trade, companies selling across national borders, increased
more than 28-fold from 1970 to the present.
International trade in merchandise alone topped $18 trillion last year.6 During the same
period foreign direct investment (FDI), companies building factories and stores in foreign
countries, increased more than 500 percent (see Figure 9.1).7 Although there is no consensus
on why FDI flows to some countries and not others common factors include low labor and
tax costs, low trade barriers, and favorable exchange rates.8
This trend toward increased international trade has allowed organizations to place
parts of their value chains in different countries, depending on where each part can
foreign direct investment Direct
investment in production or
business in one country by a
business from another country.
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CH09
ì INTERNATIONAL STRATEGY
[ Figure 9.1 ] Global Foreign Direct Investments, 1970–2013 (in 2013 U.S. dollars)
2,500,000
2,000,000
1,500,000
1,000,000
500,000
19
70
19
71
19
72
19
73
19
74
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
20
13
0
Source: UNCTAD, Inward and outward foreign direct investment flows, annual, 1970–2012 and OECD FDI in Figures, February 2014.
multinational firms Firms that sell
or produce in multiple countries.
generate the most value. Manufacturing, as well as service industries, has become global.
Trade in commercial services, such as licensing and franchise fees, and various types of
services such as financial, information, computing, insurance, and consulting services,
etc. has increased 272 percent just in the last decade, totaling over $4.3 trillion in exports
alone last year.9
What this means for strategy is that both production and the market for many products
and services isn’t national anymore—it’s regional (a part of the world) or global.10 For most
industries, the competition isn’t just local or national anymore, either—it’s also global, and
key competitors may be located in another country. Indeed, the World Trade Organization
says that half of all the productive wealth in the world is generated by multinational firms
that compete with an international strategy.
Even for small companies, international strategy is the key to success. Of the more
than 302,000 U.S. firms that competed across borders in 2011, 98 percent were small to
medium-sized firms.11 Companies that do international strategy right tend to dominate
both at home and throughout the world. Most organizations that hope to be a leader
in their industry realize that they have to compete on a global scale.12 Indeed, for many
companies even basic survival is predicated on a clear understanding of international
strategy.
Of course, competing on a global stage isn’t just about protecting oneself from foreign
competition. It also opens up tremendous new opportunities13 although these new opportunities come with an exponential increase in complexity. Just ask the top management team
at Lincoln Electric. Some of the differences between countries that increase complexity and
affect the success of international strategies include variations in:
ì Customer tastes, needs and income levels
ì Government regulations
ì Legal systems
ì Public tolerance for foreign firms
ì Reliability, and even existence, of basic infrastructure, such as roads and electricity
ì Strength of supporting industries, including distribution channels to customers
This chapter addresses the complexity of international strategy by answering three questions strategists ask when thinking about going international:
1. Why should we go international? What advantages might we gain?
2. Where should we expand? Of all the countries we could enter, which are the right
ones?
3. How should we expand? What international strategy should we employ? How can we
tell if we have the right one? And, what strategic options do we have for entering a
foreign country?
One thing to keep in mind as you read this chapter is that many of the concepts actually
apply to geographic expansion within a country as well as international expansion.
We focus the chapter on international expansion because the complex issues behind a
successful expansion strategy are magnified exponentially when you cross international
borders.
WHY FIRMS EXPAND INTERNATIONALLY
[ 173 ]
WHY FIRMS EXPAND INTERNATIONALLY
There are a number of reasons why firms choose to compete in international markets. These
include increasing sales to grow the company beyond what the home market can offer,
becoming more efficient (raising profits by lowering costs), managing risks better, learning
from consumers in other markets, and responding to the globalization moves of other
firms.
Growth
The need to grow sales is one of the biggest reasons that firms expand internationally.14
Some firms have saturated their home markets, and entering foreign markets is the only
way for them to sustain growth. This is one of the primary reasons Walmart entered Mexico
in 1991. Figure 9.2 shows how important expanding internationally has been for Walmart’s
continued growth. Of course, firms that haven’t saturated their home market also might
seek to go global in order to increase their rate of growth. This is one of the main reasons
Lincoln Electric chose to expand overseas.
Efficiency
Many firms enter additional markets in order to become more efficient. Efficiency takes a
number of forms, including obtaining lower-cost resources, extending the lifespan of products, and achieving economies of scale and scope.
Lower-Cost Resources. In many cases, key resources may be cheaper in foreign countries.
One of the most common resources firms seek abroad is low-cost labor, which is often
referred to by the buzzwords offshoring or outsourcing. Firms may also expand abroad in
search of lower-cost sources of raw materials.15 For example, the United States is seeing an
increase in foreign companies opening new plants in the United States to take advantage
of cheap natural gas made available through hydraulic fracturing technology, known as
fracking.
Beyond looking at the price of a particular resource, though, companies also have to
take into account factors that might increase the cost to use the resource, including labor
[ Figure 9.2 ] Walmart’s Growth, Domestic and International, 1989–2011
Walmart Sales* as a Share of U.S. GDP, 1989–2011 (est.)
3.2%
*includes Sam’s Club
2.94% est.
for 2011
2.8%
Total sales
2.4%
2.20% est.
for 2011
2.0%
U.S. sales
only
1.6%
1.2%
0.8%
0.37%
in 1989
0.0%
1990
1995
Source: Walmart Annual Reports
2000
2005
2010
globalization The spread of
businesses across national
borders.
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CH09
ì INTERNATIONAL STRATEGY
productivity, and the transportation and communication costs needed to acquire the
resource. Moreover, companies must also consider a variety of other costs of doing business
in a particular country, such as regulations and the challenges of managing in a different
culture. Companies tend to seek an optimal location for expansion, not just the one with
the lowest cost resources. For instance, while sub-Saharan Africa has the cheapest labor in
the world, China’s abundance of relatively skilled and productive cheap labor, coupled with
excellent communications and transportation infrastructure and a relatively stable political
climate, has often made it the target of most firms looking for low-cost labor.
product’s life cycle The stages a
product or service goes through
during its lifespan.
Longer Product Life. Sometimes firms enter foreign countries to extend a product’s life
cycle, leveraging their investment in assets and equipment.16 For example, in Chapter 2
we introduced the plight of Nokia, a one-time world leader in the cell phone industry.
Although Nokia’s cell phone business, now a subsidiary of Microsoft, is no longer the
world’s leading manufacturer of cell phones and smart phones, the company continues to
generate substantial revenue by selling its older-model phones in Africa, the Middle East,
and Southeast Asia.
In addition to leveraging prior investments in their products, firms can also leverage their
capabilities. As discussed in Chapter 3, capabilities that generate competitive advantage for
firms typically are difficult and costly to build. Some firms try to leverage their investments
in building capabilities by using those capabilities in multiple countries.17 Fast-food restaurants such as McDonald’s are masters of this technique.18 Manufacturing firms can also gain
efficiencies from leveraging their capabilities. Toyota, for instance, has been quite successful
in implementing the Toyota Production System in its U.S. auto plants, helping to keep its
costs lower than those of rivals GM and Ford.
Economies of Scale and Scope. Another critical source of efficiency that firms seek to gain
by going international is economies of scale, whether they come in manufacturing, R&D,
or sourcing.19 Recall from Chapter 4 that economies of scale occur when firms are able to
spread the costs of investments in plant, equipment, or knowledge across many sales. As
firms compete in foreign markets, they increase the number of units sold, possibly reaping
greater economies of scale.
Related to efficiencies gained through economies of scale are economies of scope. Competing in multiple markets allows firms to spread their costs across more units in multiple
product categories. This is the approach Pepsi takes by owning snack-food companies such
as Frito-Lay. Pepsi sells its foods and drinks to the same retailers. This allows Pepsi to spread
the costs of distribution across a greater volume of products, lowering its distribution costs.
Managing Risk
Operating in more than one country can also provide firms with a measure of protection
against disaster, both economic and natural.20 Even when there are worldwide economic
downturns, such as during the period from 2007 to 2012, problems are not usually spread
evenly across all countries. During that period, the United States and the European Union
fell into recession while China continued to grow at a fairly rapid pace. When firms have
sales in multiple countries, a slowdown in one country may be offset by continued sales in
another. For instance, many observers thought that General Motors (GM), a U.S.-based firm,
would lose a good portion of its market share in 2007, when the U.S. market for automobiles
collapsed. However, within a short time, GM had actually increased its worldwide market
share, regaining the title of largest auto company based mostly on sales growth in China.
The same principle works for other types of disasters, such as natural disasters or social
upheaval. If firms have operations in multiple locations they may be able to relocate production or increase sales in another country to make up for the shortfall in the area where the
disaster occurred.
Knowledge
Another reason for expanding into other countries is to generate more knowledge, the
basis for innovation. When a firm sells in different countries, to people with different
WHERE FIRMS SHOULD EXPAND
tastes and needs, it often gains new insights about its products and services. Serving
multiple types of customers can help a firm to identify unmet needs in multiple markets.
Those insights can be valuable for increasing sales in many locations. Gathering information from customers in multiple countries can also help organizations more easily
identify changes in customer needs making it more likely that they will be at the forefront of the next big innovation in their industry. Research suggests that generating more
knowledge may be the greatest advantage a multinational organization has over purely
domestic companies.21
As an example, GE’s Healthcare division developed an inexpensive, portable ultrasound
machine to serve the rural Chinese market, where health-care providers couldn’t afford GE’s
large, expensive ones. GE realized that there were also markets for an inexpensive, portable
ultrasound machine in Europe and the United States, specifically with first responders who
don’t have space in ambulances and fire trucks for large ultrasound machines. GE now sells
the product in all of its markets.
Not only can companies generate knowledge from diverse customers but also from their
own units in different locations. For instance, Europe has higher energy costs than the
United States does. U.S. firms that operate in Europe have been learning how to save energy
costs more rapidly than those that aren’t in Europe.
Responding to Customers or Competitors
Last, but not least, firms may expand internationally in response to either customers or
competitors. This is particularly true of business-to-business (B2B) firms that perform intermediate steps of the value chain for large customers.22 For example, the “Big 4” accounting
firms—Deloitte Touche Tohmatsu, Ernst & Young, KPMG, and PricewaterhouseCoopers—
have all expanded globally to better serve their largest clients, who are multinationals with
operations around the globe. Indeed, sometimes customers demand that their suppliers go
international when they do.
Sometimes firms feel compelled to go global because their rivals do. If the rivals gain any
of the advantages previously discussed, they may use those advantages to subsidize aggressive sales and marketing campaigns in the home markets of their competitors.23 If a firm
doesn’t expand to replicate those advantages it may be at a distinct disadvantage. This is one
of the primary reasons Lincoln Electric expanded abroad—to respond to ESAB, a Swedish
welding company, who had just entered the United States.
WHERE FIRMS SHOULD EXPAND
Once a firm has decided to go international, the next question it must answer is where to
expand. The easiest answer is to enter the country with the largest number of potential
customers—often, a country with a huge population, such as China or India. However,
wise managers also think about how likely they are to succeed in a particular foreign
market. After all, the word foreign means different and different can be difficult to deal
with. Research on the risks of international expansion refers to this as the liability of
foreignness.
Successful international expansion requires a clear understanding of the possible risks.
Some risks are market driven—will foreign customers buy your products at the same rate as
your home country customers? Will distribution work the same way or will it cost more to
get products to the end customer?
Other risks are political. Sometimes foreign governments enact policies that place additional burdens on foreign firms, such as tariffs that increase the cost of foreign products, laws
requiring a certain percentage of each product be made in the foreign country, or a certain
percentage of managers be locals, or laws prohibiting foreign ownership of local firms. Other
burdens come from the uneven application of local laws. For instance, in some countries it
is difficult for foreign firms to protect their intellectual property as local courts may side
[ 175 ]
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CH09
ì INTERNATIONAL STRATEGY
primarily with local firms. And sometimes nationalistic sentiment leads governments to
threaten foreign firms with additional tariffs, lawsuits in both local and world courts (such
as the World Trade Organization), inspections and fines not levied against local firms, and
even seizure of plants and equipment. Companies entering foreign markets need to be well
aware of the possibility of government action.
Finally, other risks are economic in nature. Not all markets are equally stable. Some countries are more susceptible to economic recessions, directly affecting the bottom line of the
firms selling in those markets. Foreign countries may also be susceptible to monetary crises,
where the value of the local currency fluctuates wildly as shown in Figure 9.3. The currencies of some countries, even when not in crisis, may fluctuate significantly compared to the
U.S. dollar. This can create an adverse exchange rate. This matters because a firm selling
in a foreign market earns profit in that market’s currency and those producing in a foreign
country buy goods and pay labor in the local currency. If that currency fluctuates, the costs
and profits, when transferred back into the home currency, fluctuate as well. This can make
a significant difference in how competitive a firm is. If the exchange rate is favorable, they
can lower their prices and steal market share from other firms. If the exchange rate is not
favorable, the opposite can happen.
Organizations considering international expansion need to carefully consider the
market, political, and economic risks of each country they are thinking about entering.
Since companies want to do business in the countries where they are most likely to succeed, that means choosing locations that have the lowest risks. Another way to think
about managing the risk of expansion is to consider the distance between countries.
Even though transportation and communication have advanced to the point where
firms can realistically do business in nearly every country on the planet, the distance
between countries still matters. In addition to geographic distance, there are three
other kinds of distance that managers should consider when undertaking international
expansion: cultural, administrative, and economic distances.24 A useful mnemonic for
remembering the four types of distance is CAGE—cultural, administrative, geographic,
and economic.25
Even if there are a lot of potential customers, a country might not be the right one to
enter if the likelihood of success is low because of greater distance. The lower the distance
across all four distances, with an emphasis on the distance that most affects your specific
industry, the greater the likelihood of a successful expansion.
[ Figure 9.3 ] Exchange Rate versus U.S. Dollar of Brazilian Real (BRL) and Indian Rupee
(INR), 2009–2014
USD/BRL
USD/INR
40.00%
30.00%
20.00%
10.00%
0.00%
–10.00%
–20.00%
–30.00%
–40.00%
Jan 1, 2010
Jan 1, 2011
Source: Oanda.com, Historical Exchange Rates
Jan 1, 2012
Jan 1, 2013
Jan 1, 2014
WHERE FIRMS SHOULD EXPAND
[ 177 ]
Cultural Distance
Cultural distance refers to differences in language and culture, the way people live and
think about the world. People in another country might hold different beliefs about a
host of significant issues, including how people should interact and how business should
be conducted. They might have very different worldviews about human nature and the
role of individuals and companies in society. All of these can add up to a very foreign
environment that makes it difficult for firms to understand their customers and local
employees.26
Although it’s only one aspect of culture, the issue of language is influential. Firms are
42 percent less likely to do business in a country with a different language.27 Language
differences are relatively easy to fix, but potential problems increase rapidly when companies
move into countries with deeper, more difficult to overcome types of cultural distance. These
may include differences in:
cultural distance The degree of
difference between the cultures of
two nations.
ì Religion
ì Ethnicity
ì Trust for outsiders28
ì How genders are expected to behave
ì The degree to which the culture is focused on individuality or collective action
ì How people accept ambiguity or follow rules and laws
ì The degree to which people allow abuses of political or market power29
Many of these types of cultural differences can be subtle but still have a significant impact on
consumer behavior and shape the market demand for foreign products.
Not all industries are affected the same way by cultural distance. Firms that sell commodity products, such as corn, wheat, oil, or cement, don’t tend to have difficulty with
cultural distance. However, firms with products that have high linguistic content, such
as TV shows, movies, music, and even textbooks, have to be careful. Likewise, products
that affect how people see themselves, such as food and clothing, are affected by cultural
distance. This is particularly true if those products clash with religious or national identities. It is difficult to sell pork products in the Middle East, as pork is forbidden by both
Judaism and Islam. Other products might not directly clash with religion, but they might
not match cultural norms. For instance, in Germany parents have a tendency to prefer
well-crafted, wooden toys for their children. Firms that focus on less-expensive plastic
toys do much better in markets like the United States.
Sometimes, however, cultural distance can be a selling point for multinationals. For
instance, in Russia, foreign products are often seen as superior to local ones. Likewise, being
associated with a particular country can sometimes increase sales of a product worldwide,
as is the case for German luxury automobiles, Italian fashion, and U.S. fast food.
Administrative Distance
Administrative distance refers to differences in the legal, political, and regulatory institutions between countries. For example, are laws and government policies similar or different?
This is important for firms because understanding the political and legal environment is
often a key to success in a foreign country.30
You can have the best product or service at the cheapest price, but if you don’t understand
how contracts will be enforced or how local and national policies apply to foreign firms, you
may fail. Administrative distance can cause some challenges for U.S. firms in industrialized
nations like France (which relies on a different legal system than the United States and the
United Kingdom), but it can become bewildering in many emerging and third-world markets, where regulations and laws may be applied capriciously.
Low administrative distance can increase the rate of entry by foreign firms into a country
by as much as 300 percent.31 Administrative distance is low among countries that: (1) use
the same legal system, such as the common law system used in the Anglo sphere (the United
Kingdom and its former colonies, including the United States, Canada, Australia, and India);
administrative distance The
degree of differences between the
legal and regulatory frameworks of
two nations.
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CH09
ì INTERNATIONAL STRATEGY
(2) used to be part of a colonizer/colony network, such as some European countries and
their former African colonies; (3) use the same currency; or (4) are part of the same trading
bloc, such as NAFTA in North America or the European Union.
Industries most directly affected by administrative distance are those in which governments are most likely to have a stake. This includes industries that provide equipment
or services critical to national security, such as providers of steel or telecommunications;
those that employ large numbers of people; those that serve government directly, such as
mass-transportation equipment manufacturers; those that extract natural resources; and
those that produce staple goods that most people buy, such as rice in Thailand or corn in
Mexico. A specific firm might also confront increased administrative distance if it competes head-to-head with a local champion, a local firm that government sees as important
to its future, such as Airbus, the EU airplane manufacturer, or CINOOC, the Chinese oil
company.
Geographic Distance
geographic distance The distance
in miles, or kilometers, between
two countries.
At its most basic, geographic distance refers to how many miles separate two countries.
Companies are more likely to succeed in nearby countries, because physical proximity lowers both transportation and communication costs. That’s one reason most U.S. companies
expand first to Canada and Mexico. Even with fast air travel and consistent, reliable container shipping, research suggests that for each 1 percent increase in the distance between
countries there is a 1 percent decrease in firms selling in those countries.32 Clearly, miles
still matter.
In addition to the actual physical distance between countries, however, geographic distance is also influenced by how easy it is to travel between countries. For instance, firms
enter countries with seaports much more frequently than they expand to landlocked
nations. Companies are also more likely to enter countries with good transportation infrastructure. For most firms, geographic distance increases the cost of managing daily operations and coordinating activities. Despite the availability of instant communications and
video conferencing, many overseas operations require hands-on help from headquarters.
When those operations are many hours away from headquarters by plane, the communication and transportation costs start to add up.
Not all industries are affected the same way by geographic distance. Firms such as
Google, which sell electronic products that can be transmitted to the other side of the world
in fractions of a second at almost no cost don’t have to worry as much about geographic distance as firms that sell heavy, bulky products like cement. Other industries that are heavily
affected by geographic distance are those that sell fragile products that might be damaged
in transport, or perishable products, such as fresh-cut flowers, that must be transported
rapidly. Even for Google, however, the need to oversee operations means that the company
must set up local offices in some countries, such as Russia, because the product still needs
to be localized (if only for language and currency reasons) and constant travel from California is too unwieldy.
Economic Distance
economic distance The degree
of difference between the average
income of people in two different
countries.
Economic distance refers primarily to differences in the average income of customers in
two countries, usually measured as per capita GDP (Gross Domestic Product). Firms from
wealthy nations tend to expand to other wealthy nations because the customers there earn
enough income to buy similar products. This is clearly true for expensive products such as
cars or home appliances but is also true of a wide variety of products including ones that
wealthier customers tend to think of as inexpensive, such as laundry detergent or snack
food (see the Strategy in Practice for an example).
The industries most affected by economic distance are those for which the demand for
products is very elastic—meaning demand changes dramatically as prices go up or down. In
these types of industries, demand is significantly affected by customers’ purchasing power
and the ability of producers to lower prices.
HOW FIRMS COMPETE INTERNATIONALLY
[ 179 ]
S T R AT E GY I N P R A CT I C E
How Coca-Cola Manages Economic Distance in Ghana
Y
ou can find Coca-Cola products in pricey restaurants
in Tokyo as well as in the poorest urban areas in Africa.
How does Coca-Cola manage the economic distance? In
the United States in 2012, the average income per person
adjusted for differences in currency exchange rates, or GDP
per capita PPP (purchasing power parity in economic terms),
was around $51,749/year, or $142/day.33 In Ghana, it was
$2014/year, or $5.52/day,34 and that number included the
wealthy. More than 28 percent of the population in Ghana
lived on less than $2.00 a day.35 Coca-Cola can easily sell its
products to someone earning $142/day but how does it reach
those making $2.00/day? The answer is to lower its prices to
a point that even many of the poor can afford it.
The actual ingredients in Coca-Cola are typically
inexpensive. What are relatively expensive are the cans and
bottles and the distribution of the product. To keep these
prices in check, Coca-Cola uses an innovative distribution
model for the poorest urban areas in Ghana in East Africa.
Although it uses more traditional bottling and distribution
in wealthier areas of the country, Coca-Cola sells daily
franchise rights to small-scale entrepreneurs in the poor
urban areas. These entrepreneurs pay a modest deposit fee
to take possession of a crate of Coca-Cola products in glass
bottles at the bottling plant.
Using their own bicycles or small carts, these
entrepreneurs then sell the products on street corners or
from small roadside stands throughout the city. Customers
drink the product on the spot so that the entrepreneur can
return the empty bottles, along with a portion of the profits,
to Coca-Cola at the end of the day. This approach eliminates
distribution costs and significantly limits the cost of the
bottles by reusing them, thus lowering Coca-Cola’s costs to
a point where price can match the purchasing power of poor
customers.
HOW FIRMS COMPETE INTERNATIONALLY
As companies expand internationally, they often find themselves torn by two competing
pressures.36 The first pressure is toward local responsiveness, the need to tailor their products, marketing, and distribution strategies to the local customers in a foreign country. For
instance, Coca-Cola isn’t the same in every country. In fact, Coca-Cola demonstrates its
responsiveness by manufacturing dozens of varieties of cola—all under the same brand
name—to suit local tastes. As mentioned in the Strategy in Practice, Coca-Cola also changes
its distribution method to fit local markets.
However, adapting products and operations to fit local circumstances isn’t cheap. In general, the more a company tailors a product or service to a local market, the higher the cost.
Higher costs are risky, because, all else being equal, companies with lower costs can beat
their competition through lower prices. When firms begin to compete on a global stage,
the number of rivals can increase dramatically, putting intense pressure on firms to cut
costs. Furthermore, many firms expand internationally in order to increase efficiency and to
lower costs. Firms achieve economies of scale by standardizing their products, or producing
them without variations. Thus, firms have two competing pressures they must address: local
responsiveness and cost reduction, which typically comes through standardization, either
of products or processes—otherwise known as global integration.
There are three primary strategies firms can use to do business internationally:
1. Multidomestic strategy—emphasizes local responsiveness over standardization
2. Global strategy—emphasizes global standardization and economies of scale over local
responsiveness
3. Arbitrage strategy—takes advantage of country-comparative advantages—sources of
low cost (e.g., cheap labor) or unique resources (e.g., skilled workers)
local responsiveness A firm’s
adjustments to products, services,
and processes in order to account
for local culture and needs.
standardization Making products
and/or processes consistent across
different units within a firm and/or
across different countries the firm
operates in.
global integration The
standardization of processes within
a single business in different
locations around the world.
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[ Figure 9.4 ] International Strategies and Local Responsiveness versus Standardization
Global
strategy
Pressures for
standardization
High
Multidomestic
strategy
Low
Low
Pressures for local
responsiveness
High
The first two strategies deal directly with the tug-of-war between local responsiveness
and cost-reducing standardization differently as illustrated in Figure 9.4. The third strategy, arbitrage, can focus on either local responsiveness or standardization, but does so
from a position of taking advantage of country differences rather than trying to overcome them.
Each strategy is appropriate for a different set of industry dynamics and firm capabilities. We’ll discuss each in turn as well as discussing combining strategies. The three primary
strategies are not mutually exclusive. Some firms are successful at pursuing two at the same
time, although it becomes increasingly complicated to manage operations and maintain
strategic focus when doing so. At the end of the chapter we’ll introduce a tool for determining which strategy is best for any given firm.
Multidomestic Strategy—Adapt to Fit the Local Market
multidomestic strategy A strategy
involving tailoring products or
services to local markets.
The multidomestic strategy centers on tailoring products and operations to individual
markets.37 Firms in industries where customer needs and preferences vary widely from
country to country, such as food or media often use this strategy. By tailoring their products and services to better meet the needs of local customers, firms can maximize their
responsiveness to local customers, increasing their sales and market share in each country. They usually succeed through a differentiation strategy rather than a cost leadership
strategy.
As firms enter more countries and the differences between the home country and
each foreign country increase, firms must expand the degree of tailoring, or adaptation. Consequently, many firms that pursue a multidomestic strategy put autonomous
decision-making authority into the hands of managers in charge of individual regions or
countries.38
To enable such autonomous decisions, significant parts of the value chain have to be
replicated in each country. For instance, each country may have a product development and
design lab, manufacturing plants, and sales and distribution personnel. Replicating these
different functions in each country comes at a significant cost. Not surprisingly, firms find it
hard to tap into economies of scale if they are designing and producing something different
in each country.
As companies decentralize their operations to be locally responsive, it also makes it difficult to share valuable knowledge across the firm globally. As a consequence, firms that
HOW FIRMS COMPETE INTERNATIONALLY
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S T R AT E GY I N P R A CT I C E
National Competitive Advantage
H
ave you ever wondered how firms from the same country
dominate their industries worldwide? For example
U.S. companies Apple, Google, and Microsoft control the
worldwide industry for computer operating systems; Japanese
companies Nikon, Sony, and Olympus lead the digital camera
industry; German organizations dominate in machine tools;
and Italian firms lead in the sale of leather goods. Michael
Porter developed a tool, the Porter’s Diamond of National
Competitive Advantage, that explains how this happens.
Four factors help push organizations toward greater
innovation with those companies that innovate the most
having an advantage in international competition:
1. Factor conditions. An abundance of critical
resources including skilled labor, a technologically
advanced knowledge base, easy access to capital,
and solid infrastructure provide firms with the tools
they need to innovate. Germany is known for an
educated, manufacturing-oriented workforce, giving
it an advantage in the machine tool industry.
2. Demand conditions. The more a country’s customers
demand innovation, the more likely domestic firms are
going to be at the forefront of innovation. Japanese
consumers tend to be ahead of the curve in demanding
the latest in camera technology giving Japanese digital
camera firms direction in developing new products.
3. Related and supporting industries. If a country has
multiple parts of the value chain co-located it is easier
to coordinate innovation, speeding up the pace. Italy
is known not just for leatherworking but leatherworking machinery, fashion, and shoes. The four industries
being co-located allows for closer coordination and
faster innovation.
4. Firm strategy, structure, and rivalry. Different types of
firm structure are suited to particular types of industries. Laws governing how firms are started and how
they interact with labor have a large impact on the
international strategies that firms pursue. Rivalry also
plays a large role. While rivalry, according to the five
forces model discussed in Chapter 2 and illustrated in
Figure 9.5, tends to decrease profit, it also spurs innovation. Firms that survive high levels of rivalry are usually more prepared to take on international competition.
[ Figure 9.5 ] Porter’s Diamond of National Competitive
Advantage
Firm Strategy, Structure,
and Rivalry
Factor Conditions
Demand Conditions
Related and Supporting
Industries
Source: Adapted from Michael E. Porter, The Competitive Advantage of Nations
(New York: Free Press, 1990).
pursue a multidomestic strategy often find it difficult to develop a worldwide competitive
advantage. At best, they produce a series of local competitive advantages.
In most industries, firms find a pure multidomestic strategy unworkable. Cost pressures
become too intense. The key to successfully pursuing this strategy is to manage the variation
that occurs across countries. Firms can manage variation in three major ways:
1. Focus adaptations. Some firms manage the variation by tightly focusing on a particular
product, customer segment, or geographic area. Such highly focused firms still tailor
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ì INTERNATIONAL STRATEGY
their products, but the amount of variety they face is more manageable by maintaining
a tight focus.
2. Externalize adaptations. Some firms externalize the work of adapting the product for local needs, generally by arranging for local customers to do it. Methods of
externalization include franchising and alliances, which are discussed later in this
chapter.
3. Design adaptability. A third method for managing the costs of localization involves
designing a product so that it can be adapted while still maintaining some economies
of scale. Some companies design for cheap adaptation by investing in flexible manufacturing that reduces the costs of short manufacturing runs. Others modularize their
product, creating a set of standard interfaces that allow many different types of alternatives to plug into one another. For example, appliance manufacturers such as GE
and LG offer a variety of refrigerators, with different sizes, different number of doors,
and other features, but all their different refrigerators are designed to share a common set of core components. This allows some economies of scale while still adapting
refrigerators to local tastes.
Global Strategy—Aggregate and Standardize to Gain Economies
of Scale
global strategy A strategy involving
selling standardized products,
using standardized processes,
around the world.
A global strategy centers on capturing the efficiencies that can come with expanding overseas, particularly economies of scale, learning, and leveraging firm capabilities. Most firms
that pursue a global strategy standardize their products, marketing, and operational practices, and aggregate, or centralize, them in only a few locations, to achieve economies of
scale.39 Individual country-level units are tasked mostly with implementing decisions made
at a central headquarters40 and the firm uses the same strategy in most, if not every, country
where it competes.
The most extreme versions of a global strategy might have all functions located in the
same place, with country units overseeing only local sales. For example, consumer electronics giant Panasonic was long known for doing virtually all of its research and development, product design, and manufacturing of its TVs, VCRs, and DVD players in Japan. It
then shipped its standardized products around the globe. In theory, a firm could do all of
its manufacturing in a single factory and then ship products around the world. In practice,
many global firms have factories producing the same product on multiple continents in
order to reduce transportation costs and manage risk. Moreover, when factories in different locations are producing the same products, they are more likely to share best practices,
helping firms accelerate down the learning curve.
A global strategy is typically a low-cost strategy, with low costs achieved through economies of scale. However, it can also be used effectively as a differentiation strategy that the
company applies in the same way, to the same customer segment, worldwide. Apple is a
great example of a firm that standardizes its products to achieve economies of scale but
differentiates them from other smart phones, computers, or tablets in order to increase the
price customers are willing to pay for them. Firms that pursue a global strategy tend to
enter countries that have a large, ready-made market for their products. They also tend to be
in industries where cost pressures are high and standardized products can meet relatively
universal needs. For instance, semiconductor chips for use in computers and smart phones
are used in more or less the same way worldwide, enabling Intel and ARM to design and sell
very standardized products.
The downside of a global strategy, however, is that standardized products may not meet
the needs of customers in particular countries. As a consequence, global firms may not be
able to compete in as many markets as multidomestic firms, and they may not be able to
penetrate those markets as deeply.41 Another disadvantage is that, although global firms
share knowledge between units with greater ease than multidomestic firms do, a global firm
generates less knowledge overall, because it isn’t as actively trying to meet a wider variety of
customer needs. So, in the short term, global firms may miss sales by not being responsive
and in the long term they may miss changes in local market conditions.
HOW FIRMS COMPETE INTERNATIONALLY
[ 183 ]
However, just as there are ways to manage the cost of variation in multidomestic firms,
there are also methods for dealing with excessive centralization and standardization in
global firms. First, a firm need not centralize all parts of the value chain. The greatest
cost savings from economies of scale often occur in R&D and manufacturing. A global
firm can centralize some functions while localizing others in order to penetrate local
markets more fully. For instance, in the 1980s and 1990s, the household appliance manufacturer Whirlpool pursued component manufacturing and R&D primarily on a global
scale, but carried out product design, final assembly, marketing, and sales at regional and
local levels.
Arbitrage Strategy
An arbitrage strategy is the third of the three primary international strategies. While the
other two strategies view foreign markets as sales opportunities with the need to minimize
differences between countries, the essence of arbitrage is taking advantage of those differences. Arbitrage, at its simplest, is defined as buying and selling in different markets to take
advantage of differences in prices between them.
ETHICS
arbitrage strategy A strategy
involving buying where costs are
low and selling where they are
high.
A N D ST R AT E GY
Is Economic Arbitrage Ethical? Won’t It Lead to
Worker Exploitation?
I
n recent years, numerous news reports have emerged
detailing the exploitation of low-cost labor in foreign
countries. China Labor Watch, a nonprofit working to
raise awareness of worker exploitation issues in China,
found that suppliers of Mattel, the U.S. toy maker,
exploited lax enforcement of labor laws in order to keep
its costs low.42
Mistreatment of workers included:
ì Requiring excessive overtime work per month, frequently
two to three times the legal limit without extra pay.
ì Failing to pay into employee social insurance funds,
such as retirement funds.
ì Delaying payment of workers by as much as a month
at a time. Some companies in China have even
intermittently refused to pay workers a week’s and even
a month’s pay and fired them if they complained.
ì Assessing workers large fines for small infractions of
company rules. For instance, answering a cell phone
even once can cost a worker a day’s wages.
ì Not providing protective safety equipment even for
workers working with harmful chemicals or dangerous
machinery.
ì Disposing of toxic waste in dangerous and improper ways.
Such abuses are common across a wide range of
industries, and not just in China but also in many low-wage
countries. Indeed, in one case in Bangladesh, over 1,100
workers were killed when an eight-story building housing
multiple garment factories collapsed. The factories had not
installed appropriate safety measures. Many companies,
including Nike, Apple, and Walmart, have been accused of
exploiting workers in foreign countries.43
Economic arbitrage, in and of itself, is not necessarily
unethical. In many cases, foreign firms pay better than
average wages and bring improved safety and labor
practices to their factories and their supplier’s factories.44
However, when many firms in the same industry are
seeking a cost advantage by utilizing an arbitrage strategy,
the pressure to decrease costs can be immense, and
firms have to be vigilant that workers aren’t exploited. To
that end, companies like Nike and Apple have developed
a supplier code of conduct, which they use to audit their
overseas suppliers.45 While this doesn’t always work,
suppliers sometimes find ways around the audits;46 it
does decrease the incidence of unethical exploitation of
workers.47
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ì INTERNATIONAL STRATEGY
economic arbitrage Capitalizing
on differences in costs by buying
where costs are low and selling
where prices are high. This is the
traditional, age-old, definition of
arbitrage.
capital arbitrage Capitalizing on
differences in the cost of capital by
acquiring capital where it is less
expensive.
cultural arbitrage Capitalizing
on differences in culture between
countries by actively using the
culture of one country as a selling
point for products being marketed
in another country.
administrative
arbitrage Capitalizing on
differences in taxes, regulations,
and laws between countries by
operating where they are the lower
or more lax.
It can involve economic, cultural, administrative, or capital arbitrage. One of the most
common modern forms of arbitrage is also one of the basic reasons firms expand internationally, to find the lowest-cost source of labor or raw materials. This is called economic
arbitrage, and it often involves offshoring manufacturing or R&D to countries with low
labor costs. However, some firms also practice capital arbitrage. For instance CEMEX, a
Mexican cement manufacturer, operates plants in Spain so that it can raise capital in the
European Union, where interest rates are often lower than they are in Mexico.
Not all arbitrage involves sourcing low-cost resources, however. Some forms of arbitrage
take advantage of differences between countries to sell products. Cultural arbitrage trades
on the culture of one nation to sell in another. U.S.-based fast-food restaurant chains are
popular worldwide partly because they embody U.S. culture. Likewise, for centuries the
French were able to sell wine at a premium price because it came from France. Some firms
also utilize what is known as administrative arbitrage, taking advantage of differences
between countries that are created by laws and government regulations. Many companies
incorporate in the Cayman Islands because of low corporate tax rates. Likewise, nearly onethird of all foreign capital flowing into China actually originates in China, but the investors process their financial transactions through Hong Kong in order to avoid government
regulation.
Combining International Strategies
[ Figure 9.6 ] International Strategies and Local Responsiveness versus Standardization
High
Global
strategy
Transnational
Strategy
Pressures for
standardization
transnational strategy A
strategy involving a combination
of both local responsiveness and
standardization.
As many industries have become increasingly global, the pressures for both local responsiveness and the efficiency that comes from standardization have become more intense.
Some companies try to use a hybrid of the multidomestic and global strategy in order
to be glocal. These firms typically begin with a strong emphasis in a single strategy and
then work to minimize the downsides associated with that strategy as much as possible
as they begin to implement the second strategy. As shown in Figure 9.6, competing with
both a multidomestic and a global strategy, in order to achieve both local responsiveness
and standardization, is often called a transnational strategy.48 Strategy combinations,
of course, can also include multidomestic and arbitrage strategies or global and arbitrage
strategies as well.
Procter & Gamble (P&G) is an example of a firm that started with a strong position in a
multidomestic strategy and then added a global one. When P&G first expanded internationally, it replicated its operations in each country where it competed. However, beginning in
the 1980s, P&G began to balance adaptation with a greater focus on centralized decision
Multidomestic
strategy
Low
Low
Pressures for local
responsiveness
High
HOW A FIRM GETS INTO A COUNTRY: MODES OF ENTRY
[ 185 ]
making to allow for greater economies of scale across countries. It established global business units (GBUs), one for each major product category, which operated concurrently with
the traditional country units using the IT systems to tie the two types of organizations
together. They also required executive career paths to include both organizations. Although
it took more than a decade, P&G succeeded in gaining some of the benefits of a global strategy without losing its multidomestic focus.
At the end of this chapter we present a tool, the international strategy triangle, that can
help you assess the international strategies that firms currently pursue or help you determine which international strategy a firm should pursue if it is considering doing business
overseas.
HOW A FIRM GETS INTO A COUNTRY: MODES OF ENTRY
In this final section, we discuss four different modes of international market entry: (1)
exporting, (2) licensing and franchising, (3) joint ventures and alliances, and (4) wholly
owned subsidiaries. Entering foreign markets can be very risky. There are pros and cons to
each entry mode. The best method for a firm is often based on which international strategy
the firm has chosen: global, multidomestic, or arbitrage. We will look at each mode in turn,
starting with those that involve the least risk and least control and moving to those with the
most risk and most control.
modes of international market
entry Methods for entering a
foreign market for the purposes of
either selling or producing products
or services.
Exporting
Exporting involves producing goods in a single location and selling them in foreign markets. 49 Although most exporting happens from a home country, firms can also use it with an
arbitrage strategy by producing in a low-cost location and exporting to other countries from
there. Exporting is the first entry mode most companies choose when they decide to go
international.50 Exporting allows a firm to ramp up production in a single location, thereby
increasing economies of scale. Exporting is how Honda captured a dominant position in the
worldwide motorcycle industry. It is how Samsung is keeping pace with Apple in the smartphone and tablet computer industries.
Exporting works well when little adaptation of a product is required and good distribution
networks are in place in the foreign market. It is also the least risky of the entry modes, as it
involves the least investment in the foreign country. If cultural or administrative distance is
large, exporting might be the right decision, because you avoid the challenges of managing a
culturally different workforce in a foreign country. It is also a good choice if speed to market
is important, as products can be shipped and sold in foreign markets quickly.
Of course, exporting also has its limitations. Transportation costs and government trade
tariffs can both increase the cost of selling in a foreign market. Your company and its products will likely be viewed as “foreign,” which can be a problem in some countries. Exports
also may suffer if the value of the home nation’s currency rises compared to the currency of
target foreign markets.51 As the exchange rate fluctuates, so does the price of a firm’s product in the foreign market. For instance, in 2007, one U.S. dollar cost 121 Japanese yen. By
2012, the dollar was trading for only 77 yen.52 A product manufactured in Japan and sold in
the United States for $100 brought the Japanese company 12,100 yen in 2007, but only 7700
yen in 2012. Although firms can try to cut costs to compensate for such involuntary price
changes, exporters are often at the mercy of exchange rates.
Licensing and Franchising
Licensing and franchising both involve selling the rights to produce a firm’s products or
services.52 The licensee or franchisee typically pays a negotiated fee (usually 5 to 10 percent)
as a royalty, based on the number of units sold. As described in Chapter 8, Disney received
royalties from the Oriental Land Company on revenues derived from Tokyo Disneyland.
exporting Sending goods or
services to another country for
sale.
licensing Granting another
business the permission to use or
sell a firm’s product, technology,
or process.
franchising A license that allows
a person or firm access to a
business’s proprietary knowledge,
processes, or trademarks in order
to allow them to sell a product or
service under the business’s name.
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ì INTERNATIONAL STRATEGY
Franchising is a special form of licensing with a longer-term commitment, the use of the
brand name, and more often involves a transfer of firm knowledge and business processes.
In addition to negotiating a contract concerning royalty payments, firms that franchise usually impose strict rules on franchisees concerning how the business is operated and marketed, and provide them with ongoing support and oversight.
Licensing and franchising are good entry modes for firms that have unique know-how or
a solid brand that can be easily valued (so the price of the license or franchise can be negotiated), but do not have the capital or resources and capabilities to expand abroad themselves. Because they only involve the transfer of knowledge, rather than building operations
in a foreign country, these two modes of entry require less investment and are often among
the faster ways to earn a profit in foreign markets. The lower risk and speed of entry make
these attractive entry choices when the risk is otherwise high due to large distances (any of
the four distances) between countries.
As with each mode of entry, there are downsides to licensing and franchising. First,
they offer the least amount of control of all the various modes of entry.53 Firms may try to
include contractual safeguards, but the firm that buys the license or franchise is ultimately
in charge of manufacturing and marketing. Sometimes the licensee or franchisee does not
invest enough in the business to maintain quality and build a strong brand. Lack of control
also can make it hard to tap into local knowledge and innovation. Moreover, any knowledge
being generated from the foreign operations belongs to the licensee or franchisee. Extracting that knowledge for use in other locations can be problematic.
Finally, there is a risk that the firm licensing the product or service can become a competitor. If you let others manufacture your product or operate your business model, they are
going to gain critical capabilities in your business. RCA, a U.S.-based manufacturer of color
televisions, met its death this way. It licensed its technology to Japanese firms in the 1970s,
only to have them enter the U.S. market soon after their licenses expired and put RCA out of
the television business.
Alliances and Joint Ventures
alliances An agreement between
two businesses to cooperate on
a mutually beneficial project. It
usually involves the sharing of
resources and/or knowledge.
complementary assets Assets
owned by another company that
are needed in order to successfully
commercialize and market a
product or service.
joint venture An alliance between
firms involving the creation of
a new entity where both firms
provide assets and/or knowledge,
processes or technology.
Alliances (discussed in detail in Chapter 8) involve sharing resources, risks, and rewards.54
They are an increasingly favored way to enter markets that are distant (i.e., more risky) from
the home market.55 Following its initial international failures, Lincoln Electric now usually
forms a joint venture, a type of alliance, with a local partner when it enters a country with
high administrative distance from the United States.
Many companies use alliances to access complementary assets.56 For instance, a common way to enter a distant, foreign market is to create an alliance with a local company who
knows what consumers want and knows how to navigate local government regulations and
distribution channels. An alliance with a local firm also mitigates some of the foreignness of
the entering firm, allowing the alliance to be perceived by both government and consumers
as local. Sometimes this is the only way to enter a market. For instance, until recently, in
many industries India did not allow foreign retailers to enter the country unless they partnered with a local firm.
A joint venture is a special form of alliance involving the joint creation of a new firm.
Most joint ventures involve a 50/50 share of ownership; each company puts in 50 percent of
the value and gets 50 percent of the rewards. If the venture doesn’t work, the home-country
firm only loses half the overall investment in the joint venture.
Although alliances allow faster and less risky access to new markets than wholly owned
subsidiaries (discussed next), they also present significant management challenges. Overcoming cultural and linguistic barriers to bring together teams of managers from both
companies increases the difficulty of operations. Each party in the alliance may also hold
different strategic goals. These challenges cause many alliances to fail. Moreover, as with
licensing, the lack of tight control can create serious problems by allowing the partner firm
to develop resources and capabilities that enable it to become a competitor. Indeed, the
Chinese government forces foreign firms in strategic industries to form joint ventures with
Chinese firms for the explicit purpose of learning their technology in order to compete
against them.
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[ 187 ]
Wholly Owned Subsidiaries
Wholly owned subsidiaries are local units owned outright by the entering firm. This type
of entry requires the most investment and creates the most risk, as the firm has to put up all
of the capital itself. Wholly owned subsidiaries can, however, overcome trade and transportation barriers by producing locally. They may also allow a foreign firm to appear more local
to host-country governments and consumers.
In addition, this mode offers the firm the most control over what its local subsidiary
does. Many high-tech firms form wholly owned subsidiaries as a way to control access to
their technology and avoid leaking it to a licensee or partner. A wholly owned approach
gives firms that use a combination of international strategies sufficient control to realize
economies of scale. For example, wholly owned entry can allow a firm enough control to
coordinate a worldwide value chain with key elements of the value chain located in the
lowest-cost location to gain an arbitrage advantage. Such a firm might manufacture all of a
certain type of component in one location in order to gain economies of scale, and then ship
the components from one location to another for assembly.
There are two ways of entering with wholly owned subsidiaries: (1) a greenfield investment, in which the firm builds operations from scratch; or (2) acquiring a local firm.
Greenfield investments give the firm the greatest amount of control, because they build
the operations, marketing, and distribution from the ground up. However, they are also the
slowest entry mode, as it takes time to build capabilities. Moreover, although the firm maintains tight control over its own technology and processes, it also has to learn about the local
market and government regulations on its own. As Lincoln Electric learned in Japan, the
learning process can take a while and sometimes leads to failure.
Acquisitions involve buying local firms. Such a purchase allows the entering firm to
acquire local resources, knowledge, and expertise while still maintaining control through
100 percent ownership. However, acquisitions typically involve paying a price premium and
they can also be notoriously difficult to integrate into the rest of the firm’s worldwide operations. Merging two firms is difficult enough within the same country. Cultural differences complicate the process considerably, often resulting in a slower integration process and a higher
risk of failure.57 Table 9.2 summarizes some of the key differences among the modes of entry.
wholly owned subsidiary A unit
in a foreign country that is wholly
owned by the parent company.
greenfield investment A wholly
owned subsidiary where the firm
involved builds the facility from the
ground up.
Choosing a Mode of Entry
The choice of which mode to use is based on the firm’s situation, including its access to
capital and need for local resources or capabilities, as well as the firm’s primary international strategy. Global strategies require more control, moving firms toward exporting and
wholly owned subsidiaries, whereas multidomestic strategies encourage local innovation,
which could involve joint ventures, franchising, or autonomous wholly owned subsidiaries.
[ Table 9.2 ] Entry Modes
Exporting
Licensing/
Franchising
Alliance/
Joint Venture
Wholly Owned
Subsidiary
Investment required
Low
Low
Medium
High
Level of risk
Low
Low
Medium
High
Overcome trade barriers?
No
Yes
Yes
Yes
Speed of entry
Fast
Fast
Medium
Slow (faster for
acquisition than
greenfield)
Acquire local resources, including
knowledge?
No
No
Yes
Yes
Viewed as insider or outsider?
Outsider
Insider
Possibly insider
Possibly insider
Degree of control
Low
Low
Medium
High
ì INTERNATIONAL STRATEGY
[ Figure 9.7 ] Experience and Entry Modes
Time
Franchising
Licensing
Joint Venture
Exporting
Wholly Owned
(Greenfield, Acquisition)
CH09
Control
[ 188 ]
Risk
Source: Adapted from F. R. Root, Entry Strategies for International Markets (San Francisco: Jossey-Bass,
1994), p. 18.
Arbitrage strategies require ownership, suggesting that exporting and licensing/franchising
will not be good choices.
The choice of which mode to use is also based on a firm’s international experience. Most
firms start their international expansion by first exporting, or selling to target country
wholesalers. Firms may then move to joint ventures, and finally to wholly owned subsidiaries as they become more comfortable managing operations in the foreign market. Figure 9.7
highlights this effect of learning over time in a more nuanced fashion. It shows the typical
paths followed by firms who first enter a foreign market through exporting, licensing, or
franchising. The beginning points for most firms are on the left with most firms moving
toward the right as they gain experience.
SUMMARY
ì This trend toward increased international trade has allowed organizations to place parts
of their value chains in different countries, depending on where each part can generate
the most value.
ì Firms expand internationally for many reasons, the most important of which are growth,
efficiency, managing risk, gaining access to more knowledge and responding to customers and/or competitors.
ì There are four types of distance—cultural, administrative, geographic, and economic
(CAGE)—that firms should keep in mind when entering a particular country. The shorter
the overall distance, the greater the likelihood of success.
ì There are three types of international strategy—multidomestic, global, and arbitrage.
ì Exporting, licensing/franchising, alliances/joint ventures, and wholly owned subsidiaries
are four different ways of entering a country.
KEY TERMS
administrative arbitrage
(p. 183)
administrative distance
(p. 177)
alliances (p. 186)
arbitrage strategy (p. 183)
capital arbitrage (p. 183)
complementary assets
(p. 186)
cultural arbitrage (p. 183)
cultural distance (p. 177)
economic arbitrage
(p. 183)
economic distance
(p. 178)
Innovative Strategies
That Change the
Nature of Competition
10
TRIPPLAAR KRISTOFFER/SIPA
P /Newscom
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1
Discuss innovative strategy and the differences between the
types of innovation.
2
Identify the different categories of innovative strategies.
3
Describe the accelerating pace of innovation and the product,
business, and industry life cycle.
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10
Innovative Strategies in
Home Movie
Entertainment
I
n the early 1980s, a radical, new product was introduced to
the market by Japanese companies Sony and Panasonic:
the home video player. For the first time, consumers
could purchase or rent a movie and watch it on their video
player in the comfort of their own home whenever they
wanted. Video players gave rise to video rental stores—a less
expensive alternative to buying movies. By the early 1990s,
Blockbuster had built 3,400 stores and dominated the home
video rental market.1 The company reached its peak in 2004
with close to 9,000 stores and over $6 billion in revenue.2
Blockbuster invested heavily in their stores and inventory—
each store carried more than 1,000 different movies—so that
customers could conveniently find a store and the movie
they wanted to rent. The cost of each store ranged from
$225,000 to $750,000.3
a movie to watch. But the upside was the ability to access
90,000 movies. Netflix shipped movies from 50 strategically
located warehouses around the country to ensure that most
customers got their orders within two days.4
This business model gave customers more movie
options to choose from, and since Netflix customers paid a
monthly fee, their business model profited in the opposite
way of Blockbuster’s. Netflix made money when customers
didn’t watch the DVDs they ordered. As long as the DVDs
sat unwatched at a customer’s home, Netflix didn’t have to
pay return postage or mail out the next DVD. And because
Netflix didn’t have to build stores, hire sales clerks, or buy a
huge inventory of DVDs to put in each store, it had more than
a 30 percent cost advantage over Blockbuster. It was able
to share some of this cost advantage with customers in the
IF NETFLIX TOOK BLOCKBUSTER TO THE MAT, REDBOX TAGGED IN FOR THE PIN. BLOCKBUSTER’S
PRIMARY ADVANTAGE OVER NETFLIX WAS THE ABILITY TO PROVIDE MOVIES FOR THE IMPULSE MOVIE
WATCHER. REDBOX ENTERED THE MARKET RENTING MOVIES THROUGH VENDING MACHINES.
Blockbuster’s leaders quickly discovered that
Blockbuster didn’t make money from the videos sitting on
the shelves. It needed to get customers to rent the DVD and
return it as quickly as possible so Blockbuster could rent
it to another customer. To encourage customers to return
the DVD rentals quickly, Blockbuster charged late fees that
were unpopular with customers but helped Blockbuster
get the DVDs to the next customer as quickly as possible.
Blockbuster’s overall strategy worked well until Netflix
entered the movie rental business in 1997. Instead of
building stores, Netflix rented DVDs over the Internet and
shipped movies directly to the customer’s home. Rather
than charge a per-use fee, Netflix charged customers a
monthly subscription fee that allowed them to rent one to
eight movies at a time. From the customer’s perspective,
the downside of renting movies over the Internet was that it
required planning ahead—no impulse movie watching. You
couldn’t just pop down to the Blockbuster store and grab
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form of lower prices, and keep some of this advantage in the
form of higher profits.
If Netflix took Blockbuster to the mat, Redbox tagged
in for the pin. Blockbuster’s primary advantage over
Netflix was the ability to provide movies for the impulse
movie watcher. Redbox entered the market renting movies
through vending machines. Each vending machine cost
approximately $15,0005 and was placed in convenient and
well-traveled locations like grocery stores, pharmacies,
convenience stores, and even McDonald’s. By 2013, Redbox
had placed more than 47,0006 vending machines around
the United States, making them far more accessible than
a Blockbuster store for most customers. Because vending
machines were cheaper than stores, Redbox could rent
movies at the low price of $1.20 per night and still make
money. By 2010, Blockbuster had filed for bankruptcy.
Netflix’s market value as of January 2014 was over $20
billion, and Outerwall’s (Redbox’s parent company) market
WHAT IS AN INNOVATIVE STRATEGY?
value was $1.9 billion.7 But the battle for home video
entertainment isn’t over. Apple, Amazon, and Microsoft
have attempted to leverage their online capabilities and
customer bases to win share in the video on demand (VOD)
and Internet video on demand (iVOD) markets. For example,
Amazon offers free streaming of older movies and pay
per view for newer movies to its Amazon Prime members.
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Moreover, Hulu (backed by NBC Universal and Fox) offers
both free streaming (supported by advertisements) and Hulu
Plus, a subscription-based service like Netflix. The market
entry of these new competitors—each attempting to gain
advantage by leveraging different capabilities—suggests
that new innovative strategies will continue to emerge in the
home movie entertainment industry.
ì
The opening case illustrates how Netflix and Redbox used innovative strategies to defeat
Blockbuster in the video rental business. Innovation is a powerful driver of competition and
competitive advantage. New entrants, in particular, have strong incentives to offer different
value propositions than incumbents—and preferably in a way that is hard to imitate.
Strategies that offer a different value proposition to customers using different resources
and capabilities are often referred to as “innovative strategies,” “revolutionary strategies,”8
or “disruptive innovations.”9 Famed economist Joseph Schumpeter argued that competition
is a process that is driven by the “perennial gale of creative destruction.”10 Innovative
strategies—like the ones launched by Netflix and Redbox—simultaneously create and
destroy value. This is what makes strategy a dynamic process. The strategy that worked
yesterday might not work today—and what works today might not work tomorrow. Consequently, companies must be able to innovate and change in order to weather the storms
of creative destruction that will certainly come their way. The primary focus of this chapter
is to examine innovation-based strategies—like the ones used by Netflix and Redbox—that
prove to be revolutionary or disruptive in their industries.
WHAT IS AN INNOVATIVE STRATEGY?
To understand innovation, it is first important to understand the difference between an
invention and innovation. Invention describes the creation of a unique or novel concept,
method or process that is often turned into a tangible outcome—such as new product. An
innovation is the conversion of a novel concept (an invention) into a product, process, or
business model that generates revenues and profits.11 Innovation differs from invention in
that innovation refers to the use of a novel idea or method, whereas invention refers more
directly to the creation of the idea or method itself.12
For example, the scientists at Xerox PARC (Palo Alto Research Center) invented the computer mouse as a new way to navigate a computer. This invention would allow users to select
from images and menus on a computer monitor through a Graphical User Interface (GUI).
But it was Steve Jobs and Apple computer who launched the Macintosh computer—the
first commercialized microcomputer that came with a mouse and graphical user interface.
Apple’s Macintosh turned Xerox’s invention into an innovation that could generate revenues
and profits. In similar fashion, the Wright brothers invented the airplane at Kitty Hawk,
but Boeing and others commercialized the idea by designing and building commercial aircraft that could be sold as products. As shown in Figure 10.1, an innovation needs to be
(1) novelc, (2) useful, and (3) successfully implemented in order to help companies succeed
in the marketplace.
invention The creation of an idea
or method; a novel concept.
innovation The conversion of a
novel concept (an invention) into
a product, process, or business
model that generates revenues and
profits.
Incremental versus Radical Innovation.
Innovation enables firms to deliver value in new ways. Innovations can be thought of as
falling into two general categories: incremental innovations and radical innovations.
An incremental innovation builds on a firm’s established knowledge base and steadily
improves the product or service it offers.
incremental innovation Building
on a firm’s established knowledge
base to create minor improvements
to the product or service a firm
offers.
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[ Figure 10.1 ] Definition of Innovation
Novel
Useful
Implemented
radical innovation Innovation that
draws on a different knowledge
base, technologies, or methods to
deliver value in a truly unique way.
innovative strategy A strategy
that introduces a fundamentally
different business model than
rivals.
revenue model The approach, or
pricing strategy, a company uses
to get paid for the value it delivers
through its business model.
For example, when Gillette offers a razor with five blades instead of four, or when Samsung offers a TV with an LED screen instead of a plasma screen, those are incremental
innovations. In similar fashion, when any company makes incremental improvements to
their operations to accomplish a task faster, better, or with fewer resources, these are also
incremental innovations. Incremental innovations are also sometimes called “sustaining”
innovations because they sustain a company’s current product offering and revenues.
In contrast, a radical innovation draws on a different knowledge base, technologies,
or methods to deliver value in a truly unique way. Examples of products based on radical
innovations include the computer (versus the typewriter), CT scanner (versus the X-Ray),
cell phone (versus the landline phone), and MP3 player (vs. CD player).
Processes can also be based on more radical innovations. For example, Toyota engineer Taichi Ohno developed a set of flexible production techniques, often referred to as
lean manufacturing, that minimizes inventories and waste despite being designed for rapid
product changeovers.13 This system of production was significantly different from the mass
production system developed by Henry Ford that was based on standardization, significant
automation, and few product changeovers. Toyota’s deployment of its “flexible” or “lean”
production system has helped it produce high-quality cars at low cost and propelled it to
worldwide leadership in the automobile industry.
Strategies that draw on more radical innovations often use new technologies or employ
a fundamentally different business model than rivals, meaning they create, deliver, and
capture value through very different resources and capabilities. As illustrated in the opening case, Netflix used the Internet, software, and warehouses to deliver video rentals in a
radically different way than Blockbuster. In similar fashion, Redbox uses vending machines
to rent videos, which requires different technologies—and a very different distribution
system—than those used by either Blockbuster or Netflix. This chapter focuses on innovative
strategies that are based on more radical innovations.
We define an innovative strategy as a strategy that introduces a fundamentally different business model than rivals. The term business model refers to the rationale of how an
organization delivers and captures value. More specifically, business models typically differ
on one of three dimensions:
1. The choice of customer segments to serve and the unique value (value proposition)
offered by the company
2. The choice of activities the company performs and the resources utilized to deliver
value to customers
3. The way a company generates revenue streams to get paid for the value it delivers. The
term revenue model is sometimes used to refer to the approach, or pricing strategy,
a company uses to get paid for the value it delivers through its business model (see
Strategy in Practice: Understanding Business Models).
WHAT IS AN INNOVATIVE STRATEGY?
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S T R AT E GY I N P R A CT I C E
Understanding Business Models
O
ver the past few years, the term business model has
often been used to describe a company’s strategy.
Perhaps the most comprehensive approach to defining a
company’s business model has been developed by Alex
Osterwalder and Yves Pigneur in their tool, the Business
Model Canvas.14 They argue that there are nine components
to a business model and firms can innovate by changing one
or more of those components as they seek to deliver and
capture value. The nine components are:
1. Value propositions. A firm seeks to solve customer problems and satisfy needs with a particular unique value
or value proposition.
2. Customer segments. The value propositions are
designed to meet the needs of one or several customer
segments.
3. Channels. Value propositions are delivered to customer
segments through communication, distribution, or
sales channels.
4. Customer relationships. Customer relationships are
established and maintained with each customer
segment.
5. Revenue streams. Revenue streams result from value
propositions that are successfully offered to customers
through pricing strategies.
6. Key resources. Key resources are the assets required to
offer and deliver the company’s value proposition.
7. Key activities/capabilities. Value propositions are developed and delivered through key activities or capabilities.
8. Key partnerships. Some resources and activities that
are critical to delivering the value proposition are outsourced to partners outside the company.
9. Cost structure. The business model elements above
result in the cost structure for delivering the value
proposition to the customer. These costs must be
covered by the revenue streams in order for a firm to
be profitable.
To illustrate, Amazon has a different business model than
Barnes & Noble (B&N), with the most obvious difference
being channels—Amazon sells books over the Internet
rather than through bookstores. But this means that
Amazon’s value proposition is different, as are its primary
customer segments. Amazon’s primary customer segment
prefers the lower prices that Amazon offers but they also
like the convenience of shopping from their computers. In
contrast, B&N’s customers like the ability to get their book
immediately and may enjoy the shopping experience at a
B&N store. To deliver their value propositions through the
distribution channels they’ve chosen, each firm must be
good at different activities and have different resources. For
example, Amazon needs to be good at writing software and
fulfilling orders from warehouses, whereas Barnes & Noble
has to be good at finding the best locations for its stores,
designing stores to create a great shopping experience, and
efficiently operating each store. Amazon and Barnes & Noble
are described as having different business models because
they differ on most, if not all, of the nine components of the
business model canvas.
In some cases, firms deliver similar value to similar
customer segments—and may even use similar resources
and capabilities to deliver value—but they may differ in their
pricing strategy or their approach to generating revenues
streams and capturing value. For example, Apple, Spotify,
and Pandora use different revenue models or pricing
strategies to generate revenue streams. Apple makes money
by selling songs and albums over the Internet for a specific
price. In contrast, Spotify provides consumers with unlimited
access to all songs in its library for a monthly subscription
fee. Pandora uses a “free” revenue model like a radio
station, and provides songs via the Internet that are tailored
to a listener’s preferences. Pandora makes money by selling
advertising.
Companies sometimes attempt to change their business
model in response to competition. For example, Barnes &
Noble added the online book retailing business model to its
bricks-and-mortar bookstore business model in response to
Amazon’s entry into book retailing.15 In similar fashion, Apple
launched iTunes Radio in 2013 to directly compete with
Pandora.16 In this way, they have imitated Pandora’s business
model including the revenue model for capturing value. In
most cases, the company that is first to launch a business
model has a first-mover advantage because it becomes
known as the pioneer. In order to successfully compete with
pioneers, second movers must offer unique value relative to
the first mover—for example, lower prices, more features, or
greater convenience—to lure customers in their direction.
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disruptive innovation Radical
innovative strategies in which
companies in the same industry
find the innovation so disruptive
that they can no longer do business
as usual.
Innovative strategies based on radical innovations are sometimes referred to as
disruptive innovation because companies in the same industry find the innovation so
disruptive that they can no longer do business as usual.
For example, when Netflix introduced an innovative way for customers to access home
entertainment, it “disrupted” Blockbuster’s strategy and Blockbuster could no longer succeed by doing business as usual. Blockbuster had to make a drastic change or it would end
up going out of business. Innovative strategies are disruptive when they offer value that is
attractive to incumbent’s customers, and are delivered through a business model that is difficult for incumbents to imitate. Not surprisingly, new entrants with innovative strategies
want to disrupt established companies and offer value in a way that is difficult to imitate.
We now turn to discussing different types or categories of innovative strategies that have
been successfully deployed by various companies.
CATEGORIES OF INNOVATIVE STRATEGIES
Since innovative strategies are about delivering unique value through a business model that
differs from the competition, there are many different ways to offer an innovative strategy.
It would be impossible to put each new strategy into a predefined category, because new
innovative strategies are often unique relative to strategies being used by established firms.
That’s the power of innovation. However, over the years strategists have noticed that some
types of innovative strategies enable disruptive innovation through similar tactics and patterns—or what some strategy scholars have referred to as a similar dominant logic.17 By dominant logic, strategists mean the primary logic behind how the company is trying to deliver
unique value to customers.
For example, the dominant logic behind the strategies of Netflix (versus Blockbuster)
and Amazon (versus Barnes & Noble) was to lower costs by eliminating retail stores and
shipping directly to the customer. The categories of innovative strategies we identify in
Figure 10.2 can be useful as a guide to launching a disruptive innovation. In this section
we examine a few of the most well-known patterns of innovative strategies as identified by
various strategy scholars.
Reconfiguring the Value Chain to Eliminate Activities
(Disintermediation)
One type of innovative strategy is based on reconfiguring the value chain to eliminate
activities or steps. The most typical pattern is to eliminate a step in the path from production to customer, such as eliminating a store, which also eliminates the need for salespeople and inventory. This allows the disruptor—the firm launching the game-changing
strategy—to offer lower prices for similar products and services. This is the approach
that Netflix used to gain a cost advantage against Blockbuster. Amazon used this same
approach—selling books over the Internet—to offer books at lower cost than Barnes &
Noble (see Figure 10.3).
[ Figure 10.2 ] Categories of Innovative Strategies
Reconfiguring the Value Chain to Eliminate Activities
Low-End Disruptive Innovations
High-End Disruptive Innovations
Reconfigure the Value Chain to Allow for Mass Customization
Blue Ocean Strategy—Creating New Markets by Targeting Non-Consumers
Free Business Models
CATEGORIES OF INNOVATIVE STRATEGIES
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[ Figure 10.3 ] Value Chains of Barnes & Noble versus Amazon.com
Barnes & Noble
Authors
Warehouse
Publishers
Store
Customer
Distributor
Amazon. com
Authors
Publishers
Warehouse
Customer
The approach of eliminating stores and selling products over the Internet has worked
well for products like books and movies—items that are standardized and predictable. But
can this work for a product that people like to try out before buying? What about a mattress?
The company 1-800-Mattress has been quite successful selling mattresses online as well as
over the phone. Since the company sells mattresses that are similar to models sold in stores,
customers can go try one out to see what they like. Their strategy is to sell mattresses for
20 to 30 percent lower than the competition and deliver it to your home. Not only that, but
if the customers are not satisfied, they can exchange it for another mattress, satisfaction
guaranteed.
Southwest Airlines has used a similar strategy of eliminating steps in the value chain to
offer low airfares relative to other airlines. By eliminating meals, seat reservations, and luggage transfers, Southwest is able to lower total costs and offer less expensive airline tickets
to its customers.
Low-End Disruptive Innovations
A second type of innovative strategy is called a low-end disruption.21 Rather than eliminating steps in the value chain, some firms use a different set of activities or technologies than
their rivals to produce a low cost product or service. Harvard professor Clayton Christensen
observed a pattern in a number of industries where a firm leverages new technologies to
launch a product at the low end—the most price-sensitive segment of the market—and then
gradually moves upmarket as it improves its technology and processes.
For example, Nucor used this approach to disrupt integrated steel producers like U.S.
Steel. Nucor pioneered a new way to create steel products using small electric arc furnaces
to melt scrap metal in mini-mills. This process was much simpler and less expensive than
the traditional method of melting iron ore and other ingredients in enormous blast furnaces.
When mini-mills first emerged, the quality of their output was poor, which meant they could
only make rebar (steel rods) used to reinforce concrete. This was a low-margin market that
the big steel makers were happy to abandon because of the low profitability. But as Nucor’s
mini-mills improved their processes and product quality, their cost advantage enabled them
to offer lower prices than the integrated producers in higher-margin products such as angle
iron, structural beams, and sheet steel. Eventually, many of the integrated steel companies
like Bethlehem Steel were unable to compete because of their cost disadvantage, and they
went bankrupt.
In a similar fashion, Honda started at the low end in the automobile industry by offering 50cc and 150cc motorcycles. When Honda first launched, Harley-Davidson wasn’t
concerned about the competition because its market was superheavyweight motorcycles.
Harley-Davidson’s CEO even proclaimed that Honda’s entry was good for Harley-Davidson
low-end disruption Producing a
low-cost product or service for the
low-end or most price-sensitive
segment of the market, and then
gradually moving upmarket as the
product or service improves its
technology and processes.
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The Internet as a “Disruptive” Technology
T
he Internet has frequently been described as a
“disruptive” technology—one that has enabled innovative
strategies that are disruptive—by allowing digitized
information and products to be easily accessed by anyone
throughout the world. By now, we are all familiar with the
impact that the digitization of music, books, and movies
has had on bricks-and-mortar retailers such as Virgin
Records, Borders, and Blockbuster. Web applications such
as TurboTax and LegalZoom are replacing professional tax
accountants and attorneys, and online gaming is the fastestgrowing segment in the $97 billion video-game industry.18
The Internet, and the online digitization it enables, can be
either a threat or an opportunity.
The primary impact of the Internet on companies is that
it has become a low cost distribution channel for anyone
wanting to sell a product or service. As a result it has
dramatically lowered the barriers to entry into new markets.
Just when Barnes & Noble and Borders thought they had
created barriers to entry by building large book superstores,
Amazon entered selling books over the Internet. The
business models of Amazon, Netflix, and eTrade would not
have been possible without the Internet. The Internet has
enabled new entrants to create new business models and
deliver value in innovative ways while lowering costs.
As a result of the Internet lowering the cost of distribution,
it has enabled business models that rely on the long-tail
phenomenon, where broader inventory can be offered to
meet a wider variety of consumer needs. Before the Internet,
products and services were usually sold through bricksand-mortar stores that could only handle limited inventory.
As a result, only those products fortunate enough to get
widespread distribution were big sellers. The “long-tail”
phenomenon explains that 80 percent of offerings in a product
category (books, songs, movies, clothing, etc.) are not big hits
and only account for about 20 percent of units sold, whereas
20 percent of offerings account for 80 percent of sales.19
This phenomenon is captured by the Pareto principle, also
known as the 80-20 rule, which says that roughly 80 percent
of effects come from 20 percent of the causes. The Pareto
principle is named after Italian economist Vilfredo Pareto,
who observed in 1906 that 80 percent of the land in Italy was
owned by 20 percent of the population.20 The Pareto principle
is applied to many situations in business but perhaps
most notably to sales, where in most cases 80 percent of a
company’s sales come from 20 percent of its customers. The
Internet provides an opportunity for online retailers to benefit
from marketing the “long tail,” which is the remaining 80
percent of offerings as outlined in Figure 10.4.
Online retailers can “sell less of more” by taking
advantage of unlimited virtual shelf space. This is what
allowed Netflix to offer 90,000 different movies versus 1,000
at a Blockbuster store, and Amazon to offer 5 million book
titles versus 100,000 at a Barnes & Noble store.
The Internet has also allowed more companies to employ a
free revenue model because the marginal cost (the incremental
cost of producing one additional unit) of producing and
distributing most digital products is zero. Once a software
program has been written, it can be copied and shared at
virtually zero cost. Skype would not be able to provide free phone
calls, nor could Zynga provide free games without the Internet.
Number of Units Sold
[ Figure 10.4 ] The Long-Tail Phenomenon
20%
Number of Different Products Offered
CATEGORIES OF INNOVATIVE STRATEGIES
because Honda would get more people riding a motorcycle and eventually they would
graduate to a Harley.22 But over time, Honda used profits from its large volume of small
motorcycles to invest in the development of larger motorcycles and eventually entered the
superheavyweight motorcycle categories with bikes that were less expensive but more technologically advanced than Harley-Davidson’s.
Apple and IBM’s first microcomputers were inferior to the minicomputers sold by
DEC and Data General. They simply did not have the speed or processing power to handle complex data analysis. But over time, their speed and processing power improved
enough that companies dumped minicomputers for the microcomputers that were
now good enough to do the complex data analysis that large companies required. Once
microcomputers could offer similar computing power as minicomputers at a much
lower cost, DEC and Data General were unable to compete, and both eventually went
bankrupt (See Strategy in Practice: Why Incumbents Don’t Respond Effectively to LowEnd Disruptions).
Another example is Skype’s cheap—and often free—phone service that has been gradually moving upmarket as the quality of calls improves and the technology allows for video
conferencing and other higher-end business services. Skype has already taken over about
one third of all long distance international phone calls from AT&T and other long-distance
providers.23 It will be interesting to see if Skype’s free phone service will move to Internetenabled cell phones and eventually be disruptive to the cell phone giants such as Verizon,
AT&T, Sprint, and T-Mobile.
High-End/Top-Down Disruptive Innovations
High-end, or top-down, disruption is as revolutionary as a bottom-up disruptive innovation. But in stark contrast to the low-end variety, high-end disruptive innovations actually
outperform existing products when they’re introduced, and they sell for a premium price
rather than at a discount.24 History provides a number of examples: Apple’s iPod outplays
the Sony Walkman; Starbucks’s high-end coffee drinks and atmosphere drowns out local
coffee shops; and flash drives fly past zip drives and floppy disks. Products created through
high-end disruptive innovations are initially purchased by the most discriminating and least
price-sensitive buyers, and then they move steadily downward, into mainstream markets.
New entrants launching high-end innovations typically rely on “radical” or leapfrog technological innovations that are expensive initially, but with improvements in technology, and as
they are produced in larger volumes with greater scale, the costs gradually decline.
A high-end disruptive innovation may initially serve the specialized, high-end niche of a
market for years before it finally trickles down to mainstream markets. Such was the case
with electronic fuel injection (EFI), a technology that first replaced carburetors in high-performance racing cars before finally making its way to the high-volume cars made by the
major automakers like General Motors and Toyota. The innovation slowly penetrates from
above until the product becomes practical and affordable in mainstream markets, at which
point consumers generally flock to the new offering.
Cell phones, which originally cost $3,995, only appealed to the high-end niche.25 But as
the price (and size) of the phones dropped, they became accessible to a much larger segment of the market. Today, almost 36 percent of homes are “wireless only” households.26 The
cell phone example also introduces an important point: high-end disruptive innovations
don’t need to be superior on every product feature relative to incumbent product offerings.
But they do need to be superior on at least some attributes that customers care about. While
cell phones offered the superior advantage of portability, they were disadvantaged relative to
landline phones in terms of sound quality. But over time, sound quality has improved and is
now comparable to landlines. In similar fashion, digital cameras offered advantages of storing thousands of images than can be immediately viewed and edited, but initially offered
inferior picture quality relative to 35 mm cameras. As the picture quality improved, digital
cameras began to dominate the camera market.
High-end disruptions are new products or services that offer either superior performance
on some existing product features or offer new features customers are willing to pay for. In
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Why Incumbents Don’t Respond Effectively
to Low-End Disruptions
I
n many cases, rivals do not attempt to respond to a new
low-cost offering. Why don’t they respond? They see little
to gain by selling what they view as an inferior, inexpensive
product to a price-sensitive niche market. After all, why would
Harley-Davidson want to offer an inexpensive motorcycle?
The margins are small, and Harley might tarnish its brand
by offering an inexpensive, possibly inferior, motorcycle.
Instead, companies like Harley focus on the needs of their
most profitable customers, who tend to ask for more features
and better performance from their products. By the time
they realize that the new low-end product has improved its
performance enough to attract their mainstream customers,
incumbents find it is too late to respond.
Some organizations also find it difficult to respond
because a response would require them to develop a new
set of resources and capabilities. Integrated steel makers
would have to learn how to make steel using mini-mill
technology. Harley-Davidson would have to learn to produce
smaller motorcycles in large volumes at low cost. In some
cases these new resources and capabilities are viewed as
incompatible with the firms existing set of resources and
capabilities. For example, it would be very challenging for
Harley-Davidson to simultaneously manufacture and sell
mostly customized heavyweight motorcycles while producing
high volumes of standardized smaller motorcycles like
Honda. The production processes that Honda uses to
produce millions of motorcycles each year differ significantly
from Harley’s production processes that produce less than
250,000.
Finally, some companies are afraid of cannibalization.
They are concerned that if they provide a less-expensive
offering, customers will switch to it, resulting in a loss in
revenues and profits. In the long run, this can be a recipe
for disaster as customers eventually move to the low-end
offering and the incumbent loses significant profits. For
example, AT&T did not want to offer free phone service over
the Internet like Skype because it would cannibalize the paid
phone service that AT&T was providing. AT&T didn’t want
to do anything to encourage customers to move from paid
phone service to free phone service.
most cases, these new top down products are only possible because of innovations in technology that leapfrog the technologies used in earlier products.
Reconfiguring the Value Chain to Allow for Mass Customization
mass customization When a
company mass-produces the
various modules of the product and
then allows the customer to select
which modules will be combined
together.
Some firms, like Build-A-Bear Workshop, Dell, and Timbuk2, have launched innovative
strategies based on a concept that is known as mass customization. Mass customization
is an oxymoron, like “jumbo shrimp” or “act naturally.” Until recently, most products in business were either mass produced OR customized, but not both. However, new technologies
and processes have allowed for the mass production of individually customized goods or
services.
Take Build-A-Bear Workshop, for example. Customers “build” their own teddy bear or
other stuffed animal by choosing from a large variety of body styles, after which the animal is
stuffed at the store to the customer’s liking. The customer can also add a heart or sound box
during stuffing, enabling the animal to “talk” or play music. After helping to stuff their animal, the customer can dress their furry friend in an outfit of their choice from a soccer uniform, or witch costume, to a sequin shirt and jeans, and they can even add shoes. In short,
the components of the teddy bear are mass produced but put together in a customized way
by each individual customer. But mass customization isn’t just for children. Online retailer
Timbuk2 uses a similar approach, allowing customers to choose from a set of modules to
design their own bag or purse.27 Both Build-A-Bear and Timbuk2 find that many customers
enjoy the experience of creating their own unique product.
CATEGORIES OF INNOVATIVE STRATEGIES
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Dell used a similar strategy when it successfully launched its PC business using the “Dell
Direct model.” Dell sells directly to customers and allows them to choose the components
that matter most to them; they then custom build and ship the PC to the customer within
48 hours. Dell’s ability to mass-produce customized PC’s requires a flexible and responsive
assembly system and supply chain. These companies find that customers enjoy creating
their own unique product.
Mass customization seems to work best in markets where customers have a variety of
different needs and many want a product that is personalized to their particular needs. It
also works best when the product can be broken into modules that offer different features
or performance. This requires that the product be designed as separate modules that can
be mass produced but that can be quickly and easily linked together to create a functioning
product.
Blue Ocean Strategy—Creating New Markets by Targeting
Nonconsumers
INSEAD professors Chan Kim and Renee Mauborgne identify another type of innovative
strategy that they call blue ocean strategy. They argue that a company can succeed by creating new demand in an uncontested market space. Where sharks competing for the same
scarce food create a red ocean of blood due to intense rivalry, blue ocean success relies on
swimming to empty water. In other words, offering value that is very different from anything
on the market.
For example, when Cirque de Soleil opened its first show, it was clear that it would be
nothing like a Ringling Brothers circus. A Cirque de Soleil show combines elements of a traditional circus, acrobatic troupe, street performers, and a Broadway show to offer a unique
entertainment experience. Cirque’s shows are so original that there is no direct competition.
The tagline for one of the first Cirque productions was revealing: “We reinvent the circus.”
Moreover, it attracted a new group of customers who were willing to pay several times the
price of a conventional circus ticket for a unique entertainment experience.
As companies try to create new demand, they sometimes target nonconsumption—
individuals who do not currently purchase a product or service—with an offering that might
induce consumption. For example, more than 70 percent of households in India do not have
a refrigerator because they are large, expensive, and require continuous electricity to run. So,
appliance maker Godrej decided to try to create an innovative small refrigerator targeted
at nonconsumption—those 125 million households without a refrigerator. Using battery
technology and solid-state thermo electric cooling, it created a $59 cooler-size refrigerator—
called Chotukool, which translates as “little cool”—to bring affordable refrigeration to everyone in India. One challenge Godrej had to overcome was how to give Indians in the poorer
rural areas of India access to Chotukool. Since these potential customers didn’t have access
to an appliance store, Godrej thought of a unique way to distribute Chotukool: through the
Post Office. Since the postman goes to every home in India and is often viewed as a trusted
friend, Godrej partnered with the India Post Office as the distribution partner for Godrej in
many parts of India. By selling a unique product through an innovative distribution channel,
Godrej was able to create new demand in a market without any direct competition.
According to Kim and Maubougne, most companies focus on incremental improvements to existing offerings rather than seeking to create new markets. In a study of business launches in 108 companies, they found that 86 percent of those new ventures were
line extensions—incremental improvements to existing industry offerings—and a mere
14 percent were aimed at creating new markets or industries. Although the line extensions
did account for 62 percent of the total revenues, they delivered only 39 percent of the total
profits. By contrast, the 14 percent invested in creating new markets and industries generated 38 percent of total revenues and 61 percent of total profits.28 Clearly, success in new
markets brings much greater rewards.
However, organizations don’t necessarily have to venture into distant waters to create new markets. Indeed, many new markets are created from within, not beyond, existing industries. Godrej’s Chotukool represents a good example. Godrej was already in the
blue ocean strategy Creating new
demand in an uncontested market
space.
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ì INNOVATIVE STRATEGIES THAT CHANGE THE NATURE OF COMPETITION
appliance business but was able to create a new refrigerator market within the industry (see
Strategy in Practice: Where Do Innovative Strategies Come From?). Chrysler did the same
thing in the automobile industry when it launched the first minivan targeted to families who
wanted more room than a station wagon but didn’t want a huge van. The minivan—a vehicle
that was essentially a hybrid between a sedan and a van—created an entirely new category
of vehicle and was the staple of Chrysler’s profits for years.
Free Business/Revenue Models
A final category of innovative new business or revenue models involves offering products
or services for “free.”29 During the past two decades, we have witnessed the emergence of
“free” products and services in a way never seen before. Free newspapers (Metro), software (Google Docs), stock trades (ZeccoTrading), telephone calls (Skype), and cell phones
(AT&T and Verizon bundle free phones with contracts). Free product strategies, once the
exclusive province of the digital realm, have also been popping up in markets far removed
from the Internet. From free prescriptions for expensive pharmaceuticals, to free airline tickets, and even free automobile leases, the “free” business models popularized by software
companies like Google, Adobe, and Mozilla are spreading across markets everywhere, in
some cases eliminating rivals. One example is Wikipedia, which destroyed Encyclopedia
Britannica and Microsoft Encarta.
Although many companies offered short-term “freebies” in the past—for example a
30-day free trial of software—these products and services are perpetually free. What are the
characteristics of products or services that are most likely to succeed being offered for free?
And how is it that firms like Google are making lots of money by not charging users? What
is their revenue model? Here are three “free” strategies that companies use:
Strategy 1: Cross-Sell (Freemium) Strategy. The cross-sell strategy involves offering a free
high conversion rate When a high
percentage of free users are willing
to convert to paid customers for
premium features.
third-party pay strategy Providing
free products to a community
of product users as a method of
generating revenue from a third
party who pay to access those
users.
basic product to gain widespread initial use, after which users are offered a nonfree premium
version (often called freemium) or are sold products not directly tied to the free product.
Virtually every app on the iPhone uses the cross sell strategy (e.g., Zynga games), as does
Skype, which offers free phone calls but makes money on the add-ons, such as voicemail
and calls to landlines or cell phones. One tactic is to offer a free version of the product to
consumers to use at home, but offer a paid version with additional features to the enterprise
market.
For example, Adobe only charges corporate customers for its Reader software—it is free
to all others. Craigslist uses a version of this approach by offering free listings in every category but one—jobs—which is free for job seekers but not for companies.
Large-scale success with this strategy requires either: (1) a free product that appeals to a
very large product user base (e.g., roughly 1.5 billion people with computers are interested in
using Skype to make phone calls); or (2) a high conversion rate, meaning a high percentage
of free users are willing to convert to paid customers for premium features. Skype is successful
because of the sheer total numbers of customers that use its free product. Even if Skype has a
low conversion rate, (the rule of thumb is 5 percent of free product users tend to become paying customers) it can make still money because it has over 400 million product users.
In contrast, Flickr, the photo-sharing site, has a much smaller total market. The number
of camera users that want to use a photo-sharing service is much smaller than the market
for making free phone calls. Moreover, the conversion rate to Flickr Pro is relatively low
because for most users, the free version is good enough. The fact that Skype appeals to more
users with a conversion rate that is better than Flickr’s translates into a superior business
model. This explains why eBay was willing to pay $2.6 billion for Skype, whereas Yahoo!
reportedly paid only $22 to $25 million for Flickr.32
Strategy 2: Third-Party Pay Strategy. Firms utilizing a third-party pay strategy—
sometimes called a two-sided market—provide free products to a community of product
users as a method of generating revenue from a third party who pay to access those
users. In the digital age, Google is the poster child for this strategy, offering free Internet
search services while companies pay Google to advertise to its millions of product users.
CATEGORIES OF INNOVATIVE STRATEGIES
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S T R AT E GY I N P R A CT I C E
Where Do Innovative Strategies Come From?
W
hat makes a business innovator like Thomas Edison,
Steve Jobs, or Jeff Bezos different from a typical
manager? How did they come up with the innovative ideas
that helped them found General Electric, Apple, and
Amazon.com, respectively? Is it genetic? Where they born
intuitive and divergent thinkers?
Research by Jeff Dyer, Hal Gregersen, and Clayton
Christensen reported in The Innovator’s DNA confirms others’
work that creativity skills are not simply genetic traits
endowed at birth, and that they can be developed. In fact,
the most comprehensive study confirming this was done by
a group of researchers, Merton Reznikoff, George Domino,
Carolyn Bridges, and Merton Honeymon, who studied
creative abilities in 117 pairs of identical and fraternal twins.
Testing twins aged 15 to 22 years old, they found that only
about one-third of the performance of identical twins on a
battery of 10 creativity tests could be attributed to genetics.
In contrast, roughly 80 percent of twins’ performance on
general intelligence (IQ) tests could be attributed to genetics.
So general intelligence (at least the way scientists measure
it) is basically a genetic endowment, but creativity is not.
Nurture trumps nature as far as creativity goes. That means
that about two-thirds of our innovation skills comes through
learning—first, from understanding the skill, then practicing
it, and ultimately gaining confidence in our capacity to create.
If innovators can be made, then how did business
innovators like Edison, Jobs, and Bezos come up with their
great ideas? Five discovery skills distinguish innovators
from typical executives.30 First and foremost, innovators
count on a cognitive skill called associational thinking, or
simply associating. Associating happens as the brain tries
to synthesize and make sense of novel inputs. It helps
innovators discover new directions by making connections
across seemingly unrelated questions, problems, or ideas.
Innovative breakthroughs often happen at the intersection
of diverse disciplines and fields. Author Frans Johanssen
described this phenomenon as the Medici effect,31 referring to
the creative explosion that occurred when the Medici family
brought together creators from a wide range of disciplines—
sculptors, scientist, poets, philosophers, painters, and
architects—in fifteenth-century Italy. As these individuals
connected, they created new ideas at the intersection of their
respective fields, spawning the Renaissance, one of the most
innovative eras in history. Put simply, innovative thinkers
connect fields, problems, or ideas that others find unrelated.
The other four discovery skills trigger associational
thinking by helping innovators increase their buildingblock ideas. Specifically, innovators engage the following
behavioral skills more frequently.
Questioning. Innovators are consummate questioners
who show a passion for inquiry. Their queries frequently
challenge the status quo, or push people to think differently.
One of Steve Job’s favorite questions was: “If money were
not object, what kind of product would we create?” He
wanted Apple engineers to imagine the perfect product—and
then try to design and build it. Innovators ask questions to
understand how things really work, why they are that way,
and how they might be changed or disrupted. Collectively,
their questions provoke new insights, connections,
possibilities, and directions.
Observing. Innovators are also intense observers.
They carefully watch the world around them and their
observations of customers, products, services, technologies
and companies help them gain insights into and ideas for
new ways of doing things. Steve Jobs’s observation trip
to Xerox’s research lab, the Palo Alto Research Center
(PARC), provided the insight that was the catalyst for both
Macintosh’s innovative operating system and mouse and
Apple’s current OSX operating system.
Networking. Innovators spend a lot of time and energy
finding and testing ideas through a diverse network of
individuals. They actively search for new ideas by talking to
people who may offer a radically different view of things. For
example, Steve Jobs was told by Apple Fellow Alan Kay to,
“go visit these crazy guys up in San Rafael, California.” The
crazy guys were Ed Catmull and Alvy Ray, who headed up a
small computer graphics operation called Industrial Light
& Magic (the group that created special effects for George
Lucas’s movies). Fascinated by their operation, Jobs bought
Industrial Light & Magic’s computer animation group for
$10 million, renamed it Pixar, and eventually took it public
for $1 billion. Had he never chatted with Kay, he would never
have purchased Pixar, and the creative Toy Story, Monster’s
Inc., and Finding Nemo films might not have been produced.
Experimenting. Finally, innovators are constantly
trying out new experiences and piloting new ideas.
Experimenters explore the world intellectually and
experientially, holding convictions at bay and testing
hypotheses along the way. They visit new places, try new
things, seek new information, and experiment to learn
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ì INNOVATIVE STRATEGIES THAT CHANGE THE NATURE OF COMPETITION
new things. Jobs, for example, tried new experiences all
his life—from meditation and living in an ashram in India,
to dropping in on a calligraphy class at Reed College. All
these varied experiences triggered ideas for innovations
at Apple.
customer segment Groups of
people who share similar needs
and thus are likely to desire the
same features in a product.
Collectively, these discovery skills—the cognitive skill
of associating and the behavioral skills of questioning,
observing, networking, and experimenting—constitute “The
Innovator’s DNA,” or the code for generating innovative
business ideas.
Google’s approach works well because product users type in key search words and
identify themselves as prime candidates for advertisers. For example, typing in “skis” or
“snowboards” allows companies selling or servicing those products to advertise to those
targeted customers.
The secret to third-party pay is to provide a valuable free service that attracts either:
(1) a very large community of product users that can then be segmented in a particular way
for advertisers (the way Google does with search); or (2) a targeted community of users that
comprises a customer segment, or group of individuals similar on a key dimension (e.g., this
similarity could be based on demographics, for example “teenagers” or “retired people;” or more
need based, such as “video-game players” or “new mothers”). Blyk, a Finnish telecommunications
company that was acquired by France Telecom, competes by offering free cell phone service to
16- to 24-year-olds. Product users in the desired demographic fill out a detailed survey on their
preferences and are given 217 free minutes each month if they agree to receive advertisements.
Blyk makes money by selling access to that particular demographic and providing information
on their preferences.33 Blyk also benefits by using Freemium, since many customers go over their
free minutes and end up paying a premium for those minutes.
In similar fashion, Ryannair offers a small percentage of its airline seats for free by
using a combination of Freemium and third-party pay. The company makes money on the
add-on services: $25 per customer for checked or carry-on bags, $5 for seat reservations
and credit card use, and $4 for priority boarding. Flight attendants sell food, scratch-card
games, perfume, digital cameras, and MP3 players. Ryannair also uses the flight as a platform for advertisers. When your seat tray is up, you may see an ad for a cell phone from
Vodaphone, and when it is down, you may see an ad from Hertz. Flyers are a captive audience for advertisers targeting travelers. The key to third-party pay is to deliver a captive
audience, preferably a specific customer segment, to an advertiser willing to pay for access
to that audience.
Strategy 3: Bundling Strategy. A bundling strategy involves offering a free product with a
paid product or service. For example, Hewlett-Packard may give away a free printer with the
purchase of a computer, or Verizon may give away a free cell phone with the purchase of a
service contract. Of course, the “free” effect here is largely psychological, since the customer
must actually pay in order to get the product for free.
Offering a free product as part of a bundle works well when the product requires ongoing
maintenance or complementary goods (e.g., Hewlett-Packard makes money by selling ink
for its free printers). For example, Better Place is a company that introduced free electric car
leases in Israel. It is able to lease the car for free because it bundles the car with an energy/
maintenance contract. Customers pay 10 cents per mile (less than the cost of gas) to get
their electric car battery packs swapped out at a Better Place service station. Instead of
stopping for gas, you stop for a battery swap. But the battery swap costs Better Place less
than 10 cents per mile, so it makes money on the difference. It also makes money through
third-party pay because the Israeli government—like many other governments—are trying
to cut down on pollution, so it subsidizes Better Place’s operations.34
Additionally, bundling works particularly well when a company offers a broad array
of products. Banks are increasingly bundling free services—free accounts or stock
trades—when a customer uses other services (e.g., keeps investment balances above
some minimum). But the bundled product doesn’t have to be related to the free product. Banks sometimes give away free products, like iPods or iPads, to customers opening
accounts.
INNOVATION AND THE PRODUCT/BUSINESS/INDUSTRY LIFE CYCLE (S-CURVE)
[ 209 ]
Hypercompetition: The Accelerating Pace of Innovation
Over the past 25 years, we have witnessed an accelerated pace of innovation that has had
a significant impact on the nature of competitive advantage. In fact, Dartmouth Professor
Rich D’Aveni coined the term hypercompetition to refer to his argument that competitive
intensity has increased, and that periods of competitive advantage have decreased.35
Recent research provides evidence that the increased pace of change has made it harder
to sustain competitive advantage.36 In fact, one study found that in 1950, when a firm
reached the Fortune 500, on average it stayed in the Fortune 500 for 12 years. However, by
2000, the average firm that reached the Fortune 500 only stayed there for 7 years due to the
emergence of new, faster-growing firms.37 This all suggests that established companies need
to be constantly looking over their shoulder for new entrants who might be launching new
products with innovative strategies. It also suggests that established companies cannot rest
on their laurels. They must continue to be inventive and offer new products and services if
they hope to continue to grow. If they don’t, their current products and businesses will eventually proceed through the famous “S-curve,” which means that after the growth phase they
will eventually mature and decline.
INNOVATION AND THE PRODUCT/BUSINESS/INDUSTRY LIFE
CYCLE (S-CURVE)
Innovations frequently lead to the creation of new products, businesses, or even industries.
New products, product categories, and even industries tend to follow a predictable life
cycle, evolving over time through four stages: introduction, growth, maturity, and decline.
Figure 10.5 depicts a typical product/business/industry life cycle.
Introduction Stage
During the introduction stage the company tries to get early adopters—those types of buyers
willing to try out the latest new gadget—to try out the new product. The primary goal is to
get some reference customers that will seed future growth to increase market acceptance.
Product innovation is much more important than process innovation during this stage; as a
result, R&D, product development and design are key competencies. Google Glass, Google’s
idea for a wearable computer with an optical head-mounted display (OHMD) that responds
to voice commands and displays information on the glasses, is an example of a product in
the introduction stage.
Growth Stage
Sales accelerate during the growth stage as the initial innovation gains traction and increased
market acceptance. Tablets and smartphones are examples of product categories that are currently in the growth stage. Demand increases as the early majority, a new group of buyers, is convinced that the product concept works as demonstrated by early adopters in the introduction
stage. The company continues to refine the product during this stage as they also look for innovative ways to reach customers through marketing and new distribution channels. As the product
starts to gain widespread acceptance a standard (or dominant design) emerges that signals the
market’s agreement on a common set of engineering and design features. Toward the end of this
stage product innovation starts to give way to process innovation.
Maturity Stage
As an industry moves into the mature stage, growth starts to slow as total market penetration increases. What little growth there is comes from buyers called the late majority entering the market who want not only a proven concept but also a low price. The limited market
hypercompetition A term coined
by Professor Rich D’Aveni to refer
to his argument that competitive
intensity has increased and that
periods of competitive advantage
have decreased.
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ì INNOVATIVE STRATEGIES THAT CHANGE THE NATURE OF COMPETITION
[ Figure 10.5 ] Product/Business/Industry Life Cycle
Introduction
Growth
Maturity
Decline
Sales and Profit
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Time
growth leads to an increase in competitive rivalry and cost starts to become more important
as a determinant of success. Process innovation and operational efficiency is typically more
important to success than product innovation. Laptop computers are an example of a product that is moving from the growth to the mature stage.
Decline Stage
The decline stage is often initiated by new products entering the market that cause demand to
fall. For example, demand for Sony’s Walkman didn’t really start to fall until the introduction of
Discman and then the iPod. As iPod was taking off in its growth phase, Walkman and Discman
were both declining. Similarly, Apple and IBM’s personal computers initiated the decline of the
typewriter, and more recently we’ve seen the original desktop PC start to decline with the growth
of laptops and tablets. As the market size shrinks during the decline stage, some firms try to
minimize competition and consolidate the industry by buying rivals.
Understanding the product life cycle can be useful for identifying the strategic priorities
for a product or business. Each stage of the life cycle requires different priorities and competencies in order for the firm to succeed and satisfy that stage’s unique customer group. The
life cycle also highlight’s the importance of innovation—or the ability to launch new product
life cycles—because if you don’t, your products and business will eventually be in decline.
Although launching a business with an innovative strategy sounds alluring, it is also
risky. Why? Because, by definition, when a company launches an innovative strategy it is
offering a unique value proposition using an original business model. Since the organization
is trying to do something that has never been done before, there is tremendous uncertainty
as to whether it will work or not. Although we’ve talked about a lot of successful innovative strategies in this chapter, there are more failures than successes. For example, Apple
launched the “Newton,” a personal digital assistant (PDA) that hit the market with a thud
before the market was ready for mobile computing. The Newton didn’t attract customers
and was deemed a huge failure, costing Apple millions of dollars. It was an innovative product but it wasn’t successful. The same can be said for Iridium, founded in 1991 by Motorola
and a global partnership of 18 companies. The company spent $5.2 billion to launch 72 satellites so that its cell phone system would work “anywhere on earth”—from ships in the ocean
to jungles of Africa. The problem was that their cell phones were the size of a brick and only
worked if they had a direct connection to the sky—which meant they didn’t work inside
buildings or cars. Iridium went bankrupt and eventually an investor group bought $6 billion
worth of assets for $25 million.38
The bottom line is that if you don’t innovate, you may eventually “be overrun by a swarm
of start-ups,” says Scott Cook, founder and chairman of Intuit, a provider of financial services
software including Quicken, TurboTax, and SnapTax.39 However, innovations must be more
than novel offerings to the market. They must be deemed useful by customers and must be
successfully implemented. This makes them risky propositions. Launching an innovative
venture is not for the faint of heart. But for those who are successful, the rewards can be
extraordinary.
Competitive Strategy
11
Ethan Miller/Getty Images
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1
Create a strategic group map and a strategy canvas of a
competitive landscape.
2
Analyze a company’s competitors to identify the likely ways they
will respond to a company’s strategic moves using a competitor
response profile.
3
Describe the different types of competitive strategies that can be
deployed contingent on the environment in which a company
operates.
4
Choose or create a competitive strategy suitable to a company’s
competitive situation.
[ 215 ]
11
Delta Simplifies Its Fares
airlines were down by an average of one-third, and American
Airlines’ fares were down by 44 percent.2 Perhaps as a way
to slow the free fall, Northwest airlines warned the industry
that “fare simplifications” would immediately and adversely
affect industry revenues, but other airlines ignored the
warning.3
By July, just six months later, Delta was already making
upward price adjustments, citing a spike in the cost of
fuel.4 The company abandoned the $499 cap and raised the
ceiling by $100. Again, major carriers immediately followed
suit. On the day of the announcement, a spokesman for
Continental stated, “All I can tell you is that we did match
Delta’s fare, and the match was effective today. Whatever
Delta did, we did.”5 Meanwhile, the low-fare carriers
welcomed the move as evidence that full-fare carriers were
burdened with cost structures that were simply too high to
match their low ticket prices.
Despite the effort exerted to implement the new pricing
strategy, by 2008,
Delta had completely
RICHARD ANDERSON, DELTA’S CEO, SEEMED TO SUGGEST THAT EFFORTS TO COMPETE
abandoned the
ON PRICE WITH THE LOW-FARE CARRIERS HAD BEEN MISGUIDED. CUTTING PRICES FOR
simplifares initiative.
BUSINESS TRAVELERS HAD HAD DISASTROUS EFFECTS ON REVENUE BECAUSE THE
Richard Anderson,
EXPECTED GROWTH IN PASSENGER VOLUME NEVER MATERIALIZED.
Delta’s CEO, seemed
to suggest that
efforts to compete on price with the low-fare carriers had
low-fare carriers for their travel. In fact, near Cincinnati,
where simplifares was first piloted, many business travelers been misguided. Cutting prices for business travelers had
had disastrous effects on revenue because the expected
preferred to drive to a smaller airport and pay the fares
growth in passenger volume never materialized. This
of AirTran or ATA rather than the higher fares of Delta.
was largely due to competitive price matching. In a clear
The new pricing structure was expected to bring these
return to its previous strategy, Mr. Anderson stated, “You
customers back to Delta.
really have to have a differential [between business and
Although Delta hoped for a new source of advantage
leisure travel]. We offer different products to different
from this pricing move, Delta’s main competitors—the fullcustomers based on their attributes. That’s better for an
fare carriers such as American and United—responded to
international carrier offering … different products on the
simplifares by immediately matching Delta’s prices. Within
same airplane.”6
days, business fares in the top 40 routes flown by major
I
n January 2005, facing increasing competition from
low-fare carriers, Delta Airlines introduced a new
pricing plan called simplifares that dramatically cut
ticket prices across most of Delta’s domestic U.S. routes.
Paul Matsen, Delta’s chief marketing officer, stated,
“We could sit back and wait for low-fare competition to
force us to react, but we’re going on the offense.”1 The
company cut ticket prices by as much as 50 percent and
eliminated the Saturday-night stay requirement that had
long helped airlines distinguish between leisure travelers
and business travelers. Furthermore, it capped the price
for a last-minute coach fare at $499 and a first-class
fare to anywhere in the country at $599. Although the
new pricing scheme would immediately create a drag on
revenue, Delta expected that over the long run the pricing
move would be good for the airline by helping it take back
passenger volume from the low-fare carriers. Business
travelers, in particular, had been increasingly moving to
ì
[ 216 ]
UNDERSTANDING THE COMPETITIVE LANDSCAPE
[ 217 ]
Competition is a reality for business firms. Whether a company faces competitors in the
market that are actively striving to erode its market share or potential new entrants to its
market, nearly all managers must grapple with how to compete. In some markets, competition is light because firms are highly differentiated or because they face few rivals. In other
markets, competition can be very intense. In such markets, and as the opening case demonstrates, a company must acknowledge the reality that competitors are watching and are
likely to react to its strategic actions. Had Delta realized how quickly its competitors would
respond to its pricing moves, the company might have tried a different strategy to improve
its performance against low-fare carriers.
How does a company know which actions to take in the face of competition? And what
actions are likely to be the most effective in the differing competitive situations that a firm
might face? How will competitors respond to a company’s strategic moves? This chapter
provides answers to these questions by identifying a set of tools for competitive analysis
along with strategies for responding to competitors that are useful under a variety of market
circumstances. The overall objective is to help strategists understand how a company can
improve its performance in the face of competition.
In order to effectively compete, a company must first know the competition and then it
must launch strategies to win against the competition. The first two sections of the chapter,
“Understanding the Competitive Landscape” and “Evaluating the Competition,” address
knowing the competition. The latter two sections, “Principles of Competitive Strategy”
and “Competitive Actions for Different Market Environments,” address winning against
the competition.
UNDERSTANDING THE COMPETITIVE LANDSCAPE
In order to compete effectively, a firm must understand the structure of the competitive
environment in which it operates. Most industries contain groups of companies that compete directly against each other but only indirectly against companies in other groups. This
situation arises because of differences in customer needs and preferences, which give rise
to various customer segments. As companies pursue these segments, they develop business
models that are well-suited to serving one segment but not so well-suited to serving other
segments in the market. Firms with similar business models cluster together by pursuing
the same segments of customers.
Strategic Groups and Mobility Barriers
An analysis that breaks down the structure of a market or industry into these constituent
groups is called a strategic group analysis. Visualizing this group structure is an important
component of competitive analysis because it identifies the major arenas of competition
and who competes directly with whom.
In the United States, Delta, United, and American Airlines compete in the full-fare segment of the industry (See Animated Executive Summary on, “Competitor Interaction”).
Delta encounters American or United on many of its routes between pairs of cities because
these companies compete in Delta’s primary customer segment—business travelers. Among
the companies in this group, airlines compete head to head and watch the moves of their
competitors closely. They respond to one another’s competitive moves almost immediately
in order to maintain a valuable competitive position. Other airlines, such as Southwest,
JetBlue, Frontier, or Spirit compete in the discounted or low-fare segment of the industry.
They offer few frills, less popular airports, or no reserved seating. These companies compete
head to head with each other more than they compete with the full-fare carriers.
Even though companies within groups compete head-to-head, and companies in
other groups are less of a threat, rivals in other groups cannot be completely ignored.
Rivals could begin targeting customer segments with new offerings or more favorable
value propositions and eventually steal customers. This is exactly what happened in the
strategic group A set of companies
that compete in similar ways with
similar business models pursuing
similar sets of customers.
CH11
ì COMPETITIVE STRATEGY
barrier to mobility Any factor that
limits the ability of a company to
move between strategic groups.
case at the opening of the chapter. Low-fare carriers were gaining ground in the business
traveler segment of the market when Delta launched its effort to compete on price with
these carriers.
Strategic group maps are constructed by identifying the main differences in the ways
in which firms in an industry compete to deliver value. These differences typically relate to
value chain activities such as relative price, geographic placement, product line breadth,
extent of vertical integration, niche or full-service offerings, and so forth. The factors that
are relevant can vary based on the industry in question. In the airline industry, for example, clues about the most important differences in how firms compete can be found in the
opening case description. Two of the important factors mentioned are price and whether
airlines are flying to primarily large or small airports (recall that Delta was losing business
travelers to smaller airports near Cincinnati). Therefore, to draw a strategic group map of
the airline industry, you would place these two factors on the horizontal and vertical axes
of a simple two-dimensional chart and plot the companies relative to these axes as outlined in Figure 11.1. If you observe clustering of companies, you have identified strategic
groups within the industry, at least along the dimensions chosen. The rule is to choose
factors that are the most relevant in describing the differences in how companies compete
for customers. In other words, choose the dimensions that create the most distinctive
clusters.
Companies find that switching strategic groups is difficult once they have built a history
in one. The reason is that companies in specific strategic groups choose particular ways to
configure their activities and these activity systems do not change quickly or easily. This
creates a barrier to mobility between groups. Once a firm is in a particular group, it is not
mobile and can’t simply leap to a different group.7 For Delta to effectively compete with lowfare carriers, the company would have to acquire many of the business characteristics of the
low-fare carriers. For example, the company would have to change its cost structure, airline
fleet, routing, and airport locations, effectively abandoning much of its existing customer
base. In the opening case, Delta attempted to compete head-to-head with the low-fare carriers by changing only its price. But the company would have had to change many more of its
characteristics in order to be successful.
A strategic group map provides a basis for making competitive assessments not only
because it defines who a company’s competitors are but also because it can help to analyze
potential changes in the landscape. For example, it can indicate whether companies in one
group are beginning to appeal to the primary markets of another group. Such was the case
when low-fare carriers near Cincinnati began to steal business customers from Delta.
[ Figure 11.1 ] Strategic Group Map
Large
Full-fare
group
American
Delta
Average ariport size
[ 218 ]
United
Southwest
JetBlue
Low-fare
group
Spirit
Small
Low
High
Relative fare price
Note: Company circle size relative to revenue
UNDERSTANDING THE COMPETITIVE LANDSCAPE
Are firms in any group attempting to change the value they offer and the basis of competition? Is this leading to any changes in the boundaries of groups? Delta attempted to alter
group boundaries when it launched a low-fare pricing strategy. Are new firms entering the
industry with fundamentally different business models? Southwest certainly did when it
first entered the Texas market in Dallas. Are there “empty spaces” on the strategic group map
that may invite successful entry? In Figure 11.1, no firms currently operate with high fares
at small airports, or with low fares at large airports. If this is the case, does this fact suggest
possible alternative competitive approaches to the market? These types of questions can be
asked and addressed effectively in the context of the strategic group map (See Strategy in
Practice: A Real World Strategic Group Map).
Strategy Canvas
Another way to evaluate differences among competitors is to employ a strategy canvas. This
idea was first introduced by W. Chan Kim and Renée Mauborgne as a way to assess relative
competitive strengths and weaknesses against specific purchase criteria.8 By rating firms
on various criteria that customers use to make purchase decisions, the analyst is able to
quickly grasp similarities and differences in how companies attempt to offer unique value to
customers relative to competitors.
For example, consider a strategy canvas analysis of Southwest Airlines and its unique
value proposition relative to full-service airlines and automobile travel (see Figure 11.2).
Various features that customers care about when selecting among travel options are identified and placed on the horizontal axis. These features include things like price, meals,
lounges, seating choices, hub connectivity, and so forth. Next, company performance is
evaluated against these criteria and scored on the vertical axis. This scoring is typically
based on rigorous quantitative scales, such as those obtained from surveys or other market
research. The completed strategy canvas provides insight into how competitive offerings
are differentiated.
In Figure 11.2, Southwest’s scores more closely resemble automobile travel than they do
the scores for other full-service airlines. This analysis uncovers a key point about Southwest’s approach to the market. When Herb Kelleher founded the airline in 1971 at Luv Field
in Dallas to fly passengers to Houston and San Antonio, he set out not to compete with
airlines but, rather, with automobile travel.
The strategy canvas is a useful tool not only for uncovering existing differences among
competitors, but also for identifying new ways to beat rivals. Imagine Figure 11.2 without
Southwest’s line drawn on it. If you were launching a new airline, or even if you were running
[ Figure 11.2 ] Strategy Canvas of the Short-Haul Airline Industry
Offerings
High
Other Airlines
Southwest
Car
Low
Price
Meals
Lounges
Seating
Hub
Friendly
choices connectivity service
Speed
Frequent
departures
Source: Adapted from C. Kim and R. Mauborgne. “Charting Your Company’s Future,” Harvard
Business Review (2002).
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S T R AT E GY I N P R A CT I C E
A Real-World Strategic Group Map
L
ANDESK is a provider of enterprise software solutions
for IT Administrators who manage the many devices on
corporate computer networks. When LANDESK wanted to
gain strategic insight into the dynamics of its competitive
landscape, the company created a strategic group map
(see Figure 11.3). First, the company chose two factors that
seemed to distinguish the business models of firms in the
industry: relative price, and product capabilities, especially
around scalability, or the ability of the software to handle
very large corporate networks. All relevant competitors were
placed on the chart based on how they scored on these two
dimensions. The circle size for each company was scaled
to represent revenues. Clear strategic groups emerged
and these were circled (dotted red) and then given a name
for quick reference. Competitor bubbles were further color
coded with a proprietary LANDESK indicator.
The chart provided a clear view of which companies
were on the landscape, how the companies were
competing with respect to price and product capabilities,
and which companies LANDESK primarily competes
against. By examining the chart, it was also clear that
some of the companies were well positioned to present
threats to companies in other groups by changing products
or pricing. For example, companies in the Alternative
Delivery Providers and Small Business Segment Full Suites
groups seemed to be the biggest threat for encroaching
on LANDESK’S market share. Meanwhile, companies like
Novell, HP, and CA, who offered similar software, seemed
to have fallen out of LANDESK’S strategic group. Still
other firms, such as those in High Growth Niche Providers,
seemed to be improving their product scalability. These
dynamics are represented on the chart with arrows.
The strategic group map successfully informed the
development of targeted competitive strategies, but also
helped identify potential acquisitions, pricing, and product
feature enhancements.
[ Figure 11.3 ] LANDESK Software—Strategic Group Map and Competitive Landscape
Full Suite–Large Enterprise
High
Revenues/
Market Share
Declining
IBM
BigFix
Novell
HP
High growth Niche
Providers
CA
VDI and Point Players
Relative Price
RES
Software
Medium
Symantec/
Altiris
Absolute
Lumension
LANDesk
Microsoft
(SCCM)
AppSense
Bomgar
Threats from Below
JAMF
Dell/Kace
Wanova
Full Suit - Enterprise
Microsoft
(InTune)
Kaseya
Matrix
42
Numara
(BMC)
Low
Alternative Delivery Providers (Primarily
Small Business Segment)
Size of bubble reflects the size (Revenue) of the organization
Product Capabilities/Scalability
Small Business Segment Full
Suite
EVALUATING THE COMPETITION
[ 221 ]
an existing airline, you might be able to identify new opportunities for competitive positioning by studying the differences between how other airlines and cars are competing across
relevant purchase criteria.
EVALUATING THE COMPETITION
Now that we’ve explored how to look at the competitive landscape, we can turn to examining the motives and likely behavior of individual competitors. Anticipating the actions of
rivals is an important skill for companies because it helps them evaluate their own competitive moves to identify those that will have the most advantageous effect. A useful way to
examine a competitor is to develop a competitor response profile.9 A competitor response
profile identifies characteristics of a competitor in order to assess how it might respond in
the face of rival actions, as outlined in Figure 11.4.
What Drives the Competitor?
To illustrate how to build a profile, let’s return to the airline industry. Let’s assume that
Southwest Airlines wants to compete on international routes in Europe and is evaluating
Delta as a competitor. The first question to ask is, “What drives the competitor?” Within this
category, objectives and assumptions are identified. An objective for Delta could be, “Leverage the benefits of international scale for overall cost savings,” or, “Capture a greater share of
market by providing home-to-destination travel for international passengers.”
What assumptions reinforce these objectives? One is that passengers want to fly the
same airline domestically and internationally, possibly because of co-located terminals or
[ Figure 11.4 ] Competitive Response Profile
WHAT DRIVES THE
COMPETITOR
WHAT THE COMPETITOR
IS DOING OR IS
CAPABLE OF DOING
Objectives
Strategy
1 Leverage the benefits of
international scale for overall
cost savings.
1 Capture a greater share of
market by providing home
city to destination travel for
international passengers.
Assumptions
1 Passenger want to fly the same
airline domestically and
internationally.
1 Scale savings exist by having a
global footprint, which permits
competitive pricing on international
routes.
Delta
1 Position as an international travel
1 Delta is likely to
largely ignore entry
into its international
city-part markets by
Southwest, as long as
these entries remain
few.
choice to as many customers as
possible by building an extensive
travel network.
Resources & Capabilities
1 Locations in major cities
1 Airline partners that provide global
reach
1 Fleet of large aircraft
1 Reliable and service-oriented travel
Source: Adapted from M. E. Porter, Competitive Strategy (New York: The Free Press, 1980).
competitor response profile
A profile of a competitor that
identifies its objectives and
assumptions, its strategy, and its
resources and capabilities in order
to anticipate how the competitor
might respond to rival actions.
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easier baggage transfers. Another is that scale savings exist by having a global footprint,
and that this permits competitive pricing on international routes (since scale savings
lower costs). These kinds of assumptions often point the way to potential rival moves. For
example, if Southwest theorized that the scale savings from Delta’s global footprint were
small, or that Southwest’s own operating model gave it significant cost benefits, it could
plan on using this as an advantage against Delta and contest some of its more popular
international routes.
What Is the Competitor Doing or Capable of Doing?
After identifying the objectives and assumptions that drive the competitor, the next question would be: What is the competitor doing and capable of doing? Here is where a competitor’s strategy and their resources and capabilities are identified. What is Delta’s strategy?
Put simply, Delta’s strategy is to position itself as an international travel choice to as many
customers as possible by building an extensive travel network.
What resources and capabilities does Delta use to accomplish this? Resources include
its locations in major U.S. cities that are international gateways, such as New York, Atlanta,
Seattle, and San Francisco; airline partners that provide coverage where Delta is weak; and
a fleet of large planes that are characteristic of long-haul travel on international routes. Further, the airline has built a capability for reliable, timely, and service-oriented international
travel. These resources and capabilities point directly to what Delta can do on a competitive
basis, such as supplying international corporations with end-to-end travel services. These
are the strengths that Southwest, in our hypothetical example, must acknowledge if it is
going to go up against Delta.
How Will a Competitor Respond to Specific Moves?
Once these four factors—objectives, assumptions, strategy, and resources/capabilities—are
laid out for a specific competitor a company like Southwest can anticipate how the competitor might respond to specific moves. For example, given this profile, how would Delta
respond to Southwest entering one of its existing city-pair routes? Given that Delta differentiates, in part, by providing a broad set of international route options to customers, the
company will probably not react to Southwest entering a single city-pair route or even several routes. Why? Think of Delta’s objectives, assumptions, strategy, and resources/capabilities identified above. These included international scale, cost savings based on this scale, an
end-to-end extensive travel network, and substantial global assets. Because Delta is adding
value by being in as many places as possible and is building an extensive network, the company is unlikely to view the entry of a competitor without these objectives and resources
as a threat to its broader strategy. In formulating its competitive strategy, Southwest can
feel confident that entering into markets already occupied by Delta will be accommodated;
at least while Southwest’s international travel network remains small. If it begins to grow
large, Southwest could wind up moving into Delta’s strategic group, which could then invite
intensive competition.
Using Game Theory to Evaluate Specific Moves
game theory A structured
approach to analysis of competitor
interaction that yields predictions
about which strategic actions are
most likely to be chosen by rivals.
A competitive response profile provides an extensive look at a particular rival and also lends
insight into how this rival might respond to specific strategic actions. When rivals are locked
in intensive back and forth competition, such as that experienced in the airline industry,
a structured approach to analysis can lend even more insight. The tools of game theory
provide such a structured approach. The word game in game theory refers to strategic interaction among competitors and the word theory refers to a set of predictions about how competitors play games.
In most games, rivals are expected to make moves that deliver the greatest profit, called
a pay-off. Firms typically make their choices with this objective in mind. But rivals have
choices, too. With both firms facing choices, each must consider what the other will do
EVALUATING THE COMPETITION
[ 223 ]
in order to reach their own best outcome. This logic of anticipating what is in a rival’s best
profit interest before making your own move is central in game theory. Had Delta considered this in the opening case, the company might have anticipated how quickly rivals would
respond to its price cut.
Game theory is especially useful in contexts in which only a few rivals exist (like airlines)
and these rivals are considering such moves as price changes, capacity adjustments, or new
product features, and are wondering how competitors are likely to respond. Let’s examine
the logic of game theory to see how it can be used to anticipate and respond to rival actions.
Simultaneous Move Games. To illustrate the basic logic, let’s consider a simple game
with two players, each of whom has two choices. Assume the players make their moves
simultaneously and they only play the game once. This set up is called a simultaneous move,
one-shot game. The most famous game of this type is the prisoner’s dilemma. The prisoner’s
dilemma is as follows:10 Two individuals, prisoner 1 and prisoner 2, rob a bank of $2 million
and hide the loot. They have been captured and are being held by police in separate cells.
The police believe that the two robbed the bank but lack sufficient evidence to convict. So
they decide to separately offer to each prisoner the following deal: “If you implicate your
partner, we will give you leniency. But if your partner implicates you, you will get jail time.”
The prisoners know that if neither implicates the other, they will both go free.
Now consider the following 2 × 2 matrix representation of the game shown in Figure 11.5.
It shows that each prisoner has two choices. Prisoner 1’s choices are on the rows and prisoner 2’s choices are on the columns. The numbers in the cells are payoffs. The payoff on the
left in each cell belongs to prisoner 1 while the payoff on the right belongs to prisoner 2.
To interpret payoffs, assume that one year of jail time is the equivalent of $1 million of the
loot. If neither prisoner implicates the other, they go free and share the loot. If both implicate, they go to jail for one year each. If one implicates the other while not being implicated,
he gets off and takes all the loot for himself, while the other goes to jail for two years. Assume
that the prisoners only play the game once. They either get off free and go their separate
ways, or do so after they get out of jail. Also assume that if they both go to jail, the loot is
recovered by the authorities.
Since the prisoners are being held in separate interrogation rooms, they must make their
choices (“implicate” or “do not implicate”) without knowing the choice of their partner. This
is the simultaneous move aspect of the game. Assume both players know the structure of
the game and the payoffs accruing to their respective actions.
What is predicted outcome for this game? John Nash, a famous game theorist, developed
an equilibrium concept in games that has come to be known as the Nash equilibrium. The
Nash equilibrium is represented by a set of moves in a game that: (1) maximizes each firm’s
payoff given the choices of rivals and (2) removes incentive to defect in the sense that no
player can improve his payoffs by changing his choice. The first component of the definition
reflects that players are striving to achieve their best possible outcome while the second
ensures that the outcome is stable (i.e., the players have no incentive to change their action).
[ Figure 11.5 ] Prisoner’s Dilemma
Prisoner 2
Do not
implicate
–1, –1
2,–2
–2, 2
1, 1
Prisoner 1
Implicate
Implicate
Do not
implicate
Nash equilibrium A set of moves
in a game that simultaneously
maximize each firm’s payoff, given
the choices of rivals and from
which no player has an incentive
to defect.
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dominant strategy In game theory,
a set of actions that are always
played no matter what a rival
chooses to do.
The Nash equilibrium is the solution concept used to predict the outcome of competitive
interaction.11
To find the Nash equilibrium, think through what a player should do under each possible
move of its rival. Let’s look at the game from prisoner 1’s perspective. Suppose prisoner 1
thinks that prisoner 2 might implicate (look at the implicate column for prisoner 2). Prisoner 1 has two choices. He can implicate and receive –1, or not implicate and receive –2.
Which does he prefer? He prefers to implicate since we assume that players always prefer
the better payoff.
Now let’s consider what prisoner 1 would do if he believes prisoner 2 will not implicate.
Under this scenario, prisoner 1 receives a payoff of 2 if he implicates and a payoff of 1 if he
does not implicate. Clearly, he prefers to receive 2 over 1, so he would implicate.
Notice that no matter what player 2 chooses to do, player 1 maximizes his payoff by choosing “implicate.” Doing the analysis from prisoner 2’s perspective gives the same answer. The
intersection (cell) of any choices that are simultaneously preferred by the players of a game
is considered a Nash equilibrium, as long as there is no incentive to defect. In this game,
each player’s best choice is to implicate, and neither has an incentive to change this choice.
Implicate is also what is called a dominant strategy because it is the best choice under
every alternative choice of the rival. Searching for a dominant strategy makes finding a Nash
equilibrium easier in games where such strategies exist. In the prisoner’s dilemma, after discovering that “implicate” is a dominant strategy, the analyst can cross off both the row and
column associated with “do not implicate.” This choice would never be employed because it
is always dominated by the implicate choice.
Notice how the style of analysis that we used to solve the game resulted in the development of a strategy for play. In game theory, a strategy is a set of best responses to every
possible rival action. We systematically analyzed prisoner 1’s prospects under each possible
alternative action of prisoner 2 and selected the best outcome. In the real world as well, this
is a useful approach for developing competitive strategy. If the number of possible moves
of a rival is small, a potential response to each one of those possible rival actions can be
planned. Having done so, a company would have identified a competitive strategy.
The key lesson from the prisoner’s dilemma is that each player implicates and goes to
jail when a much better outcome exists. If they both play “do not implicate,” they share 1, or
$1 million each. However, the competitive risk, the lack of trust, the worry that a rival will
take advantage of the situation if he thinks the other will play “Do Not Implicate,” keeps both
players going to jail. The reason this is important in real markets is that it suggests a truth
about competitive behavior. Namely, competitors will play with their own best interests at
heart. Furthermore, since in most markets cooperation between competitors is anticompetitive and illegal, coordination typically does not exist—and neither does trust. Therefore,
the prisoner’s dilemma offers a compelling prediction about what happens in real markets
when companies have opposing interests.
Now consider a prisoner’s dilemma game in the business world. Let’s return to the
opening case and assume that Delta Airlines is playing a one-shot pricing game against
American Airlines (we’ll make the one-shot assumption for now and relax it in a moment).
Let’s assume that in this game each firm has two choices. It can either maintain price or
lower price. If both maintain price, each earns a profit of 5, or $5 million. If both lower price
each earns a profit of 2, or $2 million. But if one company lowers price while the other maintains price, the first company receives a profit of 10, or $10 million while its rival loses 1, or
$1 million. See Figure 11.6.
To solve this game, take the perspective of one firm and decide which move would be
best under each alternative action of the other firm. If Delta believes that American will
maintain price, it has a choice between payoffs of 5 and 10 for maintaining and lowering
price, respectively. Clearly, Delta prefers to lower price. If Delta believes that American will
lower price, then it has a choice between a payoff of –1 and 2. It prefers to lower price to
receive the payoff of 2. The logic is similar from American’s perspective.
As in the traditional prisoner’s dilemma, both firms wind up with payoffs that are worse
than they might have had. Specifically, if both companies would maintain price, they would
each wind up with $5 million. However, in the one-shot game, the pull to try for $10 million is very strong. This leads both companies to a relatively poor outcome of $2 million.
EVALUATING THE COMPETITION
[ 225 ]
[ Figure 11.6 ] Delta and American Play Out the Prisoner’s Dilemma
American
Maintain
Lower
5, 5
–1, 10
10, –1
2, 2
Delta
Maintain
Lower
This game illustrates how the prisoner’s dilemma can affect firms in real markets. Rivalrous behavior can make both firms worse off than they might’ve been if they had been able
to cooperate. The example also illustrates how a simple game structure can be utilized for
insight into how players might respond to one another’s strategic moves.
Infinitely Repeated Games. Now let’s relax the assumption that competitors interact just once
as in the one-shot game. In the real world, most companies are in competition with rivals
each and every day, month, or year with no certain end date. Game theorists call these games
infinitely repeated games. Even though the games are not literally played forever, they are
treated this way since the competitors repeatedly interact and the ending period is not known.
In infinitely repeated games, players always believe there is a future. This alters the way
they play. Specifically, they look for opportunities to get a larger amount of profit over a
longer period of time. In stable markets in which the players rarely change for instance,
firms play the game indefinitely. They know that they will be facing their rivals each
and every period.
Delta and American play an ongoing pricing game in which they must decide whether to
maintain, lower, or increase price each and every period. (In fact, pricing games are played
on each and every route, often with multiple players). The companies do not know if or when
the games will cease to be played so treating their rivalry as an “infinite horizon” game is
sensible.
To see how this affects the outcome of the game between Delta and American, consider again Figure 11.6. We already know what happens in a one-shot game— both players
choose to lower prices, which makes them both worse off. However, both players know
that they are not playing a one-shot game. They can lower prices this period, but they have
many future periods to go. In this situation, we assume that the firms look at the payoffs
and realize that they will be better off over the long run if they maintain prices. Firms reason that this type of collusion is in their mutual best interest, and they assume that their
rival is thinking the same way. Therefore, each decides to maintain price and expects rivals
to do the same.
In effect, companies in this situation enter into a style of play called “tit-for-tat.” In a
tit-for-tat strategy, companies watch each other closely and choose actions that mimic
what their rivals are doing. As long as a rival is “cooperating,” the firm chooses to cooperate.
If a rival defects from a cooperative stance, the firm responds in kind. In the game between
Delta and American, each firm chooses to maintain price unless it observes its rival choosing to lower price. If at any time the rival lowers price, the firm will “punish” by lowering its
own price. After a few periods of this kind of “punishment,” it’s possible that the rivals could
return to collusion, but doing so could grow increasingly difficult in the presence of repeated
defections (see Ethics in Strategy: Is Collusion Ethical?).
One question that arises in these types of repeated games is whether playing the oneshot Nash equilibrium is ever in a firm’s best interest. The answer depends on the differences
in cash flows between collusion and defection (defection here means playing the one-shot
action). The value of these cash flows, in turn, depends on the time value of money since payoffs are received each period in perpetuity. Typically, however, ongoing collusion is the best
tit-for-tat strategy A strategy that
responds in kind to the moves of
rivals.
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ì COMPETITIVE STRATEGY
A N D ST R AT E GY
Is Collusion Ethical?
C
ompanies that consistently do battle with the same set
of competitors eventually develop norms of competition
that help them avoid low profits. Although the companies
are not communicating directly to develop these norms
(which would be illegal), they watch each other so closely
that consistent patterns of behavior—norms—can quickly
emerge. The norms can influence pricing, product or service
features, or certain kinds of restrictions on customers that
all companies impose.
For example, many people own a cell phone and
have signed a two-year contract for service with a
telecommunications company. All of the major cellular
providers, AT&T, Verizon, and Sprint, offer this two-year
contract. How did this situation arise? Simply put, the
major telecommunications providers tacitly colluded to set
the contract requirement at two years. Whether it’s airline
pricing, in which airlines collude to keep prices high and
avoid price wars for themselves, airline service features
such as charging for bags on flights; the price of gasoline
at the pump; or the cost of an automobile or medication,
large and powerful companies—airlines, oil companies, auto
companies, pharmaceutical companies, and so on—often
collude to keep profits high.
On the one hand, by keeping profits high, these companies
are able to invest in research and development and continue
to come out with great products. Such products can even
improve the quality of life. In the pharmaceutical industry, for
example, companies would not be willing to invest billions of
dollars in research and development without a reasonable
assurance of recouping this cost through high prices.
On the other hand, high prices of drugs or other products
limit access. Through collusion, many products are priced
out of reach of less-affluent consumers. As large companies
use their power to raise prices, or contract lengths, higher
proportions of economic resources are directed toward their
products and away from other products or causes in the
economy. Some would say that this misallocates resources
in ways that make consumers worse off and unfairly
channels profits to shareholders.
What do you think? Should the legal form of collusion
practiced in markets by large firms be allowed? Should
restrictions be imposed? If so, how would such collusion be
monitored and controlled? Are you willing to accept collusion
in exchange for better-quality products in some cases? Does
your view change if you are a shareholder of a company that
practices collusion?
approach and it is what most firms in long-standing stable competition practice. As explained
in the chapter opening case, when Delta chose to lower prices, its rivals immediately followed
suit. The logic of game theory that we have just reviewed shows why. In fact, rivals did not even
wait for Delta to obtain a temporary advantage; they lowered prices immediately. They reacted
quickly with their tit-for-tat strategies, refusing to allow Delta to use price as a competitive
advantage.
PRINCIPLES OF COMPETITIVE STRATEGY
Now that we know how to evaluate the competition and to analyze the dynamics between
competitors, let’s turn to identifying competitive moves that are most likely to be effective.
There are four general principles of competitive strategy that should be followed as a company looks for successful competitive moves.12 These principles, when applied, strengthen a
company’s ability to compete:
1. Know your strengths and weaknesses
2. Bring strength against weakness
3. Protect and neutralize vulnerabilities
4. Develop strategies that cannot be easily imitated or copied (go where the competitor
is not)
PRINCIPLES OF COMPETITIVE STRATEGY
Know Your Strengths and Weaknesses
A company’s strengths are the resources and capabilities that deliver unique value (see
Chapter 3 for a detailed discussion of resources and capabilities). A company must work
to develop these strengths through focus, investment, and effort. A key strength of Apple
is product design. But it is the relentless focus on developing and investing in that strength
that turns it into a strong and enduring source of competitive advantage.
A company’s weaknesses are the resources and capabilities that are subject to rapid
obsolescence, easy imitation, or high cost not recouped by value. Apple has strengths in
product design, but its products are subject to rapid obsolescence due to the rapid pace of
technological change. Similarly, Starbuck’s atmosphere is easily imitated so the company
cannot rely on this as a source of competitive advantage.
A company must make a careful and accurate assessment of its strengths and weaknesses because these form the foundation of competitive strategy as the next two principles
illustrate.
Bring Strength against Weakness
Second, bring strength against weakness. Once a company’s key strengths are identified,
these should be targeted to competitor weaknesses. Bringing strength against weakness can
have devastating effects on the competition. When Google launched Android in 2007 as a
mobile operating system for smartphones, Microsoft was already limping along in mobile
phones, having suffered rapid market share declines because of products from Apple and
Research in Motion (RIM). Google leveraged its formidable strength in software engineering innovation and then built a coalition of manufacturers who would adopt Android (the
open handset alliance) to deliver a strong body blow to Microsoft, whose rapidly decaying
resource investments and declining market share made the company vulnerable in this area.
Sometimes competitor weaknesses may be masquerading as strengths, so any apparent
competitor strength that can be undermined or eroded through direct competitive action
can be considered a weakness. Therefore, in their hunt for competitor weaknesses, companies should not be afraid of attacking competitive strengths. As Kmart struggled to stay
afloat amidst bankruptcy, Walmart attacked what was considered one of Kmart’s few areas
of success by introducing a knockoff of Kmart’s Martha Stewart product line.13 This strong
blow contributed to Kmart’s downfall.
Protect and Neutralize Vulnerabilities
Third, protect and neutralize vulnerabilities. A company’s own weaknesses, once identified,
must either be strengthened or truly neutralized; that is, made irrelevant so that they don’t
become targets of competitors. Starbucks neutralizes the effect of an easily imitable atmosphere by also introducing a large variety of great tasting coffee blends, food items, store
convenience, and brand positioning.
In the last story, Microsoft might have assessed its weakness in mobile earlier than
Google did and made moves to strengthen this vulnerability by investing much earlier in
a new mobile operating system. As another example, some regard Apple’s closed, proprietary mobile operating system, iOS, as a competitive vulnerability since other companies
are not allowed to deploy it on its devices. This could limit its market potential. In fact,
Google attacked this weakness by making Android an open platform. However, Apple has
been highly effective at neutralizing this weakness through strong design of its products and
development of an extensive developer network in which developers of applications share
in the value of the proprietary system.
Develop Strategies That Cannot Be Easily Copied
Lastly, develop strategies that cannot be easily imitated or copied. This seems obvious, but
often companies are so busy copying competitor’s moves that they fail to see how they could
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do something altogether different. The principle might be best captured in the idea of going
to where the competitor is not. Sun Tzu, the great Chinese strategist, once said, “To be certain to take what you attack is to attack a place the enemy does not protect.”14 Whether
a company is pursuing special market niches, reconfiguring the sequence of its activities
along the value chain, or recombining and leveraging resources of themselves and partners
in ways that deliver value, competitive strategy flourishes when companies are doing something unique.15
In fact, most long-time competitors have found a way to occupy distinctive positions in
their markets so that they can coexist with other companies profitably. Returning to the
airline industry, even though American, Delta, and United compete in the same strategic
group in the United States, each has carved out distinctive hubs within their nationwide
hub and spoke system so that they don’t completely overlap as they compete. Delta has
hubs in Salt Lake City and Atlanta. United has hubs in Chicago and Denver. American has
hubs in Dallas and Chicago. So although there is some overlap between the cities to which
they fly, each of the major competitors has staked out a somewhat distinctive position
relative to rivals.
In summary, these four competitive principles may be used to develop strong and unique
competitive positions that improve the likelihood of long-term competitive success.
COMPETITIVE ACTIONS FOR DIFFERENT
MARKET ENVIRONMENTS
market structure The way rivals
in a market interact and bargain
for advantage. In its simplest
terms, it’s the number of rivals in a
particular market.
Clearly, not just any competitive move will work against a target competitor. A firm’s circumstances define which competitive actions are available and likely to be effective. Market
context strongly influences the scope of competitive action. One particular aspect of market
context, market structure, is highly influential. Think of market structure in its simplest
terms as the number of rivals in a particular market. Market structures typically fall into
one of three categories: monopoly, oligopoly, or perfect competition (sometimes referred to
as just “competition”). 16 Each of these market structures creates certain competitive conditions that lead to particular sets of strategy choices when facing competitors.
Competition under Monopoly
A monopoly is a market of one firm or one highly dominant firm, such as SIRIUS XM in
satellite radio or Microsoft in word-processing software for personal computers.17 The basic
strategic objective of a monopolist is to reinforce its monopoly. It does so in several ways,
such as by: (1) raising entry barriers, (2) limiting competitive access to scarce resources,
(3) innovating and patenting, and (4) introducing new products frequently. If a monopolist has new competitors threatening to enter its market, these are among the competitive
actions they should consider taking as a response. On the flipside, the competitor attempting to enter the monopolist’s market can expect these kinds of retaliatory actions from the
monopolist.
barrier to entry Any factor that
increases the costs, lowers the
profit margins, or limits the market
share of entrants to a market.
Raise Entry Barriers. A barrier to entry is any factor that increases the costs, lowers the
profit margins, or limits the market share of entrants to a market. For example, a monopolist
may choose to practice limit pricing, which means to set the market price of a product just
low enough so that a new entrant cannot pay the cost of entry to come into a market and
be profitable. Investing in heavy advertising or advertising over long periods of time also
raises entry barriers. Coca-Cola’s brand equity, worth billions, was built through long-term
consistent advertising, and it is a formidable barrier to entry for any firm looking to get into
the cola market.
Limit Competitive Access to Scarce Resources. If a monopolist can place a lock on
the resources that it uses to produce its product, it can effectively bar competition. The
monopolist might hire the most valuable scientists or other experts; it might secure the
COMPETITIVE ACTIONS FOR DIFFERENT MARKET ENVIRONMENTS
most advantageous geographic or real estate positions; or it may procure all of the capacity
available in a market for some particular input. For example, when JetBlue launched
its regional jet strategy, the company entered into contracts with Embraer, the Brazilian
manufacturer of regional jets, to purchase all of Embraer’s planes for three years. This
effectively blocked any other competitors from procuring the same regional jets and
implementing the same strategy.18
Innovate and Patent. To maintain its competitive position, a monopolist is often required
to innovate and patent.19 Indeed, in many monopolies both the monopolist and would-be
entrants are in an innovation race. Potential competitors can bring down a monopolist
by making the monopolist’s product obsolete through innovation, while monopolists can
stay ahead of potential market entrants by innovating themselves. As already mentioned,
Microsoft lost its hold on the operating system market in 2008 after failing to sufficiently
innovate in mobile operating systems for mobile devices.
Introduce New Products Frequently. By introducing new products frequently, monopolists
can maintain the customer demand associated with their products and stay ahead of
potential entrants who are trying to get into their markets. Apple Inc. dominated the market
for handheld music players (the iPod) in the early days. Other firms attempted to get into
this market, and certainly other devices appeared, but these devices obtained only a small
fraction of the total share of market. Apple kept would-be entrants off balance by consistently
and frequently releasing new product upgrades and enhancements. As already noted, this
was also a way for Apple to overcome a potential weakness of rapid obsolescence.
Competition under Oligopoly
Oligopolies are markets of a few firms, typically 2 to 5 firms, though in some cases the number of firms in these markets can also be up to 8 or 10. The upper bound is difficult to define
because the oligopoly designation depends on whether firms in these markets are monitoring and reacting to specific rival behavior. If there are few enough firms for each to monitor
the others effectively, then they are probably operating in an oligopoly.
Because the firms in oligopolies are locked in tight competition with only a few other
firms, they must make their moves carefully, knowing that rivals will detect their actions
and respond accordingly. We saw this as we analyzed infinitely repeated games and looked
at an illustration of the competition between Delta Airlines and American Airlines. From a
competitive perspective, oligopolists monitor and mimic rival behavior, particularly in price
and product features, and they employ tit-for-tat strategies.
Monitor and Mimic Rival Behavior. Oligopolists try to avoid the negative effects of
competition by monitoring and matching rival behavior. In this process, norms emerge in
competition around particular approaches to the market. For example, pricing norms are
very common. Companies know that they could dramatically cut their price and possibly
pick up market share in the short run, but they realize that this move would be quickly
detected and matched, leading to lower profits for all firms in the market.
We analyzed this scenario using game theory. In the opening case, Delta airlines violated
the pricing norm of its strategic group by matching prices with the low-fare carriers. This led
to immediate retaliation by rivals so that almost no advantage was obtained and the whole
industry suffered. This is a clear example of how trying to beat the norm rarely pays. Thus,
for the good of long-term profits, firms usually simply respond to one another’s pricing and
product features at levels that are profitable for all (also see infinitely repeated games).
Although the firms in oligopoly almost always respond to one another’s pricing moves,
they don’t always match price, since some companies position their products at a premium. Coke and Pepsi are oligopolistic rivals, but Coke has staked out a price position that
is slightly higher than Pepsi. Even so, if Pepsi raises its price, Coke would, too, in order to
maintain the differential.
Price is not the only area of mimicking and matching among oligopolists. The behavior
can also be seen in product or service-feature competition. When one airline announces a
new frequent-flier program or significant new upgrades to its existing plan, so do the others.
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When one hardware manufacturer, such as Apple, introduces a new touch-screen device,
rivals quickly follow suit. When Chevron adds a new detergent additive to its gasoline, Texaco does the same (the two companies have now merged). By matching product and service
features, oligopolists ensure that they do not fall behind. In this way, oligopolists protect
their profits and command higher margins from the market overall.
Finally, oligopolists may tacitly respond to one another in ways that carve up the market so that all can profitably coexist. The airlines do this with major hubs in different cities. But the behavior can also be seen in the ways that oligopolists sometimes choose to
appeal to particular market segments, with one providing price leadership in one segment
and another providing it in a different segment (see Strategy in Practice: Tacit Collusion
Between AT&T and Verizon).
Employ Tit-for-Tat Strategies. We discussed tit-for-tat strategies in the game theory
section. Tit-for-tat strategies are those that respond in kind to the moves of rivals, including
the meting out of punishments for behavior that violates norms. Because of the threat of this
type of punishment, defections from tacit collusion are reasonably rare among oligopolists.
When defections do occur, they are often accompanied by a signal that communicates the
parameters of the action, such as length of time, in a way that rivals can clearly read. For
example, airlines may run sales discounts on certain city-pair routes, but these discounts
are almost always accompanied by specific dates on which discounted fares are available.
This provides an explicit signal to rivals so that they can interpret the parameters of the
discount and avoid a price war.
“Perfect” Competition
“Competitive” markets are markets with many firms. In competitive markets, firms are price
takers rather than price setters because attempts to use price strategically, as is done in
monopolies or oligopolies, are not effective and wind up only hurting the firm that tries. The
logic goes like this: Since a firm sells a homogeneous good in a market of many firms, raising price leads to a dramatic drop in sales as customers go elsewhere. On the other hand,
lowering price can backfire since firms are assumed to operate at full capacity. If firms are at
full capacity, dropping price reduces total margin by more than it increases sales, leaving the
firm worse off. If firms are not yet at full capacity, then price will typically fall until they are,
and further attempts by individual firms to cut price sill have negative effects. This is why
firms in perfectly competitive markets set prices at the market prevailing price (they take
price) and largely avoid strategic manipulation of price.
Since a typical assumption of competitive markets is that products are largely
homogeneous, very little differentiation is assumed to exist in these markets. This leads to
a very specific set of competitive strategies that are likely to be successful. The list includes:
(1) consolidate markets, (2) pursue low cost, or (3) pursue differentiation strategies.
Merge or Consolidate Markets. Firms in competitive markets often suffer from the superior
bargaining power of buyers or suppliers ( forces that are part of Michael Porter’s five forces
model discussed in Chapter 2). Because many firms in the market are selling a homogeneous
product, bargaining power is difficult to obtain. This feature of the market also creates
intense rivalry among firms.
One strategic remedy to this problem is for firms in the market to merge. As they merge,
the overall market consolidates, reducing the number of firms and strengthening the bargaining power between the firms’ upstream suppliers and downstream customers. This
merger and consolidation process is the way that industries evolve toward oligopoly.21
A competitive market of “mom-and-pop” video rental stores gave way to a consolidated
oligopoly of Blockbuster and Hollywood video stores in the 1990s and 2000s. Hollywood
video, in particular, began as a local video rental family business and, through the vision of
its CEO, Mark Wattles, eventually expanded to 2000 stores nationwide. In the face of this
consolidation, most of the mom-and-pop video rental stores disappeared.
In this example, the consolidators built new stores and the old stores disappeared, but with
enough foresight, the old mom-and-pop stores might have merged in local markets and retained
COMPETITIVE ACTIONS FOR DIFFERENT MARKET ENVIRONMENTS
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S T R AT E GY I N P R A CT I C E
Tacit Collusion Between AT&T and Verizon
F
rom 2007 to 2011, AT&T enjoyed a monopoly on the
iPhone since it was the only cellular carrier that Apple,
Inc. allowed to provide services for the phone. But in January
2011, Verizon was also finally permitted to carry the iPhone,
setting up an oligopoly between AT&T and Verizon (Sprint
was added in October of that year). Following a short period
of offering unlimited data plans, both AT&T and Verizon
eliminated their unlimited data plans for new users.20
In addition to matching one another’s moves in this way, the
companies’ pricing behavior took on a collusive flavor. AT&T
priced slightly lower than Verizon for data plans up to 4 GB and
Verizon priced slightly lower than AT&T for data plans above 4
GB. In addition, the slope of the pricing curve (the rate at which
price rises as additional data is added to a plan) was almost
exactly the same for the two companies at key GB levels (see
Figure 11.7). In other words, as AT&T’s price rose, so did
Verizon’s as the companies sought to maintain a consistent
pricing differential. Notice in Figure 11.7 how the companies
were not necessarily matching prices, but their pricing
structures were very similar. An understanding seemed to
exist between the two in which AT&T would appeal to the lowend customers (those who used less data) while Verizon would
appeal to the high-end customers (those who used more data).
The matching behavior of the cellular carriers in pricing and
plan structure, and the different targeting of market segments,
demonstrate how oligopolists collude to maintain profitability.
[ Figure 11.7 ] Smartphone Monthly Wireless Data Cost Comparison—AT&T
Cheaper at the Low End, Verizon Cheaper at the Higher End
$120
Verizon Cheaper
AT&T Cheaper
$100
$105
Implied Cost
$80
$80
$60
$50
$60
$50
$40
$40 $30
$65
$55
$30
$45
$35
$20
$0
$30
$15
0.2
$25
$25
1.0
2.0
3.0
AT&T
4.0
5.0
6.0
Monthly Data (GB)
Source: Barclays Capital, company reports and websites
their hold on the business. This is a particularly good illustration of how firms in a competitive
market can fail to anticipate the kinds of moves that could save them from obsolescence.
Pursue a Low-Cost Strategy. Since companies in competitive markets are price takers, they
have little control over price. Therefore, in order to realize profit, they must drive down their
costs. In fact, it might be said that companies in such markets will live or die on their ability
to get costs down. Especially in markets for which differentiation is difficult, rivals can expect
other firms to be aggressively lowering costs. They must respond in kind in order to remain
competitive. Chapter 4 details strategies for reducing costs and any of those strategies can
help the firm in a competitive market be successful.
Pursue a Differentiation Strategy. When possible, companies in competitive markets
should pursue a differentiation strategy. To separate themselves from the pack, they can add
product features, store locations, bundled services, or other variations to create unique value
Verizon
10.0
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ì COMPETITIVE STRATEGY
for customers. However, in markets with many firms selling homogeneous products this is
often easier said than done. Consider book selling on the Internet. For any given title, a book
may be obtained from multiple different sources, including Amazon, Barnesandnoble.com,
Walmart, Target, or a host of smaller sellers or even used book sellers such as eBay. The firms
sell the same book. How can they differentiate? The product is the same no matter where it is
bought. In this case, firms are left to differentiate on other aspects of the buying experience,
such as the look and feel of the website, its ease-of-use, or the checkout process. Early in
its history, after realizing it could not make money on discounted bookselling, Amazon
expanded its business into many other product lines. The fact that a customer can go to
Amazon and buy not only a book but also many other items now helps Amazon differentiate
its buying experience for books alone. Chapter 5 details differentiation strategies and these
may be especially useful for firms in competitive markets.
Dynamic Environments
The strategies discussed so far apply to stable market structures. However some competitive environments are very dynamic with competition constantly changing. Perhaps technology is changing at a very rapid pace; or new entrants with new technologies, products,
or approaches are entering markets very quickly; or market consolidation is changing the
landscape in unexpected ways. In such environments, industry incumbents may not be
able to raise entry barriers or limit access to scarce resources rapidly enough to stave off
competition.
What companies must do in these environments is reconfigure their processes and capabilities to emphasize both innovation and speed. Imagine a company without these characteristics. Even if such a company were able to erect barriers to entry or secure access
to scarce inputs, these advantages are likely to be fleeting because new competitors will
rapidly innovate around them. Without capabilities of speed and innovation companies in
dynamic environments are rapidly left behind. The smart phone industry provides an example. In an important growth era, the innovations and speed of Samsung, Google, and Apple
quickly outpaced the market positions of companies like RIM, Nokia, and Microsoft. To stay
in the game, these companies too must be innovative and quick to market with value creating products.
SUMMARY
ì To effectively compete, a strategist should know the competition, including understanding the competitive landscape and how to evaluate specific competitors and their potential moves.
ì The tools of game theory can lend insight into competitive interaction by helping the
strategist think systematically about how a company’s moves impact competitors, and
vice versa.
ì Principles of competitive strategy, such as knowing strengths and weaknesses, bringing
strength against weakness, protecting and neutralizing vulnerabilities, and developing
inimitable strategies, are useful for identifying successful competitive options.
ì Competitive actions depend on the market environments in which firms compete, with
some actions being more effective for certain environments than others.
Implementing Strategy
12
© Rob Bartee/Alam
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1
Describe how the extended 7 S model is used to determine the
level of alignment within a company and between the company
and its environment.
2
Evaluate a strategic change effort and explain the underlying
reasons why the effort succeeded or failed.
3
Discuss how creating effective line-of-sight measures can assist
managers in the strategy implementation process.
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12
How Citibank Transformed
Itself into a Retail Bank
prime corporate borrowers were beginning to sidestep Citi
and obtain funds directly from bond and equity markets.
Reed began by bringing in new leaders with a new set
of skills to drive Citi’s growth. The retail banking industry
had always been conservative, with branch managers
dutifully booking deposits and making an occasional loan.
Reed changed all that. He recruited mid-level managers
and executives with extensive consumer product marketing
backgrounds. Consequently, marketing and advertising
knowledge became the skill sets that led to success in the
new Citi. Reed’s moves reflected his own aggressive style
and the underlying culture at Citi: a machismo and bravado
that had little patience for slow growth. It was “Go big or go
home.”
Citi’s retail strategy focused on customer service, and
the bank pursued opportunities to market a broad range of
financial services to individuals and households. One key to
the new strategy was Master Charge, Citi’s money-losing
in-house credit card.
[M]ARKETING AND ADVERTISING KNOWLEDGE BECAME THE SKILL SETS THAT LED TO
Richard Kane, a Reed
SUCCESS IN THE NEW CITI. REED’S MOVES REFLECTED HIS OWN AGGRESSIVE STYLE AND
associate who took
THE UNDERLYING CULTURE AT CITI: A MACHISMO AND BRAVADO THAT HAD LITTLE PATIENCE
control of Master
Charge in 1976,
FOR SLOW GROWTH. IT WAS “GO BIG OR GO HOME.”
realized the company
lost money because it paid merchants on time but failed to
In 1968, Chairman Walter Wriston radically reorganized
collect money from the purchaser’s own bank in a timely
the bank from its geographic structure to one of business
4
manner. It took Kane over a year to solve this problem. When
groups and industries. That reorganization put all the retail
he did in 1977, Citi scaled up its credit card operation. The
businesses in a single division and allowed the assets to
bank mailed out 20 million credit card solicitation letters
be managed more efficiently. Wriston and head of retail
and received 4 million new credit card subscribers.
banking John Reed, surveyed the situation in late 1970
Citi’s game changer, however, was the Automated Teller
and envisioned the future of the bank in this collection of
Machine, or ATM. Opening up retail branches all over the
underperforming assets the future for Citi.
state of New York, let alone the entire country, would be
Citi’s profits had historically come from “commercial
prohibitively expensive. Reed told his team that he envisioned
paper,” or making loans to other corporations to finance
the ATM as the central element of Citi’s retail branches,
their operations and growth. Wriston and Reed realized
“We’re going to electronify the teller position [and install] cash
the limits of this business. First, Citi had reached global
machines and customer service terminals.”5 Citi designed
saturation as it financed and followed U.S. multinationals as
they expanded around the world. Second, they realized their
and built its own terminals because existing vendors didn’t
I
f you have a credit card, chances are pretty good that you
have one issued by Citigroup. Citi is the third largest U.S.
bank, with over $1.8 trillion in assets, and it’s the second
largest distributor of credit cards in the United States with
92 million cardholders.1 For most of its two-century history,
Citi operated as a commercial bank that provided funds for
corporations, governments, and their projects, including the
Panama Canal and the Marshall Plan to rebuild Europe after
World War II.
Citi had operated retail branches since the 1920s. By the
end of the 1960s, the bank had 164 branches in and around
New York City.2 The average Citi account holder held just
$317 in an account, and Citi was not a significant competitor
in the cutthroat retail business.3 Citi’s retail operations,
including auto loans, checking accounts, mortgages, and a
fledgling credit card business, were not well-integrated, and
the lack of strategic coordination kept Citi from competing
effectively.
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ALIGNMENT: THE 7 S MODEL
have Citi’s vision. Citi’s ATMs linked transactions directly into
Citi’s huge transaction processing network, cutting the cost of
completing consumer transactions.
The Citi culture emphasized taking big bets with the
hope of an enormous payoff, and Reed made a huge bet
on the ATM. At a time when the technology was new and
[ 239 ]
unproven, Citi invested $160 million to install ATMs at Citi’s
271 New York locations, and create an eventual nationwide
system of ATMs.6 This strategy turned the bank’s retail
operations from an insignificant contributor of revenue to a
business that now generates almost one half of Citi’s total
revenue.7
ì
Citibank’s strategic change captures many of the real-world lessons you’ve learned about
in this textbook. Walter Wriston and John Reed, who would succeed Wriston as Citi’s CEO,
accurately scanned the banking environment and saw that their core business, commercial
lending to the world’s largest corporations, represented a declining business. They created a
bold new strategy that relied on the innovations of an ATM-based consumer interface and
sought massive scale in the consumer credit cards to create a valuable low-cost offering. As
the case illustrates, they did much more than just formulate a new strategy. They restructured, restaffed, reskilled, and refocused a huge banking operation to support and implement their strategic objectives. A primary objective of this chapter is to introduce you to
three important skills strategists must possess if they hope to implement strategies: Forging
alignment between the key elements of the organization and the strategy, leading an effective
change effort to accomplish that alignment, and creating measurement systems to refine the
strategy and ensure its implementation.
At one level, implementation is about action, or execution. The successful execution of a
strategy requires a process that translates broad strategic objectives into clearly definable,
everyday actions that make the strategy real, and then creating systems where people take
those actions. Executive Larry Bossidy learned how to execute strategy working for General Electric’s CEO Jack Welch. Bossidy ran GE’s capital division and guided that business
through a flurry of acquisitions you read about in Chapter 6. He then went on to successfully
run Allied Signal and eventually Honeywell. Bossidy was known for his ability to execute. His
recipe for execution— outlined in his book The Discipline of Getting Things Done—involves
four steps: (1) Create a set of clear goals for people to follow; (2) find ways to accurately
measure performance; (3) hold people accountable for their performance; and then
(4) richly reward those who perform well.8
When John Reed led the transformation of Citi’s retail banking he had a clear goal and
objective in mind: keep Citi’s earnings growing at 15 percent annually.9 Although he felt the
target was unreasonable over the long term, the black-or-white nature of the 15 percent
goal, and the ease with which his accounting staff could assess performance, provided a
substantial incentive to think about how to enter the highly competitive retail banking market in an innovative and profitable way.
Wriston and Reed disagreed about many details of the new strategy and its implementation, however. Reed won a number of those debates, but had to answer for his performance
based on clear metrics to an impatient and demanding boss. Wriston saw that Reed hit his
performance targets and eventually rewarded Reed with the top job at Citi.
Many strategies fail because people in organizations just don’t execute well. The strategy
doesn’t translate into a clear set of measurable goals and, for whatever reason, people either
don’t have to answer for their actions or receive no rewards, or punishments, for excellent,
or poor, performance.
ALIGNMENT: THE 7 S MODEL
Execution matters, but as you saw in the opening case, effective implementation requires
forging alignment between the external environment, the strategy, and the internal elements of the firm. Let’s learn about how this is done. Most strategy researchers focus
on strategy formulation, what you’ve spent most of this course learning about. Little
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ì IMPLEMENTING STRATEGY
[ Figure 12.1 ] The 7 S Model
Strategy
Systems
Structure
Shared
Values
Staffing
Skills
Style
alignment A condition where
organizational elements fit together
and reinforce each other.
attention typically gets paid to implementation, as it seems to be a matter of execution.10 Implementation is as much a matter of alignment as it is of execution. Alignment
means that the important elements of the organization are in the proper relationship
with each other—which means they fit well together and reinforce each other. In an
aligned organization all the elements support the strategy. This raises the question:
Which elements?
A strategist can answer this question in many different ways. The authors’ experience
with the 7 S model of organizational alignment leads us to recommend this model. Introduced by consultants at McKinsey and Company in the early 1980s, the model provides a
broad yet succinct way to capture the key strategic elements of an organization.11 The model
identifies seven important organizational elements that must be aligned in order to ensure
effective implementation of the firm’s strategy. The 7 Ss are: strategy, structure, systems, staffing, skills, style, and shared values.12 Figure 12.1 displays each S, discussed next.
Strategy
strategy The plan or process that
creates and sustains a competitive
advantage for a firm.
Strategy is the plan, process, and related activities that create and sustain a competitive
advantage for a firm in its target markets. Strategy represents the most important S. The
ultimate goal of any organization is excellent performance, whether it is a business, government, or not-for-profit. Strategy enables an organization to perform well. Citi’s original
strategy had been tightly focused on serving elite corporate clients. Its new strategy relied
on an equal focus on effectively serving retail consumers.
Structure
structure The set of organizational
arrangements that divide labor
and tasks. Structure also defines
reporting or authority relationships.
Structure answers two critical questions for an organization: Who does what? Who reports
to whom? Structure divides labor and tasks within the organization into separate units
and, by doing so, defines the reporting or authority structure of the firm. This is important
because it assigns accountability for particular tasks and allows for the measurement of
performance by a particular organizational unit. Managers can use structure to help create
alignment between goals, skills, and environmental needs.13
If you want to understand an organization’s structure, look at its organization chart.
The horizontal boxes that run across the page describe the division of labor. For example, a
company might have vice presidents for geographic regions, with functional managers for
each of those regions. This regional structure presumes that the important differences in the
firm’s market depend on geography and the strategy is best served by tailoring operations to
each region. Citi had used a geographic structure from the 1920s to the late 1960s, reflecting
the challenges of building relationships in an era of limited transportation and communication resources.
Alternatively, a company may have a vice president of marketing, vice president of operations, vice president of finance and accounting, and so on. The next level down may include
ALIGNMENT: THE 7 S MODEL
[ 241 ]
titles like director of marketing or western regional director. Walter Wriston changed the
structure of Citi in 1968 to focus on the different types of customers the bank served, rather
than where those customers lived. The company restructured around key client groups or
markets, one of which was retail banking. This move combined all the different retail products and services within the same division and made coordination across geographic markets much easier.
Companies may also want to structure using one of two “Ms:” a matrix structure or
an M-form corporation. In a matrix structure, firms give significant decision-making
authority, and the responsibility for profits and losses, to two managers. The most common matrix structure shares responsibility between a functional manager (e.g., marketing
or sales) and a product managers (e.g., diapers). The matrix builds on the assumption
that both strong functional expertise and nuanced product knowledge play vital roles in
creating competitive advantage. The matrix makes life more complicated for managers
and employees, but the structure hopes to create more value by combining expertise in
decision making.
S T R AT E GY I N P R A CT I C E
How to Use the 7 S Model
T
he 7 S model represents a tool that can guide effective
strategy implementation for the organization as a whole,
as well as for its divisions, groups, or departments. To use
this tool most effectively, follow these five steps:
1. Identify the current state of the organization and misalignments. Appendix 1 at the end of the book provides
a list of resources that consultants and managers can
use to understand the current 7 S model. For managers, interviews and surveys will be powerful tools.
Consultants or other outsiders will rely on a mix of
interviews and other sources. The goal is to create an
“as it is today” picture of the 7 Ss in the company.
2. Rank order misalignments based on the importance of
misalignment with strategy. When step one is done well,
managers will see a number of misalignments, both
within the 7 Ss themselves and between the different
elements in the model. It’s easy to get frustrated or feel
overwhelmed! Managers need to ask, “Which misalignments keep us from reaching our strategic goals?
Which ones dissipate rather than build competitive
advantages?” This question will cull the list of misalignments down to the few that really need to be changed.
3. Develop plans to create alignment. While some of the
misalignments will be company specific (particularly
those that involve the soft square), managers and
consultants should be open to looking at how other
companies have solved these problems. There is no
need for an executive team to “reinvent the wheel” in
terms of compensation, for example. Benchmarking
other companies, or divisions within their own company, provides a starting point from which companies
can customize their own solutions.
4. Understand how the proposed change affects other elements in the model. How will changes in one S affect
others? For example, moving a sales force from pure
commission to a salary structure represents a huge
change in what motivates the staff.20 How will the
company attract and retain a sales force to fit the new
pay scheme? What new skills will existing salespeople
need to learn? Where will the new system conflict with
our shared values? It’s rarely the change of compensation alone that dooms the program, it’s the pushback
from the other Ss.
5. Adjust plans accordingly. After managers see the effort
to create realignment within the entire model, they
need to adjust their plans. In the previous example,
changing the compensation system may need to follow skill training for the existing sales force. Work on
new hiring and retention plans may need to happen at
the same time, and the new system may precede and
signal a change in shared values. In any case, managers come to understand that piecemeal changes rarely
create alignment; a more complex and sophisticated
approach is usually necessary.
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The M-form is a corporate-level structure, and it builds on the idea of a corporate
parent and business unit children. M-form stands for multidivisional form. In this structure, each division is a separate business, and includes all the functions needed to run
that business. Managers of M-form organizations can structure their business units in
different ways, some may be functional, others product, and still others a matrix. The
M-form creates substantial redundancy across the corporation (think of 20 separate
accounting groups). The advantage of the M-form lies in accountability; managers of
an M-form run their own business, their successes and their failures can be traced back
to the decisions of these managers. No one can claim that “corporate made me do it,” or
use other excuses.
Systems
systems Mechanisms, policies,
or processes that coordinate and
control the work of the different
units of the organization.
The systems category describes key processes that span a firm’s organizational structure.
Systems play two important roles: they coordinate and control work of the different units
within the organization.14 Information systems such as inventory control allow sales people in the field to know which products are in stock, and which products are over stocked.
At the same time the inventory control system lets the manufacturing division plan its
production schedule based on those same stock levels. Finally, information about which
products are selling will help the accounting and finance department create accurate
profit and loss reports, and they’ll help the firm’s managers decide which products and
services to add or drop from the firm’s offerings. It took Citi six long years of intense work
in its Master Charge division to provide information on which customers were most likely
to pay their bills.15
Staffing
staffing The human resource
management processes in the
organization for recruiting, hiring,
training, and deploying human
capital.
Staffing refers to the human resource management processes in the organization: recruitment, hiring, training, deployment, performance measurement, promotion, and compensation. Some companies recruit only at elite universities, while others target public universities,
job fairs, or websites like Monster.com. Each model has its own advantages and drawbacks,
depending on the skills and personality types companies want to attract. Companies like
Marriott require managers to engage in training every year, but other hotel chains expect
people to learn on the job. Finally, some companies promote from within while others tend
to hire from the outside.
When Citi shifted its strategy toward consumer banking, it hired and promoted a new
type of employee. The traditional promote-from-within-culture of the bank was unable to
produce managers with the talents and aggressive disposition required to grow the retail
business. So Citi developed new recruiting and hiring processes to attract those types of
individuals.
Skills
skills The abilities of individuals,
groups, or organizations to perform
tasks.
Skills refer to the abilities of individuals within the firm as well as how the firm has combined
those individual talents to build capabilities (processes) to create a competitive advantage.
The relationship between skills and staffing is shown as companies either hire people who
have the skills they need or develop workers in-house through training. Google, for example,
considers itself primarily as a software company, and if you want to get hired you’d better
have outstanding software engineering skills. In fact, Google screens 20,000 software engineers each year through a software-programming tournament called “Google Code Jam.”16
Software engineers compete with each other in a timed software-coding tournament,
and the top 50 get job offers at Google. Apple also wants employees with strong software
engineering skills. However, because Apple creates hardware products, it also values design
skills because the company believes design is critical to its competitive advantage. In running its retail business, Apple had to look far beyond its traditional skill sets to find the right
executive. The company hired Angela Ahrendts to run its retail operation. Ahrendts had
ALIGNMENT: THE 7 S MODEL
ETHICS
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A N D ST R AT E GY
Creating an Ethical Climate and Culture
Through the 7 S Model
J
ames McNerney became CEO of Boeing, one of the
world’s largest aerospace companies in July of 2005,
capping a long and successful executive career that began
after he received his MBA from Harvard Business School
in 1975. His career included stints at Procter & Gamble,
McKinsey and Company, 19 years at General Electric, and a
term as chairman and CEO of 3M. McNerney came to Boeing
as the company was trying to emerge from three major
ethics crises.
In March of 2005, Boeing fired then CEO Henry Stonecipher
for having an illicit affair with a female Boeing executive.18
Stonecipher had become CEO to replace Phillip Condit, who
had his own checkered career as Boeing’s CEO. Troubles
at the top weren’t the only problems Boeing faced. After its
acquisition of McDonnell-Douglas, Boeing began to compete
more fiercely, and less ethically, for huge defense contracts.
Boeing’s former Chief Financial Officer Michael Sears and
Manager Darleen Druyun were fired from the company for
ethics violations on an $18 billion fighter jet contract; Sears
served prison time for his crimes. That scandal followed
revelations that a Boeing employee stole and inappropriately
disclosed over 25,000 pages of confidential documents
belonging to competitor Lockheed Martin.
McNerney saw his first and most important job as building
an ethical culture at Boeing, and he had his work cut out
for him. With over 150,000 employees, global operations,
and infighting between divisions resulting from Boeing’s
acquisition of McDonnell Douglas, Boeing was a large,
bureaucratic behemoth resistant to change. McNerney chose
an interesting place to begin the cultural change: He relied on
his personal style and what he referred to as “tone at the top.”
Rather than holding the annual executive retreat at a posh
resort, McNerney held a shorter retreat at a modest hotel.
McNerney spoke directly and forcefully of the ethics lapses,
and he encouraged managers throughout the company to
do the same. The culture of secrecy had to be changed.
McNerney chided leaders for a culture and environment
where, “’management had gotten carried away with itself,’
that too many executives had become used to ‘hiding in the
bureaucracy,’ that the company had failed to ‘develop the best
leadership.’”19 Before Boeing could solve the problems, the
company had to admit that problems existed and determine
the extent of unethical behavior. McNerney used his position
and personal style to model the open communication and
concern for ethics he expected throughout the company.
Style mattered, but McNerney used other elements of the
7 S model as well. The company also changed its structure.
Boeing raised the profile of compliance officers and set up
an ethics hotline so that employees could report violations
without fear of management reprisal. The company required
ethics training for employees, which meant changes in
its staffing protocols and skill development programs.
Importantly, McNerney changed the compensation system for
Boeing’s managers; it now paid to make the ethical choice.
Managers would now receive part of their annual bonus
based on compliance with ethics standards and for living,
teaching, and displaying the core Boeing values of candor,
openness, business performance, and ethical conduct.
been working as the CEO of fashion firm Burberry and had very few of Apples traditional
skills in hardware, software, or technology.17 Skills, like staffing, involve long-term investments by firms to make sure they have the right employees who will help the company gain
competitive advantage.
Style
Style refers to the interpersonal relationships between people in the organization and, along
with shared values, comprises the culture of the organization. Style generally falls into one
of two categories: Formal or informal. In most German companies, for example, people usually dress up for work and refer to each other as Mr. or Ms., and respect each other’s work
environment by keeping office doors closed. Many Silicon Valley start-ups, by contrast, find
people showing up to work in shorts, T-shirts, and flip-flops, call each other by first names or
style The interpersonal
relationships and patterns of
interaction that organizational
members consider appropriate and
legitimate.
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nicknames, and work in large, open spaces to maximize interactions. When John Reed was
trying to transform Citi’s retail business, his personal style encouraged risk taking and making big bets on the company’s future. This contrasted with an earlier style within Citi that
was more conservative and risk averse. Style helps you identify the interpersonal aspects of
a company’s culture.
Shared Values
shared values The priorities,
values, and virtues that members
of the organization see as
important.
superordinate goals High-level,
abstract goals that all stakeholders
agree on to guide organizational
action.
hard triangle The elements of
strategy, structure, and systems in
the 7 S model. The hard triangle
represents a set of “hard” levers
that managers can quickly pull to
create alignment or realignment.
soft square The elements of style,
staffing, skills, and shared values.
Soft square elements are often
difficult to codify and usually take a
long time to influence and change.
Shared values refer to the priorities, values, and virtues that members of the organization
see as important. Some people use the term superordinate goals, a set of high-level goals
that all stakeholders agree on, to capture the same thing as shared values. For example, Nordstrom strives to create shared values by focusing on respect for the individual and extraordinary customer service. One way that Nordstrom works to create these shared values is by
sharing stories with its associates and managers that provide examples of the behavior they
want to encourage—such as the story of an employee accepting a customer’s returned tires
when Nordstrom doesn’t even sell tires. The shared values of respect for the individual and
extraordinary customer service are both values and overarching goals for the company and
representative of the organizational aspect of the culture.
The 7 S model deals with ethical values as well as other business priorities. Our Strategy
and Ethics in the Real World feature describes how one leader, James McNerney of Boeing,
used the 7S model to realign the ethical values at his company.
If you look back to Figure 12.1, you’ll notice that strategy, structure, and systems form a
triangle, and that style, shared values, staffing, and skills form a square. This is no accident.
Strategy, structure, and systems constitute the hard triangle of the model. The hard triangle represents a set of “hard” levers that managers can quickly pull to create alignment,
or realignment. Hard doesn’t refer to difficulty, but, rather, tangibility. Structure appears on
paper, strategy in a formal plan or document, and systems are found in policy manuals,
computer programs, or equipment.
The other four represent the soft square, the elements that are often difficult to codify,
like style, or that take a long time to influence and change, like shared values. Strategists can
change structure in a day, strategy in a week, or systems in a quarter. That doesn’t mean the
organization practices the new strategy, works well in the new structure, or actually uses
the new systems. How well those changes actually work depends on what happens in the
soft Ss. Changing the organization’s skill set can take several months. Changing the style or
shared values may take decades. See the Strategy in Practice for a discussion of how managers can use the 7 S model to implement change.
Figures 12.2 and 12.3 illustrate the concept of creating alignment. These figures address
how an organization moves from a state of misalignment to one of alignment. As the Strategy in Practice feature indicated, creating alignment means change. Something, usually
[ Figure 12.2 ] Misalignment
Strategy
Structure
Systems
Shared
Values
Staffing
Skills
Style
Situation/Stakeholders
STRATEGIC CHANGE
[ 245 ]
[ Figure 12.3 ] Alignment
Strategy
Structure
Systems
Shared
Values
Staffing
Skills
Style
Situation/Stakeholders
something significant, has to change in order to bring the 7 Ss back into alignment. That
involves the second important process of strategy implementation: strategic change.
STRATEGIC CHANGE
In this section, we’ll explain how managers effectively lead strategic change to move their
organizations forward. We’ll also discuss how the tools of strategic change apply to individuals, since the most important firm we all manage is a firm called “Me, Inc.” Managers who
can’t lead change, in their own or their organization’s lives, find it difficult to thrive, and often
survive, in world of turbulent change.
The first time an entrepreneur sets a strategy to create unique value for customers in a
particular market she aligns the organization with that strategy. At every other point in a
company’s history, a change in strategy requires realigning the organization with the new
direction. Realigning strategy entails changing the other six Ss, and that’s not an easy thing
to do. Recent evidence puts the failure rate for organizational change at 60 to 70 percent,
and that percentage has not changed for several decades.21 Change seems to be even harder
for individuals. One study found that, out of a group of people who had experienced coronary artery bypass surgery to save their lives, 90 percent failed to change their lifestyle to
avoid a repeat of the trauma.22 Part of the problem is that individuals and leaders don’t realize that change is a process with three distinct phases.
The Three Phases of Change
Most of us think of change as the need to start doing something new, whether that’s eating healthier or, in the case of an organization, focusing on a new customer segment, such
as Citi’s concentration on retail banking. What most don’t realize, however, is that effective change requires moving through three stages of a well-defined process. We must first
stop the activity, or set of activities, we want to change, then adopt new behaviors, and
finally engrain those new behaviors into our routines. Pioneering social psychologist Kurt
Lewin used ice as a metaphor for change, and his three-step model of change is outlined
in Figure 12.4.23
Unfreezing. Unfreezing begins the change process as individuals and groups within
the organization recognize and publicly admit that the current situation is not working.
Unfreezing entails moving away from certain actions, policies, or strategies before adopting
anything new. When individuals, groups, or companies make a “stop doing” list, they have
begun the process of unfreezing.24 The process of unfreezing provides the fundamental
motivation for change.
unfreezing The first step in
organizational change. It begins
when leaders recognize and
publicly admit that the current
situation is not producing
acceptable or adequate results.
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ì IMPLEMENTING STRATEGY
[ Figure 12.4 ] Three Key Phases of Change
Motivating
Moving
Maintaining
Unfreezing
Change
Re-freezing
Make a public
admission that
current state
isn’t working
Develop new
behaviors
Engage in trial and
error process
ake a clear
break with past
actions or
processes
change process The middle step
in organizational change that a
company engages in to adapt to
its environment and learn new
behaviors.
refreeze The last phase of
organizational change. This
step involves formalizing and
institutionalizing new behaviors,
methods, processes, or routines.
Creating Alignment
Embed new
behaviors in
training
compensation,
culture
Changing. The change process is how a company adapts to its environment and learns
new behaviors. When Citibank began to focus on serving individual retail customers,
branch managers, tellers, loan officers, and even people working at Citi’s headquarters
had to experiment and learn new ways of working. Branches stopped focusing solely
on large, sophisticated business customers and learned new ways of working with, and
gaining the trust of, individuals with small balances and basic financing needs. The pain
of change comes during this phase because it is not clear which new behaviors will work,
and it is often by trial and error. Change means moving from one set of behaviors and
activities to another.
Refreezing. Have you ever gone on a diet? For longer than a couple of weeks? Well,
companies are like people in that they can adopt almost any new behavior for a short
period of time. To make change permanent, individuals and companies have to do the hard
work of aligning the rest of their activities to support the change. They have to refreeze
around the new activity set. Successful companies embed the desired changes in hiring
and training decisions, reward and compensation systems, and in the shared values of the
company’s culture. Refreezing allows organizations to maintain the progress they made
through change.
The three phases of change provide a broad overview of the process, but real-world
strategists want to know how they can unfreeze their organization, encourage productive
change, and then refreeze the gains and move ahead. Each of the three larger phases of
change contains discrete elements that help managers lead their organizations and people
through the difficult process of change. We’ll introduce you to eight discrete tasks that must
be accomplished for change to succeed.
The Eight Steps to Successful Change
Strategic changes like the one Citibank pursued to change its entire business focus don’t
happen overnight. In fact, these changes can take many years, and even up to a decade to
successfully implement.25 The eight key tasks are:
1. Generate a sense of urgency.
2. Build a guiding coalition.
3. Create a vision.
4. Communicate the vision.
5. Empower individuals to act.
6. Garner short-term wins.
7. Consolidate gains and move on for more change.
8. Institutionalize the change.
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S T R AT E GY I N P R A CT I C E
Work Gloves Create Change26
A
middle-level manager at a large, multiplant company
had been assigned to cut costs by consolidating the
company’s purchasing process. The manager identified
several areas where costs could be reduced by about $1
billion but no one took his analysis seriously. To get the
attention of the key decision makers in the organization, this
manager identified a single product—work gloves—that he
thought would highlight the purchasing problem.
The manager discovered that the company was
purchasing over 400 different brands of work gloves. One
plant would pay $5 for a pair of gloves and another plant
would pay $17 for the same pair of gloves, but a different
brand or from a different supplier. To make his case of
wasteful purchasing, the manager bought 424 different pairs
of gloves, and tagged each pair with the price each factory
paid for it. He reported what happened next:
[We] put them in our boardroom one day. Then we
invited all the division presidents to come visit the
room. What they saw was a large, expensive table,
normally clean or with few papers, now stacked high
with gloves. Each of our executives stared at this
display for a minute. Then each said something like,
“We really buy all these different kinds of gloves?”
“Well, as a matter of fact we do.” . . . It’s a rare event
when these people don’t have anything to say. But
that day, they just stood with their mouths open.27
Needless to say, the manager received a mandate
from top management to move ahead with his changes
to purchasing. He had created urgency so that decision
makers could see, feel, and understand the real impact of
the problem. Once they saw and felt the need for change, top
managers lent their energy and support to the change effort.
Generate Urgency. People and organizations won’t change without a reason. In fact,
organizations have been designed to ensure stability and that the same regular processes will
happen over and over again. Those processes and activities eventually fail to work effectively,
usually because they fail to align with changes in the market or operating environment,
managers must work to help their teams and organizations see the need for change. That
means looking at larger environmental trends, spending time with customers, suppliers,
employees, or stakeholders to gather data, and then creating a compelling case that will help
people see, understand, and also feel the need to change. Our Strategy in Practice feature
describes a compelling story of generating urgency.
Build a Coalition. Effective change requires that many people see and feel the urgency
and those with the power to change the organization grasp the sense of urgency and
actively work to create change. Managers tasked with leading change need to create
a guiding coalition, a group of influential people from all levels in the organization
who work to lead the change effort. Some members come from top management, but
most will not. All members have power within their own work groups, either as formal
managers or directors, or informally having earned the respect, admiration, and ears of
their peers.28
Create a Vision. A meaningful vision is a clear statement of where the organization wants
to go, and what life will be like when the change has been successful. Urgency helps prepare
people to move, and the coalition provides examples to follow. However, without a clear
vision of where they are going, people are either unable to move or they move in many
different directions all at once.
Perhaps the best example of a clear and compelling vision came from President John F.
Kennedy in response to the urgency generated when the Soviet Union placed a man in orbit
in the spring of 1961. Kennedy created this vision:
I believe that this nation should commit itself to achieving the goal, before this decade
is out, of landing a man on the moon and returning him safely to the earth. No single space
guiding coalition A group of
influential people from all levels in
the organization that support and
lead the change effort.
vision A clear statement of desired
outcomes and endpoints for
organizational change.
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ì IMPLEMENTING STRATEGY
project in this period will be more impressive to mankind, or more important for the longrange exploration of space; and none will be so difficult or expensive to accomplish.29
The first three tasks—generating an urgency, building a coalition, and creating a vision—
help the organization unfreeze. A sense of urgency and the development of a coalition signal
an unmistakable admission that past actions won’t work in the future. A vision creates a
clear break with the past and is an exciting call to move forward. When done well, these first
steps usually take 6 to 18 months for managers to work through.30 The next three tasks—
communicating the vision, empowering action, and garnering short-term wins—help
organizational members alter their behaviors and work patterns and create the change.
Communicate the Vision. How do most companies communicate their vision? Many
managers don’t communicate that vision clearly enough or often enough. They might
communicate through a memo or a post on the company’s intranet site. If the change is
considered central to a larger group within the organization, they might create a video and
distribute it throughout the company.
How did Kennedy’s stirring vision get communicated? First, his speech was recorded on
video and played over and over again on the nightly news programs. Kennedy used every
emerging technology and platform to share his vision. The administration made sure the
text of his speech was picked up and reprinted by hundreds of newspapers. Simply put,
Kennedy’s vision took hold because it was communicated through a variety of channels, and
repeated over and over again. Managers who successfully lead change overcommunicate
their vision. They keep repeating the message even after they are sure most people have
heard it.31
Empower Action. A paradox exists in most organizations, from business firms to university
empowerment A grant of authority,
formal or informal, that allows
organizational members to try new
practices. Empowerment includes
giving members the knowledge and
resources they need to engage in
new practices successfully. It also
includes a safety net for people
should they fail.
classrooms. Leaders and managers want creative behavior and new solutions, but many
organizational cultures and systems punish creative behavior or new solutions that don’t
work. For example, many performance reviews reward successful actions by employees, but
fail to reward innovations and experimentation that doesn’t succeed.32
Empowering people to act certainly means giving them authority to try new practices,
but it also means giving them the knowledge and resources they need to engage in new
practices. Empowerment also means providing a safety net for people should they fail, and
a system in place to learn from those failures. For example, Google has built in a number of
mechanisms to promote innovation, from Google cafes where employees can meet to share
ideas, direct e-mail access to company leaders, and its policy of allowing engineers to spend
20 percent of their work week on projects that interest them.33
Garner Short-Term Wins. Many people inside the organization may be supportive or even
excited about the change, but they may be unwilling to commit their own time, energy,
and resources until they see evidence that the change will produce positive results. Wise
managers begin with projects that require the least change and have a high probability of
success. The manager in our previous Strategy in Practice feature began by solving a small
problem, consolidating the purchase of work gloves. Work gloves alone wouldn’t save the
company over $1 billion, but solving the work gloves problem would show those waiting to
commit to the change that their efforts would likely succeed. Short-term wins create both
credibility and momentum that encourages key organizational members to get off the fence
and work to make the change successful.34
The three tasks that accomplish the bulk of the change, communicating the vision,
empowering action, and creating short-term wins, can take one to two years.35 Managers
may begin communicating early and often, and employees can be easily empowered; however, following through to make communication and empowerment effective tools of change
requires sustained effort. Short-term wins should come quickly because they are, after all,
short term. The task of pressing ahead, tackling the tough challenges, and reaping the real
rewards of change takes patient and persistent effort.
Consolidate Gains and Press On. Many organizations would stop after solving the work
gloves problem because they mistakenly believe that solving the surface symptoms of
a problem is the same as solving the root cause. The clever manager might be honored
at a company dinner, given a nice bonus, and people would assume the change effort
STRATEGIC CHANGE
[ 249 ]
was complete. What would remain would be the tough, hidden, and unglamorous
purchasing problems that would really save the company a great deal of money. If a
company stops after creating a few high-profile “wins” and fails to press ahead to work
on the deeply rooted behaviors, policies, and practices that must change for a true
realignment to occur, much of the value of the change effort will have been wasted.
This is the least glamorous and longest task of successful change, but the one that truly
prepares the organization to refreeze. The challenging projects help the organization
embed the change deeply in its operating routines and represent an important part of
making change stick, or refreezing.
Institutionalize Change. To institutionalize something is to make it so essential that
it is taken for granted and becomes part of the central values of the culture.36 Managers
institutionalize changes primarily through three of the 7 Ss: systems, staffing, and shared
values. Change becomes permanent when the routines such as sales methods, accounting
procedures, or operating processes embody the new set of behaviors and activities.
Compensation systems that reward the new behaviors further engrain the notion that the
change represents “the new way things are done around here.” In terms of staffing, change
becomes institutionalized as the firm looks for, hires, and retrains a new type of employee.
Recruiting and ongoing training reinforce changes as a new generation of employees sets
the standard for model behavior.
Finally, strategic changes always alter the shared values of the organization.37 For example, the Citi change to retail banking supplemented the value of a bank based on serving
an elite corporate clientele with a set of high end products with the value of providing
excellent service to retail customers. An innovative set of shared values spoke to the new
customer group, providing valuable, but basic financial services and products to a mass of
individuals. Institutionalizing the change takes the longest of all the stages and can take
an additional four to seven years before the old ways are forgotten. The bottom line for
managers is that successful strategic change takes substantial and sustained energy, commitment, and attention. Managers should keep in mind that others in the organization
need the time, resources, and energy to go through their own change. Change takes time
because people have to learn new skills and ways of acting, but also new mindsets and
ways of seeing the world.38
Figure 12.5 summarizes effective strategic change. You can see how the eight tasks relate
to the three phases of change, and how long each phase may take. Strategic change takes
a long time and a dedicated effort by strategic managers who are trying to enact change
while dealing with day-to-day issues of running their firms. How do they maintain a focus
on the overall change project? One way is to set up solid measurement systems to assess
the degree to which change efforts help the firm align its internal resources around its strategy.39 Setting up robust and effective measurement systems will be the final topic we consider in this chapter.
[ Figure 12.5 ] Summarizing the Change Process
Generate
urgency
Share
Vision
Consolidate
Gains
Build
Coalition
Create
Vision
The Silent Phase
(Unfreezing)
½–1½ years
Empower
Action
Garner ShortTerm
Wins
The Active Phase
(Change)
1-2 years
Institutionalize
Changes
Completion
(Refreezing)
4-7 years
institutionalize When an
organizational element or practice
becomes so essential that its value
is taken for granted.
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MEASUREMENT
principle of line of sight The
notion that individual members in
an organization should be able to
connect their daily work and tasks
to the overall strategic goals of the
organization.
Given that strategic change and realignment takes such a long time to successfully implement, strategic managers need a way to effectively measure their organization’s progress.
In fact, measurement represents a general need for assessing whether any strategy, new
or existing, works. As you learned in Chapter 3, strategies often depend on the complex
combination of a firm’s underlying values, its resource base, capabilities, and the actions
and activities of large numbers of individuals and groups. Those complex internal interactions all take place in markets and industry contexts characterized by constant, sometimes
radical, change. Effective measurement becomes an essential element of solid strategy
implementation.
Individual employees, managers, and the executives who run the firm face a challenge
that measurement helps overcome. That challenge arises because members of an organization have limited perspective.40 Employees and managers see clearly those activities and
elements of the environment they most closely interact with. Salespeople can see the organization from a customer’s perspective but have a hard time accepting the perspective of
manufacturing managers or research scientists. All people see things that are further away
less clearly, both in terms of distance but also organizational level, and time horizon. Similarly, it’s easier for employees or managers to see what needs to be done to improve shortterm performance but they rarely have a perspective, or incentive, to act in ways that further
the long-term interests of the firm. An effective measurement system helps everyone, from
top management to front-line employees, understand how their daily work contributes to
strategic success. The principle of line of sight helps managers create measurement systems to overcome the limited perspectives of individual organizational members.
Line of Sight
Put yourselves in the shoes of the following division manager. It’s 9:15 a.m. on Monday morning. You arrived late at your office, delayed by a nasty freeway accident. Your 9:30 a.m. meeting is a critical new product design decision meeting. The company’s development team
and supplier partners have cleared their busy schedules to help you make the final decision
on an important new product. Before you head into the meeting, you quickly check your
messages. You received one text from a high-level, important employee expressing deep dissatisfaction over his bonus. He’s threatening to quit on the spot unless he meets with you
this morning.
As you scroll down your text messages, you see that your division’s largest customer
texted two hours earlier, very angry about a delayed critical shipment. As you open your
office door, the director of operations informs you that a power outage last night has left
a large quantity of perishable product beginning to spoil. Moving the product will require
your direct intervention to find/arrange a suitable costly cold-storage facility. The question
is NOT what should you do, for you should do all of them. The relevant question is, what do
you do first?
The idea behind line of sight is to answer those questions quickly and effectively. Each of
these demands in our fictitious case is urgent—if you don’t act immediately, you’ll lose out
on the design project, the skill of an important employee, a valuable customer, or profit since
product spoiled. If you have a very clear idea of the company’s overall strategy, and understand your role in furthering that strategy, you would have the tools to help decide which of
the many urgent tasks is the most important. If the company strategy revolves around some
vague notion of creating shareholder value or increasing earnings, then you have little direction. If, however, the strategy is clear and explicit about creating value through low cost, a
customer centric differentiation, or bold product innovation, then you have more guidance
and you can make a better decision.
Line of sight links day-to-day organizational behaviors and decisions to their impact on
the overall strategy.41 For example, if the company’s strategy relies on relentless low-cost
MEASUREMENT
[ 251 ]
production and control, then you should postpone the meeting, leave the customer and
employee in limbo, and spend time preserving the product. In contrast, a clearly customercentric focus tells you to call the customer first. Finally, you can see that a clear strategy of
winning through innovation means the design meeting will take place as scheduled or the
employee will be contacted if he contributes important innovation skills to the team.
The line of sight principle recognizes that grand strategies don’t just happen, they only
come to fruition as individual managers and employees make decisions about how to allocate the valuable resources they control.42 The ability to formulate a clear and direct strategy, our goal throughout this book, provides the point of reference to establish line of sight.
The next step in creating a line of sight involves translating the overall strategy into a set
of specific objectives for divisions or large work groups. Line of sight tells manufacturing
managers whether quality comes before costs. With a clear line of sight, marketing and
sales staff know which customers to focus on, how deeply to discount prices to win deals,
and what levels of personal attention and service each account should receive. Line of sight
helps human resource professionals design compensation systems to encourage and reward
those behaviors that actually create strategic value. Our final Strategy in Practice feature
outlines the steps individuals and managers can use to develop line of sight systems and
create measures to know when they are effectively implementing strategy.
S T R AT E GY I N P R A CT I C E
Creating Line of Sight Measures
T
urning the principle of line of sight into useful measures
requires individuals and managers to determine which
of their actions contribute to realizing a strategy and which
activities to do first. To create a clear line of sight, move
sequentially through the following steps. As you can see,
these steps build on the company diamond introduced in
Chapter 3.
Step 1: Begin with the end in mind. What’s most important? This is the time to list the abstract and broad goals
and objectives the company cares about. Is it the creation of shareholder value? Cutting-edge innovation?
World-class customer service, or a great place to work?
Answers to these questions can be found in the company’s mission statement.
Step 2: Identify the tangible strategy that reaches that
objective. For example, does the company intend to create shareholder value through a premium price (the top
line of the income statement], or through cost leadership (the mid-section and balance sheet)? Each of those
larger strategic positions requires a company to align
and combine its resources to achieve meaningful differentiation or low cost. For division or functional managers, which resources and capabilities are under my
direct control? How does my division or function help the
company implement its strategy? This establishes the
line of sight for this level of the organization.
Step 3: At the work group level, what specific activities do
we perform that utilize and strengthen these resources?
A large part of the daily work in most organizations
keeps the doors open, pays bills, and makes sales, but
does little to develop and enhance strategic capabilities.
The key for work groups, as for higher levels, is to sort
through the daily activity set and sort activities that really
need to come first. Work group tasks can then be subdivided into individual tasks. Individuals should be able to
see the chain that connects their personal work with the
company’s strategy.
Step 4: Determine which single measure captures the
way the work should be done. Take a call center as an
example. Many call centers are seen as cost centers
for providing customer support and help lines. A common metric most employees understand is to get the
customer off the line as quickly as possible so they can
handle the greatest number of calls per shift. This works
well if the strategy is cost leadership, but not if the strategy is differentiation and a key resource is brand.
Getting customers off the phone quickly does little
to build brand, and may harm it as customers see
the company as uninterested in after-sales support.
If brand matters, then the line of sight measure is
the number of problems resolved, and the number of
satisfied customers per shift.
[ 252 ]
CH12
ì IMPLEMENTING STRATEGY
balanced scorecard A tool that
measures four broad areas of
organizational performance:
financial results, customer goals,
internal business processes, and
learning and growth.
Measurement marks the last of the three primary tools of strategy implementation.
Measurement systems like the balanced scorecard43 can serve as an early warning sign for
misalignments between the 7 Ss or between the firm and its environment. Figure 12.6 shows
you the elements of a balanced scorecard a firm can use. Measurement can help managers
monitor progress toward strategic objectives and also help them manage the process of
change and realignment. Tools such as line of sight help managers decide where, when, and
how much to allocate resources to different activities. The most important resource they
allocate will be their own time.
[ Figure 12.6 ] Elements of a balanced scorecard
Financial Metrics
How well are we meeting
shareholder/investor demands?
Current Performance
External
Performance
Customer Metrics
How well are we satisfying
customer needs and desires?
Strategy
Internal
Performance
Process Metrics
How well are we performing
our key business processes?
Future Performance
Innovation Metrics
How well are we learning to
insure future growth?
Source: Adapted from Kaplan, R. S. and Norton, D. P. (1996) The Balanced Scorecard,Cambridge: HBS Press.
SUMMARY
ì This chapter introduced you to the challenges of implementing strategy, or moving it
from a grand design to a set of day-to-day activities that actually create competitive
advantage. Sometimes implementation is simply a matter of execution. There are four
steps to consider when execution is the issue:
1. Create a set of clear goals for people to follow;
2. Find ways to accurately measure performance;
3. Hold people accountable for their performance; and then
4. Reward those who perform well.
Effective
implementation relies on three key processes: the ability to forge alignment
ì
between the different elements of the organization, the capacity to lead strategic change
over a long period of time, and the creation of a set of measures and assessments that
monitor performance and help suggest changes.
ì The 7 S model provides a powerful way to think about how organizations can create alignment. The 7 S’s are:
1. Strategy—the organization’s plan for creating competitive advantage
2. Structure— the set of organizational arrangements that divide labor and tasks. Structure also defines reporting or authority relationships.
Corporate
Governance and Ethics
13
STEPHEN JAFFE/AFP / GettyImage
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1
Discuss the purposes of a corporation, including the shareholder
primacy model and the stakeholder model.
2
Explain the role of the board of directors in governing the
corporation and their duties to shareholders and other
stakeholders.
3
Identify major ethical challenges managers face at each stage of
the value chain.
[ 257 ]
13
Ethics and Governance
Failures at Enron
been a high-risk business that requires companies to
take on large amounts of debt to finance or securitize the
futures they buy. Enron’s creditors constantly looked at the
company’s balance sheet to ensure that its assets were
valued correctly and its debts within specified ranges.
Enron executives had conflicting fiduciary duties: to advance
shareholder interests through increased growth and to
protect those interests by maintaining prudent debt levels.
They chose to sacrifice prudence in order to grow, in part
because short-term growth was tied to their financial
compensation and bonuses.
Company executives used a complex accounting
procedure called a special purpose entity (SPEs) to move
high-risk assets and large amounts of debt off Enron’s
balance sheet.3 Enron’s auditor, the accounting firm Arthur
Andersen, should not have
certified these SPEs, but it faced
ENRON EXECUTIVES HAD CONFLICTING FIDUCIARY DUTIES: TO ADVANCE
its own conflict of interest. If
SHAREHOLDER INTERESTS THROUGH INCREASED GROWTH AND TO PROTECT
Arthur Andersen called Enron on
THOSE INTERESTS BY MAINTAINING PRUDENT DEBT LEVELS. THEY CHOSE TO
these questionable accounting
SACRIFICE PRUDENCE IN ORDER TO GROW […]
tricks, it would lose millions of
dollars of consulting contracts.
The highly risky trading business flourished over the next
When energy markets plunged and the Internet bubble burst
15 years, and the company vaulted from a small, obscure
in late 2001, the true state of Enron’s financial situation
Texas power company to one of the world’s largest energy
came to light, and the company collapsed in a matter of
trading companies. The company expanded its operations into
weeks. Enron filed for bankruptcy on December 2, 2001, and
electricity futures, opened Enron On-line (EOL) to facilitate
Arthur Andersen melted down in the early months of 2002.
futures trading over the Internet, and even began a joint
Enron publicly proclaimed values of respect, integrity,
venture with Blockbuster Video to build and trade futures
communication, and excellence (RICE), but traders soon
for new Internet bandwidth. By 2001, the company ranked
realized that only one thing mattered: profit. Enron’s culture,
seventh in the Fortune 500 with over $100 billion in revenue
driven by President Jeff Skilling, encouraged employees
and reported $1 billion in profit.2 At the close of 2001, however,
to cross ethical and legal lines. Skilling created a highpressure environment where up to 15 percent of his trading
Enron filed for bankruptcy protection as its problems came
staff was fired each year for failing to produce current
to light. By 2003 the company would be bankrupt and several
profits. One trader noted, “Good deal versus bad deal? Didn’t
of its top leaders would be under criminal investigation for
matter!”4 Enron would later be found guilty of manipulating
accounting fraud. What went wrong at the energy giant?
Trading in futures markets, whether for energy,
the California electricity market to gouge customers in its
commodities, or even financial instruments, has always
relentless search for profits.5
T
he Enron Corporation began doing business in 1985
when Kenneth Lay, chairman and CEO of Houston
Natural Gas Company, used junk bonds to finance the
purchase of the Nebraska pipeline company InterNorth.1
Enron hoped to take advantage of opportunities in the
newly deregulated energy markets in the United States.
Lay transformed Enron into a natural gas “bank” that
guaranteed both sellers and buyers certain prices and
quantities of the commodity. Enron did so by buying futures
contracts, promises to buy gas in the future for a certain
price. If the market price declined from what Enron agreed
before delivering the gas to consumers, the company lost
money, but if the price of gas increased, then Enron made a
profit. The more volatile the price swings of gas, the greater
potential profits for Enron.
[ 258 ]
THE PURPOSES OF THE CORPORATION
Enron’s board of directors followed many of the
recognized best practices for corporate governance: the
directors were all experienced, the board had a code of
ethics in place to protect against fraud and other abuses,
and the audit committee, the group of directors who oversee
the firm’s financial reporting process, was composed of
directors from outside the company. Investigators later
learned that Enron’s board of directors had actually voted to
suspend its own code of ethics before it chose to establish
many of the off-balance-sheet entities that would eventually
destroy the company. In other words, the board knew it was
violating its own guidelines, but with the stock price rising,
which director would want to put the brakes on growth?6 A
U.S. Senate committee concluded:
The Enron Board of Directors failed to safeguard
Enron shareholders . . . by allowing Enron to
engage in high risk accounting, inappropriate
conflict of interest transactions, extensive
undisclosed off-the-books activities, and excessive
[ 259 ]
executive compensation. The Board witnessed
numerous indications of questionable practices
by Enron management over several years, but
chose to ignore them to the detriment of Enron
shareholders, employees and business associates.7
What did the collapse of Enron cost? Shareholders lost over
$63 billion in total value, over 20,000 Enron employees were
affected, and another 90,000 employees and partners of Enron’s
auditor Arthur Andersen saw their jobs disappear. CFO and
architect of many of Enron’s accounting tricks, Andrew Fastow,
spent six years in prison, and Jeff Skilling received a 24-year
prison sentence for his leadership of the company (later
reduced to 14 years after he struck a deal with U.S. prosecutors
to pay more than $40 million to victims and end his appeals).
Millions of California power uses paid higher utility bills and
suffered from power blackouts due in part to Enron’s deception.
Finally, every public company in the United States saw its costs
increase and its environment become more complex with the
passage of the Sarbanes–Oxley (SOX) Act in 2002.8
ì
Enron’s spectacular and costly collapse highlights the issues, challenges, and problems of
corporate governance and the importance of ethical behavior. You may be thinking, “Just
what is governance? I thought that we elected governors but corporations hired managers?”
In this chapter, we’ll use a metaphor that should help you visualize the importance of good
corporate governance. The metaphor comes from the history of the word govern. The English
word govern traces its root back to in the ancient Latin word gubernare, which meant to
steer or pilot a ship.
This metaphor paints an accurate picture of governance; it’s about steering the
corporation. The notion of steering raises three simple questions about governance that
all corporations must answer: Where will we steer the corporation? Who will act as the
pilot? How will we steer, or what principles will guide the journey? This chapter is organized
around these three key questions.
THE PURPOSES OF THE CORPORATION
If we ask where we want to steer anything, be it a boat, a car, or a business, we are also asking where we want to end up, or what the goal is that we are trying to achieve. In terms of
corporate governance, this question is often worded in one of two ways: What is the purpose of the corporation? Or, who is the corporation run for? A corporation is a legal structure for organizing a business where the corporation is considered a distinct and separate
entity from its owners, also known as shareholders. For the last 80 years, those questions
have had at least two answers. The corporation should either be run for the shareholders or
be run for the stakeholders. To understand the implications of these answers, it is important
to understand a little about the history and evolution of the corporation in the United States.
For the first 100 years of our nation’s history, corporations were very rare. Most economic
activity was carried out by individual proprietorships, where the same person owned and
ran the business. Many small businesses today still operate as proprietorships. Some businesses operated as partnerships, a business owned by two or more partners. Today, law
firms, accounting firms, medical practices, and other professional service firms organize
as partnerships. Corporations that issued stock, or shares of ownership, to investors were
rare. If you wanted to form a corporation, you had to go to the state legislature to obtain
corporate governance The
processes and structures that
provide the ultimate decisionmaking authority for the firm
Corporation A legal structure for
organizing where the organization
is a distinct and separate entity
from its owners, also known as
shareholders.
individual proprietorship A legal
structure for organizing where the
same person owns and runs the
business.
partnerships A legal structure for
organizing where the owners of
a business share ownership. The
partnership is not separate from
its owners.
[ 260 ]
CH13
ì CORPORATE GOVERNANCE AND ETHICS
shareholder primacy The belief
that a corporation should be run,
primarily or exclusively, for the
benefit of its shareholders.
stakeholder model The belief that
a corporation should be run for the
benefit of its entire stakeholder set,
with no group enjoying primacy in
decision making.
nexus of contracts A model of the
corporation suggesting that the
firm is the sum total of its contracts
with different stakeholders.
property rights The rights of
owners to: (1) claim the residual
earnings of the corporation, or the
profits after all other stakeholders
have been paid, and/or (2) monitor
the management team to make
sure that the team works in their
best interests.
permission to begin and to sell stock. That right came in a document known as a charter.
That charter authorized you to form a corporation for a very limited purpose, such as building a canal, a railroad, or a turnpike. There was no debate about the purpose of the corporation because its purpose was clearly outlined in its charter.9
As the twentieth century dawned, states relaxed their hold on the corporate form because
people realized the limited liability and dispersed ownership that came through incorporation
allowed these entities to industrialize and grow the larger economy. Eventually corporations
could be formed for whatever purposes the owners wanted to pursue. One way these generalpurpose corporations grew was to offer investors a share of ownership in the company, or
stock. Those investors contributed their money but relied on managers to run the corporation.
During the nineteenth century, the owner and operator of the businesses were most often
the same person, while in the twentieth century, as large organizations emerged, ownership
became increasingly separated from management control of the corporation’s resources.10
In the 1930s, two famous law professors, Adolf Berle and Merrick Dodd, held a very public
argument about the purposes of the corporation. Professor Berle believed that the corporation should be run primarily for the benefit of the shareholders while Professor Dodd wrote
that the corporation should be run for the benefit of the entire community.11 We know Berle’s
position today as the shareholder primacy model, and Dodd’s as the stakeholder model.
The Shareholder Primacy Model
In earlier chapters of this book we’ve explained how a business can be thought of as a bundle of resources and capabilities, physical assets such as buildings or equipment and skills,
knowledge, and processes. Just as the business itself represents a bundle of these resources,
the corporation, the legal entity that is the business, can be thought of as a bundle, or a
nexus of contracts between participating parties.12 Suppliers contract with the firm to provide needed inputs, employees contract to provide labor, and even distributors and many
customers purchase goods from the corporation through a sales contract. Governments
contract with the corporation through a business license and tax authorities. Lenders and
bondholders have explicit contracts that outline specific payment schedules and terms.
Advocates of the shareholder primacy model believe that shareholders have a special type of
contract with the corporation. Unlike other stakeholders, investors exchange money with the
corporation without a clearly specified payment in return. Shareholders put their money “at
risk” without a guaranteed return, but in exchange, they receive two property rights from the
corporation. First, shareholders have claim to the residual earnings of the corporation, or the
profits after all other stakeholders have been paid. Second, shareholders buy the right to monitor the management team to make sure that the team works in their best interests.13 The first
right specifies their reward for investing their money and the second right protects them from
being taken advantage of by the management team by providing them with oversight rights.
Proponents of the shareholder primacy model usually cite three reasons for their support. First, the shareholders are the legal owners of the corporation’s assets.14 The executive
team is hired by the board of directors, the shareholders’ oversight group, and should be
legally and morally obligated to work for the owners of the corporation. Second, proponents
of the shareholder model claim that financial capital is the most important input into making a business successful. Without funds it’s hard to hire employees, buy inventory or other
needed inputs, and produce products for customers to buy. Finally, advocates of the shareholder model point to other societies and business arrangements where business firms try
to maximize the welfare of some other stakeholder group—such as employees or the local
community. They observe that corporations run for these other stakeholder groups don’t
really maximize welfare for those groups and often cause real damage to economies, communities, and the natural environment.15
Critics of the shareholder primacy school also point to three issues as evidence against
the model. First, they note that shareholders don’t really own the corporation, since shareholders own stock that they can easily trade. Second, shareholders have different objectives
for investing in a firm. Some investors, such as Warren Buffett or pension funds such as
CALPERS (the California Pension and Retirement System), put their money in a company’s stock as a long-term investment and want to see the corporation managed to earn the
THE PURPOSES OF THE CORPORATION
[ 261 ]
greatest long-term return. Other investors (e.g., hedge funds, arbitragers, or speculators) buy
stocks and hold them for very short periods of time. They want quick returns. Managing the
corporation for the benefit of shareholders requires that managers make difficult trade-offs
to satisfy one shareholder group at the expense of others.16 Finally, opponents of the shareholder primacy model point to failures such as Enron, Long-Term Capital Management, BP
and the Deepwater Horizon oil spill, the collapse of Lehman Brothers, and the behavior of
firms during the financial crisis of 2008 as evidence that managing for shareholder value
creates negative consequences for firms, investors, and society at large.17
The Stakeholder Model
Merrick Dodd believed that because the community grants the corporation the right to
exist, the managers should run the corporation for the benefit of the community as a whole.
Dodd’s fundamental argument has been made by a number of different scholars, policy makers, and social critics over the decades. The modern version of Dodd’s argument is called the
stakeholder model, or stakeholder theory.18 A stakeholder is anyone who can affect or is
affected by the activities of the corporation.
Stakeholders have a stake, or claim, in the activities of a corporation. The primary stakeholder groups for most organizations are shareholders, customers, suppliers, employees,
and local communities (including governments). Secondary stakeholders include competitors, national or global communities, and many special-interest groups, such as those working to protect the natural environment. We are all stakeholders of many organizations.
Those who advocate stakeholder models do so from two grounds. They point to what executives and managers actually do, which is spend most of their time interacting with and managing the demands and needs of different stakeholder groups. This includes working to better
understand and meet customer needs, negotiating wages, dealing with working conditions
for employees, responding to government regulations, and reacting to the demands of special
interest and advocacy groups. The fact of life for most leaders of companies is that they engage
in a lot of stakeholder management, so it makes sense to do it more systematically and proactively. Second, many people believe that stakeholder groups have the right to be considered in
decisions that will impact them. This is known as the intrinsic stakeholder model.19
The stakeholder model, especially the version we described as the intrinsic stakeholder
model, has been criticized by many scholars, practitioners, and even policy makers. These
critics argue that managers need to focus on a single objective.20 Making shareholder value
the final decision criteria gives managers a clear direction for the tough tradeoffs they must
make in the course of formulating and implementing strategy. With no way to decide whose
claims have priority, managers have no way to efficiently and effectively run their firms.
Other critics note that stakeholder management has a dark side: stakeholders may make,
and try to enforce, unreasonable and narrow-minded claims on the firm.21 General Motors,
for example, continues to incur costs related to union contracts signed decades ago. Some
argue that this stakeholder group sought unreasonable benefits that hurt other stakeholder
groups and eventually contributed to General Motors filing for bankruptcy.
How a company engages with its key stakeholders and manages those relationships affects
the firm’s overall performance and competitive advantage. Many of the ways stakeholders
interact with the firm are predictable and not difficult to understand. Other interactions, however, are less obvious and have longer-term consequences on a firm’s performance and competitive advantage, as well as on how stakeholders benefit (or are harmed) by the business.
Companies can, and should, audit their performance in relation to stakeholder groups on a
regular basis.
Our Strategy in Practice feature helps you understand stakeholder relations. The first column describes how company actions affect stakeholders. The middle columns of the table
list how stakeholders can affect the firm. The most important element of the table, however,
is the far right column, where managers list the formal mechanisms in place for the firm to
attend and listen to its different constituencies. Once a firm has these elements in place, it
can better design actions, policies, and strategies to create positive interactions with different stakeholder groups. You can understand how effectively a company manages its stakeholders by examining the different activities listed in the third column.
stakeholder Any person or group
that can affect or is affected by the
activities of the corporation.
[ 262 ]
CH13
ì CORPORATE GOVERNANCE AND ETHICS
S T R AT E GY I N P R A CT I C E
Mapping Stakeholder Influence
Stakeholder
Group
Customers
Employees
Suppliers
Investors
Is Affected by the Business
Through . . .
Tools for Listening and
Responding to Stakeholders
ì Products and services
ì Purchases
ì Market research groups
ì Warranties, after sales
services
ì Word-of-mouth advertising
ì Warranty fulfillment
ì Integrity/honesty during
the sales process
ì Formal complaints
ì Code of ethics, mission
statements
ì Branding and advertising
ì Influence brand perception
and value
ì Wages
ì Productivity
ì Employee councils
ì Benefits
ì Loyalty (turnover)
ì Employee hotlines
ì Safe working conditions
ì Safety programs
ì Flex time
ì Word of mouth and
reputation
ì Training and development
ì Lawsuits
ì Flex time, telecommuting
ì Career path
ì Trade secrets
ì Training opportunities
ì Theft or sabotage
ì Code of ethics,
mission statements
ì Timely payment
ì Quality products
ì Supplier councils
ì Order consistency
ì Timely delivery
ì Quality control policies
ì Protection of intellectual
property
ì Price and payment terms
ì Payment policies
ì Willingness to innovate
ì Word of mouth and
reputation
ì Flexibility in responding to crises or unusual
demands
ì Joint ventures, alliances,
or other mechanisms to
promote cooperation
ì Earnings
ì Providing capital
ì Integrity/honesty in
accounting policies and
reporting
ì Short selling
ì Information disclosure
about strategies and other
material events
Communities/
Governments
Affects the Business by . . .
ì Environmental pollution,
traffic
ì Tax revenue and demand
for public services
ì Employees living in the
community
ì Philanthropy and
volunteering
ì Lobbying and other legal
activity
ì Boycotts
ì Inducing others to buy
ì Analyst reports and
recommendations
ì Customer hotlines
ì Wages and benefits
ì Investor conference calls
and guidance
ì Investor relations
offices
ì Board of directors
ì Code of ethics, mission
statements
ì Tax policy
ì Government relations
ì Regulations and
enforcement
ì Lobbying efforts
ì Investments in community
infrastructure
ì Educational systems and
quality
ì Quality of life for
employees
ì Philanthropy and
donations
ì Environmental policies
ì Community impact studies
ì Volunteering efforts
ì Employee involvement in
local/ regional political
groups, activities
GOVERNANCE: BOARDS AND INCENTIVES
[ 263 ]
The first question of effective governance—What is the purpose of the corporation?—is
hotly debated. On the one hand, corporate scandals, environmental crises, job offshoring,
and business failures from fraud, corruption, or other illegal behaviors torment shareholder
advocates. On the other hand, most adults have the majority of their retirement funds, or a
part of their personal wealth, invested in company stocks, so they all have an incentive for
managers to work for the good of the shareholder. Most people are both stakeholders and
shareholders. Regardless of where you stand on this issue, the second question of governance, the question as to who should pilot the corporation, is important as well, because
those pilots determine what the corporation actually does.
GOVERNANCE: BOARDS AND INCENTIVES
Whether a corporation is managed for shareholders or stakeholders, both of those groups
face the same problem in relation to the executive team that runs the corporation. We outlined that shareholders’ property rights are twofold; they have claim on the profits of the firm
and they have the right to monitor the performance of the managers of the corporation. The
law recognizes this right as a way to overcome the fundamental agency problem facing the
modern public corporation. As we describe the agency problem, you’ll recognize that stakeholders face the same challenge as shareholders. Figure 13.1 illustrates the agency problem.
The agency problem arises as consequence of the separation of ownership (shareholders/principals) and control (managers/agents) in the corporation.22 The shareholders of a
corporation, also called the principals, want to maximize the return on the dollars they’ve
put into the firm; they want the corporation managed in a way that maximizes revenue and
minimizes cost, leaving the most profit.
The managers who act as the agents of the principals in operating the firm want to maximize their own utility. That may mean maximizing the profit of the corporation or it may
mean engaging in behaviors that increase their income, leisure, power, status, or any other
thing they may care about.
Put simply, principals and agents have different goals. It is clear that if stakeholders
make specific investments in a firm, they face the same problem. For example, employees
may learn skills that have little value in other firms, customers may design their operations
around a firm’s unique products such as a software system, or suppliers may invest in specialized equipment to produce particular products for the firm.23
[ Figure 13.1 ] The Agency Problem
Natural
Environment:
Sustainable
Practices
Shareholders:
Return on
Investment
Customers:
Reliable
Products
Suppliers:
Reliable
Partner
Managers:
Maximize
Utility
Government:
Good Citizen
Employees:
Stable Jobs
agency problem A consequence
of the separation of ownership
(shareholders/principals) and
control (managers/agents) in the
corporation. Agency problems
occur when the goals or principals
differ from those of agents.
principals The owners of a
resource or piece of property. in
the corporation, shareholders are
considered principles.
agents Individuals or groups
hired to administer the property
or resources of principals. The
managers of a corporation are
considered to be agents of the
shareholders.
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tender offer An offer by those
hoping to control the corporation
to purchase shares of dissatisfied
investors.
proxy fight An attempt by
dissatisfied investors or
stakeholders to gain seats on the
board of directors, or to influence
corporate policy.
When agency problems arise, shareholders can always just sell their holdings in a
company. As performance declines, more investors sell, and eventually the firm’s share
price falls enough to attract the interests of some investors referred to as corporate raiders
or takeover artists. These are investor groups who believe they can manage the corporation’s assets better than the current management team. These investors then make a public
offer, called a tender offer, to purchase shares of dissatisfied investors, usually at a 10 to 30
percent premium above the current stock price but below what they believe the company
is really worth. If these takeover artists convince enough other investors to sell their shares,
then they take control of the company and begin to implement their own strategy.
Takeover artists can also mount a proxy fight, or an attempt to get the current owners of
the company to change their strategy by placing their own people on the board or directors.
Even if the takeover artists or raiders don’t gain complete control of the board, they often
gain enough to influence the strategic decisions of the company in ways they believe will
create more value for shareholders. The possibility of losing their jobs in a takeover should
keep the firm’s managers focused on creating wealth for shareholders and maintaining or
increasing the company’s stock price.24
Agency problems destroy value in two particular situations. First, when the principal’s
investments are sunk and difficult to recover and, second, when their ability to monitor
and supervise the actions and decisions of the agents, the managers of the corporation,
is limited. Most businesses today require many sunk-cost investments in equipment or
knowledge, satisfying the first condition. To protect themselves against the second condition, principals employ two tools to monitor their manager-agents: monitoring through
the board of directors, and reducing the agency problem through compensation and
incentives.
The Board of Directors
board of directors A group of
individuals who monitor the
executive team of the corporation
and ensure that those executives
are acting in the best interests of
the shareholders.
fiduciary duty The legal obligation
of an agent, a fiduciary, to act in
the best interests of the principal,
or owner. Fiduciary duties include
the duty of loyalty, to work for the
optimal good of the owner, and the
duty of care, to not take undue risk
that would jeopardize the principal.
inside directors Executives or
managers working inside the
company who also hold seats on
the board of directors.
outside directors Members of the
board of directors not employed by
the corporation in any other role.
other constituency laws Laws that
allow the board of directors to freely
consider the needs of stakeholders
other than shareholders when
making critical strategic decisions
for the firm.
U.S. corporate law, and that of most countries, requires that all publicly held corporations
have a board of directors. The board of directors is a group of individuals who monitor
the executive team of the corporation and ensure that those executives are acting in the
best interests of the shareholders.25 Directors, as well as the executives themselves, have a
legal fiduciary duty to act in the best interests of the corporation’s owners. That duty has
two different elements.26 On the one hand, a fiduciary is obligated to work for the greatest
advantage for the principle, such as maximizing profits for shareholders. On the other hand,
fiduciaries must exercise care and caution in protecting the value of the principal’s investment. As you saw in the Enron case, these two duties can conflict, and Enron’s board chose
to abandon its duty of care in favor of the duty to advance shareholder interests.
Shareholders elect the board of directors at regular intervals. The board of directors usually includes executives of the corporation as well as people outside the company. Inside
directors, executives or managers, bring their skills and working knowledge of the firm’s
operations and strategies to the board. Outside directors, people not employed by the corporation in any other role, should bring deep knowledge and a fresh perspective, both of
which ensure that the firm’s strategy will serve the financial interests of the shareholders.
Outside directors should also bring independence to the board as they don’t have to worry
about losing their jobs or compensation if they offer opinions that the firm’s executives
might not want to hear.27
The laws of the United States do not require that directors take the interests of stakeholders in mind, but the laws of many European countries protect stakeholder interests
by requiring that certain stakeholders have formal representation on the board. For example, public companies in Germany must have a representative of employees on the board;
Japanese companies have one of the firm’s lenders (e.g., a bank executive) on the board.
One half of the states in the United States have what are known as other constituency
laws that allow the board to freely consider the needs of stakeholders other than shareholders when making critical strategic decisions for the firm.28 Shareholders and many
stakeholders care about the quality of corporate boards, as illustrated in the next Strategy
in Practice feature.
GOVERNANCE: BOARDS AND INCENTIVES
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S T R AT E GY I N P R A CT I C E
America’s Best and Worst Boards
W
ith their investments at risk in an increasingly
turbulent and global business environment,
shareholders have become concerned about the
composition and quality of the board of directors at large
public companies. Government regulators, from tax
authorities to the Securities and Exchange Commission
(SEC), employee groups, and a number of social activists,
pay attention to annual ratings of board quality. One
example is Institutional Shareholder Services (ISS), http://
www.issgovernance.com/, a private company that rates
the quality of boards of directors. Bloomberg Businessweek
also rates the quality of America’s boards. Its ratings focus
on the board’s accountability to shareholders, the quality
of the board in terms of expertise, its independence from
company management, and the company’s overall financial
performance. Here are the five best and worst boards in
2013:29
Best:
1. Campbell Soup—The board engages in periodic selfreviews to make sure it is performing its monitoring
and advising roles well.
2. General Electric—Each director owns more than
$450,000 of the company’s stock, a powerful incentive
to look after shareholder interests.
3. IBM—The board directed and led the search for new
CEO Ginni Rometty.
4. Compaq Computer—This HP subsidiary reviews the
board’s performance as well as that of individual directors.
5. Colgate Palmolive—Board gets high marks for the
number and quality of outside directors.
Worst:
1. Archer Daniels Midland—Board shows little independence from company management.
2. Campion International—Directors have few stock holdings in the company.
3. H. J. Heinz—Six directors exceed 70 years in age, and
most members are insiders.
4. Rollins Environmental—All members of the board are
insiders working for the company.
5. NationsBank—Board shows little accountability to
shareholders.
Compensation and Incentives
The agency problem arises in the first place because the fundamental interests of principals
(shareholders or stakeholders) and their agents (the managers) differ. That is, they are sometimes out of alignment. For example, an executive might get a lot of value out of having a
corporate jet, but shareholders might feel that using their money to purchase a jet doesn’t
maximize the return on their investment. One way to align the agent’s and principal’s incentives is through compensation. When managers, or employees, get paid by salary, they don’t
have a strong incentive to work harder or smarter to create additional value for the company.30 If, however, they get paid more when the company generates greater profits, they’ll
have a much stronger incentive to create that additional value. Now principals and agents
both care about the same thing; the company pays agents for the performance desired by
principals. Principals employ two types of pay for performance, or variable compensation,
to align their interests with the management team.
First, companies often pay out bonuses to executives, managers, and employees
when they meet certain performance objectives. Bonuses can be discretionary and
given for any reason the principal desires or they can be nondiscretionary and tied to
some particular performance measure. Many employees receive a small bonus at the
end of the year or during the holidays as a token of the company’s appreciation for their
work. Other employees receive bonuses when they, or their work groups, hit preset targets around productivity, customer service, on-time delivery, product quality, or their
unit’s profitability. Bonuses can be a powerful tool in helping mangers align their interests with those of various stakeholder groups if the bonus is linked to measures these
stakeholders care about.
pay for performance Variable
or contingent compensation that
focuses managers on key variables,
designed to align their interests
with the management team.
bonuses Additional compensation
paid to executives, managers, and
employees when they meet certain
performance objectives.
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stock-based compensation
Payment to organizational
members in the form of shares in
the corporation.
stock option The right to buy a
certain number of the corporation’s
shares at a specified future date for
a specified price.
stock grant A gift, or grant, of
stock given to organizational
members, primarily executives.
Second, companies also use stock-based compensation, either in the form of options or
grants of stock, to align incentives. Stock-based compensation aligns the interests of executives
or employees with those of shareholders. Stock-based compensation turns managers into shareholders. A stock option gives managers the right to buy a certain number of the corporation’s
shares at a specified future date for a specified price. A CEO may receive an option to buy 1,000
shares of stock at a price of $20 on June 1, 2021. If the stock price is above $20, the executive pockets the difference. If the price is below $20, the option is worthless, often termed as underwater. In
other cases, a company will simply grant executives or others shares of stock. These stock grants
usually come with restrictions that prohibit the sale of those shares for a specified period of time.
Since scholars first identified the agency problem in the mid-1970s, the nature of executive compensation has changed dramatically. Executives used to be paid primarily in salary,
with some money coming in the form of bonuses. Today, the bulk of a CEO’s total compensation comes in the form of stock compensation. The case of Apple CEO Tim Cook is an example. In 2011, Mr. Cook received his $900,000 base salary and a one time, special grant of Apple
stock worth $376.2 million.31 Under his leadership, Apple’s share price climbed substantially
and the company created value for its shareholders.
Many critics worry that such huge paychecks create a gap between the richest CEOs and
the average worker and that the gap does not benefit society as a whole.32 In 1950, CEOs
earned about 20 times the wage of the average employee. By 1980, that number had more
than doubled to 42 times; by 2000 the gap had increased to 120 times. In 2013, the pay gap
had increased to 354 times the average worker salary.33
The answer to the question of who pilots the corporation is the same whether one believes
the corporation should be managed for shareholder or stakeholder interests. The board of directors is the body designated to look after the interests of shareholders and/or stakeholders and
monitor managers. Both shareholder and stakeholder groups can push for compensation policies that align their interests with those of managers and executives. We now turn our attention
the last question of corporate governance: What principles will guide the pilots of the journey?
CORPORATE ETHICS
ethical values Values that define
for an individual, group, or society
things that are morally right or
wrong.
We begin this section with a disclaimer. What you read in this chapter is not a substitute
for a full course on business ethics. We intend to show you that ethics matters for strategists. Remember the tale of Enron in the chapter opening case? Enron enjoyed powerful
competitive advantages in its markets and went from a small, regional energy producer to
the country’s seventh largest company. It turned out that many of those competitive advantages relied on unethical behaviors that violated time-honored ethical values of honesty and
integrity. Ethical values are those values that define for an individual, group, or society
things that are morally right or wrong. We value honesty, kindness, fair dealing, and integrity
because they are good or virtuous in a moral sense; similarly, we don’t value dishonesty, violence, or breaking promises because they are morally bad or evil.
Philosophers have debated what constitutes ethics behavior for centuries. Debates about
ethics are debates about what is right and wrong, but also which behaviors lead to the good or
just society. Participants in these debates employ one of four arguments in making their case:
1. A good society creates the greatest good for the greatest number of people. Goodness is
measured as utility, or the presence of pleasure and the absence of pain.34 Utilitarianism, the name for this position, suggests that we can calculate what’s right by looking
at the benefits created by the action and then subtracting out the costs. Utilitarian
moral philosophy provides the foundation for economics. Milton Friedman, for example, wrote that the ethical responsibility of a business is to maximize profits for shareholders as the money they make creates the most utility.35
2. The good society ensures a basic set of rights for its citizens. While utility is good, people have fundamental rights that cannot be violated or traded away and duties they
cannot ignore.36 This ethical tradition views people as ends in themselves and argues
that it is immoral to use people in any way as merely a means to an end. For example,
people have a right, and companies have a moral obligation, to provide full and fair
information about the potential risks of products.
CORPORATE ETHICS
3. The good society creates the most freedom for people to act as they please. This moral
philosophy is closely aligned with Libertarian political philosophies that advocate
very limited government and efficient markets.37 Ethical behavior is that which promotes human freedom of expression and development. Free markets are morally good
because they allow people the maximum amount of choice.38 This philosophy looks
with approval on many technology products because they empower individuals to
express themselves and develop their full potential.
4. In a good society, individuals care for each other, exhibit empathy with others, and focus
on meaningful relationships.39 Known as the ethics of care, this position believes concerns for utility, rights, duties, and human freedom are all worthy aims, but in pursuit
of these goals we need to be concerned about other people, empathetic to their plight,
and mindful of the impact of exclusion. Strategies that marginalize certain groups
or management techniques that threaten relationships are immoral for those who
believe in the ethic of care.
These four ethical orientations provide people with different perspectives on what constitutes ethical behavior; however, they are pretty abstract. It’s often difficult for people to
see the link between their behavior and human rights, justice, or freedom. To bring these
behaviors down to the level of every day behavior, researchers have identified general ethical
dimensions that lay the foundation for ethical behaviors in business.40 Although individuals,
groups, and societies differ in the weight they put on different dimensions, these areas help
us think about what it means to be ethical.
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ethical behavior That which
promotes human freedom of
expression and development.
Caring for and Avoiding Harm to Individuals. Many people include animals and the natural
environment. Companies in the mining and oil extraction industries spend substantial
resources making sure they avoid undue harm to the environment.
Concern About Fairness and the Condemnation of Cheating. Fairness for some groups means
equality while for others it means equity or merit. Employees and managers of financial services
companies work in an environment ripe for insider trading, a form of cheating. The best banks
and investment houses have clear policies and procedures to steer clear of insider trading.
Recognition of Things as Sacred or Degraded. Many cultures revere sites as holy places
or venerate people who exhibit particular virtuous behavior. Similarly, other groups view
actions or elements as degraded, impure, or polluted. As companies enter markets where
religious values and laws are strong, such as Islamic countries governed by Sharia, they must
ensure that their products and services conform to those religious norms.
Praise of Liberty and Condemnation of Oppression. Products, services, or policies that promote
human development, flourishing, freedom, and growth are praiseworthy, while those that
oppress people or cultures face condemnation. The next Strategy in Practice feature describes
how Google wrestled with the ethics of censorship and the suppression of human rights in China.
Corporate Culture and Ethics
How can company directors, executives, and managers ensure that their organizations act in
ethical ways? The RICE cultural values that Enron publicly stated—respect, integrity, communication, and excellence—could promote ethical behavior by everyone in the organization. The problem at Enron, however, was that these values were discussed and agreed on,
but they had little impact in determining how traders actually approached their jobs. Enron
traders looked to the values of the people they worked with every day. Those values, and
the culture they supported, were very different from RICE. That value was to make as much
money as possible, without regard to what rules might be broken while doing so.
When we speak about culture, we speak about “the pattern of behavioral assumptions
that a given group has invented, discovered, or developed . . . that have worked well enough
to be considered valid, and, therefore, to be taught to new members as the correct way to
perceive, think, and feel.”43 Put simply, culture is just how things are done in any organization. Culture acts like a third governance mechanism because it pilots the organization by
helping each individual employee or manager decide what to do. Culture proves to be very,
powerful because it informs action without the need for supervision or permission from
culture A pattern of behavioral
assumptions that are considered
appropriate and correct for
organizational members.
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S T R AT E GY I N P R A CT I C E
Google, Censorship, and Google.cn
T
he company we all know as Google formally incorporated
in September 1998.41 The company’s search engine
provided customers with more accurate searches more
quickly than other engines, and Google began to grow.
Google’s founders Larry Page and Sergey Brin built the
company around a mantra of “don’t be evil.” That mantra
would be tested within two years as the company entered the
world’s most populous country, China.
Google.cn, the Chinese language version of Google.
com, went live in 2000. The website didn’t run very well,
users could not access it all the time, and when they did,
they found it slow and unreliable. The reason for the poor
performance lay in the extensive filtering of Internet search
results by the Chinese government. The government
pursued an Internet polity that sought to leverage the
web’s potential to contribute to economic growth while
not allowing users to access what it considered politically
and morally sensitive material. By 2006, this slow search
engine had fallen behind the Chinese search engine Baidu in
market share.42
Google.cn relaunched in January 2006 at speeds and
accuracy equal to Google.com. There was a major difference,
however. Google.cn self-censored web content. Google
blocked content the Chinese government disapproved of
but notified searchers that content had been removed. This
represented an uneasy truce between Google’s desire to
be a player in the Chinese market and its need to adhere
to its principle of not doing evil—political censorship. The
Chinese government raised numerous allegations against
the company as a provider of pornography and, allegedly,
initiated a cyber-attack that halted Google’s operations.
Google responded in 2010 by moving its search site and
related storage capacity off the Chinese mainland. Chinese
users were directed from Google.cn to Google.hk. Search
results may be filtered, but the filtering would no longer
occur as a Google company policy. Google continued to locate
certain web-based and Android businesses in China. The
Chinese government renewed Google’s license to operate
in 2010, a move that many believed was based on the fear of
having their business environment seen as overly politicized.
managers, executives, or the board.44 An organization’s culture, by itself, is neither good nor
bad; however, a culture will influence how people perceive and react to ethical challenges
they face as they do their jobs. We’ll first look at how culture can promote unethical behavior, and then we’ll outline some steps companies can take to create an ethical culture.
Cultures influence how individuals will respond to ethical challenges in two ways.45 First,
the culture tells us the “correct way to perceive” the world around us and, second, culture
provides us with a set of reasons that justify our actions. Cultures that promote unethical
behavior allow people to deny or not see the ethical dimension of their actions. If people
do see the ethical challenge involved, the culture provides a set of justifications, or ways to
rationalize their unethical behavior. Remember that if you break apart the word rationalize
you get “rational lies.”
Creating an Ethical Climate
Just as a culture can encourage people to act unethically, cultures can also help people see
the ethical challenges they face and give them tools to make the correct choices. Enron’s RICE
values all encouraged good behavior, but they were fundamentally out of alignment with the
everyday cultural values in place at the company. The 7 S model introduced in Chapter 12
identified shared values and style as the core of a company’s culture. These two elements can
help a company create a climate where ethical behavior becomes the expected norm.
mission statement A formal
declaration of a company’s core
values, business objectives, and
ethical aspirations.
Shared Values. A good place to start is to have a mission statement. We introduced
mission statements in Chapter 1 and described how a mission outlines a company’s purpose
and articulates its core values. A mission statement represents a powerful way to formalize
CORPORATE ETHICS
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S T R AT E GY I N P R A CT I C E
The Johnson & Johnson Credo
Robert Wood Johnson, a member of the founding Johnson
family, served as CEO of Johnson & Johnson from 1932 to
1963. Just before the company went public, he took the time
to write down the core values that drove the company, its
strategy, and the executive team. Those core values have been
a reference for company managers and employees since then.
He termed it the Credo:46
We believe our first responsibility is to the doctors,
nurses and patients, to mothers and fathers and
all others who use our products and services. In
meeting their needs everything we do must be of
high quality. We must constantly strive to reduce
our costs in order to maintain reasonable prices.
Customers’ orders must be serviced promptly and
accurately. Our suppliers and distributors must
have an opportunity to make a fair profit.
We are responsible to our employees, the men and
women who work with us throughout the world.
Everyone must be considered as an individual.
We must respect their dignity and recognize their
merit. They must have a sense of security in their
jobs. Compensation must be fair and adequate,
and working conditions clean, orderly and safe. We
must be mindful of ways to help our employees
fulfill their family responsibilities. Employees must
feel free to make suggestions and complaints.
There must be equal opportunity for employment,
development and advancement for those qualified.
We must provide competent management, and
their actions must be just and ethical.
We are responsible to the communities in which we
live and work and to the world community as well.
We must be good citizens—support good works and
charities and bear our fair share of taxes. We must
encourage civic improvements and better health
and education. We must maintain in good order the
property we are privileged to use, protecting the
environment and natural resources.
Our final responsibility is to our stockholders.
Business must make a sound profit. We must
experiment with new ideas. Research must
be carried on, innovative programs developed
and mistakes paid for. New equipment must
be purchased, new facilities provided and
new products launched. Reserves must be
created to provide for adverse times. When
we operate according to these principles,
the stockholders should realize a fair return.
the company’s core values and ethical aspirations for the entire world to see. A good mission
statement clarifies who the company’s stakeholders are and how they should be treated.
The Strategy in Practice feature discusses the legendary mission statement at Johnson &
Johnson, known as the Credo.
Having a mission on paper is a great place to start, but having a mission that actually
guides people’s behavior is even better. Everyone, from the board, to the executive team and
every layer of management, to the employees on the shop floor must buy into the mission
and figure out how it influences their daily behaviors. Companies should also make a formal
code of ethics a part of their shared values.
Style. Style comes last because it might be the most important of all the 7 Ss. The tone
at the top matters, maybe more than any other factor! How individual executives behave
provides the most important cue for employees to follow as they try and figure out how they
should act at work. Enron’s Jeff Skilling received such a long prison sentence in part because
prosecutors alleged that his behavior created and drove the reckless culture of greed that led
to the company’s downfall. Moral strategic managers and executives not only walk the talk
and act ethically themselves, they provide ethical leadership for others to follow.
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Aircraft maker Boeing experienced several ethical crises in the late 1990s and early 2000s,
including allegations of bribing U.S. Defense Department personnel to win contracts. To
create a more ethical climate, the company emphasized leadership. Boeing now expects its
leaders to deliver on six tasks:
1. Chart the course for employees.
2. Set high expectations for performance.
3. Inspire others.
4. Find a way to get things done.
5. Live the Boeing values.
6. Deliver results.47
Delivering results mean earning profits and creating competitive advantage but in an
ethical and responsible way. The company value of integrity states, “We will always take the
high road by practicing the highest ethical standards.”48
Ethics provides the answer to the final question of corporate governance: What values will guide the journey? Successful corporate governance helps ensure that a company
knows who its key stakeholder or primary beneficiary is, and then works to create value for
them. Good governance relies on having a strong board of directors to guide decision making and oversee the executive team as they formulate and implement strategy. Finally, having a culture that enables and encourages ethical behavior matters because, as experience
has shown, cultural may be the most powerful, yet subtle, form of corporate governance.
SUMMARY
ì The best way to think about governance comes from the word’s original meaning, to steer
or pilot. People in the corporation need guidance and oversight to ensure that the corporation meets its strategic objectives.
ì Some people believe that corporations exist to maximize the financial value of the company’s shares. These advocates point to the many benefits that come from a clear focus
on profitability and shareholder value. Others believe that corporations exist for a larger
group of stakeholders, and the business should be run to serve their interests as well as
shareholders. This debate has been going on since the Great Depression, and there is
merit in both sides.
ì Shareholders and stakeholders both face the agency problem: their goals and interests
may differ from those of the executives who run the company. Two mechanisms exist
to overcome the agency problems and provide good governance. The board of directors,
a legal requirement for public companies, has ultimate control over corporate decision
making and can ensure that the executive team works to create value for the primary
stakeholders. Compensation systems such as bonuses and stock-based rewards, pay for
performance, can align the interests of managers and important stakeholder groups.
ì Ethics and ethical values play a significant role in good governance. The culture of the
firm can either encourage or discourage ethical behavior. The 7 S model provides a framework to describe concrete steps managers can take to create a culture that encourages
employees and others to act in ethical ways. Perhaps the most important of these is the
“tone at the top,” or the behavior and leadership of those at the top of the corporation.
KEY TERMS
agency problem (p. 263)
agents (p. 263)
board of directors
(p. 264)
bonuses (p. 265)
corporate governance
(p. 259)
corporation (p. 259)
culture (p. 267)
ethical values (p. 266)
ethical behavior (p. 267)
fiduciary duty (p. 264)
Strategy and Society
14
Michele Molinari/Danita Delimont.com "Danita Delimont Photography"/Newscom
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1
Explain the difference between economic and social value.
2
Use the value net to identify a social-value organization’s key
stakeholders and use that model to discuss opportunities for
and threats to value creation.
3
Explain how economic-value organizations can create value
through activities known as corporate social responsibility.
4
Categorize the major focus areas of social entrepreneurship and
the challenges unique to each focus.
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14
Fundacion Paraguaya:
Fighting Poverty in Latin
America
and founded a micro-credit organization, Fundacion
Paraguaya. Today Fundacion Paraguaya operates in over
130 towns in 10 of the country’s 17 provinces. Martin’s
group provides small loans to Paraguayan entrepreneurs
so they can start small businesses to support their
families. Fundacion Paraguaya also provides training in
entrepreneurship for adults, and a Junior Achievement
program for youth.
In 2002, a group of Franciscan missionaries approached
Martin about taking control of the San Francisco Agricultural
School (SFAS), which they had run for over 100 years. 3
Located about 40 miles north of the capital city of Paraguay
on the edge of the Chaco forest, the school provided a
much-needed education for the children of the poor,
rural residents. In Paraguay, the government subsidized
private schools, but
political instability led
THE CURRICULUM WOULD FOCUS ON TEACHING STUDENTS THE PRACTICAL SKILLS OF
to funding cuts that left
ENTREPRENEURSHIP IN ADDITION TO THEIR ACADEMIC STUDIES, AND THE STUDENTS
the missionaries unable
WOULD USE THE LAND AND OTHER AGRICULTURAL ASSETS OF THE SCHOOL TO CREATE
to operate the school.
A NUMBER OF INCOME-GENERATING BUSINESSES.
After watching Martin’s
organization work
Entrepreneur Martin Burt, who grew up in the capital city
tirelessly to improve the lives of Paraguayan youth through
of Asuncion, is working to change that. He explains:
Junior Achievement and other programs, the missionaries
approached Martin about running the school.
It quickly became apparent to my brothers and
Fundacion Paraguaya took control of the school on New
sisters that we were among the very privileged in
Year’s Day, 2003. The organization purchased 48 hectares of
Paraguay, a poor country, and so we always heard
agricultural land, the school buildings and dormitories, and
from my parents and my grandparents that we had
agreed to invest another $500,000 to upgrade the school’s
to take advantage of the opportunities we had but
facilities and pay its teachers. Martin decided to try a new
to also give back. I had an early sense of wanting
model, and rather than relying on government subsidies
there to be social justice in Paraguay . . . not from
and following its mandated curriculum, SFAS would fund
a position of resentment, but with joy; how can we
itself. The curriculum would focus on teaching students
amplify what “the haves” have, and extend it to the
the practical skills of entrepreneurship in addition to their
poor? How can we give back? How can we expand
academic studies, and the students would use the land and
prosperity to everybody?2
other agricultural assets of the school to create a number
of income-generating businesses. Profits from Fundacion
After completing his graduate education at George
Paraguaya’s other businesses, primarily micro-credit,
Washington University in 1985, Martin returned to Asuncion
A
Paraguayan’s annual average income is $3,020,
or just over $8 per day.1 Education for Paraguayan
children proves particularly problematic. Although
91 percent of children in the country complete elementary
school, only 60 percent enter secondary school, equivalent to
middle schools and high schools in the United States. Just
over half of those students, or about 35 percent of the total,
will pursue some education beyond high school. For many
Paraguayans, the lack of advanced education consigns them
to scratch out a meager living in the country’s agricultural
sector, or its informal economy. Informal businesses operate
without a formal business license and do not enjoy many
other legal protections, such as police and fire protection,
utility hook-ups and power, or access to services that can
help a business expand.
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STRATEGY AND SOCIAL-VALUE ORGANIZATIONS
would support the school for five years, after which time the
school’s agricultural operations would provide the income
needed to sustain the school.
Martin transformed the school into a number of
business units, from a creamery and dairy operation to
livestock businesses, including pigs, chickens, and goats.
The students sold products in local markets and the
school opened its own retail store on the main highway
from the Chaco to the capital city of Asuncion. With an
investment of $50,000, Martin and his group remodeled
[ 277 ]
the missionaries’ retreat building into a rural hotel. The
hotel attracts local businesses looking for a quiet meeting
space, international visitors to the school, and others who
choose to stay at the hotel where their room rates support
the school. This new, business-oriented school became
cash flow positive at the end of 2007, right on schedule.
The agricultural businesses fund the school and students
leave prepared with a set of entrepreneurial skills to
improve their own lives and the communities in which they
live.
ì
This chapter discusses how strategy applies to social-value organizations. You’ll see that
the tools of strategy, from industry and environmental analysis to the methods firms use to
effectively implement strategy, can help social value organizations understand their operating environment. Models like the five forces and the 7 S model can help a diverse set of
organizations formulate and implement effective strategies even when an economic competitive advantage is not the main goal of the organization. The second section of the chapter introduces you to the emerging field of social entrepreneurship. Social entrepreneurs
have a passion and clear mission to create social value and often combine the logic of business, sustainable profit making, and efficient operations with that passion to create new and
innovative approaches to benefiting society.
STRATEGY AND SOCIAL-VALUE ORGANIZATIONS
Martin Burt represents a new type of individual working to fight poverty in Paraguay and
around the world: the social entrepreneur. Social entrepreneurs use free market principles and create for-profit businesses with the goal of creating shared value, and economic
value for the business and social value for the larger community in which the business operates.4 Economic value focuses on the creation of income, wealth, and other economic outcomes for individuals and organizations. Social value, by contrast, concerns improvements
in the noneconomic elements of individual’s lives and community well-being. Social value
includes minimizing negative conditions such as blight, oppression, pollution, and violence,
as well as enabling positive outcomes such as education and literacy, mental and physical
health, political voice and inclusion, and recreation and opportunities for self-expression.5
The notion of shared value means that organizations, and the communities in which they
operate, can gain both types of value: improvements in both economic and social welfare.
Profit and social welfare are not substitutes that managers have to trade off, but complements that reinforce each other. Business firms must bring in more revenue than they spend
in costs; otherwise, they won’t survive.
Creating economic value is critical for the business of business is to make a profit. Smart
managers realize, however, that creating social value may be a way to bring in more revenue
or spend less on costs. Creating social value may increase revenue through increased customer loyalty, brand equity, and willingness to pay, or it may reduce costs through things like
efficient supply chains and engaged, productive employees. Social value may be a source of
strategic advantage.
Martin Burt and other social entrepreneurs use the tools of strategy to help them make a
difference in the world. Indeed, a deeper look at Fundacion Paraguaya reveals an organization that intimately understands its markets, environment, and customer needs. The organization operates with a clear set of values and principles that underlie a unique set of valuable
and difficult-to-imitate resources and capabilities to fight poverty. Even though Fundacion
Paraguaya doesn’t focus on creating a sustainable competitive advantage to benefit financial
investors, the organization uses all the tools of strategy you’ve learned about in this book.
social entrepreneur An individual
or organization that uses free
market principles and creates forprofit businesses with the goal of
creating value.
shared value The simultaneous
creation of economic value (for the
business) and social value (for the
larger community).
economic value The creation
of income, wealth, and other
economic outcomes for individuals
and organizations.
social value Improvements in
the noneconomic elements of
individual’s lives and community
well-being.
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While social entrepreneurs like Martin attempt to blend for-profit business principles
and a social mission, many other organizations focus exclusively on creating social value.
For example, the Bill & Melinda Gates Foundation “focuses on improving people’s health
and giving them the chance to lift themselves out of hunger and extreme poverty.”6 The
Gates Foundation works to give away money, not to earn it. Other social value organizations include the not-for profit health-care sector: hospitals, nursing homes, hospice care,
or other community-based health agencies. Social value organizations would also include
public and private universities and colleges, secondary schools, faith-based organizations,
many arts and community development organizations, and museums. A recent study found
that over 1 in 10 U.S. workers are employed in the not-for-profit sector, and that this sector
of the economy continues to grow.7 As the social-value sector of the economy continues to
develop, and as more for-profit organizations become concerned with the creation of social
value, it makes sense to ask about the role of strategy in this sector.
THE TOOLS OF STRATEGY AND THE CREATION OF SOCIAL
VALUE
sustainable stakeholder
advantage The ability of an
organization to consistently gather
resources from, or provide services
to, key stakeholders such as
donors, volunteers, students, or
clients.
You might think that a private university, a not-for-profit hospital, or a corporate foundation represents an organization so radically different from a business like Google, General
Electric, or Disney that the tools that help these companies create competitive advantages
just don’t apply. In one sense, you’re right: social value organizations don’t try to create
unique and sustainable economic advantages. Social value organizations work to create
sustainable stakeholder advantages. That is, they hope to create organizations that consistently garner resources from or provide services to key stakeholders (e.g., donors, volunteers, students, or clients) that allow them to fulfill their social mission over time.8
Sometimes, these sustainable advantages result in a unique and different organization
with inimitable resources, but other times this means becoming part of a sustainable and successful ecosystem, or group of related organizations targeting the same set of clients or social
problems. Let’s consider how some of the tools we’ve discussed in previous chapters, and
a new one, can help social value organizations create sustainable institutional advantages.
External Analysis and the Value Net
value net A model of value creation
that describes how an organization
interacts with others in its
environment to create value. The
value net consists of four elements:
customers, suppliers, competitors,
and complementors.
Consider, for a moment, your university. It competes, for example, in the market for students against other universities, public and private, but also against small liberal arts
colleges, community colleges, vocational schools, and the option of not going to school.
Understanding the five forces that drive industry structure can help university leaders create and maintain a sustainable stakeholder advantage. The categories in the five forces
model can help university leaders plan and implement an effective strategy to “win” in the
market for higher education as they interact with suppliers, such as high schools, customers
like parents and recruiters, the substitutes of community colleges and vocational training
programs, and potential entrants such as for-profit universities or online-only universities.
In the five forces model, we usually think of stakeholders playing a single role in their
interactions with the organization. Think for a moment about alumni, a group you hope to
join, and how they interact with a university. Alumni supply donations and their children
become potential students and potential tuition payments. They are also important customers when they attend events like football games or symphony concerts. Or think about
other universities. They may be competitors on the athletic field or in the hunt for donations,
but if you look closely, you’ll see that your university often partners with its rivals to create
synergies in areas like library collections, coordinated course offerings, or joint research projects between faculty members. How can university leaders effectively think through these
nuanced and complex relationships as they formulate and refine strategy?
Strategy scholars Adam Brandenburger and Barry Nalebuff created the value net
model to help strategic managers think through these complex relationships.9 Interestingly, Brandenburger works at Harvard and Nalebuff at Yale; they highlight the role of these
THE TOOLS OF STRATEGY AND THE CREATION OF SOCIAL VALUE
[ 279 ]
[ Figure 14.1 ] The Value Net
CUSTOMER
COMPETITOR
ORGANIZATION
COMPLEMENTOR
SUPPLIER
universities as both competitors and complementors. Figure 14.1 displays the value net, and
each of the four corners is described next.
Each stakeholder plays one, or more, of four roles in the value net. Customers purchase,
or receive, the outputs of the organization. Suppliers provide important inputs for the
organization. A player is a competitor if customers value the organization’s output less
when the competitive product is available. A cross-town university with a strong business
school acts as a competitor because recruiters may perceive that it provides a better education and those recruiters devalue your degree. Conversely, that university plays the role of
complementor when customers (such as recruiters) value an organization’s output more
when that product is available. That rival university may have a summer program in international studies that you participate in to make your business degree more valuable.
The value net helps social-value-focused organizations, for two reasons. First, most of the
stakeholders they interact with play multiple roles, and second, treating a stakeholder as a
“single-role player” can lead to poor decision making. Harvard and Yale compete vigorously
for the best students and government grants, but they also complement each other through
joint research and teaching collaborations, and by working together to strengthen the Ivy
League athletic conference. If Harvard treats Yale as a pure competitor, it will forgo a number of opportunities to leverage Yale’s skill through collaboration. For example, researchers
from both universities may team up to be more effective in receiving research grants from
the National Science Foundation or National Institute of Health.10
Internal Analysis: Resources and Capabilities
Cutting-edge health-care organizations view the health-care process in terms of factory production and have learned to look at their core “manufacturing” work to improve efficiency
and effectiveness. Hospitals across the nation, and even the world, have begun adopting
manufacturing techniques such as lean manufacturing or Six Sigma quality programs to
improve patient care.11 Using the value chain to understand how, when, and where social
value gets created has helped hospitals create sustainable stakeholder advantages.
customers Individuals or groups
that purchase, or receive, the
outputs of the organization.
suppliers Individuals, groups,
or organizations that provide
important inputs for the
organization.
competitor An individual or
organization that makes customers
value the organization’s output less
because it offers its own product or
service.
complementor An individual or
organization that makes customers
value the organization’s output
more because of its product or
service.
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S T R AT E GY I N P R A CT I C E
Detroit Mercy Law School—Creating Unique
Value for Students
O
f the 202 accredited law schools in the United States,
Detroit’s Mercy College of Law ranked somewhere
close to the bottom of the list. In fact, U.S. News & World
Report ranked the school 184th a few years ago and law
school admission websites offer similar rankings.13 What
would entice a student to apply to Mercy over Harvard,
Stanford, Yale, Duke, or Michigan? Part of the answer lies in
Mercy’s unusual access to top law firms as first jobs for its
graduates. The school, one of six law schools in the state,
boasts that the managing partners of one-third of Detroit’s
largest law firms hail from Detroit Mercy College of Law,
more than double its expected contribution.14
Mercy’s success owes to former dean Mark Gordon and
his innovative program to attract the biggest law firms to
recruit at Mercy.15 Gordon, a graduate of Harvard Law and
alum of a major New York law firm and the U.S. Department
of Housing and Urban Development became dean in 2002.
He jumped at the chance to become dean at such a small,
obscure school because “it’s the schools that are not as well
known that are open to change.”
He spent the next several years building a unique
curriculum designed to help Mercy graduates prepare for
and understand the actual work lawyers did every day, as
opposed to the theory-heavy curriculum found at top law
schools. Gordon recruited attorneys at the country’s most
prominent firms, such as the legendary corporate law
firm Skappen Alps, to help design and teach this unique
curriculum. Students received a solid, practice-oriented
education and, most importantly, they got face time with key
players at the nation’s premiere law practices. That face time
often ended in internship—and eventually job—offers for
talented Mercy students. Mercy targets students who might
not be able to attend a top-tier law school and creates real
value for them by providing a very practical legal education.
A recent survey ranked Mercy in the Top 25 Law Schools in
the Midwestern Region.16
Successful social value organizations build from a strong platform of clear values
and priorities to develop a set of resources and capabilities that result in value creating
activities. Utah-based Intermountain Health Care, for example, looks to its core values of
accountability, excellence, and mutual respect to build a nationally recognized competence in evidence-based medicine that has led to dramatic improvements in patient care
and health outcomes.12
Cost Leadership, Differentiation, and Innovative Strategies
It’s hard to imagine Harvard or Yale competing as a low-cost provider, but all private universities face immense pressure to compete on price, at least within their peer group. Many
dedicate significant fundraising energy and parts of their endowment to lower student
costs through scholarships and other aid. Some private universities like Stanford University in engineering and design, or Babson College in business entrepreneurship, choose to
compete by continually innovating and updating their curriculum. Many private colleges
and universities attract students through differentiating to create some type of unique
value. The 302 faith-based colleges in the United States represent one differentiation strategy: building a curriculum based on a unique set of moral values. The first Strategy in Practice feature describes a private college that seeks to create unique value for its students.
Corporate Strategy and Alliances
Fundacion Paraguaya’s agreement to purchase and run the San Francisco Agricultural School
represented a form of corporate diversification as the organization entered a new product
market. The school allowed the organization to exploit its skill in providing programs and
STRATEGY AND SOCIAL CHANGE
[ 281 ]
interventions to help individuals, in this case youth, escape poverty. The school significantly
expanded Fundacion Paraguaya’s resources and capabilities; indeed, the organization had to
learn how to administer a traditional educational curriculum and incorporate a new set of concepts and skills to help students become entrepreneurs. Both Fundacion Paraguaya and the
SFAS use alliances to increase their impact. Fundacion Paraguaya joined forces in 2007 with
Vision Spring.17 Vision Spring provides low-cost eye exams and sells reading glasses to people in
the developing world. Its innovative sales model uses local entrepreneurs to perform exams and
distribute glasses. The Vision Spring “optical shop in a backpack” concept allowed Fundacion
Paraguaya to supplement its micro-credit activities and bring better vision to rural Paraguayans.
Implementation and Governance
Perhaps the greatest difference between an economic-value and social-value focused organization comes in the area of governance. As we’ve explained throughout this book, the shareholders of the firm represent either the primary or an important beneficiary of the final
outputs of economic value organizations. The focus on shareholder value provides managers with a clear decision rule to guide their actions.18 Social-value organizations, however,
do not answer to shareholders but instead answer to multiple powerful stakeholder groups.
Universities must answer to students and families for the quality of the curriculum, faculty
members for the caliber of research support, donors for the efficient and effective use of
resources, and boards of trustees or local governments for their role in the larger community.
Because of the outsized role of stakeholders, governance issues play an important role
in the strategic management of social value organizations. Organizational leaders and community members take special care to create a board that provides the organization with
expert advice, legitimacy among multiple community stakeholders, and an active sensitivity
to the needs and concerns of those groups.19 Alignment between the organization and its
multiple stakeholder audiences proves to be a constant challenge for social-value organizations. Models like the McKinsey 7 S framework can help strategic managers create and
maintain effective alignment, just as they can for business firms. Similarly, the models of
change we introduced in Chapter 12 apply to the challenges these organizations face when
contemplating the need for strategic change.
In this section, we’ve considered how the tools of strategy can help managers and leaders of
organizations whose primary purpose is the creation of social value. We have offered a simplistic view of the organizational world as having a group whose purpose is the creation of social
value and another group, businesses, working to create economic value. That simplistic picture
might have been true many decades ago, but the changing and increasingly complex real world
in which we live means that all organizations must focus some energy on creating economic
and social value. In the next section, we’ll introduce you to two ways that business firms work
to create social value: corporate social responsibility (CSR) and social entrepreneurship.
STRATEGY AND SOCIAL CHANGE
Economic-value creating organizations and businesses face increasing pressure to prove
that their activities benefit more than merely their shareholders or direct stakeholders.20
Increasingly, members of the larger society want to know that businesses create social,
not merely economic, value. Business leaders have taken two approaches to meet these
demands: they have incorporated demands for corporate social responsibility (CSR) into
their existing operations or they have tried new and innovative solutions to help solve society’s most intractable problems. In this section, we’ll focus on CSR; in the next section, we’ll
look at a group of new and innovative models known collectively as social entrepreneurship.
Corporate Social Responsibility (CSR)
The term corporate social responsibility refers to activities that companies engage in that are
designed to further some social objective and that lie beyond the direct economic interests of
corporate social responsibility
Activities of companies designed to
further some social objective and
that lie beyond the direct economic
interests of the organization.
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[ Figure 14.2 ] A Firm’s Social Obligations
Philanthropic
Responsibilities
Ethical
Responsibilities
Legal Responsibilities
Economic Responsibilities
economic responsibility A firm’s
obligation to generate economic
profits.
legal responsibility A firm’s
obligation to obey the written and
codified laws of the countries in
which it operates.
ethical responsibility A firm’s
obligation to abide by the unwritten
ethical standards, norms, and
values of the communities in which
it operates.
philanthropic responsibility A
firm’s obligation to contribute to the
enhancement of the communities
in which it operates.
philanthropy Gifts that promote
the good or well-being of others.
cash donation A monetary gift as
one organization transfers money
to a recipient group.
in-kind donation Philanthropy
accomplished as one organization
transfers product, employee time,
or other services to a recipient
group.
the firm.21 CSR is closely connected to the logic of the stakeholder model of corporate governance we discussed in Chapter 13. Firms have several obligations they must meet in order to
survive, which can be arranged in a pyramid to highlight their interdependence.22 Figure 14.2
shows this pyramid and the four fundamental social responsibilities of business. First among
these is a firm’s economic responsibility. Unless the firm produces profitable products and
becomes a sustainable and ongoing contributor in society, all its other responsibilities fade
away. To survive, a firm must meet its economic obligations, but to thrive and grow, the firm
must meet both its legal and ethical obligations. Legal responsibility means that managers
and all those who make up the firm obey the written and codified laws of the countries in
which they operate. The obligation of ethical responsibility binds managers and others to
obey the unwritten but powerful ethical standards, norms, and values that underlie social life.
The fourth obligation of the firm only appears as an obligation if we view the firm as an
active member and contributing citizen of the communities in which it operates. Philanthropic responsibility implies that a firm has an obligation to give back in some way and
contribute to strengthening the fabric of its local communities, as well as the larger society.
The ways a firm meets its first three obligations are clear and straightforward: businesses
make profits, obey the law, and conform to ethical standards. A firm can fill its philanthropic
responsibilities in many ways, and managers enjoy substantial discretion about how to fulfill
those obligations.
Philanthropy means to act in a way that promotes the good or well-being of others in
the form of a gift.23 Firms engage in traditional philanthropy when they make donations of
money, employee time, or products or services to local community organizations. If you
attend symphony concerts, operas, or other art and cultural events, you’ll often see a list
of corporate sponsors. Some of these contributions are direct cash donations; others are
not. When a business allows its employees to work for a day with pay for a local United Way
agency, for example, it’s also making a philanthropic donation, but it’s an in-kind donation
of services. After Hurricane Katrina hit New Orleans and the Gulf Coast, Walmart donated
1,500 truckloads of relief supplies to affected residents—another type of in-kind donation.24
CSR and Firm Performance
Stakeholders want to know about a firm’s commitments to the larger society in which it
operates, and they want more than just feel-good stories about a few of the firm’s activities.
The Global Reporting Initiative (GRI) provides firms and stakeholders with an objective way
to assess a firm’s social performance. The GRI was founded in Boston in 1997 by a group
of business activists concerned about how businesses performed in relation to the natural
environment.25 The first version of the GRI guidelines appeared in 2000.
SOCIAL ENTREPRENEURSHIP
[ 283 ]
The GRI has developed a set of reporting guidelines firms use to produce an annual
report, much like the 10K filing that U.S. firms provide for their shareholders. The GRI standards cover many areas of a firm’s performance, including economic impacts for shareholders, stakeholders, and communities.
The GRI guidelines also cover a firm’s environmental performance along dimensions
including energy use, biodiversity protection, and levels of emissions and waste. The
social category of the GRI report holds firms accountable for their labor practices, compliance with human rights standards and goals, contributions to local communities, and
the production of safe and responsible products. More than 95 percent of the world’s
largest companies regularly create and publish sustainability reports based on the GRI
guidelines.26
CSR activities work for the benefit of society and its many stakeholder groups without
the goal of creating profits for the firm, but a lively debate centers on the question of
whether firms do well when they do good.27 Do firms profit from their CSR activities?28
What does the evidence say? In one very comprehensive review of over 100 research studies, the evidence comes out decidedly mixed.29 In just over half the studies, CSR seemed to
improve financial performance, but in just under half, CSR either had no effect or seemed
to decrease earnings.
Recent research suggests that CSR activities help preserve a company’s resource-base
when things go wrong. These researchers believe that the positive reputation for creating
social value through CSR acts like an insurance policy that protects the underlying economic
value of the firm when accidents or other negative events occur.30 Although the research
question is new, several academic studies suggest that CSR might have an insurance-like
effect that preserves shareholder value.31
CSR, when done thoughtfully, creates value for the societies in which firms operate.
Sometimes, however, the traditional tools of CSR, such as philanthropy, involvement in particular social issues, or direct stakeholder initiatives prove ill-suited to attack some of society’s most vexing and intractable problems, such as the fight against global poverty. In these
instances, companies or individuals often create innovative and entrepreneurial approaches
to these problems and fall under the rubric of social entrepreneurship.
SOCIAL ENTREPRENEURSHIP
Martin Burt, founder of the micro-credit organization Fundacion Paraguaya, can be
described as a social entrepreneur. Social entrepreneurship uses innovative organizations and business models to create social value.32 Social value is created in two ways: first,
by reducing social harms, and second by increasing the level of social benefits. Fundacion
Paraguaya enhances social value in both ways as each student who graduates from the San
Francisco School has the skills to eliminate poverty in her own life, and she takes her skills
and training to other communities to build better farms and help develop and improve the
Paraguayan economy.
Social entrepreneurs may or may not use business models and market principles to
solve social problems. The activity is entrepreneurial in the sense that social entrepreneurs look for and implement new and innovative approaches in their organizations.
Social entrepreneurs may come from any field, including the government, faith-based
organizations, large corporations, and even traditional entrepreneurial ventures. The
challenges of using new and innovative models mean that many of these organizations
must use market principles and business logic in order to survive. Finding philanthropic
donors or government grant makers willing to bet on untried models often proves to
be a very difficult task. For example, Martin realized that in order to meet the school’s
goals, it had to become a financially self-sustaining business. Similarly, Vision Spring
incorporates a direct selling model into its objective of eliminating vision problems
among the poor.
social entrepreneurship The use
of innovative organizations and
business models to create social
value.
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Types of Social Entrepreneurship
institutional change When
entrepreneurs strive to change the
way people and groups think about
problems and they work to create
or change social institutions—from
government policies to social
values and norms.
capacity building The transfer
of skills and abilities from one
organization to another.
Whether they employ market principles or rely on traditional philanthropy, social entrepreneurs create value in one of three ways: they attempt to build capacity, they sell products or
services, or they drive institutional change.33 Capacity building entails transferring the
ability to effectively perform tasks from one organization to another. Fundacion Paraguaya
builds capacity in its students through the transfer of knowledge and skill through the San
Francisco experience.
Most social entrepreneurial ventures that build capacity rely on education and training as
a key element of their business model. The next Strategy in Practice feature highlights a grassroots organization working to build community capacity through local entrepreneurship.
Products and services are usually custom-designed or tailor made for the market niche
the entrepreneurs hope to influence. Social entrepreneurs have to solve problems of logistics and distribution, but also packaging, pricing, and marketing. Learning how to design,
price, and deliver goods and services often necessitates new business models. Hindustan
Lever, the Indian subsidiary of Unilever, implemented a business model that brought its
products to women in rural communities while providing income opportunities for its local
salespeople, women from the local communities where products would be sold.36 Our Strategy in Practice feature highlights a socially entrepreneurial organization working to bring
change through new products and services.
The final type of social entrepreneurship is institutional change, which means that
entrepreneurs strive to change the way people and groups think about problems, and they
work to create or change social institutions—from government policies to social values
and norms. Institutional change agents typically focus on large-scale social problems that
have proven difficult for governments or other social actors to solve. Ohio-based Cardinal
Health Foundation, for example, provides funding for a number of social entrepreneurs
fighting the scourge of prescription drug abuse. Cardinal does not build capacity, nor does
it sell a product or service, but rather, it works to create change within the health-care sector as a whole.
S T R AT E GY I N P R A CT I C E
Community Enterprise Solutions
G
reg Van Kirk spent the early days of his career as a rising
star in the investment banking world.34 After reading a
biography of Muhammad Yunus, Van Kirk decided to change
careers. “I had just turned 30 and knew I wanted to work in
economic development, but I knew nothing about the field.
I joined the Peace Corps to gain grassroots experience.”35
Van Kirk worked in Guatemala among individuals and
communities trapped in a cycle of poverty and despair. At
the end of his Peace Corps stint, Van Kirk joined with George
“Buckey” Glickley to form Community Enterprise Solutions,
or CES.
Their first product was a concrete wood stove that local
residents could use to replace cooking over an open fire.
When used indoors, open-fire cooking creates a number
of health risks for adults and children. The stove would
help individuals, families, and communities reduce the
harms of open-fire cooking and provide a much healthier
environment. CES wanted to hire local entrepreneurs to take
the stove into outlying communities and sell them. The price
of the stove meant that most entrepreneurs could not afford
to purchase stoves and hold them in inventory prior to sales.
CES developed a pioneering new model, microconsignment, to solve this problem. CES consigns, or
lends, the stove to the entrepreneur, who then repays CES
for each unit sold, but only for each unit sold. The microconsignment model fueled the sales of stoves because it
solved the cash flow problem for entrepreneurs and shifted
the inventory risk to CES. The micro-consignment model
worked well enough that CES now offers its partners a
number of different products on consignment and the
organization is now exporting the model to other Latin
American countries.
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S T R AT E GY I N P R A CT I C E
Kinder, Lydenberg, and Domini, and the Creation of
Socially Responsible Investing37
S
ocial investors choose which stocks, bonds, or funds to
purchase based largely on the social performance of
a particular company. Social investing became popular in
the 1970s as more people began to see that the values they
supported in principle often disagreed with the way they
allocated their investment dollars. In 1971, the first socially
responsible mutual fund, the PAX World Fund, began trading.
The fund was founded by two Methodist ministers who
answered a parishioner’s call for mutual funds that excluded
weapons makers. Would it be possible to induce investors to
purchase on positive social criteria, such as a company like
Ben and Jerry’s that was committed to local development?
That question motivated Amy Domini and her colleagues
to develop an innovative financial product: a mutual fund
composed of companies engaged in positive social behaviors,
not merely those that avoided certain activities.
When Amy Domini began her career as a stockbroker
at the Boston firm of Anthony-Tucker in 1975, the options
for socially responsible investing were very limited. Domini
found that many of her clients wanted their investment
portfolio to reflect their values, but had little way to do so.
She recalls:
I found myself being questioned by clients saying,
“Why would you show me this? My father died of lung
cancer,” or “Why would you show me that? I would
never consider that.” I was feeling that it would be a
good self-defensive move to ask people first if there
was something they would not want to invest in. Lo
and behold, virtually everybody had something. So I
realized that I had to learn more about this. But when
I started looking around, there was very little on the
subject.38
Domini began researching the topic of social investing
and published a book on the subject in 1986. Her publisher
happened to be working on another book by a former
playwright turned corporate social activist, Steve Lydenberg.
The two became friends and colleagues when Lydenberg
entered the investing world, working for Franklin Research,
one of the first companies to have its own social investing
group. Lydenberg and Domini faced skeptical and often
hostile colleagues and bosses who believed that anything
that screened out potential investments on social criteria
would sacrifice financial performance. Socially responsible
investing, they believed, would only come at the cost of a
lower financial return.
In 1989, Lyndenberg and Domini, working in concert
with Domini’s then-husband Peter Kinder, decided to
test that assumption. They developed the Domini 400
stock index, a group of companies that closely tracked
the S&P 500 but contained companies with a clear social
conscience. Looking backward, they discovered that the
Domini 400 actually outperformed the S&P 500 through
the 1980s. So they formed a firm to create and market a
socially responsible mutual fund to other investors. Today,
Domini Social Investments has over $1 billion under
management.39
As a part of creating the fund, Kinder and Lydenberg
did extensive research to rate companies on their social
performance. The rankings became a valuable investment
tool that the firm of Kinder, Lydenberg, and Domini sold
throughout the investment community. For many years,
the KLD database provided the most reliable and objective
ratings of the social performance of over 2,000 companies.
The firm’s data have been the source material for a
number of academic studies looking at corporate social
performance in addition to providing valuable advice to
institutional and retail investors for over two decades. KLD
was acquired by Risk Metrics in 2009, and is now a part of
the MSCI group of companies.
Skills of Social Entrepreneurs
The different value creation strategies for social entrepreneurship each require a unique
set of organizational skills and leadership abilities. Figure 14.3 matches the three types of
social entrepreneurship with its corresponding leadership skill set.40 Organizations focused
on capacity building need a leader who is a social bricoleur, one who can successfully
bricolage, a French word that means creating something by combining diverse and different
elements, into a new setting. Martin Burt, for example, combined the traditional Paraguayan
social bricoleur A social
entrepreneur who creates
something new through the
combination of diverse and different
elements.
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CH14
ì STRATEGY AND SOCIETY
[ Figure 14.3 ] Types of Social Entrepreneurship
Focus on SE
Activities
Role of Social
Entrepreneur/Leader
Examples
Capacity
Building
Social Bricoleur:
Combines existing
resources to focus
value creation
Highlander Research and Education Center
(USA): adult education for community
problem solving in Appalachia
Social constructor:
Develops new models,
products, or services
Grameen Bank (Bangladesh, Worldwide):
developed unique model for delivery/
repayment of micro-credit
Products/
Services
BRAC (Bangladesh):organizes and trains
poor communities to create economic and
social development
Unilever(India): Project Shakti uses rural
women to sell hygiene products. Improves
local health and incomes
Institutional
Change
social constructionist A social
entrepreneur who builds something
that did not exist before.
social engineer A social
entrepreneur who designs and
creates new social systems to
create large-scale change.
Social engineers:
agitate for change,
design more effective
social systems
Bono(Ireland): becomes a voice for
worldwide poverty alleviation
Nelson Mandela (South Africa):
reconciliation commissions allow wounds
from apartheid to heal
curriculum with proven agricultural education techniques and supplemented these with
knowledge about how to train entrepreneurs from his Junior Achievement programs. He
then mixed these together in the unique physical setting of the school, its land, and stores
that provided him with important pieces of physical and social infrastructure.
Social entrepreneurship that focuses on bringing new, social-value products or services
to markets require the skills of a social constructionist. Constructionists build something
new and innovative that did not exist before. Nobel Laureate Mohammed Yunus founded
the Grameen Bank—the world’s first successful micro-credit organization—through such an
innovation. Yunus discovered that the poor Bangladeshi basket weavers he passed on the
way to work each day earned a fraction of the selling price of their goods because they had
to finance their raw materials through an intermediary. The intermediary captured most of
the value of the products and left the women in a state of perpetual poverty. Yunus’s social
construction was not merely the lending of very small amounts to these women, but rather,
in lending the money to groups of women who would assume responsibility for the loan and
ensure repayment. Women’s incomes increased through the Grameen loan program.41
Finally, social entrepreneurial organizations working to create larger, institutional changes
succeed when led by a social engineer. Engineers design and then create more effective
social systems to create large scale change. Phillip Joanus, an advertising executive, founded
the Partnership for a Drug-Free America in the early 1980s (now Drugfree.org) to combat
rampant drug abuse.42 His initial efforts didn’t bricolage a diverse set of resources to fight drug
abuse, nor did he develop a new or innovative product. He used the traditional tools of advertising to help individuals and communities fight the scourge of illegal drugs. What he really
did, however, was get people to view the problem in a new way. In other words, he changed
the most fundamental social institution of all: the collective mindset and attitude about the
type of problem drug abuse represented. Joanus helped his advertising industry colleagues—
and others in society—see drug abuse as a business and not just a social problem.
Challenges in Social Entrepreneurship
Social entrepreneurship seems to be gaining a foothold as an accepted way to combat many
social problems. High-profile social figures like Jeff Skoll, the first president of eBay and the
Skoll Foundation, encourage and reward social entrepreneurship.43 Established foundations
SOCIAL ENTREPRENEURSHIP
like the Schwab Foundation for Social Entrepreneurship also lend credibility to the growing movement through similar programs. Many colleges and universities now have centers,
institutes, and even majors devoted to advancing social entrepreneurship.
If you want to become involved in social entrepreneurship, there are a number of ways
to do so. There is likely to be an organization on your campus that has social entrepreneurship as a charter. Or, if you conduct a quick Google search on “social entrepreneurship”
or “organizations with a social agenda,” you should be able to identify a number of varied
opportunities for social entrepreneurship. In spite of all the momentum, however, serious
challenges remain that may limit the potential of social entrepreneurship to create the largescale social change its advocates hope for.
First, social entrepreneurs often work in difficult, unstable, and harsh conditions, particularly those working at the base of the economic pyramid to help the world’s poor.44 The
base of the pyramid (BoP) describes those living in conditions of extreme poverty around
the world, usually defined as less than $2 per day. BoP environments usually feature harsh
climates including excessive heat, cold, humidity, or desert conditions. Entrepreneurs face
industries and markets with little physical infrastructure like roads and bridges, and also few
legal or regulatory institutions that we take for granted in the developed world. Courts may
not exist to resolve business disputes, business registration may take a very long time, and
the pervasive presence of corruption hinders progress in many cases. Sometimes entrepreneurs have to build their own infrastructure, physical or institutional, before their projects
can succeed. For example, the Safe Water Network works to build water-treatment facilities
in Africa in order to bring clean water to communities there.45
Second, social entrepreneurs who want to combine a for-profit model with a social
mission face the difficulty of managing a hybrid organization. For example, TOMS is a
for-profit shoe and eyewear retailer whose mission includes providing a pair of shoes to
a needy person for every pair of shoes sold and helping restore a person’s eyesight with
every pair of sunglasses purchased. You can see the TOMS model in action at http://www
.toms.com/toms-us-giving/l. A hybrid organization is one with more than a single goal,
and each goal has equal importance. Managers must make tough trade-offs between the
broad and ideal social mission and the realities of generating positive cash flow. Making
these trade-offs sometimes sacrifices one in the name of the other.46 For example, when Safe
Water began selling water in Africa, the organization had to raise the price of each packet
in order to cover its costs. That meant that some consumers would not be able to purchase
the product. Finding employees or alliance partners who share all of the organization’s goals,
and have the skills to contribute to both missions, often proves difficult. Most people have
little experience and expertise in working for, or leading, hybrid organizations.
Finally, social entrepreneurs face real ethical issues and challenges in their work. Nelson
Mandela was admired for his transformative work in South Africa; but keep in mind that
he spent years in prison for what were considered at the time to be seditious views. Social
engineers are often viewed as subversive in the existing society, sometimes with good reason. Social entrepreneurs also face the challenges of cultural imperialism when they bring
products or services into new markets, or try and transplant institutions that work well in
one culture to another one. Consider, for example, the challenge for local farmers trying to
sell their crops at a profit if a nonprofit organization is giving away free grain.
Many social entrepreneurs work tirelessly to bring their preferred solution to the poor,
even if the poor do not want or need what the entrepreneur offers. Entrepreneurs must also
be cautious about matching their promises with their capabilities. It does little good over
the long term to promise capacity building that never materializes, or to have people invest
in products or services that disappear shortly after they appear. Social entrepreneurs must
continually work to provide sustainable solutions to the problems they tackle.
In this section, we’ve introduced you to a new and exciting way of creating social value:
social entrepreneurship. There are a number of different ways that social entrepreneurs
work. Time will tell whether this movement will succeed where others have failed. What
we do know, however, is that many people, both young and old, are using the idea of social
entrepreneurship to create economic value and social change in areas, or around issues,
they care passionately about. A recent survey indicated that over 12 million Americans
hoped to include social entrepreneurship in their “second career” as they aged.47
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base of the pyramid
(BoP) Describes those living in
conditions of extreme poverty
around the world, usually defined
as less than $2 per day.
hybrid organization An
organization pursuing more than
a single goal; each goal has equal
importance.