Business Strategy Essentials
Based on Initial Text by: Clinical Full Professor Sonia Marciano (Errors and oversights
are mine). Many insights and content drawn from Kellogg on Strategy by Dranove and
Marciano
Edits and Insights by: Vinay Patel (NYU MBA/JD and McKinsey Consultant)
Graphic Designers: Emanuela Frattini Magnusson and Jesse Mann
Co-Author of Appendix on Global Strategy: Professor Withold Henisz of Wharton
Additional Edits by: Donna Costa (TRIIUM 2013), Christine Cioffe, Cristina Fineza, Rajnarind Kaur and
Annie Thomas (NYU EMBA students)
Noted Throughout: Several students from Columbia, Kellogg, Stern, Wharton and Yale as well as several
executive students from various organizations have made helpful comments and contributions. Names are
noted where appropriate below.
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Table of Contents
BASIC SET UP:.......................................................................................................................... 3
CHAPTER 1: WHAT IS STRATEGY?............................................................................................. 5
Strategy vs. Tactics (Execution)........................................................................................... 5
APPLICATION ............................................................................................................................ 8
CHAPTER 2: VALUE CREATION ................................................................................................ 10
Value Creation ................................................................................................................... 11
Willingness to Pay ............................................................................................................. 16
Value Capture .................................................................................................................... 19
Added Value ...................................................................................................................... 20
Value Chain ....................................................................................................................... 29
CHAPTER 3: INDUSTRY ANALYSIS ............................................................................................ 37
Industry Attractiveness Perspective: Porter’s Five Forces Framework .............................. 38
Disruptive Technologies..................................................................................................... 48
Template for Analysis ........................................................................................................ 51
Resisting Commoditization................................................................................................. 54
CHAPTER 4: MARKET STRUCTURE........................................................................................... 60
CHAPTER 5: POSITIONING ....................................................................................................... 71
Segmentation .................................................................................................................... 71
Operating Beyond the Productivity Frontier........................................................................ 77
CHAPTER 6: RESOURCE-BASED VIEW ..................................................................................... 79
Wealth-creating, sustainable competitive Advantage ......................................................... 80
Resource-Based View vs. Positional View of the Firm ....................................................... 90
CHAPTER 7: COMPONENTS OF ENTERPRISE VALUE................................................................... 92
Employed Resource Value in Detail ................................................................................... 96
CHAPTER 8: PREEMPTION AND SUSTAINABILITY ..................................................................... 112
Investments in Capital Intensive Assets ........................................................................... 112
Securing Superior Scarce Resources .............................................................................. 113
CHAPTER 9: FIRM BOUNDARIES ............................................................................................ 126
Growth Through Acquisition ............................................................................................. 130
Strategic Interdependence ............................................................................................... 140
Integration Challenges ..................................................................................................... 142
Successful Acquirers ....................................................................................................... 144
CHAPTER 10: EXTERNALITIES AND CSR ................................................................................ 151
Remedial CSR ................................................................................................................. 152
APPENDIX 1: FINANCIAL METRICS.......................................................................................... 166
Performance Management .............................................................................................. 168
APPENDIX 2: GLOBAL STRATEGY FRAMEWORKS .................................................................... 170
APPENDIX 3: ENCAPSULATION OF CORE CONCEPTS ................................................................ 214
Strategy ........................................................................................................................... 214
Value ............................................................................................................................... 215
Industry Analysis.............................................................................................................. 218
Positioning ....................................................................................................................... 220
Preemption and Sustainability.......................................................................................... 221
Resource-Based View ..................................................................................................... 222
Shifting Perspectives: Components of Firm Value .......................................................... 224
REFERENCE LIST .................................................................................................................. 227
GLOSSARY ........................................................................................................................... 229
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Basic Set Up:
The question that is central to this text is: what are the key drivers or underlying causes
of the value of an enterprise? The value of the firm is, approximately, the sum of the
expected (or anticipated) annual revenues of the firm minus the annual operating costs
and investments in the firm’s productive capacity over a number of years long enough to
be called “the foreseeable future” (say, 20 years) plus some “terminal” or residual value
of the assets. Consider that fewer than 20% of firms in an advanced economy are solidly
economically profitable—that is, fewer than 20% of firms sustain the following for several
years: [Accounting Profit – Opportunity Cost of Capital] > 0. This residual (amount greater
than zero) is what we call an “economic” profit. An accounting profit is revenue minus
actual operating and investment costs, while economic profit is net amount over
opportunity cost of capital. In order to be able to be able to compare the profitability of
two firms to each other, we will often refer to a measure of profitability called the return
on invested capital, ROIC. ROIC is the firm’s net operating profit after taxes divided by
the book value of invested capital—it is expressed as a percentage. An ROIC of 20% for
year X means that the firm has earned an after tax income in year X that is equal to 20%
of the book value of its investments (investments we presume were made to enable the
earning of income). The opportunity cost of the invested capital is called the “weighted
average cost of capital” or WACC. WACC is the percentage return that equals what
investors collectively are demanding on investments that subject capital to various levels
of risk. For riskier investments, say, an investment in an original play on Broadway,
investors would demand a higher WACC than they would for less risky investments, such
as musical revival on Broadway. Economic profits exist when ROIC-WACC>0 and we
conjecture that fewer than 20% of firms meet this criterion in a given year and fewer still
sustain this level of performance for more than 7 years.
Courses in strategy generally focus on the 15-20% or so of firms that are high performers.
For concreteness, imagine a chain of apparel stores that is geographically concentrated
around US Midwestern states. Let’s say this chain earns an ROIC of 30%, and faces an
opportunity cost of capital of 9%—this suggests economic profits of roughly 21%. This is
impressive performance, and it is very impressive performance if it has been going on for,
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say, 15 years. It is very likely that some of this firm’s success is due to factors that could
not have been anticipated ex ante, or at “time zero” (when the chain was an idea in the
minds of its founders). Serendipity may have resulted in this firm enjoying a cult following
or signing long-term leases when real estate values were at an all-time low. But if most
of the reasons that this firm’s revenues are so much greater than its costs are due to a
set of factors we can organize using strategic frameworks, then it would make for an
excellent case to be covered in a strategy course. An MBA course on strategy will entail
the study of a range of cases:
-
Firms that have sustained high performance for many years
-
Firms that began strong but did not sustain high returns and
-
Firms that are low performers in an industry where some of their peers do well
Though analysis of this range of cases, you will develop an understanding of the
market and context conditions and firm level choices that are associated with good
financial performance. Whether you are investing your own human or financial capital
in a firm or advising investments in a firm, understanding the firm’s potential for
sustaining good performance is an essential life skill.
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Chapter 1: What Is Strategy?
Imagine a firm that produces an output (say chemical X) for which demand is much higher
than supply. As long as there is high demand for chemical X relative to supply – firms do
not have to behave very “strategically” to do well. That is, when demand is higher than
supply, firms do not have to compete with or outperform each other in order to sell their
output at prices that cover all of their costs. But when supply exceeds demand, firms
compete for customers. A firm who is able to attract more customers than its competitors
or make some segment of customers much happier than other firms do – this firm can
enjoy higher sales, higher margins or some combination of both. Strategy is a plan to
distinguish the firm from its competitors through sustainable product and/or process
(production) advantage.
An advantaged firm wins more customers or a subset of
“happier” customer; it may also attract better employees and cheaper capital – winning
with customers reinforces winning in the market for financial and human capital and leads
to more winning. In a market where supply is higher than demand, firms that outperform
are able to distinguish their output from their competitors’ outputs or they are able to
produce comparable outputs at lower costs. While not a monopoly in the traditional way
this term is used, outperforming firms are referred to in this text as “monopolists” – their
product or process is defensibly different than the output or process of their competitors.
Hence, strategy is a plan to develop a defensible “monopoly” over a market or
market segment that is big enough for the firm to spread or absorb the investment
it has made to enter and serve that market. We put “monopoly” in quotes to
indicate that this firm is not necessarily dominant in terms of market share or brand
equity overall, but is able to serve a subset of the market better than its competitors
can for the foreseeable future. The firm might be better in serving this segment
through a defensibly better product and/or process for production.
Strategy vs. Tactics (Execution)
As observed by Sun Tzu, “Strategy without tactics is the slowest route to victory. Tactics
without strategy is the noise before defeat.”
Tactics are what a firm uses in order to ensure that the strategy happens as the firm
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intended. Tactics refer, by and large, to execution. Alan Emrich1 notes that “many authors
resort to military examples when explaining the strategy vs. tactics paradigm:
Tactics vary with circumstances and, especially, technology. If I were to teach
you how to be a soldier during the American Revolution, you would learn how to
form and maneuver in lines, perform the 27 steps in loading and firing a musket,
and how to ride and tend to a horse. Naturally, yesterday’s tactics won’t win
today’s wars – but yesterday’s strategies still win today’s wars…and will win them
tomorrow and into the future.
Seth Godin,2 a popular author and speaker, uses a skiing analogy to crystallize the
concepts:
Carving your turns better is a tactic [while skiing]. Choosing the right ski area in the
first place is a strategy. Everyone skis better in Utah, it turns out.
The right strategy makes any tactic work better. The right strategy puts less
pressure on executing your tactics perfectly.
Economists and organizational scholars have defined strategy in numerous ways. In their
words, business strategy is:
•
The pursuit of economic rents [Edward Bowman]
•
Leverage of key activities to achieve competitive advantage [Michael Porter]
•
Choosing a different set of activities to deliver a unique mix of value [Hamel
and Prahalad]
•
Use of valuable, rare, non-substitutable, and inimitable resources and
capabilities to create sustainable advantage
These definitions share at least two tenets associated with financially successful firms:
•
They win on product attributes and/or production efficiency that their competitors
cannot profitably match
•
1
2
They win because their choices are excellent responses to market conditions.
See www.alanemrich.com/PGD/PGD_Strategy.htm
http://sethgodin.typepad.com/seths_blog/2007/01/the_difference_.html
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Market conditions are answers to questions such as the following:
-
What is the unmet need in the market and how much would the firm be paid to
meet that need?
-
What are the close and more distant alternatives to meet this need?
-
Whose contribution (the firm’s or its suppliers’) would matter most to the
customer? and
-
What activities should the firm own and control to satisfy the unmet need of a
segment of customers?
Once the firm has developed a strategy, the firm can develop its plan for execution (or its
tactics). Tactics fall into a set of categories, such as how the firm will:
-
Be organized and how people will be managed
-
Get its output to market, create awareness, and what the revenue model will be
-
Produce its output—what technology, location or inputs
-
Fund itself and what its capital and governance structure will be
Strategy and tactics together determine whether a firm can transform inputs that cost X
into outputs that earn more than X. This fundamental value transformation is the core of
all wealth-creation. Firms’ make their plans under various degrees of uncertainty and so,
for lack of a better word, luck, plays a role in the financial success of a firm.
The major concepts and themes that inform judicious business strategy decisions are
illustrated in Figure 1.
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Figure 1 - Key Topics of Business Strategy
Chapter 1
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Application
Throughout this text, the home security industry will be examined through SAFE, a home
security firm supplier.3 Considering questions around SAFE (see below) will help highlight
the utility of the tools, techniques, and frameworks presented here.
SAFE enters the Home Security Industry
According to 1995 Consumer’s Reports©, shoppers for home security systems based their
purchase decision upon several variables, including the firm’s reputation, its security
force, ancillary services and price. Home security firms tended to focus their selling efforts
regionally, while maintaining their own individual security force.
To that end, an enterprising group of former police officers created SAFE. Instead of each
security firm employing its own independent team of personnel, they could contract with
SAFE to provide surveillance, both alarm monitoring and response, for their customers.
SAFE offers equal or better quality of surveillance relative to the best in-house security
force, and can also cover wider geographic areas. Finally, contracting with SAFE is
significantly less expensive because of lower payroll expenses and commitment to setting
price caps on its services.
Questions:
§
Does SAFE make the firms in the home security industry better or worse off? And
how?
§
How should the typical firm in the industry respond to the entry of SAFE?
§
How would the response of the typical firm differ from the potential response of the
industry leader?
§
Could the entry of a firm like SAFE have been anticipated? If so, how?
3
SAFE represents the type of home-security firm where the home is wired to a security firm that deploys
a guard to the home when the alarm is triggered.
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Chapter 2: Value Creation
As discussed in the Introduction, the crux of business strategy is the creation of value by
an enterprise, the capture of some portion of that value by the enterprise in the form of
economic profits, and the sustainability of these profits over time. If a firm is able to sustain
economic profits (profits that are in excess of all of costs, including the opportunity cost
of the capital and resources utilized), we say that the firm is competitively advantaged
and benefiting from a strategy that is protecting the firm’s returns from contracting towards
zero economic profit. Threats to financial returns exist in the firm’s external environment,
where environment is made up of the “industry” (competitors) and also the industry “ecosystem” (suppliers, buyers, potential entrants, and substitutes (less direct competitors)
and society at large (laws and regulatory regime, taste, state of technology, availability of
capital and the state of global trade). Firm earnings are also affected by internal threats
stemming from inefficiencies in the firm’s own execution and operations.
This text is about learning how to develop a hypothesis about a firm’s likelihood of
sustaining its economic profits within a business over time. For example, how well will
McDonald’s do in the quick service restaurant space in the US for a foreseeable time
period (over the next 2-3 years)? Complementing sustainability analysis, we will evaluate
issues of corporate scope – is the firm able to create more value, capture and/or sustain
higher economic profits if it operates in more markets or in new businesses?
For
example, how well will McDonald’s perform in the quick service restaurant business in
Europe or in Asia over the next few years? Alternatively, or additionally, how well could
McDonald’s leverage its quick service restaurant business to enter the hotel business or
the consulting business?
Although the SAFE case does not ask us to explicitly describe how value is created in the
home security industry, thinking about value creation is a productive way to warm up and
begin a strategic analysis. The firm takes inputs that are worth some amount, say $X, and
converts those resources into products that consumers value, in monetary terms, as
being greater than $X. Hence firms create “value surplus,” which is the source of all of
the world’s financial prosperity. But to be precise, firms cannot create this prosperity
without the help of customers – indeed customers are the ones who perceive the value
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of the firm’s output to be greater than the cost of producing that output (including the cost
of inputs). To understand how some firms are able to retain a greater share of their selfcreated value surplus than other firms, we will dissect the process of value creation.
Value Creation
Businesses exist to create value. Value is created when the buyer’s willingness to pay
(WTP) is greater than the firm’s cost of bringing the output to the buyer (C), as shown in
In sum: WTP-P is the consumer’s net increase in happiness relative to not spending
their money. Consumers aim for the biggest net increase in happiness and so spend time
comparing their options. Firm want profits which equals (P-C) * Volume. Hence firms
work to attract customers by creating a gap between WTP-P. In this way, transactions
create a “win-win” – consumers are happier with the stuff they buy from firms relative to
just keeping their money and firms are glad to exchange the stuff they make in exchange
for money. This “win-win” is what Adam Smith referred to as the “invisible hand” – firms
and customers benefitting each other not through altruism but through their
interdependent self-interests.
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Figure 2. There is more about WTP below, but in sum WTP is the buyer’s perception of
the utility (measured in monetary terms) that the firm’s output delivers to the buyer. Think
of WTP as how high or strong the consumer’s “want” for the product is, measured
monetarily, or “how far to the right” the consumer’s demand curve is, or how “happy” or
satisfied the consumer is (measured in currency). While C can be measured definitively,
WTP is never known definitively but we do know it's a real thing. That is, we know that
consumers make purchases for goods that make them happier, on net, than they were
before they traded their money for the product. That is, consumers are generally not
indifferent between having the good and keeping their money – they feel (generally) better
off after they trade their money for the product. The difference between WTP and C is
known as the wedge—total value created. The goal of firm strategy is to convert a portion
of this wedge into economic profits and to sustain those profits over time.
Market interactions, based on a firm’s bargaining position (perception its output is unique)
and the dynamics in the market in which it operates (supply vs. demand), lead to a market
price (P). Markets fall along a continuum from contested to uncontested. Contested
markets are characterized by high supply relative to demand and the perception that the
outputs of different firms are similar. In uncontested markets, those with more demand
relative to supply and/or the perception that outputs are dissimilar, firms can attempt to
capture value through pricing. Use the diagram below to make the following few
sentences clear. Consumers review their product choices (i.e., which jacket should I
buy?). For each option, the consumer senses his/her WTP and compares this WTP to
the product price. For some options, the consumer may sense a relatively low WTP-P
(the consumer may find the jacket unappealing relative to its price) – the consumer would
rule out this option. Consumers chose the option for which their WTP-P is highest (as
long as the P is within their budget constraint—meaning as long as they can afford the
option). To make a sale to a customer, the firm has to offer a higher WTP-P relative to
its competitors at a P within the consumer’s budget. If the firm develops a way to increase
WTP (firm makes the jacket in a nicer fabric or in more appealing colors) the question is,
what happened to the firm’s cost? If WTP goes up more than C went up, then the firm is
creating more value relative to before it made the change. The firm should determine
what would be more profitable overall:
-
Increasing price to keep WTP-P the same as it was before but now have a higher
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margin (P-C).
-
Leaving P as it was before the change so that WTP-P increases for many
consumers and so the firm’s volume would increase.
-
Doing some combination of the above
In sum: WTP-P is the consumer’s net increase in happiness relative to not spending
their money. Consumers aim for the biggest net increase in happiness and so spend
time comparing their options. Firm want profits which equals (P-C) * Volume. Hence
firms work to attract customers by creating a gap between WTP-P. In this way,
transactions create a “win-win” – consumers are happier with the stuff they buy from
firms relative to just keeping their money and firms are glad to exchange the stuff they
make in exchange for money. This “win-win” is what Adam Smith referred to as the
“invisible hand” – firms and customers benefitting each other not through altruism but
through their interdependent self-interests.
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Figure 2 - Value Creation
Firms find innovative ways to combine inputs from suppliers to satisfy the needs and
wants of buyers. In general, value creation is where the cost of inputs is lower than the
price paid by buyers.
Note Bene: If a firm creates value in an easily imitable way, the firm may quickly face
substantial competition. In this case, very little of the wedge accrues to the firm as
economic profits over time.
Application to SAFE
The following three scenarios depict value creation by the home security industry.
Scenario 1
Figure 3 below is a depiction of value creation before the entry of SAFE.
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Figure 3 - Scenario 1
Organizational Slack: This refers to the costs caused by weaknesses in organizational and
managerial effectiveness…people not always doing the “right thing” because they don’t have
the right information and/or incentives.
Operational choices: This refers to operational design – how activities get done.
Technology choices: What is the underlying technology.
Optimality of firm boundaries: Firm boundaries refer to what activities are undertaken
within the firm vs. what activities does the firm purchase from the market. Firms boundaries
refer to the question of how big is the firm, where size has many different potential
dimensions – in which geographic markets, activities along the vertical chain, product
markets, etc. might the firm operate?
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Scenario 2
Figure 4 below shows the short-run effect of SAFE on the typical home security firm’s
value creation. The operational aspects of how SAFE increases industry efficiency are
easy to see. Ex-ante (before the fact), a group of security guards confined to working for
a single security firm likely spent a high fraction of their time underutilized. Certainly expost (after the fact), if one security force was shared by multiple firms, most likely the size
of the force would not need to scale up proportionally to the number of firms served. This
is the key as to why the unit cost of providing security would fall after the advent of
SAFE.
Figure 4 - Scenario 2
While profits of home security firms
will still vary across markets based
on cost differences and differences
in penetration rates, SAFE, with its
operations in many markets, will
offer firms an opportunity to
outsource an activity that represents
a high share of cost. SAFE offers
efficiency and quality to all firms
who contract with it. Profits of
SAFE’s clients will likely increase in
the short run.
We conjecture that a security firm might stop operating its own security force and instead
outsource to SAFE – this is a change in firm boundaries as the firm is replacing an activity it
used to perform in house with a service it will buy from an outside firm (SAFE). We conjecture
that the “unit cost” of security would decline as a big fixed cost is now shared among a few
security firms who are clients of SAFE.
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Scenario 3
Finally, value creation in the case of a typical home security firm in the long run is shown
in Figure 5. WTP may increase due to the investment by SAFE in the absolutely best
force they could assemble, particularly since they could keep this force better utilized and
spread the cost efficiently.
Figure 5 - Scenario 3
Willingness to Pay
A buyer’s WTP measures in monetary terms the subjective value (the utility) of goods or
services. In general, WTP and P are separable; the extent that buyers value goods or
derive utility from those goods ought to be evaluated separately from the price they pay.
In other words, avoid the intuition that price affects or causes WTP. You are correct that
price affects the amount of the product sold – this is the law of demand! But the way price
affects units sold is due to WTP. A consumer expects a certain about of utility, happiness,
or satisfaction from, say, a cookie. The consumer determines their willingness to pay and
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subtracts the price from their WTP estimation and learns their “surplus” (WTP-P) from the
purchase and consumption of the cookie. If that surplus is higher than what the consumer
expects from their alternative choices, they buy the cookie. If the price was lower, WTPP would be higher and this is why the consumer would be more likely to make the cookie
purchase. Price does not, generally, cause WTP. However, there are times when price
is used as a source of information to determine how good a product is perceived to be.
For example, if you were buying a meal during your first visit to a city, you might believe
a cheaper restaurant has worse food than a more expensive restaurant. Although WTP
and price are conceptually separate, in some cases, a consumer may reason that P is an
indicator of quality. Price may sometimes be used as signal of unobservable attributes in
products or services. In cases such as these, P can influence demand by altering the
consumer’s perception that the product has highly desirable features or functions.
Additionally, WTP and P are inter-dependent for certain luxury goods, where part of the
perceived value is exclusivity, a function of price. Hence there are times when price both
determines surplus (WPT-P) and could influence initial WTP – but think of these
situations as the exception and the general rule is that WTP and price are
independent. Consumers don’t go around buying the things with the lowest or highest
prices, but aim to buy the things that yield them the highest surpluses. Consumers make
plenty of purchases with substantial amounts of information, whether from their own
experiences or from loads of customer reviews.
While we cannot directly observe WTP (as we can prices and firm costs), we know that if
a customer buys product A and A and B were priced the same, the customer had higher
WTP for A. So what is WTP? Brandenburger and Stuart (1996) on buyers’ WTP:
Imagine that the buyer is first simply given this quantity of product free
of charge. The buyer must find this situation preferable – typically, in
fact, strictly preferable – to the original status quo. Now start taking
money away from the buyer. If only a little money is taken away, the
buyer will still gauge the new situation (product minus a little money) as
better than the original status quo. But as more and more money is taken
away, there will come a point at which the buyer gauges the new
situation as equivalent to the original status quo. (Beyond this amount
of money, the buyer will gauge the new situation as worse.) The amount
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of money at which equivalence arises is the buyer’s willingness-to-pay
for the quantity of product in question.
The WTP of an industrial buyer for a piece of capital equipment may come down to the
savings in the buyer’s operating costs that installation of the new equipment would afford.
Assessing the WTP of consumers for household products is often harder than for
products/services that have quantifiable benefits to the user.4
Firms ultimately want to maintain a gap between P and C over a share of the market,
maximizing profits in the process. Profits are defined as V*(P−C) or (Volume)*(Margin). A
firm’s approach to earning profits will vary with market conditions, but will generally fall
into one of two broad categories: Value Capture and Added Value. In weakly contested
or uncontested markets, firms have some pricing power (generally reflected in their
margins, (P-C)). High margins are a form of value capture—that is, the firm is able to
capture a portion of what would have been consumer surplus (WTP-P) if the firm faced
competition (WTP-P is lower as firm raises P). For example, imagine there is a hotel with
direct ocean access in a market in which all the other hotels are across the road. The
hotel with superior access to the water is likely able to sustain a margin advantage over
firms whose location is inferior. By contrast, in highly contested markets, firms cannot
sustain higher margins—in these markets, consumers enjoy relatively more surplus
(meaning WTP-P is relatively higher). To visualize a contested market, consider a row of
bars, souvenir shops, or restaurants in a touristy area in which no one establishment is
apparently better than the next. When a firm faces close competitors, it is possible that
the firm can increase the gap between WTP and P by improving some product/service
attributes. For example, one bar might brew its own remarkably delicious beer or a shop
might have a relationship with hotels and offer to deliver your purchases to your room.
By creating additional value (raising WTP) without reducing producer surplus (P-C), the
firm is employing an added value approach. Increasing WTP relative to the level of C is
a way to add value, as is, reducing C relative to WTP. In other words, a firm can add
4
For numerical examples of the WTP concept, see Creating Competitive Advantage, by Pankaj
Ghemawat and Jan W. Rivkin, page 8.
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value to the WTP – C wedge by increasing efficiency—where efficiency means the firm
reduces C by eliminating costs that did not drive WTP enough to be justifiable costs. It
might also be possible for a firm to reduce C through negotiations which take advantage
of a suppliers’ lack of outside options – this reduces supplier surplus (value capture). But
this improvement in C might or might not be sustainable – it depends on the
circumstances.
Table 2.1 - Pricing to Capture Value
Value Capture
A firm can adjust price to capture more value when the price elasticity is low and the firm
enjoys either a product or cost advantage. Table 2.1 shows the relationship between price
elasticity and the nature of the firm’s advantage. Another view of value capture is shown
in Figure 6. Note that the total amount of value created remains fixed – by raising price,
the firm is capturing a higher share of the value created.
A firm with cost advantages in industries with high price elasticity should price below its
competition and enjoy considerable share gains. Consider Dell’s steep growth in the past.
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Low cost manufacturing processes in the home PC market combined with WTP parity5
allowed Dell to under-price competition and dominate the market, producing considerable
profits for a number of years.
Firms with product advantages in industries with low price elasticity should charge
premium prices, which will cause only modest share loss. High quality product design in
the market for MP3 players allowed Apple to price above competition without suffering
share loss, producing considerable profits.
Figure 6 - Value Capture
Added Value
In markets where buyers perceive that firms produce fairly homogenous goods, firms
5
Consumers perceived their WTP for Dell to be approximately the same as for other branded PCs. One
could argue that customization options increased Dell’s WTP, or perhaps that its initially weaker brand
diminished WTP and it caught up, but all things considered, WTP parity is a fair stance.
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have little room to sustain value capture above costs.6 Should one of these firms
disappear, suppliers and buyers would simply switch to competitors with little perceived
loss or pain. In these markets, firms cannot simply adjust their prices irrespective of the
prices of other firms. The value of an enterprise is best measured by the extent to which
suppliers and/or buyers would miss that enterprise if it were absent – the more missed
the enterprise is, the greater its added value is. The larger the wedge the firm can capture
as profits and the longer it can sustain those profits, the greater the market value of the
firm. As indicated above, profit capture and sustainability depend on whether the firm’s
process for creating added value is proprietary.
Only by adding value to increase the gap between WTP and C in an inimitable way can
firms expect to sustain value capture. Added value represents the upper boundary on
how much value a firm can capture. Typically, firms can take one of two approaches to
add value: cut C with only marginal losses to WTP, or increase WTP with relatively
small increases in C (see
Figure 7).
Firms in under-served markets should incur higher costs and add features, while firms in
over-served markets should cut costs by removing features.
But added value MUST BE DEFENDABLE to lead to SUSTAINABLE FINANCIAL
ADVANTAGE. That is, the firm who first perceives that a market is under or over served
and innovates (makes an investment in assets and capabilities to meet the unmet
demand) does so in pursuit of profits. This move may affect the market shares of other
firms (who lose customers in absolute or relative terms). These firms then learn what the
firm has done and must choose whether to imitate or not. If competitors are WORSE
OFF if they imitate (because the cost of imitating is higher than the expected financial
gain) then the firm who innovated was strategic. If competitors are better off financially
by imitating – then the firm who innovated provoked rivalry (meaning the firm provoked
6
While firms can earn returns above cost in the absence of added value, we do not expect this to be a
long-run equilibrium. We expect entry and/or rivalry among undifferentiated sellers to drive returns down
to “normal” or cost inclusive of opportunity costs.
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competition and the industry will be, on net, worse off). Firms need to consider whether
their actions will, on net, result in distancing them from their rivals or provoking a feature
or price war among rivals. The key question is under what circumstances can a firm do
the following:
-
Drive up WTP - C
-
And put their competitors in a situation in which they are better off financially by
NOT imitating
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Figure 7 - Value Added / Firm View
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We call increasing WTP relative to C in a way that cannot be profitably copied by other
firms, differentiation. Successful differentiators add features that cost less than the
perceived value to the buyer. For example, Starbucks recognized the coffee shop market
was under-served at the time it entered, i.e., consumers craved more variety and more of
a coffee house experience.
In “over-served” markets, where firms sell products with unused or unnecessary features,
entrepreneurial firms can add value by eliminating features and lowering costs – we often
refer to this sort of innovation as “disruption.”
Airbnb serves customers willing to do
without the standard features of hotels (check in desk, house-keeping, etc) Airbnb is a
potential disruptor of some segments of the hotel business. We may decide that Airbnb
is more than a disruption – that relative to some hotels, its service is both CHEAPER and
BETTER. Making something better AND cheaper is more unusual – in this case some
incumbents (existing firms) are made obsolete.
The term innovation encompasses differentiation, disruption, and causing obsolescence.
The goal of innovation is to grow a firm’s own profits or take profits from other firms –
through innovation, customers win (getting more options) and some firms win – but not
necessarily all firms on net. For example, it is possible that Airbnb becomes a very
valuable firm but that its value is less than the amount of value lost by incumbent hotels.
Adding Value by Raising WTP (Note: WTP-C gap must increase on net)
To increase WTP, the perceived benefits of the firm’s output must be improved. Benefits
can be derived from tangible attributes, such as improved sound quality, flavor, or speed.
Benefits can also be derived from intangible attributes, such as improved image or
prestige. The Apple retail store, for example, offers benefits through an improved
shopping experience. These feature improvements directly make the product better.
Firms can also improve WTP by making the product less costly to use, i.e., WTP
increases because the “net user cost” falls. For example, by selling the product through
more channels or by changing the packaging to increase convenience (single serving vs.
bulk) the consumer incurs less costs in acquiring and/or consuming the good.
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Increases in WTP create the opportunity to increase some combination of price and
market share – that is, increase price (P), quantity (Q) or both. Methods to enhance WTP
are shown in Figure 8.
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Figure 8 - Adding Value by Raising WTP
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Adding Value by Lowering C (Note: Again, WTP-C must grow on net)
To lower C, firms must reduce the costs of critical inputs or gain efficiency in production.
Adding value by lowering C means that C falls by more than the change in WTP. In fact,
if a firm discovers it is over-serving its customer (providing too many product features
relative to the customer’s need), the firm should reduce features, which would drop WTP
only a little since the features were not valued, and costs would fall proportionately more.
Consider a hotel chain that has locations as convenient as the most premium hotels, but
which has much smaller rooms and fewer services (no concierge or room service and
limited housekeeping services).
Input cost reductions can be accomplished by reducing the relative attractiveness of an
input’s outside options,7 enabling a firm to negotiate lower C with the supplier. The inputs
the firm uses to produce output normally have outside options. For example, wheat input
could be sold to other firms or labor input (employees) could work at other firms. To
reduce the perceived value of outside options of physical inputs, a firm might absorb
transport costs (in the case of wheat inputs) or provide attractive benefits (in the case of
labor inputs, say health insurance). These strategies require the firm to face a lower cost
structure than its suppliers, in the above examples as a result of economies of scale for
transport, or by pooling risk, for example, for insurance benefits. Other strategies may
require structural adjustment, such as offering flexible work schedules to employees who
are willing to sacrifice some costly benefit. Methods to lower C are shown below:
7
Outside option refers to the input’s next best alternative. If the input is, say, wheat, then the outside
option is the next most attractive selling opportunity for the owner of the wheat. If the input is labor, then
the outside option is that laborer’s next most attractive employment opportunity. In this section, we
continually compare the input’s current opportunity to its next best alternative or outside option.
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1. Drive cost reductions through product market activities. These activities might have
first-mover advantages, though they are generally easy to imitate.
Easy to Imitate
Increase scale or accumulate experience by buying share through lower prices
Introduce new products that utilize shared facilities
Enter new geographies to increase capacity utilization
2. Control cost drivers within the firm’s activities.
Easy to Imitate
Reallocate production within existing facilities
Reallocate facilities to regions with lower input costs
Substitute inputs (labor for capital or vice versa)
Enhance worker productivity with incentive systems
Outsource major cost centers
Eliminate work force redundancies
Difficult to Imitate
Improve material yields
Reduce product operation complexities (e.g., reduce SKUs)
Alter product design to improve manufacturability
Reduce inventories and improve asset management
Enhance worker productivity with organizational change
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Strategy is all about the firm being different and moving away from price competition.
Most firm strategies relate to the general approaches outlined above for reducing C and
increasing WTP.
Value Chain
The value chain depicts the execution of value creation and (hopefully) added value. Here
strategy meets operations, marketing, finance, and management. Benchmarking or
relative cost analysis is the practical alternative to the unobservable “productivity
frontier.”8 Operating inefficiently increases the likelihood that a firm suffers resource
constraints and under-invests (partially or completely) in its strategy.
A firm’s value chain, as shown in Figure 9, is the taxonomy of all the firm’s activities
undertaken to create value. Each box relates to a buyer’s WTP as well as to a firm’s C.
Competitive advantage is created by the discrete set of activities firms perform, both
primary and secondary. By analyzing a firm in this way, managers can identify ways to
widen the WTP−C gap.
8
Being on the “productivity frontier” means the firm is efficient—and efficient means it is not possible to
reduce costs without eliminating valued product/service attributes.
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Figure 9 - Value Chain/ Activity Analysis
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Activity Analysis
Activity analysis informs managers about the cost of its activities. There are several
possible goals of activity analysis. One goal is to benchmark the productivity of a firm
against its competitors. The firm can then explicitly consider how much WTP it produces
by undertaking its activities in a particular way. Another goal is to identify opportunities
for increased efficiency. A firm is operating efficiently if cutting costs further will result in
lower WTP—that is, there is no way to perform an activity for less money without
sacrificing some product attributes valued by consumers.
The goal of activity analysis is to understand the specific WTP−C implications of each box
in the value chain. Armed with this understanding, a firm can adjust activities to maximize
its overall WTP−C gap and seek or preserve added value.
Many management-consulting projects begin with or culminate in an activity cost analysis.
Ghemawat and Rivkin (2006) focus on the WTP−C gap, describing a four-step process
of activity analysis based on the value chain:
Step 1: Catalog Activities
Using the value chain as a guide, a firm’s activities are divided into primary and support
activities. Primary activities include inbound logistics, operations, outbound logistics,
marketing and sales, and after-sales service. Support activities include firm infrastructure,
human resource management, technology development, and input procurement.
Step 2: Understand C by Activity
Next, these activities must be analyzed, relative to competitors, in terms of C and WTP.
Competitive cost analysis requires understanding the cost drivers of each of a firm’s
activities – those factors that make the cost of an activity rise or fall. By linking cost drivers
numerically to activities, a firm can compare its actual activity costs to the estimated
activity costs of its competitors. Firms focus on cost drivers to better estimate the
unobservable costs of competitor activities.
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It is critical to focus on differences in individual activities instead of total cost, because
firms may face different internal cost structures even though total costs are comparable.
This analysis should emphasize an industry’s largest costs to ensure overall relevance.
These activities should be defined narrowly enough to highlight applicable differences,
especially for larger firms. In some cases, this requires looking at activity costs on an
individual product basis, although in other cases, activity costs of a product group are
sufficient.
Step 3: Understand WTP by Activity
Just as activities are associated with discrete C for various firms, activities are associated
with distinct contributions to WTP. Linking individual activities to WTP is more complex
than linking them to C, particularly with support activities. Firms must first understand who
the customers are and what they desire. They must also understand which competitors
enjoy relative success in satisfying different customer needs. As customers become
varied, this process requires effective segmentation and linking activities to WTP for a
variety of customer segments.
Differences in WTP usually account for more observed variation in profitability among
competitors than disparities in cost levels. While any activity in the value chain can affect
WTP, physical product attributes and image tend to have the strongest effects. However,
activities associated with reducing costs to purchase also generate considerable WTP,
such as speed of delivery, availability of credit, and quality of presale advice. Consider
how the purchase and delivery experience at a car dealership affects the buyer’s overall
initial ownership experience and WTP.
Step 4: Identify Activity Changes
Identifying activity changes is the final step of activity analysis. Change falls into two
classes: opportunities to raise WTP with relatively low increases in C, and activities that
generate considerable reductions in C with little change in WTP. Firms that fundamentally
understand competitors’ strategies can isolate critical activities that they themselves do
not fully exploit. Often, the full value chain activity analysis leads to unexpected activities
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where changes can increase the WTP−C wedge.
A firm participates in one or more industries through its products. Industries are related
through the inputs necessary for the product – each product serves as an input to a
subsequent industry. These relationships create a vertical chain of industries. Figure 10
provides a conceptual model of the relationships between a product’s value chain and an
industry vertical chain.
Each box of the vertical chain is an industry, and each industry has attributes that
constrain profit opportunities and attributes that, if exploited, yield high returns. Firms sit
in one or more industries along the vertical chain from raw materials to final goods.
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Figure 10 - Product Value Chain, Industries & the Vertical Chain
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Above we have discussed strategy and its relationship to the financial success of the firm.
So far, we have attempted to convey a sense for what enables some firms to earn higher
returns than their competitors. Overall, we are interested in what explains the value of an
enterprise. As explained above, the value of the firm is, approximately, the sum of the
expected (or anticipated) annual revenues of the firm minus the annual operating costs
and investments in the firm’s productive capacity over a number of years long enough to
be called “the foreseeable future” (say, 20 years) plus some “terminal” or residual value
of the assets. Below is a table of the 10 most valuable publicly traded firms in the US as
of August 2017 and the change in the value of these firms from 2016—the values are in
BILLIONS of DOLLARS:
Rank on 8/1/17 12 Month Change
Apple
1
782.3
41.50%
Alphabet
2
655.9
18.20%
Microsoft
3
559.4
28.30%
Facebook
4
493.3
36.60%
Amazon.com
5
478.5
29.80%
Berkshire Hathaway
6
435.2
22.40%
Alibaba Group
7
391.5
83.50%
Johnson & Johnson
8
357
5.70%
Exxon Mobil
9
339.7
-6.60%
JPMorgan Chase
10
327.4
45.80%
Apple is worth approximately $780 billion in August of 2017…we want to understand,
qualitatively, what explains that value.
In order to lend structure to this qualitative
analysis, we will consider that this value can be broken down into components of value
as expressed in the picture below:
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Components of Enterprise Value
Financial
Structure
Operations
Marketing
Effectiveness
Organizational
and
Management
Quality
Industry
Attractiveness
“Positional” or
“Ownable”
Value
“Idiosyncratic”
or “Not
Ownable”
Value
Corporate
Scope
The value of Apple can be linked to the attractiveness of the industry in which it
competes, its position in the industry as defined by the particular “ownable” assets and
capabilities it has developed to compete, whether value is tied to “unownable” or
idiosyncratic inputs and to its corporate scope (breadth of geographic and product
markets in which it competes). These four components of value comprise what we will
call strategy—where and how the firm will compete. The next four components
comprise the firm’s execution or tactics: Organization and management, marketing,
operations, and finance.
We will go through each of these components in detail – starting with industry.
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Chapter 3: Industry Analysis
Now that we have a fundamental understanding of the components or slices of the firm’s
total value “pie,” we need to better understand how a firm’s environmental conditions
relate to its enterprise value. The firm’s environmental conditions determine the firm’s
competitive context—meaning what constraints a typical firm in an industry faces in
developing and/or defending its added value. There are several frameworks an analyst
can use to evaluate the attractiveness of an industry. Porter’s Five Forces is among the
most frequently cited frameworks. The Five Forces – supplier power, buyer power,
barriers to entry, threat of substitutability, and degree of rivalry – is a framework to
understand the opportunities and constraints in the competitive context of an industry.
As noted in Michael Porter’s Competitive Strategy (1998, pp. 3−5):
•
The essence of formulating competitive strategy is relating a firm to its
environment . . . the key aspect of the firm’s environment is the industry
or industries in which it competes.
•
Competition in an industry continually works to drive down the rate of
return on invested capital toward the . . . return that would be earned by
the economist’s “perfectly competitive” industry.
•
The goal of competitive strategy for a business unit in an industry is to
find a position in the industry where the firm can best defend itself
against these competitive forces or can influence them in its favor.
•
The Five Forces are concerned with identifying the key structural
features of industries that determine the strength of the competitive
forces and hence industry profitability.
Understanding this competitive situation is crucial for firms. A good industry analysis will
contain both an industry attractiveness perspective that outlines the features of an
industry that increase the likelihood that the industry will face opportunities or constraints
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as well as an examination of the outcome of intense rivalry that is analogous to the
“commoditization” of an industry. How does each of the four constituents (buyers,
suppliers, substitutes, and entrants) drive commoditization (the situation where
customers perceive that firms’ outputs are nearly indistinguishable) into the industry?
Industry Attractiveness Perspective: Porter’s Five Forces Framework
The Five Forces framework provides a systematic way to catalogue the competitive
situation a firm will face in its industry, as shown in Figure 11.
Figure 11 - Porter's Five Forces
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When a Five Forces analysis is completed for any industry, two questions should be kept
in mind:
1. Does the underlying structure of this industry indicate that competitive forces
will be strong or weak? Bottom line, is the industry attractive or unattractive?
2. If the competitive forces in the industry are strong, is there some strategy that
a firm may employ to influence the forces in its own favor?
Ultimately, the attractiveness of an industry has to do with the extent to which price is the
single determinant of choice or whether price is among a few key criteria that determine
from whom the customer buys. Rivalry can be defined as outright competition among
firms – firms compete in price or they compete by adding features (e.g., free delivery)
without raising price enough to cover additional costs. The diagram above visually
demonstrates the relationship among the Five Forces. Buyer power, supplier power,
threat of substitutes, and threat of entry can influence whether price is a central part of
the customer’s decision regarding from whom to buy. If these forces create a situation
where firms are continually making price and non-price moves (which reduce the profit
contribution of each sale), then the resulting outcome is rivalry. Further, even without
buyer/supplier power or threat of substitutes/entry, behavior among firms could lead to
competition and reduced industry profitability; this should always be kept in mind. In
addition, the Five Forces turn US antitrust law on its head – antitrust authorities take the
customer’s perspective in favoring competition – what is bad for firms is often good for
customers.
Defining the Industry/Market
It is critical to carefully define the market or industry in question.
Industry: An industry is comprised of a set of close competitors, a group of firms that
customers and suppliers see as reasonably close alternatives to each other. In reality,
industry definition is more of an art than a science. The quality of the Five Forces analysis
depends on proper framing of the industry; if the definition is too broad (for example,
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“beverages”) or too narrow (such as “colas”), the analysis will tend to yield few useful
insights. Each box along a vertical chain represents an industry. If the industry definition
is correct and the Five Forces analysis is done well, the combination will produce valuable
information. It is often valuable to perform industry analysis based on a variety of industry
definitions.
Market: There are two common ways to define markets: in terms of products and in terms
of geography. If products are interchangeable (i.e., customers are willing to use the firms’
products for the same purpose), firms are considered competitors. Therefore, product
similarity is the most common way that a market is defined. Geography also matters since
firms located far from each other might not sell to the same set of customers. The
importance of geography varies widely by industry. Some goods and services are difficult
to transact beyond a certain radius due to perishability, high shipping costs, or that the
good must be consumed on premise because it has an experience dimension. To choose
an example in a B-to-B setting, cans are produced by can manufacturers and sold to
makers of consumer packaged goods (such as soft drinks). Cans are very expensive to
ship, so can makers sell to can users who are located within a relatively small radius of
the plants in which the cans are made.
Rivals
In the traditional economic model, competition among rival firms drives profits to zero. But
competition is not perfect and firms are not unsophisticated passive price takers. Rather,
firms strive for a competitive advantage over their rivals. The intensity of rivalry among
firms varies across industries and strategic analysts are interested in these differences.
There are many sources of rivalry within an industry – firms may:
•
Face numerous competitors
•
Face equally-balanced competitors
•
Exist in a slow growth industry
•
Have high fixed costs or storage costs
•
Lack differentiation
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•
Augment capacity in large increments
•
Face high exit barriers
•
Easily adjust prices
•
Have easily observable prices and terms
In pursuing an advantage over its rivals, a firm can choose from several competitive
moves:
•
Changing prices: raising or lowering prices to gain a temporary advantage.
•
Improving product differentiation: improving features, implementing innovations
in the manufacturing process or in the product itself.
•
Creatively using channels of distribution: using vertical integration or using a
distribution channel that is novel to the industry.
•
Exploiting relationships with suppliers: setting high quality standards and
requiring suppliers to meet demands for product specifications and price.
Rivalry is behavior that, ultimately, leads to lower industry profits. If firms add easy to
imitate product features – then the addition of features is rivalrous. If firms advertise in a
way that prompts rivals to advertise, then the advertising is a form of rivalry. Imitable
product choices are a form of rivalry; imitable marketing moves, and imitable price
reductions are also forms of rivalry. Look at it this way: If firm A makes a move that its
rivals CAN imitate AND firm A’s rivals LOSE LESS if they DO imitate, than firm A’s initial
move instigated rivalry. Responding to rivalry may be necessary – but instigating rivalry
is ill-advised. Be sure it is clear to you what the difference is between rivalry and true
differentiation.
Buyers
Under some conditions, buyers may be able to capture a larger share of the surplus,
leaving little for the firms. When conditions tempt firms to compete on price, the buyers
receive the surplus. The conditions below all result from a context in which buyers are
motivated to invest in information about what they are buying. This information often has
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the effect of reducing negotiations to a pure price dimension. The price conditions that
lead buyers to behave this way are discussed in the section on commoditization.
Buyer power is caused by a number of factors:
•
Buyers purchase large volumes of firm output
•
Firm output represents a significant fraction of buyers’ costs
•
Buyer industry is more concentrated than firm industry
•
Buyers purchase a standard or undifferentiated product from firms
•
Buyers face few switching costs between firms
•
Buyers pose a credible threat of backward integration
•
Firm output is unimportant to the quality of buyers’ product
•
Buyers have full information
The following table outlines some factors that determine buyer power.
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Table 3.1 - Buyer Power
Buyers are Powerful if:
Example
Buyers are concentrated - there are a few
The government purchases from defense
buyers with significant market share
contractors
Buyers purchase a significant proportion of Circuit City’s and Sears’ large retail
output - distribution of purchases; or the
markets provide power over appliance
product is standardized
manufacturers
Buyers possess a credible backward
Large auto manufacturers' purchases of
integration threat - can threaten to buy
tires
producing firm or rival
Buyers are Weak if:
Example
Producers threaten forward integration -
Movie-producing firms have integrated
producer can take over own
forward to acquire theaters
distribution/retailing
Significant buyer switching costs -
IBM's 360 system strategy in the 1960's
products not standardized and buyer
cannot easily switch to another product
Buyers are fragmented (many, different) –
Most consumer products
no buyer has any particular influence on
product or price
Producers supply critical portions of
Intel's relationship with PC manufacturers
buyers' input - distribution of purchases
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Suppliers
A producing industry requires raw materials – labor, components, and other supplies.
This requirement leads to buyer-supplier relationships between the industry and the firms
that provide it the raw materials used to create products. Suppliers, if powerful, can exert
an influence on the producing industry, such as selling raw materials at a high price to
capture some of the industry's profits. Therefore, supplier power emerges in industries
where firms are fungible intermediaries for suppliers whose scarce or differentiated inputs
ultimately satisfy end-user needs. If suppliers have power, they can force buyers to accept
price increases (or quality reductions) that the buyers are not able to recover in their own
prices. Labor is often a very powerful supplier because it can legally form unions to
collectively bargain for prices.
Supplier power is caused by a number of factors:
•
Firm’s industry is an unimportant customer of supplier’s industry
•
Supplier industry is more concentrated than firm industry
•
Few substitute products available to the firm’s industry
•
Firms face switching costs between suppliers
•
Suppliers pose a credible threat of forward integration
•
Supplier’s product is an important input to the firm’s business
•
Firms have little information on suppliers
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The following tables outline some factors that determine supplier power.
Table 3.2 - Supplier Power
Suppliers are Powerful if:
Example
Credible forward integration threat by
Baxter International, manufacturer of
suppliers
hospital supplies, acquired American
Hospital Supply, a distributor
Suppliers concentrated
Drug industry's relationship to hospitals
Significant cost to switch suppliers
Microsoft's relationship with PC
manufacturers
Customers are powerful
Boycott of grocery stores selling non-union
picked grapes
Suppliers are Weak if:
Example
Many competitive suppliers; product is
Tire industry relationship to automobile
standardized
manufacturers
Purchasers purchase commodity products
Grocery store brand label products
Credible backward integration threat by
Timber producers relationship to paper
purchasers
companies
Concentrated purchasers
Garment industry relationship to major
department stores
Customers are weak
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Travel agents' relationship to airlines
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Barriers to Entry / Threat of Entry
When firms generate healthy profits, it is expected that new firms will attempt to join the
market. If entry occurs, capacity and output increase which puts downward pressure on
prices. Furthermore, entry can put upward pressure on input prices. The risk of entry is
determined by the relationship between the overall size of the market and the scale of
operation necessary to achieve cost parity, as well as by the entrant’s access to
potentially scarce but necessary resources. If the entrant has to be relatively large to
operate at an efficient scale, entry is daunting due to factors such as capital requirements
and the need to capture a large percent of market share to amortize the cost of entering.
Firms may be protected from competitive threats when barriers to entry hinder potential
entrants from gaining traction in the industry.
Barriers to entry that limit new entrants include:
•
Economies of scale
•
Product differentiation
•
Capital requirements
•
Access to distribution channels
•
Government policy and regulations
•
Proprietary product technology
•
Favorable access to raw materials or locations
•
Considerable learning/experience curve
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An industry's entry and exit barriers can be summarized as follows:
Table 3.3 - Entry and Exit Barriers
Easy to Enter if there is:
Difficult to Enter if there is:
Common technology
Patented or proprietary know-how
Little brand franchise
Difficulty in brand switching
Access to distribution channels
Restricted distribution channels
Low scale threshold
High scale threshold
Easy to Exit if there are:
Difficult to Exit if there are:
Salable assets
Specialized assets
Low exit costs
High exit costs
Independent businesses
Interrelated businesses
Substitutes
Substitute products are those that can perform the same (or some of the same)
functions for consumers as the industry’s product. All firms in an industry are, in a broad
sense, competing with substitute products. In Porter's model, substitute products refer to
products in other industries. To the economist, a threat of substitutes exists when a
product's demand is affected by the price change of a substitute product. Substitute
products affect a product’s price elasticity – as more substitutes become available, the
demand becomes more elastic since customers have more alternatives. A close
substitute product constrains the ability of firms in an industry to raise prices. The
competition engendered by a threat of substitutes comes from products outside the
industry. The price of aluminum beverage cans is constrained by the price of glass bottles,
steel cans, and plastic containers. These containers are substitutes, yet they are not rivals
in the aluminum can industry. While the threat of substitutes typically impacts an industry
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through price competition, there can be other concerns in assessing the threat of
substitutes. Consider the substitutability of different types of TV transmission: local station
transmission to home TV antennas via the airways versus transmission via cable,
satellite, and telephone lines. The new technologies available and the changing structure
of the entertainment media are contributing to competition among these substitute means
of connecting the home to entertainment. Except in remote areas, it is unlikely that cable
TV could compete with free TV without the greater diversity of entertainment that it affords
the customer.
Disruptive Technologies
Here, HBS Professor Clayton Christensen’s concept of disruptive technology is applicable
in exploring the threat to an industry from substitute products. A disruptive technology
is a technological innovation, product or service that uses a “disruptive,” rather than an
“evolutionary” or “sustaining” strategy, to overturn the existing dominant technologies or
status quo products in a market. The insight brought out by Porter’s analysis of substitutes
and Christensen’s analysis of competition among technology products is that technically
superior products can be at risk of losing sales to technically inferior products when the
buyer deems the inferior product to be sufficient for its needs.
Christensen, in The Innovator’s Dilemma, writes:
When the performance of two or more competing products has improved
beyond what the market demands, customers can no longer base their
choice on which is the higher performing product. The basis of product
choice often evolves from functionality to reliability, then to convenience and
ultimately, to price (p. xxiii).
New products (disruptive products) targeted at different segments (usually lower price
markets) become substitutes when consumer expectations grow more slowly than
increases in product quality. This occurs in over-served industries, as shown in Figure 12.
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Figure 12 - Christensen’s Concept of Disruptive Technology
In the above diagram, we consider a sustaining technology such as the mainframe
industry. We see that eventually the mainframe industry faces competitive pressure from
the substitute product (the disruptive technology), which in this case is the personal
computer industry. At time t=0, the performance of the PC is below the level of
performance consumers are demanding. At this point, the mainframe industry does not
perceive much of a threat from the PC because consumers of the mainframe are
unsatisfied by PCs.
In this scenario, both the mainframe and the PC improve over time (the assumption here
is that they improve at the same rate, but this assumption is not critical). In considering
substitutes, the critical assumption is that demand for performance increases at a lower
rate than the substitute product improves. Given this situation, there will be a time (t*)
when the substitute satiates the consumer. This is the point when the industry
(mainframes) feels strong pricing pressure from the substitute industry (PCs). Note that
at t* the mainframe is over serving its customers. The mainframe’s performance is so far
ahead of demand for performance that the customer likely has little WTP for it. At t* the
mainframe has trouble monetizing its research and development investments.
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Other Forces
Many consider two other important industry forces: complements and the government.
When a firm’s product is dependent on another industry’s product, that other industry is
considered a complementary industry. Complementary industries can have significant
impact on value creation in the firm’s industry. For example, complementary industries
can affect rivalries through price shocks. When oil prices rise, complementary industries
such as airline travel can be forced to increase short-term price competition because of
relatively fixed capacity.
The government is also a force on industry. Some factors include:
•
Antitrust laws that limit concentration
•
Government purchasing contracts
•
Labor policy
•
Trade policy
•
Tax policy
•
Environmental regulation
•
Financial securities regulation
•
Advertising regulation
•
Product safety regulation
•
Production subsidies
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Template for Analysis
Through the completion of an industry analysis, a firm has a more comprehensive picture
of how profitable operating in this industry would likely be. To be most effective, a firm’s
strategy will outline offensive or defensive actions designed to create a defendable
position that exploits the opportunities and neutralizes the constraints found among the
Five Forces. Below is an example template that may be used to have an initial dialogue
about the structural attractiveness of an industry. Refer to this template as an example
rather than as the best possible template imaginable.
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Resisting Commoditization
When close competitors vie for customers using price as the key distinguishing feature,
it is reasonable to say the industry has been commoditized. Technically, a commodity
market is one in which leverage through a unique value proposition is not possible.
Through the “gale of creative destruction,” industries are inevitably commoditized, while
subsets of these industries avoid commoditization through astute entrepreneurial acts.
Porter’s Five Forces framework builds around rivalry because when a group of firms
become rivals and compete on price, profits are quickly dissipated. Buyers are
unimpressed with non-price differences among firms and force down product prices.
Suppliers of critical and/or branded inputs (such as Intel in microprocessors) may also
extract surplus by forcing up input prices or driving competition in the industry they supply
to so as to create demand for themselves.
Buyers and suppliers, as well as emerging competitors and substitute firms, all benefit
from an industry’s commoditization. It is critical to trace how each of the four outer Forces
can drive commoditization of an industry. By understanding how and under what
conditions industries are commoditized, ideas to avoid commoditization may arise.
Buyer Power
Path to Commoditization: If the industry sells an input that is a high share of its customers’
cost of goods sold (COGS), the customers will create the pressure to commoditize the
industry under consideration. We will consider two cases to demonstrate this path: the
case where the industry sells something that is “high stakes” and a high share of its
customers’ COGS, and the case where the industry sells something that is “low stakes”
and a high share of COGS.
For the first case, with high stakes and high COGS, consider the microprocessor industry;
for the customer, PC assemblers, the microprocessor performance is critical and the
microprocessor is a reasonably high share of the assemblers’ overall COGS. In this case,
assemblers will create demand for information and for infrastructure that will enable them
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to easily shop and compare microprocessors from various firms and sources. In fact,
assemblers are strongly incentivized to keep themselves highly informed about virtually
every aspect of the microprocessor business. This motivation to be informed gives rise to
informed transactions based on salient product attributes rather than based on brands or
other “quick and dirty” signals of quality and performance.
In the second case, with low stakes and a high share of COGS, consider the tin can
industry. The customer in this case will be inclined to experiment with various firms and
alternatives. This experimentation will give rise to customers who are highly informed and
who are, ultimately, price shoppers. In the high stakes case, the customer must become
informed before that customer can credibly threaten the industry with “cost plus”
demands. In the low stakes case, the customer may go directly to experimentation, and
this willingness to experiment commoditizes the industry under consideration.
Supplier Power
Path to Commoditization: Supplier profits increase as the industry in question competes
on price. From the perspective of the supplier, the more the industry that it supplies
competes on price, the more final goods prices in the industry fall. Since demand curves
slope downward, the lower prices drive up the quantity sold; this higher quantity sold
results in greater profits for suppliers.
Next, consider that there are suppliers whose inputs are seen as critical to end-users –
these suppliers provide inputs that make the final product most appealing or functional to
final consumers. We like computers with “Intel on the Inside,” and diet drinks sweetened
with Splenda and restaurants that serve Coke or Pepsi. Suppliers of these critical inputs
benefit from price competition in the industries they serve. This fact suggests that
suppliers may seek opportunities to “cram down” price competition on the industries they
supply.
As an example, consider Intel’s decision to sell motherboards. By performing much of the
complex assembly before handing it over to assemblers, more firms could enter the
assembly business. Intel’s choice to produce motherboards ultimately reduced the entry
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costs to the PC manufacturing industry. With more entrants coming in, and more
consumers focused on “Intel on the Inside,” the PC assembly business becomes focused
on prices competition – that is, the industry becomes commoditized. The effect on Intel is
positive. As shown in Figure 13, as PC assembly becomes commoditized, Intel faces
higher demand, which drives up volume for the powerful supplier.
Figure 13 - The Industry's Pain is the Supplier's Gain
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New Entrants
Path to Commoditization: As discussed above, entry leads to increased capacity and
downward pressure on price (commoditization). Here we delve into the factors that
ultimately enable entry. As previously discussed, having to be large relative to the market
or having to secure particular inputs will create entry barriers. This suggests that there
are settings in which entry is preempted by firms that move first and “fill up” the industry
with the capacity needed to satisfy demand – that is, incumbents leave no room for
entrants. One factor that may enable entry is innovation, which may make it possible for
entrants to at least match the incumbent’s value proposition or productivity while
operating at a reduced scale or with available resources.
Another context in which entry is a factor is an environment of rapid change either in buyer
tastes or in the optimal configuration of production facilities. In this setting, “staging”
investments (making the investment as the firm becomes informed) reduces the odds of
superfluous big fixed investments. On the other hand, preemption (reducing the odds of
entry) becomes difficult when relatively rapid change discourages firms from coming in
with substantial investments of time and expensive plant and equipment. That is when
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firms face a high risk of obsolescence they are often unwilling to make the types of
substantial investments necessary to discourage future entrants.
If the mode of production and/or the nature of demand are in flux, it is difficult and
unattractive to make large capital investments in an effort to stake a claim on a large
portion of the market. Firms fear their investments will be nearly worthless if their guess
about production and/or demand turn out, ex post, to be incorrect. Firms that make
incorrect bets end up unable to preempt future entry. If we look back on the computer
industry, there were many computer assemblers that preceded Apple and IBM. However,
since their bets on production technology and demand attributes were incorrect, their
investments in production capacity did not, ultimately, dissuade subsequent entrants.
Substitutes
Path to Commoditization: When customers view a substitute or distant competitor as
satisfactory, price becomes more important – and commoditization sets in. If the industry
over-serves customers, customers may choose to pay less to get less once the substitute
reaches some threshold of performance. Customers switch to the substitute and the firms
in the industry must compete for revenues to recover expenditures in research and
development (which are also the source of both costs and features which ultimately overserve buyers). Unable to extract a premium, they price closer to par with disruptive firms.
Understanding Value Summary
•
The vertical chain is production from materials (natural gas) to goods
(restaurants)
•
Each box in the vertical chain is a single industry, made up of few or many firms
•
Each firm might sit in one or more industries
•
Each industry faces opportunities and constraints based on Five Forces effects
•
Each firm’s value chain is made up of activities, which each contribute to the
firm’s total WTP−C wedge
•
Each activity makes some contribution to WTP and some contribution to C
•
Value creation varies significantly across industries, firms, and activities
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Figure 14 - Connecting the Value Chain, the Vertical Chain and Activity Analysis
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Chapter 4: Market Structure
A business analyst can learn a lot from considering what is or what might eventually be
the market structure to which a firm of interest belongs. Here we assume you have
covered competitive, monopolistically competitive, homogenous oligopoly, differentiated
oligopoly and “winner-take-all” or monopoly market structures in an economics course or
have access to a good economic textbook.9 We focus here on a brief reminder of the key
factors that distinguish these market structures from each other. We also highlight some
features found in each of these markets, as well as some generic responses that firms
operating in these structures tend to employ.
Industry structure refers to how concentrated an industry is and to the amount of product
(or possibly process) differentiation we observe.
Concentration refers to the degree to which production in an industry is dominated by a
few firms. While government regulators (and sometimes customers) might interpret
concentration as an indication of “market failure,” concentration tends to be associated
with superior economic performance.
The concentration ratio is an economic measure of how concentrated the industry is.
The concentration ratio simply adds the market shares of an industry’s four, eight, twenty,
or fifty largest companies. In 1982, when new federal merger guidelines were issued, the
Herfindahl-Hirschman Index (HHI) became the standard measure of concentration.
Suppose an industry contains ten firms that individually account for 25, 15, 12, 10, 10, 8,
7, 5, 5 and 3 percent of total sales. The four-firm concentration ratio for this industry – the
most widely used number – is 25 + 15 + 12 + 10 = 62, meaning that the top four firms
account for 62 percent of the industry’s sales. The HHI, by contrast, is calculated by
summing the squared market shares of all of the firms in the industry: 252 + 152 + 122 +
102 + 102 + 82 + 72 + 52 + 52 + 32 = 1,366.
9
Too many good ones to list…I like David Besanko’s text on Microeconomics. You can look at the
reviews on Amazon if you want to own a new textbook on this important subject.
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The HHI has two distinct advantages over the concentration ratio. It uses information
about the relative sizes of firms in an industry and it weights the market shares of the
largest enterprises more heavily. Hence, the fewer the firms and the more unequal the
distribution of market shares among them, the larger the HHI. Two four-firm industries,
one containing equal sized firms each accounting for 25 percent of total sales, the other
with market shares of 97, 1, 1 and 1, have the same four-firm concentration ratio (100),
but very different HHIs (2,500 versus 9,412). According to the U.S. Department of
Justice’s merger guidelines, an industry is considered “concentrated” if the HHI exceeds
1,800; it is “unconcentrated” if the HHI is below 1,000. Concentration levels exceeding
1,800 are unusual, but they do exist. Industry examples (as of 1997) include: glass
containers (HHI = 2,959.9), motor vehicles (2,505.8), and breakfast cereals (2,445.9). At
the other extreme, the HHI for machine shops was 1.9.
Firms and regulators often spar over industry definition, because the way an industry is
defined greatly impacts the assigned HHI. An industry can be defined narrowly or broadly
in terms of products produced and the geographic area served. A narrowly defined
industry will generate a high HHI relative to a broadly defined one. The goal of considering
concentration is to understand how spread out are the sales of the whole industry – are
the sales concentrated in a few firms or diffused across many firms? The more diffused
the sales are, the more “competitive” the industry is.
Many related factors impact industry structure:
1. Structure is closely related to the typical minimum efficient scale (MES)10 in
this industry. How many firms “fit” in the market (revenues/MES)? The higher
the MES, the higher the level of revenues (demand) necessary to support Xnumber of firms.
10
Minimum efficient scale (MES) or efficient scale of production is a term used in industrial organization to
denote the smallest output that a plant (or firm) can produce such that its long run average costs are
minimized. Mathematically, the efficient scale can be computed by taking the first order derivative of the
Average Cost (AC) and equating it to 0. This would represent the minimum average cost that the firm is
incurring per quantity produced.
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2. Does size generate significant reductions in unit costs (economies of scale
and/or scope)?
3. Does size generate notable increases in WTP (demand-side economies)?
4. Can differentiation generate WTP? If “bigger is better” but there is scope for
differentiation, the industry is a differentiated oligopoly as opposed to a
homogeneous oligopoly.
5. If the firm is “bigger because it is better” – at what point does the effect of size
diminish? Essentially, how robust is the relationship between size and
customer benefits (WTP) and/or size and production costs?
Market structure results from endogenous and organic factors. Endogenous drivers of
structure result from choices made by firms inside of the industry – firms choose to enter,
they choose capacity levels, and they choose to differentiate. However, market structure
is also a result of organic factors such as the nature of customer demand, and the nature
of the differentiation that is both feasible and demanded. Hence, while market structure
is somewhat predictable based on observable factors, there is also some alchemy in how
a market is structured when all is said and done. In sum, a key dimension in describing
the structure of an industry is MES – is a firm with high market share notably advantaged
in terms of unit costs? Is a firm with high market share notably advantaged in WTP? The
second key dimension has to do with the nature of demand in the industry – can players
in the industry affect the level of demand for the good by being creative with marketing
dimensions (product, place, price, promotion)? If the level of demand is “influenceable”
with brilliant marketing, then we say demand is endogenous – or determined by factors
“inside” the industry. On the other hand, if mainly macro-economic variables such as
income, demographics, weather, regulations etc. affect the level of demand for the
product, we say demand is exogenous – determined by factors outside of the industry’s
control. If firms cannot affect demand, then this is the equivalent of being unable to
differentiate. In other words, the more demand for a good is driven by factors external to
the industry, the more homogenous (alike) the outputs of firms are perceived by
customers. If a firm could make customers like/want/value its product by adding a feature
or a marketing message, the more endogenous the level of demand is. If only variables
that ALL firms faced affected demand (economy, demographics, climate, etc) than
differentiation among firms’ outputs would be unlikely.
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Table 4.1 – Taxonomy of Market Structures
Product Differentiation
Firms which
produce a
very low share
of demand
can achieve
costs
comparable to
the most
efficient firms
FREE ENTRY MARKETS
•
•
•
•
PERFECT COMPETITION
Machine tools
Agricultural products
Sole proprietor trucking services
Barbers (?)
MONOPOLISTIC COMPETITION
• Sole proprietor restaurants
• Physicians services
• Beauty salons
• Wedding planners
Firms cannot
shape their
environment.
Interactions
are not
“strategic”
HOMOGENOUS OLIGOPOLY
Commodity metals, chemicals
Producer durables, such as
turbines
• Oil tanker shipping
Minimum Efficient Scale
•
•
DIFFERENTIATED OLIGOPOLY
• Many consumer packaged
goods
•
Automobiles
•
Universities
MONOPOLY OR “WINNER-TAKE-ALL” MARKETS
TRADITIONAL NATURAL MONOPOLY
•
Utilities
Firms must
produce a large
share of demand
to achieve unit
cost in the zone
of the most
efficient firms
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“NETWORKED” INDUSTRY
(BETTER BECAUSE IT’S BIGGER)
• PC Operating System
• Microprocessors
• Some airline routes
PRODUCT SUPERIORITY (BIGGER
BECAUSE IT’S BETTER)
• Apple i-products
• Heinz Ketchup
Nature of Firm Interactions
OLIGOPOLY MARKETS
Firms shape
their
environment.
Interactions are
highly
“strategic”
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Free Entry Markets
Perfect Competition
In a perfect competition market, firms can expect to receive zero economic profit. The
following are the basic assumptions required for conditions of pure competition to exist:
•
There are many small firms, each of which produces a very small percentage
of total market output and thus exercises no control over the ruling market price.
Firms are price takers.
•
There are many individual buyers, none of whom has any control over the
market price – i.e., there is no monopsony power.
•
Consumers view the product as a homogeneous product and see no difference
in buying from one producer or another. This leads a firm to become a passive
price taker, facing a perfectly elastic demand curve for its product.
•
There is perfect freedom of entry to and exit from the industry. Firms face no
sunk costs, making entry and exit feasible in the long run. This assumption
ensures all firms make normal profits in the long run.
•
There is perfect knowledge. Consumers have readily available information
about prices and products from competing suppliers and can access this
information at zero cost – in other words, there are few transactions costs
involved in searching for the required information about prices.
•
There are no externalities arising from production and/or consumption that lie
outside the market.
In a perfectly competitive market, we assume that each firm is attempting to maximize its
production levels (produce as much as it can), and thus maximize its level of profit – but
given the complete symmetry among all firms and the nature of customer demand,
economic profits are elusive (while firms do earn accounting profits). All firms are using
the same technology, and all are using ''least cost, greatest profit'' methods of production.
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Monopolistic Competition
Monopolistic competition is a form of imperfect competition among many competing
producers selling differentiated products. While the products are close, there are
differences in features, brands, locations, or other dimensions some customers care a lot
about. In this structure, a firm takes the prices charged by its rivals as given but ignores
the impact of its own prices on the overall market. This is because each firm is very small
relative to the overall market. In this structure, firms can behave like monopolies in the
short run, using market power to generate profit, but in the long run, other firms enter the
market and the benefits of differentiation decrease; the market becomes more like perfect
competition where firms cannot gain economic profit. Since the cost of entering is low
relative to the size of the market, firms keep entering and “squeezing each other’s niches.”
If customers are highly irrational, it is conceivable that one or a few firms can dominate a
space for a long while even though entry is completely feasible – this is when strategists
and economists scratch their heads and wonder how it is possible that firms sustain high
returns when entrants can drive those returns downs. Unlike perfect competition, in
monopolistic competition firms maintain spare capacity.
Monopolistically competitive markets have the following characteristics:
•
There are many producers and many consumers in a given market and no
business has total control over the market price.
•
Consumers perceive that there are non-price differences among the
competitors' products.
•
There are low barriers to entry and exit.
•
Producers have a degree of control over their own price
The long-run characteristics of a monopolistically competitive market are almost the same
as in perfect competition, except that monopolistic competition has heterogeneous
products and involves a great deal of non-price competition (based on subtle product
differentiation). A firm in a monopolistically competitive industry that is able to make profits
in the short run will break even in the long run because demand will eventually decrease
and average total cost will increase. Because the firm only has control over a tiny share
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of the market, it must earn high gross margins in order to monetize its fixed costs over a
small number of users. This means that in the long run a monopolistically competitive firm
will make zero economic profit. In a monopolistically competitive structure, a firm has high
power over a small portion of the market. This gives the firm a degree of influence over
the market; because of brand loyalty, it can raise its prices without losing all of its
customers. This means that an individual firm's demand curve is downward sloping, in
contrast to perfect competition, which has a perfectly elastic demand schedule.
There are barriers to entry in a monopolistically competitive industry, but these barriers
are relatively small (although higher if a firm wants to steal another firm’s core customers).
Consider the market for cutting hair in NYC. Let’s say I operate a beauty salon and I talk
about strategy while I cut hair. Believe it or not, I might appeal to a very, very small
population, those who like casing while they get their haircut. If another salon wanted to
steal the customers who value me the most (my core customers) they would have to hire
a strategy professor who can cut hair – a rare and expensive find. The “prize” for finding
such a person is splitting the market with me – probably not very appealing – hence the
word prize is in quotes. It would make more sense to differentiate from me – for example
a barbershop where the barber discusses finance.
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Oligopoly Markets
An oligopoly is a market dominated by a small number of firms that together control the
majority of market share, usually at least 80%. These firms gain the majority of total sales
revenue. These firms sell similar goods and services, which are close substitutes and
thus price sensitive. The decisions of one firm influence, and are influenced by, the
decisions of other firms. Strategic planning by firms in an oligopoly needs to take into
account the likely responses of the other market participants. The following are
characteristics of oligopolies:
•
An oligopoly maximizes profits by producing where marginal revenue equals
marginal costs.
•
Oligopolies are price setters rather than price takers.
•
Barriers to entry are high. The most typical barriers are economies of scale,
patents, access to expensive and complex technology, and strategic actions by
incumbent firms designed to discourage or destroy nascent firms.
•
Oligopolies can retain abnormal profits in the long run, because barriers of entry
prevent sideline firms from entering market to capture excess profits. Overall,
the potential for profits depends on the amount of industry capacity relative to
demand.
•
Product may be homogeneous (steel) or differentiated (automobiles) – see
below.
•
Oligopolies have perfect knowledge of their own cost and demand functions,
but their inter-firm information may be incomplete. Buyers have only imperfect
knowledge as to price, cost, and product quality.
•
The distinctive feature of an oligopoly is interdependence. Oligopolies are
typically composed of a few large firms. Each firm is so large that its actions
affect market conditions. Therefore, the competing firms will be aware of a
firm's market actions and will respond appropriately. This means that in
contemplating a market action, a firm must take into consideration the possible
reactions of all competing firms and the firm's countermoves.
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Homogenous Oligopoly
In a homogenous oligopoly, the product is homogenous. Customers are indifferent to
whom they buy from and they often buy from an intermediary. Firms perceive overall
market demand to be exogenous, or given. Consequently, firm earnings can be volatile,
moving with overall demand.
Differentiated Oligopoly
In a differentiated oligopoly, production of similar but not identical products is
concentrated in a few firms. Firms operating in a differentiated oligopoly attempt to
differentiate their products in order to be able to charge consumers a higher price.
Breakfast cereal manufacturing is an example of a differentiated oligopoly.
Monopoly and Winner-Take-All Markets
Natural Monopoly
In a natural monopoly, a single firm can produce enough product to satisfy demand. The
firm generates low costs and capacity is very high relative to demand. Economies of scale
cause efficiency to increase continuously with the size of the firm. A firm is a natural
monopoly if it is able to serve the entire demand of the market at a lower cost than a
combination of smaller, more specialized firms.
Winner-Takes-All Markets
Because of economies of scale, a firm may be better because it is bigger. In the case of
a natural monopoly, the bigger the firm, the more able the firm is to monetize or spread
fixed costs. But the firm can also benefit from size where size generates demand-side,
rather than or in addition to cost-side economies. When very deep and robust demandside economies are present, the market may be a winner-take-all market. A key
example of a winner-takes-all is Microsoft Windows, which dominates the operating
system market for desktop computers. The development costs for hardware are
significant, thus lending an advantage to Microsoft, which is “better because it is bigger.”
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Because there is only one main operating system, software developers can concentrate
their efforts on products for a single platform. This generates tremendous benefits for PC
users who get the advantage of more variety than would exist if developers had to incur
the redundant costs of developing for multiple systems.
Bigger Because It Is Better
It is conceivable that a firm does not enjoy robust cost- or demand-side economies, but
is dominant because its products appeal to many more customers than the offerings of
other firms. We can have a case where a firm might otherwise be one of many
monopolistic competitors, but because its products are very appealing to a large swath of
the market, the firm dominates due to its superiority. An example of a superior monopoly
is one with a defendable intellectual property right or proprietary access to intellectual or
physical property. Google’s search algorithm may be an example that fits here. While
there are some cost- and demand-side economies in the search engine market, these
economies were not robust enough to explain Google’s dominance through 2010.
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Table 4.2 - Generic Responses by Market Structure
FREE ENTRY MARKETS
PERFECT COMPETITION
Since We Expect…
• ROIC=WACC (industry average)
• No WTP or C asymmetries among firms
• Low gross margins due to free entry
• Small markets shares, but no need to “produce” WTP
Goal: Be operational fluent
Ambition: Be on the lookout for opportunities to introduce barriers to
entry and move down (to homogenous oligopoly. Alternatively, find a way
to differentiate and move to the right (monopolistic competition).
MONOPOLISTIC COMPETITION
Since We Expect…
• ROIC=WACC on average, but lots of variance among firms. Some firms earn
high profits, while some do not recover fixed investments made to differentiate.
• High gross margins: Many small segments driving up average cost per
customer.
• Small market shares, so relatively high fixed costs incurred to produce WTP
Goals: Improve C or to drive differentiation (constrained by the need for a sufficient
base of customers).
Ambition: Create barriers to entry (i.e., brand equity, reputation, customer inertia,
regulation). That is, become or be acquired by a differentiated oligopoly.
OLIGOPOLY MARKETS
HOMOGENOUS OLIGOPOLY
DIFFERENTIATED OLIGOPOLY
• If supply is higher than demand, ec profits unlikely
These players perceive:
• Consolidation can improve industry returns
• “Endogenous” or internally driven demand. WTP affected by firm and/or
• “Exogenous” or externally driven demand (WTP)
industry level product, place, price and promotion (4 P) choices.
may generate volatile income
• Earnings can be managed not only by financial contracts (hedges), but by
As such:
shifting 4 P’s wisely.
• Skilled CFO who understands if hedging is appropriate in particular
As such:
firm’s case. Knows not to pay to eliminate purely idiosyncratic risk.
• Identify most attractive segment for the firm
• Forecasting of demand and cost is critical so can adjust scale and
• Develop “right” product for that segment
process if possible
• Communicate with segment effectively
• Skilled COO to drive operational fluency
• Match distribution channel (place) to segment served as well as to product and
• Legally coordinate industry capacity decisions so as to avoid “gluts”
price
(i.e., trade associations)
• Track taste trends and innovate accordingly
• Develop proprietary processes for production
• Operations matter, but often get sidelined to marketing issues – keep efficiency
• Set appropriate firm boundaries: Secure scarce and valuable
“in the zone” … if sufficiently inefficient, constrains ability to innovate.
resources (higher quality inputs, better locations, etc.)
• Maintain distance from competitors – resist temptation to straddle and drive
• Develop innovative revenue model
industry to the left (homogenous olig).
• Perceive opportunities to differentiate
MONOPOLY OR “WINNER TAKE ALL” MARKETS
MONOPOLIES AND NATURAL MONOPOLIES
“WINNER TAKE ALL” (WTA)
Often benefit from regulations that discourage innovations which reduce WTA victories may be preceded by a “War of Attrition”, which is fought with
MES. Firms who enjoy dominance NOT explained by cost or demand side financial and human capital in which both sides might suffer heavy losses before a
economies have to wake up every day and win “a beauty contest” b/c they victor eventually emerges. The “asymmetry” (or point of variance) the winning firm
are bigger by being better. This means lots of competitor and customer possessed is not always clear ex ante or sometimes even ex post. If victory is too
recognizance. Often to maintain their dominance, these firms have a hard won, the victory can be more expensive than the market potential that is won.
willingness to acquire firms that extend or defend their dominance.
There are best practices and attributes that increase the odds of “winning”:
• Ability to move quickly
• Strong brand equity
• Ability to leverage existing technologies, capabilities, assets
• Ability to offer complementary products so users can use product immediately
• In sum, firm must have the benefit of some asymmetry that increases the firm’s
chances of winning. For example, MS DOS was chosen by IBM – nice!
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Chapter 5: Positioning
After having examined the fundamental premises around industry analysis, we now come
to the discussion around how best to position a firm within an industry.
Positioning is defined as the process of segmenting an industry to find a defensible
position in that industry. This goes to say that given a firm’s particular value chain, it seeks
to find its place by identifying segments of the market that it will operate in, in a defensible
manner. This requires having a clear understanding of the opportunities and constraints
at every step of the value chain. The firm effectively responds by formulating a strategy
that allows it to exploit the opportunities and neutralize the industry constraints.
Segmentation
What precisely is industry segmentation? In Michael Porter’s Competitive Advantage:
Creating and Sustaining Superior Performance (1998 edition), he describes the process
of industry segmentation as “the division of an industry into subunits for purposes of
developing competitive strategy” (p. 231). Each industry has a range of products and
range of customers with diverse sets of wants and needs. Industry segments can be
based on a particular product or other sub-grouping within those ranges.
Industry segmentation is not the same as market segmentation; the latter is a sub-set of
the former. Industry segmentation takes market segmentation into account when a firm
makes the determination as to what segments to serve and how best to serve them.
It is important to remember that differences exist among buyers and sellers in an industry
that have varying implications for all the participants in the value chain. These factors
have to be analyzed within the context of each of Porter’s Five Forces, because they
determine a firm’s success in gaining a competitive advantage.
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The four value chain-based segmentations relative to the firm’s activities are:
•
Cost
•
Uniqueness
•
Configuration
•
Buyer’s own value chain
When segmenting an industry, one tries to find factors that (a) differentiate buyers and
sellers and (b) would either affect or determine competitive advantage. Porter lists the
following as the four main classifications of segmentation:
•
Product Variety: spectrum of product features, differences that do or could
potentially exist
o Physical characteristics (e.g., size)
o Price level/image (e.g., luxury, budget)
o Features (e.g., performance, safety)
o Technological advancements
o Packaging
o Age
o Primacy (necessity or want)
o Bundling
•
Buyer Type: characteristics of the end-users
o Consumer
§
Demographics
§
Lifestyle
§
Language
§
Purchase occasion
o Commercial
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Seasonality
§
Strategy
§
Technological level
§
Buyer usage (direct or downstream)
§
Vertical integration
§
Purchase process
§
Size
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•
§
Structure
§
Financial strength
§
Order pattern
Distribution Channel: how the product gets to the end-users
o Direct vs. distributors
o Direct mail vs. retail
o Distributors vs. brokers
o Exclusive vs. non-exclusive outlets
•
Buyer Location: geographical distribution of end-users
o Localities, regions or countries
o Climate differences
o Economic development stage
Other characteristics unique to an industry may be incorporated in this framework, the
end goal being that of identifying the variables of a firm’s position that would impact its
ability to develop and sustain competitive advantage. Creating an industry segmentation
matrix would highlight those variables that have the greatest impact on the basis of the
Five Forces and match them to the firm’s value-chain capabilities. For instance, the end
result could be a matrix that represents product variables on one axis and cost variables
on another.
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Segment Selection
Effective segmentation is based on identifying meaningful differences among product and
customer segments that the firm believes it can serve effectively. This is when positioning
comes in. While segments reflect underlying realities, positioning is a firm’s choice to
serve specific segments. This is done through one of two approaches:
•
Focus on a single segment
•
Diversify across multiple segments
Table 5.1 - Segment Selection: Focus vs. Diversified
Focus
Advantages
Disadvantages
Cost
Volatile earnings
Stronger differentiation
Diversified
Convenience
Cost
Generic Strategies
Firms can utilize one of the three primary strategies that Porter lists in positioning
themselves:
•
Overall Cost leadership
•
Differentiation
•
Focus
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Overall Cost Leadership is about having a sustainable cost advantage unique to the
firm that stems from owning superior resources and possessing capabilities that are
inimitable; rivals would be unsuccessful in replicating the cost structure.
Table 5.2 - Overall Cost Leadership
Required Skills and
Organizational
Resources
Requirements
Sustained access to
Tight cost control
capital investment
Process engineering
Risks
Technology change may
nullify past investments
Frequent detailed control
Low cost learning by
reports
newcomers through
imitation or investment
Intense labor supervision
Structured organization and
Inability to see required
responsibilities
product or marketing
change
Products designed for
Incentives based on strict
Cost inflation, which
ease in manufacture
quantitative targets
narrows profit margin
Low cost distribution
Way of doing business that
Low cost distribution may
reduce absolute costs or
be the result of relationships
product generates
that can change over time.
advantages for wholesalers
and retailers such they take
a smaller than standard cut
from the firm.
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Differentiation is the ability to provide products with distinguishable characteristics
superior to those of the competition, for which customers are willing to pay a premium.
Table 5.3 - Differentiation
Required Skills and
Organizational
Resources
Requirements
Risks
Strong creative and
Strong coordination among
If cost difference grows,
marketing insights
R&D, product development,
consumers may sacrifice
and marketing
features for savings
Product engineering and
Subjective measurement of
Buyers’ need for
basic research skills
incentives with qualitative
differentiation may fall as
focus
they become sophisticated
Corporate reputation for
Amenities to attract highly
Imitation may narrow
quality or technology
skilled labor, scientists or
perceived differences as
leadership
marketers
industry matures
Strong cooperation from
Based on something
Status quo changes in a
channels to distribute
between inertia and trust.
way that disrupts what was
products to segments
Requires frequent
a “win-win”
interactions to maintain
relationship capital.
Focus hones in on targeting precise customers with specific attributes that the firm
chooses to address; it is very much a customer-centric approach. The focuser tailors the
product, as well as aspects of production and delivery, to best serve the clients’ needs.
The key for the focuser’s success lies in being able to maintain margins by lowering
overall transaction costs while retaining pricing power. If the customers’ “all in” or net
costs are lower when dealing with the focuser, those customers would be willing to pay
the firm as much as they were paying the competition.
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A focus strategy is not without risks:
•
Unforeseen or uncontrollable events may affect the cost structure of a value
chain, which would impact the focuser’s cost advantage.
•
Lines of demarcation between the focuser’s target audience and overall market
may blur, which would put the focuser in direct competition with others.
•
Competitors may encroach on the focuser’s sub-markets, causing distractions.
Operating Beyond the Productivity Frontier
Firms enjoy a cost-side advantage when they own a process, or when they uniquely face
lower input costs. To maintain its competitive advantage, a firm needs to operate beyond
the productivity frontier, i.e., deliver a high non-price value product while keeping a lid on
costs. The following questions help to understand where a firm stands with regard to its
costs:
1. Where is the firm relative to the productivity frontier?
2. Can the firm increase WTP by more than it increases costs?
3. Can the firm decrease C by more than it decreases WTP?
4. Can the firm organize operations in response to commoditization in adjacent
industries in order to gain more than its competitors? (Does the firm take
advantage of volume opportunities in response to commoditization in its
customers’ industries? Does the firm take advantage of cost reduction
opportunities in its suppliers’ industries?)
Firms can employ a host of techniques to create a cost advantage, some of which are
more easily imitable than others:
•
Buy share in existing markets through low prices to increase scale
•
Buy share in existing markets to accumulate experience
•
Introduce new products to better utilize shared facilities
•
Enter new geographies to improve capacity utilization or increase scale
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In cases where having an early-mover advantage has been observed, it has stood out as
a key to success.
Table 5.4 - Examples of two sets of drivers to control costs
Easily Imitable
More Difficult to Imitate
Relocate production within existing facilities
Improve material yields
Relocate facilities to low input-cost regions
Reduce complexity of production operations
(e.g., reduce number of SKUs)
Input substitution (e.g., capital for labor)
Alter product design to improve
manufacturability
Use lower-cost components
Push improvements in asset management
such as lower inventories
Bring economies of scope in-house but out-
Enhance worker productivity through
source major cost centers
changes in organizational architecture
Enhance worker productivity through formal
incentive systems
Reduce work force
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Chapter 6: Resource-Based View
At several points in this text, we have referred to concepts that you will soon see are
related to the resource-based view (RBV). RBV looks at resources as a source of
competitive advantage. RBV is different from positioning, which reflects the ideal
response to industry conditions and involves investing in tangible and intangible assets
to secure that position. By contrast, the RBV examines how firms can enjoy sustainable
returns as a result of resources employed. In this section, we will examine the RBV in
some depth and then contrast it with the positional view.
Here is a key point: In this section, we are going to amplify the portion of the RBV
literature that is complementary to the positioning work of Porter. We are also
going to downplay the portion of the RBV work that is competing or overlapping
with the positional view of the world. The RBV is a compilation of the contributions of
many scholars to the fields of strategy and organizational behavior. Many scholars
consider the paper The Cornerstones of Competitive Advantage: A Resource-Based View
by Margaret Peteraf (1993) to be a comprehensive description of this work. Here we
summarize the main ideas of the RBV of strategy. Again, we will focus on what the
RBV adds to a thorough discussion of firm strategy and we will downplay
discussion from the RBV literature that does not add much insight over Porter’s
work.
Similar to Porter’s work, RBV scholars address the fundamental question: “Where does
competitive advantage come from?” The RBV framework attempts to explain why some
firms, over time, outperform others in creating wealth for their owners. The RBV’s answer
starts with the assumption that firms are endowed with, choose, or acquire inherently
different bundles of resources. In the Cornerstones paper, these resources include assets
such as location, brand names, distribution channels, and patents, which all contribute to
the firm’s ability to create, produce, and deliver goods and services. The paper also
suggests that resources also include capabilities such as hiring practices, quality control
processes, and corporate culture, which also play an important role in value-creating
activities. Herein lies the potential for confusion between the two points of view.
Many of the things listed as resources in articles about the RBV framework would
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be described as attributes of a firm’s position in Porter’s world. We are going to
agree with Porter on this front – if its “ownable” it’s part of the firm’s positional
arsenal.
Here is what is not addressed by Porter’s positional view and what can be addressed
using the RBV: What if some of a firm’s competitive advantage arises by employing
unique resources that other firms do not, and by matching these resources to
economically relevant environments. As a tool for strategy formulation, the RBV
implies that firms should examine their resources and find environments appropriate for
these resources. Within these environments the firm has a competitive advantage
because its resources are superior to those of competing firms. Hence, we will consider
resources to be those things the firm employs but does not own. We will also only
contemplate resources that play a key role in the production of the firm’s product
or process advantage. So the firm employs a resource that plays a key role in the
production of the firm’s advantage.
A lesson here is that there is no single framework for the analysis of a firm’s competitive
advantage. Instead, we evaluate the firm through multiple frameworks and find that each
generates some insights, while no one framework alone “cracks the case.” The RBV is
one such paradigm that helps us identify the sources of a particular firm’s performance.
For this reason, it has become one of the most important frameworks in the modern field
of Strategy. In fact, Gary Hamel and C. K. Prahalad’s notion of core competences is a
well-known strategy concept that reflects the basic logic of the resource-based view of
the firm.
Wealth-creating, sustainable competitive Advantage
The primary goal outlined in Peteraf’s discussion of RBV is to provide a systematic way
to answer the question: “What characteristics must resources possess in order for them
to serve as the basis for a wealth-creating, sustainable competitive advantage?”
A firm has a competitive advantage if it earns a rate of economic profit that exceeds the
industry average. A firm’s competitive advantage is sustainable if that advantage persists
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over a reasonably long period of time. That advantage creates wealth for the firm’s owners
if the original costs incurred to create the advantage are less than the present value of
the stream of profits that now flow from the advantage.
There are four foundations of a wealth-creating, sustainable competitive advantage:
•
Resource Heterogeneity
•
Ex Post Limits to Competition
•
Imperfect Mobility
•
Ex Ante Limits to Competition
Resource Heterogeneity
Differences among firms are necessary for competitive advantage. According to the RBV,
these differences can be attributed to differences in the bundles of resources that firms
use to make and sell their products. If firms in a particular industry vary, there must be
some firms whose resources are superior to others. The firms with superior resources are
able to produce their output more efficiently than rivals (lower C), or they can offer
products that provide consumers with higher utility than the goods offered by rival firms
(higher WTP). Resource heterogeneity gives rise to two kinds of rents: When superior
resources lower production costs, Ricardian rents arise. And when superior resources
raise output quality, monopoly rents arise.
Ricardian Rents
Ricardian rents can occur in highly competitive markets. Picture an industry in which
many firms compete, each selling an identical commodity, such as wheat. Wheat is simply
wheat in this industry – there are no organic strains, or any other types of differentiation.
Suppose each wheat producer is so small in comparison to the overall size of the market
that no single producer can move the market price. This is the economist’s perfectly
competitive industry.
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Imagine that all land is leased because land is not ownable for some reason. All farmers
must tend land owned by a third party. Suppose that some farmers have access to more
fertile land than others, and perhaps some have more skill at harvesting their crop. A
farmer with superior resources might have lower costs, even though it produces a
standard product (wheat is wheat). The worst firm in the industry is the firm that just
breaks even. This firm just covers its average cost of production, and so this firm’s cost
(including opportunity costs of labor and capital) is equal to the market price. The superior
firm can capture the difference between its average cost and the market price. This is
demonstrated in Figure 15.
Figure 15 - Ricardian Rents
The marginal cost (MC) curve is upward sloping as a result of the Law of Diminishing
Returns – as output increases constantly, the incremental costs get larger and larger.
Second, notice that the cost curves indicate that there is some given level of fixed costs,
and variable cost is increasing to generate more output.
In highly competitive markets, firms will choose to produce an output level where their MC
is equal to P to maximize firm profits. Here, the average cost (AC) is below MC, so the
firm generates an economic surplus, which is referred to as a Ricardian rent, after the
British economist David Ricardo. This economic surplus is above all actual costs and
opportunity costs, including the market cost of capital. This surplus results purely from
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more efficient cost curves (remember, this firm cannot set prices). However, the firm is
limited in expansion because its superior resource is scarce. Luckily, the scarcity that
limits the firm’s size also prevents competing firms from replicating its cost curves and
ultimately driving prices down for the entire industry. In the wheat industry, the scarce
resource may be particularly fertile land close to a river. Or it may be a skilled owner who
has limited time to apply harvesting expertise.
Monopoly Rents
When a firm makes a product that, in the view of consumers, is differentiated from the
products of competing firms, different prices emerge. As product substitutability drops,
firms have increasing control over how they price their goods. Wheat producers have
virtually no control. Coke has some control (because Pepsi is a partial substitute). But
Microsoft has very strong control over pricing of its Windows operating system. As a result
of consumer-perceived differences, degrees of price inelasticity arise, and the firm begins
to face a downward-sloping demand curve. In this scenario, firms choose to produce
quantities where the market clears at prices well above MC, and in turn AC. Since
monopolistic firms can enjoy a gap between AC and P, they generate economic surplus
above their actual costs and opportunity costs, including the market cost of capital.
Examples
Typically, we consider Ricardian rents a supply-side phenomenon, and we consider
monopoly rents a demand-side phenomenon. Ricardian rents result from superior
production efficiency, while monopoly rents result from differentiated products that have
no good substitutes. In both cases, the ability to earn the rent ultimately derives from the
existence of valuable resources that a firm possesses but competitors do not. A firm can
have both Ricardian and monopoly rents.
Steel is one of the most competitive product markets because buyers of steel can
purchase identical grades of steel from a variety of different producers, with little care for
the specific producer. However, steel is labor intensive and firms located near cheaper
labor supplies face lower costs. The Brazilian steel firm Usiminas is one such firm, and
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has historically been one of the lowest cost producers in the world. Usiminas generates
Ricardian rents when it sells steel on the world market at prices that reflect that many
producers have higher costs – that is, when demand is high, even less efficient producers
are able to sell steel at prices that cover their costs. Very efficient producers derive a
bigger benefit from periods when demand is very high as inefficient producers give these
efficient producers a nice and high price “umbrella”. Efficient firms earn a Ricardian rent
when demand is high.
Webkinz is a good example of a particularly differentiated product due to brand image.
Other small stuffed animals are not perceived by small children to be comparable to
Webkinz, so the demand for Webkinz is downward sloping. The maker of Webkinz
therefore limits output to keep prices above average costs. This difference gives rise to
monopoly rents because the maker of Webkinz faces very similar production costs as
other stuffed animal makers.
Ex Post Limits to Competition
The second condition for a firm to enjoy a wealth-creating, sustainable competitive
advantage based on superior resources is the presence of ex post limits to competition.
These limits are barriers that ensure resource heterogeneity is preserved over time.
Without ex post limits to competition, other firms would clone the resources of a high
performance firm and drive down profit margins in the industry. The Pet Rock industry is
a well-known case of no ex post limits. Though initially extremely profitable, imitators
broke into the industry and brutal competition quickly brought down prices. Ex post limits
to competition are typically driven by imperfect imitability and imperfect substitutability.
Imperfect Imitability
“Isolating mechanisms” are factors that prevent firms from replicating other firms’ superior
economic rents. Isolating mechanisms can prevent imitation of resources that allow lowcost efficiency or allow differentiated end products for consumers. Common examples of
isolating mechanisms include:
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•
Exclusive legal franchises: franchising prevents the overlap of market
segments
•
Patents and trademarks: rival firms cannot free-ride on intellectual property
•
Channel crowding: rival firms cannot gain access to needed distribution
channels
•
Causal ambiguity: unobservable trade secrets lower costs
•
Experience curves: resources have to be developed over time
•
Buyer switching costs: additional costs discourage consumers from switching,
even to perfect imitations
Imperfect Substitutability
Imperfect substitutability is the inability of would-be rivals to acquire resources that are
good substitutes for the superior resources possessed by the firm. Whereas imperfect
imitability limits direct imitation or cloning, imperfect substitutability limits firms from
creating resources that substitute for or neutralize economically powerful resources.
In practice the distinction between imperfect imitability and imperfect substitutability is a
matter of degree rather than kind. An example of imperfect imitability would be when a
maker of a generic drug is unable to replicate all of the attributes of the branded drug due
to the branded drug’s IP protection. An example of imperfect substitutability is the poor
outcome of substituting one input (say an AMD microprocessor) for another (an Intel
microprocessor).
Imperfect Mobility
The third condition necessary for a firm to have a wealth-creating, sustainable competitive
advantage is imperfect mobility. Imperfect mobility means either (i) the resource cannot
be bought and sold in the marketplace (there is no market for resources such as corporate
culture and reputation), or (ii) the resource is more productive for one firm than it is for
others (it is co-specialized).
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Perfect Mobility
We start by considering an example of a perfectly mobile resource. Suppose that there is
a CEO named Fred, and Fred is not like other CEOs. He is so talented that the firm that
currently employs Fred, Firm A, earns an economic rent. Fred is perfectly mobile if Fred’s
superlative skills relative to other CEOs are not firm specific and if he would be an equally
extraordinary manager at any firm in the industry.
If Fred is perfectly mobile, Firm A’s rivals will compete to lure Fred away from his current
employer by offering Fred a higher salary, and Fred’s salary will be bid up to the point
that he receives the full value of his additional productivity relative to ordinary CEOs. If
the going market rate for ordinary CEOs is $1 million a year, and Fred’s skills can add an
extra $2 million in profitability to the firm that employs him, then competition among firms
for Fred’s services will drive his salary to $3 million a year. Fred gets a salary premium
equal to his extra value, while the firm that ends up employing Fred will have the same
profits as other firms because it must pay a premium to Fred equal to the added value
that Fred’s skills create. Even though Fred is an extra-productive resource, the firm that
possesses this resource is unable to secure a competitive advantage over other firms
because Fred is perfectly mobile.
Co-specialized Resources
Co-specialized resources are those that are more productive when used together – if
these assets are separated, collective productivity would be sacrificed. Unlike an asset
such as corporate culture, Fred can buy and sell his labor freely in the market. Suppose,
however, that Fred can only work his magic at Firm A creating rents, but he is unable to
bring rents to other firms in the industry because Fred’s skills perfectly complement the
other top managers at Firm A. Now, Firm A will not necessarily have to compensate Fred
for his full added value to the firm. The co-specialized resources cannot fully capture the
value of their individually superior production because the bundle is difficult to buy and
sell in the market. Fred cannot capture his full value even though he is free and willing to
move to another firm. Likely, Fred and Firm A will split the economic rent, based on
bilateral negotiations.
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Owning Mobile Resources
Unlike labor, there are many resources that a firm can openly trade in the market. We can
hypothesize that an oil firm, BesankOil, owns an especially productive tract of oil reserves.
The firm discovered these reserves and thus controls how they are used. Because of their
extra-productivity, these oil reserves allow BesankOil to extract oil from the ground at a
cost less than the production costs of rival firms – Porter would call this positional value
and the RBV would call it resource value. This is truly an academic distinction!
Mobility means the land is equally productive in the hands of any user of the land. If this
is the case than we might consider that the firm that owns the land is advantaged in the
sense that they likely bought the land at a price that was a bargain relative to the
productivity of the land, which was discovered subsequently. If the resource is mobile,
then the firm can sell the tracts to rival firms, which would attain the same low-cost
production as BesankOil. In Porter’s view, BesankOil has a sustainable competitive
advantage even though its resource is not immobile. However, recognizing the full
opportunity costs of BesankOil resolves this apparent contradiction.
Even though BesankOil is more profitable than competing oil producers, a correct
accounting of BesankOil’s economic rent should take into account the opportunity cost it
incurs by not selling the asset to the second-highest valuing user. In this case, the cash
flows that the second-highest valuing user gets from the oil tracts are (by hypothesis)
exactly the same as the cash flows received by BesankOil. This means that the
opportunity cost incurred by BesankOil from not selling the superior resource just offsets
the extra value that the resource creates. We could also consider BesankOil as two
separate value chains: tract exploration and oil extraction. BesankOil’s competitive
advantage lies in exploration (perhaps due to skill, perhaps due to luck), but its extraction
operation is merely industry average.
Ex Ante Limits to Competition
The final condition necessary for a firm to create a wealth-creating, sustainable
competitive advantage is the limited ability of the firm’s competitors to acquire the
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resources in the first place. The firm must be able to acquire the resources that underpin
its competitive advantage at below-market rates. To illustrate the importance of ex ante
limits to competition, we consider the fable recounted in David Friedman’s book Price
Theory (1990):
Suppose there is a certain valley into which a rail line can be built. Further
suppose that whoever builds the rail line first will have a monopoly; it will
never pay to build a second rail line into the valley. To simplify the
discussion, we assume that the interest rate is zero, so we can ignore
complications associated with discounting receipts and expenditures to a
common date. Assume that if the rail line is built in 1900, the total profit that
the railroad will eventually collect [over all its years of operation] will be $20
million. If the railroad is built before 1900, it will lose $1 million a year until
1900, because until then, not enough people will live in the valley for their
business to support the cost of maintaining the rail line. Lastly, suppose that
all of these facts are widely known in 1870.
I, knowing these facts, propose to build the railroad in 1900. Someone who
plans to build in 1899 forestalls me; $19 million is better than nothing, which
is all he will get if he waits for me to build first. Someone willing to build still
earlier forestalls him. The railroad is built in 1880 – and the building receives
nothing above the normal return on his capital for building it (p. 384).
In this fable, the race to acquire the valuable resource – the monopoly on rail
transportation in the valley – competes away the economic profits that result from the
monopoly. The present value of the cost of acquiring the monopoly franchise (20 years
of $1 million a year losses between 1880 and 1900) exactly offsets the present value of
the cash flows from possessing the monopoly franchise. Now, if we were to look at this
market in 1903 or 1907, we would say that the incumbent railroad has a sustainable
competitive advantage in this particular market. But, due to ex ante competition, the cost
of acquiring this advantage meant that the advantage created no net wealth for the
owners of the railroad.
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The key factor limiting ex ante competition is imperfect information, that the value-creating
potential of the resource is not widely appreciated. One of the most famous examples of
the implications of limited ex ante competition occurred in 1891 when Asa G. Chandler
purchased the secret formula for Coca Cola (called Merchandise 7X) from the inventor,
Atlanta druggist Dr. John Styth Pemberton, for $2,300. When Chandler’s sons sold the
firm in 1916, they received $25 million. For the Chandler family, this represented a rate
of return of 45 percent per year, each year for a quarter of a century!
Summary
Recall that Peteraf’s central goal of the RBV is to explain where wealth-creating,
sustainable competitive advantages come from.
The first necessary condition for wealth-creating, sustainable competitive advantage is
resource heterogeneity. If a firm does not have a unique bundle of resources, it would be
no different from rivals in its industry, and it therefore could not outperform them. Without
a portfolio of superior resources, a firm cannot have a competitive advantage.
The second necessary condition for wealth-creating, sustainable competitive advantage
is ex post limits to competition. Without ex post limits, the resources that underpin the
firm’s competitive advantage could be imitated or substituted. In the absence of ex post
limits, the firm could not enjoy a sustainable competitive advantage.
The third necessary condition for wealth-creating, sustainable competitive advantage is
imperfect mobility. In the absence of imperfect mobility, the firm would not profit from its
possession of superior resources. The extra profit gained from possessing the superior
resource is offset by the premium that it needs to pay to the owner of the resource in
order to keep the resource from moving to other competing firms. Without imperfect
mobility (i.e., with perfect mobility) a firm that possesses the superior resource would not
outperform its competitors and would thus not have a competitive advantage.
The final necessary condition for wealth-creating, sustainable competitive advantage is
ex ante limits to competition. Without ex ante limits to competition, firms compete up the
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cost to acquire the resource in the first place. Firms that incur high up-front costs to
acquire superior resources do not have a wealth-creating, sustainable competitive
advantage.
Resource-Based View vs. Positional View of the Firm
As an explanation of competitive advantage, the RBV can be contrasted with another
important perspective in strategy, the positional view of the firm, also called the activitysystems view by Pankaj Ghemawat and Jan Rivkin (1998). The positional view is best
summarized in Michael Porter’s article What is Strategy?. The positional view emphasizes
the idea that competitive advantage arises from the ability of a firm to create a unique
competitive position in the market in which it competes. Unique positions are created
relative to the activities performed by rival firms. A firm’s competitive advantage is
sustained, according to the positional view of strategy, when there are barriers that make
it difficult or undesirable for other firms to replicate the firm’s position. These barriers
include barriers to entry at the industry level, economies of scale that create room for only
one firm to occupy the position the firm has staked out in the market, and the complexity
involved in executing an integrated system of activities.
The positional view has a product market orientation – competitive advantage is based
on the creation, domination, and preservation of a unique position in the firm’s product
market. The resource-based view has a resource market orientation – competitive
advantage is based on imperfections in resource markets that give a firm privileged
access to certain valuable resources. Another way to draw the distinction is that the
positional view emphasizes the things you do, while the resource-based view emphasizes
the things you have.
A final distinction is that the positional view emphasizes the importance of unique and
valuable competitive positions as a source of competitive advantage, while the resourcebased view holds that competitive positions do not exist in the abstract but rather are
contingent on the firm possessing certain resources. For example, the RBV would
concede that Southwest has a great competitive position, but would add that its greatness
is contingent on Southwest’s resources. Meanwhile, the positional view would emphasize
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that unique and valuable resources do not exist in the abstract, because resources are
only great if the firm can build activity systems and competitive positions that are different
and better than competing firms.
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Chapter 7: Components of Enterprise Value
Chapters 1 and 2 focused on describing how firms create and capture value. Here we ask
a related but different question: Why is the enterprise itself more valuable than the
cumulative value of its discrete resources and investments? Another way to state the
question is: when it comes to the firm, why is the whole worth more than the sum of the
parts? In cases where a firm is worth less than the sum of the parts, we expect the firm
to, ultimately, be disassembled to unlock the value of the components. However, most
firms are valuable above and beyond their component parts. In other words, firms enjoy
“synergy” among their components. Synergy suggests that the interaction among two or
more components of the firm produces combined value in excess of the sum of the value
of the components would have produced if they operated separately. Consider a football
franchise – its component parts are a coach, team players, the team system, the stadium,
and the brand. It is a reasonable conjecture that if we extract a component from one
franchise and replace it with a component taken from another franchise, there would be
some effect – the new component would interact favorably or unfavorably with the other
component parts of the franchise. Understanding the precise nature of the interaction
among component parts of an enterprise is of fundamental importance.
Below we will describe three sources or components of firm value that can be used to
describe the total value of an enterprise and explain how the interaction among these
components gives rise to synergy. Describing the value of a firm in this way is, in some
respects, redundant to describing the firm’s position. Understanding and evaluating the
components of a firm’s value is highly complementary to positioning analysis. When we
describe a firm’s position, we describe:
•
Characteristics of the firm’s output
•
The segment of customers that the firm serves
•
The suppliers with whom the firm transacts
•
The locations of the firm’s activities
This description of a firm is more informative and insightful if it is framed relative to the
firm’s direct competitors. The position a firm owns, by virtue of the firm having invested in
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a value chain constructed to serve that position, can be valued in monetary terms. In our
discussion, we suggest that the value of a firm goes beyond the value of the firm’s market
position.
Below we will briefly outline the three components of value. Following this overview, we
will cover each component in more detail.
Consider that a firm is comprised of three inter-related components:
1.
Assets and Capabilities Value: The value of a firm’s assets and capabilities
(essentially the added value of the firm’s position as described above). We will
refer to this component as asset and capability value (ACV) and it is equivalent
to the positional value of the firm. Assets and capabilities are the cumulative
physical and nonphysical investments made by a firm. Assets and capabilities are
quite literally what a firm is doing, for whom, with whom, and where. Let’s get ahead
of ourselves a bit in the interest of providing a complete definition. The ACV value
of a firm is mainly the accumulation of value due to the industry the firm competes
in, the position within that industry that the firm occupies, and the configuration of
infrastructure, technology, plants, production choices, policies, and entrenched
capabilities the firm employs in that position. ACV is the cumulative value of all
investments the firm has made – if the firm is private, ACV is roughly what the firm
should fetch in a sale. For a public company, it is the value of the firm stripped of
its human capital, which is then replaced with the next best group.
2. Employed Resource Value (ERV): This can also be referred to as idiosyncratic
value. The value of a firm (its ACV) can usually be enhanced by matching that
ACV to particular unowned productive resources (generally people, but works for
other critical but unowned inputs). For example, many analysts claim that Apple’s
value is lower without Steve Jobs – the man who was Apple’s chief muse. ACV
includes assets a firm owns – but human capital (and sometimes other key inputs)
is not ownable. If particular people matter, it is because they generate a notable
share of the firm’s cash flows – cash flows that could go away if these people went
away. While we sometimes pay attention to the nature of the human capital a firm
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employs, it is unusual to pay close attention to the factors that we will elaborate on
here. For example, SWA might say they employ “upbeat and positive people” –
and in fact a workforce such as this one would enhance the value of the firm. But
we would say that this is a policy that belongs in ACV. Steve Jobs of Apple or
Saatchi of the eponymous advertising firm are examples of particular human
capital to whom cash flows are tied. We refer to this component as employed
resource value (ERV) or idiosyncratic value. ERV is the added value of the
resources used, or employed, but not owned by the firm. We will use the analogy
of a “jockey” when referring to ERV in this text. The upbeat and positive employees
of SWA may generate value, however if one set of upbeat folks leave they can be
replaced – certainly they are easy to replace relative to the ease with which a Steve
Jobs or a Jony Ive can be replaced, according to many of Apple’s investors.
3. Governance Value (GV): Finally, we know that the organizational structure
(horizontal vs. vertical) and the incentive system are examples of the context we
put human capital in (not just the jockeys like Steve Jobs, but all the employees).
GV can also be thought of as “management” generally. Management structures
and policies affect innovation, motivation and retention rates and, thereby, affect
the value of the firm. We refer to this component as governance value (GV). GV
refers to the added value of structuring the organization and incentivizing the
players such that their actions are transparent and aligned with the interest of the
firm’s capital owners. We will use the analogy of “carrots and sticks” when referring
to the incentive system component of GV.
We believe the framework presented here is in line with how investors should, and often,
intuitively think about the value of a firm. In sum, the particulars of the firm’s choices of
which market to operate in, which position to occupy, how to operate and execute who
will be the key managers, how to structure the organization and how to incentivize the
jockeys and the workforce will give rise to the three components of value. As explained
below, the three components interact with each other and with market forces, as shown
in Figure 16. These interactions determine the total value of the firm, as well as, the
relative shares of the three components of value.
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Figure 16 - ERV-ACV-GV Chart
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Assets and Capabilities Value in Detail
Perform the following thought exercise. Think of a firm and consider what would happen
to that value of that firm if all of its current non-owned inputs (mainly human capital) were
replaced with the next best alternatives available. The value of the enterprise stripped of
its non-owned resources and then replaced with the next best set of resources is the ACV
of the firm. ACV is derived from assets and capabilities owned by the firm’s shareholders
or capital owners. ACV is essentially the monetary value of the firm’s industry choice, its
position in that industry and its execution choices (Porter’s value chain, described below,
is a visual representation of the firm’s execution choices). This is the portion of the firm’s
value that cannot be expropriated away from the firm’s owners (or shareholders) by the
exit of particular people. It is the component of value that is ownable. Examples of assets
and capabilities are location, premises, brand, contacts with buyers and suppliers, patents
and documented organizational know-how (related to manufacturing, administering, etc.).
These assets and capabilities can be acquired instantly or developed over time. ACV can
be sold to other firms as the “turn-key” portion of the firm (meaning anyone can “turn the
key” and derive this value). While ACV value is the portion of the firm’s value that is not
threatened by the exit of particular people, ACV can be threatened by other firms building
up competing ACV value – that is, the value of ACV can be diminished if entry or imitation
causes that ACV to be less unique.
Employed Resource Value in Detail
ERV is the incremental value to a firm that results from superior matching of employed
resources (meaning particular human capital) to its ACV. Let’s assume that the resource
under discussion is the CEO of a large packaged goods firm. We will use the term
“resource” and “manager” interchangeably in this section. Furthermore, “firm” refers to
the firm’s capital owners. When human capital is equally productive at all firms, that
resource is able to extract the same value (compensation) across all firms – consider an
athlete whose gets teams to compete for his service. As a consequence of this
competition, the team that ultimately employs this athlete does not make much profit on
him over and above his wage. A firm cannot earn an economic profit by employing an
individual unless that individual earns less than his or her contribution to profits.
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There is scope for a win-win: If the employee is more productive when employed by this
particular firm, then we say there is ERV. Our discussion here draws on insights from the
resource-based view. A superior choice of employed resources results in synergies
between managers and the firm’s ACV and these synergies represent the ERV
component of firm value. To retain some of the value generated by employed resources
(again, mainly human) it is necessary that the firm’s ACV be complementary to the
employed resources (that is, it generates synergies or the resource is more productive
for one firm than other, i.e., it is “co-specialized”). If the firm’s ACV does not enhance the
productivity of the employee over and above what the employee would enjoy elsewhere,
then the employee is likely to capture his/her full value as compensation – the reason is
the employee’s outside options are fully credible. If the manager is more productive at the
firm in question, then both the manager and the firm are empowered by his/her
employment – this mutual empowerment gives the firm an opportunity to capture some
value over and above just ACV value. In the case of co-specialization or synergy, neither
the firm nor the manager wants the relationship to fall apart.
Let’s conclude with examples: Consider an individual who is a very gifted artist and
cartoonist. Technological inputs, a group of creative peers, a process to manage the
output of an animated film, and other sorts of assets and capabilities would likely enhance
this individual’s productivity. Likewise, assets and capabilities for animated filmmaking
are enhanced by particularly well-matched human inputs. ERV is the value due to
superior matching of particular resource inputs to particular ACV. Superior matching leads
to a balance of power between human and financial capital owners. For some service
firms, say law firms, ERV value can be a high fraction of overall firm value – the notion of
being matched in a superior way is harder to imagine for other types of human capital.
For a firm with a particularly strong brand and a lot of additional ACV, ERV may be a
small fraction of firm value. Arguably, the value of Coca-Cola would be quite nearly fully
preserved even if all human capital were replaced with the next best alternative group of
employees.
Governance Value in Detail
GV is the incremental value to the firm that results from appropriately organizing and
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properly incentivizing employed resources to generate additional ACV – organizational
structure and the incentive system affect not just the jockeys, but all employees. Every
day, managers, scientists, marketers, operators, distributors, and others come to work
and they are essentially asked to drive (meaning increase) the ACV of the firm. The more
successful these people are in their job functions, the more value the shareholders derive.
Governance is about putting in place the structures that enable and motivate the
production of ACV. In fact, motivating the production of ACV is the central challenge
facing organizations. Similarly, retaining key resources in the case of ERV is also a key
goal of good governance.
To understand how profound and central the challenge of enabling and encouraging is,
let’s develop an example. Consider an individual who is a programmer for Microsoft.
Suppose this individual comes up with an idea that would enhance the operating system
and increase the value of the firm by $50 million. While $50 million is trivial relative to the
market value of Microsoft, a number of individuals developing these ideas continually is,
essentially, what drives the ongoing value of the firm. Nothing is more fundamental to the
value of the firm than human capital driven to increase the ACV of the firm. Herein lies
the issue – once ACV is developed, it is owned by the firm. ACV cannot be taken by an
individual to another firm – the firm can sell it, but human capital cannot take ACV away
(what human capital can take from the firm is called ERV). In general, human capital
cannot threaten to move its past contributions to another firm – it can only threaten to take
future ideas – as the value of past ideas is embedded in the firm.
When human capital creates ACV, that human capital certainly appreciates how much
effort was undertaken. When considering the production of ACV, it is reasonable for that
human capital to wonder “what’s in it for me?” Governance is the answer to this question.
Good governance displays transparency, consistency, equity, and overall good sense
and, thereby, informs human capital before the effort is undertaken “what is in it for them.”
Below the sections on incentives, we give a brief (very brief) taste of organizational
structure – because the governance value is a compilation of the effects of the structure
as well as the incentives (carrots and sticks).
Consider that firms fall along a continuum. At one end of the spectrum are firms that are
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primarily made up of ERV. An example of such a firm is one that produces movie scripts
– without the script writers, the firm would not be worth much. At the other end of the
spectrum is a firm whose value is entirely ACV value – replacing non-owned resources
entirely with the next best set would not change the value of the firm at all. We doubt the
value of Cameron Cookware (a firm that makes cookware for the stovetop and
microwave) would change much if its human capital were switched out. Most firms fall
between these two extremes – but all firms are closer to one of these two types. GE is
one such in-between firm – but likely more ACV than ERV (although this varies by
business unit).
Governance in ACV Firms
Reputedly, General Electric (GE) has structured its incentive so that it drives human
capital to increase the value of the firm. Employee incentives to increase the value of the
firm are derived from some combination of the following: employees’ financial rewards
are correlated with their contributions to firm profits, employees’ contributions to firm value
over time increase their inside options (chances of promotion), and employees’
contributions to the firm value over time increase their outside options. The reason for the
latter is that GE has an external reputation for empowering managers and enabling them
to acquire strong management skills in the process. The employed resources must get
some, but not all, of the value they create. In considering GE and several other ACV firms
that have reputations for sound governance we can observe a commonality.
Good governance for an ACV value firm entails a correlation between the human capital’s
contribution to ACV value and an improvement in that human capital’s own value. This
can be accomplished in a number of ways. For example, firms can give individuals stock
options. If the individual contributes ACV and the firm’s value appreciates, so does the
value of the individual’s options. We imagine this would work well in the context of a small
firm where the individual’s wealth changed appreciably with the value of the firm.
However, we can also appreciate the limits of this approach at a large and mature firm.
How much of the firm can employee number 36,781 own?! One further note about stock
options is warranted: Beginning in 2010, Google began to note the increased challenge
it faced in recruiting uber-talent. Employees who had been with the firm for 10 years were
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greatly enriched by stock options they received when the firm was in a young and
uncertain state. Google, it turns out, was a home run – this enriched many employees
well beyond their personal contribution to the firm’s value. Many good people who joined
the firm since then are de-motivated by the idea that their effort will not return as much
as those who put in effort several years earlier. It is true that employees who joined earlier
took the risk that Google might fail and they might have accepted below-competitive
wages – that said, uber-talented people do not live in fear of being unemployed – they
are not more risk averse than the employees who joined years earlier. Employees who
joined Google in 2010 simply do not face a high probability of doing as well as employees
who joined earlier; that fact makes it more difficult now to recruit the best of the best.
Hence, much thought needs to be put into how stock options are used to create value for
the firm over time.
Furthermore, there are alternative ways to increase the value of human capital beyond
increasing the value of the human capital’s stock holdings. The firm can promote on the
basis of ACV contributions. Promotions enable individuals to enjoy more leverage for
every hour they work – promotions mean more access to the firm’s productive assets
(plants and people). With more leverage the individual can be more productive and
financially and professionally rewarded. Here, though, the limitation is firm growth – firms
can only promote as long as they are growing. As the firm’s growth slows, it becomes
challenging to find a true promotion opportunity, even for worthy individuals. Furthermore,
mature firms perceive even more of a need to produce ACV. If the firm cannot use options
or promotions, how can the firm motivate the production of ACV?
Again, let’s consider alternative means to increase the value of human capital beyond
stock options or promotions within a firm. The firm can increase human capital’s external
visibility. With higher external visibility, the human capital finds its opportunities greatly
enhanced in exchange for its contribution of ACV to a particular firm. GE is known for
imparting generally desirable skills and know-how to its managers, as well as for
encouraging movement from GE to other firms. Opportunity to segue out of a firm can be
as motivating as an opportunity to move up in a given organization. While being in the
U.S. Armed Forces may not be financially rewarding in and of itself, rapid promotion within
the armed services is externally visible and opens up opportunities in the private sector.
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Many nonprofit organizations maintain a reputation for high standards so that quality
human capital is attracted and then rewarded with outside options.
Again, there is no one-size-fits-all governance model for ACV firms. However, all ACV
firms with good governance share the idea that the value of the human capital appreciates
with the individual’s contribution to the ACV value of the firm. If the human capital owns
a stake in the firm, then the human capital’s wealth increases along with its contribution
to ACV. If the human capital is promoted within an organization for its ACV contribution,
then the value that human capital derives from its job increases through increased
leverage. If the human capital is rewarded with outside options for its ACV contribution,
then the value the human capital derives throughout his/her career increases. While the
human capital does not directly own its ACV contribution (by the very nature of ACV, the
firm owns it), good governance suggests that human capital ultimately derives value
correlated with its ACV contribution. Good governance also allows for value to be of both
monetary and nonmonetary nature. The keys to to good governance are: (a) rewards are
correlated with effort applied in ways that increase the value of the firm, (b) employees
are not rewarded or punished for results due to exogenous factors (many suggest the socalled financial crisis was partially driven by rewards given to individuals due to the bubble
in asset prices rather than creation of value by the employees), (c) metrics used to
discriminate among employees are fair measures of contribution and are judged to be
reasonable by employees and (d) overall awareness that rewarding or punishing
employees for results not related to their actions generates the perception of a random
reward system.
In the case of ACV firms, the employee cannot credibly threaten to take the ACV away
from the firm. This is a double-edged sword, as they say (good news and bad news).
While it is good for the firm that its ACV cannot be stolen by human capital, the absence
of leverage to threaten the firm can under-motivate the employee to produce ACV. Hence,
the problem the incentive system of an ACV firm is how to address under-motivation. The
firm is committing in advance to a set of rewards that it will bestow upon the human capital
after the ACV is produced. The firm will reward the human capital after the ACV is
produced and securely owned by the firm – that is, the firm promises to reward the human
capital at the point where the human capital is not empowered enough to demand the
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reward. At the beginning of this text we included the following statement in the definition
of strategy: “A wise firm that uses its advantage judiciously will be able to sustain its
position in the value chain.” Good incentive systems in an ACV firm are an example of
the judicious use of power. If a firm continually backs out of its promises, it will end up
with a lot of slack effort from otherwise talented people.
Governance in ERV Firms
The key difference between an ERV and an ACV firm is that the human capital of an ERV
firm can threaten to take the value away from the firm – in fact, each time the human
capital leaves the building, some of the value of the firm goes with that human capital. To
retain ERV value, the firm must retain the human capital. However, the trick is to retain
value without paying all of that value out in wages to human capital. Some of the value
has to be retained by the firm to deliver a return on invested capital. In the case of ERV
governance, the question is how to maintain a balance of power between the firm and the
human capital. In fact, the question is what is the firm if all or most of the value resides
with the human capital?
The first insight of ERV-heavy firms is that the firm must invest in assets that complement
and enhance the productivity of the human capital. If the “pie” is larger for talent at firm A
relative to firm B, than the best (meaning most complementary) human capital will be
attracted to and retained by firm A. Here, the incentive system must focus on what assets,
capabilities, and infrastructure to supply to talented human capital to enhance
productivity. In other words, the ERV firm needs ACV in order to retain some of the value
produced by the jockey. ACV is critical as without it the human capital shops itself around
to the highest bidder. The ultimate employer of the human capital simply passes ERV
through as wages. Consulting firms, law firms, and creative agencies have to determine
what assets and capabilities can be firm-owned and available to the talent so the talent
wants to associate with that firm.
In addition to ACV, the structure of pay matters. Often, ERV firms are structured as
partnerships. One begins as one of the “minions” – underlings who get low hourly wages,
work long hours, do grueling work, but receive lots of learning. Talent and diligence are
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rewarded with promotions. Promotions have two related upsides. One is that with
promotion the human capital gets its own minions – each hour the human capital works
is now more productive and hence more financially and professionally rewarding (like
promotions in the ACV firm). The other is that once promoted to a high level, the human
capital gets a seat at the table where the division of the firm’s profits is decided. Talented
minions ultimately stay in order to move up this pyramid of pay and power. It should be
clear that a critical governance tool of most ERV firms is an army of minions.
A cheap and productive base is critical to the financial success of those individuals higher
up on the pyramid. It stands to reason that one of two things must be true about the
minions:
•
They overestimate their chances of success. They would not accept such a bad
deal for one or two years if they realized their servitude delivered a low
probability of success.
•
They realize that their odds of promotion at the firm are low, but the grueling
work positions prepare them for many good outside options. Other employers
are attracted to them because of how much they have learned in the firm or
because having that job signals that they are hard workers.
It is also possible that rather than providing minions, the ERV firm provides advanced
technologies. Pixar offers its creative types unfathomable technology. Again, this is
retaining ERV through ownership of ACV. Minions are somewhere in between.
Organizational Structure in Brief
The objective here is not to suggest that governance can be dealt with in a few paragraphs
– of course, it cannot. However, being strategic imposes the need to get organizational
structure and incentives right – by giving a taste of these topics and arguing for their
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importance, we hope to encourage the reader to pursue additional reading and/or
coursework in these areas.
The goal of the organizational structure, at the very least, is to:
•
Enable communication (one-way or two-way)
•
Enable cooperation
•
Move decisions to the right level
•
Support innovation
•
Sustain/Increase firm value
When organization effectiveness is below potential, look for:
•
Decision making that is delayed or lacking in quality
•
A failure to respond innovatively to a changing environment
•
Too much or too little conflict
Below, three commonly discussed forms of organization are depicted. The first is
functional, which is very “vertical,” the second is divisional, which is more “horizontal”
because power is more distributed, and the third is matrix or a hybrid of the vertical and
horizontal organization. We define vertical, horizontal, and matrix below.
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Table 7.1 - Vertical, Horizontal and Matrix Organizations
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A vertical organization is a hierarchically structured organization where all management
activities are controlled by a centralized management staff. This traditional type of
organization often develops strong bureaucratic control over all organizational activities.
In contrast, a horizontal organization may be 100% non-hierarchical or more or less
flat, dependent on the situation and purpose of the organization.
A matrix organization is one in which people with similar skills are pooled for work
assignments. For example, all engineers may be in one engineering department and
report to an engineering manager, but these same engineers might be assigned to
different projects and report to a project manager while working on that project. Therefore,
each engineer might have to work under several managers to get their job done.
Below we give tables that briefly indicate the strengths and weaknesses of each type of
structure. This brief treatment is provided in order to convey that the structure needs to fit
the firm’s objectives.
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Table 7.2 - Strengths and Weaknesses of Functional and Divisional Organization
Structure
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Table 7.3 - Strengths and Weaknesses of Horizontal and Matrix Organization
Structure
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Again, the combination of the organizational structure and the incentive systems are what
we refer to here as the firm’s governance. Below we discuss the interactions among the
three components.
Value from ACV-ERV-GV Interactions
While we can consider the three components in isolation, there are important interactions
among them. First, superior ACV tends to attract superior ERV because good matching
levers up the value of human capital (though much is captured in wages). Furthermore,
ERV is maximized by good GV, because the matches themselves are dependent on
organizational structure and incentive systems. Finally, GV reinforces ACV, because
good structure and incentives enable and motivate those actions that nourish the firm’s
position and execution.
A firm’s value is made up of three components that you can think of as slices of the pie.
A firm’s total value is dependent on each component, as shown in Figure 17. Imagine that
fruitful interactions among the three components grow the pie – and firm choices and
market conditions can grow or shrink the pie. As shown in Table 3.4, ACV and ERV based
firms can use different forms for strategic preemption.
Figure 17 - Total Value of the Firm
.
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Table 7.4 - Issues for the Long term Value of the Firm
Form of
Preemption
Long Run Nature of the Firm
ERV is Critical
Mostly ACV
Quality of firm’s ACV
Quality of firm’s ACV
Investing in
Capital Intensive
Assets
Technologies that depreciate
or leap frog ACV stock
Technologies that depreciate or
leapfrog ACV stock
Divisibility of investments
Divisibility of investments
Pricing Power
Pricing Power
Extent of HR cospecialization
Demand growth potential
Scalability
Reducing consonance of firm’s
offering
Governance: reducing
reliance on specific HR
Governance: motivating HR to make
ACV investments
Ex. Disney animation,
Goldman Sachs
Ex. Pepsi Co., Mittal Steel
Ex ante limits on competition
Technologies that depreciate or
leapfrog ACV stock
Substitution and imitation
Divisibility of investments
Scalability
Pricing power
Marketing and demand
realization
Demand growth potential
Expropriation
Governance: motivating HR to make
ACV investments
Ex. Law firm of “Star and
Star”
Ex. Google, Microsoft
Securing Superior
Scarce Resources
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Strategic Fit
There are three arenas in which the concept of strategic fit is considered. The
first is the fit between the firm’s choices regarding dimensions such as product
attributes, selling attributes, channels, segments of customers to serve, location,
revenue model, scale, span, scope, speed, technology (to produce, distribute, etc.), and
supplier choices should “fit” the environment in which the firm operates. This
environmental fit is sometimes referred to as consonance. A five forces and market
structure analyses help the firm consider which choices neutralize contextual
constraints and exploit contextual opportunities.
The second arena of fit is internal fit. Internal fit suggests there are
complementarities (or “synergies”) between pairs of activities (or investments or
choices) made by the firm as well as among sets of activities made by the firm. The
general domains of internal activities are things such as organizational structure, talent
recruitment, IT systems/technology, capital budgeting, and incentive paradigms.
However, choices on how the firm’s output is positioned are also relevant to internal fit.
The appropriate sets of internal arrangements depend on whether the firm wants to sell
a high quality product vs. occupy a low cost position. Internal fit refers to whether any of
the firm’s own choices generate negative externalities on the firm’s own objectives.
Firms should not only seek to eliminate negative externalities, but should seek to
perform a set of activities that are mutually reinforcing. Through choices of mutually
reinforcing activities, the firm can more likely achieve an inimitable degree of product
differentiation or a sustainable low cost position.
The final arena of fit is between the firm’s market and internal choices and
dynamic features of the firm’s environment. A dynamic environment is one in which key
technologies are rapidly evolving and/or the characteristics of the customer are rapidly
changing. Sustainability analysis is not only about looking at the current state of
“moats” the firm enjoys the benefit of, but whether those moats are becoming more or
less surmountable over time because of technologies that may, for example, reduce
minimum efficient scale. Moats may become less relevant because changes in the
characteristics of customers are making the firm’s market less valuable.
Overall, considerations of fit are another way managers can view potential threats
to their long run success and mine for opportunities to refine their choices.
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Chapter 8: Preemption and Sustainability
The benefit of a strategy is the ability of a firm to sustain, or “own,” its position. A firm can
achieve this sustainability by preempting followers. If a firm owns its position, a potential
entrant is discouraged by the cost, risk, and/or complexity required to enter.
Strategies for value creation and value capture generally fall along a continuum between
the two general forms of preemption described below: investing in capital-intensive
assets and securing superior scarce resources.
Investments in Capital Intensive Assets
If a firm’s capacity is a large share of the overall opportunity, then a successful earlymover can preempt followers by “taking up the space” with its investments in capitalintensive activities. These investments are said to be preemptive because subsequent
investments made by incumbents and new entrants will deliver lower returns on capital.
The first-mover advantage allows a firm to establish its position by choosing the product
attributes and the modes of production and organization. Ideally, a preemptive investment
also delivers the firm’s value proposition.
Sometimes firms are able to stage their investments over time. For example, while
Microsoft’s investment in developing its operating system grew to be preemptive, it did
not have to make a big bet on day one. In markets such as CD pressing or airlines, in
order to own the market large upfront investments made under greater uncertainty are
required. These firms have a more difficult time staging investments.
In both cases, the cost of preemptive investments is large. However, where investment
can be staged, capacity choices tend to be more optimal, so an industry’s overall return
on capital is often higher. When the investments cannot be staged, upfront preemptive
investments can be excessive.
Preemptive investments may fail. Consider a first mover who identifies an attractive
market opportunity but who underestimates the size of the opportunity or who simply
cannot secure enough capital to satisfy the market. Then along comes a competitor who
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also believes in the market. If competition takes the form of winner-take-all (more on this
below), competitors will escalate their investments in an attempt to secure market
supremacy. The more the competitors sink into the market, the more they are motivated
to keep investing to preserve the value of what they have invested already. This is an
unfortunate outcome for firms in a setting that otherwise would have lent itself to
preemptive investments and attractive returns on capital.
Firms that can make preemptive investments often enjoy high and sustainable returns.
Analysts should ask themselves how well preemptive investments will hold going forward,
how matched past capacity choices are with future demand conditions, and what
alternative means of satisfying demand are on the horizon.
Securing Superior Scarce Resources
Another preemptive approach involves securing superior scarce resources that are not
widely available to other producers. These resources enable a firm to produce a superior
product and/or operate more efficiently and thereby generate a higher return on capital
than other firms.
If a firm employing superior resources is earning economic profits, then that firm was, by
definition, able to secure those resources at a cost lower than the return the resources
generate. In other words, the cost of preemption was secured for a bargain price. If this
were not the case, then the economic profits would be dissipated.
However, if a firm acquires resources that are ultimately more valuable than the work they
were acquired to do, the firm has to account for an opportunity cost – the firm delayed
capture of the resource value.
Once a firm employs superior resources, it should invest in assets and capabilities that
are complementary to those resources. Superior resources employed in the context of
complementary
assets
and
capabilities are
made more
productive
because
complementary assets and capabilities enhance the value of the resources relative to
alternative uses of the resources. As will be further discussed in the section on the
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resource-based view, the complementary assets connect the resources and the firm so
that the firm’s resources and investments are mutually dependent.
In the most valuable firms we find that both forms of preemption, the physical taking up
of space with investments in capacity, assets, and capabilities, and the employment of
scarce and superior resources, are combined. The firm's investments enable the
productivity of resources and, in turn, the superior resources increase the value of the
firm's investments. This is shown in Figure 18.
Figure 18 - Superior Resources
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Sustainability/Moats
As firms invest in physical and nonphysical assets, and employ owned and non-owned
resources, the nature of their investments and their businesses give rise to various forms
of preemption with various degrees of sustainability. Warren Buffet is credited with using
the term moat to connote both the form of preemption and the degree of sustainability of
a business.
Table 7.1 outlines five types of moats, in increasing power of sustainable preemptive
power. The strength of the moat indicates how long a firm’s competitive advantage will
last. While some individual moats are strong, almost all firms, with sustained abovemarket returns, have multiple moats, some of which are ingeniously engineered.
Table 8.1 - Sustaining Resources
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Legal Barriers
These least powerful of the moats, legal barriers, include patents, copyrights, trademarks,
and operating licenses. Their strength is determined by how long the legal barrier lasts
before expiration, and the breadth of protection against potential competition. Patents, for
example, vary widely in the degree of protection they provide to the owner. In fact,
competitors often “invent around” them. For example, Compaq was able to invent around
IBM’s formidable patents when Compaq entered the personal computer industry.
Moreover, courts are notoriously unpredictable in their findings when it comes to
copyright, trademark, and patent infringement. The courts could view what appears to be
strong legal protection as weak. Apple thought its patents were foolproof when it sued
Microsoft for copying the look and feel of its operating system, and was surprised when
Microsoft emerged victorious. Furthermore, with value chains now spanning many
countries, enforcing intellectual property rights across national boundaries is a challenge
of mind-boggling proportions.
One-of-a-Kind Strategic Assets
Assets such as superior locations, human talent, trade secrets, and brand names can be
gateways to profitable growth. While this type of moat is generally more powerful than
most legal barriers, there are many factors to consider when the firm’s sustainability is
dependent on its continued employment of particular assets. The resource-based view
(discussed in a later section) explores the nuance associated with dependency on
particular inputs. When a firm employs scarce strategic assets, sustainability is
determined by the firm’s ability to retain economic power over time without offsetting
upkeep costs. A classic example is the Coca-Cola formula, which has been a hugely
valuable asset and requires no upkeep.
Economies of Scale, Market Size, and Sunk Cost
Economies of scale, market size, and sunk costs are moderately powerful in sustaining a
firm’s competitive advantage, but history shows that it is not the most long-lived of moats.
When a market is not big enough to support multiple firms at efficient scale, competitors
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could still enter under three conditions. First, if competitors find important and underserved segments, through effective segmentation and differentiation they can make
significant inroads even if they operate without the benefits of full-scale economies.
Successful differentiation enables competitors to enter and compensate for operating at
lower scale and higher costs. Second, innovation often enables entry. The competitor's
innovative product or process enables it to produce at lower scale without a cost
disadvantage. Finally, the market may grow and support additional firms.
Information Gaps and Complexity
Often the most enduring, multi-factor moats are those that are “path dependent,” and
socially or otherwise complex. Path dependent outcomes are dependent on being
developed in a particular order and in a particular context. Coca-Cola’s brand image is an
example of path dependency. Without Coke’s rich and varied history, Coke would not
enjoy its current brand equity. By definition, path dependency is nearly impossible to
replicate. Additionally, products that need to be imitated on numerous dimensions (e.g.,
features, image, brand, distribution, reputation) enjoy powerful moats indeed. By
definition, path dependency and complexity cannot be engineered.
Increasing Returns Advantages
Under perfect competition, economic profits are ultimately dissipated. Potential entrants
seize the opportunity and share in high returns by entering the market, expanding
capacity and output, and, ultimately, reducing prices. Eventually, profits converge to the
competitive level (accounting profits just sufficient to compensate for all costs). In
contrast, many firms in a diverse array of industries avoid this downward spiral, by
securing an increasing returns advantage: as a firm gets bigger or becomes more
established, it gets stronger, as explained in Figure 17.
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Figure 19 - Increasing Returns in the OS/ Hardware Market
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At a high level, increasing returns are sustained because:
1. Potential entrants cannot imitate profitable opportunities, and
2. Barriers exist that prevent the entry of potential imitators.
For example, a firm with an installed base in a “network” market can enjoy an increasing
returns advantage (see discussion below). Hardware platforms, particularly operating
systems, are highly complementary with platform-specific applications. However, there
are very weak economies of scope for application developers to make their software
cross-platform because of significant up-front knowledge creation costs. As a result,
software developers will tend to align with a single hardware platform, typically the most
dominant system. This in turn reinforces the value to consumers of the dominant
operating system, because that system has the bulk of available software applications.
Over time, more consumers adopt the dominant platform and fewer application
developers make software for the lower share platforms. The value of learning strategy
is to be able to analyze how either or both of these explanations for profits plays out in
the case of a particular firm.
Neither of the above two explanations, however, explicitly factor in the benefit some firms
gain from being an established producer in the market for a long period of time. This
benefit is a third explanation for sustained competitive advantage. When time in the
market matters, we need to factor the mechanisms through which a firm gains an earlymover advantage into our explanation of the firm’s sustained returns.
When early-mover advantages are present, one of two conditions exists. Either the
consumers derive more benefit from the product the longer the firm is in the market, for
example the iPhone becomes more valuable to consumers as Apple develops more apps.
Or the firm realizes production cost reductions, beyond any due to the spreading of fixed
costs, as the firm’s time in the market increases (for example, Toyota continues to learn
how to manufacture more cost effectively). This is shown in Figure 20.
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Figure 20 - Learning Curves
Simply being the first mover into a market does not necessarily bestow any advantages
on a firm. As any angel investor and venture capitalist will attest, most first movers fail.
Therefore, the term “early-mover advantage” does not refer to the first firm with a
desirable product. The terms “increasing returns” and “early-mover advantage” are
reserved to describe the case in which the longer a firm is in the market, the greater its
cost and/or product advantage becomes from the perspective of a typical customer
transaction. Given these caveats about what qualifies as early-mover advantage, we see
that the term does not apply nearly as broadly as it is used. Furthermore, if several firms
recognize the advantage of being the first mover and spend resources trying to achieve
this position, they could conceivably dissipate any profits they would ultimately earn.
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Some common increasing return or early-mover advantages include:
Experience Effects
The experience effect describes any situation in which cumulative experience in
producing a product lowers a firm’s average variable cost. The experience effect is
captured by the learning curve. Note the distinction between the learning curve and
economies-of-scale – an experienced firm (with learning curve economies) would have
lower costs at any scale of production. It may be advantageous for learning curve firms
to underbid rivals for business at first in order to build up their cumulative experience. In
cases where a learning curve is present, the advantage may accrue to one or only a few
firms because of how difficult learning is and/or because learning by doing is a significant
cost driver. If these conditions were not present, the learning could be widely acquired
and would not be a source of advantage. Also note that just as in the case of scale there
is usually diminishing (or potentially even negative) additional cost savings at very high
levels of cumulative experience.
Network Effects or Installed Base Advantages
Network effects (also called network externalities) describe the situation in which each
user of a good or service impacts the value of that product to other users. The classic
example is the telephone. The more people who use telephones, the more valuable the
telephone is to each owner. This creates a positive network externality because each
user purchases a phone for its own use and unintentionally creates value for other users.
The term network effect is applied most commonly to positive network externalities as in
the case of the telephone. Negative network externalities, which occur where more users
make a product less valuable, are more commonly referred to as “congestion” (as in traffic
congestion or network congestion). Over time, positive network effects can create a
bandwagon effect; as more people join, the network becomes more valuable, which leads
more people to join, in a positive feedback loop.
The idea here is that when a network of users exists, there is an external benefit to
additional consumers. If network externalities operate, firms can gain advantage by
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building up sales in early periods and developing a large “installed base” of users. The
idea of network externalities can be captured graphically using the “S-curve” (see Figure
21). The diagonal line represents what may be considered a standard market with stable
market share and no network externalities. Sales to new customers are roughly
proportional to the installed base. When network externalities are present, this
relationship takes on an “S” shape. At very low levels of installed base, the share of new
sales is even lower. When the share of the installed base is high, however, an even
greater share of new consumers will purchase the product. As the Figure shows, over
time, firms with a larger market share will gradually become larger and the share of
smaller firms will dwindle.
Figure 21 - S-curve Representation of Network Externalities
Winner-Take-All Outcomes
The presence of network externalities can produce outcomes where the market
converges or nearly converges on a single standard (which can be supported by a single
firm or by many firms that adopt that standard). These outcomes are referred to as winnertake-all. A winner-take-all market is one in which reward depends heavily on relative, not
absolute, performance, and the lure is the high value of the top prize. A small difference
in performance between firms produces a large difference in economic profits.
Understanding whether a networked market is likely to be served by a single standard or
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by multiple standards is crucial for strategy formulation. Below are considerations for
judging the likelihood of convergence to a single winner:
•
High Network Externalities: When network effects are strong, users will want
access to as big a network as possible. A standard that attracts only a subset of
the market (or a situation in which the market breaks into sub-groups each on
different standards) is less attractive for users. If network effects are strong, this
favors convergence.
•
Multiple-Standard Association is Costly: Costs are incurred in order to “associate”
with a particular standard. These costs include: outlays for hardware (e.g., a CD
player), costs for software (the CDs), learning costs, and other transactions costs.11
Consider all the costs incurred in operating in a particular standard that are only
useful in that standard and not useful in other standards. When users
simultaneously operate in more than one standard (for example, they own
cassettes and CDs) they incur redundant costs. The higher these redundant costs
are the more users prefer to converge to a single standard. In many industries in
which standards exist, we do not see convergence to a single standard. We did
see cassettes, CDs and even LPs coexist. On the other hand, a very small fraction
of the market uses a Non-Wintel standard. Industries have an incentive to conform
to a single (or very few) standards (that is, consumers benefit from industry-wide
standards) when the product is used in conjunction with a complementary good
and it is costly to offer several configurations of the complementary good. The
more expensive it is for the suppliers of complementary goods to produce their
output in multiple configurations, or the more expensive it is for consumers to
support both standards, the more convergence we will see. Even if the
manufacturing costs are nominal, we have to consider the increase in distribution
costs if there are multiple standards. If multiple-standard association is costly (for
some combination of manufacturers, consumers, or distributors), convergence is
more likely.
11
Economics often refer to transactions in the plural.
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•
Opportunities for Product Differentiation Are Low: The question here is whether
the differentiation between standards is valuable enough to consumers to get them
to pay redundant costs in the hardware and software markets. If there is little
demand for particular and distinct features, then users will converge to a single
standard. Only if the different products satisfy different needs would we expect to
see coexistence. In the case of the CD and the cassette, one had higher sound
quality and the other was more portable for a while (CD eventually caught up in
portability). If segments of customers or individual customers have a wide range
of needs, standards can coexist. Buyers have to be willing to vote with their dollars
and pay for the redundant costs of multiple standards.
Buyer Uncertainty and Reputation
Goods for which quality is an issue can be placed into three categories: search goods
experience goods, and credence goods. A search good is a product or service where
product characteristics (that is, its “quality”), can be observed and ascertained at point of
purchase and consumption—the attributes can be confirmed by inspection.
An
experience good is a product or service where product characteristics (that is, its
“quality”), are difficult to observe in advance of consumption, but these characteristics can
be ascertained upon consumption. For experience goods, firms that have built up a good
reputation among experienced users will have a distinct advantage. New competitors
would have to offer much lower prices in order to compensate for the higher WTP of the
established products. Credence goods are products and services whose value can never
really be ascertained with certainty. To a large degree, the value of a credence good is
often a matter of faith or belief. These good often require very strong “signals” of quality
since quality cannot be observed directly. A signal of quality could be the length of time
a firm has been in business or possibility a very discerning user chooses this product
(think Michael Jordan and Nike).
Buyer Switching Costs
For certain products, buyers may face a specific cost if they want to switch suppliers. A
great example is producing a product that requires training to be able to use it – when the
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buyer purchases the product she incurs a training cost that will not have to be repeated
so long as she does not switch to a competing product.
In a consumer surplus comparison, a competing product would have to provide either a
higher WTP or lower P to offset the additional cost of training to use the new product. As
long as (WTP1−P1) > (WTP2−P2−T2), the buyer will continue to use the original product,
even if (WTP1−P1) < (WTP2−P2).
Optimal firm pricing strategy for products with switching costs can be tricky. This is
because getting new customers requires that (WTP1−P1−T1) > (WTP2−P2−T2). The
price that maximizes profits from established users may not be low enough to attract any
new users. In some cases, it may be beneficial to keep prices low to attract and “lock in”
new buyers; in other cases, it may be more profitable to charge higher prices and exploit
the experienced users.
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Chapter 9: Firm Boundaries
Boundary Decisions
Let’s consider the three types of boundary decisions:
Horizontal
Decisions about horizontal boundaries mainly pertain to increasing scale in a given
business. The firm increases the quantity of its output and/or consumers. This may refer
to adding varieties, but not to adding products. (The distinction between horizontal growth
and concentric diversification is not definitive, meaning the difference can be a very thin
line). Why grow horizontally?
a. The firm is advantaged and wants to leverage its advantage.
b. The firm’s industry is growing very slowly or declining – profits would be
buffered if industry capacity were “rationalized.”
c. In general, the industry would be more profitable with less competition among
firms.
Horizontal growth makes sense depending on the price. B and C above generate value
to ALL firms in the industry. If a firm overpays, and then shares the benefit with the entire
industry, this does not seem likely to be the right move.
Astute acquirers pounce when the industry is in “overreaction” mode – assets are being
sold at fire sale prices. As soon as the bottom is in sight, prices firm up – prices may
eventually enter the zone of overreacting in the other direction and assets become
overvalued. The window of acquisition makes all the difference – that is, how well a firm
chooses the timing of its acquisition relative to the “bottom” of the market affects its return
on the acquisition.
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Diversification
Concentric Diversification: A concentrically diversified firm is one that operates in one or
more different markets that are highly related or concentric, producing outputs that are
related on the production and/or consumption side. Pepsi’s beverage business and its
snack food business share some common inputs (print and media advertising) and many
of the same distribution channels. Hence, many would consider Pepsi and Frito-Lay to be
an example of concentric diversification.
Conglomerate Diversification: A conglomerate operates in one or more different markets
that are neither related in production nor consumption. Here a firm might operate in the
hotel space and sell car insurance.
Geographic Expansion: Here the firm enters a new geography and leverages its operating
expertise and/or its product mix.
In each of the above cases, a firm that diversifies is entering a new business. This
business may be related (concentric) or unrelated (conglomerate). Why diversify?
a. Economies of scope: Even if the business is different, the firm can leverage
some advantages that it has. While firms can always generate some story for
economies of scope, we are looking for substantive overlap here. Perhaps
being in multiple businesses makes it economical to make a big fixed
investment that generates a WTP or C advantage.
b. Capital market frictions: By reducing the volatility of its cash flows, the firm can
always fund NPV positive investments. The firm may prefer an internal capital
market to keep proprietary information from leaking out.
c. Other frictions: In general, conglomerates may be able to leverage big
investments in brand equity, connections, distribution, etc. If legal institutions
are weak, arm’s length12 transactions are risky. Hence, the firm may do better
by owning all the necessary assets to produce and access the market.
12
Arm’s length refers to transactions between firms as opposed to transactions within a single firm.
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d. Information frictions: By being in many businesses, a firm resists the temptation
to cut corners in one business for fear that bad press will spill over and tarnish
its other businesses – size is a signal of quality.
e. Human capital frictions: Level earnings reduce employee risks – it is less likely
the firm will need to lay people off or cut wages.
Hence, diversification is often a way to contend with frictions. The less the firm “over pays”
the less damage diversification does.
Vertical
This is the most interesting boundary decision from a strategic standpoint. Decisions
about vertical boundaries concern which steps in the vertical chain to conduct in-house
and which to outsource. When Pepsi bought bottlers, it was a vertical move (forward
integration). When Campbell’s began making cans, it was an example of backward
integration; in effect, Campbell’s became its own supplier. Through vertical integration,
the firm may be able to make dramatic changes to its business. There is thoughtful as
well as thoughtless vertical integration. For example, sometimes activities integrate
simply because one firm wants to “have control,” or for “assurance of supply,” or other
such platitudes. There is no reason to integrate unless through integration the firm is able
to expand the WTP-C wedge in a way that it could not if it did not own the assets above
and/or below it in the vertical chain. Let’s explicitly address the fallacy of “buying to avoid
paying a markup for an input.” To see the flaw in this way of thinking, suppose an input
costs c to make. Firm A pays p1 to buy it and pays no other costs to produce. Firm A then
charges p2 to its suppliers for its output. Total (joint) profits without integration: (p2 – p1)
+ (p1 – c) = p2 – c and total profits with integration: p2 - c. Firm A ends up paying (p1 –
c) per unit to buy the other firm – that is, Firm A pays the price either way! There’s no
synergy here. The supplier either earns rents on each unit or earns the rents on an NPV
basis when it sells itself to Firm A. Shareholders are no better off. For integration to be
justified, shareholders have to be better off in a way they could not accomplish unless the
two firms integrated.
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Now let’s try to convey how vertical integration can generate returns to investors that they
could not accomplish through diversifying their portfolio. Below is a silly, but simple
example:
Two activities, A and B, are vertically related. A makes widgets and B makes
cookies (my dogs’ names are Widget and Cookie). Should these two activities be
integrated into a single firm? The key question is whether one of these activities
generates externalities13 that impact the other (positively or negatively) when it
independently maximizes its own profits. For example, let’s say that cookie
production is difficult to scale – so on the margin, growing margin (P-C) is more
attractive to managers than driving volume (V). On the other hand, if widgets have
a very high margin, then it is a fair guess that A prefers driving V. These two
activities separately may have “vertical misalignment” – if they integrated, the
division that makes cookies would see its profits FALL but this deficit would,
hopefully, be more than made up for by an INCREASE in profits in the widget
division. They could not achieve this outcome through arm’s length negotiating –
why would the business making cookies agree to cut its profits? This misalignment
is an example of a generic category of costs transacting with another firm – called
generally TRANSACTION COST. Whether the cookie business generates a
positive or negative externality on the widget business when it is separate and
seeks to maximize its profits is irrelevant – what is relevant is that through
combining, a bigger pie is possible. By combining both activities into one firm,
optimal JOINT decisions can be made – a single firm may be able to make more
profits than the sum of these two businesses separately – it is irrelevant whether
profits grow because a negative externality is avoided or a positive externality is
amplified.
Another issue with transactions between two separate businesses is the risk of “hold-up”:
what if the business that makes cookies has to alter its plant to accommodate the needs
13
In economics, an externality (or transaction spillover) is a cost or benefit, not transmitted through prices
incurred by a party who did not agree to the action causing the cost or benefit. A benefit in this case is
called a positive externality or external benefit, while a cost is called a negative externality or external
cost.
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of the widget business? Once the alteration is done, what if the widget business
announces it will pay the cookie business less than it originally promised?
Finally, what if the widget business learns a lot of the cookie business’s proprietary knowhow when they transact with each other – this knowledge leakage puts the cookie
business at risk.
In general, transaction costs, risks of hold-up and risks of losing valuable IP may keep
businesses from jointly creating value. Through integration, these businesses can focus
on creating value without the risks associated with arm’s length transactions.
In evaluating whether activities A and B should merge, we should apply the simple rule:
We want it to be true that p(A+B) > p(A) + p(B). We should be very specific about what
the synergy between activities A and B might be, and also consider any additional costs
that might be incurred if the two activities are done within the same firm.
Growth Through Acquisition14
The Impetus to Grow
That firms face the pressure to grow is beyond a platitude – “even if you are on the right
track, standing still means certain death because you get run over.” Publicly traded firms
may face more intense pressure to deliver revenue growth than privately owned
companies for a variety of reasons. We will begin by speculating as to what these reasons
may be:
1. Growth can, in fact, be a good litmus test for whether the firm is advantaged. If the
industry is growing, the firm should be growing because:
•
Its customer base is growing at least as much as the industry on average –
that is, we want to see that the firm is not relegated to a shrinking segment
of the market.
14
Stern MBA Class of 2009 Vikram Bhaskaran prepared this M&A section of Strategy Essentials under the
supervision of Professor Sonia Marciano
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•
The firm is at least as efficient as the average firm – that is, other firms are
not, on the whole, producing more efficiently and thereby able to undercut
the firm on price.
•
The firm is offering new customers entering the market sufficient buyer
surplus and is, therefore, able to win its share of the market, if not an
increasing share of the market. That is, the firm is not showing a deficiency
on the WTP side of the wedge.
2. Pressure to grow is generated by shareholders. Investors want to profit from the
firm and the larger the firm, the greater the returns.
3. Equity analysts often use metrics correlated with growth to track the firm – even if
the metrics are not perfectly correlated with value creation, managers are
pressured to manage to these metrics.
4. Growth pressure can come from within firm management. Executives feel the
desire to grow and expand in order to, ultimately, face more opportunities
themselves (managing more revenues generally means more opportunities for
managers in terms of inside and outside options).
5.
Growth provides a “buffer” for management/strategic missteps – a growing
environment is a less stressful one to work in.
6. Managers and investors are “overconfident” about the likelihood that revenues turn
into profits.
The Evidence
McKinsey & Company studied the 100 largest companies in the U.S between 1994 and
2004 (two economic cycles) across two dimensions: Total returns to shareholders (TRS)
and growth. They found that growth matters both to firm survival and to long-term survival.
Firms that exhibited growth rates lower than GDP in the first economic cycle were five
times more likely to disappear altogether than firms that grew rapidly in the first cycle;
firms with above-average revenue in the first cycle were more likely to exhibit aboveaverage TRS in the next cycle. In short, the “grow or go” philosophy is hardwired into the
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fabric of modern corporations.15 That said, the “undisciplined pursuit of more” is
apparently more characteristic of firms in decline.16
Types of Growth
There are two types of growth: organic growth and inorganic growth. Organic growth can
be broken down into two components: growth of the specific segments in which the firm
operates (portfolio momentum) and the firm’s relative market share performance (the
difference between firm growth rates and relevant segment growth rates). Inorganic
growth is typically synonymous with M&A. McKinsey & Company studied 416 companies
between 1999 and 2006 and found that the average large firm in their dataset grew at
10.1 percent per year over the period. As seen below, most of this growth can be
explained by portfolio momentum and M&A.
Figure 22 - Breakdown of CAGR 1999-2006
Source: McKinsey & Company, Granular Growth Database
15
16
“The Granularity of Growth,” Patrick Viguerie, Sven Smit, Mehrdad Baghai
“How the Mighty Fall,” Jim Collins
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excess leverage can potentially cause future pain, I would argue that the current M&A leverage and resulting high va
istic response to the “new normal” of very low interest rates. So long as rates stay low, current valuation levels can ho
Growth through M&A
How does M&A fit into this picture? We’ve written previously about the high valuations seen for profitable middle mar
anies over the past couple of years. While PE valuations dropped from their 2013 highs, valuation multiples remained
Mergers
and
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are Treasury
arguably yields
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have
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to
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and
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seen.
2013-2014
leverage
investment and are a “go to” way to grow the firm. The following diagram summarizes
not seen even at the 2007 peak.
M&A deal flow across the nearly 30 years. While the value of M&A deals is cyclical, the
volume of deals follows a more upward trend. A merger is the (usually friendly) joining of
ould argue that, far from being in a bubble phase, M&A has not fully recovered from the effects of the financial crash w
two independent companies to form a combined entity. Generally, two mergers
volume and deal value still below 2007 levels. After a long upward run from 1985 to 2000, the M&A market suffered a
companies
are9/11,
of comparable
An acquisition
refers to trend
the purchase
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(not the global M
ing the Dot Com
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but quicklysize.
recovered
to its longer-term
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firmbelow
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Thetrend
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moved sideways
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is now of
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urrent market could
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catchall.
Figure 23 - Global M&A Deal Volume and Value (in $ Billions), 1985-2014
Global Announced Mergers & Acquisitons 1985-2014
e: IMAA; Thomson Financial
Essentials
134
are signs thatStrategy
the M&A
market could be improving. Dealogic reported that Q1 2015 global M&APage
volume
was the stron
2007. This coincides with our observations in the market. Perhaps this is the year when the dam finally breaks and th
et moves back to last decade’s heady levels. If it does, we could have a good run. That’s critically important for the gro
Types of Combinations and Rationale Behind M&A
From an economic standpoint, mergers can be horizontal, vertical, or diversifying (also
called scoping or lateral growth, conglomeration, etc). Horizontal mergers involve firms
operating in similar businesses (e.g., Chevron, Texaco). Vertical mergers occur in
different stages of production operations (e.g., a cola concentrate maker like Coke buys
many of its bottling operations which were formally separate firms) and conglomerate or
lateral mergers involve firms in different business activities (e.g., GE acquisitions back in
the 1980’s).17 Diversifying mergers range in degree of relatedness to the so-called “core”
business. If food company A buys food company B and B operates in a category of food
that A was not in before, we would call this “concentric” diversification or scope expanding.
If a firm that made engines bought a firm that made diapers, we would call this
conglomeration. However, the three labels: horizontal (more of the same), vertical (buying
above or below the firm along the value chain) and diversifying (entering a new business)
provides a sufficient taxonomy of combinations that occur among firms.
The high level (and justifiable) rationale for M&A is to use the firm’s access to capital to
grow profits as least marginally better as shareholders collectively could if they were
handed the money to reinvest as they saw fit. The table below contains broad objectives
the firm may be pursuing through its M&A plan:
Primary Objective
Example
Enter an attractive industry or
segment
Deepen, or invest in the, firm’s
current “monopoly” position in
the market in which it operates.
Firm discovers an opportunity in a business in which there is low investment
relative to the size of the opportunity.
Suppose a luxury goods designer faces a very competitive market for good
designers. While paying competitive salaries is a given, designers might
distinguish design houses by which ones have superior access to the best
inputs. Integrating into inputs to attract the best designers could be considered
an investment in the firm’s market monopoly position in design superiority.
Disney’s entry into Broadway was a means for Disney to increase its earnings
from its library of content.
To “exploit,”,monetize, or more
effectively commercialize the
firms market or segment
“monopoly.”
To increase utilization of the A firm might grow the number of CPG (consumer packaged goods) categories it
firm’s assets & capabilities. is in to take advantage of excess capacity it has in its distribution system.
Exploit excess capacity in 1 or
more of the existing value
chains
17
“Mergers and Acquisitions,” J. Fred Weston, Samuel C. Weaver
Strategy Essentials
Page 135
The first objective listed in the table above is considered a “portfolio” move – adding a
good business to the firm’s existing footprint. However, the three other objectives are
referred to as the pursuit of “synergy.” Broadly speaking, synergy is used to refer to
strategic and operational improvements that yield financial benefits when a firm partakes
in M&A, i.e., where sum of the profits of the combined firms is greater than the sum of the
profits of both firms individually. More simply, it is the increase in competitiveness and
resulting cash flows beyond what the two firms were expected to accomplish
independently.
When an acquirer pays a premium for a business it has to meet the performance targets
that the markets already expect and the even higher targets implied by the acquisition
premiums. Expected growth and future profitability are already embedded in the share
price of both businesses – adding synergy means creating value that not only does not
yet exist but is not yet expected.18 Below is an exhaustive list of articulated reasons for
why firms partake in M&A activity through the lens of strategic, operational, and financial
synergies.
List of Potential Strategic Synergies
•
Access to capabilities/know-how: A firm that wants to compete more effectively
in an existing market might lack certain capabilities to do so and might acquire
a firm with the requisite set of capabilities; allowing the acquiring firm to
“leapfrog” the process of internal capability building. This is an especially
common stated rationale in R&D-intensive and technology-centric businesses.
•
Access to new markets: A firm might want to enter a new product /geographic
market by acquiring a firm operating in that market.
•
Access to customers: A firm might acquire another firm based on the
attractiveness and revenue-generating potential of the target firm’s customer
base. A firm might do this to cross-sell new products to this customer base or
improve on the existing customer value proposition.
•
18
Elimination of competition: Tempered by the regulatory constraints of monopoly
“The Synergy Trap,” Sirower
Strategy Essentials
Page 136
rules, many M&A deals allow the acquirer to reduce existing and future
competition (increasing barriers to entry for an incumbent player) and gain a
larger market share by acquiring a smaller competitor.
Operational Synergies
•
Economies of scale: Economies of scale refer to the reduction in unit cost
achieved by producing a large volume of a product. In the context of M&A the
larger combined firm has the ability to reduce operating costs by gaining scale
in areas such as production.19 However, there could also be “demand side”
economies – some reason why the customer benefits from buying from the firm
producing a larger volume of the output. For example, air travelers benefit from
buying air travel between a city pair from the airline with the largest number of
departures between these cities. The airline that offers customers the best
choice of departures times will likely face higher demand within that city pair.
•
Economies of scope: Economies of scope can refer to efficiencies where
combined firms are able to better utilize distribution channels and marketing
efforts. Industry consolidation can also compel firms to merge in order to take
advantage of economies of scale/scope to survive and compete profitably – as
was the case with pharmaceutical companies.20
•
Economics of vertical integration: When a firm purchases up or down the value
chain, it might be able to better control the quality of the output or the unit cost
of producing that output.
Financial Synergies
•
Hedging (Diversifying cash flows): The firm might diversify or integrate into the
production of its inputs in order to level cash flows. While other firms have low
cash flow in certain periods (for example, when input prices are high), the
diversified or integrated firm would tend to have more level cash flows. The
reason to take such dramatic measures as buying new businesses to level (vs.
19
20
“Intelligent M&A, “ Scott Moeller, Christopher Bra
Ibid
Strategy Essentials
Page 137
actually grow net) cash flows is if, for example, industry cash flows tended to
decrease at the same time opportunities to acquire valuable strategic assets
were high. Hence, the firm in the industry whose cash flows were level would
be more able to take advantage of buying strategic assets at the right time and
at the right price.
•
Optimizing capital structure: Due to market inefficiencies, M&A may allow for the
cost of capital to be lowered and debt capacity increased if a combined firm is able
to avail itself of lower borrowing rates. Other financial synergies might include
generally better cash management, lease terms, management of working capital,
etc.21
•
Tax Advantages: Past losses of an acquired subsidiary may be able to be used to
minimize present profits of the parent company and thus lower tax bills. Thus, firms
may have a reason to buy firms that have accumulated tax losses. However, the
Federal government has instituted numerous restrictions regarding tax-loss
mergers and their popularity is on the decline.22
Research on M&A also focuses on the psychology of mergers where the unit of analysis
is not the firm but the individual managers that drive M&A activity. Research suggests
that manager hubris, empire building, and a desire for increased status, power and
remuneration are some of the underlying reasons for M&A.23 Because it is impossible to
diversify human capital risk at the manager level, this school of thought also suggests
that managers diversify their own risk by growing their organizations through M&A. That
is, since a multi-business firm will generally face less earnings volatility, the managers of
the firm might prefer to be on a more stable “ship.” The point here is that managers like
“smoothness” even if the M&A does not increase the value of the firm – perhaps even if
the M&A decreases the value of the firm!
21
“Valuation for M&A,” Frank C. Evans, David M. Bishop
Ibid
23
“M & A,” Jeffrey C. Hooke
22
Strategy Essentials
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M&A and Value Creation/Destruction: Evidence of Post-Merger Profitability
Depending on the source, acquiring firms fail to capture value 50%-75% of the time while
target firms get about 15%-30% of the premium on the pre-existing value of the firm. The
failure of M&A is typically determined by comparing stock prices before and after
acquisition announcements and by compiling anecdotal evidence from business
executives during the process. If you were to read all academic research papers on the
topic of M&A, you would likely develop the impression that M&A tended to destroy
shareholder value for the shareholders of the acquiring firm. But you would also see that
there is a lot of variance around that expectation. There are great deals and there is no
real consensus among practitioners, consultants, academics, and business executives
about the exact percentage of failures, there is some consensus about the root causes
behind M&A failure. In fact, failure is difficult to “prove” as we would need a parallel
universe to know how the shareholders of the acquiring firm would have faired if the
managers did not engage in the M&A – perhaps value of shares of the acquiring firm
would have fallen more without a deal. The important point is that good deals and bad
deals are possible. Hence, the important skill is to be able to distinguish potentially good
from likely bad deals and to be able to execute the merger or acquisition in a way that
optimizes the outcome.
Two schools of “failure” or bad outcome analysis exist. There is empirical performance
literature that focuses on explaining the variance in acquiring firm performance based on
the premium paid, and there is post-merger integration literature that (largely anecdotally)
explains potential problems with integration.
Premium School
Acquisition premiums can be as high as 100% of the market value.24 In this school of
thought it is believed that the premiums firms pay to acquire other firms are systematically
excessive and therefore set up acquisitions to fail from the point of view of the acquirer
by essentially giving away the value of the “synergies” to the shareholders of the target
firm. The takeover premium here is defined as the amount an acquiring firm pays for an
24
“The Synergy Trap,” Sirower
Strategy Essentials
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acquisition that is above the pre-acquisition price of the target. In this worldview, the larger
the premium paid for an acquisition, the worse the subsequent returns for the acquiring
firms.25 Also within this school is the possibility that the acquirer engaged in poor due
diligence – the acquirer believed it was acquiring strategic assets that the target did not,
in fact, possess. Along similar lines, the acquiring firm might have overestimated the
degree of strategic fit between its existing assets and the assets it was acquiring. This
issue blends with the second school of thought on M&A failure…
Post-Merger Integration School
Most surveys of corporate executives tend to highlight the execution of post-merger
integration as the dominant source of deal error. A survey of M&A executives conducted
by the Corporate Strategy Board showed that 60% of surveyed executives rank
integration as the source of value detraction. The main argument made is that the
strategic intent of the acquisition is lost in integration and that integration synergies are
harder to realize than expected. Within this school of thought, analysts view clashing
corporate “cultures” as one of the most significant obstacles to post-merger integration.
In fact, a cottage industry has emerged to help firms navigate the rough terrain of cultural
integration. However, according to Wharton M&A expert Sikora, “Culture integration is
certainly important, but it's always the excuse when something doesn't work out."26
Integration Approaches
Seasoned acquirers develop “integration playbooks” which outline specific set of
processes, people, and resources required at every stage of integration. Conceptually, it
is useful to think of integration in terms of strategic interdependence and organizational
autonomy.27 More simply, the sources of value capture combined with the degree of
autonomy required to capture the value will determine the size and scope of the
integration efforts.
25
Ibid
http://knowledge.wharton.upenn.edu/printer_friendly.cfm?articleid=1137
27 “
Managing Acquisitions: Creating Value Through Corporate Renewal,” David B. Jemison, Philippe C.
Haspeslagh
26
Strategy Essentials
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Strategic Interdependence
The degree of strategic interdependence is driven by expected value creation across a
range of areas:
•
Resource Sharing: Value created by combining the firms at the operating level.
•
Functional Skills Transfer: Value created by moving people or sharing
information, know-how, and knowledge.
•
General Management Skills Transfer: Value created through improved insight,
coordination, and control.
•
Combination Benefits: Value created by leveraging cash resources, excess
capacity, borrowing capacity, added purchasing power, or greater market
power.
Organizational Autonomy
The degree of autonomy that the acquirer gives the new target firm can be determined
by asking three simple questions:
•
Is autonomy integral to preserving the strategic capability bought?
•
If so, how much autonomy should be allowed?
•
In which areas is autonomy important?
Depending on where firms fall on both axes, four types of integration approaches
emerge28:
28 Haspeslagh, C.P. and Jemison, J. (1991) Managing Acquisitions-Creating Value Through Corporate Renewal. New York: The Free Press
Strategy Essentials
Page 141
Table 9.1 - Need for Strategic Interdependence (based on Haspeslagh and Jemison)
1. Absorption. The acquirer subsumes the acquirer into its existing structure. This
typically happens when a large firm acquires a smaller competitor to gain scale.
The objective in absorption acquisitions is to decompose all the boundaries
between the two organizations, which could potentially happen over a long time
period. This approach is positively related to the acquirer buying tangible or
intangible resources that are non-people dependent.29
2. Preservation. The target firm is run as a discrete entity. This occurs when the
acquired firm has a high need for organizational autonomy and the two firms
have a low need for strategic interdependence. Thus is common when the
strategic rationale for acquisition is a form of diversification. For example, the
preservation approach is common in cross-border M&As, due to the need of
local market adaptation, which the acquired company has relevant local
knowledge.
3. Symbiosis. In symbiosis, a substantial transfer of assets and capabilities has
to take place, while simultaneously, the assets and capabilities of the acquired
firm has to be preserved. That is, while there are synergies to be exploited,
29
“Strategic capabilities and knowledge transfer within and between organization,” Arturo Capasso,
Giovanni Battista Dagnino, Andrea Lanza
Strategy Essentials
Page 142
there are distinct aspects of the target to be preserved such as brand equity, a
set of talent with a “hot hand,”, a corporate identity that attracts talent, etc.
Hence, symbiotic acquisitions start like a preservation deals whereby the
acquirer and target start out by co-existing. The firms gradually deepen the
degree of integrate and interdependence. Symbiotic acquisitions result in both
boundary preservation and boundary permeability. For obvious reasons, these
deals require the most managerial finesse.
4. Holding. This approach takes place where there is a low need for strategic
interdependence and at the same time a low need for organizational autonomy.
Here the intention is not to integrate and value is created by financial transfers,
risk sharing, or general management capability.
Integration Challenges
A Watson Wyatt study noted that cultural incompatibility is consistently rated as the
greatest barrier to successful integration, but research on cultural factors is unlikely to be
an aspect of due diligence,30 and cultural issues are rarely factored in when deciding to
acquire another firm. Cultural challenges manifest themselves in the following areas:
Leadership
One firm’s executives may favor a command-and-control style, whereas leaders at the
other firm may prefer a more hands-off approach. Every firm’s leadership style can seem
unique. Senior leaders have different motivational styles and the resulting friction often
creates additional risks. Firms that ignore cultural issues as they relate to leadership
styles sometimes destroy much of the merger’s potential value in the process.
Governance
Effective corporate governance must encompass the way decisions are made in each
part of the firm and across organizational boundaries. This includes the work of such
governing bodies as program management steering committees, councils that oversee
30
“Mergers and Acquisitions from A-Z,” Andrew Sherman
Strategy Essentials
Page 143
the work of support functions, corporate governance boards, and even new product
development committees. Integration issues are compounded by competing governance
structures.
Communication
Communication is critical during a merger given the inherent uncertainties on the part of
employees and customers. However, communication styles vary widely among firms, and
what has worked for one may not work for another. Attitudes about confidentiality,
preferences for formal versus informal channels, and the frequency of communications
may all come into play. With employees in particular, insufficient, or inconsistent guidance
on such key issues as organizational restructuring, customer relations, and changes in
financial policies can create unnecessary business risk.
Business Processes
The ways in which the acquirer and the target develop, update, and enforce core business
processes must be understood and respected during the integration phase. Change in
the way a firm handles these tasks as a result of integration requires strong leadership,
supported by careful and frequent communications to verify that employees, customers,
and vendors understand and accept these changes. If changes in core business
processes and process interdependencies are not deliberately and systematically thought
through and addressed adequately during the integration planning phase, firms risk
internal breakdowns in the quality of products and services and may provide incorrect or
untimely data to customers, suppliers, and service providers.
Strategy Essentials
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Performance Management Systems
Differences in the way the acquiring and target firms evaluate and reward employee
performance are important and, if overlooked, can lead to morale issues, undesired
turnover, inconsistent performance and a decline in employee productivity. Thus, merger
integration plans should include efforts to harmonize performance metrics and
compensation systems, while explaining important differences as necessary. Newly
merged firms must help employees understand that their different recognition and reward
systems are fair, even if not always uniform, across the entire newly combined
organization.31
Successful Acquirers
While failure is hard to study objectively, there are firms where M&A expertise and
excellence has become a competitive advantage in its own right. Several key factors that
characterize successful acquirers include:
Timing
According to Bain & Company analysis of more than 24,000 transactions between 1996
and 2006, acquisitions completed during and right after the recession from 2001 to 2002
generated almost triple the excess returns of acquisitions made during the preceding
boom. ("Excess returns" is defined as shareholder returns from four weeks before to four
weeks after the deal, compared with peers.) This finding held true regardless of the
industry or the size of the deal. Moreover, firms that acquire in bad times as well as in
good outperform boom-time buyers over the long run.32 McKinsey & Company says that
of the potential strategic moves a firm can take to grow in a downturn – divest, acquire,
and invest to gain share – an effective acquisition strategy (defined as growth through
M&A at a rate higher than that of 75 percent of a firm’s peers) creates the most significant
31
32
“Avoiding post-merger blues,” Bearingpoint, 2008
Thompson Datastream, Thompson Financial, Bain Analysis
Strategy Essentials
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value for shareholders. During an upturn, on the other hand, divestments create slightly
more value than acquisitions do.33
Treatment of Acquisition as a Competency
Successful acquirers, such as GE and Pepsi, approach M&A as if it is a process such as
supply chain management and not as a one-time event. They codify their earnings across
each acquisition and have a systematic and well-articulated “M&A Playbook.”
Proactive vs. Reactive Acquisitions
For successful acquirers, acquisitions are not seen as a stand-alone strategy but instead
a tool to fill strategic holes (such as diversifying an asset profile or expanding a geographic
footprint) that cannot be filled as efficiently on an organic basis. The connection between
successful acquirers and their adherence to an overarching strategy is also borne out by
the fact that none of the successful acquirers acquired firms for defensive purposes – that
is, to block a competitor. For these firms, it appears that M&A strategy is proactive rather
than reactive.34
Early Involvement of Business Units
Oftentimes, business unit executives (who are charged with integration) are not involved
in the due-diligence phase of the acquisition. M&A teams that identify synergy
opportunities without significant participation by the relevant business units can engender
resentment and bring about charges that the team is setting unattainable targets. Many
rewarded acquirers therefore say that having business units lead the entire process for a
bolt-on acquisition can dramatically improve estimates of synergies and the likelihood of
capturing them.35
33
“M&A Strategies in a Down Market,” McKinsey Quarterly, 2008
“Growing through Acquisitions,” BCG, 204
35
“Habits of Busiest Acquirers,” McKinsey Quarterly
34
Strategy Essentials
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Mergers and Acquisitions: A sensible strategic choice or poor management?
Mergers and acquisitions have long been a part of corporate life. M&A has actively been
encouraged as a healthy manifestation of the free market economy. As discussed above,
M&A is pursued with the intent of expanding the firm’s boundaries. For a firm with a priority
to create economic profits, M&A often arises because of a belief that organic growth is
too expensive or won’t take place fast enough.
In considering M&A, it is important to consider the cost to complete a transaction and the
likelihood of synergies. It is also critical to understand the market dynamics. For example:
How important is this new market? What is the current cycle in this market and how do
asset prices compare to historic values? If we do not enter the market, what will our
competition do? Can we create value from this transaction? What is the maximum we can
afford to pay and what are the likely synergies?
Alternatives to Mergers and Acquisitions
Inorganic growth can be created from options other than M&A. Joint-ventures and
alliances have been created by firms as ways to create a position in a market. These
structures are usually legally complex, but can be valuable where a deal is too expensive
or where delaying in order to gain more information is valuable.
In Sum:
Often, transaction documents are fairly thin on analysis. In the “real world” deals are often
decided, and then subsequently analyzed in a way to justify the acquisition decision.
Here, let’s imagine for a moment that we are charged with putting together a deal
presentation that would be used to help us generate a decision about whether we should,
indeed, integrate. Should we also evaluate how to best integrate? Given the expected
costs and benefits of integration, what qualitative factors affect the appropriate price to
pay for the acquisition? Consider a deal presentation that addresses at least the five
following points:
Strategy Essentials
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1. A Fact-Based Assessment of the Potential for Revenue (Demand-Side)
Synergies or Cost-Side Synergies (Economies of Scope)
With each boundary decision, three groups of synergies may exist:
a. Coordination: Reducing transaction costs
•
Vertically-related production facilities working together to coordinate product
flows (e.g., paper mill located adjacent to a pulp mill).
•
Winery experimenting with grape growing to better match criteria for the wine
being produced and demanded.
b. Leveraging Power: Using size as a source of power over suppliers and buyers
•
Cross-Selling (Cost) – Selling multiple products through common promotions,
channels, and/or sales force (e.g., service contract with appliance sale;
merchandise offers in credit card statements; coupons for chips with soda).
•
Increasing concentration to reduce rivalry – Generating more market power and
higher prices. But:
o Can my firm grow large enough relative to the market to have an effect?
o Will too many of the benefits spillover to my competition?
•
Manufacturer-owned distribution – Using manufacturer-owned distribution
channels to influence market prices and as a source of information on
competitors and end customers. Note: if a firm also sells to independent
channels, there is potential channel conflict and negative synergy. Some
potential customers may eschew doing business with a firm to avoid being a
source of profits for a competitor.
Strategy Essentials
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c. Sharing Assets: Reducing costs through economies of scale or scope
•
A plant produces end products for multiple businesses (e.g., auto assembly
plants producing cars and small SUVs on the same line).
•
A manufacturer produces components that are used in a variety of different
products (e.g., diesel engines used in generators and earth moving equipment).
•
A firm undertakes an R&D project on an enabling technology that benefits
multiple businesses (e.g., GE’s breakthroughs in material sciences benefit
medical device, appliance, jet engine, and gas turbine businesses).
It is important to note that some analysts believe that managers may have motivation to
expand firm boundaries aside from creating shareholder wealth through the exploitation
of synergies. Expanding boundaries is often self-serving to managers by way of:
•
Raising their profile and compensation
•
Diversifying their job risk
Table 9.2 - Synergies
Horizontal
Vertical
Diversification
Expanding into new
geographies
• Reduce negotiations
• Timing and size of
production batches
• Input attributes
•
•
•
•
Leveraging
Power
• Over input suppliers
• Over customers
• Over input suppliers
• Over input suppliers
• Over customers
• Strategic presence in
multiple markets
Sharing
Assets
• Corporate overhead
• Equipment
• Corporate overhead
• Capital budgeting
• Corporate overhead
• Knowledge across
business units
Coordination
R&D
Innovation
Marketing
Promotions
Keep in mind that it is easy to wax poetic when it comes to identifying potential synergies.
Synergies are only interesting if they generate returns for investors that are not actually
possible without the integration of the two firms.
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2. A Fact-Based Assessment of the Potential for “Dissynergies” Among a Firm’s
Core or Existing Business(es)
Firms often try to manage risk by managing their boundaries. These firms may manage
boundaries organically (internal growth), or inorganically (through mergers and
acquisitions and other transactions in the market). Often, synergies do not materialize in
the expected magnitude. And too often, overlooked challenges arise to the detriment of
optimistic managers.
Table 9.3 – Challenges
Horizontal
Vertical
Coordination
• Low total product
demand
• Culture clash
• Loss of market
pressures reduces
discipline for in
house production
Leveraging
Power
• Buyers and
suppliers resist
pressures, learn to
respond
• In house activities
may compete with
partners, draining
goodwill
Sharing
Assets
• Firms overestimate
fit, and infrastructure
becomes strained
• Costs rise as firm
loses ability to
specialize
Diversification
• Transfer pricing
culture emerges
• Businesses are less
related than hoped
• Buyers, suppliers
competitors resist
pressures, learn to
respond
• Firm overestimates
fit, and infrastructure
becomes strained.
Firm overestimates
applicability of know
how to new
businesses
3. Alternatives to Integration
It is worth considering whether Firm A could simply make a deal with Firm B to have the
independent Firm B offer its services to Firm A’s customers. Possible reasons why such
an arms-length transaction may be difficult:
•
Transactions costs: If the benefits accruing to Firm A’s customers from
including Firm B’s features are not transparent, it may be difficult to agree on
Strategy Essentials
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an appropriate price for the service. This could potentially complicate the
contractual process, leading to additional costs to the system. In general, the
revenue model Firm B may prefer could potentially generate a negative
externality on Firm A (this is the “first derivative” issue – what if one prefers
margin and the other prefers volume?). Compare this to the situation where the
two firms integrate; in such a case, the CEO could decide that one division
should sacrifice some profitability so that the other division gets a
disproportionate benefit.
•
Hold-up: This could be a problem if Firm B needs to make specific investments
to offer its service to Firm A’s customers and the terms of the contract are hard
to specify or agree to (as discussed above). In addition, Firm B may be
justifiably concerned that specific sunk investments could be rendered useless
since Firm A could switch to an alternative supplier ex post. If this generates a
coordination failure, integration may be the only viable option.
•
Proprietary information: If there has to be a technology transfer between the
two firms in order to sufficiently coordinate a seamless experience for the
customer, this could cause the proprietary information of one or both firms to
be compromised.
4. Might Firm A Be Better Suited to a Target Other Than Firm B?
5. Specific Implementation Advice
•
Maximizing the value of the synergy
•
Minimizing the potential for dis-synergy
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Chapter 10: Externalities and CSR36
Why Is CSR Part of a Strategy Course?
Corporate social responsibility (CSR) has many different interpretations. Loosely, the
term embraces ethical and fair business practices, creating a safe workplace, promoting
gender neutrality, and diversity. More broad connotations include philanthropic endeavors
supported by the firm and its employees. However, strategic corporate responsibility
brings heightened meaning to “doing good and doing well.” Generally, it is fair to ask
“What is the obligation of business to the society in which it operates?” Ultimately, every
activity in the value chain will affect social factors in the locations where the firm operates.
While these impacts can be positive or negative, CSR is concerned with addressing the
negative spillovers.
Although firms benefit society (without firms there would be no prosperity), their
underlying motivation is monetary profits, not altruism. Frequently, firms can enhance
profits by “shifting costs” to society – for example, a process that creates more pollution
may come at a lower cost. Similarly, shifting from a labor intensive to a capital intensive
process can increase margins, but will also generate unemployment. Firms can also
enhance profitability by engaging in behavior that amounts to expropriation. For example,
the “hidden fees” of cellular and banking services. The externalities of a firm’s profit
maximization will affect the firm's net contribution, as well as public perception. Perception
could impact WTP (consumers may engage in boycotts) as well as future operating costs
(the firm may ultimately diminish its operating context, or regulators may impose
constraints). Hence, considerations of how to reduce externalities and manage the
perception of the firm's activities can be an important part of firm strategy.
36
This Chapter was prepared with significant insight and assistance from Scott Osman (NYU Stern EMBA
2009), Francine Blei (NYU Stern EMBA 2010) and Amad Shaikh (Wharton EMBA 2010).
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Why Should a Firm Be Concerned with CSR when Its Net Contribution to Society
Is Positive?
While society benefits from profitable enterprise, a firm's net benefit to society does not
necessarily increase directly with profits. Economists would argue that some production
decisions are not “first-best”37 – in other words, society loses more than the firm gains in
profits. This is certainly plausible when the firm engages in fraudulent, deceptive, or
outright incompetent behavior. Few would disagree that firms should be constrained from
engaging in such value destruction. But what about activities that generate profits while
producing smaller, but nonetheless, palpable negative externalities? In the age of Internet
and instant communication, firms find themselves dealing with an increasingly wellinformed public. Public awareness often means that firms that cause negative
externalities face the risk of social feedback that can hurt financial performance.
Firms engage in CSR to address that social feedback. Some CSR activities attempt to
directly mitigate the harm done by the firm (“junk food” maker reduces its fat content),
others attempt to offset the harm by contributing something positive (“junk food” maker
supports athletic programs). These examples of “remedial” CSR tend to increase the
firm's operating costs (sometimes a little, sometimes a lot).
Remedial CSR
Milton Friedman is often credited with making the case that it is the obligation of firms to
focus exclusively on profits. In a 1970 essay in The New York Times Magazine, Friedman
wrote:
That is why, in my book Capitalism and Freedom, I have called it
[social responsibility] a “fundamentally subversive doctrine” in a free
society, and have said that in such a society, “there is one and only
one social responsibility of business – to use its resources and engage
in activities designed to increase its profits so long as it stays within
37 The term "First best" is used by economists to distinguish between the "size of the pie" and the distribution of the pie (who gets how big of a "slice"). First best
suggests the size of the pie is maximized (for a given set of resources, constituents on the whole are made as well off as possible).
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the rules of the game, which is to say, engages in open and free
competition without deception or fraud.”
Would Friedman suggest that remedial CSR is “fundamentally subversive,” or a means
to defend profits by preserving/enhancing the firm's reputation? In the quote, Friedman
clearly disavows profitable but fraudulent, deceptive and, by extension, blatantly
incompetent enterprise. He also disavows corporate philanthropy – management giving
at its own discretion. What about the case of a firm operating within the “rules of the game”
but at the same time imposing negative externalities on society? It is fair to suggest that
Friedman would be supportive of CSR as long as shareholders were among the
beneficiaries in the long run.
The position taken here is that CSR at the expense of shareholder wealth is a slippery
slope. To what performance metric would we hold management accountable if
management is charged with serving the whole of society? The principle that
shareholders should be among the beneficiaries of CSR hardly diminishes the challenge
of developing a CSR agenda. Managers do not have a parallel universe against which
they can measure shareholder wealth derived from various levels and approaches to
CSR. Does erring on the side of caution mean that management should be vigilant in
protecting the firm's reputation and exposure to future liability? Or, as many interpret
Friedman, does caution mean that management should limit any spending of shareholder
wealth aimed at protecting the firm against vague and uncertain threats to reputational
harm or litigation that may loom somewhere in the future? In other words, is CSR akin to
“fighting imaginary enemies”?
In general, firms are increasing their attention and commitment to CSR. The current mood
is that the vague and ambiguous threats posed by the firm's own externalities on the firm's
reputation and ultimate liability are not imaginary. Firms now perceive more of an
obligation to not only “stay within the rules of the game,” but to take remedial action to
balance the harms they create. Oil companies clean up their oil spills, and chemical
companies that harm the public health make contributions to medical research efforts (in
addition to satisfying legal claims). On the other hand, the rules themselves have become
increasingly blurred and complex.
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One example is labor standards. In order to remain competitive, many firms have been
shifting production abroad to benefit from lower cost labor. Many cheap labor markets
have arguably lax labor regulations and subject workers to standards the firms' home
markets would not tolerate. Another example is lobbying. Firms are often directly involved
with promoting, and even drafting, the very rules and regulations that govern their
activities. Staying within the rules when the rules are unpalatable and/or influenced by the
firms themselves will hardly deflect accusations of corporate irresponsibility. The choice
firms currently face (e.g., cheap labor to remain competitive vs. operations which subject
the firm to financial peril in the long-run) has been a driver of CSR activism.
Firms find themselves being increasingly blamed by citizens, governments, and social
activists for causing a number of negative externalities. For example:
•
Structural unemployment caused by laid-off workers with industry-specific skills
•
Lowly paid workers who become reliant on socially financed assistance
•
Traffic congestion caused by heavy usage of public roads
Organized groups can exert influence through exclusion, such as boycotting products
from the “offending” firm. In recent times, firms have been held responsible for a widening
range of issues, and activists have become more sophisticated in generating awareness
and mobilizing action through the media. Furthermore, governments have employed a
wide range of responses, from regulation and restriction, to industry-specific taxes, and,
in extreme cases, privatization.
Remedial CSR agendas fall along a spectrum between topical appeasement and
substantive redress. Appeasement measures may include publicity campaigns,
sponsorship of community events, philanthropic contributions, or encouraging employees
to donate their time or money. Appeasement is distinct from “pure philanthropy” as the
basis is some return to shareholders. However, not much attention has been historically
paid to whether or not this premise is correct. Furthermore, firms may not want to offset
the potential efficacy of these activities by appearing self-serving. Measuring returns on
CSR would subject the firm to accusations that its motives were disingenuous.
Unfortunately, without direct ties to financial metrics, appeasement may often fall outside
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of the scope of pure profit-maximization. On the other hand, the dollars devoted to these
activities tend not to be big enough to provoke much of Friedman's (or Friedman’s ghost’s)
ire. But as constituents and feedback mechanisms have become more sophisticated,
“token-bribe-charity” initiatives by firms often fail to deflect criticism. In sum, appeasement
does not hurt much but it is not clear that it helps much either.
In the middle of the remedial CSR spectrum are programs such as selling environmentally
friendly products in addition to traditional products (e.g., hybrid automobiles). The benefit
of moving towards the middle and higher end of the remedial CSR spectrum is that
measurement is often not as confounded. It is reasonable and straightforward for a firm
to measure the profitability of a product offering. CSR qualifies as “remedial” (rather than
“strategic,” which is discussed below) if it reduces profits but raises the firm’s profile as a
“concerned producer” and, thereby, preserves the firm's reputation and, what some call,
its “license to operate.” Furthermore, in the course of participating in a market for “socially
responsible” products, the firm can point out and ponder the customer's own propensity
to express concerns about social issues while making purchases that suggest otherwise.
On the substantive end of the spectrum are solidly remedial activities. Here, firms address
problems directly, for example, by installing filters that reduce the polluting effects of
smokestacks. It is possible that the firm's costs and the negative externality decline
together, but this outcome is not the norm. Solidly remedial CSR is likely to raise the firm's
costs. The return to shareholders comes in the form of reducing the firm's future liability
and/or preserving or enhancing its reputation.
As information technology reduces the frictions of mobilizing social movements, firms are
increasingly forced to move towards substantive redress. Sometimes firms deal with
mediating organizations that monitor, rank, and report social performance. These
organizations act as information verification bodies (like the auditing function of
accounting firms) that allow private self-regulation.
Once firms embrace CSR it is difficult to “put the genie back in the bottle.” These activities
are, at the least, a tacit admission of guilt. We observe a good deal of variance among
managers in terms of their perception of what it means to have a “conservative” CSR
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policy. Managers have very different answers to the question: “Do we err on the side of
preserving the firm's reputation or the firm's return on capital?” While doing nothing is off
the table, “fighting imaginary enemies” shouldn’t be on the table either. A firm devoting
resources to remedial CSR needs to be cognizant of “crowding out” higher return projects
and/or raising its costs of operating thereby weakening the firm's competitive position.
Firms increasingly face global competitors, many of which are not under pressure to be
socially responsible. The “cognitive dissonance” of customers is a perpetual problem –
consumers indicate concerns, but are not willing to “vote with their dollars.”
Challenges aside, experience suggests that remedial CSR matters disproportionately to
the largest or most high profile firms in a given industry. Wal-Mart, for example, faces
tremendous scrutiny and bad press for labor practices that are not uncommon in the retail
industry. They claim “we're not the only ones,” or “it's right for our customers,” but scrutiny
and potential liability is thrust onto them nonetheless. When the future segment leader is
early in its life cycle, remedial CSR issues are tabled because future liability is uncertain.
But when the firm has matured, not only is growing more difficult, but externalities are
more recognized, so the firm faces a higher risk of social feedback.
A survey of corporate websites reveals that many firms devote a section of their website
to “Corporate Responsibility.” However, the definition of corporate responsibility varies
greatly, ranging from supply chain code of conduct, health and safety, nondiscriminatory
practices, environmental sustainability, responses to climate change, and communityoriented efforts. Several firms have a Corporate Responsibility section in their annual
reports and some firms have a corporate division devoted to Corporate Responsibility.
However, many firms limit their efforts to legally required policies, not altruistic or strategic
policies.
Strategies to maintain a “Context Focused” CSR profile include Marriott Corporation and
Cisco Systems, both of which provide a student trainee program that feeds the firm with
new employees oriented to their work standards, enabling the firm to extract benefit from
its outlays. While some firms identify socially responsible behavior as the backbone of
their firm – for example Tom's Shoes, Ben and Jerry's, Whole Foods, Patagonia,
Starbucks, and The Body Shop – others introduce programs as a response to negative
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publicity (e.g., pollution, oil spills, outsourcing to countries with cheaper labor, and
substandard working conditions) in an effort to garner goodwill and attract/maintain
customers. This “crisis management” is simply a form of damage control. “Cause-related
marketing” is popular, however its sustainability, other than providing a veil of social
correctness, is unclear. And in fact, consumers could be better served by donating directly
to these causes and receiving their own tax benefits from doing so.
Nonetheless, many firms pride themselves in maintaining a proper and upstanding social
image. The Corporate Responsibility Officer Organization (CRO) publishes an annual
Best Corporate Citizens List, which, for some firms, provides a “seal of approval.” It
appears, however, that there is a blurred line between ethical corporate governance,
corporate social responsibility, and strategic corporate responsibility. Intrinsic to the firm
one expects diversity, safety, etc. With globalization, the expectation is that these
business practices will be universal, thus not taking advantage of developing countries'
labor force and economies. With increased access to Internet and “real time” events,
negative exposure can quickly reverse a firm's successes.
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Figure 24 - Corporate Responsibility
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Strategic CSR
While remedial CSR is concerned with defending shareholder value, strategic CSR
focuses on investments that have clear social benefits while also producing positive
returns on capital. We began this section asserting that the net contribution of enterprise
to society is positive. What is different here? The key difference is the overtly “socially
positive” aspect of the investment. Without a doubt, firms and customers in western
economies are expressing interest in businesses whose outputs produce clear social
benefits, while not “crowding out” or coming at the expense of businesses devoted to
maximizing shareholder wealth.
Strategic CSR is the essence of the often-used phrase “doing well by doing good.” Highly
visible examples include Ben and Jerry's, Patagonia, and Seventh Generation. Some
household names, such as SC Johnson and DuPont, have also made firm-wide decisions
that social enterprise is worthwhile for them. In the case of strategic CSR, efforts can reap
financial dividends through the effect of CSR on employees, consumers, investors, and
governments.
Motivations for strategic CSR investments will range considerably. Some firms will start
from the premise that they are socially bound to make CSR investments, and then ask
themselves how to garner value from those investments. Others simply have a broad view
of profit maximization and examine CSR activities just like any other – measuring the
bottom line. Regardless, firms increasingly measure financial returns of CSR activities.
In “Putting Customers Ahead of Investors,” a point-counterpoint to Friedman, John
Mackey, CEO of Whole Foods, stated:
The enlightened firm should try to create value for all of its constituencies.
From an investor's perspective, the purpose of the business is to maximize
profits. But that's not the purpose for other stakeholders – for customers,
employees, suppliers, and the community. Each of those groups will define
the purpose of the business in terms of its own needs and desires, and each
perspective is valid and legitimate…The most successful businesses put
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the customer first, ahead of the investors. In the profit-centered business,
customer happiness is merely a means to an end: maximizing profits. In the
customer-centered business, customer happiness is an end in itself, and
will be pursued with greater interest, passion, and empathy than the profitcentered business is capable of.
Several firms have soundly demonstrated that in addition to bottom-line targets, it is
possible to creatively incorporate social considerations that do not undermine the firm's
value. In fact, recent data suggests that at least for certain segments of the population,
consumer choices are influenced by the philosophies endorsed by the firm. Furthermore,
some firms have shown that corporate philanthropy can be good for business. For
example, during five days each year, Whole Foods donates 5% of total sales to
philanthropy, and the publicity for these events “usually brings hundreds of new or lapsed
customers into our stores, many of whom then become regular shoppers.”
According to the KPMG International Survey of Corporate Responsibility Reporting 2008,
“75% of the largest 250 companies worldwide have a corporate responsibility strategy
that includes defined objectives, nearly 2/3 of G250 companies engage with their
stakeholders in a structured way, up from 33 percent in 2005, and more than 50 percent
of the world's largest 250 companies publicly disclose new business growth opportunities
and/or the financial value of corporate responsibility.”
However, Whitehead, in a survey of CSR practices, concludes that the definition of CSR
is not uniform, and that “consistent and systematic criteria for evaluating corporate
performance must be applied, a requirement that is undermined by the adoption of
differing definitions of CSR and the use of alternative terms such as CR (Corporate
Responsibility).” Other authors (e.g., Maak), who discuss “Corporate Integrity vs.
Corporate Responsibility,” suggest an underlying framework of "7 C's" of integrity:
commitment, conduct, content, context, consistency, coherence, and continuity as the
underpinnings of true CSR.
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Portnoy38 and others review motivations behind firms that “rebrand to get even more
mileage from their beyond compliance [CSR] endeavors.” He states that CSR may be
initiated to attract customers, to encourage employee loyalty and goodwill, to attract
investors, and to promote community goodwill.
Employees
Employees are aware of a firm's social impact. Firms that make CSR investments can
increase the morale in their workforce, generating returns by (1) serving as non-financial
forms of compensation, (2) increasing retention and thereby reducing overall training
costs and (3) increasing labor productivity. There is anecdotal evidence that employees
are aware/interested in the contributions to society made by the firm that they work for.
According to surveys of career counselors at top business schools, over 85% of
employees expect their firm to make a positive contribution. Over 60% of new employees
consider this in choosing the firm that they work for. In a study from a major business
school, graduating MBA students were willing to accept a 10% lower salary if the firm was
noted for its good work. The quality of a firm's CSR activity is perceived by employees as
contributing to a positive work experience, can be a factor in better relationships between
employees, and is a consideration in retention. In the best of circumstances, the result is
increased productivity and loyalty from the employees, which results in lower costs and
higher profits for the firm.
Consumers
Consumers may also be aware of a firm's social impact. Firms can increase returns by
using such consumer awareness to generate brand loyalty, increase willingness-to-pay,
enable premium pricing, and access new or previously underserved markets. Certain
consumer segments (most prominently college age) exhibit a greater willingness to pay
for products from firms sharing their political or social viewpoints.
38
Portnoy, PR. The (Not So) New Corporate Social Responsibility: An Empirical Perspective. Review of
Environmental Economics and Policy. 2008 2(2):261-275.
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However, there is insufficient hard data to support the financial returns of CSR. “Part of
the reason why CSR does not necessarily pay is that only a handful or consumers know
or care about the environmental or social records of more than a handful of firms. Socalled “ethical” products are a niche market: virtually all goods and services continue to
be purchased on the basis of price, convenience, and quality.”39 On the other hand, others
report that through certain CSR (“green”) initiatives, firms are either saving money or the
changes are “cost-neutral.”40
The concept of a “contribution” of a firm in the mind of the consumer is very broadly
defined here, spanning from the promise to make a contribution to a charity based on a
purchase, to products created with a “good” pedigree. A box of cereal emblazoned with
a pink ribbon, or a statement that a contribution of some amount will be made to a charity
by a retailer for an in-store purchase are examples of the former; fair trade harvested
coffee beans or dishtowels made from fair trade cotton are examples of the latter. In the
case of the contribution, it is generally understood by firms that these are incentives to
increase consumer willingness to make a purchase, or to choose a product over a
competitor’s product. In the case of fair trade coffee, the consumer is willing to pay
considerably more for the product to encourage and reward the good intentions of the
firm.
The most exciting, hardest to predict, and most dramatic impact of CSR efforts may come
from new business opportunities. There is a growing catalog of examples where
sustainability efforts end up saving the firm money, which then results in a significant
bottom-line impact. One dramatic example of this is what is called Bottom of the Pyramid
(BoP), where firms explore ways to serve the underserved markets of the world's
exceptionally poor. The BoP program by Unilever reached 110 million rural Indians since
it began in 2002. Awareness of germs increased by 30% and soap use increased among
79% of parents and among 93% of children in the areas targeted. As a result, soap
consumption increased by 15%. Unilever discovered that it could create a dramatic health
impact on the lives of millions of people by teaching them about cleanliness and making
soap products available at affordable costs. The firm is not only profiting from this activity,
39
40
Vogel, D. Corporate Social Responsibility: CSR Doesn't Pay. David Vogel Forbes.com. 10/06/08.
Skapinker , M. Why corporate responsibility is a survivor. www.ft.com. April 20, 2009.
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but it is building brand in a new market because improved sanitary conditions provide a
key link in lifting people out of poverty.
Investors
Investors too are aware of a firm's social impact. Firms that make CSR investments can
increase firm value by increasing the investor base, lowering the firm's cost-of-capital.
Numerous “sustainability” indices exist within stock markets around the world.
Increasingly and with the help of such indices, foundations representing enormous
amounts of invested capital are committing themselves to mission-related investing. In
fact, the Rockefeller Foundation provides consulting practices to organizations that want
to deploy their investing resources in ways that further organizational goals. As of 2007,
about one out of every nine dollars under professional management in the United States
can be attributed to socially responsible investing – that represents 11 percent of the
$25.1 trillion in total assets under management tracked in Nelson Information's Directory
of Investment Managers. This suggests that socially responsible investing can have an
impact, albeit small, on a firm's cost-of-capital.
Governments
Finally, governments are responsive to the public's view of various firms' social impacts.
While this often manifests itself at the industry level, firms can (jointly if necessary) make
CSR investments to reduce “public enemy” status, thereby increasing access to the
political process and reducing the likelihood of reactive regulation or taxes. In recent
years, oil companies and defense contractors have gone to great lengths to win public
trust. Given that these firms face unique industry-specific government oversight, they
regularly make public appeals to enhance their good name.
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Closing Thoughts
It is feasible for many firms to discover that social responsibility is not just a cost center,
but can be aligned with management's fiduciary obligation to drive shareholder returns.
However, there are substantial challenges to developing an effective and appropriate
CSR agenda. Many of these challenges were discussed above:
•
What should guide management's philosophy of what “conservative” CSR
means?
•
What are the threats of underinvesting in CSR?
•
What
principles
enable
management
to
navigate
trade-offs
among
constituents?
•
What metrics of CSR efficacy are comparable and accurate?
Additionally, consumers say they want firms to behave responsibility, but have not shown
consistent willingness to “vote with their dollars.” This consumer behavior may be
indicative of the failure of firms to effectively produce, distribute, and market the “CSR
attributes” of their output. Unquestionably, CSR is a different attribute than most firms are
experienced in selling. Firms will have to face the significant challenge of developing new
value chains to make the production and distribution of CSR more cost effective as well
as transparent to consumers, government, and social activists.
Potential Examples of CSR
I am interested in your thoughts about the NPV of the following CSR initiatives. Which
would you advocate and why?
1. Your firm operates its largest plant in town X. CSR in your organization is focused
on the impact of the plant on the constituents of X. Your firm works to minimize
environmental impact. Your firm also is strategic in choosing local organizations to
sponsor and support to maximize the purchase of “goodwill.”
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2. Your firm perceives an “empathy” correlation between its target market and a
particular cause (“cause marketing,” such as Avon and breast cancer). Your firm's
CSR takes the form of “matching” – when a customer makes a purchase, your firm
contributes a share of the proceeds to your cause.
3. Your firm seeks to drive WTP and C directly while addressing a social concern.
Your clothing firm wants to invest in a process to convert recycled materials into
textiles. Your firm believes the resulting textile would be in the cost zone of its
current costs. Your firm also believes that the resulting product will be more
durable, as well as have other positive product attributes, with a few limitations, to
result in a net better textile.
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Appendix 1: Financial Metrics
To fully understand how firms create, capture, and sustain value, it is important to
examine the firm’s financial performance. Particular advantages of a firm will show up as
“financial footprints" in several of the firm’s financials as shown in Figure .
Figure 25 - Financial Footprints
A firm’s strategy must be measurable via its financial footprint.
•
If a firm claims it enjoys high returns because of its cumulative brand equity,
evidence of that belief should be reflected in its gross margins.
•
If the firm claims to have efficacious management processes, it should be
evident in its selling, general and administrative expenses (SG&A) as a percent
of sales ratio.
•
Whatever advantage the firm claims to enjoy over its rival, should be evidenced
in one or more of its financial metrics of performance as shown in Figure 26 -.
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Figure 26 - Drivers of Financial Metrics
A complementary approach to understanding the financial footprint is the Return on
Invested Capital Tree, shown below in Figure 4. As in the economic profit derived
analysis above, the ROIC tree allows for a firm’s strategy to be disaggregated into
representative metrics.
Figure 27 - The Return on Invested Capital Tree
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Given that the objective is to generate economic profits, the ROIC tree is focused on the
activities underlying a firm’s performance. This analysis allows for comparability to other
firms and therefore a way for management to benchmark its strategy relative to other
firms.
Performance Management
It clearly follows if we can disaggregate financial performance and strategy into
quantifiable and clear measures then we should be able to orient the entire firm towards
creating value. Over the years, firms such as GE have developed systems around
economic profit that aim to align resource allocation, particularly employee actions, in
such a way as to create value. While this is a logical approach, the reality is that for many
firms, these programs have not worked. The challenge for a firm is to strike a balance
between short-term and long-term objectives, as well as planning and implementation.
The key is to use metrics to determine resource utilization and behavior so that value
creation is part of the very DNA of the firm.
The classic challenge of an economic profit-based performance measurement is that a
firm must balance the short-term and long-term health of the firm. The day-to-day
measurement of strategy execution can create distractions from long-term performance.
As the ROIC tree demonstrates, the translation of value drivers into metrics is critically
needed. In addition, milestones should be established which provide targets tied to less
quantifiable strategic actions. For example, if M&A is a part of a firm’s strategy to expand
its boundaries, then in addition to simple measures such as revenue growth or cost
savings, milestones should be developed to recognize the progress on the closing of a
transaction.
An effective performance measurement system covers both detailed and higher level
aggregate measures. An example, utilized by UPS or FedEx, would be delivery level
measures focused on number of deliveries, cost per delivery, and average time required
per delivery. At a regional or country level the focus is not just on cost control, but also
customer satisfaction, productivity developments, and capital budgeting decisions.
Finally, at the corporate level the board would be focused on not just the underlying
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drivers of economic profit created on a business unit level but also possible milestones
such as progress in entering new markets, or progress by competitors in entering the
firm’s markets.
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Appendix 2: Global Strategy Frameworks
Authored by Professor Withold Henisz of Wharton and Professor Sonia Marciano of Stern
Definition of “Competing Global”
The sub-field of Global Strategy seeks to extend insights from the field of Strategy by
examining the additional choices and constraints imposed by crossing national borders.
Strategy asks how firms create, capture, and sustain profit (economic rents). Global
Strategy focuses on the opportunities and challenges posed by crossing national borders
as part of this process.
In some respects, this extension can be relatively straightforward. Production may be
characterized by economies of scale or scope that can be leveraged through global
sourcing, production, and sales. Governance challenges of large complex organizations
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become even more acute when spanning time zones, cultures, and legal systems. Value
chains become more diverse with a wider range of competitors, buyers, suppliers,
substitutes, potential entrants, and societal pressures threatening the barriers to entry or
imitation that sustain profit.
The most important analytical frameworks in Global Strategy, by contrast, integrate
country-level factors into your existing Strategy Toolkit to identify key tradeoffs faced by
multinational enterprises as they choose their geographic scope and organizational
structure. They share many common characteristics but differ in their relative emphasis
on the differences between the host country and the home country or other countries
(Ghemawat’s CAGE), the characteristics of the host country (Porter’s Diamond, Khanna’s
institutional voids and Varieties of Capitalism) and the internal reactions of the focal firm
(Ghemawat’s AAA or internalization theory). Ghemawat’s combination of CAGE & AAA
and John Dunning’s earlier OLI framework are such powerful frameworks because they
combine these two levels of analysis, admittedly at the loss of some detail as compared
to more focused efforts. This brief study guide surveys these frameworks in turn
emphasizing their respective contributions and distinctive strengths and weaknesses.
As you review the frameworks, watch for the repeated emergence of the core tension in
the field as between
•
Aggregation of global customers and producers to better exploit an existing source
of rents as an impetus for expansion into other national markets;
•
Adaptation to inherent differences across nations needed to succeed in that
expansion; and
•
Arbitrage opportunities provided via the inherent differences or via learning from a
given national expansion.
Global managers are thus torn between strong incentives to
•
centrally coordinate the replication of their, to date, profitable business model;
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•
decentralize authority to country managers or external agents who know their host
country and what it takes to succeed there; and
•
develop, implement, and sustain a clever hybrid, matrix or network structure that
implausibly accommodates both competing forces while also promoting profitable
innovation in the global business model and structure.
Ghemawat’s ADDING Framework
The best answer to the question “why globalize” is because the firm can create economic
value through operating in multiple nations. That said, the firm should be in a position to
make this case by being specific about how the firm will be able to generate revenues in
excess of all costs, including its cost of capital, as a result of operating internationally.
Ghemawat’s ADDING framework offers a checklist or a scorecard approach for the firm
to run through and ideate for the key ways in which internationalization could enable the
firm to create economic value. The ADDING framework and the general ways in which
revenues net of all costs could be generated through internationalization are summarized
below:
Component
of How Economic Value Could be Generated
Framework
A:
Adding volume or Additional demand volume could enable the firm to
growth
achieve deeper economies of scale (for example, it’s
how a country has a few competitors or is too small to
support MES of the most efficient technology.
D: Decreasing costs
Firm might generate cost saving insights as a result of
accumulated experience in setting up operations. Firm
might also be able to leverage scale economies in
procurement. As mentioned below, the firm’s cost of
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capital
might
be
positively
affected
by
being
multinational.
D:
Differentiating or Firm may develop an expertise at serving a particular
increasing WTP
market segment. For example, the firm may develop a
capability or a set of infrastructure valuable to a subset
of the market. By operating in many locations the firm
can exploit the benefit of its WTP advantage with
respect to this segment.
I:
Improving industry The firm could cherry pick a set of nations in which the
attractiveness
bargaining power
or overall attractiveness of the industry is higher. By being
selective about the particular industry attributes or
features at the national level, the firm could be in an
overall more attractive position than many firms in this
industry.
N: Normalizing risk
Let’s say the firm’s production process is highly capital
intensive. Let’s also assume that the industry the firm
operates in faces a lot of demand volatility. If the firm
faces capital market frictions in its home market, it may
be able to enjoy lower costs of capital through the
smoothing effect of operating in many countries whose
demand are uncorrelated – capital from more advanced
capital markets might now be available to the firm.
Overall, operating in many markets may be a more
efficient way to hedge currency risks or other risk
idiosyncratic to the business.
That is, geographic
diversification might be more economical than buying
hedges.
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G:
Generating Accumulation of relationships, networks, insights,
knowledge
and
other know-how, ideas, etc. that can be deployed across
resources/capabilities
markets.
In applying the above scorecard, it is likely that an aspect of a firm’s internationalization
fits into more than one category of the framework. However, the aim of this framework is
to generate a set of possible means to generate economic value though multinational
operations. Ideation, however, is not the same as substantiation. The firm should subject
its conjectures to rigorous analysis, rather than use the framework to justify an already
existing enthusiasm for globalization. The next framework covered is related to ADDING
in that it helps identify markets in which the firm is likely to be able to leverage its
advantages. That is, the CAGE framework is used to identify markets in which the
benefits of globalization suggested by ADDING are more likely to materialize.
Ghemawat’s CAGE
The CAGE framework focuses on the differences or distance between national
environments as the core driver of a firm’s ability to create, capture and sustain profit in
its international operations. While the framework emphasizes, dyadic country “distance,”
Ghemawat subsequently applies the framework at the industry- and organizational-level
to generate insights into how industries vary in their global scope and how organizations
create, capture and sustain profits in the face of “distance.”
First, what are the various forms of “distance” between a firm’s home market and a market
it might enter?
Cultural distance (“attributes of one society sustained mainly by interactions among
people, rather than by the state”) can drive a wedge between firms from one country and
their potential customers as well as their potential employees in another, thereby
restricting the size of the market and increasing the cost of operating locally. The specific
mechanism is a lack of trust, openness or understanding caused by different values,
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norms and dispositions which are often linked to different languages, ethnicities, religions,
nationalities and histories.
Administrative distance (“laws, policies, and institutions that typically emerge from a
political process and are mandated or enforced by governments”) can alter the costs of
doing business in one nation relative to another either through taxation and subsidies that
alter costs and revenues, regulations and laws that preclude certain practices, or the
weakness and instability of laws, policies, and institutions that lead to greater uncertainty.
These costs can be partially addressed through bilateral treaties or joint membership in
multilateral governance regimes.
Geographic distance (physical distance as well as discontinuous factors such as
contiguity, time zones, and climate) raises the cost of transportation, communication, and
coordination.
Economic distance (size, per capita income, physical, institutional, and human
infrastructure and resource endowments) can also alter the costs of doing business
across nations in a manner that often shifts the composition of cross-border activity.
Industries may be more or less susceptible to the costs of “distance” or to different
dimensions of those costs. For example, cultural distance will be more important where
linguistic content, national identity, or local norms impact willingness to pay.
Administrative distance will have a greater impact for politically salient goods and services
(e.g., those that are broadly consumed, impact health and safety, have labor intensive
production processes, sell to the government especially if identified with national security,
extract natural resources, or have relatively high sunk costs). Geographic distance will
play a larger role where transportation costs are relatively high as compared to production
costs (e.g., low value to weight, hazardous or bulky goods, perishables and personal
services). Economic distance will be more important where production or distribution
costs or consumer willingness to pay are heavily impacted by wages, incomes,
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infrastructure, and resources. One can map out an industry’s global potential according
to the importance of these four dimensions of distance.41
Ghemawat’s AAA
Building on the CAGE framework, Ghemawat argues that firms’ ability to create, capture
and sustain rents in their international operations requires the deployment of some
combination of three strategies at the product- or function-level to respond to distance.
Adaptation “seeks to boost revenues and market share by maximizing a firm’s local
relevance.” Where leverage is possible but navigating distance is unavoidable – one
indicator identified is a high advertising to sales ratio, where firms must actively minimize
or undermine their distance from the host country market.
Aggregation “attempts to deliver economies of scale by creating regional or sometimes
global operations; it involves standardizing the product or service offering and grouping
together the development and production processes.” Where the costs of distance are
minimal or small relative to the potential opportunities, distance can be ignored.
Arbitrage “is the exploitation of differences between national or regional markets, often by
locating separate parts of the supply chain in different places.” Adaptation and
aggregation focus on the tradeoff between leveraging home country strategies abroad
and adapting them to local context. Arbitrage emphasizes the possibility that distance
itself creates opportunities to enhance the profitability of national strategies to create,
capture and sustain rents.
These strategies are associated with distinctive organizational structures as well as
internal and external pathologies. Adaptation requires local autonomy but must tradeoff
41
In this manner, Ghemawat mirrors Yip (1995) who plotted out industries according to the importance of
scale/scope economies (i.e., geographic distance), market similarity (i.e., cultural distance),
comparative/competitive advantage (i.e., economic distance of importance of Porterian Diamond) and
lack of government regulation (i.e., administrative distance). There is also a close link to Prahalad & Doz
(1987) who highlighted the tradeoff between responding to differences in customer needs/tastes (i.e.,
cultural and economic distance) or government policy and regulation (i.e., administrative distance) with
local responsiveness and the ability to exploit scale and scope economies via operational and strategic
integration.
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the gains from such decentralization against the costs of excessive heterogeneity and
local sub-goals that may not serve or extend the interests of the parent company.
Aggregation requires global coordination but must tradeoff the efficiency gains of
standardization and scale or scope economies against the costs of always being
perceived as an outsider or cost minimizer. Arbitrage requires flexibility and the
management of a complex network of internal and external relationships for continuous
learning but must tradeoff the benefits from such dynamism against the costs of being
perceived as a fickle rootless partner or citizen. Firms adopt all three of these strategies
across products and functions to varying degrees but the inherent tension between them
poses complexity and organizational challenges in implementation.42
Over time, firms may learn to better appreciate distance and its dimensionality as well as
to more efficiently design and implement (a mix of) adaptation, aggregation, and arbitrage
strategies. Firms with weaker abilities in this regard may choose to enter less distant
markets than their counterparts or pursue lower commitment entry strategies.43
A firm’s navigation of this complex strategy space and its learning therein is further
complicated by a natural dynamic in which strategies for industries or products may
evolve over time from aggregation to adaptation to arbitrage possibly at an accelerating
rate as communications costs decline.44 Initially, the benefits to centralized research,
development and production in a given local environment (see Porter’s Diamond below)
outweigh the costs of reaching global markets through exporting a homogenous product.
Over time, the value chain internationalizes as the benefits of local adaptation outweigh
the costs of disaggregation. Finally, innovations in host country markets are combined via
a global network of research, development and production into multiple new products and
services.
The framework is strongest in highlighting the importance of distance and drawing
attention to its dimensionality as well as link to a typology of strategies. The choice
42
These insights build upon prior organizational analysis of the multinational firm examining the tradeoff
between coordination/integration and configuration/responsiveness including Porter (1987) and Bartlett &
Ghoshal (1989) who wrote about the contrasts between home-based, multi-domestic (classic and
modified) and global/transnational/network structures.
43
These insights build upon internationalization theory (Johanson & Vahlne, 1977)
44
These insights build upon the product life cycle model of Vernon (1966).
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amongst Adaptation, Aggregation and Arbitrage and the means of implementation of
these strategies of hybrids thereof is less well developed. For more guidance as to the
means to balance centralization vs. decentralization, affect organizational change, learn
and/or develop new organizational capabilities or keep up with a transforming industry
and institutional environment, the insight generated by Ghemawat needs to be combined
with extant frameworks covering these topics in the fields of strategy and/or organizational
behavior.
Porter’s Diamond
The Diamond is a framework that enables the analyst to capture country- (or region-)
specific factors that influence the strength of local firms and/or the attractiveness of the
location to foreign firms. This framework has also been used to provide advice to
governments on the policy treatments that could best enhance the global competitiveness
of an existing cluster or facilitate the construction of a new one.
A paradox that emerges out of an understanding of the diamond is that globalization does
not reduce the importance of favorable domestic conditions, owing to several factors
related to proximity and common culture. Rather, favorable home conditions generate
“difficult to imitate” advantages which can now be leveraged globally.
Note that this review mainly takes the form of “checklists” – these checklists err on the
side of redundant to ensure they are as complete as possible. Porter’s Diamond is of
particular importance in the analysis of firms who participate in “traded clusters”. Its
strongest contribution is in its comprehensive assessment of local factors that contribute
to the competitiveness of a location (i.e., in the unpacking of Ghemawat’s construct of
economic distance). By contrast, however, it offers fewer contributions to other core
questions in global strategy including explaining the pattern of global activity across and
within industries and the organization of global operations within a given firm. These
limitations are particularly important when diamonds span national borders or are subject
to change in their geographic scope.
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The four broad attributes of a nation that shape the environment in which local firms
compete are:
Factor Conditions: Generally the analyst is looking for the nation’s factors to evolve from
basic to advanced (terms are defined below) and from general to specialized. The factors
of production critical to competitiveness are created through processes unique across
countries and industries. The rate at which these factors are generated and upgraded is
more important than their amount. The analyst also wants to determine if the
risks/incidences of mobility are declining.
•
Human Capital: Quantity and quality. Analyst should determine:
o Mix of basic vs. advanced
o Degree of specialization
o Risk of mobility
o Noteworthy disadvantages
•
Physical Resources: We think of a regions natural resources and its geographic
location/proximity as basic, endowed and nonmobile. Analyst should
determine:
o Degree of specialization
o Noteworthy disadvantages
•
Knowledge Resources: Stock of scientific, technical and other salient knowhow. Analyst should determine:
o Mix of basic vs. advanced
o Degree of specialization
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o Risk of mobility
o Noteworthy disadvantages
•
Capital Resources: Access to efficient capital markets
•
Physical Infrastructure: The “man-made” infrastructure that affects the
attractiveness of a nation as a place for enterprise – transportation systems,
delivery systems, etc. Analyst should determine:
o Mix of basic vs. advanced
o Degree of specialization
o Risk of mobility
o Noteworthy disadvantages
Terms:
•
Basic factors include natural resources, climate, location, skilled and semiskilled
labor, and debt capital.
•
Advanced factors include infrastructure on the technological edge and highly
educated workers.
•
Mobility refers to the ability and incentive of factors to migrate to opportunities in
other nations.
•
Generalized factors include highway systems, a supply of debt capital, and a pool
of educated workers who can be deployed to a wide range of industries.
•
Specialized factors require more focused and riskier private and social investments.
Specialized factors often depend on an existing base of generalized factors. As
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nations become more developed, the bar to consider a factor specialized is raised
– once specialized factors are then considered generalized factors.
•
Disadvantages are noteworthy as competitive advantage can grow out of a
response to a region’s weakness.
Demand Conditions: Here the Diamond is determining if the quality or sophistication of
home demand would provide an impulse for continual development of the product at a
rate that exceeds the development in other locations. Demand conditions shape the rate
and types of improvement and innovation undertaken by the region’s firms. The product’s
fundamental or core design generally reflects home market needs. The three broad
attributes of home demand are:
•
Composition of home demand
o Do the local firm’s get a clearer and earlier picture of buyer needs than
do foreign rivals?
o Are there important distinctions in the needs of local buyers relative to
the needs of buyers in other markets in the world?
o Is acquiring information about the home market less costly for the local
firm relative to the information acquisition costs faced by foreign rivals?
o Is there a variety of the product or service that is a large share of the
local market, but a small share of potential markets in other nations?
o Are the local buyers for the product or service sophisticated and
demanding, thereby giving local firms a window into the most advanced
buyer needs?
o Do the needs of local buyers anticipate the needs of buyers in other
nations? That is, is home demand an “early warning indicator” of buyers
needs that will become widespread?
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•
Demand size and pattern of growth
o Large local demand enables firms to achieve scale economies, and
encourages large-scale investments in improving the product/service.
o Several independent buyers rather than only a couple of buyers are a
better environment for firms.
o The rate of investment in technology and, more generally, product
improvement goes along with the rate of local demand growth.
o Local firms benefit when local demand is a leading indicator of demand
in other nations.
o Local market saturation forces local firms to lower price, add features,
improve performance, create incentives for buyers to replace old
products with newer versions and explore markets in other nations.
•
Does domestic demand pull foreign sales
o Local firms are advantaged if their buyers are mobile or multinational
firms.
o Buyers in other nations are influenced by the behavior of local buyers.
It is clear from reviewing the demand condition checklist that there are many feedback
effects. The analyst should focus on identifying conditions that encourage investments by
firms in improvements in the products and the process for producing these products.
Related and Supporting Industries: The broad question here is whether firms have
internationally competitive supplier industries or related industries with which to transact.
Related industries are those in which firms can coordinate or share activities in the value
chain when competing, or those that involve products that are complementary.
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•
Competitive advantage in supplier industries promotes:
o Efficient, early, rapid, and sometimes preferential access to the most
cost-effective inputs.
o Ease of coordination and, more generally, lower transactions cost
between firms and their supplier industries.
o Process of innovation and upgrading, as competitive suppliers help firms
perceive new methods and opportunities to apply new technology.
•
Competitive advantage in related industries promotes:
o Information flow and technical interchange.
o Likelihood that new opportunities in the industry will be perceived.
o New entrants who bring a new approach to competing.
o Sharing of activities and potential formal alliances.
o Pull through demand (particularly from internationally successful
complementary
goods).
Firm Strategy, Structure and Rivalry: The analyst needs to determine the context in which
firms are created, organized and managed as well as the nature of domestic rivalry. A
given national environment tends to germinate particular management practices and
modes of organization, and these management practices and modes of organization tend
to favor particular industries. The goal of the analyst is to understand this chain.
•
Strategy and structure of domestic firms should be viewed as a response to
prevailing conditions:
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o Degree of scale economies
o Likelihood and fruitfulness of cooperation among firms
o Attitudes toward authority
o Norms of interpersonal interaction
o Worker attitudes toward management
o Degree of materialism
o Social norms of individualistic or group behavior
•
Goals:
o Firm goals are driven by:
§
Ownership structure
§
Motivation of owners
§
Motivation of debt holders
§
Nature of corporate governance
§
Incentive processes faced by managers
o Individual goals are driven by:
§
Motivation to enhance skills
§
Reward systems
•
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•
Promotion process
§
Tax systems
§
Attitudes toward wealth
§
How competitive with peers
§
Attitude toward risk
§
Attitude toward failure
o National goals or priorities affect
•
§
Who is attracted to an industry
§
Resources available to the industry
Rivalry:
o Internal rivalry enhances the industry’s readiness for international
competition by encouraging:
§
Process improvements
§
Firms to individually seek protected niches, thereby collectively
offering great product variety
§
Firms to grow by expanding to other markets
§
Less government interference than might be the case if there was
only one or two firms in the industry.
The effect of chance and government are examples of factors that are not explicitly
addressed in the four conditions above, but are clearly can be important. For example,
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there are cases where the degree of unionization has a significant impact on the four
determinants discussed above.
Chance: Chance events are important because they create discontinuities that allow
shifts in competitive position. Chance events can nullify the advantages of previously
established competitors and create the potential for firms. Converting chance events into
competitive advantage is often about being intentional about it. That is, when looking at
a competitive industry in a nation, it is likely that industry has wisely exploited chance
events, rather than has just enjoyed “dumb” luck. Examples of chance events that can
affect the nature of determinants for many years are:
•
Acts of pure invention
•
Major technological discontinuities (revolutions as opposed to evolutions)
•
Discontinuities in input costs such as oil shocks
•
Significant shifts in world financial markets or exchange rates
•
Surges in world or regional demand
•
Political decisions by foreign governments
•
Wars
Government: Porter was quite intentional in NOT making government the fifth
determinant. Government influences the four determinants, sometimes positively and
sometimes negatively. Government actions are also a response to the government’s
perception of the nation’s determinants. A list (far from complete) of the ways in which
government exerts influence is:
•
Subsidies
•
Policies toward capital markets
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•
Policies toward education
•
Fiscal Policies
o Taxes
o Spending (whom does the government favor in its purchases)
Internalization Theory (based on Teece, 1986 and Root, 1998)
The question of the geographic scope of the firm is not merely limited to location (e.g.,
Ghemawat’s CAGE, Porter’s Diamond, Khanna’s institutional voids and Varieties of
Capitalism) and the strategic goal (e.g., Ghemawat’s AAA) but also to the mode of
operation in that location with that goal. Internalization theory’s primary contribution is to
analyze the determinants of the boundary of the firm or the choice of whether to produce
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a good or service within that boundary or outside of it via exporting (indirect, direct agent,
direct branch), contract (licensing, franchising, technical agreements, service contracts,
management contracts, construction/turnkey contracts, co-production agreements) or
foreign direct investment (a joint venture or wholly owned equity structure of a
new/greenfield facility or of an acquisition).
The application of transaction cost theory to the multinational enterprise has separately
considered motives for horizontal (e.g., accessing a host country customer in order to sell
a home country or global product) versus vertical (e.g., accessing a host country factor
for use in production) integration. In the case of horizontal integration, a common
challenge lies in the home country’s firms’ comparative analysis of its likelihood of
capturing the rents from its technological or managerial know-how or brand if it enters via
a wholly owned subsidiary versus a licensing agreement or joint venture. Because of the
paradox of information (i.e., describing information in sufficient detail to ascertain its worth
renders its worthless) and the risk of depreciation of the brand due to loss of control,
writing, monitoring and enforcing a contract between the owner of a technology or a brand
and a licensor or other counterparty who may behave opportunistically (i.e., pursue their
self-interest with guile) is costly. These transaction costs further increase when contracts
span national borders which introduce uncertainty over potential legal enforcement and
differential abilities or organizational or cultural differences that hinder technological
transfer. Similarly, for vertical integration, the inherent risk of ex post re-contracting for a
specialized good or service whose value in its next best use is substantially lower than in
its current use is again magnified in the international setting due to weak or uncertain
legal regimes and organizational or cultural differences that can hinder cooperation,
promote shirking or even foster distrust and opportunistic behavior.
Combining these arguments, yields the prediction that wholly owned subsidiaries will be
more common where
Transaction-level
- The difference between the value of the asset in its current and next best use is high
- The number of potential transactions is relatively high (allowing for the fixed costs of
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integration to be spread out over a larger number of transactions). Note that country size
may be a strong correlated with transaction frequency.
Industry-level
- Downstream market structure concentrated
Firm- or firm-dyad level
- The multinational firm has substantial technology or brand appropriability concerns
- The difference between the technological transfer and absorptive capacity of the owner
of the asset and the potential counterparties in the host country is high
- The difference between the organizational or corporate culture of the owner of
the asset and the potential counterparties in the host country is high
Country- or country-dyad-level
- The difference between the legal regime in the home and host country is high
- Public policy actively favors wholly owned subsidiaries through taxes or subsidies
Policy uncertainty is relatively low
- Cultural distance is relatively low
NB: While the following frameworks are not the subject of dedicated readings, they
will come up in class discussion
Institutional Voids (Khanna, Palepu and Sinha, 2005)
The institutional voids framework catalogues country-level gaps that makes many
emerging markets uncompetitive absent strategic adaption on the part of local or
multinational firms to internalize activities or transactions governed by the specialized
actors or the state in developed markets. According to this context, market intermediating
functions that are absent or inefficient in emerging market contexts are internalized within
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unrelated business enterprises creating novel business models and opportunities for rent
generation. Relevant functions that may be profitably internalized include the
maintenance of exchanges that allow for expert based or large scale matching between
intermediate factors including labor and capital and producers, the analysis of information
on reputation or quality and the monitoring and enforcement of contracts. The institutional
voids can thus exist within capital markets, labor markets and product markets as well as
in the interface between incumbents and entrants or the polity and political authority. A
list of factors to consider includes
Capital Markets
-
The effectiveness of banks, insurance companies and mutual funds at
matching savings and investment
-
Financial sector governance and supervision
-
Equity and debt market liquidity
-
The sophistication of the venture capital market
-
The credibility of accounting and disclosure regulation and information
providers
-
Corporate governance
-
Efficiency and impartiality of the legal system in cases of fraud
-
Efficiency of the share market for ownership including bankruptcy workouts
Labor Markets
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-
The strength, transparency and signaling capacity of the educational
infrastructure
o Technical and management training
o Foreign language training
o Elementary and secondary education
-
A culture and regulatory or legal system that allows for job mobility
-
Employment agencies and head hunters
-
Merit- or incentive-based pay
-
Efficiency and impartiality of the legal system in cases of employee
malfeasance including theft or conflict of interest
-
Openness to expatriate managers
-
Effectiveness of labor unions in representing workers’ rights
-
Labor rights
Product Markets
-
Availability of reliable information on
o consumer tastes and preferences including market research
o producer quality and reliability
o financial credibility of consumer or producer counterparties
-
Liquidity of supply chain
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-
Efficiency and impartiality of the legal system in cases of contractual breach,
product defects, deceptive advertising or health and safety violations
-
Reliability and density of distribution system for products and supporting
services including transportation infrastructure, retail network and direct to
consumer
Openness
-
Attitudes towards foreigners
-
Policies towards foreigners
o Ability to undertake foreign direct investment
§
Equity stake
§
In market intermediaries
§
In any location
o Ease of starting business
o Capital repatriation
o Exchange rate
o Tariffs and quotas
o Labor mobility
Political and Social System
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-
Nature of electorate (groups to whom rulers are accountable)
-
Clear and stable division of power across branches and levels of government
-
Extent of public involvement in owning and operating businesses or favoring
certain businesses
-
Stability and clarity of property rights
-
Bureaucratic efficiency and capacity
-
Judicial effectiveness
-
Extent of political contestation
-
Media effectiveness
-
Civil society effectiveness
-
Attitudes towards corruption and other abuses of governance
While this framework is extremely useful in many emerging market contexts, it is
somewhat ethnocentric in emphasizing the absence of market intermediation as
compared to industrialized nations rather than the possibility that varying institutional
structures could serve these functions. An analysis of such institutional variation within
industrialized nations is precisely the focus of the next literature to which we turn.
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Varieties of Capitalism (Hall & Gingerich, 2004 and Hall & Soskice, 2001)
This framework seeks to highlight complementarities that lead to two idealized
“archetypes” of configurations of financial, labor market and other institutions among
industrialized countries. The framework is built from a political economic logic in which
firms are best seen as a collection of informal relationships and formal contracts with
other firms and other political and economic actors in a society. These relationships and
contracts determine the distribution of rents generated by the firm as between its
shareholders, workers, managers, financiers, other suppliers, distributors and the broader
polity. As the choice of this distribution is inherently contentious, a key purpose of
institutions is the resolution of coordination problems and conflict.
Liberal market economies (LMEs) solve these coordination problems primarily through
competitive market arrangements that operate via price signals. Large equity markets
with dispersed shareholders assess investment opportunities via transparent and wellregulated accounting disclosure statements. The share market for ownership and the
performance signal of the short term share price discipline managers and influence their
strategy over which they have high discretion. Labor markets are fluid with little firm
specific training or coordinated wage bargaining. The complementarity speed and
flexibility of these various markets may lead to firms to investment less in specific assets
relative to more generic counterparts and economies to have higher rates of employment
in tumultuous periods but higher income inequality whereas in more stable periods
employment levels could be relatively lower due to a higher natural churn rate. The most
commonly cited examples of LMEs include the United States, the United Kingdom,
Australia, Canada, New Zealand and Ireland.
Coordinated market economies (CMEs) depend more heavily on non-market
relationships to coordinate distribution and resolve conflict. “Powerful business or
employer associations, strong trade unions, extensive networks of cross-shareholding,
and legal or regulatory systems designed to facilitate collaborative endeavors” are central
actors in CMEs. Important complementarities exist between long-term employment
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negotiated collective contracts, financiers with long-term time horizons, strong public
vocational education systems and the resulting stability of economic activity. These
institutions promote information exchange, mutual monitoring and sanctioning of noncooperative behavior leading to more consensus style management with less discretion
in strategy making. As a result of these institutional supports, firms in CMEs may be better
able to invest in specific assets (i.e., those whose value in their next best use is
substantially reduced) and economies may have higher rates of employment in stable
periods at the cost of lower levels in tumultuous periods. The most commonly cited
examples of CMEs include Germany, Japan, Switzerland, the Netherlands, Belgium,
Sweden, Denmark, Finland and Austria.
Where a country fits between these polar extremes can be evaluated through analysis of
the following observable characteristics:
•
Legal rights for shareholders
•
Dispersion (vs. concentrated) of shareholder control
•
Size of stock market
•
Level of wage coordination (e.g., national, intermediate of firm)
•
Degree of wage coordination
•
Labor turnover
These financial and labor market conditions are expected to be associated with a set of
public sector, financial or labor market outcomes including
•
Social protection
•
Product market regulation
•
Institutionalized training systems
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•
Intensity of mergers & acquisitions
•
Returns to managers relative to workers (as a proxy for their degree of discretion)
•
Employment tenure
•
Income inequality
•
Cooperative firm strategies
OLI (Lightly adapted from Marciano (2011)) (Dunning, 1979)
The OLI paradigm or framework is an integrated framework designed to simultaneously
consider firm-level drivers of internationalization, country-level drivers of attractiveness
and transaction-level drivers of internationalization in that country within the boundary of
the firm. This paradigm is meant to help the analyst consider the wisdom of a particular
FDI decision – for example, whether to establish or acquire a plant, a call center, a winery,
etc. in a given country It suggests that we look at three variables – Ownership, Location,
and Internalization – to evaluate our FDI options and identify a good configuration of
activities.
It assumed that, in undertaking FDI, the firm is likely in search for some combination of
the following:
•
Efficiency gains from accessing resources or capabilities abroad
•
New customers or markets abroad
•
Enhanced activities that drive innovation
The first “stop” in this framework is "O"- Ownership Advantages (or FSA - Firm
Specific Advantages)
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Why go abroad? The answer is so the firm can leverage its ownership of some firm
specific advantage. The firm engaging in the FDI must be in possession of a firm specific
advantage (usually intangible) that can be transferred within the multinational enterprise
at low cost. Examples of firm specific advantages that can be infused in, shared with,
downloaded into, imparted to the international subsidiary are:
•
Technology
•
Brand name
•
Trademark
•
Production technique
•
Entrepreneurial skills
•
Benefits of economies of scale
•
Benefits of economies of scope
•
Benefits of proprietary know-how
•
Patents
•
Incentive systems
•
Management know-how
•
Noncodifiable knowledge
•
Codes of conduct, norms, culture
•
Management diversity
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•
Accumulated marketing or finance experience
•
Privileged access to inputs
•
Ability to reduce intra or inter firm transactions costs
The parent firm may also enjoy some synergy in jointly governing its home and foreign
presence beyond those factors listed above. For example, the enterprise might benefit
from shifting production between the two locations opportunistically (in response to a
policy change, factor price movements, demand-conditions). Essentially we are looking
for something that makes the combination of the firm and its international subsidiary more
valuable together than apart.
The bar for synergy is higher than would be the case for a combination within a country.
The reason is that the advantage must give rise to higher revenues and/or lower costs
that can offset the costs of operating at a distance in an abroad location. That is, this FDI
is disadvantaged by its parent being in another country. Multinational enterprises compete
with fully local competitors who do not bear costs such as:
•
Less knowledge about local market conditions
•
Legal, institutional, cultural and language diversities
•
The increased costs of communicating and operating at a distance
We often call these costs the “liability of foreignness”. Consequently, if a foreign firm is to
be successful in another country, it must have some kind of an advantage that vanquishes
the costs of operating in a foreign market. Either the firm must be able to earn higher
revenues for the same costs, or have lower costs for the same revenues, than comparable
native firms.
Corporate Strategy considered a richer and more theoretically grounded set of factors
impacting the ability to create, capture and sustain profits.
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The second stop is "L" - Location Advantages (or CSA: Country Specific
Advantages)
Where do we go? The motive to move offshore is to use the FSA in conjunction with
factors in a foreign country. Examples of these factors are:
•
Labor
•
Energy
•
Materials
•
Components
•
Semi-finished goods
•
Land
•
Resources
Factors such as the above in the international location combine with the FSA to generate
profits. The choice of investment location depends on a complex calculation that includes:
•
E - Economic advantages - quantities and qualities of the factors of production,
transport and telecommunications costs, scope and size of the market, etc.
•
P - Political advantages - common and specific government policies that influence
inward FDI flows, intra-firm trade and international production, etc.
•
S - Social/cultural advantages - psychic distance between the home and host country,
linguistic and cultural diversities, general attitudes towards foreigners and overall
views about free enterprise
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Porter’s diamond, Khanna’s institutional voids and Varieties of Capitalism – all discussed
earlier – are more developed frameworks for judging a location
The third stop "I" - Internalization Advantages (or IA)
How do we go? Even if production is more profitable in a location abroad, that does not
mean that the multinational must invest in ownership. The multinational could license a
local firm there to use its FSA – for example, technology, and produce the product that
would carry its brand. In exchange the multinational would receive a financial return for
its FSA.
To explain FDI there needs to be an internalization (or control) advantage.45 Generally
this advantage arises if allowing another firm to use the FSA would increase the
probability that the value of the FSA to the multinational would be diminished by the other
firm acquiring control of use of the asset. For example, the foreign firm could copy the
technology, terminate the agreement, and then start producing the same product in
competition with the multinational. Thus, pharmaceutical firms are reluctant to license
foreign firms to produce their medicines in countries where intellectual property rights are
not strongly enforced because they would have to reveal the techniques for producing
those medicines. Another possible bad outcome is that the foreign firm would have less
incentive to maintain the quality of the product and would thus reduce the reputation for
quality that the firm has in the rest of the world.
The multinational chooses internalization where the market does not exist or functions
poorly so that transactions costs between firms are very high. The firm internalizes the
activity to be able to fully control the terms of the interaction and circumvent or exploit
market failures. Below are examples of why firms internalize:
45
Entry modes consider FDI in degrees --meaning outright ownership to joint ventures and alliances to
licensing. Reduced ownership (in general, the entry mode) alters the risks and benefits of the abroad
activity. Technically, FDI statistics include firms taking small stakes in firms abroad – so the term FDI is
comprehensive of many types of entry modes. That is, the term FDI is not strategically descriptive. The
entry mode does affect the net gain to the investing firm because of the entry mode’s affect on the
reasons to internalize outlined above – hence, the entry mode is strategically important.
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•
To avoid search and negotiating costs
•
To avoid costs of moral hazard and adverse selection and protect firm (brand)
reputation
•
To maintain proprietary nature of FSA
•
To avoid broken contracts and litigation
•
To reduce buyer uncertainty about nature and value of inputs (technology being sold)
•
When market does not permit price discrimination
•
When seller needs to protect quality of intermediate or final products
•
To capture economies of interdependent activities
•
To compensate for absence of future markets
•
To avoid or exploit government intervention (quotas, tariffs, price controls, tax
differences)
•
To control supplies and conditions of sales inputs (including technology)
•
To control market outlets (including those which might be used by competitors)
•
To be able to engage in practices such as cross subsidization, predatory pricing,
leads and lags, and transfer pricing as competitive (or anticompetitive) strategy.
Internalization (and transaction cost) theory offers a tighter explanation of why certain
transactions are undertaken within firm boundaries as opposed to across them.
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A group of Stern students46 looked at the question of how markets might react to a firm’s
decision to enter or exit an international market. The question is whether markets tend to
react favorably, or whether markets look at the particulars of the firm’s globalization
choices. The students’ findings are reflected in the slides below:
Why Do Firms Globalize? How Does the
Market React?
Why International
Expansion?
! Projected growth
boosts stock prices:
P=D1/(r-g)
! Therefore firms chase
bottom-line growth
! International expansion
assumed to enable
revenue creation,
reduce costs, and drive
up stock prices
Is International Growth
a Magic Formula?
! Does international
expansion lead to
higher stock prices?
Intl
Growth
Higher
stock price
Case Study Analysis
! Analyzed 4 companies
in the retail sector
! Takeaways:
– Intl growth does not
automatically drive up
stock price
– Markets can sniff out
bad international
expansion and will
penalize the firm
– Firm’s “wedge” is not the
same in all markets
3
46
Shane Antony | Ilana Fischer | Andres Satizabal | Nancy Wong – Stern MBAs Class of 2011
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Examples of the cases studies:
TESCO: Entrance into U.S.
Market event on 2/9/2006: enter U.S.
Company – TSCO: -1.99%
Benchmark – FTSE 350 Retail Index: +0.64%
Market reaction:
Negative
Source: Capital IQ
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TESCO: Entrance into U.S.
International Expansion Announcement Impact
Timeline
! Announcement made
on February 9, 2006 to
! 14 years of experience:
enter the U.S. Market
– Entered Poland in 1992
– Entered Asia in 1998
! Operations in Ireland,
Poland, Czech
Republic, Slovakia,
Hungary, Turkey,
China, Japan, South
Korea, Malaysia, and
Thailand
Source: Company website
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! Tesco stock price
immediately fell 1.99%
after announcement
– Compared to a 0.64%
increase in the FTSE
Retail Index
– Versus a 1.46% increase
in the FTSE 100 index
Implications
! Market suspected
expansion strategy was
a cover-up for problems
at home
! Analysts were
concerned about the
entry into a saturated
U.S. market
! On April 21, 2009,
Tesco reported trading
loss of £142MM from
US operations
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Walmart: Exit from Germany
Market event on 7/28/2006: exit Germany
Company – WMT: +2.14%
Benchmark – S&P 500 Retail Index: +1.26%
Market reaction:
Positive
Source: Capital IQ
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Walmart: Exit from Germany
International Expansion Announcement Impact
Timeline
! Announcement made
on July 28, 2006 to exit
! 15 years of experience
– First store abroad in
Germany
Mexico City in 1991
– Also in Canada, Hong
Kong, China, Argentina,
and Brazil before entry
! Entered Germany in
1997 through
acquisition
– Expanded in 1999 with
another acquisition
– Reported losses of
€250MM per year
Source: Company website
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– Expected $1B write-off
– Sell stores to Metro AG
! Walmart stock price
rose 2.14%
– Compared to a 1.26%
increase in the S&P
Retail index
– Versus a 1.22% increase
in the S&P 500
Implications
! Huge relative impact on
company value for
exiting a small market
– Only 0.7% of revenue
and -2.7% of profits
! Signal of change in
internationalization
strategy
– Focus on profitability
! Stop-loss focus
– Not worth it to stay in
money-losing markets
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Comparison of Market Reactions
Companies
Costco
Tesco
Walmart
Lululemon
Home Country
U.S.
U.K.
U.S.
Canada
Foreign Market
Australia
U.S.
Germany
Australia
Event
Entrance
Entrance
Exit
Increase Stake
Event Date
6/23/2008
2/9/2006
7/28/2006
5/12/2010
International
Experience
23 years
14 years
15 years
6 years
Stock Price
-0.42%
-1.99%
+2.14%
+9.05%
Benchmark
-2.54%
+0.64%
+1.26%
+1.40%
Market
Reaction
Source: Company website, Capital IQ
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Conclusion
Market
Efficiency
! Markets appear to have been efficient in assessing value of
firms’ foreign expansions
! CEOs and Boards shouldn’t ignore signals from the market
The
“Wedge”
! A firm’s “wedge” is not the same in all markets due to
cultural, administrative, geographic, and economic
distances
Success
Drivers
The World
is Not Flat
! Speed of expansion
! Form of entry
! Management
! International experience
! Local competitive landscape
! Incentive systems
! Intl expansion does not always increase stock price
! Liability of foreignness drives up the risk
! Success is highly contextual
Source: Ghemawat’s CAGE framework
13
The analysis above suggests the wisdom in Ghemawat’s frameworks for assessing global
potential. Firms do need to develop a global strategy to minimize the various dimensions
of distance between their home market and the market they intend to enter.
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Terms use is one or more frameworks:
•
Basic factors include natural resources, climate, location, skilled and semiskilled
labor, and debt capital.
•
Advanced factors include infrastructure on the technological edge and highly
educated workers.
•
Mobility refers to the ability and incentive of factors to migrate to opportunities in
other nations.
•
Generalized factors include highway systems, a supply of debt capital, and a pool
of educated workers who can be deployed to a wide range of industries.
•
Specialized factors require more focused and riskier private and social investments.
Specialized factors often depend on an existing base of generalized factors. As
nations become more developed, the bar to consider a factor specialized is raised
– once specialized factors are then considered generalized factors.
•
Disadvantages are noteworthy as competitive advantage can grow out of a
response to a region’s weakness.
Key Insights Connecting CAGE, OLI and the Diamond:
è For each component of the value chain location matters. When participation in a cluster
materially lowers the cost or enhances the value of the output that portion of the value
chain is likely to be concentrated, particularly in the presence of scale economies and
standardization across markets. When cluster participation generates little value relative
to having proximity to the customer, the activity is likely to be dispersed. Proximity enables
the firm to generate value through such things as customization, minimizing the effects of
trade barriers, and lower shipping costs,
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è The more the firm feels the trade-off between operating in a deep cluster and getting
closer to the customer, the more constrained is the firm’s value creation proposition.
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Rivalry in the Framework vs. Rivalry in the Diamond Framework
The discussion of rivalry in the context of the Five Forces takes a different perspective
from the discussion of rivalry in the diamond framework. Five Forces and the Diamond
framework try to answer two fundamentally different questions. The Five Forces asks
about the level of profits that the typical firm might generate in the market under
consideration – that is, how attractive is the market for a typical firm. The Diamond is
useful for investigating the level of productivity that a typical firm might achieve at a
location (or more narrowly the cluster at this location) under consideration. Clearly rivalry
is connected in these two frameworks, but since there are many factors that affect rivalry
in each framework, the relationship between rivalry in the two frameworks is a bit tricky.
Rivalry in the Five Forces: An industry creates value by producing products for which
consumers have a willingness to pay of some dollar amount that is in excess of the
industry’s unit costs of producing those products. The discussion of rivalry in the context
of the Five Forces framework focuses mainly on the level of prices firms set for their
output. In this context, it is reasonable to consider the interaction between the industry
and its customers as zero-sum – where prices are set determines how the value created
is split between customer surplus and producer surplus. When considered in this way,
rivalry imposes a cost on the industry – that is, rivalry is “bad”. The Five Forces framework
does extend to nonprice rivalry as well. Nonprice activities (such as adding product
features or advertising) are considered rivalrous if the activity does not, ultimately, reduce
the price sensitivity of buyers (that is, if the activity does not result in an increase is overall
demand or WTP).
Furthermore, the Five Forces framework also suggests the industry is subjected to
competition from industries which sell substitute products. The framework warns the
industry to consider the price/feature mix offered by industries selling substitutes.
Therefore, the framework does not take a strict zero-sum perspective. Rivalry actually
reduces the industry’s vulnerability to substitute products by improving the industry’s
price/feature profile relative to where it would be without rivalry.
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To be clear, the Five Forces framework suggests the effects of rivalry within an industry
on firms as well as on the industry as a unit. From the firm perspective, rivalry (or giving
concessions to buyers) results in a higher share of value created being given to buyers
in the form of customer surplus. That is, rivalry in form of price competition destroys rents
from the perspective of industry participants. While rivalry reduces the profitability of the
industry, rivalry makes the industry less vulnerable to losing demand to substitute
products.
Finally, the Five Forces considers adding product attributes (whether tangible or
intangible, as would be the case with an ingenious marketing campaign) that enhance
willingness to pay or reduce the price sensitivity of buyers as a means to reducing rivalry,
improving customer welfare and sustaining the profitability of firms. This last point is
important to consider when thinking about rivalry in the context of the diamond framework.
Rivalry in the Diamond Framework: Note, that in the Five Forces framework, rivalry (or
competing or striving) to be different, to segment the market, to be innovative does not
reduce profits. This is the key form of rivalry in the diamond framework. Furthermore, in
the diamond framework the effect of rivalry is not addressed from the perspective of an
individual firm, and, the industry is also not precisely the unit of consideration. The
diamond framework considers the effect of rivalry on clusters and clusters differ from
industries in the scope of their geographic activities. The Five Forces framework is applied
to industries very often at the country level, whereas clusters often face global markets.
In this sense, the discussion of rivalry in the diamond framework is analogous to the
discussion of rivalry in the Five Forces framework in the context of substitute products:
All else equal, rivalry among cluster participants results in that cluster facing higher
demand for its output that would be the case without rivalry. If a cluster within a nation
has a high degree of rivalry for sales within that nation, that cluster might earn lower
returns on domestic sales than it would if rivalry was lower. However, the cluster affected
by high rivalry will face higher demand from consumers in other nations than it would if
rivalry was lower.
Furthermore, and more importantly, a high degree of rivalry within a nation pushes firms
to enhance product attributes. That is, in addition to focusing intensely on efficient
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production, firms will pursue means to distinguish themselves from other cluster
participants. The ability of firms in a cluster to distinguish themselves depends on the
quality of the diamond. The particular strategies firms employ to differentiate themselves
can, in turn, enhance the quality of the diamond. Therefore, a cluster facing intense rivalry
may benefit from a higher productivity frontier relative to a cluster facing low rivalry, as
well as less price sensitive buyers (due to the firm’s differentiation strategies). As the
cluster and the diamond are enhanced, the cluster succeeds more in the global market.
In the way that firms beat other firms with more desirable products and/or more efficient
production, clusters beat their counterparts in other nations with more finely differentiated
products and/or more efficient production. Hence the fruit of domestic rivalry is higher
global demand if the cluster is advantaged on the product and/or production side relative
to the same cluster in other nations.
In sum, rivalry enhances prosperity in the diamond framework because consumers of the
cluster’s output benefit from product differentiation and differentiation generates higher
sustainable returns among cluster participants (just as it does in the Five Forces
framework). The effect of rivalry in the two frameworks clearly cuts both ways: Rivalry
reduces profits for any given level of productivity (Five Forces) but it also increases the
pressure to upgrade productivity (the Diamond). While the net effect on profitability is
likely to be negative in the home market, it will be positive on other markets served by the
firms. The total effect on profitability in traded clusters is expected to be positive because
they serve markets significantly larger than their home markets. For local industries the
answer might be different; while society will clearly win it is possible that rivalry will
depress profits. But rivalry will in a dynamic sense also push firms on their home market
to choose more differentiated market positions, i.e., have unique strategies, which will
enable competition to reach a higher "level" and, ultimately, raise profit levels.
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Appendix 3: Encapsulation of Core Concepts47
Strategy
To think strategically is to think about long-term goals and objectives: What do you want
to be when you grow up. What will be the firm’s “it”? Strategy means the enterprise
creates value (drives a wedge between costs and customer valuation of the output),
captures value (drives a wedge between revenues and costs), and sustains value (earns
profits long enough to monetize ALL costs). It is important that the strategist demarcate
strategy from tactics, because not doing so can lead to a situation where neither tactics
nor strategy is effective.
Strategy is not the same as Tactics
“Strategy without tactics is the slowest route to victory. Tactics without strategy is
the noise before defeat.” [Sun Tzu]
Let’s suppose that you are interested in starting a pizza parlor. You have to decide what
kind of pizza parlor you want to have: a parlor that sells (a) the cheapest pizza in town,
using innovative means of cheap production with the goal of maximizing profit with volume
OR (b) deluxe “custom” pizza, using imported high-quality ingredients with the goal of
maximizing profit with premium pricing. This is strategy. Tactics, on the other hand, is the
means you employ to achieve your strategy: the machines you use, the type of labor you
hire, your choice of suppliers, etc.
Economic Profits
Before you decide to open that pizza parlor and sink the required capital, you should
compare the returns you expect from the pizza parlor to the returns you would receive
through other potential uses of that capital. If you enter a market that is perfectly
competitive – for example, you put your shop in a strip mall with three other pizza shops
47
This section was prepared with significant input and assistance from Amad Shaikh (Wharton EMBA
Student Graduating in 2010).
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and you all sell exactly the same type of pizza – then you can be quite sure that you will
earn what economists call the “competitive return” – a return equal to the opportunity
costs of the capital. In other words, your economic profit (accounting profit less
opportunity cost) will be zero. Your strategy will revolve around how you can make more
money on your pizza than your competitors (better quality pizza or lower cost of
production compared to the competitors) and sustaining it.
Value
Let’s assume that you decide to open the pizza parlor. The consumer is willing to pay a
certain amount for your pizza (call it WTP or willingness to pay), depending on some
generic factors such as size, number of toppings, etc. But the consumer’s WTP also
depends on attributes of quality, taste, and delivery options. Are you preparing your own
dough, are you using high quality ingredients, etc.?
Then there is your inputs cost (C), including fixed costs and operating costs, all of which
will vary with your choice of production methods (capital and labor inputs), raw-materials,
etc. C includes the opportunity cost of the capital – that is, C includes the appropriate riskadjusted return on the capital you tied up in the business.
Since your WTP has to be greater than C for you to have a viable business, you must
create value equal to WTP−C, which is referred to as the wedge. You will set your pizza
price (P) somewhere in this wedge. WTP−P is the consumer’s surplus (because he is
willing to pay more than the price), and P−C is your producer’s surplus (your margin).
Multiply P−C by volume (V) and you get profit. Where you set P depends on many market
factors. The goal of strategy is to convert a portion of this wedge into profit and sustain it
over a period of time.
Value Capture vs. Value Addition
Let’s think of the value created (the wedge), WTP−C, as a pie. WTP−P is the consumer’s
piece of the pie (figurative pie, not pizza pie). P−C is your piece of the pie – this is how
much of the value created the pizza parlor is capturing. If the pizza is “distinctly” good,
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the firm may be able to raise price and increase value capture. Although the firm will likely
lose some customers when its raise price, with distinctly good pizza, the firm will retain
most of its customers. Earning more on each customer retained should more than offset
the revenues lost by losing some customers. The more distinctly good the pizza is, the
more of the value created your pizza parlor can capture. Economists say that a firm can
capture more value when the firm faces low-price elasticity (low price sensitivity, which
is, in this case, a result of the pizza being distinctly good, thereby discouraging most of
the firm’s customers from using price as the primary driver of their decision to purchase).
Firms that make output that some consumers determine is better can capture more of the
value they create by raising price. Superior firms capture more of the value created (buyer
surplus shrinks when firm’s raise price – WTP is the same, WTP−P shrinks).
In contrast, if your pizza is about as good as other pizza places in the neighborhood and
you can gain many more customers by dropping price a little bit (high price elasticity/high
price sensitivity – since pizzas are about the same, price is critical to the decision to
purchase process), then by lowering price below the price of your competitors, you can
gain share at the expense of your competitors. Here, lowering price below competitors is
the approach to value. A price war does not alter value creation. A price war increases
buyer surplus (same WTP, lower price). A price war also redistributes market share
among firms (at least in the short run). However, total value created is unchanged (in the
short run, at least).
As opposed to value capture, you can engage in value added. Let’s consider the “industry
pie”: if competitors each work to cater to a segment of customers and work to offer their
segment distinctly delicious pizza, the industry value creation pie grows. The growth in
value created is primarily driven by the higher WTP of customers. Furthermore, each
competitor has a “lock” on its particular segment by giving that segment pizza that is more
satiating to that segment than the other competitors’ offerings.
To reinforce this intuition, let’s say that you could improve the pizza’s taste such that the
consumer is willing to pay an additional $2, while it costs you only an additional $1 to
make that happen. Theoretically, you could earn an additional $1. The consumer is still
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getting the same WTP−P (both WTP & P went up by $2), but your piece of the pie just
got bigger (P went up by $2, but C only went up by $1)!
Value can also be created by eliminating product features. In this scenario you could
choose to remove that special imported topping (saving yourself, say $2 on Italian
prosciutto), because customers were willing to pay only $1 for it (so you were over-serving
them). Now you could lower price by $1. Customers will keep their piece of the pie same
(both WTP and P went down by $1) but since you made the pie bigger, you keep more
value (P went down by $1, but C went down by $2)!
How can you increase WTP in the market? You can make the product better (as described
above). You can bundle complementary products (add a 2-liter bottle of Coke with the
pizza), you can reduce buyer costs (deliver the pizza free of charge), or you can improve
your pizza’s reputation or image (through experiential results – more sustainable or
through aggressive/creative marketing).
Value Chain and Vertical Chain
Firms that make pizza are involved in many
activities – the value chain. There are the functional or “primary activities” (rolling the
dough) and there are also corporate activities – infrastructure activities or support
activities such as HR, IT, purchasing, etc. Together, these activities lead to the final sales
of goods.
By breaking the value chain into discrete activities, we can analyze what each activity
contributes in making the product or improving its attributes (WTP) and what each activity
costs (C). The sum of the WTPs and the Cs of all the pieces is equal to the overall WTP
and overall C of the product. This analysis can help uncover whether the WTP contribution
of each activity is optimized for the cost it incurs. In other words, the last drop of cost put
into the product should be less than what it contributes to increasing the product’s WTP
(marginal cost < marginal improvement in WTP). So, if we analyze the pizza delivery
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activity (an “outbound logistics” activity in Porter’s Value Chain) and find out that it costs
$2/pizza to provide this service while adding only $1.50/pizza to the product’s WTP, then
we would conclude that it is better to shut the delivery service down, reduce the price by
$1.50 (not losing any customers), and save $0.50/pizza. Or perhaps the reverse is true
and adding delivery service would increase WTP more than it would cost, leading you to
add the service. We could analyze each piece of the value chain similarly and determine
the cost vs. WTP-benefit for each.
Step back a bit and think of the pizza business, not just
the parlor, but the entire “vertical chain,” from the wheat
farm, to the flour production, to the dough production, to
pizza production, to delivery, to the marketing, and
customer process. Many industries are involved in the
production of a pizza, and what happens in those
industries (that we buy from and sell to) impacts our
business (our ability to add and capture value) in
significant ways. Industry analysis helps us organize our
thoughts about the opportunities and constraints due to
adjacent industries (as well as firms in our industry).
Industry Analysis
You have decided to offer custom-special pizza, which combines the best of imported
ingredients, and is completely organic in addition to being low-fat. You feel that you will
provide a product that is unparalleled in the market. Great taste, great ingredients, and
non-fattening – you have reached the nirvana in pizzas! You jump into the business,
advertise heavily, and sure enough the customers start coming in droves. You are hardly
able to keep up with demand and you keep adding employees in an attempt to maintain
the high standards you set for your business. But late into your second year of booming
business you start seeing your margins thin out. You sit down to account for what is
happening and it does not take you long to realize that Porter’s Five Forces have you
squarely cornered.
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Only a few months ago, the supplier of your olives, the most popular ingredient on your
pizza, started increasing prices quite drastically. You looked around for alternatives, but
none could match the superiority of this supplier. There is little you can do about the
“bargaining power of suppliers,” and you expect this olive-supplier to keep squeezing
harder. In addition, you realize that while you had started out charging $25 per medium
pizza, you are down to $20 per pizza, because customers were demanding lower prices,
threatening to switch pizza parlors, and some did. For those who enjoy your pizza weekly,
this became “high cost, low stakes,” and you lowered your price because you cannot
afford to lose these regular customers; you gave in to the “bargaining power of buyers.”
You also felt pressured by another pizza parlor that opened up several blocks away, which
was serving “premium” pizza, but at a lower price. It also gets olives from your supplier,
and the supplier has been more than happy to see both of you competing – lowering pizza
prices, increasing volume, and ultimately increasing his sales of olives. You did not think
your loyal customers would leave you, but when one customer brought you a slice of the
other place’s pizza and it tasted almost as good as yours, you became worried about the
“threat of new entrants.”
And when you thought things could not get any worse, right across the street from your
pizza parlor, another threat, the “threat of substitute products” is looming – a new “PitaStop,” marketing organic, fresh ingredients in a pita bread – and it’s about to open up. All
these forces are making your “premium pizza” into a commodity-like item, pushing you
towards price-based competition, the exact scenario you wanted to avoid by going
premium in the first place. That night you had a nightmare in which Dr. Porter explained
zero economic profits to you.
There are ways that you could have resisted some of this commoditization pressure. You
could have franchised several branches of your “premium pizza” parlors all around the
city and “crowded out” entrants and substitutes so that there was no room for a new
entrant to come in. Once you controlled all premium food real estate in the city, the buyers
would not have had much choice, and you may not have had to reduce prices as much.
You could also have made an alliance with all the major buyers of olives from this olive
supplier so that you could exert your own “buyer pressure” on this supplier. And as far as
substitutes, you could simply start offering “premium pita sandwiches” too, so that you
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could preempt the pita substitute. Even if your pita cannibalized some of your pizza profits,
at least the profits from both went into the same pocket – yours!
Positioning
Positioning involves segmenting an industry to find a defensible position in that segment.
Firms are actively positioning when they configure their value chain to neutralize industry
constraints and exploit industry opportunities. Porter describes three generic strategies
that respond to these conditions: differentiation, cost leadership, and focus. Differentiation
is reflected in your premium pizza parlor plan. With this strategy, “firms that offer distinct
products [your organic, low-fat, high-quality pizza] will likely be able to receive premium
prices from at least some customers. The inherent trade-off of a differentiation strategy is
market share for margin [as you had expected with your $25 medium-pizza price]. With a
differentiation strategy, while firms may not reach as many customers, they can charge
higher prices if they locate a meaningful segment with a higher desire for their good.”
Another strategy you could employ is “cost leadership.” This would have been the case if
you had invested in new, innovative ovens that you yourself helped invent, which
consume half the energy of standard pizza ovens, and allow employees to simply
program in the size and toppings for the pizza so that the pizza comes out of the oven in
a box! This would allow you to employ half the number of employees of other pizza
parlors, and incur lower energy cost, so you could offer pizza at a lower price than anyone
else. At the competitive market pricing, you could earn the highest margin despite your
low prices. You heard Porter: “To qualify as the low-cost producer with a sustainable cost
advantage, the source of a firm’s low-cost position must not be available to rivals.”
Finally, you could choose a strategy where you only cater your premium pizza to exclusive
“high-end” parties. With this “focus strategy,” you could serve a specific clientele, saving
retailing costs, while focusing on the folks who would most likely pay for your premium
pizza anyway. As opposed to your current “differentiation strategy” that identifies
underserved product categories and varieties, a “focus strategy” identifies underserved
segments of customers.
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Preemption and Sustainability
We already discussed the kind of preemption that you may be able to engage in with your
pizza business. A firm can “own” (sustain) some position (operate without competitors
encroaching), when the cost, risk, and/or complexity a potential entrant would face is
sufficient to discourage entry. Firms can make choices that raise barriers to entry.
Strategies for preemption generally fall between two general forms of preemption: capitalintensive assets and securing superior scarce resources – to be clear, these forms of
preemption are NOT mutually exclusive.
For a truly capital-intensive preemption strategy, we have to move beyond pizza parlors,
and consider industries that are highly capital-intensive. For instance, Reliance built a
gigantic oil refinery in India processing nearly 42 million gallons per day of oil. This one
refinery is essentially able to supply most of the product need in a significant region of
India. Even though Reliance may not run this refinery at full capacity all the time, by
investing in so much excess capacity, it has essentially preempted other refineries that
may have wanted to set up shop in the region. Sometimes, investments can be staged;
sometimes they have to be all upfront. In order to be truly successful, the capacity must
meet or exceed demand conditions for the near long-term, and there must be no cheaper
substitutes. We can apply this intuition to your pizza parlor: if you want to “own” the pizza
market in a strip mall, a preemptive choice would be to build enough capacity to satisfy
all the demand for pizza that strip mall faces.
Another form of preemption is to secure scarce and superior inputs that are not widely
available to other producers. For instance, if the olives you put on your pizza are truly the
specialty hallmark of your product, and if there are only one or two producers of these
olives, then you can either backward integrate and take over the olive producer, or
contract with the producer to make you the only pizza parlor that purchases its olives.
This way you prevent this “scarce” resource from being available to others.
Warren Buffet talked about moats to connote both the form of preemption and their
degrees of sustainability. These moats are, in increasing strength: (1) legal barriers (such
as patents), (2) one-of-a-kind strategic assets, like trade secrets, (3) sunk costs and
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economies of scale, like the refinery we just talked about, (4) information gaps and pathdependency, like Coke’s brand image that depends on a rich and varied history and so
many social associations that it is nearly impossible to replicate, and finally the strongest
of moats, (5) increasing returns advantages.
Increasing returns or early-mover advantages come from a variety of effects: (a)
experience effects, which lead to increasingly low variable costs as the firm becomes
“experienced” in producing its product, as captured by the learning curve, (b) network
effects, which relate to a situation where each user of a good or service impacts the value
of that good or service for someone else, as in the case of email (the more people use
email, the more valuable this service is to each user), (c) buyer uncertainty and reputation,
which relates to building product reputation and customer loyalty through experience (for
example, customers like your pizza so much that the other pizza parlor, even when
advertising the same attributes as yours, would still have to charge less in order to
overcome customer experience and satisfaction with your pizza), and finally (d) buyer
switching costs, which are the costs that buyers would have to face in order to switch
from your product to your competitor’s (for instance – this is not a pizza analogy – once
a training cost has been sunk, switching to a competing product would have to make up
for the cost of retraining on the new product).
Resource-Based View
The RBV examines how firms can enjoy sustainable returns as a result of resources
employed. So, while the positional view emphasizes the things you do, the RBV
emphasizes the things you have. Thus, the positional view has a product market
orientation – it sees competitive advantage in the creation, domination and preservation
of a unique position in a product market. The resource-based view has a resource market
orientation – it finds competitive advantage in imperfections in resource markets that give
a firm privileged access to valuable resources.
The RBV starts with the assumption that firms are endowed with inherently different
bundles of resources, such as brand names, locations, distribution channels, and even
quality control processes, corporate cultures, etc., that create value. It is by owning these
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unique resources that other firms do not possess and cannot acquire and by matching
these resources to economically relevant environments, that a firm gains competitive
advantage. There are four foundations of for a wealth-creating, sustainable competitive
advantage: (1) Resources Heterogeneity, (2) Ex Post Limits to Competition, (3) Imperfect
Mobility and (4) Ex Ante Limits to Competition.
Under Resources Heterogeneity, firms have different bundles of resources that they use
to produce and sell their products. Firms with superior resources are able to either (a)
produce at a lower cost (C) than other firms in the industry, earning “Ricardian Rents”
and/or (b) produce superior output (WTP) at the same cost, earning “Monopoly Rents.”
As an example of Ricardian rents, consider a wheat-farmer who has a particularly fertile
piece of land (perhaps next to the river). His cost of production would be lower due to the
resources he owns (the land), and thus while he cannot affect the market price of wheat,
he can earn more than other farmers due to his lower C. As an example of monopoly
rents, consider Microsoft, which can produce much higher WTP (and can demand high
prices), than other firms in its peer industry because of the unique resources it owns. Back
to our pizza parlor example and the unique pizza-oven (patented by your firm) that
operates at half the cost relative to other ovens—if you had this, you would own a unique
resource that helps you gain Ricardian rents.
Under Ex Post Limits, firms create barriers that ensure that resource heterogeneity is
preserved. For example, if you have a foolproof patent on innovative pizza oven, other
pizza parlors are unable to duplicate your resource superiority (imperfect imitability). You
hope that the other pizza parlors do not come up with a way to achieve comparable low
costs through a different type of production innovation (imperfect substitutability).
Under Imperfect Mobility, the goal is that other firms cannot buy your unique/superior
resource in the marketplace or that the resource is more productive for you than your
competitors (co-specialization). Let’s say you hired the best manager in the pizza world
who excelled in customer service and in reducing labor turnover. While he may be worth
a lot to you, some other parlor could offer him a higher salary and if you really want to
keep him, you may also raise the ante. Eventually, his “price” may be bid up to the point
that he has extracted everything extra that he was worth. Thus, this manager represents
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the opposite of imperfect mobility. On the other hand, if this manager is so good
BECAUSE he can run your special oven better than anyone else, then he is worth so
much partly because of your oven. So, his value is partly from co-specialization, and thus
other firms will not be able to pay him enough to extract the incremental value he is worth
(because only you own the oven).
Ex Ante Limits refers to a firm buying the resources that it needs to create its competitive
advantage at a below-market price. This can only happen when there is imperfect market
information. Only if the firm pays a lower cost for resources than the present value of the
future cash flows that these resources create, is the firm ahead in creating real wealth.
Shifting Perspectives: Components of Firm Value
While creating and capturing value are essential in strategy, we also have to look at a
related question: Why is the whole (of the enterprise) worth more than its parts? If this
were not the case, then the enterprise would be dismantled to unlock the value of the
components. However, most firms enjoy “intrinsic synergy” among their constituent parts.
Here we think of the firm as being comprised of three parts:
1. ACV (Asset and Capabilities Value): The portion of value that is “ownable” and
sellable, derived from assets and capabilities owned by the firm’s shareholders or
capital owners; essentially the monetary value of the firm’s position. Examples:
location, brands, patents.
2. ERV (Employed Resource Value also referred to as Idiosyncratic Value): The
portion of value that a firm employs but does not own, mainly the human capital.
Remember our discussion of co-specialization under imperfect mobility. When the
human capital is complementary to the firm’s ACV, then this co-specialization
results in synergies that makes the two resources more valuable than the sum of
their separate values. So, in order for ERV to increase the firm’s value, it has to be
co-specialized; otherwise the ERV will likely capture its full value as compensation
(i.e., other firms will bid up its price since it will be equally productive at other firms).
3. GV (Governance Value): The portion of value that comes from structuring the
organization such that the players’ actions are transparent and aligned with the
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interest of the firm’s capital owners. Governance is about putting in place the
appropriate infrastructure and incentive structure that motivates the production of
ACV. When considering the production of ACV, it is reasonable human capital to
wonder “what’s in it for me?” Governance is the answer to this question. Good
governance displays transparency, consistency, equity, and overall good sense
and, thereby, informs human capital before the effort is undertaken “what’s in it for
them.”
Good GV in ACV firms means that the value of the human capital should appreciate
with the ACV value of the firm. This could include performance-based stock options
and promotions, though both are limited by the firm’s growth. A firm could also open up
“external” options for employees, by increasing their external visibility. In this way, a firm
is able to use the worldwide market of opportunities to enhance its own employees’
motivation. GV in an ERV firm is a little different and involves a focus on cospecialization such that the ERV’s full value can only be retained at this firm. Also
the pay structure may be different at ERV firms; there, in many cases, entry-level
“minions” get low wages, and work long hours, but have lots of opportunity to learn. They
are motivated to work either because they will move up and get their own “minions”
eventually, or because they will learn so much that they will have increased external
opportunities.
While we can consider the three components in isolation, there are important interactions
among them. First, superior ACV tends to attract superior ERV, because good
matching levers up the value of human capital (though much is captured in wages).
Furthermore, ERV is maximized by good GV, because the matches themselves are
dependent on incentive systems. Finally, GV reinforces ACV, because good
structure motivates those actions that nourish the firm’s position.
In our pizza parlor case, ACV is the location, the special oven patent, and the brand name
that builds over time. ERV is our all star manager who can operate that special oven
better than anyone in the market, but whose value is no better than a regular manager
without that oven (in other words, the oven needs the manager, and the manager needs
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the oven). GV is how you incentivize the manager to keep producing more and more out
of the ACV.
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Reference List
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Glossary
•
Activity Analysis: Analysis done to inform managers about the cost of its activities
by cataloging activity, understanding C by activity, understanding WTP by activity, and
identifying activity changes.
•
Added Value: Increasing firm surplus by increasing the gap between WTP and C.
•
Assets and Capabilities Value (ACV): Value generated from superior tangible and
intangible inputs that are “ownable” by a firm. If the firm were sold, ACV would go to
the new owner.
•
Commoditization: When competing products’ attributes are indistinguishable and
consumers shop primarily by finding the lowest price.
•
Complementary products: Products that are dependent on another industry’s
product.
•
Co-specialized resources: Resources that are more productive when used together.
•
Cost Leadership: Reducing C with minimal effects on WTP.
•
Differentiator: A firm that adds features that cost less than the perceived value to the
buyer, i.e., raises WTP with minimal effects on C.
•
Economic Profits: Profits in excess of all costs, including the opportunity cost of the
capital and resources utilized.
•
Employed Resource Value (ERV): Value generated from good matching of
resources (mainly human) to the ACV of the firm.
•
Ex Ante Limits: Acquiring a superior resource at a price low enough to leave a
residual economic rent requires some market friction – that is, to pass ex ante limits,
there must be some market friction.
•
Ex Post Limits: If competitors can substitute other resources or can create new
resources that are as valuable as the firm’s resources, this is a failure of ex post limits.
•
Expropriation: This term describes opportunistic behavior. Consider a deal two
parties might have forged at time zero. Fast forward to some period in the future at
which point their various bargaining powers may have shifted – for example, at time
1, firm A may have no outside option while firm B still has outside options. Firm B can
now renegotiate and cram poorer terms down on firm A. For example, firm B could
force firm A to accept prices at or below firm A’s average costs (but above variable
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costs).
•
Five Forces: The industry forces that determine the competitive intensity of a market:
supplier power, buyer power, barriers to entry, threat of substitutability, and degree of
rivalry.
•
Governance Value (GV): The incremental value to the firm that results from good
corporate governance and employee incentives.
•
Increasing Returns Market: Markets with economies (in C or WTP) that improve with
share.
•
Minimum Efficient Scale (MES): The smallest output that a plant (or firm) can
produce such that its long-run average costs are minimized.
•
Mobility: The ability of inputs to be used as productively by competitor firms. Mobility
suggests that the resource (generally human) can take (make mobile) her productivity.
•
Positioning: Choosing a set of activities for value creation that neutralize industry
constraints while exploiting industry opportunities.
•
Preemption: Limiting a firm’s competitors from duplicating the firm’s position.
•
Resource-Based View (RBV): The view that superior returns lie in superior
resources.
•
Productivity Frontier: Being on the productivity frontier means the firm is efficient –
it is not possible to reduce costs without eliminating valued product attributes.
•
Resource Heterogeneity: Resource inputs vary across firms.
•
Segmentation: Dividing a market or industry based on product or customer attributes.
•
Substitute products: Products that can perform the same (or some of the same)
functions for consumers as the industry’s product.
•
Value Capture: Increasing firm surplus by adjusting P.
•
Value Chain: The taxonomy of all of a firm’s activities.
•
Value Creation: Generating a gap between WTP and C; the cost of inputs is lower
than the price paid by buyers.
•
Wedge: The difference between WTP and C.
•
Willingness to Pay: The buyer’s perception of the utility (measured in monetary
terms) that the firm’s output delivers to the buyer.
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